Valuation for merger and acquisition
March 2015
Flow of presentation
Valuation methodologies
Valuation in the context of Merger and Acquisition
Indian Regulatory Environment and Minority Interest Safeguard
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Valuation methodologies
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Valuation methodologies Business / Share
Applicability of a particular methodology guided by:Nature of industryStage of company (nascent / growth or mature)Listed / unlisted In case of listed, whether frequently traded or not
Book Value
Replacement Cost
Cash flow based Market based
Quoted Market Price
Comparable Listed Multiples
Comparable Transaction Multiples
Discounted Cash Flow Free cash flow to
firm (FCFF) Free cash flow to
equity (FCFE)
Asset based
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Generally Not Suitable for Fair Valuation of Going Concerns
Fixed Assets Revalued or Book Value?
Current Assets - Cost or Realizable Value
Differences in Accounting Policies in case of Merger or Relative Valuations
Adjustments for Contingent Liabilities
Issues Involved
Fails to factor the value of intangible assets like brands, technical know-how, distribution network etc.
Impacted by accounting
Assumes assets always have profit generating value
Ignores Returns vs. Cost of capital
Limitations
Arrives at valuation of an entity in terms of Tangible Net Worth of the entity as at valuation date
Asset Based Methodologies- Net Assets/ Replacement Value
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Is NAV completely doomed?
Not really
A Loss-making Company
Any CompanyFacing Potential
Liquidation
A Real-EstateCompany
A Company Making Inadequate Return
on Capital
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Methodology involves three elements: assessment of maintainable earnings application of an appropriate multiple of comparable companies identification and valuation of any surplus assets or liabilities
Comparable Companies Global vs. Indian comparisons Identifying direct comparables: Research on companies is the key Accounting for size differentials Accounting for differing operating conditions
Choice of multiples Transaction vs. Stock Market Multiples Sales vs. Profitability Multiples Vs. Capacity Multiples Historical vs. Forward Multiples
Valuers judgment required for appropriate choice
Comparable Multiple Method
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Choice of multiples
Sector Multiple Used Rationale
Manufacturing EV/EBITDA Often with normalized earnings
Growth firms PEG ratio Big differences in growth rates
Young growth firms with losses Revenue Multiples What choice do you have?
InfrastructureEV/EBITDA, Price/ Book equity depending on industry and capital structure
EV/EBITDA - Normalized profits can be reasonably determined;P/BV Since most of them are capital intensive
Financial Services Price/ Book equity Marked to market
Retailing Revenue multiples Margins equalize sooner or later
Oil &Gas, Mining Resource multiples (EV/resource) Cash flows are directly related to resources
Choice of multiple depends on the sector in which the Company operates
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Identifying Comparable Set of Companies
Difference in Size, Margins, Operating Efficiencies
Differences in Accounting Policies/ Leveraging Risks
Issues Involved
Markets may not necessarilyvalue companies fairly at allpoints of time
Adequate and reliable details fortransaction multiples notavailable in most of the cases
Limitations
Comparable Multiple Method
Provides a good benchmark to test reasonableness
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Considered to be the most logical method of valuation
Determines the net present value of underlying cash flows of the business
Not Impacted by accounting principles, as based on cash flows and not book profits
Incorporates all factors relevant to business e.g.
Tangible and intangible assets
Current and future competitive position
Financial and business risks
Business Value = NPV (FCFs) = NPV (NOPLAT Incremental WC Incremental Capex)
Discounted Cash Flow (DCF) Method
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Equity versus firm
Equity valuation Values the claims of the equity shareholders on the business Operating cashflows are considered and adjusted for movements in debt (debt
taken, repaid and interest) Discount rate used should only be the cost of equity capital Appropriate when the company has stable leverage
Firm valuation Values the claims of the all the stakeholders (debt and equity) on the business Operating cashflows are considered but movements in debt (debt taken, repaid
and interest) are not taken into consideration Discount rate used should only be the weighted average cost of capital (equity +
debt) Appropriate when the company has unstable leverage
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DCF Method Some key points
Valuation is at a particular date- the valuation date Preferably the date nearer to the date of the valuation workings
Cash Inflows Remember to take out non- operating cash flows Non operating cash flows are best valued as surplus asset (discussed later) Examples Interest on surplus funds, dividends, profit on sale of fixed assets
investments, liability write offs
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DCF Method Some key points.. Contd.
Cash Outflows Incremental working capital aligned with sales growth
Working capital improvements are possible, but difficult Especially without margin adjustments
Extremely important matter for high working capital companies Sugar seasonal variations. Does EV include working capital?
Capital Expenditure Incremental for Growth Dont underestimate maintenance capex
May not be immediate Gross Asset value/ Asset life is a broad benchmark. However, cannot ignore technological
obsolescence
Income tax Is on PBIT (because WACC assumes post tax debt cost) Actual rate for explicit period; Adjusted for future Stretch explicit period till exemption periods are over; Or value tax benefits
separately
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Discounting rate WACC
The Rate of Return that an Investor would require to be induced to invest in the stream of future cash flows being discounted
Weighted Average Cost of Capital
= Re X (E/(D+E)) + Rd x (1-t) X (D/(D+E))
Cost of Debt Weighted average cost of debt
The Debt- Equity weights are market based and not book based One of the most important causes for Over valuation
Weighted average Cost of Capital (WACC)
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Some key points
Discount rate used should be consistent with both the riskiness andthe type of cashflow being discounted. Equity versus Firm: cash flows to equity should be discounted with cost of
equity. Cash flows to the firm should be discounted with the cost of capital. Currency: The currency in which the cash flows are estimated should also
be the currency in which the discount rate is estimated- USD discount ratecan not be used for rupee cash flows or vice versa
Nominal versus Real: For real cash flows (i.e., excluding inflation), thediscount rate should be real
More logical to use mid year discount rate
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Perpetuity Value/ Terminal Value
Perpetuity value is the projected value of the business at the end of the outlook period
It represents a means of obtaining a proxy for the value of the future cash flows of the business after the end of the outlook period
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Common Approaches to Perpetuity Value
Cash Flow approach (Gordon Growth method)Take forecast net cash flow for the last year of the outlook periodDivide above amount by r-gr = Discount rate to be utilizedg = Long term forecast average annual rate of growth after outlook period
Capitalization of earnings/Exit multiple approachEstimate future maintainable annual EBITDA after the outlook periodSelect an appropriate EBITDA multiple to apply to those earnings
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Adjustment for surplus assets and contingent liabilities Surplus assets Key characteristics
Not used for generation of profitability
Purchased out of past cash flows
Usually land/ properties/ investments
Be careful to separate surplus cash from operating cash
When an asset is surplus, any return generated by it should not be included in operating cash flows
Contingent liabilities Usually tax cases Good idea to take expert advice
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DCF : Strengths and Limitations
Theoretically correct
Forward looking
Incorporates risk and time value of money
Focuses on cash returns
Volume and complexity of assumptions
Adequacy of data
At times, extremely sensitive to small changes in assumptions
Developing an understanding of the business is the key to a good DCF
LimitationsStrengths
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Valuation, Really a Call on Three factors..
Growth How Much? How
Sustainable? How Long?
Risk
External/Internal Price Risk
Manageable/ Non manageable
Mitigating Factors Brand, Distribution
Value
Management Quality
Reputation, Competence, Vision, Corporate Governance
Premium to HDFC Bank
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Valuation in the context of Merger and Acquisition
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Merger and Acquisition- Situations
Merger/DemergerMerger
involves absorption of one company by another or amalgamation of two companies to form a new company
Consolidation of businesses / entities to take synergy benefits
Demerger
involves transfer of identified business from one company to another
Vertical split of the company usually for Inviting investor in identified business
Acquisition Business purchase slump sale/itemized sale Usually for expansion of existing business
Share purchase Focus on inorganic growth /strategic or non strategic investments
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Valuation for merger and acquisition
Mergers Relative value of their shares - rather than absolute value. Value is determined -
on going concern basis on as is where is basis post merger synergies/benefits not to be considered
Demerger Usually not required when demerged into wholly owned subsidiary/ company with
mirror shareholding But if the demerger is into an existing operating entity, valuation is required
Acquisitions Absolute valuation of shares- not relative valuation Value is determined - on going concern basis post merger synergies/benefits are considered
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Swap ratio for merger / demerger
Since scheme of arrangement is filed in a court of law, it is generally accepted to also give weight to NAV method even though it may not be the most appropriate method Supreme court HLL case (HLL and TOMCO merger) Combination of three methods - NAV, Market Price and Earnings Capitalization
(comparable multiples) Weights to different methods: NAV : 20% Market price : 40% Earnings : 40%
However, these are not definitive and may be modified, depending upon the facts and circumstances of each case. However, weights given should be explained and justified
SEBI Fairness Opinion from Category 1 Merchant Banker
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Acquisition valuations can depart from fair values ..
Same target can have different value in the hand of different acquirers
Buyers/ Sellers leverage Competitive Positioning Distress Sale Vs. Desperate Buy
Strategic Premium/ Discounts: Strategic Premium / Discount arises on account of Operational synergy- Incremental Revenues/ cash Flows Financial synergy- reduce the debt costs Loss in value to acquirer in case target is acquired by competition Ability of acquirer to cut costs in the acquired company
Higher the quality of management, lower the scope for cutting costs
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Minority Versus Controlling Interests
All things being equal, a controlling interest is worth more than a minority interest
A holder of a minority interest generally has a passive investment and cannot initiate a sale of assets or require a higher dividend payout
The holder of a controlling interest can influence corporate policy.
Corporate Governance is a key tool to reduce minority interest.
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The Three Levels of Value
Control ValueControl Value
Marketable Minority Interest ValueMarketable Minority Interest Value
Non MarketableMinority Interest ValueNon MarketableMinority Interest Value
ControlPremium
Minority InterestDiscount
Marketability Discount
Controlling interests are considered marketable in that they can generally be sold. However, controlling interests are not marketable in the sense of publicly traded minority interests
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Indian Regulatory Environment and Minority Interest Safeguard
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Snapshot of Indian laws impacting M&A
Laws affecting M&A
Accounting Standards / GAAP
SEBI / SE Listing Requirements
Indirect Tax
Companies Act
Direct Tax
FDI & Exchange Control
Competition ActStamp Duty
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Minority interest safeguard- under regulations especially SEBIValuation report from Independent chartered accountant
Audit Committee approval on Scheme and Valuation report
Observation letter from stock exchanges after comments from SEBI
Approval from SEBI after NOC from stock exchanges
Majority votes from public shareholders
Primarily process driven rather than controlling the valuation itself.
May not required by CA firm if no change in shareholding
In addition to approval from board of directors, BoD
Required only under three above instances
Additional shares allotted to promoters*
Scheme involves listed company and any other entity involving promoters*
Listed company has purchased shares of subsidiary intended to be merged with itself, from promoters* in the past
* Includes promoter group, related parties of promoter / promoter group, associates / subsidiaries of promoter / promoter group
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Minority interest safeguard- Valuer and company role
Valuer to be independent and resist influence from the companies Extra careful especially when M&A involves related parties (e.g. increase of
stake) Explain key factors to the BoD and audit committee
Methods used/methods not used Significant business plan assumptions Significant valuation assumptions WACC/Discount rate Treatment of surplus assets/contingent liabilities Basis of selection of comparable companies, valuation multiple
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Companies Act 2013: Valuation Requirements
Section Particulars
62 (1) c Issue of shares to a non-member
230 Corporate debt restructuring situations
232 Swap ratio for mergers
236 Purchase of minority shareholders
192 Non cash transaction involving Directors
281/305/319/325 Winding up of company situations
Valuation to be done by Registered Valuer. However, Registered Valuer Guidelines are still to be notified
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To sum up
Valuation, like beauty, lies in the eyes of the beholder And like beauty, our perception of value changes
Depending upon situations, valuation can be Exactly Wrong
or Roughly correct (if you are lucky)
Questions?
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