April 2013

Valuation

Agenda

Valuation - Art or Science

Valuation Myths

Valuation Techniques' Overview

DCF Methodology: Detail

DCF Valuation Finer Points

DCF Valuation: Practical Issues

DCF Valuation: Common Errors

Why Valuation

do not buy it for more than its worth

do not sell it for less than its worth

Price is what you pay. Value is what you get. --Warren Buffett

Why Valuation?

Basics of sound investing

For every complex problem there is a simple solution that is wrong. --G B Shaw

E-I-C Analysis

Economic Analysis

If you laid all economists in the world end to end, you still wouldn’t reach a conclusion.

Economic Analysis

An economist is an expert who will know tomorrow why the things he predicted yesterday didn't happen today.

Industry Analysis

We do not have, never have had, and never will have an opinion about where the stock market, interest rates or business activity will be a year from now. --Warren Buffett

Company Analysis

Everything that can be counted does not necessarily count; everything that counts cannot necessarily be counted. --Albert Einstein

**Valuation methodologies**

Valuation Methodologies

Of two equivalent theories or explanations, all other things being equal, the simpler one is to be preferred. –-William Ockham

**Discounted Cash Flow (DCF)**

Discounted Cash Flow (DCF)

Profit, an accounting convention, does not represent cash generated by business

Profit can be influenced by accounting assumptions, but not cash.

Cash generated in the business cannot be hidden; nor can it be falsely created by accounting gimmickry

Revenue is vanity, Profit is sanity, Cashflow is reality! –-Warren Buffett

Discounted Cash Flow (DCF)

Been used in some form since money was first lent at interest in ancient times

Following the stock market crash of 1929, DCF analysis gained popularity

1930: Irving Fisher in‘Theory of Interest’ talked about modern DCF method

1938: John Burr Williams in 'The Theory of Investment Value’ formally expressed DCF method in modern economic terms

Paper profits on accrual accounting basis is of no more than secondary/tertiary importance for a start up. But cash is what keeps the doors open and pays the bills. –-Guy Kawasaki

Discounted Cash Flow (DCF)

Foundation in Present Value (PV) rule

Assumes CFs are the only source of value

Value can be measured as PV of future CFs

Most contemporary & universally applied

International Good Practice Guidance (IGPG) encourages professional accountants in business to promote use of DCF analysis and NPV to evaluate investments

Why suddenly DCF??

Why suddenly DCF??

Guidelines objective: To ensure that all transactions involving an NR in the shares of an unlisted co take place at a fair value

Share value calculated by DCF shall be

‘floor price’ for subscription of new shares by NR or in case of a transfer of shares by a resident to a non-resident

‘ceiling price’ in case of a transfer of shares by NR to R

Guidelines would also apply in case of a newly-incorporated company

Why suddenly DCF??

Erstwhile Controller of Capital Issues (CCI) guidelines were in use hitherto

RBI issued new guidelines for unlisted entities, amending pricing guidelines for:

issue of shares by Indian company to a NR

transfer of shares of an Indian company from a R to NR, or vice versa

New guidelines stipulate that share value to be determined using DCF method

But, do NOT provide any guidance on ‘discount rates’ or‘perpetual cashflows’

**Discounted Cash Flow (DCF)**

Time Value of Money (TVM)

Worth of a rupee tomorrow is lower than the worth of a rupee today

Ceteris paribus, a rational investor prefers to receive a payment of a fixed amount of money today, rather than an equal amount in future

Very useful in evaluating projects with

Different life

Different cash outflows/inflow

At different periods of time

TVM plays a rather pivotal role in corporate finance decision making

Future value of every investment is a function of its present price. Higher the price you pay, lower your return will be. –-Ben Graham

Plays key role in many allied areas of finance:

portfolio management

sell-offs

acquisitions

mergers

joint ventures

buy-backs

corporate finance

capital budgeting

Why Valuation

**DCF Valuation Process**

**Future projections**

Free cash flows (FCFs)

Weighted average cost of capital (WACC)

Cost of debt

Cost of equity

Risk-free rate of return

Market risk premium

Beta

Terminal value

Terminal growth rate

Present value of terminal value

Enterprise value/ Equity value

Recap

Free cash flows (FCFs)

Weighted average cost of capital (WACC)

Cost of debt

Cost of equity

Risk-free rate of return

Market risk premium

Beta

Terminal value

Terminal growth rate

Present value of terminal value

Enterprise value/ Equity value

Recap

**DCF Valuation Process**

**Future projections**

Free cash flows (FCFs)

Weighted average cost of capital (WACC)

Cost of debt

Cost of equity

Risk-free rate of return

Market risk premium

Beta

Terminal value

Enterprise value/ Equity value

Recap

Free cash flows (FCFs)

Weighted average cost of capital (WACC)

Cost of debt

Cost of equity

Risk-free rate of return

Market risk premium

Beta

Terminal value

Enterprise value/ Equity value

Recap

**DCF Valuation Process**

**Future projections**

Free cash flows (FCFs)

Weighted average cost of capital (WACC)

Cost of debt

Cost of equity

Risk-free rate of return

Market risk premium

Beta

Terminal value

Enterprise value/ Equity value

Recap

Free cash flows (FCFs)

Weighted average cost of capital (WACC)

Cost of debt

Cost of equity

Risk-free rate of return

Market risk premium

Beta

Terminal value

Enterprise value/ Equity value

Recap

**DCF Valuation Process**

**Future projections**

Free cash flows (FCFs)

Weighted average cost of capital (WACC)

Cost of debt

Cost of equity

Risk-free rate of return

Market risk premium

Beta

Terminal value

Enterprise value/ Equity value

Recap

Free cash flows (FCFs)

Weighted average cost of capital (WACC)

Cost of debt

Cost of equity

Risk-free rate of return

Market risk premium

Beta

Terminal value

Enterprise value/ Equity value

Recap

DCF – WACC

Discounting Factor

Generally, WACC

WACC = [(Kd*D)+(Ke*E)] /(D+E)

where

Kd = post-tax cost of debt

Ke = cost of equity

D = market value of debt

E = market value of equity

Cost of Debt

Kd = Rd (1 – Tc)

where:

Kd = post-tax cost of debt

Rd = coupon rate of interest

Tc = effective rate of tax paid by firm

E.g., if a firm borrows debt at interest rate of 12% and lies in 30% effective tax bracket, its Kd is

DCF – WACC

Cost of Equity – CAPM

Ke = Rf + β * (Rm – Rf)

where:

Ke = cost of equity

Rf = risk-free rate of return

β = risk factor of the cash-flows

Rm = rate of return on a diversified portfolio (SE benchmark index)

E.g., if the Rf is 6% and the Rm is 10%, the Ke of a firm with betaβ of 2 is

DCF – WACC

Cost of Equity – risk premium

As seen below for US stock markets, depends heavily on choice of

index

period of observation

DCF – WACC issues

Beta

Measures volatility of firm’s stock price relative to that of given market index

Statistically, beta is relationship b/w

covariance of selected stock with well- diversified market portfolio and

the variance of that portfolio

β = Covariance of asset with Market/ Variance of the market

DCF – WACC

Uncertainty is not a result of ignorance or the partiality of human knowledge, but is a characteristic of the world itself. --M Taylor

Beta

Symbolic representation of riskiness of the underlying cash flows, vis-à-vis those of a well diversified portfolio

Directly proportionate to firm’s sensitivity to market conditions

E.g., if benchmark index moves up by 5% and simultaneously scrip moves:

DCF – WACC

Beta

In case of calculations based on stock market data

Un-levered industry/segment average beta is considered

Βu = βlv / [1+ (D:E)*(1-t)]

Re-levered to target company’s target D:E ratio

DCF – WACC

Beta is a highly sensitive value driver

To be chosen/calculated carefully. Varies with choice of:

market index (for e.g., Sensex, Nifty, BSE 200, NSE 100, etc.)

time period covered by underlying observational data points (one year, two years, five years, etc.)

return interval (daily, weekly, monthly, bi-monthly, quarterly, semi-annually, annually, etc.)

DCF – WACC

**DCF Valuation Process**

**Future projections**

Free cash flows (FCFs)

Weighted average cost of capital (WACC)

Cost of debt

Cost of equity

Risk-free rate of return

Market risk premium premium

Beta

Terminal value

Terminal growth rate

Present value of terminal value

Enterprise value/ Equity value

Recap

Free cash flows (FCFs)

Weighted average cost of capital (WACC)

Cost of debt

Cost of equity

Risk-free rate of return

Market risk premium premium

Beta

Terminal value

Terminal growth rate

Present value of terminal value

Enterprise value/ Equity value

Recap

DCF – Terminal Value

Terminal Value

Business, as a going concern, is assumed to be carrying on operations in perpetuity, i.e., infinity

TV is firm’s value at end of explicit forecast period

TV captures firm’s value for operations beyond explicit forecast period

Do not count your chicken before they stop breeding. --Aesopeus

Present Value of FCFs

FCFs are discounted to their present value, using the WACC

DCF – Present Value of FCF

The really dreadful losses were realised in those common stocks where the buyer forgot to ask “how much?” --Ben Graham

DCF – Terminal Value

Terminal Value

FCFF(n+1)/ (WACC – g)

where:

FCFF(n+1) = FCFF in year after explicit forecast period

g = steady state growth rate of FCF till infinity

E.g., if FCFF for last forecast year is 1000, WACC is 18% and terminal growth rate is 3%, the TV is

DCF – Terminal Value

Terminal Value

Perpetuity formula does not work where g ≥ WACC

BUT this is impossible - g exceeding r in perpetuity implies the business eventually would be larger than the whole economy!!

**DCF Valuation Process**

**Future projections**

Free cash flows (FCFs)

Weighted average cost of capital (WACC)

Cost of debt

Cost of equity

Risk-free rate of return

Market premium

Beta

Terminal value

Enterprise value/ Equity value

Recap

Free cash flows (FCFs)

Weighted average cost of capital (WACC)

Cost of debt

Cost of equity

Risk-free rate of return

Market premium

Beta

Terminal value

Enterprise value/ Equity value

Recap

DCF – Enterprise/Equity Value

Enterprise Value

PV of FCFs during forecast period

Add: PV of terminal value

Equity Value

Enterprise value

Less: Debt

Add: Cash

Add: Market value of Investments

**DCF Valuation Process**

**Future projections**

Free cash flows (FCFs)

Weighted average cost of capital (WACC)

Cost of debt

Cost of equity

Risk-free rate of return

Market premium

Beta

Terminal value

Enterprise value/ Equity value

Recap

Free cash flows (FCFs)

Weighted average cost of capital (WACC)

Cost of debt

Cost of equity

Risk-free rate of return

Market premium

Beta

Terminal value

Enterprise value/ Equity value

Recap

DCF – Enterprise Value

Enterprise Value – broad steps in DCF-based calculation

**“DCF is difficult and subjective”**

So, aren’t others?

“Many value drivers need to be combined to produce a DCF valuation”

Multiples also consider same factors

DCF focuses on all value drivers rather than combining these into one multiple

So, aren’t others?

“Many value drivers need to be combined to produce a DCF valuation”

Multiples also consider same factors

DCF focuses on all value drivers rather than combining these into one multiple

**DCF criticism. And, defense**

**Markets can remain irrational longer than you can remain solvent. –-J M Keynes**

DCF criticism. And, defense

“DCF requires WACC and nobody seems to have a clue of what it is”

Differences in required return is a key factor in valuation

“DCF is very sensitive to long term growth assumptions”

So are multiples. The problem is mitigated by using zero value adding long term growth assumptions

Take every gain without remorse for missed profits. --Joseph de la Vega

DCF conclusion

DCF and related techniques are powerful valuation tools

DCF is a very robust methodology, but can only work right if

the assumptions are reasonable

the application is realistic

Investing should be dull. It shouldn't be exciting. Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas or Wall Street. –-Paul Samuelson

DCF – Free Cash Flows

Free Cash Flows to Firm (FCFF)

Not the same as operating CF

Residual CF after meeting all cash operating expenditure, but prior to any payments to financing stakeholder

Net of working capital and capex needed to support future forecast FCF

Always post-tax

Cash available to all finance providers

= Debt cash flow + Equity cash flow

We’d rather be vaguely right than precisely wrong. –-J M Keynes

DCF – Free Cash Flows

Interest Exclusion Principle

Free Cash Flows – calculation

Operating Profit (EBIT)

Less: Adjusted Taxes

Gives: Net Operating Profit Less Adjusted Taxes (NOPLAT)

Add: Book Depreciation

Add: Non-cash expenses/ amortization

Gives: Gross Cash Flow

Less: Increase in net Working Capital

Less: Capital Expenditure

Gives: Free Cash Flows to Firm (FCFF)

DCF – Free Cash Flows

Free Cash Flows – calculation

DCF – Free Cash Flows

Free Cash Flows – calculation

DCF – Free Cash Flows

Free Cash Flows – calculation

DCF – Free Cash Flows

Macro Economic Factors

Text

Fiscal Policies

Monetary Policies

Inflation

National Income

Exchange Rates

Interest Rate

GDP/GNP and Growth rate

Pricing Strategies

Production efficiencies

Market Structure

Cost Management

Demand & Supply conditions

Micro Economic Factors

Financing decisions reflected in WACC through D:E ratio

Financing decisions to fund long term capital funding requirements are ignored

Business’ perspective, not just equity owners’. Hence, firm’s FCF (FCFF), rather than equity holders’ FCF (FCFE)

Portor' Five Forces

GE‘s Nine Grid Matrix

PEST Analysis

SWOT Analysis

Concentration

Industry lifecycle

BCG Matrix

Tools for Industry Analysis

MD & A

Periodic Regulatory Filings

Annual Reports

Ratio Analysis- Vertical

Financial Statements

Company Analysis

Ratio Analysis- Horizontal

Interest Exclusion Principle

8.4%. since 12% (1-30%) = 8.4%

Explicit Forecast Period

CFs are projected for an explicit forecast period, based on

Past experience and performance

Future industry outlook

Specific plans

Depending on business/industry, and the state of business, forecast period may range between 5 to 15 years

DCF – Future Projections

We have two classes of forecasters: Those who don’t know and those who don’t know they don’t know. –-John K Galbraith

However good our futures research may be, we shall never be able to escape from the ultimate dilemma that all our knowledge is about the past, and all our decisions are about the future. --Ian Wilson

Explicit Forecast Period Test?

Should cover at least one cycle of boom and doom

Business should attain steady state of operations by end of forecast period

DCF – Future Projections

14%. since 6% + 2 (10% - 6%) = 14%

6867, being 1000*1.03 / (0.18-0.03)

Increase by 7%, its beta is 1.4

Decrease by 9%, its beta is -1.8

Price is what you pay. Value is what you get. --Warren Buffett

Projections - P&L

Projections - Balance Sheet

FCFF

WACC

Valuation

Most important ingredient!

Valuation - Art or a Science

Bradford Cornell, in ‘Corporate Valuation: Tools for Effective Appraisal and Decision Making’:

“Valuation is neither an Art nor a Science, but an odd combination of both. There is enough Science that appraisers are not left to rely solely on experience, but there is enough Art, that without experience and judgments, failure is assured.”

If you can keep your head when everyone around is losing theirs, then yours is the Earth and everything that’s in it. --Rudyard Kipling

Valuation - Art or a Science

Valuation is all about judgment!

Benjamin Graham, in “The Intelligent Investor” quips:

“Mathematics is ordinarily considered as producing precise and dependable results; but in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative the conclusions we draw therefrom

If you are wondering when to bank a profit, wait until all the brokers say buy and the stock is tipped in the Newspapers. -- Tom Winnifrith

Valuation Myths

Valuation techniques are quantitative, hence valuation is objective

Valuation is an art, not an exact science. Mathematical certainty is neither demanded, nor indeed is it possible

Influenced by perception of the buyer/ seller

Good valuation provides a ‘precise’ estimate of value

There is no ‘right’ value. Beyond number crunching, Valuation requires exercise of judicious discretion and judgment

Well-done valuation is timeless

Actual value depends on the needs, perceptions and negotiation power of the parties involved in the deal

Highly sensitive to changes in circumstances

“This time its different” is amongst the most costly four words in the market history. --Sir John Templeton

DCF – WACC issues

DCF – WACC issues

Things should be as simple as possible, but no simpler -- Albert Einstein

Concept of TVM can be used to

Compound all CFs over a period to a FV on a future date

Discount all CFs during a period to their PV today

You have an expected liability (cash outflow) of Rs. 100k in 5 years time, and you use a discount rate of 10%

Is it possible to calculate how much you would need

right now as savings to cover expected liability?

at the start of each year for next 5 years to cover the expected liability?

Discounted Cash flow (DCF)

Will your answer be different if the tenure to maturity is 5 years?

A Rs. 100 par value bond, bearing coupon rate of 10% will mature in exactly 2 years. What is the value of this bond if the desired rate of return is 12%. Ignore tax implications, if any.

Wait for the entire picture!!

Biggest test of Valuation

Common Sense??

Ratio Analysis

Value v/s Price

A tool is only as good as you put it to!!

**Pitfalls in case of projections**

**Top down vs bottoms up approach**

Mix up in fixed vs variable

Balance sheet not tallying. Yes, balance sheet not tallying!

Not taking impact of tax related issues

Depreciation of assets not in sync with life

Taking FS as is, without adjusting it for one-off/non-recurring items.

Increasing deposits along with revenues. If the deposits are rental office related?

Considering revaluation of fixed assets as cashflows

Seasonal companies – impact of seasonal stock or seasonal debt

Mix up in fixed vs variable

Balance sheet not tallying. Yes, balance sheet not tallying!

Not taking impact of tax related issues

Depreciation of assets not in sync with life

Taking FS as is, without adjusting it for one-off/non-recurring items.

Increasing deposits along with revenues. If the deposits are rental office related?

Considering revaluation of fixed assets as cashflows

Seasonal companies – impact of seasonal stock or seasonal debt

Possible pitfalls

WC not being recovered in fixed life projects

Release of working capital towards the end in case of a growing company

Sustenance capex missing

Still growing co but projected financials ended

Growth rates to be tempered over a period of time. Use of geometric mean vs CAGR

In case of CAGR being different from latest growth rate

FCFE vs FCFF approach – wrong application

Possible pitfalls

Market share of over 35% in 5 years for a startup is scary! Not impossible (twitter facebook are eg), but be very careful

Broad ratio between TV and EV

Interest cost for WACC different from interest cost for projections

D:E ratio for WACC different from D:E ratio for projections. Possible!

Pre-money vs post-money conundrum