Valuation for merger and acquisition. March 2015

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1 Valuation for merger and acquisition March 2015

2 Flow of presentation Valuation methodologies Valuation in the context of Merger and Acquisition Indian Regulatory Environment and Minority Interest Safeguard

3 Valuation methodologies Page 3

4 Valuation methodologies Business / Share Asset based Cash flow based Market based Book Value Replacement Cost Discounted Cash Flow Free cash flow to firm (FCFF) Free cash flow to equity (FCFE) Quoted Market Price Comparable Listed Multiples Comparable Transaction Multiples Applicability of a particular methodology guided by: Nature of industry Stage of company (nascent / growth or mature) Listed / unlisted In case of listed, whether frequently traded or not Page 4

5 Asset Based Methodologies- Net Assets/ Replacement Value Arrives at valuation of an entity in terms of Tangible Net Worth of the entity as at valuation date Issues Involved Limitations Fixed Assets Revalued or Book Value? Current Assets - Cost or Realizable Value Differences in Accounting Policies in case of Merger or Relative Valuations 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 Adjustments for Contingent Liabilities Ignores Returns vs. Cost of capital Generally Not Suitable for Fair Valuation of Going Concerns Page 5

6 Is NAV completely doomed? Not really A Loss-making Company A Company Making Inadequate Return on Capital A Real-Estate Company Any Company Facing Potential Liquidation Page 6

7 Comparable Multiple Method 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 Valuer s judgment required for appropriate choice Page 7

8 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 Infrastructure Revenue Multiples EV/EBITDA, Price/ Book equity depending on industry and capital structure What choice do you have? 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 Page 8

9 Comparable Multiple Method Issues Involved Limitations Identifying Comparable Set of Companies Difference in Size, Margins, Operating Efficiencies Differences in Accounting Policies/ Leveraging Risks Markets may not necessarily value companies fairly at all points of time Adequate and reliable details for transaction multiples not available in most of the cases Provides a good benchmark to test reasonableness Page 9

10 Discounted Cash Flow (DCF) Method 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) Considered to be the most logical method of valuation Page 10

11 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 Page 11

12 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 Page 12

13 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 Don t 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 Page 13

14 Weighted average Cost of Capital (WACC) 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 Page 14

15 Some key points Discount rate used should be consistent with both the riskiness and the type of cashflow being discounted. Equity versus Firm: cash flows to equity should be discounted with cost of equity.cash flows to the firm shouldbe discountedwith 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 rate can not be used for rupee cash flows or vice versa Nominal versus Real: For real cash flows (i.e., excluding inflation), the discountrate should be real More logical to use mid year discount rate Page 15

16 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 Page 16

17 Common Approaches to Perpetuity Value Cash Flow approach (Gordon Growth method) Take forecast net cash flow for the last year of the outlook period Divide above amount by r-g r = Discount rate to be utilized g = Long term forecast average annual rate of growth after outlook period Capitalization of earnings/exit multiple approach Estimate future maintainable annual EBITDA after the outlook period Select an appropriate EBITDA multiple to apply to those earnings Page 17

18 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 Page 18

19 DCF : Strengths and Limitations Strengths 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 Page 19

20 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 Page 20

21 Valuation in the context of Merger and Acquisition Page 21

22 Merger and Acquisition- Situations Merger/Demerger Page 22 Merger 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

23 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 Page 23

24 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 Page 24

25 Acquisition valuations can depart from fair values.. 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 Same target can have different value in the hand of different acquirers Page 25

26 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. Page 26

27 The Three Levels of Value Control Value Control Premium Marketable Minority Interest Value Minority Interest 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 Marketability Discount Non Marketable Minority Interest Value Page 27

28 Indian Regulatory Environment and Minority Interest Safeguard Page 28

29 Snapshot of Indian laws impacting M&A Direct Tax Indirect Tax SEBI / SE Listing Requirements Companies Act Accounting Standards / GAAP Laws affecting M&A FDI & Exchange Control Competition Act Stamp Duty Page 29

30 Minority interest safeguard- under regulations especially SEBI Valuation report from Independent chartered accountant May not required by CA firm if no change in shareholding Audit Committee approval on Scheme and Valuation report In addition to approval from board of directors, BoD Observation letter from stock exchanges after comments from SEBI Approval from SEBI after NOC from stock exchanges 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 Majority votes from public shareholders Required only under three above instances Primarily process driven rather than controlling the valuation itself. * Includes promoter group, related parties of promoter / promoter group, associates / subsidiaries of promoter / promoter group Page 30

31 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 Page 31

32 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 Purchaseof 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 Page 32

33 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) Page 33

34 Questions?

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