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VALUATION APPROACHES. Valuations....drive the markets!!!. BSE Sensex. Prologue. In the financial services world, Valuations are used for various purposes For valuing the shares of a company In Mergers & Acquisitions In evaluation of new projects

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Prologue l.jpg
Prologue

  • In the financial services world, Valuations are used for various purposes

    • For valuing the shares of a company

    • In Mergers & Acquisitions

    • In evaluation of new projects

  • However, the the basic principle of Valuations remain the same

    • What is the “Potential” of the business?

  • The word “Potential” refers to the future and thus most of the valuation approaches are about estimating the future and converting it into hard numbers

  • So it is not just financial concepts but ability to project and estimate the future potential

    • Discounted Cash Flow is the most robust methodology for valuations

  • This Valuation is then benchmarked against various proxies

    • Trading Comparables

    • Transaction Comparables



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Valuation Methodologies

Value Range

Discounted

Cash Flow

Analysis

Comparable

Acquisitions

Analysis

Comparable

Companies

Analysis

Sum of parts/ Asset Valuation

  • Trading valuation

  • Value based on market trading multiples of comparable companies

  • Acquisition valuation

  • Value based on multiples paid for comparable companies in sale transactions

  • Liquidation or break-up analysis – assets presumed to be representative of business value

  • Value of component parts – used when enterprise comprises of several discrete businesses

  • Inherent value of business

  • Present value of projected free cash flows


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Enterprise Value v/s Equity Value

Enterprise Value = Value of all the assets of a business

Equity Value = Value of the shareholders’ equity

Equity Value = Enterprise Value - Net Debt (1)

Net Debt

Enterprise

Value

Equity Value

(or Market Value)

  • Unaffected by leverage

  • Multiples of:

    • Sales

    • EBITDA

    • EBIT

    • Size (such as capacity or number of users)

  • A function of leverage

  • Multiples of:

    • Net Income (Earnings)

    • After Tax Cash Flow

    • Book Value

(1) Net Debt equals Total Long-Term Debt + Preferred Stock + Capitalized Leases + Short-Term Debt (other than working capital debt) - Cash and Cash Equivalents


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A DCF valuation has three main components

  • Credible forecasts for the explicit period

    • Typically the horizon reflects the time in which steady state of business is achieved

    • Revenue, cost and capex forecasts used to derive the unlevered free cash flows to the company

    • These forecasts are validated through an understanding of industry, performance trends and outlook

  • Estimation of discount rate

    • Discounting of future cash flows to make them equivalent to present value

    • Discount rate is typically the cost of capital of target companies with profiles comparable to the target – essentially it should reflect the Opportunity Cost of Capital

  • Terminalvalue

    • Terminal value comprises of value of the cash flows beyond the explicit forecast period extending upto perpetuity

    • Captures value of the business that grows at a steady state growth rate


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Unlevered Free Cash Flow

  • Unlevered free cash flow is the conceptual cash flow available for distribution to all capital providers

  • Tax shield effect of interest removed from cash flows to estimate unlevered free cash flows

  • Unlevered Free Cash Flow = After tax EBITDA - Capital Expenditures - Increase In Non-Cash Working Capital

  • EBITDA = EBIT + Amortization + Depreciation = Earnings before Depreciation, Interest, Taxes and Amortization

  • Non-Cash Working Capital = Non-Cash Current Assets - Non-Debt Current Liabilities


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rex E

D + E

rd x D

D + E

+

Principles of computation of Discount Rate

  • Weighted Average Cost of Capital or WACC used to discount free cash flows in order to estimate the present value of an enterprise

  • Defined as the weighted average sum of the cost of financing the enterprise, mainly through equity and debt

    • Cost of equity and cost of debt are weighted by the respective contributions of equity and debt in the steady state of business operations - to remove the effect of different financial structures in different companies

  • WACC =

    Where: E = Market Value of equity D = Market Value of debt (typically approximate with book value but be careful) re = return on equity derived from CAPM rd = after tax return on debt (assumed to be weighted average cost of debt)

  • CAPM assumes consistent, long-term target capital structure (D/E ratio)

  • Leveraged financing in maturing markets points to a Debt/Equity ratio of 30/70


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Computation of WACC ingredients

Cost of Debt

Cost of Equity

  • Cost of Debt is the opportunity cost of lending, net of tax shield derived through leveraging

  • Cost of debt assumed at the prevailing long term lending rates for similar companies

  • Cost of debt = rd = Y (I - T)

    Where: rd = after tax-cost of long term debt (after tax)Y= gross redemption yield on debtT= effective marginal tax rate

  • Cost of equity represents the return expectations of equity shareholders from investment of comparable risk

  • Computed by adding a market risk premium weighted by comparable asset risk over the risk free return on a long term security

  • Cost of equity = re = rf + B *(rm - rf)

    Where: re= the required future market return on the equity of the Company rf = the risk free rate rm= the return on the market (factoring in the country risk also)

    B= the beta of the Company


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FCF T+1

(WACC T+1 - g)

Terminal value =

Estimating the Terminal Value

  • Two basic methods used for computation of terminal value

    • Exit multiple basis (usually multiple of EBITDA – average of market related multiples )

    • Perpetuity basis assumes that the free cash flows of the business would grow to perpetuity at a marginal steady rate

  • Both methods should produce similar results as EBITDA multiple should capture the perpetuity growth in value

    • May differ on account of trading liquidity/ speculative forces/ market risk/ differential information availability

  • Terminal value cash flow should also truly reflect a “steady state”

    • The later years in the explicit forecasts should have reached a constant state of growth in cash flows

    • capex/ROCE assumptions in the terminal year cash flows should be realistic

    • Any non steady state assumptions used to derive the terminal year cash flow must be removed e.g. the tax impact of any accumulated losses


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Free Cash Flows : A Sample

Steady state CF growth



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Business

Industry

Products

Distribution Channels

Customers

Seasonality

Cyclicality

End Markets

Size

Growth History and Growth Prospects

Margins / Operating Track Record

Location / Geographic Focus

Ownership Profile / Liquidity

Leverage / Capital Structure

Dividend Yield / Payout

Selection Criteria for Comparable Companies

Primary Criteria

Secondary Criteria

  • Having determined a set of sample companies, multiples on parameters such as earnings, EBITDA and book value are computed

  • The average multiple for each parameter considered is applied to the respective results of the target company to arrive at a range of valuation



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Objectives of Comparisons of Acquisition Transactions

  • Measure “private” market value

  • Often a result of a combination of factors

    • Competitive bidding tension

    • Strategic value available – specific to individual buyers

    • Relative strength of target and buyer determined mainly by

      • Market position

      • Financial strength

  • Transactions may be structured as full auction, limited auction or bilateral negotiation

  • Privatisation transactions typically fall under full/ limited auctions

  • Methodology determined by

    • Need for transparency

    • Need for confidentiality

    • Universe of buyers

    • Complexity of transaction structuring

  • Enterprise Value may reflect not just the value of the target but also synergistic benefits available to buyer through other transaction agreements such as brand rights, distribution sharing, non-compete etc.


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Multiples to be computed based on financials available at the time of the transaction

Shares Outstanding for acquisition comparables consists of the fully diluted shares:

shares outstanding (as of the latest financials available); plus

shares pursuant to convertible securities (if in-the-money)

Offer Price Per Share = price per share offered by the acquiror. In the case of an offer that includes stock, acquiror’s stock price one day prior to the announcement times the exchange ratio should be used

Offer Value = offer price per share x shares outstanding

Enterprise Value = offer value + non-convertible debt + non-convertible preferred + minority interest - cash & marketable securities

Computation of multiples from “Acquisition” Comparables


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Sample Valuation Summary using the methods illustrated above the time of the transaction

(US$ million)

655

650

625

630

500

465

460

355

335

260

EBITDA Multiple Method

EBITDA

PerpetualGrowthMethod

EBITDA

Subscribers

DCF

TradingMultiples

Trading Multiples with 30% Assumed Premium

AcquisitionMultiples

The various methodologies yield an indicative valuation range between US$ 450 mn to US$ 550 mn


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Case Study : Valuation of a Telecom Company the time of the transaction


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Template used for a Telecom DCF valuation and benchmarking the time of the transaction

Revenue assumptions

Cost assumptions

All India population

Opex assumptions

Penetration of total population

Capex assumptions

Market shares

DCF

Post paid and pre-paid

WACC of 13%

ARPU and MoUs

Perpetuity Growth

Projection Period of 11 years till FY 2016

Trading comparables

Transaction comparables

  • Pure play listed mobile comparables not available in the Indian market

    • Bharti closest benchmark

  • Recently concluded transactions provide a framework of reference

  • Transaction comparables can be distorted by strategic considerations

  • Control premia and bidding environment need to be considered


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Estimation of All India Population and Wireless Subscribers the time of the transaction

1 Population and growth

  • All India wireless penetration

  • Gross additions & churn

    4 Pre-paid/post-paid split

Estimation of

Based on

Past trends and projections based on estimates by Indian Census and research reports

Published industry research reports by Gartner, Morgan Stanley, Citigroup, Merrill Lynch and Lazard estimates

Lazard estimates of fair share of gross adds in the respective circles

Past trends and projections based on Lazard estimates and Industry research

Top Down Approach

Three separate cases have been considered for the purposes of valuation. In the “Base Case” all India wireless penetration is assumed to reach 25% in FY 2016 with a CAGR of 17.8%


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Key Assumption for ARPU and Key Costs the time of the transaction

Key Assumptions For Estimating ARPU

Key Assumptions For Estimating Operating Costs

  • Activation Fee per Gross Add : is assumed to decline by 10% yoy

  • Monthly Access/ Recharge Charge per Sub : is assumed to decline by 5% yoy

  • Outgoing Airtime rate : is assumed to decline by 5% in FY 2006.

  • VAS : is assumed to stabilise at 20% of voice revenues in FY 2011; metro VAS assumed higher - stabilises at 30%

  • Gross Outroaming : is projected to stabilise at 10% of voice revenues by FY 2009

  • Interconnect Pass Through Charges: is assumed at 20% of gross revenue

  • Network Operating Costs : have been estimated at Rs 0.2 / min of usage

  • License Fee : have been estimated at 10%, 8% & 6% of net revenues for Metro, Circle A & Circle B respectively

  • Employee Costs: Cost per employee is assumed to grow at 10% yoy

  • Customer Acquisition Costs: have been assumed at the FY 2005 levels of Rs 790 / postpaid gross add and Rs 187/ prepaid gross add

  • Advertisement Costs: have been increased to 7.0% of net revenues in FY 2008 and thereafter remain constant during the projection period

Key Assumptions For Estimating Capex

  • Incremental capex is estimated at $ 75 per incremental subscriber during the projection period

  • Maintenance capex is estimated at $ 5 per opening subscriber during the projection period


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Key Outputs – Subs and ARPU the time of the transaction

Total All India Subscribers

Total Company Subscribers

  • ARPU is projected to decline in line with industry trends

  • Proportion of Prepaid subscribers is projected to increase to 86.4% in the terminal year

Company’s ARPU

* CAGR for the period FY 2005 – FY 2016


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Benchmarking With Industry Estimates the time of the transaction

CAGR*

All India Subscribers

  • Key outputs from the model have been benchmarked against research published by leading houses such as Gartner, Morgan Stanley, Citigroup & Merrill Lynch

  • The all India subscriber and penetration projections are lower than benchmarks

28.8%

55.6%

42.8%

38.0%

34.0%

All India Wireless Penetration

* Lazard – 4 year CAGR, Gartner – 4 year CAGR, Morgan Stanley/Merrill Lynch – 3 year CAGR, Citigroup – 2 year CAGR


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Benchmarking With Industry Estimates the time of the transaction

All India ARPU

  • Overall ARPU in the “Base Case” is much lower than the comparables in the initial 2 years of the projection period and thereafter follow the market trend of steady de-growth

  • ARPU in the model is assumed to reduce from Rs 375 / sub in FY 2005 to Rs 282 / sub in the terminal year representing a CAGR of –2.6%

  • ARPU decline is on account of

    • Decline in Activation & Access fees by 10% and 5% yoy

    • Decrease in call charges

      • Minutes of Usage(MoUs) are assumed to behave inversely with the call charges

All India ARPU Growth


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ARPU & Key Components of ARPU the time of the transaction

ARPU

Breakup of ARPU


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Costs the time of the transaction

  • Network operation costs form the largest chunk of the costs accounting for 37% of the total costs in FY 2016

  • Employee costs have been assumed to grow to 20% of total costs from the 11% in FY 2005

  • Advertisement and business promotions costs are projected to counteract increasing competition in all the operating circles

  • Bad debts are projected to decrease as a proportion of total costs due to the increase in quality of postpaid subscribers


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Capex Assumptions & Projections the time of the transaction

  • Key Assumptions

    • Capex for incremental growth as well as maintenance of service quality/ enhancements have been estimated on comparable benchmarks

    • Incremental capex is estimated at $ 75 per incremental subscriber in during the projection period

    • Maintenance capex is estimated at $ 5 per opening subscriber during the projection period


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Projected Profit & Loss Account the time of the transaction

* Projected P&L for FY 2005 in the original model. PBT includes other income of Rs 131 million


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Balance Sheet the time of the transaction


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Cash Flow the time of the transaction


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Free Cash Flows the time of the transaction

Steady state CF growth



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Valuation under Other Scenarios the time of the transaction

  • Valuation have been considered for two further scenarios - Pessimistic & Optimistic

    • Pessimistic Scenario

      • Terminal year all India wireless penetration 20% with a CAGR of wireless subscribers at 15.3% as compared to a penetration of 25% in the Base scenario

      • Perpetuity growth rate assumed at 2% as compared to 3% in the Base Scenario

      • Resultant all India market share in FY 2016 is 11.5% as compared to 12.1% in the Base Scenario

    • Optimistic Scenario

      • Terminal year all India wireless penetration 30% with a CAGR of 19.8%

      • Perpetuity growth rate assumed at 4%

      • Resultant all India market share in FY 2016 is 12.8%



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Benchmark Valuations in recent telecom transactions the time of the transaction

SingTel’s stake enhancement in Bharti


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Trading Comparables the time of the transaction


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Benchmarking with Trading and Transaction Comps the time of the transaction

* Prices based on existing capital base


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In Summary ... the time of the transaction

  • Valuations are more about rigour in implementing the concepts than about concepts

  • Every valuation is different

    • Industry to industry

    • Company to company

    • Of a company at different times

  • Though a thorough understanding of concepts is important to use them in different scenarios

    • Different growth parameters – how to use them?

    • Tax issues

    • Carry forward losses and their treatment

    • Split period approaches

    • Terminal Value impact

  • A thorough understanding of the industry, company, environment around it is very important

  • And lastly, an excellent hold over spreadsheet is critical …

    • Makes the difference between a good valuation and a not so good one …

Thank You


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