MODULE V

VALUATION

VALUATION
In finance, valuation is the process of estimating what something is worth. Items that are usually valued are a financial asset or liability. Valuations can be done on assets (for example, investments in marketable securities such as stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., bonds issued by a company). Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition transactions, financial reporting,

PRINCIPLES OF VALUATION

Book Value Depreciated value of assets minus outstanding liabilities Liquidation Value Amount that would be raised if all assets were sold independently Market Value (P) Value according to market price of outstanding stock Intrinsic Value (V) NPV of future cash flows (discounted at investors required rate of return) Appraisal Value - it is the value acquired from the independent appraisal agency. This value is normally based on the replacement cost of assets.

INTRINSIC VALUATION PROCEDURE

CFt V t t 1 1 k

MERGER AS A CAPITAL BUDGETING DECISION

Capital Budgeting involves acquiring fixed or long-term assets Discounted Cash Flow Approach is used determine the profitability of an asset or viability of a Project M&A involves acquiring the target firm comprising a large number of assets and liabilities It is a very long-term investment Valuation of the target firm is done in the light of additional cash flows generated additionally by the acquisition

MERGER AS A CAPITAL BUDGETING DECISION

STEPS: Determination of Incremental projected Free cash flows to the firm(FCFF). Determination of Terminal value Determination of Appropriate discount rate/ cost of capital. Determination of present value of FCFF Determination of cost of Acquisition

Methods of Valuation

Asset based valuation Earnings or dividend based valuation CAPM based valuation Valuation based on Present Value of free cash flows

Assets Based Valuation

The book value of a firm is based on the balance sheet value of owner's equity or in other words Assets minus liabilities. For assets value to be useful, the target company should have followed a regular depreciation, replacement and revaluation policy. The reasons for using this method are It can be used as a starting point to be compared and complemented by other analysis Where large investment in fixed assets is required to generate earnings, the book value could be a critical factor especially where plant and equipment are relatively new. The study of firm's working capital is also necessary. However this method suffers from certain disadvantages: It is based on historical cost of the asset which do not bear a relationship either to value of the firm or its ability to generate earnings. Some entities may wish to sell only part of their business. In such case book value may fall flat.

Example
For example: Balance sheet of A Ltd Liabilities Amt Assets Amt Equity share capital of 100000 Goodwill 20000 Rs 10 each Plant and machinery 100000 General reserve 50000 Stock 40000 Creditors 60000 Debtors 50000 Tax payable 30000 Cash at bank 30000 Total 240000 Total 240000 Goodwill is worth nothing. Plant and machinery is valued at Rs 85000. Sundry debtors declared insolvent owed Rs 5000. Compute value per share. Solution: Calculation of net worth Goodwill Plant and machinery 85000 Stock 40000 Debtors 45000 Cash at bank 30000 Less: Creditors (60000) Tax payable (30000) Net worth (Rs.) 110000 No. of shares 10000 Value per share (Rs/share) 11

Earnings based Valuation

There are two methods here. Capitalization of earnings and PE based value. Capitalization of Earnings Example: Profit available for equity shareholders(Rs.) = 225000 No. of equity share = 10000 Earning Per share (Rs/share) = 22.5 Normal Return on Investment = 16% Value per share (22.5/16%) = Rs 140.625 per share

P/E BASED VALUATION

The market value of equity share is the product of "Earning per share (EPS) " and the "Price Earnings Ratio". According to this approach the value of the prospective acquisition depends on the impact of the merger on the EPS. There could either be positive impact or a dilutive impact. Prima facie, dilution of the EPS of the acquiring firm should be avoided. However, the fact that the merger immediately dilutes the current EPS need not necessarily make the transaction undesirable. However the prevailing PE in the market may not always be feasible. Some aspects that will influence the valuer's choice of PE ratio include: Size of the target company In case of unlisted companies, there would be restricted marketability and the PE multiple will tend to be lower than listed company

Dividend Based Valuation

Quite often, the amount of dividend paid is taken as the base for deriving the value of a share. The value on the basis of the dividend can be calculated as No growth in Dividends S = D1/Ke where, S - Current share price D1 - Dividend Ke - cost of equity Constant Growth in Dividends S = [Do(1+g)] / (Ke-g) where, Do - Dividend of last year g - Expected growth rate

CAPM based valuation

The Capital Asset pricing model can be used to value the shares. This method is useful when we need to estimate the price for initial listing in the stock exchange. The crux of this model is to arrive at the cost of the equity and then use it as the capitalization of dividend or earning to arrive at the value of share. The formula is: ke = Rf + beta of the firm (Rm-Rf) where, Ke cost of equity Rf - Risk free rate of return Rm - Market rate of return.

Free Cash flow model

Free cash flow model facilitates estimating the maximum worthwhile price that one may pay for a business. Free cash flow analysis utilizes the financial statements of the target-business, to determine the distributable cash surpluses, and takes into account not merely the additional investments required to maintain growth, but also the tie-up of funds needed to meet incremental working capital requirements. Under this model value of the firm is estimated by a three step procedure: Determine the free future cash flows: Net operating income + Depreciation - incremental investment in capital or current asset for each year separately. Determine terminal cash flows, on the assumption that there would be constant growth, or no growth. Present values these cash flows can then be compared with the price that we would pay for the acquisition.. However while estimating future cash flows, the sensitivity of cash flows to various factors should also be considered.

Fair Value Instead of placing reliance on a single method, it preferable to base our valuation on the average of results of two or three types discussed above. Normally fair value is ascertained as the average of net asset value (NAV) per share and the capitalized value of earnings per share (EPS). This particular method is also known as Berliner Method.

VALUATION METHODS
When valuing a company, three techniques are commonly used: comparable company analysis (or "peer group analysis", "equity comps", " trading comps", or "public market multiples"), precedent transaction analysis (or "transaction comps", "deal comps", or "private market multiples"), and discounted cash flow ("DCF") analysis. A fourth type of analysis, a leveraged buyout ("LBO") analysis, is often used to estimate the amount a financial buyer would pay for a company. A fifth type of analysis, a sum-of-the-parts ("SOTP" or "break-up") analysis may be used to value a company as the sum of the values of its composite businesses.

VALUATION METHODS

VALUATION METHODS

VALUATION APPROACHES
Discounted Cash Flow determines the value of the firm by ascertaining the present value of future cash flows Comparable Firm determines the value of the firm at the value of a similar firm in the same industry Adjusted Book Value estimates the value of the firm at the sum of market value of assets and liabilities as a going concern Option Pricing Model regards the equity of a taken over company as an option and values it like an option

Approaches to Valuation Valuation Models

Asset Based Valuation Discounted Cashf low Models Relative Valuation Contingent Claim Models

Liquidation Value
Stable Current

Equity
Firm

Sec tor

Option to delay

Option to expand Young firms

Option to liquidate Equity in troubled firm

Market

Replac ement Cost

Two-stage
Three-stage or n-stage

Normalized

Earnings Book Revenues Value

Sec tor specific

Undeveloped land

Equity Valuation Models

Dividends

Firm Valuation Models

Patent Undeveloped Reserves

Free Cashflow to Firm

Cost of capital approach

APV approach

Excess Return Models

Discounted Cash Flow Valuation

What is it: In discounted cash flow valuation, the value of an asset is the present value of the expected cash flows on the asset. Philosophical Basis: Every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash flows, growth and risk. Information Needed: To use discounted cash flow valuation, you need to estimate the life of the asset to estimate the cash flows during the life of the asset to estimate the discount rate to apply to these cash flows to get present value Market Inefficiency: Markets are assumed to make mistakes in pricing assets across time, and are assumed to correct themselves over time, as new information comes out about

Discounted Cashflow Valuation: Basis for Approach

t = n CF t Value = t t =1 (1+ r)

where CFt is the cash flow in period t, r is the discount rate appropriate given the riskiness of the cash flow and t is the life of the asset. Proposition 1: For an asset to have value, the expected cash flows have to be positive some time over the life of the asset. Proposition 2: Assets that generate cash flows early in their life will be worth more than assets that generate cash flows later; the latter may however have greater growth and higher cash flows to compensate.

I. Equity Valuation
The value of equity is obtained by discounting expected cashflows to equity, i.e., the residual cashflows after meeting all expenses, tax obligations and interest and principal payments, at the cost of equity, i.e., the rate of return required by equity investors in the firm.
Value of Equity =
t=n

CF to Equity t (1+ k )t t=1 e

where, CF to Equityt = Expected Cashflow to Equity in period t ke = Cost of Equity Forms: The dividend discount model is a specialized case of equity valuation, and the value of a stock is the present value of expected future dividends. In the more general version, you can consider the cashflows left over after debt payments and reinvestment needs as the free cashflow to equity.

II. Firm Valuation

Cost of capital approach: The value of the firm is obtained by discounting expected cashflows to the firm, i.e., the residual cashflows after meeting all operating expenses and taxes, but prior to debt payments, at the weighted average cost of capital, which is the cost of the different components of financing used by the firm, weighted by their market value proportions. APV approach: The value of the firm can also be written as the sum of the value of the unlevered firm and the effects (good and bad) of debt.
Firm Value = Unlevered Firm Value + PV of tax benefits of debt - Expected Bankruptcy Cost

It is variant of DCF, is value of the target company if it were entirely financed by equity plus the value of the impact of debt financing in terms of the tax benefits as well as bankruptcy cost.

DCF Valuation Model

DISCOUNTED CASHFLOW VALUATION
Expected Growth Firm: Growth in Operating Earnings Equity: Growth in Net Income/EPS

Cash flows Firm: Pre-debt cash flow Equity: After debt cash flows

Firm is in stable growth: Grows at constant rate forever

Terminal Value

Value Firm: Value of Firm Equity: Value of Equity

CF1

CF2

CF3

CF4

CF5

CFn ......... Forever

Length of Period of High Growth

Discount Rate Firm:Cost of Capital Equity: Cost of Equity

RELATIVE VALUATION
What is it?: The value of any asset can be estimated by looking at how the market prices similar or comparable assets. Philosophical Basis: The intrinsic value of an asset is impossible (or close to impossible) to estimate. The value of an asset is whatever the market is willing to pay for it (based upon its characteristics) Information Needed: To do a relative valuation, you need an identical asset, or a group of comparable or similar assets a standardized measure of value (in equity, this is obtained by dividing the price by a common variable, such as earnings or book value) and if the assets are not perfectly comparable, variables to control for the differences Market Inefficiency: Pricing errors made across similar or comparable assets are easier to spot, easier to exploit and are much more quickly corrected.

RELATIVE VALUATION
In relative valuation, an asset is valued on the basis of how similar assets are currently priced in the market. every thing is relative even when it shouldnt be. Humans rarely choose in absolute terms. We dont have an internal meter that tells us how much things are worth. Rather, we focus on the relative advantage of one thing over another, and estimate value accordingly.

STEPS INVOLVED IN RELATIVE VALUATION

Analyze the subject company Select comparable companies Choose the valuation multiples Calculate the valuation multiples for the comparable companies. Value the subject company

BALANCE SHEET VALUATION MODELS

Book Value: the net worth of a company as shown on the balance sheet. Liquidation Value: the value that would be derived if the firms assets
were liquidated.

Replacement Cost:

the replacement cost of its assets less its liabilities.

DIVIDEND DISCOUNT MODELS

D D D 3 1 2 V ....... 0 2 3 1k (1k) (1k)

Where Vo = value of the firm Di k = dividend in year I = discount rate

 The Constant Growth DDM

D0 (1 g ) D0 (1 g ) 2 V0 ...... 2 1 k (1 k )

And this equation can be simplified to:

D0 (1 g ) D1 V0 kg kg

where g = growth rate of dividends.

METHODS OF FINANCING MERGERS

Cash payment pay the purchase consideration by cash Advantages of Cash payment certain and clearly understood by the target company improves the chances of a successful bid Disadvantages of cash payment raising the necessary cash can be difficult for the bidding company where the target company is large Shares issue of ordinary and preference shares Advantages of purchase by Shares a voids strain on the cash position of the company Disadvantages of purchase by Shares expensive way of raising capital low gearing Loan capital debentures convertible loans

METHODS OF FINANCING MERGERS

Cash offer: It is a straightforward means of financing a merger. It does not cause any Dilution in the earnings per share & the ownership of the existing shareholders of the acquiring company. It is also unlikely to cause wide fluctuations in the share prices of the merging companies. The shareholders of the Target company get cash for selling their shares to the acquiring company.

METHODS OF FINANCING MERGERS

Share Exchange: A share exchange offer will result in the sharing of ownership of the acquiring company between its existing shareholders and new shareholders. The earnings & benefits would also be shared between these two groups of shareholders. The precise extent of net benefits that accrue to each group depends on the exchange ratio in terms of the market prices of the shares of the acquiring and the acquired companies.

TARGET VALUATION
Methods: Asset-based methods
Balance sheet or net book values approach P = Total assets - total liabilities No of ordinary shares issued Net realisable values or replacement cost P = net realisable value - total liabilities No of ordinary shares issued

Stock market methods: For listed companies use the share price on the stock exchange

TARGET VALUATION
Cash flow methods: Gordons growth model Value of share= Dividend received Rate of return growth in dividend Free cash flow method: PV of future cash flow-total liabilities No of ordinary shares issued

TARGET VALUATION
Dividend Yield = Gross dividend per share Market value per share MV/S = Gross dividend per share Dividend yield P/E ratio = market value per share Earning per share

Market value per share = P/E ratio x EPS

CORPORATE CONTROL

Premium Buy backs Standstill Agreements Antitakeover Amendments Proxy contests

Premium buy backs

It represents the repurchase of a substantial stock holders ownership interest at a premium above the market price (called green mail).

A standstill agreement

It is written. This represents a voluntary contract in which the stockholder who is bought out agrees not to make further attempts to take over the company in the future.

Antitakeover amendments
Are changes in the corporate bylaws to make an acquisition of the company more difficult or more expensive. These include Supermajority voting provisions requiring a high percentage of stockholders to approve a merger, Golden parachutes which award large termination payments to existing management if control of the firm is changed and management is terminated.

Proxy contest An outside group seeks to obtain representation on the firms board of directors. Since the management of a firm often has effective control of the board of directors, proxy contests are usually regarded as directed against the existing management.

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