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Rajesh S Upadhyayula


Rules Synergy Valuation Cross Border Issues in Valuation


that can be counted does not necessarily count; everything that counts cannot necessarily be counted - Albert Einstein A walk of a thousand miles begins with a single step Chinese Proverb

Think like an investor

Look to the future and not the past Focus on Economic Reality Rely on flows of cash Get paid for the risks you take Time is money Opportunity Cost

Consider alternative strategies for the buyer and seller Focus on what you know about a target company that the market does not already know

Information is the source of advantage

Diversification is good

Intrinsic value is unobservable we can only estimate it


of valuation analysis are estimates vantage points only Entire process of valuation analysis is structured as a triangulation exercise from several vantage points Do not work with point estimates of values; work with ranges

An opportunity to create value exists where price and intrinsic value differs

view: Accept the proposal if: Intrinsic value of target to the buyer > Payment Sellers view: Accept the proposal if: Payment> Intrinsic value of target to the seller ValueEnterprise = Equity + Debt

Cash flows Terminal Value Cost of Capital DCF Estimates Venture Capital / Private Equity Approach Multiple Estimates Peer firms Comparable Transactions Option based Estimates Current Market Value Book Value


Triangulati on of Estimates

Liquidation Value
Replacement Value

So many estimators so little time it helps to have a view

Book Value of the target firm

Principle of conservatism that tends to reflect only what has already happened Ignores most assets or values that are not tangible These approaches are backward looking Appropriate for firms with no intangible assets, commodity type assets with stable operations

Liquidation value of the target firm

It is the most conservative approach since it sums the value to be realized in the event of liquidation Liquidation is equivalent to what price it fetches in auction Lowest of all the values Relies on estimators valuation method. Ignores the valuation of hidden rights

So many estimators so little time it helps to have a view

Replacement cost of the target firm

Useful in high inflation environments It reflects current conditions than past experience Ignores expectations of future performance Intangible assets are difficult to value using this method

Current market value of the target firm

Sum of market values of debt and equity Value of equity is share price times the number of shares outstanding Value of debt is the book value unless credit rating has changed since the issuance of debt Approach useful for less well known companies with thinly or intermittantly traded stock

So many estimators so little time it helps to have a view

Trading multiples of comparable firms applied to the target


of multiples of peer firms to the target Some multiples value the whole enterprise while others estimate the value of equity Rarely, one can find a pure play peer on which to base a valuation Accounting practices across the firms can be different and thus can be erroneous Method focus on proxies for cash flows

Discounted cashflow of the target firm

Estimate the residual or free cash flow and discount appropriately Are the cash flows net of interest and principal payments if so they are equity cash flows

Value of Firm or Assets Cash Flow FCF=[EBITX(1t)+Depreciation Capex -NWC +Def Taxes RCF=Netincome + depreciation capex - -NWC +Def Taxes +Debt Interest, fees, Principal Terminal Value FCF (1+g)/WACC-g Discount Rate Weighted average cost of capital


RCF (1+g)/K-g

Cost of equity


Principal outstanding at maturity

Cost of debt

Growth is the big enchilada of valuation. Terminal value is thus very important. Pay careful attention to the terminal value


cashflow of the target firm

Discount Rate should reflect the investors opportunity cost on assets of comparable risk WACC=id(1-t)Wd+KeWe Estimation of Cost of equity and Cost of Debt after merger are important Ke=Rf+(Rm-Rf) If the acquirer intends to change the financial leverage of the target significantly, beta should be adjusted unlevered=levered/(1+(1-t)D/E) levered=unlevered(1+(1-t)D/E)

Discounted cashflow of the target firm

Not tied to historical accounting values and is forward looking It focus on cash flows and not profits. It recognizes time value of money It can be used to value enterprise or equity One can also use a method called as Adjusted Present Value i.e., Value of Enterprise = Value of enterprise with no debt + Present value of debt tax shields FCF and RCF need to explicitly model the cost of capital changes over time as the terms of financing changes, whereas in APV the analyst need not Choosing the approach is a matter of taste, convenience and data availability

Venture Capital / Private Equity Approach

Projects the performance of firm into the future Assumes that the private equity investor would exit in three to five years Exit value at the horizon is estimated using an exit mulitiple Exit values are discounted at 30 75 percent Two important parameters are exit value and timing

Option Valuation approach

Equity is viewed as a call option

It requires knowing atleast five parameters

Value of the underlying asset. In the case of firms, this is enterprise value Exercise price of the call option. In case of firms, this is the par value of the debt outstanding The term of the option. In the case of the firms, this is the duration for debt outstanding The risk free rates. This is yield to maturity on government bonds Volatility of returns on the underlying assets

Approach is useful when the firm is highly levered Disadvantage is that one needs to have a view on enterprise value


estimators of intrinsic value to find key value drivers and bets

Analysts should define the reasonable range To identify the key drivers or assumptions to which the estimates are most sensitive Four approaches for sensitivity

Univariate and bivariate sensitivity analysis Scenario analysis Break even analysis Monte Carlo Simulation

Think Critically; Triangulate carefully

There are several possible valuation approaches. No approach is flawless. DCF is the approximate best what it means to think like an investor and deserve more weight Be flexible and adapt your view to circumstances It would be different for businesses like trading operations, firms in financial distress, assets to be liquidated and higher inflation settings Scrutinize Sensitivity assumptions Eliminate estimates in which one has little confidence Compare the finalist estimates of value (Read HP Compaq) Opening bid and walk away bid needs to be defined Judgemental

Other terms also determine the price especially deal terms, form of payment, bargaining strategy


on Process Not Product

No substitute for quality of information obtained through primary research or due diligence Scrutiny of assumptions and critical thinking Dogged persistence to test and sensitize Feedback followed by refinement Thoughtful triangulation from many estimators Acceptance of estimates, not certainty

Synergy Valuation

True synergies create value for shareholders by harvesting benefits from mergers that they would be unable to gain on their own

Most of the M&A transactions occur among privately held firms Growing cross border deals Value creation should be a fundamental aim of M&A transaction design Assessing synergies addresses an extremely important tactical problem for the designer anticipate reactions Valuing synergies in a deal can help an analyst to develop a strategy for disclosing them to investors and shaping their understanding Valuing synergies should be a foundation for developing a strategy for post merger integration

Synergy assessment is center piece of M&A analysis

Vsynergies= Vin place synergies+ Vreal options synergies Inplace synergies are reasonably predictable whereas real option synergies are not Vsynergies= FCFt/(1+WACC)t

Synergies can arise due to improvements in either FCF components (i.e., after tax operating profit, plus non cash deductions, less investments in networking capital and capital projects) or WACC
Improvements include

Revenue enhancement synergies Cost reduction synergies This is the most credible of all the synergies Asset reduction synergies these are one time and not recurring Tax reduction synergies

Increase in depreciation tax shields Transfer of net operating losses from target to buyer Does financing creates value for investors that they cannot create for themselves? Simply financing a deal doesnt do anything that investors cannot do themselves WACC optimization will not meet the economic definition of synergy Combining two cash flow streams that are less than perfectly correlated can produce a joint stream that is less risky than a simple sum of streams

Financial synergies

Real Option Synergies

Growth option synergies: It would give a right but not an obligation to grow. Examples include R&D / Creative capabilities Exit option synergies: A merger may make Newco less path dependent Options to defer: A combination of two firms could grant the flexibility to wait on developing a new technology, entering a new market or undertaking a risky action Option to alter operating scale: A combination of two firms could help the buyer to exit or enter a business more readily Options to switch: Ability to change the mix of inputs or outputs of the firm or its processes

Establish credibility of the synergy source: Requires careful due diligence and research Everything after tax Revenue or cost synergies are pretax Asset reduction synergies entail profit or loss WACC related synergies need to reflect marginal tax rate too for newco Choose a discount rate consistent with the risk of the synergy Cost synergies are most certain and revenue synergies are least certain Tax reduction and asset reduction synergies are more certain than others WACC synergies are probably in between Possible approaches to discount rate sure things could be discounted at risk free rate Cash flows that are as variable as EBIT could be discounted at the cost of debt Cash flows that are as risky as free cash flows of the enterprise could be discounted at WACC Cash flows that are as risky as residual cash flows of the firms should be discounted at firms cost of equity Cash flows that are speculative should be discounted at Venture capitalists required rate of return

Many managers are apparently over exposed in impressionable childhood years to the story in which the imprisoned handsome prince is released from the toads body by a kiss from the beautiful princess. Consequently, they are certain that the managerial kiss will do wonders for the profitability of the target company. Such optimism is essential. Absent that rosy view, why else should the shareholders of company A want to own an interest in B at a takeover cost that is two times the market price theyd pay if they made direct purchases on their own. In other words, investors can always buy toads at the going price for toads. If investors instead bankroll princesses who wish to pay double for the served many kisses, those kisses better pack some real dynamite. Weve observed many kisses, but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses even after their corporate backyards are kneedeep in unresponsive toads Warren Buffet

Cross border M&A is different


and concepts of valuation and strategy remain relevant Factor differences in inflation, currency, taxes, accounting, law and culture

There are two ways to value


can value a target in foreign local terms or in home terms adjusting for differences in currency. The investment attractiveness should be the same (interest rate parity) Assuming no political or segmentation risk (will cover later)

Adjustments in cashflows or discount rates


to accommodate cross border differences in valuation is to adjust the cashflows or the rate which to discount them


currency exchange rates Tax rates Timing of cash remittance Political risk Market segmentation Governance Accounting prinicples Social / Cultural issues


into a foreign country entails a bet on the macro economic policies of that country Policies can produce widely differing inflation rates and exchange rate uncertainty Differences affect forecasted local cash flows and local discount rates Thus real cash flows or discount rates get affected

Analyst must confront differences between foreign currency and home currency Drawing upon theories of interest rate parity and fisher equation, economists suggest a relationship between inflation rate differences between two countries and exchange rate differences SPOTLocal/home / FWDlocal/home = (1+RLocal)/(1+RHome) Assumes that there are no arbitrage opportunities available to investors. Investors are allowed to move freely in and out of these two markets

Marginal tax rate varies substantially across countries Rule: Choose the marginal tax rate appropriate to the country in which the cash flows are generated

Territorial tax system: Home country exempts further taxation on local countrys income. Analysts argue a case for using local countrys marginal tax rate World wide tax credit system: The home country recognizes taxes paid in a foreign country as a credit again tax liability at home. Analysts argue that one should sue the higher of the buyers or targets country rate

Correct analysis would dictate determining the type of tax system to which the shareholders of the parent are subject to What is India part of?


limit the outbound movement of cash and capital Costs to manufacture are incurred in one country and revenues are realized in other countries (limits mobility of cash) Such limitations sacrifice capital mobility of corporations Firms can use financial intermediaries to synthesize a repatriation of cash even though a formal transfer has not occurred Base case assumption ignore the timing of remittances of cash

Accounting principles differ across various countries. These include treatment of

Cash Expense

and investment recognition Pension accounting Inflation accounting

Since DCF focuses on cash rather than accrued earnings, those national differences in accounting are not meaningful However, the process of deriving cashflows from financial statements requires familiarity with accounting principles of foreign country

Extent to which local governments intervene in the working of markets can have a material effect on the value of corporate assets Political risk can affect through regulation, punitive tax policies, restrictions on cash transfers, employment policies Various estimates of political risk are available through different sources such Euromoney country risk rating, EIU Risk rating, International country risk guide, Institutional investor country risk rating, etc They do not agree completely. Political risk is intangible and measured imperfectly Two ways to adjust the valuation approach to political risk

Adjust the cash flows of the target firm Give a haircut Adjust the discount rate for the target firms cash flows differences in yields of government denominated in the same currency


rates and equity market multiples can vary substantially

Inflation and currency effects Degree of integration of local financial markets with global financial markets

local market is segmented when financial assets command a different price there than in global markets

Arises from barriers to trade that prevent arbitrage


affects the discount rate, the M&A analyst will choose

Approach A

Rupee Denominated Cash flows

U.S. Dollar denominated Cash flows

Approach B

Rupee Denominated NPV

U.S. Dollar denominated NPV

Approach A Key features or key bets Purchasing Power parity (PPP) and interest rate parity (IRP) hold Inflation forecasts in foreign and home currencies are appropriate Foreign country political risk premium is appropriate Information environment Can use high quality capital market information from developed countries PPP and IRD do not hold in all markets at all times Long term inflation forecasts are unreliable

Approach B Quality of foreign capital market data is good Local capital costs are free market yields


Simplicity Translation at spot foreign exchange rates Information environment is not strong in developing countries Availability and quality of capital market data may be poor Betas are not estimated for many stocks in emerging markets Interest rates are administered by central banks and thus not reflect inflation

Choice between the Weaknesses two depends on relative confidence in local capital market data versus ones relative confidence in the existence of equilibrium between currency and capital markets

Need for internal consistency

Same tax rate should be assumed in estimating after tax cash flows, a levered beta and weighted average cost of capital and value of debt tax shields The same inflation rate should be assumed in forecasting revenues, costs, additions to working capital and foreign currency exchange rates

Valuing real versus nominal cash flows

Value nominal cash flows at nominal discount rates most prevalent Value real cash flows at real discount rates used in high inflation environments In theory, if cash flows and discount rates are internally consistent, markets will value an asset the same under either approach Depreciation is a deductible expense for tax purposes. Depreciation expense is tied to historical cost of the firm not the current (inflation adjusted) value Firms will not deduct depreciation expense as inflation rises. As a result firms overpay taxes


forward exchange rates beyond few years. Markets for most currencies do not offer exchange rates beyond three years FWDRupee / Dollar = SPOTRupee / dollar (1+infRupee)n / (1+infdollar)n Strong confidence in forecast of inflation rate for home and foreign currencies Parity prevails in global currency and capital markets i.e., no segmentation


a cost of equity consistent with the risk of the foreign target Estimate risk based on targets stock prices or prices of comparable firms Check for market segmentation and require compensation for it
Target country is integrated Foreign Capital Market information environment is strong Foreign Capital Market information environment is weak CAPM, ICAPM Multifactor model Target country is segmented Multifactor model Credit Model Adjusted CAPM Adjusted CAPM Credit Model


Multifactor model

World stock market price risk Country stock market price risk Industry price risk Exchange rate risk Political risk Liquidity risk

(Ri-Rf)=+ilW(RW -Rf)+ilC(RC -Rf)+ilI(RI -Rf)+Ex(REx-Rf)+D(RDC RAAA)+L(RLoL -RHiL)+error Where R=Return; Beta=Regression Coefficient; i=specific company, f=risk free return; W=Global Equity market portfolio; C=Country equity market portfolio; I=Industry equity market portfolio; Ex=Portfolio of foreign currency deposits; D=Soverign debt instrument of the companys home country (C); AAA=Highest rated sovereign debt instrument; L= Portfolio of low or high liquidity bonds