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Valuations in M&A

National Conference Assocham

Fair Value - Approaches & Suitability
Asset DCF Market multiples

Premiums/ discounts
Control premium/ minority discount Strategic premium

Asset Based Methodologies- Net Assets/ Replacement Value

Arrives at valuation in terms of Tangible Net Worth of the entity as at valuation date Positives
Easy to compute

Fail to factor the value of intangible assets like brands, technical knowhow, distribution network etc. Impacted by accounting Assumes assets always have profit generating value Ignores Returns vs. Cost of capital

Relatively Stable

Generally Not Suitable for Fair Valuation of Going Concerns


NAV - Suitability
Asset Heavy Cyclicals (Example - steel, cement, hotels) High capital cost Well established Cycles driven by high capital cost, commodity product, bunch up in capacity

Valuation methods Discounted cash flow

Build cyclicality in the financial model however, easier said than done.

Profit Multiples Generally multiples tend to be pro-cyclical vs. countercyclical. NAV method A good benchmark to other methods

Examples Steel Industry

JSW acquisition of Ispat
Market price of Rs. 20 per share Ispat was making net losses; book value was eroded Enterprise value of $3.2 billion; EV/EBITDA multiple of >10x EV/ Tonne of $800 of HRC capacity Typical benchmark replacement cost for a similar plant likely to be in $1.1-1.3 billion/ milliontonne. Besides there were substantial strategic reasons.

Similar basis drives transaction in industries like cement, hotels etc.

DCF : Strengths and Limitations

Theoretically correct Forward looking Incorporates risk and time value of money Focuses on cash returns

Limited applicability in service industries/ new companies Volume and complexity of assumptions Adequacy of data Extremely sensitive to small changes in assumptions.

Developing an understanding of the business is the key to a good DCF

Examples - Mines/ Oil Blocks

Each Mine/ Oil Block is unique Reserves Production profile Cost structure Operating costs, logistics cost Location is critical Asset values may be negligible Approach DCF is the most common approach
Commodity price assumptions are critical

Maybe benchmarked with reserve multiple EV/boe, EV/ tonne of reserve

Example.. Criticality of assumptions

Long term price forecasts Hard coking and thermal coals (fob Australia) 2006
$/tonne Hard Coking Coal Prices Thermal Coal Prices 2006A 2007F 125 57 75 42 2008F 68 38 2009F 2010F 2011F 2012F 63 33 63 33 60 33 59 33

Significant transportation cost, considering location of mines Impacted viability of greenfield/ transactions 2011
$/tonne Hard Coking Coal Prices Thermal Coal Prices 2006A 2007A 2008A 2009A 2010A 2011E 2012F 125 57 98 65 300 118 129 75 200 96 247 122 200 120

DCF WACC Some key discussion points

WACC is current and forward looking
Cost of debt is marginal debt cost not historical; however, watch out for significant differences Debt equity ratios are market, not book

Typically, book tends to undervalue WACC

Cost of equity should factor in the leverage risk also (relever betas) Adjustments to Cost of Equity Size/ client sector concentration/ other risks

Aggressive business plan (not ideal)

Target WACC vs. acquirer WACC

Especially relevant in cross border context
Keep in mind the funding strategy

Comparable Multiple Method

Positives Limitations

Realistic valuations as benchmarked to current valuations. Relatively simpler compared to DCF Flexible can use different valuation multiples in different cases

Very volatile
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

Less impacted by valuer bias

Realistic method in a number of situations


Example - Software Sector

Key Characteristics of the Sector High to medium growth but volatile Low long term visibility, global factors Approach DCF possible but difficult NAV is meaningless, as value of intangibles. Multiples approach is widely used
P-E multiples rather than EV/EBITDA Forward multiples, to factor in growth PEG a combination of growth and multiple however be wary of short term growth

Infosys, a case study (courtesy Udayan Mukherjee)

Infosys valuation peaked in 2001 an investor at the peak did not make any returns till 2006.

Throughout this period, Infosys continued to grow its profitability.

The PE chart shows the bubble and its bursting.

Approaches in different industries

Power generation sector Very well benchmarked asset values Traditionally, each Power plant typically had a PPA
Profitability linked to Return on Equity

DCF approach was ideal, with asset values as benchmarks

However, new uncertainties
Merchant tariff has ranged from Rs. 7 to Rs. 2.50. Coal linkage and uncertainty

Significantly more variability in sector valuations than in the past

Hotels Sector
Hotel Sector is characterized by High Operating Leverage Almost all costs are fixed in nature. High Cyclicality High Operating Margins, but low Asset Turnover. Franchisee chains have the reverse. Approaches Multiples
EV/ Room multiples will depend upon location, Star Category. EV/EBITDA multiples depending upon the near term business scenario, have ranged from 5 to 15x.

EV/Room is a proxy for replacement cost. DCF should factor in the cyclicality.

Franchisee chains will have more stable models and higher intangibles. DCF may be the best approach for them.

Hotel Valuations
In September 2005
Company Name in Rs. Mn. Asian Hotels EIH Indian Hotels Hotel Leela Venture Taj GVK Average Share price 440 497 768 269 595 Market Cap 10,034 26,040 39,950 19,793 7,461 Debt EV EBITDA EV / Rooms EBITDA 13.2 x 16.7 x 21.8 x 19.0 x 16.1 x 17.4 x 1161 2631 n.a. 835 639 EV/Room 10.88 12.97 n.a. 32.06 12.88 17.20

2,601 8,092 14,155 6,976 767

12,634 34,132 54,105 26,769 8,228

958 2,041 2,486 1,410 510

December 2008
Company Name in Rs. Mn. Asian Hotels EIH Indian Hotels Hotel Leela Venture Taj GVK Average Share price 233 100 38 19 39 Market Cap 5,313 39,295 27,489 6,990 2,420 Debt EV EBITDA EV / Rooms EBITDA 1.9 x 10.4 x 3.1 x 9.9 x 1.4 x 5.3 x 1161 3083 n.a. 1086 639 EV/Room 3.78 13.12 n.a. 19.56 2.75 9.80

(930) 1,141 (6,073) 14,254 (666)

4,384 40,437 21,416 21,244 1,754

2,342 3,880 6,842 2,155 1,223

Hotel Valuations
Company Name in Rs. Mn. Asian Hotels (North) Limited Asian Hotels (West) Limited Asian Hotels (East) Limited EIH Indian Hotels Hotel Leela Venture Taj GVK Average Share price Market Cap 3,919 2,060 3,467 52,899 58,859 16,929 6,035 Debt EV EBITDA EV / Rooms EBITDA 5.5 x 7.4 x n.a. 21.2 x 17.8 x 25.7 x 6.5 x 14.0 x 624 467 233 3519 n.a. 1457 900 EV/Room 9.42 7.17 n.a. 16.33 n.a. 27.37 7.09 13.48

201 181 304 93 78 44 96

1,963 1,286 (5,857) 4,570 14,995 22,951 350

5,882 3,346 (2,390) 57,469 73,854 39,880 6,385

1,077 454 245 2,710 4,155 1,551 976

Real Estate Sector

RE Sector is the only sector, where value resides in the raw material i.e. Land Holdings. Value is driven by assumptions regarding land availability/ scarcity, its value and appreciation

Approaches NAV approach is quite important, with land being fair valued. DCF is the key to unlock value, hence cannot be ignored. However, assumption on land price appreciation make a huge impact Multiples are not very reliable, as Earnings may not be captured in line with cash flows.

Consumer Goods Sector

Key Characteristics of Consumer Goods sector Presence of Brands Low capital employed low capex, relatively low working capital Much less volatility (implying low WACC in DCF)

Approaches DCF is very suitable, as brands provide stability and visibility Because of lower risk, low capital employed and high return on capital, successful consumer goods multiples are very high. NAV is not suitable because most brands are not on books.

Key characteristics of Banks
High leverage (high risk !) Value created on both assets and liabilities side of Balance sheet

Making business plans is difficult, as growth dependant on capital All assets are liquid, hence NAV or Price/ Book value are key multiples. Adjust NAV for loan loss provisions. Approach of Management and past track record is also key

Fair valuation, Really a Call on Three factors..

How Much? How Sustainable? How Long?

External/Internal Price Risk Manageable/ Non manageable

Mitigating Factors Brand, Distribution


Management Quality
Reputation, Competence, Vision, Corporate Governance

Premiums & Discounts

Control Premium Minority Discount Marketability(Illiquidity) Discount Strategic Premium

Control Value
Value of the enterprise as a whole Control value should encompass the rights, risks and rewards of having controlling power in a business In this context controlling interests are considered to be marketable and a marketability discount is not used

Corporate Governance impacts Control Value

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

Minority Interest Value

Marketable Minority Interest Represents the value of a minority interest that is freely traded in the public market place (ie share market) Marketable minority interests in public companies lack control of a business but the holder does have control over the ability to sell at will

Non Marketable Minority Interest (DLOM)

Represents the value of minority interests of private companies for which there is no active market Holders lack control over the affairs of the business as well as over the timing and circumstances to achieve liquidity Absence of control and illiquidity results in a lower value than either the marketable minority interest value or the control value

The Three Levels of Value

Control Value Control Premium Minority Interest Discount

Minority Interest Value Marketability Discount Non Marketable

Minority Interest Value


Control premiums in India

Global evidence USA Mean premium 44%; Median premium 31% (Factset Mergerstat Control premium study 1998-2007)

Australia - Mean premium 52%; Median premium 41% (Officer, Bishop and Dodd)

Discount calculation
Minority discount is reverse of control premium Thus a 40% control premium would imply a minority discount of 28.6%

DLOM For some publicly traded stocks, a shareholder can purchase a long-term put option to insure against a price drop during the term of the put The price of the put provides market evidence of what investors are willing to pay to guarantee marketability The Black-Scholes model can be used to estimate the price of a theoretical put for non-publicly traded stock. DLOM (%) = Put Option Value / Stock Price Other methodologies Pre IPO studies, Restricted Stock studies

Strategic Premium/ Synergy

Represents the premium that a buyer will pay over fair value, for own strategic reasons Typical factors driving strategic premium
Value gain in target by efforts of acquirer
Refinancing loans Cost reductions/ sourcing discounts

Value gain in own company if target is acquired

Increased sales volume especially if target is a customer Increased sales/margins better distribution of geographical area Entry strategy in a country

Reduction in Costs/ capex cost

Access to technology Cross selling opportunities

Strategic Premium/ Synergy

Value lost in own company if target is lost to competition
Disruption of supply Improved market position of competitor leading to marginalisation in trade Entry point of new customer

Lower WACC of acquirer vis a vis target

Typically developed countries acquirers can get an advantage

Whether buyer pays for strategic premium depends upon specific situation
Competitive Bidding One on One Negotiations

Competitive Bidding Buyers Valuation Strategy

Own Value
DCF Value/ Listed Multiples Value Strategic Premium

Other Bidders Pain Value Reserve Value Price

Other bidders Strategic Premium Bidder A Bidder B Bidder C What price it pains to lose the bid Sellers Pain Value

Transactions Multiple


One on One Negotiation Buyers Strategy Build own and sellers valuation Initial bid should articulate negotiation intention

Justifiable valuation basis.

Manage Expectations on both sides

To sum up
Value, being an art or an inexact science, approach changes based on timings, industry and valuers outlook

Finally, the Valuers Curse

Depending upon situations, valuation can be

Exactly Wrong (Mostly) or

Roughly correct ( only if you are lucky)

Thank You