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“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012
Contents
TABLE OF CONTENT
Particulars Pg. No.
Valuation Overview 1
FDI Valuation
- FEMA Guidelines 13
to Valuation 15
- Approaches to 16
FDI Valuation 17
- Major 19
Characteristics 20
of DFCF 21
- DFCF Valuation 22
Process 24
- Free Cash Flow- 25
Value Trend
- DFCF Value
Approaches to ODI Valuation 27
Constituents
Other Valuation
- Free Cash Methods 32
Reason Flow
to get Valuations 38
Calculation
Key take
- Costaway
of for better Valuation 43
WhereCapital
things can go wrong 44
Calculation
International
- TerminalValuation Standards 46
& IndianValue
Scenario
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012
VALU ATIO N
OVERVIEW
Value & Valuation
Value is*
An Estimate of likely prices to be concluded by the buyer and seller of a good or service that is
Not a fact.
under certain assumptions and limiting conditions and subject to the data available on the valuation
date.
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 1
Key Facts of Valuation
PRICE IS NOT THE SAME AS VALUE
The Value of a business, by whatever valuation method it is obtained, is not the selling price of the
business. Value is an economic concept based on certain data & assumptions, however Price is
what a Buyer is willing to pay keeping in consideration the Economic and Non Economic factors like
Emotions, Perception, Greed Etc which cannot be valued as such.
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 2
Standard of Value
Standard of Value is the first step in valuation exercise which helps in determining the type of value
being utilized in a specific valuation engagement.
Purpose of Valuation;
Statute;
Case Laws;
Circumstances.
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 3
Types of Standard of Value
INVESTMENT VALUE
Value to a particular investor based on individual investment requirements &
expectations
INTRINSIC VALUE
The value of the business arising from the Fundamental or intrinsic factor
FAIR VALUE
The price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 4
Types of Premise of Value
Premise of value -
Premise of Value
Going Concern – Value as an ongoing operating business enterprise.
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 5
Valuation: The law of Economics
Turnover/Profits: Negligible
Start Up Time
Proven Track Record: None
Cos. Valuation Methodology: Entirely on Business Model
Cost of Capital: Very High
6
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012
Sources of Information for Valuation
Historical financial results –
Sources of Income Statement and Balance
Sheets
Information Data available in Public
Domain – Stock Exchange /
MCA/SEBI/Independent Report
Data on comparable
companies – SALES/EV-
EBITDA/ PAT/BV
7
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012
Key drivers of valuation
CASH FLOW
Investor assign value based on the cash flow they expect to receive in the future
- Dividends / distributions
- Sale of liquidation proceeds
Value of a cash flow stream is a function of
- Timing of cash Receipt
- Risk associated with the cashflow
ASSETS
Operating Assets
- Assets used in the operation of the business including working capital, Property, Plant &
Equipment & Intangible assets
- Valuing of operating assets is generally reflected in the cash flow generated by the
business
Non - Operating Assets
- Assets not used in the operations including excess cash balances, and assets held for
investment purposes, such as vacant land & Securities
- Non operating assets are generally valued separately and added to the value of the
operations 8
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012
Judiciary Guidance on valuation
This was also re-iterated by the Indian Courts in Commissioner of Wealth Tax
v.
Mahadeo Jalan’s case (S.C.) (86 ITR 621) and Additional Commissioner of Gift
Tax
v. Kusumben D.Master
“CKF Mahadevia (S.C.)
class on Recent (122 ITRin38).
Developments Foreign Exchange Management Law” – 17 th Aug,2012 9
Broad Approaches to Valuation
10
Broad Approaches to FDI / ODI Valuation
OODDII
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FD I
VALUATION
•Notification No. FEMA 20/2000-RB dated May 3, 2000, as amended from time to time deals with
Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India)
Regulations, 2000.
•In terms of Schedule 1 of the Notification, an Indian company may issue equity shares/compulsorily
convertible preference shares and compulsorily convertible debentures (equity instruments) to a person
resident outside India under the FDI policy, subject to inter alia, compliance with the pricing guidelines.
•The price/ conversion formula of convertible capital instruments should be determined upfront at the
time of issue of the instruments.
12
FEMA Guidelines to Valuation
Particulars Valuation before April 21, Valuation after April 21,
2010in Force
Guidelines CCI Guidelines In2010
case of FDI Transactions:
Methods Net Assets Value (NAV) Listed Company: Market
Profit Earning Capacity Value as per SEBI Preferential
Prescribed Allotment Guidelines
Value(PECV) Market Value (in case
of Listed Company)
Unlisted Company:
DFCF
In case of ODI
Transactions: No method
has been prescribed
Discount 15% Discount has been prescribed No such Discount has
on account of Lack of Marketability been prescribed
Historical / Futuristic It is based on Historical Values It is based on Future
Possibility of variation As valuation is more Formulae Projections
in Value Conclusion based, final values came As valuation is more
standardized dependent on Assumptions
and choice of factors like
Growth
may varyRate, Cost of Capital
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012
14
Approaches to FDI Valuation
RBI has prescribed DFCF as the only valuation method in case of FDI; but has not provided
In India, RBI is the only Regulator which has mandated using DFCF method
Though DFCF is one of the most acceptable Valuation methods used by Business valuers
worldwide; however DFCF for all FDI transactions (like minority stake/start up valuation
etc) may not yield Fair Value in line with the Commercial understanding. However Law
DFCF
DFCFexpresses
expressesthe thepresent
presentvalue valueofofthe
thebusiness
businessas asaafunction
functionofofitsitsfuture
future
being
cash such, suitable
cash earnings
earnings Logical adjustments
capacity.
capacity. In
In this may the
this method,
method, be
thenecessary
appraiseron
appraiser a case tothe
estimates
estimates case basis.
the cash
cash flows
flows of
of
any
any business
business after
after all
all operating
operating expenses,
expenses, taxes,
taxes, and
and necessary
necessary investments
investments inin
working
workingcapital
capitaland
andcapital
capitalexpenditure
expenditureisisbeing
beingmet.
met.Valuing
Valuingequity
equityusing
usingthe
thefree
free cash
cash
flow
flow to
to stockholders
stockholders requires
requires estimating
estimating only
only free
free cash
cash flow
flow to
to equity
equity holders,
holders, after
after
debt
debtholders
holdershave
havebeen
beenpaid
paidoff.
off.
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 15
Major Characteristics of DFCF Valuation
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 16
DFCF Valuation Process
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 18
Free Cash Flows- Value Trend
Terminal Value is calculated for the Perpetuity period based on the Adjusted
last year cash flows of the Projected period.
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 19
DFCF: MAJOR CONSTITUENTS
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 20
Free Cash Flow calculation
Taxes
Change in Non Cash Working capital Free Cash
EBITDA
EBITDA
Flow to Firm
Capital Expenditure
Note that an alternate to above is following (FCFE) method in which the value
of Equity is directly valued in lieu of the value of Firm. Under this approach,
the Interest and Finance charges is also deducted to arrive at the Free Cash
Flows. Adjustment is also made for Debt (Inflows and Outflows) over the definite
period of Cash Flows and also in Perpetuity workings.
Theoretically, the value conclusion should remain same irrespective of the method
followed (FCFF or FCFE), (Provided, assumptions are consistent).
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 21
Cost of Capital calculation
(Kdx D) + (Kex E)
WACC
(D + E)
Where:
D = Debt part of capital
structure E = Equity part of
capital structure Kd = Cost of Debt
(Post tax)
Ke = Cost of Equity
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 22
Cost of Equity calculation
The Cost of Equity (Ke) is computed by using Modified Capital Asset Pricing Model
(Mod. CAPM)
Mod. CAPM Model
ke = Rf + B ( Rm-Rf) + SCRP + CSRP
Where:
Rf = Risk free rate of return (Generally taken as 10-year Government Bond
Yield) B = Beta Value (Sensitivity of the stock returns to market returns)
Ke = Cost of Equity
Rm= Market Rate of Return (Generally taken as Long Term average return of
Stock Market)
SCRP = Small Company Risk Premium
CSRP= Company specific Risk premium
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 23
Terminal value calculation
PERPETUITY FORMULA
– Usually comprises a Large part of Total Value and is sensitive to small changes
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 24
Tricky issues in DFCF
Pre Money or Post Money: If the effect of the money coming in Company is taken in
Projections, the Expanded capital base should be considered or else the Equity Value
should be reduced by the inflow amount to reconcile with the existing capital base.
Terminal growth rate: Since it is tough to estimate the perpetual growth rate of a
company, it is preferred to take the perpetuity growth rate factoring in long term estimated
GDP of the Country and Historical/Projection Inflation of the Country.
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 25
Tricky issues in DFCF (Cont.)
Length of Projections: The Projected Cash Flows should factor in the entire Business
Cycle of a Company.
Notional/Actual Tax: Actual Tax Liability may be worked out and replaced for the
Notional Tax Liability
Surplus Assets: The Value of Surplus Assets (not being utilized for Business purposes)
should be added separately and their cash flows should be ignored while computing the
Free Cash Flows.
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 26
APPROACHES TO
ODI
VALUATION
An Insight of Valuation-
27
www.CorporateValuations
.in
Approaches to ODI Valuations
For valuing Minority Stake
Comparable Companies Market Multiples Method (CCM)
Market Multiples of Comparable Listed Companies are computed and applied to the
Company being valued to arrive at a multiple based valuation. The difficulty here is in the
selection of a comparable company, since it is rare to find two or more companies with
the same product portfolio, size, capital structure, business strategy, profitability and
accounting practices. Most Valuations in stock markets are market based. Also
Valuations for Tax purposes are done using this method.
ItItInvolves
Involvesdetermining
determininglong
longterm
termindustry
industrymultiples
multiplesusing
usingrelevant
relevantparameters
parameterslike:
like:
Sales – EV / Sales looks at the enterprise value (market value of equity and debt) of firm vis-à-
Sales – EV / Sales looks at the enterprise value (market value of equity and debt) of firm vis-à-
vis sales
vis sales
Earnings before interest, taxes and depreciation (EBDITA) – EV / EBIDTA, values the firm on
the basis of
Earnings operating
before efficiency.
interest, Net depreciation
taxes and Debt is deducted to arrive
(EBDITA) – EVat/the value of
EBIDTA, Equity
values the firm on
the Profit
Net basis –ofPoperating efficiency.
/ E, values NetonDebt
the Equity is deducted
the basis to arrive at
of net earnings of the value of Equity
company
Book Value
Net –P
Profit / BV
–P / E,values
valuesthe
theEquity
Equityon
onbasis of book
the basis value
of net of company
earnings of company
Book“CKF
Value – Pclass
Master / BVonvalues
Recentthe Equity oninbasis
Developments ofExchange
Foreign book value of company
Management Law” – 17 th Aug,2012 28
Approaches to ODI Valuations (Contd)
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 29
Approaches to ODI Valuations (Contd)
For valuing Majority Stake
Recommended Methods are as follows:
This technique is mostly used for valuing a company for M&A, the transaction that have
taken place in the Industry which are similar to the transaction under consideration are
taken into account. With the transaction multiple method, similar acquisition or
divestitures are identified, and the multiples implied by their purchase prices are used to
assess the subject company’s value. The greatest impediment in finding truly
comparable transactions is the absence of available information on private transactions
based on which such transactions took place. The more recent the transaction, the better
this technique, with all other things being equal.
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 30
Approaches to ODI Valuations (Contd)
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 31
OTHER
VALU AT I
ON
METHOD
S
Other Valuation Methods
• The first step under this method is the determination of capitalization rate - a rate of
return required to take on the risk of operating the business (the riskier the
business, the higher the required return). Earnings are then divided by that
capitalization rate. The earnings figure to be capitalized should be one that reflects
the true nature of the business based on the expected normalized profits, excluding
the impact of any extraordinary items not expected to accrue in future. While
determining a capitalization rate, it is necessary to compare with rates available to
similarly risky investments.
Other Valuation Methods
Under this valuation approach, Option Pricing Model is applied to estimate the Value.
Generally ESOP Valuation for Accounting purpose is done using the Black Scholes
Method. Now even Patent Valuation is also done using Black Scholes Method.
Rule of Thumb
a. Different methodology may derive different values, so sanity check always required.
b. Valuer shall consider relevance of each methodology depending upon the purpose and
premise of each valuation;
c. While Selecting the final value:
- Subjective Weighting
o Mathematical Weighting
Professional
- o Judgement weights are assigned to each approach and
In mathematical
weighted average calculated
weighting
- In professional judgment the conclusion is based on experience and judgment given
specific
the quality of information and the approaches applied.
-an acquiring entity must allocate the purchase price to the assets acquired and
liabilities assumed based on estimated fair values at the date of acquisition;
-The excess of the cost of an acquired entity (including tangible and intangible
assets) over the net of the amounts assigned to assets acquired and liabilities
assumed is recorded as “Goodwill”;
Tangible Assets
In Proportion
Consideration to Fair
paid for Allocated to Intangible Assets Value
acquisition
Balancing
Goodwill Figure
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 35
Purchase Price Allocation (cont’d)
-This may result in better Tax planning for undertaking the transactions of
acquisition of assets and liabilities; Under Slump sale transaction, specifically the
Intangible Assets can be separately accounted for by the Acquirer and
Depreciation also claimed under the provisions of Indian Income Tax Law.
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 36
Purchase Price Allocation (cont’d)
Fair Value of
Tangible Assets
Categorie
s
-
Technolog
y Based
-Marketing Based
-Customer Based
-Artistic Skills
38
Reason to get Valuation (cont’d)
MERGERS & ACQUISITIONS
Valuation is an important aspect in Mergers and Acquisitions (M&A). A valuation can not
only assist business owners in determining the value of their business, it can also help
them maximize value when considering a sale, merger, acquisition, joint venture or
strategic partnership.
Also in M&A, accurate determination of share exchange ratio is very important. Share
exchange ratio is generally determined by relative bargaining strength of the two
companies i.e. the weaker a company's earning capacity or financial strength renders it
weaker in bargaining strength and thus its shareholders are likely to have low value for the
share's worth. There are a number of court cases judgements and observations of stock
exchanges/ SEBI which need to be kept in mind before finalizing the swap ratio.
DISPUTE RESOLUTION
Valuations are an increasingly important aspect of many commercial disputes. Before,
deciding as to how to manage a dispute, it is necessary to determine the likelihood of a
successful outcome and the potential stake involved. Judicial precedents are also available
that affect the selection of Valuation methodologies and applicability of Discounts/Premiums.
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 39
Reason to get Valuation (cont’d)
GOING PUBLIC
In general, when a new company goes for an Initial Public Offering (IPO) it is doing
that in order to generate capital for growing its business. In such a circumstance, a
question arises as to how to evaluate the fair value of such a stock.
The Indian Capital Market follows a free pricing regime and thus the accurate pricing of
an IPO is of immense importance. Both Overpricing as well as under pricing have
negative impact. For instance, if a stock is offered to the public at a higher price than
the market will pay, the underwriters may have trouble meeting their commitments to
sell shares. Even if they sell all of the issued shares, if the stock falls in value on the
first few days of trading, it may lose its marketability and hence even more of its value.
VOLUNTARY ASSESSMENT
At times the management of the company wants to know the true worth and fair value of
the business for which they undertake the exercise of voluntary assessment for internal
management purpose and future decision making. Its better to have an idea of the
Tentative Value of the Company, before approaching any Investors.
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 40
Reason to get Valuation (cont’d)
SUCCESSION PLANNING
Types of Succession Planning
Succession to Family Members
In planning for the transfer of business to the next generation,
the following important items must be considered:
-Overall estate planning of the business owners;
-Utilization and optimization of gifting where appropriate;
-Utilization of trusts as a vehicle for transfer;
-Life insurance;
-Buy-sell agreements and shareholder agreements;
-Family limited partnerships;
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 44
Where Things can go Wrong (cont’d)
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 45
International Valuation Standards & Indian Scenario
Valuation Standards are basically codes of practice that are used in valuation analysis. However in International
arena the above mentioned bodies govern the valuation practices. At present there are no prescribed standards and
codes for valuation in India (Companies Bill, 2011 is introducing the concept of “Registered Valuers’)
After the erstwhile CCI guidelines, Technical Guide to Share Valuation and Business Valuation Standard of ICAI are
probably the only pieces of Valuation guidance in India.
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 46
IRS Revenue Ruling (59-60),USA
•Nature of the Business and the History of the Enterprise from its inception
•Economic outlook in general and outlook of the specific industry in particular
•Book Value of the stock and the Financial condition of the business
•Earning Capacity of the company
•Dividend-Paying Capacity of the company.
•Goodwill or other Intangible value
•Sales of the stock and the Size of the block of stock to be valued
•Market prices of stock of corporations engaged in the same or a similar line of
business
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 17th Aug,2012 47
Mr. Chander Sawhney
(FCA, CS, Certified Valuer (ICAI)