Valuation methods and issues that arise while conducting valuation

Valuation of a Business is conducted in order to arrive at an estimation of the Economic Value of an Owner’s Interest in a certain Business under the guidance of a certain set procedures. Valuation may be computed for a business in order to arrive at an accurate snapshot of the Financial Standing of the business which is presented to Current or Potential Investors. Valuation is generally conducted when a company is looking to merge with another company or acquire another company or sell off the entire or a fragment of its operations to another company. Some other reasons to conduct Valuation include establishing partner ownership, taxation, analysing the financial strength of the business i.e. determining solvency, planning for future growth and profitability of the business or even divorce proceedings. Further is a brief description of the approaches to Valuation Models and the issues that arise when conducting Valuation under those methods.

There are Three Different Approaches which are commonly used in Valuation:

  1. Income Approach
  2. Asset Based Approach
  3. Market Approach

Further is a brief description of the approaches to Valuation Models and the issues that arise when conducting Valuation under those methods.

I. INCOME APPROACH

  • Under the Income Approach, Valuation is based on the Economic Benefit expected from the investment and the level of risk associated with the investment.
  • There are several different Income Methods which include Capitalisation of cash flow or earnings, Discounted Future Cash Flows which is commonly known as DCF and the excess earnings method.
  • DCF is the Net Present Values of the Cash Flows projected by the company. The Value of an asset is intrinsically based on its ability to generate Cash Flows is the underlying principle of this approach.
  • This method relies more on the fundamental forthcoming expectations of the business rather than on the public market factors.

ISSUES THAT ARISE WHEN CONDUCTING VALUATION USING INCOME APPROACH:

1. USING ACCOUNTING PROFITS INSTEAD OF CASH FLOW

  • The value of a business depends largely on the profitability, financial health and earning power. Accounting Profits and Cash flows are two means to measure it.
  • Free cash flow is a better means to analyse profitability as compared to accounting profit because the Revenues and expenditures of the business are accounted for at the right time and the cash flows of a business cannot be manipulated as much as earnings.

2. OVERLY OPTIMISTIC REVENUE FORECASTS

  • At times while projecting the forecasts, the revenue is shown to be shooting up in numbers during the forecast period. This results when taking a hypothetical high growth rate.
  • What the valuer fails to notice is whether the growth of the company is aligned with the industry, what the market size of the company is or even whether the company has a strategy to achieve the desired growth goal.

3. NARROW FORECAST HORIZON

  • What should be taken as the optimal length of the Financial Forecasts is one of the key choices that need to be made.
  • If a shorter forecast period is considered, it fails to give the effect of different parameters on the business in the upcoming years. For example in case of a company under FMCG sector, it would not be right to prepare financial forecasting for a period of just two to three years.
  • On the other hand is the length considered is too long, the valuation could result as misleading. This is because in the long run, risks associated with the business cannot be anticipated easily.
  • Thus, it is essential to consider an explicit time frame while conducting valuation that is neither too short nor too long. A time frame ranging from 5 to 7 years is generally considered when performing DCF Valuation.

4. INCORRECT BETA

  • Beta comes into consideration when deriving the Cost of Equity of a company.
  • When Valuation of a company is done under the circumstances of a merger or an acquisition, majority of the times, the Beta is taken to be that of the Acquiring Company. This is done under the assumption that the Target Company is a smaller company when compared to its bidder, thus the Target Company would have no influence on the resulting Capital Structure as well as the riskiness of the New Company.
  • Other times, the Beta considered is an estimation of the emerging company’s Beta with respect to a Market Index. But just using the historical beta is very risky when the company or its future risk prospects are not analysed.
  • At times, when levering and unlevering the Beta to arrive at the estimate, incorrect formulae are used. The levering should depend on the amount of debt prospect of the company in future.

5. HIGH COST OF EQUITY

  • Along with Beta, another problem that arises in deriving the Cost of Equity is the Risk free Rate.
  • Majority of the times the Risk free rate considered is just the 10 year Government Bond Yield.
  • What one fails to consider in this is the Country Risk. If this view is taken into consideration, the Cost of Equity of a company in United States would be same as that of a company in Bolovia, which is highly incorrect.
  • Thus, the Country Risk Premium needs to be deducted to arrive at an accurate Risk Free Rate.

6. INCORRECT DISCOUNT RATES

  • It is a wrong notion to consider a higher discount rate when there are higher risk cash flows, on the basis that the discount rate on cash flows should reflect the riskiness.
  • Generally Book Values of Debt and Equity for arriving at the Weighted Average Cost of Capital (WACC). But this violates the Basic Principle of Valuation which is to arrive at a Fair Value
  • Thus, when valuing an on-going business, the market values of debt and equity should be taken into consideration to derive the WACC.

7. HIGH LONG TERM GROWTH RATE

  • There is a Material Impact created on the value of a company when a long term growth rate is used.
  • This is considered when arriving at the Terminal Value. The Terminal Value is the Present Value of all the Cash Flows at a future point in time, when the cash flows are expected to be at a stable growth rate.
  • These Long Term growth rates generally lie in the range of 5% to 6%.
  • They depend on the growth rate of the economy and never exceed that figure. This is because, a higher growth rate than the GDP rate of the economy would imply that the company would grow larger than the economy. Applying such a high rate would result in overvaluation.

II ASSET BASED APPROACH

  • Under this approach, the value of a business is derived as a sum of its parts. This method takes into account all the assets and liabilities of the Business.
  • The Value of the Business is the difference between value of all relevant assets of the business and value of all the relevant liabilities.

III MARKET APPROACH

  • This approach is used to derive the appraisal value of the business, intangible asset, security or business ownership interest by considering market prices of comparables which have been sold recently or are still available.
  • There are two main Valuation Methods under this approach-
    1. Comparable Companies Method – This method entails the use of valuation multiples of companies which are traded publically.
    2. Comparable Transactions Method – This method entails the use of valuation figures of observed transactions of companies in the same industry as that of the Target Company.
  • Certain common multiples considered for Relative Valuation are – P/E Ratio, PEG Ratio, EV/Sales, EV/EBITDA, EV/ Sales.

ISSUES THAT ARISE WHEN CONDUCTING VALUATION USING MARKET APPROACH:

1. INCORRECT PEER SELECTION

  • The industries in a market are often loosely defined. Making is difficult to select optimum peers to conduct Comparable Company Analysis.
  • Some of the major factors to be considered while selecting peers are product line, geography, seasonality, revenue, etc.
  • Another way to identify peers it to check the annual report of the companies, in case the company is a listed one, where the peers would be mentioned.
  • The same could apply for a Comparable Transaction Analysis. Where Multiples of an extra ordinary Transaction are considered for conducting Valuation.

2. INCORRECT MULTIPLES

  • There are a number of Multiples available to value the worth of a business. Each of these Multiples relate to a specific extent of the financial performance to the potential selling price of the business.
  • If a multiple is based on the Net Cash Flow, it should not be applied to the Net Profit.
  • For valuing new companies, which have small sale and negative profits, using multiples such as Price-to-Sales or Enterprise Value to EBITDA Multiples can be misleading. In such cases, Non-Financial Multiples can be helpful.
  • Certain common multiples considered for Relative Valuation are – P/E Ratio, PEG Ratio, EV/Sales, EV/EBITDA, EV/ Sales.

3. NOT ADJUSTING THE ENTERPRISE VALUE TO EBITDA MULTIPLE FOR NON-OPERATING ITEMS

  • The Enterprise Value should not include excess cash. Also the Non-Operating Assets must be evaluated separately.
  • Operating leases must be considered in the Enterprise Value, the interests costs associated to such operating leases must also be added back to the EBITDA Value.
  • This is because though the Value of Lease and the Interest Cost of the lease, affect the ratio in the same direction, the effect is not of the same magnitude.

4. TAKING AVERAGE INSTEAD OF MEDIAN

  • While conducting Relative Valuation, it is a common practice to consider the Average value of the PEER’s multiples instead of Median value.
  • The middle element of the data is the Median Value. Taking Median Value enables the extremely high or low values to be disregarded.

5. USING RELATIVE VALUATION AS PRIMARY VALUATION METHODOLOGY

  • Valuation should not be derived by depending on just one methodology, especially just Relative Valuation. Relative Valuation is a considerably good method to validate the value derived from other Valuation Methods.
  • One issue of relying on Relative Valuation is that getting data of a privately owned business is difficult. Also the shares of a public company are more liquid than that of a private company.

CERTAIN OTHER COMMON ISSUES THAT ARISE WHEN CONDUCTING VALUATION:

1. CONSIDERING VALUATION IS A SCIENTIFIC FACT

  • Most of the times it is asserted that Valuation is a Scientific Fact rather than an Opinion.
  • A logical process is followed to reach a Valuation Figure or Opinion, thus there is the role of Science.
  • But what is forgotten is that the Value arrived at from any Valuation Method, is contingent to a set of assumptions and expectations. These expectations include future prospects of the company, industry or even the country. Another thing which is factored in is the Valuer’s appraisal of Company Risk.
  • Hence, valuation is more of an Art than a Science.

2. ASSUMING THAT EVERY ESTABLISHED BUSINESS HAS A POSITIVE GOODWILL

  • Business Goodwill is actually directly related to the earning power of the business.
  • If the Business earnings fall below the return on assets, then the business has a negative goodwill.

3. FAILING TO ASSESS COMPANY SPECIFIC RISK

  • When conducting Business Valuation, risk assessment plays a very important role.
  • Each company has different financial and operational factors which contribute to its risk profile.
  • Thus, each company has different Discount and Capitalisation rates which need to be taken into consideration.

4. REDUNTANT ASSETS ARE NOT ADDED TO COMPANY VALUE

  • Redundant assets are those which are not required for the day to day operations of the business. The value of such assets should be added to the value of the business or company.

5. THINKING THAT THE BUSINESS PURCHASE PRICE AND PROJECT COST ARE THE SAME

  • Many a times the project cost is considered to be the same as the purchase price. But that is not correct.
  • In order to arrive at the Purchase price s=certain adjustments need to be made to the project cost.
  • One such adjustment is that the buyer of the business also needs to inject certain working capital.
  • If there is any deferred equipment, its maintenance cost also needs to be adjusted.
  • There are certain investments which are needed to maintain the income stream such as hiring staff replacements, licences, regulatory compliances, etc. Such costs also need to be adjusted.

The method which has the capability to incorporate all the significant factors which have a material effect on the Fair Value is the Most Appropriate Method of Valuation.

Furthermore, one must keep in mind the above issues which can arise while deriving Valuation for a Business, Stock or Company in order to avoid any misleading valuation figures.

Author
Vhabiz Lala
Volunteer – Equity Research & Valuation (M.Sc. Finance, NMIMS – Mumbai. Batch 2018-20)

Connect with Vhahbiz on LinkedIn

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Podcast 101- Valuation of Tech Companies

In Finvert’s first official podcast, Isha Khuteta – a member of Alternative Investments is joined by Mr. Ashish Rane – Senior Manager and team lead of Valuations and Advisory vertical at Aranca, a Global Research and Analytics Firm. Ashish has over 9 years of industry experience, wherein he has worked with the biggest names in the industry. Together, they discuss the valuation of technology companies and to what extent is it justified. During the discussion, Ashish gives us some insights into what factors need to be considered while valuing a technology firm and much more.

Illuminating the dark side of valuation using a Vanilla LSTM Recurrent Neural Network

One of the major problems faced by investors is to try and distinguish between “Price” and “value”, This problem arises because there are several behavioral biases as well as unethical practices that play a role while doing valuation. Sometimes, the valuation company is given a figure by their client and they do a backward calculation to keep up the pretense. The root cause for there even being a “Dark Side” of valuation is that in the DCF model, we make projected cash flows; These, projected cash flows are based on assumptions made by the valuation company. Now, based on their assumptions the valuation company could grow the cash flows at 100% or 1%, it’s perfectly acceptable as long as they have a story to back them up. Due to this ambiguity in projections, the valuation company provides their client with any valuation they want.

In this article, I have solved this problem by implementing an Artificial Recurrent Neural Network (Vanilla LSTM) to predict future cash flows. This gives us an unbiased prediction and takes away the ambiguity from a valuation that caused “The Dark Side”. The Artificial Recurrent Neural Network is able to detect interrelationships between thousands of diverse market variables and therefore is the perfect analytical tool for the financial forecast. In this article, I have used the Vanilla LSTM to forecast cash flows and arrived at a valuation of Maruti Suzuki Ltd and avoided any biases that usually pay a role while valuating a company.

What is a Recurrent Neural Network?

Recurrent Neural Network is a type of Neural Network where the output of the previous step is fed as an input of the current step. Usually in neural networks (feed-forward), the outputs and inputs are independent; But, in situations where you must predict the next word of a sentence, the previous word is essential. Recurrent Neural Networks solved this issue using hidden layers. The hidden layer remembers some of the information about a sequence. A Recurrent Neural Network remembers all the information over a period. It is considered as a powerful tool because of its ability to remember previous inputs.  An RNN remembers each information through time. It is useful in time series prediction only because of the feature to remember previous inputs as well. This is called Long Short-Term Memory (LSTM). A Vanilla LSTM is an LSTM model that has only one hidden layer of LSTM units, and an output layer used to make a prediction.

  • For forecasting Time series data Via a Vanilla LSTM Recurrent Neural Network, we are taking 10 data points or historical data. These data points are nothing but Net cash flows we arrive at while doing FCFE. Therefore, we start with getting Income statement and Profit and loss from FY 2010 to FY 2019.
  • For each of these 10 years, we take the Profit after tax add the depreciation, Changes in Debt (Current year Debt – Previous years debt) and subtract the Capital expenditure and changes in working capital (Excluding cash). Using this, we arrive at Net Cash Flows of 10 years.
Source
  • These Net Cash Flows are used as Inputs for the Vanilla LSTM Recurrent Neural Network and are used to predict the future cash flows for the next 5 years. The code for this is written on Python by Dr. Jason Brownlee. Each time the neural network is used to predict the future net cash flows, it gives only one output (the net cash flow of the next year). This output is included in the input for the next year. This is how even though the neural network is capable of forecasting only 1 year, I have forecasted for the next 5 years. The Vanilla LSTM is as follows:
  • The terminal growth rate has been assumed at 10% because that is the rate at which the automobile sector is expected to grow as per Research Cosmo. However, to avoid any biases I have done a sensitivity analysis with terminal growth rates varying from 9% to 11%. To find the terminal value we increase the Net Cash flow value of the 5th year by the terminal growth rate and divide this by the difference between the Cost of Equity (Ke) and the terminal Growth rate.
  • These discounted cash flows are added to arrive at Equity Value of the company. This equity value is divided to arrive at Expected market price of the company.

Conclusion

The objective of this article was to remove the assumptions made while valuation because these assumptions create a window for ambiguity which can be used to unethically inflate the valuation of the company. In this article no assumptions were made except the terminal growth rate (taken from a Research Cosmo Report). To tackle this, I have done a sensitivity analysis with terminal growth rates varying from 9% to 11%. Using this new model, we got a valuation at 10% terminal growth rate of Rs 8,417.22. Therefore, using the method I suggested in this article, you can find the “Value” of the company and not “price”. This way you save up on the money you would have paid the valuation company and also get a unbiased valuation.

Author
Neil Jha
Team Leader – Fintech
(M.Sc. Finance, NMIMS – Mumbai. Batch 2018-20)

Connect with Neil on LinkedIn

In relation to SBI Merger, are fewer and bigger PSU banks better?

INTRODUCTION

Public Sector Banks (PSBs) are banks where a government holds a majority stake i.e. more than 50%. Currently, there are 27 public sector banks in India. Out of these, 21 banks are nationalized and 6 banks are of State Bank Group (SBI and its 5 Associates) and the shares of these are listed on the stock exchanges. In India, out of the total banking industry, the Public sector banks constitute 72.9% share while private players cover the rest. However, PSBs seem to be losing their market share on account of the huge Non-Performing Assets. Banking industry is undergoing unprecedented changes driven by consolidation by means of mergers and acquisitions all over the world. In recent years, banking industry of India has witnessed a transformation as it was working in highly regulated environment before.

L= Listed; UL= Unlisted

OBJECTIVE

The objectives of the study are:

  1. To analyze the impact on share prices of the company during pre and post-announcement period of the merger.
  2. To see the resulting change in the value of the company after the merger.
  3. To study the synergy effects of the merger
  4. To analyze whether the mergers add value to the Indian Banking System in general and Public Sector in particular.

ANALYSIS

VALUATION OF BANK

As on March 31, 2017, the firm was undervalued even after the merger and increase in share prices. The rise in the share price was not huge and keeping the stock of SBI as undervalued.

We have use FCFE method in calculation the value of Firm.

Assumptions-

  • The company is expected to grow at a high growth rate for 3 years. (SBI sees profit boost in 3 years after merger).
  • Growth rate of the firm is constant at 4.794%; it is calculated by growth in deposits of banking sector deposits.

Free Cash Flow To Equity= Profit After Tax – Capital Expenditure – Increase in working Capital + Debt Raised – Debt Repaid + Non Cash Expense

Before merger to calculate FCFE the sum of SBI with all the associates and BMB have been taken before merger so as to reduce the impact of errors.

Capital Asset Pricing Model (CAPM)

CAPM= Risk free Rate of Return +Beta (Market Return – Risk free Rate of Return)

Here, we have take 10 years monthly average of the Government of India Bond return for % years, which comes out to be 7.91%. (Annexure 1)Sensex average monthly return for 5 years comes out to be 11.889% (Annexure 1) and Beta of SBI is 1.3871 (Capitaline)

CAPM= 7.91%+ 1.3871 (11.889%-7.91%)

=13.429%

It is assumed that CAPM is the Present Value Factor and cost of equity of the firm.

DISCOUNTING OF FCFE

TERMINAL VALUE

Terminal value =

= 345049.4575

PV of Terminal Value = 345049.4575 X 0.60= 208442.968

Value of Firm = 284733.8107

MARKET VALUE

For market value of the firm we have taken the data as on March 31, 2017, the closing price of SBI and the number of total outstanding shares on that date.

UNDERVALUED

Value of firm – Market value  = 284733.8107 – 233862.8853

= 50870.9254

SWAP RATIO CALCULATION

The company came out with Swap Ratio by analyzing three-weighted method in finding out the true value of its associates and making it a fair deal.

Three methods, which are, used are-

  • Market price method- It refer for determining the price of the similar items for determining the value of an asset. It is a business valuation method for determining the value of the business ownership. The weightage that was given to this method at the time of merger was 45%.
  • Completed Contract Method (CCM)- In this method, it enables the businesses to postpone their reporting of income and expenses until the contract is completed. This method can either under estimate the profit or over estimate it as there are contracts, which are not being accounted for till they are completed. The weightage given to this method is 45%.
  • NAV Method- This method focuses on the NAV of its total assets minus total liabilities divided by number of outstanding shares of the firm. This method was given a weightage of 10%.

The valuation of the company is done on the market value of firm as on 17 March 2017. The company came out with the Exchange rate of 2.8:1 for SBBJ, 2.2:1 in case of SBM and SBT. There was no Swap ratio for SBP and SBH as they were fully owned subsidiary of SBI and 4,42, 31,510 shares for every 100 crores shares of BMB.

(SES Governance)

CHANGES AFTER THE MERGER

Fixed Assets

The fixed assets of SBI went up to Rs. 51,884.15 crores post the merger from Rs.16,200.90 crores pre-merger as all the fixed assets of the associate banks merged with that of SBI converting it into a larger public-sector undertaking in terms of assets. The major increase in fixed assets was because of increase in Premises of SBI from Rs. 6,505.14 crores to Rs. 42,107.57 crores. After the merger, SBI joined the club of top 50 banks globally in terms of size of assets. The number of branches increased to around 24,017 and ATMs managed by SBI was nearly 59,263 across the country. This will increase the area managed and covered by the bank directly rather through its associates with a wide range of products at lower costs.

Net Profit and NPA’s

The net profit of SBI pre-merger was reported to be around Rs. 12,743.39 crores which was converted to a net loss of Rs. 390.67 crores post the merger due to integration of non-performing assets of SBI with all its associate banks. The NPA’s were reported to be at Rs. 57,155.07 crores compared to Rs. 38,024.06 before the merger. NPA’s of SBI increased by almost Rs. 19,131 crores which resulted in a great loss to SBI.

Out of all the associate banks, SBP had the largest amount of NPA’s of Rs. 2,924.03 crores and a net loss of Rs. 972.4 crores before the merger. While SBH reported the highest net profit of Rs. 1,064.92 crores with negligible NPA’s among all the associate banks. However, the loss incurred is of short-term nature and gradually with time, SBI will again start reporting profits as a result of economies of scale and reduction in costs of doing business.

VOLATILITY IN SHARES

On the date of the merger, markets were bullish on SBI and its associate as SBBJ shares price rose by 20% for two consecutive days hitting the circuit on both days. SBM’s share prices also rose by 20% after the announcement of merger following a growth of 15.74% on the next day. In fact, SBT’s share too rose by 20% after the announcement of merger and further by 15% on the following day. SBI owns a market share of 23.07% in deposits and 21.16% in advances as opposed to 18.05% and 17.02% in deposits and advances respectively.

The combined bank now caters to around 42 crore customers. There exists a large scale of inefficiency among smaller banks which when merged into a larger bank would make it more efficient in carrying its operations.

POST MERGER

Post-merger, the total customer base of the bank has reached 37 crores with a branch network of around 24,000 and nearly 59,000 ATMs across the country. The employees’ strength of SBI has increased to a total of 2,71,765. All the customers and employees of SBI associate banks have become the customers and employees of SBI. So, all the employees are now eligible for the same retirement benefits as the SBI employees. That means, the SBI employees get three retirement benefits i.e. provident fund, gratuity and pension and the associate bank staff members get two retirement benefits.

The merged SBI Bank now has a deposit base of more than Rs 26 lakh-crore and advances level of Rs 18.50 lakh crore. The board of SBI approved the merger plan under which SBBJ shareholders would get 28 shares of SBI for every 10 shares held. For both, SBM and SBT shareholders would get 22 shares of SBI for every 10 shares. However, separate schemes of acquisition for State Bank of Patiala and State Bank of Hyderabad were approved by SBI. Since they are wholly owned by the SBI, there will not be any share swap or cash outgo and for BMB, SBI’s 4,42, 31,510 shares for every 100 crores shares of BMB

Author
Apoorva Goenka
Team Leader- Equity Research & Valuation
(MSc Finance, NMIMS Mumbai. Batch 2018-20)

Connect with Apoorva on LinkedIn