VALUATION APPROACHES

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VALUATION APPROACHES

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Valuations....drive the markets!!!
BSE Sensex
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Prologue

• In the financial services world, Valuations are
  used for various purposes
• For valuing the shares of a company
• In Mergers Acquisitions
• In evaluation of new projects
• However, the the basic principle of Valuations
  remain the same
• What is the Potential of the business?
• The word Potential refers to the future and
  thus most of the valuation approaches are about
  estimating the future and converting it into hard
  numbers
• So it is not just financial concepts but ability
  to project and estimate the future potential
• Discounted Cash Flow is the most robust
  methodology for valuations
• This Valuation is then benchmarked against
  various proxies
• Trading Comparables
• Transaction Comparables

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Valuation Methodologies

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Valuation Methodologies
Value Range
Sum of parts/ Asset Valuation
Comparable Companies Analysis
Comparable Acquisitions Analysis
Discounted Cash Flow Analysis

• Trading valuation
• Value based on market trading multiples of
  comparable companies

• Acquisition valuation
• Value based on multiples paid for comparable
  companies in sale transactions

• Liquidation or break-up analysis assets
  presumed to be representative of business value
• Value of component parts used when enterprise
  comprises of several discrete businesses

• Inherent value of business
• Present value of projected free cash flows

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Enterprise Value v/s Equity Value
Enterprise Value Value of all the assets of a
business Equity Value Value of the
shareholders equity Equity Value Enterprise
Value - Net Debt (1)
Net Debt
Enterprise Value
Equity Value (or Market Value)

• Unaffected by leverage
• Multiples of
• Sales
• EBITDA
• EBIT
• Size (such as capacity or number of users)

• A function of leverage
• Multiples of
• Net Income (Earnings)
• After Tax Cash Flow
• Book Value

(1) Net Debt equals Total Long-Term Debt
Preferred Stock Capitalized Leases Short-Term
Debt (other than working capital debt) - Cash and
Cash Equivalents
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A DCF valuation has three main components

• Credible forecasts for the explicit period
• Typically the horizon reflects the time in which
  steady state of business is achieved
• Revenue, cost and capex forecasts used to derive
  the unlevered free cash flows to the company
• These forecasts are validated through an
  understanding of industry, performance trends and
  outlook
• Estimation of discount rate
• Discounting of future cash flows to make them
  equivalent to present value
• Discount rate is typically the cost of capital of
  target companies with profiles comparable to the
  target essentially it should reflect the
  Opportunity Cost of Capital
• Terminal value
• Terminal value comprises of value of the cash
  flows beyond the explicit forecast period
  extending upto perpetuity
• Captures value of the business that grows at a
  steady state growth rate

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Unlevered Free Cash Flow

• Unlevered free cash flow is the conceptual cash
  flow available for distribution to all capital
  providers
• Tax shield effect of interest removed from cash
  flows to estimate unlevered free cash flows
• Unlevered Free Cash Flow After tax EBITDA -
  Capital Expenditures - Increase In Non-Cash
  Working Capital
• EBITDA EBIT Amortization Depreciation
  Earnings before Depreciation, Interest, Taxes and
  Amortization
• Non-Cash Working Capital Non-Cash Current
  Assets - Non-Debt Current Liabilities

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Principles of computation of Discount Rate

• Weighted Average Cost of Capital or WACC used to
  discount free cash flows in order to estimate the
  present value of an enterprise
• Defined as the weighted average sum of the cost
  of financing the enterprise, mainly through
  equity and debt
• Cost of equity and cost of debt are weighted by
  the respective contributions of equity and debt
  in the steady state of business operations - to
  remove the effect of different financial
  structures in different companies

• WACC
• Where E Market Value of equity D Market
  Value of debt (typically approximate with
  book value but be careful) re return on equity
  derived from CAPM rd after tax return on debt
  (assumed to be weighted average cost of debt)
• CAPM assumes consistent, long-term target capital
  structure (D/E ratio)
• Leveraged financing in maturing markets points to
  a Debt/Equity ratio of 30/70

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Computation of WACC ingredients
Cost of Equity
Cost of Debt

• Cost of Debt is the opportunity cost of lending,
  net of tax shield derived through leveraging
• Cost of debt assumed at the prevailing long term
  lending rates for similar companies
• Cost of debt rd Y (I - T)
• Where rd after tax-cost of long term debt
  (after tax)Y gross redemption yield on debtT
  effective marginal tax rate

• Cost of equity represents the return expectations
  of equity shareholders from investment of
  comparable risk
• Computed by adding a market risk premium weighted
  by comparable asset risk over the risk free
  return on a long term security
• Cost of equity re rf B (rm - rf)
• Where re the required future market return on
  the equity of the Company rf the risk free
  rate rm the return on the market (factoring
  in the country risk also)
• B the beta of the Company

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Estimating the Terminal Value

• Two basic methods used for computation of
  terminal value
• Exit multiple basis (usually multiple of EBITDA
  average of market related multiples )
• Perpetuity basis assumes that the free cash flows
  of the business would grow to perpetuity at a
  marginal steady rate
• Both methods should produce similar results as
  EBITDA multiple should capture the perpetuity
  growth in value
• May differ on account of trading liquidity/
  speculative forces/ market risk/ differential
  information availability
• Terminal value cash flow should also truly
  reflect a steady state
• The later years in the explicit forecasts should
  have reached a constant state of growth in cash
  flows
• capex/ROCE assumptions in the terminal year cash
  flows should be realistic
• Any non steady state assumptions used to derive
  the terminal year cash flow must be removed e.g.
  the tax impact of any accumulated losses

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Free Cash Flows A Sample
Steady state CF growth
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Analysis of Publicly-Traded Comparable Companies

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Selection Criteria for Comparable Companies
Primary Criteria
Secondary Criteria

• Business
• Industry
• Products
• Distribution Channels
• Customers
• Seasonality
• Cyclicality
• End Markets
• Size
• Growth History and Growth Prospects

• Margins / Operating Track Record
• Location / Geographic Focus
• Ownership Profile / Liquidity
• Leverage / Capital Structure
• Dividend Yield / Payout

• Having determined a set of sample companies,
  multiples on parameters such as earnings, EBITDA
  and book value are computed
• The average multiple for each parameter
  considered is applied to the respective results
  of the target company to arrive at a range of
  valuation

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Analysis of Comparable Acquisition Transactions

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Objectives of Comparisons of Acquisition
Transactions

• Measure private market value
• Often a result of a combination of factors
• Competitive bidding tension
• Strategic value available specific to
  individual buyers
• Relative strength of target and buyer determined
  mainly by
• Market position
• Financial strength
• Transactions may be structured as full auction,
  limited auction or bilateral negotiation
• Privatisation transactions typically fall under
  full/ limited auctions
• Methodology determined by
• Need for transparency
• Need for confidentiality
• Universe of buyers
• Complexity of transaction structuring
• Enterprise Value may reflect not just the value
  of the target but also synergistic benefits
  available to buyer through other transaction
  agreements such as brand rights, distribution
  sharing, non-compete etc.

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Computation of multiples from Acquisition
Comparables

• Multiples to be computed based on financials
  available at the time of the transaction
• Shares Outstanding for acquisition comparables
  consists of the fully diluted shares
• shares outstanding (as of the latest financials
  available) plus
• shares pursuant to convertible securities (if
  in-the-money)
• Offer Price Per Share price per share offered
  by the acquiror. In the case of an offer that
  includes stock, acquirors stock price one day
  prior to the announcement times the exchange
  ratio should be used
• Offer Value offer price per share x shares
  outstanding
• Enterprise Value offer value non-convertible
  debt non-convertible preferred minority
  interest - cash marketable securities

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Sample Valuation Summary using the methods
illustrated above
(US million)
655
650
625
630
500
465
460
355
335
260
EBITDA Multiple Method
EBITDA
PerpetualGrowthMethod
EBITDA
Subscribers
DCF
TradingMultiples
AcquisitionMultiples
Trading Multiples with 30 Assumed Premium
The various methodologies yield an indicative
valuation range between US 450 mn to US 550 mn
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Case Study Valuation of a Telecom Company
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Template used for a Telecom DCF valuation and
benchmarking
Revenue assumptions
Cost assumptions
All India population
Opex assumptions
Penetration of total population
Capex assumptions
Market shares
DCF
Post paid and pre-paid
WACC of 13
ARPU and MoUs
Perpetuity Growth
Projection Period of 11 years till FY 2016
Trading comparables
Transaction comparables

• Pure play listed mobile comparables not available
  in the Indian market
• Bharti closest benchmark

• Recently concluded transactions provide a
  framework of reference
• Transaction comparables can be distorted by
  strategic considerations
• Control premia and bidding environment need to be
  considered

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Estimation of All India Population and Wireless
Subscribers

• 1 Population and growth
• All India wireless penetration
• Gross additions churn
• 4 Pre-paid/post-paid split

Based on
Estimation of
Past trends and projections based on estimates
by Indian Census and research reports Published
industry research reports by Gartner, Morgan
Stanley, Citigroup, Merrill Lynch and Lazard
estimates Lazard estimates of fair share of gross
adds in the respective circles Past trends and
projections based on Lazard estimates and
Industry research
Top Down Approach
Three separate cases have been considered for the
purposes of valuation. In the Base Case all
India wireless penetration is assumed to reach
25 in FY 2016 with a CAGR of 17.8
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Key Assumption for ARPU and Key Costs
Key Assumptions For Estimating ARPU
Key Assumptions For Estimating Operating Costs

• Activation Fee per Gross Add is assumed to
  decline by 10 yoy
• Monthly Access/ Recharge Charge per Sub is
  assumed to decline by 5 yoy
• Outgoing Airtime rate is assumed to decline by
  5 in FY 2006.
• VAS is assumed to stabilise at 20 of voice
  revenues in FY 2011 metro VAS assumed higher -
  stabilises at 30
• Gross Outroaming is projected to stabilise at
  10 of voice revenues by FY 2009

• Interconnect Pass Through Charges is assumed at
  20 of gross revenue
• Network Operating Costs have been estimated at
  Rs 0.2 / min of usage
• License Fee have been estimated at 10, 8 6
  of net revenues for Metro, Circle A Circle B
  respectively
• Employee Costs Cost per employee is assumed to
  grow at 10 yoy
• Customer Acquisition Costs have been assumed at
  the FY 2005 levels of Rs 790 / postpaid gross add
  and Rs 187/ prepaid gross add
• Advertisement Costs have been increased to 7.0
  of net revenues in FY 2008 and thereafter remain
  constant during the projection period

Key Assumptions For Estimating Capex

• Incremental capex is estimated at 75 per
  incremental subscriber during the projection
  period
• Maintenance capex is estimated at 5 per opening
  subscriber during the projection period

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Key Outputs Subs and ARPU
Total All India Subscribers
Total Company Subscribers
Companys ARPU

• ARPU is projected to decline in line with
  industry trends
• Proportion of Prepaid subscribers is projected to
  increase to 86.4 in the terminal year

CAGR for the period FY 2005 FY 2016
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Benchmarking With Industry Estimates
CAGR

• Key outputs from the model have been benchmarked
  against research published by leading houses such
  as Gartner, Morgan Stanley, Citigroup Merrill
  Lynch
• The all India subscriber and penetration
  projections are lower than benchmarks

All India Subscribers
28.8
55.6
42.8
38.0
34.0
All India Wireless Penetration
Lazard 4 year CAGR, Gartner 4 year CAGR,
Morgan Stanley/Merrill Lynch 3 year CAGR,
Citigroup 2 year CAGR
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Benchmarking With Industry Estimates

• Overall ARPU in the Base Case is much lower
  than the comparables in the initial 2 years of
  the projection period and thereafter follow the
  market trend of steady de-growth
• ARPU in the model is assumed to reduce from Rs
  375 / sub in FY 2005 to Rs 282 / sub in the
  terminal year representing a CAGR of 2.6
• ARPU decline is on account of
• Decline in Activation Access fees by 10 and 5
  yoy
• Decrease in call charges
• Minutes of Usage(MoUs) are assumed to behave
  inversely with the call charges

All India ARPU
All India ARPU Growth
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ARPU Key Components of ARPU
ARPU
Breakup of ARPU
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Costs

• Network operation costs form the largest chunk of
  the costs accounting for 37 of the total costs
  in FY 2016
• Employee costs have been assumed to grow to 20
  of total costs from the 11 in FY 2005
• Advertisement and business promotions costs are
  projected to counteract increasing competition in
  all the operating circles
• Bad debts are projected to decrease as a
  proportion of total costs due to the increase in
  quality of postpaid subscribers

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Capex Assumptions Projections

• Key Assumptions
• Capex for incremental growth as well as
  maintenance of service quality/ enhancements have
  been estimated on comparable benchmarks
• Incremental capex is estimated at 75 per
  incremental subscriber in during the projection
  period
• Maintenance capex is estimated at 5 per opening
  subscriber during the projection period

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Projected Profit Loss Account
Projected PL for FY 2005 in the original
model. PBT includes other income of Rs 131 million
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Balance Sheet
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Cash Flow
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Free Cash Flows
Steady state CF growth
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Intrinsic Business Valuation for Base Case
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Valuation under Other Scenarios

• Valuation have been considered for two further
  scenarios - Pessimistic Optimistic
• Pessimistic Scenario
• Terminal year all India wireless penetration 20
  with a CAGR of wireless subscribers at 15.3 as
  compared to a penetration of 25 in the Base
  scenario
• Perpetuity growth rate assumed at 2 as compared
  to 3 in the Base Scenario
• Resultant all India market share in FY 2016 is
  11.5 as compared to 12.1 in the Base Scenario
• Optimistic Scenario
• Terminal year all India wireless penetration 30
  with a CAGR of 19.8
• Perpetuity growth rate assumed at 4
• Resultant all India market share in FY 2016 is
  12.8

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Transaction and Trading comparable valuations

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Benchmark Valuations in recent telecom
transactions
SingTels stake enhancement in Bharti
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Trading Comparables
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Benchmarking with Trading and Transaction Comps
Prices based on existing capital base
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In Summary ...

• Valuations are more about rigour in implementing
  the concepts than about concepts
• Every valuation is different
• Industry to industry
• Company to company
• Of a company at different times
• Though a thorough understanding of concepts is
  important to use them in different scenarios
• Different growth parameters how to use them?
• Tax issues
• Carry forward losses and their treatment
• Split period approaches
• Terminal Value impact
• A thorough understanding of the industry,
  company, environment around it is very important
• And lastly, an excellent hold over spreadsheet is
  critical
• Makes the difference between a good valuation and
  a not so good one

Thank You