Valuation of Company - Part II (1)

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Valuation of Company – Part II Mahesh Savanth Chartered Accountant

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Contents 2 Price Earnings – Market Approach Market Approach - Example DCF Approach DCF Approach - Example Discount Factor – Major Factor Recap of Steps / Issues in Valuation Discussion Cases

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Market Approach 3

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Market Approach - Example 4 Subject Company Information Database Co – a database software company 2009 revenue = $25 (million) 2009 earnings = $2.5 (million) Identified Comparable Companies Mkt Cap./Revenues Mkt Cap./Earnings Oracle 4.4x 19.1x Oracle 1 1.5x 13.8x Oracle 2 2.0x 32.1x Average 2.6x 21.7x Multiple Calculation 2.6 x $25M 21.7 x $2.5M Implied Value of Database Co $65.8 (million) $54.1 (million) Indicated Value of Database Co (65.8 + 54.1)/2 = $59.9 (million)

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DCF - Approach 5

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DCF Approach - Example 6 Subject Company Information Database Co - an database software company - Projected Available Cash Flow in 2002 = $2.7 (million) - Projected growth rate of Cash Flow over projection period = 75% Discounted Cash Flow Calculation 2002 2003 2004 2005 2006 Residual Available Cash Flow 2.70 4.73 8.27 14.47 25.32 26.59 PV Factor (10% Discount rate) 0.91 0.83 0.75 0.68 0.62 Present Value of Available Cash Flow 2.45 3.90 6.21 9.88 15.72 Sum of Present Value of Available Cash Flow $38.18 (million) Residual Year Free Cash Flow 26.59 Capitalization Rate 15% Gross Residual Value 177.27 Present Value Factor 0.62 Present Value of Residual Available Cash Flow $109.90 (million) Indicated Value of Database Co. 38.18 + 109.90 = $148.08 (million)

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Discount Rate – Major Factor 7 Different methodologies exist for setting the discount rate Discount rates are used to account for two main factors: Time value of money Risk associated with the investment In a stable business, discount rates can be computed as the WACC Discount Rate = Weighted Average Cost of Capital (WACC) = Average Cost of Debt & Equity Example: Company ABC has a capital structure of 10% debt & 90% equity. After Tax Cost of Debt = 12% Cost of Equity = 25% WACC = 10% x 12% + 90% x 25% = 23.7% In an emerging business, it may be more appropriate to consider the return an investor expects for the level of risk involved

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Steps in Valuation 8 Analyzing Historical Performance Forecast Future Performance Estimate the Cost of Capital Estimate the Cost of Equity Capital – CAPM model Calculating, Interpreting and Test the results

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Issues in Valuation 9 1. Find appropriate comparables Individual firm that is highly comparable to the target Industry average if appropriate 2. Adjust/normalize the data (income statement and balance sheet) for differences between target and comparator including: Accounting differences LIFO versus FIFO Accelerated versus straight-line depreciation Age of depreciable assets Pension liabilities, etc. Different capital structures 3. Calculate a variety of ratios for both the target and the comparator including: Price-earnings ratio (trailing) Value/EBITDA Price/Book Value Return on Equity 4. Obtain a range of justifiable values based on the ratios

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Discussion Questions 10 Case 1 During the early 1990s there was a noticeable increase in mergers and acquisitions between company's in different countries (termed as cross-border acquisitions). What factors could explain this increase? What special issues can arise in executing a cross-border acquisition and in ultimately meeting the objectives for a successful combinations?

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Discussion Questions 11 Case 2 Mr. Jain, CFO of the Ninth Public Bank, India comments “ We are fortunate to have a cost of capital of only 10 per cent. We want to leverage this advantage by acquiring other banks that have a higher cost of funds. I believe that we can add significant value to these banks by using our low cost financing. “ Do you agree with Mr. Jain’s analysis ? Why or Why not? Reasons ?

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Discussion Questions 12 Case 3 You have been hired by GS Investment Bank to work in the merger department. The analysis required for all potential acquisition includes an examination of the target for any off-balance sheet assets or liabilities that have to be factored into the valuation. Prepare a checklist?

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Discussion Questions 13 Case 4 A leading oil exploration company decides to acquire an Internet company at a 50% premium. The acquirer argues that this move creates value for its own stockholders because it can use its excess cash flows from oil business to help finance growth in the new Internet segment. Evaluate the economic merits of this claim?