Vajira Kulatilaka Chief Executive Officer NDB Investment Banking Cluster September 4, 2010 Investor Expectations of Board Room Governance and its Impact on Company Valuations

Agenda oBoard Room Governance oLegal and Regulatory Requirements oWhat is Valuation? oSome Valuation Methodologies oHow Governance Related Issues Affect Valuations oSome Cases in Sri Lanka – Empirical Evidence oConclusion Agenda

Board Room Governance Board Room Governance is a set of mechanisms to make sure the Board of Directors maximizes shareholder value, and avoid moral hazards Moral hazards – actions by the Board that benefit itself or the shareholders they represent but destroy other investors’ value “heads I win, tails you lose” Corporate Governance deals with how the capital supplier assures the corporate will pay them reasonable return Intuitively it should affect valuation

Legal and Regulatory Requirements In Sri Lanka, regulatory or external controls to fetter Board indiscretion exist in the form of the CSE Listing Rules, the Companies Act and regulations made under the Banking Act CSE minimum requirements as per Section 7.10 of the CSE Listing Rules –Non-Executive Directors – higher of 2 or 1/3 of board of Directors –Independent Directors: to inject objectivity regarding company policy and direction – higher of 2 or 1/3 of Non-Executive directors –Disclosures relating to Directors –Appointment of Audit and Remuneration Committees

Additional corporate governance requirements and stipulations in the Companies Act and Banking Act Other investor expectations –Dividend Policy –Internal Compliance –Investor Relations / Minority Shareholder Relations –Inter Company Transactions Culture of the entity is very important for ethics and governance Legal and Regulatory Requirements

What is Valuation? The determination of the intrinsic economic value of an asset or liability Company or a firm it is the determination of its potential market value It is the modeling of the mind of an investor What is Valuation?

Valuation Methodologies Methods to be used in Valuing a Firm Discounted Cash Flow Method –Free Cash Flow –Dividend Discount Net Assets Value Method Multiples Based Methods –Price-Earnings (PE) –Price-Book Value (PBV) –Enterprise Value/EBITDA Some Valuation Methodologies

Discounted Free Cash Flow Free Cash Flows for the forecast period, determined based on the future business plans of the firm The business value attributable to the equity holders of the company consists of the present value of forecast Free Cash Flows available to the providers of equity 1 The intrinsic value = value from 1 + non-operational assets Discounted Free Cash Flow

FCF based Valuations P 0 = Σ FCF 1 + FCF 2 + … + FCF n + ∞ (1+r) (1+r) 2 (1+r) n CF 1 … CF n is determined through a forecast r P 0 FCF P 0 Risk Free Rate ( r f ) –Equity Risk –Liquidity Risk –Governance Risk r = r f + Discounted Free Cash Flow

Net Asset Value The Net Assets Value (NAV) Method indicates the value of the equity shares appearing in the balance sheet of the entity. Net Assets Value per Share = Net Assets of the Entity No. of Shares in Issue May not be suitable for a “going concern” and for valuing minority holdings Net Assets Value

Price Earnings The ratio of a firm’s price per share compared to its Earnings Per Share Price Earnings Ratio = Price Per Share Earnings Per Share (EPS) What the Firm is worth per rupee of earnings Price-Earnings Ratio

Price Earnings Intrinsic Value P = K EPS P = EPS x K K is determined through similar companies in the stock market adjusted for - growth potential - liquidity risk - governance risk Price-Earnings Ratio

Price Earnings Enterprise Value (EV) = market capitalisation + debt + minority interest + preference shares – (cash + cash equivalents) EBITDA is a firm’s earnings before interest, tax, depreciation and amoritisation. An EV/EBITDA multiple valuation may be preferred due to it being unaffected by a firm’s capital structure Enterprise Value/EBITDA

Price Earnings EV = K 1 EBITDA EV = EBITDA x K 1 K 1 will be influenced by governance risk Enterprise Value/EBITDA

How Governance Affects Known Governance Issues –In valuing a firm known governance issues may get reflected in the form of reduced free cash flows, EPS, EBITDA. Unknown Governance Issue –Unknown governance will be reflected in the discount rate in valuing a firm Attitudes of Board and Management –Entrenched bad governance practices of a firm may affect the value of a firm both ways How Governance Related Issues Affect Valuations

G Board Composition –Investor confidence in the competence and independence of the board of directors will affect a firm’s valuation Related Party Transactions Company Structure –Too many holding companies Investments made to just enhance the group size –Investments just for diversifications How Governance Related Issues Affect Valuations Some Examples

Some Cases in Sri Lanka Management Fees –The reduced P/E of companies where management fees are still in place. Lavish Spending by Senior Management Dividend policy –Inconsistent dividend policy, or one which furthers management’s own goals rather than returns to the investors Issues related to the Non-Voting shares How Governance Related Issues Affect Valuations Some Examples Image Matters: extra effort has to be put in to create a positive image

Empirical Evidence Sector Y PER Company A Company B Empirical Evidence

Sector Z Empirical Evidence Share Price Company AVoting Non-Voting Discount72%75%79%57% Company BVoting Non-Voting Discount53%49%28%34% Company CVoting Non-Voting Discount55%57%54%38%

Empirical Evidence Boardroom Governance is a crucial component of the operations of a firm There is value to be gained by a firm through good governance practices and conversely value to be lost through bad governance practices Empirical evidence, as indicated above supports this Conclusion You have to not only be compliant, but also be perceived to be compliant

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