1. Application of Valuation Approaches
(With Emphasis on Distressed and Declining companies)
Latha S Chari
Professor, NISM
id :

2. Agenda Basic concepts related to valuation
Sources of value – Valuation methods and approaches
Tying up Balance sheet with Enterprise value
Excel examples of general case valuation and check your understanding questions
Company life cycle and valuation tussle
Characteristics of distressed companies
Challenges to valuation of distressed companies

3. Basic concepts Price Vs. Value Market value Vs. Book Value
Trading value Vs. Transaction Value
Value of the firm Vs. Value of equity =
Value of the operational business i.e Enterprise Value
Value of debt (less cash) ie Bondholder value
Value of Equity
(Shareholder value)
Enterprise value is the market value of net operational assets which must equal the market value of net funding THUS :
EV = Market value of Equity + Market value of Debt - Cash

4. Sources of value - Valuation models
Sources of Value – Revenue, Earnings, Assets, Intangibles
We will look at the following approaches to valuing common shares
Net Asset value method – (Assets)
Dividend Discount Models (Net Earnings to shareholders)
Free Cash Flow Valuation (DCF) - (Earnings)
Comparable Valuation Ratios (Multiples Valuation) – (All)

5. Approaches to Valuation
Income Approach -- DDM, DCF, Earnings capitalization method
Market Approach – Relative valuation, Price multiples, Value multiples
Cost Approach – Book value, Replacement value, Liquidation of “Assets” value

6. Enterprise value Vs. Balance sheet
Cash +
Cash equivalents +
Non controlled Investments +
Non-core assets +
Enterprise value (net operating assets)
Debt (MV)
Preference Shares
Minority interest (MV –PE) -
Financial
Investments, Invt in associates, JV and other financial securities =
Eg: Land
banks
Ordinary Equity value

7. Multiple based method
Based on linking VALUE with its VALUE DRIVERS ie earnings with value
Value drivers
Interest
income
Debt
Interest
expense
Cash
Equity
Net
income
EBIT
EBITDA
Revenue
Enterprise value
Valuation

8. Excel Examples Dividend Discount models Discounted Cash flow models
Price multiplier model
Comparable company models

9. Critique of the models
DDM – Zero dividend paying companies, tends to undervalue companies in growth stage – as they may retain more and pay less dividends.
DCF – Highly sensitive to capital cost and growth rates. Cash flow estimates are difficult to predict in the long run. Model assumptions – perpetuity and steady state – Does not match with what the CEO’s would like to do.
Relative valuation – based on fundamentals – tends to overvalue during booms and undervalue during bursts
Relative valuation – based on comparables – difficult to find comparable companies in practice, circular referencing issue

10. Check your understanding
The Gorden growth model can be used to valuue dividend paying companies that are:
Expected to grow very fast
In a mature phase of growth
Very sensitive to business cycles
ANS - b

11. Check your understanding
The primary difference between PE multiple based on fundamentals and PE based on comparables is that fundamental based PE takes into account:
Future expectations
The law of one price
Historical information
ANS - a

12. Check your understanding
Asset based valuation methods are best suitable for companies where the capital structure does not have a high proportion of :
Debt
Intangible assets
Current assets and liabilities
ANS - b

13. Check your understanding
Which of the following is most likely weakness of present value models?
Present value models cannot be used for companies that do not pay dividends
Small changes in model assumptions and inputs can result in large changes in computed intrinsic value
The value of security depends on the investor holding period and comparing valuations for different investors with different holding periods is difficult
ANS - b

14. Check your understanding
Analyst has determined that the appropriate EV/EBITDA for Jaiprakash industries is The following are the forecasted numbers for company:
EBITDA –
Market value of debt –
Cash –
Value of Jaiprakash industries is closest to :
169 million
224 million
281 million
ANS - a

15. Company life cycle Vs. Valuation
Early stage companies – Cost and revenue structure not established, may not survive and grow into mature companies
Growth stage companies – estimating growth rates, building for inorganic growth
Mature companies – Relatively easier as they are more stable w.r.t. Revenue, cost structure, capital required
Declining companies or distressed companies – Valuation methods assume going concern and ignore the likelihood of liquidation/distress. DCF and Relative valuation or comparable valuations methods all suffer from this. All valuers are generally optimistic

16. Difference between Mature stage and Declining stage
Mature stage Declining stage Balance sheet Assets in place - Contribute to total value All value/ divestment Growth assets – Minimum/No value Negative value Liabilities - adequate leverage More leveraged - able to service debt falling coverage ratios Revenue - growth rate falling Revenue falling

17. Common Characteristics of declining companies
Falling revenue and inability to reverse the fall in revenue over considerable period of time, generally accompanied by sector not doing well
Fall in margins or negative margins – lose pricing power and keep reducing price to maintain overall revenue resulting in lower margins
Asset sale – as assets are worth more if sold rather than use
Financial leverage – negative impact. Cost of borrowing > ROCE. Unable to refinance the debt since lenders will demand more stringent terms.

18. Valuation challenges – implications to DCF
Assets earn less than cost of capital – value destroying preposition
Impact of asset sale/divestiture – impact on revenue and profits is hard to determine. Proceeds of asset sale may show better value in the short run
New capex to earn less than the cost of capital thereby eroding value. Reinvestment also erodes value.
Cost of capital calculation – Affected by huge dividends/buybacks. If debt is also not proportionately reduced, then cost of debt and equity are both affected as leverage ratio increase.
Tax advantage of debt disappears when EBIT < Interest.
Consequently cost of equity should also increase but the historical betas will reflect changes in equity risk on lagged basis and hence cost of equity may be < Cost of debt (pretax)

19. Valuation challenges – implications to DCF (2)
Terminal value calculation – The company may not function as a going concern. May go into liquidation which is hard to reflect in terminal value of the firm Growth rates may be negative and the company may perpetually earn less than cost of capital High cost of capital may cause terminal value to fall and implode

20. Valuation challenges – implications to DCF (3)
Enterprise value to Equity value calculation: Equity value = Enterprise value – Net debt Market value of debt of distressed firms < book value of debt. Artificially inflate value of equity. EG – Value of operating assets is 800, book value of debt is 1000 but market value of debt is 500. Value of equity is 300 (inflated) Once a healthy acquirer comes in the value of debt may increase back ... Say 800 etc. Further in a distressed company lenders may choose to convert debt to equity, take stakes as equity options. Equity options have to be valued and netted out from overall value of equity - Complex

21. Valuation challenges – implications to Relative valn
Sources of value – revenue, earnings, book value are all falling. Earnings may be negative and hence of no value. Using revenue multiple leads to the assumption that the firm will be able to turn around its operations which may not be true. Comparable firms – Compare with healthy firms – working out the discount is difficult Compare with distressed firms – difference in distress levels contributing to changes in value are difficult to capture

22. Conclusions
The falling revenue, increasing debt and inability to service debt, negative growth rates, poor margins, the potential for failure all contribute to distorting valuations in multiple ways. The problems cannot be solved by simply changing the value drivers/using revenue multiple.
Frame work for dealing with distressed company’s valuation – Next session
Thank you