corporate valuation cash flow method
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cash flowTRANSCRIPT
Ramesh LakshmanRamesh Lakshman and CompanyChartered Accountants58 B, Gurudev, R.C.Marg.,Chembur, Mumbai 400088Tel: +(91) (22) 25284588Email [email protected]
Quality is never an accident. It is always a result of intelligent effort
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Valuation Using Cash FlowDiscounting MethodsA structured Presentation forWIRC of ICAIMumbai26th December, 2014
Quality is never an accident. It is always a result of intelligent effort
Overview
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Introduction to Valuation
Historical Analysis
Future Projections
Valuation Analysis
Cash Flows tofirm/equity
Quality is never an accident. It is always a result of intelligent effort
Overview
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Cost of Equity/Firm
Continuing value
Sensitivity & ExpectedValue
Determining Value onCash flow discounting
UnderstandingLimitations
Quality is never an accident. It is always a result of intelligent effort
Introduction to valuation
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You can spend hours discussingon valuation still end up with awrong target
Quality is never an accident. It is always a result of intelligent effort
Value is all pervading
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Quality is never an accident. It is always a result of intelligent effort
What is Value in Finance
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Quality is never an accident. It is always a result of intelligent effort
Value in Finance
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Quality is never an accident. It is always a result of intelligent effort
Value in Finance
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When you value companies, future life is not finite.Projections cannot be infinite.
Hence the need to limit projections and also estimate aterminal value to factor the value of the company fromfuture cash flow thereafter to infinity.
Determining a risk based rate for discounting is also achallenge, notwithstanding deterministic approachescoupled with robust maths.
Quality is never an accident. It is always a result of intelligent effort
Value in Finance
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Perceptions differ. With the resultyou end with situations where 25/5may not be 5
Each Valuer brings some bit ofindividuality to the process ofvaluation
Quality is never an accident. It is always a result of intelligent effort
Value in Finance
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If you can estimate the cash flows and determine the ratefor discounting you can value anything on this earth.
Cash flow estimations should be incremental cash flows–For example brand valuation requires estimation ofadditional cash flows from brand not possible without thebrand
Estimation of future cash flow in valuation of companiesis driven by historical analysis, future expectations andestimations following that expectation.
Quality is never an accident. It is always a result of intelligent effort
Valuation Analysis
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In Finance there should be no room for snob value. It must bedriven by estimates of cash flow and their discounting.
Business Prospects
Competitor Mapping
Management/Succession
Threats
Quality is never an accident. It is always a result of intelligent effort
Business Prospects
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Industry Company
Growth
Threats
Technology
Market Share
Ability to grow
Brand
Quality is never an accident. It is always a result of intelligent effort
Business Prospects-Paint Industry
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Market Size as of 2014 31650 Crores. Decorativepaints will be 22450 crores
Expected to grow at 1.5 to 2 times the growth rate ofGDP around 9% to 12%
Per Capita Consumption sill low in the country
Market is divided into decorative paints and Industrial
Margins better in decorative but competition fromunorganised sector
Quality is never an accident. It is always a result of intelligent effort
Business Prospects-Paint Industry
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Unorganised sector is around 35% of total market
Decorative Paint is around 79% of total market forpaints.
Inflation deflates demand and 2014 was a bad year
Barriers to entry include Brand, distribution network,production locations, working capital efficiency
Substitutes include wall papers and paper and paintcombination.
Quality is never an accident. It is always a result of intelligent effort
Business Prospects-Kansai Nerolac
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Quality is never an accident. It is always a result of intelligent effort
Business Prospects-Kansai Nerolac
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Quality is never an accident. It is always a result of intelligent effort
Historic Analysis
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AssetAnalysis
IncomeAnalysis
LiabilityAnalysis
ExpenditureAnalysis
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Asset Analysis
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Attempt to Flush out:Assets shown but are not reallyassets.Really assets but expensed out dueto Accounting rulesImpairment –AdequacyLoss Provisions – AdequacyUndisclosed gains (MTM Gains)Asset Revaluation-Rationale
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Asset Analysis
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1. Lease vs. Buy2. Investment in Human Training3. R and D expenditure4. Good will5. Brand value6. Deferred Tax
Quality is never an accident. It is always a result of intelligent effort
Liability Analysis
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Attempt to Flush out:Liabilities shown but are not reallyLiabilities.Really liabilities but kept outside thebooks. [Enron]Loss Provisions –AdequacyProvisions due to Litigations –Adequacy
Quality is never an accident. It is always a result of intelligent effort
Liability Analysis
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1. Environment Liability2. Product warranty liability3. Guarantees and composite
service liability4. Pensions or other employee
benefit obligations5. Litigation (recent Vodafone
case)6. Hybrid Securities
Quality is never an accident. It is always a result of intelligent effort
Revenue Analysis
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Attempt to Flush out:Non revenue treated as revenue.Real Revenue is not taken intoaccountSource of Income –Business orothers
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Revenue Analysis
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1. Payments received inAdvance
2. Product/Service provided overmultiple years
3. Right to use product orservice but seller reservesresidual rights
4. Credit worthiness of customeris questionable
5. Refunds for dissatisfiedcustomers.
Quality is never an accident. It is always a result of intelligent effort
Expenditure Analysis
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Analytical Issues include:Assets consumed over variousperiodsResources are consumed but thetiming and payment of futureamounts is uncertainDecline in value of un-usedresources.
Quality is never an accident. It is always a result of intelligent effort
Expenditure Analysis
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1. Depreciation2. Goodwill Amortisation3. R and D expense4. Advertisement5. Refunds for dissatisfied
customers.
Quality is never an accident. It is always a result of intelligent effort
Ratio Analysis and Projections
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Quality is never an accident. It is always a result of intelligent effort
Making Projections
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Projections are also like that.You may end up calling it totallywrong. You may end up gettingit all wrong because marketchange
Quality is never an accident. It is always a result of intelligent effort
Projections
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My approach is simple and straight forward.
Projected Ratios Resulting Ratios
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Two Lessons
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Quality is never an accident. It is always a result of intelligent effort
Projections
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Step 1
• Projecting Ratios are the ones used toproject the future numbers
Step 2
• Once the projections are complete theresulting ratios are computed to seewhether they are in sync
Step 3
• If not you go back and revisit the projectingratios
Quality is never an accident. It is always a result of intelligent effort
Projections
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With the Computed ratios and the expectations on thebusiness of Kansai Nerolac, we project growth, cashflows and financial statements.
Quality is never an accident. It is always a result of intelligent effort
Sensitivity Analysis, Expected Value
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Since projections are projections there is no guarantee fortheir accuracy. What do you do
Sensitivity Probability+
Expected Value
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DCF APPROACH TOVALUATION
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Quality is never an accident. It is always a result of intelligent effort
A Point to Note
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Effort and approach may betailor made to specification
Valuation for a nominal stake in the company,Significant stake, an acquisition, a joint venture etc allmay be different and the efforts put in to determinevalue may also be different.
Quality is never an accident. It is always a result of intelligent effort
DCF Basics
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Cash flow projections/estimations
Determining Discount Rates
Determining Growth rate if used.
Limitation on Models used
If you know the nuts andbolts no need to panic
Quality is never an accident. It is always a result of intelligent effort
What to discount
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Discounted Cash Flow
Equity Firm
Cash flow should beappropriate
Most appropriate when cash flowsare positiveDiscounting must be for
appropriate cash flows
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A word of Caution
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Valuation is as good as cash flowestimates
Take holistic view whileprojecting
We have already coveredthis
You can loseopportunities
Quality is never an accident. It is always a result of intelligent effort
Choosing Discount Rate
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CashFlow
EquityCost ofEquity
DebtCost ofDebt
Firm WACC
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Cost Of Equity
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Flows from CAPM
COE = Rf + β * (Mr –Rf)
Computing Beta forKansai
http://www.nseindia.com/products/content/equities/equities/eq_security.htm
Quality is never an accident. It is always a result of intelligent effort
Cost Of Equity
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NSE 500 Historical Data fromhttp://www.nseindia.com/products/content/equities/indices/historical_index_data.htm
Interest Rate Historical Data fromhttp://www.nseindia.com/products/content/debt/wdm/gove_sec_index.htm
Computing Cost of Equity
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Cost of Equity
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Determining Market Return-What historical period to consider-longer the better
Determine Market Return and Premium
What Risk Free Rate to use?? Using forward rates is ananswer
Use Forward Rate Template in Excel
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Impact and Adjustment for Leverage
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Higher leverage results in higher risk.Hence must be reflected in higherbeta
Adjust the beta for leverage impact
BL=BUL*(1+((1-t))*(D/E))
Vary beta for varying leverageLevered Beta is mucheasier to understand
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Cost of Debt
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Is always themarginal cost ofborrowing (net of tax)
Ya I get that Pointclearly,
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Cost of Preference Shares
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• Cost of preference share willbe observed yield-Pref.Div/M.Price of Pref.Share
• For non quoted preferenceshares, comparative valuewill be used.
Preference Dividend isalways a pleasure toreceive.
Quality is never an accident. It is always a result of intelligent effort
WACC
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Cost of each componentweighted by its percentage tototal
Well the idea cannotchange. You know it well
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Estimation of Cash Flow
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PAT
+
Depreciation
Borrowing
+
Repayment
-
-
Capex
-
Change inW,Cap
You can remove borrowinginflow then take capex andworking capital net of debtfund.
Quality is never an accident. It is always a result of intelligent effort
Asset Life and Time Horizon
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Valuation time horizon
Asset Time Horizon
<
Hence the need for TerminalValue
Terminal Value is importantin valuation
Quality is never an accident. It is always a result of intelligent effort
Time Horizon and Cash Flows
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Significant value comes from TV
Wrong determinationcould be disastrous.
For assumed growth rate check for required return on capital.Alternatively start from ROC and determine growth.
Quality is never an accident. It is always a result of intelligent effort
Time Horizon and Cash Flows
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When you project a steady growth rate from the terminalyear, it is logical to presume that Company will maintain aconstant asset turnover and profit margin. (Sales/Assets)(Nopat/Saes)
If Sales in Year 1 is 100 and it grows by 20% andProfit Margin is 10%, Then year 1 profit is 10 and Year2 profit is 12. Also if the asset turn over ratio is 2 year1 asset is 50 and year two asset is 60. Change inasset is 10. As a percentage of turnover is 10%. Theyear 3 asset must be 72. Check this. Turnover is 144.Asset should be 72. Increased by 12 from 60 to 72
Quality is never an accident. It is always a result of intelligent effort
Time Horizon and Cash Flows
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We can then say that the change in assets ▲A is constant. If you denote this by b then b=▲A/NOPAT.
Then � ▲= NOPATt*(1-b)
But NOPAT t=NOPATt-1+ROC *b*NOPATt-1=NOPATt-1*(1+ROC*b)
Growth rate g = �
���
= ���∗
���
= b*Roc
Quality is never an accident. It is always a result of intelligent effort
Time Horizon and Cash Flows
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Growth rate g ==Going back to FCFt we have
Quality is never an accident. It is always a result of intelligent effort
Alternate View
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The same concept can be understood alternatively.Change in the asset is nothing but the amount ploughedback. Thus if profit is 100 and dividend is 20, then 80isploughed back and assets must also change by 80. Hencechange in asset is nothing but 1-payout ratio.
Growth is nothing but growth in ROE. Consider a casewhere the Equity is 500 and the profit is 100. The companypays dividend of 20. ROE is 20% 100/500. The equity forthe next year will be 500+80=580. At 20% return the PATmust be 116. ROE growth is 116/100-1=16%.Growth Rate = .80*.20=16% G=B*ROE
Quality is never an accident. It is always a result of intelligent effort
Alternate View
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Now if you have the growth at 16% and retention ratio of80% the ROE that is possible is nothing but 16%/80%.=20%
When you factor a terminal growth rate of certainpercentage say 5% and you have a retention ratio policythen you can back work what must be the sustainable ROEthat can make the estimate work. That ROE must besustainable. If not you must rework your numbers
Quality is never an accident. It is always a result of intelligent effort
Estimating Growth Rates
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Standard approach is to project frompast adjusted for external
circumstances
Trend could be linear or compounding
If not able to estimate use excels builtin functions.Honest growth rates
reaction -similar
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Pitfalls to guard against
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Projecting from past may not beright. Size also matters
Negative growth in the pastcould distort future projections
External environment might beundergoing a change
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Theory to Practice
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Moving from Theory to practice we complete the exercise
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Limitations of Cash Flow Model
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Firms in TroubleNegative cash flow Cyclical Firms
Either use smoothedout cash flows orpredict the cycle andconsequential cashflows
Firms withunused or underutilised assets
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Limiations of Cash Flow Model
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Firms underAcquisition-Synergy andManagement
Firms underrestructuring
Complex changes incash flows cannot beculled from reportedfigures.
Private Firms
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What is Value
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What is a good value? That dependsa lot on whose money is at stake
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Recap
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Cash Flow, Cash Flow, Cash Flow
Predictions and projections cango wrong
Quality is never an accident. It is always a result of intelligent effort
Recap
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Over confidence is dangerous No Consolation for badprojection
Quality is never an accident. It is always a result of intelligent effort
Recap
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You need deeper insights
Quality is never an accident. It is always a result of intelligent effort
Some Good Books On Valuation
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Damodaran Trioligy-Damodaran on ValuationThe Dark Side of ValuationInvestment Valuation
Valuation-Measuring and Managing the Value ofCompanies by Tim Koller, Marc Goedhart, DavidWessels.
Valuation for Mergers, Buyouts and Restructuring byEnrique R. Arzac
Investment Banking : Valuation, Leveraged Buyouts, andMergers and Acquisition-Josua Rosenbaum and others
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Thank You
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There are limitations on what can be achieved in a short span
If I have tickled your interest to explore the subject further Iwill consider the time well spent
Hope you enjoyed the session. All the very best for your future
What is a good value can changefrom moment to moment