Introduction to

Business Valuation

February 2013
Agenda

► Introduction to valuation
► Valuation approaches and considerations
► Market approach
► Case study

► Income approach
► Case study

► Asset-based approach

► Concluding thoughts

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What is value?

► It depends on a number of factors:

► What is being valued
► a business
► a company or a share in a company
► intangible assets (e.g. brand names)
► options
► Individual assets and liabilities
► Purpose and extent of the valuation
► Basis of valuation
► Valuation approach / method
► Valuation date

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What is being valued?

Businesses
► A business is usually funded by a mix of debt and equity
► The earnings of the business (which drive the value of the business) are shared
between the 2 funding sources
► Changes in funding mix do not alter the trading profits or the value of the business
itself
► Business value is often referred to as firm value, enterprise value or ungeared value
Companies
► May own several businesses and surplus assets
► Have borrowings and debt obligations which are part of the funding of the business
► Aggregate value of separate business + Other assets – Net Financial Debt = Equity
value
► Equity value represents the value of 100% of the issued capital of the company

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Purpose and extent of the valuation

Fair market value

Value to Acquirer Fair value

Full fledged

► Shareholder dispute
► Litigation support
► Financial reporting
► Tax valuations
► Restructuring
► Fund raising
► Mergers and
Acquisitions
► Divestment
Desktop

► Joint ventures
► MBOs

Purpose of valuation

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Valuation basis

► Fair Market Value as commonly defined:

The amount for which an asset would be exchanged between a
knowledgeable, willing but not anxious buyer and a knowledgeable, willing
but not anxious seller, acting at arm’s length in an open and unrestricted
market.

► Fair value according to accounting standards:

The price that would be received to sell an asset or paid to transfer a liability
in an orderly transaction between market participants at the measurement
date.
IFRS 13 Fair Value Measurement

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Value spectrum for M&A

Common Unique
Synergies Synergies

Liquidation Value Intrinsic Value Acquisition Value

Negotiation Zone

► Intrinsic Value is the value of a target as a going concern under its current
or anticipated operational and financial strategies.
► Acquisition Value is the value a target may have to potential acquirers.

…., the purchase price of an acquisition will nearly always be higher than the intrinsic
value of the target company. An acquirer needs to be sure that there is enough cost
savings and revenue generators – synergy value – to justify the premium so that the
target company’s shareholders don’t get all the value the deal creates.

Harvard Business Review

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The valuation process

Understanding Gathering Selecting the Determining the Valuation cross

the subject of information and valuation relevant checks and
valuation and determining approach & valuation sensitivity
the business availability and methodology parameters analysis
quality

Critical inputs to
valuation

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Critical inputs – Due diligence process

► The due diligence process is a key source of input to valuing

the target and determining what price to pay, because it:
► confirms the quality of historical earnings
► confirms what commitments/exposures the target company has
► contributes to identify the key value drivers in the target’s business
► contributes to specific acquisition price adjustments that a buyer should
consider e.g. working capital, net debt, capex

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Critical inputs – Assumptions for synergies

► Synergy value forecasts are generally based on the following

expectations:
► Revenue enhancements
► Cost savings
► Process improvements
► Financial engineering
► Tax benefits
► Uncertainty levels increase with the length of the planning
period, when defining the future strategic landscape

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Valuation approaches and considerations

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Valuation approaches

► There are three approaches to value share or businesses:

Market approach

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Market approach

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Market approach

► Value of a company can be estimated by comparing and

correlating its features to those similar companies that have
been the subject of a relevant transaction

► Two bases to approach the valuation

► By reference to similar listed businesses
► By reference to recent transactions involving similar businesses

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Market approach
Six important steps

1 2 3 4 5 6
Analyze Choose the Calculate Perform a Apply the Derive an
potential appropriate the financial selected indication of
comparable/ type of valuation analysis multiples value
guideline multiples multiples
companies

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Comparable multiples based valuation

Step 1: Analyze potential comparable companies

► Know the subject company and its industry
► SWOT analysis
► Business description and operations
► Geographic footprint of its operations
► Customers and products
► Competition
► Size in terms of assets/revenue/market share
► Historical and estimated future profitability/ growth/ drivers of growth
► Consider the specific ownership interest to be evaluated (degree of control
and marketability)
► Filtering process – Begin from a large list of potential comparable
companies and filter down, based on the most relevant selection criteria

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Comparable multiples based valuation

Step 1: Analyze potential comparable companies (cont’d)

► Search for companies with similarities in:
► Principal activities and operations
► Geographical regions where operations and customers are based
► Gearing
► Market Capitalization
► If direct comparables are not available, may consider companies that share
the economic characteristics and values that are most critical to the
valuation subject.
► Useful sources:
► Financial databases (e.g. Bloomberg, Thomson Reuters)
► Analysts’ and industry reports
► Knowledge of businesses and operations

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Comparable multiples based valuation

Step 2: Select appropriate type of multiples

Current
Current Liabilities
► Common EV Multiples
Assets ► EV/EBITDA
► EV/EBIT

Tangible
Financial Debt
Assets Enterprise ► Common Equity Value
Less Cash
Value Multiples
► Price/Earnings
Intangible Shareholders’ Equity
Assets Equity ► Price/Book Value
Value

Common multiples adopted for different industries

Industry P / BV P/E EV / EBITDA

► Financial services: Banking / Insurance √ √
► Real Estate / Infrastructure / Energy √
► Technology / Manufacturing / Services √ √
► Consumer & lifestyle / F&B / Media / Engineering / √
Logistics Resources / Life sciences

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Comparable multiples based valuation

Step 2: Select appropriate type of multiples (cont’d)

► Trading multiples (listed companies)

► Based on prices, values and forecasts at the valuation date.
► Assess what multiples listed companies in similar industries are trading at.
► Trading multiples reflect minority parcels.

► Transaction multiples
► Assess what multiples target companies in similar industries have been bought
for around the valuation date.
► Transaction multiples usually reflect a premium for control + a premium for any
synergy to the purchaser.

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Comparable multiples based valuation

Step 2: Select appropriate type of multiples (cont’d)

► The correct multiple must be applied to the correct future maintainable earnings
(“FME”), e.g. EBITDA with a EV/EBITDA multiple, EBIT with an EV/EBIT multiple,
PAT with P/E multiple etc.
► Historical multiples must be applied to historical earnings and forecast multiples
must be applied to forecast earnings.

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Comparable multiples based valuation

Step 3 & 4: Calculate the valuation multiples and perform financial

analysis
► Adjustments to consider in computing normalized multiples and FME:
► Surplus assets
► Assets which are not considered critical to the ongoing viability of a company
► Surplus assets are excluded in deriving normalized multiples
► Items of income and expenditure relating to surplus assets are excluded as well
► Should be valued separately and only reflected in the value of the issued shares in the
company
► E.g. Investment properties, term deposits
► Exceptional / non-recurring items
► E.g. One-off litigation expenses, gain on disposal of an investment
► Tax effect arising from the adjusted P&L items
► Net financial debt
► Interest bearing debt (incl. finance lease) less cash and marketable securities

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Comparable multiples based valuation

Step 3 & 4: Calculate the valuation multiples and perform financial

analysis (cont’d)
► Adjustments to consider in computing normalized multiples and FME:
► Control premium
► Marketability /minority discounts
► Related party transactions
► Adjust to arms-length basis
► Appropriate GAAP/IFRS adjustments to ensure the FME and the normalized
multiples are of comparable basis

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Comparable multiples based valuation

Step 5 & 6: Apply normalized multiple and derive indicative value

Earnings before Appropriate Amount equivalent to

x =
interest multiple Enterprise Value

e.g. EBITDA x EV/EBITDA = Enterprise value

Appropriate Amount equivalent to

Net earnings x =
multiple Equity Value

e.g. PAT x P/E = Equity value

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Comparable multiples based valuation

Step 5 & 6: Apply normalized multiple and derive indicative value

(cont’d)
► Derive equity value from enterprise value
► Where FME is based on earnings before interest, the product of FME and the
valuation multiple provides enterprise value.
► Enterprise Value = equity value + net financial debt.
► Therefore, to determine the equity value of a business, net financial debt must
be subtracted from the enterprise value.

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Premiums and discounts

► The most common valuation premiums and discounts that should be

considered in valuing an interest in a company are:
► Control premium

► Minority interest discount

► Marketability discount

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Premiums and discounts

► Control premium
► The difference in value of controlling and minority interest (all things being
equal) = control premium
► Additional consideration that an investor would pay over a marketable minority
interest to own a controlling interest
► To be considered if comparable data refers to minority interest
► Premium to be applied depending on the level of influence / control

► Minority interest discount

► The difference in value of minority and controlling interest (all things being
equal) = minority interest discount
► To be considered when valuing minority interest if value is derived based on
controlling interest characteristics
► Terms of any Shareholders Agreement must be considered in applying the
discount

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Premiums and discounts

► Marketability discount
► The difference in value of marketable and non-marketable shares (all things
being equal) = marketability discount
► Marketability discount to be considered when valuing private companies or
illiquid shares if comparable data refers to marketable value
► Terms of any Shareholders Agreement must be considered in applying the
discount
► Non-marketable interest value can be obtained by reference to actual
transaction of private companies where there is no active market

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Summary of premiums and discounts

► Obtain directly by reference to actual change of control

Control Value transactions
► Application of marketability discount on controlling
interest are dependent on the approach adopted
Minority
Control
Interest
Premium
Discount
► Obtain directly by reference to “freely tradeable” publicly
Marketable Minority Interest traded comparable companies
Value ► Holders lack control over the affairs of the company but
has the ability to sell the investment at will
Marketability
Discount

► Obtain directly by reference to actual transactions

Non Marketable Minority
► Holders lack control over the affairs of the company and
Interest Value
the ability to sell the investment at will

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Comparable multiples based valuation

► Strengths
► Valuation multiples are derived from the market and therefore reflect the
aggregate buying and selling decisions of informed investors
► Many believe that because this approach directly reflects the market for
similar businesses or assets, it provides the best indication of value of
the subject business or asset
► This approach addresses the fundamental context of the “fair value” and
“fair market value” standards; more specifically, in the context of financial
reporting this approach addresses the “market participant” perspective
► This is a widely-used approach to value (one of the most common
applications is the use of the P/E multiple in equity valuation)

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Comparable multiples based valuation

► Challenges
► Identifying adequate comparable companies/transactions
► Difficulty in assessing comparability due to a lack of publicly-available
information
► Indiscriminate use of mean or median multiples
► Making the necessary and appropriate adjustments (e.g. for different
currency or regulatory risks) to market-derived valuation multiples

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Comparable multiples based valuation

► Common oversights
► Inappropriate selection of comparable companies and transactions (e.g.
company in a different industry from target, market transaction entered
into many years ago from the valuation date)
► Using the average of multiples that have a wide dispersion without
confirming their reasonableness
► Deriving equity multiple by using an EV valuation basis (e.g. P/EBITDA)
► Performance measures used (e.g. profits, book value etc) from
comparables and the target have not been appropriately normalized
► Mismatch between the multiples and the target’s performance measure
used (e.g. use of historical earnings multiples on forward-looking
earnings)
► Application of post-tax multiples to pre-tax performance measures

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Comparable multiples based valuation

► Common oversights (cont’d)

► Omission of adjustments affecting the valuation multiples based on
differences between the target and its comparable companies (e.g.
insufficient consideration to different accounting policies)
► Omission of other adjustments (e.g. non-operating assets, premiums,
discounts etc)

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Market approach

CASE STUDY

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Income approach

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Income approach

► Value of a company can be measured by the present worth of the net

economic benefit to be received over the life of the company
► Discounted Cash Flow (multi-period), Gordon Growth model (single-
period), Dividend Discount Model
► Discount rate reflects the risk inherent in the future cash flows along with
time value of money ($1 today is worth more than $1 tomorrow)
► Requires estimation and assumptions of stream of cash inflows and
outflows over time
► Cash flows may be post tax and pre interest, pre tax and pre interest, post
interest and pre tax, or post interest and post tax

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Discounted cash flows (“DCF”) method

► The DCF calculation is built up from several components:

► Free cash flows (FCF)
► Discount factors (DF)
► Terminal value (TV)

Explicit Forecast Period Terminal Value Period

Valuation Date

FCF t1 FCF t2 FCF t3 FCF t4 FCF t5 Normalized FCF t6 Time

Enterpriseoror
Enterprise
EquityValue
Value * DF1 * DF2 * DF3 * DF4 * DF5 / Cost of Capital * DF5
Equity

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DCF method

Free Cash Flows (FCF) Computation

+ EBIT
- Effective tax rate on EBIT
= Net operating profit after tax (NOPAT)
+ Depreciation and amortisation
- Capex
+ Change in net working capital/ provisions
= Free Cash Flow to Enterprise/Firm (“FCFF“)
+ Net cash /(debt)
= Free Cash Flow to Equity (“FCFE“)

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DCF method

► Estimating cash flows

► Identify value drivers
► Sales growth rate
► Operating profit margin
► Fixed capital expenditure (replacement and incremental)
► Working capital (incremental investment)
► Cost of capital
► Forecast period
► Identify variable that affects the value of the business
► Controllable by management
► Largest impact on value

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DCF method

► Common adjustments to the cash flows

► Excess working capital/cash (cash, shares etc)
► Non-operating (or surplus) assets (property, sailboat etc)
► Tax losses
► Net financial debt
► Discounts and premiums
► Intercompany transactions (are they at arm’s length?)
► Compensation of management (especially if the management owns the
company)

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DCF method – Discount rate

► Weighted average cost of capital (“WACC”) is the rate of return that commensurate
with risk required by both equity and debt holders.
► WACC is based on the market participants’ view of capital structure (not entity
specific)  Use optimal or industry gearing level and cost of funds
► Can be computed using a set of comparable companies
► Based on rate implicit in current market transactions for similar assets
► Consider WACC of listed company that has similar assets under review
► Gearing is based on the fair value of debt and equity (not book value)

WACC = [ Ke × E ] + [ Kd (1 - t) × D ]
D+E D+E

Ke = After tax cost of equity D = Market value of debt

Kd = Pre tax cost of debt E = Market value of equity
t = Corporate tax rate

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DCF method – Discount rate

Step 1: Determining a set of comparable companies

► Search for companies with similarities in:
► Principal activities and operations
► Geographical regions where operations and customers are based
► Gearing and Beta
► Market Capitalization
► If direct comparables are not available, may consider companies that share
the economic characteristics and values that are most critical to the
valuation subject.
► Useful sources:
► Financial databases (e.g. Bloomberg, Thomson Reuters)
► Analysts’ and industry reports
► Knowledge of businesses and operations

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DCF method – Discount rate

Step 2: Determine the cost of equity (Ke)

► Derived using CAPM by adding risk premiums to the risk free rate:

Ke = Rf + (β × MRP) + α (if required)

► Rf = Risk free rate (e.g. 10-years government bonds)

► β = Equity beta measures the volatility of the return generated by the investment
relative to the market (e.g. 5-year, monthly adjusted betas)
► MRP = Market Risk Premium (e.g. Based on analyst reports)
► α = Alpha factor for company-specific risks such as size premium, country risk,
riskiness of cash flows etc

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DCF method – Discount rate

Step 2: Determine the cost of equity (Ke) (cont’d)

► How is equity beta determined?
► Equity beta measures the volatility of the return generated by the investment
relative to market.
► The following steps are taken for proxy equity betas obtained from comparable
companies:
► The equity beta should be initially adjusted to remove the effects of debt levels referred
to as “de-levering” resulting in an asset beta
► Asset beta is then “re-levered” to reflect the optimum debt and equity mix of the
company valued
► Formula:

Equity beta = Asset beta x [ 1 + ((Debt/Equity) x (1- tax))]

Beta with debt Beta with no debt

(re-levered) (de-levered)

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DCF method – Discount rate

Step 3 : Determine the cost of debt (Kd)

► Kd is based on long-term market rates being incurred at the valuation date

for new borrowings with period to maturity similar to the expected life of the
asset.
► Useful sources of information:
► Current market borrowings of comparable companies, considering both level of
debt and interest rates
► Company’s incremental borrowing rate and Kd currently incurred by company
(taking into account refinancing needs)
► Recent industry acquisitions and refinancing

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DCF method – Discount rate

Step 4 : Compute WACC (an illustration)

Consistency issues:
► Functional currency of
cash flows
► Dates of data extracted
vs. valuation date

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DCF method – Terminal value

► Multiple models to choose from

► Growth-based models
► Gordon growth, two-stage growth, and fading growth models
► Valuation multiples-based approaches
► EBITDA, EBIT, EPS, Book Value multiples

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DCF method – Terminal value
Gordon Growth model
► Gordon Growth model is based on the capitalization of normalized cash
flows.
P = D0*(1+g) /(k-g)
D0 : normalized debt free cash flow
k : discount rate
g : terminal growth rate

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DCF method – Worked example

► Terminal value calculation

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DCF method – Terminal value
Gordon Growth model
► This model is useful when:
► The subject company has reached maturity.
► Maturity occurs soon after the final operating forecast year

► Limitations
► Sensitive to high long-term growth rate and low discount rates
► Can only handle a constant growth rate assumption, but not accelerating/
decelerating growth rates
► Cash flow used to compute terminal value needs to be representative

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DCF method – Worked example

► Discounted cash flows

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DCF method – Dividend discount model (DDM)

► Defines cash flows as dividends expected to be received by an investor

► Commonly used in the financial services/banking industry
► Usually a minority stake valuation method
► Three key parameters:
► Dividend payout ratio
► Discount rate (Ke)
► Expected ROE (impacts expected growth rate)

Suitable Not suitable

► Dividend paying companies ► Companies that pay low or no dividends
► BOD has a dividend policy that has an ► No clear relationship between dividends and
understandable relationship to profitability profitability

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DCF method

► Strengths
► A theoretically sound approach; the value of a business or asset should
be equal to the present value of all future benefits generated by the
subject business or asset
► A direct approach to valuation; the specific attributes of a business or
asset, including the amount and timing of cash flows, may be explicitly
incorporated into the valuation model
► Forward-looking, taking into account the strategy and growth prospects
► Takes the capital intensity of a business into account
► Incorporates the concepts of risk and the time value of money
► Focused on cash returns

DCF method is one of the most versatile valuation methods

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DCF method

► Challenges
► Obtaining adequate and quality information and data
► Involves a significant number of assumptions for which it is difficult to
estimate future benefits with precision and/or certainty
► Auditing or otherwise definitively validating estimates of future benefits is
often problematic
► It may be difficult to estimate an appropriate rate of return that reflects
specific risk factors with precision and/or certainty
► The mechanics of the model are relatively straightforward; this may lead
to oversimplification and a lack of analytics
► Involves a wide variability of measures of the market (e.g. risk free rate,
equity beta and, in some cases, company specific risk adjustments)
► Matching analysis with definition/purpose of valuation

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DCF method

► Common oversights
► Double counting or omitting cash flows (e.g. not including working
capital requirements when calculating cash flows)
► Mismatching cash flows and discount rates (e.g. discounting free cash
flows to equity using WACC instead of cost of equity)
► Inconsistencies between risks inherent in cash flows and those reflected
in the discount rate
► Inappropriately high terminal growth rate
► A perpetuity approach applied where businesses have limited life
contracted revenue, concentrated customers and renewal risks

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DCF method

► Common oversights (cont’d)

► Mismatch between the currency used to estimate cash flow projections
and the currency of inputs used to derive the discount rate (e.g. cash
flows denominated in USD discounted with a SGD-based WACC)
► Inappropriate WACC computation (e.g. not considering the country risk)
► Omission of adjustments (e.g. discount for the lack of marketability)

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Income approach

CASE STUDY

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Asset-based approach

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Asset-based valuation method

► Asset-based valuation method determines the value of a business by

reference to the market value of its net assets employed.
► This approach is commonly used when:
► The business is investment holding, asset intensive, or at start-up stage
► Earnings of the business does not reflect the true value of the business
► The business has substantial surplus assets relative to the assets required to
undertake its principal activities
► Future prospect of a company is doubtful and/or liquidation is being
contemplated
Three core considerations
1. Going concern of the business;
2. Presumption of an orderly realization of the business’ net assets; or
3. Presumption of a “fire sale” realization of the business’ net assets

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Asset-based valuation method

► The first step is to obtain a balance sheet as close as possible to the

valuation date (ideally at the valuation date), which would be the starting
point to create a fair value balance sheet.

► Each recorded asset must be examined and adjusted to fair value, which
includes intangible assets.

► Once the asset side of the balance sheet has been restated to fair value, all
liabilities, also at fair value, would be subtracted to derive the fair value of
the company’s equity.

► Can serve as a “cross-check” of the reasonableness (or otherwise) of the

primary valuation calculations using other approaches.

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Asset-based valuation method
Orderly realization

Value of issued shares

= Market value of assets – Market value of liabilities
– estimated cost of realization

► Value self sufficient businesses based on the sale of the business as going
concern
► Value remaining assets and liabilities based on estimated net realizable
value (may need experts)
► Estimate realization cost including legal, accounting and other professional
fees relating to the liquidation, redundancy cost
► Allow income tax on sale of assets, distribution of profits

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Asset-based valuation method
Fire sale

► Assets are sold piecemeal in the shortest possible timeframe

► Does not maximize the sale proceeds, resulting in significantly lower value

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Asset-based valuation method

► An indication of the value of a controlling interest is usually given, from

which appropriate discounts may be warranted for non controlling interests.

► Useful if there is limited information on projections going forward.

► This approach does not assign any value to expected future growth and the
excess returns that flow from that growth.

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Asset-based valuation method

► Common oversights
► Measuring assets at book values instead of fair value
► Omission of unrecognized intangible assets
► Omission of assessment of collectability of trade receivables
► Omission of contingent liabilities and other unrecognized liabilities (e.g.
unrecognized commitments)
► Omission of deferred tax adjustments, when economically relevant,
arising from adjusting assets’ book values to fair value

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Use of multiple valuation approaches and
techniques
► Multiple valuation techniques may be used to test the reasonableness or
‘sanity’ of the primary method
► Common to cross-check the income approach with the market approach
and vice versa
► Questions:
► Is there a need to reconcile between two approaches?
► What is an acceptable variance between two approaches?
► Can one narrow down the range of values by referring to the intersection
of ranges indicated by two approaches?

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Questions

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