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Lesson 11
74 Question 2
Write a note on valuation of banks.
Answer
Financial Institutions like banks and insurance companies are among the most challenging companies to value, particularly for outside analysts as they do not have some crucial information such as asset-liability mismatch about these companies. Further, as these institutions are highly levered, their valuations are remarkably sensitive to small changes in key drivers. Their operations cannot be valued separately from interest income and interest expense, as they are the main components of their income statements.
In valuation of the banks, the focus has to be not on profit growth, but on growth of stability. Therefore, for financial companies which are highly levered, the equity cash flow approach is more appropriate. The equity DCF approach does not tell us how and where a Bank creates value in its operations. Is the bank creating or destroying value when receiving the percentage of interest i.e., for example assume that 6.5 percent on its loans or when paying. 4.3 percent on deposits.
When valuing banks and other financial institutions, where capital structure is an inseparable part of operations, capital cash flow and equity cash flow valuation models are used.
Question 3
Write a note on valuation of private companies.
Answer
Private companies can be of different types. These companies may include small family- owned enterprises, divisions/subsidiaries of larger private companies, or large corporations. It can be a single-employee company, unincorporated businesses and previously public companies that have been become private in management buyouts or other transactions. Many large, successful companies also exist that have remained private since inception, such as IKEA and Bosch in Europe and Life style, DHL, Marriott Hotels etc., in India. The varied features of private companies and the absence of a commonly recognized body providing guidance on valuation methods and assumptions have contributed to the progress of different valuation practices.
Private company valuation is the set of procedures used to assess a company’s current net worth. Valuation approaches for large private companies are theoretically similar to those used for public companies though the labels used for them by analysts in each field and the details of application may differ.
The three common methods for valuing private companies, using data available to the public:
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i) Market Approach: This is the most common private company valuation method.
The analysts use a relative valuation model when they apply a market-based approach in evaluating price and enterprise multiples relative to the value of a comparable.
Comparable Company Analysis (CCA) of the relative valuation model operates under the assumption that similar firms in the same industry have similar multiples and uses the recent valuation of comparable companies in the peer universe of the target company. Common valuation multiples such as EV/ Sales, EV/EBITDA were selected from the financial statements of the peers and the value of the target company is estimated based on the HIGH, LOW and AVERAGE multiples of the peer universe.
ii) Income Approach: The income approach values an asset as the present discounted value of the cash flow (DCF) expected from it. DCF method has several variations depending on the assumptions the valuator makes.
iii) Asset-based approach: This method values a private company based on the values of the underlying assets of the entity less the value of any related liabilities.
Question 4
Write a note on valuation of small companies.
Answer
Small companies are private in nature and financially less transparent than their publicly traded peers. Though often smaller in size these small private companies have a major importance in the world’s economy. These businesses have noticeably more risk than larger ones. Size contributes to the discount in the valuation since it replicates the industry.
These private company’s owners do not publicly issue shares of their company, instead they keep ownership and associated transactions at low-key.
Valuation of such closely-held private companies can be costly and difficult due to non- availability of exact financial information. Small private companies may be good acquisition targets for larger competitors and publicly-traded counterparts. There are different methodologies and financial tools to evaluate a small private company.
When it comes to small businesses which are private in nature, the following three techniques are most commonly used:
i) Comparable Company Trading Multiple Analysis, (also known as “peer group analysis”,
ii) Precedent/Comparable Transaction Analysis, and iii) Discounted Cash Flow (“DCF”) Analysis.
76 Question 5
Write a note on valuation of start-ups Answer
Start-up means an entity, incorporated or registered in India:
i) Upto a period of seven years from the date of incorporation/registration or upto ten years in case of Start-ups in Biotechnology sector.
ii) As a private limited company or registered as a partnership firm or a limited liability partnership.
iii) With an annual turnover not exceeding Rs. 25 crore for any of the financial years since incorporation/ registration.
iv) Working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation.
Unlike valuing traditional cash-generating and profit-making businesses, there is no standard methodology in valuing start-ups. Valuation of start-ups is about assessing both the risks and rewards associated. Entrepreneurs want the value to be as high as possible and the venture capital want a value low enough so that they own a reasonable portion of the company for the amount they invest. With little or no past financial performance, valuing a start-up is mostly based on potential rather than past results.
Question 6
Pinnacle Venture, PE investor is considering investing INR 4000 million in the equity of Best Systems, a start-up IT company. Pinnacle ventures required rate of return from this investment is 40 percent and it’s planned holding period is 5 years. Best Systems has projected an EBITDA of INR 5000 million for year 5. An EBITDA multiple of 6 for year 5 is considered reasonable. At the end of year 5, Best Systems is likely to have a debt of INR 2000 million and a cash balance of INR 600 million.
i. What ownership share in Best Systems should Pinnacle Venture ask for?
ii. What is the post-money investment value of Best Systems equity?
iii. What is the pre-money investment value of Best Systems?
Answer
Required rate of return of Pinnacle Venture (KPE) = 40%
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Required value PE Investments6 = 4000 x 5.3782 = INR 21,513 million.
Estimated Equity Value6 = 5000 x 6 + 600 – 2000 = INR 28,600 million.
i) Ownership share = Required value of PE investments/ Estimated Equity Value = 21,513 / 28,600 = 75.22 %
ii) Post-Money Investment Value of the firm’s equity Funds provided by the PE 40000 = --- = --- PE’s ownership interest (%) 0.7522 = INR 5,317.73 million
iii) Pre-Money Investment Value of Best System’s Equity = Post-Money Investment - Funding provided by the PE
= 5,317.73 – 4,000 = INR 1,317.73 million Question 7
Write a note on Comparable Transaction Valuation method with reference to small enterprises.
Answer
Size has consequences for the level of risk and, hence, comparable transaction valuation method of relative valuation approach is also used for small enterprises. Small size naturally increases risk levels and in estimating required rates of return for small and private companies risk premiums for small size will often be incorporated. This method is usually used when the valuation is accepted by the valuer for sale.
Under this method, peer group is compared on similar standards. Similar companies are decided based on industry they belong to as well as the market capitalization for the purpose of valuation. The companies are then assessed on common multiples such as EV/EBITDA, PE ratio, PEG ratio and so on. For fair valuation, the company should be evaluated on more than one standard to ascertain the current and the potential value of the company. However, this approach has its own set of drawbacks when the historical data of the company is not available. Therefore, this approach is not used solely, but in combination with other approaches. Comparable Transaction Valuation is often used along with Discounted Cash Flow to present fair value of business.
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