Rajagopal Deloitte Business Valuation

Business Valuation
Presenter
C.R.RAJAGOPAL
Partner
Deloitte Haskins and Sells
Value - Defined
) A quantitative representation of monetory values inherent in
a business/enitity, built by the past efforts, capable of
generating economic benefits in the future.
) Enteprise value is the value of the financial instruments
representing the ownership interests in an entity plus net
financial debt of the enitity
) Fair value is an amount for which an asset could be
exchanged between willing and knowledgable parties in an
arms length transaction.
) Value of an entity is a sum of parts of a business together
adding up resulting the streams of economic returns and
value of an enterprise can be more than sum of parts.
Overview of Business
Valuation
What is Value?
)Depends on who is asking and why
)Generally an economic concept where what
a buyer is willing to pay and what a seller is
willing to take overlap
Implies transferability
Implies agreeable to both parties
)In the real world it is a range, not a point
What is a Valuation?
) Part art, part science
) A process to arrive at an estimate of value for a
company involving:
An analysis of the economic environment;
An analysis of the industry;
An understanding of the historical, current and
future operations of the company;
An analysis of the financial history and
prospects of the company; and
Applying acceptable valuation methods
6
Why are Valuations Performed?

) Transaction pricing
(mergers, acquisitions)
) Privatization/post
privatization
) Financing
) Tax and audit support
) ESOPs
) Management buyouts
) Joint venture
investments
7
) Bankruptcy,
reorganization and
restructuring
) Allocation of purchase
price
) Litigation
) Planning
) Value based
management
) Other
What Creates Value?

) Cash Flow
Investors assign value based on the cash flow
they expect to receive in the future
Dividends/distributions
Sale or liquidation proceeds
The value of a cash flow stream is a function of:
The timing of cash receipts
The risk that less cash than expected will be
received
What Creates Value?

) Assets
Operating assets
Those assets used in the operation of the business
including working capital, property, plant and
equipment and intangible assets
The value of operating assets is generally reflected
in the cash flow generated by the business
Non-operating assets
Those assets not used in the operations including
excess cash balances, and assets held for
investment purposes, such as vacant land and
securities
Non-operating assets are generally valued
separately and added to the value of the operations
9
How is Value Measured?

) Income approach
Estimates value based on the present value of
future earnings or cash flow
) Asset approach
Estimates value based on the fair market value
of the business assets less the fair market
value of its liabilities
) Market approach
Estimates value based on the market price of
similar companies
10
What is Being Valued?

THE VALUATION BALANCE SHEET
TOTAL ASSETS
CURRENT
ASSETS
INVESTED CAPITAL
CURRENT
LIABILITIES
LONG
TERM
DEBT
PLANT,
PROPERTY &
EQUIPMENT
EQUITY
OTHER
ASSETS
OWNERS
EQUITY
INTANGIBLE
ASSETS
Market, Not Book Basis

11
Standards of Value
) Value, like beauty, is in the eyes of the beholder
) Purpose determines standard
) Three common standards of value:
Fair market value
Investment value
Liquidation value
12
Fair Market Value

) The amount at which property would change hands
between a willing seller and a willing buyer when
neither is acting under compulsion and when both
have reasonable knowledge of the relevant facts
) Fair market value encompasses:
Hypothetical cash exchange price
A willing buyer and a willing seller
Both parties being knowledgeable of the relevant
facts
Neither party acting under compulsion
) Typically used in compliance-related assignments
13
Investment Value
) The specific value of goods or services to a

particular investor (or class of investors) for
individual investment reasons
The value to a particular investor
Based on that investors requirements and
expectations, including potential synergies
Can include psychological factors, the joy of
ownership or the value of a long tradition of
family ownership
14
Liquidation Value
) The net amount the owner can realize if the
business is terminated and the assets sold
off piecemeal
The seller is compelled to sell
The time frame is either immediate (forced
liquidation) or with adequate exposure to the
market (orderly liquidation)
Implies the business is worth more dead
than alive
15
Liquidation Value (contd)
Considers the costs incurred to sell the assets

and shut down operations, such as brokerage
commissions and severance
Businesses are typically valued under the
premise of a going concern (i.e., the business is
a viable operating entity and the assemblage of
assets contributes to the value)
16
Financial Statement
Analysis
Financial Analysis
) Importance to the valuation analysis
Key factor in assessing the risk of investing in
the business
Provides a basis to analyze trends and identify
unusual items for further analysis
Provides a basis for developing a reasonable
forecast or estimate of normalized earning
power
Provides a basis for comparison to industry data
or similar company data
Key factor in selecting the appropriate valuation
multiple in the market approach
18
Financial Analysis
) The process
Financial statement adjustments to normalize
financial position and performance
Ratio analysis: asset management, leverage,
liquidity, and profitability
Common size balance sheets and income
statements
Comparison to industry financial data
Analysis of trends and unusual items
19
Financial Analysis
) Ratio analysis
Asset management ratios
A measure of how efficiently assets are being used
including total assets, inventory and receivables
Leverage ratios
The ability of the company to pay its debt obligations
If there is incremental risk because of excessive debt
Whether there is any additional debt capacity
Liquidity ratios
The ability of the company to pay its current
obligations
If the company has adequate working capital
20
Financial Analysis
) Ratio analysis (contd)
Profitability ratios
The ability of the company to convert sales
into profit
The return earned on assets
The return provided to investors
) Common size balance sheets and income
statements provide a basis for trend and
comparative analysis
21
Financial Analysis
) Comparison to industry
Provides a measure of the companys financial
performance and condition relative to its peers
Common size balance sheets
Common size income statements
Ratio analysis
Productivity statistics, such as sales per
employee
22
Financial Analysis
) Analysis of trends and unusual items
Trend analysis focuses on examining how
accounts have changed over time
Unusual items that seem out of place compared
to other years or compared to industry averages
should be discussed with management
Accounts with unusual titles or that seem out
of place compared to the normal business
operations should be investigated
23
Financial Analysis
) Conclusion & key factors to consider
Focus on the issues affecting the value of the company
Are any adjustments required to reflect the true
earnings potential of the company?
Is the overall trend in the business (sales, profits,
etc.) improving, stable or declining?
Does the company have adequate liquidity? Is
working capital well-managed?
Does the company have too much debt? Does the
company have the ability to borrow in the future if
needed?
Are the returns on equity acceptable?
Is asset utilization acceptable?
Are there any non-operating assets?
24
Financial Analysis
) Conclusion & key factors to consider (contd)
How does the company compare
with the industry?
Your conclusions are a key factor in:
Assessing the risk of investing
in the company
Developing forecast assumptions
for the company
25
Income Approach Overview and Management

Projections
Income Approach
)Key inputs to income approach
The required rate of return
The estimate of future cash flow or
normalized earnings
27
Income Approach
) Income approach
Discounted cash flow
Forecast of the cash flow available to
investors is discounted to present value
using an appropriate rate of return
Capitalized earnings
An estimate of normalized expected
earnings is capitalized based on the required
rate of return and growth prospects
28
Income Approach
Discounted Cash Flow
) Theoretically correct method
Based on future cash flows
Considers the timing of cash flows
Considers the risk of the cash flows
) Potentially dangerous
Reasonable inputs, unreasonable results
Easily manipulated
Not directly linked to market
) Typically gives a control value
29

COMPONENTS
FORECAST PERIOD
Years one through ..n
TERMINAL PERIOD
TERMINAL VALUE
Represents the value
of all cash flows beyond
the forecast period
VALUATION DATE
30

) Steps
Analyze revenues and prepare the revenue forecast
Analyze expenses and prepare an expense forecast
Analyze capital requirements and prepare a forecast
Calculate cash flow for each year
Determine the appropriate discount rate
Calculate the terminal value
Calculate the present value of the future cash flows and
terminal value and sum
Make any final adjustments
Perform review procedures
31

) Forecasting revenues
Revenue forecast considerations:
Forecasting units and prices, or overall growth
Production capacity
Impact of capital investment
What growth will the buyer pay for?
Historical growth
The economic outlook
The outlook for the industry, including competition
Demand for the product
Expected product price increases
Product mix
Management plans
32

) Steps
33

) Forecasting expenses
Expense forecast considerations:
Historical relationships and trends
Fixed versus variable costs
Inflation considerations for each expense category
Unusual and non-recurring expenses that may be included
in historical figures, but will not occur in the future
Depreciation should be based on existing fixed asset levels
plus an analysis of additions and retirements in the future
Compare forecasted margins to competitors or to industry
guideline data for reasonableness
34

) Forecasting expenses
Adjustments to current operations
Made to normalize operations so that a true and
sustainable level of operating income can be
analyzed
Examples of adjustments include:
Non-recurring income and expenses
Income and expenses relating to excess and
non-operating assets
Related party revenue or expenses
Excess compensation
35

) Steps
36

) Capital requirements
Consists of two components:
Capital expenditures needed to replace existing assets and to
purchase new assets to increase production capacity
Working capital including the adequacy of the initial working capital

level and the incremental working capital needed to fund future
growth
Typically based on either industry or company specific data
37

) Steps
38

DEBT-FREE CASH FLOW
=
EBIT*(1-Tax Rate)
(EBIT=Earnings Before Interest
and Taxes)
PLUS
NON-CASH ITEMS
(DEPRECIATION, AMORTIZATION)
MINUS
INCREMENTAL WORKING CAPITAL
CAPITAL INVESTMENT
39
Income Approach Discount Rate and PV

Calculation

) Steps
41

) Discount Rate Definition
Generally, in the context of a business valuation, the
discount rate is the rate of return that would be required
by an investor to purchase the stream of expected
benefits (e.g., future cash flows), given the risk of
achieving those benefits
Thus the discount rate is used to determine the amount an
investor would pay today (present value) for the right to
receive an anticipated stream of payments (e.g., cash
flows) in the future
42

) Discount rate analysis
Since the cash flow forecast is based on debt-free cash flows the
Weighted Average Cost of Capital (WACC) must be used to discount
the future cash flows
The WACC is based on:
The cost of equity and debt for the industry or firm, and
The proportion of the firms capital structure comprised
of equity and debt
WACC = Ke (% equity) + Kd (% debt)
Where:
Ke = Required rate of return on equity capital
% equity = equity as a percent of total capitalization
Kd = after tax required rate of return on debt capital
% debt = debt as a percent of total capitalization
43

) Cost of equity - capital asset pricing model
Formula: Ke = Rf + (Rm-Rf)
Where:
Ke = the investors required rate of return (equity)
Rf = the risk free rate
= beta
Rm = return from the equity market
Rm-Rf = the market premium
In addition to these variables, there are adjustments to
consider in applying this method to closely held companies:
Small company risk
Specific company risk
44

) Components of CAPM
Rf is the risk free rate, either nominal or real. It is typically
the yield from long-term government bonds
It represents an alternative rate of return to the investor
that is risk-free and has liquidity
Beta is a risk measure that is based on the volatility of the
price of the shares of a company compared to the volatility of
the market as a whole
A company whose share price is volatile has more risk
for an investor. Thus, the higher the beta, the higher the
risk
Betas are typically calculated for an industry to provide a
measure of risk for that particular industry
45

) Components of CAPM (contd)
Rm, the return from the equity market, is based on
historical returns over a long period
Rm-Rf (the market premium) is the amount by which the
historical equity returns from the market have exceeded
the risk-free rate
46

) Components of CAPM (contd)
Adjustments to CAPM
Small company premium: studies have shown there is
a small company premium because CAPM under
estimates the return earned by investors in small
companies
Specific company premium: in some cases the
company being valued will have specific risks that
justify an additional risk premium
CAPM equation including adjustments:
Ke = RF + (RF-RM) + S1+ S2
Where:
S1 = size premium
S2 = specific company risk
47

) Cost of debt
Typically based on industry data
Should be a long term rate to match the DCF horizon
Should be calculated after tax since interest is tax
deductible
Formula: Kd = D(1-t)
Where:
Kd = after tax required rate of return on debt capital

D = debt holders required return on debt
t = corporate marginal tax rate
48

) Capital structure
Typically based on industry data
Should be based on market value
As a practical matter debt is often considered at face
value
49

) Steps
50

COMPONENTS
FORECAST PERIOD
Years one through ..n
TERMINAL PERIOD
TERMINAL VALUE
Represents the value
of all cash flows beyond
the forecast period
VALUATION DATE
51

) Terminal value analysis
The discrete forecast period ends when cash flows have stabilized and
expected growth is moderate and sustainable
Methods of calculating terminal value include:
Gordon Model
Assumed Sale
Gordon Model assumes continued ownership of business
The Assumed Sale method is based on a multiple of a measure of financial
performance applied at the end of the forecast period
Key assumptions for the Gordon Model:
Depreciation and capital expenditures should be equal or at a steady
state differential in the residual period
Forecast period should be as long as necessary for a stable level of
growth to be achieved; the terminal period must assume a long-term
stable growth rate
52

) Gordon Model
Comments
This formula represents the value of all cash flows
remaining beyond the end of the forecast period
The model assumes a constant growth in cash flow. The
rate must be sustainable into perpetuity
The conclusion provided by the Gordon Model should be
the same answer as if continuing the cash flow model into
infinity
Formula:
CASH FLOW IN THE FIRST YEAR OF THE TERMINAL PERIOD
(DISCOUNT RATE LONG-TERM GROWTH RATE)
53

) Steps
54

TIME VALUE OF MONEY - TIMELINE
Year:
1
End-of-year factor
Cash flow is received at the end of each period

Year:
1
Mid-year factor
Cash flow is assumed to be received evenly

during the year. For calculation purposes
cash flow is assumed to be distributed
at the mid-point of the year
55

PRESENT VALUE FORMULA
END-OF-YEAR & MID-YEAR FACTORS
End-of-year formula:
PVF =
1
n
(1+r)
Mid-year formula:
PVF=
1
(n-.5)
(1+r)
Where: PVF = present value factor

r = discount rate
n = number of periods
Example calculations:
)
)
)
)
End-of-year
Mid-year
Beginning period is less than one year
Present value of terminal value
56

) Steps
57

) Final adjustments
The sum of the present values of the future cash flows and terminal
value equal the value of the operations of the business
Non-operating assets must be separately valued and added to
the value resulting from the business cash flow
Given a debt-free analysis, debt must be deducted to arrive at the
equity value
Environmental or other contingent liabilities may exist and need to
be deducted from the value
The DCF model typically results in the value of a 100% ownership
in the business assuming appropriate adjustments are made
A range of values can be developed by sensitizing the forecast or
the WACC
58

) Steps
59

) Review procedures
Math check/peer review
Reasonableness checks
Consider forecast in units compared to available capacity
Compare forecast revenue growth to forecast industry growth
Compare forecast margins to historical
Compare forecast margins to similar companies
Compare old forecasts to actual results
Compare old forecasts to current forecasts for the same period
Calculate valuation multiples implied by DCF results and compare
to industry or overall market multiples
60
Asset Approach
Asset Approach
) Asset based approach
Asset based methods
Discrete revaluation of assets and liabilities
Collective revaluation of assets and liabilities
Value is based on fair market value of assets
less fair market value of liabilities
62
Asset Approach
) Asset based methods are primarily used for
holding companies or if liquidation is a
consideration. They have limited applicability for
operating entities
) Other situations where asset approach may apply
include companies with significant tangible assets
and start ups
63
Asset Approach
) Steps to Discrete Revaluation Method
Obtain balance sheet as of valuation date
Restate balance sheet for accounting adjustments
Restate financial assets to net realizable value
Appraise and record tangible property at fair
market value
Identify, value and record intangible assets
Restate liabilities to current value and add any
unrecorded liabilities
Calculate equity value by subtracting current
value of all liabilities from FMV of total assets
64
Asset Approach
) Valuation of tangible assets
Valuation of real estate and improvements
Based on cost, market and income approaches
Considers highest and best use of the property
Should be performed by a qualified real estate appraiser
Valuation of machinery and equipment
Based primarily on cost and market approaches
Consideration should be given to physical depreciation and to
the functional, technical and economic obsolescence that may
exist in the business
Should be performed by a qualified equipment appraiser
65
Asset Approach
) Valuation of intangible assets
Intangible value is created when a company has above average return
on assets (or equity), so that the value of the business (based on
expected earnings or cash flow) exceeds the underlying net asset
value
Consequently, intangible value is the amount by which the value
of the business exceeds the value of the underlying, tangible
assets
Intangible assets can be difficult to value individually with no
guarantee of completeness
The most common technique for capturing total intangible value is
an enterprise valuation to establish total asset value. The value of
current and fixed assets is then deducted to arrive at the value of
intangible assets
66
Asset Approach
) Liquidation analysis should be considered when the

value of the business, on a control basis as
determined by the income or market approaches, is
low relative to the net asset value
) Application of the liquidation approach must consider
the expenses associated with liquidation, including
taxes, selling expenses and plant closing costs, and
the risk and timing related to the proceeds
67
Market Approach and

Reaching a Conclusion
Market Approach
) Valuation multiples, such as price/earnings ratios,
are the basis of the valuation
) Valuation multiples are adjusted for differences
between the subject and similar public companies
or mergers and acquisitions (M&A) activity
Risk factors - size, operating performance, other
Growth prospects
69
Market Approach
) Key inputs
Selection of similar companies and transactions
Publicly traded companies
M&A transactions
Adjustments to the multiples
70
Market Approach
) Adjustments to multiples
Control premium
Lack of marketability discount
71
Market Approach
) Overview
Public companies - based on prices paid for shares of similar
companies traded in the public markets
Merger & acquisition (M&A) activity - based on prices paid for
acquisitions of controlling interests in similar companies
Level of value must be analyzed. Do public company multiples
yield a minority value? What do M&A multiples indicate?
) Key advantage of market approach is that it is based on actual
transactions
) Key disadvantage is difficulty in finding similar public companies
and M&A transactions
72
Market Approach
) Steps
Selection of similar public companies and transactions
Financial analysis and comparison
Selection and calculation of valuation multiples
Application to the company being valued
Final adjustments
73
Market Approach
) Selection of guideline companies and transactions:
Management
Identification - SIC code and key words
Data sources
Business similarity
Similar industry and products
Maturity of operations
Geographic considerations
Size considerations
Operating strategies
Financial characteristics (profitability, growth, etc.)
Trading characteristics
Volume
Share price trends
What is an appropriate sample size?
74
Market Approach
) Steps
Final adjustments
75
Market Approach
) Comparable company and transaction analysis
Gather appropriate data - SEC filings, analyst reports,
press releases, etc...
Comparative analysis is used to benchmark the company
against similar companies or transactions in the areas of
asset management, leverage, liquidity, profitability, risk
and growth
The company can be compared to individual companies,
or to an average for the industry
Adjustments may be required to place companies on a
comparable basis
76
Market Approach
) Comparable company and transaction analysis
The comparison is based on both financial and qualitative data
Specific qualitative factors related to risk include:
Management depth
Size
Product and customer diversification
Volatility of financial performance
) Goal is to develop an assessment of relative risk and growth
prospects of the company versus its peers for which valuation
multiples are available
77
Market Approach
) Steps
Final adjustments
78
Market Approach
) Selection and calculation of the valuation multiples:
Market Value of Invested Capital to earnings before interest,
taxes, depreciation, and amortization (MVIC/EBITDA)
Application results in enterprise value
To arrive at equity value, interest bearing debt must be
subtracted
Other common MVIC multiples include MVIC/Revenue and
MVIC/EBIT
Price-to-earnings (P/E) ratio: application results in the value of
the equity. Sometimes used with pretax earnings
Price-to-book value: application results in the value of the equity,
but is based on net asset value rather than earnings or cash flow
79
Market Approach
) Selection and calculation of the valuation multiples:
The multiples applied to the company are based on the
relative risk and growth assessment versus the peer
companies
Multiples should show a pattern of correlation with
measures of cash flow across comparables
80
Market Approach
) Steps
Final adjustments
81
Market Approach
) Application to the subject company:
multiples should be applied to the appropriate financial data of
the subject company
consistent with the way the multiple for the public companies
or transaction was calculated
A price-to-pretax earnings ratio should not be applied to
the after tax earnings of the company being valued
In some cases, multiples are calculated based on an
average of several years; the multiple should be applied
to the average of the same period for the company being
valued
82
Market Approach
) Steps
Final adjustments
83
Market Approach
) Final adjustments
The value of non-operating, or excess assets, must be
added to the value of the business operations as
determined by market approach
Consideration should be given to significant working
capital differences
Consideration should be given to environmental liabilities
and other contingent liabilities
Debt must be subtracted from the results of applying
enterprise value multiples to arrive at the value of equity
84
Reaching a Conclusion
) Selecting the final value
Subjective weighting:
Mathematical weighting
Professional judgement
In mathematical weighting specific weights are assigned to each
approach and the weighted average calculated
In professional judgement the conclusion is based on
experience and judgment given the quality of information and
the approaches applied
Both methods require subjectivity since the weights selected in
mathematical weighting are subjective
) The final test is common sense and reasonableness
85

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Rajagopal Deloitte Business Valuation

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Business Valuation

Why are Valuations Performed?

What Creates Value?

What Creates Value?

How is Value Measured?

What is Being Valued?

Market, Not Book Basis

Fair Market Value

) The specific value of goods or services to a

Liquidation Value (contd)

Considers the costs incurred to sell the assets

Income Approach Overview and Management

Discounted Cash Flow

Years one through ..n

Discounted Cash Flow

Discounted Cash Flow

Discounted Cash Flow

Discounted Cash Flow

Discounted Cash Flow

Discounted Cash Flow

Discounted Cash Flow

Working capital including the adequacy of the initial working capital

Discounted Cash Flow

Discounted Cash Flow

Income Approach Discount Rate and PV

Discounted Cash Flow

Discounted Cash Flow

Discounted Cash Flow

Discounted Cash Flow

Discounted Cash Flow

Discounted Cash Flow

Discounted Cash Flow

Discounted Cash Flow

Kd = after tax required rate of return on debt capital

Discounted Cash Flow

Discounted Cash Flow

Discounted Cash Flow

Years one through ..n

Discounted Cash Flow

Discounted Cash Flow

Discounted Cash Flow

Discounted Cash Flow

Cash flow is received at the end of each period

Cash flow is assumed to be received evenly

Discounted Cash Flow

Where: PVF = present value factor

Discounted Cash Flow

Discounted Cash Flow

Discounted Cash Flow

Discounted Cash Flow

) Liquidation analysis should be considered when the

Market Approach and

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