Amalia Tamayo Ylanan
Course: BSAT-3 / IRREGULAR
Course Title: Philippine Literature
Date: January 16, 2023
OTHER VALUATION CONCEPTS AND TECHNIQUES
As mentioned in the previous chapters, there are various business valuation
methods appropriate for unique circumstances. You may have encountered
some terms and concepts related to valuation. The following special topics
will be discussed in this chapter.
Due Diligence
Mergers and Acquisition
Divestitures
Other Valuation techniques discussed in other literatures
Due Diligence - Reasonable steps taken by a person in order to satisfy a legal
requirement, especially in buying or selling something. a comprehensive appraisal of a
business undertaken by a prospective buyer, especially to establish its assets and
liabilities and evaluate its commercial potential.
Diligence
the initial chapters, valuation techniques facilitate the process ermining the value of an
asset or an investment. In practice, espec se who will be doing their initial private
offering provide for investr spectus that serves for the reference of the investor on how
the fund distributed or used from this the investor will have more or less an ide at the
risk he or she is about to face.
rder to minimize the investment risk, due diligence is undertaken after nt to purchase or
invest in a company. Due diligence is a proces dating the representations made by a
seller, normally to an investor. cess would require thorough examination of all records
that would vant in the realization of returns or the so-called advertised bene he investors
would procure the services of an audit or fore ountants to determine and validate the
inputs used in the determinatic value or whether there would be some information that
may pose the he realization of the perceive returns. The due diligence team is compo
awyers, auditors and technical experts. Other than the inspection and a ecords, actual
field or site inspection is also taken.
Due diligence was started to be a formal exercise since the mid 1900. In the United
States of America, the Securities Act of 1933 requires full disclosure of information from
the dealers and brokers, this provides protection to the investors in engaging with any
concealed information that would impair the value of the investment. Penalties and
sanctions were imposed by the law. This is to protect the investors at the same time the
economy that due to information or potential risks that were not disclosed may result
economic sabotage.
In the Philippines, Republic Act 8799 or the Securities Regulation Code which serves as
the equivalent regulation that protect investors in the country. This law is actually the
charter of the Securities and Exchange Commission or the SEC. The law enumerates
the information that needs to be disclosed by companies and the frequency to enable
the commission to monitor the operations of the partnerships and corporations in the
Philippines. Certain penalties were imposed by the law for noncompliance with the
requirements
set.
Types of Due Diligence
Due diligence varies and designed according to the size and nature of the investment.
The exercise maybe categorized into who conducts the process and what is the nature
of the prospective investment,
Due Diligences According to the Executor
•
Corporate Due Diligence
If the due diligence exercise is to be conducted or commissioned by a company or
corporation that will invest to business this is considered as Corporate Due Diligence.
The corporate due diligence normally commissioned external experts such as technical
experts, lawyers and auditors, since companies do not consider this exercise as their
core function. The cost of due diligence is considered as part of the cost of investment
of the company, given that the investments entered by corporations are significant it is
fitting to incur costs rather than impairing the value of the investment in the middle of the
operations.
Private Due Diligence
If the due diligence exercise is facilitated or conducted by individual or at least few
individual investors but is not yet incorporated this is called private due diligence. While
the broker-dealers are legally mandated to conduct due diligence on a security before
they bring the investment into the market, individual investors still would require due
diligence for the value that they initially calculated. Normally, private due diligence was
done by the investors themselves since most of them are not capable of forming or
hiring a team. In most cases, private investors are less aggressive than the
corporations. Although due diligence team can still be constituted, but for as long as the
engagement is with a private individual is considered private due diligence.
Government Due Diligence
In some cases, government needs to do due diligence either for investment or
regulatory purposes. If the due diligence is commissioned or conducted by the
government, it is called as government due diligence. Most of the time, this type of due
diligence is for the protection of the public or evaluation of the operations of the
company for the public interest.
Due diligence According to Subject
Hard Due Diligence
When the due diligence focuses on the data and hard evidential information this is
called hard due diligence. Hard due diligence is where the lawyers or legal team,
accountants, and deal facilitators are actively engaged. Normally, hard due diligence
focuses on earnings before interest, taxes, depreciation and amortization (EBITDA), the
aging of receivables, and payables, cash flow, and capital expenditures. Intellectual
property and physical capital are also focus, particularly for subject companies belong to
sectors such as technology or manufacturing.
Driven by mathematics and legalities, hard due diligence is prone to unrealistic and
biased interpretations by eager salespeople. Soft due diligence acts as a
counterbalance when the numbers are being manipulated or overemphasized.
Examples of hard due diligence activities include, but not limited to: Review and audit of
the financial statements
O
Validation of the projections for future performance
o Analysis of the market or industry where the subject company
belongs
O Review of operational policies, process and procedures
o Review of potential or ongoing litigation
O Review of antitrust considerations
Assessment of subcontractor and other third-party relationships
Soft Due Diligence
Soft due diligence focuses on the internal affairs or the internal organization of the
company and its customers. So essentially, this type
of due diligence is designed to validate the qualitative factors that affect the realization
of returns, which measurement cannot be normally done by use of mathematical
calculation and therefore harder to conduct compared to hard due diligence which
concentrates to verifiable data.
Most of the time the Hard Due Diligence is conducted and focused heavily on the
quantitative and economic drivers of the returns. But recently, soft due diligence started
to be seen with great importance since the realization of the perceive returns which
drives the value of an investment will be delivered by the employees and the customers
or clients.
The reason why the popularity of the soft due diligence had traction is that there are
some drivers to enable the business to realize and sustain its returns were not fully
captured through reports and even contracts, such as employee relationships, corporate
culture, leadership etc. Most failures of the business are due to inability to validate the
integrity of the internal foundation of the business.
Subcategory of soft due diligence is the Human Capital Due Diligence. This was
introduced in April 2007 issue of the Harvard Business Review. Human capital due
diligence is focus on assessing the organization, mission and vision as well as the
competencies of the employees and management of the business. This sometimes
covers even the review of the competencies of the board of directors.
Soft due diligence is concerned with employee motivation, and compensation packages
are specifically constructed to boost those motivations. It is not a panacea or a cure-all,
but soft due diligence can help the acquiring firm predict whether a compensation
program can be implemented to improve the success of a deal.
Soft due diligence can also concern itself with the target company's customers. Even if
the target employees accept the cultural and operational shifts from the takeover, the
target customers and clients may well resent a change in service, products, or
procedures. This is why many M&A analyses now include customer reviews, supplier
reviews, and test market data.
Examples of soft due diligence activities include, but not limited to: o Organizational
Review including Succession Plans
o Competency Assessment
Quality Assurance on Customer Services Quality Assurance on Processes
O On the ground interview and examination
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Combined Due Diligence
When the focus of the due diligence exercise is to cover both quantitative and
qualitative areas of the company or business it is considered as the combined due
diligence. It is also known as comprehensive due diligence.
In the combined due diligence is where the hard and soft due diligence activities
intertwine, especially when the focus of the evaluation will come across the quantitative
impact of those covered by the soft due diligence. For example, compensation and
benefits, retirement packages, quantitative impact of collective bargaining agreement,
cost benefit analysis of customer service initiatives etc.
These programs are not only based on real numbers, making them easy to incorporate
into post-acquisition planning but they can also be discussed with employees and used
to gauge cultural impact.
Factors to be considered in the Due Diligence Process
Based on the foregoing discussions, the due diligence process varies from an
investment prospect to another. There are various strategies on how the due diligence
process was administered. The process would also be affected by the factors or the
elements that would affect the investors decision to proceed with the investment or not.
Market Capitalization
The company's market capitalization or total value provides an indication on how volatile
the value of the company in the market. Recall that the market capitalization when
divided into the number of outstanding shares is the market value per share. This
represents on how broad its ownership is and the potential size of the company's target
markets.
The market capitalization is also used to categorize the companies in terms of its
volatility. The Philippine Stock Exchanges observe 3 categories of market capitalization
i.e. Large-cap, Mid-cap and Small- cap. Large-cap companies tend to have stable
revenue streams and a large, diverse investor base, which tends to lead to less
volatility. Mid-cap and small-cap companies typically have greater fluctuations in their
stock prices and earnings than large corporations. In some countries, they also have
Mega-cap which has larger values than large-cap.
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Performance/Profitability Trend Analysis
The historical performance and trend of the company would add more integrity on the
realization of the future earnings. The results of the performance and profitability trend
analysis may provide sufficient data for the projection. Some analysts use regression
line analysis to some project the future cash flows based on the historical trend. Some
of the focus of the performance are revenue growth, net income growth, net income
margin, EBITDA margin, return on invested capital, return on total assets etc.
External Environment Analysis
Assessing the position of the company in the industry is also a good input to the due
diligence exercise. It is believed that industry benchmarking would allow the analyst to
decipher how the target investment fair with the other players in the industry. This may
address the question - Are the variables inputted in the valuation relatively the same
with the other industry players?
By looking into the comparable companies will enable the validation process, this is
because if the companies used as index in the market can perform the same level
assumed in the valuation then it is highly probable. This also involves scanning the
market forces that may have an impact to the business. A sound test is to validate that
factors impact to the company for 5 to 7 years.
Management and Share Ownership
Assessment of the personalities involved in the governance and policy making of the
company is also critical. Their leadership style may serve as a reference for the analyst
or investor to assess the integrity of the initial valuation. Newer companies tend to be
founder-led. It may be helpful to conduct research on the background of the members of
the management team to find out their level of expertise and experience. This is why
most companies, especially publicly listed companies, has to post the profile of the
members of the board in their annual reports, company website and other official
channels of the company.
Also, it would be helpful to understand the percentage of share of each member of the
board and whether they have been selling shares recently. High ownership by top
managers is a plus and low ownership
is a red flag. Shareholders tend to be best served when those running the company
have a vested interest in the performance of the stock.
Financial Statements
The financial statements serve as the best document to support the financial
performance and financial position of the company including their cash flows. Careful
scrutiny of the contents of the financial statements particularly the notes to the financial
statements because it provides information on how the company is seeing its future.
Stock Price History
Similarly, investors should do the same to analyze stock price history. Investors should
research both the short-term and long-term price movement of the stock and whether
the stock has been volatile or steady. Compare the profits generated historically and
determine how it correlates with the price movement. Keep in mind that past
performance does not guarantee future price movements. If you're a retiree looking for
dividends, for example, you might not want a volatile stock price. Stocks that are
continuously volatile tend to have short- term shareholders, which can add extra risk
factors for certain
.
⚫ Stock Dilution Possibilities
Related to the analysis of stock price history, investors should know how many shares
outstanding the company has and how that number relates to the competition. If the
company is planning on issuing more shares, the stock price might take a hit and hence
the possibilities of stock dilution.
Market Expectations
Investors should find out what the consensus of market analysts is for earnings growth,
revenue, and profit estimates for the next two to three years. Information may be
available free in finance websites or from investment banks or other financial institutions
providing those services. Investors should also look for discussions of long-term trends
affecting the industry and company-specific news about partnerships, joint ventures,
intellectual property, and new products or
services
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Long and Short-term Risks
The main objective of due diligence is essentially risk management. Hence, an
important part of the process is taking into consideration the long and short-term risks.
Make sure to understand both the industry-wide risks and company-specific risks.
Example of risks are outstanding legal or regulatory matters, unstable management,
movement of interest rates, product quality, market perception, among others. Investors
should keep a healthy attitude of professional skepticism at all times, picturing
worst-case scenarios and their potential outcomes on the stock.
Mergers and Acquisitions
Mergers and acquisitions (M&A) is a corporate strategy that allows a company
to combine its assets to another company or to acquire another company.
Merger is when two companies combine to form another company. On the
other hand, acquisition is taking over or taking a part of a company. While, in
the case of merger it seems that the share in interest of two companies are
equal though it is not. For instance, in 2013 the Philippine National Bank
(PNB) and Allied Bank announced its merger, though in the end it is PNB who
became the surviving company. This is why to avoid issues on what to call a
business combination strategy it is called M&A.
M&A became a popular business strategy for some companies to expand and
for other to save from distress. In M&A, it allows the company to increase its
revenue to cover for the expenses, especially the fixed costs, or increase its
asset base or even capture a market share or control the supply chain.
The following are the top reason why companies entered into M&As:
O Manage the cost of capital
O Expansion and growth
O
O
Economies of scale
Diversify for expanded market coverage
O Widen access in the industry
O
Technological advancement
O Tax management strategies o Legal strategies
O
O Control over supply chain
In M&As there should be a (1) company must be willing to take the risk and vigilantly
make investments to benefit fully from the merger as the
competitors and the industry take heed quickly; (2) multiple bets must be
made to maximize the opportunities available; and (3) the acquiring firm must be patient
in the realization of its investment.
M&As According to Form
M&As maybe classified according to how they ay formed. It is either through absorption
or through consolidation. M&A by Absorption is done when a company takes over
another company, normally the latter are in a more disadvantageous position. This is
like when Philippine Long Distance Telephone Inc. absorbs Digitel Telecommunications
Philippines.
M&A through consolidation is when two companies combined its assets and/or
restructure their debt profile. Most of the M&A through consolidation are done by
financing institutions like banks. In 2019, Bangko Sentral ng Pilipinas has announced its
plan to launch programs that will encourage more mergers through consolidation among
rural banks.
M&As according to Economic Perspective
M&A classification may also be dependent on its economic perspective. These M&As
may be classified into horizontal, vertical or conglomerate. Horizontal M&As is when two
firms in the same industry combined. An example of this is in 2000, when Jollibee
Foods Corporation acquired Chowking Food Corporation. These two are players in the
fast food industry.
Vertical Merger is when two companies merged coming from different stages of
production or value chain. These occurs when a supplier purchased its customer or vice
versa. Conglomerate on the other hand are M&As from completely unrelated industries.
M&As based on Legal Perspective
M&As can also be classified according their legal perspective like Short-Form M&As,
Statutory M&As and Subsidiary M&As. Short-form M&As is when parent purchase more
interest from its subsidiary. Normally a parent companies that has about 90% ownership
to 100% is a Short-form M&A. Although in the case of Jollibee Foods Corporation (JFC)
and Greenwich Pizza Corporation (GPC). JFC has 80% ownership in GPC but decided
to buy-out their partner Green Foods Franchising in 2004 and changed the name of
GPC to Fresh N' Famous Inc.
Statutory M&As is when a company combines with another where the company, the
acquirer, retains its name. In 1999, Far East Bank and Trust Company merged with
Bank of Philippine Island (BPI). Today, BPI is the surviving company after the statutory
merger.
Subsidiary M&As is the consolidation of the subsidiaries of a holding or parent
company. An instance in 2006, where Chowking Foods Corp, Greenwich Pizza Corp
and Baker Fresh Foods Philippines - subsidiaries of JFC merged into Fresh N Famous
Foods Inc. and became the second largest food service in the Philippines in that time.
Five Stages of M&A
1. Pre-acquisition Review
The first step is to conduct internal evaluation with regards to the business opportunity.
This may require initial valuation based on ballpark figures. This will establish whether
an investment opportunity is palatable and worth the investment.
2. Investment Opportunity Scanning
If found to be attractive, the second step is to scan the opportunity for any potential or
interest parties. Chances if there are other potential parties interested with the M&As it
is a signal that is worth the investment. This stage is also an opportunity to gather risk
indicators that surrounds the business opportunity. In this stage, due diligence may
already begin.
3. Valuation of Target Investment
Once additional relevant information was gathered, a more comprehensive valuation
and sensitivity analysis should be conducted. The value of the offer must be relevant,
realistic and reasonable. In some cases, further due diligence is also taken place and
further analysis is involved. Some investors require the need to do discounted cash
flows analysis to validate their ballpark estimate.
4. Negotiation
This is the part where the through business comes in. The companies will have to find
the common sweet spot i.e. the selling company must know how much to sell and the
other how much to buy. It should be noted that in order for the negotiation to succeed
each party must give in something. This is where the sensitivity analyses will be given
better value and importance since the investor or seller will know how much price they
are willing to give or receive and how much risk are they are willing to take.
The final stage is the actual integration of the companies. The execution of the
agreement and reincorporation is needed. For listed companies protocols are needed to
observed like disclosures proper notification to philippine stock exchange and securities
and exchange commission
Five Stages of M&A
1. Pre-acquisition Review
The first step is to conduct internal evaluation with regards to the business opportunity.
This may require initial valuation based on ballpark figures. This will establish whether
an investment opportunity is palatable and worth the investment.
2. Investment Opportunity Scanning
If found to be attractive, the second step is to scan the opportunity for any potential or
interest parties. Chances if there are other potential parties interested with the M&As it
is a signal that is worth the investment. This stage is also an opportunity to gather risk
indicators that surrounds the business opportunity. In this stage, due diligence may
already begin.
3. Valuation of Target Investment
Once additional relevant information was gathered, a more comprehensive valuation
and sensitivity analysis should be conducted. The value of the offer must be relevant,
realistic and reasonable. In some cases, further due diligence is also taken place and
further analysis is involved. Some investors require the need to do discounted cash
flows analysis to validate their ballpark estimate.
4. Negotiation
This is the part where the through business comes in. The companies will have to find
the common sweet spot i.e. the selling company must know how much to sell and the
other how much to buy. It should be noted that in order for the negotiation to succeed
each party must give in something. This is where the sensitivity analyses will be given
better value and importance since the investor or seller will know how much price they
are willing to give or receive and how much risk are they are willing to take.
Considerations to Maximize M&A Opportunity
In evaluating an M&A opportunity, most analysts or investors observe certain signals
that would enable them to make proper recommendation or decision to pursue an M&A
opportunity.
Determine objective behind the acquisition and the benefits expected by both acquirer
and target company from the deal.
Understand industry of both acquirer and target. Horizontal integration occurs if the
acquirer buys another company that plays the same role in the industry's value chain.
Horizontal integration normally happens when an acquirer buys a competing firm.
Vertical integration happens when the acquiring company buys another company that is
vertically related to them in the value chain (i.e. a supplier or a buyer). For example, a
company that manufactures car buys a target firm that supplies tires.
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•
Identify key operational advantages of acquirer and target company. It is interesting to
identify how each firm can complement each other to improve synergy. For example, the
acquiring company might have strong research and development (R&D) capability while
the target company has an efficient distribution network in place.
Check with the acquirer if the takeover is friendly or hostile. Hostile takeover occurs
when the current management opposes the deal. Current management may prevent
access to information in hostile takeovers which increases the risk of overpayment as
the acquirer may have limited information used valuing the business.
Analyze pre-merger operating and financial performance of acquirer and target
company through key ratios such as return on equity, gross profit margins, operating
expenses % to sales and working capital metrics. This will give an idea which
opportunities can be explored to create more value.
Evaluate tax position of both companies and determine if there are net operating loss
carry forwards and deferred tax assets in their books.
Reasons for the failure of M&A
Like in any other business strategies, not all M&A opportunities succeed. There are also
times that M&As fail to realize the perceive returns.
• Poor Strategic Fit
This is when companies that entered into M&A failed to find a ground to align their
mission, vision and more importantly their goals. This happens when instead of
strategically reaping more returns it will be diluted by the higher costs because the
company keeps on compensating for the challenges faced between the merger of
another company
Poorly executed and ill managed integration phase
Integration is the most critical part of the M&A process. This is the stage as describe in
the earlier discussion of this part, where the inception of all the affairs that will start the
realization of the perceive returns of the business will take place. Setting the wrong foot
may lead to a cliff
Inadequate Due Diligence.
Due diligence is the process that validates all the assumptions and representations.
Failure to identify and validate the solidity of the inputs in the decision-making process
will end up with the risk encountering issues and unforeseen liabilities. Cost of
rectification would be fatal to the company.
Too Aggressive Projections and Estimates
Even with a solid due diligence and assumptions backed up by facts, there are risk of
over-projection or optimistic estimates about the sustainability and growth. It will be
unfortunate if the company will not provide sufficient cushion or provision to absorb
these unforeseen risks in the calculation of the initial investment or future net cash
flows.
Major Valuation Methods used in Mergers and Acquisitions
Usually the valuation process in Mergers and Acquisition transaction is conducted by
the two involved parties: the acquiring and the target companies. These 2 parties by
principle have two opposing objectives i.e. the acquiring company will want to purchase
the target company at the lowest price, while the target company will want the highest
price.
Thus, valuation is an important part of mergers and acquisitions (M&A), as it guides the
buyer and seller to reach the final transaction price.
Below are three major valuation methods that are used to value the target. All have
been discussed in the foregoing chapters.
Discounted cash flow (DCF) method.
The target's value is calculated based on its projected future cash flows with appropriate
discount rate.
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Comparable company analysis.
.
Relative valuation metrics for public companies are used to determine the value of the
target.
Comparable transaction analysis.
Valuation metrics for past comparable transactions in the industry are used to determine
the value of the target.
Divestiture
Divestiture or divestments refer to the disposal of the assets of an entity or business
segment often via sale to third party. Divestiture generally means the sale of any assets
that the company owns but is also used as a term to describe sale of a non-core
business segment. Partial or full disposal of the business may occur depending on why
management decided to sell. Divestiture is also a strategy used in portfolio
management but is used less frequently compared to mergers and acquisitions. Most
people are more familiar with buy-side transactions but companies are also keen on
disposing non-performing assets or segments in their effort to increase shareholder
value. Divestitures enable companies to improve cash flows, discontinue operating
segments that are not aligned with the strategic direction of the company and create
additional shareholder value.
Companies should constantly review performance of firm assets and business
segments in order to determine whether divestiture is the best option to take to increase
shareholder value.
When looking at the financial statements of the firms that formerly owned the divested
segment, the sales and/or profits of the divested segment are presented separately
under a separate section (e.g. Operations) up until the transaction date.
Discontinued
Rationales behind Divestiture
Sell non-core or redundant business segments - This is the most common reason
behind divestitures. Companies tend to sell non- core segments in order to focus on
maximizing profitability of their core businesses. If there is change in the parent
company's strategic direction, divestitures may also occurs to dispose assets that are
not in line with the new strategy.
Generate additional funds - If the company does not want additional liability nor equity,
they can also opt to divest assets to generate cash. In some cases, the cash
requirement is needed for new acquisitions and disposing non-core segments to
support this objective can be a feasible option.
Take advantage of resale value of non-performing segments instead of incurring losses
- If an operating segment is consistently generating losses, it might be worth more as a
divestment instead of bleeding money in retaining it
•
Ensure business stability or survival - In periods where the business face severe
financial difficulties, divesting assets can be a better option that bankruptcy or closure.
Adapt to regulatory environment - Divestment may also occur if the regulatory
authorities mandate it to improve market competition. Changes in taxation policies may
also lead to decisions to divest potentially unprofitable businesses.
Lack of internal talent - In some instances, the absence of qualified internal talent to
manage a business segment may result in consistent losses. This can make the
segment a candidate for divestment in the future.
• Take advantage of opportunistic offer from third party - Unsolicited offers from third
party to purchase an asset from the company can also be a reason for divestment.
Since the asset is not being offered for sale, the selling company is in a better position
to negotiate and demand a higher price.
Types of Divestitures
Open with
Divestitures can be done through the following transactions:
a. Partial sell-offs.
The divesting company only sells a portion of the business (an operating segment,
subsidiary, product line) in order to raise funds that can be used to fund growth of more
productive segments.
b. Equity Carve-out.
This occurs when an initial public offering is performed for up to 20% ownership of a
subsidiary. The parent company retains control of the subsidiary from the remaining
80% shareholding. Carve-outs allows some level of cash proceeds from the IPO and
establishes an equity market for the shares of the subsidiary. Companies that do
carve-outs often need additional cash and often faces uncertainty about how much the
subsidiary is worth and what are the plans and timing for the final separation.
C. Spin-off.
A business segment of the parent company is separated and is made into an
independent new company. Shares of the spin-off company is distributed to the existing
shareholders of the parent company. Ownership percentage of shareholders is the
same for both spin-off company and parent company.
In a spin-off, there is no additional cash generated and total outstanding shares is still
the same. Spin-off is recommended if there are significant tax benefits from the
incorporation of a new entity and there is no urgent need to raise cash. Spin-off allows
the business segment to further unlock its potential by getting the right focus from the
right people. Spin- offs permits shareholders to own shares in both entities.
d. Split-off.
A business segment of the parent company is also separated and made into an
independent entity. However, shareholders are offered the option to exchange parent
company shares for the new company shares or just retain the parent company shares.
No additional cash is generated in split-offs, but outstanding shares are reduced.
Split-offs are less common than spin-offs and is usually employed to adjust shareholder
ownership level in both entities.
Deciding whether to continue, liquidate or divest
When deciding to divest, three values are compared: going concern value, liquidation
value and divestiture value. Going concern value and liquidation value follows the
similar concepts discussed in previous chapters. Divestiture value refers to the price
that the highest bidder is willing to pay for the
investment or asset. Between the three, the right alternative to pursue is the option
which will yield the highest value to the seller.
Impact of divestitures to firm value is enumerated below:
o If divestiture value is same as going concern value, divestiture will not have impact to
the selling company's value
o If divestiture value is higher than going concern value, divestiture will
increase value of selling company
o If divestiture value is lower than going concern value, divestiture will reduce value of
selling company.
Ceturn on investment or ROI measures the earnings generated by the usiness in
relation to the investment made to the business. ROI-based aluation method is a quick
computation of company value based on the vestment that the investor is willing to pay
for the business.
or example, if the business is asking for Php250,000 in exchange of 25% wnership in
the business, total company value can be derived using ROI- ased valuation method. To
compute for the value of the company, divide the mount of ask (Php250,000) by the
ownership stake (25%). This will result in quick computation of business value at
Php1,000,000.
n a practical view, ROI-based valuation can be useful since they can already et a sense
of how much investment they are okay to place. However, ROI an be very subjective
since it will depend on the market.
or the above example, let us assume that cost of investment is only p600,000.00
Therefore, the ROI expected by the seller (you) is mp400,000.00 or 40% assuming
100% of the company is being sold. Now, e same ROI of 40% is being maintained here
by the seller (you) when you tched the price of Php250,000.00 for 25% of the business.
This therefore ake this approach subjective. Conversely, the prospective buyer will have
own independent valuation to validate the price you pitched.
ith this approach, additional information is still necessary to convince an vestor or buyer
of the result. An investor or buyer will want to know:
Length of time to recover the investment
The rate of returns based on the expected net income as compared with the initial
amount invested
Aggressiveness of the assumptions used and results.
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Attractiveness of the investment
At the end of the day, the investor will need to conduct its own diligence and perform
valuation exercise using the concepts discussed in previous chapters.
Dividend Paying Capacity Method
The Dividend Paying Capacity Method, also called as Dividend Payout, is conceptually
an income-based method but can also be classified as market approach as it also
considers market information. This method is somewhat similar to capitalization of
earnings method. Instead of using earnings, Dividend Paying Capacity Method uses
estimated future dividends that can be paid out by the business. The future dividends
are then capitalized using five-year weighted average of dividend yields of other
comparable companies. The Dividend Paying Capacity method links the relationship
between the following variables:
a.
Estimated amount of future dividends that can be paid out (based on historical earnings
and dividend payout of the business)
b. Weighted average dividend yields of comparable companies
C.
Estimated value of the business
Capacity to pay out dividends is also linked with liquidity and should be considered in
the analysis. Profitable companies can still be illiquid as working and fixed capital
requirements may require significant amount of cash. Without excess cash, the
company will not be able to declare dividends.
To illustrate, SV Company has a five-year history of weighted average annual profits of
Php 500,000. The weighted average dividend payout percentage of SV Company over
the last five years is 30 percent while weighted average dividend yield rate of
comparable companies is at 7.5%.
a. Compute for the future annual dividends that can be paid (capacity to pay out) by
multiplying average annual profits by the dividend payout ratio.
Wtd. Ave Profits x Wtd. Ave Dividend Payout = Future Dividends = Php 150,000.00
Php 500,000 ×30%
b. Compute for the value of the company by dividing future dividends by the weighted
average dividend yield rate of comparable companies at
Future Dividends/Wtd. Ave. Dividend Yield = Value of Company
Php 150,000/7.5% = Php 2,000,000.00
This method is useful in computing the value of companies that are stable and has
history of consistently paying dividends to their shareholders. This method is preferred
in valuation since it links the market price with how much shareholders really receive
(dividends) as a percentage of company earnings.
MARKET VALUE APPROACH
Market Value Approach follows the concept that the value of the business can be
determined by reference to reasonably comparable guideline companies for which
transaction values are known. The values may be known because these companies are
publicly traded or because they were recently sold, and the terms of the transaction
were disclosed. The business valuation methods under the market approach that are
typically used in professional business appraisals include comparative transaction
method/comparative private company sale data method, guideline publicly traded
company method and use of expert opinions of professional practitioners.
Market-based business valuation methods are routinely used by business owners,
buyers and their professional advisors to determine the business worth. This is
especially so when a business sale transaction is planned. After all, if you plan to buy or
sell your business, it is a good idea to check what the market thinks about the selling
price of similar businesses.
The market approach offers the view of business market value that is both easy to
grasp and straightforward to apply. The idea is to compare your business to similar
businesses that have actually sold.
If the comparison is relevant, analysts can gain valuable insights about the kind of price
the business would fetch in the marketplace. Analysts can use the market-based
business valuation methods to get a quick sanity check of the pricing estimate or use
this as a compelling market evidence of the likely business selling price.
All business valuation methods under the market approach fall within one or more of the
following categories. It is either based on statistics/empirical or heuristics or combination
of these methods.
Empirical/Statistical Approach
Empirical or Statistical approach generally uses research and database processing in
order to come up with conclusion and recommendation. The approach requires
references and evidences to support the determination and evaluation. Information may
take the form of Sales Data, Financial Performance and other historical information.
Trend analysis and benchmarking maybe used to process the information. Tools are
also made available to facilitate processing large information.
Comparative Private Company Sales Data
This is an empirical approach. This is formerly known as comparative transaction
method. Other literature called this as guideline transaction method or comparative
business sales data.
This method involves finding out prior transactions (i.e. mergers and acquisitions,
divestiture, etc.) of comparable companies. Such a transaction might represent either a
minority perspective or a majority perspective. Transactions data can be obtained by
finding out the exact industry of the business under consideration using the established
industry classification methods and searching valuation databases for historical
valuation evidence. A number of publications collect and disseminate information on
transactions. Most publications make their databases accessible on the Internet for free
on a per-use basis or annual subscription access. Among the most widely used are:
Institute of Business Appraisers (IBA) BIZCOMPS®
Pratt's Stats TM
Done Deal TMM
TM
Mid Market Comps TM (ValueSource) MergerstatR
An ideal guideline transaction would be the one from a very similar company in the
same industry. If no direct comparison is available, other data might be used after
considering their market, products, etc. Transactions data required adjustment for the
transaction-specific factors such as non-compete agreement, employment contracts,
etc. In selecting which method to employ in a valuation assignment, the definition of
value, the size of the company being valued and the magnitude of the valuation stake
(majority vs minority) are important. A majority stake in a large well-established should
be valued relative to either (a) a prior transaction of the same company involving a
majority stake or (b) guideline transactions representing a majority stake involving a
comparable company. A minority stake should be valued using the guideline public
company method after applying proper discounts and adjustments.
The advantage of this approach is that source data is reliable and comparable data
includes sales of small businesses that can be similar the small business being valued.
Although the limitation of this
approach is that there is insufficient market evidence in some industries, and it will
require careful data selection, analysis and consistent data reporting standards.
Guideline Public Company Data
The guideline public company method involves identifying a comparable company and
obtaining the stock price for the company's listed securities. Publicly listed companies
(PLCs) are required to file their financial statement electronically with the Securities and
Exchange Commission (SEC). These filing are public information and are available on
the SEC website at https://www.sec.gov.ph. Information are also available in Philippine
Stock Exchange website at https://pse.com.ph
In most cases, the stock prices as obtained from a public market represent a minority
stake. The advantage of this method lies in the availability of a large set of recent data.
However, it might not be very appropriate in valuing early-stage and/or small
businesses. In using public company data to value private companies, proper
adjustments must be made to the benchmarks being used on account of size, growth
potential, capital structure, business life cycle (i.e. early stage or maturity), etc.
The advantage of this approach is that there are plenty of transaction data available
from the public capital markets. Business sale data reporting is generally consistent and
reliable and business financial reporting data are readily available. Although it can be
noted that the limitation of this approach is that comparison to small businesses may not
be as relevant, the data generally involves sales of non-controlling business ownership
interest (not the entire company) and data requires adjustment for lack of marketability
of private company ownership interest.
Prior Transactions Method
The prior transaction method involves looking up historical transactions in securities of
the business undervaluation. The valuation might be for minority stake such a historical
stock quote from a listed stock exchange or it might be for a majority stake such a
merger and acquisition transaction involving the business. Additional considerations in
selecting prior transactions as a benchmark include the timeline of the transaction, the
economic situation at the time of the transaction, etc.
The advantage of this approach is that it is already a good reference for valuation, if the
data is available. Since this is reliant heavily on the data, absence of a good data may
not enable this approach to produce reliable results.
Comparable Company Analysis
In Financial Management, financial ratios are used as tools to assess and analyze
business results. Recall that one of these purposes can be used to determine the value.
These financial ratios are P/E Ratio, Book to Market Ratio, Dividend Yield Per Share
and EBITDA Multiple. Ratios or multiples are useful tools for doing comparative
company analysis. The advantage of having ratios and multiples is that it creates better
and relevant comparison knowing that opportunities or investments have distinct drivers
of their performance.
Comparable company analysis is a technique that uses relevant drivers for growth and
performance that can be used as proxy to set a reasonable estimate for the value of an
asset or investment prospective.
In determining the value using comparable company analysis, the following factors must
be considered:
Comparators must be at least with the similar operations or in the similar industry
Total or absolute values should not be compared
Variables used in determining the ratios must be the same Period of observation must
be comparable
Non quantitative factors must also be considered
Price - Earnings Ratio
Price - earnings ratio (P/E) Ratio represents the relationship of the market value per
share and the earnings per share. It sends the signal on how much the market
perceives the value of the company as compared to what it actually earns. P/E Ratio is
computed using the formula:
P/E Ratio =
Market Value Per Share Earnings Per Share
To illustrate, Chandelier Co. is a listed company with the market value per share of
Php12.0 and reported earnings per share of Php4.0.
Using the equation, the P/E ratio is 3. This means that the Chandelier Company can
create 3x the value of what it earns.
P/E Ratio is also known as P/E Multiples or Price Multiples. To determine the value of a
company using P/E ratio, management accountants and analysts use P/E of the
comparable company.
For instance, Jopet Hotels and Leisure is a hospitality company. Based on the income
statement of the company, it reported earnings of Php7.00 per share. Based on the
listed companies under hospitality industry, the average P/E ratio is 4.25. With the
foregoing information, you can expect that the value of Jopet Hotels and Leisure is
Php29.75 per share [Php29.75 = Php7.00 x 4.25].
Book-to-Market Ratio
Book-to-Market ratio is used to determine the appreciation of the market to the value of
the company as compared to the value it reported under its Statement of Financial
Position. It may be recalled that the book values of the company are based on historical
costs and does not purely incorporate the value in the market now. However, the only
limitation of this ratio is that certain values incorporated do not represent the true value
of the company. Hence, further due diligence is imperative.
Book-to-Market ratio is computed using this equation: Net Book Value Per Share Market
Value Per Share
Book to Market Ratio
Book Value per share can be derived by dividing the net book value to the number of
outstanding shares available to common or ordinary. Net book value is the difference of
the total assets and the total liabilities. This represents the claim of the equity
stockholders to the company.
To illustrate, Chandelier Co. reported a Book Value per share of Php35 and with a
market value per share of Php12.50. The Book-to- Market ratio is 2.80 which is
computed as follows:
Book to Market Ratio = 35.0 12.50
Book to Market Ratio = 2.80
This means that for every Php35 per share that is owned by a stockholder it is 2.8x
larger than its value in the market.
If Book-to-Market approach is used for comparable company analysis, the key
component of the financial statement needed is the Statement of Financial Position. To
illustrated, Jopet Hotels and Leisure reported a book value per share of Php16.5 and
the hospitality industry average Book-to-Market is 0.5, then the value of Jopet Hotels
and Leisure can be estimated around Php33 per share [Php33 = Php16.50/0.5].
Dividend-Yield Ratio
Dividend Yield Ratio describes the relationship between the dividends received per
share and the appreciation of the market on the price of the company. Dividend-Yield
Ratio is also known as dividend multiple. Next to Price Earnings Multiple, this is also a
popular tool because it provides the investors with the value which they can actually get
from the company.
The Dividend Yield Ratio (DYR) is computed using this equation
Dividend Yield Ratio =
Dividend Per Share Market Value Per Share
To illustrate, Chandelier Co. declared and paid dividends of Php1.50 per share and their
market value per share is Php12.50. Based on the foregoing, the dividend yield ratio is
0.12 computed as follows:
DYR =
Dividend Per Share
Market Value Per Share
DYR =
Php1.50 Php12.50
DYR = 0.12
This means that for every Php1.50 dividends they pay it will translate into 12% of the
market value of the equity. Using this as a tool for comparable company analysis, DYR
will works as a multiplier to the dividends per share declared by the company.
Suppose that Jopet Hotels and Leisure declared Php1.5 per share and the average
dividend multiple of the similar industry is 0.047. The market value per share can be
estimated to be around Php31.91 per share [Php31.91 = Php1.50 / 0.047].
EBITDA Multiple
EBITDA or Earnings Before Interest, Taxes, Depreciation and Amortization represents
for the net amount of revenue after deducting operating expenses and before deducting
financial fixed costs, taxes and non-cash expenses. Given the components, EBITDA
can serve as a proxy of cash flows from operating activities before tax. Traditionally,
cash flows from operating activities is computed by collections less payments for
operating expenses. Indirectly, EBITDA can be computed from net income plus
depreciation and amortization and incorporating working capital adjustments.
EBITDA Multiple is determined by this equation
EBITDA Multiple
=Market Value per Share/EBITDA per share
EBITDA per share is derived by dividing EBITDA by outstanding share for common
equity or ordinary shares. To illustrate, Chandelier Co. reported EBITDA per share of
Php6 and the market value per share being Php12.0. Given the equation the EBITDA
Multiple is 2 [2 = Php12.0 Php6.0]
This means that the value of the firm to the market is 2x for every peso of EBITDA
earned. In practice, others adjusted the EBITDA to incorporate costs relative to other
quantified risks. This is done by adding more costs or recognizing contingent expenses
to generate a more conservative EBITDA results which will serve as driver for the value
of the market.
To illustrate, Jopet Hotels and Leisure reported an EBITDA multiple of Php8.50 per
share. The average EBITDA multiple of the hospitality industry is 3.5. Given the
foregoing, the value of the equity is about Php29.75 [Php29.75 = Php8.50 x 3].
To illustrate further, it also assumed that will have to procure insurance and security
costs to protect the plant assets of the company. This is about Php0.5 per share. Given
this additional information on the
—
foregoing, the value of equity is Php28.0 [Php28.0 = (Php8.50 Php0.50) x 3.5]. You may
note that the value of the firm decreased by Php1.75 [Php1.75 = Php29.75 - Php28.0]
after the risk management cost is incorporated.
In summary, comparable company analysis uses tools to enable the comparison
between companies given the differences in 3s - Strategy, Structure and Size. The
objective is to enable the analyst or management accountant to determine the value of
the company based on the behavior of similar businesses in the industry that more or
less captured the risks factors and other micro and macro-economic considerations.
In the given illustration we can compare the results generated using comparable
company analysis under various tools discussed:
Heuristic pricing rules method
Another method may consult and use the expert opinion of professional practitioners
which uses Heuristic pricing rules method. In this method, analysts use business pricing
formulas that are developed based on the expert opinion of professionals involved in
business sales. The best-known professional group that does this is the business
intermediaries that broker business sale transactions in specific industries. Their
knowledge of the
marketplace and direct exposure to transactions puts these experts in an excellent
position to estimate the likely business selling price.
The advantage of this approach is that pricing multiples based on the expert opinion of
active market participants is made available. Also, pricing formulas are often relied upon
both by practitioners and their client business owners and buyers when pricing a deal.
However, since these are based on expert's opinion, pricing multiples may not be
sufficiently backed by rigorous statistical analysis. There will also be a concern on
availability of information for non-brokered business deals.
DISCOUNTED CASH FLOWS METHOD
In Financial Management, it has been discussed that a way to determine the value of an
investment opportunity is by determining the actual cash generated by a particular
asset. Recall that discounted cash flows analysis can be done by determining the
present value of the net cash flows of the investment opportunity. In Conceptual
Framework and Accounting Standards, it was discussed that the cash flows are
presented and analyzed based on their sources and activities which are categorized as
operating, investing and financing. In determining the value of an asset, the cash flows
are important reference or inputs. In determining the value of the asset, it is essential to
include amount of cash that will be available for the claims of the equity owners.
The Net Cash Flows refer to the amount of cash available for distribution to both debt
and equity claims of the business or asset. This is calculated from the net cash
generated from operations and for investment over time. For GCBO, the net cash flows
generated will be based on the cash flows from operating and investing activities, since
this represents already the amount earned or will be earned from the business and the
amount that is required to be infused in the operations to generate more profit.
Net Cash Flows is preferred as basis of valuation if any of the following conditions are
present:
•
•
Company does not pay dividends
Company pays dividends but the amount paid out significantly differs from its capacity
to pay dividends
Net Cash Flows and profits are aligned within a reasonable forecast period
• Investor has a control perspective. If an investor can exert control over a company,
dividends can be adjusted based on the decision of the controlling investor.
Using net cash flows over other cash flow concepts is more advantageous in a valuation
activity since this metric can be directly used as input to a DCF model. This is not the
case for other cash flow or earnings measure such as EBITDA, EBIT, net income and
cash flow from operations since these metrics might have missed or double counted an
item.
EBITDA and EBIT are both metrics that are before taxes; cash flows that are available
to investors should be after satisfying tax requirements of the government
EBITDA and EBIT also do not consider differences in capital structures since it does not
capture interest payments, dividends for preference shares and funds sourced from
bondholders to fund additional investments.
All these measures also do not consider reinvestment of cash flows made into the firm
for additional working capital and fixed assets investment that are necessary to
maximize long-term stability of the
business.
In valuation, analysts find analyzing cash flows and its sources helpful in understanding
the following:
Source of financing for needed investments
Are investments
internally funded by cash generated from operations or debt/equity financing is
necessary? The best case for firms is to fund its investments wholly or partly through
cash from operations. Heavy reliance on external financing from lenders or
shareholders may signal that cash from operations is not enough to support the firm's
long-term stability.
Reliance on debt financing - Debt financing is an excellent financing strategy especially
for expanding companies. However, it can become a problem for a firm if its cash from
operations is insufficient to repay existing debt obligations. The situation worsens if
firms continuously refinance borrowings that come due by another borrowing.
Quality of earnings - Significant disparities between cash flows and income may indicate
earnings does not get converted to cash easily, suggesting low quality.
There are two levels of Net Cash Flows: (1) Net Cash Flows to the Firm; and (2) Net
Cash Flows to Equity. The Net Cash Flows to the Firm is the amount made available to
both debt and equity claims against the company. The Net Cash Flows to Equity
represents the amount of cash flows made available to the equity stockholders after
deducting the net debt or the outstanding liabilities to the creditors less available cash
balance of the company. The net cash flows can be determined by referring to the
financial statements of the company.
Net Cash Flow to the Firm
Net cash flow to the firm refers to the cash flow available to the parties who supplied
capital (i.e. lenders and shareholders) after paying all operating expenses, including
taxes, and investing in capital expenditures and working capital as required by business
needs. NCF to the firm is cash flows
generated from operating activities of the business which is intended to pay required
return of fund providers. Valuation models based on enterprise value encompass cash
flows available to all investors - whether debt or equity.
Enterprise value of a company refers to the theoretical value of its core business
activities as reflected by its net cash flows. This is the basic premise of most corporate
valuation methodologies.
Net cash flow only capture items that are directly related to the operating and investing
activities of the business. Consequently, net cash flow excludes items associated with
financing activities. Net cash flows to the firm can be computed or derived using the
following approaches.
A. Based from Net Income (or indirect approach)
Net Income Available to Common shareholders Add: Non Cash Charges (net)
Add: Interest Expense (net of Taxes) Add/Less: Adjustment in Working Capital
Less: Net Investment in Fixed Capital
(Purchases - Sales of Fixed Capital Investment)
Net Cash Flows to the Firm
Net Income Available To Common Shareholders.
Basic measure of a firm's profitability which refers to the bottom line figure in an income
statement. This is the amount left for the common shareholders after deducting all
costs, expenses, depreciation, amortization, interest, taxes and dividends to preferred
shareholders. This is an accounting measure, meaning that non-cash items like
depreciation and amortization is also included as a deduction to arrive at net income.
However, this measure does not include changes in working capital nor capital
investments made during the specific period which significantly affects a firm's cash
flows.
Non-Cash Charges (Net).
o Depreciation and amortization
When a firm acquires a fixed asset like equipment or intangible asset, the initial cash
outflow is made at point of acquisition and is presented in the balance sheet. In
succeeding periods, a portion of the initial cash outflow is recorded as depreciation and
amortization which reduces net income, despite not having an actual cash outflow. As a
result, this should be added back to arrive at the real cash flow.
0
Restructuring charges
Restructuring refers to the change in the organizational structure or business model of a
company adapt to changing economic climate or business needs. Most restructuring
involves involuntary separation of employees. As a result, the restructuring requires the
company to pay them severance pay. Severance pay should comply with the minimum
requirements set in the Labor Code of the Philippines. Severance pays are normally
outright cash outflows.
The company may also need to record write-down in value of pension assets (or
reversal of previous accruals) as a result of the restructuring activity. This is usually
recorded as part of the restructuring expenses (income) in the income statement.
However, since there are no cash outlays involved in write- downs (reversal gains), this
should be added back to (deducted from) net income to get NCF.
o Provisions for Doubtful Accounts
These are estimated amount to be incurred for the customers inability to pay on time
which is cumulatively accounted under the statement of financial position reported
against the accounts receivable. Since these amounts represent the value that may
have high probability of collection but not yet written off, meaning there is a positive
chance that it can still be collected then it should be added back to the net income
attributable to common.
After-Tax Interest Expense Interest expense (net of any tax savings)
This interest expense is a cash flow intended for the debt providers. In the Philippines,
interest expense is a tax-deductible expense for the company. This means that when
the company pays interest, it reduces tax to be paid. Hence, the cash outflow is the
amount of interest expense less any tax savings.
After-tax interest expense is added back to net income since the objective of NCF is to
measure the cash flows associated with the operating activity of the business. The
impact of financing should be neutralized to arrive at the real business value based on
its operations.
Working Capital Adjustment
Also known as working capital, this item represents the net investment in current assets
such as receivables and inventory reduced by current liabilities like payables. The
amount captured is based on the movements in these accounts from prior year.
The
Required investment in current assets tend to increase when a firm's sales grow
consistently year on year. Higher receivables and inventories are needed in order to
support rising revenues. company also needs higher financing through accounts
payable or taxes payable to fund these receivables and inventories. Increase in current
assets means cash outflow while higher current liabilities are cash inflows. Otherwise,
the company may miss out on sales growth if they lack the current assets and liabilities
to support it. Fast growing firms engaged in industries with high working capital needs
like retailing and manufacturing tend to have substantial rise in working capital.
Companies do not need to pay for taxes when they are investing in their operating
capital. On the other hand, if current assets requirement decline, this means that more
cash is available to debt and equity providers, thus, added back.
For NCF and valuation purposes, movements in cash, marketable securities short-term
notes payable and current portion of long-term debt is excluded in the computation.
Cash is excluded since the purpose of the NCF exercise is to identify what is the real
cash flow of the business. Marketable securities are also excluded since these are not
directly linked to operations. On the other hand, notes payable and current portion of
long-term debt are excluded since they are associated with the financing side of the
business.
Investment in Fixed Capital.
like
Pertains to cash outflows made to purchase or pay for capital expenditures that are
required to support existing and future operating needs. Capital expenditures range
from property, plant and equipment necessary for production requirements to intangible
assets trademark, patent and copyrights. Firms expect that they will reap benefits for
more than one year as a result of these investments. The investment in fixed capital
assumes that the projects financed acceptable and has positive net present value.
Increases in fixed capital investments use cash, hence, a reduction to Net Cash Flow.
This is captured in the year that the cash outflow is made. Information related to these
can be found in the balance sheet and statement of cash flows. Once initial cash
payment is made, this is charged to succeeding year's income statement as
depreciation and amortization. Treatment for depreciation and amortization applies.
When gaps exist between amount of capital investment and depreciation (called as net
capital expenditures), this is usual related to the growth profile of the company.
Company expecting high growth tend to report high net capital expenditures compared
to earnings while low-growth companies usually have negative net capital
expenditures.
When gaps exist between amount
and
of capital investment depreciation (called as net capital expenditures), this is usual
related to the growth profile of the company. Company expecting high growth tend to
report high net capital expenditures compared to earnings while low-growth companies
usually have negative net capital
expenditures.
Cash paid for acquisition of a new business also falls into this category. The full
purchase amount reduces the Net Cash Flow in the year of acquisition. If the acquisition
involves non-cash settlement, analysts should be careful in capturing only portion
denominated in cash as reduction to Net Cash Flows.
On the other hand, if there are sale of capital expenditures that occurred, this should be
added back to the Net Cash Flow. This sales increase the cash inflow which
consequently reduces the investment in fixed capital for that period. For example, if a
property is sold for Php 1,000,000, then this should reduce the amount of investment in
fixed capital (i.e. ultimately, an addition to net cash flows).
Hence, net investment in fixed capital is deducted to arrive at Net Cash Flow
computation. A negative net investment signifies that firm received cash since it sold
more assets than it purchased for the year. Analyst should use the statement of cash
flows to analyze cash flows related to fixed capital investments. There are instances
when
From Statement of Cash Flows
NCF can also be computed using cash flows from operating activities (in the statement
of cash flows) as the starting point. Analysts usually start from this item since it already
considers adjustment for noncash expenses and working capital investments.
As a refresher, the statement of cash flows classifies cash flow into three major
sections: cash flow from operating activities, cash flow from investing activities and cash
flow from financing activities.
Cash Flows from Operating Activities Add: Interest Expense (net of Taxes)*
Php xxx
XXX
Less: Cash Flows from Investing Activities Net Cash Flows to the Firm
XXX
Php xxx
*only if deducted from the operations
Cash flow from operating activities
This represents how much cash the company generated from its operations. This shows
how much cash is received from customers and how much cash outflows are paid to
vendors. This also captures changes in current assets and current liabilities. Normally,
this is computed from net income by considering non- cash items and working capital
changes. This is considered in computing for NCFF.
Cash flow from investing activities
This represents how much cash is disbursed (received) for investments in (sale of)
long-term assets like property, plant and equipment and strategic investments in other
companies. This is considered in computing for NCFF. If this section reflects
transactions involving financial assets, this should be excluded.
Cash flow from financing activities
This represents how much cash was raised (or repaid) to finance the company. This is
not considered when computing NCFF. Thisis simply because these figures will be
accounted for in the calculation of the Net Cash Flows to the Equity.
Analysts should be mindful how interest and dividends are classified in the statement of
cash flows. IFRS allows interest and dividends received to be classified under operating
or investing activities while interest and dividends paid out is placed under operating or
financing activities. One-time or extraordinary items should also be eliminated from the
computation
C. From Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)
EBITDA, net of Taxes
Add: Tax Savings on Noncash Charges
Add / Less: Working Capital Adjustments Less: Investment in Fixed Capital
Php xxx
XXX
XXX
Xxx
Php xxx
•
Net Cash Flows to the Firm
EBITDA or Earnings Before Interest, Taxes, Depreciation and Amortization pertains to
income before deducting interest, taxes, depreciation and amortization expenses, net of
taxes
Since the basis of the computation for the NCFF is already the earnings after excluding
the financing costs, taxes and other non cash charges, the NCFF should only consider
the amount net of the applicable taxes to be paid. This to conservatively show the
EBITDA at the amount net to be realized by the investor.
Tax Savings on Non-cash Charges.
Non-cash charges are not typically adjusted if NCFF starts with EBITDA. However, it is
important that analyst should check whether non-cash charges were already deducted
in computing for EBITDA or not. If deducted, then there is a need to add the item back.
If non-cash charges are not yet deducted from EBITDA, there is no need to add it back
to compute for NCFF.
Instead of adjusting for the full amount, analyst should add back the corresponding tax
savings related to this non-cash charges to EBITDA. Several non-cash charges such as
depreciation and amortization are tax-deductible. This means that occurrence of these
expenses reduces the taxes that the company should pay,
thus, reducing cash outflow. This is added back to EBITDA to capture this impact.
Concepts on investments in fixed and working capital is same as previous discussion.
Net Cash Flow to Equity
Net Cash Flow to Equity or NCFE refers to cash available for common equity
participants or shareholders only after paying operating expenses, satisfying operating
and fixed capital requirements and settling cash flow transactions involving debt
providers and preferred shareholders. NCFE can be computed from NCFF by
considering items related to lenders and preferred shareholders.
NCFE signifies the level of available cash that a business can freely declare as
dividends to its common shareholders. This may still differ significantly from the
dividends actually declared and paid out since this decision is made upon the discretion
of a company's board of directors. Companies tend to manage their dividend policy:
some slowly increase dividends over time while some maintain current dividends
despite actual profitability. As a result, dividend trend is seen as less volatile compared
to earnings as this is managed by the board of directors.
Net Cash Flows to the Firm
Add: Proceeds from Borrowings Less: Debt Service
Add: Proceeds from Preferred Shares Issuance Less: Dividends on Preferred Shares
Net Cash Flows to the Equity
Php xxx
XXX
XXX
XXX
XXX
Php xxx
• Proceeds from Borrowing
This refers to the amount of cash received by the company as a result of borrowing of
long-term debt. Since NCFF did not include items related to financing, it did not capture
cash received by the company from lenders. Since the cash from the borrowing is with
the company already, it is added back to NCFF and forms part of the cash flow available
to common shareholders.
• Debt Service
Debt Service is the total amount used to service the loans or debt financing. This is the
total amount of loan repayment and the interest expenses, net of income tax benefit.
The interest expense is considered as part of the financing activities and hence
deducted from Net Cash Flow since this is associated with long- term debt of the
company. The amount to be included must exclude the equivalent tax benefits from the
interest. The tax benefit must accord with what was allowed by the tax regime where the
business operates. Please note that this amount must be similar should an adjustment
was made to compute for the NCFF.
•
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Proceeds from Issuance of Preferred Shares
Same with the debt, preferred shares as another form of financing, other than the
issuance of ordinary equity, must also be factored in the calculation of the net cash
flows available to equity.
• Dividends on Preferred Shares.
Since payments made to preferential shareholders in the form of dividends are outflows.
This must be incorporated in the calculation as a reduction of the net cash flows to
equity.
Similarly, given the above formula as guiding principle, NCFE can be determined under
the following approaches:
A. Based from Net Income (or indirect approach)
Net Income Available to Common shareholders
Add: Non Cash Charges (net)
Add: Interest Expense (net of Taxes)
Add/Less: Adjustment in Working Capital
(Purchases - Sales of Fixed Capital
Less: Net Investment in Fixed Capital
Investment)
Net Cash Flows to the Firm
Php xxx
XXX
XXX
XXX
Add: Proceeds from Borrowing
Less: Debt Service
Add: Proceeds from Preferred Shares Issuance
Less: Dividends on Preferred Shares
Net Cash Flows to the Equity
XXX
XXX
XXX
Xxx
Xxx
Xxx
Php xxx
B. From Statement of Cash Flows
Cash Flows from Operating Activities
Add: Interest Expense (net of Taxes)*
Less: Cash Flows from Investing Activities
Net Cash Flows to the Firm
Add: Proceeds from Borrowing
Less: Debt Service
Add: Proceeds from Preferred Shares Issuance
Less: Dividends on Preferred Shares
Net Cash Flows to the Equity
C. From Earnings Before Interest, Taxes, Depreciation and
Amortization (EBITDA)
EBITDA, net of Taxes
Add: Tax Savings on Noncash Charges
Add / Less: Working Capital Adjustments Less: Investment in Fixed Capital Net Cash
Flows to the Firm
Add: Proceeds from Borrowing
Less: Debt Service
Add: Proceeds from Preferred Shares Issuance
Less: Dividends on Preferred Shares
Net Cash Flows to the Equity
Terminal Value
Since GCBOS is assumed to operate in a long period of time to almost perpetuity, the
risk and returns are inherent to the opportunity at the end of the projection period should
also be quantified. Furthermore, the economic value that will be generated by the
assets is expected to be stable after some point in time since the projections are reliant
on certain assumptions made. The challenge for the determination of the value of the
asset is to also account for the economic returns that it will generate in perpetuity. This
is addressed by the Terminal Value. Terminal Value represents the value of the
company in perpetuity or in a going concern environment. In practice, there are several
ways on how to determine the terminal value.
Financial Models in Discounted Cash Flows Analysis
Financial Modelling is a sophisticated and confidential activity in a company or for an
analyst. Information is can also be considered as competitive advantage of a company
or a person. Most of the companies hire financial modelers to assist them in determining
the value of GCBOS or other opportunities. They also ask them to validate ballpark
estimates and may also be used to determine impairments. Most financial modelers
have extensive financial acumen and vast knowledge and experience. Financial
modelers normally are economists, financial managers, and accountants. Management
accountants are good candidate for this role given their ability to understand operational
models and design long term financial strategies.
Basis of Terminal Value
1. Liquidation Value
Some analysts find that the terminal value be based on the estimated salvage value of
the assets. Methodologies on how to determine the salvage or liquidation value was
discussed in Chapter 3.
2. Estimated Perpetual Value
Another way to determine the terminal value is by using the farthest cash flows you can
estimate divided by the cost of capital less the growth rate.
TV =
CFn+1 r-g
TV = Terminal Value
CFn+1 = Farthest net cash flows
r = cost of capital
g= growth rate
In order to develop financial models, the following steps needs to be observed:
1. Gather historical information and references
Historical information must be made available before the financial model is to be
constructed. Historical information may be generated from, but not limited to the
following: audited financial statements, corporate disclosures, contracts, and peer
information.
Audited Financial Statements are the most ideal reference for the historical performance
of the company. The components of the Audited Financial Statements enable the
analyst or the financial modeler to assess the future of the company based on its past
performance. Statement of Income are used to determine the historical financial
performance, Statement of Financial Position is used to determine the book value of the
assets and the disclosed stakes of the debt and equity financiers, Statement of Cash
Flows illustrate how the company historically financing its operations and investments.
Statement of Changes in Stockholder's Equity provides the information on how much is
the claim and dividend background of the company. One of the most important
components of the financial statements are the Notes to the Financial Statements. It
provides the summary of important disclosure that should be considered in the
valuation. The financial modeler must be able to quantify these disclosures and more
importantly the risks involved.
For example, a Filipino company is expecting for 15% returns for a venture and
assumes that their net cash flows for the next five years are as follows:
Year
1
2
3
4
5
Net Cash Flows (in million Php)
5.00
5.50
6.05
6.66
7.32
In the given illustration, you may note that the net cash flows are growing annually.
Assuming this is a GCBO, and it is expected that the net cash flows will behave on a
normal trend. The growth rate (g) is computed using compounded annual growth rate
formula:
g=
NCF- NCFO
1 x 100%
Corporate disclosures are also key in developing the financial model. Corporate
disclosures provide more context for the future plans and strategies of the company.
This will enable the analysts or the financial modelers to identify the risks about the
GCBO and quantify them accordingly. Since these are available to the public, it is the
same information that is known to others. The difference among modelers are their
personal appreciation to risk and their client's appetite for risks.
Contracts are formal agreements between parties. In valuing the GCBOS, it is important
for the modeler to also know the existing contracts and the covenants contained in it.
Large accounting firms offer transaction advisory services to assist their clients who
enter into new ventures. Due diligence is necessary to verify any contingent liability and
other legal risks surrounding that opportunity and quantify it accordingly to have a more
conservative value. The modeler must be able to classify the probability of these from
occurring. Gathering this information is important to have a reasonable basis to quantify
and incorporate it in the financial model.
=
NCF。 net cash flows at the beginning
NCF, latest net cash flows
n
=
= latest time
Substituting the given figures, the growth is computed as
.32\5-1
g=
x 100%
5.00
g= (1.10-1) x 100%
g= 10%
Peer information and other public information are also essential inputs to the financial
model. Peer information provides more context and even supports the risks identified or
will be assumed in the valuation process. Peers may be other analysts, industry experts
and other consultants. Internal members of the organization may also be considered as
peers. However, the information sharing is restricted by law since these are insider
information and is not fair for the public. Researches and studies can also be used as
peer information. In the Philippines, reliable sources could be the National Library and
Philippine Institute on Development Studies. Researches and studies shared through
conventions and forums will also be relevant inputs in the development of the financial
model and in valuation.
Collectively, the financial model must be able to filter the information that would be
necessary for the valuation. Relevance and reliability of information are important. Not
all information should be given consideration.
Materiality is another consideration. Even if there are additional information gathered,
there should be a sense of materiality assessment involved. Note that projections
remain to be estimates. Therefore, only relevant items should be considered in the
valuation.
Since the growth rate is 10%, it will be applied on the farthest cash flows i.e. on the 5th
year equivalent to Php7.32, thus the farthest cash flows is now Php8.05 or will
substitute the CF. It is now assumed that the cash flows will continuously growth at the
rate of 10% per annum. Thus, the formula can now be applied.
TV
=
CFn+1
r-g
Php 8.05
TV =
15%- 10%
Php 8.05
TV =
5%
Php 8.05 5%
TV =
TV = Php161
In some cases, that the historical growth pattern is undetermined, some analysts only
consider the cost of capital or their required return to determine the terminal value. In
the given illustration, you may note that difference on the terminal value:
TV =
CFn+1 r-g
2. Establish drivers for growth and assumptions
Once all relevant information was gathered and validated, drivers and assumptions can
be established by conducting financial analysis. Drivers are suggested to be those
validated and is represented by authorities like government or experts. Growth drivers
are normally based on population, since most of the businesses are consumer goods. If
services, industry growth may be used as a driver. In the Philippines, information is
available from the Philippine Statistics Authority. Because the government needs to be
transparent to its citizens, it fortunate that the information can be found in the
government website or is disclosed to public through media with wider reach and scale.
Php 8.05
TV =
15% 0%
Php 8.05
TV =
15%
TV =
Php53.66
3.
4.
You may observe that the terminal value in this case is more conservative by about
Php107.
Constant Growth
Challenges for some valuators is to determine the amount of required return for a
specific type of asset or investment. In lieu of the required return, they use the growth
rate as the proxy especially if the growth is constant and significant.
Scientific Estimates
Other valuators especially those with vast experience already in some types of
investments uses other basis for them to determine the reasonable terminal value.
Using guesstimates is not prevented because in the end, equity values will still be
based on negotiation.
Philippine Statistics Authority Dashboard
For other economic factors, drivers, and estimates, Bangko Sentral ng Pilipinas and
National Economic and Development Authority are also other agencies that can be
relied with. Certain statistical information can also be found from the websites or
research centers of the Local Government Units and National Government Agencies.
Research organizations may also be used, however, strong validation and evaluation
needs to be done to isolate any form of biases that may affect value.
There is no perfect approach to determine the terminal value. Actually, some risk averse
investors don't consider the terminal value in their valuation. The differences in their
appreciation on the determination or even the inclusion of the terminal value is
dependent on their risk appetite. Then again, the valuation method will only serve as a
reference to determine the reasonable value for the equity or the asset being
purchased. This is why negotiation plays a key role in finalizing the determined value.
Other inputs in the Net Cash Flows
The present value of the Net Cash Flows represents the value of the assets. It may be
recalled further that the assets are financed by debt and equity. Hence, these are the
claims which are presented at the right side of the Statement of Financial Position,
under an account form of reporting.
The discounted cash flows analysis factors in all the projected stream of cash flows that
the project, opportunity or investment and valuing it in present time to determine
whether the investment made on this year would be less than
The usual growth indicators used are: inflation, population growth, GNP or GDP growth.
In economics, the inflation is the result of the movement of prices from a year to
another. This is calculated by comparing the movement of the price of the basket of
commodities from a year to another or a period to another. Inflation is computed using
this formula:
Inflation = (CPI) CPI,
1 x 100%
consumer price index - current year
CPI, = consumer price index - base year
The consumer price index represents the price of the basket of commodities for a
particular period. In financial modelling, you need the inflation to be used as driver for
certain operating and capital expenditures. There are two ways to calculate the value:
(1) nominal and (2) real.
Nominal financial models are already in current prices, meaning, the prices stated in the
model already assumes that the prices grew or decline, in the case of inflation or
deflation respectively. Some uses the headline inflation to determine the current price.
Real financial model, on the other hand, does not include the effect of changes in
prices, but rather preserve the price of
the value it will generate in the future, that means the investment yielded an amount
sufficient to cover the investment and allowing the investors to earn more. Same
principle applies that the best opportunity is the one that will yield the highest present
value or solely if the opportunity will result into a positive amount it should be accepted.
Conservatively, the total outstanding liabilities must be considered and deducted versus
the asset value to determine the amount appropriated to the equity shareholders. This is
called the equity value. The opportunity that will result in the highest equity value is
considered.
DCF Analysis is most applicable to use when the following are available: Validated
Operational and Financial Information
•
Reasonable appropriated cost of capital or required rate of return New quantifiable
information
operating expenses and capital expenditures, as if no changes in prices occur. If the
financial model is in real prices, the cost of capital should also excludes the effect of
inflation.
With the given equation, to illustrate, that in year 2019 the CPI is 151 meaning the cost
of the basket is Php151. In year 2020, the CPI published is Php155. Obviously, the
price of the basket grew, hence, inflation is expected to be 2.64% [(155/151) -1 x 100%].
On the other hand, if the CPI published for 2020 is Php149, then it will be a deflation or
decrease in prices at 1.32% [(149/151) - 1 x 100%].
To illustrate its application, supposed you are projecting for how much is the
communication costs for 2021 when the cost in 2020 is Php5 Million. Given the
calculated inflation of 2.64%, the communication costs to be incorporated in the
financial model is Php5.132 Million.
Other indicator is population growth rate. Population growth rate is factored in to serve
as a growth driver for the demand of the product, particularly for the merchandising or
manufacturing business. The services sector may use the growth rate in the businesses
or the industry or sector that they are going to serve. The formula to calculate for the
population growth rate is similar with the inflation, except that the input is the population
count of a particular segment in a particular year. To illustrate, suppose that in Barangay
A in 2019 the population is 25,200. The survey is conducted in 2020 and the population
is 26,460. Using the formula of inflation to calculate for population growth rate:
3. Determine the reasonable cost of capital
In determining the reasonable cost of capital, the financial modeler must be able to use
the appropriate parameters for the company. Generally, cost of debt and cost of equity
are weighted to determine the cost of capital reasonable for the valuation.
4. Apply the formulae to compute for the value
Normally in Financial Modelling, DCF is used to calculate for the value. Since most
information are already available in Financial model, it can be easier to use other capital
budgeting techniques like Internal Rate of Return, Profitability Index etc.
3. Determine the reasonable cost of capital
In determining the reasonable cost of capital, the financial modeler must be able to use
the appropriate parameters for the company. Generally, cost of debt and cost of equity
are weighted to determine the cost of capital reasonable for the valuation.
4. Apply the formulae to compute for the value
Normally in Financial Modelling, DCF is used to calculate for the value. Since most
information are already available in Financial model, it can be easier to use other capital
budgeting techniques like Internal Rate of Return, Profitability Index etc.
5. Make scenarios and sensitivity analysis based on the results.
The advantage of having a financial model is that you can easily tweak the given
information and get the results immediately. For instance, in the previous illustration the
cost of capital used is 10%. How about if you find that cost of capital will be 12% or
15%, what will be the Enterprise Value?
If this is the case, we need to design the financial model to accommodate this through
the use of Data Table feature in Microsoft Excel. First, design a table where the values
will be inputted.
Next, select the table we prepared by highlighting cells C17 to D19 and you go to DATA
Tab and go to 'What if' Analysis then select 'Data Table'.
5. Make scenarios and sensitivity analysis based on the results.
The advantage of having a financial model is that you can easily tweak the given
information and get the results immediately. For instance, in the previous illustration the
cost of capital used is 10%. How about if you find that cost of capital will be 12% or
15%, what will be the Enterprise Value?
If this is the case, we need to design the financial model to accommodate this through
the use of Data Table feature in Microsoft Excel. First, design a table where the values
will be inputted.
Next, select the table we prepared by highlighting cells C17 to D19 and you go to DATA
Tab and go to 'What if' Analysis then select 'Data Table'.
It will be easier for you to determine which value to use. Since, in our example the
outstanding debt is Php500,000 then you have to play in the range of Php1.2 Million to
Php1.02 Million.
The scenarios will be developed based on the set of possible occurrences like level of
operating expense, mode of operations, capital expenditure development period etc.
Emerging trend is having a Risk Based Valuation, wherein major systematic risk is
incorporate such as climate change, war, economic sabotage, pandemic etc.
Sensitivity Analysis is almost similar with Scenario Modelling. The difference is that
sensitivity analysis will have to select a driver or few drivers, ceteris paribus, and check
the degree of change it will cause to the results. Sensitivity analysis is a useful exercise
in developing ballpark estimates.
Components of Financial Model
As described in the earlier part of this chapter, a financial model should be
understandable, printable and auditable. The financial model should be designed in a
way that the investor or the client of the analysts or the proponent themselves can
understand the dynamics and follow the drivers to enable them to have a better
appreciation and sound judgment of the results. Please bear in mind that the results of
the financial models are just guide for the investors or even sellers of investment to
determine the reasonable value. As a quick guide in developing a financial model the
following components are recommended, particularly when using Microsoft Excel:
Title Page
This provides an overview and the project being valued or assessed. This includes also
necessary information to secure the proprietary rights of the modeler or the firm he or
she is working with. It may also include data cut-off to serve as a guide to the readers
Data Key Results
This sheet summarizes the results of the study. This will serve as the dashboard to
enable the modelers to analyze the results and to facilitate the readers' appreciation on
the results of the project. This also facilitate preparation of pertinent reports.
This also contains the valuation results, scenarios, and sensitivity analysis. Graphs can
also be found in this sheet.
·
Assumption Sheet
This sheet summarizes the assumptions used in the model. This is normally an input
sheet where all inputs should be made. The information that can be found in this sheet
must be linked to all the output sheets like Pro-forma Financial Statements, Supporting
Schedules and Data Key Results.
Pro-forma Financial Statements
This presents the 3 components of the financial statements namely: Statement of
Income, Statement of Financial Position and Statement of Cash Flows. In this sheet,
you can also find some key financial ratios particularly those that has to do with financial
performance and efficiency ratios.
Some modelers also find it convenient to have their valuation computation be done in
this sheet since the inputs of cash flows are already available here.
Supporting Schedules
This is like a subsidiary ledger which provides supporting computation to the
components of the pro forma financial statements. There is no limit for the supporting
schedules the only challenge is that the electronic financial models consume large
amount of data because of the supporting schedules.