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8/11/2019 Class on Valuation - Economics of Strategy
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Valuation (Economics of Strategy)By Gaurav Jalan, MD, Avant Garde Wealth Management
IMI Kolkata, December 9 2013
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Investor Presentation - 1104
BOS 2
What is valuation?
Valuation is simply the process of estimating the value of an
asset or a business
A cash flow or asset basedvalue of an operating
business
Value that can be realizedfrom sale of the asset or
business
Two primary ways to think about value
Operating value Strategic value
Theoretically, a prospective buyer should also value the asset/businessbased on its cash flows so these two methods should yield the same
result, but this is often not true in practice (more on this later)
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Investor Presentation - 1104
BOS 3
Replacement cost, ROIC and WACC
*Invested capital is ideally calculated using replacement cost but can be estimated usingbalance sheet values
ROIC = NOPAT / Invested Capital*
NOPAT (Net Operating Profit After Tax) = EBIT * (1 tax rate)
Invested Capital = Fixed assets + net working capital + intangibles (if appropriate)
ROIC (Return On Invested Capital)
The reproduction cost of an asset is the cost of reproducing its economic function asefficiently as possible Competition Demystified
Enterprise valuation of the business is equal to reproduction cost of the following
Fixed assets
Intangible assets
Working capital = Current assets Current liabilities
Equity value = Enterprise value Value of liabilities (debt + other LT liabilities)
Calculating replacement cost
Weighted average of cost of equity and cost of debt assuming a certain capital structure
In plain English, this is the return that an investor expects to earn on the investedcapital in this business and others with a similar risk profile
WACC (Weighted Average Cost of Capital)
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Investor Presentation - 1104
BOS 4
Appropriate valuation framework depends on businesseconomics
Key measure of economic viability of a business -> ROIC - WACC
ROIC WACC < 0
ROIC WACC = 0
ROIC WACC > 0
Unviable business
that is destroyingvalue by operating
Operating in aperfectly
competitiveenvironment
Business withcompetitiveadvantages
Liquidation value
Replacement cost
Earnings / cash flowbased valuation
Versusreplacement cost
Smaller
Equal
Greater
Businesseconomics
Businessdescription
Valuationframework
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Investor Presentation - 1104
BOS 6
Replacement value
If ROIC = WACC the business operates in economist heaven, a perfectly competitivelandscape where all excess profits are competed away
In this case the value of the business is exactly equal to the replacement cost of theassets as the capital invested in it is earning the same as it would elsewhere(adjusted for risk)
When is replacement value appropriate?
Given tendency for mean reversion, replacement cost is a good benchmark for valueeven if currently ROIC WACC
Unless sustainable competitive advantages can be identified there is a tendencyfor excess returns to shrink over time as competition increases
Unless there are reasons for permanent unviability, a business earnings lowreturns tends to improve over time as competition reduces
Key points to consider
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BOS 7
Cash flow based valuation
The value of an asset or a business is the net present value of the cash
flows that will be received by the owner over time
Two primary ways to calculate cash flow based valuation
Discounted cash flow Multiple based
Explicit forecasts of cash flows for acertain period + terminal value
Theoretically most appropriate
Drawbacks Very sensitive to terminal value
Explicit forecasts are likely to havelarge errors as well
Garbage in = Garbage out
Based on some multiple of a currentmeasurable value. E.g. Price/Earnings,Price/Cash Flow, Price/Earnings Power,EV/EBITDA, etc.
Metrics such as earnings or EBITDA aretypically used as a proxy for cash flow
Easy to calculate and easily comparableacross assets/industries/geographies
Primary drawback is that a currentperiod metric is effectively assumed toaccurately reflect a long term stream of
cash flows
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BOS 8
The math behind multiple based valuation
Proxy for sustainable
free cash flowEnterprise value = Multiplex
Earnings power (as defined in Competition Demystified)
Earnings power = Normalized EBIT * (1 tax rate) +
Depreciation Maintenance Capex
Normalized EBIT = Sales * Normalized EBIT margin
In real life, due to easy availability, reported after tax earnings(despite the drawbacks) are often used as a crude proxy for cash flow
Note that a multiple on reported earnings leads to calculation ofequity value and not enterprise value
Multiple (without growth)
Multiple = 1 / WACC
E.g. 1/12.5% = 8x
Multiple (with growth)
Multiple = 1 / (WACC g), where g = perpetual growth rate
E.g. 1/(12.5%-6%) = 15.4x
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BOS 9
The three tranches of value
Assumptions about a business:
Replacement cost = Rs.10 billion
Earnings power = Rs.2 billion
WACC = 12.5%
Perpetual growth rate = 6%
Rs.10 b
Rs.6 b
Rs.14.8 b
Rs.10 b
Rs.6 b
Rs.10 bReplacement cost of assets
Total valueEarnings
power valueReplacement
value
2
(12.5%-6%)
=2
12.5%
=
Free entryNo competitive advantages
Franchise value
Franchise value from current
competitive advantages
Value of growth
Only if the growth benefits from
competitive advantages
Source: Framework from Figure 16.1 in Competition Demystified
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BOS 10
Cummins India: High ROIC business
10%
20%
30%
40%
50%
60%
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
ROIC (on avg capital invested) ROE (on avg equity)
ROE is consistently below ROIC because company has maintained a net cashbalance over the years
Hence WACC = Cost of Equity = 15% (lets work with this assumption for now)
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BOS 11
Cummins India: Replacement cost
Balance sheet
(in Rs. Million) 2013 (Sep)
Net fixed assets 6,830
Current assets 21,142
Cash + liquid funds 8,340
Investments 700
Total assets 37,012
Current liabilities and provisions 9,728Deferred tax liability 307
Total liabilities 10,035
Total shareholders' equity 26,977
Total liabilities + SE 37,012
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BOS 12
Cummins India: Replacement cost
1997 2007 20102013
Se
Net fixed assets 1,291 1,817 3,337 6,830
Most of the fixed assets have been added in the last 3-4 years
Balance sheet
(in Rs. Million) 2013 (Sep)
Net fixed assets 6,830
Current assets 21,142
Cash + liquid funds 8,340
Investments 700
Total assets 37,012
Current liabilities and provisions 9,728Deferred tax liability 307
Total liabilities 10,035
Total shareholders' equity 26,977
Total liabilities + SE 37,012
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BOS 13
Cummins India: Replacement cost
1997 2007 20102013
Se
Net fixed assets 1,291 1,817 3,337 6,830
Most of the fixed assets have been added in the last 3-4 years
Balance sheet
(in Rs. Million) 2013 (Sep)
Net fixed assets 6,830
Current assets 21,142
Cash + liquid funds 8,340
Investments 700
Total assets 37,012
Current liabilities and provisions 9,728Deferred tax liability 307
Total liabilities 10,035
Total shareholders' equity 26,977
Total liabilities + SE 37,012
Replacement cost
(in Rs. Million) 2013 (Sep)
Net fixed assets 18,449
Current assets 21,142
Current liabilities and provisions (9,728)
Deferred tax liability (307)
Replacement cost 29,557
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BOS 14
Cummins India: Recalculating ROIC
Note: Fixed assets revalued up from 2003 onwards
Even after adjusting value of fixed assets upward ROIC remains high and wellabove the WACC
10%
20%
30%
40%
50%
60%
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
ROIC (on avg capital invested) ROIC (adjusted for fixed asset value)
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BOS 15
Cummins India: The three tranches of value
Assumptions for Cummins:
Replacement cost = Rs.29.6 b
Rs.29.6 bRs.29.6 bRs.29.6 bReplacement cost of assets
Total valueEarnings
power valueReplacement
value
Free entry
No competitive advantages
Rs.30 b
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Investor Presentation - 1104
BOS 16
Cummins India: Earnings Power Value (1)
Let us assume that normalized EBIT margins are 16%
10%
12%
14%
16%
18%
20%
22%
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
EBIT % of sales EBIT % (97-14 avg) EBIT % (05-14 avg)
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Investor Presentation - 1104
BOS 17
Cummins India: Earnings Power Value (2)
EPV > Replacement cost as expected since ROIC > WACC
(in Rs. Million) 2013
Sales 45,894Normalized EBIT margin 16.0%
Normalized EBIT 7,343
Normalized tax rate 27.0% Some tax benefits due to exports
NOPAT 5,360
Assuming that Depreciation = Maintenance Capex
Earnings Power (2013) 5,360
Earnings Power (2014) 6,164 Assumed 15% growth rate
WACC 15.0%
Earnings Power multiple 6.7
Earnings Power Value (no growth) 41,096
Replacement cost 29,557
Franchise value (no growth) 11,540
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Investor Presentation - 1104
BOS 18
Cummins India: The three tranches of value
Assumptions for Cummins:
Replacement cost = Rs.29.6 b
Earnings power = Rs.6.2 billion
WACC = 15%
Rs.29.6 b
Rs.11.5 b
Rs.29.6 b
Rs.11.5 b
Rs.29.6 bReplacement cost of assets
Total valueEarnings
power valueReplacement
value
Free entry
No competitive advantages
Franchise value
Franchise value from current
competitive advantages
Rs.30 b
Rs.41 b
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Investor Presentation - 1104
BOS 19
Cummins India: Value of Growth (1)
From 1997 to 2014 (est) revenue and EBIT CAGR has been 12.1% and 13.7%respectively. However, assuming such high growth in perpetuity is likely
unrealistic
5%
10%
15%
20%
25%
30%
2007 2008 2009 2010 2011 2012 2013 2014
Revenue growth (10-yr CAGR) EBIT growth (10-yr CAGR)
Revenue CAGR (97-14) EBIT CAGR (97-14)
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Investor Presentation - 1104
BOS 20
Cummins India: Value of growth
When businesses have the ability to reinvest capital at an ROIC that issignificantly higher than WACC growth can create substantial value
The larger the spread between ROIC and WACC the more sensitive thevaluation will be to the rate of growth
(in Rs. Million) Low Base High
Earnings Power 6,164 6,164 6,164
WACC 15.0% 15.0% 15.0%
Growth rate 8.0% 10.0% 12.0%
Earnings Power multiple 14.3 20.0 33.3
Earnings Power Value (with growth) 88,064 1,23,289 2,05,482
Earnings Power Value (no growth) 41,096 41,096 41,096
Value of growth 46,967 82,193 1,64,385
2014
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Investor Presentation - 1104
BOS 21
Cummins India: The three tranches of value
Assumptions for Cummins:
Replacement cost = Rs.29.6 b
Earnings power = Rs.6.2 billion
WACC = 15%
Perpetual growth rate = 8-12%
Rs.29.6 b
Rs.11.5 b
Rs.47 b
to
Rs.164 b
Rs.29.6 b
Rs.11.5 b
Rs.29.6 bReplacement cost of assets
Total valueEarnings
power valueReplacement
value
Free entry
No competitive advantages
Franchise value
Franchise value from current
competitive advantages
Value of growth
Only if the growth benefits from
competitive advantages
Rs.30 b
Rs.41 b
Rs.88-205 b
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Investor Presentation - 1104
BOS 22
Cummins India: The three tranches of value
Assumptions for Cummins:
Replacement cost = Rs.29.6 b
Earnings power = Rs.6.2 billion
WACC = 15%
Perpetual growth rate = 8-12%
Rs.29.6 b
Rs.11.5 b
Rs.47 b
to
Rs.164 b
Rs.29.6 b
Rs.11.5 b
Rs.29.6 bReplacement cost of assets
Total valueEarnings
power valueReplacement
value
Free entry
No competitive advantages
Franchise value
Franchise value from currentcompetitive advantages
Value of growth
Only if the growth benefits from
competitive advantages
Current enterprise value of the company (Dec 6 2013) is Rs.116 billion
Rs.30 b
Rs.41 b
Rs.88-205 b
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Investor Presentation - 1104
BOS 23
Cummins India: Actual valuation history
On actual reported earnings the stock has historically traded at a P/E of 10-30xwhich is not very different from our calculated multiple range of 14-33x
5
10
15
20
25
30
35
Apr-97 Apr-98 Apr-99 Apr-00 Apr-01 Apr-02 Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11 Apr-12 Apr-13
Price / Earnings (Trailing Twelve Months)
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Investor Presentation - 1104
BOS 24
What is valuation?
Valuation is simply the process of estimating the value of an
asset or a business
A cash flow or asset basedvalue of an operating
business
Value that can be realizedfrom sale of the asset or
business
Two primary ways to think about value
Operating value Strategic value
Theoretically, a prospective buyer should also value the asset/businessbased on its cash flows so these two methods should yield the same
result, but this is often not true in practice (more on this later)
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Investor Presentation - 1104
BOS 25
Cummins India: Strategic value?
The buyer will only sell when he thinks he can get a good price for the
asset If the assets are sold in an auction the buyer is likely to suffer from
winners curse
The buyer will knowingly pay some strategic premium for the businessover its operating value as it gives him control over the cash flows of thebusiness
The buyer may believe that he can run the business better (high revenues,lower costs) and hence generate higher cash flows from the same assets
There may be synergies with an existing business of the buyer
Strategic value -> The price an informed buyer would pay for theentire business if the company were up for sale
Unless it is a distress sale the strategic value can be expected to exceedthe operating value, often substantially, for the following reasons:
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Investor Presentation - 1104
BOS 26
Valuation is more art than science
Given the number of variables involved and the sensitivity of theresulting valuation to each variable it is possible to justify a very
wide range of valuation figures for most businesses
Guess how the following people will respond when you ask them to valuea certain stock (relative to its current price):
An analyst when he has just put out a buy rating (hint: undervalued)
An analyst who has a sell rating (hint: overvalued)
A fund manager who has recently sold the stock (hint: overvalued)
An investment banker who is tasked with finding a buyer for the company(hint: very undervalued)
A competitor who is trying to sell shares in an IPO (hint: undervalued)
The promoter, when he is in the process of selling some of his holdings(hint: undervalued)
The promoter, when he wants to price some ESOPs for himself in the nearfuture (hint: very overvalued)