International Valuation Newsletter - KPMG Valuation Newsletter June 2017 4 How does neglecting debt beta affect the levered cost of equity? If the debt beta is not taken into account,

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International Valuation NewsletterJune 2017

A series of surprising election results in Europe and unprecedented political instability in the US have produced yet further economic uncertainties. In our second International Valuation Newsletter of 2017, we share an update on recent capital market data that are highly pertinent to any valuation analysis in these turbulent times:

• Major stock market performances: Positive throughout• EURO STOXX 600 sector multiples: Stable in Q1 2017• Current risk-free rates for major currencies: Will the recent upward trend

continue?• Recent country risk premiums and inflation forecasts for the BRIC countries:

Uncertainties remain

We also provide our insights into the following topics that are relevant to valuati-on practitioners:

• Debt beta – sharing risk between capital providers• Challenges in valuing new technologies

We wish you a pleasant summer and look forward to discussing with you any questions you might have regarding valuation trends and practices.

Yours faithfully

Dear reader

Lisa TaylorPartner, Deal Advisory Valuation / Financial Modelling

Christopher BromePartner, Deal AdvisoryValuation / Financial Modelling

International Valuation Newsletter June 2017 3

The (levered) beta factor is a key parameter in estimating the cost of equity using the Capital Asset Pricing Model (CAPM). But why is a so-called debt beta vital to calculating the beta factor? Not least because ignoring the debt beta can lead to material differences in valuations.

When valuing a company it is imperative to factor the relevant cash flows’ operating risks into the cost of capital. It should be noted that the source of financing (debt or equity) is irrelevant. Investors’ cost of capital in a completely unindebted company (equity only) is equal to the weighted average cost of capital (WACC) of all investors in an indebted company (providers of equity and debt). Both types of investors expect to be equitably reimbursed for the operating risk of the operating cash flows (pro rata, according to their applicable capital ratio and order of claims). Providers of equity and debt therefore equitably share compensation for operating risk, irrespective of how the company is financed. Part of the operating risk is also the probability of a partial or complete payment default.

Operating risk and the risk premiumAs returns on investment are generated by operating cash flows, both groups of investors (equity and debt capital providers) demand a risk premium for assuming part of the operating risk. Depending on the investors’ ranking, risk premiums can vary upon their claims being disbursed. Debt providers whose share in the total value of the company – and thus in operating cash flow – is minimal regularly demand a relatively minor risk premium. Conversely, the demand from debt providers with a major share is significantly higher. Where the share of debt providers in the overall value of the company makes them in effect the economic owners, their return expectations and required risk premium will be comparable to that of an equity investor in an unindebted company.

According to the CAPM, the risk premium of a company comprises the company-specific risk (reflected by the beta factor) and the market risk premium (the premium for

systematic risk). This applies to equity as well as debt holdings. Comparable to equity shares’ risk premiums, the debt providers’ expected risk premium (spread) is derived from the debt beta and the market risk premium. Disregarding debt beta would imply risk-free debt, as the debt spread would amount to zero and the cost of debt correspond to the base rate (risk-free interest rate). In reality, under regular circumstances, this is normally not the case.

Splitting the operating risk among capital providersNeglecting debt beta can potentially result in a valuation error. This can be illustrated by the generally applicable formula for the levered cost of equity (formula 1):

In a debt-financed company, equity providers only participate in the residual operating cash flow once debt providers have been remunerated. Equity providers are therefore exposed not only to the operating risk (reflected in the unlevered cost of capital), but also to the additional financial risk of the encumbrance. Due to this additional financial risk, equity providers’ return expectations increase by the extent of the known leverage effect.

Debt beta – sharing risk between capital providers

k k kL U U kD

kD

E

kLE

E

kUE

E= + -

DE—

( )

= return on equity of a levered company

= return on equity of an unlevered company

= interest rate of debt capital

= leverage ratio

DE—*


How does neglecting debt beta affect the levered cost of equity? If the debt beta is not taken into account, a base rate would need to be applied to the cost of debt, as the debt spread would implicitly amount to zero. This suggests that the levered cost of equity – compared to applying a debt beta – will increase as the leverage premium on the unlevered cost of equity increases. The above formula illustrates this through the delta between unlevered cost of equity and the debt capital’s interest rate.

In order to interpret this effect economically, the leverage premium on the unlevered cost of equity reflects the risk premium for the additional assumption of the financial risk by equity investors. The below illustration shows the leverage effect on the levered cost of equity if the leverage increases (assuming the cost of debt corresponds to the base rate).

As debt providers will also be remunerated via a premium on the base rate (the cost of levered debt is thus derived from the base rate plus the spread) for assuming operating risk, the leverage effect will decrease, as illustrated below:

Source: KPMG analysis

0%

2%

4%

6%

8%

10%

12%

14%

0% 20% 40% 60% 80% 100%

leverage rate

cost of equity cost of debt base rate WACC

Cost of debt equals base rate

Source: KPMG analysis

0%

2%

4%

6%

8%

10%

12%

14%

0% 20% 40% 60% 80% 100%

leverage rate

cost of equity cost of debt base rate WACC

Cost of debt including spread

In the market, the assumption of operating risks is not remunerated multiple times. If debt providers take on part of the operating risk and are remunerated through a debt spread, the operating risk of equity providers falls and the leverage premium declines correspondingly. Overall, the leverage premium increases if debt providers’ yield expectations are close to the base rate. Conversely, it decreases in line with debt providers’ greater spread.


A prerequisite to accurately determining cost of capitalIn principle, valuing a company would be possible based on the above equation (formula 1), and therefore solely on knowing the cost of the unlevered equity and debt and the leverage. Given how widespread the CAPM is applied in determining the risk-equivalent cost of capital and the empirical derivation of capital market parameters, however, valuation practice has established an alternative approach. By applying a levered beta factor, the cost of levered equity is determined as follows (formula 2):

In fact, valuation theory contains various approaches to determine the levered beta factor. These approaches differ in terms of underlying assumptions, particularly concerning the absorption of operating risks by the providers of debt and the risk level of tax benefits (the cost of debt can be deducted from the taxable amount). In practice, one often sees inconsistent conversion formulae between the levered and unlevered beta factor being applied to valuation assumptions. As a consequence, an inadequately computed cost of capital can lead to valuation errors.

If an expected return from debt capital deviates from the risk-free return, the above-mentioned economic facts are only comprehensively factored into the levered beta factor where a debt beta is applied. In practice, debt beta is calculated as the debt capital spread divided by the market risk premium (the structure of formula 3 is essentially the same as that of formula 1):

When deriving the cost of levered equity using a levered betafactor, the resulting cost of equity is too high, if the debt beta is neglected. This would result, ceteris paribus, in a too low market value of equity. The fact that the debt capital would assume an equity-like character at a certain level of leverage, would be ignored. The above examples and calculations therefore show that the application of a debt beta is pivotal to determining coherent cost of capital parameters and, thereby, a company’s (equity) value on a solid, coherent basis.

k MRPrfL ßLE = + *

MRP

krf

ßL

LE

= cost of equity of a levered company

= risk-free interest rate

= levered beta factor

= market risk premium

ßU ßDebtßU

ßU

ßL

ßL

= +

= levered beta

= unlevered beta

= debt beta

= leverage ratio

-( ) DE—*

ßDebt

DE—


“This telephone has too many shortcomings to be seriously considered as a means of communication. The device is inherently of no value to us.“ (Western Union internal communication, 1876). As even the most important technologies of our modern world can be unappreciated, what are the lessons for valuing technology assets and their owners?

The technology market is huge, and its value has massively increased in recent years. The importance of technological innovations over the past decade can be seen in how the share prices of some dominant technology companies have developed. If one had bought shares in Apple in 2007 – the year Apple presented its iPhone 3 – one would have enjoyed an increase in the share price of around ten times.

Challenges in valuing new technologies

Other technology giants such as Facebook and Google (Alphabet) have also rewarded their shareholders with an impressive appreciation in share prices. Even established technology companies such as IBM and Microsoft, which have a poorer public perception than Apple or Facebook, have (nearly) doubled in share price value over the past decade.

0.1

1.0

10.0

8.0

6.0

4.0

2.0

Jan 2007 Jan 2008 Jan 2009 Jan 2010 Jan 2011 Jan 2012 Jan 2013 Jan 2014 Jan 2015 Jan 2016 Jan 2017

Loga

rithm

ic in

dex

(1=

100%

)

Microsoft

Apple

Google

Nasdaq

IBM

Facebook

Benchmarking of selected technology shares compared to the Nasdaq Composite Index

Source: Capital IQ, KPMG analysis


This attractiveness of the technology sector is also reflected in mergers & acquisitions (M&A) activity. Globally, transactions in the sector totaled USD 267.6 billion in 2016,

Largest acquisitions in the technology sector by deal size, 2016 and 2017

No. Date Acquirer TargetDeal size –USDbn

Target – Country

Sector % Sought

1 27 Oct 16 Qualcomm NXP Semiconductors 47.0 Netherlands Semiconductor 100.0%

2 05 Sep 16 SoftBank ARM Holdings 31.6 United Kingdom Semiconductor 98.6%

3 08 Dec 16 Microsoft LinkedIn 26.2 United StatesInternet software and services

100.0%

4 10 Mar 17 Analog Linear Technology 14.8 United States Semiconductor 100.0%

5 03 Oct 16 Quintiles Transnational IMS Health 10.4 United States Healthcare

technology 100.0%

6 04 Nov 16 Oracle NetSuite 9.5 United States Systems software 76.5%

7 10 Mar 17 Samsung Harman 8.9 United States Consumer electronics 100.0%

8 07 Sep 16 Miro-Focus

Hewlett Packard Enterprise (software)

8.8 United States Application software 100.0%

9 30 Sep 16 Tencent Supercell 8.6 FinlandHome entertainment software

84.3%

10 03 Apr 17Computer Sciences Corp (CSC)

HPE 8.3 United States

Technology hardware, storage and peripherals

100.0%

11 01 Aug 16 Didi Chuxing Uber China 7.0 China Application software 100.0%

with the eleven largest transactions in 2016 and 2017 to date being in semi-conductors and information technology.

Especially given the sums of money involved, extreme care must be taken when valuing businesses and the technologies they hold. Prior to an M&A transaction or initial public offering (IPO), for example, a valuation should be considered in light of the significant R&D expenses to be invested. Irrespective of whether the technology is complex – such as in information and communications – or more discreet such as in chemicals, pharmaceuticals and steel – the value is based on the discounted future economic benefit it is expected to yield.

How can a technology’s value be determined? While a technology valuation is specific to the industry and individual case, some general statements hold true. How a given technology is intended to be commercialized is as important as the development costs to be incurred, the timespan before returns are generated, the marketing potential, and the related technological, economic and legal risks. It is therefore pertinent to ask the following questions:

• Will the technology also function outside the underlying lab conditions and can it be scaled?

• Which development and production activities are required to advance the technology to marketability, and what are the related costs?

• What level of technology do direct competitors possess?• What client benefit does the technology provide and what

is the client’s willingness to pay?• To what extent can the technology be utilized without

infringing on third-party rights?• What legal protection does the technology enjoy and how

easily can this protection be circumvented?• For what timespan will this technology yield an economic

benefit, compared with alternative technologies and substitute products?

Source: Techcrunch


The uncertainty surrounding a technology’s future potential can be taken into account through sensitivity analyses and by determining alternative future scenarios. Scenario planning may, for example, look at the financial benefits of the company developing the technology into marketable products, licensing the technology to a third party, or combining the two.

Applying the relief-from-royalty method As the price of a technology reflects the amount for which it can be traded with third parties, licenses (specifically, royalties) may provide the framework for price negotiations. Potential licence and royalty incomes can therefore be relied upon when estimating the value of a technology. It is widely assumed in practice that the holder of a technology is not its proprietor and must pay a royalty for his own technology. As the royalties will not be paid to the actual proprietors, they represent savings which, discounted, determine the technology’s value. The fact that an adequate licensing fee must be derived from comparable licensing agreements is, however, a shortcoming of this method, as such agreements tend to be unavailable in real life.

Choosing the added value or residual value approach Fair value-oriented methods of added value or residual value are frequently adopted to value technologies. The choice of method is guided by the relative importance of the technology to creating value in a given product or process and allows for the isolation of technology-specific payment flows from other payment flows of jointly

generated economic goods. As the name suggests, the added value method estimates the sales increase or cost savings that can be assigned to the given technology. For the residual value method, by contrast, technology is the pivotal point in the value creation process – all other goods provide support benefits, with their value contributions being relatively easily deducted from those of the technology.

Keeping your eye on a moving targetValuations always focus on a specific point in time. The value and price of a given technology change with the company’s constantly evolving environment. Successful companies understand not only their technologies and the property rights of the innovations, but also their relative significance to corporate success. They develop a consistent technology utilization strategy and embed it in their corporate strategy.

The risk of unrecognized (and thus unexploited) technological potential leading to companies exiting the market is significant. Hence, companies can be fearful of missing out on latest developments and emerging technologies can give rise to significant M&A transactions. Take Facebook’s acquisition of WhatsApp in February 2014 as an example. At the time, WhatsApp was only five years old, with sales of around USD 10 million and fewer than 100 employees. Despite this, Facebook was willing to pay USD 22 billion. This shows that, no matter how the value of a technology is determined, it often has the capacity to surprise.


The February 2017 edition of this newsletter introduced a selection of key financial market data. We now provide the first of our periodic updates, covering:

• Comparison of major stock market performances for the 12 months ending 31 of March 2017

• EURO STOXX 600 sector multiples• Risk-free rates for major currencies• Country risk premiums and inflation forecasts for the

BRIC countries Performance of major stock market indices: Positive throughout Stock markets have been extremely resilient over the past

twelve months, weathering such unexpected results as the Brexit referendum and the US presidential elections. Between Q1 2016 and Q1 2017, outstanding performances were noted from the DAX (+23.6 percent), technology-driven NASDAQ (+21.4 percent), Spain’s Ibex 35 (+19.9 percent) and FTSE 100 (+18.6 percent) index.

The Ibex 35 outperformed its peers with a growth rate of 11.9 percent on a quarterly basis (in Q1 2017), closely followed by MSCI Emerging Markets and NASDAQ which grew by 11.1 percent and 9.8 percent respectively. The only one of these major indices to perform negatively in Q1 2017 was the Nikkei 225 index at minus 1.1 percent – although it posted an impressive annual increase of 12.8 percent.

Capital market data

Performance of leading indices31 March 2016 – 31 March 2017

5,9%

11,1%

5,5%

2,5%

7,2%

5,4%

11,9%

5,3% 5,5%

9,8%

(1,1)%

12,5%

14,5%12,9%

18,6%

23,6%

16,8%

19,9%

10,9%

14,7%

21,4%

12,8%

MSCI World MSCIEmergingMarkets

STOXXEurope 600

FTSE 100 DAX CAC 40 Ibex 35 SMI S&P 500 NASDAQ Nikkei 225

Inde

x pe

rfor

man

ce (%

)

QoQ YoY

Source: Capital IQ, KPMG analysis


EURO STOXX 600 sector multiplesThe enterprise value (EV) multiple states the market value of the business in relation to an appropriate base metric, with commonly used EV multiples being revenue and EBITDA. The numerator (EV) and denominator (revenue, EBITDA) represent all investor claims on the business.

The Euro STOXX 600 sector overview of trading multiples showed no significant outliers or other extremes based on EV/revenue and EV/EBITDA in Q1 2017 compared to Q4 2016. Only the utilities sector (with an EV/EBITDA multiple increase from 8.1x to 10.0x) and the energy (oil and gas) sector (with an EV/EBITDA multiple decrease from 10.3x to 9.0x) displayed noticeable movements in Q1 2017.

1.6x 1.8x 1.9x 1.8x

9.9x 10.6x 11.1x 10.9x

0.0x

3.0x

6.0x

9.0x

12.0x

15.0x

18.0x

30

Jun

16

30

Sep

16

31

Dec

16

31

Mar

17

30

Jun

16

30

Sep

16

31

Dec

16

31

Mar

17

EV/Revenue EV/EBITDA

Consumer Discretionary Median

1.1x 1.1x 1.3x 1.2x

10.2x 10.1x 10.3x9.0x

0.0x

3.0x

6.0x

9.0x

12.0x

15.0x

18.0x

30

Jun

16

30

Sep

16

31

Dec

16

31

Mar

17

30

Jun

16

30

Sep

16

31

Dec

16

31

Mar

17


Energy (Oil and Gas) Median

3.9x 3.9x 3.7x 3.8x

16.3x 15.8x 15.4x 15.5x

0.0x

3.0x

6.0x

9.0x

12.0x

15.0x

18.0x

30

Jun

16

30

Sep

16

31

Dec

16

31

Mar

17

30

Jun

16

30

Sep

16

31

Dec

16

31

Mar

17


Healthcare Median

2.0x 2.0x 1.9x 2.0x

12.7x 12.7x 12.3x 12.5x

0.0x

3.0x

6.0x

9.0x

12.0x

15.0x

18.0x

30

Jun

16

30

Sep

16

31

Dec

16

31

Mar

17

30

Jun

16

30

Sep

16

31

Dec

16

31

Mar

17


Consumer Staples Median

1.3x 1.4x 1.5x 1.3x

0.9x 1.0x 1.1x 1.1x

0.0x

1.0x

2.0x

3.0x

30

Jun16

30

Sep16

31

Dec16

31

Mar17

30

Jun16

30

Sep16

31

Dec16

31

Mar17

EV/Revenue P/BV

Financials Median(1)

1.3x 1.5x 1.4x 1.5x

10.3x 11.0x 11.4x 11.8x

0.0x

3.0x

6.0x

9.0x

12.0x

15.0x

18.0x

30

Jun

16

30

Sep

16

31

Dec

16

31

Mar

17

30

Jun

16

30

Sep

16

31

Dec

16

31

Mar

17


Industrials Median

Source: Capital IQ, KPMG analysisNote: (1) Financial services companies differ from many other companies in how they operate. For those companies, debt acts more like “raw material” than operational capital. A common valuation metric used by analysts evaluating such firms is the price to book (P/B) ratio.


4.2x 4.3x 3.7x 4.6x

14.1x 15.0x 14.3x 15.0x

0.0x

3.0x

6.0x

9.0x

12.0x

15.0x

18.0x

30

Jun

16

30

Sep

16

31

Dec

16

31

Mar

17

30

Jun

16

30

Sep

16

31

Dec

16

31

Mar

17


Information Technology Median

2.3x 2.4x 2.3x 2.4x

8.4x 8.5x 8.2x 8.5x

0.0x

3.0x

6.0x

9.0x

12.0x

15.0x

18.0x

30

Jun

16

30

Sep

16

31

Dec

16

31

Mar

17

30

Jun

16

30

Sep

16

31

Dec

16

31

Mar

17


Telecommunication Services Median

1.5x 1.7x 1.8x 1.9x

9.0x10.7x 10.3x 9.7x

0.0x

3.0x

6.0x

9.0x

12.0x

15.0x

18.0x

30

Jun

16

30

Sep

16

31

Dec

16

31

Mar

17

30

Jun

16

30

Sep

16

31

Dec

16

31

Mar

17


Materials Median

1.5x 1.6x 1.7x 1.8x

8.4x 8.7x 8.1x10.0x

0.0x

3.0x

6.0x

9.0x

12.0x

15.0x

18.0x

30

Jun

16

30

Sep

16

31

Dec

16

31

Mar

17

30

Jun

16

30

Sep

16

31

Dec

16

31

Mar

17


Utilities Median

Risk-free rates: Will the recent upward trend continue?The risk-free rate (or base rate) can generally be broken down into two key components that seek to compensate the investor: the first for expected inflation and the second for deferred consumption. The base rate is free of risks except for risks embedded in the underlying currency and risks related to investments in the particular country (including general political, legal, regulatory and tax risks, as well as the risk of a moratorium). As no investment is truly risk free, the risk-free rate is typically approximated by

reference to the yield on long-term debt instruments issued by presumably financially healthy governments. The historical risk-free rates for Germany, the Eurozone, the US, the UK and Switzerland are below.

An upward movement in risk-free rates can be observed in Q1 2017, except for the UK and Switzerland. The US Federal Reserve’s decisions to raise the interest rates in 2016 and at the beginning of 2017 have pushed the US risk-free-rate to almost a two-year high.

Risk-free rates

rounded Euro-countries Germany UK Switzerland USADate EUR EUR GBP CHF USD

31/3/201330/6/201330/9/201331/12/2013

2.50%2.74%2.71%2.88%

2.24%2.51%2.62%2.81%

3.23%3.60%3.57%3.72%

1.34%1.60%1.74%1.93%

3.17%3.56%3.81%4.06%

31/3/201430/6/201430/9/201431/12/2014

2.53%2.28%1.92%1.46%

2.51%2.26%1.97%1.56%

3.58%3.49%3.12%2.58%

1.65%1.56%1.28%0.80%

3.67%3.44%3.30%2.85%

31/3/201530/6/201530/9/201531/12/2015

0.69%1.79%1.51%1.70%

0.70%1.65%1.38%1.55%

2.39%2.80%2.58%2.77%

0.43%0.79%0.81%0.70%

2.66%3.31%3.06%3.17%

31/3/201630/6/201630/9/201631/12/2016

1.03%0.46%0.53%0.97%

0.90%0.49%0.47%0.95%

2.39%1.85%1.61%2.03%

0.25%(0.03)%(0.06)%0.35%

2.81%2.50%2.48%3.06%

31/03/2017 1.25% 1.24% 1.88% 0.32% 3.27%

Source: KPMG analysisApproach: Determination of a present value-equivalent uniform interest rate based on the yield curve of the specific central bank

Source: Capital IQ, KPMG analysisNote: Deviations in historical EV-Multiples compared to the previous edition (February 2017) are due to changes in the constituents of the EURO STOXX 600 index


Country risk premium: Lowest for China (among BRIC)The country risk premium is a measure of risk faced by businesses when investing in sovereign states, reflecting a number of risks including economic, financial, political and institutional. The country risk premium is effectively the risk of low probability, high impact events that could lead to significant losses in investment values. These types of risk are at the forefront of many investors’ thinking now more than ever due to a number of major economic and geopolitical events such as the Eurozone sovereign debt crisis and events in the Middle East and North Africa, all of which have led to previously stable countries becoming

much riskier. KPMG’s Valuation practice has been analyzing and measuring country risk for 15 years and covers more than 150 sovereign states in a proprietary KPMG analyst model.

The country risk premium for Brazil, Russia, India and China as of 31 March 2017 for an investment period between 0.5 and 2 years are set out below. The country risk premium for China is substantially lower than for Brazil, Russia or India. This is driven chiefly by political and institutional uncertainties in Brazil for various investment horizons.

Growth ratesGrowth rates are a major component of the terminal value calculation for the discounted value method and are based on country-specific inflation forecasts. The growth rates for Brazil, Russia, India and China are based on the International Monetary Fund Economist Intelligence Unit inflation forecast for the years 2017 until 2022.

Brazil, Russia and India demonstrate high growth rates for 2017 as well as a stable growth in the long run. A more moderate growth rate development is expected for China for 2017 to 2019 with an increase from 2020 onwards.

Country risk premium 0.5 year 1.0 year 2.0 year

Brazil 2.8% 3.0% 3.3%

Russia 1.7% 1.9% 2.4%

India 1.9% 2.1% 2.1%

China 0.9% 1.0% 1.0%

Inflation forecast 2017 2018 2019 2020 2021 2022

Brazil 4.4% 4.3% 4.5% 4.5% 4.5% 4.5%

Russia 4.5% 4.2% 4.0% 4.0% 4.0% 4.0%

India 4.8% 5.1% 5.0% 4.9% 4.9% 5.0%

China 2.4% 2.3% 2.6% 3.0% 3.0% 3.0%

Source: KPMG CRP study

Source: IMF

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received, or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough exa-mination of the particular situation. The scope of any potential collaboration with audit clients is defined by regulatory requirements governing auditor independence.

© 2017 KPMG, a Barbados partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity, All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International Cooperative (“KPMG International”), a Swiss entity.

Lisa TaylorPartner, Deal AdvisoryCaricom Head of Valuation

+1 246 434 [email protected]

Christopher BromePartner, Deal AdvisoryValuation / Financial Modelling

+1 246 434 [email protected]

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International Valuation Newsletter - KPMG Valuation Newsletter June 2017 4 How does neglecting debt beta affect the levered cost of equity? If the debt beta is not taken into account,