By Gaurav Jalan, MD, Avant Garde Wealth Management
IMI Kolkata, December 9 2013 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 based value of an operating business Value that can be realized from 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/business based 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) Investor Presentation - 1104 BOS 3 Replacement cost, ROIC and WACC *Invested capital is ideally calculated using replacement cost but can be estimated using balance 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 as efficiently 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 invested capital in this business and others with a similar risk profile WACC (Weighted Average Cost of Capital) Investor Presentation - 1104 BOS 4 Appropriate valuation framework depends on business economics
Key measure of economic viability of a business -> ROIC - WACC ROIC WACC < 0 ROIC WACC = 0 ROIC WACC > 0 Unviable business that is destroying value by operating Operating in a perfectly competitive environment Business with competitive advantages Liquidation value Replacement cost Earnings / cash flow based valuation Versus replacement cost Smaller Equal Greater Business economics Business description Valuation framework Investor Presentation - 1104 BOS 5 Liquidation value
If ROIC < WACC the business is by definition destroying value as the capital invested in it is earning less than it would elsewhere (adjusted for risk) Once it is determined that this is a permanent state of affairs, value is maximized by closing down the business and freeing up the capital for alternative uses Note that by investing further capital to grow such a business the overall value of the business actually declines Why liquidate a business? Realizable value of assets minus value of liabilities Can be estimated using the balance sheet. As a rough proxy, shareholders equity is equal to value of assets minus liabilities. However, to the extent that the balance sheet may not reflect market or realizable value of assets/liabilities figures will need to be adjusted Mechanics of calculating liquidation value Important to differentiate between permanent and cyclical business performance In case where an industry as a whole seems uneconomical, it is important to determine if it will remain so permanently Key points to consider Investor Presentation - 1104 BOS 6 Replacement value
If ROIC = WACC the business operates in economist heaven, a perfectly competitive landscape where all excess profits are competed away In this case the value of the business is exactly equal to the replacement cost of the assets 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 value even if currently ROIC <> WACC Unless sustainable competitive advantages can be identified there is a tendency for excess returns to shrink over time as competition increases Unless there are reasons for permanent unviability, a business earnings low returns tends to improve over time as competition reduces Key points to consider Investor Presentation - 1104 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 a certain period + terminal value Theoretically most appropriate Drawbacks Very sensitive to terminal value Explicit forecasts are likely to have large errors as well Garbage in = Garbage out Based on some multiple of a current measurable value. E.g. Price/Earnings, Price/Cash Flow, Price/Earnings Power, EV/EBITDA, etc. Metrics such as earnings or EBITDA are typically used as a proxy for cash flow Easy to calculate and easily comparable across assets/industries/geographies Primary drawback is that a current period metric is effectively assumed to accurately reflect a long term stream of cash flows Investor Presentation - 1104 BOS 8 The math behind multiple based valuation
Proxy for sustainable free cash flow Enterprise value = Multiple x 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 of equity 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 Investor Presentation - 1104 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 b Replacement cost of assets Total value Earnings power value Replacement value 2 (12.5%-6%) = 2 12.5% = Free entry No 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 Investor Presentation - 1104 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 cash balance over the years Hence WACC = Cost of Equity = 15% (lets work with this assumption for now) Investor Presentation - 1104 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 9,728 Deferred tax liability 307 Total liabilities 10,035 Total shareholders' equity 26,977 Total liabilities + SE 37,012 Investor Presentation - 1104 BOS 12 Cummins India: Replacement cost
1997 2007 2010 2013 (Sep) 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 9,728 Deferred tax liability 307 Total liabilities 10,035 Total shareholders' equity 26,977 Total liabilities + SE 37,012 Investor Presentation - 1104 BOS 13 Cummins India: Replacement cost
1997 2007 2010 2013 (Sep) 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 9,728 Deferred 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 Investor Presentation - 1104 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 well above 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) Investor Presentation - 1104 BOS 15 Cummins India: The three tranches of value Assumptions for Cummins: Replacement cost = Rs.29.6 b Rs.29.6 b Rs.29.6 b Rs.29.6 b Replacement cost of assets Total value Earnings power value Replacement value Free entry No competitive advantages Rs.30 b 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) Investor Presentation - 1104 BOS 17 Cummins India: Earnings Power Value (2) EPV > Replacement cost as expected since ROIC > WACC (in Rs. Million) 2013 Sales 45,894 Normalized 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 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 b Replacement cost of assets Total value Earnings power value Replacement value Free entry No competitive advantages Franchise value Franchise value from current competitive advantages Rs.30 b Rs.41 b 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) Investor Presentation - 1104 BOS 20 Cummins India: Value of growth When businesses have the ability to reinvest capital at an ROIC that is significantly higher than WACC growth can create substantial value The larger the spread between ROIC and WACC the more sensitive the valuation 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 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 b Replacement cost of assets Total value Earnings power value Replacement 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 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 b Replacement cost of assets Total value Earnings power value Replacement 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 Current enterprise value of the company (Dec 6 2013) is Rs.116 billion Rs.30 b Rs.41 b Rs.88-205 b Investor Presentation - 1104 BOS 23 Cummins India: Actual valuation history On actual reported earnings the stock has historically traded at a P/E of 10-30x which 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) 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 based value of an operating business Value that can be realized from 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/business based 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) 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 business over its operating value as it gives him control over the cash flows of the business 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 the entire business if the company were up for sale Unless it is a distress sale the strategic value can be expected to exceed the operating value, often substantially, for the following reasons: Investor Presentation - 1104 BOS 26 Valuation is more art than science
Given the number of variables involved and the sensitivity of the resulting 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 value a 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 near future (hint: very overvalued)