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Valuation (Economics of Strategy)

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)