Valuation

• Some of possible reasons to perform valuation exercise are:
  • preparation for sale
  • impairment test to estimate value of goodwill
  • redemption of co-owner wishing to exit from ownership structure
  • financial institution may ask for valuation of shares of a company to which it provided loan facility and now wishes to mortgage the shares as collateral
  • preparation for recapitalisation
  • as part of preparation for initial public offering (IPO)
• At companies which combine several business units (such as independent divisions of food and beverages), valuation can be performed for a specific unit or part of a company. Reason for this might be preparation to carve out and sell a specific unit or part or something else. GRUBISIC & Partners are experts for preparation of valuations part of which is development of sophisticated financial models which include sensitivity analysis and scenario analysis.

• Value of any type of asset, therefore of a company also, relates to two main questions:
  • What are expected benefits of owning the company / business?
  • What is the risk of realized benefits being different than expected benefits?
• The ultimate „benefit“ from the investment does not come in the form of profit but rather positive free cash flow. The higher the expected cash flow the company can generate in the future, the higher its current value. Why is cash flow important instead of profit? Because profit is an accounting term and accounting is a standard within which it is defined how to record business activities. Each standard is based on specific rules which are at the same time in some parts subject to discretionary interpretation and application by the management of the company. As a consequence, accounting profit is often different from cash flow. Here are few examples:
  • Depreciation is a cost item in income statement (decreases profit) but does not represent cash outflow.
  • While issuing invoices increase in revenue is recorded, but that does not necessarily indicate that it was collected (if not, this will result in increase in trade receivables in balance sheet).
  • While selling products, cost of their purchase or production is recorded in income statetement, but that does not necessarily indicate that the raw materials consumed in production were paid for (if not, this will result in increase in trade payables in the balance sheet).
  • Purchase of a building which will be used for many years will not be reflected in income statement as an expense in the year of acquisition but will be linearly depreciated (as an expense in income statement) during the coming years i.e. estimated useful life (but cash outflow has happened today).
  • During repayment of loan installment which includes interest and principal, income statement will reflect the interest part only while repayment of principal will be reflected in decrease in loan liabilities in the balance sheet (cash outflow included entire installment amount, while profit reflects only the interest part).
• Therefore, to calculate cash flow of a company we need information contained in income statement and changes in balance sheet at beginning and end of period for which we calculate cash flow. To prepare projection of cash flows in the coming periods, we need projections or future income statements and balance sheets. This leads to the conclusion that today's value of company reflects our expectations of its ability to generate future cash flows, which is a direct outcome of movement in income statement and balance sheet.
• Income statement and balance sheet projections are based on assumptions of future revenue, margins, operating expenses, taxes, collection period of receivables, inventory turnover, payment period of liabilities, financing sources, expenses and terms, amount and dynamics of investments in long term assets, depreciation rates, etc. All stated should be incorporated in a financial model. This all depends on our assumptions regarding market conditions, competition, consumer preferences and other elements specific for the industry.
• Considering that projections are based on assumptions relating to a set of important variables, there is a possibility that actual results will differ from those projected. This implies that expected cash flow is a risky category. Amount of assesed risk will influence investor's required rate of return. Higher the risk, higher the required rate of return. In turn, higher the required rate of return, lower the amount an investor is ready to pay for the expected future cash flows of the company.

• Market value is market price of a share (on stock exchange) multiplied by the number of shares issued. On the other side, intrinsic value is considered to be the value based on all relevant information and facts necessary for valuation of a company (regardless if those are publicly available pieces of information or insider-type of information usually gained during due diligence process). Very rarely is the case that market value is equal to intrinsic value. Some of the reasons for these differences are:
  • Sometimes number of shares which are traded on stock exchange (free float) is very low which decreases share's liquidity (lack of liquidity contributes to higher share price fluctuations).
  • Market psychology results in a fact that stock exchange prices are under big influence of general trends on capital markets (most share prices rise or fall more or less in line with the market independently of the actual status of the company – too much optimism results in euphoria and price bubbles, while on the other side too much pessimism leads to panic sale and meltdown of market prices).
  • Demand for a share can be a consequence of specific sector attractiveness as a whole or high liquidity at disposal to institutional investors.
  • Most participants on capital markets have short investment horizon (traders) which do not care if the share is overvalued, undervalued or has fair value, but rather they focus on abilitiy to assume a position in a share and realize a gain through varios possible ways of trading with a share (selling it long, short, etc.)
• In case of taking over controlling stake in ownership structure, interested buyer usually seeks permission to conduct due diligence. If the buyer believed that the current market price equals intrinsic value, there would be no reason for due diligence. Practice shows that majority of level-headed acquirers does not take market prices easily but instead during due diligence tries to come to important understandings to perform (intrinsic) valuation of a company.

• Value of a company depends on its ability to generate cash flows. Potential to generate cash flow further depends on management quality, procurement and sales terms, as well as many other factors. Stand-alone value is value of a company as is – with current management, negotiating power with suppliers, existing distribution channels, production process, product portfolio, etc.
• One of the motives for mergers and acquisitions is an estimate that combined value of two companies will be greater after merger (acquisition). What was 1+1=2 before transaction takes place should be worth more than 2 after the transaction if future combined cash flow is greater than that before the transaction. Combined cash flow can be increased due to cost reduction (better purchase terms due to bigger quantities, merging and/or optimisation of part of administrative functions, more efficient distribution, sharing of strategic resources, etc.) or increase in revenue (better utilisation of production capacities, access to new markets, etc.). Additionally created value arising as a consequence of acquisition is called synergy effect.
• First question with synergies is which side to merit for creation of synergies. Most often, the acquirer enters into acquisition because of belief that there are synergies which will be created by putting target under its control. In other words, it is estimated that value of target will increase under acquirer's control. This leads us to the second question – how will (as part of transaction) planned synergies be divided between acquirer's shareholders and target's shareholders. Let's take simple example – stand-alone value of acquirer is 1.800 and target 576. It was estimated that synergy effects arising due to merger (or acquisition of target by the acquirer) would amount to 120. During negotiation phase, acquirer has negotiated purchase price of 648 with target's shareholders. Value of acquirer's company post acquisition and merger of target will amount to 1.800 + 576 + 120 – 648 = 1.848, which indicates that out of total estimated synergy 72 belongs to target's shareholders and 48 to acquirer's shareholders. Depending on which party is meritorious for generation of synergy, readiness to offer or accept certain price will depend upon. What usually happens in practice is that the role of acquirer is key to synergy generation but also that a good part of synergy becomes a ˝gift˝ to target's shareholders through premium paid above fair (stand-alone) value of target. Risk of „overpaying“ target increases as competition in takeover process steps in.

• This method calls for projections of company cash flows because the value of the company is assumed to be its current (discounted) value of future cash flows. Cash flows are discounted at a rate which represents investor's required rate of return. To project cash flow, it is necessary to prepare projections of income statement and balance sheet. Depending on desired level of details, income statement and balance sheet can be projected as only few main items or at the most detailed level.
• Two predominant DCF models are:
  • Free cash flow to firm (FCFF) discounted at weighted average cost of capital (WACC). Free cash flow to firm is a cash flow available to shareholders and creditors. Current value of free cash flows to firm represents total value of a company (debt + shareholder's equity), which is also referred to as enterprise value (EV). Value of shareholder's equity is a result of subtracting debt out of total enterprise value.
  • Free cash flow to equity (FCFE) discounted at cost of equity. FCFE to equity is FCFF reduced for principal and interest payment to creditors. Current value of FCFE represents value of shareholder's equity.

• In this method we seek relative values of companies from the same industry (as our subject of valuation) listed on stock exchanges.
• "Relative value" refers to multipliers such as:
  • EV / Income
  • EV / EBITDA
  • EV / EBIT
  • EV / free cash flow
  • P /E (price to earnings ratio)
  • P / cash flow to shareholders

EBITDA = earnings before interest, taxes, depreciation and amortization
EBIT = earnings before interest and taxes

• Average or median values of the above stated multiples calculated for similar companies listed on stock exchanges are then multiplied with indicators of the company which is being valued. For example – average ratio EV/EBITDA for a listed company is 7x and EBITDA of the company being valued is EUR 10 million. Implied value of the company (EV) based on traded multiple EV/EBITDA is EUR 70 million (10m x 7 = 70m). Out of this amount, we then have to subtract debt of the company under valuation to get its equity value.

• Similar to trading multiples, here we talk about a method where we seek relative values of companies. To be more specific, we are interested to find at which mupltiples of sales, EBITDA, etc. have transactions been talking place in the industry in which the company under valuation is in.