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FEMA Valuation Aspects
By: Chander Sawhney(FCA, CS, Certified Valuer (ICAI)
Asst. Vice President
SEBI REGISTERED (CAT -I) MERCHANT BANKER
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“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 10 th April,2013
Contents
TABLE OF CONTENT
Particulars Pg. No.
Valuation Overview 3
FDI Valuation - Background of FEMA Valuation - Approaches to FDI Valuation - Major Characteristics of DFCF - DFCF Valuation Process - Free Cash Flow Calculation - Cost of Capital Calculation - Terminal Value Calculation - Tricky Issues in DFCF - Case Study
111415161718202123
Approaches to ODI Valuation 29
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 10 th April,20132
VALUATION OVERVIEW
3
Valuation
Valuation is the process of determining the “Economic Worth” of an Asset or Company
under certain assumptions and limiting conditions and subject to the data available on the
valuation date. * Source -International Valuation Standard Council
Depends upon :
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• Mergers
• IPO
• RBI
• Income Tax
• ESOP
• Companies Act
• SEBI
• Stock Exchange
Purpose Regulatory Accounting
• Purchase Price Allocation
Dispute Resolution
• Company Law Board/ Courts
• Impairment / Diminution
• Arbitration
• Mediation• Acquisitions / Investment
• Voluntary Assessment
Key Facts of Valuation
The Value of a business, by whatever valuation method it is obtained, is not the selling price of the business. Value is an economic concept based on certain data & assumptions, however Price is what a Buyer is willing to pay keeping in consideration the Economic and Non Economic factors like Emotions, Perception, Greed Etc which cannot be valued as such.
The Value is a subjective term and can have different connotations meaning different things to different people and the result may not be the same, as the context or time changes.
Valuation is more of an art and not an exact science. The Art is Professional Judgment and Science is Statistics. Mathematical certainty is neither determined nor indeed is it possible as use of professional judgment is an essential component of estimating value
Though the value of a business can be objectively determined employing valuation approaches, this value is still subjective, dependent on buyer and seller expectations and subsequent negotiations and the Transaction happens at negotiated price only.
PRICE IS NOT THE SAME AS VALUE
TRANSACTION CONCLUDES AT NEGOTIATED PRICES
VALUATION IS HYBRID OF ART & SCIENCE
VALUE VARIES WITH PERSON, PURPOSE AND TIME
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 10 th April,20135
Growing Cos.
Turnover/Profits: Increasing still Low Proven Track Record: Limited Valuation Methodology: Substantially on Business Model Cost of Capital: Quite High
High Growth Cos.
Turnover/Profits : Good Proven Track Record: Available Valuation Methodology: Business Model with Asset
Base Cost of Capital: Reasonable
Mature Cos.
Turnover/Profits: Saturated Proven Track Record: Widely Available Method of Valuation: More from Existing Assets Cost of Capital: May be High
Declining Cos.
`
Turnover/Profits: Drops Proven Track Record:
Substantial Operating History Method of Valuation: Entirely
from Existing Assets Cost of Capital: N.A.
Turnover/Profits: Negligible Proven Track Record: None Valuation Methodology: Entirely on Business Model Cost of Capital: Very High
Start Up Cos.
Tu
rno
ver
/ P
rofi
ts
Time
Valuation across business cycle follow the law of economics
Valuation: The law of Economics
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CASH FLOW Investor assign value based on the cash flow they expect to receive in the future - Dividends / distributions - Sale of liquidation proceeds Value of a cash flow stream is a function of - Timing of cash Receipt - Risk associated with the cashflow
ASSETS
Operating Assets - Assets used in the operation of the business including working capital, Property, Plant & Equipment & Intangible assets - Valuing of operating assets is generally reflected in the cash flow generated by the businessNon - Operating Assets - Assets not used in the operations including excess cash balances, and assets held for investment purposes, such as vacant land & Securities - Non operating assets are generally valued separately and added to the value of the operations
Key drivers of valuation
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Broad Approaches to Valuation
8
Broad Approaches to FDI / ODI Valuation
FDIFDI
ODIMinority Stake
Valuation
ODIMinority Stake
Valuation
ODIControl Stake
Valuation
ODIControl Stake
Valuation
Proxy Minimum
Value
Proxy Minimum
Value
9
FDI VALUATION
• Notification No. FEMA 20/2000-RB dated May 3, 2000, as amended from time to time deals with
Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India)
Regulations, 2000.
•In terms of Schedule 1 of the Notification, an Indian company may issue equity shares/compulsorily
convertible preference shares and compulsorily convertible debentures (equity instruments) to a person
resident outside India under the FDI policy, subject to inter alia, compliance with the pricing guidelines.
•The price/ conversion formula of convertible capital instruments should be determined upfront at the
time of issue of the instruments.
10
Particulars Valuation before April 21, 2010 Valuation after April 21, 2010
Guidelines in Force CCI Guidelines In case of FDI Transactions:Listed Company: Market Value as per SEBI Preferential Allotment Guidelines
Unlisted Company: DFCF
In case of ODI Transactions:No method has been prescribed
Methods Prescribed Net Assets Value (NAV)Profit Earning Capacity Value(PECV)Market Value (in case of Listed Company)
Discount 15% Discount has been prescribed on account of Lack of Marketability
No such Discount has been prescribed
Historical / Futuristic It is based on Historical Values It is based on Future Projections
Possibility of variation in Value Conclusion
As valuation is more Formulae based, final values came standardized
As valuation is more dependent on Assumptions and choice of factors like Growth Rate, Cost of Capital etc, value conclusion may vary significantly.
Background of FEMA Valuation
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Recent Development in FDI Valuation
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 10 th April,2013
The RBI is considering inclusion of any internationally accepted valuation method in place of the
existing discounted cash flow method (DFCF) prescribed in the FDI policy to remove the practical
difficulties faced by strictly following this method in all closely held companies though it may not be
relevant in case of minority stake/start up valuation etc. The strict approach thus restricts the
commercial flexibility of the parties.
Globally, investors have the freedom to pick valuation method of their choice due to absence of
capital controls in most countries.
The above is a welcome step as it gives liberty to the Valuer to choose the most relevant valuation
method based on the facts of each case and may boost foreign capital inflows to India.
12
13
Discounted Free Cash Flow Method (DFCF)
Approaches to FDI Valuation
As on date, RBI has prescribed DFCF as the only valuation method in case of FDI for closely
held companies as it is one of the most acceptable Valuation methods used by Business
valuer’s worldwide; but has not provided any guidance on its technical aspects.
DFCF expresses the present value of the business as a function of its future cash earnings capacity. In this method, the appraiser estimates the cash flows of any business after all operating expenses, taxes, and necessary investments in working capital and capital expenditure is being met to arrive at Enterprise Value (EV).
Valuing equity using the free cash flow to stockholders requires estimating only free cash flow to equity holders, after debt holders have been paid off.
DFCF expresses the present value of the business as a function of its future cash earnings capacity. In this method, the appraiser estimates the cash flows of any business after all operating expenses, taxes, and necessary investments in working capital and capital expenditure is being met to arrive at Enterprise Value (EV).
Valuing equity using the free cash flow to stockholders requires estimating only free cash flow to equity holders, after debt holders have been paid off.
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 10 th April,2013 14
Forward Looking and focuses on cash generation
Recognizes Time value of Money
Allows operating strategy to be built into a model
Incorporates value of Tangible and Intangible assets
Only as accurate as assumptions and projections used
Works best in producing a range of likely values
It Represents the Control Value
Major Characteristics of DFCF Valuation
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DFCF Valuation Process
Understand Business Model
Identify Business Cycle
Analyze Historical Financial Performance
Review Industry and Regulatory Trends
Understand Future Growth Plans (including Capex needs)
Segregate Business and Other Cash Generating Assets
Identify Surplus Assets (assets not utilized for Business say
Land/Investments)
Create Business Projections (Profitability statement and Balance Sheets)
Discount Business Projections to Present (Explicit Period and Perpetuity)
Add Value of Surplus Assets and Subtract Value of Contingent Liabilities
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Free cash flows to firm (FCFF) is calculated as
EBITDAEBITDA
Taxes
Change in Non Cash Working capital
Capital Expenditure
Free Cash Flow to Firm
Note that an alternate to above is following (FCFE) method in which the value of Equity is directly valued in lieu of the value of Firm. Under this approach, the Interest and Finance charges is also deducted to arrive at the Free Cash Flows. Adjustment is also made for Debt (Inflows and Outflows) over the definite period of Cash Flows and also in Perpetuity workings.
Theoretically, the value conclusion should remain same irrespective of the method followed (FCFF or FCFE), (Provided, assumptions are consistent).
FREE CASH FLOWS
Free Cash Flow calculation
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DISCOUNT RATE – WEIGHTED AVERAGE COST OF CAPITAL
Where:D = Debt part of capital structureE = Equity part of capital structureKd = Cost of Debt (Post tax)Ke = Cost of Equity
(Kd x D) + (Ke x E)
(D + E)
In case of following FCFE, Discount Rate is Ke and Not WACC
WACC
Cost of Capital calculation
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 10 th April,2013 18
DISCOUNT RATE - COST OF EQUITY
Where:Rf = Risk free rate of return (Generally taken as 10-year Government Bond Yield)B = Beta Value (Sensitivity of the stock returns to market returns)Ke = Cost of EquityRm= Market Rate of Return (Generally taken as Long Term average return of Stock Market)SCRP = Small Company Risk PremiumCSRP= Company specific Risk premium
Mod. CAPM Modelke = Rf + B ( Rm-Rf) + SCRP + CSRP
The Cost of Equity (Ke) is computed by using Modified Capital Asset Pricing Model
(Mod. CAPM)
Cost of Equity calculation
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 10 th April,2013 19
PERPETUITY FORMULA
– Usually comprises a Large part of Total Value and is sensitive to small changes
– Capitalizes FCF after definite forecast period as a growing perpetuity;
– Estimate Terminal Value using Terminal Value Multiplier applied on last year cash flows;
– Gordon Formula is often used to derive the Terminal CashFlows by normalizing the last year cash flows as a multiple of the growth rate and discounting factor;
– Estimated Terminal Value is then discounted to present day at company’s cost of capital based on the discounting factor of last year projected cash flows
(1 + g)
(WACC – g)
IMPORTANT TIP- It is advised to do Sanity check by applying Relative Valuation Multiples to the Terminal Year Financials and also doing Scenario Analysis.
Terminal value calculation
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Tricky issues in DFCF
Pre Money or Post Money: If the effect of the money coming in Company is taken in
Projections, the Expanded capital base should be considered or else the Equity Value
should be reduced by the inflow amount to reconcile with the existing capital base.
Terminal growth rate: Since it is tough to estimate the perpetual growth rate of a
company as it is based on the cyclical Industry trends, however the maximum perpetuity
growth rate factors in long term average GDP and Inflation of a Country.
Projection Validation via-a-vis Industry: Need to have Sanity check of the
projections with the trend of the industry, particularly in Terminal Value.
Beta of Unlisted Company: It is calculated on relative basis by adjusting the average
beta of its comparable companies for differences in Capital Structure of the unlisted
company with the listed peers.
Risk Free Rate: Yield of a Zero Coupon Bond or Long Term government Bond yield
should be taken as the risk free rate since it does not have any reinvestment risk .
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 10 th April,2013 21
Adjustment of Company Specific Risk Premium or Small Company Risk Premium:
Small Companies are generally more risky than big companies. CAPM model does not
take into consideration the size risk and specific company risk as Beta measures only
systematic risk and Market Risk Premium (generally pertaining to Sensex Companies).
These risks should also be taken into account while computing the cost of equity.
Length of Projections: The Projected Cash Flows should factor in the entire Business
Cycle of a Company.
Notional/Actual Tax: Actual Tax Liability may be worked out and replaced for the
Notional Tax Liability
Investments: Investments should be valued separately based on their Independent Cash
Flows
Surplus Assets: The Value of Surplus Assets (not being utilized for Business purposes)
should be added separately and their cash flows should be ignored while computing the
Free Cash Flows.
Tricky issues in DFCF (Cont.)
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 10 th April,201322
CASE STUDY
23
Valuation of a Hotel Industry Company – DCF Approach
All Amount in Rs. Million
Particulars Year –I Year-II Year-III Year-IV Year-V
Sales 811.48 1,020.65 1,221.10 1,305.91 1,379.81
PAT 196.61 204.79 213.72 218.05 214.43
CAPEX 2,109.40 252.64 71.95 - -
Interest
- 8.48 44.82 82.90 118.51
Business ModelEngaged in the business of development, operation & management
of Hotels in India
Projected Financials for 5 Years
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Risk-free Rate – 8.36%
EMRP – 9.04%
Beta – 0.75
Cost of Equity – 15.14%
Pre-tax cost of debt – 0%
Tax Rate – 32.45%
Post-tax cost of debt – 0%
WACC15.14%
Debt – Equity – 100% EquityPerpetuity Growth
Rate – 4%
Discount and Perpetuity growth rates
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 10 th April,2013 25
Particulars Year I Year II Year III Year IV Year V Terminal
Profit After Tax 197.00 205.00 214.00 218.00 214.00
Add : Depreciation 61.00 116.00 134.00 136.00 133.00
Add : Interest(Post Tax) - 6.00 30.00 56.00 80.00
Less :Capital Expenditure 2,109.00 253.00 72.00 -
Free Cash Flows (1,852.00) 74.00 306.00 410.00 427.00 4,004.00
Discounting Factor 0.87 0.76 0.66 0.57 0.50 0.50
Present value of Cash flows (1,611.00) 56.00 202.00 234.00 214.00 2,002.00
Cumulative present value of Cash Flows 1,097.00
Enterprise Value 1,097.00
Add: cash as on Valuation date 121.00
Less: Debt as on Valuation date -
Equity Value 1,218.00
Discounted Free Cash Flow
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 10 th April,2013 26
Valuation Assumptions
• For the sake of simplicity-
– Working capital changes not considered above;
– Full Year discount rates have been considered;
– During Terminal Value, Capex has not been deducted. A better view is to keep
Depreciation and Capex as same while normalizing the last year cash flows;
– Depending upon changes in Capital structure in projections, WACC may be
adjusted based on the Debt Equity ratio of each year;
27
• Selection of Comparable companies based on the industry, size, product profile, nature of business etc.
• Evaluation of Enterprise Value to Net Sales or EBITDA multiples
• Evaluation of Equity Value to Profit multiples
• Evaluation of a range of observed multiples
• Evaluation of Maintainable financials of the company
• Based on observed multiples
– Industry EV / Net Sales Range = 1.30 – 1.50
– Industry PE Range = 8.0-9.0
• Enterprise Value Range – Rs. 1027 Million – Rs. 1185 Million
• Equity Value Range- Rs. 1240 Million – Rs. 1395 Million
Current Financials of Company A
Net Sales – Rs 790 Million
Net Profit - Rs 155 Million
Comparable Companies EV/Net Sales PE
Company I 1.50 8.00
Company II 1.40 8.00
Company III 1.30 9.00
Sanity Check of Our DFCF Analysis
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 10 th April,2013 28
APPROACHES TO ODI
VALUATION
29
30
Market Multiples of Comparable Listed Companies are computed and applied to the Company being valued to arrive at a multiple based valuation. The difficulty here is in the selection of a comparable company, since it is rare to find two or more companies with the same product portfolio, size, capital structure, business strategy, profitability and accounting practices. Most Valuations in stock markets are market based. Also Valuations for Tax purposes are done using this method.
It Involves determining long term industry multiples using relevant parameters like:
Sales – EV / Sales looks at the enterprise value (market value of equity and debt) of firm vis-à-vis sales
Earnings before interest, taxes and depreciation (EBDITA) – EV / EBIDTA, values the firm on the basis of operating efficiency. Net Debt is deducted to arrive at the value of Equity
Net Profit – P / E, values the Equity on the basis of net earnings of company
Book Value – P / BV values the Equity on basis of book value of company
It Involves determining long term industry multiples using relevant parameters like:
Sales – EV / Sales looks at the enterprise value (market value of equity and debt) of firm vis-à-vis sales
Earnings before interest, taxes and depreciation (EBDITA) – EV / EBIDTA, values the firm on the basis of operating efficiency. Net Debt is deducted to arrive at the value of Equity
Net Profit – P / E, values the Equity on the basis of net earnings of company
Book Value – P / BV values the Equity on basis of book value of company
Comparable Companies Market Multiples Method (CCM)
Approaches to ODI Valuations
For valuing Minority Stake
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 10 th April,2013 31
Approaches to ODI Valuations (Contd)
For valuing Majority StakeRecommended Methods are as follows:
DFCF (Already discussed in earlier slides)
Comparable Transaction Multiple Method
This technique is mostly used for valuing a company for M&A, the transaction that have taken place in the
Industry which are similar to the transaction under consideration are taken into account. With the transaction
multiple method, similar acquisition or divestitures are identified, and the multiples implied by their purchase
prices are used to assess the subject company’s value. The greatest impediment in finding truly comparable
transactions is the absence of available information on private transactions based on which such transactions
took place. The more recent the transaction, the better this technique, with all other things being equal.
“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 10 th April,2013 32
Price of Recent Investment (PORI)
Under this valuation approach, the recent investment in the business by an Independent party may be taken as
the base value for the current appraisal, if no substantial changes have taken place since the date of such last
investment. Generally the last Investment is seen over a period of last 1 year and suitable adjustments are made
to arrive at current value.
Inbound Investment Inbound Investment DFCFDFCF
Gift of Unquoted Equity Shares (Min)
Gift of Unquoted Equity Shares (Min)
NAVNAV
Outbound Investment Outbound Investment Valuer DiscretionValuer Discretion
Gift of Unquoted Shares other than Equity Shares Gift of Unquoted Shares
other than Equity Shares Price it would fetch if sold in
open marketPrice it would fetch if sold in
open market
Takeover Code/ Delisting - Infrequently Traded
Takeover Code/ Delisting - Infrequently Traded
Only Parameters Prescribed – Return on Net Worth, EPS, NAV
vis-a vis Industry Average
Only Parameters Prescribed – Return on Net Worth, EPS, NAV
vis-a vis Industry Average
Takeover Code/ Delisting - Frequently Traded
Takeover Code/ Delisting - Frequently Traded
Based on Market PriceBased on Market Price
Reserve Bank of India
ESOP Tax ESOP Tax Valuer DiscretionValuer Discretion
ESOP AccountingESOP Accounting Option – Pricing ModelOption – Pricing Model
Income Tax
SEBI
CA / MBCA / MB
>5Mn$ - MB, otherwise CA/MB>5Mn$ - MB, otherwise CA/MB
--
MBMB
MBMB
--
CA/MBCA/MB
--
Stock Exchanges Relisting Base Price Determination
Relisting Base Price Determination
Valuer DiscretionValuer Discretion
Companies Act Sweat EquitySweat Equity Valuer DiscretionValuer Discretion
MBMB
--
Transactions
Prescribed Methodologies
Mandate to be done by
REGULATORY VALUATIONS
35
Gift of Unquoted Equity Shares from Resident (Max)
Gift of Unquoted Equity Shares from Resident (Max)
DCF (Valuation Based on Assets, Business & Intangibles
is also acceptable)
DCF (Valuation Based on Assets, Business & Intangibles
is also acceptable)
FCA / MBFCA / MB
Any Specific Valuation Query may be mailed @ [email protected] / [email protected]
M: +91 9810557353; Ph: 011-40622252W: www.corporatevaluations.in; corporateprofessionals.com
Mr. Chander Sawhney(FCA, CS, Certified Valuer (ICAI)
Disclaimer:This presentation contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither corporatevaluations.in nor any other member of the Corporate Professionals organization accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this presentation. On any specific matter, reference should be made to the appropriate advisor.
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