Introduction

In any sale process, the sale will materialize only when the seller is satisfied that the price given by the buyer is not less than the value of the object being sold, which in his perception is adequate. Determination of that threshold amount, which the seller considers adequate, therefore, is the first pre-requisite for conducting any sale. This threshold amount is called the Reserve Price. Thus Reserve Price is the threshold amount below which the seller generally perceives any offer or bid inadequate. Reserve Price in case of sale of a company is determined by carrying out valuation of the company. In companies, which are listed on the Stock Exchanges, market price of the shares is a good indicator of the value of the company. However most of the PSUs are either not listed on the Stock Exchanges or their shares are highly undervalued. Therefore, deciding the worth of a PSU is indeed a challenging task.

Another point worth mentioning is that valuation of a PSU is different from establishing the price for which it can be sold. Experts are of the opinion that valuation must be differentiated from price. A purchase and sale would be possible only when two parties form different views as to the value of an asset but are able to reach agreement on the same price. It would be better appreciated by all that the Government can only realise what a buyer is willing to pay for the PSU, as the purchase price ultimately agreed reflects its value to the buyer.

Another notable point is that valuation is a subjective figure arrived at by the bidder by leveraging his strengths with the potential of the company. Depending on the synergy of various bidders with the company and the assumptions of the bidders on potential of the company regarding productivity and capex, this figure may vary from bidder to bidder.

Disinvestment Commission's Recommendations

Keeping in view the above problems regarding valuation, specific to a PSU, the issue was discussed in detail by the Disinvestment Commission in its 1st Report. Underlining the importance of valuation, the Commission felt that the valuation of equity of a firm gains importance in case of disinvestment of companies which are not listed or in cases where capital markets may not fully reflect the intrinsic worth of a share disinvested earlier.

Disinvestment Commission while emphasizing that valuation should be independent, transparent and free from bias has recommended three methods of valuation:

1. The discounted cash flow relates the value of an asset to the present value of expected future cash flows of the asset.

2. The relative valuation is used to estimate the value of an asset by looking at the pricing of comparable assets relative to a     common variable like earnings, cash flows, book value or sales.

3. The net asset value of the shares is used as a basis for valuation.

Regarding the application of Valuation Methods, Disinvestment Commission felt that the use of a particular method of valuation will depend on the health of the company being evaluated, the nature of industry in which it operates and the company's intrinsic strengths. The depth of capital markets will also have an impact on the valuation. For example, in the United Kingdom, the London Stock Exchange has helped in creating markets by enabling credible price discovery for the shares of privatized companies listed on the exchange. Although valuation methods will indicate a range of valuations, Disinvestment Commission felt that some discounts might need to be applied for arriving at the final value depending on the liquidity of the stock and the extent of disinvestment.

a) Lack of marketability discount takes into account the degree of marketability (or the lack of it) of the stocks being valued. This     is applicable especially to cases, which had been disinvested earlier and have been referred for disinvestment again. Discount     on this consideration stems from the fact that investor will probably pay more for a liquid stock than for a less liquid one.     However, the concern of overhand of supply may adversely affect valuation even for liquid stocks.

b) Disinvestment Commission felt that the extent of disinvestment in core, non-strategic & non-core PSUs will have a bearing on     the valuation process. The transfer of a controlling block may help to reduce the discount that has to be applied. If all the     businesses of a PSU are not equally profitable, it may be necessary to restructure the business before disinvestment.     However, if this is not possible, a minority discount may have to be applied.

Disinvestment Commission also sought to correct some erroneous perceptions about valuation. There is a general perception that since valuation models are quantitative, valuation is objective. The Commission felt that though it is true that valuation does make use of quantitative models, yet the inputs leave plenty of room for subjective judgments. At the same time, there may be no such thing as a precise estimate of a value. Even after the end of the most careful and detailed valuation of a company, there could be uncertainty about the final numbers, as they are shaped by assumptions about the future of the company.

Another wrong perception sought to be corrected, by the Commission was the relationship attributed between valuation and market price. The benchmark for most valuations remains the market price (either its own price, if it is listed or that of a comparable company). When the value from a valuation analysis is significantly different from the market price, the two possibilities are that either one of the valuations could be incorrect. The Commission felt that the valuation done before listing takes into account anticipated factors, whereas market price reflects realized events that are influenced by unanticipated factors. However, a specific valuation itself may not be valid over a period of time. It is a function of the competitive position of the company, the nature of market in which it operates and Government policies. Therefore, it may be appropriate to update or revise valuations.

In cases where strategic sale is done with transfer of management control, the Commission felt that asset valuation should also be done. The views of the Commission in this regard are as follows:

"Strategic sale implies sale of a substantial block of Government holdings to a single party which would not only acquire substantial equity holdings of upto 50% but also bring in the necessary technology for making the PSU viable and competitive in the global market. It should be noted that the valuation of the share will depend on the extent of disinvestment and the nature of shareholder interest in the management of the company. Where Government continues to hold 51% or more of the share holding, the valuation will relate mainly to the shares of the companies and not to the assets of the company. On the other hand, where shares are sold through strategic sale and management is transferred to the strategic partner, the valuation of the enterprise would be different, as the strategic partner will have control of the management. In such cases, the valuation of land and other physical assets should also be computed at current market values in order to fix the reserve price for the strategic sale.

To get best value through strategic sales, it would be necessary to have a transparent and competitive procedure and encourage enough competition among viable parties."

Valuation Methodologies being followed

Making a valuation requires an examination of several aspects of a company's activities, such as analysing its historical performance, comparisons with the other players in the industry, forecasting performance, estimating the cost of capital, estimating the continuing value, calculating and interpreting results, the regulatory frame work, the global competition, the level of technology and several other environmental factors.

Based on the recommendations of the Disinvestment Commission and in keeping with the best market practices the following four methodologies are being used for valuation of PSUs:-
a) DCF Method.
b) Balance Sheet Method.
c) Transaction Multiple Method.
d) Asset Valuation Method.

While the first three are business valuation methodologies generally used for valuation of a going concern, the last methodology would be relevant only for valuation of assets in case of liquidation of a company.

Discounted Cash Flow (DCF) method

The Discounted Cash Flow (DCF) methodology expresses the present value of a business as a function of its future cash earnings capacity. This methodology works on the premise that the value of a business is measured in terms of future cash flow streams, discounted to the present time at an appropriate discount rate.

The DCF methodology is the most appropriate methodology in the following cases:

Where the business is being transferred / acquired on a going concern basis;

Where the business possesses substantial intangibles like brand, goodwill, marketing and distribution network, etc;

Where the business is not being valued for the substantial undisclosed assets it possesses.

The DCF methodology is considered to be the best methodology for valuation the world over because it takes into account all the factors relevant for valuation:

1. It takes care of all the free cash flows available to stakeholders of a firm. The free cash flows are calculated taking into    account the average cost of capital, cost of debt, cost of equity and market returns.

2. It also takes into account the risk factor to which the enterprise is exposed. The discount rate is based on the risk perception     of the business.

3. It also takes into account the value of the core assets of the company. Any business has two kinds of assets - core assets     that are a part of the business and non-core assets that are not directly a part of the business. The asset value of core assets     is reflected in the cash flows of the company and therefore should not be added separately to it. However non-core assets are     not reflected in the cash flows. Therefore asset valuation of non-core assets should be done separately and should be added     to DCF valuation.

4. A prudent DCF valuation should also capture the capital costs for renovation and modernization of plant and machinery. The    age and condition of assets like plant and machinery and their replacement value would be relevant for estimating expenditure    on their replacement whenever necessary. This expenditure will reduce cash flows and DCF value. Valuation of plant and    machinery would be a relevant item that would influence the DCF valuation. For example, a person acquiring a company    operating a fleet of taxis would examine the conditions of vehicles for valuation of the company. If the vehicles need    replacement of a low cost item like hub caps the impact on DCF will be less than if they need to replace gear boxes in a high    proportion of vehicles. The person would also calculate DCF with reference to the demand for taxis, the average mileage, cost    of maintenance etc. Valuation of plant and machinery is not a simple addition to DCF, but a factor to be taken into account    while calculating DCF. In such calculation, plant and machinery may be a net negative factor in the DCF if replacement costs    are high. Where surplus land would be sold this would be a positive factor. If the sale of land can cover the cost of plant    replacement the net effect would be neutral on DCF.

5. For a going Concern, various intangibles like market share, competition, etc have a significant bearing on the valuation of the     company. One cannot place a money value for these factors. They have no financial value of their own that can be merely in     money terms. Hence, there is no way of evaluating them in any other methodology. DCF is the only methodology, which     takes into account these factors by incorporating them in various cash flows. In calculating DCF different assumptions will be     made of market share, competition from imports etc, which are translated into financial terms. Sensitivity analysis can also     be made for different assumptions. The Financial Advisor and the Seller should exercise the judgment on the most likely     financial values for the market share etc. and also on the discount rate to be applied while arriving at the optimum DCF value.

6. In a strategic sale the bidders take into account not only DCF valuation, but also a premium for management control.     Premium for management control would be a subjective item for each bidder and will be reflected in the competitive bids.     Therefore, this premium need not be incorporated in the valuation amount separately.

7. In DCF method, while computing the cash flows, cash out flows for renovation and modernization of plant and machinery need     to be discounted for arriving at realistic figures. Since non-core assets are not reflected in the cash flows, the non-core assets     need to be separately valued by the Asset Valuation method and added to the valuation figure arrived at by the DCF method.

Balance Sheet method

The Balance sheet or the Net Asset Value (NAV) methodology values a business on the basis of the value of its underlying assets. This is relevant where the value of the business is fairly represented by its underlying assets. The NAV method is normally used to determine the minimum price a seller would be willing to accept and, thus serves to establish the floor for the value of the business. This method is pertinent where:

The value of intangibles is not significant;
The business has been recently set up.

This method takes into account the value of the assets of a business or the net-worth as represented in the financial statements. Hence, this method takes into account the amount that is historically spent and earned from the business. This method does not, however, consider the earnings potential of the assets and is, therefore, seldom used for valuing a going concern. The above method is not considered appropriate, particularly in the following cases:

When the financial statement sheets do not reflect the true value of assets, being either too high on account of possible      losses not reflected in the balance sheet or too low because of initial losses which may not continue in future;

Where intangibles such as brand, goodwill, marketing infrastructure, and product development capabilities, etc., form a major      part of the value of the company.

Transaction Multiple method

This method takes into account the value paid for similar transactions in the industry and benchmarks it against certain parameters, like earnings or sales. Two such parameters are:

Earnings Before Interest, Taxes, Depreciation & Amortisations (EBITDA)
Sales

Although the Transaction Multiples method captures most value elements of a business, it does not properly reflect the cash flows generated by a business, or take into account the time value of money. However, it is considered as a useful rule of thumb, in valuing businesses by various valuation experts. Accordingly, one may have to review a series of comparable transactions to determine a range of appropriate capitalisation factors to value a company as per this methodology.

a) EBITDA multiple

The EBITDA multiple or the earnings method is based on the premise that the value of a business is directly related to the quantum of its profits. The adjusted maintainable profits are capitalised by an appropriate factor ("capitalisation factor") to arrive at the business value. The profits are adjusted to reflect the operating recurring profits of the business on a standalone basis (i.e. after deducting extraordinary or unusual items, or items of a non-recurring nature). As a further refinement, the profits may be adjusted for non-cash items (including depreciation and amortisation) and other factors, such as interest and taxation (which vary from business to business) to derive EBITDA (Earnings Before Interest, Taxation, Depreciation and Amortisations).

The EBITDA multiple method takes into account the value or consideration paid by acquirers of similar businesses, and is computed by dividing the total consideration paid (after adjusting for any debt assumed) by the EBITDA to derive a multiple, which can be applied to the EBITDA figure of the business being valued.

EBITDA multiple = Enterprise Value / EBITDA z

Where:

Enterprise Value = Market value of Equity + Market value of Debt

EBITDA = Earnings Before Interest, Tax, Depreciation and Amortization

b) Sales multiple

The sales multiple technique is based on a similar analysis of relevant acquisitions and is the ratio of Enterprise Value to the current sales. It is calculated as follows:

Sales multiple = Enterprises Value / Net sales of the current year

The Transaction Multiple methodology suffers from the following drawbacks:

Actual monies required to earn the maintainable profits / sales of the business as a going concern (for instance, future capital      expenditure) are not reflected.

This methodology does not take into account the time value of money. Notwithstanding these limitations, these multiples are      widely used by investors to arrive at benchmark values for a company.

Asset Valuation Methodology

The asset valuation methodology essentially estimates the cost of replicating the tangible assets of the business. The replacement cost takes into account the market value of various assets or the expenditure required to create the infrastructure exactly similar to that of a company being valued. Since the replacement methodology assumes the value of business as if we were setting a new business, this methodology may not be relevant in a going concern. Instead it will be more realistic if asset valuation is done on the basis of the new book value of the assets. The asset valuation is a good indicator of the entry barrier that exists in a business. Alternatively, this methodology can also assume the amount which can be realized by liquidating the business by selling off all the tangible assets of a company and paying off the liabilities.

The asset valuation methodology is useful in case of liquidation/closure of the business.

In a strategic sale process, the proposal is normally to transfer management control of an on going concern to a strategic partner and restrictions are imposed on the SP. The land and property of the business cannot be sold or put to alternate use by the strategic partner. Moreover, its value is already reflected in the cash flows from the business, which are valued in other methodologies of valuation. Therefore, asset valuation method is not the correct reflection of the value of the enterprise. However, it has been used so far in the valuation of CPSUs under disinvestment because the Disinvestment Commission had recommended that this method should also be followed for valuation in the case of strategic sale. The asset valuation methodology also fails to factor in some important aspects for a running business such as the following and is normally not favoured for pricing equity: · Value of intangibles like brands, goodwill, marketing, distribution, development and research capabilities, etc.; · Profit or cash generating ability of a business; · Opportunity loss during the period before a business is fully operational.

The asset valuation methodology is particularly questionable in the following circumstances:

Where it is impossible to replicate a business intended to be transferred on account of a complete change in technology;

Where a business was set up several years before its competitors and has a real cost advantage reflected in a higher return      on invested capital;

Where a business set-up several years ago had witnessed a significant appreciation in the value of real estate, which is not      reflected in the earnings capacity of a business.

The Asset Valuation would be more realistic, if we compute the value of only the realizable amount, after discounting the non-realizable portions. The realizable market value of all real estate assets, either owned by the company as freehold properties or on a lease/rental basis may be determined, assuming a non-distress sale scenario. The value would be assessed after taking into account any defects/restrictions/encumbrances on the use/lease/sublease/sale etc. of the properties or in the title deeds etc.

Since Assest Valuation normally reflects the amount which may need to be spent to create a similar infrastructure as that of a business to be valued or the value which may be realized by liquidation of a company through the sale of all its tangible assets and repayment of all liabilities, adjustments for an assumed capital gains tax consequent to the (hypothetical) outright sale of these assets as also adjustments to reflect realization of working capital, settlement of all liabilities including VRS to all the employees will have to be made.