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CAIIB Paper 3 ABFM Module C Unit 4 : Special Cases Of Valuation (New Syllabus)
IIBF has released the New Syllabus Exam Pattern for CAIIB Exam 2023. Following the format of the current exam, CAIIB 2023 will have now four papers. The CAIIB Paper 3 (ADVANCED CONCEPTS OF FINANCIAL MANAGEMENT) includes an important topic called “Special Cases Of Valuation”. Every candidate who are appearing for the CAIIB Certification Examination 2023 must understand each unit included in the syllabus.
In this article, we are going to cover all the necessary details of CAIIB Paper 3 (ABFM) Module C (Valuation, Mergers & Acquisitions) Unit 4 : Special Cases Of Valuation, Aspirants must go through this article to better understand the topic, Special Cases Of Valuation and practice using our Online Mock Test Series to strengthen their knowledge of Special Cases Of Valuation. Unit 4 : Special Cases Of Valuation
Intangibles –Brand, Human Valuation
- The traditional forms of intellectual property assets, such as patents, trademarks, and copyrights, are what are meant to be referred to as “intellectual capital.” Intangible assets might take the form of a company’s brand name, patents or technological competence.
- Conventional accounting standards either grossly underestimate their value or ignore intangibles entirely; as a result, the balance statements of these companies provide little indication in this regard.
- Intangible assets contribute significantly to the market valuations of organisations; there is evidence, that brand name alone may explain more than half of the value in many consumers’ product companies.
- The failure to value these intangible assets causes a distortion not just in accounting measures of profitability like return on equity and capital, but also in market measures of value like P/E ratios and EV/EBITDA multiples.
Independent & Cash-Flow-Generating Intangible Assets
Those intangible assets that are attached to a particular product or product line and create cash flows, are the ones that are the least complicated to evaluate. These assets typically have finite lifespan, over which the cash flows have to be estimated.
Trademarks, Copyrights, and Licenses:
- The owner of a trademark, copyright, or licence has the sole authority to manufacture or sell the associated goods or render the associated service. As a direct result of this, their value is determined by the cash flows that can be produced as a result of holding the exclusive right.
- A discounted cash flow valuation of the asset can be obtained by first estimating the expected cash flows that will result from owning the asset, then applying a discount rate to these cash flows that is reflective of the uncertainty associated with them, and finally taking the present value of this value.
- Alternately, we have the option of attempting a relative value, which is when we apply a multiple to the revenues or income that we believe can be earned by the copyright or the trademark. The multiple is often estimated by taking a look at the prices at which assets of a comparable nature have been sold in the past.
- The owner of a franchise is granted the right to promote and sell a company’s branded good or service under the franchise’s name.
- In either scenario, the individual who buys the franchise, known as the franchisee, is responsible for paying the franchisor (McDonald’s or Maruti Suzuki), either an initial charge or an ongoing annual cost in order to operate the franchise. In exchange, the individual receives the power of the brand name, as well as the support of the corporation and advertising backing.
Approaches For Valuation
There are three distinct approaches that we can take in order to arrive at an estimate of the worth of these intangible assets.
- Capital Investment: The amount of money that a company has put into an asset over the course of its existence can give us a good idea of how much that asset is worth on paper.
- Discounted Cash Flow Valuation: We have the ability to discount the anticipated increase in cash flows that will be brought to the company as a result of the intangible asset. This will require isolating the percentage of an organization’s aggregate cash flows that can be attributable to its brand name or its level of technological expertise and then discounting back these cash flows at a rate that is appropriate for the situation.
- Relative valuation: Comparing the market value of a company (with the intangible asset) to the market value of companies that are similar but do not have the intangible asset is one approach to isolating the effect of an intangible asset such as a brand name.
Real Estate Firms
- The approaches of intrinsic and relative valuation, that we used to analyse equities, ought to be applicable to the analysis of real estate as well.
- Both real estate and financial assets share a number of aspects in common, including the fact that their values should be decided by the cash flows that they create, the degree of uncertainty associated with those cash flows, and the predicted growth in those cash flows. The asset’s value rises in proportion to the risk level.
- Many people believe that the risk and return models, that are utilised in the analysis of financial assets, cannot be utilised in the analysis of real estate due to the differences in the levels of liquidity that exist between the two markets as well as the types of investors that participate in each market.
Discounted Cash Flow Valuation
- The value of any asset that produces cash flows is equal to the asset’s predicted cash flows multiplied by their present value. It is possible to use discounted cash flow valuation models, such as the dividend discount model, to determine the value of cash-flow producing real estate investments in the same way that these models can be used to determine the value of financial assets.
In order to properly evaluate real estate investments by using discounted cash flow valuation, the following steps need to be taken:
- Determination of the level of risk associated with real estate investments and basing your estimate of the appropriate discount rate on this level of risk.
- Determination of an estimate of the anticipated cash flows which are expected from the real estate investment over the course of the asset’s life.
- There are many analysts who contend that it is impossible to assign a value to these companies because they do not have a history and, in certain cases, do not have any goods or services that they can sell.
- The current value of the predicted cash flows from a young company’s operations is what determines its worth.
- There are some companies, particularly those operating in emerging parts of the economy, in which you can experience informational difficulties. To begin, most of these businesses have not been around for more than a year or two, which results in a history that is quite limited in scope.
- Second, the existing disclosures of their financial position provide relatively little information regarding the aspect of their assets—expected growth and Third, these companies are frequently the pioneers in the industry in which they operate. In many instances, there is neither a competition nor a peer group against whom they can be evaluated in order to determine their standing.
The Analysis Framework in General
Step 1: Assessment of the Enterprise’s Current Standing-
- When valuing companies, it is normal practice to collect the inputs for the current year by using data from the most recent fiscal year as a point of reference. it is prudent to consider the most recent information that one is able to acquire, at the very least with regard to revenues and profits.
Step 2: Revenue Growth Estimation-
- Young companies often bring in a relatively modest quantity of revenue, but it is reasonable to anticipate that this amount will increase at a significant rate in the foreseeable future.
- Rate of expansion in the general market that this company operates in needs to be examined in detail. Barriers to entry and competitive advantages held by the company must be examined in detail. To be able to maintain high growth rates over time, a company needs to have some sort of competitive edge that can be maintained over time.
Step 3: Stable-growth Associated Operating Margin Estimation-
- A young firm’s value depends on the anticipation that its negative operating margin will turn positive. The key test in valuation is estimating a young, high-growth company’s operating margin when its growth stabilises.
Step 4: Estimate Reinvestment to Generate Growth-
- When examining a new company, one cannot ignore the importance of reinvestment because it is necessary for the company’s growth and cannot be ignored under any circumstances.
- It is necessary to first estimate the growth in revenues, and then the reinvestment must be based on the growth in revenues. In order to establish this connection, we utilise a sales-to-capital ratio, which is a ratio that indicates the number of additional rupees of revenue that will be earned for each additional rupee of capital.
- Expected Reinvestment = Expected Change in Revenue/ (Sales/Capital) For example, if you have a sales-to-capital ratio of 5, then you will need to make an additional investment of Rs. 2 lakhs in order to expand your revenues by Rs. 10 lakhs.
Step 5: Risk and Discount Rate Estimates:
- We estimate beta using the conventional methods, which involve performing a regression of stock returns versus market returns. There are alternative methods for estimating betas. The first method is called the bottom-up approach. If there are comparable companies that have been listed for at least two years, then it is possible to determine the current risk parameters for the company by looking at the averages of these comparable companies.
- Even if there are no companies that fit this description, risk factors can be determined by looking at the firm’s financial characteristics, such as their size, the nature of their cash flow, and the degree to which they are leveraged financially.
- When attempting to estimate the cost of debt for a new company that is in debt, we run into a different dilemma. Because the company won’t typically be rated, we won’t have the opportunity to calculate an estimate of the cost of debt based on the rating. One method would be to calculate a synthetic rating using the predicted interest coverage ratio.
Step 6: Firm Valuation-
- When we use the discounted cash flow method to value companies, we almost always make the assumption that the company will continue to exist as a going concern and produce cash flows into the foreseeable future. When valuing young companies, it is possible that this assumption is flawed due to the fact that many of these organisations will not be able to withstand the challenges that they will face over the next few years.
- Value of Firm = Probability of surviving as a going concern * Discounted Cash Flow of Firm + (1- Probability of surviving as a going concern) * Distress or Liquidation sale value.
Step 7: Estimating Equity Value and Per-Share Value-
- In order to go from the value of the firm to the value of the equity, we typically deduct all claims on the firm that are not equity claims. When companies reach a certain level of maturity, the non-equity claims take the form of outstanding bank debt and bonds.
Firms With Negative Or Low Earnings
Valuing Loss Making Firms: The reasons why a company has negative earnings in the first place will dictate how we approach the problem of negative earnings in the company.
- Companies Facing Momentary Challenges: When earnings are low due to issues that will only last for a limited time or are just transitory, it is reasonable to anticipate that earnings will improve in the not-too-distant future. Therefore, the solutions will be replacing the present earnings, which are in the red, with the normalized profits.
- Concerns Unique to the Company: It is possible for a company to have a bad year in terms of earnings, but the problems may be unique to the company and be of a sort that’s just temporary. we should deduct not just the expense but also any and all tax benefits that were achieved as a result of the expense.
- Industry-Wide or Market-Driven Issues: Earnings at cyclical companies are characterized by their inherent instability and sensitivity to changes in the status of the economy. we can acquire deceptive estimations of value if we use the current year’s results as our base year earnings.
- Companies with Long-Term Issues: Negative earnings are symptom of larger systemic issues that have been present at the company for a longer period of time. In these kinds of circumstances, we will be compelled to make judgements as to whether or not the problem will be solved, and if it will, as to when this will take place.
- Strategic Issues: we will need to determine the company’s value based on the presumption that it will never regain the ground it has lost and adjust our forecasts for revenue growth and expected margins accordingly. On the other hand, if we have a more positive outlook regarding the company’s ability to recover or its expansion into new areas, we can safely expect that the company will be able to return to the high growth and margins that it was accustomed to experiencing
- Operating Issues: There are several instances in which the causes can be linked back to a failure to stay up with the times, replace assets, and keep up with the most recent technologies.
- The Company’s Size: In most cases, the amount of time required to eradicate inefficiencies is proportional to the size of the company.
- Aspects of the Inefficiency: There are some inefficiencies that can be corrected significantly faster than others. For instance, a company can swiftly replace ageing machinery or an inefficient inventory management system, but retraining an existing workforce will take far more time.
- External Limitations: Contractual constraints, Government restrictions and social pressure frequently place limitations on the scope and velocity of change that companies can implement in order to address inefficiencies in their operations.
- The Quality of Management: A management team that is willing to embrace changes is one of the most important ingredients for a successful turnaround. It is possible that an organisation will need to make changes to its senior management in order to be successful in resolving the operational issues it is facing.
Financial Service Companies
The special features of financial services companies include:
- Use of debt for earning income
- Heavily Regulated Sector
- Difficulty in measuring reinvestment
- Capital Adequacy Norms
- Difficulty in choice of multiples
- Issues faced for income estimation due to Provisioning for Losses
- Government directives about the choice of financial mix
Discounted Cash Flow Valuation:
- The present value of the anticipated cash flows that will be generated by an asset is what is taken into consideration when developing a discounted cash flow model to determine the asset’s worth.
- We will begin by analysing dividend discount models, cash flow to equity models, and excess return models. These models are used to determine the worth of banks and other financial sector companies.
Dividend Discount Models
- We evaluate equity as the present value of the anticipated dividends by using the rationale that dividends are the only source of cash flows that a stakeholder in a publicly traded company is entitled to receive.
- According to the fundamental dividend discount model, the value of a stock is equal to the present value of the dividends that are anticipated to be received from that specific stock. If we make the assumption that a publicly listed company’s equity has an endless life, then we get the following results:
Inputs to Model:
We require estimates of the cost of equity, the expected payment ratios, and the estimated growth rate in profits per share over time in order to evaluate a stock via the dividend discount model.
- Cost of Equity: the cost of equity for a financial services company needs to reflect the share of the risk in the equity that the marginal investor in the stock is unable to diversify away. In the capital asset pricing model, a beta or betas are used to evaluate this risk.
- Payout Ratios: The payout ratio of a bank, is calculated by dividing the dividend by the firm’s earnings. Financial service corporations have traditionally distributed a greater amount of dividends than the vast majority of other companies operating in the market.
- Expected growth: If the amount of dividends is determined by earnings, then the predicted growth rate in earnings is the one that will be used to calculate the value of the stock. financial service companies’ earnings growth can be estimated in one of the following three ways:
- Historical Earnings Growth Rate: This would imply that the growth in earnings over the course of the company’s history is a significantly better predictor of the company’s future earnings.
- Analyst estimates in growth in earnings: Growth rate of Earnings projected by analysts are provided for a large number of publicly traded companies. You are able to obtain these projections of future growth since there are a lot of significant banks and insurance businesses that are well monitored.
- Fundamental growth: The anticipated increase in earnings per share is a function that may be described in terms of the retention ratio and the return on equity (ROE).
Expected growth EPS = Retention ratio × ROE
Asset Based Valuation:
- We determine the value of a financial services company’s existing assets, deduct the amount of debt and any other claims that are still due, and then report the difference as the equity’s value.
- In the case of a bank, for instance, this would entail estimating the value of the bank’s equity by first assessing the loan portfolio of the bank (which would represent the firm’s assets) and then deducting the value of any outstanding debt.
- Estimating the worth of the equity in a company requires first valuing the policies that are now in effect at the company (in the case of an insurance provider), then deducting the predicted claims that would come from these policies as well as any other debt that is currently outstanding.
Here, we examine companies with negative earnings, substantial assets, and substantial debt. Equity investors in this company have the choice to dissolve the company and pay off the debt. This call option on the underlying firm can increase the value of the shares, particularly when there is substantial uncertainty over the value of the assets.
Equity In Highly Levered Distressed Firms:
- The majority of publicly traded companies have two aspects of equity. The first advantage is that the equity investors run the company and have the power to decide at any time whether or not to liquidate its assets and pay off any other claim holders.
- The second benefit is that the liability of equity investors is limited to the amount of equity that they have invested in those companies. It is possible for the option value of equity to be higher than the discounted cash flow value in companies that have big obligations and negative earnings.
Payoff on Equity as an Option:
- The holders of equity have a right to any cash flows that remain after all other financial claimholders have been paid off (including debt holders, preferred stock holders, and so on).
- The same rule applies in the event that a company is put into liquidation. Equity owners are entitled to the cash that remains in the company after all of the company’s outstanding debt and other financial demands have been satisfied.
Valuation Of Cash and Cross Holdings
- There is a line item for cash and marketable securities on the balance sheet of every company. This line item refers to the company’s holdings of cash and assets that are nearly equivalent to cash. Investments in short-term government securities or commercial paper are examples of near-cash investments. Both of these types of investments can be easily turned into cash at a very cheap cost and in a very short amount of time.
- As time goes on, fewer and fewer transactions will be conducted using currency as a medium of exchange. As a direct result of this, we anticipate that the need for cash will reduce as technological advancements in the banking industry make it possible for customers to make payments using credit cards or through various digital modes.
Differences between Cash Valuation Approaches
Warrants And Convertibles
- Convertible bonds and stock allows the holder to convert the bonds or stock into shares of common equity at a predetermined price per share.
- Because the value of such debt is equivalent to the value of the common stock, it is dependent of the enterprise value of the company; as a result, it cannot be subtracted from the enterprise value of the company in order to determine the equity value of the company.
- The assumption that all of a target company’s debt and preferred stock will be converted into equity upon acquisition is one strategy for determining the value of such debt and stock
Cyclical & Non-cyclical Companies
Valuing Cyclical Firms:
- The amount of earnings generated in the base year can have a major impact on the valuation of cyclical companies. There are two potential remedies to this problem: the first is to alter the predicted growth rate in the near term to reflect cyclical swings, and the second is to value the company based on normalized rather than current earnings.
- The real growth rate in earnings in turning-point years, which are years when the economy enters or exits an economic downturn, can be predicted by looking at the experience of this company (or similar firms) in earlier recessions.
- Utilizing the earnings average from the periods before the current one is the easiest method for normalizing earnings.
- Holding companies can be appraised using a variety of different approaches, including those based on free cash flow and dividend discount models. Holding companies need to be valued for their ability to provide superior investment opportunities and to make sound strategic decisions.
- As new technology is always being developed in different parts of the world, it can be challenging to assign a value to these businesses. Still today, valuers will determine a price for these businesses by taking a number of different criteria into consideration.
- These aspects include Changes in Future Technology, Habits of Individuals (buyers), the Advantages and Disadvantages of Conducting Business via E-Commerce, and Competitors.
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