April 2015 – Page 4 – Gargfinanceblog

What is WACC? How do you calculate it?

April 14, 2015April 20, 2015Nitin GargLeave a comment

While valuing an organization using Discounted Cash Flow (DCF), forecasted Free Cash Flow (FCF) is discounted by the Weighted Average Cost of Capital (WACC). WACC represents the opportunity cost of capital for investors when they allocate their funds towards a business.

WACC can be calculated using the following formula:

WACC = D/V x Kd (1 – T) + E/V x Ke

Where,

D/V = Debt to Enterprise Value (EV) based on market value

E/V = Equity to EV based on market value

Kd = Cost of debt

Ke = Cost of equity

T = Company’s tax rate

None of the above components are readily available. Hence, we use various models, assumptions and approximations to arrive at each of the values. There are 3 important factors that need further attention.

Cost of equity is depended on (1) Risk-free rate (2) Market risk premium and (3) Beta. We employ CAPM to estimate the cost of equity.
After-tax cost of debt depends on (1) Risk-free rate (2) Default spread and (3) Marginal tax rate. For an investment grade company, we employ yield to maturity (YTM) on its long-term debt, and for a public company, we use YTM on bonds’ cash flows and price.
Capital Structure (proportion of debt and equity to the EV). The target capital structure is derived by the company’s current debt-to-value ratio. We always use the market values (and not the book values).

Couple of points noteworthy:

WACC based models works well when a company maintains a relatively stable debt-to-value ratio. But for a LBO, it can understate or overstate the impact of the tax shield. In such a situation, we should discount the FCF at unlevered cost of equity and value tax shields separately.
If a company’s debt-to-value ratio changes, we use Adjusted Present Value (APV).

Let’s take an example. Consider a startup wants to raise a capital of $1 million so that it can buy office space and equipments needed to run its business. The company issues 6,000 shares at $100 each to raise $600,000. The shareholders expect a return of 10% on their investment. So, the cost of equity is 10%.

The company then issues 400 bonds of $1,000 each to raise $400,000. The bondholders expect a return of 8%. So, the cost of debt is 8%.

Now, the startup’s total market value ($600,000 equity + $400,000 debt) = $1 million. Let’s assume its tax rate is 35%. So, the company’s WACC is 6%

(($600,000/$1,000,000) x 0.1) + [(($400,000/$1,000,000) x .08) x (1 – 0.35))] = 0.0598 ~6%

This means that for every $1 the start-up raises from its investors, it must return $0.06 to them.

You may also want to read about Enterprise Value here.

Valuation: Asset Approach, Income Approach and Market Approach

April 14, 2015April 20, 2015Nitin GargLeave a comment

There are three approaches to valuing a business. I’ll discuss them in detail.

1. Asset Approach

Asset approach looks at a business from a set of assets and liabilities of the company for business valuation. It’s based on the economic principle of substitution and tries to answer the question:

What would cost me to recreate a similar business that generates the same economic benefits for its owners?

Every operating business holds assets and liabilities. So, valuing these assets and liabilities and taking the difference between the two values would give us the value of the company. While it sounds simple, valuing a business can be a daunting task since most of the components do not find a place in the balance sheet. Internally developed products (unless patented) are such an example. But the market value of these assets can be far greater than the combined value of all the assets that resides in the financial statement.

Few points noteworthy

An asset-based valuation approach is usually adopted when a business has a very low or negative value as an ongoing business. Consider the case of an airline company that has few routes, high labor and operating costs, and is losing money every year. Using the other valuation methodologies, one can derive a negative valuation for the company. But to its competitors, the assets (routes, landing rights, leases, equipment and airplanes) can have a significant value. In this case, this approach will value the company’s assets separately and will set them aside from the money losing business. The asset-based valuation approach will typically yield the lowest valuation of the 3 approaches for a profitable company, but it may result in an appropriate value depending on the situation.
Asset approach may be used in conjunction with the other valuation methods. For example, let’s consider a retail business which has only one location. It owns the property and the building in which the business operates. If the company has EBIT of $200,000 and a buyer is willing to pay 3x EBIT for a similar retail business which leases its operating facilities, the buyer will value it by adjusting EBIT for the cost the buyer would have to incur, if it were to lease comparable facilities, and adjusting the company’s valuation for the value of the property and building assets. If the buyer has to pay $20,000 a year for leasing similar property, and can sell the property and building for $600,000, the buyer might value this company at 3x adjusted EBIT, plus the value of the property and building.

3x ($200,000 – $20,000) = $540,000 + $600,000 = $1,140,000

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Startup Valuation: Pre-money and Post-money

April 14, 2015January 27, 2018Nitin GargLeave a comment

Pre-money and post-money are measures of valuing a company. Pre-money valuation refers to the company’s value before the investor makes an investment in the company and post-money valuation refers to the value of the company after the fund is infused into the company. Let’s take an example to understand the concept.

Let’s assume that an Investor agrees to invest $300,000 in a start-up which is valued at $1 million. The following table explains how the ownership changes in both the situation for the same amount of investment. Let’s ignore the option pool for now to keep it simple.

Individual	Pre-Money Valuation		Post-Money Valuation
Individual	Value	Ownership	Value	Ownership
Entrepreneur	1,000,000	77%	700,000	70%
Investor	300,000	23%	300,000	30%
Total	1,300,000	100%	1,000,000	100%

As we can see above, the ownership percentage depends on the value placed on the company – pre-money or post-money. In pre-money valuation, the company is valued at $1 million before the investment. So, after the investor’s funding, the total value of the company increases, thereby decreasing the investor’s share of ownership. In post-money valuation, the company is valued at $1 million after the investment. So, the investor share increases by 7%. This percentage difference looks small, but can reflect millions when the company goes public.

Investors like Venture Capitalists and Angel Investors generally use the pre-money valuation to determine the “ask” – percentage ownership in the company against the funding – and is calculated on a fully diluted basis. Usually, a fund raising company receives a series of funds (Series A, Series B, Series C, etc.) so that investors minimize the risk of their investment. It’s also a way to motivate the Entrepreneur to achieve the agreed upon milestones. The pre-money and post-money concepts apply to each subsequent series of funding.

Determining pre-money and post-money valuation through formula

Post-money valuation = New funding x (post investment shares outstanding /
shares issued for new investment)

Pre-money valuation = Post-money valuation – new funding

For example, Company A owns 100% stake with 1,000 shares. Investor A infuses $1 million capital into the company against 200 shares (20% ownership), the post-money valuation will be:

$1,000,000 x (1,200/200) = $6 million

Pre-money valuation = $6 million – $1 million = $5 million

The same approach to calculation applies to subsequent series of funding as well.

You may also refer my article on Valuation: Asset Approach, Income Approach and Market Approach here.

What’s my blog “Terms Simplified” all about?

April 12, 2015April 13, 2015Nitin GargLeave a comment

According to The Economic Survey, Year 2014–15 witnessed hyper-growth in Technology start-ups and software product landscape with India ranking fourth among the world’s largest start-up hubs with over 3,100 start-ups. Software products and services revenue is estimated to grow @ 12-14 % in the fiscal year 2015–16.

Year 2014 also witnessed the largest ever Venture Capital infusion into the Indian start-up ecosystem. With an increase of 47.7% from the previous year, Venture Capitalists invested $2.1 billion with 1,108 deals. E-commerce, consumer web and payments dominated the funding in the country, whereas technology start-ups formed the spinal cord, playing a vital role in economic growth of India.

I have discovered that most of the young Business Leaders lack the understanding of the terminologies that are prevalent in the VC circle. My blog “Terms Simplified” makes a sincere effort to educate the young Entrepreneurs on the most frequent jargon prevalent the investor community. I’ll add a series of articles in this category over a period of time that focuses on Venture Capital and Terms Sheet. I’d love to hear your thoughts and views regarding my endeavor.

Stay tuned…

Where do I find company’s capital structure?

April 12, 2015April 15, 2015Nitin Garg1 Comment

A company’s financial health is indicated by the balance sheet, and can be evaluated by 3 broad categories:

Working Capital
Asset Performance, and
Capital Structure

Capital structure depicts a company’s debt and equity mix. A healthy proportion of equity and debt represents a healthy capital structure. Equity capital consists of Preferred Stock, Common Stock and Retained Earnings, which are summed up to form ‘Total Shareholder’s Equity’ in the Balance Sheet. Debt Capital generally comprises of short-term borrowings, long-term debt and current portion of the long-term debt. Equity capital is always costlier than the debt capital because the company shares its profit with the investors. The debt capital burdens the company with periodic interest payments, but the owners earn a tax rebate on the interest, with no profit sharing with the debt holders. But a highly leverage company can become a watchdog since the investors put restrictions to its activities. During economic downturn, if a competitive business is not able generate enough cash flows from its operations, it might have to file Chapter 11 Bankruptcy.

There is no magical debt levels defined. A company debt-to-equity ratio varies according to its stage of development, industry it operates in, and the lines of businesses it has. Analyst use various debt measuring ratios (debt-equity ratio, leverage ratio, EBITDA/interest, liquidity ratio, solvency ratio, to name a few) to analyze the financial health of the company. Various credit rating companies (like S&P, Moody’s, Fitch) evaluate a company’s ability to repay the principal along with the interest on debt obligations before awarding any rating. Capital Structure affects EPS (earnings per share) depending on whether it’s simple or complex. If the company has dilutive securities (complex capital structure), its diluted EPS is lower than the basic EPS; if it’s simple, then basic EPS equals diluted EPS.

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Key metrics that reflect Technology industry’s fundamentals

April 12, 2015April 20, 2015Nitin Garg28 Comments

Technology companies form an idea, commercialize it through various resources (including Sales & Marketing) and then engage in R&D for further enhancement and innovation. They follow various compliance standards and government regulations across countries. India harbors one of the largest technology hubs in the world and supplies its technology offerings to the developed nations like US and Europe and emerging markets including herself. So, its fundamentals will be reflected by (not necessarily in this order of precedence):

Supply and demand of experienced and talented human resources in India
Cost of resources in India
Supply and demand of technology across borders
Political stability across borders
Cost of production in India (including proprietary technology)
Cost of distribution from India (including mobile technology)
Cost of R&D in India
Cost of data processing in India
Access to capital in India
Valuation of highly cyclical technology companies like semi-conductor
Access to high-speed, uninterrupted internet connectivity across borders
Sales of hardware equipments and accessories in India
Resource utilization
Other metrics like utility cost, real estate sales, etc.

You may also want to read my article on Information Technology Industry here.

Management’s CapEx forecast: Where and how to find it?

April 12, 2015April 15, 2015Nitin GargLeave a comment

Research reports are a good place. Else, we need to attend the investor meetings, presentations and conferences hosted by the company. We can try in MD&A section to get a hint (for example, a statement that says “$150M wind farm being built by 2020”), but generally, management does not disclose such information in a usable format (like public 10-K/Q reports) unless it’s a major project for them. There are some Oil and Gas and many utility companies that discloses such information. Oil and Gas highlights it as it impacts their production growth directly; it’s a big driver for them. Analysts need to see if Oil and Gas companies are generating enough FFO over CapEx needed to sustain or grow their production.

If I were to guess, I’d look at asset replacement based on the life of the existing assets and replacements values. And then, the cost of the expanded capacity they may highlight elsewhere. If they are forecasting a 15% growth on higher units, there will be a likely event of CapEx, assuming no under-utilization of capacities.

Common-size statement analysis to identify trends: We can also try to derive the capital expenditure by looking at the company’s historical financial statements (balance sheet, income statement and cash flow statement). Usually, companies in an industry spend in a proportion to their sales or EBITDA. If the sales are growing, using the same ratios (as in the past) can help derive the figure. Similarly, if the revenue / EBITDA estimates are flat, reducing the CapEx in proportion to the sales will help arriving at the estimate.

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Month: April 2015