Comparable Transaction Multiple (CTM) Method
I. Comparable Transaction Multiple Method, also known as ‘Guideline Transaction Method’ involves valuing an asset based on transaction multiples derived from prices paid in transactions of asset to be valued /market comparables (comparable transactions). The price paid in comparable transactions generally include control premium, except where transaction involves acquisition of noncontrolling/ minority stake. The following are the major steps in deriving a value using the CTM method:
(a) identify comparable transaction appropriate to the asset to be valued;
(b) select and calculate the transaction multiples from the identified comparable transaction;
(c) compare the asset to be valued with the market comparables and make necessary adjustments to the transaction multiple to account where differences, if any existed;
(d) apply the adjusted transaction multiple to the relevant parameter of the asset to be valued to arrive at the value of such asset; and
(e) if valuation of the asset is derived by using transaction multiples based on different metrics or parameters, the valuer shall consider the reasonableness of the range of values and exercise judgement in determining a final value.
II. The transaction multiples are generally computed based on the following two inputs:
(a) price paid in the comparable transaction; and
(b) financial metrics such as EBITDA, PAT, Sales, Book Value, etc of the market comparable.
III. Even multiples based on non-financial metrics such as EV per room for hotels, EV/Bed for hospitals) can be considered.
IV. A valuer shall preferably use multiple comparable transactions of recent past rather than relying on a single transaction.
V. The following are some of the differences between the asset to be valued and comparable transaction that the valuer may consider while making adjustments to the transaction multiple:
(a) size of the asset;
(b) geographic location;
(d) stage of life-cycle of the asset;’
(f) historical and expected growth;
(g) management profile such as private ownership vs. public sector undertaking; or
(h) conditions if any governing the comparable transaction such as deferred payment of consideration contingent on achievement of certain milestones).
Discounts and Control Premium
A valuer shall evaluate and make adjustments for differences between the asset to be valued and market comparables/comparable transactions. The most common adjustment under CCM method and CTM method pertain to ‘Discounts’ and ‘Control Premium’. ‘Discounts’ include Discount for Lack of Marketability (DLOM) and Discount for Lack of Control (DLOC).
DLOM is based on the premise that an asset which is readily marketable (such as frequently traded securities) commands a higher value than an asset which requires longer marketing period to be sold (such as securities of an unlisted entity) or an asset having restriction on its ability to sell (such as securities under lock-in-period or regulatory restrictions).
Control Premium generally represents the amount paid by acquirer for the benefits it would derive by controlling the acquiree’s assets and cash flows. Control Premium is an amount that a buyer is willing to pay over the current market price of a publicly-traded company to acquire a controlling interest in an asset. It is opposite of discount for lack of control to be applied in case of valuation of a noncontrolling/ minority interest.
INCOME APPROACH: -
I. Income approach is a valuation approach that converts maintainable or future amounts (e.g., cash flows or income and expenses) to a single current (i.e., discounted or capitalised) amount. The fair value measurement is determined on the basis of the value indicated by current market expectations about those future amounts. This approach involves discounting future amounts (cash flows/income/cost savings) to a single present value.
II. The following are some of the instances where a valuer may apply the income approach:
(a) where the asset does not have any market comparable or comparable transaction;
(b) where the asset has fewer relevant market comparables; or
(c) where the asset is an income producing asset for which the future cash flows are available and can reasonably be projected.
III. Some of the common valuation methods under income approach are as follows:
(a) Discounted Cash Flow (DCF) Method;
(b) Relief from Royalty (RFR) Method;
(c) Multi-Period Excess Earnings Method (MEEM);
(d) With and Without Method (WWM); and
(e) Option pricing models.
Discounted Cash Flow (‘DCF’) Method: -
I. The DCF method values the asset by discounting the cash flows expected to be generated by the asset for the explicit forecast period and also the perpetuity value (or terminal value) in case of assets with indefinite life. The DCF method is one of the most common methods for valuing various assets such as shares, businesses, real estate projects, debt instruments, etc. This method involves discounting of future cash flows expected to be generated by an asset over its life using an appropriate discount rate to arrive at the present value.
II. The following are the major steps in deriving a value using the DCF method:
(a) Consider the projections to determine the future cash flows expected to be generated by the asset;
(b) analyse the projections and its underlying assumptions to assess the reasonableness of the cash flows;
(c) choose the most appropriate type of cash flows for the asset, viz., pre-tax or post-tax cash flows, free cash flows to equity or free cash flows to firm;
(d) determine the discount rate and growth rate beyond explicit forecast period; and
(e) apply the discount rate to arrive at the present value of the explicit period cash flows and for arriving at the terminal value.
III. While using the DCF method, it may also be necessary to make adjustments to the valuation to reflect matters that are not captured in either the cash flow forecasts or the discount rate adopted. In case of the DCF method, projected cash flows reflect the benefits of control and accordingly the value of asset arrived under this method is not to be grossed up for control premium.
IV. The following are important inputs for the DCF method:
A. Cash flows;
B. Discount rate; and
C. Terminal value
A. Cash flows: -
I. In most cases, the projections shall comprise the statement of profit & loss, balance sheet, cash flow statement, along with the underlying key assumptions. However, in certain cases, if balance sheet and cash flow statement are not available, details of future capital expenditure and working capital requirements may also suffice.
II. The projections reflect the accrual based accounting income and expenses. For arriving at the cash flows, non-cash expenses, such as depreciation and amortisation, shall be added back. Further, cash outflows relating to capital expenditure and incremental working capital requirements, if any shall be deducted.
III. Generally, historical financial statements are used as the base for preparation of projections. If in future, changes in circumstances are anticipated the assumptions underlying the projections shall reflect differences on account of such differences vis-à-vis the historical financial statements.
IV. The length of the period of projections (explicit forecast period) shall be determined based on the following factors:
(a) Nature of the asset- where the business is of cyclical nature, explicit forecast period should ordinarily consider one entire cycle (for example cement business).
(b) Life of the asset- In case of asset with definite life, explicit period should be for the entire life of the asset (for example, debt instruments, Build Operate Transfer (BOT) road projects).
(c) Sufficient period- The forecast period should have a length of time that is sufficient for the asset to achieve stable levels of operating performance.
(d) Reliable data- The data that are used for projecting the cash flows, should be reliable.
V. The following are the cash flows which are used for the projections:
(a) Free Cash Flows to Firm (FCFF): FCFF refers to cash flows that are available to all the providers of capital, i.e. equity shareholders, preference shareholders and lenders. Therefore, cash flows required to service lenders and preference shareholders such as interest, dividend, repayment of principal amount and even additional fund raising are not considered in the calculation of FCFF.
(b) Free Cash Flows to Equity (FCFE): FCFE refers to cash flows available to equity shareholders and therefore, cash flows after interest, dividend to preference shareholders, principal repayment and additional funds raised from lenders / preference shareholders are considered.
B. Discount rate: -
I. Discount Rate is the return expected by a market participant from a particular investment and shall reflect not only the time value of money but also the risk inherent in the asset being valued as well as the risk inherent in achieving the future cash flows.
II. The following discount rates are most commonly used depending upon the type of the asset:
i. cost of equity;
ii. weighted average cost of capital;
iii. Internal Rate of Return (‘IRR’);
iv. cost of debt; or
III. Different methods are used for determining the discount rate. The most commonly used methods are as follows:
i. Capital Asset Pricing Model (CAPM) for determining the cost of equity.
ii. Weighted Average Cost of Capital (WACC) is the combination of cost of equity and cost of debt weighted for their relative funding in the asset.
iii. Build-up method (generally used only in absence of market inputs).
IV. A valuer may consider the following factors while determining the discount rate:
i. cash flows used for the projections as FCFE needs to be discounted by Cost of Equity whereas FCFF to be discounted using WACC;
ii. pre-tax cash flows need to be discounted by pre-tax discount rate and post-tax cash flows to be discounted by post-tax discount rate;
C. Terminal value: -
I. Terminal value represents the present value at the end of explicit forecast period of all subsequent cash flows to the end of the life of the asset or into perpetuity if the asset has an indefinite life.
II. In case of assets having indefinite or very long useful life, it is not practical to project the cash flows for such indefinite or long periods. Therefore, the valuer needs to determine the terminal value to capture the value of the asset at the end of explicit forecast period.
III. There are different methods for estimating the terminal value. The commonly used methods are:
(a) Gordon (Constant) Growth Model: The terminal value under this method is computed by dividing the perpetuity maintainable cash flows with the discount rate as reduced by the stable growth rate. The estimation of stable growth rate is of great significance because even a minor change in stable growth rate can have an impact on the terminal value and the value of the asset too.
(b) Variable Growth Model: The Constant Growth Model assumes that the asset grows (or declines) at a constant rate beyond the explicit forecast period whereas the Variable Growth Model assumes that the asset grows (or declines) at variable rate beyond the explicit forecast period.
(c) Exit Multiple: The estimation of terminal value under this method involves application of a market-evidence based capitalisation factor or a market multiple (for example, Enterprise Value (EV) / Earnings before Interest, Tax, Depreciation and Amortisation (EBITDA), EV / Sales) to the perpetuity earnings / income.
(d) Salvage / Liquidation value: In some
cases, such as mine or oil fields, the terminal value has limited or no
relationship with the cash flows projected for the explicit forecast period.
For such assets, the terminal value is calculated as the salvage or realisable
value less costs to be incurred for disposing of such asset.