Appendix 3: Case Study in Emerging Markets
Here is
the sequence that we will follow for this exercise:
a- Model
the cashflows for the planning period and for the terminal period.
b- Adjust
cashflows for overcompensation, over expensing, and currency
corrections.
c- Define
the discount rate via a CAPM or a non CAPM based method and compute the present
value of the company.
d- Apply
the corresponding unsystematic risk adjustments, dependant on the method used
for computing the cost of capital.
e- Report
a final company value.
The
purpose of this case study is to give a comprehensive and detailed valuation f
a closely held company operating in a transitional market. The idea is to show
the types of challenges that may arise in a real-life valuation
exercise.
The
Company:
Quimicos
del Sur (QDS) is an Argentine closely held company that manufacture industrial
inorganic chemicals.
Valuation
Purpose:
TMA
Chemicals, a private US chemical manufacturer, offers to buy a majority
shareholding in QDS. The purpose of the valuation exercise is to determine the
market cash value of a majority shareholding comprising 70% of the common stock
of QDS. This value will be used as a starting point in the negotiation leading
to the sale of the majority of QDS stock to TMA through a private
transaction.
QDS Net
Sales were $21.5 million for the last year.
Data
Normalization:
The first
step in the valuation exercise is to gather relevant financial information for
the company, data that reveal the fundamentals of the business (Growth,
Profitability, Indebtedness, and Liquidity) that ultimately impact the value of
the company's equity.
Financial
data should also be normalized to allow consistent comparisons with other
companies. A close look a QDS financial statements show that the owner-manager
salaries are 30% more than the average amount paid to professional managers in
similar positions in similar medium-sized chemical firms in the country. Other
distortions are also corrected adding back estimated over expenses and
overcompensations to the P&L statement.
Search
for Comparable Companies:
QDS is a
non quoting company, therefore we could use as references the values investors
pay for the stock of quoting companies that re similar to QDS, then we could
value-adjust those figures for unsystematic risk to capture the closely held
condition f QDS.
It should
be apparent that the first candidate to be compared with the company is TMA,
the potential acquirer. However, TMA is also closely held company whose market
value is not publicly available.
Here, the
experience dictates that in any valuation for which an ideal quoting comparable
does not exist, a portfolio of comparables should be assembled, which will
reasonably reflect, on average, the profile of the target company. In the
search for comparables for QDS, the following criteria will be used:
- Operates
in similar industries
- Has a
similar product portfolio
- Has a
similar customer portfolio
- Has a
similar scale (sales or assets)
- Has a
similar financial and performance structure
- Was
profitable in the last year
- Operates
in Argentina or USA
- Is
operating normally (not under financial distress or threat of liquidation)
The core
business of QDS is the production of inorganic commodity chemicals in addition
to some specialty organic-based chemicals. Using the Standard Industry
Classification (SIC) codes, we'll search for Argentine and US comparables in
Bloomberg's and Hoover's financial databases looking for at least 10 profitable
companies with sales of less than $2.5 billion in last year. Note that in the
US case, chemical giants such as Dow Chemical are deliberately excluded because
it is far away from the scale of QDS, and while we will be adjusting for size
at the end of the valuation exercise, it is recommended to use the smallest
(for U.S. standards) comparables that can be found.
The only
publicly held Argentine comparable found is Atanor which net sales were $154
million for the last year.
The other
suitable comparables found for QDS in the US are:
-
Albemarle Corporation (ALB): Net sales $845.9 million
- Church
& Dwight Co. (CHD): Net sales $730 million
- Georgia
Gulf Co. (GCC): Net sales $857.8 million
- Great
Lakes Chemical Co. (GLK): Net sales $1.45 billion
- Hawkins
Chemical, Inc. (HWKN): Net sales $95.5 million
- KMG
Chemicals. Inc. (KMGB): Net sales $36.4 million
- Mineral
Technologies, Inc. (MTX): Net sales $637.5 million
- NL
Industries, Inc. (NL): Net sales $1.05 billion million
- OM Group
(OMG): Net sales $507 million
- Tor
Minerals International (TORM): Net sales $11.6 million
Comparability
Check:
The most
important highlights are:
- At $29.1
million in assets and $21.5 million in sales, QDS is clearly much smaller than
both the US median ($838.8 million; $683.8 million) and the Argentine benchmark
($228.1 million; $154 million). This problem will be solved later by carefully
applying corrections for size later in the process. Note also that within the
US based firms, KMG Chemicals and TOR Minerals have a scale similar to that of
QDS.
- QDS's
Return on Assets and Return on Equity are lower than the US industry median,
but higher than the Argentine comparable.
- QDS is
less leveraged than the US and Argentine industry medians (D/E=0.67 versus 1.01
and 1.20), while having a larger liquidity (2.93 versus 2.38 and 1.08).
Valuation
Plan:
QDS status
is characterized by the following features:
- No real
option is generated by a reserve of exploitation rights.
- It's
ongoing.
- It's
established.
- It is
being appraised to be sold to a strategic investor.
- It uses
a mature or established technology.
- It
operates in an emerging market.
- It is
non quoting.
- It is
planning to sell a majority shareholding position.
- It is
small, both in terms of sales and assets.
A quick
look to the chart (.....) shows which valuation techniques better fit QDS. The
company will be valued using two main methods:
- DCF, to
compute an «intrinsic» value. Based on management forecasts, a DCF
and will be modeled and discounted to the present by using an appropriate
discount rate.
-
Comparable company and transactions multiples, to compute an
«extrinsic» value for the company. Multiples will be based on the
stock price of quoting comparable companies, and the transaction prices of the
sale of controlling positions of comparable companies in both Argentina and the
USA. (This pat of the valuation will not be included in this case study since
the topic of this Section is about DCF valuation)
Unsystematic
risk adjustments should be applied properly to the values computed via both
methods.
Discounted
Cash Flows Valuation:
QDS free
cash flow will be discounted at an adequate WACC. Since, we will be working at
the «company» level and not the «shareholders» level, the
present value of the free cash flows so computed will be equivalent to the
«Market Value of Invested Capital» (MVIC) of QDS. Only one cash flow
scenario will be computed.
For
computing the WACC, the beat factor (unavailable for QDS since it is a non
quoting company) will be estimated from the betas of comparable companies. An
«unlevered» beta (the beta of a company after subtracting out the
impact of its debt obligations, It is calculated by dividing the levered beta
by [1 + (1 - tax rate) x (D / E)]) will be computed for the portfolio of
Argentine-US comparables and «relever» it via the future target of
D/E ratio expected by the QDS management.
In
addition, the WACC will be computed using four CAPM based versions: Global,
Local, Adjusted Local and Adjusted Hybrid; this will render four different MVIC
of the company.
Four
values of companies will be then determined by subtracting company debt from
MVIC; they will correspond conceptually to the stock value of a minority
position in a large quoting comparable company, since references used to
compute the WACC came from this type of benchmark.
Then, the
equity values will be adjusted to account for unsystematic risk (the small
firm, majority non quoting nature of the target company).
Finally, a
synthetic equity value will be obtained for QDS.
Modeling
the Free Cashflows:
The FCF
have been modeled under the following assumptions:
- The
growth in sales fluctuates between 4.5% and 5.5%, reflecting management
expectations on future economic conditions.
- Gross
profit as a percentage of sales climbs from 21.3% to 23% in next year, due to
productivity improvements realized after the investments made up the previous
years. This ratio is about 16.2% for the US industry and 12.1% for
Atanor.
-
Interests paid by the company will be about 4% of sales.
-
Depreciation is expected to at 8% of sales. This ratio is between 4% and 9% for
the US industry.
Calculation
of Beta:
The first
benchmark comprises sector betas for the chemical industry in the US, they
render a median value of 0.66. However, it is preferred to do an exercise of
maximum approximation by using a small group of maximally similar companies,
those defined as true comparables in a precedent paragraph. The median beta for
this group is 0.35. As for the local comparables, Atanor, it has an unlevered
beta of 0.40 against the local stock market, and of 0.30 against the US
market.
QDS
management estimates a future D/E ratio of about 0.55 for the company.
Relevering beta with D/E, four different beta values are obtained, one for each
CAPM model.
Cost-of-Equity
Capital:
The
results of cost of equity calculations under each CAPM model fluctuate between
8.2% and 17.8% dependant on the variant considered.
Computation
of WACC:
The
computation of the WACC as a function of its proportion of debt, the cost of
debt, and the corresponding corporate tax rate fluctuates between 7.3% and
13%.
Computation
of MVIC:
First, the
PV of the company is calculated for the planning period of 5 years using the
WACC figures obtained. But because the company is still valuable beyond the 5
years, a terminal value is computed assuming the free cash flow of the last
year planned will sustain perpetually beyond that year. No growth of the cash
flow is assumed, since QDS competitive environment is expected to prevent the
company from extracting extraordinary returns in the terminal period. Based on
this assumption, the MVIC of QDS oscillates between $14.9 million and $27.3
million.
Calculation
of Stock Value and Unsystematic Risk Adjustment:
To compute
QDS stock value, debt will be subtracted from the alternative MVIC values. The
stock value then fluctuates between $3.3 million and $15.7 million. But this
range of values reflects how much a minority stock position is worth in a large
quoting company that is systematically similar to QDS, and our goal is to value
a majority position a a small, non quoting company; therefore, we should adjust
for unsystematic risk: for size, control and illiquidity. These three elements
must be accounted for, because we have used CAPM-based models for determining
the cost of capital.
An
assumption suggests that a combined unsystematic risk discount for Argentina is
of 56%, which implies multiplying stock value by the coefficient 0.44.
Under this
assumption, adjusted stock value for QDS oscillates between $1.4 million and
$6.9 million.
Synthetic
Company Value:
A simple
average will be used to compute a synthetic value for QDS. Note that this
method assigns equal importance to the four CAPM based methods used; an analyst
who has no faith in market integration could, instead, assign a greater weight
to the local CAPM or the adjusted local CAPM models.
Using a
simple average, QDS stock is worth: $3.4 million
Since
stock is composed of 1,362,000 ordinary shares, share value will be: $2.5 per
share.
Finally,
since QDS's management plans to sell 70% of its stock to TMA Chemicals, such
portion will be worth: $2.38 million.
See
exhibits here after annexed for the detailed data, calculations and steps of
this case study.
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