The Private Equity Asset Class

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.