Setting up corporate valuation advisory service at mekong securities joint stock company

NATIONAL ECONOMIC UNIVERSITY BUSINESS SCHOOL NGUYEN QUANG HUY SETTING UP CORPORATE VALUATION ADVISORY SERVICE AT MEKONG SECURITIES JOINT STOCK COMPANY BACHELOR OF BUSINESS ADMINISTRATION IN ENGLISH (E[.]

NATIONAL ECONOMIC UNIVERSITY

BUSINESS SCHOOL

NGUYEN QUANG HUY

SETTING UP CORPORATE VALUATION

ADVISORY SERVICE AT MEKONG SECURITIES

JOINT STOCK COMPANY

BACHELOR OF BUSINESS ADMINISTRATION IN ENGLISH (E-BBA)

THESIS

HANOI, 2014

NATIONAL ECONOMIC UNIVERSITY

BUSINESS SCHOOL

SETTING UP CORPORATE VALUATION

ADVISORY SERVICE AT MEKONG SECURITIES

JOINT STOCK COMPANY

BACHELOR OF BUSINESS ADMINISTRATION IN ENGLISH (E-BBA)

me basic knowledge to conduct this thesis.

I want to sincerely thank to Mekong Securities Joint Stock Company for givingpermission to commence this thesis in the first instance, providing me with theeffective data, helped to supply relevant material and support me much for thecompetition of this thesis

Without the support of all those people I could not complete my thesis and gain agreat knowledge for my field of research Thus, I want to thank all of them again

ACKNOWLEDGEMENT 1

ABBREVIATION 5

LIST OF TABLES 6

LIST OF FIGURES 7

EXECUTIVE SUMMARY 8

INTRODUCTION 11

I Rationale 11

II Objectives 12

III Research questions: 12

IV Research methodology 12

V Data collection 13

VI Structure of thesis 13

CHAPTER 1 THEORETICAL BACKGROUND ON CORPORATE EVALUATION OF SECURITIES COMPANY 14

1.1 Theoretical background on securities company 14

1.1.1 Definitions of Securities Company 14

1.1.2 Classification of Securities Company 14

1.1.3 The roles of Securities Company 15

1.2 Theoretical background on corporate valuation 15

1.2.1 Corporate value 15

1.2.2 Principles of corporate valuation 16

1.2.3 Definition and theoretical background 17

1.2.4 Misconceptions about valuation 18

1.2.5 Reasons for valuation application and using situation 20

1.2.6 Valuation approaches 21

1.2.7 Discounted cash-flow valuation 24

1.2.8 Economic value added valuation 33

1.2.9 Asset-based method 39

CHAPTER 2 SETTING UP CORPORATION VALUATION ADVISORY SERVICE AT MSC 41

2.1 Introduction of Mekong Securities Joint Stock Company 41

2.1.1 Overview of Mekong Securities Joint Stock Company 41

2.1.2 Professional services at MSC 41

2.1.3 MSC’s organization structure 43

2.2 Setting up corporate valuation advisory service in MSC 46

2.2.1 General description of corporation valuation advisory service 46

2.2.2 Market research 47

2.2.3 Price strategy 52

2.2.4 Selling plan 53

2.2.5 Human resources 55

2.2.6 Financial plan 58

2.2.6.1 Estimated cost 58

2.2.6.2 Forecast income statement 60

2.2.7 Legal requirements for providing corporation valuation advisory service 61

2.2.8 Corporation valuation process 64

2.2.9 Carry out the entire valuation process 64

CHAPTER 3 RECOMMENDATIONS WHEN LAUNCHING SERVICE 76

3.1 General comment 76

3.1.1 Strengths of MSC 76

3.1.2 Weaknesses of MSC 76

3.1.3 Opportunities for MSC 77

3.1.4 Threats for MSC 77

3.2 Recommendations when launching service 78

3.2.1 Valuation method 78

3.2.2 Legal issues 78

REFERENCES 81

APPENDIXES 85

CAPM Capital assets pricing model

M&A Mergers and Acquisitions

MSC Mekong Securities Joint Stock Company

TDGVN Vietnam valuation standard

ROIC Return on invested capital

VVA Vietnam Valuation Associations

WACC Weighted average cost of capital

LIST OF TABLES

Table 1.1: EVA analysis 38

Table 2.1: Target customers 49

Table 2.2: Sales forecast from 2014 - 2017 55

Table 2.3: Suggested salary 58

Table 2.4: Estimated annual cost 59

Table 2.5: Forecast income statement 60

Table 2.6: Legal requirements for providing advisory service 61

Table 2.7: Steps for determining intangible assets 70

Table 2.8: Classification of intangible assets 71

LIST OF FIGURES

Figure 1: Research Process 13

Figure 1.1: Corporation valuation approaches 22

Figure 1.2: The relations of WACC 29

Figure 1.3: Inputs of DCF method 31

Figure 1.4: Basic concept of EVA 34

Figure 2.1: MSC’s organization structure 44

Figure 2.2: Expected market shares of MSC 48

Figure 2.3: Forecasted demand for the period 2014-2015 50

Figure 2.4: Structure of competitors 51

Figure 2.5: Price strategy of MSC 53

Figure 2.6: Reporting structure 56

Figure 2.7: Suggested valuation process 64

Figure 2.8: Process of choosing valuation methods 67

EXECUTIVE SUMMARY

In the past 5 years, M&A and equitzation activities in Vietnam have beengrowing rapidly in both quantity and value Vietnam is known as an attractiveinvestment destination with the rapid GDP growth rate, young population, well-trained In addition to that the increase of population is going with the demandfor improving the quality of life Vietnamese citizens enjoy the increase of level

of disposable income, favorable investment environment with low cost and speed

of urbanization is increasing rapidly

Regard to the development of those activities, determining the corporate value isthe very first step to support them According to the Announcement No.48 ofMOF dated January 24th 2013, there are 83 firms which have permissions forproviding corporation valuation advisory service in Vietnam In those firms,there are 53 firms in Hanoi can be considered as the potential competitors ofMSC

From that to explore the demand of that market and the comparative advantage ofMSC, MSC should provide corporation valuation advisory service which has notprovided yet Therefore, this thesis comes up with the idea of setting up thisadvisory service at MSC in order to fulfill the demand of market The advisoryservice which is built up within this thesis in accordance with the most updatedlaws and guidance documents of government and the theories which arementioned in some references books and documents Therefore, it is acombination of theories and the reality

This thesis uses only secondary data which are extracted from laws and guidance

of government in Vietnam and the good practices of some competitors Fromthose analyses, this thesis helps MSC to build up a standard process ofdetermining corporate value It allows MSC to compete later on the market withothers

This thesis is presented in three parts which are theoretical framework onsecurities company and corporation valuation; setting up the valuation advisoryservice and recommendations when launching this service

In the first chapter, basic related concepts are showed They are the basic for thenext chapter After studying the theoretical background, based on that the thesiscan develop the idea and the objective which is defined in the introduction part ofthis thesis

In the second chapter, the suggested process includes four steps: preparation,choosing valuation method, evaluating and report

- In preparation step, MSC valuators and managers will carry out some necessarytasks in order to determine the duties and the rights of each party From thosetasks, the result of this step is a contract which is signed between MSC andclients

- In the step of choosing valuation method, MSC must work out the needed tasksand plan to achieve the objectives which are set out by MSC and clients in theprevious step In addition to that, MSC valuators also need to choose the mostappropriate method to apply Moreover, auditing every single related documents

is compulsory and MSC valuators must be sure about the accuracy of eachdocument

- Then, MSC valuators conduct the evaluating step In this step, MSC valuatorscollect data and apply the method which is chose before to determine thecorporate value

- In next step, MSC valuators will check the validity and the accuracy of theresult The valuation report, valuation dossier and valuation certificate are threeimportant documents which are released and issued by MSC valuators

The final chapter is some recommendations which help MSC to provide thisservice properly with the highest quality It also shows the direction ofdevelopment of MSC in the future to expand the business However, in this

chapter, the advantages, challenges, opportunities and strengths of MSC whenlaunching this service are also discussed in detailed From that they can beconsidered as necessary notice for MSC and its valuators when providing theservice Those notices can make MSC different from others Moreover, theincome of MSC from launching this service is forecasted in this chapter Thishelps MSC can make decision whether launching this advisory service or not.

I Rationale

After nearly 20 years of changing from close economy to market orientedeconomy under the control of government, Vietnam has achieved some successes

in some field of economy The rapid development of Vietnam’s economy creates

a challenge for all enterprises, even state-own or private enterprises, which isdetermine the value of their corporate It creates a milestone and requirementswhen they want to finance their businesses

In recent decade, equitization advisory service and M&A advisory service aretwo core services which generate huge profits for all securities companies.Therefore, customers seeking purpose which enhance to change and supply newservices become more and more competitive Nowadays, all securities companiescompete with each other not base on only the network or fee of each service butalso the diversifications of advisory services which can be supplied by thecompanies

In terms of M&A or equitation advisory service, a securities company will followseveral compulsory steps However, the clients can choose what package ofservice they want Corporate valuation plays an important role in the entireprocess of implementation equitization or M&A This step may consume manyefforts and time of both client s and securities company Up to January 2013, inVietnam, there are only 83 companies who have permissions for providingvaluation advisory service However, there are only 53 companies in Hanoi.According to the forecast and historical data about M&A and equitization, it isvery easy to see that this trend still develop rapidly in Vietnam, especially inHanoi On the other hand, those 53 companies have not satisfied the demand inthis market Therefore, this is a great opportunity for any securities companies tocompete and develop their valuation service

Regard to the huge demand of this advisory service, many companies haveprovided it to their clients and expand this service However, in Mekongsecurities Joint Stock Company (MSC), this service has not provided yet tosatisfy the huge demand of customers Therefore, it is very necessary for thecompany to provide this service to take advantage of this great opportunity.

Hence, from above practical requirements, the topic “Setting up corporate valuation advisory service at Mekong Securities Joint Stock Company” is

selected for my thesis research

II Objectives

This research will focus on the some following objectives

- Understanding the market of valuation advisory service in Hanoi

- Setting up corporate valuation advisory service which is a new advisory service

at MSC

- Understanding the legal requirements for providing this new advisory service

III Research questions:

From the above objectives, the research is conducted to find the answer for the following questions:

- How potential the market is to provide the corporate valuation advisory service?

- How to set up a new advisory service at MSC?

- What are legal requirement to get permits from the government for providing this new advisory service?

IV Research methodology

Figure 1: Research Process

V Data collection

In collecting data, secondary data collection method is applied in this researchwhich is used mainly as information for corporate valuation advisory service andthe other relevant materials These secondary data are used as theoreticalbackground and recommendation

VI Structure of thesis

The research consists of 3 chapters, which are further described as follows

Introduction

Chapter 1: Theoretical background

Chapter 2: Setting up corporate advisory service at MSC

Chapter 3: Recommendations for launching service

Conclusion

Setting upcorporateadvisory serviceRecommendations

Collecting data

Theoreticalbackground Research

objectives

CHAPTER 1 THEORETICAL BACKGROUND ON CORPORATE EVALUATION OF SECURITIES COMPANY1.1 Theoretical background on securities company

1.1.1 Definitions of Securities Company

Securities Company is a financial institution in the securities market which islicensed by the State Securities Commission to carry out business activities in thesecurities sector The company is a legal entity which has its own capital andfinancial accounting system In other words, a securities company shall bepermitted to conduct one, a number, or all of the following professional businessactivities:

(a) Securities brokerage;

(b) Securities self-trading;

(c) Underwriting issues of securities;

(d) Securities investment consultancy

1.1.2 Classification of Securities Company

According to the business formulation which is regulated in the Law onEnterprise 2005, a securities company can be: a joint stock company, a limitedliability company or a partnership company

A partnership is an enterprise in which there are no less than two partners whoare joint owners of the company and carry out business under one commonname; in addition to general partner (must be individual and will be liable to allobligations of the partnership with his entire property), there maybe also belimited partners (will be liable to debts of the partnership only to the extend of

their capital contributed to the partnership) Partnership is not permitted to issueany type of securities.

A limited liability company is an enterprise of which members can beorganization and/or individual and total number of members is no more thanfifty Moreover, members are responsible for debts and other liabilities of theenterprise within amount of capital that they committed to contribute to theenterprise It not entitled to issue shares

A joint stock company is an enterprise of which charter capital is divided intoequal portions known as shares Shareholder can be organization of individual,the minimum number of shareholders is three and without any limit of maximumnumber of shareholders Moreover, shareholders are liable for debts and otherliabilities of the company within amount of their contributed capital In addition

to that a joint stock company is entitled to issue securities for the purpose ofcapital mobilization

It is very easy to see that a joint stock company and a limited liability companyhave advantage outweigh disadvantage in comparison with a partnership.Therefore, all securities company will establish as a joint stock company or alimited liability company

1.1.3 The roles of Securities Company

Securities Company plays an essential role in developing fund mobilizationmechanism for issuers At the present, the public issuance is mostly conductedthrough consulting firms which are securities companies This is compulsory ifthe issuance is initial offer or public offer

In addition to that, a securities company helps investor enhance efficiency, savetime and minimize risks through consultation They also assist in increasingliquidity of financial products and provide information for administrativeauthorities for their market management

1.2 Theoretical background on corporate valuation

1.2.1 Corporate value

Value of corporate has the following features:

Firstly, corporate value is a special value which is determined through theperformance of the corporate Moreover, it is different from corporate tocorporate

Secondly, corporate value is not just the book value of the corporate but also it isincluded the goodwill of that corporate When an investor carries out the duediligence the value of corporate, he mainly focuses on the potential profit of thatcorporate in the future

Thirdly, the value of corporate which is determined at the evaluation period is notthe final and the only one value of the corporate The value of a corporate isvaried from time to time and depends on the demand and changes of the market

1.2.2 Principles of corporate valuation

In order to understand the necessity of corporate valuation, it is essential to knowthe environment where the appraisal process takes place and who needs the result

of appraisal and why specific financial decisions are made In order to make itclear, the beginning will sum up the principal points of corporate finance whichtakes place in equity capital market and the role of financial manager in onecorporation

Not all businesses are corporations A corporation is defined as a group ofstockholders who have limited liability up to the limit of his or her investment(Pik & Neale 2009, 1-3) For example, Fiskars and Nokia are corporations.Although stockholders have shares and invest in the corporation, they are notallowed to manage or control it A board of directors is elected to be thepresenters of shareholders This action‘s purpose is to make sure that managersact in the shareholders’ sake In addition, in terms of existing time of acorporation, it can be immortal because of the separation between ownership and

management In case managers are dismissed or quit, the corporation still cansurvive On the other hand, if stockholders sell their shares to new owners, theoperations of the business are not interrupted and still maintain (Meyers 2003, 5).The financial department in every corporation is the place where monetarydecisions are made Corporate finance brings the tools and analysis to make thosedecisions It can be also said that everything a business does fit under the rubric

of corporate finance because the primary goal is to maximize the shareholdervalue The three principal decisions in corporate finance are allocation decision,financing decision and dividend decision The allocation decision answers thequestions of where to invest the scarce resources of the business The financingdecision finds the sources to raise for these investments and a suitable ratio ofowner’s equity and borrowed money Finally, dividend decision deals with theamount of money a firm should reinvest in business or distribute to shareholders.(Khan M.Y & Jain P.K 2005, 8-11)

1.2.3 Definition and theoretical background

When a corporation is appraised, it is necessary to find suitable valuationmethods to apply based on the company’s internal and external conditions Firstly, a company should separate its non-operating assets and operating assets.Operating assets are fundamentally the principal sources of a company’s cashflows The valuation of operating assets applies two different fundamentalsconcepts: a liquidation assumption and a going concern assumption While most

of the analysis values a business as a going concern, liquidation valuationfundamental is used occasionally, especially when considering distressedcompanies (Macabacus beta 2011)

In a liquidation scenario, all assets of a distressed company will be valuedindependently These assets should be in place and generate cash flows today.Shortly it can be said that liquidation valuation concerns only about investmentsthat are already made Besides, in going concern assumption, the businesscontinues existing for the foreseeable future so that accountants can prepare for a

realistic financial report When applying the going concern assumption, auditorscan value the earning power and cash generating capability of the assets Theseassets, owned by the company, can make up operating business and non-operating business They can be intangible or tangible assets Going concernvaluation is applied more frequently than liquidation valuation In addition, there

is a surplus between the going concern value and the liquidation value because anoperating business usually makes a greater return of assets than a separatingbusiness in liquidation assumption (Macabacus beta 2011)

Normally, the use of valuation models in investment decisions is also based upon

an assumption that markets are inefficient It makes mistakes in assessing thevalue These mistakes will be corrected after a certain time (ValuTech Pty Ltd.1992)

A market is considered as efficient when it is able to correct price of securitiesautomatically by the time the latest information available It cannot makeeconomic profit on the basis of the available information Shortly, it conceivesthat financial markets are “informational efficient” (Downing, Underwood &Xing 2007, 3) Professor Eugene Fama (1965, 1), who brought the phrase

“efficient market”, defined market efficiency as all participants making excellentdecisions This leads to the situation that the actual price of securities equals toits intrinsic value Therefore, there is no undervalued stock because every stock isalways traded at an intrinsic value of it Economic profits term here is known asthe profits after actual return deduces all risk and transaction cost such asbrokerage fees, investment advisory fees In an efficient market, the market priceequals to company value and the purpose of valuation model is the onlyjustification of this value No investors can use any technical analysis to beat themarket

1.2.4 Misconceptions about valuation

There is some significant confusion when appraising a company Dr AswathDamodaran showed in the books “Damodaran on valuation” that auditors need tounderstand the misconceptions of valuation order to get the basic background

idea of every valuation method (Damodaran A 2006, 35-50) He claims thatthere are basically 3 misconceptions that auditors should be aware of during thevaluation process.

1 Myth 1: A valuation is an objective search for a ―true value

The truth is all valuations are biased It depends on how truthful consultants orfinancial managers are The only questions concerning bias are how much and towhich direction CFO or inside financial employees will evaluate the companywith the positive prediction In contrast, competitor’s financial employee willevaluate in the negative way Hence, in order to have the most exact value,outsourcing consultant tends to have the clearest mind

Therefore, valuation results would rather be in a range of values than to be anumber Whenever an output of valuation has been made, it should be plus orminus the percentage of true value which is also just estimation

2 Myth 2: A good valuation provides a precise estimate of value

There are no precise valuations Based on myth 1, even outsourcing consultantshave the clearest minds and do not tend to be biased However, no consultantscan predict the future 100% accurately Future here can be the market situations,world trade affection, new competitors or inside company problems that makethe estimation might be wrong

3 Myth 3: The more quantitative a model is, the better the valuation

The more input required, the more prediction should be made As the result, theoutput will be manipulated and less precise In addition, auditors would ratheruse simple valuation instead of complex one It means that complicated modelsneed more inputs and estimations It may lead to input fatigue and causeproblems with the output That will make consultant more confused and mightmake mistakes during the valuation process Professional analyst shouldaggregate in order to make simpler models to follow

All in all, no valuation is exact and true 100%, therefore, the result should be arange of value In order to keep the range of value as small as possible, valuationshould be simple and less estimation.

1.2.5 Reasons for valuation application and using situation

People do valuate in daily life For instance, when selling an old computer, weremember the price of the computer when we bought it and then minus thedepreciation and any broken items to see the selling price When auditors want toknow how much stock is in the portfolio worth, they look up the price of thestock and multiply with the amount of shares Indeed, we have valued thecomputer and auditors value their stock to see how much we can get in cash if wesold the item at that moment

The reasons for business valuation can be divided into 3 categories which are: taxpurpose, litigation purpose and transaction purpose Each of these purposes hasdifferent approaches and methodologies in order to determine a company‘s valueaccurately (Frykman & Tolleryd 2003, 11-15)

1 Tax purposes: Normally, companies need to know about their fair marketvalues in order to know the amount of tax they have to pay Valuations for taxpurposes should seriously take the changes of laws and regulations intoconsideration (Business appraisal, Litigation support and Corporate Finance

2007, 1-3) If a company wishes to donate or give all or part of their businessaway, tax offices needs to determine the value of the business to support thededuction for a year in which the gift was given

2 Litigation purposes: There are cases in which shareholders do not agree withthe share price or they want to exit the business with reasonable sale price orsuspect about the best course of action for a company In these cases, a businessappraisal may need to be attached in a formal buy - sell agreement in order tosettle disputes on the shares value In a joint ownership of a closely-heldbusiness, if one or more owner wants to split up, they will also have to retain thebusiness and allocate the value of the shares (Selvaraj A 2012)

3 Transaction purposes:

- Mergers and acquisition: Business owners who are considering selling theirbusiness need business valuation to see how much their company is worth, thusgiving a suitable price It can also bring involved parties the final values thatmight encourage them to invest or to reconsider

- Employee stock ownership plans (ESOP): because regulations prohibit payingmore than fair value of the shares Therefore, the formation of an ESOP and thesubsequent selling of shares to the related trust require an independent appraisal.These plans must be independently appraised every year to publish fair marketvalue for administrative purposes, purchase price and the value of contributions(Bigelow L.2010)

- Financing: when obtaining debt or equity financing, often the lender orinvestors will obtain an independent business valuation to validate theirinvestment For smaller business interest, a loan might be an option for debtfinancing A certain loans package usually requires an independent businessappraisal file (Frykman & Tolleryd 2003, 11-15)

1.2.6 Valuation approaches

There are many different valuation approaches that can be applied to determinethe value of a business However all of those valuation methods can becategorized into 4 types of approaches based on the sources of input andvaluation processes: income approaches, market approaches, asset-basedapproaches and option pricing approaches (Koller, Goedhart & Wessels 2005,47) The Figure 1.1 shows the list of four mains valuation approaches anddifferent main models involved in each approach:

Figure 1.1: Corporation valuation approaches

The most common approaches in business valuation are income approaches,market-based approaches, asset-based approaches and option pricing approachwhich is also known as contingent valuation

The income approaches determine the fair market value of targeted company bymultiplying cash flows brought by the subject and then multiplied by adiscounted factor or rate The discount rate helps to discount the cash flows value

to be the present value The output after the appraisal process will be the fairmarket value of the subjected company This value is minus or plus a range ofvalue of uncertainties which were discussed in the limitation of this thesis Thephilosophical basis of income approach is that every asset has an intrinsic valuethat can be estimated based upon its characteristics in term of cash flows, growthand risks The market inefficiency hypothesis is applied in this category asmarket are assumed to make mistakes in pricing assets across time and areassumed to correct themselves over time as new information comes out aboutassets (Hack 2012, 10)

The market-based approach estimates the value of an asset or company byevaluating the pricing of comparable assets such as sales, cash flows, earnings

and book value The comparable assets or companies can be in the same industry

or have the same size or/and within the same region The philosophical basis ofmarket-based valuation is that it is extremely difficult to estimate a precise value

of assets The real value of an asset is whatever the market is willing to pay for itbased upon its characteristic (Hack 2012, 16) In another way, in a free market,supply and demand forces will drive the price of the business assets to certainequilibrium Therefore, it is very difficult to have in intrinsic value given in theoutput of an appraisal method using calculation only In order to apply themarket-based approach, comparable assets of the subject should be identified andconverted to standardized values Finally, auditors can compare this standardizedvalue or multiple of the assets to others Mostly analysts use this approach to findweak points in the calculation process of other approaches and fix them It isdifficult to find an absolute similar company or asset to carry on the comparingprocess As a result, this thesis does not use the market-based approach

The third approach is called asset-based and concerns the sum of the differentparts of company fair market value minus the total liability According to James

R Hitchner, the asset approaches are based on the principle of substitution It isassumed that a buyer will not pay for a particular investment more than its costs

In contrast to the income-based approaches, the adjusted netbook value method ismore likely objective and assets approaches assume that the business will nolonger exist or not be a going concern any more These methods are typicallyused for valuating tangible assets because tangible assets have reliable historiccosts associated with their development (Hitchner 2011, 1169)

The last approach is contingent claim valuation method which applies optionpricing models The assets in this model have to have share optioncharacteristics Scholes and Black in 1973 in their paper “The Pricing of Optionand Corporate Liabilities” published in the Journal of Political Economy, so it isalso known as Black-Scholes model (Scholes & Black 1973, 637-654) Thismodel was built in 6 assumptions that:

- There is no arbitrage opportunity It is possible for investors to take advantage

of the surplus between two securities price Making riskless profit is impossible

- Borrowing and lending cash at a constant risk-free rate is always possible

- Buying and selling all kind of stock in a frictionless market, where there are notransaction costs

- There is a geometric Brownian motion (GMB) which has constant volatility

- Security does not pay a dividend

However, in reality, these assumptions make the application of the modeldifficult to apply because the proper application requires understanding eachassumption‘s limitation In short, while the Black-Scholes model can hedgeoption easily by all of their assumption, there are lots of other sources of risk inreality such as tail risk, liquidity risk, volatility risk and yield gap risk that makesthe application impossible to apply in this thesis This is the reason why thisspecial approach is excluded

1.2.7 Discounted cash-flow valuation

The discounted cash-flow (DCF) valuation is one of the income approaches.Therefore it is based on the same philosophical basis and market inefficiencyassumption as the income approach Further details will be discussed in thefollowing sections

1.2.7.1 Definition

This valuation method is applied to estimate the value of a firm or an asset Ituses future cash flows projections and discounts them with a suitable rate inorder to calculate the present value of the target In a simple illustration, acompany‘s value is equal to all the cash they have that could make futureinvestment and generate more money However, cash in the future always worthless than cash today due to the inflation As the result, the net present valueshould be multiplied with a discounted factor

There are three pathways to carrying on DCF valuation approach: classic DCFvaluation, adjusted present value approach and excess returns approach Theclassic DCF valuation is considered to be the most popular one due to its ease.Analysts simply discount cash flows (to firm or equity) at the appropriatediscount rate (cost of capital or cost of equity) The sum of net present value ofthe cash flows is the value of equity or firm The effects of debt financing arebuilt either into the cash flows in equity valuation or into the cost of capital infirm valuation The second pathway values the firm by combining theassumption that the company is funded all by equity, present value of expectedtax benefits of debt and deducted to the expected bankruptcy costs The final way

of valuation values the company by the sum of capital invested It presents value

of excess return cash flows from current and future projects (Hack 2012, 25) The following part will show advantages and disadvantages of DCF valuation indetail It also describes more about factors required for DCF valuation and therelationships between them

1.2.7.2 Advantages and disadvantages

Because DCF valuation approach is done based on the asset’s fundamentals, itshould be less exposed to the market moods and perception If good investorsbuy businesses rather than stocks, DCF valuation is the suitable tool to choose Itcan determine what the company is getting when it buys an asset DCF valuationforces the company to consider the underlying characteristic of the company.(The Basics of Business Valuation: What Matters and Why 2010)

However, DCF valuation has some disadvantages as well It requires a highervolume of input than other valuation approaches because the output is an attempt

to estimate intrinsic value The company should also exist in a long time, so it iseasier to estimate the value in the future based on the performance of it in thepast In addition, the inputs data are not only quite difficult to forecast or estimatebut also manipulated in the bias of analyst In addition, in an intrinsic valuationmodel, there is no guarantee that it will emerge as under or over-valued.(Damodaran A 2005, 8)

In order to use DCF in an appropriate way, analysts should understand theadvantages and disadvantages of DCF As the result, DCF valuation should beapplied for firms that cash flows are currently positive and data allows analysts toestimate easily in the future periods The company should have an indicator forrisks that can be used to estimate discount rate Moreover, DCF valuation worksbest for investors who either have a long time tracking the market to correct itsvaluation mistakes (Damodaran A 2005, 9).

1.2.7.3 Key components

In this context, there are basically five components mentioned: Free cash flow tofirm (FCFF) and net present value; net operating profit after taxes (NOPAT);current assets, current liabilities and net working capital; weighted average ofcost of capital (WACC); capital expenditure (CAPEX); capital assets pricingmodel (CAPM) and terminal value

NOPAT is one essential input for DCF valuation approach It shows the profitgenerated from a company‘s operations after subtracting the income taxes It isthe net operating income of a company including its shareholders and debt-holders It is equivalent to earnings before interest and taxes (EBIT) adjusted forthe impact of taxes (Bhattacharyya 2007, 434)

The tax rate is the marginal rate of tax which is the corporate tax rate legally Current assets, current liabilities and net working capital: If an asset can be sold

in the normal operating cycle of the enterprise, it is considered as a current asset

In addition, even cash or cash equivalent is also current assets if it is freely touse, not restricted to the exchange Normally, current assets can be seen in thebalance sheet as account receivables, stock, prepayment short-term investmentsor/and work in progress Likewise, a liability is current if it exists in a normaloperating cycle For example, current liabilities can be accounts payable, tax due,payment or short-term loans The difference between current assets and current

liabilities is net working capital Consequently, net working capital is considered

as one of the classic metric of firm operating liquidity (Bhattacharyya 2007, 33,42)

FCFF and net present value: FCFF is the basis for measuring any company’sability to meet continuing capital requirements In other words, it is thehypothetical equity cash flows without company’s debt It shows the availablecash to pay investors after a company pays for its costs and invests in short-term

or long term assets Because a company has to invest in order to keep operating,

a positive value would indicate that the firm still has cash after investments andexpenses In contrast, a negative value of FCFF would show that the firm is ininability of generating more cash to pay for its operating costs and raise moremoney In order to calculate the FCFF, the combination of EBIT, tax anddepreciation deducting to change in net working capital and capital expenditure

is determined (Mills, Bible and Mason 2002)

Cost of debt, Capital Assets Pricing models (CAPM) and cost of equity: Cost ofdebt is calculated as the cost of acquiring debt capital at a certain time It issimply the current rate of a company‘s debt or it can be estimated as the averagedebt level of the whole industry (G Bennett Stewart 1991, 434) However, cost

of equity is more difficult to distinguish It takes risks in the overall market and

on the enterprise itself into consideration This is the reason why it is difficult toforecast or calculate a precise number In other words, cost of equity isdetermined based on the unpredictable behavior of investors and certainassumptions regarding their decisions making Although risks are oftenunavoidable, investors always try to minimize it in order to increase the value ofthe company

Consequently, the riskier the company, the less it is worth In short, the return relationship is positive However, there are some methods to calculate the

risk-cost of equity based on three components: the risk-free rate, the market riskpremium, and a company-specific risk adjustment Those are capital asset pricingmodel (CAPM), Fama-French and arbitrage pricing theory model In thisresearch, only CAPM will be used CAPM is developed independently byWilliam F Sharpe, John Linter and Jan Mossing and based on the portfoliotheory of Harry Markowitz which shows that investors cannot avoid risk but can

be diversified away when combining multiple investments in a portfolio In thatsense, CAPM is calculated by taking the risk-free rate of a security plus riskpremium The risk premium equals to the beta of security times a risk premium

of the security (Kuerschner 2008, 10)

ß: a measure of systematic risk which shows the volatility of anasset return (or a security) to the volatility of the market returnssince the beta of the market portfolio is always equal to 1

E (Ri): the expected return on asset given its beta

Rf: risk free rate of returnE(Rm): Expected return of the market portfolioE(Rm) – Rf: Market risk premium

Gross investment in operating capital (or capital expenditure or CAPEX) is thefixed assets amount rise from the previous year to the most recent year Thisfactor can be the alternative approach to the net investment in operating capital.Net investment in operating capital is the surplus between total investment inoperating capital generating today and last year Hence, the different betweengross investment in operating capital and net investment in operating capital isdepreciation (Michael C Ehrhardt 2011)

Weighted average cost of capital is the discount rate applied to FCFF in thisapproach This element is considered as the smallest acceptable return oninvestment Cost of capital is an invisible indicator of good or bad corporateperformance (G Bennett Stewart 1991, 431) Stewart describes it as the

“opportunity cost” for investors to invest to the firm in terms of time and money(Stewart 1991, 431) If costs of capital do not worth money and time investorsmake, they will invest to somewhere else (Mäkeläinen and Roztocki 1998, 10).Mathematically, it is the combination of rate of return and rate of debt.Consequently, it is neither a cost nor a required return but a weighted average ofboth components (G Bennett Stewart 1991, 432) Figure 1.2 shows the relationpresents the relations of WACC with cost of debt and cost of equity

Figure 1.2: The relations of WACC

In general, the discounted factor of free cash flow is calculated by the belowformula (Koller, Goedhart and Wessels 2005):

D: Value of debt E: Value of equity

Kd: rate of returned by debt holders

Ke: rate of return by equity holders

Tm: marginal tax rate Terminal value is the concept that is applied to all kinds of valuation methods.However it is impossible to know an exact value of the asset over an infinite timeperiod, we assume that the asset in the future will have a steady growth orconditions Such conditions will show the end of the explicit forecast period Thegeneral formula to calculate discounting approach is:

Because we assume that Zn has a steady growth (g), the above equation changesto:

After some changing steps, we can get:

We assume the asset has an infinite life, the terminal value of the asset is:

V: value of all future value of asset Z

gz: perpetual growth rate of value of asset Zn: period of time

This is also called the value of an annuity (Wilson 1997, 44-45)

The relation among the above components will be discussed further in the belowchapter.

1.2.7.4 Steps

The inputs of DCF are shown clearly in the figure 1.3 In order to get the result ofinputs, the financial statements and balance sheets should be reorganized clearly

so that we can calculate ROIC and FCF easily

Figure 1.3: Inputs of DCF method

Firstly, the “free cash flows to firm” (FCFF) needs to be identified with differentcomponents from financial statements such as EBIT, depreciation andamortization, current assets and current liabilities Then the expected growth isapplied to free cash flow to firm results, and it is calculated based onreinvestment rate and return on capital Secondly, the discount rate is identified

as being mentioned above However, discount rate can be in either nominal terms

or real terms depending on the terms of cash flows After that, the firm‘s stable

growth is estimated, and we have to forecast when the firm can reach that growthrate and what characteristics it will have when it does (Hack 2012)

In order to forecast the growth rate and the company‘s characteristics, auditorsevaluate the company’s historical performance because from that, we canestimate whether the performance of the company is good or bad, how much ithas created and grown The company’s performance can be compared to itscompetitors Some key factors can be compared are return on invested capital,sales growth, ROE and free cash flow “Understanding how these driversbehaved in the past will help to make more reliable estimates of future cashflows” (Koller, Goedhart and Wessels 2005)

After having estimated cash flows, the next step is to determine the value of thediscount factor per year The discount factor is WACC which is applied to theprojected financial and operating performance of the business in the period of 5 –

10 years The below formula show how to calculate the value of the businessusing FCFF and discounted factor (Barlow 2008)

After adding the terminal value, we have the value of the asset in an infinite life.The formula is:

Finally, in order to see the company performance, we look at the result of theabove formula A constant positive result of DCF over time gives the company agood future and increases the company value However, if a company is failed toearn a positive result of DCF through years, its management should employ thedivision‘s asset elsewhere in order to prevent the company from distress

1.2.8 Economic value added valuation

Economic value added valuation is one of the income approaches helpingauditors to calculate an intrinsic value for the company It has the samephilosophical basis and market inefficiency assumption as discounted cash flowvaluation The below chapters will show more details of this valuation method

1.2.8.1 Definition

EVA® is an analytical tool to estimate a company’s economic profit It isdeveloped in 1982 by Joel Stern and G Bennett Stewart III (Grant 2003) Sincethen, EVA® became a registered trademark owned by Stern Stewart & Co.Throughout this paper, EVA® appears without the ‘®’ symbol but will still beunderstood as a registered trademark of Stern Stewart & Co It has excellentmetric for monitoring a firm‘s profitability and use of capital Accordingly, itwas soon accepted as one of the most useful analytical tools for appraising acompany‘s financial performance (Blair 1997, 42-45)

The basic underlying concept of EVA is that if the company’s actual return isgreater than it is expected, the value has been added In general, EVA measuresthe economic profit of the company It is based on its residual profitability which

is computed by net operating profit after taxes (NOPAT) subtracts theopportunity cost of invested capital The opportunity cost of invested capital,which is also known as the capital charged, determined by multiplying WACCand the capital invested (Wilson 1997) Figure 1.4 illustrates graphically thebasics concept of EVA

Figure 1.4: Basic concept of EVA

After that, all future EVA results need to be added together, and this will give thetotal value added to the invested capital of the company Therefore in order to seethe fair market value of the company, we only have to sum up invested capitaland the total future annual EVAs

1.2.8.2 Advantages and disadvantages

Like DCF, the result of EVA valuation is also to give an intrinsic value fromwhich company owners can see their own business management performance.This helps managers to make a better investment decisions in both long-term andshort-term (Stewart 2013) EVA is considered as one of the most reliablemeasurement of managerial skills of company owners as well as a good indicator

of a company‘s value growth in the future With relatively unsophisticatedprinciples, business owners can convey the result of EVA to their employees andshow them what they should contribute to enhance the company competitiveness.Instead of using the market price per share which business owners cannotcontrol, EVA gives the top managers a full vision of what they should do to use

as little capital as possible because the return on equity and the cost of foreigncapital are affected by their decisions directly In addition, through the

calculation process, EVA can be a diagnostic tool showing managers where thefirm needs to improve to increase its value in the future (Wilson 1997, 12).Consequently, while EVA can give users some useful insights for the companies,

it also has disadvantages that need to be considered Although the principle ofEVA valuation is easy to understand, its application is quite complex whichneeds accurate estimations of cost of capital after tax, and accurate forecasts ofcapital spend on assets, investments or acquisitions Furthermore, EVAvaluations are mathematically identical to DCF valuations, but it does notinvolve future cash flows forecasting and does not measure the present value likeDCF valuation does (Wilson 1997, 12) Therefore, EVA valuation does notencourage who invests in a long period projects or start-up companies but ratherrewards managers who take on business with quick paybacks since it concernsabout the earning level at the moment Likewise, there is no official standard forEVA valuation, so different companies implement different EVA metrics tovaluate As a result, the EVA output might not fair comparability among them

In addition, positive EVA results through years does not mean that the companyoperates well, but it might be the situation occurred when the invested capitalused in accounting return is too small Unlike DCF-approach, which concernsabout both internal and external factor to the formula, EVA does not takeexternal effects like inflations consideration of accounting value in capital andaccounting profit (Wilson 1997, 13)

Understanding the above advantages, the case company uses EVA as one tool toevaluate company financial management and track the growth in earnings.Although the disadvantages might bring to this research some difficulty duringthe valuation process, it is still chosen because it is a supreme applicationincentivizing management to do the best for shareholders

1.2.8.3 Key components

The EVA input is less than DCF valuation The metric needs data exacted fromincome statement and balance sheet to calculate the surplus value betweenNOPAT and capital cost rate (Mäkeläinen & Roztocki, 1998, 7) There are

several pathways to get the final value of the company using EVA but all of thembased on the foundation of Stern Stewart which needs NOPAT, company’scapital (C), Capital cost rate, Cost of debt capital, cost of equity capital and tax(Rago 2008, 8)

Company capital: in order to determine capital cost rate, we need to identify thecompany‘s capital The company‘s capital is interest bearing liabilities which isequal to total liabilities deducts non-interest liabilities (Mäkeläinen and Roztocki,evanomics 1998) It is basically as below formula

However, in the normal financial statement, company capital does not onlyconcern liabilities but also shareholder’s equity Therefore the formula that will

be used further is (Roztocki and Needy n.d., 3):

For terminal year, capital invested is computed as:

Present value of capital base change: The capital base change is the differencebetween capital invested in the terminal year and capital invested in the lastforecasted year In order to compute the present value of the capital base change,capital base change is multiplied with a discount factor (Mäkeläinen 2001)

1.2.8.4 Steps

This method includes of five key steps which are: Reviewing the company’sfinancial report, identifying the company’s capital (C), determining the

company’s WACC, calculating the company‘s NOPAT, and finally calculatingits EVA (Roztocki and Needy n.d., 2-4).

The first step requires auditors to reorganize the financial statement and balancesheet from where relevant information is extracted Usually the most current data

is sufficient (Roztocki and Needy n.d., 3) After that, all the capital that has beeninvested to the company needs to be determined by summing up all interestbearing debt to owners’ equity Step 3 needs the same calculation of WACC inDCF This is one serious challenge of both methods because it requires twocomponents that are: cost of debt and cost of equity In reality, cost of debt is notusually public in SMEs, so it is difficult to estimate In addition, cost of equity isalso difficult to distinguish in a precise number in practice The reason is that itincludes of three different estimating components that are beta, market riskpremium, and risk free rate (Roztocki and Needy n.d., 4)

After that, auditors need to calculate the company‘s NOPAT and the final step is

to compute the company’s value by using EVA formula The EVA can becalculated by deducting the NOPAT with capital charge (Mäkeläinen, Economicvalue added as managment tool 1998, 15)

The results of EVA in the forecasted year are adjusted to the suitable discountedfactors in order to get the net present value of future EVA This calculationprocess is the same as the DCF valuation final step It also uses WACC as theinput of discounted factor The sum of net present value of EVA in the forecastedyears and terminal year less the present value of capital base change is the value

of the firm

Interpreting the result of EVA formula is indispensable Its result shows themanagement performance of the company If the EVA is positive, the companycreates more value than the capital owners invested On the other hand, if theEVA is negative, the owners are making less than what they have invested.Furthermore, the performance of the company in recent time can be compared tothe past, to other company in the same sectors to see its development andcompetitiveness in the market Table 1 shows how to interpret the results of anEVA analysis

Table 1.1: EVA analysis