Adapting
Valuation Approaches
for
Hybrid Business
Models
By C.G.
Srividya
Many
of the standard
valuation techniques
need to be revisited
and adapted
appropriately
with globalization
and with the
changing business
models of India
Inc.
There
are several
time-tested
valuation methodologies
used for arriving
at the enterprise
and equity values
of a company.
Some of the
accepted and
standard measures
are
• Net
asset value
(book value
or adjusted
/ revised book
value / liquidation
value)
• Discounted
cash flow (free
cash flow to
firm / free
cash flow to
equity)
• Stock
market based
methods (market
capitalization
for listed stock
/ comparable
companies' multiple
for unlisted
stock)
• Precedent
transaction
multiple (based
on investment
in/acquisition
of comparable
companies)
There are also
several other
methods that
are appropriate
in more specific
situations such
as earning capitalization
method, excess
earnings method
etc.
While using
methods like
the discounted
cash flow or
the market based
methods (stock
market / transaction
multiple), it
is important
to understand
the “locus
operandi”
of the business.
The dynamics
of each region
as well as each
stock market
is different.
The expected
return in a
specific country
could be significantly
higher than
another country
as this takes
into consideration
the growth of
the economy,
growth of the
industry, margins
of the industry,
demand and supply
of capital etc.
Similarly, the
market multiples
(such as enterprise
value / sales
(EV/sales),
price / earnings
(P/E), enterprise
value / earnings
before interest
tax depreciation
& amortization
(EV/EBITDA)
vary significantly
from economy
to economy,
even for the
same industry.
The fact that
in certain economies,
P/E is a more
popular measure
than EV/EBITDA
shows the cultural
difference and
risk perceptions.
In the Indian
context, with
the growing
hybrid models
in business,
the above assumption
of giving importance
to the local
economy / country
/ region is
changing rapidly
and dynamically.
There is a significant
shift from focus
on the locus
operandi to
the modus operandi
of the business.
The evolution
of hybrid business
models (shown
in exhibit below)
and hence the
need for using
appropriate
valuation approaches
is illustrated
below:
Level 0 Think
Local
Traditionally,
most of the
Indian industries
have had their
businesses with
a base in India.
While many of
these catered
to the Indian
market, few
of them had
some export
orientation,
though with
their assets
capitalized
in India.
There are several
examples of
such businesses
across industries,
such as manufacturing,
media, telecommunications,
construction
& infrastructure,
banking, retail
etc.
The valuation
approaches used
primarily in
the Indian context
such as expected
risk-free return
on Indian Government
papers, long
term return
in the Indian
market, market
multiples of
comparable Indian
companies listed
on Indian bourses
etc. The perpetuity
value of the
business being
valued was determined
based on the
sustainable
growth in the
economy and
the industry.
Level
1-
Asset location
and markets
vary distinctly
With the emergence
and growth of
businesses like
information
technology,
business process
outsourcing,
pharmaceutical
research and
few other segments,
the location
where assets
are capitalized
and the market
locations are
no longer the
same. This has
been the first
step in the
evolution of
hybrid business
models.
Examples of
such models
are many of
the small /
mid sized software
businesses,
generic pharmaceutical
companies, offshore
research companies,
call centers
etc.
To keep pace
with the changing
business model,
the valuation
approach has
to change as
well. For example,
to value an
Indian business
catering primarily
to the US market,
one has to take
into account
the risk perception
of the Indian
(or any other)
investor, geo-political
risks, expected
high growth
from tapping
the US market,
expected high
margins due
to cost efficiencies
and purchasing
power parity
etc. At the
same time, it
is also important
to consider
the long term
growth in the
US economy which
will reflect
the sustainable
growth rate
for the specific
Indian company.
While using
market based
methodologies,
it is important
to look at market
multiples of
similar companies
listed in India
but catering
largely to the
US markets.
It is also important
to consider
the currency
in which the
revenues are
earned, the
currency in
which costs
are incurred,
relative risk
in exchange
rates etc suitably.
Level
2 Building
assets outside
the local economy
The next stage
of the hybrid
model was developed
when Indian
companies started
setting up a
local presence
in their market
locations (US
/ UK / Europe
etc) and grew
them to larger
and larger sizes.
It is not a
simple equation
of having some
of the Indian
employees relocate
and work in
the market locations,
but having a
significant
local presence,
local resources
etc. In many
case, this has
been achieved
through acquisitions
of businesses
located and
catering to
the overseas
market locations,
though some
of the Indian
companies have
managed to do
this primarily
through organic
growth. Many
of these Indian
companies have
also gone for
a foreign listing
and raised capital
overseas.
Examples of
this kind include
companies such
as Ranbaxy,
Wipro, Matrix
Pharma, iflex
Solutions, WNS
Global Services,
Sun Pharma,
Infosys etc.
In these cases,
the valuation
approach needs
to adapt a suitable
mix of expected
returns in the
overseas market
(say US) and
the geo-political
and other risks
of operating
in India. To
arrive at the
expected return
for such businesses,
two different
methods (which
converge at
some point)
can be used:
1) Use a capital
asset pricing
model (CAPM)
based on US
returns and
betas of comparable
Indian companies
that are listed
in the US (based
on their ADR
performance),
and add a suitable
premium for
size. Or
2) Use a CAPM
based on US
returns and
betas of US
companies in
the same industry
and add a country
risk premium
in addition
to a size premium
Similarly while
using comparable
stock multiples,
appropriate
companies with
a similar modus
operandi needs
to be chosen.
Level
3 Acquiring
overseas, expanding
in international
markets and
also supplying
to local markets
In the next
level of hybrid
model, there
are several
permutations
and combinations
where any mix
is possible.
These include
Indian companies
who have acquired
very large overseas
companies to
move to a leading
position in
their industry
worldwide (from
a leading position
only in India),
who have shifted
part of the
production base
of the acquired
business to
India and who
service the
Indian market
with the products
of the acquired
business in
addition to
supplying to
the international
markets of the
acquired business.
Such models
leverage on
the size of
international
business, cost
advantage of
India, size
of the local
Indian market,
customer base
of the international
business, experience
of management
of the international
business, availability
of cost efficient
skilled labour
in the Indian
market and several
other benefits
wherever they
come from.
Examples of
such models
could include
Tata Steel's
acquisition
of Corus, Hindalco's
acquisition
of Novelis,
Tata Tea's acquisition
of Tetley, Dr
Reddy's acquisition
of Betapharm
etc.
There could
be further complexities
and possibilities,
such as Indian
company acquiring
a large European
/ US company,
but soon gets
acquired by
another international
business (Matrix
Pharma, iflex
Solution etc);
international
businesses setting
up Indian subsidiaries
with local production
capabilities
to cater to
local market
or sometimes
even for export
markets (Hyundai
/ Ford / IBM);
Indian companies
primarily having
international
investors (Genpact)
and several
more. Valuation
methodologies
in such cases
have to look
at the dynamics
of the specific
nature of the
business and
adapt suitably
to take into
account the
business dynamics.
Conclusion
There are different
companies who
are at different
levels of the
hybrid models.
These levels
are not based
on a business
life cycle,
but the evolution
is more company
specific. There
are still several
companies in
Level 0. Some
of them aspire
to move to higher
levels, while
the others feel
they are already
at the optimal
Level. Hence,
we can conclude
that while fundamental
valuation methodologies
do not change,
we need to understand
the dynamics
of a specific
business and
hence develop
(or hybridize
in some cases)
a suitable valuation
approach for
them, else the
results of the
valuation exercise
could be far
from being accurate.
C.G. Srividya
is a Partner
with Grant Thornton,
India and can
be contacted
at cgs@gt-india.com.
The views expressed
in the article
are her own.
