Valuation – Business Perspective -
By Interlink Knowledge Cell
Introduction Valuation of business is assuming critical significance in today’s fast changing and highly competitive global business. Business in modern days is riddled with environmental issues, regulatory changes and competitive dynamics. Destructive technologies have changed the structure and shape of the industry. In order to achieve economies of scale, size and synergy, a wave of consolidation in the form of mergers and acquisitions has set in. There is mounting evidence that a large number of mergers and acquisitions have not achieved the intended results. This has raised doubts whether the acquisitions were completed after only accounting based valuation. Forward looking business houses are developing strategies to obtain a more authentic valuation of the business to be acquired or merged. There is a growing acceptance that such an authentic valuation will go much beyond financial parameters as also legal or technical due diligence. Need for Business Due Diligence Business Due Diligence is normally associated with creating or acquiring a new business. The need for due diligence of a business arises in various situations. Such situations include i) buying an existing company or investing in a new company or a division ii) buying stocks or diversification portfolio. iii) loaning money or raising money for maintaining or expanding business. Due diligence means investigation and evaluation of business opportunities. Venture capitalists always look forward to a projected annual return and require a reassurance of the potential of earning capacity of the firm selected for investment. Business due diligence gives perspective which integrates all aspects of business relating to products, processes and people. It looks closely at all these aspects through a validation of the drivers and barriers for the business growth and its prospects. It examines critically growth drivers and barriers. The potential of business is evaluated by assessing financial, technical and managerial capabilities. The entire business – both domestic and cross-border is audited with reference to market dynamics. As a result, valuation of business, based on stock value and market capitalization, may be upgraded or downsized. Process The process includes review of the current business, business conditions, industry benchmarks, ranking with competitors and validation of the assumptions on which the business forecast is prepared. The validation process consists of checking audited accounts, management information systems, assessment of legal contracts and warranties, asset valuation and valuation of intangible assets including patents. Unpublished accounting information as also insights derived from in-depth meetings with key managers, customers, suppliers, distributors, lawyers and bankers are found useful for arriving at an authentic
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business due diligence. Information available in trade journals and discussions with industry associations can supplement the analysis. Beyond Financial Parameters There is a growing evidence that the traditional financial reporting model is too complex and predominant. It is not always capable or assessing business performance and business health, particularly in the longer term. By and large, financial statements present and analyze past performance. While this is necessary it becomes more important to evaluate business health in the context of global competition and chaos. In a globalised economy there is a higher degree of inter-dependence and no national economy can be insulated completely from the global economic developments. Financial details tell the board or company‟s investors very little about long term prospects. Accountants have not learnt to design measurements which can give a better prediction of the long term and sustainable competitive advantage. In the context of evaluation of business performance both the short and long term investors need to have a comprehensive picture of business performance, including its market opportunities, strategies, risks, resources and other important non-financial information. This is precisely the information needed by investors, be they individuals or investment firms. Empirical Evidence On the premises that many board members and senior executives are mostly in the dark about the overall health of their organization in the absence of high quality and non-financial data to be acted upon, Deloitte Touch Tohmatsu, in cooperation with Economist Intelligence Unit, conducted a survey in March and April 2004. The research results were based on a survey of 249 senior executives and board members around the world. The sample included corporate directors in North America, Europe and Asia. The report concluded: “While the overwhelming majority of board members and senior executives say they need incisive non-financial information on their company’s key drivers of success, they largely find such data to be lacking or when available of mediocre, poor value”. In order to find out whether things have changed, Deloitte intelligence unit conducted the research along the same lines after three years. This global survey conducted in December 2006 obtained responses from 175 senior executives and board members. Again in January 2007, in-depth telephonic interviews were conducted with senior executives and board members at large companies. The following is the brief summary of main research findings:
Many board members and senior executives are in the dark about the overall health of their organisations and have a lack of high quality non-financial data that they can act upon. 83% of the respondents agreed that non-financial performance measures are important as the market itself emphasizes this aspect. Companies are feeling pressure to expand their use of non-financial performance metrics. Moreover, a growing number of executives see numerous potential advantages in pursuing nonfinancial performance metrics.
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The 2007 survey emphasizes that the value of non-financial performance metrics is more important than just a few years ago. According to Jay Lorche a non-executive director at CA Inc. and Professor at Harvard Business School “There are some leading companies who are using more and getting more value from non-traditional metrics”. There is a linkage between financial and non-financial parameters. For example it is employees commitment and customer satisfaction which drives the cash flow of a company. The trend for using and measuring non-financial parameters is getting reinforced due to the following influential forces: Increasing reputational risk Increasing global competition Increasing customer influence Need for accelerating innovation Greater scrutiny of non-financial performance measures by the media.
The survey provided an illustrative list of key non-financial parameters:
Employee commitment Customer satisfaction Quality of governance Impact on society Operational performance Supply chain / partner performance
Non-Financial Metrics & Valuation: Financial performance metrics are the ultimate results of the business. While they are useful to know the basics of business performance they may not necessarily provide critical information about the shape of business that is changing and the relation of this change to business success. Non-financial metrics can give you insights and an idea of what is driving or distracting results. This kind of insight is hard to develop. As a director and an investor you need to know both financial and non-financial metrics to get a true picture of what is happening in the company as also at the market place. A growing number of executives believe that there may be under-discovered value in non-financial metrics. For example, one potential role for non-financial metrics in the advancement of predictive capabilities is forward looking information. Such information is of greater value to the management and the board than the historical information. Certain deals, particularly those focused on building revenue or new capabilities; require fundamentally different approaches to sourcing, valuation, due diligence and integration. In many companies, senior managers are often much impressed by what appears to be low price for a deal or the attraction of a
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new product. They fail to look beyond the financials to identify red flags which directly or indirectly impact valuation of business or work as barriers in realizing potential of the business. The review in business due diligence must articulate a rationale that fits a story line of the entire organization and spell out complete requirements for integration. Many organizations have poorly defined processes or are plagued with choke points. Good targets walk away from such acquisitions. Most managers struggle to get the underlying process right. The deals do not become successful unless backed by an efficient end-to-end process. Many companies go into M&A mode to acquire size, scale or synergy to become world class. To be counted world-class, a company need to be not just well run and large, but should have many more value drivers such as unique brands, leading edge technology and dynamic business methods. These should be assessed with proper weightages in valuation of a business in due diligence. The above pointers, based on research of successful deals by I.B.M. and G.E. bring out the fact that, in addition to financial benchmarks, non-financial parameters like customer perceptions, supply chain efficiency, distributors‟ network and discounts and the dynamics relating to market and positioning of the company as also potential for growth have to be assessed on ground reality factors. This is extremely important. Redefining Business With globalised economy and spread of digital revolution the dynamics of business have fundamentally changed. The past success is no guarantee for viability and sustainability of business today. Due to competitive dynamics the rate of mortality of business houses has considerably increased. Out of top companies in „Fortune 500‟ in 1994, 153 companies did not survive in the following decade. The average life span of companies is shortened from about 14 years to 10 – 12 years. This is also reflected in declining length of the tenure of CEOs. This has reduced to around five years now from eight years a decade ago. In order to arrive at as accurate evaluation as possible of the business, certain questions need to be addressed and responses have to be analysed for building weightages in business due diligence. Illustratively, some the of the pertinent questions relate to :
DNA of an organization core of the business USP of business Susceptibility to market changes and Organizational capabilities
As elaborated in Chris Zook’s book entitled ‘Unstoppable’, every company has some hidden assets. These are assets which the company possesses, whose values, properties or potentials have not been fully appreciated or realized. They do not appear in the typical financial statements of the company. Some of the hidden assets include supportive services, customer information, proprietary knowledge 4
and capabilities such as R&D. Some of the business platforms might be undervalued. Few customer assets may be underexploited and certain capabilities may be unused. These need to be looked into closely and appropriate weightages have to be accorded. There are also non-performing assets which adversely affect the current valuation as also prospects of business growth. A number of bank businesses have improved after the issue of non-performing assets has been managed effectively. A recent example is the statement of Mr. Vikram Pandit, C.E.O. of Citigroup when he describes “Legacy Assets” as ‘hobbies’. These accounted for a staggering 22 per cent of Citi’s $ 200 billion plus balance sheet and ranged from residential mortgages to bank branches and complex derivatives. Market Dynamics: Business plans, including targets to be achieved and forecast for the growth, are prepared at the corporate level. However, the real business takes place at the market place. In a way markets drive the business and play an instrumental role in maintaining and strengthening both the top- line and the bottom-line. A market is a mix and volume of products sold, not the business economics of those products. The profit pool for a market consists of earning of each participant in that market from the beginning of the value chain (supplier of raw-materials and packaging materials) to the end user (customer). A deep understanding and insight into the inter-play of various market forces is critical in the context of business growth. The composition of the customer groups as also their preference and choice of brands are constantly changing. For example, the Indian consumer now has a more demanding and youthful mindset. This will have to be reflected in the marketing and branding strategy. Godrej and Ceat have realized this and are redesigning their marketing strategies. For the pharmaceutical industry in India the growing middle class with higher disposable income and health consciousness will change the structure of pharmaceutical market. A larger segment of people below poverty line in developing countries will drive the generic business. The opening of health insurance industry and growth in stand alone insurance companies with liberalized products will increase affordability of the people who now spend for medicines out of their own pockets. With a higher degree of consolidation in the pharmaceutical industry, the multiplicity of the brands is an issue which the companies will have to address and plan for strategies for revival of certain brands which have the potential for growth. The perceptions and aspirations of suppliers, customers and distributors are of material importance in ascertaining the ground realities in the market. Businesses are now using ideas available from any source – especially their customers, contractors, suppliers and distributors – for innovating their products and services in the process of innovation. It is a well-known fact that Wikipedia has been created entirely by its users and not by the corporate development staff in California.
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A field work consisting of research to examine the ground realities should include in-depth interviews with customers, suppliers and distributors. This research may follow after close meetings with the company’s management and the research results relating to market dynamics can be reviewed with them. The analysis of this research and its relativity to viability and sustainability of the company’s business has to be incorporated suitably in business due diligence. Managerial Quality In the success of an organization in today’s globalised business, managers play a key role. They have to strive continuously to focus on ‘firm value’. They are expected to enhance firm value while complying with laws and regulations, respecting the rights of all stakeholders and following norms of socially responsible and ethical behaviour. Market processes and operations are now interconnected. New work cultures and organizational structures are evolving. Employees look forward to key managers to lead the process and foster new patterns of thinking to position the organization in a business world without traditional boundaries. The performance of a manager has to be evaluated on these parameters, something which cannot be done using accounting information alone. New performance measurement metrics like Economic Value Added (EVA) or Market Value Added (MVA) are evolving. Various aspects of manager’s performance have been measured by additional, most probably qualitative metrics. The ways of identifying value stocks are many, including looking at ratios like price to earning (PE) and price to book value (P/BV), besides factors like replacement cost and dividend yields. But if factors like company management and track record, healthy growth prospects and sound business models are also considered, it only increases the margin of safety. Business due diligence, therefore, has to incorporate an assessment of the role and its performance of key managers in important functional areas like research and development, manufacturing and marketing. Interlink has designed an econometric model for business due diligence. The model addresses both external and internal factors to assess viability and sustainability of business. The external factors include benchmarks of industry development, both in domestic and global market, risks and opportunities, regulatory requirements, competitive dynamics and the organizational fitment with environmental and social issues like health, safety and ecological balance. The internal factors include validation of financial measurements and converting them into business metrics and a quantified valuation of business performance and business health based on the defined criteria. Assessment of business performance is measured through financial performance, corporate brand value and business potential. Drivers like technological leverage, innovation and R&D capabilities and marketing mix are examined. In order to find out business health, professional management processes, human resource management as also contribution of technical facilities and utilities are reviewed.
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Components of each parameter are listed and weightages are ascribed. A score is worked out for each component to arrive at a total score. After developing a SWOT analysis of the organization the valuation index is prepared by calculating a composite score for the entire business:
Valuation of Pharma Business: While the methodology and measurement metrics can be commonly applied for business due diligence to any economic sector, evaluation of pharma business calls for a much deeper analysis. This is because the business models and methods of generating and developing pharma business world over are fast changing. The traditional block buster model has outlived its utility. Several new approaches to undertake better and faster business are evolving. The challenges to developing pharma business are far too complex. Markets are likely to shift from mature and regulated markets to emerging and semi-regulated markets including BRIC countries. The R&D pipeline has dried up. The nature of pharmaceutical industry is quite different from other industries. Its primary role is to discover, manufacture and distribute drugs which prolong life and cure sickness. Diseases like tuberculosis and malaria have developed drug resistance. As a result the drugs which were effective at one time acquire obsolesce. The technology is also continuously changing from chemical based medicines. We will soon have biotechnology based medicines. People require both innovative medicines which have long patent protection as also cheaper drugs which are available in the generic forms. However, whether innovative or generic drugs the quality, safety and efficacy of medicines cannot be compromised. As a result the product life of any drug is limited and there is a continuous search for newer, better and faster medicines. The pharmaceutical industry has to deal with this challenge effectively. While the new product introductions can leverage a faster growth, the rate of such introductions is not accelerating. A large number of patented products estimated at around $80 bn. will be losing patent protection by 2010. Challenges arising out of generic competition and pricing pressures are quite formidable. In the context of these uncertainties and challenges, business due diligence has to identify specific growth drivers and barriers and work out their weightages in business due diligence. An illustrated list of growth drivers, which push up the business and barriers which pull down the business, is given below: Insights 7
Interlink’s research in the form of field investigations in the market place and in-depth discussions with various stakeholders including management revealed interesting insights for business due diligence. A Venture Fund Company (VFC) acquiring pharma business of a leading Indian company had apprehensions about viability of stand alone business after acquisition. The concerns primarily related to loss of corporate brand and the performance of distributors, suppliers and customers while responding to the new corporate entity. Surprisingly enough customers gave valuable suggestions for developing biotech products. Distributors did not perceive loss of corporate brand as a major concern, provided their margins and service support were safeguarded. However, loss of I.T. support and managerial talents warranted considerable investment. The impending withdrawal of a strategic partner sharing advanced technology made a big dent. All these inputs were given due weightage in scaling down valuation in business due diligence. The VFC was guided to prefer ‘management buy in’. Today, the acquired company is on a fast growth track. In another case, an international bank wanted to decide on funding additional support to a debt ridden company. It was guided through business due diligence about red herrings. These related to susceptibility of manufacturing facilities for renewal of USFDA renewal and material value of Advanced New Drug Application (ANDA). It was discovered that even if a particular ANDA with considerable market potential was presented as a trump card, six companies had already obtained approval of this particular ANDA and two of them were well equipped to launch the product in both domestic as also US market. This was duly considered in business due diligence. Interlink’s business due diligence model, which integrates all aspects of current and future business, including financial, technical, legal, marketing and organizational aspects was used effectively in valuation of pharma business, a domain expertise of Interlink. However, recently the model has evolved into a secular model capable of being adopted to any economic sector. In a family owned and managed chemical company, business due diligence has provided an authentic valuation of business. Even if a split takes place, either of the partners has a ready blueprint for a correct valuation and a plan for business growth in domestic as well as global market. Conclusion Business due diligence, integrating all aspects of current business and its prospects, has a potential to serve as a useful and authentic tool to the board and investors for taking strategic decisions for a faster growth of the business.
Interlink Knowledge Cell comprises of a team of experienced subject matter experts in various domains like Pharma, Nutra, Biotech, Animal Health and Wellness, to provide insights and business perspectives focused on Management, Marketing & Training areas.
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