Pre-acquisition valuation in Russia

Most common motives for acquisition of a Russian company by foreign comapnies are:

– Expanding business outside country of origin or further international growth into BRICS countries.
– If foreign companies see an undervalued Russian company that well fits their corporate expantion plans it will be targeted for acquisition by those who recognize this. It may well be diversification of existing business in Russia with the intent of stabilizing earnings and reducing risk.
– Synergies form acquisitions are very common and can bring potential additional value to firms involved. Operating Synergy can come from higher growth or lower costs. Financial Synergy can come from tax savings, increased debt capacity or cash slack.
– Poorly managed firms are taken over and restructured by the new owners, who lay claim to the additional value.

Three Business Valuation Methods

– Asset-Based Approach. Basically, this method totals up all the investments in the business. Asset-based business valuations are done on a going concern or on a liquidation basis. Going concern asset-based approach is very common in Russia. It lists the business’s net balance sheet value of its assets and subtracts the value of its liabilities.
– Earning Value Approach. This business valuation  method determines company’s ability to produce wealth in the future. The most common earning value approach is Capitalizing Past Earning – and it is the most common in Russia. With this approach valuator determines an expected level of cash flow for the company using a company’s record of past earnings, normalizes them for unusual revenue or expenses, and multiplies the expected normalized cash flows by a capitalization factor.
– Market Value Approach. Basically, this is an attempt to establish the value of a business by comparing such business to similar businesses that have recently sold. More difficult one to use in Russia.

Capitalization of Earning:

Lets be honest, this method in Russia is hard to jusitfy because it is difficlut to predict the cap rate (also due to currency fluctuations). The capitalization rate should reflect the buyer’s risk tolerance, market characteristics and the company’s expected growth factor. The buyer needs to clearly know what risks he is willing to take and what ROI he wants to receive. If investing in a startup – they often lack sufficient data for determining an accurate valuation of the business and therefore it is best to use Venture Capital Method. An investor is always looking for a specific return on investment, let’s say 20x – and say, the company could be sold for $100M in 8 years. Based on those two elements, the investor can easily determine the maximum price he is willing to pay for investing in the company, after adjusting for dilution. Anticipated exit $100M / Target ROI x20 = Post-money valuation $5M – Amount invested $1M = Pre-money valuation $4M x Dilution 70% = Pre-money valuation assuming dilution $2,8M.

Discounted Cash Flow:

Example: Simplified calculation of discounted cash flows PV
 Period year 1 year 2 year 3  year 4 Total
 Net Cash Flow, NCF 31 378 35 843 36 782 38 908 142 911
Discount rate, % 12 12 12 12
Discounted cash flow, PV *28 016 **28 574 ***26 181 ****24 727 107 498

Breakdown of calculations of the values of discounted cash flows in each step of the calculation:

* 28 016 = 31 378 / (1+0,12)
** 28 574 = 35 843 / (1+0,12)2
*** 26 181 = 36 782 / (1+0,12)3
**** 24 727 = 38 908 / (1+0,12)4

Net Cash Flow – balance sheets data
Discount Rate – 12 % annually for all years
Calculation Step – one year

The most important indicator to determine is the Discount Rate…

For LLC companies WACC (Weighted Average Cost of Capital) method is normally used:

WACC = rS * wS + rP * wP + rD * wD * (1 – tC)
r– costs of equity capital (common stocks)
wS – share of common stocks in total capital structure
rP – costs of attracted capital (preferred stocks)
wP – share of preferred stocks in total capital structure
rD – costs of debt capital
wD – share of debt capital in total capital structure
tC – corporate income tax rate.

For JSC and PJSC companies Multipliers method is normally used:

 It implies calculation of different kinds of profit for one company share then used as denominator in P/E ratio:
  • Earnings before interest, tax, depreciation and amortization / Share price;
  • Earnings before interest and tax / Share price;
  • Earnings before tax / Share price;
  • Earnings / Share price.
The more common P/E multiplier in Russia is the Market Capitalization/Net Profit. P/E TTM (trailing twelve months) in particular. Although the P/CF (cash flow) if more often used by investment copmanies in Russia. And, of course, P/B Ratio = Market Price per Share / Book Value per Share where Book Value per Share =  (Total Assets – Total Liabilities) / Number of shares outstanding.  A lower P/B ratio could mean that the stock is undervalued. However, it could also mean that something is fundamentally wrong with the company. As with most ratios, be aware that this varies by industry.vThis ratio also gives some idea of whether you’re paying too much for what would be left if the company went bankrupt immediately. And, of course, for LLCs Total Liabilities/Total Assets –  is the most important indicator.
An advantage of using market multipliers is that they fully reflect the situation in the industry, at the same time a disadvantage is that they don’t consider company specific risks.
Buit-up method can be used for both types of organizations LLC and JSC.
Build-up model is commonly used in Russian valuation practice and it is based on financial analysis of a company and its comparison with the competitors and it includes both the risk-free rate and additional premium for risk belonging to investment in a company:

r = rF + ∑rR 

– discount rate
rF – risk-free rate
rR – additional premium for risk belonging to investment in this company

This method in the best way and takes into account all kind of risks – the ones of an industry and the whole economy, as well as the ones of company specific operations. There are three main groups of such risks:
  • Macro economical risks – the ones of national economy functionality in general. They are considered at their minimum level;
  • Industry risks – the ones which show how much risk of investing in this company is higher than a risk-free rate (rate with a minimum risk);
  • Company risks – the ones which depend on company’s financial situation, informational openness, liquidity, quality of managements and other factors.
The risk of investing in the selected company is normally evaluated among following parameters, each of those gets its weight in a discount rate calculation:
  1. Management members in sense of availability (lack) of qualified personnel, dependence (independence) on one key person, characteristics of a director. This all has a direct influence on whether the company is prospering or close to bankruptcy, whether customer base is continuously increasing or if the company has high dependence on a limited amount of clients
  2. Company size in a sense that smaller companies have higher risks (and therefore require higher premium to cover it), because they have insufficient creditworthiness and not stable financial situation.
  3. Financial structure in a sense of a debt to equity ratio size. Such parameters are taken into consideration like: compliance with a normal level of the selected industry, limitation of financial sources and ignoring of new kinds of investment (e.g. financial leasing), financial non-stability of a company (e.g. insufficiency of liquid assets to cover debt).
  4. Diversification of a customer base and product range in a sense of a market where the company operates, i.e. availability of customers and company market share (the more customers – the more stable business is – the lower risks are), a range of products and services offered.
  5. Volume and possibility to forecast profits in a sense of its stability over the last years (the less fluctuations – the lower risk premium is), availability of necessary information and the sources of income (if it is from main company activities or not and an opportunity to derive it in future).
  6. Specific risks in a sense of ones, belonging exclusively to this company. Such ones can be: unreliable suppliers, lease of all main property, lack of government support, unsecured geographical presence, quality of contracts, company’s public image and country specific risks.
It is important to make a complex analysis of each risk component. If all signs of a risk are present, then each group of risks gets the highest possible weight in per cent. The less this risk is presented in a company, the less premium is required to cover it and the less weight is given (up to zero per cent). If there is only a part of all signs of a risk is figured out, then the final weight is determined, depending on how this sings are important for the company and influence its operational life.