Sunday, April 30, 2006

Valuation of firms with high debt

In the cases where the debt is high relative to the size of operation
the proper method of valuation is Firm Valuation rather than Equity
valuation. In Firm valuation the total value of enterpise i.e. debt +
equity, is calculated based on earnings before interest. This value
can give equity valuation if you subtract the debt.

I would like to explain this using valuation of MALCO where I did a
mistake by using Equity Valuation method.

If you use Equity Valuation you would find that MALCO was quoting at
Rs 142 which means market cap of Rs. 320 Crs. MALCO had net profit of
Rs. 37.22 crs. on standalone basis. If you consolidate the profits of
its 7.18% stake in Sterlite it would have consolidate profit of around
65 crs. That's why I considered MALCO an undervalued stock and
ecommended a Buy.

If you do Firm Valuation then you would find that MALCO is not that
attractive afterall. This is because it has huge debt of 434 Crs. at
Debt/Equity ratio of 4.27.

In such cases the Firm valuation is better approach than Equity

At price of Rs 142
Equity Value = 320 Crs
Debt(06/2003)= 434 Crs.
Enterprise Value = Equity Value + Debt = 754 Crs.

If you remove the value of 7.18% Sterlite stake 262 Crs(@515) the
enterprise value of the MALCO core operations is still Rs 492 Crs.

FCFF(free cash flow to firm) =
EBIT (1-t) - (Cap Ex - Depreciation) - Change in Working Capital

Under no growth situation, assuming that the depreciation cancels out
Cap Expenditure and no changes to working capital the free cash flow
to firm for MALCO would be

EBIT 62.35
Tax rate = 15.23%
FCFF = 62.35*(1-0.15) = 52.84 Crs.

At Rs 142 the market was valuing the enterprise value of MALCO core
operations at Rs 492 Crs. Which means a EV/FCFF multiple of 9.30 which
is not underpriced for a commodity company.

The only catch is that I have used the debt value for the year 2003.
The debt must have come down as the interest charges for year 2004
were 8.99 Crs., compared to 16.06 Crs. Even that value will make it a
definite SELL at RS. 162.

More on Firm valuation

On choosing the right model

Posted: Sep 13 2004

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