The request of the supervisory board is to determine the economic value of Ordina on a going-concern, both stand-alone and in a transactional context, to decide how shareholder value will be maximized in case a bid from a strategic buyer arrives.
To answer that request, the value of the firm in these two contexts has been assessed in two separate chapters, both based on an income approach: chapter 8 covers the stand-alone value and chapter 9 covers the value including synergies. Either valuation consists of a management case and a base case, which results are weighted on probability. As value is driven by fundamentals, but an actual price is set by demand and supply (Damodaran, 2018), the two resulting valuations are benchmarked by the applicable market approaches.
The discounted cash flow (DCF) is the most commonly used income approach and relies upon the discounting of future amounts of cash flow to its present value. The DCF reflects the net present value (NPV) of a business’ forecasted cash flows, net of the cash that is required to sustain (the growth) of the business.
The forecasted cash flows during the explicit forecast period are combined with the terminal value of the business, and both are discounted back to the NPV at a discount rate that represents time value of money and risks associated with the firm and its business, to determine total enterprise value.
The essence of this approach makes the DCF the preferred method: the supervisory board needs to know value of forecasted scenarios, adjusted for the time value of money and that future oriented assessment is exactly what the DCF provides.
Because the DCF is based on many assumptions, the results will be benchmarked against trading market multiples. It is noted that these multiples reflect a minority perspective where the DCF reflects a control perspective.
As Ordina has no debt and neither do its peers, there is no compelling reason to use the Adjusted Present Value and the regular DCF-approach will be applied.
The DCF is based on assumptions and choices which are not only reflected in the forecasted cash flows, but also in the parameters that will be used in the execution of the approach.
The risk-free rate is the minimum return an investor expects for any investment because she will not accept additional risk unless the potential rate of return is greater than the risk-free rate.
Risk-free rate is determined by:
• Expected inflation over the term of the risk-free investment
• Compensation for reinvestment risks and opportunity cost
• Compensation for risks of default (default of government)
Bonds are the common proxies used to determine the risk-free rate. At the moment however, rates are extremely low (if not negative) and spot-rates don’t seem to reflect the inflation and maturity risk over the period that will be forecasted.
The defined risk-free rate will therefor deviate from current market rates. Based on the yield of a composite index consisting of Euro-generic government bonds, with a maturity of 30 years, a synthetic (Koller, 2015) risk-free rate of 1,5% is applied. Although 30-year bonds are less frequently traded and their maturity don’t match the forecasted planning period of the cash flow (Damodaran, 2018), they better reflect long term inflation and opportunity costs. The synthetic rate is benchmarked against the average risk-free rate used by valuators in 2018 across the world, which provides a similar rate.
The equity market risk premium (“MRP”) is the average return that investors require over the risk-free rate for accepting the higher variability in returns that are common for equity investments.
To determine MRP one can use historical or market implied premiums. As historical MRPs are heavily influenced by inflation at that time and include some survivor bias of active stock markets, a market implied MRP will be used. The advantage of this implied premium is that it uses up-to-date market prices and underlying corporate performance and is quite consistent as it is stripped after inflation.
KPMG is one of the leading publishers of current market implied risk premiums. They adopted a global approach, assuming that investors tend to be globally diversified players. This matches the information available about Ordina’s shareholders and will be the view taken. According to quarterly published KPMG research the MRP measured was 5,50% on 31 December 2018, the reference date of this valuation.
Besides once using a revolving credit facility, Ordina had no debt in its books at years end during the past 5 years.
As management policy on the target capital structure isn’t communicated, the average capital structure of the peer group is used under the assumption that all peers strive for value maximization.
This assumed optimal capital structure actually matches the normal debt level of Ordina of 0% and will the basis for valuation purposes.
Sensitivity indicator betaβproofs how sensitive equity returns are compared to market returns. To determine Ordina’s equityβ, the median of the analyzed peer group has been used based on the MSCI global index. Investors diversify their holdings globally and the cost of capital should reflect this.
This led to an unlevered betaβof 0.97, which implies that Ordina’s stock tends to move with the market. That is in line with the conclusion in 6.1 of Ordina’s cyclicality characteristics.
The opportunity costs that investors face for investing in securities are represented by the Weighted Average Cost of Capital (WACC) (Damodaran, 2018). The WACC reflects an optimal cost structure of the business and considers a weighted average of the firm’s cost of debt (if any) and market-based cost of equity.
The WACC is subject to debate, because of several shortcomings: a steady debt/equity ratio is assumed, the firm is assumed to be immediately at this target capital structure without a migration and it neglects tax issues like carry forwards because one tax rate is used. But it is still the main tool for any DCF-calculation, and the mentioned shortcomings seem to be less relevant for Ordina, as the target debt level is zero. In other words, the WACC approach will be applied as such.
The WACC is calculated based on the fore-mentioned parameters: WACC = Ke * (E/V) + Kd * (D/V) * (1-t)
To determine the cost of equity (Ke), the build-up model has been used. The model is derived from the Capital Asset Pricing Model (CAPM) but ‘builds up’ the rate from individual components:
Ke = Rf + (β*MRP) + additional risk premia
For the unlevering and relevering of the equity beta (β) which shows the sensitivity of equity returns to the market returns, the Miller & Modigliani formula has been used. In line with the usage of CAPM and the assumed proportional debt to firm value.
WACC = 10,0% * (100/100) + 0% = 10,0%
Because the forecasts have been built while the results of Ordina over the first three quarters of 2019 are published, the WACC over the corresponding period has been adjusted to the risk-free rate.
The explicit forecast period should be of such length that a stabilized level of growth and profits can be achieved, after which a normative cash flow can be used to derive terminal value.
Ordina is still in the middle of reorganizations that should lead to new sustainable competitive advantages. If these advantages can be successfully established (management case), research proofs that such benefits last up to a maximum of 5 years.
Considering the fast-changing environment of IT-services providers, a shorter period of 3-4 years will be assumed after completion of reorganization.
This assumption results in a 5 years detailed forecasting period. After these first years, leading to increased performance, the results gradually revert back to the industry’s mean as the sustainable competitive advantages erode. After 10 years Ordina has moved into a steady state.
The forecasts are based on mid-year cash flows, as it is fair to assume that cash flows are earned gradually through the year and not only at year-end.
And as Ordina is a cyclical company, the explicit forecast period is assumed to include an entire economic cycle.
The continuing value considers the potential future growth of the business beyond the explicit forecast period. To define the continuing value, the convergence formula has been used. This formula assumes that in steady state a company generates a return on new investments equal to WACC. That basically means there is supposed to be no value creation in steady state. Analyzing the performance of Ordina in the previous decade, this appears to be a realistic assumption.
In the industry analysis of 3.2 it is concluded that although growth in the IT-industry is significant, the current and expected growth in Ordina’s original market segment of IT-services providers is limited. This fact in combination with the high level of competition in this segment of the industry makes the convergence formula the obvious method of choice: it is not realistic to assume that due to infinite sustainable competitive advantages Ordina will be able to grow faster than the economy into perpetuity.
The Bradley and Jarrell variant of the convergence formula will be applied where it is assumed that NOPLAT will continue to grow with long term inflation.
To determine the stand-alone DCF-value of Ordina, based on the management case and the base case, the probability of both scenarios has been estimated by professional judgement based on the analyses of Ordina’s macro, meso and micro-environment:
Management case – 40%
Reorganizations are starting to pay off as cost structures are improving and more revenue is gained from higher value markets, making Ordina less vulnerable to its traditional cyclical business. Competition is high though, making this scenario less likely than the base case.
Base case – 60%
Economy is falling back and Ordina is still dependent on the cyclical part of its business. The previous 10 years have been difficult, and the current positive signs would be caught up within a few years if the economy turns down to a next recession. The war for talent adds to the probability of this scenario.
The DCF-valuations of the operating enterprise value for both scenarios and the probability weighted derivative are calculated including a sensitivity in WACC of -0,75% and +0,75% and a sensitivity in the long-term growth rate of
-0,5% and +0,5%. The valuations provide substantiation for a probability weighted stand-alone value for Ordina in the range of €178 - €202m.
To determine Ordina’s equity value on a stand-alone basis, the calculates enterprise value must first be corrected for non- operating assets and liabilities and then for equity claims.
These adjustments lead to the following enterprise-value-to- equity-bridge.
The calculated equity value of €207m implies a share price of €2,22, which is well above the actual share price of €1,42 on 31 December 2018. In other words, Ordina is trading at a discount at the valuation date: the market does not seem to recognize the future earnings potential that management does, or it calculates the NPV of these earnings against a higher cost of capital.
Besides the income approach a regular method to determine business value are the so-called ‘multiples’. This approach derives the value of a company from prices of comparable companies, adjusted for size on the basis of an appropriate value driver (e.g. EBITDA). So, ‘value’ is expressed in the price of a substitute, hence the multiples approach is also called a relative valuation approach.
The idea behind this approach is that similar assets should sell for similar prices (Koller, 2015). The method provides an indication of value by comparing the asset with comparable assets for which public price information is available.
The main argument to use multiples is that they overcome issues inherent in the application of the DCF-method: subjectivity, access to information and a high sensitivity to changes in assumptions.
Multiples solely rely on observable market metrics and, when applied prudently, provide a pretty clean market perspective on value, possibly less subjective then a valuators interpretation of available data applied in a DCF.
Disadvantages of multiples are that they may ignore key value drivers and apply to the metrics of today, while investors will mainly be interested in future performance/value. Multiples basically indicate the price the market is willing to pay today for a firm, where the valuation of a forward-looking DCF is based on a firm’s fundamentals and less sensitive for the market game of demand and supply.
Multiples are however well suited to act as a benchmark for the calculated DCF-values.
For a relative valuation two type of multiples are available: trading multiples for the comparable company analysis and transaction multiples for the comparable transaction analysis.
The two types of multiples provide different insights: trading multiples provide a perspective from a minority shareholder, while transaction multiples indicate a control perspective (which most likely includes a premium). Trading multiples cover current market conditions, while transaction multiples comprise pricing in a M&A context. And while trading multiples weigh down volatility in stock prices, transaction multiples are depending on transaction structures.
For the valuation of Ordina as a target, a comparable transaction analysis based on transaction multiples (chapter 9) is obvious while for the stand-alone valuation in this chapter a comparable company analysis based on trading multiples is the apparent choice.
A prerequisite for prudent application of multiples is the ascertainment that actual peers are used for the analysis. Distinctive factors in the process are Industry, Geography, Size, Lifecycle phase and operating performance.
For the comparable company analysis (CCA) both tier 1 and tier 2 of the peer group (3.2.4) are used: a CCA based on earnings multiples of either tier separately produces valuations that deviate, but not substantially (<15% on EBITDA), which made me decide to let the importance of sufficient peers prevail.
Based on this peer group different multiples can be used for comparison. In general Enterprise Value (EV) multiples are more reliable than equity multiples, as the latter can easily be distorted by the capital structures of peers. For this comparable company analysis EV multiples will be applied.
In the case of Ordina, the best input for EV multiples are revenue to profit metrics, based on the fact that Ordina is in a mature stage of is lifecycle (Damodaran 2018).
Other multiples are less applicable:
• Market to book multiples relate to book value and are less useful for a capital light industry.
• P/E ratio, which is easily distorted by different capital structures of different peers.
For the CCA enterprise value multiples will be used based on EBITDAR, EBITDA and EBITA:
The EV/EBITDA multiple in general is one of the most applied multiples as it is robust and less distorted by accounting conventions and capital structure than net income for example. EBITDA is generally considered to be a proxy for the earning potential of a firm.
And the EV/EBITA has been used as EV/EBIT may be distorted by amortization of intangible assets resulting from acquisitions and is less used in capital light industries.
Sales multiples relate value to sales but don’t take into account profitability. They do provide insight in the likelihood of an increase in future sales and are added for benchmarking purposes.
Both current and forward-looking multiples have been applied. The use of forward multiples in the valuation of a company implies that an element of forecasting enters the multiples analysis, making the multiples approach more prone to subjectivity and bias. But they are more consistent with the principles of valuation (present value of future earnings instead of past) and not distorted by one-offs.
Of these multiples the 3 year-average medians have been taken to exclude outliers. The results are plotted in Figure 23 and indicate value ranges between the management case and the base case.
The multiples indicate a larger market value for Ordina than its market cap at the valuation date (€138m), but also than the calculated DCF-value. One reason for this may be that, compared to the peer group, Ordina is an underperformer. The usage of multiples of all peers to value Ordina, might have inflated its value.
Other reasons for the differences in value:
EV / EBITA – Within the peer group most companies seem to have more tangible assets on the balance sheet. This may cause a relatively high EV / EBITA multiple.
Similar to the conclusion of the stand-alone DCF-valuation, is the conclusion of the comparable company analysis that the market undervalues Ordina. The multiples indicate an equity value of €233m, which implies a share price of €2,50 and that’s well above the actual share price of €1,42 on 31 December 2018. Possibly, Ordina is exposed to a higher implied cost of capital than peers.