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By Arun Kottolli

Introduction

The collapse of Sliverline technologies (SLT) last week brought to mind the need for methods to valuate fast growing companies and the techniques to discount risky cash flows. During the Internet bubble, companies were being evaluated at a ridiculous value. (luckily I did not invest in dot.com companies) Many were trading at 300 times their P/E ratios. SLT probably fell victim to such fancy valuations. Problems at SLT started after the acquisition of indiainfo.com for a price of 200 million dollars. The acquisition involved lot of debt, which in-turn demanded a steady cash flow.

The demise of SLT brought a question of how to value companies in emerging sectors where companies experience a fast growth rates, have negative cash flows or risky cash flows. Traditional techniques like Weighted Average Cost of Capital, Adjusted Present Value and Flows to equity do not work very well in such conditions. Adjusted Present Value may be best suited but choosing the appropriate discount rates is the tough challenge.

One method would be to use Free Cash Flows (FCF) method where tax shields are excluded from FCF and the tax deductibility of interest is treated as a decrease in the cost of capital using the after tax Weighted Average Cost of Capital (WACC). This method poses computational problems as the capital structure of the company or project is constantly changing, thus forcing us to compute the appropriate WACC every time the capital structure changes.

Alternatively, one can use Capital Cash Flow method (CCF) because the cash flows include all the cash flows available to the investors, including the interest tax shields. Since interest tax shields are included in the cash flows appropriate discount rates is before tax and corresponds to riskiness of the asset. Richard S Ruback proved the the algebraic equivalence of FCF and CCF methods, we can use CCF method to simplify our calculations.

Capital Cash Flow method

CCF includes all the cash flows that is paid to could be paid to the capital provider. By including cash flows to bond holders, CCF method measure all the after tax cash generated by the assets. Since CCF measures the after tax cash flows of the company, the net present value of the cash flows in the value of the company.

Capital cash flows can be estimated either from net income or from Earnings before interest and taxes (EBIT).

Selecting the Discount rate R_WACC

Pre-Tax R_WACC = (D/V)R_D + (E/V)R_E

Where R_D = R_F + Beta_D (Risk premium)

R_E = R_F + Beta_E (Risk premium)

The Capital cash flows are then discounted at Pre-Tax R_WACC.

Evaluating high growth - High Risk companies

The FCF or CCF methods are relatively new methods to valuate risky cash flows, but often times their application is limited due our inability to correctly calculate the Debt & Equity Betas. Another major problem in using FCF and CCF method is that the value of the company in question is greatly affected by the terminal value. (Companies are treated as perpetuity) Choosing the appropriate discount rates for the terminal value is tough and requires a lot of judgement.

In my opinion, CCF or FCF methods just give a general ball park number which should be used carefully while valuating a company. As mentioned above, these methods are not perfect and have their deficiencies.

Another alternative is to include other factors other than cash flows into consideration while valuating a company. Often times this sounds like gambling in Las Vegas, but there is some merit in this if this method of valuation is used for mergers and acquisition.

In my opinion, the value of the target company's cash flows computed by CCF or FCF method is to be added to the value of the technology or patents the target company holds which are of value to the acquiring company. For example, if Microsoft were to buy Google, Microsoft would add the value of Google's search technology to its base NPV. One way to calculate the value of the intellectual property would be to estimate the cost & time to develop a similar technology & then discount it to the current date. The other would be to find the NPV of money Google spent to develop that technology. The future value of the technology is not important here as its already considered in the future cash flow estimation. The discount rate must be chosen such that it reflects all the risks. This implies that the discount rate may be closer to R_A Rate of return to the investors of the target company. This gives the negotiating price range with discount rate of R_A

being the lower end of the price range & R_WACC being the upper end of the range.

Where SLT went wrong

I am not in a position to see all details of the demise of SLT. However it is clear that the company (SLT) made a serious error in estimating the future cash flows while acquiring indiainfo.com. SLT could be aware of the debt levels of the target company and therefore knew about the minimum cash flows required to service the debt at the time of acquisition. SLT should have estimated the cash flows after the acquisition to see if they can service the debt. It is not clear if SLT ever carried out such estimations, and if they did they were wrong.

A major mistake was in valuating the the company it was acquiring. Indiainfo.com did have certain value and could have been valuable for SLT. But estimating the correct value was the key.

Estimating future cash flows

It is always difficult to estimate future cash flows in a newly emerging sector. A lot of dot.com blunders were in estimating the cash flows. So a better way to valuate companies would be find the NPV of the technology or the Brand name etc.. and use that price and forget about the future cash flows. (Which is uncertain anyway) This is not perfect either as it looks at historical costs of the technology etc.. and not the future value of it.