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Vajira KulatilakaChief Executive Officer
NDB Investment Banking Cluster
September 4, 2010
Investor Expectations of Board Room Governance and its Impact on
Company Valuations
Agendao Board Room Governanceo Legal and Regulatory Requirementso What is Valuation?o Some Valuation Methodologieso How Governance Related Issues Affect Valuationso Some Cases in Sri Lanka – Empirical Evidenceo Conclusion
Agenda
Board Room Governance
Board Room Governance is a set of mechanisms to make sure the Board of Directors maximizes shareholder value, and avoid
moral hazards
Moral hazards – actions by the Board that benefit itself or the shareholders they represent but destroy other investors’ value
“heads I win, tails you lose”
Corporate Governance deals with how the capital supplier assures the corporate will pay them reasonable return
Intuitively it should affect valuation
Legal and Regulatory Requirements
In Sri Lanka, regulatory or external controls to fetter Board indiscretion exist in the form of the CSE Listing Rules, the
Companies Act and regulations made under the Banking Act
•CSE minimum requirements as per Section 7.10 of the CSE Listing Rules
– Non-Executive Directors – higher of 2 or 1/3 of board of Directors
– Independent Directors: to inject objectivity regarding company policy and direction – higher of 2 or 1/3 of Non-Executive directors
– Disclosures relating to Directors
– Appointment of Audit and Remuneration Committees
• Additional corporate governance requirements and stipulations in the Companies Act and Banking Act
• Other investor expectations
– Dividend Policy – Internal Compliance– Investor Relations / Minority Shareholder Relations
– Inter Company Transactions
Culture of the entity is very important for ethics and governance
Legal and Regulatory Requirements
What is Valuation?• The determination of the intrinsic economic value of an asset
or liability
• Company or a firm it is the determination of its potential market value
It is the modeling of the mind of an investor
What is Valuation?
Valuation Methodologies
Methods to be used in Valuing a Firm• Discounted Cash Flow Method
– Free Cash Flow– Dividend Discount
• Net Assets Value Method
• Multiples Based Methods– Price-Earnings (PE)– Price-Book Value (PBV)– Enterprise Value/EBITDA
Some Valuation Methodologies
Discounted Free Cash Flow• Free Cash Flows for the forecast period, determined based on
the future business plans of the firm
• The business value attributable to the equity holders of the company consists of the present value of forecast Free Cash Flows available to the providers of equity 1
• The intrinsic value = value from 1 + non-operational assets
Discounted Free Cash Flow
Net Asset Value• The Net Assets Value (NAV) Method indicates the value of the
equity shares appearing in the balance sheet of the entity.
• Net Assets Value per Share = Net Assets of the Entity No. of Shares in Issue
• May not be suitable for a “going concern” and for valuing minority holdings
Net Assets Value
Price Earnings• The ratio of a firm’s price per share compared to its Earnings
Per Share
• Price Earnings Ratio = Price Per Share Earnings Per Share (EPS)
• What the Firm is worth per rupee of earnings
Price-Earnings Ratio
Price Earnings• Enterprise Value (EV) = market capitalisation + debt + minority interest +
preference shares – (cash + cash equivalents)
• EBITDA is a firm’s earnings before interest, tax, depreciation and amoritisation.
• An EV/EBITDA multiple valuation may be preferred due to it being unaffected by a firm’s capital structure
Enterprise Value/EBITDA
How Governance Affects• Known Governance Issues
– In valuing a firm known governance issues may get reflected in the form of reduced free cash flows, EPS, EBITDA.
• Unknown Governance Issue– Unknown governance will be reflected in the discount rate in valuing a
firm
• Attitudes of Board and Management– Entrenched bad governance practices of a firm may affect the value of
a firm both ways
How Governance Related Issues Affect Valuations
G• Board Composition
– Investor confidence in the competence and independence of the board of directors will affect a firm’s valuation
• Related Party Transactions
• Company Structure– Too many holding companies
• Investments made to just enhance the group size– Investments just for diversifications
How Governance Related Issues Affect ValuationsSome Examples
Some Cases in Sri Lanka• Management Fees
– The reduced P/E of companies where management fees are still in place.
• Lavish Spending by Senior Management
• Dividend policy– Inconsistent dividend policy, or one which furthers management’s own
goals rather than returns to the investors
• Issues related to the Non-Voting shares
How Governance Related Issues Affect ValuationsSome Examples
Image Matters: extra effort has to be put in to create a positive image
Empirical Evidence• Sector Y
PER
2006 2007 2008 2009
Company A 7.56 7.05 6.32 4.18
Company B 29.77 25.41 14.98 8.37
Empirical Evidence
Empirical Evidence• Sector Z
Empirical Evidence
Share Price 2006 2007 2008 2009
Company A Voting 35.00 32.00 28.50 37.00
Non-Voting 9.75 8.00 6.00 16.00
Discount 72% 75% 79% 57%
Company B Voting 190.00 147.00 67.00 189.50
Non-Voting 89.00 74.50 48.00 124.75
Discount 53% 49% 28% 34%
Company C Voting 155.75 122.50 69.75 170.25
Non-Voting 70.00 53.25 32.00 104.75
Discount 55% 57% 54% 38%
Empirical Evidence• Boardroom Governance is a crucial component of the
operations of a firm
• There is value to be gained by a firm through good governance practices and conversely value to be lost through bad governance practices
• Empirical evidence, as indicated above supports this
Conclusion
You have to not only be compliant, but also be perceived to be compliant
THANK YOUTHANK YOU