Valuation & Challenges Micro Finance Organisations
Transcript of Valuation & Challenges Micro Finance Organisations
Micro Finance & Valuations
“Valuation approaches & challenges
in Micro Finance”
Taco Lens
19 June 2013
Introduction
“Exploratory thesis” with a practical impact
• Explore existing theoretical frameworks
• How can they be applied within Triodos Investment Management –
Emerging Markets, Micro Finance Investments
• Directly apply the findings and conclusions of the thesis in daily practice
• Result: New valuation policy including tools and databases is being
developed and made ready for implementation.
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Problem Definition
Overall Problem Definition:
• Which valuation methodology(s) could be applied when valuing MFIs and
what are the challenges?
Sub questions:
• How to define MFIs?
• Which valuation methodology(s) exist when valuing “conventional”
banks?
• How do MFIs differ from banks from a valuation perspective?
• Which valuation methodologies could be applied in practice when valuing
MFIs?
• Which challenges arise when valuing MFIs?
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How to define MFI’s?
• Organizations active within inclusive finance; active in emerging markets
• The activities of these organizations are aimed at supplying financial
services to segments which are not served by the conventional banking
sector; i.e. the low to middle income populations as well as micro and
small – enterprises (SME).
• While often the initial focus is on supplying credit, more and more MFIs
have started to diversify their offering and their income streams by
offering savings, insurance and payment products & services.
• Look at valuations and transactions from a private equity investment
point of view.
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Which valuation methodology(s) exist when valuing
“conventional” banks?
“Conventional” Bank Valuation:
• Free Cash Flow to Equity method (FCFE)
• Residual Income Method
• Multiple Based (P/E and P/BV)
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How do MFIs differ from banks from a valuation
perspective? (1)
• Initially MFIs are performing activities which banks also perform, such as
attracting deposits and providing loans
• The differences occur for a large part from the incorporation of
sustainability in the overall strategy & business model by MFIs and their
focus on providing financial products & services to the real economy and
using their capital to support that strategy.
• These differences will become apparent via the different patterns and
ratios in the forecast of the P&L and balance sheet.
• To be able to identify and structure the key drivers of value the value
driver tree concept can (also) be applied for MFIs.
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How do MFIs differ from banks from a valuation
perspective? (2)
• The most important difference: Life Cycle Development Framework
Life Cycle Development Framework MFIs
Early Stage
Loans (Majority Interest income & minority fee income)
Savings (Interest income)
Payments Services & Insurance Products (Fee income)
Product Offering &
Income Sources High Growth Maturing
+
+
Time & Development
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How do MFIs differ from banks from a valuation
perspective? + Challenges (3)
Challenges:
• Emerging Markets
- Country risk / Cost of equity
• Non-traded organizations
- Cost of equity / Beta generation
• High growth
- Cost of equity/ Terminal value
Additional Valuation Method to mitigate the challenges:
• Venture Capital Approach
Many banks can be positioned
in the maturing phase and are
quoted on a stock exchange
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How do MFIs differ from banks from a valuation
perspective? + Challenges (4)
Challenges: Emerging Markets; Country risk / Cost of Equity
• Methods:
- Incorporate the specific risks in the cash flows
- Apply a specific adjustment in the discount factor; Country Risk
Premium
- Combination of both methods where company specific elements are
considered in the cash flow and country specific elements in the
discount rate.
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How do MFIs differ from banks from a valuation
perspective? + Challenges (5)
Challenges: High Growth & Non-Traded
• In general, when an organization is in a high growth phase the discount
rate should be higher and when the organization is in a more
mature/stable phase the discount rate should have decreased.
• This implies that the cost of capital should be adjusted during the
forecasted period for the changes in risk profile over time when this is
justifiable.
• Gordon Growth: Key for determining the terminal value the organization
needs to have reached a stable state at the end of the forecast period.
• For high growth companies which are also non-traded it is a challenge to
derive the beta since no objective model exists at the moment which
derives the beta of a fast growth non-traded organization. Challenge to
apply CAPM model to derive the cost of equity at the start of the life cycle
development model.
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Which valuation methodologies could be applied in
practice when valuing MFIs? (1)
• General banking valuation methods, both cash flow driven methods and
multiple driven methods, are a good starting point to value Micro Finance
Institutions (MFIs): MFIs show similarity in their operating model when
compared to banks and know the same challenges when defining debt,
working capital and reinvestments.
• However.....
• Following the life cycle development framework, the stage in which an
MFI finds itself is a key element to consider when selecting valuation
methodologies and when performing a valuation. Depending on the stage
of development, start-up, high growth phase or a maturing phase
different valuation techniques can be applied.
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Which valuation methodologies could be applied in
practice when valuing MFIs? (2)
Valuation Methodologies & Life Cycle Development Framework MFIs:
Valuation
Methods:
Venture Capital
Approach
FCFE FCFE
Multiples (P/E +
P/BV)
Venture Capital
Approach
Residual Income
Method
Residual Income
Method
Multiples (P/E +
P/BV)
Multiples (P/E +
P/BV)
Early Stage High Growth Maturing
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Valuation
Method
Pro’s Con’s Challenges
FCFE Can treat excess returns as free
cash flow to equity holders
Detailed method
Complex; sensitive to
assumptions
Sensitivity towards the
Terminal Value and discount
rate
Cost of Equity; Beta
determination
Projecting Future Cash
Flows & Terminal Value
Venture
Capital
Approach
Applicable to start/up & high
growth companies
Terminal Value less impact
Use IRR instead of cost of
equity
Discount rate based upon
“broad” target
Blend of a DCF valuation
method and a relative method
Select appropriate multiple
from peer group
Residual
Value
Method
Conceptually a sound method
Applicable to high growth
companies; based upon book
value
Terminal Value less impact
when compared to
FCFE/Venture Capital Approach
Discount rate & future net
income growth rate
Not applicable when capital
structure changes significantly
(e.g. equity raise, IPO)
Projecting Future Cash
Flows & Terminal Value
Multiples:
P/BV Meaningful for MFIs being a
financial institution
Ease of use and understand
ability
No view on future earnings
Less applicable to start ups &
fast growth MFIs
Peer group selection; lack
of listed companies and in
different stages of
development
Foreign exchange
exposure
P/E Widely used/recognized
Meaningful for a margin based
industry like microfinance
Ease of use and understand
ability
Comparability of peers
Volatility of earnings / can be
negative
Peer group selection; lack
of listed companies
Case Study
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• A “real-life” case was selected to test the identified valuation approaches
• The case example was positioned in the life cycle development model on
the edge of the high growth/maturing phase and therefore all valuation
techniques could be applied
• The findings confirmed the findings from the theoretical framework; such
as:
• In general, significant impact of the terminal value; challenging to
apply Gordon Growth appropriately and to create a highly
comparable peer group for multiples due to information restrictions
• Significant difference in valuation outcome between cash flow driven
methods versus multiple methods; possible due to “significant
optimism” within the forecast and/or market circumstances
influencing trading multiples versus transaction multiples
Limitations
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Current theoretical frameworks;
• How to derive cost of equity (estimation of beta) of an organization not
yet in stable growth stage
• Challenging to complete a detailed multi stage or longer period forecast
Limited availability of public data;
• Compilation of comparable peer groups
Recommendations - Theoretical
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• Further empirical research of the applied valuation methodologies; to
further understand the application & impact of the methodologies in the
MFI market. A preferred approach can potentially be identified or
developed.
• Further research regarding the estimation of the cost of equity when
extending the forecast period and/or when applying multi stage
forecasting. Emphasis should be put on the theoretical framework
regarding the beta estimation in the early stage and growth phase to be
able to complete a multi stage forecasting approach.
• Further research the topic of discounts & premiums specifically for the
MFI segment.
Recommendations - Practical
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• Develop a structured valuation template, which contains all of the
identified valuation methods; the outcomes should be captured in a
database and compared. These insights and conclusions can provide
input to come to a preferred valuation approach.
• Develop (further) a peer group benchmark for traded organizations,
which is sufficiently comparable when investing in the MFI market, which
is comparable to own circumstances and characteristics.
• To be of higher statistical meaning it is recommended to perform more
case studies and compare the outcomes.