Interview

‘The secret is in assumptions’

Price is what we pay and value is what we get. Valuation is key to successful acquisitions. Raman Manglorekar, Principal Pharma Division, AT Kearney talks about different aspects of valuation in conversation with Katya Naidu.

What is the importance of valuation in an acquisition?

I think valuation is certainly a big part of M&A failures. We interviewed people who recently went through mergers and asked them to take us through the whole process starting from the strategy of acquisition to making the acquisition work, and success factors that were important in the merger process. Firstly, the strategy upfront is very important. The second point that is very important is the valuation. Because acquisition might be a good strategic fit and it might make sense but if you are over-paying for it, then it doesn't reward the shareholders who have acquired the company. This is the reason why a lot of companies' share prices go down after making an acquisition.

How do we assess the value of a company?

The traditional way is to value it as an ongoing concern. So there is a set of revenues that you expect the company to have and a set of costs; certain investments and therefore a set of cash flows that you expect the company to generate over the course of its flight. You discard those cash flows based on certain discount factors called the cost of capital, driven by the risk rate in the country, the risk in business and so forth and then you get a value. That's typically the classical theoretical approach to valuing a company.

But the secret is in the assumptions that you make, the synergies that you have in place and the value that you attribute to management initiative.

What are the factors that determine the value of a company?

In the pharma industry it is certainly the product pipeline, whether it is a generic company or one dealing in biologicals, biotech or APIs. It also depends on the management strength, distribution structure, network, branding, price positioning and competitive advantage. If this company is in the pharma discovery business, a significant portion of the value depends on the pipeline they have, whether pre-discovery or clinical trials or other stages of the different drugs in the process of launching. The value of a company is determined by what drugs it currently has and what drugs are in the pipeline.

What are the nuances of assessing CROs? Since they go by contract basis, is it futile to predict their future?

A CRO business is performing a service which is constrained to some extent by its ability to scale up. It is based on a variety of factors which need to interact to make it successful including people and time and all of that. It is difficult for them to have the same levels of valuation that you expect a drug discovery company to have.

At the end of the day, to some extent the asset bases of a CRO go up and down the elevator on a daily basis with people. The relationships that people have with companies can be transient. In India today there is so much growth (for CROs) so they are getting a decent valuation but in a stable situation you would not get the same level of growth.

Do industry dynamics affect the valuation of a company?

There are a variety of dynamics like competitor dynamics, in terms of which you compete, the threat from different competitors and the intensity of competition. Second is the regulatory framework: what is government intervention, is it putting a price cap or changing price rules, or changing patent rules and laws.

And also the dynamics of customers, doctors and stakeholders and chemists—all these drive the valuation of a company. If a company for instance has a robust pipeline but has very less distribution strength, it will have a certain valuation versus a company that may not have a robust pipeline but has strong market relationships with doctors, a spot in the marketplace or gains significant traction.

Is market capitalisation a good way of assessing the value of a company?

If you believe that the market is right, then the market capitalisation is the true value that the world has ascribed towards the value of this company. At the end of the day, the market value is what the common public, a few financial institutions, the guys who own the company believe are the future cash flows of the company or the value of the company. The market is volatile and it may change on a daily basis. The logic around that is that the whole world believes that the future cash flows are changing or the probability of the future cash flows is changing on a daily basis. How do people know it? They use surrogates, PE multiples, revenues multiples, margins and competitor valuations. Inherently, the market believes that the value of future cash flows of the company is equal to the value that it currently is trading at.

Markets can be fickle. Can they be a definitive method to assess a company?

Certainly, the market is fickle. The whole thing about market cap is the lead steer concept. If you see cattle going through a meadow, instead of asking every cow, just ask the cow in front where it is going and you will know where all the cows are going, because everybody follows the cow in the front. There is a lead steer mentality in all markets as well and there are some people in the margin who tend to make the market. They typically tend to be financial institutions, hedge funds and large institutional buyers who take positions on the particular stock and they have a very strong understanding on that stock and they are lead steers.

The aggregate behaviour of the Sensex is also a reflection of the optimism in the economy, interest rate levels, balance of payment levels, the access to liquidity, investments from outside in terms of capital markets and strengths of capital markets. Those are the systemic factors under which a corporate operates. When the fundamental assumptions change, then the value of a particular stock changes.

The value of the company cannot fluctuate as much as the market. At the end of the day, the fundamental assumptions and the methodology to value a company tend to remain the same. It is an interpretation of what those assumptions are and the fundamental basis of interpretations that might change that causes the value to fluctuate.

How does one value a sick company?

When you think about a sick company it is all about potential. Sick today is loss making, the question is how we would be able to turn it around based on the strength of the assets, customer relationships, employees, brands, pricing strengths, competitive factors and so forth. That could be the potential of that company rather than its performance in the last quarter.

What is the kind of company which is easiest to value and which one is the hardest?

The easiest is a standard company that makes APIs and generics. You know what the capacity is, the sales channels, pipeline and customer base pricing. It is a pretty straightforward process.

The most difficult to value is a company that is into pure research, especially research that we are not sure of, like a biotech company that is trying to formulate a new biological. IPR valuation is difficult and becomes a challenge. What is the strength of the R&D portfolio that the company has, what are the competencies and the track record of those people in terms of generating blockbuster drugs, how many of them are coming off-patent; all these factors come into play in determining the value of the IPR. This is where it moves from a science to an art.