Unlocking the value
The secret of a successful acquisition lies in right valuation. And the secret of a successful valuation depends on going beyond the obvious. Katya Naidu ascertains the value of intangibles in the process of valuation.
The real value of a person is not in the looks but in intelligence, innate abilities and capability. Similarly, the true worth of a company does not depend only on a strong asset base. It also depends, to a great extent on that which cannot be seen—the intangible assets or intangibles as they are known in the common parlance. This is especially true for companies in the pharma and biotech arena which are knowledge-driven, research-oriented and have to fight to survive in a thick jungle of complex IP laws, patent issues and regulatory requirements. As a result, these days in particular, assessment of intangible assets have become a challenge and the core focus of a valuation exercise before an acquisition.
Sifting through financial records and tracking the business of the company to be acquired, is the basic approach to valuing a company. But tracking and including the X factor while computing the value of a company is also very important as they contribute significantly to profits and earnings of a company. Thus, today, there has been a shift to the application of earnings-based methods of valuation like the present value of future cash flows and multiples methods rather than asset-based methods. Today, we also account for unseen assets like goodwill of a company, its brands and their brand equity, the relationships that a company has with consumers, distribution network, knowledge embodied by the employees or results of R&D initiatives which are yet to transform into products, which have a sizeable impact on the balance sheet of a company.
|“In IPR valuation, unless you are well versed with the industry, you might come up with a valuation which is very inappropriate”
– Sanjiv Agrawal Partner and National Director Valuation and Business Modelling services
Ernst & Young
Intellectual Property Rights (IPR), the most valuable of all the intangibles, yet is the most intricate of all to value. IPR valuation poses a challenge to analysts and financial wizards as it needs great expertise and a lot of serendipity, thereby transforming the valuation exercise from a science to an art. “In IPR valuation, unless you are well versed with the industry, you might come up with a valuation which is very inappropriate,” observes Sanjiv Agrawal, Partner and National Director, Valuation and Business Modelling services, Ernst & Young. The IPR in pharma context comprises of yet-to-be-developed drugs in the pipeline. And it is the uncertainty of their success that makes IPR valuation in pharma a complex issue.
|“There are a variety of dynamics like the competitor dynamics, in terms of whom are you competing with and what is the threat from different competitors and the intensity of competition”
– Raman Mangalorkar Principal Pharma Division
A discovery-based company comes with a high risk and high reward component and an unpredictable nature of the future cash flows. “It is very difficult is to value a company that is into pure research. Especially a company into research that we are not sure of, like a biotech company that is trying to formulate the newest biological for curing diabetes or AIDS,” says Raman Mangalorkar Principal, Pharma Division, AT Kearney.
This is because nobody would be able to determine if the molecule would be a blockbuster or not when it is going through trials. Agrees Agrawal, “Who knew four years earlier that Glenmark would make money every year by licensing the molecules? It very difficult to know about their success.”
“They will make the most money when the product reaches the market. But they have not reached that stage, and will take another 5-10 years. How do we predict if the product will be successful or not,” he adds.
|It is common knowledge that markets are fickle, volatile and sentiment driven. So the question goes—is it right to depend on the Sensex? Manglorakar defends these questions, “At the end of the day, the market value is what the common public, you, me, a few financial institutions, the guys who own the company believe are the future cash flows of the company and that is the value of the company.”
In addition, the aggregate behaviour of the Sensex is also a reflection of the optimism in the economy, interest rate levels, balance of payment levels, access to liquidity, investments from outside in terms of capital markets and strengths of capital markets. When the fundamental assumptions change, the value of a stock changes. “The whole logic is that the future cash flows are changing or the probability of the future cash flows is changing on a daily basis. Inherently, the market value of a company is the future cash flow of that company,” Manglorekar adds.
Even though stock markets could be an indicator of collective confidence in a company, they also fluctuate rapidly. To dim these effects, the stock market value should be observed for longer periods like six months. “You have to see it for longer periods and you have to look at the company’s data—if it is too much speculative, over-valued or under-valued,” says Agrawal. Some companies tend to have very high values even for longer periods like six months. In these cases, these prices have to be compared to other companies in the sector and an analysis has to be done as to what are the reasons for this company to have such investor confidence.
Hit or flop
|“As a new drug compound progresses through various phases of clinical trials, you get more data and there is more comfort in terms of whether the molecule has the
possibility of being a blockbuster or not”
– Shiraz Bugwadia Assistant Vice-President
The factors which broadly determine the value of the IPR are the strength of the R&D portfolio, the company and its competency in discovery research, its track record in terms of generating blockbuster drugs and strength of the R&D team. These parameters give an idea of the research capabilities of a company. Yet, these are not sure shot parameters that affect the success of a molecule. The stage of research is also a determining factor. Likewise, a molecule which is in Phase II or Phase III of clinical trials is more valuable than a molecule in pre-clinical stage as it is closer and closer to the success. “As a new drug compound progresses through various phases of clinical trials, you get more data and there is more comfort in terms of whether the molecule has the possibility of being a blockbuster or not. So at every stage of the clinical trial process, the valuation will keep on changing to reflect the positive or negative news flow,” explains Shiraz Bugwadia, Assistant Vice-President, Avendus Advisors. The valuation of any IPR depends on two aspects—the technical aspect and the market aspect. There are chances that a molecule might be technically successful but it might not sell well in the market. “Ultimately what matters is that the market should accept it. If the market does not accept it in spite of it being technically very good, you will not make any profit, so there will not be any value,” clarifies Agrawal. Market success can be attributed to the size of the market, strength of the pricing in the market, distribution and marketing strengths of the company, incidence of the disease that the molecule is indicated for and the competition. A successful IPR should also be valued in terms of the company’s market power, relationships with doctors, position in the marketplace, customer loyalty and the host of brands that the company is selling through its chemists.
|There are certain cross checks that need to be done while valuing a company and that depends on the way these questions are answered:
Yet another aspect of intangible assets is that feature, which collates all the tangibles and intangibles of a company and drives it to success—the human capital of the company. Human resources are central to the operations of a company, irrespective of the industry segment, and hence, are given a great deal of importance during valuation. The management team is also the factor that is responsible for profits. However, they are also loosely bound to the organisation and also have the maximum tendency to quit after an acquisition. “Most acquirers would definitely want the incumbent management to stay on and hence the quality of the management team is very important. You need to have a very good management team to ensure that when you do the transition, not much is lost in terms of products and customers,” explains Bugwadia. The acquirer needs to ensure that the critical resources of the company acquired have and will survive after the acquisition.
While the valuation of intangibles play an important role while valuing a company, one cannot completely ignore the tangibles. Also, while valuing the assets (tangibles, as well as the intangibles) one cannot afford to ignore the dynamics of the external environment.
No valuation is ever complete without the analysis of the market, which impacts the company positively and negatively. Industry dynamics give an overview of a company’s future. “Industry dynamics will determine how the company will grow. If the industry itself is not accepted it is very difficult for a company to grow and also margins are also dependent upon industry,” elucidates Agrawal. An analysis of the competition gives an account of the threat that a company will have to fight off to make a place in the country. “There are a variety of dynamics like the competitor dynamics in terms of whom are you competing with and what is the threat from different competitors and the intensity of competition,” says Mangalorkar. Competition analysis will also give a projection of future profits. “The ultimate drivers of acquisition is profit or free cash flow. How do you know the future profit or future cash flow? You will have to understand how much the company will sell in the future at what profit margin and this will all lead to how the company will do in the market,” says Agrawal.
In India, government also plays a role in the future of the pharma industry. Hence, factors like government intervention, price cap on medicines, patent rules and laws and the space for new participants play a role in the value of a company. Moreover, customers and doctors’ dynamics, stakeholders, dynamics of chemists drive the valuation of a company. However, pharma industry in general is considered a safe industry in comparison to others as the demand for medicines is largely unaffected by recession in the economy or the earnings of consumers.
|Though profit based methods are the most popular ways of estimating the value of a company, they might not be the right parameters while assessing a sick company or a company in bad financial condition. There are instances where companies have acquired sick companies like Sun Pharma which has bought US based ABLE Labs. “While looking at acquiring loss making companies one of the valuation methods that can be adopted is asset valuation,” says Bugwadia. Agrawal too agrees with the fact that asset based methods can be used while valuing a sick company since they have no profits to assess. But Mangalorkar opposes, according to him, asset based buyouts would be good only when one buys a loss making company and split it into parts and sell it.
A sick company could have no profits but it also has the assets which the buyer could use to make profits in the future and hence, the company should be valued in terms of the potential it displays in helping the buyer turn around its prospects. “We can use the future cash flows methods. Unless you are picking the company and intend to close it and sell off a bunch of assets, asset based methods typically are not an accurate reflection of a company’s value,” says Mangalorkar.
A successful acquisition is, amongst other things highly dependent on the valuation of the company to be acquired. Like a housewife, who evaluates each and every vegetable she buys from the mandi for intangible and tangible characteristics like the ripeness, colour, size of the purchase, reputation of the seller and negotiates on the right price; companies, too, in a similar manner negotiate their way through an acquisition. Just as the intangibles are important to the housewife, they are too, to the companies. There is more to business than ‘seeing is believing’.