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.

2

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?

3

4

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.

5

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)

6

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.

7

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

8

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

9

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.

10

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.

11

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.

12

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

13

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

14

• 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

15

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

16

• 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

17

• 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.