satyam post crisis valuation

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Satyam Computer Services Intrinsic Valuation – post Acquisition

Check out more on my blog: fundamentalvaluation.blogspot.com

Author: Puneet Malik

Date: Sep 01, 2009

Executive Summary

Satyam investors have witnessed a massive wipe-out of their wealth, with its market cap nose-diving by 501% since Dec, 08. Typical of any financial scam ridden company, Satyam stock got punished once its Chairman Mr. Ramalinga Raju jolted the market with the news of billion dollars financial irregularities. The acquisition by Tech-Mahindra infused confidence among investors community, reflected in the 300% stock appreciation since approval by India Law Board. The valuation report conducted the fundamental analysis of Satyam and valued it at Rs. 214.49, with 75% of its value coming from terminal phase.

1 SAY has recovered since post-acquisition

Fundamental valuation is good as long as market gets it.

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How has Satyam Valuation changed post-acquisition by Tech-Mahindra?

With increased government intervention, Satyam managed to sell 41% stake to Tech-Mahindra in Apr, 2009. In the previous valuation(pre-acquisition), controlling for all the risk factors facing company at the time, Satyam was valued at Rs. 102 in May,09 (the stock was trading at 45 at the time).

There have been several developments post-acquisition such as release of Q3 09 audited financial results, addition of new clients and disclosure of consolidated financial liabilities/assets of Satyam. This, in addition to management takeover, has improved the investor confidence level, reflected in the stock price, trading at Rs. 123.20.

The valuation report will re-evaluate Satyam’s enterprise value, taking into account all new developments since Tech-Mahindra acquisition.

Valuation model

The 2 most popular valuation models are Relative valuation and Fundamental analysis (a.k.a Discounted Cash flow model).

Without getting into much detail, relative valuation does a comparative valuation of similar companies based on various metrics (P/E,PEG,EV/Sales). This approach works best if the companies are relatively similar from growth, margins, cost of capital and industry perspective. For example, one can compare TCS and Wipro using P/E as both of them operate in IT outsourcing industry and get bulk of their revenue from outside India. Although Satyam operates in the similar industry as HCL, the idiosyncratic risks facing company today creates uncertainty about its future growth prospects. To use relative valuation, one must control for all such risk factors before slapping a multiple on Satyam. Not impossible, but it is fairly challenging to control for such risk factors in determining P/E multiple of Satyam.

The Fundamental analysis is a more comprehensive and intuitive model to value firms like Satyam, facing unsystematic risk such as higher cost of capital, uncertain growth prospects and distorted financial statements. The research paper uses a 2 stage FCFF (free cash flow to firm) model, appropriate for growth oriented companies. Satyam is a growth oriented company, operating in IT outsourcing industry2. The 2 stage model categorizes company’s growth into – High growth phase, followed by low growth phase leading to a terminal/stable growth. 3

Years 2009-2012 2013-2016 2017 and going forwardType of growth High growth Low growth Terminal year and Stable growth

2 Revenues from Indian exports of software and back-office outsourcing services rose by 16 percent in the 08-09 FY until mar09 to US$46.3 billion3


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Global IT outsourcing industry

IT outsourcing industry can be categorized into –

1. Application Outsourcing (AO)This includes outsourcing application development/support to countries, possessing competitive advantage of skilled technical labor. Gartner forecasts the AO worldwide market to grow from $70.9 billion in 2008 to $97.9 billion in 2012, registering a four-year CAGR of 8.9%.

2. Business Process Outsourcing (BPO)This category includes contracting out company’s internal processes – Back office operations like Finance/Human Resources and Front office systems like CRM. BPO is the fastest growing segment in the IT outsourcing industry, expected to grow at a CAGR of 9% in the next 5 years (2008 – 2012). According to Gartner, the worldwide BPO market is expected to grow from $171 billion in 2008 to $239 billion in 2012.

3. IT management This business segment includes outsourcing of company’s Information Technology Network management and other infrastructure management services. Gartner forecasts the worldwide IT Management segment to grow at a CAGR of 7.3% from $202 billion in 2007 to $292 billion in 2012.

Application Outsourcing16%

Business Process Outsourcing

38%

IT Management46%

Global IT outsourcing market distribution(2008)

(Source: Gartner)


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Application outsourcing Business Process Outsourcing IT Management

8.9 97.3

5 year CAGR of IT outsourcing segments(%)5 year CAGR of IT outsourcing segments(%)

(Source: Gartner)

Based on above data, the worldwide IT outsourcing market in 2008 totaled around $456 billion. (AO - $70.9b, BPO - $171b, IT Mgmt – $216.7b)

India’s share of outsourcing market

13%

87%

Share of worldwide outsourcing marketIndia Others

According to NASSCOM, India’s FY 08-09 outsourcing export revenue increased by 16 percent to US$46.3 billion. On the other hand, the domestic IT outsourcing revenue grew by 21% to $11.8 billion, resulting in India’s share of worldwide outsourcing market to be 12.6%.4

4 (46.3+11.8)/456=12.6%


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In 2008, Indian AO export grew by 14.7% to $26.5 billion and BPO related exports registered a 16.5% gain moving to $12.7 billion5. Engineering and Product services exports increased to $7.1 billion.

AO exports57%

BPO exports27%

Product services15%

Indian IT-BPO exports distribution (2008)

Satyam Intrinsic valuation

Although several financial projections go into DCF valuation, the paper highlights the salient parameters that have bigger impact on Satyam’s valuation. The research paper will reference the most recently released audited Q3, 09 estimates of Tech-Satyam that presents a much clearer picture of its financial situation.

Revenue projection

As discussed above, India’s share of worldwide IT outsourcing industry in 2008 was 12.6% - Application outsourcing share of global market is 46.60%6 and BPO share of global market is 9.35 %7. Since India emerged as the outsourcing leader in early 2000s, several other countries like China have emerged as the competing destination for outsourcing buyers. But in a 2008 Gartner study on Outsourcing, analyzing 42 countries on criterion like cost, education, labor, infrastructure and government support, India emerged as the most preferred destination for outsourcing.

The US financial crisis has increased the cost sensitivity of large buyers, putting India at a cost advantage compared to western BPO providers. India, among other outsourcing destinations, enjoys several advantages such as language skills, excellent government support and most importantly, moving up of IT

5 Doesn’t include companies with Corporate HQ outside India6 Assuming domestic market has same AO (57%) and BPO (28%) distribution as in exports market. Total Indian AO revenue=26.5+0.57*11.8=33. Global AO market share=33/70.9=46.6% where 26.5 is AO export and 11.8 is domestic IT market7 (12.7+0.28*11.8)/171 where 12.7 is BPO export, 11.8 is domestic market and 171 is total market


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vendors in supply chain, providing higher value added services. BPO being the fastest growing segment in IT outsourcing, Gartner forecasts the Indian share of global BPO market to double by 2010.

Indian Application outsourcing (AO) exports already controls a healthy market share of 38.15%. But the spiraling labor costs, higher cost of living, increased attrition and margin pressures due to financial crisis will pose challenges to Indian IT market players in strengthening its market share. On the positive note, the domestic IT market is estimated to grow at a CAGR of 18.3% through 2012 to $22.87 billion, propelling the growth for Indian IT service providers. Indian share of global AO market is estimated to increase to at least 55% in next 4 years.

With Indian BPO market share growing to 18.7% and AO to 55% through 2012, the total Indian IT revenue in 2012 will be (.187*2398+.55*97.99)=98.53. This results in a 4 year CAGR of (98.53/56.310)^.25 -1=15%. NASSCOM estimates 2009-2010 IT revenues to grow in the range of 4-7%. Based on the above estimates, the revenue growth for next 4 years is -

2009 2010 2011 2012Rev growth (%) 5 18.5 18.5 18.5

In the terminal year, Satyam will exhibit characteristics of a mature and stable growth company, growing at a rate not greater than Indian risk free rate11 of 3%.

Sensitivity analysis in the appendix addresses the valuation impact for different growth rates.

EBIT margins

Lacking any other credible financials, recently disclosed audited Q3 2009 results are used to estimate next 4 years EBIT margins. Q3 2009 income statement has high legal expenses (attributed to lawsuits) and high bench costs (economy downturn and financial irregularity) depressing the Dec Q3 EBIT margins to 12.99%. In Q3, legal expenses constituted Rs 108 cr/4.7% of Q3 revenue (historically legal expenses were 2.23% of revenue) and bench costs were Rs. 120 cr. At the time of this valuation, global economy is seen to be ramping up and it is estimated that bench costs should decrease with the recovery in sight. Additionally, it is believed that legal costs will continue to depress company’s margins for next 2 years until the legal liabilities are settled. The valuation analysis adjusts Q3 EBIT margins for high bench costs (keeping the high legal expenses), estimating the next 2 year EBIT margin of 18.2212%.

Satyam’s Q3-2009 EBIT margin of 12.99% is below SWITCH average, attributed to instability and legal challenges. Normalizing Q3-09 EBIT margins for legal and bench costs, company is expected to maintain 18.22% margin for next 2 years, increasing to 21%13 in 2012.

8 This is the AO market in 20129 This is the BPO market in 201210 46.3 is export market and 85% of domestic market of 11.8 results in 56.33 total IT-BPO market11 Indian 10 year yield is 7% and Indian Moody’s rating for local currency is Ba2, corresponding to a spread of ~4%12 See Appendix for calculation of next 2 years margin using Q3-09 financials13 See Appendix for normalized margin calculations


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Last 5 Yr Avg. of EBIT margins

Wipro IBM Infosys TCS HCL Avg. of IT industry5 Yr average (%) 20.03 17.82 28.39 23.87 17.01 19.61

With increased competition and maturing of IT outsourcing industry, margins are expected to get depressed through terminal year (2017). The terminal/stable growth EBIT margin is the profit margin of a larger/mature company in a stable growth mode. In a stable growth mode, Satyam is expected to deliver EBIT margin of 19.61%, average margin of IT service industry.

Future capital investments

Company requires infusion of new capital to continue growing. The model uses Capital turnover ratio, defined as Revenue/Invested capital14, to determine future capital needs.

Last 5 year average of Capital turnover for SWITCH companies

Wipro Cognizant Infosys TCS HCL Avg. of SWITCH5 Yr average 1.74 3 2.76 2.06 2.2 2.38

To estimate Satyam’s Capital turnover during growth phase (through 2012), the model uses average Capital turnover of SWITCH companies of 2.38. In low growth phase, company’s turnover ratio will decrease to 115(average turnover of Sensex-30), reflecting the maturity of the industry.

The Capital requirement in stable growth period is determined by the Return on Invested capital and the amount of growth16. The retention ratio (net of Capex) is estimated to be 23% in stable growth. See section below on Excess Return in stable growth phase.

Cost of capital

Cost of capital is the weighted average of 2 components –

1. After tax cost of debt2. Cost of Equity

Cost of Debt

Satyam’s annualized cost of debt as of Q3, 09 (ending in Dec) was 16%. The company took a loan of Rs.600cr to meet its working capital needs, carrying a high rate of 13.5%. Cost of debt is

14 Minus cash15 See Appendix for Sensex-30 Capital turnover16 Retention ratio=Growth/Return on Capital.


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determined by the risk free rate + risk premium attributed to risk default. The risk default premium for Indian companies generally has 2 components –

a. Country default – Unlike USA, India has a default rating of Ba2 according to Moody’s. This carry a ~400bp spread over risk free rate.

b. Company default – This is company specific and identifies company’s ability to service its debt, generally determined by Interest ratio coverage.

Indian IT sector receives bulk of its revenue (95% on an average) from outside India (USA/Europe), nullifying the country risk premium. Company default is the only risk component, contributing to spread on top of Indian risk free rate. As of Q3-09, Satyam has an outstanding liability of Rs.5817.96cr17 and the interest coverage ratio of 7.0418, corresponding to a spread of 250bp over Indian risk free rate of 3%19. According to new management, company plans to retire Rs300cr of debt this year, carrying an interest rate of 13.5%. Once the impending lawsuit liability is settled in 2 years, company’s interest coverage ratio should improve further, lowering its after-tax cost of debt to 3.4520% through 2012 and to 2.7621% in the terminal year.

Cost of Equity

This is determined by company’s levered beta and the market risk premium. Although historically, market risk premium ran around 4%, financial crisis has drastically increased premium to around 7.5%. It is expected that market will continue to exact high premium for next couple of years before reverting to historical average of 4%.

The paper uses top-down approach to calculate Satyam’s unlevered beta of 0.8 – average beta of SWITCH companies. As company grows and scale up, its beta also approaches 1. The valuation uses a beta of 1 in the terminal year.

The cost of equity in the growth phase is 10.16%, reducing to 8.1% in the terminal year. (The contribution of country risk premium is ignored as Satyam receives bulk of its revenue from developed economies, carrying zero country risk premium)

WACC

Using above costs of debt and equity, weighted average cost of capital for Satyam decreases from 9.73% in growth phase to 7.83% in the stable phase. (See Appendix for WACC calculation)

17 See section on Total outstanding debt18 See Appendix for Synthetic Credit Rating19 Indian 10 Yr Yield is 7% and Indian country risk premium is 400bp corresponding to Moody’s Ba2 rating20 Corresponds to 200bp spread over Indian risk free21 Corresponds to 100bp spread over Indian risk free


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Excess Return in Stable phase

This is the most important component in any valuation that generates value for the company. It is the excess return over cost of capital that adds/detracts value from a company – companies generating higher excess returns will have higher valuations than others. Maintaining excess returns require company to have sustainable competitive advantage. Companies like Microsoft, maintaining a monopoly, have managed to enjoy higher excess returns for several years.

There is another school of thought, like Mckinsey, which believes that the company will generate zero excess returns in stable growth – higher excess returns attracts new entrants, increasing competition and thus depressing excess returns.

The sustainability of competitive advantage determines the longevity of excess returns. The bigger the competitive advantage, the longer the company enjoys excess returns.

Although there have been several players in the outsourcing industry, it is believed that each player holds some competitive advantage, supported by the fact that SWITCH average ROI for the last 5 years has been 33.5022%.

Average of last 5 year ROI

Wipro Infosys TCS Cognizant HCL AverageROI (%) 23.42 50.98 30.11 38.69 24.32 33.50

These high ROIs may be justified by higher switching costs of IT outsourcing buyers or by company’s competitive advantage in different verticals. (Tech Mahindra’s focus on Telecommunication niche)

Matured technology companies such as Dell23 and HP24 enjoys an excess return of around 6% in their most recent fiscal results. With the maturing of IT outsourcing industry and increased competition, it is estimated that IT outsourcing companies like Satyam will continue to enjoy excess return, though of the order of ~5-6%. As discussed in cost of capital section, WACC in the stable growth is estimated to be 7.83%, resulting in ROC of 7.83+5=12.83%. The company will need to retain 23% (G=b*ROC; G=3%, ROC=12.83%) of capital in the stable growth, as part of capex. Investors, who hold a different opinion about excess returns, can visit the sensitivity analysis section to find the variance analysis.

Debt/liabilities

According to Q3-09 released financials, Satyam’s outstanding consolidated debt as of Mar-09 was Rs.966cr.

Type of Debt Amount (cr)BPO loan 169

22 This figure adjusts for any R&D expense, not treated as equity. Indian IT company’s average WACC is ~9%.23 Dell generated 4.17% excess return in FY ending Jan-09.24 HP generated 6.02% excess return in FY ending Oct-08.


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Financial leases 328Fund based loan 469

=966 (Source: Q3-09 financials)

Facing lawsuits due to financial irregularities, company has pending litigation that can cost company from 3500-7000cr, according to legal experts. The class action suit is with United States District Court for the Southern District of New York, pending consideration of lead plaintiff, according to Q3-09 released company financials. It is estimated that lawsuit charges should settle in 2-3 years, resulting in a legal liability of Rs.4492.2625cr.

Other liabilities26:

Type of liability Amount27(cr)Caterpillar 192Bridge 105.6S&V management 62.1

=359.7 (Source: Q3-09 financials)

This results in total debt and liability of 966+4492.26+359.7=Rs 5817.96

Cost of Options/RSUs

According to Q3-09 financials, company has following options and RSUs outstanding.

Option/RSU type Term (yrs) Number in force(mil)ASOP-B 5 12.79ASOP-ADS 5 1.2RSU 5 3.9

Total options in force=19.09mil

Using Black Scholes, option value is 9828 and total cost of options/RSU =98*19.09=Rs. 187.02cr

Discounted Cash Flow Analysis

Revenue Growth (%) 5 18.5 18.5 18.5 10.75 6.88 4.94 3 3Mar-09 ttm29

FY09E FY10E FY11E FY12E FY13E FY14E FY15E FY16E Terminal-Yr

Sales 9767.00 10255.00 12152.59 14400.82 17064.97 18899.45 20198.79 21196.11 21831.99 22486.95EBIT margin (%) 17.46 18.22 18.22 21.00 21.00 19.26 18.39 17.96 17.52 17.52EBIT 1705.00 1868.52 2214.20 3024.17 3583.64 3640.25 3714.90 3806.18 3825.46 3940.22Tax-rate 14.0030 14.00 22.50 31.00 31.00 31.00 31.00 31.00 31.00 31.00

25 Expected value of liability=5000. Settlement in 2 years, so PV(5000,@5.5%)=4492.2626 Source Q3-09 financials27 US$=Rs48 Eur=Rs6928 Using vol=40%, K=2, t=5, rf=3%, Stock price=100 and div-yield=0.78%29 TTM is through Mar-09, as Balance Sheet details are given until Mar-09. Mar rev is projected to be same as Feb


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EBIT(1-T) 1466.30 1606.93 1716.01 2086.68 2472.71 2511.77 2563.28 2626.27 2639.57 2718.75

Sales/Inv. Capital 2.22 2.22 2.22 2.22 1 1 1 1New Cap. Investments 220.42 697.12 802.10 922.90 1410.62 1024.48 813.90 566.12 524.93Total Invested Capital 2808.0031 3028.42 3725.54 4527.64 5450.54 6861.16 7885.65 8699.55 9265.67 9790.60

FCFF 1386.51 859.66 1071.90 1270.21 677.29 1263.94 1628.95 2003.68 2083.18

Total cash 1521.4032

LTD/OBD 5817.96Market Leverage (%) 14.6133 7.81 4.4 2.7 1 3 4 4.5 5 5Levered-Beta 0.94 0.94 0.87 0.83 0.8 0.9 0.95 0.98 1 1Cost of debt (%) 16 5.5 5.5 5 5 4.5 4.25 4.13 4 4After-tax cost of Debt 13.76 4.73 4.26 3.45 3.45 3.11 2.93 2.85 2.76 2.76Cost of Equity (%) 10.16 10.16 9.68 9.44 7.2 7.65 7.88 7.99 8.1 8.1Mkt. Risk premium (%) 7 7 7 7 4.5 4.5 4.5 4.5 4.5 4.5WACC (%) 10.68 9.73 9.44 9.28 7.16 7.51 7.68 7.76 7.83 7.83

ROIC (%) 53.06 44.17 42.59 40.52 31.65 27.75 25.66 24.29 12.83

PV 1263.51 715.82 816.77 903.19 447.88 776.18 928.29 1058.60Terminal Value 22772.70

EV 29682.94Total Cash 1521.434

LTD/OBD 5817.96Unfunded pension 89Cost of Options 187.02Total Equity Val 25110.30Outstanding shares 11735

Share value (Rs.) 214.49

Value from Growth 23.28%Value from Terminal 76.72%

Appendix

A. EBIT Margin for Q3-2009

Revenue 2294Operating expense 1930Depreciation 66

31 See Appendix for invested capital as of Mar-0930 Missing tax info for Jan and Mar, tax rate of FY-07/08 is used32 Including cash from second round of allotment to Tech Mahindra33 Base year calculated by recursive function in Excel, using calculated market value and current net debt34 Includes cash inflow from second round of allocation of 19.8cr shares @5835 Includes 19.8cr second round of allocation


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EBIT 298EBIT margin 12.99%

(Source Q3-2009 financials)

Operating expenses

Expense type Amount (Rs. Cr)Bench cost 120

Legal cost 108

B. EBIT margin without high Bench cost36, attributed to instability and slump in economy

Revenue 2294Operating expense 1930Depreciation 66Remove Bench cost (120)

EBIT 418EBIT margin 18.22%

C. Normalized EBIT margin without high Bench and Legal cost

Revenue 2294Operating expense 1930Depreciation 66Remove Bench cost (120)Remove Legal cost37 (62.12)

EBIT 480.12EBIT margin 20.93%

(Source Q3-2009 financials)

D. Synthetic rating for Satyam’s Debt

Total Net debt = 5775.6838-1521.4(total cash after second round of allotment)=4254.28

EBIT-next Year = 1868.52

36 Legal cost will continue to be high for next 2 years, until legal claims are settled37 Historically legal costs are 2% of revenue38 See Section on Total debt


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Net Capex required next year =220.42

Before-tax cash flow=1868.52-220.42=1648.10

Interest-coverage-ratio=1648.10/(4254.28*Interest-rate)

The above interest rate can be solved using excel against the default spreads corresponding to respective S&P credit ratings.

Implied spread over Indian risk free rate based on S&P ratings= ~2.5%

Credit rating = A

Indian risk free rate=3% (400bp is country risk premium leading to 7% 10 Yr yield)

Because Satyam gets 95% of its revenue39 from outside India (primarily developed economies), company’s risk drivers are least related to India-specific risk and hence, shouldn’t be punished by slapping a 400bp country risk premium for just operating out of India.

Cost of debt= 3+2.5=5.5%

E. Total Assets as of Mar-200940

Current Assets:

Account Receivables: 1324

39 Source 2007-08 financials40 Source Q3-2009 financials


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Account Receivables (past due 0-180): 587

Cash: 373

Fixed Assets: 1085

Investments at cost: 627

Total Assets: 3996

Current Liabilities: 815

Invested Capital = 3996-373-815 = 2808

F. Sensex Capital turnover41

Code Name Revenue Capital Cash Sales/Cap

500410 ACC Ltd. 80000.00 84925 9914 1.06651

500103 Bharat Heavy Electricals Ltd. 271440.00 307468 86209 1.226798

41 Latest financials from Reuters


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532454 Bharti Airtel Ltd. 270250.00 472643 54863 0.646872

532868 DLF Ltd. 100440.00 396191 21421 0.268004

500300 Grasim Industries Ltd. 188571.00 243871 5595 0.791397

500182 Hero Honda Motors Ltd. 125378.00 50735 1310 2.536732

500440 Hindalco Industries Ltd. 656252.00 761005 17168 0.882252

500696 Hindustan Unilever Ltd. 210592.00 86539 18373 3.089399

500209 Infosys Technologies Ltd. 216930.00 221630 112460 1.987084

500875 ITC Ltd. 168444.00 204562 13183 0.880159

532532 Jaiprakash Associates Ltd. 44067.00 207270 24621 0.241266

500510 Larsen & Toubro Limited 410718.00 568129 14397 0.741727

500520 Mahindra & Mahindra Ltd. 269198.00 319079 29675 0.930181

532500 Maruti Suzuki India Ltd. 217811.00 140616 19868 1.803848

532555 NTPC Ltd. 465082.00 935533 153605 0.594789

500312 ONGC Ltd. 1052567.00 1307376 186525 0.939078

532712 Reliance Communications Limited 222346.00 775891 24800 0.296031

500325 Reliance Industries Ltd. 1371470.00 1757672 44741 0.800657

500390 Reliance Infrastructure Ltd. 140554.00 347129 5552 0.411486

500900 Sterlite Industries (India) Ltd. 214484.00 393942 24535 0.580617

524715 Sun Pharmaceutical Industries Ltd. 44808.00 82634 16690 0.679486

532540 Tata Consultancy Services Limited 278129.00 226858 13440 1.303212

500570 Tata Motors Ltd. 717378.00 731595 41213 1.039103

500400 Tata Power Company Ltd. 181515.00 318464 11779 0.591861

500470 Tata Steel Ltd. 1475950.00 1216060 61483 1.278347

507685 Wipro Ltd. 259616.00 278866 54993 1.159657

Average 1.029483

G. Sensitivity Analysis

Because 7542% of Satyam’s value is attributed to Terminal value, any valuation will be incomplete without conducting sensitivity analysis43 on terminal parameters.

42 See section on DCF model


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Terminal Growth rate (%)

Term

inal

Exc

ess

Retu

rn (%

)

0 1 2 3 4

0 165.38 165.38 165.38 165.38 165.38

2 165.38 173.24 183.05 196.19 215.05

4 165.38 176.13 190.08 209.42 238.17

6 165.38 178.18 195.07 218.82 254.60

43 Sophisticated models will do sensitivity analysis in multidimensional space, changing more than 1 parameter simultaneously. For such models, contact author@ [email protected]


satyam post crisis valuation

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