Fianl Reportbizval

Business Valuation project report on DSP Merrill Lynch Limited

Prepared under the guidance of:

Prof. Asish K. Bhattacharyya

SUBMITTED BY: Group 1 Kamod Arora (208/42) Sameer (309/42) Srikar Adavi (335/42)

TABLE OF CONTENTS

Executive Summary Introduction to Financial Services Industry Introduction to DSP Merrill Lynch Industry Analysis Valuation by DCF / Equity method Market Multiples WACC Issues Faced and Assumptions made Key learnings

EXECUTIVE SUMMARY

Financial year 2005 witnessed one of the most exciting years for the Indian capital markets and DSP Merrill lynch ltd has been riding up a high tide in the merchant banking business. Total equity raisings for the year was over Rs. 580 bn, highest ever in the history of Indian Capital.

DSPML is one of the strongest investment banking houses in India. The company is focused mainly on the following institutional businesses 1.

2. 3. 4. 5.

Global markets & investment banking (Equity Issuance / Sales /Broking) Mergers & Acquisitions Fixed Income Global Private Client (GPC) Indirect Sales

Salient Features about the company 1. DSPML was at the forefront of the domestic and international Equity & Equity-linked offering league table for CY2005 and raised to the tune of US$ 6.1 bn 2. DSPML maintained its leadership position in the Institutional Segment of Equity Broking Business with the Equity Sales division scoring another record year. 3. DSP ML closed a path-breaking US$ 1 bn deal, the largest in the Indian cement sector, advising Holcim in its acquisition of 50% stake in ACC Ltd. Investment highlights 1. Compelling macro story India continues to remain one of the fastest growing economies in the world with an expected growth rate of 7-8% over the next few years and the same is reflected in investor confidence in the equity markets. 2. Deregulation in various sectors/industries in India

3. MF industry growth 4. Opportunities to further build on a strong franchise driven by: • Positive macroeconomic parameters • Continued emphasis on economic reforms Investment concerns 1. Highly volatile industry The company operates in the highly volatile equity markets, which relies heavily on the performance of the economy. India being heavily reliant on the agricultural sector makes it vulnerable to volatile economic performance. As a result company in this sector need to have diversification in revenues.

2. Competition Risk The risks to company performance stems from a significant competition in the Indian market, particularly from players seeking to establish themselves. The challenges of operating in such a highly competitive and volatile business environment could continue to pressurize margins. Considering the economic growth rate, the macro economic environment, the merger and acquisition activity in different industries, the positioning of DSP in investment banking industry, DSP Merrill lynch is poised for a good growth rate for the near foreseeable future The valuation of share by Equity DCF yields that current prevailing price of Rs 2143 is apt and capture the growth story of DSP Merrill lynch in the upcoming future.

THE FINANCIAL SERVICES INDUSTRY PROFILE INDUSTRY Capital formation is an important ingredient for economic development of any country. An efficient securities market provides the necessary channel for flow of resources from the providers of capital to the users of capital for economic development. Domestic savings and capital inflows (domestic and foreign) are channelised in the securities markets. The flow of resources in the securities market depends on the depth and efficiency of the markets, robust risk management system, attractiveness of securities and the ability of the users of capital to attract resources. In a post reform period in India, capital formation through securities market has become an important tool for achieving economic growth. The overall growth of the economy and economic activity are also important factors, which determine availability of resources. The following table outlines the growth of the economy and growth in savings. The increasing savings ratio presents an opportunity to divert the savings from traditional instruments to capital markets. FY02 5.8% 23.4%

Growth in GDP(%) Gross Domestic Savings as % of GDP (Source: Central Statistical Organisation)

FY03 4.0% 26.1%

FY04 8.5% 28.1%

The following table shows India’s economic growth in comparison to some of the developing countries Percent Change (annually) Growth in Real GDP 2000 2001 2002 2003 2004P 1996-2004 (Avg) World Advanced economies Emerging Market and developing Countries Of which: Argentina Brazil China India Indonesia Malaysia Mexico Pakistan Philippines Thailand

3.8 2.8

4.7 3.9

2.4 1.2

3 1.6

3.9 2.1

5 3.6

5

5.9

4

4.8

6.1

6.6

1.5 5.2 8.4 5.9 2.4 4.6 3.7 3.9 3.8 2.6

-0.8 4.4 8 5.4 4.9 8.9 6.6 3.4 4.4 4.8

-4.4 -10.9 1.3 1.9 7.5 8.3 3.9 5 3.5 3.7 0.3 4.1 -0.2 0.8 2.7 4.4 1.8 4.3 2.1 5.4

8.8 -0.2 9.1 7.2 4.1 5.3 1.3 6.2 4.7 6.8

7 4 9 6.4 4.8 6.5 4 6.3 5.2 6.2

Source: World Economic Outlook, September 2004, IMF nd

India has been the 2 fastest growing economy in the world over the last 8 years (1995-2003). The average growth during the period has been about 6% whereas China grew at 8% during the same period. The growth in the Indian economy until now (FY06) remains one of the fastest in the world. India would require massive capital investment in various sectors to sustain its growth. Securities market provide route for raising capital by bringing providers and utilisers of capital. Key participants in the Securities Market The securities market essentially has four types of participants viz. • • • •

Issuer of Securities Investors Financial Intermediaries; and Regulators

The Issuers and Investors are the consumers of services rendered by the intermediaries and the investors are consumers (they subscribe for / and trade in

securities) of securities issued by the Issuer as well. Those who deal in securities need an assurance that it is safe to do so and this reassurance is provided by the

3 4

laws framed in relation to the securities markets, which in turn are enforced by the regulator. The regulator exercises control over the market and market practices through rules, regulations and guidelines for market participants and intermediaries. Intermediaries play an important role in the securities market by providing a critical link between the various market participants. The efficiency of the market is often determined by the level of intermediation and efficacy of the regulatory framework. Segments of Securities Market The securities market comprises of two broad segments Primary markets Secondary markets Primary markets create a flow of new securities to the securities market. This is achieved through public offerings of debt or equity or a composite structure of debt and equity to the investors. Here the issuer of securities raises the funds to meet its fund requirements. Primary market offerings could either be in the form of public offerings or private placements. The issuers here could include corporates, Government, municipal corporations and in some cases existing shareholders and institutional investors offering their securities for sale. The product offerings by intermediaries in the primary markets include management of IPOs of issuers, mobilization of resources from retail and institutional investors, private placement of issues, debt syndications etc. Intermediaries in the primary market include merchant bankers, registrars and brokers. The following table indicates growth of primary markets over past five years (Rs. in mn.)

Corporate Sec. Domestic Issues Non-Govt Public cos. PSU Bonds Govt. cos Banks & FIs Pvt. Placement Euro Issues Govt. securities Central govt. State govt. Total

1998-99 601920 590440 50130

1999-00 724500 689630 51530

2000-01 783956 741986 48900

2001-02 744032 720612 56920

2002-03 752,411 718,147 18,777

2003-04 695,030 664,050 62,100

43520 496,790 11,480

25510 612590 34870

14720 678360 41970

3500 10700 649500 23420

29,890 669,480 34,264

1,000 38,800 592,150 30,980

10,60,670 939,530 121,140

1133360 996300 137060

1284830 1151830 133000

1525080 1338010 187070

1,819,790 1,511,260 308,530

1,981,570 1,476,360 505,210

798350

1857860

2068786

2269112

2,572,201

2,676,600

Source: ISMR 2003-04 Secondary markets provide a medium of exchange and enable investors to trade in the securities. An efficient securities market distinguishes financial investments from various forms of other illiquid investments. Stock Exchanges provide the platform and the mechanism for effecting transactions between different market participants. Secondary market comprises of trading in equities, bonds and derivatives. The depth of the market is determined by number of factors such as liquidity of the instruments traded, number of market participants, types of instruments traded, settlement practices etc. There are 23 exchanges in the country, which offer screen based trading system. The trading system is connected using the VSAT technology from over 357 cities. There were 9,368 trading members registered with SEBI as at end March 2004 The trading volumes on exchanges have been witnessing phenomenal growth over the past decade. The trading volume, which peaked at Rs. 28,809,900 million in 2000-01, fell substantially to Rs. 9,689,093 million in 2002-03. However, the year 2003-04 saw a turnaround in the total trading volumes on the exchanges. It registered a volume of Rs. 16,204,977 million. The turnover ratio, which reflects the volume of trading in relation to the size of the market, has been increased after the advent of screen based trading

35

system by the National Stock Exchange (NSE). NSE accounted for 85% of total turnover (volumes of all segments) in 2003-04 As can be seen from the following table, National Stock Exchange has seen consistent growth in volumes in India Growth of volume traded in Secondary Market (National Stock Exchange) Unit 1999-00 2000-01 2001-02 2002-03 2003-04 Capital Market Segment No of Trades 984 1676 1753 2398 3626 No in

2004-Jan 05 3780

Lak hs Traded Qty

242704

329536 624314

278408

364065

713301

No in Turnover No. of listed companies

Lak hs Rs Cr.

839,052 720

1,339,510 785

513,167 793

617,989 818

1,099,535 909

Jan’05) Wholesale Debt Market Segment No of Trades No. Net Traded Value Rs Cr.

64,470

144,851 107,666 428,581.51 947,191.2 1,068,701

46,987 304,216.

24 4 Futures & Options Segment No of Contracts No. Turnover Rs Cr. Source: www.nseindia.com

90580 2365

167,778 1,316,09 6.2 2

4196873 16768909 101925

189,518

439863 2,248,135

759892.9 0 .54

56886776 69322301 2,130,612

Market Participants The Indian securities market is characterised by different players in the various product segments. The IPO market in India consists of merchant bankers, which help issuers in bringing companies to the market. In India this product is offered by domestic as well as foreign players. Foreign players have typically helped corporates access foreign capital The issues are distributed to the retail investors through a vast network of brokers across the length and breadth of the country. These brokers act as a distribution link between the ultimate investor and the issuers. Another set of participants in the primary markets are the registrar and transfer agents who manage the entire process of applications, refunds, allotments etc in an issue and the maintenance of records of transfer of shares. The secondary market is also characterised by brokers who are members of the stock exchanges. This space is also represented by domestic as well as foreign brokers. The last few years have seen a consolidation in the industry

927027 958 (as on

since capital requirements and technology are becoming key differentiators. The following table outlines the market share of top brokers over the years. As can be seen, the larger brokers have increased their market share. For e.g. market share of top 100 brokers has progressively increased from 47% in FY99 to 65% in March 2004. Percentage of market Share of Top brokers (NSE) Brokers 5 10 25 50

100

2003-2004

12

17

30

44

61

2002-2003

10

16

29

42

59

2001-2002

7

12

24

36

53

2000-2001

8

13

23

34

49

1999-2000

8

13

23

34

50

3 6

1998-1999

8

12

21

32

47

Source: www.nseindia.com Mutual Fund Industry: (Source: AMFI) The mutual fund industry has shown a considerable growth over last few years with the total assets under management growing from Rs 79,464 crores in as on March 31, 2003 to Rs 139,616 crores as on March 31, 2004 and to Rs.152,280 crores as on January 31, 2005. The year also saw a consolidation of business in favour of the private sector mutual funds with their assets under management growing from Rs 104,992 crores as on March 31, 2004 to Rs. 120,028 crore as on January 31, 2005. Most of the funds that dominate the sector are open ended funds. The mutual fund sector can broadly be divided based on the nature of the schemes launched by the mutual funds. The fixed income segment, which comprises of income, liquid, gilt and money market schemes have major share in the total corpus of the industry. The other two categories of funds comprising of equity and balanced schemes have shown a good growth in FY04 on account of buoyant stock market. Assets under Management

(Rs in Crores) FY02 55788 13852 16954 8069 5931

Income Growth Balanced Liquid/ Money Market Gilt & Others Total (source : AMFI monthly)

FY03 47564 9887 3141 13734 5138

100594

79464

FY04 62524 23613 4080 41704 7695

As on 31/01/05 48490 31834 5454 60028 6474

139616

152280

In the recent past, there have been steps taken to ensure good governance practices in the industry which has helped in the healthy growth of the industry consequently distribution of mutual fund products has seen healthy growth in the recent past. Foreign Institutional Investors (FII) inflows: (source : SEBI website) FIIs play crucial role in determination of market sentiments and price trends. FII activity has shown considerable interest in Indian investment story and is viewed favourably by them. The FII registration with SEBI has increased from 502 in 2002-03 to 657 as on February, 2005. FII investments have gone up considerably in recent years. The table depicts investment by FIIs over past few years. FII investment in India Year

(Rs. in crores) Investments

2004-05

45038.80

2003-04

39745.10

2002-03

2526.90

2001-02

8072.50

2000-01

10120.20

INTERNATIONAL SCENARIO: Stock markets worldwide have grown in size as well as depth over the last onedecade. At the end of 2003, Standard and Poor (S&P) ranked India 17th in terms of market capitalization (19th in 2002), 16th in terms of total value traded in stock

exchanges (17th in 2002) and 6th in terms of turnover ratio (7th in 2002) India has the number one ranking in terms of listed securities on the Exchanges followed by the USA. 3 7

The turnover on all markets taken together has grown from US$5.5 trillion in 1990 to US$29.6 trillion in 2003 (US$38 trillion in 2002). It is significant to note that US alone accounted for about 52.4% of worldwide turnover in 2003. Despite having a large number of companies listed on Stock Exchange, India accounted for a meager 0.96% in total turnover in 2003. It can also be noticed that Developed markets accounted for 90.23% of turnover in 2003 (93.52% in 2002) while emerging markets comprising developing nations accounted for roughly 9.77% of turnover in 2003 (6.47% in 2002). Market Capitalisation ratio and Turnover ratio: end December 2003: Singapo Particulars USA UK Japan Germany re No. of Listed 5,295 2311 3,116 684 475 Companies Market Capitalisation 14,266 2,412 3,041 1,079 145 ($Bn.) Market 57.5 139.8 159.7 70.3 168.4 Capitalisation Ratio (%) Turnover ($ Mn.) 15,547 2,151 2,273 1,147 88 Turnover ratio 122.8 100.6 88.0 130.0 71.1 (%)

Hong Kong

China

India

1,029

1,296

5,644

715

681

279

426.4

55.2

56.4

332

477

285

56.3

83.3

138.5

(Source: S&P Emerging Stock Market Fact book, 2004, Reproduced from: NSE Indian Securities Market Review 2004) The market capitalisation of all listed companies taken together on all markets stood at US$31 trillion in 2003 (US$23 trillion in 2002). The share of US in worldwide market capitalisation decreased from 47.24% as at end – 2002 to 44.66% in end – 2003 while Indian listed companies accounted for 0.87% of total market capitalization in 2003. Performance of Indices on Indian and Foreign Markets Index 31.03.2002 31.03.2003 31.03.2004 S&P CNX Nifty 1129.55 978.2 1771.9 BSE Sensex 3469.35 3048.72 5590.6 Hang Seng 11032.92 8634.45 12681.67 Dow Jones 10403.94 7992.13 10381.7 Nasdaq 1845.35 1341.17 2000.63 Nikkei 11024.94 7972.71 11715.39 FTSE 5271.8 3613.3 4417.5 * Figures as on 30.12.2004 (source : Bloomberg)

31.12.2004 2080.5 6602.69 1854.06 10783.01 2175.44 11488.76* 4814.3

05.04.2005 2063.4 6604.42 1789.75 10421.14 1991.07 11667.54 4896.7

MAJOR DEVELOPMENTS IN SECURITIES MARKET POST 1990’s The reforms in the capital markets during the 1990s in terms of market microstructure and transactions have ensured that the Indian capital market in particular is now comparable to the capital markets in most developed markets. The early 1990s saw a greater willingness of the saver to place funds in capital market instruments, on the supply side as well as an enthusiasm of corporate entities to take recourse to capital market instruments on the demand side. The size of the capital market is now comparable to other developing countries but there is still a long way to go. It is important to note that developed economies with bank-based systems, such as Germany and Japan, also have capital markets with substantial market capitalisation in relation to GDP Capitalisation of Stock Markets (Percentage of GDP) Economy 1990 1999 Japan 98 105 Germany 22 68 UK 86 203

38

USA 53 Indonesia 7 Malaysia 110 Thailand 28 India 12 Source: World Development Indicators, 2001.

182 45 184 47 41

Some of the major reforms/changes in securities market since 1990 include 1) SEBI Act, 1992 replacing Capital Issues (Control) Act, 1947: As a part of liberalisation process, Capital Issues (Control) Act, 1947 was repealed in 1992 paving a way for (SEBI Act, 1992) market-determined allocation of resources. Under the new Act, issuers complying with eligibility criteria were allowed freedom to issue securities at market-determined rates. SEBI exercises control over the market through issuance of guidelines and rules for various capital market activities and through regulations for intermediaries and stock exchanges. 2) Screen Based Trading: The trading on stock exchanges in India used to take place through open outcry without use of information technology for immediate matching or recording of trades. In order to provide efficiency, liquidity and transparency, NSE introduced a nation-wide on-line fully automated screen based trading system (NEAT). The Stock Exchange, Mumbai has also introduced nation-wide screen based trading system (BOLT). Introduction of these trading systems is one of the key developments, which has transformed Indian capital markets in different league. 3) Trading Cycle: The trades were accumulated over a trading cycle and at the end of the cycle, these were clubbed together, and positions were netted out and payment of cash and delivery of securities settled the balance. This trading cycle varied from 14 days for specified securities to 30 days for others and settlement took another fortnight. Often this cycle was not adhered to. There were several occasions of defaults and risks in settlement. In order to reduce large open positions, the trading cycle was reduced over a period of time to a week. The exchanges, however, continued to have different weekly trading cycles, which enabled shifting of positions from one exchange to another. Rolling settlement on T+5 basis was introduced in respect of specified scrips reducing the trading cycle to one day. It was made mandatory for all exchanges to follow a uniform weekly trading cycle in respect of scrips not under rolling settlement. All scrips moved to rolling settlement from December 2001. The settlement period has been reduced progressively from T+5 to T+3 days. Currently T+2 day settlement cycle is being followed. 5) Derivatives Trading: To assist market participants to manage risks better through hedging, speculation and arbitrage, SCRA was amended in 1995 to lift the three decade old ban on options in securities. The SCRA was amended further in December 1999 to expand the definition of securities to include derivatives so that the whole regulatory framework governing trading of securities could apply to trading of derivatives also. In the meanwhile exchanges developed adequate infrastructure and the information systems required to implement trading discipline in derivative instruments. Derivative trading took off in June 2000 on NSE and BSE only. The market presently offers index futures and index options on three indices and stock options and stock futures on individual stocks (presently 51 stocks on NSE) and futures in interest rate products like notional 91-day T-bills and notional 10-year bonds. 6) Demutualisation (Segregation of ownership from management): Historically, brokers owned, controlled and managed stock exchanges. Government proposed in March 2001 to corporatise the stock exchanges by which ownership, management and trading membership would be segregated from one another. Few exchanges have already initiated demutualisation process. Government has offered a variety of tax incentives to facilitate corporatisation and demutualisation of stock exchanges. NSE adopted a demutualised governance structure where ownership, management and trading are with three different sets of people. This completely eliminates any conflict of interest and helped it to aggressively pursue policies. 7) Investors Protection: The SEBI Act established SEBI with the primary objective of protecting the interests of investors in securities and empowers it to achieve this objective. SEBI specifies that the critical data should be disclosed in the specified formats regarding all the concerned market participants. The Central Government has established a fund called Investor Education and Protection Fund (IEPF) in October 2001 for the

39

promotion of awareness amongst investors and protection of the interest of investors. Department of Economic Affairs (DEA), Department of Company Affairs (DCA), the SEBI and the stock exchanges have set up investor grievance cells for redressal of investor grievance. The exchanges maintain investor protection funds to take care of investor claims. In January 2003, SEBI launched a nation-wide Securities Market Awareness Campaign that aims at educating investors about the risks associated with the market as well as the rights and obligations of investors. 8) Depositories Act: Settlement system on Indian stock exchanges gave rise to settlement risk due to the time that elapsed before trades were settled. Trades were settled by physical movement of paper. The process of physically moving the securities among different parties involved, took time with the risk of delay somewhere along the chain. Significant proportion of transactions ended up as bad delivery due to faulty compliance of paperwork. This added to costs, and delays in settlement, restricted liquidity and made investor grievance redressal time consuming and at times intractable. To obviate these problems, the Depositories Act, 1996 was passed. At the end of March 2004, number of companies connected to NSDL and CDSL were 5,212 and 4,720 respectively. The number of demat securities increased to 97.7 billion at the end of March 2004 from 76.9 billion as of end March 2003. As on the same date, the value of dematerialsied securities was Rs. 10,701 billion and the number of investor accounts was 5,832,552. All actively traded scrips are held, traded and settled in demat form. Demat settlement accounts accounted for over 99% of turnover settled by delivery. This has almost eliminated the bad deliveries and associated problems. To prevent physical certificates from coming into circulation, it has been made mandatory for all new IPOs to be compulsorily traded in dematerialised form. The admission to a depository for dematerialisation of securities has been made a pre-requisite for making a public or rights issue or an offer for sale. 9) Globalization: Indian securities market is getting increasingly integrated with the rest of the world. Indian companies have been permitted to raise resources from abroad through issue of ADRs, GDRs, FCCBs and ECBs. ADRs/GDRs have two-way fungibility. The two-way fungibility for ADRs/GDRs has been permitted by RBI, which meant that the investors (foreign institutional or domestic) in any company that has issued ADRs/ GDRs can freely convert the ADRs/GDRs into underlying domestic shares. They could also reconvert the domestic shares into ADRs/GDRs, depending on the direction of price change in the stock. This is expected to bring about an improvement in the liquidity in ADR/GDR market and elimination of arbitrage opportunity. This will better align ADR/GDR prices and domestic share prices of companies that have floated ADRs/GDRs. (Source: Information provided in this section is based on various industry reports such as Indian Securities Market Review 2003, AMFI Monthly reports, Statistical data taken from the websites of BSE, NSE, RBI and CSO. Such information while relied upon by the Company as true, has not been independently verified. Data/ information may have been reclassified for the purpose of presentation)

40

KEY INDUSTRY REGULATION The Company’s key activities are broking, merchant banking, underwriting and portfolio management services. The Company’s primary business is in relation to the securities markets. The Securities and Exchange Board of India Act, 1992 The main legislation governing the activities in relation to the securities markets is the Securities and Exchange Board of India Act, 1992 (the “SEBI Act”) and the rules, regulations and notifications framed thereunder. The SEBI Act was enacted to provide for the establishment of SEBI whose function is to protect the interests of investors and to promote the development of, and to regulate the securities market, and for matters connected therewith and incidental thereto. The SEBI Act regulates functioning of SEBI and enumerates its powers. The SEBI Act also provides for the registration and regulation of the function of various market intermediaries like the stock-brokers, merchant bankers, portfolio managers, etc. Pursuant to the SEBI Act, SEBI has formulated various rules and regulations to govern the functions and working of these intermediaries. SEBI also issues various circulars, notifications and guidelines from time to time in accordance with the powers vested with it under the SEBI Act.

In addition to the SEBI Act, the key activities of the Company are also governed by the following rules, regulations, notifications and circulars: Broking The stock broking activities of the Company are regulated by the SEBI (Stock-Brokers and Sub-Brokers) Rules, 1992 and the SEBI (Stock-Brokers and Sub-Brokers) Regulations, 1992. These rules and regulations govern the registration and functioning of stock-brokers, sub-brokers and the trading members of derivatives exchanges or the derivatives segment of a stock exchange. The regulations prescribe the criteria, standards and the procedure for registration of stock-brokers, sub-brokers and persons seeking to be trading members of a derivatives exchange or the derivatives segment of a stock exchange. The intermediaries are required to abide by a code of conduct prescribed by these regulations. The penalties for failure to comply with the regulations are also laid down. SEBI has the authority to inspect the books of accounts of the intermediaries and take such appropriate action as it deems fit after giving an opportunity for hearing. The Company also provides margin trading facilities to its clients. The Company also is a trading member on the derivatives segments of the NSE and the BSE. Margin Trading and derivatives trading are regulated by SEBI by various circulars which have been issued from time to time. Merchant Banking The Company is registered as a Category I Merchant banker with SEBI. The merchant banking activities of the Company are regulated by the (Merchant Bankers) Rules, 1992 and the SEBI (Merchant Bankers) Regulations, 1992. For carrying on the activities as a merchant banker, a person has to be registered in any one of the categories prescribed under the regulations. The registration in any one particular category determines the actions and functions that the merchant banker can carry on. One of the criteria for eligibility as a merchant banker is a capital adequacy requirement based on the category of registration. There are also restrictions on the appointment of lead managers and responsibilities prescribed in the regulations. The merchant bankers are also required to abide by a code of conduct prescribed by these regulations. The penalties for failure to comply with the regulations are laid down in the regulations. SEBI has the authority to inspect the books of accounts and take such action as it deems fit after giving an opportunity for hearing. Underwriting Being registered as an underwriter, the underwriting activities of the Company are regulated by the SEBI (Underwriters) Rules, 1993 and the SEBI (Underwriters) Regulations, 1993 (the “Underwriters Regulations”). The Underwriting Regulations regulate the registration and functioning of underwriters. It prescribes the criteria, standards and the procedure for registration as underwriters, including a capital adequacy requirement. Further, the duties and responsibilities of the underwriters are prescribed in the Underwriting Regulations. The underwriter is required to enter into an agreement with the client providing details including inter alia the duration, the amount underwritten, commission or brokerage payable etc. A code of conduct to be followed by the underwriters is also prescribed. It also

lays down liabilities and the

41

penalties for failure to comply with the regulations. The SEBI has the authority to inspect the books of accounts of the intermediaries and take such action as it deems fit after giving an opportunity for hearing. Portfolio Management The portfolio management activities of the Company are regulated by the SEBI (Portfolio Managers) Rules, 1992 and SEBI (Portfolio Managers) Regulations, 1993 (the "Portfolio Manager Regulations”). The Portfolio Manager Regulations regulates the registration and functioning of portfolio managers. It prescribes the criteria, standards and the procedure for registration as portfolio managers. In addition to qualifications, experience of personnel etc the portfolio manager regulations also mandates a stipulated capital adequacy requirement of Rs. 50 lakhs. Further, the duties and responsibilities of the portfolio manager are prescribed, along with the code of conduct and the measures to be adopted during inter-se dealings with clients. It also lays down liabilities and the penalties for failure to comply with the regulations. The SEBI has the authority to inspect the books of accounts of the intermediaries and take appropriate action if it deems fit after giving an opportunity for hearing. Other Regulations The Company is governed by the provisions of the SEBI (Prohibition of Insider Trading) Regulations, 1992. The regulations prohibit the dealing by any person or company in securities of any other company when in possession of unpublished price sensitive information of such company. SEBI is empowered to inspect, investigate the books of accounts or other documents of an insider and pass appropriate directions, where it deems fit. The regulations also prescribe a model code of conduct to be followed by all companies and organisations associated with the securities markets. Further, the regulations mandate a disclosure, of the number of shares or voting rights held by any person who holds in excess of 5% of the shares or voting rights of a listed company. Any change in the aforementioned shareholding / voting rights must be intimated to the SEBI. In addition to the aforementioned regulations, the criteria for determination of whether an entity can be registered under any of the above regulations are governed by the SEBI (Criteria for Fit and Proper Person) Regulations, 2004. The Company is also required, as an intermediary, to be registered under the SEBI (Central Database of Market Participants) Regulations, 2003. In addition, the Company is also regulated by the rules and regulations framed by the Association of Mutual Funds in India (AMFI). Stock Exchange Rules, Regulations and Bye-laws Further, the Company is also regulated by the rules, regulation and by-laws of the stock exchanges where it is registered as a trading member. Hence it is also governed by the rules, regulations and by-laws of the NSE, the BSE and the Delhi Stock Exchange (DSE), the stock exchanges on which it is a trading member.

42

Indian financial services Sector: Functional Classification 1.

Investment Banking a. Underwriting i. Capital/Debt Issuance, FCCB etc b. Trading / Dealership i. Capital markets ii. Debt markets c. Mergers & Acquisitions

2.

Financial Services a. Retail / Corporate advisory b. brokerage services c. financial advisory

3.

Insurance a. Life Insurance b. Non Life Insurance

4.

Asset Management and Mutual funds

5.

Non Banking Financial Services Firm a. b.

Project finance Loan and Credit

Market Players in India Investment Banking / Underwriting / Capital Markets

Merger and Acquisitions

Asset Management Companies/ Wealth Management / Mutual Funds

1.

DSP Merrill Lynch ltd

1.

DSP Merrill Lynch ltd

1. Prudential ICICI Mutual Fund

2.

JM Morgan Stanley ltd

2.

JM Morgan Stanley ltd

2. UTI Mutual Fund

3.

Kotak Mahindra Capital Company Ltd

3.

Kotak Mahindra Capital Company Ltd

3. Reliance Mutual Fund

4.

SBI Capital Markets ltd

4.

SBI Capital Markets ltd

4. HDFC Mutual Fund

5.

ICICI Securities ltd

5.

ICICI Securities ltd

6.

UTI Securities ltd

6.

Rabo India Finance

5. Franklin Templeton Mutual Fund 6. Birla Sun Life Mutual Fund

7.

BOB Capital Markets ltd

7.

7. SBI Mutual Fund

8.

Allianz Securities ltd.

8.

HSBC Securities & Capital Markets (India) Pvt. Ltd. PricewaterhouseCoopers Ltd.

9.

Edelweiss Capital Ltd.

9.

Ernst & Young

9. DSP Merrill Lynch Mutual Fund

8. Tata Mutual Fund

10. Karvy Investor Services Ltd

10. Ambit Corporate Finance Pte. ltd

10. HSBC Mutual Fund

11. Centrum Capital Ltd.

11. KPMG Corporate Finance

11. Kotak Mahindra Mutual Fund

12. HSBC Securities & Capital Markets (India) Pvt. Ltd.

12. JP Morgan

12. PRINCIPAL Mutual Fund

13. ENAM Financial Consultants Private Ltd.

13. Citigroup (previously Salomon Smith Barney India Pvt. Ltd)

13. Standard Chartered Mutual Fund

14. IL&FS Investsmart Ltd.

14. McKinsey & Co.

14. LIC Mutual Fund

15. SSKI Corporate Finance Pvt. Ltd.

15. ING Vysya Investment Banking

15. Deutsche Mutual Fund

16. Allianz Securities Ltd.

16. Lazard India

17. Edelweiss Capital Ltd.

17. Deloitte

16. Sundaram BNP Paribas Mutual Fund 17. Fidelity Mutual Fund

Retail Financial Services 1.

IL & FS Investsmart ltd

Debt Market- Primary Dealers 1. IDBI Capital Market Services Ltd

2.

Indiabulls finance ltd

2.

SBI Gilts

2. IDBI

3.

Kotak Mahindra Securities ltd

3.

Gilt Securities Trading Corporation Ltd

3.

4.

India Infoline ltd

4.

PNB Gilts

5.

Geojit financial services ltd ICICI Brokerage Services ltd LKP Securities ltd

6. 7.

Non Banking Financial firms 1. IDFC

Research: About DSP Merrill Lynch Limited (DSPML) DSPML is a leading financial service provider in India. It is an alliance between DSP Financial Consultants Limited, and Merrill Lynch and Co, the leading international capital raising, financial management and advisory company. DSPML is the leading underwriter and broker for debt and equity securities and a leading advisor to corporations and institutions. It is among the first firms to set up a full-fledged research team in India. The Company is among the major players in the debt and equity markets and is also a primary dealer of Government Securities. Understanding the Business model of DSP ML: The company has two reportable business segments namely 1) Advisory and Transactional services and consist of Merchant Banking, Broking and Distribution of Securities, thereby earning transaction based fees. 2) Trading segment consists of earnings from trading in Securities (including equity/debt derivatives). The Company is mainly into following four business areas 1.

Investment banking a. Equity Issuance b. Debt Issuance

2.

Primary Dealership a. Underwriting G-Sec

3.

Merger and Acquisitions

4.

Mutual funds (through DSPML Fund Managers ltd)

1) Investment Banking DSPML is India's leading full service Investment Bank with leadership in providing financial and advisory services to a prestigious client base including India's leading corporates, state governments, foreign institutional investors, public and private sector companies and banks. 2) Primary Dealership DSPML is an accredited primary dealer with the Reserve Bank of India and a leading trader in the Fixed Income market comprising of Government Securities / Treasury bills and Interest Rate Swaps. We maintain a leadership position in the secondary market. As a primary dealer we regularly quote bid / offer rates in both cash and derivative products as per our clients requirements. Central Government Dated Securities • These dated securities are issued by the Government of India with a maturity period of more than a year. Treasury Bills • These are discounted securities issued by the Central Government of India through the auction route. The following maturity T-Bills are available: Duration

o o o

91 Day 182 Day 364 Day

State Government Securities • These are loans issued by State Governments in the country Interest Rate Swaps • Fixed to floating swaps upto 5 year maturity are traded actively amongs banks and Primary Dealers o Overnite Mibor o MIFOR (forward implied rupee rate) o INBMK (Govt security yield based benchmark 3) Merger and Acquisitions DSP Merrill Lynch Limited is one of the India's leading investment bank in the M&A space. It has been It topped the Bloomberg 2005 Mergers & Acquisitions (M&A) Financial Advisory League Tables (representing publicly disclosed transactions announced between January 1, 2005 - June 30, 2005). DSPML has been ranked No 1 with a market share of 19.4%, advising altogether nine deals valued at US$ 1,400 million USD, followed by Citigroup with a market share of 13.8 %, with three deals to its credit valued at US$ 998 million and ICICI Securities with a market share of 8.1%, with nine deals valued at US$ 589 million. Rank 2005

Advisor

Number of Deals

Value of deals US $ mn.

1

DSP Merrill Lynch

9

1400

2

Citigroup

3

998

3

ICICI Securities Ltd

9

589

4

PricewaterhouseCoopers Ltd.

11

463

5

UBS

2

347

6

Kotak Mahindra Capital Company Limited

3

334

7

JP Morgan

2

323

8

Ernst & Young

21

267

9

Standard Chartered PLC

2

240

10

Ambit Corporate Finance Pte.Ltd.

10

173

Some of the deals closed by DSP Merrill Lynch during this period were Sr. No.

Acquirer/PE Fund

Target

Type of Acquisition

Date Announced

1

Holcim Ltd

Ambuja Cement India Ltd

Acquisition

20-Jan-05

2

Holcim Ltd

Associated Cement Cos. Ltd

Open Offer

20-Jan-05

3

Holcim Ltd

Ambuja Cement Eastern Ltd

Acquisition

20-Jan-05

4

IDBI

IDBI Bank Ltd

Merger

20-Jan-05

5

Indian Express Newspapers Ltd

Mid Day Multimedia

Acquisition

03-Mar-05

6

Xerox Corporation

Xerox Modicorp Ltd

Open Offer

27-Dec-04

7

Reliance Industries Ltd

Reliance Industries Ltd

Buyback

28-Dec-04

8

Tata Motors Ltd

Hispano Carocera

Acquisition

25-Feb-05

9

Tractors & Farm Equipments Tractor Unit of Eicher Motors Acquisition Ltd Ltd

10

Caterpillar Commercial SA

Hindustan Powerplus Ltd

Delisting Offer

15-Apr-05

4) Mutual funds DSPML is one of the leading distributors of quality mutual fund schemes in the country. Depending n client objectives, we provide our clients access to a variety of mutual fund schemes offered by various asset management houses. Category

Investment Objective

Investment Pattern

Income Funds

To generate attractive return from a portfolio comprising fixed income and money market securities

Corporate Debt, Institutional/PSU Bonds, Money Market Securities

Equity Funds

To generate long term capital appreciation from a portfolio comprising equity and equity-related securities

Equity and Equity-related securities

Balanced Funds

To generate long term capital appreciation and current income from a portfolio comprising equity as well as fixed income securities

Mix of fixed income and equity & equity related securities

Fixed Income Funds a)DSP Merrill Lynch Liquidity Fund This is an open-ended income scheme seeking to generate a reasonable return commensurate with low risk and a high degree of liquidity from a portfolio constituted of money market securities and a high-quality debt securities. b)DSP Merrill Lynch Short Term Fund This is an open-ended income scheme seeking to generate income commensurate with prudent risk, from a portfolio constituting of money market securities, floating rate debt securities and debt securities. c)DSP Merrill Lynch Floating Rate Fund This is an open-ended income scheme seeking to generate income commensurate with prudent risk from a portfolio substantially constituted of floating rate debt securities and fixed rate debt securities swapped for floating rate returns. The scheme may also invest in fixed rate debt securities and money market securities. d)DSP Merrill Lynch Bond Fund This is an open-ended income scheme seeking to generate an attractive return, consistent with prudent risk from a portfolio substantially constituted of high-quality debt securities of issuers domiciled in India.

INDUSTRY ANALYSIS

Level 1 analysis: FINANCIAL SERVICES INDUSTRY ANALYSIS

Definition of the industry: We limit the definition of the industry to “Indian Financial Services Industry, specially , but not limited to Trading and Advisory services”.

Porters 5 force Analysis: We use the porters 5 force analysis to understand how the industry is doing and try to forecast these five forces for the next 10 year horizon.

Industry Drivers: Drivers are defined as those which create new demand, change the existing demand or create a new way of satisfying the existing demand. These are the drivers for financial services industry in a country. Financial Services Industry in general:      

Maturity of Corporates in the country. Maturity of Stock markets. Robustness of economy. Political stability in a country. Presence of Sunrise industries Internationalization, MNC activity.

Brokerage Service (specific drivers) 1. 2.

Average daily trading volumes Retail interest in equity market

Average daily trading volumes at the NSE have risen from Rs 2,400 crore to Rs 4,500 crore in the last two years.

Investment banking (specific drivers) 1. 2. 3. 4.

No of Equity IPO’s Quantum of money raised No of cross border M&A FCCB issuances

Over the past two years, stockmarkets have risen by 56 per cent. In this period, there have been 70 equity IPOs, which have raised close to Rs 50,000 crore. The quantum of cross-border M&As, a chief attraction for foreign investment bankers, rose from about $5 billion in 2004 to $6.5 billion in the first 10 months of 2005, according to accounting firm Grant Thornton. Then, there are the lucrative foreign currency convertible borrowings (FCCB) by corporates, which have boosted fee incomes. The amount of FCCB issues till November this year was $6.13 million, as against $4.76 million in 2004.

CHANGE IN INDUSTRY FORCES FROM 2005 TO 2015 PORTER’S 5 FORCES

In 2005

In 2015

Threat of New entrants Supplier Power Customer power

Low Medium Low

High Low Medium

Threat of Substitutes

Low

Medium

Industry Rivalry

Medium

High

PORTER’S 5 FORCE ANALYSIS FOR 2005 Threat of New entrants: LOW   

Established players like DSP ML, Kotak etc. High need for brand credibility. Hence deterrent for new entrants. Capital requirements make entry very hard. Possibility of onset of Global investment banks through Joint ventures.

Supplier Power: MEDIUM  

Suppliers in this industry are the parties supplying capital to the Brokerage firm in order to raise money for its clients. The need for earning premium on capital invested, and limited investment avenues makes the suppliers if capital increasingly dependent.

Customer Power: LOW

 

Limited number of trustworthy advisory and brokerage firms makes the customers dependant of the firms. Abstruseness of financial technicalities vest the power in Advisory firms.

Threat of Substitutes: MEDIUM   

Unlike US markets, in India, the investment avenues are not stock markets alone. Hence the dependence on Advisory services of large I banks is still nascent. Lack of large investment banking firms that can serve the needs of large Indian corporates. Brokerage service being offered by large number of players.

Rivalry: MEDIUM  

Among established players, winning the deal comes down to personal relationships and track records. No objective basis for clients to choose one over the other, as most clients donot understand the intricacies of financial products/services. Hence resort to brand names.

PORTER’S 5 FORCE ANALYSIS FOR 2015:

Threat of New entrants: HIGH  

Internationalization of Indian corporates and onslaught of foreign I banks in to India. Early signs through back offices being established.

Supplier Power: LOW

 

Most financial services/ideas can be easily replicated by other big companies. Hence little scope for differentiation. Greater choice of brand name firms for the client.

Customer Power: MEDIUM   

Customer power will increase because of increased choice of the firms. Globalization means increased/innovative avenues to raise capital from. Need not always be through I Bank services. Increasingly educated customers, means more demanding.

Threat of Substitutes: MEDIUM

 

Due to greater choice of avenues to raise funding from Innovative services to rasie capital etc.

Rivalry: HIGH 

Due to increased competition among big firms.

Thus we observe that almost all 5 forces deteriorate by 2015. This signals a dip in profitability of the industry and need for a strategic positioning of the firm if it has to be profitable. Level 2 analysis: DSP ML BUSINESS STRATEGY: Most of the services offered by DSP ML are highly dependent on the state of the economy and hence are subjected to an inherent risk. As a prudent strategy, DSP ML has been involving itself in a wide range of services which can hedge its revenues from economic downturns. For example, investment banking a cyclical industry with revenues driven solely by the number of underwriting deals, which in turn go down if the economy, goes down. When it comes to M& A deals the correlation is slightly lesser, in that a downturn in economy also entails some M& A activity. Extending this argument to DSP ML‘s presence in Mutual funds, equity management, forays in to wealth management, makes it an all weather firm with its revenues suitably hedged. Second important benefit accrued is the “ECONOMY OF SCOPE”. In a knowledge driven industry like financial services, an expertise cultivated in one area will aid expertise and lend credibility in adjacent areas. A brand name built in one service comes to aid in all the other financial services offered. Also, the primary input in this industry is Human Capital and larger number of services only adds to the skill development and multitasking of the employees. They now become a redeployable assets. STRUCTURAL POSITIONING OF DSP ML WITIHIN THE INDUSTRY: As learnt from Industry Competitive Analysis course, a company which has the right structural positioning within an industry will always make profits, even though the industry a whole is doing badly. The key factor is the ‘mobility barriers’ or the ‘Economic Moats’ that are set around the company which helps in it making profits. We now set out to identify the structural positioning of DSP ML in the financial services industry and see evaluate its Mobility Barriers. 1) Brand Name: DSP ML is a trusted brand name in Indian corporate world and it has been built over time. It is important to note that building credibility and trust in financial services industry is the biggest entry barrier for a new entrant.

2) Evolving Services and Positioning of DSP ML: A) Onset of Cross border M&A services: The quantum of cross-border M&As, rose from about $5 billion in 2004 to $6.5 billion in the first 10 months of 2005, according to accounting firm Grant Thornton. This is a chief attraction for foreign investment bankers because of the huge profits involved. DSP ML with its association with ML the bulge bracket international player is positioned to capture the market. B) Moving up the value chain: As Indian corporates and stock markets mature, there will be increasing need for High-end, customized services like a) New structured products for the corporate advisory business b) Advisory services for companies about the assets side of their balance sheets, apart from advising them on raising capital and buying stakes c) Asset management business and commodities foray.( to be able to advise companies on hedging commodities risk on their balance sheets) DSP ML has already started customized structuring of products for corporates and has proclaimed through management discussions on its intentions to expand Value Added high end services. The quest to move away from a simple brokerage to a high end services was proclaimed time and again through market statements and MDA.

3) Quest for differentiation and Internationalization: there is little need for Differentiation for DSP ML in the current competitive scenario. The only area with tough competition is low end brokerage services where India bulls, Geojit and other new players are competing. But with its proclaimed intent of moving up the value chain, we see little cause for concern and need for immediate differentiation. Thus it can be concluded that DSP ML as a stand alone firm is Structurally well positioned to take up the challenges caused by deteriorating industry structure. However many conclusions above were based on strategic intent of management rather than hard facts.

Challenges faced during valuation of DSP Merrill Lynch Ltd DSPML is an investing banking firm in financial services domain. Banks, insurance companies and other financial service firms pose a particular challenge for an analyst attempting to value them for two reasons. The first is the nature of their businesses makes it difficult to define both debt and reinvestments, making the estimation of cash flows much more difficult. The other is that they tend to be heavily regulated, and the effects of regulatory requirements on value have to be considered. 1.

Which cash flows discounting method to be used? While working we realized that equity cash flows discounting method is suited for valuation of a financial services firm instead of free cash flows or capital cash flows. Some of the reasons involved are a.

Frequent fluctuations in debt / capital employed / invested capital

b.

Regulatory requirement in net-worth for merchant banking and primary dealership in Government Securities i. One of the criteria for eligibility as a merchant banker is a capital adequacy requirement based on the category of registration ii. Primary dealers have to maintain a maintain capital to risk weighted assets ratios in excess of the minimum requirement of 15 per cent.

It makes far more sense to value equity directly at financial service firms, rather than the entire firm. 2.

What is so unique / difficult about financial service firms? The following aspects of financial service firms that make them different from other firms a.

Debt: Raw Material or Source of Capital

b.

The Regulatory Overlay

c.

Reinvestment at Financial Service Firms

Consider two items in reinvestment – net capital expenditures and working capital. Unfortunately, measuring either of these items at a financial service firm can be problematic. i. Net Capital Expenditure - Financial service firms invest in intangible assets such as brand name and human capital. Consequently, their investments for future growth often are categorized as operating expenses in accounting statements. ii. Increase in working capital - If we define working capital as the different between current assets and current liabilities, a large proportion of a bank’s balance sheet would fall into one or the other of these categories. Changes in this number can be both large and volatile and may have no relationship to reinvestment for future growth. 3.

Complications in computation of beta? When estimating betas for non-financial service firms, we emphasized the importance of un-levering betas (whether they be historical or sector averages) and then re-levering them, using a firm’s current debt to equity ratio. With financial service firms, we would skip this step for two reasons. First, financial service firms tend to be much more homogeneous in terms of capital structure – they tend to have similar financial leverage. Second, debt is difficult to measure for financial service firms. In practical terms, this will mean that we will use the average levered beta for comparable firms as the bottom-up beta for the firm being analyzed.

4.

Why do financial service firms pay out more in dividends than other firms? An obvious response would be that they operate in much more mature businesses than firms in sectors such as telecommunications and software, but this is only part of the story. Even if we control for differences in expected growth rates, financial service firms pay out far more in dividends than other firms for two reasons. a.

Financial services companies need to invest far less in capital expenditures than other firms. This, in turn, means that far more of the net income of these firms can be paid out as dividends than for a manufacturing firm.

b.

A second factor is history. Financial services companies have developed a reputation as reliable payers of high dividends. Over time, they have attracted investors who like dividends, making it difficult for them to change dividend policy. In recent years, in keeping with a trend that is visible in other sectors as well, financial service firms have increased stock buybacks have increased as a way of returning cash to stockholders.

5.

Challenges faced while finding market multiples A big hurdle in the use of earnings multiples is the diversification of financial service firms into multiple businesses. The multiple that an investor is willing to pay for a dollar in earnings from commercial lending should be very different than the multiple that the same investor is will to pay for a dollar in earnings from trading. When a firm is in multiple businesses with different risk, growth and return characteristics, it is very difficult to find truly comparable firms and to compare the multiples of earnings paid across firms. In such a case, it makes far more sense to break the firm’s earnings down by business and assess the value of each business separately. India, being a nascent and emerging financial market, most of the investment banking firm are privately held. Hence finding a reliable comparable firm with the market data is a big challenge.

Valuation of DSP Merrill lynch We will analyze its value over three phases – an initial period of sustained high growth, a transition period where growth drops towards stable growth and a stable growth phase. High Growth rate Phase The key question is how long the firm can sustain this growth. Given the large potential size of the Indian market, we assume that this growth will continue for 5 years. The growth rate of during 2003-04 and 200405 years was 30% plus. Considering the cyclical nature of the business and the high growth of the economy, capital markets and industry, the revenue growth rate of 25% has been estimated. Transition Phase We expect DSP Merrill Lynch to continue growing beyond year 5 but at a declining rate. Instead of estimating each year growth rates and reducing it linearly, we have reduced the expected growth rate to an average growth rate of 15.00% - these growth rates are all in nominal rupees. Stable Growth In stable growth, we assume that DSP Merrill lynch revenues will grow in perpetuity at GDP growth rate of 4-5% a year and discount them at the stable period cost of equity The present value of these dividends in perpetuity, which yield the terminal price per share, can be computed to be: Terminal price per share = Expected Earnings per share9 * Payout / (Cost of equity – g) Assumptions Made S No 1

Income and Expense growth rates

%

2 3

Income growth rate (initial 5 years) Income growth rate (later 5 years) Terminal growth rate

0.25 0.15 0.06

5 6 7

Personal Cost / Income Administrative Expense / Income Rent / Taxes etc / income

0.3 0.09 0.04

9 10

Income Tax Payout ratio (average)

0.35 0.5

MARKET MULTIPLES

The following deals were closed in the last two years in the investment banking space. A big hurdle in the use of earnings multiples is the diversification of financial service firms into multiple businesses. The multiple that an investor is willing to pay for a dollar in earnings from commercial lending should be very different than the multiple that the same investor is will to pay for a dollar in earnings from trading. When a firm is in multiple businesses with different risk, growth and return characteristics, it is very difficult to find truly comparable firms and to compare the multiples of earnings paid across firms. In such a case, it makes far more sense to break the firm’s earnings down by business and assess the value of each business separately.

India, being a nascent and emerging financial market, most of the investment banking firm are privately held. Hence finding a reliable comparable firm with the market data is a big challenge and was not feasible. SN o 1 2

3 4

Company

Date

Stake (%)

Investment (cr)

Share Price

Net Worth

Revenues (cr)

EBIT (Cr)

PAT (Cr)

Growth Rate %

DSP Merrill lynch Karvy Stock broking IL&FS Investsmart SBI Capital Markets

Dec 2005

50

2200

2130.55

552.15

580

288.81

169.98

32.07

May 2005

20

83

NA

NA

177

NA

NA

40

34

64

110

627

826

408

220

NA

NA

NA

NA

NA

NA

NA

NA

NA

Nov 2004 Dec 2005

Hence conducting a valuation of DSP Merrill lynch using market multiples was not feasible. Multiples Method of Evaluation

1.

Multiples are used more to test plausibility of cash flow forecast, explain mismatches between a company’s performance and that of its competitors, and support useful discussions about whether the company is strategically positioned to create more value than its competitors. DSP ML has competitors like JM Morgan Stanley, Edelweiss capital etc which are not listed on capital markets.

2.

DSP ML has expertise in various fields like M&A, Underwriting, Primary dealership, mutual funds. There are very few companies which are operating in these turfs and exclusively on these turfs. Hence using their market multiples may not be a right indicator of DSP ML’s standing.

3.

Even companies like SBI Capial markets, Kotak Capital markets, IL&FS investsmart are assumed to be in the same industry, still using multiples may not be the right step since companies in the same industry P/E ration can have drastically different expected growth rates, returns on invested capital and capital structures.

4.

P/E ratio used in comparing DSP ML with companies like SBI capital markets may not be accurate as it commingles operating and non operating items.

Following guidelines were kept in mind to overcome the aforementioned drawbacks associated with multiples: 1.

Use comparables with similar prospects for RoIC and growth

2.

Use Multiples based on forward looking estimates

3.

Use enterprise-value multiples based on EBITA to mitigate problems with capital structure and one-time gains and losses

4.

Adjust the enterprise-value for non-operating items such as excess cash, operating leases, ESOP and pension expenses.

WACC 1. Calculation of WACC Rf (Riskfree rate) for various years in India were as follows as per BSE data: 2005

2004 6.5

2003 5

2002

5.75

2001 6.5

9

1.1. Cost of debt DSP ML has a rating of AA (P1+ according to CRISIL). Hence the spread is 1.18% as per FIMMDA data (Here it is assumed to be same for all years due to non-availability of data) Hence Rd (Cost of debt) is as follows: 2005

2004 7.68

2003

6.18

2002

6.93

2001 7.68

10.18

1.2 Calculation for beta Beta for various years is as follows: 2005

2004 0.7334

0.6452

2003 0.803

2002

2001

0.8212

0.65

This was obtained by regressing five years market returns vs stock capital gains and dividend. 1.3 Cost of Equity Market risk premium is assumed at a flat rate of 10.5% for all 5 years due to lack of data. With all this data Re (Cost of equity) is as follows: 2005

2004 14.20

11.77

2003 14.18

2002 15.12

2001 15.83

1.4 Weighted average cost of capital Since D/V and E/V has already been calculated. Using these WACC is calculated as WACC = Rd (1-T) D/V + Re E/V 2005

2004 12.02

8.58

2003

2002

8.43

2001

8.97

11.04

Note on WACC To ensure consistency, the cost of capital must meet several criteria: •

It should comprise a weighted average of the costs of all sources of capital—debt, equity, and so on—since the free cash flow represents cash available to all providers of capital.

•

Should be computed after corporate taxes, since the free cash flow is stated after taxes.

•

Should use nominal rates of return built up from real rates and expected inflation, because the expected free cash flow is expressed in nominal terms (or real rates if inflationary effects are appropriately removed from the cash flows that are being forecasted)

•

Adjust for the systematic risk borne by each provider of capital, since each expects a return that compensates for the risk taken.

•

Employ market value weights for each financing element, because market values reflect the true economic claim of each type of financing outstanding, whereas book values usually do not

•

Be subject to change across the cash flow forecast period, because of expected changes in inflation, systematic risk, or capital structure.

Issues and assumptions in calculating WACC 1.

DSP ML’s debt is not traded actively on the market. Hence due to this illiquidity, it is difficult to estimate the cost of debt. DSP ML has a rating of AA. Hence a spread of 1.18% is used.

2.

To obtain risk-free rate is difficult as treasury bonds issued by Government carry inherent benefits and hence they are purchased for an interest lower than risk-free rate. Since debt market is not strong in India, it is all the more difficult to obtain risk free interest rate. Risk free interest rate as quoted on BSE website was used

3.

Beta is obtained by regressing DSP ML stock returns versus BSE 500 index returns. Since DSP ML is not a very illiquid stock and moreover it is almost on a path to delisting, beta so obtained may not be accurate.

4.

Since only 3% of equity is traded on the markets, the equity value of DSP ML may not be a true reflection of its inherent value.

5.

Since neither debt and nor equity is liquid enough to accurately estimate their value, the value V so obtained to calculate WACC may not be accurate.

Key Learnings 1.

Structured way of Industry analysis was one of the key takeaways from this project

2.

By undertaking this project, we ingrained a structured method to analyze the financial statements. This included making various adjustments to estimate cash flows of the company, estimating capital structure to undertake a thorough historical analysis.

3.

We learnt to estimate WACC (Weighted Average Cost of Capital) which is an important step in valuing a company. We also learnt about the limitations and various constraints involved in estimating WACC as outlined in the report

4.

Another important learning was estimating the future cash flows and also estimating terminal value of the company. Key learning in this aspect was the fact that even the slightest aberration in forecasting the growth rate could change the terminal value and hence the valuation of the company.

5.

Using multiples to compare a company to its competitors was another key takeaway.

6.

Different kinds of cash flows (capital, free or equity) are used for different companies based on their capital structure. This led to differences in discount rate and cash flows arising from various methods. This learning an important insight to value a company.

7.

Valuation of company using the forecasted cash flows is possibly the most important learning. Valuation of a company is the key activity involved not only when acquiring or merging with a company but also for a simple investment decision like whether to invest in a company or not.

8.

What is most important is the basis of various assumptions one makes and also how one approach one undertakes to tackle various issues while valuing a company.

EQUITY AND DEBT ISSUANCE – Indian Capital Market 1989-90 to 2006-07 (18 years) EQUITY %g Year Amount rate No. of (Rs.crore ) Issues 1989-90 1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06

2793 3955 5749 19572 30653 27642 23659 25440 13890 11265 15425 24320 20079 16561 34820 66658 90309

Total

432790

41.60 45.36 240.44 56.62 -9.82 -14.41 7.53 -45.40 -18.90 36.93 57.67 -17.44 -17.52 110.25 91.44 35.48

187 349 512 1018 1181 1728 1733 909 171 128 188 581 379 459 1331 4623 11799

27276

%g rate

86.63 46.70 98.83 16.01 46.32 0.29 -47.55 -81.19 -25.15 46.88 209.04 -34.77 21.11 189.98 247.33 155.22

Amount (Rs.crore ) 0 0 0 0 0 0 10035 18391 30983 38643 55073 62449 59134 70154 68526 78186 100777

592351

DEBT %g rate No. of

%g rate

Issues 0 0 0 0 0 0 0 83.27 68.47 24.72 42.52 13.39 -5.31 18.64 -2.32 14.10 28.89

0 0 0 0 0 0 73 204 252 444 711 887 1052 1134 1291 1018 1201

8267

0 0 0 0 0 0 0 179.45 23.53 76.19 60.14 24.75 18.60 7.79 13.84 -21.15 17.98

Amount (Rs.crore ) 2793 3955 5749 19572 30653 27642 33694 43831 44873 49908 70498 86769 79213 86715 103346 144844 191086

1025141

Capital Raised %g rate No. of

%g rate

Issues

41.60 45.36 240.44 56.62 -9.82 21.89 30.09 2.38 11.22 41.26 23.08 -8.71 9.47 19.18 40.15 31.93

187 349 512 1018 1181 1728 1806 1113 423 572 899 1468 1431 1593 2622 5641 13000

35543

86.63 46.70 98.83 16.01 46.32 4.51 -38.37 -61.99 35.22 57.17 63.29 -2.52 11.32 64.60 115.14 130.46

1. DSPML Equity

Cash Flows forecasts

2. DSPML Equity

Cash Flows forecasts - Profit and Loss Statement