Micro Finance & Valuations

“Valuation approaches & challenges

in Micro Finance”

Taco Lens

19 June 2013

Introduction

“Exploratory thesis” with a practical impact

• Explore existing theoretical frameworks

• How can they be applied within Triodos Investment Management –

Emerging Markets, Micro Finance Investments

• Directly apply the findings and conclusions of the thesis in daily practice

• Result: New valuation policy including tools and databases is being

developed and made ready for implementation.

2

Problem Definition

Overall Problem Definition:

• Which valuation methodology(s) could be applied when valuing MFIs and

what are the challenges?

Sub questions:

• How to define MFIs?

• Which valuation methodology(s) exist when valuing “conventional”

banks?

• How do MFIs differ from banks from a valuation perspective?

• Which valuation methodologies could be applied in practice when valuing

MFIs?

• Which challenges arise when valuing MFIs?

3

4

How to define MFI’s?

• Organizations active within inclusive finance; active in emerging markets

• The activities of these organizations are aimed at supplying financial

services to segments which are not served by the conventional banking

sector; i.e. the low to middle income populations as well as micro and

small – enterprises (SME).

• While often the initial focus is on supplying credit, more and more MFIs

have started to diversify their offering and their income streams by

offering savings, insurance and payment products & services.

• Look at valuations and transactions from a private equity investment

point of view.

5

Which valuation methodology(s) exist when valuing

“conventional” banks?

“Conventional” Bank Valuation:

• Free Cash Flow to Equity method (FCFE)

• Residual Income Method

• Multiple Based (P/E and P/BV)

6

How do MFIs differ from banks from a valuation

perspective? (1)

• Initially MFIs are performing activities which banks also perform, such as

attracting deposits and providing loans

• The differences occur for a large part from the incorporation of

sustainability in the overall strategy & business model by MFIs and their

focus on providing financial products & services to the real economy and

using their capital to support that strategy.

• These differences will become apparent via the different patterns and

ratios in the forecast of the P&L and balance sheet.

• To be able to identify and structure the key drivers of value the value

driver tree concept can (also) be applied for MFIs.

7

How do MFIs differ from banks from a valuation

perspective? (2)

• The most important difference: Life Cycle Development Framework

Life Cycle Development Framework MFIs

Early Stage

Loans (Majority Interest income & minority fee income)

Savings (Interest income)

Payments Services & Insurance Products (Fee income)

Product Offering &

Income Sources High Growth Maturing

+

+

Time & Development

8

How do MFIs differ from banks from a valuation

perspective? + Challenges (3)

Challenges:

• Emerging Markets

- Country risk / Cost of equity

• Non-traded organizations

- Cost of equity / Beta generation

• High growth

- Cost of equity/ Terminal value

Additional Valuation Method to mitigate the challenges:

• Venture Capital Approach

Many banks can be positioned

in the maturing phase and are

quoted on a stock exchange

9

How do MFIs differ from banks from a valuation

perspective? + Challenges (4)

Challenges: Emerging Markets; Country risk / Cost of Equity

• Methods:

- Incorporate the specific risks in the cash flows

- Apply a specific adjustment in the discount factor; Country Risk

Premium

- Combination of both methods where company specific elements are

considered in the cash flow and country specific elements in the

discount rate.

10

How do MFIs differ from banks from a valuation

perspective? + Challenges (5)

Challenges: High Growth & Non-Traded

• In general, when an organization is in a high growth phase the discount

rate should be higher and when the organization is in a more

mature/stable phase the discount rate should have decreased.

• This implies that the cost of capital should be adjusted during the

forecasted period for the changes in risk profile over time when this is

justifiable.

• Gordon Growth: Key for determining the terminal value the organization

needs to have reached a stable state at the end of the forecast period.

• For high growth companies which are also non-traded it is a challenge to

derive the beta since no objective model exists at the moment which

derives the beta of a fast growth non-traded organization. Challenge to

apply CAPM model to derive the cost of equity at the start of the life cycle

development model.

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Which valuation methodologies could be applied in

practice when valuing MFIs? (1)

• General banking valuation methods, both cash flow driven methods and

multiple driven methods, are a good starting point to value Micro Finance

Institutions (MFIs): MFIs show similarity in their operating model when

compared to banks and know the same challenges when defining debt,

working capital and reinvestments.

• However.....

• Following the life cycle development framework, the stage in which an

MFI finds itself is a key element to consider when selecting valuation

methodologies and when performing a valuation. Depending on the stage

of development, start-up, high growth phase or a maturing phase

different valuation techniques can be applied.

12

Which valuation methodologies could be applied in

practice when valuing MFIs? (2)

Valuation Methodologies & Life Cycle Development Framework MFIs:

Valuation

Methods:

Venture Capital

Approach

FCFE FCFE

Multiples (P/E +

P/BV)

Venture Capital

Approach

Residual Income

Method

Residual Income

Method

Multiples (P/E +

P/BV)

Multiples (P/E +

P/BV)

Early Stage High Growth Maturing

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Valuation

Method

Pro’s Con’s Challenges

FCFE Can treat excess returns as free

cash flow to equity holders

Detailed method

Complex; sensitive to

assumptions

Sensitivity towards the

Terminal Value and discount

rate

Cost of Equity; Beta

determination

Projecting Future Cash

Flows & Terminal Value

Venture

Capital

Approach

Applicable to start/up & high

growth companies

Terminal Value less impact

Use IRR instead of cost of

equity

Discount rate based upon

“broad” target

Blend of a DCF valuation

method and a relative method

Select appropriate multiple

from peer group

Residual

Value

Method

Conceptually a sound method

Applicable to high growth

companies; based upon book

value

Terminal Value less impact

when compared to

FCFE/Venture Capital Approach

Discount rate & future net

income growth rate

Not applicable when capital

structure changes significantly

(e.g. equity raise, IPO)

Projecting Future Cash

Flows & Terminal Value

Multiples:

P/BV Meaningful for MFIs being a

financial institution

Ease of use and understand

ability

No view on future earnings

Less applicable to start ups &

fast growth MFIs

Peer group selection; lack

of listed companies and in

different stages of

development

Foreign exchange

exposure

P/E Widely used/recognized

Meaningful for a margin based

industry like microfinance

Ease of use and understand

ability

Comparability of peers

Volatility of earnings / can be

negative

Peer group selection; lack

of listed companies

Case Study

14

• A “real-life” case was selected to test the identified valuation approaches

• The case example was positioned in the life cycle development model on

the edge of the high growth/maturing phase and therefore all valuation

techniques could be applied

• The findings confirmed the findings from the theoretical framework; such

as:

• In general, significant impact of the terminal value; challenging to

apply Gordon Growth appropriately and to create a highly

comparable peer group for multiples due to information restrictions

• Significant difference in valuation outcome between cash flow driven

methods versus multiple methods; possible due to “significant

optimism” within the forecast and/or market circumstances

influencing trading multiples versus transaction multiples

Limitations

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Current theoretical frameworks;

• How to derive cost of equity (estimation of beta) of an organization not

yet in stable growth stage

• Challenging to complete a detailed multi stage or longer period forecast

Limited availability of public data;

• Compilation of comparable peer groups

Recommendations - Theoretical

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• Further empirical research of the applied valuation methodologies; to

further understand the application & impact of the methodologies in the

MFI market. A preferred approach can potentially be identified or

developed.

• Further research regarding the estimation of the cost of equity when

extending the forecast period and/or when applying multi stage

forecasting. Emphasis should be put on the theoretical framework

regarding the beta estimation in the early stage and growth phase to be

able to complete a multi stage forecasting approach.

• Further research the topic of discounts & premiums specifically for the

MFI segment.

Recommendations - Practical

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• Develop a structured valuation template, which contains all of the

identified valuation methods; the outcomes should be captured in a

database and compared. These insights and conclusions can provide

input to come to a preferred valuation approach.

• Develop (further) a peer group benchmark for traded organizations,

which is sufficiently comparable when investing in the MFI market, which

is comparable to own circumstances and characteristics.

• To be of higher statistical meaning it is recommended to perform more

case studies and compare the outcomes.