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Net asset value: unlocks hidden potential - Views on News from Equitymaster
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  • Aug 11, 2000

    Net asset value: unlocks hidden potential

    How do we value companies?

    This is a question which often comes up in the mind of investors. Well the basic valuation techniques hold good for most companies across sectors. Some of these are earnings, revenue, cash flows, net asset and brand valuations. The purpose of this article is to familiarise investors with the methodology of calculating Net Asset Value (NAV). This valuation technique unlike most others is not available in finance books, but is essential in valuing certain type of companies, especially those which have a large asset base.

    Net Asset Value
    Net Asset Value (NAV) is popularly used as a valuation parameter around the world for valuing real estate, shipping and hotel companies. This technique is important when an investor wants to invest in a company which has a large asset base and the usage of assets are critical to the company's earnings capacity. It attempts to reflect the true market value of the company to its shareholders. Let's take a simple example like that of a hotel property. For example if the "Taj Mahal hotel" in Mumbai were to be bought by an investor (to be used in future as a hotel or for some other purpose), what would be the value that the investor is willing to pay for the same. If here we say that in future it would be continued to be used as a hotel, then the average industry replacement cost benchmark has been pegged at Rs 5 m per room for a five star deluxe hotel, excluding the cost of land. This is basically what the market is willing to pay for the hotel, based on returns it expects if the property were to be used a hotel.

    The property valuation will be done taking into account the cost per room of a five star hotel and the land valuation. Or incase the particular investor plans to start a new hotel property in South Mumbai to compete with this existing hotel, what would be the kind of investment he would have to make at current market prices for land and construction.

    In large asset base companies like real estate, shipping and hotel companies where usually the historical cost of assets purchased is not comparable to its current market value this parameter is widely used. The net asset value is basically the price that an investor maybe willing to pay based on expected future cash flows the market expects from that particular asset. There are two basic methods used for calculating NAV, one is the replacement cost method and the other is the future cash flows method. Of these the former is more widely used as it takes into account the replacement cost of assets at current prices, and is hence more realistic and widely used by equity analysts. The future cash flow method takes into account a longer time frame and is more theoretical, hence is more uncertain from that angle. However it is a useful technique when making an acquisition or taking an equity stake in a company, as the investor will be interested in the future cash flows expectations of the particular investment it plans to make.

    Practically though NAV has been rarely used for valuing Indian hotel companies as hotel assets in India have never really been traded. However this concept is interesting from an investor's perspective when valuing these kind of companies. It attempts in unlocking the true value of a company's properties and brands. It is a useful valuation technique to be used in times of a takeover, acquisition or investment. Besides using the usual valuation principles of earnings or revenues, it helps in understanding that for particular type of companies their assets are the key to valuations.

    Net asset value on replacement cost basis
    To take a very simple example of replacement cost of assets, we have calculated the replacement value of the Oberoi Hotels, Mumbai. As the per the industry estimates the construction cost per hotel room works out Rs 5 m for a five star deluxe property. The Oberoi hotels has 912 rooms, hence its cost of construction works out to Rs 4.6 bn. Besides this we have to take into account the cost of land, on which the hotel is built. To take a comparison of a sale of a similar property, ITC Ltd paid approximately Rs 2 bn for a four acre plot in North Mumbai to build a hotel. Hence the price per square foot works out to approximately Rs 11,400. This sale however took place three-four years ago at peak land rates.

    Assuming that prices have fallen by 40%-50% since then, and keeping in mind that South Mumbai commands a premium as compared to North Mumbai, we assume that to buy land for a hotel (with FSI) in South Mumbai today would cost around Rs 7,500 on a very conservative basis. The Oberoi hotels is built on a 3.4 acre plot of land and hence the replacement cost of land works out close to Rs 1.1 bn. The total replacement value of Oberoi, works out to Rs 5.7 bn.

    We have attempted to calculate the net asset value of two of India's largest hotel chains, Indian Hotels Company Ltd and EIH using this method. As both of them have prime properties, widespread hotel network and capital cost advantage it would be interesting to know their replacement cost values on current market prices. Indian Hotels (IHCL) owns 17 hotels and has an equity interest and manages around 30 more. EIH on the other hand owns 10 hotels and manages 4 hotels across the country.

    EIH's and IHCL's NAV using the replacement cost method
    Net asset value on replacement cost for EIH
    1 Valuation of owned and leased land = Total area in sq ft X price per sq. ft
    = 4,457, 625 area in sq. ft x Rs 2,001 per sq. ft
    Total value = Rs 8,917 m
    2 Valuation of hotels
    (Replacement cost excluding cost of land)
    = Number of rooms * average cost
      Value of hotels = Total 1,828 rooms x Rs 4.9 m
    construction cost per room = Rs 8,896 m
    3 Add other cash and non cash assets Rs 3,839 m as at 30th March'2000
    4 Less all external liabilities Rs 3,167 m as at 30th March'2000
      Net asset value = 1 + 2 + 3 - 4 = Rs 18, 485 m
      No. of shares o/s (m) = 52.3
      Net asset value per share = Rs 353

    Net asset value on replacement cost for Indian Hotels
    1 Valuation of owned and leased land =Total area in sq ft X price per sq. ft
    = 3,364,682 area in sq. ft x Rs 1,737 per sq. ft
    Total value = Rs 5,846 m
    2 Valuation of hotels
    (Replacement cost excluding cost of land)
    = Number of rooms * average cost
      Value of hotels =Total 3,001 rooms x Rs 4.4 m
    construction cost per room = Rs 13,354 m
    3 Flight catering = 2x sales
      Flight catering = Rs 850 m x 2= Rs 1,700 m
    4 Add other cash and non cash assets Rs 7,829 m as at 30th March'2000
    5 Less all external liabilities Rs 4,323 m as at 30th March'2000
      Net asset value = 1 + 2 + 3 + 4 - 5 = Rs 24,406 m
      No. of shares o/s (m) = 45.1
      Net asset value per share = Rs 541

    The above figures do not include the brand values of Indian Hotels' 'Taj' brand and EIH's 'Oberoi' brands. They also do not include the market value of assets of the company's investments in affiliate companies, as we have taken into account investments of the company as stated in the books. Hence our net asset valuation is more on the conservative side.

    EIH has 10 hotels with a total room base of 1,828 rooms, and considering that 89% of the room base is contributed by its five star hotels, the replacement construction cost per room works out to Rs 4.9 m per room. EIH has a total land bank (owned and leased land) of 4,457,625 square feet and the average price per square feet for all its properties in Mumbai, Delhi, Bangalore, Calcutta and others works out to Rs 2,000 per square foot. In our calculation for replacement cost the lease properties are taken into account as majority of these are for long periods of time, like 99 years and hence in that sense are as good as owned. On a replacement cost basis if a new company was to enter these cities, we have to take into account the lease properties in our calculation as the scarcity of land may not allow new players to lease out such properties but actually take them on ownership basis.

    Indian Hotels has 17 hotels with a total room base of 3,001 rooms. The replacement construction cost per room in the case of IHCL works out to Rs 4.4 m per room, as 67% of total room base is in the five star category. IHCL has a land bank of approximately 3,364,682 square feet and average price of this works out to Rs 1,737 per square foot.

    (Rs) Current share price NAV per share Share price disc. / prem.
    to net asset value
    Indian Hotels Co. Ltd 226 541 -58.2%
    EIH Ltd 153 353 -56.8%

    If the current market price of the company trades at a huge discount to its net asset value per share, it implies upside to its share price on the basis of this technique and vice versa. In India investors still continue to largely focus on traditional valuation techniques to value hotel companies. However this tool will be of use in future with the entry of foreign hotel chains and for acquisitions and takeovers by foreign hotel chains in the country. This technique will be useful to shareholders and hotel companies in unlocking their true potential and value.



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