Valuation Appraoches

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Comprehensive note on valuation Methodologies

By Taxpert Professionals Private Limited

wwwtaxpertprocom


BUSINESS VALUATION

A business is required to be valued for many reasons The reason may be sale of business or merger and acquisition or a simple process of self appraisal by

the company The motive of any valuation is to estimate the value of the business at which an asset can be sold Although the term value has been elaborately

discussed in the earlier chapter yet it is discussed briefly to make this chapter coherent in itself

Value is perceived amount depicting the worth of an assetliabilitybusiness Value is usually taken to be Fair Market Value FMV as such is an hypothetical

value for any model transaction which are governed by conditions of full knowledge and freedom to act

Fair market value is not designed with any particular individual or transaction in mind It is rather a hypothetical value The governing conditions in FMV are

full knowledge and freedom to act and that the transaction should be at Arms length price but in reality it is hardly the case as the transaction is driven by

lot of other factors being emotional and subjective elements which often override rational considerations and also full knowledge is not easy to attain by

arms length potential buyer who has limited access to the information and is also not previously involved in the business In case of public company more

information is available as it is governed by requirement of disclosure however it is difficult to get same level of information about private companies

Value is the privilege to receive the future benefits as at that partic ular time There is difference between price and value Price is

the amount actually paid for the property and it may be more or less than its value Value is the benefit perceived to be derived by

the asset and price is something which is actually paid to acquire it

VALUATION TECHNIQUES

Valuation is a looking forward exercise There are three broad approach through which the valuation can be done The approach depends on the method that

is being followed to value the asset The approaches are divided into three types being

1 The Asset based valuation

2 Earnings based valuation

` 3 Market based valuation

In the following paragraphs we have discussed each of the approach in detail



I Valuation based on Assets

In the asset approach it is assumed that the value of business is derived by adding the value of all the assets of the company and subtracting the liabilities

This valuation approach often serves as a floor price since most companies will have more value as a going concern then as being liquidated Besides the usual

assets there is always a valuation of assets in the business which cannot be seen but which are necessary to run the business

CCI guidelines 1990 state that ldquoThe net asset value as at the latest audited balance-sheet date will be calculated starting from the total assets of the Company

or of the branch and deducting there from all debts dues borrowings and liabilities including current and likely contingent liabilities and preference capital

if any In other words it should represent the true ldquonet worthrdquo of the business after providing for all outside present and potential liabilities In the case of

companies the net asset value as calculated from the asset side of the balance-sheet in the above manner will be cross checked with equity share capital plus

free reserves and surplus less the likely contingent liabilitiesrdquo

Under this method the value of a share employed in the equity method is simply the estimate what the assets less liabilities are worth The value taken for

measuring individual asset or liability can be book value market value liquidation value etc

Under asset approach the valuation is based on the balance sheet However it may be noted that balance sheet gives the accurate indication only of short

term assets and liabilities as in case of long terms ones there by hidden liabilities that may not be seen on the face of balance sheet Asset approach gives the

fair estimation of the minimum price Greater the portion of purchase price is explained by tangible assets the less risky the proposition shall be

The following steps are applied while employing the asset approach

(1) Take the balance from the balance sheet ideally ldquoas ofrdquo the same date as the valuation date

(2) Make adjustments where necessary in the value of asset and liabilities (for eg Reinstating the assets and liabilities)

3) The off balance sheet and their impact on balance sheet are identified

4) The value under the asset approach shall be equal to Assets ndash Liabilities


At what value the assets and liabilities are to be valued is a big challenge For eg as shown below

Cash Is cash

Marketable securities Market value

Accounts receivables and prepaid expenses Mostly book value

Property plant and equipment Book value - Depreciation

Cash is valued at cash Marketable securities are valued at their market value and accounts receivables are mostly valued at book value etc we have discussed

the about valuation each of the balance sheet item in the subsequent chapters Liabilities provides judgmental decisions for valuation While accounts payable

and many accrued expenses are straightforward in their value due to a specific amount stated on an invoice a liability such as a warranty accrual or a litigation

accrual may not be very clear in its fair value and what it should be carried at during a valuation Significant consideration should be given to these more

opaque items on the balance sheet when performing the valuation

Intangible Assets

The most difficult assets to value are intangible assets such as trade mark patents goodwill etc they are the assets which cannot be seen touched and they

are created over a period of time and are created with efforts and are identifiable as separate assets In the world changing with technology most valuable

assets have gone from tangible to intangibles It is a world of ideas relationship associations and human wealth There are two types of intangibles IND AS

26 deals elaborately on the valuation of intangible assets Usually Self-created intangibles are not put on the balance sheet of a company and therefore do

not automatically require valuing and adding to the balance sheet Few considerations that need to be made when using the asset approach are Premise of

Value Control Marketability Asset or Income based business Going concern basis etc

The asset based valuation can be classified into four broad categories

1 Book value

The book value of the asset and liability as appearing in the balance sheet is taken for the purpose of calculation The value of intangible

assets is excluded in the calculation This method of valuing the assets at book value is adopted in statutes like gift tax Act Wealth Tax Act


for valuation of unquoted equity shares for companies other than an investment company The limitation of book value is that book value does not give the

true indication of a companys value and it does not take into account the cash flow that can be generated from the companyrsquos assets While doing valuation

based on book following adjustments should be seen to be applicable to be made

inventory undervaluation

Bad debt reserves

Market value of assets

Copyrights and patents

Investment in affiliates

Carry forward of tax losses

2 Replacement value

Replacement value is the cost which is required to replicate the present operations of the company It is essentially to make a buy decision It is the cost which

the seller will ask from buyer who otherwise would have to expend for getting such assets and liabilities It is the value at which the existing asset will be

replaced at the current market prices with similar assets

3 Liquidated Value

Liquidated value is the least a business can fetch While offering a business for sale seller would like to know the least value he will be able to get on just

liquidating the assets

Liquidation value should be considered when the value of business as determined on the basis of income or market approaches is low relative to net asset

value Application of the liquidation should consider the expenses associated with liquidation taxes and all the other relevant cost involved in liquidation

To get the value of business a premium is added to the net assets of the company The premium is calculated by comparing the earnings of a business before

a sale and the earning after sale It is assumed in this approach that the business is run more efficiently after sale

Relevance Asset approach is relevant in the cases where the earning potential of the company is difficult to be evaluated or estimate or is where it is not

getting captured appropriately under the income market approach It is also relevant in the cases where intangible asset makes the considerable portion of

the business and for evaluating surplus non-operational assets and contingent off balance sheet liabilities



2 THE INCOME APPROACH

The income approach is more practical approach to follow In the Income approach value of assets is measured based on its earning capacity Earnings are

linked with other fundamentals of business like growth capital requirements risk involvement or uncertainty

The Income approach derives an estimation of value based on the sum of present value of expected benefits estimated to be derived from assets or business

Economic benefits may be in the nature of dividends and capital appreciation

Two methods may be followed to arrive at value under income approach

a Single period capitalisation or a

Multi period discounted future income method

Single period capitalisation It is also known as capitalisation The capitalization method basically divides the business expected earnings by the capitalization

rate The idea is that the business value is defined by the business earnings and the capitalization rate is used to relate the two For example if the

capitalization rate is 33 then the business is worth about 3 times its annual earnings An alternative is a capitalization factor that is used to multiply the

income Either way the result is what the business value is today

Under the capitalisation method Fair market value of the company is estimated by converting the future income stream into value and by applying a

capitalisation rate incorporating a required rate of return for risk assumed by an investor along with a factor for future growth in the earning stream being

capitalised This gives the value based on the present value of the future economic benefits that the owner will receive through earnings dividends or cash

flow

Therefore for capitalisation method it is required determine the two factors

(1) normalized income stream and

(2) rate of capitalization or multiple for capitalization

There are different types of income streams which can be taken for valuation like PAT (profit after tax) or Profit before depreciation interest and taxes (PBDIT)

or cash flows etc This earnings may be considered from recent year earnings OR simple average of few yearsrsquo earnings or weighted average

or geometric average of few yearsrsquo earnings ie it can be a forward looking or trailing (based on past) For forward looking (also known as


leading) earnings the forecasted figures must be checked whatever income stream is chosen it should be made sure that the multiple should also co-relate

with the nature of earnings used For example if it is PBDIT then multiple should be based on capital invested and not only the ownersrsquo fund This will give

value of business But if the earnings used is PAT then the multiple should reflect the factors applicable to ownership only It will provide the value of ownersrsquo

fund in the business While arriving at multiple we should consider the business risk specific to the business size risk market risk growth rate expected

return and such other factors having impact on the business operations

CCI guidelines state that The crux of estimating the Profit Earning Capacity Value lies in the assessment of the future maintainable earnings of the business

While the past trends in profits and profitability would serve as a guide it should not be overlooked that valuation is for the future and that it is the future

maintainable stream of earnings that is of great significance in the process of valuation All relevant factors that have a bearing on the future maintainable

earnings of the business must therefore be given due consideration

Capitalisation model is based on the Gordon growth model which estimates the value of ownership based on next yearrsquos dividend payment capacity and

capitalizing it considering the expected rate of return (cost of capital) and estimated growth rate This method is based on the Gordon Constant Growth

Model that uses a single period proxy Gordon constant growth model is based on the future series of dividends that are expected to grow at a constant rate

Given a dividend per share that is payable in one year and the assumption that the dividend grows at a constant rate in perpetuity the model solves for the

present value of the infinite series of future dividends

Following formula is used to estimate a value using this approach

Value = Normalized earnings (Ke ndash g)

Where

Ke = required rate of return on investments

g = growth rate in earnings forever

Or

Value = Normalized earnings Appropriate multiple


As discussed there are lot of factors which should be considered while arriving at normalised earning and the appropriate multiple and it is on the best

judgment of the appraiser to decide the same

In Multi period discounting method future income stream on year by year basis back to a present value using an appropriate discount rate Discount rate

reflects the required rate of return on the investment In this method projections are used to determine the value of business ProjectionsBusiness cycle

period is divided into two periods being

- Un stable growth period

- Stable growth period

Unstable growth period is the income for several periods and stable growth period is assumed to be period after the last year The model can be extended to

three or four stage model based on the business cycle Past results may be helpful in giving an idea regarding the future cash flows but it cannot be made

basis for future projections

There are two ways in which present value of future stream of income can be determined

1) adjust the expected cash flows for risk

2) adjust the discount rate for risk in DCF valuation

Under the first approach cash flows are adjusted for the systematic (market) risk by subtracting a cash risk premium (risk-adjusted expected cash flows) The

risk adjusted expected cash flows are discounted at a risk free interest rate under the second approach the discount rate is adjusted for systematic (market)

risk by adding a risk premium to the risk-free interest rate

For the final year of the projection period it is assumed that the growth rate shall be till perpetuity In the final year the income stream that represents the

cash flow of final year is assumed to continue till perpetuity which is then discounted to present value The terminal value of the business can be derived

through using the (1) Stable growth method (2) Multiple approach (3) Liquidation value


(1) Under the Stable growth method gordon model is followed Gordon model is very popular while estimating terminal value based on earnings Key

assumptions for the Gordon model are as follows

Forecast period should be as long as necessary for a stable level of growth to be achieved the terminal period must assume a long term stable growth

rate (it may be negative or zero or positive)

Depreciation and capital expenditure should be either equal or at a steady state differential in the residual period

This formula represents the value of all cash flows remaining beyond the end of the forecast period

Assumption of constant growth in cash flow Growth rate used can be more than the expected nominal growth rate of the overall economy in which

the firm operates

The rate must be sustainable into perpetuity

Formula for deriving terminal value under this model is cash flow in the first year of the terminal period (discount rate - long term growth rate)

The stable growth model is technically sound but it requires a judgment about the stable status of the business and applicable stable growth rate that can

sustain forever

(2) Multiple approaches is based on a multiple of a measure of financial performance applied at the end of the forecast period This is fairly simple method

and easiest to use However it is difficult to come out with relevant multiple

(3) Under Liquidation value the terminal value is determined by estimating the value of individual assets at the end of the forecasting period The liquidation

value is most useful when assets are separable and marketable

Following method is followed for doing the valuation as per Income approach under discounted cash flow method


Discounted cash flow method (DCF) It is a method under which the intrinsic value of the company asset is valued As the name specifies it is the value is

arrived at by discounting the future cash flows to the present value It is forward looking valuation and depends more on the earning capacity in future or

future expectations rather than historical results Following steps are involved in calculation of value under DCF method

Step 1mdashThe first step in Discounted cash flow valuation is to estimate the cash flows expected to be available to equity holdersother investors The free cash

flows is the cash that may be available to the investors after taking into account investment in new assets need of working capital capital expenditure etc

and on assumptions regarding the companys revenue growth rate net operating profit margin income tax rate fixed investment requirement and

incremental working capital requirement etc

Determination of the cash flows

Determining the Discounting rate

Determination of terminal value

Determination of present value of cash flows and terminal value


depending on for whom the value of business is ascertained Free cash flows may be calculated in two manner ndash (1) Free cash flows to the equity holder (FCFE)

(2) Free cash flows to the Firm (FCFF) Free Cash Flow to the Equity is the cash is available to pay to a companys equity shareholders after accounting for all

expenses reinvestment and debt repayment

It is calculated as Net Income - (Capital Expenditures - Depreciation) - Changes in non-cash Working Capital - (Principal Repayments - New Debt Issues) OR

alternatively Cash From Operations - (Capital Expenditures - Depreciation) + Net Borrowing

Please see that the cash will be available to equity holders only after repayment of debt and the interest We subtract depreciation to arrive at FCF because

it is non cash item and it is only accounting entry and no actual cash outflow happens in case of depreciation

Free cash flow to the firm is the cash available to bond holders and stock holders after all expense and investments have taken place It is calculated as follows

Earning before interest and taxes(EBIT) ( 1 - tax rate) - (Capital Expenditures - Depreciation) - Change in Working Capital

Whether to use the free cash flow to equity or to use free cash flows to firm will depend on for whom the value of the business is ascertained If we are

looking to value the equity then the most appropriate option is to use FCFE FCFF is preferred if the company is unstable or has huge amount of debt because

the FCFE might be very low or negative in this case

Calculation of cash flows is dependant on what we want to arrive at Ie value of equity value of firm or the enterprise value

Step 2 The next step is to estimate the discount rate

Once cash flows are projected we need an obtain an appropriate discount rate Discount rate is then used to projections to arrive at the new present value

of the cash flows If the cash flows are cash flows to the firm the appropriate discount rate is the cost of capital (or WACC - the weighted average cost of

capital)

Cost of capital is equivalent to Cost of Equity + Cost of debt

Cost of Equity is the return which Equity shareholders expect to obtain on their equity investment in a company From the companys perspective the equity

holders required rate of return is a cost However unlike the cost of debt which is relatively easy to determine from observation of interest rates in the

capital markets a companys current cost of equity is unobservable and must be estimated


There are various models for estimating the cost of capital like Gordon Model which have already been discussed one of the other method is Capital Asset

Pricing Model or CAPM under which cost of equity is calculated as follows

Cost of Equity (Re) = Risk Free Rate (Rf) + Beta Equity Risk Premium

where

i) Risk-Free Rate - This is the amount obtained from investing in securities considered free from credit risk such as government bonds etc

ii) szlig - Beta - This measures how much a companys share price moves against the market as a whole A beta of one for instance indicates that the company

moves in line with the market If the beta is in excess of one the share is amplifying the markets movements less than one means the share is more stable

iii) Equity Market Risk Premium - The equity market risk premium represents the returns investors expect over and above the risk-free rate to compensate

them for taking extra risk by investing in the stock market In other words it is the difference between the risk-free rate and the market rate

Step 3 calculation of Terminal Value

Instead of trying to project the cash flows to infinity terminal value techniques are used One way of calculating the terminal value (TV) is by using the Gordon

Growth Model which essentially assumes that companys cash flow will stabilize after last projected year and will continue at the same rate forever Here is

the formula

Final Projected Year Cash Flow X (1+Long-Term Cash Flow Growth Rate) (Discount Rate ndash Long-Term Cash Flow Growth Rate)

Another possibility of determining terminal value of the company is to use multipliers of income or cash flow measures (net income net operating profit

EBITDA operating cash flow or FCF) which are determined with reference to comparable companies on the market

The TV often represents a large percentage of the total DCF valuation

Step 4mdashCalculation of fair value of company amp Equity

To arrive at a total company value or enterprise value (EV) we simply have to take the present value of the cash flows and the Terminal value divide them

by the discount rate and finally add up the results


To arrive at the value of equity - Divide Free cash flows for equity by cost of equity

To arrive at the value of debt Divide free cash flows for firm by weighted average cost of capital this would give the value of the firm

Relevance

Valuation is forward looking exercise An asset is mostly purchased for the value it may be able to derive in future Income approach is most scientific approach

as it considers the time value of money and the cash outflows including working capital amp capital expenditure that required for increased levels of business

forecasted

It is considered relevant and appropriate in an acquisition divestment deal where management amp control may be acquired diluted and also for the

companies which are in growth phase



3 THE MARKET APPROACH

The Broad principle of market approach is the assumption that is comparable asset is able to fetch a certain price then the subject asset shall also be able to fetch the same price This is based on the assumption that market gives the accurate pricing of the asset Market value is also known as extrinsic value The difference between the market approach and the Income approach is that in income approach we estimate the intrinsic value of the asset while in the market approach we estimate the extrinsic value of the asset Intrinsic value is based on the earning capacity to generate cash flows in the future and in extrinsic value we are looking what is the value that the market is paying for similar and comparable asset If the market is correct and giving the correct value for the asset the two values being intrinsic value and extrinsic value should be same However it is hardly the case ever the market is either under priced or over priced therefore the two values hardly converge Extrinsic value is dependent on how efficiently securities market are efficient in reflecting information about individual stocks and about the stock market as a whole Under Market approach two techniques are used being the Comparable companies multiple method and comparable transactions multiple method Under the comparable companies multiple method the market quoted prices of comparable companies in the same or similar line of business are looked and relevant pricing multiples are applied to the subject company to determine its value The relevant multiples are then adjusted for factors like size growth profitability etc A variety of valuation measures may be used like Enterprise value to sales EV to EBIDTA etc Adjustments are made to get the like to like comparison between the companies Under Comparable transactions multiples method under this valuation is based on the price paid in recent transactions which include reviewing published data on actual transactions and transaction price is converted into a relevant multiple and applied after adjustments for factors like size growth etc to the relevant parameter of subject company We have discussed in detail the various multiples that are commonly used in the subsequent chapters For the understanding here the business can be valued based on the multiples like earning multiples book value multiple revenue multiple and business specific multiple etc Steps that can be used to determine a value under market approach

Firstly the similar public companies or transactions are selected

Comparison of same is done with the subject company

Then valuation multiples are selected and calculated

After that the valuation multiple is applied to the company being valued


As a last step the final adjustments are made Market price method is not relevant in the following cases

valuation of a division of a company

where the share are not listed or are thinly traded

in case of companies where there is an intention to liquidate it and to realise the assets and distribute the net proceeds

in case of unsteady markets the market price may not be indicative of true value of the share

Regulatory bodies have often considered market value as on of the very important basis of valuation for Eg Preferential allotment buyback of share open

offer price calculation under the takeover code etc

Multiple as discussed above is arrived at by = what you are paying for the assetWhat you are getting in return

What you are paying for asset is

- Market value of Equity (Market value of Equity)

- Market value for the firm (Market value of Equity + Market value of debt)

- Market value for the operating assets of the firm (Market value of Equity + Market value of debt ndash cash)

What you are getting in return may be

- Revenue is accounting revenue of which drivers are customers subscribers and units

- Earnings (to equity shareholders may be Net Income earning per share To firm it may be operating Income (EBIT)

- Cash Flow (to equity shall be net income + depreciation To Firm it shall be EBIT + DA (EBITDA))

- Book Value (a Equity = Book value of equity b Firm = BV of debt + BV of equity c Invested capital = BV of equity + BV of debt ndash cash)


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Secretaries and Lawyers Our professional expertise in the field helps to grow your business and brings

to you the opportunities from around the Globe

Get in touch with us at 09769134554 || infotaxpertprocom


BUSINESS VALUATION

A business is required to be valued for many reasons The reason may be sale of business or merger and acquisition or a simple process of self appraisal by

the company The motive of any valuation is to estimate the value of the business at which an asset can be sold Although the term value has been elaborately

discussed in the earlier chapter yet it is discussed briefly to make this chapter coherent in itself

Value is perceived amount depicting the worth of an assetliabilitybusiness Value is usually taken to be Fair Market Value FMV as such is an hypothetical

value for any model transaction which are governed by conditions of full knowledge and freedom to act

Fair market value is not designed with any particular individual or transaction in mind It is rather a hypothetical value The governing conditions in FMV are

full knowledge and freedom to act and that the transaction should be at Arms length price but in reality it is hardly the case as the transaction is driven by

lot of other factors being emotional and subjective elements which often override rational considerations and also full knowledge is not easy to attain by

arms length potential buyer who has limited access to the information and is also not previously involved in the business In case of public company more

information is available as it is governed by requirement of disclosure however it is difficult to get same level of information about private companies

Value is the privilege to receive the future benefits as at that partic ular time There is difference between price and value Price is

the amount actually paid for the property and it may be more or less than its value Value is the benefit perceived to be derived by

the asset and price is something which is actually paid to acquire it

VALUATION TECHNIQUES

Valuation is a looking forward exercise There are three broad approach through which the valuation can be done The approach depends on the method that

is being followed to value the asset The approaches are divided into three types being

1 The Asset based valuation

2 Earnings based valuation

` 3 Market based valuation

In the following paragraphs we have discussed each of the approach in detail
























Cash Is cash









Intangible Assets








1 Book value








Bad debt reserves





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Bad debt reserves





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Where



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Valuation Appraoches

Law

Transcript of Valuation Appraoches