886E220 1- 13

ANNAMALAI UNIVERSITY DIRECTORATE OF DISTANCE EDUCATION

M.Sc. PLANT AND MACHINERY VALUATION

Second Year

INTRODUCTION TO BUSINESS VALUATION LESSONS: 1 – 13

Copyright Reserved (For Private Circulation Only)

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M.Sc. Plant and Machinery Valuation SECOND YEAR

INTRODUCTION TO BUSINESS VALUATION

Editorial Board

Members

Dr. C. Antony Jeyasehar Dean

Faculty of Engineering and Technology

Annamalai University

Annamalainagar

Dr.G.Ganesan HOD of Manufacturing Engineering

Faculty of Engineering & Technology

Annamalai University

Annamalainagar.

Dr.A.Prabhaghar

Associate Professor and Wing Head

Engineering Wing, DDE

Annamalai University

Annamalainagar.

Internals

Dr.K.Srinivasan

Assistant Professor

Manufacturing Engineering, FEAT

Annamalai University

Annamalainagar.

Dr.M.Arulselvan

Assistant Professor

Manufacturing Engineering, FEAT

Annamalai University

Annamalainagar.

Lesson Writer

Mr.R.K.Patel

Valuer, Plant and Machinery

79, Nirman Park

Vishwamitri Road

Vadodora–390 011

Gujarat

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M.Sc. Plant and Machinery Valuation

SECOND YEAR

INTRODUCTION TO BUSINESS VALUATION

SYLLABUS

Valuation Fundamentals & Contexts, Concept of Valuation –Standard of value,

Purpose and Role of Valuation, Valuation contexts, Distinction between Price and

Value; Independence and objectivity; Overview of different valuation models,

financial statements and value drivers.

Reorganizing and Analysis of Financial Statements Accounting policy

Accounting policy, Reorganizing and Analyzing Key Financial and Non-Financial

Ratios to support forecasting future cash flows.

Forecasting Cash Flows, Industry Analysis e.g. (Porter’s Five Force Model),

Audit of internal and external environment e.g. (PEST Analysis); Company analysis

eg. Analysis of the sources of past growth in ROIC and revenue and sustainability

of the same in the context of capabilities of the company. Analyzing the core

competence of the business and its ability to take future opportunities and

resilience to address challenges).

Establishing the relationship between each line item in the Profit and Loss

account with revenue and other drivers of costs and expenses.

Income Approach in valuation.(i) DCF Methods of Valuation: Enterprise Value

Approach, Capital cash Flow Approach, Equity Cash Flow Approach; Adjusted

present value, Valuation based on residual income or economic value added;

forecasting cash flows, determining the cost of capital and discount rate;

determining the terminal value and determining the value of equity from the

enterprise value. (ii) Accounting Based Valuation. (iii) Business valuation in

international setting. (iv) Techniques to manage Risk in Business Valuation.

(v) Market Approach Direct comparison with comparators and multiples. (vi) Other

approaches Asset approach and real option/contingent claim approach. (vii)

Criteria for selecting the appropriate Valuation Method.

Suitability of different valuation methods in different contexts, Choice of

valuation method based on the growth stage of the firm, nature of the industry and

availability of information

References:

1. Aswath Damodaran, Investment Valuation – Tools and Techniques for

Determining the Value of any Asset, John Wiley Publication, 3ed Edition, 2012.

2. Krishna G. Palepu, Paul M. Healy, Business Analysis and Valuation using Financial Statements – Text & Cases, South Western Publication,

4th Edition, 2007.

3. Tom Copeland, Tim Koller, Valuation Workbook – Step by Step Exercise, John Wiley & Sons Publication, 3ed Edition, 2000.

4. Study Material, Paper – 18, Business Valuation Management, the Institute of Cost Accountants of India Publication. (http://icmai.in/upload/Students

/Syllabus-2008/StudyMaterialFinal/P-18.pdf).

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M.Sc. Plant and Machinery Valuation

SECOND YEAR

INTRODUCTION TO BUSINESS VALUATION

CONTENTS

Chapter No.

Title Page No.

1 Introduction to Business Valuation 1

2 Concepts of Business Valuation 13

3 Commonly used Methods of Valuation 30

4 Adjustments to Financial Statements 53

5 Comparative Financial Statement Analysis 61

6 Economic and Industry Analysis 72

7 Business Analysis – Pestle Analysis 77

8 Site Visits and Interviews 83

9 Income Approach to Business Valuation 87

10 Market Approach to Business Valuation 103

11 The Asset-Based Approach to Business Valuation 121

12 Discounts and Premiums 127

13 Weighing of Business Valuation Approaches 137

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CHAPTER - 1

INTRODUCTION TO BUSINESS VALUATION

1.1 INTRODUCTION

Everything has a value. Putting value in monetary terms is the cornerstone not

only of running a business but also of investing in almost any form. Knowing how

to arrive at a value for the physical and intrinsic characteristics of a business is

essential to building wealth of all kinds. To that end, people who invest in

companies need to look beyond the current state of the business they own (or want

to own) and consider what decisions they need to make to boost value. People who

have experience in those industries are often best equipped to make those

decisions, but it often helps to engage a business valuation expert for guidance. In

this section, we discuss the concept of value and note some of the main principles

of business valuation.

1.2 OBJECTIVES

The main objective of this lesson is to give brief introduction of business

valuation and explain art and science of business valuation.

1.3 CONTENTS

1.3.1 Evaluation of Business Valuation

1.3.2 Overview of Business Valuation Industry

1.3.3 Purposes of Valuation

1.3.4 The Science and Art of Business Valuation

1.3.1 Evolution of Business Valuation

“How much is this business interest worth?” This question is not one that is

easily answered. The answer depends on 1) economic factors (these can be local,

regional, national, and international); 2) the premise and standard of value

selected; 3) appropriate valuation method applied; and, 4) interest being valued, to

name just a few factors. In this course, all of the above factors are discussed in

detail.

Historically, the valuation of a closely held company was more of an art than a

science; there was some guidance provided by the IRS and minimal reporting

standards. Accordingly, many in the business valuation profession served as

advocates for the client, rather than as an expert (or advocate for the conclusion of

value). The growth and diversity within the valuation profession, improvement in

software, growing sophistication of the judiciary1 and availability of data through

the Internet has transformed the profession and practice. There is now less

guesswork and more scrutiny.

If the value of a company were determined by a sample of inexperienced or

unqualified valuation professionals, the distribution of Conclusions of Value can be

illustrated by the following bell curve. This bell curve depicts a wide range of values

demonstrating valuation as more of an art than science:

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The distribution of values, obtained from a sample of experienced valuation

professionals, illustrates two important things:

1. The curve is relatively flat, indicating a broad range of opinions of values

2. The range or spread between the highest and lowest conclusion of value

would be relatively large

A vast difference in values is considered detrimental to the credibility of

professionals involved in business valuation activities. Consequently, valuation

valuers must attempt to explain the difference between their different conclusions

of value. One of the primary purposes in this course is to place more emphasis on

the science of performing valuations of closely held companies. That said this does

not mean the course is intended to teach a prescribed format or preferred

methodology.

As valuation theory and practice evolve, one expects the bell curve to evolve

and appear as follows:

This illustration reflects a situation where the various “conclusions of value”

are more similar and the range between the highest and lowest value is smaller.

1.3.2 Overview of the Business Valuation Industry

In the first decade of the 21st century, certain key factors will continue to fuel

the need for valuations of closely held companies.

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History

The valuation of closely held businesses first became a formal issue during the

1920s when businesses involved in the alcoholic beverage industry were forced to

close and found it necessary to value their businesses in order to determine the

extent of their losses. Since the 1920s, closely held businesses have been valued

for a variety of reasons, resulting in the creation of the consulting service niche in

which today’s professionals play a pivotal role.

Economic Instability

During a recessing economy, companies of all sizes react by laying off

personnel. Historically, these layoffs have involved only blue–collar workers. Past

recessions have affected both blue–collar and white–collar employees. In prior

years, companies such as IBM Microsoft and Boeing, once thought of as companies

that could provide unquestioned employment security, have had to lay off

employees. Many employees near retirement are often encouraged to leave early

with golden parachutes or similar incentives. However, other employees became

victims of downsizing, which was especially true at the turn of the 21st century.

Many of these individuals consider the possibility of starting their own

businesses or purchasing an entire or partial interest in an existing business.

Those considering a purchase of an existing business generally require a valuation

of that business. Unstable economic conditions have also caused many companies

to reassess their long-term objectives and strategic direction.

During the 1980s there were mergers and acquisitions of many larger

companies. In the 1990s, and now currently, small- to medium-sized companies

entered the M&A arena. Companies consider merging with or acquiring another

company in order to:

1. Help ensure economic stability in a recessing economy through overhead sharing

2. Maintain or increase market share

3. Establish strategic alliances for growth and diversification

Presently, acquiring companies often require valuations of each company

associated with the proposed combination or purchase. In addition, economic

instability has resulted in increased numbers of bankruptcies. Tax and other

regulations related to these bankruptcies frequently necessitate a business

valuation.

Age Demographics

The retiring parents, who represent the wealthiest generation in history and

whose major assets frequently consist of interests in closely held businesses, need

assistance with their succession planning. Succession planning entails transferring

their businesses in the following ways:

1. Gift the business to their heirs

2. Sell the business to their heirs

3. Sell the business to third parties

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4. Establish a charitable trust

5. Establish an Employee Stock Ownership Plan (ESOP)

6. Issue options to key employees

Regardless of the alternative selected, a valuation is usually necessary.

Litigation Engagements

It has been said that ours is a litigious society; it is. When finances become

strained, there is more pressure on relationships, which often leads to dissolution

or a break-up amongst key employees/ partners/ management, resulting in the

need for a valuation.

1. Valuations are often required in situations involving:

a. Partner disputes

b. Dissenting shareholder actions

c. Fairness opinions

d. Divorces2

2. Valuations are also often necessary in situations that may involve litigation3

related to the establishment of an economic loss involved in the following

types of cases:

a. Wrongful death

b. Wrongful injury

c. Wrongful loss of property

d. Patent infringement

Tax Planning

Tax planning is associated with rights/restrictions of ownership interests in

non–traditional legal entities.

1. Family Limited Partnerships and Family Limited Liability Companies

2. Limited Liability Companies

Financial Reporting

Relatively new but important changes in financial reporting are also increasing

the demand for business valuations. For example, A Financial Reporting Standard

requires that goodwill be tested for impairment at least annually. In order to test

goodwill for impairment, it is necessary to estimate the Fair Value of the acquired

company or business unit.

1.3.3 Purposes of Valuations

Purposes for Valuing Business

Before valuing a company, one must know the purpose of the valuation. There

are four basic purposes for valuing a business; tax, litigation, transaction and

regulatory. The purpose of the valuation will affect the assumptions and

methodologies used to determine value. There are many reasons to have a closely

held business valued, including:

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1. Mergers and acquisitions

2. Sales and divestitures

3. Buy/sell agreements

4. Fairness opinions

5. Shareholder transactions

6. Capital infusions

7. Employee Stock Ownership Plans (ESOPs)

8. Employee benefit plans

9. Expert testimony/litigation support

10. Estate planning and taxation

11. Gift taxes

12. Solvency opinions

13. Insolvency opinions

14. Collateral valuations

15. Purchase price allocations

16. GAAP valuations under FAS 141 and/or FAS 142

17. Charitable contributions

18. Determination of net operating loss in bankruptcy

19. Determination of liquidation value in bankruptcy

20. S Corporation Elections – calculation of built-in gain per asset

21. Banks – loan applications

22. Eminent domain proceedings

23. Marital dissolution

Some of the common reasons for valuations are expanded in the following

paragraphs.

1. Mergers, Acquisitions and Sales

Whenever a company merges with another company, is acquired by another

company, or sold, a valuation is necessary. In a merger situation, a professional

may be asked to establish an “exchange value” of the companies involved. The

valuator may be engaged to establish the value for either or both of the companies.

In a sale or divestiture of a company or of an interest in a company, the seller may

engage a professional’s services to establish a range of values of the business that

will assist the seller in negotiating a sales price. Conversely, a person or company

may engage a professional to perform a valuation of a company they want to

acquire. When businesses are acquired, they are often acquired for a flat or lump-

sum amount. For accounting and tax reasons, the lump-sum purchase price must

be allocated among the various classes of tangible and intangible assets of the

business.

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2. Buy- Sell Agreements

All closely held businesses should adopt a buy-sell agreement among the

partners or shareholders. Much protracted litigation could be avoided if, in the

beginning, the business owners would address the issue of a buy-sell agreement in

their partnership or shareholders agreements. A buy-sell agreement is an

agreement that establishes the methodology to be followed by the parties regarding

the ultimate disposition of a departing or a deceased owner’s interest in a closely

held business. The process of determining the value of the business is directed by

the buy-sell agreement and there are many alternative procedures for doing so.

Some buy-sell agreements provide for the determination of value merely by agreeing

to a value at the beginning of each year. Some agreements are based on a

predetermined or prescribed formula, whereas other agreements require that an

independent valuation be performed periodically. Regardless of the alternative

selected by the owners, a professional may be asked to assist in the valuation

process.

There are two basic types of buy-sell agreements: the stock-repurchase and

cross-purchase agreements. Under a stock-repurchase agreement, the company

agrees to purchase the interest of a departing owner. A cross-purchase agreement

allows the remaining owners to purchase the departing owner’s stock.

An appropriately constructed buy-sell agreement will address several

important items including:

1. What events (e.g., death, disability, etc.) trigger the buyout?

2. How will the buyout be funded: insurance, financing or something else?

3. How soon will the buyout occur, in 30 days, 60 days or longer?

4. How is the interest to be valued, i.e., based on a fixed value, a formula, or a

valuation?

When preparing a business valuation one should always review the existing

buy-sell agreements for restrictions, valuation methodology, puts/calls, terms of

purchase, etc.

3. Employee Stock Ownership Plans (ESOPS)

An ESOP is a type of employee benefit plan. It is considered a defined

contribution plan and is intended to invest primarily in the employer’s stock. The

ESOP is a mechanism by which employees become beneficial owners of stock in

their company.

To establish an ESOP, a firm creates a trust which the employer funds by

either contributing shares of the company and/or contributing cash to buy

company shares. The company can also have the ESOP borrow funds to buy new or

existing shares of company stock. The trustee responsible for managing the ESOP

trust may be a bank, trust company, disinterested individual, company officer or

employee. The contributions a company makes to its ESOP can be tax-deductible

up to an amount equal to 25 percent of the payroll of the participants in the plan.

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Many small- to mid-sized employers have instituted ESOPs. Generally, any

non-publicly traded company with an ESOP must obtain a valuation of its stock on

an annual basis. One significant advantage of an ESOP is that shareholders of a

closely held corporation can defer taxation on the gain resulting from their sale of

company stock to an ESOP, provided the ESOP owns 30 percent or more of a

company’s shares after the sale.

4. Estate, Gift and Income Taxes

In many cases, the value of an interest in a closely held business is an

individual’s primary asset. The value of the closely held business must be

ascertained to adequately perform a thorough and comprehensive estate or

financial plan. It may also be necessary to establish the value of an interest in a

closely held business to properly prepare estate or gift tax returns and to establish

the basis of inherited stock in the hands of an heir to an estate.

Age demographics, as previously stated, will involve parents wanting to retire

who will have to properly deal with the value that has accumulated in their closely

held businesses. There are various ways a business owner can transfer the value

that has accumulated in a closely held business. These include giving the business

to the heirs, selling the business to the heirs or to third parties, or giving the

business to a charity. Regardless of how the business is transferred, an

independent valuation of the business interest is imperative.

If parents die before making transfer arrangements for the business, a value

will have to be established for reporting on an estate tax return.

5. Litigation Support

For a variety of reasons, an attorney involved in a pending lawsuit might need

to determine the value of a closely held business. The professional, as the expert,

will be asked to give expert testimony regarding the conclusions. The need for

litigation support4 relative to business valuations can arise in divorces, partner

disputes, dissenting shareholder actions, insurance claims or wrongful death and

injury cases.

6. Regulatory – Financial Accounting Standards

The FASs now require that independent valuations be made to establish the

purchase value of all intangibles included in a business combination. Similarly,

they also require an annual review of the values of intangible assets in order to

measure whether or not any impairment of the original or carrying value has

occurred.

The independent valuations discussed above will be subject to the audit

process. The independent auditor must possess the skills necessary to evaluate the

valuer’s methods, critical assumptions, and data.

1.3.4 The Science and Art of Business Valuation

Business valuations have become an increasingly attractive practice area for

both large and small firms. As the visibility of this niche market has grown, so too

have the number of articles written about the pros and cons of developing a

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business valuation practice. Many of these, including the recent Journal do a fair

job of identifying the good and the bad of entering the business valuation arena.

While a great deal has been published regarding the development of a business

valuation practice, many of the pitfalls that await the unseasoned practitioner have

not been identified.

And primary among those pitfalls, especially for accountants is the reality that

business valuation, by its very nature, is as much an art as it is a science.

Perhaps the most important difference between business valuation work, and

the more standard accounting staples of audit and tax work, is that business

valuation is still less defined. Although most accountants are familiar with the

liability issues that encumber audit and tax engagements, far fewer are as well

versed in the liabilities associated with offering business valuation services.

When considering the viability of adding business valuation services to the

firm roster, it is important to assess what existing skills can be capitalized on and

what necessary skills must be obtained in order to become a competent business

appraiser.

The Science

A good business valuation product will incorporate skills that many

accountants develop independently in tax and audit work: the ability to think

analytically and question the numbers. In many instances accountants are better

qualified to perform business valuations because of their in-depth knowledge of

financial statements and their understanding of how accounting data can be

reconciled or manipulated. This is especially important as many non-accountant

business valuers, with only limited backgrounds in accounting, are more likely to

take financial data provided by management at face value or perhaps only scratch

the surface when assessing the integrity of the data.

Testing the integrity of the data used in business valuations is very important.

Due diligence is as imperative in business valuation work as it is in any other area

of accounting or consulting services. Given the litigious or regulatory environment

in which business valuations are often performed, reneging on due diligence may

erode the appearance of objectivity or fail to identify materially relevant issues.

While the application of quantitative financial techniques is only part of a

complete business valuation, it is important to understand that a common problem

in the business valuation process is the lack of proper financial information. The

best business valuation scenario would find the valuer receiving all of the

information needed, in a timely manner, and accurately stated.

Unfortunately, in a typical engagement, a more likely scenario places the

appraiser in a situation where the client does not have complete financial records

and only provides those records piecemeal over time. In such instances the

appraiser will likely have to act in a dual capacity reconstructing accounting

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records and then using those records to value the business within the regulatory

confines of valuation organizations to which they may be bound.

In fact, the very processes undertaken in the performance of business

valuations will be controlled, to a certain extent, by the practitioner’s professional

affiliations with such professional valuation organizations. It is fairly rare and very

foolhardy for an accountant to undertake business valuation work without having

had some business valuation training and without having earned one or more

designations from an valuation organization.

While the analysis of financial data may seem a fairly routine task, if

somewhat complex, the affiliations of the valuer may require a more stringent

analysis or may require the valuer to adhere to ethical or operational constraints

that are more restrictive than those that bind the average accountant. Although

there is an emerging trend towards creating uniform standards across the various

valuation organizations, no universal standard has yet been approved or mandated.

The very fact that differences exist indicates the evolving nature of the

business valuation industry. Although a number of guidelines regulate or attempt

to regulate the quality of business valuation services, one appreciates that there is

still a noticeable lack of uniformity between the mandates of various designating

bodies. As such, business valuers must understand exactly what quantitative

analyses are required, and in many cases what analyses are not required, in order

to comply with the requirements of the appraisal organizations with which they are

affiliated.

The Art

Although thoroughly analyzing the quantitative aspects of a business is

important, a good business valuation also incorporates qualitative analyses of the

business, the industry, and the economic conditions in which the business

operates. Since business valuation is as much an art as it is a science, there are

many nuances involved in the determination of value that cause even seasoned and

respected practitioners to disagree on important issues.

Complicating matters is the fact that court rulings in business valuation cases

have not always been historically consistent in setting precedents. Furthermore, in

certain cases even the term “business value” has yet to be defined. For example,

business valuations performed for use in dissenting shareholder actions are usually

completed under the fair value standard of value.

In dissenting shareholder actions, the definition of fair value has been left to

the interpretation in which such actions are brought.

Unlike tax work, business valuations have no clear-cut formulae to follow. A

lot of personal and professional judgment is required in deriving business value,

and it is this subjective element that presents such a challenge for some valuers

who seek inroads into this line of work.

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The lack of a definitive one-size-fits-all approach or formula that can be

applied to all valuation issues is just one of the many challenges a valuer can

encounter when performing business valuations. One of the other major challenges

is obtaining the necessary education and experience in business valuation work to

be able to offer a useful product.

Education Vs. Experience

The Uniform Standards of Professional Valuation Practice, which are

referenced as either rule or guidance by most of the major valuation organizations,

contains the following statement in its Competency Rule: Prior to accepting an

assignment or entering into an agreement to perform any assignment, an appraiser

must properly identify the problem to be addressed and have the knowledge and

experience to complete the assignment competently; or alternatively:

1. Disclose the lack of knowledge and/or experience to the client before

accepting the assignment; and

2. Take all steps necessary or appropriate to complete the assignment

competently; and

3. Describe the lack of knowledge and or experience and the steps taken to

complete the assignment competently in the report.

Becoming a competent business valuer is not an overnight process. While

some advertisements attempt to sell business valuation software programs as

cheap all-in-one packages, the realities of business valuation work are far more

complex.

With the increased use of business valuation reports in litigated matters, the

experience and qualifications of the business valuer are quickly gaining

significance. While an accountant without any specific business valuation training

may be able to go through the proper motions to conduct a business valuation, an

educated and qualified business valuation expert will very likely be able to

damagingly dissect and dispute specific areas of such a valuation. Even in non-

litigated matters the strength and quality of valuer qualifications is also important,

if only to assure the client that they are getting a good product and that they

needn’t look elsewhere for business valuation services.

Selling business valuation services will also rely heavily on the practitioner’s

reputation as a valuer and, given the disparity between the quality and consistency

of business valuation services performed by valuers, it is important to be aware of

the various credentials available to practitioners as well as the regulations adhered

to by the members of each credentialing organization. The following organizations

are the most prominent amongst those that offer business valuation education and

confer business valuation designations.

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1.4 REVISION POINTS

1. Business Valuation

2. Business Accounting

3. Appraisal

1.5 INTEXT QUESTIONS

1. Briefly explain evaluation of business valuation practice.

2. Discuss various purposes for which business valuations are required.

3. How valuation purpose conclusion of business valuation?

4. Elaborate “Business Valuation is an Art and Science”.

5. Do you agree it is very important of qualifications and experience of business

valuer? Justify your views

1.6 SUMMARY

The business valuation is briefly introduced. The purposes for which business

valuations required is discussed. Also discussed “Business Valuation as an art and

science”. Lastly importance of education and experience of business valuer is

discussed.

1.7 TERMINAL EXERCISE

1. Discuss the concepts of business appraisal, business accounting?

2. Discuss the difference in education and experience of sensible asset valuers

and business valuers?

1.8 SUPPLEMENTARY MATERIALS

1. www.business valuation.inc.com

2. www.business dictionary.com

3. www.business valuation.co

1.9 ASSIGNMENTS

1. Discuss the concepts of business appraisal, business accounting, and

business management. Howe they differ from concepts of business

valuation.

2. Discuss how business valuation practice differs from an accountancy

practice and legal advocacy.

3. Discuss differences in education and experience of tangible asset valuers

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1.10 SUGGESTED READINGS/REFERENCE BOOKS

1. Aswath Damodaran, Investment Valuation – Tools and Techniques for

Determining the Value of any Asset, John Wiley Publication, 3ed Edition,

2012.

2. Krishna G. Palepu, Paul M. Healy, Business Analysis and Valuation using

Financial Statements – Text & Cases, South Western Publication, 4th

Edition, 2007.

3. Tom Copeland, Tim Koller, Valuation Workbook – Step by Step Exercise,

John Wiley & Sons Publication, 3ed Edition, 2000.

4. Study Material, Paper – 18, Business Valuation Management, the Institute of

Cost Accountants of India Publication.

(http://icmai.in/upload/Students/Syllabus-2008/StudyMaterialFinal/P-

18.pdf)

1.11 LEARNING ACTIVITIES

Group discussion during PCP days

1. Discuss the concepts of business appraisal, business accounting, and

business management. Howe they differ from concepts of business

valuation.

2. Discuss how business valuation practice differ from an accountancy practice

and legal advocacy.

3. Discuss differences in education and experience of tangible asset valuers

and business valuers

1.12 KEY WORDS

Business Valuation, Purpose

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CHAPTER - 2

CONCEPTS OF BUSINESS VALUATION

2.1 INTRODUCTION

Before embarking on a business valuation, it is essential to gain an

understanding of the Conceptual framework. Some aspects of the valuation may be

mandated by statutory and/or case law, such as the standard of value; other

aspects may be influenced by the law, such as the applicability of certain discounts

or premiums.

It is important to understand the purpose of the valuation, that is, the use to

which the valuation will be put, because that will determine which laws and

regulations govern the valuation. Some valuations are governed by central law and

some by state law, which may vary widely from state to state. Statutes apply for

some valuations, but not for others. Binding precedential case law exists for most

valuations today but not for all.

Whatever the purpose of the valuation, it is subject to attack, both by

regulatory authorities and by parties to the transaction. Knowing and complying

with the basic business valuation concepts is essential to avoiding those attacks in

the first place and to successfully defending against such attacks should they

occur.

2.2 OBJECTIVES

The main objective of this lesson is “search for truth” as it relates to valuation

theory and makes an attempt to reconcile it with practice. In order to develop our

understanding of valuation theory, we must understand and agree upon certain

valuation concepts.

2.3 CONTENTS

2.3.1 Valuation Concepts – Valuation, Appraisal, Value Defined

2.3.2 Theoretical Basis of Value

2.3.3 Value v/s Cost v/s Price

2.3.4 Business Valuer’s Job

2.3.5 Value Determination

2.3.6 Standards of Value

2.3.7 Premise of Value

2.3.8 Purpose Affects the Conclusion of Value

2.3.9 Equity Interest as an Investment

2.3.10 Business Valuation Experts

2.3.11 Due Diligence of Business Valuation Process

2.3.12 Jurisdiction of Business Valuation

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2.3.1 Valuation Concepts A. Valuation

A valuation is a process taken to establish a value for an entire or partial

interest in a closely held business or professional practice, taking into account both

quantitative and qualitative tangible and intangible factors associated with the

specific business being valued.

Definition: The act or process of determining the value of a business, business

ownership interest, security, or intangible asset (as defined in the International

Glossary of Business Valuation Terms (IGBVT)).

B. Appraisal

In the process of performing a valuation of a closely held business, the

valuation valuer may require property appraisals of various specific assets owned

by the company, such as:

1. Art (from a reputable art dealer)

2. Coins (from a reputable coin dealer)

3. Real estate

4. Machinery and equipment (from a reputable appraiser)

5. Jewelry (from a reputable gemologist or dealer)

6. Antiques (from a reputable dealer)

7. Other collectibles (from other reputable dealers)

C. Value of a Particular Business (Defined)

“One of the frequent sources of legal confusion between cost and value is the

tendency of courts, in common with other persons, to think of value as something

inherent in the thing being valued, rather than an attitude of persons toward that

thing in view of its estimated capacity to perform a service. Whether or not, as a

matter of abstract philosophy, a thing has value except to people to whom it has

value, is a question that need not be answered for the sake of appraisal theory.

Certainly for the purpose of a monetary valuation, property has no value unless

there is a prospect that it can be exploited by human beings.” James C. Bonbright

(1891–1985), Professor of Finance, Columbia University

Similar to the value of many items or possessions, the value of an interest in a

closely held business is typically considered to be equal to the future benefits that

will be received from the business, discounted to the present, at an appropriate

discount rate.

This seemingly simple definition of value raises several problems, some of

which are:

1. Whose definition of “benefits” applies?

2. Future projections are extremely difficult to make (absent a crystal ball) and also very difficult to get two opposing parties to agree to.

3. What is an appropriate discount rate?

4. How long of a stream of benefits should be included in this determination of

value?

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The following chapters will address each of the problems posed above, and

provide a variety of practical methods/solutions for resolving them.

2.3.2 Theoretical Basis of Value

Almost everyone has an opinion of value, be it of a business, a tangible asset,

or an intangible asset. Unfortunately, the term “value” means different things to

different people. This presents problems for the valuation valuer who has the

extremely important task of working with clients and other parties to come up with

an appropriate definition of value for a specific valuation.

As defined by Webster’s dictionary, value is:

“A fair return or equivalent in goods, services, or money for something

exchanged; the monetary worth of something; marketable price; relative worth,

utility, or importance; something intrinsically valuable or desirable.”

Three Standards of Value:

Fair Market Value

In the 1990s, Arthur Andersen & Co. provided a tongue-in-cheek definition of FMV:

“Fair Market Value is the amount, price, highest price, most probable price,

cash or cash–equivalent price at which property would change hands or the

ownership might be justified by a prudent investor or at which a willing buyer and

seller would exchange, would agree to exchange, have agreed to exchange, should

agree to exchange or may reasonably be expected to exchange, possibly with equity

to both and both fully aware or having knowledge or at least acting knowledgeably

of the relevant facts, possibly even acting prudently and for self–interest and with

neither being under compulsion, abnormal pressure, undue duress or any

particular compulsion.”

In the U.S., the most widely recognized and accepted standard of value is

termed fair market value (FMV). It is the standard used in all Federal tax matters,

whether it is gift taxes, estate taxes, income taxes or inheritance taxes. The IRS has

defined FMV in Revenue Ruling 59–60 as follows:

“The price at which the property would change hands between a willing buyer

and a willing seller, when the former is not under any compulsion to buy and the

latter is not under any compulsion to sell, both parties having reasonable

knowledge of relevant facts.”

It is important to remember the “willing buyer and willing seller” mentioned

above are considered hypothetical as opposed to specific. Thus a representative

price would not be considered a FMV if it were affected by a buyer’s or seller’s

unique motivations. This would be an example of investment value, defined by real

estate terminology as “value to a particular investor based on individual investment

requirements.”

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In the International Glossary of Business Valuation Terms (IGBVT) (see

Chapter Eight for the full glossary), Fair Market Value has this common definition:

Fair Market Value

Fair market valuer si the price, expressed in terms of cash equivalents, at

which property would change hands between a hypothetical willing and able buyer

and a hypothetical willing and able seller, acting at arms length in an open and

unrestricted market, when neither is under compulsion to buy or sell and when

both have reasonable knowledge of the relevant facts. (NOTE: In Canada, the term

"price" should be replaced with the term "highest price.")

Fair Value

Fair Value can have several meanings, depending on the purpose of the

valuation.

a) In most states, fair value is the statutory standard of value applicable in

cases of dissenting stockholders’ valuation rights. In these states, if a corporation

merges, sells out, or takes certain other major actions, and the owner of a minority

interest believes that he is being forced to receive less than adequate consideration

for his stock, he has the right to have his shares appraised and to receive fair value

in cash. In states that have adopted the Uniform Business Corporation Act, the

definition of fair value is as follows:

“Fair value,” with respect to a dissenter’s shares, means the value of the

shares immediately before the effectuation of the corporate action to which the

dissenter objects, excluding any appreciation or depreciation in anticipation of the

corporate action unless exclusion would be inequitable.

Even in states that have adopted this definition, there is no clearly recognized

consensus about the interpretation of fair value in this context, but published

precedents established in various state courts certainly have not equated it to fair

market value.

Within the valuation profession the strictest definition of fair value of a

minority interest is a pro rata share of a controlling interest valuation on a non-

marketable basis.

The authors of Ibbotson Associates SBBI Valuation Edition 2005 Yearbook

define Fair Value as “…the amount that will compensate an owner involuntarily

deprived of property. Commonly, there is a willing buyer but not a willing seller,

and the buyer may be more knowledgeable than the seller. Fair value is a legal term

left to judicial interpretation. Many consider fair value to be fair market value

without discounts.”

b) Fair Value is also the standard of value used by the Financial Accounting

Standards Board (FASB) in its pronouncements pertaining to business valuation. In

June of 2004 the FASB released its Exposure Draft Fair Value Measurements

which attempts, for the first time, to “define fair value and establish a framework

for applying the fair value measurement objective in GAAP.” Although FASB uses

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the term “fair value” just as it is used in various state statutes, it should be clearly

understood that this is a completely different definition of value. Although FASB’s

definition of fair value should be considered a work in progress, as of June 2006

FASB’s revised definition of Fair Value was as follows:

“Fair value is the price that would be received for an asset or paid to transfer a

liability in a transaction between marketplace participants at the measurement

date.”

c) Fair value may also relate to value in divorce. It may have specific

definitions of fair value with regard to marital dissolution.

Note: The differences in the various definitions used for Fair Value are, at

present, irreconcilable. That is why you will not find this term in the International

Glossary of Business Valuation Terms (IGBVT).

Strategic/Investment Value

Investment value is the value to a particular investor based on individual

investment requirements and expectations. (NOTE: In Canada, the term used is

"Value to the Owner.") (IGBVT)

2.3.3 Value V/s Cost V/s Price

Value

1. Value will vary depending on the perceived value to a specific type of

investor. There are strategic buyers, financial buyers, vulture buyers, ego

buyers, etc. The intangible asset being purchased probably has a different

value to each of them.

2. The value of any financial asset is equal to the net present value of the

expected future cash flows (CF) derived from the asset.

a. Discounted at the required rate of return (k), which is also referred to as

the discount rate.

b. The required rate of return will vary depending on the type of buyer.

Cost

1. One viable perspective on the concept of cost is the fact that it simply

represents a historical fact.

2. The fact that you paid X dollars for an asset one day, one year or one decade

ago has little, if any, relationship to its current value. Examples: home

appreciation; new car depreciation one minute after driving it off the sales

lot.

3. In a business context, the balance sheet simply represents a historical

tracking of costs incurred to acquire certain assets. The book value of the

stockholders’ equity account is, in fact, a misnomer. It is more properly

entitled book cost.

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Price

1. Price is a term that is used in many ways. Offering price, market price,

dealer’s price, FMV price, are common variations of the term.

2. Offering price simply represents a number that a seller is asking for an

asset; (a) Examples: sticker price on a new auto, store price tag on a

garment, (b) The unsophisticated layperson believes that if there is a wide

enough gap between the (asking) price and the cost he/she will actually pay

(in effect a discount), he is receiving value.

3. In the business valuation world, price is most commonly thought of as the

value received as adjusted for the terms of the transaction. For example, An

owner A sells his company for Rs. 10,000,000 for cash and Owner B sells his

business for Rs. 10,000,000 on a non-interest-bearing note for 10 equal

annual payments of Rs. 1,000,000. Both owners paid the same price, but

the underlying value is different.

2.3.4 Business Valuer’s Job

1. To estimate economic value

2. Achieve the above goal by rigorously exercising the three approaches

available to him/her

a. In reality, the asset-based (cost) approach references a distinct historical

market— the market responsible for the creation of the historical balance

sheet.

b. The market approach references actual transactions in either distinct

entire company acquisitions or thousands of fractional market

transactions in the public stock market.

c. Even the income approach, in one very real sense, is market-based due

to the fact that the risk-free rate, the equity market premium (market

again) and even the valuer’s estimate of the company-specific risk

premium, are all market derived.

2.3.5 Value Determination

1. The litmus test to verify that one is reasonably determining value is to

invoke the three valuation approaches.

2. By correlating the results of one approach against the other two approaches,

one can reasonably (and comfortably) validate that one has received (or

determined) value.

Example: you are buying a new car at a dealership. You are being told that

you are getting a great deal because of the huge cash back rebate amounting to a

sizable discount from the original sticker price. Once you drive the new vehicle off

the lot, it becomes a used car. Check the evidence derived from the market

approach to verify if the recommended prices for your newly acquired used car with

one-mile on it closely approximates your hugely discounted cost. If the price

exceeds your purchase cost, you indeed received value—as of that moment.

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2.3.6 Standards of Value

Fair Market Value

FMV addresses the broadest end of the spectrum of potential buyers. It is the

most common standard of value used in business appraisals today, particularly for

U.S. tax-related events. Two definitions are classically given for this standard:

1. The price at which the property would change hands between a willing buyer

and a willing seller, when the former is not under any compulsion to buy

and the latter is not under any compulsion to sell; both parties having

reasonable knowledge of relevant facts.

2. The price, expressed in terms of cash equivalents, at which property would

change hands between a hypothetical willing and able buyer and a

hypothetical willing and able seller acting at arm’s length in an open and

unrestricted market, when neither is under compulsion to buy or sell and

when both have reasonable knowledge of the relevant facts.

3. Key concepts:

a. Presumed ownership change at a specific date Hypothetical willing

buyer, willing seller – Fair market value does not contemplate specific

individuals as the buyer or seller. In most cases, the presumed

hypothetical buyer is interested only in a financial return from the

business (the hypothetical buyer is a financial buyer) and has no special

interest, such as combining the business with similar operations already

owned. However, in the limited case where the pool of willing buyers for

a business consists primarily of special buyers (or strategic buyers), as

can be the case in periods of intense industry consolidation, the willing

buyer may be defined as a special buyer, and some level of synergistic

value may be incorporated into fair market value. No compulsion to

transact on either party’s part

b. Reasonable knowledge by both parties

c. Cash or cash equivalent price

d. Transaction costs not included

e. Generally assumed to include a covenant not to compete. However, this

can be somewhat controversial in some jurisdictions.

Investment Value

Investment value—is defined as the value to a particular buyer (or small

handful of buyers).

1. By definition, this extremely small and limited market is typically

characterized by a premium because of the unique synergy(ies) the perceived

particular buyer would realize as a result of acquiring the asset.

2. The value that a particular investor considers, on the basis of individual

investment requirements such as:

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a. Differences in estimates of future earning power

b. Differences in perception of the degree of risk and the required rate of

return

c. Differences in financing costs and tax status

d. Synergies with other operations owned or controlled

3. Investment value is sometimes referred to as strategic value due to the

synergy aspect of the transaction. An exchange transaction is contemplated

in this standard of value.

Fair value

Fair value has two different contexts:

1. Fair value for legal purposes

a. Primarily used in dissenting stockholder actions and shareholder

oppression cases

b. The definition varies from jurisdiction to jurisdiction as specified in state

statutes and developed in the state’s case law precedents.

c. This standard of value is legal community-based, not economically or

market based.

2. Fair value for financial reporting purposes

a. Fair value is defined as: the price that would be received to sell an asset

or paid to transfer a liability in an orderly transaction between market

participants at the measurement date.

b. Fair value is now an exit price (sell-side), which means the price a

company would receive if they were to sell an asset in the marketplace or

paid if they were to transfer the liability. Transaction costs are excluded

from fair value.

c. Market participants are buyers and sellers in the principal or most

advantageous market for an asset or liability. Market participants are:

1. Unrelated (i.e., independent) to the reporting entity Knowledgeable

about factors relevant to the asset or liability and the transaction

2. Have the financial and legal ability to transact

Are willing to transact without compulsion

d. The “fair value hierarchy” prioritizes the inputs used in valuation and

impacts the level of disclosure, but not the valuation techniques

themselves (i.e., choose the best approach first, then the highest priority

inputs).

1. Level I : Quoted prices in active markets for identical assets/liabilities

2. Level II : (a) Observable prices for similar assets/liabilities, (b) Prices

for identical assets/liabilities in an inactive market, (c) Directly

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observable inputs for a substantially full term of an asset/liability, (d)

Market inputs derived from or corroborated by observable market

data.

3. Level III : Unobservable inputs based on the reporting entity’s own

assumptions about the assumptions a market participant will use

e. Fair value for financial reporting purposes and fair market value are

similar concepts, although differences can exist.

f. Fair value assumes the highest and best use for an asset. Reporting

entities need to determine if highest and best use for an asset is in-use

or in-exchange (valuation basis), regardless of management’s intended

use for the asset. (Market participant perspective)

1. Highest and Best Use is In-Use if: (a) Asset has maximum value in

combination with other assets as a group (installed or configured),

and (b) Typically non-financial assets

2. Highest and Best Use is In-Exchange if: (a) Asset has maximum value

on a stand-alone basis, (b) Typically financial assets

g. There are many other issues that need to be considered in determining

fair value for financial reporting purposes, which are beyond the scope of

this course.

Intrinsic value

1. The value that a prudent investor considers, on the basis of an evaluation or

available facts, to be the “true” or “real” value that will become the market

value when other investors reach the same conclusion

2. What the value should be based on analysis of all the fundamental factors

inherent in the business or the investment

3. Does not consider extreme aspects of market conditions and behaviour.

2.3.7 Premise of Value

A. Going concern value premise—all the foregoing definitions of value assume

an ongoing business, though FMV could also be a liquidation value.

B. Liquidation value premise—the appraiser / prudent investor (buyer)

assumes the business will NOT continue in its present form and will be

dismantled. This dismantling is driven by the belief that the business is

better off dead than alive. There are two forms of liquidation:

1. Orderly liquidation : The expected gross proceeds from the sale of the

asset (i) Held under orderly sales conditions; (ii) Given a reasonable

period of time in which to find purchasers; (iii) Considering a complete

sale of all assets as is, where is, with the buyer assuming all costs of

removal; (iv) With all sales free and clear of all liens and encumbrances;

(v) With the seller acting under compulsion; (vi) Under current economic

conditions, as of a specific date.

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2. Forced liquidation: The expected gross proceeds from the sale of the

asset that could be realized at a properly advertised and conducted

public auction held under forced sale conditions, with a sense of

immediacy, lack of adequate time to find purchasers. Fire sale values

may apply under current economic conditions, as of a specific date.

C. Value in exchange vs. value in use

1. The premise of value in exchange presupposes a proposed transaction of

the property, wherein the property actually changes ownership hands.

This value premise references market conditions external to the company

being appraised. As such, the value standards of investment value, fair

market value and liquidation value are properly classified under this

premise.

2. The premise value in use does not presuppose a proposed transaction of

the property, whereby the property actually changes ownership hands. It

does not reference market or economic conditions external to the

company being appraised. It assumes that the current economic return

(profitability) of the company being appraised is of sufficient magnitude

to provide a reasonable basis to a prudent investor that the company has

adequate financial strength to continue operating into the future.

3. This value in use premise is sometimes (confusingly) referred to as fair

market value in continued use (because no exchange market vehicle is

contemplated). By definition, this premise is softer in nature than the

value in exchange premise -which has hard market contours defining its

shape.

2.3.8 Purpose Affects the Conclusion of Value

Before a valuation expert proceeds in valuing a business, he/she must

recognize the purpose for which the valuation is needed. Different purposes require

the use of different valuation methods and approaches and will frequently generate

different values. A Professional Standards require the valuation expert specifically

and carefully define the purpose of each valuation. “No single valuation method is

universally applicable to all appraisal purposes. The context in which the appraisal

is to be used is a critical factor. Many business appraisals fail to reach a number

representing the appropriate definition of value because the appraiser failed to

match the valuation methods to the purpose for which it was being performed. The

result of a particular appraisal can also be inappropriate if the client attempts to

use the valuation conclusion for some purpose other than the intended one.”

All valuations can be classified as either for Tax Purpose or Non-Tax Purpose:

A. Tax Valuations

1. Estate tax

2. Gift tax

3. ESOPs

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4. Allocation of lump-sum purchase price (Code §§338 and 1060 allocations)

5. Charitable contributions

6. Calculation of the Built-in Gain (BIG) for S Corporation Elections

B. Non-Tax Valuations

1. Purchase

2. Sale

3. Merger

4. Buy-sell agreements

5. Regulatory valuations: asset allocation/valuation under Financial Accounting Standards

6. Litigation support

a. Partner/shareholder disputes: There is a growing need for valuation

services in this area

b. Divorce actions: State law governs disputed property settlements. Most

states have failed to establish standards of value

c. Damage/economic loss cases : (1) Breach of contract (2) Lost business

opportunity (3) Antitrust and like

2.3.9 Equity Interest as an Investment

The purchase of an equity interest in a closely held business should be treated

no differently than the purchase of any other investment. The investor should not

only expect to receive the investment (the amount invested or principal) back, but

should also expect to receive a fair return on the investment. The return should be

commensurate with the amount of risk involved. When thinking of the purchase of

an equity interest as an investment, there are certain principles to be kept in mind.

A. The Alternatives Principle

a. This principle applies to valuing businesses in the context of buying or

selling a business.

b. In any valuation involving a business that is being offered for sale, it must

be realized that both the buyer and the seller have alternatives (choices), and

do not necessarily need to enter or proceed with a proposed purchase/sale

transaction

B. The Principle of Substitution

The value of an asset tends to be determined by the cost of acquiring an

equally desirable substitute.

C. The Investment Value Principle

1. Valuation of security interests in closely held businesses is often a very

difficult process. This is due to the lack of an active free trading market for

securities in closely held businesses. Because of this lack of a market, many

small closely held businesses are valued based on the investment value

principle or approach.

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2. Simplified formula:

Value = (Benefit stream) / (Required Rate of Return)

If any two of the three variables are known, the value of the third can be

calculated:

a. The investment value of the business (present value)

b. The amount of return (profit) that a business provides to its owner

c. The rate of return expected on the investment (sometimes referred to as

yield)

2.3.10 Business Valuation Experts

Preferably, the expert also will be certified by one of the relevant accrediting

bodies. Merely being qualified as a business appraiser does not qualify one as an

expert in the field. Instead, experts are distinguished by their credentials, skills,

experience, and training. To be recognized as an expert, testimony often requires

that the appraiser has distinguished himself among his peers, has exceptional

qualifications or training, has spoken at professional meetings on the topic, and/or

has published scholarly articles on the relevant subject matter.

There are as many different kinds of valuers as there are uses for them. Some

valuers concentrate only on real estate or perhaps further sub-specialize in certain

types of real estate such as commercial land. Others, business valuers, specialize in

closely held businesses, or even single aspects of closely held businesses, such as

compensation issues pertaining to executives or owners. Still other valuers may

address issues such as transfer pricing, employee stock ownership plans (ESOPs),

or limited partnerships.

Various roles an Expert is expected to play are:

Advising a client on a business valuation independent of, and prior to, a

controversy relating to the valuation

Providing an opinion that will be used before the Service in an audit, or at

the Appellate

Division in an appeals conference

Assisting counsel out of court in understanding technical issues and

preparing for the case

Testifying in court to an opinion that will be included in a trial record

2.3.11 Due Diligence of Business Valuation Process

Questions to be Answers

1. Whether the expert’s testimony is reliable

2. Whether the theory or technique can be and has been tested

3. Whether the theory or technique has been subjected to peer review and

publication.

4. The method’s known or potential rate of error

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5. Whether the theory or technique finds general acceptance in the relevant

subject matter’s Community

6. Whether the expert is proposing to testify about matters related to research

conducted independent of the litigation

7. Whether the expert has unjustifiably extrapolated from an accepted premise

to an unsubstantiated conclusion

8. Whether the expert has accounted for alternative explanations

9. Whether the expert employs in the courtroom the same level of intellectual

rigor that characterizes the practice of the expert in the expert’s workplace

2.3.12 Jurisdiction of Business Valuation

Valuers must carefully consider the various features of each business

organization when performing a business valuation. An organization’s

characteristics affect valuation because they define and influence such things as

cash flow and transferability of the business interest. Central and state laws

determine many parameters of the entity, but counsel can also contribute to the

ultimate valuation of an entity by drafting agreements with terms and conditions

that restrict ownership of securities and conduct of the business. By adding a put

or call option to a limited partnership interest, by restricting shares with the right

of first refusal, or by limiting dividends on corporate shares, one seriously impacts

the rights and privileges of those property interests and correspondingly affects

their value for tax purposes.

We now turn to the role that the kind of business organization may have on

valuation. A brief example will be helpful to our discussion. Assume that RKP has

been in the business of selling computers for the last several years, operating as a

sole proprietor. Business has been good and so he decides to expand. He needs

additional investment capital and decides to solicit a few investors.

Assume that he has the choice of incorporating his business or organizing as a

limited partnership. Will the choice of organization alter value? Would it make any

difference to the value of the business if he incorporated and then has corporation

elected to be taxed as corporation? In essence, does the form of the organization

affect its valuation for any purposes?

Among the major organizational choices or forms are:

Corporations

Limited liability companies

Partnerships

Limited partnerships

Sole proprietorships

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Corporations

A corporation is an artificial person or legal entity created under the laws of a

state; it has six major attributes:

1. A corporation is created by filing articles of incorporation. The articles of

incorporation contain information about authorized shares and possible

restrictions on the shares. The bylaws of the corporation come into existence

at about this time and may also address restrictions applicable to the

shares. For instance, the corporation may decide to restrict the number of

shares to be issued, establish rules for voting control, or define how

directors are elected. Restrictive provisions may inhibit transferability of

shares and thus negatively impact the value of the shares in the corporation.

2. The corporation is a separate legal entity. The corporation does business in

its own name and on its own behalf, rather than in the name of its

shareholders. The corporation may contract in its own name, similar to a

person doing business; it has powers to do all things necessary to conduct

business.

3. A corporation has centralized management that is distinct from the owners

of the corporation. A corporation is run by its board of directors. Each

director is elected by the shareholders. The board, in turn, appoints

management to conduct the daily affairs of the corporation. This means that

investors may remain passive. Valuers pay careful attention to management,

as they want to know if management is talented and capable enough to

create a successful business. Valuers must also look at management’s

compensation to ensure that it is structured to reward successful

management, and thereby ensure the continued vitality of the business.

4. A corporation has perpetual life. The corporation endures by law until

merger, dissolution, or some other matter causes it to terminate. It is never

destroyed by a person’s death. Valuers may consider perpetual life to be an

advantage over a form of organization with a finite life, such as ten years or

the life of the owner.

5. Corporate ownership is freely transferable. Absent restrictions adopted by

shareholders or the corporation itself, shareholders are free to sell, gift, or

transfer their shares. When, however, the transferability of the shares is

restricted, either by law or agreement, the restrictions are likely to reduce

the value of the shares. This reduction in value is sometimes desirable. For

instance, family members may want to have a buy-sell agreement that

defines and restricts the sale of shares to only family members. Such

restrictions may inhibit value, but the Service closely scrutinizes such

agreements out of concern that values may be artificially reduced.

6. Limited liability. Shareholders, management, and board members do not

become personally liable for corporate obligations. This alone is a strong

attraction of the corporation. Members of limited liability companies, and

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limited partners in a limited partnership, also enjoy some aspects of limited

liability. However, partners in a general partnership are personally liable for

the obligations of the partnership. Valuers must take into consideration

exposure to liabilities as an element of value. Since the corporate form limits

the liability of the shareholders, the corporate form itself has added value.

Quantifying that value depends on the facts and circumstances of the

particular business being valued. The biggest downside of traditional

corporations is double-taxation. Corporations are taxed as legal entities

separate from their shareholders. Income, taxed at the corporate level, is

taxed again, either as ordinary income when distributed as a dividend or as

capital gains when shareholders sell their shares.

Limited Liability Partnerships/ Companies

A limited liability partnership/ company (LLP) is a hybrid, unincorporated

business organization that shares some aspects of corporations and partnerships.

The Service has ruled that the LLP can be taxed as a partnership, if the taxpayers

so elect. Gains and losses are not taxed at the entity level, but are passed through

to its members. LLP members may actively participate in management. The LLP

nominally offers limited liability to its members similar to that of a corporation. And

it is not as hard to qualify as an LLP as it is to qualify for corporation status.

General Partnerships

A general partnership is an association of two or more people or entities

engaged in an activity for profit. The partnership is not taxed; the gains and losses

are passed through to the partners, who are taxed on their share of partnership

gains. Each partner is jointly and severally liable for the partnership obligations, for

the acts of the other partners, and for acts of the partnership’s agents in

furtherance of partnership business. Potential liability is unlimited, and partners

can be pursued personally for partnership debts.

Limited Partnerships

The limited partnership (or limited liability company) seems to be the entity of

choice for practitioners who desire to maximize discounts for lack of marketability

and minority interests. Limited partnerships and limited liability companies lend

themselves to valuation discounts. To create a limited partnership, one must file a

certificate of limited partnership with the state where the partnership is formed.

The certificate identifies key features of the partnership and indicates whom its

partners are. A limited partnership has at least two classes of partners: a general

partner, who has unlimited liability and is responsible for making the major

partnership business decisions; and limited partners, whose liability exposure is

limited to the capital that they have invested. Limited partners have limited liability

similar to that of shareholders in a corporation. To achieve this limited liability,

however, limited partners must refrain from participating in most business

decisions of the partnership. Those decisions, instead, are made by the general

partner, who is liable for them. Income or loss passes through to the partners, who

have the responsibility to report it and pay any resulting tax. An important wrinkle

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is that, while gains and losses are passed through to the partners, the decision to

distribute cash is left to the general partner. Thus, if a general partner withholds

cash distributions, a limited partner must pay taxes on money he does not receive.

This aspect is particularly important to creditors of limited partners, who cannot

access partnership assets to pay the partnerships debts. In this regard, the limited

partnership provides some asset protection.

There are three more typical features of limited partnerships:

a. Limited partners usually are not able to assign or pledge their limited

partnership interest as collateral. (Notwithstanding prohibitions in the partnership agreement, most lending institutions would not make a loan

based on a limited partnership interest, anyhow.)

b. General partners control the decisions of the partnership pertaining to the acquisition of assets and the incurring of partnership liabilities.

c. Limited partners who desire to sell must usually first offer their partnership interests to the partnership or other partners.

Sole Proprietorships

A sole proprietorship is an individual carrying on business under his/ her own

name or under an assumed name. He is taxed as an individual. He has unlimited

tort and contract liability.

2.4 REVISION POINTS

1. Concept of Business valuation

2. Standard of value

3. Investment value

2.5 INTEXT QUESTIONS

1. Describe and Differentiate: (1) Valuation and Appraisal, (2) Fair Value and

Fair Market Value, (3) Investment Value and Liquidation Value, (4) Value,

Cost and Price, (5) Intrinsic Value and Liquidation Value, (6) Going Concern

Value and Liquidation Value, (7) Orderly Liquidation Value and Force

Liquidation Value

2. Discuss various basis of business value.

3. Explain standards of value.

4. Elaborate “Purpose Affect Business Value”.

5. Discuss “Equity Interest as an Investment”.

6. What are the qualities of Business Valuation Expert?

7. How will you conduct due diligence of business valuation process?

8. Explain jurisdictions of business valuation in view of different kinds of

organization.

2.6 SUMMARY

The basic concepts of the business valuations have been discussed. The

business vlauer is expected to be conceptually clear about the basic concepts.

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2.7 TERMINAL EXERCISE

1. Explain the valuation concept?

2. Differentiate fair market value and fair value?

2.8 SUPPLEMENTARY MATERIALS

1. https://www.fundera.com

2. https://www.business.gov.in

2.9 ASSIGNMENTS

1. Remind the industry in which you have reasonable knowledge or expertise.

You are consulted to do valuation of that industry. You are required to

collect necessary information basically required to make basis of further

valuation exercise.

2. To act as business valuer, list out what qualities, educations, experience,

training you need to acquire

2.10 SUGGESTED READINGS/REFERENCE BOOKS

1. Aswath Damodaran, Investment Valuation – Tools and Techniques for

Determining the Value of any Asset, John Wiley Publication, 3ed Edition,

2012.

2. Krishna G. Palepu, Paul M. Healy, Business Analysis and Valuation using

Financial Statements – Text & Cases, South Western Publication, 4th

Edition, 2002.15.

3. Tom Copeland, Tim Koller, Valuation Workbook – Step by Step Exercise,

John Wiley & Sons Publication, 3ed Edition, 2000.

4. Study Material, Paper – 18, Business Valuation Management, the Institute of

Cost Accountants of India Publication.

(http://icmai.in/upload/Students/Syllabus-2008/StudyMaterialFinal/P-

18.pdf)

2.11 LEARNING ACTIVITIES

Group discussion during PCP days

1. Remind the industry in which you have reasonable knowledge or expertise.

You are consulted to do valuation of that industry. You are required to

collect necessary information basically required to make basis of further

valuation exercise.

2. To act as business valuer, list out what qualities, educations, experience,

training you need to acquire

2.12 KEY WORDS

Valuation, Appraisal, Investment Value, Fair Value, Intrinsic Value,

Liquidation Value, Premise of Value, Expert, Due Diligence

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CHAPTER - 3

COMMONLY USED METHODS OF VALUATION

3.1 INTRODUCTION

Here we do a quick but rigorous review of valuation techniques. Traditional

methods, including discounted cash flow, asset accumulation, value multiples and

option pricing, are covered, in the context of the challenges they pose to real-world

practitioners. Addressed first is the general framework is constructed for selecting a

valuation method. This feature is extremely valuable to the professional valuer who

first has to decide which technique to use. The explicit consideration is given to

methods for combining different values for the same asset into given circumstances

and because practitioners normally use more than one valuation methods, specific

guidance on how to do so needs thorough understanding of valuation techniques

and methods. It is also required to understand where to get the data to structure

cash flows; how to account for the impact of inflation—which may be a worrisome

issue in many emerging markets—and whether perfecting cash flows may be more

important than computing a plausible cost of capital. Finally, it is required to

emphasize the importance of intermingling theoretical finance with the approaches

used by real-world professional valuers.

3.2 OBJECTIVES

The main objective of this lesson is to give adequate knowledge of various

business valuation approaches and methods and application of appropriate method

for given circumstances and cases of valuation.

3.3 CONTENTS

3.3.1 Overview of Business Valuation Methods

3.3.2 Asset Based Approach

3.3.3 Income Approach

3.3.4 Effect of Controlling Interest in Business

3.3.5 Lack of Control Interest

3.3.6 Mid-Period vs. End-of-Period Discounting Method

3.3.7 Gordon Growth Model

3.3.8 Market Approach

3.3.9 Other Approaches: Income/Asset Approaches

3.3.1Overview of Business Valuation Methods

Business owners frequently have the need or desire to establish a value for

their business. As was discussed in Chapter One, there are many reasons for

valuing a business. Professionals involved in valuing closely held businesses know

it is not a simple task. The complexity is further compounded by the fact that each

business owner’s purpose, motive, and goal in valuing the business varies greatly

from those of others. No two businesses are alike; therefore, no one size fits all. The

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effect these issues may and usually do have on the valuation process gives rise to

the concept that the valuation process is more of an art than a science.

There are several commonly used methods of valuation. Each method may at

times appear more theoretically justified in its use than others. The soundness of a

particular method is entirely based on the relative circumstances involved in each

individual case. The valuation valuer responsible for selecting the most appropriate

method must base his or her choice of methods on knowledge of the details of each

case. When this knowledge is appropriately applied, much of the art factor is

eliminated from the process and valuation becomes more of a science. The objective

of the Business Valuation Certification Training Center is to make the entire

process more objective in nature.

The commonly used methods of valuation can be grouped into one of three

general approaches, as follows:

Asset Based Approach

a. Book Value Method

b. Adjusted Net Asset Method

Replacement Cost Premise

Liquidation Premise

Going Concern Premise

Income Approach

a. Capitalization of Earnings/Cash Flows Method

b. Discounted Earnings/Cash Flows Method

Market Approach

a. Guideline Public Company Method

b. Comparable Private Transaction Method

c. Dividend Paying Capacity Method

d. Prior Sales of interest in subject company

Other Approaches

a. Income/Asset

Excess Earnings/Treasury Method1

Excess Earnings/Reasonable Rate Method1

b. Sanity Checks

Justification of Purchase

Rules of Thumb

These lists, while not 100 percent inclusive, represent the commonly used

methods within each approach a valuation valuer will use.

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3.3.2 Asset Based Approach

The asset based approach is defined in the International Glossary of Business

Valuation Terms as “a general way of determining a value indication of a business,

business ownership interest, or security using one or more methods based on the

value of the assets net of liabilities.” Any asset-based approach involves an analysis

of the economic worth of a company’s tangible and intangible, recorded and

unrecorded assets in excess of its outstanding liabilities. Thus, this approach

addresses:

“The value of the stock of a closely held investment or real estate holding

company, whether or not family owned, is closely related to the value of the assets

underlying the stock. For companies of this type the appraiser should determine

the fair market values of the assets of the company … adjusted net worth should be

accorded greater weight in valuing the stock of a closely held investment or real

estate holding company, whether or not family owned, than any of the other

customary yardsticks of appraisal, such as earnings and dividend paying capacity.”

While the quote above clearly applies to holding companies, asset based

approaches can also be valid in the context of a company which has very poor

financial performance. An important consideration when using an asset approach

is the premise of value, both for the company and for individual assets.

Book Value Method

This method is based on the financial accounting concept that owners’ equity

is determined by subtracting the book value of a company’s liabilities from the book

value of its assets. While the concept is acceptable to most valuers, most agree that

the method has serious flaws. Under generally accepted accounting principles

(GAAP), most assets are recorded at historical cost minus, when appropriate,

accumulated depreciation or cumulative impairments. These measures were never

intended by the accounting profession to reflect the current values of assets.

Similarly, most long-term liabilities (bonds payable, for example) are recorded at the

present value of the liability using rates at the time the liability is established.

Under GAAP, these rates are not adjusted to reflect market changes. Finally, GAAP

does not permit the recognition of numerous and frequently valuable assets such

as internally developed trademarks, trade names, logos, patents and goodwill.

Thus, balance sheets prepared under GAAP make no attempt to either include or

correctly measure the value of many assets. Thus, by definition, owners’ equity will

not normally yield a valid measure of the value of the company. Despite these

significant limitations, this approach can frequently be found in buy/sell

agreements.

Adjusted Net Assets Method

This method is used to value a business based on the difference between the

fair market value of the business assets and its liabilities. Depending on the

particular purpose or circumstances underlying the valuation, this method

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sometimes uses the replacement or liquidation value of the company assets less the

liabilities. Under this method the valuer adjusts the book value of the assets to fair

market value (generally measured as replacement or liquidation value) and then

reduces the total adjusted value of assets by the fair market value of all recorded

and unrecorded liabilities. Both tangible and identifiable intangible assets are

valued in determining total adjusted net assets. If the valuer will be relying on other

professional valuers for values of certain tangible assets, the valuer should be

aware of the standard of value used for the appraisal. This method can be used to

derive a total value for the business or for component parts of the business.

The Adjusted Net Assets Method is a sound method for estimating the value of

a non-operating business (e.g., holding or investment companies). It is also a good

method for estimating the value of a business that continues to generate losses or

which is to be liquidated in the near future.

The Adjusted Net Assets Method, at liquidation value, generally sets a “floor

value” for determining total entity value. In a valuation of a controlling interest

where the business is a going concern, there would have to be a reason why the

controlling owner would be willing to take less than the asset value for the

business. This might occur where the assets are under- performing, resulting in a

conclusion of value that is less than the adjusted net assets value but more than

the liquidation value. Before concluding the Adjusted Net Assets Method has

established the floor value, the valuer should consider the potential of overstating

the value of assets, existence of non-operating assets, and other omissions in

his/her determination.

The negative aspect to this method is that it does not address the operating

earnings of the business. Therefore, it would be inappropriate to use this method

to value intangible assets, such as patents or copyrights, that are typically valued

based on some type of operating earnings (e.g., royalties). However, replacement

cost methodology may be utilized in determining values of certain intangibles such

as patents.

Illustration – the following reconciliation between book values and fair market

values incorporates four major adjustments:

1. To remove non-operating assets, for example: excess cash and cash

surrender value of life insurance.

2. To convert LIFO inventory to FIFO inventory.

3. To estimate NPV of the deferred income tax liability associated with the

built-in gain on LIFO reserve and PP&E based on a liquidation horizon

discounted to NPV using a discount rate (risk free rate).

4. To adjust property and equipment to estimated fair market value based on

appraisal performed by ABC Appraisals, Inc.

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Book Value (Rs.)

Adjustment (Rs.)

Fair Market Value (Rs.)

A. Current Assets:

Cash and Cash

Equivalents

11,19,300 -5,18,000 6,01,300

Accounts Receivable 16,68,232 - 16,68,232

Raw Materials 3,06,752 1,87,706 4,94,458

Work in Process and

Finished Goods

70,930 - 70,930

Deferred Income Taxes 86,000 - -

Prepaid Expenses 60,850 - 60,850

Total Current Assets

33,12,064

-

28,95,770

B. Property, Plant and

Equipment, at Cost:

Land 88,828 4,572 93,400

Buildings and

Improvements

11,22,939 - 8,17,451

Machinery and

Equipment

25,60,044 - 11,80,334

Vehicles 8,04,336 - 1,75,465

Office Equipment 4,19,284 -3,63,859 55,425

Total Property and

Equipment

49,95,431 - 23,22,075

Less Accumulated

Depreciation

-33,76,371 33,76,371 -

Net Property and

Equipment

16,19,060 7,03,015 23,22,075

C. Other Assets:

Cash Value of Life

Insurance

2,52,860 - -

Deposits 30 - 30

Total other Assets 2,52,890 -2,52,860 30

Total Assets 51,84,014 33,861 52,17,875

D. Current Liabilities:

Note Payable to

Shareholders

17,000 - 17,000

Accounts Payable 3,14,554 - 3,14,554

Income Taxes Payable -80,199 - -80,199

Accrued Liabilities 4,11,512 - 4,11,512

Total Current Liabilities 6,62,867 - 6,62,867

E. Long-Term Debt, Less

Current Portion

1,00,000 - 1,00,000

Deferred Income Taxes – 2,53,000 2,53,000

Total Liabilities 7,62,867 2,53,000 10,15,867

E. Net Assets 44,21,147

F. Adjusted Net Tangible Operating Asset Value (Rounded)

42,02,000

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Book Value (Rs.)

Adjustment (Rs.)

Fair Market Value (Rs.)

G. Non-Operating Assets:

Excess Cash

5,18,000

Cash Surrender Value of

Life Insurance (Rounded) 2,53,000

H. Adjusted Net Tangible Assets

49,73,000

In this example, an adjustment for deferred taxes was made. Not making an

adjustment for deferred taxes would be theoretically justified in a situation where

the valuer is valuing a business for purposes of an Asset Purchase/Sale. However,

an adjustment for deferred taxes may be appropriate in a valuation of a Corporation

when the equity securities of the corporation are to be valued and adjustment has

been made to adjust the value of assets from historical amounts to an

economic/normalized balance sheet.

A crucial point to consider in dealing with taxes is the nature of the

investment being valued. A buyer who is considering acquiring an interest in a

company as an asset purchase should be aware that a step-up in basis will be

received, resulting in additional depreciation and tax benefits. In this case, the tax

liability for any capital gains will be with the former owner. As such, the buyer

should be willing to pay full market price for the assets (less any commissions or

brokers’ fees).

3.3.3 Income Approach

An income approach be used when it lists “the earning capacity of the

company,” as a factor to be considered. The income approach is defined in the

International Glossary of Business Valuation Terms as, “A general way of

determining a value indication of a business, business ownership interest, security,

or intangible asset using one or more methods that convert anticipated economic

benefits into a present single amount.”

Capitalization of Earnings/Cash Flows Method

The Capitalization of Earnings Method is an income-oriented approach. This

method is used to value a business based on the future estimated benefits,

normally using some measure of earnings or cash flows to be generated by the

company. These estimated future benefits are then capitalized using an

appropriate capitalization rate. This method assumes all of the assets; both tangible

and intangible are indistinguishable parts of the business and does not attempt to

separate their values. In other words, the critical component to the value of the

business is its ability to generate future earnings/cash flows. This method

expresses a relationship between the following:

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Estimated future benefits (earnings or cash flows)

Yield (required rate of return) on either equity or total invested capital (capitalization rate)

Estimated value of the business

It is important that any income or expense items generated from non-operating

assets and liabilities be removed from estimated future benefits prior to applying

this method. The fair market value of net non-operating assets and liabilities is

then added to the value of the business derived from the capitalization of earnings.

This method is more theoretically sound in valuing a profitable business where

the investor’s intent is to provide for a return on investment over and above a

reasonable amount of compensation and future benefit streams or earnings are

likely to be level or growing at a steady rate.

Example

Company RKP has five-year weighted average earnings on an after-tax basis of

Rs. 5,91,00,000. It has been determined that an appropriate rate of return for this

type of business is 21.32 percent (after-tax). Assuming zero future growth and

non-operating assets of Rs. 7,71,00,000 the value of RKP Company based on the

capitalization of earnings method is as follows:

Net earnings to equity Rs.5,91,00,000

Capitalization rate 21.32%

Total (rounded) Rs. 27,72,00,000

Value of non-operating assets + 7,71,00,000

Marketable controlling interest value Rs.35,43,00,000

Discounted Earnings/Cash Flows Method

The Discounted Earnings Method is sometimes referred to as the Discounted

Cash Flow Method, which suggests the only type of earnings to be valued, using

this method, would be some definition of cash flow, such as operating cash flow,

after-tax cash flow or discretionary cash flow. The Discounted Earnings Method is

more general in its definition as to the type of earnings that can be used.

The Discounted Earnings Method allows several possible definitions of

earnings. It does not limit the definition of earnings only to cash flows. The

Discounted Earnings Method is an income-oriented approach. It is based on the

theory that the total value of a business is the present value of its projected future

earnings, plus the present value of the terminal value. This method requires that a

terminal-value assumption be made. The amounts of projected earnings and the

terminal value are discounted to the present using an appropriate discount rate,

rather than a capitalization rate.

The Discounted Earnings Method of valuing a closely held business uses the

following steps:

1. Determine the estimated future earnings of the business (in this example we

have projected earnings for five years and have assumed no growth beyond

this period).

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2. A terminal or residual value is often determined at the end of the fifth year.

The terminal value that is often used is merely the fifth-year earnings

projected into perpetuity.

3. The discount rate determined incorporates an appropriate safe rate of

return, adjusted to reflect the perceived level of risk for the business being

valued.

4. The estimated future earnings and the terminal value are then discounted

to the present using the discount rate determined in Step (3) and summed.

The resulting figure is the total value of the business using this method.

Example

Assume the following pre-tax fully adjusted cash flows as they relate to

RKP&Co.: Projected annual cash flows to be received at the end of:

Rs. Year 1 10,500 Year 2 40,700

Year 3 80,600

Year 4 110,100

Year 5 150,300 Year 1 of the projected cash flows is the year following the valuation date. The

pre-tax discount rate is 24 percent. The pre-tax capitalization rate is 24 percent.

Calculation of present value factors:

Year Formula for

Present Value Factor Present value factors for 24%

rate of return

1 1/(1.24)^1

0.8065

2 1/(1.24)^2

0.6504

3 1/(1.24)^3

0.5245

4 1/(1.24)^4 0.423

5 1/(1.24)^5 0.3411

Calculate the value of the business

Calculate the present value of the annual cash flows:

End of Year

Net Cash Flow Rs.

Present Value Factor

Present Value Rs.

1 10,500 0.8065 8,468

2 40,700 0.6504 26,470

3 80,600 0.5245 42,274

4 110,100 0.4230 46,572

5 150,300 0.3411 51,268

175,052

Calculate the present value of the terminal value:

End of Year

Terminal Value Rs.

Present Value Factor

Present Value Rs.

5 626,250 0.3411 213,614

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No long-term sustainable growth is assumed. Had we assumed sustainable

growth at three percent, our discount rate would have to be reduced by three

percent to arrive at an appropriate capitalization rate. The company’s terminal

value is Rs. 626,250 at the end of year 5 (150,300 / 24%). This value, also know at

the “terminal value”, is equal to the present value of a perpetual annual cash flow of

Rs.150,300.

Add both present values:

PV of annual cash flows Rs. 175,052

PV of terminal value + 213,614

Total Value of Business Rs. 388,666

Practice Pointer:

The valuer must use caution when using Cash Flows to Invested Capital as a

benefit stream in a Discounted Cash Flow Model, where the capital structure of the

Company is changing over the projected period. In order to understand this issue, it

is important to address whether the subject interest is a controlling interest or a

minority interest.

3.3.4 Effect of Controlling Interest in Business

A controlling interest has the ability to change the capital structure. When

valuing a controlling interest, the valuer will generally (subject to the purpose and

standard of value) base the weighted average cost of capital (WACC) on the

optimum capital structure or the average industry capital structure. In most cases,

the optimum capital structure and the average industry capital structure is the

same. If a difference did exist between the optimum capital structure and the

average industry capital structure, the valuer will generally utilize the optimum

capital structure for the subject interest. The cost of capital will generally be based

on the following:

1. Debt Capital: The cost of debt capital can generally be determined based on

the current borrowing rate (credit risk) of the Subject Interest. However, in

cases where the Subject Interest does not have debt capital, the valuer can

determine the cost of debt capital from various sources that monitor the cost

of debt capital, Cost of Capital, Gold Sheets, etc.

2. Equity Capital: The cost of equity capital can generally be determined based

on a build-up approach, Capital Asset Pricing Model (CAPM), or published

sources of cost of equity capital, etc.

3.3.5 Lack of Control Interest

A lack of control interest cannot change the capital structure of the Company.

If the valuer uses Net Cash Flow to Invested Capital as a benefit stream in a DCF

model with a constant WACC where the capital structure is changing over the

forecast period, the net present value of the future cash flows will be distorted by

utilizing an inappropriate application of a constant WACC (when the cost of capital

is constantly changing) as a discount rate applied to the net cash flows to invested

capital representative of a constantly changing capital structure. The valuer should

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avoid using Net Cash Flow to Invested Capital as a benefit stream in a DCF model

when the capital structure is constantly changing during the forecast period.

3.3.6 Mid-Period vs. End-of-Period Discounting Method

The method used for discounting a future benefit stream will depend on the

availability of the cash flows to the equity holder. If the equity holder has access to

the cash flows throughout the year, then the valuer should use a mid-period

discounting method. If the equity holder only has access to the cash flows at the

end of the year, then the valuer should use an end of period discounting method.

The following illustration serves to underscore the point made here:

End of period discounting:

NPV = sum of (cash flow at time t) / (1 + discount rate) ^ t

Mid-period discounting:

NPV = sum of (cash flow at time t) / (1 + discount rate) ^ t – 0.5

Assume discount rate = 40% per annum and that cash flows are received/paid throughout each period.

Discount factor using: PV Using: Period

(t) Nominal

Cash Flow Mid-Period Discounting

End Period Discounting

Mid-Period Discounting

End Period Discounting

% of Mid Period PV

1 -1,000 1.1832 1.4 -845 -714 85% 2 1,000 1.6565 1.96 604 510 85%

3 3,000 2.3191 2.744 1,294 1,093 85% 4 4,000 3.2467 3.8416 1,232 1,041 85% 5 5,000 4.5454 5.3782 1,100 930 85%

6 6,000 6.3636 7.5295 943 797 85% 7 7,000 8.9091 10.5414 786 664 85% 8 8,000 12.4727 14.7579 641 542 85%

9 9,000 17.4618 20.661 515 436 85% 10 10,000 24.4465 28.9255 409 346 85%

NPV NET PRESENT VALUE 6,679 5,644 85%

3.3.7 Gordon Growth Model

The Gordon Growth Model assumes that cash flows will grow at a uniform rate

in perpetuity. Under this model, value can be calculated as:

Present Value = CFo (l + g) k – g

Where,

Cfo = Cash flow in period o (the period immediately preceding the valuation

date.) k = Discount rate (or cost of capital)

g = Expected long-term sustainable growth rate of the cash flow used

(remember, in the context of valuation of closely held companies, valuation valuers

will generally use either Net Cash Flow to Equity or Net Cash Flow to Invested

Capital)

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Two-Stage Gordon Growth Model assumes that cash flow growth will change

(the growth rate is not constant under this model, the present value is calculated as

follows):

Present Value =

2 n n12 n n

CF CF CF (1 g) /(k g)CF....

1 k 1 k 1 k 1 k

Where,

CF1…CFn = Cash flow expected in each of the periods one thru n, n is the last

period of the cash flow projection

k = Discount rates (or cost of capital)

g = Expected long-term sustainable growth rate of the cash flow used

(remember, in the context of valuation of closely held companies, valuation valuers

will generally use either Net Cash Flow to Equity or Net Cash Flow to Invested

Capital)

In the two-stage model, the terminal year calculation (CFn (l+g)/k-g/(l+k)n)

refers to the years during which cash flows are expected to grow at a constant rate

into perpetuity.

1. Two Stage Model Using Mid-Year Convention

The Capitalization and Discounting Models presented thus far assume Cash

Flow (CF) is received at year-end. That assumption does not always hold. More

often than not CF is received evenly throughout the year. In this situation, the use

of the “mid-year convention” is appropriate.

The mid-year convention, as opposed to the year-end convention always

results in a higher value since the investor receives the CF sooner. The Mid-year

Discounting Convention Equation is presented as follows:

PV =

2 3 n1.5 1.5 2.5 n 0.5

CF CF CFCF....

1 k 1 k 1 k 1 k

The Mid-year Capitalization Convention is written similarly to the traditional

capitalization convention; however, it reflects the receipt of CF throughout the year:

PV =

.5

.

CF1(1 k)

k g

The Mid-year Convention in the two- stage model is written as follows:

PV =

n

2 3 n1.5 1.5 2.5 n 0.5 n 0

CF 1 g

k gCF CF CFCF....

1 k 1 k 1 k 1 k 1 k

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3.3.8 Market Approach

The market approach is covered in a survey manner in this part of the course.

The complexity and importance of understanding this approach is to cover this

topic in greater depth in separate material. What follows, therefore, is an overview

of this important topic.

The idea behind the market approach is that the value of a business can be

determined by reference to reasonably comparable guideline companies (“comps”)

for which transaction values are known. The values may be known because these

companies are publicly traded or because they were recently sold and the terms of

the transaction were disclosed.

This approach is commonly used especially in contexts where the user(s) of the

valuer’s report do not have specialized business valuation knowledge. There is an

obvious parallel in a lay person’s mind to consulting with a real estate agent prior

to listing your home for sale to find out for what amount similar homes in your

neighborhood have sold. The market approach is the most common approach

employed by real estate appraisers. Real estate appraisers generally have from

several to even hundreds of comps from which to choose.

For a business valuation professional, a good set of comps may be as many as

two or three – and sometimes no comparable company data can be found. (The

objective of analyzing these components is to determine if the comparable company

has a similar risk profile.) There are three sources of comparable company

transaction data:

• Public company transactions

• Private company transactions

• Prior transactions of the subject company

A. Advantages and Disadvantages

As with any valuation approach, there are significant advantages and

disadvantages.

1. Advantages

a. It is “user friendly.” Companies with similar product, geographic, and/or

business risk and/or financial characteristics should have similar pricing

characteristics. People outside of business valuation can understand this

logic. Users of valuation reports (transaction participants, juries, judges,

etc.) tend to find market based methods to be familiar and easy to

understand in comparison to other approaches.

b. It uses actual data. The estimates of value are based on actual transaction

prices, not estimates based on number of complex assumptions or

judgments. The data can be independently obtained, verified, and tested.

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c. It is relatively simple to apply. The market approach derives estimates of

value from relatively simple financial ratios, drawn from a group of similar

companies. The most complicated mathematics involved is multiplication.

However, this is an advantage more in perception than in reality.

d. It does not rely on explicit forecasts. The income approach requires a set of

assumptions used in developing the forecasted cash flows. The market

approach does not require as many assumptions.

2. Disadvantages

a. Sometimes, no recent comparable company data can be found. This may be

the biggest reason the approach is not used in valuation; the valuer may not

be able to find guideline companies that are sufficiently similar to the

subject. Some companies are so unusual, small, diversified, etc. that there

are no other similar companies.

b. The standard of value may be unclear. Most transaction databases provide

financial and pricing data but do not explicitly indicate whether the reported

transaction was arms-length, strategic, synergistic, fire sale, asset vs. stock,

etc. Some argue that the occurrence of actual fair market value transactions

reported in transaction databases is probably less than 50%. If the guideline

transaction was synergistic, the resulting values multiple will likely produce

a synergistic value – not fair market value.

c. Most of the important assumptions are hidden. Among the most important

assumptions in a guideline price multiple is the company’s expected growth

in sales or earnings. In the income approach the growth rates are disclosed.

When applying multiples from guideline companies the implicit subject

company growth will be a function of the growth rates built into the prices of

the guideline companies on which the value of the subject is based.

d. It is a costly approach. Done correctly, the valuation valuer must perform

significant financial analysis on the subject company and equally on each of

the comparable companies. The analysis must be done to verify

comparability as well as to identify underlying assumptions built into the

pricing multiple. This is after and in addition to the significant time and

effort to first identify possible comps.

e. It is not as flexible or adaptable as other approaches. Unlike the income

approach, the market approach is sometimes difficult to include unique

operating characteristics of the firm in the value it produces.

f. Reliability of the transaction data is questionable. Great strides have been

made in improving the accuracy, completeness, and depth of the data

reported by various subscription services (discussed below). However,

particularly with private company transactions, the valuer would do well to

use such data with caution.

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B. Basic Implementation

As discussed earlier, one of the advantages to the market approach is the

apparent simplicity in implementing it. At its simplest, it requires only

multiplication and perhaps some subtraction, depending on the multiple selected.

The basic format is:

Value = (Price/Parameter) comp x Parameter Subject (For invested capital

multiples, debt should be subtracted.)

C. Sources of Guideline Company Data

The first part of the pricing multiple is the numerator – the price measure of

the guideline company.

Guideline company transactions refer to acquisitions and sales of entire

companies, divisions or large blocks of stock of either private or publicly traded

firms. There are several sources available to obtain pricing date for public and

private companies. The following is not an exhaustive presentation of sources.

Instead, it is a presentation of commonly used sources.

1. Data Sources – Private Companies Transactions

A number of publications collect and disseminate information on transactions.

Most publications make their databases accessible on the Internet for a fee on a

per-use basis or annual subscription access.

2. Data Sources – Public Companies Transactions

Publicly traded companies are required to file their financial statements

electronically with the Securities and Exchange Board of India (SEBI). These filings

are public information and are available on the SEBI website.

Documents can also be obtained from a number of commercial vendors, who

add value by allowing the user to extract selected items (i.e., the balance sheet,

income statement, etc.) or to search all filings for those meeting certain criteria. In

addition, vendors put the data for most or all publicly traded companies in a

standardized format.

It is also important to remember that in this, the information age; there is a

vast amount of financial information available for free. For example, historical

financial data, pricing, disclosures, SEBI filings, and valuer reports are available at

free web sites. If the valuer has identified a public company as a possible

comparable, they would do well to go to that company’s web site and go to the

“Investor Relations” page.

D. Parameters

The second part of the pricing multiple is the denominator, the financial

statement parameter that scales the value of the company.

Some specific common measures include:

1. Revenues

2. Gross profit

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3. EBITDA

4. EBIT

5. Debt-free net income (net income plus after-tax interest expense)

6. Debt-free cash flow (debt-free net income plus depreciation/amortization)

7. Pretax income

8. Net after-tax income

9. Cash flows

10. Asset related

11. Tangible assets

12. Book value of equity

13. Book value of invested capital (book value of equity plus debt)

14. Tangible book value of invested capital (book value of equity, less intangible

assets, plus book value of debt)

15. Number of employees

E. Matching Price to Parameter

“Price” should be matched to the appropriate parameter based on which

providers of capital in the numerator will be paid with the monies given in the

denominator. For example, in price/EBIT, price is the market value of invested

capital (MVIC), since the earnings before interest payments and taxes will be paid to

both the debt and equity holders. In price/net income, price is the market value of

equity (MVEq) only, since net income is after interest payments to debt holders and

represents amounts potentially available to shareholders. Any denominators that

exclude interest (e.g., EBIT or EBITDA) should usually be matched with

corresponding numerator (e.g., MVIC).

MVIC is usually the numerator paired with:

1. Revenues

2. EBITDA

3. EBIT

4. Debt-free net income

5. Debt-free cash flows

6. Assets

7. Tangible book value of invested capital

MVEq is usually the numerator paired with:

1. Pretax income

2. Net income

3. Cash flow

4. Book value of equity

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F. Basic Financial Indicators

Finally, when determining whether you have found comparable company data,

some financial measures that should be included in an analysis for both guideline

and subject companies include:

1. Size Measures

These include sales, profits, total assets, market capitalization, employees, and

total invested capital. Given how size may affect value, at least one, and maybe all,

of these should be included.

2. Historical Growth Rates

Consider growth in sales, profits, assets, or equity.

3. Activity and Other Ratios

Examples are the total asset and inventory turnover ratios. Depending on the

type of business being analyzed, other ratios also may be important.

4. Measures of Profitability and Cash Flow

Consider the four most common measures:

a. Earnings before interest, taxes, depreciation and amortization (EBITDA)

b. Earnings before interest and taxes (EBIT)

c. Net income

d. Cash flow

5. Profit Margins

The current level of profits is probably less important than the ratio of profits

relative to some base item—usually sales, assets, or equity.

6. Capital Structure

It is essential to use some measures derived from the current capital

structure. The most common measures are the values of outstanding total debt,

preferred stock (if it exists), and the market value of common equity, since book

equity generally has very little to do with how stock investors view their relative

position with a company. The ratio of debt to market value of equity can be

included since this represents the true leverage of the company.

7. Other Measures

These will be a function of what is important in the industry in which the

subject company operates.

G. Market Approach: Dividend Paying Capacity Method

The Dividend Paying Capacity Method, sometimes referred to as the Dividend

Payout Method, is an income-oriented method but is considered a market approach

as it is based on market data. It is similar to the capitalization of earnings method.

The difference between this method and the capitalization of earnings method lies

in the difference in the type of earnings used in the calculations and the source of

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the capitalization rate. This method of valuation is based on the future estimated

dividends to be paid out or the capacity to pay out. It then capitalizes these

dividends with a five-year weighted average of dividend yields of five comparable

companies.

1. Description

This method expresses a relationship between the following:

a. Estimated future amount of dividends to be paid out (or capacity to pay out)

b. Weighted average “comparable” company dividend yields of comparable

companies, further weighted by degree of comparability each year using a

sufficient number of comparable companies, generally more than three

c. Estimated value of the business

This method is particularly useful for estimating the value of businesses that

are relatively large and businesses that have had a history of paying dividends to

shareholders. It is highly regarded because it utilizes market comparisons.

Similar to the Price/Earnings Ratio or other methods relying on market data,

this method may not be appropriate for valuing most small businesses because

they do not have comparable counterparts in the publicly traded arena. Another

problem with this method is that most closely held businesses avoid paying

dividends. For tax reasons, compensation is usually the preferred method of

disbursing funds.

In determining dividend-paying ability, liquidity is an important consideration.

A relatively profitable company may be illiquid, as funds are needed for fixed assets

and working capital.

2. Example (Pre-Tax Basis)

RKPCO has a five-year history of weighted average profits of Rs. 250 Lakhs. Its

weighted average dividend payout percentage over the last five years has been 30

percent.

Dividend Payout Ratio = Rs. 250 Lakhs x 30%

Amount of Dividend = Rs. 75 Lakhs

The weighted average dividend yield rate of five comparable companies over the

last five years is 7.5 percent. Therefore, the value of RKPCO, under the dividend

payout method is as follows.

.75 Lakhs . .

.

RsRs 1000 Lakhs

075

3. Observation

It has been suggested that large, “well-heeled” corporations pay out to their

shareholders about 40 to 50 percent of their earnings. Therefore, keep this fact in

mind when estimating dividend payout potential for companies without a history of

paying dividends.

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3.3.9 Other Approaches: Income/Asset Approaches

A. Excess earnings/treasury method

The Excess Earnings Treasury Method is a derivative method stemming from

what is often called the Excess Earnings Return on Assets Method, also referred as

the “formula approach” and asserts that “the formula approach may be used for

determining the fair market value of intangible assets of a business only if there is

no better basis therefore available.”

Unlike all of the other methods discussed thus far, this method combines the

income and asset based approaches to arrive at a value of a closely held business.

Its theoretical premise is that the total estimated value of a business is the sum of

the values of the adjusted net assets (as determined by the adjusted net assets

method) and the value of the intangible assets. The determination of the value of

the intangible assets of the business is made by capitalizing the earnings of the

business that exceed a “reasonable” return on the adjusted (identified) net assets of

the business.

1. Description

A valuation of a business using the Excess Earnings Treasury Method uses the

following steps:

a. Determining the estimated future earnings of the company without regard to

growth. Usually this is the historical economic unweighted or weighted

average earnings over the last five years, adjusted for any non-recurring

items or any other normalizing adjustments.

b. Determining the unweighted or weighted average of the GAAP (or tax basis)

net assets. This calculation should exclude goodwill or other intangible

assets, whose value is also to be estimated by this method. The valuer uses

GAAP net assets in this step in order to ensure as much comparability with

industry data as possible, from which a reasonable rate of return will be

obtained in Step (c).

c. Selecting a reasonable rate of return to apply to the GAAP net assets whose

value was determined in Step (b). The most appropriate rate of return is the

average return on assets (unweighted or weighted) for comparable

companies, or as determined from industry averages.

d. Multiply the value of the GAAP net tangible assets of the business, as

determined in Step b), by the rate of return determined in Step (c). The

product is that portion of total earnings of the business attributable to a

reasonable return on the weighted average or unweighted average net

adjusted assets.

e. The earnings determined in Step (d) are then subtracted from the total

earnings determined in Step (a). The difference is the excess earnings

attributable to the intangible assets being valued by this method.

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f. Select a capitalization rate that corresponds to an appropriate rate for a safe

return, adjusting it accordingly to reflect the perceived level of risk

associated with the company.

g. The amount of excess earnings determined in Step e) is then divided by the

capitalization rate determined in Step (f). The amount thus derived is the

estimated total value of intangible assets.

h. Determine the adjusted net assets at fair market value, as of the valuation

date; use the adjusted net assets method. This determination excludes

goodwill and all other intangible assets.

i. The final step in valuing the entire business is the mere addition of the value

of the intangible assets (determined in Step (g)) to the adjusted net tangible

assets (determined in Step (h)).

2. Example (After-Tax Basis)

a) Assume the following data as they relate to RKPCO:

1. The five-year weighted average historical after-tax economic earnings

are Rs. 250 Lakhs

2. The GAAP weighted average net assets are Rs. 980 Lakhs

3. The value of adjusted net assets are Rs. 1,050 Lakhs

4. The industry weighted average after-tax return on equity is 12 percent

5. The appropriate after-tax intangible capitalization rate for RKPCO is 29.69

percent

6. The company's current adjusted net assets are Rs. 1,050 Lakhs

b) Determine the value of the entire business of Poker Co.:

Calculate the value of intangibles

Weighted average historical after-tax economic earnings

Rs.250 lakhs

Less earnings attributable to tangible assets: GAAP net assets (weighted average) Rs.980 x industry ROE(weighted average) x .12 = (117.60)

Excess earnings attributable to intangible assets Rs.132.40 lakhs

Divided by intangible capitalization rate ÷ .2969

Estimated value of intangibles (Rounded) Rs.446 lakhs c) The total value of the business is the sum of the value of net adjusted assets and

the value of intangible assets. Therefore, the total value of RKPCO under the excess

earnings-return on assets (treasury method) is as follows:

Determine the value of the entire business Value of intangibles Rs. 446 lakhs

(+) Value of adjusted net assets (date of valuation)

Rs.1,050 lakhs

Total Value of Business Rs.1,496 lakhs

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B. Excess Earnings/Reasonable Rate Method

The Excess Earnings Reasonable Rate Method (formally referred to as “Safe

Rate Method”) is another derivative of the Excess Earnings Return on Assets

Method. This method has acquired its name from the fact it applies a reasonable

rate of return to the adjusted net assets rather than an industry rate of return as in

the Treasury Method. Another distinction between this method and the Treasury

Method is the reasonable rate of return is applied to the latest year's balance of

adjusted net assets rather than to an unweighted or weighted average of net assets

(as in the Treasury Method). Similar to the Treasury Method, this method is an

income-and-asset- oriented approach. It is also based on the theory that the total

value of a business is the sum of the adjusted net assets and the value of the

intangibles, as determined by capitalizing the “excess” earnings of the business.

The amount of earnings capitalized is those earnings which exceed a reasonable

rate of return on the adjusted net assets of the business.

1. Description

To value a business using the Excess Earnings Reasonable Rate Method,

follow these steps:

a. Determine the estimated future earnings of the company.

b. Determine the current adjusted net assets at fair market value, using the

adjusted net assets method. This determination must exclude goodwill and

other intangible assets.

c. Select a reasonable rate of return to apply to adjusted net assets whose

value was determined in Step b). The rate chosen should correspond to the

relative liquidity and risk of the underlying assets to which it is being

applied.

d. Multiply the value of the adjusted net tangible assets of the business

determined in Step b) by the rate of return determined in Step c). The

product is the part of total earnings attributable to a return on adjusted net

assets. Adjusted net assets, once again, exclude intangible assets.

e. The earnings determined in Step d) are then subtracted from the total

earnings determined in Step a). The difference is the excess earnings

considered to be attributable to the intangible assets being valued by this

method.

f. Select a capitalization rate that corresponds to an appropriate rate for a

reasonable return and that has been adjusted for any perceived level of risk

and other relevant concerns associated with the company.

g. The amount of excess earnings determined in Step e) is then divided by the

capitalization rate selected in Step f), to arrive at the estimated value of the

intangible assets.

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h. The final step in valuing the entire business is the mere addition of the value

of the intangible assets (determined in Step g)) to the value of the adjusted

net tangible assets (determined in Step b)).

2. Example (Pre-Tax Basis)

a. Assume the following as they relate to RKPCO

1. The five-year weighted average historical pre-tax economic

earnings are Rs.380 lakhs

2. Value of the latest year’s net adjusted assets are Rs.1,050 lakhs

3. The company’s assumed reasonable rate on adjusted net assets is 10

percent

4. The appropriate pre-tax intangible capitalization rate for RKPCO is 49.48

percent

b) Determine the value of the entire business of RKPCO.

Calculate the value of intangibles Weighted average historical pre-tax

economic earnings

Rs.380 lakhs

Less earnings attributable to tangible

assets:

Adjusted net assets Rs.1,050

lakhs

x reasonable rate .10 = (105 lakhs)

(cost of debt in this example)*

Excess earnings attributable to intangible

assets

Rs. 275 lakhs

Divided by intangible capitalization rate**

.4948

Estimated value of intangibles (Rounded) Rs.556 lakhs

The total value of the business is the sum of the value of net adjusted assets

and the value of intangible assets. Therefore, the total value of RKPCO under the

Excess Earnings (Return on Assets) Reasonable Rate Method follows:

Determine the value of the entire business

Value of intangibles Rs.556 lakhs

(+) Value of adjusted net assets Rs.1,050 lakhs

Total Value of Business Rs.1,606 lakhs

NOTE: The Excess Earnings (Return on Assets) Treasury Method is applied to

after- tax economic earnings. By comparison, the Excess Earnings (Return on

Assets) Reasonable Rate Method example is applied to pre-tax economic earnings.

Different types of earnings (after-tax versus pre-tax) have been used to demonstrate

that these methods can be applied regardless of the benefit stream. This is not

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intended to imply that after-tax economic earnings are the only appropriate benefit

stream to be used with the Treasury Method. Similarly, this is not intended to

imply that pre-tax economic earnings are the only appropriate benefit stream to be

used with the Reasonable Rate Method. Any appropriate benefit stream (pre-tax or

after-tax, earnings or cash flow, etc.) can be used with either the Treasury Method,

the Reasonable Rate Method or any of the other income or market approaches

discussed in this chapter.

3.4 REVISION POINTS

1. Market approach

2. Income approach

3. Asset based approach

3.5 INTEXT QUESTIONS

1. Write short notes on (a) Book Value Method, (b) Adjusted NAV Method, (c )

Discounted Cash Flow Method (d) Effect of Controlling Interest, (e) Lack of

Controlling Interest

2. Explain in detail with example end-year and mid-year discounting and its

effect on valuation.

3. Explain in detail Gordon Growth Model.

4. Explain the importance of Excess Earning Method and how it is applied in

business valuation.

3.6 SUMMARY

Various methods of business valuation have been discussed and appropriate

selection of method for given circumstances. The mathematical formulae have also

been explained in detail with examples enabling to student to prepare valuation

models.

3.7 TERMINAL EXERCISE

1. Write the advantages and disadvantages of market approach?

2. What are the methods commonly used for valuation? Explain?

3.8 SUPPLEMENTARY MATERIALS

1. https://www.business valuation.co.in

2. www.business valuation.inc.com

3.9 ASSIGNMENTS

1. Take last 3 to 5 years annual reports of a public listed company, analyze

and device models for business valuation of that company as discussed in

this chapter

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3.10 SUGGESTED READINGS/REFERENCE BOOKS

1. Aswath Damodaran, Investment Valuation – Tools and Techniques for

Determining the Value of any Asset, John Wiley Publication, 3ed Edition,

2012.

2. Krishna G. Palepu, Paul M. Healy, Business Analysis and Valuation using

Financial Statements – Text & Cases, South Western Publication, 4th

Edition, 2002.15.

3. Tom Copeland, Tim Koller, Valuation Workbook – Step by Step Exercise,

John Wiley & Sons Publication, 3ed Edition, 2000.

4. Study Material, Paper – 18, Business Valuation Management, the Institute of

Cost Accountants of India Publication.

(http://icmai.in/upload/Students/Syllabus-2008/StudyMaterialFinal/P-

18.pdf)

3.11 LEARNING ACTIVITIES

Group discussion during PCP days

1. Take last 3 to 5 years annual reports of a public listed company, analyze

and device models for business valuation of that company as discussed in

this chapter

3.12 KEY WORDS

Discounted Cash Flow (DCF), Excess Earning, Dividend Paying Capacity, Lack

of Control

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CHAPTER - 4

ADJUSTMENTS TO FINANCIAL STATEMENTS

4.1 INTRODUCTION

During the 1990s, the Internet enhanced our ability to obtain and disseminate

information dramatically. Information that was once privately owned or perhaps

available only to experts is now widely accessible, almost instantaneously. The

availability and accessibility of all this data provides the valuer with an expanded

tool set by which to gain a deeper insight into the strengths, weaknesses,

opportunities, and threats of a given company or industry.

Due to the enormously expanded amount of data available, valuers must go

beyond simply measuring the economic income of a given enterprise. They also

must attempt to determine what factors give rise to the ability (or inability) of the

enterprise to generate required returns for the foreseeable future; that is, they must

make in-depth enterprise risk assessments. Consequently, a well-reasoned

valuation analysis includes certain critical elements:

An estimation of the amount of future economic benefits (normalization and

projection of future cash flows)

An assessment of the probability that the projected future economic benefits

will be realized

4.2 OBJECTIVES

Almost all business valuations use information from financial statements. This

chapter discusses adjusting the financial statements to provide a relevant basis for

fair market value opinions for given circumstances and cases of valuation.

4.3 CONTENTS

4.3.1 Why Adjustments to Financial Statements for Business Valuation

4.3.2 Separating Non-operating Items from Operating Items

4.3.3 Addressing Excess Assets and Asset Deficiencies

4.3.4 Handling Contingent Assets and Liabilities

4.3.5 Adjusting Cash-Basis Statements to Accrual-Basis Statements

4.3.6 Normalizing Adjustments

4.3.7 Controlling Adjustments

4.3.1 Why Adjustments to Financial Statements for Business Valuation

Almost all business valuations use information from financial statements. This

chapter discusses adjusting the financial statements to provide a relevant basis for

fair market value opinions. Following Chapter discusses analyzing the statements

to provide insights to be used in the valuation.

In most valuation cases, certain adjustments to the subject company’s

historical financial statements should be made. This chapter discusses, in broad

terms, the categories of such adjustments and why each is appropriate. If no

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adjustments were made to the subject company’s statements, the report should

contain a statement that the analyst has reviewed the company’s statements and

that no adjustments were considered appropriate.

If a publicly traded guideline company method is used, the same categories of

adjustments should be made to the guideline companies as to the subject company.

If the valuer/ analyst has made no adjustments to the guideline companies, the

report should contain a statement to the effect that the analyst has reviewed the

guideline company statements and no adjustments were necessary.

There are six categories of financial statement adjustments:

1. Separating non-operating items from operating items

2. Adjusting for excess assets or asset deficiencies

3. Adjusting for contingent assets and/or liabilities

4. Adjusting the cash-basis financial statements to accrual-basis statements (if

the company accounts are on a cash basis)

5. Normalizing adjustments

6. Controlling adjustments

The financial statement adjustments section of the report should be reviewed

with these questions in mind:

Were all the adjustments that should have been made actually made

(including parallel adjustments to the financial statements of the guideline

companies)?

Were any adjustments made that were inappropriate?

Is there convincing rationale for the magnitude of the adjustments?

4.3.2 Separating Non-operating Items from Operating Items

Generally speaking, when valuing an operating company, non-operating assets

on the balance sheet should be removed and treated separately from the value of

the company as an operating company. When non-operating assets are removed

from the balance sheet, any income or expense associated with them should also be

removed from the income statement.

For example, some companies own portfolios of marketable securities. These

should be removed from the balance sheet, and any related income should be

removed from the income statement. The fair market value of the marketable

securities should be added to the value of the company as an operating company

(i.e., aggregated with the going-concern value of the business operation to arrive at

the value of the company and its issued shares).

An exception would be when the securities are required to be held to meet

certain contingent liabilities of the operating company.

Another example of a non-operating item would be real estate not involved in

the company’s operation.

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There can be legitimate controversy over whether certain items are operating

or non-operating. Most non-operating assets are worth more on a liquidation basis

than they are based on the value of the income they contribute to the operation.

Therefore, those who want a high value usually argue to classify questionable items

as non-operating, while those who want a low value argue to classify the items as

operating assets. A case in point would be defunct drive-in theaters owned by a

theater chain, used for swap meets at the valuation date. (They were classified for

tax purposes as non-operating assets.)

In any case, where an asset approach is being used in a tax context, any write-

ups of assets should be offset by the capital gains liability on the write-ups.

Some argue for not reclassifying non-operating items when valuing minority

interests. The minority stockholder does not have the power to liquidate the assets;

therefore, reclassifying non-operating items and adding back their value would

usually result in overvaluation for a minority stockholder. An alternative for

minority interest valuations would be to find the fair market value of nonoperating

assets, net of a minority interest discount, and add it to the value of the operating

company.

4.3.3 Addressing Excess Assets and Asset Deficiencies

Excess assets or asset deficiencies should be treated similarly to nonoperating

assets. That is, to the extent that there are excess assets or asset deficiencies, their

value should be added to or subtracted from the value of the operating company.

If valuing a minority interest, a minority interest discount may be applied to

the value of the non-operating assets. This is because the minority interest holder

has no power to liquidate the excess assets, and the market usually does not give

full credit to excess assets in the stock price. The most common category of

controversy regarding excess or deficient assets involves working capital. The most

common measurement of the adequacy of working capital is the amount of working

capital as a percentage of the company’s sales. Benchmarks can be indus- try

averages or working capital-to-sales percentages of guideline companies. Either of

these benchmarks usually produces a range. If working capital is within a

reasonable range relative to the benchmarks, no adjustment is ordinarily required.

The following example is typical of the treatment of excess assets, in this case

for the valuation of stock in a bank:

The bank held cash and marketable securities—primarily intermediate term

Treasury notes, equal to 22 percent of assets, compared to 9 percent or less for peer

groups. The valuation expert separated out cash and securities representing 13

percent of the total assets and calculated an adjusted operating book value. He

separated out the earnings from the excess assets and calculated adjusted

operating earnings. He then estimated the company’s value on an operating basis

and added the value of the excess assets, the latter net of a 10 percent minority

interest discount.

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The same calculation can be performed in reverse in case of a working capital

deficiency.

4.3.4 Handling Contingent Assets and Liabilities

Many companies have contingent liabilities, and some have contingent assets.

The contingent liabilities often arise from environmental issues. They can also arise

from product liability lawsuits and from other actual or potential lawsuits.

Contingent assets sometimes arise from unknown collections or lawsuits where the

subject company is a plaintiff.

Contingent assets or liabilities are often handled as percentage adjustments at

the end of the valuation process. However, they are sometimes handled as specific

financial statement adjustments.

4.3.5 Adjusting Cash-Basis Statements to Accrual-Basis Statements

Some companies, usually small businesses and professional practices, use

cash-basis accounting. This means that both revenues and expenses are recorded

when they are received or paid, rather than when they are incurred.

Accrual-basis accounting, by contrast, records revenues and expenses when

they are earned, measurable, and collectible, based on the accounting principle of

matching costs with related revenues. Most valuations use accrual-basis

accounting. Therefore, for any given period, figures should be adjusted to reflect

revenues earned and expenses incurred during the period. Accounts receivable and

accounts payable should also be adjusted.

4.3.6 Normalizing Adjustments

The general idea of normalizing adjustments is to present data in conformance

with GAAP and any industry accounting principles and to eliminate nonrecurring

items. The goal is to present information on a basis comparable to that of other

companies and to provide a foundation for developing future expectations about the

subject company. Another objective is to present financial data on a consistent

basis over time.

The following are some examples of normalizing adjustments:

Adequacy of allowance and reserve accounts:

1. Allowance for doubtful accounts (correct to reasonable amount, in light

of historical results and/or management interviews)

2. Pension liabilities

Inventory accounting methods:

1. First in, first out (FIFO); last in, first out (LIFO); and other methods

(adjust to methods usually used in the industry)

2. Write-down and write-off policies (adjust to normal industry practices)

Depreciation methods and schedules

Depletion methods and schedules (adjustments to industry reporting norms)

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Treatment of intangible assets:

1. Leasehold interest (adjust to market value)

2. Other intangible assets

Policies regarding capitalization or expensing of various costs (adjust to

industry norms)

Timing of recognition of revenues and expenses:

1. Contract work (including work in progress; e.g., percentage of completion

or completed contract)

2. Installment sales

3. Sales involving actual or contingent liabilities (e.g., guarantees,

warranties)

4. Prior period adjustments (e.g., for changes in accounting policy or items

overlooked)

5. Expenses booked in one year applying to other years

Net operating losses carried forward

Treatment of interests in affiliates

Adequacy or deficiency of assets:

1. Excess or deficient net working capital (adjust to industry average

percent of sales)

2. Deferred maintenance (based on plant visit and management interviews)

Adequacy or deficiency of liabilities:

1. Pension termination liabilities

2. Deferred income taxes

3. Unrecorded payables

Unusual gains or losses on sale of assets

Nonrecurring gains or losses:

1. Fire, flood, or other casualty, both physical damage and business

interruption to extent not covered by insurance

2. Strikes (unless common in the industry and considered probable to

recur)

3. Litigation costs, payments, or recoveries

4. Gain or loss on sale of business assets

5. Discontinued operations

A valuer should consider all of these adjustments, whether they have been

made, and, if not, why not.

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4.3.7 Controlling Adjustments

A control owner or potential owner might make control adjustments, but a

minority owner, generally, could not force the same changes. Therefore, control

adjustments normally would be made only in the case of a controlling interest

valuation, unless there was reason to believe that the changes were imminent and

probable. These include:

Excess or deficient compensation and perquisites

Gains, losses, or cash realization from sale of excess assets

Elimination of operations involving company insiders (e.g., employment,

non-market-rate leases)

Changes in capital structure

When experts present objective evidence to support their opinion, the objective

evidence will almost always be scrutinized by opposing experts and will be subject

to criticism. The more sources that are available, the greater is the onus on the

expert to defend his source. There is a minority (but legitimate) school of thought

that considers what we have just classified as control adjustments to be

normalizing adjustments, even in a minority interest valuation where the minority

holder cannot force the company policy to change. The reason for this is to put the

subject company on a basis comparable to the guideline companies. The minority

interest factor is then handled as a separate discount at the end of the valuation.

4.4 REVISION POINTS

1. Financial statements

2. Normalizing adjustments

3. Controlling adjustments

4.5 INTEXT QUESTIONS

1. Why adjustments in financial statements necessary before proceeding to

business valuation process?

2. How will you treat excess assets and deficiencies in assets for the purpose of

business valuation?

3. Explain difference between operating and non-operating assets in regards to

business valuation and how you will treat them.

4. How will you adjust contingent assets and contingent liabilities adjusting

financial statements for the purpose of business valuation?

5. Differentiate cash based and accrual based accounting.

6. What is your understanding about normalizing adjustments in financial

statements for the purpose of business valuation?

7. Discuss in detail controlling adjustments in financial statements for the

purpose of business valuation.

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4.6 SUMMARY

In this chapter we have classified financial statement adjustments into six

categories:

1. Separating non-operating items from operating items

2. Addressing excess assets and asset deficiencies

3. Handling contingent assets and liabilities

4. Adjusting cash-basis statements to accrual-basis statements

5. Normalizing adjustments

6. Controlling adjustments

There is nothing wrong with an analyst’s using a different categorization of

financial statement adjustments; this categorization is merely presented for the

convenience of the reader. However, if any of the items in this chapter are relevant,

adjustments to the financial statements should be made, however categorized. If no

adjustments are warranted, the analyst should include a statement in the report

that the financial statements were analyzed and no adjustments were warranted.

Once the financial statements have been adjusted to provide a relevant basis

for arriving at fair market value, the next step is to analyze them so as to recognize

trends, strengths, and weaknesses.

4.7 TERMINAL EXERCISE

1. Write short notes on

a. Normalizing adjustments

b. Controlling adjustments

2. Difference between normalizing adjustments and controlling adjustments.

4.8 SUPPLEMENTARY MATERIALS

1. www.business valuation.inc.com

2. https\\www.business.gov.in

4.9 ASSIGNMENTS

1. Take last 3 to 5 years annual reports of a public listed company, analyze

and work out various adjustment in financial statements for the purpose of

business valuation of that company as discussed in this chapter

4.10 SUGGESTED READINGS/REFERENCE BOOKS

1. Aswath Damodaran, Investment Valuation – Tools and Techniques for

Determining the Value of any Asset, John Wiley Publication, 3ed Edition,

2012.

2. Krishna G. Palepu, Paul M. Healy, Business Analysis and Valuation using

Financial Statements – Text & Cases, South Western Publication, 4th

Edition, 2002.15.

3. Tom Copeland, Tim Koller, Valuation Workbook – Step by Step Exercise,

John Wiley & Sons Publication, 3ed Edition, 2000.

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4. Study Material, Paper – 18, Business Valuation Management, the Institute of

Cost Accountants of India Publication.

(http://icmai.in/upload/Students/Syllabus-2008/StudyMaterialFinal/P-

18.pdf)

4.11 LEARNING ACTIVITIES

Group discussion during PCP days

1. Take last 3 to 5 years annual reports of a public listed company, analyze

and work out various adjustment in financial statements for the purpose of

business valuation of that company as discussed in this chapter

4.12 KEY WORDS

Operating and non-operating items, Cash Based and Accrual Based, Excess

assets and Deficiencies, Normalizing, Controlling

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CHAPTER - 5

COMPARATIVE FINANCIAL STATEMENT ANALYSIS

5.1 INTRODUCTION

Comparative analysis is a valuable tool for highlighting differences between the

subject company’s historical performance and industry averages, pointing out

relative operating strengths and weaknesses of the subject company as compared

to its peers, assessing management effectiveness, and identifying areas where the

company is outperforming or underperforming the industry. Comparative analysis

is performed by comparing the ratios of the subject company to industry ratios

taken from commonly accepted sources of comparative

5.2 OBJECTIVES

Once the financial statements have been adjusted to provide a sound basis for

arriving at an opinion as to fair market value, the next step is to analyze the

statements to reveal trends, strengths, and weaknesses. This chapter discusses the

financial statement analysis.

5.3 CONTENTS

5.3.1 Objective of Financial Statement Analysis

5.3.1.1 Assessment of Risk

5.3.1.2 Assessment of Growth Prospects

5.3.2 Comparable Ratio Analysis

5.3.2.1 Activity Ratios (sometimes also called Asset Utilization Ratios)

5.3.2.2 Performance Ratios (Income Statement)

5.3.2.3 Return-on-Investment Ratios

5.3.2.4 Leverage Ratios

5.3.2.5 Liquidity Ratios

5.3.2.6 Other Risk-Analysis Ratios

5.3.3 Common Size Statements

5.3.4 Tying the Financial Statement Analysis to the Value Conclusion

5.3.1Objective of Financial Statement Analysis

The objective of financial statement analysis is to provide analytical data to

guide the valuation. The reliability of a valuation report may be evaluated partially

on whether the financial analysis is adequate, and on the relevance of that analysis

to the valuation conclusion.

Since “valuation . . . is, in essence, a prophecy [sic] as to the future,”1 the

relevance of historical financial statements is merely as a guide for what to expect

in the future. For most companies, a pure extrapolation of past results would

provide a misleading prophecy as to the company’s future.

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5.3.1.1 Assessment of Risk

Risk can be defined as the degree of certainty (or lack thereof) of achieving

future expectations at the times and in the amounts expected.

One of the most important products of financial statement analysis is to

provide an objective basis for assessment of risk relative to industry average risk

and/or risk of specific guide- line companies. Risk analysis is of critical importance

because, other things being equal, the higher the risk, the lower the fair market

value of the company.

In the income approach, the higher the risk, the higher the market’s required

rate of expected return on investment. The market’s required rate of return on

investment is called the discount rate, the rate at which projected cash flows

are discounted back to a present fair market value. The discount rate represents

the total expected rate of return on the value of the investment, including both

cash distributions and capital appreciation, whether realized or unrealized. The

higher the risk, the higher the discount rate and thus the lower the value of the

company or interest in the company.

In the market approach, risk is reflected in valuation multiples. The higher the

risk, the lower the valuation multiples and thus the lower the fair market value of

the company or interest in the company.

Risk also affects the discount for lack of marketability. Other things being

equal, the higher the risk, the higher the discount for lack of marketability.

5.3.1.2 Assessment of Growth Prospects

Another purpose of financial statement analysis is to provide a basis for

assessing the prospects for growth. The higher the company’s prospective growth in

net cash flows (or earnings, or some other measure of benefit to shareholders), all

else being equal, the higher the present fair market value of the company.

In the discounted cash flow method within the income approach, growth is

reflected directly in the projections. Financial statement analysis can provide a

basis for evaluating the reasonableness of the projections. The discounted cash flow

method requires that all projected future benefits to the owners be discounted

back to a present value at a discount rate that reflects the risk of realizing the

benefits projected.

In the capitalization method within the income approach, growth is reflected

by subtracting the rate of expected long-term growth from the discount rate to

arrive at the capitalization rate. Financial statement analysis can help to evaluate

the reasonableness of the estimate of the long-term growth rate. The capitalization

method consists of dividing some measure of benefit by a capitalization rate, which

is either the discount rate minus the expected long-term growth rate or a rate ob-

served from comparative companies.

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In the market approach, expected growth is reflected in the valuation

multiples. Financial statement analysis can be helpful in evaluating the

reasonableness of the multiples applied to the subject company’s fundamentals.

5.3.2 Comparable Ratio Analysis

For convenient analytical purposes, ratios can be arbitrarily classified into half

a dozen categories:

1. Activity ratios

2. Performance ratios

3. Return-on-investment ratios

4. Leverage ratios

5. Liquidity ratios

6. Other risk-analysis ratios

The following list of financial statement ratios is not all-inclusive, but presents

those most commonly used.

Following are different ways for application of ratios, which help in planning

financial decisions and in solving decision-making problems and business

valuation:

1. Trend analysis

2. Inter-firm comparison

3. Comparison with industrial average i.e., digging out strength and weakness.

5.3.2.1 Ratios (Sometimes also called Asset Utilization Ratios)

Activity ratios relate an income statement variable to a balance sheet variable.

Ideally, the balance sheet variable would represent the average of the line item for

the year, or at least the average of the beginning and ending values for the line

item. However, many sources of comparative industry ratios are based only on

year-end data. For the ratios to have comparative meaning, it is imperative that

they be computed from the subject company on the same basis as the average or

individual company ratios with which they are being compared. It also should be

noted that many ratios can be distorted significantly by seasonality, so it may be

important to match comparative time periods.

Accounts receivable turnover:

Sales

Accounts receivable

The higher the accounts receivable turnover, the better the company is

doing in collecting its receivables.

Inventory turnover:

S

Cost of goods

old Inventory

The higher the inventory turnover, the more efficiently the company is using

its inventory. Note: Some people use sales instead of cost of goods sold in this ratio.

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This method inflates the ratio, since it does not really reflect the physical turnover

of the goods.

Sales to net working capital:

–

S le

a

s

Net working capital Current assets Current liabilities

The higher the sales to net working capital, the more efficiently the company is

using its net working capital. However, too high a sales-to-working-capital ratio

could indicate the risk of inadequate working capital.

Sales to net fixed assets:

Sale

(

s

)Net fixed assets Cost Accumulated depreciationt

Sales to total assets:

Sales

Total assets

Generally speaking, activity ratios are a measure of how efficiently a company

is utilizing various balance sheet components.

5.3.2.2 Performance Ratios (Income Statement)

The four most common measures of operating performance are:

Gross profit as a percentage of sales:

Sales

Gross profi

Operating profit (earnings before interest and taxes [EBIT]) as a percentage of sales:

Sa s

le

EBIT

Pretax income as a percentage of sales:

I sales

Pretax

ncome

Net profit as a percentage of sales:

Sale

s

Net profit

All four measures can be read directly from the common size income

statements, which are discussed in the following section. A higher performance

ratio means that a higher price- to-sales multiple can be justified.

5.3.2.3 Return-on-Investment Ratios

Like activity ratios, return-on-investment ratios relate an income statement

variable to a balance sheet variable. Ideally, the balance sheet variable would

represent the average of the line item for the year, or at least the average of the

beginning and ending values for the line item. Unlike activity ratios, return-on-

investment ratios sometimes are computed on the basis of the balance sheet line

item at the beginning of the year. However, many sources of comparative ratios are

based only on year-end data. For the ratios to have comparative meaning, it is

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imperative that they be computed for the subject company on the same basis as the

average or individual company ratios with which they are being compared.

Return on equity:

Net income

Equity

Note: The preceding ratio normally is computed based on book value of equity.

It also may be enlightening to compute it based on market value of equity.

Return on investment:

–

Net income Interest 1 Tax rate

Equity Long term debt

Return on total assets:

–

Net income Interest 1 Tax rate

Total assets

Note: These ratios are normally computed based on book values.

Each measure of investment returns provides a different perspective on

financial performance. In valuation, return on equity influences the price-to-book-

value multiple, and return on investment influences the market-value-of-invested-

capital (MVIC)-to-EBIT multiple. A higher return on various balance sheet

components justifies a higher value multiple relative to those components.

5.3.2.4 Leverage Ratios

The general purpose of balance sheet leverage ratios (capital structure ratios)

is to aid in quantifiable assessment of the long-term solvency of the business and

its ability to deal with financial problems and opportunities as they arise. Balance

sheet leverage ratios are important in assessing the risk of the individual

components of the capital structure. Above-average levels of debt may increase both

the cost of debt and the company-specific equity risk factor in a build-up model for

estimating a discount or capitalization rate. Alternatively, above-average debt may

increase the levered beta in the capital asset pricing model (CAPM). The CAPM,

discussed in Chapter 14, is a procedure for developing a discount rate applicable to

equity.

Total debt to total assets:

Total liabilities

Total assets

Equity to total assets:

Total equity

Total assets

Long-term debt to total capital:

 

Long term debt

Long term debt Equity

Equity to total capital:

 

Total equity

Long term debt Equity

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Fixed assets to equity:

Net fixed assets

Total equity

Debt to intangible equity:

Total liabilities

Total equity

Note: The preceding ratio sometimes is computed using total equity minus

intangible assets in the denominator.

Leverage ratios are a measure of the overall financial risk of the business.

5.3.2.5 Liquidity Ratios

Liquidity ratios are indications of the company’s ability to meet its obligations

as they come due—in this sense, they are factors that may be considered in

assessing the company-specific risk.

Current ratio:

Current assets

Current liabilities

Quick (acid test) ratio:

Cash Cash equivalents Short term investments Receivables

Current liabilities

Times interest earned:

a.

EBIT

Interest expense

or

b. E

EBIT Interest

xpense

Note: Depreciation in the preceding formula is usually construed to include

amortization and other noncash charges, sometimes expressed by the acronym

EBITDA (earnings before interest, taxes, depreciation, and amortization).

Coverage of fixed charges:

, ,

     

Earnings before interest taxes and lease payments

Interest Current portion of long term debt Lease payments

5.3.2.6 Other Risk-Analysis Ratios

Business risk (Variability of return over time):

Standard deviation of net

income Mean of net income

Business risk measures volatility of operating results over time. The higher the

historical business risk, the less predictable future results are likely to be.

Variability of past results is a better predictor of variability of future results (risk)

than a past upward or downward trend is of a future upward or downward trend.

Note: This measure is called the coefficient of variation. It can be applied to

any measure of income; including sales, EBITDA, EBIT, gross profit, pretax profit,

or net cash flow.

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Degree of operating leverage:

Percentage change in operating

earnings Percentage change in sales

Note: This is really another measure of business risk. The numerator could be

any of the measures of income listed earlier.

Financial risk (Degree of financial leverage):

Percentage change in income to common equity

Percentage change in EBIT

5.3.3 Common Size Statements

A common size statement is a balance sheet that expresses each line item as a

percentage of total assets or an income statement that expresses each line item as a

percentage of revenue.

When several years of financial statements are available for a company,

common size statements can be used to compare the company against itself over

time. This is called trend analysis. Note that past years of statements produce only

year-to-year changes and thus a compound rate of growth, or decline, in each line

item.

When a number of years’ worth of common size statements are used, the

volatility of each line item can be measured using the standard deviation of the

year-to-year changes.

When a comparable number of years of common size statements are available

for industry averages or specific guideline companies, the relative volatility of each

line item can be com- pared. Higher volatility is indicative of higher risk.

A single year’s common size statements can be used to compare Subject

Company to industry averages or to specific guideline companies.

5.3.4 Tying the Financial Statement Analysis to the Value Conclusion

The implications of the financial statement analysis for the conclusion of value

should be identified in the financial statement analysis section, the valuation

section, or both. Some reports have an extensive financial analysis section with no

mention of implications for value either in the analysis or valuation section. To be

convincing, the report should be cohesive; the report should hang together, with

each section lending support for the value conclusion. The connection should be

explained, not leaving the reader to guess. Many readers will not be financial

experts, and a connection that might be apparent to a financial analyst might not

be obvious to a less sophisticated reader.

5.4 REVISION POINTS

1. Activity Ratio

2. Return – on – Investment Ratio

3. Liquidity Ratio

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5.5 INTEXT QUESTIONS

1. Discuss the objectives of Financial Statement Analysis for the purpose of

business valuation.

2. Write short notes on

a. Activity Ratios

b. Performance Ratios

c. Return-on-Investment Ratios

d. Leverage Ratios

e. Liquidity Ratios

3. Explain Common Size Statements in view of business valuation.

4. How financial statement analysis impacts business valuation?

5. A firm’s sales are Rs. 4,50,000, cost of goods sold is Rs. 2,40,000 and

inventory is Rs. 90,000. What is Stock turnover? Also calculate the gross

margins.

6. The only current assets possessed by a firm are cash Rs. 1,05,000,

inventories Rs. 5,60,000 and debtors Rs. 4,20,000. If the current ratio for

the firm is 2 to 1, determine its current liabilities. Also, calculate the firm’s

quick ratio.

7. A company has a gross profit margin of 10% and asset turnover of 3. What

is its ROI?

8. A company has current liabilities of Rs. 2,00,000, mortgage of Rs. 3,00,000

and bonds of Rs. 5,00,000. Its total equity is Rs. 1,50,000. What is its debt

equity ratio?

9. A company has net income after tax of Rs. 4,00,000 and pays cash dividend

of Rs. 2,40,000 on its Rs. 2,00,000 shares when the stock is selling for Rs.

20. What is the dividend yield and dividend payout ratio of the company.

10. The total sales of a firm are Rs. 4,00,000 and it has a gross profit margin of

20 percent. If the company has an average inventory of Rs. 50,000,

determine the inventory turnover.

11. A company has an inventory of Rs. 18,00,000, debtors of Rs. 1,15000 and

an inventory turnover of 6. The gross profit margin of the company is 10

percent and its credit sales are 20 percent of total sales. Calculate the

average collection period (assume a 360 day year).

12. A company has shareholders equity of Rs. 2,00,000. Total assets are 160

percent of the shareholders equity while the assets turnover is 4. If the

company has an inventory turnover of 5, determine the amount of inventory.

13. A firm has cost of Rs. 2,00,000, sales of Rs. 2,50,000 and asset turnover of

4. What is the rate of return on asset?

14. A firm has profit before interest and taxes of Rs. 30,000, total assets of Rs.

5,00,000 and total liabilities Rs. 3,00,000. What is its (1) return of equity (2)

interest coverage?

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15. State whether the following statements are ‘true’ or ‘false’:

a. A ratio is a quotient.

b. Liquidity ratios indicate financial soundness of a company.

c. Gross profit margin covers administrative and selling expenses.

d. Debt ratios have no implications in overall capital structure of the

company.

e. Earnings per share shows turnover ratio.

16. State whether following transactions will result in decline, improvement or

have no effect on current ratios.

a. Payment of a current liability.

b. Purchase of fixed assets in cash.

c. Cash collected form debtors.

d. Issue of new shares.

e. Sell 15% debenture.

17. Give the formula for calculating the following ratios:

a. Current ratio

b. Acid test ratio

c. Debt equity ratio

d. Inventory turnover ratio

e. Gross profit margin

f. Earnings per share

g. Return on investment.

5.6 SUMMARY

The primary objectives of financial statement analysis are to identify trends

and to identify the strengths and weaknesses of the subject company relative to its

peers. Perhaps the most important outgrowth of financial statement analysis is

objective evidence of the subject company’s risk relative to its peers. This relative

riskiness plays a part in the discount and capitalization rates in the income

approach and in the valuation multiples in the market approach.

5.7 TERMINAL EXERCISE

1. Define the term

a. Current ratio

b. performance ratio

c. leverage ratio

d. liquidity ratio

2. Explain the term “common size statements”

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5.8 SUPPLEMENTARY MATERIALS

1. www.business valuation.inc.com

2. www.business.gov.in

5.9 ASSIGNMENTS

Take last 3 years annual reports of two public listed companies of similar

nature in the same product line/ industry analyze and work out various

comparable ratios of both the companies for the purpose of business valuation.

Discuss the trends of ratios Intra Company each and inter-company. Also reply

following questions:

1. Which company is using the shareholder’s money more profitably?

2. Which company is better able to meet its current debts?

3. If you were to purchase the debentures of one company, which company’s

debenture would you buy?

4. Which company collects its receivables faster, assuming all sales to be credit

sales?

5. Which company has extended credit for a greater period by the creditors,

assuming all purchases to be credit purchases?

6. How long does it take each company to convert an investment in stock to

cash?

5.10 SUGGESTED READINGS/REFERENCE BOOKS

1. Aswath Damodaran, Investment Valuation – Tools and Techniques for

Determining the Value of any Asset, John Wiley Publication, 3ed Edition,

2012.

2. Krishna G. Palepu, Paul M. Healy, Business Analysis and Valuation using

Financial Statements – Text & Cases, South Western Publication, 4th

Edition, 2002.15.

3. Tom Copeland, Tim Koller, Valuation Workbook – Step by Step Exercise,

John Wiley & Sons Publication, 3ed Edition, 2000.

4. Study Material, Paper – 18, Business Valuation Management, the Institute of

Cost Accountants of India Publication.

(http://icmai.in/upload/Students/Syllabus-2008/StudyMaterialFinal/P-

18.pdf)

5.11 LEARNING ACTIVITIES

Group discussion during PCP days

Take last 3 years annual reports of two public listed companies of similar

nature in the same product line/ industry analyze and work out various

comparable ratios of both the companies for the purpose of business valuation.

Discuss the trends of ratios Intra Company each and inter-company. Also reply

following questions:

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1. Which company is using the shareholder’s money more profitably?

2. Which company is better able to meet its current debts?

3. If you were to purchase the debentures of one company, which company’s

debenture would you buy?

4. Which company collects its receivables faster, assuming all sales to be credit

sales?

5. Which company has extended credit for a greater period by the creditors,

assuming all purchases to be credit purchases?

6. How long does it take each company to convert an investment in stock to

cash?

5.12 KEY WORDS

Risk, Growth Prospects, Comparable Ratio Analysis, Common Size Statements

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CHAPTER - 6

ECONOMIC AND INDUSTRY ANALYSIS

6.1 INTRODUCTION

The purpose of economic research is to understand the effects of economic

conditions on the subject company both at the national level and at the company’s

market level. These macroeconomic forces are factors over which the company has

no control. Valuers must consider the key external factors that affect value, such as

interest rates, inflation, technological changes, dependence on natural resources,

and legislation. It is important to identify trends that may be particularly favorable

or unfavorable to the subject company. For example, low home mortgage rates are

favorable if the subject company is a residential contractor. Low unemployment

may be a negative factor if the subject company is heavily dependent on labor

resources. Additional issues to consider when analyzing a local economy include:

Whether the local economy is dependent on a single employer or industry

The extent and condition of the area’s infrastructure

Announcements of major plant openings or closings

Income levels and poverty rates

6.2 OBJECTIVES

Almost every company is affected to some extent by economic conditions and

by conditions in the industry in which it operates. No discussion of business

valuation would be complete without at least a brief discussion of external factors.

Various economic and industry factors affect each company differently, and the key

to effective economic and industry analysis is to show how each factor impacts the

subject company. This chapter discusses economic and industry analysis of

business for valuation.

6.3 CONTENTS

6.3.1 Objective of Economic and Industry Analysis

6.3.2 National Economic Analysis

6.3.3 Regional and Local Economic Analysis

6.3.4 Industry Analysis

6.3.5 Management Compensation Information

6.3.1 Objective of Economic and Industry Analysis

Almost every company is affected to some extent by economic conditions and

by conditions in the industry in which it operates. No discussion of business

valuation would be complete without at least a brief discussion of external factors.

Various economic and industry factors affect each company differently, and the key

to effective economic and industry analysis is to show how each factor impacts the

subject company.

Some companies are affected by certain aspects of the national economy.

Others are affected primarily by regional and local economic factors. Some are

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affected more heavily than others by conditions in the industry in which they

operate. Economic and industry analysis identifies those factors that affect the

subject company.

The objective of economic and industry analysis is to provide relevant data on

the context within which the company is operating.

The key word here is relevant

No company operates in a vacuum. All companies are impacted to a greater or

lesser extent by external conditions. These could be national, regional, or local

economic conditions and/or conditions in the industry in which the company

operates.

The extent to which various economic and industry conditions affect differing

companies varies widely from company to company.

It is the valuer’s job to identify what aspects of economic and/or industry

conditions tend to affect the subject company, to identify how those conditions are

expected to change in the future, and to assess the impact of those changes on the

subject company. “It is essential for the appraiser to relate economic indicators and

outlook to the specific circumstances of the subject company and valuation

engagement.”

A great deal of economic and industry data are available online. The most

comprehensive source of economic and industry data available online is Best

Websites for Financial Professionals, Business Appraisers, and Accountants,

6.3.2 National Economic Analysis

Companies in some industries are heavily impacted by certain aspects of the

U.S. economy. In some cases those aspects of the national economy have little or no

relevance. Major components of national economic analysis include the following:

General economic conditions:

1. Gross domestic product (GDP)

2. Consumer spending

3. Government spending

4. Business investments

5. Inventories (increases or decreases)

6. Trade deficit

Consumer prices and inflation rates

Interest rates

Unemployment

Consumer confidence

Stock markets

Construction

Manufacturing

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The valuer should identify which of these economic variables affects the

subject company, and should concentrate the economic analysis on those variables.

Long-term outlooks for certain national economic variables can be very important

to some companies, especially the long-term growth forecast. Projections of long-

term growth in excess of the sum of fore- casted growth in real gross domestic

product (GDP), plus inflation, should generally be viewed with suspicion and

require strong justification. For example, some valuating practitioners use the

expected growth in a company or industry for the coming five years with the

assumption that this is going to continue for the long term. This is usually wrong,

and can lead to an inflated estimate of value.

6.3.3 Regional and Local Economic Analysis

Regional and/or local economic analysis is relevant to those companies whose

fortunes are affected primarily by regional and/or local economic conditions. These

would include such companies as regional or local financial institutions, retailers,

building contractors, and various types of service companies. Sources of regional

and local economic analysis include banks, public utilities, state departments of

economic development, and chambers of commerce.

6.3.4 Industry Analysis

Industry analysis can be categorized into three components:

1. General industry conditions and outlook

2. Comparative industry financial statistics

3. Management compensation information’s

Web sites for industry analysis are available in Best Websites.6

General Industry Conditions and Outlook

Almost all industries have one or more trade associations. Many also have

other independent publications devoted to industry conditions. Also, most national

stock brokerage companies publish outlook information for the industries in which

they specialize. There are several di- rectories of these sources included in the

bibliography at the end of this chapter.

Comparative Industry Financial Statistics

Industry average financial statistics can be useful to compare the subject

company’s financial performance with industry norms. The comparisons can take

either or both of two forms:

1. Ratio analysis. Comparing a company’s financial ratios to industry norms

2. Common size statements. Income statements and balance sheets where

each line item is expressed as a percentage of total revenue or total assets

Sources for specific industry financial statistics can be found in the directories

of trade associations and industry information.

Each source of industry information has its own source of data. The valuation

analyst should be aware of the sources for each industry information compilation

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and the potential distortions or biases that might result from the source. For

example, compilations based on the Department of Commerce’s Sources of Income

are compiled from federal tax returns, with data about three to four years old. For

industries in which statistics remain relatively stable over time, this is a good

source, because it has the advantage of more company-size break- downs than any

other. However, in industries for which statistics are volatile over time, a

comparison to four-year-old data may not be valid.

Also, each source has its own definitions. When using comparative industry

data, the valuer must be certain that the definitions used for the subject company

are the same as those used in the industry source. Otherwise, the comparisons will

not be valid.

6.3.5 Management Compensation Information

The most frequent (and controversial) adjustment to the subject company’s

income statement is to management compensation. There are whole income tax

cases where the sole issue is reasonable compensation. There are many sources of

average industry compensation, some more specific as to job description than

others, but all having some weaknesses.

Also, even in the case where specific compensation by position is available for

an industry, adjustments may need to be made for the specific individual’s

contribution to the company versus the average industry executive’s contribution.

More specific sources by industry are found in the directories of trade

associations and industry information and in the Business Valuation Data,

Publication, and Internet Directory.

6.4 REVISION POINTS

1. Economic analysis

2. Industry analysis

3. Financial statistics

6.5 INTEXT QUESTIONS

1. What are the objectives of economic and industry analysis for business valuation?

2. Write short notes on:

a. National Economic Analysis

b. Regional Economic Analysis

c. Local Economic Analysis

d. Comparative Industry Financial Statistics

6.6 SUMMARY

Economic and industry information is such a broad subject that we could only

address it briefly in this chapter. Some companies are affected by various national

or regional economic factors. Others are affected largely by local conditions. The

importance of industry conditions varies greatly from one industry to another. As

with financial statement analysis, the analyst should point out the connection

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between the economic and industry factors and the valuation of the subject

company.

6.7 TERMINAL EXERCISE

1. Difference between national economic analysis and regional economic

analysis.

2. Describe the national economic analysis.

6.8 SUPPLEMENTARY MATERIALS

1. www.business valuation.inc.com

2. https\\www.business.gov.in

6.9 ASSIGNMENTS

1. Take a case of public listed company and conduct economic and industry

analysis in view of business valuation

6.10 SUGGESTED READINGS/REFERENCE BOOKS

1. Aswath Damodaran, Investment Valuation – Tools and Techniques for

Determining the Value of any Asset, John Wiley Publication, 3ed Edition,

2012.

2. Krishna G. Palepu, Paul M. Healy, Business Analysis and Valuation using

Financial Statements – Text & Cases, South Western Publication, 4th

Edition, 2002.15.

3. Tom Copeland, Tim Koller, Valuation Workbook – Step by Step Exercise,

John Wiley & Sons Publication, 3ed Edition, 2000.

4. Study Material, Paper – 18, Business Valuation Management, the Institute of

Cost Accountants of India Publication.

(http://icmai.in/upload/Students/Syllabus-2008/StudyMaterialFinal/P-

18.pdf)

6.11 LEARNING ACTIVITIES

Group discussion during PCP days

1. Take a case of public listed company and conduct economic and industry

analysis in view of business valuation

6.12 KEY WORDS

Economic Analysis, Industry Analysis, National and Regional Economic

analysis

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CHAPTER - 7

BUSINESS ANALYSIS – PESTLE ANALYSIS

7.1 INTRODUCTION

The development of business analysis as a professional discipline has

extended the role and responsibilities of the business valuers (BV). They investigate

ideas and problems, formulate options for a way forward and produce business

cases setting out their conclusions and recommendations. As a result, the

responsibility for advising organisations on effective courses of action lies with BVs,

and their work precedes that of the project manager.

The engagement of BVs also places a critical responsibility upon them – the

need to ensure that all business changes are in line with the mission, objectives

and strategy of the organisation. This business context is the key foundation for

understanding and evaluating all ideas, proposals, issues and problems put

forward by managers. While few BVs are involved in analysing and developing

strategy, it is vital that they know about the strategy of the organisation so that

they can conduct their work with a view to objectives of valuation. Therefore, it

could be argued that BVs look for the following areas:

Identifying the tactical options that will address a given situation that

support the delivery of the business strategy;

Defining the tactics that will enable the organisation to achieve its strategy;

Supporting the implementation and operation of those tactics;

Redefining the tactics after implementation to take account of business

changes and to ensure continuing alignment with business objectives.

An understanding of strategic analysis techniques is essential for all BVs. This

chapter describes a range of techniques for carrying out strategic analysis and

definition, plus techniques to monitor ongoing performance.

7.2 OBJECTIVES

This chapter appraises the students about PEST Analysis and techniques of

anlysing the business which is required for business valuation.

7.3 CONTENTS

7.3.1 Business Strategy and Objectives

7.3.2 Strategy Analysis – External Business Environment

7.3.3 Strategy Analysis – Internal Capability

7.3.4 Strategy Definition

7.3.5 Strategy Implementation

7.3.6 Performance Measurement

7.3.7 Approaches to Business Environment Analysis

7.3.8 PASTLE Analysis

7.3.9 Difference and Relationship between PESTLE and SWOT

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7.3.1 Business Strategy and Objectives

The following four areas are covered:

1. Strategy analysis, including external environment and internal capability;

2. Strategy definition;

3. Strategy implementation;

4. Performance measurement.

7.3.2 Strategy Analysis – External Business Environment

All organisations have to address the changes that have arisen, or can be

predicted to arise, within their operating business environment. Such changes

occur constantly, and any organisation that fails to identify and respond to them

runs the risk of encountering business problems or even the failure of the entire

enterprise. Senior management carries out regular monitoring of the business

environment in order to identify any influences that may require action.

There are two techniques that are used to examine the business environment

within which an organisation is operating: PESTLE analysis and Porter’s Five

Forces analysis.

The analysis of the external environment should be an ongoing process for

senior management, since the factors identified may provide insights into problems

for the future or opportunities for new successes. Using the PESTLE and five forces

techniques together helps to provide a detailed picture of the situation facing an

organisation. Just using one technique may leave gaps in the knowledge and

understanding.

7.3.3 Strategy Analysis – Internal Capability

Analysing the internal capability of an organisation provides insights into its

areas of strength and the inherent weaknesses within it. Business commentators

often recommend ‘sticking to the knitting’ when considering business changes.

An analysis of internal capability is essential to understanding where the core

skills of the organisation lie, so that relevant courses of action can be identified,

and any changes be made in the knowledge that they have a good chance of

success. There is little point in adopting strategies that are dependent upon areas

of resource where strong capability is lacking.

7.3.4 Strategy Definition

During strategy definition, the results of the external and internal

environmental analyses are summarised and consolidated in order to examine the

situation facing the organisation and identify possible courses of action. When

defining the business strategy, the factors outside the management’s control are

examined within the context of the organization and its resources. The technique

that may be used to define organisational strategy is the SWOT analysis.

7.3.5 Strategy Implementation

When the strategy has been defined, it is important to consider the range of

issues associated with implementing it. One of the key problems here is recognising

the range of areas that need to be coordinated if the business changes are to be

implemented successfully.

The approaches that support the implementation of strategy are McKinsey’s

7-S model and the four-view model.

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7.3.6 Performance Measurement

All organisations need to monitor performance and carry out the evaluation.

These are critical success factors/key performance indicators, and the Balanced

Business Scorecard technique.

7.3.7 Approaches to Business Environment Analysis

There are several similar approaches used to investigate the global business

environment within which an organisation operates. The most commonly used

approaches to external environment analysis are:

1. PEST (political, economic, socio-cultural, technological);

2. PESTEL (political, economic, socio-cultural, technological, environmental (or

ecological), legal);

3. PESTLIED (political, economic, socio-cultural, technological, legal,

international, environmental (or ecological), demographic);

4. STEEPLE (socio-cultural, technological, environmental (or ecological),

economic, political, legal, ethical).

7.3.8 Pastel Analysis

PESTLE analysis provides a framework for investigating and analysing the

external environment for an organisation. The framework identifies six key areas

that should be considered when attempting to identify the sources of change.

These six areas are:

Political: Examples of political factors could be a potential change of

government, with the corresponding changes to policies and priorities, or the

introduction of a new government initiative. These may be limited to the home

country within which the organisation operates, but this tends to be rare these

days since many changes have an effect in several countries. This has increased the

possibility of political issues arising that may impact upon the organisation and

how it operates.

The political arena has a huge influence upon the regulation of businesses, and the spending power of consumers and other businesses. BVs must consider issues such as:

a. How stable is the political environment?

b. Will government policy influence laws that regulate or tax your business?

c. What is the government's position on marketing ethics?

d. What is the government's policy on the economy?

e. Does the government have a view on culture and religion?

f. Is the government involved in trading agreements such as EU, NAFTA,

ASEAN, or others?

Economic: Economic factors may also be limited to the home country, but as

global trade continues to grow, economic difficulties in one nation tend to have a

broad, often worldwide, impact. Examples of economic factors could be the level of

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growth within an economy, or market confidence in the economies within which the

organisation operates.

BVs need to consider the state of a trading economy in the short and long-

terms:

a. Interest rates

b. The level of inflation

c. Employment level per capita

d. Long-term prospects for the economy Gross Domestic Product (GDP) per

capita, and so on

Socio-cultural: Socio-cultural factors are those arising from customers or

potential customers. These changes can often be subtle, and they can be difficult to

predict or identify until there is a major impact. Examples could be demographic

issues such as an increase in the number of working mothers, or consumer

behaviour patterns such as the rise of disposable fashion.

The social and cultural influences on business vary from country to country. It

is very important that such factors are considered. Factors include:

a. What is the dominant religion?

b. What are attitudes to foreign products and services?

c. Does language impact upon the diffusion of products onto markets?

d. How much time do consumers have for leisure?

e. What are the roles of men and women within society?

f. How long are the population living? Are the older generations wealthy?

g. Do the populations have a strong/weak opinion on green issues?

Technological: This area covers factors arising from the development of

technology. There are two types of technological change: there can be developments

in IT, and there can be developments in technology specific to an industry or

market, for example enhancements to manufacturing technology. IT developments

can instigate extensive business impacts, often across industries or business

domains and on a range of organisations. It is often the case that there is a failure

to recognise the potential use of the technology – at least until a competitor emerges

with a new or enhanced offering. For example, increased functionality of mobile

technology or extended bandwidth for internet transactions can present

opportunities to many organisations. However, the identification of such

technological advances is critical if an organisation is to recognise the potential

they offer.

Technology is vital for competitive advantage, and is a major driver of

globalization. Consider the following points:

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1. Does technology allow for products and services to be made more cheaply and to a better standard of quality?

2. Do the technologies offer consumers and businesses more innovative

products and services such as Internet banking, new generation mobile telephones, etc?

3. How is distribution changed by new technologies e.g. books via the Internet, flight tickets, auctions, etc?

4. Does technology offer companies a new way to communicate with consumers

e.g. banners, Customer Relationship Management (CRM), etc?

Legal: It is vital to consider factors arising from changes to the law, since the

last decade has seen a significant rise in the breadth and depth of the legal

regulations within which organisations have to operate. Legal compliance has

become such an important issue during this period that many business analysis

assignments have been carried out for the purpose of ensuring compliance with

particular laws or regulations. Some legal issues may originate from the national

government but others may operate across a broader spectrum. One key issue

when considering the legal element of the PESTLE analysis is to recognise laws that

have an impact upon the organisation even though they originate from countries

other than that in which the organisation is based. This situation may occur where

an organisation is operating within the originating country or working with other

organisations based in that country. Recent examples of this have concerned

changes to international financial compliance regulations.

Environmental: Examples of factors arising from concerns about the natural

(or Ecological): environments, in other words the ‘green’ issues, include increasing

concerns about packaging and the increase of pollution.

7.3.9 Difference and Relationship between PESTLE and SWOT

PESTLE is useful before SWOT - not generally vice-versa - PESTLE definitely

helps to identify SWOT factors. There is overlap between PESTLE and SWOT, in

that similar factors would appear in each. That said, PESTLE and SWOT are

certainly two different perspectives:

PESTLE assesses a market, including competitors, from the standpoint of a

particular proposition or a business.

SWOT is an assessment of a business or a proposition, whether own or a

competitor's. Strategic planning is not a precise science - no tool is mandatory - it's

a matter of pragmatic choice as to what helps best to identify and explain the

issues.

PESTLE becomes more useful and relevant the larger and more complex the

business or proposition, but even for a very small local businesses a PESTLE

analysis can still throw up one or two very significant issues that might otherwise

be missed.

The four quadrants in PESTLE vary in significance depending on the type of

business, eg., social factors are more obviously relevant to consumer businesses or

a business close to the consumer-end of the supply chain, whereas political factors

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are more obviously relevant to a global munitions supplier or aerosol propellant

manufacturer.

All businesses benefit from a SWOT analysis, and all businesses benefit from

completing a SWOT analysis of their main competitors, which interestingly can

then provide some feed back into the economic aspects of the PESTLE analysis.

7.4 REVISION POINTS

1. Strategy analysis

2. PASTLE Analysis

3. Business environment analysis

7.5 INTEXT QUESTIONS

1. Why and how business analysis is important for business valuation?.

2. Define “Business Strategy” and explain in detail “Strategic Analysis”.

3. What is PESTLE Analysis and how it is useful in business valuation?

7.6 SUMMARY

The business analysis techniques have been discussed in particular reference

to PEST Analysis. This helps the business valuers while performing valuation

assignment.

7.7 TERMINAL EXERCISE

1. Explain details in PASTLE Analysis.

2. Discuss the relation and difference between PESTLE and SWOT.

7.8 SUPPLEMENTARY MATERIALS

1. https\\www.business.gov.in

2. https\\fundera.com

7.9 ASSIGNMENTS

1. The students are required to take a case of business and prepare a report on

PEST Analysis of that business which they are acquainted with or of which

they have reasonable knowledge or wherein they consider themselves as

experts

7.10 SUGGESTED READINGS/REFERENCE BOOKS

1. Operations Management And Strategic Management, Study Notes, The

Institute of Cost Accountants of India, Kolkata

2. Neil Ritson, Strategic Management, www.bookboon.com

7.11 LEARNING ACTIVITIES

Group discussion during PCP days

1. The students are required to take a case of business and prepare a report on

PEST Analysis of that business which they are acquainted with or of which

they have reasonable knowledge or wherein they consider themselves as

experts

7.12 KEY WORDS

PEST, SWOT, Strategy.

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CHAPTER - 8

SITE VISITS AND INTERVIEWS

8.1 INTRODUCTION

When a valuer does site visits and management interviews, the valuer usually

gains an improved understanding of the subject company. For this reason,

although site visits are not required, more credibility is accorded to an expert who

has performed site visits and management interviews than to one who has not.

The primary objectives of site visits and interviews are twofold:

To gain an understanding of the subject company’s operations and the

economic reason for its existence, and

To identify those factors that will cause the company’s future results to be

different from an extrapolation of its recent past results.

8.2 OBJECTIVES

This chapter discusses the importance of site visit and interviewing key

persons and information to the gathered while performing business valuation.

8.3 CONTENTS

8.3.1 Importance of Site Visits and Interviews

8.3.2 Site Visits

8.3.3 Management Interviews

8.3.4 Interviews with Persons outside the Company

8.3.1 Importance of Site Visits and Interviews

When a valuer does site visits and management interviews, the valuer usually

gains an improved understanding of the subject company. For this reason,

although site visits are not required, more credibility is accorded to an expert who

has performed site visits and management interviews than to one who has not.

The primary objectives of site visits and interviews are twofold:

1. To gain an understanding of the subject company’s operations and the

economic reason for its existence, and

2. To identify those factors that will cause the company’s future results to be

different from an extrapolation of its recent past results.

8.3.2 Site Visits

A site visit can enhance the understanding of such factors as the subject

company’s operations, the efficiency of its plant, the condition of its equipment, the

advantages and disadvantages of its location, the quality of its management, and its

general and specific strengths and weaknesses.

8.3.3 Management Interviews

Management interviews can be helpful in understanding the history of the

business, compensation policy, dividend policy, markets and marketing policies

and plans, labour relations, regulatory relations, supplier relations, inventory

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policies, insurance coverage, reasons for financial analysis to reveal deviations from

industry or guideline company norms, and off-balance sheet assets or liabilities.

Inquiries should be made as to whether there were any past transactions in

the company’s ownership and, if so, whether they were arm’s length. Another

related inquiry should be whether there were any bona fide offers to buy the

company and, if so, the details of such offer(s).

Areas of investigation for the management interview could include, for

example:

Management’s perspective on the company’s position in its industry

Any internal or external facts that could cause future results to differ

materially from past results

Prospects, if any, for a liquidity event (e.g., sale of the company, public

offering of stock)

Why the capital structure is organized as it is, and any plans to change it

Identification of prospective guideline companies, either publicly traded

companies or private companies that have changed ownership

The management interview can also be a good occasion on which to identify

sources of industry information. The following questions are a good place to

start:

What trade associations do you belong to?

Are there any other trade associations in your industry?

What do you read for industry information?

Most valuers have checklists of areas of inquiry for site visits and management

interviews. At the end of each interview, many experienced valuers ask a catch-all

question such as, “Is there any information that we haven’t covered which might

bear on the value?” This can accomplish two objectives:

1. Protect the valuer against material omissions

2. Place the burden on management to not withhold relevant information

8.3.4 Interviews with Persons outside the Company

Sometimes it is also helpful to interview persons outside the company, such as

the outside accountant, the company’s attorney, the company’s banker, industry

experts, customers, suppliers, and even competitors.

The company’s outside accountant has two key functions:

1. Explain or interpret appraiser’s questions about items on the financial

statements.

2. Provide audit working papers for additional details regarding the financial

statements.

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The company’s attorney may be helpful in interpreting the legal implications of

various documents or in assessing the potential impact of contingent assets or

liabilities, especially unsettled law suits.

The company’s banker may provide a perspective on the company’s risk, as

well as on the availability of bank financing. Documents submitted by the company

to its bankers for borrowing purposes may also provide certain insight.

Industry experts may be helpful in a variety of ways, such as:

1. Assessing industry trends and their potential impact on the company

2. Assessing the impact of imminent changes in the industry or its regulations

3. Assessing the potential impact of various contingent liabilities, such as

environmental concerns or liability from, for example, asbestos lawsuits.

Customers, former customers, suppliers, and competitors may be helpful in

assessing such things as the company’s position in the industry and the market’s

perceived quality of the company’s products and services.

8.4 REVISION POINTS

1. Site Visits

2. Interviews

3. Business valuation

8.5 INTEXT QUESTIONS

1. Explain importance of interviews and site visits are important for business

valuation.

2. Explain the factors to be considered while interviewing the management of

the business.

3. Who are the persons outside the business important to cater information

useful for business valuation? Explain what kind of information/ data they

can provide help in business valuation.

8.6 SUMMARY

Site visits and interviews with management and possibly others can provide

the valuer with Insight available from no other source. These insights strengthen

the valuer’s understanding of the company, its business risks, and its growth

prospects. Armed with this background information, one can now proceed to the

valuation methodology. Deal first with the three basic approaches to value (income,

market, and asset-based), then to discounts and/or premiums, and finally to the

weight to be accorded to each so as to reach a final opinion of value.

8.7 TERMINAL EXERCISE

1. Explain the “site visit” and “measurement” interview

8.8 SUPPLEMENTARY MATERIALS

1. https\\www.business.gov.in

2. www.business valuation.inc.com

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8.9 ASSIGNMENTS

1. The students are required to take a case of business, say small

manufacturing setup, and visit the site; interview management and various

outside persons; prepare a detailed report analysing the information

collected recommending important factors to be considered while concluding

the valuation of that business

8.10 SUGGESTED READINGS/REFERENCE BOOKS

1. Aswath Damodaran, Investment Valuation – Tools and Techniques for

Determining the Value of any Asset, John Wiley Publication, 3ed Edition,

2012.

2. Krishna G. Palepu, Paul M. Healy, Business Analysis and Valuation using

Financial Statements – Text & Cases, South Western Publication, 4th

Edition, 2002.15.

3. Tom Copeland, Tim Koller, Valuation Workbook – Step by Step Exercise,

John Wiley & Sons Publication, 3ed Edition, 2000.

4. Study Material, Paper – 18, Business Valuation Management, the Institute of

Cost Accountants of India Publication.

(http://icmai.in/upload/Students/Syllabus-2008/StudyMaterialFinal/P-

18.pdf)

8.11 LEARNING ACTIVITIES

Group discussion during PCP days

1. The students are required to take a case of business, say small

manufacturing setup, and visit the site; interview management and various

outside persons; prepare a detailed report analysing the information

collected recommending important factors to be considered while concluding

the valuation of that business

8.12 KEY WORDS

Visits, Interviews

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CHAPTER - 9

INCOME APPROACH TO BUSINESS VALUATION

9.1 INTRODUCTION

Theoretically, the income approach is the most valid way to measure the value

of a business or business interest. Most corporate finance texts say that the value of

a company (or an interest in a company) is the value of all of its future benefits to

its owners (usually measured in net cash flows) discounted back to a present value

at a discount rate (cost of capital) that reflects the time value of money and the

degree of risk of realizing the projected benefits.

The income approach is widely used by corporate acquirers, investment

bankers, and in situational investors who take positions in private companies.

Within the income approach are two basic methods:

1. Discounting: All expected future benefits are projected and discounted back

to a present value.

2. Capitalizing: A single benefit is divided by a capitalization rate to get a

present value.

As will be explained, the latter method is simply a derivation of the former

method. The income approach requires two categories of estimates:

1. Forecast of future results, such as net cash flow or earnings

2. Estimation of an appropriate discount rate (cost of capital or cost of equity)

Reasonable business valuers may disagree widely on each of these inputs. As

with the market approach, the income approach can be used to value common

equity directly or to value all invested capital (common and preferred stock and

long-term debt). As with the mar- ket approach, if it is invested capital that was

valued, the value of the debt and preferred stock included in the valuation must be

subtracted to arrive at the value of the common equity. Some business valuation

practitioners also subtract all the cash and cash equivalents from the subject

company and omit the returns applicable to the cash equivalents, and then add the

value of the cash to the indicated value of the operating company.

9.2 OBJECTIVES

In the hierarchy of widely used business valuation terminology, there are

approaches, methods, and procedures. In business valuation, as in real estate

appraisal, there are three generally recognized approaches: income, market (sales

comparison), and asset-based (cost). Within these approaches, there are methods.

Within the income approach, the methods are discounting and capitalizing. Within

the market approach, the primary methods are guideline publicly traded companies

and the guideline transaction (mergers and acquisitions) method (sales of entire

companies). Also conventionally classified under the market approach are prior

transactions, offers to buy, buy/sell agreements, and rules of thumb. Within the

asset approach, the methods are the adjusted net asset method and the excess

earnings method.

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Procedures are techniques used within these methods, such as the direct

equity procedure versus the invested capital procedure. For example, in any of the

three approaches, the procedure could be to value the common equity directly or to

value all of the invested capital and then subtract the value of all the senior

securities to arrive at the value of the common equity.

9.3 CONTENTS

9.3.1 Net Cash Flow: The Preferred Measure of Economic Benefit in the

Income Approach

9.3.2 Discounting versus Capitalizing

9.3.3 Relationship between Discount Rate and Capitalization Rate

Capitalization

9.3.4 The Discounting Method

9.3.5 Projected Amounts of Expected Returns

9.3.6 Developing Discount and Capitalization Rates for Equity Returns the

Build-Up Model

9.3.7 The Capital Asset Pricing Model (CAPM) Weighted Average Cost of

Capital (WACC) - The Midyear Convention, the Midyear Convention in

the Capitalization Method and the Midyear Convention in the

Discounting Model

9.3.1 Net Cash Flow: The Preferred Measure of Economic Benefit in the Income

Approach

The income approach can be applied to any level of economic benefits, such as

earnings, dividends, or various measures of returns. However, the measure of

economic benefits preferred by most professional valuation practitioners for use in

the income approach is net cash flow. Net cash flow to equity is defined in Exhibit

9.1; net cash flow to invested capital is defined in Exhibit 9.2.

Exhibit 9.1 Definition of Net Cash Flow to Equity

In valuing equity by discounting or capitalizing expected cash flows (keeping in

mind the important difference between discounting and capitalizing, as discussed

elsewhere), net cash flow to equity is defined as

Net income to common stock (after tax)

+ Noncash charges

_ Capital expenditures*

± Additions to net working capital*

_ Dividends on preferred stock

± Changes in long-term debt (add cash from borrowing, subtract repayments)*

= Net cash flow to equity

* Only amounts necessary to support projected operations

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Exhibit 9.2 Definition of Net Cash Flow to Invested Capital

In valuing the entire invested capital of a company or project by discounting or

capitalizing expected cash flows,

net cash flow to invested capital is defined as

Net income to common stock (after tax)

+ Noncash charges (e.g., depreciation, amortization, deferred revenue, deferred taxes)

_ Capital expenditures*

+ Additions to net working capital*

+ Dividends on preferred stock

+ Interest expense (net of the tax deduction resulting from interest as a tax-deductible expense)

= Net cash flow to invested capital

*Only amounts necessary to support projection operations

There are three reasons for the general preference to use net cash flow as the

economic benefit to be capitalized or discounted in the income approach:

1. Net cash flow represents the amounts of cash that owners can withdraw or

reinvest at their discretion without disrupting ongoing operations of the

business.

2. More data are readily available to develop an empirically defensible discount

rate for net cash flow than any other economic benefit measure.

3. Net cash flow is one variable not normally used in the market approach.

Therefore, use of net cash flow in the income approach makes the income

and market approaches more in- dependent from each other and thus more

reliable checks on each other.

For these reasons, the authors will use net cash flow in the text and examples

through- out this chapter. Any other economic income variable may be discounted

or capitalized, but the discount or capitalization rate must be modified to match the

definition of the economic income variable being discounted or capitalized.

Development of discount or capitalization rates to be used with income variables

other than net cash flow is beyond the scope of this book.

9.3.2 Discounting Versus Capitalizing

The income approach is applied using one of two methods:

1. Discounted future economic benefits

2. Capitalization of economic benefits

It would be redundant to use both methods in the same valuation because

capitalization is simply a shortcut form of discounting.

9.3.3 Relationship between Discount Rate and Capitalization Rate

When the applicable standard of value is fair market value, the market drives

the discount rate. It represents the market’s required expected total rate of return

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to attract funds to an in- vestment (in the case of stock, dividends plus capital

appreciation). It is comprised of a “safe” rate of return plus a premium for risk.

Development of discount rates is the subject of a later section of this chapter.

The capitalization rate in the income approach is based on the discount rate.

The capitalization rate is calculated by subtracting the long-term expected growth

rate in the variable being capitalized from the discount rate.

Many people confuse discount rates with capitalization rates. The only case in

which the discount rate equals the capitalization rate is where the amount of the

variable being discounted or capitalized remains constant (i.e., there is a zero

growth rate), theoretically in perpetuity.

Capitalization

The International Glossary of Business Valuation Terms defines capitalization

as “the conversion of a single period of economic benefits into value.” It also has the

following definitions:

Capitalization factor. Any multiple or divisor used to convert anticipated

economic benefits of a single period into value

Capitalization-of-earnings method. A method within the income approach whereby economic benefits for a representative single period are converted to value through division by a capitalization rate

Capitalization rate. Any divisor (usually expressed as a percentage) used to convert anticipated economic benefits of a single period into value

One important assumption is implicit in the capitalization method: that the

income variable being capitalized will either remain constant or will grow or decline

at a reasonably constant and predictable rate over a long period of time. The “long

period of time” theoretically is in perpetuity, but, as a practical matter, changes

after 10 years have very little impact on present value.

Constant Level Assumption

The simplest use of the capitalization method involves an assumption that the

variable being capitalized remains constant (i.e., a no-growth scenario). In this case,

we merely divide the variable being capitalized by the discount rate:

Expected net cash flow per year

Discount rate rate of return or cost of capital

For example, if expected net cash flow is Rs 20 Lakhs per year and the

capitalization rate is 10 percent, the value of Rs 20 Lakhs per year capitalized at 10

percent is Rs 200 Lakhs:

20 Lakhs ÷ 0.10 = 200 Lakhs

In this unique (and unrealistic) case, the discount rate equals the

capitalization rate because there is no growth to subtract from the discount rate.

Constant Growth or Decline Assumption (The “Gordon Growth Model”)

If one assumes a constant rate of growth in net cash flow, one can simply

multiply the latest 12 months’ normalized net cash flow by one plus the growth rate

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and then divide that amount by the discount rate minus the growth rate. This is

called the Gordon Growth Model.

Net cash flow (1 + Growth rate) (Discount rate – Growth rate)

To illustrate the model, assume that the latest 12 months’ normalized net cash

flow was Rs. 10 Lakhs and the assumed growth rate is 5 percent. The amount to

be capitalized would be:

Rs 10 Lakhs x 1.05 = Rs 10.50 Lakhs

If one assumes that the discount rate is 15 percent, the capitalization rate

would be:

15% – 5% = 10%

One would then divide the amount of next year’s anticipated cash flow by the

capitalization rate to arrive at the value:

Rs. 10.50 Lakhs ÷ 0.10 = Rs. 105 Lakhs

In this example, the company’s fair market value is Rs. 10 Lakhs, the amount

a willing buyer would expect to pay and a willing seller would expect to receive

(before any transaction costs or valuation discounts or premiums).

The investor in this example thus earns a total rate of return of 15 percent,

comprised of 10 percent current return (the capitalization rate), plus 5 percent

annually compounded growth in the value of the investment.

This is shown in formula form in Exhibit 9.3.

Exhibit 9.3 Gordon Growth Model

The assumption is that cash flows will grow evenly in perpetuity from the

period immediately preceding the valuation date. This scenario is stated in a

formula known as the Gordon Growth Model:

where:

PV= Present value

PV =

 

NCF0 1 g

k g

NCF0 = Net cash flow in period 0, the period immediately preceding the

valuation date

k = Discount rate (cost of capital)

g = Expected long-term sustainable growth rate in net cash flow to investor

Note that for this model to make economic sense, NCF0 must represent a

normalized amount of cash flow from the investment for the previous year, from

which a steady rate of growth is expected to proceed. Therefore, NCF0 need not be

the actual cash flow for period zero but may be the result of certain normalization

adjustments, such as elimination of the effect of one or more nonrecurring factors

(see following chapters for a discussion of normalization adjustments).

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In fact, if NCF0 is the actual net cash flow for period 0, the valuation analyst

must take reasonable steps to be satisfied that NCF0 is indeed the most reasonable

base from which to start the expected growth embedded in the growth rate.

Furthermore, the valuation report should state the steps taken and the

assumptions made in concluding that last year’s actual results are the most

realistic base for expected growth.

9.3.4 The Discounting Method

Even though the discounting method is complex, one needs to review it until

they have a basic understanding of how it works. Whether or not the discounting

method is used, the results from any valuation method should be compatible with

results from the discounting method.

Description of the Discounting Method

In arithmetic terms, discounting is the opposite of compounding. We

understand compounding because we make deposits in savings accounts at

compound interest and calculate how much the deposit will be worth some years in

the future at a given rate of interest. In discounting, we do the opposite. We are

calculating what a given amount of dollars, to be received at some time in the

future, will be worth in today’s dollars, assuming the market requires a particular

expected rate of return to attract funds to the investment.

In theory, the discounting method projects the expected returns over the life of

the business. These expected returns are then discounted back to present value at

a discount rate that reflects the time value of money and the market’s required rate

of return for investments of similar risk characteristics.

In other words, we are trying to determine what the investment’s future cash

flows are worth to an investor in today’s dollars. Thus, if our projected cash flow

and rate of return are accurate, the present value of the business, if invested today,

will ultimately yield the expected cash flows to an investor.

The Terminal Value in the Discounting Method

For some types of investments, such as proposed utility plant investments

based on feasibility studies, analysts actually do make forecasts for the entire

expected life of the business. More commonly, however, analysts make projections

for a finite number of years often five to ten years. At the end of the specific

projection period, analysts estimate what is referred to as a terminal value, or the

investment’s expected present value as of the end of the specific projection period.

Terminal value is then discounted back to today’s dollars at an appropriate

discount rate. The present value of the terminal value is then added to the present

value of the projected cash flows from the specified projection period to arrive at the

total estimated present value of the investment.

The terminal value may be estimated either by the Gordon Growth Model or by

market valuation multiples. Generally, most professional business valuation

analysts prefer estimating the terminal value by the Gordon Growth Model because

this preserves the independence of the income approach from the market approach.

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However, most investment bankers prefer to estimate the terminal value with

valuation multiples, on the basis that this best represents the manner in which the

business might be sold at the end of the projected period.

Each year’s expected cash flows, and the terminal value, are divided by one

plus the discount rate, raised to the power of the number of years into the future

that the cash flows are expected. The terminal value is discounted by the number of

years in the specific forecast period, because the terminal value represents the

value of the company as of the end of the specific forecast period. Each year’s cash

flows are discounted using the year in which they occur as the exponent.

An Example of the Discounting Method

Assume: Discount rate (market’s requirement as to expected compound

annual return to attract funds to an investment of this level of risk) = 20%

Expected Net Cash Flows (Rs.)

Year 1 1,200

Year 2 1,500

Year 3 1,700

Expected long-term growth rate following year 3 = 5%

Using the Gordon Growth Model to estimate the terminal value, these

assumptions would result in the following calculations:

PV =

2 3 3

1700X .05

1200 1500 1700 .20 .05 (1 .20) (1 .20) (1 .20) (1 .

+ +20)

1

= 1,000 + 1,041.67 + 983.96 + 6886.57

= Rs. 9,912.20

This is the amount that a willing buyer would expect to pay and a willing seller

would expect to receive for this investment (before considering any transaction

costs).

Note how much of the present value is accounted for by the terminal value.

This is so because, in this example, we kept the specific projection period unusually

short; it is not, however, unusual for the terminal value to account for half or more

of the present value. Thus, it is extremely important to assess the reasonableness of

the terminal value in determining the reasonableness of an estimated present

value. The discounting method is shown in formula form in Exhibit 9.4.

Exhibit 9.4 Formula for Discounted Cash Flow Calculation Using Gordon Growth Model for Terminal Value

PV =

n

2 n12 n n

NCF (1 g)

NCF NCFNCF g

(1 k) (1 k) (1 k) (1 k)+ +

where:

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NCF1 ... NCFn = Net cash flow expected in each of the periods 1 through n, n

being the last period of the discrete cash flow projections.

k = Discount rate (cost of capital)

g = Expected long-term sustainable growth rate in net cash flow, starting with

the last period of the discrete projections as the base year.

Note how this works in reverse. If we deposited the present value of each of

the cash flows and their values grew over the discount period at the discount rate,

we would have the following:

Year PV of Cash

Flow Discount Rate

Compounded for n year Future Value

1 Rs.1,000.00 x1.20 = Rs. 1,200

2 Rs.1,041.67 x 1.20 x 1.20 = Rs. 1,500

3 Rs. 983.96 x 1.20 x 1.20 x 1.20 = Rs. 1,700

Terminal value Rs.6,886.57 x 1.20 x 1.20 x 1.20 = Rs.11,900

The present value calculation is sometimes presented in tabular form using

capitalization factors for each year’s cash flows and for the terminal value. These

capitalization factors are the reciprocals of the divisors just presented:

1/1.20 = 0.833333

1/(1.20)2 = 0.694444

1/(1.20)3 = 0.578704

When using such a table, the presentation looks like this:

Year Cash Flow Capitalization Factor Present Value

1 Rs. 1,200 x 0.833333 = Rs. 1,000.00

2 Rs. 1,500 x 0.694444 = Rs. 1,041.67

3 Rs. 1,700 x 0.578704 = Rs. 983.80

Terminal value Rs. 11,900 x 0.578704 = Rs. 6,886.57

Present value of investment Rs. 9,912.04

The slight difference between this presentation and the previous presentation

is due to rounding off the capitalization factors to six digits. If the capitalization

factors were carried out to a few more digits, the values would be exactly the same.

9.3.5 Projected Amounts of Expected Returns

Sometimes the valuation analyst will undertake the task of developing

projections for expected returns independently, but usually the projections are

provided by management.

Some companies routinely make projections of net cash flows for budgeting

and other purposes. There is a presumption that projections prepared in the

normal course of business are free of any bias that may creep into projections

prepared for litigation.

If management routinely prepares projections, the analyst may request prior

projections and compare them with actual results to evaluate the reliability of

management’s projections. In any case, all assumptions underlying the projections

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should be clearly explained in the valuation report. The analyst should understand

any underlying assumptions and evaluate them for reasonableness.

If the analyst believes that the projections supplied by management are either

too high or too low, she has several possible courses of action, including:

Reject the income approach as unreliable.

Adjust the projections in light of more reasonable assumptions.

Adjust the discount rate for company-specific risk. (Estimating the

appropriate discount rate is the subject of a subsequent section.)

Accept the projections on their face, and disclaim any responsibility for

independent verification.

Some analysts regularly use sensitivity analysis. That is, they change one or

more of the assumptions and rerun the calculations to see how the change in

assumptions affects the results. The degree of sensitivity to reasonable changes in

assumptions can impact the reliability of the results. For example, when very low

discount rates are used, a few points’ change in the discount rate can have a major

impact on the indicated value.

Projections are usually denominated in nominal currency, which include the

effects of inflation. This is because discount rates are usually estimated in nominal

terms. In the unusual cases where projections are made in real currency (not

reflecting inflation) then the estimated rate of inflation must be removed from the

discount rate to make the calculations consistent.

9.3.6 Developing Discount and Capitalization Rates for Equity Returns

Arguably, even more challenging than projecting future results is estimating

an appropriate discount rate by which to discount the expected cash flows back to

a present value.

Discount rates applicable to debt are readily observable in the market. Unlike

stocks, bonds have a fixed amount of promised future payments of interest and

principal.

Yield to maturity (an approximation of the discount rate) data are published

daily in financial bulletins for bonds of all risk grades (AAA, AA, A, BBB, etc.). The

requirements for each risk grade are published by rating services, so the valuer can

easily value a company’s debt by estimating the risk category into which it falls and

looking up the yields to maturity for that risk category.

Since there are no such published expected rates of return for stocks, the

valuer must estimate the rate of return the market would require to invest in the

subject stock. This market- driven required rate of return is called the discount

rate.

There are many models for developing discount rates for equity. Two are most

widely used:

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1. The build-up model

2. The capital asset pricing model (CAPM)

The Build-Up Model

The build-up model incorporates some or all of the following elements:

A risk-free rate

A general “equity risk premium” (a premium over the risk-free rate for the added risk of in- vesting in any kind of stocks over the risk-free rate)

A size premium

An industry risk adjustment

A company-specific risk adjustment

The Risk-Free Rate

The risk-free rate is the yield to maturity on government obligations. The most-

used rate is the yield to maturity on 20-year Treasury bonds as of the valuation

date. This incorporates a real rate of return, which is compensation for giving up

the use of money until the maturity of the bond. It also incorporates the market’s

expectation of the amount of inflation expected over the term of the bond. This

means that the rate is a nominal rate, which includes expected inflation. It is called

a risk-free rate because it is presumably free of risk of default. However, it also

incorporates horizon risk or maturity risk, the risk that the market value of the

principal may fluctuate with changes in the general level of interest rates.

The Equity Risk Premium

The equity risk premium is the amount of return over and above the risk-free

rate for investing in a portfolio of large common stocks. Much research and

controversy are devoted to estimating the level of the equity risk premium at any

given time. The valuer’s report should disclose the source of the estimated equity

risk premium.

The Size Premium

In general, small companies are more risky than large ones, all other things

being equal. Size can be measured in many dimensions, such as market value of

equity, revenues, or assets. A size premium is usually incorporated into the

estimation of the discount rate. In any case, the valuer’s report should indicate how

any applicable size premium was derived.

The Industry Adjustment

The industry adjustment is applied to the combined equity risk premium and

size premium and can be either positive or negative.

The Company-Specific Risk Adjustment

This company-specific element of the discount rate captures any aspects of

risk factors unique to the subject company, as opposed to the risk factors

incorporated in the companies from which the discount rate was otherwise derived.

It is usually positive, but could be negative. If an industry adjustment is not used,

the company-specific risk adjustment may incorporate industry risk factors not

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generally characteristic of other companies in the size range. This adjustment is

based entirely on the valuer’s analysis and judgment, so it should be well

supported in the narrative discussion of risk factors.

The Capital Asset Pricing Model (CAPM)

The CAPM differs from the build-up model in that it incorporates a factor

called beta as a modifier to the general equity risk premium. Beta is a measure of

systematic risk, that is, the correlation of fluctuations in the excess returns on the

specific stock with the excess returns on the market as a whole as measured by

some index. Excess returns are those returns over and above the risk-free rate of

return.

The average beta for the market is, by definition, 1.0. Thus, for a company

with a beta of 1.2, the company’s excess returns can be expected to fluctuate by

120 percent above the market; a company with a beta of 0.8 can be expected to

fluctuate by 80 percent of the market as a whole.

Because private companies do not have public market prices, when valuing a

private company using the CAPM, average betas of companies in the same industry

are usually used as a proxy for the beta of the subject private company.

In the CAPM, the equity risk premium is modified by multiplying it by the

assumed beta. Because the beta reflects the risk of the industry, the industry risk

adjustment is not used in the CAPM.

The size premium factor is used for companies smaller than those. The

company-specific risk adjustment is used where appropriate.

Exhibit 9.5 is a comparative sample illustration of the development of the

equity dis- count rate using three models:

1. The build-up model with an industry adjustment

2. The build-up model without an industry adjustment. The industry

adjustment is an attempt to replace beta. It works reasonably well in the

cases where the companies used to calculate the industry adjustment are

adequately homogeneous with the subject company.

3. The CAPM

Exhibit 9.5 Developing Equity Discount Rates Using the Build-Up Model with and without an Industry Adjustment and Using the Capital Asset Pricing Model

Build-Up Model w/ Industry

Adjustment

Build-Up Model w/o Industry Adjustment

Capital Asset Pricing Model

Risk-free rate 5.4% 5.4% 5.4%

Equity risk premium 7.0% 7.0%

Beta of .8 (7.0 x .8 = 5.6) 5.6%

Size premium 3.5% 3.5% 3.5%

Industry adjustment –3.6% — —

Estimated Equity Discount Rate 12.3% 15.9% 14.5%

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Estimating Capitalization Rates

Capitalization rates are used in the income approach for the capitalization

method, and for the discounting method in cases where the Gordon Growth Model

is used to develop the terminal value. In the context of the income approach, the

capitalization rate is derived by subtracting the estimated long-term growth rate

from the discount rate. Since the capitalization rate is such a crucial factor in the

income approach, it is important that both the discount rate and the long- term

growth rate be estimated very carefully in order to obtain a reliable value estimate.

9.3.7 Weighted Average Cost of Capital (WACC)

When valuing a company’s invested capital by the income approach, the

projected cash flows include those available to all the invested capital. Therefore,

the market rate of return at which they should be discounted is the weighted

average of the components of the capital structure (common equity, preferred

equity, and long-term debt), known as the weighted average cost of capital (WACC).

The components of the WACC are weighted at their respective market values,

NOT their book values. Since market values (at least for the equity component) are

unknown, calculating the WACC often requires an iterative process, that is,

repeating the calculations at various weightings of the components until they

balance. Fortunately, modern computer programs can perform the necessary

iterations in seconds.

Since interest paid on debt is tax deductible, the actual cost of debt to the

company is the after-tax cost. Thus, the company’s tax rate should be deducted

from the pretax cost of debt when calculating the debt component of the weighted

average cost of capital.

Exhibit 9.6 is an example of the weighted average cost of capital. Assume:

Exhibit 9.6 Weighted Average Cost Of Capital (WACC) Cost Weight

Common equity 20% 70%

Long-term debt 10% 30%

Tax rate 40%

Then:

Component Cost Weight Weighted Cost

Equity 0.20 x 0.70 = 14.0%

Long-term debt 0.10 x (1 – 0.40) = 0.60 x 0.30 = 1.8%

Weighted average cost of capital 15.8%

This would be used as a discount rate when valuing invested capital. In

appraisals for property tax purposes, the weighted average cost of capital is often

referred to as the band of investment theory.

One question that arises in estimating the WACC is whether to use the

company’s actual capital structure or a hypothetical capital structure. In general,

when valuing a minority interest, the company’s actual capital structure should be

used because the minority owner has no power to change the capital structure.

However, when valuing a controlling interest, the control holder has the power to

change the capital structure, so in some cases analysts use an industry average

capital structure.

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The Midyear Convention

The capitalization and discounting procedures previously discussed implicitly

reflect the assumption that the cash flows will be received at the end of each

projected year. This is a reasonable assumption for many companies because

management may wait until the end of the year to determine the capital

expenditure and working capital requirements for the following year before deciding

on distributions, if any.

However, some companies receive cash flows more or less evenly throughout

the year. To reflect this situation, some business valuation practitioners employ a

modification to the capitalization and discounting calculations called the midyear

convention.

The midyear convention, in effect, assumes that investors receive cash flows in

the middle of each year. This assumption approximates the value that would be

calculated from receiving cash flows evenly throughout the year.

The Midyear Convention in the Capitalization Method

In the Gordon Growth Model, the modification to reflect the midyear

convention is to raise the growth factor to the exponential level of 0.5. The

calculation for the amount to be capitalized would be Rs 10.50 x (1.05)0.5 = Rs

10.76. This would be divided by the capitalization rate, which was .10, to arrive at

the value:

Rs. 10.76 ÷ .10 = Rs. 107.60

The midyear convention will always produce a higher value than the year-end

convention so long as the cash flows are positive, because investors are assumed to

have received each projected cash flow six months earlier.

The formula for the Gordon Growth Model using the midyear convention is

shown in Exhibit 9.7.

Exhibit 9.7 Formula for the Gordon Growth Model Incorporating the Midyear Convention

PV = 0.5

1NCF (1 K)

(k g)

PV = Present value

NCF1 = Net cash flow expected in period 1, the period immediately following

the valuation date

k = Discount rate (cost of capital, total required rate of return)

g = Long-term growth rate

The Midyear Convention in the Discounting Model

The midyear modification to the discounting model is accomplished by raising

each component of the divisors to an exponent of 0.5 less than would be the case in

the year-end procedure.

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In the previous example, the computations would be revised as follows:

PV =

5 1.5 2.5 2.5

1700X .05

1200 1500 1700 .20 .05 (1 .20) (1 .20) (1 .20) (1 .20

+ +)

1

=1200 1500 1700 11900

, . 1.314534 1.577441 1.57

+7441

+ 1 095 45

= Rs.1, 095.45 + Rs.1,141.09 + Rs.1, 077.69 + Rs.7, 543.86

= Rs.10,858.09

This compares with Rs. 9,912.20 by the year-end convention; the assumption

that investors receive their cash earlier can make a significant difference in the

indicated value.

The formula for the discounting method incorporating the midyear convention

is shown as Exhibit 9.8.

Exhibit 9.8 Formula for the Discounting Method Incorporating the Midyear Convention

P =

n

2 n10.5 1.5 n 0.5 n 0.5

NCF (1 g)

NCF NCFNCF

(1 k) (1 k) (1 k) (1 k)

g+ +

NCF1 . . . NCFn = Net cash flows expected in periods 1 through n

k = Discount rate (cost of capital, total required rate of return)

g = Long term growth rate

Alternatively, the modified Gordon Growth Model formula may be used for the

terminal value, in which case the terminal value would be discounted for n periods

instead of n – 0.5 periods.

9.4 REVISION POINTS

1. Income approach

2. Expected returns

3. Discount - Method

9.5 INTEXT QUESTIONS

1. Explain importance of income approach for business valuation.

2. Discuss Gordon Growth Model with illustration.

3. Discuss Capital Asset Pricing Model with illustrations.

4. How does midyear conversion affect business value?

5. Elaborate “Beta” in business valuation and how it is being derived.

6. A company manufacturing, needle roller bearings, is financed by debt and

equity to the extent of 3:7, with total debts of Rs. 10.82 crores. The

company’s debt is valued at 8%. The beta of the company’s equity is known

to be 1.5. The company generates a free cash flow Rs. 2 crores with the

known growth projection of 5% to perpetuity. If it is known that the market

risk premium is 6% and the risk free rate is 5%, what is the value of each

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equity share for the 1 million shareholders of the company? Assume that the

company is in the 35% tax bracket.

7. The free cash flow of RKP Ltd is projected to grow at a compound annual

average rate of 35% for the next 5 years. Growth is then expected to slow

down to a normal 5% annual growth rate. The current year’s cash flow of

RKP Ltd is `Rs.4 crores. RKP Ltd’s cost of capital during the high growth

period is 18% and 12% beyond the fifth year, as growth stabilizes. Calculate

the value of the RKP Ltd.

8. A task has been assigned to a valuer in a mutual fund to find out at what

price the fund should subscribe to an IPO issue (through Book Building) of a

transformer company X Ltd. The following details of the company from

31.3.13 Annual Report are available:

Particulars 31.03.2017

Revenues 248.79

Operating expenses 214.41

EBIDTA 34.38

Other Income 3.84

Interest expense 1.00

Preliminary Expenses W/O 0.00

Depreciation 1.92

Profit before taxes 35.30

Income taxes 12.35

Tax at the rate of 35%

Net profit 22.95

To calculate future cash flows, the following projections for the financial year

ended 31.3.2018 till 31.3.2022 is available:

Amount in lakhs

Particulars FY18 FY19 FY 20 FY21 FY22

Revenue growth 55% 50% 28% 20% 14%

Operating exp/ Income 87% 87% 87% 88% 88%

Other Income 2.50 2.20 2.50 2.50 2.50

Interest expense 2.00 3.00 3.00 3.00 3.00

Preliminary Expenses W/O 0.00 0.00 0.00 0.00 0.00

Depreciation 2.60 3.50 4.10 3.90 3.70

Capital spending 2.00 5.00 5.00 2.00 2.00

Incremental Working capital 2.00 5.00 5.00 2.00 2.00

It is given that revenues would grow at 0% after the explicit forecast period. X

Ltd. total assets of Rs. 219.98 lakhs are financed with equity of Rs. 208.66 lakhs

and balance debts sourced at 8% p.a. Assume risk free rate of 7.5%, risk premium

of 7.5% and beta of stock as 1.07. The firm falls in the 35% tax bracket. The

company including the shares floated in this issue would have issued a total of 1.02

lakhs shares. Find out the intrinsic value of share using Discounted Cash Flow

Analysis.

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9.6 SUMMARY

The income approach represents the theory around which business valuation

revolves. However, as noted in the introduction to this chapter, the inputs

necessary for the income approach can be subject to substantial differences, even

among reasonable experts. We turn to the market approach in next chapter.

9.7 TERMINAL EXERCISE

1. Explain importance of income approach for business valuation.

9.8 SUPPLEMENTARY MATERIALS

1. https\\www.business.gov.in

2. www.business valuation.inc.com

9.9 ASSIGNMENTS

1. The students are required to open excel sheet and incorporate all the

models.

The students are required to take a case of a company they are conversant

with and analysing its financials and industry data, stock data, etc. and

derive capitalization rates, discount rates, beta, WACP, etc. necessary for

enterprise valuation of that company

9.10 SUGGESTED READINGS/REFERENCE BOOKS

1. Shannon P. Pratt, Cost of Capital: Estimation and Applications, 2nd ed.

(New York: John Wiley & Sons, Inc., 2002): 16.

2. The International Glossary of Business Valuation Terms defines

capitalization

3. Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs, Valuing a

Business: The Analysis and Appraisal of Closely Held Companies, 4th ed.

(New York: McGraw-Hill, 2000

9.11 LEARNING ACTIVITIES

Group discussion during PCP days

1. The students are required to open excel sheet and incorporate all the

models.

2. The students are required to take a case of a company they are conversant

with and analyzing its financials and industry data, stock data, etc. and

derive capitalisation rates, discount rates, beta, WACP, etc. necessary for

enterprise valuation of that company

9.12 KEY WORDS

Income Approach, WACC, Discounting, Capitalising, Midyear Conversion

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CHAPTER - 10

MARKET APPROACH TO BUSINESS VALUATION

10.1 INTRODUCTION

The market approach to business valuation is a pragmatic way to value

businesses, essentially by comparison to the prices at which other similar

businesses or business interests changed hands in arm’s-length transactions. It is

widely used by buyers, sellers, investment bankers, brokers, and business

appraisers.

The market approach to business valuation has its roots in real estate

appraisal, where it is known as the comparable sales method. The fundamental idea

is to identify the prices at which other similar properties changed hands in order to

provide guidance in valuing the property that is the subject of the appraisal.

Of course, business appraisal is much more complicated than real estate

appraisal because there are many more variables to deal with. Also, each business

is unique, so it is more challenging to locate companies with characteristics similar

to those of the subject business, and more analysis must be performed to assess

comparability and to make appropriate adjustments for differences between the

guideline businesses and the subject being valued.

Different variables are relatively more important in appraising businesses in

some industries than in others, and the analyst must know which variables tend to

drive the values in the different industries. These variables are found on (or

developed from) the financial statements of the companies, mostly on the income

statements and balance sheets. There are also qualitative variables to assess, such

as quality of management.

10.2 OBJECTIVES

Although the income approach as addressed in the previous chapter is

theoretically the best approach to business valuation, it requires estimates (the

projections and the discount rate) that are subject to potential disagreement. The

market approach is quite different in that it relies on more observable data,

although there can be (and often are) disagreements as to the comparability of the

guideline companies used and the appropriate adjustments to the observed

multiples to reach a selected multiple to apply to the subject company’s

fundamental data. This chapter discussed market approach to the business

valuation.

10.3 CONTENTS

10.3.1 The Market Approach

10.3.2 The Guideline Publicly Traded Company and the Guideline

Transaction (Merger and Acquisition) Method

10.3.3 How Many Guideline Companies?

10.3.4 Selection of Guideline Companies

10.3.5 Documenting the Search for Guideline Companies

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10.3.6 What Prices to Use in the Numerators of the Market Valuation

Multiples?

10.3.7 Choosing the Level of the Valuation Multiple

10.3.8 Mechanics of Choosing Levels of Market Multiples

10.3.9 Selecting Which Valuation Multiples to Use

10.3.10 Relevance of Various Valuation Multiples to the Subject Company

10.3.11 Availability of Guideline Company Data

10.3.12 Other Methods Classified under the Market Approach Past

Transactions in the Subject Company

10.3.13 Illustration

10.3.1 The Market Approach

The market approach to business valuation is a pragmatic way to value

businesses, essentially by comparison to the prices at which other similar

businesses or business interests changed hands in arm’s-length transactions. It is

widely used by buyers, sellers, investment bankers, brokers, and business

appraisers.

The market approach to business valuation has its roots in real estate

appraisal, where it is known as the comparable sales method. The fundamental

idea is to identify the prices at which other similar properties changed hands in

order to provide guidance in valuing the property that is the subject of the

appraisal.

Of course, business appraisal is much more complicated than real estate

appraisal because there are many more variables to deal with. Also, each business

is unique, so it is more challenging to locate companies with characteristics similar

to those of the subject business, and more analysis must be performed to assess

comparability and to make appropriate adjustments for differences between the

guideline businesses and the subject being valued.

Different variables are relatively more important in appraising businesses in

some industries than in others, and the analyst must know which variables tend to

drive the values in the different industries. These variables are found on (or

developed from) the financial statements of the companies, mostly on the income

statements and balance sheets. There are also qualitative variables to assess, such

as quality of management.

10.3.2 The Guideline Publicly Traded Company and the Guideline Transaction

(Merger and Acquisition) Method

The professional business appraisal community breaks the market approach

down into two methods:

1. The guideline publicly traded company method

2. The guideline transaction (merger and acquisition) method

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The guideline publicly traded company method consists of prices relative to

underlying financial data in day-to-day trades of minority interests in active

publicly traded companies, either on stock exchanges or the over-the-counter

market.

The guideline transaction (merger and acquisition) method consists of prices

relative to underlying fundamental data in transfers of controlling interests in

companies that may have been either private or public before the transfer of

control. The transactions in the databases usually were done through

intermediaries (business brokers, M&A specialists, or investment bankers), so they

are virtually all on an arm’s-length basis.

Both methods are implemented by computing multiples of prices of the

guideline company transactions to financial variables (earnings, sales, etc.) of the

guideline companies, and then applying the multiples observed from the guideline

company transactions to the same financial variables in the subject company.

Also generally subsumed under the market approach are the following:

1. Past transactions in the subject company

2. Bona fide offers to buy

3. Rules of thumb

4. Buy–sell agreements

There is no compiled source of transactions in minority interests in private

companies. The vast majority of brokers do not accept listings for minority interests

in private companies because there is no market for them. The fact that brokers

will not even accept listings for minority interests in privately held companies is

evidence of the wide gulf in degree of marketability between minority interests in

private companies and restricted stocks of public companies.

In any method under the market approach, the price can be either the price of

the common equity (equity procedure) or the price of all the invested capital (market

value of invested capital, or MVIC). When the invested capital procedure is used,

the result is the value of all the invested capital (usually common equity and long-

term debt), so the long-term debt must be subtracted in order to reach the

indicated value of the common equity. If cash was eliminated for the purpose of the

comparison, it should be added back.

See Exhibit 10.1 for a list of the market value multiples generally employed in

the equity procedure. See Exhibit 10.2 for a list of market value multiples generally

employed in the in- vested capital procedure. Neither of these lists is all-inclusive,

but they include the multiples most commonly found in business valuation reports.

It usually is not appropriate to use all the multiples in a single business valuation.

The appraiser should select one or a few that are most relevant to the subject

company.

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Exhibit 10.1 Market Value Multiples Generally Employed in the Equity Procedure

In the publicly traded guideline company method, market value multiples are

conventionally computed on a per- share basis, while in the merged and acquired

company methods they are conventionally computed on a total company basis.

Both conventions result in the same values for any given multiple.

Price/Earnings

Assuming that there are taxes, the term earnings, although used ambiguously

in many cases, is generally considered to mean earnings after corporate-level taxes,

or, in accounting terminology, net income.

Price/Gross Cash Flow

Gross cash flow is defined here as net income plus all noncash charges (e.g.,

depreciation, amortization, depletion, deferred revenue).

The multiple is computed as

. . .

   .=

.

Price per shareRs 100051

Gross cash flow per share Rs 196

Price/Cash Earnings

Cash earnings equals’ net income plus amortization, but not other traditional

noncash charges, such as depreciation. This is a measure developed by investment

bankers in recent years for pricing mergers and acquisitions as an attempt to even

out the effects of very disparate accounting for intangibles.

The multiple is computed as

. . .

  .=

.

Price per shareRs 100071

Cash earnings per shareRs 140

Price/ Pretax Earnings

The multiple is computed as

. .

. .

Price per shareRs 100

Pretax income per share Rs 167

Price/Book Value (or Price/Adjusted Net Asset Value) = 6.0

Book value includes the amount of par or stated value for shares outstanding,

plus retained earnings.

The multiple is computed as

. .00

   . .

Price per shareRs 10

Book value per share Rs 172= 5.8

Price/Adjusted Net Asset Value

Sometimes it is possible to estimate adjusted net asset values for the guideline

and subject companies, reflecting adjustments to current values for all or some of

the assets and, in some cases, liabilities. In the limited situations where such data

are available, a price to adjusted net asset value generally is a more meaningful

indication of value than price/book value. Examples could include real estate

holding companies where real estate values are available, or forest products

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companies for which estimates of timber values are available. This procedure can

be particularly useful for family limited partnerships.

Tangible versus Total Book Value or Adjusted Net Asset Value

If the guideline and/or subject companies have intangible assets on their

balance sheets, analysts generally prefer to subtract them out and use only

price/tangible book value or price/tangible net asset value as the valuation

multiple.

This is to avoid the valuation distortions that could be caused because of

accounting rules. On one hand, if a company purchases intangible assets, the item

becomes part of the assets on the balance sheet. If, on the other hand, a company

creates the same intangible asset internally, it usually is expensed and never

appears on the balance sheet. Because of this difference, tangible book value or

tangible net asset value may present a more meaningful direct comparison among

companies that may have some purchased and some internally created assets.

Price/Dividends (or Partnership Withdrawal)

If the company being valued pays dividends or partnership withdrawals, the

multiple of such amounts can be an important valuation parameter. This variable

can be especially important when valuing minority interests, since the minority

owner normally has no control over payout policy, no matter how great the

company’s capacity to pay dividends or withdrawals.

The market multiple is computed as follows:

   . .

.0.50

Dividend per share Rs 100

Price per shareRs= 20

This is one market multiple that is more often quoted as the reciprocal of the

multiple; that is, the capitalization rate (also called the yield). The yield is computed

as

   . .

. .

Dividend per share Rs 050

Price per share Rs 100= 5.0% yield

Price/Sales

This multiple is more often used as an invested capital multiple, because all of

the invested capital, not just the equity, is utilized to support the sales. If the

subject and guideline companies have different capital structures, the equity

price/sales can be very misleading. However, if none of the companies has long-

term debt, then the equity is equal to the total invested capital, and the multiple is

meaningful on an equity basis.

This multiple is computed as

   . .

.13.9

Dividend per share Rs 100

Price per shareRs= 0.72

Price/Discretionary Earnings

The International Business Brokers Association defines discretionary earnings

as pretax income plus interest plus all noncash charges plus all compensation and

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benefits to one owner/operator. Because the multiple of discretionary earnings is

normally used only for small businesses where no debt is assumed, it is usually

computed on a total company basis.

The multiple is computed as

. , ,

. , ,

MVIC or price Rs 10 200 00

Discretionary earningsRs 2 450 000= 4.2

The multiple of discretionary earnings is used primarily for smaller

businesses and professional practices where the involvement of the key

owner/operator is an important component of the business or practice. For such

businesses or practices, meaningful multiples generally fall between 1.5 and 3.5

although some fall outsider range

Exhibit 10.2 Market Value Multiples Generally Employed in the Invested Capital

Procedure

MVIC stands for market value of invested capital, the market value of all the

common and preferred equity and long-term debt. Some analysts also include all

interest-bearing debt.

MVIC/EBITDA (Earnings before Interest, Taxes, Depreciation, and

Amortization)

The multiple is computed as

. , ,

  . , ,

MVIC Rs 10 200 000

EBITDARs 1 950 000= 5.2

EBITDA multiples are particularly favored to eliminate differences in

depreciation policies.

MVIC/EBIT (Earnings before Interest and Taxes)

The multiple is computed as

. , ,

. , ,

MVIC Rs 10 200 000

EBIT Rs 1 500 000= 6.8

EBIT multiples are good where differences in accounting for noncash charges

are not significant.

MVIC/TBVIC (Tangible Book Value of Invested Capital)

The multiple is computed as

. , ,

. , ,

MVIC Rs 10 200 000

TBVIC Rs 3 100 000= 3.3

This MVIC multiple can be used on TBVIC and also with adjusted net asset

value instead of book value if data are available.

MVIC/Sales

The multiple is computed as

. , ,

    . , ,

MVIC Rs 10 200 000

Sales Rs 10 000 000= 1.02

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MVIC/Physical Activity or Capacity

The denominator in a market value multiple may be some measure of a

company’s units of sales or capacity to produce. Analysts generally prefer that the

numerator in such a multiple be MVIC rather than equity for the same reasons as

the sales multiple—that is, the units sold or units of capacity are attributable to the

resources provided by all components of the capital structure, not just the equity.

10.3.3 How Many Guideline Companies?

For a market approach valuation by the publicly traded guideline company

method or the transaction (merger and acquisition) method, the analyst usually will

select about three to seven guideline companies, although there may be more. The

more data there are available for each company and the greater the similarity

between the guideline companies and the subject company, the fewer guideline

companies are needed.

10.3.4 Selection of Guideline Companies

A major area of controversy in the market approach in some cases is the

selection of guideline companies. There are cases where the valuer may not weight

whatsoever to the market approach, because the valuer felt that the guideline

companies selected were not adequately comparable. There are other cases where

the valuer adopts one side’s market approach over the others because of

inadequate comparability of companies on the side that was rejected.

The primary criteria for similar line of business are the economic factors that

impact the company’s revenues and profits, such as markets, sources of supply,

and products. For example, for a company manufacturing electronic controls for

the forest products industry it would make much more sense to select companies

manufacturing a variety of capital equipment for the forest products industry than

to select companies manufacturing electronic controls for unrelated industries. This

is so because the company’s manufacturing capital equipment for the forest

products industry would be subject to the same economic conditions as the subject

company.

10.3.5 Documenting the Search for Guideline Companies

The guideline company search criteria should be clearly spelled out in the

report so that another valuer could replicate the same criteria and expect to

produce the same source list. The search criteria should include, for example, these

six factors:

1. The line or lines of businesses searched

2. Size range (e.g., revenue, assets)

3. Geographical location, if applicable (location may be of great importance in

certain industries, such as retailing, yet of no importance in other industries

such as software)

4. Range of profitability (e.g., net income, EBITDA)

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5. If using the guideline merger and acquisition method, range of transaction

dates

6. The database(s) searched

If any companies that meet the stated search criteria are eliminated, the valuer

should list the companies and the reason they were eliminated (e.g., ratio analysis

far from subject company). The valuer should then give a brief description of each

company selected. This procedure should be sufficient to assure that there is no

bias in the selection of guideline companies.

10.3.6 What Prices to Use in the Numerators of the Market Valuation Multiples?

First of all, the prices must be market values, NOT book values. For invested

capital multiples, book value of debt is usually assumed to equal market value, but

it may require adjustment from book value to market value if market conditions

have changed significantly since the issuance of the debt.

In the guideline publicly traded company method the price is almost always

the closing price of the companies’ stock on the valuation date. However, on

occasion, such as in an extremely volatile market, it might be an average of some

period of time (usually 20 to 30 trading days) either immediately preceding, or

preceding and following, the valuation date.

In the guideline merger and acquisition method, the price is as of the guideline

company transaction closing date. That price may require adjustment if industry

conditions (e.g., typical valuation multiples for the industry) have changed

significantly between the guideline company transaction date and the subject

company valuation date.

10.3.7 Choosing the Level of the Valuation Multiple

Valuation pricing multiples calculated from guideline publicly traded

companies can vary widely. For example, price/earnings multiples for the guideline

companies may range between 8 and 20 times the trailing 12 months’ earnings. A

great deal of valuer’s judgment goes into the choice of where the valuation multiple

to be applied to the subject company should fall relative to the multiples observed

in the guideline companies. However, this judgment should be backed up by

quantitative and qualitative analysis to the greatest extent possible. This requires a

thorough analysis of the financial statement, as discussed in earlier chapter.

The preferred measure of central tendency in most arrays is the median (the

middle observation in the array, or, in the case of an even number of observations,

the number halfway in between the numbers immediately above and immediately

below the middle of the array). The median is generally preferred over the average

(the mean) because the average may be distorted by one or a few very high

numbers.

In general, there are two main determinants of the multiple that should be

applied to the subject company relative to the guideline companies:

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1. Relative degree of risk (uncertainty as to achievement of expected results)

2. Relative growth prospects

In addition, other financial analysis variables, such as return on sales and

return on book value, may impact the selection of specific market multiples?

Relative Degree of Risk

Risk is the degree of uncertainty regarding the achievement of expected future

results, especially future cash flows. In the market approach, risk is factored into

value through market multiples, while risk in the income approach is factored in

through the discount rate.

High risk for the subject company relative to the guideline companies should

have a downward impact on the multiples chosen for the subject company relative

to the guideline company multiples, and vice versa.

Leverage (debt-to-equity ratio) is one measure of relative risk. The relative

degree of stability or volatility in past operating results is another measure of

relative risk.

Although objective financial analysis should be utilized in assessing risk, the

analyst must also use subjective judgment based on management interviews, site

visits, economic and industry conditions, past experience, and other sources that

may impact the assessment of risk. Both objective and subjective adjustments

must be thoroughly explained.

Relative Growth Prospects

In the market approach, growths prospects are factored into the valuation

through market multiples, while growth prospects in the income approach are

factored in through projected operating results. High growth prospects for the

subject company relative to the guideline companies should have an upward impact

on the multiples chosen for the subject company relative to the guideline company

multiples, and vice versa. The key phrase here is relative to the guideline

companies.

Relative growth between the subject and guideline companies should be

considered, if available, but there is no assurance that relative past trends will

continue in the future. The valuer should assess growth prospects carefully in light

of the management interviews, the site visit (for example, is there evidence of future

costs for deferred maintenance?), and analysis of how economic and industry

conditions will impact the subject company relative to the guideline companies.

Return on Sales

If the subject company has a higher return on sales than the guideline

companies, it would deserve a higher price/sales multiple than the guideline

companies, all other things being equal, assuming that the higher relative return on

sales is expected to continue in the future.

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Return on Book Value

To the extent that the subject company’s return on book value of equity or

invested capital is higher than the guideline companies’ returns on book value of

equity or invested capital, it would deserve a higher price/book value multiple than

those of the guideline companies, all other things being equal and assuming that

the higher relative return on book value is expected to continue in the future.

10.3.8 Mechanics of Choosing Levels of Market Multiples

In light of these factors, the analyst should select the level of each market

multiple to apply to the subject company. There are several acceptable procedures

for doing this.

Medians of multiples from the guideline companies provide a good starting

point. How- ever, analysis of relative risk, growth prospects, return on sales, and

return on book value will usually lead the analyst to select one or even all of the

multiples at levels above or below the medians of the guideline companies? If

median multiples are chosen, the analyst should demonstrate that the subject and

guideline companies are relatively homogeneous.

There are many techniques for choosing multiples other than the median. One

is to select a subset of the guideline companies whose characteristics most

resemble the characteristics of the subject and to use the averages or medians of

their multiples. Another is to choose a percentage above or below the mean. Still

another is to choose a point in the array of multiples such as the upper or lower

quartile, quintile, or decile.

Regression analysis may be used to select the price/sales and price/book

value multiples. It is not necessary that all multiples chosen bear the same

relationship to the median multiple. For example, if return on book value for the

subject company is above that of the guideline companies, the selected price or

MVIC-to-book-value multiple may be higher than that of the guideline companies,

while if return on sales for the subject company is lower than that of the guideline

companies, the selected price or MVIC-to-sales multiple may be lower than that of

the guideline companies.

Occasionally, in extreme circumstances, the multiple selected to apply to the

subject company may even be outside of the range observed for the guideline

companies. For ex- ample, if return on book value is outside the range of observed

returns on book value, the selected price or MVIC to book value may be outside the

range of observed price or MVIC-to-book-value multiples.

10.3.9 Selecting Which Valuation Multiples to Use

From the array of valuation multiples in Exhibits 10.1 and 10.2 (or other

possible multiples), the analyst must select which one or ones to use. The analyst

should explain in the report why he or she chose the particular multiples used.

Generally speaking, invested capital multiples (which reflect the value of all

equity and long-term debt) are preferable for controlling interests. This is because a

control owner is not bound by the existing capital structure. A control owner has

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the right to increase or decrease leverage; the minority owner does not have this

right.

Sometimes, however, invested-capital multiples are used when valuing

minority interests. Invested-capital multiples are especially relevant where the

degree of leverage (ratio of debt to equity) varies significantly between the subject

and guideline companies.

Some appraisers use invested-capital multiples in all their valuations. Others

use both in- vested-capital and equity-valuation multiples, depending on the

circumstances.

Three criteria have the most impact on the choice of valuation multiples:

1. The relevance of the particular multiple to the subject company

2. The quantity of guideline company data available for the multiple

3. The relative tightness or dispersion of the data points within the multiple

10.3.10 Relevance of Various Valuation Multiples to the Subject Company

The degree of relevance of any valuation multiple for a subject company

depends on both the industry and the company’s financial data. Exhibit 10.3 gives

some suggestions as to when certain valuation multiples are appropriate to be

used.

Exhibit 10.3 When to Use a Valuation Multiple

Price/Net Earnings

Relatively high income compared with depreciation and amortization

When depreciation represents actual physical wear and tear

Relatively normal tax rates

Price/Pretax Earnings

Same as above except company has relatively temporary abnormal tax rate

“S” corporations may be valued using pretax income or may be taxed

hypothetically at “C” corporation rates or personal tax rates

Price/Cash Flow (often defined as net income plus depreciation and amortization)

Relatively low income compared with depreciation and amortization

Depreciation represents low physical, functional, or economic obsolescence

Price/Sales

When the subject company is “homogeneous” to the guideline companies in

terms of operating expenses

Service companies and asset-light companies are best suited for this ratio

Price/Dividends or Dividend-Paying Capacity

Best when the subject company actually pays dividends

When the company has the ability to pay representative dividends and still

have adequate ability to finance operations and growth

In minority interest valuation, actual dividends are more important

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Price/Book Value

When there is a good relationship between price/book value and return on equity

Asset-heavy companies

For example, property and casualty insurance agencies are usually valued on a price/sales basis because they are service businesses, they are asset light, and they have relatively homogeneous cost structures.

By contrast, many manufacturing companies are valued largely or entirely on

the basis of MVIC/EBITDA multiples to even out potentially significant differences

in depreciation schedules.

Availability of Guideline Company Data

Data used to compute certain valuation multiples might not be available for all

selected guide- line companies. If too few guideline companies’ data are available for

a certain valuation multiple, this may be reason to eliminate that multiple from

consideration.

Relative Tightness or Dispersion of the Valuation Multiples

Generally speaking, multiples that have tightly clustered values are the most

relevant, because the tight clustering usually indicates that the particular multiple

is one that the market relies on. Widely dispersed valuation multiples provide less

reliable valuation guidance.

One way to judge the tightness or relative dispersion of the data is just to look

at it. A mathematical tool for measuring the relative tightness or dispersion of the

data is called the coefficient of variation (the standard deviation divided by the

mean). Valuation multiples with lower coefficients of variation are usually more

reliable than multiples with higher coefficients of variation.

10.3.11 Assigning Weights to Various Market Multiples

In unusual cases, one valuation multiple may dominate the concluded

indication of value. In most cases, however, two or more market value multiples will

have a bearing on value, and the analyst must deal with how much weight to

accord to each.

The same factors considered in choosing the relevant multiples should also be

considered in deciding the weight to be accorded to each. For example, where

assets are important to a company’s value—such as holding companies, financial

institutions, and distribution companies—weight should be given to price/book-

value multiples. Where earnings are of paramount importance—such as service and

manufacturing companies—weight should be given to operating multiples, such as

price/sales, price/earnings, price (MVIC)/EBITDA, and so on. The analyst may

either use subjective weighting or assign mathematical weights. Al- though there is

no formula for assigning mathematical weights, doing so may be helpful in

understanding the analyst’s thinking. If assigning weights, the analyst should

include a disclaimer to the effect that there is no empirical basis for the weights

and that they are shown only as guides to the analyst’s thinking.

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10.3.12 Other Methods Classified Under the Market Approach

Four other methods are conventionally classified under the market approach:

1. Past transactions in the subject company

2. Offers to buy

3. Rules of thumb

4. Buy–sell agreements

Past Transactions in the Subject Company

The analyst should inquire as to whether there have been any past

transactions in the company’s equity, either on a control or a minority basis. The

analyst should also inquire as to whether the company has made any acquisitions.

If past transactions occurred, the next question is whether they were on an arm’s-

length basis.

If past arm’s-length transactions did take place, they should be analyzed like

any other guideline company transactions. The past transactions method may be

one of the most useful market methods, yet it is often overlooked.

Past Acquisitions by the Subject Company

Past acquisitions by the subject company are often a fertile field for very valid

guideline market transaction data, and are a source often overlooked. We would

suggest, “Have you made any acquisitions?” as a standard question in management

interviews. Appropriate adjustments must be made, as just discussed.

Offers to Buy

For offers to buy to be probative evidence of value, they must be: (1) firm, (2) at

arm’s length, (3) with sufficient detail of terms to be able to estimate the cash

equivalent value, and (4) from a source with the financial ability to consummate the

offer (i.e., a bona fide offer). It is rare that all of these requirements are met.

If the requirements are met, the offer to buy can be handled in the same way

as a past transaction to arrive at one indication of value as of the valuation date.

Since the offer did not conclude in a consummated transaction, however, the

weight accorded its indication of value may be limited.

Rules of Thumb

Many industries, especially those characterized by very small businesses, have

valuation rules of thumb, some more valid than others. If they exist, they should be

considered if they have a wide industry following. However, they should never be

relied on as the only valuation method.

Nature of Rules of Thumb

Rules of thumb come in many varieties, but the most common are:

Multiple of sales

Multiple of some physical nature of activity

Multiples of discretionary earnings

Assets plus any of the above

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Proper Use of Rules of Thumb

Rules of thumb are best used as a check on the reasonableness of the

conclusions reached by other valuation methods, such as capitalization of earnings

or a market multiple methods. A good source for guidance on when to use rules of

thumb is in the American Society of Appraisers Business Valuation Standards:

Rules of thumb may provide insight on the value of a business, business

ownership interest, or security. However, value indications derived from the use of

rules of thumb should not be given substantial weight un- less supported by other

valuation methods and it can be established that knowledgeable buyers and sellers

place substantial reliance on them.13

Problems with Rules of Thumb

One problem with rules of thumb is the lack of knowledge about the derivation

of the rules. Several other problems are:

Not knowing what was transacted. Most, but not all, rules of thumb

presume that the valuation rule applies to an asset sale. Few of them,

however, specify what assets are assumed to be transferred. The asset

composition may vary substantially from one transaction to another. It is

also important to remember that the rules of thumb almost never specify

whether they assume a non-compete agreement or an employment

agreement, even though such types of agreements are very common for the

kinds of businesses for which rules of thumb exist.

Not knowing assumed terms of the transactions. Most transactions for

which there are rules of thumb are not all-cash transactions, but involve

some degree of seller financing. The financing terms vary greatly from one

transaction to another, and affect both the face value and the fair market

value (which, by definition, assumes a cash or cash equivalent value).

Not knowing the assumed level of profitability. The level of profitability

impacts almost all real-world valuations. However, for rules of thumb that

are based on either gross revenue or some measure of physical volume,

there is no indication of the average level of profitability that the rule of

thumb implies.

Uniqueness of each entity. Every business is, to some extent, different from

every other business. Rules of thumb give no guidance for taking the unique

characteristics of any particular business into account.

Multiples change over time. Rules of thumb rarely change, but in the real

world market valuation multiples do change over time. Some industries are

more susceptible than others to changes in economic and industry

conditions. Changes occur in the supply/demand relationship for valuing

various kinds of businesses and professional practices because of many

factors, sometimes including legal/regulatory changes. When using market

transaction multiples, adjustments can be made for changes in conditions

from the time of the guideline transaction to the subject valuation date, but

there is no base date for rules of thumb.

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Sources for Rules of Thumb

For some industries, articles or trade publications may provide some industry

rules of thumb.

Buy-Sell Agreements

Buy–sell agreements are included here as a market approach category on the

assumption that they represent parties’ agreements on pricing transactions that are

expected to occur in the future. The pricing mechanism set forth in the buy–sell

agreement may be determinative of value in certain circumstances, such as where

it is legally binding for the purposes of the valuation. In other cases, the buy–sell

agreement price might be one method of estimating value, but not determinative. In

still other instances, the buy–sell agreement might be ignored be- cause it does not

represent a bona fide arm’s-length sale agreement.

For estate tax purposes, for example, a buy–sell agreement price is binding for

estate tax determination only if it meets all of the following conditions:

The agreement is binding during life as well as at death.

The agreement creates a determinable value as of a specifically determinable

date.

The agreement has at least some bona fide business purpose (this could

include the pro- motion of orderly family ownership and management

succession, so this is an easy test to meet).

The agreement results in a fair market value for the subject business

interest, when executed. Often, buy–sell agreement values will generate

future date of death or gift date values substantially above or below what the

fair market value otherwise would have been for the subject interest—even

though the value was reasonable when the agreement was made.

Its terms are comparable to similar arrangements entered into by persons in

arm’s-length transactions.

If a buy–sell agreement does not meet these conditions, it is entirely possible to

have a buy–sell value that is legally binding on an estate for transaction purposes,

but not for estate tax purposes, and that may not even provide enough money for

estate taxes.

10.3.13 Illustration

True Value Ltd. (TVL) is planning to raise funds through issue of common

stock for the first time. However, the management of the company is not sure about

the value of the company and, therefore, they attempted to study similar companies

in the same line which are comparable to True value in most of the aspects.

From the following information, you are required to compute the value of TVL

using the comparable firms approach.

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(Rs. in crore)

Company True value

Ltd. Jewel-

value Ltd. Real value

Ltd. Unique value

Ltd.

Sales 250 190 210 270

Profit after tax 40 30 44 50

Book value 100 96 110 128

Market Value 230 290 440

TVL feels that 50% weightage should be given to earnings in the valuation

process; sales and book value may be given equal weightages.

Solution:

The valuation multiples of the comparable firms are as follows:

Particular Jewel-value

Ltd. Real value

Ltd. Unique

value Ltd. Average

Prices/Sales ratio* 1.21 1.38 1.63 1.41

Price/Earnings ratio** 7.67 6.59 8.80 7.69

Price/Book value ratio 2.40 2.64 3.44 2.83

Applying the multiples calculated as above, the value of TVL can be calculated

as follows:

Particular Multiple Average Parameter (` cr.) Value (` cr.)

Prices/Sales 1.41 250 352.50

Price/Earnings 7.69 40 307.60

Price/Book value 2.83 100 283.00

By applying the weightage to the P/S ratio, P/E ratio and P/BV ratio we get:

[(352.50 x 1)+(307.60 x 2)+(283.00 x 1)]/(1+2+1)= 312.675, i.e. Rs. 312.675

crores is the value.

Alternative:

(352.50 × 0.25 + 307.60 × 0.50 + 283.00 × 0.25) = Rs. 312.675 crore.

Working Notes:

*Price/Sales Ratio = Market Value / Sales

**Price/Earnings Ratio = Market Value / Profit after tax

***Price/Book value ratio = Market Value/ Book Value

10.4 REVISION POINTS

1. Market approach

2. Market value

3. Book value

10.5 INTEXT QUESTIONS

1. Explain importance of market approach for business valuation.

2. Discuss “Rule of Thumb”.

3. Discuss various valuation multiples and their relevance in business

valuation.

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4. Discuss mechanics of valuation multiples and selection of relevant

multiples.

5. A rule of thumb for gas stations is 1.5 to 3.5 times owner’s cash flow for the

most recent 12 months, which yields the value of equipment, lease, and

intangibles. After investigating the operations of RKP Gas Services Co., you

believe that the business deserves a multiple of 3.0 times owner’s cash flow.

Given the information below, what is the value of equity for RKP Gas

Services based on the rule of thumb? Given that in last financial year the

net cash flow was Rs. 20 Lakhs, Cash Rs. 70,000/-, Inventory Rs. 9 Lakhs

and Liabilities Rs. 13.5 Lakhs.

6. RKP Ltd is in the business of making sports equipment. The Company

operates from Thailand. To globalize its operations RKP has identified Try

Toys Ltd, an Indian Company, as a potential takeover candidate. After due

diligence of Try Toys Ltd, the following information is available :-

(a) Cash Flow Forecasts (in Crores)

Year 10 9 8 7 6 5 4 3 2 1

Try Toys Ltd 24 21 15 16 15 12 10 8 6 3

RKP Ltd 108 70 55 60 52 44 32 30 20 16

(b) The Net Worth of Try Toys Ltd (in Lakh) after considering certain

adjustments suggested by the due diligence team reds as under —

Tangible 750

Inventories 145

Receivables 75 970

Less: Creditors 165

Bank Loans 250 (415)

Represented by Equity Shares of Rs. 1000 each 555

Talks for the takeover have crystallized on the following –

1. RKP Ltd will not be able to use Machinery worth `75 Lakhs which will be

disposed of by them subsequent to take over. The expected realization

will be `50 Lakhs.

2. The inventories and receivables are agreed for takeover at values of Rs.

100 and Rs 50 Lakhs respectively, which is the price they will realize on

disposal.

3. The liabilities of Try Toys Ltd will be discharged in full on take over along

with an employee settlement of `90 Lakhs for the employees who are not

interested in continuing under the new management.

4. RKP Ltd will invest a sum of Rs 150 Lakhs for upgrading the Plant of Try

Toys Ltd on takeover. A further sum of Rs 50 Lakhs will also be incurred

in the second year to revamp the machine shop floor of Try Toys Ltd.

5. The anticipated cash flow (in Rs. Crore) post takeover are as follows-

Year 1 2 3 4 5 6 7 8 9 10

Cash Flows 18 24 36 44 60 80 96 100 140 200

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You are required to advise the management the maximum price which they

can pay per share of Try Toys Ltd., if a discount factor of 15% is considered

appropriate.

10.6 SUMMARY

The two primary methods within the market approach are the guideline

publicly traded company method and the guideline transaction (merger and

acquisition) method. Other methods often classified under the market approach are

past transactions, offers to buy, rules of thumb, and buy–sell agreements. The

income and market approaches are the main approaches used for operating

companies when the premise of value is a going-concern basis. For holding

companies and operating companies for which the appropriate premise of value is a

liquidation basis, an asset approach is typically employed. The asset approach is

the subject of next chapter.

10.7 TERMINAL EXERCISE

1. Difference between market value and book value.

2. Discuss the “Rule of thumb”

10.8 SUPPLEMENTARY MATERIALS

1. https\\www.business.gov.in

2. www.business valuation.inc.com

10.9 ASSIGNMENTS

1. The students are required to take a case of a company they are conversant

with and collecting and analyzing its valuation multiples/ comparables in

relation to guideline companies necessary for valuation of that company

10.10 SUGGESTED READINGS/REFERENCE BOOKS

1. Shannon P. Pratt, The Market Approach to Valuing Businesses (New York:

John Wiley & Sons, Inc., 2001)

2. American Society of Appraisers, BV-201, Introduction to Business Valuation,

Part I, from Principles of Valuation course series, 2002

3. American Society of Appraisers, Business Valuation Standards

4. Glenn Desmond, Handbook of Small Business Valuation Formulas and

Rules of Thumb, 3rd ed. (Camden, Me.: Valuation Press, 1993).

10.11 LEARNING ACTIVITIES

Group discussion during PCP days

1. The students are required to take a case of a company they are conversant

with and collecting and analyzing its valuation multiples/ comparables in

relation to guideline companies necessary for valuation of that company

10.12 KEY WORDS

Market Approach, Market Comparables/ Multiples, MVIC, MVIC/EBITDA,

Rule of Thumb

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CHAPTER - 11

THE ASSET-BASED APPROACH TO BUSINESS VALUATION

11.1 INTRODUCTION

In the valuation of a business or business enterprise, the asset approach

presents the value of all the tangible and intangible assets and liabilities of the

company. As typically used, this approach starts with a book basis balance sheet

as close as possible to the valuation date and restates the assets and liabilities,

including those that are unrecorded, to fair value (financial reporting) or fair market

value (tax and other purposes). On the surface, the asset approach seems to be

simple, but deceptively so. The application of this approach introduces a number of

complicating factors that must be addressed before a satisfactory analysis is

concluded.

11.2 OBJECTIVES

The asset-based approach is relevant for holding companies and for operating

companies that are contemplating liquidation or are unprofitable for the foreseeable

future. It should also be given some weight for asset-heavy operating companies,

such as financial institutions, distribution companies, and natural resources

companies such as forest products companies with large timber holdings. There are

two main methods within the asset approach (1) The adjusted net asset value

method and (2) The excess earnings method. Either of these methods produces a

controlling interest value. If valuing a controlling interest, a discount for lack of

marketability may be applicable. If valuing a minority interest, discounts for both

lack of control and lack of marketability would be appropriate in most cases. This

chapter discussed asset-based approach to the business valuation.

11.3 CONTENTS

11.3.1 Adjusted Net Asset Value Method

11.3.2 Excess Earnings Method (The Formula Approach)

11.3.3 Steps in Applying the Excess Earnings Method

11.3.4 Example of the Excess Earnings Method

11.3.5 Reasonableness Check for the Excess Earnings Method

11.3.6 Problems with the Excess Earnings Method

11.3.1 Adjusted Net Asset Value Method

The adjusted net asset value method involves adjusting all assets and

liabilities to current values. The difference between the value of assets and the

value of liabilities is the value of the company. The adjusted net asset method

produces a controlling interest value.

The adjusted net asset value encompasses valuation of all the company’s

assets, tangible and intangible, whether or not they are presently recorded on the

balance sheet. For most companies, the assets are valued on a going-concern

premise of value, but in some cases they may be valued on a forced or orderly

liquidation premise of value.

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The adjusted net asset method should also reflect the potential capital gains

tax liability for appreciated assets. As a result, this can be done as an adjustment

to the balance sheet rather than a separate adjustment at the end.

Exhibit 11.1 is a sample of the application of the adjusted net asset value

method. In a real valuation, the footnotes should be explained in far greater detail

in the text of the report. Intangible assets are usually valued by the income

approach.

Exhibit 11.1 Adjusted Net Asset Value for RKP Co.

31/3/2016 Adjusted As Adjusted Rs. ‘000 Rs. ‘000 Rs. ‘000

Assets: Current Assets:

Cash Equivalents 740,000 740,000

Accounts Receivable 2,155,409 2,155,409 Inventory 1,029,866 200,300a

1,230,166

Prepaid Expenses 2,500 2,500

Total Current Assets 3,927,775 200,300 4,128,075 Fixed Assets:

Land & Buildings 302,865 (49,760)b 253,105

Furniture & Fixtures 155,347 (113,120)b 42,227

Automotive Equipment 478,912 (391,981)b 86,931

Machinery & Equipment 759,888 (343,622)b 416,266

Total Fixed Assets, Cost 1,697,012 (898,483) 798,529

Accumulated Depreciation 1,298,325) 1,298,325 c

0

Total Fixed Assets, Net 398,687 399,842 798,529 Real Estate—Non-operating

Other Assets: Goodwill, Net

90,879

95,383

43,121 d

(95,383)e

134,000

0

Organization Costs, Net 257 (257)e 0

Investments 150,000 20,000 d 170,000

Patents 0 100,000 e 100,000

Total Other Assets 245,640 24,360 270,000

Total Assets 4,662,981 667,623 5,330,604 Liabilities and Equity:

Current Liabilities: Accounts Payable

1,935,230

1,935,230

Bank Note, Current 50,000 50,000

Accrued Expenses 107,872 107,872 Additional Tax Liability 0 267,049 f

267,049 Total Current Liabilities 2,093,103 267,049 2,360,151

Long-Term Debt 350,000 350,000 Total Liabilities 2,443,102 267,049 2,710,151 Equity:

Common Stock 2,500 2,500 Paid-in Capital 500,000 500,000 Retained Earnings 1,717,379 400,574 g

2,117,953

Total Equity 2,219,879 400,574 2,620,453

Total Liabilities and Equity 4,662,981 667,623 5,330,604

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Notes:

1. Add back LIFO reserve.

2. Deduct economic depreciation.

3. Remove accounting depreciation.

4. Add appreciation of value, per real estate appraisal.

5. Remove historical goodwill. Value identifiable intangibles and put on books.

6. Add tax liability of total adjustment at 40% tax rate.

7. Summation of adjustments.

Two methods are used here:

a. The Liquidation Value, which is the sum as estimated sale values of the

assets owned by a company.

b. Replacement Cost: The current cost of replacing all the assets of a company

at times for specific purposes professional valuers also consider depreciated

replacement cost of the asset(s).

This approach is commonly used by property and investment companies, to

cross check for asset based trading companies such as hotels and property

developers, underperforming trading companies with strong asset base (market

value vs. existing use), and to work out break – up valuations.

11.3.2 Excess Earnings Method (The Formula Approach)

The excess earnings method is classified under the asset approach because it

involves valuing all the tangible assets at current fair market values and valuing all

the intangible assets in a big pot loosely labeled goodwill. It is also sometimes

classified as a hybrid method.

Thus, the concept of the excess earnings method is to value goodwill by

capitalizing any earnings the company was enjoying over and above a fair rate of

return on their tangible assets. Thus the descriptive label, excess earnings method.

The result of the excess earnings method is value on a control basis. This approach

may be used for determining the fair market value of intangible assets of a business

only if there is no better basis therefore available.

11.3.3 Steps in Applying the Excess Earnings Method

1. Estimate net tangible asset value (usually at market values).

2. Estimate a normalized level income.

3. Estimate a required rate of return to support the net tangible assets.

4. Multiply the required rate of return to support the tangible assets (from step 3) by the net tangible asset value (from step 1).

5. Subtract the required amount of return on tangibles (from step 3) from the

normalized amount of returns (from step 2); this is the amount of excess earnings. (If the results are negative, there is no intangible value and this method is no longer an appropriate indicator of value. Such a result

indicates that the company would be worth more on a liquidation basis than on a going-concern basis.)

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6. Estimate an appropriate capitalization rate to apply to the excess economic

earnings. (This rate normally would be higher than the rate for tangible

assets and higher than the overall capitalization rate; persistence of the

customer base usually is a major factor to consider in estimating this rate.)

7. Divide the amount of excess earnings (from step 5) by a capitalization rate

applicable to excess earnings (from step 6); this is the estimated value of the

intangibles.

8. Add the value of the intangibles (from step 7) to the net tangible asset value

(from step 1); this is the estimated value of the company.

9. Reasonableness check: Does the blended capitalization rate approximate a

capitalization rate derived by weighted average cost of capital (WACC)?

10. Determine an appropriate value for any excess or nonoperating assets that

were adjusted for in step 1. If applicable, add the value of those assets to the

value determined in step 8. If asset shortages were identified in step 1,

determine whether the value estimate should be reduced to reflect the value

of such shortages. If the normalized income statement was adjusted for

identified asset shortages, it is not necessary to further re- duce the value

estimate.

11.3.4 Example of the Excess Earnings Method

Assumptions: Rs. ‘000

Net tangible asset value 100,000

Normalized annual economic income 30,000

Required return to support tangible assets 10%

Capitalization rate for excess earnings 25%

Calculations:

Net tangible asset value 100,000

Required return on tangible assets 0.10 100,000 = 10,000

Excess earnings 30,000 – 10,000 = 20,000

Value of excess earnings 20,000/0.25 = 80,000

Indicated value of company 180,000

11.3.5 Reasonableness Check for the Excess Earnings Method

. , , . . %

, , ,

Normalized income Rs 30 000 0000167 or 167

Indicated value of company Rs 180 000 000

If 16.7 percent is a realistic WACC for this company, then the indicated value

of the in- vested capital meets this reasonableness test. If not, then the values

should be reconciled. More often than not, the problem lies with the value indicated

by the excess earnings method rather than with the WACC.

11.3.6 Problems with the Excess Earnings Method

Tangible Assets Not Well Defined

Some valuers simply use book value due to lack of existing asset appraisals.

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It is not clear whether clearly identifiable intangible assets (e.g., leasehold

interests) should be valued separately or simply left to be included with all

intangible assets under the heading of goodwill.

Most appraisers will include built-in capital gains, however, if assets are

adjusted upward to reflect their fair market value.

Definition of Income Not Specified

Practice is mixed. Some use net cash flow, but many use net income, pretax

income, or some other measure.

Since some debt usually is contemplated in estimating required return on

tangible assets, returns should be amounts available to all invested capital.

If no debt is contemplated, then returns should be those available to equity.

The implication of the preceding two bullet points is that the method can be

conducted on either an invested capital basis or a 100 percent equity basis.

Capitalization Rates Not Well Defined

1. Required return on tangibles is controversial, but usually a blend of the

following:

1. Borrowing rate times percentage of tangible assets that can be financed

by debt

2. Company’s cost of equity capital

2. Difficulty for estimating a required capitalization rate for excess earnings.

The result of these ambiguities is highly inconsistent implementation of the

excess earnings method.

11.4 REVISION POINTS

1. Assets value

2. Excess learning

3. Fixed assets

11.5 INTEXT QUESTIONS

1. Difference between net assets value and adjusted net asset value?

11.6 SUMMARY

Within the asset approach, the two primary methods are the adjusted net

asset value method and the excess earnings method. Under the adjusted net asset

value method, all assets, tangible and intangible, are identified and valued

individually. Under the excess earnings method, only tangible assets are

individually valued; all the intangibles are valued together by the capitalization of

earnings over and above a fair return on the tangible assets. Once indications of

value have been developed by the income, market, and/or asset approaches, the

next consideration is whether to adjust these values by applicable premiums

and/or discounts. In valuations for tax purposes, the premiums and/or discounts

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often are a bigger and more contentious money issue than the underlying value to

which they are applied. Premiums and discounts are the subject of next chapter.

11.7 TERMINAL EXERCISE

1. Explain importance of asset approach for business valuation.

2. Discuss “Net Asset Value and Adjusted NAV”.

3. What is Excess Earning Method and its importance in business valuation?

4. Discuss reasonability and potential problems with Excess Earning Method of

business valuation

11.8 SUPPLEMENTARY MATERIALS

1. https\\www.business.gov.in

2. www.business valuation.inc.com

11.9 ASSIGNMENTS

1. The students are required to take a company’s annual accounts and (1)

prepare adjusted balance sheet, (2) work out normalized annual economic

income, (3) make appropriate assumptions of rate of return on tangible

assets and capitalization rate of excess earning, and finally (4) derive value

of excess earning and value of the company using asset-based approach as

illustrated in this chapter

11.10 SUGGESTED READINGS/REFERENCE BOOKS

1. American Society of Appraisers, BV-201, Introduction to Business Valuation,

Part I from Principles of Valuation course series, 2002.

2. Estate of Dunn v. Comm’r, T.C. Memo 2000-12, 79 T.C.M. (CCH) 1337; rev’d

301 F.3d 339 (5th Cir. 2002).

3. Valuation of intangible assets see Robert F. Reilly, and Robert P. Schweihs,

Valuing Intangible Assets (New York: McGraw-Hill, 1998).

11.11 LEARNING ACTIVITIES

Group discussion during PCP days

1. The students are required to take a company’s annual accounts and (1)

prepare adjusted balance sheet, (2) work out normalized annual economic

income, (3) make appropriate assumptions of rate of return on tangible

assets and capitalization rate of excess earning, and finally (4) derive value

of excess earning and value of the company using asset-based approach as

illustrated in this chapter

11.12 KEY WORDS

Net Asset Value, Excess Earning, Intangible Assets

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CHAPTER - 12

DISCOUNTS AND PREMIUMS

12.1 INTRODUCTION

Discounts and premiums typically are applied near the end of a valuation

engagement after the initial analysis is completed. If the initial analysis produces a

minority interest value, then depending on the nature of the engagement, a control

premium may be added to reach a control value or a marketability discount may be

taken to lower the value. This lesson discusses the applications of a control

premium, a discount for lack of control (or minority discount), and a discount for

lack of marketability (or marketability discount).

12.2 OBJECTIVES

The objectives of this chapter are to introduce the students application of

discounts and premiums to vales derived applying one or all the basic approaches

to business valuations.

12.3 CONTENTS

12.3.1 Entity Level Discounts/ Premiums

12.3.2 Discounts for Lack of Marketability

12.3.3 Other Shareholder – Level Discounts

12.3.1 Entity Level Discounts/ Premiums

Entity-level discounts are those that apply to the company as a whole. That is,

they apply to the values of the stock held by all the shareholders alike, regardless of

their respective circumstances. As such, they should be deducted from value

indicated by the basic approach or approaches used. Since they apply to the

company as a whole, regardless of individual shareholder circumstances, the

entity-level discounts should be deducted before considering shareholder-level

discounts or premiums.

There are four primary categories of entity-level discounts:

1. Trapped-in capital gains discount

2. Key person discount

3. Portfolio (non-homogeneous assets) discount

4. Contingent liabilities discount

Trapped-in Capital Gains Discount

The concept of the trapped-in capital gains tax discount is that a company

holding an appreciated asset would have to pay capital gains tax on the sale of the

asset. If ownership in the company were to change, the cost basis in the

appreciated asset(s) would not change. Thus, the built-in liability for the tax on the

sale of the asset would not disappear, but would remain with the corporation under

the new ownership.

Under the standard of fair market value, the premise for this discount seems

very simple. Suppose that a privately held corporation owns a single asset (e.g., a

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piece of land) with a fair market value of Rs. 1 crore and a cost basis of Rs.

10,00,000. Would the hypothetical willing buyer pay Rs. 1 crore for the stock of the

corporation, knowing that the underlying asset will be subject to corporate tax on

the Rs. 90,00,000 gain, when the asset (or a comparable asset) could be bought

directly for Rs. 1 crore with no underlying embedded taxes? Of course not.

And would the hypothetical, willing seller of the private corporation reduce the

asking price of his stock below Rs. 1 crore in order to receive cash not subject to

the corporate capital gains tax? of course.

The most common reason cited in decisions for denying a discount for

trapped-in capital gains is lack of intent to sell. If the reason for rejecting the

discount for trapped-in capital gains tax is that liquidation is not contemplated,

this same logic could also lead to the conclusion that the asset approach is

irrelevant and that the interest should be valued using the income approach or,

possibly, the market approach.

Key Person Discount

Sometimes the impact or potential impact of the loss of the entity’s key person

may be reflected in an adjustment to a discount rate or capitalization rate in the

income approach or to valuation multiples in the market approach. Alternatively,

the key person discount may be quantified as a separate discount, more often as a

percentage. It is generally considered to be an enterprise-level discount (taken

before shareholder-level adjustments), because it impacts the entire company. All

else being equal, a company with a realized key person loss is worth less than a

company with a potential key person loss.

Factors to Consider in Analyzing the Key Person Discount

Some of the attributes that may be lost upon the death or retirement of the key

person include:

Relationships with suppliers

Relationships with customers

Employee loyalty to key person

Unique marketing vision, insight, and ability

Unique technological or product innovation capability

Extraordinary management and leadership skill

Financial strength (ability to obtain debt or equity capital, personal

guarantees)

Some of the other factors to consider in estimating the magnitude of a key

person discount, in addition to special characteristics of the person just listed,

include:

Services rendered by the key person and degree of dependence on that

person

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Likelihood of loss of the key person (if still active)

Depth and quality of other company management

Availability and adequacy of potential replacement

Compensation paid to key person and probable compensation for

replacement

Lag period before new person can be hired and trained

Value of irreplaceable factors lost, such as vital customer and supplier

relationships, insight and recognition, and personal management styles to

ensure companywide harmony among employees

Risks associated with disruption and operation under new management

Lost debt capacity

There are three potential offsets to the loss of a key person:

1. Life or disability insurance proceeds payable to the company and not

earmarked for other purposes, such as repurchase of a decedent’s stock

2. Compensation saved (after any continuing obligations), if the compensation

to the key person was greater than the cost of replacement

3. Employment agreements

Quantifying the Magnitude of the Key Person Discount

Ideally, the magnitude of the key person discount should be the estimated

difference in the present value of the net cash flows with and without involvement

of the key person. If the key person is still involved, the projected cash flows for

each year should be multiplied by the mean of the probability distribution of that

person’s remaining alive and active during the year. Notwithstanding, the fact is

that most practitioners and courts express their estimate of the key person

discount as a percentage of the otherwise undiscounted enterprise value.

In any case, the analyst should investigate the key person’s actual duties and

areas of active involvement. A key person may contribute value to a company both

in day-to-day management duties and in strategic judgment responsibilities based

on long-standing contacts and reputation within an industry. The more detail

presented about the impact of the key person, the better.

Portfolio (Non-homogeneous Assets) Discount

A portfolio discount is applied, usually at the entity level, to a company or

interest in a company that holds disparate or non-homogeneous operations and/or

assets. This section explains the principle and discusses empirical evidence of its

existence and magnitude.

Investors generally prefer to buy pure plays rather than packages of dissimilar

operations and/or assets. Therefore, companies, or interests in companies, that

hold a non-homogeneous group of operations and/or assets frequently sell at a

discount from the aggregate amount those operations and/or assets would sell for

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individually. The latter is often referred to as the breakup value. This disinclination

to buy a miscellaneous assortment of operations and/or assets, and the resulting

discount from breakup value, is often called the portfolio effect.

It is quite common for family-owned companies, especially multigenerational

ones, to accumulate an unusual (and often unrelated) group of operations and/or

assets over the years. This often happens when different decision makers acquire

holdings that particularly interest them at different points in time. For example, a

large privately owned company might own a life insurance company, a cable

television operation, and a hospitality division.

The following have been suggested as some of the reasons for the portfolio

discount:

The diversity of investments held within the corporate umbrella

The difficulty of managing the diverse set of investments

The expected time needed to sell undesired assets

Extra costs expected to be incurred upon sale of the various investments

The risk associated with disposal of undesired investments

The portfolio discount effect is especially important when valuing non-

controlling interests, because minority stockholders have no ability to redeploy

underperforming or nonperforming assets, nor can they cause a liquidation of the

asset portfolio and/or dissolution of the company. Minority stockholders place little

or no weight on nonearning or low-earning as- sets in pricing stocks in a well-

informed public market. Thus, the portfolio discount might be greater for a minority

position because the minority stockholder has no power to implement changes that

might improve the value of the operations and/or assets, even if the stockholder

desires to.

Empirical Evidence Supports Portfolio Discounts

Three categories of empirical market evidence strongly support the prevalence

of portfolio discounts in the market:

1. Prices of stocks of conglomerate companies

2. Breakups of conglomerate companies

3. Concentrated versus diversified real estate holding companies

Stocks of Conglomerate Companies

Stocks of conglomerate companies usually sell at a discount to their estimated

breakup value. Several financial services provide lists of conglomerate companies,

most of which are widely followed by securities analysts. The analyst reports

usually provide an estimate as to the aggregate prices at which the parts of the

company would sell if spun off. This breakup value is consistently more than the

current price of the conglomerate stock.

Actual Breakups of Conglomerate Companies

Occasionally, a conglomerate company actually does break up. The resulting

aggregate market value of the parts usually exceeds the previous market value of

the whole.

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Evidence from Real Estate Holding Companies

An article on real estate holding companies made the point that the negative

effect of a disparate portfolio also applies to real estate holding companies, such as

real estate investment trusts (REITs): “REITs that enjoy geographic concentrations

of their properties and specialize in specific types of properties, e.g., outlet malls,

commercial office buildings, apartment complexes, shopping centers, golf courses.

etc., are the most favored by investors. This is similar to investor preferences for the

focused ‘pure play’ company in other industries.”

Discount for Contingent Liabilities

Contingent assets and liabilities are among the most difficult to value simply

because of their nature. The challenge lies in estimating just how much may be

collected or will have to be paid out, and thus in quantifying any valuation

adjustments.

Concept of the Contingent Liability Discount

In real-world purchases and sales of businesses and business interests, such

items often are handled through a contingency account. For example, suppose a

company with an environmental problem were being sold, and estimates had placed

the cost to cure the environmental problem at Rs. 10 crores to Rs. 20 million. The

seller might be required to place Rs. 20 million to pay for the cleanup, and once the

problem was cured, any money remaining would be released back to the seller. In

gift, estate, and certain other situations, however, a point estimate of value is

required as of the valuation date, without the luxury of waiting for the actual

outcome of a contingent event. In such cases, some estimate of the cost of recovery

must be made. It can be added or deducted as a percentage of value.

12.3.2 Shareholder-Level Discounts and Premiums

Valuation discounts and/or premiums are meaningless unless the base to

which they are applied is defined. It is therefore necessary to define what level of

value is indicated by the results of the income, market, and/or asset approaches.

The approaches discussed generally produce one of the following levels of value:

1. Control

2. Marketable minority

The income approach can produce either a control or a minority value. The key

to which value is indicated is whether the numerators (cash flows, earnings, etc.)

represent results that a control owner could be expected to produce by results from

business as usual. If a minority value is indicated, it would be considered

marketable because the discount rates and capitalization rates used in the income

approach are based on publicly traded stock data.

In the guideline publicly traded stock method, the guideline companies are, by

definition, minority interests. Therefore, if valuing a minority interest, a minority

interest discount normally would not be appropriate, but a discount for lack of

marketability would be, because the publicly traded stock can be sold immediately

and the proceeds received, while the privately held stock enjoys no such liquid

market. However, minority shares of publicly traded companies may sell at their

control value. If the analyst can demonstrate that this is the case, a minority

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discount might be considered. If valuing a controlling interest, a control premium

normally would be appropriate, subject to the caveat in the previous sentence.

The transaction method, being based on acquisitions of entire companies,

produces a control value. Therefore, if valuing a minority interest, both minority

and marketability discounts would be appropriate. If valuing a controlling interest,

it might be appropriate to consider some discount for lack of marketability, as

discussed later in this chapter.

If past transactions or buy-sell agreements are used, they should be studied to

determine their implications. Rules of thumb normally indicate a control interest

value.

Asset-based approaches (both adjusted net asset value and excess earnings)

normally result in a control-interest value.

All adjustments to indicated values for any approach should be based on

differences between the characteristics of the subject interest and the

characteristics implicit in the approach from which the adjustment is made.

Definition of Marketability

The discount for lack of marketability is the largest single issue in most

disputes regarding the valuation of businesses and business interests, especially in

tax matters. This is true both in the number of cases in which the issue arises and

the magnitude of the differential money involved in the disputes.

Marketability is defined by the International Glossary of Business Valuation

Terms as the ability to quickly convert property to cash at minimal cost. The

benchmark for marketability for business valuation is the market for active,

publicly traded stocks. The holder can have the stock sold in less than a minute at

or near the price of the last trade, and have cash in hand in few business days.

Discount for lack of marketability is defined by the International Glossary of

Business Valuation Terms as an amount or percentage deducted from the value of

an ownership interest to reflect the relative absence of marketability. The term

relative in this definition usually refers to the value of the interest as if it were

publicly traded, sometimes referred to as the publicly traded equivalent value or the

value if marketable.

Investors Cherish Liquidity, Abhor Illiquidity

Investors cherish liquidity. The public market allows investors to sell their

interest and get cash immediately for any reason: when they believe that the value

may go down, when they believe that the company should be managed differently,

or when they just desire to have cash with which to do something else. The public

market also provides liquidity in that it creates the ability to hypothecate the

interest—that is, use it as collateral for a loan.

Consequently, all other things being equal, a stock that can be readily sold in

the public market is worth much more than one which cannot be readily sold.

When a company first completes an initial public offering (IPO), the price usually

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will be more than twice the price of the last transaction in the stock when it was

private.

Conversely, investors abhor illiquidity. They may be forced to hold a stock and

watch it decline in value or even become worthless. They may be forced to hold a

stock when they object vehemently to management policies. Whatever their

alternative needs or desires, they are generally “locked in” to the stock and are

unable to get their money out of it. Banks will rarely accept stock of private

companies, even controlling interests, as collateral for loans because of the lack of a

market in case of default.

Consequently, all other things being equal, investors demand a large discount

from an otherwise comparable public stock to induce them to invest in a private

company.

Degrees of Marketability or Lack Thereof

Marketability is not a black-and-white issue. A stock is considered marketable

if it is publicly traded and nonmarketable if it is not. But along the way there are

degrees of marketability or lack of marketability. Without attempting to address

every conceivable situation, the following gives a general idea of the spectrum of

marketability or lack thereof:

Registered with the stock exchange and with an active trading market (the

benchmark from which some lack of marketability discount usually is

indicated)

Registered with the stock exchange and fully reporting, but with a somewhat

thin trading market

A stock with contractual put rights (right of the owner to sell, usually to the

issuing company, under specified circumstances and terms). (The most

common example is employee stock ownership plan (ESOP) stock, where the

plan includes a put option to sell the stock at the employee’s retirement or at

certain other times.)

Private company with an imminent (or likely) public offering

Private company with frequent private transactions

Private company with few or no transactions

Private company with interests subject to restrictive transfer provisions

Private company with ownership interests absolutely prohibited from

transfer (for example, tied up in a trust for some period of time)

12.3.3 Other Shareholder – Level Discounts

A shareholder-level discount or premium is one that affects only a defined

group of share- holders rather than the whole company. As with discounts for lack

of marketability, other shareholder-level discounts should be applied to the net

amount after entity-level discount, if any. Besides the discount for lack of

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marketability, other shareholder-level discounts and premiums largely fall into

three categories:

1. Minority discounts/control premiums

2. Voting versus nonvoting interests

3. Blockage

In addition, there can be discounts for fractional interests in property such as

real estate.

Minority Discounts/Control Premiums

Minority discounts are often (and more properly) referred to as lack of control

discounts because it is possible to have a majority interest and still not have

control, and, conversely, a minority interest may have control, perhaps because of

voting trusts and other arrangements. For example, on one hand, no limited

partner has control, regardless of the percentage interest.

After marketability, minority/control is the next most frequent issue in

disputed valuations. Virtually everyone recognizes that, in most cases, control

shares are worth more than minority shares. However, there is little consensus on

how to measure the difference. As with lack of marketability, lack of control is not a

black-and-white issue, but covers a spectrum:

100 percent control

Less than 100 percent interest

Less than supermajority where state statutes or articles of incorporation

require supermajority for certain actions

50/50 interest

Minority, but enough for blocking control (in states or under articles of

incorporation that require supermajority for certain actions)

Minority, but enough to elect one or more directors under cumulative voting

Minority, but participates in control block by placing shares in voting trust

Nonvoting stock (covered in following section)

Minority, with no ability to elect even one director

The value of control lies in the following (partial) list of actions that

shareholders with some degree of control can take, and that others cannot:

Appoint or change operational management.

Appoint or change members of the board of directors.

Determine management compensation and perquisites.

Set operational and strategic policy and change the course of the business.

Acquire, lease, or liquidate business assets, including plant, property, and

equipment.

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Select suppliers, vendors, and subcontractors with whom to do business

and award contracts.

Negotiate and consummate mergers and acquisitions.

Liquidate, dissolve, sell out, or recapitalize the company.

Sell or acquire treasury shares.

Register the company’s equity securities for an initial or secondary public

offering.

Register the company’s debt securities for an initial or secondary public

offering.

Declare and pay cash and/or stock dividends.

Change the articles of incorporation or bylaws.

Set one’s own compensation (and perquisites) and the compensation (and

perquisites) of related-party employees.

One question is whether the synergistic portion of the control premium is part

of fair market value. Under the hypothetical willing-buyer presumption, the

synergies with any particular buyer would not be included. But in certain instances

where there are enough synergistic buyers to create a market, a case can be made

for including the value of synergies in fair market value. An example would be an

industry undergoing consolidation through rollups, that is, acquisitions of many

companies in an industry in order to achieve a target size for some objective, such

as an initial public offering.

12.4 REVISION POINTS

1. Discount

2. Premium

3. Share holder

12.5 INTEXT QUESTIONS

1. Discuss why the business value worked out using basic approaches need to

be adjusted for discounts and premiums.

2. Briefly discuss Entity Level Discounts/ Premiums.

3. Briefly discuss Discounts on account of Lack of Marketability.

4. Briefly discuss Shareholder Level Discounts/ Premiums.

12.6 SUMMARY

In this chapter the discounts and premiums; have been discussed; to be

applied once the valuation is derived using basic approach(es). From the

indication(s) of value from the basic valuation approach test, entity-level discounts

(those that affect all the shareholders), if any, should be applied. The most

important of these, in most cases, is the discount for lack of marketability. The

discount for lack of marketability often is the biggest and most controversial issue

in a business valuation. There are two distinct categories of empirical databases

(and studies based on them): (1) Restricted stock studies (transactions in publicly

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traded stocks that are temporarily restricted from public funding), and (2) Pre-IPO

studies (trading in private companies’ stocks prior to an initial public offering). This

empirical evidence is based on transactions in minority interests, and is not

relevant to controlling interests. Controlling interests may be subject to some

marketability discount, but the analyst should explain the factors on which the

discounts are based, as discussed in this chapter. Shareholder-level discounts (or

premiums) should be applied after entity-level discounts. If more than one

valuation approach has been used, now that any appropriate adjustments have

been made, the analyst must decide the relative weight to be accorded to each

approach as discussed in following chapter.

12.7 TERMINAL EXERCISE

1. Discuss factors considering the analyzing the key person discount.

12.8 SUPPLEMENTARY MATERIALS

1. https\\www.business.gov.in

2. www.business valuation.inc.com

12.9 ASSIGNMENTS

1. In continuation of the chosen self learning assignment/ activity of previous

chapter, discuss and work of various premiums / discounts applicable for

chosen case

12.10 SUGGESTED READINGS/REFERENCE BOOKS

1. Aswath Damodaran, Investment Valuation – Tools and Techniques for

Determining the Value of any Asset, John Wiley Publication, 3ed Edition,

2012.

2. Krishna G. Palepu, Paul M. Healy, Business Analysis and Valuation using

Financial Statements – Text & Cases, South Western Publication, 4th

Edition, 2002.15.

3. Tom Copeland, Tim Koller, Valuation Workbook – Step by Step Exercise,

John Wiley & Sons Publication, 3ed Edition, 2000.

4. Study Material, Paper – 18, Business Valuation Management, the Institute of

Cost Accountants of India Publication.

(http://icmai.in/upload/Students/Syllabus-2008/StudyMaterialFinal/P-

18.pdf)

12.11 LEARNING ACTIVITIES

Group discussion during PCP days

1. In continuation of the chosen self learning assignment/ activity of previous

chapter, discuss and work of various premiums / discounts applicable for

chosen case

12.12 KEY WORDS

Discounts, Premiums, Entity-Level, Marketability, Shareholder-level

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CHAPTER - 13

WEIGHING OF BUSINESS VALUATION APPROACHES

13.1 INTRODUCTION

Normally, holding companies are valued by the asset approach and operating

companies are valued by the income or market approach. However, some

companies may have characteristics of both a holding company and an operating

company. In such cases, some weight may be given to the asset approach and some

to the income or market approach.

If a company’s assets can be divided between operating assets and

nonoperating assets, the company’s operating assets can be valued by the income

and/or market approach, and the nonoperating assets by the asset approach.

When more than one approach is to be accorded some weight, there is a

difference of opinion as to whether the weighting should be mathematical (assigning

a percentage to each approach to be accorded some weight) or subjective.

13.2 OBJECTIVES

The business values are derived using various approaching. Thus it gives

range of values and not the point. To arrive to the reasonable value different

approaches/ methods are assigned different weightage based on certain logics/

strategies for given case. And finally weighted average of values derived by different

methods is finally concluded a business value. This chapter discusses this aspect of

business valuation.

13.3 CONTENTS

13.3.1 Why Weighing Business Valuation Approaches?

13.3.2 Theory and Practice of Weighing

13.3.3 Mathematical Versus Subjective Weighting

13.3.4 Example of Weighting of Approaches

13.3.1 Why Weighing Business Valuation Approaches?

Normally, holding companies are valued by the asset approach and operating

companies are valued by the income or market approach. However, some

companies may have characteristics of both a holding company and an operating

company. In such cases, some weight may be given to the asset approach and some

to the income or market approach.

If a company’s assets can be divided between operating assets and

nonoperating assets, the company’s operating assets can be valued by the income

and/or market approach, and the nonoperating assets by the asset approach.

When more than one approach is to be accorded some weight, there is a

difference of opinion as to whether the weighting should be mathematical (assigning

a percentage to each approach to be accorded some weight) or subjective.

13.3.2 Theory and Practice of Weighing

In theory, the discounted cash flow method within the income approach is the

most correct method. There is virtually unanimous agreement that a company is

worth the future benefits it will produce for its owners (benefits preferably

measured by net cash flows or some other measure of earnings), discounted back to

a present value by a discount rate that reflects the risk of achieving the benefits in

the amounts and at the times expected. A typical statement of this theory is as

follows:

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“The value of an asset is the present value of its expected returns. Specifically,

you expect an asset to provide a stream of returns during the period of time you

own it. To convert this estimated stream of returns to a value for the security, you

must discount this stream at your required rate of return. This process of valuation

requires estimates of (1) the stream of expected returns, and (2) the required rate of

return on the investment.”

If good guideline companies can be found, the market approach provides the

most objective and unbiased indication of value. Some in the Service make the

point that the income approach can be subject to bias in the projections presented

and/or in the discount or capitalization rates chosen. Also, the income approach

can produce widely divergent results based on small variations in assumptions

such as the growth rate or discount rate.

Often, the quality of the data presented in support of various approaches

determines which approach or approaches should be utilized, or how much weight

should be accorded to each. Frequently, zero weight is accorded to an approach on

the basis that the underlying data is inadequate to support the conclusion reached.

13.3.3 Mathematical Versus Subjective Weighting

Because valuations cannot be made on the basis of a prescribed formula, there

is no means whereby the various applicable factors in a particular case can be

assigned mathematical weights in deriving the fair market value. For this reason,

no useful purpose is served by taking an average of several factors (for example,

book value, capitalized earnings and capitalized dividends) and basing the valuation

on the result. Such a process excludes active consideration of other pertinent

factors and the end result cannot be supported by a realistic application of the

significant facts in the case except by means of chance.

But when analysts use subjective weighting, the stakeholder/ user of

valuation report usually want to know how much weight was accorded to the

various approaches. So the analysts usually apply mathematical weights when

giving weight to two or more approaches, with a disclaimer that there is no

empirical basis for assigning mathematical weights, and that the weights are

presented only to help clarify the thought process of the analyst. A good report will

also go on to demonstrate that all relevant factors were considered.

13.3.4 Example of Weighting of Approaches

In a manufacturing company, the expert recommended 70 percent weight be

given to his value by the market approach and 30 percent weight to his value by the

income approach. In his market approach, he narrowed down a list of guideline

public companies to three that most closely resembled the subject company in such

characteristics as line of business and earnings growth. For his income approach,

he projected five years of cash flow available for distributions, estimated a terminal

value, and discounted the components to a present value.

13.4 REVISION POINTS

1. Weighing

2. Valuation approach

3. Mathematical weighing

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13.5 INTEXT QUESTIONS

1. Discuss why there is need to give weightage to different approaches to business valuation.

2. With reasoning discuss how you will weigh the basis there valuation approaches under given circumstances.

13.6 SUMMARY

For operating companies, most or all of the weight is usually accorded to

indications of value from either the income or the market approach. For holding

companies, most or all of the weight is normally accorded to value from the asset

approach. For operating companies that are operating asset intensive the weight

may be divided between the asset approach and the market approach. For

operating companies with significant nonoperating assets, the company might be

valued by the income or market approaches, plus the value of the nonoperating

assets, with some discount in case of a minority interest.

13.7 TERMINAL EXERCISE

1. Discuss the sum of the weighing approach in business valuation.

13.8 SUPPLEMENTARY MATERIALS

1. https\\www.business.gov.in

2. www.business valuation.inc.com

13.9 ASSIGNMENTS

In continuation of the chosen self learning assignment/ activity of previous

chapter, recommend how much weightage should be given to each approach of

business valuation with appropriate logics and reasons

13.10 SUGGESTED READINGS/REFERENCE BOOKS

1. Aswath Damodaran, Investment Valuation – Tools and Techniques for Determining the Value of any Asset, John Wiley Publication, 3ed Edition,

2012.

2. Krishna G. Palepu, Paul M. Healy, Business Analysis and Valuation using Financial Statements – Text & Cases, South Western Publication, 4th Edition, 2002.15.

3. Tom Copeland, Tim Koller, Valuation Workbook – Step by Step Exercise,

John Wiley & Sons Publication, 3ed Edition, 2000.

4. Study Material, Paper – 18, Business Valuation Management, the Institute of Cost Accountants of India Publication. (http://icmai.in/upload/Students/Syllabus-2008/StudyMaterialFinal/P-

18.pdf)

13.11 LEARNING ACTIVITIES

Group discussion during PCP days

In continuation of the chosen self learning assignment/ activity of previous

chapter, recommend how much weightage should be given to each approach of

business valuation with appropriate logics and reasons

13.12 KEYWORDS

Weighing the valuation approaches

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