Business Valuation

Introduction

Key Drivers of Valuation

Concepts of Value

Golden Rules of Valuation

Valuation Methods

Valuation of Shares

Goodwill / Brand Valuation

Contents

IntroductionLiberalization of economy, emphasis on core competence, and relaxation of tax laws led to spurt of mergers, takeover, acquisitions, de-mergers etc.

Aligning business activities in line with the prime objective of creating & maximizing shareholders’ wealth, has propelled large organizations into such strategic decisions.

In all these strategic decisions, one common thing that assumes very critical proposition is “Business Valuations”.

‘Value’ means economic value, an amount expressed in monetary terms, to be paid in exchange for an asset or right to receive future benefits from use of the asset.

Introduction

Business Valuation

• Total economic environment

• Potential use of the asset

• Timing of the value estimate

• Location of the asset

• Relative scarcity

• Availability of substitutes

• Extent of ownership involved

• Liquidity of the asset

• Physical condition of asset

Valuation dynamics

Value is not a static or homogenous concept

Value is different from price or cost.

Price is the amount Price is the amount spent to acquire an spent to acquire an asset, while Value is asset, while Value is what lies in the eyes of what lies in the eyes of the payerthe payer

Key Drivers of ValuationPurpose of Valuation• Buyer vs. Seller• Acquisition vs. Investment• Legal vs. Commercial

Industry and Sector• Economy – Boom vs. Gloom• Emerging vs. Dying Sector• Manufacturing vs. Service• Structured vs. Traditional

Macro factors• Economic scenario• Investment patterns in sector• Government role• Fin. Inst, Banks role

Micro factors• Nature of product / service• Business life cycles• Seasonal nature• Growing vs. Maturity

Regulations• SEBI Takeover Regulations• Banking mergers – RBI role• Stock Exchange guidelines• Companies Act

Concepts of Value Fair Market Value – the amount (arms’ length price) at which an

asset would exchange between a willing seller and a willing buyer

(having reasonable knowledge).

Investment Value – the value of future benefits of ownership of an

asset to a particular buyer. Similar to Opportunity Cost.

Book Value – it means the value of a business, as reflected in the

audited financial statements of an enterprise.

Intrinsic Value – it is the total value of business after considering all

hidden and latent facts. Also defined as the present value of future

earnings stream discounted at the current market rate of return.

Going Concern Value – the value under the assumption that the

business will never die. Value is based on future maintainable

income as a going concern, capitalized by a suitable rate of return.

Concepts of Value Replacement Value – replacement value is the cost of acquiring a

new asset of equal utility.

Goodwill / Brand Value – the value of intangible assets. Difference

between price paid for acquiring a business and the fair market

value of all assets acquired, net of liabilities.

Liquidation Value – it is the net amount that can be realized if a

business is terminated, its assets sold and liabilities satisfied.

Benchmark Value – based on comparative company valuation,

used for justifying valuation of companies via several adjustments.

Salvage Value – the amount realisable upon sale or other

disposition of an asset after it is no longer useful to the current

owner and is to be taken out of service. Different from scrap value,

where the asset is not useful for anyone for any purpose.

Golden Rules of ValuationValuation is an art, more than science

Valuation is more of subjective nature than objective

Valuation depends upon perceptions and skills of valuer

Valuation has a reference to time, even a single person can have different values at different times

Price is paid for the deal, Value is in the eyes of the payer

Valuation is an critical tool for strategic decision making

Valuation is an application of theory and practice

Business Valuation Methods

Historical Cost

Current Cost

Economic Valuation

Asset Valuation

Market Valuation

Business Valuation MethodsHistorical Cost Valuation – Also known as the Book Value

Method. All assets are taken at their respective historical

costs. Value of goodwill is ascertained and added to such

historical cost of assets.

Current Cost Valuation – Current cost of assets are taken

for valuation purposes, instead of historical costs.

• Tangible assets – current replacement price is taken

• Investment – valued at current market prices, unquoted

investments are taken at cost, unless MP determined

• Inventory – current market prices

• Debtors – net collection / realizable amount

• Intangibles – current acquisition prices (Patents, TM, CP)

Business Valuation MethodsEconomic Valuation (Income based) – Fundamental logic behind the concept is that values of business are determined by its profitability (present and future) and cash generation ability. There are three techniques:

Capitalization method – past profits (3-4 yrs) are capitalized at a proper rate of return, as applicable to the company and the industry. Adjustments are made for extraordinary items, abnormal losses, taxation, appropriate weights to profits etc.

Profit Earning Capacity Value – similar to capitalization method, except that future maintainable profits are considered for capitalization.

Discounted Cash Flow – value of business is the present value of all future cash flows. Better method, since it considers time value of money. WACC be used as the discount factor. Future cash flows calculation based on taxes, depreciation etc.

Business Valuation Methods

Asset based Valuation – this method is used in combination

with profitability and market value methods.

• While valuing assets under this approach, total assets are

divided into operating and non-operating assets.

• Non-operating assets are valued at realizable value, while

operating assets are valued at their book values.

Market Valuation – applicable for listed companies, where

share price is determined by market forces. Average price is

selected for valuation purposes

Comparative companies – certain parameters of comparative

companies are used for valuation. This method is more used

for negotiation, rather than valuation.

Valuation of SharesValuation of SharesComputation of the share value of a firm, using various techniques. It involves arriving at the proper share value, i.e. value which ‘ought to be’.

Considerations governing share valuation are intricate, varied and numerous. They are quantifiable as well as non-quantifiable, objective as well as subjective.

Valuer’s approach is influenced by purpose of valuation. E.g. a valuer may use liberal ways in compensation cases, while a strict view for taxation. (basic principles being same)

Valuation requires judicious assessment of the interests, advantages, expectations, hazards of parties involved

Valuation of Shares – Purpose Purchase of a block of shares, which may or may not give

the holder – a controlling stake in the company

Formulation of scheme of amalgamation, absorption,

merger and acquisition etc.

Acquisition of interest of dissenting shareholders under a

scheme of reconstruction

Compensating shareholders by the Govt. under scheme

of nationalization

Advancing a loan on the security of shares

Assessment under Wealth Tax Act

Conversion purposes (Deb., Pref. into equity shares)

Valuation of Shares In case of shares quoted on recognized stock exchanges,

these prices are normally taken as the basis for valuation.

However, stock exchange quotations are not acceptable –

o Stock exchange prices are driven by demand-supply cycles

o Prices are more sentiment based, rather than fact based e.g. Tata Motors price fell on acquisition of Jaguar, Rover

o Many factors other than company performance affect the prices such as inflation, crude oil rate, political turmoil etc.

o Reign of speculation, intelligence, guess-work, fear etc.

Two factors stand-out to be basically important for share

valuation viz. assets employed and earning capacity. For a

going concern, earning power plays a major role, while

assets are considered only to indicate safety margin.

Share Valuation Methods Net Assets Basis

# Net assets available to Equity share holders

Number of equity shares

# Tangible fixed assets (plant, bldg. etc.) and intangibles

(patents, copyrights etc) should be taken at their current

market costs. Separate valuation for goodwill is necessary.

# Investment at market prices / book value (availability basis)

# Stock of FG @ market price, but RM, WIP, stores may be

taken at cost. (using a conservative approach)

# Receivables be taken based on quality, with provisions.

# Fictitious assets, P&L debit balance, preliminary expenses

should be excluded.

Share Valuation Methods Net Assets Basis

# All short-term and long-term liabilities should be deducted

from total assets. (incl. accrued interest and expenses)

# Preference capital, including dividend arrears be deducted.

# If ex-dividend equity share value is reqd., proposed equity

dividend should also be deducted.

# Adequate provisions for taxation and liabilities not provided

in the books of accounts.

Share Valuation Methods Yield Basis

∂ Yield based valuation is earnings and rate of return centric.

∂ If a block of shares (controlling interest) is to be taken, rate

of earnings should be the basis.

∂ For a small block of shares, rate of dividend is the basis.

∂ Steps in valuation include determination of the future

maintainable profits and establishing desired rate of return.

Suitable adjustments be made in calculation of profits such

as abnormal items, taxation, depreciation, govt. policy etc.

∂ Capitalize the earnings by the rate of return to arrive at the

total value. Divide the total value with the number of shares

to get the value per share.

Valuation of Goodwill / Brand Goodwill is an intangible asset and contributes to

the profit earning capacity of a business.

Goodwill is the difference between the value of a business as a whole and the aggregate of the fair values of its separable net assets. (UK A/c Std.)

Peculiarities of goodwill –

No direct / predictable relation with any costs incurred

Distinct factors adding brand value cannot be valued

Value of goodwill fluctuates widely, over short periods

Assessment of brand / goodwill is highly subjective

Types of goodwill – ‘Dog’, ‘Cat’ and ‘Rat’

Goodwill / Brand Creationג Steady, growing profitability ג Minimal risk exposureג Superior managementג High quality productsג Exceptional sales sectionג Secret / patent processesג Effective advertisingג Outstanding credit ratingsג Cost savingsג Technology advantage

ג Strong capital baseג Better liquidity positionג Good public imageג Strategic locationג Favourable govt. policiesג Good labour relationsג Social commitmentsג Weak competitorsג Market dominanceג Economies of scale

Goodwill / Brand ValuationSimple Profit Method – In this method, goodwill is valued

on the basis of certain number of years purchase of average

profits of the past few years.

Average profits = Capital employed * normal rate of return

Goodwill = Average profits * no. of years purchase

Super Profit Method – Excess of future maintainable profit

over normally expected profit is known as super profits.

Under this method, goodwill is taken as the number of years

purchase of super profits expected to be maintained.

Super Profit = future profits – (capital employ * normal rate)

Goodwill = Super profits * no. of years maintained

Goodwill / Brand ValuationCapitalization Method – Future maintainable profits are

capitalized, by using a normal rate of return to arrive at the

normal capital employed. Goodwill is the excess of normal

capital employed over actual capital employed.

Normal Capital Employed = Future maintainable profit

Normal rate of return

Goodwill = Normal capital employ (-) Actual Capital employ