Firm Valuation Tehniques and Its Trends

7/29/2019 Firm Valuation Tehniques and Its Trends

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FIRM VALUATION TEHNIQUES AND ITS TRENDS

Valuation is like a Swiss Army knife...you will be

prepared for just about any contingency.

-- Martin H.Dubilier, Chairman of the Board, Calton & Dubilier, Inc

The above Statement by the Chairman of Calton and Dubilier Inc. clearly sums up the

importance attached to valuation by the company stalwarts. Valuation of a your business

helps one to be prepared for any contingency that one may face during the operations of

the company. Valuing the value of ones organization is like holding a weapon with

armour and being ready for any assault. The assault in this case may be an M&A

proposal, litigation against the company, and so on.

Getting ones company valued or the exercise of valuing a firm is not as simple as it

sounds. Business valuation is not just plugging numbers into formulas; it is both science

and art. It is not just looking just looking at the asset base of the firm and adjusting the

liabilities. Though this is at the heart of valuation, the actual process is quite an effort and

requires a lot of estimation and assumption.

Escalating competition has led to an increasing number of acquisitions and merger

activities, resulting in the requirement for specialist calculation of company valuations.

Also the various types of industries that are coming into being traditional techniques are

sometimes found wanting while valuing these sectors. Valuing a business, whether as a

potential acquirer or a share purchaser, requires competence in a wide range of analytical

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skills. Thus it becomes very necessary for any finance manager and financial person to

keep himself updated with the emerging trends in this area of finance.

Valuations can serve many purposesto establish a price, to help increase value, to

attract capital, to aid in estate planning, and to meet governmental requirements. With a

broad variety of business and legal situations triggering the need to know the value of a

businessstrategic partnerships, merger or acquisition of a business, estate planning,

eminent domain issues, marital disputes, employee stock ownership plans (ESOPs), and

joint venturesit is important to have a professional estimate the value of a business and

to have periodic valuation updates. From the perspective of a valuator, a business owner,

or an interested financial party, a valuation provides a useful baseline to establish a price

for a business or to help increase a company's value and attract capital.

Planning for estate, gift, and other taxes is demanding and complicated, and a

professional valuation is one of the most important tools to assist a specialist in these

areas. Because tragedy can strike without warning, it is important to estimate the value of

a business in advance so that a business owner's family can be prepared to deal with third

parties, such as partners, shareholders, and governmental authorities like the IRS.

Otherwise, family members may be left at a disadvantage without the same knowledge

and wisdom as the business owner. The war stories surrounding estate taxes abound;

some examples are presented later in this chapter.

In certain situations, the government steps in and mandates a business valuation. For

marital dissolutions, the establishment and management of employee stock ownership

plans (ESOPs), eminent domain issues, minority shareholder actions, election of S

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corporation status, corporate divorce, and estate taxes, governmental regulations are the

driving forces behind the standard of value.

Two other broad factors also create the need for valuations. First, as business owners try

to sell a business, there is no efficient market to help buyers and sellers connect; thus,

there is no analog for small companies to the role that major stock exchanges play for

public companies. Second, many business owners need an exit strategy to obtain value

from their companies when they desire to sell. Below are listed the reasons why

companies may be valued.

Estate, Inheritance and Gift Tax. Valuations of a closely-held business are

useful for estate planning, estate settlement, and

IRS reporting of estate transactions. Valuations are

also important to determine the amount of lifetime

gifts. Inaccurate valuations or valuations prepared

by parties who are not independent can cause the IRS to challenge and overturn

the estate plan, lead to lawsuits among heirs and expose the estate to under

valuation penalties.

Mergers, Acquisitions, and Spin-offs. One company may acquire or be

acquired by another. One or both of the companies may need to be valued to

determine a fair price or exchange ratio.

Value-based Planning. Management may use the current value of a business to

analyze the effect that various management decisions could have on the value to

determine which course of action to pursue.

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Employee Stock Ownership Plans. An annual valuation is required by IRS and

Department of Labor regulations for this type of employee benefit plan.

Litigation. Attorneys rely on an expert's valuation of a company in various

instances including divorce, compensatory damage cases, and insurance claims.

Minority Shareholder Interests. Minority shareholders may request a valuation

when they feel that a restructuring of the company is having a negative impact on

their interests.

Allocation of Acquisition Price. When a business is acquired, a valuation is

needed to determine the allocation of purchase price to assets acquired for

financial and tax reporting.

Charitable Contributions. The gift of stock of a closely-held business to a

charity may trigger the need for a valuation.

Liquidation or Reorganizations. Valuations can be necessary for tax reporting,

financial reporting, and distribution of assets.

Issuing Stock. When a company is obtaining additional funds by issuing stock, a

valuation may be necessary to determine the fair cash-stock transaction level.

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VALUATION PROCESS

Business valuation is part art and part science. The term judgment may be regarded as

art; the term systematic may also be related to science. There are many dimensions

of the science in business valuation that are listed as follows:

General accounting principles and the financial data of the business

Facts associated with the historical growth of the business

Extrapolation of financial data into future time periods

Calculation of various valuation ratios and statistical formulae

There are also many dimensions of the art in business valuation as follows:

Understanding the economically efficient life of productive assets

Understanding the economically relevant industry in which the business is valued

Understanding the appropriateness of one valuation method

Understanding the limitations of financial information from comparable

businesses

Understanding the economic environment

A business valuation is often dependent on valuators knowledge, both accounting

concepts and economic concepts. Accounting is a systematic way of documenting the

businesss financial activities, while economics is a systematic way of understanding the

market environment in which the businesss financial activities take place. Accounting

methods are relatively more static in nature than economic methods; there are more

systematic practices and principles that guide the application of accounting methods.

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There is rarely a situation where all aspects of a valuation are accounting related or all

aspects are economics related.

Analyzing the business environment

The process of valuing a company begins with an analysis of its environment; the study

of the firms environment is typically called a top-down process. The objective of the

analysis of the firms environment is to estimate the firms sales in future years. Three

questions concerned are as follows:

Are industry sales expected to rise or fall?

Is the companys market share expected to expand or shrink?

Are industry prices expected to increase or decrease?

The study of the companys environment begins with a study of the economy. Various

industries tend to perform differently in different stages of the economic cycle. For

instance, basic industries perform well when the economy gets out of a recession,

cosmetic goods sell well in economic downturns and interest-sensitive industries such as

banks and insurers do especially poorly when the economy enters a recession. Thus, to

the extent that economic activity can be predicted, an understanding of the future course

of the economy is useful information in analyzing industries and companies.

After analyzing the macroeconomic conditions, the industry in which the firm operates is

analyzed. The objective of the analysis of the industry is to obtain sales projections for

the company. Obviously, the industry analysis should incorporate the macroeconomic

conditions. Beside the macro-conditions, the current and potential competition in the

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industry, the relative advantages and disadvantages of the major players have to be

considered. Moreover, the relative industry that sells substitute products needs to be

considered. These factors could be used to determine the growth in the industrys sales,

changes in the companys market share and the growth in the companys sales.

Constructing a model of expected financial performance

After analyzing the corporate environment, the next step is to analyze the companys

operating and financial prospects. The marketing view of the company is converted into

the sales projections and the sales projections are translated into financial performance,

which are expressed in the form of pro-forma financial statement. I proceed by

converting the marketing view of the firm the sales projections into overall projections

of financial performance. The way is to use various financial ratios according to its

historical accounting statement. The projections of future financial performance should

not be confined to an analysis of past relations. Firm and industry change should be

incorporated into the projection of future financial performance.

Converting the projected financial performance into value

After using the pro-forma accounting statement, the projected cash flow has been

predicted. However, the firm does not cease to exist after the expected periods of cash

flow. Therefore, the firms ability to generate cash flows after the expected period has to

be taken into account. This is done by a terminal value as the last cash flow. Discounting

the FCFs at the WACC gives us the value of the firm as a whole-the value of the firms

assets. This value equals the sum of the values of all the securities that the firm has

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issued, such as debt, equity, preferred stock and convertible bonds. In financial

terminology this is usually called the value of the firm.

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VALUATION APPROACHES

There are a wide variety of models for evaluating a company. They are applied in the

same context. Here I have classified these valuation methods into discounted cash flow

(DCF) models and relative methods as follows:( see figure 3-1)

Figure 3-1 Valuation models

Discounted cash flow method

A valuation technique that s dealt with all corporate finance manuals, it is the most

popular technique for valuation of companies. The value of an enterprise s equals to the

discounted values of all the future free operating cash flows generated buy the enterprise.

The theory for any financial investment evaluation is the capital budgeting approach that

includes four concepts:

Free cash flow

The investor has put money into projects because he expects it to generate cash

throughout the lifetime of his investment. We define these as cash flow to the

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investors. In the following analysis, the cash flow is defined as free cash flow.

Free cash flow is a companys true operating cash flow. Free cash flow is

generally not affected by the companys financial structure. Free cash flow is

defined to ensure consistency between the cash flow and the discount rate used to

value the company.

Time value of money

One unit of currency is worth more today than it is tomorrow, since there is a cost

of capital. This refers to opportunity cost. The sooner they are received, the less

they are worth.

Cost of capital

o If the cash flow is not risk free, a risk premium will be concerned in the

investment. The expected return on an asset should be positively related to

its risk. The relationship between expected return on an individual security

and Beta of the security could be described as capital-asset-price model

(CAPM)

o R= Rf+[E(Rm)-Rf]*(beta)

Where

R represents expected return on a security

Rf represents risk free rate

E(Rm)-Rf represents the difference between expected return on market

and risk free rate

Beta represents the Beta of the security.

o The CAPM is used to estimate the cost of equity in this thesis.

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Weighted average cost of capital

o The average cost of capital is a weighting of its cost of equity and its cost

of debt

o WACC=Kb*(1-T)*(B/V)++Ks(S/V)

Where

Kb = the pretax market expected yield to maturity on debt =the

market-determined opportunity cost of equity capital

T = the tax rate

B =the value of debt

S= the value of equity

V=the value of assets

Advantages:

Since DCF valuation, done right, is based upon an assets fundamentals, it should

be less exposed to market moods and perceptions.

If good investors buy businesses, rather than stocks (the Warren Buffet adage),

discounted cash flow valuation is the right way to think about what you are

getting when you buy an asset.

DCF valuation forces you to think about the underlying characteristics of the firm,

and understand its business. If nothing else, it brings you face to face with the

assumptions you are making when you pay a given price for an asset.

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Disadvantages:

Since it is an attempt to estimate intrinsic value, it requires far more inputs and

information than other valuation approaches

These inputs and information are not only noisy (and difficult to estimate), but

can be manipulated by the savvy analyst to provide the conclusion he or she

wants.

In an intrinsic valuation model, there is no guarantee that anything will emerge as

under or over valued. Thus, it is possible in a DCF valuation model, to find every

stock in a market to be over valued. This can be a problem for

o Equity research analysts, whose job it is to follow sectors and make

recommendations on the most under and over valued stocks in that sector

o Equity portfolio managers, who have to be fully (or close to fully)

invested in equities

Relative approaches

Besides the DCF approach, there are five commonly used relative approaches that exist,

liquidation value, replacement cost, price-to-earnings ratio, market-to-book ratio, and

book value.

The liquidation-value approach sets the continuing value equal to an estimate of

the proceeds from the sales of the assets. Liquidation value is often far different

from the value of the company as a going concern. In a growing, profitable

industry, a companys liquidation value is probably far below the going-concern

value. In a dying industry, liquidation value may exceed going-concern value.

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The replacement-cost approach sets the continuing value equal to the expected

cost to replace the companys assets. This approach has a number of drawbacks.

The most important ones are the following:

o Only tangible assets are replaceable. The companys organizational

capital can be valued only on the basis of the cash flow the company

generates. The replacement cost of the companys tangible assets may

greatly understate the value of the company.

o Not all the companys assets will ever be replaced. Consider a machine

used only by this particular industry. The replacement cost of the asset

may be so high that it is not economic to replace it. Yet, as long as it

generates a positive cash flow, the asset is valuable to the ongoing

business of the company. Here, the replacement cost may exceed the value

of the business as an ongoing entity.

The price-to-earnings (P/E) ratio approach assumes that the company will be

worth some multiple of its future earnings in the continuing period. Of course,

this will be true; the difficulty arises in trying to estimate an appropriate P/E ratio.

Suppose the current industry average P/E ratio is chosen. However, prospects at the end

of the forecast period are likely to be very different from todays P/E ratio. Therefore, the

drawbacks of price-to-earning (P/E) ratio are as follows:

o It is too affected by transitory events

o It hardly reflects future trends and historical fluctuation.

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o It does not include enough financial information such as different

leverages used by firms in the same industry.

o It hardly reflects risk differences even when restricted to the same

industrys comparison.

The market-to-book ratio approach assumes that the company will be worth some

multiple of its book value, often the same as its current multiple or the multiples

of comparable companies. This approach is conceptually similar to the P/E

approach and therefore faces the same problems. In addition to the complexity of

deriving an appropriate multiple, the book value itself is distorted by inflation and

the arbitrariness of some accounting assumptions.

The book-value approach assumes that the continuing value equals the book value

of the company. Often, the implicit assumption of this approach is that the

company will earn a return on capital (measured in terms of book values) exactly

equal to its cost of capital. Therefore, the book value should represent the

discounted expected future cash flow. Unfortunately, book values are affected by

inflation and the choice of accounting rules. Therefore, they do not provide

reliable information for these assumptions.

Advantages:

Relative valuation is much more likely to reflect market perceptions and moods

than discounted cash flow valuation. This can be an advantage when it is

important that the price reflect these perceptions as is the case when

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o The objective is to sell a security at that price today (as in the case of an

IPO)

o Investing on momentum based strategies

With relative valuation, there will always be a significant proportion of securities

that are under valued and over valued.

Since portfolio managers are judged based upon how they perform on a relative

basis (to the market and other money managers), relative valuation is more

tailored to their needs

Relative valuation generally requires less information than discounted cash flow

valuation (especially when multiples are used as screens)

Disadvantages:

A portfolio that is composed of stocks, which are under valued on a relative basis,

may still be overvalued, even if the analysts judgments are right. It is just less

overvalued than other securities in the market.

Relative valuation is built on the assumption that markets are correct in the

aggregate, but make mistakes on individual securities. To the degree that markets

can be over or under valued in the aggregate, relative valuation will fail

Relative valuation may require less information in the way in which most analysts

and portfolio managers use it. However, this is because implicit assumptions are

made about other variables (that would have been required in a discounted cash

flow valuation). To the extent that these implicit assumptions are wrong the

relative valuation will also be wrong.

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Adjusted Price Value Method

Valuation by this method states that the value of a company is equal to the base value of

the operations plus the value of all the financial side effects.

The base value of the operating activities is determined by means of the value of the free

operating cash flows (identical to those used in DCF), discounted at the cost of equity, as

if the company was financed entirely by equity. This is therefore the (unlevered) cost of

equity based on the asset beta, which only reflects the risk of the operations.

Financial side effects, such as tax shields on interest charges, possible grants, and

financial guarantees, potential bankruptcy costs, specific management policies and issue

costs, are explicitly estimated. Estimating the associated CFs and discounting them at a

rate reflecting the risks related to the CFs obtain these values.

The advantages of the APV method are:

It provides clear insights into how the value of a company is calculated (operating

vs. financing), which is not the case with the DCF method.

In case of DCF, dynamic capital structures often lead to errors as an incorrect

WACC is used. But in case of APV, determining CFs for each year considering

the changes in the capital structure, this can be solved.

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Value of company = Base Value of operations + Value of

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Another advantage is that the value of the operations can be split up and the value

of the potential operational changes can be unequivocally estimated because the

corresponding CFs is discounted at the same cost of equity.

However a crucial aspect of APV method remains the accurate determination of the value

of the financial side effects. Also, like DCF, the method is not capable of taking account

of the value of opportunities, or the real options at the companys disposal.

Decision-Tree Analysis (DTA) and Real Options (RO)

The market values of many companies is much higher than computed by DCF or APV,

because these methods do not consider the value of the future opportunities/ real options

which the company has. This is mainly true in technological and innovative sectors, with

a higher level of uncertainty, a great deal of value is determined by the portfolio of future

options that these companies have at their disposal, and not as much by their current

activities.

By means of real options (RO) a value is therefore assigned to the options at the

managements disposal. The total value of a company is formulated in the so-called

extended DCF rule: the value according a static DCF or APV analysis increased with

the value of these options. These option values can be determined in a manner that is

similar to the valuation technique for financial options. As a general rule it has been

found that the binomial trees are more applicable in real option valuation than the Black-

Scholes model, as they allow the valuation of various options simultaneously and put less

restrictions on the distribution of the underlying value.

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Table below shows the corresponding parameters, which are important for valuation of

real options and financial options. Because of these parallels, real options can be valued

in the same way as financial options.

Table 3.1 Investment Opportunities/ Real Options

Investment Opportunities Options of a Share

PV of the FCF generated by the project Price of the underlying Share (S)

Investment required to carry out the project ordisinvestments amount Exercise price of the option (X)

For what period of times does the company have thisopportunity? Duration of the option (t)

Time Value of money (risk free rate of return) Risk free interest rate (rf)

Degree of risk of the project Volatility of the underlying Share

Lost CF due to not immediately committing to theproject Dividends Paid (d)

Source: Copeland and Antikarov, 2001

Table 3.2 Summary ofTypes of real options: the 7S framework

To invest/grow further(CALL)

Scale up Expand Project as market grows

Switch upExpand project to the following generation of theproduct/technology

Scope upExtend investment to other applications andindustries

To postpone/learn (CALL)Study/Start

Postpone investment until more information isreleased or capabilities are obtained.

Disinvest/ cut back(PUT)

Scale downStop or cut back project if new info is released thatreduces the expected CF

Switch downSwitch to more cost efficient and more flexible assetin new circumstances

Scope downReduce the scope of project if the potential in thatactivity is insufficient.

Source: Copeland and Antikarov, 1998a

Advantages:

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Option pricing models allow us to value assets that we otherwise would not be

able to value. For instance, equity in deeply troubled firms and the stock of a

small, bio-technology firm (with no revenues and profits) are difficult to value

using discounted cash flow approaches or with multiples. They can be valued

using option pricing.

Option pricing models provide us fresh insights into the drivers of value. In cases

where an asset is deriving it value from its option characteristics, for instance,

more risk or variability can increase value rather than decrease it.

Disadvantages:

When real options (which includes the natural resource options and the product

patents) are valued, many of the inputs for the option pricing model are difficult

to obtain. For instance, projects do not trade and thus getting a current value for a

project or a variance may be a daunting task.

The option pricing models derive their value from an underlying asset. Thus, to

do option pricing, you first need to value the assets. It is therefore an approach

that is an addendum to another valuation approach.

Finally, there is the danger of double counting assets. Thus, an analyst who uses a

higher growth rate in discounted cash flow valuation for a pharmaceutical firm

because it has valuable patents would be double counting the patents if he values

the patents as options and adds them on to his discounted cash flow value.

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INDUSTRY TRENDS IN VALUATION

BIOTECH INDUSTRY VALUATION

What is a biotechnology company really worth? Corporations, investors, and bankers

alike who may be putting their capital at risk in a biotechnology company often face this

question. Unfortunately, there is no definitive answer to the question; no standard

valuation methodology can be applied universally in order to determine value.

Additionally, each available approach involves assumptions compounded by additional

assumptions. More often than not, there is no method to isolate any specific scenario and

guarantee, or even state with a reasonable degree of certainty, that the specific scenario or

event will occur. For example, how can market share be predicted for a company when

neither the product nor the market exists? Faced with such uncertainty, valuation of a

biotech company appears to be a challenging endeavor.

Yet it is still imperative that a value can be estimated within a reasonable range for

practical purposes such as raising capital, negotiating strategic alliances and joint venture

agreements, investment decisions, and licensing strategies. Investors need to benchmark

the company against other companies, to evaluate whether the markets valuation for

biotech companies are efficient or not.

There are difficulties faced in valuing most technology companies. The fair value of the

company is typically driven by the value of the companys intellectual property. For

many high tech companies, the value of their tangible assets are minimal in comparison

to their intangible assets, to which their returns can primarily be attributed. This difficulty

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is magnified in biotech companies, where a companys ability to convert its intellectual

property into a revenue stream is subject to strict government regulations and a lengthy

approval process. Before proceeding with valuation, it is imperative that the unique

features of a biotech company are understood so that the valuation method or methods are

structured appropriately.

Unique Industry Factors

Companies in the biotech industry are characterized by many unique features which add

significant complexity to biotech valuation and which impact their results. It is essential

that those performing a biotech valuation assess the impact that these factors have on the

company being valued to ensure that the valuation model selected is appropriate, as well

as to determine the appropriate level of confidence that can be placed in the results

derived from the model used. This is especially true for biotech companies that may not

have any products on the market at the time of valuation. Once a product is marketed, the

revenues and costs and product potential can be estimated with comparative ease. But,

given the long time period between idea inception, regulatory approval and product

marketing as well as the small number of ideas that ultimately result in a marketable

product, this is rarely the valuation problem that will be presented. Significant uncertainty

exists about whether the company will ever market a product.

One of the first things which should be appraised in a valuation is the companys product

pipeline, which is (1) the number of products that a company is developing and (2) the

stage of development of those products. A company whose success or failure is entirely

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dependent on one product has a higher associated risk than a company that is developing

several products. For example, in the drug development and approval process, only one in

five thousand compounds that enter preclinical testing make it to human testing, and then

only one in five are approved. Of those products which are approved, few biotechnology

products which reach the market generate sufficient return to cover their cost. The stage

of development for a companys products is also critical. It will help the appraiser in

estimating both the length of time before a product can be marketed and the likelihood

that the product will even reach the market.

Another important issue to consider when valuing biotech companies is the burn rate.

This refers to the level and rate of expenditures required for research and development

(R&D) of the product. Comparing a companys burn rate to its cash on hand and funds

otherwise available is an important exercise when assessing risk. The Survival Index

measures the relationship between cash on hand and net burn rate. Small companies have

the smallest Survival Index, averaging enough cash on hand to cover only 13 months of

research and development. A company needs to have access to sufficient capital

resources in order to sustain the significant levels of R&D required before a product will

make it to market. Over 60 percent of therapeutic drugs currently on the market required

in excess of $100 million in development costs. A company might obtain these funds

through private investments, public offerings, loans, and alliances with larger companies

who are willing to invest in their products and ideas.

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Partnerships and strategic alliances have assumed an important role in the success of

many start-up biotech companies, and therefore positively affect value. Very few

companies have sufficient cash available to last more than five years. In fact, 33 percent

of biotech companies have less than one years cash requirements on hand and over 50

percent of biotech companies have less than 2 years cash on hand. Understandably, there

is a great impetus for startup biotech companies to find venture capital, often in the form

of a partner, to survive the development process. The biotech companies gain access to

enormous pools of capital through the partnership arrangement in order to maintain their

development efforts. The partners, often established pharmaceutical companies, are able

to benefit from the knowledge transfer by obtaining marketing and manufacturing rights

to products developed by their biotech partners. They might also share in the biotech

companys rights to the intellectual property itself.

While access to capital and improved chances for success are aspects of a partnership

arrangement, which increase value, another important aspect of these arrangements must

be considered. In a strategic relationship, how are the rights shared between the parties?

This sharing arrangement will impact the value of the biotech company, because different

rights have different associated values. For example, the marketing and manufacturing

rights mentioned above can be very valuable. If these have been given to a partner, the

value of the biotech company has been reduced. It is important to determine if the biotech

company has obtained comparable value in return through means such as invested capital

or licensing fees.

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Manufacturing, marketing and distribution capabilities impact value because they

determine whether and how quickly a product can generate desired levels of revenue

once it reaches the market. The existence of products is not sufficient to sustain value.

The company has to be able to sell the product in a quantity and at a price to recover their

investment and generate returns. This requires that they can manufacture the product in

sufficient quantities and at reasonable cost (or arrange for its manufacture), create

demand for the product, and then get the product into the hands of the public. This stage

of the process also requires a significant amount of capital, something that many startup

biotech companies do not have, especially after having just completed the lengthy

development and cash draining process. So then one must determine the existence and

availability of financing alternatives. This is where strategic alliances once more assume

importance.

Protection of intellectual property is also an important element of valuation. Valuation

requires some estimates on the future revenue generated by the product, and often these

revenue forecasts are worldwide. Yet protection of intellectual property rights is difficult

and expensive, especially on a global scale. Pirating, means that the product will not

reach the entire market, that there will be competing products which can steal both

market share and profits. Even in the United States, where there are strict patent laws and

available forums for protection, infringement of intellectual property rights occurs

frequently, as evidenced by the growing amount of related litigation. As protection of

intellectual property improves, the risk factor associated with revenue streams can be

lowered which leads to greater value.

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One feature of the biotech industry that makes valuation so complex is the product life

cycle. A product has two distinct life cycles, (1) the development life cycle and (2) the

product life cycle. The development life cycle is very long, on average ranging anywhere

from 16 to 20 years. During this cycle no revenue is generated. The product life cycle

begins once the product reaches the market. This is when a return on the investment

finally takes place. The anticipated length of the product life cycle (the revenue

generation phase) obviously affects value. This can be a fairly short time in contrast to

the long development life cycle, sometimes lasting only a few years despite the fact that

almost two decades of a government authorized monopoly is granted through patents.

This is because the market is continuously refreshed with new or improved products that

will compete with the subject product. If a market is perceived to be lucrative,

development efforts will be targeted at that market and another product will likely be

introduced and may assume market leadership.

The uncertainty of the biotechnology industry is compounded by the impact of changing

regulations and government policies. Changing regulations can affect the length of time

for a product to reach the market, and whether or not the product is granted approval.

Changes in health care policies can have a major impact on product pricing and market

size. As an extreme example, failure of insurance companies to reimburse expenses for

certain drugs could potentially eliminate an entire market.

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Dealing with Uncertainty

All of the unique features of the biotech industry discussed above have one factor in

common, they all affect risk. As with any valuation, there is a defined relationship

between risk and value. Greater risk associated with revenue and profit translates into less

value today. Numerous questions exist which are impossible to answer with certainty.

Will the product work? Will the product be approved? Will there be a market for the

product? How long will it take to get the product to market? Will the regulatory process

undergo change? How will the market change during a lengthy development and testing

process? Can the company obtain the resources to survive over this time? Will the

technology be valuable ten to twenty years in the future?

There are no definitive answers to these questions; only forecasts, estimates, projections

and pure guesses. Assumptions must be made based on experience, historical data,

research, marketing savvy and instinct. The reasonableness of these assumptions can be

improved by: researching the historical performance (i.e. success rates) of the developer,

the biotech company and the biotechs partner, if any; assessing milestones achieved to

date in development of the product and the products actual position in the development

life cycle; considering historical industry ranges or averages for such things as likelihood

of regulatory approval, length of time until regulatory approval, development costs, etc.;

performing research related to the potential market (i.e., determining the number of

individuals affected by the ailment/condition to be treated by the new product,

determining existing treatment methods, etc.); assessing the commitment of the investors

or partners to the project; and considering the specific characteristics of the company

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which impact these risks (i.e., whether the company has entered into a partnership or

alliance which secures access to capital). Once the unique features and risks faced by

biotech companies have been identified and assessed, they must be quantified. From

available information numerous estimates must be derived with respect to market size,

price sensitivity, competing alternative products and other factors. The challenge is this:

to be able to estimate earnings of a product, company and market for which no historical

information is available.

Valuation Methodologies

There are a variety of methods, which can be used for valuation. The method selected

should be suitable for the specific company. For biotech valuation, three main

approaches, which are generally as a norm in the industry, are:

Discounted cash flow analyses,

Monte Carlo models, and

Option pricing models.

There is a benefit to performing more than one type of valuation, as the results can be

compared against each other. If the results are divergent, the assumptions made in the

models may require reevaluation.

Discounted Cash Flow

Performing a discounted cash flow is a traditional approach to valuation, where estimated

future cash flows are multiplied by a discount factor in order to obtain a present value.

First, revenue and revenue growth projections must be formed for the company based on

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product expectations. Revenue forecasts involve projections of potential market share

which is dependent on availability of competing products, product pricing, insurance

reimbursement for the product and acceptance in the market place. Remember that often

no active market exists at the time of the valuation as no products may be offered at that

time. For biotech products, there might be quick market penetration followed by a

tapering off of the growth as the product meets price resistance and/or competitive

resistance. In the typical product life cycle, the product plateaus as the product matures in

the marketplace.

In a discounted cash flow analysis, time is very important factor. A reasonable estimate

must be made for the timing of revenues. For the biotech industry, this involves

estimating the time required to obtain product approval, to bring the product to market,

and to penetrate the market. A general rule in discounted cash flow is that projections

should not be further than ten years into the future, since time magnifies uncertainty. This

may not be feasible for valuing a biotech company, when it might be more than ten years

before the product can be marketed.

After projecting revenues, the next step is to estimate expenses in order to project

margins and incremental profits. Again, this is a complex process for biotech companies,

as margins are dependent on the assumptions as to the availability of product substitutes

more than ten years in the future. Margins are also dependent on the manufacturing,

marketing, and distribution arrangements, for which there is no historical information on

which to base an estimate.

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The next step in performing a discounted cash flow analysis is to determine an

appropriate discount rate which is driven by an evaluation of the company and product

risk. The discount rate for biotech companies may reach as much as 25 percent to 50

percent, depending on the circumstances. While this might appear high, it is appropriate

given the level of risk faced associated with biotech companies. The discount rate can be

adjusted, based on milestones events which have been achieved at the time of the

valuation. A discount of rate of 25 percent might be appropriate for a company with a

product in advanced clinical trials since there is less time to market, more information

available on the product, and thus lower risk. A discount rate at the high end of the range

(i.e., 50 percent) may be more appropriate when a companys product is only beginning

clinical trials since little information is available and the time to market is greater,

meaning higher levels of risk.

Monte Carlo Simulation

Discounted cash flow analyses can be limited, since any specific method can only

consider one set of assumptions at a time. With so many uncertainties associated with

biotech companies, a discounted cash flow approach might be too confining. A flexible

approach may be more suitable. Monte Carlo simulation, which is a tool for considering

all possible combinations of events, is a method for determining the probability of certain

outcomes and their related values.

In this simulation, potential payoffs are analyzed based on the statistical probability of

certain outcomes. Ranges of estimates are determined for the various factors that affect

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value, including; market size, capital expenditures, product pricing, manufacturing rights,

economic environment, time to market, existence of market, etc. After the significant

variables have been identified, the probability distributions for output variables must be

determined. A computer simulation is then used to predict results based on simultaneous

changes in the variables.

On a cautionary note, the results of the simulation must be critically evaluated for

reasonableness. The use of probability distributions and computer simulations causes this

approach to appear to be very scientific. Although there are some distinct benefits to

using this approach, common sense and experience must be used in evaluating the results

since the method still involves a great degree of subjectivity. The assumptions regarding

the probability and the significance of the variables are still subjective, and if the

assumptions are not reasonable the results are meaningless.

Option Pricing Models

As already seen the best method to be used is the option-pricing model. These models are

valuable in the biotech industry, which is faced with uncertainty (as discussed above,

where the size and profitability of future markets are unknown, sales will not commence

for several years, there is an uneven distribution of returns, and there is overwhelming

upside potential).

The most common option-pricing model is Black-Scholes, which can generate a value

from a continuum of possible outcomes, and can be modified to value a biotech company.

The exercise price is the capital investment required. Duration would be the time until the

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product can reach the market. The standard deviation of stock returns for typical

biotechnology stocks can be used as a measure of project volatility. Option pricing

models were scarcely used a decade ago; few were familiar with what they were or how

to apply them. But these models have increased in popularity as business schools have

incorporated them into their curriculum and emphasized the value of these methods to

their students who graduate and join corporations.

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HIGH GROWTH COMPANIES

Had you decided that Yahoo! could not possibly be worth $1billion in 1997, as the

market then said, you would have missed a three-year run that took it to more than 100

times that figure. But had decided to believe the market last spring and bought Yahoo!

then, you would now have lost 80% of the money.

- Is there life in e-commerce? (www.economist.com)

Companies in the high tech industry are continuously challenged to innovate (both

products and services) to sustain their competitiveness. To be the market leader in this

highly competitive industry, characterized by ever evolving technology benchmarks,

requires speed and flexibility. Herein Intangible assets like technological capability,

intellectual property, business processes, experience curve based learning efficiencies,

network of highly skilled partners, customer relationships provide the critical competitive

advantage and drive the profitability of the firm in the industry. However, these are not

reflected in the balance sheet of the companies.

Hi tech firms, in initial stages, need to incur huge costs in building up these critical

assets, which are expected to generate cash flows in subsequent periods. These costs are

not capitalized but are expensed in the period in which are incurred and this explains the

losses posted by a high tech company in its initial phases. A valuation model based on

either cash flows or earnings will fail to value the firm appropriately, unless cash flows

are estimated over a sufficiently long period as these investments (that drive the future

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profitability and hence the value of the company) reduce cash flows and earnings in the

short term.

The following exhibit shows that the market valuation (capitalization) of a high tech

company Amazon.com increased from US $ 1437.5 million in 1997 to US $ 25824.25

mn in 1999 even as it continued to have increasingly negative cash flows during 1997-99.

Exhibit 4.2.1:Amazon.com-Market Valuation: Do the Cash Flows Capture Real Value?

Source: Nasdaq and Compustat

Exhibit 1 shows how a valuation of a high tech company like amazon.com based on cash

flows in the short-term horizon would have failed to capture the value created.

Moreover, even the estimation of cash flows itself is a challenge as high tech companies

are characterized by high growth, high uncertainty and high losses in the transient phase.

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The following exhibit depicts the high variability in cash flows of amazon.com during

1995-2001.

Exhibit 4.2.2:Amazon.com- Variability of Cash Flows


High tech companies propelled by their competitive advantage are expected to enjoy

higher profit margins, characterized by speed & flexibility and driven by market

conditions are expected to experience higher grow rates vis--vis traditional companies,

however their returns are much more risky. Comparables like Price Earnings Ratio or

Revenue Multiples are difficult to employ due to the uniqueness in prospects of each

individual company.

Further, use of multiples becomes meaningless if the earnings are negative. In a high tech

company, characterized by negative earnings and high revenue growth, multiples cannot

be used for valuation. Moreover, the multiples estimated on the basis of past data are not

applicable in the fast changing environment.

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We now examine the different valuation approaches, their applicability to valuation of

high-tech companies, identify the issues associated and recognize the factors that drive

the value of high tech companies

COST APPROACH: ISSUES IN VALUATION OF HIGH TECH COMPANIES

The cost approach attempts to measure the replacement cost. This approach is based on

the logic that the fair market value can be no more than the cost of acquiring a substitute

with same features and functionalities. It values a company based on the estimation of

costs incurred / investment required to replace the future earning ability of the firm (and

its assets).

The cost approach is not appropriate to value high tech companies with valuable

intangible assets. It ignores the value of intangible assets and the opportunity costs of

earnings that would be lost without such intangible assets. Actually, the benefits of an

intangible asset like innovation may far exceed costs incurred in its acquisition e.g. huge

benefits accrued versus minimal costs incurred in invention of 3M Post-It Notes. The

approach equates value to the costs incurred and does not measure the value of future

benefits likely to accrue as a result of investments made.

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Exhibit 4.2.3: Amazon.com - Revenue Growth: Function of Tangible Assets or

Intangible Assets?


Exhibit 3 shows that intangible assets like loyal customer base created by increasing

SG&A expenses are important drivers of the revenue. The exhibit compares the

importance of fixed assets and intangible assets in driving the revenues in a high tech

company like Amazon.

MARKET APPROACH: ISSUES IN VALUATION OF HIGH TECH

COMPANIES

The market approach measures the present value of future benefits based on market

estimate / assessment. It involves identifying actively traded comparable companies

within the industry and using their multiples to estimate the companys fair market value.

It becomes difficult to use this approach for valuation of high tech companies, as their

uniqueness and asset specificity makes it difficult to find comparable companies and

appropriate multiples. Also the lack of active markets in the specific assets owned by

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high-tech companies make it difficult to use this method in valuation. For Telecom

Operators in Developing Markets

The following exhibit lists P/E, EV/Sales and EV/EBITDA Ratios of comparable IT

companies in India

Table 4.2.1:Multiples for comparable Indian IT Companies

Source: EMC Report on Asia Pacific Mobile Communications- June 2003

The huge variation in the multiples indicates the limitation of use of this approach in

valuation. Similarly comparing the multiples for telecom operators in developing

countries in the Exhibit 5 below, we see PE Ratio varies from 5.70 to 28.10 (almost five

times).

Exhibit 4.2.2: Multiples for Telecom Operators in Developing Markets

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Source: EMC Report on Asia Pacific Mobile Communications- June 2003

Further the multiples do not provide reasonable results in case of high tech companies

specially those in the initial stages when huge investments significantly reduce the cash

flows, earnings and net-income. Negative earnings may give meaningless results.

Moreover in rapidly changing environment, the multiples obtained on the basis of past

data are not applicable in the changed environment (the projected growth for a high tech

company is generally higher making comparisons even more inappropriate). However,

the market approach can be used to validate / cross check the valuation obtained by other

approaches. Industry ratios and multiples provide confidence in the assumptions made to

arrive at the valuation using other approaches as discussed below.

INCOME APPROACH: ISSUES IN VALUATION OF HIGH TECH COMPANIES

The income approach employs the discounted cash flow method of valuation. It measures

the present value of expected future cash flows at a reasonable present value discount

rate. The income approach may employ single-period or multiple-period method. The

single-period method employs capitalizing the recurring cash flow using the discount

rate. The issue is determination of an appropriate discount rate. The multiple-period

method estimates the value of a company as the sum of the estimated cash flows over a

finite period (transient state) and terminal / continuing value for the stable state at the end

of the horizon.

The income approach take into account the macroeconomic factors as well as the

company-specific factors. Despite its reliance on numerous estimations, the income

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approach is most appropriate in valuing high tech companies as it is based on estimation

of future cash flows and the ability of a firm to generate them.

The problem however, with applying the approach to valuation of high tech firms is, that

not only does it require lot of estimation and projection, but also that the estimated cash

flows of a high tech company are highly uncertain. This is illustrated in the following

Exhibit 6.

Exhibit 4.2.3: Cash Flows of Amazon.com

Source: Compustat

This combined with the market/environment uncertainty reduces confidence in the

valuation obtained using the DCF approach. Modified DCF approach is therefore most

appropriate to value the high tech companies. Some factors that need to be considered in

valuation of the high tech companies using DCF approach are

Taking an Appropriate Horizon for Explicit Forecasts

In valuation of high-tech companies projection of the duration of high

(extraordinary) growth transient period and when this high growth will be

replaced by long term normal growth is critical. It is vital to estimate and capture

the cash flows in the transient and stable state. It is important to forecast the profit

margins, turnover ratios, demand, size and share of the market and other relevant

drivers of companys profitability for the transient as well as the long-term steady

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state. Given high uncertainty in the environment and that associated with the

performance of the high tech company, it may not be possible to accurately

forecast the parameters yet it is important to envisage the possible scenarios and

outcomes viz. cash flows, earnings in different situations.

Consider an example of Indian Cellular Telecommunications Industry. A company in this

industry is faced with huge capital investments in infrastructure, technology, licenses,

customer acquisition, etc. It needs to incur huge costs in setting up efficient supplier and

distribution networks. It is likely to incur substantial expenses in customer acquisitions. A

typical company in this industry is faced with huge initial costs, losses in the initial

phase, high-expected growth rates (given currently low tele-density and huge potential)

and high uncertainty on account of technology, regulations and changing customer

preferences. The high operating profit margins are constrained by increasing competition.

To arrive at an appropriate valuation of such a company we need to anticipate the future

possible states and their associated probabilities. We need to project the drivers of growth

viz. expected tele-density, expected ARPU (Average Revenue Per User) expected market

share, profit margins, etc.

Factoring for Uncertainty: Use of Probability Weighted Scenarios

Different possibilities need to be identified and probabilities need to be assigned

to such possibilities. Expected cash flows can then be achieved by taking a

weighted sum of possible cash flows under different possible situations.

Continuing with our example of an Indian Cellular Company, we need to

envisage different situations with respective market share, revenues, and margins

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and determine likelihood (probability) associated with each situation. We also

need to undertake sensitivity analysis of projected cash flows to the changes in

probabilities. This shall give us an idea of possible variations in the valuation

undertaken.

Assessment of Sustainability of Growth / Profitability

(Determination of Level of Confidence in the Valuation)

Given the high risk associated with and high variance expected in the cash flows

of a high tech companies, it is vital to analyze the sustainability of estimated

growth and profitability. This detailed analysis is what will differentiate a good

investment from a bad one. This is an important factor in the valuation of high

tech companies as given the uncertainty of environment and uncertainty inherent

in the technology and operations of a high tech company, a large number of such

companies are likely to become unviable and only a few shall be able to stand out

winners.

Picking up the would-be winners is a vital factor. Consider the example of a number of

high tech start-ups in Indian Telecom Sector a shake up in the industry is likely and a

large of players are likely to exit. We need to identify the streams of revenue and

profitability of the company and the capability of the company to protect those streams.

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OTHER IMPORTANT ISSUES

Identification and Estimation of Factors that Really Drive Value

To arrive at right projections, it is important to identify what actually drives the

creation of value. For example for Amazon.com some of the factors that drive its

value are

o Extent of its customer base.

o The average revenue and contribution per customer.

o Customer Acquisition and retention rate.

o Other sources of revenue viz. advertisements, etc.

Is High Return on Capital Sustainable? What Factors Differentiate a High

Tech Company from Traditional Companies and are They Sustainable?

High tech companies tend to earn a high return on investment in the initial stages.

It is however important to study the factors that differentiate them from traditional

companies. Let us continue with the Amazon example- what differentiates

Amazon from a brick and mortar retailer like Wal-Mart speed and flexibility;

low inventory as a percentage of sales; ability to turnover the inventory fast. But

is it sustainable over the long term? We see that as Amazon expands building

warehouses around the world and staffing them with increasing workforce, it is

continually loosing its differentiation. We need to factor in the business

opportunity, competitive landscape, differentiating competitive advantage,

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customer base, aspirations and capability of the management team, availability of

capital / funding over the short and long term in our projections.

Investment Risk Associated with High Tech Companies

A high tech start-up company is characterized by high-expected growth in the

future. The long gestation (lock-in) period along with associated uncertainty

limits the number of investors willing to invest in such companies. The stock may

not be publicly traded and readily marketable. Reduced marketability creates

additional investment risk and needs to be compensated by increase in expected

return.

Valuation of Intangible Assets Like Intellectual Property

Intangible Assets like intellectual property, technological capability, business

processes, network of highly skilled partners, customer relationships, unique

value proposition, competitive advantage, customer base, are critical assets and

likely to generate economic benefits yet these are not reflected as assets in the

balance sheet of the companies.

High Uncertainty and Flexibility (Options) Introduce an Asymmetry in the

Probability Distribution of the Value of a High Tech Firm

The Option Value of Capturing Future Growth Opportunities

A high tech company faced with high uncertainty invests in certain projects viz.

R&D, if the situation turns out to be favorable, firm can benefit by exercising the

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option to accelerate the pace of investment step. This option value associated with

uncertainty adds to the valuation of the company.

Exhibit 4.3.4: Option Value of Growth Opportunities

Source: Real Option Valuation in High Tech Firm- By Hu Pengfei & Hua Yimin

This is similar to a call option to acquire an additional part (x%) of the base-scale project.

The total value with opportunity option will be V + max (xV - IE, 0).

The Option to Abandon a Project

Option to abandon a project for salvage value when its cash flows do not measure

up to expectations. The option to abandon can be viewed as an American put

option as below:

Exhibit 4.3.5: Option Value of Abandoning the Project

Source: Real Option Valuation in High Tech Firm- By Hu Pengfei & Hua Yimin

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The value with option increases to V+ max (A V, 0) i.e. max (V, A).

These options introduce an asymmetry in the expected value of a high tech firm as shown

in exhibit below:

Exhibit 4.3.6:Asymmetry in Probability Distribution of Firm Value

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BUSINESS INFORMATION SERVICE

Valuing a business information service is a tricky, complex and difficult process. There is

no panacea or easy option. When a business information service manager is asked to

prepare a valuation of their service and department, in any context and in any type of

organization, they will realize only too soon how hard it is going to be. Even if they are

well organized, have rigorously collected all the necessary metrics and have researched

the appropriate and copious professional literature on the subject, they will soon be

overwhelmed at the variety of methods and practices that can be used. Over the past five

years, the writer has compiled a huge bibliography, currently running to about 40 pages,

on library and information services literature. None give a clear idea for putting a value

on the whole department and tend to describe one or two value indicators that might be

used. Many articles seem to pose more questions about the valuation process than they

answer, particularly, if one or a group of value indicators is to be used, the question of

which might be the most appropriate for their circumstances. There are also plenty of

reviews of value indicators, most of which do not really suggest how these might be used

in practice to value a department.

Perspective

Perhaps the most important aspect of valuing any business information service is to

develop what is known as a business value philosophy. It will be argued of course, that

knowledge of business valuation is not necessary to successfully manage a business

information service or be a competent librarian or information specialist. But those

having a basic understanding of commercial value, and business valuation in particular,

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will have a tremendous advantage. This means setting up your management activities to

use as many aspects of business valuation as possible and adopting Value Based

Management (VBM) principles. These advocate the attitude of acting on all

opportunities in producing any product or service to increase value for the customers or

clients, whether they be internal or external, or in a commercial profit making business or

in a non-profit organization.

Business valuations are usually done for a specific purpose and the most usual reason is

for a value at the time of takeover, merger or divestment of a complete company. They

are also only valid at the time they are done and have to be repeated, sometimes many

times over the period of an acquisition or sale, as circumstances change. Similarly, these

points need to be appreciated by the business information service manager; when

preparing their model they must realize that any valuation is not static or a one-off

exercise

Valuations are not exclusively done of a whole company though. There are many

instances in business where valuation is required for part of a company. The most

common is for investment purposes, by a private equity limited or general partnership,

which wants to assess a stake in a private company, but certainly doesnt want to make a

full takeover. So the precedent is there is business for valuing small parts of a company,

and this can be used for valuing individual departments such as the business information

service.

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The position of the business information service in the organization

In most commercial organizations, the business information service is regarded as a cost

or overhead department. It is very rare to find a service that is a fully profit making

concern. It is often the case though, that there may be some income flow from a special

service or product that has been developed by the business information service and this

would be one of the major value generators or premia that would be used in the valuation

model.

So, the usual best case valuation for any business information service is to show their

management that they are effectively at zero cost to the organization. They can do this by

using a valuation that puts a notional monetary value on all of their unique (to their

organization) services that can be discounted against the actual costs of running the

business information service.

The business information service valuation mode

There will always be costs involved in acquiring information in any company or

organization, and as most have no dedicated business information service this is often

overlooked in that costs are dissipated through a series of user departments. Senior

managers often dispute this, but it is really not difficult for the experienced business

information service manager to point out these hidden costs, especially by reference to

outsourcing services, which are now more numerous and outgoing about their charges. A

good example is the new British Library Research Service being charged at 84 per hour,

plus online search costs and document retrieval and copying costs if used.

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An outsourcing cost should always be followed up and calculated if a business

information service is to be closed, in addition to an estimate of the management time

required to manage outsourced contracts. These should be estimated as the charges for an

external accountant, who would be the only suitable external choice. Occasionally, the

decision to close the business information service entirely may be influenced by this

valuation alone.

Business information service valuation exercises are often required at the time when new,

senior management are brought in from companies that have no formal services of their

own and so have no experience of their effectiveness. The business information service

manager should be prepared with these basic facts and arguments, if there is a significant

management change on the horizon.

Accepting that the usual position of any active and viable business information service is

as a cost to the organization, there will be a set of figures that represents the total cost of

the service. These costs will be presented in different ways in different companies. The

business information service manager ideally is able to have access and control over a

full scale budgeted expenditure, with regular updates showing actual versus planned

expenditure for the whole department. Unfortunately, many business information service

units do not get this clear financial picture of their unit. Fixed costs, such as services and

utilities, in particular are often not given. Full staff costs are also commonly omitted. But,

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to do a complete valuation, it is important that all this data is available and should be

specifically requested if it is not usually distributed for the valuation exercise

To calculate the business information service valuation for an ongoing business

information service there are two main elements, a base cost, which is carefully justified,

based on the existing total cost of the business information service and then a series of

premia and discounts, which are estimated as percentages of the adjusted base cost.

Premia are subtracted from the base cost and make the cost of the business information

service less to the company. Costs are added back to the base cost if they are discounts,

which would increase the base cost of the business information service to the company.

The premia will reflect the unique services the business information service provides to

users (customers) in the organization. It is actually these concepts that are described as

premia in this paper that are most often described in the general library and information

services literature concerned with valuation and justification of services. Concepts such

as impact values or contribution to decision making are good examples.

The idea for this model is based on several company and business valuation methods,

which are often used to value both whole companies and parts of businesses. The

business valuation method that the idea perhaps derives from most is the capitalized

earnings valuation. This uses a base valuation of a (price to earnings) ratio that can be

compared to a similar company that is listed on a stock exchange. Some attempts to do

this type of business information service valuation have been tried by using the concept

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of Return on Investment (ROI) calculations, but they are all rather disappointing in that

they have tended to concentrate on one or two services to measure and not made any

attempt to value the whole department. ROI is a very specific measurement in assessing

listed companies and should be used with caution in the business information service

context.

The model has been split into two stages:

1. Calculating the base cost of the business information service.

2. Adjusting the cost of the business information service by deducting premia and

adding back discounts.

Stage 1 of the model: The business information service base cost

The first calculation for the model is to establish the actual base cost of the business

information service. This can be very difficult, especially if the service manager is unable

to access accurate and complete details of both indirect and direct costs of the service, or

to gain some insight into the methods and practices of their calculation internally.

Sometimes although this is unusual these days the business information service is

simply regarded as one overhead cost, and no breakdown is made available to the service

manager. If this is the case, then this non-analyzed figure will have to be used as the base

cost for the valuation model. It must be made clear, though, in preparing the model, that

there has been no scope to decrease the base cost of the business information service

initially, which is obviously the most desirable scenario in trying to demonstrate the

concept of the service as representing a zero cost to the organization.

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Types of costs

Indirect costs Indirect costs that can be considered will include all the elements of

funding the service that are not directly chosen and controlled by the business

information service. Most commonly these include space costs, utilities, security

and the overhead costs charged by other headquarters service departments,

particularly human resources and computing/ automation. These can all be

legitimately deducted from the total base cost on the premise that if the business

information service were to close, then other departments and employees of the

organization would use the space and incur all the other indirect costs. The only

exception to this would be the case of a significant downsizing of the whole

company, involving a substantial closure and disposal of buildings. This is often

the case in merger of companies, where significant overlap in operations occurs.

If the business information service valuation is being done in these circumstances,

there are few deductions that can be made to base cost.

Direct costs Direct costs are all those that the business information service has

complete responsibility for. These include all the staff costs and all the costs of

the published information and information services acquired. However,

information services are often purchased for the whole organization and charged

out to users in various ways. The business information service might also control

other large areas of expenditure for the whole organization, although these are

hardly used by the business information service itself. Some of the most usual are

the costs of maintaining knowledge management systems, which might include

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conventional records management and the dedicated databases and systems that

manage internal information. So, many direct costs can be charged out internally

to users and are therefore legitimately deducted from the business information

service base cost. If this is not already an internal requirement, the business

information service manager may have to do much work in apportioning costs

accurately, appropriately and fairly.

Staff costs Staff costs the headcount are usually the highest costs of any

overhead department. The obvious purpose of many business information service

valuations is to reduce the headcount and so immediately decrease the base cost

of the department and so save money. This is the easiest way to make an

immediate impact through an external (to the business information service)

valuation, and many business information service departments have suffered in

this way. Hopefully, the lessons of the past have shown that this can be far too

simplistic a view for any overhead department, not least for the business

information service. The valuation proposed here presents a much more balanced

picture of the whole service rather than just looking at staff costs.

Having said this, there are some deductions to base cost that might be made for staff

costs, without losing headcount, Candidates might be staff members who work for a large

part of their time exclusively for one user department or group. An appropriate

percentage of time must be apportioned fairly, if the staff members time is not 100 per

cent dedicated to specific user departments. Valuations of this kind can be justified by

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keeping accurate statistics about work flow, and it is probably not a good idea to deduct

the staff costs of anyone who spends less than one third of their total time working for

any single user group. These approximations and rules are known in valuations as rules

of thumb. If they are used they should be indicated and explained in the valuation model.

Temporary staff, contract staff, consultancy and student placements are also deductible

from base cost.

Some elements of staff benefits may also be deducted, depending on the range offered by

the company and how they are costed. The business information service manager needs

to be aware of the staff loading factor that is used in their company. This is the

percentage used above the base salary cost to indicate the average amount that should be

added to any recruitment of permanent staff for additional benefits and national

insurance. The average loading is currently around 30 per cent of base salary, but in some

companies, giving a range of high quality and expensive benefits can be much higher.

When every element of the base cost has been examined, and all that can be deducted

from the total cost of the business information service has been removed, then the base

cost of the business information service has been found to use in the model. The

calculation of this base cost must be fully documented and described as the first part of

the model. It can then be used as the starting point for the really interesting part of the

valuation: the application of premia, which highlight the business information

departments unique services to the company.

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Stage 2 of the model: Premia and discounts to business information services

As explained above, premia and discounts are simply adjustments made to a base value to

reach a final and more elegant numerical valuation of all or part of a company. The real

benefit of doing a business information service valuation is that it is usually made to

facilitate the valuation of the intangible assets of a company, such as brands, or to

estimate the lack of marketability of the shares of a private company, which cannot be

easily sold on a stock exchange.

So, in applying premia and discounts in a business information service valuation, the

service manager is using a well established business technique to express a value of the

(sometimes very intangible) services the department offers. The way that these premia

and discounts are applied is as calculations of percentages of the adjusted base value of

the business information service, which has been determined as discussed above as Stage

1 of the valuation model.

It is the expertise of the business information service manager that will determine and

justify these percentages as representing their various services in the valuation model.

This is the chance to highlight the unique and expert services provided by the business

information service, and give them a numerical value that might bring them the attention

they deserve amongst senior management, who may never directly use the service.

In preparing the valuation model, though, it is important not just to concentrate on the

premia the wonderful services the business information service is providing to the

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company. It is necessary to balance the valuation with discounts, which will need to be

honestly applied, showing the more negative aspects of the servic

Documents

Firm Valuation Tehniques and Its Trends