GAURAV Valuation Content Edited Revised

7/30/2019 GAURAV Valuation Content Edited Revised

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ABOUT US

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DECYPHERING THE VALUATION CODE

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INTRODUCTION

Valuation is the process of determining the economic value of a business or company.

The first step while attempting any valuation exercise is to collect relevant and optimal information required for

valuing Share or Business of a company. Such information is obtained from one or more of the following

sources:

Management & Promoter Group Future prospects and growth potential Competitive Environment Industry Peer Group Regulatory Environment Analysis of financial statementsHistorical and Future Projections Variance analysis The Minority discounts and control premium Margin analysis Market Surveys, Other Publicly available data Stock Market quotations

1. What is valuation?Valuation is the process of arriving at the current monetary value of an asset.

The valuation of any company rests on a few key drivers, which will vary from company to company. Valuation

of a company reflects the performance of the company both its past performance as well as expectations of its

future performance. Based on the facts and assumptions of these two broad time frames, one attempts tounderstand what the company is currently worth.

Do you know what a share in Reliance or Infosys is really worth? What about the office premise that you own?

Should you bother? Knowing the value of an asset may not be a prerequisite for successful investing, but it does

help you make more informed judgements.


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2. How is a business valuation done?There are dozens of valuation models, but only two valuation approaches: intrinsic and relative.

The intrinsic value of an asset is determined by the cash flows that the asset is expected to generate over its life,

keeping in mind the certainty of such cash flows. Assets with high and predictable cash flows should be worth

more than assets with low and volatile cash flows.

In relative valuation, assets are valued by looking at how similar assets are priced by the market and performinga comparative analysis. When you determine what to pay for a property, you do so by comparing the prices of

similar properties in the market.

3. Is Value same as Price of a Business?Warren Buffet describes Price is what you pay & Value is what you get.

Value of a business is not the selling price of the business. Let us decode this further:

A sound investment is one where an investor does not pay more for an asset than it is worth. Others may arguethat value is in the eyes of the beholder, and that any price can be justified if there are other investors willing to

pay that price.

Remember the Facebook IPO?

Did you pay a price too high for the value that you received?

4. If Value is not the same as Price, then how does a transaction finalize?Value of a business can be arrived at by using objective analysis, but the transaction is finalized at the

negotiated price at which the Seller is willing to sell and the Buyer is willing to buy.


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METHODS OF VALUATION

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I. Asset Based MethodThe asset approach to business valuation is based on the principle of substitution: no rational investor will pay

more for the business assets than the cost of procuring assets of similar economic utility. The value of asset-based analysis of a business is equal to the sum of its parts.

The value of a companys intangible assets, such as goodwill, is generally impossible to determine apart from

the companys overall enterprise value. For this reason, the asset -based approach is not the most probative

method of determining the value of going business concerns. In these cases, the asset-based approach yields a

result that is probably lesser than the fair market value of the business. In considering an asset-based approach,

the valuation professional must consider whether the shareholder whose interest is being valued would have any

authority to access the value of the assets directly. Shareholders own shares in a corporation, but not its assets,

which are owned by the corporation. A controlling shareholder may have the authority to direct the corporationto sell all or part of the assets it owns and to distribute the proceeds to the shareholder(s). The non-controlling

shareholder, however, lacks this authority and cannot access the value of the assets.
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As a result, the value of a corporation's assets is not the true indicator of value to a shareholder who cannot avail

himself of that value. The asset based approach is the entry barrier value and should preferably to be used in

businesses having mature or declining growth cycle and is more suitable for capital intensive industry.

1. Net Asset Value/Book Value Methodi. It is a type of business valuation that focuses on a company's net asset value, or the fair-marketvalue of its total assets minus its total liabilities.

Valuation of net assets is calculated with reference to the historical cost of the assets ownedby the company. Such value usually represents the minimum value or a support value of a

going concern. It is usual to ignore market value of the operating assets for the simple reason

that under the going concern valuation, it is not the intention to sell the assets on a piece meal

basis.

While the historical cost is adopted in respect of the assets that are to continue as a part of thegoing concern, it is necessary to adjust the market value of non-operating assets like unused

land which are capable of being easily disposed of without affecting the operations of the

company.

The value as per Net Assets Method is arrived at as follows:

Net Assets value represents equity value which is arrived at after reducing all external liabilities and preference

shareholders claims, if any, from the aggregate value of all assets, as valued and stated in the Balance Sheet as

on valuation date.

Net Assets Value = Total Assets (excluding Miscellaneous Expenditure & Debit balance of Profit & Lossaccount) Total Liabilities

Or

Net Assets Value = Share Capital + Reserves (excluding revaluation reserves) MiscellaneousExpenditure Debit Balance of Profit & Loss Account

ii. Situations Where Net Assets Method May Be AdoptedNet Assets Method may be adopted in the following cases:

In case of start-up companies (which are capital intensive in nature), where the commercialproduction has not yet started.

In case of Investment Companies as Earnings Value based on its income in the form of dividendand/or interest may not reflect its true value.

In case of companies, which do not have a sustainable track record of profits and has no prospectsof earning profits in future.

In case of manufacturing companies, where fixed assets has greater relevance for earningrevenues. It would also be appropriate to use Net Assets Method for valuation in case of

companies operating in the industry, which is capital intensive and is relevant to revenues in anindustry, where norms are related to the capital cost per unit.

In case of companies, where there is an intention to liquidate it and to realise the assets anddistribute the net proceeds.

iii. Adjustments to NAV - A measure of a company's valuation after liabilities, including off-balancesheet liabilities, and assets are adjusted to reflect true fair market value.

The Net Asset Value (NAV) as arrived at by using the above-mentioned formula may be adjusted dependingupon circumstances of a particular case. The list given below showcases some of the adjustments commonly

made:


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Contingent LiabilitiesThe amount of Contingent Liabilities as disclosed in the financial statements of the entity needs to be adjusted

from the value of net assets. The managements perception of s uch liability materialising should be considered

and a detailed assessment for the same should be carried out and if necessary, an expert opinion regarding

sustainability of claims or contingent liabilities should be called for.Some examples of Contingent liabilities are:

1. Income tax demands

2. Excise demands

3. Sales tax/ Entry Tax demands

4. Entertainment tax

5. DPCO claim for pharmaceutical companies

6. Claims from customers

7. Matters referred to Arbitrations

8. Labour related issues

InvestmentsInvestments, whether trade or non-trade should be considered at their Market value while arriving at the

Adjusted Net Assets value as they can be sold in the market on a piece meal basis without affecting the

operations of the company. For this, notional adjustment should be made for any appreciation/ depreciation in

the value of investments on a net of tax basis.

Contingent AssetsIf the company has made escalation claims, insurance claims or other similar claims, then the possibility of their

recovery should be carefully made on a fair basis, particularly having regard to the time frame in which they are

likely to be recovered. The likely cost to be incurred for realizing the amount needs to be adjusted.

Qualifications & Notes to AccountsQualifications in the Auditors Report and Notes to Accounts should also be given due consideration. If it calls

for any adjustment, the same should be carried out while arriving at the Net Assets Value. Example - diminution

in the value of long term investments not provided for, provision for gratuity and leave encashment not made,

provision for doubtful debts not made, etc.

Surplus AssetsThe market value of surplus assets such as land and building not used for the business of the company should beconsidered. The appreciation or depreciation in the value of surplus assets adjusted for the tax liability or the tax

shield on such appreciation or depreciation would be added/deducted from the Net Assets Value.

This is more of a notional adjustment. Market value of such assets could be based on the report of a technical

valuer or on the estimates of the Management. Care should be taken if the title of the assets is not clear or the

possession of the property under consideration is not with the owner.

ESOPS, Warrants and Convertible instrumentsWhere the Company has issued warrants/ ESOPS or any other convertible instruments which are likely to be

exercised, appropriate adjustment needs to be made for the amount receivable on the exercise of such options

and resultant increase in share capital base.

2. Liquidation Value Method


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i. This approach is similar to the book valuation method, except that the value of assets onliquidation is used instead of the book or market value of the assets.

ii. The liquidation value of a business is the price that can be obtained for a business that is,or will soon be, ceasing operations. Where the business of the company is being

liquidated, its assets have to be valued as if they were individually sold and not on a going

concern basis. Because there is no longer a customer base, there is no value ingoodwill and the value of assets is lower.

iii. Using this approach, the liabilities of the business are deducted from the liquidation valueof the assets to determine the liquidation value of the business. You should also consider

liabilities which will arise on closure such as retrenchment compensation, termination of

critical contracts, etc. Regard should also be made to the tax consequences of liquidation.

Any distribution to the shareholders of the company on its liquidation, to the extent of

accumulated profits of the company is regarded as deemed dividend. DividendDistribution tax will have to be captured for such valuation.

3. Replacement Value Methodi. Replacement value is different from Book Value/Liquidation Value as it uses the replacement value ofassets, which is usually higher than the book valuation. The term replacement cost refers to the amount

that a company would have to pay, at the present time, to replace any one of its existing assets.

ii. Replacement value includes not only the cost of acquiring or replicating the assets, but also all therelevant costs associated with replacement. Liabilities are deducted from the replacement value of the

assets to determine the net replacement value of the business.

iii. Asset Based Method may not be relevant in case of - Companies operating in an industry where human knowledge and creativity are more relevant

as compared to physical assets in value creation.

In the case of valuation for a going concern, since the replacement methodology assumes thevalue of business as if a new business is being set up.

II. INCOME BASED METHOD

1. PROFIT EARNING CAPITALISATION VALUE METHOD (PECV)i. Capitalization of Profit Earnings Method determines the business value using a single measure of

the expected business economic benefit as the numerator. This is divided by the capitalization

rate that represents the risk associated with receiving this benefit in the future. Capitalization refers

to the return on investment that is expected by an investor for taking on the risk of operating the

business (the riskier the business, the higher the required return).

ii. The earnings figure to be capitalized should reflect the true nature of the business, such as the lastthree years average, current year or projected year excluding the impact of any extraordinary itemsnot expected to accrue in future.

iii. Valuation as per PECV involves determining of the future maintainable earnings (after tax) fromnormal operations. These earnings are then capitalised at an appropriate rate to arrive at the Equity

Value.

PECV = Future Maintainable Profit after Tax/Capitalization RateOr

PECV = Future Maintainable Profit after Tax* PE Multiple


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2. DISCOUNTED FREE CASH FLOW METHODDCF is a method of valuing a company, typically a going concern by estimating the cash flows & adjusting it

for the time value of money.

In this method, all future cash flows of the company are estimated and discounted by an appropriate discount

rate (to cover riskiness or expectation) to give their present values (PVs).

There are two main variants of this method:

i. The Equity Method - The equity version values just the equity stake in the business. So, this applies toall equity shareholders in the company.

ii. The Firm Method - The Firm variant values the entire business, which includes both the shareholdersand all the other claimholders of the firmespecially lenders to the company.

Free Cash Flow to Equity (FCFE)Let us explain this in simple terms. A company sells products and earns revenues, say R.

It costs C to make these products and a further E as ancillary expenses (advertising, marketing, clerical staff,

company off-sites, etc.).

What is left is EBITDA (R-(C+E)).

EBITDA = Earnings Before Interest, Tax, Depreciation & Amortization

Now, it has to pay interest on its debt and taxes to the government.

What is left can be distributed to the shareholders> this is the cash flow to equity.

Firm Valuation Method (Free Cash Flow to Firm - FCFF)The value of the firm is obtained by discounting expected cash flows to the entire firm.

That is the cash flows after meeting all operating expenses and taxes, but prior to debt payments. This is

discounted at the weighted average cost of capital (WACC)> Cost of Equity plus Cost of Debt.

Weighted Average Cost of Capital (WACC)WACC is the calculation of a firm's cost of capital. Each category of capital is proportionately weighted.

The categories include:

Common Stock

Preferred Stock

Bonds

Any other Long Term Debt

III. MARKET BASED METHODIn this method, value is determined by comparing the asset with similar assets. Example Comparing a

company against its peer group companies which are in the same industry of the same product line and scale.

This is also known as Relative Valuation Method.

1. Comparable company market multiples method

Comparable Company Market Multiple uses the valuation ratio of a publicly traded company and applies that

ratio to the company being valued.


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First, you find out a set of companies that are listed (and thus have all sorts of information available in public

domain) and are similar in nature of business to the company that you are valuing. This set of companies is

called the peer-set. A peer set is ideally a list of companies in the same geographical area, in the same business,

having the same target market and with revenues and profitability in the same range as the company being

valued. Such a strictly comparable set of companies is usually not available. Thus, you have to settle for

companies which are only similar, not same, in all these respects. You have to be usually OK with companies

that are larger or smaller in size, have a higher or lower profitability, have more business lines or fewer than thecompany in focus.

The valuation ratio typically expresses the valuation as a function of a measure of financial performance or

Book Value:

Earnings/Revenue Multiples Book Value Multiples Industry Specific Multiples Multiples from Recent M&A Transactions

This technique hinges upon the efficient market theory which indicates that the price of exchanged securities

reflects all readily available information, as well as the supply and demand effects of educated and rational

buyers and sellers. And since the methodology is based on the current market stock price, it is generally viewedas one of the best valuation metrics.

2. Comparable transactions multiple methodA Comparable transaction is one of the conventional methods to value a company for sale. The main approach

of the method is to look at similar or comparable transactions where the acquisition target has a similar business

model and similar client base to the company being evaluated.

With the transaction multiple method, similar acquisitions or divestitures are identified, and the multiples

implied by their purchase prices are used to assess the subject company's value. The difficulty with this

approach is the limited availability of financial data regarding past transactions between private companies.

3. Market Value Method (For Quoted Securities)The Market Price Method evaluates the value on the basis of prices quoted on the stock exchange. Average ofquoted price is considered as indicative of the value perception of the company by investors operating under free

market conditions. To avoid chances of speculative pressures, it is suggested to adopt the average quotations of

sufficiently longer period.
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WHY SHOULD YOU GO FOR VALUATION?

i. Determining the consideration for Acquisition/ Sale of Business or for Purchase/Sale of Equity stakeAccurate business valuation is one of the most important aspects of M&A as valuations like these willhave a major impact on the price that a business will be sold for. Investors in a company that areaiming to take over another one must determine whether the purchase will be beneficial to them. In

order to do so, they must ask themselves how much the company being acquired is really worth.

Naturally, both sides of an M&Adeal will have different ideas about the worth of a target company: its

seller will tend to value the company at as high of a price as possible, while the buyer will try to get the

lowest price that he can.

A valuation will assist the business owners in determining the value of their business and even

maximizing value when considering a sale, merger, acquisition, joint venture or strategic partnership.

Having a professional and independent valuation performed can be very helpful. For sellers a

valuation report can be used to help validate and support the asking price of your business which willultimately maximize your return on investment. For buyers an independent valuation report can

potentially be very helpful when negotiating the final sales price and terms of a business acquisition.

ii. Determining the swap ratio for Merger/DemergerSwap Ratio is an exchange rate of the shares of the companies that would undergo a merger. This is

calculated by the valuation of various assets and liabilities of the merging companies.

The swap ratio determines the control that each group of shareholders of the companies shall have

over the combined firm. It is an indicator of relative values of financial and strategic results of the

company.

In case of a merger valuation, the emphasis is on arriving at the relative values of the shares of the

merging companies to facilitate determination of the swap ratio. Hence, the purpose is not to arriveat absolute values of the shares of the companies. The key issue to be addressed is that of fairness to all

shareholders. This is particularly important where the shareholding pattern and shareholders

vary between the two companies.

iii. Corporate RestructuringRestructuring is the corporate management term for the act of reorganizing the legal, ownership,

operational, or other structures of a company for the purpose of making it more profitable, or better

organized for its present needs. Other reasons for restructuring include a change of ownership or

ownership structure, demerger, or a response to a crisis or major change in the business such

as bankruptcy, repositioning, orbuyout.

One of the major aspects of a corporate restructuring deal is to determine the correct value of the

organization.

iv. Sale/ Purchase of Intangible assets including brands, patents, copyrights, trademarks, rightsIntangible assets are wealth creating resources and a competitive edge for the firm. They are

identifiable, non-monetary assets that contribute in generating monetary benefits for the firm that

control these intangible assets.

Hence it is necessary to value the intangible assets for:

Transaction pricing and structuring Financing collateralization and securitization
http://www.investopedia.com/terms/m/mergersandacquisitions.asphttp://www.investopedia.com/terms/m/mergersandacquisitions.asphttp://en.wikipedia.org/wiki/Corporate_managementhttp://en.wikipedia.org/wiki/Company_(law)http://en.wikipedia.org/wiki/Demergerhttp://en.wikipedia.org/wiki/Bankruptcyhttp://en.wikipedia.org/wiki/Positioning_(marketing)#Repositioning_a_companyhttp://en.wikipedia.org/wiki/Leveraged_buyouthttp://en.wikipedia.org/wiki/Leveraged_buyouthttp://en.wikipedia.org/wiki/Positioning_(marketing)#Repositioning_a_companyhttp://en.wikipedia.org/wiki/Bankruptcyhttp://en.wikipedia.org/wiki/Demergerhttp://en.wikipedia.org/wiki/Company_(law)http://en.wikipedia.org/wiki/Corporate_managementhttp://www.investopedia.com/terms/m/mergersandacquisitions.asp


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Taxation planning and compliance Regulatory compliance and corporate governance Bankruptcy and reorganization Financial accounting and fair value reporting Forensic analysis and dispute resolution Strategic planning and management information

v. Determining the value of family owned business and assets in case of Family SeparationValuation is required in planning for the division/transfer of business in case of family separation/next

generation.

It may be a case where the existing business it to be sold to employees holding other closely related

businesses. It may also be a case of third party transfer.

vi. Determining the fair value of shares for Listing on the Stock Exchange/Going Publicvii.

Determining the Portfolio Value of Investments by Venture Funds or Private Equity Fundsviii. Liquidation of company

Valuation of a company about to be liquidated gives a fair picture of the proceeds that can be generated

from the liquidation. It is determining the total worth of a company's physical assets when it goes out

of business or if it were to go out of business.

Liquidation value is determined by assets such as the real estate, fixtures, equipment and inventory a

company owns. Intangible assets are not included in a company's liquidation value.

ix. Voluntary AssessmentThe management may opt for a voluntary assessment of the company to know the fair value of the business.This is generally done for internal management purpose and future decision making.

x. Dispute ResolutionValuations are an increasingly important aspect of many commercial disputes. Before deciding on how to

manage a dispute, it is a good idea to understand:

The likelihood of a successful outcome The currency amount involved

A valuation expert can assist by providing an early stage, high level indication of the values involved.

xi. Regulatory Mandate


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VALUER VIEWPOINT

i. Justifying key assumptions and business modelAssumptions are the key to valuation. However, more the assumptions, more is the risk of errors in valuation. A

valuers responsibility lies in formulating a business model built upon the right key assumptions such as revenuegrowth projections, capex, etc.

A common error is that of extrapolation

Adequate facts and figures need to be collected from apt resources to substantiate the above assumptions and

projections.

ii. Evaluate the current stage of the business cycleYour business is changing. With the passage of time, your company will go through various stages of the

business life cycle. A business goes through stages of development similar to the cycle of life for the human

race. Parenting strategies that work for your toddler can not be applied to your teenager. The same goes for yoursmall business.

The company will have different cash flows at the various business cycles and it is important to change the

discount rate as the stage of operation in the business cycle changes. The discount rate factors in the risk

involved in operating the business.

iii. Making sense of the financial dataThe problem that we face in financial analysis today is not that we have too little information but that we have

too much. Making sense of large and often contradictory information is part of analysing companies. A valuer

needs to select the right data set, account for non-recurring events, and chose the right manner in which to use

the dataindividual data, summarized data, etc.

iv. Choosing the right valuation modelThere are many valuation models. Selecting the right model is the key to arriving at the true value of the

business. A valuer has to factor in many points before choosing the right model.

A valuer has to define the objective of the analysis: Is it to value the entire business or only the equity?

Whether the company is in a new industry (sunrise) or an existing one?

There are many such perspectives that are considered before choosing the valuation model.

v. Minimize the impact of bias from valuationAny valuation model is subject to biasness. It is the responsibility of the valuer to account for the

biasness in the valuation process and minimize its impact in arriving at the fair value of the

business.


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CHECKPOINTS IN VALUATION

i. Non-recurring items/ Extraordinary items/Other IncomeBusiness transactions that are non-recurring, but have substantial impact on the financials in the

year in which they occur, should not be included in the valuation as may not have an impact in thefuture earnings projections.

Non-recurring other income (such as rental income for a company that is into non-rental business)

should be excluded from the valuation process. In case the Other Income component is recurring

over a period of three years or more, then the valuer may include the same in the valuation of the

business.

ii. Non-operating assets/ Excess cashNeither do Non-operating assets generate cash flows, nor does excess/idle cash add to any

operations of the company. The valuer needs to account for these in arriving at the true value ofthe business.

iii. Impact of Seasonal eventsValuation of a company is done on the basis of data on a particular date. Any seasonal events like

bad monsoons, raw material price fluctuation, etc., may have substantial impact on the valuation. It

is important to select the correct set of financial data for valuation that has not been impacted by

such temporary seasonal events.

iv. Off Balance sheet ItemsThe financial statements do not reveal the complete picture about the company being valued. The

off-balance sheet items are the invisible items that need to be factored in while arriving at thevalue. The hidden, untraceable liabilities may outweigh the glossy picture presented by the visible

financial statements.

v. Intangible asset valuationCritics of valuation analysts, in particular and quantitative valuation models, in general, argue that

we miss intangible assets because we are so focused on the bottom line - earnings and cash flows.

It is important to ensure that companies go through a robust identification and valuation process to

make certain that the fair value of the intangible assets are accurately reflected in the financial

statements and that the remaining useful life assigned to each category of asset reflects its nature

and importance to the business.

vi. Consistency in Accounting PracticesThe valuer needs to ensure that the company has followed the conventions of accounting issued bythe Recognised Accounting bodies. In case of discrepancies or inconsistency in following

accounting policies, the financial data may need adjustments and normalization.

vii. Corporate Governance & TransparencyA company that is transparent and complaint with corporate governance should command a greater

value than a similar peer company which is less transparent and complaint in terms of corporate

governance.viii. Operational EnvironmentLegal and Tax
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The valuer should take into account the operating environment of the company being valued -

whether the company is operating in a SEZ, tax-free zone or any other relevant exemptions. The

valuer also needs to check for the period for which such exemptions are valid i.e. how long will the

company continue to enjoy such benefits and if there are any future tax/legal implications that may

have substantial impact on the financial of the company.

ix. Discounts & Premiums : Discounts in termsDiscounts in terms of illiquidity discounting, in order to capture the risk associated with companies that are not

listed.

Premiums in case of highly liquid stock, in order to capture the liquidity associated with such companies.

Control Premium - An amount or percentage by which the pro-rata value of a controlling interest exceeds the

pro-rata value of a non-controlling interest in a business enterprise to reflect the power of control.

Discount on Lack of Control (DLOC) - An amount or percentage deducted from the pro-rata share of value of100% of an equity interest in a business to reflect the absence of some or all of the powers of control.

Discount on Lack of Marketability (DLOM) - An amount or percentage deducted from the value of an

ownership interest to reflect the relative absence of marketability.


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PAGE 5

VALUATION - THE LAW OF DIMINISHING RETURS

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GAURAV Valuation Content Edited Revised