BUSINESS VALUATION
The objective of any management today is
to maximize corporate value and
shareholder wealth. This is considered their
most important task.
A company is considered valuable not for
its past performance, but;
for what it is and
its ability to create value to its various
stakeholders in future.
Simply defined, a business valuation is an
examination conducted towards rendering
an estimate or opinion as to the fair market
value of a business interest at a given point
in time.
Same fundamental principles determine the
values of all types of assets, real as well as
financial.
Furthermore:
Some assets are easier to value than others
as;
the details of valuation vary from asset to
asset and
the uncertainty/risk associated with value
estimates is different for different assets.
However, the core principles remain the same
Basic Principles of Valuation
Value is prospective
Value is determined at a point in time
Market drives the required rate of return
Value is usually driven by earnings/cash flows,
only occasionally by liquidation value
Minority interest usually worth less than ratable
value
Foundation of Business Valuation
A postulate of sound investing is that
an investor does not pay more for an
asset than it is worth i.e.
One should not buy most assets simply for
aesthetic or emotional reasons.
People buy financial assets for the cash flows
they expect to receive from them.
Perceptions of value have to be backed up by
reality, which implies that the price we pay for
any asset should reflect the cash flows it is
expected to generate
Purpose of Business Valuation
Purpose of Valuation Examples
Valuation for Business purchase,
transactions business sale, M&A,
reverse merger,
recapitalization,
restructuring, buy sell
agreement, IPO, buy
back of shares, project
planning and others
Valuation for court cases Bankruptcy, contractual
disputes, ownership
disputes, dissenting and
oppressive shareholder
cases, divorce cases,
intellectual property
disputes and others.
Valuation for Fair value
compliances accounting, tax
issues
Valuation for Estate planning,
planning personal financial
planning, M&A
planning, strategic
planning
Business Valuation Process
Valuation Approaches
[Link]-based Approach
Here, the business is estimated as being worth the
value of its net assets.
However, there are three common ways of valuing
its net assets:
book values,
net realisable values and
replacement values.
Book Value Approach
The book value approach is practically useless.
The book value of non-current assets is based on
historical (sunk) costs and relatively arbitrary
depreciation.
These amounts are unlikely to be relevant to any
purchaser (or seller).
The book values of net current assets (other than cash)
might also not be relevant as inventory and receivables
might require adjustment.
The book values of net current
assets (other than cash) might also
not be relevant as inventory and
receivables might require
adjustment
Net Realisable Value Approach
Net realisable values of the assets
less liabilities.
This amount would represent what
should be left for shareholders if the
assets were sold off and the liabilities
settled..
However, if the business being sold is
successful, then shareholders would
expect to receive more than the net
realisable value of the net assets
because SUCCESSFUL BUSINESSES
ARE MORE THAN THE SUM OF
THEIR NET TANGIBLE ASSETS:
I.E They have intangible assets such as
goodwill,
knowhow,
brands and
customer lists – none of which is likely
to be reflected in the net realisable
value of the assets less liabilities.
THEREFORE: Net realisable value
represents a ‘worst case’ scenario
because, presumably, selling off the
tangible assets would always be
available as an option
Replacement values Approach
The approach tries to determine what
it would cost to set up the business if it
were being started now.
Once again, not of great practical benefit.
Reasons?
The value of a successful business using
replacement values is likely to be lower than its
true value unless an estimate is made for the value
of goodwill and other intangible assets, such as
brands.
Estimating the replacement cost of a variety of
assets of different ages can be difficult.
THUS: Of the three approaches,
net realisable value is likely to be
the most useful because it presents
the sellers with the lowest value
they should accept.
2. Income-based Approach/DCF Approach
In this approach the value is determined by
calculating the net present value of the stream of
benefits generated by the business or the asset.
Thus, the DCF approach equals the enterprise value
to all future cash flows discounted to the present
using the appropriate cost of capital.
3. Relative Valuation/Market approach.
In this approach, value is determined
by comparing the subject company or
asset with other companies or assets in
the same industry, of the same size,
and/or within the same region, based on
common variables such as earnings,
sales, cash flows, etc.
The P/E ratio is another which method is widely
used in practice.
This method relies on finding listed companies
in similar businesses to the company being
valued (the target company), and then looking
at the relationship they show between share
price and earnings.
Using that relationship as a model, the share
price of the target company can be estimated.
4. Economic Value added (EVA) Approach
This analysis is based on the premise that
shareholder value is created by earning a
return in excess of the company’s cost of
capital.
EVA is calculated by subtracting a capital
charge (invested capital x WACC) from the
company’s net operating profit after taxes
(NOPAT).
If the EVA is positive, shareholder
value has increased.
Therefore, increasing the company’s
future EVA is key to creating
shareholder value
A simple illustration is given below;
NOPAT = $15,000
Invested capital =$a5l0 ,000
WACC = 12%
EVA = NOPAT – (Invested capital x WACC
=$15,000 – ($50,000 x 12%)
= $9,000
Choice of Approach:
In determining which of these
approaches to use, the valuer must
exercise discretion as each technique has
advantages as well as drawbacks.
It is normally considered advisable to
employ more than one technique, which
must be reconciled with each other
before arriving at a value conclusion .
The valuation analyst should use all
valuation approaches and methods
that are appropriate to the engagement
and consider all three generally
accepted valuation approaches.
For the valuation of a business, business
ownership interest or security, the valuer
should consider:
The DCF approach.
The market approach.
The asset-based approach i.e NRV
For the valuation of an intangible asset, the valuer
should consider:
The DCF approach.
The market approach.
The cost approach
PRINCIPLES AND TECHNIQUES OF VALUATION
Like other areas of finance, valuation is also based on
some basic foundations which we refer to as principles.
Principles of valuation are;
Principle of Substitution
Principle of Alternative
Principle of Time Value of Money
Principle of Expectation
Principle of Risk & Return
Principle of Reasonableness and Reconciliation of value
(i) Principle of Substitution
If business ‘A’ can be replicated at ‘X’ amount then business is
worth ‘X’ amount. If a similar business ‘B’ is available at a price
less than ‘X’ amount then business ‘A’ has worth less than ‘X’
amount.
This principle ensures that understanding of market is
important and forced comparison would lead to flawed
valuation.
This simply indicates that risk-averse investor will not pay
more for a business if another desirable substitute exists either
by creating new or by buying.
(ii) Principle of Alternatives
No single decision maker is confined to one transaction.
Each party to the transaction has alternatives to fulfilling
the transaction for a different price and with different party.
Since no single transaction could be a perfect substitute
to another transaction one may consider paying some
premium if investment meets strategic interest.
When someone is buying business it should be kept in mind
that the same should not be bought at any cost as if no
alternative exists.
(iii) Principle of Time Value of Money
This is the most basic area corporate finance as well as
valuation.
It suggests that value can be measured by calculating
present value of future cash flows discounted at the
appropriate discount rate.
Investment opportunities may offer differing cash flows,
growth prospects and risk profile. Principle of time value
of money helps us to discriminate those opportunities
and to select the best subject to given parameter.
(iv) Principle of Expectation
Cash flows are based on the expectations about the
performance in future and not the past.
In case of mature companies we may conservatively
assume that growth from today or after some certain
period would be constant. THE DIFFICULT PART
IS TO DETERMINE THE EXTENT AND
DIRECTION OF GROWTH.
These assumptions will have significant impact on the
valuation.
(v) Principle of Risk & Return
Based on risk- return criteria this suggests ways to identify
optimal portfolio.
This suggests two important assumptions.
First, an investor is risk averse.
Second, an investor would prefer higher amount of wealth
than the lower one. Given two possible portfolios with similar
risk profile, the one with higher expected return will be
preferred.
These two assumptions are most integral part of valuation
exercise.
(vi) Principle of Reasonableness & Reconciliation of value
In valuation exercise we need to deal with large number of
uncertainties and we have to go for assumptions.
A valuation without reasonable check and reconciliation
exercise is not complete and would be difficult to defend.
Seven factors that must be considered in any valuation
exercise.
The nature of the business and the history of the enterprise
from its inception
Economic outlook in general and condition of the
outlook of the specific industry in particular
The book value of the stock and financial
condition of the business
The earnings and dividend paying capacity of the
company
Whether the business is having any intangible
assets
Sales of the stock and the size of the block of stock
to be valued
The market price of stocks of corporations
engaged in similar business having their stocks
actively traded in a free and open market or an
exchange or over the counter
Standard of Value
Standard of value means the type of value being
sought/required
Most common ‘standard of value’ which are used
practice are;
Fair market value
Investment value
Intrinsic value
Fair value
Choice of appropriate standard of value may be
dictated by
circumstances,
objective,
contract and
operation of law or other factors.
Pertinent questions to be answered before choosing
an appropriate standard of value are;
• What is being valued?
• What is the purpose of valuation?
• Does the property or business changes hands?
• Who are the buyer and seller?
Fair Market Value
Fair market value is the reasonable selling price of a
business, stock, real estate or other assets.
Fair Value
Fair value is a broad measure of an asset's worth and is
not the same as market value, which refers to the price
of an asset in the marketplace.
In accounting, fair value is a reference to the
estimated worth of a company's assets and liabilities
that are listed on a company's financial statement
Fair Value vs FMV
Fair value is a broad measure of an asset's
intrinsic worth while market value refers solely to
the price of an asset in the marketplace as
determined by the laws of demand and supply.
Investment Value
Investment value is the amount of money an
investor would pay for a property.
Investment value - the value of an asset to the
owner or a prospective owner for individual
investment or operational objectives
Intrinsic value
Intrinsic value is a measure of what an asset is worth.
Intrinsic value = Current price – Strike price
A strike price is the set price at which a derivative
contract can be bought or sold when it is exercised.
For call options, the strike price is where the
security can be bought by the option holder; for
put options, the strike price is the price at which
the security can be sold.
Valuation of a Firm Vs Valuation of Equity
(Methods)
1. Free Cash flow Method
The free cash flow method is one method often
used internally or by long-term investors to value a
company.
This method focuses on the operational cash flow
the company generates and its expected growth rate
in the future.
It can be FCFF or FCFE
FCFF = EBIT(1-t) + Depre&Amort –Capital Exp- ∆WC
The free cash flow to firm formula is capital
expenditures and change in working capital subtracted
from the product of earnings before interest and taxes
(EBIT) and one minus the tax rate(1-t).
The free cash flow to firm formula is used to
calculate the amount available to debt and equity
holders.
b)Free cash flow to equity (FCFE)
Is the amount of cash a business generates that is
available to be potentially distributed
to shareholders.
It is calculated as Cash from Operations
less Capital Expenditures plus net debt issued.
FCFE = Cash from Operating Activities –
Capital Expenditures + Net Debt Issued
(Repaid)
Other Methods
Equity Valuation
The value of equity is obtained by discounting
expected cashflows to equity, i.e.,
the residual cashflows after meeting all expenses,
tax obligations and
interest and principal payments, at the cost of
equity, i.e., the rate of return required by equity
investors in the firm
Equity Valuation
Firm Valuation
The value of the firm is obtained by discounting
expected cashflows to the firm, i.e.,
the residual cashflows after meeting all
operating expenses and taxes, but prior to debt
payments, at the weighted average cost of
capital, which is the cost of the different
components of financing used by the firm,
weighted by their market value proportions.
H-Model
The H-model is a quantitative method of valuing a
company’s stock price
The majority of organizations increase or decrease
dividends over time, as opposed to shifting rapidly
from high yields to stable growth.
Thus, the H-model was invented to approximate
the value of a company whose dividend growth
rate is expected to change over time.
Stock Value = (D0(1+g2))/(r-g2) +
(D0*H*(g1-g2))/(r-g2)
Where
D0 is the dividend received in the present year
r is the rate of return expected by the investor
g2 is the long term growth rate
g1 is the short term growth rate
H is the half-life of the high growth period
