This document provides an overview of various business valuation methodologies. It discusses three main approaches to valuation: asset-based valuation, earnings-based valuation, and market-based valuation. Under the asset approach, the value of a business is derived by adding the value of all assets and subtracting liabilities. The income approach values a business based on expected future income, using methods like capitalization of a single period or discounted cash flow analysis of multiple periods. The market approach uses market prices from comparable publicly traded companies to value a private business. The document then focuses on explaining methods under the asset and income approaches in more detail.
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BUSINESS VALUATION
A business is required to be valued for many reasons. The reason may be sale of business or merger and acquisition or a simple process of self appraisal by
the company. The motive of any valuation is to estimate the value of the business at which an asset can be sold. Although the term value has been elaborately
discussed in the earlier chapter yet it is discussed briefly to make this chapter coherent in itself.
Value is perceived amount depicting the worth of an asset/liability/business. Value is usually taken to be Fair Market Value. FMV as such is an hypothetical
value for any model transaction which are governed by conditions of full knowledge and freedom to act.
Fair market value is not designed with any particular individual or transaction in mind. It is rather a hypothetical value. The governing conditions in FMV are
full knowledge and freedom to act and that the transaction should be at Arm's length price, but in reality it is hardly the case as the transaction is driven by
lot of other factors being emotional and subjective elements which often override rational considerations and also full knowledge is not easy to attain by
arms length potential buyer who has limited access to the information and is also not previously involved in the business. In case of public company more
information is available as it is governed by requirement of disclosure however, it is difficult to get same level of information about private companies.
Value is the privilege to receive the future benefits as at that particular time. There is difference between price and value. Price is
the amount actually paid for the property and it may be more or less than its value. Value is the benefit perceived to be derived by
the asset and price is something which is actually paid to acquire it.
VALUATION TECHNIQUES
Valuation is a looking forward exercise. There are three broad approach through which the valuation can be done. The approach depends on the method that
is being followed to value the asset. The approaches are divided into three types being :
1. The Asset based valuation
2. Earnings based valuation
` 3. Market based valuation
In the following paragraphs we have discussed each of the approach in detail:
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I. Valuation based on Assets
In the asset approach it is assumed that the value of business is derived by adding the value of all the assets of the company and subtracting the liabilities.
This valuation approach often serves as a floor price since most companies will have more value as a going concern then as being liquidated. Besides the usual
assets, there is always a valuation of assets in the business which cannot be seen but which are necessary to run the business.
CCI guidelines, 1990 state that “The net asset value, as at the latest audited balance-sheet date, will be calculated starting from the total assets of the Company
or of the branch and deducting there from all debts, dues, borrowings and liabilities, including current and likely contingent liabilities and preference capital,
if any. In other words, it should represent the true “net worth” of the business after providing for all outside present and potential liabilities. In the case of
companies, the net asset value as calculated from the asset side of the balance-sheet in the above manner will be cross checked with equity share capital plus
free reserves and surplus, less the likely contingent liabilities.”
Under this method the value of a share employed in the equity method is simply the estimate what the assets less liabilities are worth. The value taken for
measuring individual asset or liability can be book value, market value, liquidation value etc.
Under asset approach the valuation is based on the balance sheet. However, it may be noted that balance sheet gives the accurate indication only of short
term assets and liabilities as in case of long terms ones there by hidden liabilities that may not be seen on the face of balance sheet. Asset approach gives the
fair estimation of the minimum price. Greater the portion of purchase price is explained by tangible assets, the less risky the proposition shall be.
The following steps are applied while employing the asset approach:
(1) Take the balance from the balance sheet ideally “as of” the same date as the valuation date
(2) Make adjustments where necessary in the value of asset and liabilities (for eg. Reinstating the assets and liabilities)
3) The off balance sheet and their impact on balance sheet are identified.
4) The value under the asset approach shall be equal to Assets – Liabilities
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At what value the assets and liabilities are to be valued is a big challenge. For e.g, as shown below.
Cash Is cash
Marketable securities Market value
Accounts receivables and prepaid expenses Mostly book value
Property, plant and equipment Book value - Depreciation
Cash is valued at cash, Marketable securities are valued at their market value and accounts receivables are mostly valued at book value etc. we have discussed
the about valuation each of the balance sheet item in the subsequent chapters. Liabilities provides judgmental decisions for valuation. While accounts payable
and many accrued expenses are straightforward in their value due to a specific amount stated on an invoice, a liability such as a warranty accrual or a litigation
accrual may not be very clear in its fair value and what it should be carried at during a valuation. Significant consideration should be given to these more
opaque items on the balance sheet when performing the valuation.
Intangible Assets
The most difficult assets to value are intangible assets such as trade mark, patents, goodwill etc they are the assets which cannot be seen , touched and they
are created over a period of time and are created with efforts and are identifiable as separate assets. In the world changing with technology most valuable
assets have gone from tangible to intangibles. It is a world of ideas, relationship, associations and human wealth. There are two types of intangibles. IND AS
26 deals elaborately on the valuation of intangible assets. Usually, Self-created intangibles are not put on the balance sheet of a company and therefore do
not automatically require valuing and adding to the balance sheet. Few considerations that need to be made when using the asset approach are Premise of
Value, Control, Marketability, Asset or Income based business, Going concern basis etc
The asset based valuation can be classified into four broad categories.
1. Book value
The book value of the asset and liability as appearing in the balance sheet is taken for the purpose of calculation. The value of intangible
assets is excluded in the calculation. This method of valuing the assets at book value is adopted in statutes like gift tax Act, Wealth Tax Act
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for valuation of unquoted equity shares for companies other than an investment company. The limitation of book value is that book value does not give the
true indication of a company's value and it does not take into account the cash flow that can be generated from the company’s assets. While doing valuation
based on book following adjustments should be seen to be applicable to be made:
inventory undervaluation
Bad debt reserves
Market value of assets
Copyrights and patents
Investment in affiliates
Carry forward of tax losses
2. Replacement value
Replacement value is the cost which is required to replicate the present operations of the company. It is essentially to make a buy decision. It is the cost which
the seller will ask from buyer who otherwise would have to expend for getting such assets and liabilities. It is the value at which the existing asset will be
replaced at the current market prices with similar assets.
3. Liquidated Value
Liquidated value is the least a business can fetch. While offering a business for sale, seller would like to know the least value he will be able to get on just
liquidating the assets.
Liquidation value should be considered when the value of business as determined on the basis of income or market approaches is low relative to net asset
value. Application of the liquidation should consider the expenses associated with liquidation, taxes and all the other relevant cost involved in liquidation.
To get the value of business a premium is added to the net assets of the company. The premium is calculated by comparing the earnings of a business before
a sale and the earning after sale. It is assumed in this approach that the business is run more efficiently after sale.
Relevance: Asset approach is relevant in the cases where the earning potential of the company is difficult to be evaluated or estimate or is where it is not
getting captured appropriately under the income / market approach. It is also relevant in the cases where intangible asset makes the considerable portion of
the business and for evaluating surplus / non-operational assets and contingent / off balance sheet liabilities.
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2. THE INCOME APPROACH
The income approach is more practical approach to follow. In the Income approach value of assets is measured based on its earning capacity. Earnings are
linked with other fundamentals of business like growth, capital requirements, risk involvement or uncertainty.
The Income approach derives an estimation of value based on the sum of present value of expected benefits estimated to be derived from assets or business.
Economic benefits may be in the nature of dividends and capital appreciation.
Two methods may be followed to arrive at value under income approach
a Single period capitalisation or a
Multi period discounted future income method
Single period capitalisation: It is also known as capitalisation. The capitalization method basically divides the business expected earnings by the capitalization
rate. The idea is that the business value is defined by the business earnings and the capitalization rate is used to relate the two. For example, if the
capitalization rate is 33%, then the business is worth about 3 times its annual earnings. An alternative is a capitalization factor that is used to multiply the
income. Either way, the result is what the business value is today.
Under the capitalisation method Fair market value of the company is estimated by converting the future income stream into value and by applying a
capitalisation rate incorporating a required rate of return for risk assumed by an investor along with a factor for future growth in the earning stream being
capitalised. This gives the value based on the present value of the future economic benefits that the owner will receive through earnings, dividends or cash
flow.
Therefore for capitalisation method it is required determine the two factors:
(1) normalized income stream and
(2) rate of capitalization or multiple for capitalization
There are different types of income streams which can be taken for valuation like PAT (profit after tax) or Profit before depreciation, interest and taxes (PBDIT)
or cash flows etc This earnings may be considered from recent year earnings, OR simple average of few years’ earnings, or weighted average
or geometric average of few years’ earnings i,e. it can be a forward looking or trailing (based on past). For forward looking (also known as
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leading) earnings the forecasted figures must be checked. whatever income stream is chosen it should be made sure that the multiple should also co-relate
with the nature of earnings used. For example, if it is PBDIT then multiple should be based on capital invested and not only the owners’ fund. This will give
value of business. But if the earnings used is PAT then the multiple should reflect the factors applicable to ownership only. It will provide the value of owners’
fund in the business. While arriving at multiple we should consider the business risk specific to the business, size risk, market risk, growth rate, expected
return and such other factors having impact on the business operations.
CCI guidelines state that "The crux of estimating the Profit Earning Capacity Value lies in the assessment of the future maintainable earnings of the business.
While the past trends in profits and profitability would serve as a guide, it should not be overlooked that valuation is for the future and that it is the future
maintainable stream of earnings that is of great significance in the process of valuation. All relevant factors that have a bearing on the future maintainable
earnings of the business must, therefore, be given due consideration"
Capitalisation model is based on the Gordon growth model which estimates the value of ownership based on next year’s dividend payment capacity and
capitalizing it considering the expected rate of return (cost of capital) and estimated growth rate. This method is based on the Gordon Constant Growth
Model that uses a single period proxy. Gordon constant growth model is based on the future series of dividends that are expected to grow at a constant rate.
Given a dividend per share that is payable in one year, and the assumption that the dividend grows at a constant rate in perpetuity, the model solves for the
present value of the infinite series of future dividends.
Following formula is used to estimate a value using this approach:
Value = Normalized earnings / (Ke – g)
Where,
Ke = required rate of return on investments
g = growth rate in earnings forever
Or
Value = Normalized earnings * Appropriate multiple
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As discussed there are lot of factors which should be considered while arriving at normalised earning and the appropriate multiple and it is on the best
judgment of the appraiser to decide the same.
In Multi period discounting method future income stream on year by year basis back to a present value using an appropriate discount rate. Discount rate
reflects the required rate of return on the investment. In this method projections are used to determine the value of business. Projections/Business cycle
period is divided into two periods being
- Un stable growth period
- Stable growth period
Unstable growth period is the income for several periods and stable growth period is assumed to be period after the last year. The model can be extended to
three or four stage model based on the business cycle. Past results may be helpful in giving an idea regarding the future cash flows but it cannot be made
basis for future projections.
There are two ways in which present value of future stream of income can be determined
1) adjust the expected cash flows for risk
2) adjust the discount rate for risk in DCF valuation
Under the first approach cash flows are adjusted for the systematic (market) risk by subtracting a cash risk premium (risk-adjusted expected cash flows). The
risk adjusted expected cash flows are discounted at a risk free interest rate. under the second approach the discount rate is adjusted for systematic (market)
risk by adding a risk premium to the risk-free interest rate.
For the final year of the projection period it is assumed that the growth rate shall be till perpetuity. In the final year the income stream that represents the
cash flow of final year is assumed to continue till perpetuity which is then discounted to present value. The terminal value of the business can be derived
through using the (1) Stable growth method (2) Multiple approach (3) Liquidation value.
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(1) Under the Stable growth method gordon model is followed. Gordon model is very popular while estimating terminal value based on earnings. Key
assumptions for the Gordon model are as follows :
Forecast period should be as long as necessary for a stable level of growth to be achieved; the terminal period must assume a long term stable growth
rate (it may be negative or zero or positive)
Depreciation and capital expenditure should be either equal or at a steady state differential in the residual period
This formula represents the value of all cash flows remaining beyond the end of the forecast period
Assumption of constant growth in cash flow. Growth rate used can be more than the expected nominal growth rate of the overall economy in which
the firm operates.
The rate must be sustainable into perpetuity
Formula for deriving terminal value under this model is cash flow in the first year of the terminal period/ (discount rate - long term growth rate).
The stable growth model is technically sound but it requires a judgment about the stable status of the business and applicable stable growth rate that can
sustain forever.
(2) Multiple approaches is based on a multiple of a measure of financial performance applied at the end of the forecast period. This is fairly simple method
and easiest to use. However, it is difficult to come out with relevant multiple.
(3) Under Liquidation value the terminal value is determined by estimating the value of individual assets at the end of the forecasting period. The liquidation
value is most useful when assets are separable and marketable.
Following method is followed for doing the valuation as per Income approach under discounted cash flow method
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Discounted cash flow method (DCF): It is a method under which the intrinsic value of the company asset is valued. As the name specifies it is the value is
arrived at by discounting the future cash flows to the present value. It is forward looking valuation and depends more on the earning capacity in future or
future expectations rather than historical results. Following steps are involved in calculation of value under DCF method
Step 1—The first step in Discounted cash flow valuation is to estimate the cash flows expected to be available to equity holders/other investors. The free cash
flows is the cash that may be available to the investors after taking into account investment in new assets, need of working capital, capital expenditure etc
and on assumptions regarding the company's revenue growth rate, net operating profit margin, income tax rate, fixed investment requirement, and
incremental working capital requirement etc.
Determination of the cash flows
Determining the Discounting rate
Determination of terminal value
Determination of present value of cash flows and
terminal value
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depending on for whom the value of business is ascertained Free cash flows may be calculated in two manner – (1) Free cash flows to the equity holder (FCFE)
(2) Free cash flows to the Firm (FCFF). Free Cash Flow to the Equity is the cash is available to pay to a company's equity shareholders after accounting for all
expenses, reinvestment, and debt repayment.
It is calculated as : Net Income - (Capital Expenditures - Depreciation) - Changes in non-cash Working Capital - (Principal Repayments - New Debt Issues) OR
alternatively Cash From Operations - (Capital Expenditures - Depreciation) + Net Borrowing.
Please see that the cash will be available to equity holders only after repayment of debt and the interest. We subtract depreciation to arrive at FCF because
it is non cash item and it is only accounting entry and no actual cash outflow happens in case of depreciation.
Free cash flow to the firm is the cash available to bond holders and stock holders after all expense and investments have taken place. It is calculated as follows:
Earning before interest and taxes(EBIT) * ( 1 - tax rate) - (Capital Expenditures - Depreciation) - Change in Working Capital.
Whether to use the free cash flow to equity or to use free cash flows to firm will depend on for whom the value of the business is ascertained. If we are
looking to value the equity, then the most appropriate option is to use FCFE. FCFF is preferred if the company is unstable or has huge amount of debt because
the FCFE might be very low or negative in this case.
Calculation of cash flows is dependant on what we want to arrive at I,e. value of equity , value of firm or the enterprise value.
Step 2 : The next step is to estimate the discount rate
Once cash flows are projected we need an obtain an appropriate discount rate. Discount rate is then used to projections to arrive at the new present value
of the cash flows. If the cash flows are cash flows to the firm, the appropriate discount rate is the cost of capital (or WACC - the weighted average cost of
capital).
Cost of capital is equivalent to Cost of Equity + Cost of debt
Cost of Equity is the return which Equity shareholders expect to obtain on their equity investment in a company. From the company's perspective, the equity
holders' required rate of return is a cost. However, unlike the cost of debt which is relatively easy to determine from observation of interest rates in the
capital markets, a company's current cost of equity is unobservable and must be estimated.
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There are various models for estimating the cost of capital like Gordon Model which have already been discussed one of the other method is Capital Asset
Pricing Model, or CAPM under which cost of equity is calculated as follows :
Cost of Equity (Re) = Risk Free Rate (Rf) + Beta * Equity Risk Premium.
where,
i) Risk-Free Rate - This is the amount obtained from investing in securities considered free from credit risk, such as government bonds etc.
ii) ß - Beta - This measures how much a company's share price moves against the market as a whole. A beta of one, for instance, indicates that the company
moves in line with the market. If the beta is in excess of one, the share is amplifying the market's movements; less than one means the share is more stable.
iii) Equity Market Risk Premium - The equity market risk premium represents the returns investors expect, over and above the risk-free rate, to compensate
them for taking extra risk by investing in the stock market. In other words, it is the difference between the risk-free rate and the market rate.
Step 3 calculation of Terminal Value
Instead of trying to project the cash flows to infinity, terminal value techniques are used. One way of calculating the terminal value (TV) is by using the Gordon
Growth Model, which essentially assumes that company's cash flow will stabilize after last projected year and will continue at the same rate forever. Here is
the formula:
Final Projected Year Cash Flow X (1+Long-Term Cash Flow Growth Rate) / (Discount Rate – Long-Term Cash Flow Growth Rate).
Another possibility of determining terminal value of the company is to use multipliers of income or cash flow measures (net income, net operating profit,
EBITDA, operating cash flow or FCF), which are determined with reference to comparable companies on the market.
The TV often represents a large percentage of the total DCF valuation.
Step 4—Calculation of fair value of company & Equity
To arrive at a total company value, or enterprise value (EV), we simply have to take the present value of the cash flows and the Terminal value, divide them
by the discount rate and, finally, add up the results.
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To arrive at the value of equity : - Divide Free cash flows for equity by cost of equity
To arrive at the value of debt : Divide free cash flows for firm by weighted average cost of capital, this would give the value of the firm.
Relevance :
Valuation is forward looking exercise. An asset is mostly purchased for the value it may be able to derive in future. Income approach is most scientific approach
as it considers the time value of money and the cash outflows including working capital & capital expenditure that required for increased levels of business
forecasted.
It is considered relevant and appropriate in an acquisition / divestment deal where management & control may be acquired / diluted and also for the
companies which are in growth phase.
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3. THE MARKET APPROACH
The Broad principle of market approach is the assumption that is comparable asset is able to fetch a certain price then the subject asset shall also be able to
fetch the same price. This is based on the assumption that market gives the accurate pricing of the asset. Market value is also known as extrinsic value. The
difference between the market approach and the Income approach is that in income approach we estimate the intrinsic value of the asset while in the market
approach we estimate the extrinsic value of the asset. Intrinsic value is based on the earning capacity to generate cash flows in the future and in extrinsic
value we are looking what is the value that the market is paying for similar and comparable asset.
If the market is correct and giving the correct value for the asset the two values being intrinsic value and extrinsic value should be same. However, it is hardly
the case ever, the market is either under priced or over priced therefore the two values hardly converge. Extrinsic value is dependent on how efficiently
securities market are efficient in reflecting information about individual stocks and about the stock market as a whole.
Under Market approach two techniques are used being the Comparable companies multiple method and comparable transactions multiple method.
Under the comparable companies multiple method, the market quoted prices of comparable companies in the same or similar line of business are looked
and relevant pricing multiples are applied to the subject company to determine its value. The relevant multiples are then adjusted for factors like size, growth,
profitability etc. A variety of valuation measures may be used like Enterprise value to sales, EV to EBIDTA etc . Adjustments are made to get the like to like
comparison between the companies.
Under Comparable transactions multiples method under this valuation is based on the price paid in recent transactions which include reviewing published
data on actual transactions and transaction price is converted into a relevant multiple and applied after adjustments for factors like size, growth etc to the
relevant parameter of subject company.
We have discussed in detail the various multiples that are commonly used in the subsequent chapters. For the understanding here the business can be valued
based on the multiples like earning multiples, book value multiple, revenue multiple and business specific multiple etc.
Steps that can be used to determine a value under market approach
Firstly the similar public companies or transactions are selected
Comparison of same is done with the subject company.
Then, valuation multiples are selected and calculated
After that the valuation multiple is applied to the company being valued
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As a last step the final adjustments are made.
Market price method is not relevant in the following cases
valuation of a division of a company
where the share are not listed or are thinly traded
in case of companies where there is an intention to liquidate it and to realise the assets and distribute the net proceeds
in case of unsteady markets the market price may not be indicative of true value of the share
Regulatory bodies have often considered market value as on of the very important basis of valuation for. Eg: Preferential allotment, buyback of share, open
offer price calculation under the takeover code etc.
Multiple as discussed above is arrived at by = what you are paying for the asset/What you are getting in return
What you are paying for asset is
- Market value of Equity (Market value of Equity)
- Market value for the firm (Market value of Equity + Market value of debt)
- Market value for the operating assets of the firm (Market value of Equity + Market value of debt – cash)
What you are getting in return may be
- Revenue is accounting revenue of which drivers are customers, subscribers and units
- Earnings (to equity shareholders may be Net Income, earning per share . To firm it may be operating Income (EBIT)
- Cash Flow (to equity shall be net income + depreciation. To Firm it shall be EBIT + DA (EBITDA))
- Book Value (a. Equity = Book value of equity b. Firm = BV of debt + BV of equity c. Invested capital = BV of equity + BV of debt – cash)
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