This blog is written by Mr. Haseeb Ahmad. Please read this blog and provide your valued comments
Introduction to business valuation
The term valuation implies the task of estimating the value/worth of a security an asset or a business. The price that an investor is willing to pay would be related to this value. Since different buyers have different objectives and perceptions; one may perceive the security, asset or business to be of higher worth and hence willing to pay higher price than the others. A seller would consider the negotiated selling price to be greater than the value/worth of security, asset or business he is selling.
There is also subjectivity involved in the process of business valuation and this is also more complex than that of an individual security or asset. The valuation is required not only for tangible assets but also for intangible assets like goodwill, Patents, brands, trademark as well as management’s efficiency, because these assets make up a significant part to real value of a company. The liabilities both recorded, unrecorded or contingencies should also be considered so that buyer is aware of total amount to purchase a business.
Objectives of business valuation
- To establish terms of merger etc,
- To make buy, hold or sale decisions for shares,
- For fiscal purpose like tax on capital gain,
- To estimate value of share held by retiring director,
- For the valuation of companies entering in stock market
Methods of business valuation
The most common methods of valuation are
- Asset based method
- Earning based method
- Market based method and
- Fair value method.
These method should be viewed as providing a range of values depending upon varied needs and circumstances.
- Asset based method
This method focuses on valuation of net assets from prospective of equity share valuation and is based on going concern concept. The method is a starting point to the valuation of a firm, which can be calculated by taking all assets appearing on balance sheet minus total liabilities including preference share .However it depends on valuer needs and company specific factors that whether the asset should be valued at (a) market, (b) replacement, (c) book or (d) liquidation value. Like in case of a firm who has major fully depreciated fixed assets market value will be more appropriate for such firm. In case of book value all assets are taken at balance sheet value but this value is historic and not a reliable indicator, in case of replacement value this represent the cost of setting up a business from scratch but this is not easy to identify in practice, in case of market value all items are revalued to their current market price.
- Earning based method,
This method is guided by economic proposition that valuation should be related to firm’s earning potential or cash flow capacity and overcomes the limitation of asset based method which ignores both earning potential and ability to generate cash flows. The earnings can be expressed in terms of
- Earning based on accounting
As per this method the valuation is based on two parameters the earnings that are future maintainable profits and capitalization rate applicable to such earnings. Earnings are normal annual profits, to smoothen out the fluctuations in profit, average of past profits should be computed and extraordinary/one off items should be removed like gain/loss on disposal of assets, abnormal loss due to theft, major fire, expenditure on voluntary retirement scheme, loss due to strikes, lockouts of major competitor and effects of natural calamities because these are not normal course of business and are not expected to continue in long run. Apart from these major growth and income drivers should also be considered, if such drivers are not expected to be continued profits needs to be adjusted, any additional income from launch of a new product or investment should also be considered.
Capitalization rate: Capitalization rate refers to investment sum that an investor is willing to make to earn a specified income. Given the risk return framework, business that are exposed to high business & financial risk warrants a higher capitalization factor and business having low risk factor are subject to low capitalization factor. There are lot of factors that affect the capitalization rate like sales, degree of operating & financial leverage, competition, substitute products and their prices, level of technology and government regulations. The determination of capitalization factor is not an easy task, a few guidelines may be helpful to a valuer but the capitalization factor for a firm should be high than that of a government security. The rate should also be match with the firms operating in the same type of business. A valuer can also apply different rate but there should be a proper weight and convincing reasons to do so. The valuer can also refer the rate to P/E ratio as the cost of equity is reciprocal of P/E ratio.
Another method falling in earning based method is use of P/E ratio to value a share. The method is commonly used because it relates the price to earnings. The application of this method requires EPS which should be based on future maintainable profits. The P/E ratio should be used with cautions because published P/E multiples are based on published financial statements which are not adjusted for extra ordinary items. A valuer can use P/E ratio of similar firm or average of industry in which the firms operates, a adjustment factor to P/E ratio can also be made with respect to firms specific factor.
- Earning based on cash flow
The crux of this method is application of discounted cash flow (DCF) techniques to value a firm. This involves calculation of free cash flow to firm and a discount rate that reflects the riskiness of cash flow. The discount rate should be the opportunity cost of funds that is equal to the rate of return that investors expect to earn on other investments having equivalent risk. Thus value of firm is present value of cash flow discounted at appropriate discount rate. The value of equity is present value of firm minus total external liabilities or free cash flow to equity holders discounted at cost of equity. However in practice firms have indefinite life which should also be consider in valuation, one approach to incorporate indefinite life is to forecast future cash flow for a long period say 30-40 years and ignore all subsequent cash flow because discounted value of cash flow of such distant years will be insignificant but problems can arise in forecasting the decades performance. To overcome this problem the exercise can be segregated into two periods, cash flows during the explicit period say 5-10 years and after the explicit forecast period. Thus value of firm is present value of cash flow during explicit forecast period plus present value of cash flow after explicit forecast period.
Another method falling in DCF technique is use of adjusted present value (APV) method which separates the investment side from financing side. The method is more appropriate in case of investment in new assets or merger/acquisition which results in significant changes in capital structure and hence the risk profile of the firm.
- Market based method to valuation,
The market value of securities reflected in stock market can be used and this can be (a) average value say for 12 months or (b) average of high and low value .The justification of this approach is the fact that market quotations indicates the consensus of large investors as to firm’s earning potential and corresponding risk factor. The major problems in this method is that market value is influenced by financial fundamentals and speculative factors, this approach can be applied to the shares of listed companies only and the shares that are actively traded and this method is also not in tune with going concern concept.
- Fair value method
This method is not an independent approach like those discussed above and uses the average of two or more of above methods. It helps in smoothening out wide variations in the valuation as per above methods and provides a balance figure. Main problem in this method is “limited application in practice”.
Other methods to valuation
In recent years a number of new methods are developed and practiced. The most common are
- Market value addition approach (MVA)
This method measures the change in MV of firm by comparing the MV of equity with equity funds (share capital and retain earnings). Thus MVA is market value of equity minus equity funds. The method can also be used from prospective of all providers of all funds, thus MVA is total market value of firm’s security minus equity funds, preference share and debentures. The main limitation of this approach is that it can be used for firms whose market prices are available.
- Economic value addition (EVA)
This method is based on firm’s past performance the underlying principle of this method is whether firm is earning a higher rate of return on funds invested than cost of these funds. If such is the case than management is adding to the shareholder’s value by earning extra for them. Thus EVA is operating profit after tax minus total capital multiple of WACC.
- Valuation of intangible assets
The main flaw of asset based valuation is that it ignores the value of intangibles. If a firm has skilled, creative and efficient staff because of spending on research, development and staff training program, these expenditure enhance the value of firm rather than profits of current year. The intangibles can be valued using,
- Calculated intangible value method
This method is based on comparing the return on total assets of firm with the industry average, or a similar firm operating in same industry. The difference can be used to value intangibles. The time factor for such additional earnings depends upon forecast period for which the firm is expected to earn these extra earnings. The main problem is that comparable firm may have also intangibles which are ignored while calculating the return on asset of that firm.
- Lev’s knowledge earning model
This method involves calculation of earnings that are deemed to be related to intangibles. The results of this model are close to actual share price, but isolation of earnings is often considered as complex since valuation in the end depends on bargaining between the parties.
Since valuation is an “art rather than a science” different methods provides different values because each has different assumptions and inputs no method is appropriate for all situations but it is important to recognize that some methods are appropriate in certain situations rather than others. For example for firms operating at loss with no bright results in near future, new firms entered in market whose accounts does not guide to future profits or firms with unreliable statistics because of factors like strikes, disruption in business, the net asset method will be more appropriate, in normal circumstances discounted cash flow will be appropriate and in case of wide variations in valuation fair value can be used. In the end final value depends on negotiation between parties. Therefore a valuer, investor or manager should know a range of values from different perspectives depending upon circumstances.
NOVEMBER 11, 2020