886E220 1- 13
ANNAMALAI UNIVERSITY DIRECTORATE OF DISTANCE EDUCATION
M.Sc. PLANT AND MACHINERY VALUATION
Second Year
INTRODUCTION TO BUSINESS VALUATION LESSONS: 1 – 13
Copyright Reserved (For Private Circulation Only)
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M.Sc. Plant and Machinery Valuation SECOND YEAR
INTRODUCTION TO BUSINESS VALUATION
Editorial Board
Members
Dr. C. Antony Jeyasehar Dean
Faculty of Engineering and Technology
Annamalai University
Annamalainagar
Dr.G.Ganesan HOD of Manufacturing Engineering
Faculty of Engineering & Technology
Annamalai University
Annamalainagar.
Dr.A.Prabhaghar
Associate Professor and Wing Head
Engineering Wing, DDE
Annamalai University
Annamalainagar.
Internals
Dr.K.Srinivasan
Assistant Professor
Manufacturing Engineering, FEAT
Annamalai University
Annamalainagar.
Dr.M.Arulselvan
Assistant Professor
Manufacturing Engineering, FEAT
Annamalai University
Annamalainagar.
Lesson Writer
Mr.R.K.Patel
Valuer, Plant and Machinery
79, Nirman Park
Vishwamitri Road
Vadodora–390 011
Gujarat
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M.Sc. Plant and Machinery Valuation
SECOND YEAR
INTRODUCTION TO BUSINESS VALUATION
SYLLABUS
Valuation Fundamentals & Contexts, Concept of Valuation –Standard of value,
Purpose and Role of Valuation, Valuation contexts, Distinction between Price and
Value; Independence and objectivity; Overview of different valuation models,
financial statements and value drivers.
Reorganizing and Analysis of Financial Statements Accounting policy
Accounting policy, Reorganizing and Analyzing Key Financial and Non-Financial
Ratios to support forecasting future cash flows.
Forecasting Cash Flows, Industry Analysis e.g. (Porter’s Five Force Model),
Audit of internal and external environment e.g. (PEST Analysis); Company analysis
eg. Analysis of the sources of past growth in ROIC and revenue and sustainability
of the same in the context of capabilities of the company. Analyzing the core
competence of the business and its ability to take future opportunities and
resilience to address challenges).
Establishing the relationship between each line item in the Profit and Loss
account with revenue and other drivers of costs and expenses.
Income Approach in valuation.(i) DCF Methods of Valuation: Enterprise Value
Approach, Capital cash Flow Approach, Equity Cash Flow Approach; Adjusted
present value, Valuation based on residual income or economic value added;
forecasting cash flows, determining the cost of capital and discount rate;
determining the terminal value and determining the value of equity from the
enterprise value. (ii) Accounting Based Valuation. (iii) Business valuation in
international setting. (iv) Techniques to manage Risk in Business Valuation.
(v) Market Approach Direct comparison with comparators and multiples. (vi) Other
approaches Asset approach and real option/contingent claim approach. (vii)
Criteria for selecting the appropriate Valuation Method.
Suitability of different valuation methods in different contexts, Choice of
valuation method based on the growth stage of the firm, nature of the industry and
availability of information
References:
1. Aswath Damodaran, Investment Valuation – Tools and Techniques for
Determining the Value of any Asset, John Wiley Publication, 3ed Edition, 2012.
2. Krishna G. Palepu, Paul M. Healy, Business Analysis and Valuation using Financial Statements – Text & Cases, South Western Publication,
4th Edition, 2007.
3. Tom Copeland, Tim Koller, Valuation Workbook – Step by Step Exercise, John Wiley & Sons Publication, 3ed Edition, 2000.
4. Study Material, Paper – 18, Business Valuation Management, the Institute of Cost Accountants of India Publication. (http://icmai.in/upload/Students
/Syllabus-2008/StudyMaterialFinal/P-18.pdf).
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M.Sc. Plant and Machinery Valuation
SECOND YEAR
INTRODUCTION TO BUSINESS VALUATION
CONTENTS
Chapter No.
Title Page No.
1 Introduction to Business Valuation 1
2 Concepts of Business Valuation 13
3 Commonly used Methods of Valuation 30
4 Adjustments to Financial Statements 53
5 Comparative Financial Statement Analysis 61
6 Economic and Industry Analysis 72
7 Business Analysis – Pestle Analysis 77
8 Site Visits and Interviews 83
9 Income Approach to Business Valuation 87
10 Market Approach to Business Valuation 103
11 The Asset-Based Approach to Business Valuation 121
12 Discounts and Premiums 127
13 Weighing of Business Valuation Approaches 137
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CHAPTER - 1
INTRODUCTION TO BUSINESS VALUATION
1.1 INTRODUCTION
Everything has a value. Putting value in monetary terms is the cornerstone not
only of running a business but also of investing in almost any form. Knowing how
to arrive at a value for the physical and intrinsic characteristics of a business is
essential to building wealth of all kinds. To that end, people who invest in
companies need to look beyond the current state of the business they own (or want
to own) and consider what decisions they need to make to boost value. People who
have experience in those industries are often best equipped to make those
decisions, but it often helps to engage a business valuation expert for guidance. In
this section, we discuss the concept of value and note some of the main principles
of business valuation.
1.2 OBJECTIVES
The main objective of this lesson is to give brief introduction of business
valuation and explain art and science of business valuation.
1.3 CONTENTS
1.3.1 Evaluation of Business Valuation
1.3.2 Overview of Business Valuation Industry
1.3.3 Purposes of Valuation
1.3.4 The Science and Art of Business Valuation
1.3.1 Evolution of Business Valuation
“How much is this business interest worth?” This question is not one that is
easily answered. The answer depends on 1) economic factors (these can be local,
regional, national, and international); 2) the premise and standard of value
selected; 3) appropriate valuation method applied; and, 4) interest being valued, to
name just a few factors. In this course, all of the above factors are discussed in
detail.
Historically, the valuation of a closely held company was more of an art than a
science; there was some guidance provided by the IRS and minimal reporting
standards. Accordingly, many in the business valuation profession served as
advocates for the client, rather than as an expert (or advocate for the conclusion of
value). The growth and diversity within the valuation profession, improvement in
software, growing sophistication of the judiciary1 and availability of data through
the Internet has transformed the profession and practice. There is now less
guesswork and more scrutiny.
If the value of a company were determined by a sample of inexperienced or
unqualified valuation professionals, the distribution of Conclusions of Value can be
illustrated by the following bell curve. This bell curve depicts a wide range of values
demonstrating valuation as more of an art than science:
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The distribution of values, obtained from a sample of experienced valuation
professionals, illustrates two important things:
1. The curve is relatively flat, indicating a broad range of opinions of values
2. The range or spread between the highest and lowest conclusion of value
would be relatively large
A vast difference in values is considered detrimental to the credibility of
professionals involved in business valuation activities. Consequently, valuation
valuers must attempt to explain the difference between their different conclusions
of value. One of the primary purposes in this course is to place more emphasis on
the science of performing valuations of closely held companies. That said this does
not mean the course is intended to teach a prescribed format or preferred
methodology.
As valuation theory and practice evolve, one expects the bell curve to evolve
and appear as follows:
This illustration reflects a situation where the various “conclusions of value”
are more similar and the range between the highest and lowest value is smaller.
1.3.2 Overview of the Business Valuation Industry
In the first decade of the 21st century, certain key factors will continue to fuel
the need for valuations of closely held companies.
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History
The valuation of closely held businesses first became a formal issue during the
1920s when businesses involved in the alcoholic beverage industry were forced to
close and found it necessary to value their businesses in order to determine the
extent of their losses. Since the 1920s, closely held businesses have been valued
for a variety of reasons, resulting in the creation of the consulting service niche in
which today’s professionals play a pivotal role.
Economic Instability
During a recessing economy, companies of all sizes react by laying off
personnel. Historically, these layoffs have involved only blue–collar workers. Past
recessions have affected both blue–collar and white–collar employees. In prior
years, companies such as IBM Microsoft and Boeing, once thought of as companies
that could provide unquestioned employment security, have had to lay off
employees. Many employees near retirement are often encouraged to leave early
with golden parachutes or similar incentives. However, other employees became
victims of downsizing, which was especially true at the turn of the 21st century.
Many of these individuals consider the possibility of starting their own
businesses or purchasing an entire or partial interest in an existing business.
Those considering a purchase of an existing business generally require a valuation
of that business. Unstable economic conditions have also caused many companies
to reassess their long-term objectives and strategic direction.
During the 1980s there were mergers and acquisitions of many larger
companies. In the 1990s, and now currently, small- to medium-sized companies
entered the M&A arena. Companies consider merging with or acquiring another
company in order to:
1. Help ensure economic stability in a recessing economy through overhead sharing
2. Maintain or increase market share
3. Establish strategic alliances for growth and diversification
Presently, acquiring companies often require valuations of each company
associated with the proposed combination or purchase. In addition, economic
instability has resulted in increased numbers of bankruptcies. Tax and other
regulations related to these bankruptcies frequently necessitate a business
valuation.
Age Demographics
The retiring parents, who represent the wealthiest generation in history and
whose major assets frequently consist of interests in closely held businesses, need
assistance with their succession planning. Succession planning entails transferring
their businesses in the following ways:
1. Gift the business to their heirs
2. Sell the business to their heirs
3. Sell the business to third parties
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4. Establish a charitable trust
5. Establish an Employee Stock Ownership Plan (ESOP)
6. Issue options to key employees
Regardless of the alternative selected, a valuation is usually necessary.
Litigation Engagements
It has been said that ours is a litigious society; it is. When finances become
strained, there is more pressure on relationships, which often leads to dissolution
or a break-up amongst key employees/ partners/ management, resulting in the
need for a valuation.
1. Valuations are often required in situations involving:
a. Partner disputes
b. Dissenting shareholder actions
c. Fairness opinions
d. Divorces2
2. Valuations are also often necessary in situations that may involve litigation3
related to the establishment of an economic loss involved in the following
types of cases:
a. Wrongful death
b. Wrongful injury
c. Wrongful loss of property
d. Patent infringement
Tax Planning
Tax planning is associated with rights/restrictions of ownership interests in
non–traditional legal entities.
1. Family Limited Partnerships and Family Limited Liability Companies
2. Limited Liability Companies
Financial Reporting
Relatively new but important changes in financial reporting are also increasing
the demand for business valuations. For example, A Financial Reporting Standard
requires that goodwill be tested for impairment at least annually. In order to test
goodwill for impairment, it is necessary to estimate the Fair Value of the acquired
company or business unit.
1.3.3 Purposes of Valuations
Purposes for Valuing Business
Before valuing a company, one must know the purpose of the valuation. There
are four basic purposes for valuing a business; tax, litigation, transaction and
regulatory. The purpose of the valuation will affect the assumptions and
methodologies used to determine value. There are many reasons to have a closely
held business valued, including:
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1. Mergers and acquisitions
2. Sales and divestitures
3. Buy/sell agreements
4. Fairness opinions
5. Shareholder transactions
6. Capital infusions
7. Employee Stock Ownership Plans (ESOPs)
8. Employee benefit plans
9. Expert testimony/litigation support
10. Estate planning and taxation
11. Gift taxes
12. Solvency opinions
13. Insolvency opinions
14. Collateral valuations
15. Purchase price allocations
16. GAAP valuations under FAS 141 and/or FAS 142
17. Charitable contributions
18. Determination of net operating loss in bankruptcy
19. Determination of liquidation value in bankruptcy
20. S Corporation Elections – calculation of built-in gain per asset
21. Banks – loan applications
22. Eminent domain proceedings
23. Marital dissolution
Some of the common reasons for valuations are expanded in the following
paragraphs.
1. Mergers, Acquisitions and Sales
Whenever a company merges with another company, is acquired by another
company, or sold, a valuation is necessary. In a merger situation, a professional
may be asked to establish an “exchange value” of the companies involved. The
valuator may be engaged to establish the value for either or both of the companies.
In a sale or divestiture of a company or of an interest in a company, the seller may
engage a professional’s services to establish a range of values of the business that
will assist the seller in negotiating a sales price. Conversely, a person or company
may engage a professional to perform a valuation of a company they want to
acquire. When businesses are acquired, they are often acquired for a flat or lump-
sum amount. For accounting and tax reasons, the lump-sum purchase price must
be allocated among the various classes of tangible and intangible assets of the
business.
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2. Buy- Sell Agreements
All closely held businesses should adopt a buy-sell agreement among the
partners or shareholders. Much protracted litigation could be avoided if, in the
beginning, the business owners would address the issue of a buy-sell agreement in
their partnership or shareholders agreements. A buy-sell agreement is an
agreement that establishes the methodology to be followed by the parties regarding
the ultimate disposition of a departing or a deceased owner’s interest in a closely
held business. The process of determining the value of the business is directed by
the buy-sell agreement and there are many alternative procedures for doing so.
Some buy-sell agreements provide for the determination of value merely by agreeing
to a value at the beginning of each year. Some agreements are based on a
predetermined or prescribed formula, whereas other agreements require that an
independent valuation be performed periodically. Regardless of the alternative
selected by the owners, a professional may be asked to assist in the valuation
process.
There are two basic types of buy-sell agreements: the stock-repurchase and
cross-purchase agreements. Under a stock-repurchase agreement, the company
agrees to purchase the interest of a departing owner. A cross-purchase agreement
allows the remaining owners to purchase the departing owner’s stock.
An appropriately constructed buy-sell agreement will address several
important items including:
1. What events (e.g., death, disability, etc.) trigger the buyout?
2. How will the buyout be funded: insurance, financing or something else?
3. How soon will the buyout occur, in 30 days, 60 days or longer?
4. How is the interest to be valued, i.e., based on a fixed value, a formula, or a
valuation?
When preparing a business valuation one should always review the existing
buy-sell agreements for restrictions, valuation methodology, puts/calls, terms of
purchase, etc.
3. Employee Stock Ownership Plans (ESOPS)
An ESOP is a type of employee benefit plan. It is considered a defined
contribution plan and is intended to invest primarily in the employer’s stock. The
ESOP is a mechanism by which employees become beneficial owners of stock in
their company.
To establish an ESOP, a firm creates a trust which the employer funds by
either contributing shares of the company and/or contributing cash to buy
company shares. The company can also have the ESOP borrow funds to buy new or
existing shares of company stock. The trustee responsible for managing the ESOP
trust may be a bank, trust company, disinterested individual, company officer or
employee. The contributions a company makes to its ESOP can be tax-deductible
up to an amount equal to 25 percent of the payroll of the participants in the plan.
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Many small- to mid-sized employers have instituted ESOPs. Generally, any
non-publicly traded company with an ESOP must obtain a valuation of its stock on
an annual basis. One significant advantage of an ESOP is that shareholders of a
closely held corporation can defer taxation on the gain resulting from their sale of
company stock to an ESOP, provided the ESOP owns 30 percent or more of a
company’s shares after the sale.
4. Estate, Gift and Income Taxes
In many cases, the value of an interest in a closely held business is an
individual’s primary asset. The value of the closely held business must be
ascertained to adequately perform a thorough and comprehensive estate or
financial plan. It may also be necessary to establish the value of an interest in a
closely held business to properly prepare estate or gift tax returns and to establish
the basis of inherited stock in the hands of an heir to an estate.
Age demographics, as previously stated, will involve parents wanting to retire
who will have to properly deal with the value that has accumulated in their closely
held businesses. There are various ways a business owner can transfer the value
that has accumulated in a closely held business. These include giving the business
to the heirs, selling the business to the heirs or to third parties, or giving the
business to a charity. Regardless of how the business is transferred, an
independent valuation of the business interest is imperative.
If parents die before making transfer arrangements for the business, a value
will have to be established for reporting on an estate tax return.
5. Litigation Support
For a variety of reasons, an attorney involved in a pending lawsuit might need
to determine the value of a closely held business. The professional, as the expert,
will be asked to give expert testimony regarding the conclusions. The need for
litigation support4 relative to business valuations can arise in divorces, partner
disputes, dissenting shareholder actions, insurance claims or wrongful death and
injury cases.
6. Regulatory – Financial Accounting Standards
The FASs now require that independent valuations be made to establish the
purchase value of all intangibles included in a business combination. Similarly,
they also require an annual review of the values of intangible assets in order to
measure whether or not any impairment of the original or carrying value has
occurred.
The independent valuations discussed above will be subject to the audit
process. The independent auditor must possess the skills necessary to evaluate the
valuer’s methods, critical assumptions, and data.
1.3.4 The Science and Art of Business Valuation
Business valuations have become an increasingly attractive practice area for
both large and small firms. As the visibility of this niche market has grown, so too
have the number of articles written about the pros and cons of developing a
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business valuation practice. Many of these, including the recent Journal do a fair
job of identifying the good and the bad of entering the business valuation arena.
While a great deal has been published regarding the development of a business
valuation practice, many of the pitfalls that await the unseasoned practitioner have
not been identified.
And primary among those pitfalls, especially for accountants is the reality that
business valuation, by its very nature, is as much an art as it is a science.
Perhaps the most important difference between business valuation work, and
the more standard accounting staples of audit and tax work, is that business
valuation is still less defined. Although most accountants are familiar with the
liability issues that encumber audit and tax engagements, far fewer are as well
versed in the liabilities associated with offering business valuation services.
When considering the viability of adding business valuation services to the
firm roster, it is important to assess what existing skills can be capitalized on and
what necessary skills must be obtained in order to become a competent business
appraiser.
The Science
A good business valuation product will incorporate skills that many
accountants develop independently in tax and audit work: the ability to think
analytically and question the numbers. In many instances accountants are better
qualified to perform business valuations because of their in-depth knowledge of
financial statements and their understanding of how accounting data can be
reconciled or manipulated. This is especially important as many non-accountant
business valuers, with only limited backgrounds in accounting, are more likely to
take financial data provided by management at face value or perhaps only scratch
the surface when assessing the integrity of the data.
Testing the integrity of the data used in business valuations is very important.
Due diligence is as imperative in business valuation work as it is in any other area
of accounting or consulting services. Given the litigious or regulatory environment
in which business valuations are often performed, reneging on due diligence may
erode the appearance of objectivity or fail to identify materially relevant issues.
While the application of quantitative financial techniques is only part of a
complete business valuation, it is important to understand that a common problem
in the business valuation process is the lack of proper financial information. The
best business valuation scenario would find the valuer receiving all of the
information needed, in a timely manner, and accurately stated.
Unfortunately, in a typical engagement, a more likely scenario places the
appraiser in a situation where the client does not have complete financial records
and only provides those records piecemeal over time. In such instances the
appraiser will likely have to act in a dual capacity reconstructing accounting
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records and then using those records to value the business within the regulatory
confines of valuation organizations to which they may be bound.
In fact, the very processes undertaken in the performance of business
valuations will be controlled, to a certain extent, by the practitioner’s professional
affiliations with such professional valuation organizations. It is fairly rare and very
foolhardy for an accountant to undertake business valuation work without having
had some business valuation training and without having earned one or more
designations from an valuation organization.
While the analysis of financial data may seem a fairly routine task, if
somewhat complex, the affiliations of the valuer may require a more stringent
analysis or may require the valuer to adhere to ethical or operational constraints
that are more restrictive than those that bind the average accountant. Although
there is an emerging trend towards creating uniform standards across the various
valuation organizations, no universal standard has yet been approved or mandated.
The very fact that differences exist indicates the evolving nature of the
business valuation industry. Although a number of guidelines regulate or attempt
to regulate the quality of business valuation services, one appreciates that there is
still a noticeable lack of uniformity between the mandates of various designating
bodies. As such, business valuers must understand exactly what quantitative
analyses are required, and in many cases what analyses are not required, in order
to comply with the requirements of the appraisal organizations with which they are
affiliated.
The Art
Although thoroughly analyzing the quantitative aspects of a business is
important, a good business valuation also incorporates qualitative analyses of the
business, the industry, and the economic conditions in which the business
operates. Since business valuation is as much an art as it is a science, there are
many nuances involved in the determination of value that cause even seasoned and
respected practitioners to disagree on important issues.
Complicating matters is the fact that court rulings in business valuation cases
have not always been historically consistent in setting precedents. Furthermore, in
certain cases even the term “business value” has yet to be defined. For example,
business valuations performed for use in dissenting shareholder actions are usually
completed under the fair value standard of value.
In dissenting shareholder actions, the definition of fair value has been left to
the interpretation in which such actions are brought.
Unlike tax work, business valuations have no clear-cut formulae to follow. A
lot of personal and professional judgment is required in deriving business value,
and it is this subjective element that presents such a challenge for some valuers
who seek inroads into this line of work.
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The lack of a definitive one-size-fits-all approach or formula that can be
applied to all valuation issues is just one of the many challenges a valuer can
encounter when performing business valuations. One of the other major challenges
is obtaining the necessary education and experience in business valuation work to
be able to offer a useful product.
Education Vs. Experience
The Uniform Standards of Professional Valuation Practice, which are
referenced as either rule or guidance by most of the major valuation organizations,
contains the following statement in its Competency Rule: Prior to accepting an
assignment or entering into an agreement to perform any assignment, an appraiser
must properly identify the problem to be addressed and have the knowledge and
experience to complete the assignment competently; or alternatively:
1. Disclose the lack of knowledge and/or experience to the client before
accepting the assignment; and
2. Take all steps necessary or appropriate to complete the assignment
competently; and
3. Describe the lack of knowledge and or experience and the steps taken to
complete the assignment competently in the report.
Becoming a competent business valuer is not an overnight process. While
some advertisements attempt to sell business valuation software programs as
cheap all-in-one packages, the realities of business valuation work are far more
complex.
With the increased use of business valuation reports in litigated matters, the
experience and qualifications of the business valuer are quickly gaining
significance. While an accountant without any specific business valuation training
may be able to go through the proper motions to conduct a business valuation, an
educated and qualified business valuation expert will very likely be able to
damagingly dissect and dispute specific areas of such a valuation. Even in non-
litigated matters the strength and quality of valuer qualifications is also important,
if only to assure the client that they are getting a good product and that they
needn’t look elsewhere for business valuation services.
Selling business valuation services will also rely heavily on the practitioner’s
reputation as a valuer and, given the disparity between the quality and consistency
of business valuation services performed by valuers, it is important to be aware of
the various credentials available to practitioners as well as the regulations adhered
to by the members of each credentialing organization. The following organizations
are the most prominent amongst those that offer business valuation education and
confer business valuation designations.
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1.4 REVISION POINTS
1. Business Valuation
2. Business Accounting
3. Appraisal
1.5 INTEXT QUESTIONS
1. Briefly explain evaluation of business valuation practice.
2. Discuss various purposes for which business valuations are required.
3. How valuation purpose conclusion of business valuation?
4. Elaborate “Business Valuation is an Art and Science”.
5. Do you agree it is very important of qualifications and experience of business
valuer? Justify your views
1.6 SUMMARY
The business valuation is briefly introduced. The purposes for which business
valuations required is discussed. Also discussed “Business Valuation as an art and
science”. Lastly importance of education and experience of business valuer is
discussed.
1.7 TERMINAL EXERCISE
1. Discuss the concepts of business appraisal, business accounting?
2. Discuss the difference in education and experience of sensible asset valuers
and business valuers?
1.8 SUPPLEMENTARY MATERIALS
1. www.business valuation.inc.com
2. www.business dictionary.com
3. www.business valuation.co
1.9 ASSIGNMENTS
1. Discuss the concepts of business appraisal, business accounting, and
business management. Howe they differ from concepts of business
valuation.
2. Discuss how business valuation practice differs from an accountancy
practice and legal advocacy.
3. Discuss differences in education and experience of tangible asset valuers
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1.10 SUGGESTED READINGS/REFERENCE BOOKS
1. Aswath Damodaran, Investment Valuation – Tools and Techniques for
Determining the Value of any Asset, John Wiley Publication, 3ed Edition,
2012.
2. Krishna G. Palepu, Paul M. Healy, Business Analysis and Valuation using
Financial Statements – Text & Cases, South Western Publication, 4th
Edition, 2007.
3. Tom Copeland, Tim Koller, Valuation Workbook – Step by Step Exercise,
John Wiley & Sons Publication, 3ed Edition, 2000.
4. Study Material, Paper – 18, Business Valuation Management, the Institute of
Cost Accountants of India Publication.
(http://icmai.in/upload/Students/Syllabus-2008/StudyMaterialFinal/P-
18.pdf)
1.11 LEARNING ACTIVITIES
Group discussion during PCP days
1. Discuss the concepts of business appraisal, business accounting, and
business management. Howe they differ from concepts of business
valuation.
2. Discuss how business valuation practice differ from an accountancy practice
and legal advocacy.
3. Discuss differences in education and experience of tangible asset valuers
and business valuers
1.12 KEY WORDS
Business Valuation, Purpose
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CHAPTER - 2
CONCEPTS OF BUSINESS VALUATION
2.1 INTRODUCTION
Before embarking on a business valuation, it is essential to gain an
understanding of the Conceptual framework. Some aspects of the valuation may be
mandated by statutory and/or case law, such as the standard of value; other
aspects may be influenced by the law, such as the applicability of certain discounts
or premiums.
It is important to understand the purpose of the valuation, that is, the use to
which the valuation will be put, because that will determine which laws and
regulations govern the valuation. Some valuations are governed by central law and
some by state law, which may vary widely from state to state. Statutes apply for
some valuations, but not for others. Binding precedential case law exists for most
valuations today but not for all.
Whatever the purpose of the valuation, it is subject to attack, both by
regulatory authorities and by parties to the transaction. Knowing and complying
with the basic business valuation concepts is essential to avoiding those attacks in
the first place and to successfully defending against such attacks should they
occur.
2.2 OBJECTIVES
The main objective of this lesson is “search for truth” as it relates to valuation
theory and makes an attempt to reconcile it with practice. In order to develop our
understanding of valuation theory, we must understand and agree upon certain
valuation concepts.
2.3 CONTENTS
2.3.1 Valuation Concepts – Valuation, Appraisal, Value Defined
2.3.2 Theoretical Basis of Value
2.3.3 Value v/s Cost v/s Price
2.3.4 Business Valuer’s Job
2.3.5 Value Determination
2.3.6 Standards of Value
2.3.7 Premise of Value
2.3.8 Purpose Affects the Conclusion of Value
2.3.9 Equity Interest as an Investment
2.3.10 Business Valuation Experts
2.3.11 Due Diligence of Business Valuation Process
2.3.12 Jurisdiction of Business Valuation
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2.3.1 Valuation Concepts A. Valuation
A valuation is a process taken to establish a value for an entire or partial
interest in a closely held business or professional practice, taking into account both
quantitative and qualitative tangible and intangible factors associated with the
specific business being valued.
Definition: The act or process of determining the value of a business, business
ownership interest, security, or intangible asset (as defined in the International
Glossary of Business Valuation Terms (IGBVT)).
B. Appraisal
In the process of performing a valuation of a closely held business, the
valuation valuer may require property appraisals of various specific assets owned
by the company, such as:
1. Art (from a reputable art dealer)
2. Coins (from a reputable coin dealer)
3. Real estate
4. Machinery and equipment (from a reputable appraiser)
5. Jewelry (from a reputable gemologist or dealer)
6. Antiques (from a reputable dealer)
7. Other collectibles (from other reputable dealers)
C. Value of a Particular Business (Defined)
“One of the frequent sources of legal confusion between cost and value is the
tendency of courts, in common with other persons, to think of value as something
inherent in the thing being valued, rather than an attitude of persons toward that
thing in view of its estimated capacity to perform a service. Whether or not, as a
matter of abstract philosophy, a thing has value except to people to whom it has
value, is a question that need not be answered for the sake of appraisal theory.
Certainly for the purpose of a monetary valuation, property has no value unless
there is a prospect that it can be exploited by human beings.” James C. Bonbright
(1891–1985), Professor of Finance, Columbia University
Similar to the value of many items or possessions, the value of an interest in a
closely held business is typically considered to be equal to the future benefits that
will be received from the business, discounted to the present, at an appropriate
discount rate.
This seemingly simple definition of value raises several problems, some of
which are:
1. Whose definition of “benefits” applies?
2. Future projections are extremely difficult to make (absent a crystal ball) and also very difficult to get two opposing parties to agree to.
3. What is an appropriate discount rate?
4. How long of a stream of benefits should be included in this determination of
value?
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The following chapters will address each of the problems posed above, and
provide a variety of practical methods/solutions for resolving them.
2.3.2 Theoretical Basis of Value
Almost everyone has an opinion of value, be it of a business, a tangible asset,
or an intangible asset. Unfortunately, the term “value” means different things to
different people. This presents problems for the valuation valuer who has the
extremely important task of working with clients and other parties to come up with
an appropriate definition of value for a specific valuation.
As defined by Webster’s dictionary, value is:
“A fair return or equivalent in goods, services, or money for something
exchanged; the monetary worth of something; marketable price; relative worth,
utility, or importance; something intrinsically valuable or desirable.”
Three Standards of Value:
Fair Market Value
In the 1990s, Arthur Andersen & Co. provided a tongue-in-cheek definition of FMV:
“Fair Market Value is the amount, price, highest price, most probable price,
cash or cash–equivalent price at which property would change hands or the
ownership might be justified by a prudent investor or at which a willing buyer and
seller would exchange, would agree to exchange, have agreed to exchange, should
agree to exchange or may reasonably be expected to exchange, possibly with equity
to both and both fully aware or having knowledge or at least acting knowledgeably
of the relevant facts, possibly even acting prudently and for self–interest and with
neither being under compulsion, abnormal pressure, undue duress or any
particular compulsion.”
In the U.S., the most widely recognized and accepted standard of value is
termed fair market value (FMV). It is the standard used in all Federal tax matters,
whether it is gift taxes, estate taxes, income taxes or inheritance taxes. The IRS has
defined FMV in Revenue Ruling 59–60 as follows:
“The price at which the property would change hands between a willing buyer
and a willing seller, when the former is not under any compulsion to buy and the
latter is not under any compulsion to sell, both parties having reasonable
knowledge of relevant facts.”
It is important to remember the “willing buyer and willing seller” mentioned
above are considered hypothetical as opposed to specific. Thus a representative
price would not be considered a FMV if it were affected by a buyer’s or seller’s
unique motivations. This would be an example of investment value, defined by real
estate terminology as “value to a particular investor based on individual investment
requirements.”
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In the International Glossary of Business Valuation Terms (IGBVT) (see
Chapter Eight for the full glossary), Fair Market Value has this common definition:
Fair Market Value
Fair market valuer si the price, expressed in terms of cash equivalents, at
which property would change hands between a hypothetical willing and able buyer
and a hypothetical willing and able seller, acting at arms length in an open and
unrestricted market, when neither is under compulsion to buy or sell and when
both have reasonable knowledge of the relevant facts. (NOTE: In Canada, the term
"price" should be replaced with the term "highest price.")
Fair Value
Fair Value can have several meanings, depending on the purpose of the
valuation.
a) In most states, fair value is the statutory standard of value applicable in
cases of dissenting stockholders’ valuation rights. In these states, if a corporation
merges, sells out, or takes certain other major actions, and the owner of a minority
interest believes that he is being forced to receive less than adequate consideration
for his stock, he has the right to have his shares appraised and to receive fair value
in cash. In states that have adopted the Uniform Business Corporation Act, the
definition of fair value is as follows:
“Fair value,” with respect to a dissenter’s shares, means the value of the
shares immediately before the effectuation of the corporate action to which the
dissenter objects, excluding any appreciation or depreciation in anticipation of the
corporate action unless exclusion would be inequitable.
Even in states that have adopted this definition, there is no clearly recognized
consensus about the interpretation of fair value in this context, but published
precedents established in various state courts certainly have not equated it to fair
market value.
Within the valuation profession the strictest definition of fair value of a
minority interest is a pro rata share of a controlling interest valuation on a non-
marketable basis.
The authors of Ibbotson Associates SBBI Valuation Edition 2005 Yearbook
define Fair Value as “…the amount that will compensate an owner involuntarily
deprived of property. Commonly, there is a willing buyer but not a willing seller,
and the buyer may be more knowledgeable than the seller. Fair value is a legal term
left to judicial interpretation. Many consider fair value to be fair market value
without discounts.”
b) Fair Value is also the standard of value used by the Financial Accounting
Standards Board (FASB) in its pronouncements pertaining to business valuation. In
June of 2004 the FASB released its Exposure Draft Fair Value Measurements
which attempts, for the first time, to “define fair value and establish a framework
for applying the fair value measurement objective in GAAP.” Although FASB uses
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the term “fair value” just as it is used in various state statutes, it should be clearly
understood that this is a completely different definition of value. Although FASB’s
definition of fair value should be considered a work in progress, as of June 2006
FASB’s revised definition of Fair Value was as follows:
“Fair value is the price that would be received for an asset or paid to transfer a
liability in a transaction between marketplace participants at the measurement
date.”
c) Fair value may also relate to value in divorce. It may have specific
definitions of fair value with regard to marital dissolution.
Note: The differences in the various definitions used for Fair Value are, at
present, irreconcilable. That is why you will not find this term in the International
Glossary of Business Valuation Terms (IGBVT).
Strategic/Investment Value
Investment value is the value to a particular investor based on individual
investment requirements and expectations. (NOTE: In Canada, the term used is
"Value to the Owner.") (IGBVT)
2.3.3 Value V/s Cost V/s Price
Value
1. Value will vary depending on the perceived value to a specific type of
investor. There are strategic buyers, financial buyers, vulture buyers, ego
buyers, etc. The intangible asset being purchased probably has a different
value to each of them.
2. The value of any financial asset is equal to the net present value of the
expected future cash flows (CF) derived from the asset.
a. Discounted at the required rate of return (k), which is also referred to as
the discount rate.
b. The required rate of return will vary depending on the type of buyer.
Cost
1. One viable perspective on the concept of cost is the fact that it simply
represents a historical fact.
2. The fact that you paid X dollars for an asset one day, one year or one decade
ago has little, if any, relationship to its current value. Examples: home
appreciation; new car depreciation one minute after driving it off the sales
lot.
3. In a business context, the balance sheet simply represents a historical
tracking of costs incurred to acquire certain assets. The book value of the
stockholders’ equity account is, in fact, a misnomer. It is more properly
entitled book cost.
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Price
1. Price is a term that is used in many ways. Offering price, market price,
dealer’s price, FMV price, are common variations of the term.
2. Offering price simply represents a number that a seller is asking for an
asset; (a) Examples: sticker price on a new auto, store price tag on a
garment, (b) The unsophisticated layperson believes that if there is a wide
enough gap between the (asking) price and the cost he/she will actually pay
(in effect a discount), he is receiving value.
3. In the business valuation world, price is most commonly thought of as the
value received as adjusted for the terms of the transaction. For example, An
owner A sells his company for Rs. 10,000,000 for cash and Owner B sells his
business for Rs. 10,000,000 on a non-interest-bearing note for 10 equal
annual payments of Rs. 1,000,000. Both owners paid the same price, but
the underlying value is different.
2.3.4 Business Valuer’s Job
1. To estimate economic value
2. Achieve the above goal by rigorously exercising the three approaches
available to him/her
a. In reality, the asset-based (cost) approach references a distinct historical
market— the market responsible for the creation of the historical balance
sheet.
b. The market approach references actual transactions in either distinct
entire company acquisitions or thousands of fractional market
transactions in the public stock market.
c. Even the income approach, in one very real sense, is market-based due
to the fact that the risk-free rate, the equity market premium (market
again) and even the valuer’s estimate of the company-specific risk
premium, are all market derived.
2.3.5 Value Determination
1. The litmus test to verify that one is reasonably determining value is to
invoke the three valuation approaches.
2. By correlating the results of one approach against the other two approaches,
one can reasonably (and comfortably) validate that one has received (or
determined) value.
Example: you are buying a new car at a dealership. You are being told that
you are getting a great deal because of the huge cash back rebate amounting to a
sizable discount from the original sticker price. Once you drive the new vehicle off
the lot, it becomes a used car. Check the evidence derived from the market
approach to verify if the recommended prices for your newly acquired used car with
one-mile on it closely approximates your hugely discounted cost. If the price
exceeds your purchase cost, you indeed received value—as of that moment.
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2.3.6 Standards of Value
Fair Market Value
FMV addresses the broadest end of the spectrum of potential buyers. It is the
most common standard of value used in business appraisals today, particularly for
U.S. tax-related events. Two definitions are classically given for this standard:
1. The price at which the property would change hands between a willing buyer
and a willing seller, when the former is not under any compulsion to buy
and the latter is not under any compulsion to sell; both parties having
reasonable knowledge of relevant facts.
2. The price, expressed in terms of cash equivalents, at which property would
change hands between a hypothetical willing and able buyer and a
hypothetical willing and able seller acting at arm’s length in an open and
unrestricted market, when neither is under compulsion to buy or sell and
when both have reasonable knowledge of the relevant facts.
3. Key concepts:
a. Presumed ownership change at a specific date Hypothetical willing
buyer, willing seller – Fair market value does not contemplate specific
individuals as the buyer or seller. In most cases, the presumed
hypothetical buyer is interested only in a financial return from the
business (the hypothetical buyer is a financial buyer) and has no special
interest, such as combining the business with similar operations already
owned. However, in the limited case where the pool of willing buyers for
a business consists primarily of special buyers (or strategic buyers), as
can be the case in periods of intense industry consolidation, the willing
buyer may be defined as a special buyer, and some level of synergistic
value may be incorporated into fair market value. No compulsion to
transact on either party’s part
b. Reasonable knowledge by both parties
c. Cash or cash equivalent price
d. Transaction costs not included
e. Generally assumed to include a covenant not to compete. However, this
can be somewhat controversial in some jurisdictions.
Investment Value
Investment value—is defined as the value to a particular buyer (or small
handful of buyers).
1. By definition, this extremely small and limited market is typically
characterized by a premium because of the unique synergy(ies) the perceived
particular buyer would realize as a result of acquiring the asset.
2. The value that a particular investor considers, on the basis of individual
investment requirements such as:
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a. Differences in estimates of future earning power
b. Differences in perception of the degree of risk and the required rate of
return
c. Differences in financing costs and tax status
d. Synergies with other operations owned or controlled
3. Investment value is sometimes referred to as strategic value due to the
synergy aspect of the transaction. An exchange transaction is contemplated
in this standard of value.
Fair value
Fair value has two different contexts:
1. Fair value for legal purposes
a. Primarily used in dissenting stockholder actions and shareholder
oppression cases
b. The definition varies from jurisdiction to jurisdiction as specified in state
statutes and developed in the state’s case law precedents.
c. This standard of value is legal community-based, not economically or
market based.
2. Fair value for financial reporting purposes
a. Fair value is defined as: the price that would be received to sell an asset
or paid to transfer a liability in an orderly transaction between market
participants at the measurement date.
b. Fair value is now an exit price (sell-side), which means the price a
company would receive if they were to sell an asset in the marketplace or
paid if they were to transfer the liability. Transaction costs are excluded
from fair value.
c. Market participants are buyers and sellers in the principal or most
advantageous market for an asset or liability. Market participants are:
1. Unrelated (i.e., independent) to the reporting entity Knowledgeable
about factors relevant to the asset or liability and the transaction
2. Have the financial and legal ability to transact
Are willing to transact without compulsion
d. The “fair value hierarchy” prioritizes the inputs used in valuation and
impacts the level of disclosure, but not the valuation techniques
themselves (i.e., choose the best approach first, then the highest priority
inputs).
1. Level I : Quoted prices in active markets for identical assets/liabilities
2. Level II : (a) Observable prices for similar assets/liabilities, (b) Prices
for identical assets/liabilities in an inactive market, (c) Directly
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observable inputs for a substantially full term of an asset/liability, (d)
Market inputs derived from or corroborated by observable market
data.
3. Level III : Unobservable inputs based on the reporting entity’s own
assumptions about the assumptions a market participant will use
e. Fair value for financial reporting purposes and fair market value are
similar concepts, although differences can exist.
f. Fair value assumes the highest and best use for an asset. Reporting
entities need to determine if highest and best use for an asset is in-use
or in-exchange (valuation basis), regardless of management’s intended
use for the asset. (Market participant perspective)
1. Highest and Best Use is In-Use if: (a) Asset has maximum value in
combination with other assets as a group (installed or configured),
and (b) Typically non-financial assets
2. Highest and Best Use is In-Exchange if: (a) Asset has maximum value
on a stand-alone basis, (b) Typically financial assets
g. There are many other issues that need to be considered in determining
fair value for financial reporting purposes, which are beyond the scope of
this course.
Intrinsic value
1. The value that a prudent investor considers, on the basis of an evaluation or
available facts, to be the “true” or “real” value that will become the market
value when other investors reach the same conclusion
2. What the value should be based on analysis of all the fundamental factors
inherent in the business or the investment
3. Does not consider extreme aspects of market conditions and behaviour.
2.3.7 Premise of Value
A. Going concern value premise—all the foregoing definitions of value assume
an ongoing business, though FMV could also be a liquidation value.
B. Liquidation value premise—the appraiser / prudent investor (buyer)
assumes the business will NOT continue in its present form and will be
dismantled. This dismantling is driven by the belief that the business is
better off dead than alive. There are two forms of liquidation:
1. Orderly liquidation : The expected gross proceeds from the sale of the
asset (i) Held under orderly sales conditions; (ii) Given a reasonable
period of time in which to find purchasers; (iii) Considering a complete
sale of all assets as is, where is, with the buyer assuming all costs of
removal; (iv) With all sales free and clear of all liens and encumbrances;
(v) With the seller acting under compulsion; (vi) Under current economic
conditions, as of a specific date.
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2. Forced liquidation: The expected gross proceeds from the sale of the
asset that could be realized at a properly advertised and conducted
public auction held under forced sale conditions, with a sense of
immediacy, lack of adequate time to find purchasers. Fire sale values
may apply under current economic conditions, as of a specific date.
C. Value in exchange vs. value in use
1. The premise of value in exchange presupposes a proposed transaction of
the property, wherein the property actually changes ownership hands.
This value premise references market conditions external to the company
being appraised. As such, the value standards of investment value, fair
market value and liquidation value are properly classified under this
premise.
2. The premise value in use does not presuppose a proposed transaction of
the property, whereby the property actually changes ownership hands. It
does not reference market or economic conditions external to the
company being appraised. It assumes that the current economic return
(profitability) of the company being appraised is of sufficient magnitude
to provide a reasonable basis to a prudent investor that the company has
adequate financial strength to continue operating into the future.
3. This value in use premise is sometimes (confusingly) referred to as fair
market value in continued use (because no exchange market vehicle is
contemplated). By definition, this premise is softer in nature than the
value in exchange premise -which has hard market contours defining its
shape.
2.3.8 Purpose Affects the Conclusion of Value
Before a valuation expert proceeds in valuing a business, he/she must
recognize the purpose for which the valuation is needed. Different purposes require
the use of different valuation methods and approaches and will frequently generate
different values. A Professional Standards require the valuation expert specifically
and carefully define the purpose of each valuation. “No single valuation method is
universally applicable to all appraisal purposes. The context in which the appraisal
is to be used is a critical factor. Many business appraisals fail to reach a number
representing the appropriate definition of value because the appraiser failed to
match the valuation methods to the purpose for which it was being performed. The
result of a particular appraisal can also be inappropriate if the client attempts to
use the valuation conclusion for some purpose other than the intended one.”
All valuations can be classified as either for Tax Purpose or Non-Tax Purpose:
A. Tax Valuations
1. Estate tax
2. Gift tax
3. ESOPs
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4. Allocation of lump-sum purchase price (Code §§338 and 1060 allocations)
5. Charitable contributions
6. Calculation of the Built-in Gain (BIG) for S Corporation Elections
B. Non-Tax Valuations
1. Purchase
2. Sale
3. Merger
4. Buy-sell agreements
5. Regulatory valuations: asset allocation/valuation under Financial Accounting Standards
6. Litigation support
a. Partner/shareholder disputes: There is a growing need for valuation
services in this area
b. Divorce actions: State law governs disputed property settlements. Most
states have failed to establish standards of value
c. Damage/economic loss cases : (1) Breach of contract (2) Lost business
opportunity (3) Antitrust and like
2.3.9 Equity Interest as an Investment
The purchase of an equity interest in a closely held business should be treated
no differently than the purchase of any other investment. The investor should not
only expect to receive the investment (the amount invested or principal) back, but
should also expect to receive a fair return on the investment. The return should be
commensurate with the amount of risk involved. When thinking of the purchase of
an equity interest as an investment, there are certain principles to be kept in mind.
A. The Alternatives Principle
a. This principle applies to valuing businesses in the context of buying or
selling a business.
b. In any valuation involving a business that is being offered for sale, it must
be realized that both the buyer and the seller have alternatives (choices), and
do not necessarily need to enter or proceed with a proposed purchase/sale
transaction
B. The Principle of Substitution
The value of an asset tends to be determined by the cost of acquiring an
equally desirable substitute.
C. The Investment Value Principle
1. Valuation of security interests in closely held businesses is often a very
difficult process. This is due to the lack of an active free trading market for
securities in closely held businesses. Because of this lack of a market, many
small closely held businesses are valued based on the investment value
principle or approach.
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2. Simplified formula:
Value = (Benefit stream) / (Required Rate of Return)
If any two of the three variables are known, the value of the third can be
calculated:
a. The investment value of the business (present value)
b. The amount of return (profit) that a business provides to its owner
c. The rate of return expected on the investment (sometimes referred to as
yield)
2.3.10 Business Valuation Experts
Preferably, the expert also will be certified by one of the relevant accrediting
bodies. Merely being qualified as a business appraiser does not qualify one as an
expert in the field. Instead, experts are distinguished by their credentials, skills,
experience, and training. To be recognized as an expert, testimony often requires
that the appraiser has distinguished himself among his peers, has exceptional
qualifications or training, has spoken at professional meetings on the topic, and/or
has published scholarly articles on the relevant subject matter.
There are as many different kinds of valuers as there are uses for them. Some
valuers concentrate only on real estate or perhaps further sub-specialize in certain
types of real estate such as commercial land. Others, business valuers, specialize in
closely held businesses, or even single aspects of closely held businesses, such as
compensation issues pertaining to executives or owners. Still other valuers may
address issues such as transfer pricing, employee stock ownership plans (ESOPs),
or limited partnerships.
Various roles an Expert is expected to play are:
Advising a client on a business valuation independent of, and prior to, a
controversy relating to the valuation
Providing an opinion that will be used before the Service in an audit, or at
the Appellate
Division in an appeals conference
Assisting counsel out of court in understanding technical issues and
preparing for the case
Testifying in court to an opinion that will be included in a trial record
2.3.11 Due Diligence of Business Valuation Process
Questions to be Answers
1. Whether the expert’s testimony is reliable
2. Whether the theory or technique can be and has been tested
3. Whether the theory or technique has been subjected to peer review and
publication.
4. The method’s known or potential rate of error
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5. Whether the theory or technique finds general acceptance in the relevant
subject matter’s Community
6. Whether the expert is proposing to testify about matters related to research
conducted independent of the litigation
7. Whether the expert has unjustifiably extrapolated from an accepted premise
to an unsubstantiated conclusion
8. Whether the expert has accounted for alternative explanations
9. Whether the expert employs in the courtroom the same level of intellectual
rigor that characterizes the practice of the expert in the expert’s workplace
2.3.12 Jurisdiction of Business Valuation
Valuers must carefully consider the various features of each business
organization when performing a business valuation. An organization’s
characteristics affect valuation because they define and influence such things as
cash flow and transferability of the business interest. Central and state laws
determine many parameters of the entity, but counsel can also contribute to the
ultimate valuation of an entity by drafting agreements with terms and conditions
that restrict ownership of securities and conduct of the business. By adding a put
or call option to a limited partnership interest, by restricting shares with the right
of first refusal, or by limiting dividends on corporate shares, one seriously impacts
the rights and privileges of those property interests and correspondingly affects
their value for tax purposes.
We now turn to the role that the kind of business organization may have on
valuation. A brief example will be helpful to our discussion. Assume that RKP has
been in the business of selling computers for the last several years, operating as a
sole proprietor. Business has been good and so he decides to expand. He needs
additional investment capital and decides to solicit a few investors.
Assume that he has the choice of incorporating his business or organizing as a
limited partnership. Will the choice of organization alter value? Would it make any
difference to the value of the business if he incorporated and then has corporation
elected to be taxed as corporation? In essence, does the form of the organization
affect its valuation for any purposes?
Among the major organizational choices or forms are:
Corporations
Limited liability companies
Partnerships
Limited partnerships
Sole proprietorships
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Corporations
A corporation is an artificial person or legal entity created under the laws of a
state; it has six major attributes:
1. A corporation is created by filing articles of incorporation. The articles of
incorporation contain information about authorized shares and possible
restrictions on the shares. The bylaws of the corporation come into existence
at about this time and may also address restrictions applicable to the
shares. For instance, the corporation may decide to restrict the number of
shares to be issued, establish rules for voting control, or define how
directors are elected. Restrictive provisions may inhibit transferability of
shares and thus negatively impact the value of the shares in the corporation.
2. The corporation is a separate legal entity. The corporation does business in
its own name and on its own behalf, rather than in the name of its
shareholders. The corporation may contract in its own name, similar to a
person doing business; it has powers to do all things necessary to conduct
business.
3. A corporation has centralized management that is distinct from the owners
of the corporation. A corporation is run by its board of directors. Each
director is elected by the shareholders. The board, in turn, appoints
management to conduct the daily affairs of the corporation. This means that
investors may remain passive. Valuers pay careful attention to management,
as they want to know if management is talented and capable enough to
create a successful business. Valuers must also look at management’s
compensation to ensure that it is structured to reward successful
management, and thereby ensure the continued vitality of the business.
4. A corporation has perpetual life. The corporation endures by law until
merger, dissolution, or some other matter causes it to terminate. It is never
destroyed by a person’s death. Valuers may consider perpetual life to be an
advantage over a form of organization with a finite life, such as ten years or
the life of the owner.
5. Corporate ownership is freely transferable. Absent restrictions adopted by
shareholders or the corporation itself, shareholders are free to sell, gift, or
transfer their shares. When, however, the transferability of the shares is
restricted, either by law or agreement, the restrictions are likely to reduce
the value of the shares. This reduction in value is sometimes desirable. For
instance, family members may want to have a buy-sell agreement that
defines and restricts the sale of shares to only family members. Such
restrictions may inhibit value, but the Service closely scrutinizes such
agreements out of concern that values may be artificially reduced.
6. Limited liability. Shareholders, management, and board members do not
become personally liable for corporate obligations. This alone is a strong
attraction of the corporation. Members of limited liability companies, and
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limited partners in a limited partnership, also enjoy some aspects of limited
liability. However, partners in a general partnership are personally liable for
the obligations of the partnership. Valuers must take into consideration
exposure to liabilities as an element of value. Since the corporate form limits
the liability of the shareholders, the corporate form itself has added value.
Quantifying that value depends on the facts and circumstances of the
particular business being valued. The biggest downside of traditional
corporations is double-taxation. Corporations are taxed as legal entities
separate from their shareholders. Income, taxed at the corporate level, is
taxed again, either as ordinary income when distributed as a dividend or as
capital gains when shareholders sell their shares.
Limited Liability Partnerships/ Companies
A limited liability partnership/ company (LLP) is a hybrid, unincorporated
business organization that shares some aspects of corporations and partnerships.
The Service has ruled that the LLP can be taxed as a partnership, if the taxpayers
so elect. Gains and losses are not taxed at the entity level, but are passed through
to its members. LLP members may actively participate in management. The LLP
nominally offers limited liability to its members similar to that of a corporation. And
it is not as hard to qualify as an LLP as it is to qualify for corporation status.
General Partnerships
A general partnership is an association of two or more people or entities
engaged in an activity for profit. The partnership is not taxed; the gains and losses
are passed through to the partners, who are taxed on their share of partnership
gains. Each partner is jointly and severally liable for the partnership obligations, for
the acts of the other partners, and for acts of the partnership’s agents in
furtherance of partnership business. Potential liability is unlimited, and partners
can be pursued personally for partnership debts.
Limited Partnerships
The limited partnership (or limited liability company) seems to be the entity of
choice for practitioners who desire to maximize discounts for lack of marketability
and minority interests. Limited partnerships and limited liability companies lend
themselves to valuation discounts. To create a limited partnership, one must file a
certificate of limited partnership with the state where the partnership is formed.
The certificate identifies key features of the partnership and indicates whom its
partners are. A limited partnership has at least two classes of partners: a general
partner, who has unlimited liability and is responsible for making the major
partnership business decisions; and limited partners, whose liability exposure is
limited to the capital that they have invested. Limited partners have limited liability
similar to that of shareholders in a corporation. To achieve this limited liability,
however, limited partners must refrain from participating in most business
decisions of the partnership. Those decisions, instead, are made by the general
partner, who is liable for them. Income or loss passes through to the partners, who
have the responsibility to report it and pay any resulting tax. An important wrinkle
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is that, while gains and losses are passed through to the partners, the decision to
distribute cash is left to the general partner. Thus, if a general partner withholds
cash distributions, a limited partner must pay taxes on money he does not receive.
This aspect is particularly important to creditors of limited partners, who cannot
access partnership assets to pay the partnerships debts. In this regard, the limited
partnership provides some asset protection.
There are three more typical features of limited partnerships:
a. Limited partners usually are not able to assign or pledge their limited
partnership interest as collateral. (Notwithstanding prohibitions in the partnership agreement, most lending institutions would not make a loan
based on a limited partnership interest, anyhow.)
b. General partners control the decisions of the partnership pertaining to the acquisition of assets and the incurring of partnership liabilities.
c. Limited partners who desire to sell must usually first offer their partnership interests to the partnership or other partners.
Sole Proprietorships
A sole proprietorship is an individual carrying on business under his/ her own
name or under an assumed name. He is taxed as an individual. He has unlimited
tort and contract liability.
2.4 REVISION POINTS
1. Concept of Business valuation
2. Standard of value
3. Investment value
2.5 INTEXT QUESTIONS
1. Describe and Differentiate: (1) Valuation and Appraisal, (2) Fair Value and
Fair Market Value, (3) Investment Value and Liquidation Value, (4) Value,
Cost and Price, (5) Intrinsic Value and Liquidation Value, (6) Going Concern
Value and Liquidation Value, (7) Orderly Liquidation Value and Force
Liquidation Value
2. Discuss various basis of business value.
3. Explain standards of value.
4. Elaborate “Purpose Affect Business Value”.
5. Discuss “Equity Interest as an Investment”.
6. What are the qualities of Business Valuation Expert?
7. How will you conduct due diligence of business valuation process?
8. Explain jurisdictions of business valuation in view of different kinds of
organization.
2.6 SUMMARY
The basic concepts of the business valuations have been discussed. The
business vlauer is expected to be conceptually clear about the basic concepts.
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2.7 TERMINAL EXERCISE
1. Explain the valuation concept?
2. Differentiate fair market value and fair value?
2.8 SUPPLEMENTARY MATERIALS
1. https://www.fundera.com
2. https://www.business.gov.in
2.9 ASSIGNMENTS
1. Remind the industry in which you have reasonable knowledge or expertise.
You are consulted to do valuation of that industry. You are required to
collect necessary information basically required to make basis of further
valuation exercise.
2. To act as business valuer, list out what qualities, educations, experience,
training you need to acquire
2.10 SUGGESTED READINGS/REFERENCE BOOKS
1. Aswath Damodaran, Investment Valuation – Tools and Techniques for
Determining the Value of any Asset, John Wiley Publication, 3ed Edition,
2012.
2. Krishna G. Palepu, Paul M. Healy, Business Analysis and Valuation using
Financial Statements – Text & Cases, South Western Publication, 4th
Edition, 2002.15.
3. Tom Copeland, Tim Koller, Valuation Workbook – Step by Step Exercise,
John Wiley & Sons Publication, 3ed Edition, 2000.
4. Study Material, Paper – 18, Business Valuation Management, the Institute of
Cost Accountants of India Publication.
(http://icmai.in/upload/Students/Syllabus-2008/StudyMaterialFinal/P-
18.pdf)
2.11 LEARNING ACTIVITIES
Group discussion during PCP days
1. Remind the industry in which you have reasonable knowledge or expertise.
You are consulted to do valuation of that industry. You are required to
collect necessary information basically required to make basis of further
valuation exercise.
2. To act as business valuer, list out what qualities, educations, experience,
training you need to acquire
2.12 KEY WORDS
Valuation, Appraisal, Investment Value, Fair Value, Intrinsic Value,
Liquidation Value, Premise of Value, Expert, Due Diligence
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CHAPTER - 3
COMMONLY USED METHODS OF VALUATION
3.1 INTRODUCTION
Here we do a quick but rigorous review of valuation techniques. Traditional
methods, including discounted cash flow, asset accumulation, value multiples and
option pricing, are covered, in the context of the challenges they pose to real-world
practitioners. Addressed first is the general framework is constructed for selecting a
valuation method. This feature is extremely valuable to the professional valuer who
first has to decide which technique to use. The explicit consideration is given to
methods for combining different values for the same asset into given circumstances
and because practitioners normally use more than one valuation methods, specific
guidance on how to do so needs thorough understanding of valuation techniques
and methods. It is also required to understand where to get the data to structure
cash flows; how to account for the impact of inflation—which may be a worrisome
issue in many emerging markets—and whether perfecting cash flows may be more
important than computing a plausible cost of capital. Finally, it is required to
emphasize the importance of intermingling theoretical finance with the approaches
used by real-world professional valuers.
3.2 OBJECTIVES
The main objective of this lesson is to give adequate knowledge of various
business valuation approaches and methods and application of appropriate method
for given circumstances and cases of valuation.
3.3 CONTENTS
3.3.1 Overview of Business Valuation Methods
3.3.2 Asset Based Approach
3.3.3 Income Approach
3.3.4 Effect of Controlling Interest in Business
3.3.5 Lack of Control Interest
3.3.6 Mid-Period vs. End-of-Period Discounting Method
3.3.7 Gordon Growth Model
3.3.8 Market Approach
3.3.9 Other Approaches: Income/Asset Approaches
3.3.1Overview of Business Valuation Methods
Business owners frequently have the need or desire to establish a value for
their business. As was discussed in Chapter One, there are many reasons for
valuing a business. Professionals involved in valuing closely held businesses know
it is not a simple task. The complexity is further compounded by the fact that each
business owner’s purpose, motive, and goal in valuing the business varies greatly
from those of others. No two businesses are alike; therefore, no one size fits all. The
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effect these issues may and usually do have on the valuation process gives rise to
the concept that the valuation process is more of an art than a science.
There are several commonly used methods of valuation. Each method may at
times appear more theoretically justified in its use than others. The soundness of a
particular method is entirely based on the relative circumstances involved in each
individual case. The valuation valuer responsible for selecting the most appropriate
method must base his or her choice of methods on knowledge of the details of each
case. When this knowledge is appropriately applied, much of the art factor is
eliminated from the process and valuation becomes more of a science. The objective
of the Business Valuation Certification Training Center is to make the entire
process more objective in nature.
The commonly used methods of valuation can be grouped into one of three
general approaches, as follows:
Asset Based Approach
a. Book Value Method
b. Adjusted Net Asset Method
Replacement Cost Premise
Liquidation Premise
Going Concern Premise
Income Approach
a. Capitalization of Earnings/Cash Flows Method
b. Discounted Earnings/Cash Flows Method
Market Approach
a. Guideline Public Company Method
b. Comparable Private Transaction Method
c. Dividend Paying Capacity Method
d. Prior Sales of interest in subject company
Other Approaches
a. Income/Asset
Excess Earnings/Treasury Method1
Excess Earnings/Reasonable Rate Method1
b. Sanity Checks
Justification of Purchase
Rules of Thumb
These lists, while not 100 percent inclusive, represent the commonly used
methods within each approach a valuation valuer will use.
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3.3.2 Asset Based Approach
The asset based approach is defined in the International Glossary of Business
Valuation Terms as “a general way of determining a value indication of a business,
business ownership interest, or security using one or more methods based on the
value of the assets net of liabilities.” Any asset-based approach involves an analysis
of the economic worth of a company’s tangible and intangible, recorded and
unrecorded assets in excess of its outstanding liabilities. Thus, this approach
addresses:
“The value of the stock of a closely held investment or real estate holding
company, whether or not family owned, is closely related to the value of the assets
underlying the stock. For companies of this type the appraiser should determine
the fair market values of the assets of the company … adjusted net worth should be
accorded greater weight in valuing the stock of a closely held investment or real
estate holding company, whether or not family owned, than any of the other
customary yardsticks of appraisal, such as earnings and dividend paying capacity.”
While the quote above clearly applies to holding companies, asset based
approaches can also be valid in the context of a company which has very poor
financial performance. An important consideration when using an asset approach
is the premise of value, both for the company and for individual assets.
Book Value Method
This method is based on the financial accounting concept that owners’ equity
is determined by subtracting the book value of a company’s liabilities from the book
value of its assets. While the concept is acceptable to most valuers, most agree that
the method has serious flaws. Under generally accepted accounting principles
(GAAP), most assets are recorded at historical cost minus, when appropriate,
accumulated depreciation or cumulative impairments. These measures were never
intended by the accounting profession to reflect the current values of assets.
Similarly, most long-term liabilities (bonds payable, for example) are recorded at the
present value of the liability using rates at the time the liability is established.
Under GAAP, these rates are not adjusted to reflect market changes. Finally, GAAP
does not permit the recognition of numerous and frequently valuable assets such
as internally developed trademarks, trade names, logos, patents and goodwill.
Thus, balance sheets prepared under GAAP make no attempt to either include or
correctly measure the value of many assets. Thus, by definition, owners’ equity will
not normally yield a valid measure of the value of the company. Despite these
significant limitations, this approach can frequently be found in buy/sell
agreements.
Adjusted Net Assets Method
This method is used to value a business based on the difference between the
fair market value of the business assets and its liabilities. Depending on the
particular purpose or circumstances underlying the valuation, this method
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sometimes uses the replacement or liquidation value of the company assets less the
liabilities. Under this method the valuer adjusts the book value of the assets to fair
market value (generally measured as replacement or liquidation value) and then
reduces the total adjusted value of assets by the fair market value of all recorded
and unrecorded liabilities. Both tangible and identifiable intangible assets are
valued in determining total adjusted net assets. If the valuer will be relying on other
professional valuers for values of certain tangible assets, the valuer should be
aware of the standard of value used for the appraisal. This method can be used to
derive a total value for the business or for component parts of the business.
The Adjusted Net Assets Method is a sound method for estimating the value of
a non-operating business (e.g., holding or investment companies). It is also a good
method for estimating the value of a business that continues to generate losses or
which is to be liquidated in the near future.
The Adjusted Net Assets Method, at liquidation value, generally sets a “floor
value” for determining total entity value. In a valuation of a controlling interest
where the business is a going concern, there would have to be a reason why the
controlling owner would be willing to take less than the asset value for the
business. This might occur where the assets are under- performing, resulting in a
conclusion of value that is less than the adjusted net assets value but more than
the liquidation value. Before concluding the Adjusted Net Assets Method has
established the floor value, the valuer should consider the potential of overstating
the value of assets, existence of non-operating assets, and other omissions in
his/her determination.
The negative aspect to this method is that it does not address the operating
earnings of the business. Therefore, it would be inappropriate to use this method
to value intangible assets, such as patents or copyrights, that are typically valued
based on some type of operating earnings (e.g., royalties). However, replacement
cost methodology may be utilized in determining values of certain intangibles such
as patents.
Illustration – the following reconciliation between book values and fair market
values incorporates four major adjustments:
1. To remove non-operating assets, for example: excess cash and cash
surrender value of life insurance.
2. To convert LIFO inventory to FIFO inventory.
3. To estimate NPV of the deferred income tax liability associated with the
built-in gain on LIFO reserve and PP&E based on a liquidation horizon
discounted to NPV using a discount rate (risk free rate).
4. To adjust property and equipment to estimated fair market value based on
appraisal performed by ABC Appraisals, Inc.
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Book Value (Rs.)
Adjustment (Rs.)
Fair Market Value (Rs.)
A. Current Assets:
Cash and Cash
Equivalents
11,19,300 -5,18,000 6,01,300
Accounts Receivable 16,68,232 - 16,68,232
Raw Materials 3,06,752 1,87,706 4,94,458
Work in Process and
Finished Goods
70,930 - 70,930
Deferred Income Taxes 86,000 - -
Prepaid Expenses 60,850 - 60,850
Total Current Assets
33,12,064
-
28,95,770
B. Property, Plant and
Equipment, at Cost:
Land 88,828 4,572 93,400
Buildings and
Improvements
11,22,939 - 8,17,451
Machinery and
Equipment
25,60,044 - 11,80,334
Vehicles 8,04,336 - 1,75,465
Office Equipment 4,19,284 -3,63,859 55,425
Total Property and
Equipment
49,95,431 - 23,22,075
Less Accumulated
Depreciation
-33,76,371 33,76,371 -
Net Property and
Equipment
16,19,060 7,03,015 23,22,075
C. Other Assets:
Cash Value of Life
Insurance
2,52,860 - -
Deposits 30 - 30
Total other Assets 2,52,890 -2,52,860 30
Total Assets 51,84,014 33,861 52,17,875
D. Current Liabilities:
Note Payable to
Shareholders
17,000 - 17,000
Accounts Payable 3,14,554 - 3,14,554
Income Taxes Payable -80,199 - -80,199
Accrued Liabilities 4,11,512 - 4,11,512
Total Current Liabilities 6,62,867 - 6,62,867
E. Long-Term Debt, Less
Current Portion
1,00,000 - 1,00,000
Deferred Income Taxes – 2,53,000 2,53,000
Total Liabilities 7,62,867 2,53,000 10,15,867
E. Net Assets 44,21,147
F. Adjusted Net Tangible Operating Asset Value (Rounded)
42,02,000
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Book Value (Rs.)
Adjustment (Rs.)
Fair Market Value (Rs.)
G. Non-Operating Assets:
Excess Cash
5,18,000
Cash Surrender Value of
Life Insurance (Rounded) 2,53,000
H. Adjusted Net Tangible Assets
49,73,000
In this example, an adjustment for deferred taxes was made. Not making an
adjustment for deferred taxes would be theoretically justified in a situation where
the valuer is valuing a business for purposes of an Asset Purchase/Sale. However,
an adjustment for deferred taxes may be appropriate in a valuation of a Corporation
when the equity securities of the corporation are to be valued and adjustment has
been made to adjust the value of assets from historical amounts to an
economic/normalized balance sheet.
A crucial point to consider in dealing with taxes is the nature of the
investment being valued. A buyer who is considering acquiring an interest in a
company as an asset purchase should be aware that a step-up in basis will be
received, resulting in additional depreciation and tax benefits. In this case, the tax
liability for any capital gains will be with the former owner. As such, the buyer
should be willing to pay full market price for the assets (less any commissions or
brokers’ fees).
3.3.3 Income Approach
An income approach be used when it lists “the earning capacity of the
company,” as a factor to be considered. The income approach is defined in the
International Glossary of Business Valuation Terms as, “A general way of
determining a value indication of a business, business ownership interest, security,
or intangible asset using one or more methods that convert anticipated economic
benefits into a present single amount.”
Capitalization of Earnings/Cash Flows Method
The Capitalization of Earnings Method is an income-oriented approach. This
method is used to value a business based on the future estimated benefits,
normally using some measure of earnings or cash flows to be generated by the
company. These estimated future benefits are then capitalized using an
appropriate capitalization rate. This method assumes all of the assets; both tangible
and intangible are indistinguishable parts of the business and does not attempt to
separate their values. In other words, the critical component to the value of the
business is its ability to generate future earnings/cash flows. This method
expresses a relationship between the following:
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Estimated future benefits (earnings or cash flows)
Yield (required rate of return) on either equity or total invested capital (capitalization rate)
Estimated value of the business
It is important that any income or expense items generated from non-operating
assets and liabilities be removed from estimated future benefits prior to applying
this method. The fair market value of net non-operating assets and liabilities is
then added to the value of the business derived from the capitalization of earnings.
This method is more theoretically sound in valuing a profitable business where
the investor’s intent is to provide for a return on investment over and above a
reasonable amount of compensation and future benefit streams or earnings are
likely to be level or growing at a steady rate.
Example
Company RKP has five-year weighted average earnings on an after-tax basis of
Rs. 5,91,00,000. It has been determined that an appropriate rate of return for this
type of business is 21.32 percent (after-tax). Assuming zero future growth and
non-operating assets of Rs. 7,71,00,000 the value of RKP Company based on the
capitalization of earnings method is as follows:
Net earnings to equity Rs.5,91,00,000
Capitalization rate 21.32%
Total (rounded) Rs. 27,72,00,000
Value of non-operating assets + 7,71,00,000
Marketable controlling interest value Rs.35,43,00,000
Discounted Earnings/Cash Flows Method
The Discounted Earnings Method is sometimes referred to as the Discounted
Cash Flow Method, which suggests the only type of earnings to be valued, using
this method, would be some definition of cash flow, such as operating cash flow,
after-tax cash flow or discretionary cash flow. The Discounted Earnings Method is
more general in its definition as to the type of earnings that can be used.
The Discounted Earnings Method allows several possible definitions of
earnings. It does not limit the definition of earnings only to cash flows. The
Discounted Earnings Method is an income-oriented approach. It is based on the
theory that the total value of a business is the present value of its projected future
earnings, plus the present value of the terminal value. This method requires that a
terminal-value assumption be made. The amounts of projected earnings and the
terminal value are discounted to the present using an appropriate discount rate,
rather than a capitalization rate.
The Discounted Earnings Method of valuing a closely held business uses the
following steps:
1. Determine the estimated future earnings of the business (in this example we
have projected earnings for five years and have assumed no growth beyond
this period).
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2. A terminal or residual value is often determined at the end of the fifth year.
The terminal value that is often used is merely the fifth-year earnings
projected into perpetuity.
3. The discount rate determined incorporates an appropriate safe rate of
return, adjusted to reflect the perceived level of risk for the business being
valued.
4. The estimated future earnings and the terminal value are then discounted
to the present using the discount rate determined in Step (3) and summed.
The resulting figure is the total value of the business using this method.
Example
Assume the following pre-tax fully adjusted cash flows as they relate to
RKP&Co.: Projected annual cash flows to be received at the end of:
Rs. Year 1 10,500 Year 2 40,700
Year 3 80,600
Year 4 110,100
Year 5 150,300 Year 1 of the projected cash flows is the year following the valuation date. The
pre-tax discount rate is 24 percent. The pre-tax capitalization rate is 24 percent.
Calculation of present value factors:
Year Formula for
Present Value Factor Present value factors for 24%
rate of return
1 1/(1.24)^1
0.8065
2 1/(1.24)^2
0.6504
3 1/(1.24)^3
0.5245
4 1/(1.24)^4 0.423
5 1/(1.24)^5 0.3411
Calculate the value of the business
Calculate the present value of the annual cash flows:
End of Year
Net Cash Flow Rs.
Present Value Factor
Present Value Rs.
1 10,500 0.8065 8,468
2 40,700 0.6504 26,470
3 80,600 0.5245 42,274
4 110,100 0.4230 46,572
5 150,300 0.3411 51,268
175,052
Calculate the present value of the terminal value:
End of Year
Terminal Value Rs.
Present Value Factor
Present Value Rs.
5 626,250 0.3411 213,614
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No long-term sustainable growth is assumed. Had we assumed sustainable
growth at three percent, our discount rate would have to be reduced by three
percent to arrive at an appropriate capitalization rate. The company’s terminal
value is Rs. 626,250 at the end of year 5 (150,300 / 24%). This value, also know at
the “terminal value”, is equal to the present value of a perpetual annual cash flow of
Rs.150,300.
Add both present values:
PV of annual cash flows Rs. 175,052
PV of terminal value + 213,614
Total Value of Business Rs. 388,666
Practice Pointer:
The valuer must use caution when using Cash Flows to Invested Capital as a
benefit stream in a Discounted Cash Flow Model, where the capital structure of the
Company is changing over the projected period. In order to understand this issue, it
is important to address whether the subject interest is a controlling interest or a
minority interest.
3.3.4 Effect of Controlling Interest in Business
A controlling interest has the ability to change the capital structure. When
valuing a controlling interest, the valuer will generally (subject to the purpose and
standard of value) base the weighted average cost of capital (WACC) on the
optimum capital structure or the average industry capital structure. In most cases,
the optimum capital structure and the average industry capital structure is the
same. If a difference did exist between the optimum capital structure and the
average industry capital structure, the valuer will generally utilize the optimum
capital structure for the subject interest. The cost of capital will generally be based
on the following:
1. Debt Capital: The cost of debt capital can generally be determined based on
the current borrowing rate (credit risk) of the Subject Interest. However, in
cases where the Subject Interest does not have debt capital, the valuer can
determine the cost of debt capital from various sources that monitor the cost
of debt capital, Cost of Capital, Gold Sheets, etc.
2. Equity Capital: The cost of equity capital can generally be determined based
on a build-up approach, Capital Asset Pricing Model (CAPM), or published
sources of cost of equity capital, etc.
3.3.5 Lack of Control Interest
A lack of control interest cannot change the capital structure of the Company.
If the valuer uses Net Cash Flow to Invested Capital as a benefit stream in a DCF
model with a constant WACC where the capital structure is changing over the
forecast period, the net present value of the future cash flows will be distorted by
utilizing an inappropriate application of a constant WACC (when the cost of capital
is constantly changing) as a discount rate applied to the net cash flows to invested
capital representative of a constantly changing capital structure. The valuer should
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avoid using Net Cash Flow to Invested Capital as a benefit stream in a DCF model
when the capital structure is constantly changing during the forecast period.
3.3.6 Mid-Period vs. End-of-Period Discounting Method
The method used for discounting a future benefit stream will depend on the
availability of the cash flows to the equity holder. If the equity holder has access to
the cash flows throughout the year, then the valuer should use a mid-period
discounting method. If the equity holder only has access to the cash flows at the
end of the year, then the valuer should use an end of period discounting method.
The following illustration serves to underscore the point made here:
End of period discounting:
NPV = sum of (cash flow at time t) / (1 + discount rate) ^ t
Mid-period discounting:
NPV = sum of (cash flow at time t) / (1 + discount rate) ^ t – 0.5
Assume discount rate = 40% per annum and that cash flows are received/paid throughout each period.
Discount factor using: PV Using: Period
(t) Nominal
Cash Flow Mid-Period Discounting
End Period Discounting
Mid-Period Discounting
End Period Discounting
% of Mid Period PV
1 -1,000 1.1832 1.4 -845 -714 85% 2 1,000 1.6565 1.96 604 510 85%
3 3,000 2.3191 2.744 1,294 1,093 85% 4 4,000 3.2467 3.8416 1,232 1,041 85% 5 5,000 4.5454 5.3782 1,100 930 85%
6 6,000 6.3636 7.5295 943 797 85% 7 7,000 8.9091 10.5414 786 664 85% 8 8,000 12.4727 14.7579 641 542 85%
9 9,000 17.4618 20.661 515 436 85% 10 10,000 24.4465 28.9255 409 346 85%
NPV NET PRESENT VALUE 6,679 5,644 85%
3.3.7 Gordon Growth Model
The Gordon Growth Model assumes that cash flows will grow at a uniform rate
in perpetuity. Under this model, value can be calculated as:
Present Value = CFo (l + g) k – g
Where,
Cfo = Cash flow in period o (the period immediately preceding the valuation
date.) k = Discount rate (or cost of capital)
g = Expected long-term sustainable growth rate of the cash flow used
(remember, in the context of valuation of closely held companies, valuation valuers
will generally use either Net Cash Flow to Equity or Net Cash Flow to Invested
Capital)
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Two-Stage Gordon Growth Model assumes that cash flow growth will change
(the growth rate is not constant under this model, the present value is calculated as
follows):
Present Value =
2 n n12 n n
CF CF CF (1 g) /(k g)CF....
1 k 1 k 1 k 1 k
Where,
CF1…CFn = Cash flow expected in each of the periods one thru n, n is the last
period of the cash flow projection
k = Discount rates (or cost of capital)
g = Expected long-term sustainable growth rate of the cash flow used
(remember, in the context of valuation of closely held companies, valuation valuers
will generally use either Net Cash Flow to Equity or Net Cash Flow to Invested
Capital)
In the two-stage model, the terminal year calculation (CFn (l+g)/k-g/(l+k)n)
refers to the years during which cash flows are expected to grow at a constant rate
into perpetuity.
1. Two Stage Model Using Mid-Year Convention
The Capitalization and Discounting Models presented thus far assume Cash
Flow (CF) is received at year-end. That assumption does not always hold. More
often than not CF is received evenly throughout the year. In this situation, the use
of the “mid-year convention” is appropriate.
The mid-year convention, as opposed to the year-end convention always
results in a higher value since the investor receives the CF sooner. The Mid-year
Discounting Convention Equation is presented as follows:
PV =
2 3 n1.5 1.5 2.5 n 0.5
CF CF CFCF....
1 k 1 k 1 k 1 k
The Mid-year Capitalization Convention is written similarly to the traditional
capitalization convention; however, it reflects the receipt of CF throughout the year:
PV =
.5
.
CF1(1 k)
k g
The Mid-year Convention in the two- stage model is written as follows:
PV =
n
2 3 n1.5 1.5 2.5 n 0.5 n 0
CF 1 g
k gCF CF CFCF....
1 k 1 k 1 k 1 k 1 k
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3.3.8 Market Approach
The market approach is covered in a survey manner in this part of the course.
The complexity and importance of understanding this approach is to cover this
topic in greater depth in separate material. What follows, therefore, is an overview
of this important topic.
The idea behind the market approach is that the value of a business can be
determined by reference to reasonably comparable guideline companies (“comps”)
for which transaction values are known. The values may be known because these
companies are publicly traded or because they were recently sold and the terms of
the transaction were disclosed.
This approach is commonly used especially in contexts where the user(s) of the
valuer’s report do not have specialized business valuation knowledge. There is an
obvious parallel in a lay person’s mind to consulting with a real estate agent prior
to listing your home for sale to find out for what amount similar homes in your
neighborhood have sold. The market approach is the most common approach
employed by real estate appraisers. Real estate appraisers generally have from
several to even hundreds of comps from which to choose.
For a business valuation professional, a good set of comps may be as many as
two or three – and sometimes no comparable company data can be found. (The
objective of analyzing these components is to determine if the comparable company
has a similar risk profile.) There are three sources of comparable company
transaction data:
• Public company transactions
• Private company transactions
• Prior transactions of the subject company
A. Advantages and Disadvantages
As with any valuation approach, there are significant advantages and
disadvantages.
1. Advantages
a. It is “user friendly.” Companies with similar product, geographic, and/or
business risk and/or financial characteristics should have similar pricing
characteristics. People outside of business valuation can understand this
logic. Users of valuation reports (transaction participants, juries, judges,
etc.) tend to find market based methods to be familiar and easy to
understand in comparison to other approaches.
b. It uses actual data. The estimates of value are based on actual transaction
prices, not estimates based on number of complex assumptions or
judgments. The data can be independently obtained, verified, and tested.
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c. It is relatively simple to apply. The market approach derives estimates of
value from relatively simple financial ratios, drawn from a group of similar
companies. The most complicated mathematics involved is multiplication.
However, this is an advantage more in perception than in reality.
d. It does not rely on explicit forecasts. The income approach requires a set of
assumptions used in developing the forecasted cash flows. The market
approach does not require as many assumptions.
2. Disadvantages
a. Sometimes, no recent comparable company data can be found. This may be
the biggest reason the approach is not used in valuation; the valuer may not
be able to find guideline companies that are sufficiently similar to the
subject. Some companies are so unusual, small, diversified, etc. that there
are no other similar companies.
b. The standard of value may be unclear. Most transaction databases provide
financial and pricing data but do not explicitly indicate whether the reported
transaction was arms-length, strategic, synergistic, fire sale, asset vs. stock,
etc. Some argue that the occurrence of actual fair market value transactions
reported in transaction databases is probably less than 50%. If the guideline
transaction was synergistic, the resulting values multiple will likely produce
a synergistic value – not fair market value.
c. Most of the important assumptions are hidden. Among the most important
assumptions in a guideline price multiple is the company’s expected growth
in sales or earnings. In the income approach the growth rates are disclosed.
When applying multiples from guideline companies the implicit subject
company growth will be a function of the growth rates built into the prices of
the guideline companies on which the value of the subject is based.
d. It is a costly approach. Done correctly, the valuation valuer must perform
significant financial analysis on the subject company and equally on each of
the comparable companies. The analysis must be done to verify
comparability as well as to identify underlying assumptions built into the
pricing multiple. This is after and in addition to the significant time and
effort to first identify possible comps.
e. It is not as flexible or adaptable as other approaches. Unlike the income
approach, the market approach is sometimes difficult to include unique
operating characteristics of the firm in the value it produces.
f. Reliability of the transaction data is questionable. Great strides have been
made in improving the accuracy, completeness, and depth of the data
reported by various subscription services (discussed below). However,
particularly with private company transactions, the valuer would do well to
use such data with caution.
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B. Basic Implementation
As discussed earlier, one of the advantages to the market approach is the
apparent simplicity in implementing it. At its simplest, it requires only
multiplication and perhaps some subtraction, depending on the multiple selected.
The basic format is:
Value = (Price/Parameter) comp x Parameter Subject (For invested capital
multiples, debt should be subtracted.)
C. Sources of Guideline Company Data
The first part of the pricing multiple is the numerator – the price measure of
the guideline company.
Guideline company transactions refer to acquisitions and sales of entire
companies, divisions or large blocks of stock of either private or publicly traded
firms. There are several sources available to obtain pricing date for public and
private companies. The following is not an exhaustive presentation of sources.
Instead, it is a presentation of commonly used sources.
1. Data Sources – Private Companies Transactions
A number of publications collect and disseminate information on transactions.
Most publications make their databases accessible on the Internet for a fee on a
per-use basis or annual subscription access.
2. Data Sources – Public Companies Transactions
Publicly traded companies are required to file their financial statements
electronically with the Securities and Exchange Board of India (SEBI). These filings
are public information and are available on the SEBI website.
Documents can also be obtained from a number of commercial vendors, who
add value by allowing the user to extract selected items (i.e., the balance sheet,
income statement, etc.) or to search all filings for those meeting certain criteria. In
addition, vendors put the data for most or all publicly traded companies in a
standardized format.
It is also important to remember that in this, the information age; there is a
vast amount of financial information available for free. For example, historical
financial data, pricing, disclosures, SEBI filings, and valuer reports are available at
free web sites. If the valuer has identified a public company as a possible
comparable, they would do well to go to that company’s web site and go to the
“Investor Relations” page.
D. Parameters
The second part of the pricing multiple is the denominator, the financial
statement parameter that scales the value of the company.
Some specific common measures include:
1. Revenues
2. Gross profit
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3. EBITDA
4. EBIT
5. Debt-free net income (net income plus after-tax interest expense)
6. Debt-free cash flow (debt-free net income plus depreciation/amortization)
7. Pretax income
8. Net after-tax income
9. Cash flows
10. Asset related
11. Tangible assets
12. Book value of equity
13. Book value of invested capital (book value of equity plus debt)
14. Tangible book value of invested capital (book value of equity, less intangible
assets, plus book value of debt)
15. Number of employees
E. Matching Price to Parameter
“Price” should be matched to the appropriate parameter based on which
providers of capital in the numerator will be paid with the monies given in the
denominator. For example, in price/EBIT, price is the market value of invested
capital (MVIC), since the earnings before interest payments and taxes will be paid to
both the debt and equity holders. In price/net income, price is the market value of
equity (MVEq) only, since net income is after interest payments to debt holders and
represents amounts potentially available to shareholders. Any denominators that
exclude interest (e.g., EBIT or EBITDA) should usually be matched with
corresponding numerator (e.g., MVIC).
MVIC is usually the numerator paired with:
1. Revenues
2. EBITDA
3. EBIT
4. Debt-free net income
5. Debt-free cash flows
6. Assets
7. Tangible book value of invested capital
MVEq is usually the numerator paired with:
1. Pretax income
2. Net income
3. Cash flow
4. Book value of equity
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F. Basic Financial Indicators
Finally, when determining whether you have found comparable company data,
some financial measures that should be included in an analysis for both guideline
and subject companies include:
1. Size Measures
These include sales, profits, total assets, market capitalization, employees, and
total invested capital. Given how size may affect value, at least one, and maybe all,
of these should be included.
2. Historical Growth Rates
Consider growth in sales, profits, assets, or equity.
3. Activity and Other Ratios
Examples are the total asset and inventory turnover ratios. Depending on the
type of business being analyzed, other ratios also may be important.
4. Measures of Profitability and Cash Flow
Consider the four most common measures:
a. Earnings before interest, taxes, depreciation and amortization (EBITDA)
b. Earnings before interest and taxes (EBIT)
c. Net income
d. Cash flow
5. Profit Margins
The current level of profits is probably less important than the ratio of profits
relative to some base item—usually sales, assets, or equity.
6. Capital Structure
It is essential to use some measures derived from the current capital
structure. The most common measures are the values of outstanding total debt,
preferred stock (if it exists), and the market value of common equity, since book
equity generally has very little to do with how stock investors view their relative
position with a company. The ratio of debt to market value of equity can be
included since this represents the true leverage of the company.
7. Other Measures
These will be a function of what is important in the industry in which the
subject company operates.
G. Market Approach: Dividend Paying Capacity Method
The Dividend Paying Capacity Method, sometimes referred to as the Dividend
Payout Method, is an income-oriented method but is considered a market approach
as it is based on market data. It is similar to the capitalization of earnings method.
The difference between this method and the capitalization of earnings method lies
in the difference in the type of earnings used in the calculations and the source of
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the capitalization rate. This method of valuation is based on the future estimated
dividends to be paid out or the capacity to pay out. It then capitalizes these
dividends with a five-year weighted average of dividend yields of five comparable
companies.
1. Description
This method expresses a relationship between the following:
a. Estimated future amount of dividends to be paid out (or capacity to pay out)
b. Weighted average “comparable” company dividend yields of comparable
companies, further weighted by degree of comparability each year using a
sufficient number of comparable companies, generally more than three
c. Estimated value of the business
This method is particularly useful for estimating the value of businesses that
are relatively large and businesses that have had a history of paying dividends to
shareholders. It is highly regarded because it utilizes market comparisons.
Similar to the Price/Earnings Ratio or other methods relying on market data,
this method may not be appropriate for valuing most small businesses because
they do not have comparable counterparts in the publicly traded arena. Another
problem with this method is that most closely held businesses avoid paying
dividends. For tax reasons, compensation is usually the preferred method of
disbursing funds.
In determining dividend-paying ability, liquidity is an important consideration.
A relatively profitable company may be illiquid, as funds are needed for fixed assets
and working capital.
2. Example (Pre-Tax Basis)
RKPCO has a five-year history of weighted average profits of Rs. 250 Lakhs. Its
weighted average dividend payout percentage over the last five years has been 30
percent.
Dividend Payout Ratio = Rs. 250 Lakhs x 30%
Amount of Dividend = Rs. 75 Lakhs
The weighted average dividend yield rate of five comparable companies over the
last five years is 7.5 percent. Therefore, the value of RKPCO, under the dividend
payout method is as follows.
.75 Lakhs . .
.
RsRs 1000 Lakhs
075
3. Observation
It has been suggested that large, “well-heeled” corporations pay out to their
shareholders about 40 to 50 percent of their earnings. Therefore, keep this fact in
mind when estimating dividend payout potential for companies without a history of
paying dividends.
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3.3.9 Other Approaches: Income/Asset Approaches
A. Excess earnings/treasury method
The Excess Earnings Treasury Method is a derivative method stemming from
what is often called the Excess Earnings Return on Assets Method, also referred as
the “formula approach” and asserts that “the formula approach may be used for
determining the fair market value of intangible assets of a business only if there is
no better basis therefore available.”
Unlike all of the other methods discussed thus far, this method combines the
income and asset based approaches to arrive at a value of a closely held business.
Its theoretical premise is that the total estimated value of a business is the sum of
the values of the adjusted net assets (as determined by the adjusted net assets
method) and the value of the intangible assets. The determination of the value of
the intangible assets of the business is made by capitalizing the earnings of the
business that exceed a “reasonable” return on the adjusted (identified) net assets of
the business.
1. Description
A valuation of a business using the Excess Earnings Treasury Method uses the
following steps:
a. Determining the estimated future earnings of the company without regard to
growth. Usually this is the historical economic unweighted or weighted
average earnings over the last five years, adjusted for any non-recurring
items or any other normalizing adjustments.
b. Determining the unweighted or weighted average of the GAAP (or tax basis)
net assets. This calculation should exclude goodwill or other intangible
assets, whose value is also to be estimated by this method. The valuer uses
GAAP net assets in this step in order to ensure as much comparability with
industry data as possible, from which a reasonable rate of return will be
obtained in Step (c).
c. Selecting a reasonable rate of return to apply to the GAAP net assets whose
value was determined in Step (b). The most appropriate rate of return is the
average return on assets (unweighted or weighted) for comparable
companies, or as determined from industry averages.
d. Multiply the value of the GAAP net tangible assets of the business, as
determined in Step b), by the rate of return determined in Step (c). The
product is that portion of total earnings of the business attributable to a
reasonable return on the weighted average or unweighted average net
adjusted assets.
e. The earnings determined in Step (d) are then subtracted from the total
earnings determined in Step (a). The difference is the excess earnings
attributable to the intangible assets being valued by this method.
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f. Select a capitalization rate that corresponds to an appropriate rate for a safe
return, adjusting it accordingly to reflect the perceived level of risk
associated with the company.
g. The amount of excess earnings determined in Step e) is then divided by the
capitalization rate determined in Step (f). The amount thus derived is the
estimated total value of intangible assets.
h. Determine the adjusted net assets at fair market value, as of the valuation
date; use the adjusted net assets method. This determination excludes
goodwill and all other intangible assets.
i. The final step in valuing the entire business is the mere addition of the value
of the intangible assets (determined in Step (g)) to the adjusted net tangible
assets (determined in Step (h)).
2. Example (After-Tax Basis)
a) Assume the following data as they relate to RKPCO:
1. The five-year weighted average historical after-tax economic earnings
are Rs. 250 Lakhs
2. The GAAP weighted average net assets are Rs. 980 Lakhs
3. The value of adjusted net assets are Rs. 1,050 Lakhs
4. The industry weighted average after-tax return on equity is 12 percent
5. The appropriate after-tax intangible capitalization rate for RKPCO is 29.69
percent
6. The company's current adjusted net assets are Rs. 1,050 Lakhs
b) Determine the value of the entire business of Poker Co.:
Calculate the value of intangibles
Weighted average historical after-tax economic earnings
Rs.250 lakhs
Less earnings attributable to tangible assets: GAAP net assets (weighted average) Rs.980 x industry ROE(weighted average) x .12 = (117.60)
Excess earnings attributable to intangible assets Rs.132.40 lakhs
Divided by intangible capitalization rate ÷ .2969
Estimated value of intangibles (Rounded) Rs.446 lakhs c) The total value of the business is the sum of the value of net adjusted assets and
the value of intangible assets. Therefore, the total value of RKPCO under the excess
earnings-return on assets (treasury method) is as follows:
Determine the value of the entire business Value of intangibles Rs. 446 lakhs
(+) Value of adjusted net assets (date of valuation)
Rs.1,050 lakhs
Total Value of Business Rs.1,496 lakhs
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B. Excess Earnings/Reasonable Rate Method
The Excess Earnings Reasonable Rate Method (formally referred to as “Safe
Rate Method”) is another derivative of the Excess Earnings Return on Assets
Method. This method has acquired its name from the fact it applies a reasonable
rate of return to the adjusted net assets rather than an industry rate of return as in
the Treasury Method. Another distinction between this method and the Treasury
Method is the reasonable rate of return is applied to the latest year's balance of
adjusted net assets rather than to an unweighted or weighted average of net assets
(as in the Treasury Method). Similar to the Treasury Method, this method is an
income-and-asset- oriented approach. It is also based on the theory that the total
value of a business is the sum of the adjusted net assets and the value of the
intangibles, as determined by capitalizing the “excess” earnings of the business.
The amount of earnings capitalized is those earnings which exceed a reasonable
rate of return on the adjusted net assets of the business.
1. Description
To value a business using the Excess Earnings Reasonable Rate Method,
follow these steps:
a. Determine the estimated future earnings of the company.
b. Determine the current adjusted net assets at fair market value, using the
adjusted net assets method. This determination must exclude goodwill and
other intangible assets.
c. Select a reasonable rate of return to apply to adjusted net assets whose
value was determined in Step b). The rate chosen should correspond to the
relative liquidity and risk of the underlying assets to which it is being
applied.
d. Multiply the value of the adjusted net tangible assets of the business
determined in Step b) by the rate of return determined in Step c). The
product is the part of total earnings attributable to a return on adjusted net
assets. Adjusted net assets, once again, exclude intangible assets.
e. The earnings determined in Step d) are then subtracted from the total
earnings determined in Step a). The difference is the excess earnings
considered to be attributable to the intangible assets being valued by this
method.
f. Select a capitalization rate that corresponds to an appropriate rate for a
reasonable return and that has been adjusted for any perceived level of risk
and other relevant concerns associated with the company.
g. The amount of excess earnings determined in Step e) is then divided by the
capitalization rate selected in Step f), to arrive at the estimated value of the
intangible assets.
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h. The final step in valuing the entire business is the mere addition of the value
of the intangible assets (determined in Step g)) to the value of the adjusted
net tangible assets (determined in Step b)).
2. Example (Pre-Tax Basis)
a. Assume the following as they relate to RKPCO
1. The five-year weighted average historical pre-tax economic
earnings are Rs.380 lakhs
2. Value of the latest year’s net adjusted assets are Rs.1,050 lakhs
3. The company’s assumed reasonable rate on adjusted net assets is 10
percent
4. The appropriate pre-tax intangible capitalization rate for RKPCO is 49.48
percent
b) Determine the value of the entire business of RKPCO.
Calculate the value of intangibles Weighted average historical pre-tax
economic earnings
Rs.380 lakhs
Less earnings attributable to tangible
assets:
Adjusted net assets Rs.1,050
lakhs
x reasonable rate .10 = (105 lakhs)
(cost of debt in this example)*
Excess earnings attributable to intangible
assets
Rs. 275 lakhs
Divided by intangible capitalization rate**
.4948
Estimated value of intangibles (Rounded) Rs.556 lakhs
The total value of the business is the sum of the value of net adjusted assets
and the value of intangible assets. Therefore, the total value of RKPCO under the
Excess Earnings (Return on Assets) Reasonable Rate Method follows:
Determine the value of the entire business
Value of intangibles Rs.556 lakhs
(+) Value of adjusted net assets Rs.1,050 lakhs
Total Value of Business Rs.1,606 lakhs
NOTE: The Excess Earnings (Return on Assets) Treasury Method is applied to
after- tax economic earnings. By comparison, the Excess Earnings (Return on
Assets) Reasonable Rate Method example is applied to pre-tax economic earnings.
Different types of earnings (after-tax versus pre-tax) have been used to demonstrate
that these methods can be applied regardless of the benefit stream. This is not
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intended to imply that after-tax economic earnings are the only appropriate benefit
stream to be used with the Treasury Method. Similarly, this is not intended to
imply that pre-tax economic earnings are the only appropriate benefit stream to be
used with the Reasonable Rate Method. Any appropriate benefit stream (pre-tax or
after-tax, earnings or cash flow, etc.) can be used with either the Treasury Method,
the Reasonable Rate Method or any of the other income or market approaches
discussed in this chapter.
3.4 REVISION POINTS
1. Market approach
2. Income approach
3. Asset based approach
3.5 INTEXT QUESTIONS
1. Write short notes on (a) Book Value Method, (b) Adjusted NAV Method, (c )
Discounted Cash Flow Method (d) Effect of Controlling Interest, (e) Lack of
Controlling Interest
2. Explain in detail with example end-year and mid-year discounting and its
effect on valuation.
3. Explain in detail Gordon Growth Model.
4. Explain the importance of Excess Earning Method and how it is applied in
business valuation.
3.6 SUMMARY
Various methods of business valuation have been discussed and appropriate
selection of method for given circumstances. The mathematical formulae have also
been explained in detail with examples enabling to student to prepare valuation
models.
3.7 TERMINAL EXERCISE
1. Write the advantages and disadvantages of market approach?
2. What are the methods commonly used for valuation? Explain?
3.8 SUPPLEMENTARY MATERIALS
1. https://www.business valuation.co.in
2. www.business valuation.inc.com
3.9 ASSIGNMENTS
1. Take last 3 to 5 years annual reports of a public listed company, analyze
and device models for business valuation of that company as discussed in
this chapter
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3.10 SUGGESTED READINGS/REFERENCE BOOKS
1. Aswath Damodaran, Investment Valuation – Tools and Techniques for
Determining the Value of any Asset, John Wiley Publication, 3ed Edition,
2012.
2. Krishna G. Palepu, Paul M. Healy, Business Analysis and Valuation using
Financial Statements – Text & Cases, South Western Publication, 4th
Edition, 2002.15.
3. Tom Copeland, Tim Koller, Valuation Workbook – Step by Step Exercise,
John Wiley & Sons Publication, 3ed Edition, 2000.
4. Study Material, Paper – 18, Business Valuation Management, the Institute of
Cost Accountants of India Publication.
(http://icmai.in/upload/Students/Syllabus-2008/StudyMaterialFinal/P-
18.pdf)
3.11 LEARNING ACTIVITIES
Group discussion during PCP days
1. Take last 3 to 5 years annual reports of a public listed company, analyze
and device models for business valuation of that company as discussed in
this chapter
3.12 KEY WORDS
Discounted Cash Flow (DCF), Excess Earning, Dividend Paying Capacity, Lack
of Control
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CHAPTER - 4
ADJUSTMENTS TO FINANCIAL STATEMENTS
4.1 INTRODUCTION
During the 1990s, the Internet enhanced our ability to obtain and disseminate
information dramatically. Information that was once privately owned or perhaps
available only to experts is now widely accessible, almost instantaneously. The
availability and accessibility of all this data provides the valuer with an expanded
tool set by which to gain a deeper insight into the strengths, weaknesses,
opportunities, and threats of a given company or industry.
Due to the enormously expanded amount of data available, valuers must go
beyond simply measuring the economic income of a given enterprise. They also
must attempt to determine what factors give rise to the ability (or inability) of the
enterprise to generate required returns for the foreseeable future; that is, they must
make in-depth enterprise risk assessments. Consequently, a well-reasoned
valuation analysis includes certain critical elements:
An estimation of the amount of future economic benefits (normalization and
projection of future cash flows)
An assessment of the probability that the projected future economic benefits
will be realized
4.2 OBJECTIVES
Almost all business valuations use information from financial statements. This
chapter discusses adjusting the financial statements to provide a relevant basis for
fair market value opinions for given circumstances and cases of valuation.
4.3 CONTENTS
4.3.1 Why Adjustments to Financial Statements for Business Valuation
4.3.2 Separating Non-operating Items from Operating Items
4.3.3 Addressing Excess Assets and Asset Deficiencies
4.3.4 Handling Contingent Assets and Liabilities
4.3.5 Adjusting Cash-Basis Statements to Accrual-Basis Statements
4.3.6 Normalizing Adjustments
4.3.7 Controlling Adjustments
4.3.1 Why Adjustments to Financial Statements for Business Valuation
Almost all business valuations use information from financial statements. This
chapter discusses adjusting the financial statements to provide a relevant basis for
fair market value opinions. Following Chapter discusses analyzing the statements
to provide insights to be used in the valuation.
In most valuation cases, certain adjustments to the subject company’s
historical financial statements should be made. This chapter discusses, in broad
terms, the categories of such adjustments and why each is appropriate. If no
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adjustments were made to the subject company’s statements, the report should
contain a statement that the analyst has reviewed the company’s statements and
that no adjustments were considered appropriate.
If a publicly traded guideline company method is used, the same categories of
adjustments should be made to the guideline companies as to the subject company.
If the valuer/ analyst has made no adjustments to the guideline companies, the
report should contain a statement to the effect that the analyst has reviewed the
guideline company statements and no adjustments were necessary.
There are six categories of financial statement adjustments:
1. Separating non-operating items from operating items
2. Adjusting for excess assets or asset deficiencies
3. Adjusting for contingent assets and/or liabilities
4. Adjusting the cash-basis financial statements to accrual-basis statements (if
the company accounts are on a cash basis)
5. Normalizing adjustments
6. Controlling adjustments
The financial statement adjustments section of the report should be reviewed
with these questions in mind:
Were all the adjustments that should have been made actually made
(including parallel adjustments to the financial statements of the guideline
companies)?
Were any adjustments made that were inappropriate?
Is there convincing rationale for the magnitude of the adjustments?
4.3.2 Separating Non-operating Items from Operating Items
Generally speaking, when valuing an operating company, non-operating assets
on the balance sheet should be removed and treated separately from the value of
the company as an operating company. When non-operating assets are removed
from the balance sheet, any income or expense associated with them should also be
removed from the income statement.
For example, some companies own portfolios of marketable securities. These
should be removed from the balance sheet, and any related income should be
removed from the income statement. The fair market value of the marketable
securities should be added to the value of the company as an operating company
(i.e., aggregated with the going-concern value of the business operation to arrive at
the value of the company and its issued shares).
An exception would be when the securities are required to be held to meet
certain contingent liabilities of the operating company.
Another example of a non-operating item would be real estate not involved in
the company’s operation.
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There can be legitimate controversy over whether certain items are operating
or non-operating. Most non-operating assets are worth more on a liquidation basis
than they are based on the value of the income they contribute to the operation.
Therefore, those who want a high value usually argue to classify questionable items
as non-operating, while those who want a low value argue to classify the items as
operating assets. A case in point would be defunct drive-in theaters owned by a
theater chain, used for swap meets at the valuation date. (They were classified for
tax purposes as non-operating assets.)
In any case, where an asset approach is being used in a tax context, any write-
ups of assets should be offset by the capital gains liability on the write-ups.
Some argue for not reclassifying non-operating items when valuing minority
interests. The minority stockholder does not have the power to liquidate the assets;
therefore, reclassifying non-operating items and adding back their value would
usually result in overvaluation for a minority stockholder. An alternative for
minority interest valuations would be to find the fair market value of nonoperating
assets, net of a minority interest discount, and add it to the value of the operating
company.
4.3.3 Addressing Excess Assets and Asset Deficiencies
Excess assets or asset deficiencies should be treated similarly to nonoperating
assets. That is, to the extent that there are excess assets or asset deficiencies, their
value should be added to or subtracted from the value of the operating company.
If valuing a minority interest, a minority interest discount may be applied to
the value of the non-operating assets. This is because the minority interest holder
has no power to liquidate the excess assets, and the market usually does not give
full credit to excess assets in the stock price. The most common category of
controversy regarding excess or deficient assets involves working capital. The most
common measurement of the adequacy of working capital is the amount of working
capital as a percentage of the company’s sales. Benchmarks can be indus- try
averages or working capital-to-sales percentages of guideline companies. Either of
these benchmarks usually produces a range. If working capital is within a
reasonable range relative to the benchmarks, no adjustment is ordinarily required.
The following example is typical of the treatment of excess assets, in this case
for the valuation of stock in a bank:
The bank held cash and marketable securities—primarily intermediate term
Treasury notes, equal to 22 percent of assets, compared to 9 percent or less for peer
groups. The valuation expert separated out cash and securities representing 13
percent of the total assets and calculated an adjusted operating book value. He
separated out the earnings from the excess assets and calculated adjusted
operating earnings. He then estimated the company’s value on an operating basis
and added the value of the excess assets, the latter net of a 10 percent minority
interest discount.
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The same calculation can be performed in reverse in case of a working capital
deficiency.
4.3.4 Handling Contingent Assets and Liabilities
Many companies have contingent liabilities, and some have contingent assets.
The contingent liabilities often arise from environmental issues. They can also arise
from product liability lawsuits and from other actual or potential lawsuits.
Contingent assets sometimes arise from unknown collections or lawsuits where the
subject company is a plaintiff.
Contingent assets or liabilities are often handled as percentage adjustments at
the end of the valuation process. However, they are sometimes handled as specific
financial statement adjustments.
4.3.5 Adjusting Cash-Basis Statements to Accrual-Basis Statements
Some companies, usually small businesses and professional practices, use
cash-basis accounting. This means that both revenues and expenses are recorded
when they are received or paid, rather than when they are incurred.
Accrual-basis accounting, by contrast, records revenues and expenses when
they are earned, measurable, and collectible, based on the accounting principle of
matching costs with related revenues. Most valuations use accrual-basis
accounting. Therefore, for any given period, figures should be adjusted to reflect
revenues earned and expenses incurred during the period. Accounts receivable and
accounts payable should also be adjusted.
4.3.6 Normalizing Adjustments
The general idea of normalizing adjustments is to present data in conformance
with GAAP and any industry accounting principles and to eliminate nonrecurring
items. The goal is to present information on a basis comparable to that of other
companies and to provide a foundation for developing future expectations about the
subject company. Another objective is to present financial data on a consistent
basis over time.
The following are some examples of normalizing adjustments:
Adequacy of allowance and reserve accounts:
1. Allowance for doubtful accounts (correct to reasonable amount, in light
of historical results and/or management interviews)
2. Pension liabilities
Inventory accounting methods:
1. First in, first out (FIFO); last in, first out (LIFO); and other methods
(adjust to methods usually used in the industry)
2. Write-down and write-off policies (adjust to normal industry practices)
Depreciation methods and schedules
Depletion methods and schedules (adjustments to industry reporting norms)
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Treatment of intangible assets:
1. Leasehold interest (adjust to market value)
2. Other intangible assets
Policies regarding capitalization or expensing of various costs (adjust to
industry norms)
Timing of recognition of revenues and expenses:
1. Contract work (including work in progress; e.g., percentage of completion
or completed contract)
2. Installment sales
3. Sales involving actual or contingent liabilities (e.g., guarantees,
warranties)
4. Prior period adjustments (e.g., for changes in accounting policy or items
overlooked)
5. Expenses booked in one year applying to other years
Net operating losses carried forward
Treatment of interests in affiliates
Adequacy or deficiency of assets:
1. Excess or deficient net working capital (adjust to industry average
percent of sales)
2. Deferred maintenance (based on plant visit and management interviews)
Adequacy or deficiency of liabilities:
1. Pension termination liabilities
2. Deferred income taxes
3. Unrecorded payables
Unusual gains or losses on sale of assets
Nonrecurring gains or losses:
1. Fire, flood, or other casualty, both physical damage and business
interruption to extent not covered by insurance
2. Strikes (unless common in the industry and considered probable to
recur)
3. Litigation costs, payments, or recoveries
4. Gain or loss on sale of business assets
5. Discontinued operations
A valuer should consider all of these adjustments, whether they have been
made, and, if not, why not.
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4.3.7 Controlling Adjustments
A control owner or potential owner might make control adjustments, but a
minority owner, generally, could not force the same changes. Therefore, control
adjustments normally would be made only in the case of a controlling interest
valuation, unless there was reason to believe that the changes were imminent and
probable. These include:
Excess or deficient compensation and perquisites
Gains, losses, or cash realization from sale of excess assets
Elimination of operations involving company insiders (e.g., employment,
non-market-rate leases)
Changes in capital structure
When experts present objective evidence to support their opinion, the objective
evidence will almost always be scrutinized by opposing experts and will be subject
to criticism. The more sources that are available, the greater is the onus on the
expert to defend his source. There is a minority (but legitimate) school of thought
that considers what we have just classified as control adjustments to be
normalizing adjustments, even in a minority interest valuation where the minority
holder cannot force the company policy to change. The reason for this is to put the
subject company on a basis comparable to the guideline companies. The minority
interest factor is then handled as a separate discount at the end of the valuation.
4.4 REVISION POINTS
1. Financial statements
2. Normalizing adjustments
3. Controlling adjustments
4.5 INTEXT QUESTIONS
1. Why adjustments in financial statements necessary before proceeding to
business valuation process?
2. How will you treat excess assets and deficiencies in assets for the purpose of
business valuation?
3. Explain difference between operating and non-operating assets in regards to
business valuation and how you will treat them.
4. How will you adjust contingent assets and contingent liabilities adjusting
financial statements for the purpose of business valuation?
5. Differentiate cash based and accrual based accounting.
6. What is your understanding about normalizing adjustments in financial
statements for the purpose of business valuation?
7. Discuss in detail controlling adjustments in financial statements for the
purpose of business valuation.
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4.6 SUMMARY
In this chapter we have classified financial statement adjustments into six
categories:
1. Separating non-operating items from operating items
2. Addressing excess assets and asset deficiencies
3. Handling contingent assets and liabilities
4. Adjusting cash-basis statements to accrual-basis statements
5. Normalizing adjustments
6. Controlling adjustments
There is nothing wrong with an analyst’s using a different categorization of
financial statement adjustments; this categorization is merely presented for the
convenience of the reader. However, if any of the items in this chapter are relevant,
adjustments to the financial statements should be made, however categorized. If no
adjustments are warranted, the analyst should include a statement in the report
that the financial statements were analyzed and no adjustments were warranted.
Once the financial statements have been adjusted to provide a relevant basis
for arriving at fair market value, the next step is to analyze them so as to recognize
trends, strengths, and weaknesses.
4.7 TERMINAL EXERCISE
1. Write short notes on
a. Normalizing adjustments
b. Controlling adjustments
2. Difference between normalizing adjustments and controlling adjustments.
4.8 SUPPLEMENTARY MATERIALS
1. www.business valuation.inc.com
2. https\\www.business.gov.in
4.9 ASSIGNMENTS
1. Take last 3 to 5 years annual reports of a public listed company, analyze
and work out various adjustment in financial statements for the purpose of
business valuation of that company as discussed in this chapter
4.10 SUGGESTED READINGS/REFERENCE BOOKS
1. Aswath Damodaran, Investment Valuation – Tools and Techniques for
Determining the Value of any Asset, John Wiley Publication, 3ed Edition,
2012.
2. Krishna G. Palepu, Paul M. Healy, Business Analysis and Valuation using
Financial Statements – Text & Cases, South Western Publication, 4th
Edition, 2002.15.
3. Tom Copeland, Tim Koller, Valuation Workbook – Step by Step Exercise,
John Wiley & Sons Publication, 3ed Edition, 2000.
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4. Study Material, Paper – 18, Business Valuation Management, the Institute of
Cost Accountants of India Publication.
(http://icmai.in/upload/Students/Syllabus-2008/StudyMaterialFinal/P-
18.pdf)
4.11 LEARNING ACTIVITIES
Group discussion during PCP days
1. Take last 3 to 5 years annual reports of a public listed company, analyze
and work out various adjustment in financial statements for the purpose of
business valuation of that company as discussed in this chapter
4.12 KEY WORDS
Operating and non-operating items, Cash Based and Accrual Based, Excess
assets and Deficiencies, Normalizing, Controlling
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CHAPTER - 5
COMPARATIVE FINANCIAL STATEMENT ANALYSIS
5.1 INTRODUCTION
Comparative analysis is a valuable tool for highlighting differences between the
subject company’s historical performance and industry averages, pointing out
relative operating strengths and weaknesses of the subject company as compared
to its peers, assessing management effectiveness, and identifying areas where the
company is outperforming or underperforming the industry. Comparative analysis
is performed by comparing the ratios of the subject company to industry ratios
taken from commonly accepted sources of comparative
5.2 OBJECTIVES
Once the financial statements have been adjusted to provide a sound basis for
arriving at an opinion as to fair market value, the next step is to analyze the
statements to reveal trends, strengths, and weaknesses. This chapter discusses the
financial statement analysis.
5.3 CONTENTS
5.3.1 Objective of Financial Statement Analysis
5.3.1.1 Assessment of Risk
5.3.1.2 Assessment of Growth Prospects
5.3.2 Comparable Ratio Analysis
5.3.2.1 Activity Ratios (sometimes also called Asset Utilization Ratios)
5.3.2.2 Performance Ratios (Income Statement)
5.3.2.3 Return-on-Investment Ratios
5.3.2.4 Leverage Ratios
5.3.2.5 Liquidity Ratios
5.3.2.6 Other Risk-Analysis Ratios
5.3.3 Common Size Statements
5.3.4 Tying the Financial Statement Analysis to the Value Conclusion
5.3.1Objective of Financial Statement Analysis
The objective of financial statement analysis is to provide analytical data to
guide the valuation. The reliability of a valuation report may be evaluated partially
on whether the financial analysis is adequate, and on the relevance of that analysis
to the valuation conclusion.
Since “valuation . . . is, in essence, a prophecy [sic] as to the future,”1 the
relevance of historical financial statements is merely as a guide for what to expect
in the future. For most companies, a pure extrapolation of past results would
provide a misleading prophecy as to the company’s future.
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5.3.1.1 Assessment of Risk
Risk can be defined as the degree of certainty (or lack thereof) of achieving
future expectations at the times and in the amounts expected.
One of the most important products of financial statement analysis is to
provide an objective basis for assessment of risk relative to industry average risk
and/or risk of specific guide- line companies. Risk analysis is of critical importance
because, other things being equal, the higher the risk, the lower the fair market
value of the company.
In the income approach, the higher the risk, the higher the market’s required
rate of expected return on investment. The market’s required rate of return on
investment is called the discount rate, the rate at which projected cash flows
are discounted back to a present fair market value. The discount rate represents
the total expected rate of return on the value of the investment, including both
cash distributions and capital appreciation, whether realized or unrealized. The
higher the risk, the higher the discount rate and thus the lower the value of the
company or interest in the company.
In the market approach, risk is reflected in valuation multiples. The higher the
risk, the lower the valuation multiples and thus the lower the fair market value of
the company or interest in the company.
Risk also affects the discount for lack of marketability. Other things being
equal, the higher the risk, the higher the discount for lack of marketability.
5.3.1.2 Assessment of Growth Prospects
Another purpose of financial statement analysis is to provide a basis for
assessing the prospects for growth. The higher the company’s prospective growth in
net cash flows (or earnings, or some other measure of benefit to shareholders), all
else being equal, the higher the present fair market value of the company.
In the discounted cash flow method within the income approach, growth is
reflected directly in the projections. Financial statement analysis can provide a
basis for evaluating the reasonableness of the projections. The discounted cash flow
method requires that all projected future benefits to the owners be discounted
back to a present value at a discount rate that reflects the risk of realizing the
benefits projected.
In the capitalization method within the income approach, growth is reflected
by subtracting the rate of expected long-term growth from the discount rate to
arrive at the capitalization rate. Financial statement analysis can help to evaluate
the reasonableness of the estimate of the long-term growth rate. The capitalization
method consists of dividing some measure of benefit by a capitalization rate, which
is either the discount rate minus the expected long-term growth rate or a rate ob-
served from comparative companies.
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In the market approach, expected growth is reflected in the valuation
multiples. Financial statement analysis can be helpful in evaluating the
reasonableness of the multiples applied to the subject company’s fundamentals.
5.3.2 Comparable Ratio Analysis
For convenient analytical purposes, ratios can be arbitrarily classified into half
a dozen categories:
1. Activity ratios
2. Performance ratios
3. Return-on-investment ratios
4. Leverage ratios
5. Liquidity ratios
6. Other risk-analysis ratios
The following list of financial statement ratios is not all-inclusive, but presents
those most commonly used.
Following are different ways for application of ratios, which help in planning
financial decisions and in solving decision-making problems and business
valuation:
1. Trend analysis
2. Inter-firm comparison
3. Comparison with industrial average i.e., digging out strength and weakness.
5.3.2.1 Ratios (Sometimes also called Asset Utilization Ratios)
Activity ratios relate an income statement variable to a balance sheet variable.
Ideally, the balance sheet variable would represent the average of the line item for
the year, or at least the average of the beginning and ending values for the line
item. However, many sources of comparative industry ratios are based only on
year-end data. For the ratios to have comparative meaning, it is imperative that
they be computed from the subject company on the same basis as the average or
individual company ratios with which they are being compared. It also should be
noted that many ratios can be distorted significantly by seasonality, so it may be
important to match comparative time periods.
Accounts receivable turnover:
Sales
Accounts receivable
The higher the accounts receivable turnover, the better the company is
doing in collecting its receivables.
Inventory turnover:
S
Cost of goods
old Inventory
The higher the inventory turnover, the more efficiently the company is using
its inventory. Note: Some people use sales instead of cost of goods sold in this ratio.
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This method inflates the ratio, since it does not really reflect the physical turnover
of the goods.
Sales to net working capital:
–
S le
a
s
Net working capital Current assets Current liabilities
The higher the sales to net working capital, the more efficiently the company is
using its net working capital. However, too high a sales-to-working-capital ratio
could indicate the risk of inadequate working capital.
Sales to net fixed assets:
Sale
(
s
)Net fixed assets Cost Accumulated depreciationt
Sales to total assets:
Sales
Total assets
Generally speaking, activity ratios are a measure of how efficiently a company
is utilizing various balance sheet components.
5.3.2.2 Performance Ratios (Income Statement)
The four most common measures of operating performance are:
Gross profit as a percentage of sales:
Sales
Gross profi
Operating profit (earnings before interest and taxes [EBIT]) as a percentage of sales:
Sa s
le
EBIT
Pretax income as a percentage of sales:
I sales
Pretax
ncome
Net profit as a percentage of sales:
Sale
s
Net profit
All four measures can be read directly from the common size income
statements, which are discussed in the following section. A higher performance
ratio means that a higher price- to-sales multiple can be justified.
5.3.2.3 Return-on-Investment Ratios
Like activity ratios, return-on-investment ratios relate an income statement
variable to a balance sheet variable. Ideally, the balance sheet variable would
represent the average of the line item for the year, or at least the average of the
beginning and ending values for the line item. Unlike activity ratios, return-on-
investment ratios sometimes are computed on the basis of the balance sheet line
item at the beginning of the year. However, many sources of comparative ratios are
based only on year-end data. For the ratios to have comparative meaning, it is
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imperative that they be computed for the subject company on the same basis as the
average or individual company ratios with which they are being compared.
Return on equity:
Net income
Equity
Note: The preceding ratio normally is computed based on book value of equity.
It also may be enlightening to compute it based on market value of equity.
Return on investment:
–
Net income Interest 1 Tax rate
Equity Long term debt
Return on total assets:
–
Net income Interest 1 Tax rate
Total assets
Note: These ratios are normally computed based on book values.
Each measure of investment returns provides a different perspective on
financial performance. In valuation, return on equity influences the price-to-book-
value multiple, and return on investment influences the market-value-of-invested-
capital (MVIC)-to-EBIT multiple. A higher return on various balance sheet
components justifies a higher value multiple relative to those components.
5.3.2.4 Leverage Ratios
The general purpose of balance sheet leverage ratios (capital structure ratios)
is to aid in quantifiable assessment of the long-term solvency of the business and
its ability to deal with financial problems and opportunities as they arise. Balance
sheet leverage ratios are important in assessing the risk of the individual
components of the capital structure. Above-average levels of debt may increase both
the cost of debt and the company-specific equity risk factor in a build-up model for
estimating a discount or capitalization rate. Alternatively, above-average debt may
increase the levered beta in the capital asset pricing model (CAPM). The CAPM,
discussed in Chapter 14, is a procedure for developing a discount rate applicable to
equity.
Total debt to total assets:
Total liabilities
Total assets
Equity to total assets:
Total equity
Total assets
Long-term debt to total capital:
Long term debt
Long term debt Equity
Equity to total capital:
Total equity
Long term debt Equity
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Fixed assets to equity:
Net fixed assets
Total equity
Debt to intangible equity:
Total liabilities
Total equity
Note: The preceding ratio sometimes is computed using total equity minus
intangible assets in the denominator.
Leverage ratios are a measure of the overall financial risk of the business.
5.3.2.5 Liquidity Ratios
Liquidity ratios are indications of the company’s ability to meet its obligations
as they come due—in this sense, they are factors that may be considered in
assessing the company-specific risk.
Current ratio:
Current assets
Current liabilities
Quick (acid test) ratio:
Cash Cash equivalents Short term investments Receivables
Current liabilities
Times interest earned:
a.
EBIT
Interest expense
or
b. E
EBIT Interest
xpense
Note: Depreciation in the preceding formula is usually construed to include
amortization and other noncash charges, sometimes expressed by the acronym
EBITDA (earnings before interest, taxes, depreciation, and amortization).
Coverage of fixed charges:
, ,
Earnings before interest taxes and lease payments
Interest Current portion of long term debt Lease payments
5.3.2.6 Other Risk-Analysis Ratios
Business risk (Variability of return over time):
Standard deviation of net
income Mean of net income
Business risk measures volatility of operating results over time. The higher the
historical business risk, the less predictable future results are likely to be.
Variability of past results is a better predictor of variability of future results (risk)
than a past upward or downward trend is of a future upward or downward trend.
Note: This measure is called the coefficient of variation. It can be applied to
any measure of income; including sales, EBITDA, EBIT, gross profit, pretax profit,
or net cash flow.
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Degree of operating leverage:
Percentage change in operating
earnings Percentage change in sales
Note: This is really another measure of business risk. The numerator could be
any of the measures of income listed earlier.
Financial risk (Degree of financial leverage):
Percentage change in income to common equity
Percentage change in EBIT
5.3.3 Common Size Statements
A common size statement is a balance sheet that expresses each line item as a
percentage of total assets or an income statement that expresses each line item as a
percentage of revenue.
When several years of financial statements are available for a company,
common size statements can be used to compare the company against itself over
time. This is called trend analysis. Note that past years of statements produce only
year-to-year changes and thus a compound rate of growth, or decline, in each line
item.
When a number of years’ worth of common size statements are used, the
volatility of each line item can be measured using the standard deviation of the
year-to-year changes.
When a comparable number of years of common size statements are available
for industry averages or specific guideline companies, the relative volatility of each
line item can be com- pared. Higher volatility is indicative of higher risk.
A single year’s common size statements can be used to compare Subject
Company to industry averages or to specific guideline companies.
5.3.4 Tying the Financial Statement Analysis to the Value Conclusion
The implications of the financial statement analysis for the conclusion of value
should be identified in the financial statement analysis section, the valuation
section, or both. Some reports have an extensive financial analysis section with no
mention of implications for value either in the analysis or valuation section. To be
convincing, the report should be cohesive; the report should hang together, with
each section lending support for the value conclusion. The connection should be
explained, not leaving the reader to guess. Many readers will not be financial
experts, and a connection that might be apparent to a financial analyst might not
be obvious to a less sophisticated reader.
5.4 REVISION POINTS
1. Activity Ratio
2. Return – on – Investment Ratio
3. Liquidity Ratio
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5.5 INTEXT QUESTIONS
1. Discuss the objectives of Financial Statement Analysis for the purpose of
business valuation.
2. Write short notes on
a. Activity Ratios
b. Performance Ratios
c. Return-on-Investment Ratios
d. Leverage Ratios
e. Liquidity Ratios
3. Explain Common Size Statements in view of business valuation.
4. How financial statement analysis impacts business valuation?
5. A firm’s sales are Rs. 4,50,000, cost of goods sold is Rs. 2,40,000 and
inventory is Rs. 90,000. What is Stock turnover? Also calculate the gross
margins.
6. The only current assets possessed by a firm are cash Rs. 1,05,000,
inventories Rs. 5,60,000 and debtors Rs. 4,20,000. If the current ratio for
the firm is 2 to 1, determine its current liabilities. Also, calculate the firm’s
quick ratio.
7. A company has a gross profit margin of 10% and asset turnover of 3. What
is its ROI?
8. A company has current liabilities of Rs. 2,00,000, mortgage of Rs. 3,00,000
and bonds of Rs. 5,00,000. Its total equity is Rs. 1,50,000. What is its debt
equity ratio?
9. A company has net income after tax of Rs. 4,00,000 and pays cash dividend
of Rs. 2,40,000 on its Rs. 2,00,000 shares when the stock is selling for Rs.
20. What is the dividend yield and dividend payout ratio of the company.
10. The total sales of a firm are Rs. 4,00,000 and it has a gross profit margin of
20 percent. If the company has an average inventory of Rs. 50,000,
determine the inventory turnover.
11. A company has an inventory of Rs. 18,00,000, debtors of Rs. 1,15000 and
an inventory turnover of 6. The gross profit margin of the company is 10
percent and its credit sales are 20 percent of total sales. Calculate the
average collection period (assume a 360 day year).
12. A company has shareholders equity of Rs. 2,00,000. Total assets are 160
percent of the shareholders equity while the assets turnover is 4. If the
company has an inventory turnover of 5, determine the amount of inventory.
13. A firm has cost of Rs. 2,00,000, sales of Rs. 2,50,000 and asset turnover of
4. What is the rate of return on asset?
14. A firm has profit before interest and taxes of Rs. 30,000, total assets of Rs.
5,00,000 and total liabilities Rs. 3,00,000. What is its (1) return of equity (2)
interest coverage?
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15. State whether the following statements are ‘true’ or ‘false’:
a. A ratio is a quotient.
b. Liquidity ratios indicate financial soundness of a company.
c. Gross profit margin covers administrative and selling expenses.
d. Debt ratios have no implications in overall capital structure of the
company.
e. Earnings per share shows turnover ratio.
16. State whether following transactions will result in decline, improvement or
have no effect on current ratios.
a. Payment of a current liability.
b. Purchase of fixed assets in cash.
c. Cash collected form debtors.
d. Issue of new shares.
e. Sell 15% debenture.
17. Give the formula for calculating the following ratios:
a. Current ratio
b. Acid test ratio
c. Debt equity ratio
d. Inventory turnover ratio
e. Gross profit margin
f. Earnings per share
g. Return on investment.
5.6 SUMMARY
The primary objectives of financial statement analysis are to identify trends
and to identify the strengths and weaknesses of the subject company relative to its
peers. Perhaps the most important outgrowth of financial statement analysis is
objective evidence of the subject company’s risk relative to its peers. This relative
riskiness plays a part in the discount and capitalization rates in the income
approach and in the valuation multiples in the market approach.
5.7 TERMINAL EXERCISE
1. Define the term
a. Current ratio
b. performance ratio
c. leverage ratio
d. liquidity ratio
2. Explain the term “common size statements”
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5.8 SUPPLEMENTARY MATERIALS
1. www.business valuation.inc.com
2. www.business.gov.in
5.9 ASSIGNMENTS
Take last 3 years annual reports of two public listed companies of similar
nature in the same product line/ industry analyze and work out various
comparable ratios of both the companies for the purpose of business valuation.
Discuss the trends of ratios Intra Company each and inter-company. Also reply
following questions:
1. Which company is using the shareholder’s money more profitably?
2. Which company is better able to meet its current debts?
3. If you were to purchase the debentures of one company, which company’s
debenture would you buy?
4. Which company collects its receivables faster, assuming all sales to be credit
sales?
5. Which company has extended credit for a greater period by the creditors,
assuming all purchases to be credit purchases?
6. How long does it take each company to convert an investment in stock to
cash?
5.10 SUGGESTED READINGS/REFERENCE BOOKS
1. Aswath Damodaran, Investment Valuation – Tools and Techniques for
Determining the Value of any Asset, John Wiley Publication, 3ed Edition,
2012.
2. Krishna G. Palepu, Paul M. Healy, Business Analysis and Valuation using
Financial Statements – Text & Cases, South Western Publication, 4th
Edition, 2002.15.
3. Tom Copeland, Tim Koller, Valuation Workbook – Step by Step Exercise,
John Wiley & Sons Publication, 3ed Edition, 2000.
4. Study Material, Paper – 18, Business Valuation Management, the Institute of
Cost Accountants of India Publication.
(http://icmai.in/upload/Students/Syllabus-2008/StudyMaterialFinal/P-
18.pdf)
5.11 LEARNING ACTIVITIES
Group discussion during PCP days
Take last 3 years annual reports of two public listed companies of similar
nature in the same product line/ industry analyze and work out various
comparable ratios of both the companies for the purpose of business valuation.
Discuss the trends of ratios Intra Company each and inter-company. Also reply
following questions:
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1. Which company is using the shareholder’s money more profitably?
2. Which company is better able to meet its current debts?
3. If you were to purchase the debentures of one company, which company’s
debenture would you buy?
4. Which company collects its receivables faster, assuming all sales to be credit
sales?
5. Which company has extended credit for a greater period by the creditors,
assuming all purchases to be credit purchases?
6. How long does it take each company to convert an investment in stock to
cash?
5.12 KEY WORDS
Risk, Growth Prospects, Comparable Ratio Analysis, Common Size Statements
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CHAPTER - 6
ECONOMIC AND INDUSTRY ANALYSIS
6.1 INTRODUCTION
The purpose of economic research is to understand the effects of economic
conditions on the subject company both at the national level and at the company’s
market level. These macroeconomic forces are factors over which the company has
no control. Valuers must consider the key external factors that affect value, such as
interest rates, inflation, technological changes, dependence on natural resources,
and legislation. It is important to identify trends that may be particularly favorable
or unfavorable to the subject company. For example, low home mortgage rates are
favorable if the subject company is a residential contractor. Low unemployment
may be a negative factor if the subject company is heavily dependent on labor
resources. Additional issues to consider when analyzing a local economy include:
Whether the local economy is dependent on a single employer or industry
The extent and condition of the area’s infrastructure
Announcements of major plant openings or closings
Income levels and poverty rates
6.2 OBJECTIVES
Almost every company is affected to some extent by economic conditions and
by conditions in the industry in which it operates. No discussion of business
valuation would be complete without at least a brief discussion of external factors.
Various economic and industry factors affect each company differently, and the key
to effective economic and industry analysis is to show how each factor impacts the
subject company. This chapter discusses economic and industry analysis of
business for valuation.
6.3 CONTENTS
6.3.1 Objective of Economic and Industry Analysis
6.3.2 National Economic Analysis
6.3.3 Regional and Local Economic Analysis
6.3.4 Industry Analysis
6.3.5 Management Compensation Information
6.3.1 Objective of Economic and Industry Analysis
Almost every company is affected to some extent by economic conditions and
by conditions in the industry in which it operates. No discussion of business
valuation would be complete without at least a brief discussion of external factors.
Various economic and industry factors affect each company differently, and the key
to effective economic and industry analysis is to show how each factor impacts the
subject company.
Some companies are affected by certain aspects of the national economy.
Others are affected primarily by regional and local economic factors. Some are
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affected more heavily than others by conditions in the industry in which they
operate. Economic and industry analysis identifies those factors that affect the
subject company.
The objective of economic and industry analysis is to provide relevant data on
the context within which the company is operating.
The key word here is relevant
No company operates in a vacuum. All companies are impacted to a greater or
lesser extent by external conditions. These could be national, regional, or local
economic conditions and/or conditions in the industry in which the company
operates.
The extent to which various economic and industry conditions affect differing
companies varies widely from company to company.
It is the valuer’s job to identify what aspects of economic and/or industry
conditions tend to affect the subject company, to identify how those conditions are
expected to change in the future, and to assess the impact of those changes on the
subject company. “It is essential for the appraiser to relate economic indicators and
outlook to the specific circumstances of the subject company and valuation
engagement.”
A great deal of economic and industry data are available online. The most
comprehensive source of economic and industry data available online is Best
Websites for Financial Professionals, Business Appraisers, and Accountants,
6.3.2 National Economic Analysis
Companies in some industries are heavily impacted by certain aspects of the
U.S. economy. In some cases those aspects of the national economy have little or no
relevance. Major components of national economic analysis include the following:
General economic conditions:
1. Gross domestic product (GDP)
2. Consumer spending
3. Government spending
4. Business investments
5. Inventories (increases or decreases)
6. Trade deficit
Consumer prices and inflation rates
Interest rates
Unemployment
Consumer confidence
Stock markets
Construction
Manufacturing
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The valuer should identify which of these economic variables affects the
subject company, and should concentrate the economic analysis on those variables.
Long-term outlooks for certain national economic variables can be very important
to some companies, especially the long-term growth forecast. Projections of long-
term growth in excess of the sum of fore- casted growth in real gross domestic
product (GDP), plus inflation, should generally be viewed with suspicion and
require strong justification. For example, some valuating practitioners use the
expected growth in a company or industry for the coming five years with the
assumption that this is going to continue for the long term. This is usually wrong,
and can lead to an inflated estimate of value.
6.3.3 Regional and Local Economic Analysis
Regional and/or local economic analysis is relevant to those companies whose
fortunes are affected primarily by regional and/or local economic conditions. These
would include such companies as regional or local financial institutions, retailers,
building contractors, and various types of service companies. Sources of regional
and local economic analysis include banks, public utilities, state departments of
economic development, and chambers of commerce.
6.3.4 Industry Analysis
Industry analysis can be categorized into three components:
1. General industry conditions and outlook
2. Comparative industry financial statistics
3. Management compensation information’s
Web sites for industry analysis are available in Best Websites.6
General Industry Conditions and Outlook
Almost all industries have one or more trade associations. Many also have
other independent publications devoted to industry conditions. Also, most national
stock brokerage companies publish outlook information for the industries in which
they specialize. There are several di- rectories of these sources included in the
bibliography at the end of this chapter.
Comparative Industry Financial Statistics
Industry average financial statistics can be useful to compare the subject
company’s financial performance with industry norms. The comparisons can take
either or both of two forms:
1. Ratio analysis. Comparing a company’s financial ratios to industry norms
2. Common size statements. Income statements and balance sheets where
each line item is expressed as a percentage of total revenue or total assets
Sources for specific industry financial statistics can be found in the directories
of trade associations and industry information.
Each source of industry information has its own source of data. The valuation
analyst should be aware of the sources for each industry information compilation
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and the potential distortions or biases that might result from the source. For
example, compilations based on the Department of Commerce’s Sources of Income
are compiled from federal tax returns, with data about three to four years old. For
industries in which statistics remain relatively stable over time, this is a good
source, because it has the advantage of more company-size break- downs than any
other. However, in industries for which statistics are volatile over time, a
comparison to four-year-old data may not be valid.
Also, each source has its own definitions. When using comparative industry
data, the valuer must be certain that the definitions used for the subject company
are the same as those used in the industry source. Otherwise, the comparisons will
not be valid.
6.3.5 Management Compensation Information
The most frequent (and controversial) adjustment to the subject company’s
income statement is to management compensation. There are whole income tax
cases where the sole issue is reasonable compensation. There are many sources of
average industry compensation, some more specific as to job description than
others, but all having some weaknesses.
Also, even in the case where specific compensation by position is available for
an industry, adjustments may need to be made for the specific individual’s
contribution to the company versus the average industry executive’s contribution.
More specific sources by industry are found in the directories of trade
associations and industry information and in the Business Valuation Data,
Publication, and Internet Directory.
6.4 REVISION POINTS
1. Economic analysis
2. Industry analysis
3. Financial statistics
6.5 INTEXT QUESTIONS
1. What are the objectives of economic and industry analysis for business valuation?
2. Write short notes on:
a. National Economic Analysis
b. Regional Economic Analysis
c. Local Economic Analysis
d. Comparative Industry Financial Statistics
6.6 SUMMARY
Economic and industry information is such a broad subject that we could only
address it briefly in this chapter. Some companies are affected by various national
or regional economic factors. Others are affected largely by local conditions. The
importance of industry conditions varies greatly from one industry to another. As
with financial statement analysis, the analyst should point out the connection
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between the economic and industry factors and the valuation of the subject
company.
6.7 TERMINAL EXERCISE
1. Difference between national economic analysis and regional economic
analysis.
2. Describe the national economic analysis.
6.8 SUPPLEMENTARY MATERIALS
1. www.business valuation.inc.com
2. https\\www.business.gov.in
6.9 ASSIGNMENTS
1. Take a case of public listed company and conduct economic and industry
analysis in view of business valuation
6.10 SUGGESTED READINGS/REFERENCE BOOKS
1. Aswath Damodaran, Investment Valuation – Tools and Techniques for
Determining the Value of any Asset, John Wiley Publication, 3ed Edition,
2012.
2. Krishna G. Palepu, Paul M. Healy, Business Analysis and Valuation using
Financial Statements – Text & Cases, South Western Publication, 4th
Edition, 2002.15.
3. Tom Copeland, Tim Koller, Valuation Workbook – Step by Step Exercise,
John Wiley & Sons Publication, 3ed Edition, 2000.
4. Study Material, Paper – 18, Business Valuation Management, the Institute of
Cost Accountants of India Publication.
(http://icmai.in/upload/Students/Syllabus-2008/StudyMaterialFinal/P-
18.pdf)
6.11 LEARNING ACTIVITIES
Group discussion during PCP days
1. Take a case of public listed company and conduct economic and industry
analysis in view of business valuation
6.12 KEY WORDS
Economic Analysis, Industry Analysis, National and Regional Economic
analysis
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CHAPTER - 7
BUSINESS ANALYSIS – PESTLE ANALYSIS
7.1 INTRODUCTION
The development of business analysis as a professional discipline has
extended the role and responsibilities of the business valuers (BV). They investigate
ideas and problems, formulate options for a way forward and produce business
cases setting out their conclusions and recommendations. As a result, the
responsibility for advising organisations on effective courses of action lies with BVs,
and their work precedes that of the project manager.
The engagement of BVs also places a critical responsibility upon them – the
need to ensure that all business changes are in line with the mission, objectives
and strategy of the organisation. This business context is the key foundation for
understanding and evaluating all ideas, proposals, issues and problems put
forward by managers. While few BVs are involved in analysing and developing
strategy, it is vital that they know about the strategy of the organisation so that
they can conduct their work with a view to objectives of valuation. Therefore, it
could be argued that BVs look for the following areas:
Identifying the tactical options that will address a given situation that
support the delivery of the business strategy;
Defining the tactics that will enable the organisation to achieve its strategy;
Supporting the implementation and operation of those tactics;
Redefining the tactics after implementation to take account of business
changes and to ensure continuing alignment with business objectives.
An understanding of strategic analysis techniques is essential for all BVs. This
chapter describes a range of techniques for carrying out strategic analysis and
definition, plus techniques to monitor ongoing performance.
7.2 OBJECTIVES
This chapter appraises the students about PEST Analysis and techniques of
anlysing the business which is required for business valuation.
7.3 CONTENTS
7.3.1 Business Strategy and Objectives
7.3.2 Strategy Analysis – External Business Environment
7.3.3 Strategy Analysis – Internal Capability
7.3.4 Strategy Definition
7.3.5 Strategy Implementation
7.3.6 Performance Measurement
7.3.7 Approaches to Business Environment Analysis
7.3.8 PASTLE Analysis
7.3.9 Difference and Relationship between PESTLE and SWOT
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7.3.1 Business Strategy and Objectives
The following four areas are covered:
1. Strategy analysis, including external environment and internal capability;
2. Strategy definition;
3. Strategy implementation;
4. Performance measurement.
7.3.2 Strategy Analysis – External Business Environment
All organisations have to address the changes that have arisen, or can be
predicted to arise, within their operating business environment. Such changes
occur constantly, and any organisation that fails to identify and respond to them
runs the risk of encountering business problems or even the failure of the entire
enterprise. Senior management carries out regular monitoring of the business
environment in order to identify any influences that may require action.
There are two techniques that are used to examine the business environment
within which an organisation is operating: PESTLE analysis and Porter’s Five
Forces analysis.
The analysis of the external environment should be an ongoing process for
senior management, since the factors identified may provide insights into problems
for the future or opportunities for new successes. Using the PESTLE and five forces
techniques together helps to provide a detailed picture of the situation facing an
organisation. Just using one technique may leave gaps in the knowledge and
understanding.
7.3.3 Strategy Analysis – Internal Capability
Analysing the internal capability of an organisation provides insights into its
areas of strength and the inherent weaknesses within it. Business commentators
often recommend ‘sticking to the knitting’ when considering business changes.
An analysis of internal capability is essential to understanding where the core
skills of the organisation lie, so that relevant courses of action can be identified,
and any changes be made in the knowledge that they have a good chance of
success. There is little point in adopting strategies that are dependent upon areas
of resource where strong capability is lacking.
7.3.4 Strategy Definition
During strategy definition, the results of the external and internal
environmental analyses are summarised and consolidated in order to examine the
situation facing the organisation and identify possible courses of action. When
defining the business strategy, the factors outside the management’s control are
examined within the context of the organization and its resources. The technique
that may be used to define organisational strategy is the SWOT analysis.
7.3.5 Strategy Implementation
When the strategy has been defined, it is important to consider the range of
issues associated with implementing it. One of the key problems here is recognising
the range of areas that need to be coordinated if the business changes are to be
implemented successfully.
The approaches that support the implementation of strategy are McKinsey’s
7-S model and the four-view model.
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7.3.6 Performance Measurement
All organisations need to monitor performance and carry out the evaluation.
These are critical success factors/key performance indicators, and the Balanced
Business Scorecard technique.
7.3.7 Approaches to Business Environment Analysis
There are several similar approaches used to investigate the global business
environment within which an organisation operates. The most commonly used
approaches to external environment analysis are:
1. PEST (political, economic, socio-cultural, technological);
2. PESTEL (political, economic, socio-cultural, technological, environmental (or
ecological), legal);
3. PESTLIED (political, economic, socio-cultural, technological, legal,
international, environmental (or ecological), demographic);
4. STEEPLE (socio-cultural, technological, environmental (or ecological),
economic, political, legal, ethical).
7.3.8 Pastel Analysis
PESTLE analysis provides a framework for investigating and analysing the
external environment for an organisation. The framework identifies six key areas
that should be considered when attempting to identify the sources of change.
These six areas are:
Political: Examples of political factors could be a potential change of
government, with the corresponding changes to policies and priorities, or the
introduction of a new government initiative. These may be limited to the home
country within which the organisation operates, but this tends to be rare these
days since many changes have an effect in several countries. This has increased the
possibility of political issues arising that may impact upon the organisation and
how it operates.
The political arena has a huge influence upon the regulation of businesses, and the spending power of consumers and other businesses. BVs must consider issues such as:
a. How stable is the political environment?
b. Will government policy influence laws that regulate or tax your business?
c. What is the government's position on marketing ethics?
d. What is the government's policy on the economy?
e. Does the government have a view on culture and religion?
f. Is the government involved in trading agreements such as EU, NAFTA,
ASEAN, or others?
Economic: Economic factors may also be limited to the home country, but as
global trade continues to grow, economic difficulties in one nation tend to have a
broad, often worldwide, impact. Examples of economic factors could be the level of
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growth within an economy, or market confidence in the economies within which the
organisation operates.
BVs need to consider the state of a trading economy in the short and long-
terms:
a. Interest rates
b. The level of inflation
c. Employment level per capita
d. Long-term prospects for the economy Gross Domestic Product (GDP) per
capita, and so on
Socio-cultural: Socio-cultural factors are those arising from customers or
potential customers. These changes can often be subtle, and they can be difficult to
predict or identify until there is a major impact. Examples could be demographic
issues such as an increase in the number of working mothers, or consumer
behaviour patterns such as the rise of disposable fashion.
The social and cultural influences on business vary from country to country. It
is very important that such factors are considered. Factors include:
a. What is the dominant religion?
b. What are attitudes to foreign products and services?
c. Does language impact upon the diffusion of products onto markets?
d. How much time do consumers have for leisure?
e. What are the roles of men and women within society?
f. How long are the population living? Are the older generations wealthy?
g. Do the populations have a strong/weak opinion on green issues?
Technological: This area covers factors arising from the development of
technology. There are two types of technological change: there can be developments
in IT, and there can be developments in technology specific to an industry or
market, for example enhancements to manufacturing technology. IT developments
can instigate extensive business impacts, often across industries or business
domains and on a range of organisations. It is often the case that there is a failure
to recognise the potential use of the technology – at least until a competitor emerges
with a new or enhanced offering. For example, increased functionality of mobile
technology or extended bandwidth for internet transactions can present
opportunities to many organisations. However, the identification of such
technological advances is critical if an organisation is to recognise the potential
they offer.
Technology is vital for competitive advantage, and is a major driver of
globalization. Consider the following points:
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1. Does technology allow for products and services to be made more cheaply and to a better standard of quality?
2. Do the technologies offer consumers and businesses more innovative
products and services such as Internet banking, new generation mobile telephones, etc?
3. How is distribution changed by new technologies e.g. books via the Internet, flight tickets, auctions, etc?
4. Does technology offer companies a new way to communicate with consumers
e.g. banners, Customer Relationship Management (CRM), etc?
Legal: It is vital to consider factors arising from changes to the law, since the
last decade has seen a significant rise in the breadth and depth of the legal
regulations within which organisations have to operate. Legal compliance has
become such an important issue during this period that many business analysis
assignments have been carried out for the purpose of ensuring compliance with
particular laws or regulations. Some legal issues may originate from the national
government but others may operate across a broader spectrum. One key issue
when considering the legal element of the PESTLE analysis is to recognise laws that
have an impact upon the organisation even though they originate from countries
other than that in which the organisation is based. This situation may occur where
an organisation is operating within the originating country or working with other
organisations based in that country. Recent examples of this have concerned
changes to international financial compliance regulations.
Environmental: Examples of factors arising from concerns about the natural
(or Ecological): environments, in other words the ‘green’ issues, include increasing
concerns about packaging and the increase of pollution.
7.3.9 Difference and Relationship between PESTLE and SWOT
PESTLE is useful before SWOT - not generally vice-versa - PESTLE definitely
helps to identify SWOT factors. There is overlap between PESTLE and SWOT, in
that similar factors would appear in each. That said, PESTLE and SWOT are
certainly two different perspectives:
PESTLE assesses a market, including competitors, from the standpoint of a
particular proposition or a business.
SWOT is an assessment of a business or a proposition, whether own or a
competitor's. Strategic planning is not a precise science - no tool is mandatory - it's
a matter of pragmatic choice as to what helps best to identify and explain the
issues.
PESTLE becomes more useful and relevant the larger and more complex the
business or proposition, but even for a very small local businesses a PESTLE
analysis can still throw up one or two very significant issues that might otherwise
be missed.
The four quadrants in PESTLE vary in significance depending on the type of
business, eg., social factors are more obviously relevant to consumer businesses or
a business close to the consumer-end of the supply chain, whereas political factors
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are more obviously relevant to a global munitions supplier or aerosol propellant
manufacturer.
All businesses benefit from a SWOT analysis, and all businesses benefit from
completing a SWOT analysis of their main competitors, which interestingly can
then provide some feed back into the economic aspects of the PESTLE analysis.
7.4 REVISION POINTS
1. Strategy analysis
2. PASTLE Analysis
3. Business environment analysis
7.5 INTEXT QUESTIONS
1. Why and how business analysis is important for business valuation?.
2. Define “Business Strategy” and explain in detail “Strategic Analysis”.
3. What is PESTLE Analysis and how it is useful in business valuation?
7.6 SUMMARY
The business analysis techniques have been discussed in particular reference
to PEST Analysis. This helps the business valuers while performing valuation
assignment.
7.7 TERMINAL EXERCISE
1. Explain details in PASTLE Analysis.
2. Discuss the relation and difference between PESTLE and SWOT.
7.8 SUPPLEMENTARY MATERIALS
1. https\\www.business.gov.in
2. https\\fundera.com
7.9 ASSIGNMENTS
1. The students are required to take a case of business and prepare a report on
PEST Analysis of that business which they are acquainted with or of which
they have reasonable knowledge or wherein they consider themselves as
experts
7.10 SUGGESTED READINGS/REFERENCE BOOKS
1. Operations Management And Strategic Management, Study Notes, The
Institute of Cost Accountants of India, Kolkata
2. Neil Ritson, Strategic Management, www.bookboon.com
7.11 LEARNING ACTIVITIES
Group discussion during PCP days
1. The students are required to take a case of business and prepare a report on
PEST Analysis of that business which they are acquainted with or of which
they have reasonable knowledge or wherein they consider themselves as
experts
7.12 KEY WORDS
PEST, SWOT, Strategy.
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CHAPTER - 8
SITE VISITS AND INTERVIEWS
8.1 INTRODUCTION
When a valuer does site visits and management interviews, the valuer usually
gains an improved understanding of the subject company. For this reason,
although site visits are not required, more credibility is accorded to an expert who
has performed site visits and management interviews than to one who has not.
The primary objectives of site visits and interviews are twofold:
To gain an understanding of the subject company’s operations and the
economic reason for its existence, and
To identify those factors that will cause the company’s future results to be
different from an extrapolation of its recent past results.
8.2 OBJECTIVES
This chapter discusses the importance of site visit and interviewing key
persons and information to the gathered while performing business valuation.
8.3 CONTENTS
8.3.1 Importance of Site Visits and Interviews
8.3.2 Site Visits
8.3.3 Management Interviews
8.3.4 Interviews with Persons outside the Company
8.3.1 Importance of Site Visits and Interviews
When a valuer does site visits and management interviews, the valuer usually
gains an improved understanding of the subject company. For this reason,
although site visits are not required, more credibility is accorded to an expert who
has performed site visits and management interviews than to one who has not.
The primary objectives of site visits and interviews are twofold:
1. To gain an understanding of the subject company’s operations and the
economic reason for its existence, and
2. To identify those factors that will cause the company’s future results to be
different from an extrapolation of its recent past results.
8.3.2 Site Visits
A site visit can enhance the understanding of such factors as the subject
company’s operations, the efficiency of its plant, the condition of its equipment, the
advantages and disadvantages of its location, the quality of its management, and its
general and specific strengths and weaknesses.
8.3.3 Management Interviews
Management interviews can be helpful in understanding the history of the
business, compensation policy, dividend policy, markets and marketing policies
and plans, labour relations, regulatory relations, supplier relations, inventory
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policies, insurance coverage, reasons for financial analysis to reveal deviations from
industry or guideline company norms, and off-balance sheet assets or liabilities.
Inquiries should be made as to whether there were any past transactions in
the company’s ownership and, if so, whether they were arm’s length. Another
related inquiry should be whether there were any bona fide offers to buy the
company and, if so, the details of such offer(s).
Areas of investigation for the management interview could include, for
example:
Management’s perspective on the company’s position in its industry
Any internal or external facts that could cause future results to differ
materially from past results
Prospects, if any, for a liquidity event (e.g., sale of the company, public
offering of stock)
Why the capital structure is organized as it is, and any plans to change it
Identification of prospective guideline companies, either publicly traded
companies or private companies that have changed ownership
The management interview can also be a good occasion on which to identify
sources of industry information. The following questions are a good place to
start:
What trade associations do you belong to?
Are there any other trade associations in your industry?
What do you read for industry information?
Most valuers have checklists of areas of inquiry for site visits and management
interviews. At the end of each interview, many experienced valuers ask a catch-all
question such as, “Is there any information that we haven’t covered which might
bear on the value?” This can accomplish two objectives:
1. Protect the valuer against material omissions
2. Place the burden on management to not withhold relevant information
8.3.4 Interviews with Persons outside the Company
Sometimes it is also helpful to interview persons outside the company, such as
the outside accountant, the company’s attorney, the company’s banker, industry
experts, customers, suppliers, and even competitors.
The company’s outside accountant has two key functions:
1. Explain or interpret appraiser’s questions about items on the financial
statements.
2. Provide audit working papers for additional details regarding the financial
statements.
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The company’s attorney may be helpful in interpreting the legal implications of
various documents or in assessing the potential impact of contingent assets or
liabilities, especially unsettled law suits.
The company’s banker may provide a perspective on the company’s risk, as
well as on the availability of bank financing. Documents submitted by the company
to its bankers for borrowing purposes may also provide certain insight.
Industry experts may be helpful in a variety of ways, such as:
1. Assessing industry trends and their potential impact on the company
2. Assessing the impact of imminent changes in the industry or its regulations
3. Assessing the potential impact of various contingent liabilities, such as
environmental concerns or liability from, for example, asbestos lawsuits.
Customers, former customers, suppliers, and competitors may be helpful in
assessing such things as the company’s position in the industry and the market’s
perceived quality of the company’s products and services.
8.4 REVISION POINTS
1. Site Visits
2. Interviews
3. Business valuation
8.5 INTEXT QUESTIONS
1. Explain importance of interviews and site visits are important for business
valuation.
2. Explain the factors to be considered while interviewing the management of
the business.
3. Who are the persons outside the business important to cater information
useful for business valuation? Explain what kind of information/ data they
can provide help in business valuation.
8.6 SUMMARY
Site visits and interviews with management and possibly others can provide
the valuer with Insight available from no other source. These insights strengthen
the valuer’s understanding of the company, its business risks, and its growth
prospects. Armed with this background information, one can now proceed to the
valuation methodology. Deal first with the three basic approaches to value (income,
market, and asset-based), then to discounts and/or premiums, and finally to the
weight to be accorded to each so as to reach a final opinion of value.
8.7 TERMINAL EXERCISE
1. Explain the “site visit” and “measurement” interview
8.8 SUPPLEMENTARY MATERIALS
1. https\\www.business.gov.in
2. www.business valuation.inc.com
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8.9 ASSIGNMENTS
1. The students are required to take a case of business, say small
manufacturing setup, and visit the site; interview management and various
outside persons; prepare a detailed report analysing the information
collected recommending important factors to be considered while concluding
the valuation of that business
8.10 SUGGESTED READINGS/REFERENCE BOOKS
1. Aswath Damodaran, Investment Valuation – Tools and Techniques for
Determining the Value of any Asset, John Wiley Publication, 3ed Edition,
2012.
2. Krishna G. Palepu, Paul M. Healy, Business Analysis and Valuation using
Financial Statements – Text & Cases, South Western Publication, 4th
Edition, 2002.15.
3. Tom Copeland, Tim Koller, Valuation Workbook – Step by Step Exercise,
John Wiley & Sons Publication, 3ed Edition, 2000.
4. Study Material, Paper – 18, Business Valuation Management, the Institute of
Cost Accountants of India Publication.
(http://icmai.in/upload/Students/Syllabus-2008/StudyMaterialFinal/P-
18.pdf)
8.11 LEARNING ACTIVITIES
Group discussion during PCP days
1. The students are required to take a case of business, say small
manufacturing setup, and visit the site; interview management and various
outside persons; prepare a detailed report analysing the information
collected recommending important factors to be considered while concluding
the valuation of that business
8.12 KEY WORDS
Visits, Interviews
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CHAPTER - 9
INCOME APPROACH TO BUSINESS VALUATION
9.1 INTRODUCTION
Theoretically, the income approach is the most valid way to measure the value
of a business or business interest. Most corporate finance texts say that the value of
a company (or an interest in a company) is the value of all of its future benefits to
its owners (usually measured in net cash flows) discounted back to a present value
at a discount rate (cost of capital) that reflects the time value of money and the
degree of risk of realizing the projected benefits.
The income approach is widely used by corporate acquirers, investment
bankers, and in situational investors who take positions in private companies.
Within the income approach are two basic methods:
1. Discounting: All expected future benefits are projected and discounted back
to a present value.
2. Capitalizing: A single benefit is divided by a capitalization rate to get a
present value.
As will be explained, the latter method is simply a derivation of the former
method. The income approach requires two categories of estimates:
1. Forecast of future results, such as net cash flow or earnings
2. Estimation of an appropriate discount rate (cost of capital or cost of equity)
Reasonable business valuers may disagree widely on each of these inputs. As
with the market approach, the income approach can be used to value common
equity directly or to value all invested capital (common and preferred stock and
long-term debt). As with the mar- ket approach, if it is invested capital that was
valued, the value of the debt and preferred stock included in the valuation must be
subtracted to arrive at the value of the common equity. Some business valuation
practitioners also subtract all the cash and cash equivalents from the subject
company and omit the returns applicable to the cash equivalents, and then add the
value of the cash to the indicated value of the operating company.
9.2 OBJECTIVES
In the hierarchy of widely used business valuation terminology, there are
approaches, methods, and procedures. In business valuation, as in real estate
appraisal, there are three generally recognized approaches: income, market (sales
comparison), and asset-based (cost). Within these approaches, there are methods.
Within the income approach, the methods are discounting and capitalizing. Within
the market approach, the primary methods are guideline publicly traded companies
and the guideline transaction (mergers and acquisitions) method (sales of entire
companies). Also conventionally classified under the market approach are prior
transactions, offers to buy, buy/sell agreements, and rules of thumb. Within the
asset approach, the methods are the adjusted net asset method and the excess
earnings method.
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Procedures are techniques used within these methods, such as the direct
equity procedure versus the invested capital procedure. For example, in any of the
three approaches, the procedure could be to value the common equity directly or to
value all of the invested capital and then subtract the value of all the senior
securities to arrive at the value of the common equity.
9.3 CONTENTS
9.3.1 Net Cash Flow: The Preferred Measure of Economic Benefit in the
Income Approach
9.3.2 Discounting versus Capitalizing
9.3.3 Relationship between Discount Rate and Capitalization Rate
Capitalization
9.3.4 The Discounting Method
9.3.5 Projected Amounts of Expected Returns
9.3.6 Developing Discount and Capitalization Rates for Equity Returns the
Build-Up Model
9.3.7 The Capital Asset Pricing Model (CAPM) Weighted Average Cost of
Capital (WACC) - The Midyear Convention, the Midyear Convention in
the Capitalization Method and the Midyear Convention in the
Discounting Model
9.3.1 Net Cash Flow: The Preferred Measure of Economic Benefit in the Income
Approach
The income approach can be applied to any level of economic benefits, such as
earnings, dividends, or various measures of returns. However, the measure of
economic benefits preferred by most professional valuation practitioners for use in
the income approach is net cash flow. Net cash flow to equity is defined in Exhibit
9.1; net cash flow to invested capital is defined in Exhibit 9.2.
Exhibit 9.1 Definition of Net Cash Flow to Equity
In valuing equity by discounting or capitalizing expected cash flows (keeping in
mind the important difference between discounting and capitalizing, as discussed
elsewhere), net cash flow to equity is defined as
Net income to common stock (after tax)
+ Noncash charges
_ Capital expenditures*
± Additions to net working capital*
_ Dividends on preferred stock
± Changes in long-term debt (add cash from borrowing, subtract repayments)*
= Net cash flow to equity
* Only amounts necessary to support projected operations
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Exhibit 9.2 Definition of Net Cash Flow to Invested Capital
In valuing the entire invested capital of a company or project by discounting or
capitalizing expected cash flows,
net cash flow to invested capital is defined as
Net income to common stock (after tax)
+ Noncash charges (e.g., depreciation, amortization, deferred revenue, deferred taxes)
_ Capital expenditures*
+ Additions to net working capital*
+ Dividends on preferred stock
+ Interest expense (net of the tax deduction resulting from interest as a tax-deductible expense)
= Net cash flow to invested capital
*Only amounts necessary to support projection operations
There are three reasons for the general preference to use net cash flow as the
economic benefit to be capitalized or discounted in the income approach:
1. Net cash flow represents the amounts of cash that owners can withdraw or
reinvest at their discretion without disrupting ongoing operations of the
business.
2. More data are readily available to develop an empirically defensible discount
rate for net cash flow than any other economic benefit measure.
3. Net cash flow is one variable not normally used in the market approach.
Therefore, use of net cash flow in the income approach makes the income
and market approaches more in- dependent from each other and thus more
reliable checks on each other.
For these reasons, the authors will use net cash flow in the text and examples
through- out this chapter. Any other economic income variable may be discounted
or capitalized, but the discount or capitalization rate must be modified to match the
definition of the economic income variable being discounted or capitalized.
Development of discount or capitalization rates to be used with income variables
other than net cash flow is beyond the scope of this book.
9.3.2 Discounting Versus Capitalizing
The income approach is applied using one of two methods:
1. Discounted future economic benefits
2. Capitalization of economic benefits
It would be redundant to use both methods in the same valuation because
capitalization is simply a shortcut form of discounting.
9.3.3 Relationship between Discount Rate and Capitalization Rate
When the applicable standard of value is fair market value, the market drives
the discount rate. It represents the market’s required expected total rate of return
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to attract funds to an in- vestment (in the case of stock, dividends plus capital
appreciation). It is comprised of a “safe” rate of return plus a premium for risk.
Development of discount rates is the subject of a later section of this chapter.
The capitalization rate in the income approach is based on the discount rate.
The capitalization rate is calculated by subtracting the long-term expected growth
rate in the variable being capitalized from the discount rate.
Many people confuse discount rates with capitalization rates. The only case in
which the discount rate equals the capitalization rate is where the amount of the
variable being discounted or capitalized remains constant (i.e., there is a zero
growth rate), theoretically in perpetuity.
Capitalization
The International Glossary of Business Valuation Terms defines capitalization
as “the conversion of a single period of economic benefits into value.” It also has the
following definitions:
Capitalization factor. Any multiple or divisor used to convert anticipated
economic benefits of a single period into value
Capitalization-of-earnings method. A method within the income approach whereby economic benefits for a representative single period are converted to value through division by a capitalization rate
Capitalization rate. Any divisor (usually expressed as a percentage) used to convert anticipated economic benefits of a single period into value
One important assumption is implicit in the capitalization method: that the
income variable being capitalized will either remain constant or will grow or decline
at a reasonably constant and predictable rate over a long period of time. The “long
period of time” theoretically is in perpetuity, but, as a practical matter, changes
after 10 years have very little impact on present value.
Constant Level Assumption
The simplest use of the capitalization method involves an assumption that the
variable being capitalized remains constant (i.e., a no-growth scenario). In this case,
we merely divide the variable being capitalized by the discount rate:
Expected net cash flow per year
Discount rate rate of return or cost of capital
For example, if expected net cash flow is Rs 20 Lakhs per year and the
capitalization rate is 10 percent, the value of Rs 20 Lakhs per year capitalized at 10
percent is Rs 200 Lakhs:
20 Lakhs ÷ 0.10 = 200 Lakhs
In this unique (and unrealistic) case, the discount rate equals the
capitalization rate because there is no growth to subtract from the discount rate.
Constant Growth or Decline Assumption (The “Gordon Growth Model”)
If one assumes a constant rate of growth in net cash flow, one can simply
multiply the latest 12 months’ normalized net cash flow by one plus the growth rate
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and then divide that amount by the discount rate minus the growth rate. This is
called the Gordon Growth Model.
Net cash flow (1 + Growth rate) (Discount rate – Growth rate)
To illustrate the model, assume that the latest 12 months’ normalized net cash
flow was Rs. 10 Lakhs and the assumed growth rate is 5 percent. The amount to
be capitalized would be:
Rs 10 Lakhs x 1.05 = Rs 10.50 Lakhs
If one assumes that the discount rate is 15 percent, the capitalization rate
would be:
15% – 5% = 10%
One would then divide the amount of next year’s anticipated cash flow by the
capitalization rate to arrive at the value:
Rs. 10.50 Lakhs ÷ 0.10 = Rs. 105 Lakhs
In this example, the company’s fair market value is Rs. 10 Lakhs, the amount
a willing buyer would expect to pay and a willing seller would expect to receive
(before any transaction costs or valuation discounts or premiums).
The investor in this example thus earns a total rate of return of 15 percent,
comprised of 10 percent current return (the capitalization rate), plus 5 percent
annually compounded growth in the value of the investment.
This is shown in formula form in Exhibit 9.3.
Exhibit 9.3 Gordon Growth Model
The assumption is that cash flows will grow evenly in perpetuity from the
period immediately preceding the valuation date. This scenario is stated in a
formula known as the Gordon Growth Model:
where:
PV= Present value
PV =
NCF0 1 g
k g
NCF0 = Net cash flow in period 0, the period immediately preceding the
valuation date
k = Discount rate (cost of capital)
g = Expected long-term sustainable growth rate in net cash flow to investor
Note that for this model to make economic sense, NCF0 must represent a
normalized amount of cash flow from the investment for the previous year, from
which a steady rate of growth is expected to proceed. Therefore, NCF0 need not be
the actual cash flow for period zero but may be the result of certain normalization
adjustments, such as elimination of the effect of one or more nonrecurring factors
(see following chapters for a discussion of normalization adjustments).
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In fact, if NCF0 is the actual net cash flow for period 0, the valuation analyst
must take reasonable steps to be satisfied that NCF0 is indeed the most reasonable
base from which to start the expected growth embedded in the growth rate.
Furthermore, the valuation report should state the steps taken and the
assumptions made in concluding that last year’s actual results are the most
realistic base for expected growth.
9.3.4 The Discounting Method
Even though the discounting method is complex, one needs to review it until
they have a basic understanding of how it works. Whether or not the discounting
method is used, the results from any valuation method should be compatible with
results from the discounting method.
Description of the Discounting Method
In arithmetic terms, discounting is the opposite of compounding. We
understand compounding because we make deposits in savings accounts at
compound interest and calculate how much the deposit will be worth some years in
the future at a given rate of interest. In discounting, we do the opposite. We are
calculating what a given amount of dollars, to be received at some time in the
future, will be worth in today’s dollars, assuming the market requires a particular
expected rate of return to attract funds to the investment.
In theory, the discounting method projects the expected returns over the life of
the business. These expected returns are then discounted back to present value at
a discount rate that reflects the time value of money and the market’s required rate
of return for investments of similar risk characteristics.
In other words, we are trying to determine what the investment’s future cash
flows are worth to an investor in today’s dollars. Thus, if our projected cash flow
and rate of return are accurate, the present value of the business, if invested today,
will ultimately yield the expected cash flows to an investor.
The Terminal Value in the Discounting Method
For some types of investments, such as proposed utility plant investments
based on feasibility studies, analysts actually do make forecasts for the entire
expected life of the business. More commonly, however, analysts make projections
for a finite number of years often five to ten years. At the end of the specific
projection period, analysts estimate what is referred to as a terminal value, or the
investment’s expected present value as of the end of the specific projection period.
Terminal value is then discounted back to today’s dollars at an appropriate
discount rate. The present value of the terminal value is then added to the present
value of the projected cash flows from the specified projection period to arrive at the
total estimated present value of the investment.
The terminal value may be estimated either by the Gordon Growth Model or by
market valuation multiples. Generally, most professional business valuation
analysts prefer estimating the terminal value by the Gordon Growth Model because
this preserves the independence of the income approach from the market approach.
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However, most investment bankers prefer to estimate the terminal value with
valuation multiples, on the basis that this best represents the manner in which the
business might be sold at the end of the projected period.
Each year’s expected cash flows, and the terminal value, are divided by one
plus the discount rate, raised to the power of the number of years into the future
that the cash flows are expected. The terminal value is discounted by the number of
years in the specific forecast period, because the terminal value represents the
value of the company as of the end of the specific forecast period. Each year’s cash
flows are discounted using the year in which they occur as the exponent.
An Example of the Discounting Method
Assume: Discount rate (market’s requirement as to expected compound
annual return to attract funds to an investment of this level of risk) = 20%
Expected Net Cash Flows (Rs.)
Year 1 1,200
Year 2 1,500
Year 3 1,700
Expected long-term growth rate following year 3 = 5%
Using the Gordon Growth Model to estimate the terminal value, these
assumptions would result in the following calculations:
PV =
2 3 3
1700X .05
1200 1500 1700 .20 .05 (1 .20) (1 .20) (1 .20) (1 .
+ +20)
1
= 1,000 + 1,041.67 + 983.96 + 6886.57
= Rs. 9,912.20
This is the amount that a willing buyer would expect to pay and a willing seller
would expect to receive for this investment (before considering any transaction
costs).
Note how much of the present value is accounted for by the terminal value.
This is so because, in this example, we kept the specific projection period unusually
short; it is not, however, unusual for the terminal value to account for half or more
of the present value. Thus, it is extremely important to assess the reasonableness of
the terminal value in determining the reasonableness of an estimated present
value. The discounting method is shown in formula form in Exhibit 9.4.
Exhibit 9.4 Formula for Discounted Cash Flow Calculation Using Gordon Growth Model for Terminal Value
PV =
n
2 n12 n n
NCF (1 g)
NCF NCFNCF g
(1 k) (1 k) (1 k) (1 k)+ +
where:
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NCF1 ... NCFn = Net cash flow expected in each of the periods 1 through n, n
being the last period of the discrete cash flow projections.
k = Discount rate (cost of capital)
g = Expected long-term sustainable growth rate in net cash flow, starting with
the last period of the discrete projections as the base year.
Note how this works in reverse. If we deposited the present value of each of
the cash flows and their values grew over the discount period at the discount rate,
we would have the following:
Year PV of Cash
Flow Discount Rate
Compounded for n year Future Value
1 Rs.1,000.00 x1.20 = Rs. 1,200
2 Rs.1,041.67 x 1.20 x 1.20 = Rs. 1,500
3 Rs. 983.96 x 1.20 x 1.20 x 1.20 = Rs. 1,700
Terminal value Rs.6,886.57 x 1.20 x 1.20 x 1.20 = Rs.11,900
The present value calculation is sometimes presented in tabular form using
capitalization factors for each year’s cash flows and for the terminal value. These
capitalization factors are the reciprocals of the divisors just presented:
1/1.20 = 0.833333
1/(1.20)2 = 0.694444
1/(1.20)3 = 0.578704
When using such a table, the presentation looks like this:
Year Cash Flow Capitalization Factor Present Value
1 Rs. 1,200 x 0.833333 = Rs. 1,000.00
2 Rs. 1,500 x 0.694444 = Rs. 1,041.67
3 Rs. 1,700 x 0.578704 = Rs. 983.80
Terminal value Rs. 11,900 x 0.578704 = Rs. 6,886.57
Present value of investment Rs. 9,912.04
The slight difference between this presentation and the previous presentation
is due to rounding off the capitalization factors to six digits. If the capitalization
factors were carried out to a few more digits, the values would be exactly the same.
9.3.5 Projected Amounts of Expected Returns
Sometimes the valuation analyst will undertake the task of developing
projections for expected returns independently, but usually the projections are
provided by management.
Some companies routinely make projections of net cash flows for budgeting
and other purposes. There is a presumption that projections prepared in the
normal course of business are free of any bias that may creep into projections
prepared for litigation.
If management routinely prepares projections, the analyst may request prior
projections and compare them with actual results to evaluate the reliability of
management’s projections. In any case, all assumptions underlying the projections
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should be clearly explained in the valuation report. The analyst should understand
any underlying assumptions and evaluate them for reasonableness.
If the analyst believes that the projections supplied by management are either
too high or too low, she has several possible courses of action, including:
Reject the income approach as unreliable.
Adjust the projections in light of more reasonable assumptions.
Adjust the discount rate for company-specific risk. (Estimating the
appropriate discount rate is the subject of a subsequent section.)
Accept the projections on their face, and disclaim any responsibility for
independent verification.
Some analysts regularly use sensitivity analysis. That is, they change one or
more of the assumptions and rerun the calculations to see how the change in
assumptions affects the results. The degree of sensitivity to reasonable changes in
assumptions can impact the reliability of the results. For example, when very low
discount rates are used, a few points’ change in the discount rate can have a major
impact on the indicated value.
Projections are usually denominated in nominal currency, which include the
effects of inflation. This is because discount rates are usually estimated in nominal
terms. In the unusual cases where projections are made in real currency (not
reflecting inflation) then the estimated rate of inflation must be removed from the
discount rate to make the calculations consistent.
9.3.6 Developing Discount and Capitalization Rates for Equity Returns
Arguably, even more challenging than projecting future results is estimating
an appropriate discount rate by which to discount the expected cash flows back to
a present value.
Discount rates applicable to debt are readily observable in the market. Unlike
stocks, bonds have a fixed amount of promised future payments of interest and
principal.
Yield to maturity (an approximation of the discount rate) data are published
daily in financial bulletins for bonds of all risk grades (AAA, AA, A, BBB, etc.). The
requirements for each risk grade are published by rating services, so the valuer can
easily value a company’s debt by estimating the risk category into which it falls and
looking up the yields to maturity for that risk category.
Since there are no such published expected rates of return for stocks, the
valuer must estimate the rate of return the market would require to invest in the
subject stock. This market- driven required rate of return is called the discount
rate.
There are many models for developing discount rates for equity. Two are most
widely used:
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1. The build-up model
2. The capital asset pricing model (CAPM)
The Build-Up Model
The build-up model incorporates some or all of the following elements:
A risk-free rate
A general “equity risk premium” (a premium over the risk-free rate for the added risk of in- vesting in any kind of stocks over the risk-free rate)
A size premium
An industry risk adjustment
A company-specific risk adjustment
The Risk-Free Rate
The risk-free rate is the yield to maturity on government obligations. The most-
used rate is the yield to maturity on 20-year Treasury bonds as of the valuation
date. This incorporates a real rate of return, which is compensation for giving up
the use of money until the maturity of the bond. It also incorporates the market’s
expectation of the amount of inflation expected over the term of the bond. This
means that the rate is a nominal rate, which includes expected inflation. It is called
a risk-free rate because it is presumably free of risk of default. However, it also
incorporates horizon risk or maturity risk, the risk that the market value of the
principal may fluctuate with changes in the general level of interest rates.
The Equity Risk Premium
The equity risk premium is the amount of return over and above the risk-free
rate for investing in a portfolio of large common stocks. Much research and
controversy are devoted to estimating the level of the equity risk premium at any
given time. The valuer’s report should disclose the source of the estimated equity
risk premium.
The Size Premium
In general, small companies are more risky than large ones, all other things
being equal. Size can be measured in many dimensions, such as market value of
equity, revenues, or assets. A size premium is usually incorporated into the
estimation of the discount rate. In any case, the valuer’s report should indicate how
any applicable size premium was derived.
The Industry Adjustment
The industry adjustment is applied to the combined equity risk premium and
size premium and can be either positive or negative.
The Company-Specific Risk Adjustment
This company-specific element of the discount rate captures any aspects of
risk factors unique to the subject company, as opposed to the risk factors
incorporated in the companies from which the discount rate was otherwise derived.
It is usually positive, but could be negative. If an industry adjustment is not used,
the company-specific risk adjustment may incorporate industry risk factors not
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generally characteristic of other companies in the size range. This adjustment is
based entirely on the valuer’s analysis and judgment, so it should be well
supported in the narrative discussion of risk factors.
The Capital Asset Pricing Model (CAPM)
The CAPM differs from the build-up model in that it incorporates a factor
called beta as a modifier to the general equity risk premium. Beta is a measure of
systematic risk, that is, the correlation of fluctuations in the excess returns on the
specific stock with the excess returns on the market as a whole as measured by
some index. Excess returns are those returns over and above the risk-free rate of
return.
The average beta for the market is, by definition, 1.0. Thus, for a company
with a beta of 1.2, the company’s excess returns can be expected to fluctuate by
120 percent above the market; a company with a beta of 0.8 can be expected to
fluctuate by 80 percent of the market as a whole.
Because private companies do not have public market prices, when valuing a
private company using the CAPM, average betas of companies in the same industry
are usually used as a proxy for the beta of the subject private company.
In the CAPM, the equity risk premium is modified by multiplying it by the
assumed beta. Because the beta reflects the risk of the industry, the industry risk
adjustment is not used in the CAPM.
The size premium factor is used for companies smaller than those. The
company-specific risk adjustment is used where appropriate.
Exhibit 9.5 is a comparative sample illustration of the development of the
equity dis- count rate using three models:
1. The build-up model with an industry adjustment
2. The build-up model without an industry adjustment. The industry
adjustment is an attempt to replace beta. It works reasonably well in the
cases where the companies used to calculate the industry adjustment are
adequately homogeneous with the subject company.
3. The CAPM
Exhibit 9.5 Developing Equity Discount Rates Using the Build-Up Model with and without an Industry Adjustment and Using the Capital Asset Pricing Model
Build-Up Model w/ Industry
Adjustment
Build-Up Model w/o Industry Adjustment
Capital Asset Pricing Model
Risk-free rate 5.4% 5.4% 5.4%
Equity risk premium 7.0% 7.0%
Beta of .8 (7.0 x .8 = 5.6) 5.6%
Size premium 3.5% 3.5% 3.5%
Industry adjustment –3.6% — —
Estimated Equity Discount Rate 12.3% 15.9% 14.5%
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Estimating Capitalization Rates
Capitalization rates are used in the income approach for the capitalization
method, and for the discounting method in cases where the Gordon Growth Model
is used to develop the terminal value. In the context of the income approach, the
capitalization rate is derived by subtracting the estimated long-term growth rate
from the discount rate. Since the capitalization rate is such a crucial factor in the
income approach, it is important that both the discount rate and the long- term
growth rate be estimated very carefully in order to obtain a reliable value estimate.
9.3.7 Weighted Average Cost of Capital (WACC)
When valuing a company’s invested capital by the income approach, the
projected cash flows include those available to all the invested capital. Therefore,
the market rate of return at which they should be discounted is the weighted
average of the components of the capital structure (common equity, preferred
equity, and long-term debt), known as the weighted average cost of capital (WACC).
The components of the WACC are weighted at their respective market values,
NOT their book values. Since market values (at least for the equity component) are
unknown, calculating the WACC often requires an iterative process, that is,
repeating the calculations at various weightings of the components until they
balance. Fortunately, modern computer programs can perform the necessary
iterations in seconds.
Since interest paid on debt is tax deductible, the actual cost of debt to the
company is the after-tax cost. Thus, the company’s tax rate should be deducted
from the pretax cost of debt when calculating the debt component of the weighted
average cost of capital.
Exhibit 9.6 is an example of the weighted average cost of capital. Assume:
Exhibit 9.6 Weighted Average Cost Of Capital (WACC) Cost Weight
Common equity 20% 70%
Long-term debt 10% 30%
Tax rate 40%
Then:
Component Cost Weight Weighted Cost
Equity 0.20 x 0.70 = 14.0%
Long-term debt 0.10 x (1 – 0.40) = 0.60 x 0.30 = 1.8%
Weighted average cost of capital 15.8%
This would be used as a discount rate when valuing invested capital. In
appraisals for property tax purposes, the weighted average cost of capital is often
referred to as the band of investment theory.
One question that arises in estimating the WACC is whether to use the
company’s actual capital structure or a hypothetical capital structure. In general,
when valuing a minority interest, the company’s actual capital structure should be
used because the minority owner has no power to change the capital structure.
However, when valuing a controlling interest, the control holder has the power to
change the capital structure, so in some cases analysts use an industry average
capital structure.
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The Midyear Convention
The capitalization and discounting procedures previously discussed implicitly
reflect the assumption that the cash flows will be received at the end of each
projected year. This is a reasonable assumption for many companies because
management may wait until the end of the year to determine the capital
expenditure and working capital requirements for the following year before deciding
on distributions, if any.
However, some companies receive cash flows more or less evenly throughout
the year. To reflect this situation, some business valuation practitioners employ a
modification to the capitalization and discounting calculations called the midyear
convention.
The midyear convention, in effect, assumes that investors receive cash flows in
the middle of each year. This assumption approximates the value that would be
calculated from receiving cash flows evenly throughout the year.
The Midyear Convention in the Capitalization Method
In the Gordon Growth Model, the modification to reflect the midyear
convention is to raise the growth factor to the exponential level of 0.5. The
calculation for the amount to be capitalized would be Rs 10.50 x (1.05)0.5 = Rs
10.76. This would be divided by the capitalization rate, which was .10, to arrive at
the value:
Rs. 10.76 ÷ .10 = Rs. 107.60
The midyear convention will always produce a higher value than the year-end
convention so long as the cash flows are positive, because investors are assumed to
have received each projected cash flow six months earlier.
The formula for the Gordon Growth Model using the midyear convention is
shown in Exhibit 9.7.
Exhibit 9.7 Formula for the Gordon Growth Model Incorporating the Midyear Convention
PV = 0.5
1NCF (1 K)
(k g)
PV = Present value
NCF1 = Net cash flow expected in period 1, the period immediately following
the valuation date
k = Discount rate (cost of capital, total required rate of return)
g = Long-term growth rate
The Midyear Convention in the Discounting Model
The midyear modification to the discounting model is accomplished by raising
each component of the divisors to an exponent of 0.5 less than would be the case in
the year-end procedure.
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In the previous example, the computations would be revised as follows:
PV =
5 1.5 2.5 2.5
1700X .05
1200 1500 1700 .20 .05 (1 .20) (1 .20) (1 .20) (1 .20
+ +)
1
=1200 1500 1700 11900
, . 1.314534 1.577441 1.57
+7441
+ 1 095 45
= Rs.1, 095.45 + Rs.1,141.09 + Rs.1, 077.69 + Rs.7, 543.86
= Rs.10,858.09
This compares with Rs. 9,912.20 by the year-end convention; the assumption
that investors receive their cash earlier can make a significant difference in the
indicated value.
The formula for the discounting method incorporating the midyear convention
is shown as Exhibit 9.8.
Exhibit 9.8 Formula for the Discounting Method Incorporating the Midyear Convention
P =
n
2 n10.5 1.5 n 0.5 n 0.5
NCF (1 g)
NCF NCFNCF
(1 k) (1 k) (1 k) (1 k)
g+ +
NCF1 . . . NCFn = Net cash flows expected in periods 1 through n
k = Discount rate (cost of capital, total required rate of return)
g = Long term growth rate
Alternatively, the modified Gordon Growth Model formula may be used for the
terminal value, in which case the terminal value would be discounted for n periods
instead of n – 0.5 periods.
9.4 REVISION POINTS
1. Income approach
2. Expected returns
3. Discount - Method
9.5 INTEXT QUESTIONS
1. Explain importance of income approach for business valuation.
2. Discuss Gordon Growth Model with illustration.
3. Discuss Capital Asset Pricing Model with illustrations.
4. How does midyear conversion affect business value?
5. Elaborate “Beta” in business valuation and how it is being derived.
6. A company manufacturing, needle roller bearings, is financed by debt and
equity to the extent of 3:7, with total debts of Rs. 10.82 crores. The
company’s debt is valued at 8%. The beta of the company’s equity is known
to be 1.5. The company generates a free cash flow Rs. 2 crores with the
known growth projection of 5% to perpetuity. If it is known that the market
risk premium is 6% and the risk free rate is 5%, what is the value of each
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equity share for the 1 million shareholders of the company? Assume that the
company is in the 35% tax bracket.
7. The free cash flow of RKP Ltd is projected to grow at a compound annual
average rate of 35% for the next 5 years. Growth is then expected to slow
down to a normal 5% annual growth rate. The current year’s cash flow of
RKP Ltd is `Rs.4 crores. RKP Ltd’s cost of capital during the high growth
period is 18% and 12% beyond the fifth year, as growth stabilizes. Calculate
the value of the RKP Ltd.
8. A task has been assigned to a valuer in a mutual fund to find out at what
price the fund should subscribe to an IPO issue (through Book Building) of a
transformer company X Ltd. The following details of the company from
31.3.13 Annual Report are available:
Particulars 31.03.2017
Revenues 248.79
Operating expenses 214.41
EBIDTA 34.38
Other Income 3.84
Interest expense 1.00
Preliminary Expenses W/O 0.00
Depreciation 1.92
Profit before taxes 35.30
Income taxes 12.35
Tax at the rate of 35%
Net profit 22.95
To calculate future cash flows, the following projections for the financial year
ended 31.3.2018 till 31.3.2022 is available:
Amount in lakhs
Particulars FY18 FY19 FY 20 FY21 FY22
Revenue growth 55% 50% 28% 20% 14%
Operating exp/ Income 87% 87% 87% 88% 88%
Other Income 2.50 2.20 2.50 2.50 2.50
Interest expense 2.00 3.00 3.00 3.00 3.00
Preliminary Expenses W/O 0.00 0.00 0.00 0.00 0.00
Depreciation 2.60 3.50 4.10 3.90 3.70
Capital spending 2.00 5.00 5.00 2.00 2.00
Incremental Working capital 2.00 5.00 5.00 2.00 2.00
It is given that revenues would grow at 0% after the explicit forecast period. X
Ltd. total assets of Rs. 219.98 lakhs are financed with equity of Rs. 208.66 lakhs
and balance debts sourced at 8% p.a. Assume risk free rate of 7.5%, risk premium
of 7.5% and beta of stock as 1.07. The firm falls in the 35% tax bracket. The
company including the shares floated in this issue would have issued a total of 1.02
lakhs shares. Find out the intrinsic value of share using Discounted Cash Flow
Analysis.
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9.6 SUMMARY
The income approach represents the theory around which business valuation
revolves. However, as noted in the introduction to this chapter, the inputs
necessary for the income approach can be subject to substantial differences, even
among reasonable experts. We turn to the market approach in next chapter.
9.7 TERMINAL EXERCISE
1. Explain importance of income approach for business valuation.
9.8 SUPPLEMENTARY MATERIALS
1. https\\www.business.gov.in
2. www.business valuation.inc.com
9.9 ASSIGNMENTS
1. The students are required to open excel sheet and incorporate all the
models.
The students are required to take a case of a company they are conversant
with and analysing its financials and industry data, stock data, etc. and
derive capitalization rates, discount rates, beta, WACP, etc. necessary for
enterprise valuation of that company
9.10 SUGGESTED READINGS/REFERENCE BOOKS
1. Shannon P. Pratt, Cost of Capital: Estimation and Applications, 2nd ed.
(New York: John Wiley & Sons, Inc., 2002): 16.
2. The International Glossary of Business Valuation Terms defines
capitalization
3. Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs, Valuing a
Business: The Analysis and Appraisal of Closely Held Companies, 4th ed.
(New York: McGraw-Hill, 2000
9.11 LEARNING ACTIVITIES
Group discussion during PCP days
1. The students are required to open excel sheet and incorporate all the
models.
2. The students are required to take a case of a company they are conversant
with and analyzing its financials and industry data, stock data, etc. and
derive capitalisation rates, discount rates, beta, WACP, etc. necessary for
enterprise valuation of that company
9.12 KEY WORDS
Income Approach, WACC, Discounting, Capitalising, Midyear Conversion
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CHAPTER - 10
MARKET APPROACH TO BUSINESS VALUATION
10.1 INTRODUCTION
The market approach to business valuation is a pragmatic way to value
businesses, essentially by comparison to the prices at which other similar
businesses or business interests changed hands in arm’s-length transactions. It is
widely used by buyers, sellers, investment bankers, brokers, and business
appraisers.
The market approach to business valuation has its roots in real estate
appraisal, where it is known as the comparable sales method. The fundamental idea
is to identify the prices at which other similar properties changed hands in order to
provide guidance in valuing the property that is the subject of the appraisal.
Of course, business appraisal is much more complicated than real estate
appraisal because there are many more variables to deal with. Also, each business
is unique, so it is more challenging to locate companies with characteristics similar
to those of the subject business, and more analysis must be performed to assess
comparability and to make appropriate adjustments for differences between the
guideline businesses and the subject being valued.
Different variables are relatively more important in appraising businesses in
some industries than in others, and the analyst must know which variables tend to
drive the values in the different industries. These variables are found on (or
developed from) the financial statements of the companies, mostly on the income
statements and balance sheets. There are also qualitative variables to assess, such
as quality of management.
10.2 OBJECTIVES
Although the income approach as addressed in the previous chapter is
theoretically the best approach to business valuation, it requires estimates (the
projections and the discount rate) that are subject to potential disagreement. The
market approach is quite different in that it relies on more observable data,
although there can be (and often are) disagreements as to the comparability of the
guideline companies used and the appropriate adjustments to the observed
multiples to reach a selected multiple to apply to the subject company’s
fundamental data. This chapter discussed market approach to the business
valuation.
10.3 CONTENTS
10.3.1 The Market Approach
10.3.2 The Guideline Publicly Traded Company and the Guideline
Transaction (Merger and Acquisition) Method
10.3.3 How Many Guideline Companies?
10.3.4 Selection of Guideline Companies
10.3.5 Documenting the Search for Guideline Companies
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10.3.6 What Prices to Use in the Numerators of the Market Valuation
Multiples?
10.3.7 Choosing the Level of the Valuation Multiple
10.3.8 Mechanics of Choosing Levels of Market Multiples
10.3.9 Selecting Which Valuation Multiples to Use
10.3.10 Relevance of Various Valuation Multiples to the Subject Company
10.3.11 Availability of Guideline Company Data
10.3.12 Other Methods Classified under the Market Approach Past
Transactions in the Subject Company
10.3.13 Illustration
10.3.1 The Market Approach
The market approach to business valuation is a pragmatic way to value
businesses, essentially by comparison to the prices at which other similar
businesses or business interests changed hands in arm’s-length transactions. It is
widely used by buyers, sellers, investment bankers, brokers, and business
appraisers.
The market approach to business valuation has its roots in real estate
appraisal, where it is known as the comparable sales method. The fundamental
idea is to identify the prices at which other similar properties changed hands in
order to provide guidance in valuing the property that is the subject of the
appraisal.
Of course, business appraisal is much more complicated than real estate
appraisal because there are many more variables to deal with. Also, each business
is unique, so it is more challenging to locate companies with characteristics similar
to those of the subject business, and more analysis must be performed to assess
comparability and to make appropriate adjustments for differences between the
guideline businesses and the subject being valued.
Different variables are relatively more important in appraising businesses in
some industries than in others, and the analyst must know which variables tend to
drive the values in the different industries. These variables are found on (or
developed from) the financial statements of the companies, mostly on the income
statements and balance sheets. There are also qualitative variables to assess, such
as quality of management.
10.3.2 The Guideline Publicly Traded Company and the Guideline Transaction
(Merger and Acquisition) Method
The professional business appraisal community breaks the market approach
down into two methods:
1. The guideline publicly traded company method
2. The guideline transaction (merger and acquisition) method
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The guideline publicly traded company method consists of prices relative to
underlying financial data in day-to-day trades of minority interests in active
publicly traded companies, either on stock exchanges or the over-the-counter
market.
The guideline transaction (merger and acquisition) method consists of prices
relative to underlying fundamental data in transfers of controlling interests in
companies that may have been either private or public before the transfer of
control. The transactions in the databases usually were done through
intermediaries (business brokers, M&A specialists, or investment bankers), so they
are virtually all on an arm’s-length basis.
Both methods are implemented by computing multiples of prices of the
guideline company transactions to financial variables (earnings, sales, etc.) of the
guideline companies, and then applying the multiples observed from the guideline
company transactions to the same financial variables in the subject company.
Also generally subsumed under the market approach are the following:
1. Past transactions in the subject company
2. Bona fide offers to buy
3. Rules of thumb
4. Buy–sell agreements
There is no compiled source of transactions in minority interests in private
companies. The vast majority of brokers do not accept listings for minority interests
in private companies because there is no market for them. The fact that brokers
will not even accept listings for minority interests in privately held companies is
evidence of the wide gulf in degree of marketability between minority interests in
private companies and restricted stocks of public companies.
In any method under the market approach, the price can be either the price of
the common equity (equity procedure) or the price of all the invested capital (market
value of invested capital, or MVIC). When the invested capital procedure is used,
the result is the value of all the invested capital (usually common equity and long-
term debt), so the long-term debt must be subtracted in order to reach the
indicated value of the common equity. If cash was eliminated for the purpose of the
comparison, it should be added back.
See Exhibit 10.1 for a list of the market value multiples generally employed in
the equity procedure. See Exhibit 10.2 for a list of market value multiples generally
employed in the in- vested capital procedure. Neither of these lists is all-inclusive,
but they include the multiples most commonly found in business valuation reports.
It usually is not appropriate to use all the multiples in a single business valuation.
The appraiser should select one or a few that are most relevant to the subject
company.
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Exhibit 10.1 Market Value Multiples Generally Employed in the Equity Procedure
In the publicly traded guideline company method, market value multiples are
conventionally computed on a per- share basis, while in the merged and acquired
company methods they are conventionally computed on a total company basis.
Both conventions result in the same values for any given multiple.
Price/Earnings
Assuming that there are taxes, the term earnings, although used ambiguously
in many cases, is generally considered to mean earnings after corporate-level taxes,
or, in accounting terminology, net income.
Price/Gross Cash Flow
Gross cash flow is defined here as net income plus all noncash charges (e.g.,
depreciation, amortization, depletion, deferred revenue).
The multiple is computed as
. . .
.=
.
Price per shareRs 100051
Gross cash flow per share Rs 196
Price/Cash Earnings
Cash earnings equals’ net income plus amortization, but not other traditional
noncash charges, such as depreciation. This is a measure developed by investment
bankers in recent years for pricing mergers and acquisitions as an attempt to even
out the effects of very disparate accounting for intangibles.
The multiple is computed as
. . .
.=
.
Price per shareRs 100071
Cash earnings per shareRs 140
Price/ Pretax Earnings
The multiple is computed as
. .
. .
Price per shareRs 100
Pretax income per share Rs 167
Price/Book Value (or Price/Adjusted Net Asset Value) = 6.0
Book value includes the amount of par or stated value for shares outstanding,
plus retained earnings.
The multiple is computed as
. .00
. .
Price per shareRs 10
Book value per share Rs 172= 5.8
Price/Adjusted Net Asset Value
Sometimes it is possible to estimate adjusted net asset values for the guideline
and subject companies, reflecting adjustments to current values for all or some of
the assets and, in some cases, liabilities. In the limited situations where such data
are available, a price to adjusted net asset value generally is a more meaningful
indication of value than price/book value. Examples could include real estate
holding companies where real estate values are available, or forest products
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companies for which estimates of timber values are available. This procedure can
be particularly useful for family limited partnerships.
Tangible versus Total Book Value or Adjusted Net Asset Value
If the guideline and/or subject companies have intangible assets on their
balance sheets, analysts generally prefer to subtract them out and use only
price/tangible book value or price/tangible net asset value as the valuation
multiple.
This is to avoid the valuation distortions that could be caused because of
accounting rules. On one hand, if a company purchases intangible assets, the item
becomes part of the assets on the balance sheet. If, on the other hand, a company
creates the same intangible asset internally, it usually is expensed and never
appears on the balance sheet. Because of this difference, tangible book value or
tangible net asset value may present a more meaningful direct comparison among
companies that may have some purchased and some internally created assets.
Price/Dividends (or Partnership Withdrawal)
If the company being valued pays dividends or partnership withdrawals, the
multiple of such amounts can be an important valuation parameter. This variable
can be especially important when valuing minority interests, since the minority
owner normally has no control over payout policy, no matter how great the
company’s capacity to pay dividends or withdrawals.
The market multiple is computed as follows:
. .
.0.50
Dividend per share Rs 100
Price per shareRs= 20
This is one market multiple that is more often quoted as the reciprocal of the
multiple; that is, the capitalization rate (also called the yield). The yield is computed
as
. .
. .
Dividend per share Rs 050
Price per share Rs 100= 5.0% yield
Price/Sales
This multiple is more often used as an invested capital multiple, because all of
the invested capital, not just the equity, is utilized to support the sales. If the
subject and guideline companies have different capital structures, the equity
price/sales can be very misleading. However, if none of the companies has long-
term debt, then the equity is equal to the total invested capital, and the multiple is
meaningful on an equity basis.
This multiple is computed as
. .
.13.9
Dividend per share Rs 100
Price per shareRs= 0.72
Price/Discretionary Earnings
The International Business Brokers Association defines discretionary earnings
as pretax income plus interest plus all noncash charges plus all compensation and
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benefits to one owner/operator. Because the multiple of discretionary earnings is
normally used only for small businesses where no debt is assumed, it is usually
computed on a total company basis.
The multiple is computed as
. , ,
. , ,
MVIC or price Rs 10 200 00
Discretionary earningsRs 2 450 000= 4.2
The multiple of discretionary earnings is used primarily for smaller
businesses and professional practices where the involvement of the key
owner/operator is an important component of the business or practice. For such
businesses or practices, meaningful multiples generally fall between 1.5 and 3.5
although some fall outsider range
Exhibit 10.2 Market Value Multiples Generally Employed in the Invested Capital
Procedure
MVIC stands for market value of invested capital, the market value of all the
common and preferred equity and long-term debt. Some analysts also include all
interest-bearing debt.
MVIC/EBITDA (Earnings before Interest, Taxes, Depreciation, and
Amortization)
The multiple is computed as
. , ,
. , ,
MVIC Rs 10 200 000
EBITDARs 1 950 000= 5.2
EBITDA multiples are particularly favored to eliminate differences in
depreciation policies.
MVIC/EBIT (Earnings before Interest and Taxes)
The multiple is computed as
. , ,
. , ,
MVIC Rs 10 200 000
EBIT Rs 1 500 000= 6.8
EBIT multiples are good where differences in accounting for noncash charges
are not significant.
MVIC/TBVIC (Tangible Book Value of Invested Capital)
The multiple is computed as
. , ,
. , ,
MVIC Rs 10 200 000
TBVIC Rs 3 100 000= 3.3
This MVIC multiple can be used on TBVIC and also with adjusted net asset
value instead of book value if data are available.
MVIC/Sales
The multiple is computed as
. , ,
. , ,
MVIC Rs 10 200 000
Sales Rs 10 000 000= 1.02
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MVIC/Physical Activity or Capacity
The denominator in a market value multiple may be some measure of a
company’s units of sales or capacity to produce. Analysts generally prefer that the
numerator in such a multiple be MVIC rather than equity for the same reasons as
the sales multiple—that is, the units sold or units of capacity are attributable to the
resources provided by all components of the capital structure, not just the equity.
10.3.3 How Many Guideline Companies?
For a market approach valuation by the publicly traded guideline company
method or the transaction (merger and acquisition) method, the analyst usually will
select about three to seven guideline companies, although there may be more. The
more data there are available for each company and the greater the similarity
between the guideline companies and the subject company, the fewer guideline
companies are needed.
10.3.4 Selection of Guideline Companies
A major area of controversy in the market approach in some cases is the
selection of guideline companies. There are cases where the valuer may not weight
whatsoever to the market approach, because the valuer felt that the guideline
companies selected were not adequately comparable. There are other cases where
the valuer adopts one side’s market approach over the others because of
inadequate comparability of companies on the side that was rejected.
The primary criteria for similar line of business are the economic factors that
impact the company’s revenues and profits, such as markets, sources of supply,
and products. For example, for a company manufacturing electronic controls for
the forest products industry it would make much more sense to select companies
manufacturing a variety of capital equipment for the forest products industry than
to select companies manufacturing electronic controls for unrelated industries. This
is so because the company’s manufacturing capital equipment for the forest
products industry would be subject to the same economic conditions as the subject
company.
10.3.5 Documenting the Search for Guideline Companies
The guideline company search criteria should be clearly spelled out in the
report so that another valuer could replicate the same criteria and expect to
produce the same source list. The search criteria should include, for example, these
six factors:
1. The line or lines of businesses searched
2. Size range (e.g., revenue, assets)
3. Geographical location, if applicable (location may be of great importance in
certain industries, such as retailing, yet of no importance in other industries
such as software)
4. Range of profitability (e.g., net income, EBITDA)
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5. If using the guideline merger and acquisition method, range of transaction
dates
6. The database(s) searched
If any companies that meet the stated search criteria are eliminated, the valuer
should list the companies and the reason they were eliminated (e.g., ratio analysis
far from subject company). The valuer should then give a brief description of each
company selected. This procedure should be sufficient to assure that there is no
bias in the selection of guideline companies.
10.3.6 What Prices to Use in the Numerators of the Market Valuation Multiples?
First of all, the prices must be market values, NOT book values. For invested
capital multiples, book value of debt is usually assumed to equal market value, but
it may require adjustment from book value to market value if market conditions
have changed significantly since the issuance of the debt.
In the guideline publicly traded company method the price is almost always
the closing price of the companies’ stock on the valuation date. However, on
occasion, such as in an extremely volatile market, it might be an average of some
period of time (usually 20 to 30 trading days) either immediately preceding, or
preceding and following, the valuation date.
In the guideline merger and acquisition method, the price is as of the guideline
company transaction closing date. That price may require adjustment if industry
conditions (e.g., typical valuation multiples for the industry) have changed
significantly between the guideline company transaction date and the subject
company valuation date.
10.3.7 Choosing the Level of the Valuation Multiple
Valuation pricing multiples calculated from guideline publicly traded
companies can vary widely. For example, price/earnings multiples for the guideline
companies may range between 8 and 20 times the trailing 12 months’ earnings. A
great deal of valuer’s judgment goes into the choice of where the valuation multiple
to be applied to the subject company should fall relative to the multiples observed
in the guideline companies. However, this judgment should be backed up by
quantitative and qualitative analysis to the greatest extent possible. This requires a
thorough analysis of the financial statement, as discussed in earlier chapter.
The preferred measure of central tendency in most arrays is the median (the
middle observation in the array, or, in the case of an even number of observations,
the number halfway in between the numbers immediately above and immediately
below the middle of the array). The median is generally preferred over the average
(the mean) because the average may be distorted by one or a few very high
numbers.
In general, there are two main determinants of the multiple that should be
applied to the subject company relative to the guideline companies:
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1. Relative degree of risk (uncertainty as to achievement of expected results)
2. Relative growth prospects
In addition, other financial analysis variables, such as return on sales and
return on book value, may impact the selection of specific market multiples?
Relative Degree of Risk
Risk is the degree of uncertainty regarding the achievement of expected future
results, especially future cash flows. In the market approach, risk is factored into
value through market multiples, while risk in the income approach is factored in
through the discount rate.
High risk for the subject company relative to the guideline companies should
have a downward impact on the multiples chosen for the subject company relative
to the guideline company multiples, and vice versa.
Leverage (debt-to-equity ratio) is one measure of relative risk. The relative
degree of stability or volatility in past operating results is another measure of
relative risk.
Although objective financial analysis should be utilized in assessing risk, the
analyst must also use subjective judgment based on management interviews, site
visits, economic and industry conditions, past experience, and other sources that
may impact the assessment of risk. Both objective and subjective adjustments
must be thoroughly explained.
Relative Growth Prospects
In the market approach, growths prospects are factored into the valuation
through market multiples, while growth prospects in the income approach are
factored in through projected operating results. High growth prospects for the
subject company relative to the guideline companies should have an upward impact
on the multiples chosen for the subject company relative to the guideline company
multiples, and vice versa. The key phrase here is relative to the guideline
companies.
Relative growth between the subject and guideline companies should be
considered, if available, but there is no assurance that relative past trends will
continue in the future. The valuer should assess growth prospects carefully in light
of the management interviews, the site visit (for example, is there evidence of future
costs for deferred maintenance?), and analysis of how economic and industry
conditions will impact the subject company relative to the guideline companies.
Return on Sales
If the subject company has a higher return on sales than the guideline
companies, it would deserve a higher price/sales multiple than the guideline
companies, all other things being equal, assuming that the higher relative return on
sales is expected to continue in the future.
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Return on Book Value
To the extent that the subject company’s return on book value of equity or
invested capital is higher than the guideline companies’ returns on book value of
equity or invested capital, it would deserve a higher price/book value multiple than
those of the guideline companies, all other things being equal and assuming that
the higher relative return on book value is expected to continue in the future.
10.3.8 Mechanics of Choosing Levels of Market Multiples
In light of these factors, the analyst should select the level of each market
multiple to apply to the subject company. There are several acceptable procedures
for doing this.
Medians of multiples from the guideline companies provide a good starting
point. How- ever, analysis of relative risk, growth prospects, return on sales, and
return on book value will usually lead the analyst to select one or even all of the
multiples at levels above or below the medians of the guideline companies? If
median multiples are chosen, the analyst should demonstrate that the subject and
guideline companies are relatively homogeneous.
There are many techniques for choosing multiples other than the median. One
is to select a subset of the guideline companies whose characteristics most
resemble the characteristics of the subject and to use the averages or medians of
their multiples. Another is to choose a percentage above or below the mean. Still
another is to choose a point in the array of multiples such as the upper or lower
quartile, quintile, or decile.
Regression analysis may be used to select the price/sales and price/book
value multiples. It is not necessary that all multiples chosen bear the same
relationship to the median multiple. For example, if return on book value for the
subject company is above that of the guideline companies, the selected price or
MVIC-to-book-value multiple may be higher than that of the guideline companies,
while if return on sales for the subject company is lower than that of the guideline
companies, the selected price or MVIC-to-sales multiple may be lower than that of
the guideline companies.
Occasionally, in extreme circumstances, the multiple selected to apply to the
subject company may even be outside of the range observed for the guideline
companies. For ex- ample, if return on book value is outside the range of observed
returns on book value, the selected price or MVIC to book value may be outside the
range of observed price or MVIC-to-book-value multiples.
10.3.9 Selecting Which Valuation Multiples to Use
From the array of valuation multiples in Exhibits 10.1 and 10.2 (or other
possible multiples), the analyst must select which one or ones to use. The analyst
should explain in the report why he or she chose the particular multiples used.
Generally speaking, invested capital multiples (which reflect the value of all
equity and long-term debt) are preferable for controlling interests. This is because a
control owner is not bound by the existing capital structure. A control owner has
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the right to increase or decrease leverage; the minority owner does not have this
right.
Sometimes, however, invested-capital multiples are used when valuing
minority interests. Invested-capital multiples are especially relevant where the
degree of leverage (ratio of debt to equity) varies significantly between the subject
and guideline companies.
Some appraisers use invested-capital multiples in all their valuations. Others
use both in- vested-capital and equity-valuation multiples, depending on the
circumstances.
Three criteria have the most impact on the choice of valuation multiples:
1. The relevance of the particular multiple to the subject company
2. The quantity of guideline company data available for the multiple
3. The relative tightness or dispersion of the data points within the multiple
10.3.10 Relevance of Various Valuation Multiples to the Subject Company
The degree of relevance of any valuation multiple for a subject company
depends on both the industry and the company’s financial data. Exhibit 10.3 gives
some suggestions as to when certain valuation multiples are appropriate to be
used.
Exhibit 10.3 When to Use a Valuation Multiple
Price/Net Earnings
Relatively high income compared with depreciation and amortization
When depreciation represents actual physical wear and tear
Relatively normal tax rates
Price/Pretax Earnings
Same as above except company has relatively temporary abnormal tax rate
“S” corporations may be valued using pretax income or may be taxed
hypothetically at “C” corporation rates or personal tax rates
Price/Cash Flow (often defined as net income plus depreciation and amortization)
Relatively low income compared with depreciation and amortization
Depreciation represents low physical, functional, or economic obsolescence
Price/Sales
When the subject company is “homogeneous” to the guideline companies in
terms of operating expenses
Service companies and asset-light companies are best suited for this ratio
Price/Dividends or Dividend-Paying Capacity
Best when the subject company actually pays dividends
When the company has the ability to pay representative dividends and still
have adequate ability to finance operations and growth
In minority interest valuation, actual dividends are more important
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Price/Book Value
When there is a good relationship between price/book value and return on equity
Asset-heavy companies
For example, property and casualty insurance agencies are usually valued on a price/sales basis because they are service businesses, they are asset light, and they have relatively homogeneous cost structures.
By contrast, many manufacturing companies are valued largely or entirely on
the basis of MVIC/EBITDA multiples to even out potentially significant differences
in depreciation schedules.
Availability of Guideline Company Data
Data used to compute certain valuation multiples might not be available for all
selected guide- line companies. If too few guideline companies’ data are available for
a certain valuation multiple, this may be reason to eliminate that multiple from
consideration.
Relative Tightness or Dispersion of the Valuation Multiples
Generally speaking, multiples that have tightly clustered values are the most
relevant, because the tight clustering usually indicates that the particular multiple
is one that the market relies on. Widely dispersed valuation multiples provide less
reliable valuation guidance.
One way to judge the tightness or relative dispersion of the data is just to look
at it. A mathematical tool for measuring the relative tightness or dispersion of the
data is called the coefficient of variation (the standard deviation divided by the
mean). Valuation multiples with lower coefficients of variation are usually more
reliable than multiples with higher coefficients of variation.
10.3.11 Assigning Weights to Various Market Multiples
In unusual cases, one valuation multiple may dominate the concluded
indication of value. In most cases, however, two or more market value multiples will
have a bearing on value, and the analyst must deal with how much weight to
accord to each.
The same factors considered in choosing the relevant multiples should also be
considered in deciding the weight to be accorded to each. For example, where
assets are important to a company’s value—such as holding companies, financial
institutions, and distribution companies—weight should be given to price/book-
value multiples. Where earnings are of paramount importance—such as service and
manufacturing companies—weight should be given to operating multiples, such as
price/sales, price/earnings, price (MVIC)/EBITDA, and so on. The analyst may
either use subjective weighting or assign mathematical weights. Al- though there is
no formula for assigning mathematical weights, doing so may be helpful in
understanding the analyst’s thinking. If assigning weights, the analyst should
include a disclaimer to the effect that there is no empirical basis for the weights
and that they are shown only as guides to the analyst’s thinking.
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10.3.12 Other Methods Classified Under the Market Approach
Four other methods are conventionally classified under the market approach:
1. Past transactions in the subject company
2. Offers to buy
3. Rules of thumb
4. Buy–sell agreements
Past Transactions in the Subject Company
The analyst should inquire as to whether there have been any past
transactions in the company’s equity, either on a control or a minority basis. The
analyst should also inquire as to whether the company has made any acquisitions.
If past transactions occurred, the next question is whether they were on an arm’s-
length basis.
If past arm’s-length transactions did take place, they should be analyzed like
any other guideline company transactions. The past transactions method may be
one of the most useful market methods, yet it is often overlooked.
Past Acquisitions by the Subject Company
Past acquisitions by the subject company are often a fertile field for very valid
guideline market transaction data, and are a source often overlooked. We would
suggest, “Have you made any acquisitions?” as a standard question in management
interviews. Appropriate adjustments must be made, as just discussed.
Offers to Buy
For offers to buy to be probative evidence of value, they must be: (1) firm, (2) at
arm’s length, (3) with sufficient detail of terms to be able to estimate the cash
equivalent value, and (4) from a source with the financial ability to consummate the
offer (i.e., a bona fide offer). It is rare that all of these requirements are met.
If the requirements are met, the offer to buy can be handled in the same way
as a past transaction to arrive at one indication of value as of the valuation date.
Since the offer did not conclude in a consummated transaction, however, the
weight accorded its indication of value may be limited.
Rules of Thumb
Many industries, especially those characterized by very small businesses, have
valuation rules of thumb, some more valid than others. If they exist, they should be
considered if they have a wide industry following. However, they should never be
relied on as the only valuation method.
Nature of Rules of Thumb
Rules of thumb come in many varieties, but the most common are:
Multiple of sales
Multiple of some physical nature of activity
Multiples of discretionary earnings
Assets plus any of the above
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Proper Use of Rules of Thumb
Rules of thumb are best used as a check on the reasonableness of the
conclusions reached by other valuation methods, such as capitalization of earnings
or a market multiple methods. A good source for guidance on when to use rules of
thumb is in the American Society of Appraisers Business Valuation Standards:
Rules of thumb may provide insight on the value of a business, business
ownership interest, or security. However, value indications derived from the use of
rules of thumb should not be given substantial weight un- less supported by other
valuation methods and it can be established that knowledgeable buyers and sellers
place substantial reliance on them.13
Problems with Rules of Thumb
One problem with rules of thumb is the lack of knowledge about the derivation
of the rules. Several other problems are:
Not knowing what was transacted. Most, but not all, rules of thumb
presume that the valuation rule applies to an asset sale. Few of them,
however, specify what assets are assumed to be transferred. The asset
composition may vary substantially from one transaction to another. It is
also important to remember that the rules of thumb almost never specify
whether they assume a non-compete agreement or an employment
agreement, even though such types of agreements are very common for the
kinds of businesses for which rules of thumb exist.
Not knowing assumed terms of the transactions. Most transactions for
which there are rules of thumb are not all-cash transactions, but involve
some degree of seller financing. The financing terms vary greatly from one
transaction to another, and affect both the face value and the fair market
value (which, by definition, assumes a cash or cash equivalent value).
Not knowing the assumed level of profitability. The level of profitability
impacts almost all real-world valuations. However, for rules of thumb that
are based on either gross revenue or some measure of physical volume,
there is no indication of the average level of profitability that the rule of
thumb implies.
Uniqueness of each entity. Every business is, to some extent, different from
every other business. Rules of thumb give no guidance for taking the unique
characteristics of any particular business into account.
Multiples change over time. Rules of thumb rarely change, but in the real
world market valuation multiples do change over time. Some industries are
more susceptible than others to changes in economic and industry
conditions. Changes occur in the supply/demand relationship for valuing
various kinds of businesses and professional practices because of many
factors, sometimes including legal/regulatory changes. When using market
transaction multiples, adjustments can be made for changes in conditions
from the time of the guideline transaction to the subject valuation date, but
there is no base date for rules of thumb.
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Sources for Rules of Thumb
For some industries, articles or trade publications may provide some industry
rules of thumb.
Buy-Sell Agreements
Buy–sell agreements are included here as a market approach category on the
assumption that they represent parties’ agreements on pricing transactions that are
expected to occur in the future. The pricing mechanism set forth in the buy–sell
agreement may be determinative of value in certain circumstances, such as where
it is legally binding for the purposes of the valuation. In other cases, the buy–sell
agreement price might be one method of estimating value, but not determinative. In
still other instances, the buy–sell agreement might be ignored be- cause it does not
represent a bona fide arm’s-length sale agreement.
For estate tax purposes, for example, a buy–sell agreement price is binding for
estate tax determination only if it meets all of the following conditions:
The agreement is binding during life as well as at death.
The agreement creates a determinable value as of a specifically determinable
date.
The agreement has at least some bona fide business purpose (this could
include the pro- motion of orderly family ownership and management
succession, so this is an easy test to meet).
The agreement results in a fair market value for the subject business
interest, when executed. Often, buy–sell agreement values will generate
future date of death or gift date values substantially above or below what the
fair market value otherwise would have been for the subject interest—even
though the value was reasonable when the agreement was made.
Its terms are comparable to similar arrangements entered into by persons in
arm’s-length transactions.
If a buy–sell agreement does not meet these conditions, it is entirely possible to
have a buy–sell value that is legally binding on an estate for transaction purposes,
but not for estate tax purposes, and that may not even provide enough money for
estate taxes.
10.3.13 Illustration
True Value Ltd. (TVL) is planning to raise funds through issue of common
stock for the first time. However, the management of the company is not sure about
the value of the company and, therefore, they attempted to study similar companies
in the same line which are comparable to True value in most of the aspects.
From the following information, you are required to compute the value of TVL
using the comparable firms approach.
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(Rs. in crore)
Company True value
Ltd. Jewel-
value Ltd. Real value
Ltd. Unique value
Ltd.
Sales 250 190 210 270
Profit after tax 40 30 44 50
Book value 100 96 110 128
Market Value 230 290 440
TVL feels that 50% weightage should be given to earnings in the valuation
process; sales and book value may be given equal weightages.
Solution:
The valuation multiples of the comparable firms are as follows:
Particular Jewel-value
Ltd. Real value
Ltd. Unique
value Ltd. Average
Prices/Sales ratio* 1.21 1.38 1.63 1.41
Price/Earnings ratio** 7.67 6.59 8.80 7.69
Price/Book value ratio 2.40 2.64 3.44 2.83
Applying the multiples calculated as above, the value of TVL can be calculated
as follows:
Particular Multiple Average Parameter (` cr.) Value (` cr.)
Prices/Sales 1.41 250 352.50
Price/Earnings 7.69 40 307.60
Price/Book value 2.83 100 283.00
By applying the weightage to the P/S ratio, P/E ratio and P/BV ratio we get:
[(352.50 x 1)+(307.60 x 2)+(283.00 x 1)]/(1+2+1)= 312.675, i.e. Rs. 312.675
crores is the value.
Alternative:
(352.50 × 0.25 + 307.60 × 0.50 + 283.00 × 0.25) = Rs. 312.675 crore.
Working Notes:
*Price/Sales Ratio = Market Value / Sales
**Price/Earnings Ratio = Market Value / Profit after tax
***Price/Book value ratio = Market Value/ Book Value
10.4 REVISION POINTS
1. Market approach
2. Market value
3. Book value
10.5 INTEXT QUESTIONS
1. Explain importance of market approach for business valuation.
2. Discuss “Rule of Thumb”.
3. Discuss various valuation multiples and their relevance in business
valuation.
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4. Discuss mechanics of valuation multiples and selection of relevant
multiples.
5. A rule of thumb for gas stations is 1.5 to 3.5 times owner’s cash flow for the
most recent 12 months, which yields the value of equipment, lease, and
intangibles. After investigating the operations of RKP Gas Services Co., you
believe that the business deserves a multiple of 3.0 times owner’s cash flow.
Given the information below, what is the value of equity for RKP Gas
Services based on the rule of thumb? Given that in last financial year the
net cash flow was Rs. 20 Lakhs, Cash Rs. 70,000/-, Inventory Rs. 9 Lakhs
and Liabilities Rs. 13.5 Lakhs.
6. RKP Ltd is in the business of making sports equipment. The Company
operates from Thailand. To globalize its operations RKP has identified Try
Toys Ltd, an Indian Company, as a potential takeover candidate. After due
diligence of Try Toys Ltd, the following information is available :-
(a) Cash Flow Forecasts (in Crores)
Year 10 9 8 7 6 5 4 3 2 1
Try Toys Ltd 24 21 15 16 15 12 10 8 6 3
RKP Ltd 108 70 55 60 52 44 32 30 20 16
(b) The Net Worth of Try Toys Ltd (in Lakh) after considering certain
adjustments suggested by the due diligence team reds as under —
Tangible 750
Inventories 145
Receivables 75 970
Less: Creditors 165
Bank Loans 250 (415)
Represented by Equity Shares of Rs. 1000 each 555
Talks for the takeover have crystallized on the following –
1. RKP Ltd will not be able to use Machinery worth `75 Lakhs which will be
disposed of by them subsequent to take over. The expected realization
will be `50 Lakhs.
2. The inventories and receivables are agreed for takeover at values of Rs.
100 and Rs 50 Lakhs respectively, which is the price they will realize on
disposal.
3. The liabilities of Try Toys Ltd will be discharged in full on take over along
with an employee settlement of `90 Lakhs for the employees who are not
interested in continuing under the new management.
4. RKP Ltd will invest a sum of Rs 150 Lakhs for upgrading the Plant of Try
Toys Ltd on takeover. A further sum of Rs 50 Lakhs will also be incurred
in the second year to revamp the machine shop floor of Try Toys Ltd.
5. The anticipated cash flow (in Rs. Crore) post takeover are as follows-
Year 1 2 3 4 5 6 7 8 9 10
Cash Flows 18 24 36 44 60 80 96 100 140 200
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You are required to advise the management the maximum price which they
can pay per share of Try Toys Ltd., if a discount factor of 15% is considered
appropriate.
10.6 SUMMARY
The two primary methods within the market approach are the guideline
publicly traded company method and the guideline transaction (merger and
acquisition) method. Other methods often classified under the market approach are
past transactions, offers to buy, rules of thumb, and buy–sell agreements. The
income and market approaches are the main approaches used for operating
companies when the premise of value is a going-concern basis. For holding
companies and operating companies for which the appropriate premise of value is a
liquidation basis, an asset approach is typically employed. The asset approach is
the subject of next chapter.
10.7 TERMINAL EXERCISE
1. Difference between market value and book value.
2. Discuss the “Rule of thumb”
10.8 SUPPLEMENTARY MATERIALS
1. https\\www.business.gov.in
2. www.business valuation.inc.com
10.9 ASSIGNMENTS
1. The students are required to take a case of a company they are conversant
with and collecting and analyzing its valuation multiples/ comparables in
relation to guideline companies necessary for valuation of that company
10.10 SUGGESTED READINGS/REFERENCE BOOKS
1. Shannon P. Pratt, The Market Approach to Valuing Businesses (New York:
John Wiley & Sons, Inc., 2001)
2. American Society of Appraisers, BV-201, Introduction to Business Valuation,
Part I, from Principles of Valuation course series, 2002
3. American Society of Appraisers, Business Valuation Standards
4. Glenn Desmond, Handbook of Small Business Valuation Formulas and
Rules of Thumb, 3rd ed. (Camden, Me.: Valuation Press, 1993).
10.11 LEARNING ACTIVITIES
Group discussion during PCP days
1. The students are required to take a case of a company they are conversant
with and collecting and analyzing its valuation multiples/ comparables in
relation to guideline companies necessary for valuation of that company
10.12 KEY WORDS
Market Approach, Market Comparables/ Multiples, MVIC, MVIC/EBITDA,
Rule of Thumb
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CHAPTER - 11
THE ASSET-BASED APPROACH TO BUSINESS VALUATION
11.1 INTRODUCTION
In the valuation of a business or business enterprise, the asset approach
presents the value of all the tangible and intangible assets and liabilities of the
company. As typically used, this approach starts with a book basis balance sheet
as close as possible to the valuation date and restates the assets and liabilities,
including those that are unrecorded, to fair value (financial reporting) or fair market
value (tax and other purposes). On the surface, the asset approach seems to be
simple, but deceptively so. The application of this approach introduces a number of
complicating factors that must be addressed before a satisfactory analysis is
concluded.
11.2 OBJECTIVES
The asset-based approach is relevant for holding companies and for operating
companies that are contemplating liquidation or are unprofitable for the foreseeable
future. It should also be given some weight for asset-heavy operating companies,
such as financial institutions, distribution companies, and natural resources
companies such as forest products companies with large timber holdings. There are
two main methods within the asset approach (1) The adjusted net asset value
method and (2) The excess earnings method. Either of these methods produces a
controlling interest value. If valuing a controlling interest, a discount for lack of
marketability may be applicable. If valuing a minority interest, discounts for both
lack of control and lack of marketability would be appropriate in most cases. This
chapter discussed asset-based approach to the business valuation.
11.3 CONTENTS
11.3.1 Adjusted Net Asset Value Method
11.3.2 Excess Earnings Method (The Formula Approach)
11.3.3 Steps in Applying the Excess Earnings Method
11.3.4 Example of the Excess Earnings Method
11.3.5 Reasonableness Check for the Excess Earnings Method
11.3.6 Problems with the Excess Earnings Method
11.3.1 Adjusted Net Asset Value Method
The adjusted net asset value method involves adjusting all assets and
liabilities to current values. The difference between the value of assets and the
value of liabilities is the value of the company. The adjusted net asset method
produces a controlling interest value.
The adjusted net asset value encompasses valuation of all the company’s
assets, tangible and intangible, whether or not they are presently recorded on the
balance sheet. For most companies, the assets are valued on a going-concern
premise of value, but in some cases they may be valued on a forced or orderly
liquidation premise of value.
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The adjusted net asset method should also reflect the potential capital gains
tax liability for appreciated assets. As a result, this can be done as an adjustment
to the balance sheet rather than a separate adjustment at the end.
Exhibit 11.1 is a sample of the application of the adjusted net asset value
method. In a real valuation, the footnotes should be explained in far greater detail
in the text of the report. Intangible assets are usually valued by the income
approach.
Exhibit 11.1 Adjusted Net Asset Value for RKP Co.
31/3/2016 Adjusted As Adjusted Rs. ‘000 Rs. ‘000 Rs. ‘000
Assets: Current Assets:
Cash Equivalents 740,000 740,000
Accounts Receivable 2,155,409 2,155,409 Inventory 1,029,866 200,300a
1,230,166
Prepaid Expenses 2,500 2,500
Total Current Assets 3,927,775 200,300 4,128,075 Fixed Assets:
Land & Buildings 302,865 (49,760)b 253,105
Furniture & Fixtures 155,347 (113,120)b 42,227
Automotive Equipment 478,912 (391,981)b 86,931
Machinery & Equipment 759,888 (343,622)b 416,266
Total Fixed Assets, Cost 1,697,012 (898,483) 798,529
Accumulated Depreciation 1,298,325) 1,298,325 c
0
Total Fixed Assets, Net 398,687 399,842 798,529 Real Estate—Non-operating
Other Assets: Goodwill, Net
90,879
95,383
43,121 d
(95,383)e
134,000
0
Organization Costs, Net 257 (257)e 0
Investments 150,000 20,000 d 170,000
Patents 0 100,000 e 100,000
Total Other Assets 245,640 24,360 270,000
Total Assets 4,662,981 667,623 5,330,604 Liabilities and Equity:
Current Liabilities: Accounts Payable
1,935,230
1,935,230
Bank Note, Current 50,000 50,000
Accrued Expenses 107,872 107,872 Additional Tax Liability 0 267,049 f
267,049 Total Current Liabilities 2,093,103 267,049 2,360,151
Long-Term Debt 350,000 350,000 Total Liabilities 2,443,102 267,049 2,710,151 Equity:
Common Stock 2,500 2,500 Paid-in Capital 500,000 500,000 Retained Earnings 1,717,379 400,574 g
2,117,953
Total Equity 2,219,879 400,574 2,620,453
Total Liabilities and Equity 4,662,981 667,623 5,330,604
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Notes:
1. Add back LIFO reserve.
2. Deduct economic depreciation.
3. Remove accounting depreciation.
4. Add appreciation of value, per real estate appraisal.
5. Remove historical goodwill. Value identifiable intangibles and put on books.
6. Add tax liability of total adjustment at 40% tax rate.
7. Summation of adjustments.
Two methods are used here:
a. The Liquidation Value, which is the sum as estimated sale values of the
assets owned by a company.
b. Replacement Cost: The current cost of replacing all the assets of a company
at times for specific purposes professional valuers also consider depreciated
replacement cost of the asset(s).
This approach is commonly used by property and investment companies, to
cross check for asset based trading companies such as hotels and property
developers, underperforming trading companies with strong asset base (market
value vs. existing use), and to work out break – up valuations.
11.3.2 Excess Earnings Method (The Formula Approach)
The excess earnings method is classified under the asset approach because it
involves valuing all the tangible assets at current fair market values and valuing all
the intangible assets in a big pot loosely labeled goodwill. It is also sometimes
classified as a hybrid method.
Thus, the concept of the excess earnings method is to value goodwill by
capitalizing any earnings the company was enjoying over and above a fair rate of
return on their tangible assets. Thus the descriptive label, excess earnings method.
The result of the excess earnings method is value on a control basis. This approach
may be used for determining the fair market value of intangible assets of a business
only if there is no better basis therefore available.
11.3.3 Steps in Applying the Excess Earnings Method
1. Estimate net tangible asset value (usually at market values).
2. Estimate a normalized level income.
3. Estimate a required rate of return to support the net tangible assets.
4. Multiply the required rate of return to support the tangible assets (from step 3) by the net tangible asset value (from step 1).
5. Subtract the required amount of return on tangibles (from step 3) from the
normalized amount of returns (from step 2); this is the amount of excess earnings. (If the results are negative, there is no intangible value and this method is no longer an appropriate indicator of value. Such a result
indicates that the company would be worth more on a liquidation basis than on a going-concern basis.)
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6. Estimate an appropriate capitalization rate to apply to the excess economic
earnings. (This rate normally would be higher than the rate for tangible
assets and higher than the overall capitalization rate; persistence of the
customer base usually is a major factor to consider in estimating this rate.)
7. Divide the amount of excess earnings (from step 5) by a capitalization rate
applicable to excess earnings (from step 6); this is the estimated value of the
intangibles.
8. Add the value of the intangibles (from step 7) to the net tangible asset value
(from step 1); this is the estimated value of the company.
9. Reasonableness check: Does the blended capitalization rate approximate a
capitalization rate derived by weighted average cost of capital (WACC)?
10. Determine an appropriate value for any excess or nonoperating assets that
were adjusted for in step 1. If applicable, add the value of those assets to the
value determined in step 8. If asset shortages were identified in step 1,
determine whether the value estimate should be reduced to reflect the value
of such shortages. If the normalized income statement was adjusted for
identified asset shortages, it is not necessary to further re- duce the value
estimate.
11.3.4 Example of the Excess Earnings Method
Assumptions: Rs. ‘000
Net tangible asset value 100,000
Normalized annual economic income 30,000
Required return to support tangible assets 10%
Capitalization rate for excess earnings 25%
Calculations:
Net tangible asset value 100,000
Required return on tangible assets 0.10 100,000 = 10,000
Excess earnings 30,000 – 10,000 = 20,000
Value of excess earnings 20,000/0.25 = 80,000
Indicated value of company 180,000
11.3.5 Reasonableness Check for the Excess Earnings Method
. , , . . %
, , ,
Normalized income Rs 30 000 0000167 or 167
Indicated value of company Rs 180 000 000
If 16.7 percent is a realistic WACC for this company, then the indicated value
of the in- vested capital meets this reasonableness test. If not, then the values
should be reconciled. More often than not, the problem lies with the value indicated
by the excess earnings method rather than with the WACC.
11.3.6 Problems with the Excess Earnings Method
Tangible Assets Not Well Defined
Some valuers simply use book value due to lack of existing asset appraisals.
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It is not clear whether clearly identifiable intangible assets (e.g., leasehold
interests) should be valued separately or simply left to be included with all
intangible assets under the heading of goodwill.
Most appraisers will include built-in capital gains, however, if assets are
adjusted upward to reflect their fair market value.
Definition of Income Not Specified
Practice is mixed. Some use net cash flow, but many use net income, pretax
income, or some other measure.
Since some debt usually is contemplated in estimating required return on
tangible assets, returns should be amounts available to all invested capital.
If no debt is contemplated, then returns should be those available to equity.
The implication of the preceding two bullet points is that the method can be
conducted on either an invested capital basis or a 100 percent equity basis.
Capitalization Rates Not Well Defined
1. Required return on tangibles is controversial, but usually a blend of the
following:
1. Borrowing rate times percentage of tangible assets that can be financed
by debt
2. Company’s cost of equity capital
2. Difficulty for estimating a required capitalization rate for excess earnings.
The result of these ambiguities is highly inconsistent implementation of the
excess earnings method.
11.4 REVISION POINTS
1. Assets value
2. Excess learning
3. Fixed assets
11.5 INTEXT QUESTIONS
1. Difference between net assets value and adjusted net asset value?
11.6 SUMMARY
Within the asset approach, the two primary methods are the adjusted net
asset value method and the excess earnings method. Under the adjusted net asset
value method, all assets, tangible and intangible, are identified and valued
individually. Under the excess earnings method, only tangible assets are
individually valued; all the intangibles are valued together by the capitalization of
earnings over and above a fair return on the tangible assets. Once indications of
value have been developed by the income, market, and/or asset approaches, the
next consideration is whether to adjust these values by applicable premiums
and/or discounts. In valuations for tax purposes, the premiums and/or discounts
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often are a bigger and more contentious money issue than the underlying value to
which they are applied. Premiums and discounts are the subject of next chapter.
11.7 TERMINAL EXERCISE
1. Explain importance of asset approach for business valuation.
2. Discuss “Net Asset Value and Adjusted NAV”.
3. What is Excess Earning Method and its importance in business valuation?
4. Discuss reasonability and potential problems with Excess Earning Method of
business valuation
11.8 SUPPLEMENTARY MATERIALS
1. https\\www.business.gov.in
2. www.business valuation.inc.com
11.9 ASSIGNMENTS
1. The students are required to take a company’s annual accounts and (1)
prepare adjusted balance sheet, (2) work out normalized annual economic
income, (3) make appropriate assumptions of rate of return on tangible
assets and capitalization rate of excess earning, and finally (4) derive value
of excess earning and value of the company using asset-based approach as
illustrated in this chapter
11.10 SUGGESTED READINGS/REFERENCE BOOKS
1. American Society of Appraisers, BV-201, Introduction to Business Valuation,
Part I from Principles of Valuation course series, 2002.
2. Estate of Dunn v. Comm’r, T.C. Memo 2000-12, 79 T.C.M. (CCH) 1337; rev’d
301 F.3d 339 (5th Cir. 2002).
3. Valuation of intangible assets see Robert F. Reilly, and Robert P. Schweihs,
Valuing Intangible Assets (New York: McGraw-Hill, 1998).
11.11 LEARNING ACTIVITIES
Group discussion during PCP days
1. The students are required to take a company’s annual accounts and (1)
prepare adjusted balance sheet, (2) work out normalized annual economic
income, (3) make appropriate assumptions of rate of return on tangible
assets and capitalization rate of excess earning, and finally (4) derive value
of excess earning and value of the company using asset-based approach as
illustrated in this chapter
11.12 KEY WORDS
Net Asset Value, Excess Earning, Intangible Assets
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CHAPTER - 12
DISCOUNTS AND PREMIUMS
12.1 INTRODUCTION
Discounts and premiums typically are applied near the end of a valuation
engagement after the initial analysis is completed. If the initial analysis produces a
minority interest value, then depending on the nature of the engagement, a control
premium may be added to reach a control value or a marketability discount may be
taken to lower the value. This lesson discusses the applications of a control
premium, a discount for lack of control (or minority discount), and a discount for
lack of marketability (or marketability discount).
12.2 OBJECTIVES
The objectives of this chapter are to introduce the students application of
discounts and premiums to vales derived applying one or all the basic approaches
to business valuations.
12.3 CONTENTS
12.3.1 Entity Level Discounts/ Premiums
12.3.2 Discounts for Lack of Marketability
12.3.3 Other Shareholder – Level Discounts
12.3.1 Entity Level Discounts/ Premiums
Entity-level discounts are those that apply to the company as a whole. That is,
they apply to the values of the stock held by all the shareholders alike, regardless of
their respective circumstances. As such, they should be deducted from value
indicated by the basic approach or approaches used. Since they apply to the
company as a whole, regardless of individual shareholder circumstances, the
entity-level discounts should be deducted before considering shareholder-level
discounts or premiums.
There are four primary categories of entity-level discounts:
1. Trapped-in capital gains discount
2. Key person discount
3. Portfolio (non-homogeneous assets) discount
4. Contingent liabilities discount
Trapped-in Capital Gains Discount
The concept of the trapped-in capital gains tax discount is that a company
holding an appreciated asset would have to pay capital gains tax on the sale of the
asset. If ownership in the company were to change, the cost basis in the
appreciated asset(s) would not change. Thus, the built-in liability for the tax on the
sale of the asset would not disappear, but would remain with the corporation under
the new ownership.
Under the standard of fair market value, the premise for this discount seems
very simple. Suppose that a privately held corporation owns a single asset (e.g., a
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piece of land) with a fair market value of Rs. 1 crore and a cost basis of Rs.
10,00,000. Would the hypothetical willing buyer pay Rs. 1 crore for the stock of the
corporation, knowing that the underlying asset will be subject to corporate tax on
the Rs. 90,00,000 gain, when the asset (or a comparable asset) could be bought
directly for Rs. 1 crore with no underlying embedded taxes? Of course not.
And would the hypothetical, willing seller of the private corporation reduce the
asking price of his stock below Rs. 1 crore in order to receive cash not subject to
the corporate capital gains tax? of course.
The most common reason cited in decisions for denying a discount for
trapped-in capital gains is lack of intent to sell. If the reason for rejecting the
discount for trapped-in capital gains tax is that liquidation is not contemplated,
this same logic could also lead to the conclusion that the asset approach is
irrelevant and that the interest should be valued using the income approach or,
possibly, the market approach.
Key Person Discount
Sometimes the impact or potential impact of the loss of the entity’s key person
may be reflected in an adjustment to a discount rate or capitalization rate in the
income approach or to valuation multiples in the market approach. Alternatively,
the key person discount may be quantified as a separate discount, more often as a
percentage. It is generally considered to be an enterprise-level discount (taken
before shareholder-level adjustments), because it impacts the entire company. All
else being equal, a company with a realized key person loss is worth less than a
company with a potential key person loss.
Factors to Consider in Analyzing the Key Person Discount
Some of the attributes that may be lost upon the death or retirement of the key
person include:
Relationships with suppliers
Relationships with customers
Employee loyalty to key person
Unique marketing vision, insight, and ability
Unique technological or product innovation capability
Extraordinary management and leadership skill
Financial strength (ability to obtain debt or equity capital, personal
guarantees)
Some of the other factors to consider in estimating the magnitude of a key
person discount, in addition to special characteristics of the person just listed,
include:
Services rendered by the key person and degree of dependence on that
person
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Likelihood of loss of the key person (if still active)
Depth and quality of other company management
Availability and adequacy of potential replacement
Compensation paid to key person and probable compensation for
replacement
Lag period before new person can be hired and trained
Value of irreplaceable factors lost, such as vital customer and supplier
relationships, insight and recognition, and personal management styles to
ensure companywide harmony among employees
Risks associated with disruption and operation under new management
Lost debt capacity
There are three potential offsets to the loss of a key person:
1. Life or disability insurance proceeds payable to the company and not
earmarked for other purposes, such as repurchase of a decedent’s stock
2. Compensation saved (after any continuing obligations), if the compensation
to the key person was greater than the cost of replacement
3. Employment agreements
Quantifying the Magnitude of the Key Person Discount
Ideally, the magnitude of the key person discount should be the estimated
difference in the present value of the net cash flows with and without involvement
of the key person. If the key person is still involved, the projected cash flows for
each year should be multiplied by the mean of the probability distribution of that
person’s remaining alive and active during the year. Notwithstanding, the fact is
that most practitioners and courts express their estimate of the key person
discount as a percentage of the otherwise undiscounted enterprise value.
In any case, the analyst should investigate the key person’s actual duties and
areas of active involvement. A key person may contribute value to a company both
in day-to-day management duties and in strategic judgment responsibilities based
on long-standing contacts and reputation within an industry. The more detail
presented about the impact of the key person, the better.
Portfolio (Non-homogeneous Assets) Discount
A portfolio discount is applied, usually at the entity level, to a company or
interest in a company that holds disparate or non-homogeneous operations and/or
assets. This section explains the principle and discusses empirical evidence of its
existence and magnitude.
Investors generally prefer to buy pure plays rather than packages of dissimilar
operations and/or assets. Therefore, companies, or interests in companies, that
hold a non-homogeneous group of operations and/or assets frequently sell at a
discount from the aggregate amount those operations and/or assets would sell for
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individually. The latter is often referred to as the breakup value. This disinclination
to buy a miscellaneous assortment of operations and/or assets, and the resulting
discount from breakup value, is often called the portfolio effect.
It is quite common for family-owned companies, especially multigenerational
ones, to accumulate an unusual (and often unrelated) group of operations and/or
assets over the years. This often happens when different decision makers acquire
holdings that particularly interest them at different points in time. For example, a
large privately owned company might own a life insurance company, a cable
television operation, and a hospitality division.
The following have been suggested as some of the reasons for the portfolio
discount:
The diversity of investments held within the corporate umbrella
The difficulty of managing the diverse set of investments
The expected time needed to sell undesired assets
Extra costs expected to be incurred upon sale of the various investments
The risk associated with disposal of undesired investments
The portfolio discount effect is especially important when valuing non-
controlling interests, because minority stockholders have no ability to redeploy
underperforming or nonperforming assets, nor can they cause a liquidation of the
asset portfolio and/or dissolution of the company. Minority stockholders place little
or no weight on nonearning or low-earning as- sets in pricing stocks in a well-
informed public market. Thus, the portfolio discount might be greater for a minority
position because the minority stockholder has no power to implement changes that
might improve the value of the operations and/or assets, even if the stockholder
desires to.
Empirical Evidence Supports Portfolio Discounts
Three categories of empirical market evidence strongly support the prevalence
of portfolio discounts in the market:
1. Prices of stocks of conglomerate companies
2. Breakups of conglomerate companies
3. Concentrated versus diversified real estate holding companies
Stocks of Conglomerate Companies
Stocks of conglomerate companies usually sell at a discount to their estimated
breakup value. Several financial services provide lists of conglomerate companies,
most of which are widely followed by securities analysts. The analyst reports
usually provide an estimate as to the aggregate prices at which the parts of the
company would sell if spun off. This breakup value is consistently more than the
current price of the conglomerate stock.
Actual Breakups of Conglomerate Companies
Occasionally, a conglomerate company actually does break up. The resulting
aggregate market value of the parts usually exceeds the previous market value of
the whole.
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Evidence from Real Estate Holding Companies
An article on real estate holding companies made the point that the negative
effect of a disparate portfolio also applies to real estate holding companies, such as
real estate investment trusts (REITs): “REITs that enjoy geographic concentrations
of their properties and specialize in specific types of properties, e.g., outlet malls,
commercial office buildings, apartment complexes, shopping centers, golf courses.
etc., are the most favored by investors. This is similar to investor preferences for the
focused ‘pure play’ company in other industries.”
Discount for Contingent Liabilities
Contingent assets and liabilities are among the most difficult to value simply
because of their nature. The challenge lies in estimating just how much may be
collected or will have to be paid out, and thus in quantifying any valuation
adjustments.
Concept of the Contingent Liability Discount
In real-world purchases and sales of businesses and business interests, such
items often are handled through a contingency account. For example, suppose a
company with an environmental problem were being sold, and estimates had placed
the cost to cure the environmental problem at Rs. 10 crores to Rs. 20 million. The
seller might be required to place Rs. 20 million to pay for the cleanup, and once the
problem was cured, any money remaining would be released back to the seller. In
gift, estate, and certain other situations, however, a point estimate of value is
required as of the valuation date, without the luxury of waiting for the actual
outcome of a contingent event. In such cases, some estimate of the cost of recovery
must be made. It can be added or deducted as a percentage of value.
12.3.2 Shareholder-Level Discounts and Premiums
Valuation discounts and/or premiums are meaningless unless the base to
which they are applied is defined. It is therefore necessary to define what level of
value is indicated by the results of the income, market, and/or asset approaches.
The approaches discussed generally produce one of the following levels of value:
1. Control
2. Marketable minority
The income approach can produce either a control or a minority value. The key
to which value is indicated is whether the numerators (cash flows, earnings, etc.)
represent results that a control owner could be expected to produce by results from
business as usual. If a minority value is indicated, it would be considered
marketable because the discount rates and capitalization rates used in the income
approach are based on publicly traded stock data.
In the guideline publicly traded stock method, the guideline companies are, by
definition, minority interests. Therefore, if valuing a minority interest, a minority
interest discount normally would not be appropriate, but a discount for lack of
marketability would be, because the publicly traded stock can be sold immediately
and the proceeds received, while the privately held stock enjoys no such liquid
market. However, minority shares of publicly traded companies may sell at their
control value. If the analyst can demonstrate that this is the case, a minority
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discount might be considered. If valuing a controlling interest, a control premium
normally would be appropriate, subject to the caveat in the previous sentence.
The transaction method, being based on acquisitions of entire companies,
produces a control value. Therefore, if valuing a minority interest, both minority
and marketability discounts would be appropriate. If valuing a controlling interest,
it might be appropriate to consider some discount for lack of marketability, as
discussed later in this chapter.
If past transactions or buy-sell agreements are used, they should be studied to
determine their implications. Rules of thumb normally indicate a control interest
value.
Asset-based approaches (both adjusted net asset value and excess earnings)
normally result in a control-interest value.
All adjustments to indicated values for any approach should be based on
differences between the characteristics of the subject interest and the
characteristics implicit in the approach from which the adjustment is made.
Definition of Marketability
The discount for lack of marketability is the largest single issue in most
disputes regarding the valuation of businesses and business interests, especially in
tax matters. This is true both in the number of cases in which the issue arises and
the magnitude of the differential money involved in the disputes.
Marketability is defined by the International Glossary of Business Valuation
Terms as the ability to quickly convert property to cash at minimal cost. The
benchmark for marketability for business valuation is the market for active,
publicly traded stocks. The holder can have the stock sold in less than a minute at
or near the price of the last trade, and have cash in hand in few business days.
Discount for lack of marketability is defined by the International Glossary of
Business Valuation Terms as an amount or percentage deducted from the value of
an ownership interest to reflect the relative absence of marketability. The term
relative in this definition usually refers to the value of the interest as if it were
publicly traded, sometimes referred to as the publicly traded equivalent value or the
value if marketable.
Investors Cherish Liquidity, Abhor Illiquidity
Investors cherish liquidity. The public market allows investors to sell their
interest and get cash immediately for any reason: when they believe that the value
may go down, when they believe that the company should be managed differently,
or when they just desire to have cash with which to do something else. The public
market also provides liquidity in that it creates the ability to hypothecate the
interest—that is, use it as collateral for a loan.
Consequently, all other things being equal, a stock that can be readily sold in
the public market is worth much more than one which cannot be readily sold.
When a company first completes an initial public offering (IPO), the price usually
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will be more than twice the price of the last transaction in the stock when it was
private.
Conversely, investors abhor illiquidity. They may be forced to hold a stock and
watch it decline in value or even become worthless. They may be forced to hold a
stock when they object vehemently to management policies. Whatever their
alternative needs or desires, they are generally “locked in” to the stock and are
unable to get their money out of it. Banks will rarely accept stock of private
companies, even controlling interests, as collateral for loans because of the lack of a
market in case of default.
Consequently, all other things being equal, investors demand a large discount
from an otherwise comparable public stock to induce them to invest in a private
company.
Degrees of Marketability or Lack Thereof
Marketability is not a black-and-white issue. A stock is considered marketable
if it is publicly traded and nonmarketable if it is not. But along the way there are
degrees of marketability or lack of marketability. Without attempting to address
every conceivable situation, the following gives a general idea of the spectrum of
marketability or lack thereof:
Registered with the stock exchange and with an active trading market (the
benchmark from which some lack of marketability discount usually is
indicated)
Registered with the stock exchange and fully reporting, but with a somewhat
thin trading market
A stock with contractual put rights (right of the owner to sell, usually to the
issuing company, under specified circumstances and terms). (The most
common example is employee stock ownership plan (ESOP) stock, where the
plan includes a put option to sell the stock at the employee’s retirement or at
certain other times.)
Private company with an imminent (or likely) public offering
Private company with frequent private transactions
Private company with few or no transactions
Private company with interests subject to restrictive transfer provisions
Private company with ownership interests absolutely prohibited from
transfer (for example, tied up in a trust for some period of time)
12.3.3 Other Shareholder – Level Discounts
A shareholder-level discount or premium is one that affects only a defined
group of share- holders rather than the whole company. As with discounts for lack
of marketability, other shareholder-level discounts should be applied to the net
amount after entity-level discount, if any. Besides the discount for lack of
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marketability, other shareholder-level discounts and premiums largely fall into
three categories:
1. Minority discounts/control premiums
2. Voting versus nonvoting interests
3. Blockage
In addition, there can be discounts for fractional interests in property such as
real estate.
Minority Discounts/Control Premiums
Minority discounts are often (and more properly) referred to as lack of control
discounts because it is possible to have a majority interest and still not have
control, and, conversely, a minority interest may have control, perhaps because of
voting trusts and other arrangements. For example, on one hand, no limited
partner has control, regardless of the percentage interest.
After marketability, minority/control is the next most frequent issue in
disputed valuations. Virtually everyone recognizes that, in most cases, control
shares are worth more than minority shares. However, there is little consensus on
how to measure the difference. As with lack of marketability, lack of control is not a
black-and-white issue, but covers a spectrum:
100 percent control
Less than 100 percent interest
Less than supermajority where state statutes or articles of incorporation
require supermajority for certain actions
50/50 interest
Minority, but enough for blocking control (in states or under articles of
incorporation that require supermajority for certain actions)
Minority, but enough to elect one or more directors under cumulative voting
Minority, but participates in control block by placing shares in voting trust
Nonvoting stock (covered in following section)
Minority, with no ability to elect even one director
The value of control lies in the following (partial) list of actions that
shareholders with some degree of control can take, and that others cannot:
Appoint or change operational management.
Appoint or change members of the board of directors.
Determine management compensation and perquisites.
Set operational and strategic policy and change the course of the business.
Acquire, lease, or liquidate business assets, including plant, property, and
equipment.
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Select suppliers, vendors, and subcontractors with whom to do business
and award contracts.
Negotiate and consummate mergers and acquisitions.
Liquidate, dissolve, sell out, or recapitalize the company.
Sell or acquire treasury shares.
Register the company’s equity securities for an initial or secondary public
offering.
Register the company’s debt securities for an initial or secondary public
offering.
Declare and pay cash and/or stock dividends.
Change the articles of incorporation or bylaws.
Set one’s own compensation (and perquisites) and the compensation (and
perquisites) of related-party employees.
One question is whether the synergistic portion of the control premium is part
of fair market value. Under the hypothetical willing-buyer presumption, the
synergies with any particular buyer would not be included. But in certain instances
where there are enough synergistic buyers to create a market, a case can be made
for including the value of synergies in fair market value. An example would be an
industry undergoing consolidation through rollups, that is, acquisitions of many
companies in an industry in order to achieve a target size for some objective, such
as an initial public offering.
12.4 REVISION POINTS
1. Discount
2. Premium
3. Share holder
12.5 INTEXT QUESTIONS
1. Discuss why the business value worked out using basic approaches need to
be adjusted for discounts and premiums.
2. Briefly discuss Entity Level Discounts/ Premiums.
3. Briefly discuss Discounts on account of Lack of Marketability.
4. Briefly discuss Shareholder Level Discounts/ Premiums.
12.6 SUMMARY
In this chapter the discounts and premiums; have been discussed; to be
applied once the valuation is derived using basic approach(es). From the
indication(s) of value from the basic valuation approach test, entity-level discounts
(those that affect all the shareholders), if any, should be applied. The most
important of these, in most cases, is the discount for lack of marketability. The
discount for lack of marketability often is the biggest and most controversial issue
in a business valuation. There are two distinct categories of empirical databases
(and studies based on them): (1) Restricted stock studies (transactions in publicly
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traded stocks that are temporarily restricted from public funding), and (2) Pre-IPO
studies (trading in private companies’ stocks prior to an initial public offering). This
empirical evidence is based on transactions in minority interests, and is not
relevant to controlling interests. Controlling interests may be subject to some
marketability discount, but the analyst should explain the factors on which the
discounts are based, as discussed in this chapter. Shareholder-level discounts (or
premiums) should be applied after entity-level discounts. If more than one
valuation approach has been used, now that any appropriate adjustments have
been made, the analyst must decide the relative weight to be accorded to each
approach as discussed in following chapter.
12.7 TERMINAL EXERCISE
1. Discuss factors considering the analyzing the key person discount.
12.8 SUPPLEMENTARY MATERIALS
1. https\\www.business.gov.in
2. www.business valuation.inc.com
12.9 ASSIGNMENTS
1. In continuation of the chosen self learning assignment/ activity of previous
chapter, discuss and work of various premiums / discounts applicable for
chosen case
12.10 SUGGESTED READINGS/REFERENCE BOOKS
1. Aswath Damodaran, Investment Valuation – Tools and Techniques for
Determining the Value of any Asset, John Wiley Publication, 3ed Edition,
2012.
2. Krishna G. Palepu, Paul M. Healy, Business Analysis and Valuation using
Financial Statements – Text & Cases, South Western Publication, 4th
Edition, 2002.15.
3. Tom Copeland, Tim Koller, Valuation Workbook – Step by Step Exercise,
John Wiley & Sons Publication, 3ed Edition, 2000.
4. Study Material, Paper – 18, Business Valuation Management, the Institute of
Cost Accountants of India Publication.
(http://icmai.in/upload/Students/Syllabus-2008/StudyMaterialFinal/P-
18.pdf)
12.11 LEARNING ACTIVITIES
Group discussion during PCP days
1. In continuation of the chosen self learning assignment/ activity of previous
chapter, discuss and work of various premiums / discounts applicable for
chosen case
12.12 KEY WORDS
Discounts, Premiums, Entity-Level, Marketability, Shareholder-level
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CHAPTER - 13
WEIGHING OF BUSINESS VALUATION APPROACHES
13.1 INTRODUCTION
Normally, holding companies are valued by the asset approach and operating
companies are valued by the income or market approach. However, some
companies may have characteristics of both a holding company and an operating
company. In such cases, some weight may be given to the asset approach and some
to the income or market approach.
If a company’s assets can be divided between operating assets and
nonoperating assets, the company’s operating assets can be valued by the income
and/or market approach, and the nonoperating assets by the asset approach.
When more than one approach is to be accorded some weight, there is a
difference of opinion as to whether the weighting should be mathematical (assigning
a percentage to each approach to be accorded some weight) or subjective.
13.2 OBJECTIVES
The business values are derived using various approaching. Thus it gives
range of values and not the point. To arrive to the reasonable value different
approaches/ methods are assigned different weightage based on certain logics/
strategies for given case. And finally weighted average of values derived by different
methods is finally concluded a business value. This chapter discusses this aspect of
business valuation.
13.3 CONTENTS
13.3.1 Why Weighing Business Valuation Approaches?
13.3.2 Theory and Practice of Weighing
13.3.3 Mathematical Versus Subjective Weighting
13.3.4 Example of Weighting of Approaches
13.3.1 Why Weighing Business Valuation Approaches?
Normally, holding companies are valued by the asset approach and operating
companies are valued by the income or market approach. However, some
companies may have characteristics of both a holding company and an operating
company. In such cases, some weight may be given to the asset approach and some
to the income or market approach.
If a company’s assets can be divided between operating assets and
nonoperating assets, the company’s operating assets can be valued by the income
and/or market approach, and the nonoperating assets by the asset approach.
When more than one approach is to be accorded some weight, there is a
difference of opinion as to whether the weighting should be mathematical (assigning
a percentage to each approach to be accorded some weight) or subjective.
13.3.2 Theory and Practice of Weighing
In theory, the discounted cash flow method within the income approach is the
most correct method. There is virtually unanimous agreement that a company is
worth the future benefits it will produce for its owners (benefits preferably
measured by net cash flows or some other measure of earnings), discounted back to
a present value by a discount rate that reflects the risk of achieving the benefits in
the amounts and at the times expected. A typical statement of this theory is as
follows:
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“The value of an asset is the present value of its expected returns. Specifically,
you expect an asset to provide a stream of returns during the period of time you
own it. To convert this estimated stream of returns to a value for the security, you
must discount this stream at your required rate of return. This process of valuation
requires estimates of (1) the stream of expected returns, and (2) the required rate of
return on the investment.”
If good guideline companies can be found, the market approach provides the
most objective and unbiased indication of value. Some in the Service make the
point that the income approach can be subject to bias in the projections presented
and/or in the discount or capitalization rates chosen. Also, the income approach
can produce widely divergent results based on small variations in assumptions
such as the growth rate or discount rate.
Often, the quality of the data presented in support of various approaches
determines which approach or approaches should be utilized, or how much weight
should be accorded to each. Frequently, zero weight is accorded to an approach on
the basis that the underlying data is inadequate to support the conclusion reached.
13.3.3 Mathematical Versus Subjective Weighting
Because valuations cannot be made on the basis of a prescribed formula, there
is no means whereby the various applicable factors in a particular case can be
assigned mathematical weights in deriving the fair market value. For this reason,
no useful purpose is served by taking an average of several factors (for example,
book value, capitalized earnings and capitalized dividends) and basing the valuation
on the result. Such a process excludes active consideration of other pertinent
factors and the end result cannot be supported by a realistic application of the
significant facts in the case except by means of chance.
But when analysts use subjective weighting, the stakeholder/ user of
valuation report usually want to know how much weight was accorded to the
various approaches. So the analysts usually apply mathematical weights when
giving weight to two or more approaches, with a disclaimer that there is no
empirical basis for assigning mathematical weights, and that the weights are
presented only to help clarify the thought process of the analyst. A good report will
also go on to demonstrate that all relevant factors were considered.
13.3.4 Example of Weighting of Approaches
In a manufacturing company, the expert recommended 70 percent weight be
given to his value by the market approach and 30 percent weight to his value by the
income approach. In his market approach, he narrowed down a list of guideline
public companies to three that most closely resembled the subject company in such
characteristics as line of business and earnings growth. For his income approach,
he projected five years of cash flow available for distributions, estimated a terminal
value, and discounted the components to a present value.
13.4 REVISION POINTS
1. Weighing
2. Valuation approach
3. Mathematical weighing
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13.5 INTEXT QUESTIONS
1. Discuss why there is need to give weightage to different approaches to business valuation.
2. With reasoning discuss how you will weigh the basis there valuation approaches under given circumstances.
13.6 SUMMARY
For operating companies, most or all of the weight is usually accorded to
indications of value from either the income or the market approach. For holding
companies, most or all of the weight is normally accorded to value from the asset
approach. For operating companies that are operating asset intensive the weight
may be divided between the asset approach and the market approach. For
operating companies with significant nonoperating assets, the company might be
valued by the income or market approaches, plus the value of the nonoperating
assets, with some discount in case of a minority interest.
13.7 TERMINAL EXERCISE
1. Discuss the sum of the weighing approach in business valuation.
13.8 SUPPLEMENTARY MATERIALS
1. https\\www.business.gov.in
2. www.business valuation.inc.com
13.9 ASSIGNMENTS
In continuation of the chosen self learning assignment/ activity of previous
chapter, recommend how much weightage should be given to each approach of
business valuation with appropriate logics and reasons
13.10 SUGGESTED READINGS/REFERENCE BOOKS
1. Aswath Damodaran, Investment Valuation – Tools and Techniques for Determining the Value of any Asset, John Wiley Publication, 3ed Edition,
2012.
2. Krishna G. Palepu, Paul M. Healy, Business Analysis and Valuation using Financial Statements – Text & Cases, South Western Publication, 4th Edition, 2002.15.
3. Tom Copeland, Tim Koller, Valuation Workbook – Step by Step Exercise,
John Wiley & Sons Publication, 3ed Edition, 2000.
4. Study Material, Paper – 18, Business Valuation Management, the Institute of Cost Accountants of India Publication. (http://icmai.in/upload/Students/Syllabus-2008/StudyMaterialFinal/P-
18.pdf)
13.11 LEARNING ACTIVITIES
Group discussion during PCP days
In continuation of the chosen self learning assignment/ activity of previous
chapter, recommend how much weightage should be given to each approach of
business valuation with appropriate logics and reasons
13.12 KEYWORDS
Weighing the valuation approaches
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