With the introduction of the concept of 'Registered valuer' by Companies Act 2013, the requirement for a professional and methodological approach to valuation has arisen. Not a while ago, for the majority of professionals, the valuation of an equity instrument of a company or a financial asset generally entails the calculation of the ' Net assets Value' approach of valuation which was restrictive and in the majority of cases an incorrect approach to valuation.
Through this article, the author has tried to provide a brief on various valuation approaches to be used by registered valuers while conducting their assignments.
A registered Valuer must give careful consideration to the relevant and appropriate approach when valuing the asset such as security or business or other financial assets.
As per internationally accepted practices and valuation standards, there are three major methods or approaches used in valuation.
The principle valuation approaches are
(A) Market Approach
(B) Income Approach, and
(C) Cost Approach
The Valuer should aim to select the most appropriate valuation approach for an asset. However, valuation is not a perfect science and neither is an art. I would describe the practice of valuation as a craft and a valuer becomes better at it the more he/she practices it. Accordingly, there is no single method that is suitable for every valuation.
Which is the right approach?
The choice of method or approach will depend on the following factors:
- Terms and purpose of the valuation assignment.
- Respective strength and weakness of the possible valuation approaches and methodologies
- Nature of asset being valued
- Methodology or approaches used by relevant participants in the market for tat or similar assets.
- What kind of reliable information is available and its appropriateness to apply the suitable method.
Single or multiple valuation approach: Valuers are not required to use more than one method for the valuation of an asset but the author suggests that a valuer should consider the use of multiple approaches and methods to arrive at an indication of value.
The author does not think that mere averaging of values arrived through multiple valuations is the right approach and a valuer should analyze and reconcile the differences into a single conclusion and should disclose the fact of the same in its report.
As general rule valuers tend to average the value arrived by different methodology without giving weightage to the inherent differences between the valuation methods. In views of author this is a slippery slope and appropriate considerations should be given to assign the correct weightage to each method and reconcile the differences arising due to these approaches.
PRINCIPLE VALUATION APPROACHES:
(A) MARKET APPROACH: Market approach provides an indication of value by comparing the asset with identical or comparable assets for which market prices are available.
When comparable market information does not relate to the exact or substantially same asset, the valuer must perform a comparative analysis of qualitative and quantitative similarities and differences between the comparable assets and the subject asset. It will often be necessary to make adjustments based on this comparative analysis. The market approach can apply the following methods:
(1) Comparable Transactions Method
Under the CTM Method, the value is determined on the basis of multiples derived from valuations of similar transactions in the industry. Relevant multiples have to be chosen carefully and adjusted for differences between the circumstances. Few of such multiples are Enterprise Value/EBITDA multiple, Enterprise Value/Revenue multiple. The units of comparison used by participants can differ between asset classes and across industries and geographies.
(2) Comparable Companies Multiples ("CCM") Method or Guideline Publicly Traded Comparable Method
The guideline publicly-traded method utilizes information on publicly-traded comparables that are the same or similar to the subject asset to arrive at an indication of value.
This method is similar to the comparable transactions method.
However, there are several differences due to the comparables being publicly traded, as follows:
(a) the valuation metrics/comparable evidence are available as of the valuation date
(b) detailed information on the comparables are readily available in public filings, and
(c) the information contained in public filings is prepared under well-understood accounting standards.
The method should be used only when the subject asset is sufficiently similar to the publicly-traded comparables to allow for meaningful comparison.
In the absence of comparable listed companies of the same size and customer base, the method should not be applied for the valuation of the company.
Important considerations while applying Market Approach Considerations
In the market approach, the fundamental basis for making adjustments is to adjust for differences between the subject asset and the guideline transactions or publicly-traded securities.
Some of the most common adjustments made in the market approach are known as discounts and premiums.
(a) Discounts for Lack of Marketability (DLOM) should be applied when the comparables are deemed to have superior marketability to the subject asset. A DLOM reflects the concept that when comparing otherwise identical assets, a readily marketable asset would have a higher value than an asset with a long marketing period or restrictions on the ability to sell the asset. For example, publicly-traded securities can be bought and sold nearly instantaneously while shares in a private company may require a significant amount of time to identify potential buyers and complete a transaction. Many bases of value allow the consideration of restrictions on marketability that are inherent in the subject asset but prohibit consideration of marketability restrictions that are specific to a particular owner.
(b) Control Premiums and Discounts for Lack of Control (DLOC) are applied to reflect differences between the comparables and the subject asset with regard to the ability to make decisions and the changes that can be made as a result of exercising control. All else being equal, participants would generally prefer to have control over a subject asset than not. However, participants’ willingness to pay a Control Premium or DLOC will generally be a factor of whether the ability to exercise control enhances the economic benefits available to the owner of the subject asset. Control Premiums and DLOCs may be quantified using any reasonable method, but are typically calculated based on either an analysis of the specific cash flow enhancements or reductions in risk associated with control or by comparing observed prices paid for controlling interests in publicly-traded securities to the publicly-traded price before such a transaction is announced.
Few Examples of circumstances where Control Premiums and DLOC should be considered are
1. Shares of public companies generally do not have the ability to make decisions related to the operations of the company (they lack control). As such, when applying the guideline public comparable method to value a subject asset that reflects a controlling interest, a control premium may be required
2. The guideline transactions in the guideline transaction method often reflect transactions of controlling interests. When using that method to value a subject asset that reflects a minority interest, a DLOC is required.
© Blockage discounts are sometimes applied when the subject asset represents a large block of shares in publicly-traded security such that an owner would not be able to quickly sell the block in the public market without negatively influencing the publicly-traded price. Blockage discounts may be quantified using any reasonable method but typically a model is used that considers the length of time over which a participant could sell the subject shares without negatively impacting the publicly-traded price and as a result used rarely in valuations.
PRINCIPLE VALUATION APPROACHES
(B) INCOME APPROACH
The income approach provides an indication of value by converting future cash flow to a single current value. Under the income approach, the value of an asset is determined by reference to the value of income, cash flow or cost savings generated by the asset. It is generally used to value assets under ' Going Concern' basis.
INCOME APPROACH METHODS
Although there are many ways to implement the income approach, methods under the income approach are
'based on discounting future amounts of cash flow to present value. They are variations of the Discounted Cash Flow (DCF) method and the concepts below apply in part or in full to all income approach methods'.
Discounted Cash Flow (DCF) Method. Under the DCF method the forecasted cash flow is discounted back to the valuation date, resulting in a present value of the asset.
One of the most important factor in valuing under DCF is calculating the terminal value which represents the value of the asset at the end of the explicit projection period.
The key steps in the DCF method are:
(a) choose the most appropriate type of cash flow for the nature of the subject asset and the assignment (i.e., pre-tax or post-tax, total cash flows or cash flows to equity, real or nominal, etc),
(b) determine the most appropriate explicit period over which the cash flow will be forecast,
(c) prepare cash flow forecasts for that period,
(d) determination of terminal value that is appropriate for the subject asset at the end of the explicit forecast period
(e) determine the appropriate discount rate, and
(f) apply the discount rate to the forecasted future cash flow, including the terminal value, if any.
Explicit Forecast Period
The selection criteria will depend upon the purpose of the valuation, the nature of the asset, the information available and the required bases of value. For an asset with a short life, it is more likely to be both possible and relevant to project cash flow over its entire life.
The intended holding period for one investor should not be the only consideration in selecting an explicit forecast period and should not impact the value of an asset. However, the period over which an asset is intended to be held may be considered in determining the explicit forecast period if the objective of the valuation is to determine its investment value.
Where the asset is expected to continue beyond the explicit forecast period, valuers must estimate the value of the asset at the end of that period. The terminal value is then discounted back to the valuation date, normally using the same discount rate as applied to the forecast cash flow.
The terminal value should consider:
(a) whether the asset is deteriorating/finite-lived in nature or indefinite-lived, as this will influence the method used to calculate a terminal value,
(b) whether there is future growth potential for the asset beyond the explicit forecast period,
(c) whether there is a pre-determined fixed capital amount expected to be received at the end of the explicit forecast period,
(d) the expected risk level of the asset at the time the terminal value is calculated,
(e) for cyclical assets, the terminal value should consider the cyclical nature of the asset and should not be performed in a way that assumes 'peak' or 'trough' levels of cash flows in perpetuity, and
(f) the tax attributes inherent in the asset at the end of the explicit forecast period.
Valuers may apply any reasonable method for calculating a terminal value.
While there are many different approaches to calculating a terminal value, the three most commonly used methods for calculating a terminal value are:
(a) Gordon growth model/constant growth model (appropriate only for indefinite-lived assets),
(b) market approach/exit value (appropriate for both deteriorating/finite-lived assets and indefinite-lived assets), and
(c) salvage value/disposal cost (appropriate only for deteriorating/ finite-lived assets)
PRINCIPAL VALUATION APPROACH
(C) COST APPROACH
The cost approach focuses on the net worth or net assets of a company. The approach provides an indication of value by calculating the current replacement or reproduction cost of an asset and making deductions for physical deterioration and all other relevant forms of obsolescence.
The cost approach provides an indication of value using the economic principle that a buyer will pay no more for an asset than the cost to obtain an asset of equal utility, whether by purchase or by construction, unless undue time, inconvenience, risk or other factors are involved.
Cost Approach Methods
Broadly, there are three cost approach methods:
(a) Replacement cost method: a method that indicates value by calculating the cost of a similar asset offering equivalent utility,
(b) Reproduction cost method: a method under the cost that indicates value by calculating the cost to recreating a replica of an asset, and
(c) Summation method: a method that calculates the value of an asset by the addition of the separate values of its component parts.
The right approach and method is of utmost importance in valuation and it is the duty of every valuer to emulate as much as possible, the true value of the subject asset based on his professional judgement. The goal in selecting valuation approaches and methods for an asset is to find the most appropriate method under the particular circumstances.
The author is a registered valuer under Insolvency and Bankruptcy Board of India as well as a Chartered Accountant in Practice at www.consultantsonestop.com.
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