38-Valuation_of

Valuation of Business

BACKGROUND

Astonishing is the enormous positive stride that Brand India took in last few years. Indian Businessmen and Entrepreneurs are set out to revamp Indian image in near future by acquiring some of the biggest Corporations of the world. All the sectors, be it Steel, manufacturing, Information technology, Auto and FMCG are all buzzing with Mega Indian acquisitions. Tata’s acquisition of Corus has sealed doubt in anybody’s mind about capabilities of Indian business houses to acquire companies abroad. Connected to this aspect, there has been increasing interest seen in the subject of Valuation, both for the entrepreneurs and the professionals. Valuations are required for so many different things, at so many different point of time, and for many different purposes. One cannot use pre-set rules, principles and precedents for valuations without considering the varied circumstances for which valuations are required.

Valuation Principles is one subject which gives rise to differences of opinion/views and generates lots of argument. It is due to this that the subject is so fascinating. There is no fixed rule or basic formula which can be applied to each and every valuation. As Viscount Simon J put it: “Valuation is an art and not an exact science. Mathematical certainty is not demanded nor indeed is it possible.” Every Valuation is an estimate and not an absolute measurement.

It is my humble effort to put my thoughts in very simple way. Valuation is not a rocket science and anyone having a basic knowledge of Accounting & Finance can attempt it.

INTRODUCTION

The Indian Mergers and Acquisitions are growing exponentially. Not only are foreign investors entering corporate India, but also, Indian entrepreneurs are eyeing foreign acquisitions. The liberalization of Indian economy which commenced sometime in early nineties, continuous favourable policy changes thereafter, growing economy and high liquidity levels has given a strong impetus to mergers and acquisitions. M & A is the buzzword amongst top Corporate Houses as everyone has become conscious of competitiveness and scalability. Today’s business environment is full of challenges — ranging from strain on margins, volatile interest rates to invasion of global players. The restructuring of businesses and/or companies have resulted in long lasting benefits due to enhancement of competitiveness and sustainability. The globalization has opened floodgates for various international players to enter the Country and at the same time many Indian companies have gone ahead and acquired companies abroad.

Investors have become more active in protecting their value. Any transaction of purchase/ sale of business/ companies require determination of fair value for the transaction to satisfy stakeholders and/or Regulators. Business valuation is an unformulated and subjective process. Understanding the finer points of valuing a business is a skill that takes time to perfect. There are various methodologies for valuing a business, all having different relevance depending on the purpose of valuation. Key aspects of valuation along with various restructuring options have been explained hereunder:

VALUE & PRICE

2.1 Value is a subjective term and can have different connotations. As Warren Buffet describes “Price is what you pay & Value is what you get”. The Price paid for an asset is the result of a negotiation process between a willing Buyer and the willing Seller. Whereas Value refers to the intrinsic worth of an asset. Hence, the Value of the Product could be different from its Price.

2.2 Management of companies always sought help of Professionals like Chartered Accountants or Merchant Bankers to value the intrinsic worth of a Business/Shares using various techniques of valuation. Valuation is not an exact ‘Science’. It is more an ‘Art’. Valuation is largely influenced by the valuer’s judgement, knowledge of the business, analysis and interpretation and the use of different methods, which may result in assigning different values based on different methods. It is more an application of common sense after analysing various supportive data obtained either from the management or through other publicly available sources.

2.3 Once the ‘value’ is determined, what follows is detailed negotiations between the purchaser and seller and if there is an agreement between the two, ‘price’ of the asset (whether of shares or business) gets established. It is quite possible that the price is either far higher or far lower than the fair value.

2.4 The ultimate result is largely dependent on the answer of the question, ‘who will blink first?’ It is important to keep this differentiation between price and value in mind before attempting the valuation.

PURPOSE OF VALUATION

3.1 An important concept in valuation is recognising the intended purpose of valuation. The value often depends on its purpose. The same business often has different values depending on the valuation purpose. For example, a valuation performed for an employee stock option plan (ESOP) would normally differ from one performed for a synergistic combination.

3.2 Some of the purposes for which valuation may be required are as follows:

Determining the consideration for Acquisition/ Sale of Business or for Purchase/Sale of Equity stake

Determining the swap ratio for Merger/Demerger

Corporate Restructuring

Sale/ Purchase of Intangible assets including brands, patents, copyrights, trademarks, rights.

Determining the value of family owned business and assets in case of Family Separation.

Determining the Fair value of shares for issuing ESOP as per the ESOP guidelines.

Determining the fair value of shares for Listing on the Stock Exchange.

Disinvestment of PSU stocks by the Government

Determining the Portfolio Value of Investments by Venture Funds or Private Equity Funds

Liquidation of company

Other Corporate Decisions

3.3 A clear understanding of the purpose for which the valuation is being attempted is very important aspect to be kept in mind before commencement of the valuation exercise. There are instances where the entire conclusions had to be changed due to faulty understanding as to the purpose of valuation. The structure of the transactions also plays very important role in determining the value. For example, if only assets are being transferred out from a Company, valuation of equity shares is of no importance as it will throw up entirely faulty value. The ‘general purpose’ value may have to be suitably modified for the special purpose for which the valuation is done. The factors affecting that value with reference to the special purpose must be judged and brought into final assessment in a sound and reasonable manner.

SOURCES OF INFORMATION

The first step while attempting any valuation exercise is to collect relevant and optimal information required for valuing Share or Business of a company. Such information can be obtained from one or more of the following sources:

4.1 Historical Results

This will include Annual Reports for at least past 3 years of the Company being valued. Apart from review of detailed financials, it is very important to look carefully at the Directors Report, Management Discussions, Corporate Governance Reports, Auditors’ Report and Notes to accounts. There are instances that the growth prospects and opportunities for the company mentioned in these documents are absolutely opposite to the future outlook as demonstrated in the projections. A detailed analysis of the past performance is a very important starting point in any valuation exercise. It is critical to note from the past results various important aspects such as one time non-recurring income, expenditure, change in Government/Tax regulations affecting business, tax benefits enjoyed, and so on.

4.2 Future Projections

This will include Future Expected Profitability, Balance Sheet and Cash Flows along with detailed Assumptions underlying the projections. It is important to cover the period which will comprise the entire cycle of the business. In certain industry even 3-year period will cover the cycle whereas in certain industries like heavy engineering or cement, a longer period of 5 to 7 years may capture the cycle. It is impossible to predict the future in a precise way particularly considering the dynamic nature of the economy. One should ensure that the assumption behind the future projections is reasonable at a point of time when they are prepared. Few common mistakes which are found in the projections are: (1) assuming production much higher than the capacities without capturing additional capital cost (2) showing unreasonable changes in selling price of the final products or of raw materials (3) showing unreasonable change in the working capital movements (4) capturing tax benefits even after the sunset clause under the Tax laws (5) unreasonable changes in manpower cost and so on.

4.3 Discussions with the Management

It is very important that open, fair and detailed discussions are carried out between the Valuer and the Management. When one refers to the Management, it should not be restricted to only representatives of Finance Department. All critical people of the Management need to be interviewed. The interaction is generally done with following members of the Management:

The Managing Director/ CEO

The Director Finance/ CFO

The Technical Director/ CTO

Sourcing In-charge (Raw Material)

Marketing In-charge

HRD In-charge

Any other team member who plays critical role in the operations

It is always advisable to obtain a written Representation from the Management of various inputs given by them. This helps in defending the valuation in the eventuality of it being challenged by any Authority. At times it is experienced that in real life, there is a resistance from the Management to give a written representation in respect of various oral explanations given.

4.4 Market Surveys, Other Publicly available data

This will include various outside data available publicly. It may pertain to the industry as well as the Company being valued. Thanks to technology advancement, most of these data are available on the net. Various newspaper reports are also available on the subject. It is advisable to double check the accuracy of these data before heavily relying on such data. Nowadays various Software packages are available on Corporate data. It should be ensured that updated version of such data is used. It is experienced that a lot of time is spent by the valuer on review and analysis of irrelevant data. The relevance of the data being reviewed and used in valuation need to be strictly monitored.

4.5 Stock Market quotations

The details of stock market prices of the listed companies are nowadays available on the website of the stock exchange. It is important to keep in mind that the data should be picked up not only of the market prices but also for the volumes of the shares being traded. Due adjustments also need to be made for illiquid or Thinly traded Shares, Rights Issue, Bonus issues, Stock split, open offers, Buy Back, etc. Stock exchange website also gives details of various announcements made by the Company in last few months. This helps to capture some very critical information and at times could prove to be vital for the valuation exercise.

4.6 Data on Comparable Companies

Review of data on comparable companies is one very important feature in any valuation exercise. Care needs to be taken that such companies are really comparable. It is possible that geographically the companies are located in different areas which may have substantial difference in the operations. For example Cement Companies located near to Limestone Reserve and those which are located far off are not strictly comparable. Further, different funding pattern of two companies and investment also makes them non-comparable.

Having seen what could be relevant data for valuation, let’s now proceed to understand the various methods of Valuation.

VALUATION METHODOLOGIES

5.1 There are many methodologies that a valuer may use to value the Shares of a Company/Business. In practice, however, the valuer normally uses different methodologies of valuation and arrives at a fair value for the entire business by combining the values arrived using various methods.

5.2 The Methodologies of Valuation also depend on the purpose of the valuation. If the Valuation is for the purpose of a liquidation, the Intrinsic Value of the Net Assets of the Company is more appropriate and not the Earnings Capacity. Similarly, during a Merger, the valuer would want to value both the concerned Companies in a similar manner to have a relative value.

5.3 The Value of a Business would also differ from the point of view of the Buyer and that of the Seller, depending on the vision, strategy and future projections made by each of them independently.

5.4 The methods to be used for valuation can be broadly classified under the following heads:

Asset Based Approach

Net Assets Value

Replacement Value

Realizable Value

Earnings Based Approach

Capitalization of Maintainable Earnings (PECV)

Discounted Cash Flow Method

EBITDA Multiple

Sales Multiple

Profit Multiple

Dividend Capitalisation

Market Based Approach

Market Price Method

Market Comparables

5.5 Each method proceeds on different fundamental assumptions, which have greater or lesser relevance, and at times even no relevance to a given situation. Thus, the methods to be adopted for a particular valuation must be judiciously chosen.

ASSET BASED APPROACH

NET ASSETS METHOD

Valuation of net assets is calculated with reference to the historical cost of the assets owned by the company. Such value usually represents the minimum value or a support value of a going concern. It is usual to ignore market value of the operating assets for the simple reason that under the going concern valuation, it is not the intention to sell the assets on a piece meal basis.

While the historical cost is adopted in respect of the assets that are to continue as a part of the going concern, it is necessary to adjust the market value of non-operating assets like unused land which are capable of being easily disposed of without affecting the operations of the company.

Situations Where Net Assets Method May Be Adopted

Net Assets Method may be adopted in the following cases:

In case of start up companies (which are capital intensive in nature), where the commercial production has not yet started.

In case of Investment Companies as Earnings Value based on its income in the form of dividend and/or interest may not reflect its true value.

In case of companies, which do not have a sustainable track record of profits and has no prospects of earning profits in future.

In case of manufacturing companies, where fixed assets has greater relevance for earning revenues. It would also be appropriate to use Net Assets Method for valuation in case of companies operating in the industry, which is capital intensive and is relevant to revenues in an industry, where norms are related to the capital cost per unit.

In case of companies where there is no reliable evidence of future profits due to violent fluctuations in the business or disruption of business.

In case of companies, where there is an intention to liquidate it and to realise the assets and distribute the net proceeds.

Methodology

The value as per Net Assets Method is arrived at as follows:

Net Assets value represents equity value which is arrived at after reducing all external liabilities and preference shareholders claims, if any, from the aggregate value of all assets, as valued and stated in the Balance Sheet as on valuation date.

Net Assets Value = Total Assets (excluding Miscellaneous Expenditure & Debit balance of Profit & Loss account) – Total Liabilities

Or

Net Assets Value = Share Capital + Reserves (excluding revaluation reserves) — Miscellaneous Expenditure – Debit Balance of Profit & Loss Account

Adjustments to NAV

The Net Asset Value (NAV) as arrived at by using the above-mentioned formula may be adjusted depending upon circumstances of a particular case. The list given below showcases some of the adjustments commonly made:

Contingent Liabilities

The amount of Contingent Liabilities as disclosed in the financial statements of the entity needs to be adjusted from the value of net assets. The management’s perception of such liability materialising should be considered. If necessary, legal opinion regarding sustainability of claims or contingent liabilities should be called for.

Some examples of Contingent liabilities are:

1. Income tax demands
2. Excise demands
3. Sales tax/ Entry Tax demands
4. Entertainment tax
5. DPCO claim for pharmaceutical companies
6. Claims from customers
7. Matters referred to Arbitrations
8. Labour related issues

Care should be taken while adjusting the contingent liabilities towards Capital goods.

Investments

Investments, whether trade or non trade should be considered at their Market value while arriving at the Adjusted Net Assets value as they can be sold in the market on a piece meal basis without affecting the operations of the company. For this, notional adjustment should be made for any appreciation/ depreciation in the value of investments on a net of tax basis.

Treatment to be given for different categories of investments is summarized below:

Investment in Listed Securities

Investment in shares and securities, which are regularly traded in a stock exchange, may be valued on the basis of the prices quoted in a recognised stock exchange. This value can be considered as the closing market price as on the valuation date or the weighted average market prices quoted for a higher period of 3 or 6 months depending upon the value/ quantum of the investments.

Investment in unquoted shares/ securities

In case of unquoted shares and in case of quoted shares with isolated transactions etc., if the amount is material, a secondary valuation of such shares may be necessary. If the number or value of unquoted shares is not substantial, the value ascertained on the basis of such evidence as is available in the last annual accounts of the company concerned may be accepted.

Investment in subsidiaries

In case of investment in subsidiary company, net asset value of the subsidiary may be considered instead of the book value. In appropriate cases, an independent secondary valuation may be carried out for arriving at the value of investments in subsidiaries, which may be arrived at by using any of the valuation methods or the combination of these methods as explained further in this article.

Surplus Assets

The market value of surplus assets such as land and building not used for the business of the company should be considered. The appreciation or depreciation in the value of surplus assets adjusted for the tax liability or the tax shield on such appreciation or depreciation would be added/deducted from the Net Assets Value.

This is more of a notional adjustment. Market value of such assets could be based on the report of a technical valuer or on the estimates of the Management. Care should be taken if the title of the assets is not clear or the possession of the property under consideration is not with the owner.

Contingent Assets

If the company has made escalation claims, insurance claims or other similar claims, then the possibility of their recovery should be carefully made on a fair basis, particularly having regard to the time frame in which they are likely to be recovered. The likely cost to be incurred for realizing the amount needs to be adjusted.

Qualifications & Notes to Accounts

Qualifications in the Auditors Report and Notes to Accounts should also be given due consideration. If it calls for any adjustment, the same should be carried out while arriving at the Net Assets Value. E.g. diminution in the value of long term investments not provided for, provision for gratuity and leave encashment not made, provision for doubtful debts not made, etc.

Contingency Reserves

In case the company had set aside any specific reserve to meet future losses such as a contingency reserve, it should be considered whether they really are in the nature of reserves or provisions. If there is a definite reason to regard them as provisions, they should either be included in liabilities or deducted from the related assets.

Brought Forward Losses/Unabsorbed Depreciation

Brought forward tax losses/unabsorbed depreciation of a business should be considered if the buyer of the business would be entitled to take benefit of set off of such losses and unabsorbed depreciation

ESOPS, Warrants and Convertible instruments

Where the Company has issued warrants/ ESOPS or any other convertible instruments which are likely to be exercised, appropriate adjustment needs to be made for the amount receivable on the exercise of such options and resultant increase in share capital base.

NET REALISABLE VALUE METHOD

This method is generally used in case of liquidation. Where the business of the company is being liquidated, its assets have to be valued as if they were individually sold and not on a going concern basis. In such cases, the total net realisable value may be less than that on the basis of a going concern. Liabilities are deducted from the liquidation value of the assets to determine the liquidation value of the business. One should also consider liabilities which will arise on closure such as retrenchment compensation, termination of critical contracts, etc. Regard should also be made to the tax consequences of liquidation. Any distribution to the shareholders of the company on its liquidation, to the extent of accumulated profits of the company is regarded as deemed dividend. Dividend Distribution tax will have to be captured for such valuation.

REMAINDER REPLACEMENT VALUE METHOD

Replacement value is different from Net Assets Value as it uses the replacement value of assets, which is usually higher than the book valuation. The term replacement cost refers to the amount that a company would have to pay, at the present time, to replace any one of its existing assets. Net replacement value of the assets indicates the value of an asset similar to the original whose life is equal to the residual life of the existing asset. Replacement value includes not only the cost of acquiring or replicating the assets, but also all the relevant costs associated with replacement.

Liabilities are deducted from the replacement value of the assets to determine the net replacement value of the business.

Asset Based Method may not be relevant in case of companies operating in an industry where human knowledge and creativity are more relevant as compared to physical assets in value creation. In such cases, the Maintainable Profit Basis or the Discounted Cash Flow Method may be adopted.

Net Assets Method may sometimes be used as a backup to support the value arrived at as per other methods.

EARNINGS BASED METHOD:

Earnings based methods are generally regarded as more appropriate in case of valuation for going concern. This approach values a business by capitalizing its earnings. This involves multiplying one of the items of income statement earnings figure (like sales, profit after tax, etc.) by an appropriate multiple.

PROFIT EARNING CAPITALISATION VALUE METHOD (PECV)

Capitalization of future maintainable earnings is carried out under this approach. Here it is important to work out future maintainable profit. For this purpose past profitability generally gives the indication. However, if past profit is not indicative then, future profitability may be estimated after taking into account present value of future expected profits.

Situations Where PECV Method May Be Adopted

The PECV method of Valuation is relevant for valuing the following business enterprises as a going concern:

Companies with a proven track record

Companies operating in well established industrial segments where information as to average price to earnings multiple (P/E Multiple) is readily available.

Most business organisations have a lead-time of a few years before they start generating profits. During this period the PECV method of Valuation may not be applicable and one would have to adopt a non–traditional method such as the Discounted Cash Flow Method, which takes into account the future profitability of a business enterprise as also time value of money. Most valuers consider the PECV as a rule of thumb value.

Methodology

The value as per Profit Earning Capitalisation Value Method is arrived at as follows:

Valuation as per PECV involves determination of the future maintainable earnings on a post tax basis on the basis of its normal operations. These earnings are then capitalised at an appropriate rate to arrive at the Enterprise Value. PECV value can also be arrived at by applying the Price Earning Multiple to the net of tax future maintainable earnings.

PECV = Future Maintainable Profits After Tax/Capitalisation Rate

Or

PECV = Future Maintainable Profits After Tax* PE Multiple.

Future Maintainable Profit

Determination of future maintainable profits is a complicated task as it involves not only objective consideration of the available financial information but, subjective evaluation of many other factors such as capability of the company’s management, general economic conditions, Government policies, for example, the valuer may have to take a view on exchange rate, change in custom duty or income tax rates or changes expected in subsidy given by the Government. The valuer has to give due consideration to these factors according to his reading of the situation in each individual case.

In a company with a steady growth, past earnings will give indication of the future profitability and, therefore, average of the past three to five years’ earnings is taken as a future maintainable profit. Before selecting the number of years for averaging, valuer has to look at the business cycle, changes in business in those years or change in the scale of business. If the business is a cyclical business, care should be taken to consider at least all the years representing a single cycle.

It is logical to give higher weightage to the performance of recent years as compared to earlier years simply due to the fact that recent year’s performance is more relevant. It is also not unusual to ignore performance of the year which is not comparable (E.g. Performance of Airline Companies for the year in which 9/11 incident happened).

For instance, in case of a company whose business is dependent upon good rainfall, if in the latest year, the performance was affected due to draught, the valuer may consider giving equal weightage to the profits of the three years instead of giving higher weightage to the recent year.

Adjustments to PECV

The important considerations at this stage are how far the past values are reflective of the future maintainable value. Past values need to be adjusted for all non–recurring items and non–operating expenses/incomes. Following are some of the adjustments:

Elimination of material non-recurring items such as losses of exceptional nature, profit or loss of any isolated transaction not being part of the business of the enterprise, damages and costs in legal actions, etc.

Elimination of any abnormal or exceptional capital profit or loss or receipt or expense

Elimination of profits or losses from sale of investments which are not expected to recur in the future.

Adjustment for any interest, remuneration, commission, etc. foregone by Directors or others.

Adjustment for any matters suggested by notes appended to the accounts or by qualifications in the Auditor’s report.

Adjustment on account of Voluntary Retirement Scheme operated by the Company also considering the impact on personnel cost going forward.

Adjustment for any specific cost savings initiative taken up by the Company which were not reflected in the past profits.

If the value of Investments is added to the value arrived at under PECV method, any income received on such investments such as Dividends or Interest need to be eliminated while working out the main tenable profits otherwise it will amount to duplication.

Adjustment for discontinuance of a Business activity or an undertaking.

Adjustment for new Business activity which was not operative in all or any of the years considered in determination of Maintainable profits.

Adjustments for any inconsistencies in the accounting policies and their compliance with generally accepted accounting principles. For example, in the case of depreciation it should be ensured that the provision in each year is adequate and is calculated consistently both as to the basis and the rates. Similarly, in the case of stocks it should be ensured that the basis of valuation is consistent from year to year and is in accordance with the accepted accounting principles.

Appropriate Tax Rate

After arriving at the maintainable profit before tax, appropriate tax rate has to be applied to arrive at profit after tax. In arriving at the tax rate, currently applicable rate with the benefit on account of various reliefs and concessions available have to be considered. When the valuation is done for the equity holders, it is essential to adjust preference dividend payable. Certain tax reliefs which are going to be expired in near future, adjustment in tax rate may not be an appropriate way of dealing with it. In such situations, full tax rate is applied to the maintainable PBT and the present value of future benefit for the available years is added to the value. Further adjustment for the additional tax benefit for certain expenditure on research needs to be captured for the eligible companies. For example, Expenditure on scientific research under section 35.

Capitalisation Factor

The next important factor is the rate at which adjusted maintainable profit after tax is to be capitalised. The capitalization rate or the P/E Multiple shall be reflective of the value that the business commands as on the date of valuation. The determination of this rate is influenced by the following factors:

Prevailing rate of return on safe investment, say Government Securities

Financial position of the company

Past Track record

Prevailing Price Earning ratio in the market for companies in the same line of business and of similar size and profit performance as the company one is valuing.

Risk factors associated with the company and the industry

Size and standing of the business

Stability of profits in the industry and of the company

Reliability of Management background.

Determination of Business Value

Business/Enterprise value is derived by multiplying the inverse of the capitalization factor popularly called the P/E Multiple by the maintainable profits derived. The business value for equity shareholders is derived by further adjustments for preference shareholder’s claim, contingent liabilities and surplus assets. Surplus Assets are those assets, which do not contribute towards the earnings activity of a business whether directly or indirectly. The market value of these assets built up by an enterprise over years is added to the business value to give enterprise value. Further other adjustments as detailed in Net Assets Method and special considerations such as Controlling Interest, Illiquidity Discount, etc. may need to be made depending on the facts and circumstances of the case.

Earnings Based Method serves as an important benchmark value for most valuation exercises and is generally considered in conjunction with other methods to arrive at the business/enterprise value. A question would arise as to which method — Maintainable Profits Basis or Asset Basis — should be selected by a valuer in a particular situation. In general, the Maintainable Profits basis is used. In practice, however, the two methods are many times used simultaneously by assigning appropriate weightage to each method as applicable to the relevant case.

DISCOUNTED CASH FLOW METHOD (DCF)

DCF method proceeds on the assumption that “Cash is King”. It is superior to other methods of valuation like Maintainable Profit Basis, Net Assets Method etc. The traditional earnings related methods do not take into account the capital gearing of the enterprise, resources blocked in the Working Capital, requirements for capital expenditure, periodic tax benefits, etc.

The DCF method values the business by discounting its free cash flows for the explicit forecast period and the perpetuity value thereafter. The free cash flows represent the cash available for distribution to both the owners and the creditors of the business.

Estimation of Cash Flows

As stated earlier, DCF valuation is arrived by taking the present value of expected future cash flows. Thus it is very important to consider the reasonable projections which the enterprise can achieve. It is a known fact that nobody can predict what the future will be. Thus while preparing projections instead of being optimistic or pessimistic one has to be realistic. Each activity of the company needs to be identified and revenue assumptions need to be made for each activity. An appropriate Growth rate has to be applied to this considering the past trend of the enterprise, present and expected capacity utilisation of the enterprise, expected trend in the industry etc. Various cost and expenditure needs to be bifurcated into variable cost and fixed cost. The variable cost should be related to the revenue assumptions/activity of the company whereas fixed costs will be mainly time cost. An appropriate Growth rate has to be applied to the projections considering the past trend of the enterprise, present and expected capacity utilisation of the enterprise, expected trend of the industry, etc. In real life, projection are made by the Management and are provided to the valuer who in turn ensures that they are reasonable. Care needs to be taken to the regulation of the ICAI which prohibits its members in practice to associate his/ his firm’s name in a manner which may lead to the belief that he vouches for the accuracy of the projections.

Approaches to DCF

There are two broad approaches for valuation as per DCF Method. The equity approach and the second is the firm approach.

Equity Valuation : Under this approach, the value for equity holders is obtained by discounting expected cash flows available for the equity holders. Cash flows to equity holders is arrived by reducing from gross operational cash flows, tax payments, amount blocked in working capital, capital expenditure, interest payment, principal repayment for loans etc. The net cash flows so arrived is discounted by the cost of equity.

Firm Valuation : Under this approach the value of the firm is obtained by discounting the expected cash flows to the firm. Cash flows to firm are arrived by reducing from gross operational cash flows, tax payments, amount blocked in working capital, capital expenditure, non-cash expenditure (depreciation) etc. In this approach, the gross value of the enterprise is arrived and from this value, amount of loan as on the valuation date is reduced to arrive at the value for equity holders.

Between the above two, its most common to use Firm Valuation approach to DCF.

Estimation of Discount Rates

The discount rate is the most critical item of DCF valuation. The Cash Flow so arrived will have to be discounted by an appropriate Rate. The discount rate is arrived by determining the cost of each provider of capital and taking the weighted average of that. The discount rate so arrived is termed as Weighted Average cost of Capital (WACC). The WACC reflects the business as well as financial risk of the enterprise.

Each component of WACC is discussed in detail in the following paragraphs.

Cost of Equity : The cost of equity can be derived either by the risk and return approach or by dividend expectation approach. What is being measured in DCF valuation is the present value of total cash flows available to equity holders and not the dividend pay out by the enterprise. Considering this, generally the risk return approach is used to work out the cost of equity.

Under this approach, the cost of equity is defined as under :

Cost of equity = Risk Free Return + [Beta * Equity Risk Premium]

Where,

Risk Free Return : is the return expected by an investor where default risk is zero. (Government Securities).

Beta: It is the sensitivity of a particular stock vis a vis Market or Index. Arithmetically, beta can be calculated as follows

Covariance (X,Y)

Beta = ----------------------

Variance (X)

Equity Risk Premium is the expectation of the investor over and above the risk free return.

Equity Risk Premium = return generated by the market - risk free return

Cost of Debt

Cost of Debt is the long-term cost of debt of an enterprise. Interest on the debt is a tax-deductible item. Thus any enterprise would like to leverage on that and borrow funds to meet its requirements. While arriving at Cost of Debt, one has to take the tax benefit available on interest and take cost of debt net of tax.

Cost of Preference Shares

Cost of preference shares is the dividend rate of the preference share along with the applicable dividend distribution tax.

Weighted Average Cost of Capital (WACC)

The Weighted Average Cost of Capital is the weighted average of the costs of the different components of financing used by an enterprise. Arithmetically, WACC is calculated as follows:

WACC= [(Cost of Equity*Weight) + (Cost of Debt*Weight) + (Cost of Preference Shares*Weight)]/[Weight of Equity + Weight of Debt + Weight of Preference Shares]

To arrive at the weights of the different components of financing used by the enterprise, one has to consider the sustainable financing pattern of the enterprise and also of the industry in which it operates.

Calculation of Terminal Value

Discounted Cash Flow Valuation is calculated in two parts, i.e. present value of cash flow for explicit period (i.e., the period for which projections are made) and present value of terminal value. To work out the terminal value cash flows, explicit period’s last year’s gross cash flow is taken as base and an appropriate growth rate is applied to that.

While determining the growth rate for terminal value, one has to consider the length of the explicit period cash flow, long-term growth rate of the industry, etc.

From the gross cash flow, adjustment will have to be made for capital expenditure, incremental working capital requirement, tax payable etc. to arrive at net cash flow for terminal value.

The cash flow so arrived has to be capitalised by applying following formula to arrive at Gross Terminal Value

Net cash flow for

terminal value

Gross Terminal Value = ------------------------------------

(WACC – Growth Rate for

Terminal Value)

Discount rate of last year of explicit period has to be applied to arrive at present value of terminal value.

Present value of terminal value = Gross terminal value * Discount factor for last year of explicit period

Calculation of Value for Equity Holders

Present value of cash flow for explicit period and present value of terminal of terminal value is added to arrive at the Gross Value of the business.

This value is for all the providers of the capital.

To arrive at the value for equity holders under firm approach of valuation following adjustments needs to be made:

Value for equity holders = Present Value of Cash Flows for explicit period + Present value of Terminal Value – Opening balance of loan as on valuation date + Opening Surplus cash not considered for working capital requirement + Realisable value of surplus assets etc.

EBITDA MULTIPLE METHOD OF VALUATION

EBITDA multiple is one of the enterprise value multiples. This method is also called the “price-to-EBIDTA multiple”, or “the enterprise multiple” .The EBITDA multiple is the ratio of the value of capital employed (enterprise value) to EBITDA.

Enterprise multiple is calculated as:

Enterprise Value

EV/ EBITDA Multiple =
-------------------

EBITDA

= Market Value of Equity + Market Value of Debt

Earnings before Interest, Taxes, Depreciation & Amortisation

EBITDA multiple eliminates sometimes significant differences in depreciation methods and periods. It is very frequently used by financial analysts for companies in capital-intensive industries.

The enterprise multiple looks at a firm as a potential acquirer would, because it takes debt into account - an item which other multiples like the P/E ratio do not include. A low ratio indicates that a company might be undervalued.

Situations where EBITDA Multiple Method May Be Adopted

The enterprise multiple is used for several reasons:

It’s useful for transnational comparisons because it ignores the distorting effects of individual countries’ taxation policies.

It’s useful in companies reporting losses but whose earnings before interest, taxes and depreciation is positive.

It’s useful in case of firms in certain industries, such as cable, which require a substantial investment in infrastructure and long gestation periods, this multiple seems to be more appropriate than the price/earnings ratio.

It’s used to find attractive takeover candidates.

But one should note that enterprise multiples can vary depending on the industry. Therefore, it’s important to compare the multiple with other companies in the same industry or with the industry in general. Enterprise multiples are higher in growth industries (like Biotech) and lower in industries with slow growth.

SALES MULTIPLE METHOD OF VALUATION

A sales multiple is commonly used business valuation method and used as benchmark used in valuing a business. The information needed is annual sales and an industry multiplier, which will depend on industry. The industry multiplier can be found in various financial publications, as well as analyzing sales of comparable businesses. This method is easy to understand and use.

DIVIDEND CAPITALIZATION

Since most closely held companies do not pay dividends, when using dividend capitalization valuers must first determine dividend paying capacity of a business. Dividend paying capacity based on average net income and on average cash flow are used. To determine dividend paying capacity, near term capital needs, expansion plans, debt repayment, operation cushion, contractual requirements, past dividend paying history of a business and dividends of a comparable company should be investigated. After analyzing these factors, per cent of average net income and of average cash flow that can be used for the payment of dividends can be estimated. What also must be determined is the dividend yield, which can best be determined by analyzing comparable companies. As with the price earnings ratio method, this usually produces a relatively subjective result.

MARKET BASED APPROACH

MARKET PRICE METHOD

The Market Price Method evaluates the value on the basis of prices quoted on the stock exchange. Average of quoted price is considered as indicative of the value perception of the company by investors operating under free market conditions. To avoid chances of speculative pressures, it is suggested to adopt the average quotations of sufficiently longer period. The valuer will have to consider the effect of issue of bonus shares or rights shares during the period chosen for average.

Market Price Method is not relevant in the following cases:

Valuation of a division of a company

Where the share are not listed or are thinly traded

In the case of a merger, where the shares of one of the companies under consideration are not listed on any stock exchange

In case of companies, where there is an intention to liquidate it and to realise the assets and distribute the net proceeds.

In case of significant and unusual fluctuations in market price the market price may not be indicative of the true value of the share. At times, the valuer may also want to ignore this value, if according to the valuer, the market price is not a fair reflection of the company’s underlying assets or profitability status. The Market Price Method may also be used only as a back up for supporting the value arrived at by using the other methods.

It is important to note that Regulatory bodies have often considered market value as one of the very important basis — Preferential allotment, Buyback, Open offer price calculation under the Takeover Code.

In earlier days due to non-availability of data, while calculating the value under the market price method, high and low of monthly share prices where considered. Now with the support of technology, detailed data is available for stock prices. It is now a usual practice to consider weighted average market price considering volume and value of each transaction reported at the stock exchange.

If the period for which prices are considered also has impact on account of Bonus shares, Rights Issue, etc. The valuer needs to adjust the market prices for such corporate events.

MARKET COMPARABLES

This method is generally, applied in case of unlisted entities. This method estimates value by relating the same to underlying elements of similar companies or for past years. It is based on market multiples of ‘comparable companies’. For example

Earnings/Revenue Multiples (Valuation of Pharmaceutical Brands)

Book Value Multiples (Valuation of Financial Institution or Banks)

Industry Specific Multiples (Valuation of cement companies based on Production capacities)

Multiples from Recent M&A Transactions.

Though this method is easy to understand and quick to compute, it may not capture the intrinsic value and may give a distorted picture in case of short term volatility in the markets. There may often be difficulty in identifying the comparable companies.

SPECIAL CONSIDERATIONS

A situation may arise in the process of valuation of the shares or business, which may call for special considerations to be given to certain important factors. Few indicative situations have been discussed in the ensuing paragraphs.

6.1 Controlling Interest

When a parcel of shares carrying controlling interest in a company is to be valued, special consideration has to be given to this factor. This special consideration flows from the fact that the purchaser of such a parcel of shares does not acquire only the shares of the company but also control of that company which in itself is a valuable right. He has, therefore, to pay for this control also.

The valuer will have to study these aspects carefully and give due consideration to put a monetary value to controlling interest.

6.2 Restrictions on Transfer of Shares

Restrictions on transfer of shares generally have a depressing effect on their fair value inasmuch as the ready market for sale is restricted. This depends upon the security of the restrictions.

In such cases, it would be appropriate to discount the value arrived in order to provide for the illiquidity of the shares.

6.3 Due Diligence Review Adjustment

The outcome of the financial and accounting due diligence directly influences the value of acquisition. The findings of the DDR may call for adjustments to be considered in arriving at the value of the business of the target company.

6.4 Sales Tax Deferral Loan

Certain companies have a Sales Tax Deferral Loan where no interest is payable on the same and the entire principal amount is payable in the future. In such a case the present value of benefit of interest cost net of tax should be adjusted in the value of the company.

FAIR VALUE

7.1 As stated earlier, valuation is not an exact science. It is not a simple arithmetic exercise to arrive at the value based on a well defined model. In the final analysis, valuation is guided by the exercise of judicious discretion and judgement taking into account all the relevant factors. In addition to the various quantitative data/information considered in the relevant model of valuation, there are many qualitative factors such as quality and integrity of the management, present and prospective competition, yield on comparable securities and market sentiment etc. which have a significant influence on the worth of a share.

7.2 In the case of, Viscount Simon Bd in Gold Coast Selection Trust Ltd. vs. Humphrey reported in 30 TC 209 (House of Lords) and quoted with approval by the Supreme Court of India in the case reported in 176 ITR 417 as under:—

“If the asset takes the form of fully paid shares, the valuation will take into account not only the terms of the agreement but a number of other factors, such as prospective yield, marketability, the general outlook for the type of business of the company which has allotted the shares, the result of a contemporary prospectus offering similar shares for subscription, the capital position of the company, so forth. There may also be an element of value in the fact that the holding of the shares gives control of the company. If the asset is difficult to value, but is nonetheless of a money value, the best valuation possible must be made. Valuation is an art, not an exact science. Mathematical certainty is not demanded, nor indeed is it possible.”

7.3 In practice, as mentioned earlier, the valuer would take one and/or some of the above methods or may be some additional method to arrive at a Fair value of the business, giving adequate consideration to the earnings capacity, the asset base, market price and future earnings capacity of the concern. Value under each method may not be the same and it may give totally different picture. To overcome this, combination of different methods is used to arrive at the Fair value of the enterprise. It is a usual practice to apply weightages to values arrived under different methods. The Earnings based methods tends to get higher weightage as compared to Asset Based Method. The logic behind such treatment being any business is run for generating profits. Also, under going concern basis, assets are not expected to be sold. The Market Based Methods also gets higher importance as it reflects expectation of people at large about the fair value of the Company. It is assumed that the trader of share of a Company has reasonably good knowledge of the Company.

FORM OF VALUATION REPORT

Valuation reports could be — (a) Summarized Valuation Reports and (b) Detailed Valuation Report

Following matters should be covered in the Valuation Report:

— Background Information
— Purpose of Valuation and Appointing Authority
— Identity of the Valuer and any other experts involved in the valuation
— Disclosure of Valuer Interest/Conflict, if any
— Date of Appointment, Valuation Date and Date of Report
— Sources of Information
— Procedures adopted in carrying out the Valuation
— Valuation Methodology
— Major Factors influencing the Valuation
— Conclusion
— Caveats, Limitations and Disclaimers

RELEVANT CASE LAWS

9.1 Combination of three well-known methods — asset value, yield value and market value favoured. Hindustan Lever Employees’ Union vs. Hindustan Lever Limited (1995) 83 Com. Cases 30 AIR 1995 SC 470.

9.2 “Valuation is a technical and complex problem which can be appropriately left to the considerations of experts in the field of accountancy. Exchange Ratio shall not be disturbed by Courts unless objected and found grossly unfair” Miheer H. Mafatlal vs. Mafatlal Industries (1996) 87 Com Cases 792 and Dinesh vs. Lakhani vs. Parke-Davis (India) Ltd.. (2003) 47 SCL 80 (Bom)

9.3 In case of mergers, valuation date can be different from appointed date. Sumitra Pharmaceuticals and Chemicals Limited, In Re. (1997) 88 Com Cases 619 (AP)

9.4 Brands of a company are part of goodwill, cannot be separately valued. Brooke Bond Lipton India Limited (1998) 15 SCL 81 (Cal)

9.5 The Supreme Court has held in the case of CWT vs. Mahadeo Jalan [1972] (86 ITR 621) has held that valuation on net assets or break up basis should be considered only when the company is ripe for winding up.

9.6 In the case of Commissioner of Gift Tax vs. Smt. Kusumben D. Mahadevia [1991] 122 ITR 038, Supreme Court has held that where the shares in a public limited company are not quoted on the stock exchange or the shares are in a private limited company, the proper method of valuation would be the profit earnings capacity method.

9.7 In the case of Chintan Textiles Pvt. Ltd. & Others vs. Varuna Investments Limited [2001] (106 Com. Cases 410), the Bombay High Court has accepted the valuation on basis of fair value of the shares which has been determined by merging the values under different methods, namely, the net assets method, the earning capitalisation method and the market price method.

CONCLUSION

Many people hold the mistaken notion that there could be only one “value”. As held earlier, valuation is a subjective process. Different valuers may come up with different values. The difficulty in valuing a business is not the understanding of various valuation methodologies and techniques. It is in fact, identifying and defining the objective of business valuation. Defining the valuation objective provides focus and clarity leading to the most logical conclusion.