IBusiness Valuation- An Objective or Subjective Perception
Historical cost values and business valuation:
We all understand that financial statements of companies are prepared under historical cost conventions fulfilling requirements of various statutes. However, information of such financial statements cannot quench the thirst of investors, acquirers or players in the share market. Figures especially of assets and liabilities, recognized or unreported intangibles have to be recast to understand the true potential of a business enterprise. In other words, financial wizards and valuation experts deploy their skill to find the true or the fair value of the business, to recommend investors to take decisions of ‘buy or sell’, on their investments.
If experts are called in to value businesses, we are sure that each will adopt their methods and arrive at valuations that may or may not be comparable. Based on some assumptions, certain estimates and the prevailing surrounding circumstances, all of them will justify their stands for arriving at a particular valuation. Obviously we have to understand that there is a backdrop to their exercise and therefore it is subject to such assumptions and estimates. The business valuation, that has more information at its disposal, would probably be more realistic and this requires careful analysis of the depth of information that has gone into the valuation process.
To sum up what has been stated above, a reference is made to ‘Business Valuation and Taxes, Procedure Law and Perspective’ co-authored by David Laro & Shannon Pratt who describe value in the following words: ‘Like beauty, value is in the eye of the beholder. What is value to one may be inconsequential to another. In this regard, value is mere subjective perception. We use standard of value synonymously with definition of value. Stated concisely, business value must be measured and defined by a definition of value that is relevant, predictable, and reliable. Recognizing that the same business interest may have different values if more than one standard of value is used …….’
Objectives of business valuation:
We may arrive at a destination in business valuation only if we know what we are looking for. If the objective is unclear, then any result that is arrived at in the valuation process would really be a number without any significance. No valuation is done without a purpose. The technique of valuation will be based on the objective and the purpose. What common reasons we can find to undertake business valuation? To know the intent and purpose of valuation, we come across some of the following issues that may call for the exercise:
Acquisitions, Mergers and Amalgamations;
Fresh investors participating in business;
Hiving off an undertaking;
Buy-back of shares;
Business separation;
Augmenting or raising financial resources;
Deciding premiums in public offers;
Impairments and revaluation of assets;
Litigation; and
Market experts playing advisory role in public.
Methods of business valuation:
There are different methods that one can look at in the valuation approach. The choice can be either of them or combination of them, so as to realistically represent a value that can be sustained under the going concern concept. Some of the important valuation methodologies include:
Asset based valuation;
Discounted cash flow method;
Comparable company method; and
Market approach method.
Asset Based Valuation Method: This method requires careful analyses of all assets possessed by the enterprise. It can be the replacement cost of the assets as on a particular date, the assets being tangible and useful to the business in generating a cash flow. In respect of intangible assets, an attempt is made to determine how such inherent strengths of the undertaking are going to help the company in deriving positive cash flows and to what extent. When we talk of intangibles it may relate to technology, market strength, customer base, licenses, trademarks & copyrights, etc. A fair value is placed on the intangibles along with the replacement cost of the tangibles to arrive at a comprehensive value under this method.
Discounted Cash Flow Method: Under this method future expected earnings are discounted with weighted average cost of capital. By this method one arrives at the present value of the business. Future cash flows have to be worked out realistically, which of course have to be an extrapolation of the past with appropriate adjustments. The past cash flows of comparable industries should also be verified to avoid any aberrations in projecting the cash flows. The weighted average cost of capital is arrived by determining actual cost of debt and calculated cost of equity. Again calculated cost of equity is determined by aggregating risk free rate of return and risk premium. To the projected period of cash flows, say 5 years or 10 years, there is a terminal value perpetuity growth, expressed as a percentage that defines a static growth factor thereafter. Gordon Model provides a formula for determining the cash flow into perpetuity as follows:
Cash Flow in the First Year of the Terminal Period [Discount Rate – Long Term Growth Rate]
Comparable Company Method: Under this method, comparable companies are selected from the public database. Adjustments are made for various economic issues to bring them to a common platform for comparisons. In fact, companies may be rejected for comparison if it is felt that there are more dissimilarities than similarities. Rejection could be on the basis of different geographical locations, different infrastructural facilities, different governmental policies, etc. However, if adjustments can be made then they are compared by making appropriate adjustments. The business is thereafter valued by determining it as a ratio of sales to the benchmarked comparable industries. Depending on the source of data available and its reliability, the valuation measures could include enterprise value (EV) to EBITDA (earnings before interest, tax, depreciation and amortization), EV to EBIT, and Price to Earnings.
Market Approach Method: Unlike the discounted cash flow method, the market approach method is an extrinsic valuation model. In discounted cash flow method, we try to determine how the assets are going to be used to generate a cash flow. It looks at the inherent strength of the assets within the undertaking to determine the sustainability and growth of the business. However, in the market approach method the market value or the external factors play a significant role in the valuation. It is also called as the relative valuation method wherein we are making a decision based on how similar assets are rated in the market. Most listed companies look at market valuation of shares of similar companies and judge the valuations of different companies in a particular industry segment. This has a persuasive role to play in determining business valuations of companies that are similar.
It was believed under the ‘efficient market hypothesis’ that stock markets were efficient and that prices fully reflect all known information. This would factor both adverse and beneficial conditions at a given point in time, and that fundamental or technical analysis would not match with the speed of the market perception and dissemination of value information of any business or industry.
Standards of value:
While the methods of valuation have been briefly discussed in the above paragraphs, we need to understand the ‘Standards of Value’ in the process of business valuation. It is important to know that depending on the standards of value, a business can have different values. Generally, the standards of value adopted in business valuations are of 3 types. The valuation process will describe what standards of value have been selected giving the backdrop for the process to proceed. Hence, it is inevitable that the concepts are understood in their proper perspective. They include:
Fair Market Value (both intrinsic and extrinsic factors);
Investment Value; and
Liquidation Value.
Fair Market Value: It is the price that a buyer could be reasonably expected to pay, and the seller willing to accept, in a open market in a given time frame, with both the buyer and seller being knowledgeable and without any compulsion to act. Whether the fair value is intrinsic or extrinsic depends upon whether asset values have been adjusted based on the ‘value in use’ or it is a relative value in comparison with other similar assets in the market.
Investment Value: It is a value to the investor based on his own investment requirement, perception and expectations. For example, investment in gold for some could be a matter of what return it can give in a given time frame and for others it can be an investment for enhancing the prestige. The risk perception is going to be totally different for the two. Value in use to one may be higher, for he can see a greater cash flow from the asset, and for the other it may not look attractive. The perceptions differ and hence the investment value of the asset. It all depends upon how the individual is exposed to the asset and its underlying.
Liquidation Value: This is more an asset based approach, wherein it is believed that the entity being valued has no going concern approach. It is based on the underlying net assets of the business, which literally is its realization value. In case of a going concern, the predominant factor is its cash flow or the earning capacity. Assets although are important in the valuation process but are not recognized with primary importance. In the liquidation value approach, the intention to earn revenue or to maintain a sustained cash flow is totally absent. It represents net equity of the business after assets and liabilities of the business have been adjusted. It represents the net present value of cash flows on liquidation and paying off the liabilities of a company.
Valuation Premise: The premise of value is a fundamental assumption where the business is to be valued, whether it is going to remain a ‘going concern’ or that it is going to be ‘liquidated’ by selling the assets to pay of its liabilities. The going concern concept and liquidation are mutually exclusive and one cannot remain if the other needs to exist. If liquidation is considered, it can either happen now or it may take some time and go into the future. If there is a considerable time for completing the liquidation, the process involves discounting the future cash flows to present value at risk-free rate matching with the definite period of complete closure. If a going concern is assumed, the business has no intention of immediate liquidation, with uncertainties of price and the timing. Methods of valuation and adoption of any value that have been defined above have a bearing on the valuation premise. Going concern and liquidation premises are two vectors that drag the valuation models in different directions.
Valuations of intangibles:
It is difficult to value intangibles. This apart the intangibles are to be valued at a fair value, which makes the valuation process even more difficult. Why do we reckon intangibles separately? It is because the existence of that additional feature in a business is capable of bringing in additional cash flow exceeding the cash flows from the underlying net asset value. Any expenditure or development over the years, to qualify for being an intangible asset has to bring in additional benefits and such expectations need to be evidenced or demonstrated. There are 3 methods that are normally employed in the valuation of intangibles. They include:
Market based approach;
Cost based approach; and
Past estimates of future economic benefit approach.
Market based approach: In this approach, attempt is made to search for similar transactions in the market. This has its own limitation as many intangibles have no active market. Also, the search process has to consider transactions that are not influenced or biased. To find arms length transactions is not an easy task and again it is hard to come by similar or same transactions in the market. If the intangible turns out to be unique then one can understand that market comparables will not exist. If market arms length comparables are available, then this is the most appropriate method in the intangible valuation process. It is also a good method, if adjustments are required to made for peculiarities in the intangible being compared, or for certain peculiarities in the chosen comparable to arrive at a reliable result.
Cost based approach: It is the cost to create the intangible or the replacement cost if similar items are available in the market. For example, liquor license, route permits construction rights and leasehold rights can all be purchased in the market. Premiums are attached and therefore valuation of such intangibles is based on cost of acquisition. Obviously, such valuations do not factor maintenance costs and inflation costs as they can be compared like off-the-shelf products in the market. Very reliable as costs are known and both the buyer and the seller have information about such intangibles. This method is not appropriate when intangibles are created or evolve over a period of time without reference to cost and are unique by themselves.
Estimate of past and future economic benefit (income method): We can classify this approach into 4 classifications.
Capitalization of historic profits: A multiple is decided for the intangible based on its inherent strength and the same is multiplied by maintainable historic profits. This provides the valuation of the intangible. But, this approach ignores the future derivable profits from the intangible. The cash flow of an intangible, if on the ascent path has more value than that is on its descent or the tail-end.
Gross profit differential method: This is normally associated with trademark and brand valuation. Sales consideration and sales potential of a branded product and an unbranded product or a generic product in the market are compared. Future cash flows are estimated for the products and differentials are established. This paves the way for intangible valuation under this method.
Excess profits method: Normally investors invest in an asset based on the normal returns. If the asset can generate a higher cash flow than normal or a higher cash flow than the comparables, it can claim a premium for the additional cash flow. It induces the investor to pay higher than the normal because of the additional cash flow, and therefore sets a base for a higher valuation of the intangible. This method however does not capture alternate use of the asset but adopts a linear approach which is a limitation on the valuation process.
Relief from royalty: It is a intuitive approach that is simple and assumes that the company does not own any brand. The method calculates how much it has to pay as license fee if it was to be procured from third parties. The present value of the hypothetical royalty payments represents the value of the intangible. The royalty stream can also capitalized establishing a risk return relationship.
The last three methods exhaustively apply the discounted cash flow method to arrive net present value or the worth of the intangibles; therefore prospective flows have to be realistic and best estimates to arrive at credible results. The discount rate should best reflect compensations for risk and for expected rates of inflation. Option pricing methods are gaining ground for valuing patents.
Best approach to business valuation:
The question that comes up to any mind is to determine what is the best approach or the method for valuation and thereafter to decide what value needs to be adopted. Different methods provide different answers and hence it is important that the business valuation process should engage the appraiser to undertake multiple exercises so as to be convinced about what method is important in a given situation to fulfill the objectives of the valuation. The ‘standard of value’ and the ‘premise’ are stated upfront in the business valuation reports so that the direction of the drag is established to value business as a going concern or under the liquidatio method. All methods are employed and a reasonable approach is determined under the give set of facts and circumstances. Again it is important to explain as to why the selected approach scores over the rest.
Contents of a business valuation report:
A business valuation report should generally contain the following aspects to justify the results of business valuation:
Executive summary
Scope and objective of business valuation exercise;
External and internal sources of information;
Assumptions and the limitations encountered in the course of the exercise;
Background of the company;
Economic and the industry condition in which the business operates;
Historical financial statements and its review;
Normalizing the historical financial statements and reasons thereof;
Analytical and ratio analysis of the normalized financial statements;
Valuation process and methodology of the business entity;
Conclusions regarding the valuation result.
Relevance of intangibles in a good business valuation report:
A good business valuation report requires sound analytical skills and intuition. An in depth understanding of the financial statements and the ability to challenge each of the premises, that the buyer or the seller is heading to make for their own individual advantage, is an important step in the valuation process. Data integrity has to be tested to its logical end and due diligence has much to offer in this direction. Apart from the financial and quantitative analysis, valuation process must consider the qualitative factors associated with the business entity, the industry to which it belongs and the economy in which the business operates. Valuation has to be subjected to judicious discretion, with suitable explanations, taking all factors into consideration. Factors such as reliability of information, integrity and professionalism of management, present and prospective opportunities and competition for the business, public perception and psychology, etc., have an influencing and persuasive effect on the business valuation that needs a proper adjustment. It should be remembered that intangible and inherent strengths that are not reflected in historical cost financial statements have a great role to play in arriving at the business value. Let’s hope that fair value accounting should provide answers to such limitations.
By K.S.Ravi, B.Sc, F.C.A K.Madhusudhan, B.Com, ACMA