Business Valuation Methods

The cardinal rule of business valuation is, that the value of something cannot  stated in an abstract form; all that can be stated is the value of a thing in a particular place, at a particular time, in particular circumstances.

Valuation of the target requires valuation of the totality of the incremental cash  flows and earnings.  Valuation of a target is based on expectations of both the magnitude and the timing of  realization  of the anticipated benefits. Where, these benefits are difficult to forecast, the valuation of the target is not precise. This exposes the bidder to valuation risk. The degree of this risk depends on the quality of information available to the bidder, which, in turn, depends upon whether the target is a private  or a public company, whether the bid is hostile or friendly, the time spent in preparing the bid and the pre-acquisition audit of the target.

There are four main value concepts namely:

  1. Owner value
  2. Market value
  3. Tax value and
  4. Fair value.

Owner value determines the price in negotiated deals and is often led by a proprietor’s view of value if he were deprived of the property.  The basis of market value is the assumption that if comparable property has fetched a certain price, then the subject property will realize a price something near to it.  The fair value concept in essence, is the desire to be equitable to both parties. It  recognizes that the transaction is not in the open market and that vendor and purchaser have been brought together in a legally binding manner.  Tax valuation has been the subject of case law since the turn of the century. There are concepts of value that  impinge  upon each of these main areas; namely, investment value, liquidation value, and going concern value.

1. Valuation based on Assets

This business valuation method is based on the simple assumption that adding the value of  all the assets of the company and subtracting the liabilities, leaving a net asset valuation, can best determine the value of a business. However, for the purposes of the amalgamation the amount of the consideration for the acquisition of a business may be arrived at either by valuing its individual assets and goodwill or by valuing the business as a whole by reference to its earning capacity. If this method is employed, the fixed assets of all the amalgamating companies should preferably be valued by the same professional value on a going concern basis. The term ‘going concern’ means that a business is being operated at not less than normal or reasonable profit and value will assume that the business is earning reasonable profits when appraising the assets. If it is found when all the assets of the business, both fixed and current, have been valued that the profits represent more than a fair commercial return upon the capital employed in the business as shown by such valuation the capitalized value of the-excess (or super profits) will be the value of the goodwill, which must be added to the values of the other assets   n arriving at the consideration to be paid for the business. This method may be summarized thus: The procedure of arriving at the value of a share employed in  the equity method is simply to estimate what the assets less liabilities are worth, that is, the net assets lying for a probable loss or possible profit on book value, the balance being available for shareholders included in the liabilities may be debentures, debenture interest, expenses outstanding and possible preference dividends if the articles of association stipulate for payment of shares in winding up.

However, although a balance sheet usually gives an accurate indication of short-term assets and liabilities, this is not the case of long-term ones as they may be hidden by techniques such as “off balance sheet financing”. Moreover, a balance sheet is a historical record of previous expenditure and existing liabilities. As a   valuation is a forward looking exercise, acquisition purchase prices generally do not bear any relation to published balance sheet. Nevertheless a company’s net book value is still taken into account as net book values have a tendency to become minimum prices and the greater the proportion of purchase price is represented by tangible assets, the less risky it’s acquisition is perceived to be.

Valuation of a listed and quoted company has to be done on a different footing as  compared to an unlisted company. The real value of the assets may or may not reflect the market price of the shares; however, in unlisted companies, only the information relating to the profitability of the company as reflected in the accounts is available and there is no indication of the market price. Using existing public companies as a benchmark to value similar private companies is a viable valuation methodology.

The comparable public company method involves selecting a group of publicly traded companies that, on average, are representative of the company that is to be valued. Each comparable company’s financial or operating data (like revenues, EBITDA or book value) is compared to each company’s total market capitalization to obtain a valuation multiple. An average of these multiples is then applied to get company value. An asset-based valuation can be further separated into four approaches:

1.  Book value

The tangible book value of a company is obtained from the balance sheet by taking the adjusted historical cost of the company’s assets and subtracting the liabilities; intangible assets (like goodwill) are excluded in the calculation.

Statutes like the Gift Tax Act, Wealth Tax Act, etc., have in fact adopted book value method for valuation of unquoted equity shares for companies other than an  investment company. Book value of assets does help the valuer in determining the  useful employment of such assets and their state of efficiency. In turn, this leads the valuer to the determination of rehabilitation requirements with reference to current replacement values.

In all cases of valuation on assets basis, except book value basis, it is important to  arrive at current replacement and realization value. It is more so in case of assets like patents, trademarks, know-how, etc. which may posses value, substantially more or less than those shown in the books.

Using book value does not provide a true indication of a company’s value, nor does it take into account the cash flow that can be generated by the company’s assets.

2. Replacement Cost

Replacement cost reflects the expenditures required to replicate the operations of the company. Estimating replacement cost is essentially a make or buy decision.

3. Appraised Value

The difference between the appraised value of assets, and the appraised value of  liabilities is the net appraised value of the firm.  This approach is most commonly used in a liquidation analysis because it reflects the divestiture of the underlying assets rather than the ongoing operations of the firm.

4. Excess Earnings

In order to obtain a value of the business using the excess earnings method, a premium is added to the appraised value of net assets. This premium is calculated by comparing the earnings of a business before a sale and the earnings after the sale, with the difference referred to as excess earnings.

In this approach, it is assumed that the business is run more efficiently after a sale;  the total amount of excess earnings is capitalized (e.g., the difference in earnings is  divided by some expected rate of return) and this result is then added to the appraised value of net assets to derive the value of the business.

2. Open Market Valuation

Open market value refers to a price of the assets of the company which could be  fetched or realized by negotiating sale provided there is a willing seller, property is  freely exposed to market, sale could materialize within a reasonable period, orders will remain static throughout this period and without interruption from any purchaser giving an extraordinarily higher bid. Each asset of the company is normally valued on the basis of liquidation as resale item rather than on a going-concern basis. The assets of the company, which are not subject to regular sale, could be assessed on depreciated or replacement cost. Besides, intangible assets like goodwill are also assessed as per normal practices and recognized conventions.

3. Valuation based on Earnings

The normal purpose of the contemplated purchase is to provide for the buyer the  annuity for his outlay. He will expect yearly income, return great or small, stable or fluctuating but nevertheless some return which is commensurate with the price paid therefore. Valuation based on earnings based on the rate of return on capital  employed is a more modern method being adopted. From the last earnings declared by a company, items such as tax, preference dividend, if any, are deducted and net   earnings are taken.

An alternate to this method is the use of the price-earning (P/E) ratio instead of  the rate of return. The P/E ratio of a listed company can be calculated by dividing  the current price of the share by earning per share (EPS). Therefore, the reciprocal of P/E ratio is called earnings – price ratio or earning yield.

The share price can thus be determined as;  P = EPS x P/E ratio

Leave a Reply

Your email address will not be published. Required fields are marked *