Basics Of Valuation

1. Basics Of Valuation

2. Introduction • Business valuation is a logical, defendable process of arriving at the opinion as to the worth of a business given the information available, assumptions and limiting conditions on the valuation date. • Valuation is neither a science nor an art. It is a combination of the two. • It is complex and imperfect. • Basic principles of valuation can be learned but the skills are developed through experience, by continuously practicing the art of valuation

3. Valuation Contexts • Mergers and acquisitions: • Value forms the basis for negotiating price • Analysts’ report: • Value forms the basis for advising clients • Valuation in court cases: • Value forms the basis of decisions such as partition of wealth • Valuation for compliances of different laws and regulations • Evaluation of alternative strategies by managers • Measurement of assets and liabilities in the balance sheet

4. Valuation By Financial Analysts • Financial analysts value equity shares of publicly traded companies to advise their clients on buy and sell decisions. • Valuation of equity shares issued by a company is often preceded by the valuation of the enterprise. • The value of the equity is the difference between enterprise value and value of the debt.

5. Valuation By Financial Analysts (Contd.) • Value per equity share is calculated by dividing the value of the equity capital by the number of outstanding shares. • It is not necessary that equity value should always be derived from the enterprise value. • Analysts can calculate the equity value directly from the information available in the public domain.

6. Valuation By Financial Analysts (Contd.) • It is not that every time an analyst advises her client she calculates the value of the enterprise or the equity abinitio. • She adjusts the value calculated earlier for the new information available to her. • This brings out the fact that the value determined at a particular point in time may not remain valid in future.

7. Value in Mergers and Acquisitions • In mergers and acquisitions both the parties, the acquirer and the acquiree, value the enterprise from their own perspectives. • The acquirer takes into consideration synergies or other benefits that will arise when the assets will come under its control.

8. Value in Mergers and Acquisitions (Contd.) • The acquiree also takes into consideration likely benefits to the acquirer to estimate the value of the assets to the acquirer. • It also calculates the value of the assets if they remain under its control. • Values determined by the parties provide the basis for negotiating the deal. • The price is determined through negotiation between the parties.

9. Value • An economic concept: • Future looking • Uncertainties surrounding valuation • Bias • A basis for price negotiation • Not a fact: Only an estimated range can be determined • Correct only at the point in time when the value is calculated

10. Principals of Valuation • Principles of substitution: • Risk averse investor will not pay more for a business if another desirable substitute exists • Principle of alternatives: • Alternative opportunity is waiting • Principle of time value • Principle of expectation • Principle of risk and return • Principle of reasonableness

11. Standard Value • The identification of the type of value being utilized in a specific engagement • Five more common ‘standard value’: • Fair market value • Investment value • Intrinsic value • Fair value • Market value

12. Book Value • It is rarely used

13. Fair Market Value • The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts • Fair market value reflects the consensus opinion among all buyers and sellers constituting the market for an asset as to its worth rather than opinion of any individual investor

14. Fair Market Value (Contd.) • FMV contemplated: • Price is cash or cash equivalents at the prevailing economic condition • Willingness to buy or sell exists • No compulsion to accept the deal • Potential buyer of similar assets exists • Reasonable time and knowledge exists • No separate price for not to compete

15. Fair Market Value (Contd.) • FMV does not contemplate: • Plan to sell to a particular buyer and adopting a planned strategy • Buyer has specific knowledge • Engagement of experienced and well connected negotiator to get a fair deal • Other benefits attached with the deal like making finance or key personnel available

16. Investment Value • The value to a particular investor based on individual investment requirements and expectations • Investment value may be higher than the fair market value • The control premium • The synergy premium • Minority discount

17. Intrinsic Value or fundamental Value • It is the true economic worth of share, business or property • The value that an investor considers, on the basis of evaluation or available facts, to be ‘true’ or ‘real’ value that will become the market value when other investors reach the same conclusion • Most analysts use it for buy or sell recommendation

18. Fair Value • Legally created standard value • Aim is to give a fair treatment to parties who seek remedy under law • Fair value uses highest and best use (HABU) of an asset from perspective of market participants • Assumes that the use of the asset is physically possible financially feasible and legally permissible • Discount for lack of marketability (DLOM) may require in certain cases but adjustment for discount for lack of control (DLOC) is doubtful

19. Fair Value For Corporate Financial Reporting • The price that could be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date [US GAAP SFAS 157] • Exit price • No adjustment for transaction cost • Principal market or most advantageous market • The amount at which an asset could be exchanged, or liability settled between knowledgeable, willing parties in an arm’s length transaction [IFRS]

20. Fair Value hierarchy • Observable prices in the active market at the valuation date • Observable prices in most recent transactions, adjusted for changes in the intervening period • Observable prices for similar assets • Value determined using an economic model

21. Market Value • Market value is the estimated amount for which property should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently and without compulsion

22. Value Premises • Going concern • Profit earning capacity should be the key • Discounted cash flow methods are most appropriate • Liquidation • Break up value may be used • Value in exchange • Value in use • Value in place • Value to the specific holder

23. Steps in Determining The Value • Determine the purpose of valuation • Define standard value • Select value premise • Carry out historical analysis • Carry out environment (internal and external) scan • Select appropriate valuation approaches • Select appropriate valuation methods • Calculate value • Carry out reconciliation and reasonableness check • Value conclusions

24. Caution • Avoid bias • Use different valuation methods for reality check • Do not tinker with the value conclusion

25. Sum-Of-The Parts • Businesses are the building blocks of an entity • Each business should be valued separately • The whole can be worth more or less than the sum of the parts • Applying a discount (e.g. conglomerate discount) to SOTP is not only arbitrary, it is wrong • If a subsidiary or associate is a listed company, it is preferable to use the market value

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