ch. 32 valuation of business

8/19/2019 Ch. 32 Valuation of Business

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The term ‘valuation’ implies the estimated worth of an asset or asecurity or a business. The alternative approaches to value afirm/an asset are:

Book value,

Market value,

ntrinsic value,

!i"uidation value,

#eplacement value,

$alva%e value

&alue of 'oodwill

(air value.


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)The book value of an asset refers to the amount atwhich an asset is shown in the balance sheet of arm. Generally, the sum is equal to the initialacquisition cost of an asset less accumulateddepreciation.

)In other words, book value of an asset shown inbalance does not reect its current sale value.

) Book value of a business refers to total book valueof all valuable assets (ecludin! ctitious assets,such as accumulated losses and deferred revenueependitures, like advertisement, preliminary

epenses, cost of issue of securities not written o"#less all eternal liabilities (includin reference


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)$arket value refers to the price at which anasset can be sold in the market.

)The market value can be applied with respect

to tan!ible assets only% intan!ible assets (inisolation#, more often than not, do not have any

sale value.

)$arket value of a business refers to thea!!re!ate market value (as per stock market

quotation# of all equity shares outstandin!.

)The market value of business is relevant tolisted companies only.


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Intrinsic/Economic Value:

ntrinsic/*conomic &alue is the present value of incremental future cash inflowsusin% an appropriate discount rate.

Liquidation Value :

) +s the name su%%ests, li"uidation value represents the price at which eachindividual asset can be sold if business operations are discontinued in the wake of

li"uidation of the firm.)n operational terms, the li"uidation value of a business is e"ual to the sum of i-realisable value of assets and ii- cash and bank balances minus the paymentsre"uired to dischar%e all eternal liabilities.

)n %eneral, amon% all measures of value, the li"uidation value of an asset/orbusiness is likely to be the least.


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Replacement Value:

)The replacement value is the cost of ac"uirin% a new asset of e"ual

utility and usefulness.

)t is normally useful in valuin% tan%ible assets such as office e"uipment

and furniture and fitures, which do not contribute towards the revenue of

the business firm.

Salvage Value:

)$alva%e value represents realisable/scrap value on the disposal of

assets after the epiry of their economic useful life.

)t may be employed to value assets such as plant and machinery.

)$alva%e value should be considered net of removal costs.


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Value of Goodwill:

)The valuation of %oodwill is conceptually the most difficult.

) + business firm can be said to have ‘real’ %oodwill in case it earns a rate of return##- on invested funds hi%her than the ## earned by similar firms with thesame level of risk-.

)n operational terms, %oodwill results when the firm earns ecess ‘super’- profits.

Fair Value:

)(air value is the avera%e of book value, market value and intrinsic value.)The fair value is hybrid in nature and often is the avera%e of these three values.

)n ndia, the concept of fair value has evolved from case laws and hence is morestatutory in nature- and is applicable to certain specific transactions, like paymentto minority shareholders.

)t may be noted that most of the concepts related to value are ‘stock’ based in

that they are %uided by the worth of assets at a point of time and not the likelycontribution they can make towards earnin%s/cash flows of the business in thefuture.


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There are four approaches to valuation of business

with focus on e"uity share valuation-:

0- +ssets based,

1- *arnin%s based,

2- Market value based and

3- (air value method.


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+ssets4based method focuses on determinin% the value of

5et assets 6 Total assets 7 Total eternal obli%ations- 0-

5et assets per share can be obtained dividin% total net assets by

the number of e"uity shares outstandin%. t indicates the net

assets backin% per e"uity share also known as net worth per

share-.

5et assets per share 6 5et assets / 5umber of e"uity shares

issued and outstandin% 1-


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*arnin%s based method relates the firm’s value to its potential future earnin%s

or cash flow %eneratin% capacity. +ccordin%ly, there are two ma8or variants of

this approach i- *arnin%s measure on accountin% basis and ii- earnin%s

measure on cash flow basis.

i- *arnin%s measure on accountin% basis

+s per this method, the earnin%s approach of business valuation is based ontwo ma8or parameters, that is, the earnin%s of the firm and the capatilisationrate applicable to such earnin%s %iven the level of risk- in the market. *arnin%s,in the contet of this method, are the normal epected annual profits. 5ormally

to smoothen out the fluctuations in earnin%s, the avera%e of past earnin%s say,of the last three to five years- is computed.

&alue of business &B- 6 (uture maintainable profits 9 #elevant capitalisation

factor 3-


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The /* ratio also known as the /* multiple- is the method most widely usedby finance mana%ers, investment analysts and e"uity shareholders to arrive atthe market price of an e"uity share. The application of this method primarilyre"uires the determination of earnin%s per e"uity share *$-. The *$ is

computed as per *"uation

*$ 6 5et earnin%s available to e"uity shareholders durin% the period/5umber

of e"uity shares outstandin% durin% the period. ;-

The *$ is to be multiplied by the /* ratio to arrive at the market price ofe"uity share M$-.

M$6 *$ < /* ratio =-

The /* ratio may be derived %iven the M$ and *$.

/* ratio 6 M$/*$ >->-


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)The second method makes use of the discounted cash flow techni"ue tovalue the business.

) +ccordin% to the ?@( approach, the value of business/firm is e"ual to thepresent value of epected future operatin% cash flows @(- to the firm,

discounted at a rate that reflects the riskiness of the cash flows k A-, that is,

)8(∑∞

= +=

0t t

Ak0

t(irmto@(

Afirmof &alue


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To use the ?@( approach, accountin% earnin%s as shown by the firm’s

income statement- are to be converted to cash flow fi%ures as shown in(ormat 0.

(ormat 0: @omputation of @ash (lows

+fter ta operatin% earnin%s

lus: ?epreciation

lus: ther non4cash items say, amortisation of non4tan%ible asset,

such as patents, trade marks, etc and loss on sale of lon%4

term assets-

The interest costs are included as a part of the discount rate CA-.


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(ormat 1 shows computation of operatin% free cash flows (@(- for the

purpose of valuation of a business.

(ormat 1: ?etermination of peratin% (ree @ash (lows (@((-

+fter ta operatin% earnin%s

lus: ?epreciation, amortisation and other non4cash items

!ess: nvestments in lon%4term assets

!ess: nvestments in operatin% net workin% capital

peratin% free cash flows (@((-

*clusive of income from i- marketable securities and non4

operatin% investments and ii- etraordinary incomes or losses.

+ddition is to be made in the event of decrease of net workin%

capital.


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(ormat 2: ?etermination of (ree @ash (lows (@((-

peratin% free cash flows as per (ormat 1-

lus: +fter ta non4operatin% income/cash flows

lus: ?ecrease minus increase- in non4operatin% +ssets, say marketable securities

(ree cash flows to (irm (@((-

5on4operatin% income 0 7 ta rate-

The free cash flow (@((- is the le%itimate cash flow for the purpose ofbusiness valuation in that it reflects the cash flows %enerated by a

company’s operations for all the providers debt and e"uityof its

‘capital’. The (@(( is a more comprehensive term as it includes cash

flows due to after ta non4operatin% income as well as ad8ustments for

non4operatin% assets. (ormat 2 ehibits the procedure of determinin%(@((.


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+lternatively, the value of e"uity can be determined directly by discountin% thefree cash flows available to e"uityholders (@(*- after meetin% interest,

preference dividends and principal payments, the discount rate bein% k e.

+nother variant of cash flow approach is to discount estimated free cash flows tothe firm (@((- instead of operatin% cash flows. The (@((s are computed bydeductin% incremental investments in lon%4term assets as well as investment inworkin% capital from operatin% cash flows. Te value of firm is

( )∑∞

= +=

0tt

A

tA D-

k0

investorsallto(@(((irmof &alue

( )∑∞

= +=

0tt

e

tA 0A-

k0

erse"uityholdto(@((*"uityof &alue


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n *ample 3, for the sake of simplicity, we have assumed the life of the corporatefirm as ; years. n practice, firms have perpetual lon%4term eistence/indefinite life.*vidently, the indefinite life of business/corporate firms, in %eneral, is an additionalaspect to be reckoned in a firm’s valuation.

deally, one approach is to forecast future (@(( for a very lon% period of time, say2A43A years and i%nore all subse"uent year’s (@((. The reason is the discountedvalue of such (@(( in such distant years will be insi%nificant.

Eowever, there are %enuine difficulties in eplicitly forecastin% decades ofperformance. n fact, it is virtually impossible to make reasonably accurateforecasts of profits/cash flows beyond a certain period say >70A years- in most ofthe businesses.

To overcome the problem @opeland et al su%%est that the eercise related tovaluation of business can be se%re%ated into two periods, durin% and after aneplicit forecast period. The value of a business/firm is

resent value of cash flows durin% eplicit forecast period F resent value of cashflows after eplicit forecast period 01-

i- & of cash flows durin% eplicit forecast period

n the contet of cyclical businesses, the eplicit forecast period can correspond toone full business cycleG in other businesses, the period can match with the numberof years durin% which they are likely to perform well. The firm is said to haveattained a steady state at the end of eplicit period. $ubse"uent to this period, thefirm %rows at a steady rate normal or less than normal- which is likely to continuein future years.


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ii- & of cash flows after eplicit forecast period.

The value determined after the eplicit forecast period T F 0- is referred to as thecontinuin% value. ts value can be determined as per the followin% e"uation:

Hhere 5!+TTF0 = The normalised level of net operatin% profits less ad8usted

taes in the first year after the eplicit forecast period.

% = The epected %rowth rate in 5!+T in perpetuity. #@ = The epected rate of return on the net new investment.

The derivation of the formula as per *"uation 02 to compute continuin% value is asfollows:

Where FCFF T+1 refers to the normalized level of free cash ow in the rst

year after the explicit forecast period.

( )(1!

"#

"$%&'C1&)*Tval,eContin,in"

-

'1 T

−−

= +

(13.1)gk

FCFFvalueContinuing

0

1T

−= +


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ii- & of cash flows after eplicit forecast period

(ree cash flows (@((- can be defined in terms of 5!+T and investment rate, #

that is, the percenta%e of 5!+T reinvested in the business each year-.(@(( 6 5!+T 07#- 02.1-

He know, %rowth rate, % is the product of return on invested capital, #@ and #, ie,

% 6 #@ # 02.2-

or # 6 %/#@ 02.3-

ncorporatin% value of # in (@(( definition

( )

(13.5)gk

g/ROIC1NOPLAT

valueContinuing

)g/ROIC(1NOPLATFCFF

0

I

I

−

−

=

−=


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*"uation 02 is termed as a value driven formula. $ince *"uations 02 and 02.0

provide the same answer of continuin% value, it is lo%istically more convenient to

compute continuin% value based on *"uation 02.0.

0. The ma8or simplifyin% assumptions made in determinin% continuin% value are:

i- the firm earns a constant return on the eistin% invested capitalG

1. the firm’s NOPLAT %rows at a constant rate and it invests the same proportion

of its %ross cash flow in business each year and2. the firm earns a constant return on all new investments.

+ll the items in e"uation 02 are self eplanatory, ecept the term adjusted taxes.

+d8usted taes is the increase in the estimated ta liability due to the eclusion of the

ta shield provided by interest char%es. This is illustrated in *ample ;.


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2. Market &alue Based +pproach to &aluation

)The market value reflected in the stock market "uotations- is the most

widely used approach to determine the value of a business, in particular oflar%e listed firms.

)The market value indicates the price the investors are willin% to pay for the

firm’s earnin% potentials and the correspondin% risk.

)This method is particularly useful in decidin% swap ratios in the case of

mer%er decisions.

3.(air &alue Method

)(air value method is not an independent method of share valuation.

)The method uses the avera%e/wei%hted avera%e of two or more of the

above methods.

)Therefore, such a method helps in smoothenin% out wide variations caused

by different methods and indicates the ‘balanced’ fi%ure of valuation.


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The market value added M&+- approach measures the chan%e

in the value of the firm from the perspective of all the providers of

funds i.e., shareholders as well as debenture holders-.

M&+ 6 ITotal market value of the firm’s securities 7 *"uity

shareholder funds F reference share capital F ?ebentures-J.

03-

The M&+ from the point of view of e"uity shareholders is 6Market value of firm’s e"uity 7 *"uity funds 0;-


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The *&+ method measures economic value added or

destroyed- for e"uity4owners by the firm’s operations in a

%iven year. The underlyin% economic principle in thismethod is to determine whether the firm is earnin% a

hi%her rate of return on the entire invested funds than the

cost of such funds.

*&+ 6 I5et operatin% profits after taes 7 Total invested

funds < H+@@-J 0=-


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Thank Kou

ch. 32 valuation of business

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