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Valuations Approaches

There are three approaches to value any asset, business or business interests-

  • Asset Approach
  • Income Approach
  • Market Approach

There are no other approaches to value However there are numerous methods within each of the approaches

Asset Based Approach (NAV)

The asset based method views the business as a set of assets and liabilities that are used as building blocks of a business value. The difference in the value of these assets and liabilities on a book value basis, or realizable value basis or replacement cost basis is the business value. However, the Net Asset Value reflected in books do not usually include intangible assets and earning potential of the business and are also impacted by accounting policies which may be discretionary at times. Thus, NAV is not perceived as a true indicator of the business value. However, it is used to evaluate the entry barrier that exists in a business and is considered viable for mature companies and also for property and investment companies having strong asset base. It is also used to evaluate surplus / non-operational assets.

Adjusted Net Asset method

For Calculating the Adjusted NAV, the valuer should factor in the fair value of the assets, contingent liability, Tax Shield on accumulated losses, impact of Auditor qualification and Due Diligence, money to be received from warrants, stock options and impact of corresponding shares etc.

Income Based Approach

The Income based method of valuation based on the premise that the current value of any business is a function of the future value that the Company can expect to receive It is generally used for valuing businesses that are expected to continue operating for the foreseeable future.

Capitalization Of Earning Method (PECV):

In its simplest form, the capitalization method basically divides the expected stable earnings of a business by the capitalization rate. The first step under this method is the determination the capitalization rate - a rate of return required to take on the risk of operating the business (the riskier the business, the higher the required return). Earnings are then divided by that capitalization rate. The earnings figure to be capitalized should be one that reflects the true nature of the business, such as the last three years average, current year or projected year excluding the impact of any extraordinary items not expected to accrue in future. While determining a capitalization rate, it is necessary to compare with rates available to similarly risky investments.

Discounted Free Cash Flow Method (DFCF):

The DFCF method expresses the present value of the business as a function of its future cash earnings capacity. This methodology works on the premise that the value of a business is measured in terms of future cash flow streams, discounted to the present time at an appropriate discount rate. The value of the firm is arrived at by estimating the Free Cash Flows (FCF) to Firm after all operating expenses, taxes, working capital and capital expenditure is met. The Perpetuity value of a business is computed after the business has stabilised, using Gordon model. The FCF is then discounted with Weighted Average cost of capital (WACC). The WACC is selected based on the inherent risks in the investment (including both systematic / market risks and unsystematic / company risks) using modified Capital Asset Pricing Method (CAPM). Adjustments for Debt and Cash as on Valuation date is then made to the Enterprise Value to arrive at the Equity Value for Shareholders.

The steps in DFCF method are as under

  • Understand Business Model
  • Identify Business Cycle
  • Analyze Historical Financial Performance
  • Review Industry and Regulatory Trends
  • Understand Future Growth Plans (including Capex and Opex needs)
  • Segregate Business and Other Cash Generating Assets
  • Identify Surplus Assets (assets not utilized for Business say Land/Investments)
  • Create Business Projections (Profitability statement and Balance Sheets)
  • Discount Business Projections to Present (Explicit Period and Perpetuity)
  • Add Value of Surplus Assets and Subtract Value of Contingent Liabilities
  • Arrive at Enterprise Value
  • Adjust for Net Debt to arrive at Equity Value

Market Based Approach

In this method, value is determined by comparing the subject, company with its peers in the same industry of the similar size and region. Most Valuations in capital markets / M&A transactions are market based. This is also known as Relative Valuation Method. This method is easiest to use when there are companies comparable to the one being valued, assets are priced in the market, and there exist some common variable that can be used to standardize the price.

Comparable Company Market Multiples Method (CCM)

Comparable Company Market Multiple uses the valuation ratio of a publicly traded company and applies that ratio to the company being valued. The valuation ratio typically expresses the valuation as a function of a measure of financial performance or Book Value (e.g. Revenue, EBITDA, EBIT, Earnings per Share or Book Value).

A key benefit of Comparable Company Market Multiple analysis is that the methodology is based on the current market stock price. The current stock price is generally viewed as one of the best valuation metrics because markets are considered somewhat efficient.

The difficulty here is in the selection of a comparable company since it is rare to find two or more companies with the same product portfolio, size, capital structure, business strategy, profitability and accounting practices. Whereas no publicly traded company provides an identical match to the operations of a given company, important information can be drawn from the way similar enterprises are valued by public markets. Adjustments are made to the derived multiples on account of dissimilarities with the comparable companies and strengths, weakness and other factors peculiar to the company being valued.

Comparable Transaction Multiples Method (CTM)

With this technique of valuing a company for a merger or acquisition, the transactions that have taken place in the industry which are similar to the transaction under consideration are taken into account. With the transaction multiple method, similar acquisitions or divestitures are identified, and the multiples implied by their purchase prices are used to assess the subject company's value.

The greatest impediment in finding truly comparable transactions is the absence of available information on private transactions. In addition to the lack of information on the sales of private companies, the available information in public transactions may be outdated. There is no rule of thumb for the appropriate age of a comparable transaction, although one should be aware of the competitive market at the time of the transaction and factor any changes in the marketplace environment into the analysis. The more recent the transaction, the better this technique, with all other things being equal.

Market Value Method (For Quoted Securities)

The Market Value method is generally the most preferred method in case of frequently traded Equity Shares of Companies listed on Stock Exchanges having nationwide trading as it is perceived that the market value of listed equity shares over an appropriate period of time takes into account the true potential of any Company.

Other Methods

Contingent Claim Valuation: Under this valuation approach, Option Pricing Models (OPM) is applied to estimate the Value. Valuations for complex instruments like ESOP, Corporate Guarantees, OCPS, FCCD’s, Patents etc are done using OPM. The OPM is used to calculate a “call” or “put” price using the 6 key determinants of an option’s price:

The OPM is used to calculate a “call” or “put” price using the 6 key determinants of an option’s price:

  • Stock Price (equity value of company)
  • Strike Price (exercise price)
  • Expected time to exit
  • Expected risk-free interest rate
  • Expected volatility
  • Expected dividend yield

Option Pricing Model is broadly of Three Types

Black Scholes Model – It is applied in most of the cases but its limitation is that it calculates the option price only at one point in time i.e. at Expiration.

Binomial Model – It is applied when the exercise period is not at a particular point in time and there can be multiple dates for the same i.e. even before the Expiration.

Backsolve Model – Refer PORI below

Price Of Recent Investment Method (PORI):

The recent investment in the business is often taken as the base value if there are no substantial changes since the last investment. As Investors are generally given preferred shares, so using Backsolve Option pricing model, we can derive implied value of Equity Shares.

According to the AICPA, the backsolve is the most reliable indicator of enterprise value for early-stage customers, provided the transactions in the enterprise's shares have occurred at arm's length price and the most recent transaction occurred within ninety days of the date of valuation date.

Rule of Thumb

Although technically not a valuation method, a rule of thumb or benchmark indicator is used as a reasonableness check against the values determined by the use of other valuation approaches. For each Industry there are certain parameters which can assist in arriving as a benchmark value ex- in Hotel Industry – EV/Room, in Mutual Fund Industry - % of AUM, in Power – EV/MW etc.

Purpose of Valuation (Regulatory or Transaction), Size of Transaction (Minority or Control), Stage of Business, and Business Model determine Valuation Approaches