MODULE VALUATION CONCEPTS AND METHODS
CHAPTER 1: CONCEPT OF VALUE
Objectives:
1. An understanding of ‘Value’
2. The nature and scope of Valuation
3. Importance of Business Valuation and Objectives of Valuation
What is Value?
Value is the ‘worth’ of a thing. It can also be defined as ‘a bundle of benefits’
expected from it. It can be tangible or intangible.
Value is defined as:
a.
The worth, desirability, or utility of a thing, or the qualities on which these depend
b.
Worth as estimated
c.
The amount for which a thing can be exchanged in the market
d.
Purchasing power
e.
Estimate the value of, appraise (professionally)
Valuation is defined as:
•
Estimation (esp. by professional valuer) of a thing’s worth
•
Worth so estimated
•
Price set on a thing
How is Value different from cost and price?
Cost is defined as ‘resources sacrificed to produce or obtain a thing, (a product or
service).
Price is what is charged by a seller or provider of product or service. Many a
time, it is a function of market forces.
Oscar Wilde said, “A cynic is one who knows the price of everything and the value of
nothing”.
Different connotations of Value:
Value, like ‘utility’, has different connotations in different contexts, and may
vary from person, place and time. It can range from a precise figure to
something bordering on sentimental or emotional, or even the absurd.
Value is also different from ‘Values’, which refers to one’s principles or standards.
MODULE VALUATION CONCEPTS AND METHODS
What has Value?
Everything under the sun has value. There is nothing in God’s creation that does
not have value. This applies to all physical things. If something has not been
assigned any value, it can only be said that its value or utility has not yet been
explored or discovered yet.
A case in point is the element called Gadolinium. It was considered a useless
rare earth element by the chemists, till hundred years later when magnetic
resonance imaging (MRI) was invented and the use of Gadolinium was found in
MRI as the perfect contrast material. This only goes to show that no material can
be perceived to be useless, i.e., without any value.
In a philosophical context, ‘Values’ have ‘Value’, as they guide a person through
life and provide the moorings or anchorage in the sea of life. Refer Swami
Dayanand Saraswathi’s “The Value of Values”.
Why Value?
Value is sought to be known in a commercial context on the eve of a transaction
of ‘buy or sell’ or to know the ‘worth’ of a possession.
Who wants to Value?
The following entities may require valuation to be carried out:
1.
A buyer or a seller
2.
A lender
3.
An intermediary like an agent, a broker
4.
Regulatory authorities such as tax authorities, revenue authorities
General public
Global/corporate investors have become highly demanding and are extremely
focused on maximizing corporate value. The list of investors includes high net
worth individuals, pension and hedge funds, and investment companies. They no
longer remain passive investors but are keen followers of a company’s strategies
and actions aimed at maximizing and protecting the value of their investments.
5.
When to Value?
Valuation is done for “numerous purposes, including transactions, financings,
taxation planning and compliance, intergenerational wealth transfer, ownership
transition, financial accounting, bankruptcy, management information, and
planning and litigation support”, as listed by AICPA.
We see that the corporate world has increasingly become more dynamic, and
sometimes volatile. Globalization, enhanced IT capabilities, the all-pervasive role
of the media, and growing awareness of investors have rendered the situation
quite complex. Mergers, acquisitions, disinvestment and corporate takeovers
have become the order of the day across the globe, and are a regular feature
today.
MODULE VALUATION CONCEPTS AND METHODS
Understanding the factors that determine the value of any business will pay
tangible dividends by focusing the management on ways to increase the firm’s
short and long - run profitability.
Investors in shares and companies seeking to make acquisitions need to know how
much a company is worth and how much to pay for their investment. We need to
determine ‘Value’ mainly on the following occasions:
1.
Portfolio Management/transactions: A transaction of sale or purchase,
i.e., whenever an investment or disinvestment is made. Transaction
appraisals include acquisitions, mergers, leveraged buy-outs, initial public
offerings, ESOPs, buy-sell agreements, sales of interest, going public,
going private, and many other engagements.
Mergers and Acquisition: Valuation becomes important for both the parties
– for the acquirer to decide on a fair market value of the target organization
and for the target organization to arrive at a reasonable for itself to enable
acceptance or rejection of the offer being made.
2.
Corporate Finance: The desire to know intrinsic worth and enhance
value is important, as financial management itself is defined as
“maximization of corporate value”. A proper valuation will help in linking
the value of a firm to its financial decisions such as capital structure,
financing mix, dividend policy, recapitalization and so on.
3.
Resolve disputes among stakeholders/litigation: Divorce, bankruptcy,
breach of contract, dissenting shareholder and minority oppression
cases, economic damages computations, ownership disputes, and other
cases.
4.
Taxes (or estate planning), including gift and estate taxes, estate
planning, family limited partnerships, ad valorem taxation, and other taxrelated reasons.
Who determines Value?
The concept of Value is like beauty. Just as it is said that ‘beauty lies in the
eyes of the beholder’, value is determined by a person who seeks or perceives
value in a thing.
Value can also be estimated, assessed, or determined by a professional called
‘Valuer’. The process of determining value is called ‘Valuation’. Business
Valuation is the process of determining the economic value of a business.
Valuation is an estimation, by a professional valuer, of a thing’s worth.
What to Value?
Value all assets and liabilities to know the value of ‘what we own’ and ‘what we owe’.
Assets will include both the tangibles and intangibles.
Liabilities will include both the apparent and contingent.
MODULE VALUATION CONCEPTS AND METHODS
How to Value?
There are several tools and techniques, covered in the field of valuation,
depending on what is valued. These range from simple thumb rules to
complex models.
Business Valuation:
The objective of any management today is to maximize corporate value and
shareholder wealth. This is considered their most important task. A company
is considered valuable not for its past performance, but for what it is and its
ability to create value to its various stakeholders in future.
Therefore, in analyzing a company, it is not sufficient just to study its past
performance. We must understand the environment – economic, industrial,
social and so on – and its internal resources and intellectual capital in order
to gauge its future earning capabilities.
It is therefore essential to understand that business valuation is important in
determining the present status as well as the future prospects of a company,
which in turn is important to understand how to maximize the value of a
company. The creation and development of corporate value is the single
most important long – term measure of the performance of a company’s
management. Further, this is the only common goal all shareholders agree
on.
Business Valuation is a fascinating topic, as it requires an understanding of
financial analysis techniques in order to estimate value, and for acquisitions,
it also requires good negotiating and tactical skills needed to fix the price to
be paid.
The aim of the study materials on Business Valuation Management is to
equip the student in the following areas:
1.
Become familiar with various methods and techniques of business
valuation.
2.
Appreciate the advantages and disadvantages of each technique.
3.
Be able to decide on the most appropriate method or methods of
valuation according to the circumstance, i.e., the purpose for which it is
being done.
Valuation Approaches:
Discounted Cash Flow Valuation: This approach is also known as the
Income approach , where the value is determined by calculating the net present
value of the stream of benefits generated by the business or the asset. Thus,
the DCF approach equals the enterprise value to all future cash flows discounted
to the present using the appropriate cost of capital.
Relative Valuation: This is also known as the market approach . In this
approach, value is determined by comparing the subject company or asset with
other companies or assets in the same industry, of the same size, and/or within
MODULE VALUATION CONCEPTS AND METHODS
the same region, based on common variables such as earnings, sales, cash
flows, etc.
The Profit multiples often used are: (a) Earnings before interest tax depreciation
and amortization (EBITDA), (b) Earnings before interest and tax (EBIT), (c)
Profits before tax, and
(d) Profits after tax.
Contingent Claim Valuation: This approach uses the option pricing models to
estimate the value of assets.
Asset-based approach: A fourth approach called asset-based approach is
also touted as another approach to valuation.
The valuation here is simply the difference between the assets and liabilities taken
from the balance sheet, adjusted for certain accounting principles.
Two methods are used here:
a.
The Liquidation Value, which is the sum of estimated sale values of the
assets owned by a company.
b.
Replacement Cost: The current cost of replacing all the assets of a company.
However, the asset-based approach is not an alternative to the first three
approaches, as this approach itself uses one of the three approaches to
determine the values.
This approach is commonly used by property and investment companies,
to cross check for asset based trading companies such as hotels and
property developers, underperforming trading companies with strong
asset base (market value vs. existing use), and to work out break – up
valuations.
Other Approaches:
The two other approaches are the EVA and Performance-based
compensation plans. Refer CPA article titled “Building Long-Term
Value” included in the Reader.
Extracts are given below:
Economic Value added (EVA): This analysis is based on the premise that
shareholder value is created by earning a return in excess of the company’s
cost of capital. EVA is calculated by
subtracting a capital charge (invested capital x WACC) from the company’s net
operating profit after taxes (NOPAT). If the EVA is positive, shareholder value has
increased. Therefore, increasing the company’s future EVA is key to creating
shareholder value.
An EVA model normally includes an analysis of the company’s historical EVA
performance and projected future EVA under various assumptions. By changing the
assumptions, such as for revenue growth and operating margins, management can
see the effects of certain value improvement initiatives.
A simple illustration is given below;
NOPAT
= $15,000
Invested capital = $50,000
MODULE VALUATION CONCEPTS AND METHODS
WACC
= 12%
EVA
= NOPAT – (Invested capital x WACC)
= $15,000 – ($50,000 x 12%)
= $9,000
Performance-based compensation. This effective tool for motivating employees
aligns their interests with the shareholders. For example, establish a base level of
compensation plus a bonus pool tied to certain EVA targets. A minimum level of EVA
is required for any bonus to apply, and the pool increases based on how much actual
EVA exceeds the minimum threshold.
For more knowledge, please follow the link provided;
https://www.youtube.com/watch?v=w8G3rhsWl2s
https://www.youtube.com/watch?v=3_R14_eFCOg
https://www.youtube.com/watch?v=xVtyyJPGo1o