BUSINESS VALUATION BASICS
- Nuts and Bolts
CA RAJIV SINGH
FCA, LIFA(USA),CISA(USA) LIII Co- Founder Explico Consulting
First Jt. Tech. Director: Valuation Course (ICAI) & Master of Business Finance Course (ICAI)
Agenda
• Introduction • Value vs Price
• Valuation-Art or Science? • Efficient Market Hypothesis
• Business Valuation – how to define ? • Business Valuation Principles
• Business Valuation Process
• Valuation Purpose • Standard of Value • Premise of Value
• Valuation Case Laws • Valuation Myths
BUSINESS VALUATION Introduction
“Some men know the price of everything and the value of nothing - Oscar Wilde
“ It’s better to be roughly right than to be precisely wrong”
-J.M. Keynes
“It’s stupid the way people extrapolate the past and not slightly stupid, but massively stupid” -Charlie Munger
BUSINESS VALUATION Introduction
Appraisers have a value in mind before they start the process and try to back into it Aswath Damaodaran, Jan 14,2009
There is a vast difference between understanding something well enough to buy it as opposed to understanding it well enough to sell it.
Zig Ziglar, Secrets of Closing the Sale, 1984
The numbers are never a whole story , only a starting point.
We must always remember that market research, no matter how well done, is based on the past. We are always susceptible to discovering a truth whose time has gone.
BUSINESS VALUATION Introduction
Are Financial Models solution for forecasting?
‘Financial Models use scenario analysis and subjective probability to get ‘expected value’.
What this expected value is?
Functional equivalent of the statistician who drowned in water which was, on average, only 4 feet deep.
He forgot that the range of depth was between 2 feet & 10 feet.
Value vs Price
General definition of ‘value’ as per IVSC
•
An
economic
concept
•
An estimate of the likely price at a given time in
accordance with definition of value
•
Not a fact
Price is the amount of money or other consideration
asked for or given in exchange of something
Value vs. Price
value
• Not a static figure
• Nothing called precise
value
• Arrival of transaction not necessary
• Fundamentals are the key
• Always involves economic benefits • Value is ‘should be
price’ - the basis of negotiation of price
price
• A static figure • Always precise • An outcome of a transaction• May not be driven by fundamentals always
• Includes economic & non-economic factors
• BV is promoted as more Art than Science.
• The art is professional judgement and science is statistics. • Art is nebulous and synonyms with subjective judgement.
• Valuation conclusions are susceptible to challenge when based mainly on
professional judgement.
• Professional judgement should be the method applied to evaluate
relevance & reliability of data, applied methodology and the inference derived thereon.
• Professional judgement is not a substitute for properly applied statistical
methods analysis and logical reasoning.
• A judicious man uses statistics, not to get knowledge, but to save himself
from having ignorance foisted upon him.
[ Thomas Carlyle ]
• A relevant and reliable valuation conclusion is the product of the analysis of
historical financial data, economic, industry and comparative data.
• The requisite financial analysis can not be performed absent applied
statistical method.
• The analysis is most important – how you took the data, analysed it, and
wed it to your conclusion. I want transparency; I want to see your thinking – because that’s what appellant courts want to see from me
-[ Judge David Laro ]
Efficient Market Hypothesis
•
The market acts rationally using all relevant
information leaving no opportunity for profit
•
Weak form of efficiency-
market prices incorporate all past price information•
Semi strong form of efficiency –
market prices include all publicly available information•
Strong form of market -
efficiency-market prices incorporate all information public as well as private.Summary : If every stock price is rationally determined then expected return on every stock will be the same. You can’t systematically beat the market and hence follow passive investment strategy and not active investment strategy.
Evidence against EMH
• Small cap effect
–
small cap earned more return than others• January Effect
-
stock prices rising from Dec to Jan• Market overreaction , excessive volatility
• New information not always incorporated into prices
Should you hire a chimp as your investment adviser - A true story
• A Swedish newspaper gave $1250 each to five stock
analysts and a chimpanzee named Ola, to test who could make the most money on the market in a one month period. • Ola the Chimp, who made his choice of purchases by
throwing darts at the name of companies listed on the Stockholm exchange , won the competition.
Business Valuation Principles
*PV
1: Principle of Substitution
*PV
2: Principle of Alternative
PV
3: Principle of Time value
**PV
4: Principle of Expectation
PV
5: Principle of Risk & Return
PV
6: Principle of Reasonableness & Reconciliation of
Valuation
* Gary R. Trugman
** Mercer and Harms
Business Valuation-how to define ?
Business Valuation
‘An act or process of determining the value of a
business, business ownership interest, security or
intangible assets’
{The International Glossary of Business Valuation Terms}
Alternative Definition
‘Business Valuation is a logical, defendable
process of arriving at the opinion as to the worth of a
business given the information available, assumption
& limiting conditions as on the valuation date’
Business Valuation Process
• Subject interest to be valued • Ownership characteristics • Valuation date • Purpose • Standard of value • Premise of value • Deliverables • Limitations • Special instructions.
Define Valuation Assignment
Information Collection
Site visits & Entrance conference Environmental Scan
Global Economy Domestic Economy
Industry overview
Company overview & historical financial analysis
Business Valuation Process
• Income approach • Market approach.
• Asset based approach
Company strategy & risk analysis
Selection of approaches & methods Prospective analysis
Discounts & Premiums
Value calculation & sanity check
Purpose of Valuation
Purpose of valuation Examples
Valuation for transactions
Business purchase , Business sale, M&A (Mergers & Acquisition), Reverse merger, Recapitalization, Restructuring, LBO (Leverage Buy Out), MBO (Management Buy Out), MBI (Management Buy In), BSA (Buy Sell Agreement), IPO, ESOPs, Buy back of shares, Project financing and others
Valuation for court cases
Bankruptcy, Contractual disputes, Ownership disputes, Dissenting and Oppressive shareholder cases, Divorces cases, Intellectual property disputes and other
Valuation for compliances Fair value accounting, Tax Issues
Valuation for planning
Estate planning, Personal financial planning, M&A planning, strategic planning
Standard of Value
•
a definition of type of value being sought
Types of Standards of Value
The identification of the type of value being utilised in
a specific engagement
The International Glossary of Business Valuation Terms
• Fair Market Value (FMV) • Investment Value
• Intrinsic Value • Fair Value
Standard of Value
Selecting Standard of Value
•
Subject matter of Valuation
•
Purpose of Valuation
•
Statute
•
Contracts
•
Case Laws
•
Circumstances
Fair Market Value (FMV)
As defined by Statement on Standards for Valuation Services Issued by the AICPA
• the price, expressed in terms of cash equivalents • at which property would change hands
• between a hypothetical willing and able buyer and a hypothetical
willing and able seller
• Acting at arms length in an open and unrestricted market, • when neither is under compulsion to buy or sell and
Fair Market Value (FMV)
As defined by Revenue Ruling 59-60,
• the price at which the property would change hands • between a willing buyer and a willing seller
• when the former is not under any compulsion to buy and the
latter is not under any compulsion to sell,
Fair Market Value (FMV)
Cash or Cash equivalent: Price without any financing support or special concession and contemplates prevalent economic & market condition on the valuation date.
Hypothetical: does not contemplate real but refer Potential
Willingness: motivated and assets would be exposed to the market for a reasonable period
Fair Market Value (FMV)
Open & unrestricted market: excludes specific buyer
One transaction involving a willing buyer & seller can not establish a market price
‘Able’: pushes value downward
No Compulsion: Forced conditional transactions excluded
Reasonable Knowledge of facts: Average knowledge & not specific knowledge
Fair Market Value (FMV)
What Hypothetical Sale Transaction
Contemplate Does not contemplate
Price is cash or cash equivalents at the prevailing economic condition
Willingness and ability to buy sell exist
No compulsion to accept the deal
Potential buyers of similar assets exist
Reasonable time and knowledge exist
No separate price for not to compete
Plan to sell to a particular buyer and adopting a planned strategy
Buyer have specific knowledge
Engagement of experienced and well connected negotiator get a favorable deal
Other benefits attached with the deal like making available finance or key persons
Investment Value
• Investment value may be more than FMV or
less than FMV
Value to a particular investor based on individual
investment requirements & expectations
FMV vs. Investment Value
FMV Investment Value
Consensus opinion of market
participants
Sale is always contemplated
Hypothetical investor
Impersonal
DLOC & DLOM may apply
Opinion of a specific investor
Sale is not necessary
Specific investor
Personal
Control premium & synergy premium apply
Factors creating difference between FMV
and Investment Value
• Estimation of cash flows • Risk
• Tax
• Product synergy & cannibalisation • Other strategic advantages
Intrinsic Value or Fundamental Value
The International Glossary of Business Valuation Terms defines
‘the value that an investor considers on the basis of an
evaluation or available facts, to be the ‘true’ or ‘real’ value that will become market value when other investors reach the same conclusion.
When the term applies to options, it is the difference between the exercise price or strike price of an option and the market value of the underlying security’
Intrinsic Value or Fundamental Value
Kohler’s Dictionary for Accountants defines
‘the amount that an investor considers on the basis of an evaluation of available facts, to be the ‘true’ or ‘real’ worth of an item, usually equity security. The value that will become the market value when other investors reach the same conclusions.’
Intrinsic Value or Fundamental value
• Value based on fundamentals not by market • Value derived by one analyst
• Market consensus may or may not be there
• Transaction value (price) is not similar to investment value which is
used to estimate FMV
Graham & Dodd definition
‘the value which is justified by assets, earnings, dividends, definite prospects and the factor of management.’
• Level of normal earning power and profitability in the
employment of assets as distinguished from the reported earnings, which may be, and frequently are, distorted by transient influences
• Dividends actually paid or the capacity to pay such dividends
currently and in the future
• A realistic expectation about the trend line growth of earning
power
• Stability and predictability of these quantitative and
qualitative projections of the future economic value of the enterprise
Graham and Dodd’s Security analysis, fifth edition, Tata McGraw Hill, page 41 ,42
• Most complicated & definition varies with type of transaction
and facts of each case
• Definition has two dimensions
Fair value for legal purpose
Fair value for financial reporting
• For legal purpose Courts give fair treatment to parties who
seek remedy under law – DLOM & DLOC generally not allowed
• Stock holder is entitled to be paid for that which has been
taken from him viz. his proportionate interest in a going concern
[Tri-continental Corp.]
Premise of value
Talks about types of market conditions likely to be encountered. Two premises of Value
Going Concern – value as an ongoing operating business enterprise
Liquidation – value when business is terminated - could be ‘forced’ or ‘orderly’
‘Going concern’ is not a standard of value
Premise Of Value
In-Use : If the asset would provide maximum value to the market participants principally through its use in combination with other assets as a group
In-Exchange :If the asset would provide maximum value to market participants principally on a stand-alone
basis
Premise of value & Standard of value Value in exchange Liquidation Value in use Going concern Value to specific holder Value in place Value in exchange Fair value For financial reporting Investment value FMV or Fair value For financial reporting Value to specific holder Value to specific holder Forced Orderly FMV or Fair value Investment Value or Fair value for Legal purpose
Premise of value
Investment Value or Fair value for Legal purpose
Purpose Standard of Value Tax related
Financial Reporting
Security Analysis
Going private, shareholders
dissent & oppression, dissolution
Divorce Buy or Sell M & A IPO Property Bankruptcy FMV Fair Value Intrinsic Value Fair value Fair value or FMV or Investment Value FMV Investment Value FMV MV FMV or MV
Before 1983 – Delaware Block method (DBM)
A mechanical combination of three approaches – net asset, market and earning
• Step I: determine the value under three approaches.
• Step II: assign a percentage weight to the values derived in step I considering nature of the business.
• Step III: calculate the weighted average of the three
valuations -this is the fair value or appraised value of the business.
After 1983 – Weinberger
Judicial birth of DCF & demise of DBM
‘more liberal approach must include proof of value by
any technique or methods that are generally
considered acceptable to financial community’
Did not prohibits DBM but allowed other methods
Valuation case laws
Fair value must take ‘fairness’ & equity
Minority discount should not be applied for fair value
in case of dissenting stockholders
1.Mahadev Jalan , wealth tax, 1972 (SC)
Break-up value for going concern is nor correct. Court laid down principles of valuation
2.Kusumben Mahadevia, Gift Tax 1979(SC)
Reinforced principles laid down in the Mahadev Jalan
3.Bharat Hari Singhania , wealth tax, 1994 (SC)
Court recognised practical difficulties in application of principles of Mahadev Jalan
4.HLL, Companies Act 1994(SC)
All or combination
of methods can be applied for fair value
5.Miheer Mafat Lal , Companies Act, 1996 (SC)
Fair exchange ratio based on manageable profit method, net worth or break up method and market value accepted
6.Mrs Renuka Datla, Companies Act 2003(SC)
DCF is acceptable
Combination of methods accepted
Intrinsic value cannot include control premium
• Valuation is objective • Valuation is a science
• Valuation gives precise number
• A single valuation serves more than one purpose • A complex financial model gives better valuation • Growth in earning increases value
• Valuation is worthless as it involves lot of assumptions
• All valuation approaches and methods apply in all situations • There is single definition of value
