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Different Valuation Approaches: Market, Income and Cost Approach

Varun Hariharan

| Updated: Apr 18, 2020 | Category: Business Registrations

Valuation Approaches

What is Valuation?

Valuation is the process of estimating the real and market value of a company, a specific instrument, or the value of the business.  This term is used in finance to understand the value of an asset. Valuation Approaches are used to estimate the value of the business. These approaches are applied according to international adopted principles which are accepted throughout the world. The fair value of a company or an asset is obtained through proper valuation methods. Valuation approaches are derived from the International Financial Reporting Standards (IFRS). According to the standards, as the number of valuation processes increase, valuation professionals would be more in demand.

Use of Valuation Approaches in Business

Valuation approaches are used in everyday business needs. Right from the procedure to sell a company, to transferring a capital instrument from one country to another, to a complex merger and acquisition transaction valuation is extensively used by business and finance professionals. However, the main areas in which valuation is used are as follows:

  • Taxation Business– Here, valuation is used to understand the value which is derived in the business post taxation.
  • Selling of a company- When the sale of the company is advertised, valuation professionals are recruited to find out the real market or the fair value of the business. Usually, the valuation is done based on a “going concern.” Going concern basis, the valuation is based on the price at which the business assets and liabilities are being sold at.
  • Financial Transactions and Financial Planning– Valuation approaches are also used in complex commercial transactions in companies. If a company is planning to raise funds or going for an Initial Public Offering (IPO), then valuation methods have to be adopted. This is also considered in a situation that involves financial planning.
  • Foreign Exchange- Transfer of Capital Resources from one country to another– Valuation approaches are also used in a transaction between two different countries, the laws related to foreign exchange would apply. The transfer of capital instruments between the two countries would bring in the provision of valuation. As the prices of capital instruments are subject to fluctuations, proper valuation approaches must be followed by a business.
  • Restructuring a business- The business restructuring process also uses valuation. If the activity of the company wants to sell a subsidiary, then to calculate the rate of the subsidiary valuation is used.
  • Litigation- Corporate and Civil Litigations would also use valuation processes for understanding the payment/ real value of the assets of the business.

From the above, it is understood that valuation approaches are utilized not only in businesses but are also used for international transactions. However, from the above, it can be understood that the principles of valuation use methods related to finance. These principles of finance develop with the development of business. Therefore there are no specific formulae for a valuation process.  Valuation approaches must be prepared according to the particular transaction and the need of the company. Valuation principles have developed due to technical and scientific methodologies.

Valuation Approaches in India

Before the introduction of the Companies Act 2013, there was no specific methodology for carrying out the valuation process. The international adopted method for a valuation for the calculation of a capital instrument/ share value of a particular asset was determined based on the Net Assets Valuation method (NAV method). The NAV method has been used exclusively. However, there are various drawbacks of using this method. According to different business valuers, this method of valuation is very restrictive and not right in the valuation approach. Hence there was a requirement of having an independent way of valuation of India. Even the Companies Act 1956, did not bring of a specific method for valuation.

The Companies Act 2013 brought out a specific process when valuation is carried out. One of the steps taken by the Companies’ Act 2013 was to bring out the system of a ‘registered valuer’. The law relating to the supervision of valuers is under the Companies (Registered Valuers and Valuation) Rules 2017. This regulation explains the meaning of independent valuation that is carried out by a professional agency. It also specifies the procedure of valuation. Apart from this, the organization also monitors valuation agencies throughout the world. A registered valuer is considered as an authority to measure the value of assets and a particular class of assets. Since this was introduced, there was a proper mechanism followed for carrying out valuation processes.

Apart from the Companies Act 2013, the procedures and principles carried out for valuation are monitored and developed by the Securities Exchange Board of India (SEBI). Many transactions would require a valuation, which is carried out by a SEBI registered merchant banker or a Chartered Accountant as per the rules laid down by the Institute of Chartered Accountant of India or a Certified Cost Accountant.

According to the Foreign Exchange Management Act, 1999 (FEMA), the valuation of transfer of instrument from one country to another shall be carried out by a SEBI registered Merchant Banker or Chartered Accountant / Cost Accountant. When this form of valuation is carried out, it is done according to international standards adopted by the IFRS. 

From the above, it is understood that before the implementation of the Companies Act 2013, the internationally accepted method of valuation was used. However, the NAV method was extensively used in various valuation processes. This was considered to be restrictive to the needs of the business. Therefore with the introduction of the Companies Act 2013, there is specific guidance regarding the generally accepted method of valuation.  

Types of Valuation Approaches- Market, Income and Cost Approach

To come to the right choice of valuation approaches, it is crucial to understand the critical differences between the various approaches to valuation.  The international standards of valuation propose three methods of valuation that is used across the globe. The primary valuation approaches used are:

  1. Market Approach
  2. Income Approach
  3. Cost Approach/ Asset-Based Approach

According to the above methods of valuation, there is no right or wrong way, which can be used for valuation. However, simultaneously using all the valuation approaches is not possible.  Hence an analysis is required for using the appropriate method according to a specific situation. This will depend on the circumstances of the type of asset or the transaction, which is considered. One method may be suitable for a particular transaction, but the same approach may not be ideal for a transaction involving another form of instrument or asset. Therefore a valuer must analyze the practicalities before considering the valuation approaches.

Valuation Approaches: Which is the best approach for valuation?

There is no universally accepted approach to a proper valuation process. The methodology of valuation must be based on the following factors:

  • What is the instrument/ asset/ transaction involved in the valuation process;
  • The advantages and disadvantages of choosing the mechanism for valuation;
  • The prospects of choosing the method of valuation;
  • The approaches that are considered by competitors and other companies in the market; and
  • The amount of information which is available regarding a particular method.

Hence valuation approaches are determined not just by a single factor but a combination of multiple factors. To come to the correct method of valuation, the valuer must take into consideration all the above factors. Using various valuation approaches for a particular asset is not allowed. To assess the right approach to valuation, there is a requirement of comparing the real value of all the valuation methodologies to come up with the best method for valuation. If this principle is followed and adopted, then a precise method of valuation can be achieved.

1.Market Approach

This is one of the first valuation approaches. This method indicates the requirement of calculating the value of an asset by comparing the asset with similar assets that are present in the market place. This can be done with companies also. The products and services offered by companies are compared to businesses providing similar products and services. If there is no proper way to compare the assets of the business to another business, then the valuer has to consider the quantitative and qualitative characteristics of the assets and differences between the asset, which needs to be valued and comparable assets. In other words, this approach can be understood as a comparison method which the company follows to get its assets valued.  Publically traded companies are used for comparison in this form of valuation. The market Approach method has the following ways:

  • Comparable Transactions Method (CTM)-

From the name of the above method, the valuation is carried out by understanding the similar form of transactions that are carried out in the industry. An example of this form of method is got from the value that is derived from the multiples of revenue or the enterprise value

  • Guideline Publically Tradable Comparable Method-

In this method, the asset required to be valued will use other publically traded companies as a guideline to come to an absolute value. The Guideline Publically Tradable Comparable method can only be used as a valuation method when the subject matter or the asset valued is similar to that of the public traded companies. If there are no same types of companies that are dealing with the products or assets which have to be valued, then this form of valuation must not be carried out.

  • Guideline for Merged / Acquired Company Method-

In this form of the method, the multiples of transactions of companies in similar industries must be considered and applied to the income of the company.

From the market approach valuation, the methodologies of the market can be understood.  Through this method of valuation, the market can be analyzed based on comparison with other companies.

2. Income Approach

This approach uses the principles of economics. There is a formula for this form of approach. The method indicates that the business value is equal to the current value of the income that is generated by the company. Therefore:

Income Approach Formulae: Company Business Value = Income Generated by the company

In this form of approach, the previous earning of the business and the potential earning of the business are taken into consideration. Income-based approaches can be divided into the following:

  • Excess Income Capitalisation Method- This method is also called as the Internal Revenue Service (IRS) Method.  This can be understood as the business value is equal to the sum of the assets of the business, plus the intangible properties of the business.  There is a mixture of two methods here, the income method and the asset method. The valuation of the company is derived from the book value of the potential earning capacity of the company.
  • Economic Income Capitalized Method- In this method, the previous earning of the business is taken into picture for valuation. It works on the principle that the earlier revenues of the company are meant to continue as the future income of the business. In this method, the revenues of the business are estimated to be stable based on the historical earnings. 
  • Discounted Cash Flow Method (DCF Method) – This form of valuation takes into account the valuation based on the future cash flows of the business. This value is determined by considering what returns would be received in the future based on the present amount of investment. The value of the future cash flows of the business is discounted based on the current value of risk based on the amount of investment. This form of valuation is typically used in complex mergers and acquisitions, share sales. This type of valuation is considered when businesses identify that they will grow at a significant basis in the future. This method is one of the signs used methods under the income-based approach of valuation approaches.  

The DCF method is done by discounting the future cash flows to the present date of valuation. The price of the assets is finalized based on this form of method.

Some factors which are crucial in the discounted cash flow model:

  • Present value of the business;
  • Future amount of cash flows in the business;
  • Finding a method to understand the cash flow process in a business;
  • Considering the discount rate regarding the cash flows; and
  • Type of asset that is discussed in the business.

3. Cost Approach

Of the valuation approaches, the final type of valuation approach is the Cost Approach. This approach mainly focuses on the assets that are present with the business. The focus on this approach is based on the worth of the business and the assets of the business.

Value is obtained by calculating the reproduction value or the replacement cost of assets and subtract this with the deterioration and other damages that occur to the asset.

This approach is based on the factor that the buyer will pay more for the asset. This would be more economical to consider rather than the cost of purchasing an asset of the same utility.   The following approaches are present under the cost approach:

NAV= Value of the Net Assets of the Business- Liabilities of the Business.

The NAV method is extensively used in business dealings.

  • Adjusted Book Value Method- The assets and liabilities of the business are adjusted according to the fair market values of the business. This type of valuation is called as the going concern valuation, and it takes all the present value of the assets and liabilities of the business. During this form of valuation, goodwill is no taken.
  • Replacement Cost- As the name indicates, the valuation of cost is determined through the cost of a similar asset, which provides the same features and other functions.
  • Reproduction Cost Method- When the asset of similar features and qualities is produced, then this is considered as reproduction. Thus in the reproduction cost method, the valuation is got through by reproducing the asset in the same form as the original asset.
  • Summation Method- The value of the asset is obtained in this form of method, by considering the services which are derived from the components of the assets.

Conclusion

Valuation approaches are used in businesses. These valuation approaches are used in different sectors for assessing the real value of the asset or the share.  Valuation approaches have to be according to the recommendations made by the IFRS. Businesses consider valuation principles based on the IFRS standards of valuation. Before the Companies Act 2013, one of the main types of valuation method used was the NAV method. The Companies Act 2013 brought out the registered valuers rules to come out with a positive approach regarding valuation processes used in businesses.

Market, Income, and Cost Approach are the three methods of valuation. Based on the above three methods of valuation, the business needs to consider certain factors before choosing an appropriate method. The valuer has to know that one method of valuation cannot be used in all valuation processes.

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Varun Hariharan

Varun Hariharan has completed the Legal Practice Course from BPP Law School, Manchester. He has a Masters in Commercial and Corporate Law from the Queen Mary University of London and LLB Honours from Bangor University, UK. He specialises in law related to corporate, artificial intelligence and technology law.

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