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Business Valuation is required at the time of takeover or merger or sale of the business. In this article, We will discuss the business valuation method.
The word ‘going concern’ is coined that a business is being operated at not less than normal profit & the valuer will assume that the business is earning reasonable profits when appraising the assets.
However, although a balance sheet usually gives an accurate indication of short-term assets & liabilities. This is not the case of long-term ones as they may be hidden by techniques such as “off-balance-sheet financing”. Moreover, a balance sheet is the historical record of previous expenditure & existing liabilities. As the valuation is forward-looking exercise, acquisition purchase prices generally do not bear any relation to the published balance sheet.
Nevertheless, a Producer’s company net book value is still taken into account as netbook values have a tendency to become minimum prices & the greater the proportion of purchase price is represented by the tangible assets, the less risky its acquisition is supposed to be.
Valuation of the listed & quoted company has to be done on a different basis as compared to the unlisted company. The real value of assets may or may not reflect the market price of the shares; though in unlisted companies, only such information relating to the profitability of the company as reflected in the accounts is available & there is no indication of the market price. Using existing public companies as a benchmark to value similar private companies is a viable valuation methodology.
An asset-based valuation is divided into 4 approaches:
The tangible book value of a company is obtained from the balance sheet by taking into account adjusted the historical cost of company’s assets & subtracting liabilities; intangible assets (such as goodwill) are omitted while doing the calculation. The book value of assets helps valuer in defining the useful employment of such assets & their state of efficiency.
In all the cases of valuation on assets basis, excluding the book value basis, it’s important to arrive at the current replacement & realization value. It is more so in the case of assets such as patents, trademarks, etc. which possess the value, substantially more or less than those shown in books.
The book value approach of calculation doesn’t provide a true indication of the company’s value, nor does it take into account the cash flow that can be generated by the company’s assets.
Replacement cost reflects the expenditures required to replicate the operations of the company. Approximating the replacement cost is fundamentally make or buy decision.
The difference between the appraised value of assets, & appraised value of the liabilities is the net appraised value of the firm.
This approach is most ordinarily used in the liquidation analysis because it reflects the divestiture of underlying assets instead of the ongoing operations of the firm.
In order to obtain a value of the business using the excess earnings method, a premium is added to the appraised value of net assets. This premium is to be calculated by matching earnings of the business before the sale & earnings after the sale, with difference referred to as excess earnings.
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In this approach, it is assumed that the business is run more efficiently after a sale; the total amount of excess earnings is capitalized (e.g., the difference in earnings is separated by some expected rate of return) & this result is then added to an appraised value of net assets to derive value of business.
The normal purpose of the anticipated purchase is to provide the buyer the annuity for their outlay. The buyer will expect yearly income, returns on it whether great or small/ stable or fluctuating but nonetheless some return which is proportionate to a price paid therefor. Valuation based on earnings based on the rate of return on capital employed is the modern method.
The alternative to the valuation based earning method is the use of the price-earnings (P/E) ratio in the place of the rate of return. The P/E ratio of a listed company can be calculated by dividing the current price of the share by earning per share (EPS). Thus, the reciprocal of P/E ratio is also called the earnings-price ratio or earnings yield.
Therefore P/E = EPS.
Where P is the current price of the shares
Formula to find share price (P)
To determine P = EPS x P/E ratio
III. MARKET-BASED APPROACH TO VALUATION
Market-based methods help strategic buyer estimate the subject of business value by comparison to similar businesses. Where a company is listed, the market price method helps in estimating the price in the secondary market. Average of the quoted price is considered as indicative of value awareness of the company by the investors operating under free-market conditions. To evade the chances of speculative pressures, it is suggested to take on the average quotations of the suitably long period. The valuer will have to consider the effect of the issue of the bonus shares or the right shares during the period chosen for average.
(i) where Market Price Method isn’t relevant in the following cases:
(ii) In the event of significant & unusual fluctuations in market price, the market price may not be indicative of the true value of shares. At times, the valuer may also want to ignore such a value, if according to the valuer, the market price is not a fair reflection of the company’s underlying assets or profitability status. The Market Price Method is also be used as the backup for supporting the value arrived at by using other methods.
(iii) It is important to note that the regulatory bodies have often considered market value as one of the very important bases for the preferential allotment, buyback, open offer price calculation under Takeover Code.
(iv) In earlier days due to non-availability of data, while calculating the value under the market price method, high and low of monthly share prices were considered. Now with the support of technology, detailed data is available for stock prices. It is a usual practice to consider the weighted average market price considering the volume & value of each transaction reported on the stock exchange.
(v) If the period for which prices are considered also has an impact on account of bonus shares, rights issue, etc., the valuer needs to adjust the market prices for such corporate events.
Following methods are used for valuation under such an approach:
(i) Comparable companies multiple approaches – Market multiples of comparable listed companies are computed and applied to the company being valued to arrive at a multiple based valuation.
(ii) Comparable transaction multiples method – This technique is generally used for valuing the company for Merger & Acquisition, the transaction that is taken place in the industry which is similar to the transaction under consideration are taken into account.
(iii) Market value approach – The market value method is generally the most preferred method in case of frequently traded shares of companies listed on stock exchanges having nationwide trading as it is perceived that the market value takes into account the inherent potential of the company.
Other aspects as to the methods of valuation: valuation can be carried out by following methods too
Discounted cash flow valuation, relates to the value of the asset to present value of expected future cash flows on that asset. In this kind of approach, the cash flows are discounted at the risk-adjusted discount rate to arrive at the estimate of value. The discount rate will function as the riskiness of estimated cash flows, with lower rates for the safe projects & higher rate for riskier assets.
Valuation is an important aspect of merger and acquisition & it should be done by a team of experts keeping into consideration the basic objectives of acquisition. The Team of experts should comprise of the financial experts, the accounting specialists, the technical & the legal experts who should look into the aspects of valuation from all different angles.
Nonetheless, the experts must take into account the following consideration for determining the exchange ratio
4. Valuation by Registered Valuer: Registered Valuer is one among the many new concepts introduced by the Companies Act, 2013 to provide for a proper mechanism for valuation of various assets & liabilities related to the company & to standardize the procedure thereof.
Who can act as Registered valuer?
Registered Valuer is the person who is registered as a Valuer under the Act. A person who is registered as a Registered Valuer in pursuance of the Act with the Central Government & whose name appears in the register of the Registered Valuers maintained by Central Government or the authority, institution or agency, as may be notified by Central Government only can act as the registered valuer.
2. The fair value of shares = (Value by net assets method + Value by yield method)/
Read Also: Brief on business valuation methods in India.