Business Valuation

Needs & Techniques

Submitted by CA Hozefa Natalwala

A Brief note:

The basic purpose of this research work is to study the purposes that create the need of valuation for Small businesses and to relate the appropriate technique/s which can help in making a better decision for that particular purpose. Research involves basic attitudes and way of thinking. References are taken from many books, articles and other materials and also at many places the valuable write ups of some authors or writers are sited in order to provide the basis to the intended users of this research work. Value of business is estimation only and being which it is subjective in nature. Debates are going on and different views are prevailing regarding applicability of specific techniques, as well as on validity and correctness of the formulas used for estimation. These all are making the reliability on specific technique questionable. The objective is not to go through the roots that how a specific technique is emerged and on which financial or economic theory it is based. A two thousand pager book might not be enough space to cover all the issues related to estimation of business value. The research into valuation models and metrics in finance is surprisingly spotty, with some aspects of valuation being deeply analyzed and others, such as how best to estimate cash flows and reconciling different versions of models, not receiving the attention that they deserve. To write about valuation is a humbling task. No matter how ambitious and dedicated an author may be, eventually he or she is forced to acknowledge that even a lifetime of work would leave some aspects of the subject untouched. It must be noted that the research work has been seriously limited by the lack of access to literature on business valuation for small and medium sized businesses in India. Being an evolving field of finance and accountancy, there are very little developed doctrines relating to the application of the specific method amongst various valuation methods. I have relied also on the accessible materials like relevant notes available on web as well as authorative and unauthorative views of valuation experts and consultants. I was also limited by finances as this research study was not funded in the way and to the extent to which I could have carried out the work. I wanted to study valuation needs for MSMEs in totality but for financial support it is confined to study only the literature views and basics of MSME needs of valuation.

While all reasonable attempts have been made to ensure that the information contained herein is accurate, I accept no responsibility or liability whatsoever for any errors or omissions it may contain, whether caused by negligence or otherwise, or for any losses, however caused, sustained by any person relying upon it.

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Methodology:

Research methodology refers to the procedural framework within which the research is conducted. I had started with the compilation of literatures and materials available on valuation and specifically for small business units. In India, valuation of business, itself being a emerging filed and also not being graced by the statue, very small amount of material was found and I have more to rely on the US based books and materials. Valuation of business requires major consideration for financial and economic theories and of course, the business characteristics and valuation fundaments are indifferent to the region differentiation. The purpose was to study the valuation reports and to analyze the preferred approaches of the value analysts while appraising a business. It also proposes to present the case analysis at the subsequent stage. But the ratio of response, received from concerned entities, was near to zero. The empirical data is not available for needs of valuation in MSME sector. Also there is no private of public organization offering the transactional data relevant for MSME valuation. So, the views shown under this work are based on study of literature and opinion of experts, obtained while conducting the study. And so the approach of the study is descriptive. The write up begins with describing the valuation in general and then to define and relating the value, purpose and need in the context of valuation. The objective behind is to show the conventional relationship of “purpose” and valuation “need”. The basic terms of valuation like types of valuation reports, premise of valuation, importance of date of valuation, standard of valuation and approaches are described next. The views expressed and definitions issued by various authorities, researchers and respected authors are also mentioned to describe the prevailing debates. The importance of “standards of value” in valuing a MSME business is emphasized. How the appraisers strive in selecting the appropriate technique/s and determining the conclusive value is attempted to uncover.

This is just an endeavor to match the valuation technique with specific purpose on logical basis considering the need behind each purpose.

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Standards of value (with table) and relevant technique/s to value a business (with table) Conclusion Useful data Valuation Procedures Data collection procedure Illustrative list of assumptions. as mentioned by Prof. Purpose and narrating sequence of write up Brief about Business Value? What is Valuation? o Purposes & Needs (definition) o Types of reports o Premise of value o Date o Standards of value o Approaches to valuation Detailing approaches to valuation Valuation purpose Vs. asset vs. approach. approach. Aswath damodaran References 4 .Index BUSINESS VALUATION Need. Yegge for application with “Excess earnings capitalization Method” Table showing purpose Vs. limitations and disclaimers Contents of exhaustive valuation report International glossary of valuation terms Multipliers suggested by author Mr. Wilbur M. recommended techniques Time vs.

John Wooden BUSINESS VALUATION In the wake of economic liberalization. Be more concerned with your character than with your reputation. debentures and loans. and regulatory bodies are struggling with tariff determination. The most widely accepted definition of fair market value was laid down by the Internal Revenue Service (IRS) of the US. Your character is what you really are while your reputation is merely what others think you are.A. So.P. we must clarify what is meant by “fair market value” and what is meant by “a company”.” When the asset being appraised is “a company”. Publicly traded companies seek to show bottom-line profit to satisfy ‘‘public owners. preference shares. before profit falls to the bottom line. FMV is a hypothetical value for the ‘model’ transaction. these ideal conditions are rarely present. The governing conditions in this ideal concept are full knowledge and freedom to act. financial records are massaged for tax avoidance. Emotional and subjective elements often override rational considerations. Thus the ‘‘documents’’ by which the psychology of ownerships are measured send out different messages in each. C. and sometimes do. acquisitions and restructuring are becoming commonplace. S. play the game of chance by stretching the ‘‘gray’’ areas in law beyond the limits. It defined fair market value as “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.’’ . The family-owned and/or closely held business is the more difficult tiger to tame. But in reality. But note that. In addition. All of this leads to difficult interpretations of what really goes on in these companies. ‘Fair market value’ (FMV) is not designed with any particular individual in mind. employee stock plans are proliferating. In these exercises a crucial issue is: How should the value of a company or a division thereof be appraised? The goal of such an appraisal is essentially to estimate a fair market value of a company. companies are relying more on the capital market.) 5 . Thus. (Summarized from comments of T. Tony Leung. nor the ‘real’ transaction for that matter. the property the buyer and seller are trading consists of the claims of all the investors of the company. the necessary conclusion is that few buy/sell transactions involving closely held small businesses are done at so-called fair market values. private ownerships can.’’ while closely held enterprises seek only to satisfy private interests.‘‘Character. and full knowledge is something rarely attained by the arm’s-length potential buyer who previously has not been involved in the business. both parties having reasonable knowledge of relevant facts. at the outset. Since ownership and management of closely held enterprises are often one and the same. This includes outstanding equity shares. strategic alliances are gaining popularity.

The value of Business enterprise containing more than one stream is generally more than just a sum total of values of every such stream. Volume 4 (2005) pp 61-72. Fair value of all company assets Replacement value of recorded assets (Balance sheet) Book value Added value Source: Juhász (2004) Figure showing differences between book value and market value of a business enterprise * from “Non-Quantitative Measures In Company Evaluation” by Ágnes Horváth. or goodwill. Intangible business value is a highly judgmental aspect of business valuation and requires conscientious attention. business valuation refers to estimation of business value. The fair value of business is something more than the fair assets value and this added value is towards its intangible strength which may or may not be quantitatively measurable. So. we receive in future out of a subject property. as that amount paid for a business in excess of the market value of hard assets. European Integration Studies. The economic returns or the assets involved frames the value of specific business stream and this value can be generally more than the value of individual asset valued as a stand alone basis. Valuation is just to estimate What (cash flow) + When (time period) + How (risk). The value of these intangible factors is generated by collective usage of assets and joint operations of several business streams. IRS (US) roughly defines intangible value.In pure sense. Miskolc. 6 . the business value is affected by tangible as well as non-tangible factors. Ágnes Horváth * presents the value inequalities as follows showing the general relation between “values of business” derived by different perceptions.

much more by hopes and fears of humanity. 7 . The valuation of business enterprises and business assets is well-founded in academic publications and empirical studies. and ‘‘right’’ is a matter of opinion. Even a 2000 pager book may not be an enough space to cover all the issues related with valuation. invention. The use of public company information has provided the foundation for the analysis of business valuation. Valuation. unfortunately the results may or may not reflect the “real world” value of a specific company if it were formally offered for sale. by greed. It is eloquently stated by Gerald Loeb. discovery. the author of The Battle for Investment Survival. fashion and numberless other causes impossible to be listed without omission". acts of God. The application of recognized valuation methodology and rigorous analysis of the private company provides the foundation for estimating a business value. Market values are fixed only in part by balance sheets and income statements. by its very nature. weather. To assume there is only one “correct” estimate of value is a mistake. It often happens that a few moments later each would alter his verdict if given a chance to reconsider because of a changed condition. “There is no such thing as a final answer to security values. ambition. contains many controversial issues. who wrote. “A dozen experts will arrive at 12 different conclusions. financial stress and strain.However. The biggest difference between valuing investments in public companies and nonpublic businesses is the lack of information. Although considerable time and effort is involved in preparing formal business valuations.

For example. Although historical information can be used to set a value. Value. we frequently use a word “VALUE”. “Price” is a number determined by market forces and personal beliefs.VALUE In our day to day life. Parties to buy-sell agreements often determine value by specific terms and conditions in contracts. or by a specified multiple of earnings. What is a value? Value is expressible in terms of a single lump sum of money consideration payable or expendable at a particular point of time in exchange for property. and this may be more or less than its value. Another source for definitions of value may be found in contractual agreements of the parties. But the question is how to measure this worth in financial terms? Here. and amortization. the expectation of future economic benefits is the primary value driver. the right to receive future benefits as at that particular time–point (now). that contract provides the definition of value. Similarly.. less its accumulated depreciation. shows the present value of future benefits that can be derived from the subject property. is in the eyes of beholder. let us first go through the meaning of “Value” in finance. It expresses the worth which may be more or less compared to some other or even it may be nothing or negative. It may be with regards to price of some commodity or for extending esteem to some one or to express the perceived worth of some thing. i. like beauty. The insurance contract may limit coverage to the actual cash value of an insured item. It signifies the worth. Acquirer gets tomorrow’s cash flow. why business value is needed to measure and what are the ways to determine a value of a business? So. Contractual measures of value are limited only by the creativity of the parties to the contract. Other contracts may indicate that the value of the business is defined by earnings before interest. Price and cost refer to an amount of money asked or actually paid for a property. While the “value” is an actual worth or the intended user/s’ belief about the worth of specific “item”.e. Parties to a contract are free to bargain for their own definition of value to meet their special situation. In all sense. 8 . not yesterday’s or even today’s. which may or may not conform to any accepted definition of value in any general legal context. Price and cost can equal value but don’t necessarily have to equal value. value differs from price OR cost. depreciation. Some of these contracts may provide that the value of a business is defined by its book value. Insurance contracts provide for specific values as a basis for their coverage. If so. taxes. VALUE” is a word expressing positive posture. So. Value is future looking. Business interruption insurance or loss of profit agreements provide specific definitions of just what values they will cover if a business is interrupted due to various insured causes.

business valuation is also subject to varying standards of valuation. drive it to work. *estate here means a property that a person left after his/her demise for the usage by heirs. Alternatively. In one sense. law and perspective” (John wiley & Sons. It is the standard of the value which draws a path towards destination. When we value the diamond by a standard that puts a premium on beauty and permanence.000 and given to a young woman as an engagement gift. Assume further that the diamond is insured and. she would likely refuse an offer from someone to buy her diamond. as determined by Treasury regulations. suppose that the diamond ends up in an estate* that must value it for federal estate tax purposes. Except for some limited enhancement created by cutting and polishing. the diamond. the diamond is nothing more than carbon. business value must be measured and defined by a definition of value that is relevant. one has to decide the standard of value first. the diamond is still just inert carbon. So. the diamond has a value equal to the sum of its carbon content. the 9 . ranging from intrinsic value to contractual value. an inert mineral found in the earth’s layers. but. As this example illustrates. If we define the diamond’s value based on its raw mineral content. some insurance policies may replace the diamond at today’s cost. however. in the hands of the woman. the diamond’s value is determined by the terms of a contract. there are a variety of different standards of value that can be used. cut. What is value to one may be inconsequential to another. that “Like beauty. value is mere subjective perception. regrettably. it has limited economic value. Fair market value is now the standard. and reliable. procedure. if we continue to value the diamond by its pure mineral status. is stolen. Change the definition of value. …. we instead define the diamond’s value by a standard that measures carats. we have an object of fairly low value. Consider the various definitions of value throughout the life cycle of a diamond. We also value the diamond as a perceived commodity. Inc) narrates VALUE in a very explicable words. The diamond has a transaction value equal to its purchase price. Meaning which. value is in the eye of the beholder. Finally. we increase its value considerably. We use standard of value synonymously with definition of value. In this regard. Instead of measuring the diamond’s value strictly by the economic value of carbon. or use it to take shelter when it rains. even if the amount offered were significantly more than its original purchase price. and color. a fiction due in large part to the millions of dollars poured into advertisements convincing the public that the diamond has special economic value as an object of beauty. Either way.Mr. Shannon Pratt in their co-authored book “Business valuation and taxes. clarity. the diamond now takes on a new value measured by her sentiment. Stated concisely. Similarly. The emphasis of value has changed. has little inherent value. David laro and Mr. The insurance policy provides that the diamond is insured for its actual cash value. In this regard. except for some limited commercial uses. We cannot eat it. in order to find a value. Now let us suppose that our diamond is purchased from a retail store for $1. predictable. and so has the value to the average consumer. Recognizing that the same business interest may have different values if more than one standard of value is used.

or the reason it is done in a particular way. an intention.wiktionary. Purpose serves to change the state of conditions in a given environment. 4. http://en.wikipedia. The purpose defines “value” applicable to specific purpose and this value varies once the purpose is changed. determination the object for which something exists or is done. A result that is desired. a target.org/wiki/Purpose Purpose is the cognitive awareness in cause and effect linking for achieving a goal in a given system. Purpose of Valuation Let us first go through how the term “purpose” is defined by various wesites: http://en. an aim. end in view To summarize the definition of “purpose”. 3.org/wiki/Purpose purpose (plural purposes) 1. An object to be reached.standard/s of value will help in deciding the valuation technique/s to be used to determine a value for specific requirement. The act of intending to do something. intention.merriam-webster. The reason for which something is done. http://www. the question is what does decide the standard/s of value? The answer is the “purpose”. Its most general sense is the anticipated result which guides decision making in choosing appropriate actions within a range of strategies in the process (a conceptual scheme) based on varying degrees of ambiguity about the knowledge that creates the contextualisation for the action. aim resolution. whether human or machine. 2.com/dictionary/purpose 1 a: something set up as an object or end to be attained : INTENTION b: RESOLUTION . determination. This requirement of making decision creates need of considering the facts. The subject of discourse. it can be said as an “object” or an “end result” to achieve and it involves several decisions to make for achievement of that objective. the point at issue.britannica. Then. DETERMINATION 2: a subject under discussion or an action in course of execution http://www.com/bps/search?query=purpose&source=MWTEXT something one intends to get or do. usually to one with a perceived better set of conditions or parameters from the previous state. a goal. resolution. This change is the motivation that serves the locus of control and goal orientation. 5. situations and possibilities linked with achievement or non-achievement of that specific objective. 10 .

Businesses or their assets are valued for a variety of reasons. the “purpose” creates a “need” for valuation.thefreedictionary. dissolution of partnership. desirable.org/wiki/need To have an absolute requirement for. Some of the most noticeable purposes for valuation of MSME business are demonstrated below: • • • • • • • • • • • • • • • Buy/sell agreements Addition or retirement of partner. http://www. a requisite 3.merriam-webster. to feel that one must have something. To be obliged or required to. Necessity.wiktionary. A condition or situation in which something is required or wanted: 2. A condition of poverty or misfortune http://www. Therefore. To want strongly. obligation 4. Need Definition of need is taken from some different web sites and produced below: http://en. or useful b: a physiological or psychological requirement for the well-being of an organism 3: a condition requiring supply or relief 4: lack of the means of subsistence : POVERTY 11 . Something required or wanted. succession planning Ownership disputes Sharing on family separations and related family disputes Mergers and acquisitions Allocation of purchase price Recapitalizations / Restructuring the business / Raising funds Business planning and value added management Investment decisions / divestitures IPO Financial reporting Wealth planning / tax planning Will planning Goodwill impairment Litigation issues involving lost profits or economic damages While going for some business deal or to make decision on any of the purposes shown above.com/dictionary/need[1] 1: necessary duty : OBLIGATION 2 a: a lack of something requisite. giving due consideration to the value of business may be an inevitable preference.com/need 1.

So, the “need” applicable to us is a requirement or sometimes a necessity (though considered as such or not) which helps to take decision for specific purpose. In other words, Value a business is a NEED for specific PURPOSE requiring a decision to make. Before we go to determine a value of MSME business, for specific purpose, let us go through some basic terms associated with Business valuation.

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TYPES OF REPORTS

Based on the purpose and requirement of client, the report normally is prepared as: • Comprehensive report • Limited “Abbreviated” report • Fairness opinion • Review of an Appraisal Comprehensive report: A report which requires analysis of Business dataqualitative & Quantitative, review of Industry/sector & economy, consideration of various appraisal techniques and based on all these to estimate the VALUE by applying relevant technique/s. Limited “Abbreviated” report: A report which requires specific consideration only as per need of person requiring the APPRAISAL. Like- owner may require calculating the firm value based on his forecast by application of any specific technique (like DCF) only. - Or for limited purpose of finding the tangible worth of Company only. Fairness opinion: A report which requires the opinion of Appraiser on fairness of specific value or range of value quoted by a person requiring the APPRAISAL. The opinion does not express a specific value; rather it states whether or not appraiser feels the value offered is fair or not. Review of an Appraisal: A report to review and comment on valuation derived/ obtained by a person requiring an APPRAISAL. It is generally in form of letter describing the review and critiques.

As per AICPA : statement on standards for valuation services; the valuation analyst can be engaged for any of two assignment and sought for any or more of following three types of reports: Valuation engagement Detailed report: This type of report is structured to provide sufficient information to permit intended users to understand the data, reasoning and analyses underlying the valuation analyst’s conclusion value. Summary report: This type of is structured to provide an abridged version of the information that would be provided in a detailed report, and therefore, need not contain the same level of detail as a detailed report. Calculation engagement Calculation report: This report shows the calculations used by the value analyst and any assumptions and limiting conditions applicable to engagement.

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VALUATION DATE

The monetary worth of any property including a business changes from time to time and so, any valuation offers a “VALUE” on a particular point of time. It is important that the users of valuations understand this fact. The International Glossary defines the valuation date as, “The specific point in time as of which the valuator’s opinion of value applies (also referred to as ‘Effective Date’ or ‘Appraisal Date’).” The valuation date is the specific date at which the valuation analyst estimates the value of the business and concludes on his or her estimation of value. Generally, the valuation analyst should consider only circumstances existing at the valuation date and events occurring up to the valuation date. An event that could affect the value may occur subsequent to the valuation date; such an occurrence is referred to as a “subsequent event.” Subsequent events are indicative of conditions that were not known or knowable at the valuation date, including conditions that arose subsequent to the valuation date. The valuation would not be updated to reflect those events or conditions. Moreover, the valuation report would typically not include a discussion of those events or conditions because a valuation is performed as of a point in time—the valuation date—and the events described in this subparagraph, occurring subsequent to that date, are not relevant to the value determined as of that date. In situations in which a valuation is meaningful to the intended user beyond the valuation date, the events may be of such nature and significance as to warrant disclosure (at the option of the valuation analyst) in a separate section of the report in order to keep users informed. Such disclosure should clearly indicate that information regarding the events is provided for informational purposes only and does not affect the determination of value as of the specified valuation date

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” It defines going concern value as “The value of a business enterprise that is expected to continue to operate into the future. and procedures in place. The International Glossary defines orderly liquidation value as “Liquidation value at which the asset or assets are sold over a reasonable period of time to maximize proceeds received. Some companies are worth more dead than alive. The International Glossary defines premise of value as “An assumption regarding the most likely set of transactional circumstances that may be applicable to the subject valuation.” It also defines liquidation value as “The net amount that can be realized if the business is terminated and the assets are sold piecemeal. liquidation.’” 15 .PREMISE OF VALUE The premise of value decides the applicable standard/s of value. going concern. The intangible elements of going concern value result from factors such as having a trained work force.. systems. It is important for an appraiser. There are two types of liquidation value. Liquidation value If a business is capable of sustaining future operations.g. the appraiser may blindly accept the entity value returned by the calculations. reputation and employee resources that have intrinsic value for the entity. it has certain intangible assets such as customer base. orderly liquidation and forced liquidation. and the necessary licenses.” There are two premises of value: 1. In a going concern valuation. but fails to recognize the higher minimum turnkey value. we have to make our best judgments not only on existing investments but also on expected future investments and their profitability. When an enterprise is financially distressed or only marginally profitable. This is one of the primary reasons for the under-valuation of small businesses. e. an operational plant. to determine if the going concern value exceeds the liquidation value. Going concern value 2. Liquidation can be either ‘orderly’ or ‘forced. such as at an auction. particularly while valuing an entire company.” It defines forced liquidation value as “Liquidation value at which the asset or assets are sold as quickly as possible.

some authors does not consider it as a standard of value. fair values (derivatives and asset revaluations). the value varies. respectively. why not to find a fair value only and then to negotiate for best applicable price setting. fair market value. Investment value 3. The business appraiser must ensure that the standard of value identified upon engagement is the standard of value used in the report to produce the indication of value. (e. I have considered it as a fair value representing the appropriate worth of business under the prevailing conditions and facts attached to it. fair value. 16 . “Liquidation value” being a basic term or premise of value. modified (i. But here. plant and equipment and receivables). Rather they treat them as a premise itself and view liquidation value as a fair value under the premise of Liquidation. plant and equipment). Fair Market Value (FMV) or Fair Value Many authors define fair market Value and Fair vale as different standards of value but here. the possible dismissal of the value altogether. Fair market value (FMV) or Fair value (Intrinsic value & extrinsic value) 2. it is possible that the investor or the seller may cross their upper or lower borders. I have divided the standards of valuation into three categories: 1. a fair market value standard can produce an indication of value that is substantially different than one under an investment value standard. There are even different types of measurement attributes in financial reporting. These include historical cost. we should note that the need of investment value or liquidation value is equally important as the fair value. Similarly.” A business can have different values under different standards of value. property. in a dispute setting. he or she must fully understand the standard of value that applies. Liquidation Value One may argue that instead of going for finding values based on different standard. the liquidation value helps the seller the lowest point of deal.STANDARDS OF VALUE The International Glossary defines standard of value as “the identification of the type of value being used in a specific engagement. cash and liabilities in general). After all.e. Relying on the wrong standard of value can result in a very different value and. And it depends on who is asking and why? Before analyst can attempt to value a business. while going for sale-purchase transactions.g. Base on fair value only. depreciated) historical cost (e. and entity specific value (impaired property. investment value.g.g. Depending on standard of value. e. Investment value helps the proposed investor to define a border up to which he can take a maximum move.

FASB (Financial Accounting Standard Board) decided to issue a standard on fair value measurement. both parties having reasonable knowledge of relevant facts.” IFRS 3. Internal Revenue Service Revenue Ruling 59-60 defines fair market value as “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. the most often used definition has the exact wordings that exist in IAS / IFRS as of now. market value or net realizable value provides an evidence of fair value” in AS 13: Accounting for Investments.” The common definition of fair value is “The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties. in AS 14: Accounting for Amalgamations the wording ‘Or a liability settled’ is missing from the regular definition. Intangible Assets define “Fair Value is the amount for which an asset could be exchanged. between knowledgeable. and published in final form in September 2006 as the Statement of Financial Accounting Standard (SFAS) No.157 on ‘Fair Value 17 . Business Combinations prescribes a number of alternatives that can be used as fair value which includes estimated value.In US. acting at arms-length in an open and unrestricted market. However. other than in a forced or liquidation sale. Indian AS does not list a uniform fair value definition and measurement criteria. that is. This was issued as an exposure draft in June 2004. expressed in terms of cash equivalents. This is a contrast to investment value which identifies a particular buyer or seller and the attributes that buyer or seller brings to a transaction. Fair market value also assumes an arm’s-length deal and that the buyer and seller are able and willing. Instead individual standards indicate preferences for certain inputs and measures of fair value over others and lacks consistency. AS 19 on Leases. So. depreciated replacement cost. at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller. See the addendum at the end of this chapter for the complete International Glossary. or a liability settled. present value. where neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. which would provide a single set of rules to be applied whenever other standards require the use of fair value. AS 11: Accounting for the effects of changes in Foreign Exchange Rates. selling price less the costs of disposal plus a reasonable profit allowance etc. As per Indian Accounting Standards. current replacement cost.” Fair market value assumes a hypothetical willing buyer and a hypothetical willing seller. Its definition of fair market value reads: “The price. AS 20: Earnings per share & AS 26. International Accounting standards (IAS / IFRS) currently do not have a single hierarchy that applies to all fair value measures.” The same definition is used with the additional wordings of “Under appropriate circumstances. willing parties in an arm’s length transaction.

The company’s intended use of an asset is not necessarily indicative of the highest and best use as determined by a market participant. not the price that would be paid to acquire the asset or received to assume the liability (an entry price). This Statement defines fair value. while market participants would consider a site for manufacturing as the highest and best use of the property. FAS 157 defines fair value as “Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”. A full convergence would mean adoption of IFRS in its full form. ICAI is considering convergence to IFRS. the definition focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price). even if the adjustment is difficult to determine. “Fair value In-Use” (when value is maximum to market participants through its use in combination with other assets as a group) and “Fair Value In-exchange” (when maximum value to market participants principally on a standalone basis). establishes a framework for measuring fair value. Under FAS 157. not an entity-specific measurement. FAS 157 specifically defines price to be an exit price. the fair value measurement assumes the asset’s highest and best use by the market participants. In that case. Therefore. a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. Therefore. For example. and expands disclosures about fair value measurements. Contrast this with the present definition under IAS / IFRS and Indian Accounting Standards “Fair Value is the amount for which an asset could be exchanged. willing parties in an arms length transaction.” The words ‘exchanged’ in this definition can either be an ‘exit’ price or an ‘entry’ price. In any case AS are formulated on the basis of IAS/IFRS principles. considered from the perspective of a market participant that holds the asset or owes the liability. This Statement emphasizes that fair value is a market-based measurement. 18 . The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date. the property’s fair value measure should be based on the property’s use as a site for manufacturing. Namely. one could draw the conclusion that FAS 157 would be relevant to the Indian accounting professionals.Measurements’ (FAS 157). the fair value measure is not an entity-specific measure that reflects only the company’s expectations for the asset. The highest and best use of the asset establishes the valuation premise used to measure the fair value of the asset. a company’s management may intend to operate a property as a site for residential house. or a liability settled. FAS 157 specifically requires that the valuation techniques used to measure fair value should maximize the use of observable inputs and minimize the use of unobservable inputs. A fair value measurement should include an adjustment for risk if market participants would include one in pricing the related asset or liability. between knowledgeable. therefore. Therefore.

Unobservable inputs are inputs that reflect the reporting entity's own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. The reporting entity should consider factors specific to the transaction and to the asset or the liability. the reporting entity’s own data used to develop unobservable inputs shall be adjusted if information is reasonably available without undue cost and effort that indicates that market participants would use different assumptions. Inputs may be observable or unobservable: a. but not necessarily all-inclusive. which might include the reporting entity’s own data. 19 . FAS 157 cite four instances that might indicate that the transaction price does not represent fair value. The said instances are helpful in determining the fair value at initial recognition. including assumptions about risk.g. Assessing the significance of a particular input to the fair value measurement in its entirety requires judgment. the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model) and/or the risk inherent in the inputs to the valuation technique. The four instances when the transaction price might not represent the fair value of an asset or liability at initial recognition are: 1) The transaction is between related parties 2) The transaction occurs under duress or the seller is forced to accept the transaction price because of some urgency 3) The unit of account represented by the transaction price is different from the unit of account for the asset or the liability that is measured at fair value. inputs refer broadly to the assumptions that market participants would use in pricing the asset or liability. considering factors specific to the asset or liability. the transaction price includes transaction costs) 4) The market in which the transaction occurs is different from the principal (or most advantageous) market in which the reporting entity would sell or otherwise dispose of the asset or transfer the liability. The level in the fair value hierarchy within which the fair value measurement in its entirety falls shall be determined based on the lowest level input that is significant to the fair value measurement in its entirety. In developing unobservable inputs. the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions. Observable inputs are inputs that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the reporting entity.. However.” The inputs used to measure fair value might fall in different levels of the fair value hierarchy. the reporting entity shall not ignore information about market participant assumptions that is reasonably available without undue cost and effort. for example. say. b. Unobservable inputs shall be developed based on the best information available in the circumstances. (For e.Here in this statement. Therefore.

then subject asset (or property) will realize a price something near to it. showing an excess of current market value of assets (including intangibles) over the current value of liabilities presents the actual net worth of the business and widely used while transacting the buy/ sell agreement for small businesses. if the market price is higher than the intrinsic value. 20 . based on an evaluation of available facts. Under the intrinsic value method. defines intrinsic value as the “Amount an investor considers to be the ‘true’ or ‘real’ worth of an item. It is sometimes called fundamental value. It is also sometimes presented by the net asset value. The extrinsic value is based on the assumption that if comparable asset (or property) has fetched a certain price. capital investment and the growth potentials. For listed companies. The theory behind this approach is that valuation measures of similar companies that have been sold in arms-length transactions should represent a good proxy for the specific company being valued.A single definition of fair value. intrinsic value is based on fundamental analyses of business. Intrinsic Value presents the actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business. future dividends are derived from earnings forecasted and then discounted to the present. In other words.” So. should result in increased consistency and comparability in fair value measurements. This value may or may not be the same as the current market value. AICPA (American Institute of Certified Public Accountants). it is a ‘buy’. if the shares are trading at a price lower than this calculation. in its course Fundamentals of Business Valuation—Part 1. The fair value of business can be determined by using the internal fundamentals only considering the impact of outer world or it can be measured focusing on worth of similar businesses in the market and applying the fundamentals of subject business on it. expected rate of return. Value investors use a variety of analytical techniques in order to estimate the intrinsic value of securities in hopes of finding investments where the true value of the investment exceeds its current market value. together with a framework for measuring fair value. in terms of both tangible and intangible factors. the fair value of a business can be derived by using the intrinsic valuation measures or extrinsic (market based) valuation measures. based on its own characteristics and situations. thereby establishing a present value for the equity. The value of business can be determined by discounting the future cash flow considering business fundamentals like risk. the share is a ‘sell. It is an analytical judgment of value based on perceived characteristics inherent in the investment (not characteristic peculiar to any one investor).

which reflects the particular and specific attributes of that investor. the Board concluded that quoted market prices provide the most reliable measure of fair value. Each potential investor will have their own priorities from five key value drivers: earnings. or factors such as having an in-house research or testing facility. Its worth will then be magnified by this enhancement of value. for example. If. new customers. risk and bulking. or to become more visible for sale. better stocking and distribution. Quoted market prices are easy to obtain and are reliable and verifiable. This may arise from cross selling to its customers. The investor may save on administrative functions. Bulking is the ‘2+2=5’ factor. using those proceeds to pay down any of the firm's liabilities. lowering risk is as much a target as increasing profit. Each of the bidders is more likely to offer a different price based on the individual outlook and synergies that he/she brings to the transaction.Under FAS 157. The best example would be an auction setting for a property (or a business) in which four different bidders’ quotes to acquire. etc. The other bulking factor which may come into play is classic economy of scale. or be able to service in-house a requirement previously bought in at a higher cost. the investor wishes to approach the AIM market. from improvements in its own product or services when linked with those of the target.” Investment value is the value to a particular investor. which may be very difficult to quantify. Investment value reflects more of the risk perception of a particular investor on specific investment/s. Liquidation value: One common standard of value is to look at the liquidation worth of an asset (or property). Hope is the ability to grow that profit from the existing resources of the business acquired – new products. They will evaluate each in the context of the future performance of the business in their specific circumstances. and other users of financial information. is found in the acquirer’s ability to generate extra profits from its own business from its connection with the target – using it as a launch platform. synergy. or simply reputation. Those are used and relied upon regularly and are well understood by investors. Earnings and hope pick up the worth of the business’ existing and potential profitability. all of which can be delivered by the business’ existing management. the investment may not just add profits. Synergy value. It considers the proceeds that could be realized from selling off the firm's assets. new markets. but enable it to achieve an exit or other growth in capital value for the investor’s own business. Synergy can be operational or financial or both. which purely arises from investor’s own strategy. 21 . Investment Value The International Glossary of business valuation terms defines investment value as “The value to a particular investor based on individual investment requirements and expectations. creditors. hope. Earnings value is the capital equivalent of the existing profitability of the business. and then counting as the business valuation whatever the leftover amount equals. may gain greater buying power. on the assumption that this can be sustained.

As said earlier. this standard is opposed to Investment value.Theoretically. 22 . some authors does not consider it as a standard of value. “Liquidation value” being a basic term or premise of value. It is on the mode of termination while the investment is the starting point or the point of holding something. Rather they treat them as a premise itself and view liquidation value as a fair value under the premise of Liquidation.

Growth options give a firm the ability to increase its future business. The income approach 3. There are two types of real options: • Growth options • Flexibility options. expand. business or business interest: 1. The value of an option is determined by six variables – the current value of the underlying asset. The asset approach 2. Management can purchase the option to delay. strike price. contract. or—most pertinent—launching a technology initiative. life of option. on the other hand. the variance in this value. Real option is said to be embedded in a decision or an asset: When there has to be a clearly defined underlying asset whose value changes over time in unpredictable ways. There are some assets that cannot be valued with conventional valuation models because their value derives almost entirely from their option characteristics. Of these. In broadest possible terms. the binomial method provides an intuitive feel and insight into the determinants of option value. patent or brand development. switch uses. give a company the ability to change its plans in the future. 23 . The market approach (Relative valuation approach) One other approach called. Several methodologies have been developed to value options. there are three approaches to value any asset. mergers and acquisitions. leasing or developing land. a biotechnology firm with a single promising patent for cancer drug wending its way through the approval process can not be easily valued using discount cash flow or relative valuation models.APPROACHES TO VALUATION Choosing the right model to use in valuation is as critical to arriving at a reasonable value as understanding how to use the model. Option pricing OR contingent claim method is emerging as a better contender to value assets that have option like characteristics. For example. the risk less interest rate and the expected dividends on the assets. It is also used when we want to consider the option to delay making investments decisions or option to expand the business or to value a patent or an undeveloped natural resource reserve as an option. Examples include research and development. The payoffs on this asset (real option) have to be contingent on and specified event occurring within a finite period. Flexibility options. outsource or abandon projects.

relevant for the purpose of valuation. Income approach. Option pricing being a technique useful for particular cases and to value specific assets or business only. One critical difference between traditional income approach and real options is the effect of uncertainty (or risk) on value. So. I have concentrated more on three basic approaches which are the most popular and applicable while valuing a MSME business. dividend changes. factors relating to whether and when the options may be exercised and other relevant terms of the options. In the income approach. Each probability-weighted value may then be discounted back to present value using a risk free rate of return (normally taken as the return on ‘risk-free’ government bonds). Analyst determines final value by applying average/weighted average / mean / geometric mean on values derived by one or more methods. Uncertainty typically is considered bad for the valuation of traditional cash flows. In contrast. all have recognized the above three as major approaches to business valuation. Whilst flexible in terms of being able to deal with dividends and various different option exercise dates. There are numerous methods within each of these approaches that the appraiser or analyst may consider in performing valuation. Therefore.This model provides insight into determinants of option value. The value of an option is not determined by the expected prices of the shares but by its current price. Asset approach. In the market approach. the analyst can use guideline company multiples or multiples derived from near past transactions. of course. which. Principally these are fluctuations in share price over discrete time periods. some give some other weight to expected performance in near future while some relies on current data and market happenings. These are plotted on a ‘decision tree’ and probabilities allocated to each branch. the analyst can use a discounted cash flow method or a capitalization of earnings method. the method can be very complicated with myriad possible outcomes and challenges in allocating probabilities to each. the analyst often need to choose between either valuing just tangible assets or valuing tangible and intangible assets on stand alone basis or all intangible assets as a collective group. the American society of Appraisers (ASA). The Black-Scholes model removes the need to create such complex decision trees and has become widely used for valuing options. let we get back to the most widely used approaches to valuation viz. many times. in today’s uncertain environment. the Institute of Business Appraisers (IBA) and the National Association of Certified Valuation Analysts (NACVA). and Relative valuation approach The leading business valuation associations. For example. under the asset approach. This method considers one by one the events that may occur between the options being granted and exercised. Some methods focuses usage of historical performance. may be of public or/and private business concern. the value of options actually increases. reflects expectation about the future. uncertainty increases the value of real options. So. Again these can be applied to value the entire business or only equity value. 24 .

location. rules of thumb can be useful in testing the value conclusion arrived through the appraiser’s selected approaches and methods. Widely-accepted business appraisal theory and practice does not include specific methodology for rules of thumb in developing a value estimate. “Be careful. As such. For example. business appraisers do not use rules of thumb in determining an indication of value. customer relationships. such as management depth. capital structure and other information unique to the business. Such sanity checks are a way for business appraisers to test the reasonableness of their value conclusion. the rules are reflective of transactions in the market. 25 . RULE OF THUMB International glossary of business valuation terms define “Rule of thumb” as “ a mathematical formula developed from the relationship between price and certain variable based on experience. It may be a multiple of specific measure of a business like price per seat in case of call centre business or price per room for hotel business or price per student for private coaching classes or price per Bed for nursing-home operators. In addition.All three approaches should be considered in each valuation. or competitive factors over time. reputation. it is usually better to use them for reasonableness tests of the value conclusion. in fact. thumbs come in many sizes and shapes!” So. Rules of thumb fail to consider the specific characteristics of a company as compared to the industry or other similar companies. or price per subscriber for cable television business. rules of thumb do not reflect changes in economic. However. observation. we can conclude that although rules of thumb may provide insight on the value of a business. competition. It is also a question for an appraiser to decide whether to use a trailing or historical data OR current years data OR estimated figures (forecasted or leading) to apply with the chosen rule of thumb. a rule of thumb for pricing a auto manufacturer may be 40% of annual revenues plus inventory or two times seller’s discretionary earnings (pre-tax net income + depreciation + interest + salary for one owner/operator at the market rate of compensation). Rules of thumb are simple pricing techniques that are typically used to approximate the market value of a business. Rules of thumb typically come in the form of a percentage of revenues or a multiple of a level of earnings. industry. hearsay or a combination of these. usually industry specific”. industry trends. None of the rules provide sufficient information to assess the uniqueness of the business. However. as there is typically no empirical evidence relating to how the rules were derived or if. it is not common to use all three approaches in each valuation.

they must also choose among different models. The true measure of a valuation model is how well it works in (i) explaining differences in the pricing of assets at any point in time and across time and (ii) how quickly differences between model and market prices get resolved. which multiple we should use to value firms or equity based on comparable business or transaction. and the appraiser has significant flexibility in formulating an opinion.. It is established for specific purpose and specific point of time. whether to use equity or firm valuation in the context of discounted cash flow valuation. it is inversely proportional to Business risk. relative valuation (and in some cases. Actually. the stability of leverage and dividend policy.WHICH APPROACH SHOULD BE USED? Now. It is like a kitchen that has many chefs with multifarious stuff on platform but no recipes. The origin of the methods employed to measure values of assets can be traced back 26 . growth potential. discounted cash flow valuation. Often. It is the asset prices that we observe and report.. option pricing models) and within each approach.” Valuation is relative to purpose. Therefore. Matching the valuation model to the business being valued is as important a part of valuation as understanding the models and having the right inputs. an appraiser will find wide differences of opinion as to the fair market value of a particular stock. The value established for tax purposes or for litigation is not the same value established for divestiture. we have further choices to make – which value of asset to consider. Revenue Ruling 59-60 of Internal Revenue Service (IRS) at US recognizes this dilemma and states “No general formula may be given that is applicable to the many different valuation situations arising in the valuation of (closely-held) stock. Normally. A business appraisal is in fact the opinion of the individual appraiser. entity value is driven by assets and earnings potentials. Once we decide to go with one or another of these approaches. a replacement value or a liquidation value. the calculated value of a business will vary depending on how it’s intended to be used.. In resolving such differences. and the differences can be substantial. As per the views of the analyst. he should maintain a reasonable attitude in recognition of the fact that valuation is not an exact science. Intrinsic value is something that cannot be observed. the fundamental question is which approach is to consider for valuing a business? The analyst faced with the task of valuing a business or its equity has to choose among different approaches – Asset valuation. Valuation process is undertaken on the belief that values can be measured on the basis of certain parameters using relevant techniques and methods. these choices will be driven by the characteristics of business being valued the level of earnings. the sources of earnings growth.

” IPEV indicates the usage of DCF for the businesses with absence of significant revenues.the stage of development of the enterprise. These methodologies may be useful as a cross-check of values estimated using the market-based methodologies. James DiGabriele. This Statement does not specify the valuation technique that should be used in any 27 .Due to high level of subjectivity in selecting inputs for this technique.to finance theory and economics. Fair value estimates based entirely on observable market data will be of great reliability that those based on assumptions. service or holding companies. For FAS 157.2006) says that “The valuer will select the valuation methodology that is the most appropriate and consequently make valuation adjustments on the basis of their informed and experienced judgment. divided into various sub groups based on Industry classification codes. and these methods are constantly evolving with related newer developments taking place. It narrates that “In accessing whether a methodology is appropriate. Methodologies utilizing discounted cash flows and industry benchmarks should rarely be used in isolation of the market-based measures and then only with extreme caution. DCF based valuations are useful as a cross check of values estimated under market based methodologies and should only be used in isolation of other methodologies under extreme caution. This will include consideration of facts such as: .Quality and reliability of the data used in each methodology . So.” “……. however with the caution about the inherent disadvantage of high level of subjectivity involved in the method. FASB (Financial Accounting Standard Board) clarifies that.any additional considerations unique to the subject enterprise”. He also derived a conclusion that each of the three valuation approaches is equally popular for tangible companies and equally popular for intangible companies. IPEV also emphasis to consider the basic characteristics of all the three approaches.relative applicability of the methodologies used given the nature of industry and current market conditions . came on conclusion than the income approaches are more popular for manufacturing companies and less popular for companies not classified as manufacturing. He had performed various mean tests on a sample of 164 cases. However it gives more weight age to use market based approach for deciding the fair investment value. profits or positive cash flows.Comparability of enterprise or transaction data . International Private Equity and Venture Capital Valuation (IPEV) Guidelines (Oct. “consistent with existing valuation practice. valuation techniques that are appropriate in the circumstances and for which sufficient data are available should be used to measure fair value. while market approaches were most popular for holding companies. and . while studying the preferences of court for valuation approaches of closely held companies based on Industry type. the valuer should be biased towards those methodologies that draw heavily on market-based measures of risk and return.

The fair value hierarchy under FAS 157 also. This judgment.” The statement provides for using single technique or multiple techniques. “The guidelines are intended to provide the basic framework for valuation and to minimize the element of subjective consideration.particular circumstances. the objective is to use the valuation technique (or combination of valuation techniques) that is appropriate in the circumstances and for which there are sufficient data.” So. depending on the asset or liability and the availability of data. As read from the Para 13 of CCI guidelines (1990). IPEV (International Private Equity and Venture) valuation Board while commenting on the IASB’s discussion paper “Fair value measurements” published in November 2006 expresses its apprehension that “Having a single source of guidance for all fair value measurements in IFRS’s would probably reduce complexity and improve consistency in measuring fair value. as appropriate. The IPEV valuation Board fears that doing so will create principles and guidelines that are too theoretical and difficult to apply to specific situations. Determining the appropriateness of valuation techniques in the circumstances requires judgment. in determining fair value. the document should adopt a consistent theoretical approach and should not try to solve issues that are specific to certain markets. will depend upon several factors. the valuation guidelines should not aim to be exhaustive and it must not restrict the analyst’s wisdom to apply in specific circumstance. However. however. subject that.” The values that we obtain from the different approaches described above can be very different and deciding which one to use can be a critical step. assets or asset classes and then apply those solutions to all other situations. 28 . the results of those techniques evaluated and weighted. such a document should not aim at being exhaustive in its guidance in order not to create more confusion for accounts preparers. in order to achieve its objective. The valuation techniques may differ. in all cases. While they should be applied fairly and consistently in all cases. However. Consequently. focuses on the inputs. thereby requiring judgment of appraiser in the selection and application of valuation techniques. users and auditors. they should not be regarded as eliminating the exercise of discretion and judgment needed to arrive at a fair and equitable valuation. not the valuation techniques. as the appraiser. some of which relate to the business being valued but many of which relate to us.

patents. This approach is generally preferred to value intangible asset (like brands. will be calculated starting from the total assets of the Company or of the branch and deducting there from all debts. which are of great relevance in industries such as utilities. CCI guidelines. the present value of future cash flows generated by the assets usually far exceed the liquidation value of those assets.. the net asset value as calculated from the asset side of the balance-sheet in the above manner will be cross checked with equity share capital plus free reserves and surplus. the appraiser may determine that the asset approach is inappropriate for determining an indication of value. However. Net asset values. i. Given that most business valuations are typically conducted under the premise of a going concern.1. This valuation approach often serves as a valuation floor since most companies have greater value as a going concern than they would if liquidated. including current and likely contingent liabilities and preference capital. pharmaceutical that are driven by intangibles not recorded in the books. it should represent the true “net worth” of the business after providing for all outside present and potential liabilities. goodwill etc) of the business. In other words. This methodology is likely to be appropriate for a business whose value derives mainly from the underlying value of its assets rather than its earnings. may not have particular significance in industries such as information technology. if any. In the case of companies.e. An exception to this might be a low-margin business in a competitive industry that owns its real estate. less the likely contingent liabilities. This method may also be appropriate for a business that is not making an adequate return on assets and for which a greater value can be realized by liquidating the business and selling its assets. dues.1) state that “The net asset value.” 29 . borrowings and liabilities. In this case. 1990 (para 6. which has appreciated over time due to its development value. such as property holding and investment business. the appraiser may test if the company is worth more in liquidation as opposed to as a going concern by utilizing an asset approach. the asset value may exceed the going concern value of the business. This difference between the asset value and going concern value is commonly referred to as “goodwill”. THE ASSET APPROACH The Asset-based Approach involves methods of determining a company’s value by analyzing the value of a company’s assets. manufacturing and transport that are dependent on physical infrastructure and assets. as at the latest audited balance-sheet date.

Assets less liabilities equals the owners’ equity. Adjusted book value: This method involves reviewing each and every assets and liabilities on the company’s balance sheet and adjusting it to reflect its estimated market value.. Depending on the mix of assets owned by the company. other types of appraisers (e. little or no growth opportunities and no potential for excess returns.Following figure shows a business value based on asset approach. Is it possible for book value to be a reasonable proxy for the true value of a business? For mature firms with predominantly fixed assets. VALUATION BALANCESHEET Total Asset Current Assets Invested Capital Plant. the book value of the assets may yield a reasonable measure of the true value of these firms. In simple term. machinery and equipment) might need to be consulted as part of the valuation process. book values will be very different from true value. which is the "Book Value" of the business. it is important to consider intangible items that 30 .Term Debts Owner’s fund Other Assets Intangible Assets Equity And Reserves Some of the most common techniques of valuation considered under this approach are to value a business enterprise on the basis of book value of the assets or Adjusted book value of the assets or at Replacement value or applying cost to create approach or just deriving the liquidation proceeds. For firms with significant growth opportunities in businesses where they can generate excess returns. Property & equipments Current Liabilities Long .g. real estate. In addition. Book value This is simply a value based upon the accounting books of the business.

is low relative to the net asset value.Coca Cola. There are several elements 31 . In the new economy. This value can help to negotiate a better price. the most valuable assets have gone from tangible to intangible.might not necessarily be reflected on the balance sheet. Application of the liquidation approach must consider the expenses associated with liquidation. or patent. a seller would like to know the least value of the business that he or she can get on just liquidating the business assets. The cost to build similar intangible worth or asset for the business is also considered. but which might have considerable value to a user. patents. including taxes. While intangible assets don't have the obvious physical value of a factory or equipment. and the risk and timing related to the proceeds. In the world of business today. “Cost to create” value is basically from the view point of the buyer or investor. franchise. which are created through time and/or effort and that are identifiable as a separate asset. selling expenses and plant closing costs. Mr. for example. touched or physically measured. Replacement value and Cost to create value: Replacement value is a least value that a seller will insist from buyer who otherwise would have to expend for getting such assets and creating such liabilities. companies today compete on ideas and relationships. whose brand strength drives global sales year after year. In case of business purchase. Intangible assets and its valuation Intangible assets are something of value that cannot be seen. The unrecorded and contingent liabilities are also considered at their fairly estimated value. such as trade names. Just an opposite of tangible assets. the buyer or investor would like to know the cost that he may have to incur for purchase of the assets (and liabilities also) in similar conditions or bringing the identical assets to the place of use. such as a brand. its positive effects on bottom-line profits can prove extremely valuable to firms. Ágnes Horváth in his article “Non Quantitative measures in company valuation” summarizes factors determining the company value. Although brand recognition is not a physical asset you can see or touch. while offering a business for sell. started out from the fact that a company does not exist in complete isolation. etc. Instead of plant and equipment. trademark. on a control basis as determined by the income or market approaches (discussed later). Liquidation value Generally. It is a value at which the similar assets (and liabilities also) can be replaced with existing assets of the business. they can prove very valuable for a firm and can be critical to its long-term success or failure. Liquidation analysis should be considered when the value of the business. things are not what they used to be. The value so derived can help him to negotiate a fair price.

or is destroyed. Goodwill also may manifest itself in the form of trademarks.in the environment that contribute to its operation. Competitive intangibles. including those with customers.and therefore costs. inventory. productivity. and structural activities). location of operations. whilst legally non-ownable. and goodwill) and competitive intangibles (such as knowledge activities (know-how. copyrights..legal intangibles (such as trade secrets (e. trade names. Intangible Asset categories Examples include: 1. employees’-management relations. patents. Competitive intangibles are the source from which competitive advantage flows. etc. and license rights. equipment. directly impact effectiveness. company size and critical mass. When a business is bought. order or production backlogs. the price paid will often be above the market value of its infrastructure. It is essential to focus not only on factors closely related to the company operation. noncompetition agreements. customer contracts and customer . knowledge). This all together give rise to goodwill of the business concern. wastage. dominant market size. service marks. distributors. Goodwill is the most common and popular intangible asset in the world of MSMEs. though not exhaustive. goodwill covers other valuable albeit intangible aspects of a business. Below mentioned examples. technological capabilities and expertise. internet domain names. goodwill reflects the buyer's perception that the business as a whole is worth more than the sum of the identifiable physical assets. On occasions. market value. collaboration activities. but on micro and macro factors as well. leverage activities. and opportunity costs within an organization . Marketing-related intangible assets Trademarks. revenues. Legal intangibles generate legal property rights defensible in a court of law. reputation. enterprises even sell their goodwill without the sale of other assets. which must not be discounted or must not be over looked. It refers to the price or value above the market value of the identifiable assets of a company. Human capital is the primary source of competitive intangibles for organizations today. provide a useful framework for the determination of intangible assets. and share price. strength of customer-vendor relationship.g. manufacturing processes.relationships including noncontractual relationships. A business enterprise cultivates this intangible asset by establishing a strong business track record and by establishing many beneficial relationships. such as its credit rating. These significant qualitative characteristics. In any event. and name. trademarks. customer service. satisfaction. They fall into five categories (as shown below). Customer-related intangible assets Customer lists. includes. customer lists). competence of management etc. 2. and suppliers. strength of competition. location. There are two primary forms of intangibles . size of backlog. 32 . In addition.

new tools and techniques for an economy based on intangibles. intangible value is the amount by which the value of the business exceeds the value of the underlying. or settled in a transaction between willing parties. A further complication with such companies is that their high R&D expenses reduce current earnings even though R&D projects could be perceived as investments for the future. may be particularly hard to value because such a small portion of their value lies in assets in place whereas a large portion derives from uncertain future growth opportunities. computer software. tangible assets. When it is time to sell assets. books. Obviously. photographs. newspapers. Artistic-related intangible assets 4. it remains difficult to quantify its economic and monetary value. Technology-based intangible assets Plays. advertising. Patented technology. Licensing and royalty agreements. Valuation of intangible assets While intangible assets play an increasingly important role in today’s business world. new reporting forms. . franchise agreements. Intangible assets are significantly more difficult to value than their tangible counterparts. employment contracts. Difficult questions about intangibles assets are to drive finance professionals and Accounting Standard Setters to develop new measurements.3. The “fair” value of an intangible asset is the amount that such asset can be bought. magazines. 33 . The method most often used in the valuation of intangible property determines the present value of the cash flows derived from using such property. can cause real problem in the form of financial and legal obstacles if improperly valued. Companies with a large part of their value in intangible “assets. it is more difficult to determine the value of a trade secret than the value of office space. so that the value of the business (based on expected earnings or cash flow) exceeds the underlying net asset value. construction.” such as high-technology companies and companies with substantial research and development activities. sold. current earnings may be a bad predictor of value. intangible assets. Contract-based intangible assets 5. trade secrets such as secret formulas. processes and recipes. Intangible value is created when a company has above average return on assets (or equity). in such a case. such as goodwill and patent. unpatented technology (know-how). service or supply agreements. lease agreements. pictures. Intangible assets can be difficult to value individually with no guarantee of completeness.Consequently. databases. not involving forced or liquidation sale.

3) excess profits methods. assume that there is some relationship between cost and value and the approach has very little to commend itself other than ease of use. huge advertisement cost on initial start ups for product publicity. This is not only due to lack of compatibility. or based on estimates of past and future economic benefits. a value analyst will always prefer to determine a market value by reference to comparable market transactions.. mostly 34 .The most common technique for capturing total intangible value is an enterprise valuation to establish total asset value. For example. Expenditures such as those on advertising. such as the “cost to create” or the “cost to replace” a given asset. a business enterprise must expect benefits in the coming years and support that expectation with evidence. The method ignores changes in the time value of money and ignores maintenance. and 4) the relief from royalty method. This is difficult enough when valuing assets such as bricks and mortar because it is never possible to find a transaction that is exactly comparable. The methods of valuation flowing from an estimate of past and future economic benefits (also referred to as the income methods) can be broken down in to four limbs. 1) capitalization of historic profits. in order for expenditure to qualify as an intangible asset. 1. Methods for the Valuation of Intangibles Acceptable methods for the valuation of identifiable intangible assets and intellectual property fall into three broad categories. cost based. In an ideal situation. it has major shortcomings. While this capitalization process recognizes some of the factors which should be considered. 2) gross profit differential methods. Cost-based methodologies. for example. The capitalization of historic profits arrives at the value of intangibles by multiplying the maintainable historic profitability of the asset by a multiple that has been assessed after scoring the relative strength of the intangible assets. a multiple is arrived at after assessing a brand in the light of factors such as leadership. The analyst should note that. but the benefits are so uncertain and unpredictable that the business classify them as current expenses. internationality.. They are market based. claim existence of intangible worth arisen due to these expenditures. Many times a business owner incurring specific expenses like research on value addition of a product. may promise future benefits. the search for a comparable market transaction becomes almost futile. stability. The value of current and fixed assets is then deducted to arrive at the value of intangible assets. trend of profitability. In valuing an item of intellectual property. market share. but also because intellectual property is generally not developed to be sold and many sales are usually only a small part of a larger transaction and details are kept extremely confidential. extra amount paid on purchase of specific formula etc. marketing and advertising support and protection.

When undertaking an Intangible valuation. Relief from royalty considers what the purchaser could afford. These methods look at the differences in sale prices. This formula is used to drive out cash flows and calculate value. finance. The method pays little regard to the future. and investment. Potential profits and cash flows need to be assessed carefully and then restated to present value through use of a discount rate. 4. It is rash to attempt any valuation adopting so-called industry/sector norms in ignorance of the fundamental theoretical framework of valuation. accounting. the method has difficulty in adjusting to alternative uses of the asset. or would be willing to pay. The discount rate is used to calculate economic value and includes compensation for risk and for expected rates of inflation. economics. While theoretically relying upon future economic benefits from the use of the asset.associated with historic earning capability. Finding generic equivalents for a patent and identifiable price differences is far more difficult than for a retail brand. 3. adjusted for differences in marketing costs. or rates. it is important to note that valuation is an art more than a science and is an interdisciplinary study drawing upon law. 2. 35 . Discounted cash flow (“DCF”) analysis sits across the last three methodologies and is probably the most comprehensive of appraisal techniques. This is used to calculate the profits that are required in order to induce investors to invest into those net tangible assets. the context is all-important. Any return over and above those profits required in order to induce investment is considered to be the excess return attributable to the intangible assets. Real option or option pricing method is now a days getting more recognition for valuing the patent. That is the difference between the margin of the branded and/or patented product and an unbranded or generic product. Gross profit differential methods are often associated with trade mark and brand valuation. for a license of similar intangible asset. The excess profits method looks at the current value of the net tangible assets employed as the benchmark for an estimated rate of return. While some of the above methods are widely used by the financial community. and the value appraiser will need to take it into consideration to assign a realistic value to the asset. The royalty stream is then capitalized reflecting the risk and return relationship of investing in the asset.

return and time. The Income Approach derives an estimation of value based on the sum of the present value of expected economic benefits associated with the asset or business (Economic benefits have two components: cash flow (or dividends) and capital appreciation). This method is most commonly used when the company is expected to experience a period of abnormal growth or when the growth rate for the near term is anticipated to be significantly different from the long-term rate of growth. or cash flow. This results in a value based on the present value of the future economic benefits that the owner will receive through earnings. etc. an appropriate multiple can be used with the normalized earnings to arrive at fair estimation of business value. Alternately. THE INCOME APPROACH The concept is to value a business or asset based on its earning capacity. The capitalization method estimates the fair market value of a company by converting the future income stream into value by applying a capitalization rate incorporating a required rate of return for risk assumed by an investor along with a factor for future growth in the earnings stream being capitalized. which is then discounted back to a present value (at the same discount rate) and added to the present value of the prior years’ income streams to arrive at the indication of fair intrinsic value. This is predicated upon the ability to create a reasonable forecast of the company’s income stream for the forecast period. Earnings is a final crux of the business activity. the appraiser may select a single period capitalization method or a multi-period discounted future income method. If these conditions are satisfied. Single period capitalization method: The basic of this approach is find the normalized earning capacity of the business and to capitalize it on the basis of appropriate rate considering the business fundamentals of safety. valuation of business based on its earning capacity can be a better proxy. and so. Earnings are linked with all other fundamentals of the business like growth.2. the income stream that represents the expected income stream in perpetuity is capitalized to arrive at a terminal value. risk involvement or uncertainty. the multi-period discounted future income method may more reliably capture the value impacts of cyclicality or abnormal short-term factors impacting the company’s results than a capitalization method. This method is usually employed when a company is expected to experience steady financial performance for the foreseeable future and when growth is expected to remain fairly constant. For the final year of the projection period. Multi-period discounted future income methods involve discounting a projected future income stream on a year-by-year basis back to a present value using an appropriate discount rate that reflects the required rate of return on the investment (compensating for risk). The capitalization method is based on the Gordon constant growth model that uses a single period proxy of future earnings to determine the present value of the asset. dividends. Under the Income Approach. 36 . capital requirements.

The important task is to determine two factors (1) normalized earnings and (2) rate of capitalization or multiple for capitalization (capitalization rate is the inverse of multiple – 20% rate of returns equals a multiple of 5). The normalized earnings can be a Profit after tax (PAT) OR a profit before Depreciation, Interest, and taxes (PBDIT) OR Net operation profit before amortization OR it may be simply a cash flow from the business operations. This earnings may be considered from recent year earnings, OR simple average of few years’ earnings, OR weight age average or geometric average of few years’ earnings. Again it can be a forward looking or trailing (based on past). For forward looking (also known as leading) earnings the forecasted figures must be checked. CCI guidelines prescribe usage of simple average of last three financial years’ profit as future maintainable earnings of the company. CCI guidelines, 1990 (para 7.3) state that "The crux of estimating the Profit Earning Capacity Value lies in the assessment of the future maintainable earnings of the business. While the past trends in profits and profitability would serve as a guide, it should not be overlooked that valuation is for the future and that it is the future maintainable stream of earnings that is of great significance in the process of valuation. All relevant factors that have a bearing on the future maintainable earnings of the business must, therefore, be given due consideration" Gorden growth model estimates the value of ownership based on next year’s dividend payment capacity and capitalizing it considering the expected rate of return (cost of capital) and estimated growth rate. Following formula is used to estimate a value using this approach:

Value = Normalized earnings / (Ke – g)
Where, Ke = required rate of return on investments g = growth rate in earnings forever Or

Value = Normalized earnings * Appropriate multiple
Appropriate multiple should be arrived at by considering the specific business risk, size risk, market risk, growth rate, expected return and such other factors having impact on the business operations. This multiple should also co-relate with the nature of earnings used. For example, if it is PBDIT then multiple should be based on capital invested and not only the owners’ fund. This will give value of business. But if the earnings used is PAT then the multiple should reflect the factors applicable to ownership only. It will provide the value of owners’ fund in the business. To conclude, we can say that it is on the best judgment of the appraiser to decide normalized earnings and appropriate rate of capitalization.

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Multi period discounting Method (Discounted Cash Flow - DCF) This method uses financial projections to determine the value of business or value of ownership based on future income for several periods (un stable growth period) and terminal value after expiry of that period (stable growth period). Then, a discount rate is employed to convert those future values back to a present value. The business life being divided in to two phases: unstable growth period and stable growth period – it is also known as two stage model of cash flow discounting. The model can be extended to three or four stage model based on the business cycle. The value of an undertaking really depends on its future profits, cash flows or distributions and the associated risks. Past results may serve as an aid for estimating the likely future results; they cannot determine them. The advantage of this method is that it can be used for businesses or assets with unstable earnings and non constant growth rates. But it is important that the discount rate being used is appropriate for the income being discounted as small changes in the discount rate can have considerable impact on the present value. Following formula is used to estimate a value using this approach:

Value =

CF t ∑ (1+ R) t t=1
t=n

Using discounted cash flow, we can derive value of equity holders by (i) choosing present value of free cash available to equity holders and (ii) choosing present value of the cash flow available to firm and subtracting the present value of debts there from. Done right, the value of equity should be the same whether it is valued directly (by discounting cash flows to equity at the cost of equity) or indirectly (by valuing the firm and subtracting out the value of all non-equity claims). The primary difference between equity and debt holders in firm valuation models lies in the nature of their cash flow claims – lenders get prior claims to fixed cash flows and equity investors get residual claims to remaining cash flows. Formula to get a value of a firm:

Value of Firm =
Formula to find a value of equity:

∑ (1+ WACC)
t =1

t= n

CF to Firm t
t

Value of Equity =

FCFE t ∑ (1+ Ke) t t=1
t=n

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So, the fundamentals to estimate value under this technique are cash flows, and discounting rate. 1) Determination of the cash flows:

The cash flow of perpetual business is generally divided into to segments. (1) flow for periods up to abnormal earnings or unsteady growth (2) flow after this unsteady period when the business gets stabilized i.e. terminal flow or terminal value. Cash Flow: The free flow to firm is calculated as follow:

CF to Firm = Net income + Amortizations + Interest + Depreciation – Capital expenditure – change in non cash working capital
The free flow to equity is calculated as follows:

FCFE = Net income + Amortizations + Depreciation – Capital expenditure – change in non cash working capital + (new debts – debts repayments)
Terminal value: The discrete forecast period ends when cash flows have stabilized and expected growth is moderate and sustainable. In simple term, it a value of business at the end of forecasted period. This value can be derived by using (1) stable growth method or (2) multiple approach or (3) liquidation value. The multiple approaches is easiest but it makes the valuation “relative valuation”. The stable growth model is technically sound but it requires a judgment about the stable status of the business and applicable stable growth rate that can sustain forever. The liquidation value is most useful when assets are separable and marketable. The estimation of terminal value is as challenging as the valuation of business NOW. The only comfort here is that the business is assumed to be on steady phase. 1. Stable growth method Gordon Model is very popular while estimating terminal value based on earnings. It assumes continued ownership of business. Key assumptions for the Gordon Model: - Depreciation and capital expenditure should be equal or at a steady state differential in the residual period - Forecast period should be as long as necessary for a stable level of growth to be achieved; the terminal period must assume a long term stable growth rate (it may be negative or zero or positive) Comments

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The conclusion provided by the Gordon Model should be the same answer as if continuing the cash flow model into infinity Formula: CASH FLOW IN THE FIRST YEAR OF THE TERMINAL PERIOD (DISCOUNT RATE . We must take care that discounting earnings as if they were cash flows paid out to stockholders while also counting the growth that is created by reinvesting those earnings will lead to the systematic overvaluation of stocks. that capital expenditures. for instance..10 1.24 1. of years 40 . of gap years -1 -1 EPS 0.38 growth rate 17.73 09. relative to depreciation. Formula for compounding growth or geometric average of growth Current year EPS (OR earnings OR cash flow) Based year EPS (OR earnings OR cash flow) For example: Years 2000 2001 2002 2003 2004 2005 1/ No.02 12. the terminal value will be lower and the business is assumed to be disappearing over time.The model assumes a constant growth in cash flow.26 1. are not disproportionately large and the firm is of 'average' risk.LONG TERM GROWTH RATE) The stable growth rate should not exceed the growth rate of economy but can be set at ant lower figure. .The rate must be sustainable into perpetuity . The assumption that a firm is in steady state also implies that it possesses other characteristics shared by stable firms. This would mean. Growth rate: The growth rate used in the model has to be less than or equal to the expected nominal growth rate in the economy in which the firm operates.68 -07.35 09.52 Arithmetic mean = sum of growth rates / no. It can be negative but in such case.36 1. Historical growth rate is generally estimated based on arithmetic average or geometric average or regression models.94 1.This formula represents the value of all cash flows remaining beyond the end of the forecast period .

e.68+(-07. i. if it is decided to use multiple of 7 with EBITDA of first year of terminal period then the terminal value of business will be 7 * EBITDA t 1.35)+09.32 Geometric mean = (1. but prior to debt payments. Liquidation value: The terminal value of business is derived by estimating the value of individual assets at the end of the forecasting period.The cost of equity and debt for the industry or firm. Multiple approaches .02+12.38/. weighted by their market value proportions. Weighted Average Cost of Capital (WACC) The value of the firm is obtained by discounting expected cash-flows to the firm.73+09. the rate normally used is rate of return expected by equity holders.= (17. Cost of Debt 41 .52)/5 = 8.. at the weighted average cost of capital. 2) Determining the Discounting rate: For finding the value of firm the most popular and widely used rate is Weighted Average Cost of Capital (WACC) rate.98 -1 2. The WACC is based on: . the appraiser is required to determine a cost of equity first. In both the cases. For example.The proportion of the firm’s capital structure comprised of equity and debt WACC = Ke (% equity) + Kd (% debt) Where: Ke = required rate of return on equity capital % equity = equity as a percent of total capitalization Kd = after tax required rate of return on debt capital % debt = debt as a percent of total capitalization In general WACC is an appropriate valuation framework as long as the debt ratio is expected to be constant.is based on a multiple of a measure of financial performance applied at the end of the forecast period. the residual cash-flows after meeting all operating expenses and taxes. and . 3. which is the cost of the different components of financing used by the firm. And for determining the value of equity.094)^(1/5) = 7. This approach is discussed in detail under market approach.

Small company risk Studies have shown there is a small company premium because CAPM under estimates the return earned by investors in small companies. . So. CAPM equation including adjustments will be Ke = RF + β (RF . It is typically the yield from long-term government bonds. Kd = D (1 . Ke = Rf + β (Rm – Rf) Where: Ke = the investor’s required rate of return (equity) Rf = the risk free rate β = beta Rm = return from the equity market Rm .The cost of debt is usually the rate of interest at which the loan and other debts are aerated by the organization. either nominal or real. It represents an alternative rate of return to the investor that is risk free and has liquidity 42 .RM) + S1+ S2 Where: S1 = size premium = size premium S2 = specific company (business) risk Components of CAPM Rf is the risk free rate.Rf = the market premium In addition to these variables. there are adjustments to consider in applying this method to closely held companies or MSME businesses: .Specific company risk In some cases the company being valued will have specific risks that justify an additional risk premium. Under CAPM. Capital Assets Pricing Model (CAPM) is commonly used technique.t) Where: Kd = after tax required rate of return on debt capital D = debt holders’ required return on debt t = corporate marginal tax rate Determination of Cost of capital In order to find the cost of equity (Ke).

However. Thus. and Robert Schweihs state the following with respect to the investment specific risk: “ …the unsystematic risk specific to the subject business or businesses interest still remains largely a matter of the analyst’s judgment. fundamental beta or bottom-up beta are used to determine the cost of equity. Shannon Paratt. the return from the equity market. The measure to quantify the market risk is known as beta (β). the higher the risk Betas are typically calculated for an industry to provide a measure of risk for that particular industry Rm. In “Valuing a Business: The Analysis and Appraisal of Closely Held Companies. there is no empirical data or observable data regarding the specific company (business) risk premium to assist the appraiser in analyzing the appropriate increment to the discount rate to account for firm-specific risk. fourth edition. many times accounting beta. Business risk is the risk associated with the particular activities undertaken by the enterprise whereas the financial risk is the risk resulting from the existence of debt in the capital structure of the enterprise. is based on historical returns over a long period Rm --Rf (the market premium) is the amount by which the historical equity returns from the market have exceeded the risk free rate Risk : The Risk can be divided in to two parts: Market risk (systematic/ non diversifiable risk) and firm specific risk (diversifiable / unsystematic risk). the discounting rate is generally considered based on the specific company (business) risk and expected rate of return by the owner or equity holders. Market risk can be broken down further into business risk and financial risk. the higher the beta. Beta measures nondiversifiable risk. The analyst must depend on experience and judgment in this final element of the discount rate development. Robert Reilly. Being this a study on valuation of MSME concerns. Effectively. the higher shall be its beta.” 43 . It shows how the price of a security responds to market forces. The analyst will base this judgment on factors…such as financial statements and comparative ratio analysis and the qualitative matters to be considered during the site visit and management interviews. However. there is no specific model for quantifying the exact effect of these factors of the discount rate. but should explicitly describe the factors that impact this final element. after carefully analyzing these elements of investment specific risk. without a commonly accepted set of empirical support evidence. In MSMEs where the prices are not listed on any stock exchange. In order to measure a fair value. expected rate of return is considered based on average rate of return in the industry in which the business unit pertains. I am not going into analyzing beta. In case of non-public companies where the shares are not trading on open market.Beta (β) is a risk measure that is based on the volatility of the price of the shares of a company compared to the volatility of the market as a whole A company whose share price is volatile has more risk for an investor. the more responsive the price of a security is to changes in the market.

Sensitivity test. however. the estimated equity return within the Weighted Average Cost of Capital (WACC) the calculation of terminal values and growth assumptions. in particular. rescue refinancing. While this method may be applied to businesses going through a period of great change. best guess of an appropriate premium. the estimation of specific business risk is nothing more than the appraiser’s educated. Models such as Arbitrage Pricing Theory (APT) and FamaFrench Three Factor Model (TFM) are examples of the alternatives which have been developed. however. there is a need for a quantifiable analysis for the specific business risk premium to further strengthen the business valuations and to limit the appraiser’s exposure to attacks on credibility and results. This method is used by many acquirers. In practice. Expected Cash flow method (Certainty equivalent cash flow). against corporate targets for minimum returns on investment. or is in its start up phase. The uncertainly can be reduced by applying some advanced techniques including The First Chicago method. The CAPM. loss making. However. the specific business risk premium for one company (in textile industry for example) is not necessarily representative of the appropriate specific business risk premium applicable to another firm (auto part manufacturing company for example). Probabilities cash flows Method and Monte Carlo simulations which improve on the single point estimates generated by the classic DCF method. such as a turn around.It should be apparent that the lack of any guidelines to estimate the specific business risk presents significant challenges to the appraiser in conducting the valuation. as is common with most valuations methodologies. if conducted. who will test the value acquired in comparison to the price paid. Therefore. Therefore. finance experts and professionals agree that the DCF based valuation methodology is theoretically robust. DCF may be the only way to reach realistic valuation. Though an appraiser may have performed hundreds of valuation. The assumptions and validity of CAPM have been questioned and there are doubts on the predictive power of the CAPM Beta which is a key input for determination of the WACC in a DCF. has retained its appeal and continues to be widely used by practitioners for among other reasons its simplicity. Specifically this is due to the inevitable uncertainties around: • • • the achievability of the projections determining. can help to know the significance of change in discounting rate (or capitalization rate) on overall value of the business. there is a significant risk in utilizing this method because of inherent difficulty for estimating the fundaments required for 44 . strategic repositioning. understanding the risks and sensitivities within them. the advantages of a DCF valuation are that it requires the appraiser to appraise the business’ operations and future cash flows in some detail. Academics. DCF valuations are highly sensitive to the assumptions which underlie them. When accounting information is incomplete or not reliable or impossible to interpret.

It requires estimation of cash flows. So. Views of Prof. risk-adjusted discount rate and also that of terminal value. All of these inputs require substantial subjective judgments to be made and the derived present value amount is often sensitive to small changes in these inputs.this method. Aswath damodaran for choosing an appropriate technique under Income approach of valuation. is produced below: 45 . using discounted cash flow models is in some sense an act of faith. The disadvantages of the DCF centre around the “Estimates”.

Choosing the right Discounted Cashflow Model Can you estimate cash flows? Yes No Are the current earnings positive & normal? Yes Use current earnings as base Yes Stable leverage Unstable leverage Replace current earnings with normalized earnings No Is the cause temporary? What rate is the firm growing at currently? < Growth rate of economy Stable growth model No Is the firm likely to survive? Yes > Growth rate of economy Are the firm’s competitive advantges time limited? Is leverage stable or likely to change over time? Use dividend discount model No 3-stage or n-stage model FCFE FCFF 2-stage model No Does the firm have a lot of debt? Yes Adjust margins over time to nurse firm to financial health Yes No Estimate liquidation value Value Equity as an option to liquidate 46 .

using debt to fund a firm’s operations creates tax benefits (because interest expenses are tax deductible) on the plus side and increases bankruptcy risk (and expected bankruptcy costs) on the minus side. Firm Value = Un-levered Firm Value + PV of tax benefits of debt . We begin by estimating the value of the firm with no leverage. normally bankruptcy cost is not considered while determining value as per this method. the formula for calculating APV is. EBIT (1 . we evaluate the effect of borrowing the amount on the probability that the firm will go bankrupt. the APV approach attempts to estimate the expected value of debt benefits and costs separately from the value of the operating assets. V = EBIT (1 – t) / (Ke – g) + DT Where.Expected Bankruptcy Cost In practice. we estimate the value of the firm in three steps. The value of the firm can also be written as the sum of the value of the un-levered firm and the effects (good and bad) of debt. project financing and real estate financing. And so. we separate the effects on value of debt financing from the value of the assets of a business. It is rare that the debt equity ratio in the business remains constant. where the effects of debt financing are captured in the discount rate.t) = earnings before Interest but after tax Ke = Cost of Equity DT = tax savings on debts g = growth rate APV has generally applicability in transactions that involve a structured financing. In the adjusted present value (APV) approach. We then consider the present value of the interest tax savings generated by borrowing a given amount of money. like leveraged buyouts (LBOs). In contrast to the conventional approach. In the adjusted present value approach. In general. Finally. The better way is to find the value of firm ignoring the debt in capital and to add the tax benefit proposed on debt creation. 47 . and the expected cost of bankruptcy.Adjusted Present Value: Many experts believe that the estimate value of business determined from using discounted cash flow method is not free from the limitations of using WACC as a discounting rate.

the researcher Shri Raj S Dhankar and Shri Ajit S Boora. all these three methods of valuation (if used correctly) always yield the same result. It is computed as the product of the "excess return" made on an investment and the capital invested in that investment. This is because of the fact that the value of a firm is affected by a multiplicity of factors and capital structure is just one of them. Franco Modigliani and Merton Miller in their seminal work on the theory of capital structure propagated the idea that the enterprise value is independent of its capital structure. Economic value added = NOPAT – (Cost of capital) * (Capital invested) NAPAT = Net Operating Profit After Tax or operating profit minus the taxes that would be payable without any deduction for interest expenses.As written by Prof. and value of Firm: An Empirical Study of Indian Companies”. excess returns can therefore be either positive or negative. Earning the risk-adjusted required return (cost of capital or equity) is considered a normal return cash flow but any cash flows above or below this number are categorized as excess returns. With the excess return valuation framework. came on the conclusion that there is no significant relationship between change in capital structure and the value of a firm. the value of a business can be written as the sum of two components: Value of business = Capital Invested in firm today + Present value of excess return cash flows from both existing and future projects In pure terms. In a article “Cost of Capital. we separate the cash flows into excess return cash flows and normal return cash flows. Pablo Fernández. Economic Value Added – EVA (also known as an Excess Earnings Model or Residual Income Model) The economic value added (EVA) is a measure of the surplus value created by an investment. at the micro level. In the excess return valuation approach. Firm Value = Value of Assets in Place + Value of Expected Future Growth 48 . APV. Optimal capital Structure. WACC and FLOWS TO EQUITY APPROACHES to firm Valuation.

such as vacant land and securities. Any of the two basic approaches of income approach. single period capitalization model and multi period income discounting model.This approach is widely used for appraising MSME business because of ease in calculation and simplicity in understanding. This method is very popular in valuing MSME businesses but care must be taken to choose the multiple. and assets held for investment purposes. The resultant value can be cross checked for reasonability through deriving rate of return as if single period capitalization method is applied. The value of operating assets is generally reflected in the cash flow generated by the business Non operating assets Non operating assets are assets which are not used in the operations including excess cash balances. can be used to determine a business value using this technique. Steps for business valuation. Non operating assets are generally valued separately and added to the value of the operations. we first come to know the value of business and then after deducting capital investments we can determine an addition earnings. 49 . Using the single period capitalization method we can determine the EVA first and then the estimated value of business. whichever is appropriate) Calculate excess earnings: Fair earnings (as per 5 above) Less: normal return on investment (3 * 4) Decide multiple to determine value of excess earnings Calculate value of intangible / excess earnings (6 * 7) Value of business: (8 + 3) Current value of business : ( 8 + 3 + 2) 7) 8) 9) 10) Operating assets Operating assets are assets which are used in the operation of the business including working capital. While applying multi period income discounting model (DCF). using single period capitalization method with Excess Earning Technique: 1) 2) 3) 4) 5) 6) Prepare the Balance sheet as per fair value principles Separate the value of surplus assets or non-operating assets Determine the value of fixed assets and working capital (investment value) Determine the applicable rate of finance (normally bank financing /loan rate) Find out the fair earnings (based on weighted average / current. plant and equipment and intangible assets. property.

it is still an expected cash flow and is not risk adjusted.100 with probability 90% and only Rs. FAS 157 provides a very good example to show the relation between Certainty equivalent cash-flow and Risk adjusted rate of return while determining the value using discounted cash flow technique. there are some who prefer to adjust the expected cash flows for risk. risk-averse market participants would consider the risk inherent in the expected cash flows. 95 but risk-averse investors would pick the first investment with guaranteed cash flows over the second one. and then discounting the cash flow at the risk free rate is equivalent to discounting the cash flow at a risk adjusted discount rate. Portfolio theory holds that in a market in equilibrium. but do they yield different values. While it is true that bad outcomes have been weighted in to arrive at this cash flow. In making an investment decision. which one is more precise? After all. 95-117).. The first is risk specific to a particular asset or liability. also referred to as systematic (nondiversifiable) risk. (In markets that are inefficient or out of equilibrium. (The proposition that risk adjusted discount rates and certainty equivalents yield identical net present values is shown in the following paper: Stapleton. 95 with certainty and in the second. The systematic or non-diversifiable risk of an asset (or liability) refers to the amount by which the asset (or liability) increases the variance of a diversified portfolio when it is added to that portfolio.) 50 . adjusting the cash flow. R. There are some who consider the cash flows of an asset under a variety of scenarios. To see why. The expected value of both alternatives is Rs.C. Journal of Finance. Risk Adjusted Rate Of Return While most analysts adjust the discount rate for risk in DCF valuation. take an expected value of the cash flows and consider it risk adjusted. Portfolio Analysis. The second is general market risk. also referred to as unsystematic (diversifiable) risk. using the certainty equivalent. you are offered Rs. Stock Valuation and Capital Budgeting Decision Rules for Risky Projects. market participants will be compensated only for bearing the systematic or non-diversifiable risk inherent in the cash flows. 50 the rest of the time. In the first one. other forms of return or compensation might be available. Certainty cash flow = Expected cash flow / (1+ Risk premium in Risk adjusted discount rate) Adjusting the discount rate for risk or replacing uncertain expected cash flows with certainty equivalents are alternative approaches to adjusting for risk. assign probabilities to each one. 1971.Certainty Equivalent Cash-Flow Vs. you will receive Rs. Portfolio theory distinguishes between two types of risk. and if so. assume that you were given a choice between two alternatives. v26. ranging from best case to catastrophic.

adjusted for risk such that one is indifferent to trading a certain cash flow for an expected cash flow. which is an expected rate of return relating to expected or probability-weighted cash flows. industry trends. Accordingly. assume that an asset has expected cash flows of $780 in 1 year based on the possible cash flows and probabilities shown below. there could be many possible outcomes. it should be possible to develop a limited number of discrete scenarios and probabilities that capture the array of possible cash flows. the $1. as indicated below. To illustrate Methods 1 and 2. In that case. In more realistic situations. The applicable risk-free interest rate for cash flows with a 1-year horizon is 5 percent. For example. In theory. and competition as well as changes in internal factors impacting the entity more specifically).000 is the certainty equivalent of the $1. and the systematic risk premium is 3 percent. changes in external factors. such as the Capital Asset Pricing Model. Rather. the expected cash flows ($780) represent the probability-weighted average of the 3 possible outcomes. including economic or market conditions. However. the expected cash flows are discounted at a rate that corresponds to an expected rate associated with probability-weighted cash flows (expected rate of return).200 for a certain cash flow of $1. adjusted for changes in circumstances occurring subsequently (for example. a reporting entity might use realized cash flows for some relevant past period. considering the assumptions of market participants. if one were willing to trade an expected cash flow of $1. can be used to estimate the expected rate of return.200 (the $200 would represent the cash risk premium). Specifically: 51 . These risk-adjusted expected cash flows represent a certainty-equivalent cash flow. Models used for pricing risky assets. it likely will be higher than the discount rate used in Method 1 of the expected present value technique. Risk adjusted rate of return (Method 2) : of the expected present value technique adjusts for systematic (market) risk by adding a risk premium to the risk-free interest rate. it is not always necessary to consider distributions of literally all possible cash flows using complex models and techniques to apply the expected present value technique.000. In this simple illustration. the present value (fair value) of the asset's cash flows is the same ($722) whether determined under Method 1 or Method 2.Certainty equivalent cash-flow (Method 1) : of the expected present value technique adjusts the expected cash flows for the systematic (market) risk by subtracting a cash risk premium (risk-adjusted expected cash flows). Because the discount rate used in the discount rate adjustment technique is a rate of return relating to conditional cash flows. which is discounted at a risk-free interest rate. A certainty-equivalent cash flow refers to an expected cash flow (as defined). For example. one would be indifferent as to the asset held.

52 . Under Method 2. For example. either Method 1 or Method 2 could be used.08)]). the expected cash flows are adjusted for systematic (market) risk. the expected cash flows are discounted at an expected rate of return of 8 percent (the 5 percent risk free interest rate plus the 3 percent systematic risk premium). The selection of Method 1 or Method 2 will depend on facts and circumstances specific to the asset or liability being measured.05). b. the expected cash flows are not adjusted for systematic (market) risk. The $758 is the certainty equivalent of $780 and is discounted at the risk-free interest rate (5 percent). such adjustment could be derived from an asset pricing model using the concept of certainty equivalents. When using an expected present value technique to measure fair value.05/1.08). the risk adjustment (cash risk premium of $22) could be determined based on the systematic risk premium of 3 percent ($780 – [$780 (1. Under Method 1. Rather. The present value (fair value) of the asset is $722 ($758/1. which results in risk-adjusted expected cash flows of $758 ($780 – $22). the adjustment for that risk is included in the discount rate. In the absence of market data directly indicating the amount of the risk adjustment. Thus. the extent to which sufficient data are available. The present value (fair value) of the asset is $722 ($780/1.a. and the judgments applied.

THE MARKET APPROACH (RELATIVE VALUATION APPROACH) Market value is also known as extrinsic value. In discounted cash flow valuation. would enable an investor to achieve returns greater than those that could be obtained by holding a randomly selected portfolio of individual stocks.” which is a term loosely used in the finance literature to characterize a price series where all subsequent price changes represent random departures from previous prices. The accepted view was that when information arises. always changing always mystifying. The market. The prices that move in “random walk” can not be predicted. The logic of the random walk idea is that if the flow of information is unimpeded and information is immediately reflected in stock prices. we are attempting to estimate the intrinsic value of an asset based upon its capacity to generate cash flows in the future. nor even fundamental analysis. If the market is correct. at least on average. a generation ago. which is the analysis of financial information such as company earnings and asset values to help investors select “undervalued” stocks. There is a significant philosophical difference between discounted cash flow and relative valuation. the news spreads very quickly and is incorporated into the prices of securities without delay. is like a beautiful womanendlessly fascinating endlessly complex. In relative valuation. in the way it prices assets. at least not with comparable risk. says Mr. If. Damodaran (2002) notes that almost 90% of equity research valuations and 50% of acquisition valuations use some combination of multiples and comparable companies and are thus relative valuations. we are making a judgment on how much an asset is worth by looking at what the market is paying for similar assets. however. The efficient market hypothesis is associated with the idea of a “random walk. then the subject asset (or property) will realize a price something near to it. Johnson in Adam smith's The Money Game.3. let we first go through the past studies and beliefs of the economist and financial analyst about the correctness of and dependency on Market prices. neither technical analysis. discounted cash flow valuations can deviate from relative valuations. The basis of market value is the assumption that if comparable Asset (or property) has fetched a certain price. In relative valuation. Thus. then tomorrow’s price change will reflect only tomorrow’s news and will be independent 53 . which is the study of past stock prices in an attempt to predict future prices. The probability of prices moving either up or down is equal. the market is systematically over pricing or under pricing a group of assets or an entire sector. we have given up on estimating intrinsic value and essentially put our trust in markets getting it right. The efficient market hypothesis (EMH) was widely accepted by academic financial economists. It was generally believed that securities markets were extremely efficient in reflecting information about individual stocks and about the stock market as a whole. Before going long to consider “Market approach”. on average. It can be argued that most valuations are relative valuations. discounted cash flow and relative valuations may converge.

thus. As a result. Therefore. for the most part. Formal statistical tests of the ability of dividend yields (that is. and once they are accounted for. therefore. It assumes that all foreseeable events have already been built into the current market price.” Efficient market theory submits that in an efficient market all investors receive information instantly and that it is understood and analyzed by all the market players and is immediately reflected in the market prices. This information also contains the rumors and wrong beliefs of investors and market players. the ratio of dividend to stock price) to forecast future returns have been conducted by Fama and French (1988) and Campbell and Shiller (1988). Fama and French suggest that size may be a far better proxy for risk than beta. Burton Malkiel uses definition of efficient financial markets that such markets do not allow investors to earn above-average returns without accepting aboveaverage risks. as much as 40 percent of the variance of future returns for the stock market as a whole can be predicted on the basis of the initial dividend yield of the market index. 54 . Depending on the forecast horizon involved. They conclude that equity returns have been predictable in the past to a considerable extent. at every point in time represents the latest position at all times. Fama and French (1997) also conclude that the P/BV effect is important in many world stock markets other than the United States. and they came to believe that future stock prices are somewhat predictable on the basis of past stock price patterns as well as certain “fundamental” valuation metrics. little additional influence can be attributed to P/E multiples. Campbell and Shiller (1998) report that initial P/E ratios explained as much as 40 percent of the variance of future returns. the dependability of the size phenomenon is also open to question. But news is by definition unpredictable. The market values are very sensitive and changes with each new information. Markets can be efficient even if stock prices exhibit greater volatility than can apparently be explained by fundamentals such as earnings and dividends. On the other hand. But as we know. They emphasized psychological and behavioral elements of stock-price determination. The market price. accurately. resulting price changes must be unpredictable and random.of the price changes today. it influences by irrelevant facts and information as well as by personal thoughts and interpretation of information by market players. and. The efficient market theory submits it is not possible to make profits looking at old data or by studying the patterns of previous price changes. He believes that “the markets can be efficient even if many market participants are quite irrational.” Further to his believes he adds that “Many of us economists who believe in efficiency do so because we view markets as amazingly successful devices for reflecting new information rapidly and. Above all. many financial economists and statisticians believe that stock prices are at least partially predictable. prices fully reflect all known information. we believe that financial markets are efficient because they don’t allow investors to earn above-average risk adjusted returns. Fama and French (1993) concluded that size and price-to-book-value together provide considerable explanatory power for future returns. Prof.

The guideline publicly traded company method is appropriate when similar and relevant proxy companies may be identified and employed in estimating the value of a closely held company. Price to Earnings. etc. and other users of financial information.. etc. EBIT etc) Book value (or replacement value) multiple Revenue Multiples Business specific Multiple 55 . customer concentration. access to financing. the Board concluded that quoted market prices provide the most reliable measure of fair value. Quoted market prices are easy to obtain and are reliable and verifiable.(PAT. EV to EBITDA. but these public company multiples usually need to be discounted significantly to reflect the higher risks (e. Adjustments are commonly made to these valuation measures before applying to the subject company to ensure an “apples-to-apples” comparison. EV to EBIT. One or many comparable sales might be considered under this method depending on the data available and the degree of similarity to the company being valued. Commonly used Multiples Business can be valued based on the multiples like Earning multiples. public company transactions. The method might involve private company transactions. This method involves using market multiples derived from market prices of stocks for companies that are engaged in the same or similar industries as the subject company. EBITDA. Valuation Techniques There are two primary sources or methods that can be applied to determine a value based on market transactions or market behavior. creditors. Depending on the source of data available and the underlying company being valued. Guideline Public Company Method – The premise of the guideline company method is based on the economic principle of substitution stating that one will not pay more for an asset than the amount at which they can acquire an equally desirable substitute.g. a variety of valuation measures might be used including Enterprise Value (EV) to Sales. management depth. The theory behind this approach is that valuation measures of similar companies that have been sold in arms-length transactions should represent a good proxy for the specific company being valued. This can be a helpful tool in valuing private companies. Merger and Acquisition Method (Comparable Sales or completed transaction) – This method involves reviewing transactions for companies that are in the same or similar line of business as the company being valued and then applying the relevant pricing multiples to the subject company to determine its value.) inherent in smaller private companies as well as the “lack of marketability” of private company stock. as well as public company valuation measures using current share market data. Those are used and relied upon regularly and are well understood by investors.Under FAS 157.

Although a simple indicator to calculate. than it is to compare earnings or book value multiples. P/R Ratio = Market Value / Revenue Business Specific Multiple 56 . appraisers often misuse this term and place more value in the P/E than is warranted. The accounting estimate of book value is determined by accounting rules and is heavily influenced by the original price paid for assets and any accounting adjustments (such as depreciation) made since. Both EBIT and EBITDA are independent of capital structure. As a result. so differences in capital structure among companies should not introduce bias when one is using the EBIT and EBITDA multiples to estimate total enterprise values. with different accounting systems at work. The result will be different under each different choice. is to use the ratio of the value of a business to the revenues it generates. P/E Ratio = Market Value (OR Price) / Earnings It may be based on trailing data (historical figure) or forward data (estimates) or average of both.or undervalued a business or assets are. The book figure being accounted on historical basis is easy to compare. while at other times it is next to meaningless. is that it becomes far easier to compare firms in different markets.Price to Earnings (P/E) Multiple When it comes to valuing equity or ownership. in order to give effect of current value of assets of the business. share price used with earnings per share is a right measure but if it is used with rate of return on capital then the measure is not correct one. It can be extremely informative in some situations. the P/E is actually quite difficult to interpret. Price to Book value (OR replacement value) multiple This is also a widely used multiple to compare the equity value of the value of firm. For example. An alternative approach. P/BV Ratio = Market Value / Book Value of Capital or Owners’ fund Sometimes. Price to Revenue multiple Both earnings and book value are accounting measures and are determined by accounting rules and principles. Unlike net income. The market capitalization is divided by the book value of capital to determine a multiple. which is far less affected by accounting choices. The advantage of using revenue multiples. Proposed buyer often look at the relationship between the price they pay for a business and the book value of equity (or net worth) as a measure of how over. the appraiser should take care that the earnings used here to derive a multiple is proper in relation to price applied. the price/earnings ratio is one of the oldest and most frequently used metrics. In other words. however. the balance sheet is redrafted with adjusted values and then the adjusted book value so arrived is used with market capitalization to derive a P/BV multiple. Rate of return on capital can be applied with value of firm or business value.

while there is scope for bias in any type of valuation.why is relative valuation so widely used? There are several reasons. One of the key tests to run on a multiple is to examine whether the numerator and denominator are defined consistently. or too low. then the denominator should be an equity value as well. If the price of particular sector is over valued then based on specific multiple we also tend to over cast the estimated value of target firm. The strengths of relative valuation are also its weaknesses. Selection and calculation of valuation multiples 4. a relative valuation is much more likely to reflect the current mood of the market. It 57 . when it is under valuing these firms. book value and revenue multiples are multiples that can be computed for firms in any sector and across the entire market. If the numerator is a firm value. For example. the question is . when the market is over valuing comparable firms. growth potential. The question comes here is : What is then a comparable firm? A comparable firm is one with cash flows. there are some multiples that are specific to a sector. valuing a call centre based on per seat criteria or a steel manufacturing business on the basis of per ton production. Steps to determine a value under market approach 1. Selection of similar public companies and transactions 2. since it is an attempt to measure relative and not intrinsic value. one must keep following in mind: When discussing a valuation based upon a multiple is to ensure that everyone in the discussion is using the same definition for that multiple. In other words. So. The caution here requires is to take care in analyzing the behavior of the entire sector or industry.While earnings. For example. Final adjustments Multiples are easy to use and intuitive. knowing the distributional characteristics of a multiple is a key part of using that multiple to identify under or over valued firms. Like. while using P/E multiple the price per share will be used with earnings per share while EBITDA multiple is be used to value a firm since the numerator and denominator are both firm value measures. the fact that multiples reflect the market mood also implies that using relative valuation to estimate the value of an asset can result in values that are too high. it is always useful to have a sense of what a high value. Like forward P/E must not be compared with trailing P/E. Also. Also. and risk similar to the firm being valued. If the numerator for a multiple is an equity value. When using a multiple. they are also easy to misuse. Financial analysis and comparison 3. a low value or a typical value for that multiple is in the market. Application to the company being valued 5. To illustrate. the lack of transparency regarding the underlying assumptions in relative valuations makes them particularly vulnerable to manipulation. a valuation based upon a multiple and comparable firms can be completed with far fewer assumptions and far more quickly than a discounted cash flow valuation. then the denominator should be a firm value as well. While using Relative approach for valuing a business. A relative valuation is simpler to understand and easier to present to clients and customers than a discounted cash flow valuation.

and cash flow profiles and therefore can be compared with much more legitimacy. So. Boatman and Baskin (1981) compare the precision of PE ratio estimates that emerge from using a random sample from within the same sector and a narrower set of firms with the most similar 10-year average growth rate in earnings and conclude that the latter yields better estimates. There is no reason why a firm cannot be compared with another firm in a very different business. In most analyses. firms with higher growth rates. growth and cash flows . growth and risk. growth and cash flow characteristics. Thus. growth and cash flow generating potential. the value of a firm is a function of three variables – its capacity to generate cash flows. Nowhere in this definition is there a component that relates to the industry or sector to which a firm belongs. the expected growth in these cash flows and the uncertainty associated with these cash flows. less risk and greater cash flow generating potential should trade at higher multiples than firms with lower growth. it is difficult to determine “the right comparable”. analysts define comparable firms to be other firms in the firm’s business or businesses. whether it is of earnings. if the two firms have the same risk. Traditional analysis is built on the premise that firms in the same sector are comparable firms. then. revenues or book value. Every multiple. we can summarize based on valuation theory that a comparable firm is one which is similar to the one being analyzed in terms of fundamentals.is priced. In discounted cash flow valuation.would be ideal if we could value a firm by looking at how an exactly identical firm in terms of risk. higher risk and less cash flow potential. The implicit assumption being made here is that firms in the same sector have similar risk. However in reality. a telecommunications firm can be compared to a software firm. A major disadvantage of this valuation method is that often. growth. Multiples are sensitive to the following qualitative factors when comparing similar companies or businesses: Operations – Relative competitive position – Industry – Products – Markets – Distribution channels – Customer base – Seasonality Financial Aspects – Size – Leverage – Margins & Profitability – Growth prospects – Shareholder base – Market conditions – Consideration paid – Surrounding circumstances 58 . Intuitively. growth and cash flow profiles across firms within a sector are large. if the two are identical in terms of cash flows. is a function of the same three variables – risk. it is also difficult to define firms in the same sector as comparable firms if differences in risk.

In order to normalize the comparison.has high gearing or . telecomm) and price to book ratios common in financial service company valuations. Fernandez (2001) presents evidence on the relative popularity of different multiples at the research arm of one investment bank – Morgan Stanley Europe – and notes that PE ratios and EV/EBITDA multiples are the most frequently employed. Liu. It is impossible to find exactly identical firms to the one you are valuing and figuring out how to control for the differences is a significant part of relative valuation. we will end up with firms that are different from the firm we are valuing. The differences may be small on some variables and large on others and we will have to control for these differences in a relative valuation.879 firm-year observations between 1982 and 1999 and suggest that multiples of forecasted earnings per share do best in explaining pricing differences. vary greatly by company size. the accuracy and bias of value estimates. and the extent of intangible value in the company.is dependent on one product or one customer . it is important that the earnings multiple of each comparator is adjusted for points of difference between the comparator and the company being valued. that multiples of sales and operating cash flows do 59 . the firm will be viewed as over valued (if its multiple is higher than the average) or undervalued (if its multiple is lower than the average). the difference on the multiple cannot be explained by the fundamentals. less able generally to withstand adverse economic conditions . Damodaran (2002) notes that the usage of multiples varies widely across sectors.is reliant on a small number of key employees . These differences are generally controlled by using subjective adjustments or using modified multiple or applying statistical technique like sector regression or Marker regression. as well as the relative performance of the multiples. the earnings before interest. The value of business may be reduced if it: . Finally. taxes. If. and amortization (EBITDA) multiple generally yields better estimates than does the EBIT multiple. in your judgment. company profitability. No matter how carefully we construct our list of comparable firms. with Enterprise Value/EBITDA multiples dominating valuations of heavy infrastructure businesses (cable.for any other reason has poor quality earnings. the question now is which multiple is to select? Or which is better than the others? Is it depends on fundamentals or upon type of Industry or upon size or any other factor? Erik Lie and Heidi J. Which Multiple is to use? Going through various alternates available for choosing a multiple. Lie (2002) while evaluating the various multiples came on the findings that the asset multiple (market value to book value of assets) generally generates more precise and less biased estimates than do the sales and the earnings multiple.is smaller and less diverse than the comparator(s) and therefore. Nissim and Thomas (2002) compare how well different multiples do in pricing 19. Also. depreciation.

worst and that multiples of book value and EBITDA fall in the middle. Lie and Lie (2002) examine 10 different multiples across 8,621 companies between 1998 and 1999 and arrive at similar conclusions. Erik Lie and Heidi J. Lie (2002), upon their study of comparing the performance of various multiples concludes that although practitioners and academic researchers frequently use multiples to assess company values, there is no consensus as to which multiple performs best. They result that using forecasted earnings rather than trailing earnings improves the estimates of the P/E multiple. This decision of choosing appropriate multiple is also dependent on the judgment of the appraiser using best of his skills and experience considering all, including the fundamentals, type of industry, size of company, nature of transaction and of course, the purpose of valuation.

No one human can be predicted even to run the same company the same way as another would. Where, then, is comparability? Comparable value is just an appraisal term, Comparability evaluation of ‘‘hard’’ assets is a valuable determinant for business’s factory, premises, raw material, and equipment and fixturing, but not for it’s ‘‘intangible’’ portions.

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WHICH APPROACH IS MORE CERTAIN OR LESS SUBJECTIVE? Obviously, the asset approach can determine the current value of assets on stand alone basis or sometimes even on collective basis and so less uncertain or better estimation is possible. BUT this is good while adopting a liquidation premise. Is it a best approach using going concern premise? The answer is exceptionally yes. The “going concern” itself indicates value of intangible and valuing intangible on the basis of cost incurred may not be a proper respect to its worth. It is difficult to identify and separate the earnings derived from intangible assets. For doing so, again the uncertainty and subjectivity enters into the field. Business being run with profit motive, the concentrating point is obviously EARNINGS and therefore, it becomes necessary to give reasonable weight age to earnings approach and market approach. The two approaches to valuation – discounted cash flow valuation and relative valuation – will generally yield different estimates of value for the same firm at the same point in time. It is even possible for one approach to generate the result that the business is under valued while the other concludes that it is over valued. Furthermore, even within relative valuation, we can arrive at different estimates of value depending upon which multiple we use and what firms we based the relative valuation on. The differences in value between discounted cash flow valuation and relative valuation come from different views of market efficiency, or put more precisely, market inefficiency. In discounted cash flow valuation, we assume that markets make mistakes, that they correct these mistakes over time, and that these mistakes can often occur across entire sectors or even the entire market. In relative valuation, we assume that while markets make mistakes on individual stocks, they are correct on average. As narrated by Aswath Damodaran “it was argued that relative valuations require fewer assumptions than discounted cash flow valuations. While this is technically true, it is only so on the surface. In reality, you make just as many assumptions when you do a relative valuation as you make in a discounted cash flow valuation. The difference is that the assumptions in a relative valuation are implicit and unstated, whereas those in discounted cash flow valuation are explicit. The two primary questions that you need to answer before using a multiple are: What are the fundamentals that determine at what multiple a firm should trade? How do changes in the fundamentals affect the multiple?”

To conclude, we can say that irrespective of approach being used, the appraiser has to apply his mind in choosing applicable premise of value, standard of value and based on these selecting the techniques to apply so as to serve the purpose of valuation.

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DETERMINATION OF CONCLUSIVE VALUE

We have gone through various approaches and some of the widely used techniques amongst numerous techniques under each of these approaches. Each one has specific importance with relative subjectivity and limitations. Some experts are favouring discounted cash flow technique over others at the same time others are treating it as prejudicial being consists of so many assumptions and so highly subjective. According to them, value determination based on market approach is robust and widely accepted. But again as we discussed earlier, though very popular and widely used, it is also not free from subjectivity and implied set of assumptions. The problem may become undemanding if the value arrived from different techniques are adjacent. But mostly the fact reveals contrary. There may be wide gap between the values determined using different approaches which quietly puts appraiser in awkward situation. In such situations, the appraiser stands on a point to revalidate his own assumptions and decisions. Let we go through some views and guidelines helpful (?) for deriving a conclusion. Which Technique to prefer to arrive at a conclusion? To assume there is only one correct estimate of value is a mistake, and ‘‘right’’ is a matter of opinion. In most of the situations the shortcoming is not lack of sophistication of the valuation model but it is our inherent limitation in forecasting the future. Though we need to equip ourselves with contemporary methods and practices it may be wise to constantly remind ourselves that valuation is essentially about trying to peek into the future which is uncertain. It’s difficult to gauge valuation accuracy without standards. Being realistic is perhaps a more appropriate objective. When appraiser prefers more than one valuation technique, many times he thinks it proper to arrive at the conclusive business value on the basis of weighing different techniques as per his perceptions about the business and need of the valuation. This approach method of giving appropriate weights to different technique is also a debatable issue. Some experts believe that individual technique has its own unique feature and business value, using that particular technique, is arrived at with relevant assumptions and facts. It is rare that the value derived by using some other technique will be fair if tested with the same assumptions. For example, P/E ratio calculated on the basis of value derived by DCF method and that is derived by adjusting the peer company’s or industry’s average will rarely shows same figure. Giving different weight age to various approaches will dilute the effect of unique considerations and subjective judgment of appraiser and therefore resultant figure based on appropriate weight age to different techniques may not fit with appraiser’s own BEST set of assumptions and considerations for particular technique. While the other group of experts believes that though various techniques applied for valuation show different values individually, more weight age to less subjective consideration will help to derive the nearest value and also, dilute the limitations of individual

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So. one usually wants to know how much weight is accorded to the various techniques. Revenue Ruling 59-60 of Internal Revenue Service (IRS) at US. But when appraiser uses subjective weighting. 7.. yield and market price were the methods used by applying appropriate weights for determination of the exchange ratio in that case. For example.technique by considering more aspects of business to arrive at a conclusive value. AVERAGE OF FACTORS Because valuations cannot be made on the basis of a prescribed formula. it considers simple net asset value and earning capacity as a deciding factor for determining a fair value.1) prescribes “The fair value will be determined on the basis of average of the net asset value and the reworked profit-earning capacity value. CCI guidelines. market perceptions (market value) and performance strength (DCF based intrinsic value) of the business and therefore better than a value derived from any one technique or approach. For this reason. In arriving at a conclusion of value. capitalized earnings and capitalized dividends) and basing the valuation on the result. A good report will also go on to demonstrate that all relevant factors are considered while deciding the weights. Such a process excludes active consideration of other pertinent factors and the end result cannot be supported by a realistic application of the significant facts in the case except by means of chance. it will be recognised and made use of ……. Para 42 of the statement is produced below: “Conclusion of Value 42. However. Net assets. a value arrived on the basis of considering proper weight ages of market value. “Statement on standards for valuation services” issued by the American Institute of Certified Professional Accountants (AICPA) consulting services executive committee also provides for consideration of more than one approach while deriving a conclusion of value. with a disclaimer that there is no empirical basis for assigning mathematical weights. there is no means whereby the various applicable factors in a particular case can be assigned mathematical weights in deriving the fair market value. book value. DFC value and Net asset value will take care of existing position (net asset). Thus. 1990 (Para 8. The Supreme Court judgment in the Hindustan Lever Employees Union v Hindustan Lever Limited and others (1995) 83 Comp Cases 30 has held that fair value based on averaging the values arrived at by using a combination of valuation methods is appropriate for arriving at relative values in determination of exchange ratio. no useful purpose is served by taking an average of several factors (for example. while the market value will not be a direct “input” in valuation. and that the weights are presented only to help clarifying the thought process of the analyst. the guidelines read altogether are criticized as a conservative approach and not practically preferred by experts.”. the valuation analyst should: 63 . So. rejects a mathematical weighting of approaches with the following language: SEC. the appraisers usually apply mathematical weights when giving weight to two or more approaches.

we can conclude that the conclusive value rests on COMMON SENSE AND REASONABLENESS. To assure that integrity. Each methodology provides additional clarity on valuation and evaluating results of numerous methods provides a better understanding of a business’ true “worth”. the valuer may consider the outcome of these different valuation methodologies so that the results of one particular method may be used as a cross-check of values or to corroborate or otherwise be used in conjunction with one or more other methodologies in order to determine the Fair value of Investment”. So. Determine. A fair amount of experience. which helps its possessor to draw correct conclusions. providing a valid and supportable value. not all methodologies would be appropriate for all situations.a. c.’’ John Maynard Keynes Actual pricing of business (Buy sell transaction) 64 . There are plenty of pros and cons for each method. your type of business. While there is no such thing as absolute truth in business valuation. ‘‘ The theory of economics does not furnish a body of settled conclusions immediately applicable to policy. Correlate and reconcile the results obtained under the different approaches and methods used. a technique of thinking. computing a weighted average to arrive at their final number. many valuation professionals use more than one method. It is a method rather than a doctrine.. Assess the reliability of the results under the different approaches and methods using the information gathered during the valuation engagement. This wide variety of methods available can be a confusing array to choose from. It narrates that ”…. The important factor in any valuation is that the method used is relevant to your purpose of valuation. whether the conclusion of value should reflect (1) the results of one valuation approach and method or (2) a combination of the results of more than one valuation approach and method. 2006) also permits usage of more than one technique to arrive at the fair value of investment. While there are numerous valuation methodologies that can be utilized to begin establishing value. based on items a and b. confidence in the eventual number is based on the integrity of the underlying process. b. an apparatus of the mind.Where the valuer considers that several methodologies are appropriate to value a specific investment. judgment and corporate finance and equity markets skill is required in each case as even the seemingly straightforward tools contain several hidden layers of complexity and subtle ties.” IPEV guidelines (October.

This does not mean that the Seller should not value its business on DCF. nearly half opted for radiation therapy. non-competition. lung cancer patients at a certain hospital had a shorter life expectancy if they received radiation therapy than if they opted for surgery. and the additional investment the Buyer will have to make in company in order to tap the targeted market. Patients who were given the same choice expressed in terms of life expectancy. if the Seller can objectively argue value that the Buyer can verify to its satisfaction. Prospect Theory examines the ways that people are affected by their emotions and also make intellectual errors when making choices. When patients were presented with the options in terms of the risk of death under surgery. For example. the Buyer will try to avoid pegging valuation on future markets or on the Seller's plans.and question the Buyer on its assumptions in setting its price. Developed by psychologists Daniel Kahneman and Amos Tversky.the valuation will generally be high based on the potential for the targeted market. Rather. that the small-company appraisal process begins with evaluating human behavior through the antics of their buyers and sellers. No facts were hidden: they were simply presented in a different light.such as the Discounted Cash Flow Technique ("DCF"). the Buyer will tell the Seller what he or she is willing to pay . Not nearly true for publicly held business evaluations. The overall difference in life expectancy was not great and it was difficult to choose which therapy to accept. Unlike the Seller. Prospect Theory is an important contribution to the psychological aspect of risk and decisiontaking. But these will be in addition to the value of “business” proposed for sale. employment and consulting fees.based on its subjective view of the attractiveness of the asset or business or company. It is an opportunity cost of seller which he will loose upon selling the business. The seller may want to increase the total transaction price by proposing that separate consideration be paid for other items of value to the Buyer. but a few patients died on the operating table. such as lock-ups. the risks inherent in operating the Seller's business. As this valuation method pegs the company's value on the growth of future markets . the Buyer will minimize value by looking at the maturity of Seller. but some do so without knowing they do. break up fees etc. This represents the first of many issues that the business appraiser must resolve during the process of estimating closely held business value. This might have the effect of raising the price. and what it thinks other competitors might pay if they were also to pursue the Seller. Essentially. Instead. 65 . non-employment. The DCF accounts for the going-concern value of the company as indicated by the present value of the company's projected cash flows for a determined maturity period of from 3 to 5 years. Much depends on how the problem is depicted. only a fifth chose radiation therapy.Seller will try to maximize the value of the company by applying a forward-looking valuation methodology . Not all appraisers will agree. the Seller should base its price on DCF .

Services Sector Services sector refers to enterprises engaged in providing or rendering of services. 1722(E) dated October 5.10 crore.2 lakh should be for working capital requirements except in case of professionally qualified medical practitioners setting up of practice in semi-urban and rural areas. Small. 66 . Please refer First Schedule to the Industries (Development and Regulation) Act. and iii. 2006) is more than Rs.5 crore but does not exceed Rs. A small enterprise is an enterprise where the investment in plant and machinery [original cost excluding land and building and the items specified by the Ministry of Small Scale Industries vide its notification No. it is a general term and difficult to define. The definition of Micro. Practically. S. 1722(E) dated October 5. and Medium Enterprises.10 lakh. The definition of Micro.BUSINESS VALUATION and MSMEs What is MSME business? MSME business stands for business run by Micro. S. Small and Medium Enterprises under the manufacturing sector is as below: i.10 lakh of which not more than Rs. it is defined as follow: Manufacturing Sector Manufacturing sector refers to enterprises engaged in manufacture or production. 1722(E) dated October 5. Small and Medium Enterprises under the services sector is as below: i. ii. A micro enterprise is an enterprise where investment in plant and machinery [original cost excluding land and building and the items specified by the Ministry of Small Scale Industries vide its notification No. In India.3 lakh for working capital requirements). 25 lakh.O.O. 1951 for the list of eligible industries engaged in the manufacturing sector. A medium enterprise is an enterprise where the investment in plant and machinery (original cost excluding land and building and the items specified by the Ministry of Small Scale Industries vide its notification No. small business (whose original cost price of the equipment used for the purpose of business does not exceed Rs. 2006] is more than Rs. the borrowing limits should not exceed Rs. 2006] does not exceed Rs.O.5 crore.15 lakh with a sub-ceiling of Rs. These will include small road & water transport operators (owning a fleet of vehicles not exceeding ten vehicles).20 lakh) and professional & self employed persons (whose borrowing limits do not exceed Rs. A micro enterprise is an enterprise where the investment in equipment does not exceed Rs. S. processing or preservation of goods.25 lakh but does not exceed Rs.

And a medium sized business unit may have its activities spread in many regions or with numbers of franchisees. The definition is restricted to investment / borrowings only. A small enterprise is an enterprise where the investment in equipment is more than Rs. My answer is “NO”. The fundamentals of 67 . A medium enterprise is an enterprise where the investment in equipment is more than Rs.5 crore. the important thing is to know whether the fundamentals of valuation changes when applied for business unit which are relatively small in size. there can not be any strict definition for a business to regard as a small or medium or large or giant.2 crore but does not exceed Rs. It is matter of debate to fix a basis for treatment of business as a small or large.10 lakh but does not exceed Rs.ii. it constitutes Manufacturing sector and Service sector units.2 crore. The definition of MSME varies from country to country and from mind to mind. In our case. and iii. is there any need to separate the relatively small businesses from other large businesses? Whether investment criteria is enough or sufficient to allot an identity of MSME. It may have branches abroad. I am going to analyze the definition. for business valuation. So. But our question for Business valuation is. to any business or unit? What are the factors which differentiate the relevant small business from large businesses? Business Valuation and MSMEs In general.

reflecting their limited access to debt capital and a frequent reluctance of owners to take on the risk 68 . in general and (2) functioning of which are controlled by the owners. But yes. etc. the business may rely on a single person for sales. Many small businesses operate with little or no debt. and the owner usually must personally guarantee debt. Access to debt capital is also more limited because of the higher risk of smaller businesses. Of course. influence of client. I have considered the businesses (1) which are relatively small and medium in size. leaders of small businesses frequently are entrepreneurs who are not comfortable with delegation of management duties to others and may not work well with middle managers. friends or relatives. To be profitable. friends and/or owner employees. Small businesses often have a high degree of reliance on one or more key owner/managers.valuation like Premises of value. the difficulties to be faced and the considerations require by an appraiser changes due to some inherent characteristics of relatively small businesses. Thus. family members. and/or personal contacts and may not be able to survive without that person. themselves. size of discount for lack of marketability and lack of control. In extreme cases. valuation approaches techniques remains unchanged irrespective of size and identity. Professional middle managers are a luxury that small businesses seldom can afford. The cost of borrowing is higher. Characteristics of MSME Some of the major characteristics observed are as follows: Ownership MSME businesses usually are owned by individuals. Their statements tend to be tax oriented rather than oriented to stockholder disclosure as in larger companies. Small companies are apt to have a board of directors composed of insiders. Whereas large companies usually keep separate records for the preparation of tax returns and generally accepted accounting principles for financial statements. Standards of value. In addition.members of the owner’s family and/or employees. the need of valuation differs in case of MSMEs when compared to large of public Companies. and are likely to be highly dependent on the owner/manager. if any. Thus they lack the diverse expertise and perspective which otherwise outsiders can bring to a board of directors. quantifying the size risk and business specific risk. And referred these businesses as “MSME” businesses throughout this study. In includes availability and reliability of financial data and other information. technical expertise. Here. Financial records Small businesses tend to have lower-quality financial statements that are less likely to have been prepared by a professional accountant or qualified auditor. small businesses that have no outside owners have no reason to go to the expense of maintaining separate records for tax and book purposes. their financial statements tend to reflect a bias toward minimizing income and taxes. small businesses must operate with a very thin management group. Access to Capital Small businesses have less access to capital than larger companies and often must rely on capital infusions from the owner family.

markets. we can say that “Risk tends to increase as size decreases”. Good managers may perceive less opportunity for promotions because of the company’s small size and the owning family’s dominance on top management positions. Knowledge of markets and competition must come from the experience of a relatively limited number of managers—quite often the experience of a single person.of substantial debt. Many small business owners minimize debt to reduce risk during economic downturns and to increase the probability of keeping the business in the family. Frequently they are very dependent on a few key customers. MSME unit generally run by owners themselves and they have direct control over workings and performance of the business. Trade associations supplement this personal knowledge of the market. The obligated task of management in the publicly traded company is to maximize bottom-line profits. Under MSME. the portfolio of operations or products frequently reflects the interests and contacts of a particular owner. and geographic location. Thus small businesses operating in industries in which the trade associations are strong may be at less of a disadvantage. Practically. Sometimes these operations or products have few synergies. as when a manufacturer’s key raw material is a by-product of a single large local manufacturer. Small businesses can be less informed about their market and competition. They also may be dependent on a key supplier. Summary Differences between Public Companies and MSMEs (as they relate to business value) 1. 69 . The closely held Companies or small enterprises runs for own as oppose to public companies which run for profit or better returns to shareholders. The owner’s goal is to maximize own profit whether separable from business or not. owners ‘‘bet’’ their own money and returns on the assets of their own business. Other Operational Characteristics Small businesses can lack diversity in products. These characteristics tend to be extreme in the smallest of small businesses. whereas the elective task in the MSME is to minimize profits that can be taxed. the returns (even negative returns) under small enterprises go on the hands of owners only irrespective whether financials are reflecting the facts or not. and the portfolio may have little appeal to potential buyers. They may not be able to offer competitive benefit packages and may be in less desirable locations. as when a small manufacturing company primarily produces parts for a single automobile manufacturer. So in general. They are seldom in a position to pay for sophisticated market studies. Small businesses may have difficulty competing for employees. The characteristics of small businesses tend normally to result in overall higher risk than is found in larger businesses. Stockholders of the publicly traded company are principally investors in the stock market rather than the company itself. 2. In small companies. Under showing profits to save tax is a very good example.

we can conclude that perceptions of value in MSME are individually swayed and factually weighted by productivity of assets employed.3. The application of recognized valuation methodology and rigorous analysis of the closely held entity provides the foundation for valuation of business. Not their shares but the value of businesses themselves is subjected more to industry and local market economies. In cases of closely held businesses. this can present the classic dilemma of ‘‘getting lost in the numbers. Professional service organizations. This requires us to examine the following: (a) general market conditions. Take the specific practitioner out of the business. are among the more difficult types of businesses for which to establish an intangible value. and (c) individual perceptions. the concept for values must be carried out to include tangible assets. and perception . consultants. involving many issues that are unrelated to a specific company’s performance. The biggest difference between valuing business of the public Companies and nonpublic business is lack of information. 4. personalities. MSME have virtually no stock market value and serve only the interests and wishes of the investor(s) in the business assets. with safety in mind. therefore. Stocks of the public company can fall separately under the influence of supply and demand. and broadly influenced by general market economies—perhaps. manpower. because individuals are quite regularly one and the same as management. A ‘‘business continuation’’ risk tends to decrease with increasing size of staff and. including any reference to facts. cannot be overlooked. by the demands of administrative duty. the value of a privately owned company must be calculated using both qualitative and quantitative analysis.’’ and how much of that value will remain if he or she leaves? To the unwary. individual stockholders tend to have little or no direct control in how the company runs. ‘‘business’’ value depends on the skills that vary widely among individuals. (b) specific business conditions. Owners of MSME. each component of business value. when the present owner is more separated from practice work. and reputation play heavily into the generation of cash streams. a fundamental question is: How much business value is directly attributable to a ‘‘person. It may be necessary to make 70 . might change through the personal perceptions of individual calling for valuation. the purchase of a ‘‘sole practitioner’’ business can be much more risky than the purchase of a business with multiple practitioners who remain after the purchase. intangible assets. and material to produce profits. accountants. Therefore. and the cash stream will quite often suffer considerably. Unlike a publicly traded company that has a published market-driven share price.So. An Overview of the Task of Estimating Values in Small Companies Business value depends on the effective employment of capital. In other words.’’ Subsequently. These ‘‘people’’ or owner-restrictive elements can be present in all types of small businesses and. interwoven with other company stock offerings. Although company performance influences stock market performance of the public company’s trade prices. such as those for physicians. machine. and so on. Practitioner characteristics. generally have all controls in how the business runs. lawyers.

publicly traded companies. time consuming and requires highly specialized professional skills. or companies involved in market transactions considered in the valuation process. The appraisal process is subjective. 71 .certain adjustments to improve comparability of the subject company to industry norms.

relatives and friends at the rate significantly different from prevailing market rate. unrecorded removal of goods for tax saving purposes. which provide no level of assurance and may not contain footnote disclosure. the analyst may have to rely on income tax returns or internally generated financial statements. and profitability Comparison to industry financial data Analysis of trends and unusual items Accounting practices vary considerably throughout the world. despite ongoing efforts to create harmonized standards. the appraiser is first required to play a role of analyst for which he needs to put the data in normalized mode. Some common practices which condense the straight reliability of financials of MSMEs and require restructuring of financials are. The accounts of small firms are prepared considering the tax friendly structure. Missing treatment of deferred tax Inconsistency in accounting practices 72 . liquidity. In other cases. deficiency in charging the depreciation on business assets. However. the special care should be taken to disclose the facts and degree of responsibility assumed based on financial statements. He must satisfy himself about the genuineness and correctness behind the reconstructed figures. This makes it vary difficult to value a business only on the basis of its annual report or financial statements. missing to account the interest. commissions. withdrawal of goods for own usage without proper accounting. treatment of personal expenses as a business expenses. • • • • • • • • • • charging the salaries and commission in name of owner or family member charging interest on loans from family. leverage. So.TESTING THE FINANCIALS A company’s historical financial statements generally provide the most reliable information for estimating future performance and risk assessment. remunerations etc foregone by owner or directors withdrawing unreasonable rent for own premises for business utilization. The process Financial statement adjustments to normalize financial position and performance Common size balance sheets and income statements Ratio analysis: asset management. reconstruction of financial becomes necessary. With accounts and information of many of MSMEs. the analyst may have to rely on compiled financial statements. If the historical information is unreliable. the transactions are not properly accounted. In many cases. one must keep the mind and vision open and to consider the documented papers only as far as possible. since the financial statements of many MSME businesses are neither audited nor reviewed. Audited financial statements are preferred. While reconstructing the financials. the quality of which may be suspect for purposes of proper financial statement analysis.

treatment of contingent liabilities etc. The comparable financial will be used to determine the extrinsic (market based value) of the business. Ratios express mathematically the relationship between performance figures and/or assets/liabilities in a form that can be easily understood and interpreted.) improving. Financial Analysis helps to decide the key factors to consider before arriving at the conclusion on valuation of business. impact of deferred tax. he also requires to consider the impact of historical transactions affecting the value of the business.The analyst is required to consider all these and other relevant factors to design a normalized financials. stable or declining the liquidity position of the business concern management efficiency of working capital debt coverage and scope for capital structuring performance efficiency like returns on equity. auditors’ qualifications. The analysis of historical financials can help the analyst to know and understand: • • • • • • • any adjustments required to reflect the true earnings potential of the company the overall trend in the business (sales. role of nonperforming assets inputs to compare with Industry or specific sector or business The conclusions derived from analysis can further be helpful for assessing the risk involved in the business and the also to develop the forecast assumptions while calculating the intrinsic value of the business. etc. nature and frequency of abnormal or exceptional items and non-recurring items. For valuation purpose. These are like. weaknesses and performance of businesses and to also determine whether it is improving or deteriorating in profitability or financial strength. Ratio analysis is the most useful tool because it helps an analyst to compare the strengths. 73 . asset utilization. profits.

comfort.VALUATION NEED FOR MSME SECTOR In the previous sections I have presented the stuff necessary while considering valuation of any business or a concern. The “Business value” is not simply a value of business but a specific value of business in the eye of the involved participants. This is due to difference in views and synergies expected by different buyers. Each transaction will have its own specific characteristic and the standards and premise of valuation should be appropriately selected to match with the characteristics of such transaction. Out of several experts in this field to whom I met. premise and the relevant approaches. the purpose is not material. So. the distance of which to “Victoria Terminus” will differ. 74 . he may choose a way amongst numbers of alternative ways available to reach at the destination. The only and the most important difference is that the destination viz. To my knowledge. The purpose of this study is to identify and present the needs of valuation in Medium. all play a crucial role while going for business appraisal. In broad terms. questions and arguments never end. Small and Micro enterprises (MSME) and to relate the best matching technique with specific purpose. Each will lead him to Mumbai but will differ in terms of time. expertise and professional judgments applied while deriving a conclusive value. or By air or By sea. the result of valuation fully depends on the competence of the valuation analyst and the experience. He may have to select an option from By road or By rail. Again. the valuation process is just like this journey BUT without knowing where to purchase the best of item “A”! Here. Each of these alternate will put him first at a specific place in Mumbai. the job of the valuation analyst is like a stranger searching a place in Mumbai to purchase item “A”. While others are of the opinion that the valuation technique should be liked with the purpose giving rise to the need for valuation. The value of business remains neutral irrespective of the change in the purpose of valuation. money etc involved with each option. Let me try to relate the valuation need with a simple understandable situation. some are of the views that the valuation technique can be industry specific or sector based but as the intention is to find a Value of the business. Being indifferent in terms of time. And so. the best of which is available only at “Victoria Terminus”. “Victoria Terminus” can be reached which is near to impossible in case of valuation. The argument behind is that business has of course different value in eye of different persons based on their specific purpose if not then why one would invest their time and energy to get or to transact for the similar amount of consideration they are departing now. Every need is specific purpose oriented and the same logic is equally applicable to valuation need. “the investment value” of a business may differ if considered for two different buyers even at the same point of time. one should not prepare an index of values presenting the different value against each of different purpose. In their views. The standards of value. comfort and money – the best option is that which puts him at a place nearest to “Victoria Terminus”. When subjectivity comes. The approaches are the different ways which help to move towards the destination.If some one wants to reach at Mumbai to purchase “A” item. this is a first study to relate the purpose with the valuation techniques which fulfill the specific need/s.

First of all. Giant or public organizations call for valuation to take a better decision relying on valuation report. For example. 53. 2) expected growth in cash in the foreseeable future. the owner believes that the Businesses in industry to which his business pertains always sell for “X” times annual revenue (the revenue multiple). 10. Thus.80.000. Giants may afford the cost involved in terms of both the transaction value as well as the statutory requirements which may not be the case applicable to MSME.).I met some of the professionals practicing in valuing the businesses and come to know that the MSME generally not come to value their businesses. What happened six months ago is not really relevant to what something is worth today. like the value of any public company share value (say Reliance Industries Ltd. that firm's revenue multiple is irrelevant to valuing this firm.98 to a high of 5. The median value indicates that half of the revenue multiples are below the median value and half are above.000.00. The owner further argues that a local competitor sold his business for three times revenue six months ago.00. the value of this business.9 and if we are valuing a firm with annual revenue of Rs. So his business is worth at least this much! The answer is: May be yes and may be no. as high as Rs. May be due to ignorance or due to the cost involved or may be its relative importance to transaction value being very less. While on a verge of selling a business. I am representing some common thoughts of the owners of MSMEs. or somewhere in between. is likely different today than six months ago because economic conditions have changed. the median value is just a convenient midpoint and does not represent the revenue multiple for any actual transaction. In short. unless this firm's cash flows and growth prospects are very similar to the competitor firm. and 3) the return the owner or proposed owner require on their investment in this business. Unless the firm that is being valued is truly a median firm.known source for business transaction data. So why should he pay someone to value a business? The short answer is that these rules of thumb are generally median multiple values. then using the industry rule of thumb for this purpose is clearly wrong. the firms would likely sell for less than three times revenue. if interest rates were higher today than 6 months ago. For example. What his business is worth today depends on three factors: 1) how much cash it generates today. we derive recent revenue multiples for firms in the auto parts industry ranging from a low of . if rates were lower today than six months ago. 75 . if according to a well. Moreover. then the value of this business could be as low as Rs. 9. even if the competitor firm was equivalent to this in every respect and both firms were sold today. Conversely. the firms may be worth more than three times revenue.000. Normally. Where this firm lies along this continuum is obviously of the utmost importance and can only be determined by a valuation approach that incorporates academically validated methods with industry-specific valuation factors.3 with a median of 2. without getting into the nuances of finance.

looking at the existing. etc. Valuing a business can help the MSME business community in numbers of ways. The second group includes person / persons proposed to establish the direct or indirect relations or having proposed interest in that specific business. (1) Existing stake holders and (2) Proposed stake holders. share holder/s. Obviously. If the apprehension of the MSME is a cost involvement then it is a duty of authorities to derive a technique whereby they can match the cost-benefit. the second group. to know the fair status and the growth of the business. While normally. employee. the first group is interested in a “Business value” being existing value. to get the finance with fair terms and confidence level. getting the fair value on sell or purchase transaction and thereby at all to get a better mental comforts. who are likely to be effected by the business value. For example. partners. share holders. to resolve the family issues involving same business or more than one businesses. the valuation of specific business can be helpful to two groups. partners. being currently outsider. to settle the sharing issues amongst the owners. like proposed buyers. statutory authorities etc.Looking positively to involve and encourage MSME to value own business/ businesses. interests in a “Business value” based on risk adjusted possible benefits that can be derived in future. The competitor or proposed entrant in the industry or sector may be interested to know the value of specific business but being outsider he may not have access on major information on specific MSME and could not give the justice to the purpose if he himself calls for valuation based on incomplete data or vague information. First group includes the existing stake holders of the business and person / persons having direct or indirect relations or having some kind of interest in business. 76 . investors. based on different perceptions the value of business differs from eye to eye. Normally. we can spread the information on possible benefits that can be derived by valuing own business. analyzed with past but also incorporated with their current business or activities. employees. based on past but incorporating the fair benefits that can be derived in future. financiers. investors. financiers. like owner/s.

Based on relevant standards. He should also bear in mind that the value arrived on applying each these selected techniques is very likely to differ and the range between the least value and highest value may be significant. the value analyst is required to apply his professional wisdom and experience to finalize the technique/s to consider. Here again. after deriving values using different applied techniques. in order to achieve the intended benefits from valuation.relative value) Investment value: based on the individual perceptions of the investor. It will mainly be based on the intended use of value. It includes the value of synergy with investors’ existing status. the valuation process begins with deciding the standard of value based on the accepted premise. business appraise can derive a specific value or may come out with different value depending upon the techniques applied. The standard of value may be loosely said as a definition of value.VALUATION PROCESS: After going through the profile of client and understanding the purpose of engagement. If the valuation report could not be used for the purpose it is intended to be used then where is the NEED of valuation? The purpose. The basics of standards are reproduced as follow: Fair value: that may be intrinsic value (adjusted asset based value or earning capacity based value) or the extrinsic value (market based value. If the owner wants to launch a new project then he may like to know “the fair value” of existing business and the “investment value” of business combined with proposed projects. As we know. the valuation analyst needs to finalize the appropriate techniques to consider while moving towards deriving the value of business. Base on his best of 77 . Based on the requirement of specific purpose. Just on the other side. as well as intended use of valuation. If the fundamentals are well considered and assumptions are well decided then this difference may not be so. These approaches are having numerous sub-approaches or techniques within each. a financer while financing the same project. analyst should consider the purpose forcing towards the need of valuation. may like to know the “fair value” as well as the “liquidation value” of the business. (it could be a liquidation value of concerned asset plus marginal benefits derived from the transaction) Realizable value of assets Liquidation value: Selection of Valuation Techniques Once the standard of value if decided. the Analyst is on the subjective mode and he can choose one or more techniques with different weight age to arrive at the conclusive value of business. The assumptions should be explicit to make the value better useful. In my view. there are three approaches to valuation used widely to arrive at the conclusive value. not always demands the fair value but a value which can help the best to arrive at a better decision.

The features differ with change of formation or change of legal status but the fact will remain that the owner himself. The other stakeholders will also. We will also check the assumptions and impact of these factors on selection of specific technique amongst numerous techniques of business valuation. While concluding a value for specific interest. So. portfolio discount (the business enterprise may include more than one business streams and there may not be perfect co relation within those streams or it owns dissimilar operations or assets that do not fit well together) . I would like to focus the four factors imbedded with the need of the valuation. a value analyst should also consider the premiums and discounts necessary to incorporate in business estimation. this factor is not likely to affect the selection of valuation technique for specific purpose. invest their money with expectation of getting return. (2) expected return on capital (earnings). synergy premium (the likely benefit directly or indirectly effecting the existing profile of proposed investor) . he may also end up with range of value based on requirement and circumstances. financier needs interest. While selecting the appropriate technique to apply to arrive at the conclusive value of business enterprise subject to valuation. and salesman needs commission. Purpose for which the capital is used is assumed to be legal and pre-intended purpose only. The reason for considering the above four factors is vary simple. is not a business. (3) time span and (4) purpose for which the capital is used. These are (1) safety of capital (asset coverage). A business is separate entity whether it may be a corporate enterprise or partnership concern or even a proprietary business. employee needs salary. normally. Business is a game of finance and all stakeholders are investors expecting return on their investments. investor needs return in terms of interest or dividend and capital appreciation. lack of control discount (the ownership may come but not 78 .professional judgment. all investors (including the owner of the business) would like to link their timely returns with the time span to know the actual return on their investment. Owner needs profit against investment of his time and energy in addition to finance. investor they are concerned about the safety of their capital depending on the expected return. Examples of these premiums and discounts are control premium (an investor may be willing to pay some thing extra for getting control over business or management or specific area/s). Also. He also invests his money. Being all. the valuation techniques are used to derive the value of business at a specific point of time and not concerned with the area of capital where it is used and not concerned whether it is used for intended purpose or not. assumed risk and other terms of investments. blockage discount (the ownership may be embedded with some restrictions on departing). Value of money being function of time. time and energy in to business with expectation of getting return on his investment. even government need taxes against permitting to business on land of the country. supplier supplies materials and services with his profits. monitory or else.

key person discount (the business may be dependable on working style. the owner of business or equity holder are not in a position to change their holdings as easily and frequently to manage their risk perceptions. normally. Now let we move towards selecting the appropriate valuation technique/s based on purpose of valuation: 79 . as they can for publicly traded companies). Illiquidity discount (in case of closely held business entities. experience and skills of one or few specific person/s) etc.with reasonable or exclusive control).

the purpose will fall under this category. their major concern is to know the “at least value” and “fair value” of the business. that is to say. (1) Relative strategy: Where more than one party with different objective/s is likely to be affected directly from the valuation. the strategy or purpose/s of involved parties are different but dependable on one and the same transaction. So. The following purposes are considered under this category: (a) Addition of Partner/s: When the existing owner / partners decides to add the partner. In the worst case. the investment value of the business. (1) (2) (3) (4) Relative strategy Investment Value added management or Planning: Other purposes The characteristics of each purpose will decide the matching standard of valuation and also the technique/s better suiting the other requirements. he would be interested to know the fair value of the business and at the most. Being the continued partner also. AS the remaining partners are continued with the “fair value”. Just on the other side. (Liquidation value in specific case) (investment value useful for negotiation) 80 . they will like to use the investment value for negotiation purpose. they would like to en cash a portion of goodwill and will try to show a better existing value of their business.SELECTION OF APPROPRIATE TECHNIQUE FOR SPECIFIC PURPOSE (Considering MSME units only) In order to present the needs for MSME business valuation. based on his own perceptions about risk taking. I have compiled the purposes giving birth to the need of valuation and then divided those purposes in to four major categories. (like existing owner / working partner is on the verge of dyeing or retiring or incapable to growth the business sufficiently or the business is in the face of shut down otherwise) the existing owner / partners would like to know at least the liquidation value of the business. the new coming partner is going to invest his time or money or both and would like to see the benefits upon choosing this option of joining as a new partner. Valuation is called for by Relevant standard of value Existing owner/ Partners Fair value.

Incoming partner (b) Business Sell / Purchase Agreement: While the seller is interested to get the maximum value towards his business the Buyer would like to pay the minimum. The Buyer. His concern is return and safety. at least the liquidation value for his business. For negotiation point of view. expecting the best from the businesses. he would like to know the fair value. Valuation is called for by Relevant valuation technique/s Existing owner/ Partners Excess earnings method Adjusted net assets method (Discounted cash flow for negotiation) Discounted cash flow Excess earnings method Adjusted net assets method The comparable company or business data or similar transactions happened in near past for such kind of business can be used as guiding data while arriving at conclusion. While sharing the business or dilute the sharing. For tiny and small businesses. safety of his investments as well as time value imbedded with return. “Excess earning method” can help them to derive existing earning capacity of the business. He is interested in return. He would prefer “Discounted cash flow” to determine his expected returns. The incoming partner would also like to know the existing earning capacity of business and the existing assets involved in business so as to decide the goodwill of the firm with which he is likely to associate.Incoming partner Investment value. an owner of colour shop situated on prime location at the heart of the city in main market wants to sell 81 . “Adjust net asset method” will help to know the existing asset strength or the invested capital of the owners. He would be interested to get the investment value of the business. The seller would like to get the fair value and in case of bad need. many times the conclusive value is compared with traditionally adopted figure derived based on “Rule of Thumb”. the existing owner or partner/s would like to get the appropriate consideration against the existing earning capacity and assets involved in the business. So. The “Discounted cash flow” based on future earnings will help to know the futuristic value of business in which the incoming partner is proposed to claim the share. here will try to pay maximum what it can derive from the business. Fair value The analyst is now on the way to select the techniques to be applied for determining the value of business. If for example.

Valuation is called for by Relevant valuation technique/s 82 . he would like to get the market price for its real estate-property (shop) and current assets including receivables and at least cost of the inventory out of which he can pay off his liabilities. Liquidation value Buyer Investment value (Fair value useful for negotiation) In order to get the better consideration for departing the own business. If the seller insists for “bundle” sale (shop and current assets plus inventory together) only then the buyer may accept the price if his investment value permits.e. He would like to know the intrinsic value of business generally preferring discounted cash flow method. consider a situation where the buyer wants to start a new business and to open a gift article shop there. He is major interested on future returns and synergies based on the existing status of the business. The buyer is looking futuristic. His concern is best return of his investments. The buyer. i. He will intend to get this price irrespective of its usage by the proposed buyer. Based on the nature of business. the seller would like to en cash the current earning capacity and therefore prefers a lump sum multiple of existing earnings or revenue. he would also compare the consideration with the replacement value of the assets he is going to own. may accept the price if he is expecting to get at least the expected rate of return on this investment. He interests to know the return and coverage of his investments. He would definitely compare the consideration figure so arrived with realization value of his existing assets based on current market values. The seller is interested in getting the fair value of its “colour business” while buyer is interested in knowing the investment value of its “gift article business”. if wants to continue to run the colour shop. He is concerned with location only and not with the stock and related current assets. that is to say he may like to negotiate for excess earning.his shop. the buyer will get enough return from gift article business to cover the possible loss on purchase of colour business assets. He may like to know the fair value of colour business for negotiation. Valuation is called for by Relevant standard of value Existing owner/ Seller Fair value. Obviously. Now. he may claim a combination of both.

Buyers subjective line Area of deal Seller’s expectations Best dealing point While estimated value of business provides basis for negotiation. at a least prices or a price very near to existing fair value so as to decide the under value 83 . For tiny and small businesses. This term of seller’s finance is of course out of the preview of valuation but a very good tool of settling a deal.Existing owner/ Seller Earnings capitalization method (or earning multiple) or Revenue multiple Excess earnings method Liquidation value Discounted cash flow Replacement cost method Buyer The comparable company or business data or similar transactions happened in near past for such kind of business can be used as guiding data while arriving at conclusion. the negotiation skills of involved parties and the structure of transaction like financing structure. the seller can get better price of his business. (c) IPO: The business enterprise while going for Initial Public Offerings likes to dilute the sharing based at a price which gives something in addition to existing value and being continued party to the business growth. the investor would like to invest as per his own risk perceptions. setting the deferred payment terms is a very good option available in the interest of both the parties is: By providing for deferred payment towards consideration of business purchase. many times the conclusive value is compared with traditionally adopted figure derived based on “Rule of Thumb”. at the same time the buyer can get the business at a low initial out flow from his pocket and then he can pay from the business itself. transition of control etc also affect the transaction price. they would like to consider the average risk and growth potentials from the view point of proposed investors and also the factors affecting while going public and therefore they also call for the investment value. For example. On the other side.

The value of assets will reveal the existing tangible strength of the business. while going public it is essential to know the intrinsic value as well as the market value of the business. So. CCI guidelines prescribe to derive Net Asset value based on the latest audited balance sheet. Investment value Investor Fair value. Valuation is called for by Relevant standard of value Existing owner/s Fair value. Valuation is called for by Relevant valuation technique/s Existing owner/s Earnings capitalization method Adjusted net assets value Discounted cash flow Comparable Companies’ multiple (P/E and P/EBITDA multiple)* Discounted cash flow Comparable Companies’ multiple (generally P/E and P/EBITDA multiple)* Investor 84 .offerings or over value offering of IPO. CCI guidelines prescribe to use the market value as a benchmark or guiding value and not to be used directly to determine the offering price at IPO. When based on the existing worth. i. analyzed by the market value of its shares and market capitalization. Discounted cash flow will help to derive the business value based on future plans and project. Investment value The business. return on investment The investor in IPO would also like to compare the IPO price with the intrinsic value and the possible market value. So. both of them would be interested to know the fair value and of business. Discounted cash flow and comparable companies’ adjusted value can serve his purpose. once listed on any stock exchange. CCI guidelines also prescribes a method of calculating “Profit Earning capacity value “(PECV) and “Net Assets value” (NAV) of the business while determining equity issue price. the intrinsic value can be calculated by applying the earnings capitalization method.e. The market value can be decided based on comparable companies’ adjusted value. His interest is to get the value of his dilution and ensuring the safety of investors funds i. and not the current market value.e. book value.

he considers the replacement value of assets he is going to acquire to know the placing of his investment on acquisition.* P/EBITDA multiple is not a correct measure of value in terms of financial logics. and can know his opportunity cost by using the discounted cash flow based on his own perceptions. While the acquirer will calculate his synergies and present value of future earnings to decide the return on investment. However. there is no established technique which incorporates uncertainties involved and gives a range of values of a target firm which can form the basis for offering a price. it can be used to compare the price worth on cash flow of two businesses which are being compared. acquisition or takeover. Although these transactions of merger. On merger. In specific case. Valuation is called for by Relevant standard of value Existing owner/ Seller Fair value. Liquidation value (investment value useful for negotiation) Investment value. Acquisitions. acquirer may like to know the option value of specific investment on acquisition. also with asset coverage of its investments. the existing owner is departing his future business which he may continue else. these are the strategy deals and the basic characteristics remain same as applicable to normal business sale-purchase transactions except that the existing owner may remain to carry the business but with some different terms and conditions. Takeovers: Generally. takeovers or acquisitions are becoming importance means of diversification. Both the parties are concerned with return on their respective investments and the acquirer. Fair value Acquirer / Buyer The transferee and the transferor both are interested for getting the best worth of their business. “P” refers to price of equity while “EBITDA” refers to flow available on capital which includes equity owners’ funds as well as debts. The existing owner would like to know the fair value of his business based on the existing earnings and wants to get at least the liquidation value of the business. Valuation is called for by Relevant valuation technique/s Existing owner/ Seller Earnings capitalization method 85 . (d) Mergers.

sees better benefits on purchase of certain business. A rational buyer will not pay more price than the worth of asset to him this worth may be measurable or may not be.Discounted cash flow Liquidation value Acquirer / Buyer Discounted cash flow Replacement cost method (2) Investments: Where the intention of the party calling the valuation is to invest in the business or finance specific project or the business growth. For negotiation point of view. The buyer pays a premium. It is different from the routine sell-purchase transactions in a sense that the investor is approaching to satisfy his own synergy/ies. 86 . he would like to know the fair value. A hypothetical buyer would have to pay a control premium. the buyer term itself is a futuristic term and the buyer is interested to know the value of any asset he is going to buy. He is concern with the return on investments as well as asset coverage of his investments. because having the “right” to control how the business assets are deployed has value. Valuation is called for by Relevant standard of value Business buyer Investment value (Fair value useful for negotiation) As written above. He would be interested to get the investment value of the business. based on his personal perceptions. When a proposed investor. The investor’s decision is for own self only and not intended to be used by the other person. So. the purpose will fall under this category. And so his concern is what comes now physically and what he will get in future against something payable now. even if this buyer plans to run the business in the same way as existing management. many times he needs the history of assets (or business) to assess the future worth. One who wants to acquire a power of controlling or expecting better synergies with his or her proposed set ups may willing to pay something more than the measured value of business. (a) Small business purchase: The value of business and the value of ownership are two different terms. The value of ownership is directly associated with power of control and synergies. he would like to offer something in addition to the fair price of the business. Of course.

Some times. They may prefer “First Chicago Method” (allocating different probabilities to various possible business scenarios and to arrive at a common value) to determine the business value.Valuation is called for by Relevant valuation technique/s Business buyer Discounted cash flow Replacement cost method The comparable company or business data or similar transactions happened in near past for such kind of business can be used as guiding data while arriving at conclusion. They want to value the business based on own perception about the risk taking and growth potentiality of the business. They are more concern about the industry under which a business pertains and the core competence of the business. (b) Private equity funding/ venture capital finance: The investors in private equity generally provide capital as a seed money or first phase start up money. option pricing model can be helpful to value such “option to expand”. It mainly depends on achievement of decided mile stones. Fair value The venture capitalist or investors in private equity are interested in better return based on their perceptions of risks. generally the investors are pure investors and financing the business to get the better returns. They would like to know the coverage of their investments in terms of physical asset also. Obviously. They consider DCF to calculate the offer price on the basis 87 . they are more interested in return of investments knowingly the asset coverage. Many times the conclusive value is compared with traditionally adopted figure derived based on “Rule of Thumb”. They prefer to know the fair value of the business. The expected return ranges from 20% to 70% depending upon the stage of investment. Here. Normally. In some cases where further investment is dependable on some happenings. it is very difficult to judge the market. the exit mode in Private equity investment is IPO and therefore they tend to consider the market situations likely to exist at the time of proposed IPO. Valuation is called for by Relevant standard of value Venture investor capital/ PE Investment value. Of course. Normally they do not have synergies to link with specific investments but they may invest in particular sector based on own portfolio diversification policies. depending upon the nature and situations of the business and agreed terms they may finance second phase development.

In order to ensure the safe guard of their funds they also would like to know the liquidation value. They are concern with debt payment capacity of the business and therefore interested to know the cash flow or earning capacity of existing business as well as the viability of new projects or expansion. financial institutions and other business financers are interested to get a reasonable return on their investments and to save their capital as well. Valuation is called for by Relevant valuation technique/s Business financer Discounted Cash flow* Liquidation value * The financer is much interested to know the actual cash flow that will be used for debt repayments (3) Value added management/ planning: 88 . Liquidation value The business financier is interested in knowing the debt payment capacity of the business and the securities for safeguarding their investments. Valuation is called for by Relevant valuation technique Venture investor capital/ PE Discounted cash flow Replacement cost method P/E multiple (as guiding data) The comparable company or business data or similar transactions happened in near past for such kind of business can be used as guiding data while arriving at conclusion.of the expected rate of return but also uses market multiples as a guiding factor. (c) Business financing for new projects/ expansion: The Bankers. Valuation is called for by Relevant standard of value Business financer Fair value.

(Liquidation value to assure the fund safety of financier) For accessing the financial viability while going for expansion or new projects. Valuation is called for by Relevant valuation technique Business Owner Discounted cash flow Adjusted net asset value (b) Restructuring the business/ divestiture: An awake owner would like to get the benefit of leverage. Also. value addition. The return may be tangible or intangible. Owner is required to consider this fact in his mind also. The financier may not be concern with the present value of cash flow but of course with the actual value of cash flow so as to satisfy himself about the repayment capacity of business. The expansion is fruitful if enhances the value of business. He also will consider his existing business value based on future earnings. His concern is additional return on investment and investment in secured assets. The outside finance can increase the return (if the business return is more than the post tax debt cost) but simultaneously it increases the probabilities of bankruptcy. 89 . Investment value. he needs sometimes to convince himself. The expansion should be viable in sense that the expected return must be more than the existing rate of return and at least the additional cost of finance. even though the owner is controlling each and every functions of owned business. in many situations. the businessman would like to know the impact of borrowings on expansion or project value. he remains more concerned about his payment capacity and expected returns. business expansion. the financer would like to analyze the existing business and viability of expansion in terms of debt payment capacity. Valuation is called for by Relevant standard of value Business Owner Fair value. In MSME. The asset value will help him in deriving the tangible value of business against which he can easily go for fund raising. The liquidation value will further help him to assure the fund safety. like to know the value of his own business. (a) Raising funds for expansion or new projects: Before an owner goes to raise a capital for expansion or new projects.The owner of the business would also. strategy forming and most importantly to make appropriate decisions on time. The valuation may be helpful for internal betterment.

goodwill being intangible asset. The approach being futuristic the forward earning capitalization or discounted cash flow will serve the purpose. creditors. Proper capital structure can help to increase the value of the equity holdings or value of ownership. (c) Goodwill impairment: Every business being going corn will have goodwill (positive or may be negative) whether shown as a part of balance sheet or not.If planned properly. The sources of generation of goodwill are the relations of business with employee. customers. the fair market value of goodwill is required to be found out by deriving a difference between the fair market value and carrying value of business assets on stand alone basis and such an implied market value of goodwill is to be compared with the carrying amount of goodwill to quantify the impairment. While calculating the value of business. location of business etc. the debt cost being tax deductible item. if not recognized on the balance sheet then there is no harm but if it carries a certain amount to the balance sheet then it must be measured for impairment. The owner would like to know the fair value of his business based upon current structure so as to increase the ownership value just by addition or repayment of outsider finance or modification of existing debt terms. the value of goodwill will be impliedly included. forward earnings capitalization method is same as the discounted cash flow method. He would like to take decision knowingly the impact of capital structure on rate of return and absolute return. Valuation is called for by Relevant standard of value Business Owner Fair value The increase in debt will reduce the profit available to the owners but at the same time it can increase the return on capital subject that the existing return is more than the proposed post-tax debt cost. But in reverse situation. it can reduce the cost of capital to a good extent. Valuation is called for by Relevant valuation technique/s Business Owner Earning capitalization method* * Theoretically. If the fair value of business is equal or more than the carrying amount of business then impliedly there is no impairment in goodwill. 90 . The owner can take reasonable steps to stop or lesser the impairment and to protect his ownership value if he undertakes business valuation regularly. Based on the conservative approach principle.

He requires to find the fair value of assets and liabilities purchased and also to find the amount paid extra as a goodwill. Valuation is called for by Relevant standard of value Business Owner Fair value Valuation is called for by Relevant valuation technique/s Business Owner Adjusted net asset value (e) Retirement of partner or dissolution of partnership or succession planning: 91 . we need the value of business as a whole and it is less than the total carrying value of the assets in balance sheet. Valuation is called for by Relevant valuation technique/s Business Owner Discounted cash flow Adjusted net asset value (d) Allocation of Purchase price: When a business is purchased and the price is paid on a lump sum basis or a fixed price is paid against the fair value of business and not being a pooling of interest method.Valuation is called for by Relevant standard of value Business Owner Fair value Goodwill is concerned with the excess earnings. we need to know the fair market value of assets on stand alone basis. In order to know the fair value for goodwill impairment purpose. the owner needs to show the fair value of acquired assets in to his balance sheet. This requires the owner to find the fair value of assets and allocate the purchase price amongst it.

The applicability of it depends on the legal status of the business enterprise and therefore MSME are generally. Valuation is called for by Relevant valuation technique/s Business Owner Discounted cash flow Adjusted net assets method Liquidation value (f) Financial reporting: Many Accounting Standards also require showing the assets and liabilities at their fair value. But of course. The comparable company or business data can be used as guiding data while determining the final value. on retirement or dissolution. Valuation is called for by Relevant standard of value Business Owner Fair value The concern is disclosing the earning capacity and coverage of capital in various business assets. They even can pre plan the business succession terms if regularly known about the value of business. They may pre decide the calculation terms of goodwill on retirement and even can invest regularly. out of the preview of Accounting Standards. without badly affecting business capital. no one is restricted to present the better. MSME can prefer to show the fair value of its business to earn the better credibility and transparency in financial reporting. 92 . a certain portion of earnings for smooth payment. Valuation is called for by Relevant standard of value Business Owner Fair value.Many times the partners would like to plan the exit mode which can strengthen the partnership relations. It may be helpful to them in long run in terms of mapping the actual growth. Liquidation value The concern is return on investments and the assets coverage.

The concern is to evaluate both. Like. he has to dilute his sharing in favour 93 . he can timely decide diversion or sell of specific loss making business stream. the partnership terms include increasing the share of working member based on the performance and business targets achieved by him. (a) Ownership issues: Sometimes. can take the best advantage of capital structuring. In some other case. Valuation is called for by Relevant standard of value Business Owner Fair value. Like. the valuation for which generally is not undertaken for any intended business transaction. Valuation is called for by Relevant valuation technique/s Business Owner Economic Value Addition method (excess earning method) Liquidation value in relevant cases (4) Other Purposes: The purposes which are not covered under above three categories will fall under this category. a specific owner may require contributing on none fulfilling the agreed term. It includes the purposes. Liquidation value The owner is interested to measure the performance of the business in terms of change in business value as well as to know the addition in asset value due to market forces. can plan expansion taking advantage of intrinsic strength. This can help him to measure the progress as well as to frame the appropriate business strategy in time and taking the decisions better knowingly the impact on ownership value. the investor partner may not fulfill his obligation to bring the agreed finance and therefore. can realize the better value through timely selling of business etc. the return on investments as well as safely of investments.Valuation is called for by Relevant valuation technique/s Business Owner Discounted cash flow Adjusted net assets method (g) Frequent progress measure: The owner may choose to know the value of the business on regular time interval.

There may be a situation where a creditor or a financier is required to offer the ownership in the business. Valuation is called for by Relevant valuation technique/s Existing Owner (person diluting sharing) Excess earning method the Discounted cash flow Adjusted net assets method Proposed Owner Excess earning method (person intended to raise Discounted cash flow the sharing) Adjusted net assets method Here. future return prospects and value of assets involved. future return prospects and value of assets involved.of new financier or any one else. the selection of technique/s for determining the value of business depends on the circumstances of each case but by and large both the parties would like to know the existing earning capacity. All these case requires a proper valuation of the business and a decision taken on the basis of figures reflected on the balance sheet only may not be wise and in may effect adversely to one of the party. Valuation is called for by Relevant standard of value Existing Owner (person diluting sharing) Fair value the Proposed Owner (person intended to raise Fair value the sharing) Here. the selection of technique/s for determining the value of business depends on the circumstances of each case but by and large both the parties would like to know the existing earning capacity. (b) Litigation issues involving lost profits or economic damages: 94 .

It may be a sharing issue on separation of family or HUF partition. Valuation is called for by Relevant standard of value Business Owner Fair value Opposition party Fair value The selection of valuation technique will be based on specific requirement of each particular case. (c) Family issues: This includes the disputes and planning matters involved due to ownership in a business. Valuation is called for by Relevant valuation technique/s 95 . Liquidation value member The purpose is to identify the rate of return and the asset coverage in family business or businesses. The comparable company or business data or similar transactions happened in near past for such kind of business can be used as guiding data while arriving at conclusion. It will be wise to allocate the business or businesses or specific sharing in a business on the basis of fair value of each business. Generally. if based on fair value of ownership. impact of merger or de merger. the prescribed techniques are used to appraise the loss or business. Valuation is called for by Relevant standard of value Business Owner or family Fair value. breach of contract etc will also call for valuation. The wealth planning and WILL planning will also be made wisely. loss of business due to impairment in reputation by whatsoever reason. The ancestral businesses and HUF businesses are co owned by the male members of the family and therefore the need arises to decide the sharing at the time of separation.Insurance claim. Specific care is required while valuing a business or a loss of business under such circumstances.

Business Owner or family Excess earning method Discounted cash flow member Adjusted net assets method Liquidation value The above four categories consider all major purposes which may need the value of business for taking a timely and wise decision. The valuation analyst. even after finalizing the standard/s of value based on characteristics of the purpose and selecting the technique/s of valuation. may rest with some different values derived by application of various selected technique/s. prevailing situations and existing requirements. 96 . It rests with the value analyst to determine the final value or a range of values of a business based on his experience and applying best of his professional skills considering the nature of business. he may choose to conclude with a value derived by applying specific technique or he may weigh particular techniques as per his wise and conclude the valuation.

A realistic business valuation requires more then merely looking at past years’ financial statement. The quality of any value analysis or value appraising is a function of the accuracy of the data and assumptions that form the basis for any conclusion reached. MSMEs are concerned with “transactional value” which can be arrived if the values under different standards of value are known. it is not a total mystery. The transaction price is impliedly dependent on not only fair value but also on investment value or liquidation value also. fair value from view of safety (based on asset approach) will differ from fair value arrived based on earnings point of view (earning or income approach). The empirical data is not available for MSME needs and its valuation. it is not always possible. The value is a function of standards to value and it varies when measured under different standards of valuation. Specific purpose will have particular requirements to take a decision and different valuation techniques when applied for different valuation standards will show the different values. For example. It is possible. A valuation requires a thorough analysis of several years of the business operation and an opinion about the future outlook of the industry. If the valuation report could not be used for the purpose it is intended to be used then where is the NEED of valuation? So. in India. like nature of industry under which the business is working. the appraiser may end with determining more than one value each representing the 97 . If available. economic situations. the value analyst can determine the final value allocating different weights to various techniques and can conclude or he may conclude with a range of values covering the safety views as well as earning expectations. Banking a business’s value solely on current operating results is risky business to say the least. Unfortunately. in MSMEs the valuation requirement is not confined to know the fair value only. It is also practically difficult to preserve or to compile the voluminous transaction data for MSMEs. an analyst will come at a point where he will have several values none of which he can say to be incorrect. however. also there is no private of public organization offering the transactional data relevant for MSME valuation.Conclusion: While valuing a business is not an exact science. Here. economic and competitive characteristics in place during the appropriate timeframe for the appraisal. In my views. Estimates of a business' value by various experts can vary significantly. In fact. Business valuation field itself. market. if the fundamental assumptions are applied differently. to make sure that any assumptions made are based on the financial. is still un-explored. the economy and how the subject business will compete. This is just an endeavor to match the valuation technique with specific purpose on logical basis considering the requirements of each purpose. market trends. value of a business depends on numbers of factors in addition to purposes of valuation. it is always better to use actual data or historical results than to rely on assumptions. availability and reliability of data etc. So. Rather the necessity is to take a decision for specific purpose based on the value so arrived and this required value is not always the FAIR value. particularly in case of MSMEs. This write up particularly pertains to valuation need in MSME sector and linking the most relevant valuation technique/s with specific purpose.

rather more concerned about its relative value to him.value under specific standard of value like fair value or investment value or liquidation value. The fair value may not going to serve his purpose with more certainty then the relative value which may be far away from fair value. The owner or a proposed buyer is always not interested to know the fair value of business only. 98 .

VALUATION REPORT Some useful notes 99 .

The valuation analyst should. obtain sufficient non financial information to enable him or her to understand the business. the client’s responsibilities. Instead.. realistic picture of valuation is a mathematical exercise that is always done with less-than-perfect information and which has uncertainty to it.e. the nature. and history • Infrastructure • Organizational structure 100 . regarding the engagement to be performed. determining the value of any business in today’s economy requires a sophisticated understanding of financial analysis as well as sound judgment from market and industry experience. Regardless of whether the understanding is written or oral. Valuation professionals understand that nobody is that good to be able to say with authority that the value of a business is a specific amount and not any other amount. the valuation analyst should document that understanding by appropriate memoranda or notations in the working papers. including its: • Nature. the valuation analyst should modify the understanding if he or she encounters circumstances during the engagement that make it appropriate to modify that understanding.PREFACE “What is the business worth?” Although a simple question. As said by Jay Abrams. There is much controversy in the professional literature about many aspects of business valuation. one’s assessment of future market conditions. purpose. and objective of the valuation engagement. the applicable assumptions and limiting conditions. the type of report to be issued. The answer can differ among buyers and depends on several factors such as one’s assumptions regarding the growth and profitability prospects of the business. The understanding with the client reduces the possibility that either the valuation analyst or the client may misinterpret the needs or expectations of the other party. at a minimum. The understanding should include. the valuation analyst’s responsibilities. and the standard of value to be used. Nobody is perfect. and it is a non issue. as available and applicable to the valuation engagement. they will focus on discussing their differences in assumptions of the sales growth rate or the profit margin. background. and there is no such thing as a perfect valuation. When buyer and seller understand the logic and the process of valuation. preferably in writing. i. They do not argue over values. If the understanding is oral. If buyer and seller can agree on assumptions. it is a mechanical calculation. The business person or seller knows the business more than valuation professional does but a competent professional knows business valuation techniques better than the businessmen do. The value is the end product of the valuation model. then they discuss and negotiate over assumptions to the model. The valuation analyst should establish an understanding with the client. the value becomes self-evident. one’s appetite for assuming risk (or discount rate on expected future cash flows) and what unique synergies may be brought to the business posttransaction.

Performing a valuation engagement with professional competence involves special knowledge and skill. Business appraiser does not always rely on one method alone and it may also be appropriate to consider the outcomes from using several different methods. It must be note that the valuation being estimation. Like existence of non balance sheet items. and use professional judgment in developing the estimate of value (whether a single amount or a range). gather. It’s not the bottom line number you’re paying for. a good appraisal is a defensible appraisal. the valuation analyst should so state and should also state that the valuation analyst assumes no responsibility for the financial information. accounting and investment. economics. If the financials of the business concerns are not audited. This means that the potential challenges of opposing parties are recognized and addressed within the appraisal itself. The appraiser must provide adequate documentation and discussion to support the opinion. officers. the appraiser should apply a methodology that is appropriate in light of the nature. contingent liabilities. Because of the uncertainties inherent in estimating a value for business. it can be challenged and therefore. finance. if possible. dispute over commercial matters such as intellectual property rights. The more structure that is added to the valuation report. facts and circumstances of the business and should use reasonable data and market inputs. and key employees) • Classes of equity/ ownership interests and rights attached thereto • Products or services. consider and apply appropriate valuation approaches and methods. the more difficult it becomes for someone to tear it apart. but the detail behind it. A valuation analyst should possess a level of knowledge of valuation principles and theory and a level of skill in the application of such principles that will enable him or her to identify. major law suits. 101 . It is rash to attempt any valuation adopting so-called industry/ sector norms in ignorance of the fundamental theoretical framework of valuation. Valuation is an art more than a science and is an interdisciplinary study drawing upon laws. or both • Economic environment • Geographical markets • Industry markets • Key customers and suppliers • Competition • Business risks • Strategy and future plans • Governmental or regulatory environment Unrecorded data and facts having effect on valuation must also be considered. assumptions and estimates. and analyze data. In estimating a value for a business. existence of major frauds within the company.• Management team (which may include owner himself. a degree of caution should be applied in exercising judgment and making the necessary estimates. directors.

VALUATION PROCEDURES Valuation procedures can generally be classified into the following areas: • • • • • • • • • • • • • • Understand the purpose of the engagement What is the intended use of the valuation Who are proposed users of the value Determine the premise of value Determine the standard of value Determine the proposed users of the value Determine the interest to be valued (whether it is a minority interest. is there any restriction on marketability or is there reasonable market available etc) Ascertain whether discounts and/or premiums are to be considered Compile information about the company. about the industry and economy Analyze the company’s financial information Consider all approaches of value and select the most appropriate Apply the most appropriate technique/s amongst the selected approaches Reconcile the values and derive a conclusive value Apply discounts and premiums. if applicable and finalize the value or a range of value Frame the opinion on valuation 102 .

The list though not exhaustive can serve as a fair guide for compilation of information on a way to valuation. The data generated for internal control and MIS can be helpful to know the financial and internal strength of the Company. Appraiser should obtain other information relevant to subjective issues affecting possible present or future worth—details of past or pending lawsuits. Appraiser should go through the primary understanding between the owners. Each purpose adds or deletes bits of information that may be important to the overall valuation project. wholesale price catalogs. past and present product/service pricing strategies. Information must be collected. keeping valuation requirements of MSME unit in mind. the appraiser should take it in to consideration. including specific problems encountered and solutions implemented. to determine ‘‘visions’’ of owners and to outline a ‘‘generic’’ resume of special skills and traits believed necessary to successfully operate the businesses. The appraiser should collect the relevant data which can help him or her to know the basic history of the enterprise and the business itself. deeds or leases. occupationally related injuries. In MSMEs. and so on (in other words. The decision whether to obtain a representation letter is a matter of judgment for the valuation analyst. and to derive the basis for useful forecasting in the process of valuation. and included. all legal and/or informal operating documents)—to include a picture of how the company functioned or functions from an internal point of view. A “Valuation Information Request List” is prepared. if there are more than one and relationship between different stake holder. the appraiser should review the collected data and should conduct in-depth interviews with owners that are sufficient to fully understand how businesses have been operated. copyrights or patents. generally the owner himself controls the business and he can provide the best data about business history. If there is any document specifying the valuation procedure or method to use under mentioned situations or purposes. It may be appropriate for the valuation analyst to obtain written representations regarding information that the management provides to the valuation analyst for purposes of his or her performing the valuation engagement. 103 .THE DATA COLLECTION PROCESS The purpose for conducting valuations will determine informational needs. In addition to analyze the data for knowing the trend in the business. analyzed.

PURPOSE OF THE APPRAISAL AND DESCRIPTION OF TRANSACTION Describe the activity or transaction creating need for valuation: BASICs FOR VALUATION • Nature of Valuation (please specify) (Ownership value or business value or specific interest value) • Date of the valuation A. We may call for other information for detail analysis of these data provided by you. 104 . and some items may not be readily available to you. Financial statements for fiscal years ending (for immediately past five years) Interim financial statements for the year-to-date (Date of valuation or for the period up to end of last month / quarter) Monthly figures of sales and inventory for past two-three years. In such cases. 2. please indicate N/A or notify us if other arrangements can be made to obtain the data. 5. Financial projections. 3. The objective of this information request is to provide us with transactional and operational information that will aid in developing the value of business for the purpose specified by you herein below: We will keep the information confidential. Some items may not pertain to your business. 4. Financial Information 1. if any.ENTERPRISE NAME :__________________________________________________________ VALUATION INFORMATION REQUEST LIST NOTE: This is a generalized information request. for the current year and next three to five years. (Include any prepared budgets and/or business plans) MIS and bank reconciliations statements.

Details of patented or licensed products with rights and conditions of usage Management perception about intangible assets like copy rights. 14.6. 11. List of top 10 suppliers (or all accounting for substantial % of total purchases) Identify product(s) on which the Company is single-sourced. 3. Operations and Markets 1. location. 8. 9. services. 105 . or suppliers on which the business is otherwise dependent. 13. 10. Payment schedules of loans. research activities. Creditors aging schedule or summary as of Date of valuation. A brief note on “nature of activities and business” List of major products. List of working capital components and estimated realizable value Capital structure with details regarding ownership capital and long term. 9. and estimated market share of each). 7. Income Tax Returns and supporting statements/ documents for fiscal years ending FIVE YEARS. Description of competition to examine price-quality-service factors in products/services of competitors in light of those prevailing in businesses being valued. Product mix. Explanation of significant nonrecurring and/or non operating items appearing on the financial statements in any above fiscal year if not detailed in footnotes. 2. 11. input-output ratio. indicating sales (or sales upon which commissions were earned) and unit volumes for each of the past three fiscal years. 6. The major competitors (full name. terms of finance. 15. catalogs. The trade associations’ memberships.short term finances. sale percentage to total sales and profit/sales ratio Unit volume analyses for existing product lines for the past five years. by product. 5. 7. Like change of inventory keeping from FIFO to LIFO or change in depreciation method from SLM to WDV etc. 8. The new products under development with expectations as to potential. if any and/or debt agreement(s) as of Date of valuation. Expense classification: fixed/semi variable/variable. for each of the past five fiscal years? Fixed assets and depreciation schedule as of Date of valuation. 12. trade mark. 14. 15. LCs and other liabilities. Details of contingent and unrecorded liabilities and assets with justification B. 13. 12. 10. employee contracts etc. Any change in accounting practices or any change in treatment of major item. or other descriptive sales materials. 4. size. Debtors aging schedule or summary and management’s general evaluation of quality and credit risk as of Date of valuation. Products. or product lines of the Company and copies of marketing materials including sales brochures. highly trained staff. The major accounts gained (lost) in the last year indicating actual sales in the current year and beyond. The detail of top 10 customers. The major products or services added in the last two years (or anticipated) and current expectations as to sales potential. The majority industry publications of interest to management.

g. and remuneration status including the bio-data of management and key employees. 7. Details of the ownership of each facility and other major fixed assets. product warranties. VAT Number. or departments. date of filing. 2. Excise code or Service tax number etc. 106 . E. if any or partnership deed or Memorandum and Articles of Association or any other formation or regulatory documents The minutes of Board of Directors and shareholders meetings for at least the most recent three years. Business registration details like. whether divisions. service contracts. include name of lessor and lease terms or agreements. and approximate size of each facility. subsidiaries. The number of employees (distinguish fulltime and part time) at year-end for the last three years and attrition ratio. age. Personnel 1. current status. include: • Date purchased • Purchase price • Recent value • Insurance coverage • Book values (gross value as well as depreciation) 2. A summary of major covenants or agreements binding on the enterprise e. 6.16. List of employees specifying their age. restrictive agreements etc. 3. A description of any pending litigation including parties involved. 2. position. If leased or rented. Please provide production capacity or estimate business volume by major facility/ factory unit/s. description and nature of the lawsuit or claim. experience within the enterprise. 4. Infrastructures 1. Details of sister concerns or subsidiaries Details of major changes or movements in ownership 3. employment contracts. vendor or agency contract. 5.. Business / Enterprise Documents and Records 1. Current organization chart. and expected outcome and financial impact. D. Proprietary deed. Name and description of the operations of all major OWN operating entities. The location. PAN. F. If owned by the enterprise. Or understandings between the partners or minutes of business meetings. capital leases.

EBIDTA. group data. comparable value basis. period of standings. capital structure and other relevant data based on specific nature of the company being valued] Industry / Sector Name: Trade Associations in this Industry: Leading Public Companies in this Industry: Trade publications in this industry: Proposed Comparable Firms: 107 . NOPLAT etc) . turn over and operation figures (PAT.INDUSTRY RESEARCH FORM The purpose is to decide the Comparable or Peer Company/ies and collect its Data [like name.

ILLUSTRATIVE LIST OF ASSUMPTIONS. differences between actual and expected results may be material. LIMITING CONDITIONS AND DISCLAIMERS FOR A BUSINESS VALUATION The valuation report should include a list of assumptions and limiting conditions under which the valuation task is performed. and assumptions of management. It may not be used for any other purpose or by any other party for any purpose. Furthermore the report and conclusion of value are not intended by the author and should not be construed by the reader to be investment advice in any manner whatsoever. or diminution of the owners’ participation would not be materially or significantly changed. We do not provide assurance on the achievability of the results forecasted by [ABC Company] because events and circumstances frequently do not occur as expected. we express no opinion or any other form of assurance on this information. plans. We have not audited. 3. 108 . and achievement of the forecasted results is dependent on actions. except as specifically noted herein. and that the character and integrity of the enterprise through any sale. or verified the correctness of the financial information provided to us and. in the course of our valuation process. 6. 2. The conclusion of value represents our opinion based on the information furnished by [ABC Company] and other sources. we make no representation as to the accuracy or completeness of such information and have performed no procedures to corroborate the information. 4. reorganization. Illustrative List of Assumptions and Limiting Conditions 1. reviewed. This report and the conclusion of value arrived at herein are for the sole and specific purposes as noted herein. Public information and industry and statistical information have been obtained from sources we believe to be reliable. exchange. accordingly. 5. This appendix includes an illustrative list of assumptions and limiting conditions that may apply to a business valuation. The conclusion of value as reported herein this report is valid only for the stated purpose as of the date of the valuation. as fully and correctly reflecting the enterprise’s business conditions and operating results for the respective periods. We have relied on the financial statements and other related information provided by [ABC Company] or its representatives. However. The conclusion of value arrived at herein is based on the assumption that the current level of management expertise and effectiveness would continue to be maintained.

Neither all nor any part of the contents of this report (especially the conclusion of value. on the subject business due to future change in state. management. except as specifically stated to the contrary in this report. Also. 11. and those differences may be material. happenings and conditions. The valuation contemplates facts and conditions existing as of the valuation date. do not express an audit opinion or any other form of assurance on the prospective financial information or the related assumptions. we have relied on the representations of the owners. we have no obligation to update the report or the calculation of value for information that comes to our attention after the date of the valuation report. or local legislation. Events and conditions occurring after that date have not been considered. should be disseminated to the public through any means of communication without our prior written consent and approval. investments used in the business. If prospective financial information approved by management has been used in our work. 8. and prospective operating results of the company.7. we have not examined or compiled the prospective financial information and therefore. and we have no obligation to update our report or calculation of value for such events. no effort has been made to determine the possible effect. We have not attempted to confirm whether or not all assets of the business are free and clear of liens and encumbrances or that the entity has good title to all assets. 12. 10. 13. Except as noted. Unless otherwise stated. and any other assets or liabilities. We have conducted interviews with the current management of [ABC Company] concerning the past. Events and circumstances frequently do not occur as expected and there will usually be differences between prospective financial information and actual results. No change of any item in this appraisal report shall be made by anyone other than us and we shall have no responsibility for any such unauthorized change. 109 . present. properties. and other third parties concerning the value and useful condition of all equipment. 9. The assets and investments are physically verified by us to the extent available and for others we have relied on the certification provided by the management and experts. if any.

inventory. limiting conditions. Often.CONTENTS OF A COMPREHENSIVE BUSINESS APPRAISAL REPORT A detailed valuation report should include the followings: o o o o o o o o o o o o o Identity of the client Purpose and intended use of the valuation Intended users of the valuation What is being appraised? (Ownership. the valuation analyst is assuming for the specialist’s work (like valuation of property. Business or Minority sharing or specific interest value) Valuation date Valuation report date Type of report issued Applicable premise of value Applicable standard of value Sources of information used in the valuation engagement Assumptions and limiting conditions of the valuation engagement The scope of work or data available for analysis including any restrictions or limitations If the work of a specialist is used in the valuation. a description of how the specialist’s work is used. and the valuation analyst’s representation are provided in appendices to the report. brand value etc. o o o o o o o 110 . jewellary. if any with justification. the assumptions. if such are valued by other/s) An economic analysis and industry section A financial analysis of the subject company The valuation approaches and methods used Disclosure of subsequent events (if feel appropriate) A section summarizing the reconciliation of the estimates and the conclusion of value Application of discounts or premiums. Employees’ retirement benefits. if any. and the level of responsibility. Appendices or exhibits may be used for required information or information that supplements the summary report.

The valuation professional must be diligent in ensuring that the valuation report is free from errors that may compromise its integrity. informed judgment in conducting a valuation and preparing a credible valuation report. the interests on which are not charged as per the prevailing rates in the market.e. Non-recurring or abnormal items require special attention of the appraiser. a minority shareholder would not have the ability to effect control decisions related to financial statement adjustments (i.SOME OF THE MOST COMMON ERRORS IN BUSINESS VALUATION A valuation professional must rely upon experience and reasoned. In addition. Salaries of management is one of the area which the closely hold businesses commonly use for adjusting the profit to save taxes. Failure to remove property associated expenses from the financial statements and failure to replace this with a market rate of rent is a common adjustment error made. The errors may result in significant disparities in value of the subject company. In the case of a minority interest valuation. the value estimate must be reconciled to a minority basis using a lack of control discount. If the cash flows are adjusted to reflect control decision. adjustments made to the financial statement must be on a comparable basis as the interest being valued. and calculations that the appraiser must make in the process gives rise to potential errors that could have an adverse impact upon the indication of value and the credibility of the valuation report and the appraiser. Many times the loans are received from family. The following are some of the most deadly errors that the valuation professional may commit in preparing a valuation. These factors must be adjusted to make the financials normalized. Personal expenses are also very common tom charge in business to evade the taxes. Incorrect adjustments to financial statements Improperly developed financial forecasts Not matching the benefit stream to the capitalization or discount rate Errors in estimating risks specific to a particular business Failing to show how the appraiser arrived at his or her conclusion Developing a value conclusion inconsistent with the standard of value and purpose of the appraisal Errors concerning valuation discounts for fractional interests (lack of control and lack of marketability) These are discussed below: Incorrect Adjustments to the Income Statement and Balance Sheet Incorrect adjustments to the income statement and balance sheet may produce an unreliable indication of value. management compensation or discretionary expenses). relatives and friends. assumptions. The number of inputs. 111 .

management guru Discount Rate & Income Stream Mismatch Capitalizing or discounting a net cash flow to equity income or owners’ profit stream by the firm’s weighted average cost of capital (WACC) would produce an unreliable indication of value. Many companies operate at low net incomes (or even negative net incomes). Likewise. which may tarnish the reputation of the valuation professional.Ungrounded Forecasting of Earnings Forecasting earnings is likely the most important part of the income approach to valuing a business. this high growth rate cannot be maintained in perpetuity as the company’s earnings would eventually surpass the size of the nation’s economy. The 112 . the appraiser must be cognizant of the range of growth rates that may be applicable to the subject company’s future earnings and use this range to bound the appropriate growth rate applicable to future earnings. This mismatch of the discount (capitalization) rate and income stream is a glaring error in business valuations. Care must be taken to ensure the reliability of the data. while they may actually be highly profitable. ‘‘Forecasting is not a respectable intellectual activity. using a net cash flow to equity rate to discount or capitalize net cash flow to invested capital results in an incorrect value. Though a company may be able to grow its earnings (or revenues for that matter) by an above trend growth rate in the short-term. the valuation professional may examine the historical relationship between capital expenditures and depreciation over the last five years or so. since the value is driven by the firm’s anticipated future earnings. The appraiser may use an above trend growth rate for the first years of a multi-period forecast but must then use a longterm sustainable growth rate in perpetuity that is bound by a reasonable estimate of the long-term sustainable growth of our economy (usually as measured by GDP growth). Therefore. The prevailing market conditions and industry trend should be considered while forecasting the revenue and expenses.’’ . Failure to match these rates and benefit streams results in an erroneous value conclusion. and not worthwhile beyond the shortest of periods. It is generally accepted that the projected capital expenditures and depreciation are best estimated based on a proportional relationship between the two. inconsistent assumptions regarding capital expenditures and depreciation may result in forecasts under which fixed assets are depreciated at a rate faster than which they are replaced or actually depleted. Applicable tax rate should also be applied to consider the post tax earnings or cash flow. This may also skew the value indication and discredit the entire valuation. For a stable.Peter Drucker. mature business. Using unrealistically high growth assumptions may result in an earnings stream that is overly optimistic and that produces an indication of value that is too high when discounted or capitalized. Many times discretionary cash flow is consider due to the facts that the most of small businesses calculated income in such a way that income taxes are minimized. Likewise.

This gives rise to a factor analysis for supporting the selection of a specific company risk premium. Given the possible arbitrary selection of this premium. There is no empirical data available in India on the specific company risk premium. great care and diligence must be taken to select and defend the specific company risk premium applied in a valuation. finances. In turn. A skilled appraiser critiquing the report would likely be able to easily discredit the valuation and the appraiser based on this issue. The importance of the ability to replicate the valuation should not be underestimated. Whether valuation professionals use a factor analysis or another method of selecting an appropriate premium. etc. This not only fails a fundamental of the business valuation profession but also fails the client by compromising the integrity of the valuation report and the valuation conclusions. Inability to Replicate the Valuation It is crucial that the valuation professional’s valuation be clearly written and fully explained so that the value estimate or conclusions may be replicated by a reader or third party that is not part of the valuation process. this could lead to significant valuation errors when determining the value of a specific asset.client may also be severely disadvantaged by the disparity in value resulting from the mismatch of rate and income stream. The valuation professional must ensure that the value estimate presented in the valuation report matches the standard of value if the report and its 113 . The failure to clearly delineate the reasoning. The valuation professional must ensure that the valuation process reaches a value conclusion consistent with the standard of value selected at the outset of the process. This specific company risk premium reflects the risks associated with the particular business’s operations. and procedures used to develop the indication of value is a significant error in the preparation of a valuation report. Incorrect Value Conclusion for the Standard of Value Upon engagement. industry position. and calculations made to arrive at an indication of value could lead a reader to believe that the values are arbitrary or that the appraiser engaged in “fuzzy math” to reach a specific value. Unreasonable assumptions regarding the specific company risk premium may result in a discount rate that is too low or too high for the particular investment being valued. The failure of the appraiser to thoroughly discuss the assumptions. Estimating this risk premium is at the sole discretion of the valuation professional and is typically based on the appraiser’s experience and informed judgment. assumptions. An error in estimating an indication of value that is not consistent with the selected standard of value may significantly impact the value conclusion. the valuation professional identifies the standard of value that will be used in developing an indication of value. Specific Company Risk Premium Estimation The specific company risk premium is an important part in the development of an appropriate discount rate/capitalization rate for a specific investment. there is a need for a quantifiable analysis for the specific company risk premium to further strengthen business valuations and to limit the appraiser’s exposure to attacks on credibility and results. approaches.

may have a detrimental effect upon the credibility of the valuation. there is a great deal of latitude for applying discounts that are too high or too low. These errors and failures by the valuation professional compromise the valuation and render the value conclusions irrelevant. the valuation professional must use experience and reasoned. Application of Appropriate Discounts Once the valuation professional has arrived at indications of value using the selected approaches and methods. and for that matter. leading to potential overvaluation or undervaluation of the subject interest. informed judgment in determining the appropriate level of these discounts. Given that discounts for lack of control and marketability may range from 10%-50%. Consideration of a number of factors impacting each discount would be helpful in providing a solid foundation for the selection of the appropriate discount. informed judgment in the valuation process as well as be cognizant of the potential errors that may be inadvertently made and the impact such errors may have upon the valuation. In order for the valuation to be credible and withstand scrutiny. Failure to provide enough reasoning or explanation for the selection of discounts applied to a value estimate makes replication of the value conclusion nearly impossible. it may be appropriate to apply discounts for lack of control and lack of marketability. The errors discussed here may have a significant adverse impact upon the indication of value produced in the valuation report. the appraiser must use reasoned. of the valuation professional or M&A professional involved. these errors. To be sure. To ensure a meaningful and credible valuation. Therefore. Erring in this aspect will totally discredit the valuation. the valuation professional should clearly explain the reasoning for the amount of the ultimate discounts selected. if made.conclusions are to be meaningful and credible. There is no specific formula or set of guidelines for determining the appropriate discount applicable to a specific investment or company. 114 .

Arbitrage Pricing Theory—a multivariate model for estimating the cost of equity capital. Appraisal Date—see Valuation Date. Appraisal Approach—see Valuation Approach. 115 . more particularly.INTERNATIONAL GLOSSARY OF BUSINESS VALUATION TERMS To enhance and sustain the quality of business valuations for the benefit of the profession and its clientele. it is recommended that the term be defined as used within that valuation engagement. the communication of how that value was determined. which incorporates several systematic risk factors. This duty is advanced through the use of terms whose meanings are clearly established and consistently applied throughout the profession. The performance of business valuation services requires a high degree of skill and imposes upon the valuation professional a duty to communicate the valuation process and conclusion in a manner that is clear and not misleading. the below identified societies and organizations have adopted the definitions for the terms included in this glossary. Departure from this glossary is not intended to provide a basis for civil liability and should not be presumed to create evidence that any duty has been breached. and contingent) are adjusted to their fair market values (NOTE: In Canada on a going concern basis). Appraisal Method—see Valuation Method. Appraisal Procedure—see Valuation Procedure. Appraisal—see Valuation. This glossary has been developed to provide guidance to business valuation practitioners by further memorializing the body of knowledge that constitutes the competent and careful determination of value and. If. Adjusted Net Asset Method—see Adjusted Book Value Method. in the opinion of the business valuation professional. American Institute of Certified Public Accountants American Society of Appraisers Canadian Institute of Chartered Business Valuators National Association of Certified Valuation Analysts The Institute of Business Appraisers Adjusted Book Value Method—a method within the asset approach whereby all assets and liabilities (including off-balance sheet. intangible. one or more of these terms needs to be used in a manner that materially departs from the enclosed definitions.

Capitalization of Earnings Method—a method within the income approach whereby economic benefits for a representative single period are converted to value through division by a capitalization rate. or investment entity (or a combination thereof) pursuing an economic activity. It may be used in a general sense to encompass various levels of specifically defined cash flows. Business Valuation—the act or process of determining the value of a business enterprise or ownership interest therein. the mix of debt and equity financing. Blockage Discount—an amount or percentage deducted from the current market price of a publicly traded stock to reflect the decrease in the per share value of a block of stock that is of a size that could not be sold in a reasonable period of time given normal trading volume. Capitalization Factor—any multiple or divisor used to convert anticipated economic benefits of a single period into value. Capital Asset Pricing Model (CAPM)—a model in which the cost of capital for any stock or portfolio of stocks equals a risk-free rate plus a risk premium that is proportionate to the systematic risk of the stock or portfolio. Cash Flow—cash that is generated over a period of time by an asset. group of assets. service. Business—see Business Enterprise. Book Value—see Net Book Value. See Financial Risk. Beta—a measure of systematic risk of a stock. industrial. business ownership interest.Asset (Asset-Based) Approach—a general way of determining a value indication of a business. 116 . Business Risk—the degree of uncertainty of realizing expected future returns of the business resulting from factors other than financial leverage. it should be supplemented by a qualifier (for example. or security using one or more methods based on the value of the assets net of liabilities. Capital Structure—the composition of the invested capital of a business enterprise. When the term is used. Business Enterprise—a commercial. Capitalization—a conversion of a single period of economic benefits into value. or business enterprise. the tendency of a stock’s price to correlate with changes in a specific index. Capitalization Rate—any divisor (usually expressed as a percentage) used to convert anticipated economic benefits of a single period into value. “discretionary” or “operating”) and a specific definition in the given valuation context.

Cost of Capital—the expected rate of return that the market requires in order to attract funds to a particular investment. Debt-Free—we discourage the use of this term. each item is expressed as a percentage of sales. etc. Discounted Cash Flow Method—a method within the income approach whereby the present value of future expected net cash flows is calculated using a discount rate. Discount for Lack of Voting Rights—an amount or percentage deducted from the per share value of a minority interest voting share to reflect the absence of voting rights. net cash flows. Control Premium—an amount or a percentage by which the pro rata value of a controlling interest exceeds the pro rata value of a non-controlling interest in a business enterprise. Discount Rate—a rate of return used to convert a future monetary sum into present value. net income. Discount for Lack of Marketability—an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability. Effective Date—see Valuation Date.Common Size Statements—financial statements in which each line is expressed as a percentage of the total. Economic Benefits—inflows such as revenues. See Invested Capital. 117 . to reflect the power of control. On the balance sheet. each line item is shown as a percentage of total assets. Control—the power to direct the management and policies of a business enterprise. and on the income statement. Discounted Future Earnings Method—a method within the income approach whereby the present value of future expected economic benefits is calculated using a discount rate. Economic Life—the period of time over which property may generate economic benefits. Enterprise—see Business Enterprise. Discount for Lack of Control—an amount or percentage deducted from the pro rata share of value of 100 percent of an equity interest in a business to reflect the absence of some or all of the powers of control. Cost Approach—a general way of determining a value indication of an individual asset by quantifying the amount of money required to replace the future service capability of that asset.

Goodwill Value—the value attributable to goodwill. and procedures in place. The intangible elements of Going Concern Value result from factors such as having a trained work force. and the necessary licenses. 118 . at which the asset or assets are sold as quickly as possible. the term “price” should be replaced with the term “highest price. systems. Going Concern Value—the value of a business enterprise that is expected to continue to operate into the future. reputation. Fair Market Value—the price. location. See Excess Earnings. business ownership interest. and similar factors not separately identified. when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. (NOTE: In Canada. customer loyalty. products. See Net Cash Flows. Excess Earnings—that amount of anticipated economic benefits that exceeds an appropriate rate of return on the value of a selected asset base (often net tangible assets) used to generate those anticipated economic benefits. expressed in terms of cash equivalents. an operational plant. Also frequently used to value intangible assets. such as at an auction.free rate to reflect the additional risk of equity instruments over risk free instruments (a component of the cost of equity capital or equity discount rate). at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller. Free Cash Flows—we discourage the use of this term.Equity—the owner’s interest in property after deduction of all liabilities. See Business Risk. Excess Earnings Method—a specific way of determining a value indication of a business. Forced Liquidation Value—liquidation value.”) Fairness Opinion—an opinion as to whether or not the consideration in a transaction is fair from a financial point of view. Equity Risk Premium—a rate of return added to a risk. acting at arm’s length in an open and unrestricted market. Going Concern—an ongoing operating business enterprise. Equity Net Cash Flows—those cash flows available to pay out to equity holders (in the form of dividends) after funding operations of the business enterprise. Financial Risk—the degree of uncertainty of realizing expected future returns of the business resulting from financial leverage. or security determined as the sum of a) the value of the assets derived by capitalizing excess earnings and b) the value of the selected asset base. making necessary capital investments. and increasing or decreasing debt financing. Goodwill—that intangible asset arising as a result of name.

When the term is used. and that are actively traded on a free and open market. business ownership interest. Liquidity—the ability to quickly convert property to cash or pay a liability. Income (Income -Based) Approach—a general way of determining a value indication of a business. and have value for the owner. it is the difference between the exercise price or strike price of an option and the market value of the underlying security. 119 . Internal Rate of Return—a discount rate at which the present value of the future cash flows of the investment equals the cost of the investment.Guideline Public Company Method—a method within the market approach whereby market multiples are derived from market prices of stocks of companies that are engaged in the same or similar lines of business. Investment Value—the value to a particular investor based on individual investment requirements and expectations. or scope. Levered Beta—the beta reflecting a capital structure that includes debt. or intangible asset using one or more methods that convert anticipated economic benefits into a present single amount. to be the “true” or “real” value that will become the market value when other investors reach the same conclusion. patents. security. equities. (NOTE: in Canada. Intangible Assets—non-physical assets such as franchises. trademarks. the term used is “Value to the Owner. Debt is typically a) all interest-bearing debt or b) long-term interest-bearing debt. or intangible asset with limitations in analyses. business ownership interest. securities and contracts (as distinguished from physical assets) that grant rights and privileges. mineral rights. Investment Risk—the degree of uncertainty as to the realization of expected returns.”) Key Person Discount—an amount or percentage deducted from the value of an ownership interest to reflect the reduction in value resulting from the actual or potential loss of a key person in a business enterprise. Invested Capital Net Cash Flows—those cash flows available to pay out to equity holders (in the form of dividends) and debt investors (in the form of principal and interest) after funding operations of the business enterprise and making necessary capital investments. on the basis of an evaluation or available facts. copyrights. When the term applies to options. it should be supplemented by a specific definition in the given valuation context. Intrinsic Value—the value that an investor considers. Limited Appraisal—the act or process of determining the value of a business. security. procedures. goodwill. Invested Capital—the sum of equity and debt in a business enterprise.

120 . security. Marketability—the ability to quickly convert property to cash at minimal cost. approximating the effect of economic benefits being generated evenly throughout the year. securities. Merger and Acquisition Method—a method within the market approach whereby pricing multiples are derived from transactions of significant interests in companies engaged in the same or similar lines of business. and amortization) and total liabilities as they appear on the balance sheet (synonymous with Shareholder’s Equity). or intangible assets that have been sold. With respect to a specific asset. Minority Discount—a discount for lack of control applicable to a minority interest. Multiple—the inverse of the capitalization rate. Market (Market-Based) Approach—a general way of determining a value indication of a business.Liquidation Value—the net amount that would be realized if the business is terminated and the assets are sold piecemeal. it should be supplemented by a qualifier. the difference between total assets (net of accumulated depreciation. Net Book Value—with respect to a business enterprise. Market Multiple—the market value of a company’s stock or invested capital divided by a company measure (such as economic benefits. Marketability Discount—see Discount for Lack of Marketability. business ownership interest. number of customers).” Majority Control—the degree of control provided by a majority position. business ownership interests. See Equity Net Cash Flows and Invested Capital Net Cash Flows. depletion. Market Capitalization of Equity—the share price of a publicly traded stock multiplied by the number of shares outstanding. Minority Interest—an ownership interest less than 50 percent of the voting interest in a business enterprise. Majority Interest—an ownership interest greater than 50 percent of the voting interest in a business enterprise. Mid-Year Discounting—a convention used in the Discounted Future Earnings Method that reflects economic benefits being generated at midyear. the capitalized cost less accumulated amortization or depreciation as it appears on the books of account of the business enterprise. Liquidation can be either “orderly” or “forced. Market Capitalization of Invested Capital—the market capitalization of equity plus the market value of the debt component of invested capital. Net Cash Flows—when the term is used. or intangible asset by using one or more methods that compare the subject to similar businesses.

of future cash inflows less all cash outflows (including the cost of investment) calculated using an appropriate discount rate. or other unusual items to eliminate anomalies and/or facilitate comparisons.”) Normalized Earnings—economic benefits adjusted for nonrecurring. 121 . as of a specified date. Present Value—the value. Redundant Assets—see Non-Operating Assets.g. Net Tangible Asset Value—the value of the business enterprise’s tangible assets (excluding excess assets and non-operating assets) minus the value of its liabilities. non economic. e. Normalized Financial Statements—financial statements adjusted for non operating assets and liabilities and/or for nonrecurring. non economic. Price/Earnings Multiple—the price of a share of stock divided by its earnings per share. expressed as a percentage of that investment. liquidation.Net Present Value—the value. as of a specified date. Non-Operating Assets—assets not necessary to ongoing operations of the business enterprise. Orderly Liquidation Value—liquidation value at which the asset or assets are sold over a reasonable period of time to maximize proceeds received. calculated using an appropriate discount rate. Rate of Return—an amount of income (loss) and/or change in value realized or anticipated on an investment. Premise of Value—an assumption regarding the most likely set of transactional circumstances that may be applicable to the subject valuation. the term used is “Redundant Assets. Portfolio Discount—an amount or percentage deducted from the value of a business enterprise to reflect the fact that it owns dissimilar operations or assets that do not fit well together. Reproduction Cost New—the current cost of an identical new property. Report Date—the date conclusions are transmitted to the client. of future economic benefits and/or proceeds from sale. going concern. or other unusual items to eliminate anomalies and/or facilitate comparisons. Required Rate of Return—the minimum rate of return acceptable by investors before they will commit money to an investment at a given level of risk. Replacement Cost New—the current cost of a similar new property having the nearest equivalent utility to the property being valued. (NOTE: in Canada.

Rule of Thumb—a mathematical formula developed from the relationship between price and certain variables based on experience. or intangible asset. fair market value. hearsay. Return on Invested Capital—the amount. investment value. earned on a company’s common equity for a given period. Unlevered Beta—the beta reflecting a capital structure without debt. inventory. Sustaining Capital Reinvestment—the periodic capital outlay required to maintain operations at existing levels. The measure of systematic risk in stocks is the beta coefficient. Return on Investment—see Return on Invested Capital and Return on Equity. etc. Systematic Risk—the risk that is common to all risky securities and cannot be eliminated through diversification. business ownership interest. Risk-Free Rate—the rate of return available in the market on an investment free of default risk. expressed as a percentage. Unsystematic Risk—the risk specific to an individual security that can be avoided through diversification.Residual Value—the value as of the end of the discrete projection period in a discounted future earnings model. or a combination of these.g. Return on Equity—the amount. e. or strategic advantages by combining the acquired business interest with their own. Valuation—the act or process of determining the value of a business. usually industry specific. Standard of Value—the identification of the type of value being used in a specific engagement. Tangible Assets—physical assets (such as cash. fair value. Transaction Method—see Merger and Acquisition Method. Terminal Value—see Residual Value. 122 . Special Interest Purchasers—acquirers who believe they can enjoy post-acquisition economies of scale. Risk Premium—a rate of return added to a risk-free rate to reflect risk. observation. synergies. accounts receivable. plant and equipment. expressed as a percentage.). net of the tax shield available from such outlays. property. earned on a company’s total capital for a given period. security.

Valuation Procedure—the act. security. operating. 123 . business ownership interest. Valuation Method—within approaches. of the cost of all financing sources in the business enterprise’s capital structure.Valuation Approach—a general way of determining a value indication of a business. or physical data serves as the denominator. Valuation Date—the specific point in time as of which the valuator’s opinion of value applies (also referred to as “Effective Date” or “Appraisal Date”). Valuation Ratio—a fraction in which a value or price serves as the numerator and financial. Value to the Owner—see Investment Value. manner. Weighted Average Cost of Capital (WACC)—the cost of capital (discount rate) determined by the weighted average. or intangible asset using one or more valuation methods. and technique of performing the steps of an appraisal method. Voting Control—de jure control of a business enterprise. at market value. a specific way to determine value.

As per “A basic guide for Valuing a Company” – 2nd edition by Wilbur M. Inc Multiplier for using with Excess earnings under “Excess earnings capitalization Method” 124 . Yegge. John Wiley & Sons.

(Liquidation value to assure the fund safety of financier) 125 . (Liquidation value in specific case) (investment value useful for negotiation) Fair value.PURPOSE AND RELEVANT STANDARD OF VALUATION The overall relation between the purpose and standard of value is summarized as below: Relevant Standard of Value Purpose giving rise to valuation need Existing stake holder/s Valuation is called by proposed stake holders (1) Relative strategy (a) Addition of Partner/s Fair value. Investment value Fair value. Liquidation value (b) Private equity funding/ venture capital finance (c) Business financing for new projects/ expansion (3) Value added management/ planning (a) Raising funds for expansion or new projects Fair value. Investment value. Takeovers Fair value. Liquidation value Investment value. Fair value Fair value. Investment value Investment value. Acquisitions. Liquidation value (investment value useful for negotiation) (2) Investments (a) Small business purchase Investment value (Fair value useful for negotiation) Investment value. Fair value (c) IPO (d) Mergers. Fair value (b) Business Sell / Purchase Agreement Investment value (Fair value useful for negotiation) Fair value.

dissolution of partnership Liquidation value or succession planning (f) Financial reporting (g) Frequent progress measure (4) Other Purposes (a) Ownership issues (b) Litigation issues involving lost profits or economic damages (c) Family issues Fair value Fair value Fair value Fair value. Liquidation value Fair value Fair value Fair value Liquidation value 126 .(b) Restructuring the business/ divestiture (c) Goodwill impairment (d) Allocation of Purchase price Fair value Fair value Fair value (e) Retirement of partner or Fair value.

Takeovers Discounted cash flow Replacement cost method (2) Investments (a) Small business purchase Discounted cash flow Replacement cost method Discounted cash flow Replacement cost method P/E multiple (as guiding data) Discounted Cash flow* Liquidation value (b) Private equity funding/ venture capital finance (c) Business financing for new projects/ expansion 127 . Acquisitions.PURPOSE AND APPROPRIATE TECHNIQUE/S OF VALUATION The overall relation between the purpose and appropriate valuation technique/s is summarized as below: Relevant Valuation Technique/s Purpose giving rise to valuation need Existing stake holder/s Valuation is called by proposed stake holders (1) Relative strategy (a) Addition of Partner/s Excess earnings method Adjusted net assets method (Discounted cash flow for negotiation) Earnings capitalization method (or earning multiple) or Revenue multiple Excess earnings method Liquidation value Earnings capitalization method Adjusted net assets value Discounted cash flow Comparable Companies’ multiple (P/E and P/EBITDA multiple)* Earnings capitalization method Discounted cash flow Liquidation value Discounted cash flow Excess earnings method Adjusted net assets method Discounted cash flow Replacement cost method (b) Business Sell / Purchase Agreement (c) IPO Discounted cash flow Comparable Companies’ multiple (generally P/E and P/EBITDA multiple)* (d) Mergers.

(3) Value added management/ planning (a) Raising funds for expansion or new projects (b) Restructuring the business/ divestiture (c) Goodwill impairment Discounted cash flow Adjusted net asset value Earning capitalization method Discounted cash flow Adjusted net asset value Adjusted net asset value (d) Allocation of Purchase price (e) Retirement of partner or Discounted cash flow dissolution of partnership Adjusted net assets method Liquidation value or succession planning (f) Financial reporting Discounted cash flow Adjusted net assets method Economic Value Addition method (excess earning method) Liquidation value in relevant cases (g) Frequent progress measure (4) Other Purposes (a) Ownership issues Excess earning method Discounted cash flow Adjusted net assets method Excess earning method Discounted cash flow Adjusted net assets method (b) Litigation issues involving lost profits or economic damages Depends on specific case and requirements Depends on specific case and requirements (c) Family issues Excess earning method Discounted cash flow Adjusted net assets method Liquidation value 128 .

Aswath Damodaran (Stern School of Buiness) WHICH APPROACH SHOULD BE USED? Depends Upon The Assets (Business) Being Valued …. Assets Marketability and Valuation Approaches Mature Businesses Separable & Marketable assets Growth businesses Linked and non-marketable assets Liquidation & Replacement cost value Other valuation models Cash Flow and Valuation Approaches Cash flow currently or Expected in near future Cash flow if a contingency occurs Assets that will never generate cash flows DCF or relative valuation models Option pricing models Relative valuation models Uniqueness of Assets and Valuation Approaches Unique asset or business Large number of similar assets that are priced DCF or option pricing models Relative valuation models 129 ..As per Prof.

. Investor time horizon and Valuation approaches Very short time horizon Long time horizon Liquidation value Relative Valuation Option pricing models DCF Views on market and valuation approaches Markets are correct on an average but make mistakes on individual assets Asset markets and financial markets may diverge Markets make mistakes but corrects them over time Relative valuation Liquidation value DCF or Option pricing model 130 . Aswath Damodaran (Stern School of Buiness) And The Analyst Doing The Valuation ….As per Prof.

Inc FAS 157 “fair value Measurement” “Valuation” by Leo Gough. European Integration Studies.References (books. Inc. volume 3. spring.winter 2003 pages 59-82 “impact of deferred tax facility on firm value” by Prof. notes.issue 1. April2007 pages 1564-1574 IPEV valuation board’s comments on the IASB’s discussion paper “Fair value measurements” published in November 2006 “The efficient market hypothesis and its critics” by Burton G. law and perspective” by David Laro and Shannon P. Journal of Business Valuation and Economic Loss Analysis. Miskolc. 2002 printed by capstone publishing “Valuation of a Business. article 7. June 2007 “Non-Quantitative Measures In Company Evaluation” by Ágnes Horváth.2004 “Valuation of Small business: An Alternative point of view” by Francisco J. Prasanna Chandra. McGraw Hill “Damodaran on Valuation . July 2006 Page 056-063 “All P/Es are not created equal”.security analysis for Investment and corporate finance” by Aswath Damodaran “Investment valuation” 2nd edition by Aswath Damodaran ”Business valuation and taxes – procedure. Inc. John Wiley & Sons. Harisha. Nov 1. Hitchner. Christopher Mercer The CPA Journal.S. July 2003 “Fair Value Measurement” by CA Shrikant Sortur The Chartered Accountant. Lopez. 2008 131 . “Financial Valuation – Applications and Models” by James R. or intangible asset” Statement on standards for valuation services issued by the AICPA consulting services executive committee. articles and websites) “A basic guide for Valuing a Company” – 2nd edition by Wilbur M.V.volume 17. Volume 4 (2005) pp 6172. “Financil management – Theory and practice” 6th edition by Dr. Healy. Mckinsey on Finance. Bernard “Quantitative Business Valuation .Business Valuation. “A Premier on the Quantitative Marketability Discount Model” by Z. John Wiley & Sons. The Chartered Accountant. Narsimhan and B. M. Journal of Economic Perspective. John Wiley & Sons. Business ownership interest. Yegge.A mathematical approach for today’s professional” by Jay Abrams. Malkiel. Pratt. Tata McGraw hill publishing Company Limited “Business Analysis and Valuation – using financial statements” 2nd edition by Palepu. security.

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