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17798business_valuation

17798business_valuation

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07/30/2012

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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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approach. 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. Yegge for application with “Excess earnings capitalization Method” Table showing purpose Vs.Index BUSINESS VALUATION Need. limitations and disclaimers Contents of exhaustive valuation report International glossary of valuation terms Multipliers suggested by author Mr. 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. recommended techniques Time vs. approach. asset vs. Aswath damodaran References 4 . as mentioned by Prof. Wilbur M.

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

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. 6 . IRS (US) roughly defines intangible 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. The value of Business enterprise containing more than one stream is generally more than just a sum total of values of every such stream. or goodwill. 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. 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. European Integration Studies. Volume 4 (2005) pp 61-72. as that amount paid for a business in excess of the market value of hard assets.In pure sense. Miskolc. Intangible business value is a highly judgmental aspect of business valuation and requires conscientious attention. So. the business value is affected by tangible as well as non-tangible factors. business valuation refers to estimation of business value. we receive in future out of a subject property. Ágnes Horváth * presents the value inequalities as follows showing the general relation between “values of business” derived by different perceptions.

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

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

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

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

A condition or situation in which something is required or wanted: 2. to feel that one must have something.thefreedictionary.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. A condition of poverty or misfortune http://www. Therefore.com/need 1. Need Definition of need is taken from some different web sites and produced below: http://en. Necessity. 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. To be obliged or required to.wiktionary.merriam-webster.Businesses or their assets are valued for a variety of reasons. To want strongly. Something required or wanted. http://www. 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 . Some of the most noticeable purposes for valuation of MSME business are demonstrated below: • • • • • • • • • • • • • • • Buy/sell agreements Addition or retirement of partner.org/wiki/need To have an absolute requirement for. a requisite 3. desirable. dissolution of partnership. the “purpose” creates a “need” for valuation. obligation 4.

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

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

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

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

which might include the reporting entity’s own data. for example. The said instances are helpful in determining the fair value at initial recognition. b. Assessing the significance of a particular input to the fair value measurement in its entirety requires judgment. the reporting entity shall not ignore information about market participant assumptions that is reasonably available without undue cost and effort. 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. 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 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. Unobservable inputs shall be developed based on the best information available in the circumstances. but not necessarily all-inclusive. including assumptions about risk.” The inputs used to measure fair value might fall in different levels of the fair value hierarchy. 19 . inputs refer broadly to the assumptions that market participants would use in pricing the asset or liability. Therefore. 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. 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. say.g. considering factors specific to the asset or liability. The reporting entity should consider factors specific to the transaction and to the asset or the liability. However. Inputs may be observable or unobservable: a.Here in this statement. 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. FAS 157 cite four instances that might indicate that the transaction price does not represent fair value.. 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. (For e. In developing unobservable inputs. the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions.

In other words. if the market price is higher than the intrinsic value. in terms of both tangible and intangible factors. It is an analytical judgment of value based on perceived characteristics inherent in the investment (not characteristic peculiar to any one investor). For listed companies. based on an evaluation of available facts. expected rate of return.” So. future dividends are derived from earnings forecasted and then discounted to the present. intrinsic value is based on fundamental analyses of business. 20 . 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. thereby establishing a present value for the equity. in its course Fundamentals of Business Valuation—Part 1.A single definition of fair value. the fair value of a business can be derived by using the intrinsic valuation measures or extrinsic (market based) valuation measures. capital investment and the growth potentials. Under the intrinsic value method. the share is a ‘sell. if the shares are trading at a price lower than this calculation. based on its own characteristics and situations. It is also sometimes presented by the net asset value. 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. then subject asset (or property) will realize a price something near to it. The extrinsic value is based on the assumption that if comparable asset (or property) has fetched a certain price. This value may or may not be the same as the current market value. 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. AICPA (American Institute of Certified Public Accountants). together with a framework for measuring fair value. 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. should result in increased consistency and comparability in fair value measurements. It is sometimes called fundamental value. The value of business can be determined by discounting the future cash flow considering business fundamentals like risk. defines intrinsic value as the “Amount an investor considers to be the ‘true’ or ‘real’ worth of an item. 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. it is a ‘buy’.

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

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

23 . the variance in this value. there are three approaches to value any asset. The income approach 3. on the other hand. Flexibility options. Of these. There are some assets that cannot be valued with conventional valuation models because their value derives almost entirely from their option characteristics. patent or brand development. 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. For example. Several methodologies have been developed to value options. There are two types of real options: • Growth options • Flexibility options. The payoffs on this asset (real option) have to be contingent on and specified event occurring within a finite period. the risk less interest rate and the expected dividends on the assets. leasing or developing land. Option pricing OR contingent claim method is emerging as a better contender to value assets that have option like characteristics. Growth options give a firm the ability to increase its future business. The asset approach 2. expand. The market approach (Relative valuation approach) One other approach called. Examples include research and development. outsource or abandon projects. business or business interest: 1.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. mergers and acquisitions. contract. 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. or—most pertinent—launching a technology initiative. The value of an option is determined by six variables – the current value of the underlying asset. In broadest possible terms. 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. the binomial method provides an intuitive feel and insight into the determinants of option value. Management can purchase the option to delay. strike price. give a company the ability to change its plans in the future. switch uses. life of option.

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

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. observation. usually industry specific”. For example. Rules of thumb fail to consider the specific characteristics of a company as compared to the industry or other similar companies. 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). capital structure and other information unique to the business. or price per subscriber for cable television business. As such. 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. rules of thumb can be useful in testing the value conclusion arrived through the appraiser’s selected approaches and methods. Rules of thumb typically come in the form of a percentage of revenues or a multiple of a level of earnings. competition. industry. hearsay or a combination of these.All three approaches should be considered in each valuation. it is not common to use all three approaches in each valuation. in fact. reputation. Widely-accepted business appraisal theory and practice does not include specific methodology for rules of thumb in developing a value estimate. Rules of thumb are simple pricing techniques that are typically used to approximate the market value of a business. as there is typically no empirical evidence relating to how the rules were derived or if. it is usually better to use them for reasonableness tests of the value conclusion. In addition. the rules are reflective of transactions in the market. thumbs come in many sizes and shapes!” So. 25 . However. rules of thumb do not reflect changes in economic. such as management depth. location. 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. customer relationships. None of the rules provide sufficient information to assess the uniqueness of the business. industry trends. However. or competitive factors over time. we can conclude that although rules of thumb may provide insight on the value of a business. “Be careful. Such sanity checks are a way for business appraisers to test the reasonableness of their value conclusion. business appraisers do not use rules of thumb in determining an indication of value.

As per the views of the analyst. relative valuation (and in some cases. option pricing models) and within each approach. it is inversely proportional to Business risk. In resolving such differences. and the differences can be substantial. entity value is driven by assets and earnings potentials. 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. the sources of earnings growth. which multiple we should use to value firms or equity based on comparable business or transaction. Once we decide to go with one or another of these approaches. 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. Often. growth potential. an appraiser will find wide differences of opinion as to the fair market value of a particular stock. It is established for specific purpose and specific point of time.” Valuation is relative to purpose.. a replacement value or a liquidation value. Intrinsic value is something that cannot be observed. Actually. the stability of leverage and dividend policy. 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. The origin of the methods employed to measure values of assets can be traced back 26 .WHICH APPROACH SHOULD BE USED? Now. Therefore. 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. the calculated value of a business will vary depending on how it’s intended to be used. they must also choose among different models. Valuation process is undertaken on the belief that values can be measured on the basis of certain parameters using relevant techniques and methods... The value established for tax purposes or for litigation is not the same value established for divestiture. A business appraisal is in fact the opinion of the individual appraiser. these choices will be driven by the characteristics of business being valued the level of earnings. we have further choices to make – which value of asset to consider. It is the asset prices that we observe and report. It is like a kitchen that has many chefs with multifarious stuff on platform but no recipes. he should maintain a reasonable attitude in recognition of the fact that valuation is not an exact science. discounted cash flow valuation. and the appraiser has significant flexibility in formulating an opinion. whether to use equity or firm valuation in the context of discounted cash flow valuation.

International Private Equity and Venture Capital Valuation (IPEV) Guidelines (Oct.” IPEV indicates the usage of DCF for the businesses with absence of significant revenues. 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. 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.” “……. “consistent with existing valuation practice. profits or positive cash flows. while studying the preferences of court for valuation approaches of closely held companies based on Industry type. FASB (Financial Accounting Standard Board) clarifies that. valuation techniques that are appropriate in the circumstances and for which sufficient data are available should be used to measure fair value. This will include consideration of facts such as: . IPEV also emphasis to consider the basic characteristics of all the three approaches. divided into various sub groups based on Industry classification codes. Fair value estimates based entirely on observable market data will be of great reliability that those based on assumptions. This Statement does not specify the valuation technique that should be used in any 27 .relative applicability of the methodologies used given the nature of industry and current market conditions . However it gives more weight age to use market based approach for deciding the fair investment value.the stage of development of the enterprise. while market approaches were most popular for holding companies.Comparability of enterprise or transaction data . James DiGabriele. however with the caution about the inherent disadvantage of high level of subjectivity involved in the method. the valuer should be biased towards those methodologies that draw heavily on market-based measures of risk and return. and these methods are constantly evolving with related newer developments taking place. He also derived a conclusion that each of the three valuation approaches is equally popular for tangible companies and equally popular for intangible companies.any additional considerations unique to the subject enterprise”. It narrates that “In accessing whether a methodology is appropriate.to finance theory and economics. So. He had performed various mean tests on a sample of 164 cases. For FAS 157. service or holding companies.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. and . These methodologies may be useful as a cross-check of values estimated using the market-based methodologies.Due to high level of subjectivity in selecting inputs for this technique. came on conclusion than the income approaches are more popular for manufacturing companies and less popular for companies not classified as manufacturing.Quality and reliability of the data used in each methodology .

in all cases. The fair value hierarchy under FAS 157 also. 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. the document should adopt a consistent theoretical approach and should not try to solve issues that are specific to certain markets. the valuation guidelines should not aim to be exhaustive and it must not restrict the analyst’s wisdom to apply in specific circumstance. thereby requiring judgment of appraiser in the selection and application of valuation techniques.” So. However. not the valuation techniques.” The statement provides for using single technique or multiple techniques. However. subject that. in determining fair value. however. assets or asset classes and then apply those solutions to all other situations. as the appraiser. some of which relate to the business being valued but many of which relate to us. will depend upon several factors.” 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. Determining the appropriateness of valuation techniques in the circumstances requires judgment. The valuation techniques may differ. As read from the Para 13 of CCI guidelines (1990). “The guidelines are intended to provide the basic framework for valuation and to minimize the element of subjective consideration. While they should be applied fairly and consistently in all cases. The IPEV valuation Board fears that doing so will create principles and guidelines that are too theoretical and difficult to apply to specific situations. the results of those techniques evaluated and weighted. users and auditors. in order to achieve its objective. 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. This judgment. focuses on the inputs. depending on the asset or liability and the availability of data. they should not be regarded as eliminating the exercise of discretion and judgment needed to arrive at a fair and equitable valuation. as appropriate. such a document should not aim at being exhaustive in its guidance in order not to create more confusion for accounts preparers. 28 . Consequently.particular circumstances.

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

Book value This is simply a value based upon the accounting books of the business. 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. Property & equipments Current Liabilities Long . machinery and equipment) might need to be consulted as part of the valuation process. real estate. Assets less liabilities equals the owners’ equity. little or no growth opportunities and no potential for excess returns. In simple term. For firms with significant growth opportunities in businesses where they can generate excess returns. the book value of the assets may yield a reasonable measure of the true value of these firms. In addition.Following figure shows a business value based on asset approach.g.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.. it is important to consider intangible items that 30 . which is the "Book Value" of the business. VALUATION BALANCESHEET Total Asset Current Assets Invested Capital Plant. other types of appraisers (e. book values will be very different from true value. Depending on the mix of assets owned by the company. 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.

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

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

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

a value analyst will always prefer to determine a market value by reference to comparable market transactions. They are market based. assume that there is some relationship between cost and value and the approach has very little to commend itself other than ease of use. 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. internationality. In valuing an item of intellectual property.. The value of current and fixed assets is then deducted to arrive at the value of intangible assets. trend of profitability. While this capitalization process recognizes some of the factors which should be considered. Expenditures such as those on advertising. 3) excess profits methods. may promise future benefits.The most common technique for capturing total intangible value is an enterprise valuation to establish total asset value. This is not only due to lack of compatibility. The analyst should note that. For example. mostly 34 . marketing and advertising support and protection. and 4) the relief from royalty method. but the benefits are so uncertain and unpredictable that the business classify them as current expenses. the search for a comparable market transaction becomes almost futile. 2) gross profit differential methods.. such as the “cost to create” or the “cost to replace” a given asset. stability. a business enterprise must expect benefits in the coming years and support that expectation with evidence. cost based. Methods for the Valuation of Intangibles Acceptable methods for the valuation of identifiable intangible assets and intellectual property fall into three broad categories. 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. 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. market share. 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. Cost-based methodologies. huge advertisement cost on initial start ups for product publicity. 1) capitalization of historic profits. claim existence of intangible worth arisen due to these expenditures. it has major shortcomings. Many times a business owner incurring specific expenses like research on value addition of a product. In an ideal situation. a multiple is arrived at after assessing a brand in the light of factors such as leadership. 1. The method ignores changes in the time value of money and ignores maintenance. in order for expenditure to qualify as an intangible asset. for example. or based on estimates of past and future economic benefits.

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

the appraiser may select a single period capitalization method or a multi-period discounted future income method. risk involvement or uncertainty. 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. and so. 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. dividends. etc. 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. Earnings is a final crux of the business activity. If these conditions are satisfied. Earnings are linked with all other fundamentals of the business like growth.2. an appropriate multiple can be used with the normalized earnings to arrive at fair estimation of business value. 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. 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. 36 . 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). THE INCOME APPROACH The concept is to value a business or asset based on its earning capacity. the income stream that represents the expected income stream in perpetuity is capitalized to arrive at a terminal value. This is predicated upon the ability to create a reasonable forecast of the company’s income stream for the forecast period. or cash flow. For the final year of the projection period. Alternately. capital requirements. 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. return and time. Under the Income Approach. valuation of business based on its earning capacity can be a better proxy. 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 results in a value based on the present value of the future economic benefits that the owner will receive through earnings. 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 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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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. 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. the terminal value will be lower and the business is assumed to be disappearing over time. for instance. It can be negative but in such case. of years 40 .52 Arithmetic mean = sum of growth rates / no.94 1.35 09.LONG TERM GROWTH RATE) The stable growth rate should not exceed the growth rate of economy but can be set at ant lower figure.68 -07.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 . . that capital expenditures.This formula represents the value of all cash flows remaining beyond the end of the forecast period .24 1. 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.The model assumes a constant growth in cash flow. are not disproportionately large and the firm is of 'average' risk.26 1.36 1.02 12. This would mean. The assumption that a firm is in steady state also implies that it possesses other characteristics shared by stable firms.10 1. Historical growth rate is generally estimated based on arithmetic average or geometric average or regression models.The rate must be sustainable into perpetuity .38 growth rate 17.73 09. of gap years -1 -1 EPS 0.

the appraiser is required to determine a cost of equity first. In both the cases. but prior to debt payments. For example.The cost of equity and debt for the industry or firm. weighted by their market value proportions. This approach is discussed in detail under market approach.73+09. Weighted Average Cost of Capital (WACC) The value of the firm is obtained by discounting expected cash-flows to the firm. 3.e. which is the cost of the different components of financing used by the firm. 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. the residual cash-flows after meeting all operating expenses and taxes.32 Geometric mean = (1. And for determining the value of equity.35)+09. The WACC is based on: .38/.68+(-07. Multiple approaches .52)/5 = 8.02+12.is based on a multiple of a measure of financial performance applied at the end of the forecast period.094)^(1/5) = 7.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.98 -1 2. Cost of Debt 41 . and . 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. i.= (17. Liquidation value: The terminal value of business is derived by estimating the value of individual assets at the end of the forecasting period. at the weighted average cost of capital.. the rate normally used is rate of return expected by equity holders.

Small company risk Studies have shown there is a small company premium because CAPM under estimates the return earned by investors in small companies.Rf = the market premium In addition to these variables. either nominal or real. Capital Assets Pricing Model (CAPM) is commonly used technique. It represents an alternative rate of return to the investor that is risk free and has liquidity 42 . Kd = D (1 .RM) + S1+ S2 Where: S1 = size premium = size premium S2 = specific company (business) risk Components of CAPM Rf is the risk free rate. there are adjustments to consider in applying this method to closely held companies or MSME businesses: . .The cost of debt is usually the rate of interest at which the loan and other debts are aerated by the organization. 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 .Specific company risk In some cases the company being valued will have specific risks that justify an additional risk premium. Under CAPM. So.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). CAPM equation including adjustments will be Ke = RF + β (RF . It is typically the yield from long-term government bonds.

In order to measure a fair value. the return from the equity market. Being this a study on valuation of MSME concerns. 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). In MSMEs where the prices are not listed on any stock exchange. fourth edition.” 43 . In case of non-public companies where the shares are not trading on open market. Robert Reilly. there is no specific model for quantifying the exact effect of these factors of the discount rate. It shows how the price of a security responds to market forces. Effectively. Shannon Paratt. expected rate of return is considered based on average rate of return in the industry in which the business unit pertains. 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. but should explicitly describe the factors that impact this final element. without a commonly accepted set of empirical support evidence.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 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. the more responsive the price of a security is to changes in the market. However. I am not going into analyzing beta. the higher shall be its beta. However. fundamental beta or bottom-up beta are used to determine the cost of equity. Market risk can be broken down further into business risk and financial risk. the higher the risk Betas are typically calculated for an industry to provide a measure of risk for that particular industry Rm. after carefully analyzing these elements of investment specific risk. many times accounting beta. Beta measures nondiversifiable risk. the higher the beta. 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. The analyst must depend on experience and judgment in this final element of the discount rate development. The measure to quantify the market risk is known as beta (β). the discounting rate is generally considered based on the specific company (business) risk and expected rate of return by the owner or equity holders. 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.

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

So. Aswath damodaran for choosing an appropriate technique under Income approach of valuation. Views of Prof. risk-adjusted discount rate and also that of terminal value. is produced below: 45 .this method. The disadvantages of the DCF centre around the “Estimates”. 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. using discounted cash flow models is in some sense an act of faith. It requires estimation of cash flows.

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 .

Firm Value = Un-levered Firm Value + PV of tax benefits of debt .Expected Bankruptcy Cost In practice. In the adjusted present value approach. EBIT (1 . Finally. V = EBIT (1 – t) / (Ke – g) + DT Where. In general.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. 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. 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.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. It is rare that the debt equity ratio in the business remains constant. project financing and real estate financing. and the expected cost of bankruptcy. where the effects of debt financing are captured in the discount rate. In the adjusted present value (APV) approach. In contrast to the conventional approach. we estimate the value of the firm in three steps. normally bankruptcy cost is not considered while determining value as per this method. We begin by estimating the value of the firm with no leverage. 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. the APV approach attempts to estimate the expected value of debt benefits and costs separately from the value of the operating assets. 47 . We then consider the present value of the interest tax savings generated by borrowing a given amount of money. we separate the effects on value of debt financing from the value of the assets of a business. the formula for calculating APV is. And so. like leveraged buyouts (LBOs). we evaluate the effect of borrowing the amount on the probability that the firm will go bankrupt.

Firm Value = Value of Assets in Place + Value of Expected Future Growth 48 . WACC and FLOWS TO EQUITY APPROACHES to firm Valuation. Pablo Fernández. APV. came on the conclusion that there is no significant relationship between change in capital structure and the value of a firm. 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. It is computed as the product of the "excess return" made on an investment and the capital invested in that investment. all these three methods of valuation (if used correctly) always yield the same result. 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. In the excess return valuation approach. With the excess return valuation framework. 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. excess returns can therefore be either positive or negative. In a article “Cost of Capital. Optimal capital Structure. at the micro level. we separate the cash flows into excess return cash flows and normal return cash flows.As written by Prof. the researcher Shri Raj S Dhankar and Shri Ajit S Boora. 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. and value of Firm: An Empirical Study of Indian Companies”. 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. 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.

The resultant value can be cross checked for reasonability through deriving rate of return as if single period capitalization method is applied. can be used to determine a business value using this technique.This approach is widely used for appraising MSME business because of ease in calculation and simplicity in understanding. 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. such as vacant land and securities. Using the single period capitalization method we can determine the EVA first and then the estimated value of business. 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. Non operating assets are generally valued separately and added to the value of the operations. single period capitalization model and multi period income discounting model. 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. and assets held for investment purposes. This method is very popular in valuing MSME businesses but care must be taken to choose the multiple. 49 . plant and equipment and intangible assets. While applying multi period income discounting model (DCF). we first come to know the value of business and then after deducting capital investments we can determine an addition earnings. Any of the two basic approaches of income approach. property. Steps for business valuation.

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

200 (the $200 would represent the cash risk premium). Because the discount rate used in the discount rate adjustment technique is a rate of return relating to conditional cash flows. For example. there could be many possible outcomes. industry trends. Models used for pricing risky assets. which is an expected rate of return relating to expected or probability-weighted cash flows. adjusted for risk such that one is indifferent to trading a certain cash flow for an expected cash flow. 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. including economic or market conditions. In theory. and competition as well as changes in internal factors impacting the entity more specifically). which is discounted at a risk-free interest rate. 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. In that case. it should be possible to develop a limited number of discrete scenarios and probabilities that capture the array of possible cash flows. To illustrate Methods 1 and 2. For example. 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). and the systematic risk premium is 3 percent. assume that an asset has expected cash flows of $780 in 1 year based on the possible cash flows and probabilities shown below. the expected cash flows ($780) represent the probability-weighted average of the 3 possible outcomes. The applicable risk-free interest rate for cash flows with a 1-year horizon is 5 percent. such as the Capital Asset Pricing Model. Rather. However. it likely will be higher than the discount rate used in Method 1 of the expected present value technique. adjusted for changes in circumstances occurring subsequently (for example.000 is the certainty equivalent of the $1. can be used to estimate the expected rate of return.000. changes in external factors. Specifically: 51 . In more realistic situations. if one were willing to trade an expected cash flow of $1.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). Accordingly. considering the assumptions of market participants. 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. These risk-adjusted expected cash flows represent a certainty-equivalent cash flow. as indicated below. A certainty-equivalent cash flow refers to an expected cash flow (as defined). a reporting entity might use realized cash flows for some relevant past period. one would be indifferent as to the asset held. the $1.200 for a certain cash flow of $1.

The $758 is the certainty equivalent of $780 and is discounted at the risk-free interest rate (5 percent). For example. Rather. The present value (fair value) of the asset is $722 ($758/1. and the judgments applied. 52 . Under Method 2.08). the expected cash flows are adjusted for systematic (market) risk. such adjustment could be derived from an asset pricing model using the concept of certainty equivalents. the adjustment for that risk is included in the discount rate. which results in risk-adjusted expected cash flows of $758 ($780 – $22).05/1.05).a. Thus.08)]). 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 extent to which sufficient data are available. In the absence of market data directly indicating the amount of the risk adjustment. either Method 1 or Method 2 could be used. The present value (fair value) of the asset is $722 ($780/1. b. the risk adjustment (cash risk premium of $22) could be determined based on the systematic risk premium of 3 percent ($780 – [$780 (1. When using an expected present value technique to measure fair value. The selection of Method 1 or Method 2 will depend on facts and circumstances specific to the asset or liability being measured. Under Method 1. the expected cash flows are not adjusted for systematic (market) risk.

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

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

Valuation Techniques There are two primary sources or methods that can be applied to determine a value based on market transactions or market behavior. 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. The method might involve private company transactions. as well as public company valuation measures using current share market data. the Board concluded that quoted market prices provide the most reliable measure of fair value. etc.(PAT. etc. public company transactions. creditors. Adjustments are commonly made to these valuation measures before applying to the subject company to ensure an “apples-to-apples” comparison. Quoted market prices are easy to obtain and are reliable and verifiable.) inherent in smaller private companies as well as the “lack of marketability” of private company stock. Commonly used Multiples Business can be valued based on the multiples like Earning multiples. and other users of financial information.g. EBITDA. 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. management depth. EV to EBIT. a variety of valuation measures might be used including Enterprise Value (EV) to Sales. EV to EBITDA. customer concentration. access to financing.. 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. Those are used and relied upon regularly and are well understood by investors. 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. This can be a helpful tool in valuing private companies. EBIT etc) Book value (or replacement value) multiple Revenue Multiples Business specific Multiple 55 . 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. Price to Earnings. but these public company multiples usually need to be discounted significantly to reflect the higher risks (e. 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. Depending on the source of data available and the underlying company being valued.Under FAS 157.

Although a simple indicator to calculate. Unlike net income. P/BV Ratio = Market Value / Book Value of Capital or Owners’ fund Sometimes. 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 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. The result will be different under each different choice. The book figure being accounted on historical basis is easy to compare. the price/earnings ratio is one of the oldest and most frequently used metrics. An alternative approach. The market capitalization is divided by the book value of capital to determine a multiple. 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.or undervalued a business or assets are. Price to Revenue multiple Both earnings and book value are accounting measures and are determined by accounting rules and principles. 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. in order to give effect of current value of assets of the business. is that it becomes far easier to compare firms in different markets. 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. The advantage of using revenue multiples. Rate of return on capital can be applied with value of firm or business value. appraisers often misuse this term and place more value in the P/E than is warranted. however. P/R Ratio = Market Value / Revenue Business Specific Multiple 56 . the appraiser should take care that the earnings used here to derive a multiple is proper in relation to price applied. than it is to compare earnings or book value multiples. 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. is to use the ratio of the value of a business to the revenues it generates. It can be extremely informative in some situations. the P/E is actually quite difficult to interpret. In other words. As a result. For example. 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. Both EBIT and EBITDA are independent of capital structure. while at other times it is next to meaningless. which is far less affected by accounting choices.Price to Earnings (P/E) Multiple When it comes to valuing equity or ownership.

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

growth and cash flow characteristics. There is no reason why a firm cannot be compared with another firm in a very different business. Intuitively. less risk and greater cash flow generating potential should trade at higher multiples than firms with lower growth. Thus. In most analyses. revenues or book value. whether it is of earnings. So. growth and cash flows . the expected growth in these cash flows and the uncertainty associated with these cash flows. Traditional analysis is built on the premise that firms in the same sector are comparable firms. then. growth and risk.would be ideal if we could value a firm by looking at how an exactly identical firm in terms of risk. 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 . firms with higher growth rates. and cash flow profiles and therefore can be compared with much more legitimacy. growth and cash flow profiles across firms within a sector are large. The implicit assumption being made here is that firms in the same sector have similar risk. Nowhere in this definition is there a component that relates to the industry or sector to which a firm belongs. 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.is priced. a telecommunications firm can be compared to a software firm. higher risk and less cash flow potential. growth. if the two are identical in terms of cash flows. In discounted cash flow valuation. A major disadvantage of this valuation method is that often. the value of a firm is a function of three variables – its capacity to generate cash flows. Every multiple. it is difficult to determine “the right comparable”. growth and cash flow generating potential. However in reality. 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. it is also difficult to define firms in the same sector as comparable firms if differences in risk. if the two firms have the same risk. is a function of the same three variables – risk. analysts define comparable firms to be other firms in the firm’s business or businesses.

as well as the relative performance of the multiples. 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). depreciation. No matter how carefully we construct our list of comparable firms. Nissim and Thomas (2002) compare how well different multiples do in pricing 19. the accuracy and bias of value estimates. Liu. in your judgment. and amortization (EBITDA) multiple generally yields better estimates than does the EBIT multiple. with Enterprise Value/EBITDA multiples dominating valuations of heavy infrastructure businesses (cable. 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. These differences are generally controlled by using subjective adjustments or using modified multiple or applying statistical technique like sector regression or Marker regression. taxes. it is important that the earnings multiple of each comparator is adjusted for points of difference between the comparator and the company being valued. telecomm) and price to book ratios common in financial service company valuations.is reliant on a small number of key employees . Which Multiple is to use? Going through various alternates available for choosing a multiple. vary greatly by company size. Finally. that multiples of sales and operating cash flows do 59 . the difference on the multiple cannot be explained by the fundamentals. we will end up with firms that are different from the firm we are valuing. company profitability.is dependent on one product or one customer . 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. If. 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.879 firm-year observations between 1982 and 1999 and suggest that multiples of forecasted earnings per share do best in explaining pricing differences. The value of business may be reduced if it: . the earnings before interest. 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.has high gearing or . less able generally to withstand adverse economic conditions .for any other reason has poor quality earnings.In order to normalize the comparison. Damodaran (2002) notes that the usage of multiples varies widely across sectors. 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.is smaller and less diverse than the comparator(s) and therefore. and the extent of intangible value in the company. Also.

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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technique by considering more aspects of business to arrive at a conclusive value. Thus.. rejects a mathematical weighting of approaches with the following language: SEC. A good report will also go on to demonstrate that all relevant factors are considered while deciding the weights. it considers simple net asset value and earning capacity as a deciding factor for determining a fair value. yield and market price were the methods used by applying appropriate weights for determination of the exchange ratio in that case. and that the weights are presented only to help clarifying the thought process of the analyst. a value arrived on the basis of considering proper weight ages of market value. the appraisers usually apply mathematical weights when giving weight to two or more approaches. DFC value and Net asset value will take care of existing position (net asset). book value. 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. 1990 (Para 8. Para 42 of the statement is produced below: “Conclusion of Value 42. with a disclaimer that there is no empirical basis for assigning mathematical weights. the valuation analyst should: 63 . there is no means whereby the various applicable factors in a particular case can be assigned mathematical weights in deriving the fair market value. 7.”. 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. In arriving at a conclusion of value. AVERAGE OF FACTORS Because valuations cannot be made on the basis of a prescribed formula. So. For this reason. 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. one usually wants to know how much weight is accorded to the various techniques. the guidelines read altogether are criticized as a conservative approach and not practically preferred by experts. For example. “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. no useful purpose is served by taking an average of several factors (for example. But when appraiser uses subjective weighting. CCI guidelines.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. So. it will be recognised and made use of ……. Net assets. capitalized earnings and capitalized dividends) and basing the valuation on the result. while the market value will not be a direct “input” in valuation. However. Revenue Ruling 59-60 of Internal Revenue Service (IRS) at US.

There are plenty of pros and cons for each method. we can conclude that the conclusive value rests on COMMON SENSE AND REASONABLENESS. which helps its possessor to draw correct conclusions. While there are numerous valuation methodologies that can be utilized to begin establishing value. computing a weighted average to arrive at their final number. 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. confidence in the eventual number is based on the integrity of the underlying process. To assure that integrity. This wide variety of methods available can be a confusing array to choose from. providing a valid and supportable value. based on items a and b. Each methodology provides additional clarity on valuation and evaluating results of numerous methods provides a better understanding of a business’ true “worth”. a technique of thinking. not all methodologies would be appropriate for all situations. b. 2006) also permits usage of more than one technique to arrive at the fair value of investment. 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. an apparatus of the mind.” IPEV guidelines (October. Assess the reliability of the results under the different approaches and methods using the information gathered during the valuation engagement.a. It is a method rather than a doctrine. It narrates that ”….. Correlate and reconcile the results obtained under the different approaches and methods used. your type of business. A fair amount of experience. c. The important factor in any valuation is that the method used is relevant to your purpose of valuation. While there is no such thing as absolute truth in business valuation.’’ John Maynard Keynes Actual pricing of business (Buy sell transaction) 64 .Where the valuer considers that several methodologies are appropriate to value a specific investment. Determine. So. many valuation professionals use more than one method. 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”. ‘‘ The theory of economics does not furnish a body of settled conclusions immediately applicable to policy.

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

5 crore but does not exceed Rs. Please refer First Schedule to the Industries (Development and Regulation) Act. it is defined as follow: Manufacturing Sector Manufacturing sector refers to enterprises engaged in manufacture or production. In India. S. S. Small and Medium Enterprises under the manufacturing sector is as below: i.O.BUSINESS VALUATION and MSMEs What is MSME business? MSME business stands for business run by Micro.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. 1722(E) dated October 5. Small. The definition of Micro.3 lakh for working capital requirements). 66 . 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. 1951 for the list of eligible industries engaged in the manufacturing sector.10 lakh of which not more than Rs. processing or preservation of goods.10 lakh.5 crore. 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. 25 lakh. 2006] is more than Rs. These will include small road & water transport operators (owning a fleet of vehicles not exceeding ten vehicles). 2006] does not exceed Rs. the borrowing limits should not exceed Rs.O. small business (whose original cost price of the equipment used for the purpose of business does not exceed Rs. 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. S. 1722(E) dated October 5.10 crore. 1722(E) dated October 5. ii. A micro enterprise is an enterprise where the investment in equipment does not exceed Rs. and Medium Enterprises.20 lakh) and professional & self employed persons (whose borrowing limits do not exceed Rs. 2006) is more than Rs. Practically.25 lakh but does not exceed Rs. Small and Medium Enterprises under the services sector is as below: i.15 lakh with a sub-ceiling of Rs. and iii. it is a general term and difficult to define. The definition of Micro.O. Services Sector Services sector refers to enterprises engaged in providing or rendering of services.

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

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

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

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

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

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

) improving. Financial Analysis helps to decide the key factors to consider before arriving at the conclusion on valuation of business. These are like. 73 . The comparable financial will be used to determine the extrinsic (market based value) of the business. 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. Ratio analysis is the most useful tool because it helps an analyst to compare the strengths.The analyst is required to consider all these and other relevant factors to design a normalized financials. auditors’ qualifications. treatment of contingent liabilities etc. For valuation purpose. 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. 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. impact of deferred tax. asset utilization. he also requires to consider the impact of historical transactions affecting the value of the business. nature and frequency of abnormal or exceptional items and non-recurring items. profits. weaknesses and performance of businesses and to also determine whether it is improving or deteriorating in profitability or financial strength. etc. Ratios express mathematically the relationship between performance figures and/or assets/liabilities in a form that can be easily understood and interpreted.

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

that firm's revenue multiple is irrelevant to valuing this firm. The owner further argues that a local competitor sold his business for three times revenue six months ago. then the value of this business could be as low as Rs. we derive recent revenue multiples for firms in the auto parts industry ranging from a low of .known source for business transaction data. 53. For example. May be due to ignorance or due to the cost involved or may be its relative importance to transaction value being very less. or somewhere in between. Normally. Giant or public organizations call for valuation to take a better decision relying on valuation report.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. Conversely. without getting into the nuances of finance.00.80.3 with a median of 2. 10.000. What his business is worth today depends on three factors: 1) how much cash it generates today. So why should he pay someone to value a business? The short answer is that these rules of thumb are generally median multiple values. unless this firm's cash flows and growth prospects are very similar to the competitor firm.000. the value of this business. 9. For example. 2) expected growth in cash in the foreseeable future. if rates were lower today than six months ago.00. While on a verge of selling a business.). 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. as high as Rs.000. I am representing some common thoughts of the owners of MSMEs. then using the industry rule of thumb for this purpose is clearly wrong.98 to a high of 5.9 and if we are valuing a firm with annual revenue of Rs. even if the competitor firm was equivalent to this in every respect and both firms were sold today. Unless the firm that is being valued is truly a median firm. In short. the median value is just a convenient midpoint and does not represent the revenue multiple for any actual transaction. is likely different today than six months ago because economic conditions have changed. 75 . Moreover. and 3) the return the owner or proposed owner require on their investment in this business. What happened six months ago is not really relevant to what something is worth today. the firms may be worth more than three times revenue. The median value indicates that half of the revenue multiples are below the median value and half are above. the firms would likely sell for less than three times revenue. 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. the owner believes that the Businesses in industry to which his business pertains always sell for “X” times annual revenue (the revenue multiple). Thus. So his business is worth at least this much! The answer is: May be yes and may be no. First of all. if according to a well. like the value of any public company share value (say Reliance Industries Ltd. if interest rates were higher today than 6 months ago.

employee. like proposed buyers. For example. looking at the existing. analyzed with past but also incorporated with their current business or activities. like owner/s. 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. Normally. getting the fair value on sell or purchase transaction and thereby at all to get a better mental comforts. financiers. 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. the first group is interested in a “Business value” being existing value. who are likely to be effected by the business value. While normally. financiers. being currently outsider. The second group includes person / persons proposed to establish the direct or indirect relations or having proposed interest in that specific business. the valuation of specific business can be helpful to two groups. partners. investors. to know the fair status and the growth of the business. 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. we can spread the information on possible benefits that can be derived by valuing own business. (1) Existing stake holders and (2) Proposed stake holders. to settle the sharing issues amongst the owners. share holders. based on different perceptions the value of business differs from eye to eye. share holder/s.Looking positively to involve and encourage MSME to value own business/ businesses. employees. etc. 76 . interests in a “Business value” based on risk adjusted possible benefits that can be derived in future. Obviously. Valuing a business can help the MSME business community in numbers of ways. to get the finance with fair terms and confidence level. investors. based on past but incorporating the fair benefits that can be derived in future. to resolve the family issues involving same business or more than one businesses. statutory authorities etc. the second group. partners.

Based on relevant standards. the valuation process begins with deciding the standard of value based on the accepted premise. as well as intended use of valuation. Just on the other side. As we know. 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. Base on his best of 77 . In my view. a financer while financing the same project. 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. may like to know the “fair value” as well as the “liquidation value” of the business. Based on the requirement of specific purpose.VALUATION PROCESS: After going through the profile of client and understanding the purpose of engagement. not always demands the fair value but a value which can help the best to arrive at a better decision. analyst should consider the purpose forcing towards the need of valuation. the value analyst is required to apply his professional wisdom and experience to finalize the technique/s to consider. It will mainly be based on the intended use of value. (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. there are three approaches to valuation used widely to arrive at the conclusive value. 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 assumptions should be explicit to make the value better useful. business appraise can derive a specific value or may come out with different value depending upon the techniques applied. Here again. The standard of value may be loosely said as a definition of value. These approaches are having numerous sub-approaches or techniques within each. It includes the value of synergy with investors’ existing status. 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 valuation analyst needs to finalize the appropriate techniques to consider while moving towards deriving the value of business. 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. If the fundamentals are well considered and assumptions are well decided then this difference may not be so.

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

Now let we move towards selecting the appropriate valuation technique/s based on purpose of valuation: 79 . 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. key person discount (the business may be dependable on working style. 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). normally.

So. The following purposes are considered under this category: (a) Addition of Partner/s: When the existing owner / partners decides to add the partner. their major concern is to know the “at least value” and “fair 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. based on his own perceptions about risk taking. Just on the other side. I have compiled the purposes giving birth to the need of valuation and then divided those purposes in to four major categories. AS the remaining partners are continued with the “fair value”. (1) Relative strategy: Where more than one party with different objective/s is likely to be affected directly from the valuation. they would like to en cash a portion of goodwill and will try to show a better existing value of their business. In the worst case. that is to say. they will like to use the investment value for negotiation purpose. Valuation is called for by Relevant standard of value Existing owner/ Partners Fair value. the strategy or purpose/s of involved parties are different but dependable on one and the same transaction. the investment value of the business. the purpose will fall under this category. (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. (Liquidation value in specific case) (investment value useful for negotiation) 80 . (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. Being the continued partner also. he would be interested to know the fair value of the business and at the most.SELECTION OF APPROPRIATE TECHNIQUE FOR SPECIFIC PURPOSE (Considering MSME units only) In order to present the needs for MSME business valuation.

many times the conclusive value is compared with traditionally adopted figure derived based on “Rule of Thumb”. So. He would be interested to get the investment value of the business. 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. here will try to pay maximum what it can derive from the business. 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. He is interested in return. “Excess earning method” can help them to derive existing earning capacity of the business. While sharing the business or dilute the sharing. expecting the best from the businesses. safety of his investments as well as time value imbedded with return. The Buyer. 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. 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. the existing owner or partner/s would like to get the appropriate consideration against the existing earning capacity and assets involved in the business. at least the liquidation value for his business. For negotiation point of view. The seller would like to get the fair value and in case of bad need. “Adjust net asset method” will help to know the existing asset strength or the invested capital of the owners. For tiny and small businesses.Incoming partner Investment value. he would like to know the fair value. Fair value The analyst is now on the way to select the techniques to be applied for determining the value of business. His concern is return and safety. If for example. an owner of colour shop situated on prime location at the heart of the city in main market wants to sell 81 . He would prefer “Discounted cash flow” to determine his expected returns.

the seller would like to en cash the current earning capacity and therefore prefers a lump sum multiple of existing earnings or revenue.his shop. He is major interested on future returns and synergies based on the existing status of the business. if wants to continue to run the colour shop. 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 will intend to get this price irrespective of its usage by the proposed buyer. he may claim a combination of both. i. The buyer is looking futuristic. 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. His concern is best return of his investments. 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. 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. Valuation is called for by Relevant valuation technique/s 82 . Based on the nature of business. the buyer will get enough return from gift article business to cover the possible loss on purchase of colour business assets. He would like to know the intrinsic value of business generally preferring discounted cash flow method. Now.e. 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”. 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. he would also compare the consideration with the replacement value of the assets he is going to own. consider a situation where the buyer wants to start a new business and to open a gift article shop there. The buyer. Obviously. He would definitely compare the consideration figure so arrived with realization value of his existing assets based on current market values.

the investor would like to invest as per his own risk perceptions. On the other side. 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. 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. the seller can get better price of his business. For example. Buyers subjective line Area of deal Seller’s expectations Best dealing point While estimated value of business provides basis for negotiation. (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 negotiation skills of involved parties and the structure of transaction like financing structure. 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. many times the conclusive value is compared with traditionally adopted figure derived based on “Rule of Thumb”.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. at a least prices or a price very near to existing fair value so as to decide the under value 83 .

So.offerings or over value offering of IPO. once listed on any stock exchange.e. return on investment The investor in IPO would also like to compare the IPO price with the intrinsic value and the possible market value. 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. i. 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 . Investment value The business. So. the intrinsic value can be calculated by applying the earnings capitalization method. Discounted cash flow will help to derive the business value based on future plans and project.e. The market value can be decided based on comparable companies’ adjusted value. Investment value Investor Fair value. and not the current market value. His interest is to get the value of his dilution and ensuring the safety of investors funds i. both of them would be interested to know the fair value and of business. while going public it is essential to know the intrinsic value as well as the market value of the business. The value of assets will reveal the existing tangible strength of the business. CCI guidelines prescribe to derive Net Asset value based on the latest audited balance sheet. Discounted cash flow and comparable companies’ adjusted value can serve his purpose. 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. book value. analyzed by the market value of its shares and market capitalization. Valuation is called for by Relevant standard of value Existing owner/s Fair value. When based on the existing worth.

Although these transactions of merger. While the acquirer will calculate his synergies and present value of future earnings to decide the return on investment. acquirer may like to know the option value of specific investment on acquisition. acquisition or takeover. 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. Acquisitions. Liquidation value (investment value useful for negotiation) Investment value. On merger. Valuation is called for by Relevant valuation technique/s Existing owner/ Seller Earnings capitalization method 85 . also with asset coverage of its investments. However. takeovers or acquisitions are becoming importance means of diversification. it can be used to compare the price worth on cash flow of two businesses which are being compared. (d) Mergers. and can know his opportunity cost by using the discounted cash flow based on his own perceptions.* P/EBITDA multiple is not a correct measure of value in terms of financial logics. 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. Valuation is called for by Relevant standard of value Existing owner/ Seller Fair value. Takeovers: Generally. 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. 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. he considers the replacement value of assets he is going to acquire to know the placing of his investment on acquisition. In specific case. Both the parties are concerned with return on their respective investments and the acquirer. the existing owner is departing his future business which he may continue else.

And so his concern is what comes now physically and what he will get in future against something payable now. 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. many times he needs the history of assets (or business) to assess the future worth.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. He is concern with the return on investments as well as asset coverage of his investments. he would like to offer something in addition to the fair price of the business. The buyer pays a premium. When a proposed investor. A rational buyer will not pay more price than the worth of asset to him this worth may be measurable or may not be. The investor’s decision is for own self only and not intended to be used by the other person. because having the “right” to control how the business assets are deployed has value. 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. based on his personal perceptions. It is different from the routine sell-purchase transactions in a sense that the investor is approaching to satisfy his own synergy/ies. the purpose will fall under this category. So. 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. he would like to know the fair value. (a) Small business purchase: The value of business and the value of ownership are two different terms. sees better benefits on purchase of certain business. The value of ownership is directly associated with power of control and synergies. For negotiation point of view. Of course. 86 . A hypothetical buyer would have to pay a control premium. even if this buyer plans to run the business in the same way as existing management.

Some times. Many times the conclusive value is compared with traditionally adopted figure derived based on “Rule of Thumb”. Obviously. generally the investors are pure investors and financing the business to get the better returns. it is very difficult to judge the market. Fair value The venture capitalist or investors in private equity are interested in better return based on their perceptions of risks. They are more concern about the industry under which a business pertains and the core competence of the business. They consider DCF to calculate the offer price on the basis 87 . Here. They would like to know the coverage of their investments in terms of physical asset also. It mainly depends on achievement of decided mile stones.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. (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”. In some cases where further investment is dependable on some happenings. Normally they do not have synergies to link with specific investments but they may invest in particular sector based on own portfolio diversification policies. 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. they are more interested in return of investments knowingly the asset coverage. The expected return ranges from 20% to 70% depending upon the stage of investment. They want to value the business based on own perception about the risk taking and growth potentiality of the business. depending upon the nature and situations of the business and agreed terms they may finance second phase development. They prefer to know the fair value of the business. Normally. 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. Of course. Valuation is called for by Relevant standard of value Venture investor capital/ PE Investment value.

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. (c) Business financing for new projects/ expansion: The Bankers. Valuation is called for by Relevant standard of value Business financer Fair value.of the expected rate of return but also uses market multiples as a guiding factor. In order to ensure the safe guard of their funds they also would like to know the liquidation value. 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 . 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.

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. 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. Valuation is called for by Relevant standard of value Business Owner Fair value. strategy forming and most importantly to make appropriate decisions on time. His concern is additional return on investment and investment in secured assets. The valuation may be helpful for internal betterment. business expansion. even though the owner is controlling each and every functions of owned business. the financer would like to analyze the existing business and viability of expansion in terms of debt payment capacity. In MSME. the businessman would like to know the impact of borrowings on expansion or project value. The return may be tangible or intangible. The asset value will help him in deriving the tangible value of business against which he can easily go for fund raising. like to know the value of his own business. Owner is required to consider this fact in his mind also. in many situations. He also will consider his existing business value based on future earnings. he remains more concerned about his payment capacity and expected returns. 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. Investment value. 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. he needs sometimes to convince himself. (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. (Liquidation value to assure the fund safety of financier) For accessing the financial viability while going for expansion or new projects. The liquidation value will further help him to assure the fund safety. value addition. Also. The expansion is fruitful if enhances the value of business. 89 .

the value of goodwill will be impliedly included. customers. If the fair value of business is equal or more than the carrying amount of business then impliedly there is no impairment in goodwill. Proper capital structure can help to increase the value of the equity holdings or value of ownership. Based on the conservative approach principle. the debt cost being tax deductible item. Valuation is called for by Relevant valuation technique/s Business Owner Earning capitalization method* * Theoretically. goodwill being intangible asset. While calculating the value of business. creditors. 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. 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. He would like to take decision knowingly the impact of capital structure on rate of return and absolute return. The owner can take reasonable steps to stop or lesser the impairment and to protect his ownership value if he undertakes business valuation regularly. it can reduce the cost of capital to a good extent. (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. forward earnings capitalization method is same as the discounted cash flow method. 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. But in reverse situation. 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. The sources of generation of goodwill are the relations of business with employee. The approach being futuristic the forward earning capitalization or discounted cash flow will serve the purpose. location of business etc. 90 .If planned properly.

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. 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. we need the value of business as a whole and it is less than the total carrying value of the assets in balance sheet. the owner needs to show the fair value of acquired assets in to his balance sheet. He requires to find the fair value of assets and liabilities purchased and also to find the amount paid extra as a goodwill. This requires the owner to find the fair value of assets and allocate the purchase price amongst it. 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 . In order to know the fair value for goodwill impairment purpose.

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

In some other case. 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. the return on investments as well as safely of investments. can realize the better value through timely selling of business etc. 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. It includes the purposes. can plan expansion taking advantage of intrinsic strength. Like. 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. he has to dilute his sharing in favour 93 . can take the best advantage of capital structuring. (a) Ownership issues: Sometimes. the partnership terms include increasing the share of working member based on the performance and business targets achieved by him. Like. the valuation for which generally is not undertaken for any intended business transaction. he can timely decide diversion or sell of specific loss making business stream. Valuation is called for by Relevant standard of value Business Owner Fair value.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. a specific owner may require contributing on none fulfilling the agreed term. the investor partner may not fulfill his obligation to bring the agreed finance and therefore. The concern is to evaluate both.

(b) Litigation issues involving lost profits or economic damages: 94 . 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. 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.of new financier or any one else. future return prospects and value of assets involved. There may be a situation where a creditor or a financier is required to offer the ownership in the business. 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. future return prospects and value of assets involved.

if based on fair value of ownership.Insurance claim. It may be a sharing issue on separation of family or HUF partition. 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. (c) Family issues: This includes the disputes and planning matters involved due to ownership in a business. Generally. 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. impact of merger or de merger. Liquidation value member The purpose is to identify the rate of return and the asset coverage in family business or businesses. Specific care is required while valuing a business or a loss of business under such circumstances. 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 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. Valuation is called for by Relevant valuation technique/s 95 . loss of business due to impairment in reputation by whatsoever reason. The wealth planning and WILL planning will also be made wisely. the prescribed techniques are used to appraise the loss or business.

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. 96 . The valuation analyst.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. may rest with some different values derived by application of various selected technique/s. prevailing situations and existing requirements. 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. even after finalizing the standard/s of value based on characteristics of the purpose and selecting the technique/s of valuation.

in India. an analyst will come at a point where he will have several values none of which he can say to be incorrect. The value is a function of standards to value and it varies when measured under different standards of valuation. economic and competitive characteristics in place during the appropriate timeframe for the appraisal. MSMEs are concerned with “transactional value” which can be arrived if the values under different standards of value are known. market. 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. value of a business depends on numbers of factors in addition to purposes of valuation. 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. The empirical data is not available for MSME needs and its valuation. the economy and how the subject business will compete. the appraiser may end with determining more than one value each representing the 97 . Business valuation field itself. it is not a total mystery. 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. Estimates of a business' value by various experts can vary significantly. is still un-explored.Conclusion: While valuing a business is not an exact science. 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 fact. it is not always possible. economic situations. Banking a business’s value solely on current operating results is risky business to say the least. 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. however. also there is no private of public organization offering the transactional data relevant for MSME valuation. In my views. Unfortunately. So. 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). This is just an endeavor to match the valuation technique with specific purpose on logical basis considering the requirements of each purpose. A valuation requires a thorough analysis of several years of the business operation and an opinion about the future outlook of the industry. it is always better to use actual data or historical results than to rely on assumptions. like nature of industry under which the business is working. if the fundamental assumptions are applied differently. to make sure that any assumptions made are based on the financial. particularly in case of MSMEs. availability and reliability of data etc. 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. If available. It is possible. This write up particularly pertains to valuation need in MSME sector and linking the most relevant valuation technique/s with specific purpose. Here. A realistic business valuation requires more then merely looking at past years’ financial statement. market trends. For example.

rather more concerned about its relative value to him. 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. 98 .value under specific standard of value like fair value or investment value or liquidation value. The owner or a proposed buyer is always not interested to know the fair value of business only.

VALUATION REPORT Some useful notes 99 .

it is a mechanical calculation. the applicable assumptions and limiting conditions. at a minimum. 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. When buyer and seller understand the logic and the process of valuation. 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. As said by Jay Abrams. and the standard of value to be used. The understanding should include. the client’s responsibilities. then they discuss and negotiate over assumptions to the model. If the understanding is oral. purpose. Instead. There is much controversy in the professional literature about many aspects of business valuation. preferably in writing. 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. 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. i. obtain sufficient non financial information to enable him or her to understand the business. 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. the type of report to be issued.e. the valuation analyst should document that understanding by appropriate memoranda or notations in the working papers. They do not argue over values.. The value is the end product of the valuation model. regarding the engagement to be performed. If buyer and seller can agree on assumptions.PREFACE “What is the business worth?” Although a simple question. the valuation analyst should modify the understanding if he or she encounters circumstances during the engagement that make it appropriate to modify that understanding. the nature. as available and applicable to the valuation engagement. and it is a non issue. background. The valuation analyst should establish an understanding with the client. the valuation analyst’s responsibilities. and objective of the valuation engagement. 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. realistic picture of valuation is a mathematical exercise that is always done with less-than-perfect information and which has uncertainty to it. and there is no such thing as a perfect valuation. and history • Infrastructure • Organizational structure 100 . Nobody is perfect. The valuation analyst should. one’s assessment of future market conditions. Regardless of whether the understanding is written or oral. including its: • Nature. they will focus on discussing their differences in assumptions of the sales growth rate or the profit margin.

The more structure that is added to the valuation report. In estimating a value for a business. finance. 101 . It must be note that the valuation being estimation. accounting and investment. a good appraisal is a defensible appraisal. gather. Because of the uncertainties inherent in estimating a value for business. economics. and analyze data. major law suits. but the detail behind it. dispute over commercial matters such as intellectual property rights. If the financials of the business concerns are not audited. The appraiser must provide adequate documentation and discussion to support the opinion. facts and circumstances of the business and should use reasonable data and market inputs. assumptions and estimates. Like existence of non balance sheet items. it can be challenged and therefore. 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. 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. 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. the valuation analyst should so state and should also state that the valuation analyst assumes no responsibility for the financial information. and use professional judgment in developing the estimate of value (whether a single amount or a range). the more difficult it becomes for someone to tear it apart. This means that the potential challenges of opposing parties are recognized and addressed within the appraisal itself. consider and apply appropriate valuation approaches and methods. Performing a valuation engagement with professional competence involves special knowledge and skill. contingent liabilities. 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 is rash to attempt any valuation adopting so-called industry/ sector norms in ignorance of the fundamental theoretical framework of valuation. the appraiser should apply a methodology that is appropriate in light of the nature. It’s not the bottom line number you’re paying for. and key employees) • Classes of equity/ ownership interests and rights attached thereto • Products or services. Valuation is an art more than a science and is an interdisciplinary study drawing upon laws. directors. if possible. officers.

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 .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.

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

and some items may not be readily available to you. In such cases. Some items may not pertain to your business. 104 . 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. for the current year and next three to five years. (Include any prepared budgets and/or business plans) MIS and bank reconciliations statements. 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. 3. please indicate N/A or notify us if other arrangements can be made to obtain the data. 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. 2. if any. Financial Information 1.ENTERPRISE NAME :__________________________________________________________ VALUATION INFORMATION REQUEST LIST NOTE: This is a generalized information request. 4. Financial projections. We may call for other information for detail analysis of these data provided by you. 5.

and estimated market share of each). Products. LCs and other liabilities. 15. The new products under development with expectations as to potential. 9. 10. catalogs. Creditors aging schedule or summary as of Date of valuation. employee contracts etc. List of working capital components and estimated realizable value Capital structure with details regarding ownership capital and long term. or suppliers on which the business is otherwise dependent. Operations and Markets 1. 10. 5. location. Income Tax Returns and supporting statements/ documents for fiscal years ending FIVE YEARS. Like change of inventory keeping from FIFO to LIFO or change in depreciation method from SLM to WDV etc. Any change in accounting practices or any change in treatment of major item. if any and/or debt agreement(s) as of Date of valuation. indicating sales (or sales upon which commissions were earned) and unit volumes for each of the past three fiscal years. Explanation of significant nonrecurring and/or non operating items appearing on the financial statements in any above fiscal year if not detailed in footnotes. The majority industry publications of interest to management. Debtors aging schedule or summary and management’s general evaluation of quality and credit risk as of Date of valuation. The major competitors (full name. 105 . 9.6. 7. Details of contingent and unrecorded liabilities and assets with justification B. Payment schedules of loans. 7. highly trained staff. for each of the past five fiscal years? Fixed assets and depreciation schedule as of Date of valuation.short term finances. by product. 2. size. services. The detail of top 10 customers. 11. or product lines of the Company and copies of marketing materials including sales brochures. 3. 8. terms of finance. The major products or services added in the last two years (or anticipated) and current expectations as to sales potential. Product mix. The trade associations’ memberships. List of top 10 suppliers (or all accounting for substantial % of total purchases) Identify product(s) on which the Company is single-sourced. 8. sale percentage to total sales and profit/sales ratio Unit volume analyses for existing product lines for the past five years. 13. Description of competition to examine price-quality-service factors in products/services of competitors in light of those prevailing in businesses being valued. 11. or other descriptive sales materials. The major accounts gained (lost) in the last year indicating actual sales in the current year and beyond. trade mark. 14. Expense classification: fixed/semi variable/variable. Details of patented or licensed products with rights and conditions of usage Management perception about intangible assets like copy rights. research activities. 14. 13. 4. 12. 12. 6. 15. A brief note on “nature of activities and business” List of major products. input-output ratio.

4.16. If leased or rented. product warranties. include: • Date purchased • Purchase price • Recent value • Insurance coverage • Book values (gross value as well as depreciation) 2. 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. and remuneration status including the bio-data of management and key employees. List of employees specifying their age. 2. date of filing. and approximate size of each facility. and expected outcome and financial impact. A summary of major covenants or agreements binding on the enterprise e. restrictive agreements etc. 106 . Business registration details like. Please provide production capacity or estimate business volume by major facility/ factory unit/s. VAT Number. service contracts. include name of lessor and lease terms or agreements. position. 5. Excise code or Service tax number etc. 3. E. Proprietary deed. Or understandings between the partners or minutes of business meetings. or departments. 2. vendor or agency contract. Current organization chart.. Details of sister concerns or subsidiaries Details of major changes or movements in ownership 3. Personnel 1. A description of any pending litigation including parties involved. 7. employment contracts. PAN. The location. F. Details of the ownership of each facility and other major fixed assets. D. Infrastructures 1. capital leases. age.g. subsidiaries. The number of employees (distinguish fulltime and part time) at year-end for the last three years and attrition ratio. Business / Enterprise Documents and Records 1. whether divisions. description and nature of the lawsuit or claim. experience within the enterprise. If owned by the enterprise. 6. current status. Name and description of the operations of all major OWN operating entities.

EBIDTA. NOPLAT etc) . 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 . period of standings. group data. comparable value basis.INDUSTRY RESEARCH FORM The purpose is to decide the Comparable or Peer Company/ies and collect its Data [like name. turn over and operation figures (PAT.

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

Events and conditions occurring after that date have not been considered. 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. If prospective financial information approved by management has been used in our work. and any other assets or liabilities. The valuation contemplates facts and conditions existing as of the valuation date. on the subject business due to future change in state. happenings and conditions. and those differences may be material. and other third parties concerning the value and useful condition of all equipment.7. present. Events and circumstances frequently do not occur as expected and there will usually be differences between prospective financial information and actual results. if any. 11. 8. investments used in the business. 109 . 12. Unless otherwise stated. and we have no obligation to update our report or calculation of value for such events. management. no effort has been made to determine the possible effect. 9. 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. 13. except as specifically stated to the contrary in this report. 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. Also. 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. properties. 10. should be disseminated to the public through any means of communication without our prior written consent and approval. or local legislation. 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. we have not examined or compiled the prospective financial information and therefore. Neither all nor any part of the contents of this report (especially the conclusion of value. and prospective operating results of the company. We have conducted interviews with the current management of [ABC Company] concerning the past. Except as noted.

Often. o o o o o o o 110 . Employees’ retirement benefits. a description of how the specialist’s work is used. jewellary.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. if any with justification. 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. inventory. Appendices or exhibits may be used for required information or information that supplements the summary report. brand value etc. limiting conditions. and the level of responsibility. 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. and the valuation analyst’s representation are provided in appendices to the report. the valuation analyst is assuming for the specialist’s work (like valuation of property. the assumptions. if any.

e. The errors may result in significant disparities in value of the subject company. Personal expenses are also very common tom charge in business to evade the taxes. In addition. 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. In the case of a minority interest valuation. relatives and friends. the value estimate must be reconciled to a minority basis using a lack of control discount. 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.SOME OF THE MOST COMMON ERRORS IN BUSINESS VALUATION A valuation professional must rely upon experience and reasoned. Non-recurring or abnormal items require special attention of the appraiser. The valuation professional must be diligent in ensuring that the valuation report is free from errors that may compromise its integrity. Salaries of management is one of the area which the closely hold businesses commonly use for adjusting the profit to save taxes. informed judgment in conducting a valuation and preparing a credible valuation report. The number of inputs. If the cash flows are adjusted to reflect control decision. 111 . a minority shareholder would not have the ability to effect control decisions related to financial statement adjustments (i. 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. the interests on which are not charged as per the prevailing rates in the market. 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. adjustments made to the financial statement must be on a comparable basis as the interest being valued. assumptions. Many times the loans are received from family. management compensation or discretionary expenses).

It is generally accepted that the projected capital expenditures and depreciation are best estimated based on a proportional relationship between the two. Therefore. This may also skew the value indication and discredit the entire valuation. 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. the valuation professional may examine the historical relationship between capital expenditures and depreciation over the last five years or so. 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. while they may actually be highly profitable. ‘‘Forecasting is not a respectable intellectual activity.Peter Drucker. Many companies operate at low net incomes (or even negative net incomes). 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. 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). using a net cash flow to equity rate to discount or capitalize net cash flow to invested capital results in an incorrect value. The prevailing market conditions and industry trend should be considered while forecasting the revenue and expenses. 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. which may tarnish the reputation of the valuation professional. Likewise. this high growth rate cannot be maintained in perpetuity as the company’s earnings would eventually surpass the size of the nation’s economy.Ungrounded Forecasting of Earnings Forecasting earnings is likely the most important part of the income approach to valuing a business. 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. mature business. Likewise. and not worthwhile beyond the shortest of periods.’’ . This mismatch of the discount (capitalization) rate and income stream is a glaring error in business valuations. For a stable. Care must be taken to ensure the reliability of the data. Failure to match these rates and benefit streams results in an erroneous value conclusion. 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 112 . Applicable tax rate should also be applied to consider the post tax earnings or cash flow. since the value is driven by the firm’s anticipated future earnings.

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. An error in estimating an indication of value that is not consistent with the selected standard of value may significantly impact the value conclusion. 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. this could lead to significant valuation errors when determining the value of a specific asset. great care and diligence must be taken to select and defend the specific company risk premium applied in a valuation. finances. The failure of the appraiser to thoroughly discuss the assumptions. The importance of the ability to replicate the valuation should not be underestimated.client may also be severely disadvantaged by the disparity in value resulting from the mismatch of rate and income stream. Whether valuation professionals use a factor analysis or another method of selecting an appropriate premium. 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 . industry position. approaches. 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. This gives rise to a factor analysis for supporting the selection of a specific company risk premium. 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. 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. Given the possible arbitrary selection of this premium. and procedures used to develop the indication of value is a significant error in the preparation of a valuation report. 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. 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. the valuation professional identifies the standard of value that will be used in developing an indication of value. In turn. Incorrect Value Conclusion for the Standard of Value Upon engagement. This specific company risk premium reflects the risks associated with the particular business’s operations. A skilled appraiser critiquing the report would likely be able to easily discredit the valuation and the appraiser based on this issue. There is no empirical data available in India on the specific company risk premium. etc. assumptions. 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.

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

Appraisal Method—see Valuation Method. If.INTERNATIONAL GLOSSARY OF BUSINESS VALUATION TERMS To enhance and sustain the quality of business valuations for the benefit of the profession and its clientele. more particularly. the communication of how that value was determined. Arbitrage Pricing Theory—a multivariate model for estimating the cost of equity capital. Appraisal Date—see Valuation Date. This duty is advanced through the use of terms whose meanings are clearly established and consistently applied throughout the profession. Appraisal—see Valuation. 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. it is recommended that the term be defined as used within that valuation engagement. Appraisal Approach—see Valuation Approach. which incorporates several systematic risk factors. the below identified societies and organizations have adopted the definitions for the terms included in this glossary. 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. 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. one or more of these terms needs to be used in a manner that materially departs from the enclosed definitions. and contingent) are adjusted to their fair market values (NOTE: In Canada on a going concern basis). Appraisal Procedure—see Valuation Procedure. Adjusted Net Asset Method—see Adjusted Book Value Method. 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. 115 . intangible.

Book Value—see Net Book Value. Business Risk—the degree of uncertainty of realizing expected future returns of the business resulting from factors other than financial leverage. 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. industrial. 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. or business enterprise. it should be supplemented by a qualifier (for example. or investment entity (or a combination thereof) pursuing an economic activity. Business—see Business Enterprise. business ownership interest. service. Business Valuation—the act or process of determining the value of a business enterprise or ownership interest therein. Cash Flow—cash that is generated over a period of time by an asset. or security using one or more methods based on the value of the assets net of liabilities. Business Enterprise—a commercial. 116 . Capitalization Rate—any divisor (usually expressed as a percentage) used to convert anticipated economic benefits of a single period into value.Asset (Asset-Based) Approach—a general way of determining a value indication of a business. Capital Structure—the composition of the invested capital of a business enterprise. It may be used in a general sense to encompass various levels of specifically defined cash flows. When the term is used. Capitalization—a conversion of a single period of economic benefits into value. “discretionary” or “operating”) and a specific definition in the given valuation context. 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. the tendency of a stock’s price to correlate with changes in a specific index. group of assets. Beta—a measure of systematic risk of a stock. Capitalization Factor—any multiple or divisor used to convert anticipated economic benefits of a single period into value. See Financial Risk.

See Invested Capital. Debt-Free—we discourage the use of this term. Control—the power to direct the management and policies of a business enterprise. Effective Date—see Valuation Date. to reflect the power of control. Discount Rate—a rate of return used to convert a future monetary sum into present value. On the balance sheet. Discount for Lack of Marketability—an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability. Economic Life—the period of time over which property may generate economic benefits. net cash flows. net income. and on the income statement. etc. Cost of Capital—the expected rate of return that the market requires in order to attract funds to a particular investment. Economic Benefits—inflows such as revenues. 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.Common Size Statements—financial statements in which each line is expressed as a percentage of the total. 117 . 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. 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. each item is expressed as a percentage of sales. 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. 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. 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. each line item is shown as a percentage of total assets. Enterprise—see Business Enterprise.

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

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. (NOTE: in Canada. Income (Income -Based) Approach—a general way of determining a value indication of a business. business ownership interest. equities. trademarks. the term used is “Value to the Owner. securities and contracts (as distinguished from physical assets) that grant rights and privileges. Intrinsic Value—the value that an investor considers. security. Invested Capital—the sum of equity and debt in a business enterprise. When the term is used. goodwill. it is the difference between the exercise price or strike price of an option and the market value of the underlying security.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. When the term applies to options. to be the “true” or “real” value that will become the market value when other investors reach the same conclusion. 119 . business ownership interest. Investment Risk—the degree of uncertainty as to the realization of expected returns. mineral rights. or intangible asset using one or more methods that convert anticipated economic benefits into a present single amount. 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. Debt is typically a) all interest-bearing debt or b) long-term interest-bearing debt. or intangible asset with limitations in analyses.”) 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. Intangible Assets—non-physical assets such as franchises. procedures. Liquidity—the ability to quickly convert property to cash or pay a liability. and have value for the owner. Levered Beta—the beta reflecting a capital structure that includes debt. on the basis of an evaluation or available facts. patents. it should be supplemented by a specific definition in the given valuation context. or scope. Investment Value—the value to a particular investor based on individual investment requirements and expectations. copyrights. Limited Appraisal—the act or process of determining the value of a business. and that are actively traded on a free and open market. security.

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

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

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

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

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 . John Wiley & Sons. Yegge.

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. Liquidation value (investment value useful for negotiation) (2) Investments (a) Small business purchase Investment value (Fair value useful for negotiation) Investment value. Takeovers 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. Investment value Investment value. Fair value Fair value. (Liquidation value to assure the fund safety of financier) 125 . Liquidation value Investment value. Fair value (c) IPO (d) Mergers. Acquisitions. (Liquidation value in specific case) (investment value useful for negotiation) Fair value. Investment value. Fair value (b) Business Sell / Purchase Agreement Investment value (Fair value useful for negotiation) Fair value.

(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. 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 .

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. Acquisitions. 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 .

(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 ….As per Prof. 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 ..

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.

July 2003 “Fair Value Measurement” by CA Shrikant Sortur The Chartered Accountant. 2008 131 . Harisha. European Integration Studies. “Financial Valuation – Applications and Models” by James R. John Wiley & Sons. 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. The Chartered Accountant.winter 2003 pages 59-82 “impact of deferred tax facility on firm value” by Prof. or intangible asset” Statement on standards for valuation services issued by the AICPA consulting services executive committee. John Wiley & Sons. Christopher Mercer The CPA Journal. Journal of Business Valuation and Economic Loss Analysis. Nov 1. Mckinsey on Finance. volume 3. M. notes. Prasanna Chandra. Inc. “A Premier on the Quantitative Marketability Discount Model” by Z. Business ownership interest. security. McGraw Hill “Damodaran on Valuation . 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. 2002 printed by capstone publishing “Valuation of a Business. June 2007 “Non-Quantitative Measures In Company Evaluation” by Ágnes Horváth. Miskolc. Journal of Economic Perspective. John Wiley & Sons. law and perspective” by David Laro and Shannon P. Volume 4 (2005) pp 6172. Yegge. article 7. Healy. Inc FAS 157 “fair value Measurement” “Valuation” by Leo Gough. Narsimhan and B.A mathematical approach for today’s professional” by Jay Abrams.References (books.2004 “Valuation of Small business: An Alternative point of view” by Francisco J.Business Valuation.issue 1. Pratt.S. “Financil management – Theory and practice” 6th edition by Dr. Bernard “Quantitative Business Valuation .V. spring. Hitchner. articles and websites) “A basic guide for Valuing a Company” – 2nd edition by Wilbur M. Lopez. Tata McGraw hill publishing Company Limited “Business Analysis and Valuation – using financial statements” 2nd edition by Palepu.volume 17. Malkiel.

March/ April 2002 “Finding value where NONE exists: Pitfalls in using Adjusted Present Value” by Laurence Booth. Vikalpa. Lewis and Jeffrey W.Spain. summer 1999. Joishy. Lippitt. New York university “Calculating value during uncertainty: Getting real with ‘real option’ ” by Dan Latimore. volume 11. article 5. Volume 15. No. and Related Disclosures” issued by ICAI “Financial factors” by Michael J. November. department of economic affairs. Lie. issued by ministry of finance. 2. Eric E.1 Guidelines for valuation of equity shares of Companies and the business and net assets of branches. Giddy.R.October-December 1990. 3 “Estimating capitalization rates for the Excess Earnings Method using Publicly traded comparables” by Harry Howe.“Trends in Valuation” by CA Gurudutt N. Financial Analysts Journal. Volume 21. Vikalpa. 2007 Explanatory Memorandum to the Exposure draft – Revised standard on Auditing (SA) 540 – “Auditing Accounting Estimates. Optimal capital Structure. summer 2005. 292. volume 2. November 1. CFA – IBM Institute for Business value “How to Price a Share for acquisition” by Malay Kanti Roy. research paper no. pages 08-17 “Hotel valuation Techniques” by Jan deRoos and Stephen Rushmore Briefing “Methods of Corporate Valuation” by Prof. Ian H. volume 12. spring 2002. April 1995 “Do Court preferences for Valuation Approaches of Closely Held Companies Vary by Industry?” by James DiGabriele. No.issue 1. article 1. 1990 “Guidelines on Share Valuation: How Fair is Fair value?” by Jayanth Varma and N venkiteswaran. volume 15. Mard. Fair value TM “EVA and its critics” by Stephen F. November 2. WACC and FLOWS TO EQUITY APPROACHES to firm Valuation” by Pablo Fernández. No. Including fair Value Accounting Estimates. Rajagopal. The licensing journal. O’Byrne. Journal of applied corporate finance. Journal of Business Valuation and Economic Loss Analysis. 1 “Cost of Capital. 4 132 . Journal of applied corporate Finance. Journal of Business Valuation and Economic Loss Analysis. page 21-23 “The return of the leveraged Buyout: LBO is back in vogue” Dealmaker – A quarterly magazine from Grant Thornton. Vikalpa. Vol. 2007 “Valuation Approaches and Metrics: A survey of the Theory and Evidence” by Aswath Damodaran. No.2007 pages 1930-1933 “Business valuation” slides prepared by C. pages 92-96 “Multiples used to estimate corporate value” by Erik Lie and Heidi J. University of Navarra . 2006 “Public and Private Company differences can have major valuation implications” by George Hawkins. The Chartered Accountant. January-March 1986. and value of Firm: An Empirical Study of Indian Companies” by Raj S Dhankar and Ajit S Boora. June. volume 2. July-September 1996.issue 1. April 2001. Stern school of business. Deloitte Haskins and Sells “Equivalence of the APV.

valmetrics. MBA “Valuing a start up and raising equity – Dealing with venture capitalist and private investors” by Martin Heucher.com www. McKinesy & Company “WACC or APV” by Jaime Sabal. CVA A note “Accuracy of your valuation” by Jay B. “Salty” Schumann. Global Jurist Frontiers.P. Bruno Schläpfer. ASA.natinalbizval. Heinz Marchesi.whiteandlee.Oct 2006: 4-13 A note “Common errors in Business Valuation Reports – Revisited” by Robert R. by C.iasplus. Wietzka. Sept.issue 2. Valuation Strategies Magazine. MBA www. August 199. The McKinsy quarterly 2000 Number 4: Asia revalued “Valuation Effects of Entity Form” by Jay B. Koller. Journal of Business Valuation and Economic Loss Analysis. article 1. Abrams. CPA.businessvaluation-explained. Ueli Looser. Volume 1 (2001) issue 2. Abrams.com www. volume 2.com www.com www. CPA.com www.bvappraisers.org 133 .tscpa. article 4 “Improving Certainty in valuation using the Discounted cash flow Method”. CPA.com www. 2007 “The Value of ownership” by Meir Dan-Cohen.investopedia.appraisers. ASA.com www.“Valuation in Emerging markets’” by Mimi James and Timothy M.org www.

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