INTRODUCTION to BUSINESS VALUATION

BASIS for VALUATION

A business valuation is a general process in determining the economic value of a whole business or
company unit. Business valuation can be used to determine the fair value of a business for a variety of
reasons, including sales value, establishing partner ownership, taxation and even divorce proceedings.

The Basics of Business Valuation

Business valuation is typically conducted when a company is looking to sell all or a portion of its
operations or looking to merge with or acquire another company. The valuation of a business is the
process of determining the current worth of a business, using objective measures, and evaluating all
aspects of the business.

A business valuation might include an analysis of the company’s management, its capital structure, its
future earnings prospects or the market value of its assets. The tools used for valuation can vary among
evaluators, businesses, and industries. Common approaches to business valuation include a review of
financial statements, discounting cashflow models and similar company comparisons.

Valuation is also important for tax reporting. The Internal Revenue Service (IRS) requires that a business
is valued based on its fair market value. Some tax-related events such as sale, purchase or gifting of
shares of a company will be taxed depending on valuation.

Estimating the fair value of a business is an art and a science; there are several formal models that can
be used, but choosing the right one and then the appropriate inputs can be somewhat subjective.

COMPONENTs of a PRACTICAL VALUATION: ( Huwee )

1. Theoretically acceptable
2. Legally defensible
3. Professionally conducted

VALUATION CONCEPTs

Business valuation is the process of ascertaining : ( Huwee )

1. The worth of an entire business

2. The worth of a particular asset or liability of the business

Valuation is based on economic factors, industry variables , and an analysis of the financial statements
and the outlook for the individual firm. The purpose of valuation is to determine the long-run
fundamental economic value of a specific company’s common stock. When a firm is considering the
purchase of marketable securities – debt, preferred stock or common stock – it must have some
knowledge of investment value.

If the firm is evaluating an acquisition it must have techniques to determine how much to pay for the
stock to be acquired. When a firm is considering a public offering to sell its own stock in order to raise
additional equity capital, it must establish a price for the issue and the time of the offering to achieve a
maximum benefit to existing shareholders.
There is no single value. Value can change dramatically depending on the answers to these questions:

What is being valued?

Why is it being valued?
What is the appropriate standard of value?
What are the appropriate premises of value?
When it is, being valued?
How will you value it?
What discounts or premiums are appropriate?

The valuation of a security is defined as its worth In money or other securities at a given moment in
time.

PRINCIPLEs of VALUATION

BUSINESS VALUATION PURPOSES

Most of the purposes on business valuation are as follows:

Shareholder disputes – sometimes a break up of the company is in the shareholder’s best interests. This
could also include transfers of shares from shareholders who are withdrawing.

Estate and gift – a valuation would need to be done prior to estate planning or a gifting of interests or
after the death of an owner. This is also required by the IRS for charitable donations.

Divorce – when a divorce occurs, a division of assets and business interests is needed.

Merger and acquisition ( M&A ) , and Sales – valuation is necessary to negotiate a merger, acquisition, or
sale, so the interested parties can obtain the best market price

Buy-sell agreements – this typically involves a transfer of equity between partners or shareholders

Financing – have a business appraisal before obtaining a loan, so the banks can validate their investment

Purchase price allocation – this involves reporting the company’s assets and liabilities to identify tangible
and intangible assets

TYPES of VALUEs

Going concern value - the value of the securities of a profitable operating firm with prospects for
indefinite future business might be expressed as a going concern value. The worth of the firm would be
expressed in terms of the future profits, dividends, or expected growth of the business.

Liquidation value – if the analyst is dealing with the securities of a firm that is about to go out of
business, the net value of its assets, or liquidation value, would be of primary concern.

Market value – if the analyst is examining a firm whose stock or debt is traded in a security market, he
can determine the market value of the security. This is the value of the debt and equity securities as
reflected in the bond or stock market’s perception of the firm.
Book Value – This is determined by the use of standardized accounting techniques and is calculated
from the financial reports, particularly the balance sheet, prepared by the firm. The book of the debt is
usually family close to its par or face value. The book value of the common stock is calculated by
dividing the firm’s equity on the balance sheet by the number of shares outstanding.

Intrinsic value – A security’s intrinsic value is the price that is justified for it when the primary factors of
value are considered. In other words, it is the real worth of the debt or equity instrument are
distinguished from the current market price.

IMPORTANT POINTS in using the ESTIMATED VALUE/VALUATION: ( Huwee )

1. Value is as good as the information available to valuer

Ex. A bidder in an M&A and how he values the target co based on the information he holds which might
or not might be the same with insiders.

2. Value is time dependent

It is influenced by new information

Valuation date will be necessary

3. Value is purpose dependent

Valuation differs due to different objectives

4. Value is not objective

Rather valuation is subjective, thus even if objectives are similar between the parties; valuation may still
differ

5. Value and current market price are not necessarily the same

Are markets efficient?

If yes, then market price is the best estimate of value

More often not that efficient, then there will be deviation of cashflows vs. current price due to :

- Information
- Temporary irrational market behavior by investors
- Influenced by minority interest

Trivia: it has been observed that due to high frequency trading; market is more speculative with less
emphasis with fundamentals

ROLE of BUSINESS VALUATION in CORPORATE FINANCE and BUSINESS ACQUISITION

ROLE of BUSINESS VALUATION in CORPORATE FINANCE

What is valuation?

Valuation refers to the process of determining the present value of a company or an asset. It can be
done using a number of techniques. Analysts who want to place value on a company normally look at
the management of the business, the prospective future earnings, the market value of the company’s
assets, and its capital structure composition.

Valuation may also be used in determining a security’s fair value, which depends on the amount that a
buyer is ready to pay a seller, with the assumption that both parties will enter the transaction. During
the trade of a security on an exchange, seller and buyers will dictate the market value of a bond or
stock. However, intrinsic value is a concept that refers to a security’s perceived value on the basis of
future earnings or other attributes of the entity that are not related to a security’s market value.
Therefore, the work of analysts when doing valuation is to know if an asset or a company is undervalued
or overvalued by the market.

Valuations can be performed on assets or on liabilities such as company bonds. They are required for a
number of reasons including merger and acquisition transactions, capital budgeting, investment
analysis, litigation and financial reporting.

PREMISE of VALUE

The corrections for defining value may never be more important than when making decisions related to
business continuity and financial restructuring. Countless clients have demonstrated a sense of
confusion regarding the various descriptions of value used in valuation settings. More than a few
valuation stakeholders have mused that the value of anything ( a business or an asset as the case
maybe) should be an absolute numerical expression and unambiguous in meaning. Unfortunately for
those seeking simplicity in a trying time, the conditional cliché “it depends” is critical when defining
value for the assessment of bankruptcy decisions and financing.

The premise of value is an assumption regarding the most likely set of transactional circumstances that
maybe applicable to the subject valuation for example going concern, liquidation.

VALUATION PRINCIPLEs

What are valuation principles?

Business valuation involves the determination of the fair economic value of a company or business for
various reasons such as sales value, divorce, litigation and the establishment of partner ownership.

Valuing a business or asset:

Cost approach = cost to build, replacement cost

Market approach (relative value) = public company comparable, precedent transactions

Discounted cashflow (intrinsic value) = forecast future cash flows

KEY PRINCIPLEs of BUSINESS VALUATION

The following are the key principles of business valuation that business owners who want to create
value in their business must know.

1. The value of a business is defined only at a specific point in time.

The value of a privately-held business usually experiences changes every single day. The earnings, cash
position, working capital, and market conditions of a business are always changing. The valuation
prepared by business owners a few months or years ago may not reflect the true current value of the
business.

The value of a business requires consistent and regular monitoring. This valuation principle helps
business owners to understand the significance of the date of valuation in the process of business
valuation.

2. Value primarily varies in accordance with the capacity of a business to generate future
cashflows.

A company’s valuation is essentially a function of its future cashflow except in rare situations where net
asset liquidation leads to a higher value. The first key takeaway in the second principle is “future”. It
implies that historical results of the company’s earnings before the date of valuation are useful in
predicting the future results of the business under certain conditions.

The second key in this principle is “cashflow”. It is because cashflow, which takes into account capital
expenditure, working capital changes, and taxes, is the true determinant of business value. Business
owners should aim at building a comprehensive estimate of future cashflows for their companies.

Even though making estimates is a subjective undertaking, it is vital that the value of the business is
validated. Reliable historical information will help in supporting the assumptions that the forecasts will
use.

3. The market commands what the proper rate of return for acquirers is.

Market forces are usually in a state of flux, and they guide the rate of return that is needed by potential
buyers in a particular market place. Some of the market forces include the type of industry, financial
costs, and the general economic conditions.

Market rates of return offer significant benchmark indicators at a specific point in time. They influence
the rates of return wanted by individual company buyers over the long term. Business owners need to
be wary of the market forces in order to know the right time to exit that will maximize value.

4. The value of a business maybe impacted by underlying net tangible assets.

This principle of business valuation measures of the relationship between the operational value of a
company and its net tangible value. Theoretically, a company with a higher underlying net tangible
asset value has higher going concern value. It is due to the availability of more security to finance the
acquisition and lower risk of investment since there are more assets to be liquidated in case of
bankruptcy.

Business owners need to built an asset base. For industries that are not capital intensive, the owners
need to find means to support the valuation of their goodwill.

5. Value is influenced by transferability of future cashflows.

How transferable the cashflows of the business are to a potential acquirer will impact the value of the
company. Valuable businesses usually operate over the delivery of service, revenue growth,
maintenance of customer relationships, etc., then the owner will secure the goodwill and not the
business. Thus valuation of a business is defined by its cashflows which may result to goodwill yet may
provide very little or no commercial value and may not transferable.

In such a case, the total value of the business to an acquirer maybe limited to the value of the
company’s tangible assets in case the business owner does not want to stay. Business owners need to
build a strong management team so that the business is capable of running efficiently even if they left
the company for a long period of time. They can build a stronger and better management team through
enhanced corporate alignment, training, and even through hiring.

6. Value is impacted by liquidity.

This principle functions based on the theory of demand and supply. If the marketplace has many
potential buyers, but there are a few quality acquisition targets, there will be a rise in valuation
multiples and vice versa.

In both open market and notional valuation contexts, more business interest liquidity translates into
more business interest value.

Business owners need to get the best potential purchasers to the negotiating table to maximize price. It
can be achieved through a controlled auction process.

VALUATION TECHNIQUES

3 widely used valuation techniques:

● Market approach

● Cost approach or asset based

● Income approach

One method or more methods combined, based on sufficient data; entities should maximize the use of
relevant observable inputs and minimize the use of unobservable inputs.

Market approach

Uses price and other relevant information generated by market transactions involving identical or
similar assets and liabilities. Valuation techniques based on market approach often use market
multiples derived for certain variables. For example, businesses are often valued based on their revenue
or EBITDA multiples.

Matrix pricing is another example given by IFRS 13 where a fair value of certain financial instruments
( usually bonds ) is measured by interpolating values for similar instruments ( ex. Credit rating ) arranged
in matrix format.

Market approach is usually used for the measurement of:

● Cash generating units and businesses ( by reference to quoted prices or transactions in the same
industry and based on revenues/EBITDA/other multiples
 ● Properties ( by reference to transactions for similar properties )

Cost approach

Current replacement cost. This aims to reflect the amount that would be currently required to replace
the service capacity of an asset adjusted for obsolescence ( ex. Physical deterioration, technological or
economic obsolescence)

Cost approach is usually used for measurement of:

- tangible assets

- assets that are used in combination with other assets and liabilities

Income approach

The income approach converts future amounts ( ex cashflows or income and expenses ) to a simple
discounted amount taking into account, inter alia, risk and uncertainty

Examples of valuation techniques consistent with income approach include:

● Present value techniques

● Option pricing models

● Multi-period excess earnings method

Present value techniques usually used for measurement of:

● Cash generating units and businesses ( based on estimated revenue and expenses )

● Financial assets/liabilities when quoted prices are not available for identical or similar items
( based on contractual and/or estimated cashflows)
● Investment properties ( based estimated rental revenue and operating expenses )

Discount rate adjustment technique

Uses a single set of cashflows from the range of possible estimated amounts whether
contractual/promised on most likely cashflows. These cashflows are then discounted using an observed
or estimated market rate of return ( WACC is used most often ) All the risk is therefore reflected in the
discount rate.
ROLE of VALUATION

Valuation :

● provide a baseline = where are we now?

● help chart the course for the future = where are we heading?

● Measures progress

● Can identify gaps = structure, client demographics, technology, infrastructure, improvement in

the business to increase value
● Help you manage your business

● Create accountability

● Provide a benchmark

● Provide a perspective on price

● Can provide the gateway to capital

● Are part of your estate plan

VALUATION BIAS

A postulate of sound investing is that an investor does not pay more for an asset than it is worth

● We buy financial assets for the cash flows we expect to receive from them

● The price we pay for any asset should reflect the cash flows it is expected to generate

● Little room for analyst views or human error

● Savvy analysts can manipulate the number to generate whatever result they want

● The bias that analysts bring to the process, the uncertainty that they have to grapple with and
the complexity that modern technology and easy access to information have introduced into
valuation

Sources of bias

● Starts with the companies who choose to value

● News; expert’s valuation = over or undervaluation

● Institutional factors = difficulty in obtaining access and collecting information

 ● Analyst’s pressures from portfolio managers with their large positions or the firm the analyst
works
● Analyst’s view vs his/her pay

● Bias on past financial data

How to curb bias?

● Reduce institutional pressures

● De-link valuations from reward/punishment

● No pre-commitment

● Sefl awareness

● Honest reporting

COMMON PROBLEMS with BUSINESS VALUATIONS

1. Not using the correct earning system

● EBITDA can overvalue a business that is too small to use EBITDA

● SDE ( Seller’s Discretionary Earnings ) can undervalue a company that is too large to
use SDE
● Net income generally undervalues businesses and is not a good method
2. Not using the right multiple because on use of wrong computation
3. Trying to use the wrong approach for the size of the company
4. Trying to value based off future performance instead of historical performance
5. Misunderstanding what is and is not included in comparable sales databases
6. Interpretations of expenses
7. Using cash basis statement instead of accrual basis statements and P&L’s instead of tax returns

Thank you 😊