The etymology of “business” relates to the state of being busy either as an individual or society as a whole, doing commercially viable and profitable work. The term “business” has at least three usages, depending on the scope — the singular usage (above) to mean a particular company or corporation, the generalized usage to refer to a particular market sector, such as “the music business” and compound forms such as agribusiness, or the broadest meaning to include all activity by the community of suppliers of goods and services. However, the exact definition of business, like much else in the philosophy of business, is a matter of debate and complexity of meanings.
The dictionary meaning of “Valuation” is “The act or process of assessing value or price;” Business valuation is the act or process of assessing value or price of financial asset or liability. Financial valuation involves valuation of assets as well as valuation of the complete business.
3. BUSINESS VALUATION
Business valuation is a process and a set of procedures used to estimate the economic value of an owner’s interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to consummate a sale of a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners’ ownership interest for buy-sell agreements, and many other business and legal purposes.
4. VALUATION vs. APPRAISAL
Valuation and appraisals are similar, but they are not interchangeable. The key difference between a valuation and an appraisal is that a valuation includes both tangible and intangible assets, while an appraisal just includes tangible or physical assets.
Two external factors considered during appraisal of a busines distinguishes Appraisal from a Valuation(also known as Evaluation). “Economic outlook” refers to issues involving both the general economy and the specific industry to which the business belongs. Health of the economy; growing, downsizing, staying the same of the industry; existing of barriers of entry to the industry in terms of technology, capital, etc. “Market price of stocks…in similar businesses” implies that valuation comparisons be made to publicly traded companies. And, according to accepted appraisal techniques when the information is available, comparisons be made to the valuations of other similar, privately held businesses where recent transactions have set fair market values.
Generally, the external factors may be ignored or treated minimally. Valuing a business under these conditions, is called VALUATION (or Evaluation).
In situations where the value is the basis of a significant lawsuit or involve a disputed tax situation, the external factors may have to be taken fully into consideration which is called an APPRAISAL.
5. NEED FOR VALUATION
All sorts of events could trigger a need for a valuation; so whenever major changes occur within the business discuss with check with the accountant or consultant whether valuation will be beneficial or required. Valuation may be required for the following purposes:
a) Disputing the conclusions of regulatory investigation
b) Planning for an initial public offering of company shares
c) Selling the company or hiving off a division
d) Conducting a major strategic-planning
e) Applying for loan
f) Seeking investors
g) Creating a company stock-option plan
h) Breaking up a partnership
i) Getting a divorce
j) Liquidation /Filing for bankruptcy
k) Doing estate or gift planning that involves company stock
6. THE COMPONENTS OF A VALUATION PROCESS
Valuation process includes the following stages:
A Initial Conversation
B Engagement of Professional accountant/consultant
C Research and data gathering
D Analysis and estimate of value
E Reporting Process
A. Initial Conversation
Whenever the need for valuation arise its process start with a discussion to understand the specifics situation, what will be needed, and how the information will be gathered. This all depends on nature of the business and the percentage and type of interest to be valued, as well as the reason for the valuation (e.g., taxation, transaction, litigation, regulatory compliance, or some other reason.)
B. Engagement of Professional accountant/consultant
Business valuers estimate the value of:
i. Financial and intangible assets and liabilities such as contracts, and intellectual property
iii. Securities such as debt, equity and derivatives.
In the last few years, professional accountants have seen dramatic changes in accounting rules, standards, regulation and corporate governance practice. This has brought about sweeping changes to their traditional roles and requires them to acquire new skills. One such area is business valuation.
Skills required from consultant /professional accountant
a) Understanding of the concept and purpose of professional valuation within the accounting profession.
b) Knowledge of taxation aspects- tax on sale, gains, creating tax saving entities
c) Knowledge of Accounting standards related to business combinations, intangible assets, employee options and financial instruments
d) Understanding of employee performance measurement criteria when valuation is for stock options
e) Awareness of issues impacting clients and ability to provide advice and direction to respond to these issues
C. Research and data gathering
The consultant requires certain information to perform the engagement. Most of the data is available within the organization.
1. The following are some of the areas that should be considered in a valuation
a) The nature of the business
b) The history of the business
c) The economic outlook and the conditions of the specific industry
d) The book value of the stock
e) The financial condition and Management of the company
f) The dividend paying capacity and dividend paying history of the company
g) Previous sales of stock
h) Dividend paying capacity and history
i) Market price of comparable publicly traded companies
j) Goodwill of the company
k) Dependency of company’s value on current management
2 Information to be provided to the consultant includes financial & corporate documents and other information including:
a) Financial statements
b) Corporate documents for your company (Certificate of Incorporation, Memorandum & Articles of Association, Resolution of Directors, etc.)
c) Governance body minutes
d) Organization chart
e) Tax returns
f) Accounts receivable, accounts payable and inventory detail
i) Marketing material/price lists
j) List of Liabilities, Loans and Mortgages including taxes, insurance policies, etc.
k) Valuation of intangible assets, goodwill, trademarks, etc
l) List of Services/Products
m) Present Marketing and Advertising Information
n) Major competitors and market position
o) Customer lists
p) Financing terms
q) Financing for possible expansion and projections for financial statements (if applicable)
r) Other inducements, present employees, managers, etc.
3 External Resources required
The following are illustrative of the external sources required:
1) Business valuation publications including:
a) General Business Valuation
b) Transaction Data
c) Industry-Specific Valuation
d) Cost of Capital
e) Professional Practice Valuation
f) Partnership Valuation
g) ESOP Valuation
h) Mergers & Acquisitions Valuation
i) Intangible Assets Valuation
j) Sample Valuation Reports
k) Financial Reporting Valuation
l) Valuation Software Technology Valuation
m) Real Estate Valuation etc.
2) Industry information including:
a) industry overview
c) Trends & outlook
d) financial ratios and benchmarking
e) compensation and salary structure
3) Economic data including:
a) bond yields and interest rates
b) inflation and cost living data
c) economic forecast resources
4) Market transaction data including:
a) cost of equity capital,
b) equity risk premiums
5) Business valuation multiples (derived from company merger and acquisition transaction data)
6) Legal and tax resources
a) Tax regulations
b) Case laws
D. Analysis and estimate of value
The organization and the consultant have to decide on business valuation method to be used based on the nature and requirements of the engagement. This will also involve analyzing the company information in conjunction with the industry and other comparable company data.
BUSINESS VALUATION METHODS:The following are some of the business valuation methods:
i. Discounted Cash Flow (DCF) Method
The Discounted Cash Flow (DCF) methodology expresses the present value of a business as a function of its future cash earnings capacity. This methodology works on the premise that the value of a business is measured in terms of future cash flow streams, discounted to the present time at an appropriate discount rate.
This method is used to determine the present value of a business on a going concern assumption. It recognizes that money has a time value by discounting future cash flows at an appropriate discount factor. The DCF methodology depends on the projection of the future cash flows and the selection of an appropriate discount factor.
When valuing a business on a DCF basis, the objective is to determine a net present value of the cash flows (“CF”) arising from the business over a future period of time (say 5 years), which period is called the explicit forecast period. Free cash flows are defined to include all inflows and outflows associated with the project prior to debt service, such as taxes, amount invested in working capital and capital expenditure. Under the DCF methodology, value must be placed both on the explicit cash flows as stated above, and the ongoing cash flows a company will generate after the explicit forecast period. The latter value, also known as terminal value, is also to be estimated.
The further the cash flows can be projected, the less sensitive the valuation is to inaccuracies in the assumed terminal value. Therefore, the longer the period covered by the projection, the less reliable the projections are likely to be. For this reason, the approach is used to value businesses, where the future cash flows can be projected with a reasonable degree of reliability. For example, in a fast changing market like telecom or even automobile, the explicit period typically cannot be more than at least 5 years. Any projection beyond that would be mostly speculation.
The discount rate applied to estimate the present value of explicit forecast period free cash flows as also continuing value, is taken at the “Weighted Average Cost of Capital” (WACC). One of the advantages of the DCF approach is that it permits the various elements that make up the discount factor to be considered separately, and thus, the effect of the variations in the assumptions can be modeled more easily. The principal elements of WACC are cost of equity (which is the desired rate of return for an equity investor given the risk profile of the company and associated cash flows), the post-tax cost of debt and the target capital structure of the company (a function of debt to equity ratio). In turn, cost of equity is derived, on the basis of capital asset pricing model (CAPM), as a function of risk-free rate, Beta (an estimate of risk profile of the company relative to equity market) and equity risk premium assigned to the subject equity market.
ii. Balance Sheet Method or the Net Asset Value Method
The Balance sheet or the Net Asset Value (NAV) methodology values a business on the basis of the value of its underlying assets. This is relevant where the value of the business is fairly represented by its underlying assets. The NAV method is normally used to determine the minimum price a seller would be willing to accept and, thus serves to establish the floor for the value of the business. This method is pertinent where:
• The value of intangibles is not significant;
• The business has been recently set up.
This method takes into account the net value of the assets of a business or the capital employed as represented in the financial statements. Hence, this method takes into account the amount that is historically spent and earned from the business. This method does not, however, consider the earnings potential of the assets and is, therefore, seldom used for valuing a going concern. The above method is not considered appropriate, particularly in the following cases:
• When the financial statement sheets do not reflect the true value of assets, being either too high on account of possible losses not reflected in the balance sheet or too low because of initial losses which may not continue in future;
• Where intangibles such as brand, goodwill, marketing infrastructure, and product development capabilities, etc., form a major part of the value of the company;
• Where due to the changes in industry, market or business environment, the assets of the company have become redundant and their ability to create net positive cash flows in future is limited.
iii. Market Multiple Method
This method takes into account the traded or transaction value of comparable companies in the industry and benchmarks it against certain parameters, like earnings, sales, etc. Two of such commonly used parameters are:
• Earnings before Interest, Taxes, Depreciation & Amortizations (EBITDA).
Although the Market Multiples method captures most value elements of a business, it is based on the past/current transaction or traded values and does not reflect the possible changes in future of the trend of cash flows being generated by a business, neither takes into account the time value of money adequately. At the same time it is a reflection of the current view of the market and hence is considered as a useful rule of thumb, providing reasonableness checks to valuations arrived at from other approaches. Accordingly, one may have to review a series of comparable transactions to determine a range of appropriate capitalization factors to value a company as per this methodology.
iv. Asset Valuation Method
The asset valuation methodology essentially estimates the cost of replacing the tangible assets of the business. The replacement cost takes into account the market value of various assets or the expenditure required to create the infrastructure exactly similar to that of a company being valued. Since the replacement methodology assumes the value of business as if a new business is set, this methodology may not be relevant in a going concern. Instead it will be more realistic if asset valuation is done on the basis of the new book value of the assets. The asset valuation is a good indicator of the entry barrier that exists in a business. Alternatively, this methodology can also assume the amount which can be realized by liquidating the business by selling off all the tangible assets of a company and paying off the liabilities.
The asset valuation methodology is useful in case of liquidation/closure of the business.
v. Liquidation Value
Liquidation value uses the value of the assets at liquidation. Liabilities are deducted from the liquidation value of the assets to determine the liquidation value of the business. Liquidation value can be used to determine the bare bottom benchmark value
vi. Capitalization methods :
This method calculates a business’s value by discounting the future business profits or dividends flowing to the entity’s owners, which is derived from future commercial profits (statement of earnings). There are two methods:
INCOME CAPITALIZATION VALUATION METHOD: First determine the capitalization rate – a rate of return required to take on the risk of operating the business (the riskier the business, the higher the required return). Earnings are then divided by that capitalization rate. The earnings figure to be capitalized should be one that reflects the true nature of the business, such as the last three years average, current year or projected year. When determining a capitalization rate, compare with rates available to similarly risky investments
DIVIDEND CAPITALIZATION: Since most closely held companies do not pay dividends, when using dividend capitalization consultants first determine dividend paying capacity of a business. Dividend paying capacity depends on net income and on cash flow of the business. To determine dividend paying capacity, near future capital requirements, expansion plans, debt repayment, operation cushion, contractual requirements, past dividend paying history of a business should be studied. After analyzing these factors, percent of average net income and of average cash flow that can be used for the payment of dividends can be estimated. The dividend yield can be also determined by analyzing comparable companies. .
E. Documentation and Reporting
D.1. Working papers
The normal professional principles with respect to working papers are to be applied for business valuations too. The consultant should ensure that he receives a letter of representation and provides an engagement letter.
The working papers must enable a knowledgeable third party to understand the results of the valuation and estimate the effects on the business valuation of any assumptions made.
D.2. Valuation report
The contents of the report should include the following:
1) Description of valuation engagement
a) Name of client
b) Engagement (reason for valuation; in which function the valuation is being carried out)
2) Description of business being valued
a) Legal background
b) Financial aspects
c) Tax matters
3) Description of the information underlying the valuation
a) analysis of past results
b) budgets, with underlying assumptions
c) availability and quality of underlying data
d) review of budgets for plausibility
e) statement of responsibility for information received
4) Description of specific valuation of assets used in the business
b) The principles used in the valuation.
c) Description of the procedures carried out
d) The valuation method used
e) The procedures involved in making projections
f) The scope and quality of underlying data and
g) The extent of estimates and assumptions together with considerations underlying them
The valuation report must clearly state the significant assumptions upon which the business value is based. When reporting there may be instances, where there are confidential figures they must be summarized in a separate exhibit.
h) Conclusion: In his valuation report the consultant must set out a clear value or range of values for the business and explain the values.
D.3 Types of Valuation Reports
Typical Valuation Reports include:
a) Limited Scope Valuations
Limited Scope Calculation of Value reports are particularly useful for small businesses whose owners are considering the sale of the business.
b) Formal Valuations
A Formal Valuation report is the next step up from a Limited Scope Valuation and involves more detailed analysis with market research to support the end result. The final suggested value is not a range, but rather a distilled value of the business. Formal Valuations are used for businesses which are contemplating an uncontested sale of their shares in the business
c) Mergers and Acquisitions
This type of report is used where shareholders or interested parties in the company want to obtain the value of a business. It typically takes longer than Limited Scope or Formal Valuations to complete the analysis, interviews and written report that are involved in this type of valuation. Such reports reflect the more complex and detailed analysis that needs to be done to arrive at the business value in this context.
d) Comprehensive Valuations
These valuation reports are much more comprehensive and detailed than the other types of valuation reports and because of their purpose require extensive documentation. The valuators involved in these reports are litigation-trained and accredited business valuators who can be made available to provide testimony and litigation support to assist with critiquing opposing valuation testimony.
To conclude, a valuation provides the foundation for skilled business appraisers to estimate what your business is worth. Valuation is frequently used in setting a price for an enterprise that is being bought or sold. Professional valuations are now also being used by financial institutions to determine the amount of credit that should be extended to a company, by courts in determining litigation settlement amounts and by investors in evaluating performance of company management. Lastly, a valuation is often required under a variety of accounting and tax regulations. Hence, there are many important reasons that business owners should know the value of their businesses long before they decided to sell.
Do you think CBDT should extend Tax Audit Report and relevant ITR Due Date? Please Comment, Vote, Retweet and Like.— Tax Guru (@taxguru_in) September 18, 2018