CA Anand Varma

CA Anand VarmaValuation intricacies and different views of capital for investors to see how secure is their investment against risk?

Goodwill and Entity valuation

Goodwill of an enterprise is an important ‘asset’ which is relevant for investors in their decision to invest or not and to know how goodwill is quantified? A chartered accountant may think this to be his forte to provide an answer but how much is the value of goodwill of an entity and value of an entity may be difficult to answer but not impossible. It should be remembered entrepreneurs are more interested to know the values of his goodwill and entity which could be used in a buy and sell deal or just to build further upon those values, than the accounting values of goodwill and entity. This article has endeavored to deal with the more complex business valuation side whilst the accounting valuation has been dealt with briefly.

Business notion of goodwill: Value of a business is not always defined by what assets an entity owns and what it owes. If one goes by the Asset Valuation Method, value of a business is determined by adding up the value of its assets and subtracting liabilities. It tells you the value of your business if it were closed down today and its assets sold off, but doesn’t take into account the ability of those assets to generate future revenue. For that reason, it may understate the true value of the business.

Example
X wants to buy a manufacturing business with assets of $500,000 and liabilities of $400,000. The net asset value of the business is $100,000.

What about goodwill?

Method 1: Net asset (asset valuation) method

This method doesn’t include a value for goodwill so it may understate the true value of a business. Goodwill is the difference between the true value of a business and the value of its net assets. It can be crucial to the value of retail and service-based businesses.

For example, if you value a business such as an established retail store, where service, location and reputation are important, the value of any goodwill would have to be added to net assets to get a valuation.

Can goodwill be transferred if you buy a business? It can come from physical features such as location, or from personal factors, like the owner’s reputation or their relationships with customers or suppliers, which may not be transferable.

If the business is underperforming and has no goodwill, then using the net assets valuation method could be an accurate way of determining its value.

How to quantify goodwill of an entity as a business notion?

A successful business will develop customer loyalty and an overall positive reputation in its community (superior competitiveness, innovation and managerial expertise), which will cause its market value to be greater than its book value. Difference between the value of an entity as reflected in its balance sheet and its market value (e.g., market cap) is known as its goodwill. However a business is not allowed to record goodwill that it generates for itself.

How to determine the market value of net assets of an entity that can be regarded as its market capitalisation or value, for investors to take a forward looking view from a statutory balance sheet?

The aggregate of value of business goodwill as explained above and the value of in-force (VIF) business will give the entity level market capitalisation, to capture a market view of its net assets in financial statements. Value of in-force (VIF) business is the present value of expected future shareholder profits (capital inflows) less the present value cost of holding capital required to support the in-force business (capital outflows).Cost of holding risk adjusted capital = initial risk capital minus present value of expected return on risk capital plus present value of tax plus/minus present value of increase/release of risk capital –this component is the balancing figure =required closing risk adjusted capital aligned to capital management and business plan. Added to the VIF figure the value of goodwill being the difference between the market capitalisation and net assets value (book value) gives the view of market value of net assets. This view is also called the statutory balance sheet view of capital.

“The value of in-force” has to do with the amount of current or present value of the future profits that owners and investors of an entity anticipate will be realized from its business activities over a period of time. Projecting this figure is key to entrepreneurs, since it helps to determine if the he will remain solvent over the long term and generate some sort of profit above and beyond honoring expenses and claims submitted by customers.

Since providing business activities is considered a type of in-force business, owners must project the revenue stream, operational costs and ultimately the net profit that is realized from the business endeavor. This process involves considering the present value of all the business contracts currently written and projecting what type of revenue will be generated from those up to the point of execution on those contracts including returns and customer claims. Doing so makes it easier to determine if new contracts are being written at a pace that helps to balance the payouts, effectively keeping the entity solvent. It also helps to determine if the investments held by the entity are producing a sufficient return to help support the overall business model. When this is the case, the value of in-force is considered positive and the provider is highly likely to remain in business.

Accounting notion of goodwill: Accounting goodwill is the excess value of a firm’s net assets over the acquisition price and is recorded by the acquiring entity at the time of business acquisition or combination. Goodwill is not associated with a physical object that the business owns, so it is an intangible asset and is listed on a company’s balance sheet. Further, accounting goodwill is not amortised but is tested for impairment on the reporting date of financial statements.

Method 2: Capitalised future earnings

This method to value an entity is another method close to that of value of in-force business but it does not take into account the value of goodwill. When you sell a business, you’re selling not only its assets but also the right to all profits the business might generate. Capitalising future earnings is the most common method used to value small businesses. The method looks at the rate of return on investment (ROI) a buyer can expect to get from the business.

How it works

  • Work out the average net profit of the business over the last three years using its profit-and-loss statements. Adjust the profit for any one-off expenses or other irregular items each year.
  • Decide on the annual rate of return a buyer might be looking for. There are no hard and fast rules about the number to choose, except higher risk should give higher returns. Compare the business with other investment opportunities — from safe havens like term deposits, to riskier investments like shares. Also look at the rate of return that similar businesses in the same industry achieve.
  • John net profits by the rate of return to determine the value of the business, then multiply by 100.

Example
John is looking at buying a bakery business with average net profits of $100,000 per annum after adjustments. John wants an annual rate of return of 20%. The capitalised earnings valuation is:

 1212121

Other two methods to value an entity are given below, but again goodwill does not find a special weightage.

Method 3: Earnings multiple

This method is often used to assess the value of entities whose shares are traded on a stock exchange and reflect market expectations. But it can also be used to value unlisted businesses. Its big advantage is its simplicity. The difficulty lies in deciding which multiple to use.

How it works

Multiply the business’ earnings before interest and tax (EBIT) by your selected multiple. For example, you might value the business at twice its annual earnings — so a business with an EBIT of $200,000 might be valued at $400,000.

The multiple you choose will depend on the industry and the growth potential of the business. A service-based business might be valued at as little as one year’s earnings, while an established business with sustainable profits might sell for as much as six times earnings.

Method 4: Comparable sales

Whatever other valuation method you use, you should also look at prices for recent sales of similar businesses. It makes sense to know what is happening in the market you’re interested in. This is a relative value notion.

Speak to business brokers and gauge their feeling about the business’ value. They might know what similar operations are selling for and how the market is placed. Check business-for-sale listings in relevant industry magazines, newspapers or websites.

2 Different views of capital –economic v. accounting capital

Problem with financial statement capital is it does not recognise various ‘hidden’ values such as goodwill. Accounting capital does not provide dynamic view of an ongoing, active entity. It is not forward looking. It looks backward only to previous exposure. Economic capital gives management a universal risk metric tool to quantify risk. Without a common metric in place, entities and investors will struggle to address both (i) individual risks and (ii) to understand how much economic capital (present or fair value) in total is being put at risk across the organization to support a given level of business activity linked with capital management and business plan.

Investors will find economic capital to be much more useful in addressing the risk investors carry like market volatility, uncertainty and calamity. Available economic capital is calculated as equal to market value of assets minus market (fair) value of liabilities plus depreciation allowance. Required economic capital is equal to capital required to support a business with a certain probability of default (VaR). Excess capital =available economic capital –required economic capital. Economic franchise value =pv of revenue-cost linked to barriers of entry. If barriers to entry are low, then according to the textbooks a profitable firm is likely to face many competitors, leading to erosion of franchise value. Only if barriers to entry are high will the firm be able to earn monopoly rents for a long time.

Economic significance of franchise value is such that the value represents entity’s superior consumer satisfying attributes of products and services resulting into stronger revenues and returns on investment compared to other entities in the same line. It is these much desirable higher revenues and returns which provide that extra layer of market-related economic capital to improve the coverage of the risk inventory held and valued at fair value or pv, over and above (i) the required economic capital and (ii) any excess capital.

Economic capital, an aggregate of franchise value, required economic capital and any excess capital gives an economic balance sheet view to investors which can be useful in knowing if the entity is supported with enough market-consistent capital to survive in the worst case scenario. No goodwill.

Spotting franchise value

One way to help ensure your portfolio has above average results over the long-term is to purchase shares of business that possess significant franchise value. In the investment world, franchise value refers to the popularity of a particular brand or product with consumers. If you are trying to decide if a business has franchise value, ask yourself these three questions:

1 Am I willing to pay more for the brand (e.g., Hershey’s) as opposed to another, cheaper brand (e.g., the generic chocolate bar)?

2 If a store didn’t have the brand in which I was interested, would I walk across the street to buy the product I wanted?

3 If I started a business in direct competition with this product, what are my chances of success? Would I be able to make a dent in its market share or is the product so firmly entrenched it would be difficult to wrestle away even a small portion?

In other words, economic capital is the (a) discounted value of (i) future cash flows of future expected (pv of best estimated liability) and unexpected liability and allocated to existing capital resources at fair value within the balance sheet or (b) excess of capital over targeted financial strength. Unexpected future losses should be restricted to VaR threshold over a day, week, month, quarter or a year.

Therefore, there is an interest in establishing what is the ‘correct’ level of capital under given parameters so that providers of capital don’t not expect to earn a risk return that is too high, since this leads to an excessive cost of products to customers of a bank or insurance or other entity, and capital is not too low either, since this leads to an unacceptable risk of insolvency.

Different views of capital

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Conclusion

Aiming for consistent and higher business valuations by continuous business improvement processes and responsive competitiveness could give entity a sustainable microeconomic business model, besides strengthening the country’s macroeconomic indicators like the GDP, Current Account Balance and Exchange Rates, instilling investor confidence. Economic capital helps entity a right level of risk appetite and risk tolerance aligned with entity level goals. In case of inadequate EC, entity needs to raise more debt or equity capital with specific fair valued risk inventory held.

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 $ (reserve currency) has been used in this write up just to provide a common business understanding across borders.

Disclaimer: As this write up has been prepared without considering reader’s objectives, financial situation or needs, you should, before acting on this note, consider its appropriateness to your circumstances and may take a professional advice.

(Author may be contacted at varma1002003@yahoo.co.in)

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