Valuation is one of the most important aspect that ought to be considered in any restructuring exercise. Since various restructuring options necessarily involve exchange of payment/ consideration, valuation assumes great significance.
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Valuation of assets comprises two kinds of assets:
- Tangible Assets:
- Fixed Assets- Plant & Machinery, Land & Buildings mainly
- Current Assets
- Intangible Assets:
- Brand Valuation
- Valuation of Goodwill
- Valuation of copyright, patents, trademarks
Valuation of Assets in Typical Mergers, Demergers and acquisitions:
For recommending fair swap ratio valuation of the companies involved is carried out. Method of valuation may be different in different cases. Where the company has good income prospects, normally DCF is used to estimate the value. However, if the company has asset base operation and income prospects are not clear asset based valuation is generally preferred. In typical mergers and demergers cases where asset based method is used, normally book value of assets is considered. However, for stamp duty purpose market value of immovable assets is considered by the stamp authorities.
It may happen that a typical merger or demerger has been structured between two unconnected companies to acquire the company or a division of the company so in that case market value of the assets may be more relevant. Price to be decided for a particular asset may be sometimes different that prevalent market price of similar assets in the same location. This case arises when there is strategic benefits are attached to the acquirer company.
In plain vanilla acquisitions deals, usually, market price or strategic price of the assets is more relevant.
Valuation of Fixed Assets:
Fixed Assets are valued because it gives benefits to the owner over a period of time, usually called commercial life of the assets.
While valuing the fixed assets at least following are to be considered:
- What is the normal market value of the fixed assets (especially land & buildings)? It is compared with the similar assets in the same location
- What are the super benefits (benefits other than revenue) attached with the assets if purchased by the buyer
- What are the routine costs associated with assets
- Is there any loss of present revenue of the acquirer/buyer of the assets?
- Is the asset subject to technology change? If yes then how frequently?
As now days most of the states have announced rates of different areas (which is known as Ready Reckoner rates) and all taxes are to be paid with reference to the said rate even if actual transaction is at the rate lower than the said Reckoner rate.
Valuation of Intangible assets:
Approach of valuing all the intangible assets are same- discounting the incremental benefits to the buyer at a certain discount rate, when income based approach is used and summing up all the costs associated in generating/creating the intangibles and giving compounding effect to present at ascertain rate, say average rate of inflation plus premium, when cost based approach is used.
For financial valuation of an intangible asset the following characteristics should be:
- Intangible Asset should be specifically identifiable.
- The ownership of the intangible assets is the right of ownership, and the ownership should be transferable. If transferred to another party for consideration it will bring similar or enhanced benefits.
- It should be subject to maintenance.
- It is subject to legal existence and protection.
Valuing brand may adopt any or all the approaches of cost, income and market. Cost approach of brand valuation is the minimum expected valuation for the brand which is summing up all the investment done in creating and maintaining brand till now and giving it compounding effect at certain rate, say average inflation rate or average interest rate. Cost approach tries to estimate the costs to replace or recreate the same brand with similar brand equity/strength.
While valuing the brand based on income approach we normally use two methods-excess earning approach or/and sales premium approach. Under Excess Earning approach we assume that there are two kind of assets employed in the business-Fixed Assets and Investment in working capital. Deployment of funds in these two assets has some opportunity costs which may be assumed to be normal interest rate charged by the lenders of the fund while lending money for these investments. On the other hand the company, by exploiting these assets generates Profit for the shareholders which may be higher than the cost paid on financing these investments. The excess return of profit over the cost when discounted at certain rate will give fair value of brand. Of course, the discount rate should be higher than the equity capitalization rate because of intangible nature of brand considering the fact that brand may fade away with increasing competition or altogether change in demographic change in the target consumers.
Another approach which is normally considers the capability of charging excess price by the producer vis-à-vis those charged by counterparts for the similar products. This is known as “sales premium approach”. The excess price is discounted at certain rate say equity capitalization rate plus premium.
In nut shell, while valuing any assets, we have to consider the commercial benefits which the assets are supposed to bring to the owner.
Why value your business?
Any restructuring exercise, be it the sale of a unit, investment consideration in a business, acquisition of a business, hiving off an undertaking or buyback of shares, requires a particular value to be assigned to the activity under consideration in order to make for meaningful analysis. Besides undertaking a valuation exercise at the time of restructuring activity it could also be used to value a business in the normal course of its activity or on a periodic basis whereby the valuation outcome acts as a decision making tool to the management. Apart from profitability, value creation is an equally important objective and this aspect should also be given due consideration. There are many cases where the profitability of a business has been increasing however the value creation has been nil or negligible.
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There are various methods adopted across the globe, however we discuss some of the common and widely accepted methods of valuation.
- Discounted cash flow method:
This valuation method based on free cash flow is considered a strong tool because it concentrates on cash generation potential of a business. This valuation method uses the future free cash flow of the company (after providing for changes in working capital and capital expenditures) and discounts it by the firm's weighted average cost of capital (the average cost of all the capital used in the business, including debt and equity) to arrive at the value of the enterprise as a whole. According to the discounted cash flow valuation model, the intrinsic value of a company is the present value of all future free cash flows, plus the cash proceeds from its eventual sale. The presumption is that the cash flows are used to pay dividends to the shareholders. In general, the DCF method is a strong and widely accepted valuation tool, as it concentrates on cash generation potential of a business.
- Net Asset Value Method:
Under this method a business is valued on the basis of the net assets of business i.e. the total assets less the liabilities and the preferred shareholders claims and dividing the resultant number by the equity shares outstanding as on a particular date. Valuation for this purpose can be done on a number of basis such as
- Book Value
- Net replacement value
- Net realizable value
NAV method of valuation is rarely used for valuing a going concern as it does not consider the future earnings capacity of the business. However it is a widely used method of valuation in cases where the projections of future profits cannot be made with reasonable accuracy, where there are losses or where the value of the entity is derived substantially from the value of its assets.
- Comparable company Analysis:
Comparable company method of valuation is widely used to value private firms. It values an asset or firm based on how an exactly identical firm (in terms of risk, growth rate and cash flows) is priced. In this method, price multiples of comparable listed companies are applied to key financials to arrive at the valuation. Commonly used comparables are the PE multiple, EV/EBIDTA multiple, Price/Sales etc. Comparable company analysis method is much likely to reflect the current mood of the market since it attempts to measure the relative value and not the intrinsic value. Even though it is not an independent valuation methodology, comparable company method may be used to support valuations churned out by cash flow and other futuristic valuation methodologies. This is based on the premise that the market multiples of comparable listed companies are a good benchmark to derive valuation. The price earnings ratio expresses the stock price in terms of earnings per share (EPS). The P/E ratio uses the earnings of a company to value that company’s stock. The price to cash flow measure compares the value of a company relative to its cash flow generation. The price to cash flow ratio is based on the actual cash flow generated by the company unlike the PE ratio, which is an accounting measure and is susceptible to manipulation. The price to sales ratio measures the value of the company relative to its revenue. This measure provides a very useful benchmark for companies that are in commodity business with similar margins and operating characteristics. However certain issues like measurement of revenue and the revenue recognition policy need to be considered while using this ratio.
- Maintainable Profit Method:
Under this method a reasonable estimate of the average future maintainable operating profits is made by taking past earnings as a base and adjusting it for the trend and the future plans of the company. The resulting profit, after deducting for preference dividend, if any, is capitalized at an appropriate rate, and the resultant figure is the value of the equity shares. The determination of average future maintainable profits and suitable rate of capitalization is a complex task and necessitates subjective evaluation of many factors such as government policies, prospects of expansion, competition, nature of industry, entry barriers in business, technological obsolescence, investors’ perception etc. The capitalization rate could be taken as the aggregate of the long term risk free rate and the additional earnings expected to cover the risk involved in the business. Reliance has also to be placed on the market quotations of shares of the companies in a similar business, after making necessary adjustments for various factors which affect the stock markets. If the company which is being valued has diversified businesses then the future maintainable profits may be capitalized at different rates on account of different risk levels of each business.