conceptual framework of valuation

8/9/2019 Conceptual Framework of Valuation

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Enterprise Valuation

(In lieu Of Mid-Semester )

By

Mohd Asif Anis

MBA(IB)FinanceSemester 4

th


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VALUATION

The term 'valuation' implies the task of estimating the

worth/value of an asset, a security or a business. The price

an investor or a firm (buyer) is willing to pay to purchase

a specific asset/ security would be related to this value.

Obviously, two different buyers may not have the same

valuation for an asset/business as their perception

regarding its worth/value may vary; one may perceive the

asset/business to be of higher worth (for whatever reason)

and hence may be willing to pay a higher price than the

other. A seller would consider the negotiated selling price

of the asset/business to be greater than the value of the

asset/business he is selling.

Evidently, there are unavoidable subjective considerations

involved in the task and process of valuation. Inter-se, thetask of business valuation is more awesome than that of

an asset or an individual security. In the case of business

valuation, the valuation is required not only of tangible


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assets (such as plant and machinery, land and buildings,

office equipments, and so on) but also of intangible assets

(like, goodwill, brands, patents, trademark and so on) as

well as human resources that run/manage the business.

Likewise, there is an imperative need to take into

consideration recorded liabilities as well as

unrecorded/contingent liabilities so that the buyer is

aware of the total sums payable, subsequent to the

purchase of business. Thus, the valuation process is

affected by, subjective considerations. In order to reduce

the element of subjectivity, to a marked extent, and help

the finance manager to carry out a more credible

valuation exercise in an objective manner, the following

concepts of value are explained in this Section: (i) book

value, (ii) market value, (iii) intrinsic value, (iv)

liquidation value, (v) replacement value, (vi) salvagevalue, (vii) value of goodwill and (viii) fair value.


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Book Value

The book value of an asset refers to the amount at which

an asset is shown in the balance sheet of a firm. Generally,

the sum is equal to the initial acquisition cost of an asset

less accumulated depreciation. Accordingly, this mode of

valuation of assets is as per the going concern principle of

accounting. In other words, book value of an asset shown

in balance does not reflect its current sale value.

Book value of a business refers to total book value of all

valuable assets (excluding fictitious assets, such as

accumulated losses and deferred revenue expenditures,

like advertisement, preliminary expenses, cost of issue of

securities not written off) less all external liabilities

(including preference share capital). It is also referred to

as net worth.


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Market Value

In contrast to book value, market value refers to the price

at which an asset can be sold in the market. The market

value can be applied with respect to tangible assets only;

intangible assets (in isolation), more often than not, do not

have any sale value. Market value of a business refers to

the aggregate market value (as per stock market

quotation) of all equity shares "outstanding. The market

value is relevant to listed companies only.

Intrinsic/Economic Value

The intrinsic value of an asset is equal to the present value

of incremental future cash inflows likely to accrue due to

the acquisition of the asset, discounted at the appropriaterequired rate of return (applicable to the specific asset

intended to be purchased). It represents the maximum

price the buyer would be willing to pay for such an asset.


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The principle of valuation based on the dis-counted cash

flow approach (economic value) is used in capital

budgeting decisions.

In the case of business intended to be purchased, its

valuation is equivalent to the present value of incremental

future cash inflows after taxes, likely to. accrue to the

acquiring firm, discounted at the relevant risk adjusted

discount rate, as applicable to the acquired business. The

economic value indicates the maximum price at which the

business can be acquired.

Liquidation Value

As the name suggests, liquidation value represents the

price at which each individual asset can be sold if business operations are discontinued in the wake of

liquidation of the firm. In operational terms, the

liquidation value of a business is equal to the sum of (i)


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realisable value of assets and (ii) cash and bank balances

minus the payments required to discharge all external

liabilities. In general, among all measures of value, the

liquidation value of an asset/or business is likely to be the

least.

Replacement Value

The replacement value is the cost of acquiring a new asset

of equal utility and usefulness. It is normally useful in

valuing tangible assets such as office equipment and

furniture and fixtures, which do not contribute towards

the revenue of the business firm.

Salvage Value

Salvage value represents realisable/scrap value on the

disposal of assets after the expiry of their economic useful

life. It may be employed to value assets such as plant and


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machinery. Salvage value should be considered net of

removal costs.

Value of Goodwill

The valuation of goodwill is conceptually the most

difficult. A business firm can be said to have 'real'

goodwill in case it earns a rate of return (ROR) on

invested funds higher than the ROR earned by similar

firms (with the same level of risk). In operational terms,

goodwill results when the firm earns excess ('super')

profits. Defined in this way, the value of goodwill is

equivalent to the present value of super profits (likely to

accrue, say for 'n' number of years in future), the discount

rate being the required rate of return applicable to such

business firms.

The value of goodwill in terms of the present value ofsuper profits method can serve as a useful benchmark in

terms of the amount of .goodwill the firm would be

willing to pay for the acquired business. In the case of


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mergers and acquisition decisions, the value of goodwill

paid is equal to the net difference between the purchase

price paid for the acquired business and the value of

assets acquired net of liabilities the acquiring firm has

undertaken to pay for.

Fair Value

The concept of 'fair' value draws heavily on the value

concepts discussed above, in particular, book value,

intrinsic value and market value. The fair value is hybrid

in nature and often is the average of these three values. In

India, the concept of fair value has evolved from case

laws (and hence is more statutory in nature) and is

applicable to certain specific transactions, like payment to

minority shareholders.

It may be noted that most of the concepts related to value

are 'stock' based in that they are guided by the worth of


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assets at a point of time and not the likely contribution

they can make towards earnings/cash flows of the

business in the future. Ideally, business valuation should

be related to the cash flow generating ability of acquired

business. The intrinsic value reflects the firm's capacity to

generate cash flows over the long-run and, hence, seems

to be more aptly suited for business valuation.

In fact, in general, business firms are not acquired with

the intent to sell their assets in the post-acquisition period.

They are to be deployed primarily for generating more

earnings. However, from the conservative point of view, it

will be useful to know the realisable value, market value,

liquidation value and other values, if the acquiring firm

has to resort to liquidation. In brief, the finance manager

will find it useful to know business valuation fromdifferent perspectives. For instance, the book value may

be very relevant form accounting/tax purposes; the market

value may be useful in determining share exchange ratio


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and liquidation value may provide an insight into the

maximum loss, if the business is to be wound up.

APPROACHES/METHODS OF VALUATION

The various approaches to valuation of business with

focus on equity share valuation are examined in this

Section. These approaches should not be considered as

competing alternatives to the dividend valuation model.

Instead, they should be viewed as providing a range of

values, catering to varied needs, depending on the

circumstances. The major approaches, namely, the (i)

asset based approach to valuation, (ii) earnings based

approach to valuation, (iii) market value based approach

to valuation and (iv) the fair value method to valuation are

described below.


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Asset-Based Approach to Valuation

Asset-based approach focuses on determining the value of

net assets from the perspective of equity share valuation.

What should the basis of assets valuation be, is the central

issue of this approach. It should be determined whether

the assets should be valued at book, market, replacement

or liquidation value. More often than not, they are (and

should be) valued at book value that is, original

acquisition cost minus accumulated depreciation, as assets

are normally acquired with the intent to be used in

business and not for resale. Thus, the valuation of assets is

based on the going concern concept. Some other value

measure may be used depending on circumstances of the

case. For instance, if the plant and machinery has outlived

its economic useful life (earlier than its initial estimatedperiod), and is not in use for production, it will be in order

to value the machinery at liquidation value.


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Apart from tangible assets, intangible assets, such as

goodwill, patents, trademark, brands, know how, and so

on, also need to be valued satisfactorily. It may be useful

to adopt the super profit method to value some of these

assets.

To arrive at the net assets value, total external liabilities

(including preference share capital) payable are deducted

from total assets (excluding fictitious assets). The

company's net assets are computed as per Equation

Net assets = Total assets - Total external liabilities

The value of net assets is also known as net worth or

equity/ordinary shareholders funds. Assuming the figure

of net assets to be positive, it implies the value available

to equity shareholders after the payment of all external

liabilities. Net assets per share can be obtained, dividingnet assets by the number of equity shares issued and

outstanding. Thus,


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Net assets per share = Net assets/Number of equity shares

issued and outstanding

The value of net assets is contingent upon the measure of

value adopted for the purpose of valuation of assets and

liabilities. In the case of book value, assets and liabilities

are taken at their balance sheet values. In the market value

measure, assets shown in the balance sheet are revalued at

the current market prices. For the purpose of valuing

assets, and liabilities, it will be useful for a finance

manager/valuer to accord special attention to the

following points:

(i) While valuing tangible assets, such as plant and

machinery, he should consider aspects related to

technological obsolescence and capital improvementsmade in the recent years. Depreciation adjustment may

also be needed in case the company is following unsound

depreciation policy in this regard.


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(ii) Is the valuation of goodwill satisfactory, given the

amount of profits, capital employed and average rate of

return available on such businesses?

(iii) With respect to current assets, are additional

provisions required for "unrealisability" of debtors?

Likewise, are adjustments required for "unsaleable" stores

and stock?

(iv) With respect to liabilities, there is a need for careful

examination of 'contingent liabilities', in particular when

there is mention of them in the auditor's report, with a

view to assess what portion of such liabilities may

fructify. Similarly, adjustments may be required on

account of guarantees invoked, income tax, sales tax and

other tax liabilities that may arise.

The net assets valuation based on book value is in

tune with the going concern principle of. accounting. In

contrast, liquidation value measure is guided by the


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realisable value available on the winding up/liquidation of

a corporate firm.

Liquidation value is the final net asset value (if any)

per share available to the equity shareholder. The value is

given as per Equation.

Net assets per share = (Liquidation value of assets -

Liquidation expenses - Total external liabilities)/Number

of equity shares issued and outstanding.

In the case of liquidation, assets are likely to be sold

through an auction. In general, they are likely to realise

much less than their market values. This apart, sale

proceeds from assets are further dependent on whether the

company has been forced to go into liquidation or has

voluntarily liquidated. In the case of the 'former' type ofliquidation, the realisable value is likely to be still lower.

conceptual framework of valuation

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