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Valuations Approaches
There are three approaches to value any asset, business or business interests-
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Asset Approach
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Income Approach
Market Approach
There are no other approaches to value However there are numerous methods within each of
the approaches
The asset based method views the business as a set of assets and liabilities that are used as
building blocks of a business value. The difference in the value of these assets and liabilities on (../UI/VA
a book value basis, or realizable value basis or replacement cost basis is the business value.
However, the Net Asset Value reflected in books do not usually include intangible assets and
earning potential of the business and are also impacted by accounting policies which may be (../UI/CO
discretionary at times. Thus, NAV is not perceived as a true indicator of the business value.
However, it is used to evaluate the entry barrier that exists in a business and is considered
viable for mature companies and also for property and investment companies having strong
asset base. It is also used to evaluate surplus / non-operational assets.
The Income based method of valuation based on the premise that the current value of any
business is a function of the future value that the Company can expect to receive It is generally
used for valuing businesses that are expected to continue operating for the foreseeable future.
In its simplest form, the capitalization method basically divides the expected stable earnings of
a business by the capitalization rate. The first step under this method is the determination 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
excluding the impact of any extraordinary items not expected to accrue in future. While
determining a capitalization rate, it is necessary to compare with rates available to similarly
risky investments.
The DFCF method expresses the present value of the 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. The value of the firm is arrived at by estimating the Free Cash Flows
(FCF) to Firm after all operating expenses, taxes, working capital and capital expenditure is met.
The Perpetuity value of a business is computed after the business has stabilised, using Gordon
model. The FCF is then discounted with Weighted Average cost of capital (WACC). The WACC is
selected based on the inherent risks in the investment (including both systematic / market risks
and unsystematic / company risks) using modified Capital Asset Pricing Method (CAPM).
Adjustments for Debt and Cash as on Valuation date is then made to the Enterprise Value to
arrive at the Equity Value for Shareholders.
Identify Surplus Assets (assets not utilized for Business say Land/Investments)
In this method, value is determined by comparing the subject, company with its peers in the
same industry of the similar size and region. Most Valuations in capital markets / M&A
transactions are market based. This is also known as Relative Valuation Method. This method is
easiest to use when there are companies comparable to the one being valued, assets are priced
in the market, and there exist some common variable that can be used to standardize the price.
A key benefit of Comparable Company Market Multiple analysis is that the methodology is
based on the current market stock price. The current stock price is generally viewed as one of
the best valuation metrics because markets are considered somewhat efficient.
The difficulty here is in the selection of a comparable company since it is rare to find two or
more companies with the same product portfolio, size, capital structure, business strategy,
profitability and accounting practices. Whereas no publicly traded company provides an
identical match to the operations of a given company, important information can be drawn
from the way similar enterprises are valued by public markets. Adjustments are made to the
derived multiples on account of dissimilarities with the comparable companies and strengths,
weakness and other factors peculiar to the company being valued.
With this technique of valuing a company for a merger or acquisition, the transactions that
have taken place in the industry which are similar to the transaction under consideration are
taken into account. With the transaction multiple method, similar acquisitions or divestitures
are identified, and the multiples implied by their purchase prices are used to assess the subject
company's value.
The greatest impediment in finding truly comparable transactions is the absence of available
information on private transactions. In addition to the lack of information on the sales of
private companies, the available information in public transactions may be outdated. There is
no rule of thumb for the appropriate age of a comparable transaction, although one should be
aware of the competitive market at the time of the transaction and factor any changes in the
marketplace environment into the analysis. The more recent the transaction, the better this
technique, with all other things being equal.
The Market Value method is generally the most preferred method in case of frequently traded
Equity Shares of Companies listed on Stock Exchanges having nationwide trading as it is
perceived that the market value of listed equity shares over an appropriate period of time takes
into account the true potential of any Company.
Other Methods
Contingent Claim Valuation: Under this valuation approach, Option Pricing Models (OPM) is
applied to estimate the Value. Valuations for complex instruments like ESOP, Corporate
Guarantees, OCPS, FCCD’s, Patents etc are done using OPM. The OPM is used to calculate a “call”
or “put” price using the 6 key determinants of an option’s price:
Black Scholes Model – It is applied in most of the cases but its limitation is that it calculates the
option price only at one point in time i.e. at Expiration.
Binomial Model – It is applied when the exercise period is not at a particular point in time and
there can be multiple dates for the same i.e. even before the Expiration.
According to the AICPA, the backsolve is the most reliable indicator of enterprise value
for early-stage customers, provided the transactions in the enterprise's shares have
occurred at arm's length price and the most recent transaction occurred within ninety
days of the date of valuation date.
Rule Of Thumb
Although technically not a valuation method, a rule of thumb or benchmark indicator is used as
a reasonableness check against the values determined by the use of other valuation
approaches. For each Industry there are certain parameters which can assist in arriving as a
benchmark value ex- in Hotel Industry – EV/Room, in Mutual Fund Industry - % of AUM, in
Power – EV/MW etc.
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