A Winter Project Report On

BUSINESS VALUATION
In the partial fulfillment of the Degree of Master of Management Studies under the University of Mumbai BY

ROHAN IRANNA MANGALURE [Roll No: 30] Under the Guidance of

Mr.ROHAN GADKARI
(EXTERNAL GUIDE, QUEST PROFIN ADVISORY LTD)

Prof. N.C. MEHTA

(INTERNAL GUIDE)

Aruna Manharlal Shah Institute of Management and Research

Ghatkopar [W], Mumbai-86

2010-11

CHAPTER 1 INTRODUCTION

In the wake of economic liberalization, companies are relying more on the capital market, acquisitions. Restructuring are becoming commonplace, strategic alliances are gaining popularity, employee stock plans are proliferating, and regulatory bodies are struggling with tariff determination. In these exercises a crucial issue is: How should the value of a company or a division thereof be appraised? The objective of any management today is to maximize corporate value and shareholder wealth. This is considered their most important task. A company is considered valuable not for its past performance, but for what it is and its ability to create value to its various stakeholders in future. Therefore, in analyzing a company, it is not sufficient just to study its past performance. We must understand the environment economic, industrial, social and so on and its internal resources and intellectual capital in order to gauge its future earning capabilities. It is therefore essential to understand that Business Valuation is important in determining the present status as well as the future prospects of a company, which in turn is important to understand how to maximize the value of a company. The creation and development of corporate value is the single most important long term measure of the performance of a companys management. Further, this is the only common goal all shareholders agree on. So In the pure sense, Business valuation refers to estimation of business value. Valuation is just to estimate What (cash flow) + When (time period) + How (risk), we receive in future out of a subject property. The economic returns or the assets involved frames the value of specific business stream and this value can be generally more than the value of individual asset valued as a stand alone basis. The value of Business enterprise containing more than one stream is generally more than just a sum total of values of

every such stream. So, the business value is affected by tangible as well as non-tangible factors. The project at Quest Profin Advisor Pvt Ltd therefore involved analyzing various companies and deriving a right value for them based on purpose. For such valuations different models were used. However, Valuation, by its very nature, contains many controversial issues. Even a 2000 pager book may not be an enough space to cover all the issues related with valuation. The biggest difference between valuing investments in public companies and nonpublic businesses is the lack of information. The application of recognized valuation methodology and rigorous analysis of the private company provides the foundation for estimating a business value. Although considerable time and effort is involved in preparing formal business valuations, unfortunately the results may or may not reflect the real world value of a specific company if it were formally offered for sale.

NEED FOR VALUATION

This is an era of merger and acquisition. Business Valuation is absolutely essential if someone is considering selling a business or looking for fresh investment. Ultimately, the value of any business winds up being what all interested parties agree it is worth. Hence, various methods of 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 All sorts of events could trigger a need for a valuation; so whenever major changes occur within the business, corporates discuss with the accountant or consultant whether valuation will be beneficial or required Some of the Events where it is required are a) b) c) d) e) f) g) h) i) planning j) k) l) m) n) o) p) Financial Reporting Litigation or ownership issues Conducting a major strategic-planning Creating a company stock-option plan Getting a divorce/Family issues Liquidation /Filing for bankruptcy Wealth planning/Tax planning Buy/Sell transactions Planning for an initial public offering of company shares (IPO) Mergers and Acquisitions Private Equity funding/Venture capital finance Expansion Raising funds Restructuring the business/ divestiture: Goodwill Impairment Retirement of partner or dissolution of partnership or succession

All the above needs would entail different methods or approach to arrive at a fair value. So it is very important that the while doing valuation appropriate approach is used.

Selection of Appropriate Approach for Specific Purpose

In order to present the needs for business valuation, the above purposes that have been compiled giving birth to the need of valuation are divided in to four major categories. (1) Relative strategy (2) Investment (3) Value added management or Planning: (4) Other purposes 1. Relative strategy:

Where more than one party with different objective/s is likely to be affected directly from the valuation, that is to say, the strategy or purpose/s of involved parties are different but dependable on one and the same transaction, the purpose will fall under this category. The following purposes are considered under this category: (a) Business Sell / Purchase Agreement: While the seller is interested to get the maximum value towards his business the Buyer would like to pay the minimum, expecting the best from the businesses. The seller would like to get the fair value and in case of bad need, at least the liquidation value for his business. So, He would be interested to get the investment value of the business. For negotiation point of view, he would like to know the fair value. If for example, an owner of colour shop situated on prime location at the heart of the city in main market wants to sell his shop, he would like to get the market price for its real estate-property (shop) and current assets including receivables and at least cost of the inventory out of which he can pay off his liabilities. He will intend to get this price irrespective of its usage by the proposed buyer. The buyer, if wants to continue to run the colour shop, may accept the price if he is expecting to get at least the expected rate of 5

return on this investment. Now, consider a situation where the buyer wants to start a new business and to open a gift article shop there. He is concerned with location only and not with the stock and related current assets. If the seller insists for bundle sale (shop and current assets plus inventory together) only then the buyer may accept the price if his investment value permits. i.e. the buyer will get enough return from gift article business to cover the possible loss on purchase of colour business assets. The seller is interested in getting the fair value of its colour business while buyer is interested in knowing the investment value of its gift article business. He may like to know the fair value of colour business for negotiation. The buyer is looking futuristic. He is major interested on future returns and synergies based on the existing status of the business. He would like to know the intrinsic value of business generally preferring discounted cash flow method. Obviously, he would also compare the consideration with the replacement value of the assets he is going to own. He interests to know the return and coverage of his investments. (b) IPO: The business enterprise while going for Initial Public Offerings likes to dilute the sharing based at a price which gives something in addition to existing value and being continued party to the business growth, they would like to consider the average risk and growth potentials from the view point of proposed investors and also the factors affecting while going public and therefore they also call for the investment value. On the other side, the investor would like to invest as per his own risk perceptions, at a least prices or a price very near to existing fair value so as to decide the under value offerings or over value offering of IPO. So, both of them would be interested to know the fair value and of business. The business, once listed on any stock exchange, analyzed by the market value of its shares and market capitalization. So, while going public it is essential to know the intrinsic value as well as the market value of the business. (c) Mergers, Acquisitions, Takeovers:

Generally, these are the strategy deals and the basic characteristics remain same as applicable to normal business sale-purchase transactions except that the existing owner may remain to carry the business but with some different terms and conditions. The transferee and the transferor both are interested for getting the best worth of their business. The existing owner would like to know the fair value of his business based on the existing earnings and wants to get at least the liquidation value of the business. On merger, acquisition or takeover, the existing owner is departing his future business which he may continue else, and can know his opportunity cost by using the discounted cash flow based on his own perceptions. While the acquirer will calculate his synergies and present value of future earnings to decide the return on investment, he considers the replacement value of assets he is going to acquire to know the placing of his investment on acquisition. Although these transactions of merger, takeovers or acquisitions are becoming important means of diversification, there is no established technique which incorporates uncertainties involved and gives a range of values of a target firm which can form the basis for offering a price. Both the parties are concerned with return on their respective investments. 2. Investments: Where the intention of the party calling the valuation is to invest in the business or finance specific project or the business growth, the purpose will fall under this category. The investors decision is for own self only and not intended to be used by the other person. (a)Small business purchase: The value of business and the value of ownership are two different terms. The value of ownership is directly associated with power of control and synergies. One who wants to acquire a power of controlling or expecting better synergies with his or her proposed set ups may willing to pay something more than the measured value of business. When a proposed investor, based on his personal perceptions, sees better benefits on purchase of certain business, he would like to offer something in addition to the fair price of the 7

business. It is different from the routine sell-purchase transactions in a sense that the investor is approaching to satisfy his own synergy/ies. A hypothetical buyer would have to pay a control premium, even if this buyer plans to run the business in the same way as existing management. The buyer pays a premium, because having the right to control how the business assets are deployed has value. So, He would be interested to get the investment value of the business. For negotiation point of view, he would like to know the fair value. (b) Private equity funding/ venture capital finance: The investors in private equity generally provide capital as a seed money or first phase start up money. Some times, depending upon the nature and situations of the business and agreed terms they may finance second phase development. It mainly depends on achievement of decided mile stones. Here, generally the investors are pure investors and financing the business to get the better returns. The expected return ranges from 20% to 70% depending upon the stage of investment. They are more concern about the industry under which a business pertains and the core competence of the business. They prefer to know the fair value of the business. Normally they do not have synergies to link with specific investments but they may invest in particular sector based on own portfolio diversification policies. They want to value the business based on own perception about the risk taking and growth potentiality of the business. (c) Business financing for new projects/ expansion: The Bankers, financial institutions and other business financers are interested to get a reasonable return on their investments and to save their capital as well. They are concern with debt payment capacity of the business and therefore interested to know the cash flow or earning capacity of existing business as well as the viability of new projects or expansion. In order to ensure the safe guard of their funds they also would like to know the liquidation value. The business financier is interested in knowing the debt payment capacity of the business and the securities for safeguarding their investments.

The financer is much interested to know the actual cash flow that will be used for debt repayments.

3.

Value added management/ planning:

The owner of the business would also, in many situations, like to know the value of his own business. In a company, even though the owner is controlling each and every functions of owned business, he needs sometimes to convince himself. The valuation may be helpful for internal betterment, business expansion, value addition, strategy forming and most importantly to make appropriate decisions on time. (a)Raising funds for expansion or new projects: Before an owner goes to raise a capital for expansion or new projects, he remains more concerned about his payment capacity and expected returns. The expansion is fruitful if enhances the value of business. The expansion should be viable in sense that the expected return must be more than the existing rate of return and at least the additional cost of finance. The return may be tangible or intangible. Also, the financer would like to analyze the existing business and viability of expansion in terms of debt payment capacity. Owner is required to consider this fact in his mind also. The financier may not be concern with the present value of cash flow but of course with the actual value of cash flow so as to satisfy himself about the repayment capacity of business. The liquidation value will further help him to assure the fund safety. For accessing the financial viability while going for expansion or new projects, the businessman would like to know the impact of borrowings on expansion or project value. He also will consider his existing business value based on future earnings. The asset value will help him in deriving the tangible value of business against which he can easily go for fund raising. His concern is additional return on investment and investment in secured assets. (b) Restructuring the business/ divestiture:

An awake owner would like to get the benefit of leverage. The outside finance can increase the return (if the business return is more than the post tax debt cost) but simultaneously it increases the probabilities of bankruptcy. If planned properly, the debt cost being tax deductible item, it can reduce the cost of capital to a good extent. Proper capital structure can help to increase the value of the equity holdings or value of ownership. The owner would like to know the fair value of his business based upon current structure so as to increase the ownership value just by addition or repayment of outsider finance or modification of existing debt terms. The increase in debt will reduce the profit available to the owners but at the same time it can increase the return on capital subject that the existing return is more than the proposed post-tax debt cost. The approach being futuristic the forward earning capitalization or discounted cash flow will serve the purpose. He would like to take decision knowingly the impact of capital structure on rate of return and absolute return. (c) Goodwill impairment: Every business being going concern will have goodwill (positive or may be negative) whether shown as a part of balance sheet or not. While calculating the value of business, the value of goodwill will be impliedly included. The sources of generation of goodwill are the relations of business with employee, creditors, customers, location of business etc. Based on the conservative approach principle, goodwill being intangible asset, if not recognized on the balance sheet then there is no harm but if it carries a certain amount to the balance sheet then it must be measured for impairment. If the fair value of business is equal or more than the carrying amount of business then impliedly there is no impairment in goodwill. But in reverse situation, the fair market value of goodwill is required to be found out by deriving a difference between the fair market value and carrying value of business assets on stand alone basis and such an implied market value of goodwill is to be compared with the carrying amount of goodwill to quantify the impairment. The owner can take reasonable steps to stop or lesser the impairment and to protect his ownership value if he undertakes business valuation regularly.

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(d) Retirement of partner or dissolution of partnership or succession planning: Many times the partners would like to plan the exit mode which can strengthen the partnership relations. They may pre decide the calculation terms of goodwill on retirement and even can invest regularly, a certain portion of earnings for smooth payment, on retirement or dissolution, without badly affecting business capital. They even can pre plan the business succession terms if regularly known about the value of business. (f) Financial reporting: Many Accounting Standards also require showing the assets and liabilities at their fair value. The applicability of it depends on the legal status of the business enterprise . But of course, no one is restricted to present the better.. The concern is disclosing the earning capacity and coverage of capital in various business assets. 4. Other Purposes:

The purposes which are not covered under above three categories will fall under this category. It includes the purposes, the valuation for which generally is not undertaken for any intended business transaction. (a)Ownership issues: Sometimes, the partnership terms include increasing the share of working member based on the performance and business targets achieved by him. In some other case, a specific owner may require contributing on none fulfilling the agreed term. Like, the investor partner may not fulfill his obligation to bring the agreed finance and therefore, he has to dilute his sharing in favour of new financier or any one else. There may be a situation where a creditor or a financier is required to offer the ownership in the business. All these case requires a proper valuation of the business and a decision taken on the basis of figures reflected on the balance sheet only may not be wise and in may effect adversely to one of the party.

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(b) Litigation issues involving lost profits or economic damages: Insurance claim, loss of business due to impairment in reputation by whatsoever reason, impact of merger or de merger, breach of contract etc will also call for valuation. Specific care is required while valuing a business or a loss of business under such circumstances. Generally, the prescribed techniques are used to appraise the loss or business. (c) Family issues: This includes the disputes and planning matters involved due to ownership in a business. It may be a sharing issue on separation of family or HUF partition. The ancestral businesses and HUF businesses are co owned by the male members of the family and therefore the need arises to decide the sharing at the time of separation. It will be wise to allocate the business or businesses or specific sharing in a business on the basis of fair value of each business. The wealth planning and WILL planning will also be made wisely, if based on fair value of ownership.

The above four categories consider all major purposes which may need the value of business for taking a timely and wise decision. The valuation analyst, even after finalizing the standard/s of value based on characteristics of the purpose and selecting the technique/s of valuation, may rest with some different values derived by application of various selected technique/s. he may choose to conclude with a value derived by applying specific technique or he may weigh particular techniques as per his wise and conclude the valuation. It rests with the value analyst to determine the final value or a range of values of a business based on his experience and applying best of his professional skills considering the nature of business, prevailing situations and existing requirements

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CHAPTER 3 BASIC TERMINOLOGIES

Before Starting the with Valuation process it is important to know the some terms which form basis of valuation and their meaning in view of valuation process.
BUSINESS

The etymology of "business" refers to the state of being busy, in the context of the individual as well as the community or society. In economics, business is the social science of managing people to organize and maintain collective productivity toward accomplishing particular creative and productive goals, usually to generate profit. With some exceptions, (such as cooperatives, non-profit organizations and (typically) government institutions), in predominantly capitalist economies, businesses are formed to earn profit and grow the personal wealth of their owners. VALUE In our day to day life, we frequently use a word VALUE. It may be with regards to price of some commodity or for extending esteem to some one or to express the perceived worth of some thing. In all sense, VALUE is a word expressing positive posture. But the question is how to measure this worth in financial terms? Here, let us first go through the meaning of Value in finance, why business value is needed to measure and what are the ways to determine a value of a business? So, What is a value? Value is expressible in terms of a single lump sum of money consideration payable or expendable at a particular point of time in exchange for property, i.e., the right to receive future benefits as at that particular timepoint (now). Value is future looking, shows the present value of future benefits that can be derived from the subject property. Although historical information can be used to set a value, the expectation of future economic benefits is the primary value driver. Acquirer gets tomorrows cash flow, not yesterdays or even todays.

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So, value differs from price OR cost. Price and cost refer to an amount of money asked or actually paid for a property, and this may be more or less than its value. Price and cost can equal value but dont necessarily have to equal value. In order to find a value, one has to decide the standard of value first. It is the standard of the value which draws a path towards destination. Meaning which, the standard/s of value will help in deciding the valuation technique/s to be used to determine a value for specific requirement. Then, the question is what does decide the standard/s of value? The answer is the purpose. The purpose defines value applicable to specific purpose and this value varies once the purpose is changed. VALUATION The dictionary meaning of Valuation is The act or process of assessing value or price; 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. BUSINESS VALUATION A business valuation determines the value of a business enterprise or ownership interest. A valuation estimates the economic benefits that arise from combining a group of physical assets with a group of intangible assets of the business as a going concern. For ex: When valuation is done with the purpose of merger or purchase, it estimates the price that prospective informed buyers and sellers would negotiate at arms length for an entire business or a partial equity interest. The theoretical valuation arrived at has to be perfected with market criteria, as the final purpose is usually to determine potential market prices The process of business valuation can be a complex thing owing to numerous methods of valuation in practice. 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 14

CHAPTER 5 Relevant Aspects of Business Valuation

Business Valuation is a complex thing. There can be no set procedure and method for valuing business as each business is distinct from other. The method selected and procedure followed for valuing a business should be commensurate with the size and nature of the business to be valued. 1. Economic Conditions: As we see in Portfolio Management Theory, wherein we adopt the Economy-IndustryCompany (E-I-C) approach, in Business Valuation too, a study and understanding of the national, regional and local economic conditions existing at the time of valuation, as well as the conditions of the industry in which the subject business operates, is important. For instance, while valuing a company involved in sugar manufacture in India in January 2008, the present conditions and forecasts of Indian economy, industries and agriculture need to be understood, before the prospects of Indian sugar industry and that of a particular company are evaluated. 2. Important Considerations: The other important considerations that determine the valuation of business are: The Nature of companys business Business earnings, Availability of assets History of the enterprise from its inception, The enterprises goodwill and other intangible values, Book value of the stock, and The financial condition of the business.

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3. Valuation Date The monetary worth of any property including a business changes from time to time and so, any valuation offers a VALUE on a particular point of time. It is important that the users of valuations understand this fact. The International Glossary defines the valuation date as, The specific point in time as of which the valuators opinion of value applies (also referred to as Effective Date or Appraisal Date). The valuation date is the specific date at which the valuation analyst estimates the value of the business and concludes on his estimation of value. Generally, the valuation analyst should consider only circumstances existing at the valuation date and events occurring up to the valuation date.

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CHAPTER 6 PREMISE AND STANDARDS OF VALUE

Premise Of Value
The premise of value decides the applicable standard/s of value. The International Glossary defines premise of value as An assumption regarding the most likely set of transactional circumstances that may be applicable to the subject valuation, e.g., going concern, liquidation. It defines going concern value as The value of a business enterprise that is expected to continue to operate into the future. The intangible elements of going concern value result from factors such as having a trained work force, an operational plant, and the necessary licenses, systems, and procedures in place. There are two premises of value: 1. Going concern value 2. Liquidation value If a business is capable of sustaining future operations, it has certain intangible assets such as customer base, reputation and employee resources that have intrinsic value for the entity. When an enterprise is financially distressed or only marginally profitable, the appraiser may blindly accept the entity value returned by the calculations, but fails to recognize the higher minimum turnkey value. This is one of the primary reasons for the under-valuation of small businesses. Some companies are worth more dead than alive. It is important for an appraiser, particularly while valuing an entire company, to determine if the going concern value exceeds the liquidation value. In a going concern valuation, we have to make our best judgments not only on existing investments but also on expected future investments and their profitability. There are two types of liquidation value, orderly liquidation and forced liquidation. The International Glossary defines orderly liquidation value as Liquidation value at which the asset or assets are sold over a reasonable period of time to maximize proceeds 17

received. It defines forced liquidation value as Liquidation value at which the asset or assets are sold as quickly as possible, such as at an auction. It also defines liquidation value as The net amount that can be realized if the business is terminated and the assets are sold piecemeal. Liquidation can be either orderly or forced.

Standards Of Value
The International Glossary defines standard of value as the identification of the type of value being used in a specific engagement; e.g. fair market value, fair value, investment value. A business can have different values under different standards of value. The business appraiser must ensure that the standard of value identified upon engagement is the standard of value used in the report to produce the indication of value. After all, a fair market value standard can produce an indication of value that is substantially different than one under an investment value standard. Depending on standard of value, the value varies. And it depends on who is asking and why? Before analyst can attempt to value a business, he or she must fully understand the standard of value that applies. Relying on the wrong standard of value can result in a very different value and, in a dispute setting, the possible dismissal of the value altogether. Based on different purposes of valuations Standards of valuation are divided into three categories: 1. Fair market value (FMV) or Fair value (Intrinsic value & extrinsic value) 2. Investment value 3. Liquidation Value One may argue that instead of going for finding values based on different standard, why not to find a fair value only and then to negotiate for best applicable price setting. But here, we should note that the need of investment value or liquidation value is equally important as the fair value, while going for sale-purchase transactions. Investment value helps the proposed investor to define a border up to which he can take a maximum move.

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Similarly, the liquidation value helps the seller the lowest point of deal. Base on fair value only, it is possible that the investor or the seller may cross their upper or lower borders, respectively. Liquidation value being a basic term or premise of value, some authors does not consider it as a standard of value. Rather they treat them as a premise itself and view liquidation value as a fair value under the premise of Liquidation. 1. Fair Market Value (FMV) or Fair Value: Many authors define fair market Value and Fair value as different standards of value. Fair market value assumes a hypothetical willing buyer and a hypothetical willing seller. It assumes that both have fair knowledge of the deal. The common definition of fair value is The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale. A fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. A fair value measurement should include an adjustment for risk if market participants would include one in pricing the related asset or liability, even if the adjustment is difficult to determine. The highest and best use of the asset establishes the valuation premise used to measure the fair value of the asset. Namely, Fair value In-Use (when value is maximum to market participants through its use in combination with other assets as a group) and Fair Value Inexchange (when maximum value to market participants principally on a standalone basis). The fair value of business can be determined by using the internal fundamentals only considering the impact of outer world or it can be measured focusing on worth of similar businesses in the market and applying the fundamentals of subject business on it. In other words, the fair value of a business can be derived by using the intrinsic valuation measures or extrinsic (market based) valuation measures. 2. Investment Value The International Glossary of business valuation terms defines investment value as The value to a particular investor based on individual investment requirements and 19

expectations. Investment value is the value to a particular investor, which reflects the particular and specific attributes of that investor. The best example would be an auction setting for a property (or a business) in which four different bidders quotes to acquire. Each of the bidders is more likely to offer a different price based on the individual outlook and synergies that he/she brings to the transaction. Investment value reflects more of the risk perception of a particular investor on specific investment/s. Each potential investor will have their own priorities from five key value drivers: earnings, hope, synergy, risk and bulking. They will evaluate each in the context of the future performance of the business in their specific circumstances. Earnings value is the capital equivalent of the existing profitability of the business, on the assumption that this can be sustained. Hope is the ability to grow that profit from the existing resources of the business acquired new products, new customers, new markets, all of which can be delivered by the business existing management. Synergy value, which may be very difficult to quantify, is found in the acquirers ability to generate extra profits from its own business from its connection with the target using it as a launch platform. Synergy can be operational or financial or both. This may arise from cross selling to its customers, from improvements in its own product or services when linked with those of the target, or factors such as having an in-house research or testing facility, better stocking and distribution, or simply reputation, or be able to service in-house a requirement previously bought in at a higher cost, etc. Risk lowering is as much a target as increasing profit. Bulking is the 2+2=5 factor. If, for example, the investor wishes to approach the AIM market, or to become more visible for sale, the investment may not just add profits, but enable it to achieve an exit or other growth in capital value for the investors own business. Its worth will then be magnified by this enhancement of value, which purely arises from investors own strategy.

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3. Liquidation value: One common standard of value is to look at the liquidation worth of an asset (or property). It considers the proceeds that could be realized from selling off the firm's assets, using those proceeds to pay down any of the firm's liabilities, and then counting as the business valuation whatever the leftover amount equals. Theoretically, this standard is opposed to Investment value. It is on the mode of termination while the investment is the starting point or the point of holding something. As said earlier, Liquidation value being a basic term or premise of value, some authors does not consider it as a standard of value. Rather they treat them as a premise itself and view liquidation value as a fair value under the premise of Liquidation.

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CHAPTER 7 THE COMPONENTS OF A VALUATION PROCESS

Valuation process at Quest Profin Advisors Ltd includes the following stages: A Engagement of Professional consultant by the Client B Research and data gathering C Analysis and estimate of value D Reporting Process

A.

Engagement of Professional accountant/consultant Business valuers estimate the value of: i. ii. iii. Financial and intangible assets and liabilities such as contracts, and intellectual property Businesses Securities such as debt, equity and derivatives.

In the last few years, professional consultants 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 The Client depending on the situation would specify the need for valuation and its purpose. A team would start working on it with the following steps. B. Research and data gathering

The consultant requires certain information to perform the engagement. Most of the data is available within the organization.

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B.1 The following are some of the areas that were 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 companys value on current management B.2 Information to be provided to the consultant included 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 g) Contracts/leases h) Budgets/forecasts 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 23

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. B.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

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b) issues 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 C. 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 involved analyzing the company information in conjunction with the industry and other comparable company data. 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.

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a) 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.

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 b) analysis of past results c) budgets, with underlying assumptions d) availability and quality of underlying data e) review of budgets for plausibility f) statement of responsibility for information received

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4) Description of specific valuation of assets used in the business a) b) c) d) e) Procedure The principles used in the valuation. Description of the procedures carried out The valuation method used The procedures involved in making projections g) The scope and quality of underlying data and h) The extent of estimates and assumptions together with considerations underlying them 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. 27

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. COST OF VALUATION The factors that influence the cost of a valuation are a) the availability, completeness and organization of the company's financial records b) Revenue of the business (not always) c) The purpose of the valuation d) The type of details required in the report As an example, a valuation prepared for estate planning purposes with a limited scope report will cost significantly less than a valuation prepared for a high net worth divorce case that requires a full scope report and expert testimony in a court proceeding. Fee structure: Usually the fees are structured in the following manner: a) A deposit to review the project and list of fixed assets b) After the review, the adviser will prepare an outline for business valuation and will prepare a quote for services c) Disbursements and other miscellaneous charges are additional. These include expenses incurred during the project, for example, travelling, telephone and photocopy

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CHAPTER 8 Methods of Business Valuation

The process of business valuation can be comparatively easier task if done for a company that has shares listed on a stock exchange has a clear value, namely, the number of shares outstanding multiplied by their value set by the exchange at a given time. However, determining the value for unlisted entities or small business can be much complicated as it depends on such factors as assets, liabilities, earnings, cash flow, annual sales and revenues, its customer base, even its reputation and standing in its community. There are three broad approaches to estimating value: The Income approach, the Asset-based approach, and the Market approach. The Income approach uses an entitys estimated future income flows as a basis for value. The asset-based approach focuses on determining an entitys cumulative asset values. The market approach derives the value from some market multiple of assets or income. Various Valuation models under each approach are discussed below.

Income Based Approach

The most common method of estimating value is the income approach which involves discounting or capitalizing of an income stream. In the income approach, variables such as earnings or cash flows are used as they are assumed to be indicators of expected benefits to the owners. Common examples of valuation methods under the income approach are the Capitalisation of earnings model and the discounted cash flows model. The income approach requires a reasonable estimate of: 1. Expected future benefits 2. An appropriate rate at which to discount the benefit stream.

29

The following are some of the business valuation methods under this approach (a)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

30

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). Therefore WACC is WACC (r) = Equity* Ke+Debt*Kd(1-tax rate)/(TF) Ke= Cost of equity Kd=Cost of Debt TF=Total financing=Equity +Debt

Net Valuation = Why Discount?

..

The cash flow predictions are discounted, or reduced, to adjust for the risk the investor faces and to make up for the fact that the investor could invest the money somewhere else. The underlying idea of a discounted cash flow is that Rs.100 today is worth more than Rs.100 a year from now. In fact, Rs.100 today is equal to Rs.110 next year or Rs.161 in five years, if interest rate is assumed to be 10% per year. One hundred rupees in the present is equivalent to Rs.161 in the future because the Rs.100 you have today can be invested to earn interest and there is no risk you may not receive it. Thus, the investor has to be offered significantly more than Rs.161 in five years. Otherwise, the investor is not going to be attracted to the investment. Residual value: Residual Value can be estimated in a variety of ways. For example, one might consider what the potential sale price for the business would be at the end of the forecast period, and discount that sale price back to its present value. One can use the perpetuity method for estimating residual value which assumes that the company will continue to generate a steady cash flow in perpetuity. The value of that cash flow is simply the cash flow divided by the required rate of return. That value estimated for the end of the forecast

31

period, is then discounted back to present value to determine its worth today. The value of the business, then, is the sum of the present values of the net cash flows in the forecast period plus the present value of the residual value at the end of the forecast period. (b) PECV (Profit Earning Capacity Value Method) The normalized earnings can be a Profit after tax (PAT) OR a profit before Depreciation, Interest, and taxes (PBDIT) OR Net operation profit before amortization OR it may be simply a cash flow from the business operations. This earnings may be considered from recent year earnings, OR simple average of few years earnings, OR weight age average or geometric average of few years earnings. Again it can be a forward looking or trailing (based on past). For forward looking (also known as leading) earnings the forecasted figures must be checked. Value = Average earnings * Appropriate factor Appropriate factor should be arrived at by considering the specific business risk, size risk, market risk, growth rate, expected return and such other factors having impact on the business operations. This multiple should also co-relate with the nature of earnings used. For example, if it is PBDIT then multiple should be based on capital invested and not only the owners fund. This will give value of business. But if the earnings used is PAT then the multiple should reflect the factors applicable to ownership only. It will provide the value of owners fund in the business. To conclude, we can say that it is on the best judgment of the appraiser to decide average earnings and appropriate rate of capitalization.

Asset-based Approach
The Asset-based Approach involves methods of determining a companys value by analyzing the value of a companys assets. This valuation approach often serves as a valuation floor since most companies have greater value as a going concern than they would if liquidated, i.e., the present value of future cash flows generated by the assets

32

usually far exceed the liquidation value of those assets. This difference between the asset value and going concern value is commonly referred to as goodwill. An exception to this might be a low-margin business in a competitive industry that owns its real estate, which has appreciated over time due to its development value. In this case, the assevalue may exceed the going concern value of the business. This approach is generally preferred to value intangible asset (like brands, patents, goodwill etc) of the business. This methodology is likely to be appropriate for a business whose value derives mainly from the underlying value of its assets rather than its earnings, such as property holding and investment business. This method may also be appropriate for business that is not making an adequate return on assets and for which a greater value can be realized by liquidating the business and selling its assets. Net asset values, which are of great relevance in industries such as utilities, manufacturing and transport that are dependent on physical infrastructure and assets, may not have particular significance in industries such as information technology, pharmaceutical that are driven by intangibles not recorded in the books. Given that most business valuations are typically conducted under the premise of a going concern, the appraiser may determine that the asset approach is inappropriate for determining an indication of value. However, the appraiser may test if the company is worth more in liquidation as opposed to as a going concern by utilizing an asset approach. (a) Balance Sheet Method or the Net Asset Value Method ( Book value). 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.

33

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. (b)Replacement Method This methodology 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 (c)Liquidation value Generally, while offering a business for sell, a seller would like to know the least value of the business that he or she can get on just liquidating the business assets. This value can 34

help to negotiate a better price. Liquidation analysis should be considered when the value of the business, on a control basis as determined by the income or market approaches (discussed later), is low relative to the net asset value. Application of the liquidation approach must consider the expenses associated with liquidation, including taxes, selling expenses and plant closing costs, and the risk and timing related to the proceeds.

The Market Approach

The market approach to business valuation is based on the principle of substitution: that buyers would not pay more for an item than the price at which they can obtain an equally desirable substitute. The market price of the stocks of publicly traded companies engaged in the same or a similar line of business, whose shares are actively traded, can be a valid indicator of value when the transactions in which stocks are traded are sufficiently similar to permit meaningful comparison. This approach can be used as an indicator of the value and the investor can use it for comparison between different methods. The difficulty lies in identifying public companies that are sufficiently comparable to the subject company for this purpose. There is a significant philosophical difference between discounted cash flow and relative valuation. In discounted cash flow valuation, we are attempting to estimate the intrinsic value of an asset based upon its capacity to generate cash flows in the future. In relative valuation, we are making a judgment on how much an asset is worth by looking at what the market is paying for similar assets. If the market is correct, on average, in the way it prices assets, discounted cash flow and relative valuations may converge. If, however, the market is systematically over pricing or under pricing a group of assets or an entire sector, discounted cash flow valuations can deviate from relative valuations. In relative valuation, we have given up on estimating intrinsic value and essentially put our trust in markets getting it right, at least on average. (a)Merger and Acquisition Method (Comparable Sales or completed transaction) :

35

This method involves reviewing transactions for companies that are in the same or similar line of business as the company being valued and then applying the relevant pricing multiples to the subject company to determine its value. The method might involve private company transactions, public company transactions, as well as public company valuation measures using current share market data. The theory behind this approach is that valuation measures of similar companies that have been sold in arms-length transactions should represent a good proxy for the specific company being valued. Depending on the source of data available and the underlying company being valued, a variety of valuation measures might be used including Enterprise Value (EV) to Sales, EV to EBITDA, EV to EBIT, Price to Earnings, etc. Adjustments are commonly made to these valuation measures before applying to the subject company to ensure an apples-toapples comparison. One or many comparable sales might be considered under this method depending on the data available and the degree of similarity to the company being valued. (b)Guideline Public Company Method The premise of the guideline company method is based on the economic principle of substitution stating that one will not pay more for an asset than the amount at which they can acquire an equally desirable substitute. This method involves using market multiples derived from market prices of stocks for companies that are engaged in the same or similar industries as the subject company. This can be a helpful tool in valuing private companies, but these public company multiples usually need to be discounted significantly to reflect the higher risks (e.g., customer concentration, management depth, access to financing, etc.) inherent in smaller private companies as well as the lack of marketability of private company stock. The guideline publicly traded company method is appropriate when similar and relevant proxy companies may be identified and employed in estimating the value of a closely held company. Commonly used Multiples Business can be valued based on the multiples like - Earning multiples- (PAT, EBITDA, EBIT etc) - Book value (or replacement value) multiple 36

- Revenue Multiples - Business specific Multiple

Price to Earnings (P/E) Multiple When it comes to valuing equity or ownership, the price/earnings ratio is one of the oldest and most frequently used metrics. Although a simple indicator to calculate, the P/E is actually quite difficult to interpret. It can be extremely informative in some situations, while at other times it is next to meaningless. As a result, appraisers often misuse this term and place more value in the P/E than is warranted. P/E Ratio = Market Value (OR Price) / Earnings It may be based on trailing data (historical figure) or forward data (estimates) or average of both. The result will be different under each different choice. Unlike net income, Both EBIT and EBITDA are independent of capital structure, so differences in capital structure among companies should not introduce bias when one is using the EBIT and EBITDA multiples to estimate total enterprise values. Inother words, the appraiser should take care that the earnings used here to derive a multiple is proper in relation to price applied. For example, share price used with earnings per share is a right measure but if it is used with rate of return on capital then the measure is not correct one. Rate of return on capital can be applied with value of firm or business value. Market Cap/Sales: Sometimes the earnings of the company do not give a true picture of the company. Also earnings of the company are function of the its capital structure which is different for different companies. Also in some cases the profits of the company are not that good, so it may wrong to judge a company solely on earnings. Sales of a company give a better picture as they are mostly independent of other factors and mostly depend on companys ability to produce and market quality products. In view of this Market cap/Sales ratio of comparable firms is taken for analysis.

37

Business Specific Multiple While earnings, book value and revenue multiples are multiples that can be computed for firms in any sector and across the entire market, there are some multiples that are specific to a sector. Like, valuing a call centre based on per seat criteria or a steel manufacturing business on the basis of per ton production. The caution here requires is to take care in analyzing the behavior of the entire sector or industry. If the price of particular sector is over valued then based on specific multiple we also tend to over cast the estimated value of target firm. Steps to determine a value under market approach

1. Selection of similar public companies and transactions 2. Financial analysis and comparison 3. Selection and calculation of valuation multiples 4. Application to the company being valued 5. Final adjustments Multiples are easy to use and intuitive; they are also easy to misuse. So, the question is why is relative valuation so widely used? There are several reasons. For example, a valuation based upon a multiple and comparable firms can be completed with far fewer assumptions and far more quickly than a discounted cash flow valuation. A relative valuation is simpler to understand and easier to present to clients and customers than a discounted cash flow valuation. Also, a relative valuation is much more likely to reflect the current mood of the market, since it is an attempt to measure relative and not intrinsic value. The strengths of relative valuation are also its weaknesses. For example, the fact that multiples reflect the market mood also implies that using relative valuation to estimate the value of an asset can result in values that are too high, when the market is over valuing comparable firms, or too low, when it is under valuing these firms. Also, while there is scope for bias in any type of valuation, the lack of transparency regarding the underlying assumptions in relative valuations makes them particularly vulnerable to manipulation.

38

The question comes here is : What is then a comparable firm? A comparable firm is one with cash flows, growth potential, and risk similar to the firm being valued. It would be ideal if we could value a firm by looking at how an exactly identical firm - in terms of risk, growth and cash flows - is priced. Nowhere in this definition is there a component that relates to the industry or sector to which a firm belongs. Thus, a telecommunications firm can be compared to a software firm, if the two are identical in terms of cash flows, growth and risk. Traditional analysis is built on the premise that firms in the same sector are comparable firms. In most analyses, analysts define comparable firms to be other firms in the firms business or businesses. So, we can summarize based on valuation theory that a comparable firm is one which is similar to the one being analyzed in terms of fundamentals. There is no reason why a firm cannot be compared with another firm in a very different business, if the two firms have the same risk, growth and cash flow characteristics. A major disadvantage of this valuation method is that often, it is difficult to determine the right comparable. It is impossible to find exactly identical firms to the one you are valuing and figuring out how to control for the differences is a significant part of relative valuation. If, in your judgment, the difference on the multiple cannot be explained by the fundamentals, the firm will be viewed as over valued (if its multiple is higher than the average) or undervalued (if its multiple is lower than the average). Which Multiple is to use? Going through various alternates available for choosing a multiple, the question nowis which multiple is to select? Or which is better than the others? Is it depends onfundamentals or upon type of Industry or upon size or any other factor? Also, the earnings before interest, taxes, depreciation, and amortization (EBITDA) multiple generally yields better estimates than does the EBIT multiple. Finally, the accuracy and bias of value estimates, as well as the relative performance of the multiples, vary greatly by company size, company profitability, and the extent of intangible value in the company. Damodaran (2002) notes that the usage of multiples varies widely across sectors, with Enterprise Value/EBITDA multiples dominating valuations of heavy infrastructure 39

businesses (cable, telecomm) and price to book ratios common in financial service company valuations. This decision of choosing appropriate multiple is also dependent on the judgment of the appraiser using best of his skills and experience considering all, including the fundamentals, type of industry, size of company, nature of transaction and of course, the purpose of valuation. WHICH APPROACH SHOULD BE USED? Now, the fundamental question is which approach is to consider for valuing a business? The analyst faced with the task of valuing a business or its equity has to choose among different approaches Asset valuation, discounted cash flow valuation, relative valuation (and in some cases, option pricing models) and within each approach, they must also choose among different models. As per the views of the analyst, these choices will be driven by the characteristics of business being valued -The level of earnings, growth potential, the sources of earnings growth, the stability of leverage and dividend policy. Matching the valuation model to the business being valued is as important a part of valuation as understanding the models and having the right inputs. Once we decide to go with one or another of these approaches, we have further choices to make which value of asset to consider, a replacement value or a liquidation value, whether to use equity or firm valuation in the context of discounted cash flow valuation, which multiple we should use to value firms or equity based on comparable business or transaction. It is like a kitchen that has many chefs with multifarious stuff on platform but no recipes. A business appraisal is in fact the opinion of the individual appraiser, and the appraiser has significant flexibility in formulating an opinion. The true measure of a valuation model is how well it works in (i) explaining differences in the pricing of assets at any point in time and across time and (ii) how quickly differences between model and market prices get resolved. Valuation is relative to purpose. Therefore, the calculated value of a business will vary depending how its intended to be used, and the differences can be substantial. The value established for tax purposes or for litigation is not the same value established for divestiture. 40

So, we can say that the conclusive value rests on COMMON SENSE AND REASONABLENESS. The important factor in any valuation is that the method used is relevant to your purpose of valuation, your type of business, providing a valid and supportable value. This wide variety of methods available can be a confusing array to choose from. There are plenty of pros and cons for each method. While there is no such thing as absolute truth in business valuation, confidence in the eventual number is based on the integrity of the underlying process. To assure that integrity, many valuation professionals use more than one method, computing a weighted average to arrive at their final number. To conclude, we can say that irrespective of approach being used, the appraiser has to apply his mind in choosing applicable premise of value, standard of value and based on these selecting the techniques to apply so as to serve the purpose of valuation. Intangible assets Intangible assets are something of value that cannot be seen, touched or physically measured, which are created through time and/or effort and that are identifiable as a separate asset, such as a brand, franchise, trademark, or patent. Just an opposite of tangible assets. There are several elements in the environment that contribute to companys operation. These significant qualitative characteristics, which must not be discounted or must not be over looked, includes;dominant market size, company size and critical mass, employeesmanagement relations, strength of competition, technological capabilities and expertise, size of backlog, location operations, strength of customer-vendor relationship, competence of management etc. It is essential to focus not only on factors closely related to the company operation, but on micro and macro factors as well. This all together give rise to goodwill of the business concern. Valuation of intangible assets While intangible assets play an increasingly important role in todays business world, it remains difficult to quantify its economic and monetary value. At Quest Profin Advisor Ltd the intangible asset valuation would not be reflected in methods used for valuation.

41

But once the value is fixed for tangible assets, the agreement of the other party to pay above/below the price would amount to positive/negative goodwill. Intangible assets are significantly more difficult to value than their tangible counterparts. Obviously, it is more difficult to determine the value of a trade secret than the value of office space. When it is time to sell assets, intangible assets, such as goodwill and patent, can cause real problem in the form of financial and legal obstacles if improperly valued.

CHAPTER 9 COMPANY PROFILE

Quest Profin Advisor Private Limited (Quest) is a Mumbai based Financial Advisors established in 1994. Quest is promoted by professionals having an experience of more than two decades in the field of Corporate Finance and Advisory. Quest has a dedicated team of experience Professionals specialized in a wide range of Financial Services and corporate Laws. Quest is the Financial Consultancy arm of a 20-year-old firm of Chartered Accountants. They are engaged in providing Corporate Advisory services to reputed Companies in Financial Structuring, Project Funding, Private Equity, Loan Syndication, IPO Management, Compliance, Due Diligence and Corporate Law matters. Over the years, they have provided their services to a number of corporate clients including MNCs, NRI as well as Indian companies. They are a team of MBAs/ Chartered Accountants, have handled various types of assignments involving funds raising & corporate advisory and earned reputation for their knowledge of corporate laws, diligence and task-oriented approach and adaptation to the latest trends in the industry. Mission of the organisation To bestow value based chain of quality financial & consultancy services. To build mutual beneficial long-term business relationship with the clients by delivering high quality service with utmost confidentiality.

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Vision of the Organisation To be a globally renowned Financial Consultancy House Professional Approach of Quest profin:The team members bring a rich transaction closure and consulting experience with senior managements of large corporate. Leveraging on vast industry experience and incisive knowledge of investment strategies, the organisation assists the clients in developing and executing capital raising transactions. Clients like the two fold advantage they get with Quest- extensive knowledge and capabilities to process and manage growth capital transactions. Quest work closely with the Board of Companies and their management teams to support their acquisitions, recapitalization and business enhancement objectives through both the equity (public and Private) and debt routes. Services offered by the organisation The company provides strategic advisory services to assist clients in choosing the best financing option in congruence with their strategic goal. They provide end-to-end financing services to corporate clients. The organisation is headed by young and dynamic professional, having immense experience in financial sector. It has two divisions viz. 1. Corporate Advisory. 2. Corporate Finance.

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Sr.

Corporate Advisory

Sr.

Corporate Finance

No. 1. Advisor for Initial Public Offerings

No. 1. Providing range of services in sanction as well as disbursement of the finance in various classes.

2.

Private Equity Syndication

2.

Arranging funding for overseas Acquisition.

3. 4. 5.

Mergers and Acquisitions. Partner Search (Cross Border Deals). Project Advisory Services towards SEZ approvals, Hotels, Townships etc. Corporate Law. Business Valuation Due Diligence Review

3. 4. 5.

Syndication of corporate Loans/ Term Loans. Arranging Short/ Long Term Rupee\ Foreign Currency Loans for corporates. Syndication of Foreign Currency Loans.

6. 7. 8.

6. 7. 8.

Discounting Future Receivables. Debt Swaps Syndication of Working Capital Finance. Fund based Non-fund based

9.

Corporate and Financial Restructuring

ORGANIZATIONAL STRUCTURE

44

BOARD OF DIRECTORS

BUSSINESS DEVELOPMENT & STRATIGIES

CORPORATE ADVISORY

CORPORATE FINANCE

45

CHAPTER 10 Valuation at Quest Profin Advisor Private Ltd:

The firm being a boutique investment firm had many cases dealing with the valuation of companies. Maximum cases were of clients having unlisted firms, which made the task althomore difficult. The four main methods that were widely followed at the firm were: 1. Discounted Cash flow (DCF) 2. Profit Earning Capacity Value (PECV) 3. Net Asset Value (NAV) 4. Peer Comparison (Mcap/Sales multiple) We will see the calculation of value of the firm via the above methods with an example. Shown below are the income statement and balance sheet of XYZ ltd firm. The data for 2010-11 is given. While projections are being made for the next five years. The valuation of the firm is being made on going concern basis. The companys cost of capital is 15% and it is growing at 3% INCOME STATEMENT Sales Domestic Exports Misc Income Total growth y-o-y COGS 2010-11 5,722.23 7.67 5,729.89 38.19% 4,927.46 2011- 12P 4,94 8.01 94 8.39 5 6.90 5,95 3.30 3.90% 4,73 0.80 2012-13P 10,825.3 3 2, 562.03 1 53.72 13,5 41.07 127.45% 10,3 47.14 2013-14P 11,41 4.23 2,8 53.56 1 71.21 14,43 9.00 6.63% 10,85 7.15 8.41 46 (Rs lakhs) 2014-15P 12,45 2.8 3,1 13.21 1 86.79 15,75 2.83 9.10% 11,79 6.36 2015-16P 13,23 8.5 3,3 09.64 1 98.58 16,74 6.75 6.31% 12,56

35 Direct Expenses Total Cost of Production Gross Profit Margin Admin & Other Exp Total EBITDA Margin Depreciation EBIT Margin Interest PBT Margin Taxes PAT Margin 27.61 0.48% 113.86 1.99% 86.24 4.30 4.27% 8 6.44 33.99% 16 7.87 2.82% BALANCE 201112P 326.61 5.70% 212.76 1.54 7.92% 21 7.24 25 433.98 7.57% 107.37 8.92 10.73% 16 7.37 47 158.84 5,086.30 643.60 11.23% 209.61 209.61 7.20 5,08 8.00 86 5.30 14.53% 22 6.38 22 6.38 63 53.55 53.55

8 12.46 11,1 59.61 2,3 81.47 17.59% 2 89.05 2 89.05 2,1 27.92 15.71% 1 67.37 1,9 60.55 14.48% 2 05.92 1,7 54.63 12.96% 5 96.40 33.99% 1,1 58.23 8.55% SHEET

8 66.34 11,72 3.49 2,7 15.51 18.81% 2 29.51 2 29.51 2,4 26.46 16.80% 1 67.37 2,2 59.09 15.65% 1 94.91 2,0 64.18 14.30% 7 01.61 33.99% 1,3 62.56 9.44%

9 45.17 12,74 3.58 3,0 09.25 19.10% 3 69.05 3 69.05 2,6 79.74 17.01% 1 67.37 2,5 12.36 15.95% 1 83.91 2,3 28.46 14.78% 7 91.44 33.99% 1,5 37.02 9.76% (Rs Lakhs)

8 37.34 13,40 3.69 3,3 43.06 19.96% 3 3 2,9 74.01 17.76% 1 67.37 2,8 06.63 16.76% 1 73.69 2,6 32.94 15.72% 8 94.94 33.99% 1,7 38.00 10.38%

2010-11 SOURCES OF FUNDS Equity Share Capital Reserves &

201213P

201314P

201415P

201516P

317.10

2,317. 10

2,317. 10

2,317. 10

2,317. 10

2,317. 10

47

Surplus Equity Share Premuim General Reserves Profit & Loss Appropriation Total Shareholders Equity Loans (Liability) Secured Loans Secured Loans(plusLIC ) Bank Loans & OD(WC) Unsecured Loans

137.70 240.00

137.70 240.00

137.70 240.00 1,363. 85

137.70 240.00 2,726. 41

137.70 240.00 4,263. 43

137.70 240.00 6,001. 43

37.76

205.62

732.56

2,900. 42

4,058. 65

5,421. 21

6,958. 23

8,696. 23

1,830.4 8

1,711. 34

1,595. 80

1,480. 25

1,377. 99

1,275. 74

681.12 1,149.3 5 304.36 2,134.8 3

561.99 1,149. 35 304.36 2,015. 70 54.24 4,970. 37

446.45 1,149. 35 304.36 1,900. 15 54.24 6,013. 05

330.90 1,149. 35 304.36 1,784. 60 54.24 7,260. 06

228.64 1,149. 35 304.36

126.38 1,149. 35 304.36

Net deferred tax liability Total Sources of funds

54.24 2,921.6 3

54.24 8,694. 82

54.24 1 0,330. 5

BALANCE SHEET (Rs Lakhs) APPLICATION OF FUNDS 201011P 201112P 201213P 201314P 201415P 201516P

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Fixed Assets Gross Less: Depreciation 1,431.5 2 304.84 1,126.6 8 2231.5 22 472.21 1,759. 31 2231.5 22 639.58 1,591. 94 2231.5 22 806.96 1,424. 57 2231.5 22 974.33 1,257. 19 2231.5 22 1,141. 70 1,089. 82

Net Block Current Assets Inventories [Incl.Pkg.Crdt .) Sundry Debtors Loans and Advances Cash and Bank Balances

792.95 1,878.2 6 247.13 143.82 3,062.1 7

660.51 1,785. 99 247.13 1,018. 99 3,712. 61

1,440. 60 4,062. 32 247.13 -250.5 9 5,499. 47

1,514. 15 4,331. 70 247.13 874.44 6,967. 43

1,646. 41 4,725. 85 247.13 2,047. 07 8,666. 46

1,732. 44 5,024. 03 247.13 3,528. 70 1 0,532. 3

Current Liabilities Sundry Creditors Provision for Income tax Total CL Net Current Assets Total Application of

1,249.0 2 18.20 1,267.2 2 1,794.9 5 2,921.6

483.36 18.20 501.56

1,060. 16 18.20 1,078. 36 4,421. 11 6,013.

1,113. 73 18.20 1,131. 93 5,835. 49 7,260.

1,210. 64 18.20 1,228. 84 7,437. 63 8,694.

1,273. 35 18.20 1,291. 55 9,240. 75 1 0,330. 49

3,211. 06 4,970.

funds

37

05

06

82

Cashflow for DCF 201112 NPAT Add: Depreciation Add: Interest (post tax) Operating cash flow Investment in WC Investment in Gross Fixed assets Net Investments Free Cash Flows Discounted Cash Flow Value at the end of Explicit Period Present Value of the above Present Enterprise Value (SUM of all DCF+Explicit) 167.87 16 7.37 14 3.40 47 8.64 54 0.94 80 0.00 1,34 0.94 2,479 .62 28 9.36 1,369 .24 90 0.30 2012-13 1, 158.23 167 .37 135 .93 1,461 .53 2,479. 62

(Rs Lakhs) 201420152013-14 15 16 1,362. 1,537. 1,73 56 02 8.00 16 16 16 7.37 7.37 7.37 12 12 11 8.66 1.40 4.65 1,65 8.60 28 9.36 1,82 5.78 42 9.50 2,0 20.03 32 1.50 3 21.50 1,69 8.53

42 9.50 1,396 .28 782.8 9

(862 (1,018. .31) 10) (749.8 3) (769.8 2)

844.47 1457 9.04 724 8.36

8256. 37 50

Less: Illequidity Discount (@20%) Net Valuation Discount rate (k) (WACC) Growth rate after explicit period (g)

1651 .28 660 5.10 15% 3%

Calculations:
WACC = (Equity*Ke+ Debt*Kd)/(TF) Equity Debt Ke Kd = Rs 20 Cr = Rs17.11 Cr = 20% = 13%

Tax rate = 33.99% Therefore substituting above values in the formula we get WACC= 14.93 =15% Value at the end of explicit period: It is residual or terminal value. The growth as stated is 3% with WACC = 15% So Residual Value Present value of Residual value = 1698.53 (1+.03)/(0.15-0.03) = 14579.04 = 14579.04/(1+.15)5 = 7248.36 Illiquid Discount: The discount associated with the liquidity of the assets. In short there is cost to illiquidity of the assets that needs to be taken into account before getting the real value.

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The difficulties associated with selling private businesses can spill over into smaller equity stakes in these businesses. Thus, private equity investors and venture capitalists have to consider the potential illiquidity of their private company investments when considering how much they should pay for them and what stake they should demand in private businesses in return

(Rs lakhs) Calculation of Net Asset Values based on Intrinsic Values 2010-11 Intrinsic Particulars Value 3,60 Market value of Fixed Assets (including Land) Market value of Current Assets Loans & Advances Total less: Liabilities Secured Loans Unsecured Loans Current Liabilities & Provisions Net Intrinsic Value 6.64 3,06 2.17 6,66 8.81 1,83 0.48 1,26 7.22 3,57 1.11

Market value of Fixed Assets included cost of land Which was Rs 2480 Lac

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Calculation of PECV based on projected profits Particulars Projected Profit After Tax for Fiscal 2010-11 (in Lacs) 7 Projected Profit After Tax for Fiscal 2011-12 (in Lacs) 3 Projected Profit After Tax for Fiscal 2012-13 (in Lacs) Average Profit Expected rate of Return (for Investor) Fair Value of the Firm 6 896.2 2 13.2% 6787.87 Amount 167.8 1,158.2 1,362.5

Expected Return is calculated after tax= 20*(1-.33) = 13.2%

Peer Comparison using Mcap/Sales Multiple A analysis of similar companies to XYZ was done and ratio MarketCap/Sales of all companies was found. MCap/Salesavg =0.40 Considering this average multiple for XYZ , we calculate sales for XYZ =0.40 *5729.89 = 2290 lac Based on this the Market Cap of the XYZ company is found to be Rs 2290 Lac

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As seen from above methods the value of the firm ranges widely depending on the purpose and method used. The firm would then be valued as per the need of the buyer or the investor and approach suitable to him.

CHAPTER 11
Conclusion The valuation of the company can be done by various approaches and using different models as seen above. Each of which gives a different value of the firm. The investor would like to relate to the value which is very close his purpose. While putting valuations across it is very important that assumptions are specified and justification is given for every estimate or projection done. Controversy exists as to which methods are most appropriate. Research on the theory and application of valuation methods often yields mixed results, which has only added to the confusion. In determining which of these approaches to use, one must exercise discretion. Each technique has advantages and drawbacks, which must be considered when applying those techniques to a particular company. Most treatises suggest that more than one technique should be considered, which must be reconciled with each other to arrive at a value conclusion. Whichever approach is followed, it is important that valuation estimates are reliable. While valuing a business is not an exact science, it is not a total mystery either. A realistic business valuation requires more then merely looking at past years financial statement. The quality of any value analysis or value appraising is a function of the accuracy of the data and assumptions that form the basis for any conclusion reached. 54

Bibliography
Documents and papers at Quest Profin Advisor Pvt Ltd. Damodaran on Valuation. Mergers and Takeovers (BCAI) www.stern.nyu.edu (Damodaran online) www.karvy.com

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