BUSINESS VALUATIONS

Introduction
Determining the business valuation of any enterprise is an expensive, complex and time-consuming
task. Business valuation is frequently used in setting a price for an enterprise that is being bought or
sold. Professional valuation is now also being used by financial institutions to determine the amount of
credit that should be extended to a company, by courts in determining litigation settlement amounts
and by investors in evaluating the performance of a company’s management. Lastly, a valuation is
often required under a variety of accounting and tax regulations.

Valuation is a relative term which changes from time to time and situation to situation. Various
methods are used to value businesses. The method used is subjective in nature and is dependent
upon the perception and skills of the valuer. The appropriate method to be used depends on the
purpose of the valuation. Sometimes one valuation method is appropriate and, in other instances, four
or five methods are appropriate. An expert valuer can therefore use one appropriate method or a
combination of different methods. The value arrived at often depends on the valuation purpose and
how the appraiser weighs each approach.

Reasons for valuing businesses and financial assets

In practice, there are many instances where we need to value a business. Some of the more common
reasons for valuation are:
1. reconstruction of business i.e. merger, de-merger, acquisition, takeover, liquidation
2. litigation and ownership disputes
3. buy / sell agreements
4. reorganisations and bankruptcies
5. to comply with statutory or regulatory compliance, valuing employee stock option
6. admission or retirement of partner in a partnership firm

Business valuations
The market value of a business is determined by a business valuation. By combining and estimating
the multifaceted economic benefits of both intangible and physical assets, a valuation can be made.
The valuation of a business forms a basis to determine the estimated price. It helps sellers and buyers
to use it as a basis for their negotiations, when deciding whether to buy or sell the entire business or a
partial equity share. This process is both an art and a science.

Reasons for valuing business

Valuing a business will benefit a company in various ways. The reasons for carrying out a business
valuation include:

1. To assist in buying or selling a business by arriving at an appropriate value for further dealings.
Understanding the valuation process can help to:
a) improve the real or perceived value of a business
b) choose a good time to buy or sell
c) negotiate better terms
d) complete a purchase transaction more quickly and appropriately
e) provide better chance of a sale being completed as both the buyer and seller start with realistic
expectations of price

2. To raise equity capital: a valuation can help a company intending to introduce an Initial Public
Offering (IPO) in raising funds from the public by providing a price parameter for the new shares being
issued.
3. To buy and sell shares in a business at a fair price.
4. To motivate management: regular valuation is a good discipline. It can:
a) provide a measurement for management performance.
b) encourage management focus on important issues.

5. To meet government or regulatory requirements, e.g:

a) a valuation for employee stock ownership plans (ESOP's).
b) in a merger or acquisition case if directed by Court.
c) valuations required in divorce proceedings or minority shareholder actions.

6. Estate and gift planning: if a share in a private company is substantial to a person's net worth, a
valuation of that investment should be an integral part of the person's estate planning. When a person
dies, a posthumous valuation of a closely-held business is often done as a part of the tax return of the
estate.

7. Legal purposes: if there is a dispute in the business regarding estate issues, partnership disputes
etc. the business may require a valuation to resolve them.

Reasons for valuing financial assets

Financial asset valuation

Valuation of financial assets is the process of estimating the market value of a financial asset.
Valuations can be made for assets (for example, investments in marketable securities such as stocks,
options, business enterprises, or intangible assets such as patents and trademarks) or for liabilities
(e.g. bonds issued by a company). Valuations are required in many contexts including investment
analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to
determine the proper tax liability, and in litigation.

The following are key reasons for conducting financial asset valuation:
a) For reporting in financial statements: to facilitate for accurately documenting and reporting on
financial assets.
b) To buy insurance cover: to provide a more defined measurement of risk exposure and the need
for insurance coverage.
c) To improve performance: to generate the information that is needed for allocation of resources,
performance assessment and internal control. This process establishes the basis for asset realisation
or for earning maximum return on company assets.
d) Security for a proposed mortgage: banks require independent appraisals of value to accompany
a loan application.
e) Annual accounts / audit: financial asset valuations are performed as companies need to report to
shareholders on asset values.
f) Legal disputes: the valuation of financial assets is regularly referred to across a range of legal
cases.

Factors to consider in business valuation

While valuing a business, the following factors need to be considered:

a) the nature and history of the business.
b) the general economic outlook and the conditions of the specific industry.
c) the book value of the stock and other current assets.
d) the financial condition of the company.
e) the earning capacity of the company.
f) the dividend paying capacity of the company.
g) whether the company has goodwill or other intangible assets.
h) previous sales of stock.
i) location and life of non-current assets.
j) the market price of publicly-traded companies who are engaged in the same or similar lines of
business.

The tools used for asset valuation include quantitative methods and statistics, financial statement
analysis, ratio analysis, fundamental analysis, and valuation economics.

In order to value a business, the information requirement largely depends on the premise considered
for valuation. Four typical premises are:
1. Going concern: the going-concern premise of value assumes that the business will continue to
operate in the foreseeable future.
2. Group of assets: this premise of value assumes that the business has a collection of assets in
place and the combined value of all the assets is more than the addition of the isolated values of each
individual asset.
3. Orderly liquidation: the orderly-liquidation premise of value assumes that the assets of a business
will be sold individually and not as an assemblage of assets. In an orderly liquidation, it is assumed
that the assets will endure for a reasonable length of time in the secondary market.
4. Forced Liquidation: the forced-liquidation premise of value is similar to the orderly-liquidation
premise; however, it assumes that the assets will not endure for a reasonable length of time in the
secondary market but, rather, will be sold in an urgent manner.

Information required for valuation gathered from internal and external sources
Valuation includes planning, identifying critical factors, documenting specific information, and
analysing the relevant information.

Internal sources
1. General information which includes:
a) history of the organisation
b) products and services rendered
c) customers and suppliers
d) seasonality and business cycle of the business or products
e) ownership, management skill, organisation chart
f) location and physical size of non-current assets i.e. land, building, plant and machinery

2. Past financial performance:

a) SOCI
 revenue
 gross profit
 net profit
b) previous years’ SOFP
c) statement of cash flows
3. Tax Returns
4. Accounts receivables, accounts payables, and inventory levels
5. Contracts, agreement, lease entered into with third parties
6. Budgets, forecast, projections
7. Board of directors’ minutes
8. Price list

External sources
1. Economic analysis:
a) GDP trend of the country in which the company is situated.
b) Trend in interest rates, consumer price index.

2. Industry and competition analysis:

a) Threat of new entrants and existing competitors.
b) Threat of substitute products.
c) Threat of purchasing power of consumers.
d) Threat of change in bargaining power of suppliers.
e) Threat of technological changes.
f) Threat of changes in legislation.
g) Threat of dependence on natural resources.

Limitations of internal sources of information

1. The majority of the information required for valuation is collected from internal sources. As this
information is gathered from the organisation itself, it is difficult to rely on such information unless it
has been audited by an independent auditor.
2. The majority of the information is gathered from past events. As the value of information changes
over time, old information loses its relevance in the valuation process. A history of the company often
includes a description of the organisation, its business lines, products and services, its management,
customers, competitors, employees and its financial performance. This information needs to be
reviewed at the time of valuation in the light of changes which may have occurred between the time
this information was gathered and the time the valuation was made.
3. Many value drivers that are to be considered in the valuation process are subjective and open to
interpretation.
4. The financial statement analysis generally includes a description of the subject company. These
financial statements are prepared using generally-accepted accounting principles (GAAP). These
statements are susceptible to manipulation by management.
5. Accounting policies also change over time. As a result, records of previous accounting policies
need adjustment to make them comparable over time.

To make the financial statements comparable, one of the techniques that a business valuation
professional applies is called “normalisation” of the subject company’s financial statements.
Normalising the company's financial statements permits the valuation expert to compare the subject
company to other businesses in the same geographical area and industry, and to discover trends
affecting the company over time. Normalisation includes the following adjustments to the financial
statements:

a) comparability adjustments
b) non-operating adjustments
c) non-recurring adjustments
d) discretionary adjustments

Limitations of external sources of information

1. A business valuation process begins with a description of the national, regional and local economic
conditions existing on the valuation date, as well as the conditions of the industry in which the subject
business operates. This kind of information is generally not available and, if it is derived from external
sources, its reliability is highly questionable.
2. Government departments and industry associations often publish useful statistics describing
regional and industry conditions, but, again, the information is sometimes too vague and the cost of
procuring the information is high.
3. Stock market trends, gross domestic product, employment, inflation, interest rates, and consumer
spending are some of the economic indicators that need to be compared and contrasted with the data
of the company under consideration. It is difficult to get this kind of information for a particular line of
business.
4. The conditions that are examined as at the valuation date may substantially pre-date the valuation
date. The valuer can consider only those facts that are known or knowable as at the valuation date.

MODELS FOR THE VALUATION OF SHARES

Introduction
Where shares are being valued, it is important to understand the precise capital structure and the
terms applying to the shares. This is particularly so where less than a 100% shareholding is being
valued. It is necessary to refer to the company’s constitution and shareholders’ agreement, if it exists.
These documents typically regulate the arrangement between the shareholders and may contain
restrictions on the transferability of shares.

Share valuation may be required in any of the following situations

 When shareholders wish to dispose of their shares, they need to have an estimate of the
realisation from the disposal of the shares.
 When a private company wishes to become public by obtaining a stock exchange quotation.
 When some companies have a proposal for merger or takeover involving a private company.
 For taxation purposes. The objective is to have a basis for levying relevant taxes, i.e. capital
gains, capital transfer tax, stamp duty, etc.

1. Asset-based valuation models, including:

i. net book value (basis)
ii. net realisable value basis
iii. net replacement cost basis
 i. Net book value (SOFP basis)
Net book value is simply the business valuation based upon the accounting books of the business.
Assets less liabilities equal the owner’s equity, which is the "book value" of the business. The book
value method is one of the most commonly used methods of valuation. As the name suggests, it is the
net value of all the assets of the company. If we divide net book value by the number of outstanding
shares, we get the net book value per share.

Example
A company’s share capital is $100m (10m shares of $10 each) and its reserves and surplus is another
$100m. The net worth of the company would be $200m (equity and reserves) and net book value
would be $20 per share ($200m divided by 10m outstanding shares).

The limitation of this valuation method is that the accounting records may not accurately reflect the
true value of the assets in the business valuation. Assets and liabilities are shown at historical cost
that sets the floor (minimum value) for stock prices under a worst-case scenario.

Book value is the amount at which an asset is recorded in an entity’s books of accounts. The amount
could be its original purchase price or possibly it’s assessed value. It is not necessarily the price the
asset would fetch if sold in the market, nor what it would cost to replace.

Example
Total Assets = $10 million; Total Liabilities = $4 million; Number of common stock shares outstanding
= 3 million

ii. Net realisable value basis

Net realisable value is the amount for which an asset can be sold less the cost of selling it. In the
context of company valuation it is defined as follows:
Net realisable value (NRV) is the residual value after selling assets, deducting liquidation cost and
paying off liabilities.

In the event of an entity winding up its operations, there is normally a limited amount of time in which
its assets are to be realised. This requirement to liquidate the assets of an entity in the short term may
result in the asset not realising the full value that it would have had realised as an asset of a going
concern.

Net realisable value will usually be adopted by:

1. entities facing liquidation,
2. operating at a loss or with little prospect of future profits or
3. with a low earnings rate in comparison to the value of the assets employed.

Adjustments for the following need to be made while arriving at the net realisable value:
1. Differences between the estimated liquidation value of non current assets (before liquidation costs)
and the net book value of those assets.
2. Differences between the estimated liquidation value of other assets (e.g. accounts receivable,
inventory, and investments), before liquidation costs and the net book value of these assets.
3. Elimination of book values of goodwill and other intangible assets, unless these assets are
separately realisable.
4. Estimated liquidation costs.
 iii. Net replacement cost basis
Replacement cost is the amount required to replace an asset at current prices. In other words,
replacement cost means the cost to replace the asset on the same premises with another asset of
comparable material and quality, used for the same purpose. For instance, it is the amount required to
erect a building which replaces or serves the functions of a previous structure.

Note that replacement cost is likely to be different from fair market value or net realisable value.

2. Income-based valuation models, including:

i. price / earnings ratio method
ii. earnings yield method

The income-based valuation or capitalisation of earnings method is particularly appropriate where a

controlling interest in a company is being assessed i.e. when valuing a majority shareholding. The
relevance of the capitalisation of earnings method for controlling interests stems from the fact that a
shareholder with such an interest is able to influence the company’s dividend policy and therefore will
be more concerned with the earnings.

2.1 Price / earnings ratio method

The price to earnings ratio assumes that the corporation will be worth some multiple of its future
earnings.

The P/E ratio of a stock (also called its "earnings multiple", or simply "multiple", "P/E", or "PE") is used
to measure how cheap or expensive the stock’s share price is. The lower the P/E, the less you have
to pay for the stock, relative to what you can expect to earn from it.

Example
A company earned $10m last year, with one million shares outstanding, and had earnings per share
of $10($10m/1m). The current market price is quoted at $100. Therefore, the company’s P/E multiple
will be 10 ($100/$10). The company's earnings this year rose to $12m and, accordingly, EPS rose to
$12. Assuming the same P/E multiple, i.e. investors are willing to pay $10 for every $1 of last year's
earnings, the company’s valuation using the P/E ratio method will be $120m ($12 x 10).

By relating price and earnings per share for a company, one can analyse the market valuation of a
company's shares relative to the wealth the company is actually creating.

This method has two drawbacks:

1. It is based on earnings and accounting profits, which are not good indicators of actual value
creation for shareholders.
2. Selection of the multiplier is not consistent i.e. the company can choose whether to use the industry
average or the adjusted industry average based on the company's expected growth, the rate of return
on new capital and the costs of capital.

2.2 Earnings yield method

One way of calculating earnings yield is the reverse (or reciprocal) of the P/E which is the E/P. The
earnings yield is quoted as a percentage, and is useful in comparing a share valuation or the market's
valuation relative to bonds.

Earnings yield simply means the earnings per share for the most recent 12 months divided by market
price per share. In this case, value is derived by capitalising the company’s annual maintainable
expected earnings by an appropriate required earnings yield or return on investment. Annual
maintainable expected earnings can be calculated using past earnings adjusted for future increase
and synergy or economies of scale.
The capitalisation rate should be appropriate for the company’s size and industry prospects.
The advantage of the earnings yield method is that it is a forward-looking measure as it uses
expected earnings and encourages forecasting of future performance. The limitation of this method is
that it uses the earnings figure from the financial statements, which is largely subjective.

Question
E Ltd is expected to generate future profits of $6,500,000. What is the value of the business if
investments of this type are expected to give an annual return of 20%?

3. Cash flow-based valuation models, including:

i. dividend valuation model and the dividend growth model
ii. discounted cash flow basis.

Cash flow-based valuation models use intrinsic measures calculated from free cash flows rather than
using equity market value to estimate firm (asset) value distribution.

These models are based on the premise that the worth of a company is based on today's value of the
future after-tax cash a company can generate for the benefit of its shareholders.

3.1 Dividend valuation model and the dividend growth model

The important feature of the dividend valuation model is the recognition of the fact that shares are in
themselves perpetuities (expected to be in existence for indefinite period). Individual investors may
buy or sell them, but only very exceptionally are they actually redeemed.

1. Dividend discount model (DDM)

The dividend discount model can be a worthwhile tool for equity valuation. Financial theory states that
the value of stock is the value of all the future cash flows expected to be generated by the firm
discounted by an appropriate risk-adjusted rate. We can use dividends as a measure of the cash
flows returned to the shareholders.

The dividend discount model assumes that any share is ultimately worth no more than what it will
provide investors in current and future dividends.

2. Dividend growth model

Under the dividend discount model, two basic factors are considered: expected dividends and
expected return (i.e. cost on equity). It assumes a constant dividend, however, in practice, the
expected dividends may increase.

The dividend growth model takes into account growth rates in earnings and payout ratios when pricing
shares. The required rate of return on stock is determined by the degree of risk.

Myron Gordon created a constant dividend growth model which assumes that, if a company issues a
dividend with a current value of D, this value will grow at a constant rate g. The Gordon growth
model is a variant of the discounted dividend model.

Where,
D0 is the current year’s dividend
re is the expected rate of return
g is the expected growth rate for dividends

Example
A company is expected to pay $1 as annual dividend. If we assume that the company's dividend will
increase by 3% annually, then how much is an investor willing to pay for a share in this company?
Assume that the 'required rate of return' is 5%.
Then, according to the Gordon Growth Model, the company will be worth $50.00 ($1.00/ (0.05 -
0.03)).

3.2 Discounted cash flow (DCF) method

The DCF approach calculates the value of a business by discounting its future cash flows at a rate
which reflects the risk inherent to the business.

According to the DCF approach, the market value of any company is simply the discounted value of
all anticipated future free cash flows generated by the firm. DCF recognises the time value of money
by discounting future cash inflows and outflows to the present, using an appropriate discount rate
which reflects the risk profile associated with these cash flows.

Discounted Cash Flow (DCF) method

Stock can be valued in many ways. The soundest method of valuation is the discounted cash flow
method (DCF) or income valuation. This involves a final value of disposition and a discounting of the
profits (cash flows, earnings and dividends) that the stock will deliver to the stockholder in the near
future. A risk premium, which is normally included in the discount rate, is normally based on the
capital asset pricing model.

The DCF valuation method requires the valuer to:

 forecast the future cash flows of the company for at least 4 to 5 years in the light of the
current market situation, industry prospects, synergy if any, including an assessment of the
terminal value and the likely cash benefits and costs arising from business transactions.
 assess an appropriate discount rate, which is usually the subject company’s weighted
average cost of capital (WACC).

Weighted average cost of capital (WACC)

In finance, a firm’s cost of capital is measured using the weighted average cost of capital (WACC).
Two main sources of money are available to corporations: equity and debt. Taking into consideration
the relative weights of each component of the capital structure, the WACC calculates the expected
cost of new capital for a firm.

Example
Details of MTC Ltd are as follows:

Projected cash flow

If outstanding equity shares are 10m, the value per share under the DCF method will be $40.13 (i.e.
$401.30/10m shares).

Question
The following information relates to Hackles Inc

Hackles Inc has 10,000,000 shares outstanding.

Required:
Calculate the value per share according to:
(a) the net book value method
(b) the net realisable value method
(c) the net replacement cost method

THE VALUATION OF DEBT AND OTHER FINANCIAL ASSETS

A debt instrument is a contractual or written assurance to repay a debt. A debt instrument can be a
promissory note, a bill of exchange, a bond or other instrument.
Debentures and long-term debts are the alternative to equity in meeting an entity’s long-term finance
requirements. The distinguishing feature of debt finance is that it is less risky than equity finance to
the investor, as interest and capital repayments are prioritised ahead of any profit distributions to
shareholders.

Bonds / debentures are money borrowed from investors and repaid with fixed interest over a period
of time. The distinctive feature of a bond is that only the interest or coupon rate is paid periodically.
When the bond matures, the issuer returns only the face value of the bond to the investors.
Debentures are unsecured bonds.

Debt valuation is a process or system for assigning a fair value to a security or to cash flows
associated with a portfolio of securities.

Value of debt
The value of a debt is usually set out in the contract terms that exist between a creditor and debtor.
The amount that a debtor owes a creditor at that moment is the nominal value of a debt instrument.

1. Irredeemable debt
These debts involve a company paying interest every year in perpetuity, without ever having to
redeem the loan.

2. Redeemable debt
The market value of the redeemable debt is the discounted present value of future interest receivable,
up to the year of redemption, plus the discounted present value of the redemption payment.

Example
A company has issued 9% debentures, which will be redeemable at par in three years’ time. Investors
now require an interest yield of 10%. What will the current market value of the debentures be?
Assume the face value of a debenture is $100.

Market value of redeemable debt

Where,
P0 = Ex-interest market value
I = Annual interest paid
Kd = Rate of return required by debt investors
N = Number of years to maturity
RV = Redemption Value

i. Zero coupon bonds (ZCB)

A coupon is the interest rate on the nominal amount of the bond. Zero coupon bonds do not make any
periodic payments. The investor realises interest as the difference between maturity value and
purchase price. These types of bonds are issued at a high discount and pay the full face value at
maturity.
The price of a zero coupon bond is always less than its redemption value.

Where,
P = Current MV of ZCB
n = Number of periods to maturity
Y = Periodic interest rate
M = Value at maturity

Example
A zero coupon bond will be redeemed at par in 3 years. The average annual discount rate is 6%.
What is the price of this bond? (Assume that maturity value at par is $100).

ii. Bonds issued by foreign entities

a. A Eurodollar bond is a bond issued by a non-European entity in the European market in
Eurodollar denominations.
b. A Maple bond is a bond issued by a non-Canadian entity in the Canadian market in Canadian
Dollar denominations.
c. A Samurai bond is a bond issued by a non-Japanese entity in the Japanese market in Japanese
Yen denominations.
d. A Yankee bond is a bond issued by a non-US entity in the US market in US Dollar denominations.

3. Convertible debt
Convertible bonds give bondholders the right but not the obligation to convert their bonds into a
predetermined number of shares at predetermined dates prior to the bond's maturity. Of course, this
only applies to corporate bonds.

Convertible bonds are exchangeable into shares of common stock, at a fixed price, at the option of
the bondholder. On the other hand, bonds issued with warrants are options that permit the holder to
buy stock for a stated price, thereby providing a capital gain if the stock’s price rises.

Example
Bondholders have the right to convert the $100 par amount (i.e. conversion value) of their convertible
bonds into common shares at $25 per share. In this case, the conversion ratio is 4:1 (four to one).

From a valuation perspective, a convertible bond consists of two assets: a bond and a warrant.
The actual market value of a convertible bond depends on:
  the current conversion value
 the time of conversion
 the expected conversion value

Conversion value

Example
A convertible bond which is selling for $950 per unit can be converted into 40 of XYZ shares. The
current market price of an XYZ share is $20. The ex-interest market value of ordinary bonds of a
similar risk class and maturity is $940.

Conversion ratio = 40 unit

CV = Current share price x CR
= $20 x 40 =$800

Conversion premium = Bond value – CV

= $950 - $800 = $150

Current rights premium = $950 - $940 = $10 i.e. 0.25 per share ($10/40shares)

A simple method of calculating the value of a convertible bond involves calculating the present value
of future interest and principal payments (usually at the cost of debt) and adding the present value of
the warrant (usually the conversion value).

Market value of convertible bond

Where,
V0 = Ex-interest market value
I = Annual interest paid
Kd = Rate of return required by debt investors
n = Number of years to maturity
CV = Conversion value at time t
 4. Preference shares
Preference shares differ from ordinary shares in the sense that they carry certain preferential rights. A
preference share is valued as perpetuity, as it is normally repaid on liquidation of the company.

Preference shares may have one or more of the features described below:
Redeemable: the shares are repayable normally at par in a given period without liquidation.
Participating: in addition to the fixed dividend, shareholders participate in an additional dividend,
usually in proportion to the ordinary dividend, or in surplus assets on liquidation, or both.
Convertible: shareholders have the option to convert the preference shares into ordinary shares
within a given period.

Where,
P0 = Ex-dividend market value
D = Dividend payable
Kd = Cost of irredeemable preference share

Example
JTL Ltd pays annual dividend of $4 on its preference shares and has required a return of 10%. What
will the price of each preference share be?

Question
R Company has in issue 10 % debentures, which are redeemable at par in 4 years’ time. Investors
now require a yield of 11%. What will be the current ex-interest market value of $110 worth of
debentures? What would be the current ex-interest market value if the issue had been of
irredeemable bonds?