Valuation methods and issues that arise while conducting valuation

Valuation of a Business is conducted in order to arrive at an estimation of the Economic Value of an Owner’s Interest in a certain Business under the guidance of a certain set procedures. Valuation may be computed for a business in order to arrive at an accurate snapshot of the Financial Standing of the business which is presented to Current or Potential Investors. Valuation is generally conducted when a company is looking to merge with another company or acquire another company or sell off the entire or a fragment of its operations to another company. Some other reasons to conduct Valuation include establishing partner ownership, taxation, analysing the financial strength of the business i.e. determining solvency, planning for future growth and profitability of the business or even divorce proceedings. Further is a brief description of the approaches to Valuation Models and the issues that arise when conducting Valuation under those methods.

There are Three Different Approaches which are commonly used in Valuation:

  1. Income Approach
  2. Asset Based Approach
  3. Market Approach

Further is a brief description of the approaches to Valuation Models and the issues that arise when conducting Valuation under those methods.

I. INCOME APPROACH

  • Under the Income Approach, Valuation is based on the Economic Benefit expected from the investment and the level of risk associated with the investment.
  • There are several different Income Methods which include Capitalisation of cash flow or earnings, Discounted Future Cash Flows which is commonly known as DCF and the excess earnings method.
  • DCF is the Net Present Values of the Cash Flows projected by the company. The Value of an asset is intrinsically based on its ability to generate Cash Flows is the underlying principle of this approach.
  • This method relies more on the fundamental forthcoming expectations of the business rather than on the public market factors.

ISSUES THAT ARISE WHEN CONDUCTING VALUATION USING INCOME APPROACH:

1. USING ACCOUNTING PROFITS INSTEAD OF CASH FLOW

  • The value of a business depends largely on the profitability, financial health and earning power. Accounting Profits and Cash flows are two means to measure it.
  • Free cash flow is a better means to analyse profitability as compared to accounting profit because the Revenues and expenditures of the business are accounted for at the right time and the cash flows of a business cannot be manipulated as much as earnings.

2. OVERLY OPTIMISTIC REVENUE FORECASTS

  • At times while projecting the forecasts, the revenue is shown to be shooting up in numbers during the forecast period. This results when taking a hypothetical high growth rate.
  • What the valuer fails to notice is whether the growth of the company is aligned with the industry, what the market size of the company is or even whether the company has a strategy to achieve the desired growth goal.

3. NARROW FORECAST HORIZON

  • What should be taken as the optimal length of the Financial Forecasts is one of the key choices that need to be made.
  • If a shorter forecast period is considered, it fails to give the effect of different parameters on the business in the upcoming years. For example in case of a company under FMCG sector, it would not be right to prepare financial forecasting for a period of just two to three years.
  • On the other hand is the length considered is too long, the valuation could result as misleading. This is because in the long run, risks associated with the business cannot be anticipated easily.
  • Thus, it is essential to consider an explicit time frame while conducting valuation that is neither too short nor too long. A time frame ranging from 5 to 7 years is generally considered when performing DCF Valuation.

4. INCORRECT BETA

  • Beta comes into consideration when deriving the Cost of Equity of a company.
  • When Valuation of a company is done under the circumstances of a merger or an acquisition, majority of the times, the Beta is taken to be that of the Acquiring Company. This is done under the assumption that the Target Company is a smaller company when compared to its bidder, thus the Target Company would have no influence on the resulting Capital Structure as well as the riskiness of the New Company.
  • Other times, the Beta considered is an estimation of the emerging company’s Beta with respect to a Market Index. But just using the historical beta is very risky when the company or its future risk prospects are not analysed.
  • At times, when levering and unlevering the Beta to arrive at the estimate, incorrect formulae are used. The levering should depend on the amount of debt prospect of the company in future.

5. HIGH COST OF EQUITY

  • Along with Beta, another problem that arises in deriving the Cost of Equity is the Risk free Rate.
  • Majority of the times the Risk free rate considered is just the 10 year Government Bond Yield.
  • What one fails to consider in this is the Country Risk. If this view is taken into consideration, the Cost of Equity of a company in United States would be same as that of a company in Bolovia, which is highly incorrect.
  • Thus, the Country Risk Premium needs to be deducted to arrive at an accurate Risk Free Rate.

6. INCORRECT DISCOUNT RATES

  • It is a wrong notion to consider a higher discount rate when there are higher risk cash flows, on the basis that the discount rate on cash flows should reflect the riskiness.
  • Generally Book Values of Debt and Equity for arriving at the Weighted Average Cost of Capital (WACC). But this violates the Basic Principle of Valuation which is to arrive at a Fair Value
  • Thus, when valuing an on-going business, the market values of debt and equity should be taken into consideration to derive the WACC.

7. HIGH LONG TERM GROWTH RATE

  • There is a Material Impact created on the value of a company when a long term growth rate is used.
  • This is considered when arriving at the Terminal Value. The Terminal Value is the Present Value of all the Cash Flows at a future point in time, when the cash flows are expected to be at a stable growth rate.
  • These Long Term growth rates generally lie in the range of 5% to 6%.
  • They depend on the growth rate of the economy and never exceed that figure. This is because, a higher growth rate than the GDP rate of the economy would imply that the company would grow larger than the economy. Applying such a high rate would result in overvaluation.

II ASSET BASED APPROACH

  • Under this approach, the value of a business is derived as a sum of its parts. This method takes into account all the assets and liabilities of the Business.
  • The Value of the Business is the difference between value of all relevant assets of the business and value of all the relevant liabilities.

III MARKET APPROACH

  • This approach is used to derive the appraisal value of the business, intangible asset, security or business ownership interest by considering market prices of comparables which have been sold recently or are still available.
  • There are two main Valuation Methods under this approach-
    1. Comparable Companies Method – This method entails the use of valuation multiples of companies which are traded publically.
    2. Comparable Transactions Method – This method entails the use of valuation figures of observed transactions of companies in the same industry as that of the Target Company.
  • Certain common multiples considered for Relative Valuation are – P/E Ratio, PEG Ratio, EV/Sales, EV/EBITDA, EV/ Sales.

ISSUES THAT ARISE WHEN CONDUCTING VALUATION USING MARKET APPROACH:

1. INCORRECT PEER SELECTION

  • The industries in a market are often loosely defined. Making is difficult to select optimum peers to conduct Comparable Company Analysis.
  • Some of the major factors to be considered while selecting peers are product line, geography, seasonality, revenue, etc.
  • Another way to identify peers it to check the annual report of the companies, in case the company is a listed one, where the peers would be mentioned.
  • The same could apply for a Comparable Transaction Analysis. Where Multiples of an extra ordinary Transaction are considered for conducting Valuation.

2. INCORRECT MULTIPLES

  • There are a number of Multiples available to value the worth of a business. Each of these Multiples relate to a specific extent of the financial performance to the potential selling price of the business.
  • If a multiple is based on the Net Cash Flow, it should not be applied to the Net Profit.
  • For valuing new companies, which have small sale and negative profits, using multiples such as Price-to-Sales or Enterprise Value to EBITDA Multiples can be misleading. In such cases, Non-Financial Multiples can be helpful.
  • Certain common multiples considered for Relative Valuation are – P/E Ratio, PEG Ratio, EV/Sales, EV/EBITDA, EV/ Sales.

3. NOT ADJUSTING THE ENTERPRISE VALUE TO EBITDA MULTIPLE FOR NON-OPERATING ITEMS

  • The Enterprise Value should not include excess cash. Also the Non-Operating Assets must be evaluated separately.
  • Operating leases must be considered in the Enterprise Value, the interests costs associated to such operating leases must also be added back to the EBITDA Value.
  • This is because though the Value of Lease and the Interest Cost of the lease, affect the ratio in the same direction, the effect is not of the same magnitude.

4. TAKING AVERAGE INSTEAD OF MEDIAN

  • While conducting Relative Valuation, it is a common practice to consider the Average value of the PEER’s multiples instead of Median value.
  • The middle element of the data is the Median Value. Taking Median Value enables the extremely high or low values to be disregarded.

5. USING RELATIVE VALUATION AS PRIMARY VALUATION METHODOLOGY

  • Valuation should not be derived by depending on just one methodology, especially just Relative Valuation. Relative Valuation is a considerably good method to validate the value derived from other Valuation Methods.
  • One issue of relying on Relative Valuation is that getting data of a privately owned business is difficult. Also the shares of a public company are more liquid than that of a private company.

CERTAIN OTHER COMMON ISSUES THAT ARISE WHEN CONDUCTING VALUATION:

1. CONSIDERING VALUATION IS A SCIENTIFIC FACT

  • Most of the times it is asserted that Valuation is a Scientific Fact rather than an Opinion.
  • A logical process is followed to reach a Valuation Figure or Opinion, thus there is the role of Science.
  • But what is forgotten is that the Value arrived at from any Valuation Method, is contingent to a set of assumptions and expectations. These expectations include future prospects of the company, industry or even the country. Another thing which is factored in is the Valuer’s appraisal of Company Risk.
  • Hence, valuation is more of an Art than a Science.

2. ASSUMING THAT EVERY ESTABLISHED BUSINESS HAS A POSITIVE GOODWILL

  • Business Goodwill is actually directly related to the earning power of the business.
  • If the Business earnings fall below the return on assets, then the business has a negative goodwill.

3. FAILING TO ASSESS COMPANY SPECIFIC RISK

  • When conducting Business Valuation, risk assessment plays a very important role.
  • Each company has different financial and operational factors which contribute to its risk profile.
  • Thus, each company has different Discount and Capitalisation rates which need to be taken into consideration.

4. REDUNTANT ASSETS ARE NOT ADDED TO COMPANY VALUE

  • Redundant assets are those which are not required for the day to day operations of the business. The value of such assets should be added to the value of the business or company.

5. THINKING THAT THE BUSINESS PURCHASE PRICE AND PROJECT COST ARE THE SAME

  • Many a times the project cost is considered to be the same as the purchase price. But that is not correct.
  • In order to arrive at the Purchase price s=certain adjustments need to be made to the project cost.
  • One such adjustment is that the buyer of the business also needs to inject certain working capital.
  • If there is any deferred equipment, its maintenance cost also needs to be adjusted.
  • There are certain investments which are needed to maintain the income stream such as hiring staff replacements, licences, regulatory compliances, etc. Such costs also need to be adjusted.

The method which has the capability to incorporate all the significant factors which have a material effect on the Fair Value is the Most Appropriate Method of Valuation.

Furthermore, one must keep in mind the above issues which can arise while deriving Valuation for a Business, Stock or Company in order to avoid any misleading valuation figures.

Author
Vhabiz Lala
Volunteer – Equity Research & Valuation (M.Sc. Finance, NMIMS – Mumbai. Batch 2018-20)

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