UNIT I
Business Valuation
It is called "valuation" to estimate the value of an asset or a security or a company. Before buying a major portion of the assets or a security, any investor would be interested in knowing the value of a company. The valuation task involves not only estimating the values of the current plant and equipment, machinery, furniture & fittings, etc., but also intangible assets such as patents, copyrights, goodwill, etc.
Any unrecorded contingent liabilities would also be included in the valuation process so that the buyer is fully aware, as at a specific date, of the entire business assets and liabilities. The valuation process is thus influenced by subjective considerations and affected by them. The following valuation concepts are generally used to help the finance manager arrive at a more precise valuation, reducing the subjectivity element to the maximum extent possible.
- Book value - The book value is the value of the accounting record of assets shown on the balance sheet. It is typically the cost of an asset's purchase less the accumulated depreciation on it. It may not reflect the value of the sale or the asset's fair value. This valuation is based on the accounting principle of going concern. It is the total book value, excluding fictitious assets, of all assets that are valuable, minus external liabilities. It is otherwise referred to as a net asset.
- Market value - Market value is the value at which an asset or a company's security may be sold on the market. Market value can only be applied to tangible assets because, in general, intangible assets cannot be sold. As quoted in the stock market, the total market value of all outstanding equity shares can be referred to as the market value of an enterprise. For listed companies only, the market value can be determined.
- Intrinsic/Economic value - The present value can be termed as the intrinsic value of all the incremental future cash flows. By discounting the incremental cash flows at an appropriate discount rate, the present value arrives. Economic value is the maximum price at which a business can be acquired.
- Liquidation value - This represents the price at which, in the event of business liquidation, each individual asset can be sold. After subtracting all external liabilities, it is valued. Generally, the liquidation value would be the smallest.
- Replacement value - It is the expense of buying or replacing a new asset that is of equal utility to the company. In general, it is used for tangible assets such as equipment, plants, etc.
- Salvage value - The salvage value, also referred to as the scrap or residual value after its use, is the sale value of an old asset.
- Valuation of goodwill - Goodwill appreciation is one of the toughest, as goodwill is non-monetary. A company is said to have real goodwill if, compared to its rival with the same risk, it can earn a higher rate of return on an investment. Goodwill results when the firm earns super profits. It can be valued as the present value for all the future expected super profits for ‘n’ number of years. In merger and acquisition decisions, it is very useful.
- Fair value - All the valuations explained above are based on fair value. It is the average of the value of the market, the book value and the intrinsic value.
- A valuation of a business is a way to determine a company's economic value, which could be useful in several situations.
For example:
- Because of retirement, health, divorce, or for family reasons, you may need to sell the business.
- For expansion or due to cash flow issues, you may need debt or equity funding, in which case potential investors will want to see that the business has sufficient value.
- You may add shareholders to the (or one or more shareholders may ask for a buyout). The share value will need to be determined in this case.
- Whatever the reason, performing a business valuation will assist you to set a suitable price for the company's sale.
Key Takeaways:
- The task of valuation involves not only the estimating the values of the existing plant and equipment, machinery, furniture & fittings etc., but also of intangible assets like patents, copyrights, good will etc.
- The process of valuation would also include any unrecorded contingent liabilities so that the purchaser is totally aware of the entire business assets and liabilities as on a particular date. The valuation process is thus influenced by subjective considerations and affected by them.
- A business valuation is a way to determine the economic value of a company, which could be useful in several situations.
- A business is said to have a real goodwill if it can earn a higher rate of return on an investment when compared with its competitor having the same risk.
There are three ways to assess value when determining the value of a business:
- Asset-based approaches
- Earning value approaches
- Market value approaches
Each approach has its considerations, and there are further factors to consider if you own a sole proprietorship.
Asset-Based Approaches
Essentially, all the investments in the company will be totalized by an asset-based business valuation. Business valuations based on assets can be done in one of two ways:
- A continuing asset-based approach takes a look at the balance sheet of the company, lists the total assets of the company, and subtracts its total liabilities. This is also called the value of books.
- The liquidation value, or the net money that would be received if all assets were sold and liabilities paid off, is determined by a liquidation asset-based approach. Asset-based Sole Proprietorships Valuations it is more difficult to use the asset-based method to value a sole proprietorship. In a corporation, the company owns all assets and would normally be included in the sale of the company. On the other hand, assets in a sole proprietorship exist in the owner's name, and it can be difficult to separate business assets from personal ones.
- For example, in a lawn care company, a sole proprietor may own different pieces of lawn care equipment for both business and personal use. As part of the business, a potential buyer of the company would need to sort out which assets the owner intends to sell.
Earning Value Approaches
An approach to earning value is based on the concept that the value of a business lies in its ability to generate wealth in the future.
- Capitalizing Past Earnings determines the expected level of cash flow for the company using the record of past earnings of a company, normalizes them for unusual revenue or expenses, and multiplies by a capitalization factor the expected normalized cash flows. The capitalization factor is a reflection of what rate of return a reasonable buyer would expect on the investment, as well as a measure of the risk of not achieving the expected earnings.
- Another earning value approach to business valuation is Discounted Future Earnings, where an average of the trend of expected future earnings is used and divided by the capitalization factor instead of an average of past earnings.
- Sole Proprietorships' earning-based valuations
- In terms of past earnings, valuing a sole proprietorship can be tricky, as customer loyalty is directly linked to the business owner's identity. Whether the company involves plumbing or management consulting, the question is: will existing clients automatically expect the same degree of service and professionalism to be delivered by a new owner?
Any valuation of a sole proprietorship that is service-oriented needs to include an estimate of the percentage of business that could be lost under a change of ownership.
INCOME APPROACH
Revenue Ruling clearly requires that an income approach be used as a factor to be considered when it lists "the company's earning capacity." In the International Glossary of Business Valuation Terms, the income approach is defined as, “A general way of determining a value indication of a business, business ownership interest, security, or intangible asset using one or more methods that convert anticipated economic benefits into a present single amount.”
CAPITALIZATION OF EARNINGS/CASH FLOWS METHOD
An income-oriented approach is the Earnings Method Capitalization. This method is used to value a company based on the estimated future benefits, usually using some measure of the company's earnings or cash flows to be generated. Using a suitable capitalization rate, these estimated future benefits are then capitalized. This method assumes that all of the assets are indistinguishable parts of the company, both tangible and intangible, and does not attempt to separate their values. In other words, its ability to generate future earnings/cash flows is the key component of the company's value. This method expresses a relationship between the following:
- Estimated future benefits (earnings or cash flows)
- Yield (required rate of return) on either equity or total invested capital (capitalization rate)
- Estimated value of the business
Before applying this method, it is important that any revenue or expense items generated from non-operating assets and liabilities are removed from estimated future benefits. The fair market value of net non-operating assets and liabilities is then added to the value of the earnings capitalization derived from the enterprise. In evaluating a profitable company, this method is more theoretically sound.
Even though the Earning Value Approach is the most popular method of business valuation, some combination of business valuation methods will be the fairest way to set a selling price for most companies.
The first step is to hire a professional business valuator; she will be able to advise you on the best method or techniques to use to set your price so that your company can be sold successfully.
Having the Valuation Done Professionally
Business owners should not do their own business valuation; they will not have the necessary distance to be objective. Have it performed by a professional to ensure that you set and get the best price when selling a business. A Chartered Business Valuator (CBV) can be found by the American Society of Appraisers (ASA) in the U.S.; in Canada, you can find them through the Canadian CBV Institute.
If the intention of the investor is to provide a return on investment above and above a reasonable amount of compensation, it is likely that future benefit streams or earnings will be steady or growing at a steady rate.
Market Value Approach
By comparing your business to similar ones that have recently sold, market value approaches to business valuation attempt to establish the value of your business. The idea is similar or comparable to using real estate comps to value a house. If there are a enough similar companies to compare, this method only works well.
Market-Based Valuations of Sole Proprietorships
It is particularly hard to assign a value based on market value to a sole proprietorship. By definition, sole proprietorships are individually owned, so it is not an easy task to try to find public information on previous sales of similar companies.
Non-Competition Clauses
In contracts for the sale of a business, non-competition clauses are often included, especially in cases where goodwill is an important part of the valuation. On the assumption that current clients will continue to patronize the business only to have the previous owner join a competitor immediately or even open a similar business in the same area, no one wants to buy a business.
Typically, non-competition clauses contain restrictions such as:
- Prohibiting the seller in the same geographical area from opening up a competing business.
- Placing a time limit restricting the seller from direct competition—say, for five years
- Non-competition agreements can be a thorny legal issue and are often the subject of court cases between buyers and sellers after a business is sold.
- From a legal standpoint, to enforce the restrictions placed in a non-competition clause, they must be clearly defined and 'reasonable'. Non-competition covenants can be nullified by the courts if it is determined that enforcement places overly broad and/or unreasonable restrictions on the seller's ability to continue his trade and earn a living.
- The legal representatives of both the buyer and the seller should review non-competition clauses prior to the sale of the business.
Economic Value Added
Economic Value Added (EVA) is a measure of the financial performance of a company based on residual wealth, calculated by deducting its capital cost from its operating profit, adjusted on a cash basis for taxes. EVA can also be referred to as economic profit, as it tries to capture a company's true economic profit. This measure was devised by the management consulting firm Stern Value Management, originally incorporated as Stern Stewart & Co.
The incremental difference in the rate of return (RoR) over the cost of capital of a company is EVA. In essence, it is used to measure the value generated by a company from funds invested in it. If the EVA of a company is negative, this implies that the company does not generate value from the funds invested in the company. Conversely, a positive EVA demonstrates that a company generates value from the funds invested in it.
The formula for calculating EVA is:
EVA = NOPAT - (Invested Capital * WACC)
Where:
- NOPAT = Net operating profit after taxes
- Invested capital = Debt + capital leases + shareholders' equity
- WACC = Weighted average cost of capital
- The equation for EVA shows that there are three key components to a company's EVA—NOPAT, the amount of capital invested, and the WACC. NOPAT can be calculated manually, but is typically listed in the financials of a public company.
- Capital invested is the amount of money that is used to fund a business or a particular project. WACC is the average rate of return a company expects to pay its investors; in a company's capital structure, the weights are derived as a fraction of each financial source. It is also possible to calculate WACC but is normally provided.
- The equation used in EVA for invested capital is generally total assets minus current liabilities-two figures that are easily found on the balance sheet of a company. In this instance, NOPAT - (total assets - current liabilities) WACC is the modified formula for EVA.
- EVA's objective is to quantify the cost of investing capital in a particular project or company and then evaluate whether it produces enough cash to be considered a good investment. A positive EVA indicates that a project is generating returns in excess of the minimum return required. As Stern Value Management notes, "In 1983 we developed the Economic Value Added metric to measure value that companies generate."
- EVA evaluates a company's performance and its management through the idea that a company is only profitable when it generates shareholder wealth and returns, requiring performance above the capital cost of a company.
- EVA is very useful as a performance indicator. By including balance sheet items, the calculation shows how and where a company created wealth. This requires administrators to be mindful of assets and expenses when making management decisions.
- The EVA calculation, however, relies heavily on the amount of invested capital and is best used for stable or mature asset-rich companies. Companies with intangible assets may not be good candidates for an EVA evaluation, such as technology companies.
Key Takeaways:
- Essentially, an asset-based business valuation will total up all the investments in the company
- Economic value added (EVA) is a measure of a company's financial performance based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis
- Although the Earning Value Approach is the most popular business valuation method, for most businesses, some combination of business valuation methods will be the fairest way to set a selling price.
- Any valuation of a service-oriented sole proprietorship needs to involve an estimate of the percentage of business that might be lost under a change of ownership.
Reference books:
1) Financial Management: Theory and Practice by Prasanna Chandra, Tata McGraw Hill, New Delhi
2) Financial Management by I.M. Pandey, Vikas Publishing House, New Delhi
