BUSINESS VALUATION BASICS - Nuts and Bolts

Transcription

1 BUSINESS VALUATION BASICS - Nuts and Bolts CA RAJIV SINGH FCA, LIFA(USA),CISA(USA) LIII Co- Founder Explico Consulting First Jt. Tech. Director: Valuation Course (ICAI) & Master of Business Finance Course (ICAI) rajivsinghfca@gmail.com

2 Agenda Introduction Value vs Price Valuation-Art or Science? Efficient Market Hypothesis Business Valuation how to define? Business Valuation Principles Business Valuation Process Valuation Purpose Standard of Value Premise of Value Valuation Case Laws Valuation Myths

3 BUSINESS VALUATION Introduction Some men know the price of everything and the value of nothing - Oscar Wilde It s better to be roughly right than to be precisely wrong - J.M. Keynes It s stupid the way people extrapolate the past and not slightly stupid, but massively stupid -Charlie Munger

4 BUSINESS VALUATION Introduction Appraisers have a value in mind before they start the process and try to back into it Aswath Damaodaran, Jan 14,2009 There is a vast difference between understanding something well enough to buy it as opposed to understanding it well enough to sell it. Zig Ziglar, Secrets of Closing the Sale, 1984 The numbers are never a whole story, only a starting point. We must always remember that market research, no matter how well done, is based on the past. We are always susceptible to discovering a truth whose time has gone. Mark A. Johnson, The Random Walk and Beyond, 1988

5 BUSINESS VALUATION Introduction Are Financial Models solution for forecasting? Financial Models use scenario analysis and subjective probability to get expected value. What this expected value is? Functional equivalent of the statistician who drowned in water which was, on average, only 4 feet deep. He forgot that the range of depth was between 2 feet & 10 feet.

6 Value vs Price General definition of value as per IVSC An economic concept An estimate of the likely price at a given time in accordance with definition of value Not a fact Price is the amount of money or other consideration asked for or given in exchange of something

7 Value vs. Price value Not a static figure Nothing called precise value Arrival of transaction not necessary Fundamentals are the key Always involves economic benefits Value is should be price - the basis of negotiation of price price A static figure Always precise An outcome of a transaction May not be driven by fundamentals always Includes economic & noneconomic factors May not look on valuation

8 Business Valuation: Arts or Science BV is promoted as more Art than Science. The art is professional judgement and science is statistics. Art is nebulous and synonyms with subjective judgement. Valuation conclusions are susceptible to challenge when based mainly on professional judgement. Professional judgement should be the method applied to evaluate relevance & reliability of data, applied methodology and the inference derived thereon. Professional judgement is not a substitute for properly applied statistical methods analysis and logical reasoning.

9 Business Valuation: Arts or Science A judicious man uses statistics, not to get knowledge, but to save himself from having ignorance foisted upon him. [ Thomas Carlyle ] A relevant and reliable valuation conclusion is the product of the analysis of historical financial data, economic, industry and comparative data. The requisite financial analysis can not be performed absent applied statistical method. The analysis is most important how you took the data, analysed it, and wed it to your conclusion. I want transparency; I want to see your thinking because that s what appellant courts want to see from me - [ Judge David Laro ]

10 Efficient Market Hypothesis The market acts rationally using all relevant information leaving no opportunity for profit Weak form of efficiency- market prices incorporate all past price information Semi strong form of efficiency market prices include all publicly available information Strong form of market -efficiency-market prices incorporate all information public as well as private. Summary : If every stock price is rationally determined then expected return on every stock will be the same. You can t systematically beat the market and hence follow passive investment strategy and not active investment strategy.

11 Efficient Market Hypothesis Evidence against EMH Small cap effect small cap earned more return than others January Effect - stock prices rising from Dec to Jan Market overreaction, excessive volatility New information not always incorporated into prices Should you hire a chimp as your investment adviser - A true story A Swedish newspaper gave $1250 each to five stock analysts and a chimpanzee named Ola, to test who could make the most money on the market in a one month period. Ola the Chimp, who made his choice of purchases by throwing darts at the name of companies listed on the Stockholm exchange, won the competition.

12 Business Valuation Principles *PV 1 : Principle of Substitution *PV 2 : Principle of Alternative PV 3 : Principle of Time value **PV 4 : Principle of Expectation PV 5 : Principle of Risk & Return PV 6 : Principle of Reasonableness & Reconciliation of Valuation * Gary R. Trugman ** Mercer and Harms

13 Business Valuation-how to define? Business Valuation An act or process of determining the value of a business, business ownership interest, security or intangible assets {The International Glossary of Business Valuation Terms} Alternative Definition Business Valuation is a logical, defendable process of arriving at the opinion as to the worth of a business given the information available, assumption & limiting conditions as on the valuation date

14 Business Valuation Process Define Valuation Assignment Subject interest to be valued Ownership characteristics Information Collection Site visits & Entrance conference Environmental Scan Global Economy Domestic Economy Industry overview Company overview & historical financial analysis Valuation date Purpose Standard of value Premise of value Deliverables Limitations Special instructions.

15 Business Valuation Process Company strategy & risk analysis Selection of approaches & methods Prospective analysis Income approach Market approach. Asset based approach Discounts & Premiums Value calculation & sanity check Value Conclusion

16 Purpose of valuation Valuation for transactions Valuation for court cases Purpose of Valuation Examples Business purchase, Business sale, M&A (Mergers & Acquisition), Reverse merger, Recapitalization, Restructuring, LBO (Leverage Buy Out), MBO (Management Buy Out), MBI (Management Buy In), BSA (Buy Sell Agreement), IPO, ESOPs, Buy back of shares, Project financing and others Bankruptcy, Contractual disputes, Ownership disputes, Dissenting and Oppressive shareholder cases, Divorces cases, Intellectual property Valuation for compliances Valuation for planning disputes and other Fair value accounting, Tax Issues Estate planning, Personal financial planning, M&A planning, strategic planning

17 Standard of Value a definition of type of value being sought The identification of the type of value being utilised in a specific engagement The International Glossary of Business Valuation Terms Types of Standards of Value Fair Market Value (FMV) Investment Value Intrinsic Value Fair Value Market Value

18 Standard of Value Selecting Standard of Value Subject matter of Valuation Purpose of Valuation Statute Contracts Case Laws Circumstances Professional judgement & Experience

19 Fair Market Value (FMV) As defined by Statement on Standards for Valuation Services Issued by the AICPA the price, expressed in terms of cash equivalents at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller Acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.

20 Fair Market Value (FMV) As defined by Revenue Ruling 59-60, the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.

21 Fair Market Value (FMV) Cash or Cash equivalent: Price without any financing support or special concession and contemplates prevalent economic & market condition on the valuation date. Hypothetical: does not contemplate real but refer Potential Willingness: motivated and assets would be exposed to the market for a reasonable period Arm s length: third Party

22 Fair Market Value (FMV) Open & unrestricted market: excludes specific buyer One transaction involving a willing buyer & seller can not establish a market price Able : pushes value downward No Compulsion: Forced conditional transactions excluded Reasonable Knowledge of facts: Average knowledge & not specific knowledge

23 Fair Market Value (FMV) What Hypothetical Sale Transaction Contemplate Does not contemplate Price is cash or cash equivalents at Plan to sell to a particular buyer the prevailing economic condition Willingness and ability to buy sell exist No compulsion to accept the deal Potential buyers of similar assets exist Reasonable time and knowledge exist No separate price for not to compete and adopting a planned strategy Buyer have specific knowledge Engagement of experienced and well connected negotiator get a favorable deal Other benefits attached with the deal like making available finance or key persons

24 Investment Value Value to a particular investor based on individual investment requirements & expectations The International Glossary of Business Valuation Terms Investment value may be more than FMV or less than FMV

25 FMV vs. Investment Value FMV Consensus opinion of market participants Investment Value Opinion of a specific investor Sale is always contemplated Sale is not necessary Hypothetical investor Specific investor Impersonal Personal DLOC & DLOM may apply Control premium & synergy premium apply

26 Factors creating difference between FMV and Investment Value Estimation of cash flows Risk Tax Product synergy & cannibalisation Other strategic advantages

27 Intrinsic Value or Fundamental Value The International Glossary of Business Valuation Terms defines the value that an investor considers on the basis of an evaluation or available facts, to be the true or real value that will become market value when other investors reach the same conclusion. When the term applies to options, it is the difference between the exercise price or strike price of an option and the market value of the underlying security

28 Intrinsic Value or Fundamental Value Kohler s Dictionary for Accountants defines the amount that an investor considers on the basis of an evaluation of available facts, to be the true or real worth of an item, usually equity security. The value that will become the market value when other investors reach the same conclusions.

29 Intrinsic Value or Fundamental value Value based on fundamentals not by market Value derived by one analyst Market consensus may or may not be there Transaction value (price) is not similar to investment value which is used to estimate FMV Graham & Dodd definition the value which is justified by assets, earnings, dividends, definite prospects and the factor of management.

30 Intrinsic Value or Fundamental value Level of normal earning power and profitability in the employment of assets as distinguished from the reported earnings, which may be, and frequently are, distorted by transient influences Dividends actually paid or the capacity to pay such dividends currently and in the future A realistic expectation about the trend line growth of earning power Stability and predictability of these quantitative and qualitative projections of the future economic value of the enterprise Graham and Dodd s Security analysis, fifth edition, Tata McGraw Hill, page 41,42

31 Fair Value Most complicated & definition varies with type of transaction and facts of each case Definition has two dimensions Fair value for legal purpose Fair value for financial reporting For legal purpose Courts give fair treatment to parties who seek remedy under law DLOM & DLOC generally not allowed Stock holder is entitled to be paid for that which has been taken from him viz. his proportionate interest in a going concern [Tri-continental Corp.]

32 Premise Of Value Premise of value Talks about types of market conditions likely to be encountered. Two premises of Value Going Concern value as an ongoing operating business enterprise Liquidation value when business is terminated - could be forced or orderly Going concern is not a standard of value

33 Premise Of Value for fair value In-Use : If the asset would provide maximum value to the market participants principally through its use in combination with other assets as a group In-Exchange :If the asset would provide maximum value to market participants principally on a stand-alone basis

34 Premise of value & Standard of value Premise of value Going concern Liquidation Value in use Value in place Value to specific holder Value in exchange Forced Orderly Fair value For financial reporting Investment value FMV or Fair value For financial reporting Value to specific holder Investment Value or Fair value for Legal purpose Value in exchange FMV or Fair value Value to specific holder Investment Value or Fair value for Legal purpose

35 Purpose Tax related Financial Reporting Security Analysis Going private, shareholders dissent & oppression, dissolution Divorce Buy or Sell M & A IPO Property Bankruptcy Standard of Value FMV Fair Value Intrinsic Value Fair value Fair value or FMV or Investment Value FMV Investment Value FMV MV FMV or MV

36 Valuation case laws Before 1983 Delaware Block method (DBM) A mechanical combination of three approaches net asset, market and earning Step I: determine the value under three approaches. Step II: assign a percentage weight to the values derived in step I considering nature of the business. Step III: calculate the weighted average of the three valuations -this is the fair value or appraised value of the business.

37 Valuation case laws After 1983 Weinberger Judicial birth of DCF & demise of DBM more liberal approach must include proof of value by any technique or methods that are generally considered acceptable to financial community Did not prohibits DBM but allowed other methods

38 Lawson Wheaton Fair value must take fairness & equity Minority discount should not be applied for fair value in case of dissenting stockholders

39 Valuation case laws India 1.Mahadev Jalan, wealth tax, 1972 (SC) Break-up value for going concern is nor correct. Court laid down principles of valuation 2.Kusumben Mahadevia, Gift Tax 1979(SC) Reinforced principles laid down in the Mahadev Jalan

40 Valuation case laws India 3.Bharat Hari Singhania, wealth tax, 1994 (SC) Court recognised practical difficulties in application of principles of Mahadev Jalan 4.HLL, Companies Act 1994(SC) All or combination of methods can be applied for fair value

41 Valuation case laws India 5.Miheer Mafat Lal, Companies Act, 1996 (SC) Fair exchange ratio based on manageable profit method, net worth or break up method and market value accepted 6.Mrs Renuka Datla, Companies Act 2003(SC) DCF is acceptable Combination of methods accepted Intrinsic value cannot include control premium

42 Valuation Myths Valuation is objective Valuation is a science Valuation gives precise number A single valuation serves more than one purpose A complex financial model gives better valuation Growth in earning increases value Valuation is worthless as it involves lot of assumptions All valuation approaches and methods apply in all situations There is single definition of value

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