Business Valuation. Needs & Techniques. Submitted by CA Hozefa Natalwala

Transcription

1 Business Valuation Needs & Techniques Submitted by CA Hozefa Natalwala

2 A Brief note: The basic purpose of this research work is to study the purposes that create the need of valuation for Small businesses and to relate the appropriate technique/s which can help in making a better decision for that particular purpose. Research involves basic attitudes and way of thinking. References are taken from many books, articles and other materials and also at many places the valuable write ups of some authors or writers are sited in order to provide the basis to the intended users of this research work. Value of business is estimation only and being which it is subjective in nature. Debates are going on and different views are prevailing regarding applicability of specific techniques, as well as on validity and correctness of the formulas used for estimation. These all are making the reliability on specific technique questionable. The objective is not to go through the roots that how a specific technique is emerged and on which financial or economic theory it is based. A two thousand pager book might not be enough space to cover all the issues related to estimation of business value. The research into valuation models and metrics in finance is surprisingly spotty, with some aspects of valuation being deeply analyzed and others, such as how best to estimate cash flows and reconciling different versions of models, not receiving the attention that they deserve. To write about valuation is a humbling task. No matter how ambitious and dedicated an author may be, eventually he or she is forced to acknowledge that even a lifetime of work would leave some aspects of the subject untouched. It must be noted that the research work has been seriously limited by the lack of access to literature on business valuation for small and medium sized businesses in India. Being an evolving field of finance and accountancy, there are very little developed doctrines relating to the application of the specific method amongst various valuation methods. I have relied also on the accessible materials like relevant notes available on web as well as authorative and unauthorative views of valuation experts and consultants. I was also limited by finances as this research study was not funded in the way and to the extent to which I could have carried out the work. I wanted to study valuation needs for MSMEs in totality but for financial support it is confined to study only the literature views and basics of MSME needs of valuation. While all reasonable attempts have been made to ensure that the information contained herein is accurate, I accept no responsibility or liability whatsoever for any errors or omissions it may contain, whether caused by negligence or otherwise, or for any losses, however caused, sustained by any person relying upon it. 1

3 Methodology: Research methodology refers to the procedural framework within which the research is conducted. I had started with the compilation of literatures and materials available on valuation and specifically for small business units. In India, valuation of business, itself being a emerging filed and also not being graced by the statue, very small amount of material was found and I have more to rely on the US based books and materials. Valuation of business requires major consideration for financial and economic theories and of course, the business characteristics and valuation fundaments are indifferent to the region differentiation. The purpose was to study the valuation reports and to analyze the preferred approaches of the value analysts while appraising a business. It also proposes to present the case analysis at the subsequent stage. But the ratio of response, received from concerned entities, was near to zero. The empirical data is not available for needs of valuation in MSME sector. Also there is no private of public organization offering the transactional data relevant for MSME valuation. So, the views shown under this work are based on study of literature and opinion of experts, obtained while conducting the study. And so the approach of the study is descriptive. The write up begins with describing the valuation in general and then to define and relating the value, purpose and need in the context of valuation. The objective behind is to show the conventional relationship of purpose and valuation need. The basic terms of valuation like types of valuation reports, premise of valuation, importance of date of valuation, standard of valuation and approaches are described next. The views expressed and definitions issued by various authorities, researchers and respected authors are also mentioned to describe the prevailing debates. The importance of standards of value in valuing a MSME business is emphasized. How the appraisers strive in selecting the appropriate technique/s and determining the conclusive value is attempted to uncover. This is just an endeavor to match the valuation technique with specific purpose on logical basis considering the need behind each purpose. 3

4 Index BUSINESS VALUATION Need, Purpose and narrating sequence of write up Brief about Business Value? What is Valuation? o Purposes & Needs (definition) o Types of reports o Premise of value o Date o Standards of value o Approaches to valuation Detailing approaches to valuation Valuation purpose Vs. Standards of value (with table) and relevant technique/s to value a business (with table) Conclusion Useful data Valuation Procedures Data collection procedure Illustrative list of assumptions, limitations and disclaimers Contents of exhaustive valuation report International glossary of valuation terms Multipliers suggested by author Mr. Wilbur M. Yegge for application with Excess earnings capitalization Method Table showing purpose Vs. recommended techniques Time vs. approach, asset vs. approach, as mentioned by Prof. Aswath damodaran References 4

5 Character. Be more concerned with your character than with your reputation. Your character is what you really are while your reputation is merely what others think you are. - John Wooden BUSINESS VALUATION In the wake of economic liberalization, companies are relying more on the capital market, acquisitions and 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 goal of such an appraisal is essentially to estimate a fair market value of a company. So, at the outset, we must clarify what is meant by fair market value and what is meant by a company. The most widely accepted definition of fair market value was laid down by the Internal Revenue Service (IRS) of the US. It defined fair market value as 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 relevant facts. When the asset being appraised is a company, the property the buyer and seller are trading consists of the claims of all the investors of the company. This includes outstanding equity shares, preference shares, debentures and loans. But note that, Fair market value (FMV) is not designed with any particular individual in mind, nor the real transaction for that matter. FMV is a hypothetical value for the model transaction. The governing conditions in this ideal concept are full knowledge and freedom to act. But in reality, these ideal conditions are rarely present. Emotional and subjective elements often override rational considerations, and full knowledge is something rarely attained by the arm s-length potential buyer who previously has not been involved in the business. The family-owned and/or closely held business is the more difficult tiger to tame. Publicly traded companies seek to show bottom-line profit to satisfy public owners, while closely held enterprises seek only to satisfy private interests, before profit falls to the bottom line. Thus the documents by which the psychology of ownerships are measured send out different messages in each. Since ownership and management of closely held enterprises are often one and the same, financial records are massaged for tax avoidance. In addition, private ownerships can, and sometimes do, play the game of chance by stretching the gray areas in law beyond the limits. All of this leads to difficult interpretations of what really goes on in these companies. Thus, the necessary conclusion is that few buy/sell transactions involving closely held small businesses are done at so-called fair market values. (Summarized from comments of T. S. Tony Leung, C.P.A.) 5

6 In 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 value of these intangible factors is generated by collective usage of assets and joint operations of several business streams. Intangible business value is a highly judgmental aspect of business valuation and requires conscientious attention. IRS (US) roughly defines intangible value, or goodwill, as that amount paid for a business in excess of the market value of hard assets. Ágnes Horváth * presents the value inequalities as follows showing the general relation between values of business derived by different perceptions. The fair value of business is something more than the fair assets value and this added value is towards its intangible strength which may or may not be quantitatively measurable. Fair value of all company assets Replacement value of recorded assets (Balance sheet) Book value Added value Source: Juhász (2004) Figure showing differences between book value and market value of a business enterprise * from Non-Quantitative Measures In Company Evaluation by Ágnes Horváth, European Integration Studies, Miskolc, Volume 4 (2005) pp

7 However, Valuation, by its very nature, contains many controversial issues. The valuation of business enterprises and business assets is well-founded in academic publications and empirical studies. Even a 2000 pager book may not be an enough space to cover all the issues related with valuation. The use of public company information has provided the foundation for the analysis of business 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. It is eloquently stated by Gerald Loeb, the author of The Battle for Investment Survival, who wrote, There is no such thing as a final answer to security values. A dozen experts will arrive at 12 different conclusions. It often happens that a few moments later each would alter his verdict if given a chance to reconsider because of a changed condition. Market values are fixed only in part by balance sheets and income statements; much more by hopes and fears of humanity; by greed, ambition, acts of God, invention, financial stress and strain, weather, discovery, fashion and numberless other causes impossible to be listed without omission". To assume there is only one correct estimate of value is a mistake, and right is a matter of opinion. 7

8 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. It signifies the worth. It expresses the worth which may be more or less compared to some other or even it may be nothing or negative. 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 time point (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 tomorrow s cash flow, not yesterday s or even today s. Value, like beauty, is in the eyes of beholder. While the value is an actual worth or the intended user/s belief about the worth of specific item, Price is a number determined by market forces and personal beliefs. 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 don t necessarily have to equal value. Another source for definitions of value may be found in contractual agreements of the parties. Parties to a contract are free to bargain for their own definition of value to meet their special situation. For example, Parties to buy-sell agreements often determine value by specific terms and conditions in contracts, which may or may not conform to any accepted definition of value in any general legal context. Some of these contracts may provide that the value of a business is defined by its book value, or by a specified multiple of earnings. Other contracts may indicate that the value of the business is defined by earnings before interest, taxes, depreciation, and amortization. Contractual measures of value are limited only by the creativity of the parties to the contract. Similarly, Insurance contracts provide for specific values as a basis for their coverage. The insurance contract may limit coverage to the actual cash value of an insured item, less its accumulated depreciation. If so, that contract provides the definition of value. Business interruption insurance or loss of profit agreements provide specific definitions of just what values they will cover if a business is interrupted due to various insured causes. 8

9 Mr. David laro and Mr. Shannon Pratt in their co-authored book Business valuation and taxes, procedure, law and perspective (John wiley & Sons, Inc) narrates VALUE in a very explicable words; that Like beauty, value is in the eye of the beholder. What is value to one may be inconsequential to another. In this regard, value is mere subjective perception. We use standard of value synonymously with definition of value. Stated concisely, business value must be measured and defined by a definition of value that is relevant, predictable, and reliable. Recognizing that the same business interest may have different values if more than one standard of value is used,. Consider the various definitions of value throughout the life cycle of a diamond. In one sense, the diamond is nothing more than carbon, an inert mineral found in the earth s layers. In this regard, the diamond, except for some limited commercial uses, has little inherent value. If we define the diamond s value based on its raw mineral content, we have an object of fairly low value. We cannot eat it, drive it to work, or use it to take shelter when it rains; the diamond has a value equal to the sum of its carbon content. Change the definition of value. Instead of measuring the diamond s value strictly by the economic value of carbon, we instead define the diamond s value by a standard that measures carats, clarity, cut, and color. We also value the diamond as a perceived commodity, a fiction due in large part to the millions of dollars poured into advertisements convincing the public that the diamond has special economic value as an object of beauty. Except for some limited enhancement created by cutting and polishing, the diamond is still just inert carbon; if we continue to value the diamond by its pure mineral status, it has limited economic value. When we value the diamond by a standard that puts a premium on beauty and permanence, however, we increase its value considerably. The emphasis of value has changed, and so has the value to the average consumer. Now let us suppose that our diamond is purchased from a retail store for $1,000 and given to a young woman as an engagement gift. The diamond has a transaction value equal to its purchase price, but, in the hands of the woman, the diamond now takes on a new value measured by her sentiment; she would likely refuse an offer from someone to buy her diamond, even if the amount offered were significantly more than its original purchase price. Assume further that the diamond is insured and, regrettably, is stolen. The insurance policy provides that the diamond is insured for its actual cash value. Alternatively, some insurance policies may replace the diamond at today s cost. Either way, the diamond s value is determined by the terms of a contract. Finally, suppose that the diamond ends up in an estate* that must value it for federal estate tax purposes. Fair market value is now the standard, as determined by Treasury regulations. As this example illustrates, there are a variety of different standards of value that can be used, ranging from intrinsic value to contractual value. Similarly, business valuation is also subject to varying standards of valuation. *estate here means a property that a person left after his/her demise for the usage by heirs. So, 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 9

10 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. Purpose of Valuation Let us first go through how the term purpose is defined by various wesites: Purpose is the cognitive awareness in cause and effect linking for achieving a goal in a given system, whether human or machine. Its most general sense is the anticipated result which guides decision making in choosing appropriate actions within a range of strategies in the process (a conceptual scheme) based on varying degrees of ambiguity about the knowledge that creates the contextualisation for the action. Purpose serves to change the state of conditions in a given environment, usually to one with a perceived better set of conditions or parameters from the previous state. This change is the motivation that serves the locus of control and goal orientation. purpose (plural purposes) 1. An object to be reached; a target; an aim; a goal. 2. A result that is desired; an intention. 3. The act of intending to do something; resolution; determination. 4. The subject of discourse; the point at issue. 5. The reason for which something is done, or the reason it is done in a particular way. 1 a: something set up as an object or end to be attained : INTENTION b: RESOLUTION, DETERMINATION 2: a subject under discussion or an action in course of execution something one intends to get or do; intention; aim resolution; determination the object for which something exists or is done; end in view To summarize the definition of purpose, it can be said as an object or an end result to achieve and it involves several decisions to make for achievement of that objective. This requirement of making decision creates need of considering the facts, situations and possibilities linked with achievement or non-achievement of that specific objective. 10

11 Businesses or their assets are valued for a variety of reasons. Some of the most noticeable purposes for valuation of MSME business are demonstrated below: Buy/sell agreements Addition or retirement of partner, dissolution of partnership, succession planning Ownership disputes Sharing on family separations and related family disputes Mergers and acquisitions Allocation of purchase price Recapitalizations / Restructuring the business / Raising funds Business planning and value added management Investment decisions / divestitures IPO Financial reporting Wealth planning / tax planning Will planning Goodwill impairment Litigation issues involving lost profits or economic damages While going for some business deal or to make decision on any of the purposes shown above, giving due consideration to the value of business may be an inevitable preference. Therefore, the purpose creates a need for valuation. Need Definition of need is taken from some different web sites and produced below: To have an absolute requirement for. To want strongly; to feel that one must have something. To be obliged or required to A condition or situation in which something is required or wanted: 2. Something required or wanted; a requisite 3. Necessity; obligation 4. A condition of poverty or misfortune 1: necessary duty : OBLIGATION 2 a: a lack of something requisite, desirable, or useful b: a physiological or psychological requirement for the well-being of an organism 3: a condition requiring supply or relief 4: lack of the means of subsistence : POVERTY 11

12 So, the need applicable to us is a requirement or sometimes a necessity (though considered as such or not) which helps to take decision for specific purpose. In other words, Value a business is a NEED for specific PURPOSE requiring a decision to make. Before we go to determine a value of MSME business, for specific purpose, let us go through some basic terms associated with Business valuation. 12

13 TYPES OF REPORTS Based on the purpose and requirement of client, the report normally is prepared as: Comprehensive report Limited Abbreviated report Fairness opinion Review of an Appraisal Comprehensive report: A report which requires analysis of Business dataqualitative & Quantitative, review of Industry/sector & economy, consideration of various appraisal techniques and based on all these to estimate the VALUE by applying relevant technique/s. Limited Abbreviated report: A report which requires specific consideration only as per need of person requiring the APPRAISAL. Like- owner may require calculating the firm value based on his forecast by application of any specific technique (like DCF) only. - Or for limited purpose of finding the tangible worth of Company only. Fairness opinion: A report which requires the opinion of Appraiser on fairness of specific value or range of value quoted by a person requiring the APPRAISAL. The opinion does not express a specific value; rather it states whether or not appraiser feels the value offered is fair or not. Review of an Appraisal: A report to review and comment on valuation derived/ obtained by a person requiring an APPRAISAL. It is generally in form of letter describing the review and critiques. As per AICPA : statement on standards for valuation services; the valuation analyst can be engaged for any of two assignment and sought for any or more of following three types of reports: Valuation engagement Detailed report: This type of report is structured to provide sufficient information to permit intended users to understand the data, reasoning and analyses underlying the valuation analyst s conclusion value. Summary report: This type of is structured to provide an abridged version of the information that would be provided in a detailed report, and therefore, need not contain the same level of detail as a detailed report. Calculation engagement Calculation report: This report shows the calculations used by the value analyst and any assumptions and limiting conditions applicable to engagement. 13

14 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 valuator s 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 or her estimation of value. Generally, the valuation analyst should consider only circumstances existing at the valuation date and events occurring up to the valuation date. An event that could affect the value may occur subsequent to the valuation date; such an occurrence is referred to as a subsequent event. Subsequent events are indicative of conditions that were not known or knowable at the valuation date, including conditions that arose subsequent to the valuation date. The valuation would not be updated to reflect those events or conditions. Moreover, the valuation report would typically not include a discussion of those events or conditions because a valuation is performed as of a point in time the valuation date and the events described in this subparagraph, occurring subsequent to that date, are not relevant to the value determined as of that date. In situations in which a valuation is meaningful to the intended user beyond the valuation date, the events may be of such nature and significance as to warrant disclosure (at the option of the valuation analyst) in a separate section of the report in order to keep users informed. Such disclosure should clearly indicate that information regarding the events is provided for informational purposes only and does not affect the determination of value as of the specified valuation date 14

15 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 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. 15

16 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. There are even different types of measurement attributes in financial reporting. These include historical cost, (e.g. cash and liabilities in general), modified (i.e. depreciated) historical cost (e.g. property, plant and equipment and receivables), fair values (derivatives and asset revaluations), and entity specific value (impaired property, plant and equipment). I have divided the standards of valuation 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. 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. Fair Market Value (FMV) or Fair Value Many authors define fair market Value and Fair vale as different standards of value but here, I have considered it as a fair value representing the appropriate worth of business under the prevailing conditions and facts attached to it. 16

17 In US, Internal Revenue Service Revenue Ruling defines fair market value as 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 relevant facts. Fair market value assumes a hypothetical willing buyer and a hypothetical willing seller. This is a contrast to investment value which identifies a particular buyer or seller and the attributes that buyer or seller brings to a transaction. Fair market value also assumes an arm s-length deal and that the buyer and seller are able and willing. See the addendum at the end of this chapter for the complete International Glossary. Its definition of fair market value reads: 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, where neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. 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. IFRS 3, Business Combinations prescribes a number of alternatives that can be used as fair value which includes estimated value, present value, current replacement cost, depreciated replacement cost, selling price less the costs of disposal plus a reasonable profit allowance etc. International Accounting standards (IAS / IFRS) currently do not have a single hierarchy that applies to all fair value measures. Instead individual standards indicate preferences for certain inputs and measures of fair value over others and lacks consistency. As per Indian Accounting Standards, the most often used definition has the exact wordings that exist in IAS / IFRS as of now. AS 11: Accounting for the effects of changes in Foreign Exchange Rates, AS 19 on Leases, AS 20: Earnings per share & AS 26, Intangible Assets define Fair Value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm s length transaction. The same definition is used with the additional wordings of Under appropriate circumstances, market value or net realizable value provides an evidence of fair value in AS 13: Accounting for Investments. However, in AS 14: Accounting for Amalgamations the wording Or a liability settled is missing from the regular definition. So, Indian AS does not list a uniform fair value definition and measurement criteria. FASB (Financial Accounting Standard Board) decided to issue a standard on fair value measurement, which would provide a single set of rules to be applied whenever other standards require the use of fair value. This was issued as an exposure draft in June 2004, and published in final form in September 2006 as the Statement of Financial Accounting Standard (SFAS) No.157 on Fair Value 17

18 Measurements (FAS 157). This Statement defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. ICAI is considering convergence to IFRS. A full convergence would mean adoption of IFRS in its full form. In any case AS are formulated on the basis of IAS/IFRS principles. Therefore, one could draw the conclusion that FAS 157 would be relevant to the Indian accounting professionals. FAS 157 defines fair value as Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the definition focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price). This Statement emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, 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. Contrast this with the present definition under IAS / IFRS and Indian Accounting Standards Fair Value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arms length transaction. The words exchanged in this definition can either be an exit price or an entry price. FAS 157 specifically defines price to be an exit price. Under FAS 157, the fair value measurement assumes the asset s highest and best use by the market participants. The company s intended use of an asset is not necessarily indicative of the highest and best use as determined by a market participant; therefore, the fair value measure is not an entity-specific measure that reflects only the company s expectations for the asset. For example, a company s management may intend to operate a property as a site for residential house, while market participants would consider a site for manufacturing as the highest and best use of the property. In that case, the property s fair value measure should be based on the property s use as a site for manufacturing. 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 In-exchange (when maximum value to market participants principally on a standalone basis). FAS 157 specifically requires that the valuation techniques used to measure fair value should maximize the use of observable inputs and minimize the use of unobservable inputs. 18

19 Here in this statement, inputs refer broadly to the assumptions that market participants would use in pricing the asset or liability, including assumptions about risk, for example, the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model) and/or the risk inherent in the inputs to the valuation technique. Inputs may be observable or unobservable: a. Observable inputs are inputs that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the reporting entity. b. Unobservable inputs are inputs that reflect the reporting entity's own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. Unobservable inputs shall be developed based on the best information available in the circumstances, which might include the reporting entity s own data. In developing unobservable inputs, the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions. However, the reporting entity shall not ignore information about market participant assumptions that is reasonably available without undue cost and effort. Therefore, the reporting entity s own data used to develop unobservable inputs shall be adjusted if information is reasonably available without undue cost and effort that indicates that market participants would use different assumptions. The inputs used to measure fair value might fall in different levels of the fair value hierarchy. The level in the fair value hierarchy within which the fair value measurement in its entirety falls shall be determined based on the lowest level input that is significant to the fair value measurement in its entirety. Assessing the significance of a particular input to the fair value measurement in its entirety requires judgment, considering factors specific to the asset or liability. FAS 157 cite four instances that might indicate that the transaction price does not represent fair value. The said instances are helpful in determining the fair value at initial recognition, but not necessarily all-inclusive. The reporting entity should consider factors specific to the transaction and to the asset or the liability. The four instances when the transaction price might not represent the fair value of an asset or liability at initial recognition are: 1) The transaction is between related parties 2) The transaction occurs under duress or the seller is forced to accept the transaction price because of some urgency 3) The unit of account represented by the transaction price is different from the unit of account for the asset or the liability that is measured at fair value. (For e.g., say, the transaction price includes transaction costs) 4) The market in which the transaction occurs is different from the principal (or most advantageous) market in which the reporting entity would sell or otherwise dispose of the asset or transfer the liability. 19

20 A single definition of fair value, together with a framework for measuring fair value, should result in increased consistency and comparability in fair value measurements. 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. AICPA (American Institute of Certified Public Accountants), in its course Fundamentals of Business Valuation Part 1, defines intrinsic value as the Amount an investor considers to be the true or real worth of an item, based on an evaluation of available facts. It is sometimes called fundamental value. It is an analytical judgment of value based on perceived characteristics inherent in the investment (not characteristic peculiar to any one investor). So, intrinsic value is based on fundamental analyses of business. Under the intrinsic value method, future dividends are derived from earnings forecasted and then discounted to the present, thereby establishing a present value for the equity. For listed companies, if the shares are trading at a price lower than this calculation, it is a buy ; if the market price is higher than the intrinsic value; the share is a sell. The value of business can be determined by discounting the future cash flow considering business fundamentals like risk, expected rate of return, capital investment and the growth potentials. Intrinsic Value presents the actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value. Value investors use a variety of analytical techniques in order to estimate the intrinsic value of securities in hopes of finding investments where the true value of the investment exceeds its current market value. It is also sometimes presented by the net asset value, showing an excess of current market value of assets (including intangibles) over the current value of liabilities presents the actual net worth of the business and widely used while transacting the buy/ sell agreement for small businesses. The extrinsic value is based on the assumption that if comparable asset (or property) has fetched a certain price, then subject asset (or property) will realize a price something near to it, based on its own characteristics and situations. 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. 20

21 Under FAS 157, the Board concluded that quoted market prices provide the most reliable measure of fair value. Quoted market prices are easy to obtain and are reliable and verifiable. Those are used and relied upon regularly and are well understood by investors, creditors, and other users of financial information. 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 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 and hope pick up the worth of the business existing and potential profitability. 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 acquirer s 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. lowering risk 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 investor s own business. Its worth will then be magnified by this enhancement of value, which purely arises from investor s own strategy. The other bulking factor which may come into play is classic economy of scale. The investor may save on administrative functions, may gain greater buying power. 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. 21

22 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. 22

23 APPROACHES TO VALUATION Choosing the right model to use in valuation is as critical to arriving at a reasonable value as understanding how to use the model. In broadest possible terms, there are three approaches to value any asset, business or business interest: 1. The asset approach 2. The income approach 3. The market approach (Relative valuation approach) One other approach called, Option pricing OR contingent claim method is emerging as a better contender to value assets that have option like characteristics. There are some assets that cannot be valued with conventional valuation models because their value derives almost entirely from their option characteristics. For example, a biotechnology firm with a single promising patent for cancer drug wending its way through the approval process can not be easily valued using discount cash flow or relative valuation models. It is also used when we want to consider the option to delay making investments decisions or option to expand the business or to value a patent or an undeveloped natural resource reserve as an option. The value of an option is determined by six variables the current value of the underlying asset, the variance in this value, strike price, life of option, the risk less interest rate and the expected dividends on the assets. Real option is said to be embedded in a decision or an asset: - When there has to be a clearly defined underlying asset whose value changes over time in unpredictable ways. - The payoffs on this asset (real option) have to be contingent on and specified event occurring within a finite period. There are two types of real options: Growth options Flexibility options. Growth options give a firm the ability to increase its future business. Examples include research and development, patent or brand development, mergers and acquisitions, leasing or developing land, or most pertinent launching a technology initiative. Flexibility options, on the other hand, give a company the ability to change its plans in the future. Management can purchase the option to delay, expand, contract, switch uses, outsource or abandon projects. Several methodologies have been developed to value options. Of these, the binomial method provides an intuitive feel and insight into the determinants of option value. 23