VALUATIONS OF SHARES/BUSINESS

VALUATIONS OF SHARES/BUSINESS

BACKGROUND

When a Business or Shares are transferred from one party to another, it becomes very important for both buyer as well as seller to know what is the worth of that particular asset which is being transferred. The process which is undertaken to know the worth is nothing but "Valuation". India has witnessed huge increase in share transfers as well as Business transfers in the recent past. Such transactions are likely to increase many fold in near future.

It is popularly said that "Price is what you pay and "Value" is what you get. "Value" refers to the worth of an asset, whereas "Price" is the result of a negotiation process between a willing but not an overeager buyer and a willing but not an overeager seller. In simple terms, valuation is a process of determining value of a company or an asset. Valuation is an art and not exact science. What the buyer thinks is whether the product is "worth the Price" he has paid. This "worth" itself is the value of the product.

Depending on the structure of the transaction, the management may want to value the entire Business or a component of a business – such as division, a brand, distribution network, etc.

The importance of intangible assets such as brands, patents, intellectual property rights, human resources, etc. is increasing and the valuation of such assets is becoming a more common phenomenon.

Shares of a Company/Business are valued under the following circumstances: :

1. Initial Public Offer (IPO)

2. Determination of share exchange ratio for Merger/ Demerger

3. Purchase/Sale of Equity stake by joint Venture partners

4. Purchase/Sale of Business

5. Corporate Restructuring

6. Family Separation

7. Liquidation

8. Disinvestment by Government

9. To comply with the requirements of Accounting Standards issued by the ICAI

10. Determining the Portfolio Value of investments

11. To comply with certain statutory requirements eg transfer pricing, Reserve Bank of India.

VALUATION METHODOLOGIES

There are many methodologies that a valuer may use/ consider to value the Shares of a Company/Business. Though different values are arrived under various methods, it is necessary for a valuer to arrive at a fair value for the company. In practice, the valuer normally, uses several methodologies of valuation, and arrives at a fair price for the entire business.

The Methodologies of Valuation also depend on the purpose of the valuation. If the Valuation is for the purpose of liquidation, the valuer would want to use the Realisable Value of the Net Assets of the Company and not the Earnings Capacity since; in this case the Company will not exist and the shareholders will be left with the Net Assets. Similarly, during a Merger, the valuer would want to value the companies involved in a similar manner to arrive at a relative value.

Generally accepted valuation methods are as follows:

1. Net Asset Method

2. Earnings Capitalisation Method

3. Yield Method

4. Market Price Method

5. Discounted Cash Flow Method

Each method proceeds on different fundamental assumptions, which have greater or lesser relevance, and at times even no relevance to a given situation. Thus, the methods to be adopted for a particular valuation must be judiciously chosen.

NET ASSET VALUE ("NAV") METHOD

The Net Assets Method represents the value of the business with reference to the asset base of the entity and the attached liabilities on the valuation date.

The Net Assets Value can be calculated in two different methods, viz.:

1. At Book Value

While valuing the Shares/Business of a Company, the valuer takes into consideration the last audited financial statements and works out the net asset value. This method would however only give the historical cost of the assets and may not be indicative of the true worth of the assets in terms of income generating potential. Also, in case of businesses which are not capital intensive viz. service sector companies or trading companies this method may not be relevant. The shortcomings of this method may be partly overcome by applying the Price to Book multiple of a listed company to derive market price of a business with given underlying value of assets. Also, self-generated intangible assets viz., brands, knowhows, patents, etc. owned by an enterprise may be appropriately recognised.

2. At Intrinsic Value

At times, when a transaction is in the nature of transfer of asset from one entity to another, or when the intrinsic value of the assets is easily available, the valuer would like to consider the intrinsic value of the underlying assets. The intrinsic value of assets is worked out by considering current market/replacement value of the assets. At times even remainder replacement value is also considered. In such a case however all the notional costs attached to such arrangement should also be considered.

Some of the common adjustments that the valuer takes into account while valuing the Shares of a company/Business are the Contingent Liabilities, Appreciation/Depreciation in the Value of Investments, Surplus assets, etc. In case of a revaluation of assets whether operating or surplus the effect of tax outgo in the event of transfer of the assets should also be considered. However, the position of outgo will also depend on the availability of set off of any loss against such hypothetical transfer.

EARNINGS CAPITALISATION METHOD

This method is used while valuing a going concern with a good profitability history. It involves determining the future maintainable earning level of the entity from its normal operations. It is essential for the valuer to understand the business of the entity and take into account the normal business profits. Non recurring/extraordinary expenses or incomes are to be removed. Eg a one time Voluntary Retirement Scheme (VRS) expense borne by the entity or an award won by the concern in monetary terms. It is important to remove all non-recurring business expenses and incomes as the valuer is calculating the future maintainable profits of the entity with normal operations. The valuer must give optimal weights to each financial year and even discount the future profits (if considered) for inflation.

This maintainable profit, considered on a post tax basis, is then capitalised at a rate, which in the opinion of the valuer, combines an adequate expectation of reward from enterprise and risk, to arrive at the business value.

Such factor may also be taken from the Market data available for comparable businesses, which reflects the fair expectation of the price by the market for the given earnings of the business.

The selection of the Capitalisation rate, inverse of the Price Earning Multiple, is a judgement of the valuer taking into account strengths and weaknesses of the company as well as market situations prevailing at the time of valuation. It would be essential for the valuer to know the approximate Price Earning Multiple of other firms in the same business and market advantages of the concern to give it a fair multiple.

Value of assets which do not contribute to the operating profit of the business need to be added to the earnings capitalisation value.

YIELD METHOD

Under Yield Method the value is calculated by considering the return on capital employed. This method is applied when the company has established past track record. This method in recent times is used very rarely due to certain drawbacks. This method fails to capture the future capital expenditure or working capital needs of the business.

The shift is towards usage of Discounted Cash Flow method in view of its superiority over other traditional earnings related methods.

MARKET PRICE METHOD

This method evaluates the value on the basis of prices quoted on the stock exchange. Average of quoted price is considered as indicative of the value perception of the company by investors operating under free market conditions.

The average for such Market Prices could be taken on a Simple or Weighted Average method taking into consideration the value and the volumes of the transactions taken place on the stock exchange.

Since the Secondary Equity Market is not only a reflection of the fair value of the concern, but also of other market information it is important for a valuer to know the perception of the market prevailing during the span of time for which he evaluates the price of the share.

At times, the valuer may also want to ignore this value, if according to the valuer, the market price is not a fair reflection of the company’s underlying asset or profitability status.

DISCOUNTED CASH FLOW (DCF) METHOD

In today’s market, it is essential for valuers to not only take into consideration the past profits of the company, but also look at its future profitability. With the increase of the knowledge sector, where the asset base of the company is much smaller than its future profitability, this method has become very popular. Recent changes in FEMA Regulations have also accepted use of DCF method for regulating the consideration for transfer of shares between a Resident and Non-Resident.

The DCF method values the business by discounting its free cash flows for the explicit forecast period and the perpetuity value thereafter. The free cash flows represent the cash available for distribution to both the owners and the creditors of the business.

The perpetuity value of the entity is calculated to fully capture the growth capacity of the entity to infinity, after the explicit period. It is important for the valuer to take into consideration the past growth rate of the concern as well as the future projections for the explicit period, while determining the perpetuity growth rate.

The free cash flows and perpetuity are discounted by a Weighted Average Cost of Capital (WACC). WACC is an appropriate rate of discount to calculate the present value of the cash flows as it considers equity-business risk and the debt-equity ratio of the company.

The Cost of Equity is worked out by taking into consideration the risk-free rate of return and adjusting the same for the equity risk premium and the Beta factor. The risk free rate of return is taken based on the current return on Government Treasury Bills. The Beta factor indicates the sensitivity of the business to external factors.

On the other hand, net of tax long-term cost of debt is taken after considering the existing cost for the debt raised by the entity. The Debt-Equity ratio is applied and a WACC can be calculated in a manner shown by the formula below:

After discounting the future cash flows and the perpetuity value, the present value calculated is a fair indicator of the value of the business.

CONCLUSION

In practice, as mentioned earlier, the valuer may consider one and or some of the above methods or may be some additional methods to arrive at a fair value of the business, giving adequate weightage to the foregoing methods. A judicial recognition to the weighted average of the Net Assets method, the Earning Capitalisation Method and the Market Price Method is found in the decision of the Supreme Court in Hindustan Lever Employees’ Union vs. 1-1LL & Others (1995) 83 Company Cases 30. However it may be relevant for Merger Valuations only.

Besides, at times, the valuation arrived at as per above methods may be enhanced by a premium (say for acquiring controlling interest in a company) or may be discounted (say for lack of liquidity in case of unquoted shares).