Valuation – An Art or science?

In today’s dynamic world every organisation feels the need to know the worth of value of its assets, business or even the company.  Valuation in simple terms means the economic value or worth of a business, asset or company.

We often come across this question why do we need valuation?

Whether you are thinking of selling your business, buying a company, or searching for a way to better present your company to investors, it is important to know the actual value of your company. Moreover, valuation provides a baseline for future targets and a course for future.

This serves as a critical part of operating a business, and there are many methods of valuation that you can choose from. Thus business valuation is a general process of determining the economic value of a whole business or company unit. The goal is to determine a fair market value of the company or any business and there is no one certain way to calculate the ultimate price. Typically, it depends on various factors including industry, sectors, valuation methods and economic conditions.

Various Areas in which valuation is required :

• Valuation for Mergers, Acquisitions and Sales
• Valuation for Financing
• Pricing you Deal Right
• Valuation for Estate or Gifting
• Shareholders Dispute

 Regulatory Compliance or Voluntary Assessment :

We often come across another question as to who requires valuation? Whether it is a regulatory requirement or voluntary one?

Valuation can be voluntary value assessment or can be used for regulatory compliance, tax and financial reporting purpose in India under RBI, Income Tax, Companies Act, SEBI laws etc. Better Corporate Governance is also leading to requirement of independent Business Valuations.

Though the valuation of a listed company whose shares are actively traded on a nationwide stock exchange in India can be derived from its prevailing market price over a period of time, the valuation of an unlisted company and its shares is the real challenge.

Let us know the various Approaches through which valuation can be done.

Approaches to valuing a business :

There are majorly three business valuation approaches which are as follows:

• Income Approach – This applies to Going Concern.
• Market Approach – considers value to be related to other companies in a similar line of business
• Cost/Asset Approach – The asset theories consider a Liquidation approach.

Let us understand in depth about the approaches:

1.  Market Approach

Market Approach refers to the notion of arriving at the value of a company by comparing it to the market value of similar publicly listed companies. The methods most commonly used for the market business valuation approach are the Guideline Public Company Method, Gross Revenue Multiple Method, Merger and acquisition (M&A) method.

Guideline public company method : This technique considers the market price of comparable (or “guideline”) public company stocks. A pricing multiple is developed by dividing the comparable stock’s price by an economic variable (for example, net income or operating cash flow).

Merger and acquisition (M&A) method : Here, the expert calculates pricing multiples based on real-world transactions involving entire comparable companies or operating units that have been sold. These pricing multiples are then applied to the subject company’s economic variables (for example, net income or operating cash flow).

2. Income Approach:

When market data is hard to find then, the business valuation experts may turn to the Income Approach. This approach converts future expected economic benefits — generally, cash flow — into a present value.  As this approach bases value on the business’s ability to generate future economic benefits, it is generally best suited for established, profitable businesses. There are two major methods that fall under this category which are

• Capitalisation of Earning Method: This method is accomplished by finding the net present value (NPV) of expected future profits or cash flows and dividing them by the capitalization rate (cap rate). This method is most appropriate for companies with stable earnings or cash flow.
• Discounted Cash Flow Method: DCF analysis attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future. 

3. Cost Approach :

The cost approach also known as Asset approach derives value from the combined fair market value (FMV) of the business’s net assets i.e it focuses on a company’s net asset value (NAV), or the fair market value of its total assets minus its total liabilities, to determine what it would cost to recreate the business. This approach is particularly useful when valuing holding companies, asset-intensive companies and distressed entities that aren’t worth more than their net tangible value.

There are two methods under this approach :

• Book Value: In this method, it calculates value using the data in the company’s book. Its flaws include the failure to account for unrecorded intangibles and its reliance on historical costs, rather than current FMV.
• Adjusted Net Assets Method: The adjusted net asset method converts book values to FMV and accounts for all intangibles and liabilities (recorded and unrecorded)

Each method has its own advantage and disadvantage based on various factors from industry valuation norms to the current economic market and interest rates. In deciding the most appropriate method, we need to keep in mind that each business is different, and each would have a different way of having the valuation done.

Conclusion :

Valuation is a combination of both art and science. As the ‘art’ element of valuation involves various factors such as sales forecasts, economic outlook and capitalisation rate/ discount rate determination whereas science involves valuation approaches.

Moreover, valuation has lot to do with the mindset or the need of the person buying it.

In a layman words, with the recent outbreak of Covid-19 and restrictions imposed by government the sentiments for every aspect of our life has changed. Going back to pre-covid situation has created a lot of value.

This article is also published in Taxguru : https://taxguru.in/corporate-law/valuation-art-science.html

Author : Tanvi Pahwa