Art or Science? Issues and Concepts
“Everything that can be counted does not necessarily count; everything that counts cannot necessarily be counted” – Albert Einstein
BEYOND a doubt, valuation of a business is extremely intriguing and by far the most subjective domain, where the valuer/investor is trying to figure out what the business is worth, which often largely depends on “everything that counts but cannot necessarily be counted easily”. One needs to understand that the accounting numbers are just the beginning, and not the end in a business valuation exercise. Thus, valuation can be more of an art than a science.
Value versus Price
“Value” and “Price” are two terms, which are often used interchangeably, whereas the two are rather different and can be best described as follows in the words of Warren Buffet. The fundamental difference between price and value is “Price” of a business may fluctuate in a relatively small period of time depending on emotions (best described as greed or fear representing optimism or pessimism in the minds of buyers and/or sellers) whereas “Value”, being more of a rational concept, tries to determine “what the business is worth”, irrespective of the price at which it is being offered/bought. Thus, value is defined as follows:
The value of an asset is the price at which an exchange between a willing buyer and willing seller can take place, on an arms’ length basis, each having access to all pertinent information, as at the valuation date, and neither being forced to buy or to sell.
Accordingly, a typical valuation exercise is carried out on following premises:
- Usually simulates the interaction between a “willing buyer” and a “willing seller” in an arm’s length transaction;
- Assumes all relevant information is available;
- Assumes equal bargaining strengths;
- Generally, does not consider a “special purchaser”;
- Usually, is on an “as is where is” basis
Need to Determine the Value of the Business
Set out below are some of the key drivers/ circumstances (amongst others) where the need for a valuation may arise:
- Succession planning;
- Acquisition of a business;
- Realisation of capital (sale of the company);
- Shareholder entry or exit;
- Venture capital investment (expansion);
- Initial Public Offer (IPO);
- Taxation; or
- Venture capital investment (expansion);
- Just to assess “What am I worth”?
Methods of valuation
The following are the methods which are used for valuation of businesses:
1. Net Assets Basis
This method is used when the company cannot continue as a going concern. The formula used to derive the value is:
Value = Fair value of assets minus liabilities
2. Quoted Market/Comparable data basis
This method is used when there are listed companies available that are similar to the entity being valued. Take the ratio of a comparable listed company, modify it based on the differences with the company being valued (e.g. lack of marketability, size discount, etc.) and then multiply by the respective underlying fundamental [Earning Per Share (EPS), cash flow per share, book value per share, etc.]
3. Capitalised Earnings Basis
This method is used when the perspective is that of a controlling stakeholder and the company is stable and profit making. Accordingly,
Value = Expected earnings during coming years / Capitalisation rate
4. Dividend Yield Basis
This method is used when the perspective is that of a minority shareholder and the company has a history of paying dividends.
Value = Dividends expected during residual life of business / (Required rate of return – long term growth rate in dividends)
5. Discounted Cash Flow (DCF)
Most commonly used when the perspective is that of a controlling stakeholder and the company has stable and positive free cash flows (can be used instead of capitalised earnings method when the company is not making a profit every year). Under the DCF technique, the value of a company is a function of expected future cash flows attributable to the company appropriately adjusted by the discount rate, to arrive at its present value for an explicit period, plus the terminal value. The cash flows considered must be expected cash flows rather than ‘target’ cash flows. The discount rate reflects both the time value of money and the inherent risk associated with the cash flow stream. Generally, one needs to compute the cash flows ad infinitum in order to value them. Since this is not feasible, one considers the cash flows for a specified number of years until they become relatively stable, and then develop a measure of value at the end of the period, which is the terminal value. The terminal value is then discounted back to the present.
In the first 2 methods, the data required for valuation can be obtained largely through the audited/ unaudited financial statements and information available in the public domain.
In methods 3, 4 and 5, the numerator (i.e. expected earnings/cash flows/dividends) are estimated by the entity’s management and reviewed by the valuer, whereas the denominator (i.e. capitalization rate, required rate of return and long term growth rates) is worked out by the valuer using models, such as the Capital Asset Pricing Model (CAPM), after considering various factors such as risk free rates, market risk premiums, lack of marketability discounts, gearing of the business and beta factor (which measures the risk or volatility for the business/its industry as compared with the stock market).
Goodwill – The Synergy effect
“What is Synergy? Simply defined, it means that the whole is greater than sum of its parts.” – Stephen Covey in his best-selling book “7 Habits of Highly Effective People”
Assessing goodwill is an integral part of the business valuation exercise. The value of any profit-making business can be divided into the following components:
1. Identifiable tangible and intangible assets – Liabilities = Net Assets. These are the assets which can be easily identified and are reflected in the entity’s financial statements.
2. various off-balance sheetIntangible assets such as customer base, trademarks, patents, non-compete clauses, favorable long-term contracts, skilled labour force, etc. These assets though identifiable are often not recorded in the entity’s financial statements and are considered during a valuation exercise.
3. Goodwill is a residual part of the equation and represents the synergy of the above two components which makes “the whole (i.e. value), greater than the sum of its parts”
Organizations that are consistently making profits higher than normal rate of returns command a premium in the form of goodwill. However, goodwill cannot be traced to an identifiable source and careful consideration should be given in a valuation exercise about how much premium one should pay over and above the identifiable tangible and intangible assets. This is the key to avoid taking risks, far beyond what would be dictated by rational business judgment.
In countries such as Oman where corporate income tax is applicable, sale/transfer of businesses, divisions, investments in private companies, capital/intangible assets, etc., are required by law to be on an arm’s length, fair market value basis. Further, these sales/transfers are closely scrutinized by the income tax authorities if they are between related parties. Certain sales/transfers are occasionally undertaken at cost/net book value due to a corporate restructuring, and are questioned by taxation authorities at the time of the income tax assessment. The onus is on the tax payer to prove that all sales/transfers are on an arm’s length fair market value basis. In certain cases, the tax department considers the excess of derived fair market value over the actual sale/transfer price as the tax payers’ income, resulting in a substantial additional tax liability during tax assessments. It is therefore advisable that an independent business valuation be obtained to support management’s contention that the sales/transfers are on an arm’s length basis.
Valuation is more of an art than a science. Experience has shown that no two businesses/ situations are likely to be the same, and the valuer will encounter peculiar and diferent scenarios that need to be assessed in each valuation. Methodologies are only a means to an end and these have to be selected depending on the circumstances, and most importantly, there is unlikely to be a single “right answer” as, in the final analysis, the valuation is only an opinion.
(This article is compiled by Mr. Amit C. Athalye, a Director in PKF L.L.C., the PKF member firm in the Sultanate of Oman.)