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A

Project Report
On
Business Valuation Methods and Techniques
Submitted by
Tamutgiri Shishir Vijaykumar
Under the guidance of
Vidula Adkar
Submitted to
Savitribai Phule Pune University
In the Partial fulfillment of the Requirement for the award of Degree of
Master of Business Administration (MBA)
Through
Vishwakarma Institute of Management
Pune
2014-15

Declaration
I, Tamutgiri Shishir Vijaykumar student of MBA II have undertaken a Dissertation
Project entitled Business Valuation Methods and Techniques as a part of academics of
the MBA Programme. The basic aim behind this is to get familiar with the corporate actions
like M&A and to get a knowledge about specified area.
This project report is written and submitted by me to the University of Pune, in partial
fulfillment of the requirement for the award of degree of Master of Business Administration
under the project guidance of Prof. Vidula Adkar in my original work and the conclusions
drawn therein are based on the material collected by myself.

Place: Pune
Date

Signature of Student

Table of Contents
Sr. No.

Chapters

Page No.

1.

Executive Summary

2.

Introduction

5-24

3.

Literature Review

25-26

4.

Objective of the Study

27

5.

Data Analysis & Interpretation

28-34

6.

Findings

35-37

7.

Conclusion

38

8.

References and Bibliography

39

CHAPTER I
EXECUTIVE SUMMARY
Business valuation is a process and a set of procedures used to estimate the economic
value of an owners interest in a business. Valuation is used by financial market participants
to determine the price they are willing to pay or receive to effect a sale of a business. In
addition to estimating the selling price of a business, the same valuation tools are often used
by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation,
allocate business purchase price among business assets, establish a formula for estimating the
value of partners' ownership interest for buy-sell agreements, and many other business and
legal purposes such as in shareholders deadlock, divorce litigation and estate contest. In some
cases, the court would appoint a forensic accountant as the joint expert doing the business
valuation.
Once the floor or lowest value of the business has been determined, the financial history of
the business is reviewed to determine if any goodwill or blue sky exits. If the business is
more profitable than the average business of its type, the owner has done something to create
these excess earnings and should be compensated for that extra effort. Information is
published regularly regarding profit as it relates to sales and assets.
Another method commonly used is the capitalization of earnings at the rate of return required
by the buyer. This capitalization of earnings yields a value for the business applicable to one
individual buyer. Some buyers require only a return equal to the cost of borrowing (after
owners compensation) while some buyers require more.
In addition to the information requested on the Business Valuation Documents Request
Datasheet, a buyer should provide

1. The amount of cash available for a down payment.


2. The amount of cash required for personal living expenses.
3. The most current personal income tax return.
Any changes in the operation of the business that the buyer will make and the dollar amount
of those changes.

Chapter II
INTRODUCTION
Conceptual Background Related to Variables
Business valuation is a process and a set of procedures used to estimate the economic
value of an owners interest in a business. Valuation is used by financial market participants
to determine the price they are willing to pay or receive to effect a sale of a business. In
addition to estimating the selling price of a business, the same valuation tools are often used
by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation,
allocate business purchase price among business assets, establish a formula for estimating the
value of partners' ownership interest for buy-sell agreements, and many other business and
legal purposes such as in shareholders deadlock, divorce litigation and estate contest. In some
cases, the court would appoint a forensic accountant as the joint expert doing the business
valuation.
STANDARD AND PREMISE OF VALUE
Before the value of a business can be measured, the valuation assignment must specify the
reason for and circumstances surrounding the business valuation. These are formally known
as the business value standard and premise of value. The standard of value is the hypothetical
conditions under which the business will be valued. The premise of value relates to the
assumptions, such as assuming that the business will continue forever in its current form
(going concern), or that the value of the business lies in the proceeds from the sale of all of its
assets minus the related debt (sum of the parts or assemblage of business assets).
STANDARD VALUE

Fair market value - a value of a business enterprise determined between a willing buyer
and a willing seller both in full knowledge of all the relevant facts and neither compelled
to conclude a transaction.

Investment value - a value the company has to a particular investor. Note that the effect
of synergy is included in valuation under the investment standard of value.

Intrinsic value - the measure of business value that reflects the investor's in-depth
understanding of the company's economic potential.

BUSINESS VALUATION APPROACHES


Three different approaches are commonly used in business valuation: the income approach,
the asset-based approach, and the market approach. Within each of these approaches, there
are various techniques for determining the value of a business using the definition of value
appropriate for the appraisal assignment. Generally, the income approaches determine value
by calculating the net present value of the benefit stream generated by the business
(discounted cash flow); the asset-based approaches determine value by adding the sum of the
parts of the business (net asset value); and the market approaches determine value by
comparing the subject company to other companies in the same industry, of the same size,
and/or within the same region. A number of business valuation models can be constructed
that utilize various methods under the three business valuation approaches. Venture
Capitalists and Private Equity professionals have long used the First Chicago method which
essentially combines the income approach with the market approach.
In certain cases equity may also be valued by applying the techniques and frameworks
developed for financial options, via a real options framework, as discussed below.
In determining which of these approaches to use, the valuation professional must exercise
discretion. Each technique has advantages and drawbacks, which must be considered when
applying those techniques to a particular subject company. Most treatises and court decisions
encourage the valuator to consider more than one technique, which must be reconciled with
each other to arrive at a value conclusion. A measure of common sense and a good grasp of
mathematics is helpful.
INCOME APPROACH
The income approach relies upon the economic principle of expectation: the value of business
is based on the expected economic benefit and level of risk associated with the investment.
Income based valuation methods determine fair market value by dividing the benefit stream
generated by the subject or Target Company times a discount or capitalization rate. The
discount or capitalization rate converts the stream of benefits into present value. There are
several different income methods, including capitalization of earnings or cash flows,
discounted future cash flows ("DCF"), and the excess earnings method (which is a hybrid of
asset and income approaches). The result of a value calculation under the income approach is
generally the fair market value of a controlling, marketable interest in the subject company,
since the entire benefit stream of the subject company is most often valued, and the

capitalization and discount rates are derived from statistics concerning public companies. IRS
Revenue Ruling 59-60 states that earnings are preeminent for the valuation of closely held
operating companies.
However, income valuation methods can also be used to establish the value of a severable
business asset as long as an income stream can be attributed to it. An example is licensable
intellectual property whose value needs to be established to arrive at a supportable royalty
structure.
Discount or Capitalization Rates
A discount rate or capitalization rate is used to determine the present value of the expected
returns of a business. The discount rate and capitalization rate are closely related to each
other, but distinguishable. Generally speaking, the discount rate or capitalization rate may be
defined as the yield necessary to attract investors to a particular investment, given the risks
associated with that investment.

In DCF valuations, the discount rate, often an estimate of the cost of capital for the
business is used to calculate the net present value of a series of projected cash flows. The
discount rate can also be viewed as the required rate of return the investors expect to
receive from the business enterprise, given the level of risk they undertake.

On the other hand, a capitalization rate is applied in methods of business valuation that
are based on business data for a single period of time. For example, in real estate
valuations for properties that generate cash flows, a capitalization rate may be applied to
the net operating income (NOI) (i.e., income before depreciation and interest expenses) of
the property for the trailing twelve months.

There are several different methods of determining the appropriate discount rates. The
discount rate is composed of two elements:
(1) The risk-free rate, which is the return that an investor would expect from a secure,
practically risk-free investment, such as a high quality government bond.
(2) A risk premium that compensates an investor for the relative level of risk associated with
a particular investment in excess of the risk-free rate. Most importantly, the selected discount
or capitalization rate must be consistent with stream of benefits to which it is to be applied.

Capitalization and discounting valuation calculations become mathematically equivalent


under the assumption that the business income grows at a constant rate.
Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) is one method of determining the appropriate
discount rate in business valuations. The CAPM method originated from the Nobel Prize
winning studies of Harry Markowitz, James Tobin and William Sharpe. The CAPM method
derives the discount rate by adding a risk premium to the risk-free rate. In this instance,
however, the risk premium is derived by multiplying the equity risk premium times "beta,"
which is a measure of stock price volatility. Beta is published by various sources for
particular industries and companies. Beta is associated with the systematic risks of an
investment.
One of the criticisms of the CAPM Method is that beta is derived from the volatility of prices
of publicly traded companies, which differ from private companies in their liquidity,
marketability, capital structures and control. Other aspects such as access to credit markets,
size, management depth, and many other respects are often different also. The rate build-up
method also requires an assessment of the subject company's risk, which is a valuation of
itself. Where private companies can be shown to be sufficiently similar to public companies,
however, the CAPM method may be appropriate.
Modified Capital Asset Pricing Model
The Cost of Equity (Ke) is computed by using the Modified Capital Asset Pricing Model
(Mod. CAPM)

Where:
= Risk free rate of return (Generally taken as 10-year Government Bond Yield)
= Beta Value (Sensitivity of the stock returns to market returns)
= Cost of Equity
= Market Rate of Return
SCRP = Small Company Risk Premium

CSRP= Company specific Risk premium


Weighted average cost of capital ("WACC")
The weighted average cost of capital is an approach to determining a discount rate.
The WACC method determines the subject companys actual cost of capital by calculating
the weighted average of the companys cost of debt and cost of equity. The WACC must be
applied to the subject companys net cash flow to total invested capital.
One of the problems with this method is that the valuator may elect to
calculate WACC according to the subject companys existing capital structure, the average
industry capital structure, or the optimal capital structure. Such discretion detracts from the
objectivity of this approach, in the minds of some critics.
Indeed, since the WACC captures the risk of the subject business itself, the existing or
contemplated capital structures, rather than industry averages, are the appropriate choices for
business valuation.
Once the capitalization rate or discount rate is determined, it must be applied to an
appropriate economic income stream: pretax cash flow, after-tax cash flow, pretax net
income, after tax net income, excess earnings, projected cash flow, etc. The result of this
formula is the indicated value before discounts. Before moving on to calculate discounts,
however, the valuation professional must consider the indicated value under the asset and
market approaches.
Careful matching of the discount rate to the appropriate measure of economic income is
critical to the accuracy of the business valuation results. Net cash flow is a frequent choice in
professionally conducted business appraisals. The rationale behind this choice is that this
earnings basis corresponds to the equity discount rate derived from the Build-Up
or CAPM models: the returns obtained from investments in publicly traded companies can
easily be represented in terms of net cash flows. At the same time, the discount rates are
generally also derived from the public capital markets data.

ASSET-BASED APPROACH

The value of asset-based analysis of a business is equal to the sum of its parts. That is the
theory underlying the asset-based approaches to business valuation. The asset approach to
business valuation is based on the principle of substitution: no rational investor will pay more
for the business assets than the cost of procuring assets of similar economic utility. In contrast
to the income-based approaches, which require the valuation professional to make subjective
judgments about capitalization or discount rates, the adjusted net book value method is
relatively objective. Pursuant to accounting convention, most assets are reported on the books
of the subject company at their acquisition value, net of depreciation where applicable. These
values must be adjusted to fair market value wherever possible. The value of a companys
intangible assets, such as goodwill, is generally impossible to determine apart from the
companys overall enterprise value. For this reason, the asset-based approach is not the most
probative method of determining the value of going business concerns. In these cases, the
asset-based approach yields a result that is probably lesser than the fair market value of the
business. In considering an asset-based approach, the valuation professional must consider
whether the shareholder whose interest is being valued would have any authority to access
the value of the assets directly. Shareholders own shares in a corporation, but not its assets,
which are owned by the corporation. A controlling shareholder may have the authority to
direct the corporation to sell all or part of the assets it owns and to distribute the proceeds to
the shareholder(s). The non-controlling shareholder, however, lacks this authority and cannot
access the value of the assets. As a result, the value of a corporation's assets is not the true
indicator of value to a shareholder who cannot avail himself of that value. The asset based
approach is the entry barrier value and should preferably to be used in businesses having
mature or declining growth cycle and is more suitable for capital intensive industry.
Adjusted net book value may be the most relevant standard of value where liquidation is
imminent or ongoing; where a company earnings or cash flow are nominal, negative or worth
less than its assets; or where net book value is standard in the industry in which the company
operates. The adjusted net book value may also be used as a "sanity check" when compared
to other methods of valuation, such as the income and market approaches.

MARKET APPROACH
The market approach to business valuation is rooted in the economic principle of
competition: that in a free market the supply and demand forces will drive the price of
business assets to certain equilibrium. Buyers would not pay more for the business, and the
sellers will not accept less, than the price of a comparable business enterprise. The buyers and
sellers are assumed to be equally well informed and acting in their own interests to conclude
a transaction. It is similar in many respects to the "comparable sales" method that is
commonly used in real estate appraisal. The market price of the stocks of publicly traded
companies engaged in the same or a similar line of business, whose shares are actively traded
in a free and open market, can be a valid indicator of value when the transactions in which
stocks are traded are sufficiently similar to permit meaningful comparison.
The difficulty lies in identifying public companies that are sufficiently comparable to the
subject company for this purpose. Also, as for a private company, the equity is less liquid (in
other words its stocks are less easy to buy or sell) than for a public company, its value is
considered to be slightly lower than such a market-based valuation would give.
When there is a lack of comparison with direct competition, a meaningful alternative could
be a vertical value-chain approach where the subject company is compared with, for example,
a known downstream industry to have a good feel of its value by building useful correlations
with its downstream companies. Such comparison often reveals useful insights which help
business analysts better understand performance relationship between the subject company
and its downstream industry. For example, if a growing subject company is in an industry
more concentrated than its downstream industry with a high degree of interdependence, one
should logically expect the subject company performs better than the downstream industry in
terms of growth, margins and risk.
Guideline Public Company Method
Guideline Public Company method entails a comparison of the subject company to publicly
traded companies. The comparison is generally based on published data regarding the public
companies stock price and earnings, sales, or revenues, which is expressed as a fraction
known as a "multiple." If the guideline public companies are sufficiently similar to each other
and the subject company to permit a meaningful comparison, then their multiples should be
similar. The public companies identified for comparison purposes should be similar to the
subject company in terms of industry, product lines, market, growth, margins and risk.

However, if the subject company is privately owned, its value must be adjusted for lack of
marketability. This is usually represented by a discount, or a percentage reduction in the
value of the company when compared to its publicly traded counterparts. This reflects the
higher risk associated with holding stock in a private company. The difference in value can
be quantified by applying a discount for lack of marketability. This discount is determined by
studying prices paid for shares of ownership in private companies that eventually offer their
stock in a public offering. Alternatively, the lack of marketability can be assessed by
comparing the prices paid for restricted shares to fully marketable shares of stock of public
companies.

Guideline Transaction Method or Direct Market Data Method


Using this method, the valuation analyst may determine market multiples by reviewing
published data regarding actual transactions involving either minority or interesting either
publicly traded or closely held companies. In judging whether a reasonable basis for
comparison exists, the valuation analysis must consider:
(1) The similarity of qualitative and quantitative investment and investor characteristics;
(2) The extent to which reliable data is known about the transactions in which interests in the
guideline companies were bought and sold.
(3) Whether or not the price paid for the guideline companies was in an arms-length
transaction, or a forced or distressed sale. In regards to data reliability and both the guideline
transaction method and the direct market data method, unlike real estate sales data, sales of
privately held companies are neither actively traded or regularly reported to city or county
recording offices, nor verified by these same local government offices. Sales of privately held
companies are voluntarily reported by business brokers to data re-sellers or unscientifically
accumulated by these same private, for profit data re-sellers. Consequently the data is
considered, by the very nature of the data collection process, to be corrupted by sampling bias
and non-sampling error, and of questionable reliability.

Option Pricing Approaches


As above, in certain cases equity may be valued by applying the techniques and frameworks
developed for financial options, via a real options framework. For general discussion as to
context see "Valuing flexibility" under corporate finance; for detail as to applicability and
other considerations see "Limitations" under real options valuation.
In general, equity may be viewed as a call option on the firm, and this allows for the
valuation of troubled firms which may otherwise be difficult to analyze; see distressed
securities. Here, since the principle of limited liability protects equity investors, shareholders
would choose not to repay the firms debt where the value of the firm (as perceived) is less
than the value of the outstanding debt; see bond valuation. Of course, where firm value is
greater than debt value, the shareholders would choose to repay (i.e. exercise their option)
and not to liquidate. Thus analogous to out the money options which nevertheless have value,
equity will (may) have value even if the value of the firm falls (well) below the face value of
the outstanding debtand this value can (should) be determined using the appropriate option
valuation technique. (A further application of this principle is the analysis of principalagent
problems; see contract design under principalagent problem.)
Certain business situations, and the parent firms in those cases, are also logically analyzed
under an options framework; see "Applications" under the Real options valuation references.
Just as a financial option gives its owner the right, but not the obligation, to buy or sell a
security at a given price, companies that make strategic investments have the right, but not
the obligation, to exploit opportunities in the future. Thus, for companies facing uncertainty
of this type, the stock price may (should) be seen as the sum of the value of existing
businesses (i.e., the discounted cash flow value) plus any real option value. Equity valuations
here, may (should) thus proceed likewise. Compare PVGO.
A common application is to natural resource investments. Here, the underlying asset is the
resource itself; the value of the asset is a function of both quantity of resource available and
the price of the commodity in question. The value of the resource is then the difference
between the value of the asset and the cost associated with developing the resource. Where
positive ("in the money") management will undertake the development, and will not do so
otherwise, and a resource project is thus effectively a call option. A resource may (should)
therefore also be analyzed using the options approach. Specifically, the value of the firm
comprises the value of already active projects determined via DCF valuation (or other

standard techniques) and undeveloped reserves as analyzed using the real options framework.
See Mineral economics.
Product patents may also be valued as options, and the value of firms holding these patents
typically firms in the bio-science, technology, and pharmaceutical sectors can (should)
similarly be viewed as the sum of the value of products in place and the portfolio of patents
yet to be deployed. As regards the option analysis, since the patent provides the firm with the
right to develop the product, it will do so only if the present value of the expected cash flows
from the product exceeds the cost of development, and the patent rights thus correspond to
a call option. See Patent valuation# Option-based method. Similar analysis may be applied
to options on films (or other works of intellectual property) and the valuation of film studios.
Discounts and Premiums
The valuation approaches yield the fair market value of the Company as a whole. In valuing a
minority, non-controlling interest in a business, however, the valuation professional must
consider the applicability of discounts that affect such interests. Discussions of discounts and
premiums frequently begin with a review of the "levels of value." There are three common
levels of value: controlling interest, marketable minority, and non-marketable minority. The
intermediate level, marketable minority interest, is less than the controlling interest level and
higher than the non-marketable minority interest level. The marketable minority interest level
represents the perceived value of equity interests that are freely traded without any
restrictions. These interests are generally traded on the New York Stock Exchange, AMEX,
NASDAQ, and other exchanges where there is a ready market for equity securities. These
values represent a minority interest in the subject companies small blocks of stock that
represent less than 50% of the companys equity, and usually much less than 50%.
Controlling interest level is the value that an investor would be willing to pay to acquire more
than 50% of a companys stock, thereby gaining the attendant prerogatives of control. Some
of the prerogatives of control include: electing directors, hiring and firing the companys
management and determining their compensation; declaring dividends and distributions,
determining the companys strategy and line of business, and acquiring, selling or liquidating
the business. This level of value generally contains a control premium over the intermediate
level of value, which typically ranges from 25% to 50%. An additional premium may be paid
by strategic investors who are motivated by synergistic motives. Non-marketable, minority
level is the lowest level on the chart, representing the level at which non-controlling equity
interests in private companies are generally valued or traded. This level of value is discounted

because no ready market exists in which to purchase or sell interests. Private companies are
less "liquid" than publicly traded companies, and transactions in private companies take
longer and are more uncertain. Between the intermediate and lowest levels of the chart, there
are restricted shares of publicly traded companies. Despite a growing inclination of the IRS
and Tax Courts to challenge valuation discounts, Shannon Pratt suggested in a scholarly
presentation recently that valuation discounts are actually increasing as the differences
between public and private companies is widening. Publicly traded stocks have grown more
liquid in the past decade due to rapid electronic trading, reduced commissions, and
governmental deregulation. These developments have not improved the liquidity of interests
in private companies, however. Valuation discounts are multiplicative, so they must be
considered in order. Control premiums and their inverse, minority interest discounts, are
considered before marketability discounts are applied.
Discount For Lack Of Control
The first discount that must be considered is the discount for lack of control, which in this
instance is also a minority interest discount. Minority interest discounts are the inverse of
control premiums, to which the following mathematical relationship exists: MID = 1 [1 / (1
+ CP)] The most common source of data regarding control premiums is the Control Premium
Study, published annually by Merger stat since 1972. Merger stat compiles data regarding
publicly announced mergers, acquisitions and divestitures involving 10% or more of the
equity interests in public companies, where the purchase price is $1 million or more and at
least one of the parties to the transaction is a U.S. entity. Merger stat defines the "control
premium" as the percentage difference between the acquisition price and the share price of
the freely traded public shares five days prior to the announcement of the M&A transaction.
While it is not without valid criticism, Merger stat control premium data (and the minority
interest discount derived therefrom) is widely accepted within the valuation profession.

Discount for lack of marketability


Another factor to be considered in valuing closely held companies is the marketability of an
interest in such businesses. Marketability is defined as the ability to convert the business
interest into cash quickly, with minimum transaction and administrative costs, and with a
high degree of certainty as to the amount of net proceeds. There is usually a cost and a time
lag associated with locating interested and capable buyers of interests in privately held

companies, because there is no established market of readily available buyers and sellers. All
other factors being equal, an interest in a publicly traded company is worth more because it is
readily marketable. Conversely, an interest in a private-held company is worth less because
no established market exists. The IRS Valuation Guide for Income, Estate and Gift Taxes,
Valuation Training for Appeals Officers acknowledges the relationship between value and
marketability, stating: "Investors prefer an asset which is easy to sell, that is, liquid." The
discount for lack of control is separate and distinguishable from the discount for lack of
marketability. It is the valuation professionals task to quantify the lack of marketability of an
interest in a privately held company. Because, in this case, the subject interest is not a
controlling interest in the Company, and the owner of that interest cannot compel liquidation
to convert the subject interest to cash quickly, and no established market exists on which that
interest could be sold, the discount for lack of marketability is appropriate. Several empirical
studies have been published that attempt to quantify the discount for lack of marketability.
These studies include the restricted stock studies and the pre-IPO studies. The aggregate of
these studies indicate average discounts of 35% and 50%, respectively. Some experts believe
the Lack of Control and Marketability discounts can aggregate discounts for as much as
ninety percent of a Company's fair market value, specifically with family-owned companies.
Restricted Stock Studies
Restricted stocks are equity securities of public companies that are similar in all respects to
the freely traded stocks of those companies except that they carry a restriction that prevents
them from being traded on the open market for a certain period of time, which is usually one
year (two years prior to 1990). This restriction from active trading, which amounts to a lack
of marketability, is the only distinction between the restricted stock and its freely traded
counterpart. Restricted stock can be traded in private transactions and usually do so at a
discount. The restricted stock studies attempt to verify the difference in price at which the
restricted shares trade versus the price at which the same unrestricted securities trade in the
open market as of the same date. The underlying data by which these studies arrived at their
conclusions has not been made public. Consequently, it is not possible when valuing a
particular company to compare the characteristics of that company to the study data. Still, the
existence of a marketability discount has been recognized by valuation professionals and the
Courts, and the restricted stock studies are frequently cited as empirical evidence. Notably,
the lowest average discount reported by these studies was 26% and the highest average
discount was 40%.

Option Pricing
In addition to the restricted stock studies, U.S. publicly traded companies are able to sell
stock to offshore investors (SEC Regulation S, enacted in 1990) without registering the
shares with the Securities and Exchange Commission. The offshore buyers may resell these
shares in the United States, still without having to register the shares, after holding them for
just 40 days. Typically, these shares are sold for 20% to 30% below the publicly traded share
price. Some of these transactions have been reported with discounts of more than 30%,
resulting from the lack of marketability. These discounts are similar to the marketability
discounts inferred from the restricted and pre-IPO studies, despite the holding period being
just 40 days. Studies based on the prices paid for options have also confirmed similar
discounts. If one holds restricted stock and purchases an option to sell that stock at the market
price (a put), the holder has, in effect, purchased marketability for the shares. The price of
the put is equal to the marketability discount. The range of marketability discounts derived by
this study was 32% to 49%. However, ascribing the entire value of a put option to
marketability is misleading, because the primary source of put value comes from the
downside price protection. A correct economic analysis would use deeply in-the-money puts
or Single-stock futures, demonstrating that marketability of restricted stock is of low value
because it is easy to hedge using unrestricted stock or futures trades.

Pre-IPO Studies
Another approach to measure the marketability discount is to compare the prices of stock
offered in initial public offerings (IPOs) to transactions in the same companys stocks prior to
the IPO. Companies that are going public are required to disclose all transactions in their
stocks for a period of three years prior to the IPO. The pre-IPO studies are the leading
alternative to the restricted stock stocks in quantifying the marketability discount. The preIPO studies are sometimes criticized because the sample size is relatively small, the pre-IPO
transactions may not be arms length, and the financial structure and product lines of the
studied companies may have changed during the three year pre-IPO window.

ECONOMIC VALUE ADDED APPROACHES


In corporate finance, Economic Value Added (EVA), is an estimate of a firm's economic
profit being the value created in excess of the required return of the company's investors
(being shareholders and debt holders). Quite simply, EVA is the profit earned by the firm less
the cost of financing the firm's capital. The idea is that value is created when the return on the
firm's economic capital employed is greater than the cost of that capital. This amount can be
determined by making adjustments to GAAP accounting. There are potentially over 160
adjustments that could be made but in practice only five or seven key ones are made,
depending on the company and the industry it competes in.
Calculation
EVA is net operating profit after taxes (or NOPAT) less a capital charge, the latter being the
product of the cost of capital and the economic capital. The basic formula is:

Where:

, is the Return on Invested Capital (ROIC);

is the weighted average cost of capital (WACC);

is the economic capital employed;


NOPAT is the net operating profit after tax, with adjustments and translations,
generally for the amortization of goodwill, the capitalization of brand advertising and
other non-cash items.
EVA Calculation:
EVA = net operating profit after taxes a capital charge [the residual income method]
Therefore EVA = NOPAT (c capital), or alternatively
EVA = (r x capital) (c capital) so that
EVA = (r-c) capital [the spread method, or excess return method]
Where;
r = rate of return, and
c = cost of capital, or the weighted Average Cost of Capital

MARKET VALUE ADDED


Market value added (MVA) is the difference between the current market value of a firm and
the capital contributed by investors. If MVA is positive, the firm has added value. If it is
negative, the firm has destroyed value. The amount of value added needs to be greater than
the firm's investors could have achieved investing in the market portfolio, adjusted for the
leverage (beta coefficient) of the firm relative to the market.
Basic Formula
The formula for MVA is:

Where:

MVA is market value added


V is the market value of the firm, including the value of the firm's equity and debt
K is the capital invested in the firm
MVA is the present value of a series of EVA values. MVA is economically equivalent to
the traditional NPV measure of worth for evaluating an after-tax cash flow profile of a
project if the cost of capital is used for discounting.

THE MOST COMMON ERRORS IN VALUATIONS

For anyone involved in the field of corporate finance, understanding the mechanisms of
company valuation is an indispensable requisite. This is not only because of the importance
of valuation in acquisitions and mergers but also because the process of valuing the company
and its business units helps identify sources of economic value creation and destruction
within the company.
The methods for valuing companies can be classified in six groups:

Value and Price. What Purpose Does a Valuation Serve?


Generally speaking, a companys value is different for different buyers and it may also be
different for the buyer and the seller. Value should not be confused with price, which is the
quantity agreed between the seller and the buyer in the sale of a company. This difference in
a specific companys value may be due to a multitude of reasons. For example, a large and
technologically highly advanced foreign company wishes to buy a well-known national
company in order to gain entry into the local market, using the reputation of the local brand.
In this case, the foreign buyer will only value the brand but not the plant, machinery, etc. as it
has more advanced assets of its own. However, the seller will give a very high value to its
material resources, as they are able to continue producing. From the buyers viewpoint, the
basic aim is to determine the maximum value it should be prepared to pay for what the
company it wishes to buy is able to contribute. From the sellers viewpoint, the aim is to
ascertain what should be the minimum value at which it should accept the operation. These
are the two figures that face each other across the table in a negotiation until a price is finally
agreed on, which is usually somewhere between the two extremes.2 A company may also

have different values for different buyers due to economies of scale, economies of scope, or
different perceptions about the industry and the company. A valuation may be used for a wide
range of purposes:
1. in company buying and selling operations:
- For the buyer, the valuation will tell him the highest price he should pay.
- For the seller, the valuation will tell him the lowest price at which he should be
prepared to sell.
2. Valuations of listed companies:
- The valuation is used to compare the value obtained with the shares price on the stock
market and to decide whether to sell, buy or hold the shares.
- The valuation of several companies is used to decide the securities that the portfolio
should concentrate on: those that seem to it to be undervalued by the market.

ADVANTAGE AND DISADVANTAGE OF VALUATION METHODS


There are many different methods for valuing a business, with some better suited to a specific
type of business than others. A key task of the valuation specialist is to select the most
appropriate method for valuing a particular business. The method chosen should provide a
reasonable estimate of value, be suitable for the intended purpose and be able to face legal
challenges by the IRS or other opposing parties. As a part of the process, a valuation
specialist will often employ several different methods and average the results to arrive at a
ballpark estimate. Because each method has strengths and weaknesses, business owners
and their advisors should be familiar with the most commonly used valuation techniques.

Net Asset Value


The value is based on a sale at fair market value (FMV) of the firms assets on a goingconcern basis.

Strengths

Data required to perform the valuation are usually easily available.


Allows for adjustments (up and down) in estimating FMV.
Suitable for firms with heavy tangible investments (e.g. equipment, land).
Helpful when the firms future is in question or where the firm has a brief or volatile
earnings record.

Weaknesses

Can understate the value of intangible assets such as copyrights or goodwill.


Does not take into account future changes (up or down) in sales or income.
Balance sheet may not accurately reflect all assets.

Discounted Future Earnings

The value of the firm is equivalent to the capital required to produce income equal to
a projected future income stream from continuing operations of the firm. The rate of
return used is adjusted to take into account the level of risk assumed by a buyer in
purchasing the business as a going concern.

Strengths

The value of the firm is based on projected future results, rather than assets.
Can be used with either net earnings or net cash flow.
Useful when future results are expected to be different (up or down) from recent
history.

Weaknesses
May understate the value of balance sheet assets.
Discounts the valuation based on the level of risk. A business perceived as riskier
typically receives a lower valuation than a more stable business.
Projections are not guarantees; unforeseen future events can cause income or earnings
projections to be completely invalid.

Excess Earnings (Treasury Method)


The value of the firm is determined by adding the estimated market value of its
tangible assets to the capitalized value of projected income resulting from goodwill.
Strengths
Takes into account both tangible and intangible assets.
Includes projected future values of income resulting from goodwill.
Is based on IRS Rev. Rul. 68-609, 1968 CB 327.
Weaknesses
Relies on estimate of period for which goodwill is expected to last, which is often
difficult to assess. Projections based on this value can be unreliable.

May understate future revenues or value of intangible assets.


Though based on IRS rulings, the IRS cautions that the method can be relied on only
if there is no better basis therefore available.

Capitalization of Earnings

Value is equivalent to the capital (invested at a reasonable rate of return) required to


generate an income equal to an average of the firms recent, historical results.
Strengths
A simplified approach that arrives at an easily determined value.
Does not rely on projections, but on an average of results from the recent past.
Most useful for businesses with stable, predictable cash flows and earnings.
Weaknesses
May understate value for firms using aggressive strategies to reduce taxable income.
May overlook value of tangible or intangible assets.
Reliance on past earnings may ignore potential future growth.

CHAPTER III
LITERATURE REVIEW
Study of Business Valuation Methods and Techniques is important because of
the in day to business and future forecasting purpose it is very important to
study very deeply. When firm carries the wellbeing business then its important
to take care of that because of that the to maintain and sustain this business in
future kind of way.
Business Valuation and Methods is the increase the efficiency and effective of
entire and impact individual companys ability. Often this are only manner to
looking future kind of the business and to implement the various thoroughly.
In the Research Paper submitted by the Pablo Fernndez (IESE Business School
University of Navarra) in that study the topic discuss that the Company
Valuation Methods. The Most Common Errors in Valuation.
He said that what is main common errors occur in the Business valuation
Methods and Techniques and how to identify this errors to minimizing the risk
the of market and to protect the future consequence to avoid loss of the
company and to create of the investor point of view.
There are number of Methods used by finance managers for valuing a business.
The most appropriate methods is the selected keeping in view the circumstance
of each case.
The author speak about the generally speaking, a companys value is different
for different buyers and it may also be different for the buyer and the seller.
Value should not be confused with price, which is the quantity agreed between
the seller and the buyer in the sale of a company. This difference in a specific
companys value may be due to a multitude of reasons. For example, a large and
technologically highly advanced foreign company wishes to buy a well-known

national company in order to gain entry into the local market, using the
reputation of the local brand. In this case, the foreign buyer will only value the
brand but not the plant, machinery, etc. as it has more advanced assets of its
own.
However, the seller will give a very high value to its material resources, as they
are able to continue producing. From the buyers viewpoint, the basic aim is to
determine the maximum value it should be prepared to pay for what the
company it wishes to buy is able to contribute.
From the sellers viewpoint, the aim is to ascertain what should be the minimum
value at which it should accept the operation. These are the two figures that face
each other across the table in a negotiation until a price is finally agreed on,
which is usually somewhere between the two extremes.
A company may also have different values for different buyers due to
economies of scale, economies of scope, or different perceptions about the
industry and the company.
A valuation may be used for a wide range of purposes:
1. In company buying and selling operations
2. Valuations of listed companies
3. Public offerings
4. Inheritances and wills
5. Compensation schemes based on value creation
6. Identification of value drivers
7. Strategic decisions on the companys continued existence
8. Strategic planning

CHAPTER IV
OBJECTIVE OF THE STUDY
To study and Analyze the Various Business Approaches.
Find answers to the questions that confront the owners and managers of finance
companies and the financial directors of all kinds of companies in the performance of
their duties.
Develop new tools for financial management.
Study in depth the changes that occur in the market and their effects on the financial
dimension of business activity.

SCOPE OF THE STUDY


To understand the Business Valuation within the Firm.
This Study deals with the internal costing (Valuation of Business)
Business Valuation deals with various approaches using in day to day business
procedures and techniques.

LIMITATIONS OF THE STUDY


This study deals with the Historical data base. Market Flexibility is very less
Some techniques using in day to day basis is very difficult to implement.

CHAPTER V
DATA ANALYSIS AND INTERPRETATION
Asset Based Approaches to Business Valuation
Net Asset = Value of Asset Amount of Liabilities Amount due to Preference
Shareholders
1. Balance Sheet of Slack Ltd. is given to you. You are required to calculate the price
per equity share on the basis of net assets methods.
Liabilities
Equity Shares of
Reserves
Dividend Equalization Fund
Secured Loan
Staff Welfare Fund
Creditors
Accrued Expenses
Proposed Dividend

600000
1320000
200000
800000
20000
360000
100000
90000
3490000

Asset
Land and Building
Plant and Equipment
Motor Vehicles
Patents etc.
Stock
Debtors
Cash and Bank Balance
Deferred Advertisement

1600000
900000
120000
24000
400000
300000
66000
80000
3490000

Net profits of the company after tax and interest for the last 5 years were - 180000,
160000, 210000 and 200000. The fixed assets have been valued by independent experts
as follows:
Land and Building 2150000, Plant and Equipment 960000 and Motor Vehicles 90000.
The applicable price earnings ratio is 8. Compute the value per equity share of the company
based on Net Assets Methods.

Particulars
Computation of Net Asset
Land and Building
Plant and Equipment
Motor Vehicles
Intangibles
Stock
Debtors
Cash and Bank
Total (a)
Secured Loan
Creditors
Accrued Expenses
Total (b)
Net Assets (a-b)
Number of Equity Shares
Value of per Equity Share

2150000
960000
90000
0
400000
300000
66000
3966000
800000
360000
100000
1260000
2706000
60000
45.1

Earnings Based Approach


A. Earnings Capitalization (as per Accounting) Methods: Under the method future
maintainable profit is determined and the amount so calculated is divided by an
appropriate capitalization rate, to arrive at the value of the business.
Maintainable Profit is the average profit after tax adjusted for the following items:
(i)
(ii)
(iii)
(iv)
(v)

Additional income expected in the future years due to new product etc.
Profits or Loss from the sale of fixed assets;
Loss due to theft or natural calamities, strike, lock-outs;
Expenditure on Voluntary retirement;
Any other item which is which is extraordinary in nature and is not expected to
occur in the future years.

2. Super Tech Ltd. earned a profit of 478000 after tax and after preference dividend.
The capital structure of the company consisted of
Particulars
100000 Equity Shares of 10 each
12% Preference Share Capital

1000000
350000

Company is going to produce and sell a new product. The details

350000
100000
120000
130000
50000
80000
28000
52000

Particulars
Sale of new product
Less Material Cost
Less Labor Cost
Contribution
Additional Fixed Cost
Operating Profit before Tax
Less Tax @ 35%
Profit After Tax

Calculate the value of Business if Capitalization rate applicable to the company is


15% extraordinary items debited to current years profit include 45000.
Calculation of Maintainable Profit After Tax
Particulars
Profit after tax and after preference dividend
Add: Preference Dividend
Profit After Tax
Profit before Tax (520000/0.65)
Add: Extraordinary items debited

478000
42000
520000
800000
45000
845000
80000
925000
323750
601250
15%

Add: Additional Profit on New Product


Total Operating Profit
Less: Tax @ 35%
Maintainable Profits After Tax
Capitalization Rate
Value Business (Profit/0.15)
Value of Business from the perspective of equity
shareholders is Value of the firm - Preference Capital

4008333350000=3658333

Price Earnings Ratio:


Profit Available for equity Shareholders
Earnings Per Share = --------------------------------------------------------Total Number of Equity Shares
Market Price of Share=

EPS X P/E

3. From the details given in Problem number 1, we can calculate market price per share
on the basis of Price-earnings ratio.
Solution:
P/E method
Total Profit for the average maintainable profits
Total profit for the last 5 years
180000+160000+210000+180000+200000+930000
Average Profit = 930000/5 = 186000
Earnings Per Share = Average Profit/Number of equity shares = 186000/60000 = 3.10
P/E ratio = 8
Value Per Share = EPS X P/E ratio
= 3.10 X 8
= 24.80
B. Earnings Approaches to Business Valuations, Cash Flow Basis
Value of a Firm =

Cash flow computation:


After tax Operating Earnings (excluding extraordinary items, income from
marketable securities and non-Operating investments)
Add: Depreciation
Add: Other non- cash items, say amortization of non-tangible assets, such as patents,
trademarks etc. and loss on sale of long-term assets
Less: Investment in long-term assets
Less: Investments in Operating net working Capital
Operating Free Cash Flows
Add: Non-Operating income after tax
Add: Decrease in non-operating assets like marketable securities

Free Cash Flows to Firm (FCFF)


A Company has the following capital structure:
5000000 Equity Shares of 10 Each
12% Debentures

5000000
3000000

The Cash flows to all investors expected over the next 5 years are

3000000
1900000
2200000
3200000
4150000

Year
1
2
3
4
5

The corporate tax applicable to the company is 40%. Compute the Value of Business and also
value of firm from the perspective of equity shareholders. The capitalization rate is 14%.
1. Calculation of Overall cost of Capital
Capital
Equity

Amount
5000000

Cost
0.14

Proportion
0.625

WACC
0.0875

Debt

3000000

0.12 (1-0.40)=0.072

0.375

0.027

WACC
2. Value of Firm DCF Basis
Year
1
2
3
4
5

FCFF
3000000
1900000
2200000
3200000
4150000

Value of the Firm


Less: Debt
Value of Equity

PV Factor
0.897
0.805
0.722
0.648
0.582

Total Present Value


2691000
1529500
1588400
2073600
2415300
10297800
3000000
7297800

Note: Present Value Factor is calculated by applying the Formula

For instance PV Factor for Year 1 = 1


----------------(1+0.1145)1
t is the Number years, r is the Cost of Capital.

Market Value Added Method (MVA)


MVA is the Value added to the equity during a year it is found out by subtracting
from the market value of a firms equity. The amount of equity investment.
MVA= Market value of Firms equity Equity Capital Investment
The Market Value of well managed companies will be high hence the MVA will also
be high. On the other hand a new company or a company not managed will may even
have negative MVA.
1. Sunrise Companys Shares are quoted in the Market @ 250 per share. The face
value of the share is 100 each. The reserves and surplus of the company amount
to 2000000. The Equity share capital is 144000. Calculation the market value
added.
Solution
Market Value of equity is 144000 shares @ 250 per share = 36000000.
The Equity of the company consisting of Capital and Reserves = 16400000
The MVA is 19600000.
Economic Value Added Method (EVA)
It is the difference between operating profits after taxes and cost of funds. It
compares the cost of funds employed by the firm and the return on such
investment. Cost of funds is the WACC or employed average cost of capital. The
accounting profit is adjusted for the interest cost. The interest cost is a part of
WACC.
The difference between the net operating profit and cost of funds is the real
profit of the company, after considering the cost of all funds employed.
1. Following information has been extracted from the Income Statement of

Shishir Ltd. For the current year:

( in Lakhs)

Particulars
Sales
Less: Operating Cost
Less: Interest Cost
Earnings before tax
Less: Tax (40%)
Earnings After Tax (EAT)

500
300
12
188
75.2
112.8

The firms capital consists of 150 lakh equity funds, having 15% cost and of
100 lakh, 12% debt. Determine the EVA during the year.
Solutions
(i)

Determination of Net operating Profit After Tax


( in Lakhs)

Particulars
Sales
Less: Operating Cost
Less: Tax (40%)
Operating Profit After Tax

(ii)

500
300
80
120

Calculation of WACC

Capital
Equity Share Capital
12% Debenture

Amount
15000000
10000000

Cost
0.15
0.12(1-0.40)=0.072

Proportion
0.6
0.4

WACC
0.09
0.0288

Weighted Average Cost of Capital = 0.1188

(iii)

Economic Value Added = Net Operating Profit After Tax (Return expected on
Capital Employed)

EVA = 120 lakh - (11.88% of Total capital i.e., 250 lakh)


= 120 29.70
= 90.30 lakh

CHAPTER VI
FINDINGS AND OBSERVATION
Business Valuation Methods and Techniques using for the to run the business good
kind of way to avoid the future consequence
For the above finding in various methods of Pricing the followings come to the study
point of view this are as follows.
Asset Based Valuation Approach: The assets may be valued on the basis of
the accounting principle of going concern or on the basis of the value on
winding up.
Earnings Based Valuation Approach: This Approach is totally based on the
future prospects of the business.
Market Value Based Valuation Approach: The MVA is the basis of
determination of market value quoted in the stock market.
Fair Value Valuation Method: This is based on the average of the values
determined by any two or of the other methods.
Economic Value Added: In this EVA approaches difference between
operating profit and cost of funds is the real profit of the company.
Market Value Added Approach: MVA is the value added to the equity during
a year. It is found out by subtracting from the Market value of a firms equity,
the amount of equity investment.
Identifying the most commonly happening errors in Business Valuation Methods.
1. Errors in the discount rate calculation and concerning the companys riskiness
A. Wrong risk-free rate used for the valuation
1. Using the historical average of the risk-free rate.
2. Using the short-term Government rate.
3. Wrong calculation of the real risk-free rate.

B. Wrong beta used for the valuation


1. Using the historical industry beta, or the average of the betas of
similar companies, when the result goes against common sense.

2. Using the historical beta of the company when the result goes
against common sense.
3. Assuming that the beta calculated from historical data captures the
country risk.
4. Using the wrong formulae for levering and levering the beta.
5. Arguing that the best estimation of the beta of a company from an
emerging market is the beta of the company with respect to the S&P
500.
6. When valuing an acquisition, using the beta of the acquiring
company.

C. Wrong market risk premium used for the valuation


1. The required market risk premium is equal to the historical equity
premium.
2. The required market risk premium is equal to zero.
3. Assume that the required market risk premium is the expected risk
premium.

D. Wrong calculation of WACC


1. Wrong definition of WACC.
2. The debt to equity ratio used to calculate the WACC is different
from the debt to equity ratio resulting from the valuation.
3. Using discount rates lower than the risk-free rate.
4. Using the statutory tax rate, instead of the effective tax rate of the
levered company.
5. Valuing all the different businesses of a diversified company using
the same WACC (same leverage and same Ke).
6. Considering that WACC / (1-T) is a reasonable return for the
companys stakeholders.
7. Using the wrong formula for the WACC when the value of debt is
not equal to its book value.
8. Calculating the WACC assuming a certain capital structure and
deducting the outstanding debt from the enterprise value.
9. Calculating the WACC using book values of debt and equity.

10. Calculating the WACC using strange formulae.

E. Wrong calculation of the value of tax shields


1. Discounting the tax shield using the cost of debt or the required
return to unlevered equity.
2. Odd or ad-hoc formulae.

F. Wrong treatment of country risk


1. Not considering the country risk, arguing that it is diversifiable.
2. Assuming that a disaster in an emerging market will increase the
beta of the countrys companies calculated with respect to the S&P
500.
3. Assuming that an agreement with a government agency eliminates
country risk.
4. Assuming that the beta provided by Market Guide with the
Bloomberg adjustment incorporates the illiquidity risk and the small
cap premium.
5. Odd calculations of the country risk premium.

G. Including an illiquidity, small-cap, or specific premium when it is not


appropriate
1. Including an odd small-cap premium.
2. Including an odd illiquidity premium.
3. Including a small-cap premium equal for all companies.
2. Errors when calculating or forecasting the expected cash flows.

CHAPTER VII
CONCLUSION OF THE STUDY
The Project entitled A Study and Analysis of Business Valuation Methods and
Techniques is mainly concentrated on the basis knowledge of the Corporate Finance
and Capital Market.
The Study has helped me to clarify my conceptual understanding about the Business
Valuation Methods and its Techniques. During this study I got Opportunity to avail a
thorough knowledge regarding the corporate finance and Capital market, How to
Calculate the Value through different Methods and techniques. Its give me clear idea
about the business requires the careful selection of method of Valuation of assets for
both tangible and intangible assets, fixed and current assets, existing liabilities and
contingent liabilities. Business Valuation the corporate restructuring has now these
affect the organization and outside the firm also, to how much this will effective to
various methods and techniques. In the new business era now taking into
consideration is the very importance to the various business valuation and methods.
Companies are now become very much serious about the regarding their business to
choosing appropriate business valuation methods and techniques because of the some
of the corporate entity wanted to earn huge revenue if at all they wanted to survive in
the highly competitive world and provide world class service to their client and
customer.
To sustain in the market and to maximize the profit volume and to creating smile on
the investor and customer face then you have to deals with various approaches.

CHAPTER VIII
REFERENCE AND BIBLIOGRAPHY

Books:

1. Management Accounting: Khan and Jain


2. Corporate Finance: Khan and Jain

Websites
1. www.rbi.org.in
2. www.moneycontrol.com
3. www.investpoedi.com
Business Article
Company Valuation Methods. The most common Errors in Valuations (Pablo FernandezIESE Business School University of Navarra)