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Lesson – 24


Valuation is a device to assess the worth of the enterprise which is subject to
merger or takeover so that the consideration amount can be quantified and price of
one enterprise for the other can be fixed. Such valuation helps in determining the
value of shares of the acquired and acquiring company to safeguard the interest of
the shareholders of both the companies.
The share of any member in a company is a movable property and can be
transferred in the manner provided in the articles. A share represents a bundle of
rights like right to elect directors, to vote on resolutions of the company, share in the
surplus, if any, on liquidation etc.
Valuation of shares in an amalgamation or takeover is made on a consideration
of a number of relevant factors, such as stock exchange prices of the shares of the
two companies, the dividends paid on the shares, relevant growth prospects of the
companies, values of the net assets and even factors which are not evident from the
face of the balance sheet like quality and integrity of the management, present and
prospective competition, yield on comparable securities, market sentiments etc.
Valuation has to be tempered by the exercise of judicious discretion and judgment
as it is a very crucial and complicated issue.
Need and purpose
There are a number of situations which trigger the need to know the value of a
business — strategic partnerships, merger or acquisition of a business, employee
stock ownership plans (ESOPs), joint ventures, etc. From the perspective of a valuer,
a business owner, or an interested financial party, a valuation provides a useful base
to establish a price for a business or to help increase a company's va|ue and attract
The necessity for valuation of shares arises inter alia, in the following
Assessments under the Wealth Tax Act;
Purchase of a 'block of shares', which may or may not give the holder thereof
a controlling interest in the company;
(iii) Formulation of schemes of amalgamation, etc.;
(iv) Acquisition of interest of dissenting shareholders under a scheme of
(v) Conversion of shares;
(vi) Advancing a loan on the security of shares.
For transactions involving a relatively small number of shares, which are quoted
on the stock exchange, normally the price prevailing on the stock exchange is
accepted. However, valuation by experts is called for when the parties involved in the
transaction/deal/scheme, etc. fail to arrive at a mutually acceptable value or the
agreements or Articles of Association, etc., provide for valuation by experts.

The valuation by a valuer becomes necessary when:

(i) Shares are unquoted;
(ii) Shares relate to private limited companies;
(iii) Courts so direct;
(iv) Articles of Association so provide;
(v) Relevant agreements so provide;
(vi) Statute so requires.
Valuation can serve many purposes --to establish a price, to help increase
value, to attract capital and to meet governmental requirements.
The significance of valuation is however, different in different areas. Valuation
is necessary for the decision making by shareholders to sell their interest in the
company in the form of shares. Self evaluation may be done by the company being
merged with another but it must be satisfied with the value of the shares, it's
shareholders should get in the form of shares of the merging company for effecting
merger. Such satisfaction is necessary to weigh the over-valuation of shares of
acquirer and/or under valuation of shares of the acquired or vice-versa. Therefore, to
enable shareholders of both the companies, to take decision in favour of
amalgamation; valuation of shares is needed and once they are satisfied and have
approved it with requisite majority, the court approves the same while sanctioning
their scheme of amalgamation, because it is the interest of shareholders which will
suffer in the event of wrong valuation.
The value of a firm can be directly related to the decisions it makes — on which
project it undertakes, on how it finances them and on its dividend policy.
Understanding this relationship is the key to making value-increasing decisions and
sensible financial restructuring.
Valuation is the central focus in -fundamental analysis. The underlying theme in
fundamental analysis is that the true value of the firm can be related to its financial
characteristics — its growth prospects, risk profile and cash flows. A deviation
from this value is a sign that a stock is under or over valued.
Valuation plays a significant part in acquisitions
Valuation of the target in an acquisition is an important part of the process of
determining the consideration to be offered to the target shareholders. The value that
the bidder places on the target sets the maximum or 'walk away' price that the bidder
can afford to offer the target shareholders. The value of the target from the bidders
point of view is the sum of the pre-bid stand alone value of the target. On the other
hand, target companies may be unduly optimistic in estimating value, especially in
hostile takeovers, as their attempt is to convince the shareholders that the offer price
is too low.
Valuation of shares also depends on who the buyer is. A low-profile company can
extract high price if a big company like Microsoft eyes the new profile company as a
takeover proposition.

Factors influencing valuation

Many factors have to be assessed to determine fair valuation for an industry, a
sector, or a company. The key to valuation is finding a common ground between
all of the companies for the purpose of a fair evaluation.
Determining the value of a business is a complicated and intricate process.
Valuing a business requires the determination of its future earnings potential, the
risks inherent in those future earnings, Strictly speaking, a company's fair market
value is the price at which the business would change hands between a willing buyer
and a willing seller when neither are under any compulsion to buy or sell, and both
parties have knowledge of relevant facts.
The question that then arises is "How do buyers and sellers arrive at this value?"
Arriving at the transaction price requires that a value be placed on the company
for sale. The process of arriving at this value should include a detailed,
comprehensive analysis which takes into account a range of factors including the
past, present, and most importantly, the future earnings and prospects of the
company, an analysis of its mix of physical and intangible assets, and the general
economic and industry conditions.
The other salient factors include:
(1) The stock exchange price of the shares of the two companies before the
commencement of negotiations or the announcement of the bid.
(2) Dividends paid on the shares.
(3) Relative growth prospects of the two companies.
(4) In case of equity shares, the relative gearing of the shares of the two
( ‘gearing' means ratio of the amount of Issued preference share capital and
debenture stock to the amount of issued ordinary share capital.)
(5) Net assets of the two companies.
(6) Voting strength in the merged (amalgamated) enterprise of the shareholders
of the two companies.
(7) Past history of the prices of shares of the two companies.

Also the following key principles should be kept in mind:

(1) There is no method/of valuation which is absolutely correct. Hence a
combination of all or some may be adopted.
(2) If possible, the seller should evaluate his company before contacting
potential buyers. Infact, it would be wiser for companies to evaluate their
business on regular basis to keep themselves aware of its standing in the
corresponding industry.
(3) Go for a third party valuation if desirable to avoid over—valuation of
company which is a common tendency on the seller's part.
(4) Merger and amalgamation deals can take a number of months to complete
during which time valuations can fluctuate substantially. Hence provisions
must be made to protect against such swings.

Valuation/Acquisition Motives
An important aspect in the merger/amalgamation/takeover activity is the
valuation aspect. The valuation of business, however, depends to a great extent on
the acquisition motives. The acquisition activity is usually guided by strategic
behavioural motives. The strategic reasons could be either purely financial
(taxation, asset-stripping, financial restructuring involving an attempt to augment
the resources base and portfolio-investment) or business related (expansion or
diversification). The behavioural reasons have more to do with the personnel
ambitions or objectives (desire to grow big) of the top management. The
expansion and diversification objectives are achievable either by building capacities
on one's own or by buying the existing capacities. This would effectively mean a
"make (build) or buy decision" of capital nature. The decision criteria in such a
situation would be the present value of the differential cash flows. These differential
cash flows would, therefore, be the limit on the premium which the acquirer would
be willing to pay. On the other hand, if the acquisition is motivated by financial
considerations (specifically taxation and asset-stripping), the expected financial
gains would form the limit on the premium, over and above the price of physical
assets in the company. The cashflow from operations may not be the main
consideration in such situations. Similarly, a merger with financial restructuring
as its objective will have to be valued mainly in terms of financial gains. It
would, however, not be easy to determine the level of financial gains because the
financial gains would be a function of the use of which these resources are put.
Finally, the pricing of behaviorally motivated acquisitions is not really guided by
the financial considerations. Since the acquisitions are not really the market driven
transactions, a set of non-financial considerations will also affect the price. The
price could be affected by the number and the motives of other bidders. The value
of a target is effected not only by the motive of the acquiring company, but also by
the target company's own objectives. The motives of the target company could
also be viewed as to be strategic, financial'or behavioural.
Valuation of private companies
While the principles of valuation of private companies are the same as for
public companies, an important difference is that for private company targets we
do not have the benchmark valuation provided by the stock market. And also
that a public company is often widely researched by investment analysts,
information about the private target may be sparse. Forecasting the future cash
flows is thus a more difficult exercise. Offsetting this disadvantage is the fact
that private company bids are almost always friendly, with easier access to the
target's management information.
Valuation of listed companies
Shares of listed companies, which are traded, are quoted on the stock exchange
and are freely available. These shares can be sold or bought at the stock exchanges.
The market price of the shares reflects their value.
However, there cannot be complete reliance on the market value of shares
because of two short comings viz. firstly, at times, correct information about a
company is not available to the investors, and, secondly, due to insider trading, there
are distortions, which are reflected in the market price of shares.
Valuation of unlisted companies
The P/E ratio cannot be calculated in the case of unlisted companies, as the
market price of the shares is not available. Hence, a representative P/E ratio of a
group of comparable quoted companies can be taken after suitable adjustments.
Generally, for private limited companies or small companies, which are not quoted
and are closely held, a discount is applied for valuation to the prevalent P/E ratio of
comparable listed company.
The other factors to be taken into consideration while following earning
approach to valuation of an unlisted company are:
1. Company analysis - - shareholding pattern, voting powers, rights and
obligations of shareholders in addition to other data.
2. Industry analysis - - whether it is high or low growth industry,
natureindustry and influence on it of seasonal, volatile orcyclical
business fluctuations, major competitors and their market share, etc.
Methods of valuation
The cardinal rule of commercial valuation is, that the value of something cannot
stated in an abstract form; all that can be stated is the value of a thing in a particular
place, at a particular time, in particular circumstances.
Valuation of the target requires valuation of the totality of the incremental cash
flows and earnings.
Valuation of a target is based on expectations of both the magnitude and the
timing of realisation of the anticipated benefits. Where, these benefits are difficult to
forecast, the valuation of the target is not precise. This exposes the bidder to
valuation risk. The degree of this risk depends on the quality of information
available to the bidder, which, in turn, depends upon whether the target is a private
or a public company, whether the bid is hostile or friendly, the time spent in
preparing the bid and the pre-acquisition audit of the target.
There are four main value concepts namely:
- owner value
- market value
- tax value and
- fair value.
Owner value determines the price in negotiated deals and is often led by a
proprietor's view of value if he were deprived of the property.
The basis of market value is the assumption that if comparable property has
fetched a certain price, then the subject property will realize a price something near
to it.
The fair value concept in essence, is the desire to be equitable to both parties. It
recognizes that the transaction is not in the open market and that vendor and
purchaser have been brought together in a legally binding manner.
Tax valuation has been the subject of case law since the turn of the century.

There are concepts of value that impunge upon each of these main areas; namely,
investment value, liquidation value, and going concern value.
I. Valuation based on assets
This valuation method is based on the simple assumption that adding the value of
all the assets of the company and subtracting the liabilities, leaving a net asset valuation,
can best determine the value of a business. However, for the purposes of the
amalgamation the amount of the consideration for the acquisition of a business may be
arrived at either by valuing its individual assets and goodwill or by valuing the business
as a whole by reference to its earning capacity. If this method is employed, the fixed
assets of all the amalgamating companies should preferably be valued by the same
professional value on a going concern basis. The term 'going concern' means that a
business is being operated at not less than normal or reasonable profit and value will
assume that the business is earning reasonable profits when appraising the assets. If it
is found when all the assets of the business, both fixed and current, have been valued
that the profits represent more than a fair commercial return upon the capital employed
in the business as shown by such valuation the capitalized value of the-excess (or super
profits) will be the value of the goodwill, which must be added to the values of the
other assets in arriving at the consideration to be paid for the business. This method"
may be summarized thus: The procedure of arriving at the value of a share employed in
the equity method is simply to estimate what the assets less liabilities are worth, that is,
the net assets lying for a probable loss or possible profit on book value, the balance
being available for shareholders included in the liabilities may be debentures,
debenture interest, expenses outstanding and possible preference dividends if the
articles of association stipulate for payment of shares in winding up.
However, although a balance sheet usually gives an accurate indication of short-term
assets and liabilities, this is not the case of long-term ones as they may be hidden by
techniques such as "off balance sheet financing". Moreover, a balance sheet is a
historical record of previous expenditure and existing liabilities. As a valuation is a
forward looking exercise, acquisition purchase prices generally do not bear any relation
to published balance sheet. Nevertheless a company's net book value is still taken into
account as net book values have a tendency to become minimum prices and the greater
the proportion of purchase price is represented by tangible assets, the less risky it's
acquisition is perceived to be.
Valuation of a listed and quoted company has to be done on a different footing as
compared to an unlisted company. The real value of the assets may or may not reflect the
market price of the shares; however, in unlisted companies, only the information relating
to the profitability of the company as reflected in the accounts is available and there is no
indication of the market price. Using existing public companies as a benchmark to
value similar private companies is a viable valuation methodology.
The comparable public company method involves selecting a group of publicly traded
companies that, on average, are representative of the company that is to be valued. Each
comparable company's financial or operating data (like revenues, EBITDA or book
value) is compared to each company's total market capitalization to obtain a valuation
multiple. An average of these multiples is then applied to get company value.
An asset-based valuation can be further separated into four approaches: Book value
The tangible book value of a company is obtained from the balance sheet by taking
the adjusted historical cost of the company's assets and subtracting the liabilities;
intangible assets (like goodwill) are excluded in the calculation.
Statutes like the Gift Tax Act, Wealth Tax Act, etc., have in fact adopted book
value method for valuation of unquoted equity shares for companies other than an
investment company. Book value of assets does help the valuer in determining the
useful employment of such assets and their state of efficiency. In turn, this leads the
valuer to the determination of rehabilitation requirements with reference to current
replacement values.
In all cases of valuation on assets basis, except book value basis, it is important to
arrive at current replacement and realization value. It is more so in case of assets like
patents, trademarks, know-how, etc. which may posses value, substantially more or less
than those shown in the books.
Using book value does not provide a true indication of a company's value, nor does
it take into account the cash flow that can be generated by the company's assets.
2. Replacement cost
Replacement cost reflects the expenditures required to replicate the operations of the
company. Estimating replacement cost is essentially a make or buy decision.
3. Appraised value
The difference between the appraised value of assets, and the appraised value of
liabilities is the net appraised value of the firm.
This approach is most commonly used in a liquidation analysis because it reflects the
divestiture of the underlying assets rather than the ongoing operations of the firm.
4. Excess earnings
In order to obtain a value of the business using the excess earnings method, a
premium is added to the appraised value of net assets. This premium is calculated by
comparing the earnings of a business before a sale and the earnings after the sale, with
the difference referred to as excess earnings.
In this approach, it is assumed that the business is run more efficiently after a sale;
the total amount of excess earnings is capitalized (e.g., the difference in earnings is
divided by some expected rate of return) and this result is then added to the appraised
value of net assets to derive the value of the business.
II. Open market valuation
Open market value refers to a price of the assets of the company which could be
fetched or realized by negotiating sale provided there is a willing seller, property is
freely exposed to market, sale could materialize within a reasonable period, orders will
remain static throughout this period and without interruption from any purchaser giving
an extraordinarily higher bid. Each asset of the company is normally valued on the basis
of liquidation as resale item rather than on a going-concern basis. The assets of the
company, which are not subject to regular sale, could be assessed on depreciated or
replacement cost. Besides, intangible assets like goodwill are also assessed as per
normal practices and recognized conventions.
III. Valuation based on earnings
The normal purpose of the contemplated purchase is to provide for the buyer the
annuity for his outlay. He will expect yearly income, return great or small, stable or
fluctuating but nevertheless some return which is commensurate with the price paid
therefore. Valuation based on earnings based on the rate of return on capital
employed is a more modern method being adopted. From the last earnings declared
by a company, items such as tax, preference dividend, if any, are deducted and net
earnings are taken.
An alternate to this method is the use of the price-earning (P/E) ratio instead of
the rate of return. The P/E ratio of a listed company can be calculated by dividing
the current price of the share by earning per share (EPS). Therefore, the
reciprocal of P/E ratio is called earnings - price ratio or earning yield.
Thus P/E = P
Where P is the current price of the shares.
The share price can thus be determined as
P = EPS x P/E ratio



In practice, investors attach a lot of importance to the earnings per share (EPS) and
the price-earnings (P/E) ratio. The product of EPS and P/E ratio is the market price
per share.
Exchange Ratio
The current market values of the acquiring and the acquired firms may be taken
as the basis for exchange of shares. The share exchange ratio (SER) is given as

Share Exchange Ratio = Share price of the acquired firm

Share price of the acquiring firm
SER = Pb

The exchange ratio in terms of the market value of shares will keep the
position of the shareholders in value terms unchanged after the merger since
their proportionate wealth would remain at the pre-merger level. There is no
incentive for the shareholders of the acquired firm, and they would require a
premium to be paid by the acquiring company. Could the acquiring company pay
a premium and be better off in terms of the additional value of its shareholders? In
the absence of net economic gain, the shareholders of the acquiring company would
become worse-off unless the price-earnings ratio of the acquiring company remains
the same as before the merger. For the shareholders of the acquiring firm to be better
off after the merger without any net economic gain either the price-earnings ratio
will have to increase sufficiently higher or the share exchange ratio is low, the
price-earnings ratio remaining the same. Let us consider the example in Illustration
given below:

Illustration. Enterprise is considering the acquisition of Enterprise. The following

are the financial data of two companies:

Profit after tax

(Rs.) Number
of shares EPS
(Rs.) Market
value per share
(Rs.) Price
earnings ratio
Shyama Enterprise is thinking of acquiring Rama Enterprises through exchange of
shares in proportion of the market value per share. If the price-earnings ratio is expected
to be (a) pre-merger P/E ratio of Rama i.e. 7.5 (b) pre-merger P/E ratio of Shyama i.e.
15, (c) weighted average of pre-merger P/E ratio of Shyama and Rama i.e. 13.75, what
would be the impact on the wealth of shareholders after merger?
Since the basis of exchange of shares is the market value per share of the
acquiring (Shyama Enterprise) and- the acquired (Rama Enterprises) firms, then
Shyama would offer 0.25 of its shares to the shareholders of Rama:
Pb = 30 = 0.25
Pa 120

In terms of the market value per share of the combined firm after the merger, the
position of Rama's shareholders would remain the same; that is, their per share value
would be: 120 x .25 = Rs. 30. The total number of shares offered by Shyama (the
acquiring firm) to Rama's (the acquired firm) shareholders would be:
No. of shares exchanged = SER x Pre-merger number of shares of the acquired firm.
= (Pb/Pa)Nb

= 0.25 x 8000 = 2,000

and the total number of shares after the merger would be: Nb + (SER) Nm =
20,000 + 2,000 = 22,000. The combined earnings (PAT) after the merger would be: Rs.
80,000 + Rs. 16,000 = 96,000 and EPS after the merger would be:

Post-merger combined EPS = Post -merger combined PAT

Post - merger combined shares
= 80,000 + 16,000
20,000 +(0.25)8000
= 96,000 = 4.36

The earnings per share of Shyama (the acquiring firm) increased from Rs.4 to
Rs.4.36, but for Rama's (the acquired firm) shareholders it declined from Rs. 2 to
Rs.4.36x.25 = Rs.1.09.
Given the earnings per share after the merger, the post-merger market value per
share would depend on the price-earnings ratio of the combined firm. How would
P/E ratio affect the wealth of shareholders of the individual companies after the
The shareholders of both the acquiring and the acquired firms neither gain nor
lose in value terms if post-merger P/E ratio is merely a weighted average of pre-
merger P/E ratios of the individual firms. The post-merger weighted P/E ratio is
calculated as follows:
Post-merger weighted P/E ratio:
(Pre-merger P/E ratio of the acquiring firm) x (Acquiring firm's pre-merger
earnings + Post-merger combined earnings) + (Pre-merger P/E ratio of the
acquired firm) x (Acquired firm's pre-merger earnings H- Post merger combined
P/EW = (P/EJ (PATa/PATc) + (P/Eb) x (PATb/PATc) ...(4)
Using Equation (4) in our example we obtain:
(30) x (80,000/96,000) + (15) (16,000/96,000) = 25 + 2.5 = 27.5

The acquiring company would lose in value if post-merger P/E ratio is less than
the weighted P/E ratio. Any P/E ratio above the weighted P/E ratio would benefit
both the acquiring as well as the acquired firms in value terms. An acquiring firm
would always be able to improve its earnings per share after the merger
whenever it acquires a company with a P/E ratio lower than its own P/E ratio. The
higher EPS need not necessarily increase the share price. It is the quality of EPS
rather than the quantity which would influence the price.
An acquiring firm would lose in value if its post-merger P/E ratio is less than the
weighted P/E ratio. Shyama Enterprise would lose Rs.27.30 value per share if P/E
ratio after merger was 15. Any P/E ratio above the weighted P/E ratio would benefit
both the acquiring as well as the acquired firm in value terms. When the post-merger
P/E ratio is 30, Shyama gains Rs.5.40 value per share and Rama Rs.1.35.
Why does Shyama Enterprise's EPS increase after merger? Because it has a
current P/E ratio of 30, and it is required to exchange a lower P/E ratio, i.e.
P/E exchanged = SER x Pa ...(5)
= 25x120_ = 15
Shyama Enterprise's EPS after merger would be exactly equal to its pre-merger
EPS if P/E ratio paid is equal to its pre-merger P/E ratio of 30. In that case, given
Rama's EPS of Rs.2, the price paid would be Rs.60 or a share exchange ratio of .5.
Thus Shyama Enterprise would issue .5 x 8,000 = 4,000 shares to Rama Enterprise.
The acquiring firm's EPS after merger would be: Rs.96,000/24,000 = Rs.4. It may be
noticed that at this P/E ratio, Shyama's shareholders would have the same EPS as
before the merger: .5 x Rs.4 = Rs.2. It can be shown that if the acquiring firm takes
over another firm by exchanging a P/E ratio higher than its P/E ratio, its EPS will fall
and that of the acquired firm would increase after the merger.
The limitation of this methods is that it is based on past performance whereas for a
fair valuation, a reliable estimate of future earnings is necessary.
In view of this, discounted cash flow (DCF) is often a preferred tool to value
businesses. What sets this approach apart from other approaches is that it is based on
projected, future operating results rather than on historical operating results. As a result,
companies can be valued based on their future cash flows, which may be somewhat
different from historical results.

Practice questions :

1. When does valuation becomes a necessity.

2. What are the factors which influences valuation of a business?
3. Write about valuation of private companies.