Business Valuation

Business Valuation

SEMINAR 2 – The Valuation Context

Business valuation is said to combine both art and science – the science aspect involves a rational and commercial approach of concepts and principles, whereas the art form involves applying judgment to the particular circumstances affecting the subject.

Business valuation, by definition, is the valuation of a business or ownership interest in a company. It is, because of its technical nature, relevant to the accounting, corporate and legal community.

International Glossary of Business Valuation Terms is developed by a task force which includes representatives from professional valuation bodies based in North America – these bodies include the American Society of Appraisals (ASA), the Institute of Business Appraisal (IBA), etc.

Business valuation can be viewed from various perspectives – market investors, analysts, corporate finance advisers, investment bankers, auditors, regulatory bodies etc. However, regardless of whichever perspectives, the underlying concepts, principles and practices remain essentially the same.

Valuation relates to an estimation of the “true worth” of an asset – as it is, the current value of any asset is related to its expected future returns (as no one can accurately predict the future, there is always uncertainty). The higher the level of uncertainty, the riskier the asset.

In financial terms, the current value of any asset is equal to the present value of the future returns generated by the asset. Often, the future returns are represented by the future net cash flows discounted to present value by an appropriate rate – the more uncertain (risky) the future net cash flow, the higher the rate to discount it. It is also worth to remember the difference between value and price: value is the estimate of the true worth of an asset, price is the amount actually realised for that asset.

Valuation is performed at a specific period in time and relates to expected future returns – this principles underline that it is the future economic benefit that generates value and past history is often irrelevant except for an indication of future projections.

There are different standards of value:

• Fair market value > the price, expressed in terms of cash equivalents, at which property would be changed between a buyer and a seller in an open and unrestricted market, when neither is under compulsion to buy and they both have reasonable knowledge about the facts
• Fair value > estimated price for the transfer of an asset or liability between parties
• Fair value (financial reporting) > the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date
• Intrisic (fundamental) value > the value that an investor considers, on the basis of an evaluation or available facts, to be the true or real value that will become the market value when other investors reach the same conclusion
• Market value > the estimated amount for which an asset should exchange on the date of evaluation between a willing buyer and a willing seller (market cap)
• Investment value (or value to the acquirer): the value to a particular investor based on individual investment requirements and expectations

The gap between the fair market value and the investment value is the negotiation value.

FAIR MARKET VALUE is the most commonly used definition of value and applies to situations where valuations are conducted for tax purposes, to comply with the terms of shareholders’ agreements, and M&A.

For valuation of a publicly traded company, a term commonly used by investment analysts is intrinsic value: this is generally considered to be the appropriate price for a share, following an analysis of a company’s assets, earnings and other factors. If the intrinsic value is higher than the market price, analysts will provide a Buy recommendation. On the contrary, if the intrinsic value is lower, it will be a “Sell”. The term investment value is often used in the acquisition space – usually this is a higher value that reflects the synergistic benefits or cost savings that the particular owner is able to extract from the transaction.

A going concern value is the value of a business enterprise that is expected to continue to operate in the future – in normal conditions and circumstances, most business valuations are performed under this premise. However, when valuing a business that may cease operations, a valuation under the liquidation scenario is contemplated. A liquidation value is the net amount that would be realised if the business is terminated and the assets are sold. Liquidation can be orderly (if assets are sold over a reasonable period of time to obtain the best available price) or forced (if assets are sold as quickly as possible). All this being equal, valuation performed on the premise of going concern will yield the highest value, while the lowest one would be derived from valuation carried out under the premise of forced liquidation.

What do we value?

Companies and businesses, tangible and intangible assets, others (e.g. financial instruments).

A business enterprise is defined as a commercial, industrial, service or investment entity (or a combination thereof) pursuing an economic activity. It comprises of both tangible and intangible assets. The assets could be classified as fixed assets, working capital assets, identifiable intangible assets, workforce and goodwill – they all generate future economic benefits in the form of revenues, earnings, cash flows, etc.

The going concern value is the value of a business enterprise that is expected to continue to operate in the future. The intangible elements of going concern value result from factors such as having a trained workforce, an operational plant, necessary licences and systems.

Generally, the future economic benefits generated by the assets are shared between two funding sources: debt and equity. This value of the business is commonly referred to as “Firm or enterprise value” in many markets. Enterprise Value (EV) is calculated as market capitalization plus debt, minority interest and preferred equity minus total cash and cash equivalents.