Valuation analysis: The price should be right by

Bernadette T. Cauan (August 29, 2011)

SUITS THE C-SUITE By Bernadette T. Cauan
Business World (08/29/2011)
Valuation is a vital part of management decision making, particularly in relation to
acquisitions, divestments, fi nancial reporting, tax planning and compliance, dispute
resolution, business strategy, and performance management.
Regardless of the purpose and/or subject of the valuation, there are general approaches
and methods to performing valuation analysis.
General valuation approaches, as well as valuation methods more commonly used, are
described in this article.
INCOME APPROACH
This approach is anchored on the concept that value can be estimated by determining
the present value of expected future net cash fl ows to be generated, based on the
anticipated timing of its receipt.
The Discounted Cash Flow (DCF) analysis is commonly used in performing a valuation
based on the income approach. Since the resulting range of values is substantially
infl uenced by the amounts of anticipated future net cash fl ows and the discount rate to
be used, the fi nancial projections are subjected to rigorous review, and the range of
discount rates to be used are carefully derived.
Prior to fi nalizing the net cash fl ows to be used for the DCF analysis, underlying
assumptions are analyzed vis--vis historical fi gures, fi nancial results or key
performance indicators of peer companies, and the relevant sector outlook. Selected key
assumptions used in preparing the fi nancial projections are also benchmarked against
available documents or reports.
MARKET APPROACH
The market approach is predicated on the concept that value can be estimated through
a comparison of companies, shares, or assets that have similar features.
The usual challenge in utilizing this approach is the availability of relevant information
to be used in the valuation analysis.
The market approach is implemented through two methods:
Guideline Company Method Here, relevant comparable companies are identifi ed
through an iterative process.
Appropriate multiples are selected, adjustments, if any, are implemented, and then an
indication of value is derived based on the selected multiples.
The Guideline Company Method necessitates meticulous analysis to be able to identify
appropriate comparable companies.
Among the areas considered are the nature of business operations, business segments,
fi nancial results, cash fl ow patterns, key performance indicators and other corporate
statistics.
In case of enterprise value (EV), common multiples include EV to sales or revenues, EV
to earnings before interest, taxes, depreciation and amortization (EBITDA) or EV to
earnings before interest and taxes (EBIT), whereas in the case of equity value, usual
multiples include price-to-earnings (P/E) ratio, and the price-to-book value (P/B) ratio.

 Similar Transaction Method In this method, an indication of value is derived based

on the actual price paid by acquirers in comparable transactions.
The process for implementing the Similar Transaction Method is similar to the Guideline
Company Method.
COST APPROACH
This approach is founded on the principle of substitution, specifi cally, that no rational
buyer will pay for a company more than the cost of acquiring the corresponding net
assets that have similar condition and function.
The Adjusted Net Asset Value (NAV) method is typically used to derive value based on
the cost approach.
The NAV method requires restating all of the assets and liabilities of the company from
their historical cost basis to the appropriate standard of value, which is most often
either its fair market value or fair value.
The cost approach is commonly used to value holding companies, capital-intensive
companies, loss-making businesses or companies facing imminent liquidation.
However, it is not the best approach to value companies with predictably robust cash
fl ows or those with signifi cant intangible value.
In practice, it is advisable to select a primary valuation approach, as well as a
secondary approach for purposes of cross-checking.
Ideally, the resulting range of values should be within a relatively tight range.
If the results are substantially far apart, it may suggest that the valuation analysis
needs to be revisited.
The selection of the valuation approaches and methods to be applied are normally
infl uenced by the condition and attributes of the subject of the valuation and the
availability of information.
Inherent, of course, to performing valuation analysis will be the exercise of professional
judgment based on experience and market practice.
Moreover, valuation analysis involves estimation based on accepted models and market
practice.
This process necessitates an understanding of underlying assets, risks, potential
premiums, business models, industry practices, regulatory frameworks and the market
environment.
Hence, valuation is often said to be a combination of art and science.
(Bernadette T. Cauan is a Partner of SGV & Co.)

A Re-evaluation of Share Valuation

Harold Christian S. Talledo
March 06, 2014

With the issuance of Revenue Regulations No. (RR) 6-2013 last April, the Bureau of
Internal Revenue (BIR) has tightened the tax rules on transactions involving the sale of
unlisted shares of stock. RR 6-2013 prescribes a new method to determine the fair
market value (FMV) of shares to be sold.
Under the previous rule, the FMV of shares is its book value i.e., total assets minus total
liabilities, as shown in the corporations latest audited financial statements. Under RR 62013, if the corporation that issued the shares has real properties, the FMV of such
shares shall be determined based on the Adjusted Net Asset Method. Using this
method, the net assets are adjusted to reflect the FMV of the real properties, i.e., the
highest of the following: zonal value of the real properties; fair market value per tax
declaration; or fair market value as determined by an Independent Appraiser.
The foremost result of RR 6-2013 is an increase in possible taxes, in the form of
additional capital gains tax and/or donors tax, especially in instances when real
properties are recorded in the financial statements at cost, which is most often the
case. Presumably, the aim is to compel shareholders to sell at or above the FMV using
the Adjusted Net Asset Method; otherwise, donors tax will be imposed on the difference
between the selling price and the FMV.
While RR 6-2013 seemingly attempts to plug the loophole that has allowed sellers to
undervalue their shares (by maintaining the value of the corporations real properties
at cost), it is debatable whether this new method is a fair gauge to determine the actual
FMV of shares of stock.
It is interesting to note that the National Internal Revenue Code (Tax Code) does not
explicitly provide a definition of the FMV of shares of stocks. The term fair market
value, however, has been defined by the Supreme Court as the price at which a
property may be sold by a seller who is willing but not compelled to sell and bought by a
buyer who is willing but not compelled to buy. Given this definition, will the Adjusted
Net Asset Method yield a price at which shares may be sold by a seller who is willing but
not compelled to sell and bought by a buyer who is willing but not compelled to buy?
To illustrate, consider a corporation whose sole asset is a real property with a cost of P1
million. Under the old rule, the FMV of the shares would be P1 million, assuming the
corporation has no liabilities and earnings accumulated. Under RR 6-2013, however, if
the real property is currently appraised at P101 million, then the FMV of the shares
would also be P101 million. Hence the question: will there be a buyer who is willing to
buy the shares at P101 million?

Assume the buyer buys the shares at P101 million. If the corporation (now wholly
owned by the buyer) subsequently sells the real property at its current appraised value,
discounting the effect of value-added tax, the buyer then effectively shoulders and pays
a total of P37 million in taxes (30% corporate income and 10% tax on dividends). If he
considers this tax consequence, he will normally be willing to buy the shares only at P63
Million and not at P101 million. RR 6-2013 effectively forces the buyer to assume the
taxes that should have been for the account of the seller.
This resulting anomaly, or inequity at that, arises because the determination of FMV
under RR 6-2013 does not consider other relevant factors that differentiate the
corporation itself from the real properties it owns. For one, the Tax Code has, in fact,
historically recognized (under Republic Act No. 6141) that the FMV of unlisted shares
should be determined not only by the book value of the shares, but also the nature and
history of the business of the corporation, earning and dividend paying capacity of the
corporation, goodwill, and sales of both the shares to be valued and that of companies
similarly situated. Secondly, even under recognized accounting rules, a mark-to-market
method (i.e., deriving the fair value of a corporations equity instruments by reference
to the fair value of the underlying assets and liabilities) is more appropriate for
corporations such as holding companies, whose value is mainly derived from holding of
assets rather than from deploying those assets as part of a broader business. Hence,
accounting rules apply a different method in valuing a corporation whose real properties
are used in business. Section 43 of the Tax Code allows taxpayers to adopt any
accounting method on the condition that the method accurately reflects the income.
Lastly, it is a basic rule in taxation that any gain from the increase in the valuation of
property is not a taxable gain unless and until it is realized, i.e., the property is sold or
disposed of. What is being sold, under RR 6-2013, however, is the share of stock, not
the real property.
Aside from the increase in taxes, RR 6-2013 also burdens taxpayers with the additional
cost of securing an appraisal report from an independent appraiser, which is really
superfluous since the BIR is already mandated to consult competent appraisers from
both the public and private sectors in determining zonal values.
All told, the issuance of RR 6-2013 can result to a boon or a bane insofar as share
acquisition is concerned. While the most complete and accurate manner through which
the determination of FMV can be done has yet to be fully known, RR 6-2013 has
reopened the debate on what truly constitutes a fair and reasonable value of shares of
stock. Nonetheless, unless and until it is revised or otherwise declared unlawful by the
courts, RR 6-2013 is the prevailing interpretation of the law and must therefore be

considered by the parties in deciding whether to buy or sell shares of the corporation or
the real properties owned by the seller corporation.
(The author is an Associate of the Angara Abello Concepcion Regala & Cruz Law Offices. He may
be contacted at 830-8000 or through his email address: hstalledo@accralaw.com. The views and
opinions expressed in this article are those of the author. This article is for general informational and
educational purposes and not offered as and does not constitute legal advice or legal opinion)

BUSINESS VALUATION: AN IMPORTANT MANAGEMENT ADVISORY

SERVICE
Business valuation is not a new service for CPAs. Although the demand has
grown as a result of the increase in mergers and acquisitions, there are many
other instances in which a valuation would be required. The American
Institute of CPAs MAS Small Business Consulting Practice Aid no. 8,
Valuation of a Closely Held Business, lists some 20 reasons for valuing a
small business.
Business valuations determine the fair market value of an established
company. They can be based on valuations of tangible and intangible assets
and on forecasts of future profits and cash flow.
CPAs' QUALIFICATIONS
CPAs who provide valuations are in competition with other business
valuators and appraisers. Why is it appropriate for CPAs to perform this
service? Because valuation is not an exact science. It is an art that requires
not paint and canvas but the application of a variety of quantitative methods
to establish a value or range of values for a unique item--a specific business.
CPAs are well-suited to perform this service because of their skills in
applying quantitative methods.
CPAs' general knowledge of the business environment and of long-term
clients' businesses and financial histories is another important qualification.

For example, the appraised replacement value of tangible assets may differ
from their value as part of an ongoing business. Also, the intangible element
of goodwill may be a key factor in the valuation of a small business.
ENGAGEMENT CONSIDERATIONS
Let's assume a CPA is asked to provide a business valuation in connection
with the possible sale of a company. The practitioner should not accept the
engagement if he or she does not have or wish to acquire the competence
required for this professional service. The CPA should understand
* The client's business and industry.
* The purpose of the valuation.
* The qualifications and technical resources necessary to complete the
engagement.
* Whether sufficient client data are available to make the valuation.
Tax considerations also are an important ingredient in valuations. CPAs
should review each of the Internal Revenue Service guidelines in EXHIBIT 1
IRS guidelines related to valuating a closely held business when valuing a
closely held business.
The CPA then must decide if it's appropriate to work for this client or on this
job. For example, he must consider audit independence with an existing audit
client, particularly one that's publicly held. Also, some states have regulations
pertaining to appraisals or valuations, especially for real estate.
While some CPA firms offer specialized appraisal services, most are
concerned with the overall valuation of small businesses, which may or may
not include appraisals of tangible assets. Specialized appraisers may be called
in to provide valuations of diverse tangible assets such as real estate,
machinery, trucks, jewelry, works of art and postage stamps for collectors.

CHOOSING THE METHOD

The reason for a valuation often affects the valuation process. For example,
valuing a business for tax purposes and arriving at a fair market value for a
sale or other reason may differ in approach and result.
The choice of an appropriate valuation method or methods for a specific
business under specific circumstances is the "art" of a valuation. Many
industries and professions use rule-of-thumb formulas to determine value, but
such formulas alone may not provide appropriate valuations. Rules of thumb
do not consider current market forces. Nevertheless, these industry methods
often provide a good starting point.
Industry formulas fall into four basic categories, according to the Handbook
of Small Business Valuation Formulas by Glenn Desmond and John Marcello
(Valuation Press, Los Angeles, 1988). These are gross sales multiplier;
monthly or annual profit (cash flow) multiplier; unit multipliers based on an
appropriate unit; and summation formulas, which combine the results of the
other three categories and include the appraised value of tangible assets.
Business Valuation Methods
Adapted from content excerpted from the American Express OPEN Small Business Network

There are a number of instances when you may need to determine the market value of a business. Certainly, buying
and selling a business is the most common reason. Estate planning, reorganization, or verification of your worth for
lenders or investors are other reasons.
Valuing a company is hardly a precise science and can vary depending on the type of business and the reason for
coming up with a valuation. There are a wide range of factors that go into the process -- from the book value to a host
of tangible and intangible elements. In general, the value of the business will rely on an analysis of the company's
cash flow. In other words, its ability to generate consistent profits will ultimately determine its worth in the
marketplace.
Business valuation should be considered a starting point for buyers and sellers. It's rare that buyers and sellers come
up with a similar figure, if, for no other reason, than the seller is looking for a higher price. Your goal should be to
determine a ballpark figure from which the buyer and the seller can negotiate a price that they can both live with.
Look carefully at the numbers, but keep in mind this caution from Bryan Goetz, president of Capital Advisors, Inc., a

business appraiser: "Businesses are as unique and complex as the people who run them and are not capable of
being valued by a simplistic rule of thumb."
Here are some of the common methods used to come up with a value.

Asset valuation

Capitalization of income valuation

Owner benefit valuation

Multiplier or market valuation

Asset Valuation
Asset valuation is used when a company is asset-intensive. Retail businesses and manufacturing companies fall into
this category. This process takes into account the following figures, the sum of which determines the market value:

Fair market value of fixed assets and equipment (FMV/FA) - This is the price you would pay on the open
market to purchase the assets or equipment.

Leasehold improvements (LI) - These are the changes to the physical property that would be considered
part of the property if you were to sell it or not renew a lease.

Owner benefit (OB) - This is the seller's discretionary cash for one year; you can get this from the adjusted
income statement.

Inventory (I) - Wholesale value of inventory, including raw materials, work-in-progress, and finished goods or
products.
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Capitalization of income valuation
This method places no value on fixed assets such as equipment, and takes into account a greater number of
intangibles. This valuation method is best used for non-asset intensive businesses like service companies.
In his book "The Complete Guide to Buying a Business" (Amacom, 1994), Richard Snowden cites a dozen areas that
should be considered when using Capitalization of Income Valuation. He recommends giving each factor a rating of
0-5, with 5 being the most positive score. The average of these factors will be the "capitalization rate" which is
multiplied by the buyer's discretionary cash to determine the market value of the business. The factors are:

Owner's reason for selling

Length of time the company has been in business

Length of time current owner has owned the business

Degree of risk

Profitability

Location

Growth history

Competition

Entry barriers

Future potential for the industry

Customer base

Technology
Again, add up the total ratings, and divide by 12 to come up with an average value to use as the capitalization rate.
You next have to come up with a figure for "buyer's discretionary cash" which is 75% of owner benefit (seller's
discretionary cash for one year as stated on the income statement). You multiply the two figures to determine the
market value.
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Owner benefit valuation
This formula focuses on the seller's discretionary cash flow and is used most often for valuing businesses whose
value comes from their ability to generate cash flow and profit. It uses a fairly simple formula -- you multiply the owner
benefit times 2.2727 to get the market value. The multiplier takes into account standard figures such as a 10% return
on investment, a living wage equal to 30% of owner benefit, and debt service of 25%.
[Back to top]
Multiplier or market valuation
This approach finds the value of a business by using an "industry average" sales figure as a multiplier. This industry
average number is based on what comparable businesses have sold for recently. As a result, an industry-specific
formula is devised, usually based on a multiple of gross sales. This is where some people have trouble with these
formulas, because they often don't focus on bottom line profits or cash flow. Plus, they don't take into account how
different two businesses in the same industry can be.
Here are a few industry multiplier examples, as mentioned in "The Complete Guide to Buying a Business" by Richard
Snowden (Amacom, 1994):

Travel agencies - .05 to .1 X annual gross sales

Ad agencies - .75 X annual gross sales

Retail businesses - .75 to 1.5 X annual net profit + inventory + equipment

To find the right multiplier for your industry, you can try contacting your trade association. Another option is to utilize
the services of a broker or appraiser who specializes in businesses such as yours.

What Your Financial Statements Tell You

Provided by SME.com.ph

As an entrepreneur, one of the things you need to learn is how to analyze your financial
statements. Understanding financial statements is critically important to the success of a
small business especially during its first two years.
Financial statements can be used as a roadmap on your business journey to economic
success. Using numbers as navigation aids can steer you in the right direction and help
you avoid costly mistakes. Most entrepreneurs dont realize that financial statements
have a value that goes far beyond their use to prepare tax returns or loan applications.
Any business, whether new or old, has to have updated financial statements all the
time. An entrepreneur will have a better understanding of how this business is doing by
analyzing the different critical information which financial statements present. By doing
so, he can nip in the bud any problem besetting his business before its too late.
First, ask your accountant to derive the following financial information from the balance
sheet and income statement:
1) Sales Growth on a monthly basis
2) Gross Margins as a percentage of Sales
3) Net Operating Expenses as a percentage of Sales
4) Accounts Receivables (Days)
5) Inventory (Days)
6) Accounts Payables (Days)
The first three data are what we call the Growth and Fundamental Profitability Indicators
of an enterprise. These are critical factors that determine whether the business can
generate enough cash to be sustainable in the long-term.
The second set of data (Account Receivables Days, Inventory Days and Accounts
Payable Days) is called the Swing Factors. They are called swing factors because any
small improvement or decline in any of the three variables can result in a significant shift
or swing to the cash position of the company.
Now, whats the implication or importance of this financial information to your
operations? First, the analysis of your monthly (annual) sales growth will reveal whether
the business is generating enough cash. It is worth noting that any changes in
monthly/annual sales will impact on your monthly/annual cash flow. Sales growth is an
indication that your business is using a large amount of cash to finance any business
growth.
As an entrepreneur, you know that sales is a function of the selling price and the
quantity sold. Manipulate these two critical variables to achieve your desired sales level.

Analyze where the bulk of your sales is coming from by deriving percentage of each
business units contribution to the total sales. How much is your present gross margin
and operating expenses (net of depreciation and amortization expenses) as a
percentage of total sales? Procedurally, you will arrive at your gross margin by
deducting your cost of sales/revenues from your net sales. Consequently, deducting
from your gross margins the net operating expenses will give you your cash cushion.
Gross Margin = Net Sales Cost of Sales
You should remember that by definition, gross margin represents the amount of profit
per peso of sales that the company retains after accounting for its cost of sales. It is
important for you as a starting entrepreneur to remember that any increase in gross
margin is a source of cash flow. A higher gross margin will enable your enterprise to
cover your operating expenses.
The operating expenses on the other hand, is the amount of gross margins that is
consumed by operating expense. An increasing trend in your operating expenses
means a decrease in your cash flow. A higher cushion will enable the enterprise to cover
its current operation and make the enterprise liquid in the current term. Being liquid
would mean that it would have the ability to pay its overhead expenses including
interest and tax payments.
Take a look at the last set of financial information that you should examine. These are
your Accounts Receivables Days, Inventory Days, and Accounts Payable Days. As a
manager, you can control them through rules and regulations that you will put in place
with regard to extending credit, terms of payment and collection policies.
Accounts Receivables (AR) are your credit sales. And here we are looking at the
average time your business takes to collect trade receivables arising from credit sales.
An increasing trend in the AR days reflects a decrease in cash flow and vice-versa. On
the other hand, Inventory Days tells you the average time your business takes to sell its
inventory goods. You should remember that a rising inventory (INVTY) is costly to your
operation. It is money lying idly in your storeroom or warehouse. Similarly, an increasing
trend in your INVTY days also reflects a decrease in cash flow and vice-versa. The
Accounts Payables Days is the average time it takes your business to pay its trade
creditors or suppliers. An increase in AP days reflects a source of cash. This is so
because as long as you can delay payment to your suppliers, you can hold on to our
use your cash for other purposes than payment.
Source: Business Line Vol. 2 No. 2 2004