BUSINESS VALUATION

APPROACHES AND METHODS

Overview of Valuation Approaches ,Methods &
Procedures
The Valuation methodology is organized into a hierarchy
of three basic levels
Approaches
Methods
Procedures

Valuation Approach -General course of action in which

an indication of value is to be developed

Valuation Method - a way an Approach can be

implemented.

Valuation Procedures- specific calculations, data used
and other details involved in a method
 VALUATION APPROACHES
Income Approach valuing the business
based on some form of economic income
stream

Market Approach or Relative approach

valuation by reference to other transactions

Asset-Based Approach valuation on the

basis of assets and liabilities
 VALUATION METHODS
Income Approach
Discounting method

Capitalizing method

Market Approach
Guideline public company method (GPM)

Guideline merged and acquired company method

(GMAM)

Asset-Based Approach
Adjusted net asset value method

Excess earnings method

 DCF method
DCF value = PV of CAP CF + PV of the
terminal period CF

generally two phase DCF model is adopted

discount rate is the cost of capital for the

type of investment and not the investor

capitalisation rate = discount rate - growth

rate

The growth rate during the terminal period

cannot exceed the the growth rate of the
economy
DCF method

NPV (Net Present value under free cash flow

approach is called firm value or enterprise
value)

NPV (Net Present value under Equity cash flow

approach called equity value)

Gordon Model or DDGM

Adjusted present value (APV)

Real option

 DCF method
The enterprise value of the company is calculated as
under:
Free cash flow discounted at WACC (weighted Average Cost
Of capital) plus value of excess cash and marketable
securities, cross holding and other non operating assets
(like pension fund assets, joint venture investments etc)
Step I Determine phase I (an initial time period over which
you expect the company to maintain a competitive
advantage and it is generally 5 years and the range may be
3 to 10 years)
Step II Estimate the free cash flows (FCF): amount of cash
generated by the business before allowing for financing
Step III: Estimate the Horizontal value (HV) or Terminal
value - what will be the worth of the business at the end of
that initial period (called horizontal value or PV of phase II
CF)
 DCF method
How to Calculate Horizontal value?
It could be :
HV = earning of the last year of the forecast period x
suitable multiple
HV = Constant perpetuity or growing perpetuity
Step IV Determine a suitable WACC (discount rate) for
the investment
Step V Discount the FCF using the WACC
Step VI Add the value of excess cash and marketable
securities, cross holding and other non operating assets.
Step VII In order to calculate the value of the equity of
the company, deduct the current amount of debt from
the enterprise value
Step VI value is called the value of status quo (that is
value under existing management
value of a company V= VSQ + VCP + VSP + VEO

The VSQ is the value of a company based on Status Quo

Valuation. If the investment is speculative and the
motive is undervaluation, VSQ is the maximum price to
be paid.

VCP is the value of control premium that is the

difference between the value of an optimally managed
firm and the value resulting from Status Quo Valuation:

Control Premium (CP) = Value of an optimally managed

firm VSQ
VSP is the positive added-value from combining two
firms and includes diversification premium.
Theoretically, synergy premium (SP) is synergy
Premium (SP) = Value of the combined firms -Value of
the target firm -Value of the Acquiring Firm

VEO The value of options to expand initial investments

via new markets or new products, to postpone
expansion, or to abandon projects should be taken into
consideration
 DCF METHODTEN CIRCLES OF HELL by
DAMODARAN

Current year numbers: Its amazing how wedded we are to that one-
year, baseline number.

Cash flows. You cant stop forecasting cash flows until youre willing
to make an extraordinary assumption: that your cash flows are going to
grow at a constant rate into perpetuity, Its the tail that wags every
valuation dog.

Taxes:We double count some, add some, ignore some.

Growth. We want all our businesses to grow, but ask the wrong people
the owners and managersand youll get 30% growth rate for as far
as the eye can see. Dont ever let the growth rate exceed the risk-free
rate,
 DCF METHODTEN CIRCLES OF HELL by
DAMODARAN

Discount
, rate. I think we spend far too much time talking about cost of equity,
cost of capital, cost of debtand not enough on cash flows. Analysts
outsource so many of the elements of the calculation (to Ibbotsons data,
Bloomberg data, Duff & Phelps, etc.), that its frightening.

Growth rate revisited. To grow a business, owners have to put money back
into the business, and thats a cost of growth analysts may overlook. Instead,
the focus should be on the quality of the business growth.

Debt ratio revisited. We spend a lot of time trying to get the discount rate
right, But given your own assumptions about the company, you should expect
the discount rage to change [over time]. Instead, the discussion should be
about the discount rates.
 DCF METHODTEN CIRCLES OF HELL by
DAMODARAN
Garnishing valuations : The practice of garnishing defeats the entire
point of the valuation, It puts you back totrying to get the number
,
that you want and puts all of our biases into play.

Per-share value. An issue primarily for public company valuations, which

questions the easy practice of determining per-share value by dividing
the companys market value by the number of sharesbut often overlooks
stock options, liquid/illiquid shares, etc.

I-bankers inferno. The darkest, deepest layer of hell is reserved for

those investment bankers who have forgotten the purpose of a
valuation, and in pricing an M&A deal, will often pick the wrong company
(the target company instead of the acquirer) and the wrong discount rate
(cost of debt instead of cost of equity) to arrive at the number (fees) they
want
 Adjusted Present Value

Under this approach, FCF is discounted at the

un-levered cost of equity capital.
financing Cash Flows (Tax Shield of financial
benefit on Debt and other financing benefits)
are discounted at before tax cost of
borrowing.
APV = Un-levered Project Value + Value of
Financing
APV and NPV will give similar result if
WACC is constant
When WACC is changing APV is the
superior model
Determinants of the value of a
business
History of stable growth and profits
Product Cycle point
Size Market share
Industry
Customer base -diversification
Growth potential-topline and bottom line trends
Competitive positioning
Product mix
Uniqueness
The value of similar companies
Strategy for continued growth and profitability
Timing
 Steps for business Valuation

Step I: Pre-engagement Procedures

Step II: Data Gathering

Step III: Valuation Analysis

Step IV: Selection of Valuation Methods

Step V: Determining Final Value

Step VI: Report Preparation

Step VII: Wrap-up Procedures

 Concept of cash flow
Free cash flows (FCF)

equal to its after tax cash flows from operations less

incremental investments made in the firms operating
assets

Cash flow to the firm as if there is no debt in the firm

Equity cash flow

Cash flow to the equity shareholders

The major differences in computation of cash flows are

due to computation of taxes and treatment of debt.
Concept of cash flow

The other difference may arise due to extra

ordinary items or non operating items that
affect PAT but not the operating Income.

Top down approach

FCF FCFE
Cash flow EBIT EBIT
Definition Less: Tax on EBIT Less :Interest
EBIT(1-T)=NOPAT Less: Tax on EBT
Add: Depreciation Add: Depreciation
Add/less: changes in net Add/less: changes in net
operating working capital operating working capital
Less: Repayment of principal
Less: CAPEX amount of debt)
ADD: proceeds of debt issue
Less: CAPEX

IRR Project IRR Equity IRR

Appropriate WACC Cost of equity

discount
rate
PV of cash Project NPV Equity NPV
flow
 Bottom Up approach
Profit after taxes

Add back after-tax Interest expenses are a financial (non operating) item
interest expenses and should therefore be added back. On the other
hand, the profit after taxes includes only after-tax
interest; this is the amount added back in the FCF
calculation.

Add back depreciation Depreciation is a non-cash expense and is therefore

added back.
Subtract increase in For purposes of the FCF, this item does not include cash
current assets used for or marketable securities
operations
Add increase in current Accounting current liabilities include items like short-term
liabilities from operations debt and current portion of long-term debt. These
financial items are not included in the FCF.
Subtract increase in fixed This represents the amount spent on new assets over
assets at cost the period. The capital expenditures
(CAPEX).
 RELATIVE VALUATION (MULTIPLES)
APPROACH
Relative valuation is more about market
perception and mood
Under lying concept of the relative
valuation is the law of one price-similar
asset should command similar price
A multiple is the ratio of market price
variable to a particular value driver of the
firm
This approach is relevant as it uses
observable factual evidence of COMPS
 RELATIVE VALUATION (MULTIPLES) APPROACH

Key Issues:

Multiples
are easy to use but also easy to misuse
have very short shelf life (as compared to
fundamentals)
use requires less time & efforts
Easier to justify and sell
closer to the market more value if comparable
firm is getting more value in rising market
RGC (Risk, Growth, Cash flow) may be ignored.
Accrual flow multiple dominates cash flow
multiples
Types of Multiples
Equity based multiples

Entity or MVIC (Market Value of Invested Capital)

multiples

MVIC = no. of shares x MPS + AIBL

Equity based multiples either give value of equity on

market basis or book basis

MVIC based multiples either give value of firm on

market basis or book basis

Must make adjustment for non-operating assets and

value of AIBL under MVIC method
 HOW TO USE MULTIPLES IN VALUATION
Step I: selection of value relevant measure and
value drivers

Step II: Identification of COMPS

Step III: Select and calculate appropriate multiple

aggregation of multiple into single number through analysis of COMPS

multiple

Step IV: Apply to the company

Step V: Make final adjustments for non-operating

assets, Contingent liabilities and convertibles.

 Selection of value relevant measure

Equity multiple or entity multiple ?

Which value driver/ multiple to use?

Trailing multiple or forward looking

multiple?

More number of multiples vs. less

multiples- purpose relevant multiple vs. sanity
check multiples
 Selection of value relevant measure

Matching principle numerator and

denominator should have consistent definition
Capital structure equity multiple is greatly
affected by the capital structure than entity
multiple
Difference in earning guidance and
investment and payout policy
Enterprise value most of the requires
approximation of debt value
Stage of business life cycle
Empirical research supports forward looking
multiples processing two years analysts
forecast
Criteria for identification of comparable
firm
Use industry classification system or at
least list firms competitors
SIC: Standard Industrial classification
GICS: Global industry classification
benchmark)
Go up to 3 or 4 digits classification (more
homogeneous) rather than 1 or 2 digits
(broad industry group)
Size and region
Number of comparables- 4 to 8 ideal
size( plus or minus 2
 Criteria for selection of multiple

Select comparable companies or transactions how?

Management Style
Size
Product & Customer diversification
Technology
Key Financial trends
Strategic & operational strategies
Market positioning & maturity of operation
Geographical consideration
Trading volume of selected companies
Price volatility ()
Distribution of multiples across the sector & market
Equity Multiples
P/E (Price Earning Ratio)

P/B (Price to Book Ratio)

Equity / Sales

Equity / Cash flow

Equity / PAT

Equity / Book value of share

MVIC Multiples
MVIC / Sales

MVIC / EBITDA

MVIC / EBIT

MVIC / Book value of invested capital

MVIC/TA
Equity multiple
Price Earning Ratio most commonly used
multiples
Make sure definition is consistent & uniform
PER = MPS / EPS
Variant of PER
Current PER = Current MPS / Current EPS
Some analyst may use average price over last 6m or a year
Trailing PER = Current MPS / EPS based on last 4 quarters.
[or, LTM: Last twelve months]
Forward PER = Current MPS / expected EPS during next F/Y
EPS may further be based on fully diluted basis or primary
basis
EPS may include or exclude extraordinary items
 Equity multiple - PER
For Growth Company forward PER will consistently
give low value than trailing PER
Bullish valuer use forward PER to conclude that stock
is undervalued.
Bearish valuer will consider Current PER to justify that
Stock is overvalued.
Full Impact of dilution may not occur during next year
leading to lower EPS.
While using industry PER be careful about outliers
MLF (money loosing firm) creates a bias in selection
Equity value is calculated based on existing
outstanding shares but EPS is on fully diluted basis.
Equity multiple PEG (Price Earning
growth)
PEG = PER / expected growth in EPS
One mistake analyst will make to consider growth in
operating income rather than EPS
Growth should be consistent with PER calculation
Never use forward PER for peg as it amounts to
double counting of growth
Lower the PEG better the stock
If PER is high without growth prospect, PEG will be
high risky firm
PEG does not consider risk taken in growth and
sustainability of growth.
Equity multiple
P/B ratio = market value of equity / book value of
equity
Book value is computed from the Financial Statement
Price of book ratio near to 4 is highly priced stock
[mean P/B ratio of all listed firm in USA during 2006
was 2.4]
Price to Sales ratio
(Revenue multiple) = market value of equity
Revenue
The larger the revenue multiple better it is.
Generally there is no sectoral Revenue multiple.
MVIC multiple vs Equity multiple

MVIC multiple look at market value of operating assets

of the firm (and not only for equity invested).

MVIC multiple is not affected by Finance leverage.

If firms under comparison are differing in their

financial leverage, put more reliance on MVIC
multiple.
 ASSET BASED APPROACH

determining a value indication of a

business, business ownership interest, or
security using one or more methods based
on the value of the assets net of liabilities

Method 1: Adjusted Net Value Method

Method2: Excess Earnings Method

 ASSET BASED APPROACH
Adjusted Net Value Method
Identify all assets & liabilities (recorded and
unrecorded tangible and intangible assets,
liabilities & contingents)
Determine which assets and liabilities on
the balance sheet require valuation
Value the items identified
Construct a value-based balance sheet
using the adjusted values

Value of assets = value of assets - outside

liabilities
 ASSET BASED APPROACH
Excess Earnings Method Steps:
Estimate a normalized level of operating earnings,
the operating tangible asset value, and a reasonable
rate of return to support the tangible assets
Multiply the reasonable rate of return by the value of
tangible assets to arrive at the reasonable money
return on tangible assets
Determine excess earnings by subtracting the return
on tangible assets from normalized earnings- if it is
negative then there is no intangible value
 ASSET BASED APPROACH
Excess Earnings Method Steps
(continued):

Determine the capitalization rate appropriate

for the excess earnings
Determine the value of intangible assets by
dividing the capitalization rate into the
excess earnings
Add the value of tangible assets to the value
of intangible assets
 ASSET BASED APPROACH
Apply this approach generally where
Company is going in liquidation

Asset intensive companies -Significant value of assets

for going concern
For control valuation

Real estate companies

Investment companies

Finance companies

Startup stage company

Distressed companies