Let us continue with our previous month’s discussion on the factors affecting business valuation.
Reliance / non-reliance on founder
The background, capacity and profile of the founder(s) of the organization speak a lot about a Company. The weight given to the profile or background of the promoter increases if the Company is either directly run by the promoter(s) themselves or management team of the Company is dependent on the directions of the promoter(s) for its functioning. But, if the Company is more in the hands of a team of professionals, then, that weight placed on the reliance on founder automatically comes down. The reliance factor of the promoter plays an important role as the guiding principles and the method of operation of the Company is designed by them.
The Financial Aspect
The value of assets and liabilities and the financial condition of the business is one of the obvious measures of valuing a Company. The values of the assets and liabilities can be based on the book value or the market value. One should attach a valuation based on what you know rather than an assumption. Though, assumption plays a key role in the process of valuation, what is primary is to consider what is available as a fact or certified fact. Audited Financial statements provide a true and fair view of the overall financial status of the Company. However, optimistic a future projection of the Company is, what is underlying is their past history. Due weight must be given to the past trend of the financial condition of the Company.
The earning capacity
The primary driver for any Company is its earning, so naturally, earning capacity of a company is the primary driver of its value too. The preferred measure of earning capacity for the purpose of valuation is Cash Flow as it represents a purer form of earnings. Adjusting the net income or loss of a company for the items like depreciation & amortization, non-recurring items, transactions with your own self, discretionary expenses, interest expenses, common errors and the like produces a cash flow figure that represents a much more accurate picture of the earning capacity of a company.
Dividend paying capacity
While valuing a business, better consideration is given to the dividend-paying capacity of the company rather than to dividends actually paid in the past. Retention of a rational portion of profits in a company to meet competition must gain more recognition. For example, dividends paid out in a closely held Company is generally dependent on the needs of the shareholders or by their methods of tax planning, instead of by the ability of the company to pay dividends. The controlling team can choose salaries and bonuses as alternates for dividends, thus reducing net income and understating the dividend-paying capacity of the company. Since, the declaration of dividends is discretionary with the controlling shareholders, dividend payments are considered less reliable criteria of fair market value than the capacity to pay.
Intangible assets and goodwill
Valuation of intangible assets and goodwill are made based on certain generally accepted principles of calculation. Many times, intangible assets and goodwill calculation is given less importance due to the complexity of their calculation. But, when valued and considered, the intangibles become a major consideration in the process of valuation. Valuation of the business considers the high value of the business intangibles and their impact on the future success of the business. The intangibles many times are specifically noted as the major source of company growth and success after the business purchase.
The size of the block to be valued
The effect of fund size has an on the valuation of the business. There exists a convex relationship between fund size and the valuations. The valuation is positively correlated to measures of limited attention such as fund size per shareholder and excess fund size per shareholder.
The marketability of shares
Lack of Marketability of the shares is one of the most common discounts considered in business valuation. It directly has a monetary impact on the determination of the final value. This is because marketability is directly related to the ability to convert an investment into cash quickly at a known price and with minimal transaction costs. Similarly, a higher capability to market the shares results in improvement of the business value. A valuation professional cannot directly apply the discounts based on average method based on industry, a thorough analysis of the characteristics of the business and a rational must support the discount on account of marketability factor.
Rights attached to shares
Controlling interest level is the value that an investor would be willing to pay to acquire more than 50% of a company’s stock, thereby gaining the attendant prerogatives of control. Some of the prerogatives of control include electing directors, hiring and firing the company’s management and
determining their compensation; declaring dividends and distributions, determining the company’s
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.
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)]. Mergerstat 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.
Rights attached to minority interests
The intermediate level, marketable minority interest, is lesser 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 stock exchanges where there is a ready market for equity securities. These values represent a minority interest in the subject companies which are small blocks of stock that represent less than 50% of the company’s equity.
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.
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.
Written by: CA. Aparna RamMohan
Source: Published in the Feb 2011 issue of the News Bulletin of KSCAA (same author)
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