I walk into a classroom and wish everyone good morning, write the topic “Valuation” on the board and silently sit down. In the silent classroom, each one of the student will be engrossed in associating a different meaning to the same term of ‘valuation’, just like each one of you, the readers.
Yes, indeed valuation is a vast subject with varied meaning associated with itself. The dictionary meaning for the term valuation is “the act of estimating or setting the value of something*; appraisal” or “ an estimated value or worth”. But, the definition of the term valuation changes the minute, the *something is defined.
In finance, valuation is the process of estimating the potential market value of a financial asset or liability.
Financial Valuation can be associated with valuation of assets or valuation of liabilities. The most common examples for valuation of assets will include business valuation, valuation of intangible assets and valuation of investments in securities. The best example to quote valuation of liabilities is valuation of Bonds issued by a company.
The list of the need to get a financial valuation done is exhaustive. But, the most common reasons are investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in case of litigation.
Before we get into the details, let us first understand, what a valuator should be equipped with, before he starts gets into financial valuation. A financial valuator should have adequate knowledge of the local accounting practices, industry norms, economic conditions affecting the subject under valuation, local tax laws and an understanding of the governing law (both state and central). In addition, knowledge of the capital structure, management strategy and growth statistics is very essential for the valuator.
A good valuation model should be cost effective and computationally possible yielding consistent results. Assumptions governing the valuation model and the integrity of the data considered are the key to an accurate result. Further, the model should not only be logical with theory supporting the expected outcome, but also be impervious to extreme values.
Valuation does not mean arriving at any figure or financial number which can be supported by a theory or argument. Though, there still isn’t any “strictly to be followed” standards of valuation, there are generally accepted guidelines, methods and procedures of valuation. Even if the generally accepted methods are followed, choice of a wrong approach, incorrect assumption, usage of data lacking integrity, failure to define the business plan and the time period correctly will result in an inaccurate financial value.
To identify the correct approach of valuation, we need to know, whether the approach for a going concern entity or for an entity considering liquidation. For a going concern entity, it is essential to understand the benefits, business is able to generate in future out of its existing stock of assets although value of existing assets is not ignored by accountants. However, for an entity considering liquidation, the emphasis is on what can be fetched by selling the assets either on piecemeal basis or taking as a whole.
Valuation of tangible assets: Value maximization is the central focus in financial management and the owners of the corporate securities. Hence, it is essential for all senior managers to understand what determines value and how to measure it. This value is basically the fair market value or the price at which the buyer of the business is willing to buy and the seller of the business is willing to sell. There are four broad approaches to value the business of the Company: adjusted book value approach, stock and debt approach, direct comparison approach and discounted cash flow approach.
Valuation of intangible assets: It is not only the valuation measure of the tangible assets of a business but also the intangibles assets, which affects the final bid value. The intangible asset valuation could include everything from client goodwill to niche fit to the potential for growing market share. The dot-com boom of the late-1990s provides a good example of how intangibles drove the sale of technology and Internet businesses. Businesses were bought and sold based on the potential for idea development and customer base, rather than profit. What killed the boom was that the potential wasn't converted into bottom-line reality.
Another important intangible in valuing a business concerns the employees, particularly those who own or manage the firm. The owner or the management team is the key towards the performance and growth of the organization. The buyer of the business will loose something valuable, if the management team undergoes a change due to the purchase of the business, which could affect the overall value of the business.
Another intangible is brand or company loyalty. Change of brand name could affect the value of the business. If the brand loyalty for the current name is ardent, then, even though everything else about the product might be the same, the change of name could effect the brand value negatively. Again, this is an important factor to be considered for ascertaining the value of the business.
Valuation of investments in securities: Securities are classified as marketable securities when the firm can readily convert them into cash, and intends to do so when it needs cash. If either of the two tests for marketable securities do not apply, then the securities are properly classified as investment in securities. Investment in securities are held for long-term goals and are classified as long-term assets.
Marketable securities are initially recorded at acquisition cost, which includes purchase price plus any commissions, taxes or other costs related to the acquisition. This is the same rule as the general rule for valuing assets at acquisition.
Due to the existence of a market value, marketable securities can be reliably written up or down to the market value giving a more current estimate of economic worth. This also results in a holding gain or loss which is not due to the normal operations of a firm. For the purposes of valuation after acquisition, there are three classes of marketable securities Debt held to maturity, Trading securities and Securities available for sale.
Valuation of Bonds issued by a company: In addition to the knowledge of valuing securities, it is also important for the investors and the managers of the Company to value the bonds. This helps them to compare its value to the prevailing market price to decide whether to hold it or sell it. Generally, a bond is valued using the basic discounted cash flow valuation model.
KSCAA intends to provide more articles on valuation in every newsletter going forward providing more in depth knowledge on this topic. In this article, we have touched upon the topic on introduction to the world of valuation. We welcome feedback, suggestion and queries by our readers on the article published in our newsletter in this series. We intend to make this series as a discussion forum to touch upon the complicated topic of valuation and help our readers in knowledge acquisition.
Written by: CA. Aparna RamMohan
Source: Published in the Dec 2010 issue of the News Bulletin of KSCAA (same author)
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