Factors affecting Business Valuation

Last month, we got introduced to the world of valuation. Our discussion on what is valuation, characteristics of a good business valuation model and a brief on the approaches of valuation got us started. Let us move on to the next phase of discussion, which is on the factors affecting a business value.

In an environment as dynamic as prevalent in a business world, definitely, there are more than one factor which determines the growth, sustainability and value of a business. The factors affecting the value obviously differ with industry, scale, location, market so on and so forth. If we start listing down all of them to analyse its affect on value then valuation will become a never ending too complicated a process. Hence, one of the generally accepted rules is to consider the “relevant” valuation factors affecting the performance of the business.

Each case needs a careful consideration of the factors affecting the business in a significant manner. To list down a few of the commonly considered factors while valuing a business are:

·         The nature of the business and its history,

·         Business Growth

·         Customer Base

·         Audited Financial Statements

·         Litigation and Disputes

·         Minimize Discretionary Spending

·         Deal Structure

·         Role of management, vision, and strategy,

• Staff competency
• Reliance / non-reliance on founder

·         The book values of assets and liabilities, and the financial condition of the business,

·         The earning capacity,

·         Dividend paying capacity,

·         Intangible assets and goodwill,

·         The size of the block to be valued,

·         The marketability of shares,

·         Rights attaching to shares, minority interests,

·         Market share, and strategic positioning,

·         Risk/reward aspects,

·         Level of gearing, and

·         Accounting adjustments.

• Business reputation
• Potential for growth
• Industry conditions
• Superiority
• Vulnerability
• Political and economic outlook
• Cash flow
• Production capacity
• Ability to increase revenues
• Cost competitiveness
• Business’s use of technology
• Ability to reduce costs
• Comparable businesses and industries

·         Prevailing legal issues

• Potential to improve customer relationships
• Ability to borrow against business or assets
• Performance results and ratios
• Location
• Presentation of premises
• Existing relationships with suppliers and customers
• Intellectual property
• Goodwill  and other intangibles
• Condition of books and records
• Computerisation
• Tax implications
• Alternative opportunities
• Affordability
• Working conditions
• Property lease conditions

·         Rate of growth in the economy,

·         The amount of inflation,

·         Interest rates as well as the value of other stocks and bonds

·         Scale of operation

·         Barriers to entry

·         Whether the business has any monopolistic powers in buying or selling goods and services, or in intellectual property such as registered trade-marks and patents

Having listed such a long list of factors that can affect business valuation, let us move on to understand each one of them in depth:

Nature and history of the business

The first impression about a business is totally dependent on its history and the nature of business it is into. A business with strong background and a success story behind its growth earns more attention and value. The decision of considering a business for purchase or investment is based on its prior years’ growth pattern and its future projection of further growth. Another related factor is the nature of business, whether the current market conditions are favourable to its sustainability and growth or not.

Business Growth

What is that buyers look for? Growth!!! If a business can display methodical quality revenue and earnings growth, then the business valuation will be favourable. It helps to improve the value if future growth prospects can be substantiated and clearly articulated to the buyer.

Customer Base

The growth of a business is directly proportional to the growth of revenue which again depends on the growth in customer base. If a business has a diverse customer base, then its value will be higher than the businesses dependent on a few key customers only. If the top ten customers constitute more than 50% of the revenue for the year, then, this factor will have a negative impact on valuation.

Audited Financial Statements

An audited financial statement improves the certainty and accuracy of the numbers presented by the business, as it represents a third party confirmation by an independent qualified professional. The audited financial statement by a reputed auditor adds value. An unaudited financial statement leads to uncertainty prompting the buyer to increase their risk premium thereby reducing the valuation of the venture.

Management Team

Management team plays a key role in determination of the value of the business. The quality of the management teams is one of the most important requirements for silent buyers like a private equity or a venture capitalist firm. Whenever the silent buyers’ role is only to invest in the Company and not to manage it, the investments are based on various projections and future potential of the Company. In such cases, the investor places more reliance on those businesses, wherein, the management capacity and capability to run the show is better. A professional and experienced management team can add value.

Competency of the Staff

The value of the Company is not only affected by the management team but also by the key employees of the organization. The employees who fit into the definition of key employees are those who manage the important functions of the organization, eg: operation head, plant in charge, warehouse in charge, finance head, HR head etc. Having too many employees does not help as it shows a lower per employee efficiency, similarly, an understaffed business also looses value as the organization becomes dependent on the available employees and the loss of those employees could be detrimental to the business.

Litigation and Disputes

Exhibition of any kind of legal and / or customer dispute to the buyer or investor will only lead to reducing the value of the business. It does not mean that a business with disputes cannot be sold at all. The seller has to ensure that all the legal and / or customer disputes pertaining to the business is solved and closed before the organization is marketed for sale. The mistake of slaying a litigation or dispute will not help, as if it gets detected in the due diligence, then, this could be a major deal breaker. In addition to the buyer walking out of the deal, the price of your business to others in the market will also be significantly reduced.

Minimize Discretionary Spending

Strictly keep the personal expenses away from the Company’s books. Personal expenses how much ever supported by documents are “personal”. If detected by the due diligence team or the buyer, the personal expenses will be reduced from the total expenses shown in your books for the purpose of valuation. Further, buyers or investors will become sceptical of substantial discretionary add-backs and will price the business accordingly.

Deal Structure

Tax implications of a deal structure needs to be clearly understood. It is not only what the seller gets from the sale of the organization that matters, what matters is ultimately what you keep. The deal structure has to be beneficial to the seller not only with respect to the sale proceeds but with respect to the net sale proceeds. It is important to consider the tax liabilities and other liabilities arising from the business incorporation status and hold back provisions. What the seller finally retains is the sale proceeds after discounting such liabilities. It is advisable to analyse asset vs. equity sales, earn-outs, sinking fund provisions, capital etc before the decision for sale is taken.

Written by: CA. Aparna RamMohan

Source: Published in the Jan 2011 issue of the News Bulletin of KSCAA (same author)

Introduction to the world of Valuation

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)

Latest Economic Statistics – FY 10-11

Quick Facts

·         Food inflation back in single digits at 9.5 per cent

·         External debt jumps USD 1.7 billion in December quarter

·         Banks in India report 22.8 per cent growth in February credit flows Corporate India raised USD 1.44 billion overseas in February  

·         Service tax on forex transactions capped at ` 5,000

·         Census of India 2011: Shocking gender bias among 17.5 per cent humanity

·         Gold demand in India to rise 33 per cent by 2020: WGC

·         Electronics, IT sector to need 3.2 million workforce by 2022: NSDC

·         China's forex reserves up at record high of USD 2.8 trillion

·         U.S. jobless drops to 8.8 per cent, payrolls increase by 216K in March

Source: Assocham Research Bureau

Outlook on Indian Industry:

		2010-11	2011-12
Growth	Agriculture	5.0	2.7
	Industry	8.6	8.2
	Services	9.4	9.6
Inflation	WPI – Average	8.0-8.5	5.8-6.0
Interest Rate	10 Year G-Sec	8.1-8.3	7.9-8.2
Exchange Rate	Re / USD	43.5-44.0	42.5-43
Fiscal Deficit	As a % of GDP	5.0	5.5

Source: Crisil Ecoview

Compiled into an article by: CA. Aparna RamMohan

Sources: Assocham Research Bureau, Economic Times, Business Standard and CRISIL Newsletter