How to carry out business valuation

(International Valuation Standard -200 (IVS-200 (2020)) – Businesses and Business Interests)

 

Valuations of businesses are required for different purposes including acquisitions, mergers and sales of businesses, taxation, litigation, insolvency proceedings and financial reporting. Business valuations may also be needed as an input or step in other valuations such as the valuation of stock options, particular class(es) of stock, or debt.

 Following are the typical steps for carrying out the business valuations:

  1. Valuers must establish whether the valuation is of the entire entity, shares or a shareholding in the entity (whether a controlling or non-controlling interest), or a specific business activity of the entity.

 

 It is especially critical to clearly define the business or business interest being valued as, even when a valuation is performed on an entire entity, there may be different levels at which that value could be expressed. For example: 

(a) Enterprise value: Often described as the total value of the equity in a business plus the value of its debt or debt-related liabilities, minus any cash or cash equivalents available to meet those liabilities. 

(b) Total invested capital value: The total amount of money currently invested in a business, regardless of the source, often reflected as the value of total assets less current liabilities and cash. 

(c) Operating Value: The total value of the operations of the business, excluding the value of any non-operating assets and liabilities.

 (d) Equity value: The value of a business to all of its equity shareholders

  1.   A valuer must select the appropriate basis(es) of value. Bases of valuations includes Fair Value, Liquidation value etc depending upon the purpose.
  2. The three principal valuation approaches described in IVS 105 Valuation Approaches and Methods may be applied to the valuation of businesses and business interests.

Market Approach:

The three most common sources of data used to value businesses and business interests using the market approach are: 

(a) public stock markets in which ownership interests of similar businesses are traded, 

(b) the acquisition market in which entire businesses or controlling interests in businesses are bought and sold, and

(c) prior transactions in shares or offers for the ownership of the subject business.

There must be a reasonable basis for comparison with, and reliance upon, similar businesses in the market approach. These similar businesses should be in the same industry as the subject business or in an industry that responds to the same economic variables. 

 

Factors that should be considered in assessing whether a reasonable basis for comparison exists include: 

(a) similarity to the subject business in terms of qualitative and quantitative business characteristics, 

(b) amount and verifiability of data on the similar business, and

(c) whether the price of the similar business represents an arm’s length and orderly transaction.

 

  1. Income Approach

Income and cash flow related to a business or business interest can be measured in a variety of ways and may be on a pre-tax or post-tax basis. The capitalisation or discount rate applied must be consistent with the type of income or cash flow used.

The type of income or cash flow used should be consistent with the type of interest being valued. For example: 

  1. enterprise value is typically derived using cash flows before debt servicing costs and an appropriate discount rate applicable to enterprise level cash flows, such as a weighted-average cost of capital, and 
  2. equity value may be derived using cash flows to equity, that is, after debt servicing costs and an appropriate discount rate applicable to equity level cash flows, such as a cost of equity.

The income approach requires the estimation of a capitalisation rate when capitalising income or cash flow and a discount rate when discounting cash flow.

Under the income approach, the historical financial statements of a business entity are often used as guide to estimate the future income or cash flow of the business. Determining the historical trends over time through ratio analysis may help provide the necessary information to assess the risks inherent in the business operations in the context of the industry and the prospects for future performance

Adjustments

Adjustments may be appropriate to reflect differences between the actual historic cash flows and those that would be experienced by a buyer of the business interest on the valuation date. Examples include: 

(a) adjusting revenues and expenses to levels that are reasonably representative of expected continuing operations, 

(b) presenting financial data of the subject business and comparison businesses on a consistent basis, 

(c) adjusting non-arm’s length transactions (such as contracts with customers or suppliers) to market rates, 

(d) adjusting the cost of labour or of items leased or otherwise contracted from related parties to reflect market prices or rates, 

 

(e) reflecting the impact of non-recurring events from historic revenue and expense items. Examples of non-recurring events include losses caused by strikes, new plant start-up and weather phenomena. However, the forecast cash flows should reflect any non-recurring revenues or expenses that can be reasonably anticipated, and past occurrences may be indicative of similar events in the future, and 

(f) adjusting the inventory accounting to compare with similar businesses, whose accounts may be kept on a different basis from the subject business, or to more accurately reflect economic reality.

When using an income approach, it may also be necessary to make adjustments to the valuation to reflect matters that are not captured in either the cash flow forecasts or the discount rate adopted. Examples may include adjustments for the marketability of the interest being valued or whether the interest being valued is a controlling or non-controlling interest in the business. However, valuers should ensure that adjustments to the valuation do not reflect factors that were already reflected in the cash flows or discount rate. For example, whether the interest being valued is a controlling or non-controlling interest is often already reflected in the forecasted cash flows.

While many businesses may be valued using a single cash flow scenario, valuers may also apply multi-scenario or simulation models, particularly when there is significant uncertainty as to the amount and/or timing of future cash flows.

  1. Cost Approach

the cost approach is sometimes applied in the valuation of businesses, particularly when: (a) the business is an early stage or start-up business where profits and/ or cash flow cannot be reliably determined and comparisons with other businesses under the market approach is impractical or unreliable, (b) the business is an investment or holding business, in which case the summation method is as described in IVS 105 Valuation Approaches and Methods, paras 70.8-70.9, and/or (c) the business does not represent a going concern and/or the value of its assets in a liquidation may exceed the business’ value as a going concern

 

  1. Special Considerations for Businesses and Business Interests

Additional considerations should be given to following items to arrive at value:

 

  • Ownership Rights 

 

The rights, privileges or conditions that attach to the ownership interest, whether held in proprietorship, corporate or partnership form, require consideration in the valuation process. E.g.

  1. liquidation preferences, 
  2. voting rights, 
  3. redemption, conversion and participation provisions, and 
  4. put and/or call rights.

(b) Business Information 

Valuer must assess the reasonableness of information received from management, representatives of management or other experts and evaluate whether it is appropriate to rely on that information for the valuation purpose.

 

(c ) Economic and Industry Considerations 

Awareness of relevant economic developments and specific industry trends is essential for all valuations.

For example, a business may be impacted by economic and industry factors specific related to: 

(i) the registered location of the business headquarters and legal form of the business, 

(ii) the nature of the business operations and where each aspect of the business is conducted (ie, manufacturing may be done in a different location to where research and development is conducted), 

(iii) where the business sells its goods and/or services, 

(iv) the currency(ies) the business uses,

 (v) where the suppliers of the business are located, and

 (vi) what tax and legal jurisdictions the business is subject to.

(d ) Operating and Non-Operating Assets  

 

Most valuation methods do not capture the value of assets that are not required for the operation of the business. For example, a business valued using a multiple of EBITDA would only capture the value the assets utilised in generating that level of EBITDA. If the business had non-operating assets or liabilities such as an idle manufacturing plant, the value of that non-operating plant would not be captured in the value. Depending on the level of value appropriate for the valuation engagement, the value of non-operating assets may need to be separately determined and added to the operating value of the business.

 

Businesses may have unrecorded assets and/or liabilities that are not reflected on the balance sheet. Such assets could include intangible assets, machinery and equipment that is fully depreciated and legal liabilities/lawsuits.

 

( e) Capital Structure Considerations 

Businesses are often financed through a combination of debt and equity. However, in many cases, valuers could be asked to value only equity, particular class of equity, or some other form of ownership interest. While equity or a particular class of equity can occasionally be valued directly, more often the enterprise value of the business is determined and then that value is allocated between the various classes of debt and equity.

 

While there are many ownership interests in an asset which a valuer could be asked to value, a non-exhaustive list of such interests includes: 

(a) bonds, 

(b) convertible debt, 

(c) partnership interest, 

(d) minority interest,

 (e) common equity, 

(f) preferred equity, 

(g) options, 

(h) warrants.

 

When a valuer is asked to value only equity, or determine how the business value as a whole is distributed among the various debt and equity classes, a valuer must determine and consider the different rights and preferences associated with each class of debt and equity. Rights and preferences can broadly be categorised as economic rights or control rights. A non-exhaustive list of such rights and preferences may include: 

 

(a) dividend or preferred dividend rights, 

(b) liquidation preferences, 

(c) voting rights, 

(d) redemption rights, 

(e) conversion rights, 

(f) participation rights, 

(g) anti-dilution rights 

(h) registration rights, and 

(i) put and/or call rights.

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