Business Valuation

Needs & Techniques

Submitted by
CA Hozefa Natalwala
A Brief note:

The basic purpose of this research work is to study the purposes that create the need
of valuation for Small businesses and to relate the appropriate technique/s which
can help in making a better decision for that particular purpose. Research involves
basic attitudes and way of thinking. References are taken from many books, articles
and other materials and also at many places the valuable write ups of some authors
or writers are sited in order to provide the basis to the intended users of this research
work. Value of business is estimation only and being which it is subjective in nature.
Debates are going on and different views are prevailing regarding applicability of
specific techniques, as well as on validity and correctness of the formulas used for
estimation. These all are making the reliability on specific technique questionable.
The objective is not to go through the roots that how a specific technique is emerged
and on which financial or economic theory it is based. A two thousand pager book
might not be enough space to cover all the issues related to estimation of business
value.

The research into valuation models and metrics in finance is surprisingly spotty,
with some aspects of valuation being deeply analyzed and others, such as how best
to estimate cash flows and reconciling different versions of models, not receiving the
attention that they deserve. To write about valuation is a humbling task. No matter
how ambitious and dedicated an author may be, eventually he or she is forced to
acknowledge that even a lifetime of work would leave some aspects of the subject
untouched.

It must be noted that the research work has been seriously limited by the lack of
access to literature on business valuation for small and medium sized businesses in
India. Being an evolving field of finance and accountancy, there are very little
developed doctrines relating to the application of the specific method amongst
various valuation methods. I have relied also on the accessible materials like relevant
notes available on web as well as authorative and unauthorative views of valuation
experts and consultants.

I was also limited by finances as this research study was not funded in the way and
to the extent to which I could have carried out the work. I wanted to study valuation
needs for MSMEs in totality but for financial support it is confined to study only the
literature views and basics of MSME needs of valuation.

While all reasonable attempts have been made to ensure that the information contained herein is accurate, I accept
no responsibility or liability whatsoever for any errors or omissions it may contain, whether caused by negligence
or otherwise, or for any losses, however caused, sustained by any person relying upon it.

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Methodology:

Research methodology refers to the procedural framework within which the

research is conducted.

I had started with the compilation of literatures and materials available on valuation
and specifically for small business units. In India, valuation of business, itself being a
emerging filed and also not being graced by the statue, very small amount of
material was found and I have more to rely on the US based books and materials.
Valuation of business requires major consideration for financial and economic
theories and of course, the business characteristics and valuation fundaments are
indifferent to the region differentiation.

The purpose was to study the valuation reports and to analyze the preferred
approaches of the value analysts while appraising a business. It also proposes to
present the case analysis at the subsequent stage. But the ratio of response, received
from concerned entities, was near to zero. The empirical data is not available for
needs of valuation in MSME sector. Also there is no private of public organization
offering the transactional data relevant for MSME valuation. So, the views shown
under this work are based on study of literature and opinion of experts, obtained
while conducting the study. And so the approach of the study is descriptive.

The write up begins with describing the valuation in general and then to define and
relating the value, purpose and need in the context of valuation. The objective
behind is to show the conventional relationship of “purpose” and valuation “need”.
The basic terms of valuation like types of valuation reports, premise of valuation,
importance of date of valuation, standard of valuation and approaches are described
next. The views expressed and definitions issued by various authorities, researchers
and respected authors are also mentioned to describe the prevailing debates. The
importance of “standards of value” in valuing a MSME business is emphasized.
How the appraisers strive in selecting the appropriate technique/s and determining
the conclusive value is attempted to uncover.

This is just an endeavor to match the valuation technique with specific purpose on
logical basis considering the need behind each purpose.

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Index

BUSINESS VALUATION

¾ Need, Purpose and narrating sequence of write up

¾ Brief about Business Value?
¾ What is Valuation?
o Purposes & Needs (definition)
o Types of reports
o Premise of value
o Date
o Standards of value
o Approaches to valuation
¾ Detailing approaches to valuation
¾ Valuation purpose Vs. Standards of value (with table) and relevant
technique/s to value a business (with table)
¾ Conclusion

Useful data
¾ Valuation Procedures
¾ Data collection procedure
¾ Illustrative list of assumptions, limitations and disclaimers
¾ Contents of exhaustive valuation report
¾ International glossary of valuation terms
¾ Multipliers suggested by author Mr. Wilbur M. Yegge for application with
“Excess earnings capitalization Method”
¾ Table showing purpose Vs. recommended techniques
¾ Time vs. approach, asset vs. approach, as mentioned by Prof. Aswath
damodaran
¾ References

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 ‘‘Character.
Be more concerned with your character than with your reputation.
Your character is what you really are while your reputation is merely what others think you are.’’
- John Wooden

BUSINESS VALUATION

In the wake of economic liberalization, companies are relying more on the capital
market, acquisitions and restructuring are becoming commonplace, strategic
alliances are gaining popularity, employee stock plans are proliferating, and
regulatory bodies are struggling with tariff determination. In these exercises a
crucial issue is: How should the value of a company or a division thereof be
appraised?

The goal of such an appraisal is essentially to estimate a fair market value of a

company. So, at the outset, we must clarify what is meant by “fair market value” and
what is meant by “a company”. The most widely accepted definition of fair market
value was laid down by the Internal Revenue Service (IRS) of the US. It defined fair
market value as “the price at which the property would change hands between a
willing buyer and a willing seller when the former is not under any compulsion to
buy and the latter is not under any compulsion to sell, both parties having
reasonable knowledge of relevant facts.” When the asset being appraised is “a
company”, the property the buyer and seller are trading consists of the claims of all
the investors of the company. This includes outstanding equity shares, preference
shares, debentures and loans.

But note that, ‘Fair market value’ (FMV) is not designed with any particular
individual in mind, nor the ‘real’ transaction for that matter. FMV is a hypothetical
value for the ‘model’ transaction. The governing conditions in this ideal concept are
full knowledge and freedom to act. But in reality, these ideal conditions are rarely
present. Emotional and subjective elements often override rational considerations,
and full knowledge is something rarely attained by the arm’s-length potential buyer who
previously has not been involved in the business.

The family-owned and/or closely held business is the more difficult tiger to tame.
Publicly traded companies seek to show bottom-line profit to satisfy ‘‘public
owners,’’ while closely held enterprises seek only to satisfy private interests, before
profit falls to the bottom line. Thus the ‘‘documents’’ by which the psychology of
ownerships are measured send out different messages in each. Since ownership and
management of closely held enterprises are often one and the same, financial records
are massaged for tax avoidance. In addition, private ownerships can, and sometimes
do, play the game of chance by stretching the ‘‘gray’’ areas in law beyond the limits.
All of this leads to difficult interpretations of what really goes on in these companies.
Thus, the necessary conclusion is that few buy/sell transactions involving closely
held small businesses are done at so-called fair market values. (Summarized from
comments of T. S. Tony Leung, C.P.A.)

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In pure sense, business valuation refers to estimation of business value.

Valuation is just to estimate

What (cash flow) + When (time period) + How (risk), we receive in future out of a
subject property.

The economic returns or the assets involved frames the value of specific business
stream and this value can be generally more than the value of individual asset
valued as a stand alone basis. The value of Business enterprise containing more than
one stream is generally more than just a sum total of values of every such stream. So,
the business value is affected by tangible as well as non-tangible factors. The value of
these intangible factors is generated by collective usage of assets and joint operations
of several business streams.

Intangible business value is a highly judgmental aspect of business valuation and

requires conscientious attention. IRS (US) roughly defines intangible value, or
goodwill, as that amount paid for a business in excess of the market value of hard
assets.

Ágnes Horváth * presents the value inequalities as follows showing the general
relation between “values of business” derived by different perceptions. The fair
value of business is something more than the fair assets value and this added value
is towards its intangible strength which may or may not be quantitatively
measurable.

Fair value of all company assets

Replacement value of recorded assets

(Balance sheet)
Book value

Added value

Source: Juhász (2004)

Figure showing differences between book value and market value of a business
enterprise

* from “Non-Quantitative Measures In Company Evaluation” by Ágnes Horváth, European

Integration Studies, Miskolc, Volume 4 (2005) pp 61-72.

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However, Valuation, by its very nature, contains many controversial issues. The
valuation of business enterprises and business assets is well-founded in academic
publications and empirical studies. Even a 2000 pager book may not be an enough
space to cover all the issues related with valuation. The use of public company
information has provided the foundation for the analysis of business valuation. The
biggest difference between valuing investments in public companies and nonpublic
businesses is the lack of information. The application of recognized valuation
methodology and rigorous analysis of the private company provides the foundation
for estimating a business value.

Although considerable time and effort is involved in preparing formal business

valuations, unfortunately the results may or may not reflect the “real world” value
of a specific company if it were formally offered for sale.

It is eloquently stated by Gerald Loeb, the author of The Battle for Investment
Survival, who wrote, “There is no such thing as a final answer to security values. “A
dozen experts will arrive at 12 different conclusions. It often happens that a few moments
later each would alter his verdict if given a chance to reconsider because of a changed
condition. Market values are fixed only in part by balance sheets and income statements;
much more by hopes and fears of humanity; by greed, ambition, acts of God, invention,
financial stress and strain, weather, discovery, fashion and numberless other causes
impossible to be listed without omission".

To assume there is only one “correct” estimate of value is a mistake, and ‘‘right’’ is a
matter of opinion.

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VALUE

In our day to day life, we frequently use a word “VALUE”. It may be with regards to
price of some commodity or for extending esteem to some one or to express the
perceived worth of some thing. In all sense, VALUE” is a word expressing positive
posture. It signifies the worth. It expresses the worth which may be more or less
compared to some other or even it may be nothing or negative. But the question is
how to measure this worth in financial terms? Here, let us first go through the
meaning of “Value” in finance, why business value is needed to measure and what
are the ways to determine a value of a business?

So,
What is a value?
Value is expressible in terms of a single lump sum of money consideration payable
or expendable at a particular point of time in exchange for property, i.e., the right to
receive future benefits as at that particular time–point (now).

Value is future looking, shows the present value of future benefits that can be
derived from the subject property. Although historical information can be used to set
a value, the expectation of future economic benefits is the primary value driver.
Acquirer gets tomorrow’s cash flow, not yesterday’s or even today’s.

Value, like beauty, is in the eyes of beholder.

While the “value” is an actual worth or the intended user/s’ belief about the worth of
specific “item”, “Price” is a number determined by market forces and personal
beliefs.

So, value differs from price OR cost. Price and cost refer to an amount of money
asked or actually paid for a property, and this may be more or less than its value.
Price and cost can equal value but don’t necessarily have to equal value.

Another source for definitions of value may be found in contractual agreements of

the parties. Parties to a contract are free to bargain for their own definition of value
to meet their special situation. For example, Parties to buy-sell agreements often
determine value by specific terms and conditions in contracts, which may or may not
conform to any accepted definition of value in any general legal context. Some of
these contracts may provide that the value of a business is defined by its book value,
or by a specified multiple of earnings. Other contracts may indicate that the value of
the business is defined by earnings before interest, taxes, depreciation, and
amortization. Contractual measures of value are limited only by the creativity of the
parties to the contract. Similarly, Insurance contracts provide for specific values as a
basis for their coverage. The insurance contract may limit coverage to the actual cash
value of an insured item, less its accumulated depreciation. If so, that contract
provides the definition of value. Business interruption insurance or loss of profit
agreements provide specific definitions of just what values they will cover if a
business is interrupted due to various insured causes.

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Mr. David laro and Mr. Shannon Pratt in their co-authored book “Business valuation
and taxes, procedure, law and perspective” (John wiley & Sons, Inc) narrates
VALUE in a very explicable words; that

“Like beauty, value is in the eye of the beholder. What is value to one may be inconsequential
to another. In this regard, value is mere subjective perception.
We use standard of value synonymously with definition of value. Stated concisely, business
value must be measured and defined by a definition of value that is relevant, predictable, and
reliable. Recognizing that the same business interest may have different values if more than
one standard of value is used, ….

Consider the various definitions of value throughout the life cycle of a diamond. In one sense,
the diamond is nothing more than carbon, an inert mineral found in the earth’s layers.

In this regard, the diamond, except for some limited commercial uses, has little inherent
value. If we define the diamond’s value based on its raw mineral content, we have an object of
fairly low value. We cannot eat it, drive it to work, or use it to take shelter when it rains; the
diamond has a value equal to the sum of its carbon content.
Change the definition of value. Instead of measuring the diamond’s value strictly by the
economic value of carbon, we instead define the diamond’s value by a standard that measures
carats, clarity, cut, and color. We also value the diamond as a perceived commodity, a fiction
due in large part to the millions of dollars poured into advertisements convincing the public
that the diamond has special economic value as an object of beauty. Except for some limited
enhancement created by cutting and polishing, the diamond is still just inert carbon; if we
continue to value the diamond by its pure mineral status, it has limited economic value.
When we value the diamond by a standard that puts a premium on beauty and permanence,
however, we increase its value considerably. The emphasis of value has changed, and so has
the value to the average consumer.
Now let us suppose that our diamond is purchased from a retail store for $1,000 and given to
a young woman as an engagement gift. The diamond has a transaction value equal to its
purchase price, but, in the hands of the woman, the diamond now takes on a new value
measured by her sentiment; she would likely refuse an offer from someone to buy her
diamond, even if the amount offered were significantly more than its original purchase price.

Assume further that the diamond is insured and, regrettably, is stolen. The insurance policy
provides that the diamond is insured for its actual cash value. Alternatively, some insurance
policies may replace the diamond at today’s cost. Either way, the diamond’s value is
determined by the terms of a contract.
Finally, suppose that the diamond ends up in an estate* that must value it for federal estate
tax purposes. Fair market value is now the standard, as determined by Treasury regulations.
As this example illustrates, there are a variety of different standards of value that can be used,
ranging from intrinsic value to contractual value. Similarly, business valuation is also
subject to varying standards of valuation.

*estate here means a property that a person left after his/her demise for the usage by heirs.

So, in order to find a value, one has to decide the standard of value first. It is the
standard of the value which draws a path towards destination. Meaning which, the

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standard/s of value will help in deciding the valuation technique/s to be used to
determine a value for specific requirement.

Then, the question is what does decide the standard/s of value? The answer is the
“purpose”. The purpose defines “value” applicable to specific purpose and this
value varies once the purpose is changed.

Purpose of Valuation

Let us first go through how the term “purpose” is defined by various wesites:

http://en.wikipedia.org/wiki/Purpose
Purpose is the cognitive awareness in cause and effect linking for achieving a goal in
a given system, whether human or machine. Its most general sense is the anticipated
result which guides decision making in choosing appropriate actions within a range
of strategies in the process (a conceptual scheme) based on varying degrees of
ambiguity about the knowledge that creates the contextualisation for the action.
Purpose serves to change the state of conditions in a given environment, usually to
one with a perceived better set of conditions or parameters from the previous state.
This change is the motivation that serves the locus of control and goal orientation.

http://en.wiktionary.org/wiki/Purpose
purpose (plural purposes)

1. An object to be reached; a target; an aim; a goal.

2. A result that is desired; an intention.
3. The act of intending to do something; resolution; determination.
4. The subject of discourse; the point at issue.
5. The reason for which something is done, or the reason it is done in a
particular way.

http://www.merriam-webster.com/dictionary/purpose
1 a: something set up as an object or end to be attained : INTENTION b: RESOLUTION ,
DETERMINATION
2: a subject under discussion or an action in course of execution

http://www.britannica.com/bps/search?query=purpose&source=MWTEXT
something one intends to get or do; intention; aim
resolution; determination
the object for which something exists or is done; end in view

To summarize the definition of “purpose”, it can be said as an “object” or an “end

result” to achieve and it involves several decisions to make for achievement of that
objective. This requirement of making decision creates need of considering the facts,
situations and possibilities linked with achievement or non-achievement of that
specific objective.

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Businesses or their assets are valued for a variety of reasons. Some of the most
noticeable purposes for valuation of MSME business are demonstrated below:

• Buy/sell agreements
• Addition or retirement of partner, dissolution of partnership, succession
planning
• Ownership disputes
• Sharing on family separations and related family disputes
• Mergers and acquisitions
• Allocation of purchase price
• Recapitalizations / Restructuring the business / Raising funds
• Business planning and value added management
• Investment decisions / divestitures
• IPO
• Financial reporting
• Wealth planning / tax planning
• Will planning
• Goodwill impairment
• Litigation issues involving lost profits or economic damages

While going for some business deal or to make decision on any of the purposes
shown above, giving due consideration to the value of business may be an inevitable
preference. Therefore, the “purpose” creates a “need” for valuation.

Need

Definition of need is taken from some different web sites and produced below:

http://en.wiktionary.org/wiki/need
To have an absolute requirement for.
To want strongly; to feel that one must have something.
To be obliged or required to.

http://www.thefreedictionary.com/need
1. A condition or situation in which something is required or wanted:
2. Something required or wanted; a requisite
3. Necessity; obligation
4. A condition of poverty or misfortune

http://www.merriam-webster.com/dictionary/need[1]
1: necessary duty : OBLIGATION
2 a: a lack of something requisite, desirable, or useful b: a physiological or
psychological requirement for the well-being of an organism
3: a condition requiring supply or relief
4: lack of the means of subsistence : POVERTY

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So, the “need” applicable to us is a requirement or sometimes a necessity (though
considered as such or not) which helps to take decision for specific purpose. In other
words, Value a business is a NEED for specific PURPOSE requiring a decision to
make.

Before we go to determine a value of MSME business, for specific purpose, let us go

through some basic terms associated with Business valuation.

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TYPES OF REPORTS

Based on the purpose and requirement of client, the report normally is prepared as:
• Comprehensive report
• Limited “Abbreviated” report
• Fairness opinion
• Review of an Appraisal

Comprehensive report: A report which requires analysis of Business data-

qualitative & Quantitative, review of Industry/sector & economy, consideration of
various appraisal techniques and based on all these to estimate the VALUE by
applying relevant technique/s.

Limited “Abbreviated” report: A report which requires specific consideration only

as per need of person requiring the APPRAISAL. Like- owner may require
calculating the firm value based on his forecast by application of any specific
technique (like DCF) only. - Or for limited purpose of finding the tangible worth of
Company only.

Fairness opinion: A report which requires the opinion of Appraiser on fairness of

specific value or range of value quoted by a person requiring the APPRAISAL. The
opinion does not express a specific value; rather it states whether or not appraiser
feels the value offered is fair or not.

Review of an Appraisal: A report to review and comment on valuation derived/

obtained by a person requiring an APPRAISAL. It is generally in form of letter
describing the review and critiques.

As per AICPA : statement on standards for valuation services; the valuation analyst
can be engaged for any of two assignment and sought for any or more of following
three types of reports:

Valuation engagement
Detailed report: This type of report is structured to provide sufficient information to
permit intended users to understand the data, reasoning and analyses underlying
the valuation analyst’s conclusion value.
Summary report: This type of is structured to provide an abridged version of the
information that would be provided in a detailed report, and therefore, need not
contain the same level of detail as a detailed report.

Calculation engagement
Calculation report: This report shows the calculations used by the value analyst and
any assumptions and limiting conditions applicable to engagement.

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VALUATION DATE

The monetary worth of any property including a business changes from time to time
and so, any valuation offers a “VALUE” on a particular point of time. It is important
that the users of valuations understand this fact. The International Glossary defines
the valuation date as, “The specific point in time as of which the valuator’s opinion
of value applies (also referred to as ‘Effective Date’ or ‘Appraisal Date’).”

The valuation date is the specific date at which the valuation analyst estimates the
value of the business and concludes on his or her estimation of value. Generally, the
valuation analyst should consider only circumstances existing at the valuation date
and events occurring up to the valuation date. An event that could affect the value
may occur subsequent to the valuation date; such an occurrence is referred to as a
“subsequent event.” Subsequent events are indicative of conditions that were not
known or knowable at the valuation date, including conditions that arose
subsequent to the valuation date. The valuation would not be updated to reflect
those events or conditions. Moreover, the valuation report would typically not
include a discussion of those events or conditions because a valuation is performed
as of a point in time—the valuation date—and the events described in this
subparagraph, occurring subsequent to that date, are not relevant to the value
determined as of that date. In situations in which a valuation is meaningful to the
intended user beyond the valuation date, the events may be of such nature and
significance as to warrant disclosure (at the option of the valuation analyst) in a
separate section of the report in order to keep users informed. Such disclosure
should clearly indicate that information regarding the events is provided for
informational purposes only and does not affect the determination of value as of the
specified valuation date

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PREMISE OF VALUE

The premise of value decides the applicable standard/s of value.

The International Glossary defines premise of value as “An assumption regarding

the most likely set of transactional circumstances that may be applicable to the
subject valuation, e.g., going concern, liquidation.” It defines going concern value as
“The value of a business enterprise that is expected to continue to operate into the
future. The intangible elements of going concern value result from factors such as
having a trained work force, an operational plant, and the necessary licenses,
systems, and procedures in place.”

There are two premises of value:

1. Going concern value
2. Liquidation value

If a business is capable of sustaining future operations, it has certain intangible assets

such as customer base, reputation and employee resources that have intrinsic value
for the entity. When an enterprise is financially distressed or only marginally
profitable, the appraiser may blindly accept the entity value returned by the
calculations, but fails to recognize the higher minimum turnkey value. This is one of
the primary reasons for the under-valuation of small businesses.

Some companies are worth more dead than alive. It is important for an appraiser,
particularly while valuing an entire company, to determine if the going concern
value exceeds the liquidation value. In a going concern valuation, we have to make
our best judgments not only on existing investments but also on expected future
investments and their profitability.

There are two types of liquidation value, orderly liquidation and forced liquidation.
The International Glossary defines orderly liquidation value as “Liquidation value at
which the asset or assets are sold over a reasonable period of time to maximize
proceeds received.” It defines forced liquidation value as “Liquidation value at
which the asset or assets are sold as quickly as possible, such as at an auction.” It
also defines liquidation value as “The net amount that can be realized if the business
is terminated and the assets are sold piecemeal. Liquidation can be either ‘orderly’ or
‘forced.’”

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STANDARDS OF VALUE

The International Glossary defines standard of value as “the identification of the type of
value being used in a specific engagement; e.g. fair market value, fair value, investment
value.”

A business can have different values under different standards of value. The
business appraiser must ensure that the standard of value identified upon
engagement is the standard of value used in the report to produce the indication of
value. After all, a fair market value standard can produce an indication of value that
is substantially different than one under an investment value standard.

Depending on standard of value, the value varies. And it depends on who is asking
and why?

Before analyst can attempt to value a business, he or she must fully understand the
standard of value that applies. Relying on the wrong standard of value can result in
a very different value and, in a dispute setting, the possible dismissal of the value
altogether. There are even different types of measurement attributes in financial
reporting. These include historical cost, (e.g. cash and liabilities in general), modified
(i.e. depreciated) historical cost (e.g. property, plant and equipment and receivables),
fair values (derivatives and asset revaluations), and entity specific value (impaired
property, plant and equipment).

I have divided the standards of valuation into three categories:

1. Fair market value (FMV) or Fair value (Intrinsic value & extrinsic value)
2. Investment value
3. Liquidation Value

One may argue that instead of going for finding values based on different standard,
why not to find a fair value only and then to negotiate for best applicable price
setting. But here, we should note that the need of investment value or liquidation
value is equally important as the fair value, while going for sale-purchase
transactions. Investment value helps the proposed investor to define a border up to
which he can take a maximum move. Similarly, the liquidation value helps the seller
the lowest point of deal. Base on fair value only, it is possible that the investor or the
seller may cross their upper or lower borders, respectively.

“Liquidation value” being a basic term or premise of value, some authors does not
consider it as a standard of value. Rather they treat them as a premise itself and view
liquidation value as a fair value under the premise of Liquidation.

Fair Market Value (FMV) or Fair Value

Many authors define fair market Value and Fair vale as different standards of value
but here, I have considered it as a fair value representing the appropriate worth of
business under the prevailing conditions and facts attached to it.

16
In US, Internal Revenue Service Revenue Ruling 59-60 defines fair market value as
“the price at which the property would change hands between a willing buyer and a willing
seller when the former is not under any compulsion to buy and the latter is not under any
compulsion to sell, both parties having reasonable knowledge of relevant facts.”

Fair market value assumes a hypothetical willing buyer and a hypothetical willing
seller. This is a contrast to investment value which identifies a particular buyer or
seller and the attributes that buyer or seller brings to a transaction. Fair market value
also assumes an arm’s-length deal and that the buyer and seller are able and willing.

See the addendum at the end of this chapter for the complete International Glossary.
Its definition of fair market value reads:
“The price, expressed in terms of cash equivalents, at which property would change hands
between a hypothetical willing and able buyer and a hypothetical willing and able seller,
acting at arms-length in an open and unrestricted market, where neither is under compulsion
to buy or sell and when both have reasonable knowledge of the relevant facts.”

The common definition of fair value is “The amount at which an asset (or liability)
could be bought (or incurred) or sold (or settled) in a current transaction between
willing parties, that is, other than in a forced or liquidation sale.”

IFRS 3, Business Combinations prescribes a number of alternatives that can be used

as fair value which includes estimated value, present value, current replacement
cost, depreciated replacement cost, selling price less the costs of disposal plus a
reasonable profit allowance etc. International Accounting standards (IAS / IFRS)
currently do not have a single hierarchy that applies to all fair value measures.
Instead individual standards indicate preferences for certain inputs and measures of
fair value over others and lacks consistency.

As per Indian Accounting Standards, the most often used definition has the exact
wordings that exist in IAS / IFRS as of now. AS 11: Accounting for the effects of
changes in Foreign Exchange Rates, AS 19 on Leases, AS 20: Earnings per share & AS
26, Intangible Assets define “Fair Value is the amount for which an asset could be
exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s
length transaction.” The same definition is used with the additional wordings of
“Under appropriate circumstances, market value or net realizable value provides an
evidence of fair value” in AS 13: Accounting for Investments. However, in AS 14:
Accounting for
Amalgamations the wording ‘Or a liability settled’ is missing from the regular
definition. So, Indian AS does not list a uniform fair value definition and
measurement criteria.

FASB (Financial Accounting Standard Board) decided to issue a standard on fair

value measurement, which would provide a single set of rules to be applied
whenever other standards require the use of fair value. This was issued as an
exposure draft in June 2004, and published in final form in September 2006 as the
Statement of Financial Accounting Standard (SFAS) No.157 on ‘Fair Value

17
Measurements’ (FAS 157). This Statement defines fair value, establishes a framework
for measuring fair value, and expands disclosures about fair value measurements.

ICAI is considering convergence to IFRS. A full convergence would mean adoption

of IFRS in its full form. In any case AS are formulated on the basis of IAS/IFRS
principles. Therefore, one could draw the conclusion that FAS 157 would be relevant
to the Indian accounting professionals.

FAS 157 defines fair value as

“Fair value is the price that would be received to sell an asset or paid to transfer a liability in
an orderly transaction between market participants at the measurement date”.

The transaction to sell the asset or transfer the liability is a hypothetical transaction
at the measurement date, considered from the perspective of a market participant
that holds the asset or owes the liability. Therefore, the definition focuses on the
price that would be received to sell the asset or paid to transfer the liability (an exit
price), not the price that would be paid to acquire the asset or received to assume the
liability (an entry price). This Statement emphasizes that fair value is a market-based
measurement, not an entity-specific measurement. Therefore, a fair value
measurement should be determined based on the assumptions that market
participants would use in pricing the asset or liability. A fair value measurement
should include an adjustment for risk if market participants would include one in
pricing the related asset or liability, even if the adjustment is difficult to determine.

Contrast this with the present definition under IAS / IFRS and Indian Accounting
Standards “Fair Value is the amount for which an asset could be exchanged, or a
liability settled, between knowledgeable, willing parties in an arms length
transaction.” The words ‘exchanged’ in this definition can either be an ‘exit’ price or
an ‘entry’ price. FAS 157 specifically defines price to be an exit price.

Under FAS 157, the fair value measurement assumes the asset’s highest and best use
by the market participants. The company’s intended use of an asset is not necessarily
indicative of the highest and best use as determined by a market participant;
therefore, the fair value measure is not an entity-specific measure that reflects only
the company’s expectations for the asset. For example, a company’s management
may intend to operate a property as a site for residential house, while market
participants would consider a site for manufacturing as the highest and best use of
the property. In that case, the property’s fair value measure should be based on the
property’s use as a site for manufacturing.
The highest and best use of the asset establishes the valuation premise used to
measure the fair value of the asset. Namely, “Fair value In-Use” (when value is
maximum to market participants through its use in combination with other assets as
a group) and “Fair Value In-exchange” (when maximum value to market
participants principally on a standalone basis).

FAS 157 specifically requires that the valuation techniques used to measure fair
value should maximize the use of observable inputs and minimize the use of
unobservable inputs.

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Here in this statement, inputs refer broadly to the assumptions that market
participants would use in pricing the asset or liability, including assumptions about
risk, for example, the risk inherent in a particular valuation technique used to
measure fair value (such as a pricing model) and/or the risk inherent in the inputs to
the valuation technique. Inputs may be observable or unobservable:

a. Observable inputs are inputs that reflect the assumptions market participants would
use in pricing the asset or liability developed based on market data obtained from
sources independent of the reporting entity.

b. Unobservable inputs are inputs that reflect the reporting entity's own assumptions
about the assumptions market participants would use in pricing the asset or liability
developed based on the best information available in the circumstances.

Unobservable inputs shall be developed based on the best information available in

the circumstances, which might include the reporting entity’s own data. In
developing unobservable inputs, the reporting entity need not undertake all possible
efforts to obtain information about market participant assumptions. However, the
reporting entity shall not ignore information about market participant assumptions
that is reasonably available without undue cost and effort. Therefore, the reporting
entity’s own data used to develop unobservable inputs shall be adjusted if
information is reasonably available without undue cost and effort that indicates that
market participants would use different assumptions.”

The inputs used to measure fair value might fall in different levels of the fair value
hierarchy. The level in the fair value hierarchy within which the fair value
measurement in its entirety falls shall be determined based on the lowest level input
that is significant to the fair value measurement in its entirety. Assessing the
significance of a particular input to the fair value measurement in its entirety
requires judgment, considering factors specific to the asset or liability.

FAS 157 cite four instances that might indicate that the transaction price does not
represent fair value. The said instances are helpful in determining the fair value at
initial recognition, but not necessarily all-inclusive. The reporting entity should
consider factors specific to the transaction and to the asset or the liability. The four
instances when the transaction price might not represent the fair value of an asset or
liability at initial recognition are:
1) The transaction is between related parties
2) The transaction occurs under duress or the seller is forced to accept the
transaction price because of some urgency
3) The unit of account represented by the transaction price is different from the
unit of account for the asset or the liability that is measured at fair value. (For
e.g., say, the transaction price includes transaction costs)
4) The market in which the transaction occurs is different from the principal (or
most advantageous) market in which the reporting entity would sell or
otherwise dispose of the asset or transfer the liability.

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A single definition of fair value, together with a framework for measuring fair value,
should result in increased consistency and comparability in fair value
measurements.

The fair value of business can be determined by using the internal fundamentals
only considering the impact of outer world or it can be measured focusing on worth
of similar businesses in the market and applying the fundamentals of subject
business on it. In other words, the fair value of a business can be derived by using
the intrinsic valuation measures or extrinsic (market based) valuation measures.

AICPA (American Institute of Certified Public Accountants), in its course

Fundamentals of Business Valuation—Part 1, defines intrinsic value as the “Amount
an investor considers to be the ‘true’ or ‘real’ worth of an item, based on an evaluation of
available facts. It is sometimes called fundamental value. It is an analytical judgment of value
based on perceived characteristics inherent in the investment (not characteristic peculiar to
any one investor).”

So, intrinsic value is based on fundamental analyses of business.

Under the intrinsic value method, future dividends are derived from earnings
forecasted and then discounted to the present, thereby establishing a present value
for the equity. For listed companies, if the shares are trading at a price lower than
this calculation, it is a ‘buy’; if the market price is higher than the intrinsic value; the
share is a ‘sell. The value of business can be determined by discounting the future
cash flow considering business fundamentals like risk, expected rate of return,
capital investment and the growth potentials.

Intrinsic Value presents the actual value of a company or an asset based on an

underlying perception of its true value including all aspects of the business, in
terms of both tangible and intangible factors. This value may or may not be the same
as the current market value. Value investors use a variety of analytical techniques in
order to estimate the intrinsic value of securities in hopes of finding
investments where the true value of the investment exceeds its current market value.

It is also sometimes presented by the net asset value, showing an excess of current
market value of assets (including intangibles) over the current value of liabilities
presents the actual net worth of the business and widely used while transacting the
buy/ sell agreement for small businesses.

The extrinsic value is based on the assumption that if comparable asset (or property)
has fetched a certain price, then subject asset (or property) will realize a price
something near to it, based on its own characteristics and situations. The theory
behind this approach is that valuation measures of similar companies that have been
sold in arms-length transactions should represent a good proxy for the specific
company being valued.

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Under FAS 157, the Board concluded that quoted market prices provide the most
reliable measure of fair value. Quoted market prices are easy to obtain and are
reliable and verifiable. Those are used and relied upon regularly and are well
understood by investors, creditors, and other users of financial information.

Investment Value
The International Glossary of business valuation terms defines investment value as
“The value to a particular investor based on individual investment requirements and
expectations.”

Investment value is the value to a particular investor, which reflects the particular
and specific attributes of that investor. The best example would be an auction setting
for a property (or a business) in which four different bidders’ quotes to acquire. Each
of the bidders is more likely to offer a different price based on the individual outlook
and synergies that he/she brings to the transaction. Investment value reflects more
of the risk perception of a particular investor on specific investment/s.

Each potential investor will have their own priorities from five key value drivers:
earnings, hope, synergy, risk and bulking. They will evaluate each in the context of
the future performance of the business in their specific circumstances.
Earnings and hope pick up the worth of the business’ existing and potential
profitability. Earnings value is the capital equivalent of the existing profitability of
the business, on the assumption that this can be sustained. Hope is the ability to
grow that profit from the existing resources of the business acquired – new products,
new customers, new markets, all of which can be delivered by the business’ existing
management. Synergy value, which may be very difficult to quantify, is found in the
acquirer’s ability to generate extra profits from its own business from its connection
with the target – using it as a launch platform. Synergy can be operational or
financial or both. This may arise from cross selling to its customers, from
improvements in its own product or services when linked with those of the target, or
factors such as having an in-house research or testing facility, better stocking and
distribution, or simply reputation, or be able to service in-house a requirement
previously bought in at a higher cost, etc. lowering risk is as much a target as
increasing profit. Bulking is the ‘2+2=5’ factor. If, for example, the investor wishes to
approach the AIM market, or to become more visible for sale, the investment may
not just add profits, but enable it to achieve an exit or other growth in capital value
for the investor’s own business. Its worth will then be magnified by this
enhancement of value, which purely arises from investor’s own strategy. The other
bulking factor which may come into play is classic economy of scale. The investor
may save on administrative functions, may gain greater buying power.

Liquidation value:
One common standard of value is to look at the liquidation worth of an asset (or
property). It considers the proceeds that could be realized from selling off the firm's
assets, using those proceeds to pay down any of the firm's liabilities, and then
counting as the business valuation whatever the leftover amount equals.

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Theoretically, this standard is opposed to Investment value. It is on the mode of
termination while the investment is the starting point or the point of holding
something.

As said earlier, “Liquidation value” being a basic term or premise of value, some
authors does not consider it as a standard of value. Rather they treat them as a
premise itself and view liquidation value as a fair value under the premise of
Liquidation.

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APPROACHES TO VALUATION

Choosing the right model to use in valuation is as critical to arriving at a reasonable

value as understanding how to use the model.

In broadest possible terms, there are three approaches to value any asset, business or
business interest:

1. The asset approach

2. The income approach
3. The market approach (Relative valuation approach)

One other approach called, Option pricing OR contingent claim method is emerging
as a better contender to value assets that have option like characteristics.

There are some assets that cannot be valued with conventional valuation models
because their value derives almost entirely from their option characteristics. For
example, a biotechnology firm with a single promising patent for cancer drug
wending its way through the approval process can not be easily valued using
discount cash flow or relative valuation models. It is also used when we want to
consider the option to delay making investments decisions or option to expand the
business or to value a patent or an undeveloped natural resource reserve as an
option. The value of an option is determined by six variables – the current value of
the underlying asset, the variance in this value, strike price, life of option, the risk
less interest rate and the expected dividends on the assets.
Real option is said to be embedded in a decision or an asset:

- When there has to be a clearly defined underlying asset whose value

changes over time in unpredictable ways.
- The payoffs on this asset (real option) have to be contingent on and
specified event occurring within a finite period.

There are two types of real options:

• Growth options
• Flexibility options.

Growth options give a firm the ability to increase its future business. Examples
include research and development, patent or brand development, mergers and
acquisitions, leasing or developing land, or—most pertinent—launching a
technology initiative.

Flexibility options, on the other hand, give a company the ability to change its plans in
the future. Management can purchase the option to delay, expand, contract, switch
uses, outsource or abandon projects.

Several methodologies have been developed to value options. Of these, the binomial
method provides an intuitive feel and insight into the determinants of option value.

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This model provides insight into determinants of option value. The value of an
option is not determined by the expected prices of the shares but by its current price,
which, of course, reflects expectation about the future. This method considers one by
one the events that may occur between the options being granted and exercised.
Principally these are fluctuations in share price over discrete time periods, dividend
changes, factors relating to whether and when the options may be exercised and
other relevant terms of the options. These are plotted on a ‘decision tree’ and
probabilities allocated to each branch. Each probability-weighted value may then be
discounted back to present value using a risk free rate of return (normally taken as
the return on ‘risk-free’ government bonds).

Whilst flexible in terms of being able to deal with dividends and various different
option exercise dates, the method can be very complicated with myriad possible
outcomes and challenges in allocating probabilities to each. The Black-Scholes
model removes the need to create such complex decision trees and has become
widely used for valuing options.

One critical difference between traditional income approach and real options is the
effect of uncertainty (or risk) on value. Uncertainty typically is considered bad for
the valuation of traditional cash flows. In contrast, uncertainty increases the value of
real options. So, in today’s uncertain environment, the value of options actually
increases.

Option pricing being a technique useful for particular cases and to value specific
assets or business only, I have concentrated more on three basic approaches which
are the most popular and applicable while valuing a MSME business. So, let we get
back to the most widely used approaches to valuation viz. Asset approach, Income
approach, and Relative valuation approach

The leading business valuation associations, the American society of Appraisers

(ASA), the Institute of Business Appraisers (IBA) and the National Association of
Certified Valuation Analysts (NACVA), all have recognized the above three as major
approaches to business valuation.

There are numerous methods within each of these approaches that the appraiser or
analyst may consider in performing valuation. For example, under the asset
approach, the analyst often need to choose between either valuing just tangible
assets or valuing tangible and intangible assets on stand alone basis or all intangible
assets as a collective group. In the income approach, the analyst can use a discounted
cash flow method or a capitalization of earnings method. Again these can be applied
to value the entire business or only equity value. In the market approach, the analyst
can use guideline company multiples or multiples derived from near past
transactions, may be of public or/and private business concern. Some methods
focuses usage of historical performance, some give some other weight to expected
performance in near future while some relies on current data and market
happenings. Therefore, many times, Analyst determines final value by applying
average/weighted average / mean / geometric mean on values derived by one or
more methods, relevant for the purpose of valuation.

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All three approaches should be considered in each valuation. However, it is not
common to use all three approaches in each valuation.

RULE OF THUMB
International glossary of business valuation terms define “Rule of thumb” as “ a
mathematical formula developed from the relationship between price and certain variable
based on experience, observation, hearsay or a combination of these; usually industry
specific”.

Rules of thumb are simple pricing techniques that are typically used to approximate
the market value of a business. Rules of thumb typically come in the form of a
percentage of revenues or a multiple of a level of earnings. For example, a rule of
thumb for pricing a auto manufacturer may be 40% of annual revenues plus
inventory or two times seller’s discretionary earnings (pre-tax net income +
depreciation + interest + salary for one owner/operator at the market rate of
compensation). It may be a multiple of specific measure of a business like price per
seat in case of call centre business or price per room for hotel business or price per
student for private coaching classes or price per Bed for nursing-home operators, or
price per subscriber for cable television business.

Rules of thumb fail to consider the specific characteristics of a company as compared

to the industry or other similar companies. In addition, rules of thumb do not reflect
changes in economic, industry, or competitive factors over time. None of the rules
provide sufficient information to assess the uniqueness of the business, such as
management depth, customer relationships, industry trends, reputation, location,
competition, capital structure and other information unique to the business. It is also
a question for an appraiser to decide whether to use a trailing or historical data OR
current years data OR estimated figures (forecasted or leading) to apply with the
chosen rule of thumb.

Widely-accepted business appraisal theory and practice does not include specific
methodology for rules of thumb in developing a value estimate, as there is typically
no empirical evidence relating to how the rules were derived or if, in fact, the rules
are reflective of transactions in the market. As such, business appraisers do not use
rules of thumb in determining an indication of value. However, rules of thumb can
be useful in testing the value conclusion arrived through the appraiser’s selected
approaches and methods. Such sanity checks are a way for business appraisers to
test the reasonableness of their value conclusion.

“Be careful, thumbs come in many sizes and shapes!”

So, we can conclude that although rules of thumb may provide insight on the value
of a business, it is usually better to use them for reasonableness tests of the value
conclusion.

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WHICH APPROACH SHOULD BE USED?

Now, the fundamental question is which approach is to consider for valuing a

business?

The analyst faced with the task of valuing a business or its equity has to choose
among different approaches – Asset valuation, discounted cash flow valuation,
relative valuation (and in some cases, option pricing models) and within each
approach, they must also choose among different models. As per the views of the
analyst, these choices will be driven by the characteristics of business being valued -
the level of earnings, growth potential, the sources of earnings growth, the stability
of leverage and dividend policy. Matching the valuation model to the business being
valued is as important a part of valuation as understanding the models and having
the right inputs. Once we decide to go with one or another of these approaches, we
have further choices to make – which value of asset to consider, a replacement value
or a liquidation value, whether to use equity or firm valuation in the context of
discounted cash flow valuation, which multiple we should use to value firms or
equity based on comparable business or transaction.

It is like a kitchen that has many chefs with multifarious stuff on platform but no
recipes. A business appraisal is in fact the opinion of the individual appraiser, and the
appraiser has significant flexibility in formulating an opinion.

The true measure of a valuation model is how well it works in (i) explaining
differences in the pricing of assets at any point in time and across time and (ii) how
quickly differences between model and market prices get resolved.

Revenue Ruling 59-60 of Internal Revenue Service (IRS) at US recognizes this

dilemma and states “No general formula may be given that is applicable to the many
different valuation situations arising in the valuation of (closely-held) stock.... Often, an
appraiser will find wide differences of opinion as to the fair market value of a particular stock.
In resolving such differences, he should maintain a reasonable attitude in recognition of the
fact that valuation is not an exact science.”

Valuation is relative to purpose. Therefore, the calculated value of a business will

vary depending on how it’s intended to be used, and the differences can be
substantial. The value established for tax purposes or for litigation is not the same
value established for divestiture.

Actually, entity value is driven by assets and earnings potentials. Normally, it is

inversely proportional to Business risk. It is established for specific purpose and
specific point of time.

Intrinsic value is something that cannot be observed. It is the asset prices that we
observe and report. Valuation process is undertaken on the belief that values can be
measured on the basis of certain parameters using relevant techniques and methods.
The origin of the methods employed to measure values of assets can be traced back

26
to finance theory and economics, and these methods are constantly evolving with
related newer developments taking place.

James DiGabriele, while studying the preferences of court for valuation approaches
of closely held companies based on Industry type, came on conclusion than the
income approaches are more popular for manufacturing companies and less popular
for companies not classified as manufacturing, service or holding companies, while
market approaches were most popular for holding companies. He had performed
various mean tests on a sample of 164 cases, divided into various sub groups based
on Industry classification codes. He also derived a conclusion that each of the three
valuation approaches is equally popular for tangible companies and equally popular
for intangible companies.

International Private Equity and Venture Capital Valuation (IPEV) Guidelines

(Oct,2006) says that
“The valuer will select the valuation methodology that is the most appropriate and
consequently make valuation adjustments on the basis of their informed and experienced
judgment. This will include consideration of facts such as:
- relative applicability of the methodologies used given the nature of industry and current
market conditions
- Quality and reliability of the data used in each methodology
- Comparability of enterprise or transaction data
- the stage of development of the enterprise; and
- any additional considerations unique to the subject enterprise”.

So, IPEV also emphasis to consider the basic characteristics of all the three
approaches. However it gives more weight age to use market based approach for
deciding the fair investment value. It narrates that
“In accessing whether a methodology is appropriate, the valuer should be biased towards
those methodologies that draw heavily on market-based measures of risk and return. Fair
value estimates based entirely on observable market data will be of great reliability that those
based on assumptions.
Methodologies utilizing discounted cash flows and industry benchmarks should rarely be
used in isolation of the market-based measures and then only with extreme caution. These
methodologies may be useful as a cross-check of values estimated using the market-based
methodologies.”
“…….Due to high level of subjectivity in selecting inputs for this technique, DCF based
valuations are useful as a cross check of values estimated under market based methodologies
and should only be used in isolation of other methodologies under extreme caution.”

IPEV indicates the usage of DCF for the businesses with absence of significant
revenues, profits or positive cash flows, however with the caution about the inherent
disadvantage of high level of subjectivity involved in the method.

For FAS 157, FASB (Financial Accounting Standard Board) clarifies that,
“consistent with existing valuation practice, valuation techniques that are appropriate in the
circumstances and for which sufficient data are available should be used to measure fair
value. This Statement does not specify the valuation technique that should be used in any

27
particular circumstances. Determining the appropriateness of valuation techniques in the
circumstances requires judgment.”

The statement provides for using single technique or multiple techniques, subject
that, the results of those techniques evaluated and weighted, as appropriate, in
determining fair value. The valuation techniques may differ, depending on the asset
or liability and the availability of data. However, in all cases, the objective is to use
the valuation technique (or combination of valuation techniques) that is appropriate
in the circumstances and for which there are sufficient data.

IPEV (International Private Equity and Venture) valuation Board while commenting
on the IASB’s discussion paper “Fair value measurements” published in November
2006 expresses its apprehension that

“Having a single source of guidance for all fair value measurements in IFRS’s would
probably reduce complexity and improve consistency in measuring fair value. However, in
order to achieve its objective, such a document should not aim at being exhaustive in its
guidance in order not to create more confusion for accounts preparers, users and auditors.

Consequently, the document should adopt a consistent theoretical approach and should not
try to solve issues that are specific to certain markets, assets or asset classes and then apply
those solutions to all other situations. The IPEV valuation Board fears that doing so will
create principles and guidelines that are too theoretical and difficult to apply to specific
situations.”

So, the valuation guidelines should not aim to be exhaustive and it must not restrict
the analyst’s wisdom to apply in specific circumstance.

As read from the Para 13 of CCI guidelines (1990), “The guidelines are intended to
provide the basic framework for valuation and to minimize the element of subjective
consideration. While they should be applied fairly and consistently in all cases, they should
not be regarded as eliminating the exercise of discretion and judgment needed to arrive at a
fair and equitable valuation.”

The values that we obtain from the different approaches described above can be very
different and deciding which one to use can be a critical step. This judgment,
however, will depend upon several factors, some of which relate to the business
being valued but many of which relate to us, as the appraiser.

The fair value hierarchy under FAS 157 also, focuses on the inputs, not the valuation
techniques, thereby requiring judgment of appraiser in the selection and application
of valuation techniques.

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1. THE ASSET APPROACH

The Asset-based Approach involves methods of determining a company’s value by

analyzing the value of a company’s assets. This valuation approach often serves as a
valuation floor since most companies have greater value as a going concern than
they would if liquidated, i.e., the present value of future cash flows generated by the
assets usually far exceed the liquidation value of those assets. This difference
between the asset value and going concern value is commonly referred to as
“goodwill”. An exception to this might be a low-margin business in a competitive
industry that owns its real estate, which has appreciated over time due to its
development value. In this case, the asset value may exceed the going concern value
of the business.

This approach is generally preferred to value intangible asset (like brands, patents,
goodwill etc) of the business.

This methodology is likely to be appropriate for a business whose value derives

mainly from the underlying value of its assets rather than its earnings, such as
property holding and investment business. This method may also be appropriate for
a business that is not making an adequate return on assets and for which a greater
value can be realized by liquidating the business and selling its assets. Net asset
values, which are of great relevance in industries such as utilities, manufacturing
and transport that are dependent on physical infrastructure and assets, may not have
particular significance in industries such as information technology, pharmaceutical
that are driven by intangibles not recorded in the books.

Given that most business valuations are typically conducted under the premise of a
going concern, the appraiser may determine that the asset approach is inappropriate
for determining an indication of value. However, the appraiser may test if the
company is worth more in liquidation as opposed to as a going concern by utilizing
an asset approach.

CCI guidelines, 1990 (para 6.1) state that “The net asset value, as at the latest audited
balance-sheet date, will be calculated starting from the total assets of the Company or of the
branch and deducting there from all debts, dues, borrowings and liabilities, including current
and likely contingent liabilities and preference capital, if any. In other words, it should
represent the true “net worth” of the business after providing for all outside present and
potential liabilities. In the case of companies, the net asset value as calculated from the asset
side of the balance-sheet in the above manner will be cross checked with equity share capital
plus free reserves and surplus, less the likely contingent liabilities.”

29
Following figure shows a business value based on asset approach.

VALUATION BALANCESHEET

Total Asset
Current Assets Current
Invested Liabilities
Capital

Plant, Property Long - Term

& equipments Debts

Owner’s fund

Other Assets
Equity
Intangible And Reserves
Assets

Some of the most common techniques of valuation considered under this approach
are to value a business enterprise on the basis of book value of the assets or Adjusted
book value of the assets or at Replacement value or applying cost to create approach
or just deriving the liquidation proceeds.

Book value
This is simply a value based upon the accounting books of the business. In simple
term, Assets less liabilities equals the owners’ equity, which is the "Book Value" of
the business.

Is it possible for book value to be a reasonable proxy for the true value of a business?
For mature firms with predominantly fixed assets, little or no growth opportunities
and no potential for excess returns, the book value of the assets may yield a
reasonable measure of the true value of these firms. For firms with significant
growth opportunities in businesses where they can generate excess returns, book
values will be very different from true value.

Adjusted book value:

This method involves reviewing each and every assets and liabilities on the
company’s balance sheet and adjusting it to reflect its estimated market value.
Depending on the mix of assets owned by the company, other types of appraisers
(e.g., real estate, machinery and equipment) might need to be consulted as part of
the valuation process. In addition, it is important to consider intangible items that

30
might not necessarily be reflected on the balance sheet, but which might have
considerable value to a user, such as trade names, patents, etc. The unrecorded and
contingent liabilities are also considered at their fairly estimated value.

Replacement value and Cost to create value:

Replacement value is a least value that a seller will insist from buyer who otherwise
would have to expend for getting such assets and creating such liabilities. It is a
value at which the similar assets (and liabilities also) can be replaced with existing
assets of the business.

“Cost to create” value is basically from the view point of the buyer or investor. In
case of business purchase, the buyer or investor would like to know the cost that he
may have to incur for purchase of the assets (and liabilities also) in similar
conditions or bringing the identical assets to the place of use. The cost to build
similar intangible worth or asset for the business is also considered. The value so
derived can help him to negotiate a fair price.

Liquidation value
Generally, while offering a business for sell, a seller would like to know the least
value of the business that he or she can get on just liquidating the business assets.
This value can help to negotiate a better price.

Liquidation analysis should be considered when the value of the business, on a

control basis as determined by the income or market approaches (discussed later), is
low relative to the net asset value. Application of the liquidation approach must
consider the expenses associated with liquidation, including taxes, selling expenses
and plant closing costs, and the risk and timing related to the proceeds.

Intangible assets and its valuation

Intangible assets are something of value that cannot be seen, touched or physically
measured, which are created through time and/or effort and that are identifiable as
a separate asset, such as a brand, franchise, trademark, or patent. Just an opposite of
tangible assets.

In the world of business today, things are not what they used to be. In the new
economy, the most valuable assets have gone from tangible to intangible. Instead of
plant and equipment, companies today compete on ideas and relationships. While
intangible assets don't have the obvious physical value of a factory or equipment,
they can prove very valuable for a firm and can be critical to its long-term success or
failure. Although brand recognition is not a physical asset you can see or touch, its
positive effects on bottom-line profits can prove extremely valuable to firms, for
example- Coca Cola, whose brand strength drives global sales year after year.

Mr. Ágnes Horváth in his article “Non Quantitative measures in company

valuation” summarizes factors determining the company value, started out from the
fact that a company does not exist in complete isolation. There are several elements

31
in the environment that contribute to its operation. These significant qualitative
characteristics, which must not be discounted or must not be over looked, includes;
dominant market size, company size and critical mass, employees’-management
relations, strength of competition, technological capabilities and expertise, size of
backlog, location of operations, strength of customer-vendor relationship,
competence of management etc. It is essential to focus not only on factors closely
related to the company operation, but on micro and macro factors as well. This all
together give rise to goodwill of the business concern.

Goodwill is the most common and popular intangible asset in the world of MSMEs.
It refers to the price or value above the market value of the identifiable assets of a
company. When a business is bought, the price paid will often be above the market
value of its infrastructure, equipment, inventory, etc. A business enterprise cultivates
this intangible asset by establishing a strong business track record and by
establishing many beneficial relationships, including those with customers,
distributors, and suppliers. In addition, goodwill covers other valuable albeit
intangible aspects of a business, such as its credit rating, location, reputation, and
name. Goodwill also may manifest itself in the form of trademarks, manufacturing
processes, and license rights.

In any event, goodwill reflects the buyer's perception that the business as a whole is
worth more than the sum of the identifiable physical assets. On occasions,
enterprises even sell their goodwill without the sale of other assets.

There are two primary forms of intangibles - legal intangibles (such as trade secrets
(e.g., customer lists), copyrights, patents, trademarks, and goodwill) and competitive
intangibles (such as knowledge activities (know-how, knowledge), collaboration
activities, leverage activities, and structural activities). Legal intangibles generate
legal property rights defensible in a court of law. Competitive intangibles, whilst
legally non-ownable, directly impact effectiveness, productivity, wastage, and
opportunity costs within an organization - and therefore costs, revenues, customer
service, satisfaction, market value, and share price. Human capital is the primary
source of competitive intangibles for organizations today. Competitive intangibles
are the source from which competitive advantage flows, or is destroyed.

Below mentioned examples, though not exhaustive, provide a useful framework for
the determination of intangible assets. They fall into five categories (as shown
below).

Intangible Asset categories Examples include:

1. Marketing-related intangible assets
2. Customer-related intangible assets
Trademarks, trade names, service
marks, internet domain names, non-
competition agreements.
Customer lists, order or production
backlogs, customer contracts and
customer - relationships including non-
contractual relationships.

32
3. Artistic-related intangible assets Plays, books, magazines, newspapers,
pictures, photographs.
4. Contract-based intangible assets Licensing and royalty agreements,
advertising, construction, service or
supply agreements, lease agreements,
franchise agreements, employment
contracts.
5. Technology-based intangible assets Patented technology, computer
software, unpatented technology
(know-how), databases, trade secrets
such as secret formulas, processes and
recipes.

Difficult questions about intangibles assets are to drive finance professionals and
Accounting Standard Setters to develop new measurements, new reporting forms,
new tools and techniques for an economy based on intangibles.

Valuation of intangible assets

While intangible assets play an increasingly important role in today’s business

world, it remains difficult to quantify its economic and monetary value. Companies
with a large part of their value in intangible “assets,” such as high-technology
companies and companies with substantial research and development activities,
may be particularly hard to value because such a small portion of their value lies in
assets in place whereas a large portion derives from uncertain future growth
opportunities. A further complication with such companies is that their high R&D
expenses reduce current earnings even though R&D projects could be perceived as
investments for the future; in such a case, current earnings may be a bad predictor of
value.

Intangible assets are significantly more difficult to value than their tangible
counterparts. Obviously, it is more difficult to determine the value of a trade secret
than the value of office space. When it is time to sell assets, intangible assets, such as
goodwill and patent, can cause real problem in the form of financial and legal
obstacles if improperly valued. The “fair” value of an intangible asset is the amount
that such asset can be bought, sold, or settled in a transaction between willing
parties, not involving forced or liquidation sale. The method most often used in the
valuation of intangible property determines the present value of the cash flows
derived from using such property.

Intangible value is created when a company has above average return on assets (or
equity), so that the value of the business (based on expected earnings or cash flow)
exceeds the underlying net asset value.

- Consequently, intangible value is the amount by which the value of the business
exceeds the value of the underlying, tangible assets. Intangible assets can be difficult
to value individually with no guarantee of completeness.

33
- The most common technique for capturing total intangible value is an enterprise
valuation to establish total asset value. The value of current and fixed assets is then
deducted to arrive at the value of intangible assets.

Many times a business owner incurring specific expenses like research on value
addition of a product, huge advertisement cost on initial start ups for product
publicity, extra amount paid on purchase of specific formula etc.; claim existence of
intangible worth arisen due to these expenditures. The analyst should note that, in
order for expenditure to qualify as an intangible asset, a business enterprise must
expect benefits in the coming years and support that expectation with evidence.
Expenditures such as those on advertising, for example, may promise future
benefits, but the benefits are so uncertain and unpredictable that the business
classify them as current expenses.

Methods for the Valuation of Intangibles

Acceptable methods for the valuation of identifiable intangible assets and

intellectual property fall into three broad categories. They are market based, cost
based, or based on estimates of past and future economic benefits.

In an ideal situation, a value analyst will always prefer to determine a market value
by reference to comparable market transactions. This is difficult enough when
valuing assets such as bricks and mortar because it is never possible to find a
transaction that is exactly comparable. In valuing an item of intellectual property,
the search for a comparable market transaction becomes almost futile. This is not
only due to lack of compatibility, but also because intellectual property is generally
not developed to be sold and many sales are usually only a small part of a larger
transaction and details are kept extremely confidential.

Cost-based methodologies, such as the “cost to create” or the “cost to replace” a

given asset, assume that there is some relationship between cost and value and the
approach has very little to commend itself other than ease of use. The method
ignores changes in the time value of money and ignores maintenance.

The methods of valuation flowing from an estimate of past and future economic
benefits (also referred to as the income methods) can be broken down in to four
limbs; 1) capitalization of historic profits, 2) gross profit differential methods, 3)
excess profits methods, and 4) the relief from royalty method.

1. The capitalization of historic profits arrives at the value of intangibles by

multiplying the maintainable historic profitability of the asset by a multiple that has
been assessed after scoring the relative strength of the intangible assets. For example,
a multiple is arrived at after assessing a brand in the light of factors such as
leadership, stability, market share, internationality, trend of profitability, marketing
and advertising support and protection. While this capitalization process recognizes
some of the factors which should be considered, it has major shortcomings, mostly

34
associated with historic earning capability. The method pays little regard to the
future.

2. Gross profit differential methods are often associated with trade mark and brand
valuation. These methods look at the differences in sale prices, adjusted for
differences in marketing costs. That is the difference between the margin of the
branded and/or patented product and an unbranded or generic product. This
formula is used to drive out cash flows and calculate value. Finding generic
equivalents for a patent and identifiable price differences is far more difficult than
for a retail brand.

3. The excess profits method looks at the current value of the net tangible assets
employed as the benchmark for an estimated rate of return. This is used to calculate
the profits that are required in order to induce investors to invest into those net
tangible assets. Any return over and above those profits required in order to induce
investment is considered to be the excess return attributable to the intangible assets.
While theoretically relying upon future economic benefits from the use of the asset,
the method has difficulty in adjusting to alternative uses of the asset.

4. Relief from royalty considers what the purchaser could afford, or would be willing
to pay, for a license of similar intangible asset. The royalty stream is then capitalized
reflecting the risk and return relationship of investing in the asset.

Discounted cash flow (“DCF”) analysis sits across the last three methodologies and
is probably the most comprehensive of appraisal techniques. Potential profits and
cash flows need to be assessed carefully and then restated to present value through
use of a discount rate, or rates. The discount rate is used to calculate economic value
and includes compensation for risk and for expected rates of inflation.

Real option or option pricing method is now a days getting more recognition for
valuing the patent.

While some of the above methods are widely used by the financial community, it is
important to note that valuation is an art more than a science and is an
interdisciplinary study drawing upon law, economics, finance, accounting, and
investment. It is rash to attempt any valuation adopting so-called industry/sector
norms in ignorance of the fundamental theoretical framework of valuation. When
undertaking an Intangible valuation, the context is all-important, and the value
appraiser will need to take it into consideration to assign a realistic value to the asset.

35
2. THE INCOME APPROACH

The concept is to value a business or asset based on its earning capacity. Earnings is
a final crux of the business activity. Earnings are linked with all other fundamentals
of the business like growth, capital requirements, risk involvement or uncertainty,
etc. and so, valuation of business based on its earning capacity can be a better proxy.

The Income Approach derives an estimation of value based on the sum of the
present value of expected economic benefits associated with the asset or business
(Economic benefits have two components: cash flow (or dividends) and capital
appreciation). Under the Income Approach, the appraiser may select a single period
capitalization method or a multi-period discounted future income method.

The capitalization method estimates the fair market value of a company by

converting the future income stream into value by applying a capitalization rate
incorporating a required rate of return for risk assumed by an investor along with a
factor for future growth in the earnings stream being capitalized. This results in a
value based on the present value of the future economic benefits that the owner will
receive through earnings, dividends, or cash flow. The capitalization method is
based on the Gordon constant growth model that uses a single period proxy of
future earnings to determine the present value of the asset. This method is usually
employed when a company is expected to experience steady financial performance
for the foreseeable future and when growth is expected to remain fairly constant.

Multi-period discounted future income methods involve discounting a projected

future income stream on a year-by-year basis back to a present value using an
appropriate discount rate that reflects the required rate of return on the investment
(compensating for risk). For the final year of the projection period, the income
stream that represents the expected income stream in perpetuity is capitalized to
arrive at a terminal value, which is then discounted back to a present value (at the
same discount rate) and added to the present value of the prior years’ income
streams to arrive at the indication of fair intrinsic value.

This method is most commonly used when the company is expected to experience a
period of abnormal growth or when the growth rate for the near term is anticipated
to be significantly different from the long-term rate of growth. This is predicated
upon the ability to create a reasonable forecast of the company’s income stream for
the forecast period. If these conditions are satisfied, the multi-period discounted
future income method may more reliably capture the value impacts of cyclicality or
abnormal short-term factors impacting the company’s results than a capitalization
method.

Single period capitalization method:

The basic of this approach is find the normalized earning capacity of the business
and to capitalize it on the basis of appropriate rate considering the business
fundamentals of safety, return and time. Alternately, an appropriate multiple can be
used with the normalized earnings to arrive at fair estimation of business value.

36
The important task is to determine two factors (1) normalized earnings and (2) rate
of capitalization or multiple for capitalization (capitalization rate is the inverse of
multiple – 20% rate of returns equals a multiple of 5).

The normalized earnings can be a Profit after tax (PAT) OR a profit before
Depreciation, Interest, and taxes (PBDIT) OR Net operation profit before
amortization OR it may be simply a cash flow from the business operations. This
earnings may be considered from recent year earnings, OR simple average of few
years’ earnings, OR weight age average or geometric average of few years’ earnings.
Again it can be a forward looking or trailing (based on past). For forward looking
(also known as leading) earnings the forecasted figures must be checked. CCI
guidelines prescribe usage of simple average of last three financial years’ profit as
future maintainable earnings of the company.

CCI guidelines, 1990 (para 7.3) state that "The crux of estimating the Profit Earning
Capacity Value lies in the assessment of the future maintainable earnings of the business.
While the past trends in profits and profitability would serve as a guide, it should not be
overlooked that valuation is for the future and that it is the future maintainable stream of
earnings that is of great significance in the process of valuation. All relevant factors that have
a bearing on the future maintainable earnings of the business must, therefore, be given due
consideration"

Gorden growth model estimates the value of ownership based on next year’s
dividend payment capacity and capitalizing it considering the expected rate of
return (cost of capital) and estimated growth rate.

Following formula is used to estimate a value using this approach:

Value = Normalized earnings / (Ke – g)

Where,
Ke = required rate of return on investments
g = growth rate in earnings forever

Or

Value = Normalized earnings * Appropriate multiple

Appropriate multiple should be arrived at by considering the specific business risk,
size risk, market risk, growth rate, expected return and such other factors having
impact on the business operations. This multiple should also co-relate with the
nature of earnings used. For example, if it is PBDIT then multiple should be based on
capital invested and not only the owners’ fund. This will give value of business. But
if the earnings used is PAT then the multiple should reflect the factors applicable to
ownership only. It will provide the value of owners’ fund in the business.

To conclude, we can say that it is on the best judgment of the appraiser to decide
normalized earnings and appropriate rate of capitalization.

37
Multi period discounting Method (Discounted Cash Flow - DCF)
This method uses financial projections to determine the value of business or value of
ownership based on future income for several periods (un stable growth period) and
terminal value after expiry of that period (stable growth period). Then, a discount
rate is employed to convert those future values back to a present value. The business
life being divided in to two phases: unstable growth period and stable growth
period – it is also known as two stage model of cash flow discounting. The model
can be extended to three or four stage model based on the business cycle.

The value of an undertaking really depends on its future profits, cash flows or
distributions and the associated risks. Past results may serve as an aid for estimating
the likely future results; they cannot determine them. The advantage of this method
is that it can be used for businesses or assets with unstable earnings and non
constant growth rates. But it is important that the discount rate being used is
appropriate for the income being discounted as small changes in the discount rate
can have considerable impact on the present value.

Following formula is used to estimate a value using this approach:

t=n CF t
Value = ∑ (1+ R) t
t=1

Using discounted cash flow, we can derive value of equity holders by (i) choosing
present value of free cash available to equity holders and (ii) choosing present value
of the cash flow available to firm and subtracting the present value of debts there
from. Done right, the value of equity should be the same whether it is valued
directly (by discounting cash flows to equity at the cost of equity) or indirectly (by
valuing the firm and subtracting out the value of all non-equity claims). The primary
difference between equity and debt holders in firm valuation models lies in the
nature of their cash flow claims – lenders get prior claims to fixed cash flows and
equity investors get residual claims to remaining cash flows.

Formula to get a value of a firm:

t= n
CF to Firm t
Value of Firm = ∑ (1+ WACC)
t =1
t

Formula to find a value of equity:

t=n FCFE t
Value of Equity = ∑ (1+ Ke) t
t=1

38
So, the fundamentals to estimate value under this technique are cash flows, and
discounting rate.

1) Determination of the cash flows:

The cash flow of perpetual business is generally divided into to segments.

(1) flow for periods up to abnormal earnings or unsteady growth (2) flow after this
unsteady period when the business gets stabilized i.e. terminal flow or terminal
value.

Cash Flow:
The free flow to firm is calculated as follow:

CF to Firm = Net income + Amortizations + Interest + Depreciation – Capital

expenditure – change in non cash working capital

The free flow to equity is calculated as follows:

FCFE = Net income + Amortizations + Depreciation – Capital expenditure –

change in non cash working capital + (new debts – debts repayments)

Terminal value:
The discrete forecast period ends when cash flows have stabilized and expected
growth is moderate and sustainable. In simple term, it a value of business at the end
of forecasted period. This value can be derived by using (1) stable growth method or
(2) multiple approach or (3) liquidation value. The multiple approaches is easiest but
it makes the valuation “relative valuation”. The stable growth model is technically
sound but it requires a judgment about the stable status of the business and
applicable stable growth rate that can sustain forever. The liquidation value is most
useful when assets are separable and marketable.

The estimation of terminal value is as challenging as the valuation of business NOW.

The only comfort here is that the business is assumed to be on steady phase.

1. Stable growth method

Gordon Model is very popular while estimating terminal value based on
earnings. It assumes continued ownership of business.

Key assumptions for the Gordon Model:

- Depreciation and capital expenditure should be equal or at a steady state
differential in the residual period
- Forecast period should be as long as necessary for a stable level of growth to
be achieved; the terminal period must assume a long term stable growth rate
(it may be negative or zero or positive)

Comments

39
- This formula represents the value of all cash flows remaining beyond the
end of the forecast period
- The model assumes a constant growth in cash flow.
- The rate must be sustainable into perpetuity
- The conclusion provided by the Gordon Model should be the same answer
as if continuing the cash flow model into infinity

Formula:
CASH FLOW IN THE FIRST YEAR OF THE TERMINAL PERIOD

(DISCOUNT RATE - LONG TERM GROWTH RATE)

The stable growth rate should not exceed the growth rate of economy but can
be set at ant lower figure. It can be negative but in such case, the terminal
value will be lower and the business is assumed to be disappearing over
time.

Growth rate:
The growth rate used in the model has to be less than or equal to the
expected nominal growth rate in the economy in which the firm operates.
The assumption that a firm is in steady state also implies that it possesses
other characteristics shared by stable firms. This would mean, for instance,
that capital expenditures, relative to depreciation, are not disproportionately
large and the firm is of 'average' risk.

We must take care that discounting earnings as if they were cash flows paid
out to stockholders while also counting the growth that is created by
reinvesting those earnings will lead to the systematic overvaluation of stocks.

Historical growth rate is generally estimated based on arithmetic average or

geometric average or regression models.

Formula for compounding growth or geometric average of growth

Current year EPS (OR earnings OR cash flow) 1/ No. of gap years -1

Based year EPS (OR earnings OR cash flow) -1

For example:
Years EPS growth rate
2000 0.94 -
2001 1.10 17.02
2002 1.24 12.73
2003 1.36 09.68
2004 1.26 -07.35
2005 1.38 09.52

Arithmetic mean = sum of growth rates / no. of years

40
 = (17.02+12.73+09.68+(-07.35)+09.52)/5
= 8.32

Geometric mean
= (1.38/.094)^(1/5) -1
= 7.98

2. Multiple approaches - is based on a multiple of a measure of financial

performance applied at the end of the forecast period. For example, if it is
decided to use multiple of 7 with EBITDA of first year of terminal period
then the terminal value of business will be 7 * EBITDA t 1.
This approach is discussed in detail under market approach.

3. Liquidation value: The terminal value of business is derived by estimating

the value of individual assets at the end of the forecasting period.

2) Determining the Discounting rate:

For finding the value of firm the most popular and widely used rate is Weighted
Average Cost of Capital (WACC) rate. And for determining the value of equity, the
rate normally used is rate of return expected by equity holders. In both the cases, the
appraiser is required to determine a cost of equity first.

Weighted Average Cost of Capital (WACC)

The value of the firm is obtained by discounting expected cash-flows to the firm, i.e.,
the residual cash-flows after meeting all operating expenses and taxes, but prior to
debt payments, at the weighted average cost of capital, which is the cost of the
different components of financing used by the firm, weighted by their market value
proportions.

The WACC is based on:

- The cost of equity and debt for the industry or firm, and
- The proportion of the firm’s capital structure comprised of equity and debt

WACC = Ke (% equity) + Kd (% debt)

Where:
Ke = required rate of return on equity capital
% equity = equity as a percent of total capitalization
Kd = after tax required rate of return on debt capital
% debt = debt as a percent of total capitalization

In general WACC is an appropriate valuation framework as long as the debt ratio is

expected to be constant.

Cost of Debt

41
The cost of debt is usually the rate of interest at which the loan and other debts are
aerated by the organization.

Kd = D (1 - t)

Where:
Kd = after tax required rate of return on debt capital
D = debt holders’ required return on debt
t = corporate marginal tax rate

Determination of Cost of capital

In order to find the cost of equity (Ke), Capital Assets Pricing Model (CAPM) is
commonly used technique.

Under CAPM,
Ke = Rf + β (Rm – Rf)

Where:
Ke = the investor’s required rate of return (equity)
Rf = the risk free rate
β = beta
Rm = return from the equity market
Rm - Rf = the market premium

In addition to these variables, there are adjustments to consider in applying this

method to closely held companies or MSME businesses:

- Small company risk

Studies have shown there is a small company premium because CAPM under
estimates the return earned by investors in small companies.

- Specific company risk

In some cases the company being valued will have specific risks that justify an
additional risk premium.

So, CAPM equation including adjustments will be

Ke = RF + β (RF - RM) + S1+ S2

Where:
S1 = size premium = size premium
S2 = specific company (business) risk

Components of CAPM
Rf is the risk free rate, either nominal or real. It is typically the yield from
long-term government bonds. It represents an alternative rate of return to the
investor that is risk free and has liquidity

42
Beta (β) is a risk measure that is based on the volatility of the price of the
shares of a company compared to the volatility of the market as a whole
- A company whose share price is volatile has more risk for an investor.
Thus, the higher the beta, the higher the risk
- Betas are typically calculated for an industry to provide a measure of
risk for that particular industry
Rm, the return from the equity market, is based on historical returns over a
long period
Rm --Rf (the market premium) is the amount by which the historical equity
returns from the market have exceeded the risk free rate

Risk : The Risk can be divided in to two parts: Market risk (systematic/ non
diversifiable risk) and firm specific risk (diversifiable / unsystematic risk).
Market risk can be broken down further into business risk and financial risk.
Business risk is the risk associated with the particular activities undertaken
by the enterprise whereas the financial risk is the risk resulting from the
existence of debt in the capital structure of the enterprise. The measure to
quantify the market risk is known as beta (β). Beta measures non-
diversifiable risk. It shows how the price of a security responds to market
forces. Effectively, the more responsive the price of a security is to changes in
the market, the higher shall be its beta. In case of non-public companies
where the shares are not trading on open market, many times accounting
beta, fundamental beta or bottom-up beta are used to determine the cost of
equity. Being this a study on valuation of MSME concerns, I am not going
into analyzing beta.

In MSMEs where the prices are not listed on any stock exchange, the
discounting rate is generally considered based on the specific company
(business) risk and expected rate of return by the owner or equity holders. In
order to measure a fair value, expected rate of return is considered based on
average rate of return in the industry in which the business unit pertains.

However, there is no empirical data or observable data regarding the specific

company (business) risk premium to assist the appraiser in analyzing the
appropriate increment to the discount rate to account for firm-specific risk. In
“Valuing a Business: The Analysis and Appraisal of Closely Held
Companies, fourth edition, Shannon Paratt, Robert Reilly, and Robert
Schweihs state the following with respect to the investment specific risk:
“ …the unsystematic risk specific to the subject business or businesses interest still
remains largely a matter of the analyst’s judgment, without a commonly accepted set
of empirical support evidence. The analyst will base this judgment on factors…such
as financial statements and comparative ratio analysis and the qualitative matters to
be considered during the site visit and management interviews. However, after
carefully analyzing these elements of investment specific risk, there is no specific
model for quantifying the exact effect of these factors of the discount rate. The analyst
must depend on experience and judgment in this final element of the discount rate
development, but should explicitly describe the factors that impact this final
element.”

43
 It should be apparent that the lack of any guidelines to estimate the specific
business risk presents significant challenges to the appraiser in conducting
the valuation. Though an appraiser may have performed hundreds of
valuation, the specific business risk premium for one company (in textile
industry for example) is not necessarily representative of the appropriate
specific business risk premium applicable to another firm (auto part
manufacturing company for example). Therefore, the estimation of specific
business risk is nothing more than the appraiser’s educated, best guess of an
appropriate premium. Therefore, there is a need for a quantifiable analysis
for the specific business risk premium to further strengthen the business
valuations and to limit the appraiser’s exposure to attacks on credibility and
results.

The assumptions and validity of CAPM have been questioned and there are doubts
on the predictive power of the CAPM Beta which is a key input for determination of
the WACC in a DCF. Models such as Arbitrage Pricing Theory (APT) and Fama-
French Three Factor Model (TFM) are examples of the alternatives which have been
developed. The CAPM, however, has retained its appeal and continues to be widely
used by practitioners for among other reasons its simplicity.

Academics, finance experts and professionals agree that the DCF based valuation
methodology is theoretically robust. In practice, however, as is common with most
valuations methodologies, DCF valuations are highly sensitive to the assumptions
which underlie them. Specifically this is due to the inevitable uncertainties around:

• the achievability of the projections

• determining, in particular, the estimated equity return within the Weighted
Average Cost of Capital (WACC)
• the calculation of terminal values and growth assumptions.

However, the advantages of a DCF valuation are that it requires the appraiser to
appraise the business’ operations and future cash flows in some detail,
understanding the risks and sensitivities within them. When accounting information
is incomplete or not reliable or impossible to interpret, DCF may be the only way to
reach realistic valuation. Sensitivity test, if conducted, can help to know the
significance of change in discounting rate (or capitalization rate) on overall value of
the business. The uncertainly can be reduced by applying some advanced techniques
including The First Chicago method, Expected Cash flow method (Certainty
equivalent cash flow), Probabilities cash flows Method and Monte Carlo simulations
which improve on the single point estimates generated by the classic DCF method.
This method is used by many acquirers, who will test the value acquired in
comparison to the price paid, against corporate targets for minimum returns on
investment. While this method may be applied to businesses going through a period
of great change, such as a turn around, strategic repositioning, loss making, rescue
refinancing, or is in its start up phase, there is a significant risk in utilizing this
method because of inherent difficulty for estimating the fundaments required for

44
this method. The disadvantages of the DCF centre around the “Estimates”. It
requires estimation of cash flows, risk-adjusted discount rate and also that of
terminal value. All of these inputs require substantial subjective judgments to be
made and the derived present value amount is often sensitive to small changes in
these inputs. So, using discounted cash flow models is in some sense an act of faith.

Views of Prof. Aswath damodaran for choosing an appropriate technique under

Income approach of valuation, is produced below:

45
 Choosing the right Discounted Cashflow Model

Can you estimate cash flows? Are the current earnings What rate is the firm growing
positive & normal? at currently?
Yes No Yes No < Growth rate > Growth rate of
of economy economy

Use current Is the cause

Is leverage stable or Use dividend earnings as temporary? Stable growth Are the firm’s
likely to change over discount model base model competitive
time? advantges time
limited?
Yes No

Stable Unstable
leverage leverage Replace current Is the firm Yes No
earnings with likely to
normalized survive?
earnings 3-stage or
FCFE FCFF 2-stage n-stage
model model
Yes No

Adjust Does the firm

margins over have a lot of
time to nurse debt?
firm to financial
health

No
Yes

Value Equity Estimate 46

as an option liquidation
to liquidate value
Adjusted Present Value:

Many experts believe that the estimate value of business determined from using
discounted cash flow method is not free from the limitations of using WACC as a
discounting rate. It is rare that the debt equity ratio in the business remains constant.
The better way is to find the value of firm ignoring the debt in capital and to add the
tax benefit proposed on debt creation.

In the adjusted present value (APV) approach, we separate the effects on value of debt
financing from the value of the assets of a business. In contrast to the conventional
approach, where the effects of debt financing are captured in the discount rate, the
APV approach attempts to estimate the expected value of debt benefits and costs
separately from the value of the operating assets. In general, using debt to fund a
firm’s operations creates tax benefits (because interest expenses are tax deductible)
on the plus side and increases bankruptcy risk (and expected bankruptcy costs) on
the minus side.

In the adjusted present value approach, we estimate the value of the firm in three
steps. We begin by estimating the value of the firm with no leverage. We then
consider the present value of the interest tax savings generated by borrowing a
given amount of money. Finally, we evaluate the effect of borrowing the amount on
the probability that the firm will go bankrupt, and the expected cost of bankruptcy.

The value of the firm can also be written as the sum of the value of the un-levered
firm and the effects (good and bad) of debt.

Firm Value = Un-levered Firm Value + PV of tax benefits

of debt - Expected Bankruptcy Cost

In practice, normally bankruptcy cost is not considered while determining value as

per this method. And so, the formula for calculating APV is,

V = EBIT (1 – t) / (Ke – g) + DT
Where,
EBIT (1 - t) = earnings before Interest but after tax
Ke = Cost of Equity
DT = tax savings on debts
g = growth rate

APV has generally applicability in transactions that involve a structured financing,

like leveraged buyouts (LBOs), project financing and real estate financing.

47
As written by Prof. Pablo Fernández, APV, WACC and FLOWS TO EQUITY
APPROACHES to firm Valuation, all these three methods of valuation (if used
correctly) always yield the same result.

Franco Modigliani and Merton Miller in their seminal work on the theory of capital
structure propagated the idea that the enterprise value is independent of its capital
structure.

In a article “Cost of Capital, Optimal capital Structure, and value of Firm: An

Empirical Study of Indian Companies”, the researcher Shri Raj S Dhankar and Shri
Ajit S Boora, came on the conclusion that there is no significant relationship between
change in capital structure and the value of a firm, at the micro level. This is because
of the fact that the value of a firm is affected by a multiplicity of factors and capital
structure is just one of them.

Economic Value Added – EVA

(also known as an Excess Earnings Model or Residual Income Model)

The economic value added (EVA) is a measure of the surplus value created by an
investment. It is computed as the product of the "excess return" made on an
investment and the capital invested in that investment.

Economic value added = NOPAT – (Cost of capital) * (Capital

invested)
NAPAT = Net Operating Profit After Tax or operating profit minus the taxes that
would be payable without any deduction for interest expenses.

In the excess return valuation approach, we separate the cash flows into excess
return cash flows and normal return cash flows. Earning the risk-adjusted required
return (cost of capital or equity) is considered a normal return cash flow but any
cash flows above or below this number are categorized as excess returns; excess
returns can therefore be either positive or negative. With the excess return valuation
framework, the value of a business can be written as the sum of two components:

Value of business = Capital Invested in firm today + Present

value of excess return cash flows from both existing and future
projects
In pure terms,
Firm Value = Value of Assets in Place + Value of Expected
Future Growth

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This approach is widely used for appraising MSME business because of ease in
calculation and simplicity in understanding. Any of the two basic approaches of
income approach, single period capitalization model and multi period income
discounting model, can be used to determine a business value using this technique.
Using the single period capitalization method we can determine the EVA first and
then the estimated value of business. While applying multi period income
discounting model (DCF), we first come to know the value of business and then after
deducting capital investments we can determine an addition earnings.

Steps for business valuation, using single period capitalization method with Excess
Earning Technique:

1) Prepare the Balance sheet as per fair value principles

2) Separate the value of surplus assets or non-operating assets
3) Determine the value of fixed assets and working capital (investment value)
4) Determine the applicable rate of finance (normally bank financing /loan rate)
5) Find out the fair earnings (based on weighted average / current, whichever
is appropriate)
6) Calculate excess earnings:
Fair earnings (as per 5 above)
Less: normal return on investment (3 * 4)
7) Decide multiple to determine value of excess earnings
8) Calculate value of intangible / excess earnings (6 * 7)
9) Value of business: (8 + 3)
10) Current value of business : ( 8 + 3 + 2)

Operating assets
Operating assets are assets which are used in the operation of the business including
working capital, property, plant and equipment and intangible assets. The value of
operating assets is generally reflected in the cash flow generated by the business

Non operating assets

Non operating assets are assets which are not used in the operations including
excess cash balances, and assets held for investment purposes, such as vacant land
and securities. Non operating assets are generally valued separately and added to
the value of the operations.

This method is very popular in valuing MSME businesses but care must be taken to
choose the multiple. The resultant value can be cross checked for reasonability
through deriving rate of return as if single period capitalization method is applied.

49
 Certainty Equivalent Cash-Flow
Vs.
Risk Adjusted Rate Of Return

While most analysts adjust the discount rate for risk in DCF valuation, there are
some who prefer to adjust the expected cash flows for risk.

There are some who consider the cash flows of an asset under a variety of scenarios,
ranging from best case to catastrophic, assign probabilities to each one, take an
expected value of the cash flows and consider it risk adjusted. While it is true that
bad outcomes have been weighted in to arrive at this cash flow, it is still an expected
cash flow and is not risk adjusted. To see why, assume that you were given a choice
between two alternatives. In the first one, you are offered Rs. 95 with certainty and
in the second, you will receive Rs.100 with probability 90% and only Rs. 50 the rest
of the time. The expected value of both alternatives is Rs. 95 but risk-averse investors
would pick the first investment with guaranteed cash flows over the second one.

Certainty cash flow = Expected cash flow / (1+ Risk premium

in Risk adjusted discount rate)
Adjusting the discount rate for risk or replacing uncertain expected cash flows with
certainty equivalents are alternative approaches to adjusting for risk, but do they
yield different values, and if so, which one is more precise?

After all, adjusting the cash flow, using the certainty equivalent, and then
discounting the cash flow at the risk free rate is equivalent to discounting the cash
flow at a risk adjusted discount rate. (The proposition that risk adjusted discount rates
and certainty equivalents yield identical net present values is shown in the following paper:
Stapleton, R.C., 1971, Portfolio Analysis, Stock Valuation and Capital Budgeting Decision
Rules for Risky Projects, Journal of Finance, v26, 95-117).

FAS 157 provides a very good example to show the relation between Certainty
equivalent cash-flow and Risk adjusted rate of return while determining the value
using discounted cash flow technique.

In making an investment decision, risk-averse market participants would consider the risk
inherent in the expected cash flows. Portfolio theory distinguishes between two types of risk.
The first is risk specific to a particular asset or liability, also referred to as unsystematic
(diversifiable) risk. The second is general market risk, also referred to as systematic (non-
diversifiable) risk. The systematic or non-diversifiable risk of an asset (or liability) refers to
the amount by which the asset (or liability) increases the variance of a diversified portfolio
when it is added to that portfolio. Portfolio theory holds that in a market in equilibrium,
market participants will be compensated only for bearing the systematic or non-diversifiable
risk inherent in the cash flows. (In markets that are inefficient or out of equilibrium, other
forms of return or compensation might be available.)

50
Certainty equivalent cash-flow (Method 1) : of the expected present value technique
adjusts the expected cash flows for the systematic (market) risk by subtracting a cash risk
premium (risk-adjusted expected cash flows). These risk-adjusted expected cash flows
represent a certainty-equivalent cash flow, which is discounted at a risk-free interest rate. A
certainty-equivalent cash flow refers to an expected cash flow (as defined), adjusted for risk
such that one is indifferent to trading a certain cash flow for an expected cash flow. For
example, if one were willing to trade an expected cash flow of $1,200 for a certain cash flow of
$1,000, the $1,000 is the certainty equivalent of the $1,200 (the $200 would represent the
cash risk premium). In that case, one would be indifferent as to the asset held.

Risk adjusted rate of return (Method 2) : of the expected present value technique adjusts
for systematic (market) risk by adding a risk premium to the risk-free interest rate.
Accordingly, the expected cash flows are discounted at a rate that corresponds to an expected
rate associated with probability-weighted cash flows (expected rate of return). Models used
for pricing risky assets, such as the Capital Asset Pricing Model, can be used to estimate the
expected rate of return. Because the discount rate used in the discount rate adjustment
technique is a rate of return relating to conditional cash flows, it likely will be higher than the
discount rate used in Method 1 of the expected present value technique, which is an expected
rate of return relating to expected or probability-weighted cash flows.

To illustrate Methods 1 and 2, assume that an asset has expected cash flows of $780 in 1 year
based on the possible cash flows and probabilities shown below. The applicable risk-free
interest rate for cash flows with a 1-year horizon is 5 percent, and the systematic risk
premium is 3 percent.

In this simple illustration, the expected cash flows ($780) represent the probability-weighted
average of the 3 possible outcomes. In more realistic situations, there could be many possible
outcomes. However, it is not always necessary to consider distributions of literally all
possible cash flows using complex models and techniques to apply the expected present value
technique. Rather, it should be possible to develop a limited number of discrete scenarios and
probabilities that capture the array of possible cash flows. For example, a reporting entity
might use realized cash flows for some relevant past period, adjusted for changes in
circumstances occurring subsequently (for example, changes in external factors, including
economic or market conditions, industry trends, and competition as well as changes in
internal factors impacting the entity more specifically), considering the assumptions of
market participants.

In theory, the present value (fair value) of the asset's cash flows is the same ($722) whether
determined under Method 1 or Method 2, as indicated below. Specifically:

51
 a. Under Method 1, the expected cash flows are adjusted for systematic (market) risk.
In the absence of market data directly indicating the amount of the risk adjustment,
such adjustment could be derived from an asset pricing model using the concept of
certainty equivalents. For example, the risk adjustment (cash risk premium of $22)
could be determined based on the systematic risk premium of 3 percent ($780 – [$780
(1.05/1.08)]), which results in risk-adjusted expected cash flows of $758 ($780 – $22).
The $758 is the certainty equivalent of $780 and is discounted at the risk-free interest
rate (5 percent). The present value (fair value) of the asset is $722 ($758/1.05).

b. Under Method 2, the expected cash flows are not adjusted for systematic (market)
risk. Rather, the adjustment for that risk is included in the discount rate. Thus, the
expected cash flows are discounted at an expected rate of return of 8 percent (the 5
percent risk free interest rate plus the 3 percent systematic risk premium). The present
value (fair value) of the asset is $722 ($780/1.08).

When using an expected present value technique to measure fair value, either Method 1 or
Method 2 could be used. The selection of Method 1 or Method 2 will depend on facts and
circumstances specific to the asset or liability being measured, the extent to which sufficient
data are available, and the judgments applied.

52
3. THE MARKET APPROACH
(RELATIVE VALUATION APPROACH)

Market value is also known as extrinsic value. The basis of market value is the
assumption that if comparable Asset (or property) has fetched a certain price, then
the subject asset (or property) will realize a price something near to it. The market,
says Mr. Johnson in Adam smith's The Money Game, is like a beautiful woman-
endlessly fascinating endlessly complex, always changing always mystifying.

There is a significant philosophical difference between discounted cash flow and

relative valuation. In discounted cash flow valuation, we are attempting to estimate
the intrinsic value of an asset based upon its capacity to generate cash flows in the
future. In relative valuation, we are making a judgment on how much an asset is
worth by looking at what the market is paying for similar assets. If the market is
correct, on average, in the way it prices assets, discounted cash flow and relative
valuations may converge. If, however, the market is systematically over pricing or
under pricing a group of assets or an entire sector, discounted cash flow valuations
can deviate from relative valuations.

In relative valuation, we have given up on estimating intrinsic value and essentially

put our trust in markets getting it right, at least on average. It can be argued that
most valuations are relative valuations. Damodaran (2002) notes that almost 90% of
equity research valuations and 50% of acquisition valuations use some combination
of multiples and comparable companies and are thus relative valuations.

Before going long to consider “Market approach”, let we first go through the past
studies and beliefs of the economist and financial analyst about the correctness of
and dependency on Market prices.

The efficient market hypothesis (EMH) was widely accepted by academic financial
economists, a generation ago. It was generally believed that securities markets were
extremely efficient in reflecting information about individual stocks and about the
stock market as a whole. The accepted view was that when information arises, the
news spreads very quickly and is incorporated into the prices of securities without
delay. Thus, neither technical analysis, which is the study of past stock prices in an
attempt to predict future prices, nor even fundamental analysis, which is the
analysis of financial information such as company earnings and asset values to help
investors select “undervalued” stocks, would enable an investor to achieve returns
greater than those that could be obtained by holding a randomly selected portfolio
of individual stocks, at least not with comparable risk. The efficient market
hypothesis is associated with the idea of a “random walk,” which is a term loosely
used in the finance literature to characterize a price series where all subsequent price
changes represent random departures from previous prices. The prices that move in
“random walk” can not be predicted. The probability of prices moving either up or
down is equal. The logic of the random walk idea is that if the flow of information is
unimpeded and information is immediately reflected in stock prices, then
tomorrow’s price change will reflect only tomorrow’s news and will be independent

53
of the price changes today. But news is by definition unpredictable, and, thus,
resulting price changes must be unpredictable and random. As a result, prices fully
reflect all known information.

Prof. Burton Malkiel uses definition of efficient financial markets that such markets
do not allow investors to earn above-average returns without accepting above-
average risks. He believes that “the markets can be efficient even if many market
participants are quite irrational. Markets can be efficient even if stock prices exhibit greater
volatility than can apparently be explained by fundamentals such as earnings and
dividends.” Further to his believes he adds that “Many of us economists who believe in
efficiency do so because we view markets as amazingly successful devices for reflecting new
information rapidly and, for the most part, accurately. Above all, we believe that financial
markets are efficient because they don’t allow investors to earn above-average risk adjusted
returns.”

Efficient market theory submits that in an efficient market all investors receive
information instantly and that it is understood and analyzed by all the market
players and is immediately reflected in the market prices. The market price,
therefore, at every point in time represents the latest position at all times. The
efficient market theory submits it is not possible to make profits looking at old data
or by studying the patterns of previous price changes. It assumes that all foreseeable
events have already been built into the current market price.

The market values are very sensitive and changes with each new information. This
information also contains the rumors and wrong beliefs of investors and market
players. Therefore, it influences by irrelevant facts and information as well as by
personal thoughts and interpretation of information by market players.

On the other hand, many financial economists and statisticians believe that stock
prices are at least partially predictable. They emphasized psychological and
behavioral elements of stock-price determination, and they came to believe that
future stock prices are somewhat predictable on the basis of past stock price patterns
as well as certain “fundamental” valuation metrics.

Formal statistical tests of the ability of dividend yields (that is, the ratio of dividend
to stock price) to forecast future returns have been conducted by Fama and French
(1988) and Campbell and Shiller (1988). Depending on the forecast horizon involved,
as much as 40 percent of the variance of future returns for the stock market as a
whole can be predicted on the basis of the initial dividend yield of the market index.
Campbell and Shiller (1998) report that initial P/E ratios explained as much as 40
percent of the variance of future returns. They conclude that equity returns have
been predictable in the past to a considerable extent. Fama and French (1993)
concluded that size and price-to-book-value together provide considerable
explanatory power for future returns, and once they are accounted for, little
additional influence can be attributed to P/E multiples. Fama and French suggest
that size may be a far better proxy for risk than beta. But as we know, the
dependability of the size phenomenon is also open to question. Fama and French
(1997) also conclude that the P/BV effect is important in many world stock markets
other than the United States.

54
Under FAS 157, the Board concluded that quoted market prices provide the most
reliable measure of fair value. Quoted market prices are easy to obtain and are
reliable and verifiable. Those are used and relied upon regularly and are well
understood by investors, creditors, and other users of financial information.

Valuation Techniques
There are two primary sources or methods that can be applied to determine a value
based on market transactions or market behavior.

Merger and Acquisition Method (Comparable Sales or completed transaction) –

This method involves reviewing transactions for companies that are in the same or
similar line of business as the company being valued and then applying the relevant
pricing multiples to the subject company to determine its value. The method might
involve private company transactions, public company transactions, as well as
public company valuation measures using current share market data. The theory
behind this approach is that valuation measures of similar companies that have been
sold in arms-length transactions should represent a good proxy for the specific
company being valued. Depending on the source of data available and the
underlying company being valued, a variety of valuation measures might be used
including Enterprise Value (EV) to Sales, EV to EBITDA, EV to EBIT, Price to
Earnings, etc. Adjustments are commonly made to these valuation measures before
applying to the subject company to ensure an “apples-to-apples” comparison. One
or many comparable sales might be considered under this method depending on the
data available and the degree of similarity to the company being valued.

Guideline Public Company Method – The premise of the guideline company

method is based on the economic principle of substitution stating that one will not
pay more for an asset than the amount at which they can acquire an equally
desirable substitute. This method involves using market multiples derived from
market prices of stocks for companies that are engaged in the same or similar
industries as the subject company. This can be a helpful tool in valuing private
companies, but these public company multiples usually need to be discounted
significantly to reflect the higher risks (e.g., customer concentration, management
depth, access to financing, etc.) inherent in smaller private companies as well as the
“lack of marketability” of private company stock.

The guideline publicly traded company method is appropriate when similar and
relevant proxy companies may be identified and employed in estimating the value
of a closely held company.

Commonly used Multiples

Business can be valued based on the multiples like
- Earning multiples- (PAT, EBITDA, EBIT etc)
- Book value (or replacement value) multiple
- Revenue Multiples
- Business specific Multiple

55
Price to Earnings (P/E) Multiple
When it comes to valuing equity or ownership, the price/earnings ratio is one of the
oldest and most frequently used metrics. Although a simple indicator to calculate,
the P/E is actually quite difficult to interpret. It can be extremely informative in
some situations, while at other times it is next to meaningless. As a result, appraisers
often misuse this term and place more value in the P/E than is warranted.
P/E Ratio = Market Value (OR Price) / Earnings
It may be based on trailing data (historical figure) or forward data (estimates) or
average of both. The result will be different under each different choice.

Unlike net income, Both EBIT and EBITDA are independent of capital structure, so
differences in capital structure among companies should not introduce bias when
one is using the EBIT and EBITDA multiples to estimate total enterprise values. In
other words, the appraiser should take care that the earnings used here to derive a
multiple is proper in relation to price applied. For example, share price used with
earnings per share is a right measure but if it is used with rate of return on capital
then the measure is not correct one. Rate of return on capital can be applied with
value of firm or business value.

Price to Book value (OR replacement value) multiple

This is also a widely used multiple to compare the equity value of the value of firm.
The market capitalization is divided by the book value of capital to determine a
multiple. The accounting estimate of book value is determined by accounting rules
and is heavily influenced by the original price paid for assets and any accounting
adjustments (such as depreciation) made since. Proposed buyer often look at the
relationship between the price they pay for a business and the book value of equity
(or net worth) as a measure of how over- or undervalued a business or assets are;
The book figure being accounted on historical basis is easy to compare.

P/BV Ratio = Market Value / Book Value of Capital or Owners’ fund

Sometimes, in order to give effect of current value of assets of the business, the
balance sheet is redrafted with adjusted values and then the adjusted book value so
arrived is used with market capitalization to derive a P/BV multiple.

Price to Revenue multiple

Both earnings and book value are accounting measures and are determined by
accounting rules and principles. An alternative approach, which is far less affected
by accounting choices, is to use the ratio of the value of a business to the revenues it
generates. The advantage of using revenue multiples, however, is that it becomes far
easier to compare firms in different markets, with different accounting systems at
work, than it is to compare earnings or book value multiples.
P/R Ratio = Market Value / Revenue
Business Specific Multiple

56
While earnings, book value and revenue multiples are multiples that can be
computed for firms in any sector and across the entire market, there are some
multiples that are specific to a sector. Like, valuing a call centre based on per seat
criteria or a steel manufacturing business on the basis of per ton production. The
caution here requires is to take care in analyzing the behavior of the entire sector or
industry. If the price of particular sector is over valued then based on specific
multiple we also tend to over cast the estimated value of target firm.

Steps to determine a value under market approach

1. Selection of similar public companies and transactions
2. Financial analysis and comparison
3. Selection and calculation of valuation multiples
4. Application to the company being valued
5. Final adjustments

Multiples are easy to use and intuitive; they are also easy to misuse. So, the question
is - why is relative valuation so widely used? There are several reasons. For example,
a valuation based upon a multiple and comparable firms can be completed with far
fewer assumptions and far more quickly than a discounted cash flow valuation. A
relative valuation is simpler to understand and easier to present to clients and
customers than a discounted cash flow valuation. Also, a relative valuation is much
more likely to reflect the current mood of the market, since it is an attempt to
measure relative and not intrinsic value. The strengths of relative valuation are also
its weaknesses. For example, the fact that multiples reflect the market mood also
implies that using relative valuation to estimate the value of an asset can result in
values that are too high, when the market is over valuing comparable firms, or too
low, when it is under valuing these firms. Also, while there is scope for bias in any
type of valuation, the lack of transparency regarding the underlying assumptions in
relative valuations makes them particularly vulnerable to manipulation.

While using Relative approach for valuing a business, one must keep following in
mind: When discussing a valuation based upon a multiple is to ensure that everyone
in the discussion is using the same definition for that multiple. Like forward P/E
must not be compared with trailing P/E. One of the key tests to run on a multiple is
to examine whether the numerator and denominator are defined consistently. If the
numerator for a multiple is an equity value, then the denominator should be an
equity value as well. If the numerator is a firm value, then the denominator should
be a firm value as well. To illustrate, while using P/E multiple the price per share
will be used with earnings per share while EBITDA multiple is be used to value a
firm since the numerator and denominator are both firm value measures.

When using a multiple, it is always useful to have a sense of what a high value, a
low value or a typical value for that multiple is in the market. In other words,
knowing the distributional characteristics of a multiple is a key part of using that
multiple to identify under or over valued firms.

The question comes here is : What is then a comparable firm? A comparable firm is
one with cash flows, growth potential, and risk similar to the firm being valued. It

57
would be ideal if we could value a firm by looking at how an exactly identical firm -
in terms of risk, growth and cash flows - is priced. Nowhere in this definition is there
a component that relates to the industry or sector to which a firm belongs. Thus, a
telecommunications firm can be compared to a software firm, if the two are identical
in terms of cash flows, growth and risk.

Traditional analysis is built on the premise that firms in the same sector are
comparable firms. In most analyses, analysts define comparable firms to be other
firms in the firm’s business or businesses. The implicit assumption being made here
is that firms in the same sector have similar risk, growth, and cash flow profiles and
therefore can be compared with much more legitimacy. However in reality, it is also
difficult to define firms in the same sector as comparable firms if differences in risk,
growth and cash flow profiles across firms within a sector are large. Boatman and
Baskin (1981) compare the precision of PE ratio estimates that emerge from using a
random sample from within the same sector and a narrower set of firms with the
most similar 10-year average growth rate in earnings and conclude that the latter
yields better estimates.

So, we can summarize based on valuation theory that a comparable firm is one
which is similar to the one being analyzed in terms of fundamentals. There is no
reason why a firm cannot be compared with another firm in a very different
business, if the two firms have the same risk, growth and cash flow
characteristics.

In discounted cash flow valuation, the value of a firm is a function of three variables
– its capacity to generate cash flows, the expected growth in these cash flows and the
uncertainty associated with these cash flows. Every multiple, whether it is of
earnings, revenues or book value, is a function of the same three variables – risk,
growth and cash flow generating potential. Intuitively, then, firms with higher
growth rates, less risk and greater cash flow generating potential should trade at
higher multiples than firms with lower growth, higher risk and less cash flow
potential.

A major disadvantage of this valuation method is that often, it is difficult to

determine “the right comparable”. Multiples are sensitive to the following
qualitative factors when comparing similar companies or businesses:

Operations Financial Aspects

– Relative competitive position – Size
– Industry – Leverage
– Products – Margins & Profitability
– Markets – Growth prospects
– Distribution channels – Shareholder base
– Customer base – Market conditions
– Seasonality – Consideration paid
– Surrounding circumstances

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In order to normalize the comparison, it is important that the earnings multiple of
each comparator is adjusted for points of difference between the comparator and the
company being valued. The value of business may be reduced if it:
- is smaller and less diverse than the comparator(s) and therefore, less able generally
to withstand adverse economic conditions
- is reliant on a small number of key employees
- is dependent on one product or one customer
- has high gearing or
- for any other reason has poor quality earnings.

It is impossible to find exactly identical firms to the one you are valuing and figuring
out how to control for the differences is a significant part of relative valuation. If, in
your judgment, the difference on the multiple cannot be explained by the
fundamentals, the firm will be viewed as over valued (if its multiple is higher than
the average) or undervalued (if its multiple is lower than the average).

No matter how carefully we construct our list of comparable firms, we will end up
with firms that are different from the firm we are valuing. The differences may be
small on some variables and large on others and we will have to control for these
differences in a relative valuation. These differences are generally controlled by
using subjective adjustments or using modified multiple or applying statistical
technique like sector regression or Marker regression.

Which Multiple is to use?

Going through various alternates available for choosing a multiple, the question now
is which multiple is to select? Or which is better than the others? Is it depends on
fundamentals or upon type of Industry or upon size or any other factor?

Erik Lie and Heidi J. Lie (2002) while evaluating the various multiples came on the
findings that the asset multiple (market value to book value of assets) generally
generates more precise and less biased estimates than do the sales and the earnings
multiple. Also, the earnings before interest, taxes, depreciation, and amortization
(EBITDA) multiple generally yields better estimates than does the EBIT multiple.
Finally, the accuracy and bias of value estimates, as well as the relative performance
of the multiples, vary greatly by company size, company profitability, and the extent
of intangible value in the company.

Damodaran (2002) notes that the usage of multiples varies widely across sectors,
with Enterprise Value/EBITDA multiples dominating valuations of heavy
infrastructure businesses (cable, telecomm) and price to book ratios common in
financial service company valuations. Fernandez (2001) presents evidence on the
relative popularity of different multiples at the research arm of one investment bank
– Morgan Stanley Europe – and notes that PE ratios and EV/EBITDA multiples are
the most frequently employed. Liu, Nissim and Thomas (2002) compare how well
different multiples do in pricing 19,879 firm-year observations between 1982 and
1999 and suggest that multiples of forecasted earnings per share do best in
explaining pricing differences, that multiples of sales and operating cash flows do

59
worst and that multiples of book value and EBITDA fall in the middle. Lie and Lie
(2002) examine 10 different multiples across 8,621 companies between 1998 and 1999
and arrive at similar conclusions.

Erik Lie and Heidi J. Lie (2002), upon their study of comparing the performance of
various multiples concludes that although practitioners and academic researchers
frequently use multiples to assess company values, there is no consensus as to which
multiple performs best. They result that using forecasted earnings rather than
trailing earnings improves the estimates of the P/E multiple.

This decision of choosing appropriate multiple is also dependent on the judgment of

the appraiser using best of his skills and experience considering all, including the
fundamentals, type of industry, size of company, nature of transaction and of course,
the purpose of valuation.

No one human can be predicted even to run the same company the same way
as another would.
Where, then, is comparability?
Comparable value is just an appraisal term,
Comparability evaluation of ‘‘hard’’ assets is a valuable determinant for business’s factory,
premises, raw material, and equipment and fixturing, but not for it’s ‘‘intangible’’ portions.

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WHICH APPROACH IS MORE CERTAIN OR LESS SUBJECTIVE?

Obviously, the asset approach can determine the current value of assets on stand
alone basis or sometimes even on collective basis and so less uncertain or better
estimation is possible. BUT this is good while adopting a liquidation premise. Is it a
best approach using going concern premise? The answer is exceptionally yes. The
“going concern” itself indicates value of intangible and valuing intangible on the
basis of cost incurred may not be a proper respect to its worth. It is difficult to
identify and separate the earnings derived from intangible assets. For doing so,
again the uncertainty and subjectivity enters into the field. Business being run with
profit motive, the concentrating point is obviously EARNINGS and therefore, it
becomes necessary to give reasonable weight age to earnings approach and market
approach.

The two approaches to valuation – discounted cash flow valuation and relative
valuation – will generally yield different estimates of value for the same firm at the
same point in time. It is even possible for one approach to generate the result that the
business is under valued while the other concludes that it is over valued.
Furthermore, even within relative valuation, we can arrive at different estimates of
value depending upon which multiple we use and what firms we based the relative
valuation on.

The differences in value between discounted cash flow valuation and relative
valuation come from different views of market efficiency, or put more precisely,
market inefficiency. In discounted cash flow valuation, we assume that markets
make mistakes, that they correct these mistakes over time, and that these mistakes
can often occur across entire sectors or even the entire market. In relative valuation,
we assume that while markets make mistakes on individual stocks, they are correct
on average.

As narrated by Aswath Damodaran “it was argued that relative valuations require fewer
assumptions than discounted cash flow valuations. While this is technically true, it is only so
on the surface. In reality, you make just as many assumptions when you do a relative
valuation as you make in a discounted cash flow valuation. The difference is that the
assumptions in a relative valuation are implicit and unstated, whereas those in discounted
cash flow valuation are explicit. The two primary questions that you need to answer before
using a multiple are: What are the fundamentals that determine at what multiple a firm
should trade? How do changes in the fundamentals affect the multiple?”

To conclude, we can say that irrespective of approach being used, the appraiser has
to apply his mind in choosing applicable premise of value, standard of value and
based on these selecting the techniques to apply so as to serve the purpose of
valuation.

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DETERMINATION OF CONCLUSIVE VALUE

We have gone through various approaches and some of the widely used techniques
amongst numerous techniques under each of these approaches. Each one has specific
importance with relative subjectivity and limitations. Some experts are favouring
discounted cash flow technique over others at the same time others are treating it as
prejudicial being consists of so many assumptions and so highly subjective.
According to them, value determination based on market approach is robust and
widely accepted. But again as we discussed earlier, though very popular and widely
used, it is also not free from subjectivity and implied set of assumptions. The
problem may become undemanding if the value arrived from different techniques
are adjacent. But mostly the fact reveals contrary. There may be wide gap between
the values determined using different approaches which quietly puts appraiser in
awkward situation. In such situations, the appraiser stands on a point to revalidate
his own assumptions and decisions.

Let we go through some views and guidelines helpful (?) for deriving a conclusion.

Which Technique to prefer to arrive at a conclusion?

To assume there is only one correct estimate of value is a mistake, and ‘‘right’’ is a
matter of opinion.

In most of the situations the shortcoming is not lack of sophistication of the

valuation model but it is our inherent limitation in forecasting the future. Though we
need to equip ourselves with contemporary methods and practices it may be wise to
constantly remind ourselves that valuation is essentially about trying to peek into
the future which is uncertain. It’s difficult to gauge valuation accuracy without
standards. Being realistic is perhaps a more appropriate objective.

When appraiser prefers more than one valuation technique, many times he thinks it
proper to arrive at the conclusive business value on the basis of weighing different
techniques as per his perceptions about the business and need of the valuation. This
approach method of giving appropriate weights to different technique is also a
debatable issue. Some experts believe that individual technique has its own unique
feature and business value, using that particular technique, is arrived at with
relevant assumptions and facts. It is rare that the value derived by using some other
technique will be fair if tested with the same assumptions. For example, P/E ratio
calculated on the basis of value derived by DCF method and that is derived by
adjusting the peer company’s or industry’s average will rarely shows same figure.
Giving different weight age to various approaches will dilute the effect of unique
considerations and subjective judgment of appraiser and therefore resultant figure
based on appropriate weight age to different techniques may not fit with appraiser’s
own BEST set of assumptions and considerations for particular technique. While the
other group of experts believes that though various techniques applied for valuation
show different values individually, more weight age to less subjective consideration
will help to derive the nearest value and also, dilute the limitations of individual

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technique by considering more aspects of business to arrive at a conclusive value.
For example, a value arrived on the basis of considering proper weight ages of
market value, DFC value and Net asset value will take care of existing position (net
asset), market perceptions (market value) and performance strength (DCF based
intrinsic value) of the business and therefore better than a value derived from any
one technique or approach.

The Supreme Court judgment in the Hindustan Lever Employees Union v

Hindustan Lever Limited and others (1995) 83 Comp Cases 30 has held that fair
value based on averaging the values arrived at by using a combination of valuation
methods is appropriate for arriving at relative values in determination of exchange
ratio. Net assets, yield and market price were the methods used by applying
appropriate weights for determination of the exchange ratio in that case.

CCI guidelines, 1990 (Para 8.1) prescribes “The fair value will be determined on the basis
of average of the net asset value and the reworked profit-earning capacity value. Thus, while
the market value will not be a direct “input” in valuation, it will be recognised and made use
of ……..”. So, it considers simple net asset value and earning capacity as a deciding
factor for determining a fair value. However, the guidelines read altogether are
criticized as a conservative approach and not practically preferred by experts.

Revenue Ruling 59-60 of Internal Revenue Service (IRS) at US, rejects a mathematical
weighting of approaches with the following language:

SEC. 7. AVERAGE OF FACTORS

Because valuations cannot be made on the basis of a prescribed formula, there is no means
whereby the various applicable factors in a particular case can be assigned mathematical
weights in deriving the fair market value. For this reason, no useful purpose is served by
taking an average of several factors (for example, book value, capitalized earnings and
capitalized dividends) and basing the valuation on the result. Such a process excludes active
consideration of other pertinent factors and the end result cannot be supported by a realistic
application of the significant facts in the case except by means of chance.

But when appraiser uses subjective weighting, one usually wants to know how much
weight is accorded to the various techniques. So, the appraisers usually apply
mathematical weights when giving weight to two or more approaches, with a
disclaimer that there is no empirical basis for assigning mathematical weights, and
that the weights are presented only to help clarifying the thought process of the
analyst. A good report will also go on to demonstrate that all relevant factors are
considered while deciding the weights.

“Statement on standards for valuation services” issued by the American Institute of

Certified Professional Accountants (AICPA) consulting services executive committee
also provides for consideration of more than one approach while deriving a
conclusion of value. Para 42 of the statement is produced below:

“Conclusion of Value
42. In arriving at a conclusion of value, the valuation analyst should:

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a. Correlate and reconcile the results obtained under the different approaches and methods
used.
b. Assess the reliability of the results under the different approaches and methods using the
information gathered during the valuation engagement.
c. Determine, based on items a and b, whether the conclusion of value should reflect (1) the
results of one valuation approach and method or (2) a combination of the results of more than
one valuation approach and method.”

IPEV guidelines (October, 2006) also permits usage of more than one technique to
arrive at the fair value of investment. It narrates that
”…..Where the valuer considers that several methodologies are appropriate to value a specific
investment, the valuer may consider the outcome of these different valuation methodologies
so that the results of one particular method may be used as a cross-check of values or to
corroborate or otherwise be used in conjunction with one or more other methodologies in
order to determine the Fair value of Investment”.

So, we can conclude that the conclusive value rests on COMMON SENSE AND
REASONABLENESS. The important factor in any valuation is that the method used
is relevant to your purpose of valuation, your type of business, providing a valid
and supportable value. This wide variety of methods available can be a confusing
array to choose from. There are plenty of pros and cons for each method. While there
is no such thing as absolute truth in business valuation, confidence in the eventual
number is based on the integrity of the underlying process. To assure that integrity,
many valuation professionals use more than one method, computing a weighted
average to arrive at their final number. While there are numerous valuation
methodologies that can be utilized to begin establishing value, not all methodologies
would be appropriate for all situations. Each methodology provides additional
clarity on valuation and evaluating results of numerous methods provides a better
understanding of a business’ true “worth”. A fair amount of experience, judgment
and corporate finance and equity markets skill is required in each case as even the
seemingly straightforward tools contain several hidden layers of complexity and
subtle ties.

‘‘ The theory of economics does not furnish a body of settled conclusions immediately
applicable to policy. It is a method rather than a doctrine, an apparatus of the mind, a
technique of thinking, which helps its possessor to draw correct conclusions.’’
John Maynard Keynes

Actual pricing of business (Buy sell transaction)

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Seller will try to maximize the value of the company by applying a forward-looking
valuation methodology - such as the Discounted Cash Flow Technique ("DCF"). It is
an opportunity cost of seller which he will loose upon selling the business. The DCF
accounts for the going-concern value of the company as indicated by the present
value of the company's projected cash flows for a determined maturity period of
from 3 to 5 years. As this valuation method pegs the company's value on the growth
of future markets - the valuation will generally be high based on the potential for the
targeted market.

Unlike the Seller, the Buyer will try to avoid pegging valuation on future markets or
on the Seller's plans. Rather, the Buyer will minimize value by looking at the
maturity of Seller, the risks inherent in operating the Seller's business, and the
additional investment the Buyer will have to make in company in order to tap the
targeted market. Essentially, the Buyer will tell the Seller what he or she is willing to
pay - based on its subjective view of the attractiveness of the asset or business or
company, and what it thinks other competitors might pay if they were also to pursue
the Seller.

This does not mean that the Seller should not value its business on DCF. Instead, the
Seller should base its price on DCF - and question the Buyer on its assumptions in
setting its price. This might have the effect of raising the price, if the Seller can
objectively argue value that the Buyer can verify to its satisfaction. The seller may
want to increase the total transaction price by proposing that separate consideration
be paid for other items of value to the Buyer, such as lock-ups, non-competition,
non-employment, employment and consulting fees, break up fees etc. But these will
be in addition to the value of “business” proposed for sale.

Not all appraisers will agree, but some do so without knowing they do, that the
small-company appraisal process begins with evaluating human behavior through the
antics of their buyers and sellers. Not nearly true for publicly held business
evaluations. This represents the first of many issues that the business appraiser must
resolve during the process of estimating closely held business value.

Prospect Theory is an important contribution to the psychological aspect of risk and decision-
taking. Developed by psychologists Daniel Kahneman and Amos Tversky, Prospect Theory
examines the ways that people are affected by their emotions and also make intellectual errors
when making choices. Much depends on how the problem is depicted. For example, lung
cancer patients at a certain hospital had a shorter life expectancy if they received radiation
therapy than if they opted for surgery, but a few patients died on the operating table. The
overall difference in life expectancy was not great and it was difficult to choose which therapy
to accept. When patients were presented with the options in terms of the risk of death under
surgery, nearly half opted for radiation therapy. Patients who were given the same choice
expressed in terms of life expectancy, only a fifth chose radiation therapy. No facts were
hidden: they were simply presented in a different light.

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BUSINESS VALUATION and MSMEs

What is MSME business?

MSME business stands for business run by Micro, Small, and Medium Enterprises.
Practically, it is a general term and difficult to define. In India, it is defined as follow:

Manufacturing Sector

Manufacturing sector refers to enterprises engaged in manufacture or production,

processing or preservation of goods. Please refer First Schedule to the Industries
(Development and Regulation) Act, 1951 for the list of eligible industries engaged in
the manufacturing sector. The definition of Micro, Small and Medium Enterprises
under the manufacturing sector is as below:

i. A micro enterprise is an enterprise where investment in plant and machinery

[original cost excluding land and building and the items specified by the Ministry of
Small Scale Industries vide its notification No. S.O. 1722(E) dated October 5, 2006]
does not exceed Rs. 25 lakh;

ii. A small enterprise is an enterprise where the investment in plant and machinery
[original cost excluding land and building and the items specified by the Ministry of
Small Scale Industries vide its notification No. S.O. 1722(E) dated October 5, 2006] is
more than Rs.25 lakh but does not exceed Rs.5 crore; and

iii. A medium enterprise is an enterprise where the investment in plant and

machinery (original cost excluding land and building and the items specified by the
Ministry of Small Scale Industries vide its notification No. S.O. 1722(E) dated
October 5, 2006) is more than Rs.5 crore but does not exceed Rs.10 crore.

Services Sector

Services sector refers to enterprises engaged in providing or rendering of services.

These will include small road & water transport operators (owning a fleet of vehicles
not exceeding ten vehicles), small business (whose original cost price of the
equipment used for the purpose of business does not exceed Rs.20 lakh) and
professional & self employed persons (whose borrowing limits do not exceed Rs.10
lakh of which not more than Rs.2 lakh should be for working capital requirements
except in case of professionally qualified medical practitioners setting up of practice
in semi-urban and rural areas, the borrowing limits should not exceed Rs.15 lakh
with a sub-ceiling of Rs.3 lakh for working capital requirements). The definition of
Micro, Small and Medium Enterprises under the services sector is as below:

i. A micro enterprise is an enterprise where the investment in equipment does not

exceed Rs.10 lakh;

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ii. A small enterprise is an enterprise where the investment in equipment is more
than Rs.10 lakh but does not exceed Rs.2 crore; and

iii. A medium enterprise is an enterprise where the investment in equipment is

more than Rs.2 crore but does not exceed Rs.5 crore.

So, it constitutes Manufacturing sector and Service sector units. The definition is
restricted to investment / borrowings only. And a medium sized business unit may
have its activities spread in many regions or with numbers of franchisees. It may
have branches abroad. I am going to analyze the definition. But our question for
Business valuation is, is there any need to separate the relatively small businesses
from other large businesses? Whether investment criteria is enough or sufficient to
allot an identity of MSME, to any business or unit? What are the factors which
differentiate the relevant small business from large businesses?

Business Valuation and MSMEs

In general, there can not be any strict definition for a business to regard as a small or
medium or large or giant. It is matter of debate to fix a basis for treatment of
business as a small or large. The definition of MSME varies from country to country
and from mind to mind. In our case, for business valuation, the important thing is to
know whether the fundamentals of valuation changes when applied for business
unit which are relatively small in size. My answer is “NO”. The fundamentals of

67
valuation like Premises of value, Standards of value, valuation approaches
techniques remains unchanged irrespective of size and identity. But yes, the
difficulties to be faced and the considerations require by an appraiser changes due to
some inherent characteristics of relatively small businesses. In includes availability
and reliability of financial data and other information, quantifying the size risk and
business specific risk, size of discount for lack of marketability and lack of control, if
any, influence of client, etc. Here, I have considered the businesses (1) which are
relatively small and medium in size, in general and (2) functioning of which are
controlled by the owners, themselves. And referred these businesses as “MSME”
businesses throughout this study. Of course, the need of valuation differs in case of
MSMEs when compared to large of public Companies.

Characteristics of MSME
Some of the major characteristics observed are as follows:

Ownership
MSME businesses usually are owned by individuals, family members, friends or
relatives, and are likely to be highly dependent on the owner/manager. Small
businesses often have a high degree of reliance on one or more key
owner/managers. In extreme cases, the business may rely on a single person for
sales, technical expertise, and/or personal contacts and may not be able to survive
without that person. Professional middle managers are a luxury that small
businesses seldom can afford. To be profitable, small businesses must operate with a
very thin management group. In addition, leaders of small businesses frequently are
entrepreneurs who are not comfortable with delegation of management duties to
others and may not work well with middle managers. Small companies are apt to
have a board of directors composed of insiders- members of the owner’s family
and/or employees. Thus they lack the diverse expertise and perspective which
otherwise outsiders can bring to a board of directors.

Financial records
Small businesses tend to have lower-quality financial statements that are less likely
to have been prepared by a professional accountant or qualified auditor. Their
statements tend to be tax oriented rather than oriented to stockholder disclosure as
in larger companies.

Whereas large companies usually keep separate records for the preparation of tax
returns and generally accepted accounting principles for financial statements, small
businesses that have no outside owners have no reason to go to the expense of
maintaining separate records for tax and book purposes. Thus, their financial
statements tend to reflect a bias toward minimizing income and taxes.

Access to Capital
Small businesses have less access to capital than larger companies and often must
rely on capital infusions from the owner family, friends and/or owner employees.
Access to debt capital is also more limited because of the higher risk of smaller
businesses. The cost of borrowing is higher, and the owner usually must personally
guarantee debt. Many small businesses operate with little or no debt, reflecting their
limited access to debt capital and a frequent reluctance of owners to take on the risk

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of substantial debt. Many small business owners minimize debt to reduce risk
during economic downturns and to increase the probability of keeping the business
in the family.

Other Operational Characteristics

Small businesses can lack diversity in products, markets, and geographic location.
Frequently they are very dependent on a few key customers, as when a small
manufacturing company primarily produces parts for a single automobile
manufacturer. They also may be dependent on a key supplier, as when a
manufacturer’s key raw material is a by-product of a single large local manufacturer.
Small businesses may have difficulty competing for employees. They may not be
able to offer competitive benefit packages and may be in less desirable locations.
Good managers may perceive less opportunity for promotions because of the
company’s small size and the owning family’s dominance on top management
positions. Small businesses can be less informed about their market and competition.
They are seldom in a position to pay for sophisticated market studies. Knowledge of
markets and competition must come from the experience of a relatively limited
number of managers—quite often the experience of a single person. Trade
associations supplement this personal knowledge of the market. Thus small
businesses operating in industries in which the trade associations are strong may be
at less of a disadvantage. In small companies, the portfolio of operations or products
frequently reflects the interests and contacts of a particular owner. Sometimes these
operations or products have few synergies, and the portfolio may have little appeal
to potential buyers.

The characteristics of small businesses tend normally to result in overall higher risk
than is found in larger businesses. These characteristics tend to be extreme in the
smallest of small businesses. So in general, we can say that “Risk tends to increase as
size decreases”.

Summary Differences between Public Companies and MSMEs

(as they relate to business value)

1. The obligated task of management in the publicly traded company is to

maximize bottom-line profits, whereas the elective task in the MSME is to minimize
profits that can be taxed. The closely held Companies or small enterprises runs for
own as oppose to public companies which run for profit or better returns to
shareholders. MSME unit generally run by owners themselves and they have direct
control over workings and performance of the business. Practically, the returns (even
negative returns) under small enterprises go on the hands of owners only
irrespective whether financials are reflecting the facts or not. The owner’s goal is to
maximize own profit whether separable from business or not. Under showing
profits to save tax is a very good example.

2. Stockholders of the publicly traded company are principally investors in the

stock market rather than the company itself; Under MSME, owners ‘‘bet’’ their own
money and returns on the assets of their own business.

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3. Although company performance influences stock market performance of the
public company’s trade prices, individual stockholders tend to have little or no direct
control in how the company runs. Owners of MSME, generally have all controls in how
the business runs, because individuals are quite regularly one and the same as
management.

4. Stocks of the public company can fall separately under the influence of
supply and demand, interwoven with other company stock offerings, and broadly
influenced by general market economies—perhaps, involving many issues that are
unrelated to a specific company’s performance. MSME have virtually no stock
market value and serve only the interests and wishes of the investor(s) in the
business assets. Not their shares but the value of businesses themselves is subjected
more to industry and local market economies.

An Overview of the Task of Estimating Values in Small Companies

Business value depends on the effective employment of capital, manpower, machine,
and material to produce profits; therefore, ‘‘business’’ value depends on the skills
that vary widely among individuals. In cases of closely held businesses, the concept
for values must be carried out to include tangible assets, intangible assets, and
perception .So, we can conclude that perceptions of value in MSME are individually
swayed and factually weighted by productivity of assets employed. In other words, each
component of business value, including any reference to facts, might change through
the personal perceptions of individual calling for valuation. This requires us to
examine the following: (a) general market conditions; (b) specific business
conditions; and (c) individual perceptions.

Professional service organizations, such as those for physicians, lawyers,

accountants, consultants, and so on, are among the more difficult types of businesses
for which to establish an intangible value. Practitioner characteristics, personalities,
and reputation play heavily into the generation of cash streams. Take the specific
practitioner out of the business, and the cash stream will quite often suffer
considerably. Therefore, a fundamental question is: How much business value is
directly attributable to a ‘‘person,’’ and how much of that value will remain if he or
she leaves? To the unwary, this can present the classic dilemma of ‘‘getting lost in
the numbers.’’ Subsequently, the purchase of a ‘‘sole practitioner’’ business can be
much more risky than the purchase of a business with multiple practitioners who
remain after the purchase. These ‘‘people’’ or owner-restrictive elements can be
present in all types of small businesses and, with safety in mind, cannot be
overlooked. A ‘‘business continuation’’ risk tends to decrease with increasing size of
staff and, when the present owner is more separated from practice work, by the
demands of administrative duty.

Unlike a publicly traded company that has a published market-driven share price,
the value of a privately owned company must be calculated using both qualitative
and quantitative analysis. The biggest difference between valuing business of the
public Companies and nonpublic business is lack of information. The application of
recognized valuation methodology and rigorous analysis of the closely held entity
provides the foundation for valuation of business. It may be necessary to make

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certain adjustments to improve comparability of the subject company to industry
norms, publicly traded companies, or companies involved in market transactions
considered in the valuation process. The appraisal process is subjective, time
consuming and requires highly specialized professional skills.

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TESTING THE FINANCIALS

A company’s historical financial statements generally provide the most reliable

information for estimating future performance and risk assessment. Audited
financial statements are preferred. However, since the financial statements of many
MSME businesses are neither audited nor reviewed, the analyst may have to rely on
compiled financial statements, which provide no level of assurance and may not
contain footnote disclosure. In other cases, the analyst may have to rely on income
tax returns or internally generated financial statements, the quality of which may be
suspect for purposes of proper financial statement analysis. If the historical
information is unreliable, the special care should be taken to disclose the facts and
degree of responsibility assumed based on financial statements.

The process
¾ Financial statement adjustments to normalize financial position and
performance
¾ Common size balance sheets and income statements
¾ Ratio analysis: asset management, leverage, liquidity, and profitability
¾ Comparison to industry financial data
¾ Analysis of trends and unusual items

Accounting practices vary considerably throughout the world, despite ongoing

efforts to create harmonized standards. The accounts of small firms are prepared
considering the tax friendly structure. In many cases, the transactions are not
properly accounted. This makes it vary difficult to value a business only on the basis
of its annual report or financial statements. So, the appraiser is first required to play
a role of analyst for which he needs to put the data in normalized mode. With
accounts and information of many of MSMEs, reconstruction of financial becomes
necessary. While reconstructing the financials, one must keep the mind and vision
open and to consider the documented papers only as far as possible. He must satisfy
himself about the genuineness and correctness behind the reconstructed figures.
Some common practices which condense the straight reliability of financials of
MSMEs and require restructuring of financials are,

• charging the salaries and commission in name of owner or family member

• charging interest on loans from family, relatives and friends at the rate
significantly different from prevailing market rate,
• missing to account the interest, commissions, remunerations etc foregone by
owner or directors
• withdrawing unreasonable rent for own premises for business utilization,
• treatment of personal expenses as a business expenses,
• unrecorded removal of goods for tax saving purposes,
• withdrawal of goods for own usage without proper accounting,
• deficiency in charging the depreciation on business assets,
• Missing treatment of deferred tax
• Inconsistency in accounting practices

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The analyst is required to consider all these and other relevant factors to design a
normalized financials. For valuation purpose, he also requires to consider the impact
of historical transactions affecting the value of the business. These are like, impact of
deferred tax, auditors’ qualifications, nature and frequency of abnormal or
exceptional items and non-recurring items, treatment of contingent liabilities etc.

Ratio analysis is the most useful tool because it helps an analyst to compare the
strengths, weaknesses and performance of businesses and to also determine whether
it is improving or deteriorating in profitability or financial strength. Ratios express
mathematically the relationship between performance figures and/or
assets/liabilities in a form that can be easily understood and interpreted.

Financial Analysis helps to decide the key factors to consider before arriving at the
conclusion on valuation of business. The analysis of historical financials can help the
analyst to know and understand:

• any adjustments required to reflect the true earnings potential of the company
• the overall trend in the business (sales, profits, etc.) improving, stable or
declining
• the liquidity position of the business concern
• management efficiency of working capital
• debt coverage and scope for capital structuring
• performance efficiency like returns on equity, asset utilization, role of non-
performing assets
• inputs to compare with Industry or specific sector or business

The conclusions derived from analysis can further be helpful for assessing the risk
involved in the business and the also to develop the forecast assumptions while
calculating the intrinsic value of the business. The comparable financial will be used
to determine the extrinsic (market based value) of the business.

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VALUATION NEED FOR MSME SECTOR

In the previous sections I have presented the stuff necessary while considering
valuation of any business or a concern. The standards of value, premise and the
relevant approaches, all play a crucial role while going for business appraisal. Each
transaction will have its own specific characteristic and the standards and premise of
valuation should be appropriately selected to match with the characteristics of such
transaction. The approaches are the different ways which help to move towards the
destination.

Let me try to relate the valuation need with a simple understandable situation- If
some one wants to reach at Mumbai to purchase “A” item, the best of which is
available only at “Victoria Terminus”, he may choose a way amongst numbers of
alternative ways available to reach at the destination. He may have to select an
option from By road or By rail, or By air or By sea. Each will lead him to Mumbai but
will differ in terms of time, comfort, money etc involved with each option. Again,
Each of these alternate will put him first at a specific place in Mumbai, the distance
of which to “Victoria Terminus” will differ. Being indifferent in terms of time,
comfort and money – the best option is that which puts him at a place nearest to
“Victoria Terminus”. In broad terms, the valuation process is just like this journey
BUT without knowing where to purchase the best of item “A”! Here, the job of the
valuation analyst is like a stranger searching a place in Mumbai to purchase item
“A”. The only and the most important difference is that the destination viz.
“Victoria Terminus” can be reached which is near to impossible in case of valuation.
So, the result of valuation fully depends on the competence of the valuation analyst
and the experience, expertise and professional judgments applied while deriving a
conclusive value.

Every need is specific purpose oriented and the same logic is equally applicable to
valuation need. The purpose of this study is to identify and present the needs of
valuation in Medium, Small and Micro enterprises (MSME) and to relate the best
matching technique with specific purpose. To my knowledge, this is a first study to
relate the purpose with the valuation techniques which fulfill the specific need/s.
Out of several experts in this field to whom I met, some are of the views that the
valuation technique can be industry specific or sector based but as the intention is to
find a Value of the business, the purpose is not material. The value of business
remains neutral irrespective of the change in the purpose of valuation. In their
views, one should not prepare an index of values presenting the different value
against each of different purpose. While others are of the opinion that the valuation
technique should be liked with the purpose giving rise to the need for valuation. The
argument behind is that business has of course different value in eye of different
persons based on their specific purpose if not then why one would invest their time
and energy to get or to transact for the similar amount of consideration they are
departing now. The “Business value” is not simply a value of business but a specific
value of business in the eye of the involved participants. And so, “the investment
value” of a business may differ if considered for two different buyers even at the
same point of time. This is due to difference in views and synergies expected by
different buyers. When subjectivity comes, questions and arguments never end.

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I met some of the professionals practicing in valuing the businesses and come to
know that the MSME generally not come to value their businesses. May be due to
ignorance or due to the cost involved or may be its relative importance to transaction
value being very less. Normally, Giant or public organizations call for valuation to
take a better decision relying on valuation report. Giants may afford the cost
involved in terms of both the transaction value as well as the statutory requirements
which may not be the case applicable to MSME.

I am representing some common thoughts of the owners of MSMEs. For example,

While on a verge of selling a business, the owner believes that the Businesses in
industry to which his business pertains always sell for “X” times annual revenue
(the revenue multiple). So why should he pay someone to value a business?

The short answer is that these rules of thumb are generally median multiple values.
The median value indicates that half of the revenue multiples are below the median
value and half are above. Thus, the median value is just a convenient midpoint and
does not represent the revenue multiple for any actual transaction. Unless the firm
that is being valued is truly a median firm, then using the industry rule of thumb for
this purpose is clearly wrong. For example, if according to a well- known source for
business transaction data, we derive recent revenue multiples for firms in the auto
parts industry ranging from a low of .98 to a high of 5.3 with a median of 2.9 and if
we are valuing a firm with annual revenue of Rs. 10,00,000, then the value of this
business could be as low as Rs. 9,80,000, as high as Rs. 53,00,000, or somewhere in
between. Where this firm lies along this continuum is obviously of the utmost
importance and can only be determined by a valuation approach that incorporates
academically validated methods with industry-specific valuation factors.

The owner further argues that a local competitor sold his business for three times
revenue six months ago. So his business is worth at least this much!

The answer is: May be yes and may be no. What happened six months ago is not
really relevant to what something is worth today. What his business is worth today
depends on three factors:
1) how much cash it generates today;
2) expected growth in cash in the foreseeable future; and
3) the return the owner or proposed owner require on their investment in this
business.

First of all, unless this firm's cash flows and growth prospects are very similar to the
competitor firm, that firm's revenue multiple is irrelevant to valuing this firm.
Moreover, without getting into the nuances of finance, even if the competitor firm
was equivalent to this in every respect and both firms were sold today, if interest
rates were higher today than 6 months ago, the firms would likely sell for less than
three times revenue. Conversely, if rates were lower today than six months ago, the
firms may be worth more than three times revenue. In short, the value of this
business, like the value of any public company share value (say Reliance Industries
Ltd.), is likely different today than six months ago because economic conditions have
changed.

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Looking positively to involve and encourage MSME to value own business/
businesses, we can spread the information on possible benefits that can be derived
by valuing own business. Valuing a business can help the MSME business
community in numbers of ways. For example, to know the fair status and the growth
of the business, to get the finance with fair terms and confidence level, to settle the
sharing issues amongst the owners, to resolve the family issues involving same
business or more than one businesses, getting the fair value on sell or purchase
transaction and thereby at all to get a better mental comforts. If the apprehension of
the MSME is a cost involvement then it is a duty of authorities to derive a technique
whereby they can match the cost-benefit.

Normally, the valuation of specific business can be helpful to two groups. (1)
Existing stake holders and (2) Proposed stake holders. First group includes the
existing stake holders of the business and person / persons having direct or indirect
relations or having some kind of interest in business, like owner/s, partners, share
holders, investors, financiers, employees, statutory authorities etc. The second group
includes person / persons proposed to establish the direct or indirect relations or
having proposed interest in that specific business, like proposed buyers, partners,
share holder/s, investors, financiers, employee, etc. who are likely to be effected by
the business value. While normally, the first group is interested in a “Business
value” being existing value, based on past but incorporating the fair benefits that can
be derived in future, the second group, being currently outsider, interests in a
“Business value” based on risk adjusted possible benefits that can be derived in
future, looking at the existing, analyzed with past but also incorporated with their
current business or activities. Obviously, based on different perceptions the value of
business differs from eye to eye.

The competitor or proposed entrant in the industry or sector may be interested to

know the value of specific business but being outsider he may not have access on
major information on specific MSME and could not give the justice to the purpose if
he himself calls for valuation based on incomplete data or vague information.

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VALUATION PROCESS:

After going through the profile of client and understanding the purpose of
engagement, as well as intended use of valuation, the valuation process begins with
deciding the standard of value based on the accepted premise. The standard of value
may be loosely said as a definition of value. It will mainly be based on the intended
use of value. If the owner wants to launch a new project then he may like to know
“the fair value” of existing business and the “investment value” of business
combined with proposed projects. Just on the other side, a financer while financing
the same project, may like to know the “fair value” as well as the “liquidation value”
of the business. If the valuation report could not be used for the purpose it is
intended to be used then where is the NEED of valuation? The purpose, not always
demands the fair value but a value which can help the best to arrive at a better
decision.

In my view, in order to achieve the intended benefits from valuation, analyst should
consider the purpose forcing towards the need of valuation. Based on relevant
standards, business appraise can derive a specific value or may come out with
different value depending upon the techniques applied. The assumptions should be
explicit to make the value better useful.

The basics of standards are reproduced as follow:

Fair value: that may be intrinsic value (adjusted asset based value or
earning capacity based value) or the extrinsic value (market
based value- relative value)

Investment value: based on the individual perceptions of the investor. It includes

the value of synergy with investors’ existing status. (it could
be a liquidation value of concerned asset plus marginal
benefits derived from the transaction)

Liquidation value: Realizable value of assets

Selection of Valuation Techniques

Once the standard of value if decided, the valuation analyst needs to finalize the
appropriate techniques to consider while moving towards deriving the value of
business. As we know, there are three approaches to valuation used widely to arrive
at the conclusive value. These approaches are having numerous sub-approaches or
techniques within each. Based on the requirement of specific purpose, the value
analyst is required to apply his professional wisdom and experience to finalize the
technique/s to consider. He should also bear in mind that the value arrived on
applying each these selected techniques is very likely to differ and the range
between the least value and highest value may be significant. If the fundamentals are
well considered and assumptions are well decided then this difference may not be
so. Here again, after deriving values using different applied techniques, the Analyst
is on the subjective mode and he can choose one or more techniques with different
weight age to arrive at the conclusive value of business. Base on his best of

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professional judgment, he may also end up with range of value based on
requirement and circumstances.

While selecting the appropriate technique to apply to arrive at the conclusive value
of business enterprise subject to valuation, I would like to focus the four factors
imbedded with the need of the valuation. These are

(1) safety of capital (asset coverage),

(2) expected return on capital (earnings),
(3) time span and
(4) purpose for which the capital is used.

Purpose for which the capital is used is assumed to be legal and pre-intended
purpose only. Also, the valuation techniques are used to derive the value of business
at a specific point of time and not concerned with the area of capital where it is used
and not concerned whether it is used for intended purpose or not. So, this factor is
not likely to affect the selection of valuation technique for specific purpose.

The reason for considering the above four factors is vary simple. Business is a game
of finance and all stakeholders are investors expecting return on their investments. A
business is separate entity whether it may be a corporate enterprise or partnership
concern or even a proprietary business. The features differ with change of formation
or change of legal status but the fact will remain that the owner himself, is not a
business. He also invests his money, time and energy in to business with expectation
of getting return on his investment, monitory or else. The other stakeholders will
also, normally, invest their money with expectation of getting return. Owner needs
profit against investment of his time and energy in addition to finance, financier
needs interest, investor needs return in terms of interest or dividend and capital
appreciation, supplier supplies materials and services with his profits, employee
needs salary, and salesman needs commission, even government need taxes against
permitting to business on land of the country. Value of money being function of
time, all investors (including the owner of the business) would like to link their
timely returns with the time span to know the actual return on their investment.
Being all, investor they are concerned about the safety of their capital depending on
the expected return, assumed risk and other terms of investments.

We will also check the assumptions and impact of these factors on selection of
specific technique amongst numerous techniques of business valuation.

While concluding a value for specific interest, a value analyst should also consider
the premiums and discounts necessary to incorporate in business estimation.
Examples of these premiums and discounts are control premium (an investor may
be willing to pay some thing extra for getting control over business or management
or specific area/s), synergy premium (the likely benefit directly or indirectly
effecting the existing profile of proposed investor) , portfolio discount (the business
enterprise may include more than one business streams and there may not be perfect
co relation within those streams or it owns dissimilar operations or assets that do not
fit well together) , blockage discount (the ownership may be embedded with some
restrictions on departing), lack of control discount (the ownership may come but not

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with reasonable or exclusive control), Illiquidity discount (in case of closely held
business entities, normally, the owner of business or equity holder are not in a
position to change their holdings as easily and frequently to manage their risk
perceptions, as they can for publicly traded companies), key person discount (the
business may be dependable on working style, experience and skills of one or few
specific person/s) etc.

Now let we move towards selecting the appropriate valuation technique/s based on
purpose of valuation:

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SELECTION OF APPROPRIATE TECHNIQUE FOR SPECIFIC PURPOSE
(Considering MSME units only)

In order to present the needs for MSME business valuation, I have compiled the
purposes giving birth to the need of valuation and then divided those purposes in to
four major categories.

(1) Relative strategy

(2) Investment
(3) Value added management or Planning:
(4) Other purposes

The characteristics of each purpose will decide the matching standard of valuation
and also the technique/s better suiting the other requirements.

(1) Relative strategy:

Where more than one party with different objective/s is likely to be affected directly
from the valuation, that is to say, the strategy or purpose/s of involved parties are
different but dependable on one and the same transaction, the purpose will fall
under this category. The following purposes are considered under this category:

(a) Addition of Partner/s:

When the existing owner / partners decides to add the partner, they would
like to en cash a portion of goodwill and will try to show a better existing
value of their business. In the worst case, (like existing owner / working
partner is on the verge of dyeing or retiring or incapable to growth the
business sufficiently or the business is in the face of shut down otherwise) the
existing owner / partners would like to know at least the liquidation value of
the business. Being the continued partner also, they will like to use the
investment value for negotiation purpose. So, their major concern is to know
the “at least value” and “fair value” of the business.

Just on the other side, the new coming partner is going to invest his time or
money or both and would like to see the benefits upon choosing this option
of joining as a new partner. AS the remaining partners are continued with the
“fair value”, he would be interested to know the fair value of the business
and at the most, based on his own perceptions about risk taking, the
investment value of the business.

Valuation is called for by Relevant standard of value

Existing owner/ Partners Fair value,

(Liquidation value in specific case)
(investment value useful for negotiation)

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 Incoming partner Investment value, Fair value

The analyst is now on the way to select the techniques to be applied for
determining the value of business. While sharing the business or dilute the
sharing, the existing owner or partner/s would like to get the appropriate
consideration against the existing earning capacity and assets involved in the
business. “Excess earning method” can help them to derive existing earning
capacity of the business. “Adjust net asset method” will help to know the
existing asset strength or the invested capital of the owners. The “Discounted
cash flow” based on future earnings will help to know the futuristic value of
business in which the incoming partner is proposed to claim the share. His
concern is return and safety.

The incoming partner would also like to know the existing earning capacity
of business and the existing assets involved in business so as to decide the
goodwill of the firm with which he is likely to associate. He would prefer
“Discounted cash flow” to determine his expected returns. He is interested in
return, safety of his investments as well as time value imbedded with return.

Valuation is called for by Relevant valuation technique/s

Existing owner/ Partners Excess earnings method

Adjusted net assets method
(Discounted cash flow for negotiation)

Incoming partner Discounted cash flow

Excess earnings method
Adjusted net assets method
The comparable company or business data or similar transactions happened
in near past for such kind of business can be used as guiding data while
arriving at conclusion. For tiny and small businesses, many times the
conclusive value is compared with traditionally adopted figure derived
based on “Rule of Thumb”.

(b) Business Sell / Purchase Agreement:

While the seller is interested to get the maximum value towards his business
the Buyer would like to pay the minimum, expecting the best from the
businesses. The seller would like to get the fair value and in case of bad need,
at least the liquidation value for his business. The Buyer, here will try to pay
maximum what it can derive from the business. So, He would be interested
to get the investment value of the business. For negotiation point of view, he
would like to know the fair value. If for example, an owner of colour shop
situated on prime location at the heart of the city in main market wants to sell

81
his shop, he would like to get the market price for its real estate-property
(shop) and current assets including receivables and at least cost of the
inventory out of which he can pay off his liabilities. He will intend to get this
price irrespective of its usage by the proposed buyer. The buyer, if wants to
continue to run the colour shop, may accept the price if he is expecting to get
at least the expected rate of return on this investment. Now, consider a
situation where the buyer wants to start a new business and to open a gift
article shop there. He is concerned with location only and not with the stock
and related current assets. If the seller insists for “bundle” sale (shop and
current assets plus inventory together) only then the buyer may accept the
price if his investment value permits. i.e. the buyer will get enough return
from gift article business to cover the possible loss on purchase of colour
business assets. The seller is interested in getting the fair value of its “colour
business” while buyer is interested in knowing the investment value of its
“gift article business”. He may like to know the fair value of colour business
for negotiation.

Valuation is called for by Relevant standard of value

Existing owner/ Seller Fair value, Liquidation value

Buyer Investment value

(Fair value useful for negotiation)

In order to get the better consideration for departing the own business, the
seller would like to en cash the current earning capacity and therefore prefers
a lump sum multiple of existing earnings or revenue. He would definitely
compare the consideration figure so arrived with realization value of his
existing assets based on current market values. Based on the nature of
business, he may claim a combination of both, that is to say he may like to
negotiate for excess earning. His concern is best return of his investments.

The buyer is looking futuristic. He is major interested on future returns and

synergies based on the existing status of the business. He would like to know
the intrinsic value of business generally preferring discounted cash flow
method. Obviously, he would also compare the consideration with the
replacement value of the assets he is going to own. He interests to know the
return and coverage of his investments.

Valuation is called for by Relevant valuation technique/s

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 Existing owner/ Seller Earnings capitalization method (or earning
multiple) or Revenue multiple
Excess earnings method
Liquidation value

Buyer Discounted cash flow

Replacement cost method

The comparable company or business data or similar transactions happened

in near past for such kind of business can be used as guiding data while
arriving at conclusion. For tiny and small businesses, many times the
conclusive value is compared with traditionally adopted figure derived
based on “Rule of Thumb”.

Buyers subjective line

Area of deal

Seller’s expectations

Best dealing point

While estimated value of business provides basis for negotiation, the

negotiation skills of involved parties and the structure of transaction like
financing structure, transition of control etc also affect the transaction price.
For example, setting the deferred payment terms is a very good option
available in the interest of both the parties is: By providing for deferred
payment towards consideration of business purchase, the seller can get better
price of his business, at the same time the buyer can get the business at a low
initial out flow from his pocket and then he can pay from the business itself.
This term of seller’s finance is of course out of the preview of valuation but a
very good tool of settling a deal.

(c) IPO:
The business enterprise while going for Initial Public Offerings likes to dilute
the sharing based at a price which gives something in addition to existing
value and being continued party to the business growth, they would like to
consider the average risk and growth potentials from the view point of
proposed investors and also the factors affecting while going public and
therefore they also call for the investment value. On the other side, the
investor would like to invest as per his own risk perceptions, at a least prices
or a price very near to existing fair value so as to decide the under value

83
offerings or over value offering of IPO. So, both of them would be interested
to know the fair value and of business.

Valuation is called for by Relevant standard of value

Existing owner/s Fair value, Investment value

Investor Fair value, Investment value

The business, once listed on any stock exchange, analyzed by the market
value of its shares and market capitalization. So, while going public it is
essential to know the intrinsic value as well as the market value of the
business. When based on the existing worth, the intrinsic value can be
calculated by applying the earnings capitalization method. The value of
assets will reveal the existing tangible strength of the business. CCI
guidelines also prescribes a method of calculating “Profit Earning capacity
value “(PECV) and “Net Assets value” (NAV) of the business while
determining equity issue price. CCI guidelines prescribe to derive Net Asset
value based on the latest audited balance sheet, i.e. book value, and not the
current market value. Discounted cash flow will help to derive the business
value based on future plans and project. The market value can be decided
based on comparable companies’ adjusted value. CCI guidelines prescribe to
use the market value as a benchmark or guiding value and not to be used
directly to determine the offering price at IPO. His interest is to get the value
of his dilution and ensuring the safety of investors funds i.e. return on
investment

The investor in IPO would also like to compare the IPO price with the
intrinsic value and the possible market value. Discounted cash flow and
comparable companies’ adjusted value can serve his purpose.

Valuation is called for by Relevant valuation technique/s

Existing owner/s Earnings capitalization method

Adjusted net assets value
Discounted cash flow
Comparable Companies’ multiple (P/E and
P/EBITDA multiple)*

Investor Discounted cash flow

Comparable Companies’ multiple (generally
P/E and P/EBITDA multiple)*

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* P/EBITDA multiple is not a correct measure of value in terms of financial
logics. “P” refers to price of equity while “EBITDA” refers to flow available
on capital which includes equity owners’ funds as well as debts. However, it
can be used to compare the price worth on cash flow of two businesses which
are being compared.

(d) Mergers, Acquisitions, Takeovers:

Generally, these are the strategy deals and the basic characteristics remain
same as applicable to normal business sale-purchase transactions except that
the existing owner may remain to carry the business but with some different
terms and conditions.

Valuation is called for by Relevant standard of value

Existing owner/ Seller Fair value, Liquidation value

(investment value useful for negotiation)

Acquirer / Buyer Investment value, Fair value

The transferee and the transferor both are interested for getting the best
worth of their business. The existing owner would like to know the fair value
of his business based on the existing earnings and wants to get at least the
liquidation value of the business. On merger, acquisition or takeover, the
existing owner is departing his future business which he may continue else,
and can know his opportunity cost by using the discounted cash flow based
on his own perceptions. While the acquirer will calculate his synergies and
present value of future earnings to decide the return on investment, he
considers the replacement value of assets he is going to acquire to know the
placing of his investment on acquisition. In specific case, acquirer may like to
know the option value of specific investment on acquisition. Although these
transactions of merger, takeovers or acquisitions are becoming importance
means of diversification, there is no established technique which incorporates
uncertainties involved and gives a range of values of a target firm which can
form the basis for offering a price. Both the parties are concerned with return
on their respective investments and the acquirer, also with asset coverage of
its investments.

Valuation is called for by Relevant valuation technique/s

Existing owner/ Seller Earnings capitalization method

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 Discounted cash flow
Liquidation value

Acquirer / Buyer Discounted cash flow

Replacement cost method

(2) Investments:
Where the intention of the party calling the valuation is to invest in the business or
finance specific project or the business growth, the purpose will fall under this
category. The investor’s decision is for own self only and not intended to be used by
the other person.

(a) Small business purchase:

The value of business and the value of ownership are two different terms.
The value of ownership is directly associated with power of control and
synergies. One who wants to acquire a power of controlling or expecting
better synergies with his or her proposed set ups may willing to pay
something more than the measured value of business. When a proposed
investor, based on his personal perceptions, sees better benefits on purchase
of certain business, he would like to offer something in addition to the fair
price of the business. It is different from the routine sell-purchase
transactions in a sense that the investor is approaching to satisfy his own
synergy/ies. A hypothetical buyer would have to pay a control premium,
even if this buyer plans to run the business in the same way as existing
management. The buyer pays a premium, because having the “right” to
control how the business assets are deployed has value. So, He would be
interested to get the investment value of the business. For negotiation point
of view, he would like to know the fair value.

Valuation is called for by Relevant standard of value

Business buyer Investment value

(Fair value useful for negotiation)

As written above, the buyer term itself is a futuristic term and the buyer is
interested to know the value of any asset he is going to buy. A rational buyer
will not pay more price than the worth of asset to him this worth may be
measurable or may not be. Of course, many times he needs the history of
assets (or business) to assess the future worth. And so his concern is what
comes now physically and what he will get in future against something
payable now. He is concern with the return on investments as well as asset
coverage of his investments.

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 Valuation is called for by Relevant valuation technique/s

Business buyer Discounted cash flow

Replacement cost method

The comparable company or business data or similar transactions happened

in near past for such kind of business can be used as guiding data while
arriving at conclusion. Many times the conclusive value is compared with
traditionally adopted figure derived based on “Rule of Thumb”.

(b) Private equity funding/ venture capital finance:

The investors in private equity generally provide capital as a seed money or
first phase start up money. Some times, depending upon the nature and
situations of the business and agreed terms they may finance second phase
development. It mainly depends on achievement of decided mile stones.
Here, generally the investors are pure investors and financing the business to
get the better returns. The expected return ranges from 20% to 70%
depending upon the stage of investment. They are more concern about the
industry under which a business pertains and the core competence of the
business. They prefer to know the fair value of the business. Normally they
do not have synergies to link with specific investments but they may invest
in particular sector based on own portfolio diversification policies. They want
to value the business based on own perception about the risk taking and
growth potentiality of the business.

Valuation is called for by Relevant standard of value

Venture capital/ PE Investment value, Fair value

investor

The venture capitalist or investors in private equity are interested in better

return based on their perceptions of risks. They may prefer “First Chicago
Method” (allocating different probabilities to various possible business
scenarios and to arrive at a common value) to determine the business value.
In some cases where further investment is dependable on some happenings,
option pricing model can be helpful to value such “option to expand”. They
would like to know the coverage of their investments in terms of physical
asset also. Obviously, they are more interested in return of investments
knowingly the asset coverage. Normally, the exit mode in Private equity
investment is IPO and therefore they tend to consider the market situations
likely to exist at the time of proposed IPO. Of course, it is very difficult to
judge the market. They consider DCF to calculate the offer price on the basis

87
 of the expected rate of return but also uses market multiples as a guiding
factor.

Valuation is called for by Relevant valuation technique

Venture capital/ PE Discounted cash flow

investor Replacement cost method
P/E multiple (as guiding data)

The comparable company or business data or similar transactions happened

in near past for such kind of business can be used as guiding data while
arriving at conclusion.

(c) Business financing for new projects/ expansion:

The Bankers, financial institutions and other business financers are interested
to get a reasonable return on their investments and to save their capital as
well. They are concern with debt payment capacity of the business and
therefore interested to know the cash flow or earning capacity of existing
business as well as the viability of new projects or expansion. In order to
ensure the safe guard of their funds they also would like to know the
liquidation value.

Valuation is called for by Relevant standard of value

Business financer Fair value, Liquidation value

The business financier is interested in knowing the debt payment capacity of

the business and the securities for safeguarding their investments.

Valuation is called for by Relevant valuation technique/s

Business financer Discounted Cash flow*

Liquidation value

* The financer is much interested to know the actual cash flow that will be
used for debt repayments

(3) Value added management/ planning:

88
The owner of the business would also, in many situations, like to know the value of
his own business. In MSME, even though the owner is controlling each and every
functions of owned business, he needs sometimes to convince himself. The valuation
may be helpful for internal betterment, business expansion, value addition, strategy
forming and most importantly to make appropriate decisions on time.

(a) Raising funds for expansion or new projects:

Before an owner goes to raise a capital for expansion or new projects, he
remains more concerned about his payment capacity and expected returns.
The expansion is fruitful if enhances the value of business. The expansion
should be viable in sense that the expected return must be more than the
existing rate of return and at least the additional cost of finance. The return
may be tangible or intangible.
Also, the financer would like to analyze the existing business and viability of
expansion in terms of debt payment capacity. Owner is required to consider
this fact in his mind also. The financier may not be concern with the present
value of cash flow but of course with the actual value of cash flow so as to
satisfy himself about the repayment capacity of business. The liquidation
value will further help him to assure the fund safety.

Valuation is called for by Relevant standard of value

Business Owner Fair value, Investment value,

(Liquidation value to assure the fund safety of
financier)

For accessing the financial viability while going for expansion or new
projects, the businessman would like to know the impact of borrowings on
expansion or project value. He also will consider his existing business value
based on future earnings. The asset value will help him in deriving the
tangible value of business against which he can easily go for fund raising. His
concern is additional return on investment and investment in secured assets.

Valuation is called for by Relevant valuation technique

Business Owner Discounted cash flow

Adjusted net asset value

(b) Restructuring the business/ divestiture:

An awake owner would like to get the benefit of leverage. The outside
finance can increase the return (if the business return is more than the post
tax debt cost) but simultaneously it increases the probabilities of bankruptcy.

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If planned properly, the debt cost being tax deductible item, it can reduce the
cost of capital to a good extent. Proper capital structure can help to increase
the value of the equity holdings or value of ownership. The owner would like
to know the fair value of his business based upon current structure so as to
increase the ownership value just by addition or repayment of outsider
finance or modification of existing debt terms.

Valuation is called for by Relevant standard of value

Business Owner Fair value

The increase in debt will reduce the profit available to the owners but at the
same time it can increase the return on capital subject that the existing return
is more than the proposed post-tax debt cost. The approach being futuristic
the forward earning capitalization or discounted cash flow will serve the
purpose. He would like to take decision knowingly the impact of capital
structure on rate of return and absolute return.

Valuation is called for by Relevant valuation technique/s

Business Owner Earning capitalization method*

* Theoretically, forward earnings capitalization method is same as the
discounted cash flow method.

(c) Goodwill impairment:

Every business being going corn will have goodwill (positive or may be
negative) whether shown as a part of balance sheet or not. While calculating
the value of business, the value of goodwill will be impliedly included. The
sources of generation of goodwill are the relations of business with
employee, creditors, customers, location of business etc. Based on the
conservative approach principle, goodwill being intangible asset, if not
recognized on the balance sheet then there is no harm but if it carries a
certain amount to the balance sheet then it must be measured for
impairment. If the fair value of business is equal or more than the carrying
amount of business then impliedly there is no impairment in goodwill. But in
reverse situation, the fair market value of goodwill is required to be found
out by deriving a difference between the fair market value and carrying
value of business assets on stand alone basis and such an implied market
value of goodwill is to be compared with the carrying amount of goodwill to
quantify the impairment. The owner can take reasonable steps to stop or
lesser the impairment and to protect his ownership value if he undertakes
business valuation regularly.

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 Valuation is called for by Relevant standard of value

Business Owner Fair value

Goodwill is concerned with the excess earnings. In order to know the fair
value for goodwill impairment purpose, we need the value of business as a
whole and it is less than the total carrying value of the assets in balance sheet,
we need to know the fair market value of assets on stand alone basis.

Valuation is called for by Relevant valuation technique/s

Business Owner Discounted cash flow

Adjusted net asset value

(d) Allocation of Purchase price:

When a business is purchased and the price is paid on a lump sum basis or a
fixed price is paid against the fair value of business and not being a pooling
of interest method, the owner needs to show the fair value of acquired assets
in to his balance sheet. He requires to find the fair value of assets and
liabilities purchased and also to find the amount paid extra as a goodwill.
This requires the owner to find the fair value of assets and allocate the
purchase price amongst it.

Valuation is called for by Relevant standard of value

Business Owner Fair value

Valuation is called for by Relevant valuation technique/s

Business Owner Adjusted net asset value

(e) Retirement of partner or dissolution of partnership or succession

planning:

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Many times the partners would like to plan the exit mode which can
strengthen the partnership relations. They may pre decide the calculation
terms of goodwill on retirement and even can invest regularly, a certain
portion of earnings for smooth payment, on retirement or dissolution,
without badly affecting business capital. They even can pre plan the business
succession terms if regularly known about the value of business.

Valuation is called for by Relevant standard of value

Business Owner Fair value, Liquidation value

The concern is return on investments and the assets coverage. The

comparable company or business data can be used as guiding data while
determining the final value.

Valuation is called for by Relevant valuation technique/s

Business Owner Discounted cash flow

Adjusted net assets method
Liquidation value

(f) Financial reporting:

Many Accounting Standards also require showing the assets and liabilities at
their fair value. The applicability of it depends on the legal status of the
business enterprise and therefore MSME are generally, out of the preview of
Accounting Standards. But of course, no one is restricted to present the
better. MSME can prefer to show the fair value of its business to earn the
better credibility and transparency in financial reporting. It may be helpful to
them in long run in terms of mapping the actual growth.

Valuation is called for by Relevant standard of value

Business Owner Fair value

The concern is disclosing the earning capacity and coverage of capital in

various business assets.

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 Valuation is called for by Relevant valuation technique/s

Business Owner Discounted cash flow

Adjusted net assets method

(g) Frequent progress measure:

The owner may choose to know the value of the business on regular time
interval. This can help him to measure the progress as well as to frame the
appropriate business strategy in time and taking the decisions better
knowingly the impact on ownership value. Like, he can timely decide
diversion or sell of specific loss making business stream, can plan expansion
taking advantage of intrinsic strength, can take the best advantage of capital
structuring, can realize the better value through timely selling of business etc.

Valuation is called for by Relevant standard of value

Business Owner Fair value, Liquidation value

The owner is interested to measure the performance of the business in terms

of change in business value as well as to know the addition in asset value due
to market forces. The concern is to evaluate both, the return on investments
as well as safely of investments.

Valuation is called for by Relevant valuation technique/s

Business Owner Economic Value Addition method

(excess earning method)
Liquidation value in relevant cases

(4) Other Purposes:

The purposes which are not covered under above three categories will fall under this
category. It includes the purposes, the valuation for which generally is not
undertaken for any intended business transaction.

(a) Ownership issues:

Sometimes, the partnership terms include increasing the share of working
member based on the performance and business targets achieved by him. In
some other case, a specific owner may require contributing on none fulfilling
the agreed term. Like, the investor partner may not fulfill his obligation to
bring the agreed finance and therefore, he has to dilute his sharing in favour

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of new financier or any one else. There may be a situation where a creditor or
a financier is required to offer the ownership in the business.
All these case requires a proper valuation of the business and a decision
taken on the basis of figures reflected on the balance sheet only may not be
wise and in may effect adversely to one of the party.

Valuation is called for by Relevant standard of value

Existing Owner Fair value

(person diluting the
sharing)

Proposed Owner
(person intended to raise Fair value
the sharing)

Here, the selection of technique/s for determining the value of business

depends on the circumstances of each case but by and large both the parties
would like to know the existing earning capacity, future return prospects and
value of assets involved.

Valuation is called for by Relevant valuation technique/s

Existing Owner Excess earning method

(person diluting the Discounted cash flow
sharing) Adjusted net assets method

Proposed Owner Excess earning method

(person intended to raise Discounted cash flow
the sharing) Adjusted net assets method

Here, the selection of technique/s for determining the value of business

depends on the circumstances of each case but by and large both the parties
would like to know the existing earning capacity, future return prospects and
value of assets involved.

(b) Litigation issues involving lost profits or economic damages:

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Insurance claim, loss of business due to impairment in reputation by
whatsoever reason, impact of merger or de merger, breach of contract etc will
also call for valuation. Specific care is required while valuing a business or a
loss of business under such circumstances. Generally, the prescribed
techniques are used to appraise the loss or business.

Valuation is called for by Relevant standard of value

Business Owner Fair value

Opposition party Fair value

The selection of valuation technique will be based on specific requirement of

each particular case.

(c) Family issues:

This includes the disputes and planning matters involved due to ownership
in a business. It may be a sharing issue on separation of family or HUF
partition. The ancestral businesses and HUF businesses are co owned by the
male members of the family and therefore the need arises to decide the
sharing at the time of separation. It will be wise to allocate the business or
businesses or specific sharing in a business on the basis of fair value of each
business. The wealth planning and WILL planning will also be made wisely,
if based on fair value of ownership.

Valuation is called for by Relevant standard of value

Business Owner or family Fair value, Liquidation value

member

The purpose is to identify the rate of return and the asset coverage in family
business or businesses. The comparable company or business data or similar
transactions happened in near past for such kind of business can be used as
guiding data while arriving at conclusion.

Valuation is called for by Relevant valuation technique/s

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 Business Owner or family Excess earning method
member Discounted cash flow
Adjusted net assets method
Liquidation value

The above four categories consider all major purposes which may need the value of
business for taking a timely and wise decision.

The valuation analyst, even after finalizing the standard/s of value based on
characteristics of the purpose and selecting the technique/s of valuation, may rest
with some different values derived by application of various selected technique/s.
he may choose to conclude with a value derived by applying specific technique or he
may weigh particular techniques as per his wise and conclude the valuation. It rests
with the value analyst to determine the final value or a range of values of a business
based on his experience and applying best of his professional skills considering the
nature of business, prevailing situations and existing requirements.

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Conclusion:

While valuing a business is not an exact science, it is not a total mystery. A realistic
business valuation requires more then merely looking at past years’ financial statement.
Banking a business’s value solely on current operating results is risky business to say
the least. A valuation requires a thorough analysis of several years of the business
operation and an opinion about the future outlook of the industry, the economy and
how the subject business will compete.

The quality of any value analysis or value appraising is a function of the accuracy of the
data and assumptions that form the basis for any conclusion reached. Estimates of a
business' value by various experts can vary significantly, if the fundamental
assumptions are applied differently. If available, it is always better to use actual data or
historical results than to rely on assumptions. Unfortunately, it is not always possible,
particularly in case of MSMEs. It is possible, however, to make sure that any
assumptions made are based on the financial, market, economic and competitive
characteristics in place during the appropriate timeframe for the appraisal.

Business valuation field itself, in India, is still un-explored. This write up particularly
pertains to valuation need in MSME sector and linking the most relevant valuation
technique/s with specific purpose. In fact, value of a business depends on numbers of
factors in addition to purposes of valuation, like nature of industry under which the
business is working, economic situations, market trends, availability and reliability of
data etc. The empirical data is not available for MSME needs and its valuation, also there
is no private of public organization offering the transactional data relevant for MSME
valuation. It is also practically difficult to preserve or to compile the voluminous
transaction data for MSMEs. This is just an endeavor to match the valuation technique
with specific purpose on logical basis considering the requirements of each purpose.

Specific purpose will have particular requirements to take a decision and different
valuation techniques when applied for different valuation standards will show the
different values. The value is a function of standards to value and it varies when
measured under different standards of valuation. So, an analyst will come at a point
where he will have several values none of which he can say to be incorrect. For example,
fair value from view of safety (based on asset approach) will differ from fair value
arrived based on earnings point of view (earning or income approach). Here, the value
analyst can determine the final value allocating different weights to various techniques
and can conclude or he may conclude with a range of values covering the safety views
as well as earning expectations.

In my views, in MSMEs the valuation requirement is not confined to know the fair value
only. Rather the necessity is to take a decision for specific purpose based on the value so
arrived and this required value is not always the FAIR value. MSMEs are concerned
with “transactional value” which can be arrived if the values under different standards
of value are known. The transaction price is impliedly dependent on not only fair value
but also on investment value or liquidation value also. If the valuation report could not
be used for the purpose it is intended to be used then where is the NEED of valuation?
So, the appraiser may end with determining more than one value each representing the

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value under specific standard of value like fair value or investment value or liquidation
value.

The owner or a proposed buyer is always not interested to know the fair value of
business only, rather more concerned about its relative value to him. The fair value may
not going to serve his purpose with more certainty then the relative value which may be
far away from fair value.

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VALUATION REPORT

Some useful notes

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PREFACE

“What is the business worth?” Although a simple question, determining the value of
any business in today’s economy requires a sophisticated understanding of financial
analysis as well as sound judgment from market and industry experience. The answer
can differ among buyers and depends on several factors such as one’s assumptions
regarding the growth and profitability prospects of the business, one’s assessment of
future market conditions, one’s appetite for assuming risk (or discount rate on expected
future cash flows) and what unique synergies may be brought to the business post-
transaction.

As said by Jay Abrams, realistic picture of valuation is a mathematical exercise that is

always done with less-than-perfect information and which has uncertainty to it. There is
much controversy in the professional literature about many aspects of business
valuation.

Valuation professionals understand that nobody is that good to be able to say with
authority that the value of a business is a specific amount and not any other amount.
Nobody is perfect, and there is no such thing as a perfect valuation. The business person
or seller knows the business more than valuation professional does but a competent
professional knows business valuation techniques better than the businessmen do.
When buyer and seller understand the logic and the process of valuation, then they
discuss and negotiate over assumptions to the model. They do not argue over values.
Instead, they will focus on discussing their differences in assumptions of the sales
growth rate or the profit margin. The value is the end product of the valuation model. If
buyer and seller can agree on assumptions, the value becomes self-evident, i.e., it is a
mechanical calculation, and it is a non issue.

The valuation analyst should establish an understanding with the client, preferably in
writing, regarding the engagement to be performed. If the understanding is oral, the
valuation analyst should document that understanding by appropriate memoranda or
notations in the working papers. Regardless of whether the understanding is written or
oral, the valuation analyst should modify the understanding if he or she encounters
circumstances during the engagement that make it appropriate to modify that
understanding. The understanding with the client reduces the possibility that either the
valuation analyst or the client may misinterpret the needs or expectations of the other
party. The understanding should include, at a minimum, the nature, purpose, and
objective of the valuation engagement, the client’s responsibilities, the valuation
analyst’s responsibilities, the applicable assumptions and limiting conditions, the type of
report to be issued, and the standard of value to be used.

The valuation analyst should, as available and applicable to the valuation engagement,
obtain sufficient non financial information to enable him or her to understand the
business, including its:
• Nature, background, and history
• Infrastructure
• Organizational structure

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• Management team (which may include owner himself, officers, directors, and key
employees)
• Classes of equity/ ownership interests and rights attached thereto
• Products or services, or both
• Economic environment
• Geographical markets
• Industry markets
• Key customers and suppliers
• Competition
• Business risks
• Strategy and future plans
• Governmental or regulatory environment

Unrecorded data and facts having effect on valuation must also be considered. Like
existence of non balance sheet items, contingent liabilities, major law suits, existence of
major frauds within the company, dispute over commercial matters such as intellectual
property rights. If the financials of the business concerns are not audited, the valuation
analyst should so state and should also state that the valuation analyst assumes no
responsibility for the financial information.

Performing a valuation engagement with professional competence involves special

knowledge and skill. A valuation analyst should possess a level of knowledge of
valuation principles and theory and a level of skill in the application of such principles
that will enable him or her to identify, gather, and analyze data, consider and apply
appropriate valuation approaches and methods, and use professional judgment in
developing the estimate of value (whether a single amount or a range).

In estimating a value for a business, the appraiser should apply a methodology that is
appropriate in light of the nature, facts and circumstances of the business and should
use reasonable data and market inputs, assumptions and estimates. Because of the
uncertainties inherent in estimating a value for business, a degree of caution should be
applied in exercising judgment and making the necessary estimates. Business appraiser
does not always rely on one method alone and it may also be appropriate to consider the
outcomes from using several different methods.

It must be note that the valuation being estimation, it can be challenged and therefore, a
good appraisal is a defensible appraisal. This means that the potential challenges of
opposing parties are recognized and addressed within the appraisal itself, if possible.
The appraiser must provide adequate documentation and discussion to support the
opinion. The more structure that is added to the valuation report, the more difficult it
becomes for someone to tear it apart. It’s not the bottom line number you’re paying for,
but the detail behind it.

Valuation is an art more than a science and is an interdisciplinary study drawing upon
laws, economics, finance, accounting and investment. It is rash to attempt any valuation
adopting so-called industry/ sector norms in ignorance of the fundamental theoretical
framework of valuation.

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VALUATION PROCEDURES

Valuation procedures can generally be classified into the following areas:

• Understand the purpose of the engagement

• What is the intended use of the valuation Who are proposed users of the value
• Determine the premise of value
• Determine the standard of value
• Determine the proposed users of the value
• Determine the interest to be valued (whether it is a minority interest, is there any
restriction on marketability or is there reasonable market available etc)
• Ascertain whether discounts and/or premiums are to be considered
• Compile information about the company, about the industry and economy
• Analyze the company’s financial information
• Consider all approaches of value and select the most appropriate
• Apply the most appropriate technique/s amongst the selected approaches
• Reconcile the values and derive a conclusive value
• Apply discounts and premiums, if applicable and finalize the value or a range of
value
• Frame the opinion on valuation

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THE DATA COLLECTION PROCESS

The purpose for conducting valuations will determine informational needs. Each
purpose adds or deletes bits of information that may be important to the overall
valuation project. Information must be collected, analyzed, and included.

It may be appropriate for the valuation analyst to obtain written representations

regarding information that the management provides to the valuation analyst for
purposes of his or her performing the valuation engagement. The decision whether to
obtain a representation letter is a matter of judgment for the valuation analyst.

The appraiser should collect the relevant data which can help him or her to know the
basic history of the enterprise and the business itself. Appraiser should go through the
primary understanding between the owners, if there are more than one and relationship
between different stake holder. In MSMEs, generally the owner himself controls the
business and he can provide the best data about business history. The data generated for
internal control and MIS can be helpful to know the financial and internal strength of
the Company. Appraiser should obtain other information relevant to subjective issues
affecting possible present or future worth—details of past or pending lawsuits,
occupationally related injuries, copyrights or patents, deeds or leases, past and present
product/service pricing strategies, wholesale price catalogs, and so on (in other words,
all legal and/or informal operating documents)—to include a picture of how the
company functioned or functions from an internal point of view. If there is any
document specifying the valuation procedure or method to use under mentioned
situations or purposes, the appraiser should take it in to consideration.

In addition to analyze the data for knowing the trend in the business, and to derive the
basis for useful forecasting in the process of valuation, the appraiser should review the
collected data and should conduct in-depth interviews with owners that are sufficient to
fully understand how businesses have been operated, including specific problems
encountered and solutions implemented, to determine ‘‘visions’’ of owners and to
outline a ‘‘generic’’ resume of special skills and traits believed necessary to successfully
operate the businesses.

A “Valuation Information Request List” is prepared, keeping valuation requirements of

MSME unit in mind. The list though not exhaustive can serve as a fair guide for
compilation of information on a way to valuation.

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ENTERPRISE NAME :__________________________________________________________

VALUATION INFORMATION REQUEST LIST

NOTE: This is a generalized information request. Some items may not pertain to your business,
and some items may not be readily available to you. In such cases, please indicate N/A or notify
us if other arrangements can be made to obtain the data. We may call for other information for
detail analysis of these data provided by you.

The objective of this information request is to provide us with transactional and

operational information that will aid in developing the value of business for the purpose
specified by you herein below:

We will keep the information confidential.

PURPOSE OF THE APPRAISAL AND DESCRIPTION OF TRANSACTION

Describe the activity or transaction creating need for valuation:

BASICs FOR VALUATION

• Nature of Valuation (please specify)
(Ownership value or business value or specific interest value)
• Date of the valuation

A. Financial Information

1. Financial statements for fiscal years ending (for immediately past five years)
2. Interim financial statements for the year-to-date (Date of valuation or for the
period up to end of last month / quarter)
3. Monthly figures of sales and inventory for past two-three years.
4. Financial projections, if any, for the current year and next three to five years.
(Include any prepared budgets and/or business plans)
5. MIS and bank reconciliations statements.

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6. Income Tax Returns and supporting statements/ documents for fiscal years
ending FIVE YEARS.
7. Explanation of significant nonrecurring and/or non operating items appearing
on the financial statements in any above fiscal year if not detailed in footnotes.
8. Creditors aging schedule or summary as of Date of valuation.
9. Debtors aging schedule or summary and management’s general evaluation of
quality and credit risk as of Date of valuation.
10. Any change in accounting practices or any change in treatment of major item.
Like change of inventory keeping from FIFO to LIFO or change in depreciation
method from SLM to WDV etc, for each of the past five fiscal years?
11. Fixed assets and depreciation schedule as of Date of valuation.
12. List of working capital components and estimated realizable value
13. Capital structure with details regarding ownership capital and long term- short
term finances. Payment schedules of loans, LCs and other liabilities, terms of
finance, if any and/or debt agreement(s) as of Date of valuation.
14. Expense classification: fixed/semi variable/variable.
15. Details of contingent and unrecorded liabilities and assets with justification

B. Products, Operations and Markets

1. A brief note on “nature of activities and business”

2. List of major products, services, or product lines of the Company and copies of
marketing materials including sales brochures, catalogs, or other descriptive
sales materials.
3. Product mix, input-output ratio, by product, sale percentage to total sales and
profit/sales ratio
4. Unit volume analyses for existing product lines for the past five years.
5. Details of patented or licensed products with rights and conditions of usage
6. Management perception about intangible assets like copy rights, trade mark,
research activities, highly trained staff, employee contracts etc.
7. The major products or services added in the last two years (or anticipated) and
current expectations as to sales potential.
8. The new products under development with expectations as to potential.
9. The detail of top 10 customers, indicating sales (or sales upon which
commissions were earned) and unit volumes for each of the past three fiscal
years.
10. The major accounts gained (lost) in the last year indicating actual sales in the
current year and beyond.
11. List of top 10 suppliers (or all accounting for substantial % of total purchases)
12. Identify product(s) on which the Company is single-sourced, or suppliers on
which the business is otherwise dependent.
13. The major competitors (full name, location, size, and estimated market share of
each). Description of competition to examine price-quality-service factors in
products/services of competitors in light of those prevailing in businesses being
valued.
14. The trade associations’ memberships.
15. The majority industry publications of interest to management.

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16. Name and description of the operations of all major OWN operating entities,
whether divisions, subsidiaries, or departments.

D. Infrastructures

1. The location, age, and approximate size of each facility. Please provide
production capacity or estimate business volume by major facility/ factory
unit/s.
2. Details of the ownership of each facility and other major fixed assets. If leased or
rented, include name of lessor and lease terms or agreements.
If owned by the enterprise, include:
• Date purchased
• Purchase price
• Recent value
• Insurance coverage
• Book values (gross value as well as depreciation)

E. Personnel

1. Current organization chart.

2. The number of employees (distinguish fulltime and part time) at year-end for the
last three years and attrition ratio.
3. List of employees specifying their age, position, experience within the enterprise,
and remuneration status including the bio-data of management and key
employees.

F. Business / Enterprise Documents and Records

1. Proprietary deed, if any or partnership deed or Memorandum and Articles of

Association or any other formation or regulatory documents
2. The minutes of Board of Directors and shareholders meetings for at least the
most recent three years. Or understandings between the partners or minutes of
business meetings.
3. Business registration details like, PAN, VAT Number, Excise code or Service tax
number etc.
4. A summary of major covenants or agreements binding on the enterprise e.g.,
capital leases, vendor or agency contract, employment contracts, service
contracts, product warranties, restrictive agreements etc.
5. A description of any pending litigation including parties involved, date of filing,
description and nature of the lawsuit or claim, current status, and expected
outcome and financial impact.
6. Details of sister concerns or subsidiaries
7. Details of major changes or movements in ownership

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 INDUSTRY RESEARCH FORM

The purpose is to decide the Comparable or Peer Company/ies and collect its Data [like
name, comparable value basis, period of standings, group data, turn over and operation
figures (PAT, EBIDTA, NOPLAT etc) , capital structure and other relevant data based on
specific nature of the company being valued]

Industry / Sector Name:

Trade Associations in this Industry:

Leading Public Companies in this Industry:

Trade publications in this industry:

Proposed Comparable Firms:

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ILLUSTRATIVE LIST OF ASSUMPTIONS, LIMITING CONDITIONS AND
DISCLAIMERS FOR A BUSINESS VALUATION

The valuation report should include a list of assumptions and limiting conditions under
which the valuation task is performed. This appendix includes an illustrative list of
assumptions and limiting conditions that may apply to a business valuation.

Illustrative List of Assumptions and Limiting Conditions

1. The conclusion of value as reported herein this report is valid only for the stated
purpose as of the date of the valuation.

2. We have relied on the financial statements and other related information

provided by [ABC Company] or its representatives, in the course of our
valuation process, as fully and correctly reflecting the enterprise’s business
conditions and operating results for the respective periods, except as specifically
noted herein. We have not audited, reviewed, or verified the correctness of the
financial information provided to us and, accordingly, we express no opinion or
any other form of assurance on this information.

3. Public information and industry and statistical information have been obtained
from sources we believe to be reliable. However, we make no representation as
to the accuracy or completeness of such information and have performed no
procedures to corroborate the information.

4. We do not provide assurance on the achievability of the results forecasted by

[ABC Company] because events and circumstances frequently do not occur as
expected; differences between actual and expected results may be material; and
achievement of the forecasted results is dependent on actions, plans, and
assumptions of management.

5. The conclusion of value arrived at herein is based on the assumption that the
current level of management expertise and effectiveness would continue to be
maintained, and that the character and integrity of the enterprise through any
sale, reorganization, exchange, or diminution of the owners’ participation would
not be materially or significantly changed.

6. This report and the conclusion of value arrived at herein are for the sole and
specific purposes as noted herein. It may not be used for any other purpose or by
any other party for any purpose. Furthermore the report and conclusion of value
are not intended by the author and should not be construed by the reader to be
investment advice in any manner whatsoever. The conclusion of value
represents our opinion based on the information furnished by [ABC Company]
and other sources.

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7. Neither all nor any part of the contents of this report (especially the conclusion of
value, should be disseminated to the public through any means of
communication without our prior written consent and approval.

8. No change of any item in this appraisal report shall be made by anyone other
than us and we shall have no responsibility for any such unauthorized change.

9. Unless otherwise stated, no effort has been made to determine the possible effect,
if any, on the subject business due to future change in state, or local legislation.

10. If prospective financial information approved by management has been used in

our work, we have not examined or compiled the prospective financial
information and therefore, do not express an audit opinion or any other form of
assurance on the prospective financial information or the related assumptions.
Events and circumstances frequently do not occur as expected and there will
usually be differences between prospective financial information and actual
results, and those differences may be material.

11. We have conducted interviews with the current management of [ABC Company]
concerning the past, present, and prospective operating results of the company.

12. Except as noted, we have relied on the representations of the owners,

management, and other third parties concerning the value and useful condition
of all equipment, properties, investments used in the business, and any other
assets or liabilities, except as specifically stated to the contrary in this report. The
assets and investments are physically verified by us to the extent available and
for others we have relied on the certification provided by the management and
experts. We have not attempted to confirm whether or not all assets of the
business are free and clear of liens and encumbrances or that the entity has good
title to all assets.

13. The valuation contemplates facts and conditions existing as of the valuation date.
Events and conditions occurring after that date have not been considered, and
we have no obligation to update our report or calculation of value for such
events, happenings and conditions. Also, we have no obligation to update the
report or the calculation of value for information that comes to our attention after
the date of the valuation report.

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CONTENTS OF A COMPREHENSIVE BUSINESS APPRAISAL REPORT

A detailed valuation report should include the followings:

o Identity of the client

o Purpose and intended use of the valuation
o Intended users of the valuation
o What is being appraised? (Ownership, Business or Minority sharing or specific
interest value)
o Valuation date
o Valuation report date
o Type of report issued
o Applicable premise of value
o Applicable standard of value
o Sources of information used in the valuation engagement
o Assumptions and limiting conditions of the valuation engagement
o The scope of work or data available for analysis including any restrictions or
limitations
o If the work of a specialist is used in the valuation, a description of how the
specialist’s work is used, and the level of responsibility, if any, the valuation
analyst is assuming for the specialist’s work (like valuation of property, jewellary,
inventory, Employees’ retirement benefits, brand value etc, if such are valued by
other/s)
o An economic analysis and industry section
o A financial analysis of the subject company
o The valuation approaches and methods used
o Disclosure of subsequent events (if feel appropriate)
o A section summarizing the reconciliation of the estimates and the conclusion of
value
o Application of discounts or premiums, if any with justification.
o Appendices or exhibits may be used for required information or information that
supplements the summary report. Often, the assumptions, limiting conditions, and
the valuation analyst’s representation are provided in appendices to the report.

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SOME OF THE MOST COMMON ERRORS IN BUSINESS VALUATION

A valuation professional must rely upon experience and reasoned, informed judgment
in conducting a valuation and preparing a credible valuation report. The number of
inputs, assumptions, and calculations that the appraiser must make in the process gives
rise to potential errors that could have an adverse impact upon the indication of value
and the credibility of the valuation report and the appraiser. The valuation professional
must be diligent in ensuring that the valuation report is free from errors that may
compromise its integrity.

The following are some of the most deadly errors that the valuation professional may
commit in preparing a valuation.

¾ Incorrect adjustments to financial statements

¾ Improperly developed financial forecasts
¾ Not matching the benefit stream to the capitalization or discount rate
¾ Errors in estimating risks specific to a particular business
¾ Failing to show how the appraiser arrived at his or her conclusion
¾ Developing a value conclusion inconsistent with the standard of value and purpose
of the appraisal
¾ Errors concerning valuation discounts for fractional interests (lack of control and
lack of marketability)

These are discussed below:

Incorrect Adjustments to the Income Statement and Balance Sheet

Incorrect adjustments to the income statement and balance sheet may produce an
unreliable indication of value. Failure to remove property associated expenses from the
financial statements and failure to replace this with a market rate of rent is a common
adjustment error made. Many times the loans are received from family, relatives and
friends, the interests on which are not charged as per the prevailing rates in the market.
Salaries of management is one of the area which the closely hold businesses commonly
use for adjusting the profit to save taxes. Personal expenses are also very common tom
charge in business to evade the taxes. Non-recurring or abnormal items require special
attention of the appraiser. These factors must be adjusted to make the financials
normalized. The errors may result in significant disparities in value of the subject
company.

In addition, adjustments made to the financial statement must be on a comparable basis

as the interest being valued. In the case of a minority interest valuation, a minority
shareholder would not have the ability to effect control decisions related to financial
statement adjustments (i.e. management compensation or discretionary expenses). If the
cash flows are adjusted to reflect control decision, the value estimate must be reconciled
to a minority basis using a lack of control discount.

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Ungrounded Forecasting of Earnings
Forecasting earnings is likely the most important part of the income approach to valuing
a business; since the value is driven by the firm’s anticipated future earnings. Many
times discretionary cash flow is consider due to the facts that the most of small
businesses calculated income in such a way that income taxes are minimized. Many
companies operate at low net incomes (or even negative net incomes), while they may
actually be highly profitable. Care must be taken to ensure the reliability of the data.

Using unrealistically high growth assumptions may result in an earnings stream that is
overly optimistic and that produces an indication of value that is too high when
discounted or capitalized. Though a company may be able to grow its earnings (or
revenues for that matter) by an above trend growth rate in the short-term, this high
growth rate cannot be maintained in perpetuity as the company’s earnings would
eventually surpass the size of the nation’s economy.

Therefore, the appraiser must be cognizant of the range of growth rates that may be
applicable to the subject company’s future earnings and use this range to bound the
appropriate growth rate applicable to future earnings. The appraiser may use an above
trend growth rate for the first years of a multi-period forecast but must then use a long-
term sustainable growth rate in perpetuity that is bound by a reasonable estimate of the
long-term sustainable growth of our economy (usually as measured by GDP growth).

Likewise, inconsistent assumptions regarding capital expenditures and depreciation

may result in forecasts under which fixed assets are depreciated at a rate faster than
which they are replaced or actually depleted. This may also skew the value indication
and discredit the entire valuation. It is generally accepted that the projected capital
expenditures and depreciation are best estimated based on a proportional relationship
between the two. For a stable, mature business, the valuation professional may examine
the historical relationship between capital expenditures and depreciation over the last
five years or so. The prevailing market conditions and industry trend should be
considered while forecasting the revenue and expenses. Applicable tax rate should also
be applied to consider the post tax earnings or cash flow.

‘‘Forecasting is not a respectable intellectual activity,

and not worthwhile beyond the shortest of periods.’’
- Peter Drucker, management guru

Discount Rate & Income Stream Mismatch

Capitalizing or discounting a net cash flow to equity income or owners’ profit stream by
the firm’s weighted average cost of capital (WACC) would produce an unreliable
indication of value. Likewise, using a net cash flow to equity rate to discount or
capitalize net cash flow to invested capital results in an incorrect value. This mismatch
of the discount (capitalization) rate and income stream is a glaring error in business
valuations. Failure to match these rates and benefit streams results in an erroneous
value conclusion, which may tarnish the reputation of the valuation professional. The

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client may also be severely disadvantaged by the disparity in value resulting from the
mismatch of rate and income stream.

Specific Company Risk Premium Estimation

The specific company risk premium is an important part in the development of an
appropriate discount rate/capitalization rate for a specific investment. This specific
company risk premium reflects the risks associated with the particular business’s
operations, finances, industry position, etc. There is no empirical data available in India
on the specific company risk premium. Estimating this risk premium is at the sole
discretion of the valuation professional and is typically based on the appraiser’s
experience and informed judgment. Unreasonable assumptions regarding the specific
company risk premium may result in a discount rate that is too low or too high for the
particular investment being valued. In turn, this could lead to significant valuation
errors when determining the value of a specific asset.

Given the possible arbitrary selection of this premium, there is a need for a quantifiable
analysis for the specific company risk premium to further strengthen business
valuations and to limit the appraiser’s exposure to attacks on credibility and results.
This gives rise to a factor analysis for supporting the selection of a specific company risk
premium. Whether valuation professionals use a factor analysis or another method of
selecting an appropriate premium, great care and diligence must be taken to select and
defend the specific company risk premium applied in a valuation.

Inability to Replicate the Valuation

It is crucial that the valuation professional’s valuation be clearly written and fully
explained so that the value estimate or conclusions may be replicated by a reader or
third party that is not part of the valuation process. The failure to clearly delineate the
reasoning, assumptions, and calculations made to arrive at an indication of value could
lead a reader to believe that the values are arbitrary or that the appraiser engaged in
“fuzzy math” to reach a specific value. The failure of the appraiser to thoroughly
discuss the assumptions, approaches, and procedures used to develop the indication of
value is a significant error in the preparation of a valuation report. The importance of
the ability to replicate the valuation should not be underestimated. A skilled appraiser
critiquing the report would likely be able to easily discredit the valuation and the
appraiser based on this issue. This not only fails a fundamental of the business
valuation profession but also fails the client by compromising the integrity of the
valuation report and the valuation conclusions.

Incorrect Value Conclusion for the Standard of Value

Upon engagement, the valuation professional identifies the standard of value that will
be used in developing an indication of value. The valuation professional must ensure
that the valuation process reaches a value conclusion consistent with the standard of
value selected at the outset of the process. An error in estimating an indication of value
that is not consistent with the selected standard of value may significantly impact the
value conclusion. The valuation professional must ensure that the value estimate
presented in the valuation report matches the standard of value if the report and its

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conclusions are to be meaningful and credible. Erring in this aspect will totally discredit
the valuation.

Application of Appropriate Discounts

Once the valuation professional has arrived at indications of value using the selected
approaches and methods, it may be appropriate to apply discounts for lack of control
and lack of marketability. There is no specific formula or set of guidelines for
determining the appropriate discount applicable to a specific investment or company.
Therefore, the appraiser must use reasoned, informed judgment in determining the
appropriate level of these discounts. Given that discounts for lack of control and
marketability may range from 10%-50%, there is a great deal of latitude for applying
discounts that are too high or too low, leading to potential overvaluation or
undervaluation of the subject interest.

In order for the valuation to be credible and withstand scrutiny, the valuation
professional should clearly explain the reasoning for the amount of the ultimate
discounts selected. Consideration of a number of factors impacting each discount
would be helpful in providing a solid foundation for the selection of the appropriate
discount. Failure to provide enough reasoning or explanation for the selection of
discounts applied to a value estimate makes replication of the value conclusion nearly
impossible. These errors and failures by the valuation professional compromise the
valuation and render the value conclusions irrelevant.

The errors discussed here may have a significant adverse impact upon the indication of
value produced in the valuation report. To be sure, these errors, if made, may have a
detrimental effect upon the credibility of the valuation, and for that matter, of the
valuation professional or M&A professional involved. To ensure a meaningful and
credible valuation, the valuation professional must use experience and reasoned,
informed judgment in the valuation process as well as be cognizant of the potential
errors that may be inadvertently made and the impact such errors may have upon the
valuation.

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INTERNATIONAL GLOSSARY OF BUSINESS VALUATION TERMS

To enhance and sustain the quality of business valuations for the benefit of the
profession and its clientele, the below identified societies and organizations have
adopted the definitions for the terms included in this glossary.

The performance of business valuation services requires a high degree of skill and
imposes upon the valuation professional a duty to communicate the valuation process
and conclusion in a manner that is clear and not misleading. This duty is advanced
through the use of terms whose meanings are clearly established and consistently
applied throughout the profession.

If, in the opinion of the business valuation professional, one or more of these terms
needs to be used in a manner that materially departs from the enclosed definitions, it is
recommended that the term be defined as used within that valuation engagement.

This glossary has been developed to provide guidance to business valuation

practitioners by further memorializing the body of knowledge that constitutes the
competent and careful determination of value and, more particularly, the
communication of how that value was determined.

Departure from this glossary is not intended to provide a basis for civil liability and
should not be presumed to create evidence that any duty has been breached.

American Institute of Certified Public Accountants

American Society of Appraisers
Canadian Institute of Chartered Business Valuators
National Association of Certified Valuation Analysts
The Institute of Business Appraisers

Adjusted Book Value Method—a method within the asset approach whereby all assets
and liabilities (including off-balance sheet, intangible, and contingent) are adjusted to
their fair market values (NOTE: In Canada on a going concern basis).
Adjusted Net Asset Method—see Adjusted Book Value Method.

Appraisal—see Valuation.

Appraisal Approach—see Valuation Approach.

Appraisal Date—see Valuation Date.

Appraisal Method—see Valuation Method.

Appraisal Procedure—see Valuation Procedure.

Arbitrage Pricing Theory—a multivariate model for estimating the cost of equity
capital, which incorporates several systematic risk factors.

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Asset (Asset-Based) Approach—a general way of 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.

Beta—a measure of systematic risk of a stock; the tendency of a stock’s price to correlate
with changes in a specific index.

Blockage Discount—an amount or percentage deducted from the current market price
of a publicly traded stock to reflect the decrease in the per share value of a block of stock
that is of a size that could not be sold in a reasonable period of time given normal
trading volume.

Book Value—see Net Book Value.

Business—see Business Enterprise.

Business Enterprise—a commercial, industrial, service, or investment entity (or a

combination thereof) pursuing an economic activity.

Business Risk—the degree of uncertainty of realizing expected future returns of the

business resulting from factors other than financial leverage. See Financial Risk.

Business Valuation—the act or process of determining the value of a business

enterprise or ownership interest therein.

Capital Asset Pricing Model (CAPM)—a model in which the cost of capital for any
stock or portfolio of stocks equals a risk-free rate plus a risk premium that is
proportionate to the systematic risk of the stock or portfolio.

Capitalization—a conversion of a single period of economic benefits into value.

Capitalization Factor—any multiple or divisor used to convert anticipated economic

benefits of a single period into value.

Capitalization of Earnings Method—a method within the income approach whereby

economic benefits for a representative single period are converted to value through
division by a capitalization rate.

Capitalization Rate—any divisor (usually expressed as a percentage) used to convert

anticipated economic benefits of a single period into value.

Capital Structure—the composition of the invested capital of a business enterprise, the

mix of debt and equity financing.

Cash Flow—cash that is generated over a period of time by an asset, group of assets, or
business enterprise. It may be used in a general sense to encompass various levels of
specifically defined cash flows. When the term is used, it should be supplemented by a
qualifier (for example, “discretionary” or “operating”) and a specific definition in the
given valuation context.

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Common Size Statements—financial statements in which each line is expressed as a
percentage of the total. On the balance sheet, each line item is shown as a percentage of
total assets, and on the income statement, each item is expressed as a percentage of sales.

Control—the power to direct the management and policies of a business enterprise.

Control Premium—an amount or a percentage by which the pro rata value of a

controlling interest exceeds the pro rata value of a non-controlling interest in a business
enterprise, to reflect the power of control.

Cost Approach—a general way of determining a value indication of an individual asset

by quantifying the amount of money required to replace the future service
capability of that asset.

Cost of Capital—the expected rate of return that the market requires in order to attract
funds to a particular investment.

Debt-Free—we discourage the use of this term. See Invested Capital.

Discount for Lack of Control—an amount or percentage deducted from the pro rata
share of value of 100 percent of an equity interest in a business to reflect the absence of
some or all of the powers of control.

Discount for Lack of Marketability—an amount or percentage deducted from the value
of an ownership interest to reflect the relative absence of marketability.

Discount for Lack of Voting Rights—an amount or percentage deducted from the per
share value of a minority interest voting share to reflect the absence of voting rights.

Discount Rate—a rate of return used to convert a future monetary sum into present
value.

Discounted Cash Flow Method—a method within the income approach whereby the
present value of future expected net cash flows is calculated using a discount rate.

Discounted Future Earnings Method—a method within the income approach whereby
the present value of future expected economic benefits is calculated using a discount
rate.

Economic Benefits—inflows such as revenues, net income, net cash flows, etc.

Economic Life—the period of time over which property may generate economic
benefits.

Effective Date—see Valuation Date.

Enterprise—see Business Enterprise.

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Equity—the owner’s interest in property after deduction of all liabilities.

Equity Net Cash Flows—those cash flows available to pay out to equity holders (in the
form of dividends) after funding operations of the business enterprise, making
necessary capital investments, and increasing or decreasing debt financing.

Equity Risk Premium—a rate of return added to a risk- free rate to reflect the additional
risk of equity instruments over risk free instruments (a component of the cost of equity
capital or equity discount rate).

Excess Earnings—that amount of anticipated economic benefits that exceeds an

appropriate rate of return on the value of a selected asset base (often net tangible assets)
used to generate those anticipated economic benefits.

Excess Earnings Method—a specific way of determining a value indication of a

business, business ownership interest, or security determined as the sum of a) the value
of the assets derived by capitalizing excess earnings and b) the value of the selected
asset base. Also frequently used to value intangible assets. See Excess Earnings.

Fair Market Value—the price, expressed in terms of cash equivalents, at which property
would change hands between a hypothetical willing and able buyer and a hypothetical
willing and able seller, acting at arm’s length in an open and unrestricted market, when
neither is under compulsion to buy or sell and when both have reasonable knowledge of
the relevant facts. (NOTE: In Canada, the term “price” should be replaced with the term
“highest price.”)

Fairness Opinion—an opinion as to whether or not the consideration in a transaction is

fair from a financial point of view.

Financial Risk—the degree of uncertainty of realizing expected future returns of the

business resulting from financial leverage. See Business Risk.

Forced Liquidation Value—liquidation value, at which the asset or assets are sold as
quickly as possible, such as at an auction.

Free Cash Flows—we discourage the use of this term. See Net Cash Flows.

Going Concern—an ongoing operating business enterprise.

Going Concern Value—the value of a business enterprise that is expected to continue to

operate into the future. The intangible elements of Going Concern Value result from
factors such as having a trained work force, an operational plant, and the necessary
licenses, systems, and procedures in place.

Goodwill—that intangible asset arising as a result of name, reputation, customer

loyalty, location, products, and similar factors not separately identified.

Goodwill Value—the value attributable to goodwill.

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Guideline Public Company Method—a method within the market approach whereby
market multiples are derived from market prices of stocks of companies that are
engaged in the same or similar lines of business, and that are actively traded on a free
and open market.

Income (Income -Based) Approach—a general way of determining a value indication of

a business, business ownership interest, security, or intangible asset using one or more
methods that convert anticipated economic benefits into a present single amount.

Intangible Assets—non-physical assets such as franchises, trademarks, patents,

copyrights, goodwill, equities, mineral rights, securities and contracts (as distinguished
from physical assets) that grant rights and privileges, and have value for the owner.

Internal Rate of Return—a discount rate at which the present value of the future cash
flows of the investment equals the cost of the investment.

Intrinsic Value—the value that an investor considers, on the basis of an evaluation or

available facts, to be the “true” or “real” value that will become the market value when
other investors reach the same conclusion. When the term applies to options, it is the
difference between the exercise price or strike price of an option and the market value of
the underlying security.

Invested Capital—the sum of equity and debt in a business enterprise. Debt is typically
a) all interest-bearing debt or b) long-term interest-bearing debt. When the term is used,
it should be supplemented by a specific definition in the given valuation context.

Invested Capital Net Cash Flows—those cash flows available to pay out to equity
holders (in the form of dividends) and debt investors (in the form of principal and
interest) after funding operations of the business enterprise and making necessary
capital investments.

Investment Risk—the degree of uncertainty as to the realization of expected returns.

Investment Value—the value to a particular investor based on individual investment

requirements and expectations. (NOTE: in Canada, the term used is “Value to the
Owner.”)

Key Person Discount—an amount or percentage deducted from the value of an

ownership interest to reflect the reduction in value resulting from the actual or potential
loss of a key person in a business enterprise.

Levered Beta—the beta reflecting a capital structure that includes debt.

Limited Appraisal—the act or process of determining the value of a business, business

ownership interest, security, or intangible asset with limitations in analyses, procedures,
or scope.

Liquidity—the ability to quickly convert property to cash or pay a liability.

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Liquidation Value—the net amount that would be realized if the business is terminated
and the assets are sold piecemeal. Liquidation can be either “orderly” or “forced.”

Majority Control—the degree of control provided by a majority position.

Majority Interest—an ownership interest greater than 50 percent of the voting interest
in a business enterprise.

Market (Market-Based) Approach—a general way of determining a value indication of

a business, business ownership interest, security, or intangible asset by using one or
more methods that compare the subject to similar businesses, business ownership
interests, securities, or intangible assets that have been sold.

Market Capitalization of Equity—the share price of a publicly traded stock multiplied

by the number of shares outstanding.

Market Capitalization of Invested Capital—the market capitalization of equity plus the

market value of the debt component of invested capital.

Market Multiple—the market value of a company’s stock or invested capital divided by

a company measure (such as economic benefits, number of customers).

Marketability—the ability to quickly convert property to cash at minimal cost.

Marketability Discount—see Discount for Lack of Marketability.

Merger and Acquisition Method—a method within the market approach whereby
pricing multiples are derived from transactions of significant interests in companies
engaged in the same or similar lines of business.

Mid-Year Discounting—a convention used in the Discounted Future Earnings Method

that reflects economic benefits being generated at midyear, approximating the effect of
economic benefits being generated evenly throughout the year.

Minority Discount—a discount for lack of control applicable to a minority interest.

Minority Interest—an ownership interest less than 50 percent of the voting interest in a
business enterprise.

Multiple—the inverse of the capitalization rate.

Net Book Value—with respect to a business enterprise, the difference between total
assets (net of accumulated depreciation, depletion, and amortization) and total liabilities
as they appear on the balance sheet (synonymous with Shareholder’s Equity). With
respect to a specific asset, the capitalized cost less accumulated amortization or
depreciation as it appears on the books of account of the business enterprise.

Net Cash Flows—when the term is used, it should be supplemented by a qualifier. See
Equity Net Cash Flows and Invested Capital Net Cash Flows.

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Net Present Value—the value, as of a specified date, of future cash inflows less all cash
outflows (including the cost of investment) calculated using an appropriate discount
rate.

Net Tangible Asset Value—the value of the business enterprise’s tangible assets
(excluding excess assets and non-operating assets) minus the value of its liabilities.

Non-Operating Assets—assets not necessary to ongoing operations of the business

enterprise. (NOTE: in Canada, the term used is “Redundant Assets.”)

Normalized Earnings—economic benefits adjusted for nonrecurring, non economic, or

other unusual items to eliminate anomalies and/or facilitate comparisons.

Normalized Financial Statements—financial statements adjusted for non operating

assets and liabilities and/or for nonrecurring, non economic, or other unusual items to
eliminate anomalies and/or facilitate comparisons.

Orderly Liquidation Value—liquidation value at which the asset or assets are sold over
a reasonable period of time to maximize proceeds received.

Premise of Value—an assumption regarding the most likely set of transactional

circumstances that may be applicable to the subject valuation; e.g. going concern,
liquidation.

Present Value—the value, as of a specified date, of future economic benefits and/or

proceeds from sale, calculated using an appropriate discount rate.

Portfolio Discount—an amount or percentage deducted from the value of a business

enterprise to reflect the fact that it owns dissimilar operations or assets that do not fit
well together.

Price/Earnings Multiple—the price of a share of stock divided by its earnings per share.

Rate of Return—an amount of income (loss) and/or change in value realized or

anticipated on an investment, expressed as a percentage of that investment.

Redundant Assets—see Non-Operating Assets.

Report Date—the date conclusions are transmitted to the client.

Replacement Cost New—the current cost of a similar new property having the nearest
equivalent utility to the property being valued.

Reproduction Cost New—the current cost of an identical new property.

Required Rate of Return—the minimum rate of return acceptable by investors before

they will commit money to an investment at a given level of risk.

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Residual Value—the value as of the end of the discrete projection period in a
discounted future earnings model.

Return on Equity—the amount, expressed as a percentage, earned on a company’s

common equity for a given period.

Return on Investment—see Return on Invested Capital and Return on Equity.

Return on Invested Capital—the amount, expressed as a percentage, earned on a

company’s total capital for a given period.

Risk-Free Rate—the rate of return available in the market on an investment free of

default risk.

Risk Premium—a rate of return added to a risk-free rate to reflect risk.

Rule of Thumb—a mathematical formula developed from the relationship between

price and certain variables based on experience, observation, hearsay, or a combination
of these; usually industry specific.

Special Interest Purchasers—acquirers who believe they can enjoy post-acquisition

economies of scale, synergies, or strategic advantages by combining the acquired
business interest with their own.

Standard of Value—the identification of the type of value being used in a specific

engagement; e.g. fair market value, fair value, investment value.

Sustaining Capital Reinvestment—the periodic capital outlay required to maintain

operations at existing levels, net of the tax shield available from such outlays.

Systematic Risk—the risk that is common to all risky securities and cannot be
eliminated through diversification. The measure of systematic risk in stocks is the beta
coefficient.

Tangible Assets—physical assets (such as cash, accounts receivable, inventory,

property, plant and equipment, etc.).

Terminal Value—see Residual Value.

Transaction Method—see Merger and Acquisition Method.

Unlevered Beta—the beta reflecting a capital structure without debt.

Unsystematic Risk—the risk specific to an individual security that can be avoided

through diversification.

Valuation—the act or process of determining the value of a business, business

ownership interest, security, or intangible asset.

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Valuation Approach—a general way of determining a value indication of a business,
business ownership interest, security, or intangible asset using one or more valuation
methods.

Valuation Date—the specific point in time as of which the valuator’s opinion of value
applies (also referred to as “Effective Date” or “Appraisal Date”).

Valuation Method—within approaches, a specific way to determine value.

Valuation Procedure—the act, manner, and technique of performing the steps of an

appraisal method.

Valuation Ratio—a fraction in which a value or price serves as the numerator and
financial, operating, or physical data serves as the denominator.

Value to the Owner—see Investment Value.

Voting Control—de jure control of a business enterprise.

Weighted Average Cost of Capital (WACC)—the cost of capital (discount rate)

determined by the weighted average, at market value, of the cost of all financing sources
in the business enterprise’s capital structure.

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As per “A basic guide for Valuing a Company” – 2nd edition by Wilbur M. Yegge, John Wiley & Sons, Inc

Multiplier for using with Excess earnings under “Excess earnings capitalization Method”

124
PURPOSE AND RELEVANT STANDARD OF VALUATION
The overall relation between the purpose and standard of value is summarized as
below:
Purpose giving
rise to
valuation need
(1) Relative strategy
(a) Addition of Partner/s
(b) Business Sell / Purchase
Agreement
(c) IPO
(d) Mergers, Acquisitions,
Takeovers
(2) Investments
(a) Small business purchase
(b) Private equity funding/
venture capital finance
(c) Business financing for
new projects/ expansion
(3) Value added management/ planning
(a) Raising funds for
expansion or new projects
Relevant Standard of Value
Existing stake holder/s Valuation is called by
proposed stake holders
Fair value, Investment value,
(Liquidation value in Fair value
specific case)
(investment value useful
for negotiation)
Fair value, Investment value
Liquidation value (Fair value useful for
negotiation)
Fair value, Fair value,
Investment value Investment value
Fair value, Investment value,
Liquidation value Fair value
(investment value useful
for negotiation)
Investment value
(Fair value useful for
negotiation)
Investment value,
Fair value
Fair value,
Liquidation value
Fair value,
Investment value,
(Liquidation value to
assure the fund safety of
financier)
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(b) Restructuring the Fair value
business/ divestiture

(c) Goodwill impairment Fair value

(d) Allocation of Purchase Fair value

price

(e) Retirement of partner or Fair value,

dissolution of partnership Liquidation value
or succession planning

(f) Financial reporting Fair value

(g) Frequent progress Fair value,

measure Liquidation value

(4) Other Purposes

(a) Ownership issues Fair value Fair value

(b) Litigation issues

involving lost profits or Fair value Fair value
economic damages

(c) Family issues Fair value

Liquidation value

126
PURPOSE AND APPROPRIATE TECHNIQUE/S OF VALUATION

The overall relation between the purpose and appropriate valuation technique/s is
summarized as below:

Relevant Valuation Technique/s

Purpose giving
rise to
valuation need Existing stake holder/s Valuation is called by
proposed stake holders

(1) Relative strategy

(a) Addition of Partner/s Excess earnings method Discounted cash flow

Adjusted net assets method Excess earnings method
(Discounted cash flow for Adjusted net assets method
negotiation)
(b) Business Sell / Purchase Earnings capitalization Discounted cash flow
Agreement method (or earning Replacement cost method
multiple) or Revenue
multiple
Excess earnings method
Liquidation value
(c) IPO Earnings capitalization Discounted cash flow
method Comparable Companies’
Adjusted net assets value multiple (generally P/E
Discounted cash flow and P/EBITDA multiple)*
Comparable Companies’
multiple (P/E and
P/EBITDA multiple)*
(d) Mergers, Acquisitions, Earnings capitalization Discounted cash flow
Takeovers method Replacement cost method
Discounted cash flow
Liquidation value
(2) Investments

(a) Small business purchase Discounted cash flow

Replacement cost method

(b) Private equity funding/ Discounted cash flow

venture capital finance Replacement cost method
P/E multiple (as guiding
data)

(c) Business financing for Discounted Cash flow*

new projects/ expansion Liquidation value

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(3) Value added management/ planning

(a) Raising funds for Discounted cash flow

expansion or new projects Adjusted net asset value

(b) Restructuring the Earning capitalization

business/ divestiture method

(c) Goodwill impairment Discounted cash flow

Adjusted net asset value

(d) Allocation of Purchase Adjusted net asset value

price

(e) Retirement of partner or Discounted cash flow

dissolution of partnership Adjusted net assets method
or succession planning Liquidation value

(f) Financial reporting Discounted cash flow

Adjusted net assets method

(g) Frequent progress Economic Value Addition

measure method
(excess earning method)
Liquidation value in
relevant cases
(4) Other Purposes

(a) Ownership issues Excess earning method Excess earning method

Discounted cash flow Discounted cash flow
Adjusted net assets method Adjusted net assets method

(b) Litigation issues

involving lost profits or Depends on specific case Depends on specific case
economic damages and requirements and requirements

(c) Family issues Excess earning method

Discounted cash flow
Adjusted net assets method
Liquidation value

128
 As per Prof. Aswath Damodaran
(Stern School of Buiness)

WHICH APPROACH SHOULD BE USED?

Depends Upon The Assets (Business) Being Valued …..

Assets Marketability and Valuation Approaches

Mature Businesses Growth businesses

Separable & Marketable assets Linked and non-marketable assets

Liquidation & Replacement cost value Other valuation models

Cash Flow and Valuation Approaches

Cash flow currently or Cash flow if a Assets that will never

Expected in near future contingency occurs generate cash flows

DCF or relative Option pricing Relative valuation

valuation models models models

Uniqueness of Assets and Valuation Approaches

Unique asset or business Large number of similar

assets that are priced

DCF or option pricing models Relative valuation models

129
 As per Prof. Aswath Damodaran
(Stern School of Buiness)

And The Analyst Doing The Valuation …..

Investor time horizon and Valuation approaches

Very short time horizon Long time horizon

Liquidation value Relative Option pricing DCF

Valuation models

Views on market and valuation approaches

Markets are correct on Asset markets and Markets make

an average but make mistakes financial markets mistakes but

on individual assets may diverge corrects them
over time

Relative valuation Liquidation value DCF or Option

pricing model

130
References
(books, notes, articles and websites)

ƒ “A basic guide for Valuing a Company” – 2nd edition by Wilbur M. Yegge, John Wiley &
Sons, Inc.
ƒ “Financial Valuation – Applications and Models” by James R. Hitchner. John Wiley &
Sons, Inc.
ƒ “Financil management – Theory and practice” 6th edition by Dr. Prasanna Chandra. Tata
McGraw hill publishing Company Limited
ƒ “Business Analysis and Valuation – using financial statements” 2nd edition by Palepu,
Healy, Bernard
ƒ “Quantitative Business Valuation - A mathematical approach for today’s professional”
by Jay Abrams. McGraw Hill
ƒ “Damodaran on Valuation - security analysis for Investment and corporate finance” by
Aswath Damodaran
ƒ “Investment valuation” 2nd edition by Aswath Damodaran
ƒ ”Business valuation and taxes – procedure, law and perspective” by David Laro and
Shannon P. Pratt. John Wiley & Sons, Inc
ƒ FAS 157 “fair value Measurement”
ƒ “Valuation” by Leo Gough, 2002 printed by capstone publishing
ƒ “Valuation of a Business, Business ownership interest, security, or intangible asset” -
Statement on standards for valuation services issued by the AICPA consulting services
executive committee, June 2007

ƒ “Non-Quantitative Measures In Company Evaluation” by Ágnes

Horváth, European Integration Studies, Miskolc, Volume 4 (2005) pp 61-
72.
ƒ “A Premier on the Quantitative Marketability Discount Model” by Z. Christopher Mercer
The CPA Journal- Business Valuation, July 2003
ƒ “Fair Value Measurement” by CA Shrikant Sortur The Chartered Accountant, April-
2007 pages 1564-1574
ƒ IPEV valuation board’s comments on the IASB’s discussion paper “Fair value
measurements” published in November 2006
ƒ “The efficient market hypothesis and its critics” by Burton G. Malkiel, Journal of
Economic Perspective- volume 17, Nov 1- winter 2003 pages 59-82

ƒ “impact of deferred tax facility on firm value” by Prof. M.S. Narsimhan and B.V.
Harisha, The Chartered Accountant, July 2006 Page 056-063
ƒ “All P/Es are not created equal”, Mckinsey on Finance, spring- 2004
ƒ “Valuation of Small business: An Alternative point of view” by Francisco J. Lopez,
Journal of Business Valuation and Economic Loss Analysis, volume 3- issue 1, article 7,
2008

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ƒ “Trends in Valuation” by CA Gurudutt N. Joishy, The Chartered Accountant, June- 2007
pages 1930-1933
ƒ “Business valuation” slides prepared by C.R. Rajagopal, Deloitte Haskins and Sells
ƒ “Equivalence of the APV, WACC and FLOWS TO EQUITY APPROACHES to firm
Valuation” by Pablo Fernández, University of Navarra - Spain, research paper no. 292,
April 1995
ƒ “Do Court preferences for Valuation Approaches of Closely Held Companies Vary by
Industry?” by James DiGabriele, Journal of Business Valuation and Economic Loss
Analysis, volume 2- issue 1, article 5, 2007
ƒ “Valuation Approaches and Metrics: A survey of the Theory and Evidence” by Aswath
Damodaran, Stern school of business, November, 2006
ƒ “Public and Private Company differences can have major valuation implications” by
George Hawkins, Fair value TM
ƒ “EVA and its critics” by Stephen F. O’Byrne, Journal of applied corporate finance,
November 2, summer 1999, volume 12, pages 92-96
ƒ “Multiples used to estimate corporate value” by Erik Lie and Heidi J. Lie, Financial
Analysts Journal, March/ April 2002
ƒ “Finding value where NONE exists: Pitfalls in using Adjusted Present Value” by
Laurence Booth, Journal of applied corporate Finance, November 1, spring 2002, volume
15, pages 08-17
ƒ “Hotel valuation Techniques” by Jan deRoos and Stephen Rushmore
ƒ Briefing “Methods of Corporate Valuation” by Prof. Ian H. Giddy, New York university
ƒ “Calculating value during uncertainty: Getting real with ‘real option’ ” by Dan Latimore,
CFA – IBM Institute for Business value
ƒ “How to Price a Share for acquisition” by Malay Kanti Roy, Vikalpa, January-March
1986, volume 11, No. 1
ƒ “Cost of Capital, Optimal capital Structure, and value of Firm: An Empirical Study of
Indian Companies” by Raj S Dhankar and Ajit S Boora, Vikalpa, July-September 1996,
Volume 21, No. 3
ƒ “Estimating capitalization rates for the Excess Earnings Method using Publicly traded
comparables” by Harry Howe, Eric E. Lewis and Jeffrey W. Lippitt, Journal of Business
Valuation and Economic Loss Analysis, volume 2- issue 1, article 1, 2007
ƒ Explanatory Memorandum to the Exposure draft – Revised standard on Auditing (SA)
540 – “Auditing Accounting Estimates, Including fair Value Accounting Estimates, and
Related Disclosures” issued by ICAI
ƒ “Financial factors” by Michael J. Mard, The licensing journal, April 2001, page 21-23
ƒ “The return of the leveraged Buyout: LBO is back in vogue” Dealmaker – A quarterly
magazine from Grant Thornton, summer 2005, Vol. 2, No.1
ƒ Guidelines for valuation of equity shares of Companies and the business and net assets
of branches, issued by ministry of finance, department of economic affairs, 1990
ƒ “Guidelines on Share Valuation: How Fair is Fair value?” by Jayanth Varma and N
venkiteswaran, Vikalpa,October-December 1990, Volume 15, No. 4

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ƒ “Valuation in Emerging markets’” by Mimi James and Timothy M. Koller, The McKinsy
quarterly 2000 Number 4: Asia revalued
ƒ “Valuation Effects of Entity Form” by Jay B. Abrams, ASA, CPA, MBA
ƒ “Valuing a start up and raising equity – Dealing with venture capitalist and private
investors” by Martin Heucher, Ueli Looser, Heinz Marchesi, Bruno Schläpfer, August
199, McKinesy & Company
ƒ “WACC or APV” by Jaime Sabal, Journal of Business Valuation and Economic Loss
Analysis, volume 2- issue 2, article 1, 2007
ƒ “The Value of ownership” by Meir Dan-Cohen, Global Jurist Frontiers, Volume 1 (2001)
issue 2, article 4
ƒ “Improving Certainty in valuation using the Discounted cash flow Method”, by C.P.
“Salty” Schumann, Valuation Strategies Magazine, Sept- Oct 2006: 4-13
ƒ A note “Common errors in Business Valuation Reports – Revisited” by Robert R.
Wietzka, CPA, CVA
ƒ A note “Accuracy of your valuation” by Jay B. Abrams, ASA, CPA, MBA

ƒ www.appraisers.org
ƒ www.iasplus.com
ƒ www.tscpa.com
ƒ www.valmetrics.com
ƒ www.whiteandlee.com
ƒ www.natinalbizval.com
ƒ www.investopedia.com
ƒ www.businessvaluation-explained.com
ƒ www.bvappraisers.org

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