Chapter 2 Purpose of Valuation – CS Professional Valuations and Business Modelling Study Material is designed strictly as per the latest syllabus and exam pattern.
Purpose of Valuation – CS Professional Valuations and Business Modelling Study Material
What do you mean by business valuation? Explain the purpose of valuation.
Business Valuation is the process of determining economic value of a business or company. It assesses a variety of factors to determine the fair market value in a sale, but there is no one way to verify the worth of a company. Business valuation can depend on the values of the assessor, tangible and intangible assets, goodwill and varying economic conditions. Business valuation provides an expected price of sale; however, the real price of sale can vary.
It is to be noted that the topic of business valuation is frequently discussed in corporate finance. Business valuation is typically conducted when a company is looking to sell all or a portion of its operations or looking to merge with or acquire another company. The valuation of a business is the process of determining the current worth of a business, using objective measures, and evaluating all aspects of the business. A business valuation might include an analysis of the company’s management, its capital structure, its future earnings prospects or the market value of its assets. The tools used for valuation can vary among valuators, businesses and industries. Common approaches to business valuation include review of financial statements, discounting cash flow models and similar company comparisons.
A business valuation requires a working knowledge of a variety of factors, and professional judgment and experience. This includes recognizing the purpose of the valuation, the value drivers impacting the subject company, and an understanding of industry, competitive and economic factors, as well as the selection and application of the appropriate valuation approach /(es) and method(s).
Some of the significant considerations for undertaking valuation are as under:
- What is the purpose of the valuation?
- What basis of value should apply?
- What premise of value should be used?
- What is the subject of the valuation?
- How has the business performed historically?
- What is the future outlook for the business?
- Which valuation approaches should be utilized?
- How do you arrive at a conclusion of value?
Business Valuation Purposes
The primary purpose of business valuation is preparing a company for sale, there are many purposes. -The following are a few examples:
Shareholder Disputes: Sometimes a breakup of the company is in the shareholder’s best interests. This could also include transfers of shares from shareholders who are withdrawing.
Estate and Gift: A valuation would need to be done prior to estate planning or a gifting of interests or after the death of an owner. This is also required by the IRS for Charitable donations.
Divorce: When a divorce occurs, a division of assets and business interests is needed.
Mergers, Acquisitions, and Sales: Valuation is necessary to negotiate a merger, acquisition, or sale, so the interested parties can obtain the best fair market price.
Buy-Sell Agreements: This typically involves a transfer of equity between partners or shareholders.
Financing: Have a business appraisal before obtaining a loan, so the banks can validate their investment.
Purchase price allocation: This involves reporting the company’s assets and liabilities to identify tangible and intangible assets.
Discuss reasons and important consideration for merger and acquisition?
Mergers and Acquisition
Mergers and acquisitions (M&A) are defined as consolidation of companies. Differentiating the two terms, Mergers is the combination of two companies to form one, while Acquisitions is one company taken over by the other. M&A is one of the major aspects of corporate finance. The reasoning behind M&A generally given is that two separate companies together create more synergy than being existing separately. With the objective of wealth maximization, companies keep evaluating different opportunities through the route of merger or acquisition.
Mergers & Acquisitions can take place:
- by purchasing assets
- by purchasing common shares
- by exchange of shares for assets
- by exchanging shares for shares
Reasons for Mergers and Acquisitions:
- Financial synergy for lower cost of capital
- Improving company’s performance and accelerate growth
- Economies of scale
- Diversification for higher growth products or markets
- To increase market share and positioning giving broader market access
- Strategic realignment and technological change
- Tax considerations
- Undervalued target
- Diversification of risk
Three important considerations for merger and acquisition that should be taken into account:
- The company must be willing to take the risk and vigilantly make, investments to benefit fully from the merger as the competitors and the industry take heed quickly
- To reduce and diversify risk, multiple bets must be made, in order to narrow down to the one that will prove fruitful
- The management of the acquiring firm must learn to be resilient, patient and be able to adapt to the change owing to ever-changing business dynamics in the industry
Discuss the stages of Mergers and Acquisition. What are the reasons for failure of Mergers and Acquisitions.
Stages involved in any M&A:
Phase 1: Pre-acquisition Review: This would include self assessment of the acquiring company with regards to the need for M&A, ascertain the valuation (undervalued is the key) and chalk out the growth plan through the target.
Phase 2: Search and Screen Targets: This would include searching for the company that is appropriate for acquisition. This process is mainly to scan for a good strategic fit for the acquiring company.
Phase 3: Investigate and valuation of the Target: Once the appropriate company is shortlisted through primary screening, detailed analysis of the target company has to be done. This is also referred to as due diligence.
Phase 4: Acquire the target through Negotiations: Once the target company is selected, the next step is to start negotiations to come to consensus for a negotiated merger or a bear hug. This brings both the companies to agree mutually to the deal for the long term working of the M&A.
Phase 5: Post Merger Integration: If all the above steps fall in place, there is a formal announcement of the agreement of merger by both the participating companies.
Reasons for the failure of M&A – Analyzed during the stages of M&A: Poor Strategic Fit: Wide difference in objectives and strategies of the company.
Poorly Managed Integration: Integration is often poorly managed without planning and design. This leads to failure of implementation
Incomplete Due Diligence: Inadequate due diligence can lead to failure of M&A as it is the crux of the entire strategy
Overly optimistic: Too optimistic projections about the target company leads to bad decisions and failure of the M&A.
What is the purpose of valuation at the time of mergers and acquisition?
Purpose of Valuation in Merger and Acquisition
Business combinations which may take shapes of mergers, acquisitions, amalgamation and takeovers are critical facets of corporate structural changes. They have played a crucial role in the external growth of a number of leading companies across the globe.
Valuation during merger and acquisition is important as it is observed that at times, the merger and acquisition is given a go ahead without enquiring whether there is any potential benefit out of the merger or acquisition.
In a merger or acquisition transaction, valuation is essentially the price that one party will pay for the other, or the value that one side will give up to make the transaction work. Valuations can be made via appraisals or the price of the firm’s stock if it is a public company, but at the end of the day valuation is often a negotiated number.
The most common method is to look at comparable companies in an industry, but deal makers employ a variety of other methods’ and tools when assessing a target company. Here are just a few of them:
1. Discounted Cash Flow (DCF): A key valuation tool in M&A, discounted cash flow analysis determines a company’s current value according to its estimated future cash flows. Forecasted free cash flows (net income + depreciation/amortization – capital expenditures – change in working capital) are discounted to a present value using the company’s weighted average costs of capital (WACC). Admittedly, DCF is tricky to get right, but few tools can rival this valuation method.
2. Comparative Ratios: The following are two examples of the many comparative metrics on which acquiring companies may base their offers:
Price-Earnings Ratio (P/E Ratio) – With the use of this ratio, an acquiring company makes an offer that is a multiple of the earnings of the target company. Looking at the P/E for all the stocks within the same industry group will give the acquiring company good guidance for what the target’s P/E multiple should be. Price-to-Earnings Ratio (P/E) = Market value per share / Earnings Per Share (EPS)
3. Replacement Cost: In few cases, acquisitions are based on the cost of replacing the target company. For the sake of simplicity, suppose the value of a company is simply the sum of all its equipment and staffing costs. The acquiring company can literally order the target to sell at that price, or it will create a competitor for the same cost. Naturally, it takes a long time to assemble good management, acquire property and get the right equipment. But this method of establishing a price certainly wouldn’t make much sense in a service industry where the key assets – people and ideas – are hard to value and develop.
What are the reasons for sale of Business?
Sale of a Business
The sale of a business usually is not a sale of one asset. Instead, all the assets of the business are sold. Generally, when this occurs, each asset is treated as being sold separately for determining the treatment of gain or loss. A business usually has many assets.
Reasons for Sale of Business:
1. Partnership interests
An interest in a partnership or joint venture is treated as a capital asset when sold. The part of any gain or loss from unrealized receivables or inventory items will be treated as ordinary gain or loss.
2. Corporation interests
Your interest in a corporation is represented by stock certificates. When you sell these certificates, you usually realize capital gain or loss.
3. Corporate liquidations
Corporate liquidations of property generally are treated as a sale or exchange. Gain or loss generally is recognized by the corporation on a liquidating sale of its assets. Gain or loss generally is recognized also on a liquidating distribution of assets as if the corporation sold the assets to the distribute at fair market value.
In certain cases in which the distribute is a corporation in control of the distributing corporation, the distribution may not be taxable.
4. Allocation of consideration paid for a business
The sale of a trade or business for a lump sum is considered a sale of each individual asset rather than of a single asset. Except for assets exchanged under any non-taxable exchange rules, both the buyer and seller of a business must use the residual method to allocate the consideration to each business asset transferred. This method determines gain or loss from the transfer of each asset and how much of the consideration is for goodwill and certain other intangible property. It also determines the buyer’s basis in the business assets.
The buyer’s consideration is the cost of the assets acquired. The seller’s ‘ consideration is the amount realized (money plus the fair market value of property received) from the sale of assets.
Explain key facts for doing valuation for voluntary Assessment.
The key facts for doing valuation for Voluntary Assessment are:
1. Price is not the same as Value
The Value of a business, by whatever valuation method it is obtained, is not the selling price of the business. Value is an economic concept based on certain data & assumptions, however Price is what a Buyer is willing to pay keeping in consideration the Economic and Non Economic factors like Emotions, Perception, Greed Etc which cannot be valued as such.
2. Value varies with Person, Purpose and Time
The Value is a subjective term and can have different connotations meaning different things to different people and the result may not be the same, as the context or time changes.
3. Transaction concludes at Negotiated Prices
Though the value of a business can be objectively determined employing valuation approaches, this value is still subjective, dependent on buyer and seller expectations and subsequent negotiations and the Transaction happens at negotiated price only.
4. Valuation is Hybrid of Art & Science
Valuation is more of an art and not an exact science. The Art is Professional Judgment and Science is Statistics. Mathematical certainty is neither determined nor indeed is it possible as use of professional judgment is an essential component of estimating value.