An idea that delivers

BUSINESS VALUATION –BASICS AND BEYOND

CA RAJIV SINGH FCA, CISA(USA), LIII

First Joint Technical Director valuation and MBF

courses of ICAI

FOUNDER EXPLICO CONSULTING

rajivsinghfca@gmail.com

An idea that delivers

Question Presented

Valuation opportunities-What is the needand significance of valuation?

Valuers’ Role-What is the Role of a valuer?

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Question Presented

Valuation Dubiety-What makes onevaluation plausible and the next completelyunbelievable ?

Valuation Principles &Practices- Why thereis a need to review counterfactual quality ofvaluation by means of some aphorism?

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Question Presented

Measuring ‘Dhandho’-Can we carry outvaluation assignments withoutunderstanding the Dhandho ?

Valuer’s Qualities- Do we need ‘logician’ or‘number cruncher’

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Question Presented

Valuation ‘Dharma’-What are valuationstandards and why they are necessary?

Credible valuation report-What decidesAcceptability of a valuation report ?

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Who says there’s no money in valuation?

In LightSquared Inc., 2014 Bankr. LEXIS 2984 July 11, 2014) a bankruptcycase in USA, the valuation fee paid was $1.25 million to a valuationexpert for a short-term assignment

• The expert was mandated to disprove the debtors’ claim

• He had three weeks to submit his report

• He had no industry expertise

• He applied faulty and arbitrary assumptions in valuing the assets

• The court called his report “an unimpressive piece of work and hismethodology is all over the place,” the court further added.

Takeaway: Don’t take an assignment—however lucrative—for whichyou lack the necessary expertise. A bad review from the court travelsfast and leaves a lasting stain on your reputation.

Two difference concepts – determined and driven by different forces

They would yield different numbers in most of the circumstances

Pricing process has mind of its own

Value of an asset is based on its fundamentals – cash flow, growth and risk

Price of an asset is based mainly on demand and supply forces

• The deal price for Steve Ballmer to buy the Clippers finalized at $2 billion

which is 12.1 times the expected 2014 revenues of the team, as per numbers

given to the bidders by Bank of America

• Forbes valued the ‘team’ at $575 million

• A confidential Bank of America valuation report (disguised as “Project Claret”

valued the ‘team’ much higher primarily due to projected increases in media

revenue. Before the bidding began, Bank of America valued the Clippers between

$1 billion and $1.3 billion

• But BoA’s estimated value is still a far cry from the price.

No team in the history of sports was sold for six times total revenues before this deal

and this gives an idea of how crazy this purchase price is

Do you understand how the value process works?

(How the value investors think)

Do you understand how the pricingprocess works?

(How traders react to

information)

Which camp you belong to?

Can a successful value investor treat traders (pricers) with disdain?

√ Investor Camp

√ Trading Camp

√ Value Camp

√ Pricing Camp

Nothing called precise value

Not a static figure

Arrival of a transaction is not necessary

Fundamentals are the key

Always precise

A static figure

An outcome of a transaction

Fundamentals play a role indetermining both demand &supply but not always.MMI (Mood, Momentum &Irrational behavior) has a keyrole in determining demand &supply.

Always involves economic benefitsIncludes economic and non

economic factors

Many pricing decisions only pretend to be valuations

The bankers recently put a price on Alibaba of $155 billion. The illusion

that this price came out of a valuation model creates a great deal of

confusion. In reality, says Damodaran, what they did was set an IPO price.

DCF “valuations” that rely on EBITDA multiples at terminal value is price

oriented and conceptually not appropriate

Thinking, Fast and Slow – A Valuation Perspective

Two models of processing information & making decision

System 1 System 2

Automatic, instinctive andemotional(Relieson mental short-cut)

Slow, logical and deliberate

(Relies on methodical thinking)

In many cases this reachescorrect conclusion nearlyeffortlessly using intuitionand rules of thumb. But canlead to astray.

Check whether emotionshave clouded judgment orintuition is wrong. System 2helps in correcting snapjudgment.

Poor Valuation Report: Allowing System 1 output to gounchecked by system 2.However System 1 outputshould not be entirelysuppressed

Daniel Kahneman Noble Prize winner in Economics

Thinking, Fast and Slow

A bat and a ball cost INR1.10 in total. The bat costsINR 1 more than the ball.How much does the ballcost?

Thinking about the Future – Forecast vs. projection

‘The expected never occurs and never in expected manner’ Vernon A. Walters

Financial Forecast

Prospective Financial Statements that present, tothe best of responsible party’s knowledge andbelief, an entity’s expected financial position,result of operation and cash flows.

Financial Projection

Prospective Financial Statement that present, tothe best of the responsible party’s knowledge andbelief, given one or more hypotheticalassumptions, an entity’s expected financialposition , results of operations and cash flows.

Hypothetical assumption

It is used to present a condition or course of actionthat is not necessarily expected to occur, but thatis consistent with the purpose of a financialprojection or a partial presentation of projectedinformation.

Common biases with Financial Projection/ Forecast

Excessive Optimism

Overestimate the likelihood of positive events andunderestimate negative events

OverconfidenceOverestimate skill level comparative to others’ andconsequently ability to affect future

Confirmation bias

Place extra value on evidence consistent with afavored belief and not enough on evidence thatcontradict it

(i)

(ii)

(ii)

Escalation of Commitment

Groupthink Strive for consensus at the cost of a realisticappraisal of alternative course of action

Egocentric

Investment in resources in an apparently losingproposition because of the effort , money and timealready involved

Focus too narrowly on own perspective ignoringhow others will be affected by a strategy

(iv)

(v)

(vi)

Thinking about the Future – Forecast vs. projection

• “Nudge” to allow for risk and uncertainty

• Make three forecast/ projection

Low Medium High

Unlikely

• Use premortem (or perspective hindsight) to tamper optimism.

Imagine a future failure and then explain the cause.

• Use ‘outside view’ ( what happened in similar venture/ project) to

tamper results of ‘Inside View’ (cause of excessive optimism)

• Disconfirm the projection / forecast- What evidence

would contradict your assumptions and how likely is that

you would see it.

• Reduce confirm bias- Don’t search and use information

that supports your assumptions & gloss over information

that contradicts them.

Component process of projection/ forecast

Business Environment & Strategy analysis

Industry analysis Strategy analysis

Accounting Analysis

Prospective Analysis

Financial Analysis

Analysis of cash flow

Profitability Analysis

Risk Analysis

Estimate Value

Estimate cost of capital

(a)Date of Valuation

(b)Date of Valuation Report

(a) (b)

(a) (b)

(a)(b)

Valuation Standards – What and Why?

Valuation Standards are basically codes

of practices that are used while

performing valuation engagement.

The business is intensely, vigorously, bitterly, savagely competitive … Robert

Crandall

Valuation Standards – What and Why?

To promote ‘best practices’ and credibility

To enhance quality, consistency ,comparability and

uniformity of valuation practices

To ensure professional competence in the valuation

engagement -undertake only those professional services that the

member or the member’s firm can reasonably expect to be completed

with professional competence.”

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Valuation Standards – What and Why?

To improve corporate governance and public

confidence

To improve market efficiency

To enhance market knowledge and efficiency

Valuation Standards

Valuation Standards

Valuation Standards

Acceptability of Valuation Reports

valuation standards

Best practices

Approaches , Methods and Techniques

•Subject interest to be valued

•Ownership Characteristics

•Valuation date

•Purpose

•Standard of Value

•Premise of Value

•Deliverables

•Limitations

•Special Instructions

•Income Approach

•Market Approach

•Asset Based Approach

Fundamental concepts of defining value

• Standard of value • Premise of value • Level of value

Standard of Value

• a definition of type of value being sought

Types of Standards of Value

The identification of the type of value being utilised in a specific engagement

The International Glossary of Business Valuation Terms

• Fair Market Value (FMV)

• Investment Value

• Intrinsic Value

• Fair Value

• Market Value

Standard of Value

Selecting Standard of Value

• Subject matter of Valuation

• Purpose Valuation

• Statute

• Contracts

• Case Laws

• Circumstances

• Professional judgement & Experience

Fair Market Value (FMV)As defined by Statement on Standards for Valuation Services Issued by the AICPA

• 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,

• when neither is under compulsion to buy or sell and

• when both have reasonable knowledge of the relevant facts.

Fair Market Value (FMV)

As defined by Revenue Ruling 59-60,

• 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 the relevant facts.

Fair Market Value (FMV)

Cash or Cash equivalent: Price without any financing support or

special concession and contemplates prevalent economic &

market condition on the valuation date.

Hypothetical: does not contemplate real but refer Potential

Willingness: motivated and assets would be exposed to the market

for a reasonable period

Arm’s length: third Party

Fair Market Value (FMV)

Open & unrestricted market: excludes specific buyer

One transaction involving a willing buyer & seller can not establish a market price

‘Able’: pushes value downward

No Compulsion: Forced conditional transactions excluded

Reasonable Knowledge of facts: Average knowledge & not

specific knowledge

Fair Market Value (FMV)What Hypothetical Sale Transaction

Contemplate Does not contemplate

Price is cash or cash equivalents at

the prevailing economic condition

Willingness and ability to buy sell

exist

No compulsion to accept the deal

Potential buyers of similar assets

exist

Reasonable time and knowledge exist

No separate price for not to compete

Plan to sell to a particular buyer

and adopting a planned strategy

Buyer have specific knowledge

Engagement of experienced and

well connected negotiator get a

favorable deal

Other benefits attached with the

deal like making available finance

or key persons

Investment Value

• Investment value may be more than FMV or less than FMV

Value to a particular investor based on individual investment requirements & expectations

The International Glossary of Business Valuation Terms

FMV vs. Investment Value

FMV Investment Value

Consensus opinion of market

participants

Sale is always contemplated

Hypothetical investor

Impersonal

DLOC & DLOM may apply

Opinion of a specific investor

Sale is not necessary

Specific investor

Personal

Control premium & synergy

premium apply

Factors creating difference between FMVand Investment Value

• Estimation of cash flows

• Risk

• Tax

• Product synergy & cannibalisation

• Other strategic advantages

Intrinsic Value or Fundamental Value

The International Glossary of Business Valuation Terms defines

‘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 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’

Intrinsic Value or Fundamental Value

Kohler’s Dictionary for Accountants defines

‘the amount that an investor considers on the basis of an

evaluation of available facts, to be the ‘true’ or ‘real’ worth of

an item, usually equity security. The value that will become

the market value when other investors reach the same

conclusions.’

Intrinsic Value or Fundamental value

• Value based on fundamentals not by market

• Value derived by one analyst

• Market consensus may or may not be there

• Transaction value (price) is not similar to investment value which is

used to estimate FMV

Graham & Dodd definition

‘the value which is justified by assets, earnings, dividends,

definite prospects and the factor of management.’

• Level of normal earning power and profitability in the employment of assets as distinguished from the reported earnings, which may be, and frequently are, distorted by transient influences

• Dividends actually paid or the capacity to pay such dividends currently and in the future

• A realistic expectation about the trend line growth of earning power

• Stability and predictability of these quantitative and qualitative projections of the future economic value of the enterprise

Graham and Dodd’s Security analysis, fifth edition, Tata McGraw Hill, page 41 ,42

Intrinsic Value or Fundamental value

• Most complicated & definition varies with type of transaction and facts of each case

• Definition has two dimensions

Fair value for legal purpose

Fair value for financial reporting

• For legal purpose Courts give fair treatment to parties who seek remedy under law – DLOM & DLOC generally not allowed

• Stock holder is entitled to be paid for that which has been taken from him viz. his proportionate interest in a going concern

[Tri-continental Corp.]

Fair Value

IFRS 13 defines fair value as

“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.”

• Fair value is the exit price from the perspective of market participants who

hold the asset or owe the liability at the measurement date

• It is based on the perspective of market participants rather than just the

entity itself- so fair value is not affected by an entity’s intentions towards

the asset, liability or equity item that is being fair valued

Fair Value

Premise of value

Talks about types of market conditions likely to be encountered.

Two premises of Value

Going Concern – value as an ongoing operating business enterprise

Liquidation – value when business is terminated

- could be ‘forced’ or ‘orderly’

‘Going concern’ is not a standard of value

Premise Of Value- Status of the business

Report Writing: It’s where the rubber meets the road. Theculmination of every business valuation engagement is thevaluator’s report.

• Failure to Valuation Date

• Failure to identify the Subject Interest

• Failure to disclose sources of Data

• Failure to Provide Sufficient Explanation

• Disregard of Material Facts

• Failure to Find Available Information

• Failure to Adequately Support Selection of Beta

• Improper Sampling Techniques

• Ignoring Off Financial Statement Items

Pitfalls in valuation Report

• Insufficient due diligence

• Failure to Factor in Income Tax

• Failure to Set Forth the Adjustments to Financial

• Failure to Discuss Weightings

• Failure to Distinguish between Tax and Book Depreciation

• Failure to List Guideline Companies

• Failing to Separate Operating and Non –operating Aspects of a Company

• Failing to Lay Foundation for Small company risk premium

• Failing to Justify Capitalization or Discount Rates

• Failure to Think Like an Investor

• Failure to Accurately Describe the Subject Property

Pitfalls in valuation Report

Pitfalls in valuation Report

• Failure to Properly Classify the Subject Company

• Failure to Explain the Basis for a Valuation Discount

• Failure to Properly Consider the Subject Company’s Growth Rate

• Failure to Explain Market Multiples Selected for Guideline

• Companies

• Failure to Consider Differences between the Subject Company and the Guideline

Companies

• Failure to Explain the Selection of the Range of Performance Ratios Selected

• Failure to Adequately Explain Why Companies Selected as Guideline Companies

Are in Fact Comparable to the Subject Company

• Failure to Explain Why So Few Comparable Properties or Guideline Companies

Were Selected

• Conclusion of Value Offends Common Sense

• Mathematical Errors

• Inconsistency

• Double Counting

• Conflicting Conclusions of Value

• Sole Reliance on a Valuation Model

• Incorrect Usage of Discounted Cash Flow Method

• Failure to validate management projections

• Skewed Assumptions

• Overemphasis on Buy-Sell Restrictions among Related Parties

• Using Historic Book Value of Assets in Net Asset

• Misapplication of Pre- and Post-Tax Figures

• Inconsistent Use of Commercially Available Data

• Use of Commercially Available Data That Warns of Statistical Inaccuracy

• Using a Valuation Method without Laying a Foundation

Pitfalls in valuation Report

• Apparently Conflicting Assumptions Used for the Same general Purposes without

Sufficient Explanation

• Use of Different Valuation Methods in Valuing the Same Interest in Valuation

Reports Offered at Different Times without Adequate Explanation

• Making Improper Adjustments to Financial Statements

• Inconsistency in Valuation Methodology Expressed in Testimony versus the valuers’s

Methodology as Expressed in another Writing

• Unreasonably Low or high Projections

• Combining the Discount for Lack of Control with the Discount for Lack ofMarketability

• Utilizing an Assumed Income Tax Rate That Differed from the Actual Past Tax Rates of the Subject Company

• Disconnect between Assumption about When Revenues or Expenses Would Be Received or Incurred and When Those Items Were Actually Received or Incurred

Pitfalls in valuation Report

• Error in Computing Terminal Value When Using the Income Approach

• Discounting an Income Stream Only at or Close to the Risk-Free Rate

• Modifying or Abandoning Positions Taken in the written report during testimony

• Relying upon Guideline Companies That Were Not Comparable to the Subject

Company

• Preparing and Utilizing Earnings Projections That Vary Significantly from the Earnings

Projections Prepared by the Subject Company

• Use of Only One Year’s Worth of Guideline Company Data

• Cherry Picking Valuation Multiples

• Using an Inexcusably Old Comparable Sale

• Mismatching the Valuation Dates of the Guideline Companies and the Subject

Company in Computing Price Multiples

• Relying too much on ‘beta projects’ while making projections

Pitfalls in valuation Report