5.

1 Business Valuation – Approaches of Valuation

CORPORATE FINANCE
Business Valuation
A business valuation is a general process of
determining the economic value of a whole
business or company unit. Business valuation
can be used to determine the fair value of a
business for a variety of reasons, including
sale value, establishing partner ownership,
taxation etc. Owners will often turn to
professional business evaluators for an
objective estimate of the value 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 evaluators,
businesses, and industries. Common approaches
to business valuation include a review of
financial statements, discounting cash flow
models and similar company comparisons.
Valuation is also important for tax reporting.
The Internal Revenue Service (IRS) requires
that a business is valued based on its fair
market value. Some tax-related events such as
sale, purchase or gifting of shares of a company
will be taxed depending on valuation.
Methods of Valuation
There are numerous ways a company can be
valued.
1. Market Capitalization
Market Capitaliation is the simplest method of
business valuation. It is calculated by
multiplying the company’s share price by its
total number of shares outstanding. For
example, as of January 3, 2018, Microsoft Inc.
traded at $86.35. With a total number of
shares outstanding of 7.715 billion, the
company could then be valued at $86.35 x
7.715 billion = $666.19 billion.
2. Times Revenue Method
Under the times revenue business valuation method,
a stream of revenues generated over a certain period
of time is applied to a multiplier which depends on
the industry and economic environment. The times-
revenue method is a valuation method used to
determine the maximum value of a company.
The times-revenue method uses a multiple of
current revenues to determine the "ceiling" (or
maximum value) for a particular business. One major
limitation of the times revenue method is that it is not
an indicator that can be dependable on to determine
a company’s valuation. The reason is that revenue
does not actually mean profit. The same way, revenue
increase, does not mean an increase in profits.
3. Earnings Multiplier
Instead of the times revenue method,
the earnings multiplier may be used to get a
more accurate picture of the real value of a
company, since a company’s profits are a more
reliable indicator of its financial success than
sales revenue is. The earnings multiplier is a
financial metric that frames a company's
current stock price in terms of the company's
earnings per share (EPS) of stock, that's
simply computed as price per share/earnings
per share. It can help investors judge current
stock prices against their historical prices on
an earnings-relative basis.
4. Discounted Cash Flow (DCF) Method
The DCF method of business valuation is
similar to the earnings multiplier. This method
is based on projections of future cash flows,
which are adjusted to get the current market
value of the company. The main difference
between the discounted cash flow method and
the profit multiplier method is that it takes
inflation into consideration to calculate the
present value.
5. Book Value
This is the value of shareholders’ equity of a
business as shown on the balance sheet
statement. The book value is derived by
subtracting the total liabilities of a company
from its total assets.
6. Liquidation Value
Liquidation value is the net cash that a
business will receive if its assets were
liquidated and liabilities were paid off today.
Approaches of business valuation
1.Asset approach
2.Income Approach
3.Market approach
4.Rules of thumb
1.An asset-based approach is a type
of business valuation that focuses on the
net asset value of a company. There can be
some room for interpretation in terms of
deciding which of the company's assets and
liabilities to include in the valuation and how
to measure the worth of each.
Asset-based valuation is a form of valuation in business
that focuses on the value of a company’s assets or the
fair market value of its total assets after deducting
liabilities. Assets are evaluated, and the fair market
value is obtained.

Income Approach
The income approach quantifies the present value of
anticipated future income generated by a business or an
asset. The income approach, sometimes referred to as
the income capitalization approach, is a type of real
estate appraisal method that allows investors to
estimate the value of a property based on the income
the property generates.


Valuation of Bonds and Shares
Bond is a long-term debt instrument that
promises to pay a fixed annual sum as interest
for specified period of time. The basic features
of bonds are:
(i) Bonds have face value. The face value is
called par value. The bonds may be issued at
par or at discount.
(ii)The interest rate is fixed. Sometimes it may
be variable as in the case of floating rate
bond. The interest is paid semi-annually or
annually. The interest rate is known as
coupon rate
(iii) The maturity date of the bond is usually
specified at the issue time except in the case
of perpetual bonds.
(iv) The redemption value is also stated in the
bonds. The redemption value maybe at par
value or at premium.
(v)Bonds are traded at the stock market.
Valuation of Bonds
Bond valuation is a technique for determining
theoretical fair value of a particular bond. Bond
valuation includes calculating the present value of
a bond’s future interest payments also known as
its cash flow, and the bond’s value upon maturity,
also known as its face value or par value.
Bond valuation in effect, is calculating the present
value of a bond’s expected future coupon
payments. The theoretical fair value of a bond is
calculated by discounting the present value of its
coupon’s payment by an appropriate discount
rate.
Bond Return
1.Holding period return: An investor buys a
bond and sells it after holding for a period.
The rate of return in that holding period is :
Holding period return=
Price gain + Coupon payment
Purchase price
2. Yield To Maturity(YTM)
The concept of yield to maturity is one of the
widely used tools in bond investment
management.
Arithmetically, YTM is the single discount
factor
that makes present value of future cash
outflows from a bond equal to the current
price of the bond.
 Valuation of shares
The valuation of shares may be done by an
accountant for two reasons:
Where there is no market price as in the case of
a proprietary company
Where for special reasons, the market price
does not reflect the true or intrinsic value of
the shares
Factors affecting valuation of shares
Valuation of shares depend upon the purpose
of valuation, the nature of the business of the
company concerned, demand and supply of
shares, the government policy, past
performance of the company, growth
prospects of the company, the management of
the company, economic climate, accumulated
reserves of the company, prospects of the
bonus or rights issued, dividend declared by
the directors and many other related factors.
The basic factor in the valuation of shares is
the dividend yield that the investor expects to
get as compared to the normal rate prevailing
in the market in the same industry. For small
investors, the rate of dividend declared by the
directors plays an important role in the
valuation of shares whereas investors holding
bulk of shares would be able to affect the
dividend rate, therefore for them total profits
play an important part in the valuation of
shares.
There are also some special factors affecting
valuation of shares such as
A) Importance of the size of the block of
shares
 B) Restricted transferability
 C) Dividends and valuations
D) Bonus issue and right issue
Methods of valuation
1. Net Assets Basis or Intrinsic Value Method
2. Earning Capacity or Yield Basis Method
3. Dual or Fair Value Method
4. Exchange Rate Method
1. Net Assets Basis- This method is concerned
with the asset backing per share and maybe
based either:
A) On the view that the company is a going
concern
B) On the fact that the company is being
liquidated
A) company as a going concern- if this view is
accepted, there are two approaches:
1. To value the shares on the net tangible
assets basis(excluding the good will)
2. To value the shares on the net tangible
assets plus an amount for goodwill.
1. Net tangible assets excluding goodwill-
Under this method, it is necessary to estimate
the net tangible assets of the company in
order to value the shares.
Net tangible assets = Assets-Liabilities
Here, intangible assets and preliminary
expenses are eliminated and all liabilities are
deducted from the value of the tangible assets.
2. Net assets including goodwill- In many
cases, the goodwill maybe worth the figure at
which it is stated in the balance sheet or if
there is no book value for goodwill, it may
nevertheless exist. It is generally considered
that the value of fixed assets of the company
depends on their ability to earn profits. In
such a case goodwill should be included with
other tangible assets for valuation purposes.
2. Earning capacity
This method of valuation of shares may do
valuation by any of the following three ways:
1. Valuation based on rate of return
2. valuation based on price earning ratio
3. Valuation based on productivity factor
1. Valuation based on rate of return- The term
rate of return here means a return which a
shareholder earns on his investment. The rate
of return can further be classified as:
A)Rate of dividend- This method of valuation
of shares is suitable for small blocks of shares
because small shareholders are usually
interested in dividends. Value of share=
Possible rate of dividend x Paid-up value of
share
 Normal rate of dividend
B) Rate of earning- This method of valuation
of shares is particularly suitable in case of big
investors because they are more interested in
company’s earnings rather than what the
company distributes in the form of dividends.
Value of share=
Possible earning rate x Paid-up value of share
Normal earning rate
2. Valuation based on price earning ratio- This value is
suitable for ascertaining the market value of shares
which are quoted on a recognized stock exchange.
Price earning ratio=Market value per share
Earnings per share
 3. Dual or Fair Value Method
 This method takes the average of the values obtained
in net assets basis and earnings basis methods
Value of Share =
Value of a share on net assets basis+Value of a share on earnings
basis
2
4. Exchange rate method: under this method,
funds available for equity shareholders of two
companies are calculated and are divided by
the number of shares of each company in
order to calculate the value per share of each
company. Comparison of value per share of
each company will provide the exchange ratio
for valuation of shares.
Tobin’s Q method: Tobin’s Q is a ratio between a
physical asset’s market value and its
replacement value. It was first introduced by
Nicholas Kaldor in 1966 in his article ‘Marginal
productivity and Microeconomic Theories of
Distribution: Comment on Samuelson and
Modigliani’. It was popularized and decayed
later however by James Tobin, who describes its
two quantities(1977).
1. The numerator is the market valuation, the
going price in the market for exchanging
existing assets. The other, the denominator is the
replacement or the reproduction cost, the price
in the market for newly produced commodities.
It is believed that this ratio has considerable
macroeconomic significance and usefulness.
Tobin’s Q: Market Value
Replacement value
The Q ratio expresses the relationship between market
valuation and intrinsic value. In other words, it is a
means of estimating whether a given business or market
is overvalued or undervalued. For example, a law
Q(between 0 and 1)means that the cost to replace a
firm’s assets is greater than the value of its stock. This
implies that the stock is undervalued. Conversely, a high
Q (greater than 1) implies that the firm’s stock is more
expensive than the replacement cost of its assets, which
implies that the stock is overvalued. This measure of
stock valuation is the driving factor behind investment
decisions in Tobin’s Q ratio.
Corporate Restructuring
Corporate restructuring is a corporate action
taken to significantly modify the structure or
the operations of the company. This usually
happens when a company is facing significant
problems and is in financial jeopardy(danger
of loss). Often, the restructuring is referred to
the ways to reduce the size of the company
and make it small. Corporate restructuring is
essential to eliminate all the financial troubles
and improve the performance of the company.
Types of Corporate Restructuring
Financial Restructuring: This type of restructuring
may take place due to a severe fall in the overall sales
because of the adverse economic conditions. Here, the
corporate entity may alter its equity pattern, debt-
servicing schedule, the equity holdings, and cross-
holding pattern. All this is done to sustain the market
and the profitability of the company.
Organizational Restructuring: The Organizational
Restructuring implies a change in the organizational
structure of a company, such as reducing its level of
the hierarchy, redesigning the job positions,
downsizing the employees, and changing the reporting
relationships. This type of restructuring is done to cut
down the cost and to pay off the outstanding debt to
continue with the business operations in some manner.
MERGERS & DEMERGERS
 A legal merger is a transaction by which two
or more companies combine to form a single
legal entity.
To carry out a merger, one need to
determine the exchange ratio, that is the ratio
of the number of shares of one company to be
issued for each share of the other company
received. A merger is an agreement that
unites two existing companies into one new
company. There are several types
of mergers and also several reasons why
companies complete mergers.
Mergers and acquisitions are commonly done
to expand a company's reach, expand into new
In simple terms, a Merger or
Amalgamation is an arrangement whereby
the assets of two or more companies become
vested in one company (which may or may
not be one of the original two companies). It
is a legal process by which two or more
companies are joined together to form a new
entity or one or more companies are
absorbed by another company and as a
consequence the amalgamating company
loses its existence and its shareholders
become the shareholders of the new or
amalgamated company.
De-merger is an arrangement whereby some part
/undertaking of one company is transferred to another
company which operates completely separate from the
original company. Shareholders of the original
company are usually given an
equivalent stake of ownership in the new company.
De-merger is undertaken basically for two reasons. The
first as an exercise in corporate restructuring and the
second is to give effect to kind of family partitions in
case of family owned enterprises. A de-merger is also
done to help each of the segments operate more
smoothly, as they can now focus on a more specific
task.
A demerger is a separation of the activities of a group,
the original shareholders become the shareholders of
the separated company.
Demerger is the business strategy wherein
company transfers one or more of its business
undertakings to another company. Wipro's
information technology division is the
best example of spin-off, which got separated
from its parent company long back in 1980's
Legal and Procedural aspects of mergers
Approval of board of directors: After the
approval of this scheme by the respective
boards of directors it must be put before the
share holders. According to section 391 of
companies act, the amalgamation or merger
scheme should be approved at a meeting of
the members three fourth in the value and
Consideration of interests of the creditors: The
views of creditors should also be taken into
consideration. According to section 391,
amalgamation scheme should be approved by the
majority of creditors in the number and three fourth
in value.
Approval of the court: After getting the scheme
approved, an application is filled that court of its
sanction . The court will consider the viewpoint of
all parties appearing, if any, before it, before giving,
its consent. It will see that the interests of all
concerned parties are protected in the amalgamation
scheme. The court may aspect, modify or reject an
amalgation scheme and pass orders accordingly.
However, it is up to the share holders whether to
accept the modified scheme or not.
Clearance under MRTP Act: Every scheme of
amalgamation or merger requires the
approval of central government under MRTP
Act. The idea behind this approval is to see
that it does not result in control, ownership
and management of important undertakings
into a few hands and which is not likely to be
in the public interest. Any scheme of
amalgation or merger leading to
concentration of the economic power is not
allowed by the government.
Amalgamation, Absorption and Takeovers
Sometimes companies carrying on similar
business combine with each other to obtain
the economies of large scale production or to
avoid the disastrous results of cut throat
competition. It is being done by
Amalgamation and Absorption. The term
amalgamation is used when two or more
companies carrying on similar business go
into liquidation and a new company is formed
to take over their business. The term
absorption is also used when an existing
company takes over the business of one or
more existing companies.
Features of amalgamation
1. For amalgamation two or more companies
are required to amalgamate(or merge)
themselves.
2. All the existing companies which are to be
merged are to be liquidated.
3. A new company is formed to take over the
business of the companies which are to be
merged.
4. The value of the new company formed is
expected to be greater than the total of the
independent values of the amalgamating
companies because of economies of large
scale production, saving in cost by elimination
Absorption of Companies
In absorption, an existing company takes
over the business of one or more existing
companies, which dissolve their businesses.
In other words, no new company will be
formed to take over the business of the
liquidating companies. Only an existing
company will acquire the business of these
companies.
For example, If ALtd(an existing company)
acquires the business of BLtd(an existing
company),it will be a case of absorption. In
this case B Ltd. has to dissolve itself.
Objectives of amalgamation and
absorption
1. To eliminate or reduce cut-throat
competition.
2.To reap the economies of the production of
goods and services on a large scale.
3.To gain control over the market.
4.To gain the benefits of the service of the
experts.
5.To promote research and development
schemes.
A takeover or acquisition is the purchase of
one company by another. The purchaser is
termed as bidder or acquirer while the
company it wants to buy is the target. There
are different types of takeovers. Some of them
are:
1. Friendly takeover: It occurs when the
target company is happy about the
arrangement. In other words, the directors
and shareholders have approved the offer.
2.Hostile takeover: In a hostile takeover
situation, the target company does not want
the bidder to acquire it. This can only really
happen in a publicly listed company because
the directors are not typically majority of the
Memorandum of Understanding
A Memorandum of Understanding(MoU) is a
type of agreement between two or more
parties. It expresses a convergence of will
between the parties ,indicating an intended
common line of action. It is often used either
in cases where parties do not imply a legal
commitment or in situations where the parties
cannot create a legally enforceable
agreement.
Many companies and government agencies
use MoUs to define a relationship between
departments, agencies or closely held
companies.
MoUs must include the following:
1.Identification: All parties involved are listed
by their legal name ,address and business.
2.The MoU must also identify itself as an
MoU,not a contract.
3.The MoU must clearly identify the purpose
of the agreement
Disinvestment
In business, disinvestment means to sell off
certain assets such as a manufacturing plant,
a division or subsidiary or product line.
Disinvestment is sometimes described as the
opposite of capital expenditures.
Disinvestments, in most cases are primarily
motivated by the optimization of resources to
deliver maximum returns. To achieve this
objective , disinvestment may take the form
of selling, spinning off or reducing capital
expenditures. It may also be undertaken for
political or legal reasons.