Enterprise Valuation

(In lieu Of Mid-Semester )

By
Mohd Asif Anis
MBA(IB)Finance
Semester 4th
 VALUATION

The term 'valuation' implies the task of estimating the

worth/value of an asset, a security or a business. The price
an investor or a firm (buyer) is willing to pay to purchase
a specific asset/ security would be related to this value.
Obviously, two different buyers may not have the same
valuation for an asset/business as their perception
regarding its worth/value may vary; one may perceive the
asset/business to be of higher worth (for whatever reason)
and hence may be willing to pay a higher price than the
other. A seller would consider the negotiated selling price
of the asset/business to be greater than the value of the
asset/business he is selling.
Evidently, there are unavoidable subjective considerations
involved in the task and process of valuation. Inter-se, the
task of business valuation is more awesome than that of
an asset or an individual security. In the case of business
valuation, the valuation is required not only of tangible
assets (such as plant and machinery, land and buildings,
office equipments, and so on) but also of intangible assets
(like, goodwill, brands, patents, trademark and so on) as
well as human resources that run/manage the business.
Likewise, there is an imperative need to take into
consideration recorded liabilities as well as
unrecorded/contingent liabilities so that the buyer is
aware of the total sums payable, subsequent to the
purchase of business. Thus, the valuation process is
affected by, subjective considerations. In order to reduce
the element of subjectivity, to a marked extent, and help
the finance manager to carry out a more credible
valuation exercise in an objective manner, the following
concepts of value are explained in this Section: (i) book
value, (ii) market value, (iii) intrinsic value, (iv)
liquidation value, (v) replacement value, (vi) salvage
value, (vii) value of goodwill and (viii) fair value.
Book Value
The book value of an asset refers to the amount at which
an asset is shown in the balance sheet of a firm. Generally,
the sum is equal to the initial acquisition cost of an asset
less accumulated depreciation. Accordingly, this mode of
valuation of assets is as per the going concern principle of
accounting. In other words, book value of an asset shown
in balance does not reflect its current sale value.

Book value of a business refers to total book value of all

valuable assets (excluding fictitious assets, such as
accumulated losses and deferred revenue expenditures,
like advertisement, preliminary expenses, cost of issue of
securities not written off) less all external liabilities
(including preference share capital). It is also referred to
as net worth.
Market Value

In contrast to book value, market value refers to the price

at which an asset can be sold in the market. The market
value can be applied with respect to tangible assets only;
intangible assets (in isolation), more often than not, do not
have any sale value. Market value of a business refers to
the aggregate market value (as per stock market
quotation) of all equity shares "outstanding. The market
value is relevant to listed companies only.

Intrinsic/Economic Value

The intrinsic value of an asset is equal to the present value

of incremental future cash inflows likely to accrue due to
the acquisition of the asset, discounted at the appropriate
required rate of return (applicable to the specific asset
intended to be purchased). It represents the maximum
price the buyer would be willing to pay for such an asset.
The principle of valuation based on the dis-counted cash
flow approach (economic value) is used in capital
budgeting decisions.

In the case of business intended to be purchased, its

valuation is equivalent to the present value of incremental
future cash inflows after taxes, likely to. accrue to the
acquiring firm, discounted at the relevant risk adjusted
discount rate, as applicable to the acquired business. The
economic value indicates the maximum price at which the
business can be acquired.

Liquidation Value

As the name suggests, liquidation value represents the

price at which each individual asset can be sold if
business operations are discontinued in the wake of
liquidation of the firm. In operational terms, the
liquidation value of a business is equal to the sum of (i)
realisable value of assets and (ii) cash and bank balances
minus the payments required to discharge all external
liabilities. In general, among all measures of value, the
liquidation value of an asset/or business is likely to be the
least.

Replacement Value

The replacement value is the cost of acquiring a new asset

of equal utility and usefulness. It is normally useful in
valuing tangible assets such as office equipment and
furniture and fixtures, which do not contribute towards
the revenue of the business firm.

Salvage Value

Salvage value represents realisable/scrap value on the

disposal of assets after the expiry of their economic useful
life. It may be employed to value assets such as plant and
machinery. Salvage value should be considered net of
removal costs.
Value of Goodwill

The valuation of goodwill is conceptually the most

difficult. A business firm can be said to have 'real'
goodwill in case it earns a rate of return (ROR) on
invested funds higher than the ROR earned by similar
firms (with the same level of risk). In operational terms,
goodwill results when the firm earns excess ('super')
profits. Defined in this way, the value of goodwill is
equivalent to the present value of super profits (likely to
accrue, say for 'n' number of years in future), the discount
rate being the required rate of return applicable to such
business firms.
The value of goodwill in terms of the present value of
super profits method can serve as a useful benchmark in
terms of the amount of .goodwill the firm would be
willing to pay for the acquired business. In the case of
mergers and acquisition decisions, the value of goodwill
paid is equal to the net difference between the purchase
price paid for the acquired business and the value of
assets acquired net of liabilities the acquiring firm has
undertaken to pay for.

Fair Value

The concept of 'fair' value draws heavily on the value

concepts discussed above, in particular, book value,
intrinsic value and market value. The fair value is hybrid
in nature and often is the average of these three values. In
India, the concept of fair value has evolved from case
laws (and hence is more statutory in nature) and is
applicable to certain specific transactions, like payment to
minority shareholders.

It may be noted that most of the concepts related to value

are 'stock' based in that they are guided by the worth of
assets at a point of time and not the likely contribution
they can make towards earnings/cash flows of the
business in the future. Ideally, business valuation should
be related to the cash flow generating ability of acquired
business. The intrinsic value reflects the firm's capacity to
generate cash flows over the long-run and, hence, seems
to be more aptly suited for business valuation.

In fact, in general, business firms are not acquired with

the intent to sell their assets in the post-acquisition period.
They are to be deployed primarily for generating more
earnings. However, from the conservative point of view, it
will be useful to know the realisable value, market value,
liquidation value and other values, if the acquiring firm
has to resort to liquidation. In brief, the finance manager
will find it useful to know business valuation from
different perspectives. For instance, the book value may
be very relevant form accounting/tax purposes; the market
value may be useful in determining share exchange ratio
and liquidation value may provide an insight into the
maximum loss, if the business is to be wound up.

APPROACHES/METHODS OF VALUATION

The various approaches to valuation of business with

focus on equity share valuation are examined in this
Section. These approaches should not be considered as
competing alternatives to the dividend valuation model.
Instead, they should be viewed as providing a range of
values, catering to varied needs, depending on the
circumstances. The major approaches, namely, the (i)
asset based approach to valuation, (ii) earnings based
approach to valuation, (iii) market value based approach
to valuation and (iv) the fair value method to valuation are
described below.
Asset-Based Approach to Valuation

Asset-based approach focuses on determining the value of

net assets from the perspective of equity share valuation.
What should the basis of assets valuation be, is the central
issue of this approach. It should be determined whether
the assets should be valued at book, market, replacement
or liquidation value. More often than not, they are (and
should be) valued at book value that is, original
acquisition cost minus accumulated depreciation, as assets
are normally acquired with the intent to be used in
business and not for resale. Thus, the valuation of assets is
based on the going concern concept. Some other value
measure may be used depending on circumstances of the
case. For instance, if the plant and machinery has outlived
its economic useful life (earlier than its initial estimated
period), and is not in use for production, it will be in order
to value the machinery at liquidation value.
Apart from tangible assets, intangible assets, such as
goodwill, patents, trademark, brands, know how, and so
on, also need to be valued satisfactorily. It may be useful
to adopt the super profit method to value some of these
assets.

To arrive at the net assets value, total external liabilities

(including preference share capital) payable are deducted
from total assets (excluding fictitious assets). The
company's net assets are computed as per Equation
Net assets = Total assets - Total external liabilities
The value of net assets is also known as net worth or
equity/ordinary shareholders funds. Assuming the figure
of net assets to be positive, it implies the value available
to equity shareholders after the payment of all external
liabilities. Net assets per share can be obtained, dividing
net assets by the number of equity shares issued and
outstanding. Thus,
Net assets per share = Net assets/Number of equity shares
issued and outstanding

The value of net assets is contingent upon the measure of

value adopted for the purpose of valuation of assets and
liabilities. In the case of book value, assets and liabilities
are taken at their balance sheet values. In the market value
measure, assets shown in the balance sheet are revalued at
the current market prices. For the purpose of valuing
assets, and liabilities, it will be useful for a finance
manager/valuer to accord special attention to the
following points:

(i) While valuing tangible assets, such as plant and

machinery, he should consider aspects related to
technological obsolescence and capital improvements
made in the recent years. Depreciation adjustment may
also be needed in case the company is following unsound
depreciation policy in this regard.
(ii) Is the valuation of goodwill satisfactory, given the
amount of profits, capital employed and average rate of
return available on such businesses?
(iii) With respect to current assets, are additional
provisions required for "unrealisability" of debtors?
Likewise, are adjustments required for "unsaleable" stores
and stock?
(iv) With respect to liabilities, there is a need for careful
examination of 'contingent liabilities', in particular when
there is mention of them in the auditor's report, with a
view to assess what portion of such liabilities may
fructify. Similarly, adjustments may be required on
account of guarantees invoked, income tax, sales tax and
other tax liabilities that may arise.

The net assets valuation based on book value is in

tune with the going concern principle of. accounting. In
contrast, liquidation value measure is guided by the
realisable value available on the winding up/liquidation of
a corporate firm.
Liquidation value is the final net asset value (if any)
per share available to the equity shareholder. The value is
given as per Equation.

Net assets per share = (Liquidation value of assets -

Liquidation expenses - Total external liabilities)/Number
of equity shares issued and outstanding.

In the case of liquidation, assets are likely to be sold

through an auction. In general, they are likely to realise
much less than their market values. This apart, sale
proceeds from assets are further dependent on whether the
company has been forced to go into liquidation or has
voluntarily liquidated. In the case of the 'former' type of
liquidation, the realisable value is likely to be still lower.