3.3.

3 Corporate Valuation and Restructuring

Module 2
Faculty: Dr. Shalini H S
Contents: Approaches/Methods of valuation: Asset-Based Approach, Earnings Based
Approach (Earnings- Capitalization Method, P/E Ratio), DCF Approach: Market value Based
Approach, Market value Added Approach. Enterprise DCF Valuation: Two stage and three
stage growth models, Relative Valuation –Direct Comparison and Peer group approach,
Contingent claim valuation.

Valuation: Valuation is the analytical process of determining the current (or projected)
worth of an asset or a company. There are many techniques used for doing a valuation. An
analyst placing a value on a company looks at the business's management, the composition
of its capital structure, the prospect of future earnings, and the market value of its assets,
among other metrics.

Fundamental analysis is often employed in valuation, although several other methods may
be employed such as the Capital asset pricing model (CAPM) or the Dividend discount
model (DDM).

1. Asset based approach: An asset-based approach is a type of business valuation that

focuses on the net asset value (NAV) of a company. The net asset value is identified by
subtracting total liabilities from total assets. 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.

This approach aims at determining the value of net assets. Assets can be valued at their book
value, market value, replacement value or liquidation value and this method determines
the basis of assets valuation.

Net assets = Total assets - Total external liabilities

Net assets per share = Net assets/Number of equity shares issued & outstanding.

Understanding an Asset-Based Approach: Identifying and maintaining awareness of the

value of a company is an important responsibility for financial executives. Overall,

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stakeholder and investor returns increase when a company’s value increases and vice
versa.

There are a few different ways to identify a company’s value. Two of the most common are:

i) The Equity value and

ii) The Enterprise value

The asset-based approach can also be used in conjunction with these two methods or as a
standalone valuation. Both equity value and enterprise value require the use of Equity in the
calculation. If a company does not have equity, analysts may use the asset-based valuation as
an alternative. Many stakeholders will also calculate asset-based value and use it
comprehensively in valuation comparisons. Asset-based value may also be required for
private companies in certain types of analysis as added due diligence. Furthermore, asset-
based value can also be an important consideration when a company is planning a sale or
liquidation.

Calculating Asset-Based Value:

In its most basic form, the asset-based value is equivalent to the company’s book value or
shareholders’ equity. The calculation is generated by subtracting liabilities from assets.

Oftentimes, the value of assets minus liabilities can be different than the values reported on
the balance sheet due to timing and other factors. Asset-based valuations can provide latitude
for using market values rather than balance sheet values. Analysts may also include certain
intangible assets in asset-based valuations that may or may not be on the balance sheet.

Adjusting Net Assets:

One of the biggest challenges in arriving at an asset-based valuation is the adjusting of net
assets. An adjusted asset-based valuation seeks to identify the market value of assets in the
current environment. Balance sheet valuations use depreciation to decrease the value of
assets over time. Thus, the book value of an asset is not necessarily equivalent to the fair
market value. Other considerations for net asset adjustments may include certain intangibles
that are not fully valued on the balance sheet or included on the balance sheet at all.
Companies might not find it necessary to value certain trade secrets but since an adjusted

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asset-based approach looks at what a company could potentially sell for in the current market
these intangibles would be important to consider.

In an adjusted net asset calculation, adjustments can also be made for liabilities. Market
value adjustments can potentially increase or decrease the value of liabilities which directly
affects the calculation of adjusted net assets.

2. Earnings Based Approach: The earnings based approach to valuation is on the

proposition that the business valuation should be based on future earnings or the firm's
capacity to generate cash flows. Thus, this approach eliminates the limitation of the asset
based approach which totally ignores the firm's potential to generate cash flows and earnings.
Earnings can be measured on two bases:

a. Earnings measured by accounting and

b. Earnings measured by cash flows.

The earnings per share (EPS) formula is stated as earnings available to common
shareholders divided by the number of common stock shares outstanding. EPS is an indicator
of company profit because the more earnings a company can generate per share, the more
valuable each share is to investors.

Analysts also use the price-to-earnings (P/E) ratio for stock valuation, which is calculated
as market price per share divided by EPS. The P/E ratio calculates how expensive a stock
price is relative to the earnings produced per share.

For example, if the P/E ratio of a stock is 20 times earnings, an analyst compares that P/E
ratio with other companies in the same industry and with the ratio for the broader market. In
equity analysis, using ratios like the P/E to value a company is called a multiples-based, or
multiples approach, valuation.

Capitalization of earnings: Capitalization of earnings is a method of determining the value

of an organization by calculating the worth of its anticipated profits based on current earnings
and expected future performance. This method is accomplished by finding the net present
value (NPV) of expected future profits or cash flows, and dividing them by the capitalization
rate (cap rate). This is an income-valuation approach that determines the value of a business

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by looking at the current cash flow, the annual rate of return, and the expected value of the
business.

Understanding Capitalization of Earnings: Calculating the capitalization of earnings helps

investors determine the potential risks and return of purchasing a company. However, the
results of this calculation must be understood in light of the limitations of this method. It
requires research and data about the business, which in turn, depending on the nature of the
business, may require generalizations and assumptions along the way. The more structured
the business is, and the more rigor applied to its accounting practices, the less impact any
assumptions and generalizations may have.

When all variables are known, calculating the capitalization rate is achieved with a simple
formula, operating income / purchase price. First, the annual gross income of the
investment must be determined. Then, its operating expenses must be deducted to identify the
net operating income. The net operating income is then divided by the investment's/property's
purchase price to identify the capitalization rate.

3. DCF Approach: Discounted cash flow (DCF) is a valuation method used to estimate the
value of an investment based on its future cash flows. DCF analysis attempts to figure out the
value of a company today, based on projections of how much money it will generate in the
future.

DCF analysis finds the present value of expected future cash flows using a discount rate. A
present value estimate is then used to evaluate a potential investment. If the value calculated
through DCF is higher than the current cost of the investment, the opportunity should be
considered.

DCF is calculated as follows:

Where CF = Cash flow, r = Discount Rate

4. Market value based approach: The market approach is a method of determining the
value of an asset based on the selling price of similar assets.

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5. Market Value Added Approach (MVA): Market value added (MVA) is a calculation
that shows the difference between the market value of a company and the capital
contributed by all investors, both bondholders and shareholders. In other words, it is the
sum of all capital claims held against the company plus the market value of debt and equity.
It is calculated as:

MVA = V – K

where MVA is the market value added of the firm, V is the market value of the firm,
including the value of the firm's equity and debt (its enterprise value), and K is the total
amount of capital invested in the firm.

MVA is closely related to the concept of economic value added (EVA), representing the net
present value (NPV) of a series of EVA values.

Understanding Market Value Added (MVA): When investors want to look under the hood
to see how a company performs for its shareholders, they first look at MVA. A company’s
MVA is an indication of its capacity to increase shareholder value over time. A high MVA is
evidence of effective management and strong operational capabilities. A low MVA can
mean the value of management’s actions and investments is less than the value of the capital
contributed by shareholders. A negative MVA means the management's actions and
investments have diminished and reversed the value of capital contributed by shareholders.

MVA Reflects Commitment to Shareholder Value: Companies with a high MVA are
attractive to investors not only because of the greater likelihood they will produce positive
returns but also because it is a good indication they have strong leadership and sound
governance. MVA can be interpreted as the amount of wealth that management has created
for investors over and above their investment in the company. Companies that are able to
sustain or increase MVA over time typically attract more investment, which continues to
enhance MVA. The MVA may actually understate the performance of a company
because it does not account for cash payouts, such as dividends and stock buybacks,
made to shareholders. MVA may not be a reliable indicator of management
performance during strong bull markets when stock prices rise in general.

6. Enterprise DCF Valuation: Refer PPT

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7. Relative Valuation: A relative valuation model is a business valuation method that
compares a company's value to that of its competitors or industry peers to assess the firm's
financial worth. Relative valuation models are an alternative to absolute value models, which
try to determine a company's intrinsic worth based on its estimated future free cash flows
discounted to their present value, without any reference to another company or industry
average. Like absolute value models, investors may use relative valuation models when
determining whether a company's stock is a good buy.

a. Direct comparison: The Direct Comparison Approach method provides the market value
of an expropriated property by “comparing” it to values obtained in the open market of
similar properties. The appraiser follows three basic steps in arriving at the value of the
property in question: identifying the highest and best use of the property in question; the
identification of similar properties that have previously sold (“the comparable sales”); and,
adjusting the value of the comparable sales.

For example, assume that the expropriated property is a five acre square parcel of flat land. It
is near a highway. Its highest and best use was determined to be for a gas station. The
appraiser would then search for past sales of land that were purchased for gas station
development. Assume that he finds two sales (“Comparable A” and “Comparable B”).

Comparable A was 5 acres, square, flat but close to a secondary road, not a highway.
Closeness to the highway is a very desirable characteristic, so the expropriated property was
superior to Comparable A. Comparable A sold for $10,000.

Comparable B was 5 acres, square, near a highway, but had several hills that had to be
levelled. The cost of levelling the land was $4,000. Comparable B sold for $12,000.

The appraiser would then compare these two parcels of land to the expropriated land and
adjust them to fit the characteristics of the expropriated land. In this example, Comparable A
is inferior because it is not near a highway, thus the expropriated land is worth more than
$10,000. Comparable B is also inferior because the developer had to pay $4,000 to put that
land into a useable state, making the cost of Comparable C $16,000. The appraiser would
then consider these adjustments, use his or her professional judgment, and reach a value of
the expropriated land. The likely value for the expropriated land would be in the $16,000
range.

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b. Peer group approach: A peer group is a group of individuals or entities that share similar
characteristics and interests. Peer groups, in the case of people, have characteristics which
include similarities such as socio-economic status, level of education, ethnic background, and
so on among its individual members.

In the context of financial markets, a peer group refers to companies that are competitors in
the same industry sector and are of similar size.

In investment research, peer group analysis is a vital part of establishing a valuation for a
particular stock. The emphasis here is on comparing "apples to apples," which means that the
constituents of the peer group should be more or less similar to the company being
researched, particularly in terms of their main areas of business and market capitalization.

Peer group analysis can enable investors to spot valuation anomalies for a specific stock. For
example, a stock that is trading at an earnings multiple of 15x – compared with an average
multiple of 10x for its peer group – could justifiably be considered overvalued. Alternatively,
investors can uncover the potential reasons for the higher earnings multiple and ultimately
determine that it is deserved.

c. Contingent claim valuation: A contingent claim or option is an asset which pays off only
under certain contingencies - if the value of the underlying asset exceeds a pre-specified
value for a call option, or is less than a pre-specified value for a put option. Much work has
been done in the last twenty years in developing models that value options, and these option
pricing models can be used to value any assets that have option-like features.

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