BUSINESS VALUATION
Objectives
At
the end of this lecture you will be able to:
- Explain
the reasons for business valuation
- Apply
business valuation approaches where there is a going concern
- Apply
business valuation approaches where there is no a going concern
- Discuss
the significance of each valuation approach.
Content
- Motives
for business valuation
- Valuation
bases where there is no a going concern
- Valuation
bases where there is a going concern
4.1 Introduction
The
value of a business is the price of its share in the market. How a business is
valued internally may be different from how the market perceives it. A business
may conduct a valuation from time to time to see its actual worth. In this
case, a business may be valued when there is a going concern and when there is
no going concern.
The
business as a going concern is a time when a business wants to value its shares
for the purpose of selling them, buying another company or entering a merger
and acquisition. In this case, the value of a share of the business is expected
to be higher than if a business is valued as a no going concern.
When
a business is not a going concern, is where there is a material reason and
intension to end the affairs of the business. For instance, when a business
wants to be sold due to its poor performance or when the business is
liquidated. In this situation, the value of the assets of the business and
hence the value of its shares will both be at a low value. The reason for this
is the pressure for selling of the assets of the business which in turn will
lower down its value and hence the share price.
When
the business is not a going concern, the valuation techniques used would always
be that which will report a lower price than compared to if it were a going
concern. In this case the Liquidation method and Net Book Value method will be
the best techniques for valuation. On the other hand, if a business is a going
concern, then most of the income based approaches will be the best techniques
for valuation.
Definition:
Business Valuation is the act or the process of determining the value of a
business enterprise or ownership interest therein. It is simply the process of
determining how much a business is worth. The business may worth more or less
depending on its assets availability and market capitalization. The net worth
of the business is then converted into share price to determine the value per
share. The final answer to this, determines the actual value of the business.
4.2 Reasons for Conducting a Business Valuation
There
are several reasons for conducting a business valuation. Some could be as
internal while others could be as external. These reasons are as explained
below:
- Merger
and acquisition/ Business Sales
In
considering the acquisition or sale of a business, or portion hereof, a
business valuation is a critical tool. In a typical merger, an independent
market valuation of each company is a requirement to determine distribution. A
valuation can serve to bridge any discrepancy in the two party’s opinion of
value and provide a reasonable starting point for discussion
- Buy-Sell
and Shareholders Agreements
Many
buy-sell agreements require a business valuation so that ownership will be
transferred at fair market value. Agreements between partners or shareholders
should be based upon a business appraisal rather than a simple formula. The
formula approach may yield an unrealistic value.
- Non-Controlling
interest Disputes and Litigation
Situations
may arise when non-controlling interest is not receiving any dividends or other
return on his or her investment in a closely held company, and majority owners
are receiving substantial sums benefits from the company. In this situation of
litigation, a comprehensive valuation is a necessity
- Financing
Increasingly,
lenders will request an independent market valuation prior to approving a small
business loan or credit line. It a valuable tool to include in a loan package
when approaching the lender.
- Valuation
for Tax purposes
When
a business is needed to pay appropriate amount of tax then the valuation is
necessary. By doing this the tax authority will be able to establish the
required and fair tax on property or on business itself
Factors
to Consider in the Valuation Process
a) Nature
and history of the Business. These are things like how long the business has
existed, the business’s reputation, if there is a need to replace or update
equipment, the geographical location of the business, and major competitors
b) General
Economic and Industry Outlook. There are many sources that will project key
economic statistics for future periods. Also, checking the larger banks in your
area to see if they have economic forecaster that may be able to provide you
with assistance
c) Book
value and Financial Condition. Book value is the total net assets of the
business (historical cost of the assets minus the accumulated depreciation)
minus the total liabilities. An analysis of the income statements and balance
sheets will help determine the book value and financial condition
d) Earnings
capacity of the Business. How much cash a business can generate or earn in
terms of cash flow
e) Dividends
paying capacity of the business. The share of profits given to the stockholders
f) Goodwill
and other intangible assets. Goodwill is the excess earnings over and above a
fair return on equity. While such factors as the prestige of a business, the
ownership of a trade or brand name and the record of successful operation over
a prolonged period and a particular locality are supportive.
g) Market
price of stocks of Comparable Companies. Sales information relating to similar
trading companies may hep to provide discounts. Discounts need to be applied to
make the stock of one company comparable to a publicly traded company’s stock.
4.3 Methods of Valuation of Shares (Business)
There
are mainly two methods used to value businesses. Normally, a business value is
determined based on how much its shares worth. The higher the value of the
share, the more the business is worth compared to other competitors
These
methods are categorised into two groups
1. Assets
based methods of valuation
2. Market
based methods of valuation
4.4.1 Assets Based Methods of Business Valuation
The
assets based approaches are based on adjusting the Assets and liabilities on
the balance sheet to fair market value. Asset based methods are common in
estates businesses and banks because the nature of their business must keep
large assets in terms of property
Assets
based methods are calculated into different ways as follows:
i.
Net Book Value Method
ii. Break Up Basis/Liquidation basis/Net
Realisable value
Iii.
Replacement Cost Basis
4.4.2 Book Value Basis
In
this method, the net value of the business is calculated based on the
difference between the total assets and the total liabilities without
separating the current from the non-current items.
Book
Value = Total Assets – Total Liabilities
Business
Value = Total Assets – Total Liabilities
After
that the business value is determined by taking the Book Value divided by the
total number of ordinary shares issued. The value per share gives the value of
the business
Value
of a Share = Business Value
Number of Shares
NB:
Total Assets is the total value of all the assets both current and non current
assets as they appear in the last balance sheet
4.4.3 Break-Up basis/Liquidation basis/Net Realisable Value
This
method is used to determine the value of the business by considering the value
of the assets upon liquidation. That is how much the Assets would have realised
if they were to be sold in a forced sale. In this case normally the assets sold
during this period have a lower realisable due to a pressure for sale and the
unwillingness of the buyer to acquire them at a reasonable price equivalent to
a fair market price. This is a situation where a company ceases to be a going
concern.
The
calculation of the value of the business based on Break up basis is the same as
for the Net Asset Basis except, the assets value will not be the same as the
Book Value (which is the balance sheet assets value) rather a new assets value
will be given or ascertained according to the pressure of the sale. The new
realisable value might be slightly higher than the Net Book Value or it may be
lower than that.
Business
Value = Total Assets – Total Liabilities
Value
of a Share = Business Value
Number of Shares
NB:
Total Assets in this case will be the net realisable value of assets from the
forced sale upon liquidation. The
value of the asset is expected (but not always) to be small due to a forced
sale. The business in this case is not a going concern
4.4.5 Replacement Cost Method
This
is the valuation of the business based on the new realisable market value.
Unlike break-up basis, this one is when the business is considered to be a
total going concern and the value is estimated based on the fair market price
by assuming the new market value of the assets upon replacing them. If the
assets were replaced with new ones, then the value would be more than that of a
forced sale under liquidation basis and even higher as compared to Book Value
Business
Value = Total Assets – Total Liabilities
Value
of a Share = Business Value
Number of Shares
NB:
Total Assets in this case is the value of the Assets upon replacement to new cost.
The new cost will be in accordance to the fair market value of the assets. In
this case the value might be higher because the business is a going concern
4.5 Income Based Approaches to Business Valuation
These
methods are based on capitalisation of income streams to determine the business
value. The methods further involve determining the appropriate discount rate to
apply to income streams to arrive at present value. These methods are best
applicable in manufacturing companies and other highly profitable businesses
where the value of net profit and the costs are determined based on performance
of profitability.
Income
based methods include the following
i.
Dividend Yield
ii.
Price Earnings Ratio
Method/Earnings Yield
iii.
Dividend Growth Model
iv.
Discounted Cash Flow
Method
4.5.1 Dividends Yield Basis
The
dividends yield method is calculated as the percentage of gross dividend to the
market price. Dividend yield is especially important to those investors whose
objective is to minimise the dividend revenue from their investments.
Dividend
Yield = Dividend per share
Market Price per Share
OR
Dividend
Yield = Total Dividend
Total Market Capitalization
The
dividend valuation basis (model) is based on the theory that an equilibrium
price for any share or bond on a stock market is: ‘The future expected stream
of income from the security discounted at a suitable cost of capital.
Equilibrium market price is thus a present value of a future expected income
stream for a share expected in perpetuity’.
4.5.2 Price Earnings Ratio Basis
This
method is used when a large stock of shares or a whole business is being
valued. This method can be problematic when quoted companies price earnings
ratios are used to value unquoted companies. It is a common method of valuing a
controlling interest in a company where the owner can decide on dividend and
retention policy. The price earnings ratio relates earnings per share to a
share’s value
P/E
ratio = Market Value per Share
Earnings per Share
4.5.3 Dividend Growth Model
This
method the value of the business is measured by the Price of a Share. And the
price of a share depends on growth of dividend, which also depends on the
increase in income. This is also another income based approaches that relies on
growth of dividend over time. It assumes
that as income increases, shareholders will anticipate a steady growth of
dividend. In this case their share price will also be more. The share price in
this case is the value of the business.
Dividend
Growth = Po
Po
= Do (1 + g)
Ke – g
Where
by:
Po
= Price per share
Do
= Current Dividend Payout Ratio
g = Growth
rate of Dividend
Ke
= Return to Equity shares on
comparable companies, normally listed on Stock Exchange
Limitations
on the Approaches used in Valuing Businesses
Some Advantages and
Limitations of the different methods of valuation
Dividend Growth Model
The
Approach is based on expectations and forecasts on earnings and dividends which
is very difficult to predict
Net Asset Based (Net
Book Value)- This method uses historical Cost
convention which leads to small values compared to realistic market values
Price Earnings Ratio:
Is argued to be the most realistic method in valuing businesses especially when
there is a going concern. This is because it is based on assessment of market
valuation of similar businesses in the same industry.
NB:
No single method is best on its own. Normally when business valuation is
undertaken, more than three methods needs to be used for better results and
comparability of the choice between different results
Computations
of Business Valuations
Illustration
Kahama
Company Ltd supplies cold drinks and mineral water to retail shops and
restaurant chains throughout Tanzania. The company has enjoyed a strong growth
since it was formed ten years ago and is now considering a listing on the stock
exchange. At a forthcoming meeting of the board of directors, the likely price
of the company’s shares upon listing is one of the key items on the agenda. The
draft financial statements for Kahama Company Ltd for the most recent year are
set out below.
Kahama Company
Ltd
Statement of Financial
Position as at 30 November 2012
ASSETS Tshs.
Non-Current Assets
Property,
Plant and Equipment 19,100,000
Land
and Buildings
2,600,000
Fixtures
and Fittings 6,700,000
28.400,000
Current Assets
Inventories 2,300,000
Trade
Receivables 5,900,000
Cash
and Cash equivalents 1,300,000
Total
Assets 37,900,000
Equity and Liabilities
Equity
Ordinary
share capital (Tshs. 0.25nominal) 12,000,000
Retained
Earnings 13,600,000
25,600,000
Non-Current Liabilities
Loan
Notes 8,000,000
Current Liabilities
Trade
Payables 3,800,000
Taxation 500,000
4,300,000
Total
Equity and Liabilities
37,900,000
Kahama Company
Ltd
Statement of Comprehensive Income for the year
ended 30 November 2012
Revenue 40,600,000
Cost
of Sales (21,500,000)
Gross
Profit
1 9,100,000
Distribution
expenses (6,700,000)
Administration
expenses (7,200,000)
Finance
expenses (800,000)
Profit
before tax 4,400,000
Taxation (1,200,000)
Profit
for the year 3,200,000
The
assets of Kahama Company have recently been provided with the following
independent valuations concerning realisable values
Land
and buildings 29,800,000
Motor
vehicles
2,000,000
Fixtures
and Fittings 4,100,000
Inventories 3,500,000
Trade
Receivables 4,700,000
The
following additional information is also available
- The
current dividend payout ratio is 60%
- Dividends
are expected to grow at the rate of 5% per year for the foreseeable future
- The
required return to equity share in similar companies listed on Stock
Exchange is 9%
- The
average price/earnings (P/E) ratio for similar businesses listed on the
Stock Exchange is 12.6 times
Required:
(a) Calculate
the value of an ordinary share in Kahama Company using the following valuation
methods
(i)
Net Assets basis (Net
Book Value Basis)
(ii)
Liquidation
basis/Break-up basis
(iii)
Dividend growth basis
(iv)
Price Earnings ratio
basis
(b) Advice
the management of Kahama Company Ltd on the most realistic value on the market
price of an ordinary share of the company. You
may use assumptions both if a company is a going concern and if a company is
not a going concern
Solution:
(i)
Value
of the Business according to Net Asset Basis/Net Book Value Basis
Total
Assets (Book Value) 37,900,000
Less:
Total Liabilities
Non-Current
Liabilities 8,000,000
Current
Liabilities 4,300,000 12,300,000
Net
Assets at Book Value 25,600,000
Value
of the Business =
Tshs. 25,600,000
Price
per Share = Value of the Business
Number of Share
= 25,600,000
48,000,000
= Tshs.
0.53 per share
(ii)
Value
of the Business according to Liquidation Basis
Land
and Buildings 29,800,000
Motor
Vehicles 2,000,000
Fixtures
and Fittings 4,100,000
Inventories 3,500,000
Trade
Receivables 4,700,000
Cash 1,300,000
45,400,000
Less;
Liabilities
Non-Current
Liabilities 8,000,000
Current
Liabilities 4,300,000 12,300,000
Market
Value of the Business 33,100,000
Price
per Share = Value of the Business
Number of Shares
= 33,100,000
48,000,000
= Tshs 0.69 per share
(iii)
Value
of the Business according to Dividend Growth basis
Given
Do
= 60%
g = 5%
Ke
= 9%
Profit
for the year = 3,200,000
Earnings
per share (EPS) = Profit = 3,200,000
Shares 48,000,000
EPS
= 0.067
Do
= EPS x Dividend pay-out ratio
= 0.067
X 0.6
= 0.04
Value
of the Business is calculated from the Formula:
Po = Do
(1 + g)
Ke – g
= 0.04
x (1 + 0.05)
0.09 - 0.05
= Tshs. 1.05 per share
(iv)
Value
of the Business based on Price Earnings Ratio
Value
of the Business will be calculated directed from the Price per share. The price
per share is dependable on earnings. Hence the formula:
P
o = P/E
Ratio X EPS
= 12.6 x 0.067
= Tshs
0.84 per share
Comments
on the actual valuation and the best value of the company:
To
comment on the best value of the company, relies on the reason for conducting
the valuation. If the reason shows that the business is on the side of a going
concern ie for mergers with another company, for buying another company,
whether a company is a bidding company or a target company.
If
a company is a bidding company (a buying company), then it would bargain for a
lesser value (hence a small answer would be right). If the business is a target
company/a seller (accompany to be bought), then the business would bargain for
a higher value of the business.
For
this question, the purpose of this valuation is to list Kahama Ltd in the stock
market for the first time. In this case the company is growing and hence it is
a going concern. Investors need to see this company as a promising company and
the shares for Kahama will best be selling based on comparable businesses in
the same industry. In this case, the best method to use is the dividend growth
model, and the value for Kahama will be at Tshs. 1.05 per share.
To
comment on this also, it would be better if you could include the limitations
of other valuation approaches in terms of a growing company like Kahama Ltd.
Summary of the Topic
Business
valuation is the process of determining how much the business is worth. It is
normally represented in the form of value per share or price per share. A
company may need to value a business for tax purposes, for mergers and
acquisition purposes, when there are any disputes between parent and
non-controlling interest; and also for making decision on either selling or
buying of shares. There are two approaches of calculating value of a business.
These are Assets based and Income based approaches. Assets based methods
include Net Assets basis, Liquidation/break-up basis and Replacement Cost.
While Income methods include Price Earnings ratio, Dividends Growth method and
Dividend Yield. In the actual practice, it is always advised to use a
combination of the two methods to get a better chance for proper judgment and
decision. Both the two approaches have advantages and limitations.