How to Determine the Valuation of a Company

A business valuation, also known as a company valuation, is the process of determining the economic value of a business. During the valuation process, all areas of a business are analyzed to determine its worth and the worth of its units.

The following are three generally accepted approaches to valuation:

Cost Approach:

A cost approach is a valuation approach that reflects the amount derived from the combined fair market value (FMV) of the business’s net assets. This approach is useful for investors or buyers to determine whether the asset or property is undervalued or overvalued.

Formula:

Asset Value = Reproduction/Replacement Cost – Depreciation + The value of Land

Market Approach:

Under the Market approach, the valuation is based on the market value of the company in the case of listed companies and comparable companies trading or transaction multiples for unlisted companies. The Market approach generally reflects the investors' perception of the true worth of the company.

• Comparable Companies Multiples ("CCM") Method:

Under this method, the value of the company is determined by comparing it to other companies of similar size in similar industries. The most common valuation multiples used are price to earnings (P/E), enterprise value to sales (EV/S), price to book (P/B), and price to sales (P/S).

• Comparable Transactions Multiples ("CTM") Method:

?This method is mainly used in Mergers & acquisitions (M&A) to determine the value of a target company. This approach looks for similar past transactions that happened in a similar industry. The most common valuation multiples used are price to earnings (P/E), enterprise value to EBITDA (EV/EBITDA), price to book (P/B), and enterprise value to sales (EV/S).

Income Approach:

The income approach is widely used for valuation under the "Going Concern" basis. It focuses on the income generated by the company in the past as well as its future earning capability.

The income approach includes a number of methods, such as Discounted Cash Flow (DCF) method, Relief from Royalty (RFR) method, multi-period excess earnings method (MEEM), Dividend Discount Model (DDM) with and without method (WWM) and Option pricing models such as the Black-Scholes-Merton formula or binomial (lattice) model.

The above mentioned are varied but fall into one or two categories mentioned below: -

• Single-period methods, for example, capitalization of earnings or free cash flow
• Multi-period methods like the discounted cash flow (DCF)

The most commonly used method under the income approach is Discounted Cash Flow (DCF)

Under the DCF Method, the business is valued by discounting its free cash flows for the explicit forecast period and the perpetuity value thereafter. The free cash flows represent the cash available for distribution to both, the owners and creditors of the business. The free cash flows in the explicit period and those in perpetuity are discounted by the Weighted Average Cost of Capital (WACC). The WACC based on an optimal vis-a-vis actual capital structure, is an appropriate rate of discount to calculate the present value of the future cash flows as it considers equity-debt risk by incorporating the debt-equity ratio of the firm.

Where the asset has an n-year life, E(CFt) is the expected cash flows in period t and r is the risk-adjusted discount rate.

Risk-adjusted discount rate:

Generally, companies having higher risk have high discount rates. Companies with little track record receive a higher discount rate than those with a long history of growth and profitability and more obvious future prospects.

Risk in the DCF Model:

The discount rate should reflect the risk the marginal investor perceives by investing in the company. Risks can be two types: (a)Systematic Risk i.e., risk related to economy, markets, etc.  (b)Unsystematic risk is the risk related to a specific business (like high level of debt, etc.).

Company Valuation: A Regulatory Perspective

Valuation Requirements under Income Tax Act, 1961

Valuation under the Income tax act is necessary for determining Fair Market Value under various rules that include Rule 11U, Rule 11UA, Rule 11UAA, Rule 11UAB, Rule 11UAE, and Rule 11UB. This is necessary for the valuation of various assets and securities for the purpose of taxation of the transactions involving such assets and securities.

Valuation Requirements under the Companies Act, 2013

Valuation under the companies act, 2013 is governed by section 247 read with Companies (Registered Valuers and Valuation) Rules, 2017. It gives guidelines for qualification, independence, and methodology of working as a registered valuer under the Companies Act 2013.

Section 247 permits only Registered Valuers to undertake the valuation of any stock, share, debenture or security. Goodwill, asset, liability or net worth of the company as required under this act. The eligibility of being a registered valuer under the Companies Act 2013 is stated under the Companies (Registered Valuers and Valuation) Rules, 2017.

As per Rule 16 of Companies (Registered Valuers and Valuation) Rules, 2017, a valuation is required to be performed as per the Central Government notified valuation standards. Until any standard is notified, the Registered valuer shall perform the valuation according to:

• Valuation standard of any valuation professional organization.
• Internationally accepted Valuation Methodology.