Valuation

Brief Overview

When the business is transferred as part of merger/demerger or amalgamation or shares are bought and sold, it becomes very important for both buyer as well as seller to know what is the worth of that particular asset which is being transferred. The process which is undertaken to know the worth is nothing but "Valuation". It is popularly said that "Price" is what you pay and "Value" is what you get. "Value" refers to the worth of an asset, whereas "Price" is the result of a negotiation process between a willing but not an overeager buyer and a willing but not an overeager seller.

In simple terms, valuation is a process of determining value of a company or an asset. Valuation is an art and not exact science. What the buyer thinks is whether the product is "worth the price" he has paid, this "worth" itself is the value of the product.

Valuation is normally undertaken in following cases:

1. Specific Provisions under the Companies Act, 2013 which requires Valuation Report from a Registered Valuer
   • 62(1)C : Valuation report for Further Issue of Shares
   • 192(2): Valuation of Assets Involved in Arrangement of Non-cash transactions involving Directors
   • 230(2)(c)(v): Valuation of shares, property and assets of the Company under a scheme of Corporate Debt Restructuring
   • 230(3): Valuation report along with Notice of creditors/shareholders meeting – Under scheme of compromise/Arrangement
   • 232(2(d): The report of the expert with regard to valuation, if any, would be circulated for meeting of creditors/Members
   • 232(3)(h): The Valuation report to be made by the tribunal for exit opportunity to the shareholders of transferor Company – Under the scheme of Compromise/Arrangement in case the Transferor company is Listed Company and the Transferee-company is an unlisted Company
   • 236(2): Valuation of equity shares held by the Minority Share Holders
   • 281(1): Valuing assets for submission of report by liquidator
2. Valuation under the Insolvency Code Insolvency and Bankruptcy Board of India Regulations, 2016
3. Valuation under the SEBI (REIT AND INVIT) Regulations, 2016
4. Determining the Portfolio Value of investments
5. Indian Accounting Standards issued by the ICAI E.g. Impairment testing
6. Transfer Pricing Norms
7. Reserve Bank of India and Foreign Exchange Management Act (FEMA) in case of transfer of security between person resident outside India and president resident in India

Different Regulators in India have prescribed different valuation methodologies for different purposes. However till now due to lack of Indian Valuation Standards and absence of any Regulatory Authority to control, guide and develop the practice of valuation in India, different valuers have been taking different assumptions leading to drastic differences in value conclusion.

Now, the Ministry of Corporate Affairs (MCA) has now issued the Companies (Registered Valuers and Valuation) Rules, 2017 (Rules) on 18th October, 2017, and it has come into force w.e.f. 18th October, 2017.

These rules contain various aspects pertaining to Registered Valuers including:

Individual prespective

1. Eligibility, Qualification and experience, clearance of Valuation examination for each Asset Class and the process involved;
2. It also mentions the process involved in Application for certificate of registration, conditions for refusal to grant certificate and other Transitional Arrangement

Valuation Professional Organization prespective

3. Eligibility and Role of Registered Valuers Organisation (RVO) for conducting educational courses, granting membership, conducting training, laying code of conduct, monitoring the functioning of valuers and addressing grievances including conducting disciplinary proceedings against valuers who are its members;
4. It also mentions the process involved in Application for certificate of registration, conditions for refusal to grant certificate and other Transitional Arrangement

Valuation Standard

5. The Valuation Standards required to be adhered to while performing and reporting;
6. Contents of the Valuation Report including permissible caveats and limitations;
7. Formulation of Advisory Committee

Disciplinary Proceedings

8. Cancellation or suspension of certificate of registration or recognition

As per Companies (Registered Valuers and Valuation) Rules, 2017, the valuer can apply one of the following Valuation Standards while conducting valuation exercise.

1. A registered valuer shall make valuations as per the Valuation Standards notified from time to time by the Central Government.
2. Until such time as the Valuation Standards are notified by the Central Government, a valuer shall make valuations as per
   1. an internationally accepted valuation methodology;
   2. valuation standards adopted by any valuation professional organisation; or
   3. valuation standards specified by Reserve Bank of India, Securities and Exchange Board of India or any other statutory regulatory body.

The Companies (Registered Valuers and Valuation) Rules, 2017 prescribes use of Internationally accepted Valuation Standard.

So, here is a synopsis of International Valuation Standard (IVS) issued by International Valuation Standard Council that can be considered for valuation of Companies.

IVS 101 Scope of Work

A scope of work (sometimes referred to as terms of engagement) describes the fundamental terms of a valuation engagement, such as the asset(s) being valued, the purpose of the valuation and the responsibilities of parties involved in the valuation

Wherever possible, the scope of work should be established and agreed between parties to a valuation assignment prior to the valuer beginning work

A valuer must communicate the scope of work to its client prior to completion of the assignment, including the following:

1. Identity of the valuer: The valuer must disclose any material connection or involvement with the subject asset or the other parties to the valuation assignment, or if there are any other factors that could limit the valuer's ability to provide an unbiased and objective valuation.
2. Identity of the client(s) (if any): The report must 
   highlight for whom the valuation assignment is being produced.
3. Identity of other intended users (if any): It must state the intended users, their identity and their needs, to 
   ensure that the report content and format meets those users' needs.
4. Asset(s) being valued: The asset under valuation must be clearly identified.
5. The valuation currency.
6. Purpose of the valuation: The purpose for which the valuation is being undertaken must be clearly identified to ensure that the valuation advice is not used out of context or for purposes for which it is not intended.
7. Basis/bases of value used: The bases of Valuation is based on the purpose of the valuation. The IVS 104 Bases of Value states that the valuation basis must be appropriate for the valuation.
8. Valuation date: The valuation date must be stated.
9. The nature and extent of the valuer's work and any limitations thereon.
10. The nature and sources of information upon which the valuer relies.
11. Significant assumptions and/or special assumptions.
12. The type of report being prepared.
13. Restrictions on use, distribution and publication of the report.
14. That the valuation will be prepared in compliance with IVS and that the valuer will assess the appropriateness of all significant inputs.

IVS 102 Investigations and Compliance

Investigations made during the course of a valuation assignment must be appropriate for the purpose of the valuation assignment and the basis(es) of value.

When a valuation assignment involves reliance on information supplied by a party other than the valuer, consideration should be given as to whether the information is credible or that the information may otherwise be relied upon without adversely affecting the credibility of the valuation opinion.

In considering the credibility and reliability of information provided, valuers should consider matters such as:

1. the purpose of the valuation,
2. the significance of the information to the valuation conclusion
3. the expertise of the source in relation to the subject matter, and
4. whether the source is independent of either the subject asset and/or the recipient of the valuation.

IVS 103 Reporting

This standard applies to all valuation reports or reports on the outcome of a valuation review which may range from comprehensive narrative reports to abbreviated summary reports

The report must set out a clear and accurate description of

1. the scope of the assignment,
2. its purpose and intended use (including any limitations on that use) and
3. the approach or approaches adopted,
4. the method or methods applied,
5. the key inputs used
6. disclosure of any assumptions,
7. special assumptions,
8. significant uncertainty or limiting conditions that directly affect the valuation
9. the conclusion(s) of value and principal reasons for any conclusions reached, and
10. the date of the report (which may differ from the valuation date)

IVS 104 Bases of Value

Bases of value (sometimes called standards of value) describe the fundamental premises on which the reported values will be based. It is critical that the basis (or bases) of value be appropriate to the terms and purpose of the valuation assignment, as a basis of value may influence or dictate a valuer's selection of methods, inputs and assumptions, and the ultimate opinion of value.

A valuer may be required to use bases of value that are defined by statute, regulation, private contract or other document. Such bases have to be interpreted and applied accordingly

Definitions

Market Value – Market Value is the estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm's length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion.

Market Rent – Market Rent is the estimated amount for which an interest in real property should be leased on the valuation date between a willing lessor and a willing lessee on appropriate lease terms in an arm's length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion.

Equitable Value – Equitable Value is the estimated price for the transfer of an asset or liability between identified knowledgeable and willing parties that reflects the respective interests of those parties.

Investment Value – Investment Value is the value of an asset to a particular owner or prospective owner for individual investment or operational objectives.

Synergistic Value – Synergistic Value is the result of a combination of two or more assets or interests where the combined value is more than the sum of the separate values

Liquidation Value is the amount that would be realised when an asset or group of assets are sold on a piecemeal basis. Liquidation Value should take into account the costs of getting the assets into saleable condition as well as those of the disposal activity. Liquidation Value can be determined under two different premises of value:

1. an orderly transaction with a typical marketing period, or
2. a forced transaction with a shortened marketing period

IFRS 13 defines Fair Value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

The OECD defines Fair Market Value as the price a willing buyer would pay a willing seller in a transaction on the open market.

IVS 105 Valuation Approaches and Methods

The goal in selecting valuation approaches and methods for an asset is to find the most appropriate method under the particular circumstances. No one method is suitable in every 
possible situation. The selection process should consider, at a minimum:

1. the appropriate basis(es) of value and premise(s) of value, determined by the terms and purpose of the valuation assignment,
2. the respective strengths and weaknesses of the possible valuation approaches and methods,
3. the appropriateness of each method in view of the nature of the asset, and the approaches or methods used by participants in the relevant market, and
4. the availability of reliable information needed to apply the method(s).

Use of Methods

Valuers are not required to use more than one method for the valuation of an asset, particularly when the valuer has a high degree of confidence in the accuracy and reliability of a single method, given the facts and circumstances of the valuation engagement.

However, valuers should consider the use of multiple approaches and methods and more than one valuation approach or method should be considered and may be used to arrive at an indication of value, particularly when there are insufficient factual or observable inputs for a single method to produce a reliable conclusion.

Where more than one approach and method is used, or even multiple methods within a single approach, the conclusion of value based on those multiple approaches and/or methods should be reasonable and the process of analysing and reconciling the differing values into a single conclusion, without averaging, should be described by the valuer in the report.

When different approaches and/or methods result in widely divergent indications of value, a valuer should perform procedures to understand why the value indications differ, as it is generally not appropriate to simply weight two or more divergent indications of value.

Valuers should maximise the use of relevant observable market information in all three approaches.

Valuation Methodologies

There are 3 valuation methodologies

• Market Approach
• Income Approach
• Cost Approach

Market Approach

The market approach provides an indication of value by comparing the asset with identical or comparable (that is similar) assets for which price information is available.

The market approach should be applied and afforded significant weight under the following circumstances:

1. the subject asset has recently been sold in a transaction appropriate for consideration under the basis of value,
2. the subject asset or substantially similar assets are actively publicly traded, and/or
3. there are frequent and/or recent observable transactions in substantially similar assets

When comparable market information does not relate to the exact or ubstantially the same asset, the valuer must perform a comparative analysis of qualitative and quantitative similarities and differences between the comparable assets and the subject asset. It will often be necessary to make adjustments based on this comparative analysis. Those adjustments must be reasonable and valuers must document the reasons for the adjustments and how they were quantified.

Market Approach Methods

Comparable Transactions Method

The comparable transactions method, also known as the guideline transactions method, utilises information on transactions involving assets that are the same or similar to the subject asset to arrive at an indication of value.

The key steps in the comparable transactions method are:

1. identify the units of comparison that are used by participants in the relevant market,
2. identify the relevant comparable transactions and calculate the key valuation metrics for those transactions,
3. perform a consistent comparative analysis of qualitative and quantitative similarities and differences between the comparable assets and the subject asset,
4. make necessary adjustments, if any, to the valuation metrics to reflect differences between the subject asset and the comparable assets,
5. apply the adjusted valuation metrics to the subject asset, and
6. if multiple valuation metrics were used, reconcile the indications of value.

Guideline publicly-traded comparable method

The guideline publicly-traded method utilises information on publicly-traded comparables that are the same or similar to the subject asset to arrive at an indication of value.

The key steps in the guideline publicly-traded comparable method are to:

1. identify the valuation metrics/comparable evidence that are used by participants in the relevant market,
2. identify the relevant guideline publicly-traded comparables and calculate the key valuation metrics for those transactions,
3. perform a consistent comparative analysis of qualitative and quantitative similarities and differences between the publicly-traded comparables and the subject asset,
4. make necessary adjustments, if any, to the valuation metrics to reflect differences between the subject asset and the publicly-traded comparables,
5. apply the adjusted valuation metrics to the subject asset, and
6. if multiple valuation metrics were used, weight the indications of value.

Normally, the earnings multiple is arrived for the selected companies. The earnings multiple are then analysed with Enterprise Value (EV) of the Company. Commonly used multiple are EV/EBITDA, EV/EBIT or P/E.

(Enterprise Value) (Market Value of Equity + Market Value of Debt)
_______________ = ___________________________________________

EBITDA EBITDA

In the market approach, the fundamental basis for making adjustments is to adjust for differences between the subject asset and the guideline transactions or publicly-traded securities

• Discounts for Lack of Marketability
• Discounts for Lack of Control

Income Approach

The income approach provides an indication of value by converting future cash flow to a single current value. Under the income approach, the value of an asset is determined by reference to the value of income, cash flow or cost savings generated by the asset.

The income approach should be applied and afforded significant weight under the following circumstances:

1. the income-producing ability of the asset is the critical element affecting value from a participant perspective, and/or
2. reasonable projections of the amount and timing of future income are available for the subject asset, but there are few, if any, relevant market comparables.

Discounted Cash Flow (DCF) Method

Under the DCF method the forecasted cash flow is discounted back to the valuation date, resulting in a present value of the asset.

In some circumstances for long-lived or indefinite-lived assets, DCF may include a terminal value which represents the value of the asset at the end of the explicit projection period. In other circumstances, the value of an asset may be calculated solely using a terminal value with no explicit projection period. This is sometimes referred to as an income capitalization method.

The key steps in the DCF method are:

1. choose the most appropriate type of cash flow for the nature of the subject asset and the assignment (ie, pre-tax or post-tax, total cash flows or cash flows to equity, real or nominal, etc.),
2. determine the most appropriate explicit period, if any, over which the cash flow will be forecast Valuers should consider the following factors when selecting the explicit forecast period:
   1. the life of the asset,
   2. a reasonable period for which reliable data is available on which to base the projections,
   3. the minimum explicit forecast period which should be sufficient for an asset to achieve a stabilized level of growth and profits, after which a terminal value can be used,
   4. in the valuation of cyclical assets, the explicit forecast period should generally include an entire cycle, when possible, and
   5. for finite-lived assets such as most financial instruments, the cash flows will typically be forecast over the full life of the asset
3. prepare cash flow forecasts for that period, typically the projected cash flow will reflect one of the following – contractual or promised cash flow, the single most likely set of cash flow, the probability-weighted expected cash flow, or multiple scenarios of possible future cash flow
4. determine whether a terminal value or exit value is appropriate for the subject asset at the end of the explicit forecast period (if any)

Terminal Value

Where the asset is expected to continue beyond the explicit forecast period, valuers must estimate the value of the asset at the end of that period. The terminal value is then discounted back to the valuation date, normally using the same discount rate as applied to the forecast cash flow

Exit Value

The ultimate goal of market approach – exit value is to calculate the value of the asset at the end of the explicit cash flow forecast. However, the valuers should consider the expected market conditions at the end of the explicit forecast period and make adjustments accordingly.

5. determine the appropriate discount rate, and

there are many methods for developing or determining the reasonableness of a discount rate, a non-exhaustive list of common methods includes:

1. the capital asset pricing model (CAPM),
2. the weighted average cost of capital (WACC),
3. the observed or inferred rates/yields,
4. the internal rate of return (IRR),
5. the weighted average return on assets (WARA), and
6. the build-up method (generally used only in the absence of market inputs).

The Debt-Equity ratio is applied and a WACC can be calculated in a manner shown by the formula below:

WACC = (Cost of Equity x Equity Weight) + (After Tax Cost of Debt x Debt weight)
(Debt weight + Equity weight) (Debt weight + Equity weight)

6. apply the discount rate to the forecasted future cash flow, including the terminal value, if any

Cost Approach

The cost approach provides an indication of value using the economic principle that a buyer will pay no more for an asset than the cost to obtain an asset of equal utility, whether by purchase or by construction, unless undue time, inconvenience, risk or other factors are involved. The approach provides an indication of value by calculating the current replacement or reproduction cost of an asset and making deductions for physical deterioration and all other relevant forms of obsolescence

Broadly, there are three cost approach methods:

1. replacement cost method: a method that indicates value by calculating the cost of a similar asset offering equivalent utility,
2. reproduction cost method: a method under the cost that indicates value by calculating the cost to recreating a replica of an asset, and
3. summation method: a method that calculates the value of an asset by the addition of the separate values of its component parts

Replacement Cost Method

Replacement cost is the cost that is relevant to determining the price that a participant would pay as it is based on replicating the utility of the asset, not the exact physical properties of the asset.

The key steps in the replacement cost method are:

1. calculate all of the costs that would be incurred by a typical participant seeking to create or obtain an asset providing equivalent utility,
2. determine whether there is any depreciation related to physical, functional and external obsolescence associated with the subject asset, and
3. deduct total depreciation from the total costs to arrive at a value for the subject asset.

Reproduction Cost Method

Reproduction cost is appropriate in circumstances such as the following:

1. the cost of a modern equivalent asset is greater than the cost of recreating a replica of the subject asset, or
2. the utility offered by the subject asset could only be provided by a replica rather than a modern equivalent.

The key steps in the reproduction cost method are:

1. calculate all of the costs that would be incurred by a typical participant seeking to create an exact replica of the subject asset,
2. determine whether there is any depreciation related to physical, functional and external obsolescence associated with the subject asset, and
3. deduct total depreciation from the total costs to arrive at a value for the subject asset.

Summation Method

The summation method, also referred to as the underlying asset method, is typically used for investment companies or other types of assets or entities for which value is primarily a factor of the values of their holdings.

The key steps in the summation method are:

1. value each of the component assets that are part of the subject asset using the appropriate valuation approaches and methods, and
2. add the value of the component assets together to reach the value of the subject asset

Model Code of Conduct for Registered Valuers

Schedule I of the Companies (Registered Valuers and Valuation) Rules, 2017 prescribes Model Code of Conduct for Registered Valuers

1. Integrity and Fairness
2. Professional Competence and Due Care
3. Independence and Disclosure of Interest
4. Confidentiality
5. Information Management
6. Gifts and hospitality
7. Remuneration and Costs
8. Occupation, employability and restrictions

Valuation Methodologies – An Overview

Selection of Methods

Brand Valuation Methods