An Insight of Valuation
by- www.CorporateValuations.in a venture of
SEBI REGISTERED (CAT -I) MERCHANT BANKER
Contents
TABLE OF CONTENT
Particulars Valuation Overview Approaches to Valuation - Asset Based Method; - Market Based Method; - Income Based Method; - Other Valuation Methods; - Reconciliation and Value Conclusion. Purchase Price Allocation Reason to get Valuations Key take away for better Valuation Pg. No. 1
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Where things can go wrong
International Valuation Standards
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VALUATION OVERVIEW
Value & Valuation
Value is*
An Economic concept;
An Estimate of likely prices to be concluded by the buyer and seller of a good or service that is available for purchase;
Not a fact.
Valuation is the process of determining the Economic Worth of an Asset or Company
under certain assumptions and limiting conditions and subject to the data available on the
valuation date.
* Source -International Valuation Standard Council
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Key Facts of Valuation
PRICE IS NOT THE SAME AS VALUE
The Value of a business, by whatever valuation method it is obtained, is not the selling price of the business. Value is an economic concept based on certain data & assumptions, however Price is what a Buyer is willing to pay keeping in consideration the Economic and Non Economic factors like Emotions, Perception, Greed Etc which cannot be valued as such.
VALUE VARIES WITH PERSON, PURPOSE AND TIME
The Value is a subjective term and can have different connotations meaning different things to different people and the result may not be the same, as the context or time changes.
TRANSACTION CONCLUDES AT NEGOTIATED PRICES
Though the value of a business can be objectively determined employing valuation approaches, this value is still subjective, dependent on buyer and seller expectations and subsequent negotiations and the Transaction happens at negotiated price only.
VALUATION IS HYBRID OF ART & SCIENCE
Valuation is more of an art and not an exact science. The Art is Professional Judgment and Science is Statistics. Mathematical certainty is neither determined nor indeed is it possible as use of professional judgment is an essential component of estimating value
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Few Valuation Quotes
Appraisers have a value in mind before they start the process and try to back into
it.
Aswath Damaodaran
Price is what you pay, value is what you get. They are not same.
Warren Buffett
The analysis is most important how you took the data, analysed it, and wed it to your conclusion . I want to see your thinking because thats what appellant
court wants to see from me.
Judge David LARO A senior Judge of the US Tax court
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Standard of Value
Standard of Value is the first step in valuation exercise which helps in determining the type of
value being utilized in a specific valuation engagement.
While selecting the Standard of Value following points is to be taken care of
Subject matter of Valuation;
Purpose of Valuation;
Statute; Case Laws; Circumstances.
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Types of Standard of Value
FAIR MARKET VALUE
The price at which the property would change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell & both parties having reasonable knowledge of the relevant facts.
INVESTMENT VALUE
Value to a particular investor based on individual investment requirements & expectations
INTRINSIC VALUE
The value of the business arising from the Fundamental or intrinsic factor
FAIR VALUE
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
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Types of Premise of Value
Premise of value -
Talks about types of market conditions likely to be encountered
Premise of Value
Going Concern Value as an ongoing operating business enterprise. Liquidation Value when business is terminated . It could be forced or orderly.
Premise of value is of utmost important while undertaking any valuation assignment because there is a significant change in value if its valued as a going concern or on liquidation.
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Valuation: The law of Economics
Valuation across business cycle follow the law of economics
Declining Cos. Turnover / Profits
Turnover/Profits: Drops Proven Track Record: Substantial Operating History Method of Valuation: Entirely from Existing Assets Cost of Capital: N.A.
Mature Cos.
Turnover/Profits: Saturated Proven Track Record: Widely Available Method of Valuation: More from Existing Assets Cost of Capital: May be High
High Growth Cos.
Turnover/Profits : Good Proven Track Record: Available Valuation Methodology: Business Model with Asset Base Cost of Capital: Reasonable
Growing Cos.
Turnover/Profits: Increasing still Low Proven Track Record: Limited Valuation Methodology: Substantially on Business Model Cost of Capital: Quite High
Start Up Cos.
Turnover/Profits: Negligible Proven Track Record: None Valuation Methodology: Entirely on Business Model Cost of Capital: Very High
Time
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Sources of Information for Valuation
Sources of Information
Historical financial results Income Statement and Balance Sheets
Data available in Public Domain Stock Exchange / MCA/SEBI/Independent Report
Data on comparable companies SALES/EVEBITDA/ PAT/BV Stock market quotations BSE/ NSE Discussion and Representation with/by the management of the Company Data on projects planned/under implementations including future projection
Dr. W. Edwards Demings
In God we trust, all others bring data
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Key drivers for Value Creation
CASH FLOW
Investor assign value based on the cash flow they expect to receive in the future - Dividends / distributions
- Sale of liquidation proceeds
Value of a cash flow stream is a function of - Timing of cash Receipt
- Risk associated with the cashflow
ASSETS
Operating Assets
- Assets used in the operation of the business including working capital, Property, Plant & Equipment & Intangible assets - Valuing of operating assets is generally reflected in the cash flow generated by the business
Non - Operating Assets
- Assets not used in the operations including excess cash balances, and assets held for investment purposes, such as vacant land & Securities - Non operating assets are generally valued separately and added to the value of the operations
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APPROACHES TO VALUATION
Broad Approaches to Valuation
Valuation Approaches
Asset Based Method
Income Based Method
Market Based Method
Other Methods
Book Value Method
Capitalization of Earning Method
Comparable Companies Market Multiples Method
Contingent Claim Valuation
Liquidation Value Method
Discounted Free Cash Flow Method
Comparable Transaction Multiples Method
Price of Recent Investment Method
Replacement Value Method
Market Value Method (For Quoted Securities)
Rule of Thumb
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ASSET BASED METHOD
Asset Based Method
Asset based method (NAV) views the business as a set of assets and liabilities that are used as building blocks to construct the picture of business value. The difference of these Assets and Liabilities is the business Value through Assets based method. However, as the Value reflected in books is historical in nature and do not usually include intangible assets and earning potential and is also impacted by accounting policies which may be discretionary at times, thus NAV is not perceived as a true indicator of the fair business value. However, it is used to evaluate the entry barrier that exists in a business and is considered viable for companies having reached the mature or declining growth cycle and also for property and investment companies having strong asset base. Adjusted Net Asset method - For Calculating the Adjusted NAV, the valuer should factor in the contingent liability, Tax Shield on accumulated losses, impact of Auditor qualification and Due Diligence, money to be received from warrants, stock options and impact of corresponding shares.
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Asset Based Method (contd)
TYPES OF ASSET BASED METHOD
Book Value Method This form of valuation is based on the books of a business, where owners' equity i.e. total assets minus total liabilities are used to set a price. As this method is entirely dependent on the Accounting values which most like are not the fair values , so most business valuation experts prefer to use an adjusted book value. Liquidation Value Method This method is similar to the book valuation method, except that the value of assets at liquidation is used instead of the book or market value of the assets. Replacement Value Method Replacement value is different from liquidation/book value as it uses the replacement value of assets which assumes the value of business as if a new business is being set up, this methodology may not be relevant in case of valuation for a going concern.
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MARKET BASED METHOD
Market Based Method
In this method, value is determined by comparing the subject, company or assets with its peers or Transactions happening in the same industry and preferably of the same size and region. This is also known as Relative Valuation Method. Whereas no publicly traded company provides an identical match to the operations of a given company, important information can be drawn from the way similar enterprises are valued by public markets. A key benefit of market analysis is that this methodology is based on the current market stock price which is generally viewed as one of the best valuation metrics because markets are considered somewhat efficient. This method is easiest to use when - Large number of assets comparable to the one being valued - Assets are priced in the market - There exist some common variable that can be used to standardize the price
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Market Based Method (contd)
TYPES OF MARKET BASED METHOD
Comparable Companies Market Multiples Method (CCM)
Comparable Transaction Multiples Method (CTM)
Market Value Method (For Quoted Securities)
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Market Based Method (contd)
Comparable Companies Market Multiples Method (CCM)
Market Multiples of Comparable Listed Companies are computed and applied to the Company being valued to arrive at a multiple based valuation. The difficulty here is in the selection of a comparable company, since it is rare to find two or more companies with the same product portfolio, size, capital structure, business strategy, profitability and accounting practices. Most Valuations in stock markets are market based. Also Valuations for Tax purposes are done using this method.
It Involves determining long term industry multiples using relevant parameters like: Sales EV / Sales looks at the enterprise value (market value of equity and debt) of firm vis-vis sales Earnings before interest, taxes and depreciation (EBDITA) EV / EBIDTA, values the firm on the basis of operating efficiency. Net Debt is deducted to arrive at the value of Equity Net Profit P / E, values the Equity on the basis of net earnings of company Book Value P / BV values the Equity on basis of book value of company
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Market Based Method (contd)
Comparable Transaction Multiples Method (CTM)
This technique is mostly used for valuing a company for M&A, the transaction that have taken place in the Industry which are similar to the transaction under consideration are taken into account. With the transaction multiple method, similar acquisition or divestitures are identified, and the multiples implied by their purchase prices are used to assess the subject companys value. The greatest impediment in finding truly comparable transactions is the absence of available information on private transactions based on which such transactions took place. The more recent the transaction, the better this technique, with all other things being equal.
Market Value Method (For Quoted Securities)
The Market Value method is generally the most preferred method in case of frequently traded Shares of Companies listed on Stock Exchanges having nationwide trading as it is perceived that the market value takes into account the inherent potential of the Company.
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INCOME BASED METHOD
Income Based Method
The Income based method of valuations are based on the premise that the current value of any business is a function of the future value that an investor can expect to receive from purchasing all or part of the business. As in most cases, the interest of any Investor is linked with the inherent earning capacity of a company which also factors in the value of Intangibles so the value derived through Income based methods is generally given more weight in the value conclusion.
TYPES OF INCOME BASED METHOD Capitalization of Earning Method Discounted Cash Flow Method
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Income Based Method (contd)
Capitalization of Earning Method
The capitalization method basically divides the business expected earnings by the so-called capitalization rate. The idea is that the business value is defined by the business earnings and the capitalization rate is used to relate the two. The first step under this method is the determination of capitalization rate - a rate of return required to take on the risk of operating the business (the riskier the business, the higher the required return). Earnings are then divided by that capitalization rate. The earnings figure to be capitalized should be one that reflects the true nature of the business based on the expected normalized profits, excluding the impact of any extraordinary items not expected to accrue in future. While determining a capitalization rate, it is necessary to compare with rates available to similarly risky investments.
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Income Based Method (contd)
Discounted Cash Flow Method (DCF)
DCF expresses the present value of the business as a function of its future cash earnings capacity. In this method, the appraiser estimates the cash flows of
any business after all operating expenses, taxes, and necessary investments in working capital and capital expenditure is being met. Valuing equity using the free cash flow to stockholders requires estimating only free cash flow to equity holders, after debt holders have been paid off.
Characteristics of DCF Valuation
Forward Looking and focuses on cash generation Recognizes Time value of Money Allows operating strategy to be built into a model Only as accurate as assumptions and projections used Works best in producing a range of likely values
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Income Based Method (contd)
DCF: MAJOR CONSTITUENTS
Free cash Flows
Terminal Value
To use discounted cash flow valuation one needs
Beta Value, Terminal Growth Rate, Risk premium, Specific company risk premium, Company Specific risk
Cost of Capital (WACC)
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Income Based Method (contd)
FREE CASH FLOWS Free cash flows to firm (FCFF) is calculated as
Taxes EBITDA Change in Non Cash Working capital Capital Expenditure Free Cash Flow to Firm
Note that an alternate to above is following (FCFE) method in which the value of Equity is directly valued in lieu of the value of Firm. Under this approach, the Interest and Finance charges is also deducted to arrive at the Free Cash Flows. Adjustment is also made for Debt (Inflows and Outflows) over the definite period of Cash Flows. Though theoretically the value conclusion should remain same irrespective of the method followed (FCFF or FCFE), however practically it seldom matches due to use of a plethora of other factors.
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Income Based Method (contd)
DISCOUNT RATE WEIGHTED AVERAGE COST OF CAPITAL
(Kd x D) + (Ke x E)
WACC
(D + E)
Where:
D = Debt part of capital structure E = Equity part of capital structure Kd = Cost of Debt (Post tax) Ke = Cost of Equity
In case of following FCFE, Discount Rate is Ke and Not WACC
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Income Based Method (contd)
DISCOUNT RATE - COST OF EQUITY
The Cost of Equity (Ke) is computed by using Modified Capital Asset Pricing Model (Mod. CAPM) Mod. CAPM Model ke = Rf + B ( Rm-Rf) + SCRP + CSRP
Where:
Rf = B = Ke = Rm= Risk free rate of return (Generally taken as 10-year Government Bond Yield) Beta Value (Sensitivity of the stock returns to market returns) Cost of Equity Market Rate of Return (Generally taken as Long Term average return of Stock Market) SCRP = Small Company Risk Premium CSRP= Company specific Risk premium
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Income Based Method (contd)
TERMINAL VALUE
PERPETUITY FORMULA
Capitalizes FCF after definite forecast period as a growing perpetuity;
Estimate Terminal Value using Terminal Value Multiplier applied on last year cash flows Gordon Formula is often used to derive the Terminal Cash Flows by applying the last year cash flows as a multiple of the growth rate and discounting factor
(1 + g)
(WACC g)
Estimated Terminal Value is then discounted to present day at companys cost of capital based on the discounting factor of last year
IMPORTANT TIP- It is advised to do Sanity check by applying Relative Valuation Multiples to the Terminal Year Financials and also doing Scenario Analysis
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OTHER VALUATION METHODS
Other Valuation Methods
Price of Recent Investment Method (PORI)
Under this valuation approach, the recent investment in the business by an Independent party may be taken as the base value for the current appraisal, if no substantial changes have taken place since the date of such last investment. Generally the last Investment is seen over a period of last 1 year and suitable adjustments are made to arrive at current value.
Contingent Claim Valuation
Under this valuation approach, the recent investment in the business by an Independent party may be taken as the base value for the current appraisal, if no substantial changes have taken place since the date of such last investment. Generally the last Investment is seen over a period of last 1 year and suitable adjustments are made to arrive at current value.
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Other Valuation Methods (contd)
Rule of Thumb
Although technically not a valuation method, rule of thumb or benchmark indicator is used as a reasonableness check against the values determined by the use of other valuation approaches. For example: in case of Hotel Valuations- EV/No. of Rooms, in case of Mutual Funds- % of Asset Under Management (AUM) and likewise for each Industry there are certain parameters which can assist in arriving as a benchmark value.
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Reconciliation and Value Conclusion
a. Different methodology shows different range of values; b. Valuer shall consider relevance of each methodology depending upon the purpose and premise of each valuation; c. While Selecting the final value: Subjective Weighting o o Mathematical Weighting Professional Judgement
In mathematical weighting specific weights are assigned to each approach and weighted average calculated
In professional judgment the conclusion is based on experience and judgment given the quality of information and the approaches applied.
While concluding Value, all the methodologies must be considered and then weights applied as per the facts of the case. In other words, Value conclusion should be based on the Professional Judgement and Simple Average should best be avoided while concluding Value.
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PURCHASE PRICE ALLOCATION
Purchase Price Allocation
What is a Purchase Price Allocation? an acquiring entity must allocate the purchase price to the assets acquired and liabilities assumed based on estimated fair values at the date of acquisition; The excess of the cost of an acquired entity (including tangible and intangible assets) over the net of the amounts assigned to assets acquired and liabilities assumed is recorded as Goodwill;
Tangible Assets
In Proportion to Fair Value
Consideration paid for acquisition
Allocated to
Intangible Assets
Goodwill
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Balancing Figure
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Purchase Price Allocation (contd)
Why Purchase Price Allocation? Intangible assets recognized separately from goodwill must be valued and amortized for financial reporting purposes, if appropriate This may result in better Tax planning for undertaking the transactions of acquisition of assets and liabilities; Under Slump sale transaction, specifically the Intangible Assets can be separately accounted for by the Acquirer and Depreciation also claimed under the provisions of Indian Income Tax Law. IFRS 3: Business Combinations, requires the allocation of the purchase price in a purchase combination to be allocated between tangible and intangible assets based on fair value.
It may be noted that even under IFRS, there is no separate requirement of accounting separately for Intangibles. Thus the Valuation of Intangibles is needed specifically for PPA
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Purchase Price Allocation (contd)
Fair Value of Tangible Assets Categories -Technology Based -Marketing Based -Customer Based -Artistic Skills
Total Value of Company equals to the Value of Tangible Assets, Intangible Assets and the Goodwill. In other words, Intangible Assets form part of the Total Value computed using the Valuation Methodologies. PPA is used to allocate the Value amongst Tangible and Intangible Assets.
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Reason to get Valuation
Mergers & Acquisitions Going Public
Regulatory Mandate
Succession Planning
Dispute Resolution
Voluntary Assessment
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Reason to get Valuation (contd)
MERGERS & ACQUISITIONS
Valuation is an important aspect in Mergers and Acquisitions (M&A). A valuation can not only assist business owners in determining the value of their business, it can also help them maximize value when considering a sale, merger, acquisition, joint venture or strategic partnership. Also in M&A, accurate determination of share exchange ratio is very important. Share exchange ratio is generally determined by relative bargaining strength of the two companies i.e. the weaker a company's earning capacity or financial strength renders it weaker in bargaining strength and thus its shareholders are likely to have low value for the share's worth. There are a number of court cases judgements and observations of stock exchanges/ SEBI which need to be kept in mind before finalizing the swap ratio.
DISPUTE RESOLUTION
Valuations are an increasingly important aspect of many commercial disputes. Before, deciding as to how to manage a dispute, it is necessary to determine the likelihood of a successful outcome and the potential stake involved. Judicial precedents are also available that affect the selection of Valuation methodologies and applicability of Discounts/Premiums.
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Reason to get Valuation (contd)
GOING PUBLIC
In general, when a new company goes for an Initial Public Offering (IPO) it is doing that in order to generate capital for growing its business. In such a circumstance, a question arises as to how to evaluate the fair value of such a stock. The Indian Capital Market follows a free pricing regime and thus the accurate pricing of an IPO is of immense importance. Both Overpricing as well as under pricing have negative impact. For instance, if a stock is offered to the public at a higher price than the market will pay, the underwriters may have trouble meeting their commitments to sell shares. Even if they sell all of the issued shares, if the stock falls in value on the first few days of trading, it may lose its marketability and hence even more of its value.
VOLUNTARY ASSESSMENT
At times the management of the company wants to know the true worth and fair value of the business for which they undertake the exercise of voluntary assessment for internal management purpose and future decision making. Its better to have an idea of the Tentative Value of the Company, before approaching any Investors.
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Reason to get Valuation (contd)
SUCCESSION PLANNING
Types of Succession Planning
Succession to Family Members In planning for the transfer of business to the next generation, the following important items must be considered: - Overall estate planning of the business owners; - Utilization and optimization of gifting where appropriate; - Utilization of trusts as a vehicle for transfer; - Life insurance; - Buy-sell agreements and shareholder agreements; - Family limited partnerships; - Retirement income planning of the owners; - Capital and financing needs of the business. Succession to Employees For many closely held businesses, the sale of the business to one or more key employees is often a viable succession strategy. Succession to Outside Parties It comprises of mergers, acquisitions, purchases and sales of businesses.
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Reason to get Valuation (contd)
REGULATORY VALUATIONS
Transactions Prescribed Methodologies DFCF Valuer Discretion NAV Price it would fetch if sold in open market Valuer Discretion Option Pricing Model Only Parameters Prescribed Return on Net Worth, EPS, NAV vis-a vis Industry Based on Market Price Average Valuer Discretion Mandate to be done by
Inbound Investment
CA / MB
Reserve Bank of India
Outbound Investment Gift of Unquoted Equity Shares
>5Mn$ - MB, otherwise CA/MB MB
Income Tax
Gift of Unquoted Shares other than Equity Shares ESOP Tax ESOP Accounting
MB CA/MB
SEBI
Takeover Code/ Delisting - Infrequently Traded
Takeover Code/ Delisting - Frequently Traded
Stock Exchanges
Relisting Base Price Determination Sweat Equity
MB
Companies Act
Valuer Discretion
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Key Takeaways for Better Valuation
Use Simple Models; Follow law of Economy; Minimize bias in Valuation process; Evaluate the stage of business Cycle; Do sanity check by multiple methods;
Justify business model and key assumptions;
Substantiate Data.
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Where Things can go Wrong
Excess, Cash & Non operating assets; Transparency & Corporate Governance; Accounting Practices; Cross Holdings; Legal Environment & Tax Implications;
Intangibles and IPRs;
Subsequent Events; Off Balance Sheet Items; Discounts and Premiums.
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Where Things can go Wrong (contd)
DISCOUNTS & PREMIUMS
Discounts & Premiums come into picture when there exist difference between the subject being valued and the Methodologies applied. As this can translate control value to non-control and vise versa , so these should be judiciously applied.
Control Premium - An amount or percentage by which the pro-rata value of a controlling interest exceeds the pro-rata value of a non controlling interest in a business enterprise to reflect the power of control. Discount on Lack of Control (DLOC) - An amount or percentage deducted from the pro-rata share of value of 100% of an equity interest in a business to reflect the absence of some or all of the powers of control. Discount on Lack of Marketability (DLOM) - An amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability.
FOR BETTER VALUE CONCLUSION: If valuing on control basis, Valuer should prefer methods that reach control value without having to start with minority value and estimate control premium; If valuing on minority basis, Valuer should prefer methods that reach minority value directly without having to start with control value and estimate minority discount.
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International Valuation Standards
Valuation Standards of American Institute of CPAs (AICPA) The Canadian Institute of Chartered Business Valuators (CICBV)
Internationally Business Valuation standards
American Society of Appraisers (ASA)
National Association of Certified Valuation Analysts (NACVA)
Institute of Business Appraisers (IBA)
Valuation Standards are basically codes of practice that are used in valuation analysis. However in International arena the above mentioned bodies govern the valuation practices. At present there are no prescribed standards and codes for valuation in India (Companies Bill, 2011 is introducing the concept of Registered Valuers)
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IRS Revenue Ruling (59-60),USA
Revenue Ruling (RR) 59-60 is one of the oldest guidance available on Valuation in the world but still most relevant for Tax Valuations specifically for Valuing closely held common stock. It is the most widely referenced revenue ruling, also often referenced for Non Tax Valuations. While Valuing , it gives primary guidance on eight basic factors to consider Nature of the Business and the History of the Enterprise from its inception Economic outlook in general and outlook of the specific industry in particular Book Value of the stock and the Financial condition of the business Earning Capacity of the company Dividend-Paying Capacity of the company. Goodwill or other Intangible value Sales of the stock and the Size of the block of stock to be valued Market prices of stock of corporations engaged in the same or a similar line of business
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