“Valuation analysis: The price should be right” by Bernadette T. Cauan (August 29, 2011)

SUITS THE C-SUITE By Bernadette T. Cauan
Business World (08/29/2011)

Valuation is a vital part of management decision making, particularly in relation to acquisitions, divestments, financial reporting, tax planning and compliance, dispute resolution, business strategy, and performance management.

Regardless of the purpose and/or subject of the valuation, there are general approaches and methods to performing valuation analysis.

General valuation approaches, as well as valuation methods more commonly used, are described in this article.

INCOME APPROACH

This approach is anchored on the concept that value can be estimated by determining the present value of expected future net cash flows to be generated, based on the anticipated timing of its receipt.

The Discounted Cash Flow (“DCF”) analysis is commonly used in performing a valuation based on the income approach. Since the resulting range of values is substantially influenced by the amounts of anticipated future net cash flows and the discount rate to be used, the financial projections are subjected to rigorous review, and the range of discount rates to be used are carefully derived.

Prior to finalizing the net cash flows to be used for the DCF analysis, underlying assumptions are analyzed vis-à-vis historical figures, financial results or key performance indicators of peer companies, and the relevant sector outlook. Selected key assumptions used in preparing the financial projections are also benchmarked against available documents or reports.

MARKET APPROACH

The market approach is predicated on the concept that value can be estimated through a comparison of companies, shares, or assets that have similar features.

The usual challenge in utilizing this approach is the availability of relevant information to be used in the valuation analysis.

The market approach is implemented through two methods:

• Guideline Company Method — Here, relevant comparable companies are identified through an iterative process.

Appropriate multiples are selected, adjustments, if any, are implemented, and then an indication of value is derived based on the selected multiples.

The Guideline Company Method necessitates meticulous analysis to be able to identify appropriate comparable companies.

Among the areas considered are the nature of business operations, business segments, financial results, cash flow patterns, key performance indicators and other corporate statistics.

In case of enterprise value (“EV”), common multiples include EV to sales or revenues, EV to earnings before interest, taxes, depreciation and amortization (“EBITDA”) or EV to earnings before interest and taxes (“EBIT”), whereas in the case of equity value, usual multiples include price-to-earnings (P/E) ratio, and the price-to-book value (P/B) ratio.

• Similar Transaction Method — In this method, an indication of value is derived based on the actual price paid by acquirers in comparable transactions.

The process for implementing the Similar Transaction Method is similar to the Guideline Company Method.

COST APPROACH

This approach is founded on the principle of substitution, specifically, that no rational buyer will pay for a company more than the cost of acquiring the corresponding net assets that have similar condition and function.

The Adjusted Net Asset Value (“NAV”) method is typically used to derive value based on the cost approach.

The NAV method requires restating all of the assets and liabilities of the company from their historical cost basis to the appropriate standard of value, which is most often either its fair market value or fair value.

The cost approach is commonly used to value holding companies, capital-intensive companies, loss-making businesses or companies facing imminent liquidation.

However, it is not the best approach to value companies with predictably robust cash flows or those with significant intangible value.

In practice, it is advisable to select a primary valuation approach, as well as a secondary approach for purposes of cross-checking.

Ideally, the resulting range of values should be within a relatively tight range.

If the results are substantially far apart, it may suggest that the valuation analysis needs to be revisited.

The selection of the valuation approaches and methods to be applied are normally influenced by the condition and attributes of the subject of the valuation and the availability of information.

Inherent, of course, to performing valuation analysis will be the exercise of professional judgment based on experience and market practice.

Moreover, valuation analysis involves estimation based on accepted models and market practice.

This process necessitates an understanding of underlying assets, risks, potential premiums, business models, industry practices, regulatory frameworks and the market environment.

Hence, valuation is often said to be a combination of art and science.

(Bernadette T. Cauan is a Partner of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.