The importance of Business Valuation

An opinion editorial piece by Mr Harsha Basnayake, Head of Transactions at Ernst and Young Singapore

Business Valuation is an exercise, if properly undertaken, that will give an unbiased, credible assessment of the value of a business. Professor Aswath Damodaran at the Stern School of Business at New York University who has taken great pains to simplify the understanding of valuations explains that, “Knowing what an asset (or business) is worth and what determines that value is a pre-requisite for intelligent decision making – in choosing investments for a portfolio, in deciding on the appropriate price to pay or receive in a takeover and in making an investment, financing and dividend choices when running a business.” There are many other circumstances in modern business why valuations are important. These include financial reporting, legal disputes, fund raising, intellectual property and when it comes to determining relative performance of a business.

Knowing what an asset (or business) is worth and what determines that value is a pre-requisite for intelligent decision making

Valuing a business is a complex exercise. It is an exercise that takes into consideration several attributes – purpose of the valuation, date of the valuation, selection of a methodology to apply, cash flows of the business, economic circumstances, prospects of the industry in which the business operates, ownership considerations, capital structure of the business and the experience of the Business Valuer. Therefore the details of the exercise and the uncertainty or limitations attached to the ultimate assessment can vary depending on these attributes.

In this discussion, we examine different purposes of Business Valuations and their significance for decision making:

When buying or selling a business

Buying or selling a business is an essential activity that any company will undertake as part of its capital agenda and is integral to its growth strategy. Every M&A deal is undertaken with sound objective of wanting to create better value for the key stakeholders.

Sound investment decisions dictate that one does not pay anything more than what a business is truly worth. Having an objective assessment of the value of the business that is the subject of the deal is extremely important in an M&A transaction. The ultimate negotiated price compared to the value that may have been assessed as part of the sale or an acquisition gives an indication to the seller or the buyer about the premium or discount at which the deal was concluded.

Having a clear appreciation of the key value drivers of the business, its future cash flow generation capacity, risks attached to generating future cash flows, an objective peer comparability of performance, capital structure of the business, knowledge about the industry, liquidity of the shares transacted and synergies to the buyer and the seller is important. It will allow the Business Valuer to arrive at a sensible assessment of the value of the business that is transacted, and will become an objective reference point for the deal makers in their price negotiations.

Financial reporting purposes

Fair value measurement is the foundation for modern financial reporting. The current financial reporting framework implemented internationally or in differing jurisdictions have all adopted fair value measurement principles to determine the value of assets and liabilities that make up balance sheets of businesses. The argument for fair value measurement in financial reporting is that it makes accounting information more relevant.

Financial reporting standards sets out a framework and bases that have to be applied when measuring the fair value of investments and other assets that the prepares of financial statements must take into consideration. And users of financial statements must have an appreciation of those standards so that the financial statements become meaningful.

An appreciation of Business Valuation principles is fundamental to both preparers and users of financial statements across the world. As financial statements impact not just management decisions and investment choices but wider economic activities.

When settling legal disputes

Shareholder disputes, joint venture disagreements, breach of contracts, award of damages in conflicts are common in the business world. A fair assessment of the value of the subject assets/companies is an important reference for advocates, judges and arbitrators to arrive at a fair and equitable settlement of such disputes. Often these settlements include either a sale or an acquisition or allocation of shares in a business. It may also include situations where the Courts may seek guidance on the mode of settlement by assessing the value to be monetised or created by considering a sale or a liquidation of the business/asset.

Authoritative references to appropriate bases of assessing values in settling legal disputes provide an objective basis to resolve such disputes as well as to ensure that justice has been served to all parties concerned in a fair and consistent manner.

Mr Harsha Basnayake, Head of Transactions at Ernst and Young Singapore

When assessing intellectual property (IP)

With the rise of the global knowledge-based economy, there is a growing recognition in corporate boardrooms that IP is a strategic asset that has tremendous potential to be unlocked and monetised. Assessing the value of IP therefore has gained significance over the years. Sensible, impartial assessment of value of IP is essential for companies to determine the value that they have created, monetise such value as part of their growth strategy through franchise or joint venture arrangements or when it comes to fund raising. All of these issues reinforce the significance of a scientific and unbiased assessment of the underlying value of IP. This is especially important in light of tax incentives and financing schemes that encourage investments in IP.

When raising funds

Whether you are a start-up, a growth company or a matured listed business, when it comes to raising money through private or public investors or seeking alternative capital, an expert valuation of the underlying business is essential. A properly conducted valuation adds credibility for investors to determine risk reward profile of the investment, allow regulators to ensure that the underlying price at which the deal has been consummated is based on arm’s length value and that no shareholder is placed in an unfair position. All of this adds substantial transparency and credibility to the fund raising process.

When assessing overall performance of the business

Most management teams and CEOs are rewarded today by assessing the overall value that their decisions are contributing to create in the business. Business Valuations can help ensure appropriate measurement of such incentives as well as their appropriateness particularly when the company concerned is not listed. Business Valuations can also aid greatly in assessing the relative performance of a business as well as the overall returns that a business is contributing to its investors by designing an appropriate dividend policy, an optimal capital structure or generating an appropriate return.

There are many reasons why Business Valuations are important. It is an essential input to many of the decisions that boards, management, regulators and investors make every day in modern business.

Stay tuned for more articles on Business Valuation as the Institute of Valuers and Appraisers (IVAS) prepares to launch the inaugural Chartered Valuer and Appraiser Programme on 19 April 2016. #