Conceptual Framework of Valuation
The term 'valuation' implies the task of estimating the worth/value of an asset, a security or a business. The price an investor or a business firm is ready to pay to purchase a specific asset or security would be associated to this value. Obviously, two different buyers may not have the same valuation for an asset/business as their perception regarding its worth/value may vary; one may perceive the asset/business to be of higher worth (for whatever reason) and thus may be willing to pay a higher price than the other. A seller would consider the negotiated trading price of the asset/business to be greater than the value of the asset/business he is selling.
Evidently, there are unavoidable subjective circumstances necessitated in the task and operation of evaluation. The undertaking of business evaluation is more splendid than that of an individual security or an asset. In the case of business evaluation, the evaluation is requisite not only of tangible assets like office equipments,machinery, land, plant, buildings, and to a very great extent intangible assets such as trademark, brands, goodwill, patents as well as human resources that manage the business. Likewise, there is an imperative need to take into circumstance recorded financial obligation as well as unrecorded or contingent financial obligation. To a very great extent that the buyer is mindful of the total sums payable, subsequent to the purchase of business.
Thus, the evaluation process is affected by, subjective circumstances. In order to bring down the element of subjectivity, to a marked extent, and aid the finance manager to carry out a more credible evaluation practice in an objective manner, the following concepts of value are mentioned below:
(a) Book value
(b) Market value
(c) Intrinsic value
(d) Liquidation value
(e) Replacement value
(f) Salvage value
(g) Value of goodwill
(h) Fair value.
a)Book Value
The book value of an asset refers to the amount at which an asset is demonstrated in the balance sheet of a business firm. In general, the sum is equal to the initial acquisition cost of an asset less accumulated depreciation. Consequently, this manner of valuation of assets is as per the going concern principle of accounting. In other sense, book value of an asset demonstrated in balance does not reflect its current sale value.
Book value of a business refers to total book value of all valuable assets excluding fictitious assets, such as accumulated losses and deferred revenue expenditures, like preliminary expenses, advertisement, cost of issue of securities not written off less all external financial obligation. It is to a very great extent referred to as net worth.
b) Market Value
In contrast to book value, market value refers to the price at which an asset can be traded in the market. The market value can be applied with respect to tangible assets only, of intangible assets, more often than not, do not have any sale value. Market value of a business refers to the total market value as per stock market quotation of all equity shares outstanding. The market value is applicable to listed companies only.
c) Intrinsic/Economic Value
The intrinsic value of an asset and the present value of incremental future cash inflows are equal and are likely to accrue due to the acquisition of the asset, discounted at the appropriate requisite rate of return. It constitutes the maximum price the buyer would be inclined to compensate for such an asset. The rationale of valuation based on the discounted cash flow approach is employed in capital budgeting conclusions.
In the case of business intended to be purchased, its valuation is equal to the present value of incremental future cash inflows after taxes, likely to grow by addition to the acquiring business firm, discounted at the applicable risk aligned discount rate, as applicable to the acquired business. The economic value points the maximum price at which the business can be acquired.
d) Liquidation Value
Liquidation value shows the price at which every individual asset can be traded if business operations are ceased in the wake of liquidation of the business firm. In operational terms, the liquidation value of a business is equal to the sum of
a) Realizable value of assets
b) Cash and bank balances subtract the payments requisite to discharge all external financial obligation.
In general, among all appraises of value, the liquidation value of a business or an asset is likely to be the to the lowest degree.
e) Replacement Value
The replacement value is the cost of taking on a new asset of equal utility and usefulness. It is normally practicable in valuing tangible assets such as furniture, fixtures and office equipment and which do not bring towards the revenue of the business firm.
f) Salvage Value
Salvage value comprises realizable scrap value on the disposal of assets after the expiry of their economic practicable life. It may be hired to value assets such as machinery and plant. Salvage value should be regarded net of removal costs.
g) Value of Goodwill
The valuation of good will is, in a conceptual manner the most hard. A business firm can be said to have 'real' goodwill in case it earns a rate of return (ROR) on invested funds higher than the ROR earned by similar business firms with the same level of risk. In operational terms, goodwill results when the business firm earns excess superprofits. outlined in this way, the value of goodwill is equivalent to the present value of super profits likely to accrue, say for 'n' number of years in future, the discount rate being the requisite rate of return applicable to such business firms.
The value of good will with respect to the present value of super profits method can serve as a practicable benchmark in terms of the amount of goodwill the business firm would be willing to pay for the acquired business. In the case of mergers and acquisition decisions, the value of goodwill compensated is equal to the net difference amongst the purchase price compensated for the acquired business and the value of assets acquired net of financial obligation the acquiring business firm has undertaken to pay for.
h) Fair Value
The concept of 'fair' value depicts heavily on the value concepts, in particular, book value, intrinsic value and market value. The fair value is combined in nature and often is the average of these three values. In India, the concept of fair value has acquired from case laws and thus is more statutory in nature and is applicable to certain specific transactions, such as payment to minority shareholders.
It may be mentioned that most of the concepts associated to value are 'stock' based in that they are guided by the worth of assets at a point of time and not the likely share they can make towards earnings or cash flows of the business in the future. In ideal case, business valuation should be associated to the cash flow giving ability of acquired business. The intrinsic value reflects the firm's capacity to give cash flows over the long-run and, therefore, seems to be more competently suited for business valuation.
In fact, broadly, business firms are not acquired with the intention to sell their assets in the post acquisition period. They are to be distributed primarily for generating more earnings. However, from the conservative point of view, it will be practicable to know the realizable value, market value, liquidation value and other values, if the acquiring business firm has to resort to liquidation. In brief, the finance manager will find it practicable to know business valuation from different perspectives. For instance, the book value may be very relevant form accounting or tax purposes, the market value may be practicable in determining share exchange ratio and liquidation value may render an insight into the maximum loss, if the business is to be wound up.
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