How to Set Up a New Business an Online in India | Venture Care
Posted: Dec 20, 2017
Business valuation is largely dependent upon –
- Purpose of evaluation
- Situation under which valuation is carried out
- Bargaining power of the parties
Let us elaborate the above three a bit. First of all, business valuation is done for a certain purpose such as:
- M&A deals
- Buy Back
- Outright sale
- IPO etc.
Valuation approach and of course valuation figure will change in all the above cases.
Another is the situation under which valuation is done. For example, if we consider product valuation, a 1 LTR mineral water bottle may be sold at Rs. 20 in a normal situation but when there is the scarcity of water bottle it may bay sold double of its price.
The 3rd one is that we all know that wherever there is transaction there is valuation. If there is arm’s length transaction then valuation figure does not need any adjustment. Interestingly, valuation figure largely depends upon bargaining power of either buyer or seller. The stressed sale is an example where bargaining power of buyer is strong and when there is the hunger for inorganic growth then bargaining power of seller is strong.
Let us start observing the challenges involved in valuation on-by-one:-
1.Availability of data (qualitative & quantitative)
Quantitative data of listed company is easily available (there is the minimal scope of manipulation).But qualitative data is very difficult to find out due to being price sensitive.
In the case of private limited companies, quantitative data is not freely available. But if values have been approached by the management of Pvt Ltd company then they share data easily. However, it has been found that many companies lack qualitative aspects. For example, although the business has taken legal status of Pvt Ltd company, decision-making authority lies with single promoter-director i.e. eventually it becomes a sole proprietorship business.
Moreover, there is a huge scope of manipulation in data which is unaudited and the values have no option but to rely on it.
2.Lack of concrete "business model":-
Every company has some business model. The business model is a platform to survive at present and it helps in exploiting the current opportunities. We can observe that business managers are very much obsessed with their business models and find them full proof and no change is required in it.
The business model is an integral part of the valuation. For values, it is very challenging to validate the prescribed business model (by companies) and incorporate it into the valuation.
3.Lack of growth-oriented business plan:-
Present valuation of business significantly depends upon business plan. The business plan is formulated to tap the future market opportunities. Of course business plan has to be dynamic and self-adjustable. Change in the business plan will change the valuation figure. It is very challenging to assess the actual impact of the business plan on valuation.
4.Sales projections for the future-
Estimating sales for future is difficult. Sales depend upon either or both of the two things- quantity and price. There is the trade-off between these two. Predicting either of the two things is challenging. It becomes even much more challenging in the case of start-up companies (it seems like a baby is born and her parents are predicting that she will be a doctor).
5.Challenges in estimating discount rate:
Estimating exact discount rate is impossible. Even estimation of nearby discount rate is very much challenging. Discount rate depends upon many factors such as fiscal and monetary policy, inflation rate, sudden policy changes by central govt, an impact of changes in global economic scenario etc. We cannot overlook the effect of demonetization of India which propelled sluggish demand and hence higher discount rate in almost all the industry.
6.Challenge in converting qualitative aspects into quantitative one:-
We can say that this is the biggest challenge in business valuation. For example, how we will convert the following in quantitative figure-
- Concrete business model
- Validity of business plan
- Outstanding management
- Well established R & D
- Organizational culture
- Professional attitude of management
- Committed execution team etc.
7.Challenges in choosing the right valuation method and assigning them weights:-
Generally, there are four popular valuation models:
- Discounted Cash flow (DCF) model
- Relative valuation model
- Earning Capitalization model
Challenges in this model
- Expected future cash flows are prone to change due to various factors such as competitors’ strategy, technological changes, brand dilution, change in management strategy etc.
- How to fix up the discount rate? It is also subject to change over years. Also, there are many factors which affect the discount rate and these factors are unpredictable.
Relative valuation model:
This model is used to value a business in relation to similar business. Earnings and/or cash flows of the business undervaluation is compared with those of the similar business and with the help of the given price of the similar business, the price of the business undervaluation is estimated.
Challenges in this method are
- Whether the similar business operates in the same products, markets
- Whether the similar business uses the same technology
- Whether the similar business is as old as this business
- Whether price/value of the chosen similar business is unbiased etc.
The last popular model is Earning Capitalization model:
Under this method, Equity earning is capitalized at a certain rate. This model assumes that the present earning shall remain fixed forever.
- This model does not consider growth in the business.
- The rate at which earning is capitalized is prone to change
- No valuation method is without challenges. Valuers assign different weights to different valuation methods and use them in combination. But is becomes pure subjective that how much weight should be given to which method.
8.Challenges arising out of biases of the values
Some values are biased about any particular industry. Bias may be positive or negative. Not only these many values consider already well-tested models as pure academic such as Michel Porter’s five forces, BCG matrix et al. and discard it right away.
Another bias is that values always consider their valuation figures logical and correct and believe that there is no scope of change anywhere.
Overcoming pills prescribed
- Track down the performance and strategy of listed company.
- Prepare the questionnaire to be asked to the management of Pvt Ltd company. If the management seems to be reluctant then leave asking now and after some time convince the management that the same questions may be asked by investors/lenders.
- If values find any loophole in the qualitative aspects then he must bring it to the notice of management.
- Analyze and ask questions on unaudited data
- Ask questions on the business model and if required suggest alternative business model orally first.
- Same as 2nd pill
- If the business is already existing then past trend in sales may work like the pill at least to some extent.
- For start-ups, it very difficult and macro factors can be a guide to predict sales. Intuition may play bit positively.
In both the cases, sensitivity analysis becomes bit helpful.
- Only macroeconomic factors, general expectations prevailing in market and sensitivity analysis will work.
- Brainstorming internally
- The combination of methods is good but for assigning weights, more than once weights should be assigned and a "range" of valuation figure should be reached at.
- Users of the valuation report must get clarification from the values.
To conclude, although there are many challenges at every step in valuation, valuation figure has to be arrived at. A range of valuation figure is more practical. As and when required sensitivity results should be analysed.