Business Valuation Methodology Survey 2017...contribution which are invaluable. We look forward to...

EXPERIENCE | CLARITY | FOCUS

Business Valuation Methodology

Survey 2017

Privileged – For limited circulation

September 2017

Contents

• Foreword 03

• Executive summary 04

• Detailed survey results 05

The survey report focuses on business valuation

issues and compiles information from specialists

intended to provide investors and corporates a

reference for valuation analysis.

Foreword

Dear Clients and Friends,

Welcome to Valueonshore’s Business Valuation Survey 2017. We

are pleased to publish the results of a web-based survey designed

to gather, analyse and share information about emerging trends in

the business valuation practices and approaches.

Doing business valuations can be challenging given the use of

varied methodologies and assumptions.

The survey aims at enhancing the uniformity and consistency in

assumptions and factors used for valuation purposes under varied

situations. We believe the results of the survey would be useful for

private equity/venture capital funds, corporates and valuation

specialists in their valuation analysis.

We would like to thank every respondent for their time and

contribution which are invaluable.

We look forward to your feedback which will help us to refine future

surveys and ensure that we are providing the support you need for

performing valuation analysis.

With best regards,

Gaurav Sahu

Managing Director

Valueonshore Advisors

EXPERIENCE | CLARITY | FOCUS Business Valuation Survey 2017 | 3

Executive Summary

Valueonshore Advisors has complied the results of

the Business Valuation Methodology Survey

carried out recently. The survey covered senior

executives from Corporates, Private Equity/

Venture Capital funds and Advisory firms.

The key highlights of the Business Valuation

Methodology Survey relate to:

• Valuation Analysis – The key concerns

highlighted by the participants while reviewing

reports included demonstrating commercial

reasonableness and sensitivity analysis on

subjective inputs impacting valuation.

• Valuation Methods – Amongst various

methods, the Income Approach and Market

Approach seem to be the preferred approaches

given these methods factor the future earning

potential of an enterprise.

• Terminal Value – Gordon Growth Model is the

preferred model to determine Terminal Value.

The key factor impacting terminal value is the

terminal growth rate which is considered closer

to the regional GDP growth rate.

• Discounting Factor – The mid year

discounting convention is preferred over the

year end discounting factor given that cash

flows accrue to an entity throughout the year

and not at a particular point in time.

• Debt Level – While performing a valuation

analysis, participants preferred to utilise target

level of gearing of the company for beta and

WACC computation purposes.

• Beta – Given the high volatility in emerging

markets, respondents preferred to utilise a

longer duration beta implying that cash flows

generally take time to stabilise for growth

companies being valued.

• Risk Free Rates – Participants preferred to

use Treasury bills, represented by the local

currency government bond yields, for

determining risk free rates.

• Adjustments to discounting – There were

divergent views on taking additional

discounting factors. We have observed that

participants considered additional discounting

adjustments such as control premium,

marketability discount, small stock premium,

etc. for the valuation analysis.

Business Valuation Survey 2017 | 4EXPERIENCE | CLARITY | FOCUS


Detailed survey results

Business valuation can be challenging due to technical methods requiring multiple inputs

which may not be readily available. A sensitivity analysis helps in analysing subjective

inputs impacting valuation.

The results of the survey indicate that 35% of the respondents find

“Lack of commercial reasonableness” and “Subjective inputs not

reasoned” to be the major concern while reviewing valuation reports.

This is perhaps not surprising given transparency and quality of

information is not adequate in growth stage companies, due to lower

management focus on financial reporting systems.

A relatively smaller number of participants faced the challenge of

“Questionable methodologies” and “Simplistic analysis”.

11

35

35

19

0% 20% 40%

Simplistic analysis

Lack of commercial reasonableness

Subjective inputs not reasoned

Questionable methodologies

Q: What are the most common issues faced while reviewing valuation reports?

Business Valuation Survey 2017 | 6

1. Valuation Reporting


There are various methodologies that can be utilized by financial analysts and corporate

finance professionals when performing a business valuation. In growing economies, it is

more difficult to forecast the profitability of privately held companies possibly due to lack

of reliable financial information and non- availability of comparable company data.

Income Approach (Discounted Cash-Flow Approach) and Market Approach are

the preferred valuation approaches with an underlying assumption of going

concern.

In the survey, participants preferred the use of “Income Approach” and “Market

Approach” since these approaches consider the income generating potential of

the business.

Lesser number of respondents considered the “Asset Based Approach”, since

this is more suitable in situations where the company is being liquidated as an

standalone asset and not as a going concern.

Q: Which is the most preferred Valuation methodology assuming a business is a going concern?


18

61

72

56

39

28

26

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Asset Based Approach

Market Approach

Income Approach

Always Sometimes Never

2. Valuation Methodology


The Capital Asset Pricing Model (‘CAPM’) is the most widely used risk-return model in

determining cost of equity (‘Ke’). It measures risk in terms of systematic risk (i.e. Beta or

risk inherent to the entire market) and relates expected returns to this risk measure. CAPM

only compensates for systematic risk as it assumes that a rational investor will hold a

diversified portfolio, resulting in the elimination of unsystematic risk (also referred to as

"firm-specific" or "diversifiable risk").

Majority of the participants in the survey use the CAPM method which

describes the relationship between risk and expected return. “Capital

Asset Pricing Model” and multi factor “International CAPM” are

preferred since these methods are easy to use and provide a

meaningful outcome.

Q. When using the Income Approach, which are the methods used to calculate cost of equity?

3. Income Approach:

Discounted Cash Flow


31

60

9

0 10 20 30 40 50 60 70

Other

International Capital Asset Pricing Model

Capital Asset Pricing Model

Mostly Never

As far as Market Approach is concerned, a number of valuation benchmarks can be used

in its application. The EV/EBITDA is the preferred approach while deriving the value of a

business. It’s prominence in business valuation is rooted in how the Market Approach

methods are also used as "sanity checks" in valuing enterprises.

In the survey, participants favored the use of Enterprise Value / Earnings

Before Interest Tax Depreciation and Amortization (‘EV/EBITDA’) in their

analysis since this approach allows comparison with firms having different

capital structures when analysing the cash flow to all providers of capital.


Q. When using the Market based Approach, which are the preferred multiples you use?

4. Market Approach

15

80

50

35

55

20

30

40

30

20

25

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

EV/Revenue

EV/EBITDA

EV/EBIT

Price/Earnings

Always Sometimes Never


For a going concern business, we wanted to understand the dynamics of arriving at the

Terminal Value (i.e. value at perpetuity). An estimate of Terminal Value is crucial in the

Valuation Analysis as it accounts for a considerable portion of the business value, more

so in growth oriented companies. The Terminal Value should normally be determined for

steady state cash flows to have a commercially reasonable valuation analysis.

The Gordon Growth Model (also known as the Perpetuity Model) is the

most popular methodology used in terminal value calculations.

Most of the participants i.e. 72% consider the use of “Gordon GrowthModel” since the model can be used on the future period cash flows that

are assumed to grow at a constant rate.

Few participants consider the “Exit Multiple Model” which is easy and

quick to use since it factors expected return and is normally based on

EV/EBITDA of similar or competitor companies.

Q: When determining the Terminal Value, which methods are considered?

5.1 Income Approach:

Terminal Value Method

28

72

Exit Multiple Gordon Growth Model


Percentage

Terminal growth rate is a key input required in the Gordon Growth Model. Estimation of

terminal growth rate involves a significant amount of judgment, since this is a constant /

steady-state growth rate that extends to perpetuity. Typically, steady-state growth rates

are assumed to be closer to the country specific GDP growth rate in which the business

operates. Given the variability in GDP rates, a sensitivity analysis is performed on the

assumption.

GDP growth rate is a preferred factor considered for long term growth rate

given all companies (in different stages of growth) contribute jointly to add

value to the economy.

Most of the participants use “GDP growth” for determining residual growth

rate.

Additionally, a smaller number of participants consider the use of “Long term

Bond yields”, “Inflation” and “Industry Trend”.


Q : When using the Gordon Growth Model, how do you usually determine the residual

(terminal year) growth rate?

5.2: Income Approach:

Terminal Value Growth Rate

45

22

22

11

0% 10% 20% 30% 40% 50%

GDP Growth

Long Term bond Yields

Inflation (specific to a country)

Industry Trend


The method of discounting cash flows inherits a problem of assuming that the entire value

of cash flow for a given year arrives at the very end of a year. However, commercially, the

cash flows in over the year and not at a particular point in time. Accordingly, we asked

our respondents on whether they apply Year End discounting or Mid Year Discounting, to

understand the industry convention on discounting.

The mid-year discounting convention is the preferred approach given it is

safer to assume that cash flows are generated evenly throughout the

period.

It can be seen that majority of the participants use the “mid year”convention since it helps even out the impact of seasonality that certain

industries may witness.

Q: When discounting under DCF, which discounting convention is preferred?

6: Income Approach:

Discounting

Year End33

Mid Year67


Percentage

The application of Country Risk Premium (‘CRP’) in the multi factor model is important

since stakeholders assess and quantify the risks inherent in investing in different regions.

The CRP is higher for emerging markets. CRP refers to the difference between the higher

interest rates (that less stable and riskier countries must pay to attract investors) and the

interest rates of an investor's home country.

When using the International Cost of Equity method, the CAPM is adjusted

with Country Risk Premium. Sanity checks on the premium are performed

basis the published studies / research data on Country Risk Premium.

In the survey, participants prefer to work with “Determining an

appropriate risk free rate for a country based on impliedpremiums using country credit ratings” and adjusting it to the cost

of capital to factor country specific risks. This approach relies on

standardized data for country risk adjustments.


Q: When valuing assets in Emerging Markets, how do you generally adjust for country risk?

7. Adjusting for Country Risk

Premium

65

20

15

0 10 20 30 40 50 60 70

Determing an appropriate risk free rate for acountry based on implied premiums using

country credit ratings

Add an appropriate Premium

Premium based on Local Bond Yields andUSD Bond Yields

Percentage


Risk free rate is the rate of return for an investment with no risk factor. It represents the

interest an investor would expect from an absolutely risk-free investment over a specified

period of time.

The survey findings show that majority of participants considered the use

of “Local Currency Bond Yield” followed by 67% who considered the

use of “US risk Free rate plus a country risk premium” during their

valuation analysis.

Treasury bills are the most common example of assets that offer a risk-

free rate of return. Accordingly, long duration local government bond yield

are used as a proxy for risk free rates which is important in the CAPM

model.

Q: Which of the following do you use for Risk free rate determination?

8. Risk-free rate

10

67

90

Others

US risk free rate plus a country riskpremium

Local Currency Bond Yield

Percentage


The CAPM model describes the relationship between systematic risk and expected return.

Additionally, each firm depending on their valuation purposes may factor additional

adjustments in determining the discounting factor.

Based on the valuation objectives additional adjustments are factored

to make the Valuation Analysis commercially reasonable.

‒ Majority of the participants considered the use of “MinorityDiscount” or “Control Premium” depending on the proposed

shareholding

‒ Participants also considered the use of “Marketability Discount”where the business is not listed implying the illiquid nature of the

stock


Q: Which of the following premiums do you consider during a valuation analysis?

9. Analyzing Premium

90

50

23

0 10 20 30 40 50 60 70 80 90 100

Control Premium / Minority Discount

Marketability Discount

Small Stock Premium

Percentage


Beta measures a company’s volatility or systematic risk relative to the market. Capital

structure varies from company to company and is one of the factors leading to a change

in beta in similar/ comparable companies. Unlevered beta removes the effects of debt of

similar / comparable companies. Re-levering the beta takes into account the capital

structure relevant for the target company.

Re-levering beta specific to a company is the preferred approach since this

takes into effect the capital structure.

In the survey, majority of respondents consider to “unlever and thenrelever equity beta” while performing a valuation analysis since this

factors the debt level of the entity being valued. A minority of respondents

considered to “Source Equity beta directly” which is performed for

determining quick estimates with an assumption of industry debt level.


Q: Do you apply equity betas directly or first unlever and relever the observed equity betas to

apply to the subject company?

10.1: Beta – Concept and

Timeframe

15

85

Source Equity beta directly Unlever and then relever observed equity beta


Percentage

Time frame (i.e. period and frequency for estimation) chosen for calculating beta is critical

for the purpose of valuation analysis. The equity duration is a measure of a share’s cash-

flow maturity. Stocks that pay a large fraction of cash flows in the distant future should

use a long period and lesser frequency beta. Rapidly growing companies may need

growth capital expenditure and may have negative cash flows resulting in non payment of

dividends in the initial phase. In contrast, stocks with stable cash flow use a short period

and higher frequency beta. For instance, utility companies with stable cash flows may not

require growth capex and may have stable dividend-price ratios.

In emerging markets, a longer duration beta is preferred since it

brings more stability to the valuation analysis.

In the survey, when it comes to understanding the time frame for

beta, more than half of the survey’s participants considered “3years beta” as it captures the longer duration of cash flow

maturity for the valuation analysis.

Less than half of respondents considered beta of less than

3 years.


Q: When calculating the beta, what period do you generally consider appropriate?

10.2: Beta – Period to be used

5834

8

3 Years 1 Years Others

Percentage


Greater use of leverage may increase the likelihood of financial distress, which will

increase both the cost of debt as well as the cost of equity. Thus, it is important to

understand the current and future cost of debt and the interest coverage ratio of the

company.

Cost of debt refers to the effective rate a company pays on its current

debt and would pay on anticipated debt levels. A large majority of the

respondents preferred to use the “Incremental cost of debt of company

being valued” for determining the cost of debt for valuation purposes.

Participants also considered the “cost of debt for comparable companies”

which would mostly be for cases where publicly available data on

comparable companies is available.

Another method used is the “Implied cost of debt given credit rating of

company being valued” where data on similar rated debt instrument is

available for comparison.

Q: How do you determine the cost of debt for valuation purposes ?

11 : Applying Cost of debt


10

10

80

0 10 20 30 40 50 60 70 80 90 100

Implied cost of debt given credit rating ofcompany being valued

Cost of debt for comparable companies

Incremental cost of debt of companybeing valued

Percentage

Evaluating a company’s capital structure is a significant aspect while doing a valuation

analysis. Using an appropriate level of debt and equity can potentially boost the financial

performance of the company. The level of debt to equity in a company and the approach in

determining the appropriate level of debt to equity may vary from industry to industry.

Most of the participants considered “Acquirer’s intended levelof gearing for the entity” as the appropriate method for debt to

equity ratio. This is since anticipated debt levels are factored in the

future financial projections.

Participants also considered the “Average gearing level of theindustry in which the entity operates” and “Entity’s actual

debt to equity ratio”.

Only a small percentage of respondents considered the use of

“Theoretical target gearing level of the entity”.


Q: What are the approaches you use in determining the appropriate level of debt and equity?

12: Debt and Equity

20

30

60

75

0 10 20 30 40 50 60 70 80

Theoretical target gearing level of the entity

Entity's actual debt to equity

Average gearing level of the industry in whichthe entity operates

Acquirer's intended level of gearing for theentity

Percentage


The information contained in this publication has been compiled or arrived at from sources believed to be reliable,

but no representation or warranty is made to its accuracy, completeness or correctness. The information contained

in this document is published for the knowledge of the recipient but is not to be relied upon as authoritative or taken

in substitution for the exercise of judgment by any recipient. This document is not intended to be a substitute for

professional, technical or legal advice or opinion and the contents is not intended to answer specific questions or

suggest suitability of action in a particular case.

Whilst due care has been taken in the preparation of this report and information contained herein, Valueonshore

Advisors does not take ownership of or endorse any findings or personal views expressed herein or accept any

liability whatsoever, for any direct or consequential loss howsoever arising from any use of this report or its contents

or otherwise arising in connection herewith.

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