Firm Valuation Tehniques and Its Trends

FIRM VALUATION TEHNIQUES AND ITS TRENDS
Valuation is like a Swiss Army knife...you will be prepared for just about any contingency.
-- Martin H.Dubilier, Chairman of the Board, Calton & Dubilier, Inc
The above Statement by the Chairman of Calton and Dubilier Inc. clearly sums up the importance attached to valuation by the company stalwarts. Valuation of a your business helps one to be prepared for any contingency that one may face during the operations of the company. Valuing the value of ones organization is like holding a weapon with armour and being ready for any assault. The assault in this case may be an M&A proposal, litigation against the company, and so on.
Getting ones company valued or the exercise of valuing a firm is not as simple as it sounds. Business valuation is not just plugging numbers into formulas; it is both science and art. It is not just looking just looking at the asset base of the firm and adjusting the liabilities. Though this is at the heart of valuation, the actual process is quite an effort and requires a lot of estimation and assumption.
Escalating competition has led to an increasing number of acquisitions and merger activities, resulting in the requirement for specialist calculation of company valuations. Also the various types of industries that are coming into being traditional techniques are sometimes found wanting while valuing these sectors. Valuing a business, whether as a potential acquirer or a share purchaser, requires competence in a wide range of analytical
skills. Thus it becomes very necessary for any finance manager and financial person to keep himself updated with the emerging trends in this area of finance. Valuations can serve many purposesto establish a price, to help increase value, to attract capital, to aid in estate planning, and to meet governmental requirements. With a broad variety of business and legal situations triggering the need to know the value of a businessstrategic partnerships, merger or acquisition of a business, estate planning, eminent domain issues, marital disputes, employee stock ownership plans (ESOPs), and joint venturesit is important to have a professional estimate the value of a business and to have periodic valuation updates. From the perspective of a valuator, a business owner, or an interested financial party, a valuation provides a useful baseline to establish a price for a business or to help increase a company's value and attract capital. Planning for estate, gift, and other taxes is demanding and complicated, and a professional valuation is one of the most important tools to assist a specialist in these areas. Because tragedy can strike without warning, it is important to estimate the value of a business in advance so that a business owner's family can be prepared to deal with third parties, such as partners, shareholders, and governmental authorities like the IRS. Otherwise, family members may be left at a disadvantage without the same knowledge and wisdom as the business owner. The war stories surrounding estate taxes abound; some examples are presented later in this chapter. In certain situations, the government steps in and mandates a business valuation. For marital dissolutions, the establishment and management of employee stock ownership plans (ESOPs), eminent domain issues, minority shareholder actions, election of S
corporation status, corporate divorce, and estate taxes, governmental regulations are the driving forces behind the standard of value. Two other broad factors also create the need for valuations. First, as business owners try to sell a business, there is no efficient market to help buyers and sellers connect; thus, there is no analog for small companies to the role that major stock exchanges play for public companies. Second, many business owners need an exit strategy to obtain value from their companies when they desire to sell. Below are listed the reasons why companies may be valued. Estate, Inheritance and Gift Tax. Valuations of a closely-held business are
useful for estate planning, estate settlement, and IRS reporting of estate transactions. Valuations are also important to determine the amount of lifetime gifts. Inaccurate valuations or valuations prepared by parties who are not independent can cause the IRS to challenge and overturn the estate plan, lead to lawsuits among heirs and expose the estate to under valuation penalties. Mergers, Acquisitions, and Spin-offs. One company may acquire or be
acquired by another. One or both of the companies may need to be valued to determine a fair price or exchange ratio. Value-based Planning. Management may use the current value of a business to analyze the effect that various management decisions could have on the value to determine which course of action to pursue.
Employee Stock Ownership Plans. An annual valuation is required by IRS and Department of Labor regulations for this type of employee benefit plan.
Litigation. Attorneys rely on an expert's valuation of a company in various instances including divorce, compensatory damage cases, and insurance claims.
Minority Shareholder Interests. Minority shareholders may request a valuation when they feel that a restructuring of the company is having a negative impact on their interests.
Allocation of Acquisition Price.
When a business is acquired, a valuation is
needed to determine the allocation of purchase price to assets acquired for financial and tax reporting. Charitable Contributions. The gift of stock of a closely-held business to a
charity may trigger the need for a valuation. Liquidation or Reorganizations. Valuations can be necessary for tax reporting, financial reporting, and distribution of assets. Issuing Stock. When a company is obtaining additional funds by issuing stock, a valuation may be necessary to determine the fair cash-stock transaction level.
VALUATION PROCESS
Business valuation is part art and part science. The term judgment may be regarded as art; the term systematic may also be related to science. There are many dimensions of the science in business valuation that are listed as follows: General accounting principles and the financial data of the business Facts associated with the historical growth of the business Extrapolation of financial data into future time periods Calculation of various valuation ratios and statistical formulae
There are also many dimensions of the art in business valuation as follows: Understanding the economically efficient life of productive assets Understanding the economically relevant industry in which the business is valued Understanding the appropriateness of one valuation method Understanding the limitations of financial information from comparable businesses Understanding the economic environment
A business valuation is often dependent on valuators knowledge, both accounting concepts and economic concepts. Accounting is a systematic way of documenting the businesss financial activities, while economics is a systematic way of understanding the market environment in which the businesss financial activities take place. Accounting methods are relatively more static in nature than economic methods; there are more systematic practices and principles that guide the application of accounting methods.
There is rarely a situation where all aspects of a valuation are accounting related or all aspects are economics related.
Analyzing the business environment The process of valuing a company begins with an analysis of its environment; the study of the firms environment is typically called a top-down process. The objective of the analysis of the firms environment is to estimate the firms sales in future years. Three questions concerned are as follows: Are industry sales expected to rise or fall? Is the companys market share expected to expand or shrink? Are industry prices expected to increase or decrease?
The study of the companys environment begins with a study of the economy. Various industries tend to perform differently in different stages of the economic cycle. For instance, basic industries perform well when the economy gets out of a recession, cosmetic goods sell well in economic downturns and interest-sensitive industries such as banks and insurers do especially poorly when the economy enters a recession. Thus, to the extent that economic activity can be predicted, an understanding of the future course of the economy is useful information in analyzing industries and companies.
After analyzing the macroeconomic conditions, the industry in which the firm operates is analyzed. The objective of the analysis of the industry is to obtain sales projections for the company. Obviously, the industry analysis should incorporate the macroeconomic conditions. Beside the macro-conditions, the current and potential competition in the
industry, the relative advantages and disadvantages of the major players have to be considered. Moreover, the relative industry that sells substitute products needs to be considered. These factors could be used to determine the growth in the industrys sales, changes in the companys market share and the growth in the companys sales.
Constructing a model of expected financial performance After analyzing the corporate environment, the next step is to analyze the companys operating and financial prospects. The marketing view of the company is converted into the sales projections and the sales projections are translated into financial performance, which are expressed in the form of pro-forma financial statement. I proceed by converting the marketing view of the firm the sales projections into overall projections of financial performance. The way is to use various financial ratios according to its historical accounting statement. The projections of future financial performance should not be confined to an analysis of past relations. Firm and industry change should be incorporated into the projection of future financial performance.
Converting the projected financial performance into value After using the pro-forma accounting statement, the projected cash flow has been predicted. However, the firm does not cease to exist after the expected periods of cash flow. Therefore, the firms ability to generate cash flows after the expected period has to be taken into account. This is done by a terminal value as the last cash flow. Discounting the FCFs at the WACC gives us the value of the firm as a whole-the value of the firms assets. This value equals the sum of the values of all the securities that the firm has
issued, such as debt, equity, preferred stock and convertible bonds. In financial terminology this is usually called the value of the firm.
VALUATION APPROACHES
There are a wide variety of models for evaluating a company. They are applied in the same context. Here I have classified these valuation methods into discounted cash flow (DCF) models and relative methods as follows:( see figure 3-1) Figure 3-1 Valuation models
Discounted cash flow method A valuation technique that s dealt with all corporate finance manuals, it is the most popular technique for valuation of companies. The value of an enterprise s equals to the discounted values of all the future free operating cash flows generated buy the enterprise. The theory for any financial investment evaluation is the capital budgeting approach that includes four concepts: Free cash flow The investor has put money into projects because he expects it to generate cash throughout the lifetime of his investment. We define these as cash flow to the
investors. In the following analysis, the cash flow is defined as free cash flow. Free cash flow is a companys true operating cash flow. Free cash flow is generally not affected by the companys financial structure. Free cash flow is defined to ensure consistency between the cash flow and the discount rate used to value the company. Time value of money One unit of currency is worth more today than it is tomorrow, since there is a cost of capital. This refers to opportunity cost. The sooner they are received, the less they are worth. Cost of capital o If the cash flow is not risk free, a risk premium will be concerned in the investment. The expected return on an asset should be positively related to its risk. The relationship between expected return on an individual security and Beta of the security could be described as capital-asset-price model (CAPM) o R= Rf+[E(Rm)-Rf]*(beta) Where R represents expected return on a security Rf represents risk free rate E(Rm)-Rf represents the difference between expected return on market and risk free rate Beta represents the Beta of the security. o The CAPM is used to estimate the cost of equity in this thesis.
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Weighted average cost of capital o The average cost of capital is a weighting of its cost of equity and its cost of debt o WACC=Kb*(1-T)*(B/V)++Ks(S/V) Where Kb = the pretax market expected yield to maturity on debt =the market-determined opportunity cost of equity capital T = the tax rate B =the value of debt S= the value of equity V=the value of assets
Advantages: Since DCF valuation, done right, is based upon an assets fundamentals, it should be less exposed to market moods and perceptions. If good investors buy businesses, rather than stocks (the Warren Buffet adage), discounted cash flow valuation is the right way to think about what you are getting when you buy an asset. DCF valuation forces you to think about the underlying characteristics of the firm, and understand its business. If nothing else, it brings you face to face with the assumptions you are making when you pay a given price for an asset.
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Disadvantages: Since it is an attempt to estimate intrinsic value, it requires far more inputs and information than other valuation approaches These inputs and information are not only noisy (and difficult to estimate), but can be manipulated by the savvy analyst to provide the conclusion he or she wants. In an intrinsic valuation model, there is no guarantee that anything will emerge as under or over valued. Thus, it is possible in a DCF valuation model, to find every stock in a market to be over valued. This can be a problem for o Equity research analysts, whose job it is to follow sectors and make recommendations on the most under and over valued stocks in that sector o Equity portfolio managers, who have to be fully (or close to fully) invested in equities
Relative approaches Besides the DCF approach, there are five commonly used relative approaches that exist, liquidation value, replacement cost, price-to-earnings ratio, market-to-book ratio, and book value. The liquidation-value approach sets the continuing value equal to an estimate of the proceeds from the sales of the assets. Liquidation value is often far different from the value of the company as a going concern. In a growing, profitable industry, a companys liquidation value is probably far below the going-concern value. In a dying industry, liquidation value may exceed going-concern value.
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The replacement-cost approach sets the continuing value equal to the expected cost to replace the companys assets. This approach has a number of drawbacks. The most important ones are the following: o Only tangible assets are replaceable. The companys organizational capital can be valued only on the basis of the cash flow the company generates. The replacement cost of the companys tangible assets may greatly understate the value of the company. o Not all the companys assets will ever be replaced. Consider a machine used only by this particular industry. The replacement cost of the asset may be so high that it is not economic to replace it. Yet, as long as it generates a positive cash flow, the asset is valuable to the ongoing business of the company. Here, the replacement cost may exceed the value of the business as an ongoing entity.
The price-to-earnings (P/E) ratio approach assumes that the company will be worth some multiple of its future earnings in the continuing period. Of course, this will be true; the difficulty arises in trying to estimate an appropriate P/E ratio.
Suppose the current industry average P/E ratio is chosen. However, prospects at the end of the forecast period are likely to be very different from todays P/E ratio. Therefore, the drawbacks of price-to-earning (P/E) ratio are as follows: o It is too affected by transitory events o It hardly reflects future trends and historical fluctuation.
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o It does not include enough financial information such as different leverages used by firms in the same industry. o It hardly reflects risk differences even when restricted to the same industrys comparison. The market-to-book ratio approach assumes that the company will be worth some multiple of its book value, often the same as its current multiple or the multiples of comparable companies. This approach is conceptually similar to the P/E approach and therefore faces the same problems. In addition to the complexity of deriving an appropriate multiple, the book value itself is distorted by inflation and the arbitrariness of some accounting assumptions. The book-value approach assumes that the continuing value equals the book value of the company. Often, the implicit assumption of this approach is that the company will earn a return on capital (measured in terms of book values) exactly equal to its cost of capital. Therefore, the book value should represent the discounted expected future cash flow. Unfortunately, book values are affected by inflation and the choice of accounting rules. Therefore, they do not provide reliable information for these assumptions.
Advantages: Relative valuation is much more likely to reflect market perceptions and moods than discounted cash flow valuation. This can be an advantage when it is important that the price reflect these perceptions as is the case when
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o The objective is to sell a security at that price today (as in the case of an IPO) o Investing on momentum based strategies With relative valuation, there will always be a significant proportion of securities that are under valued and over valued. Since portfolio managers are judged based upon how they perform on a relative basis (to the market and other money managers), relative valuation is more tailored to their needs Relative valuation generally requires less information than discounted cash flow valuation (especially when multiples are used as screens)
Disadvantages: A portfolio that is composed of stocks, which are under valued on a relative basis, may still be overvalued, even if the analysts judgments are right. It is just less overvalued than other securities in the market. Relative valuation is built on the assumption that markets are correct in the aggregate, but make mistakes on individual securities. To the degree that markets can be over or under valued in the aggregate, relative valuation will fail Relative valuation may require less information in the way in which most analysts and portfolio managers use it. However, this is because implicit assumptions are made about other variables (that would have been required in a discounted cash flow valuation). To the extent that these implicit assumptions are wrong the relative valuation will also be wrong.
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Adjusted Price Value Method Valuation by this method states that the value of a company is equal to the base value of the operations plus the value of all the financial side effects.
Value of company = Base Value of operations + Value of financial side effects

The base value of the operating activities is determined by means of the value of the free operating cash flows (identical to those used in DCF), discounted at the cost of equity, as if the company was financed entirely by equity. This is therefore the (unlevered) cost of equity based on the asset beta, which only reflects the risk of the operations. Financial side effects, such as tax shields on interest charges, possible grants, and financial guarantees, potential bankruptcy costs, specific management policies and issue costs, are explicitly estimated. Estimating the associated CFs and discounting them at a rate reflecting the risks related to the CFs obtain these values.
The advantages of the APV method are: It provides clear insights into how the value of a company is calculated (operating vs. financing), which is not the case with the DCF method. In case of DCF, dynamic capital structures often lead to errors as an incorrect WACC is used. But in case of APV, determining CFs for each year considering the changes in the capital structure, this can be solved.
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Another advantage is that the value of the operations can be split up and the value of the potential operational changes can be unequivocally estimated because the corresponding CFs is discounted at the same cost of equity.
However a crucial aspect of APV method remains the accurate determination of the value of the financial side effects. Also, like DCF, the method is not capable of taking account of the value of opportunities, or the real options at the companys disposal.
Decision-Tree Analysis (DTA) and Real Options (RO) The market values of many companies is much higher than computed by DCF or APV, because these methods do not consider the value of the future opportunities/ real options which the company has. This is mainly true in technological and innovative sectors, with a higher level of uncertainty, a great deal of value is determined by the portfolio of future options that these companies have at their disposal, and not as much by their current activities.
By means of real options (RO) a value is therefore assigned to the options at the managements disposal. The total value of a company is formulated in the so-called extended DCF rule: the value according a static DCF or APV analysis increased with the value of these options. These option values can be determined in a manner that is similar to the valuation technique for financial options. As a general rule it has been found that the binomial trees are more applicable in real option valuation than the BlackScholes model, as they allow the valuation of various options simultaneously and put less restrictions on the distribution of the underlying value.
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Table below shows the corresponding parameters, which are important for valuation of real options and financial options. Because of these parallels, real options can be valued in the same way as financial options. Table 3.1 Investment Opportunities/ Real Options
Investment Opportunities PV of the FCF generated by the project Investment required to carry out the project or disinvestments amount For what period of times does the company have this opportunity? Time Value of money (risk free rate of return) Degree of risk of the project Lost CF due to not immediately committing to the project Options of a Share Price of the underlying Share (S)
Exercise price of the option (X)
Duration of the option (t) Risk free interest rate (rf) Volatility of the underlying Share
Dividends Paid (d)
Source: Copeland and Antikarov, 2001
Table 3.2
Summary of Types of real options: the 7S framework

Scale up Expand Project as market grows Expand project to the following generation of the product/technology Extend investment to other applications and industries Postpone investment until more information is released or capabilities are obtained. Stop or cut back project if new info is released that reduces the expected CF Switch to more cost efficient and more flexible asset in new circumstances Reduce the scope of project if the potential in that activity is insufficient.
To invest/grow further (CALL)
Switch up Scope up
To postpone/learn (CALL)
Study/Start Scale down
Disinvest/ cut back (PUT)
Switch down Scope down
Source: Copeland and Antikarov, 1998a
Advantages: 18
Option pricing models allow us to value assets that we otherwise would not be able to value. For instance, equity in deeply troubled firms and the stock of a small, bio-technology firm (with no revenues and profits) are difficult to value using discounted cash flow approaches or with multiples. They can be valued using option pricing.
Option pricing models provide us fresh insights into the drivers of value. In cases where an asset is deriving it value from its option characteristics, for instance, more risk or variability can increase value rather than decrease it.
Disadvantages: When real options (which includes the natural resource options and the product patents) are valued, many of the inputs for the option pricing model are difficult to obtain. For instance, projects do not trade and thus getting a current value for a project or a variance may be a daunting task. The option pricing models derive their value from an underlying asset. Thus, to do option pricing, you first need to value the assets. It is therefore an approach that is an addendum to another valuation approach. Finally, there is the danger of double counting assets. Thus, an analyst who uses a higher growth rate in discounted cash flow valuation for a pharmaceutical firm because it has valuable patents would be double counting the patents if he values the patents as options and adds them on to his discounted cash flow value.
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INDUSTRY TRENDS IN VALUATION

BIOTECH INDUSTRY VALUATION What is a biotechnology company really worth? Corporations, investors, and bankers alike who may be putting their capital at risk in a biotechnology company often face this question. Unfortunately, there is no definitive answer to the question; no standard valuation methodology can be applied universally in order to determine value. Additionally, each available approach involves assumptions compounded by additional assumptions. More often than not, there is no method to isolate any specific scenario and guarantee, or even state with a reasonable degree of certainty, that the specific scenario or event will occur. For example, how can market share be predicted for a company when neither the product nor the market exists? Faced with such uncertainty, valuation of a biotech company appears to be a challenging endeavor.
Yet it is still imperative that a value can be estimated within a reasonable range for practical purposes such as raising capital, negotiating strategic alliances and joint venture agreements, investment decisions, and licensing strategies. Investors need to benchmark the company against other companies, to evaluate whether the markets valuation for biotech companies are efficient or not.
There are difficulties faced in valuing most technology companies. The fair value of the company is typically driven by the value of the companys intellectual property. For many high tech companies, the value of their tangible assets are minimal in comparison to their intangible assets, to which their returns can primarily be attributed. This difficulty
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is magnified in biotech companies, where a companys ability to convert its intellectual property into a revenue stream is subject to strict government regulations and a lengthy approval process. Before proceeding with valuation, it is imperative that the unique features of a biotech company are understood so that the valuation method or methods are structured appropriately.
Unique Industry Factors Companies in the biotech industry are characterized by many unique features which add significant complexity to biotech valuation and which impact their results. It is essential that those performing a biotech valuation assess the impact that these factors have on the company being valued to ensure that the valuation model selected is appropriate, as well as to determine the appropriate level of confidence that can be placed in the results derived from the model used. This is especially true for biotech companies that may not have any products on the market at the time of valuation. Once a product is marketed, the revenues and costs and product potential can be estimated with comparative ease. But, given the long time period between idea inception, regulatory approval and product marketing as well as the small number of ideas that ultimately result in a marketable product, this is rarely the valuation problem that will be presented. Significant uncertainty exists about whether the company will ever market a product.
One of the first things which should be appraised in a valuation is the companys product pipeline, which is (1) the number of products that a company is developing and (2) the stage of development of those products. A company whose success or failure is entirely
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dependent on one product has a higher associated risk than a company that is developing several products. For example, in the drug development and approval process, only one in five thousand compounds that enter preclinical testing make it to human testing, and then only one in five are approved. Of those products which are approved, few biotechnology products which reach the market generate sufficient return to cover their cost. The stage of development for a companys products is also critical. It will help the appraiser in estimating both the length of time before a product can be marketed and the likelihood that the product will even reach the market.
Another important issue to consider when valuing biotech companies is the burn rate. This refers to the level and rate of expenditures required for research and development (R&D) of the product. Comparing a companys burn rate to its cash on hand and funds otherwise available is an important exercise when assessing risk. The Survival Index measures the relationship between cash on hand and net burn rate. Small companies have the smallest Survival Index, averaging enough cash on hand to cover only 13 months of research and development. A company needs to have access to sufficient capital resources in order to sustain the significant levels of R&D required before a product will make it to market. Over 60 percent of therapeutic drugs currently on the market required in excess of $100 million in development costs. A company might obtain these funds through private investments, public offerings, loans, and alliances with larger companies who are willing to invest in their products and ideas.
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Partnerships and strategic alliances have assumed an important role in the success of many start-up biotech companies, and therefore positively affect value. Very few companies have sufficient cash available to last more than five years. In fact, 33 percent of biotech companies have less than one years cash requirements on hand and over 50 percent of biotech companies have less than 2 years cash on hand. Understandably, there is a great impetus for startup biotech companies to find venture capital, often in the form of a partner, to survive the development process. The biotech companies gain access to enormous pools of capital through the partnership arrangement in order to maintain their development efforts. The partners, often established pharmaceutical companies, are able to benefit from the knowledge transfer by obtaining marketing and manufacturing rights to products developed by their biotech partners. They might also share in the biotech companys rights to the intellectual property itself.
While access to capital and improved chances for success are aspects of a partnership arrangement, which increase value, another important aspect of these arrangements must be considered. In a strategic relationship, how are the rights shared between the parties? This sharing arrangement will impact the value of the biotech company, because different rights have different associated values. For example, the marketing and manufacturing rights mentioned above can be very valuable. If these have been given to a partner, the value of the biotech company has been reduced. It is important to determine if the biotech company has obtained comparable value in return through means such as invested capital or licensing fees.
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Manufacturing, marketing and distribution capabilities impact value because they determine whether and how quickly a product can generate desired levels of revenue once it reaches the market. The existence of products is not sufficient to sustain value. The company has to be able to sell the product in a quantity and at a price to recover their investment and generate returns. This requires that they can manufacture the product in sufficient quantities and at reasonable cost (or arrange for its manufacture), create demand for the product, and then get the product into the hands of the public. This stage of the process also requires a significant amount of capital, something that many startup biotech companies do not have, especially after having just completed the lengthy development and cash draining process. So then one must determine the existence and availability of financing alternatives. This is where strategic alliances once more assume importance.
Protection of intellectual property is also an important element of valuation. Valuation requires some estimates on the future revenue generated by the product, and often these revenue forecasts are worldwide. Yet protection of intellectual property rights is difficult and expensive, especially on a global scale. Pirating, means that the product will not reach the entire market, that there will be competing products which can steal both market share and profits. Even in the United States, where there are strict patent laws and available forums for protection, infringement of intellectual property rights occurs frequently, as evidenced by the growing amount of related litigation. As protection of intellectual property improves, the risk factor associated with revenue streams can be lowered which leads to greater value.
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One feature of the biotech industry that makes valuation so complex is the product life cycle. A product has two distinct life cycles, (1) the development life cycle and (2) the product life cycle. The development life cycle is very long, on average ranging anywhere from 16 to 20 years. During this cycle no revenue is generated. The product life cycle begins once the product reaches the market. This is when a return on the investment finally takes place. The anticipated length of the product life cycle (the revenue generation phase) obviously affects value. This can be a fairly short time in contrast to the long development life cycle, sometimes lasting only a few years despite the fact that almost two decades of a government authorized monopoly is granted through patents. This is because the market is continuously refreshed with new or improved products that will compete with the subject product. If a market is perceived to be lucrative, development efforts will be targeted at that market and another product will likely be introduced and may assume market leadership.
The uncertainty of the biotechnology industry is compounded by the impact of changing regulations and government policies. Changing regulations can affect the length of time for a product to reach the market, and whether or not the product is granted approval. Changes in health care policies can have a major impact on product pricing and market size. As an extreme example, failure of insurance companies to reimburse expenses for certain drugs could potentially eliminate an entire market.
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Dealing with Uncertainty All of the unique features of the biotech industry discussed above have one factor in common, they all affect risk. As with any valuation, there is a defined relationship between risk and value. Greater risk associated with revenue and profit translates into less value today. Numerous questions exist which are impossible to answer with certainty. Will the product work? Will the product be approved? Will there be a market for the product? How long will it take to get the product to market? Will the regulatory process undergo change? How will the market change during a lengthy development and testing process? Can the company obtain the resources to survive over this time? Will the technology be valuable ten to twenty years in the future?
There are no definitive answers to these questions; only forecasts, estimates, projections and pure guesses. Assumptions must be made based on experience, historical data, research, marketing savvy and instinct. The reasonableness of these assumptions can be improved by: researching the historical performance (i.e. success rates) of the developer, the biotech company and the biotechs partner, if any; assessing milestones achieved to date in development of the product and the products actual position in the development life cycle; considering historical industry ranges or averages for such things as likelihood of regulatory approval, length of time until regulatory approval, development costs, etc.; performing research related to the potential market (i.e., determining the number of individuals affected by the ailment/condition to be treated by the new product, determining existing treatment methods, etc.); assessing the commitment of the investors or partners to the project; and considering the specific characteristics of the company
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which impact these risks (i.e., whether the company has entered into a partnership or alliance which secures access to capital). Once the unique features and risks faced by biotech companies have been identified and assessed, they must be quantified. From available information numerous estimates must be derived with respect to market size, price sensitivity, competing alternative products and other factors. The challenge is this: to be able to estimate earnings of a product, company and market for which no historical information is available.
Valuation Methodologies There are a variety of methods, which can be used for valuation. The method selected should be suitable for the specific company. For biotech valuation, three main approaches, which are generally as a norm in the industry, are: Discounted cash flow analyses, Monte Carlo models, and Option pricing models.
There is a benefit to performing more than one type of valuation, as the results can be compared against each other. If the results are divergent, the assumptions made in the models may require reevaluation.
Discounted Cash Flow
Performing a discounted cash flow is a traditional approach to valuation, where estimated future cash flows are multiplied by a discount factor in order to obtain a present value. First, revenue and revenue growth projections must be formed for the company based on
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product expectations. Revenue forecasts involve projections of potential market share which is dependent on availability of competing products, product pricing, insurance reimbursement for the product and acceptance in the market place. Remember that often no active market exists at the time of the valuation as no products may be offered at that time. For biotech products, there might be quick market penetration followed by a tapering off of the growth as the product meets price resistance and/or competitive resistance. In the typical product life cycle, the product plateaus as the product matures in the marketplace.
In a discounted cash flow analysis, time is very important factor. A reasonable estimate must be made for the timing of revenues. For the biotech industry, this involves estimating the time required to obtain product approval, to bring the product to market, and to penetrate the market. A general rule in discounted cash flow is that projections should not be further than ten years into the future, since time magnifies uncertainty. This may not be feasible for valuing a biotech company, when it might be more than ten years before the product can be marketed.
After projecting revenues, the next step is to estimate expenses in order to project margins and incremental profits. Again, this is a complex process for biotech companies, as margins are dependent on the assumptions as to the availability of product substitutes more than ten years in the future. Margins are also dependent on the manufacturing, marketing, and distribution arrangements, for which there is no historical information on which to base an estimate.
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The next step in performing a discounted cash flow analysis is to determine an appropriate discount rate which is driven by an evaluation of the company and product risk. The discount rate for biotech companies may reach as much as 25 percent to 50 percent, depending on the circumstances. While this might appear high, it is appropriate given the level of risk faced associated with biotech companies. The discount rate can be adjusted, based on milestones events which have been achieved at the time of the valuation. A discount of rate of 25 percent might be appropriate for a company with a product in advanced clinical trials since there is less time to market, more information available on the product, and thus lower risk. A discount rate at the high end of the range (i.e., 50 percent) may be more appropriate when a companys product is only beginning clinical trials since little information is available and the time to market is greater, meaning higher levels of risk.
Monte Carlo Simulation
Discounted cash flow analyses can be limited, since any specific method can only consider one set of assumptions at a time. With so many uncertainties associated with biotech companies, a discounted cash flow approach might be too confining. A flexible approach may be more suitable. Monte Carlo simulation, which is a tool for considering all possible combinations of events, is a method for determining the probability of certain outcomes and their related values.
In this simulation, potential payoffs are analyzed based on the statistical probability of certain outcomes. Ranges of estimates are determined for the various factors that affect
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value, including; market size, capital expenditures, product pricing, manufacturing rights, economic environment, time to market, existence of market, etc. After the significant variables have been identified, the probability distributions for output variables must be determined. A computer simulation is then used to predict results based on simultaneous changes in the variables. On a cautionary note, the results of the simulation must be critically evaluated for reasonableness. The use of probability distributions and computer simulations causes this approach to appear to be very scientific. Although there are some distinct benefits to using this approach, common sense and experience must be used in evaluating the results since the method still involves a great degree of subjectivity. The assumptions regarding the probability and the significance of the variables are still subjective, and if the assumptions are not reasonable the results are meaningless.
Option Pricing Models
As already seen the best method to be used is the option-pricing model. These models are valuable in the biotech industry, which is faced with uncertainty (as discussed above, where the size and profitability of future markets are unknown, sales will not commence for several years, there is an uneven distribution of returns, and there is overwhelming upside potential).
The most common option-pricing model is Black-Scholes, which can generate a value from a continuum of possible outcomes, and can be modified to value a biotech company. The exercise price is the capital investment required. Duration would be the time until the
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product can reach the market. The standard deviation of stock returns for typical biotechnology stocks can be used as a measure of project volatility. Option pricing models were scarcely used a decade ago; few were familiar with what they were or how to apply them. But these models have increased in popularity as business schools have incorporated them into their curriculum and emphasized the value of these methods to their students who graduate and join corporations.
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HIGH GROWTH COMPANIES Had you decided that Yahoo! could not possibly be worth $1billion in 1997, as the market then said, you would have missed a three-year run that took it to more than 100 times that figure. But had decided to believe the market last spring and bought Yahoo! then, you would now have lost 80% of the money. - Is there life in e-commerce? (www.economist.com)
Companies in the high tech industry are continuously challenged to innovate (both products and services) to sustain their competitiveness. To be the market leader in this highly competitive industry, characterized by ever evolving technology benchmarks, requires speed and flexibility. Herein Intangible assets like technological capability, intellectual property, business processes, experience curve based learning efficiencies, network of highly skilled partners, customer relationships provide the critical competitive advantage and drive the profitability of the firm in the industry. However, these are not reflected in the balance sheet of the companies.
Hi tech firms, in initial stages, need to incur huge costs in building up these critical assets, which are expected to generate cash flows in subsequent periods. These costs are not capitalized but are expensed in the period in which are incurred and this explains the losses posted by a high tech company in its initial phases. A valuation model based on either cash flows or earnings will fail to value the firm appropriately, unless cash flows are estimated over a sufficiently long period as these investments (that drive the future
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profitability and hence the value of the company) reduce cash flows and earnings in the short term.
The following exhibit shows that the market valuation (capitalization) of a high tech company Amazon.com increased from US $ 1437.5 million in 1997 to US $ 25824.25 mn in 1999 even as it continued to have increasingly negative cash flows during 1997-99.
Exhibit 4.2.1: Amazon.com- Market Valuation: Do the Cash Flows Capture Real Value?
Source: Nasdaq and Compustat Exhibit 1 shows how a valuation of a high tech company like amazon.com based on cash flows in the short-term horizon would have failed to capture the value created.
Moreover, even the estimation of cash flows itself is a challenge as high tech companies are characterized by high growth, high uncertainty and high losses in the transient phase.
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The following exhibit depicts the high variability in cash flows of amazon.com during 1995-2001. Exhibit 4.2.2: Amazon.com- Variability of Cash Flows
Source: Nasdaq and Compustat High tech companies propelled by their competitive advantage are expected to enjoy higher profit margins, characterized by speed & flexibility and driven by market conditions are expected to experience higher grow rates vis--vis traditional companies, however their returns are much more risky. Comparables like Price Earnings Ratio or Revenue Multiples are difficult to employ due to the uniqueness in prospects of each individual company.
Further, use of multiples becomes meaningless if the earnings are negative. In a high tech company, characterized by negative earnings and high revenue growth, multiples cannot be used for valuation. Moreover, the multiples estimated on the basis of past data are not applicable in the fast changing environment.
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We now examine the different valuation approaches, their applicability to valuation of high-tech companies, identify the issues associated and recognize the factors that drive the value of high tech companies
COST APPROACH: ISSUES IN VALUATION OF HIGH TECH COMPANIES The cost approach attempts to measure the replacement cost. This approach is based on the logic that the fair market value can be no more than the cost of acquiring a substitute with same features and functionalities. It values a company based on the estimation of costs incurred / investment required to replace the future earning ability of the firm (and its assets).
The cost approach is not appropriate to value high tech companies with valuable intangible assets. It ignores the value of intangible assets and the opportunity costs of earnings that would be lost without such intangible assets. Actually, the benefits of an intangible asset like innovation may far exceed costs incurred in its acquisition e.g. huge benefits accrued versus minimal costs incurred in invention of 3M Post-It Notes. The approach equates value to the costs incurred and does not measure the value of future benefits likely to accrue as a result of investments made.
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Exhibit 4.2.3: Amazon.com - Revenue Growth: Function of Tangible Assets or Intangible Assets?
Source: Nasdaq and Compustat Exhibit 3 shows that intangible assets like loyal customer base created by increasing SG&A expenses are important drivers of the revenue. The exhibit compares the importance of fixed assets and intangible assets in driving the revenues in a high tech company like Amazon.
MARKET
APPROACH:
ISSUES
IN
VALUATION
OF
HIGH
TECH
COMPANIES The market approach measures the present value of future benefits based on market estimate / assessment. It involves identifying actively traded comparable companies within the industry and using their multiples to estimate the companys fair market value.
It becomes difficult to use this approach for valuation of high tech companies, as their uniqueness and asset specificity makes it difficult to find comparable companies and appropriate multiples. Also the lack of active markets in the specific assets owned by 36
high-tech companies make it difficult to use this method in valuation. For Telecom Operators in Developing Markets
The following exhibit lists P/E, EV/Sales and EV/EBITDA Ratios of comparable IT companies in India Table 4.2.1: Multiples for comparable Indian IT Companies
Source: EMC Report on Asia Pacific Mobile Communications- June 2003 The huge variation in the multiples indicates the limitation of use of this approach in valuation. Similarly comparing the multiples for telecom operators in developing countries in the Exhibit 5 below, we see PE Ratio varies from 5.70 to 28.10 (almost five times). Exhibit 4.2.2: Multiples for Telecom Operators in Developing Markets
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Source: EMC Report on Asia Pacific Mobile Communications- June 2003 Further the multiples do not provide reasonable results in case of high tech companies specially those in the initial stages when huge investments significantly reduce the cash flows, earnings and net-income. Negative earnings may give meaningless results. Moreover in rapidly changing environment, the multiples obtained on the basis of past data are not applicable in the changed environment (the projected growth for a high tech company is generally higher making comparisons even more inappropriate). However, the market approach can be used to validate / cross check the valuation obtained by other approaches. Industry ratios and multiples provide confidence in the assumptions made to arrive at the valuation using other approaches as discussed below.
INCOME APPROACH: ISSUES IN VALUATION OF HIGH TECH COMPANIES The income approach employs the discounted cash flow method of valuation. It measures the present value of expected future cash flows at a reasonable present value discount rate. The income approach may employ single-period or multiple-period method. The single-period method employs capitalizing the recurring cash flow using the discount rate. The issue is determination of an appropriate discount rate. The multiple-period method estimates the value of a company as the sum of the estimated cash flows over a finite period (transient state) and terminal / continuing value for the stable state at the end of the horizon.
The income approach take into account the macroeconomic factors as well as the company-specific factors. Despite its reliance on numerous estimations, the income
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approach is most appropriate in valuing high tech companies as it is based on estimation of future cash flows and the ability of a firm to generate them. The problem however, with applying the approach to valuation of high tech firms is, that not only does it require lot of estimation and projection, but also that the estimated cash flows of a high tech company are highly uncertain. This is illustrated in the following Exhibit 6. Exhibit 4.2.3: Cash Flows of Amazon.com
Source: Compustat This combined with the market/environment uncertainty reduces confidence in the valuation obtained using the DCF approach. Modified DCF approach is therefore most appropriate to value the high tech companies. Some factors that need to be considered in valuation of the high tech companies using DCF approach are Taking an Appropriate Horizon for Explicit Forecasts In valuation of high-tech companies projection of the duration of high (extraordinary) growth transient period and when this high growth will be replaced by long term normal growth is critical. It is vital to estimate and capture the cash flows in the transient and stable state. It is important to forecast the profit margins, turnover ratios, demand, size and share of the market and other relevant drivers of companys profitability for the transient as well as the long-term steady
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state. Given high uncertainty in the environment and that associated with the performance of the high tech company, it may not be possible to accurately forecast the parameters yet it is important to envisage the possible scenarios and outcomes viz. cash flows, earnings in different situations.
Consider an example of Indian Cellular Telecommunications Industry. A company in this industry is faced with huge capital investments in infrastructure, technology, licenses, customer acquisition, etc. It needs to incur huge costs in setting up efficient supplier and distribution networks. It is likely to incur substantial expenses in customer acquisitions. A typical company in this industry is faced with huge initial costs, losses in the initial phase, high-expected growth rates (given currently low tele-density and huge potential) and high uncertainty on account of technology, regulations and changing customer preferences. The high operating profit margins are constrained by increasing competition. To arrive at an appropriate valuation of such a company we need to anticipate the future possible states and their associated probabilities. We need to project the drivers of growth viz. expected tele-density, expected ARPU (Average Revenue Per User) expected market share, profit margins, etc. Factoring for Uncertainty: Use of Probability Weighted Scenarios Different possibilities need to be identified and probabilities need to be assigned to such possibilities. Expected cash flows can then be achieved by taking a weighted sum of possible cash flows under different possible situations. Continuing with our example of an Indian Cellular Company, we need to envisage different situations with respective market share, revenues, and margins
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and determine likelihood (probability) associated with each situation. We also need to undertake sensitivity analysis of projected cash flows to the changes in probabilities. This shall give us an idea of possible variations in the valuation undertaken. Assessment of Sustainability of Growth / Profitability (Determination of Level of Confidence in the Valuation) Given the high risk associated with and high variance expected in the cash flows of a high tech companies, it is vital to analyze the sustainability of estimated growth and profitability. This detailed analysis is what will differentiate a good investment from a bad one. This is an important factor in the valuation of high tech companies as given the uncertainty of environment and uncertainty inherent in the technology and operations of a high tech company, a large number of such companies are likely to become unviable and only a few shall be able to stand out winners.
Picking up the would-be winners is a vital factor. Consider the example of a number of high tech start-ups in Indian Telecom Sector a shake up in the industry is likely and a large of players are likely to exit. We need to identify the streams of revenue and profitability of the company and the capability of the company to protect those streams.
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OTHER IMPORTANT ISSUES Identification and Estimation of Factors that Really Drive Value To arrive at right projections, it is important to identify what actually drives the creation of value. For example for Amazon.com some of the factors that drive its value are o Extent of its customer base. o The average revenue and contribution per customer. o Customer Acquisition and retention rate. o Other sources of revenue viz. advertisements, etc.
Is High Return on Capital Sustainable? What Factors Differentiate a High Tech Company from Traditional Companies and are They Sustainable? High tech companies tend to earn a high return on investment in the initial stages. It is however important to study the factors that differentiate them from traditional companies. Let us continue with the Amazon example- what differentiates Amazon from a brick and mortar retailer like Wal-Mart speed and flexibility; low inventory as a percentage of sales; ability to turnover the inventory fast. But is it sustainable over the long term? We see that as Amazon expands building warehouses around the world and staffing them with increasing workforce, it is continually loosing its differentiation. We need to factor in the business opportunity, competitive landscape, differentiating competitive advantage,
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customer base, aspirations and capability of the management team, availability of capital / funding over the short and long term in our projections.
Investment Risk Associated with High Tech Companies A high tech start-up company is characterized by high-expected growth in the future. The long gestation (lock-in) period along with associated uncertainty limits the number of investors willing to invest in such companies. The stock may not be publicly traded and readily marketable. Reduced marketability creates additional investment risk and needs to be compensated by increase in expected return.
Valuation of Intangible Assets Like Intellectual Property Intangible Assets like intellectual property, technological capability, business processes, network of highly skilled partners, customer relationships, unique value proposition, competitive advantage, customer base, are critical assets and likely to generate economic benefits yet these are not reflected as assets in the balance sheet of the companies.
High Uncertainty and Flexibility (Options) Introduce an Asymmetry in the Probability Distribution of the Value of a High Tech Firm The Option Value of Capturing Future Growth Opportunities A high tech company faced with high uncertainty invests in certain projects viz. R&D, if the situation turns out to be favorable, firm can benefit by exercising the
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option to accelerate the pace of investment step. This option value associated with uncertainty adds to the valuation of the company.
Exhibit 4.3.4: Option Value of Growth Opportunities
Source: Real Option Valuation in High Tech Firm- By Hu Pengfei & Hua Yimin This is similar to a call option to acquire an additional part (x%) of the base-scale project. The total value with opportunity option will be V + max (xV - IE, 0).
The Option to Abandon a Project Option to abandon a project for salvage value when its cash flows do not measure up to expectations. The option to abandon can be viewed as an American put option as below:
Exhibit 4.3.5: Option Value of Abandoning the Project
Source: Real Option Valuation in High Tech Firm- By Hu Pengfei & Hua Yimin
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The value with option increases to V + max (A V, 0) i.e. max (V, A).
These options introduce an asymmetry in the expected value of a high tech firm as shown in exhibit below: Exhibit 4.3.6: Asymmetry in Probability Distribution of Firm Value
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BUSINESS INFORMATION SERVICE Valuing a business information service is a tricky, complex and difficult process. There is no panacea or easy option. When a business information service manager is asked to prepare a valuation of their service and department, in any context and in any type of organization, they will realize only too soon how hard it is going to be. Even if they are well organized, have rigorously collected all the necessary metrics and have researched the appropriate and copious professional literature on the subject, they will soon be overwhelmed at the variety of methods and practices that can be used. Over the past five years, the writer has compiled a huge bibliography, currently running to about 40 pages, on library and information services literature. None give a clear idea for putting a value on the whole department and tend to describe one or two value indicators that might be used. Many articles seem to pose more questions about the valuation process than they answer, particularly, if one or a group of value indicators is to be used, the question of which might be the most appropriate for their circumstances. There are also plenty of reviews of value indicators, most of which do not really suggest how these might be used in practice to value a department.
Perspective Perhaps the most important aspect of valuing any business information service is to develop what is known as a business value philosophy. It will be argued of course, that knowledge of business valuation is not necessary to successfully manage a business information service or be a competent librarian or information specialist. But those having a basic understanding of commercial value, and business valuation in particular,
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will have a tremendous advantage. This means setting up your management activities to use as many aspects of business valuation as possible and adopting Value Based Management (VBM) principles. These advocate the attitude of acting on all opportunities in producing any product or service to increase value for the customers or clients, whether they be internal or external, or in a commercial profit making business or in a non-profit organization.
Business valuations are usually done for a specific purpose and the most usual reason is for a value at the time of takeover, merger or divestment of a complete company. They are also only valid at the time they are done and have to be repeated, sometimes many times over the period of an acquisition or sale, as circumstances change. Similarly, these points need to be appreciated by the business information service manager; when preparing their model they must realize that any valuation is not static or a one-off exercise
Valuations are not exclusively done of a whole company though. There are many instances in business where valuation is required for part of a company. The most common is for investment purposes, by a private equity limited or general partnership, which wants to assess a stake in a private company, but certainly doesnt want to make a full takeover. So the precedent is there is business for valuing small parts of a company, and this can be used for valuing individual departments such as the business information service.
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The position of the business information service in the organization In most commercial organizations, the business information service is regarded as a cost or overhead department. It is very rare to find a service that is a fully profit making concern. It is often the case though, that there may be some income flow from a special service or product that has been developed by the business information service and this would be one of the major value generators or premia that would be used in the valuation model.
So, the usual best case valuation for any business information service is to show their management that they are effectively at zero cost to the organization. They can do this by using a valuation that puts a notional monetary value on all of their unique (to their organization) services that can be discounted against the actual costs of running the business information service.
The business information service valuation mode There will always be costs involved in acquiring information in any company or organization, and as most have no dedicated business information service this is often overlooked in that costs are dissipated through a series of user departments. Senior managers often dispute this, but it is really not difficult for the experienced business information service manager to point out these hidden costs, especially by reference to outsourcing services, which are now more numerous and outgoing about their charges. A good example is the new British Library Research Service being charged at 84 per hour, plus online search costs and document retrieval and copying costs if used.
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An outsourcing cost should always be followed up and calculated if a business information service is to be closed, in addition to an estimate of the management time required to manage outsourced contracts. These should be estimated as the charges for an external accountant, who would be the only suitable external choice. Occasionally, the decision to close the business information service entirely may be influenced by this valuation alone.
Business information service valuation exercises are often required at the time when new, senior management are brought in from companies that have no formal services of their own and so have no experience of their effectiveness. The business information service manager should be prepared with these basic facts and arguments, if there is a significant management change on the horizon.
Accepting that the usual position of any active and viable business information service is as a cost to the organization, there will be a set of figures that represents the total cost of the service. These costs will be presented in different ways in different companies. The business information service manager ideally is able to have access and control over a full scale budgeted expenditure, with regular updates showing actual versus planned expenditure for the whole department. Unfortunately, many business information service units do not get this clear financial picture of their unit. Fixed costs, such as services and utilities, in particular are often not given. Full staff costs are also commonly omitted. But,
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to do a complete valuation, it is important that all this data is available and should be specifically requested if it is not usually distributed for the valuation exercise
To calculate the business information service valuation for an ongoing business information service there are two main elements, a base cost, which is carefully justified, based on the existing total cost of the business information service and then a series of premia and discounts, which are estimated as percentages of the adjusted base cost.
Premia are subtracted from the base cost and make the cost of the business information service less to the company. Costs are added back to the base cost if they are discounts, which would increase the base cost of the business information service to the company. The premia will reflect the unique services the business information service provides to users (customers) in the organization. It is actually these concepts that are described as premia in this paper that are most often described in the general library and information services literature concerned with valuation and justification of services. Concepts such as impact values or contribution to decision making are good examples.
The idea for this model is based on several company and business valuation methods, which are often used to value both whole companies and parts of businesses. The business valuation method that the idea perhaps derives from most is the capitalized earnings valuation. This uses a base valuation of a (price to earnings) ratio that can be compared to a similar company that is listed on a stock exchange. Some attempts to do this type of business information service valuation have been tried by using the concept
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of Return on Investment (ROI) calculations, but they are all rather disappointing in that they have tended to concentrate on one or two services to measure and not made any attempt to value the whole department. ROI is a very specific measurement in assessing listed companies and should be used with caution in the business information service context.
The model has been split into two stages: 1. Calculating the base cost of the business information service. 2. Adjusting the cost of the business information service by deducting premia and adding back discounts. Stage 1 of the model: The business information service base cost The first calculation for the model is to establish the actual base cost of the business information service. This can be very difficult, especially if the service manager is unable to access accurate and complete details of both indirect and direct costs of the service, or to gain some insight into the methods and practices of their calculation internally. Sometimes although this is unusual these days the business information service is simply regarded as one overhead cost, and no breakdown is made available to the service manager. If this is the case, then this non-analyzed figure will have to be used as the base cost for the valuation model. It must be made clear, though, in preparing the model, that there has been no scope to decrease the base cost of the business information service initially, which is obviously the most desirable scenario in trying to demonstrate the concept of the service as representing a zero cost to the organization.
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Types of costs Indirect costs Indirect costs that can be considered will include all the elements of funding the service that are not directly chosen and controlled by the business information service. Most commonly these include space costs, utilities, security and the overhead costs charged by other headquarters service departments, particularly human resources and computing/ automation. These can all be legitimately deducted from the total base cost on the premise that if the business information service were to close, then other departments and employees of the organization would use the space and incur all the other indirect costs. The only exception to this would be the case of a significant downsizing of the whole company, involving a substantial closure and disposal of buildings. This is often the case in merger of companies, where significant overlap in operations occurs. If the business information service valuation is being done in these circumstances, there are few deductions that can be made to base cost.
Direct costs Direct costs are all those that the business information service has complete responsibility for. These include all the staff costs and all the costs of the published information and information services acquired. However, information services are often purchased for the whole organization and charged out to users in various ways. The business information service might also control other large areas of expenditure for the whole organization, although these are hardly used by the business information service itself. Some of the most usual are the costs of maintaining knowledge management systems, which might include
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conventional records management and the dedicated databases and systems that manage internal information. So, many direct costs can be charged out internally to users and are therefore legitimately deducted from the business information service base cost. If this is not already an internal requirement, the business information service manager may have to do much work in apportioning costs accurately, appropriately and fairly.
Staff costs Staff costs the headcount are usually the highest costs of any overhead department. The obvious purpose of many business information service valuations is to reduce the headcount and so immediately decrease the base cost of the department and so save money. This is the easiest way to make an immediate impact through an external (to the business information service) valuation, and many business information service departments have suffered in this way. Hopefully, the lessons of the past have shown that this can be far too simplistic a view for any overhead department, not least for the business information service. The valuation proposed here presents a much more balanced picture of the whole service rather than just looking at staff costs.
Having said this, there are some deductions to base cost that might be made for staff costs, without losing headcount, Candidates might be staff members who work for a large part of their time exclusively for one user department or group. An appropriate percentage of time must be apportioned fairly, if the staff members time is not 100 per cent dedicated to specific user departments. Valuations of this kind can be justified by
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keeping accurate statistics about work flow, and it is probably not a good idea to deduct the staff costs of anyone who spends less than one third of their total time working for any single user group. These approximations and rules are known in valuations as rules of thumb. If they are used they should be indicated and explained in the valuation model. Temporary staff, contract staff, consultancy and student placements are also deductible from base cost. Some elements of staff benefits may also be deducted, depending on the range offered by the company and how they are costed. The business information service manager needs to be aware of the staff loading factor that is used in their company. This is the percentage used above the base salary cost to indicate the average amount that should be added to any recruitment of permanent staff for additional benefits and national insurance. The average loading is currently around 30 per cent of base salary, but in some companies, giving a range of high quality and expensive benefits can be much higher.
When every element of the base cost has been examined, and all that can be deducted from the total cost of the business information service has been removed, then the base cost of the business information service has been found to use in the model. The calculation of this base cost must be fully documented and described as the first part of the model. It can then be used as the starting point for the really interesting part of the valuation: the application of premia, which highlight the business information departments unique services to the company.
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Stage 2 of the model: Premia and discounts to business information services As explained above, premia and discounts are simply adjustments made to a base value to reach a final and more elegant numerical valuation of all or part of a company. The real benefit of doing a business information service valuation is that it is usually made to facilitate the valuation of the intangible assets of a company, such as brands, or to estimate the lack of marketability of the shares of a private company, which cannot be easily sold on a stock exchange.
So, in applying premia and discounts in a business information service valuation, the service manager is using a well established business technique to express a value of the (sometimes very intangible) services the department offers. The way that these premia and discounts are applied is as calculations of percentages of the adjusted base value of the business information service, which has been determined as discussed above as Stage 1 of the valuation model.
It is the expertise of the business information service manager that will determine and justify these percentages as representing their various services in the valuation model. This is the chance to highlight the unique and expert services provided by the business information service, and give them a numerical value that might bring them the attention they deserve amongst senior management, who may never directly use the service.
In preparing the valuation model, though, it is important not just to concentrate on the premia the wonderful services the business information service is providing to the
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company. It is necessary to balance the valuation with discounts, which will need to be honestly applied, showing the more negative aspects of the service and its role in increasing the cost base of the organization. No valuation can be considered valid with either premia or discounts applied in isolation. This is why there is an inherent unfairness in any examination of the business information service by an external manager, who only looks at cost cutting measures.
Premia Here are some ideas for premia that can be deducted from the base cost and an idea of the percentage range that might be applied. They may also trigger broader ideas on services that might be provided by the business information service to make it more attractive within the company.
All these premia, as applied, need to be exceptionally well reasoned and the percentage used needs to be fully explained along with any metrics available, such as costs, performance measurement statistics and other explanations. They should be calculated with the base cost and the aim of reaching zero cost firmly in mind. They will certainly take some time to apply effectively and the business information service manager will need to try out combinations based on current services and even split up some of the more nonspecific work to get to convincing percentage for each premium.
There may also be some very specific factors important to your situation and company, which could never be described in library and information services literature, which
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should not be missed and probably need to be at the top of the premia list. It is important not to be swayed by the temptation to apply just the most common business information service value indicators. Make sure the service is looked at in its company context. Surveying a few peer level managers in other overhead departments may give a deeper perspective of how they see your service.
Discounts Discounts need to be added to the base cost, as they increase the cost of business information service to the company. Here are some of the discounts the service manager will need to consider. These are just a few ideas that can be used in the model. They are described briefly as a stimulus for thought and may not be at all applicable in an individual business information service. Be prepared to make readjustments, and certainly apply reality checks by looking at the model from the perspective of a nonbusiness information service manager. If possible, get that friendly peer manager from another overhead department in the company to look at the estimates of the premia and discounts with a fresh eye, before presenting the final valuation to senior management.
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HEALTH CARE INDUSTRY
Health care valuation is an extremely risky practice area due to civil and criminal statues which are unique to the industry.
The health-care industry has undergone a significant
changeover the last decade or so. Because of the specific characteristics and unique attributes of the industry segment valuation of health care industry players throw an interesting challenge to the finance manager. Like all the new and upcoming sector, in the health care is one sector that has been growing leaps and bound. Also healthcare tourism is on northward stride in India. The growth of this sector is definitely going to arouse the need for valuators to value such companies. Thus, it becomes important to overview how this sector is being valued the world over and the issues addressed while doing such a valuation. For health care valuation, valuators weigh the basic operating characteristics: the services provided how services are reimbursed, patient referral sources, services area covered, regulatory compliance, cost containment and utilization management. Let us now have a look at various health care centers, the issues involved in their valuation and the methods that are used to value them. Physician practices The income approach of valuation is preferably used to value the physicians practices and the valuators use the DCF method of valuation for analyzing a practices fee-for-service and capitated revenue (a dollar payment per patient per unit of time that covers specific services and admin cost). Traditionally valuators performed medical practice valuation for physician buy/sell agreements divorcee
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litigations and estate planning. Today valuations are larger and more complex. Valuing physicians practice are done for a number of reasons like a JV, group practice merger or practice acquisition by a non-physician entities forming an integrated delivery system which may include insurers, HMOs and government agencies. Home Health Agencies The method that is generally true in valuing a home health agency is one that is most commonly used methodDCF. It is so because these entities develop a better understanding of their actual and expected future performance under the PPF scheme. o Service area demographics o State licensing and other requirements o Compensation o Reimbursement resources, if any o Referral sources o Services and case mix o Accounting and financial systems and controls o Quality of clinical staff o Cost structure and operational efficiency.
In analyzing a home health agency, the valuator starts through discussion with the management, then researches recent publication related to the segment and compares
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guideline company information. The valuator obtains data from management about the following factors:
Hospitals Traditionally the hospital valuations were based on price-per-bed multiples. Today, with outpatients services generating a good amount of the average hospitals revenue, and it rising by the day, and the occupancy rates declining the price-per-bed multiple have lost its relevance.
The value of hospitals depends on the scope of services as well as on how many patients use them. The hospitals progress in developing lower-cost services and managing existing ones is an important determinant of the value, particularly as, most hospitals shift to lower cost services to remain competitive.
The valuator must factoring key value determinants such as broad array of services, flexible cost structures, tight utilization reviews and good physician relationships. The valuator must also assess local market needs and the status of other hospitals competing for same referrals. Using the DCF method of valuation one can value hospitals under various operating scenarios. They can protect varying assumptions about demographics; competition and service pricing and can vary the operating margins to in corporate overhead reduction or changes in service tax. Medical Practices In any analysis of medical practices, the valuator should consider: o Practice type
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o Specility o Physician compensation o Facilities o Historical profitability o Current physician utilization (amount of time utilization with the patient) o Payment Mix o Physicians age, health and reputation o Quality of administration staff (based on years of service, range of responsibility and software experience) o Market and Compensation Practice and Specialty type my affect the valuation due to regulatory changes, demographic changes such as shift in population age or medical advances, any of which may affect a practices services and payor mixes. Practice relocation may be
accompanied by higher rental costs, resulting in decreased operating margins. However, an anticipated increase in revenues as a result of the relocation may improve operating margins; a change in payment mix resulting from the payor demographics related to the relocation can affect anticipated earnings.
The amount of time a physician spends with a patient may be factor of patient demand, ix of health or experience of the physician.
One of the factors most crucial considerations in medical practice valuation, for buyer, seller and appraiser, is the level and nature of physicians compensation because it
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typically represents the largest expense. The age and the health of the physician within a practice, as well as the quality of the administrative staff my affect the discount rate applied to the cash flows in using the discounted cash flow methodology, due to changes in the level of perceived risk factors, related to the particular medical practices. Nursing Homes When valuing nursing home, the valuator must specifically address the services area covered, current and proposed changes affecting the reimbursement sources, services offered and the attributes and the conditions of the companys facilities.
The valuators analysis must highlight demand trends based on demographics. Another important factor in valuing nursing homes is the reimbursement source, because reimbursement affects the profitability. Reimbursement comes into picture when nursing homes those do charitable work or provide their services at a discounted rate are being valued. They are true in countries like UK or US where medical is free for citizens or when charitable hospitals are being valued.
Thus the valuator must analyze the age, condition, capacity constants and ownership of each facility, as well as future capital expenditure requirements beyond routine maintaince.
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CASE STUDY: VALUATION OF UTI BANK

Valuation of a financial service organization is not like valuing a normal manufacturing firm. The two reasons for this challenge are (1) the nature of their business that makes it difficult to define debt and reinvestment and (2) they tend to be heavily regulated. Taking the first reason further they (FIs) tend to take debt as raw material for their operations rather than debt. Also by general definition of reinvestment is a function of net capital expenditure and working capital. Both of these are difficult to define in case of a financial service firm. Secondly the regulatory aspect also makes the valuation difficult. Financial firms are generally heavily related in most countries. These regulations are also with respect to the reinvestment that these institutions can make or their company, which in turn affects the growth rate of the firm. Keeping these two issues in mind valuation of a FI is then based on some general rule. They are explained below.
As already stated defining debt and reinvestment from FI is not easy and so estimating FCFs would be a problem. Thus, equity can be valued directly by discounting the CFs to equity at the cost of equity.
If we cant estimate the net capital expenditure or the WC, then we cannot estimate the CFs to equity. So we assume that dividends paid are the CFs to equity and that the firm pays all its FCF as dividends.
ISSUES IN VALUING A FINANCIAL SERVICE FIRM
Provisions for losses: Banks and insurance companies generally set aside provisions for losses. They reduce the income in the current period but are used to
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meet the expected losses in the future. Such provisions if too large, then the net income will be understated reducing the return to equity and vice versa. Also they are used to smooth out the earnings over the period of time. So the valuator should assess these figures carefully while doing the valuation. .
Regulatory Risk and Value: Regulatory issues do affect the perceived risk of investing in these firms as also the expected CFs and thus the value of the firm. Thus when valuing financial service firms using the discounted CF model, the regulatory effect can be built explicitly in both the discount rate as well as the expected CFs.
Financing Mix and value: Unlike the manufacturing firms, financial firms are not examined for the effect of financing mix of the firm. This is because (a) difficulty of defining and measuring debt and (b) they tend to use as much debt as possible making it unlikely that they will be significantly underlevered.
Subsidies and Contracts: To shoe the effect of these one should project the expected positive excess returns or CFs that will be generated as a consequence of the subsidy and/or social investment and to separate these CFs from the rest of the valuation.
For doing the valuation of the UTI Bank, I have followed the traditional DCF method of valuation. To make the valuation I had to make certain assumptions, which have been explained below:
The economy of the country is showing good growth an also the interest rates are at comfortable levels. This would result into more demand for credit thus increasing the Interest earned for the bank @ 25% CAGR
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Interest expense or the bank is kept as a constant percentage of the banks deposits and borrowings.
The commission and brokerage charges for the bank show an increase of 13.6% CAGR. This is estimated keeping in mind the opening of 100 more branches in 2005, which is just less than 50% of the current network of 227 branches.
The huge fall in the profits on ale of investments is due to increase in the yield I the bond markets.
Since the branch network is increasing, so will the employee cost. So the employee cost is showing an increase of 30-35% and also the operating expenses are increasing at rate of 35%
The bank plans to issue fresh equity to meet the banks growth plans, thus increasing equity capital from 2315.8 cr to Rs. 2718.9 cr.
The bank plans to have an ADR issue of $175 mn in 2006. The effect of his shown in the increase in the reserves and also in the Balance with the Bank Head of the balance Sheet.
The deposits of the bank are assumed to be increasing at rate of 30% CAGR. The retention ratio of the bank is kept constant at 80%
On the basis of the assumptions mentioned below and keeping the performance constant for the rest, the projected balance sheet and profit & loss account for the bank till the FY 2007-2008 is estimated. On estimating the Pat for all these years and using the retention rate of 80% and making the necessary adjustments for changes in WC, investments in FA, changes in debt I arrived at the FCF for the bank and discounted them @14.5%.
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Finally after finding the terminal value for the bank an then dividing it by the number of outstanding shares in 2006, I arrived at the valuation f th per share price of the bank which was Rs. __________
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REFERENCES Books: 1. Valuation 2. Dark Side of Valuation 3. Recent Trends in Valuation: --Aswath Damodaran --Aswath Damodaran --Luc Keuleneer (Editor), Willem Verhoog (Editor) --Tom Copeland, Tim Koller & Jack Murrin
From Strategy to Value

4. Measuring and Managing Value of Companies Articles: 1. Is There Life in e-commerce (www.economist.com)
2. Something Old, Something New (www.economist.com) 1. The Business of Business Valuation 2. Navigating through a Biotech Valuation 3. Key Recent Valuation Trends And their Importance. 6. How much is your business worth? 7. Valuation of Technology Firms 8. Taking temperature of Health Care Websites: 1. www.amazon.com 2. www.nasdaq.com 3. www.valuationissues.com 4. www.utibank.com --Gary E. Jones and Dirk Van Dyke --V. Walter Bratic, Patricia Tilton & Mira Balakrishnan --George B. Hawkins --Martin C. Daks --Deepak Mittal and Mudit Agarwal --Loren Garruto and Oliver Loud.
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