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Journal number 4 ∘ Natela LatsabidzeMurman TsartsidzeGiorgi KhmaladzeNikoloz Khmaladze
Enterprise (business ) valuation methods and the peculiarities of their employment in practice

Expanded Summary

Business valuation is a complicated, expensive and time-consuming process. According to the norms of procedures and professional standards approved in the international practice, the definitely established approach or recommendation on applying the specific method of valuation does not exist. The method of valuation should be selected taking into consideration the specific objective of business valuation.  It is worth noting, that the evaluator is free to approach and select the valuation method, he/she can apply the various methods considering the aim of valuation and the specific situation. The process of selection should necessarily comprise thereview of appropriate basis for the value and preconditions of valuation, the analysis of the strength and limitations of possible approaches and methods of valuation, the availability of the required, credible information for applying the specific method.

According to the international standards of valuation three basic approaches of valuation – market, income and expenditure - are deemed to be admissible. All the methods of market approach to business valuation is based on the principle of competitiveness. On the one hand, the buyer does not pay for a certain business more than the value of other investment containing the analogous risk, on the other hand, the seller does not agree on the value of the analogous enterprise (business) on the market. In the case of applying this approach of valuation, the credibility and quality of the information necessary for valuation assume  great importance. If the evaluator obtains the data of several analogous sales, the data to be compared will be representative and the quality and credibility of valuation will increase. The obtained information about sales should be qualitatively similar. It is logical, that the reliable basis for comparison is the data of enterprise (business) of the same type, having the same organizational-legal form of ownership and approximately the same scale.

The approach focused on the income valuation of an enterprise is based on determining the current cost of flow of income considering the risks of receiving the income. While conducting the valuation the attention should be focused on the following circumstances: if the predictable cash flow is expressed by  real indicators, the evaluator should use such a discount rate which does not factor in the future changes of prices caused by the inflation or deflation. While applying the income approach, the valuation may necessitate corrections so as to reflect the issues which were not envisaged in the cash flow forecast or discount rates. The salient point is that a lot of enterprises can be valuated according to the same scenario of cash flow, but the evaluator can use several scenarios or imitative models as well. I think, the methods of determining the discount rate to be employed in the evaluative practice of Georgia are those acknowledged at the international level, they are as follows: capital asset pricing model (CAPM), the method of weighted average cost of capital (WACC), the empirical  (evidence) rates/profitability, the internal rate of return(IRR), the weighted average return of assets (WARA), the cumulative model.

The expenditure approach, which is rarely used in the international practice of  enterprise (business) valuation, is based on the replacement principle –the rational investor will not pay for the business assets more than for the assets having the analogous economic benefits. Within the framework of the mentioned approach the basis for the calculation of an enterprise value is the data of financial statements. However, it is worth noting that the book value rarely coincides with the market value. While applying the expenditure approach it is important for the evaluator to establish the value through making corrections to the functional, economic and physical depreciation of assets.

All the approaches of enterprise (business) valuation (market, income and expenditure) have the strong and weak sides.

Among the strong points of market approach the following should be highlighted:

√ While determining the cost the direct market benchmarks are used, the minimum corrections are made and the market “opinion” on the enterprise value is at most expressed

√ The method allows to conduct the quick preliminary “express-valuation” of the business/enterprise value.

√ The approach may also be applied to justify the value set within the framework of other approaches

The drawback of the mentioned approach is that it requires selecting the adequate  analogous objects for comparison as well as collecting the enormous amount of information that sometimes is extremely difficult to fulfill. The employment of expenditure approach depends on the current state of the market and  its effective performance. That is why, a part of specialists considers this approach to be not so accurate and the results of valuation to be less credible.

The essential point in enterprise/business valuation approach focused on the income  is to determine the current value of income flows. While applying the income approach it is important to establish the capitalization and discount rate. The anticipated growth in the process of using a discount may be evidently factored in the forecasted incomes, and applying the capitalization methods the expected growth, as a rule, is reflected in the capitalization rate.   

Analogous to other methods, the valuation approach based on the enterprise (business) incomes has its strong and weak sides.

It is considered to be positive sides that the aforesaid approach:

√ considers the possibility to earn income by the object of evaluation and the risks related to receiving income

√ allows to reflect objectively  not only the current situation of the object of valuation but the prospects of its peformance and development as well. 

√ allows to determine the adequate benchmark of the business value which is based not so much on tangible assets as on new technologies, intellectual property, etc.

√ can at most express the investors motivation, that is why, it is most acceptable, for example, to determine the investment value

As regards the drawbacks we deem it necessary to point out that the approach based on incomes should be applied for that enterprise (business) valuation, which, as a rule, can be operable and definable in the future. It is based on the long-term forecast of the future monetary return whose  credibility greatly depends on the stable performance of the enterprise as well as the economic security of the country. Its employment is also related to a certain biased approach to establishing the rate of cash income to be earned in the future and the capitalization/discount rate, it requires the detailed analysis of enormous amount of economic and statistic data.

The expenditure approach to enterprise valuation, as it was mentioned, is comparatively rarely applied. The employment of the mentioned method is recommended, when: the enterprise is at the initial stage of development, or it is newly established and the credible determination of the cash flow and its comparison to other market subjects is impossible; the business entity represents the investment or holding company and it is possible to apply the summation method; the business entity is not an operable enterprise or at the time of  liquidation the value of its assets may exceed the cost of the business entity as of an operable enterprise. Regarding the expenditure approach it should be pointed out that it has the certain strong sides implying the following:

√ it adequately reflects the assets of an enterprise, and the business value, in its turn, is determined by the existence of assets and cost;

√ it may be applied in case the initial information necessary for other valuation methods is not available;

√ the employment of the approach is possible under the conditions of liquidation of an enterprise, when the realization of assets are considered to be made piecemeal

√ it is clear and easy to explain to consumers

To be objective,  the drawbacks should be highlighted as well. The enterprise (business) valuation based on the expenditure approach cannot completely reveal the prospects of business development and requires the substantiation of the existence of intangible assets, profit, goodwill of the objects of intellectual property and their separate valuation. Its employment in practice requires quite hard and tedious jobs.

In the process of enterprise/business valuation it is necessary to evaluate the risk-factors related to functioning of an enterprise. The risks are linked to the macroeconomic as well as microeconomic (domestic manufacturing) factors. The factors conditioning the macroeconomic risks – the level of inflation, the social and economic situation of the country, the level and stages of development, the changes in the interest rate and currency exchange rate, political instability –assume particularly great significance for business valuation in Georgia. While conducting the business valuation the attention should be focused on financial risks – the low level of financial resource management, the lack of qualified specialists in the sphere of financial management, the failure to draw up the estimate documentation correctly, spending the unreasonable additional expenses, etc. It is of equal importance to consider the marketing risks- the change of consumer behavior, strengthening the competitiveness, the loss of positions on the market, the untimely market penetration, etc. While conducting the business valuation it should also be taken into account that maybe rarely, but the enterprise may still face the risk of  default, which is related to its bankruptcy or temporary insolvency.