1
Ch-29
Method Of Valuation
Method of Valuation is the process used to determine the current worth of an asset, a business,
or an investment. It’s essentially the "price tag" math used by investors, buyers, and sellers to
decide if something is a good deal.
The Central Board of Direct Taxes. Ministry Of Finance. has appointed valuers for different
assets, such as immovable [Link], agricultural land, plantation, forests, mines, stocks,
machineries, jewellery, works of art and the like. The tax payers can utilise the services of these
valuers for assessing the value of assets and filing the tax returns.
A values’ main function is to determine the market value of the property, To be a good valuer,
the Engineer or Architect should have knowledge of planning, designing, surveying, estimating,
quantity surveying, developing of estates. Development Control Rules and Building Bye- Laws
Of local authorities, acts of both the State and Central Governments.
The methods of valuation generally adopted are:
O Land and Building Method
O Development Method
O Capitalisation Method
O Profit Method
Land and Building Method
Value of land = Rs. 400.000/- Since the building is more than 60 years and assuming the
reproduction cost at Rs. 180/- per sft. the salvage value at 10% equals to Rs. 18/- per sft.
Value of building = Rs. 4000 X Rs. 18 = Rs. 72,000
Value of property = Rs. 4,00,000 + Rs. 72,000 = Rs. 4,72,000
2
Development Method
By this method, the total extent of building that can be constructed is worked out viz.
9600 x 1 .50= 14,400 Sft.
Cost of construction 14.400 X as. 180/-
Such a type Of property can be sold at = Re. 240/- per Sft.
Gross income wilt be 14,400XRs. 240/-
Rs. 34.56,OOO
Gros$ Profit
( ) Rs 25, 92,000 Rs.
8,64.000/-
Capitalisation Method
In the case of tender buildings attracted by Rent Control Act, the income should be
reckoned as that actually received. However, If the rent has not been revised due to the
owner not asking for that. the rent reckoned should be as per the market value as on the
date on which valuation is made, since the rent itself is fixed as a percentage on the
value of the property.
It should be ensured that the rent fixed Is equal to the prevailing market rate.
Whenever there is difficulty in determining the reasonable market rent, the valuation
should be done by Reproduction Cost Method.
In case of cinemas. hotels, factories etc., leased lent should
be taken into account if the building is leased out outright provided the rent fixed is
comparable to the prevailing market rent. Otherwise, the Profit method should be adopted
Out-Goings : To arrive at the net rent, a certain amount has to be deducted from the
gross rent. The deduction may be due to various factors such as taxes, maintenance
charges, insurance charges, service charges, ground rent, (if applicable) Sinking Fund
and special or capital repairs if necessary.
Taxes as levied by the Municipality as Property Tax and Urban Land Tax if
applicable. The taxes as leviable can be allowed where the taxes actually Eevied are less
than leviable taxes ag per the Act.
3
Profit Method
The Profit Method of valuation determines a property's worth based on its ability to generate
business income, making it the standard approach for specialized trade properties like hotels,
pubs, or cinemas where market comparisons are scarce. It functions by calculating the Gross
Turnover and deducting operating expenses to find the net profit, then further subtracting a
"tenant’s share" to account for the operator's labor and capital investment. The remaining
figure, known as the Fair Maintainable Operating Profit (FMOP), represents the surplus
available for rent or mortgage, which is then capitalized using a multiplier (Years' Purchase) to
arrive at the final market value. Essentially, it treats the building not just as real estate, but as a
"profit-generating machine," ensuring the valuation reflects the realistic economic potential of
that specific business location.
Three Primary Valuation Methods
Most valuations fall into these three categories:
Market Approach (Relative Valuation)
This method looks at what similar things are selling for right now. It’s like checking "comps"
when buying a home.
How it works: You look at recent sales of similar companies or assets.
Common Metric: The P/E Ratio (Price-to-Earnings).
Best for: Real estate and publicly traded stocks.
Income Approach (Intrinsic Valuation)
This method focuses on the money the asset will make in the future. If you buy a business,
you’re really buying its future cash flow.
How it works: You estimate all future earnings and "discount" them back to what they
are worth in today's dollars. This is known as Discounted Cash Flow (DCF).
The Logic: A dollar tomorrow is worth less than a dollar today.
Best for: Established businesses with predictable profits.
Cost Approach (Asset-Based)
This looks at the "replacement cost." It asks: "How much would it cost to build this exact thing
from scratch today?"
4
How it works: You add up the value of all physical assets (land, equipment, inventory)
and subtract liabilities.
Best for: Distressed companies (liquidation) or holding companies with lots of physical
assets.
Why Does It Matter?
Valuation isn't an exact science—it's more of an informed estimate. Different methods can yield
different results. For example:
A tech company might have low asset value (just some laptops and a rented office) but
high income value because of its software.
A manufacturing plant might have high asset value but low market value if the industry
is shrinking.
Informed Decision Making
Valuation tells you if an asset is overvalued or undervalued.
For Buyers: It prevents you from overpaying for a house, a stock, or a business.
For Sellers: It ensures you don't leave money on the table by asking for too little.
Raising Capital and Investing
If you want to grow a business, you often need outside money.
Equity: To give an investor 10% of your company, you must first agree on what 100% of
that company is worth.
Loans: Banks use valuation to determine collateral. They won't lend you $1 million if the
asset you're pledging is only worth $500,000.
Strategic Planning (The "Health Check")
Regular valuation acts like a medical checkup for a business. It highlights where the value is
coming from.
It helps owners identify which parts of the business are most profitable.
It shows whether the company is actually growing in value over time or just "staying
busy."
Legal and Tax Compliance
5
There are many situations where a valuation is required by law:
Taxation: Determining capital gains tax when an asset is sold.
Mergers & Acquisitions: Ensuring shareholders get a fair deal during a buyout.
Estate Planning: Valuing assets for inheritance purposes.
Comparison of Valuation Perspectives
Stakeholder Primary Goal of Valuation
Investor To find the "Entry Price" that guarantees a good return.
Business Owner To maximize the "Exit Price" when selling or retiring.
Bank/Lender To minimize "Risk" by ensuring the asset covers the loan.
. The Valuation Report
A valuation report is a formal document that explains how the value was calculated. It serves as
legal or financial proof of an asset's worth.
Key Components of a Report:
Purpose of Valuation: Why is this being done? (e.g., for a sale, a divorce settlement, or a
tax filing).
Date of Valuation: Value changes daily. A report must specify the exact "as of" date.
Description of Asset: Detailed info on the company, property, or intellectual property
being valued.
Methodology: A detailed explanation of why a specific method (like DCF or Market
Comps) was chosen.
Conclusion of Value: The final estimated "Fair Market Value."
Key Assumptions in Valuation
6
Since no one has a crystal ball, every valuation is built on a foundation of assumptions. If an
assumption is wrong, the entire valuation changes.
Financial Assumptions
Growth Rate: How much will the company’s revenue grow each year? (e.g., assuming a
steady 5% growth).
Profit Margins: Will the company become more efficient or will costs rise?
Discount Rate ($r$): The rate used to turn future money into today's value. This
represents the risk. Higher risk = higher discount rate = lower current value.
Market & Economic Assumptions
Going Concern: The assumption that the business will keep operating indefinitely and
won't go bankrupt tomorrow.
Market Conditions: Assuming the industry isn't about to be hit by a major regulation or
a sudden economic crash.
Terminal Value: The assumption of what the business will be worth at the end of the
projection period (usually after 5 or 10 years).
Why Assumptions Are Dangerous
Assumptions are the "weakest link" in a valuation. This is why analysts often use Sensitivity
Analysis.
Example: "The business is worth $1 million IF it grows at 5%. However, if it only grows at 2%, it
is worth $700,000."
Comparison: Fact vs. Assumption
The Fact The Assumption
Last year's revenue was $500k. Next year's revenue will grow by 10%.
The company owns 2 delivery trucks. The trucks will last another 5 years.
7
The Fact The Assumption
The current bank interest rate is 4%. The interest rate will remain stable for 3 years.
Valuation is the process of determining the current worth of an asset or a company. Think of it as
the "price tag" of a business, calculated through logic and math rather than just a guess.
Below is a breakdown of one of the most common methods—Discounted Cash Flow (DCF)—
followed by a practical case study.
1. Valuation Method: Discounted Cash Flow (DCF)
The DCF method is based on the idea that a company is worth the sum of all the money it will
make in the future, adjusted back to "today’s dollars."
How it works:
1. Forecast: Estimate the company’s Free Cash Flow (FCF) for the next 5–10 years.
2. Discount Rate: Choose a rate (usually the WACC, or Weighted Average Cost of Capital)
that reflects the risk of the investment.
3. Terminal Value: Estimate what the company is worth at the end of the forecast period
(since businesses ideally last forever).
4. Calculate Present Value: Use a formula to "pull" those future values back to the present.
The core formula for a single year's DCF is:
$$PV = \frac{CF_n}{(1 + r)^n}$$
$PV$: Present Value
$CF_n$: Cash flow in period $n$
$r$: Discount rate (WACC)
2. Case Study: Valuing "GreenTech Solutions"
The Scenario:
8
You are looking to buy GreenTech Solutions, a small startup that manufactures solar sensors.
You want to know if their asking price of $1.5 million is a fair deal.
Step 1: Projections
Based on their contracts, you project their Free Cash Flows for the next 3 years:
Year 1: $200,000
Year 2: $250,000
Year 3: $300,000
Step 2: The Discount Rate
You decide on a 10% discount rate. This accounts for the fact that a dollar tomorrow is worth
less than a dollar today due to inflation and the risk that the startup might fail.
Step 3: The Calculation
We calculate the Present Value (PV) for each year:
Year 1: $200,000 / (1.10)^1 = {181,818}
Year 2: $250,000 / (1.10)^2 = {206,611}
Year 3: $300,000 / (1.10)^3 = {225,394}
Step 4: Terminal Value & Final Total
For simplicity, let’s say the business is sold at the end of Year 3 for a "Terminal Value" of
$800,000.
Discounted Terminal Value: $800,000 / (1.10)^3 = \mathbf{\$601,051}$
Intrinsic Value of GreenTech:
$181,818 + 206,611 + 225,394 + 601,051 = {1,214,874}$
9