Chapter 3: Valuation Approaches and Methodologies

ICAI SPOM Set C – Valuation | Quick Revision Notes

1. THE 3 APPROACHES — OVERVIEW

Approach Basis Sub-methods

Market Approach What buyers actually paid Market Price, CCM, CTM
for similar/identical assets

Income/Earning PV of future earnings/cash P/E ratio, DCF (FCFF/FCFE), Non-DCF

Approach flows (Discounted Future Earnings), Intangibles
(RFR, MEEM, WWM)

Asset/Cost Cost to build/buy a similar Replacement Cost, Reproduction Cost

Approach new asset

Selecting the right approach depends on:

1. Nature of asset
2. Availability & reliability of inputs
3. Strengths/weaknesses of each method
4. What market participants use
5. Purpose/Premise of valuation:
Liquidation → Realizable Value of Net Assets (no going concern)
Start-up → Market Approach often unusable (illiquid, no comparables, no profit
history) → Income Approach if cash flows can be projected
Statutory requirement → e.g., Income-tax Rule 11UA prescribes method

Golden Rule: Maximize RELEVANT OBSERVABLE INPUTS, minimize

UNOBSERVABLE INPUTS.
Observable: price/cost of similar assets in active market; actual cash flow
Unobservable: estimated price of non-identical assets; projected cash flow

Multiple approaches can be used together (weighted). If results vary significantly → use
professional judgement to discard/revisit.
Key Definitions (ICAI VS 101 — MCQ favorites)
Term Para Meaning

Purpose 6.31 The reason valuation is conducted

Premise of Value 6.29 Conditions/circumstances of how asset is deployed

Observable 6.25 Developed from market data; reflect market participant assumptions
Inputs

Unobservable 6.42 No market data available; best-information based

Inputs

Market 6.24 Willing buyers/sellers who are (a) independent, (b) knowledgeable, (c)
Participants able to transact, (d) willing (not forced)

Active Market 6.1 Sufficient frequency & volume of transactions for ongoing pricing info

Orderly 6.27 Assumes normal market exposure period; NOT a forced transaction
Transaction

Asset 6.2 Includes group of assets, liability, business, or ownership interest —

"Asset" always includes "Liability"

Intangible Asset 6.19 Identifiable non-monetary asset without physical substance

Present Value 6.30 Tool linking future amounts to present amount via discount rate

2. MARKET APPROACH
Relies on real market data — supply/demand, market efficiency, comparables.

When relevant:
1. Asset traded in Active Market, OR
2. Recent, orderly, comparable transactions exist, OR
3. Reliable info available on such transactions

Benefits
Easy, simple, less time-consuming
Consistency with other valuations
Reflects current market mood (embeds discount rate & growth rate consensus)
Limitations
As good as the comparable companies' valuation (garbage in-garbage out if market
overvalues peers)
Hard to find perfect comparables
Accounting policy differences distort comparisons

2.1 Three methods under Market Approach

(A) Market Price Method

Uses traded price over a reasonable period for actively traded assets
Use weighted/volume-weighted average to smooth volatility/one-time events
If traded on multiple exchanges, use the one with highest volume
RIL example: widely traded on NSE+BSE → market price usable
Thinly traded stock (BSE only): market price not used, or given low weightage

(B) Comparable Companies Multiple (CCM) Method

AKA Guideline Public Company (GPC) / Guideline Publicly Traded Comparable
(GPTC) Method — internationally IVS 105
Comparable selection factors: operational processes, cash flows, growth potential, risk
6 Steps: (1) Identify comparables → (2) Compute multiples → (3) Compare for material
differences → (4) Identify adjustments → (5) Apply adjusted multiple → (6) Compute
value

Comparable selection factors (memorize): Industry, Geography, Line of business,

Economic forces, Size, Lifecycle stage, Profitability/margins & diversification
Multiples = Comparable Co.'s Price/Value ÷ Financial parameter
Revenue, EBITDA, PAT, EPS, Book Value
EBITDA preferred over PAT — removes effect of depreciation policy & leverage
differences
Non-financial metrics: EV/Tower (telecom), EV/Tonne capacity (cement), EV/Barrel
(oil), EV/Room (hotels)

Adjustments to multiple: size, geography, profitability, lifecycle, diversification, growth,

management, ESG adherence
Final adjustments to computed value:
1. Control Premium (for controlling stake)
2. Discount for Lack of Marketability (DLOM) — unlisted/illiquid
3. Discount for size
 4. Other (synergy, integration cost)
Enterprise Value (EV) formula:
EV = Market Capitalization + Long-term Debt + (Minority Interest − Cash) −
Investments in Affiliates/Long-term Investments
EV = Core/Operating EV + Non-Core/Non-Operating EV
CCM Illustration logic: Pick EV/Sales when PAT has one-time items (not "normal"); EV =
Multiple × Sales.

(C) Comparable Transaction Multiple (CTM) Method

AKA Guideline Transaction (GT) Method; variant of CCM but uses Transaction
Multiples (not trading multiples)
Selection factors: comparability of entity, recency of transaction, background, deal
structure
Same 6-step process as CCM but for transactions
Reliable sources: Regulatory filings, Industry magazines, M&A databases
Key point: CT method value is presumed to ALREADY include discount/premium
adjustments → avoid double counting when applying control premium/DLOM again
Non-financial metrics: EV/Room (hotels), EV/Bed (hospitals), EV/MAU (e-
commerce/start-ups)

CTM Illustration: D Ltd (20L MAU) vs Z Ltd (3.2 Cr MAU, acquired for ₹2,500 Cr) →
Multiple = 2500/3.2 = ₹781.25/MAU → Value of D Ltd = 20L × 781.25 = ₹156.25 Cr

Common Multiples Table (MUST MEMORIZE)

Enterprise Value Multiples Equity Value Multiples

EV/EBIT = (MCap+Debt)/EBIT P/E = MCap/Net Profit

EV/EBITDA = (MCap+Debt)/EBITDA P/CE = MCap/(NP+Amort+Dep)

EV/Sales = (MCap+Debt)/Sales P/BV = MCap/Equity

EV/OCF = (MCap+Debt)/OCF P/OCF = MCap/OCF

3. INCOME/EARNING BASED APPROACH

Premise: converts future maintainable cash flows into a single present value
(discounted/capitalized).
TVM formula: FV = PV × (1 + i/n)^(t×n)
When to use Income Approach
1. No market comparable/transaction available
2. Fewer relevant comparables
3. Income-producing asset with reasonably projectable cash flows
4. Initial-phase asset without matured cash flows

When to combine with/use OTHER approaches instead

1. Asset not yet generating income (projects under development)
2. Significant uncertainty in amount/timing (start-ups)
3. Client lacks access to info (e.g., minority shareholder without budgets)

3.1 Price/Earnings (P/E) Ratio Based Valuation

P/E = Market Value per Share ÷ EPS
Can be trailing (historical) or forward (projected) basis. Used to compare vs history, peers,
or market.
Other lagging multiples (from Simba Cements illustration — know the formulas):
P/CF = Price ÷ Cash Flow per share (CF/share = Net CF from ops ÷ shares)
P/S = Price ÷ Sales per share
P/B = Price ÷ Book Value per share (BV/share = Shareholders' Equity ÷ shares)

If firm's ratios < industry average → firm is undervalued (and vice versa).

3.2 Discounted Cash Flow (DCF) Method — MOST IMPORTANT TOPIC

IVS 105 method. Most recognized valuation method.
Merits: (a) Sound — based on expected future cash flows (investor's actual return driver)
(b) Business-specific, not swayed by short-term market conditions (c) Not vulnerable to
accounting conventions (depreciation, inventory) — cash-based (d) Good for start-
ups/projects with no asset base or earnings (but must adjust discount rate for execution
risk)
Drawbacks: (a) "Garbage in, garbage out" — only as good as inputs (CF projections,
discount rate, terminal value) (b) Ignores opportunity cost risk, unforeseen CF variations,
non-financial factors
Two Variants:
 FCFE FCFF

Determines Equity Value Enterprise Value

Discounted Cost of Equity (Ke) WACC

at

Formula PAT − Pref Div + Dep&Amort − CapEx − ↑Non-cash EBIT(1−t) + Dep − CapEx −
WC + ↑Debt/Pref − ↓Debt/Pref ↑Non-cash WC

Equity Value from Enterprise Value:

Equity Value = EV + Cash & Cash Equivalents (excess) + FV of Surplus Assets/Land +
FV of Investments/Deposits + PV of MAT Credit − Contingent Liability − FV of LT Debt
− FV of ST Debt
8 Major Steps in DCF:
1. Analyze historical performance
2. Ascertain what is being valued
3. Prepare projections (generally 4-6 years)
4. Calculate post-tax FCFF or FCFE
5. Calculate Discount Factor (WACC or Ke)
6. Discount the cash flows
7. Sum discounted CFs = Present Value (PV)
8. Estimate Terminal Growth Rate → Terminal Value (TV) → Add PV+TV =
Enterprise/Equity Value → Deduct Net Debt from EV → gives Equity Value

3 Prime Factors in DCF (frequently tested — MCQ 16, 18 style):

1. Cash Flow Projections
2. Discount Rate
3. Terminal Value

(a) Cash Flow Projections — key points

Ideally project full P&L + Balance Sheet
Due diligence areas: overvalued assets, unrecorded liabilities, non-operating/non-
recurring inflows, management quality, tax structure, robustness of CFs, value drivers
Explicit forecast period length depends on:
Nature of asset (cyclical → one full cycle, e.g. cement)
Life of asset (definite life → full life, e.g. BOT roads, debt instruments)
Sufficient period to reach stable operations
Reliable data availability
 CapEx must include maintenance CapEx, not just growth CapEx
Working capital & tax benefits (tax holiday, b/f losses) must be factored

(b) Discount Rate

FCFE → Ke (Cost of Equity); FCFF → WACC
WACC components: Equity, Preference shares, LT debt, ST debt (Market Value
weights preferred; Book weights common in India)

Cost of Equity (Ke) — 2 methods:

(i) Dividend Capitalization Model:
P₀ = D₁/(Ke − g) → Ke = D₁/P₀ + g
Limitation: assumes current stock price = correct value (rarely true)
(ii) CAPM (preferred method):
Ke = Rf + (Rm − Rf) × β
Rf = risk-free rate (LT govt bond yield; for MNCs use Functional Currency basis, not
HQ country)
(Rm−Rf) = Equity Risk Premium (historical approach using long-term index data e.g.
Sensex/Nifty)
β = Beta (systematic risk)

Beta:
Beta = Covariance(stock, market) ÷ Variance(market) = SLOPE(x,y) in Excel
Interpretation:
β < 0: inverse to market (rare)
β = 0: unaffected by market (cash, govt securities)
0 < β < 1: less volatile than market
β = 1: tracks market
β > 1: more volatile than market

Unlisted company Beta — 6 steps: identify comparables → get their betas → un-lever using
their D/E & tax → average → re-lever using target's own D/E & tax
Leverage adjustment formula:
Levered Beta (βl) = Unlevered Beta (βu) × [1 + (1−t) × D/E]
Cost of Debt (COD):
Rated entities: COD = Risk-free rate + Default spread (per credit rating)
 Non-rated: use latest actual borrowing rate as proxy
Always used POST-TAX in DCF: After-tax COD = Pre-tax COD × (1 − Marginal Tax
Rate)
Loss-making years: no tax shield on interest (no tax reduction); but carry-forward
losses' benefit considered when profits resume

(c) Terminal Value (TV)

TV = PV at end of explicit forecast period of ALL subsequent cash flows (till infinity/end of
life). Often 50%+ of total DCF value — very sensitive to assumptions.
3 Methods:
1. Gordon (Constant) Growth Model — most widely used
TV(n) = Expected FCF(n+1) ÷ (Discount Rate − Expected Growth Rate)
Growth rate must be ≤ economy's growth rate (capped), else TV →
infinity/negative
Factors for growth rate: capacity utilization, market share, product lifecycle,
geography, cash flow type, residual asset life, capex needs, cyclicality
2. Exit Multiple Method — applies market multiples (EV/EBITDA, EV/Sales) to
perpetuity earnings
This blends Market Approach into an Income Approach method
3. Salvage/Liquidation Value — used when entity will NOT continue as going concern
Based on book value (adjusted for inflation) OR discounted expected sale
proceeds
Usually LOWER than book/market value

Key Terminal Value pitfalls: inadequate long-term CapEx, inadequate WC vs growth rate,
depreciation-CapEx mismatch, unrealistically low effective tax rate persisting

3.3 Discounted Future Earnings (DFE) Method — Non-DCF Income Approach

Projects future earnings (not cash flows) and discounts to PV
Steps: Earnings Projection → Discount Rate Selection → Discounting → Summation
Requires accurate forecasts; used alongside other methods for robustness

EV/EBITDA illustration logic:

EV = Market Value of Equity + Market Value of Total Debt − Cash & Marketable
Securities Multiple = EV ÷ EBITDA — compare to industry average to judge
under/overvaluation

3.4 Valuation of Intangibles

Examples: Patents, Copyrights, Customer Lists, Licenses, Franchises, Marketing Rights,
Software
(i) Relief From Royalty (RFR) Method — most widely used for Brands/IP/Software
Logic: Intangible value = PV of royalty payments SAVED by owning (not licensing) it
Combination of Market + Income Approach (avoided cost concept)
Royalty rate adjusted for: geography (use/restriction), brand recall, market share
Key factors: Revenue projections, Discount rate, Royalty rate
Royalty rate depends on: bundled vs isolated asset, rights/geography/term, economic
returns (wholesale vs retail), upfront fee/cost-sharing arrangements

7 Steps: Projections → Analysis → Selection (of royalty rate) → Application (to future
income) → Tax Rate (after-tax royalty) → Discount Rate (to PV) → Tax Amortization Benefit
(TAB) if applicable
Note: Since intangible has limited useful life, generally NO terminal value in RFR
(projections cover whole useful life)

(ii) Multi-Period Excess Earnings Method (MEEM)

Used for the lead/most significant intangible among a group
Used when direct measurement of the intangible's benefits isn't possible but overall
earnings can be determined — "Residual Approach"
Commonly for: customer relationships, technology, IPR&D
Value = f(Projected Revenue/Earnings, Economic life, Contributory Asset Charges
(CAC), Discount Rate)

CAC = charges for use of other contributing assets (working capital, fixed assets, workforce,
other intangibles) at their fair value — excludes goodwill
5 Steps: Projections → Analysis → CAC (subtract from total CFs) → Discount Rate → TAB if
applicable
MEEM Illustration:
Excess Earnings = Actual Earnings − (Net Operating Assets × Required Return) Value
of Goodwill = Excess Earnings ÷ Capitalization Rate Total Value = Net Operating Assets
+ Value of Goodwill
Example: Net Assets ₹200 Cr, Earnings ₹15 Cr (note: MCQ 12 uses different numbers, check
given data), Required return 12%, Cap rate 15% → Expected return = 200×12% = ₹24 Cr;
Excess = 24−15 = ₹9 Cr; Goodwill = 9÷15% = ₹60 Cr → Company Value = 200+60 = ₹260 Cr

(iii) With and Without Method (WWM)

Value = PV of (Cash flows WITH the intangible) − PV of (Cash flows WITHOUT the
intangible)
Commonly used for Non-Compete arrangements
 4 Steps: Projections (2 scenarios) → Analysis → Discount Rate (on the differential CFs)
→ TAB if applicable
Non-compete valuation typically also applies a "Probability of Competing" factor to
the PV of differential cash flows

4. ASSET / COST BASED APPROACH

Premise: Cost to rebuild/replace = value of investment/business (aka Current Replacement
Cost)

Useful for:
1. Asset-intensive entities
2. Holding companies
3. Distressed entities
4. Entities not worth more than Net Tangible Value

Limitations
1. Ignores amount, duration, timing of future economic benefits
2. Ignores risk characteristics & competitive performance
3. Ignores company history, intangibles, discounts, contingent liabilities
4. NOT preferred for Enterprise Value of a going concern

Application scenarios
1. Asset can be quickly recreated with same utility
2. Liquidation Value needed
3. Income/Market Approach cannot be used (indeterminable future profits — new co.,
dislocation, losses, fluctuations)
4. Surplus assets to business ops: excess land, holding cos, real estate cos, investment
holding cos

4.1 Two Methods (both IVS 105)

Replacement Cost Method Reproduction Cost Method

Recreates Comparable Utility (substantially same use) Exact Replica (duplicate copy)

Key word "Utility" = quality of being useful "Replica" = exact/very good copy

Both adjusted for Obsolescence.

3 Steps: Estimate recreation cost → Assess obsolescence (physical/functional/economic) →
Adjust for obsolescence → Value

Types of Obsolescence
1. Physical Deterioration — decreased usefulness as useful life expires
2. Functional (technological) Obsolescence — newer tech makes asset inefficient
3. Economic (external) Obsolescence — external factors (regulation change, excess
supply, high interest rates)

Note: "Obsolescence" is broader than accounting "Depreciation."

Steps to derive value under Cost Approach

1. Audit/examine Balance Sheet & records
2. Ascertain Value of Assets
3. Ascertain Value of Liabilities (incl. contingent)

Value of Equity Capital = (Value of Assets − Value of Liabilities) ÷ No. of Equity

Shares

4.2 Valuation of Assets — 3 bases

1. Book Value — historical cost; immoveable property/investments often at Market
Value even if others at book
2. Net Replacement Value — for going concern; intangibles may need separate addition
3. Net Realizable Value — for entities being wound up; usually less than going-concern
value; provide for liquidation costs

Category-wise valuation approach (MCQ-relevant)

Category Basis

Fixed Assets Replacement/Reproduction cost → depreciate over new economic life →

adjust for additional obsolescence

Investments Quoted/actively traded: market price; Illiquid/unquoted: Relative Valuation

or Income Approach

Inventory Cost / adjusted for obsolescence / Current Market Price / Net Realizable
Value

Sundry Debtors Time value of recovery, adjusted for credit risk/bad debts

Contingent Assets Conservative — consider recovery probability & timing

 Category Basis

Development Review and include costs incurred to date

Expenses

Intangible Assets Book/Net Replacement/Net Realizable/Fair Value — Goodwill fetches value

only if sold as going concern

4.3 Valuation of Liabilities

1. Contingent Liability — apply probability factor (e.g., 50% chance of crystallizing)
2. Taxes — include unprovided liability
3. Proposed Dividend — include if unprovided
4. Reserves/Provisions — reclassify if actually provisions (future losses)
5. Preference Shares — dues reduced from EV to get equity value (incl. participating
rights in surplus)

5. FAIR VALUE AND ITS COMPUTATION

Fair Value = price received to sell an asset / paid to transfer a liability, in an orderly
transaction between market participants, at the valuation date.
Same definition philosophy as Ind AS 113 (Fair Value Measurement)
Under Income Approach: FV = based on current market expectations of future
amounts
Per ICAI VS: FV = price in Principal (Most Advantageous) Market at valuation date
under current conditions = Exit Price
FV is generally synonymous with Market Value (except special-asset-value
situations)

Perspective differences (conceptual MCQ trap):

Potential acquirer of controlling stake: wants "Fair Price, no less no more"
Chartered Accountant's view: arm's length transaction (per Ind AS definition)
Financial Analyst's view: PV of entity in cash terms
Speculative Investor's view: arbitrage opportunities among market participants

Key Aspects of Fair Value

1. Based on Exit Price
2. Emphasizes "Principal Market"/"Most Advantageous Market"
3. Reflects Market Participant assumptions
 4. Considers Highest and Best Use (HABU)
5. Considers characteristics: condition, location, restrictions on sale/use

Fair Value via DCF — computation logic (illustration pattern)

1. Project Revenue, Net Profit, add back non-cash Dep, less non-current investments, +/−
WC changes = FCFE
2. Compute Terminal Value: TV = FCF(n+1)×(1+g) ÷ (Ke − g)
3. Discount each year's FCFE + TV at Ke → Present Values
4. Sum PVs + PV of TV + Cash balance = Equity Value
5. Equity Value ÷ No. of shares = Fair Value per Share

6. CASE STUDIES (conceptual takeaways — often asked as theory)

Case Key Learning

Apollo/Fortis/Narayana Same industry ≠ same multiples — differences driven by size,

Hrudayalaya margins (EBITDA%), capital structure. Right peer group selection is
critical. Forward/normalized earnings > historical for multiples. Non-
operating items must be excluded to avoid distorting multiples.

Vodafone-Idea merger Used Market Value, CCM, NAV methods — NOT DCF (management
didn't provide projections). Market reacted negatively citing
undervaluation — shows valuation ≠ market perception always align.

WhatsApp-Facebook Value driven by per-user metrics (non-financial/non-traditional

multiple) — USD 55/user — used because WhatsApp had no
profits/traditional financials; growth potential (1M users/day) was the
value driver.

QUICK FORMULA SHEET

Formula Use

FV = PV(1+i/n)^(t×n) Time value of money

P/E = MV per share ÷ EPS Relative valuation

Ke = D₁/P₀ + g Dividend Cap Model

Ke = Rf + (Rm−Rf)β CAPM
Formula Use

β(levered) = β(unlevered) × [1+(1−t)(D/E)] Beta adjustment

After-tax COD = Pre-tax COD × (1−t) Cost of debt

TV = FCF(n+1) ÷ (r − g) Gordon Growth terminal

value

FCFE = PAT − Pref Div + Dep − CapEx − ↑WC + ↑Debt/Pref − Equity cash flow
↓Debt/Pref

FCFF = EBIT(1−t) + Dep − CapEx − ↑WC Firm cash flow

EV = MCap + Debt + Minority Int − Cash − Investments in affiliates Enterprise Value

Equity Value = EV − Net Debt (+ other adjustments) From EV to Equity

Value of Equity = (Assets − Liabilities) ÷ No. of shares Cost/Asset approach

Excess Earnings = Actual Earnings − (Net Assets × Required MEEM

Return)

Value of Goodwill = Excess Earnings ÷ Cap Rate MEEM

HIGH-YIELD MCQ TRAPS

EBITDA preferred over PAT in multiples (removes depreciation/leverage distortion)
CTM ≠ CCM: CTM uses transaction (deal) multiples; CCM uses trading multiples;
CTM value already includes discount/premium (avoid double counting)
DCF is NOT preferred when: no reliable projections available (see Vodafone-Idea
case)
Cost Approach NOT preferred for going concern Enterprise Value
FCFE discounted at Ke; FCFF discounted at WACC
Terminal growth rate must be ≤ economy's growth rate
Cost of Debt in DCF is always post-tax
"Asset" per ICAI VS 101 definition includes Liability
Replacement = comparable utility (need not be identical); Reproduction = exact
replica