Valuation of Stock Options – SEBI Regulations | Methods | Key Considerations

Pricing of exercise price: Regulation 17 of the SEBI (Share Based Employee Benefits & Sweat Equity) Regulations, 2021, the company granting option to its employees pursuant to ESOS will have the freedom to determine the exercise price subject to conforming to the accounting policies.

Accounting Policies: As per Regulation 15, any company implementing any of the share based schemes shall follow the requirements including the dis- closure requirements of the Accounting Standards prescribed by the Central Government in terms of section 133 of the Companies Act, 2013 including any ‘Guidance Note on Accounting for employee share-based Payments’ issued in that regard from time to time.

It is important to note that Regulatory bodies have often considered market value as one of the very important basis — Preferential Allotment, Buy-back, Open Offer Price calculation under the Takeover Regulations.

However, Market Price Method is not relevant in following cases:

1. Where the shares are not listed or are thinly traded.
2. In case of significant and unusual fluctuations in market price the market price may not be indicative of the true value of the share. At times, the valuer may also want to ignore this value, if according to the valuer; the market price is not a fair reflection of the company’s underlying assets or profitability status. The Market Price Method may also be used as a backup for supporting the value arrived at by using the other methods.
3. In earlier days due to non-availability of data, while calculating the value under the market price method, high and low of monthly share prices were considered. Now with the support of technology, detailed data is available for stock prices. It is now a usual practice to consider weighted average market price considering volume and value of each transaction reported at the stock exchange.
4. If the period for which prices are considered also has impact on account of Bonus shares, Rights Issue, the valuer needs to adjust the market prices for such corporate events.

The process of arriving at this value should include a detailed, comprehensive analysis which takes into account a range of factors including the past, present, and most importantly, the future earnings and prospects of the company, an analysis of its mix of physical and intangible assets, and the general economic and industry conditions. It includes:

1. The stock exchange price of the shares of the two companies before the commencement of negotiations or the announcement of the bid.
2. Dividends paid on the shares.
3. Relative growth prospects of the two companies.
4. In case of equity shares, the relative gearing of the shares of the two companies.
5. Net assets of the two companies.
6. Voting strength in merged (amalgamated) enterprise of the shareholders of two companies.
7. Past history of the prices of shares of the two companies.

With incremental cash flows increasing, value of brand also increases proportionately. Brands have to be constantly associated with good quality goods and services; they require proper show casing and servicing and they should remain active in appropriate markets. In order to sustain the valuation of the brand, there must be a constant attempt from the company on the following aspects:

1. To secure registration of the Brand in all relevant classes.
2. To secure registration of the Brand in all countries where there are opportunities to sell Branded Products of the company.
3. To set up a “surveillance team” within the Marketing Department of the company so as to ensure that there is no dilution to the value of the Brand.
4. To ensure that attempts to use fake brands that are similar or deceptively similar are challenged with full force so as to spread the message that the company is conscious of the value of its brand and it will be aggressive in taking steps not only to put an end to such illegal, dishonest and unauthorized use but also to punish such users and claim exemplary damages from those who had passed off their goods to people and those who are found to be guilty of infringement.
5. To ensure that there is always a budget allocation for promoting the brand and the company should devise a continuous process for being present in the existing markets and prospective markets.
6. To ensure that there is a conspicuous distinction in the description of the brand when it is used to sell premium products as opposed to use of the same brand for selling goods to the masses.
7. To ensure that the extent of growth in the value of the brand every year is always higher than the depreciation or dent that existing or new competition may cause.
8. To adopt a proper policy with regard to slogans and catchy phrases so that the company does not knowingly cause any infringement of the industrial and intellectual property rights of any other person in any country or territory.
9. To adopt a proper policy with regard to statements made in advertisements carrying the brand in order to ensure that those statements are not mere attractive words and they would stand the test of the market.
10. To adopt a proper policy to augment IP profile of the company and constantly update and upgrade the same.

Valuation of equity shares must take note of special features in the company or in a particular transaction. These are briefly stated as under:

Importance of the size of block of shares: The holder of 75% of the voting power in a company can always alter the provisions of the articles of association; a holder of voting power exceeding 50% and less than 75% can substantially influences the operation of the company even to alter the articles of association of comfortable influences the operation of the company even to alter the articles of association of comfortable pass a special resolution. A controlling interest therefore, carries a separate substantial value.

Restricted transferability: Along with principal consideration of yield and safety of capital, another important factor is easy exchangeability or liquidity. Holders of shares unquoted public companies or private companies do not enjoy easy marketability; therefore such shares, however good, are discounted for lack of liquidity at rates, which may be determined on the basis of circumstances or an increase in the normal rate of return.

Dividends and valuation: Generally, companies paying dividend at steady rates enjoy greater popularity and the prices of their shares are high while shares of companies with unstable dividends do not enjoy confidence of the investing public as to return they expect to get and, consequently, they suffer in valuation.

Discounted cash flow valuation is based upon expected future cash flows and discount rates. This approach is easiest to use for assets and firms whose cash flows are currently positive and can be estimated with some reliability for future periods.

Discounted cash flow valuation, relates the value of an asset to the present value of expected future cash flows on that asset. In this approach, the cash flows are discounted at a risk-adjusted discount rate to arrive at an estimate of value. The discount rate will be a function of the riskiness of the estimated cash flows, with lower rates for safe projects and higher rate for riskier assets.

Discounted cash flow (DCF) model is applied by taking following steps:

• Estimate the future cash flows of the target based on the assumption for its post-acquisition management by the bidder over the forecast horizon.
• Estimate the terminal value of the target at forecast horizon.
• Estimate the cost of capital appropriate for the target.
• Discount the estimated cash flows to give a value of the target.
• Add other cash inflows from sources such as asset disposals or business divestments.
• Subtract debt and other expenses, such as tax on gains from disposals and divestments, and acquisition costs, to give a value for the equity of the target.
• Compare the estimated equity value for the target with its pre-acquisition standalone value to determine the added value from the acquisition.
• Decide how much of this added value should be given away to target shareholders as control premium.

Normally the value of an enterprise could be estimated on a going-concern basis by computing the earning capacity. Net Asset Value method may not be ideal in the cases enterprises with depreciating assets unless the enterprise in question is asset intensive.

For instance, in the case of company engaged in real estate sector, the lands in the hands of the company on ownership basis could be a stock in trade and they may be highly valuable. However, in the case of Brands, which form the lifeline of the Company, there has to be a different approach.

Cost Approach for valuation of Brands may not help. The cost incurred in the last three financial years are not very high as all resources have been used up for establishing a good quality over a period of time in order to give customers high quality products for value and to ensure that customers are happy. A look at the competitive force and the predominance of the brand of the company would show that the brands of the company are premium brands. In the next phase, the Company would show that the brands of the company are premium brands. In the next phase, the company would incur expenditure brand, returns would be manifold. This enables the company to introduce its branded products in the new markets very easily as entry barriers could be easily overcome.

Considering the above background, it is advisable to approach the Brand Valuation on the basis of Premium Price Method. The commitment of the company to maintain stringent quality gives us confidence in adopting a Premium Price method for valuing the Brand.

Valuation Documentation: Valuation exercise is based on observation, inspection, analysis and calculation. During this process, the valuer goes through various documents, records his observation, makes relevant calculation and records these calculations and analyze results. In this process a lot of documents are generated which forms the basis of his conclusion on the valuation of the subject matter. It is very necessary for him to preserve all such records so that these documents may help him to substantiate his conclusion on valuation. Moreover, these documents also become a matter of reference in future.

Objectives of documentation in valuation exercise: Documentation is “an essential element” of valuation quality. Valuation documentation provides the principal written record to support the following:

1. The Valuer’s Report assertion that the valuation exercise was performed with due diligence and in accordance of generally accepted valuation principles.
2. The Valuers’ conclusions about valuation of the subject matter of the valuation exercise and other related aspects of valuation.

Following are some more specific objectives of documentation in valuation exercise:

• Assisting Valuer to plan and perform the Valuation Exercise.
• Assisting those responsible to direct, supervise, and review the work performed.
• Providing and demonstrating the accountability of those performing the work (e., compliance with applicable standards).
• Assisting quality-control reviewers to understand and assess how the engagement team reached and supported significant conclusions.
• Enabling internal and external inspection teams and peer reviewers to assess compliance with professional, legal, and regulatory standards and requirements.
• Assisting successor Valuer.

Valuation exercise in merger and acquisition should be done by a team of experts keeping into consideration the basic objectives of acquisition. Team should comprise of financial experts, accounting specialists, technical and legal experts who should look into aspects of valuation from different angles.

Accounting expert has to foresee the impact of the events of merger on profit and loss account and balance sheet through projection for next 5 years and economic forecast.

Using the accounting data he must calculate performance ratios, financial capacity analysis, budget accounting and management accounting and read the impact on stock values, etc. besides, installing accounting and deprecia- tion policy, treatment of tangible and intangible assets, doubtful debts, loans, interests, maturities, etc.

Technocrats has their own role in valuation to look into the life and obsolescence of depreciated assets and replacements and adjustments in technical process, etc. and form independent opinion on workability of plant and machinery and other assets.

Legal experts advice is also needed on matters of compliance of legal formalities in implementing acquisition, tax aspects, review of corporate laws as applica- ble, legal procedure in acquisition strategy, laws affecting transfer of stocks and assets, regulatory laws, labour laws, preparing drafts of documents to be executed or entered into between different parties, etc.

Whether it is a case of merger, amalgamation or takeover, valuation exercise is imminent to have an amicable bargaining situation. Business top management, however, have different strategies to resort for valuation. The common reasons could be:

• Either purely financial such as taxation, asset-stripping, financial restructuring involving an attempt to augment the resources base and portfolio-investment.
• Business related expansion or diversification.
• The behavioural reasons have more to do with the personal ambitions or objectives of the top management g. desire to grow big.

The expansion and diversification objectives are achievable either by building capacities on one’s own or by buying the existing capacities. In other words ‘make’ or ‘buy’ decisions. The decision criteria in such a situation would be the present value of the differential cash flows. These differential cash flows would, therefore, be the limit on the premium which the acquirer would like to pay. On the other hand, if the acquisition is motivated by financial considerations, the expected gains through taxation or asset stripping would form limit on the premium, over and above the price of physical assets.

Cash flow from operations may not be the main consideration in such a situa- tion. A merger with financial restructuring as its objective needs to be valued mainly in terms of financial gains.

The International Valuation Standards Council (IVSC) is the established international standard setter for valuation. Through the International Valua- tion Standards Board, the IVSC develops and maintains standards on how to undertake and report valuations, especially those that will be relied upon by investors and other third party stakeholders.

The IVSC also supports the need to develop a framework of guidance on best practices for valuation of the various classes of assets and liabilities and for the consistent delivery of the standards by properly trained professionals around the globe. The IVSC has published International Valuation Standards (IVS) since 1985.

Membership of IVSC is open to organizations of users, providers, professional institutes, educators, and regulators of valuation services. IVSC members appoint the IVSC Board of Trustees.

Valuations are done by experts based on detailed analysis of circumstanc- es and study of several data. As such Courts and Tribunals do not interfere in valuation exercise.

All that the Courts and Tribunals look into is reasonability and that it is free from irregularities, malicious intentions of the valuer in presenting valuation report.

The Supreme Court in the matter of Miheer H. Mafatlal v. Mafatlal Industries Ltd. held that if share exchange ratio is fixed by Chartered Accountant upon consideration of various factors and approved by majority of shareholders in meeting, the court will not disturb ratio.

Similarly, Calcutta High Court observed in case of Makham Investments Ltd. that –

“Court does not go into the matter of fixing exchange ratio in great detail or to sit in appeal over the expert decision of concerned Chartered Accountant of repute. Court sees only whether there is any manifest unreasonableness or manifest fraud involved in the matter.”

Valuation can be done on the basis of fair value. However, resort to valuation by fair value is appropriate when market value of a company is independent of its profitability.

Fair value of shares is arrived at after consideration of different modes of valuation and diverse factors. There is no mathematically accurate formula of valuation. An element of guesswork or arbitrariness is involved in valuation. Capital cover, Yield, Earning capacity, and Marketability are to be calculated or verified to arrive at fair valuation of the shares in question.

While valuing shares, the valuer is required to take into consideration any special features, such as, quantum of shares to be acquired as a percentage of total shares, in other words extent of dominance, transferability restrictions, dividend pay-outs, bonus and rights issue made earlier that influences the share value.

Over all, funds flow and cash flow analysis is also to be studied for valuation of shares. It is also necessary to follow valuation standards so that uniformity in valuation of various tangible and intangible factors are taken into account.

A business or corporate valuation involves analytical and logical application/analysis of historical/future tangible and intangible attributes of business.

Aspects preliminary study to valuation: Preliminary study to valuation involves the following aspects:

• Analysis of business history.
• Profit trends.
• Goodwill and Brand name in the market.
• Identifying economic factors directly affecting business.
• Study of exchange risk involved.
• Study of employee morale.
• Study of market capitalization aspects.
• Identification of hidden liabilities through analysis of material contracts.

Strategies that are kept in mind in valuation: In valuation exercise, some strategies are also kept in mind such as:

• Determining the consideration for Acquisition.
• Determining the swap ratio for Merger or Demerger.
• Sale or purchase of intangible assets including brands, patents, , etc.
• Determining the Fair value of shares for issuing ESOP.
• Disinvestment of PSU stocks by the Government.
• Liquidation or insolvency process of the company.

Acquiring a new product is different from acquiring a brand name. Same is the case to get rid of a product that adversely affects the brand name. At times symbols are sold to generate sufficient funds. Citibank sold the umbrella look symbol. Hotmail, WhatsApp are also one sort of brands that are sold for hefty amounts. In a related field companies think of introducing another product so that reputation and goodwill associated with a brand name could be advanta- geously exploited. The combination of the ability of the company to take over the manufacturing facility and build the said product with the company’s brand name develops a great market for the company.

Brands/marks are a class of assets like human resource, knowledge, etc. They create a value premium for the goods and services. Mergers and acquisitions help utilize or protect the brand value already earned by an enterprise. For example, Tata Motors acquired Jaguar and Land Rover British motor car brands to exploit automobiles market worldwide.

There is no mathematically accurate formula of valuation. An element of guesswork or arbitrariness is involved in valuation though it is possible to calculate book value, market value averaging quoted prices for a period.

Following four factors have to be kept in mind in the valuation of shares:

• Capital Cover
• Yield
• Earning Capacity
• Marketability

However, efforts are made to ascertain fair value just like extension of play time in Hockey or Football in case of tie even in extra time. Valuation based on fair value is appropriate when market value of a company is independent of its profitability. Dividing the aggregate of values obtained through net assets method and yield method is the process to arrive at fair value. Following well- known methods are applied to get fair value:

• Manageable profits basis method or the earning per share method.
• Net worth method or the break-up value method.
• Market value method.

The fair value of a share is the average of the value of shares obtained by the net assets method and the one obtained by the yield method. This is, in fact not a valuation, but a compromise formula for bringing the parties to an agreement.