4 April 2014 | Volume 6 Issue 1
Foreign Direct Investments - Changes in Valuation Norms

Revised Valuation Norms for Foreign Direct Investments

On 1 April 2014, the Reserve Bank of India (RBI) proposed to revise its pricing guidelines for foreign direct investment (FDI). It has been decided to withdraw all existing guidelines relating to valuation in case of any acquisition/sale of shares and accordingly, such transactions will henceforth be based on acceptable market practices. Operating guidelines are to be notified separately.

Changes in norms – Why?

In April 2010, the RBI had mandated that the valuation of shares issued by an Indian company to a foreign company should be done based on the Discounted Cash Flow (DCF) method only.  DCF method is a prominent method based on the income approach of valuation, which is based entirely on the 'Future Cash Earning Capacity' of any business and thus, often leads to an optimum value scenario.

However, DCF methodology may not always yield a fair value in line with commercials (viz. minority stake/start-up valuation, etc.). The law being such, suitable logical adjustments may be necessary on a case-by-case basis.

The use of DCF methodology might be faulted on account of its failure to properly value transactions, including investments, in early stage companies. Such entities generated little in the form of cash and created difficulties for strategic investors looking to take a stake. Market watchers had noted that investors also look at factors other than cash flow in deciding investment, including the quality of management and nature of the business. Although, the DCF method is generally regarded as closer to fair valuation, it may not be the best possible approach for arriving at the fair value of shares in certain situations where the use of the asset approach or comparable company approach may be more appropriate.

What is the appropriate approach?

With the revised valuation norms applicable from 1 April 2014, the RBI has suggested to value any acquisitions or sale of shares as per best market practices. As a result, using only the DCF method for valuing these transactions may not always portray the true picture.

The valuer needs to use professional judgement and apply the applicable valuation methodologies on a case-by-case basis. This implies that other valuation methodologies such as the Market Multiple method, Comparable Transactions method, Net Asset Value method, etc. also will need to be considered while valuing the FDI permissible instruments.

Valuation analysis should start from a thorough understanding of the business model and processes and an analysis of the expected cash flows to be generated in the future.
  1. Review of the business plan of the target company
  2. Market/Industry analysis
  3. Performance evaluation of a company with its peers
  4. Selecting appropriate valuation methodologies
  5. Fair valuation using Discounted Cash Flow methodology, Comparable Transaction, Company Multiples, etc.
  6. Scenario analysis to identify a range of values
  7. Identification of synergies pertaining to operation, customers, product, supply chain, brand, etc.
  8. Estimation of intangibles such as knowhow, brand, customer base, etc., if any
  9. Appropriate discount rates to consider the inherent risks and expected Internal Rate of Return (IRR)/Return on Invested Capital (ROIC).
SKP's Comments

The RBI while announcing the revised monetary policy on 1 April 2014 has said that "As regards foreign direct investment (FDI), it has been decided to withdraw all the existing guidelines relating to valuation in case of any acquisition/sale of shares and accordingly, such transactions will henceforth be based on acceptable market practices. Operating guidelines will be notified separately."

There are various questions that need to be answered:
  • Does valuation in case of acquisition/sale of shares mean that the valuer needs to continue to follow the DCF approach in case of issue of fresh equity shares?
  • What are best market practices and who will be the final authority in deciding that?
  • Should the valuer continue with the DCF method or the best market practices approach?
New operating guidelines will be notified shortly. These issues need to be clarified at the earliest by the RBI to avoid any ambiguity post the announcement of the monetary policy.

SKP

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