VALUATION GAP

VALUATION GAP

Saturday Brainstorming Thought (299) 01/11/2025

By:-Er. Avinash Kulkarni
9822011051

Chartered Engineer, Govt Regd Valuer, IBBI Regd Valuer,

Rera Certified Consultant, Black Money Act Regd Valuer

A Valuation Gap is a discrepancy between assets market price and its estimated intrinsic (or true) value

This can also refer to the difference between what a seller believes a company is worth versus what a buyer is willing to pay

The gap can lead to an asset being either undervalued or overvalued by the market

Situations occur in Valuation Gap

1) Mergers and Acquisitions (M&A)

When a private company is for sale, a valuation gap often arises between sellers high price expectations and buyers more conservative assessment of business’s worth

This can be a major roadblock to completing a deal

2) Public Equity Markets

In the stock market, a valuation gap exists when a stock’s market price differs from analyst’s calculated intrinsic value

This creates an opportunity for value investors to buy undervalued stocks (or sell overvalued ones) in anticipation that the price will eventually move towards its true worth

Common Causes of Valuation Gaps

1) Different Assumptions

Sellers and buyers may use different valuation models or have varying assumptions about future cash flows, growth rates or discount rates

2) Emotional Attachments

Business owners often have a personal connection to their company, which can cause them to overestimate its value based on the effort and money they have invested

3) Information Asymmetry

Not all market participants have access to the same information at the same time leading to persistent mispricing

4) Market timing and Conditions

Macroeconomic conditions and market sentiment can influence a company’s valuation

An opportunistic buyer in a downturn for instance will likely offer a lower value than a seller might expect

5) Behavioral Biases

Herd mentality, overconfidence or other psychological factors can cause market participants to consistently misprice assets

Bridging of Valuation Gaps

In Mergers and Acquisitions, various strategies can help to close a valuation gap during negotiations

1) Earnouts

The buyer makes a partial upfront payment and seller receives additional payments later if the business achieves pre-determined milestones

This allows the seller to participate in the company’s future success

2) Staged Closings

The acquisition closes in multiple phases, with the buyer paying for a portion of the company upfront

Future payments are then tied to performance goals

3) Escrow Arrangements

The buyer places a portion of the purchase price in an escrow account to cover potential risks, such as unresolved lawsuit

Once the issue is settled without financial damage, the seller receives the remaining funds

4) Strategic Value Creation

Before the sale, an owner can implement strategies to improve the company’s performance and increase its market value to better align with their expectations

Key Components of Valuation Gap

1) Perceived Value

The value that customers believe a product or service provides

2) Intrinsic Value

The actual or inherent value of a product or service, often based on its features, benefits and costs

3) External Influences

Factors like market trends, competitor actions and customer feedback that can influence perceptions of value

Importance of Valuation Gap

1) Adjust pricing strategies to align with perceived value

2) Enhance product or service features to increase intrinsic value

3) Modify marketing and branding strategies to influence perceptions

4) Improve customer satisfaction by aligning expectations with deliverables