On April 7, 2010, RBI issued a notification to amend the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations. The amendments, published in the Official Gazette on April 21, 2010, came into force from the date of their publication and amend inter alia the method of calculating the price at which shares are issued to non-residents.
Prior to the above stated amendments, a person residing outside India, or an entity outside India, whether incorporated or not, could purchase shares of Indian companies in keeping with the FDI guidelines and the FDI scheme, which forms a part of the regulations. For the shares of an unlisted company, the scheme stipulates that the price of shares issued to non-residents shall not be less than the fair valuation of shares done by a chartered accountant as per the guidelines issued by the erstwhile Controller of Capital Issues (CCI guidelines).
Under the CCI guidelines, if the consideration payable for the transfer does not exceed Rs 20 lakh per seller per company, then the price may be mutually agreed upon between the seller and the buyer. It should be based on any valuation method currently in vogue and must be substantiated by a certificate issued by the statutory auditors of the unlisted company whose shares are being transacted. Where the consideration exceeds Rs 20 lakh, the price taken is the lower of the two independent valuations of shares, one by the statutory auditors of the company, and the other by a chartered accountant or by a merchant banker registered with Sebi. These valuations could be based either on the net-asset value method or the profit earning capacity value method.
With the April amendment, the pricing of shares issued should not be less than the fair valuation of shares carried out by a Sebi-registered merchant banker or a chartered accountant as per the discounted cash flow method (DCF method). Although not defined under the regulations or the Foreign Exchange Management Act, the DCF method relates the value of an asset to the current value of expected future cash flows of the asset. Notably, the method has previously been used by the department of disinvestment since it found favour in the disinvestment commission’s recommendations for valuations of public sector undertakings. Considered fairly popular, the DCF method takes into account all the free cash flows available in the company by taking into account the cost of capital, the cost of debt, the cost of equity and market returns. It also takes into account the risk to which a corporation is exposed and attributes value to the non-core assets that may otherwise not be reflected in the cash flow of the company. The DCF method further takes into consideration the intangibles of a company like the brand, goodwill and market share, all of which have a significant bearing on a company’s valuation.
Reflecting on the amendments to the share price valuation methodology, one can’t help but note that while valuation methods use quantitative models to arrive at a determination, as the disinvestment commission observed, the input leaves plenty of room for subjective judgments. It is exactly for this reason that experts have for long argued that valuation must be differentiated from the price of the company. It is necessary to recognise that application of valuation methods depends on the intrinsic structure of the company being evaluated, the nature of the industry in which such a company operates and inherent strengths and weaknesses of the company. Since these factors are subject to constant change, so must the valuation. Interestingly, the above stated amendments, in so far as they relate to the issue of shares on a preferential allotment, are slightly unclear on the valuation process to be followed. It remains to be seen whether the erstwhile CCI guidelines will continue to apply to such preferential allotment or whether the regulator expects these valuations to be also based on the DCF method. Eventually, the process of price discovery needs to be transparent so that the seller is satisfied that the price paid by the buyer helps him realise the true value of the transaction.
First Published in the Economic Times on April 30, 2010