Company Valuation Methods in Japan: DCF, Comparables and Net Assets

Company valuation is the work of producing a price benchmark for M&A or a share transfer. The main methods are the DCF method, which works from future earnings; the comparable companies method, which benchmarks against similar listed companies; and the net asset method, which works from assets and liabilities. In practice, rather than relying on a single method, practitioners compare the results of several to set a price range.

Three approaches to company valuation

The Japanese Institute of Certified Public Accountants’ Business Valuation Guidelines divide valuation methods into three approaches: income, market and net asset. The Small and Medium Enterprise Agency’s SME M&A Guidelines also present the DCF method and the adjusted net asset method, among others, as representative methods.

Listed companies have a market share price, but there is no market price for shares in unlisted companies. In M&A and transfers between shareholders, a valuation is therefore needed to establish a price benchmark.

The income approach emphasizes future earning power, while the net asset approach emphasizes current assets. Results for the same company can differ greatly depending on the method.

Enterprise value versus equity value

When reading a valuation, check which “value” it refers to.

• Business value: the value generated by the core business
• Enterprise value: business value plus non-core assets such as surplus cash and idle assets
• Equity value: enterprise value less interest-bearing debt and similar items

In a share transfer, the buyer pays equity value. What to deduct as debt is a major point of negotiation. The price changes depending on how retirement benefit obligations, leases, unpaid overtime and similar items are treated. These items are checked using a due diligence checklist.

How the DCF method works and what to watch for

The DCF method discounts the cash flows a company will generate in future to present value and adds them up.

1. Estimate free cash flow for each year based on the business plan
2. Set a discount rate reflecting the cost of capital
3. Estimate the value beyond the plan period (terminal value)
4. Discount each year’s value to present value and add them up to arrive at business value
5. Add surplus cash and similar items and deduct interest-bearing debt and similar items to arrive at equity value

The method can reflect future earning power, but it is sensitive to assumptions.

• An optimistic business plan inflates the valuation
• Small differences in the discount rate or growth rate change the result substantially
• For companies reliant on transactions with a parent or owner, changes in costs after the acquisition must be factored in

Test the seller’s business plan against past performance and market conditions.

Discount rate and terminal value

The discount rate is generally the weighted average cost of capital (WACC), which weights the returns required by shareholders and creditors. Shareholders’ expected return is derived by adding a premium for equity risk to a risk-free yield such as that on government bonds. For unlisted SMEs, an additional risk premium is sometimes added to reflect factors such as small size.

Terminal value beyond the plan period tends to account for a large share of the valuation. Be ready to explain, with supporting evidence, the perpetual growth rate you assume.

How the comparable companies (multiples) method works and what to watch for

The comparable companies method derives multiples from the share prices of listed companies with similar businesses and applies them to the target’s earnings or other metrics. Commonly used multiples include EV/EBITDA (enterprise value ÷ earnings before interest, taxes, depreciation and amortization), PER (price-earnings ratio) and PBR (price-to-book ratio).

For example, if the median EV/EBITDA multiple of comparable companies is 6x and the target’s EBITDA is 100 million yen, the indicative business value is 600 million yen (the figures are a hypothetical illustration).

The advantage is that the method reflects market valuations. Note the following, however.

• Listed companies with similar size, growth and earnings structure may not be found
• Because unlisted shares are hard to trade, a discount is sometimes applied for this
• Results are influenced by stock market conditions

How the net asset method (book and fair value) works and what to watch for

The net asset method values a company by deducting liabilities from assets on the balance sheet. There is the book value net asset method, which uses the carrying amounts as they are, and the adjusted net asset method, which restates assets and liabilities at fair value.

The adjusted net asset method reflects unrealized gains and losses on real estate and securities, and adds off-balance-sheet liabilities. It is clear and objective but does not reflect future earning power. Because tax is payable when assets with unrealized gains are sold in future, that tax burden is sometimes deducted.

In SME M&A, a simplified method that adds goodwill, representing earning power, to adjusted net assets is sometimes used. There is no fixed standard for how many years of profit the goodwill should represent; it is settled by negotiation.

How tax-law fair value differs: inheritance tax valuation and transfer pricing

The price agreed between the parties and fair value for tax purposes are different things. Depending on the counterparty, the gap between them may be taxed.

Valuation for inheritance and gift tax (unlisted shares)

This valuation, under the National Tax Agency’s Basic Circular on Property Valuation, is for inheritance and gift tax purposes. It serves a different purpose from an M&A price. Valuation methods can change when the circular is revised, so for an actual valuation, check the circular in force at the valuation date and the National Tax Agency’s guidance.

Transactions between relatives and related companies

If an individual transfers shares to a corporation at a price significantly below fair value, the transfer may be taxed as if made at fair value. In transactions between corporations, the difference from fair value may be treated as a donation or a gain on receipt of a gift. For transactions with foreign related parties such as an overseas parent, transfer pricing rules require arm’s length prices. For details, see Transfer pricing basics.

Choosing a method and how the price is set

A valuation is generally presented as a range rather than a single figure. The final price is settled through negotiation based on that range, taking into account the buyer’s synergies, whether there are competing buyers, contract terms and other factors. The overall acquisition process is explained in How to acquire a Japanese company (M&A).

Main materials used in a valuation

• Financial statements and account breakdowns for the last several fiscal years
• The business plan and the order and customer information underlying it
• Fixed asset register and real estate appraisal materials
• Details of borrowings, leases and guarantees
• Lists of officers and employees, and retirement benefit rules

Where a foreign company is a party, also address differences between home-country and Japanese accounting standards and the treatment of exchange rates. A valuation report prepared by an independent third party is useful for explaining the deal to the home-country board and as supporting material for tax purposes.

How TIMOA can help

Valuation results vary greatly depending on the choice of method and the assumptions made. It is important to confirm a range using several methods and to consider the relationship with fair value for tax purposes at the same time.

Working with partner certified tax accountants (税理士) and other specialists, TIMOA supports you in Chinese and Japanese in organizing the financial statements and business plans that underpin a valuation, checking fair value for tax purposes, and aligning terms with sellers and buyers. For details, see our M&A, Succession & Exit page.