Gordon 's growth model · Moving the valuation forward to the valuation date · Valuing land and buildings · Two estate duty fiddles · Liquidation value - the floor of valuation

BvaValuation Buzz series is written and published by Charles Hattingh CA (SA)...

Gordon's Growth Model

I saw a valuation by one of the large auditing firms in which they used Gordon's Growth Model to value a private company. This model makes unrealistic assumptions such as continuing growth forever and it ignores the reality of life. Do not use it! You could be disciplined for unprofessional conduct if you do.

Moving a value to the Valuation Date

The book value of the equity of a company at the year end was 800. The valuer used the discounted cash flow model to value the entity and arrived at a value of 900 at the year end resulting in goodwill of 100. She then advanced the valuation to the takeover date at the discount rate for three months and arrived at a value of 940. However, the equity at this date was now 860 due to profits earned in the ensuing three months resulting in goodwill of 80. What goodwill does she use in accounting for the takeover? As the takeover date is three months after the year end, the goodwill of 80 should be used in accounting for the acquisition. Goodwill is a moving target. It is the difference between the fair value of the entity and the fair value of the underlying assets at any point in time. This is why it has to be tested for impairment each year. The valuer's client could not understand why goodwill is a moving target!

Valuation of Land and Building

Here is the valuation of fixed property I saw recently:

Rent:32 450 square metres @ R14 R454,300
Vacancy provision 5% R22,715
Gross monthly income R431,585
Gross annual income R5,179,020
Expenses born by landlord R845,000
Net rental R4,334,020
Capitalisation rate 15%
Value, say ... R28,900,000
Residual value of land R0
Value therefore R28,900,000

This is why property managers think that they are buying before tax rental income. If you take this information and enter it into my land and building valuation model you would enter something like this (R000):

Carrying value of property (say) R15,000
Existing value of land (they said nil) R6,000
Cost of demolishing building R1,000
Potential rental R5,179
Occupancy 95%
Expenses R845
Tax rate 29%
Growth in rentals first 5 years 7%
Growth in rentals next 10 years 6%
Growth in rentals next 15 years 5%
Inflation for the whole period 6%
Inflation for demolition costs 6%
Risk free rate 8.5%
Investor's tax rate 29%
Risk premium 10%
Resulting value R29,865

Using a capitalisation rate, as the so-called property experts do, is equivalent to valuing a company using a PE ratio!

Estate Duty Fiddle

Ten individuals get together to buy a property in which they are to live. They form a private company, which buys the property for R20m. They each invest R500,000 and raise a bond to cover the balance of the purchase price. They structure the rental payments in such a way that the company breaks even after expenses and interest on the bond. One of the shareholders dies and the auditor values the shares at R1,000 on the basis that the private company is not profitable and does not pay dividends and that the minority shareholder does not have the power to liquidate the company. This is total nonsense! If I were SARS I would challenge this in court and would win. When one values an asset one discounts the present value of the future cash flows. Clearly, the shareholder is benefiting by the low rental and, therefore, this should be taken into account in valuing his/her share in the company. The way to do this valuation is to fair value the fixed property, deduct the fair value of the bond and split the difference 10 ways. This is the same concept as valuing a company where the shareholder takes all the profits out of the company by way of salary. Profits should be adjusted for fair salaries and for fair rentals where related parties are involved.

Another Tax Fiddle

Daddy forms a company and sells his business to the company for R10m. He donates to each of his two children 100 ordinary shares and the company issues 1,000 voting preference shares to him. The assets are funded by loan account. By the time he dies the loan has been repaid and the total value of the shares is R20m. The auditor values his preference shares at R1,000. The flaw in this thinking is easily seen by asking the simple question: If you control a company worth R20m, thereby having the power over the assets and cash flows, would such power be worth only R1,000? If I were SARS I would contest such a value in court.

And, In Conclusion

Remember that the floor value of any valuation is what you could get out of the asset if it were liquidated today. Always perform this exercise when doing a valuation.