The Meaning Of Non-Core Income · Minority v Majority Valuations

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Maintainable Income

Many valuers using version 9.4 of the valuation models are misinterpreting what the maintainable column on the right hand side of the income statements represents. This column is the basis for the commencement of the cash flows so should be the current year's income figures as adjusted for abnormalities, non-arms length transactions, etc. Many are using this column to project the next year's results. This will result in double counting because you do your projections when inserting the du Pont ratios.

Non-Core Income

You will get weird valuations if you create non-core income when there are no non-core assets. Non-core assets are assets not required for the operations of the company, e.g. share investments in other companies. The non-core income should be what those assets yield and not income such as discounts received. Discounts received on purchases should go to reduce cost of sales. Interest received on debtors (new stupid IFRS) increases revenue. If the company requires cash to operate its business (cash in the tills, cash to pay creditors, etc.), any interest received on this cash should be treated as part of the entity's revenue for valuation purposes. The interest received in the income statement in the model should only relate to non-core assets, e.g. loans to third parties or excess cash.

Minority versus Majority Valuations

I do not agree with the school of thought that says that one should value a minority stake by applying a discount to a majority valuation. There are major conceptual differences between a majority and a minority valuation and different circumstances could result in different discounts. A majority valuation presumes that all the free cash flows can be distributed by way of a dividend (even if they are not) so uses the free cash flows as the basis for arriving at the value. In addition, the majority holder has the power to create value by, for example, unbundling non-core assets held by the entity. A minority holder, on the other hand, is only entitled to dividends and, eventually, proceeds on sale or liquidation. A completely different approach is used to do such a valuation. If the entity, for example, has a policy of distributing dividends and has no non-core assets to speak of, the gap between the minority and majority valuations will be much smaller than if the company had no dividend policy and serious non-core assets used for the private pleasure of the majority shareholder (for example, the family yacht).

More on Minority Discounts

Four years ago three brothers got together and bought a commercial property through a private company. The idea was that no dividends would be paid and the net rental would go to reduce the bond until the bond was small enough to use to fund another property, and so on and so on. The elder brother was the wealthiest of the three so subscribed for 60% of the equity and shareholders' loan and the other two brothers each subscribed for 20%. One of the younger brothers decided to emigrate so offered his shares to the other two brothers. A CA was asked to value the shares. The property is considered to be worth R5m (original cost R3m) and the bond stands at R1,5m (reduced from R2m on acquisition of the property). The shareholders loan is R1,0m and reserves stand at R0,5m. The valuer arrived at a valuation for the 20% share of the equity and loan as follows (R'000):

Value of property R5,000
Value of bond -R1,500
Capital gains tax on revaluation of property -R290
STC on reserves after capital gains tax -R26
Majority value of equity and loans R3,814
20% thereof R637
Discount because minority value (25%) R159
Value of younger brother's share R478

Would you agree with this valuation?

General comments

The property increased by 13,6% p.a. (R3m to R5m) in four years.
The 'value' of the equity and loans, as arrived at above, grew by 33,6% p.a. (R1m to R3,184m) in four years. (This is the effect of gearing.)
The 'value' of the younger brother's investment, as arrived at above, grew by 24,3% p.a. (R0,2m to R0,478).

Question: 'Why should the younger brother be penalised just because he holds a minority stake in the company?' The three went into business together so should share in the spoils together. So I would suggest that a 'fair' value should not take a minority discount into account in situations like this. If the brothers have fallen out, the older brother can refuse to buy the younger brother's shares and, by using bullying tactics, pull the transaction price down. However, I do not believe that the valuer should get involved by recommending such a discount.

Some other comments

The CGT need never be incurred so one should not provide for it in full – one could possibly provide for a small amount to take into account the risk that it may be incurred one day.

The same comment applies to the provision of STC in the valuation.