The WHY, WHAT and HOW ... Remember The Initial Steps! · Window Period Residual Value

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

Please Remember The Initial Steps!!

In my valuation workshops I am so keen to educate participants on the details that I often forget to cover the obvious. The fun part of doing a valuation is gathering the evidence, entering and running the model and doing what-if calculations. The tough part is the planning that goes before the fun part.

A few years ago I was asked to help in the valuation of an events company. This company had developed the entire infrastructure to run events but had no on-going customers. In one year they would get three large events and make mega-profits and in another year they would get only one or two small events and make mega-losses. The question was: ”How do you value such a company?“ A preceding question should be: ”What is the purpose of the valuation?“ Before addressing the WHAT and the HOW one should address the WHY. A few years ago someone asked me to assist in valuing a holding company's subsidiaries. When I asked: ”Why do you need these valuations?“ I was told: ”For IFRS purposes.“ I then pointed out that IFRS does not require one to recognise fair values of subsidiaries in separate financial statements so a valuation was not necessary and the problem was solved!

It is essential to address the three aspects: ”Why, what and how?“ before diving into the fun part. In the events company example, the major shareholder wanted to sell his shares to a trust for tax purposes. In this case one would have to arrive at a valuation that would satisfy SARS to avoid any question of donations tax. The ”how“ would be focused on a methodology that would make sense to SARS.

If the objective had been to sell the company to another person who wants to get into this business, the fair value would have been what the buyer would be prepared to pay and the seller would be prepared to sell the company for. Here, the ”what“ step becomes important. What would the buyer be buying and what would the seller be selling? The best approach here would be to use an asset based approach, i.e. to identify the assets and to attempt to place values on each part to get to the whole. The big issue would be: ”What is the goodwill worth?“ What is the reputation of the company? How is it perceived in the market place? What prospects are in the time horizon?

The ”how“ step in such a valuation would invariably involve valuations to be performed using different scenarios and then to apply probability theory to the values to arrive at a number. The valuer would then hand his work over to the buyer and seller who will do the horse trading thing.

Window period residual value

The model calculates the book value of the equity, the earnings and the dividends at the end of the window period.

The model then calculates the return on equity, the ploughback and the sustainable growth rate assuming that the entity can continue to earn the return on equity after the end of the window period.

You must then decide whether or not the projected growth rate is realistic. It is important to understand the impracticality of growing cash flow, for example, at 20% p.a. in perpetuity! I would be inclined not to exceed an estimated inflation rate plus a little real growth. Your decision will be affected by the window period, e.g. if you have chosen a window period of five years, you could possibly be more generous with the growth rate than if you chose 25 years.

The next step is the tricky part. You must estimate a price book ratio that makes sense in two ways: It will result in a dividend yield that makes sense (r–g)/(1+g)) and it will result in a meaningful goodwill. On entering this price book ratio, the model will value the equity at the end of the window period. It is problematic to argue that goodwill will last forever, especially if you are the buyer of the entity. However, if heavy investments are being made to maintain the goodwill in the operating cash flows projected, then possibly one could account for goodwill at the end of the window period.