Valuation Buzz series is written and published by Charles Hattingh CA (SA)...
Before or After Tax Rates
I cannot believe that there are still accountants and financiers who discount after tax cash flow at a pre-tax rate. I was lecturing at one such firm recently and asked the participants: ”You use a pre-tax gilt rate to which you add a risk premium. Is the risk premium before or after tax?“ They said: ”After tax.“ So I said: ”What do you get if you add a pre-tax risk free rate to an after tax risk premium?“ They did not answer. I answered for them: ”A fruit salad!“ They gave two reasons for using a pre-tax risk free rate:
- We have always done it this way.
- We can always fiddle the final discount rate to get the answer we want so it is an academic argument.
The real reason they do this is that they are terrified to change. Can you imagine admitting that all your valuations you have done in the past were wrong? If the clients found out all hell would break loose.
To illustrate why one should adjust the risk free rate by tax, I suggested that they value the big four bank's perpetual preference shares. The long term gilt rate on 30 June 2010 was 9,0%. I asked them to estimate the risk premium for each of the preference shares taking into account that the two main risks were that the prime bank overdraft interest rate could reduce and that the banks could default on the preference share dividends or the banks could collapse and the capital could be lost. They agreed on a risk premium of 2% p.a. for all four banks. Here are the results of the valuations at 30 June 2010 (the prime bank overdraft rate at this date was 10,0% p.a.):
Standard First Rand Nedbank ABSA Rate Gilt rate 9.0% 9.0% 9.0% 9.0% Premium 2.0% 2.0% 2.0% 2.0% Total 11.0% 11.0% 11.0% 11.0% Half Yearly 5.36% 5.36% 5.36% 5.36%
Nominal 100 102 10 1000 Percentage of Prime 70% 68% 75% 63% Times paid per annum 2 2 2 2 Dividends paid 3.50 3.47 0.38 31.50 Last dividend 31 Mar 23 Feb 31 Mar 9 Mar Days after 91 127 91 113
Initial Date 65 65 7 588 Valuation Date 67 67 7 607 Market Price 103 95 10 858
When I asked them to explain why their valuations were so materially below the market prices they could not tell me. If you reduce the gilt rate by a tax shield of 40% you get the following values:
Standard Bank R98 First Rand R98 Nedbank R10 ABSA R886
Do you think that this exercise will change their minds? No chance. Once an accountant has been taught something at varsity, that is it. No amount of evidence will persuade him or her to change. It is the same with children. My grandson was taught at school that 1/0 = 0. I tried to show him that in fact, the correct answer is infinity. He lost his temper with me!
What Tax Rate to Use
I am busy doing an option valuation for IFRS 2 purposes. Should I adjust the risk free rate by the tax rate of the employees who have been granted the options or should I use what the market uses (from the above exercise 40%, being the marginal tax rate of typical market players)? IFRS requires one to use market inputs. However, if I was in the process of evaluating whether or not a preference share was a sound investment for me, I would arrive at the fair rate of return as follows:
- Long term government bond rate presently...9.00%
- My tax rate is...25.00%
- Required premium for risk...2.00%
- Yield required...8.75%
Using the model I would arrive at a price I could afford to pay for Standard Bank's preference shares of R83. At R103, these shares are too expensive for me. I should rather buy government bonds.
A while back someone asked me to value a brand name. The owner had registered the name in anticipation of going into business, but the business did not take off. A large American company approached the person to buy the name. The owner approached me to value the name. Now had I been immoral, dishonest and a thief, I could have sucked numbers out of the air, populated a fancy model and churned out a number and charged a fortune for doing so. Instead, I said: ”The value is $100m.“ He said: ”Where did you get that from?“ I said: ”From sucking my left thumb.“ I said that if you would like another number, I can suck my right thumb.
If you are honest, you cannot place a value on something like this. You start negotiating by setting your price high (try to guess how badly the buyer wants it) and then negotiate down. There are courses and books on how to negotiate.
Recently I was asked to value a private company that owned the intellectual property to a specialised computer program. It had massive potential but the company did not have the resources to exploit it. How do you value such a private company? $100m.