Concept of Value · How Issuing Shares Effects Value · Exit Strategy

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

Concept of Value

Few people understand the concept of value. I received an email from a business owner recently wanting me to establish ”exactly what my business is worth“! I had to break the bad news to her. A valuation is not an exact science.

During a valuation workshop for a listed company's TOPP students I mentioned that a valuation is a discounted vision of the future. One of the students blurted ”How can you tell the future?“ I said: ”Now you understand the concept of value.“

Woolworths is in the process of acquiring its franchisees. Finweek (28 October 2010) reported that they were using the NOPAT method of valuation, i.e. multiplying historical net operating profit after tax by 4,5. Many years ago a relative of mine was in charge of a similar operation. After the company acquired the shops management could not understand why profits fell. They subsequently discovered that the owners were borrowing money from their friends, banking the ”takings“ and then paying their friends back with the proceeds from the sale of the shops!

According to this Finweek article, another method being considered was a multiple of EBITDA. Not many accountants understand the impact that capex and working capital levels can have on a valuation. To ignore these two elements (and tax) is to make the valuation exercise a joke.

A Horror Valuation

Here is an example of a valuation I was given to review. The company had made losses for the past two years so the valuer took unaudited management accounts that revealed a profit, deducted tax of 28% and divided the answer by 30%. He then multiplied the pre-tax profit by a ”pay-back“ factor of 2.7, added the two answers together and divided the sum by two (safety in numbers??). And with confidence he announced: This is the value of your business.

And Another One

My models in the wrong hands are like weapons of deceit! Here is what I found in a valuation made by a qualified accountant who applied the models:

  1. The company reported a profit in the previous year of R100k and in the current year a loss of R1m. His projections kicked off with a profit of R2m. When I asked him how the company was going to achieve this turnaround, he said: ”I have no idea.“
  2. Revenue fell by 10% in the previous year and by 20% in the current year. The valuer projected growth in revenue of 10% p.a. increasing to 15% p.a. over the next ten years. When I asked how this was to be achieved, he said that he had no idea.
  3. He projected working capital levels to increase from 10 cents per rand of sales to over 20 cents per rand of sales over a period of ten years. When I asked him why he was doing this he said that inventory must increase if sales increase!
  4. In his projection of the company's capital expenditure, he projected depreciation increasing in line with increases in property, plant and equipment. I had no problem with that. I then asked him if he had used these projected depreciation figures in his expenditure projections and he said: ”I just thumb sucked a percentage expense ratio.“

As a result of this experience, I decided to launch a two day valuation workshop so that participants could be trained thoroughly on the application of the models.

How Issuing Shares Affects Value

A 100% shareholder and CEO of a private company wishes to incentivise his COO by issuing him with a 10% share of the company. A CA valued the company at R9m prior to the issue. The company had in issue 900,000 shares, giving a value per share of R10 each.

The company intends to issue him with 100 000 shares and give him an interest free loan for 10 years. The CEO wishes to know at what price the shares should be issued, i.e. by how much it will dilute the value per share.

Assume the value per share after the issue is Rx. Then 1m shares multiplied by Rx will equal R9m plus the present value of 100 000 shares multiplied by Rx in 10 years at, say, 12% p.a., a fair rate of return on the loan. x then = :
1,000,000x = 9,000,000 + (100,000x) / (1.12)^10
1,000,000x = 9,000,000 + 32,197x
967,803x = 9,000,000
x = R9.30

Exit Strategy

Using the above scenario, the value of the company using the majority valuation methodology came to R9m and the value using the minority methodology came to R7,5m. The COO asked for guidance as to whether he should acquire the shares at the minority valuation and, on exiting the arrangement, agree with the controlling shareholder to use a minority methodology or whether he should acquire the shares at the majority valuation and, on exiting the arrangement, use a majority methodology. He is worried that on exiting the arrangement the minority valuation can be manipulated by the company's dividend policy, which is in the hands of the majority shareholder.

The answer to this question would depend on how long the arrangement is expected to last. If the COO expects to exit after only a few years, it would pay him to acquire the shares at the higher price and exit using a majority methodology. However, if he is looking at a long period of time, the present value of the exit price becomes immaterial and it would pay him to acquire the shares at the lower price and exit using a minority value methodology.