What Are You Valuing? · Strategic Buy · Extract From Mafia Buzz · Time To Increase The Systematic Risk?

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

What Are You Valuing?

I emphasise at my valuation workshops that when planning a valuation one should identify exactly what is to be valued. I have seen two situations recently in estate duty valuations where this step was not taken. In both cases the valuation involved a company with operating assets, non-core assets and loan liabilities from associates. To illustrate:

Core assets business assets 500
Loans to other companies 200
Total 700
Loans from other companies 300
Equity 400

In both cases, the valuer valued the core assets using a going concern approach and got so involved in the valuation that he did not realise that he had to add the non-core assets and deduct the non-core liabilities. In both cases the loans could have been called up at any time, so the values would be par, subject to the ability of the loan debtors to pay.

The asset in the deceased estate was the equity of the company. If the core assets were valued at 800, the value of the equity would have been 800+200–300 less any allowance for STC on the accumulated reserves after accounting for the revaluation of the core assets. Those who fail to plan will plan to fail.

Strategic Buy

A business is breaking even at present and there are no prospects for improvement. A strategic buyer appears on the scene and is considering acquiring a 50% stake as an alternative to starting his own business from scratch. The question is: what basis does one use to value this 50% stake? The suggestion made was to value the 50% stake at net asset value because there is no income on which to base the value.

In my opinion, this is a perfect case for performing a seller's and a buyer's valuation and, depending on the willingness of the two parties to do a deal, a negotiated price between the two valuations will be determined by the parties after considering all the facts.

The utility value of this business to the seller is the higher of the present value of the future cash flows as a going concern and the liquidation value. As the business is merely breaking even, the higher of the two valuations is likely to be the liquidation value (note: not the net asset value).

The utility value of this business to the buyer is the present value of the future cash flows with her (the buyer) on board. If she is to bring new know-how, customers, suppliers, etc. to the party, the value is likely to be higher than the value to the seller.

Before entering into a deal with the seller, the buyer should investigate what it would cost her to start up from scratch by projecting and discounting future cash flows using this scenario. If the cost of starting up from scratch is higher than the negotiated price, she should opt for the deal with the seller. If lower, she should, after considering the additional risks and effort of starting from scratch, abandon the negotiations.

So in essence, in such a situation, there is no one value of the 50% stake. This situation requires a process to be followed.

Extract from Mafia Buzz February 2006

Modigliani and Miller received the Nobel Prize for their assertion that the split between equity and different forms of debt and its dividend policy make no difference to the total value of the entity. [I have battled with this idea for the past 30 years! I fought many a student in the past who had this rule drilled into them by their lecturers.] The Economist says that this principle is not wrong but is only true in circumstances so rare that it is the exception rather than the rule and says that structure does affect the value of the firm. [Thank you, thank you, thank you! When I was in merchant banking, we used to structure companies to increase wealth.] The Economist says that this idea set back the study by economists of corporate finance for a generation. (Economist, 11 February 2006, page 71). Note: This is why I do not use WACC in my valuations.

Time to Increase the Systematic Risk?

When I started running the valuation workshops in 2001 I calculated the systematic risk premium to be 6% based on the inputs applicable at the time. This 6% has stuck. However, circumstances have changed over the years and it is silly to stick to 6% merely because ”we have always done it this way“. I know that we fiddle the unsystematic risk premium to get the answer we want anyway so the elements of the fair rate of return are not terribly important. But it would be nice to do the job properly. The consensus view is that we can expect to earn 13,5% p.a. on the average share on the JSE in the foreseeable future. This return can be arrived at as follows (with a stretch of the imagination):

Dividend yield on dividend paying shares 4%
Growth due to inflationLoans to other companies 6%
Growth due to GDP 3%
Growth due to generic expansion 1%
Total 14%
Withholding tax: 10% of 40%* of 14% 0.5%
Net 13.5%
Long term government bond rate: 60% of 9% 5.4%
Systematic risk premium, say, 8%

* Average dividend payout policy