How Businesses Will be Valued - News update - March 2007

If you saw the survey that appeared in the 29th March, 2007 Business Day about corporate reporting, you will have read why these documents are becoming longer and more complex. The reason is to do with the new accounting standards (International Financial Reporting Standards or IFRS) that place a heavier reporting burden on listed companies and also the need investors have for more information. IFRS 3 Business Combination is a new standard that calls for more work. It states that auditors have to estimate the costs of all the assets bought in a merger or acquisition, tangible and intangible, the idea being that this will reduce the amount attributed to acquired goodwill. It is early days to see how accountants deal with this in reality (as we explained in our May, 2006 update – number 39 on the web site - we thought the Barclay’s plc auditors thoroughly undervalued the Absa brand), but this requirement might have an unforeseen consequence that will be beneficial to the Merger & Acquisition (M & A) community.

Since IFRS 3 states that brands will be recognised under conditions of a business combination we think this ushers in a new and very useable method of valuing companies; one that values them from the bottom up.

Of course the question that arises immediately is: why would anyone need to do this? Aren’t there sufficient established approaches to company valuation? Why something so new and untested?

There are indeed many ways of valuing a company. Probably the most popular is the multiple of historic profits, using a price to earnings ratio from published listed company results. This approach is easy and implies that the industry norm is for historic profits to have a life span equivalent to the multiple. A p:e of five means that investors anticipate that the company will continue to earn at this level for at least five years.

A simple rule of thumb method used by some is simply to divide the earnings by a discount rate. If, for example, the earnings are R750 000 and a suitable discount rate is 12%, the company is worth R6 250 000 (750000/12%). Relating that to the multiple method, this is a multiple of 8, 3 (Not surprising because 12 x 8, 33 = 99.9).

Discounted cash flow (DCF) requires a projection of turnover, expenses and income tax because it relies on forecast after tax profits. The earnings are projected for a pre-determined period, say five years, and then each year is discounted by a discount rate. The sum of each year’s discounted earnings is the company value. When long lived assets such as brands are involved, the rule-of-thumb trick shown above is applied. The discounted earnings for the final year (fifth in the above example) are divided by the discount rate and the result is added to the present value of the five years DCF. That is called a growing perpetuity.

The DCF approach is not quite a simple as I have made it sound since it does involve working with projected free cash flows and looking for a sensible way of calculating the growth rate. This is sometimes linked to return on invested capital – but that is getting too complicated.

These calculations are made by advisers to investors who are trying to value a company they may wish to buy or sell. Presumably, as these things go, a seller will start negotiations at a price above the estimate and a buyer will make an opening bid far less. So the estimate is not supposed to be precise: it is a guide. More often than not once the price is determined and the net assets have been deducted there is a premium left which until recently was described as goodwill. That is the margin over the net worth of the asset that the buyer has agreed to pay for allsorts of intangibles such as brands, know-how; special business systems and established trade relationships.

It is goodwill that the new standard, IFRS 3, was created to deal with. Here is one of the key reasons why the standard writers introduced it:

“Users of financial statements (also) indicated a need for better information about intangible assets because those assets are an increasingly important economic resource for many entities and are an increasing proportion of the assets acquired in many business combinations.” (FASB , summary of statement number 141)

The problem with the conventional valuation approaches outlined above is that they simply estimate a value. They do not consider the intangibles which, in today’s economic circumstances, are frequently viewed as a vital and often dominant part of the deal. In many cases a company will buy another to acquire its brands, know how, or business system, but it is quite probable that the calculation of value will use one of the above techniques, none of which explicitly take the intangibles into account.

The new accounting standards that deal with business combinations acknowledge this but require the intangibles to be identified ex post facto. That always strikes me as strange. The people who negotiated the deal did not actually specify what price they were placing on the intangibles, but the accountants, after the event, have to suss this out. At this stage the standards are too new for us to know how this will be handled and indeed if a true and fair value will be placed on the acquired intangibles. But if the standard writers, as indeed they do, think it is possible to estimate the value of intangibles such as brands, people who buy and sell businesses would want to know this when they are working out what they should offer for the company they have in their sights; not learn what they have bought according to some post purchase balancing arithmetic. If the valuation also came with built in asset management indicators and tools, they would be twice blessed.

Surely then it makes more sense to work up the price to recognise all the assets that will be bought, both tangible and intangible and allowing for some residual goodwill, than setting a price based on some historic model that presumes to take the intangibles into account in a chunk of value called goodwill. In time the cost of all the assets will no longer be a mystery to be worked out and manipulated once the deal is complete; they will be on the table as part of the price paid.

This is how it could work assuming, that is, the brand has been valued using BrandMetrics.

• The basis of the valuation is that the brand generates economic profit. That is a profit that exceeds the company’s cost of capital. Sustainable economic profit occurs because companies have built up intangible assets that are specific to them. BrandMetrics considers the economic profit to be 100% of the intangibles and then sets about calculating what percentage of this is the brand. Let’s say for this example the percentage is 65%.

• The brand value is then calculated using the various inputs and algorithms in the BrandMetrics system. But it can be said at the end that the brand represents 65% of all the intangibles.

• If the brand is worth R25 million; the intangibles combined are worth (25/65) x 35 + 25 = 38.

• Now here is the subjective part because an allowance must be made for goodwill or the intangibles that were not captured in the above process. We normally allow 10% for this and if you worry that this is too subjective, please re-read our July 2006 news update (number 41 on our web site). This is nothing unusual.

• Now you have a total of 38 + 3.8 = 41.8 to which must be added the Net Asset Value (NAV) from the balance sheet, and you have a value.

We have tested this approach against several known company values and we are invariably close to the mark. Since no method claims absolute precision, ours might turn out to be the most accurate approach because we include all the assets, tangible and intangible, consistent with the requirements of the new accounting standards. It also solves the problem of working out the intangibles after the deal is done: this way they are part of the deal. And, the buyer gains a ready made tracking and strategic management tool into the bargain.

Is any deal maker willing to try it?