A critical analysis of the issues faced when valuing businesses in emerging economies.

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Table of Content
2.Purposes of business valuation
3.Factors affecting a company’s value in the emerging markets
4.Key valuation methods in the emerging markets
5.Major elements of the valuation process
6.Complications of valuing small and medium-sized businesses
7.Issues faced when dealing with start-ups
8.Valuation in the crisis environment: opportunities and threats


A critical analysis of the issues faced when valuing businesses in emerging economies.

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Net book value
Net realizable value
Replacement cost
Dividend approach includes two basic valuation methods
Dividend valuation model
Dividend yield
Each particular method has its pros and cons which are worth discussion. Advantages and disadvantages of the methods most often used in practice are briefly outlined below.
Net present value is based on the discounting cash flow techniques which take account of time value of money by restating each cash flow in terms of its equivalent value now. Major advantage of NPV is taking into account time value of money. NPV and payback period are the most popular methods of valuation. Advanced NPV techniques incorporate taxation and inflation into calculations. It is especially relevant for the emerging markets because such techniques are closerto “real life” and provide more reliable basis for decision making. Nevertheless there is a principal complication with NPV method. The problem is no uniform methodology is worked out to incorporate risk in the calculations. This is especially relevant to the emerging markets where risks are traditionally higher. James & Coller (2000, p. 80) state that “little agreement has emerged among academics, investment bankers, and industry practitioners about how to conduct valuations in emerging markets”. James & Coller argue with those who insist on simple risk premium. Their preferred approach is to use discounted cash flows (DCFs) together with probability-weighted scenarios that model the risks a business faces (James & Coller, 2000, p. 80 - 85).
Payback period means time it takes for the operating cash flows from a project to pay back initial investments.
Simple to calculate
Easy to understand
More attention to earlier cash flows
Useful in case of liquidity shortages
Ignores time value of money
Target period is subjective
Provides little information about changes in shareholders’ wealth
Ignores cash flows after payback period
Despite all the drawbacks this method is extremely popular due to its simplicity and clearness.
P/E ratios are likely to be the most popular ratios which investors consider. P/E of a public company takes into account its growth rate, i.e. it reflects the market expectations for the business. For unquoted companies this ratio is not published. However, it is often taken as a valuation basis and indicates acceptable price for the sellers of the shares.
Ratio analysis is as popular as the payback method and actually for the same reasons: simplicity of calculation and clearness to all users. In fact, the fastest and simplest way to assess a company’s performance is to take its financial statements and calculate some ratios. Based on the results an investor may say immediately whether the entity is solvent, over geared, or faces liquidity problems. However, ratio analysis has its limitations. The major trick and drawback of ratios is that different analysts may calculate them differently. This may ruin the comparability. In addition financial statements may be subject to “window dressing” or “creative accounting” and do not provide reliable basis for calculations. Next thing to consider is changes in accounting policies and estimates. Such changes may also affect comparability. Finally, balance sheet values are based on the historic costs which are less reliable than the market values.
Therefore, ratio analysis is never used as the only evaluation method though it provides benchmarks for further consideration.
Net book value is simple to calculate but it has serious drawbacks
Calculation is based on historic costs
NBV depends on depreciation policy and can be manipulated
Some assets such as internally generated goodwill are not presented in the Statement of financial position
Net book value may be used as an additional valuation tool but not as the primary one. Besides NBV method is only applicable in relatively stable economies. As most emerging markets demonstrate high inflation rates, methods based on historic costs can hardly be applied.
Net realizable value estimates the liquidation value of a business. It indicates the lowest possible price the seller may be offered. This method has similar drawbacks to the NBV and the same limitations for the emerging economies. In addition if there is no active market for liquidated assets, their value is hard to estimate.
Replacement cost reflects the investment required to launch a similar business. By nature this is the highest possible price the buyer may theoretically pay for the entity. This method is used relatively rare because changes in technology make replacement cost difficult to calculate.
Dividend valuation model is aimed to assess future dividend paid to shareholders. Although this method is often used as a benchmark assessment tool, it has serious disadvantages
ignores possible changes in dividend policy
difficult to determine required rate of return
difficult to determine dividend growth rate
Therefore, all valuation methods have their limitations. For quality valuation various approaches and methods must be used.
Major elements of the valuation process
The first step of the valuation process is obviously goal setting. Example goals are presented below
Developing a current fair market value for the company
Assessing a company's present financial condition
Appraising a company's future prospects
Identifying a company's strengths and weaknesses
Revision of the long run strategy
Tax planning
If the goals are not clearly outlined, the owners and managers may find the final report unsatisfactory. The report must clearly address several key goal as well as target end-users (Kistler & Shorney, 1990, p. 35).
The second step is deciding who will perform the valuation and establishing evaluation team. According to Kistler & Shorney (1990, p. 31), valuation process is most efficient when both external and internal experts are involved. Managers and owners must do their best to highlight the company’s competitive advantages. External experts can be involved in the organization of the valuation process and in preparing final report (Kistler & Shorney, 1990, p. 31). An important consideration is cost of valuation. Small and medium-sized companies may find the services of the external experts quite expensive. However, optimum balance between the service quality and valuation expenses must be found.
Then it is time for evaluation as such. Kistler & Shorney (1990, p. 34) offer the following model of structured business evaluation
Nature and history of the business are studied in order to review the company’s strategic goals and consider their revising.
General economic outlook, specific industry conditions and opportunities for growth and diversification imply changes in the economic, political risks, regulatory environment.
Financial analysis of the business involves regular review of the financial statements and ratios analysis in order to «assess the company’s performance in dynamics». Besides it helps to detect emerging trends.
Analysis of the business' earnings capacity, i.e. seeking ways to increase revenues and to reduce costs.
Review and appraisal of company's dividend-paying policy and capacity includes revision of the profits allocation policy.
Presence of goodwill or other intangibles. The experts seek the opportunity to increase the company’s value by means of recognition of the previously unnoticed goodwill.
Market value assessment of the business. Appraisal specialists may offer efficient strategy to increase the company’s value before the entity starts to seek a buyer.
Market value assessment of comparable companies is conducted not only for the company’s positioning in the market. It is also a useful tool for identification of the merger partners and potential acquisition targets.
It should be taken in mind that generally valuation is affected by demand. Lower demand means lower valuations notwithstanding how flourishing a company may be.
Kistler & Shorney conclude that “adopt­ing a structured approach to plan­ning and evaluation is particu­larly useful for small and me­dium-sized businesses” (1990, p. 35).
Complications of valuing small and medium-sized businesses
Small and medium-sized entities are most often unable to meet the strict requirements that are obligatory for listed companies. That’s where the roots of the problem lie. Unlike public companies, unquoted entities are not transparent for the investors. Information that SMECs provide is often insufficient or poorly presented. Common valuation methods do not work here. For this reason some investors are unwilling to acquire SMECs in emerging markets such as Latin America. Dan Jacobs, manager of the global Templeton Smaller Companies Growth Fund, asks a rhetorical question: “Do you really know what you're buying?" (quoted in Mattlin, 1994, p. 130). The president of Emerging Markets Investors Corp., Antoine van Agtmael agrees
We sometimes spend several weeks looking at companies that turn out to be something we don't want to buy. And the smaller the company, the more intensive the research needed. I've even hired a private detective to look into a company (quoted in Mattlin, 1994, p. 130).
According to Held (2009, p. 47), in most general case companies are valued based on their retained earnings and the potential to grow profits. Business valuation is based on the absolute amount of profits and the value multiple applied to those profits. Held gives a following example: “All other things being equal, a company with $1 million in profits would be worth less than a company with $10 million in profits - even if it has twice the revenue (or especially if it had twice the revenue).”
The value multiple applied to a company can range from “not meaningful” (if the profits are negative) to 10 times or even greater. There is another simple example: “an attractive company with $5 million in profits might be valued at eight times, or at $40 million, whereas an unattractive company with $5 million in profits might be valued at four times, or $20 million” (Held, 2009, p. 47).
Another problem with small-caps is lack of liquidity. William Truscott, a successful money manager, states that “the problem with companies that small is they're easy to buy, but when you want to sell, there's nobody there to make a market." (quoted in Mattlin, 1994, p. 130).
Local governments make effort to improve the situation. Thus, second-tier exchanges were created in many countries in Latin America in mid 90s. However, companies were cautious about newly created over-the-counter markets. Investors also relied more on P/E ratios and due deal research. Peter Gruber, portfolio manager working with Latin America, admits that liquidity problems do exist. He complains: “You have to buy slowly, and you have to hold” (quoted in Mattlin, 1994, p. 130).
In current economic downturn investors are fare more wary about risky and illiquid SMEs. Capitalization of many companies has fallen dramatically, and the recovery prospects are not quite clear.
Issues faced when dealing with start-ups

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