The primary requirements for a credible valuation are a stable historical earnings stream, a clear outlook for future earnings, low volatility and good proxies to be used as comparisons. Current market conditions both locally and globally have only served to complicate private and public equity valuations, which are tricky exercises at the best of times.
Defined as a prediction of the price at which a willing buyer is prepared to purchase and a willing seller is prepared to sell, the valuation process is bedeviled by variables, which means that arriving at a mutually acceptable, fair price is often difficult. These variables can include, but are not confined to, controlling shareholdings, warranty clauses, profit warranties and ultimately the skill and negotiating strength of the buyer and thQe seller. A certain degree of objectivity can be achieved by looking at the performance of an underlying business through an evaluation of its historical financial statements. However, while such statements can hint at uncertainties in a particular sector or the international economy, they can never fully anticipate all the future variables. Factors such as currency volatility also play their part for exporting or importing entities.
A further compounding factor is a general lack of precedent upon which a valuation can be based. As every deal is almost never identical, it is extremely difficult simply to compare an imminent deal with one that has already occurred, even if both are in the same sector or geographical area. This is always a useful starting point, at which each deal needs to be considered, based on its own merits, whether a higher or lower multiple should be paid compared to the comparative deal. The purchaser may also wish to take into account synergies that may be achieved in the transaction, as well as other relevant factors.
Having taken some of the issues into account, it should also be borne in mind that the valuation exercise should not be carried out on the eve of the imminent disposal or acquisition. Most company board members have a sense of the value of their businesses, and often these valuations emerge through the annual reporting process and liaison with analysts. However, in the presence of a potential buyer, these valuations might not be congruent with what is perceived by either side to be fair value.
Buyers are usually driven by the future potential growth that can be extracted from the acquisition, the possible synergies that could be derived from the acquisition, and the returns that can be made on the purchase price. This is true for financial, private equity and trade buyers. Sellers, on the other hand, sell on the basis of the asset being no longer core, having reached its maximum valuation potential in their minds, or for other reasons such as an owner retiring from his or her investment. Both parties are guided by the historical earnings of the business and the perceived potential growth into the future.
The current market has placed doubt and a lack of clarity on the future potential earnings of most companies. This lack of clarity has left buyers and sellers with sometimes diverse views on growth, and has led to a fair amount of paralysis, leading to stagnation in the market. One feature of the current landscape is the difficulty a vendor has in justifying growth against a falling historical earnings pattern. Sellers also believe in yesterday’s prices, and are reluctant to sell for anything less. Most stock exchanges have fallen between 30-50% in the past two years, leaving most valuators, buyers and sellers with unstable proxies. It is also difficult for a buyer to justify paying an inflated value in the face of uncertainty. Potential sellers are tending to point to a “V-shaped”, quick return to the prices of old, and buyers will point to the risk and uncertainty of the future. It is difficult under these circumstances for both parties to reach consensus on a mutually acceptable price in a transaction.
In addition, credit providers have the same difficulties and are conservatively issuing credit in lower volumes than had previously been the case. Both these factors have significantly reduced the M&A activity we are currently seeing.
We have also seen, as reflected in the behaviour of stock exchanges during this period of uncertainty, that any amount of news – good or bad – has a significant and volatile effect on share prices and overall indices. This volatility is interpreted as risk by long-term investors that are anxiously awaiting the unlikely short-term combination of consistent growth and low volatility.
Global M&A in 2008 was 30% down on the previous year. In South Africa, M&A was down 39%. From a Private Equity (PE) point of view, investments are down 18.4% from R26.1bn in 2007 to R23.1bn in 2008. It is interesting to note that a large portion of PE investment (40%) has been back into existing portfolio companies, whereas in 2007, only 5% followed this trend. This is indicative of the difficulties associated with consummating new deals, and also the possible requirement of PE houses having to recapitalise on their existing portfolio companies.
In order for a valuation practitioner to regain some credibility, market proxies and the future earnings outlook of most companies require stability. A slow but sustained increase in the market invariably yields an increase in M&A activity, as the prices of companies appease sellers when they are higher than they may have been previously. These prices also please buyers because they invariably do not absorb the full future growth potential of the company. This leaves value on the table for both the buyer and the seller. In the current market, it is difficult to predict when such a scenario will emerge in the short term. Many economic analysts foresee a bumpy ride and cannot see a simplistic V-shaped recovery. Under these circumstances, M&A activity will remain subdued.
South Africa’s circumstances are seen by many as being more favourable than those elsewhere in the world, given our commitments to infrastructure spend, the FIFA 2010 Soccer World Cup potential and the interest rate headroom. These will hopefully conspire to soften the landing.
Ultimately, it is the consumer-spending patterns in the USA that will determine the speed and strength at which the global economy will recover. Another factor leading to all the uncertainty is how the global economy is going to unwind the leverage of economies that they have incurred in order to overcome a prolonged recession. An unfavourable unwinding could cause more problems and may create more volatility in asset prices. Global investors are looking for clarity that the worst is over and that there will be no more earnings surprises. Some positive economic signs are starting to show, however, the valuers’ crystal ball remains hazy at best. As a result, this requires a return to the basic principles of valuation. At KPMG, the focus of the valuation practice is on credible forecasts supported by competent management, with an element of conservatism. This appeases the willing buyer/willing seller principles in the current market.
Warren Watkins CA(SA), is Head of Private Equity Markets for Africa, KPMG.
