Australian Valuation Handbook 2436862

MAIN MENU JUNE 2006 UPDATE #5
MAIN MENU JUNE 2006 UPDATE #5
MAIN MENU JUNE 2006 UPDATE #5 / Preface
Preface
The Australian Valuation Handbook (AVH) is a practical guide to the main issues encountered in valuations. It is not intended to cover every potential issue in every situation. AVH is aimed at the adviser who needs a useful reference and for purchasers, vendors and anyone involved in the purchase or sale of a business or having cause to prepare or understand a business valuation. We hope that it will also serve the practical tertiary education need identified by our university associates. AVH employs the use of hyperlinks. This system serves as a means of navigation within the text to related concepts. A mouse-click on a hyperlink will take the reader directly to the related section of the text. We underscore all our comments with a disclaimer and a caution that every case is unique. Although there are basic rules and tools of valuation, there can be no simple prescription of a formula or rule of thumb which can be applied universally. At the end of the day, it rests upon the valuer to understand fully the business or entity being valued. There is no substitute for due diligence. There is no substitute for quality control. Whilst the responsibility for the text is ours, we acknowledge the many colleagues, friends and clients
Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited
who have critiqued our work, encouraged and assisted in the production of this text.
MAIN MENU JUNE 2006 UPDATE #5 / Preface / About the Authors
About the Authors
MAIN MENU JUNE 2006 UPDATE #5 / Preface / About the Authors / Leadenhall VRG Pty Ltd Leadenhall VRG Pty Ltd
Level 1 31 Franklin Street Adelaide South Australia 5000 Australia Telephone (within Australia) (International) Facsimile (within Australia) (International) (08) 8385 2200 +61 8 8385 2200 (08) 8385 2299 +61 8 8385 2299
Website: <www.leadenhall.com.au> Email: <office@leadenhall.com.au> Leadenhall VRG Pty Ltd is an independent corporate advisory firm that was established in 1982. The company has its head office in Adelaide, South Australia and offices in Melbourne and Sydney. Leadenhall specialises in: the valuation of companies, businesses and assets; the development of financial strategies; financial and feasibility studies; the commercialisation of intellectual property; arranging structured funding; and negotiations.
The company has a long track record in successful financial consultancy and has undertaken significant work for Australian public and private companies, overseas corporates, government departments and statutory authorities.
MAIN MENU JUNE 2006 UPDATE #5 / Preface / About the Authors / Leadenhall VRG Pty Ltd / Tim Lebbon, FCPA, FIDA, SF Fin, FCA(UK), FIMC
Tim Lebbon, FCPA, FIDA, SF Fin, FCA(UK), FIMC
Tim Lebbon is Executive Director of Leadenhall VRG Pty Ltd, Corporate Advisers. Prior to starting Leadenhall in 1982, Tims career included working for W D Scott & Co, Management Consultants (six years), two of the Big Six accounting firms in Jakarta and Paris (five years) and chartered accounting in England (six years). Tim holds a Graduate Diploma in Applied Finance and Investment from the Securities Institute of Australia and is a Fellow of the Institute of Chartered Accountants in England and Wales, a Fellow of the Australian Society of Certified Practising Accountants, a Fellow of the Securities Institute of Australia and the Australian Institute of Company Directors. He is a chartered management consultant. He was a Councillor with the South Australian Division of the Securities Institute of South Australia from 1984 to 1996 and was President of the SA Division of the Institute of Management Consultants from 1985 to 1987. Tim Lebbon is the lead lecturer in South Australia in the Diploma Course subject Mergers and Acquisitions for the Securities Institute of Australia. Other lecturing has included Financial Statement Analysis and Applied Corporate Finance. He also chaired and arranged a seminar presented by the Securities Institute (SA Division) on Takeovers Australian Style. He has presented papers and seminars to the South Australian State Congress of the Society of CPAs and to the Institute of Chartered Accountants (Victoria), the South Australian Enterprise Workshop, Australian Business Economists, the Australian Society of CPAs and others on a variety of subjects.
MAIN MENU JUNE 2006 UPDATE #5 / Preface / About the Authors / Leadenhall VRG Pty Ltd / Michael Churchill, B.Admin, CPA, F Fin
Michael Churchill, B.Admin, CPA, F Fin
Michael Churchill was a corporate adviser with Leadenhall VRG Pty Ltd from 1988 to 1997. Prior to joining Leadenhall, Michael worked with two of the Big Six accounting firms for six years. He was awarded the inaugural Young Accountant of the Year Commerce and Industry in June 1992. Michael was instrumental in the development and subsequent writing of parts of the original reference manual, Business Valuations Digest. Much of Australian Valuation Handbook is reliant on his initial work. Michael is now with PricewaterhouseCoopers and we continue to enjoy an ongoing professional relationship with him and PwC.
MAIN MENU JUNE 2006 UPDATE #5 / Preface / About the Authors / Leadenhall VRG Pty Ltd / Gary Cornelius, B.Ec (Hons), FCT, FAICD Dip
Gary Cornelius, B.Ec (Hons), FCT, FAICD Dip

Gary Cornelius is a corporate adviser with Leadenhall VRG Pty Ltd, specialising in fund raising, mergers and acquisitions and corporate advice. He is a Fellow of the Finance and Treasury Association (formerly Australian Society of Corporate Treasurers) and the Australian Institute of Company Directors. His background includes over 25 years in international banking, trading and consulting in Australia and overseas. Gary regularly works as an adviser on economic and financial issues and as a consultant to governments at a high level. He is also a director of a number of private companies.
MAIN MENU JUNE 2006 UPDATE #5 / Preface / About the Authors / Leadenhall VRG Pty Ltd / Simon Dalgarno, B.Ec, ACA, F Fin
Simon Dalgarno, B.Ec, ACA, F Fin
Simon Dalgarno is Associate Director of Leadenhall VRG Pty Ltd. He joined Leadenhall after several years experience in the management of manufacturing companies. He is a chartered accountant and an associate member of the Securities Institute of Australia and has significant experience in computer modelling, financial analysis and feasibility studies. Whilst at Leadenhall he has provided corporate advice to the public and private sectors and has specialised in company valuations, mergers, acquisitions and divestments and transfer pricing issues.
MAIN MENU JUNE 2006 UPDATE #5 / Preface / About the Authors / Leadenhall VRG Pty Ltd / Philip Mann BSc(Ma), MBA, CPA
Philip Mann BSc(Ma), MBA, CPA
Philip Mann was a senior business analyst with Leadenhall VRG Pty Ltd. He has an MBA and significant experience in statistical analysis. Philip has specialised in financial modelling and has undertaken a number of valuations, including complex technology valuations and financial analyses. Philip has advised on the accounting for assets and alternative valuation concepts; he has worked with clients in developing asset revaluation policies and processes.
MAIN MENU JUNE 2006 UPDATE #5 / Preface / About the Authors / Leadenhall VRG Pty Ltd / Dusko Lapcevic, B.Com (Corp Fin), B.E. (Chem)
Dusko Lapcevic, B.Com (Corp Fin), B.E. (Chem)
Dusko Lapcevic was a corporate adviser with Leadenhall VRG Pty Ltd. He joined Leadenhall after completing a Bachelor of Commerce (Corporate Finance) degree and after graduating as a chemical engineer in 1989. While at Leadenhall he worked on costing and pricing issues for government instrumentalities, calculation of weighted average costs of capital for various organisations and on option pricing. He provided technical input to business and technology valuations.
MAIN MENU JUNE 2006 UPDATE #5 / Preface / About the Publisher
About the Publisher
MAIN MENU JUNE 2006 UPDATE #5 / Preface / About the Publisher / Thomson CPD Business Solutions Thomson CPD Business Solutions
Thomson CPD is a leading provider of information solutions in the financial, legal, HR, payroll and environmental fields, with a strong focus on legislative compliance and best practice. We simplify your working life with a range of software packages, compliance manuals, books and self-study courses. We conduct seminars on topical issues, have an extensive newsletter service and are Australian Securities and Investments Commissions official publisher. Plus, with a growing number of our products available on CD-ROM or online, youll receive information faster, in a flexible, easily accessible and searchable format. Complement your Australian Valuation Handbook subscription with subscriptions to the following products: Salary Packaging Toolkit easy-to-use software that provides full analyses of entire salary packages within minutes. Simply follow the prompts, fill in the information and receive a full breakdown of the total costs and benefits, plus implementation documentation. The Accountants Manual gives you fast business solutions on everything from taxation and business law to accounting and government assistance. Youll have instant access to Tax Rates & Tables indices, thresholds, rebates and benchmarks plus concise summaries, checklists, precedents and pro forma examples. 2006 XYZ Model Financial Accounts your one-stop guide to financial statements presentation. It gives you summaries of this years changes in reporting requirements and model sets of accounts for all types of entities, including superannuation entities and large and small proprietary companies.
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MAIN MENU JUNE 2006 UPDATE #5 / Preface / Major Contributors
Major Contributors
Leadenhall Australia would like to acknowledge the many colleagues, friends and clients who have critiqued their work, encouraged and assisted in the production of this text. In particular, we wish to thank: The National Association of Certified Valuation Analysts (NACVA) For their support and significant contribution of new material, which is incorporated throughout the text. NACVA is an association established in Salt Lake City, Utah, USA, in 1990 to support the needs of CPAs and other business professionals in providing business valuation services. NACVA brings together a wealth of resources, facilitates networking and the transfer of knowledge and theory in the fields of valuation and related disciplines. NACVAs membership approaches 4,500 professionals and they currently offer a large variety of courses. These courses are offered regularly throughout the United States. Additional support to NACVA members is provided via the Business Valuation Research Institute research service and mentors provide technical support to members. Additional information about courses offered, products and services are available on their web site www.nacva.com or by emailing them on <nacva@nacva.com>. Kelvin King of Valuation Consulting For his contribution on the valuation of intellectual property. Valuation Consulting are specialists in the area of intellectual property valuations. Valuation Consulting can be contacted at 97 Park Lane, London, W1Y 3TA or by telephone or
fax on 0207 499 5544 and 0207 499 2266 respectively. Additional information on their capabilities can be obtained by emailing them on <valconsult@valconsulting.co.uk> or by visiting their web site <www.valuation-consulting.co.uk>. Craig Bakker of William Buck Chartered Accountants & Business Consultants For his contribution on the GST issues for buying or selling a business in the Taxation chapter. William Buck has provided independent chartered accounting and business related services to the business community for over 100 years. They are represented in all Australian capital cities with affiliates in Asia and New Zealand. Additional information can be obtained by visiting their web site at <www.williambuck.com>. Alexander J Paior LLB, FAICD, SIA(Aff) For his contribution on directors obligations and sample contracts. Alex is a director of a number of listed and substantial private companies and was a consultant with the legal firm Phillips Fox, Solicitors. Rolffe Peacock of the University of South Australia. The staff of Leadenhall VRG Pty Ltd. Those who volunteered their services for the texts major review before its inaugural release, namely: Barbara J Oswalt, CPA/ABV, CVA, Tax Director Hoyman, Dobson & Company, PA, CPAs Suite 1 215 Baytree Drive Melbourne Florida 32940 USA Telephone: (321) 255 0088 Facsimile: (321) 259 8648 Email: boswalt@hoyman.com Website: www.hoyman.com Specialises in tax planning and compliance, succession planning, litigation support and business valuation. Smith & Co. LLC Suite 300 1517 S Fawcett Ave Tacoma Washington 98402 USA Telephone: (253) 383 3800 Facsimile: (253) 383 7287 Email: don@forensicaccountant.org Website: www.forensic-accountant.org Services include forensic accounting, fraud investigation, business valuations and litigation support. Kern & Company, PC, CPA
C Donald Smith III, MBA, CFE, CPA, CVA, President
Charles L Kern,
BS, MBA, CPA, CVA, CFA, President
2331 Market Street Camp Hill Pennsylvania 17011 USA Telephone: (717) 763 0888 Facsimile: (717) 763 1581 Email: kern@panetwork.com Website: www.kernandcompany.com Specialists in business valuations, forensic accounting and asset segregation for construction and business consulting. Client base predominantly in construction, information technology and manufacturing. David E Mensel, PC, CPA 319 21st Avenue North Nashville Tennessee 37203 USA Telephone: (615) 329 4090 Facsimile: (615) 329 1548 Email: dmensel@home.com Website: www.menselcpa.com Providers of fraud detection and prevention services as well as business valuations and litigation support services. Specialist in domestic relations matters. Forensic Accountant Inc Suite 300-C 1551 Forum Place West Palm Beach Florida 33401 USA Telephone: (561) 616 9800 Facsimile: (561) 616 9700 Email: expertwtnss@aol.com Specialists in litigation support and evaluation of business ownership interests. Acts as expert financial witness in many areas. Laura J Tindall & Company Suite 217 11440 Okeechobee Boulevard Royal Palm Beach Florida 33411 USA Telephone: (561) 795 1965 Facsimile: (561) 793 3131 Email: LJT@LJTindall.com Website: www.businessvalu.com Undertakes valuations, dispute resolution, breach of contract matters, buy/sell agreements, planning development and engineering, right-of-way acquisition, litigation, disaster insurance, estate and gift services. Certified Valuation Services, Inc
David Mensel, CPA, CFE, CVA, BA in Economics, President
Emanuel Gerstein, CPA, CVA, President Sole Shareholder
Laura J Tindall, PhD, CPA, ABV, BVAL, MCBA, Principal
Mark Cherry,
Esq., CPA, CVA, Mediator, President
385 Kings Highway North Cherry Hill New Jersey 08034 USA Telephone: (856) 667 6672 Facsimile: (856) 667 8666 Email: certvalmc@aol.com Specialises in valuation services and litigation support. Kaplan Abraham Burkert & Company Suite B-543 543 Country Club Drive Wood Ranch California 93065 USA Telephone: (805) 578 1515 Facsimile: (805) 578 0090 Email: MHA@kab-bv.com Website: www.kab-bv.com Specialises in estate planning, dissenting shareholder actions, marital dissolution, valuation and litigation support services; author of Valuation Issues and Case Law Update, A Research Guide. Pate, Cerqueda, Morgan & Gault, LLP 757 Franklin Road Marietta Georgia 30067 USA Telephone: (770) 422 5554 Facsimile: (770) 422 1569 Email: Ngaultcva@aol.com Provides business valuations, estate planning, auditing and financial reporting, corporate and personal tax services, business advisory services, personal financial services, benefit plan auditing and investment and life insurance services. Berning & Berning Ltd Suite 135 10201 Wayzata Blvd Minnetonka Minnesota 55305 USA Telephone: (952) 544 1212 Facsimile: (952) 545 8891 Email: berningcpa@aol.com Website: www.berningcpa.com Specialising in business valuations. Frequent speaker in the US on business valuation and tax related topics. Valuation Professionals, Inc
Mel H Abraham, CPA, CVA, ABV, ASA, Partner
Nancy Gault, CPA, CVA, Partner
Richard Berning, CPA/ABV, CBA, CVA, CFP, CMA, President
Robert R Wietzke,
CPA, CVA, President
Suite 400 1301 Dove Street Newport Beach California 92660 USA Telephone: (949) 476 8686 Facsimile: (949) 476 8687 Email: rwietzke@valuationpro.com Website: www.valuationpro.com Provides business valuations in relation to mergers and acquisitions, estate planning, buy/sell agreements, succession planning and litigation. Kaplan Abraham Burket & Company 1211 Addison Walk Philadelphia Pennsylvania 19147 USA Telephone: (215) 985 9370 Facsimile: (215) 985 5741 Email: rpb@kab-bv.com Website: www.kab-bv.com Undertakes business valuations in a wide variety of industries. Extensive experience in valuations for gift, estate and inheritance tax planning, mergers and acquisitions, buy/sell agreements and marital dissolution proceedings. Parente Randolph, LLC Suite 700 2 Penn Centre Plaza Philadelphia Pennsylvania 19102 USA Telephone: (215) 972 2515 Facsimile: (215) 563 5083 Email: sscherf@parentenet.com Website: www.parentenet.com Provides accounting and consulting services with concentration on business valuations, bankruptcy consulting and forensic and litigation services. Anders Minkler & Diehl, LLP Level 10 705 Olive Street St Louis Missouri 63101 USA Telephone: (314) 655 5515 Facsimile: (314) 655 5501 Email: thilton@amdcpa.com Website: www.amdcpa.com Full service consulting firm specialising in tax planning, mergers and acquisitions, valuations, litigation services, investment and insurance planning and technology assessments.
Rod P Burket, CPA/ABV, CVA, MBA, Partner
Stephen Scherf, CPA/ABV, CFE, CVA, DABFA, Principal
Thomas Hilton, MS, CPA/ABV, CVA, Director Valuation and Litigation Services Group
MAIN MENU JUNE 2006 UPDATE #5 / Preface / Acknowledgments
Acknowledgments
All Commonwealth data herein are reproduced by permission but do not purport to be the official or authorised versions. They are subject to Commonwealth of Australia copyright. The Copyright Act 1968 permits certain reproduction and publication of Commonwealth legislation. In particular, section 182A of the Act enables a copy to be made by or on behalf of a particular person. For reproduction or publication beyond that permitted by the Act, permission should be sought in writing. Requests should be addressed to Commonwealth Copyright Administration, Copyright Law Branch, Attorney-Generals Department, Robert Garran Offices, National Circuit, Barton, ACT 2600, or posted at <www.ag.gov.au/cca>. Extracts from Exposure Drafts and International Accounting Standards are reproduced by permission. Please note that the material is copyright of the International Accounting Standards Committee Foundation (IASCF) and International Accounting Standards Board (IASB). Enquiries about copyright should be directed to the IASCF, 1st Floor, 30 Cannon Street, London EC4M 6X H, United Kingdom (web site www.iasb.org.uk). Extracts from Guidance Notes and Standards are reproduced by permission. The copyright in this material belongs to APRA. Reproduction in unaltered form for personal, non-commercial use is permitted. Other than for any use permitted under the Copyright Act 1968, all other rights are reserved. Requests for other uses of copyright material should be directed to APRA Public Affairs Unit, GPO Box 9836, Sydney, NSW 2001.
MAIN MENU JUNE 2006 UPDATE #5 / Preface / Disclaimer
Disclaimer
As the topic of valuation involves making judgements about risk factors, business conditions, the economy generally and many other factors, readers are advised to seek individual advice prior to making decisions on a business valuation and should not rely solely upon a reading of this text. The authors shall not be liable for any loss, damage or penalties which may result from any failure to obtain such independent advice concerning any contemplated transaction or any related transaction. The authors are not experts in either of the fields of taxation or law and any suggestions made herein on either topic must be referred for further consideration to such an expert before being acted upon. All comments and suggestions made on taxation and legal matters have been made in good faith. However, the law is ever changing and what may have been correct at the time of writing, can quickly become irrelevant or wrong. Material used in the case studies and examples is fictitious and not intended to resemble any actual organisation. It is a condition of use of any of the materials or templates contained in this publication that the user agrees to the following: The author expressly excludes any liability for loss or damage to the user of any templates, standards or other materials contained in this publication and the user indemnifies the authors against any claim against the authors arising out of the use of the materials contained in this publication by the user. The authors have made every effort to contact copyright holders and request permission for all copyright material. However, in the event we have been unable to trace or contact copyright holders, if notified we would be pleased to acknowledge the source of the material.
MAIN MENU JUNE 2006 UPDATE #5 / Preface / Need More Help?
Need More Help?

All queries and comments regarding this text should be directed initially to Thomson Legal & Regulatory Limited. By phone: By fax: By mail: Customer Service Team 1300 304 197 1300 304 198 Thomson CPD 35 Cotham Road, Kew VIC 3101 By email: Website: LRA.Support@thomson.com www.thomson.com.au
MAIN MENU JUNE 2006 UPDATE #5 / Preface / Need More Help? / Leadenhall VRG Pty Ltd Leadenhall VRG Pty Ltd
Leadenhall is available to review and comment on valuations prepared by other organisations. Details of our consulting rates are available from our website and/or on application. Leadenhalls contact details are as follows: Level 1 31 Franklin Street Adelaide South Australia 5000 Australia Telephone (within Australia) (International) Facsimile (within Australia) (International) (08) 8385 2200 +61 8 8385 2200 (08) 8385 2299 +61 8 8385 2299
Website: www.leadenhall.com.au Email: office@leadenhall.com.au
MAIN MENU JUNE 2006 UPDATE #5 / Preface / Need More Help? / National Association of Certified Valuation Analysts National Association of Certified Valuation Analysts
NACVA is an association established in Salt Lake City, Utah in 1990 to support the needs of CPAs and other business professionals in providing business valuation services. Additional information about courses offered, products and services is available from: Suite 200 1111 Brickyard Rd
Salt Lake City Utah 84106-5401 United States of America Telephone (within USA) (International) Facsimile (within Australia) (International) Website: www.nacva.com Email: nacva@nacva.com. (800) 677 2009 +1 800 677 2009 (801) 486 7500 +1 801 486 7500
MAIN MENU JUNE 2006 UPDATE #5 / Preface / Key Questions
Key Questions
MAIN MENU JUNE 2006 UPDATE #5 / Preface / Key Questions / Before commencing Before commencing
Before commencing a valuation, it is wise to stand back and take a global view and ask the key questions: Why is the valuation being done? To whom is the valuation being provided? For what purpose is the valuation required? What is being valued? What is the appropriate standard and premise of value? Are the underlying key assumptions adequate? Is the valuation to be pre-debt and pre-tax, or post-debt and post-tax? Are the forecast numbers real or nominal and how will the valuation methodologies need to be adjusted? How many separate businesses are there to be considered?
MAIN MENU JUNE 2006 UPDATE #5 / Preface / Key Questions / For each business For each business
Is the business new, a start up or technology based? Choice of valuation method: Are reliable estimates of FME (future maintainable earnings) available? Are reliable estimates of future cash flows available? What (potential) alternative offerors are there?
Is the business worth more dead than alive? What is the life of the business is the business (reasonably) likely to exist in perpetuity? What is a sustainable debt level (without outside guarantees)? What is an appropriate rate of return for the business or price earnings multiple?
MAIN MENU JUNE 2006 UPDATE #5 / Preface / Key Questions / For the entity For the entity
Are there any tax losses? Are there any surplus assets? Is there any corporate debt? Are there any options or preference shares or any securities on issue which are not ordinary shares? Is less than the whole of the entity to be valued?
MAIN MENU JUNE 2006 UPDATE #5 / Preface / Checklists
Checklists
It can be difficult to ensure that all matters are covered. There is a danger in trying to fit all valuations into a standard mould. However, given the increasing level of attention/guidance being given on the subject, it can be useful to review matters formally before signing off on a report. Numerous lists can and should often be employed in conducting a valuation. Examples of resources, which are useful and readily obtainable, include: Audit work relating to valuations and mergers and acquisition activity of the major accounting firms. The audit practice releases contained in the CPA Australias handbook. Venture capital groups. Due Diligence Handbook by the Securities Institute of Australia (which is endorsed by ASIC). Guide to Business Valuations, Practitioners Publishing Company.
An example of checklists which might be employed include: Personnel checklist. Checklist of legal documentation (e.g. Memorandum and Articles of Association, debt documentation, supply contracts etc.). Checklist of patents, trademarks, copyrights etc. Financial information checklist (budgets, historicals, sales analyses, SWOT analyses etc.).
MAIN MENU JUNE 2006 UPDATE #5 / Preface / Conclusion
Conclusion
In conclusion, ensure in your valuations that you: Distinguish clearly between the assets and liabilities which are to be included in the valuation and those which are not. Treat items on a substance over form basis. Question most critically values ascribed to specialised assets and check that they are supported by their earnings ability. Set out clearly the assumptions and methodologies used.
At the end of the day, ask yourself how keen you would be to buy or sell at your valuation and why.
MAIN MENU JUNE 2006 UPDATE #5 / Preface / Other Organisations
Other Organisations
Following are the contact details for organisations that regulate or provide training or assistance to valuation professionals. ORGANISATION American Institute of Certified Public Accountants (AICPA) American Society of Appraisers (ASA) Australian Securities & Investments Commission (ASIC) British Venture Capital Association (BVCA) Canadian Institute of Chartered Business Valuators Financial Services Institute of Australasia Institute of Business Appraisers (IBA) Institute of Chartered Accountants in Australia (CA) International Association of Consultants Valuers & Analysts (IACVA) International Valuation Standards Committee (IVSC) National Association of Certified Valuation Analysts (NACVA) Securities Exchange Commission (SEC) Thomson Legal & Regulatory Limited COUNTRY USA USA Australia UK Canada Australia USA Australia Germany WEBSITE www.aicpa.org www.appraisers.org www.asic.gov.au www.bvca.co.uk www.cicbv.ca www.finsia.edu.au www.instbusapp.org www.icaa.org.au www.iacva.org
International USA USA Australia
www.ivsc.org www.nacva.com www.sec.gov www.thomson.com.au
MAIN MENU JUNE 2006 UPDATE #5 / Preface / Trademarks, Licence and

Copyright Information
Trademarks, Licence and Copyright Information

Windows is a registered trademark of Microsoft Corporation. All products and brand names referred to are referred to only for the purpose of explaining the use of the product and are trademarks of their respective holders. Licence Only The information and software in this product is licensed only (and not sold) and is provided under a licence agreement. This information and software may be used and copied only in accordance with the licence agreement. It is against the law to copy the information and software on to any medium not specifically allowed in the licence agreement. Copyright Copyright 2006 Leadenhall VRG Pty Ltd ABN 63 007 997 248, Level 1, 31 Franklin Street Adelaide South Australia 5000, Telephone: (08) 8385 2200, Fax: (08) 8385 2299. All rights reserved. No part of the CD-ROM content or any other peripheral documents can be reproduced or transmitted in any form or by any means electronic or mechanical including photocopying and recording for any purpose without the express permission of Leadenhall VRG Pty Ltd. Australian Valuation Handbook has been produced under a licence agreement between Leadenhall VRG Pty Ltd and its publisher Thomson Legal & Regulatory Limited ABN 64 058 914 668, 100 Harris Street, Pyrmont, NSW 2009, Australia. Thomson Legal & Regulatory Limited expressly disclaims all and any contractual, tortious or other form of liability to any person (purchaser of the publication or not) in respect of the publication and any consequences arising from its use by any person in reliance upon the whole or any part of the contents of this publication. ISBN 1 86339 256 4 Use Where the product is to be installed for multiple users on a network the appropriate network version must be purchased and the appropriate licence fee paid. Users falling outside of this criteria should contact Thomson CPD for an appropriate arrangement (see attached Licence Agreement for rights to use). Please note you are entitled to make one back up copy of the product to replace the original disk(s) in the event of the disk being damaged.
MAIN MENU JUNE 2006 UPDATE #5 / Preface / Trademarks, Licence and Copyright Information / Acknowledgments Acknowledgments
We gratefully acknowledge permission to reproduce copyright material by Kelvin King of Valuation Consulting on Intangible Assets.
MAIN MENU JUNE 2006 UPDATE #5 / Preface / Trademarks, Licence and Copyright Information / Disclaimer Disclaimer
The information contained herein is sold on the understanding that it neither represents nor is intended to be advice or that the publisher or author is engaged in rendering legal or professional advice. Whilst every care has been taken in its preparation no person should act specifically on the basis of the material contained herein. If expert assistance is required competent professional advice should be
obtained. Leadenhall VRG Pty Ltd, Thomson Legal & Regulatory Limited ABN 64 058 914 668, directors and authors or any other persons involved in the preparation and distribution of this publication, expressly disclaim all and any contractual, tortious or other form of liability to any person (purchaser of the publication or not) in respect of the publication and any consequences arising from its use by any person in reliance upon the whole or any part of the contents of this publication.
ASSIGNMENT MANAGEMENT
ASSIGNMENT MANAGEMENT
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment
1~1000
Scoping a Valuation Assignment
To scope a valuation assignment involves fully exploring all facets of the assignment to be undertaken so that the end report can be prepared as efficiently as possibly, whilst at the same time providing the maximum level of utility to its users. The valuation process represents an extension of basic risk/return concepts. Therefore the higher the risk, the higher the returns required to compensate for that risk. Two cornerstones to business and company valuations are, therefore: determining the risks inherent in the business, the industry in which the business operates and the economy generally; and identifying the expected returns from that business, company or commercial enterprise (both in absolute dollars and in percentage terms).
Business and company valuations would not be the complex task that they are if the risks and returns of every business were readily understood and quantified. Every investor has their own perceptions of the appropriate level of risk that they are prepared to bear for any given level of return. As perceptions of risk and commensurate returns differ, values can differ from investor to investor. No two people in the same room will place exactly the same value on the same business. For this reason it is crucial to understand the key elements that affect a valuation when defining the scope of an assignment and in selecting the appropriate valuation method. The key elements that affect a valuation engagement include: what is being valued; the date of the valuation; the standard of value; the premise of value; the purpose of the valuation; and
the report format and type.
Issues associated with the detailed planning of a valuation assignment and the necessary qualifications and licences for those preparing valuations are discussed in the chapter Engagement and Documentation of Assignments. The challenge for the valuer is to demystify the process and to explain facts and projections clearly and precisely. In recent times, there has been a trend in public reports to disclose more and more information on the background, purpose and methodology of valuations and this can expect to continue to increase.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1050 What is Being Valued
1~1050
What is Being Valued
This may sound like a simple question, but some of the issues that need to be considered include whether one is valuing: the shares/owners equity in the business; the underlying operating business; the entire owners equity; a controlling interest; a minority interest; or a particular class of shares.
It is crucial when undertaking a valuation to determine exactly which assets and liabilities are being valued and which assets and liabilities are being excluded. Conceptually the value of an entity is the aggregate value of each of the individual business units in that entity plus the value of any surplus assets less the value of any corporate debt. This can be represented diagrammatically as follows: Entity Valuation = Sum of the Values of each Business Unit + Value of Surplus Assets Value of Corporate Debt
Once a valuation of the business units has been completed, an important consideration would be whether the value includes or excludes fixed assets, stock and debtors. Normally earnings are taken to mean profits after interest and after tax, i.e. the amount of earnings available to the equity holders. The multiple of earnings offered therefore is normally associated with the purchase of the share capital (or its equivalent). In a purchase of a company, the purchase of the share capital entitles the purchaser to the net assets (i.e. all of the assets less all of its liabilities). In a sale of assets, it is common for the vendors to settle the majority of the liabilities, except items such as accumulated employee provisions and liabilities transferring with leased items. In this situation, a purchaser may purchase all the assets from the vendor, or the non-current assets, or selected current and non-current assets, and undertake to collect items such as debtors on behalf of
the vendor. It is important, therefore, to ensure that there is consistency between the bases on which a value has been derived and the assets and liabilities taken over. For example, if a multiple of earnings before interest and tax (EBIT) is used, then interest bearing liabilities are not included as part of the assets and liabilities being valued (and thus assumed by the purchaser). Conversely, if the valuation is based on profit after tax, a price earnings ratio (PER) should be used and the value derived in this case includes the interest bearing debt (and all other assets and liabilities required for the operation of the business). Normally, if a valuation is undertaken on an EBIT basis, a transaction price is negotiated for all of the non-current assets after recognising the ongoing maintainable net working capital required in the business. The transaction could then provide for the vendor to collect its own debtors and pay off its own creditors. Inventory would normally be an added amount at the date of settlement calculated on pre-agreed bases and an offset allowed for any liabilities to be taken over by the purchaser e.g. employee provisions. For example, if Pubco has EBIT of $100, profit after tax of $45 and an appropriate PER is 12, then:
Notes: 1. 2. This assumes an ongoing maintainable working capital base and that debt is supportable without outside guarantees. This assumes an ongoing maintainable working capital base.
Thus, if the business (defined in this case as all the non-current assets) is being purchased and working capital is being added onto the purchase price, it is necessary to deduct from the calculated value the assumed level of working capital and then pay for the actual level of working capital at the time of transfer to the purchaser. Thus, in the above example, the purchase price would be $720 plus working capital as at the purchase date.
If consideration of $720 was paid for tangible assets of $580, goodwill and intangibles would be valued at $140. Note: Goodwill is the end of the calculation, not the beginning. In a small business where working capital may effectively be zero, an EBIT multiple may also calculate the value of the business excluding working capital but including plant and equipment and goodwill. This is the assumption that many purchasers and vendors make when negotiating the purchase of a business but it is not necessarily true. Legal agreements for the purchase and sale of small businesses are often written as: The value of the business (plant and equipment and goodwill) + Selected working capital items (on the day) Employee liabilities
This is primarily for ease of settlement and involves undertaking the steps outlined above to calculate the value for plant and equipment and goodwill alone. Therefore, in summary: The value of the business calculated using a PER or an EBIT multiple includes the value of plant and equipment and working capital. These must be deducted from the value calculated to determine the value of goodwill and other intangibles. It is crucial to determine which assets and liabilities are included in the sale price as the right price or value could vary considerably. In the above example the reference point for price could vary from between $420 (equity value of $540, including debt but excluding working capital of $120) to $840 (business value excluding debt, but including working capital). Goodwill is the end of the calculation not the beginning.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1050 What is Being Valued / 1~1070 The Business v. The Entity
1~1070
The Business v. The Entity
The valuation of a business lies at the core of the valuation of any entity be it a company, trust or partnership. Commonly the business will only be part of the total company/entity. Often there are additional assets and liabilities, which do not form part of the business assets and liabilties, but which nevertheless, form part of the legal entity. The diagram that follows is a useful aid to conceptualise the composition of an entity with multiple businesses.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1050 What is Being Valued / 1~1070 The Business v. The Entity / 1~1080 Diagram Company v. business valuation
1~1080
Diagram Company v. business valuation
As the above diagram demonstrates, it is important to be specific about exactly what assets and liabilities are included in the valuation of each individual business and what assets are regarded as surplus. Conceptually the value of an entity is the aggregate value of each of the individual business units in that entity plus the value of any surplus assets less the value of any corporate debt. This can be represented diagrammatically as follows: Entity Valuation = Sum of the Values of each Business Unit + Value of Surplus Assets Value of Corporate Debt
In the circumstance where there is only one business unit and there are no surplus assets or corporate debt, then the value of the entity or company will be the same as the valuation of the business unit. In valuing a company it is the shareholders equity which is being valued. The valuation of a business will commonly take one of two principal forms: valuation of the gross assets by capitalising pre-interest earnings or cash flows and then deducting total debt to arrive at a net value for the business; or valuation of net assets by capitalising post-interest earnings or cash flow.
(Valuation methodologies are discussed in detail in later chapters: income, market and asset.)
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1050 What is Being Valued / 1~1100 The Effect of Multiple Entities
1~1100
The Effect of Multiple Entities
If an entity owns more than one distinct business, those businesses should be valued separately and aggregated. It is not unusual, for example, to value a company and its operations from a number of different viewpoints and on different bases and funding arrangements in order to create a workable transaction. It is essential in such instances that one has a clear understanding of the nature of the business and the company entity in which it operates if, at the end of the exercise, one is to produce
valuations which are part of a cohesive whole.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1050 What is Being Valued / 1~1120 Controlling Interest v. Minority Interest
1~1120
Controlling Interest v. Minority Interest
If owners equity (shares in a company, units in a trust or percentage of a partnership) in a business is to be valued, it is important to identify: the proportionate relationship of the partial interest to the whole; the level of control that ownership interest will result in; whether there are any clauses or agreements limiting the transfer of the shares/units; the specific rights and obligations of that class of shares/units as compared to the other classes; and whether there are any agreements restricting the transfer of the management of the company as distinct from the ownership of the company.
The valuation of minority interests is discussed in detail in a later chapter. It is sufficient to note at this juncture that a minority interest may not be a pro rata share of the total. Specific considerations require detailed examination within this issue.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1170 Date of the Valuation
1~1170
Date of the Valuation
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1170 Date of the Valuation / 1~1190 Importance of Valuation Date
1~1190
Importance of Valuation Date
A valuation must be at a specific point in time. At any other time the value calculated may be different due to any number of factors, including the following: perception of the future economic climate; perception of the future potential of the business; willingness to buy or sell; and treatment of intervening profits and losses.
It is therefore crucial to state clearly the date at which the valuation is being performed.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1170 Date of the Valuation / 1~1210 Practicality when Preparing a Valuation
1~1210
Practicality when Preparing a Valuation
It is usually easiest to prepare a valuation based on the normal year end of the business being valued. It may then be necessary to roll forward or backward the valuation to the required transaction date. Where a transaction or settlement date is different from the date of the valuation, the valuer should
indicate clearly how adjustments should be made between the two dates.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1260 Standard of Value

1~1260
Standard of Value
A standard of value is a definition of the type of value being sought. The most common standard of value is fair market value, but there are others. It is therefore imperative that the standard of value is established before the assignment commences. The definitions of some of the more common standards follow.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1260 Standard of Value / 1~1280 Definition of Value
1~1280
Definition of Value
The Concise English Dictionary (Omega, 1985) defines value as: Worth, the desirability of a thing, esp. as compared with other things; the qualities that are the basis of this; worth estimated in money or other equivalent, the market price; the equivalent of a thing; valuation, estimation, appreciation of worth; meaning, signification, import. Some of the more salient aspects of the definition are that value represents worth estimated in money and a notion of market price. The definition also notes that value represents the worth of an item as compared with other things. This definition would suggest that the valuer should consider three main alternative valuation methods: net present value of all future cash flows to be derived from the asset (worth estimated in money); net realisable value (derived from market price); and deprival value (i.e. the net present value of the cash flows or market price forgone if one was deprived of the asset under consideration).
However, a number of alternative valuation methods or descriptions of methods and definitions are often employed.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1260 Standard of Value / 1~1320 Market Value
1~1320
Market Value
The International Valuation Standards Committee (IVSC) defines market value at paragraph 5.2 of the statement of General Valuation Concepts & Principles as follows: The estimated amount for which an asset should exchange on the date of valuation between a willing buyer and a willing seller in an arms length transaction after proper marketing wherein the parties have each acted knowledgeably, prudently, and without compulsion.
In Valuation Standard 1 (market valuation basis of valuation) the IVSC states: 3.24 A willing buyer refers to one who is motivated but not compelled to buy. This buyer is neither over-eager nor determined to buy at any price. 3.25 A willing seller is neither an over-eager or a forced seller, prepared to sell at any price, nor one prepared to hold out for a price not considered reasonable. 3.26 An arms length transaction is one between the parties that do not have a particular or special relationship (for example, parent and subsidiary companies or landlord and tenant). 3.27 After proper marketing means that the asset would be exposed to the market in the most appropriate manner to effect its disposal at the best price reasonably obtainable in accordance with the Market Value definition. 3.28 Each party acting knowledgeably and prudently presumes that both the willing buyer and willing seller are reasonably informed about the nature and characteristics of the property. 3.29 Without compulsion establishes that each party is motivated to undertake the transaction, but neither is forced or unduly coerced to complete it. At paragraph 5.5 IVSC also notes: 5.5 In some States, the legal term Fair Market Value is used synonymously with the term Market ValueThe IVSC position is that the term Market Value never requires further qualification and that all States should move towards compliance with this usage.
In Australia, the Australian Taxation Office (Tax Office) requires the market value of entities to be determined at the time of joining a consolidated tax group. The Tax Office has not defined the term market value for the purposes of consolidation. Nor does existing tax law specifically define market value. The Tax Office summarises its approach and defines market value in Part C41, page 8 of its Consolidation Reference Manual as follows: Ask what price the head company would be willing to pay for the asset based on the value it brings to the consolidated group. Assume the head company is a willing but not anxious buyer and the joining entity is a willing but not anxious seller. For a going concern, assume continuation of existing use, subject to highest and best use market value. Apply commonly accepted valuation practice consistent with the entitys situation and nature of asset and its use.
In the Tax Offices Consolidation Reference Manual, Part C4, pages 2728, this approach is further elaborated: As a result, for the purposes of consolidation, the term takes on the meaning ordinarily applied to it when used on its own without any qualifications.
Business valuers in Australia typically define market value as: The price that would be negotiated in an open and unrestricted market between a knowledgeable, willing but not anxious buyer and a knowledgeable, willing but not anxious seller acting at arms length. In the context of consolidation and setting the costs of an asset brought into the consolidated group by a joining entity, the task of establishing the market value of an asset is approached with the typical definition in mind. For this reason, it is reasonable to focus on the price a willing purchaser would have to offer a willing seller in order to persuade them to sell for a fair price. Consequently, to determine an assets market value, the question to be asked is what price would the head company be willing to offer in order to acquire the assets of the joining entity?. It would usually be expected that the head company would pay no more for the asset than the value it would add to the consolidated group given the continuation of its existing use. The approach taken by the court in Spencer v. The Commonwealth is particularly relevant to consolidation. This is because the proposed consolidation legislation focuses on the head companys cost of acquiring the joining entitys assets at the joining time. In looking to apply the concept of willing buyer and willing seller to ascertain the market value of land, Griffith CJ commented in Spencer v. The Commonwealth (1907) 5 CLR 418 at 432: In my judgment the test of value of land is to be determined, not by inquiring what price a man desiring to sell could actually have obtained for it on a given day, i.e., whether there was in fact on that day a willing buyer, but by inquiring what would a man desiring to buy the land have had to pay for it on that day to a vendor willing to sell it for a fair price but not desirous to sell? All other things being equal, the assets of a joining entity would normally be market valued on the basis of a continuation of their existing use. This continuation of existing use principle is based on the expectation that the assets of the subsidiary member will be employed in the same business for the same purpose post-consolidation as they were pre-consolidation that is, the asset will continue to be used for its existing use. The act of consolidation does not of itself result in a change in the way an asset is employed. Nor will it necessarily result in a change in the way an asset should be valued or the level of valuation. A market valuation of an asset, based on its highest and best use within an ongoing operational entity and on the understanding that there is a continuing requirement for that asset, will generally result in the greatest value for the asset. In economic terms it is assumed that generally an entity would not continue to use an asset for its existing use if that asset could realise a greater value if it were redeployed or sold, provided this did not affect the economic use of other assets dependent upon it. Consequently, it can be expected that in all circumstances all assets of the subsidiary member would be valued at their highest and best use, regardless of which market valuation method is used, as it is this value that best reflects the value the asset brings to the group joined.
Thus, where an asset is to be valued for its existing use that use can be assumed to be its highest and best use value unless circumstances indicate otherwise.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1260 Standard of Value / 1~1330 Fair Market Value
1~1330
Fair Market Value
The definition found in the International Glossary of Business Valuation Terms is: The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. Note: In Canada, the term price should be replaced with the term highest price. This assumes: a reasonable timeframe to complete the transaction; and that neither party has any special circumstances.
This is similar to the definition used in the United States of America, by the American Society of Appraisers, which is based on Revenue Ruling 5960 and is as follows: the amount at which property would change hands between a willing seller and willing buyer when neither is acting under compulsion and when both have reasonable knowledge of the facts. In the Financial Accounting Standards Boards (FASB) project on fair value measurement, the FASB has decided to tentatively revise the definition of fair value in many accounting pronouncements to refer to: the amount at which an asset or liability could be exchanged in a current transaction between knowledgeable unrelated willing parties when neither is acting under compulsion. (FASB Fair Value Measurement Project Update, 1 October 2003, <www.fasb.org/project/fv_measurement.shtml>) The FASB notes that: The definition, as revised, is similar to (but does not replace) the definition of fair market value in IRS Revenue Ruling 5960 and is intended to apply for all assets and liabilities (including financial instruments) measured at fair value. Some of the key elements included in the definition from the International Glossary of Business Valuation Terms are: buyer and seller are hypothetical; price is equivalent to both; both buyer and seller have reasonable knowledge of the business; it is an arms length transaction; settlement is for cash or cash equivalent and in local currency; and
both parties have the ability to complete the transaction.
It is to be noted that the fair market value includes settlement for 100% of the transaction in cash. Many transactions are not undertaken on this basis and thus there is a significant difference between a price at which a transaction takes place and a theoretical fair market value. This issue is discussed in more detail in the section on value and price. The definition of fair market value commonly used in Australia, as quoted by the Securities Institute of Australia is: The price that would be negotiated in an open and unrestricted market between a knowledgeable, willing but not anxious buyer and a knowledgeable, willing but not anxious seller, acting at arms length within a reasonable time frame and with neither party having any special circumstances. This definition assumes both parties have sufficient time to investigate and complete the transaction and that settlement is in full, in cash, on the day of transfer.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1260 Standard of Value / 1~1340 Investment Value
1~1340
Investment Value
This standard of value is based upon the specific value of an investment to a particular investor and is based upon that investors individual investment requirements. Reasons for investment value differing from fair market value include the particular investors: estimate of future income; perception of risk; income tax status; and expectations of synergies that can be achieved in conjunction with other operations.
Thus it is distinguished from fair market value, which is impersonal and detached. Investment value may be the appropriate standard to utilise in mergers and acquisitions involving strategic value.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1260 Standard of Value / 1~1350 Intrinsic or Fundamental Value
1~1350
Intrinsic or Fundamental Value
This standard of value, although similar to the definition used for investment value, differs in that it represents an analytical judgment of the true or real value inherent in an investment, without regard to characteristics which are important to a specific investor. Intrinsic value is based on the following fundamental factors: the value of the companys assets; the likely future interest and dividend payments; the likely future earnings; and the likely future growth rate.
It is often the value that will become fair market value when other investors reach the same
conclusion.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1260 Standard of Value / 1~1360 Fair or Compensatory Value
1~1360
Fair or Compensatory Value
This standard of value represents the amount that will compensate an owner involuntarily deprived of property. This definition is commonly used by United States courts and is often used in cases involving dissenting shareholders or oppressed minorities. The key elements in the definition are: there is generally a willing buyer; there is generally not a willing seller; and the seller will generally have less knowledge than the buyer.
In some United States jurisdictions there are specific rulings/guidelines on how items are to be treated for specific valuations (e.g. minority shareholdings in divorces).
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1260 Standard of Value / 1~1370 Other Standards of Value
1~1370
Other Standards of Value
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1260 Standard of Value / 1~1370 Other Standards of Value / Insurance value
Insurance value
This is the amount for which assets are insured and represents the cost of replacing the asset, including all incidental costs etc., in the event of a disaster.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1260 Standard of Value / 1~1370 Other Standards of Value / Book value
Book value
The amount recorded in the financial statements (usually net of provision for depreciation). It can be a revalued amount or an historical cost amount.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1260 Standard of Value / 1~1370 Other Standards of Value / Liquidation value
Liquidation value
Usually means a value representing a quick, forced sale of assets, often on the assumption that the business is no longer a going concern, and therefore relates to the total value of anticipated sale prices for individual assets separate from the business as a whole.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1260 Standard of Value / 1~1370 Other Standards of Value / Historical cost value
Historical cost value
The amount originally paid for the asset, usually net of provision for depreciation. However, unless this is a recent amount (recent depending upon the nature of the assets and the frequency with which prices for those assets change), historical cost can be meaningless as a measure of value. The use of cost-based information is often a poor surrogate for determining value. In particular, written down replacement costs do not consider the future benefits to be obtained from the asset.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1260 Standard of Value / 1~1370 Other Standards of Value / Replacement value
Replacement value
This usually means the total current replacement cost of an asset with one of equivalent technology and capacity and with a similar remaining useful life.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1260 Standard of Value / 1~1370 Other Standards of Value / Auction value
Auction value
This is usually synonymous with liquidation value as it represents the amount that might be realised from the sale of individual assets divorced from the business in a fire sale manner.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1260 Standard of Value / 1~1370 Other Standards of Value / Asset value
Asset value
Essentially the same as liquidation value.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1260 Standard of Value / 1~1370 Other Standards of Value / Going concern value
Going concern value
Means the value of a business encompassing all of its assets, both tangible and intangible, as a going concern. This is the most common basis upon which business valuations are prepared and can encompass a number of different valuation methodologies (e.g. capitalisation of earnings, discounted cash flows, deprival value etc.).
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1260 Standard of Value / 1~1370 Other Standards of Value / Net present
value
Net present value
Net present value refers to the discounted amount of all future cash flows including capital expenditure and the initial investment.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1260 Standard of Value / 1~1370 Other Standards of Value / Deprival value
Deprival value
This is the amount that an organisation would need to expend to replace the remaining service potential embodied in an asset if an organisation were deprived of that asset.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1260 Standard of Value / 1~1370 Other Standards of Value / Other common definitions of value
Other common definitions of value
Some additional definitions of value commonly used in the United States are: Acquisition value: the propertys worth to a specific, individual buyer. Use value: the propertys value in a specified use (which may differ from the current one). Owner value: the propertys value to its current owner in its current use (which may be substantially different from what the property may be worth to any other particular buyer, to any other user or to the marketplace in general). Insurable value: the propertys value for insurance purposes (usually based on some relationship to the replacement cost of assets). Collateral value: the amount a creditor would be willing to loan against the property. Ad valorem value: the propertys value for tax purposes. Contributory value: the propertys value to the owner of a specified other property that could be operated in conjunction with it.
Refer to the section on references.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1260 Standard of Value / 1~1380 Comparison of Key Assumptions
1~1380
Comparison of Key Assumptions

International International North America
Below is a comparison of the various standards of value used internationally.

Jurisdiction Organisation USA USA FASB Concepts Statement 7 Australia Securities Institute Australia AASB 1010, 1013, 1015 & 1041 Australia AASB 3, 116, 136, 138
IVSC
IVSC
International Revenue Ruling Glossary 5960
Jurisdiction Organisation
International International
North America
USA
USA FASB Concepts Statement 7 Fair value
Australia Securities Institute
Australia AASB 1010, 1013, 1015 & 1041 Fair value
Australia AASB 3, 116, 136, 138
IVSC
IVSC
Definition
Market value
Fair value
Fair market value
Fair market value
Fair market value
Fair value
The Consideration The estimated amount In terms of cash equivalents On the date of valuation The Asset An asset should exchange Highest and best use Yes10
Yes1
Yes2
Yes3
Yes4
Yes5
Yes6
Yes7
Yes8
Yes9 Assumed Assumed Yes11
Assumed Assumed
Yes12 Assumed20
Yes13
Yes14
Yes15
Yes16
Yes17
Yes 18
Yes19 Not necessarily22a
Yes21
Yes22
The Market After proper marketing Yes23 Open and unrestricted market Reasonable timeframe to complete the transaction Active and liquid market The Parties Hypothetical Yes37 Willing Able Yes42 Yes43 Yes44 Yes50 Assumed38 Yes45 Yes51 No39 Yes46 No40 Yes48 No41 Yes49 Not necessarily24 Assumed25 Not necessarily29
Yes26 Assumed31
Yes27
Yes28
Yes30
Yes32
Not necessarily33 Yes34 Assumed35 Assumed 36
Assumed Yes47
Jurisdiction Organisation
International International
North America
USA
USA FASB Concepts Statement 7
Australia Securities Institute
Australia AASB 1010, 1013, 1015 & 1041
Australia AASB 3, 116, 136, 138
IVSC
IVSC
Acting knowledgeably and prudently At arms length Without compulsion With no special circumstances
Yes52 Yes59 Yes65
Yes53 Yes60 No66
Yes54 Yes61 Yes67
Yes55
Assumed
Yes56 Yes62
Yes57 Yes63 Assumed71
Yes58 Yes64
Yes68
Yes69
Yes70
No72
Assumed73 Assumed
Assumed74
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19.
The estimated amount IVSC Standards 2001 Concepts & Principles, Para 5.2. The amount IVSC Standards 2001 Glossary of Terms, Fair Value. The price or, in Canada, the highest price International Glossary of Business Valuation Terms, Fair Market Value. The price USA Revenue Ruling 5960. The amount glossary to Concept Statement 7 & SFAS 142 Appendix F. The price Security Institute Course Notes E102 Applied Valuations. The amount AASB 1041, Para 9.1. 'The amount' AASB 116, Para 6, Definitions. In terms of cash equivalents International Glossary of Business Valuation Terms, Fair Market Value. On the date of valuation IVSC Standards 2001 Concepts & Principles, Para 5.2. In a current transaction Glossary to Concept Statement 7 and SFAS 142 Appendix F. Should exchange IVSC Standards 2001 Concepts & Principles, Para 5.2. An asset could be exchanged, or a liability settled IVSC Standards 2001 Glossary of Terms, Fair Value. Would change hands International Glossary of Business Valuation Terms, Fair Market Value. Would change hands USA Revenue Ruling 5960. At which that asset (or liability) could be bought (or incurred) or sold (or settled) Glossary to Concept Statement 7 and SFAS 142 Appendix F. That would be negotiated Securities Institute Course Notes E102 Applied Valuations. For which an asset could be exchanged, or a liability settled AASB 1041, Para 9.1. For which an asset could be exchanged AASB 116, Para 6, Definitions.
20. 21.
The concept of highest and best use is a fundamental and integral part of Market Value estimates IVSC Standards 2001 Concepts & Principles, Para 6.7. The buyer of an asset (or the entity assuming that a liability) will put the item to its highest and best use Understanding the Issues Measuring Fair Value, Financial Accounting Standards Board Staff Paper, June 2001, Volume 3, Series 1. an assets fair value is measured having regard to the highest and best use of the assets for which market participants would be prepared to pay AASB 1041, Para 5.16.
22.
22a. AASB 136 allows an asset to be tested for impairment on a value in use basis. Value in use may not necessarily approximate the valuation from highest and best use. 23. 24. After proper marketing IVSC Standards 2001 Concepts & Principles, Para 5.2. The definition anticipates a sale which may occur in different circumstances and in conditions other than those prevailing in the (open) market for the normal, orderly disposition of assets. These include the possibility of a sale under short-term distress situations or other circumstances not contemplated in the Market Value definition IVSC Standards 2001 Glossary of Terms, Fair Value. Assumed, based on open and unrestricted market, when neither is under compulsion to buy or sell International Glossary of Business Valuation Terms, Fair Market Value. Other than in a forced or liquidation sale Glossary to Concept Statement 7 and SFAS 142 Appendix F. Based on the assumptions that the entity is a going concern and that the asset is sold after an adequate period of marketing, having regard to the highest and best use per AASB 1041 Para 5.1.6. The concept of Market Value reflects the collective perceptions and actions of a market IVSC Standards 2001 Glossary of Terms, Market Value. The definition anticipates a sale which may occur in different circumstances and in conditions other than those prevailing in the (open) market for the normal, orderly disposition of assets. These include the possibility of a sale under short-term distress situations or other circumstances not contemplated in the Market Value definition IVSC Standards 2001 Glossary of Terms, Fair Value. In an open and unrestricted market International Glossary of Business Valuation Terms, Fair Market Value. Other than in a forced or liquidation sale Glossary to Concept Statement 7 and SFAS 142 Appendix F. In an open and unrestricted market Securities Institute Course Notes E102 Applied Valuations. The definition anticipates a sale which may occur in different circumstances and in conditions other than those prevailing in the (open) market for the normal, orderly disposition of assets. These include the possibility of a sale under short-term distress situations or other circumstances not contemplated in the Market Value definition IVSC Standards 2001 Glossary of Terms, Fair Value. Within a reasonable timeframe Securities Institute Course Notes E102 Applied Valuations. If an active and liquid market is available, the price in that market represents best evidence of fair value per AASB 1041 Para 5.1.7. Ifan asset is traded in an active market, fair valueis the asset's market priceThe appropriate market price is usually the current bid price. When current bid prices are unavailable, the price of the most recent transaction may provide a basis from which to estimate fair value... AASB 136, Para 26. Hypotheticalbuyer and a hypotheticalseller International Glossary of Business Valuation Terms, Fair Market Value. Court decisions frequently statehypothetical buyer and seller USA Revenue Ruling 5960. Based on other language in the pronouncement which allows crediting values for synergies to the reporting unit and to the company to which it belongs, we can infer that the parties are, in fact, identifiable. Valuation for Impairment Testing, Mercer Capital, page 12. For further information, refer to the article in the January/February 2002 issue of Valuation Strategies entitled Goodwill Hunting by Travis W Harms and Andrew K Gibbs, which discusses the definition of fair value. It is also accessible from the web site <www.mercercapital.com>. For which market participants would be prepared to pay AASB 1041, Para 5.16.
25. 26. 27. 28. 29.
30. 31. 32. 33.
34. 35. 36.
37. 38. 39.
40.
41. 42. 43. 44. 45. 46. 47. 48. 49. 50. 51. 52. 53. 54. 55. 56. 57. 58. 59. 60. 61. 62. 63. 64. 65. 66.
Willing parties in an arms length transaction AASB 116, Para 6, Definitions. Willing buyer and a willing seller IVSC Standards 2001 Concepts & Principles, Para 5.2. Willing IVSC Standards 2001 Glossary of Terms, Fair Value. Willingbuyer and awillingseller International Glossary of Business Valuation Terms, Fair Market Value. Willing buyer and a willing seller USA Revenue Ruling 5960. Between willing parties Glossary to Concept Statement 7 and SFAS 142 Appendix F. Willingbuyer and awillingseller Securities Institute Course Notes E102 Applied Valuations. Between knowledgeable, willing parties AASB 1041, Para 9.1. Between knowledgeable, willing parties AASB 116, Para 6, Definitions. Able buyer andable seller International Glossary of Business Valuation Terms, Fair Market Value. Court decisions frequently statebuyer and seller are assumed to be able USA Revenue Ruling 5960. Each acting knowledgeably, prudently IVSC Standards 2001 Concepts & Principles, Para 5.2. Knowledgeable IVSC Standards 2001 Glossary of Terms, Fair Value. When both have reasonable knowledge of the relevant facts International Glossary of Business Valuation Terms, Fair Market Value. Both parties having reasonable knowledge of relevant facts and Court decisions frequently statebuyer and seller arewell informed about the property and concerning the market for such property USA Revenue Ruling 5960. A knowledgeablebuyer and a knowledgeableseller Securities Institute Course Notes E102 Applied Valuations. Between knowledgeable, willing parties AASB 1041, Para 9.1. Between knowledgeable, willing parties AASB 116, Para 6, Definitions. In an arms-length transaction IVSC Standards 2001 Concepts & Principles, Para 5.2. In an arms-length transaction IVSC Standards 2001 Glossary of Terms, Fair Value. Acting at arms-length International Glossary of Business Valuation Terms, Fair Market Value. Acting at arms-length Securities Institute Course Notes E102 Applied Valuations. In an arms length transaction AASB 1041, Para 9.1. In an arms length transaction AASB 116, Para 6, Definitions. Without compulsion IVSC Standards 2001 Concepts & Principles, Para 5.2. The definition anticipates a sale which may occur in different circumstances and in conditions other than those prevailing in the (open) market for the normal, orderly disposition of assets. These include the possibility of a sale under short-term distress situations or other circumstances not contemplated in the Market Value definition IVSC Standards 2001 Glossary of Terms, Fair Value. When neither is under compulsion to buy or sell International Glossary of Business Valuation Terms, Fair Market Value. Not under any compulsion to buy andnot under any compulsion to sell USA Revenue Ruling 5960. Other than in a forced or liquidation sale Glossary to Concept Statement 7 and SFAS 142 Appendix F.
67. 68. 69.
70. 71. 72.
But a not anxious buyer and anot anxious seller Securities Institute Course Notes E102 Applied Valuations. Based on the assumptions that the entity is a going concern and that the asset is sold after an adequate period of marketing, having regard to the highest and best use per AASB 1041 Para 5.1.6. The definition anticipates a sale which may occur in different circumstances and in conditions other than those prevailing in the (open) market for the normal, orderly disposition of assets. These include the possibility of a sale under short-term distress situations or other circumstances not contemplated in the Market Value definition IVSC Standards 2001 Glossary of Terms, Fair Value. The course notes published by the Australian Securities Institute state that the definition of fair market value should ignore any special value or synergies Securities Institute Course Notes E102 Applied Valuations. Based on the assumptions that the entity is a going concern and that the asset is sold after an adequate period of marketing, having regard to the highest and best use per AASB 1041 Para 5.1.6.
73. 74.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1260 Standard of Value / 1~1390 Value and Price
1~1390
Value and Price
Throughout this text we make references to the differences between price and value. There is an important distinction between the two which is critical to understand. Value, like beauty, is in the eye of the beholder. Accordingly, the asking price of a vendor may not represent value to a buyer. Furthermore, the asking price of a vendor may not be the amount at which the vendor actually sells (the traded price). Valuations prepared by the buyer and seller of a business will most likely arrive at different figures. It is only if the acceptable range of values determined by each of the buyer and seller overlap, that a deal might be finalised.
In undertaking valuations it can be instructive to assess whether there may be special circumstances which affect the price and value of a business. For example, the holder of a controlling shareholding in a listed public company may be interested in disposing of their shareholding. The value of the controlling parcel as a whole is likely to be higher than the value of small parcels of that holding as the controlling holding may be able to influence the composition of the board and therefore the operations of the company. Accordingly, the price the vendor places on their controlling shareholding may not represent value to smaller shareholders
wishing to buy blocks of 100 shares of $1 each. Similarly, if there is no buyer for the controlling shareholding as a whole, the price asked by the vendor may fall to reflect the absence of a willing but not anxious buyer of the controlling shareholding. There may be many willing but not anxious buyers of small parcels but not of a larger shareholding. Given all of the factors that ultimately determine value, there will always be differences of opinion on the weighting to be assigned to any given factor in any situation. Not only do investors perceptions of risks vary, expectations as to future returns also vary. In the context of valuations, projections of sales, cost of sales, overhead expenses, capital expenditure and other financial estimates are just that: estimates only. Few of these estimates, in todays volatile economic climate, can be made with a high degree of certainty. The lower the certainty, the higher the risk; the higher the risk, the higher the returns required which in turn translates to lower asset valuations.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1260 Standard of Value / 1~1390 Value and Price / 1~1400 Reasons for difference in price and value
1~1400
Reasons for difference in price and value
It is important to understand the distinction between price and value. There may be many reasons why a transaction takes place at a price markedly different from the value of an asset (e.g. a forced fire sale; an unknowledgeable party; shares in a thinly traded company). Following are some examples of why price and value may differ: Very few corporate transactions take place on the basis of 100% cash on the day of settlement. Most corporate transactions will include one or more of the following elements: conditional payments subject to the achievement of certain milestones; payment over a period of time; and consideration other than cash.
The accounting and tax treatments of the buyer and seller may be different. This mismatch may drive one party to allocate the purchase consideration in a more or less advantageous manner than the seller would expect, all other things being equal. The seller and buyer may have different perceptions of risk and/or expected returns. In most commercial transactions, the parties try to maximise their upside whilst minimising their downside. If there are different perceptions of risk and return then there is scope for the price to move away from an independent arms length determined value. The financial position of one or other parties may not be willing but not anxious so much so that price may be driven away from any concept of value because of the economic realities of the situation. The transaction takes place in a competitive environment and under changing economic circumstances, different parties will have differing perceptions of the future and differing levels of knowledge of the industry. The self-interest of the negotiating parties will also affect the final price. The buyer may have a
strong desire to complete the transaction to eliminate competition and/or to achieve economies of scale. The synergies that can be achieved if the business is merged with another.
All of the above scenarios illustrate why transactions can take place at a price significantly different from the calculated value. That is not to say that the value itself was not correctly assessed it is more to emphasise the importance of interpreting the value for the particular purpose for which it is being used. With a skilled negotiator of transactions, the use of those assumptions and interpretations in a competitive context, can deliver added shareholder value to the corporation being represented.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1450 Premise of Value

1~1450
Premise of Value
All businesses or interests in businesses may be valued by at least one of the following alternative premises of value. Each premise of value may result in a different value.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1450 Premise of Value / 1~1470 Effect of State of Business on Premises of Value
1~1470
Effect of State of Business on Premises of Value
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1450 Premise of Value / 1~1470 Effect of State of Business on Premises of Value / 1~1480 Going concern
1~1480
Going concern
This premise of value means the business is being valued as a viable operating entity. It is based on the assumption that the value of the whole will be greater than the sum of the value of the individual components.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1450 Premise of Value / 1~1470 Effect of State of Business on Premises of Value / 1~1490 Assemblage of assets
1~1490
Assemblage of assets
This premise covers the value of the assets, in place, as part of a mass assemblage of assets, but not in current use in the production of income or as part of a going concern business.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1450 Premise of Value / 1~1470 Effect of State of Business on Premises of Value / 1~1500 Orderly disposal
1~1500
Orderly disposal
This premise of value means the business is being valued by the net amount that can be realised if the business is terminated and the assets sold off individually over a reasonable time frame to achieve
the highest possible price for each.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1450 Premise of Value / 1~1470 Effect of State of Business on Premises of Value / 1~1510 Forced liquidation
1~1510
Forced liquidation
This premise of value means the business is being valued by the net amount that can be realised if the business is terminated and the assets sold off as quickly as possible (i.e. by auction).
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1450 Premise of Value / 1~1530 Effect of Ownership Characteristics on Premises of Value
1~1530
Effect of Ownership Characteristics on Premises of Value
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1450 Premise of Value / 1~1530 Effect of Ownership Characteristics on Premises of Value / 1~1540 Controlling v. minority
1~1540
Controlling v. minority
The degree of control may be a significant determining factor in a valuation. Control v Minority refers to the ability of the owner to impact cash flow distribution [or the direction of company]. It is extremely important to identify the value which is produced (either a control value or a minority interest value) from a particular valuation method. This is necessary to determine whether a discount or premium should be applied to the value indicated by a particular method. Refer to the section on references.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1450 Premise of Value / 1~1530 Effect of Ownership Characteristics on Premises of Value / 1~1550 Degree of marketability
1~1550
Degree of marketability
A fully tradeable stock is marketable. Therefore the Degree of Marketability or restrictions to transfer can impact value. It is extremely important to also identify whether the value which is produced by a particular method is a marketable or non-marketable value. This will determine whether a discount or a premium should be applied to the value indicated by a particular method. Refer to the section on references.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1450 Premise of Value / 1~1530 Effect of Ownership Characteristics on Premises of Value / 1~1560 Equity v. invested capital
1~1560
Equity v. invested capital
This premise determines whether equity needs to be valued directly or whether the Capital of the enterprise is to be valued without regard to a specific equity component... There may be situations where one needs to value a company on an invested capital basis, instead of valuing equity directly. Those situations include: extremely leveraged companies; complex capital structures; where industry value drivers are based on invested capital measures [e.g. multiples of revenue].
When valuing utilising the invested capital methodology, some modifications to the valuation process made [include]: adding the market value of the guideline company equity to the market value of the guideline company interest bearing debt; earnings or net cash flows should be adjusted for interest expenses (net of tax, if utilising an after tax basis); once the value of the invested capital is determined, the market value of the debt is deducted to obtain the market value of the equity.
Refer to the section on references.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1610 Purpose of the Valuation
1~1610
Purpose of the Valuation
It is tempting to launch quickly into valuation work, but, with the exception of the simplest of valuations, one will save much time and trouble and produce a better valuation, if time is spent on some introductory and preparatory issues. This not only includes collecting the information set out in the section on information requirements, but also in understanding the dynamics of a business and the inter-relationships of the units of the company/entity being valued and its owners.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1610 Purpose of the Valuation / 1~1630 For Whom is the Valuation being Prepared
1~1630
For Whom is the Valuation being Prepared
In determining why a valuation is required it is essential to understand from whose viewpoint one is undertaking the valuation. In this respect, an answer to the question why? that does not also answer the question for whom? and for what purpose? is probably the wrong answer. Understanding the circumstances of a valuation is fundamental. There may be particular statutory requirements which in turn will impact upon the scope, standard and premise of value. There may be specific agreements which will have predetermined requirements for how a particular item is to be treated. These requirements may or may not be in accordance with best valuation practice but if the valuation must be undertaken in accordance with a particular requirement, those requirements cannot
therefore be ignored. It is essential to understand all of the governing requirements, both statutory and client. In addition to the constitutional documents of the company, consideration should also be given to shareholder agreements and any employment contracts which can affect the valuation of the securities or interests in a business. It is not uncommon for company constitutional documents to be imprecise or contradictory in their requirements for valuations. If this is the case, then the overall scope of the assignment and the date, standard and premise of value being used should be clearly set out in the valuation report. If necessary, it may be appropriate to provide an alternative valuation using alternative assumptions in addition to any sensitivity analysis which might ordinarily be undertaken, for example, if a companys constitutional documents require the use of a specific price earnings multiple it may be unclear as to whether this should be applied to post, present or future earnings. In this circumstance it would be prudent to compare the values calculated with the value calculated using a discounted cash flow analysis. There are often specific legislative requirements which impact for whom an experts report is being prepared. A good valuation report is one which somebody else can replicate using their own alternative assumptions.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1610 Purpose of the Valuation / 1~1650 For What Purpose is a Valuation Being Prepared
1~1650
For What Purpose is a Valuation Being Prepared
This section highlights some of the more common circumstances that give rise to the need for a valuation. It does not pretend to be all inclusive. For example, we have not specifically addressed circumstances such as state taxes or insurance compensation. However, the principles remain the same. The need for a valuation of a business, company or some other commercial enterprise arises in a multiplicity of circumstances. These can include: sale of a company/business; public listing of a company; corporatisation; privatisation; purchase of a company/business; dissolutions; share buy-backs; disputes and litigation (experts reports for the courts); obtaining finance; tax considerations;
employee share schemes; accounting standards; and statutory requirements.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1610 Purpose of the Valuation / 1~1650 For What Purpose is a Valuation Being Prepared / 1~1660 Sale of a company/business
1~1660
Sale of a company/business
A common application of a business valuation is in the determination of a price range at which a business sale is sought. Many transactions involving the sale or purchase of a business are achieved by the purchase or sale of shares in a company. The value of the total share capital of the company may differ from the value of the business on a stand-alone basis. This can occur for a number of reasons, including: the existence of assets in the company which are unrelated to the conduct of the business; liabilities relating to assets not used in the business; and differing taxation circumstances between ownership of business assets and ownership of company shares, etc.
If the sale of a business is going to be achieved partly or wholly by the provision of vendor finance or by taking up shares in the purchaser, there may well be the need for two assessments, one of the business that is being sold and one of the company/business to which the vendor finance is to be provided or by which the shares will be issued. All too frequently vendors undertake detailed assessments of the value of their own business, but fail to assess adequately the value of the consideration which will be paid to them, by way of shares or of the terms and conditions of vendor finance. The failure to value adequately the consideration being paid for the sale of the business, represents a major downfall in the analysis of the transaction from the vendors point of view.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1610 Purpose of the Valuation / 1~1650 For What Purpose is a Valuation Being Prepared / 1~1670 Public listing of a company
1~1670
Public listing of a company
Listing a company on the stock exchange often occurs contemporaneously with an equity raising. The price at which the new and existing equity is listed is critical. Underwriters to the equity raising need to be satisfied that they will be able to find subscribers to the new equity and not be left holding a large percentage of the company themselves. Likewise, the price at which the issue is pitched must be sufficient to encourage investors to take up the issue whilst not giving away too much of the original shareholders interests. As indicated at the beginning of this chapter, price and value are rarely synonymous. The markets perception of a new listings value may be quite different to the price at which the issue is pitched. The mechanisms by which a new issue is priced are quite varied. There are no standard or set
formulas. The pricing is a combination of balancing the desire to raise as much money as cheaply as possible on the one hand and the desire on the other hand to ensure that there will be market support for the companys securities on issue. It is important, therefore, to evaluate the key components of current and expected earnings per share, dividend pay outs, dividend yields, net tangible assets per share and the price earnings ratio. These indicators for the company are then balanced against the market as a whole and other comparable listed companies. The valuation of the operating entities within the company is of critical importance in order to derive the expected ratios after listing.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1610 Purpose of the Valuation / 1~1650 For What Purpose is a Valuation Being Prepared / 1~1680 Corporatisation
1~1680
Corporatisation
One of the features of public sector reform in recent years has been the corporatisation of government owned business enterprises. The focus of corporatisation is the introduction of commercial practices, board accountabilities and explicit owner/manager (agency) relationships. In corporatising a public sector agency, many of the valuation issues ordinarily confronted in a sale are encountered. One model of corporatisation results in the establishment of an incorporated entity and the acquisition by the corporate of the commercial assets of the former department or agency. In order to establish a commercial starting point for the new corporate entity, the transaction (sale and purchase of assets) is normally conducted on an arms length and commercial basis. Frequently this gives rise to consideration of a number of issues which are not normally encountered by the public sector agency, including: the effect and incidence of taxes; explicit identification, quantification and funding arrangements of community service obligations delivered by the agency on behalf of government; the recognition that existing assets may be over-capacity, under-utilised or otherwise sub-optimally configured; and recognition of differences between estimates of the fair market value of assets and businesses and their actual written down replacement costs.
For many of the agencies which become corporatised the framework which is put in place at the commencement of the corporate will give rise to the basis for future pricing, asset replacement, outsourcing and other decisions. Thus, the importance of getting the valuation issues right is paramount.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1610 Purpose of the Valuation / 1~1650 For What Purpose is a Valuation Being Prepared / 1~1690 Privatisation
1~1690
Privatisation
The privatisation of publicly listed companies requires the determination of value.

Many publicly listed companies retain a single family or business group as a dominant shareholder. Commonly, sufficient equity is raised to fund the expansion prospects of the company but not so as to dilute the controlling interest below 50%. The stock market liquidity of companies not classified as blue chip is, typically, very low. Low liquidity in turn, results in depressed share market prices for many public companies. This frequently inhibits future equity raisings and any refinancing capabilities. Privatisation of a public venture typically takes place by either: a takeover bid for the outstanding shares; the issue of shares to the public by way of an initial public offer (IPO); or the purchase of the operating entity/entities from their public ownership.
Privatisation of public sector enterprises has increased in recent years and raised the profile of valuations of those enterprises. The recent dissension amongst commentators and valuers regarding the likely value for equity raisings highlights the need for expert valuations of public sector entities. One of the major issues arising in undertaking public sector valuations is the marked difference between the required rate of return of the public sector (ignoring the opportunity cost of public sector funds) and the required rate of return of the investing public generally. Confusing the two different rates of returns results in significantly different valuations. Public sector managers should not overlook these differences when considering the prices which assets may realise in a market place (which is a private sector market).
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1610 Purpose of the Valuation / 1~1650 For What Purpose is a Valuation Being Prepared / 1~1700 Purchase of a company/business
1~1700
Purchase of a company/business
The issues involved in conducting a valuation for the purposes of a company or business acquisition represent the flip side of those which prevail when selling out as a going concern. However, if the acquisition is a hostile take-over, there will be limited access to the necessary data to arrive at a sound valuation. This represents a risk to the buyer which must be weighed up prior to making the offer to the target. Typically, an acquisition does not proceed purely on the basis of a valuation document, but is supported by detailed cash flows that extend for a period of at least five years after the expected date of acquisition. Detailed sensitivity analyses are also conducted to test the sustainability of cash flows and profits under certain best and worst case scenarios. The capacity to fund the acquisition is a crucial consideration and will have a bearing on the value of the acquisition candidate. For example, a wholly debt funded purchase can only occur when there is little volatility in the profitability and cash flow of the target company. A business valuation involves not only the financial modelling of the numbers but also an in-depth assessment of the quality of earnings and the reasons for the past and expected future results. It is often said that whether or not a business combination is desirable may not be negotiable, the price
of a transaction is always negotiable. In other words, price is (relatively) irrelevant, unless an opportunistic asset-strip style of acquisition is sought.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1610 Purpose of the Valuation / 1~1650 For What Purpose is a Valuation Being Prepared / 1~1710 Dissolutions
1~1710
Dissolutions
It is not uncommon to find that a disagreement between partners or joint shareholders in a private company results in one or other partner being bought out or dissolution of the business/company as a resolution of the dispute. In such circumstances the valuation is a key document in the resolution of the dispute. In the event that the partners of the business take over elements of the previous operation, the determined value of the components of the business is also important. Alternatively liquidation of the entity may be necessary due to retirement or family dispute or marriage break-up. In these cases a liquidation or net asset valuation basis may be appropriate.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1610 Purpose of the Valuation / 1~1650 For What Purpose is a Valuation Being Prepared / 1~1720 Share buy-backs
1~1720
Share buy-backs
Whilst not all share buy-backs are required to be supported by a valuation, the fiduciary duties of directors would normally dictate that a valuation be obtained prior to recommending to shareholders that a share buy-back be undertaken.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1610 Purpose of the Valuation / 1~1650 For What Purpose is a Valuation Being Prepared / 1~1730 Disputes and litigation (expert reports for the courts)
1~1730
Disputes and litigation (expert reports for the courts)
The need for a valuation of shares in private companies also arises where there are a number of shareholders and a dispute arises under pre-emptive rights provisions calling for an arbitrator to determine the value of the shares. Most private companies have pre-emptive rights provisions in their articles. It is not uncommon for those pre-emptive rights provisions to provide that in the absence of a dispute the value of shares should be determined by a nominated mechanism. Some private company articles go further and also set out other restrictions. These can have a material bearing on the method of valuation and on the value of the shares.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1610 Purpose of the Valuation / 1~1650 For What Purpose is a Valuation Being Prepared / 1~1740 Obtaining finance
1~1740
Obtaining finance
Whilst recessionary jitters cause traditional debt providers to rely increasingly on hard assets, a competent valuation of a business or company can sometimes provide a potential lender with sufficient evidence for them to proceed. An increased focus on the balance sheet by lenders means that a valuation will sometimes reveal deficiencies in generally accepted accounting principles. Assets can often be significantly understated. These can include brand names, trade marks, land and buildings, and contractual rights such as management agreements and restrictive covenants. The trend in accounting standards suggests that the balance sheet is becoming a more reliable source of information about value. However, there is a long way to go before the balance sheet becomes a statement (sheet) of values (as opposed to a sheet of balances). As assets may be significantly understated, it is important to undertake a business valuation to identify the core business and its specific attributes. The valuation can assist with the negotiation of additional finance and provide a basis for imaginative structuring and financial engineering. In obtaining finance there are always risks risks can be fairly mild to quite major and can involve not only business but also political, geographic and other risks. An entrepreneur is always trying to maximise returns; generally speaking the more debt orientated the finance is, the greater the potential return, and the greater the risk if something goes wrong. The nature of the returns and risks therefore need to be understood. A financier cannot make an informed investment decision without some firm well reasoned data and part of that comes from the work on business valuations. The business is worth a reciprocal of the returns it can deliver. The magnitude of that reciprocal is a function of the risks faced.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1610 Purpose of the Valuation / 1~1650 For What Purpose is a Valuation Being Prepared / 1~1750 Tax considerations
1~1750
Tax considerations
There are a number of instances when shares (or an interest in a business venture) need to be valued for tax purposes. If a company is listed, the prices at which shares are bought and sold on the stock exchange is the normal basis for assessing any taxes on the transfer of shares. For private companies there is no such market. Thus shares need to be valued to determine the tax payment on the transfer of those shares. The following transactions give rise to valuation issues as a result of the provisions of the Income Tax Assessment Act 1936 (ITAA 1936) and the Income Tax Assessment Act 1997 (ITAA 1997): Tax Consolidation of Groups For the purposes of the Tax Consolidation Regime, market valuations will primarily be required for the following key purposes:
to determine new tax costs for the assets of a joining entity, and the cost base of membership interests in a leaving entity (the cost setting process); and to calculate the amount of a loss transferred from a joining entity that can be utilised by a head company.
Non-arms length transfer Where part of a business, an asset or intellectual property is sold or transferred between non-arms length parties it may be appropriate to establish the fair market value of that property. This will be necessary in order to calculate any tax payable (or claimable) on the gain (loss) and for the acquiring company to establishing a cost base. The Tax Consolidation Regime is expected to reduce the number of instances where this may occur.
Partial sale of a business Where part of a business is sold it may be necessary to value the business sold as at the date it was initially acquired in order to determine the proportion of the cost base that should be allocated to the component of the business that has been sold.
Partial sale of a small business Where part of a business is sold it may be necessary to value the business to determine if the total combined business is worth not more than $5 million as required by the maximum net asset value test within the small business relief provisions of section 15215 of the ITAA 1997.
Residents ceasing to be residents and non-residents becoming residents Where there is a change in residential status, section 160M(8)(15) of the ITAA 1936 states that assets that are non-taxable Australian assets are deemed either to have been disposed of or acquired for market value. Cessation of residence is treated as a deemed disposal, and becoming a resident is treated as a deemed acquisition.
Death after 19 September 1985 and assets acquired on or before that date Where the deceased died after 19 September 1985 and the deceased acquired the asset on or before that date, sections 160X(5) and 160ZN(1)(b) of the ITAA 1936 state that the legal personal representative or beneficiary will be deemed to have acquired the asset for the market value of the asset at the date of death.
Assets bequeathed to a tax exempt person Section 160Y of the ITAA 1936 requires that where an asset is bequeathed to a tax exempt person, it is treated as a disposal by the deceased for its market value at the date of death.
Realisation of traditional securities Gains on the disposal of traditional securities acquired after 10 May 1989 are assessable under section 26BB of the ITAA 1936. Section 70B provides that a loss on disposal may be an allowable deduction. Where the parties are not dealing at arms length, the Commissioner may substitute an arms length consideration or, if that cannot be determined, some other amount (section 70B(3)). A discounted cash flow analysis should be used where there is no established market and the discount rate should reflect the return and risk specific to the circumstances (TR 96/14).
It is not uncommon for key directors and employees of companies to be given small shareholdings to
cement their loyalty and encourage greater productivity. In this situation if a director or executive is given shares, the shares may have to be valued so that they can be included with other remuneration and taxed appropriately. An alternative could be to grant options, which at the time of their issue have no intrinsic value, so that any tax considerations can be deferred until, and if, the options are exercised. It should be noted that in many countries there may be specific rules for the valuation of options for taxation purposes.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1610 Purpose of the Valuation / 1~1650 For What Purpose is a Valuation Being Prepared / 1~1760 Employee share schemes
1~1760
Employee share schemes
Employees may be involved in a share transaction, and it is necessary in such instances to have a fair valuation. Whilst most employee share schemes are governed by a trust deed, which clearly sets out the rights and obligations of the employees and the employer, the valuation of shares held by an employee share scheme in a private company can become complex. It is in the interests of both employee and employer to ensure that a fair valuation is arrived at in the event of employee terminations.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1610 Purpose of the Valuation / 1~1650 For What Purpose is a Valuation Being Prepared / 1~1770 Accounting standards
1~1770
Accounting standards
In many countries the valuation of assets (including intangibles) is now required regularly for accounting purposes, particularly in the following circumstances: business combinations (purchase price allocation to intangible assets); and impairment testing.
The following requirements are pertinent to Australia.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1610 Purpose of the Valuation / 1~1650 For What Purpose is a Valuation Being Prepared / 1~1770 Accounting standards / Business combinations
Business combinations
When a business is purchased or restructured, Accounting Standards AASB 3 and 138 come into effect. These standards require all tangible and identifiable intangible assets to be brought to account separately from goodwill. The following extracts from AASB 3 specify how the purchase consideration is to be allocated across multiple assets: The acquirer shall, at the acquisition date, allocate the cost of a business combination by recognising the acquirees identifiable assets, liabilities and contingent liabilities that satisfy the recognition criteria in paragraph 37 at their fair values at that date. (paragraph
36) Paragraph 51 reads: The acquirer shall, at the acquisition date: (a) (b) recognise goodwill acquired in a business combination as an asset; and initially measure that goodwill at its cost, being the excess of the cost of the business combination over the acquirers interest in the net fair value of the identifiable assets, liabilities and contingent liabilities recognised in accordance with paragraph 36.
Further, paragraph 45 states: In accordance with paragraph 37, the acquirer recognises separately an intangible asset of the acquiree at the acquisition date only if it meets the definition of an intangible asset in AASB 138: Intangible Assets and its fair value can be measured reliably. Paragraph 46 reads: A non-monetary asset without physical substance must be identifiable to meet the definition of an intangible asset. In accordance with AASB 138, an asset meets the identifiability criterion in the definition of an intangible asset only if it: (a) is separable, that is, capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, asset or liability; or arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations.
(b)
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1610 Purpose of the Valuation / 1~1650 For What Purpose is a Valuation Being Prepared / 1~1770 Accounting standards / Impairment testing
Impairment testing
It may also be necessary to test the carrying value of assets (including intangible assets). AASB 136 is the accounting standard that relates to the impairment of non-current assets. The following extracts have been reproduced from the standard. Paragraph 9 reads: An entity shall assess at each reporting date whether there is any indication that an asset may be impaired. If any such indication exists, the entity shall estimate the recoverable amount of the asset. Paragraph 96 discusses the timing of the impairment tests: The annual impairment test for a cash-generating unit to which goodwill has been allocated may be performed at any time during an annual period, provided the test is performed at the same time every year. Different cash-generating units may be tested for impairment at different times. However, if some or all of the goodwill allocated to a cash-generating unit was acquired in a business combination during the current annual period, that unit shall be tested for impairment before the end of the current annual
period. Furthermore, impairment testing may be required whenever there is an indication that there may be impairment, as per paragraphs 88 and 89: When, as described in paragraph 81, goodwill relates to a cash-generating unit but has not been allocated to that unit, the unit shall be tested for impairment, whenever there is an indication that the unit may be impaired, by comparing the units carrying amount, excluding any goodwill, with its recoverable amount. Any impairment loss shall be recognised in accordance with paragraph 104. If a cash-generating unit described in paragraph 88 includes in its carrying amount an intangible asset that has an indefinite useful life or is not yet available for use and that asset can be tested for impairment only as part of the cash-generating unit, paragraph 10 requires the unit also to be tested for impairment annually. Paragraph 90 summarises this: A cash-generating unit to which goodwill has been allocated shall be tested for impairment annually, and whenever there is an indication that the unit may be impaired, by comparing the carrying amount of the unit, including the goodwill, with the recoverable amount of the unit. If the recoverable amount of the unit exceeds the carrying amount of the unit, the unit and the goodwill allocated to that unit shall be regarded as not impaired. If the carrying amount of the unit exceeds the recoverable amount of the unit, the entity shall recognise the impairment loss in accordance with paragraph 104.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1610 Purpose of the Valuation / 1~1650 For What Purpose is a Valuation Being Prepared / 1~1780 Statutory requirements
1~1780
Statutory requirements
Statutory reasons for valuations come from the requirements of the following: Corporations Act 2001 and supported by ASIC rulings; Stock Exchange Rules; and accounting standards.
Section 296(1) of the Corporations Act 2001 gives the accounting standards the force of law, and thus compliance with AASB 3, 116, 136 and 138 requires valuations to be prepared for tangible and identifiable intangible assets. The following table summarises the sections of the Corporations Act 2001 and other rules and regulations that require valuations to be prepared. Many of the Corporations Act 2001 requirements for the preparation of a valuation stem from section 606 which prohibits the acquisition of more than 20% voting power in a company, unless the shares are acquired under one of the exceptions set out in the table in section 611. Legislation and Quasi-legislation Circumstance Required Corporations Act 2001 Section ASIC Practice Note/Policy Statement ASX Listing Rules
Legislation and Quasi-legislation Circumstance Required Corporations Act 2001 Section ASIC Practice Note/Policy Statement ASX Listing Rules
Takeover bids Offer includes non cash consideration Bidder connected with target Joint bid the bidders must encourage the target to commission an experts report on the bid Compulsory acquisition: of convertible notes if achieve 90% of the securities in a class at end of offer period; general provisions if holder of 90% of the securities; of convertible notes if hold 100% of the securities in a class. 663B(1)(c)(ii) PN 42, PN 43, PS 75 636(1)(h)(iii), 636(2) 640(1) PS 163 PN 43, PS 75 ASIC Media Release 01/295 Ch 10
664C(2)(b)(ii) 665B(1)(c)(ii)
Approved by resolution of target Acquisition of shares approved by resolution of target company Mineral tenements 611 table, Item 7 PN 42, PN 43, PS 74 Info 95/12 Although superseded, also refer NCSC PS 102 and 149 Administration of compromises and information as to compromises with creditors Significant changes in nature or scale of activity Capital reductions Buy-back, particularly where the consideration is not cash Capital reductions not otherwise authorised by law Scheme of arrangement The company must commission a report if the other party to the reconstruction has at least 30% of the company or there are common directors
Ch 10 Appendix 5A JORC Code & VALMIN Code
411(13)
PN 42, 43, PS 74, 75
Ch 10
Ch 11
PS 110.46 256B, 256C PN 29.27
Reg 5.1.01 and Corporations Regulations Schedule 8 cl. 8303
Note: The take-over provisions of the Corporations Act 2001 apply not only to listed public companies but to all companies with more than 50 members (section 602). It is interesting to note that section 294(4) of the Corporations Act 2001 which was only repealed as it duplicated similar requirements by the accounting standards required preparers of accounts to ensure that assets are recorded in the financial statements of a company at amounts not exceeding their notional replacement cost. In most material aspects, reports under the various sections of the Corporations Act 2001 deal with the same issues. However, one of the matters a valuer must consider when preparing a report for section 640 purposes is whether the non-associated shareholders will be worse off if the transaction does or does not go ahead. ASIC Policy Statement 74 is the source of this requirement and also stipulates that the valuer should take into account likely advantages and disadvantages to non-associated shareholders if the transaction does or does not go ahead. Section 640 of the Corporations Act 2001 requires an expert opinion to be provided where the bidder is connected with the target company. Section 640 provides that if: a. b. c. the bidders voting power in the target is 30% or more; or for a bidder who is, or includes, an individual the bidder is a director of the target; or for a bidder who is, or includes, a body corporate a director of the bidder is a director of target;
a targets statement given in accordance with section 638 must include, or be accompanied by, a report by an expert that states whether, in the experts opinion, the takeover offers are fair and reasonable and gives the reasons for forming that opinion. The valuer is required to set out details of any relationship they have with the offeror, the target company or any other person associated with the offeror or the target company. In addition the valuer is required to set out particulars of any pecuniary or other interests of the valuer that could reasonably be regarded as being capable of affecting the valuers ability to give an unbiased opinion on the take-over offer. The reason that section 640 exists is that if an offeror has more than 30% in the target company and/or is connected with the target company then the offeror may have additional information or an unfair advantage over the offerees. ASIC has released a number of policy guidelines on this issue. Policy Statement 75 is the most important one on section 640 reports.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1610 Purpose of the Valuation / 1~1650 For What Purpose is a Valuation Being Prepared / 1~1790 Stock exchange listing rules
1~1790
Stock exchange listing rules
ASX Listing Rules operate separately from, and in addition to, the requirements of the Corporations Law and ASIC policy releases. As would be expected, they often cover similar ground and it is not
unusual to find a report required under, say, Chapter 6 of the Corporations Law and also under, say, Chapter 10 of the Listing Rules.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1610 Purpose of the Valuation / 1~1650 For What Purpose is a Valuation Being Prepared / 1~1790 Stock exchange listing rules / Chapter 10
Chapter 10
Listing Rule 10.10.2 provides that shareholders should be provided with a report by a valuer stating whether the values are fair and reasonable in a transaction where it is proposed to acquire a substantial asset from or dispose of an substantial asset to: a related party; a subsidiary; a substantial shareholder; an associate of any of the above parties; or a person whose relationship to the entity is such that in ASXs opinion, the transaction should be approved.
A substantial asset is defined in Rule 10.2 as an asset whose value or the value of the consideration received for it is greater than 5% of the total issued capital and reserves of the listed company as at the date of the last audited accounts. ASX expects that the value of the sale or acquisition is calculated including intangibles, deducting provisions for depreciation and amortisation and not deducting liabilities acquired as part of the acquisition (ASX Listing Rule 10.2.1). ASX rules do not specify how valuations are to be conducted. In practice, it is not uncommon for valuers to refer to ASIC guidelines. Listing Rule 10.10.2 also states that if an independent valuer does not conclude that the transaction is fair and reasonable the opinion must be displayed prominently in the notice of meeting and on the covering page of any accompanying documents.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1610 Purpose of the Valuation / 1~1650 For What Purpose is a Valuation Being Prepared / 1~1790 Stock exchange listing rules / Chapter 11
Chapter 11
Where a company proposes to change the nature or scale of its business activities or dispose of its main undertaking, ASX Listing Rule Chapter 11 comes into operation. This is commonly referred to as the backdoor listing rule. It requires shareholder approval to be obtained and for the shareholders to be provided with all information relating to the transaction necessary in making an informed decision. Chapter 11 provides ASX with discretionary powers which enable ASX to call for such information it deems appropriate. This may include a valuation as part of an independent experts report.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1840 Report Format and Type
1~1840
Report Format and Type
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1840 Report Format and Type / 1~1860 Type of Report(s) Required
1~1860
Type of Report(s) Required
The requirement for interim and final reports should be discussed and agreed with the client and then confirmed in the engagement letter. This is necessary as up to 25% of the time spent performing a valuation can be spent on preparing and checking the reports. Reports could be in any one of the following types: verbal; schedules and computations; working papers of key findings; a written summary letter; a detailed report; an experts report; or an experts report including court testimony.
The availability of information may be a limiting factor on the scope and type of report which can be prepared. Similarly the extent to which information has been prepared or is to be prepared will affect the timing of the report and also the extent to which the report is deemed independent.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1840 Report Format and Type / 1~1880 Format of Reports
1~1880
Format of Reports
In many parts of the world, various organisations have published standards or guidelines on the format of reports and the issues to be addressed in them. Some of the organisations include: American Institute of Certified Valuation Analysts; American Society of Appraisers; Canadian Institute of Chartered Business Valuers (CICBV); Institute of Business Appraisers; International Asset Valuation Standards Committee (IVSC); International Association of Consultants Valuers & Analysts (IACVA); National Association of Certified Valuation Analysts (NACVA); and Uniform Standards of Professional Appraisal Practice (USPAP).
Compliance with one of the standards of these organisations at least ensures meeting some minimum professional standard. In addition where a report is to be used in court, as support for an independent valuers testimony, there may be additional court imposed reporting guidelines.
ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment /

1~1930 References
1~1930 1. 2.
References
Reilly, R. F. 1992, Tackling a Common Appraisal Problem, Journal of Accountancy, October 1992, p 92. Scherf, Stephen J. 1999, Determining the Appropriate Valuation Method, NACVA Business Valuation Leaning Institute, August 1999 p 13 and 14
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments

2~1000
Engagement and Documentation of Assignments
One of the most important steps in any valuation assignment is to communicate the following to the client: the work to be performed (the scope of the assignment); the terms and conditions under which the work is to be performed; and the amount of remuneration for providing the services.
Following this introduction are pro formas that can be used as guides in the documentation of valuation assignments, including: a workplan; a confidentiality agreement and conflict of interest statements; an engagement letter; key terms to include in general conditions of business; and additional Australian requirements.
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1050 Necessary Licences, Qualifications and Expertise
2~1050
Necessary Licences, Qualifications and Expertise
In many countries additional licences and qualifications are required before a valuation assignment can be undertaken. These requirements sometimes also vary between states and may vary between different courts within the same state. It is crucial that you investigate and understand the licensing requirements for each specific valuation assignment. Where the valuation is being prepared to advise on the purchase or sale of a business or the purchase or sale of securities in the entity that owns the business, there are new licensing requirements to be considered. The Corporations Act 2001, ASX Listing Rules and the courts all have specific requirements regarding the necessary qualifications and experience of people who prepare experts reports. The Australian Taxation Office (Tax Office) also gives guidance on who can undertake market valuations under the tax consolidation legislation.
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1050 Necessary Licences, Qualifications and Expertise / 2~1070 Advice on Purchase and Sale of Securities
2~1070
Advice on Purchase and Sale of Securities
Under the Financial Services Reform Act 2001 (FSRA), everyone who advises on or sells financial products must: hold an AFS licence; or represent someone who does.
The definition of a financial product includes a security (e.g. shares) and advice includes issuing: a recommendation or a statement of opinion, or a report, that (a) (b) is intended to influence a person or persons in making a decision in relation to a particular financial product; or could reasonably be regarded as being intended to have such an influence.
However, Corporations Regulation 7.1.29(1) states: a person who provides an eligible service is taken not to provide a financial service if: a. b. c. the person provides the eligible service in the course of conducting an exempt service; and it is reasonably necessary to provide the eligible service in order to conduct the exempt service; and the eligible service is provided as an integral part of the exempt service.
Regulation 7.1.29(3) states that: a person who does any of the following provides an exempt service: c. provides advice on the acquisition or disposal, administration, due diligence, establishment, structuring or valuation of an incorporated or unincorporated entity, if the advice: i. ii. is given to a person who is, or is likely to become, an interested party in the entity; and to the extent that it is financial product advice is confined to advice on a decision about: A. B. securities of a body corporate, or related body corporate, that carries on or may carry on the business of the entity; or interests in a trust (other than a superannuation fund or a managed investment scheme that is registered or required to be registered), the trustee of which carries on or may carry on the business of the entity in the capacity of trustee; and
iii. iv.
does not relate to other financial products that the body corporate or the trustee of the trust may acquire or dispose of; and is not advice for inclusion in an exempt document or statement.
Those financial services businesses that were licensed or regulated, or didn't need to be, before 11 March 2002, have until 10 March 2004 to obtain an AFS licence. In the meantime, they may continue to operate under their existing arrangements. However, if they enter a new area of business on or after 11 March 2002, they must have an AFS licence covering those activities. New financial services businesses that start on or after 11 March 2002 must have an AFS licence from the day they start business. Prior to the FSRA, where the valuation was being prepared as part of advice on the purchase and sale of a legal entity (shares in a company or units in a trust) there was a requirement to be licensed as a securities dealer under the Corporations Act 2001. People and organisations that provided investment advice to retail investors had to be licensed where the advice was not merely incidental. During the transitional period, incidental advice covered by section 77(5) of the Corporations Act 2001 can be disregarded in determining if an AFS licence is required, both by accountants that were practising as an accountant before 11 March 2002 and by accountants who commence to practice after that. The transitional period will generally end on 11 March 2004, or whenever the accountant becomes licensed, whichever occurs first. ASIC Policy Statements 116.15116.19 and 122.34 discuss these issues. For further information, please consult: the Corporations Act 2001: section 9 (definitions); section 766A (when does a person provide a financial service); section 766B (meaning of financial product advice); section 911A (need for an AFS licence); section 911D (when a financial services business is taken to be carried on); section 913A (applying for a licence); section 913B (when a licence may be granted); sections 14301437 (transitional provisions treatment of people who carry on financial services businesses and their representatives); regulation 7.1.29 (circumstances in which a person is taken not to provide a financial service);
ASIC Financial Services Policy Handbook published by Thomson Legal & Regulatory Limited; and updates from ICA and CPA on FSRA.
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1050 Necessary Licences, Qualifications and Expertise / 2~1090 Purchase and Sale of a Business
2~1090
Purchase and Sale of a Business
Where a valuation is being prepared as part of advice on the purchase and sale of a business (rather than the legal entity that owns the business) there is a requirement to be licensed as a business
broker in the respective state. The following article Licensing Requirements When Buying or Selling Businesses is a summary of the relevant legislation.
LICENSING REQUIREMENTS WHEN BUYING OR SELLING BUSINESSES

It would be most unfortunate if at the end of a deal your commission was confiscated. Legislation for licensing of real estate and business agents in the States and Territories specify that commissions or fees are not payable for services as an agent, unless the service was performed by a licensed agent or employee of a licensed agent. Refer, for example to the New South Wales situation, where this is governed by the Property, Stock and Business Agents Act 1941. Section 42(1) states that: no person shall be entitled to bring any proceeding in any court to recover any commission, fee, gain or reward for any service performed by the person: (a) (c) as a real estate agent, unless the person was the holder of a real estate agents licence, or employed such a holder, at the time of performing the service, or as a business agent, unless the person was the holder of a business agents licence, or employed such a holder, at the time of performing the service,
and, in the case of a corporation, unless it was the holder of a corporation licence at the time of performing such service. In section 3(1), business agent is defined as: any person (whether or not such person carries on any other business) who for reward (whether monetary or otherwise) exercises or carries on business as an agent for performing any of the following functions, namely: (a) (b) (c) selling, buying or exchanging or otherwise dealing with or disposing of, or negotiating for the sale, purchase or exchange or any other dealing with or disposition of, or compiling for publication or compiling and publishing a document that contains a list relating solely or substantially to the acquisition or disposal by any person of, businesses or professional practices or any share or interest in or concerning or the goodwill of or any stocks connected with businesses or professional practices.
Similar legislative requirements exist in the other States and Territories, but it would pay to check out the requirements in the State in which you are living and in which you are involved in the sale of business. Some of the relevant Acts are listed at the foot of this article. If the business being sold has shares, the sale of such a business is governed by the Corporations Law and providing advice on the purchase or sale of such a business requires a dealers or investment advisers licence. For further information, please consult: New South Wales Property, Stock and Business Agents Act 1941;
Victoria Estate Agents Act 1980; Queensland Auctioneer and Agents Act 1971; Western Australia Real Estate and Business Agents Act 1978; South Australia Land Agents Act 1994, section 6(2); Tasmania Auctioneers and Real Estate Agents Act 1991; Australian Capital Territory Agents Act 1968; and Northern Territory Agents Licensing Act.
These Acts are available from <www.austlii.edu.au>. Under the FSRA, real estate agents will need to consider whether they provide any financial services (e.g. advice), even incidentally, in relation to any financial products (e.g. general insurance or real estate based managed investment schemes). Advice about real estate (which is not itself a financial product under the FSRA) together with advice about a financial product may be covered. This may include such things as comparisons between the merits of investing in securities and investing in real estate. For more information, refer to the Frequently Asked Questions on Financial Services Reform, found at <www.asic.gov.au>.
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1110 Who Can Undertake Market Valuations for Tax Consolidation Purposes?
2~1110
Who Can Undertake Market Valuations for Tax Consolidation Purposes?
The taxation consolidation legislation comes into effect from 1 July 2002, requiring market valuations to be undertaken in certain cases. Part C41, page 31 of the Australian Taxation Offices Consolidation Reference Manual specifies who can undertake market valuations: The choice of who is to undertake a valuation will depend on the nature of the asset and the taxpayers business circumstances in particular factors such as: the complexity of the valuation the value of the asset being valued relative to other assets of the taxpayer the availability of in-house valuation expertise, and the expense of an external valuation
This decision requires taxpayers to balance the risks associated with computing their own valuations and the potential consequences of that decision (such as non-compliance with the law and the likelihood of the valuations being challenged by the Tax Office) with the costs of consulting a qualified valuer. Table 4: Valuation decisions should be based on business circumstances and nature of asset
Table 4: Valuation decisions should be based on business circumstances and nature of asset Circumstances Options External valuer In-house qualified valuer Self-calculation Relative value of asset/level of certainty required The higher the assets relative value and the more central it is to the taxpayers business the higher the risks in getting the valuation wrong. Complexity of the valuations
More complex valuations (e.g. intangible assets) require higher levels of skills and experience. Less complex valuations (e.g. property or vehicles where comparable valuations are readily obtainable) may be self-calculated using reasonably objective and supportable data.
In the same section, Part C41, page 31, the Manual sets out the attributes required of a person engaged to value a particular asset: If a taxpayer decides to engage a person to value a particular asset: the person undertaking the valuation should act independently of the person commissioning the valuation report the person undertaking the valuation should be appropriately qualified and experienced in relation to the asset being valued, and there must be transparency in the commissioning of the valuation report.
The Manual also comments on the qualifications required (Part C41, page 3334): The level of qualifications and experience of the person undertaking the valuation should depend on the nature of the assets being valued, the industry in which the assets are employed, the complexity and importance of the market valuation and the level of assurance taxpayers wish to achieve. A person would be regarded as sufficiently qualified if their profession, reputation or training gives authority to their statements in relation to the assets or entities being valued. The level of qualification or expertise needed will vary depending on the relative importance of the market valuation in question and what a reasonable business person might be expected to do in similar circumstances. The person commissioning the market valuation should ensure that the person undertaking the valuation: is a member of a profession, or has a reputation or training that is relevant to the matters on which they report holds the licences or authorities, where necessary, for providing the type of advice sought
states in their report their qualifications and experience or, if the report is made by a corporation or firm, the qualifications and experience of the individuals responsible for preparing the report retains specialists to advise on any technical matters that are relevant but on which the person undertaking the market valuation report is not personally authoritative complies with any other minimum record keeping requirements set out under Documentation and record keeping, and signs the report and consents to its use for the purposes of consolidation.
For further information, refer to the Consolidation Reference Manual at <www.ato.gov.au>.
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1140 Workplans

2~1140
Workplans
Planning an engagement is crucial in terms of costing an assignment, time management and allocating tasks to individuals. A detailed workplan also serves as a checklist to ensure sufficient time is allowed to consider all issues. Leadenhall uses the following workplan when planning valuation assignments. (The workplan is not intended to cover all situations and specifically does not include issues for minority interests or the valuation of options.)
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1140 Workplans / 2~1160 Summary Workplan
2~1160
Summary Workplan
The following issues are discussed in the chapters Scoping a Valuation Assignment and Research and Data Collection. Attached is a sample Summary Workplan template.
Task 1 2 Engagement and general Preliminary reading and identification of key value drivers The market The product The expected income The costs Responsibility Due Date Period 1 Hours Period 2 Hours Period 3 Hours Total Hours Rate Total $
3 4 5 6
Task 7 The capital expenditure requirements The working capital requirements The impact of taxation The discount rate and points The valuation The report to clients Total
Responsibility
Due Date
Period 1 Hours
Period 2 Hours
Period 3 Hours
Total Hours
Rate
Total $
9 10 11 12
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1140 Workplans / 2~1180 Engagement and General
2~1180
Engagement and General
The following issues are discussed in this chapter. Attached is a sample Engagement and General template.
Task 1.01 Prepare and update workplan 1.02 Understand purpose of valuation 1.03 Determine scope, date, standard and premise of valuation 1.04 Write engagement letter 1.05 Organise signing of engagement letter by client 1.06 Determine information required and request from client Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited Responsibility Due Date Period 1 Hours Period 2 Hours Period 3 Hours Total Hours Rate Total $
Task 1.07 File signed copy of engagement letter 1.08 Obtain confidentiality agreements and declarations from staff 1.09 File confidentiality agreements 1.10 Identify jurisdiction of courts 1.11 Liaise with client Subtotal
Responsibility
Due Date
Period 1 Hours
Period 2 Hours
Period 3 Hours
Total Hours
Rate
Total $
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1140 Workplans / 2~1200 Preliminary Reading and Identification of Key Value Drivers
2~1200
Preliminary Reading and Identification of Key Value Drivers
The following issues are discussed in the chapter Research and Data Collection. Attached is a sample Preliminary Reading and Identification of Key Value Drivers template.
Task 2.01 Review of background information 2.02 Prepare research summary 2.03 Relate key documents to transaction 2.04 Prepare time line of key dates 2.05 Prepare glossary of terms 2.06 Prepare corporate structure diagram Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited Responsibility Due Date Period 1 Hours Period 2 Hours Period 3 Hours Total Hours Rate Total $
Task 2.07 Identify key value drivers 2.08 Review of key value drivers Subtotal
Responsibility
Due Date
Period 1 Hours
Period 2 Hours
Period 3 Hours
Total Hours
Rate
Total $
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1140 Workplans / 2~1220 The Market
2~1220
The Market
The following issues are discussed in the chapter Research and Data Collection. Attached is a sample Market template.
Task 3.01 Consider need for identifying experts/review their advice 3.02 Determine the market for product (who are the potential users?) 3.03 Determine total market size 3.04 Determine entry barriers 3.05 Determine likely competitors (size and resources) 3.06 Determine volatility/stability of market 3.07 Consider response of competitors to new entrant 3.08 Review Subtotal Responsibility Due Date Period 1 Hours Period 2 Hours Period 3 Hours Total Hours Rate Total $
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1140 Workplans / 2~1240 The Product
2~1240
The Product
The following issues are discussed in the chapter Research and Data Collection. Attached is a sample Product template.
Task 4.01 Consider need for identifying experts/review their advice 4.02 Determine stage of development 4.03 Determine cost and time to develop 4.04 Determine probability of successful development 4.05 Confirm probability used in similar valuations 4.06 Consider patent protection 4.07 Determine stage of development of alternative technologies 4.08 Strategic considerations (i.e. relative cost, uniqueness) 4.09 Research alternative technologies (can be expected to supplant/negate use of product or service provided?) 4.10 Obtain cost data on product and competitors 4.11 Evaluate effect of relative costs 4.12 Review Subtotal Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited Responsibility Due Date Period 1 Hours Period 2 Hours Period 3 Hours Total Hours Rate Total $
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1140 Workplans / 2~1260 The Expected Income
2~1260
The Expected Income
The following issues are discussed in the chapters Review of Historic Accounts and Preparation and Review of Forecasts and Projections. Attached is a sample Expected Income template.
Task 5.01 Determine expected sales quantities 5.02 Determine lead times/take up rates/penetration rates 5.03 Determine long term growth rates of market 5.04 Determine expected sales prices 5.05 Determine response of price and quantity to introduction of competitors 5.06 Determine response of price and quantity to new technologies 5.07 Determine response of price to changes in quantities supplied 5.08 Project industry growth rate 5.09 Review Subtotal Responsibility Due Date Period 1 Hours Period 2 Hours Period 3 Hours Total Hours Rate Total $
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1140 Workplans / 2~1280 The Costs
2~1280
The Costs
The following issues are discussed in the chapters Review of Historic Accounts and Preparation and Review of Forecasts and Projections. Attached is a sample Costs template.
Task 6.01 Determine whether historic costs are indicative of future costs 6.02 Eliminate unusual items 6.03 Normalise owners remuneration 6.04 Identify non-cash items 6.05 Determine time required to develop marketable product 6.06 Determine costs to develop marketable product 6.07 Determine marketing costs 6.08 Review Subtotal Responsibility Due Date Period 1 Hours Period 2 Hours Period 3 Hours Total Hours Rate Total $
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1140 Workplans / 2~1300 The Capital Expenditure Requirements
2~1300
The Capital Expenditure Requirements
The following issues are discussed in the chapters Review of Historic Accounts and Preparation and Review of Forecasts and Projections. Attached is a sample Capital Expenditure Requirements template.
Task Responsibility Due Date Period 1 Hours Period 2 Hours Period 3 Hours Total Hours Rate Total $
Task 7.01 Determine production constraints and capacity at which augmentation of plant is required 7.02 Determine timing and amount of future capital expenditure 7.03 Determine reasonableness of assuming depreciation will approximate capital expenditure in the long term 7.04 Consider how capital expenditure is to be funded 7.05 Review Subtotal
Responsibility
Due Date
Period 1 Hours
Period 2 Hours
Period 3 Hours
Total Hours
Rate
Total $
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1140 Workplans / 2~1320 The Working Capital Requirements
2~1320
The Working Capital Requirements
The following issues are discussed in the chapters Review of Historic Accounts and Preparation and Review of Forecasts and Projections. Attached is a sample Working Capital Requirements template.
Task 8.01 Determine whether historic requirements are indicative of future requirements Responsibility Due Date Period 1 Hours Period 2 Hours Period 3 Hours Total Hours Rate Total $
Task 8.02 Consider current economic and market conditions on working capital requirements 8.02 Calculate historic working capital ratios. 8.03 Estimate future working capital ratios and future working capital requirements 8.04 Consider how working capital requirements are to be funded 8.05 Review Subtotal
Responsibility
Due Date
Period 1 Hours
Period 2 Hours
Period 3 Hours
Total Hours
Rate
Total $
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1140 Workplans / 2~1340 The Impact of Taxation
2~1340
The Impact of Taxation
The following issues are discussed in the chapter Taxation. Attached is a sample Impact of Taxation template.
Task 9.01 Determine expected tax rate 9.02 Consider additional tax deductions and adjustments 9.03 Determine timing of tax payments 9.04 Consider future deductibility of carried forward tax losses 9.05 Determine ability to use tax credits Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited Responsibility Due Date Period 1 Hours Period 2 Hours Period 3 Hours Total Hours Rate Total $
Task 9.06 Determine tax effects of disposal 9.07 Consider rollover and other exemptions 9.08 Review Subtotal
Responsibility
Due Date
Period 1 Hours
Period 2 Hours
Period 3 Hours
Total Hours
Rate
Total $
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1140 Workplans / 2~1360 The Discount Rate and Points
2~1360
The Discount Rate and Points
The following issues are discussed in the chapters Discount Rates and Price Earnings Ratios. Attached is a sample Discount Rate and Points template.
Task 10.01 Identify existing information 10.02 Determine risk free rate 10.03 Consider discounts used for similar valuations 10.04 Evaluate beta and risk premium 10.05 Undertake review of listed companies in similar industries to determine market PE ratios 10.06 Review calculated returns and compare with other benchmarks (i.e. stock market accumulation indices) Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited Responsibility Due Date Period 1 Hours Period 2 Hours Period 3 Hours Total Hours Rate Total $
Task 10.07 Review timing of expected cash flows and determine suitable discount point 10.08 Ensure discount rate or capitalisation multiple is consistent with cash flow in terms of: real or nominal basis; and pre- or post-tax basis
Responsibility
Due Date
Period 1 Hours
Period 2 Hours
Period 3 Hours
Total Hours
Rate
Total $
10.09 Review Subtotal
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1140 Workplans / 2~1380 The Valuation
2~1380
The Valuation
The following issues are discussed in the chapters Income Approach, Market Approach, Asset Approach, Other Methods and Considerations and Guidance on Methods. Attached is a sample Valuation template.
Task 11.01 Determine business or entity valuation 11.02 Identify surplus assets 11.03 Identify corporate debt 11.04 Determine appropriate valuation methods Responsibility Due Date Period 1 Hours Period 2 Hours Period 3 Hours Total Hours Rate Total $
Task 11.05 Determine whether valuing 100% of entity or fractional interest 11.06 Determine rights attached to different classes of shares 11.07 Prepare valuation 11.08 Compare values derived from different methods and reconcile differences 11.09 Conduct sensitivity analysis for changes in key value drivers 11.10 Schedule expected cash flow stream 11.11 Tabulate all valuation assumptions 11.12 Review Subtotal
Responsibility
Due Date
Period 1 Hours
Period 2 Hours
Period 3 Hours
Total Hours
Rate
Total $
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1140 Workplans / 2~1400 Report to Client
2~1400
Report to Client
The following issues are discussed in the chapter Reports. Attached is a sample Report to Client template.
Task 12.01 Prepare draft report 12.02 Review report standards and ensure report meets requirements Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited Responsibility Due Date Period 1 Hours Period 2 Hours Period 3 Hours Total Hours Rate Total $
Task 12.03 Representation letter from client 12.04 Ensure latest disclaimer filed 12.05 Liaise and finalise report 12.06 Review Subtotal
Responsibility
Due Date
Period 1 Hours
Period 2 Hours
Period 3 Hours
Total Hours
Rate
Total $
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1450 Confidentiality Agreements and Conflict of Interest Declarations
2~1450
Confidentiality Agreements and Conflict of Interest Declarations
We find many clients request that all staff involved in the preparation of valuations sign confidentiality agreements, and, in some circumstances, conflict of interest declarations. The use of formal confidentiality agreements varies from assignment to assignment as well as from firm to firm. The following examples of a confidentiality agreement and conflict of interest declarations include some of the terms and conditions that might be included in these agreements when planning a valuation assignment. These terms and conditions are a guide only and legal advice should be obtained when drafting confidentiality agreements and conflict of interest declarations.
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1450 Confidentiality Agreements and Conflict of Interest Declarations / 2~1470 Sample Confidentiality Agreement
2~1470
Sample Confidentiality Agreement

Attached is a sample Confidentiality of Information Agreement template. Confidentiality of Information Agreement
Proposed consultancy to value XYZ (the Business) Further to your enquiry about Leadenhall providing consultancy services to assist the Business, we request the required information be provided to us upon the following terms and conditions: We will not disclose to any person that we are acting for this Business in any capacity. We agree that the information provided is the property of the Business, and is confidential and that extracts will not be taken from it, nor copies made of it, nor will it be disclosed to any person without your prior written consent. We understand that the information may be made available only to persons within our own
organisation whose names and signatures appear below and such other persons approved by you in writing who sign a confidentiality agreement with the same terms as this agreement. We agree that the obligation to maintain the confidentiality of the information provided shall continue until it properly becomes part of the public domain. We agree to return the information and all copies thereof to you at your request at any time. We shall not approach or cause to be approached any of the suppliers, customers, staff or any person associated with the Business in connection with the Business without approval beforehand in writing from you. We will not directly or indirectly for a period of 12 months from the date of this agreement, solicit or entice away or endeavour to solicit or entice away any officer, contractor, agent or employee of the Business. We understand that a breach of the above condition may result in damage to the Business and financial loss to the owners of the Business and that the Business and its owners may jointly or severally seek compensation for such loss. The names and positions of the persons to whom the information will be made available are set out hereunder and such persons have signed this agreement by way of their consent to be bound by the terms and conditions set out above. Name Position Company Signature Date
Tel No: Fax No: Address:
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1450 Confidentiality Agreements and Conflict of Interest Declarations / 2~1490 Sample Conflict of Interest Declarations
2~1490
Sample Conflict of Interest Declarations
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1450 Confidentiality Agreements and Conflict of Interest Declarations / 2~1490 Sample Conflict of Interest Declarations / 2~1500 Conflict of interest declaration Instructions to staff
2~1500
Conflict of interest declaration Instructions to staff

Attached is a sample Conflict of Interest Declaration Instructions to Staff template.
We have been appointed to act as corporate advisers for a client. This consultancy involves disclosure to us of information in relation to a number of entities. Prior to proceeding with this consultancy we
must do the following: make disclosure of any associations any staff member has with any of the entities on the attached list; detail any potential conflict of interest in relation to the disclosure of information in regard to any of the entities on the attached list; and declare any past or current interests in either the client or the company being valued and advise whether you intend undertaking any transactions in the shares of either company.
In this regard would you please complete the attached Disclosure Sheet. If your answer is no please pass on to the next staff member. If you have any disclosures to make please do so and return to me prior to handing on to the next staff member.
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1450 Confidentiality Agreements and Conflict of Interest Declarations / 2~1490 Sample Conflict of Interest Declarations / 2~1510 Conflict of interest declaration Statement required from staff
2~1510
Conflict of interest declaration Statement required from staff

Attached is a sample Conflict of Interest Declaration Staff Disclosure template.
Name: Do you have any association with any of the following entities: Company 1 Yes / No Company 2 Yes / No
If yes, set out details below including details of any potential conflict of interest: . . Signed: Date: . .
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1560 Engagement Letters
2~1560
Engagement Letters
The following is an outline of the some of the key terms to be included in an engagement letter when planning a valuation assignment.
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1560 Engagement Letters / 2~1570 Australian Requirements
2~1570
Australian Requirements
In Australia the Institute of Chartered Accountants (ICA) and CPA Australia have jointly issued a Miscellaneous Professional Statement APS 2 Terms of Engagement, which specifically considers the requirement for an engagement letter. APS 2 applies to all engagements not covered by AUS 204, AUS 902 and AUS 904. The standard states: Defining the Terms of the Engagement 5. The member must ensure that there is a clear understanding between the client and the member regarding the terms of the engagement. As a means of reducing uncertainty, it is recommended that the agreed terms be recorded in an engagement letter or other suitable form.
General Contents of an Engagement Letter 9. 10. 11. 12. 13. 14. 15. Introduction ... Purpose of the engagement ... Scope of the engagement ... Engagement output ... Relative responsibilities ... Fees and billing arrangements ... Confirmation by the client ...
Valuers preparing to undertake a valuation assignment should review the requirements of this standard in detail and the examples included in the appendices, to ensure their engagement letter addresses all relevant issues. Clauses 1729 of Guidance Note GN 2 Forensic Accounting, released with Miscellaneous Professional Statement APS 11 Statement of Forensic Accounting Standards, deal with engagement issues such as: scope of expertise; independence; terms of engagement; and fees;
and reminds ICA and CPA Australia members: of the obligations regarding engagements required under APS 2. In particular, the independent accounting expert should ensure that the role is clearly defined, and the scope and purpose of the work to be performed is clearly set out. (Clause 25) Some useful information is also available from the following web site: <www.icaa.org.au>, then Forensic Accounting Special Interest Group/Papers/Sample Letter of Engagement.
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1560 Engagement Letters / 2~1580 Sample Engagement Letter
2~1580
Sample Engagement Letter

Attached is a sample Engagement Letter template. Private and Confidential
Date The Directors Company Dear Re: Engagement of Leadenhall The purpose of this letter is to set out our understanding of the requirements of [Company X] [The Client/each a Client] and to provide for your consideration an offer for you to engage the services of [Leadenhall]: 1. Our Understanding of your Requirements Set out what you understand to be the requirements of the Client. 2. Services to be Provided Set out what you understand are to be the services provided to the Client and nominate a lead consultant. 3. Capabilities Set out a brief statement regarding the capabilities of the firm as they will apply to this assignment. 4. Remuneration for Services Set out the basis of remuneration. (Hourly rate or success fee and how both will be calculated.) Specify the hourly rate of the individuals who will work on the assignment. If required, provide an estimate of total fees. 5. General Conditions of Business Advise that a copy of your general conditions of business (and any other relevant documents) have been included with this letter. Advise that these documents contain important information about your clients rights and obligations. Advise that these documents, together with this letter of engagement, form the terms of the offer to provide services to the client. 6. Timing Set out timing of assignment milestones and key deliverables. 7. Conclusion We look forward to being of service to you. Our normal practice is to ask the Client to counter-sign two copies of our engagement letter, to
return one to us and to retain one copy, and to retain the general conditions of business and [specify any other documents], so that there is a clear understanding of our relationship. By signing and returning this letter of engagement you are warranting that you have received a copy of our general conditions of business as well as [specify any other documents], that you have read these, understood them, and agree to be bound by the terms and conditions set out in those documents. It is important that the letter of engagement sets out correctly your requirements and is tailored to your needs. If there are any matters that you wish to discuss or would like to clarify, please do not hesitate to contact us. We look forward to discussing the above with you. Yours sincerely Director .............. We have read the above and attached general conditions of business and advisory services guide and agree that it sets out the terms and conditions for the engagement. Signed: as Director/shareholder, Company name Signed: as Director/shareholder, Company name Signed: as Director/shareholder, Company name
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1630 General Conditions of Business
2~1630
General Conditions of Business
A variety of terms and conditions might need to be included in a document detailing general conditions of business when planning a valuation assignment. These terms and conditions are a guide only and legal advice should be obtained when drafting conditions of business statements. The following is an example of some of the terms and conditions that need to be documented when undertaking valuation assignments.
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1630 General Conditions of Business / 2~1650 Sample General Conditions of Business
2~1650
Sample General Conditions of Business

Attached is a sample General Conditions of Business Consulting template. Schedule 1 General Conditions of Business Consulting
1.
Definitions
2.
Acceptance These General Conditions of Business are subject to the Engagement Letter. Together, these constitute the terms and conditions of the Agreement. The consultant will proceed on the basis that the Client has accepted the terms set out in this document.
3.
Fee Estimates We will provide an estimate of the likely amount of fees and disbursements. However it is extremely difficult to predict the amount of fees. That any estimate is not a quote.
4.
Confidentiality a. On the part of the consultant We shall not disclose any confidential information. b. On the part of the Client All advice and reports provided by us are confidential, and for the exclusive use and benefit of the Client who shall not copy or disclose them. c. On the part of both parties All discussions, negotiations and the terms and conditions of all contracts are also confidential and shall not be disclosed.
5.
Rights of Engagement Nothing shall prevent the consultant from accepting an engagement in the same field of commerce as the Client provided that: a. b. c. there is no conflict of interest; the interests of clients are protected and any proprietary information that has been developed specifically for a given client is held in confidence; and we do not divulge or utilise proprietary or confidential information of the Client for the benefit of a third party.
6.
Client Co-operation The success of the assignment requires the timely co-operation of the Client in a number of ways including: a. b. c. d. provision of staff; availability of senior executives for consultation; provision of reasonable working facilities; and provision of information in an expeditious manner.
7.
Up-front Payments We may ask the Client to pay up-front an amount to enable payment of expenses, or to provide security for them and consulting fees.
8.
Trust Moneys Any moneys paid will be paid into a trust account. The Client authorises the consultant to apply trust moneys held on the Clients behalf towards payment of fees and expenses.
9.
Lien The Client authorises the consultant to retain by way of lien any funds, property or documents which are from time to time in their possession until all fees, costs, expenses and interest due have been paid.
10.
Goods and Services Tax The Client will be responsible for this tax in addition to the proposed fees.
11.
Retention of Documents The consultant has the Clients authority to destroy the Clients papers along with the file after seven years.
12.
Accuracy of Information It is the responsibility of the Client to ensure the accuracy and completeness of any information provided.
13.
Prior Approval of Disbursements Prior approval will be obtained for any significant disbursements incurred specifically on the Clients behalf.
14.
Due Date for Payment of Fees Consulting fees and all out of pocket expenses are billable at the end of each calendar month with payment due by the 15th of the following month.
15.
Additional Services Performed Additional consulting or other services will be provided at the hourly rates.
16.
Late Payment of Fees In the event payment of any sum is outstanding the consultant shall retain the right to charge interest. The consultant will also treat such non-payment as a breach of the Agreement between the parties and shall cease immediately all work.
17.
Security for Fees If required the Client will forthwith grant a fixed and floating charge over all its assets. The Client agrees that the charge made includes existing debts due by the Client to the consultant and may secure future debts incurred by the Client to the consultant.
18.
Right to Engage a Specialist The consultant retains the right to engage a specialist (at the Clients cost) to provide opinion on any aspect of the engagement with respect to which they, in their exclusive judgement, determine they do not have the requisite expertise with which to provide an opinion.
19.
Legislative Requirements relating to the Clients Work
Any transaction which will involve the transfer of real property or the sale of an unincorporated business will require the engagement of a person licensed to undertake such work. The Client will be responsible for the fees of any person reasonably engaged to perform such services on the Clients behalf. 20. Tax and Legal Disclaimer The consultant is not an expert in either of the fields of taxation or law. Therefore, any suggestion made on either topic should be referred to such an expert before being acted upon. 21. Disclaimers All projections and recommendations made in association with the engagement are made in good faith on the basis of information available. The consultant will not be liable for any loss or damage caused as a result of any errors in data. The consultant will not be liable for any loss or other consequence (whether or not due to negligence) arising out of the services rendered in relation to this engagement. It is acknowledged by the Client that the work involves making judgements which may be affected by unforeseen future. 22. Indemnification The Client agrees to indemnify the consultant against all claims and liabilities whatsoever arising out of the consultants obligations arising out of their engagement by the Client. 23. Validity This offer will remain open for a period of 30 days from the date on which it is posted. 24. Void, Voidable or Unenforceable Provisions If any provision of these General Conditions of Business shall at any time be or become void, voidable or unenforceable, that provision shall not affect or invalidate the remaining provisions hereof. 25. Termination Engagements may be terminated at any time by either party upon 90 days written notice to the other party. 26. Entire Agreement The accompanying Letter of Engagement sets out the entire understanding of the parties relating to the subject matter hereof. The contents of the proposed agreement contained in these documents cannot be modified or changed nor can any of the provisions be waived except by written agreement signed by both parties. 27. Litigation Costs In the event that the consultant is subpoenaed to produce their documents relating to this engagement for judicial or administrative proceedings to which they are not a party, then the Client agrees to reimburse the consultant at the hourly rates as set out in Schedule 1 for their professional time and expenses, including reasonable attorneys fees, incurred in responding to such requests.
28.
Jurisdiction Any legal proceedings arising from this Agreement shall be commenced and maintained in a court of the appropriate jurisdiction located within South Australia.
29.
Dispute Resolution If the Client has any complaints about the service provided or fees charged the Client should first contact the consultant and discuss it with them. If the Client is still not satisfied with the result the Client may wish to contact the Australian Securities and Investments Commission on 1300 300 630 where the Client can either make a complaint or obtain information about the Clients rights.
Schedule 2 Current Rates for Consultancy Fees Consultancy fees are payable at the following hourly rates for all work performed: Executive Director Senior Advisers Corporate Advisers Senior Business Analysts Business Analysts Research Assistants $ $ $ $ $ $
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1700 Additional Requirements
2~1700
Additional Requirements
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1700 Additional Requirements / 2~1720 Requirement for a Financial Services Guide (previously an Advisory Service Guide)
2~1720
Requirement for a Financial Services Guide (previously an Advisory Service Guide)
Prior to the introduction of the FSRA, ASICs Policy Statement PS 121.6 required an Advisory Service Guide where investment advice was being given to retail investors. As noted in PS 167, Schedule A, Part III of PS 121 has been superseded but: may continue to be useful guidance for industry participants in thinking about their obligations under the law. Note that a two-year transitional period ends on 11 March 2004. Refer to the Corporations Act 2001, as amended, and the Licensing Kits and Policy Statements listed at the end of this section for details on how the transitional period applies. The Corporations Act 2001, as amended by the FSR Act, specifies, in section 941A(1) that:
A financial services licensee (the providing entity) must give a person a Financial Services Guide in accordance with this Division if the providing entity provides a financial service to the person (the client ) as a retail client. Note that whether or not the FSR Act applies to business valuers is discussed in necessary licences, qualifications and expertise. Retail client is defined in section 761G of the Act and Chapter 7 Part 7.1 Division 2 of the Regulations. Section 941C details situations where a Financial Services Guide is not required. Section 942B(2) specifies what must be included in a Financial Services Guide: Subject to subsection (3) and to the regulations (see subsection (4)), the Financial Services Guide must include the following statements and information: a. b. c. a statement setting out the name and contact details of the providing entity; and a statement setting out any special instructions about how the client may provide instructions to the providing entity; and information about the kinds of financial services (the authorised services ) that the providing entity is authorised by its licence to provide, and the kinds of financial products to which those services relate; and information about who the providing entity acts for when providing the authorised services; and information about the remuneration (including commission) or other benefits that any of the following is to receive in respect of, or that is attributable to, the provision of any of the authorised services: i. ii. iii. iv. v. f. the providing entity; a related body corporate of the providing entity; a director or employee of the providing entity or a related body corporate; an associate of any of the above; any other person in relation to whom the regulations require the information to be provided;
d. e.
information about any associations or relationships between the providing entity, or any related body corporate, and the issuers of any financial products, being associations or relationships that might reasonably be expected to be capable of influencing the providing entity in providing any of the authorised services; and
if the providing entity provides execution-related telephone advice and g. information about the dispute resolution system that covers complaints by persons to whom the providing entity provides financial services, and about how that system may be accessed; and if the providing entity acts under a binder if the providing entity is a participant in a licensed market or a licensed CS
h. i.
facility; and j. any other statements or information required by the regulations.
Section 942B(3) specifies that: the level of information about a matter that is required is such as a person would reasonably require for the purpose of making a decision whether to acquire financial services from the providing entity as a retail client.
ASSIGNMENT MANAGEMENT / 2~1000 Engagement and Documentation of Assignments / 2~1790 References

2~1790 1.
References
LIC 60 Licensing: the scope of the licensing regime: Financial product advice and dealing. An ASIC guide. LIC 70 Licensing and disclosure: Making the transition to the FSR regime. An ASIC guide.
ASIC Licensing Kits and Guides:
2.
ASIC Policy Statements: Policy Statement 165: Licensing: Internal and external dispute resolution [PS 165]. Policy Statement 166: Licensing: Financial requirements [PS 166]. Policy Statement 167: Licensing: Discretionary powers and transition [PS 167]. Policy Statement 168: Disclosure: Product Disclosure Statements (and other disclosure obligations) [PS 168].
Copies of these Licensing Kits and Guides and Policy Statements are available from ASICs commercial publisher, Thomson Legal & Regulatory Limited, at <www.cpd.com.au/asic>. 3. 4. 5. 6. Australian Taxation Office (Tax Office) Consolidation Reference Manual, NAT 6835, <www.ato.gov.au>. Corporations Act 2001, Parts 7 and 8. Institute of Chartered Accountants and CPA Australia, Guidance Note GN 2 Forensic Accounting. Institute of Chartered Accountants and CPA Australia, Miscellaneous Professional Statement APS 11 Statement of Forensic Accounting Standards.
ASSIGNMENT MANAGEMENT / 3~1000 Reports

3~1000
Reports
The final utility of a valuation depends upon the structure, clarity and general presentation of the report format in which it is presented. This chapter discusses the various types of report formats and the bases on which they are applied internationally. Details of valuation associations and regulatory bodies from around the world are also discussed. A
comparison of these can highlight not only differences between international standards, but also those reporting practices which are common in an international context, i.e. those which can currently be considered worlds best practice.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports

3~1050
Types of Reports
A general definition of a valuation report can be found in the valuation standards of the Canadian Institute of Chartered Business Valuators and reads: A Valuation Report is defined as any written communication on letterhead and/or where the author(s) is identified, containing a valuation conclusion of shares, assets or an interest in a business, prepared by a valuator acting independently and that is not clearly marked as being in draft form. The format of a final report will normally be determined while preparing an engagement letter. The format of a report will generally follow one of the following formats: verbal report; schedules and computations; working papers of key findings; written summary letter; detailed valuation report; experts report; or experts report including court testimony.
Each of these are discussed in more detail below.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1070 Verbal Report
3~1070
Verbal Report
At Leadenhall, we are asked from time to time to advise on what a business is worth and are asked not to bother preparing a formal report, just tell me what it is worth. Having undertaken the necessary analysis we are normally in a position to provide a range of values, however there are great dangers in not preparing a written report. Part of the importance of writing a report (particularly if you follow one of the report formats included below) is that it ensures the important issues are addressed and it assists in crystallising and substantiating the valuation. Also, the client will always remember the valuation amount and never remember the conditions. For example they will not necessarily remember: what was included and what was excluded from the valuation; whether the valuation was of the business or of the company; at what date the valuation was prepared; that the valuation was contingent on future plans, i.e. on the successful launch of a new
product; what the economic conditions were at the time of the valuation; and on what basis and for what purpose the valuation was prepared.
For these reasons we strongly recommend against providing verbal reports unless they are followed up by a written report.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1090 Schedules and Computations
3~1090
Schedules and Computations
Any person that regularly undertakes valuations of businesses will probably have at their disposal a number of standard spreadsheets designed to assist in calculating the value of a business. These can facilitate a systematic and methodical approach to the valuation of a business. In certain circumstances it may be appropriate to use a spreadsheet as the basis of either a report of schedules and computations or of an indication of the value of a business. If a valuation spreadsheet is used as a summary report it is crucial that the spreadsheet incorporates each of the following: a disclaimer; a statement that it is not a valuation, but rather an indication of value; the date it was prepared; the date of the calculations; the standard and premise of value applied; the purpose of the valuation; justification of key variables (i.e. discount rates and PERs); and a list of the additional issues that might need to be considered to prepare a formal valuation.
It is worthwhile reviewing the report formats included in the latter part of this chapter to ensure the spreadsheet report (although only a summary report) addresses the required topics. We regularly use reports of this nature as preliminary reports to discuss the key issues with clients and to ensure they agree with issues such as the computation of future maintainable earnings. The use of spreadsheets to prepare this type of report enables a number of what if scenarios to be produced quickly, with the client able to see the key value drivers and how changes in them affect the value of the business. It is important that the client understands that the justification and substantiation of key variables and the consideration of any additional issues can only be outlined in a detailed written report.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1110 Working Papers of Key Findings
3~1110
Working Papers of Key Findings
Having completed an indication of value using a schedules and computations report, we sometimes find clients do not perceive great added value in proceeding to a detailed valuation report and yet there
may be a few key issues which need to be considered in more detail. In these circumstances we often prepare working papers of key findings. These working papers normally address significant issues, explain the justifications for different key variables and test the sensitivity of the value calculated to changes in those key variables. A working paper we often prepare is a justification of the appropriate discount rate and it considers and explains the following concepts: the risk-free rate; the rate of return available from a diversified portfolio of listed stocks; the return required from an investment in a single listed company; how to calculate the return required from a small private company; the return required from a start-up enterprise; and the sensitivity of the value calculated to changes in the discount rate.
Many business owners are surprised (and a little disappointed) when a higher discount rate is applied than those implied for comparable listed companies. The working paper assists the business owners understanding of the issues considered and would conclude by discussing and justifying the discount rate we believe is most appropriate.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1130 Written Summary Letter
3~1130
Written Summary Letter
Some clients work through an indication of value using a schedules and computations report and after studying a working paper on the key issues, do not then proceed to a detailed valuation report. Instead they may request a letter summarising the values calculated and final copies of the supporting calculations. If a summary letter report is requested, it is crucial that, at a minimum, the report incorporates each of the following: a disclaimer; a statement that it is not a valuation, but rather an indication of value; the date it was prepared; the date of the value calculations; the standard and premise of value applied; the purpose of the valuation; justification of key variables (i.e. discount rates and PERs); and a list of the additional issues that might need to be considered to prepare a formal valuation.
It is worthwhile reviewing the report formats included in the latter part of this chapter to ensure the letter report (although only a summary) addresses the required topics.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1150 Detailed Valuation Report
3~1150
Detailed Valuation Report
The majority of valuations do proceed to the preparation of a detailed valuation report where third parties (i.e. banks) are going to rely on the valuation or where shareholders are going to use the information as the basis of a decision to buy or sell a business. Classically, valuation reports will extend to pages of detailed analysis and discussion. They should be a self-explanatory document in that they should detail: the opinion reached; the reasons for the opinion; the major assumptions underlying the reasons given for the opinion; particulars of the business in question; the alternative methodologies for valuing a business, which are appropriate in the given circumstances and why they are appropriate; why the particular key value drivers used were believed to be appropriate; any specialists reports used or experts reports relied upon; any relationships between the company and the report preparer; and the qualifications of the report preparer.
It is worthwhile reviewing the report formats included in the latter part of this chapter to ensure the detailed valuation report addresses the required topics.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1170 Experts Reports
3~1170
Experts Reports
The valuation standards of the Canadian Institute of Chartered Business Valuators defines an expert report as: any written communication other than a Valuation Report, on letterhead and/or where the author(s) is identified, containing a conclusion as to damages or the quantum of financial gain/loss, prepared by a Valuer acting independently and that is not clearly marked as being in draft form. An experts report may also be known as a fairness opinion. An experts report is an objective opinion as to the value of a transaction.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1170 Experts Reports / 3~1180 Scoping an assignment involving an experts report
3~1180
Scoping an assignment involving an experts report
Many of the issues of concern when scoping an assignment involving an experts report are the same issues dealt with in the chapter Scoping a Valuation Assignment. In addition, when preparing to accept an assignment involving the preparation of an experts report
there may be a number of specific issues to consider including: the purpose for the experts report being prepared (including the legislation requiring the preparation of the experts report); and for whom the experts report is being prepared.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1170 Experts Reports / 3~1190 Purpose for the experts report being prepared
3~1190
Purpose for the experts report being prepared
The purpose of a valuation report is discussed in detail in the chapter Scoping a Valuation Assignment. Specifically, an experts report may be required in the following circumstances: compulsory acquisition of shares by a majority shareholder; a take-over where the offeror is connected with the target (i.e. via a common director); share buy-backs; and disputes and litigation.
The objective of independent experts reports in the context of the Corporations Act 2001 and the Australian Stock Exchange (ASX) Listing Rules is to provide shareholders (who are not associated with the proponents of the take-over or other transaction) with an objective and independent opinion of the value of their shares (or other securities) and/or the value of the proposed transaction. An independent experts report is for the shareholders; this can be likened in some ways to the role of an auditor. Experts reports are designed to provide shareholders with independent and objective information in situations where there may be, or perceived to be, a potential conflict of interest on the part of one or more parties to the transaction. Valuation reports are required in many situations by the Corporations Act 2001 and ASX listing requirements. The section on statutory requirements for valuations includes a table setting out the major reasons for preparing experts reports.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1170 Experts Reports / 3~1200 For whom is the report being prepared?
3~1200
For whom is the report being prepared?
It is easy to assume the report is being prepared for your client; however, in many cases this may not in fact be the situation. When preparing an experts report as part of a takeover, the valuers duty is not to the target company or its directors but to the individual and unrelated shareholders who will rely on the report. Similarly, when appearing as an independent expert in court, the valuers duty is to the court rather than to the client. If, at any stage, the valuer is seen to be an advocate for the client, the valuers credibility as an impartial and independent adviser will be undermined and their work will run the risk of being rejected as credible evidence by the court. Extracts from ASIC Practice Note 43 are set out below:
Duty to Security Holders and Investors [PN 43.8] When an expert accepts a retainer to provide a valuation report he or she undertakes a duty to the security holders and prospective investors to whom the report is directed, to provide a report which is for their information and decision making. The success of such a report should be measured as much by its clarity and utility to its users as by the sophistication of its analysis and its information content. [PN 43.9]It may be misleading conduct, and it would definitely be undesirable, for an expert not to disclose, clearly and prominently, any interest in the subject matter of the report. Unless those interests are clearly disclosed it would be misleading for his or her report to be described as an independent report. As a further example, the following is extracted from the Guidelines for Expert Witnesses in Proceedings in the Federal Court of Australia. General Duty to the Court 1.1 1.2 1.3 An expert witness has an overriding duty to assist the Court on matters relevant to the experts area of expertise. An expert witness is not an advocate for a party. An expert witnesss paramount duty is to the Court and not to the person retaining the expert.
As can be seen from the above it is crucial that the valuer has a proper understanding of the reports target audience. The duty of a valuer in Australian courts may vary slightly depending on the court the matter is being heard in, but generally the requirements set out above should be followed. However before preparing a report, the valuer should review the requirements of the specific court in which they are likely to appear. The guidelines for the Federal Court can be found at <www.fedcourt.gov.au/how/prac_direction.html>. Other courts have issued similar guidance, including the Supreme Court of South Australia in Practice Direction No. 46A and the New South Wales District and Supreme Court. This is amplified by Guidance Note GN 2 Forensic Accounting, issued by the Institute of Chartered Accountants and CPA Australia which notes: Role and duty of an independent accounting expert 8. These documents [the Court guidelines] have been issued by the Courts to codify the general principles of independence and objectivity. These principles are inherent in the standards generally expected of all members. the primary role of an independent accounting expert in litigation is to assist the Court by providing opinions or interpretations of factual information, based upon the experts expertise in a subject area which is outside of the knowledge, skill or experience of the Court. The primary duty of the independent accounting expert is to the Court and not to his or her client. The expert should ensure that in providing opinions he or she
9.
10.
does not act as an advocate. The expert should at all times ensure that the work done, including any opinions given in evidence, is consistent with this overriding obligation. 11. 12. The independent accounting expert is subject to the normal duty of an expert witness. An independent accounting expert must not do anything which compromises, impairs, or is likely to impair either: the experts duty to the Court; or the experts independence or integrity.
In addition, the Family Court of Australia announced that the Family Law Rules 2004 have been published as Statutory Rules No. 374 of 2003 and came into effect on 29 March 2004. These Rules are available from the Family Court of Australias web site <www.familycourt.gov.au>. Part 15.5 of the Rules deals specifically with experts evidence and the rights and duties of experts. Some of the requirements contained in the Rules are onerous and practitioners appearing before the Family Court should pay careful attention to the requirements. Furthermore the term independent, and the requirements to report on whether offers are fair and reasonable (as defined by the Corporations Act 2001), effectively move the for whom emphasis away from the clients interests to the individual shareholders.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1170 Experts Reports / 3~1210 Engagement and documentation of expert assignments
3~1210
Engagement and documentation of expert assignments
Reference should be made to the chapter on Engagement and Documentation of Assignments as the issues considered there must also be considered before accepting an engagement to prepare an experts report. In addition there may be additional requirements imposed on valuers in the way of: licences; appropriate qualifications; independence; fees; liability; reliance they place on the information provided; and court appearances.
There are also a number of issues to consider which may indicate that it is proper to decline an assignment.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1170 Experts Reports / 3~1220 Qualifications
3~1220
Qualifications
The Corporations Act 2001 provides a formal definition of expert in section 9: in relation to a matter,a person whose profession or reputation gives authority to a statement made by him or her in relation to that matter. Practice Note PN 43 expands the definition in the Act by stating: [PN 43.18]Whether a persons profession or reputation gives such authority to his or her statements is a question of fact. It is the responsibility of the expert and of the person retaining the expert to ensure that: a. b. c. the experts profession or reputation is relevant to the matters upon which he or she reports; the expert holds the licences or authorities necessary for providing the type of advice sought; the expert states in the report his or her qualifications and experience or, if the report is made by a corporation or firm, the qualifications and experience of the individuals responsible for preparing the report; the expert retains specialists to advise on any technical matters which are relevant but on which the expert is not personally authoritative; and the expert signs the report and consents to its use in the form and context in which it will be published.
d. e.
The ICA and CPA Australias Statement of Forensic Accounting Standards APS 11 also deals with the skills and competence of the member to provide the required services. Some of the questions an appointing board should ask are: Does the valuer have relevant experience in the industry in which the company operates to conduct a sound valuation? Does the valuer have relevant and sufficient experience in conducting valuations? Are the valuers qualifications (both formal and informal) suited to the intended appointment? Does the intended valuer have a sound reputation for providing good quality work? Does the valuer have a high standing amongst their peers in the areas of valuations and independent expert reports? Does the valuer have the necessary resources, including staff and research, to do the job?
In addition, before preparing a report, the valuer should review the requirements of the specific court in which they are likely to appear. The guidelines for the Federal Court can be found at <www.fedcourt.gov.au/how/prac_direction.html>. In addition, the Family Court of Australia announced that the Family Law Rules 2004 have been published as Statutory Rules No. 374 of 2003 and came into effect on 29 March 2004. These Rules are available from the Family Court of Australias web site <www.familycourt.gov.au>. Part 15.5 of the Rules deals specifically with experts evidence and the rights and duties of experts. Some of the requirements contained in the Rules are onerous and practitioners appearing before the Family Court should pay careful attention to the requirements.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports /

3~1170 Experts Reports / 3~1230 Independence

3~1230
Independence
Of overriding concern to the process of independent valuation is that the valuer provide an unbiased opinion. Usually this can only be provided when there is no relationship (financial or otherwise) between the valuer and the engaging board of directors. A good rule of thumb in determining whether a valuer is independent in any given circumstance is to consider whether an unfavourable opinion provided by the valuer could jeopardise any ongoing work that the valuer (or valuers firm) performs for the appointing company. For example, if the valuer considered that their firms tenure as auditor of the engaging company could be jeopardised by an unfavourable report, they should preclude themselves from preparing the report. This is in many respects a self-imposed restriction as shareholders, the company, ASIC and other stakeholders may be unaware of the valuers concerns. However, there will undoubtedly be instances where shareholders and other parties will perceive that the valuer is not independent. The evaluation of impartiality is an important one to make. ASIC Practice Notes 42 and 43 set out some of the issues that a valuer should consider before accepting an engagement. Extracts of Practice Note 42 are set out below: 9. The ASC is likely to consider that some approaches indicate the experts lack of independence, including where (in descending order of seriousness): a. b. c. d. e. the expert is present at discussions on the development of the proposal; the instructions the client gives to the expert evaluate the facts relevant to writing the report, or indicate how the facts should be evaluated; the client has rejected other experts after they have disclosed their likely approach to evaluating the proposal; the expert is commissioned to prepare a report before the proposal to be reported on is finalised; or the expert begins to write the report before the proposal is finalised.
In relation to paragraph (d), the Commission accepts that, as time pressure and deadlines may be such that the client needs to engage the expert before the proposal is finalised (so that the expert can start collecting information), such an approach will not necessarily indicate a lack of independence. 12. The amount the client pays the expert for the report should not depend on the success of the event or proposal to which the report relates. An expert who is paid a success fee will not be considered independent. ...On the ASCs understanding of the decision in the Pivot case, it may be acceptable for the client to state the desired conclusion of the report. However, the ASC considers that, if this statement were accompanied by the clients analysis of the facts, it would be contrary to the judgements in both the Pivot and Wormald cases. The client should not presume to determine what data or information is required for the preparation of the report. This is for the expert to do. The client, which is often
13.
14.
the best source of information for the expert, should give the expert all the information it is aware of which may relate to the subject of the experts report, in sufficient detail to enable the expert to determine its relevance... 19. An expert is not precluded from providing a report merely because, during the preceding two years, he or she: a. b. acted as auditor of the target corporation, the client or any other interested party; worked for a corporation which deals in the money market as part of its ordinary business and may hold bills of exchange or promissory notes the client or other interested party may be liable for; or worked for a corporation that manages an investment portfolio that includes shares in the client or any other interested party.
c.
These criteria do not necessarily denote or imply independence. The expert may need to demonstrate his or her independence in any particular case. 25. If a client disagrees with the experts evaluation in a draft report, the report should only be altered to substitute the contrary view if the client persuades the expert that its own assessment is objectively more correct, or all or part of the experts assessment is based on an error of fact. In this case, the expert should independently reassess the whole or relevant part of the report based on his or her revised view of the facts. Otherwise, the clients contrary assessment should only ever be incorporated in the experts report if: a. b. he or she believes that it would be in the interest of the reader to know what that assessment is; and both assessments are appraised by the expert.
An observation was recently made in the courts that by law, an auditor is required to be independent of the directors and management of a company. On this basis, many auditors argue that their role as auditor does not impinge upon their independence or perception of independence as experts, despite the prima facie conflict of interest. It is interesting to note that Terry Dalziel of the National Companies & Securities Commission noted (February 1989): ...I consider that it would be prudent for an auditor to refrain from accepting an appointment in such circumstances even though the conflict is disclosed in the report. Such reports are of interest to officers of the Commission If the valuer believes that there is a public perception that they are not independent, this is good reason to decline the offer to prepare the report. Shareholders may feel that advice given by a non-independent valuer is tantamount to not being provided with a report at all. The duty to determine whether the valuer is independent falls largely with the valuer. However, the directors appointing the valuer (or the committee comprising temporarily appointed directors specifically for the purpose) should ensure that the valuation and opinion provided to the shareholders by the valuer are not invalidated by any past, present or anticipated relationship (whether financial or otherwise). Such relationships may invalidate an otherwise sound report.
The legal case commonly known as the Pivot case (Phosphate Co-operative of Australia Limited v. Shears) highlights the need for valuers to not only be independent prior to their engagement but to retain their independence during the engagement. In the Pivot case, the valuer repeatedly amended his report until an opinion was arrived at which satisfied the engaging companys board. The Pivot case highlighted the need for valuers to have regard to professional ethics and rules of conduct. By way of example, Auditing Standard AUS 202 of the Australian Society of CPAs (now CPA Australia) and the Institute of Chartered Accountants in Australia, requires that: The auditor should comply with the ethical requirements of CPA Australia and The Institute of Chartered Accountants in Australia. Ethical principles governing the auditors professional responsibilities include: a. b. c. d. e. f. g. independence; integrity; objectivity; professional competence and due care; confidentiality; professional behaviour; and technical standards. (paragraph .04)
While this statement applies to auditors, its general application to members of the accounting profession cannot be overlooked. Professional Statement F.1 (Code of Professional Conduct) of CPA Australia and the Institute of Chartered Accountants also requires that: In each professional assignment undertaken, a member in public practice must both be and be seen to be free of any interest which is incompatible with objectivity. This is self evident in the exercise of the reporting function but also applies to all other professional work. (paragraph 10) The ICA and CPA Australias Statement of Forensic Accounting Standards APS 11 also deals with the independence of the member providing the services. Clearly, these pronouncements impose an overriding obligation on a valuer who is a member of either CPA Australia or the ICA. While the directors of an engaging company can, of course, request correction of factual inaccuracies in the experts report, there is no compulsion upon the valuer to accept a recommendation from their client to correct technical deficiencies if the valuer believes they are correct. One of the objections that Justice Brooking noted in the Pivot case was that the level of discussions between the valuer and the engaging parties created an environment wherein the valuer could be regarded, and did regard himself, as part of a team. Brooking went on to say: moreover, it is undesirable that the prospective independent expert should disclose to its prospective employer its probable general approach in evaluating the scheme.
More recently, ASIC issued a stop order on the prospectus of Marshall Edwards, Inc., preventing any offers, issues, sales or transfers of securities being made by the prospectus dated 27 April 2001. ASIC issued the final stop order following a hearing because the prospectus was found to be misleading and deceptive in a number of areas. Among the reasons given by ASIC were that the reference to the valuation report as an independent valuation report was misleading or deceptive because this created the perception that the valuation was attributed only to the expert, whereas correspondence between Marshall Edwards and the expert indicated that Marshall Edwards had input into the valuation. (ASIC Media Release MR 01/219 of 22 June 2001.) Professional Statement F.1 by CPA Australia and the Institute of Chartered Accountants includes a more specific discussion of independence. In particular, paragraph 12 notes that: The use of the word independence on its own may create misunderstandings. Standing alone, the word may lead observers to suppose that a person exercising professional judgment ought to be free from all economic, financial and other relationships. This is impossible, as every member of society has relationships with others. Therefore, the significance of economic, financial and other relationships should also be evaluated in the light of what a reasonable and informed third party, having knowledge of all relevant information, would reasonably conclude to be unacceptable. This paragraph is identical to paragraph 8.9 of the Code of Ethics for Professional Accountants published by the International Federation of Accountants (IFAC) in November 2001, which introduced new rules of independence that are intended to serve as a model on which to base national ethical guidance for accountants. Both F.1 (paragraph 14) and the IFAC Code include the following definition of independence: Independence is: a. Independence of mind the state of mind that permits the provision of an opinion without being affected by influences that compromise professional judgment, allowing an individual to act with integrity, and exercise objectivity and professional scepticism; and Independence in appearance the avoidance of facts and circumstances that are so significant a reasonable and informed third party, having knowledge of all relevant information, including any safeguards applied, would reasonably conclude a firms, or a member of the firms, integrity, objectivity or professional scepticism had been compromised.
b.
The IFAC Code can be accessed via the web site at <www.ifac.org>. Before preparing a report, the valuer should also review the requirements of the specific court in which they are likely to appear. The guidelines for the Federal Court can be found at <www.fedcourt.gov.au/how/prac_direction.html>. In addition, the Family Court of Australia announced that the Family Law Rules 2004 have been published as Statutory Rules No. 374 of 2003 and came into effect on 29 March 2004. These Rules are available from the Family Court of Australias web site <www.familycourt.gov.au>. Part 15.5 of the Rules deals specifically with experts evidence and the rights and duties of experts. Some of the requirements contained in the Rules are onerous and practitioners appearing before the Family Court
should pay careful attention to the requirements.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1170 Experts Reports / 3~1240 Licensing requirements
3~1240
Licensing requirements
Accountants, directors and advisers working with public companies (listed or otherwise) are frequently asked to prepare experts reports. Anyone proposing to prepare an experts report needs to consider if there are specific licensing requirements and if they have the necessary qualifications to be recognised as an expert. Reference should be made to the chapter on Engagement and Documentation of Assignments and particularly the section on licences, qualifications and expertise as the issues considered there must also be considered before accepting an engagement to prepare an experts report. ASIC Policy Statements 116124 required firms which have established investment advisory or securities dealing divisions to become licensed advisers or dealers. These Policy Statements have been superseded Policy Statement PS 167: Licensing: Discretionary powers and transition states: [PS 167.27] The Good Advice policies (ASICs existing Policy Statements 116124) are superseded. Nevertheless, in some cases noted in the Schedule [to PS 167], aspects of these policies may provide guidance and relevant considerations about complying with your obligations under the new regulatory regime. The thrust of the securities industry sections of the Corporations Act 2001 and the nature of independent experts reports would, ordinarily, suggest that an investment adviser or securities dealer licence is required. ASIC Practice Note 43 states that: Licensing 20. An Expert who carries on a business of providing reports for security holders in which the Expert provides opinions on securities or proposals in relation to securities, is providing securities advice and must be licensed under Pt 7.3.
Finally, as a result of the Corporate Law Economic Reform Program (CLERP) amendments to the Corporations Act, where an independent expert is required to advise on the acquisition of a minority interest in a company, they must be appointed by ASIC from ASICs panel of suitably qualified and experienced people (section 667A(1) of the Corporations Act 2001). ASIC Information Release IR 00/2 called for expressions of interest from people who wished to be on the panel; in particular: Who is eligible to be on the panel? The panel will be made up of securities industry licence holders who can demonstrate a significant level of experience in the preparation of public experts reports. ASIC will establish two panels of experts. The first will be experts who are able to prepare reports for larger companies. For this purpose a large company ( including its controlled entities) is one with gross operating revenue of more than $10 million or consolidated gross assets of more than $5
million for the past financial year. The experts must be prepared to undertake reports for all types of companies and classes of securities unless they request specialist designation to a particular industry type. The expert will need to hold an appropriate securities dealers licence. Generally experts will be expected to demonstrate that they have completed at least 20 reports in the past five years. Specialists should also be able to demonstrate at least four reports in the speciality in that period. The reports should be public reports prepared for the purposes of the Corporations Law, ASX Listing Rules or under relevant State legislation (e.g. AFIC Codes or Cooperative legislation). The second panel will be of those experts prepared to undertake reports of companies not meeting the above large criteria. It is expected that they will have a lower cost basis and will be able to undertake reports for smaller companies without the associated costs being prohibitively high. Experts will be expected to demonstrate 10 reports in the past five years.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1170 Experts Reports / 3~1250 Declining to prepare an experts report
3~1250
Declining to prepare an experts report
This is a matter of professional judgement but the questions of independence and qualifications should be at the heart of the decision. If there is a likelihood that the report has been shopped (i.e. the client has shopped around for a favourable opinion) this may be sufficient reason to decline to prepare the report. At the end of the day, the valuers livelihood is at risk if an engagement is accepted which results in a valuers opinion and independence being called into question or a report prepared outside the valuers parameters of expertise.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1170 Experts Reports / 3~1260 Engagement letters and fees
3~1260
Engagement letters and fees
ASIC, and its predecessors the ASC and the NCSC, considers that success-based fees for valuers are not appropriate and would no longer be permitted. Most valuers have long accepted that it is an inappropriate practice given the nature of the engagement. In many ways, obtaining a success fee for preparing an expert report could be likened to obtaining a success fee for preparation of an audit report. In July 1992, the ASC took action against the brokerage firm William Noall Ltd for failing to disclose a $100,000 success fee for an experts report prepared for Precision Data Holdings Ltd in 1990. The action taken by the ASC prohibited William Noall Ltd from preparing independent experts reports under the Corporations Law for a period of three years by imposing a restriction on Noalls securities dealer licence. ASIC Practice Note 42 (paragraph 12) now states:
The amount the client pays the expert for the report should not depend on the success of the event or proposal to which the report relates. An expert who is paid a success fee will not be considered independent. The engagement letter entered into between the valuer (or valuers firm) and the engaging company should create a contractual obligation upon the company to pay the valuers nominated fees on a time and responsibility basis, not on an outcome basis. Another issue is whether an appointment should be accepted knowing that the company does not have the means with which to pay the valuer. One way of ensuring payment is to negotiate for the estimated fee to be paid into a trust account to be released upon the valuer signing off the report. In addition, before preparing a report, the valuer should review the requirements of the specific court in which they are likely to appear. The guidelines for the Federal Court can be found at <www.fedcourt.gov.au/how/prac_direction.html>. The Family Court of Australia has announced that the Family Law Rules 2004 have been published as Statutory Rules No. 374 of 2003 and came into effect on 29 March 2004. These Rules are available from the Family Court of Australias web site <www.familycourt.gov.au>. Part 15.5 of the Rules deals specifically with experts evidence and the rights and duties of experts. Some of the requirements contained in the Rules are onerous and practitioners appearing before the Family Court should pay careful attention to the requirements.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1170 Experts Reports / 3~1270 Liability of valuers
3~1270
Liability of valuers
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1170 Experts Reports / 3~1270 Liability of valuers / Common law duty
Common law duty
The tort of negligence applies to the preparation of experts reports. Where a party to whom a duty of care was owed suffers a loss or damage as a result of the negligence of the valuer, the valuer is liable for remedying the loss and damage suffered by the shareholder. The two issues which the valuer must consider are: To whom is the duty of care owed? (refer Mutual Life and Citizens Assurance Co Ltd v. Evatt [1971] AC793) and What constitutes negligence?
Recent legal cases involving auditors seem to indicate that the absence of a contractual relationship between an auditor and a third party relying upon the accounts for the purposes of a takeover excludes the auditor from liability. If this precedent can be extended to the ambit of valuers, it would appear that the liability borne by a valuer is only to shareholders, the company and (possibly)
immediate and existing creditors. In the context of experts reports, negligence could result from reporting or not reporting a matter that could foreseeably result in a loss to a shareholder who then acted on the reports findings without the full facts. By way of example, if the valuer has reason to believe a substantial contingent liability will come to rest on the company, but fails to mention it in their report, a resulting loss to shareholders could be put down to the valuers negligence. In practical terms, the extent of the valuers liability would probably be the extent of any loss incurred by a shareholder as a result of an incorrect opinion in the report. Legal opinion should be sought for clarification in individual cases.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1170 Experts Reports / 3~1270 Liability of valuers / Statutory duty
Statutory duty
The principal statutory provisions relating to experts reports are contained in the Corporations Act 2001 at: section 670A misleading or deceptive statements in takeover documents; and section 728 misleading or deceptive statements in fundraising documents.
These sections provide that where an experts report contains: the misleading or deceptive statement or the omission or new circumstance, which is materially adverse from the point of view of an investor. The valuer or the valuers firm has then committed an offence and is liable to pay compensation. Note that misleading statements with regards to forecasts and other forward-looking statements are defined in sections 670A(2) and 728 (2) as: A person is taken to make a misleading statement about a future matter (including the doing of, or refusing to do, an act) if they do not have reasonable grounds for making the statement. This subsection does not limit the meaning of a reference to a misleading statement or a statement that is misleading in a material particular. Such actions can also be defended under sections 670D, 731, 732 and 733; revolving predominantly around a need to show that the matter was not omitted, false or materially misleading to the knowledge of the valuer at the time of preparing the report. There is no defined penalty for contravening these sections but the valuer is liable to pay compensation to anyone relying upon the incorrect information. It is also interesting to note that a previous Chairman of ASIC (Mr Tony Hartnell) expressed the belief that a valuer cannot disclaim liability without the disclaimer itself being a misleading statement. Action against a valuer needs to prove that the valuer was in fact not expert or was negligent.
If the valuer is found to be not expert, the Corporations Act 2001, the Trade Practices Act and common law may all be able to be invoked to show that the valuer was in fact holding out to be something that they were not. Damages could then be claimed against the valuer. The Corporations Act 2001 and Trade Practices Act are essentially statutory embodiments of the false and misleading conduct concept in negligence. However, once a valuer is proven to not be an expert, the company then has the problem of having failed to provide shareholders with an experts report. This could then result in a breach of the Corporations Act 2001 being committed by the company. Whilst the ASIC Practice Notes and Policy Statements do not have the force of law, it is possible that an experts report that fails to adhere to and satisfy the requirements of the Corporations Act 2001 and relevant ASIC releases, could cause ASIC to make a declaration that the transaction (or takeover bid) was a result of unacceptable conduct (due to inadequate information being provided to shareholders).
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1170 Experts Reports / 3~1270 Liability of valuers / Indemnities for accuracy of data
Indemnities for accuracy of data
An indemnity is different to a disclaimer and this is recognised in ASIC Practice Note 43. Whilst disclaimers are not permitted, ASIC believes that it is reasonable to obtain an indemnity from the client or another person relating to the data provided to the valuer, and that details of the indemnity or a summary are disclosed in the report. However, the indemnity cannot be disclosed in a way which implies relief from liability. Paragraph 66 of Practice Note 43 is of particular relevance: 66. An indemnity may actually improve the position of a person who relies on the report. This is by increasing the number of persons with an interest in ensuring that the report is soundly based.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1170 Experts Reports / 3~1270 Liability of valuers / Disclaimers
Disclaimers
As a disclaimer can not be used, a valuers only real defence is to ensure they have been duly diligent so that claims of negligence cannot be levelled at the valuer.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1170 Experts Reports / 3~1280 Reliance on information provided
3~1280
Reliance on information provided
There are many situations where it will be necessary for a valuer to rely on the work of other specialists. Some possible examples would be where the valuation included: real property (i.e. land and buildings); mining tenements; bio-technology developments; and other very specific technologies and/or developments.
In the chapter Research and Data Collection, we briefly consider the extent a valuer should rely on the information provided. Any valuer using the work of other specialists should consider the following authorities pronouncements: Auditing Standard AUS 606 Using the Work of an Expert; ASIC Practice Note 42 Independence of Experts Reports; ASIC Policy Statement 75 Independent Expert Reports to Shareholders; and ASIC Practice Note 43 Valuation Reports and Profit Forecasts.
Each of these is discussed below.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1170 Experts Reports / 3~1280 Reliance on information provided / Auditing Standard AUS 606 Using the Work of an Expert
Auditing Standard AUS 606 Using the Work of an Expert
This standard states: Introduction [.02] When using the work performed by an Expert, the auditor should obtain sufficient appropriate audit evidence that such work is adequate for the purposes of the audit.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1170 Experts Reports / 3~1280 Reliance on information provided / ASIC Practice Note 42 Independence of Experts Reports
ASIC Practice Note 42 Independence of Experts Reports
This Practice Note states: [42.21] If specialist advice is required on a particular aspect of the proposal, the expert would usually select and retain an independent specialist to provide it (see Policy Statement 75). The expert can use a specialists report commissioned by the client if the client is satisfied with the standard and the independence of the specialists report. However, it would be preferable for the expert to commission the specialists report, so that the expert is seen to be acting independently of the client. It is also the experts responsibility to determine whether the specialist advice is required.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1170 Experts Reports / 3~1280 Reliance on information provided / ASIC Policy Statement 75 Independent Expert Reports to Shareholders
ASIC Policy Statement 75 Independent Expert Reports to Shareholders
This Policy Statement states: Specialist [75.20] If the expert retains a specialist to write a part of his or her report, that specialists
report will not by itself constitute an experts report ... Therefore, it is not required to contain an opinion on the take-over offer and is not required to be reprinted in full. However, the expert must take care to use, quote or cite the specialists report in a way which is fair and representative. Policy Statement 75 continues to provide some guidance when it states: [75.45] Some experts have been concerned that establishing reasonable grounds for inclusion of information in a s648 report means that they must perform a detailed audit of all data. While an expert must establish reasonable grounds for including any information in his or her report, he or she is not expected to conduct an audit of the subject matter of the report for the purposes of s648.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1170 Experts Reports / 3~1280 Reliance on information provided / ASIC Practice Note 43 Valuation Reports and Profit Forecasts
ASIC Practice Note 43 Valuation Reports and Profit Forecasts
This Practice Note states: Specialists [43.26] In order to be able to establish reasonable grounds for any conclusion or opinion stated in the report, if the expert is not personally authoritative on matters which must be determined for the purpose of the report, he or she should retain an appropriate specialist. [43.27] It is the experts responsibility to satisfy him or herself that the specialist: a. b. c. is competent in the field; has used assumptions and methodologies which seem reasonable, and drawn on source data that appears to be appropriate; is independent of, and is perceived to be independent of, interested parties, or the specialists lack of independence is clearly and prominently disclosed. If the specialist is not independent, the entire experts report should not be described as, or held out to be, an independent report; has a clear agreement with the expert concerning the purpose and scope of the specialists work; and signs his or her report and consents to the use of it in the form and context in which it will be published. If the expert does not ensure that the specialist takes responsibility for and authorises the use of the report or extracts or summaries of it, the expert must accept entire responsibility for the statements as his or her own and must have his or her own reasonable grounds for believing them not to be false or misleading.
d. e.
Evaluation of information [43.57] The expert must: a. critically evaluate the information provided to him or her;
b. c.
take note of any grounds held for questioning the truth, accuracy and completeness of the information; and undertake whatever checks, enquiries, analyses and verification procedures that are necessary to afford reasonable grounds for the statements in the report.
[43.58] By way of example, the expert must review directors valuations and management accounts, partly to detect changes in the basis of compilation such as are mentioned at PN 43.42. However, if there are no indications of irregularity, manipulation or omissions, the expert will ordinarily be entitled to take at face value valuations provided by outside experts, audited accounts and the accounting records of the company. The expert may also rely on management accounts if he or she has established the reasonable grounds mentioned at PN 43.52.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1050 Types of Reports / 3~1170 Experts Reports / 3~1290 Court appearance
3~1290
Court appearance
As the circumstances requiring the preparation of an experts report can often find their way into the courts, undertaking such a report often also carries the responsibility of appearing as an expert witness and giving testimony on the report prepared. This should be borne in mind when accepting instructions from a solicitor. Appearing before a court for the first time can be a harrowing experience. One of the tactics employed is to discredit the clients expert witness. This can take many forms ranging from attacking professional qualifications and academic standing to questioning the objectivity with which the valuation task has been undertaken. A great disservice can be done to a client if the valuer is unable to defend a reports assumptions and conclusions in the court. Principles of the admissibility of experts reports and of an experts obligations are discussed in Makita (Australia) Pty Ltd v. Sprowles [2001] NSWCA 305 (14 September 2001). In addition, the Family Court of Australia announced that Family Law Rules 2004 have been published as Statutory Rules No. 374 of 2003 and came into effect on 29 March 2004. These Rules are available from the Family Court of Australias web site <www.familycourt.gov.au>. Part 15.5 of the Rules deals specifically with experts evidence and the rights and duties of experts. Some of the requirements contained in the Rules are onerous and practitioners appearing before the Family Court should pay careful attention to the requirements.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents

3~1330
Report Contents
The contents of a valuation report will depend on the scope of the assignment and the type of report agreed on in the engagement letter. The exact content of a valuation report will vary according to the assignment, but below we have considered some general requirements, which may need to be addressed. We conclude the section by addressing some specific requirements.
In addition to the Report Content Checklist, it is worthwhile reviewing the report formats in the latter part of this chapter to ensure that the required topics are addressed. Some useful information is also available from clauses 46 and 47 of the Joint Guidance Notes of the Institute of Chartered Accountants in Australia and CPA Australia, entitled GN 2 Forensic Accounting.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1350 General Requirements
3~1350
General Requirements
A valuation report should be a self-explanatory document and, in addition to explaining the assumptions made about the key value drivers used and why they were believed to be appropriate, should address the issues discussed below: the standard of value, premise of value and purpose of the valuation; a disclaimer and any limitations on scope or access to data; concerns or problems with data relied on (i.e. market prices not indicative of value); details of any instructions given; directors representations; the alternative methodologies for valuing a business, which are appropriate in the given circumstances and why they are appropriate; the comparative value of the consideration offered; whether the offer is fair and reasonable; the qualifications and experience of the valuer; all fees paid and their basis; the independence of the valuer and their work history with this client; the opinion and the reasons for that opinion; a recommendation; explanation of the likely effect of the transaction on different groups of shareholders; the reliance placed on specialists reports; and disclosure issues.
It is worthwhile reviewing the report formats included in the latter part of this chapter to ensure the valuation report addresses the required topics.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1350 General Requirements / 3~1360 Standard, premise and purpose of value
3~1360
Standard, premise and purpose of value
As discussed in the chapter Scoping a Valuation Assignment, the standard, premise and purpose of a valuation (and the date at which the entity is being valued) can all fundamentally affect the value of a business. These issues should be given prominence in any valuation report.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1350 General Requirements / 3~1370 Details of instructions given
3~1370
Details of instructions given
Instructions given by a client to a valuer can significantly affect the value calculated. This is particularly the case when the scope of the assignment has been restricted or access to information has been restricted. Many of these instructions may be covered in the engagement letter, however restrictions on access to information may only be encountered once the assignment is in progress. As a result of the impact instructions can have on the value calculated, it is therefore important that the users of the valuation report understand the instructions given and any restrictions placed on the valuer. The best way to achieve this is by clearly stating this information in the final report.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1350 General Requirements / 3~1380 Valuation methodology
3~1380
Valuation methodology
It is common sense that some clear methodology should be evident in a valuation report. Not only so that the report is self-explanatory but so that it could form the basis of a defence against any challenge that the valuer had not reached an honest view or that material omissions could warrant a different opinion. Failure to adhere to a logical and consistent methodology which forms the basis of the opinion (and therefore the valuation) might lead to a report being considered misleading and possibly paving the way to an action against the valuer. A complete discussion on the different valuation methodologies (income, market and asset) and appropriateness of each is located in the valuation method chapters.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1350 General Requirements / 3~1390 Comparative values/Conclusion of value
3~1390
Comparative values/Conclusion of value
Valuations use a number of assumptions and it is appropriate to give a range of values under the major alternative scenarios or assumptions. It is appropriate to reconcile or explain the preferred valuation conclusion where a number of valuation methods have been used and a number of valuation conclusions reached. In addition, there are many circumstances where a point valuation (rather than a range) is required. In this circumstance valuers should determine if the mid point of a range is the most appropriate. It is possible that using the mid-point of a range of discount rates may provide a better point estimate than an average of the resulting valuations. In Australia PS 163 published by ASIC provides some guidance on this issue: Range of values
[PS 163.40] If the bidder provides a range of values of the unquoted securities, it is necessary to work out an appropriate point within the range for comparison between maximum consideration and bid consideration. The appropriate point to adopt in a range of values is the point that the bidder works out is the most likely value. [PS 163.41] Without exceptional circumstances, this will be the mid-point of the range (average or mean value). If there is a normal probability distribution of values, the mid-point is the most likely value. This is consistent with the Panels decision in Re Email Limited (2000) 18 ACLC 708, 716: If we adopted a valuation which could be represented by a simple, symmetrical bell curve, we would be entitled to take the mid-point of a valuation range based by the valuer on that curve we would be adopting the valuers conclusion that it was most probable that the value lay at the peak of the curve, and that it was no more likely to lie below that peak than above it. [PS 163.42] The result produced by this approach is not unlike that produced by the approach of Lockhart and Hill JJ in BTR Plc v Westinghouse Brake and Signal Company (Australia) Ltd (1992) 34 FCR 246, 25960. Lockhart and Hill JJ characterised their approach as commonsense: If the expert, rather than arriving at a single price which he considers to be fair and reasonable, provides instead a range of figures meeting that criterion (all derived from a single method of valuation), it must follow that the expert is of the opinion that each and every figure within the range is fair and reasonable Commonsense, however, would suggest that the fairest result would be obtained by taking an average of values. [PS 163.43] Exceptionally, the bidder may consider that the mid-point of a range is not the most likely value. For example, the bidder may attach greater weight to one outcome than another, so that the probability distribution of values will be skewed. Note also it may be inappropriate to take the mid-point of values determined from different methods: Hawker de Havilland Ltd v ASC (1991) 6 ACSR 579, 591. [PS 163.44] It follows that the minimum bid price principle does not require the bidder to adopt: a. b. the lowest point in the range for unquoted securities as bid consideration as the point of comparison with pre-bid purchase consideration; or the highest point in the range for unquoted securities as pre-bid purchase consideration as the point of comparison with bid consideration.
[PS 163.45] The bidder should explain in the bidders statement the basis for fixing the point in a range for the purposes of the minimum bid price principle.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1350 General Requirements / 3~1400 Fair and reasonable
3~1400
Fair and reasonable
Depending on the nature of the valuation report, an assessment on whether an offer is fair and reasonable may need to be given.
If required, it is important to define these terms clearly, as well as considering whether the offer meets or satisfies them. ASIC Policy Statement 75 discusses the definition of fair and reasonable, how to determine both and how these two terms form the foundation of an opinion. There is more than a semantic difference between fairness and reasonableness. Once one understands the meaning of each of the two terms a much better understanding can be obtained as to the distinction between the two.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1350 General Requirements / 3~1400 Fair and reasonable / Fairness
Fairness
Of the two terms, fairness is easier to understand. PS 75 defines an offer as fair in the following circumstances: 26. 27. An offer is fair if the value of the offer price or consideration is equal to or greater than the value of the securities the subject of the offer. This comparison must be made assuming 100% ownership of the target company. In his or her opinion on the fairness of an offer, the expert should not consider the percentage holding of the offerer or its associates in the target company. In assessing the comparative values of the consideration and the securities which are the subject of the offer, the expert should not take into consideration the percentage holding of the offeror or its associates in the target company.
28.
As an example, a transaction which would result in a change of control and a projected value of $3.25 per share would not be considered fair if the current value of those shares is $3.90. Because of the subjectivity involved in the valuation process, one must be careful in introducing a level of accuracy in excess of the capacity of the valuation methodology. There are circumstances when even the determination of fairness can be clouded by excess information. As an example, consider a company whose shares are valued on an earnings basis at $1.50 and on a net tangible asset (NTA) basis at $1.05. A transaction is proposed which would result in a change of control and the introduction of additional business assets whereby an earnings based valuation would value the share at $1.75 but the NTA backing per share would fall to 65 cents. Given that we are considering two different valuation methodologies, is one methodology more appropriate? Is the transaction fair? One must consider all relevant factors and then exercise professional skill and judgement. When preparing a report under section 611, Item 7 or section 640 of the Corporations Act 2001 it is often necessary to compare the values of shares in the target with the value of the reconstructed target company (e.g. for a backdoor listing proposal or for a scrip offer under section 640). In such situations, it is not uncommon to arrive at a valuation range which overlaps slightly, but not convincingly (e.g. target shares are worth $0.25 to $0.30, whilst offeror shares are worth $0.19 to $0.26).
Where there is such a borderline determination of fairness, it is likely that the overall advantages and disadvantages of the proposal will emphasise the reasonableness aspect.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1350 General Requirements / 3~1400 Fair and reasonable / Reasonableness
Reasonableness
If an offeror in a take-over bid holds 85% of the shares on issue in the company, is an offer of 50 cents reasonable, relative to a value of 60 cents? In the absence of any alternative offeror, and depending upon industry circumstances, the answer is probably yes. This is despite the fact that the offer may be below the value of the shares and shareholders may have no alternative. In these circumstances it may be better that shareholders obtain something rather than be locked into a minority holding. This is not to say that shareholders would not have a dividend stream but that they would have a much reduced role and level of control over the activities of the company in the future. ASIC Policy Statement 75 defines reasonable as: [75.29] An offer is reasonable if it is fair. It may also be reasonable if, despite not being fair but after considering other significant factors, shareholders should accept the offer in the absence of any higher bid before the close of the offer. It is also important to realise that the definition of fair and reasonable may vary depending on what type of report is being prepared and this is discussed in Policy Statement 74 (which has not been updated since CLERP). Section References Pre-CLERP 623 648 Post-CLERP 611 Item 7 640 Description Approval of take-over resolution of target Bidder connected with target
Policy Statement 74 states: Fair and reasonable in the context of s623 20. The issue of whether a s623 proposal is fair and reasonable is different from the issue confronting an expert preparing a s648 report. Under s648, an expert is required to determine whether an offer made to shareholders in a class is fair and reasonable. This comparison of the value of the target companys shares and the consideration is more straightforward than the comparison for a s623 resolution. In the context of a s623 proposal, what is fair and reasonable for non-associated shareholders should be judged in all the circumstances of the proposal. The report must compare the likely advantages and disadvantages for the non-associated shareholders if the proposal is agreed to, with the advantages and disadvantages to those shareholders if it is not. Comparing the value of the shares to be acquired under the proposal and the value of the consideration to be paid is only one
21.
element of this assessment. 22. The expert should assist non-associated shareholders to make their decisions by providing in the report a clear summary of the possible advantages and disadvantages to them if the proposal is accepted or rejected.
It is extremely unusual to find an opinion which states that a transaction is fair but not reasonable. One such rare example was the experts report on the take-over offer for Baden Pacific by Axondale Investments Pty Ltd. In that instance, the amount offered was fair (being in excess of the valuation range arrived at by the valuer). However, since the announcement of the offer, the share price escalated significantly above the bid price on the strength of outside parties buying up shares in support of the management against the take-over bid. The apparent reasoning for the fair but not reasonable opinion was that an alternative offeror existed at a price higher than that which had been bid, regardless that the bid was in fact higher than the deemed valuation range.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1350 General Requirements / 3~1410 Qualifications
3~1410
Qualifications
Where a valuation report is being distributed or circulated to a number of parties (i.e. financial institutions), the reports credibility is increased if details of the valuers qualifications and experience are included. This is particularly the case where a report is being prepared by an expert. As far as practicable then, the report should detail the experience and qualifications of the valuer such that they can be compared with the requirements of indeed being an expert. This does not mean saying Mr X has qualifications and experience sufficient to prepare this report. Rather, the valuers membership of professional bodies and educational qualifications should be stated together with a rsum of professional experience which gives weight to the valuers ability.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1350 General Requirements / 3~1420 Fees
3~1420
Fees
Where an engagement is accepted to value a business (as distinct from an engagement to buy or sell the business) a dim view can be taken of any fee basis which is not on a time and responsibility basis. This is because: a fixed fee quotation can result in the valuer cutting corners simply to avoid cost over-runs; and a success-based fee can clearly influence the opinion and objectivity of the report.
In addition, when preparing some types of independent experts reports there may be a requirement to disclose the aggregate amount of the estimated fee this should be disclosed together with any significant disbursements. This is to enable the reader of the report to make an objective assessment of the independence of that valuer and/or whether the opinion has been purchased. In Australia, when preparing independent experts reports, there is a requirement for fees to be
disclosed and for all fees to be non-outcome related. These issues are discussed in ASIC Policy Statement 75 (which has not been updated since CLERP). Section References Pre-CLERP 648(2)(c) 703(7) Post-CLERP 648A(B)(c) 667B(2) Description Take-over experts report Compulsory acquisition
Specifically ASIC Policy Statement 75 states: Disclosure of fees 37. Paragraphs 648(2)(c) and 703(7)(c) require the expert to disclose: a. b. any fee; and any pecuniary or other benefit, whether direct or indirect,
that the expert has received or will or may receive in connection with the making of the report. 38. An actual amount must be shown in each case. It is not sufficient for the expert to state only that the fee is on the basis of normal rates. If the actual amount is not certain at the time of printing the report an estimate should be provided. For example, if the hourly rate has been fixed then the rate should be disclosed with the estimated time expended on the report. If estimates are used, the report should indicate that they are estimates.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1350 General Requirements / 3~1430 Independence/History
3~1430
Independence/History
Any event or work for a client which could be seen as prejudicing a valuers independence should be disclosed. In Australia there is a requirement to disclose past assignments and potential future business relationships when preparing independent experts reports. Specifically, ASIC Practice Note 42 implies that work conducted within two years prior to the preparation of an expert report would ordinarily preclude the valuer from accepting the assignment, but this should not be taken too literally. If considerable work has been undertaken outside a two-year period which could be seen as jeopardising independence, this should also be disclosed. This is discussed more fully at paragraphs 18 and 19 of Practice Note 42. ASIC Policy Statement 75 goes further and states: Independence 15. ...The Expert should also disclose any intention to establish future business relationships with the offeror or target.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents /

3~1350 General Requirements / 3~1440 Share market prices

3~1440
Share market prices
Where a valuation is being undertaken based on market data or on comparable sales data, it is important to ensure that the data being relied upon is not distorted. The inherent characteristics of sharemarket prices mean they can be an inadequate surrogate for market valuation. These include low volumes of trades, unusual transactions between particular parties, high price volatility, speculative purchases or sales not based upon the underlying fundamentals which are being valued. It should be noted that sharemarket transactions represent the price at which shares have changed hands. This does not necessarily reflect or imply value.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1350 General Requirements / 3~1450 Directors representations
3~1450
Directors representations
Directors representations should not be blindly accepted. They should be questioned and the basis for the representations clearly understood by the valuer. Whilst a letter of representation should be provided by the engaging company prior to signing off the report, broader representations made by management on budgets, profitability, markets, business strategy and staff may be too general to be encompassed by a letter of representation. They should nevertheless be subject to scrutiny.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1350 General Requirements / 3~1460 Opinion
3~1460
Opinion
An opinion is reached after consideration of a number of different aspects. To provide an informed report to shareholders, the aspects considered should be summarised. An example of opinion paragraphs drawn from First Boston Australia Ltds report to Elders IXL Ltd shareholders, dated 4 August 1989, is set out below: Based upon and subject to this Report, First Boston has valued, as at July 21, 1989, each Elders Ordinary share in the context of an offeror seeking to obtain full control of Elders assets and cash flow in a range of $3.36 to $3.79, from a financial point of view. As this value range exceeds the consideration proposed in the Harlin Offers by between $0.36 and $0.79 per Elders Ordinary share, it is First Bostons Opinion that, subject to the matters set out in this Report, the Harlin Offers would not be fair from a financial point of view and would not be reasonable. From the above, a shareholder can make their own informed assessment of what they wish to do.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1350 General Requirements / 3~1470 Recommendations
3~1470
Recommendations
Whether a recommendation should be made is really a question of whether the valuer should go beyond their obligation in reporting whether the transaction or offer is fair and reasonable. Should the valuer give a recommendation on whether shareholders should accept or reject the transaction or offer? In most cases, this will be up to the individual valuer to assess the circumstances of the case and exercise professional judgement. In some instances, there will be no need for a recommendation. Where the offer is obviously fair and obviously reasonable, and the directors of the target recommend accepting the offer, it should be quite apparent to shareholders that they accept the offer subject to their own tax circumstances. In the majority of cases, however, things are usually not as clear cut. In some circumstances (especially where there are differing tax considerations applying to various shareholders) it could be appropriate to recommend that low marginal rate taxpayers consider accepting an offer whilst high marginal rate taxpayers consider rejecting it. There is no simple answer to this question. However, a recommendation may be appropriate if there are a number of alternative conclusions depending on certain variables or shareholder types. It is also important to note that as the adviser will have insufficient information to satisfy the know your client rule, they should probably avoid making recommendations.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1350 General Requirements / 3~1480 Differing tax positions of shareholders
3~1480
Differing tax positions of shareholders
As referred to earlier, an experts report is a report to all (non-associated) shareholders. However, shareholders are not a homogeneous body some are top marginal rate taxpayers, some are churches and others are charitable institutions with tax exempt status, yet others are low marginal rate taxpayers such as superannuation funds. This presents a problem in terms of reporting to shareholders where there is clearly some tax impact resulting from the transaction either upon the company or the individual shareholder and being able to cover the majority of scenarios. Furthermore, the sale of a share may be subject to particular taxes due to their date of purchase (e.g. in Australia, domestic shares purchased pre-September 1985 can generally be sold capital gains tax free.) Whilst a valuer obviously cannot consider the individual circumstances of every shareholder, if taxation on the sale of a share or as a result of the transaction represents a significant proportion in relative terms, then clearly consideration must be given to the effect on these various groups. For example, a convertible note will have a different value to each group of shareholders as the interest stream payable on a convertible note is subject to income tax at varying rates. It would therefore be advisable to tabulate the before and after tax consideration for a convertible note holder subject to a take-over offer what may be fair and reasonable to one shareholder may not be to another.

3~1350 General Requirements / 3~1490 Specialists reports

3~1490
Specialists reports
In every valuation report it is crucial to clearly state what work has been undertaken by specialists and the extent to which that information has been relied on. ASIC Practice Note PN 43 stipulates that: [43.27] It is the experts responsibility of the expert to satisfy him or herself that the specialist: a. b. c. is competent in the field; has used assumptions and methodologies which seem reasonable, and drawn on source data that appear to be appropriate; is independent of, and is perceived to be independent of, interested parties, or the specialists lack of independence is clearly and prominently disclosed. If the specialist is not independent the entire experts report should not be described as, or held out to be, an independent report; has a clear agreement with the expert concerning the purpose and scope of the specialists work; and signs his or her report and consents to the use of it in the form and context in which it will be published. If the expert does not ensure that the specialist takes responsibility for and authorises the use of the report or extracts or summaries of it, the expert must accept entire responsibility for the statements as his or her own and must have his or her own reasonable grounds for believing them not to be false or misleading.
d. e.
In terms of professional guidelines, Auditing Standard AUS 606 Using the Work of an Expert provides guidance equally relevant to independent valuers as to auditors. Furthermore ASIC Policy Statement 75 states: Specialists 20. ... the Expert must take care to use, quote or cite the specialists report in a way which is fair and representative.
In addition, the Family Court of Australia announced that Family Law Rules 2004 have been published as Statutory Rules No. 374 of 2003 and came into effect on 29 March 2004. These Rules are available from the Family Court of Australia web site <www.familycourt.gov.au>. Part 15.5 of the Rules deals specifically with experts evidence and the rights and duties of experts. Some of the requirements contained in the Rules are onerous and practitioners appearing before the Family Court should pay careful attention to the requirements.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1350 General Requirements / 3~1500 Disclosure
3~1500
Disclosure
Adequate disclosure is required in order for a third party to form an opinion as to the basis and overall fairness of the conclusions reached in a valuation report.
Recent correspondence from the Australian Securities and Investments Commission (ASIC) to the Institute of Chartered Accountants in Australia in part covered transparency and disclosure within valuation reports. It was ASICs view that independent experts and valuers should clearly demonstrate in their reports the key assumptions and methodologies adopted and provide readers of those reports with sufficient information for them to understand the valuers conclusions.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1520 Specific Requirements
3~1520
Specific Requirements
As has been discussed, the specific contents of a valuation report will vary depending on the type of report and the reasons for preparing it. In addition, however, laws and regulations may impose certain requirements. Imposed requirements may arise from sources such as: legislation governing the operations of companies; foreign country and state laws; the pertinent stock exchange; security industry regulatory bodies; the courts; or professional accounting, finance and valuation organisations.
In Australia the contents of a valuation report (depending on the type of report and its purpose), may be governed by: the Corporations Act 2001; ASICs Policy Statements and Practice Notes; ASX Listing Rules; Joint Guidance Notes of the Institute of Chartered Accountants in Australia and CPA Australia, entitled GN 2 Forensic Accounting; the courts; and the Australian Taxation Office (Tax Office) Consolidation Reference Manual.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1520 Specific Requirements / 3~1530 Corporations Act 2001 requirements
3~1530
Corporations Act 2001 requirements
The Corporations Act 2001 does not have specific requirements for a valuation report, however for an independent experts report, section 640(1) requires: ... a report by an expert that states whether, in the experts opinion, the takeover offers are fair and reasonable and gives the reasons for forming that opinion. Similar statements are included in other parts of the Corporations Act 2001.

3~1520 Specific Requirements / 3~1540 ASIC requirements

3~1540
ASIC requirements
Guidance from ASIC comes in a number of forms: ASIC Policy Statements and Practice Notes; ASIC Media Releases; and the ASC Takeovers Procedures Manual.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1520 Specific Requirements / 3~1550 ASIC Policy Statements and Practice Notes
3~1550
ASIC Policy Statements and Practice Notes
ASICs Policy Statements and Practice Notes are the primary sources of guidance on the content of valuation reports. The complete text of all ASIC Policy Statements is available from ASIC Digest published by Thomson Legal & Regulatory Limited and from their web site <www.thomsonsolutions.com.au>. Extracts from Practice Note 43 are set out below: 11. Where an Expert is not independent the readers of the report have reason to expect the report to disclose his or her lack of independence. As readers do have such reasonable expectations the Expert is under a duty to disclose any interests. Failure to do so may constitute misleading or deceptive conduct under s995 of the Law. New information on the character or exploitation of corporate resources revealed through reports on asset valuations or forecasts of profits or profitability will have significant effects on the investment decisions of those reading the reports. Disclosure of this information may be of critical significance to offerees when considering whether to accept or reject takeover offers or to investors when deciding whether to buy or sell particular securities. Persons who prepare such reports should not underestimate these effects and should bear them in mind when writing their reports. The author cannot discharge his or her responsibility to the market and to investors to provide an informed, independent, Expert assessment by uncritically restating information provided by the body corporate or any other persons. A report which regurgitates the body corporates data and then simply says if all of that is true, I think the offer is fair and reasonable or the value is X etc. is hardly a report at all and is certainly not an evaluation on which security holders and investors may rely. The Expert should prominently disclose whether any of the following has any interest in the proposal, or the acquisition or disposal of securities which are the subject matter of the report: a. b. the Expert; the Experts employer;
16.
17.
24.
c. d. 25.
a family member of either the Expert or employer; or an associate of any of the above.
A relatively small note, towards the end of the report, that the Expert is not independent and may receive a success fee is well short of the standards the ASC expects of market participants. Neither the Expert nor the commissioning party should condone such lip service to disclosure.
Assumptions 33. The ASC considers that the information released to security holders and to investors in valuation reports and forecasts of profits or profitability is very important to their decisions and is concerned that the information should be clear, useable and not misleading The assumptions stated should assist the reader to judge the reasonableness of the report and its main uncertainties. The assumptions should be specific and definite. All-embracing assumptions and those relating to the general accuracy of the statements should not be included The complex valuations in an Experts report necessarily contain significant uncertainties. Because of this an Expert who gives a single point value will usually be implying spurious accuracy to his or her valuation. An Expert should, however, give as narrow a range of values as possible. An Expert report becomes meaningless if the range of values is too wide. An Expert should indicate the most probable point within the range of values if it is feasible to do so. The Expert should discuss the implications to his or her valuation if: a. he or she considers the current market value of the subject of the report is likely to change because of market volatility (for example, boom or depression); or the current market value differs materially from that derived by his or her chosen method.
34.
38.
44.
b.
Revaluations 45. Revaluations of assets have caused significant concern to investors, market participants and regulators. Asset revaluations have been used among other things to boost the asset backing of the company before seeking funds from the public by subscription. The types of assets which have been revalued include intangible assets, mining tenements, service contracts, investments in securities or companies and intellectual property. The Expert should take extra care where the assets have been purchased from an associated entity or revalued prior to or closely after the sale. Experts who are commissioned to revalue assets, or to report on revaluations or on companies whose assets have been materially revalued should exercise especial care to ensure that the revaluations are reasonable and can be substantiated by appropriate valuation methods. If the Expert has any concern over the new valuations appropriateness or the assumptions used, he or she should address them in the report.
46.
Profit forecasts and projections 49. A profit forecast or projection should disclose: a. b. c. d. 50. the assumptions used; the extent of enquiries and research undertaken by the Expert and any other compiler of the projection or forecast; the specific period to which it relates; and an explanation for the choice of the period covered by the forecast.
Any forecast should ensure readers are aware of the degrees of uncertainty which the projections entail. One way of setting out the uncertainty is by including a sensitivity analysis.
Disclosure of bases and sources 53. The Expert should disclose in the report the material he or she has relied on and the assumptions in his or her assessment. They should be in a form and to the extent reasonably necessary for the purposes of the report. The Expert should also disclose, to the extent necessary to assist readers to assess the value of the report: a. b. c. d. e. the origin of the material used in it; the inquiries the Expert has made; the time constraints he or she has worked under; whether he or she is dissatisfied with the quality of any of the information used for the report; and whether the target, the offeror or any other person has refused the Expert access to information or explanations on which he or she might have based a fuller appraisal.
54.
Confidential information 55. Where the Expert withholds material information because it is commercially sensitive, he or she should clearly indicate this in the report and should provide a summary of the information if it is material to the readers decision. If the ASC requests, the Expert should explain the nature of the information and the commercial sensitivity that led to its non-disclosure, in a report to the ASC. A report of this kind will not be placed on the public register and the Freedom of Information Act 1982 provides a defence to its disclosure.
56.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1520 Specific Requirements / 3~1560 ASIC Media Releases guidance
3~1560
ASIC Media Releases guidance
ASIC Media Releases also provide guidance on the contents of valuation reports. In May 1999, ASIC issued Media Release 99/148 ASIC Warns about Moving from Hot Rocks to Hot Stocks. In conjunction with this media release ASIC wrote to the Institute of Chartered Accountants in
Australia regarding adequate disclosures and the lack of adequate information being distributed to shareholders when a company purchases a new business and discontinues its current business operations. Below is a summary of the key points of that letter. ASIC stated there had been several recent examples, involving mineral exploration companies acquiring assets relating to the Internet or other hi-tech assets, where ASIC has requested companies amend the documents distributed as they were believed to contain significant deficiencies. Typically these acquisitions involved: the acquisition of assets vended in by parties, usually connected with the directors of the company; assets being acquired of a significantly different nature to the assets currently employed by the company; and the company changing its direction and conducting a new commercial enterprise and discontinuing its current business operations.
ASICs view is that in these circumstances, because of the significant change in direction planned for the company, shareholders should be provided with comprehensive details of the new venture proposed in order for them to consider adequately how to vote on the matter. ASIC advised they now wished to draw the attention of directors and preparers of independent expert reports (IERs) to a number of concerns they have with documents sent to shareholders for the purpose of approving transactions similar to those described above. Their comments included: 1. Independent experts report required The documents prepared for shareholders should include a report by an independent valuer stating whether the valuer considers the proposed transaction to be fair and reasonable to shareholders other than those associated with the proposed transaction (non-associated shareholders). 2. Valuation of assets to be acquired Some valuations of assets being acquired have not been based on a proper market analysis. This is particularly relevant to new hi-tech or Internet undertakings. Valuations of these undertakings may require a specialist to be engaged by the valuer. Instances have been observed where the valuer has tried to support the valuation by comparison with market capitalisations of listed Internet stocks in the USA without providing a basis for linking the performance of such stocks with the Internet asset being acquired. 3. Current operations of assets to be acquired Shareholders should be provided with information on any current operations relating to the assets being acquired. 4. Assumptions underlying the valuations Some IERs have not included sufficient information about the assumptions underlying the valuations. ASIC Practice Note 43 on valuation reports states that ASIC considers a clear statement of all material assumptions on which a valuers opinion is based to be essential for shareholders proper assessment of the valuation, e.g. where a valuation is based on future cash flows, details of the cash flows and their timing as well as the assumptions underlying the individual amounts and the relevant discount rates used should be provided.
ASICs view is that independent valuers should clearly demonstrate in their reports the key assumptions and methodologies adopted and provide readers of those reports with sufficient information for them to understand the valuers conclusions. 5. Valuation of companys existing business Where a proposed transaction involves the issue of shares, valuing the issuing companys own assets is usually required in order to compare: 6. the value of the purchase consideration with the value of the assets acquired; or the value of a non-associated shareholders interest before the transaction, with its value after the transaction has been completed.
Directors valuations It has been noted that in some cases the book value of a companys mineral assets is adopted for this purpose without further comment as to why the valuer has not engaged a specialist to carry out an independent valuation of those assets or why the book value is considered to be indicative of the current value. Where directors valuations or representations have been relied upon, the valuer should indicate the basis for this reliance and the reasons why independent valuations were not sought.
ASIC has warned that: Because of their pivotal role in providing information on the merits of proposals put to investors and regulated by the Corporations Law, ASIC will closely examine valuation reports included in meeting documents sent to shareholders for the purpose of approving acquisitions. ASIC will focus on the quality, accuracy and utility of information provided and, if it believes that investors will not receive sufficient information concerning the proposal, or will receive materially false, misleading or deceptive information, or will be misled or deceived by omission or otherwise, it will take enforcement action.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1520 Specific Requirements / 3~1570 ASC Takeovers Procedures Manual
3~1570
ASC Takeovers Procedures Manual
The ASC (the predecessor of ASIC) previously produced a text entitled the ASC Takeovers Procedures Manual. Although no longer published, this manual still provides guidance on the issues ASIC may consider when reviewing experts reports. Relevant extracts from the ASC Takeovers Procedures Manual are set out below. Note the following changes in section numbers of the Corporations Act 2001 referred to in the extract. Was section 623 section 615 section 732(c) Is section 611 Table Item 7 section 606 section 657A
[1840] Any evaluation of a reports compliance at the lodgement or registration stage

rather than in a post-vet of the takeover documents, where a thorough review of the report will occur (see the Takeovers Surveillance Manual) should include a check of the following: a. b. c. d. e. why the report is included in the document; qualifications of the report; associations of the Expert with any of the interested parties; inclusion of the opinion of the Expert on the fairness and reasonableness of the offers; and inclusion of the Experts reasons for forming that opinion.
[1845] Obvious errors or deficiencies, ambiguities or other defects should be brought to the attention of the lodging party. ASC Involvement [1860] ASC officers need to be aware of the context in which an Experts report appears when reviewing its contents in the post-vet of takeover documents. As the report is very important to the shareholders making their decision on a proposal, it will be scrutinised closely to ensure particularly that: a. b. the assumptions are sound; the Expert adopts each statement as his or her own (rather than relying on other Experts whose views are not directly included and whose consent to the reference is not obtained); and the Experts independence is explained.
c.
[2805] The issues arising from s623 (and which ASC officers will be required to consider) are: a. that only non-interested parties vote on the resolution to approve the acquisition. The acquirer and vendor (including their associates) constitute interested parties. For s623 approval of downstream acquisitions, the upstream company in addition to the acquirer and vendor will usually be precluded from voting. The basis of the upstream companys interest is that if the downstream acquisition is refused approval, then the upstream acquisition cannot proceed it may be in the upstream companys interest for the acquisition of shares in it to proceed, for example if the acquirer will gain control of it in consideration of a capital or assets investment, permitting the upstream companys business to proceed. It is inappropriate for the shareholders of the upstream company to effectively determine the change of control of the downstream company. For a similar, but different exception see paras 29903025; b. that sufficient information be provided to the disinterested shareholders for them to make an informed vote: see NCSC v. Consolidated Gold Mining Areas NL (1985) 1 NSWLR 454. If insufficient information is provided the approved resolution will be void ab initio, and the acquisition will breach s615, or the ASC could make the acquisition the subject of an application to the Panel for a declaration of unacceptability under s732(c): see paras 18751920 on the Panel.
To satisfy the information requirement directors should commission an independent Experts report to be provided or (less desirably, and where they can show a lack of partiality) provide their own due diligence report to shareholders (which they should sign): see Policy Statement 74 on s623 which replaced NCSC Release 116 on Experts reports for s623 approval; and c. the party responsible for calling the meeting, which may impact on the information disclosure requirement for the meeting.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1520 Specific Requirements / 3~1580 ASX Listing Rules
3~1580
ASX Listing Rules
The ASX rules do not specify how valuations are to be conducted. In practice, it is not uncommon for valuers to refer to the ASIC guidelines. ASX Listing Rule 10.10.2 specifies that shareholders should be provided with a report by a valuer stating whether values are fair and reasonable in a transaction where it is proposed to acquire an asset from or dispose of an asset to a director or officer or substantial shareholder of the listed company and the value of the sale or acquisition is greater than 5% of the total issued capital and reserves of the listed company as at the date to which the last audited accounts were made up. Listing Rule 10.10.2 also provides some guidance on the content of a report when it states that unless an independent valuer concludes that the transaction is fair and reasonable, the opinion must be displayed prominently in the notice of meeting and on the covering page of any accompanying documents.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1520 Specific Requirements / 3~1590 Court requirements
3~1590
Court requirements
Australian courts also have specific requirements for experts reports. As an example, the following is from the Guidelines for Expert Witnesses in Proceedings in the Federal Court of Australia which can be found at <www.fedcourt.gov.au/how/prac_direction.html>. The Form of Expert Evidence An experts written report must give details of the experts qualifications, and of the literature or other material used in making the report. All assumptions made by the expert should be clearly and fully stated. The report should identify who carried out any tests or experiments upon which the expert relied in compiling the report, and give details of the qualifications of the person who carried out any such test or experiment. Where several opinions are provided in the report, the expert should summarise them. The expert should give reasons for each opinion. At the end of the report the expert should declare that [the expert] has made all the inquiries which [the expert] believes are desirable and appropriate and that no
matters of significance which [the expert] regards as relevant have, to [the experts] knowledge, been withheld from the court. There should be attached to the report, or summarised in it, the following: (i) all instructions (original and supplementary and whether in writing or oral) given to the expert which define the scope of the report; (ii) the facts, matters and assumptions upon which the report proceeds; and (iii) the documents and other materials which the expert has been instructed to consider. If, after exchange of reports or at any other stage, an expert witness changes his or her view on a material matter, having read another experts report or for any other reason, the change of view should be communicated in writing (through legal representatives) without delay to each party to whom the expert witnesss report has been provided and, when appropriate, to the court. If an experts opinion is not fully researched because the expert considers that insufficient data is available, or for any other reason, this must be stated with an indication that the opinion is no more than a provisional one. Where an expert witness who has prepared a report believes that it may be incomplete or inaccurate without some qualification, that qualification must be stated in the report. The expert should make it clear when a particular question or issue falls outside his or her field of expertise. Where an experts report refers to photographs, plans, calculations, analyses, measurements, survey reports or other extrinsic matter, these must be provided to the opposite party at the same time as the exchange of reports.
Experts Conference If experts retained by the parties meet at the direction of the court, it would be improper conduct for an expert to be given or to accept instructions not to reach agreement. If, at a meeting directed by the court, the experts cannot reach agreement on matters of expert opinion, they should specify their reasons for being unable to do so.
The content of an experts report to Australian courts may vary slightly depending on the court the matter is being heard in, but the requirements generally follow those set out above. However before preparing a report, the valuer should review the requirements of the specific court in which they are likely to appear. The guidelines for the Federal Court can be found at <www.fedcourt.gov.au/how/prac_direction.html>. In addition, the Family Court of Australia announced that the Family Law Rules 2004 have been published as Statutory Rules No. 374 of 2003 and came into effect on 29 March 2004. These Rules are available from the Family Court of Australia's web site <www.familycourt.gov.au>. Part 15.5 of the Rules deals specifically with experts evidence and the rights and duties of experts. Some of the requirements contained in the Rules are onerous and practitioners appearing before the Family Court should pay careful attention to the requirements.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1520 Specific Requirements / 3~1600 Australian Taxation Office
requirements
3~1600
Australian Taxation Office requirements
The Australian Taxation Office (Tax Office), in Part C41 of its Consolidation Reference Manual, pages 4245, has detailed the information and documentation that it considers necessary to enable Tax Office staff to understand and check the accuracy of a market valuation: As a general principle, the Tax Office would expect that a market valuation report for consolidation purposes would contain, as a minimum, no less information than a market valuation report prepared on similar commercial terms. The amount and nature of additional information provided will ultimately be a matter of judgment in each particular circumstance. In making this determination the person undertaking the valuation should consider how problematic are the valuation outcomes, the methodologies used, the assumptions relied upon and the information provided. As a minimum, any market valuation report and supporting documentation should contain: a description of the asset valued that is sufficient to ensure the asset can be easily identified the purpose and context of the market valuation, and in particular the relevant provision under which the valuation is required a specific market value the date (or period) to which the market valuation relates, including the date the valuation was commenced and completed (to assist in establishing whether the market valuation was contemporaneous, or otherwise) details of the methodologies employed, including: the basis for determining any range of values and consequently the selection of a specific point within that range sufficient details to enable the procedure to be replicated and an assessment of the valuation made, and a statement of reasons as to why the methodologies were the most appropriate in the circumstances
information on which the market valuation is based, including: details of the source of information created or obtained and the adequacy or otherwise of that information, and a statement of the reliability of any prospective information used, such as financial forecasts
details of all assumptions relied on in the market valuation and the reasons for making the assumptions.
Reports by qualified valuers If the report has been prepared by a qualified valuer (either in-house or external), it should also contain, in addition to the items listed above: the name of the person preparing the report
the qualifications of the person preparing the report including details of any relevant: work experience, including any specialisations licences, registrations or authorities, and memberships of professional associations
the terms under which the person preparing the market valuation has been engaged and any instructions, either written or oral, they have received in relation to the valuation process details of any information that would assist the Tax Office to assess whether the valuer has prepared a report in an independent manner details and explanations of any disclaimer to the report an evaluation of the information provided for the purposes of commissioning the report, including: the origin of the information used details of the inquiries made by the valuer to establish reasonable grounds for believing that the information provided to them is accurate for each assumption relied on, details of the actions undertaken by the valuer to ensure the assumption was correct the time or any other constraints under which the valuer worked, and a statement to the effect that the valuer believes the information used was adequate, complete and appropriate for assessing the market value of the asset or if not adequate, complete and appropriate, the reasons why
the signature of the person preparing the report and the date it was signed a declaration of veracity, which would generally include statements to the effect that: the above report is a true, full and accurate account of the basis for determining the market value of the asset, and includes all relevant information, evaluations and assumptions, and except to the extent indicated in the report, all information and explanations requested and required to prepare the report were available and used subject to satisfactory verification to the extent set out in the report.
Reports by external parties If the report has been prepared by an external valuer, it should also contain, in addition to the items considered necessary for an in-house qualified valuer: a statement of the nature and details of the relationship that exists, has existed or is intended to exist at some future time, between the person preparing the market valuation report and the person commissioning the report details of any other information that would assist the Tax Office to assess the independence of the reports author
details and an explanation of any indemnities given in respect of the valuation the amount of the fee charged by or paid to the person undertaking the market valuation a statement specifically authorising the use of the report for the relevant taxation provision in the evaluation of the information provided to them by the person commissioning the report a statement as to whether the person undertaking the valuation was satisfied or dissatisfied with the quality of the information used for the report, including acknowledgment of any case of the taxpayer failing or refusing to make data or information available to the person commissioned to prepare the report; (This information will assist the Tax Office to determine the accuracy or otherwise of the market valuation report. Failure to demonstrate the reliability of such information is likely to increase the compliance risk for the taxpayer.) in the declaration of veracity a statement to the effect that payment was in no way contingent upon the outcome of the report.
In considering whether all the above information should be provided, and to what extent in a particular circumstance, a guiding principle should be whether the omission of the information is likely to lead to the integrity of the valuation being questioned. For example, where unusual market conditions prevailed at the time the valuation is applicable (e.g. the joining time), the omission from the report of this information would be likely to bring into question the integrity of the market valuation. Commissioning of other experts Where a person commissioned to prepare a market valuation report is not personally authoritative on a particular important matter, it would usually be necessary for them to retain an appropriate specialist to complete the valuation report. Consequently, where another person is relied upon, the person commissioning the specialist report should ensure that it contains sufficient detail to establish reasonable grounds for any conclusion or opinion stated. It would be usual to expect that such details would enable the person commissioning the specialist report to establish to their satisfaction, and provide a statement to the effect that the specialist: is competent in the field has used assumptions and methodologies which seem reasonable and has drawn on source data that appears appropriate, and is independent of, and is perceived to be independent of, interested parties, or the specialists lack of independence is clearly and prominently disclosed.
It would also be expected that any specialists report would contain details similar to those required generally of reports by external parties. Working papers In practice, the working papers associated with the preparation of a market valuation report do not form part of the final report. However, the report should contain sufficient details to enable the market valuation procedure to be replicated and the valuation to be
assessed by another qualified valuer. If such information is contained in the working papers but not in the final report it would be prudent for a taxpayer to retain the working papers in addition to the final market valuation report. Where those working papers are the property of an external market valuation consultant, the taxpayer should ensure, as part of the commissioning process, that the external consultant is obliged to retain their working papers in accordance with these guidelines.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1330 Report Contents / 3~1610 Report Content Checklist
3~1610
Report Content Checklist
It can be difficult to ensure that all the necessary matters are covered in a report. There is also a danger in trying to fit all valuations into a standard mould. However, given the increasing level of attention and guidance being given to valuation reports it can be useful to review matters formally before signing off on a report. The International Valuation Standards Committee (IVSC) has issued Guidance Note 11 Reviewing Valuations. This guidance note is available in International Valuation Standards 2003, which can be ordered from <www.ivsc.org/standards/index.html> and may assist in the review of valuations prepared by other valuers. Previously we have discussed valuers statutory obligations with regard to the adequacy of their reports and that there is certainly a civil liability with respect to negligence. Due to this the use of a report checklist is highly recommended. Attached is a sample Checklist for Business Valuation Report Reviews template from NACVA. Should it be decided not to complete a checklist, pertinent issues which can be cross-checked when undertaking a valuation assignment are listed below. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Target company/allotting company Offeror/allottee Corporations Act 2001 and Listing Rule requirements Report date Conclusion Offer terms/price Target valuation Valuation qualifications Valuation approaches Appropriate methodologies: earnings capitalisation; NTA/orderly realisation;
11.
discounted cash flows; alternative offeror; share market; dividend capitalisation; liquidation; or other.
Earnings capitalisation: period considered; price/earnings basis; future maintainable earnings; surplus assets; and other.
12.
NTA/orderly realisation: valuation basis; independent valuation; valuers name; assumptions cleared; qualifications cleared; and other.
13.
DCF valuation: period covered; inflation assumptions; revenue assumptions; cost assumptions; investment assumptions; tax rate assumptions; exchange rate assumptions; residual value; discount rate calculated with regard to WACC; sensitivity analysis; and other.
14.
Alternative offeror: likelihood; valuation basis; and other.
15.
Share market valuation:
16.
period assessed; high price; low price; adjusted for issues; volume considered; all listed securities considered; and other.
Dividend capitalisation: dividend basis; capitalisation rate basis; franking assumptions; capitalisation rate; pay-out ratio considered; and other.
17.
Offeror share exchange: period assessed; high price; low price; adjusted for issues; NTA; synergy relevant; synergy considered; and other.
18. 19. 20. 21.
Intangibles adequately identified and allocated? Differing tax position of shareholders considered? Minority advice provided? Control premium addressed: premium payable; and amount.
22. 23. 24. 25. 26. 27. 28.
Disadvantages/advantages summarised? Have fairness and reasonableness been considered? Independence cleared. Personnel for the assignment sourced? Qualifications. Fee estimate. Disbursements estimate.
29. 30.
Representation letters obtained? Other matters.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1660 Format of Reports

3~1660
Format of Reports
The format of a valuation report can be influenced by international and Australian requirements. These requirements may be determined by: regulatory bodies of the security industry in a specific country; national and state courts; associations of business valuers; or accounting bodies.
In this section we commence with a review of a general report format. Report format guidelines are published by a number of organisations, including the following: American Institute of Certified Valuation Analysts; American Society of Appraisers; Canadian Institute of Chartered Business Valuers; Institute of Business Appraisers; International Valuation Standards Committee (IVSC); National Association of Certified Valuation Analysts (NACVA); and Uniform Standards of Professional Appraisal Practice (USPAP).
Compliance with one of these standards at least assures meeting some minimum professional standard.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1660 Format of Reports / 3~1680 General Report Format
3~1680
General Report Format
Whilst each firm will develop its own reporting format, there are a number of practical matters which should be addressed. Valuations are often detailed and quite complex. A practice followed by many (and one which we advocate) is to provide a summary of the opinion, together with the main reasons for that opinion, early in the report. A typical report outline might be as follows: Introduction Terms of the offer (if applicable). Shareholdings. Opinion. Sources of information. Company activities.
Bases of assessment: standard and premise of value; and valuation approaches.
Capitalisation of earnings. Orderly realisation of assets. Alternative acquirers. Share price in absence of offer. Other considerations. Appendix A Specialist valuations. Appendix B Qualifications, declarations and consents.
Such a table of contents also sets out clearly the different bases which are being used to examine a valuation. If any technical terms are used in a report they should be used consistently and, if appropriate, a glossary of the terms should be provided. Shareholders cover a wide range of interest groups. The level of sophistication will in all likelihood range from highly detailed analysis by fund managers through to blank looks from individual shareholders who have acquired their shares by inheritance. The challenge is to present highly technical analysis in a readily understandable format using simple language. A report which is not understandable is of little value to a shareholder. Whilst a number of shareholders skip over experts reports in prospectuses and other documentation, we should try and encourage a wider readership of experts reports by writing them in simple English.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1660 Format of Reports / 3~1700 International Standards and Requirements
3~1700
International Standards and Requirements
A number of international organisations issue standards or provide guidance on the format and content of a valuation report. These include: the International Valuation Standards Committee; the Investment Performance Council; the British Venture Capital Association; and the US Internal Revenue Service.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1660 Format of Reports / 3~1700 International Standards and Requirements / 3~1710 International Valuation Standards Committee
3~1710
International Valuation Standards Committee
The International Valuation Standards Committee (IVSC) was founded in 1981. IVSC is a non government organisation (NGO) member of the United Nations and works
co-operatively with member States, organisations such as the World Bank, OECD, International Federation of Accountants, International Accounting Standards Board, and others including valuation societies throughout the world. Their aim is to harmonise and promote agreement and understanding of valuation standards. The principal IVSC objective is to formulate and publish, in the public interest, valuation standards and procedural guidance for the valuation of assets for use in financial statements and to promote their worldwide acceptance and observance. Although the primary interest of this group concerns real property valuations (land, buildings and/or plant and machinery), their standards are also of interest to people involved in business and intellectual property valuations. IVSC works closely with other international bodies, principally the International Accounting Standards Board, the Basel Committee on Banking Supervision, and the International Federation of Accountants, in developing its standards and guidance. IVSC standards are published in International Valuation Standards 2003, available through <www.ivsc.org/standards/index.html>. Two standards of relevance are: Standard 1: Market Value Basis of Valuation. Standard 2: Valuation Bases other than Market Value.
Two IVSC guidance notes that have particular relevance to business valuers are Guidance Note 4: Valuation of Intangible Assets and Guidance Note 6: Business Valuations. Further information on this organisation can be found at <www.ivsc.org>.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1660 Format of Reports / 3~1700 International Standards and Requirements / 3~1720 Investment Performance Council
3~1720
Investment Performance Council
In 1995, the US Association of Investment Management and Research (AIMR) recognised the need for one globally accepted set of standards. The Association sponsored the Global Investment Performance Standards (GIPS) Committee to develop and publish one global standard by which organisations calculate and present information on financial performance to clients and prospective clients. AIMR established the Investment Performance Council (IPC) to provide a practical and effective implementation structure for GIPS. The IPC strongly encourages countries without an investment performance standard in place to accept GIPS as the local standard. Countries with an existing investment performance standard are encouraged to move the standard towards GIPS by first adapting to a country version of GIPS. The principal goal of the IPC is to have all countries adopt the GIPS standard as their standard for investment organisations seeking to present historical investment performance information.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1660 Format of Reports / 3~1730 Australian Requirements
3~1730
Australian Requirements
There is very little legislative guidance on the format a valuation report or an independent experts report should take. Some guidance can be found in the following sources (however they mainly consider the content of the report rather than its format): ASIC Policy Statements and Practice Notes; ASIC Media Releases; and ASC Takeovers Procedures Manual.
Some of the key sections of these have been reproduced in the section on report contents ASIC requirements.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1660 Format of Reports / 3~1730 Australian Requirements / 3~1740 US Internal Revenue Service
3~1740
US Internal Revenue Service
In May 2001, the IRS submitted draft business valuation standards for comment to various appraisal organisations. The draft standards included parts of the Uniform Standards of Professional Appraisal Practice (USPAP), along with excerpts from valuation standards issued by the American Society of Appraisers (ASA), the Institute of Business Appraisers (IBA), and the National Association of Certified Valuation Analysts (NACVA). As noted in the final document: The purpose of this document is to provide guidelines applicable to IRS Valuation Engineers, Appraisers, Valuation Specialists and others engaged in valuation practice (hereinafter referred to as Valuators) relating to the development, resolution and reporting of issues involving business valuations and similar valuation issues. Valuators must be able to reasonably justify any departure from these guidelines. This document incorporates by reference, the Code of Conduct, applicable to all IRS employees, and all provisions of IRM 4.3.16 relevant to the development, resolution and reporting of such valuation issues.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1660 Format of Reports / 3~1730 Australian Requirements / 3~1750 Example Reports
3~1750
Example Reports
Examples of independent experts reports prepared by Leadenhall Australia follow: on the offer by Hancock & Gore Limited for all the shares in Laubman & Pank Holdings Limited; on the offer by Challenger Life Limited for the compulsory acquisition of options of eFinancial Capital Limited; and on the offer by First Process Limited for all the shares in Rib Loc Group Limited.
ASSIGNMENT MANAGEMENT / 3~1000 Reports / 3~1780 References

3~1780 1.
References
Australian Stock Exchange Limited Listing Rules, <www.asx.com.au>.
2. 3. 4. 5. 6. 7.
Australian Taxation Office, Consolidation Reference Manual, <www.ato.gov.au>. Canadian Institute of Chartered Business Valuators (CICBV), Valuation Standards, No. 110 Valuation Reports, <www.cicbv.ca>. Family Court of Australia, Family Law Rules 2004, <www.familycourt.gov.au>. Guidelines for Expert Witnesses in Proceedings in the Federal Court of Australia, <www.fedcourt.gov.au/how/prac_direction.html>. International Valuation Standards Committee, Exposure Draft of Proposed International Valuation Guidance Note Reviewing Valuations, <www.ivsc.org/pubs/index.html>. International Valuation Standards Committee, International Valuation Standards 2001, <www.ivsc.org/pubs/index.html>.
THEORETICAL FUNDAMENTALS
THEORETICAL FUNDAMENTALS
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals
4~1000
Net Present Value Fundamentals
Finance theory states that the value of a business or asset is based on the future net cash flows attributable to that asset. The process by which these future net cash flows are converted into an equivalent current day value, or net present value (NPV), is known as discounting. This chapter provides an elementary insight into the concept of discounting and the fundamentals which underlie the theory of net present value. Throughout this chapter it should be noted that the future is important (rather than the past) as: a business with a profitable history that was being forced to close would have limited value; and conversely a business with a poor history but a profitable future would have a higher value.
In the valuation of a business, the projection of future net cash flows is directly related to the revenue stream and earnings of the business. Therefore, it should also be noted that the theories discussed in this chapter form the basis of the various valuation approaches income, market and asset discussed in later chapters.
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1050 Market Approach
4~1050
Market Approach
This approach assumes the stock market has taken future expectations of profit and cash flows into consideration in the pricing of listed companies stocks or, in the case of a comparable sales analysis, that the price was determined taking future expectations of earnings or cash flows into consideration. A correlation is then drawn between the comparison companys price (including future expectations),
its current earnings and the earnings of the company being valued. Calculations supporting the theory that a price earnings ratio is derived from a future income stream can be found in the chapter Price Earnings Ratios.
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1100 Income Approach
4~1100
Income Approach
The income approach to value is based upon discounted cash flow and present value theory. It is forward looking and based on future cash generated, as ultimately, it is the cash that a business can generate which is valuable.
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1150 Asset Approach
4~1150
Asset Approach
This approach is generally not appropriate where assets are employed productively and earning more than the cost of capital, as the value of the business would be in excess of the value of its net assets. Thus, the asset approach is used primarily for businesses that are making a low economic rate of return. In the situations where it is appropriate to use an asset approach, it is assumed that the highest return from the assets can be achieved by selling the assets (and incurring some selling expenses) as opposed to receiving an income in subsequent years. This is in effect an NPV calculation, as the proceeds from the sale and the selling expenses represent the only cash flows attributable to the asset.
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1200 Cash Flows v. Earnings
4~1200
Cash Flows v. Earnings
The value of an ongoing business is the present value of its estimated future stream of cash flows. It is usual to discount future cash flows, but where future earnings approximate anticipated future cash flows, it is possible to discount future earnings, i.e. if one utilises a measure of income other than cash flow, there is an implicit assumption of the relationship between the measure of income and cash flow. The main differences between earnings and cash flow revolve around: the amount of depreciation charged against earnings; the amount of capital required to be invested in working capital to fund the growth of the business; and the amount of capital required to be invested to maintain the level of real productive capacity.
Whether to value earnings or cash flow will depend on whether one is faced with, for example, the profile of high cash flow but poor profits, or the typical J curve of low cash flow and low profits today but high cash flow and high profits tomorrow; any expectancy of high earnings but low cash flow, or relatively static cash flow and then profits, needs to be thoroughly investigated.
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1250 Time Value of Money and Discounting Cash Flow Theory
4~1250
Time Value of Money and Discounting Cash Flow Theory
In the following paragraphs we revisit the basics of discounted cash flow techniques and their relevance to business valuations. The following tables and graphs show that the use of different return rates can have a dramatic effect on the valuation outcome.
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1250 Time Value of Money and Discounting Cash Flow Theory / 4~1270 Future Value of $1,000 Invested Today
4~1270
Future Value of $1,000 Invested Today
For example, $1,000 invested today and projected forward at return rates of 5%, 10%, 20% and 30% will be valued at $1,629, $2,594, $6,192 and $13,786 respectively in 10 years time. This highlights the importance of an accurate assessment of cash flows and rates of return. FUTURE VALUE OF $1,000 At End of Year 0 1 2 3 4 5 6 7 8 9 10 Rate 5% 1,000 1,050 1,103 1,158 1,216 1,276 1,340 1,407 1,477 1,551 1,629 Rate 10% 1,000 1,100 1,210 1,331 1,464 1,611 1,772 1,949 2,144 2,358 2,594 Rate 20% 1,000 1,200 1,440 1,728 2,074 2,488 2,986 3,583 4,300 5,160 6,192 Rate 30% 1,000 1,300 1,690 2,197 2,856 3,713 4,827 6,275 8,157 10,604 13,786
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1250 Time Value of Money and Discounting Cash Flow Theory / 4~1290 Present Value of $1,000 in 10 Years
4~1290
Present Value of $1,000 in 10 Years
The converse equally applies when discounting a future amount to a present day value. The following table and graph show that an amount of $1,000 in 10 years is worth, in todays terms, $386, $162 and $73 respectively using discount rates of 10%, 20% and 30%. In other words, if $386 was invested today at 10% per annum compound it would become $1,000 at the end of 10 years. PRESENT VALUE OF $1,000 At End of Year 0 1 2 3 4 Discount Rate 10% 386 424 467 513 564 Discount Rate 20% 162 194 233 279 335 Discount Rate 30% 73 94 123 159 207
PRESENT VALUE OF $1,000 At End of Year 5 6 7 8 9 10 Discount Rate 10% 621 683 751 826 909 1,000 Discount Rate 20% 402 482 579 694 833 1,000 Discount Rate 30% 269 350 455 592 769 1,000
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1250 Time Value of Money and Discounting Cash Flow Theory / 4~1310 Present Value of Future Income Stream
4~1310
Present Value of Future Income Stream
The following table and graph demonstrate how future annual income amounts diminish incrementally in present value terms. In this example, an annual income stream of $200 has been discounted to a present value using a discount rate of 20% per annum. The graphs curve representing the cumulative value flattens out over time, reflecting the reduced value of future nominal amounts in present value
terms. At End of Year Nominal Cash Flow Present Value of Income + Capital at 20% 0 167 139 116 96 80 67 56 47 39 32 162 Cumulative Present Value of Income + Capital 0 167 306 421 518 598 665 721 767 806 838 1,000
0 1 2 3 4 5 6 7 8 9 10 end 10
0 200 200 200 200 200 200 200 200 200 200 1,000
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1250 Time Value of Money and Discounting Cash Flow Theory / 4~1330 Present Value of Typical Project Cash Flow
4~1330
Present Value of Typical Project Cash Flow
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1250 Time Value of Money and Discounting Cash Flow Theory / 4~1330 Present Value of Typical Project Cash Flow / 4~1340 Typical cash flow profile (non-discounted)
4~1340
Typical cash flow profile (non-discounted)
The following diagram shows the likely cash flows expected from a typical new project or acquisition. The key characteristics are: an initial outlay at the commencement of the project (sometimes followed by further capital outlays if there are various stages of the project); operating cash flows (sometimes net outflows in early years); the terminal value which may be a surrogate for all future cash flows or may in fact represent the sale or cessation of the project.
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1250 Time Value of Money and Discounting Cash Flow Theory / 4~1330 Present Value of Typical Project Cash Flow / 4~1350 Diagram Typical cash flow profile
4~1350 Year 0 1 2 3 4 5 5
Diagram Typical cash flow profile

Gross Cash Flows Initial Outlay (1,000) 200 250 300 350 400 Terminal Value 1,200 Present Value at 20% (1,000) 183 190 190 485 176 482 Cumulative Present Value (1,000) (817) (627) (437) (252) (76) 406
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1250 Time Value of Money and Discounting Cash Flow Theory / 4~1330 Present Value of Typical Project Cash Flow / 4~1360 Present value of typical cash flow profile
4~1360
Present value of typical cash flow profile
The following table and graph demonstrate the present value of each of the cash flows set out in the previous table and graph, discounted at 20% per annum compound. Note that the initial outlay occurring at the beginning of year 1 has not been discounted and that mid-year discounting has been applied to each of the operating cash flows in years 1 to 5. The terminal value has been discounted as though it occurred at the end of year 5. The net present value of these cash flows is $406. The discounted value of each of the period cash flows is shown in the following graph, together with the net present value for comparative purposes. DISCOUNTED CASH FLOWS AND NPV Year 0 1 2 Gross Cash Flows Initial Outlay (1,000) 200 250 Present Value at 20% (1,000) 183 190 Cumulative Present Value (1,000) (817) (627)
DISCOUNTED CASH FLOWS AND NPV Year 3 4 5 5 Gross Cash Flows 300 350 400 Terminal Value 1,200 Present Value at 20% 190 185 176 482 406 Cumulative Present Value (437) (252) (76) 406
Net Present Value at 20%:
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1250 Time Value of Money and Discounting Cash Flow Theory / 4~1330 Present Value of Typical Project Cash Flow / 4~1370 Discounted and nominal cash flow profiles
4~1370
Discounted and nominal cash flow profiles
For ease of understanding, the following table and graph are a combination of the previous two tables and graphs; they show the relative discounted cash flows with their respective actual (nominal) amounts. DISCOUNTED CASH FLOWS AND NPV Year 0 1 Gross Cash Flows Initial Outlay (1,000) 200 Present Value at 20% (1,000) 183 Cumulative Present Value (1,000) (817)
DISCOUNTED CASH FLOWS AND NPV Year 2 3 4 5 5 Gross Cash Flows 250 300 350 400 Terminal Value 1,200 Present Value at 20% 190 190 185 176 482 406 Cumulative Present Value (627) (437) (252) (76) 406
Net Present Value at 20%:
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1250 Time Value of Money and Discounting Cash Flow Theory / 4~1390 Present Value of $100 in Perpetuity
4~1390
Present Value of $100 in Perpetuity
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1250 Time Value of Money and Discounting Cash Flow Theory / 4~1390 Present Value of $100 in Perpetuity / 4~1400 Present value of $100 in perpetuity (no inflation)
4~1400
Present value of $100 in perpetuity (no inflation)
The next table and graph demonstrate that the impact of distant future cash flows upon the overall valuation can be relatively minor. We have grouped the present values of a constant $100 income stream into 5-year periods using discount rates of 15% and 30% respectively.
Of particular note is that the present value of income occurring after year 15 is very low when using 15% and negligible if 30% is used. PRESENT VALUE OF $100 PERPETUITY Year Nominal Cash Flow Present Value# at 15% Cum. % of Present Value Present Value# at 30% Cum. % of Present Value
Grouped: Years 15 Years 610 Years 1115 Years 1620 Years 21+* Total PV Years 115 Years 115 as a proportion of Total PV
* #
500 500 500 500 Infinite
335 167 83 41 41 666 585 88%
50% 75% 88% 94% 100%
244 66 18 5 2 333 327 98%
73% 93% 98% 99% 100%
Calculated as Total PV less PV1-20, i.e. (100/r)PV1-20 Discrepancy in addition due to rounding.
The following table and graph present the same data in a different form and demonstrate that the present value of cash flows up to and including year 15 represent 88% and 98% respectively of the total present value of the perpetuity at discount rates of 15% and 30% respectively. COMPOSITION OF PRESENT VALUE OF $100 PERPETUITY
The following table and graph present the same data in a different form and demonstrate that the present value of cash flows up to and including year 15 represent 88% and 98% respectively of the total present value of the perpetuity at discount rates of 15% and 30% respectively. COMPOSITION OF PRESENT VALUE OF $100 PERPETUITY Year Nominal Cash Flow Present Value# 15% Cum. % of Present Value Present Value# at 30% Cum. % of Present Value
Grouped: Years 15 Years 610 Years 1115 Years 1620 Years 21+* Total PV Years 115 Years 115 as a proportion of total PV
* #
500 500 500 500 Infinite
335 167 83 41 41 666 585 88%
50% 75% 88% 94% 100%
244 66 18 5 2 337 327 98%
73% 93% 98% 99% 100%
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1250 Time Value of Money and Discounting Cash Flow Theory / 4~1390 Present Value of $100 in Perpetuity / 4~1410 Present value of $100 in perpetuity (with 5% inflation escalator)
4~1410
Present value of $100 in perpetuity (with 5% inflation escalator)
A similar correlation applies when the income stream is escalating at a constant 5% per annum compound and discounted at 20% and 35% discount rates respectively, as shown in the following diagram.
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1250 Time Value of Money and Discounting Cash Flow Theory / 4~1390 Present Value of $100 in Perpetuity / 4~1420 Diagram Present value of $100 escalating at 5%
4~1420
Diagram Present value of $100 escalating at 5%

PRESENT VALUE OF $100 ESCALATING AT 5% Year Nominal Cash Flow Present Value# at 20% Cum. % of Present Value Present Value# at 35% Cum. % of Present Value
Grouped: Years 15 Years 610 Years 1115 Years 1620 Years 21+* Total PV Years 115 Years 115 as a proportion of total PV
* #
553 705 900 1,149 Infinite
325 167 85 44 46 666 577 87%
49% 74% 87% 93% 100%
238 68 19 5 2 333 326 98%
71% 92% 98% 99% 100%
The relative insignificance of cash flows occurring from year 15 and later is demonstrated (as previously) in the following bar graph which shows that the cash flows occurring in years 115 (inclusive) constitute 87% and 98% of total present value at discount rates of 20% and 35% respectively.
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1250 Time Value of Money and Discounting Cash Flow Theory / 4~1390 Present Value of $100 in Perpetuity / 4~1430 Diagram Composition of present value of $100 compounding at 5%
4~1430
Diagram Composition of present value of $100 compounding at 5%

COMPOSITION OF PRESENT VALUE OF $100 COMPOUNDING AT 5% Year Nominal Cash Flow Present Value# at 20% Cum. % of Present Value Present Value# at 35% Cum. % of Present Value
Grouped: Years 15 Years 610 Years 1115 Years 1620 Years 21+* Total PV
553 705 900 1,149 Infinite
325 167 85 44 46 666
49% 74% 87% 93% 100%
238 68 19 5 2 333
71% 92% 98% 99% 100%
COMPOSITION OF PRESENT VALUE OF $100 COMPOUNDING AT 5% Year Nominal Cash Flow Present Value# at 20% 577 87% Cum. % of Present Value Present Value# at 35% 326 98% Cum. % of Present Value
Years 115 Years 115 as a proportion of total PV

* #
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1250 Time Value of Money and Discounting Cash Flow Theory / 4~1480 Discount Points and Terminal Values
4~1480
Discount Points and Terminal Values
The previous sections on cash flow methodology have alluded to two very important issues which need to be considered when preparing a discounted cash flow analysis. These are: the discount point; and
the ongoing or terminal value.
Although not properly considered by many valuers, these two issues can have major ramifications on a valuation.
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1250 Time Value of Money and Discounting Cash Flow Theory / 4~1500 Discount Points
4~1500
Discount Points
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1250 Time Value of Money and Discounting Cash Flow Theory / 4~1500 Discount Points / 4~1510 Correlation of discount point with timing of cash flow
4~1510
Correlation of discount point with timing of cash flow
Commonly, cash flows are discounted using end of period (endpoint) discounting the standard formula in Microsoft Excel actually assumes end of period discounting. This means that projected cash flows are discounted as though they are all received at the end of each period. However, a methodology whereby cash flows are discounted as though they are received mid-way through the period is preferred. That is, instead of discounting at time T (where T is the period being discounted), the cash flows are discounted at T0.5 (i.e. mid-way through the period being discounted). In the event that cash flows are so significant that they should be individually discounted, the exact time of their receipt or payment should be calculated and period T should be this time. For example, if the cash flows are projected as years, and significant cash flow occurs two months into year 1, then that cash flow might be discounted at T = 2/12 = 0.17. Using mid-period discounting, each years cash flow is discounted as though it was paid or received at the end of month six. The following diagrams highlight this concept.
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1250 Time Value of Money and Discounting Cash Flow Theory / 4~1500 Discount Points / 4~1520 Effect of mid-period v. endpoint discounting
4~1520
Effect of mid-period v. endpoint discounting
Set out below are a table and graph demonstrating the effects of mid-period versus end of period discounting and the calculations using the two alternatives. MID-PERIOD VS END OF PERIOD DISCOUNTING End of period discounting: NPV = sum of (cash flow at time t) / (1 + discount rate) ^ t
MID-PERIOD VS END OF PERIOD DISCOUNTING Mid-period discounting: NPV = sum of (cash flow at time t) / (1 + discount rate) ^ t0.5 Assume discount rate = 40% p.a. and that cash flows are received/paid evenly throughout each period
DISCOUNT FACTOR USING: Period (t) 1 2 3 4 5 6 7 8 9 10 NPV Nominal Cash Flow (1,000) 1,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000 Mid-period Discounting 1.1832 1.6565 2.3191 3.2467 4.5454 6.3636 8.9091 12.4727 17.4618 24.4465 End Period Discounting 1.4000 1.9600 2.7440 3.8416 5.3782 7.5295 10.5414 14.7579 20.6610 28.9255
PV USING: Mid-period Discounting (845) 604 1,294 1,232 1,100 943 786 641 515 409 6,679 End Period Discounting (714) 510 1,093 1,041 930 797 664 542 436 346 5,644
% of Mid-period PV 85% 85% 85% 85% 85% 85% 85% 85% 85% 85% 85%
NET PRESENT VALUE
Because end of period discounting assumes the cash flows occur at a more distant point in time they are effectively more heavily discounted than the same cash flows using mid-period discounting. Accordingly, the present value of a cash flow discounted using end of period discounting will be smaller (in absolute dollars) than the equivalent cash flow discounted using mid-period discounting. In the graph above, using a discount rate of 40% per annum, the present value of cash flows using end of period discounting represents approximately 85% of the cash flows discounted using mid-period discounting. This effect is accentuated as the discount rate rises. Using modest discount rates, the effect is
ameliorated. The following table and graph demonstrate this using a discount rate of 20% per annum. MID-PERIOD VS END OF PERIOD DISCOUNTING End of period discounting: NPV = sum of (cash flow at time t) / (1 + discount rate) ^ t Mid-period discounting: NPV = sum of (cash flow at time t) / (1 + discount rate) ^ t0.5 Assume discount rate = 20% p.a. and that cash flows are received/paid evenly throughout each period
DISCOUNT FACTOR USING: Period (t) 1 2 3 4 5 6 7 8 9 10 NPV Nominal Cash Flow (1,000) 1,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000 Mid-period Discounting 1.0954 1.3145 1.5774 1.8929 2.2715 2.7258 3.2710 3.9252 4.7102 5.6523 End Period Discounting 1.2000 1.4400 1.7280 2.0736 2.4883 2.9860 3.5832 4.2998 5.1598 6.1917
PV USING: Mid-period Discounting (913) 761 1,902 2,113 2,201 2,201 2,140 2,038 1,911 1,769 16,123 End Period Discounting (833) 694 1,736 1,929 2,009 2,009 1,954 1,861 1,744 1,615 14,718
% of Mid-period PV 91% 91% 91% 91% 91% 91% 91% 91% 91% 91% 91%
NET PRESENT VALUE
As indicated by the above analysis, particular care needs to be taken when determining the appropriate discount point, particularly with large discount rates associated with start-up businesses and speculative investments with high risk.
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1250 Time Value of Money and Discounting Cash Flow Theory / 4~1540 Ongoing and Terminal Values
4~1540
Ongoing and Terminal Values
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1250 Time Value of Money and Discounting Cash Flow Theory / 4~1540 Ongoing and Terminal Values / 4~1550 Ongoing value
4~1550
Ongoing value
It is usual to be provided with earnings or cash flow projections for a 5, 10 or 20 year period. A valuation which discounts net cash flows over a finite period alone ignores the value of any cash flows occurring beyond the projection period. In many instances, for example a mining operation, no further cash flows may occur (refer next section on terminal value). However, it may often be reasonable to assume a business will continue into perpetuity, for example an electricity utility, in which case a value must be placed on the post-projection period cash flows. This value is often referred to as an ongoing value. The valuer must address the issues of how to value this ongoing cash flow stream and how to incorporate it into the current valuation of the business. The ongoing value is commonly determined by applying a capitalisation multiple to cash flows occurring at the point in time the ongoing value is assumed to occur. In other words, a capitalisation valuation is undertaken at a future point of 5, 10 or 20 years, which then forms part of the cash flows to be discounted to present day dollars. A critical factor in calculating the ongoing value is the assumption of future growth. The inverse of the discount rate can be applied as a capitalisation multiple to either earnings or cash flow if no real growth into perpetuity is assumed. In such a case, future earnings might be expected to approximate future cash flows. However, if real growth in earnings is to be assumed, cash flows may be lower than earnings due to the ongoing financing of this growth. The following formula shows the capitalisation multiple which is applied to a future maintainable cash flow stream growing at a constant rate into perpetuity. This formula is a derivative of the Gordon growth dividend model which is discussed in more detail in the chapter Discount Rates. Capitalisation Multiple = 1 / ( rg ) where: r = Discount rate g = Constant earnings growth rate As an example, the ongoing value in the following scenario is calculated as: Year 20 Cash Flow: Year 21 Cash Flow: Growth Rate: 5,715 5,886 (5,8865,715) / 5,715 = 3%
Discount Rate: Capitalisation Multiple: Ongoing Value:
20% 1/(20%3%) = 5.88 5,886 5.88 = $34,610
* Note: This formula can be applied to the future maintainable earnings figure if earnings are expected to approximate cash flows. The above multiple is applied to cash flows. It should be noted that a valuation undertaken using discounted cash flow methodology will require the capitalisation of cash flows, as opposed to earnings, when calculating the ongoing value. The above adjustment (increase) in the capitalisation multiple allows for the likelihood of perpetual cash flows being less than earnings in order to finance the assumed growth. It should also be noted that the assumption of real growth into perpetuity is somewhat risky. Care must be taken to ensure that such growth does not culminate in an unrealistic market share for the business, or even sales figures which exceed the total market size. As can be seen, in cases where it is necessary to calculate an ongoing value at the end of the projection period there is a certain circularity in determining the net present value of these cash flows by virtue of a need to first value the business 5, 10 or 20 years into the future. It can also be argued that there is a mismatch of methodologies in so far as a cash flow capitalisation methodology is required to determine ongoing value while the projection periods cash flows are valued using discounted cash flow methodology. However, it must be remembered that the terminal value, if occurring at, for example, year 10, may equate to a relatively small percentage of the total net present value. This may provide some scope for masking what otherwise might be substantial errors. Two possible ways of avoiding argument on the calculation of ongoing value are: to consider a range of ongoing values based on capitalisation multiples of, for example, plus or minus 25% of that originally chosen; or to prepare cash flow projections for a sufficiently extended period, for example 30 years, so that the ongoing value becomes insignificant. However, this method creates a secondary problem involving the preparation of accurate long-term cash flow projections.
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1250 Time Value of Money and Discounting Cash Flow Theory / 4~1540 Ongoing and Terminal Values / 4~1560 Terminal value
4~1560
Terminal value
Many businesses, for example mining ventures, have a finite life. As earnings are not expected into perpetuity, calculating an ongoing value is not required. However, cash flows generated from the sale of plant and machinery for example, must be incorporated into the valuation. A terminal value is calculated which estimates the net cash receipts upon the winding-up of the business. An appropriate valuation methodology for calculation of a terminal value is the orderly realisation of assets. As is done for an ongoing value calculation, the terminal value must be discounted to a present day value and then added to the valuation. For both ongoing value and terminal value calculations, the tax implications on the sale of a business
or business assets should be taken into consideration.
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1610 Alternative Approaches to Risk Adjustment of Cash Flows
4~1610
Alternative Approaches to Risk Adjustment of Cash Flows
The following analyses demonstrate the effect of three approaches to risk adjustment of projected cash flows on net present value via: 1. adjustment of revenues only to an amount which represents the revenues with 100% certainty through the use of certainty equivalent factors on the revenue line (i.e. calculation of expected revenue based on assumed probability factors); adjustment of net cash flows (including the terminal value) to amounts which represent the net cash flows with 100% certainty through the application of certainty equivalent factors to the net cash flows; incorporation of the risk associated with attaining the projected cash flows by utilising a higher discount rate. This uses a risk-adjusted discount rate of 17% (compared with an unadjusted rate of 15%). This increase in discount rate results in a present value which approximates the present value obtained using certainty equivalents.
2.
3.
In these examples, a zero growth factor has been incorporated.
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1610 Alternative Approaches to Risk Adjustment of Cash Flows / 4~1630 Certainty Equivalent Approach Risk Adjustment of Revenues Only
4~1630
Certainty Equivalent Approach Risk Adjustment of Revenues Only

Alternative Approaches to Risk Adjustment of Cash Flows Risk Adjusted Discount Rate Approach (Risk Adjustment Through Discount Rate Only) Budget 20x1/x2 $000 Budget 20x2/x3 $000 Budget 20x3/x4 $000 Budget 20x4/x5 $000 Budget 20x5/x6 $000
PROFIT & LOSS STATEMENT REVENUE CERTAINTY EQUIVALENT FACTOR CERTAINTY EQUIVALENT REVENUES EXPENDITURE Salaries Wages Admin Corporate Services 10.0 30.0 2.0 5.0 10.2 30.6 2.0 5.1 10.4 31.2 2.1 5.2 10.6 31.8 2.1 5.3 10.8 32.5 2.2 5.4 100.0 100% 100.0 200.0 90% 180.0 300.0 85% 255.0 400.0 85% 340.0 500.0 85% 425.0
Alternative Approaches to Risk Adjustment of Cash Flows Risk Adjusted Discount Rate Approach (Risk Adjustment Through Discount Rate Only) Budget 20x1/x2 $000 Interest Depreciation TOTAL EXPENDITURE ACCOUNTING PROFIT Less Indirect Expenses NET PROFIT/LOSS ADD-BACK Interest Depreciation TOTAL ADD-BACKS NET OPERATING CASH FLOW Less Capital Exp Add Terminal Value NET CASH FLOW CERTAINTY EQUIVALENT FACTORS CERTAINTY ADJUSTED CASH FLOWS Period PRESENT VALUE TOTAL PRESENT VALUE Discount Rate Applicable: 1 15.00% 2 17.00% 3 20.00% TERMINAL VALUE CALCULATION: Final Year Operating Cash Flow (a) Multiplier Discount Rate Invert: [Discount RateGrowth Rate] (b) Terminal Value (a b) Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited 15.00% 6.67 2,335.4 350.3 26.0 0 109.7 1 95.4 1,869.3 1.0 15.00% 83.2 2 62.9 266.9 3 175.5 2,685.7 4 1,535.6 26.0 109.7 83.2 266.9 0.0 26.0 3.1 2.0 5.1 109.7 0.0 3.1 2.1 5.2 183.2 100.0 3.2 2.1 5.3 266.9 0.0 3.2 2.2 5.4 350.3 0.0 2,335.4 2,685.7 3.0 2.0 52.0 48.0 22.0 26.0 Budget 20x2/x3 $000 3.1 2.0 53.0 127.0 22.4 104.6 Budget 20x3/x4 $000 3.1 2.1 54.1 200.9 22.9 178.0 Budget 20x4/x5 $000 3.2 2.1 55.1 284.9 23.3 261.6 Budget 20x5/x6 $000 3.2 2.2 56.3 368.7 23.8 344.9
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1610 Alternative Approaches to Risk Adjustment of Cash Flows / 4~1650 Certainty Equivalent Approach Risk Adjustment of Net Cash Flows
4~1650
Certainty Equivalent Approach Risk Adjustment of Net Cash Flows

PROFIT & LOSS STATEMENT REVENUE CERTAINTY EQUIVALENT FACTOR CERTAINTY EQUIVALENT REVENUES EXPENDITURE Salaries Wages Admin Corporate Services Interest Depreciation TOTAL EXPENDITURE ACCOUNTING PROFIT Less Indirect Expenses NET PROFIT/LOSS ADD-BACK Interest Depreciation TOTAL ADD-BACKS NET OPERATING CASH FLOW Less Capital Exp Add Terminal Value NET CASH FLOW CERTAINTY EQUIVALENT FACTORS 26.0 100% 129.7 90% 128.2 85% 326.9 85% 0.0 26.0 3.1 2.0 5.1 129.7 0.0 3.1 2.1 5.2 228.2 100.0 3.2 2.1 5.3 326.9 0.0 3.2 2.2 5.4 425.3 0.0 2,835.4 3,260.7 85% 10.0 30.0 2.0 5.0 3.0 2.0 52.0 48.0 22.0 26.0 10.2 30.6 2.0 5.1 3.1 2.0 53.0 147.0 22.4 124.6 10.4 31.2 2.1 5.2 3.1 2.1 54.1 245.9 22.9 223.0 10.6 31.8 2.1 5.3 3.2 2.1 55.1 344.9 23.3 321.6 10.8 32.5 2.2 5.4 3.2 2.2 56.3 443.7 23.8 419.9 100 200 300 400 500
Alternative Approaches to Risk Adjustment of Cash Flows Risk Adjusted Discount Rate Approach (Risk Adjustment Through Discount Rate Only) Budget 20x1/x2 $000 CERTAINTY ADJUSTED CASH FLOWS Period PRESENT VALUE TOTAL PRESENT VALUE Discount Rate Applicable: 1 15.00% 2 17.00% 3 20.00% TERMINAL VALUE CALCULATION Final Year Operating Cash Flow (a) Multiplier Discount Rate Invert: [Discount RateGrowth Rate] (b) Terminal Value (a b) 15.00% 6.67 2,835.4 425.3 26.0 0 Budget 20x2/x3 $000 116.7 1 101.5 1,951.3 1.0 15.00% Budget 20x3/x4 $000 109.0 2 82.4 Budget 20x4/x5 $000 277.9 3 182.7 Budget 20x5/x6 $000 2,771.6 4 1,584.7
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1610 Alternative Approaches to Risk Adjustment of Cash Flows / 4~1670 Risk Adjusted Discount Rate Approach
4~1670
Risk Adjusted Discount Rate Approach

PROFIT & LOSS STATEMENT REVENUE CERTAINTY EQUIVALENT FACTOR CERTAINTY EQUIVALENT REVENUES EXPENDITURE Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited 100 200 300 400 500
Alternative Approaches to Risk Adjustment of Cash Flows Risk Adjusted Discount Rate Approach (Risk Adjustment Through Discount Rate Only) Budget 20x1/x2 $000 Salaries Wages Admin Corporate Services Interest Depreciation TOTAL EXPENDITURE ACCOUNTING PROFIT Less Indirect Expenses NET PROFIT/LOSS ADD-BACK Interest Depreciation TOTAL ADD-BACKS NET OPERATING CASH FLOW Less Capital Exp Add Terminal Value NET CASH FLOW CERTAINTY EQUIVALENT FACTORS CERTAINTY ADJUSTED CASH FLOWS Period PRESENT VALUE TOTAL PRESENT VALUE Discount Rate Applicable: 1 15.00% 2 17.00% 3 20.00% TERMINAL VALUE CALCULATION Final Year Operating Cash Flow (a) Multiplier Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited 425.3 26.0 0 129.7 1 110.9 1,970.6 2.0 17.00% 128.2 2 93.7 326.9 3 204.1 2,927.1 4 1,562.1 26.0 129.7 128.2 326.9 0.0 26.0 3.1 2.0 5.1 129.7 0.0 3.1 2.1 5.2 228.2 100.0 3.2 2.1 5.3 326.9 0.0 3.2 2.2 5.4 425.3 0.0 2,501.8 2,927.1 10.0 30.0 2.0 5.0 3.0 2.0 52.0 48.0 22.0 26.0 Budget 20x2/x3 $000 10.2 30.6 2.0 5.1 3.1 2.0 53.0 147.0 22.4 124.6 Budget 20x3/x4 $000 10.4 31.2 2.1 5.2 3.1 2.1 54.1 245.9 22.9 223.0 Budget 20x4/x5 $000 10.6 31.8 2.1 5.3 3.2 2.1 55.1 344.9 23.3 321.6 Budget 20x5/x6 $000 10.8 32.5 2.2 5.4 3.2 2.2 56.3 443.7 23.8 419.9
Alternative Approaches to Risk Adjustment of Cash Flows Risk Adjusted Discount Rate Approach (Risk Adjustment Through Discount Rate Only) Budget 20x1/x2 $000 Discount Rate Invert: [Discount RateGrowth Rate] (b) Terminal Value (a b) Budget 20x2/x3 $000 Budget 20x3/x4 $000 Budget 20x4/x5 $000 Budget 20x5/x6 $000 17.00% 5.88 2,502
THEORETICAL FUNDAMENTALS / 4~1000 Net Present Value Fundamentals / 4~1820 Calculating an Appropriate Discount Rate
4~1820
Calculating an Appropriate Discount Rate
The selection of an appropriate discount rate or required rate of return is discussed in detail in the chapter Discount Rates. A brief overview is provided below. The discount rate represents two things: the risk associated with the business and the consequential future cash flows; and the return required from an investment to generate the future cash flows.
Thus it represents the rate at which the future cash flows are discounted in order to arrive at the present value of those cash flows. The discount rate or required rate of return is a combination of the opportunity cost (what an investor could earn from a risk-free investment such as a Government bond) plus a risk premium (a premium for the risk associated with obtaining the expected returns from the particular investment). When the discount rate incorporates an assessment of the probability of achieving the projected cash flows it is known as a risk adjusted discount rate. There are alternative ways of determining the present value of cash flows including the use of single-period discount rates and the application of certainty equivalents. These are discussed in more detail in the section on alternative approaches to the risk adjustment of cash flows. The most important considerations when selecting the appropriate discount rate are: the level of risk and return this investment offers; the level of risk and return offered by other investments; and that the projected cash flows and discount rate are calculated on the same basis in terms of: real or nominal cash flows; risk adjusted cash flows or risk adjusted discount rates; pre- or post-interest; or pre- or post-tax.
These are all discussed in detail in the chapter Discount Rates.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates

5~1000
Discount Rates
The terms discount rate, required rate of return or cost of capital are often used interchangeably. They represent the return required from an investment expressed as a compounding periodic percentage, that an investor needs to earn in order to justify investing in that particular investment and being exposed to its associated level of risk. This chapter expands on the previous one, Net Present Value Fundamentals, and provides a more in-depth discussion on the topic of discount rates and their determination. It takes a closer look at the required rate of return, its component parts, its alternative formulations and when they should be used. Venture capital discount rates is also discussed. When performing a business valuation, the net present value of the future net cash flows, when discounted at the required rate of return, should equal the value of the business. A discount rate is often used to assess the profitability of a project. In simple terms, the cost of capital refers to the cost of using debt, plus the cost of using equity to fund a particular project, whereas the costs of the respective funding items reflect the riskiness of the underlying assets or project which they finance. When the rate of return from a project exceeds the minimum required rate, or hurdle rate, the project should be undertaken. Projects which fail to exceed the hurdle rate should be rejected. To determine the appropriate rate of return the following topics should be considered and these are discussed in this chapter: the effect of risk on the required rate of return; the sources of capital and how that capital is utilised; the different definitions of the cost of capital and what rate should be used; the cost of equity; the cost of debt; and special considerations when determining the cost of capital.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1050 Introduction

5~1050
Introduction
For most business and company valuers, the analysis of returns (i.e. profitability and cash flows) is second nature. This text deals with the analysis techniques and valuation issues associated with identifying the assets and returns in a valuation assignment. Perhaps the most vexing issue in any valuation assignment is the determination of an appropriate discount rate. At its most basic, this determination requires an answer to: What rate of return would I expect from this asset/business/investment over the long
term? or At what price would a buyer or vendor achieve an appropriate rate of return? The next question is how do we gauge what is appropriate? Usually, a benchmark is established based on rates of return reported in the market-place for assets, investments or businesses that are similar in nature and structure. An assessment is then made as to whether there are specific differences between the benchmark and the business in question, and the benchmark is adjusted to reflect those differences. Because of the highly subjective nature of this process, we usually aim to identify a number of (often) independent reference points. These reference points will usually include some or all of the following: calculation of a weighted average cost of capital or cost of equity, using the capital asset pricing model and published Beta factors; a first principles approach (which is similar to the theory underpinning the capital asset pricing model), whereby a rate of return is built up from a risk-free rate, plus an estimate of the premium required for the riskiness of the business in question; and price earnings ratios from listed companies.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1050 Introduction / 5~1070 Risk/Return Concepts
5~1070
Risk/Return Concepts
The basic premise behind determining a rate of return is: the more risky the outcome of the investment, the greater the rate of return demanded by the investor in order to justify the decision to invest. Although people do not consciously talk each day in terms of portfolio theory, it would be very surprising if every reader had not at some stage made a conscious decision based on an assessment of risks and returns. If there are two investments which produce the same return but with different levels of risk, the investment with the lower level of risk is to be preferred. Similarly, if there are two investments with the same level of risk but with different levels of return, the one with the higher level of return is to be preferred. The following diagram demonstrates this concept: While B and C produce the same returns, C is preferred as it results in lower risk. While A and B result in the same level of risk, A is preferred as it produces a greater return.
It is not surprising, therefore, that in situations of high risk, higher returns are sought to compensate for the added risk. In stock market parlance, a companys Beta factor is often used as a surrogate for risk. The Beta factor is, in fact, a measure of volatility and it is mathematically derived by tracking a stocks past returns against those of a well diversified portfolio of assets (referred to as the market portfolio). If an investment has a high degree of volatility it is deemed to have a high degree of risk. In uncertain times, volatility of returns is expected to be greater and thus risk is greater.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1050 Introduction / 5~1090 Sources and Comparative Costs of Capital
5~1090
Sources and Comparative Costs of Capital
Generally, there are two basic sources of capital: borrowed funds (debt); and invested funds (equity).
The following chart is a useful reminder of the sources and uses of the cost of capital.
The cost of equity and the cost of debt is expressed as a percentage rate of return per annum. As a practical implication, the company will then need to generate sufficient cash in order to cover both the expected rate of return to equity holders via dividends and capital growth, and the more direct return to lenders through interest and principal repayments.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1050 Introduction / 5~1090 Sources and Comparative Costs of Capital / 5~1100 Sources of capital
5~1100
Sources of capital
The funds raised by a company are usually a mixture of the following: ordinary shares; preference shares (sometimes redeemable); convertible notes; debentures; mortgage loans; finance leases; term loans; bank overdraft; and convertible bonds.
In theory, a company could raise funds from each of these different sources of capital because each will have particular advantages depending on the individual characteristics of the instrument. For example, ordinary shares have only a residual claim on the earnings and assets of the company after all other forms of funding have been satisfied. Convertible bonds raised in overseas markets may have a low interest cost, but also a foreign exchange risk element, that can sometimes be used to offset foreign-sourced income. As a result, the funding of the company can be composed of many different types of funds with different costs and each needs to be considered individually when determining the overall cost of capital. This text does not address the issue of optimal debt/equity structures. The board and/or controlling shareholders need to communicate to managers an optimal level of debt and equity suitable for the sustainable growth of the company.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1050 Introduction / 5~1090 Sources and Comparative Costs of Capital / 5~1120 Comparative cost of equity and cost of debt
5~1120
Comparative cost of equity and cost of debt
It is important to recognise that debt is usually less expensive than equity. The reasons for differences between the cost of debt and the cost of equity are not discussed in detail here; however, some basic points are worth noting.
Reasons for why debt is usually less expensive include: there is security over specific assets of the company; servicing is scheduled to occur on a regular basis; repayment of the full debt is usually specified at a certain point in time; the cost of debt is tax deductible; the debt market, in its broader sense, is usually more accessible and investors (lenders) may be able to diversify more than in the equity markets; debt holders rank ahead of equity holders in the event of liquidation; or debt holders usually enter into agreements with the borrower to prevent their interests being adversely affected.
At the core of these reasons is the fundamental concept of risk and return. The return required by debt holders is lower because the risk they bear is correspondingly lower.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1050 Introduction / 5~1140 Uses for the Cost of Capital
5~1140
Uses for the Cost of Capital
The cost of capital has a number of uses. Sometimes the cost of capital that is applied is calculated incorrectly for the method in which it is being used. The four main uses for the cost of capital are in: pricing new issues of equity and debt; the capital budgeting process; the valuation of a company or other entity; and a regulatory role of monitoring industry rates of return.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1050 Introduction / 5~1140 Uses for the Cost of Capital / 5~1150 Pricing new debt/equity
5~1150
Pricing new debt/equity
When a new debt or equity raising is contemplated it is necessary to pitch the price of the equity at a level which will be acceptable to the market-place (i.e. one which will encourage people to take up the offer) and, at the same time, not disadvantage existing shareholders. If equity is being raised to replace existing debt then the companys historic rate of return for equity is an appropriate base for determining the rate of return required from new equity after adjusting for the reduced risk resulting from less debt.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1050 Introduction / 5~1140 Uses for the Cost of Capital / 5~1160 Capital budgeting
5~1160
Capital budgeting
Net present values and internal rates of return are appropriate measures in the evaluation of new
projects. The discount rate used in the net present value calculation is usually based on the companys historic cost of capital. Thus, if the companys historic cost of capital is 15%, new projects, funded on the same debt/equity basis, should have a net present value of greater than 0 using a discount rate of 15% and an internal rate of return in excess of 15%.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1050 Introduction / 5~1140 Uses for the Cost of Capital / 5~1170 Valuation of a company or entity
5~1170
Valuation of a company or entity
Valuations using a discounted cash flow methodology normally rely upon market measures of the companys cost of capital to discount the cash flows or to capitalise future maintainable earnings. Note that the price earnings ratio (PER) can assist with the determination of the cost of capital (see the following discussion of the relationship between PERs and discount rates).
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1050 Introduction / 5~1140 Uses for the Cost of Capital / 5~1180 Regulations
5~1180
Regulations
Many bodies that regulate monopolies monitor the risk and the overall level of returns from an industry in assessing whether pricing practices are oppressive. An example of this use of the cost of capital is in the review of the Australian music industry where it was determined that the pricing policies involved resulted in rates of return which would normally be regarded as excessive.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1230 Which Discount Rate to Use?
5~1230
Which Discount Rate to Use?
A lot of time is spent by valuers researching the industry in which the business being valued operates in order to determine the most appropriate benchmark rate of return. However, once an appropriate benchmark is obtained, a number of essential considerations are often overlooked in actually applying the rate of return to the profits or cash flows being valued. A common flaw in company valuations is the extent to which the profits or cash flows being valued fail to match the rate of return. In order to obtain a match between the two key variables (returns and the rate of return) it is necessary to ensure consistent treatment of: debt and interest flows of the subject business; tax and interest deductions; the capital structure of the subject business compared with the benchmark companies; surplus assets;
inflation; and country-specific factors.
The opportunity cost of capital is a rate of return which can be used in a number of different ways for a number of different purposes by companies and valuers alike. How the rate of return will be utilised will usually dictate the construction of the return with respect to tax, interest, capital structure, inflation etc. For example, the cost of capital can be constructed and used in the following ways: COST OF CAPITAL Real, pre-tax weighted average cost of capital PURPOSE Discount rate for relatively unsophisticated project evaluation (i.e. largely unaffected by the incidence of inflation and tax outlook). Business valuation models where inflationary/growth factors are more intricate. Benchmark for total shareholder return performance measurement. Useful for entity valuations.
Nominal, post-tax (equity)/pre-tax (debt) weighted average cost of capital Nominal, post-tax cost of equity
The weighted average cost of capital (WACC) can be described in a number of different ways to suit specific cash flow types. For example, the evaluation of infrastructure bond-funded (BOOT or Build Own Operate Transfer) schemes may necessitate the use of a classical definition of WACC expressed in nominal dollars. This would be entirely appropriate where the cash flows being evaluated are defined in a similar (i.e. consistent) fashion. Depending upon the composition of cash flows being evaluated, the discount rate can be quoted and defined in terms of: real or nominal; before or after interest (i.e. as a WACC or as a cost of equity); and pre- or post-corporate tax.
It is fundamentally important to use the correct version of cost of capital for a given cash flow definition. Failure to apply the cost of capital consistently to the definition of cash flow will result in either an overstatement or understatement of the resultant present value or business valuation. A more complete discussion of the theory underpinning the different discount rates is found later in this chapter in the section required rate of return key factors. The following tree diagram highlights the key questions which need to be asked about the underlying cash flows when determining the correct discount rate to be used.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1280 Methods for Determining Cost of Equity
5~1280
Methods for Determining Cost of Equity
A number of methods can be used. The main ones are: a constant dividend model; the Gordon dividend growth model; a subjective or first principles method; a build-up method; and the capital asset pricing model.
Of these methods, the capital asset pricing model will withstand the most rigorous scrutiny, despite its sometimes unrealistic assumptions about perfect capital markets and information dissemination. However, it is worth describing briefly the alternative methods as a point of comparison with the capital
asset pricing model (CAPM).
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1280 Methods for Determining Cost of Equity / 5~1300 Constant Dividend Model
5~1300
Constant Dividend Model
The constant dividend model attempts to relate the dividend streams and current value of equity to arrive at the cost of equity. It does not allow for growth in dividends. The constant dividend model is best applied in the scenario of a constant and reliable stream of dividends flowing to equity holders. It is best suited to a minority holding when the investor has no control over cash flows and hence is solely reliant on the companys dividend policy as a source of income for that investment. Assuming a constant dividend level relative to prices and 100% dividend payout ratio, the cost of equity capital (Ke) under the constant dividend model is calculated as: Ke = Dividend per share/Market price Set out below is an example of the constant dividend model: CONSTANT DIVIDEND MODEL Ke = Dividends per share/Market price Example: Cents Dividends per share Market price Ke = Therefore, Ke = 8.36% 23 275 23/275
In Australia, when using this model, adjustments need to be made for the level of franking (imputation) tax credits to reflect the tax position of shareholders. This is discussed in greater detail in the section required rate of return Australian adjustments.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1280 Methods for Determining Cost of Equity / 5~1320 Gordon Dividend Growth Model
5~1320
Gordon Dividend Growth Model
This model is a derivative of the constant dividend model but provides for an element of growth in dividends. The models suitability is similar to that of the constant dividend model, with the exception that ongoing growth in dividends is assured. The cost of equity capital under the Gordon dividend growth model is calculated as:
Ke = (Dividend per share/Market price) + G where: G = expected growth in dividends (%) It should be noted that the model is only valid for companies with moderate growth, as high growth companies will distort the relationship between growth and the cost of equity. The Gordon dividend growth model is discussed in more detail in the section on minority holdings of shares and convertible notes in relation to minority shareholdings.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1280 Methods for Determining Cost of Equity / 5~1340 Subjective/First Principles Method
5~1340
Subjective/First Principles Method
This method attempts to construct cost of equity capital from first principles measuring component risks associated with the investment. For example, every business is affected by the following risks: economic/country risk; industry/market risk; financial structure risk (solvency/gearing); management risk; technology risk; product life-cycle risk; and geographic risk.
A commonly-used short cut in this method is to determine the price earnings ratios of companies with apparently similar business and industry risks and then make adjustments for the specific risks associated with the business being considered. Commonly, cost of equity capital will be constructed along the following lines: Cost of equity capital determined from industry Deduct 5% for diversification of geographic risk Add 2% for additional gearing/financial risk Total 23% (5)% 2% 20%
Once the cost of equity capital has been calculated and applied to obtain a value for the business, further discounts may be required to account for factors such as non-negotiability of shares and minority interests. If this method is used, the rate calculated should be cross-checked against the rates of return for other investments in that country. Models have been developed which attempt to introduce some measure of science to what is otherwise a subjective process. Some of these models enable weightings to be placed on the various risks which a company faces in order to determine (scientifically) a discount rate from first principles. The drawbacks of such models lie in the fact that errors at a preliminary level compound themselves
and may introduce spurious accuracy to the overall rate determined. However, such a model is methodologically sound when we consider that the discount rate is represented by the risk-free rate plus a premium for the risk associated with the investment (see Sharpe (1964) and Lintner (1965)). As an alternative, one can go to the market-place and draw upon one of the services which determines discount rates, and by comparing underlying fundamentals of similar companies discount rates determine an appropriate rate for the company at hand. Details of companies that provide this type of service are included in the chapter Research and Data Collection. The advanced security analysis notes from the Securities Institute of Australia state that after-tax rates of return on equity capital display the following characteristics: they should never fall below long-term Government bonds; they rarely fall below 15% or rise above 30%; they normally fall in the range of 17% to 25%; risky industries may be between 30% and 40%; and they are greater than 40% for blue sky projects or unproven products/processes.
These rates should also be compared with those calculated in the section closely-held businesses risk premium.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1280 Methods for Determining Cost of Equity / 5~1360 Build-up Method
5~1360
Build-up Method
The build-up method is often used in the valuation of small, closely-held businesses. The method employs empirical data and is similar to the capital asset pricing model; however, a specific risk premium is incorporated which accounts for the individual characteristics of the business in question. An example follows: Nominal Risk-free Interest Rate* Market Risk Premium* Size Premium* Company-specific Risk Premium# Real Earnings Growth Rate# Capitalisation Rate
* # Empirical data. Available from Ibbotson Associates Yearbook. Estimated in line with individual characteristics of business.
5.0% 6.0% 4.5% 5.5% (2.0%) 19.0%
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1280 Methods for Determining Cost of Equity / 5~1380 Capital Asset Pricing Model (CAPM)
5~1380
Capital Asset Pricing Model (CAPM)
The capital asset pricing model is derived from modern portfolio theory and is founded on a number of basic premises including: investors are risk averse; capital markets are perfect; there is unlimited access to capital and debt; information about assets is freely available; transaction costs are ignored; investors portfolios are well diversified; and there is a component of risk (systematic risk) which cannot be diversified (e.g. the state of the economy).
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1280 Methods for Determining Cost of Equity / 5~1380 Capital Asset Pricing Model (CAPM) / 5~1400 Relationship between an asset and the market
5~1400
Relationship between an asset and the market
Intuitively, it is known that some assets are riskier than others. Thus, investing in a single asset is more risky than investing in a well diversified portfolio of assets given that the returns of most assets do not move together by way of a perfectly correlated relationship. The CAPM formalises these intuitions by relating the volatility of all individual risky assets to that of the market as a whole. Market is usually defined in terms of a surrogate such as the Stock Exchange Accumulation Index. (Note that an accumulation index captures information about the level of share prices and dividends, unlike price indices which exclude the return from dividends.) The relationship between an asset and the market is then expressed in terms of its Beta factor. The Beta of the market is 1 (i.e. the correlation between all assets). An asset which is more volatile than the market as a whole will have a Beta factor of greater than 1 (usually between 1 and 2), and an asset which is less volatile than the market as a whole will have a Beta of between 0 and 1. An asset which moves in the opposite direction to the market has a negative Beta. The Beta factor effectively measures the change in an individual assets return in relation to the change in the market portfolios risk premium. The risk premium compensates for the additional risk associated with the diversified portfolio compared with that of a risk-free asset such as a Government bond. For example (and as will be demonstrated in the next section), should a change in a market-wide risk factor increase the required risk premium on the market portfolio by 2%, the required return of an individual asset with a Beta factor of 1.5 would be expected to increase by 2 1.5 = 3%. Conversely, the opposite effect would result from a decrease in the required return of the market portfolio. Therefore, the larger an assets Beta, the more volatile its returns have been in comparison to the diversified market portfolio. While there are some flaws in the practical application of the CAPM, for example, the assumption that a surrogate for the market such as an equities index is adequate, the considerable empirical studies undertaken to determine the accuracy of the model have shown favourable results.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1280 Methods for Determining Cost of Equity / 5~1380 Capital Asset Pricing Model (CAPM) / 5~1410 The CAPM formula
5~1410
The CAPM formula
The CAPM is really only useful for listed public companies where historic price movements can be related to movements in the market as a whole to determine the companys Beta. These Betas can be obtained from a number of services and details of them are included in the chapter Research and Data Collection. The mathematical form of the CAPM is: Capital Asset Pricing Model ER = Rf + (RmRf) where: ER = expected return from equity after corporate tax; Rf = the pre-tax risk-free rate; Rm = expected return from the market portfolio; RmRf = risk premium of market portfolio relative to the risk-free asset; and = the measure of a risky assets level of volatility relative to the market. Some of the components of the CAPM are readily observable, such as the risk-free rate (usually taken to be a long-term Government note or bond) and the return on the market. As an example of the use of the model, set out below is a calculation of the expected return from equity using the following data: Rf = 7% (long-term Government bond rate) Rm = 13% = 1.4 (approx.) Therefore: ER = = = = 7% + 1.4(13%7%) 7% + 1.4(6%) 7% + 8.4% 15.4%
It should be noted that there is sometimes a mismatch between the purpose for which the CAPM is used (i.e. with respect to projected returns) and its calculation using historic relationships between the companys share price and the market. While this seems to be a major flaw of the model, empirical evidence suggests that the model is robust in its predictive capacity.
Two additional points emerge: Why use a 10-year bond rate as the surrogate for the risk-free rate? Where does a market risk premium come from?
First, the 10-year bond rate is only an appropriate surrogate for the risk-free rate where the period over which the investment is made (i.e. the time horizon of the valuation) is not less than 10 years. If the investment was being made for 30 days for example, the risk-free rate adopted could be the rate at which bank bills are exchanged with 30 days outstanding. Second, the selection of a market risk premium should be an approximation of long-term expectations and be based on empirical studies. Recently, there has been some debate over the magnitude of this premium as commentators suggest that expectation of market risk is falling.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1460 Determining the Weighted Average Cost of Capital (WACC)
5~1460
Determining the Weighted Average Cost of Capital (WACC)
The overall cost of capital to a business is an average of the cost of debt and the cost of equity weighted for their various proportions. This is commonly known as the weighted average cost of capital or WACC. Pre-interest cash flows should be discounted using the weighted cost of (debt and equity) capital (WACC) whereas post-interest cash flows should be discounted using the cost of equity only. It is common to prepare cash flow projections which provide for the cost of interest and other debt forms and, therefore, most discounted cash flow analysis is conducted using cost of equity capital only on an after-tax basis. WACC is calculated using the following formula: WACC = Ke. E D+E + Kd (1t).D D+E
where: WACC = weighted average cost of capital; Ke = shareholders required rate of return (cost of equity); Kd = lenders required rate of return (cost of debt); t = the companys tax rate; E = fair market value of the equity of the company; and D = fair market value of the debt. It is essential to consider the fair market values of debt and equity when determining the WACC. This is for the same reason that the face value of a companys shares bears no resemblance to their fair market value; likewise, shareholders funds in the balance sheet may not adequately represent the fair
market value of the company as a whole. The cost of various funding methods employed by the company are determined and then a weighted average is calculated by apportioning the costs and proportions to each type of funding used. The following (simplified) example demonstrates the methodology. WEIGHTED AVERAGE COST OF CAPITAL EXAMPLE $000s Assets Employed Funded by: Ordinary Shares Preference Shares Mortgage Loans Debentures 10,000 2,000 2,000 6,000 20,000 Market Value of Funds Employed Ordinary Shares: Number of Shares on Issue Market Price Market Value of Ordinary Shares Preference Shares: Number of Shares on Issue Market Price Market Value of Preference Shares Mortgage Loan: Debentures: Coupon Rate Interest Payable Market Rate Market Value of Debentures Market Value of Funds Employed Summary Ordinary Shares Preference Shares Mortgage Loan Debentures Market Value of Funds Employed 12,000 1,700 2,000 8,571 24,271 49% 7% 8% 36% 10% 600 7% 8,571* 24,271 2,000 $ 0.85 1,700 2,000 40,000 $ 0.30 12,000 20,000
* To arrive at market value, discount debentures remaining cash flows at the current market rate.
RISK/RETURN RELATIONSHIPS AND THE COST OF CAPITAL COST OF FUNDS EMPLOYED: Ordinary Shares Using CAPM Rm = (say) Rf = Beta = Expected Return: Preference Shares Fixed Dividend Rate of Mortgage Loan less tax at 30% 12.00% 3.60% 8.40% Debentures less tax at 30% 7.00% 2.10% 4.90% 9.41% 13.0% 7.0% 1.40 15.40%
WEIGHTED AVERAGE COST OF CAPITAL VALUE Ordinary Shares Preference Shares Mortgage Loan Debentures WEIGHTED AVERAGE COST OF CAPITAL: The key determinants in the WACC include: the debt to equity ratios; calculation of the companys debt level; the cost of equity; and the cost of debt. 12,000 1,700 2,000 8,571 PROPORTION 49.44% 7.00% 8.24% 35.31% COST 15.40% 9.41% 8.40% 4.90% WEIGHTED COST 7.61% 0.66% 0.69% 1.73% 10.70%
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1460 Determining the Weighted Average Cost of Capital (WACC) / 5~1480 Determining Debt to Equity Ratios
5~1480
Determining Debt to Equity Ratios
Typically the funding decision has the objective of maximising wealth, i.e. maximising a return on funds invested at an acceptable level of risk. However, there are three important concerns: the first is the ratio of debt to equity a question of the capital structure; the second is the relative cost of debt and equity; and the third is the mixture of short-term and long-term liabilities in the total debt.
With the increasing use of leasing and project financing, a fourth concern is the appropriate level of off balance sheet financing. A major criteria for determining the optimal debt to equity ratio is managements judgment of the companys capacity to service debt. Such an assessment can be made by determining the carrying charges (interest and principal repayments) associated with a given level of debt and assessing the ability of the companys future income and cash flow to cover these charges in various scenarios. A table for analysing the level of debt is included in the section corporate debt. If a pessimistic assessment of the future shows that a given level of debt can be serviced, without prejudice to the return on investment, then management can accept such a level of debt as satisfactory. The optimal debt ratio is the largest ratio able to satisfy, safely, the companys capacity to service the debt. However, it should be pointed out that while the use of debt increases the return on funds invested at high levels of expected earnings, it also reduces the return on funds invested at low levels of earnings and may not provide sufficient funds to cover repayments of principal. Thus, it is necessary to accept that the increased earnings available from using debt are obtained at the cost of greater risk to the company, increasing the possibility of not being able to service the debt, and receivership as a consequence. Accordingly, the determination of how much debt to employ must be based on a detailed analysis of various debt to equity ratios, the return on funds invested covering the most probable and pessimistic levels of earnings, an assessment as to whether there is a risk of failure to meet legal obligations and required rates of return on investment and whether that risk is acceptable. A prudent financial policy would not adopt more debt than that which can be handled under pessimistic conditions without jeopardy to the companys existence.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1460 Determining the Weighted Average Cost of Capital (WACC) / 5~1500 Calculation of the Companys Debt Level
5~1500
Calculation of the Companys Debt Level
A companys debt components are usually recorded in its balance sheet at book value. However, it is worth noting that where interest rates have changed significantly from the date of original debt agreement, the book value of the debt may differ substantially from its fair market value. The process of revaluing the book value of the debt to fair market value is known as marking to market. This approach involves revaluing debt using current market interest rates as opposed to the rate in the original debt agreement. Revaluation is undertaken by discounting all future cash flows associated with the debt at the current market rate. The re-appraisal of debt values is necessary in order to accurately weight the companys debt and
equity.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1460 Determining the Weighted Average Cost of Capital (WACC) / 5~1500 Calculation of the Companys Debt Level / 5~1510 Interest
5~1510
Interest
The funding costs of a privately operated business typically reflect the financial resources of the principals of the business and are not necessarily representative of the funding costs which would be incurred on an arms length basis. The level of gearing (debt) may be significantly higher or lower than that which might prevail in the industry as a whole. This has implications for the rate of return (and/or capitalisation ratios) required in valuing the business. In addition, where business operations are funded in part by shareholder or unit-holder loans, adjustments need to be made to calculate a fair third party interest cost. One approach in valuing businesses is to eliminate/add back all actual interest (paid and received) and then assume that the net working capital (current assets less current liabilities) is funded by debt and that the non-current assets of the business (including any goodwill, intangibles etc.) are funded by equity. The valuation which then results is a valuation of the non-current assets. The total value of the entity is arrived at by adding the current assets/current liabilities and the value of shareholder loans (calculated by referring to equivalent market rates not by actual interest paid). This methodology sets an initial gearing ratio as it equates equity to non-current assets and debt to net working capital. In calculating net working capital, cash balances, current investments and borrowings are eliminated so that the net working capital figure equates to the amount of funds required to be invested (borrowed) for the purposes of operating the business. Initial calculations for past periods often use an average of working capital based upon the opening and closing annual balances of net working capital. This methodology, while appealing in its simplicity, can produce misleading results as the actual amount of working capital employed can vary during a month and from one month to the next. In assessing the ongoing earnings, a calculated amount of working capital is used as a basis for interest charges. This amount is usually based upon a sustainable, ongoing level of debtors, inventory, creditors and other working capital items. The valuation for non-current assets is net of any liabilities. Thus, if any payment is made for the non-current assets it is assumed that the vendor has the responsibility to discharge the liabilities attaching to those non-current assets. Where the valuation is of an interest in an entity which owns non-current assets which have attaching liabilities, an adjustment needs to be made to the value determined for the interest to cover the attaching liabilities. Similarly, if current assets are purchased, then the payment by the buyer to the vendor for the current assets is equivalent to the net amount of assets less liabilities taken over by the purchaser. Or, where the purchaser buys into an entity with existing current assets and liabilities, an adjustment needs to be made between purchaser and vendor for the net difference between current assets and liabilities at the date of acquiring an interest in the entity.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1460 Determining the Weighted Average Cost of Capital (WACC) / 5~1500 Calculation of the Companys Debt Level / 5~1520 Treatment of debt: pre- or post-debt valuation?
5~1520
Treatment of debt: pre- or post-debt valuation?
A distinction must be made at the outset of the valuation process as to whether the valuation is going to be of earnings or cash flows after interest, or whether it will be of earnings or cash flows before interest, with debt being deducted from the earnings or cash flow valuation. The difference can be quite substantial in so far as it influences the capitalisation/discount rate applied. A brief example can highlight this pitfall. Assume the following: WEIGHTED AVERAGE COST OF CAPITAL EXAMPLE Assets Debts Earnings before interest and tax Earnings after interest, before tax Price earnings ratio applicable to equity The valuation of the company could be conducted on the following bases: Post-debt Valuation Earnings after interest, before tax less tax at 30% Maintainable earnings for capitalisation Maintainable earnings capitalised at price earnings ratio of 10 equals Pre-debt Valuation Earnings before interest and tax less tax at 30% Maintainable earnings for capitalisation Value of assets by capitalising maintainable earnings at a price earnings ratio (PER): PER of 10 equals less debt of Net value of company 700 500 200 100 (30) 70 30 (9) 21 210 1,000 500 100 30 10
It can be seen that the valuations arrive at two different numbers $210 and $200. What is the difference? The difference relates to a discrepancy between the effective capitalisation rate (10%, assuming no growth) and the interest rate on debt, assumed here to be 14% less tax at 30% = 9.8%,
post-tax. Therefore, the post-debt valuation provides a higher value due to the lower cost debt financing being incorporated. The pre-debt valuation, however, incorporates solely the higher equity cost of capital. The question which then arises is: what level of debt funding can be sustained by the business, and subsequently, what will the businesss WACC be? It should also be noted that if a specific WACC is to be assumed, market comparisons should only be made to companies with similar debt or equity structures. This example highlights the importance of matching the basis of the earnings figure to the basis of the capitalisation multiple; in other words, ensuring pre-debt multiples are applied to pre-debt earnings and post-debt multiples to post-debt earnings. Application errors can lead to significant discrepancies in values obtained, as shown above. It should also be noted that in the above example, an earnings figure after depreciation and amortisation has been applied. A before depreciation and amortisation earnings figure could also be applied; however, an appropriate adjustment must be made to the price earnings ratio. Care must also be taken to ensure consistency is maintained throughout the analysis.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1460 Determining the Weighted Average Cost of Capital (WACC) / 5~1540 Gearing Adjustments to Market Betas
5~1540
Gearing Adjustments to Market Betas
The Betas evidenced from the market-place reflect the capital structure of the company under consideration. That is, the Beta factor reflects not only the risks and returns of the underlying assets but also the additional risk/return characteristics associated with the capital structure of the company. Rather than simply adopting the Betas from comparable companies, an adjusted Beta reflecting the capital structure of the company and capital structure under consideration should be employed. This adjustment requires ungearing the market-determined Beta and re-gearing the resultant asset Beta for the capital structure of the target company. The formula for ungearing and re-gearing Beta is as follows: Asset Beta = Equity Beta/(1 + (D/E) (1t)) where: D = value of debt; E = value of equity; t = the effective tax rate; and Equity Beta = observed Beta from market data. To re-gear the asset Beta requires knowing the desired or target debt/equity proportion and is determined as follows: Equity Beta = Asset Beta (1 + (D/E) (1 t)) For example, assuming that a comparable company has an observed equity Beta of 1.1, a debt/equity proportion of 70% and an effective tax rate of 30%, then the asset Beta is:
Asset Beta = 1.1/(1 + (70%) (10.30)) Asset Beta = 1.1/1.49 Asset Beta = 0.74 If the company being valued has a capital structure with a debt/equity ratio of, for example, 40%, then the re-geared equity Beta is: Equity Beta = 0.74 (1 + (40%) (1 0.30)) Equity Beta = 0.9450 Clearly, in the above example, the capital structure of the company being valued presents less risk, in terms of volatility, to the equity holder. As a consequence, the re-geared Beta is lower than the observed equity Beta for the company with the higher debt level.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1590 Required Rate of Return Key Factors
5~1590
Required Rate of Return Key Factors

Attached is a Discount Rate Conversion template which will assist in calculating discount
rates, taking into account whether they are real or nominal or pre- or post-tax. As discussed above, when valuing a business or project it is crucial that a number of factors are considered and applied consistently. These include: Will the discount rate be a real or a nominal value? Will the discount rate be applied to pre- or post-tax cash flows? Will the discount rate be pre- or post-debt and interest? What is the discount rate to be applied to (i.e. a project, equity, debt, something else)? How is the discount rate determined? Is the risk premium applicable to a closely-held business?
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1590 Required Rate of Return Key Factors / 5~1610 Inflation
5~1610
Inflation
Whether the cash flows to be valued incorporate inflation will be crucial in determining whether a real or nominal required rate of return should be used. The distinction which needs to be drawn when choosing between a real or nominal cost of capital is whether the future cash flows are projected on a real or nominal basis. That is, do the future cash flows include an inflationary component or are they expressed in current dollar terms? If the future cash flows are expressed in current dollar terms (i.e. real dollars), it is necessary to convert the cost of capital determined from the market-place (a nominal cost of capital) to a real cost of capital. When converting nominal discount rates to real discount rates it is necessary to consider the long-run
inflationary expectation relevant to the term of the projection. Interest rate and inflationary projections are notoriously inaccurate. However, one method by which inflationary expectations can be linked to market data is to consider the differences between yields on long-term Government bonds and long-term capital-indexed Government bonds. While this method is also imperfect, the advantage of such an approach is the fact that the inflationary expectations underpinning the pricing of the capital-indexed bonds is made explicit. The chart and data contained in the chapter Reference Materials show the difference between nominal and indexed bonds. The implied inflation has then been compared with actual, 10-year inflation data.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1590 Required Rate of Return Key Factors / 5~1610 Inflation / 5~1620 Inflation and discounting Real or nominal rate of return?
5~1620
Inflation and discounting Real or nominal rate of return?
Cash flow projections often do not include inflation considerations. In other words, the cash flows have been projected in current dollar terms, i.e. on a real basis. When valuing such a cash flow stream it is inappropriate to apply the discount rate obtained from the market because this rate incorporates inflation expectations, i.e. it is a nominal discount rate. Discounting a real cash flow stream with a nominal discount rate results in an understated net present value (NPV). Likewise, discounting a nominal cash flow stream with a real discount rate results in an overstated NPV. There are two courses of action which could be taken to rectify this situation. First, the cash flow stream can be increased to incorporate inflation expectations thus allowing it to be discounted using a nominal cost of capital rate. Alternatively, the discount rate itself can be adjusted to convert it from a nominal cost of capital to a real cost of capital and then applied to the original real cash flows. To do so, apply the following formula: KReal = (1 + KNominal) (1 + Inflation) 1
This equation is attributable to Irving Fisher and is often referred to as the Fisher equation. In practice, it is not uncommon to find conversions between real and nominal discount rates being undertaken by simply adding or subtracting the expected inflation rate. Although this method will provide a similar result, it is technically incorrect and should be avoided. The following spreadsheet contains a nominal cash flow stream which incorporates an inflation expectation of 3% per annum, and the equivalent real cash flow stream. It demonstrates that equivalent NPVs will be obtained when the discount rate is adjusted using the above formula.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1590 Required Rate of Return Key Factors / 5~1610 Inflation / 5~1630 Example Real v.
nominal discount rates

5~1630
Example Real v. nominal discount rates

Post-tax Nominal Discount Rate 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% : 20.0% 20.0% 20.0% 20.0% 20.0% Nominal NPV $ Cumulative NPV $ Post-tax Real Cash Flow $ 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 : 100.0 100.0 100.0 100.0 100.0 Post-tax Real Discount Rate 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% : 16.5% 16.5% 16.5% 16.5% 16.5% Real NPV $ Cumulative NPV $ Cumulative NPV Difference $ 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 : 0.0 0.0 0.0 0.0 0.0
Year Inflation Post-tax Nominal Rate Cash % Flow $ 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 : 85 86 87 88 89 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 103.0 106.1 109.3 112.6 115.9 119.4 123.0 126.7 130.5 134.4 138.4 142.6 146.9 151.3 155.8 : 1233.6 1270.6 1308.7 1348.0 1388.4
85.8 73.7 63.2 54.3 46.6 40.0 34.3 29.5 25.3 21.7 18.6 16.0 13.7 11.8 10.1 : 0.0 0.0 0.0 0.0 0.0
85.8 159.5 222.7 277.0 323.6 363.6 397.9 427.4 452.7 474.4 493.0 509.0 522.7 534.5 544.6 : 605.9 605.9 605.9 605.9 605.9
85.8 73.7 63.2 54.3 46.6 40.0 34.3 29.5 25.3 21.7 18.6 16.0 13.7 11.8 10.1 : 0.0 0.0 0.0 0.0 0.0
85.8 159.5 222.7 277.0 323.6 363.6 397.9 427.4 452.7 474.4 493.0 509.0 522.7 534.5 544.6 : 605.9 605.9 605.9 605.9 605.9
: 3.0% 3.0% 3.0% 3.0% 3.0%
Year Inflation Post-tax Nominal Rate Cash % Flow $ 90 91 92 93 94 95 96 97 98 99 100 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 1430.0 1472.9 1517.1 1562.7 1609.5 1657.8 1707.6 1758.8 1811.5 1865.9 1921.9
Post-tax Nominal Discount Rate 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0%
Nominal NPV $
Cumulative NPV $
Post-tax Real Cash Flow $ 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Post-tax Real Discount Rate 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% 16.5%
Real NPV $
Cumulative NPV $
Cumulative NPV Difference $ 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 $0.00
0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
605.9 605.9 605.9 605.9 605.9 605.9 605.9 605.9 605.9 605.9 605.9 $605.88
0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
605.9 605.9 605.9 605.9 605.9 605.9 605.9 605.9 605.9 605.9 605.9 $605.88
Net Present Value:
Net Present Value:
As stated previously, it is fundamentally important to use the correct version of the cost of capital for a given cash flow definition. Failure to apply the cost of capital consistently to the definition of cash flow will result in either an overstatement or understatement of the resultant present value or business valuation. When attempting to reconcile real and nominal cash flows, another consideration is whether different inflation factors may apply to different income and expense lines. For example, income might be affected by 3% inflation, while salaries and wages may be impacted by only 1.5%. The key issue is to determine the rate of inflation inherent in the net cash flow. Provided the inflation rate is accurately determined and the discount rate is correctly calculated, there should be no difference between discounting real and nominal cash flows.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1590 Required Rate of Return Key Factors / 5~1650 Taxation
5~1650
Taxation
As with inflation, consideration needs to be given to the treatment of taxation in the forecasted cash flow stream; namely, do the cash flows incorporate the payment of tax or have they been projected on a pre-tax basis?
Pre-tax cash flows should be discounted using a pre-tax cost of capital and, similarly, post-tax cash flows should be discounted using a post-tax cost of capital. Inflation does complicate the transition from using a nominal post-tax discount rate to a nominal pre-tax discount rate; however, conversion between the two is relatively simple.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1590 Required Rate of Return Key Factors / 5~1650 Taxation / 5~1660 Real cash flows Conversion between real post-tax and real pre-tax discount rates
5~1660
Real cash flows Conversion between real post-tax and real pre-tax discount rates
Assume a scenario whereby a real cash flow projection is to be valued but taxation has not been incorporated into the cash flows. In this instance, not only does the observed market (nominal) discount rate require conversion to a real discount rate, a further adjustment is required to convert the real discount rate from a post-tax real basis to a pre-tax real basis. At this point it is timely to remember that the rate of return observed in the equities market is on a post-tax nominal basis. When the underlying cash flows do not contain an inflation component, conversion between a post-tax real discount rate (KPostR) and a pre-tax real discount rate (KPreR) is simply a matter of grossing-up or grossing-down by the applicable tax rate. To do so, the following formula is applied: KPreR = KPostR (1t)
The following spreadsheet shows a pre-tax and post-tax constant (no growth) cash flow stream, unaffected by inflation, from year 1 to 200. The NPVs are also incorporated of both cash flows, the cumulative NPVs and the difference between these two cumulative NPVs. REAL CASH FLOW SCENARIO (NO INFLATION/NO REAL GROWTH)
Year Pre-tax Real Cash Flow Tax Rate Post-tax Real Cash Flow Pre-tax Real Discount Rate (KPreR) Post-tax Real Discount Rate (KPostR) 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% Pre-tax Cumulative NPV Post-tax Cumulative NPV Difference in Pre- and Post-tax NPVs 29.8 49.6 62.1 69.1 72.1 72.2 70.3 67.1 63.1 58.6 Difference Attributable to Ta 36.8 31.6 27.1 23.3 20.0 17.1 14.7 12.6 10.8 9.3
1 2 3 4 5 6 7 8 9 10
142.8 142.8 142.8 142.8 142.8 142.8 142.8 142.8 142.8 142.8
30% 30% 30% 30% 30% 30% 30% 30% 30% 30%
100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
23.6% 23.6% 23.6% 23.6% 23.6% 23.6% 23.6% 23.6% 23.6% 23.6%
115.6 209.1 284.8 346.0 395.6 435.7 468.2 494.5 515.7 532.9
85.8 159.5 222.7 277.0 323.6 363.5 397.9 427.3 452.6 474.3
Year
Pre-tax Real Cash Flow
Tax Rate
Post-tax Real Cash Flow
Pre-tax Real Discount Rate (KPreR)
Post-tax Real Discount Rate (KPostR) : 16.5% 16.5% 16.5% 16.5% 16.5% : 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% : 16.5% 16.5% 16.5% 16.5% 16.5% 16.5%
Pre-tax Cumulative NPV
Post-tax Cumulative NPV
Difference in Pre- and Post-tax NPVs : 0.4 0.3 0.3 0.2 0.2 : 0.0 0.0 0.0 0.0 0.0 0.0 : 0.0 0.0 0.0 0.0 0.0 0.0
Difference Attributable to Ta : 0.0 0.0 0.0 0.0 0.0 : 0.0 0.0 0.0 0.0 0.0 0.0 : 0.0 0.0 0.0 0.0 0.0 0.0
: 48 49 50 51 52 : 100 101 102 103 104 105 : 195 196 197 198 199 200
: 142.8 142.8 142.8 142.8 142.8 : 142.8 142.8 142.8 142.8 142.8 142.8 : 142.8 142.8 142.8 142.8 142.8 142.9
: 30% 30% 30% 30% 30% : 30% 30% 30% 30% 30% 30% : 30% 30% 30% 30% 30% 30%
: 100.0 100.0 100.0 100.0 100.0 : 100.0 100.0 100.0 100.0 100.0 100.0 : 100.0 100.0 100.0 100.0 100.0 100.0
: 23.6% 23.6% 23.6% 23.6% 23.6% : 23.6% 23.6% 23.6% 23.6% 23.6% 23.6% : 23.6% 23.6% 23.6% 23.6% 23.6% 23.6%
: 605.9 605.9 605.9 605.9 605.9 : 605.9 605.9 605.9 605.9 605.9 605.9 : 605.9 605.9 605.9 605.9 605.9 606.1
: 605.6 605.6 605.6 605.6 605.7 : 605.9 605.9 605.9 605.9 605.9 605.9 : 605.9 605.9 605.9 605.9 605.9 606.1
It is shown in this spreadsheet that at year 200 the cumulative NPV of pre-tax cash flows discounted at the pre-tax discount rate is the same as the cumulative NPV of the post-tax cash flows discounted at the post-tax discount rate. However, care must be taken because this is not always the case. The difference between the two NPVs is quite significant in the earlier periods of the cash flow stream, i.e. from years 1 to 10. By year 50 the difference is minimal, reducing to zero thereafter.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1590 Required Rate of Return Key Factors / 5~1650 Taxation / 5~1670 Nominal cash flows Conversion between nominal post-tax and nominal pre-tax discount rates
5~1670
Nominal cash flows Conversion between nominal post-tax and nominal pre-tax discount rates
Assume a scenario whereby a cash flow projection is to be valued for which inflation has been incorporated but taxation has not, i.e. there is a pre-tax nominal cash flow stream. In this instance, the observed market discount rate requires an adjustment from a post-tax nominal basis to a pre-tax
nominal basis (remembering that the rate of return observed in the equities market is a post-tax nominal rate). Cash flows which incorporate inflation expectations require an additional adjustment when converting the discount rate between a post-tax nominal (KPostN) and pre-tax nominal (KPreN) basis. An inflation adjustment must be made prior to the grossing-up or grossing-down of the applicable tax rate. The inflation component is then re-incorporated. The following formula needs to be applied in these instances: KPreN = (KPostNi) (1t) +i
It is often common practice to exclude the inflation adjustment and simply gross-up or gross-down the discount rate, i.e. KPreN = KPostN/(1t). While this may suffice over short time periods, it will provide incorrect NPVs for longer-term projections. If inflation was omitted from the above formula, the NPV would be understated because KPreN would be larger. This adjustment is justified when we remember that the current years cash flow is in fact a real cash flow. When tax is paid on the following years cash flow, which incorporates inflation, we are, in effect, paying a higher tax rate. A lower discount rate is therefore required to compensate. The following spreadsheet contains pre- and post-tax cash flows which incorporate an annual inflation rate of 3%. Once again, the difference between the two cumulative NPVs is quite significant in earlier periods, i.e. from years 1 to 10, and this difference has not quite disappeared even up to year 50. As the periods progress, the difference tends towards zero. NOMINAL CASH FLOW SCENARIO (WITH INFLATION/NO REAL GROWTH)
Year Pre-tax Nominal Cash Flow Expected Inflation Rate Tax Rate Post-tax Nominal Cash Flow Pre-tax Nominal Discount Rate (KPreN) 27.3% 27.3% 27.3% 27.3% 27.3% 27.3% 27.3% 27.3% 27.3% 27.3% : 27.3% 27.3% Post-tax Nominal Discount Rate (KPostN) 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% : 20.0% 20.0% Pre-tax Cumulative NPV Post-tax Cumulative NPV
Pre- and Post-tax
1 2 3 4 5 6 7 8 9 10 : 48 49
147.1 151.6 156.1 160.8 165.6 170.6 175.7 181.0 186.4 192.0 : 590.3 608.0
3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% : 3.0% 3.0%
30% 30% 30% 30% 30% 30% 30% 30% 30% 30% : 30% 30%
103.0 106.1 109.3 112.6 115.9 119.4 123.0 126.7 130.5 134.4 : 413.2 425.6
115.6 209.1 284.8 346.1 395.7 435.8 468.2 494.5 515.7 532.9 : 605.8 605.9
85.8 159.5 222.7 277.0 323.6 363.6 397.9 427.4 452.7 474.4 : 605.3 605.4
Year
Pre-tax Nominal Cash Flow
Expected Inflation Rate
Tax Rate
Post-tax Nominal Cash Flow
Pre-tax Nominal Discount Rate (KPreN) 27.3% 27.3% 27.3% : 27.3% 27.3% 27.3% 27.3% 27.3% 27.3% : 27.3% 27.3% 27.3% 27.3% 27.3% 27.3%
Post-tax Nominal Discount Rate (KPostN) 20.0% 20.0% 20.0% : 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% : 20.0% 20.0% 20.0% 20.0% 20.0% 20.0%
Pre-tax Cumulative NPV
Post-tax Cumulative NPV
Pre- and Post-tax
50 51 52 : 100 101 102 103 104 105 : 195 196 197 198 199 200
626.3 645.1 664.4 : 2,745.5 2,827.9 2,912.7 3,000.1 3,090.1 3,182.8 : 45,515.7 46,881.1 48,287.6 49,736.2 51,228.3 52,765.1
3.0% 3.0% 3.0% : 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% : 3.0% 3.0% 3.0% 3.0% 3.0% 3.0%
30% 30% 30% : 30% 30% 30% 30% 30% 30% : 30% 30% 30% 30% 30% 30%
438.4 451.5 465.1 : 1921.9 1979.5 2038.9 2100.1 2163.1 2228.0 : 31861.0 32816.8 33801.3 34815.3 35859.8 36935.6
605.9 605.9 605.9 : 605.9 605.9 605.9 605.9 605.9 605.9 : 605.9 605.9 605.9 605.9 605.9 605.9
605.5 605.5 605.6 : 605.9 605.9 605.9 605.9 605.9 605.9 : 605.9 605.9 605.9 605.9 605.9 605.9
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1590 Required Rate of Return Key Factors / 5~1650 Taxation / 5~1680 Four possible cash flow scenarios
5~1680
Four possible cash flow scenarios
The preceding sections have discussed the four possible cash flow scenarios, being: real pre-tax; real post-tax; nominal pre-tax; and nominal post-tax.
Regardless of which scenario a valuer is faced with, by applying one of the pertinent equations, the post-tax nominal market rate of return can be adjusted so as to conform with the underlying cash flow in question. (Also, note that throughout this discussion we have held constant individual risks unique to the business being valued. These adjustments, if required, also need to be made.) To demonstrate, the following spreadsheet contains the four possible cash flow scenarios. For the purposes of this exercise the following data is assumed:
an inflation rate of 3% per annum; a tax rate of 30% per annum; and a post-tax nominal discount rate of 20%.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1590 Required Rate of Return Key Factors / 5~1650 Taxation / 5~1690 Example Conversion between discount rates
5~1690 Inflation Tax KPostN KPreN KPostR KPreR
Example Conversion between discount rates

3.00% 30.00% 20.00% 27.29% 16.50% 23.58%
Year
Pre-tax Nominal Cash Flow ($000s) 147.1 151.6 156.1 160.8 : 48287.6 49736.2 51228.3 52765.1
Present Value ($000s) 115.6 93.5 75.7 61.3 : 0.0 0.0 0.0 0.0
Cumulative Present Value ($000s) 115.6 209.1 284.8 346.1 : 605.9 605.9 605.9 605.9
Post-tax Nominal Cash Flow ($000s) 103.0 106.1 109.3 112.6 : 33801.3 34815.3 35859.8 36935.6
Present Value ($000s) 85.8 73.7 63.2 54.3 : 0.0 0.0 0.0 0.0
Cumulative Present Value ($000s) 85.8 159.5 222.7 277.0 : 605.9 605.9 605.9 605.9
1 2 3 4 : 197 198 199 200
Year
Pre-tax Real Cash Flow ($000s) 142.8 142.8 142.8 142.8 :
Present Value ($000s) 115.6 93.5 75.7 61.3 :
Cumulative Present Value ($000s) 115.6 209.1 284.8 346.0 :
Post-tax Real Cash Flow ($000s) 100.0 100.0 100.0 100.0 :
Present Value ($000s) 85.8 73.7 63.2 54.3 :
Cumulative Present Value ($000s) 85.8 159.5 222.7 277.0 :
1 2 3 4 :
Year
Pre-tax Real Cash Flow ($000s) 142.8 142.8 142.8 142.8
Present Value ($000s) 0.0 0.0 0.0 0.0
Cumulative Present Value ($000s) 605.9 605.9 605.9 605.9
Post-tax Real Cash Flow ($000s) 100.0 100.0 100.0 100.0
Present Value ($000s) 0.0 0.0 0.0 0.0
Cumulative Present Value ($000s) 605.9 605.9 605.9 605.9
197 198 199 200
This spreadsheet reveals equal NPVs for each of the four cash flow scenarios. We have arrived at this result by recognising the importance of matching the basis of the discount rate with the basis of the underlying cash flow.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1590 Required Rate of Return Key Factors / 5~1710 Interest Pre- or Post-cost of Debt?
5~1710
Interest Pre- or Post-cost of Debt?
As discussed in the section on determining the weighted average cost of capital, pre-interest cash flows should be discounted using the weighted average cost of debt and equity capital, or WACC, whereas post-interest cash flows should be discounted using the cost of equity only. However, an important consideration is that the funding costs of a privately operated business typically reflect the financial resources of the principals of the business and are not necessarily representative of the funding costs which would be incurred on an arms length basis. The level of gearing (debt) may be significantly higher or lower than that which might prevail in the industry as a whole. This has implications for the rate of return (and/or capitalisation ratios) required in valuing the business. In addition, where business operations are funded in part by shareholder/unit-holder loans, adjustments need to be made to calculate a fair third party interest cost. One approach in valuing businesses is to eliminate/add back all actual interest (paid and received) and then assume that the net working capital (current assets less current liabilities) is funded by debt and that the non-current assets of the business (including any goodwill, intangibles etc.) are funded by equity. The valuation which then results is a valuation of the non-current assets. The total value of the entity is arrived at by adding the current assets/current liabilities and the value of shareholder loans (calculated by referring to equivalent market rates not by actual interest paid). This methodology sets an initial gearing ratio as it equates equity to non-current assets and debt to net working capital. In calculating net working capital, cash balances, current investments and borrowings are eliminated so that the net working capital figure equates to the amount of funds required to be invested (borrowed) for the purposes of operating the business. Initial calculations for past periods often use an average of working capital based upon the opening and closing annual balances of net working capital. This methodology, while appealing in its simplicity, can produce misleading results as the actual amount of working capital employed can vary during a
month and from one month to the next. In assessing the ongoing earnings, a calculated amount of working capital is used as a basis for interest charges. This amount is usually based upon a sustainable, ongoing level of debtors, inventory, creditors and other working capital items. The valuation for non-current assets is net of any liabilities. Thus, if any payment is made for the non-current assets it is assumed that the vendor has the responsibility to discharge the liabilities attaching to those non-current assets. Where the valuation is of an interest in an entity which owns non-current assets which have attaching liabilities, an adjustment needs to be made to the value determined for the interest to cover the attaching liabilities. Similarly, if current assets are purchased, then the payment by the buyer to the vendor for the current assets is equivalent to the net amount of assets less liabilities taken over by the purchaser. Or, where the purchaser buys into an entity with existing current assets and liabilities, an adjustment needs to be made between purchaser and vendor for the net difference between current assets and liabilities at the date of acquiring an interest in the entity. The following table summarises the appropriate discount rate to be applied depending on whether cash flows are pre- or post-interest and pre- or post-tax: Cash Flows before Tax* Cash Flow before Interest Cash Flow after Interest WACC/(1t) Ke/(1t) Cash Flows after Tax WACC Ke
where: WACC = Ke. E D+E + Kd(1t). D D+E
(i.e. the cost of equity weighted by the proportion of equity, plus the after-tax cost of debt weighted by the proportion of debt) WACC/(1t) = Ke. 1t E D+E + Kd . D D+E
(i.e. as above but using pre-tax cost of equity and debt) Ke = Cost of equity capital (obtained by using CAPM or other suitable alternative) Ke/(1t) = Pre-tax cost of equity capital
* Pre-tax formulae assume cash flows have been projected on a real basis. Should inflation expectations be incorporated into the forecasts, amend the pre-tax formulae by applying an inflation adjustment as discussed in the section on nominal cash flows conversion between nominal post-tax and nominal pre-tax discount rates.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1590 Required

Rate of Return Key Factors / 5~1730 Closely-held Businesses Risk Premium

5~1730
Closely-held Businesses Risk Premium
Valuation of a closely-held (private) business may be required for many reasons, including the sale of the business or the exit/entry of a shareholder. However, obtaining relevant information to value closely-held businesses can be difficult. First, public companies are usually not comparable with a closely-held business, because of their size and shareholding structure. Second, private company information is hard to obtain and often there will be major differences between the operations of the business being valued and others in its industry. This text outlines several ways in which a closely-held business can be valued. The discounted cash flow approach is the main method used and it requires an assessment of the level of risk associated with the business and consequent future cash flows. The discount rate or required rate of return is a combination of the opportunity cost (what an investor could earn from a risk-free investment such as a government bond) plus a risk premium (for the risk associated with obtaining the expected returns from the particular investment). In determining the appropriate rate to apply one should take into account the nature of the business, the risks involved and the stability or regularity of past and future cash flows. The following table is a useful guide for estimating risk premiums to which the risk-free rate must be added. The figures are designed to be used with pre-tax income due to the wide variation in tax rates among privately-owned businesses. There are five categories, the selection of which depends upon the characteristics of the individual business.
Description Category Business Status Established business Established business N/A Industry Competition Strong trade position More competitive Highly competitive N/A Financing Management Requirements Depth Well financed Well financed Little capital required Little capital required N/A Depth in management Depth in management No depth in management N/A Past Earnings Stable Stable N/A Future Earnings Highly predictable Fairly predictable As risk is high not very predictable Very unpredictable Very unpredictable Extremely unpredictable Risk Premium* (Pre-tax) 610% 1115% 1620%
1 2 3
4A
Small, depends on special skills Large, established, highly cyclical Small one person business
N/A
2125%
4B
N/A
May be depth in management Managed by main operator
Past earnings may not be stable N/A
2325%
N/A
N/A
2630%
* The risk premium must be added to the risk-free rate to derive the desired discount rate. Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited
Where factors are not applicable (N/A), each case should be viewed separately and the risk premium adjusted accordingly. Acknowledgment: Developed from an article by James H. Schilt and Hanan & Kiebier, Inc, Business Valuation News. These rates should be compared with the rates calculated using other methods, including the subjective/first principles method.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1590 Required Rate of Return Key Factors / 5~1750 Time Horizon
5~1750
Time Horizon
It is important when estimating the cost of capital that the time horizon of the risk-free rate be matched to the time horizon of the cash flows being appraised. For example, a project with an expected life of nine years should be valued using a risk-free rate element in the cost of capital of 10-year Government bond with a 9-year life remaining. Similarly, cash flows of 90 days duration should be valued using a risk-free rate equivalent to, for example, the 90-day bank bill rate.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1590 Required Rate of Return Key Factors / 5~1770 Marginal v. Average Cost of Capital
5~1770
Marginal v. Average Cost of Capital
A Beta factor may be identified from companies with similar operations. However, if a valuation is being undertaken of a pure play or an investment which significantly alters the risk or return profile of the company, consideration needs to be given to the application of either: the firms overall cost of capital (i.e. average); or the investments/projects marginal cost of capital.
The decision is somewhat subjective in so far as the average cost of capital is usually applied in the first instance. If the new investment is going to contribute, for example, 25% or more of cash flows, or comprise 25% or more of the assets of the company, and is of a different nature (i.e. different business risks), then a marginal approach should be considered. In such an instance the appropriate cost of capital is one which specifically reflects the risks or returns of the marginal investment. For example, if a company involved in the manufacture of motor vehicle parts is considering a substantial investment in coal mining activities, the cost of capital appropriate to coal mining activities should be considered as the appropriate benchmark rate of return.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1590 Required Rate of Return Key Factors / 5~1790 Single Product v. Multi-product
5~1790
Single Product v. Multi-product
The weighted average cost of capital (WACC) of the entity as it stands may not be representative of the risks and returns facing the entity through an investment in a new product. For example, if a company is currently a property owner with no other investments or interests and is
funded solely by equity, its WACC may change significantly because of an investment in a retail business. The WACC would change further if the investment was funded by debt rather than equity as the investment not only changes the expected business risk of the company but also changes the financial risk (debt/equity profile) of the company. Accordingly, when evaluating an investment in a new project or product, it is necessary to utilise a discount rate or WACC based on the cost of funds used to acquire the investment (i.e. using the relative proportions of debt and equity). Similarly, if the total company is to be valued on the assumption that the investment is made, the revised WACC incorporating the incremental funds and additional risks associated with purchase of the investment should be used as the discount rate. A similar situation arises where, for example, a property company with $1 million in assets acquires a further $1 million of property, funded wholly with debt. For the purpose of evaluating the merits of the investment, the internal rate of return should exceed the marginal cost of funds (i.e. cost of debt), and when valuing the revised company the WACC will be 50% represented by the old funding and 50% weighted by the new funding.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1590 Required Rate of Return Key Factors / 5~1810 Diversified Companies
5~1810
Diversified Companies
Many companies have diversified activities. The different divisions will have different costs of capital. The cost of equity capital applicable for a gold mine will be different from the cost of equity capital for an automotive components manufacturer. This reflects the differing risk profiles of the investments. For this reason, when considering investing in a new project, the cost of equity capital relevant to the risks of the individual project must be estimated. This means, in practical terms, that a new project in the gold mining sector should not use the cost of equity capital for a company as a whole but the cost of equity capital relevant to companies which are pure gold mining companies (as a surrogate to an estimate based on first principles).
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1590 Required Rate of Return Key Factors / 5~1830 Projects with Different Debt to Equity Ratios to Those of the Company
5~1830
Projects with Different Debt to Equity Ratios to Those of the Company
Funding does not always take place in the desired proportions of debt and equity and their various forms. Accordingly, if a new project is to be funded by forms of debt or equity which are different to existing forms, and/or in proportions which vary from historic proportions, the specific cost of capital associated with those funds should be used in assessing the value of the project to the company. This is particularly so in the case of divisionalised companies where the cost of capital employed across various divisions differs substantially. If the company is to invest in a new project costing $10 million, which is to be funded with $6 million of equity and $4 million of debt, the cost of capital for the project would be: Cost of equity
15.4%
Cost of debt mortgage loan Less tax at 30%
12.0% 3.6% 8.4%*
WACC
= = = =
(15.4% $6m)/$10m + (8.4% $4m)/$10m (15.4% 60%) + (8.4% 40%) 9.24% + 3.36% 12.6%
* After-tax cost of debt = Kd (1t)
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1590 Required Rate of Return Key Factors / 5~1850 Australian Adjustments
5~1850
Australian Adjustments
In Australia, adjustments need to be made for the level of franking (imputation) tax credits to reflect the tax position of shareholders. Legislation relating to the imputation system has been effective in Australia since 1 July 1987. Under the imputation system, companies continue to pay corporate tax in the usual manner. When dividends are paid, however, calculations must be made to determine whether the dividends which have been paid are franked dividends or not. A franked dividend is, broadly speaking, one which has been paid from profits which have incurred tax after 1 July 1987 at the corporate tax rate. If franked dividends are paid to resident individual shareholders, an imputation credit will be passed on to the shareholder to effectively remove the tax liability on the dividend, subject to the shareholders income tax rate (refer to the following discussion on the effect of the change). Non-qualifying/unfranked dividends, however, will be assessable to the recipients under the old taxation provisions (with no imputation credit). Dividends paid to non-residents are exempt from dividend withholding tax to the extent they are franked. The following example highlights the need to consider the extent of franking when evaluating required rates of return to an individual shareholder. As required rates of return change, so too will the value of the company as imputation credits effectively increase the net cash flows received by the investor. From the investors perspective, the current personal tax regime means that rates of return may differ across different types of taxpayer (e.g. companies v. personal investors v. charitable institutions etc.). There are two ways in which imputation of franked dividends (or lack thereof) can affect a discounted cash flow valuation: by altering the nominal rate of return required by holders of equity in a company; or by altering the net after-tax cash flows received by an entity as the recipient of franked dividends.
The question of franked dividends altering the cost of equity is discussed first. There are a number of
issues which revolve around this question, including: whether market prices have adjusted to the fact that a share does or does not pay a franked dividend; the extent to which Beta factor (as measured by market prices) reflects the changes in return expectations; and the extent to which the surrogate for market risk (the All Ordinaries Accumulation Index or other accumulation indices) has taken into account the introduction of the imputation system.
Before the introduction of the dividend imputation system, a companys shareholder faced a double taxation regime, whereby company profits were taxed at the corporate tax rate, and the after-tax cash flow distributed to shareholders was taxed again at the investors tax rate. The introduction of the dividend imputation system has removed such double taxation. When companies pay franked dividends,shareholders can use the imputation credits attached to the franked dividends to reduce the tax payable. This is illustrated in the following table: Classical System Corporate Level Profit before tax Tax at 30% Profit after tax 100 (30) 70 Profit before tax Tax at 30% Profit after tax 100 (30) 70 Dividend Imputation System
Personal Level (assuming all profit distributed) Dividend income Personal tax @ 48.5% Net income 70 (34) 36 Dividend income Gross-up for imputation credit by factor = 1/(10.30) Grossed-up income Less personal tax @ 48.5% Add back imputation credits Tax payable Net income 100 (49) 30 (19) 52 70
The impact on after-tax returns varies by shareholder class. For instance, institutional investors and residents receive franking (or imputation) credits which can be offset against their current year tax liability, and foreign investors can use the tax credit to offset against their withholding tax. Therefore, the extent to which imputation credits impact on the cost of capital of the company depends on the imputation factor. The example above has assumed a 100% imputation factor; that is, it is assumed that shareholders can utilise 100% of the imputation credits. For the purpose of business valuation, a 50% imputation credit rate is often employed, based on the results of empirical evidence published in the Business Valuations Digest bulletin Capturing Value from Dividend Imputation (by Thomson CPD).
The tables following identify the impact of alternative (0%, 50% and 100%) valuations of imputation credits on the cost of equity (bearing in mind that imputation does not impact upon the cost of debt) and calculate three alternative discount rates which can be employed (nominal post-tax, real pre-tax and nominal pre-tax). The nominal WACC formula to be applied when imputation credits are present can be expressed as:
when calculating on a post-tax basis, and
when calculating on a pre-tax basis, where: = the proportion of imputation credits which can be used by shareholders. The following example has applied these formulae to arrive at the relevant costs of capital. Conversions between real and nominal costs of capital are achieved by applying the methods discussed earlier in the section on inflation. Example This example shows the effect of imputation on the discount rate for three scenarios with the variable factor being the proportion of imputation credits which can be used by shareholders. The first table summarises the effect on the discount rate for each scenario. 0% Imputation Adjustment Post-tax Nominal Cost of Equity Pre-tax Real WACC 14.60% 12.61% 50% Imputation Adjustment 12.02% 10.82% 100% Imputation Adjustment 10.22% 9.56%
It should be recalled that calculating the cost of capital involves making judgments about appropriate surrogate rates of return from the market-place. This is not a perfect science. Accordingly, measures of expected return shown on the following pages are examples only and the key inputs should be considered specifically for each case. Construction of Discount Rates and the Impact of Imputation Discount Rate: Nominal, post-tax equity (only), adjusted for imputation value. Cash Flow Definition: Cash dividend (no adjustment for imputation) plus business value shift +/ changes in cash/debt working capital. Real, pre-tax cash flows, pre-interest, no adjustment for imputation in cash flows. Use: TSR benchmark.
Real, pre-tax, adjusted for imputation value.
Project evaluation.
Construction of Discount Rates and the Impact of Imputation Discount Rate: Nominal, pre-tax debt, post-tax equity, no adjustment for imputation value. Cash Flow Definition: Nominal, pre-tax debt (with tax shielded by tax deduction from interest), pre-interest, imputation adjustment (50% of tax) in cash flows. Use: Business valuation.
50% Imputation Adjustment Rf RmRf Asset Beta Imputation factor Tax rate Therefore, cost of equity is: Cost of debt is: Debt/equity proportion Therefore, nominal WACC is: Inflation Therefore, real WACC is: 8.00% 6.60% 1.00 50.00% 30.00% 12.02% 8.00% 6.60% 1.00 50.00% 30.00% 17.18% 10.00% 50.00% 13.59% 2.50% 10.82% 8.00% 6.60% 1.00 0.00% 30.00% 14.60% 10.00% 50.00% 12.30% 2.50% 9.56%
0% Imputation Adjustment Rf RmRf Asset Beta Imputation factor Tax rate Therefore, cost of equity is: Cost of debt is: Debt/equity proportion Therefore, nominal WACC is: Inflation Therefore, real WACC is: 8.00% 6.60% 1.00 0.00% 30.00% 14.60% 8.00% 6.60% 1.00 0.00% 30.00% 20.86% 10.00% 50.00% 15.43% 2.50% 12.61% 8.00% 6.60% 1.00 0.00% 30.00% 14.60% 10.00% 50.00% 12.30% 2.50% 9.56%
100% Imputation Adjustment Rf RmRf

8.00% 6.60%
8.00% 6.60%
8.00% 6.60%
100% Imputation Adjustment Asset Beta Imputation factor Tax rate Therefore, cost of equity is: Cost of debt is: Debt/equity proportion Therefore, nominal WACC is: Inflation Therefore, real WACC is: 1.00 100.00% 30.00% 10.22% 1.00 100.00% 30.00% 14.60% 10.00% 50.00% 12.30% 2.50% 9.56% 1.00 0.00% 30.00% 14.60% 10.00% 50.00% 12.30% 2.50% 9.56%
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1900 Required Rates of Return with Underlying Capital Growth
5~1900
Required Rates of Return with Underlying Capital Growth
Application of unadjusted discount rates to unadjusted forecast income streams would be misleading where the underlying assets have a capital growth and an inflation component which has not been taken into consideration in forecasting the income stream; that is, where the income stream has been estimated assuming a constant average value of underlying assets. One instance in which this issue arises is where the income stream is earned from financial assets which grow (and decline) with market forces, for example, the property market. An adjustment to the discount rate is required in these circumstances to allow for the real growth in the underlying asset values. For example, a portfolio may be constructed as follows: Australian Fixed Interest, Bonds, Unit Trusts International Bonds Australian Shares International Shares Real Estate Unlisted Property Real Estate Listed Property Cash Other* Total
* Other is assumed to be items such as antiques, jewellery and other collectibles.
21% 4% 22% 16% 15% 10% 2% 10% 100%
To determine the expected real growth adjustment to the discount rate, it is necessary to first examine the growth in each of the categories of investments.
If it is assumed that long-term historic growth rates are the best measure of long-term future growth rates, a weighted average historic return for these investments can be employed as the adjustment to the discount rate. For example, an estimate can be made of the compound annual rate of growth of these classes of investment, assuming that the investments were made in 1988 and 1993, and held over a 15 and 10-year period respectively. The returns that would have been realised if these investments had been sold in 2003 can then be calculated. Measures that could be used in this analysis are discussed in the following sections.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1900 Required Rates of Return with Underlying Capital Growth / 5~1920 Fixed interest
5~1920
Fixed interest
Depending on the bonds term to maturity, fluctuating interest rates will have a varying impact upon bond prices among other factors. Bond yield data is published in the Reserve Bank of Australias Monthly Bulletin. A bond accumulation index can be constructed by: establishing a portfolio of ten 10-year bonds, each maturing at different times (i.e. 10 years to maturity, 9 years to maturity etc.); calculating total coupon income using the 10-year yield at time of issue as the coupon rate applicable to each bond (i.e. it is assumed each bond is issued at par); calculating the market value of the portfolio based on the market value of each individual bond; comparing this to the previous years portfolio market value to calculate the capital gain or loss for the past year; adding the capital gain or loss to the coupon income to arrive at total income; and dividing total income for a given period by the opening fair market value of the portfolio to give the portfolios return.
This, in turn, can proxy for the discount rate applicable to fixed interest securities. Data for the constructed Australian bond index is located in the chapter Reference Materials. Data for international bonds is located in the chapter Reference Materials.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1900 Required Rates of Return with Underlying Capital Growth / 5~1940 Shares
5~1940
Shares
It is necessary to use an accumulation index to take into account both income and capital gains. The Australian Stock Exchanges ASX 200 Index has been employed based on yearly end of June figures. This index takes into account both income and capital gains by applying reinvestment of dividends at financial year end. Calculation of annual returns (which will incorporate capital growth) can be made using opening and closing accumulation index values. ASX accumulation index data (in a variety of series) is available from the monthly bulletin of the Reserve Bank of Australia, The Australian Financial Review or Shares magazine. Specific information can also be obtained from ASX upon request. Data used for this example is located in the chapter
Reference Materials.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1900 Required Rates of Return with Underlying Capital Growth / 5~1960 Property
5~1960
Property
To determine historic growth rates in property prices it is necessary to either find a reliable source of average property values (not sales) or to obtain data from an unlisted property trust index. The advantage of an unlisted property trust index is that it is not correlated with movements in equity markets. Listed property indices have historically been highly correlated with stock market movements and as such do not reflect the general upward price trend experienced in the property market. An unlisted property trust index is available from W. M. Mercer. This is available from <www.merceric.com> and is reproduced in the chapter Reference Materials. The ASX Listed Property Trust Index is reproduced in the chapter Reference Materials.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1900 Required Rates of Return with Underlying Capital Growth / 5~1970 Cash
5~1970
Cash
A relevant index for cash accumulation is the UBS Warburg Australia Bank Bill Accumulation Index reproduced in the chapter Reference Materials.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1900 Required Rates of Return with Underlying Capital Growth / 5~1980 Other
5~1980
Other
In the absence of any data on this category, it may be assumed that this category exhibited growth of 5% per annum over both the 10 and 15-year periods.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~1900 Required Rates of Return with Underlying Capital Growth / 5~2000 Results
5~2000
Results
By applying data obtained from the above sources, the following rates of return, based on those calculated in the chapter Reference Materials, have been calculated. These incorporate the effects of underlying capital growth. Compound Rate of Growth of Investments Per Annum to June 2003 Over 10 years (p.a.) Australian Fixed Interest, Bonds, Unit Trusts International Bonds Australian Shares International Shares Real Estate Unlisted Property
Over 15 years (p.a.) 9.83% 10.88% 8.93% 7.39% 5.84%
7.53% 8.86% 9.77% 5.75% 8.21%
Compound Rate of Growth of Investments Per Annum to June 2003 Over 10 years (p.a.) Real Estate Listed Property Cash Other 11.60% 5.81% 5.00% Over 15 years (p.a.) 11.24% 7.97% 5.00%
These percentages reflect compound (geometric) per annum pre-tax rates of growth. Assuming the weightings for our portfolio as detailed earlier, the weighted average portfolio return can now be calculated. The results are as follows: Over 10 years (p.a.) Weighted Average Return Adjust for inflation over the period of*: Real Weighted Average Return 8.01% 2.60% 5.28% Over 15 years (p.a.) 8.31% 3.17% 4.98%
* Inflation has been measured on the basis of the annual average CPI index, data obtained from the Reserve Bank of Australias Bulletin (Table G02). Adjustment is made by applying the Fisher equation.
The adjusted discount rate applicable to cash flows forecast on real capital values therefore becomes: Over 10 years (p.a.) Post-tax Nominal Discount Rate witnessed in market: Adjust for expected inflation of: Equates to a Post-tax Real Discount Rate (using the Fisher equation) of: Less real growth in investments (as calculated above): Equates to a Post-tax Real Discount Rate, exclusive of growth, of: 15.00% 3.00% 11.65% (5.28%) 6.37% Over 15 years (p.a.) 20.00% 3.00% 16.50% (4.98%) 11.52%
This range of post-tax discount rates can then be applied to the forecast net after-tax income stream and will allow for growth in the underlying assets or portfolio, assuming future growth is similar to historic growth rates.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~2050 Venture Capital Discount Rates
5~2050
Venture Capital Discount Rates
The cost of capital (and therefore discount rates) employed in venture capital is often difficult to witness in the market-place. These rates should be used as a guide only as the risks and returns of every venture vary
considerably. The discount rate or rate of return declines as the risk of the business declines. This is usually reflected in the maturing of the business. On establishment of the business however, there is no record of success and significant uncertainty as to the likelihood of success is present. Accordingly, the initial investors (usually referred to as seed capitalists) expect to be rewarded commensurately. It should be noted that this return is usually only earned on a relatively small proportion of the businesss ultimate funding requirement and only for a short period of time (of the order of one to two years). As the business develops and establishes a record of success (the track record which so many investors seek), the return expectations drop. As a result, the actual return earned from a successful investment by a venture capitalist over a 5-year period for example, will average below the return required by seed capitalists. It should also be remembered that the initial return expectation reflects risk and that this risk can be realised in the form of a total loss of capital. Accordingly, a portfolio of investments in businesses exhibiting various stages of development is likely to show some success stories returning amounts of the order of those discussed here, together with some complete losses and some under-performing but nevertheless successful investments. Typically, Australian venture/development capital providers employ the following scale of discount rates when assessing potential investments: Stage Seed Start-up/Early stage Expansion % per annum (pre-tax) 80100 50+ 35
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~2050 Venture Capital Discount Rates / 5~2070 Risk Adjustment of Discount Rate
5~2070 1. 2.
Risk Adjustment of Discount Rate
The discount rate applied to cash flow projections must reflect the risk associated with earning the projected cash flows if the cash flows represent unadjusted (risky) outcomes. Financial models constructed for the purpose of valuing start-up enterprises frequently project cash flows on a risk-adjusted basis. Key revenue drivers can be grouped according to the likelihood of achieving an effective, working product (efficacy factors) and of achieving commercial success (certainty factors). For example, efficacy factors might be applied to market groupings in the projections of a new pharmaceutical product, such as: Group 1 100% Group 2 50% Group 3 25%
3.
In simple terms, the 25% efficacy factor applied to the Group 3 revenue reflects a one in four chance of the product curing the disease or affliction nominated. 4. Certainty factors might be applied in a similar fashion, such as: Group 1 100% Group 2 50% Group 3 25% The certainty factors reflect the likelihood of achieving a commercially viable market share for the product. A certainty factor of 100% should be applied to products for which contracted sales are negotiated. 5. As a result of the combination of the efficacy and certainty factors applied, the income receivable can be factored down to a proportion of the prima facie income receivable as follows: Group 1 100% 100% = 100% Group 2 50% 50% = 25% Group 3 25% 25% = 6.25% 6. The use of efficacy and certainty factors in the way described above removes a large proportion of the uncertainty (risk) associated with the generation of projected cash flows. Accordingly, a lower discount rate should be employed in such instances. The discount rate applicable to venture capital/start-up type businesses declines rapidly as the organisation progresses towards the generation of positive cash flow. Rates of return continue to decline markedly as the organisation progresses. (Dauten suggests a post-tax rate of return on seed capital of 70+% while Guilhaus suggests a pre-tax rate of return of 100+%. For further reference see Dauten, K. P. Venture Capital Risk/Reward Primer and Glossary of Terms, NASBIC Venture Capital Institute, Chicago 1986 and Guilhaus, F. W. in Accounting Forum, June 1985, pp 3139.) 8. These rates of return are based on uncertain or unknown projected cash flows. That is, they represent a risk-adjusted discount rate applied to risky cash flows. In the financial model prepared in the manner discussed above, the cash flows are largely risk adjusted. Accordingly, the discount rate applicable should be reduced. If it is accepted that the enterprise has passed the seed capital stage and is in the start-up phase, an after-tax rate of return of approximately 50% to 70% may be applicable to unadjusted cash flows. This range of discount rates equates to approximately 30% to 45% on an adjusted basis (employing efficacy and certainty factors to risky revenues).
7.
9.
THEORETICAL FUNDAMENTALS / 5~1000 Discount Rates / 5~2120 References

5~2120 1.
References
Dauten, K. P. Venture Capital Risk/Reward Primer and Glossary of Terms, NASBIC Venture Capital Institute, Chicago 1986.
2. 3. 4.
Guilhaus, F. W. Accounting Forum, June 1985, pp 3139. Lintner, John. The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets, Review of Economics and Statistics 47 (1965) 1337. Sharpe, William F. Capital Asset Prices: Theory of Market Capitalisation Under Conditions of Risk, Journal of Finance 19 (1964) 425442.
THEORETICAL FUNDAMENTALS / 6~1000 Price Earnings Ratios

6~1000
Price Earnings Ratios
The application of price earnings ratios (PERs) in the valuation process produces a value (or range of values) by multiplying a future maintainable earnings or cash flow stream with a multiple(s). For example, a PER of 5 applied to an after-tax future maintainable earnings stream of $100,000 produces a value of $500,000 for the business. People are often surprised to learn that capitalisation methodologies (via the use of PERs) are a derivative of the discounted cash flow methodology which employs the use of discount rates. Given certain assumptions, we can extrapolate a relationship between PERs and discount rates. This chapter expands on the previous one, Discount Rates, and provides the following: a comparison of discount rates and price earnings ratios; examples proving the relationship in earnings growth and no earnings growth scenarios; and examples proving the relationship in both inflation and tax scenarios.
This chapter concludes with a study of price earnings ratios and implied rates of return, the relationship between debt and price earnings ratios and a table of proportionate price earnings ratios which can be used when a project does not have an infinite life.
THEORETICAL FUNDAMENTALS / 6~1000 Price Earnings Ratios / 6~1050 Relationship between Discount Rates and Price Earnings Ratios
6~1050
Relationship between Discount Rates and Price Earnings Ratios
THEORETICAL FUNDAMENTALS / 6~1000 Price Earnings Ratios / 6~1050 Relationship between Discount Rates and Price Earnings Ratios / 6~1070 Comparison of Discount Rates and Price Earnings Ratios (PERs)
6~1070
Comparison of Discount Rates and Price Earnings Ratios (PERs)
PERs are a measure of how the market prices investments via the returns expected from that investment. The following table is a useful summary comparison of PERs and return on investment rates. Assume no earnings growth and: $ ongoing operating profit before tax
100
less corporate tax (@ 30%) earnings (= profit after tax) Then: Using a PER of: Gives a value of: Which is equivalent to a real post-tax return of*: 25% 20% 17% 14% 13% 11% 10%
(30) 70
Which is equivalent to a nominal post-tax return assuming 3% inflation of: 28.75% 23.60% 20.17% 17.72% 15.88% 14.44% 13.30%
4 5 6 7 8 9 10
280 350 420 490 560 630 700
* Assumes no real growth in earnings.
The calculations required to arrive at the above figures are: PER Equiv. to post-tax real return B (1/a) 4 5 6 7 8 9 10 25.00% 20.00% 16.67% 14.29% 12.50% 11.11% 10.00% 30% 30% 30% 30% 30% 30% 30% Assume tax rate C Pre-tax real return D (b/(1c)) 35.71% 28.57% 23.81% 20.41% 17.86% 15.87% 14.29% 3% 3% 3% 3% 3% 3% 3% Assume inflation rate E Pre-tax nominal return F (1 + d) (1 + e)1 39.79% 32.43% 27.52% 24.02% 21.39% 19.35% 17.71% Post-tax nominal return G (1 + b) (1 + e)1 28.75% 23.60% 20.17% 17.72% 15.88% 14.44% 13.30%
The table shows that as the PER rises, the return decreases reflecting the higher price being paid for the underlying asset. If one assumes a higher level of debt in the business, the value of the business will go up (capitalised value increases) if the cost of that debt is lower than the required rate of return on investment. In general, it is sometimes best to consider private company valuations on a first principles basis by considering the rate of return or return on investment that is required by an investor in that company. Care should be taken, however, that this rate of return is comparable with market rates of return.
For example, a high PER may be evidence of growth expectations relative to current reported earnings. That is, profits are expected to increase in the coming year(s) and this is reflected in a high PER relative to current or historic earnings. The following example illustrates the effect of a constant growth factor: Company A Historic (last year) earnings: Projected (next year) earnings: Adjust for inflation: (3% per annum) Projected earnings: (this years earnings) Market capitalisation: PER: (market capitalisation of last years earnings) Prospective PER (market capitalisation of next years earnings): 100 130 (3.8) 126.2 2,000 20.0 15.8 Company B 100 103 (3) 100 1,500 15.0 15.0
The following spreadsheet demonstrates the calculations required to convert PERs to the various discount rates when a constant annual inflation rate and annual growth factor are assumed. Please also refer to the sections on the Gordon dividend growth model and nominal cash flows conversion between post-tax nominal and pre-tax nominal discount rates. Conversion of PERs to Discount Rates Incorporates Growth and Inflation Factors PER Growth factor B Post-tax real return C [(1/a) + b] 1 2 3 4 5 6 7 8 9 10 11 12 2% 2% 2% 2% 2% 2% 2% 2% 2% 2% 2% 2% 102.00% 52.00% 35.33% 27.00% 22.00% 18.67% 16.29% 14.50% 13.11% 12.00% 11.09% 10.33% 30% 30% 30% 30% 30% 30% 30% 30% 30% 30% 30% 30% Tax rate D Pre-tax real return E [(cb)/ (1t) + b] 144.86% 73.43% 49.62% 37.71% 30.57% 25.81% 22.41% 19.86% 17.87% 16.29% 14.99% 13.90% 3% 3% 3% 3% 3% 3% 3% 3% 3% 3% 3% 3% Inflation rate F Pre-tax nominal return G [(1 + e) (1 + f)1] 152.20% 78.63% 54.11% 41.85% 34.49% 29.58% 26.08% 23.45% 21.41% 19.77% 18.44% 17.32% Post-tax nominal return H [(1 + c) (1 + f)1] 108.06% 56.56% 39.39% 30.81% 25.66% 22.23% 19.77% 17.94% 16.50% 15.36% 14.42% 13.64%
Conversion of PERs to Discount Rates Incorporates Growth and Inflation Factors PER Growth factor B Post-tax real return C [(1/a) + b] 13 14 15 16 17 18 19 20 2% 2% 2% 2% 2% 2% 2% 2% 9.69% 9.14% 8.67% 8.25% 7.88% 7.56% 7.26% 7.00% 30% 30% 30% 30% 30% 30% 30% 30% Tax rate D Pre-tax real return E [(cb)/ (1t) + b] 12.99% 12.20% 11.52% 10.93% 10.40% 9.94% 9.52% 9.14% 3% 3% 3% 3% 3% 3% 3% 3% Inflation rate F Pre-tax nominal return G [(1 + e) (1 + f)1] 16.38% 15.57% 14.87% 14.26% 13.72% 13.23% 12.80% 12.42% Post-tax nominal return H [(1 + c) (1 + f)1] 12.98% 12.42% 11.93% 11.50% 11.12% 10.78% 10.48% 10.21%
If growth is expected in the near term followed by a plateauing effect, a discounted cash flow approach followed by an earnings capitalisation method may be appropriate. The earnings capitalisation method is however, not appropriate where earnings are fluctuating or experiencing erratic growth.
THEORETICAL FUNDAMENTALS / 6~1000 Price Earnings Ratios / 6~1050 Relationship between Discount Rates and Price Earnings Ratios / 6~1090 Proof of Relationship between Discount Rates and Price Earnings Ratios
6~1090
Proof of Relationship between Discount Rates and Price Earnings Ratios
The spreadsheets set out below demonstrate that the earnings capitalisation method of valuation is equivalent to the discounted cash flow method in certain circumstances and that this relationship holds for both growth and no growth scenarios. In particular, if it can be assumed that cash flows are equal to earnings and future earnings growth is nil, the earnings capitalisation method can be shown to be equivalent to a discounted cash flow method. If there is an assumption that earnings will grow at a rate faster than inflation (i.e. real growth in earnings) and that the growth rate is constant (i.e. continuing in perpetuity), the growth factor can be treated in the same manner as that discussed in the sections on the Gordon dividend growth model and nominal cash flows conversion between post-tax nominal and pre-tax nominal discount rates. The following example is based on two companies, one with no earnings growth potential and one with earnings growth potential. Assumptions/observations for the two firms are: Earnings equal cash flows Inflation (p.a.)
3%
Tax rate (p.a.) No growth firm: 1. Future maintainable earnings 2. Price earnings ratio 3. Value Growth firm: 1. Constant growth rate 2. Future maintainable earnings 3. Price earnings ratio 4. Value
30%
$100 6.06 $606
2% $102 6.89 $703
THEORETICAL FUNDAMENTALS / 6~1000 Price Earnings Ratios / 6~1050 Relationship between Discount Rates and Price Earnings Ratios / 6~1090 Proof of Relationship between Discount Rates and Price Earnings Ratios / 6~1110 Relationship of discount rates and PERs (no growth)
6~1110
Relationship of discount rates and PERs (no growth)
First, if we consider the company with the no growth potential, the earnings or profit before or after tax can be projected in the following spreadsheet in order to demonstrate that: 1. Multiplying future maintainable earnings (FME) by a PER arrives at a value which is equivalent to the post-tax earnings projected at a given inflation rate and discounted at the inverse of the PER, grossed-up for inflation: i.e. FME PER = Nominal Post-tax Cash Flows discounted at: [(1 + (1/PER)) (1 + i)1] 2. Multiplying FME by a PER arrives at a value which is equivalent to the pre-tax earnings projected at a given inflation rate and discounted at the inverse of the PER, grossed-up for both tax and inflation: i.e. FME PER = Nominal Pre-tax Cash Flows discounted at: [(1 + (1/PER)/(1t)) (1 + i)1] 3. Multiplying FME by a PER arrives at a value which is equivalent to the pre-tax earnings projected at a given inflation rate and discounted at the inverse of the PER, grossed-up for inflation (i.e. the post-tax nominal discount rate), then deducting the discounted value of corporate tax using the same post-tax nominal discount rate: i.e. FME PER = Nominal Pre-tax Cash Flows discounted at: [(1 + (1/PER)) (1 + i)1] LESS income tax discounted at: [(1 + (1/PER)) (1 + i)1] It should also be noted that for each of the above three scenarios, an alternative method of confirming
the net present value is to divide each FME figure (i.e. pre- or post-tax) by the applicable discount rate. This is simply the PER calculation rearranged. RELATIONSHIP BETWEEN PERs AND DISCOUNT RATES (NO REAL GROWTH) Assumptions Inflation rate: Tax rate: Future maintainable earnings: 3% 30% 100
Scenario A Post-tax Nominal Cash Flows Discounted using a Post-tax Nominal Discount Rate Year Post-tax nominal cash flow ($000s) 1 2 3 4 5 6 7 8 9 10 : 40 41 42 43 44 45 46 47 48 49 50 103 106 109 113 116 119 123 127 130 134 : 326 336 346 356 367 378 390 401 413 426 438 Net Present Value: Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited PV post-tax ($000s) 86 74 63 54 47 40 34 29 25 22 : 0 0 0 0 0 0 0 0 0 0 0 Cumulative PV ($000s) 86 160 223 277 324 364 398 427 453 474 : 605 605 605 605 605 605 605 605 605 606 606 606
Scenario B Pre-tax Nominal Cash Flows Discounted using a Pre-tax Nominal Discount Rate Pre-tax nominal cash flow ($000s) 147 152 156 161 166 171 176 181 186 192 : 466 480 494 509 524 540 556 573 590 608 626 Net Present Value: PV pre-tax Cumulative PV ($000s) 116 209 285 346 396 436 468 495 516 533 : 606 606 606 606 606 606 606 606 606 606 606 606
Scenario C Pre-tax Nominal Cash Flows Discounted using a Pre-tax Nominal Disco Less Tax Pre-tax nominal cash flow ($000s) 147 152 156 161 166 171 176 181 186 192 : 466 480 494 509 524 540 556 573 590 608 626 Net Present Value: PV @ post-tax rate ($000s) 123 105 90 78 67 57 49 42 36 31 : 0 0 0 0 0 0 0 0 0 0 0
($000s) 116 94 76 61 50 40 32 26 21 17 : 0 0 0 0 0 0 0 0 0 0 0
Scenario A Post-tax Nominal Cash Flows Discounted using a Post-tax Nominal Discount Rate Year Post-tax nominal cash flow ($000s) Equivalent to: PER FME = NPV Discount Rate Applied Calculated as: Inverse of PER (KPostR) Gross-up for tax Gross-up for inflation (KPostN) 16.50% n/a 6.06 100 606 20.00% PV post-tax ($000s) Cumulative PV ($000s)
Scenario B Pre-tax Nominal Cash Flows Discounted using a Pre-tax Nominal Discount Rate Pre-tax nominal cash flow ($000s) Equivalent to: PER FME = NPV Discount Rate Applied Calculated as: Inverse of PER (KPostR) Gross-up for tax (KPreR) Gross-up for inflation (KPreN) 16.50% 23.57% 6.06 100 606 27.28% PV pre-tax Cumulative PV ($000s)
Scenario C Pre-tax Nominal Cash Flows Discounted using a Pre-tax Nominal Disco Less Tax Pre-tax nominal cash flow ($000s) Equivalent to: PV @ post-tax rate ($000s)
($000s)
Discount Rate Applied Calculated as: Inverse of PER (KPostR) Gross-up for tax Gross-up for inflation (KPostN)
20.00%
27.28%
THEORETICAL FUNDAMENTALS / 6~1000 Price Earnings Ratios / 6~1050 Relationship between Discount Rates and Price Earnings Ratios / 6~1090 Proof of Relationship between Discount Rates and Price Earnings Ratios / 6~1120 Relationship of discount rates and PERs (with growth)
6~1120
Relationship of discount rates and PERs (with growth)
If we now consider the company with growth potential, the earnings or profit before or after tax can be projected in the following spreadsheet in order to demonstrate that: 1. Multiplying future maintainable earnings (FME) by a PER arrives at a value which is equivalent to the post-tax earnings projected at given inflation and growth rates and discounted at the inverse of the PER, grossed-up for inflation: i.e. FME PER = Nominal Post-tax Cash Flows discounted at: [(1 + (1/PER + g)) (1 + i)1] 2. Multiplying FME by a PER arrives at a value which is equivalent to the pre-tax earnings projected at given inflation and growth rates and discounted at the inverse of the PER, grossed-up for both tax and inflation: i.e. FME PER = Nominal Pre-tax Cash Flows discounted at: [(1 + ((1/PER)/(1t) + g)) (1 + i)1] 3. Multiplying FME by a PER arrives at a value which is equivalent to the pre-tax earnings projected at given inflation and growth rates and discounted at the inverse of the PER, grossed-up for inflation (i.e. at the post-tax nominal discount rate), then deducting the discounted value of corporate tax using the same post-tax nominal discount rate:
i.e. FME PER = Nominal Pre-tax Cash Flows discounted at: [(1 + (1/PER + g)) (1 + i)1] LESS income tax discounted at: [(1 + (1/PER + g)) (1 + i)1] It should also be noted that for each of the above three scenarios, an alternative method of confirming the net present value is to divide each FME figure (i.e. pre- or post-tax) by the applicable discount rate. This is simply the inverse of the PER calculation. RELATIONSHIP BETWEEN PERs AND DISCOUNT RATES (WITH REAL GROWTH) Assumptions Inflation rate: Tax rate: Future maintainable earnings: 3% 30% 100
Scenario A Post-tax Nominal Cash Flows Discounted using a Post-tax Nominal Discount Rate Year Post-tax nominal cash flow ($000s) 1 2 3 4 5 6 7 8 9 10 : 40 41 42 43 44 45 105 110 116 122 128 134 141 148 156 164 : 720 757 795 835 877 922 PV post-tax ($000s) 88 77 67 59 51 45 39 35 30 26 : 0 0 0 0 0 0 Cumulative PV ($000s) 88 164 231 290 341 387 426 460 491 517 : 700 700 701 701 701 701
Scenario B Pre-tax Nominal Cash Flows Discounted using a Pre-tax Nominal Discount Rate Pre-tax nominal cash flow ($000s) 150 158 166 174 183 192 202 212 223 234 : 1,029 1,081 1,136 1,193 1,254 1,317 PV pre-tax Cumulative PV ($000s) 119 217 299 368 424 471 511 543 570 593 : 703 703 703 703 703 703
Scenario C Pre-tax Nominal Cash Flows Discounted using a Pre-tax Nominal Disco Less Tax Pre-tax nominal cash flow ($000s) 150 158 166 174 183 192 202 212 223 234 : 1,029 1,081 1,136 1,193 1,254 1,317 PV @ post-tax rate ($000s) 125 109 96 84 73 64 56 49 43 38 : 1 1 1 0 0 0
($000s) 119 99 82 68 57 47 39 33 27 22 : 0 0 0 0 0 0
Scenario A Post-tax Nominal Cash Flows Discounted using a Post-tax Nominal Discount Rate Year Post-tax nominal cash flow ($000s) 46 47 48 49 50 969 1018 1069 1123 1180 Net Present Value: Equivalent to: PER FME = NPV Discount Rate Applied Calculated as: Inverse of PER Add growth (KPostR) Gross-up for tax Gross-up for inflation (KPostN) 14.50% 16.50% n/a 6.89 102 703 20.00% PV post-tax ($000s) 0 0 0 0 0 Cumulative PV ($000s) 702 702 702 702 702 702
Scenario B Pre-tax Nominal Cash Flows Discounted using a Pre-tax Nominal Discount Rate Pre-tax nominal cash flow ($000s) 1,384 1,454 1,527 1,604 1,686 Net Present Value: Equivalent to: PER FME = NPV Discount Rate Applied Calculated as: Inverse of PER Add growth (KPostR) Gross-up for tax (KPreR) Gross-up for inflation (KPreN) 14.50% 16.50% 22.72% 6.89 102 703 26.40% PV pre-tax Cumulative PV ($000s) 0 0 0 0 0 703 703 703 703 703 703
Scenario C Pre-tax Nominal Cash Flows Discounted using a Pre-tax Nominal Disco Less Tax Pre-tax nominal cash flow ($000s) 1,384 1,454 1,527 1,604 1,686 Net Present Value: Equivalent to: PV @ post-tax rate ($000s) 0 0 0 0 0
($000s)
Discount Rate Applied Calculated as: Inverse of PER Add growth (KPostR) Gross-up for tax Gross-up for inflation (KPostN)
20.00%
26.40%
THEORETICAL FUNDAMENTALS / 6~1000 Price Earnings Ratios / 6~1050 Relationship between Discount Rates and Price Earnings Ratios / 6~1140 Study of Implied Rates of Return PERs and Beta Price Factors
6~1140
Study of Implied Rates of Return PERs and Beta Price Factors

Study of Implied Rates of Return Price Earnings Ratios and Beta Factors Data Extracted from AGSM RMS and ASX Summaries as at 31 December 2001
Set out below is a study of implied nominal rates of return from observed price earnings ratios (PERs) and the implied cost of equity from Scholes-Williams Beta factors (S-W Betas) as at 30 December 2001. The study serves to demonstrate that observed PERs do not equate to observed Beta factors. There are a number of reasons for this, the strongest of which are: to compare PERs and Beta factors implies that earnings equal cash flows and growth
expectations are embodied in Beta factors; expectations as to risk-free rates and implicit inflation are not always apparent; and PERs are not based on a smoothed price estimate as are S-W Betas; accordingly there can be some aberrations in observed PERs, especially around 30 June each year.
(A) INDUSTRY SECTOR PER (a) Note: Alcohol & Tobacco Banks & Finance Building Materials Chemicals Developers & Contractors Diversified Industrial Diversified Resources Energy Engineering Food & Household Goods Gold Healthcare & Biotechnology Index Infrastructure & Utilities Insurance Investment & Financial Services Media Miscellaneous Industrials Other Metals Paper & Packaging Property Trusts Retail Telecommunications Tourism & Leisure Transport Arithmetic Average 1 20.26 15.74 10.86 12.64 28.43 27.25 16.36 8.75 21.49 11.46 15.22 35.99 26.10 19.25 19.21 24.86 15.28 11.95 15.14 13.20 32.13 16.54 18.73 24.38 18.29 4.94% 6.35% 9.21% 7.91% 3.52% 3.67% 6.11% 11.43% 4.65% 8.73% 6.57% 2.78% 3.83% 5.19% 5.21% 4.02% 6.54% 8.37% 6.61% 7.58% 3.11% 6.05% 5.34% 4.10% 5.47% Invert PER (b) Add inflation (c) 3 2.49% 2.49% 2.49% 2.49% 2.49% 2.49% 2.49% 2.49% 2.49% 2.49% 2.49% 2.49% 2.49% 2.49% 2.49% 2.49% 2.49% 2.49% 2.49% 2.49% 2.49% 2.49% 2.49% 2.49% 2.49% 7.43% 8.84% 11.70% 10.40% 6.01% 6.16% 8.60% 13.92% 7.14% 11.22% 9.06% 5.27% 6.32% 7.68% 7.70% 6.51% 9.03% 10.86% 9.10% 10.07% 5.60% 8.54% 7.83% 6.59% 7.96% Nominal ROR (b) + (c) OLS Beta (e) 2 0.30 1.16 1.07 1.00 0.86 0.72 1.58 0.89 0.98 0.05 1.01 0.78 0.58 1.00 1.34 1.35 1.81 0.88 1.36 0.40 0.52 0.92 0.93 0.62 0.94 Rf (f) 4 6.01% 6.01% 6.01% 6.01% 6.01% 6.01% 6.01% 6.01% 6.01% 6.01% 6.01% 6.01% 6.01% 6.01% 6.01% 6.01% 6.01% 6.01% 6.01% 6.01% 6.01% 6.01% 6.01% 6.01% 6.01% RmRf (g) 4 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% 7.45% 11.59% 11.16% 10.82% 10.15% 9.47% 13.61% 10.29% 10.72% 6.25% 10.87% 9.76% 8.80% 10.82% 12.46% 12.50% 14.72% 10.24% 12.55% 7.93% 8.51% 10.44% 10.48% 8.99% 10.53% (B) Ke (f) + (e)(g) DIFFERENCE Nominal ROR & Ke (A)(B)
Notes: 1. 2. 3. 4. Price Earnings Ratio as at 31 December 2001. OLS Beta from AGSM Risk Measurement Service for 31 December 2001. Implied inflation as at 31 December 2001. Nominal yield on 10-year Government bonds as at 31 December 2001.
THEORETICAL FUNDAMENTALS / 6~1000 Price Earnings Ratios / 6~1050 Relationship between Discount Rates and Price Earnings Ratios / 6~1160 Effects of Debt on PERs
6~1160
Effects of Debt on PERs
The following table highlights the effects of debt on PERs. In it, we have shown the hypothetical abridged profit and loss statement of a publicly traded entity (Pubco), with its PER. It is being used as a comparable company for the (private) company being valued (Valco). However, while all other risks in this example are assumed to be equal, we have arrived at different values purely by virtue of the effects of debt. THE EFFECTS OF DEBT ON PRICE EARNINGS RATIOS Pubco Profit before interest and tax Interest at 10% p.a. (Debt $300 k) Profit before tax Income tax at 30% Profit after tax (earnings) Market capitalisation (price) PER Applying the Pubco PER to Valco: Pubco PER times Valco earnings Valco valuation versus Pubco valuation of difference which is represented by the capitalisation of: Pubco interest of less tax at 30% Net after-tax interest cost at a PER of equals valuation difference of
Valco $100 $0 $100 $30 $70
$100 ($30) $70 ($21) $49 $365 7.45
7.45
$70 $521 $365 $156
($30) $9 ($21) 7.45 ($156)
The question which arises is: is Valco worth $156 more than Pubco? Logically the answer is no! Pubco has $300 of debt! In order to adequately compare the two entities, the influences of debt must be removed. This method is demonstrated in the section on calculating earnings before interest and tax (EBIT) multiples. One of the best ways of removing the effects of debt, when comparing two companies, is to compare the multiple upon which profit before interest and tax is capitalised by the market-place. In the above example, the Pubco market capitalisation of $365 represents a multiple of 3.65 times EBIT (for the equity holders). This means the total value of Pubco assets is $365 (value of equity) plus $300 (value of debt), total $665. This represents a multiple upon which total assets have been valued by the debt and equity holders of 6.65 times EBIT. If this multiple was in turn applied to the Valco EBIT of $100 we would arrive at exactly the same value of total assets, i.e. 6.65 $100 = $665. Unfortunately, these adjustments become much more judgmental in real life as the timing of debt and equity raisings and pre-payment/deferral of interest affects reported profitability and therefore the multiples upon which publicly traded entities have been capitalised. The table continues this example, converting EBIT to an implied PE ratio and shows that, depending on the level of debt, the PE ratio can vary substantially. In the example, levels of debt between 0% and over 50% of the enterprise value of the company are assumed and these show that, even with the same EBIT, the PE ratio can vary almost 50% from a low of 6.3 to a high of 9.5 in this case. EBIT 100
EBIT Multiple, say
6.7
Enterprise Value (no Debt)
665
665
665
665
665
665
Supportable Debt, say
50
100
200
300
400
Interest
10.0%
10
20
30
40
PBT
100
95
90
80
70
60
Tax
30%
30
29
27
24
21
18
PAT
70
67
63
56
49
42
C=AB
Entity Value
665
615
565
465
365
265
C/D
Implied PE Ratio
9.5
9.2
9.0
8.3
7.4
6.3
Expert advice may be required in the use of price earnings multiples, for both the level of debt in the company being valued and the comparable company.
THEORETICAL FUNDAMENTALS / 6~1000 Price Earnings Ratios / 6~1050 Relationship between Discount Rates and Price Earnings Ratios / 6~1180 Proportionate PERs
6~1180
Proportionate PERs
While a discounted cash flow method is particularly useful for limited life ventures, it is, nevertheless, possible to capitalise a limited life earnings or cash flow stream. Earnings or cash flow streams are sometimes limited by a variety of factors such as: lease terms; franchise agreements; restrictive covenants (e.g. restraint of trade); Acts of Parliament; and call options over the assets or business under consideration.
The earnings stream may demonstrate a steady-state operation and other features of earnings which are capable of capitalisation. A PER may also be available from the market-place and be adjusted to reflect the risks of the particular business under consideration. However, the application of a PER (without any adjustment) to limited life earnings will significantly over-value the business in most cases. The tables set out below demonstrate that proportions of a PER can be employed in capitalising limited life cash flow or earnings streams. For example, in table A (constant dollar basis), a PER of five appropriate to earnings continuing into perpetuity is equivalent to a PE ratio of 3 (5 .6) for an earnings stream limited to five years. Similarly, table C (constant inflation of 5% p.a.) demonstrates that a proportion of .45 times a PER of 12 is appropriate for an earnings stream with a life limited to 10 years. These relationships can be interpreted in another way and expressed as the proportion that the limited life earnings or cash flow streams represent of a perpetuity (see tables B and D). For example, table B demonstrates that a cash flow stream limited to a life of five years represents 60% of a perpetuity when using a real discount rate of 20%. These types of relationships are particularly useful when considering the value of: businesses reliant upon Crown or other leases; franchised businesses; businesses subject to patents over key products; or
businesses subject to limited life licences granted by State or Federal Government bodies.
An interesting feature of these calculations is that it demonstrates the amount of security available for lenders as a proportion of normal freehold security. For example, the valuation of a hotel located on a Crown leasehold employing a real discount rate of 10% shows that a 10-year lease is worth approximately 61% of the freehold value (before deducting lease payments and outgoings) as per table B. A 30-year lease at the same discount rate is equivalent to 94% of freehold value (before deducting lease payments and outgoings). Any consideration paid in excess of the relevant proportion can be viewed in a number of ways, including: as a premium for an expectation that the lease will be renewed (without cost or penalty); that the purchaser believes value can be extracted from the earnings stream beyond the limited life suggested by the lease; that the underlying assets can be realised for greater than the value of the earnings stream; or that the purchaser regards the risks associated with the fixed term life as being less important than the view held by the vendor.
As an example, if a purchase price of $10 million was suggested for a leasehold property with an appropriate discount rate of 10% (real) and a lease term of 10 years, the equivalent freehold value would be $16.39 million dollars (being $10 million dollars divided by .61). This calculation is before adjusting for any lease payments or outgoings. Any amount paid for the lease in excess of $10 million represents a form of premium relating to the possibility of converting the income stream into a perpetuity or in some other way obtaining the benefit of cash flows beyond the stated term of the lease.
THEORETICAL FUNDAMENTALS / 6~1000 Price Earnings Ratios / 6~1050 Relationship between Discount Rates and Price Earnings Ratios / 6~1180 Proportionate PERs / 6~1190 Constant dollar projections
6~1190
Constant dollar projections

Proportion of Perpetuity Represented by a Fixed Term Cash Flow (e.g. a Crown leasehold) A: Assuming Constant Dollar Projections (Number in table represents proportion of perpetuity represented by the limited life cash flow) PER*: 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Year 1 2 3 4 5 50% 33% 25% 20% 17% 14% 12% 11% 10% 9% 8% 8% 7% 7% 6% 6%
75% 56% 44% 36% 31% 27% 23% 21% 19% 17% 16% 15% 14% 13% 12% 11% 88% 70% 58% 49% 42% 37% 33% 30% 27% 25% 23% 21% 20% 19% 18% 17% 94% 80% 68% 59% 52% 46% 41% 38% 34% 32% 29% 27% 26% 24% 23% 22% 97% 87% 76% 67% 60% 54% 49% 45% 41% 38% 35% 33% 31% 29% 28% 26%
Proportion of Perpetuity Represented by a Fixed Term Cash Flow (e.g. a Crown leasehold) A: Assuming Constant Dollar Projections (Number in table represents proportion of perpetuity represented by the limited life cash flow) PER*: 6 7 8 9 10 20 30 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
98% 91% 82% 74% 67% 60% 55% 51% 47% 44% 41% 38% 36% 34% 32% 30% 99% 94% 87% 79% 72% 66% 61% 56% 52% 49% 46% 43% 40% 38% 36% 35% 100% 96% 90% 83% 77% 71% 66% 61% 57% 53% 50% 47% 45% 42% 40% 38% 100% 97% 92% 87% 81% 75% 70% 65% 61% 58% 54% 51% 49% 46% 44% 42% 100% 98% 94% 89% 84% 79% 74% 69% 65% 61% 58% 55% 52% 50% 48% 45% 100% 100% 100% 99% 97% 95% 93% 91% 88% 85% 82% 80% 77% 75% 72% 70% 100% 100% 100% 100% 100% 99% 98% 97% 96% 94% 93% 91% 89% 87% 86% 84%
* Note: Inverse of the price earnings ratio is the implied discount rate. Proportion of Perpetuity Represented by a Fixed Term Cash Flow (e.g. a Crown leasehold) B: Assuming Constant Dollar Projections (Number in table represents proportion of perpetuity represented by the limited life cash Discount Rate*: Year 1 2 3 4 5 6 7 8 9 10 20 30 50% 75% 88% 94% 97% 98% 99% 100% 100% 100% 100% 100% 33% 56% 70% 80% 87% 91% 94% 96% 97% 98% 100% 100% 25% 44% 58% 68% 76% 82% 87% 90% 92% 94% 100% 100% 20% 36% 49% 59% 67% 74% 79% 83% 87% 89% 99% 100% 17% 31% 42% 52% 60% 67% 72% 77% 81% 84% 97% 100% 14% 27% 37% 46% 54% 60% 66% 71% 75% 79% 95% 99% 12% 23% 33% 41% 49% 55% 61% 66% 70% 74% 93% 98% 11% 21% 30% 38% 45% 51% 56% 61% 65% 69% 91% 97% 10% 19% 27% 34% 41% 47% 52% 57% 61% 65% 88% 96% 9% 17% 25% 32% 38% 44% 49% 53% 58% 61% 85% 94% 100.0% 50.0% 33.3% 25.0% 20.0% 16.7% 14.3% 12.5% 11.1% 10.0%
* Note: Inverse of the price earnings ratio is the price earnings ratio.
THEORETICAL FUNDAMENTALS / 6~1000 Price Earnings Ratios / 6~1050 Relationship between Discount Rates and Price Earnings Ratios / 6~1180 Proportionate PERs / 6~1200 Constant 5% inflation
6~1200
Constant 5% inflation
Proportion of Perpetuity Represented by a Fixed Term Cash Flow (e.g. a Crown leasehold) C: Assuming Constant Inflation of 5% (Number in table represents proportion of perpetuity represented by the limited life cash flow)
PER*: Year 1 2 3 4 5 6 7 8 9 10 20 30
10
11
12
13
49% 73% 84% 90% 93% 94% 95% 95% 95% 95% 95% 95%
32% 53% 66% 75% 81% 84% 87% 88% 89% 90% 91% 91%
24% 42% 54% 63% 70% 75% 78% 80% 82% 84% 87% 87%
19% 34% 45% 54% 61% 66% 70% 73% 75% 77% 83% 83%
16% 29% 39% 47% 54% 59% 63% 67% 69% 71% 79% 80%
14% 25% 34% 42% 48% 53% 57% 61% 64% 66% 75% 77%
12% 22% 30% 37% 43% 48% 53% 56% 59% 61% 72% 74%
11% 20% 27% 34% 40% 44% 48% 52% 55% 57% 69% 71%
10% 18% 25% 31% 36% 41% 45% 48% 51% 53% 65% 68%
9% 16% 23% 29% 34% 38% 42% 45% 48% 50% 63% 66%
8% 15% 21% 26% 31% 35% 39% 42% 45% 47% 60% 63%
7% 14% 20% 25% 29% 33% 36% 40% 42% 45% 57% 61%
7% 13% 18% 23% 27% 31% 34% 37% 40% 42% 55% 59%
* Note: Inverse of the PER is the implied discount rate. Proportion of Perpetuity Represented by a Fixed Term Cash Flow (e.g. a Crown leasehold)
D: Assuming Constant Inflation of 5% (Number in table represents proportion of perpetuity represented by the limited life cash f Discount Rate*: Year 1 2 3 4 5 6 7 49% 73% 84% 90% 93% 94% 95% 32% 53% 66% 75% 81% 84% 87% 24% 42% 54% 63% 70% 75% 78% 19% 34% 45% 54% 61% 66% 70% 16% 29% 39% 47% 54% 59% 63% 14% 25% 34% 42% 48% 53% 57% 12% 22% 30% 37% 43% 48% 53% 11% 20% 27% 34% 40% 44% 48% 10% 18% 25% 31% 36% 41% 45% 9% 16% 23% 29% 34% 38% 42% 100.0% 50.0% 33.3% 25.0% 20.0% 16.7% 14.3% 12.5% 11.1% 10.0%
Proportion of Perpetuity Represented by a Fixed Term Cash Flow (e.g. a Crown leasehold)
D: Assuming Constant Inflation of 5% (Number in table represents proportion of perpetuity represented by the limited life cash f Discount Rate*: 8 9 10 20 30 100.0% 95% 95% 95% 95% 95% 50.0% 88% 89% 90% 91% 91% 33.3% 80% 82% 84% 87% 87% 25.0% 73% 75% 77% 83% 83% 20.0% 67% 69% 71% 79% 80% 16.7% 61% 64% 66% 75% 77% 14.3% 56% 59% 61% 72% 74% 12.5% 52% 55% 57% 69% 71% 11.1% 48% 51% 53% 65% 68% 10.0% 45% 48% 50% 63% 66%
* Note: Inverse of the discount rate is the price earnings ratio.
THEORETICAL FUNDAMENTALS / 6~1000 Price Earnings Ratios / 6~1050 Relationship between Discount Rates and Price Earnings Ratios / 6~1180 Proportionate PERs / 6~1210 Example Proportionate PERs
6~1210
Example Proportionate PERs
Set out in the following spreadsheet is an example of a calculation of the value of an earnings stream employing PERs derived from the market-place and applied as though the earnings are receivable in perpetuity. The PERs are then adjusted for the proportion represented by a limited 10-year life to arrive at a proportion of PERs. The resultant (proportionate) PERs represent between 56% and 69% of the market-determined (unadjusted) PERs. Accordingly, the values derived from capitalising the earnings by the proportionate PERs are between 56% and 69% of the value of the perpetuity equivalent. Application of Proportionate PER Low $m a) b) Earnings PER derived from market info LOW PERs for similar companies with comparable financial structures etc Adjusted for: Controlling interest Strategic position in market Non-negotiability of proprietary company shares c) Adjusted PER perpetual earnings Value of earnings if receivable in perpetuity (a c)
High $m $400
$400
HIGH 9.00
8.00
10% 10% (20)% 8.00 $3,200
20% 20% (10)% 11.70 $4,680
Application of Proportionate PER Low $m d) e) Proportion of PER appropriate to 10-year life (from Table A interpolated) Proportionate PER 10-year life Value of earnings if receivable for fixed term of 10 years (a e) 69% 5.52 $2,208 High $m 56% 6.55 $2,620
ANALYSIS
ANALYSIS
ANALYSIS / 7~1000 Research and Data Collection
7~1000
Research and Data Collection
Once the scope of an assignment is fully understood and there is confidence in the basic theoretical fundamentals, the collection of relevant information and data can begin. This chapter discusses the various forms of information which must be researched prior to
undertaking a valuation and the sources of such information: external risks; internal business risks; company history; cash flow; information sources; and initial list of data required.
A complete understanding of why the various forms of information are required and how they relate to the valuation process will expedite the completion of an assignment.
ANALYSIS / 7~1000 Research and Data Collection / 7~1050 Understanding the Business
7~1050
Understanding the Business
The most crucial issue when attempting to value a business is understanding the business itself. The information collected, analysis undertaken and conclusions reached may be of little consequence if the valuer has not achieved a complete understanding of the business and the issues that affect it. An initial understanding of the business and its operations is best obtained by visiting the site and discussing issues with management and key personnel. Such a hands-on approach will facilitate a more knowledgeable analysis of the businesss earnings or cash flow projections (either provided by management or to be prepared by the valuer). It is also necessary to gain an understanding of the industry in which the business operates and the specific risk factors to which the business is exposed. Such an analysis will complement the valuers understanding of the business by highlighting which factors could impact upon future cash flows. Throughout this text we have emphasised that no two valuations are alike. As such, information requirements for one valuation may not be representative of those for another. Appendix 1, however, provides a comprehensive, but not exhaustive, list of information required in a valuation. The objective of information collection and analysis, therefore, is to determine the most likely earnings or cash flow profile of the business, understand the risks to this earnings or cash flow profile and, ultimately, provide the valuer with confidence in ascribing a value to the business.
ANALYSIS / 7~1000 Research and Data Collection / 7~1050 Understanding the Business / 7~1070 External Business Risks
7~1070
External Business Risks
No business or its industry operates in a vacuum. Factors in the environment that may impact on cash flows are known as external business risks. If the valuer makes only superficial enquiries, they may miss a risk which will impact upon the forecast earnings of a business. It is important, therefore, to undertake sufficient research on potential external risks so as to then have a good understanding of the specific risks a business faces. A discussion of the major external business factors follows.
1.
General economic factors Both industries and individual businesses are, to varying degrees, affected by general economic factors. In valuing a business, one needs to determine the effect of these economic factors on the business and on the industry in which it operates. Economic factors which may need to be considered include: fluctuating interest rates; current and expected levels of inflation; exchange rate exposure, both accounting and cash flow exposure; level of unemployment; private consumption patterns and consumer confidence; and specific state and regional economic factors.
2.
Industry life cycle/growth rates Industry growth rates can be applied to estimate business growth rates with consideration being given to business-specific factors. Specific factors incorporate the businesss ability, or lack thereof, to grow at a faster rate than that of the industry as a whole. Industry growth rates change over time and can be depicted graphically as per the industry (and product) life cycle diagram shown below. Five different points in the life cycle may be identified: Introductory The product is new to the market and gaining acceptance. There may be reasonable sales growth from a small base; however, profitability is limited and cash requirements (often referred to as cash burn rates) are high. Growth The product has won consumer acceptance with sales growing rapidly. Abnormally high returns prompt competitors to release me too products. Cash requirements are still high but the industry as a whole participates in relatively high levels of profit. Maturity Growth is slowing and some businesses begin to exit the market. Those businesses best able to manage the transition from growth to maturity make the largest profits. Saturation Sales growth has flattened or is receding. Competition between the remaining businesses sees a tightening in pricing and production with over-capacity becoming evident. Cash flow is generally positive but profitability is declining from its peak. Decline Sales are falling and pricing becomes very competitive as industry participants battle to maintain prior levels of sales. Profitability reduces further and cash flow, although still positive, also faces reduction.
Understanding the industry life cycle of the business is an integral step in the valuation process. 3. Competition Factors to be considered when assessing the level of competition faced by a business include: the classification of the industry, i.e. monopolistic, oligopolistic or competitive; the industry growth rate or stage in the industry life cycle; the homogeneity of competitors with regard to their origins, strategies and relationships to parent companies; level of product differentiation between businesses; the relative size of industry participants; the size of incremental changes in capacity within the industry; individual levels of fixed costs; and entry and exit barriers.
These factors will help determine the level of competition within an industry and the individual businesss level of control over pricing. 4. Substitutes Are substitutes for the businesss products available? If so, what impact will price changes in the prices of both the business and substitute have on revenue? 5. Product differentiation Are sales within the industry determined by price alone or do branding and product quality
influence consumers? In other words, are products differentiated to a degree which allows the business to impart some control over pricing and, in turn, profit? 6. Entry barriers High entry barriers to an industry make it difficult for new competitors to enter the market. Barriers may take the form of plant and equipment requirements, access to distribution channels, government regulation, natural restrictions or other factors. The level of entry barriers needs to be considered as it provides additional insight into the ongoing viability of the business. 7. Economies of scale A business enjoys economies of scale when the average cost of production falls as production levels rise. This is often achieved by spreading fixed costs over a larger level of production. The level of fixed costs incurred by industry participants needs to be investigated. Does the industry indicate a few key participants who have obtained critical mass, making entry of a new operator difficult? 8. Cost advantages independent of scale Some cost factors that require consideration include: 9. access to raw materials; location; ownership of patents, technology or brands; government subsidies; and the businesss learning curve. This refers to the time and cost involved with production as the experience of the business operator grows.
Technology Consideration must be given to the technological advancement of the businesss operations and the level which is considered necessary to compete within the industry. The risk of obsolescence posed by technological change must be taken into account, as well as the current state of the industry and the prospect of change.
10.
Suppliers The concentration and subsequent power of suppliers may have a significant effect on an industry. Issues to be given consideration include: The concentration of suppliers of key inputs, i.e. the degree of monopoly within the industry. Too few suppliers weakens purchasers bargaining power. The businesss position is considered weak if it is dependent on a particular supplier of an input which has no real substitutes. The importance of the industry to the supplier. If the supplier group has differentiated its products and has industries more important to it, the industry in question will have a less favourable bargaining position. The ability of suppliers to integrate vertically forwards into the industry may weaken the
industrys position. 11. Buyers Buyers have similar issues to suppliers. Issues to be given consideration include: 12. the concentration of buyers dependence on too few buyers may weaken a vendors bargaining position; the importance of the product to the buyer and subsequent loyalty to the product; and the ability of buyers to integrate vertically backwards into the industry which may weaken the industrys position.
Access to distribution channels Access to markets is critical to the success of a business. This includes both the physical transportation of goods as well as access to distributors themselves. New entrants to a market must pay particular attention to the availability of distribution channels.
13.
Likely retaliation of existing industry operators Is there a history of business interdependence within the industry? Have tit for tat pricing strategies or collusion between rivals been evident? The level of retaliation between businesses in response to changes in pricing or marketing strategies gives an indication of the industrys competitiveness and, in turn, the ability of the business to earn superior profits. This will also indicate the level of retaliation likely towards new entrants in the market.
14.
Political and regulatory factors Some industries will be subject to more political and regulatory governance than others, for example, chemical manufacturers and tobacco and alcohol producers. Political and regulatory concern is often centred on issues such as pollution, quality standards, market restrictions, subsidies and rebates, and foreign exchange controls. Current, pending and potential future developments in these areas must be taken into account when analysing a businesss prospects.
15.
Social factors Social change can be a source of significant risk to a business. For example, a change in the level or composition of migration will impact upon a business supplying those markets. Another example is the trend towards earlier retirement which will result in a change in general consumer trends.
ANALYSIS / 7~1000 Research and Data Collection / 7~1050 Understanding the Business / 7~1090 Internal Business Risks
7~1090
Internal Business Risks
Industry issues are not the only influence on a business. This can be demonstrated by looking at companies within the same industry with similar levels of activity but vastly different market values. What could cause this? Sources of internal risk, i.e. from within the business, play a large part in this differentiation. The following list of internal business risks is a summary. 1. Company strategy
What are the businesss strategies for growth and how risky are these strategies? The position of the business in its life cycle will often dictate the strategies available. However, it is the choice of strategy and how the business handles the risks associated with its choice which determine its likely level of success. 2. Management capability Although often hard to determine, examination of past experience and qualifications will give some indication of the capability of the management team. 3. Market position Market position incorporates factors such as relative volume of sales within an industry and size of business compared to rivals. A stronger position within the industry indicates a higher likelihood of surviving a market downturn. 4. Financial strength The level of gearing, i.e. the extent to which the business has used debt to finance its operations, directly impacts upon the level of financial risk the business can carry. High debt levels may have serious consequences on the businesss ability to meet obligations during times of rising interest rates or financial distress. 5. Centralised financial control Studies of business failures indicate that the lack of centralised financial controls is a key factor in their demise. The existence of such controls within a business can be investigated thoroughly by the valuer. 6. Research and development Is the businesss current level of R&D considered sufficient? Too little means few new products are being developed which may be insufficient to maintain market share; however, too much may be an inefficient allocation of resources. 7. Quality of plant/facilities A general understanding of this is essential in assessing the operational risk facing a business. A tour of the facilities will enable the valuer to assess the efficiency of equipment in operation and when outlays will be required for replacement of equipment. 8. Capacity utilisation When assessing capacity utilisation, the valuer must compare it to the businesss competitors. Identification of under- or over-utilisation compared to industry norms can then be further investigated.
ANALYSIS / 7~1000 Research and Data Collection / 7~1050 Understanding the Business / 7~1110 Company History
7~1110
Company History
The valuer must put the company within the context of its industry, especially its competition, as well as the general economy. In doing so, the valuer needs to understand the business strategy, as well as the particular strengths,
weaknesses, opportunities and threats facing the business. It is often useful to consider the businesss performance during periods of recession or other major changes in order to assess how such influences may impact upon the profitability of the entity in the future. In developing the reporting format for the valuation, the reader of the report is usually provided with a brief chronological history of the company in order to place its current and projected future activities in the context of its past successes and failures. Runs on the board can demonstrate the likelihood of future success. Likewise, if the entity has had a number of significant failures in its history it is worth analysing the reasons for those failures and whether they were through external influences over which the entity had no control, or through internal influences such as management failure, funding, supply or other constraints over which the entity had (or should have had) some control.
ANALYSIS / 7~1000 Research and Data Collection / 7~1050 Understanding the Business / 7~1130 Cash Flow
7~1130
Cash Flow
Businesses are at various stages in their life cycle, for example start-up, growth, maturity etc. At each stage of development is a cash flow profile which reflects the profitability and capital expenditure needs of the business. One would expect that a start-up business, will involve significant capital expenditures and operating losses in its initial stages, followed by cash flow break-even and, hopefully, positive cash flows as market share is gained. The Boston Consulting Group refined these cash flow profiles according to business growth rate and relative competitive position. It can be useful to review the Boston Consulting Group matrix when analysing financial statements for valuation purposes, as it provides a further measure of business risk (by classifying the company) and the returns that might be expected. The Boston Consulting Group matrix is set out below.
ANALYSIS / 7~1000 Research and Data Collection / 7~1050 Understanding the Business / 7~1130 Cash Flow / 7~1140 Diagram Boston Consulting Group matrix
7~1140
Diagram Boston Consulting Group matrix
ANALYSIS / 7~1000 Research and Data Collection / 7~1050 Understanding the Business / 7~1130 Cash Flow / 7~1140 Diagram Boston Consulting Group matrix / Cash cows
Cash cows
Cash cows have low growth but a high market share. They are so named because we milk them for their cash returns, and profits and cash generation should be high. Little reinvestment is required and the cash generated is all important. Cash cow businesses are often management buy-out (MBO) and leveraged buy-out (LBO) candidates. The low earnings volatility of cash cows means that they can sustain the relatively high levels of debt necessary in the early years of a MBO/LBO.
ANALYSIS / 7~1000 Research and Data Collection / 7~1050 Understanding the Business / 7~1130 Cash Flow / 7~1140 Diagram Boston Consulting Group matrix / Dogs
Dogs
Dogs are those businesses which have a low growth and a low market share. Typically, they generate little profit and have little hope of becoming worthwhile. They are not worth the further investment of corporate resources. They can become a cash trap. Basically, the conventional wisdom is to shoot dogs (of businesses).
An alternative is to group a number of dogs together to form a business unit which has a higher market share. However, turning dogs into a cash cow is not an easy process and is fraught with difficulties.
ANALYSIS / 7~1000 Research and Data Collection / 7~1050 Understanding the Business / 7~1130 Cash Flow / 7~1140 Diagram Boston Consulting Group matrix / Wild cats (question marks)
Wild cats (question marks)
These have high growth but low market share the worst cash characteristics of all. This name is derived from wild catting as in oil drilling a chance of a bonanza. There is uncertainty as to the future but the chances are such that one is prepared to invest. A number of high tech companies have been wild cats and, with the benefit of hindsight, questionable ones at that!
ANALYSIS / 7~1000 Research and Data Collection / 7~1050 Understanding the Business / 7~1130 Cash Flow / 7~1140 Diagram Boston Consulting Group matrix / Stars
Stars
Stars have high growth and high market share, and are potential winners. Typically, while they consume cash, and large amounts of it, they hold the promise of large returns. Many people believe Internet stocks fall into this category.
ANALYSIS / 7~1000 Research and Data Collection / 7~1050 Understanding the Business / 7~1130 Cash Flow / 7~1150 Effects of cash flow profiles on value
7~1150
Effects of cash flow profiles on value
In times of high interest rates and/or economic uncertainty, a business with an existing positive, maintainable cash flow is more desirable than one with prospective future earnings. Similarly, in times of low interest rates but high economic pessimism there will be less demand for future stars and greater demand for stable cash earners. The trade-off is of course profits and cash flows today with relative certainty versus future profits and capital gains with a high degree of uncertainty (risk). Valuations are subjective and understanding the cash flow characteristics of the business being valued is very important when arguing for a high or low valuation of the business. Quality of cash flow is as important as quality of earnings. A management buy-out is more easily achieved with a cash cow than a star because of the cash flow profile, i.e. the stability or predictability of future cash flows. A decision to value cash flows must also consider the present and expected profit or earnings profile, and the economic circumstances that will affect the desirability of certain income profiles over others.
ANALYSIS / 7~1000 Research and Data Collection / 7~1050 Understanding the

Business / 7~1130 Cash Flow / 7~1160 Reconciling earnings to cash flow

7~1160
Reconciling earnings to cash flow
It is generally better to value cash flows (as they are the true determinant of future value) but, in certain circumstances, earnings can provide a good approximation of cash flows and, therefore, of value. The valuation of earnings may be appropriate in circumstances where the business or business segments: are well established; are not experiencing erratic growth; do not require significant or ad hoc capital expenditure; and are expected to generate a relatively consistent level of earnings into the foreseeable future.
The main differences between valuing earnings and cash flow revolve around: the amount of depreciation and amortisation charged against earnings; the amount of capital required to be reinvested to maintain the level of real productive capacity; and the amount of capital required to be invested in working capital.
Whether to value earnings or cash flow will depend on whether one is faced with the profile, for example, of high cash flow but poor profits, or the typical J curve of low cash flow and profits today but high cash flow and profits tomorrow. Any expectancy of high earnings but low cash flow or relatively static cash flow and then profits, needs to be thoroughly investigated. Cash flow and earnings-based valuations are discussed in more detail in the chapter Income Approach.
ANALYSIS / 7~1000 Research and Data Collection / 7~1210 Information Sources

7~1210
Information Sources
When we think of information needs in a valuation, we immediately think of financial statements, however, a business interacts with the outside world and so an understanding of the prospects of the economy and the industry that the business is operating in is essential in order to assess past results and the basis for projections. There is a plethora of information in the public arena for the valuer to gain a thorough understanding of the business being valued and its standing among its peers, competitors and in the business community generally. General economic conditions and particular risks associated with the industry in which the business operates also need to be understood. There may be critical economic indicators which have a material bearing on the past and projected performance. Similarly, Government policies of the day can dramatically affect prospects. As an example, the imposition of an increased tariff or customs duty could significantly reduce the demand for a product if there are local competitors. A valuation report can be seriously deficient if a key change in external circumstances is not noted. It is easy to overlook the relevance of external information to the business being valued. However, a
discussion with the key executives of a business will normally highlight the issues which they monitor in order to manage their business. The following categories and the links contained in the chapter on Reference Materials are not exhaustive but give an indication of the range of sources that are available when it is necessary to go searching for data on an industry. It is worth noting that good managers will have their pet information sources upon which they rely for trends in business conditions etc. Before undertaking research for this data, it is worth asking management for their sources at least as a starting point for further research.
ANALYSIS / 7~1000 Research and Data Collection / 7~1210 Information Sources / Information sources economic
Information sources economic
Central bank publications. Government/Treasury bulletins/statements. International economic commentaries from bodies such as the OECD and The Economist.
ANALYSIS / 7~1000 Research and Data Collection / 7~1210 Information Sources / Information sources industry
Information sources industry
Organisations supplying industry statistics. Trade publications (e.g. Mining Monthly). Stock Exchange library files. Industry associations and organisations. Organisations supplying comparative benchmark indicators. Stock Exchange Industry Analyses and Research Handbooks. Broker research on industries (as opposed to individual companies). Note, however, that these are frequently only available to private clients of the brokerage house.
ANALYSIS / 7~1000 Research and Data Collection / 7~1210 Information Sources / Information sources the company itself
Information sources the company itself
The companys web site. Trade publications (e.g. Mining Monthly). Stock Exchange library files. Dun and Bradstreet company data. Press clippings (these can be obtained quickly via database searches).
ANALYSIS / 7~1000 Research and Data Collection / 7~1210 Information Sources / Information sources competitors
Information sources competitors

Company web sites. Trade publications (e.g. Mining Monthly). Stock Exchange library files. Jobsons/Kompass Research Volumes. Annual reports of companies in similar businesses (these often discuss, on a broad level, economic factors impinging upon the profitability of the business). Press clippings (these can be obtained quickly via database searches).
ANALYSIS / 7~1000 Research and Data Collection / 7~1210 Information Sources / Information sources supply chain
Information sources supply chain
Customers and suppliers web sites. Government reports on the industry or related industries.
ANALYSIS / 7~1000 Research and Data Collection / 7~1260 Information Requirements

7~1260
Information Requirements
This section summarises the more important documents and information commonly required in a valuation. Every item will not necessarily be required in every valuation situation. Likewise, every organisation conducts itself differently, and maintains information in different formats using differing systems. Frequently, additional information will be required, but an initial review of the available information will alert the valuer to such additional items. There is a need, therefore, to take a mass of data and to organise it into a logical and understandable format. The process of information-gathering can be likened to a funnel and sieve approach. At the outset of the valuation, a very broad approach will be taken seeking out industry, economic and other data along with company-specific data such as financial statements, brochures, personnel lists, key contracts etc. As the valuation proceeds and the risk areas inherent in the business have been identified, questions and information requests can become more detailed, specific and revealing. An introductory meeting with key management and a tour of facilities will start the process, following the initial engagement. After reviewing the early data provided, lists of queries are drawn up and additional information is usually requested of management, together with further research conducted by the valuer from public information sources. Determination of earnings and cash flows to be valued, including the assessment of the nature of the business, can take between 50% and 75% of the total valuation time. That is, the preparation of the valuation and report documentation actually takes less time than getting the background information and the basic numbers right. It is not hard to understand why this is the case if the earnings or cash flows are incorrectly determined then the valuation will be fundamentally flawed.
The information-gathering process will differ greatly from valuation to valuation. It is also highly dependent upon whether the valuers client has full and complete access to the business and its management. Many of the data items discussed in the following sections will only be available to the valuer if the valuers client has been granted access. Even then, the owners of the business may require that the valuer enter into a confidentiality agreement to reduce the risk of commercially sensitive information being revealed in the valuation report. An understanding of which information is important in each circumstance is developed with experience. Visiting the businesss premises and meeting with management is usually most revealing. The USAs Revenue Ruling 5960 provides some guidance on the types of information that should be considered when preparing a valuation. Section 4 of the Ruling lists eight factors which although not all-inclusive are fundamental and which require careful analysis in each case: a. b. c. d. e. f. g. h. The nature of the business and the history of the enterprise from its inception. The economic outlook in general and the condition and outlook of the specific industry in particular. The book value of the stock and the financial condition of the business. The earning capacity of the company. The dividend-paying capacity. Whether or not the enterprise has goodwill or other intangible value. Sales of the stock and the size of the block of stock to be valued. The market price of stock of corporations engaged in the same or similar line of business having their stock actively traded in a free and open market, either on an exchange or over-the-counter.
Finally, all valuers should also adequately investigate the source and reliability of the information on which they rely when preparing a valuation report. A discussion of the main forms of data which often require analysis follows.
ANALYSIS / 7~1000 Research and Data Collection / 7~1260 Information Requirements / 7~1280 Initial List of Data Required
7~1280
Initial List of Data Required
Examples of typical data required are included in Appendix 1. This list should be tailored to suit the individual valuation assignment.
ANALYSIS / 7~1000 Research and Data Collection / 7~1260 Information Requirements / 7~1300 Other Questions/Items to Discuss
7~1300 1.
Other Questions/Items to Discuss
To what extent would the new owner be able to continue to use the company name or
derivations thereof? 2. 3. 4. 5. 6. What geographic restrictions would the parent company put on its exclusive agreement with the company? What is known of the attitude of suppliers to a change in ownership? What are the geographic limitations on the agencies? What is the tax loss status of the company? What are the amounts and terms of the liabilities currently owed to the parent company and how will these be treated after the sale of the shares in the company?
ANALYSIS / 7~1000 Research and Data Collection / 7~1260 Information Requirements / 7~1320 Annual Financial Statements
7~1320
Annual Financial Statements
The analysis of historic financial statements is an important tool used in determining value. However, historic information is only ever useful in that past performance may be a guide to future prospects. Where significant change to an operation has occurred, less importance should be placed on historic data and a greater emphasis placed on projections. In an ideal world, we seek financial statements which are audited and prepared using generally accepted accounting principles that have remained relatively consistent during the period of review. However, in the real world, we are often faced with annual financial statements which are not audited (particularly in the case of proprietary companies) and the use of accounting principles which, while potentially within the category of generally accepted, may not provide a reliable picture of the financial position. It is most important to understand the nature of the entity, the basis of the preparation of the financial statements, the accounting policies used, any departures these policies have taken from the accounting standards and then recast the financial statements if significant changes in accounting policies have occurred. Before placing reliance on unaudited financial systems, it is useful to assess the businesss internal control system, and the extent to which taxation considerations may have affected the way transactions have been recorded. In reviewing historic financial statements, the period of review needs to be considered. This period, which is representative of the companys general operations up to and including the time of valuation, is typically at least three years and preferably five years. This will of course depend upon the length of business cycles in the industry and the extent of changes to the business operations. Year to year comparability of the companys operations is a key issue in determining the suitability of historic financial statements. Often, operations will have changed significantly over the period of review (or are budgeted to change significantly). Dissection of the historic financial statements of those operations which are expected to continue, and also those that have ceased, been sold or are about to commence, is also required. Further discussion on financial statement analysis can be found in the chapters Review of Historic Accounts and Preparation and Review of Forecasts and Projections.
ANALYSIS / 7~1000 Research and Data Collection / 7~1260 Information Requirements / 7~1340 Interim Management Accounts
7~1340
Interim Management Accounts
Interim management accounts typically take two forms: internal management accounts; and interim financial information provided to a stock exchange by a publicly listed company.
Interim accounts may be unaudited or partially audited, e.g. balance sheet audit only. They may also contain more or less detail than end of year accounts. Interim financial statements are vital when the annual financial statements are out of date. In the case of a statutory valuation report, out of date means financial statements more than six months old. On a more practical level, however, and depending on the changing nature of the organisation, annual financial statements may be out of date in only two or three months. Accordingly, it is important to obtain copies of internal management accounts right up to the current period. This is particularly relevant in the case of an asset-based valuation where the business is not a going concern and losses have been incurred in the period since the last annual accounts. Interim statements often do not contain various adjustments that typically are made in the year-end statements, e.g. prepayments, accruals, inventory adjustments etc. Therefore, to interpret interim statements and compare them with year-end statements, it will often be necessary to obtain additional information so that such adjustments are consistently treated and any seasonal factors are also taken into account. For example, estimates of warranty provisions may need to be recast in the interim accounts so that they are comparable with end of year accounts. This is best achieved by using spreadsheet software. The historic accounts are shown alongside interim accounts, together with columns for adjustments to each set of accounts. The restated accounts can then be used for analysis.
ANALYSIS / 7~1000 Research and Data Collection / 7~1260 Information Requirements / 7~1360 Income Tax Returns
7~1360
Income Tax Returns
Income tax returns can be particularly revealing in the case of small companies where more innovative and creative accounting policies may have been adopted for the purpose of income tax reporting. However, as with commercially sensitive information, the valuer needs to be aware of the impact that revealing inconsistent tax and accounting information may have on the clients or owners business. A review of income tax returns is important. Typically, people do not deliberately overstate profits and income for tax purposes; thus a reconciliation of profit figures shown on tax returns with profit figures presented in the financial statements is a vital step. There are justifiable and legitimate reasons why taxable income differs from accounting profit, even in large companies. These reasons will include timing and permanent differences relating to accelerated tax deductions, deductions allowable for tax purposes which may not be expensed for accounting purposes, and items of expenditure which may not be allowable tax deductions. The differences need to be understood to ensure a consistent picture of the companys historic profitability is obtained.
As an earnings based valuation or discounted cash flow (DCF) valuation based on post-tax cash flows inherently assumes a given level of taxation (usually a full corporate tax rate), it is important to ensure that any accelerated deductions etc. are considered when determining this tax charge. The availability and quantity of income tax losses in the future which could be offset against taxable income is also determined by reviewing income tax returns.
ANALYSIS / 7~1000 Research and Data Collection / 7~1260 Information Requirements / 7~1380 Asset/Liabilities Listings
7~1380
Asset/Liabilities Listings
These will provide detailed support for the financial statements and other key financial information and include: an aged debtors schedule and customer listing; an aged creditors schedule and supplier listing; an aged inventory schedule and parts (inventory) listing; other asset and prepayment schedules; and schedules of real estate, plant, equipment and depreciation.
The major purpose of obtaining such listings is to examine and identify special factors which may affect the valuation. Uncollectable debtors, unsaleable inventory, undervalued properties etc. can have a bearing on the valuation. Furthermore, the existence of major or significant debtor/creditor relationships with customers and suppliers needs to be ascertained. Analysis of customer information is important in gaining an understanding of the source of the companys sales. For example, a detailed analysis of customer information may reveal reliance upon one or a handful of customers, credit difficulties with particular customers or customer loyalty issues. This necessitates going behind the aged debtors schedule and obtaining individual customer details from the customers trading history with the company. As with detailed debtor information, analysis of creditors can provide useful information. Reliance upon one or a handful of suppliers can pose a significant business risk. Quality difficulties or repeated returns can also highlight supply problems which could disrupt future operations. Restrictive contracts with suppliers may also inhibit changes in the future direction or product mix of the company. The company could be tied into the purchase of particular inputs to the production process which may not be economically efficient for the company. Reluctance or refusal by suppliers to extend credit may also indicate working capital deficiencies in the business. These latter issues may impinge directly on the goodwill element of the valuation as the required rate of return increases to compensate for the risks involved.
ANALYSIS / 7~1000 Research and Data Collection / 7~1260 Information Requirements / 7~1400 Budgets/Projections
7~1400
Budgets/Projections
Budgets and projections are critical since the value of a company ultimately depends on what the
company will accomplish in the future. Clearly, any form of discounted cash flow valuation will be based on projections of future cash flows. However, the amount of detail that is usually required in the valuation process may not exist in the current projections prepared by the company. It is often necessary to revise existing budgets and cash flow projections specifically for the purpose of the valuation and extend them for a number of years where necessary. Profit projections will need to be extended to provide detailed cash flows and balance sheet projections. This ensures that management has addressed capital and other infrastructure requirements necessary to achieve the profit projections, and provides a further guide as to whether budget assumptions are reasonable. It is worthwhile obtaining budgets and projections for historic periods in addition to future periods. A review of past budgets against actual results will usually reveal how accurate and reliable the budgeting process is. This may give some comfort (or concerns!) as to the accuracy and reliability of current budgets. Interim financial statements are also useful in assessing whether budgets are likely to be attained. Of particular interest will be the management commentaries reporting on the purposes of the organisation and explaining why budgets were, or were not, met, and the action being taken as a result.
ANALYSIS / 7~1000 Research and Data Collection / 7~1260 Information Requirements / 7~1420 Capital Expenditure Requirements
7~1420
Capital Expenditure Requirements
Capital expenditure requirements will in part determine the need of the company to retain cash versus its ability to pay out earnings. Depreciation is frequently used as a substitute for the cash flows associated with capital maintenance and replacement programs. However, when depreciation is clearly not an acceptable substitute, detailed capital expenditure estimates are required. This applies whether the valuation is on an earnings capitalisation basis or discounted cash flow basis. The question of technological obsolescence can sometimes arise in industries which are undergoing significant change in manufacturing processes. For example, wet cell battery manufacture underwent significant technological change in the late 1980s (the first in nearly 50 years!). To maintain competitiveness, manufacturers needed to spend significant amounts on upgrading and replacing production lines. In these circumstances, depreciation estimates based on existing equipment would not be an acceptable substitute for the cash flows, and detailed cash flow projections of the capital expenditure would be required. If discounted cash flow projections are employed for the valuation, care should be exercised in ensuring that an adequate ongoing level of capital expenditure is provided in the terminal value calculation, or as a separate deduction from future cash flows. For example, an assignment undertaken by Leadenhall involved a business with asset lives of around 100 years. As these assets were installed over a very long time horizon, the near-term cash flow projections did not reflect the overall capital replacement program of the business. This necessitated separate net present value calculations of the asset replacement program over a full 100-year life cycle to reflect the net present value of expected capital expenditure over and above that reflected in the near-term projections.
ANALYSIS / 7~1000 Research and Data Collection / 7~1260 Information

Requirements / 7~1440 Working Capital Requirements

7~1440
Working Capital Requirements
Projections of working capital requirements are also required if the company is going through a significant growth phase and working capital increases are expected. In the event that debt funding is unavailable, equity funding may need to be raised to enable the working capital increase so that the expected profitability increases can be realised.
ANALYSIS / 7~1000 Research and Data Collection / 7~1260 Information Requirements / 7~1460 Contractual Obligations
7~1460
Contractual Obligations
Most substantial companies are a party to various contractual obligations. These will include (as a brief example): supply agreements; purchase agreements; operating leases; premises leases; award constraints; enterprise bargaining/union agreements; restrictive covenants over geographic trading areas; and employment contracts with key personnel etc.
Careful research may be needed to unearth all the major contractual obligations. A number of contingent and off balance sheet liabilities can be created through these contractual obligations. The provision of guarantees and letters of comfort to banks, major customers and others may also need to be assessed for their impact on the ongoing business.
ANALYSIS / 7~1000 Research and Data Collection / 7~1260 Information Requirements / 7~1480 Brochures, Catalogues and Price Lists
7~1480
Brochures, Catalogues and Price Lists
Brochures, catalogues and price lists issued by the company are often a good starting point in the information-gathering process as they are frequently the most common public source of information about the company. Company brochures are often quite enlightening with respect to the competitive advantages claimed by the company. In selling its product, the company will often make claims about a products efficiency or effectiveness, quality or lack of availability from other suppliers. Often these marketing claims are what the business relies on for its success. It is always worth investigating whether the message the company gives to the public agrees with the message that the company gives to the valuer. Sometimes price lists will highlight the availability of special trade or other discounts and these may not have been properly taken into consideration in the budgeting process. Client management sometimes overlooks that a particular product always carries a discount or that trade discounts are offered consistently to particular customers.
ANALYSIS / 7~1000 Research and Data Collection / 7~1260 Information Requirements / 7~1500 Key Personnel Lists
7~1500
Key Personnel Lists
An organisational chart should be obtained which identifies key personnel. This will also help identify weaknesses in the companys infrastructure, such as insufficient resources in marketing or quality control. Once the key personnel are identified, details of their employment history, together with brief curricula vitae, should be obtained. If a change in control of the company has precipitated a need for the valuation, it is important to consider whether these key personnel will remain with the company after the change in control, as suggested by the following quote: The major assets of [many businesses] go down in the lift and out into the car park at night. Its difficult to get a bank guarantee against them. (David Brocklehurst, April 1991) In addition, the key personnel list can be used as a tool to highlight accrued employee liabilities and whether they have been fully provided for in the financial statements.
ANALYSIS / 7~1000 Research and Data Collection / 7~1260 Information Requirements / 7~1520 Patents, Copyrights and Trade Marks
7~1520
Patents, Copyrights and Trade Marks
The valuation of many companies will include a value for certain identifiable intangible assets such as patents, copyrights and trade marks. Sometimes this extends to items such as drawings or computer images of products, intellectual property relating to the development of computer software, chemical formulae, manufacturing processes etc. In some companies, the ownership or access to particular patents or other identifiable intangibles can be crucial. For example, the manufacture of Coca Cola products may be relatively worthless without access to, and continuing rights to, the Coca Cola name. The introduction of accounting standards specifically covering the acquisition of assets has meant that a number of companies have considered the value of identifiable intangible assets and will, at least, have developed lists of potential candidates for inclusion in this category. (If a list has not been developed, it will need to be produced as these assets must be separately identified if the business is purchased.) Where the existence of a patent or other right is of paramount importance to the continuation of the company, it is essential to determine the life of the right, the extent to which it is exclusive to the company being valued and the ability of others to replicate or create similar concepts, products or services etc. The absence of a patent or other protection should be carefully considered as it may not represent a significant risk to the business. The practicalities of patenting are such that certain products are best marketed as quickly and aggressively as possible. Alerting potential competitors to a new product by lodging a patent application may be detrimental to the successful exploitation of the companys products. Undeniably, world breakthroughs in, for example, a generic form of chemical therapy may not be
particularly valuable unless patent protection exists. Accordingly, the valuer needs to consider the stage of the product life cycle that the companys products are at and determine whether patent protection provides substantial commercial benefits.
ANALYSIS / 7~1000 Research and Data Collection / 7~1570 Appendix 1 List of Initial Information Required
7~1570
Appendix 1 List of Initial Information Required

Attached is a sample List of Information Required template.
1.
Economic information Commodity prices. Inflation (prices, labour costs, asset prices etc.). Disposable incomes. Exchange rates. Interest rates. Credit availability and other factors. Other national, regional and local economic data as required.
2.
Background Company history, reputation and competitive position. Brochures and profiles on the company and its activities. Why the company is for sale/why would a purchaser want to buy this company? The assets and liabilities and the legal structure. Corporate structure of companies and divisions in the group. Business plan. SWOT (strengths, weaknesses, opportunities and threats) analysis. Names of key personnel. Catalogues and price lists.
3.
Product concept The current products: History of the development of the products. Technical description of products. Description of why they are unique or why they are better than those offered by competitors. Reasons for any competitive technology or products failure. R&D required for commercialisation. The consumer needs which are fulfilled by the products. Details of any independent opinions (formal or informal) as to the efficacy of the
technology employed (in the products). 4. How technological changes will affect the products.
Further R&D plans. Product families, new lines, products and developments. Patents, licences, contracts and protection of intellectual property. Major clients and any known expected purchasing requirements.
Organisational structure Management team profiles including past experience. Organisational chart. Proposed salary packages for the team. Operational personnel and associated salary packages. Whether or not key employees are willing to continue on with new owners. How long have key staff been in current positions? Will existing key staff be easy to replace if they do leave?
5.
Market research (Note: State all assumptions and list sources of all data) A copy of any data showing industry trends or economic indicators which are relevant to the business. Industry research: Definition of the market (what industry is it in?). What size is the market now and what will it be in the future (two years/five years)? Details or copies of any independent market size/growth studies prepared by Government/industry bodies. Market characteristics (is it a stable, mature market or dynamic, emerging market?). Is there under- or over-capacity in the industry. Rate of business failure in the industry. Likely major applications. Likely major customers and details of loyalty discounts paid. Industry trends. Price sensitivity, product substitution and possible import competition.
Proposed pricing strategy. Details of markets by geographic areas including: Market size. Market growth or decline. Details of any restrictions on distribution areas.
Market penetration expected. Lead times to achieve market penetration. Any statutory and other approvals required to achieve desired target market penetration.
Competitor analysis including: List of major competitors, their size and relevant market standing. Selling prices of competitors products and units sold. Explanation as to why competitors products will supplant other products or increase their market share. Competitors market share. Anticipated reaction to this product by competitors.
6.
Basis for market share data provided. Reaction to the product by potential customers. Outcome of formal market research, e.g. focus groups.
Marketing strategy Likely distribution channel and reason for selection. Proposed product promotion. Pricing strategy (volume discounts, trade, demand, cost plus etc.). Anticipated changes in selling price over time. Likely selling price response to competition. Geographic priorities. Government, regulatory or statutory approvals required. Interdependence of the product on other products, processes or services. Impact of obsolescence. Market niches.
7.
Manufacturing plan Manufacturing options. Manufacturing by lease of existing plant (including packaging). Manufacturing by building a new plant (including packaging). Sub-contracting plans (if any). Inventory policy. Production planning. Geographic location of other plants over time. Availability of raw material. Evaluation of raw material suppliers. Quality control and accreditation requirements.
8.
Proposed warranty, product recall policy. Critical components in production. List of significant contracts/work in progress (including copies of distribution/agency agreements).
Financial analysis (historic, say for five years) Management profit and loss statements including: Sales analysis by product. Gross margin analysis by product. Break-down of turnover and contribution to profit by Head Office and each branch. Order back-log situation. Method of accounting for tools, dies. Details of warranties (including original suppliers). Explanation/schedule of interest receivable/payable. Explanation/schedule of large increases and variations in individual line items of financial statements including budgets. Schedule of abnormal/extraordinary items included in financial statements. Budgets for historic periods.
Management balance sheets including: Schedule of the effect, if any, of inconsistent accounting policies or cut-off difficulties between periods covered by the financial statements. Aged creditors schedule. Basis of valuation of inventory. Detailed list of inventory including turnover, trends and fluctuations. Identification of old/surplus inventory and write-downs made or required. Aged debtors schedule. Liabilities on leased assets. Schedules of employees leave entitlements (including any not recognised in the accounts, e.g. sick leave, rostered days off and possibly long service leave). Severance pay liabilities. Schedule of any contingent liabilities.
Statutory accounts including: Reconciliation to management accounts. Confirmation of accounting policies in use.
Statement of cash flows. Details of assets employed in the business including: Depreciation schedule. Depreciation policies and rates.
List of assets used in the business. Schedule of assets surplus to operational needs of the business. Details of any recent valuations of assets used in the business.
Tax returns and details including: Reconciliation between accounts and tax return. Schedules of carried forward tax losses. Schedule of franking credits. Details of any investigations into historic accounts.
9.
Financial analysis (for, say, next five years) (Note: All assumptions to be detailed and sensitivity analysis to identify impact of critical variables on forecasts to be included.) Sales growth by product. Gross margin analysis by product. Profit and loss budgets. Projected balance sheets. Projected cash flows. Officers compensation list. Details of assumptions underlying the budgets. Future capital expenditure plans and explanation of scenarios under which such expenditure might be incurred. Assumed capital structure. Dividend policy.
10.
Other information required Schedule of insurances. List of patents and copyrights. Related party information. List of trade association memberships and industry information sources. Details of any litigation pending or in progress. Officers and directors compensation schedule including all employee benefits, expense allowances and superannuation. Schedule of worker compensation claims. Confirmation of availability to purchaser of company name, relevant brand names and other intellectual property, and restrictions on geographic areas of use. Listing of significant contracts.
11.
Statutory records Memorandum and Articles of Association.
Shareholders agreements. Where there are different classes of shares: the proportionate relationship of the partial interest to the whole; the level of control that ownership interest will result in; whether there are any clauses or agreements limiting the transfer of the shares or units; the specific rights and obligations of that class of shares or units as compared to the other classes; and whether there are any agreements restricting the transfer of the management of the company as distinct from the ownership of the company.
ANALYSIS / 8~1000 Review of Historic Accounts

8~1000
Review of Historic Accounts
A review of past trading performance through historic accounts (financial statements) is an integral step in understanding the current operations and future potential of a company. Taken on face value, the financial statements of a company may provide a misleading picture of the companys true cash generating ability. This arises due to the underlying differences between cost based accounting standards and cash flow based valuation methods. The choice of accounting procedures which can be applied, for example, depreciation methods, may also lead to manipulation of profits, again providing a misleading insight into the business. This chapter focuses on adjustments to accounts that may be required and the analytical review techniques which can be employed in assessing the past profitability and risks of an entity. Such an analysis will provide the valuer with a more precise view of the companys past economic value which, in turn, lays the foundation for projecting its future economic value. (See the chapter Preparation and Review of Forecasts and Projections for a complete discussion on projections.) This chapter covers: reasons for undertaking financial analysis of historic accounts; the importance of the integrity of financial data; commonly required adjustments to accounts; a suggested adjustment template; and financial analysis.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1050 Reasons for Undertaking Financial Analysis of Historic Accounts
8~1050
Reasons for Undertaking Financial Analysis of Historic Accounts
The analysis of historic accounts and information is only useful to the extent that it provides a guide to the future performance or profitability of an organisation. With the use of spreadsheets and special purpose analytical software, extensive analysis can be undertaken economically.
An analysis of historic financial statements, preferably up to five years, and then the budgets for two or three years into the future, is a valuable precursor to a valuation. A cross-analysis of past tax returns may also prove beneficial. In reviewing historic financial statements, the period of review needs to be considered. This period, which is representative of the companys general operations up to and including the time of valuation, is typically at least three years and preferably five years. This will of course depend upon the length of business cycles in the industry and the extent of changes to the business operations. Year to year comparability of the company operations is a key issue in determining the utility of historic financial statements. Often, operations will have changed significantly over the period of review (or are budgeted to change significantly). Dissection of the historic financial statements of those operations which are expected to continue, and those that have ceased, been sold or are about to commence, is also required. Often these analyses will raise questions such as: Why is the projected gross margin higher than actual? How will future growth be funded in the absence of the capacity to borrow? Why does budgeted capital expenditure not result in an increased return on total assets? How will losses (in the past) be transformed into profits (in the future)?
The answers to questions such as these are invaluable in assessing future profitability or cash flows and the risks associated with their realisation. Specifically, the valuer is interested in knowing: what, if any, profits and cash flow are available so that dividends can be paid; how the entity is progressing; what, if any, prospects exist for future growth which may enhance the value of the investment; what return an acquirer might receive from the investment; the risks of the investment; and the security that the investment provides.
This chapter does not canvass exhaustively all possible analytical tools but rather highlights the need for financial analysis as part of a valuation process. It is also important to remember that ratio analysis, by itself, is not particularly useful. It is equally important to understand the relationship between the entity being examined and the external environment in which it operates. This means gaining an understanding of the suppliers and customers, as both will influence a companys profitability and longevity in the market-place. A thorough understanding of the entitys products and/or services is also required. Ratio analysis will sometimes identify what appears to be a solid growth trend within product lines. However, many consumer products are me toos which have a very short life cycle due to a lack of differentiation. Also, to complement such an analysis, an understanding of the entitys customer base can provide insights into the likely continuing success of product and/or service lines. It should be clear prior to undertaking a valuation exactly what is being valued. For example, is the valuation to be of the entity itself (i.e. the corporate structure) or of one or more of the individual
business units which constitute the entity? Throughout this chapter, reference is made to both entities and businesses; however, the distinction between the two should be remembered.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1100 Additional Information Required

8~1100
Additional Information Required
A list of initial data required to commence the analysis of an entity was included in the chapter Research and Data Collection. Additional information that may be required during this stage of the assignment includes: confirmation of the accounting policies currently in use; confirmation of the accounting policies in use in previous periods; quantification of the effect of changes to tax regulations; pending (or recently passed) tax regulations that may have an impact; other pending (or recently passed) legislation that may have an effect on operations, the impact of which has not yet been fully experienced; quantification of the effect of any changes in accounting policies; quantification of the effect of changes to commonly accepted accounting policies; identification and quantification of unusual transactions which may need to be eliminated to normalise the accounts; adjustments necessary for cash based or hybrid financial statements to accrual (particularly for professional services entities); the qualifications and experience of the people responsible for preparing the accounts and whether there have been changes in the personnel responsible in the last few years; whether the accounts are audited; and past appraisals.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1150 Importance of Understanding Business Objectives
8~1150
Importance of Understanding Business Objectives
It is critical to identify the reason for analysing historic financial statements and the particular issues on which to concentrate. The focus of the analysis will vary considerably depending on the nature, profession or industry, and motivations of the organisation analysed. For example, the key financial indicators and ratios for a business that operates an open-cut coal mine will differ significantly to those appropriate for a metal products manufacturer. Set out below is a decision tree which highlights the key questions in determining the focus of the analysis:
The objectives of the organisation will place a different emphasis on different ratios. Examples of some diverse organisational objectives are listed below: Many family-owned companies exist primarily for the employment of family members. A closely-held business may aim to generate the greatest amount of cash flow and benefits for its owners. A gold mining entity may have as its primary objective the production of a certain quantity of gold each year to satisfy the needs of its loan repayments.
A charitable organisation may have as its principal objective the provision of shelter and education for disabled children. A shipbuilding entity may have a short-term objective of technological advancement.
Each of these motivations or objectives may be pursued by the organisations via different strategies, the implementation of which can be manifested in differing financial indicators between organisations. For example, the acquisition or improvement of new technology could occur by buying in the technology or implementing an in-house research and development facility. The financial implications of these two strategies would differ. For the valuer, an entitys ability to generate future cash flows is of paramount importance and the importance of cash flow is an issue which is considered throughout this text.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1200 Integrity of Financial Data

8~1200
Integrity of Financial Data
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1200 Integrity of Financial Data / 8~1220 Sources and Age of Information
8~1220
Sources and Age of Information
While the use of external information is usually critical to understanding the fortunes of a company, outdated external information or information from a dubious source (and there are many of these on the Internet) can very easily mislead the valuer. When gathering information, care should be taken to discard any material that is clearly out of date or from an unreliable source. Unless the information is of an enduring nature, current, up-to-date information is the key to useful background data.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1200 Integrity of Financial Data / 8~1240 Consistency/Comparability of Financial Information
8~1240
Consistency/Comparability of Financial Information
The basis of meaningful financial analysis begins with financial statements that have either been prepared on a consistent and comparable basis or been adjusted to account for any inconsistencies. There are a number of limitations involved in using historic financial statements. Some of these arise from the accounting and reporting processes themselves. Financial statements of audited entities are more likely to display consistency from year to year and period to period than unaudited financial statements. We expect the consistent treatment of particular items in financial statements because of the doctrine of consistency, which is one of the cornerstones of generally accepted accounting principles. This doctrine requires that once an accounting policy has been adopted by a company, it should then be applied consistently from one reporting period to the next. In the event that changed circumstances necessitate a departure from the adopted policy, or a change in policy altogether, the effect of that change is required to be reported where it is material.
The first place to look in assessing the extent of consistency between periods is in the notes to the financial statements which detail the accounting policies adopted by the company. This is usually note 1. The development of accounting standards is an attempt by the regulators and accounting bodies to enhance consistency. Consistency, of itself, will not ensure that financial statements are comparable from period to period. The addition of a new business or product line will often mean the current periods financial statements are not comparable with prior periods. In order to restore some semblance of comparability, it may be necessary to make adjustments to either the current or past periods. If adjustments are made to the current periods financial statements in order to make them comparable with the historic financial statements, the valuer must be aware that the entity has changed significantly and that restricted comparative analyses can be conducted on the new elements of the entity.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts
8~1290
Commonly Required Adjustments to Accounts
The accounting of private companies is often tax driven; it is not uncommon to see a relatively large private entity with a history of financial statements showing poor profitability but an accumulation of a relatively large asset base. One must look beyond the financial statements to understand the operations of the entity and the motivations of the owner. Private entity entrepreneurs are typically concerned with cash flow and wealth creation, not payment of income tax. One technique that can be used is to recreate statements of position at various dates and then to explain how wealth was created from one date to the next. This will often highlight the financial statements which require adjustment. The object of undertaking this type of analysis is the calculation of future maintainable earnings. In essence, future maintainable earnings represent the expected level of after-tax profits to be generated consistently by the entity for at least a further five years (and, in many cases, significantly longer). Future maintainable earnings is a key determinant of what cash will be generated by the entity. The starting point for the determination of future maintainable earnings is an assessment of historic earnings and budgeted earnings. It is therefore necessary to adjust for any items which are not representative of the entitys ongoing earnings capacity. The following items are indicative of the types of adjustment that need to be considered: standardisation of accounting policies to internationally accepted policies, and ensuring these are applied consistently across the years; elimination of unusual transactions; excessive owners remuneration or, conversely, inadequate owners remuneration; funding costs where an alternative funding structure is anticipated or where funding is on a fixed rate basis and interest rates have moved significantly; the legal ownership of assets used in the business; and the depreciation policy and whether it correctly reflects asset consumption.
The objective in adjusting historic results is to arrive at a pro forma profit and loss account which is representative of future maintainable earnings. In developing the pro forma, consideration should be given as to whether some mix or weighting of prior results (either in total or on a line by line basis) is appropriate. Great care must always be taken in assuming that historic growth rates for profit or revenue will continue into the future, and using those growth rates to project forward. As earnings are a residual calculation (being revenue less costs), there is scope for a small variation in revenue or expenses to impact significantly upon profit. Accordingly, a sound understanding of historic profits and the reason for their growth must be gained before attempting to project historic results into the future. The period of review should be long enough to cover any cyclical fluctuations and should exclude any periods where conditions were substantially different from those at present and expected. In other words, it is necessary to ascertain what period of analysis will produce a result that is representative of the entitys ongoing maintainable earnings capacity. A number of creative accounting techniques can be employed and these can distort earnings from year to year. It is important to look behind financial statements and ascertain, and adjust for, any creative accounting techniques which have been used. Often, these can be identified through the application of ratio analysis and common sense after a physical inspection of the operation, and then relating those to the financial statements. It is also easy to assume that staff, managers, customers and suppliers (especially in a small business) will continue under new management or ownership. In fact, many of these will change due to loyalties to prior owners. As a result, when conducting a valuation for the purpose of sale it is necessary to understand the level of continuity which can be expected amongst the staff, managers, customers and suppliers. Similarly, if the entity being valued has recently suffered some form of liquidity crisis, it is possible that suppliers will look to shorten credit terms and hence increase the amount of working capital which is required in the entity. This should be accounted for in the valuation process by providing for additional working capital.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts / 8~1310 Standardisation of Accounting Policies
8~1310
Standardisation of Accounting Policies
When reviewing historic accounts, the valuer should ensure that: commonly accepted accounting policies and practices have been applied; accounting polices have been applied consistently across all years; the accounting policies applied give a true and fair view of the historic results; the accounting policies will be those applied in future years; and all trends are indicative of future expected performance.
Movements toward the adoption of uniform standards are occurring. As noted by the International Accounting Standards Board on its web site <www.iasb.org>:
Many countries already endorse International Accounting Standards as their own either without amendment or else with minor additions or deletions. Furthermore, important developments are taking place in the European Union, where the European Commission is progressing proposals that will require all listed companies in the European Union to prepare their consolidated financial statements using International Accounting Standards. Already, both inside and outside the EU, many leading companies have stated that they prepare their financial reports in accordance with International Accounting Standards. This movement to International Accounting Standards may require: historic accounts to be adjusted so that common standards are applied to all years to facilitate the analysis of the historic accounts; and the accounts of one company to be adjusted so that a comparison can be made of the companys performance with the performance of another company that has already adopted IFRS.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts / 8~1310 Standardisation of Accounting Policies / 8~1315 Cross border valuation considerations
8~1315
Cross border valuation considerations
Prior to commencing the detailed analysis, it is worthwhile considering on what basis the accounts have been prepared and what additional accounting policies should be introduced. The common accounting policies that apply will vary depending on the country in which the entity operates, and also on the country in which any parent entity is located. When performing international or cross border valuations, valuers need to be particularly aware of the accounting policies being used by both the entity being valued and the accounting policies being used as the basis for the valuation. For example, if a US parent is valuing its Malaysian subsidiary, have US or Malaysian accounting policies been used? In December 2000, in a survey by the International Federation of Accountants, the large accounting firms completed a 53-country survey of the differences between national accounting rules and the International Accounting Standards. This survey was repeated in December 2001 with over 60 countries included. In December 2002, the International Federation of Accountants survey sought an overview of country plans regarding the convergence of International Accounting Standards and found that: Over 90 percent of the surveyed countries intend to converge with IFRS. However, there are still difficulties in achieving the goal of uniform global accounting standards. Even after the adoption of International Financial Reporting Standards (IFRS) in many countries, there continue to be instances of local modification to the accounting standards and/or inertia in getting local practices to fall in line with those proposed in the IFRS.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts / 8~1310 Standardisation of Accounting Policies / 8~1320 Corporations Act 2001 requirements
8~1320
Corporations Act 2001 requirements
The following extracts from the Corporations Act 2001 provide some useful insights on Australian issues.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts / 8~1310 Standardisation of Accounting Policies / 8~1320 Corporations Act 2001 requirements / Sections 292294 Who has to prepare financial reports
Sections 292294 Who has to prepare financial reports
Sections 292294 specify those companies that are required to prepare annual financial reports and directors reports.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts / 8~1310 Standardisation of Accounting Policies / 8~1320 Corporations Act 2001 requirements / Section 295 Contents of annual report
Section 295 Contents of annual report
This section requires the financial reports for a financial year to consist of: The financial statements for the year are: a. b. c. d. a profit and loss statement for the year; and a balance sheet as at the end of the year; and a statement of cash flows for the year; and if required by the accounting standards a consolidated profit and loss statement, balance sheet and statement of cash flows (section 295(2)).
The notes to the financial statements (section 295(3)). The directors declaration about the statements and notes (section 295(4)).
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts / 8~1310 Standardisation of Accounting Policies / 8~1320 Corporations Act 2001 requirements / Section 296 Compliance with accounting standards
Section 296 Compliance with accounting standards
Section 296(1) states: The financial report for a financial year must comply with the accounting standards. However, a small proprietary companys report does not have to comply with particular accounting standards if: a. b. the report is prepared in response to a shareholder direction under Section 293; and the direction specifies that the report does not have to comply with those
accounting standards.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts / 8~1310 Standardisation of Accounting Policies / 8~1320 Corporations Act 2001 requirements / Section 297 True and fair view
Section 297 True and fair view
Section 297 states: The financial statements and notes for a financial year must give a true and fair view of: a. b. the financial position and performance of the company, registered scheme or disclosing entity; and if consolidated financial statements are required the financial position and performance of the consolidated entity.
This section does not affect the obligation under Section 296 for a financial report to comply with accounting standards. Clearly, the meaning of the words true and fair view are critical to the preparation of a companys accounts. In addition, they are crucial to auditors because, pursuant to section 308(1)(b) of the Corporations Act 2001, auditors must state in their report to members whether the accounts present a true and fair view. The interpretation of true and fair view which finds the most favour with accountants is that it is a technical term which simply means that accounts must be prepared in accordance with accepted accounting standards that are consistently applied. For example, the preamble to Recommendation 18 of the Institute of Chartered Accountants in England and Wales includes the following significant paragraphs: 3. The function of a balance sheet is to give a true and fair view of the state of affairs of the company as on a particular date. A true and fair view implies appropriate classification and grouping of the items and therefore the balance sheet needs to show in summary form the amounts of the share capital, reserves and liabilities as on the balance sheet date and the amounts of the assets representing them, together with sufficient information to indicate the general nature of the items. 4. A true and fair view implies the consistent application of generally accepted principles. Assets are normally shown at cost less amounts charged against revenue to amortise expenditure over the effective lives of the assets or to provide for diminution in their value
That interpretation is however erroneous. The Corporations Act 2001 itself recognises that compliance with accounting standards may not give a true and fair view. If there is any doubt about this, we need only look at what the auditor must certify in their section 308(1) report. As cited above, that report must state whether the accounts are, in the auditors opinion,
properly drawn up: in compliance with the accounting standards; and give a true and fair view.
If true and fair view simply meant in accordance with accounting standards, why would the Corporations Act 2001 section 308(1) deal with those two matters separately? On any basis of statutory interpretation, the words true and fair view mean more than in accordance with accounting standards. Since the 1960s, academics and case law appear to support the proposition that to be true and fair balance sheets must report the net worth of a company at the end of the accounting period and profit and loss accounts must represent the change in net worth over that period (Accounting Principles and Law, Prof. Chambers (1973) 1 ABLR 112). If those academics are correct and a companys balance sheet does not show a true and fair view in terms of the net worth of that company at the end of its accounting period, directors, their advisers, auditors and the accountants involved in the preparation of those accounts will have committed criminal offences and exposed themselves to personal liability.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts / 8~1310 Standardisation of Accounting Policies / 8~1330 Accounting standard requirements
8~1330
Accounting standard requirements
For Australian companies, accounting polices are dictated to a large extent by the accounting standards issued by the Australian Accounting Standards Review Board. For legal entities not governed by the Corporations Act 2001, i.e. partnerships and sole traders, accounting policies are issued as Australian Accounting Standards. In virtually all respects, the two sets of standards are identical. The full list of AASB accounting standards (operative from 31 March 2005, excluding AASB 20043 which is operative from 1 January 2006) is set out below. AASB Framework AASB 1 AASB 2 AASB 3 AASB 4 AASB 5 AASB 6 AASB 101 AASB 102 AASB 107 Description Framework for the Preparation and Presentation of Financial Statements First-time Adoption of Australian Equivalents to International Financial Reporting Standards Share-based Payment Business Combinations Insurance Contracts Non-current Assets Held for Sale and Discontinued Operations Exploration for and Evaluation of Mineral Resources Presentation of Financial Statements Inventories Cash Flow Statements
AASB AASB 108 AASB 110 AASB 111 AASB 112 AASB 114 AASB 116 AASB 117 AASB 118 AASB 119 AASB 120 AASB 121 AASB 123 AASB 124 AASB 127 AASB 128 AASB 129 AASB 130 AASB 131 AASB 132 AASB 133 AASB 134 AASB 136 AASB 137 AASB 138 AASB 139 AASB 140 AASB 141 AASB 1004 AASB 1023 AASB 1031 AASB 1038 AASB 1039 AASB 1045 AASB 1046
Description Accounting Policies, Changes in Accounting Estimates and Errors Events after the Balance Sheet Date Construction Contracts Income Taxes Segment Reporting Property, Plant and Equipment Leases Revenue Employee Benefits Accounting for Government Grants and Disclosure of Government Assistance The Effects of Changes in Foreign Exchange Rates Borrowing Costs Related Party Disclosures Consolidated and Separate Financial Statements Investments in Associates Financial Reporting in Hyperinflationary Economies Disclosures in the Financial Statements of Banks and Similar Financial Institutions Interests in Joint Ventures Financial Instruments: Disclosures and Presentation Earnings per Share Interim Financial Reporting Impairment of Assets Provisions, Contingent Liabilities and Contingent Assets Intangible Assets Financial Instruments: Recognition and Measurement Investment Property Agriculture Contributions General Insurance Contracts Materiality Life Insurance Contracts Concise Financial Reports Land Under Roads: Amendments to AAS 27A, AAS 29A and AAS 31 Director and Executive Disclosures by Disclosing Entities
AASB AASB 1046A AASB 1048 AASB 20042 AASB 20043
Description Amendments to Accounting Standard AASB 1046 Interpretation and Application of Standards Amendments to Australian Accounting Standards Amendments to Australian Accounting Standards
The standards can be accessed at <www.aasb.com.au>.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts / 8~1310 Standardisation of Accounting Policies / 8~1340 Accounting policies requiring adjustment
8~1340
Accounting policies requiring adjustment
Adjustments to accounts may be required as a result of differences in international accounting policies, particularly when performing international or cross border valuations. The effect of these differences in accounting policies must be considered, and the necessary adjustments to accounts made, prior to undertaking a valuation. In Australia, the accounting policies that commonly cause concern and which may require adjustments to the accounts include the following:
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts / 8~1310 Standardisation of Accounting Policies / 8~1340 Accounting policies requiring adjustment / Accounting for joint ventures
Accounting for joint ventures
In the circumstances where the entity being valued is party to a joint venture, it is crucial to determine how the expenses are accounted for and whether the expenses are being paid and accounted for in the correct legal entity. In the event that a joint venture partner is bearing the expenses of the joint venture (or vice versa), then adjustments to the accounts will be required to ensure they are not misstated, so that a correct calculation of future maintainable earnings can be made.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts / 8~1310 Standardisation of Accounting Policies / 8~1340 Accounting policies requiring adjustment / Accounting for leases
Accounting for leases
Small, privately-held companies often do not comply with the requirements of international accounting standards on capitalising leased assets. This can result in a misstatement of the assets and liabilities of a company (taking a form over substance approach) and may require adjustment.
Where the leases have been capitalised, it is important to ensure that the balance of the assets and liabilities are correctly stated at year end, that lease payments have been correctly accounted for and that amortisation of the leased asset is added back in any calculation of the cash generated by the business.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts / 8~1310 Standardisation of Accounting Policies / 8~1340 Accounting policies requiring adjustment / Accounting for revaluation of non-current assets
Accounting for revaluation of non-current assets
It is not uncommon to find that the value of assets recorded on the balance sheet does not agree with their recoverable amount. Valuers should enquire about the current recoverable amount of all non-current assets and, if necessary, make an adjustment to reduce their carrying amount to the recoverable amount.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts / 8~1310 Standardisation of Accounting Policies / 8~1340 Accounting policies requiring adjustment / Accounting for goodwill
Accounting for goodwill
Although the amortisation of goodwill does not affect the cash generated by a business, it will affect the reportable profit. This may then affect some common stock ratios. Where a company has capitalised goodwill, it is prudent to ensure it is being amortised at an appropriate rate, so any potential purchaser of the company has an accurate picture of the profit the company will record.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts / 8~1310 Standardisation of Accounting Policies / 8~1340 Accounting policies requiring adjustment / Self-generating and regenerating assets (SGARAs)
Self-generating and regenerating assets (SGARAs)
SGARAs should be measured at net market value and increments (decrements) in net market values need to be recognised as revenues (expenses) in the financial year in which they occur. Movements in the net market value of SGARAs will affect reportable profit and therefore need to be taken into account when determining future maintainable earnings. Because of their effect on reportable profit, movements in the net market value of SGARAs will also affect some common stock ratios.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts / 8~1310 Standardisation of Accounting Policies / 8~1340 Accounting policies requiring adjustment / Inventories
Inventories
Some companies do not include overheads in the carrying value of stock on hand. Potentially this can understate the value of stock on hand and also of gross profits.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts / 8~1310 Standardisation of Accounting Policies / 8~1340 Accounting policies requiring adjustment / Depreciation
Depreciation
It is a worthwhile exercise to review the asset ledger and the depreciation rates used. Common problems include: assets are not capitalised; assets were capitalised but have now been disposed of; and inappropriate depreciation rates.
All of these will affect the future maintainable earnings of the company and the assets employed.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts / 8~1310 Standardisation of Accounting Policies / 8~1340 Accounting policies requiring adjustment / Employee entitlements
Employee entitlements
Employee entitlements vary significantly between countries. Some of the more common ones include: annual leave; sick leave; long service leave; study leave; and rostered days off.
It is important to determine what employee entitlements are applicable for a company and that an appropriate provision has been raised for each. This sometimes can involve estimating a balance for a few years in advance and then ensuring all between year movements are adjusted for. This will assist with determining an appropriate trend.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts / 8~1310 Standardisation of Accounting Policies / 8~1340 Accounting policies requiring adjustment / Accounting for bad and doubtful debts
Accounting for bad and doubtful debts
Some companies do not raise a provision for doubtful debts, but expense the bad debts as they occur. Other companies raise large provisions for doubtful debts during a year and then adjust the provision to the required amount at year end.
Provided there is agreement on the appropriate method of accounting for bad and doubtful debts, and this has been consistently applied, there should be no effect on the balance of future maintainable earnings calculated.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts / 8~1350 Elimination of Unusual Transactions
8~1350
Elimination of Unusual Transactions
Some of the unusual transactions that we have adjusted for in the past have included: adjustments for appraisals of real and tangible property; structural adjustments to the labour force which have occurred in the most recent period (i.e. resulting in future labour cost savings); extraordinary costs relating to labour force restructuring; depreciation (where capital expenditure is likely to exceed the depreciation charge, or where the depreciation charge did not adequately reflect ongoing levels of equipment replacement); non-recurring items (such as one-off legal costs associated with customer claims, unusual bulk sales etc.); sales (where inter-business transfers have occurred at non-arms length prices or where they may not occur in the future); other non-arms length transactions at above or below market rates; and expensing capital expenses as repairs.
Once unusual transactions have been identified, it is necessary to determine whether to eliminate them. They should only be eliminated if they are unlikely to re-occur or it is believed they do not form part of future maintainable earnings.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts / 8~1370 Normalisation of Owners Remuneration
8~1370
Normalisation of Owners Remuneration
The issues revolving around owners remuneration benefits usually relate to how much the owners benefits actually paid historically is in excess of (or less than) what might normally be expected to be paid to an arms length manager/director/employee in the same role. Excess owners benefits over and above what might be paid commercially arise because: shareholders or directors of a private entity will usually pay themselves as much as the company can afford, seeing no reason to retain profits in the company unless there is a specific purpose for those funds; and attempts at tax minimisation, which have sometimes resulted in complex corporate and personal taxation structures as owners withdraw as much profit as possible out of the company to minimise the overall tax burden on their affairs (this is especially the case when the corporate tax rate exceeds the top marginal rate of personal tax).
An assessment is required to determine what level of benefits would be realistic, given an arms length commercial relationship between the business and the employee, and given the role they perform for the business. The valuer must be careful to ensure that payroll associated on costs are also taken into account when adding back excess owners benefits. Similarly, if owners benefits include the use of entity assets (cars, homes etc.), it is quite likely that these represent surplus assets and should be separately identified for the purpose of the valuation. Similar analysis may also be required for all family members employed in a business.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts / 8~1390 Methods of Funding
8~1390
Methods of Funding
It is quite common to find private companies funded by a mix of shareholder loans and debt secured on private assets but with relatively little equity. Obviously, the funding methodology used is a result of the personal circumstances and desires of the owners or major shareholders. The situation must be normalised in order to arrive at a fair valuation. For example, if there are shareholder loans which are non-interest bearing, then those loans should either be treated as equity and the value thereof treated as part of the total value of the entity, or a notional interest charge should be made on those loans and deducted in arriving at future maintainable earnings. The following example demonstrates the two treatments. In Scenario A, the loan is treated as equity and in Scenario B, a notional interest charge is processed.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts / 8~1390 Methods of Funding / 8~1400 Diagram Spreadsheet of private entity funding
8~1400
Diagram Spreadsheet of private entity funding

PRIVATE COMPANY FUNDING REPORTED POSITION Audited SCENARIO A Pro Forma SCENARIO B Pro Forma
BALANCE SHEET CURRENT ASSETS NON-CURRENT ASSETS TOTAL ASSETS CURRENT LIABILITIES NON-CURRENT LIABILITIES Lending secured over company assets Interest-free shareholder loans 100,000 300,000 100,000 100,000 250,000 750,002 1,000,002 100,000 250,000 750,002 1,000,002 100,000 250,000 750,002 1,000,002 100,000
PRIVATE COMPANY FUNDING REPORTED POSITION Audited Loan at commercial interest rates (i.e. adjustment to pro forma P & L required) TOTAL NON-CURRENT LIABILITIES TOTAL LIABILITIES NET ASSETS SHAREHOLDERS FUNDS Ordinary shares Interest-free shareholder loans treated as equity Profits and reserves TOTAL SHAREHOLDERS FUNDS PROFIT & LOSS STATEMENT Adjusted maintainable earnings before interest effects of debt, after tax Notional interest charge on interest-free debt (at 11%) Income tax on interest effects (at 30%) Future Maintainable Earnings 100,000 $100,000 100,000 $100,000 100,000 (33,000) 9,900 $76,900 2 500,000 $500,002 2 300,000 500,000 $800,002 2 500,000 $500,002 400,000 500,000 $500,002 SCENARIO A Pro Forma 100,000 200,000 $800,002 SCENARIO B Pro Forma 300,000 400,000 500,000 $500,002
A key question to be asked in this instance is: do the owners expect to obtain value/repayment of their shareholder loans in addition to a value for their equity? Private entity shareholders have many ingenious ways of funding operations and a full consideration of the funding methods used is important.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts / 8~1420 Assets Used
8~1420
Assets Used
Due to the dynamic nature of privately owned businesses, the ownership and corporate structures employed frequently result in confusion over the ownership of assets used in the company. Often, privately owned assets are used by the company, and assets owned by the company are used by the owners. It is critical to determine which assets, in fact, generate the profits or cash flows being valued and to incorporate those assets into the valuation. If the valuer was unaware that privately owned assets (which would not be recognised on the balance sheet of the entity) contributed, say, 50% of the earnings being valued, the valuer would grossly overvalue the entity. Similarly, the business would be substantially undervalued if a large proportion of the assets owned by the business were, in fact, employed in non-income producing activities or employed in a non-optimal
manner by the owners.

PRIVATE COMPANIES EXAMPLE OF PERSONAL ASSETS OWNED BY COMPANY REPORTED POSITION Audited BALANCE SHEET CURRENT ASSETS NON-CURRENT ASSETS Plant & equipment Yacht & marina berth Land & buildings Holiday unit Surfers Paradise TOTAL NON-CURRENT ASSETS TOTAL ASSETS CURRENT LIABILITIES NON-CURRENT LIABILITIES Leasing plant & equipment Leasing yacht & marina berth Mortgage land & buildings Mortgage holiday unit TOTAL NON-CURRENT LIABILITIES TOTAL LIABILITIES NET ASSETS SHAREHOLDERS' FUNDS Ordinary shares Adjust for personal use assets Profits and reserves TOTAL SHAREHOLDERS' FUNDS PROFIT & LOSS STATEMENT Reported profit Adjust for personal use assets: Depreciation yacht and marina berth Depreciation holiday unit Interest charge on yacht and marina berth lease (at 11%) Interest charge on holiday unit mortgage (at 11%) Yacht maintenance expenditure Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited 5,150 11,000 9,570 29,260 13,000 100,000 100,000 2 433,000 $433,002 2 (25,000) 433,000 $408,002 $25,000 25,000 2 (25,000) 433,000 $408,002 33,000 87,000 125,000 266,000 511,000 611,000 $433,002 158,000 258,000 $408,002 125,000 266,000 353,000 353,000 $25,000 33,000 87,000 33,000 0 125,000 0 158,000 258,000 $408,002 50,000 103,000 366,000 275,000 794,000 1,044,002 100,000 416,000 666,002 100,000 366,000 275,000 378,000 378,000 50,000 103,000 50,000 0 366,000 0 416,000 666,002 100,000 250,002 250,002 250,002 BUSINESS ASSETS Pro Forma PERSONAL ASSETS Pro Forma SCENARIO A Pro Forma
PRIVATE COMPANIES EXAMPLE OF PERSONAL ASSETS OWNED BY COMPANY REPORTED POSITION Audited Body corporate, insurance and maint. holiday unit Total adjustments Fringe benefits tax paid (say) Income tax on adjustments (at 30%) Future Maintainable Earnings $100,000 BUSINESS ASSETS Pro Forma PERSONAL ASSETS Pro Forma SCENARIO A Pro Forma 7,000 74,980 37,490 (22,494) $189,976
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1290 Commonly Required Adjustments to Accounts / 8~1440 Depreciation Policy
8~1440
Depreciation Policy
The September 1992 edition of the International Valuation Standards Committees [IVSC] Guidance Note and Background states in Guidance Note 11: 1. Depreciation is defined as the measure of the wearing out, consumption or other permanent loss of value of a fixed asset whether arising from use, effluxion of time or obsolescence through technology and market changes. The useful economic life of an asset is the total period during which the present owner will derive economic benefits from its use. Useful economic life may be: a. b. c. d. Pre-determined as in the case of plant and machinery on leasehold premises. Directly governed by extraction or consumption as in the case of a mine. Dependent on physical deterioration through use or effluxion of time. Reduced by economic or technology obsolescence.
2. 3.
Therefore, in determining the level of depreciation to be adopted in establishing the Future Maintainable Earnings of a business, the useful life of plant and equipment must be established. This will enable a more accurate determination, if the principle of CAPEX equals depreciation is adopted (i.e. anticipated annual capital expenditure needed to maintain the trading performance of a business replaces depreciation).
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1490 Suggested Adjustment Template

8~1490
Suggested Adjustment Template

Attached is a sample Statement Adjustment template.
The following template can be used to build a spreadsheet to assist with adjusting a set of financial
statements. This design has the advantage that it allows easy auditing of: information supplied by the client; the effect of any adjustments made, with the reason for the adjustment and the other accounts affected detailed in a supporting journal; and the final balance reached.
Year Ended Jun-xx Actual Results Per client Account Income Expenses Profit Assets Liabilities Owners Equity $000 Adj $000 Note Ref#1 Jrnl Ref Adj $000 Jrnl Ref Year Ended Jun-xx Adjusted Actual Final $000
A typical pro forma adjustment calculation can also be summarised along the following lines: The accounts are restated to reflect the ongoing profitability under third party management. The calculation of this is as follows: Profit before tax as per accounts Add back (i.e. increase profits by) the following: all owners benefits (salary, private travel, car etc.) interest paid + + X
Deduct (i.e. decrease profits by) the following: interest received
Restated profits (sub-total) Less interest on working capital (this is calculated initially at x% per annum on net current assets) Less management salary Extraordinary items (adjustments are made for any extraordinary items) Third party profit before tax Less tax at corporate tax rate Third party profit on an after-tax basis $ +/
The figure which is used for profit before tax is taken from the previous years accounts (or some other period/basis as appropriate) and adjusted to reflect current maintainable earnings.
The management salary deducted is the amount that would need to be paid to an outside arms length person to run the business to achieve the profitability calculated above. (Often, this is the figure which is used as a remuneration package for the principals in the first year after acquisition.)
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis

8~1540
Financial Analysis
When undertaking financial analysis, consistency of ratios between companies and between years is a major issue. Consideration should therefore be given to the standards of the Investment Performance Council.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1560 Building Blocks of Financial Statements
8~1560
Building Blocks of Financial Statements
At its basic level, financial statement analysis compares the size of individual building blocks with other building blocks, or groups of building blocks to other groups of building blocks. The more sophisticated we become the more we look behind: what makes up an individual building block; what is included in a line item which should not be; and what is not included which should be.
This analysis can be conducted between years as horizontal analysis or within a period as vertical analysis. The pyramid of ratios chart highlights basic key financial relationships between the balance sheet and the profit and loss statement.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1560 Building Blocks of Financial Statements / 8~1570 Diagram Schematic block structure of profit and loss accounts Manufacturing entity
8~1570
Diagram Schematic block structure of profit and loss accounts Manufacturing entity
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1560 Building Blocks of Financial Statements / 8~1580 Diagram Schematic block structure of profit and loss accounts Professional service entity
8~1580
Diagram Schematic block structure of profit and loss accounts Professional service entity
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1560 Building Blocks of Financial Statements / 8~1590 Diagram Schematic block structure of balance sheet
8~1590
Diagram Schematic block structure of balance sheet
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1610 Types of Analysis
8~1610
Types of Analysis
Undertaking efficient analysis of financial statements is extremely difficult without the aid of computers and, in particular, spreadsheet or purpose built software. A number of packages have emerged, and continue to do so, which facilitate the analysis of financial statements. However, the peculiarities of many entities often require the tailoring of software. Accordingly, spreadsheet software is usually the most flexible aid to analysis. In the initial stages of the analysis, it can be revealing to enter all of the financial statements available into the spreadsheet, then calculate all of the horizontal and vertical relationships in absolute dollars and in ratios, as the first step to refining the analysis. Major changes or anomalies in financial statement data will become readily apparent. Items of significance, or items to which profitability appears particularly sensitive, can also be identified. Such an analysis should be conducted of the three main financial statements: the profit and loss statement; the statement of cash flows (or funds statement); and the balance sheet.
The valuer is primarily concerned with trends and relationships between numbers in the financial statements either within the period or between periods. These are usually found by comparing absolute dollar changes period to period, absolute dollar relationships within the period, and ratio and percentage relationships period to period and within periods. Comparing numbers period to period is commonly referred to as horizontal analysis (as the numbers being examined usually run across the page). Analysis of numbers within the period is usually referred to as vertical analysis (as the numbers being
considered usually run down the page).
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1610 Types of Analysis / 8~1620 Horizontal analysis
8~1620
Horizontal analysis
The relationship of various numbers in the financial statements to the key drivers will provide some insights. However, if these relationships are not compared on a period to period (horizontal) basis, the insights may be quite superficial.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1610 Types of Analysis / 8~1630 Diagram Comparative analysis Horizontal
8~1630
Diagram Comparative analysis Horizontal

20x1 20x2 200 % Change 100% +
Sales
100
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1610 Types of Analysis / 8~1640 Vertical analysis
8~1640
Vertical analysis
Vertical analysis is sometimes referred to as common size analysis, as it involves relating one number or a series of numbers to a common base (such as sales or working capital). Examples of vertical analysis used frequently are: gross margin;
return on net assets; net profit margin; inventory turnover; and accounts receivable turnover.
Vertical analysis enables an understanding of the relative importance of items in the financial statements to key drivers, such as sales. The key drivers will differ from one business to the next. In a plant hire business, the use of the plant available for hire will be the key driver. In a toolmaking operation, the productivity of labour and the extent to which penalty rates are paid without working additional shifts may be key drivers.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1610 Types of Analysis / 8~1650 Diagram Comparative analysis Vertical
8~1650
Diagram Comparative analysis Vertical

20x1 20x2 200 40 15 % Change 100% +
Sales Wages Consumables
100 23 12
Wages/Sales Consumables/Sales
23.0% 12.0%
20.0% 7.5%
As with horizontal analysis, the relationship of various numbers in the financial statements to the key drivers will provide some insights. However, if these relationships are not compared to industry averages, the insights may be quite superficial. There are a number of services which provide small business profiles and/or profiles of companies listed on the Australian Stock Exchange. These provide a useful guide to evaluating the performance of an individual business against that of the performance of the industry as a whole. The objective of these profiles is to provide a financial profile of a sample of businesses against which it may be possible to identify strengths and weaknesses in the ability of an individual business to generate revenue, control expenses, earn profits and provide a commensurate owners salary as well as an adequate return on capital invested in the business. This may also enhance the understanding of the balance sheet, profit and loss statement, and cash flow financial relationships and inter-relationships.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1610 Types of Analysis / 8~1660 Pyramid of ratios
8~1660
Pyramid of ratios
Apart from the market volatility of share prices, there are several external levels of risk (including economic and geographic risks) which culminate in: the return on investment ratio; and
critical success factors.
The return on investment ratio embodies the four main categories of ratios: profitability; productivity; liquidity; and business risk.
The critical success factors of the business impinge on each of these groups of ratios and the Du Pont pyramid of ratios shows how each group culminates in the return on investment ratio.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis

/ 8~1670 Basic Ratios

8~1670
Basic Ratios
Ratios and percentages or proportions are used both in common size (vertical) and comparative (horizontal) analysis. Frequently, a ratio percentage or proportion is more revealing than a comparison of absolute dollar amounts. Accordingly, by relating the particular operating expense of each year, e.g. transport, to the cartage charges of that year, and comparing the percentages, it is possible to look for explanations, such as an increase in fuel prices or wages from period to period, or changes in the nature of work done. This gives the valuer confidence that they can rely on the reasonableness of the financial statements. Where fundamental relationships are unclear, interpretation requires considerable care if ratios and percentages are to be useful. Nonetheless, in the study of financial statements, adequate recognition should be given to the complexity of the subject matter and to the limitations of financial statements. As a general rule, make sure you understand the reason for a change in a percentage or ratio before drawing conclusions from, and taking action on those changes. The intention of the following section is to highlight some of the important issues associated with a number of ratios that are commonly used in the evaluation of financial statements: current or working capital ratio; debt/equity ratio; and return on funds employed.
Throughout this section, it is important to note that a ratio by itself does not provide the basis of analysis. It is the trend in ratios over time which reveals insights into the entity being valued. The trend can then be compared against those of competitors and industry norms. We also caution that some ratios may not be relevant to a particular analysis or corporate structure.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1670 Basic Ratios / 8~1680 Current or working capital ratio
8~1680
Current or working capital ratio

= Current Ratio
Current Assets Current Liabilities
Current Ratio 20X1 $ Current Assets Inventory Accounts Receivable Total Current Assets
20X2 $
568 222 790
450 279 729
Current Liabilities Bank Overdraft Provisions Accounts Payable and Current Portion of Owners Debt Total Current Liabilities Working Capital Current Ratio 102 65 333 500 290 1.58 255 77 302 634 95 1.15
The current ratio is also referred to as the working capital ratio as it provides a measure of the working capital employed at the end of a period. The current ratio provides information as to the short-term liquidity of the business. Normally, the relationship will need to be greater than one to one to ensure the ongoing survival of the entity. In some entities, the seasonality of sales and employment of labour require that a much greater current ratio be exhibited. The current ratio should not be considered in isolation. The elements of the ratio (being the components of the current assets and current liabilities) should all be considered. Inventory build-ups to ensure availability of inventory at peak times (such as Christmas sales in a retail business) must be borne in mind. The ratio will also vary from period to period. Some entities can survive as a going concern with a current ratio of less than one. Provided there are always sufficient cash resources with which to pay debts as they fall due, and there is a reasonable expectation that the ratio will improve over time, there may be no need for concern. Similarly, significant change in an entitys operations can distort the current ratio. For example, the acquisition of a new business towards the end of the financial period under analysis
might manifest in a significantly weakened current ratio due to funding the acquisition by, for example, bank bills. If the bank bills are expected to be replaced with longer-term funding to reflect the nature of the assets acquired, an adjustment should be made to the current ratio to reflect the replacement funding. Likewise, if the disposal of a business interest has resulted in significant cash resources being made available, the current ratio will improve. If the strategy of the business is to reinvest these funds in longer-term assets, it will be necessary to adjust current assets for the surplus cash.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1670 Basic Ratios / 8~1690 Debt/equity ratio
8~1690
Debt/equity ratio
= Debt/Equity Ratio
Financial Debt Shareholders Funds
Debt/Equity Ratio A-Actual 20x1 $ Debt Leasing Long-term Borrowings Less Conv. Notes Converted Total Debt Equity Share Capital Retained Earnings Less Intangibles* Add Conv. Notes Converted Total Equity Debt/Equity Ratio 1,005 735 (605) 0 1,135 125.64% 1,005 735 (605) 500 1,635 56.64% 1,505 777 (575) 0 1,707 62.10% 361 1,065 0 1,426 361 1,065 (500) 926 335 725 0 1,060 B-Adjust 20x1 $ Actual 20x2 $
* Calculation can be performed on a pre- or post-intangibles basis; however, consistency must be applied throughout calculations.
20x1 Column A shows actual debt and equity prior to conversion of convertible notes into ordinary shares. 20x1 Column B shows the effect on debt and equity of a conversion of $500 convertible notes into shares. $500 of convertible notes were actually converted during 20x2. For comparison, the 20x1 figures need to be adjusted as per Column B. This is then a satisfactory comparison, as shown in the chart below:
The debt/equity ratio is synonymous with gearing or leverage and measures the extent to which an entity is financed by debt. However, it has different meanings for different people. Some valuers use the debt/equity ratio in terms of debt to total assets. The debt/equity ratio is a particularly useful measure of the capital structure of the business. For example, a debt/equity ratio of 50% means that for every $1 of equity there is 50 of financial debt. While the calculation of the debt/equity ratio simply requires a division of debt into equity, there are a number of difficulties involved in arriving at both these figures. The approach we prefer is that debt is defined as financial debt, i.e. interest-bearing liabilities. Therefore, it should include financing leases, as these are effectively a form of interest-bearing liabilities. It does not include liabilities such as trade creditors and provisions. Equity (from the point of view of the ordinary shareholder) is defined as shareholder funds excluding minority interests, preference shares and intangibles. The exclusion of intangibles can be debated. A major problem area in the calculation is the treatment of convertible debt securities and redeemable or convertible preference shares. The answers normally lie in considering the capital market realities and the specific terms (e.g. duration, volatility etc.) associated with such securities. For example, if, due to the prevailing share price and conversion terms, convertible notes are unlikely to be converted to equity, they should be treated as debt. However, if conversion is most probable, then they should be treated as equity, provided that they do not have a high interest rate coupon. Similar considerations apply to redeemable or convertible preference shares; if, in the circumstances, it is unlikely that the preference capital will be converted into ordinary share capital, then (from the point of view of the ordinary shareholder) the amount should be considered as debt. This conclusion may be more firmly supported if the preference shares have been issued at a large premium thereby
putting into place a ready-made mechanism for their redemption. Another major problem area in the calculation is making an adjustment for intangibles. This depends on the basis of the valuation of the intangibles and whether it is an identifiable or an unidentifiable intangible asset. Assets such as capitalised research and development, capitalised mineral exploration expenditure and mining tenements produce additional valuation problems. The effect of intangibles can be significant in some types of businesses. For example, a franchised business may have a debt/equity ratio of 36% before deducting intangibles and 67% after a deduction for intangibles, as demonstrated below: Assets: Tangible Intangible Total Assets 100 50 150
Liabilities: Financial Debt Net Assets 40 110
Equity Debt/Equity ratio including intangible assets: 40/110 = 36% Debt/Equity ratio excluding intangible assets: 40/(110 50) = 40/60 = 67%
110
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1670 Basic Ratios / 8~1700 Return on funds employed
8~1700
Return on funds employed

= % Return
Net Profit Shareholders Funds
In practice, pre- or post-tax profits can be applied in this calculation. The individual characteristics of the business will determine which alternative to use, and this decision must be made on a case by case basis. It is imperative, however, to ensure that either pre- or post-tax data are used consistently throughout the analysis. The profit figure applied must be net of preference dividends and minority interests, but before extraordinary items.
Shareholders funds are defined as ordinary equity less preference shares less minority interests. (Our preferred methodology does not reduce shareholders funds by the amount of intangibles for the purposes of this ratio.) The profit performance of a business is usually measured by the rate of return. The rate of return concentrates on the relationship between the amount of profit (return) and the resources used in generating the profit shareholders funds, total assets or the sales base. In analysing the income statement, a study should be made of profit both before and after tax. In this analysis, distinction should be made between profit from the normal operations of the business and non-operating income, such as income from investments. The figures may need to be adjusted for abnormal and extraordinary items relating to both revenue and expense, and changes in accounting or asset valuation policies. In the case of proprietary companies, there may also be a need to adjust for owners expenses, either upwards or downwards. In determining profit after tax, the tax expense calculation should be closely reviewed to establish whether special taxation provisions and allowances have significantly affected the tax expense and hence net profit after tax. If this is the case, there may be once-off distortions to the profit after tax ratio calculations. Current accounting practice requires the notes to the financial statements to include a reconciliation and explanation of any differences between income tax expense in the accounts and the tax calculated on the reported pre-tax accounting profit. In times of rising prices and inflation, traditional accounting will report an overstated profit figure and an understated investment in assets. The rate of return calculation will, therefore, compound the deficiencies of the component figures. Rate of return calculations tend to focus on the income earning capacity of the business, and neglect the capital earning capacity. That is, many businesses hold investments in long-term assets (e.g. plant and equipment, land and buildings, share investments) which may be appreciating (or depreciating) in value. Depending on the method of accounting, such changes in value may not be recognised, and, accordingly, an incomplete view of the return on equity or total assets is presented.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1720 Management Ratios
8~1720
Management Ratios
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1720 Management Ratios / 8~1730 Average receivables collection period
8~1730
Average receivables collection period

365 = Average Days Receivables
Average Accounts Receivable Sales
One of the most important key management ratios today is that of accounts receivable collection, i.e. how long on average does it take to collect accounts receivable. Very few businesses are not plagued by the worries of cash collection. Only those who sell on a cash basis, have very sound, contracted customers or receive cash in advance of delivery (of the product or
service) do not have these worries. The average receivables collection period is a measure of the time it takes from invoicing the sale to the collection of cash. A number of factors influence the average receivables collection period, including: the proportion of cash versus credit sales; the seasonality of sales; the businesss credit policy; the extent (if any) of discounts offered for early settlement; industry practices; the efficiency and effectiveness of credit control; and the economic circumstances of the customer industry group.
One of the easiest errors to make when analysing the average receivables collection period is to overlook the extent to which sales are generated by cash versus credit. Comparing accounts receivable to total sales will be erroneous if sales include significant cash sales. Depending on the seasonality of sales, the average receivables collection period can vary significantly throughout the year. For example, a wholesale business which makes most of its sales prior to Christmas may carry those sales as accounts receivable until well after the Christmas break. Measuring the average receivables collection period at 31 December would result in a significantly higher number than that which would be expected in the off season. Similarly, if the business is experiencing significant growth, comparing sales for a full year with accounts receivable outstanding at the end of the year may be misleading. In such cases, it may be preferable to relate the average accounts receivable for the year to the sales for the year. This is achieved by averaging the opening and closing accounts receivable figures for the period in question. If the entitys systems permit, it is sometimes useful to analyse accounts receivable by product lines or other groupings identified by the entity. There may be particular customer groups or products/services which are particularly difficult to collect. The formula for average days receivables shown above should be modified for the period under consideration. For example, if the period being analysed is one month, then the proportion of accounts receivable to sales should be multiplied by 30 days, not 365 days. The average days receivables is an arithmetic mean of all outstanding sales. An analysis of the aged accounts receivable by age and value will further identify whether there are particular accounts contributing to the outstanding balances (particularly if these accounts are in the 90 days and over area).
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1720 Management Ratios / 8~1740 Diagram Average receivables collection period
8~1740
Diagram Average receivables collection period

End of Month Debtors Average Receivables for Month
accounts receivable by age and value will further identify whether there are particular accounts contributing to the outstanding balances (particularly if these accounts are in the 90 days and over area). 8~1740
Diagram Average receivables collection period

End of Month Debtors Annualised Monthly Sales Average Receivables for Month Annualised Monthly Sales A/C 365 Days Receivable 18 17 18 18 17 26 29 23 15 12 12 13 E Average Receivable 70.0 75.0 82.5 87.5 105.0 155.0 167.5 122.5 85.0 65.0 62.5 67.5 E/C 365 Days Receivable 17 16 17 18 15 21 34 28 18 13 12 12
Days Receivable
A Receivables
B Month Sales 120 140 145 150 210 220 150 135 140 150 160 170 1,890
C (B 12) Annualised Sales 1,440 1,680 1,740 1,800 2,520 2,640 1,800 1,620 1,680 1,800 1,920 2,040
July August September October November December January February March April May June Total Sales Total Collections
70 80 85 90 120 190 145 100 70 60 65 70
1,890
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1720 Management Ratios / 8~1750 Average inventory processing period
8~1750
Average inventory processing period

365 = Average Days Inventory
Inventory Average Cost of Sales
The extent to which funds invested in inventory generate income (but not necessarily cash) depends on the rate of inventory turnover (and the gross margin). The average days inventory on hand also helps to highlight the entitys management of inventory. An entity which deals in fashion items or perishable goods could be expected to have a particularly low inventory holding. Conversely, an entity which manufactures durable items which are not subject to the whims of fashion or consumer desire could hold inventory for a longer period without suffering significant obsolescence. For any business, there is an optimum level of inventory, which is able to satisfy the demands of customers or retailers without delays, but which still permits production runs sufficiently long enough to minimise the costs of starting up a production line purely for a particular product. As with an analysis of average days receivables, inventory holding levels may vary throughout the year and be subject to seasonal fluctuations. If it is suspected that there is an element of seasonality in the entitys inventory holding, the average days inventory holding should be analysed at various periods
throughout the year. Again, as with average days receivables, if the business is experiencing significant growth or decline, the end of year inventory holding may not be representative of the inventory holding throughout the year. If this is the case, an average inventory holding level should be compared to the cost of sales figure. This is achieved by averaging the opening and closing inventory figures for the period in question. It should also be noted that, in practice, the inventory to sales ratio is often applied. While this may seem intuitively appealing, distortions arise from the accounting of inventories and sales, namely, the inventories figure is reported at cost whereas the sales figure incorporates a margin on those inventories. A fair comparison between the two can not be made.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1720 Management Ratios / 8~1760 Diagram Average inventory processing period
8~1760
Diagram Average inventory processing period

Average Inventory Processing Period Alternative A A Month-end Stock B Month Cost of Sales 62 61 65 60 65 100 60 65 45 47 51 55 C (B 12) Annualised Cost of Sales 744 732 780 720 780 1,200 720 780 540 564 612 660 A/C 365 Average Stock 0 85.5 79.5 77.0 69.5 47.5 26.0 17.5 17.5 23.0 34.0 42.5 Alternative B A/E 365
Days Stock 44 40 37 39 29 10 10 7 14 17 25 24
Days Stock 0 43 37 39 33 14 13 8 12 15 20 24
July August September October November December January February March April May June
90 81 78 76 63 32 20 15 20 26 42 43
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1720 Management Ratios / 8~1770 Gross margin
8~1770
Gross margin
Gross Profit Sales 100 = Gross Margin
(Gross Profit = Sales less Cost of Sales) This ratio is an analysis of operational performance as it concentrates on the profitability of sales. Gross margin is useful as a tool in conducting incremental analyses e.g. Should we sell more product at a discounted price? and other pricing decisions. It is also useful when analysing fixed and variable overheads if a major increase or decrease in sales volume or prices is anticipated. Clearly, the lower the gross margin, the more sensitive profitability becomes to the level of fixed overheads. As with many sales based analyses, it is usually instructive to consider the gross margin by the product or service the entity provides. Often, there will be products which provide a marginal gross profit but which are maintained because they are, for example, an entry to other products or services offered by the entity, or satisfy some other objective which is not intended to be highly profitable by itself. The following diagram is a good example of marginal pricing. While every additional dollar of sales
results in a gross profit of 25%, the initial $100 sales derived gross profit of 70%. If it is considered that margins will be squeezed by competitive products or services, it is important to review the cost of goods sold to determine the extent to which it is fixed or stepped, and the extent to which it is variable. If there is a large fixed cost component, it may be very difficult to trim cost of sales in order to meet the competitive pricing of competitors.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1720 Management Ratios / 8~1780 Diagram Gross margin
8~1780
Diagram Gross margin

AVERAGE GROSS PROFIT MARGIN % 70% 57% 50% 45% 42% 40% 38% 37% 36% 35% 34% 33% 25% 25% 25% 25% 25% 25% 25% 25% 25% 25% 25% GP % ON INCREMENTAL SALES
SALES July August September October November December January February March April May June 100 140 160 220 260 300 340 380 420 460 500 540
GROSS PROFIT 70 80 90 100 110 120 130 140 150 160 170 180
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1720 Management Ratios / 8~1790 Breakeven sales
8~1790
Breakeven sales
= Breakeven Sales
Fixed Overhead Costs Gross Margin
The level of breakeven sales is a critical sales volume as it determines the point at which the business has covered its overheads. Sales in excess of this volume should generate profit (assuming positive gross margins). However, the required level of profitability (as determined by the minimum acceptable return on assets or return on funds employed) will determine the target level of sales volume.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1720 Management Ratios / 8~1800 Diagram Breakeven sales 1
8~1800
Diagram Breakeven sales 1
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1720 Management Ratios / 8~1810 Diagram Breakeven sales 2
8~1810
Diagram Breakeven sales 2

Sales $000s 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000 Variable Costs $000s 0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000 Gross Margin $000s 0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000 Fixed Costs $000s 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 Profit/Loss $000s (3,000) (2,500) (2,000) (1,500) (1,000) (500) 0 500 1,000 1,500 2,000
Sales $000s 11,000 12,000
Variable Costs $000s 5,500 6,000
Gross Margin $000s 5,500 6,000
Fixed Costs $000s 3,000 3,000
Profit/Loss $000s 2,500 3,000
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1720 Management Ratios / 8~1820 Margin of safety
8~1820
Margin of safety
100 = Margin of Safety (%)
Actual Breakeven Sales Breakeven Sales
The margin of safety is a measure of the degree to which breakeven sales have been exceeded. Care should be taken in assessing margin of safety as many apparently fixed overhead costs may well be incremental. Accordingly, a large margin of safety may not be meaningful unless breakeven sales
are recalculated using the revised overhead structure.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1720 Management Ratios / 8~1830 Diagram Margin of safety
8~1830
Diagram Margin of safety

20x3 $
Actual Sales Breakeven Sales Margin of Safety Margin of Safety %
100 80 20 25.00%
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1720 Management Ratios / 8~1840 Interest cover
8~1840
Interest cover
EBIT Interest Paid = Times Covered
This ratio measures the ability of an entity to service its interest commitments.
The main points to note are: Interest expense should be calculated on a gross basis, i.e. interest received (usually) should be excluded from this calculation and not netted off against interest paid. Interest expense should include the interest expense attributable to financing leases depending on how the financial accounts have been prepared, this may or may not be readily ascertainable and may not have been included in the statutory calculation of interest expense. If the entity is shortly to roll-over a significant portion of its debt, and will be locked into higher (or lower) interest rates than those which are currently being paid, then this may have a significant bearing on future interest cover. It is necessary to be consistent in the way in which various components of debt and equity are treated all the way through the financial ratio calculations. That is, having made, for example, the decision that convertible preference shares are to be treated as debt, then it is important to include in the interest expense calculation the associated preference dividend payment made.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1720 Management Ratios / 8~1850 Diagram Interest cover
8~1850
Diagram Interest cover

Interest Cover Year EBIT $ 20x1 20x2 20x3 20x4 20x5 20x6 20x7 20x8 100 100 80 60 55 60 80 100 Interest $ 45 47 49 51 53 55 57 59 Times Covered $ 2.2 2.1 1.6 1.2 1.0 1.1 1.4 1.7
Note that earnings in this example are calculated on an after depreciation and amortisation basis. Either form of earnings, earnings before interest and tax (EBIT) or earnings before interest, tax, depreciation and amortisation (EBITDA), can be used; however, this decision will depend on the individual characteristics of the entity being analysed.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1720 Management Ratios / 8~1860 Debt to gross cash flow
8~1860
Debt to gross cash flow
Financial Debt Gross Cash Flow
= Years for Repayment
Rarely will the operating profit reported in the financial accounts equate to cash flow. It is therefore necessary to ascertain the extent of non-cash items included in operating profit (e.g. depreciation of fixed assets, amortisation of intangibles, employee provisions, profit or losses on the sale of assets, unrealised foreign exchange gains and losses) to determine the true extent to which operations are generating a cash cash flow which can then be used to repay financial debt. Another point to keep in mind is that financing leases are considered part of financial debt, and the true nature of convertible debt securities and preference shares should not be overlooked.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1720 Management Ratios / 8~1870 Return on assets
8~1870
Return on assets
EBIT Total Assets 100 = % Return on Assets
Similar comments apply for this ratio as were made for the return on funds employed calculation. This ratio brings into focus how efficiently an entity utilises the total resources at its disposal. Earnings in this example are calculated on an after depreciation and amortisation basis. Either form of earnings, EBIT or EBITDA, can be used; however, this decision will depend on the individual characteristics of the entity being analysed. It is often used for analysing divisional results where the financing decisions are centralised. In this case, the divisional management are judged on their performance before consideration of the funding costs to provide the assets managed. A review of major inventory groupings or products should be undertaken to determine whether there are particular products which are fast or slow moving. Depending on the entitys sales and marketing strategy, there may well be items within the overall inventory holding which will continue to be slow moving or may be phased out altogether. Conversely, the launch of a new product may require that inventories be built up prior to the launch on the expectation that there will be high demand after the launch, followed by a plateauing when sales stabilise. This would result in a temporarily high average days inventory holding.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1720 Management Ratios / 8~1880 Expense ratios
8~1880
Expense ratios
It can be useful to analyse a particular expenditure line in comparison to net profit; in other words, determine its proportion to net profit. Trend analysis is required, which may highlight expenditures which, over time, are having a greater or lesser degree of impact on profit. This will, in turn, alert the valuer to any issues which may need further investigation. Examples of ratios which are often applied include:
Depreciation Net Profit
and
General & Administration Expenses Net Profit
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1890 Stock Market/Capital Ratios
8~1890
Stock Market/Capital Ratios
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1890 Stock Market/Capital Ratios / 8~1900 Dividends per share
8~1900
Dividends per share
Interim Dividends per Share + Final Dividends per Share = Total Dividends per Share It is important to realise that dividends per share refers to the dividend stream available to ordinary shareholders and, accordingly, it is necessary to allow for any prior dividend commitment which the entity has to preference shareholders. This, in turn, affects the level of surplus profit available for distribution to ordinary shareholders and hence the dividend cover. The extent to which convertible debt securities of the entity will be converted into additional ordinary shares may impinge on the ability of the entity to maintain its existing dividend per share. This will depend on: the marginal profitability of the additional capital generated from conversion compared with the after-tax cost of interest expense associated with the convertible debt securities; and the relative cash flow effects associated with servicing debt as opposed to equity.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1890 Stock Market/Capital Ratios / 8~1910 Dividend yield
8~1910
Dividend yield
100 = % Yield
Dividends Per Share Market Price Per Share
This ratio complements the dividend per share ratio. It calculates the return expected if you purchased the shares at the current market price. What appears to be a high earnings yield could be caused by a low market price because of the expectation that future dividend flows will be less than average, or because of the existence of non-recurring or unsustainable profits. Dividend imputation ensures that the effective dividend yield will vary according to each particular investors taxation position, as a result of a businesss ability to pass on the tax already paid on the companys profit to shareholders. It is, therefore, important to assess the franking position. The extent to which the business can issue franked dividends, and the extent to which those franked dividends can be utilised by shareholders, will have a major impact on individual investors pre- and post-tax dividend yield.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1890 Stock Market/Capital Ratios / 8~1920 Dividend cover
8~1920
Dividend cover
= Times Covered
Net Profit Ordinary Dividend Paid
Net profit is defined as net profit after tax less preference dividends less minority interests, but before deducting extraordinary items. Dividend cover reflects the number of times that the dividend payout is covered by the profit generated by operations. It does not indicate the extent to which the entity has cash reserves to fund the dividend payment. Extraordinary items should be excluded as these profits are not available from normal operations to fund dividend payments. However, abnormal items should be included in the amount of net profit.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1890 Stock Market/Capital Ratios / 8~1930 Earnings per share
8~1930
Earnings per share
Profit or loss attributable to ordinary equity holders of the parent entity Weighted average number of ordinary shares outstanding during the period
= Basic Earnings per Share
Earnings per share (EPS) is one of the most contentious ratios. In the past, a great deal of latitude has been available in the EPS calculation as no commonly accepted accounting standard existed, until AASB 1027: Earnings per Share was issued. AASB 1027 has now been replaced with AASB 133: Earnings per Share. On the face of it, EPS represents earnings divided by the number of shares on issue. Earnings refers to the amount of profit attributable to ordinary shareholders, after deducting preference dividends and outside equity interests in profit but before extraordinary items. i.e. Net Profit After Tax Outside Equity Interest Preference Share Dividends = Profit Attributable to Ordinary Shareholders For businesses with simple and stable capital structures, the denominator in an EPS calculation is the number of shares on issue at the end of the year. But how should we adjust for shares which have been issued during the year? Some argue that the number of shares outstanding at the end of the year should be used since the aim is to indicate the earnings attributable to the shares on issue at year end. But to managers, this approach may produce lower EPS than they would like to report. The better argument is that, since some of the shares were not on issue throughout the year, it would be better to calculate EPS using the weighted average number of shares on issue throughout the period. The calculation is complicated further when there have been rights or bonus issues, and there should
be a restatement of prior years EPS figures when there have been rights or bonus issues to ensure comparability. Since the early 1980s, most valuers have agreed that options, warrants or convertible notes should not be ignored in EPS calculation. It has become common to report EPS on both an undiluted or basic and diluted basis (the latter taking account of the conversion of convertible securities on earnings and the number of shares on issue). Interest payments on convertible notes and the like are added back to profits, with corresponding adjustments made to the denominator to take account of the potential dilution of EPS arising from conversions. The earnings adjustment is based on the after-tax interest effect on reported earnings. Clearly, however, what is important is the ability of the firm to utilise the additional capital (i.e. in the case of options, partly paid shares etc.) to generate profits rather than interest income. The key elements of the adjustments necessary to ensure that the EPS calculation accounts for the time weighting of share issues during a year, and provides for comparability between years (and periods), are summarised in AASB 133.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1890 Stock Market/Capital Ratios / 8~1940 Price earnings ratio
8~1940
Price earnings ratio

= PER
Market Price Per Share Earnings Per Share
The price earnings ratio (PER) is derived from the market price of the share scrip and the earnings per share. This ratio is affected by the same issues discussed with the calculation of EPS. There is also the broader question of creative accounting and the way in which this impacts on the reported net profit figure and, therefore, the price earnings multiple. The selection of the market price also has a number of problems associated with it as the price can be distorted by specific factors at year end e.g. speculation regarding a potential takeover, or the share price could be depressed due to the existence of a controlling shareholder and therefore low volumes of shares on the stock exchange. Often, an average price over a relevant time period is more appropriate.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~1540 Financial Analysis / 8~1890 Stock Market/Capital Ratios / 8~1950 Net tangible assets per share
8~1950
Net tangible assets per share

= Cents per Share
Ordinary Shareholder Funds Less Intangibles EFPO at year end (EFPO = Equivalent Fully Paid Ordinary (shares)) This calculation involves a determination of:
the available net tangible assets (NTA); and the number of shares on issue.
As discussed earlier, the grey area associated with convertible debt securities, convertible preference shares, options and partly paid shares will impinge on both these aspects of the calculation. Furthermore, the identification of what truly represents the tangible assets in the financial statements can be a difficult process. The introduction by the Financial Accounting Standards Board (FASB) of Statement of Financial Accounting Standard (SFAS) 141 Business Combinations and SFAS 142 Goodwill and Other Intangible Assets has increased the occurrence of intangible assets being capitalised. In addition, the International Accounting Standards Board (IASB) has introduced similar accounting standards on business combinations (including purchased intangibles) and impairment of assets. As a result of harmonisation with international standards in Australia from 1 January 2005, the capitalisation of intangible assets on balance sheets will become more common. Typical intangible assets include goodwill, patents, franchises, copyright, trade marks, brand names, television licences and newspaper mastheads. Care should be exercised in consistently including or excluding intangible assets from the NTA calculation. From a practical perspective, a high value of intangibles can mean additional risk. If intangibles have been used to support borrowings, the under-performance of those intangibles may put the entity at risk sometimes necessitating distressed sales of assets. The future revenue and interest rate assumptions used in valuing many of these intangibles may be too optimistic. In assessing the worth of such assets, the role of cash flows and profitability is fundamental. Another danger area is the existence of inter-entity and associate business investments and loans. In such instances it is advisable to obtain the detailed financial statements for these investee companies to ascertain their true net tangible worth and earnings capacity. This will help establish whether the value recorded in the books of the entity being evaluated is justifiable.
ANALYSIS / 8~1000 Review of Historic Accounts / 8~2000 References

8~2000 1. 2.
References
Australian Accounting Standards Board, 2001, AASB 1027: Earnings per Share. Australian Accounting Standards Board, 2004, AASB 133: Earnings per Share.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections

9~1000
Preparation and Review of Forecasts and Projections
The one thing we know about a financial projection is that it will be incorrect (the problem is we do not know by how much or in which direction).
However, the preparation and analysis of projections is a necessary step, whether you are preparing a projection for 10 to 20 years for a discounted cash flow (DCF) analysis or for three to five years as part of a future maintainable earnings (FME) calculation for capitalisation purposes. Frequently, a great deal of emphasis is placed on an accurate and scientific estimate for the rate of return determination, while the same level of analysis is not undertaken to assess the future earnings potential and, in particular, the potential variability (the range of possible outcomes) of those earnings. Typically, the hardest thing to get right is the projection of cash flows, and these can have by far a bigger impact on a valuation than the selection of an appropriate discount rate. This chapter deals with the essential issues to be addressed when preparing a projection of future cash flows. These include: collecting the necessary information; obtaining a good understanding of the business and of the potential risks to the businesss cash flows; confirming management is ultimately responsible for the preparation of the projection; and determining the basis of the projection (real or nominal basis, before or after debt basis or preor post-tax basis).
Once these initial steps have been completed, any existing budgets need to be analysed and adjusted to ensure consistency in the application of accounting policies and normalisation of unusual transactions between the periods. These normalised budgets can be used in conjunction with the other information collected to gain an understanding of the business and develop longer-term projections. Generally, the overall accuracy of longer-term projections is determined by a few key variables, including the following: the sales revenue growth rate (short and long term); the gross margin; operating expenses; the tax expense; working capital requirements; capital expenditure requirements; and the sources and amounts of funding.
These variables are discussed in detail in this chapter.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1050 Forecasts or Projections
9~1050
Forecasts or Projections
The International Federation of Accountants has released International Standard on Auditing (ISA) 810, entitled The Examination of Prospective Financial Information, which describes prospective financial information as: financial information based on assumptions about events that may occur in the future and possible actions by an entity. It is highly subjective in nature and its preparation
requires the exercise of considerable judgement. Prospective financial information can be in the form of a forecast, a projection or a combination of both, for example, a one year forecast plus a five year projection. (Clause 3) This definition indicates that prospective financial information can be prepared on a variety of bases. The Australian Securities & Investment Commission (ASIC) has issued Policy Statement PS 170: Prospective Financial Information, which defines prospective financial information as: Financial information of a predictive character based on assumptions about events that may occur in the future and on possible actions by an entity [PS 170.97] Clause .04 of Auditing and Assurance Guidance Statement AGS 1062, entitled Reporting in Connection with Proposed Fundraisings prepared by the Auditing & Assurance Standards Board and the Australian Accounting Research Foundation, contains a definition with the same meaning
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1050 Forecasts or Projections / 9~1070 Forecasts
9~1070
Forecasts
ISA 810 defines a forecast as: Prospective financial information prepared on the basis of assumptions as to future events which management expects to take place and the actions management expects to take as of the date information is prepared (best estimate assumption). The Institute of Chartered Accountants in England and Wales issued statement 908 entitled Accountants Reports on Profit Forecasts, which defines a forecast as: Any published estimate of financial results made: a. b. c. In advance of completion of financial statements up to publication standard for any expired accounting period; For a current (or expired) accounting period; For a future accounting period.
The definition in ASIC PS 170 is almost identical to the ISA definition, with the exception that it omits the reference to best estimate assumption (although refer following discussion on the now superseded PN 67). forecast means prospective financial information prepared on the basis of assumptions as to future events which management expects to take place and the actions management expects to take as of the date the information is prepared [PS 170.97] The Auditing & Assurance Standards Board and the Australian Accounting Research Foundation in AGS 1062 expands on the definition by adding: The period for a forecast is generally consistent with the reporting period of the issuer, and may cover several periods. Forecasts are generally prepared by management on a comparable basis to the historical information in an offer document, to assist potential investors in making an informed assessment of the prospects of the client entity. Forecasts may also be estimated actual forecasts that combine historical information over part of a reporting period, with forecast information over the remainder of the period.
The Institute of Chartered Accountants in Australia and the Australian Accounting Research Foundation. This material is reproduced with the permission of the ICAA and the AARF. This material should not be reproduced, stored in a retrieval system or transmitted in any form without the prior written permission of the AARF and ICAA
It is interesting to note that the now superseded ASIC Practice Note 67, 'Financial forecasts in prospectuses', defines forecasts as follows: [PN 67.7] Prospective financial information can be prepared on the basis of assumptions about: (a) (b) future events which management expects to take place; and the actions management expects to take as at the date the information is prepared. (These are called best-estimate assumptions.) Information about likely future results prepared on this basis may be referred to as a forecast. [PN 67.8] Auditing Standard 804 issued by the Australian Accounting Research Foundation on behalf of the Institute of Chartered Accountants and Australian Society of Certified Practising Accountants, makes a distinction between a forecast and a projection. A financial forecast is generally understood to be prospective financial information based on: (a) (b) best-estimate assumptions about conditions; and events that may occur in the future and possible action intended by management.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1050 Forecasts or Projections / 9~1090 Projections
9~1090
Projections
ISA 810 defines a projection as: prospective financial information prepared on the basis of: a. hypothetical assumptions about future events and management actions which are not necessarily expected to take place, such as when some entities are in a start-up phase or are considering a major change in the nature of operations; or a mixture of best estimate and hypothetical assumptions.
b.
Such information illustrates the possible consequences as of the date the information is prepared if the events and actions were to occur (a what-if scenario). The AGS 1062 definition is almost identical. ASICs PS 170 defines projection as: prospective financial information prepared on the basis of: a. b. hypothetical assumptions about future events and management actions which are not necessarily expected to take place; or a mixture of assumptions management expects to take place and hypothetical assumptions.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1050 Forecasts or Projections / 9~1110 Usage of Forecasts and Projections
9~1110
Usage of Forecasts and Projections
The Institute of Chartered Accountants in England and Wales Corporate Finance Manual provides guidance on the use of the terms forecast and projection as follows: Forecast Period Basis of preparation Degree of certainty Not historic period or, if historic, not formally reported on Based on reliable information and/or assumption which can be forecast with a high degree of accuracy High degree of certainty (barring influences outside forecasters control) Projection Future period Based on given assumptions
Relatively high level of uncertainty
It is believed to be generally more appropriate to use the word projection when preparing valuations due to the potential number of future years covered in the analysis and the relatively high uncertainty associated with projecting a number of years into the future. It is interesting to note that the now superseded ASIC Practice Note 67, Financial forecasts in prospectuses, also provided guidance on the use of the terms forecast and projection as follows: [PN 67.10] In this Practice Note, the term: a. b. forecast is used to refer to all prospective financial information unless otherwise indicated; and projection is used to describe prospective financial information based on hypothetical assumptions or a mixture of best-estimate and hypothetical assumptions.
The Corporations Act 2001 gives a warning on the usage of forecasts and projections in section 728(2): (2) A person is taken to make a misleading statement about a future matter (including the doing of, or refusing to do, an act) if they do not have reasonable grounds for making the statement. ASIC policy on reasonable grounds is spelt out in ASIC Policy Statement PS 170, as follows: The misleading and deceptive prohibition [PS 170.16] The making of a statement that contains prospective financial information (like any forward-looking statement) must have reasonable grounds or it will be misleading under s 728(2) or 769C of the Act. [PS 170.17] What are reasonable grounds should be determined objectively in light of all of the circumstances at the time of the statement, so that a reasonable person would view as reasonable the grounds for the statement. Indicative factors that may suggest reasonable grounds
[PS 170.18] The following is a non-exhaustive list of factors that may amount to reasonable grounds for stating prospective financial information: a. b. forward sales contracts, leases or other contracts that lock in future expenses and revenue of a product/service and the quantum of supply; reliance upon an independent industry experts report which: i. ii. iii. c. is included in the document containing the prospective financial information; sets out the assumptions underlying that information; and makes a positive statement that both the prospective financial information and its assumptions are reasonable;
a review of the prospective financial information and underlying assumptions contained in an independent accountants report prepared in accordance with professional standards and included in the disclosure document or PDS. The independent accountants report should: i. ii. be based on an investigation of the reasonableness of the assumptions giving rise to the prospective financial information; state that there is no reason to believe that the assumptions do not provide reasonable grounds for the preparation of the prospective financial information; in addition to meeting professional standards for reporting requirements, also state that there is no reason to believe that the information itself is unreasonable; and clearly identify any hypothetical assumptions and state that they have no significant impact upon the projected outcome; or
iii.
iv. d.
short-term estimates (not exceeding 2 years) relating to an existing business and based on events that management reasonably expects to take place or actions management reasonably expects to occur.
[PS 170.19] For sales contracts or leases that have a renewal option at the end of the initial term, prospective financial information should only extend to the end of the initial term unless there are reasonable grounds to believe that the option will be exercised. These factors are not conclusive [PS 170.20] There may be other methods of establishing reasonable grounds and, importantly, the factors listed in [PS 170.18] may not be sufficient to establish reasonable grounds in some cases. Each case must be considered in light of its own particular facts and the requirements of the Act. Matters that of themselves do not indicate reasonable grounds [PS 170.21] The following is a non-exhaustive list of specific factors that do not, by themselves, establish reasonable grounds for prospective financial information in a disclosure document or PDS: a. prospective financial information supported only by hypothetical assumptions (rather than reasonable grounds);
b. c.
mere statements by issuers asserting reasonable grounds for the inclusion of information, with no verifiable reasons to support such statements; and statements along the lines of this is the best estimate of the directors. The test in s 728(2) requires that the grounds for prospective financial information be objectively reasonable.
PS 170 also details how prospective financial information should be disclosed, in particular: [PS 170.51] Investors should be given enough information to enable them to: a. assess whether the prospective financial information is relevant and reliable (ie to form their own view about how reasonable the grounds are for making the statement); and identify with certainty the facts and circumstances that support prospective financial information as well as being able to demonstrate that the information is reasonable.
b.
Note: Disclosure of this information is required under s 710 and 1013D of the Act.
[PS 170.52] We consider prospective financial information in a disclosure document or PDS should be accompanied by: a. b. c. d. full details of the assumptions (including the quantum of any assumption) used to prepare the prospective financial information; the time period covered by the prospective financial information; the risks that the prospective financial information will not be achieved; and an explanation of how the prospective financial information was calculated and the reasons for any departures from accounting standards or industry standards that investors would reasonably expect to be followed.
Presentation of information [PS 170.53] When prospective financial information is used in a disclosure document or PDS, we consider that: a. b. its underlying assumptions and limits must be displayed in a prominent way (when compared to the key statement); and where a range has been given, a more favourable figure or fact in the range should not be given undue prominence.
[PS 170.54] The term forecasts has a particular accounting meaning. The use of that or other technical terms should not be misleading to investors. Warning about reliability of prospective financial information [PS 170.55] Even where there are reasonable grounds to state prospective financial information, issuers should consider including a warning so that a reader of the document will understand its predictive character and the risks in placing undue reliance on that information. The care needed in this area is highlighted by the Federal Court of Australia ruling on Reiffel v. ACN 075 839 266 [2003] FCA 194, a case concerning the liability of an independent expert for statements
made in a prospectus commonly called a negative assurance, that is a statement prefaced by the words nothing has come to our attention which causes us to believe that (statements on behalf of the promoters) do not have a particular quality. The Court decided that, having chosen to express an opinion, the expert was under an obligation not to mislead in so doing. The Auditing and Assurance Standards Board (AuASB) has provided guidance on the presentation of prospective financial information in AGS 1062: Reporting in Connection with Proposed Fundraisings. Refer also to Auditing Standard AUS 804: The Audit of Prospective Financial Information. It is interesting to note that in a letter dated 16 October 2001 to ASIC, the Institute of Chartered Accountants in Australia supported the use of forecasts and projections in disclosure documents.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1160 Preparing to Project Future Cash Flows
9~1160
Preparing to Project Future Cash Flows
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1160 Preparing to Project Future Cash Flows / 9~1180 Information Requirements
9~1180
Information Requirements
Details of the information required to undertake and prepare a valuation are included in the chapter Research and Data Collection. The major information requirements for preparing a projection can be broadly categorised as general economic data and business specific data. The general economic variables that are considered when preparing projections include: the exchange rate; economic activity; interest rates; and the inflation rate.
The main business specific data that is considered include: historic accounts; historic budgets and how close actual results were to those forecast projections; interim financial statements; strategic and business plans; known and expected operational changes; and information on new products and plans for the future.
Generally, to begin preparing a projection that will ultimately form an integral part of the valuation process, information provided by the management of the business (including their own internal budgets) will be the first port of call. As discussed in the chapter Review of Historic Accounts, a review of historic accounts is only useful to
the extent that they provide an indication of future results. A review of past budgets against actual results will usually reveal how accurate and reliable the budgeting process is and determine whether managements projections can be relied upon. This may give the valuer some comfort (or concerns!) as to the accuracy and reliability of current budgets. If, in the past, actual results are consistently more (or less) than managements projections, the valuer will be in a better position to determine the reliance to place on future projections. Interim financial statements are also useful in assessing whether budgets are likely to be attained. Of particular interest will be the management commentaries reporting on the purposes of the business and explaining why budgets were, or were not, met and the actions being taken as a result. Even if the interim and historic budgets have been met, investigation should be undertaken to determine any changes in accounting policies throughout the period of analysis that would bring the actual figures even closer to the budgets prepared. Strategic plans, business plans and plans for new product launches etc. are necessary, as they will result in the future projections being less like historic results simply projected into the future, and require detailed consideration of their potential impact.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1160 Preparing to Project Future Cash Flows / 9~1200 Understanding the Business
9~1200
Understanding the Business
The reason for undertaking an analysis of the business is to obtain a thorough understanding of the business, the environment in which it operates and the potential risks to the businesss cash flows. Without this key information, and a good understanding of the economy, it would be very difficult to predict the future cash flows a business might expect. Attention should be given to the issues raised in the chapter Research and Data Collection and particularly the section on understanding the internal and external risks a business is exposed to.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1160 Preparing to Project Future Cash Flows / 9~1220 Responsibility for Projection Information
9~1220
Responsibility for Projection Information
As already discussed, one of the first steps when preparing a projection is to review the projections prepared by management. As discussed later in this chapter, during this process we regularly identify transactions which need to be eliminated or adjusted to provide a clearer picture of anticipated earnings. Although the valuer may initially prepare these adjustments (and any projections beyond existing management projections), it is imperative that these are discussed in detail with the client and confirmed by the client as reasonable. The client will have the best understanding of the business and its future potential. The client must be responsible for the preparation of the projections. This is particularly the case where the projections may end up being incorporated in a document for the sale of the business, or
advice is going to be given based on the value calculated for the business.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1160 Preparing to Project Future Cash Flows / 9~1240 Basis of Projections
9~1240
Basis of Projections
As indicated in the introduction, there are a number of fundamental decisions regarding the basis of the projections which need to be made before the detailed projections can commence. These include deciding whether the projections are to be prepared: on a real or nominal basis; on a before or after interest and debt basis; and on a pre- or post-tax basis.
The chapter Discount Rates discusses the situations where it might be useful to use each of the alternatives and reconciles the various bases.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1160 Preparing to Project Future Cash Flows / 9~1240 Basis of Projections / 9~1250 Real v. nominal
9~1250
Real v. nominal
In preparing a projection, one of the first items to address is whether the projection figures are in real or nominal amounts. Projections in real value reflect the revenues and expenses modelled in todays value. Real figures do not reflect anticipated inflation and assume that all costs and revenues will remain at the price they are at present. Nominal projections include the effect of inflation and, therefore, assume that the revenues and expenses will increase over the period of the analysis at the assumed rate of inflation. Generally the rates of return investors expect are expressed in nominal terms. Therefore it is generally easier to consider cost of capital (and hence cash flow projections) in nominal terms. The use of real (or inflation adjusted) rates of return may be of considerable help to multinational companies making investment decision rules that can be applied consistently in a number of countries with widely varying inflationary expectations. It is also useful when future inflation rates are expected to vary considerably over the period of the investment. However, it is difficult to adjust all future expenses and cash flow to real amounts (depreciation, interest and tax are normally expressed in nominal terms). In addition inflation can impact differently on each expense line. Finally, real projections can underestimate the level of finance required to complete a project and may misrepresent the level of gearing used to finance a project. Hence the temptation to analyse a project in real terms should generally be resisted. As demonstrated in the chapter Discount Rates, the value calculated should not differ whether cash flows are projected on a real or nominal basis, provided the basis is applied consistently and the discount rate is calculated correctly. The following diagram shows the value of $100 several years into the future in both real and nominal
terms. This particular model assumes a 10% per annum inflation rate (to emphasise the problem).
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1160 Preparing to Project Future Cash Flows / 9~1240 Basis of Projections / 9~1260 Diagram Future value of $100
9~1260
Diagram Future value of $100
If you dont know from the outset whether the projections are on a real or nominal basis, it is easy to believe that the company appears to have increasing sales when in fact, after removing the effects of inflation, sales may be static or even decreasing. In addition, it is important to establish whether the projections are real or nominal in order to determine the correct discount rate, multiple or price earnings ratio to use.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1160 Preparing to Project Future Cash Flows / 9~1240 Basis of Projections / 9~1270 Before or after interest and debt
9~1270
Before or after interest and debt
If debt is to be excluded from the valuation of the business (and deducted afterwards), the cash flows to be valued should exclude interest expense on that level of debt. This may be an appropriate calculation if a vendor is likely to change the level or structure of the debt being used to fund the business. As demonstrated in the section on treatment of debt, the value calculated should not differ whether cash flows are projected on a before or after interest and debt basis, provided the basis is applied consistently and the discount rate is calculated correctly.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1160 Preparing to Project Future Cash Flows / 9~1240 Basis of Projections / 9~1280 Pre- or post-tax
9~1280
Pre- or post-tax
A final fundamental decision regarding the basis of projections is whether they are to be on a pre- or post-tax basis. A potential problem that arises if dealing with pre-tax cash flows is that some items are taxed differently, resulting in different impacts on post-tax cash flows. As demonstrated in the chapter Discount Rates, the value calculated should not differ whether cash flows are projected on a pre- or post-tax basis, provided the basis is applied consistently and the discount rate is calculated correctly.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1330 Adjustments to Budgets Commonly Required
9~1330
Adjustments to Budgets Commonly Required
Budgets and projections are critical to a valuation since the value of a business ultimately depends on what the business will accomplish in the future. Clearly, any form of discounted cash flow valuation will be based on projections of future cash flows. However, the amount of detail that is usually required in the valuation process may not be incorporated in the existing projections prepared by the business. It is often necessary to have existing budgets and cash flow projections revised specifically for the purpose of the valuation and extended where necessary. The starting point for the determination of future maintainable earnings is an assessment of historic earnings and budgeted earnings. It is therefore necessary to adjust for any items which are not representative of the companys ongoing earnings capacity. The following items are indicative of the types of adjustment that need to be considered: review of managements budgets for commercial realism; standardisation of accounting policies to internationally accepted policies and ensuring that these are applied consistently across the years; elimination of unusual transactions; adjustment of excessive remuneration; and owners remuneration or, conversely, inadequate owners
funding costs (where an alternative funding structure is anticipated or where funding is on a fixed rate basis and interest rates have moved significantly).
The objective in adjusting managements budgets is to arrive at a pro forma profit and loss account which is representative of future maintainable earnings. In developing the pro forma, consideration should be given as to whether some mix or weighting of prior and future results (either in total or on a line by line basis) is appropriate.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1330 Adjustments to Budgets Commonly Required / 9~1350 Review of Managements Budgets for Commercial Realism
9~1350
Review of Managements Budgets for Commercial Realism
Management projections will generally be available for periods ranging between one and five years into the future. These projections, however, should be treated with caution as it has been our
experience that, regardless of the position in the economic cycle or historic performance of the business, the majority of business managers will project a steady increase in the revenue and return of the business into the future. It is therefore vitally important to carefully review any management projections provided, to ensure that an accurate projection is produced. We never cease to be astounded at the number of projections that show a business market share continually increasing. If the projections are taken to their logical conclusion a business could end up with more than 100% share of its market! This is demonstrated in the following chart:
As a result it is important that short- and long-term growth rates are discussed in detail with the management of the business. Even if a business is in a rapidly expanding industry, a realistic assessment needs to be made as to what size the business could grow to. These concepts are discussed in more detail later in sales growth rates facts v. fantasy. Where budgeted growth rates are found to be excessive, an adjustment will need to be made to ensure the calculation of a realistic level of future maintainable earnings.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1330 Adjustments to Budgets Commonly Required / 9~1370 Standardisation of Accounting Policies
9~1370
Standardisation of Accounting Policies
In preparing projections, one of the major data sources will be management budgets, as well as historic financial statements. If the financial statements have been audited, they should be read in conjunction with the notes to the accounts. The notes will detail the accounting policies used, and any changes made to the accounting policies. In order to prepare accurate projections, a comparative set of historic figures is necessary. Any changes in accounting policies in the period of the analysis will need to be addressed, and, if possible, a standardised set of figures prepared. In order to standardise the historic figures to match the projection being prepared, an adjusting spreadsheet should be prepared detailing any accounting policy variations that have occurred in the period of the analysis and their effect on those changes. This topic is discussed in more detail in the section on standardisation of accounting policies in the chapter Review of Historic Accounts.
An example of the effect of changes in accounting policies can be demonstrated through the inventory valuation method. Changes to this method (FIFO to average cost or to standard cost) can change the cost of goods sold and gross margin calculations significantly. The effect of such a change would need to be eliminated from the accounts to establish a realistic level of future maintainable earnings. Accounting policies that commonly require adjustment have been discussed in detail in the chapter Review of Historic Accounts.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1330 Adjustments to Budgets Commonly Required / 9~1390 Elimination of Unusual Transactions
9~1390
Elimination of Unusual Transactions
The purpose of a projection is to provide a tool to evaluate the prospects of a business into the future. One of the most common methods of projection is to use historic figures and short-term budgets as the base from which to extrapolate the projection figures. For this method to be effective, it is necessary to ensure that the historic figures and the short-term budgets used are reflective of the maintainable revenue and expenditure of the business. In some instances, transactions that are not common to the business may have occurred and may affect the profit of the business. It may also be possible that a future transaction (although accurately budgeted) may not be indicative of the ongoing level of future maintainable earnings. Some examples of such transactions are as follows: the sale of a division of the business; the sale of a portion of the businesss assets; insurance claim; natural disaster; or write-off of a large bad debt.
In situations where unusual transactions have occurred or they have been budgeted to occur in the short-term budgets in the historic financial statements being used as the base for the projection, these transactions or events need to be removed from the statements during the analysis. This can be done using an adjustment template that allows for revenues and expenses to be adjusted to reflect the maintainable operations of the business. This topic is discussed in more detail in the section on elimination of unusual transactions in the chapter Review of Historic Accounts.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1330 Adjustments to Budgets Commonly Required / 9~1410 Normalisation of Owners Remuneration
9~1410
Normalisation of Owners Remuneration
As stated above, all unusual transactions and events need to be removed from historic statements and projections to calculate a future maintainable earnings figure. One item that commonly requires adjustment is owners remuneration. In the case of privately owned businesses with free cash flow (defined as cash from operations less capital expenditure and dividends), it is common for the owner
to take the majority of spare cash as remuneration. Alternatively, where a business does not have free cash flow, the owner may be taking a smaller remuneration package than would normally be expected. To standardise the projection and provide a future maintainable earnings figure for a third party purchaser, the owners remuneration should be removed, and a market-based remuneration inserted into the projection to allow an analysis to be completed. This concept is discussed in more detail in the section on normalisation of owners remuneration in the chapter Review of Historic Accounts.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1330 Adjustments to Budgets Commonly Required / 9~1430 Supportable Debt
9~1430
Supportable Debt
One of the fundamental decisions in a projection is the basis on which cash flows are to be projected specifically, whether they are before or after interest and debt. If the business is to be valued inclusive of debt, interest expense needs to be included. In this circumstance, it is also important to consider: The availability and sources of funding for any additional capital required. When preparing a projection, it is always important to bear in mind the availability of financing for the business. Although management may be advising that revenue will increase, this may require additional capital expenditure, labour or premises. If this is the case, it is important to determine the sources of finance for these additional requirements. The level of debt the business can support. In addition, a review should be undertaken of the businesss current debt level and current assets. When reviewing the assets, a determination should be made as to the level of security that each asset could be used for. After this exercise has been completed, the total available security able to be offered by the business for lending purposes should be compared with the actual debt level of the company. This comparison will demonstrate whether the business has the ability to borrow further capital for any required expenditure, or whether the business is approaching or has passed its maximum sustainable debt level. This subject is discussed in more detail in the section on corporate debt in the chapter Valuing 100% of an Entity.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1480 Suggested Adjustment Template
9~1480
Suggested Adjustment Template

Attached is a sample Statement Adjustment template.
The following template can be used to build a spreadsheet to assist with adjusting a set of financial statements. This design has the advantage that it allows easy review of:
information supplied by the client; the effect of any adjustments made, with the reason for the adjustment and the other accounts affected detailed in a supporting journal; and the final balance reached.
Year Ended Jun-xx Actual Results Per client Adj $000 Note Ref#1 Jrnl Ref Adj $000 Jrnl Ref Year Ended Jun-xx Adjusted Projected Final $000
Account Income Expenses Profit Assets Liabilities Owners Equity
$000
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1530 The Key Variables
9~1530
The Key Variables
As discussed at the start of this chapter, initial research is necessary to gain an understanding of the business. Once this has been undertaken, the valuer, in conjunction with their client, is in a better position to determine the likely values of the key variables. The key variables normally include the following: the sales revenue growth rate (short and long term); the gross margin; operating expenses; the tax expense; working capital requirements; capital expenditure requirements; and the sources and amounts of funding.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1530 The Key Variables / 9~1550 Revenue Projections
9~1550
Revenue Projections
Growth rates are important to determine as they demonstrate the ability of a business to grow into the future. A financial model is then developed. Different growth rates are utilised over the short and long
term and will vary given the maturity of the business and/or industry. Attached is a sample Revenue Projections template. At Leadenhall, we use a spreadsheet designed along the following lines, as it allows growth rates and sales revenue to be quickly analysed for each major product group of a business. Year 1 Sales Quantity Growth Sales Price Change Sales Revenue Revenue Growth For the first few years, figures will be entered for sales quantity and sales price. After the initial few years, it is easier to drive the quantity and price figures by manipulating the growth percentages. A number of similar templates can then quickly be summarised to calculate total projected revenue for the business. Year 2 Year 3 Year 4 Year 5 Year 6
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1530 The Key Variables / 9~1550 Revenue Projections / 9~1560 Short-term growth rates
9~1560
Short-term growth rates
The short-term growth rate may only be used for the first two to three years of the analysis. It should be realistic, bearing in mind the market for the product or service provided by the business, the anticipated demand for the product or service and the level of penetration already achieved. In calculating the short-term growth rate, the following factors should be considered: management expectations of projected growth; external economic factors; industry growth rates; how successfully the product has been differentiated from others in the market; competition; future production capacity; capital availability; finance availability; and labour availability.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1530 The Key Variables / 9~1550 Revenue Projections / 9~1570 Long-term
growth rates
9~1570
Long-term growth rates
The long-term growth rate used in projections is calculated using a similar method to the short-term growth rate, with some minor alterations. In calculating the long-term growth rate, the availability of capital, labour and, to a lesser extent, finance, will become of greater importance. When projecting into the future two or three years, the business may well have capacity constraints, necessitating additional capital and labour to meet the growth anticipated. The major factor to consider in calculating the long-term growth rate will be the demand for the product or service into the future and the market positioning of the product or service offered by the business. As with the short-term growth rate, care should be taken to independently verify any growth rate projections made by management.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1530 The Key Variables / 9~1550 Revenue Projections / 9~1580 Sales growth rates facts v. fantasy
9~1580
Sales growth rates facts v. fantasy
The following facts have been extracted from an article written by Simon Anderson of MCSI Consulting, Vancouver, British Columbia. The article was entitled Valuing High Technology Businesses Fact v. Fantasy and based on a formal survey, but we believe its findings are generally consistent with many other industries: Sales growth will not remain constant (and certainly will not remain at a very high rate). Only a small number of companies will exceed the average growth rate for an industry. Smaller companies are generally capable of growing more rapidly. Some specialised parts of an industry may achieve higher growth rates than the rest of the industry.
To summarise, there must be strong justification for believing a particular company will exceed the industry growth rate, and, even if it does so, it is unlikely to do so for more than one or two years.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1530 The Key Variables / 9~1550 Revenue Projections / 9~1590 Forecasts of forward exchange rates
9~1590
Forecasts of forward exchange rates
In valuing an asset using cash flows in a foreign currency, there are several approaches which can be adopted. The approach adopted depends on: whether the cash is receivable or payable in the foreign currency at different periods of time and converted to the domestic currency at those points of time; or whether one is valuing an asset for a balance sheet at a specific point in time in the foreign currency and then converting to the domestic currency.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1530 The Key Variables / 9~1550 Revenue Projections / 9~1590 Forecasts of forward exchange rates / Cash is receivable or payable at different points in time
Cash is receivable or payable at different points in time
In this case, when translating cashflows denominated in a foreign currency for receipt at different periods of time, the most appropriate exchange rates to use are forward rates for periods that correspond with the timing of the individual cashflows. To arrive at forward exchange rates, consideration is taken of the domestic and foreign country yield curves and these are applied to the spot foreign exchange rate between the two countries by use of the following formula: f= s*(1 + (ra*t)) (1 + (rb*t))
where
f is the forward exchange rate, s is the spot exchange rate, ra is the per annum interest rate in country a for a term of t years, and rb is the per annum interest rate in country b for a term of t years.
The table below shows how this can be calculated. Theoretical Forward Exchange Rates Direct Quote: (USD/AUD) Years to Maturity from 30 Nov 2001 US$:A$1 2.06% 1 2 3 4 5 6 7 8 9 10 2.18% 2.78% 3.22% 3.60% 3.97% 4.20% 4.42% 4.50% 4.57% 4.65% 4.22% 4.47% 4.74% 4.92% 5.10% 5.29% 5.48% 5.67% 5.86% 6.05% 0.5098 0.5039 0.4992 0.4971 0.4966 0.4942 0.4921 0.4865 0.4805 0.4746 US Yields at 30 Nov 2001 Australian Yields at 30 Nov 2001 0.52 Theoretical Forward Exchange Rate
Notes US yields for one, two, three, five, seven and 10 years were obtained from <www.federalreserve.gov/releases>, Treasury Constant Maturity Series. Rates for the intervening years were interpolated on a straight line basis. Australian Commonwealth Treasury Bond data for three, five and 10 years were obtained from <www.rba.gov.au/statistics>, RBA Bulletin Table F2. Rates for the intervening years were interpolated on a straight line basis. Australian treasury note data for six months and treasury bond data for two years were obtained from <www.rba.gov.au/statistics>, Table OP 10. The treasury notes market yield for six months was 4.10%. The theoretical forward exchange rate for any particular date is calculated by multiplying the current exchange rate by the amount that USD1.00 would be worth at the time if invested at the relevant periods interest rate divided by the amount that AUD1.00 would be worth at the time if invested at the relevant periods interest rate. The theoretical forward rate for year 5 is calculated as follows: 0.52 ((1 + ( 3.97% 5 )) / (( 1 + ( 5.10% 5 )) = 0.49658 = 0.4966
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1530 The Key Variables / 9~1550 Revenue Projections / 9~1590 Forecasts of forward exchange rates / Valuing an asset for a balance sheet at a specific point in time
Valuing an asset for a balance sheet at a specific point in time
In the latter case, guidance can be taken from the International Accounting Standard, IAS 36, Impairment of Assets, paragraph 47, which states: Future cash flows are estimated in the currency in which they will be generated and then discounted using a discount rate appropriate for that currency. An enterprise translates the present value obtained using the spot exchange rate at the balance sheet date. That is, when valuing an asset for a balance sheet based on cash flows in a foreign currency, the present value of the cash flows should be calculated in that currency using a discount rate appropriate for that country. This present value should then be translated into domestic currency using the spot exchange rate.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1530 The Key Variables / 9~1600 Expenditure Projections
9~1600
Expenditure Projections
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1530 The Key Variables / 9~1600 Expenditure Projections / 9~1610 Gross margin
9~1610
Gross margin
From a review of the historic financial statements of the business, the gross margins can be
calculated for the periods analysed. Assuming that the business will continue operating under similar circumstances to the present, it may be fair to assume that the gross margins will also continue to be in the same range as they have been historically. Attached is a sample Gross Profit Projections template. A spreadsheet designed along the following lines allows cost of sales and gross margins to be linked to the revenue calculated previously. Year 1 Sales Revenue Growth Cost of Sales COGS % Gross Margin GP % Factors that could alter the gross margin used in the projection are as follows: improvements in efficiency; restructuring the business; changes in product mix; large increases or decreases in volume leading to increased or reduced economies of scale; or capacity constraints. Year 2 Year 3 Year 4 Year 5 Year 6
Where a number of products are sold by a company and they have differing growth rates, it may be necessary to repeat this analysis for every product group, to ensure the effect of sales mix on gross margin is correctly recognised. It is also usual to assume that any one-off improvements to gross margin will only result in a temporary increase. Competition will result in decreases in prices and competitors will also find ways to maintain their margins.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1530 The Key Variables / 9~1600 Expenditure Projections / 9~1630 Interest expense
9~1630
Interest expense
As discussed earlier in this chapter, a fundamental decision on whether the projection will be based on a before or after interest basis must be made before it can be prepared. Once this decision has been made, the level of supportable debt is calculated and any interest expense then determined. Interest expense is calculated as a function of the debt structure of the business. This is considered in detail later, in the section on sources of funds. These steps are necessary, as the funding costs of a privately operated business typically reflect the financial resources of the principals and are not necessarily representative of the funding costs which
would be incurred on an arms length basis. The level of gearing (debt) may be significantly higher or lower than that which might prevail in the industry as a whole; this has implications for the rate of return (and/or capitalisation ratios) required in valuing the business. In addition, where business operations are funded in part by shareholder or unit-holder loans, adjustments need to be made to calculate a fair third party interest cost. One approach in valuing a business is to eliminate or add back all actual interest amounts (paid and received) and then to assume that the net working capital (current assets less current liabilities) is funded by debt and that the non-current assets of the business (including any goodwill, intangibles etc.) are funded by equity. The valuation which then results is a valuation of the non-current assets. The total value of the entity is arrived at by adding the current assets/current liabilities and the value of shareholder loans, calculated by reference to equivalent market rates not by reference to actual interest paid. This method sets an initial gearing ratio as it equates equity to non-current assets and debt to net working capital. In calculating net working capital cash balances, investments and borrowings are eliminated so that the net working capital figure equates to the amount of funds required to be invested (borrowed) for the purposes of operating the business. Initial calculations for past periods often use an average of working capital, based upon the average of the opening and closing balances of net working capital. This method, while appealing in its simplicity, can produce misleading results as the actual amount of working capital employed can vary during a month and from one month to the next. In assessing the ongoing earnings, a calculated amount of working capital is used as a basis for interest charges. This amount is usually based upon a sustainable, ongoing level of debtors, inventory, creditors and other working capital items. The valuation for the non-current assets is net of any liabilities. Thus, if any payment is made for the non-current assets it is assumed that the vendor has the responsibility of discharging the liabilities attached to those non-current assets. Where the valuation is of an interest in an entity which owns non-current assets with attaching liabilities, an adjustment needs to be made to the value determined for the interest to take into account these liabilities. Similarly, if current assets are purchased, then the payment by the purchaser to the vendor for the current assets is equivalent to the net amount of assets less liabilities taken over by the purchaser. Or, where the purchaser buys into an entity with existing current assets and current liabilities, an adjustment needs to be made between the purchaser and the vendor for the net difference between current assets and liabilities as at the date of acquisition.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1530 The Key Variables / 9~1600 Expenditure Projections / 9~1640 Operating expenses (and remaining profit)
9~1640
Operating expenses (and remaining profit)
Revenue and cost of sales projections are primary inputs in the projection of operating expenses. Expenses can be classified according to their main cost driver. The majority of large operating expenses such as labour and depreciation will be based on productivity. As revenues have previously
been projected, the labour and capital required to earn the revenue can be calculated and inserted into the projection. Other minor operating expenditures can be extrapolated from the historic data being reviewed (if the business expects to continue operating in a similar manner as it has in the past). Variable minor operating expenditure should be increased at a similar rate to that of revenue to recognise the increase in cash outflow required to increase sales. Fixed operating expenditure can be taken from the historic financial statements, provided the existing capacity is not exceeded. Information on the average cost structures of businesses in various industries is available from a number of sources, which are discussed in the chapter Research and Data Collection.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1530 The Key Variables / 9~1600 Expenditure Projections / 9~1650 Income tax rate
9~1650
Income tax rate
The income tax rate used in the projection should be taken as the current tax rate, except where it is known that a change will be made to the tax rate at a point of time in the future. The taxation expense should be calculated based on taxable income, but in the absence of large permanent or timing differences it is usual to base the calculation on operating profit. It is important to realise that the recognition of tax expense does not necessarily correlate with the timing of the cash flow and an adjustment may be necessary. It is also important to decide whether any carry forward losses should be included in the projection or carried forward until offset against profits.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1530 The Key Variables / 9~1670 Balance Sheet Adjustments
9~1670
Balance Sheet Adjustments
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1530 The Key Variables / 9~1670 Balance Sheet Adjustments / 9~1680 Working capital requirements
9~1680
Working capital requirements
A projection should be prepared not only to detail the anticipated revenue and expenses of the business into the future, but also to anticipate the need for additional capital to fund working capital items. Working capital requirements should be included in the projection to enable the net cash position of the business to be established throughout the projection period. If additional working capital is required, the source of funds should be determined, and the effect of the funding (interest, preference dividends) should be included in the projection. Classically, the amount of working capital required to fund a business can be determined from historic trends. As sales go up, accounts receivable and inventory generally increase in proportion. As sales go up, purchases go up and accounts payable increase.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1530 The Key Variables / 9~1670 Balance Sheet Adjustments / 9~1690 Capital expenditure requirements
9~1690
Capital expenditure requirements
In addition to working capital requirements, the capital expenditure requirements of the business must also be considered. In preparing projections, attention must be given to the ability of the business to not only cover the working capital requirements, but also any future capital expenditure needed for the business to achieve its projected gross margin and profit. Analysis should be conducted on the projection to establish what, if any, capital expenditure is required to attain the level of revenue projected and whether additional operational expenditure will be required with the purchase of the additional capital. It is important that the amount, and timing, of capital expenditure requirements be carefully defined. It is usually best to base the capital expenditure requirements on a certain sales level being achieved. This allows sensitivity analysis to be undertaken with greater accuracy. As with working capital, if additional capital expenditure is required, the source of funds should be determined, and the effect of the funding (interest, preference dividends) should be included in the projection.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1530 The Key Variables / 9~1670 Balance Sheet Adjustments / 9~1700 Sources of funds
9~1700
Sources of funds
The source(s) of additional finance should be determined, and included in a projection. Depending on the source of the funds, the projection should be updated to include any interest, preference dividend or other payments required under the anticipated funding arrangements. Different levels of debt may be assumed in the ongoing operations and this, in turn, will affect risk or return balances. Valuations are often conducted for the purpose of valuing start-up ventures or venture capital-type enterprises, to enable the existing owners to assess the worth of their investment and to assist venture capitalists in their investment decision. Start-up ventures and venture capital-type enterprises are frequently valued by a DCF methodology, assuming the injection of certain types of funding and using the required rates of return for those tranches of funding.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1530 The Key Variables / 9~1670 Balance Sheet Adjustments / 9~1710 Estimating cash flows
9~1710
Estimating cash flows
Frequently, a great deal of emphasis is placed on an accurate and scientific estimate for the rate of return determination, while the same level of analysis is not undertaken to assess the future earnings potential and, in particular, the potential variability (the range of possible outcomes) of those earnings.
Typically, we find that there is little to be gained from an extended debate with a counter-party to a transaction or another business valuer about a precise rate of return. As we have highlighted throughout this text, every investor will have different perceptions about the risks attached to a particular earnings stream. This is why we suggest that a range of multiples or discount rates be employed. What is (arguably) of greater importance is acknowledgement that the expected returns may not be realised with any precision. When expressed in this fashion (i.e. acknowledging the realities of the commercial world), we often find that debates about the precise rate of return, i.e. risk measure, appropriate to the business are supplanted by the larger debate about the likely size of future returns. It is also important to recognise that the likelihood of projections coming to fruition diminishes over time and that the range of potential outcomes diminishes as time passes and actual results are achieved.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1760 Analysing the Projected Cash Flow
9~1760
Analysing the Projected Cash Flow
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1760 Analysing the Projected Cash Flow / 9~1780 Sensitivity Analysis
9~1780
Sensitivity Analysis
As stated at the beginning of this chapter, we can be certain of one thing: the projections prepared for any business will be incorrect. We have also listed methods that can be used to attempt to maximise the accuracy with which a projection can be prepared; however, we cannot remove the inaccuracies. As discussed above, rather than knowing the most likely projection, it is sometimes worthwhile knowing the range of possible outcomes. This is why sensitivity analysis is so important. Sensitivity analysis is used to observe the effect of changes to the projection. It can then determine the major cost or revenue drivers to the projection. For example, a business that is in an industry with major export or import volumes will be affected by exchange rate variations. Therefore, sensitivity analysis would be conducted to review the projection prepared within a range of exchange rates to determine how the overall projection would be affected through small or large changes in exchange rates. ISA 545 Auditing Fair Values Measurements and Disclosures, an International Standard on Auditing issued by the International Federation of Accountants (IFAC), expands on this aspect. In particular: 44. Identifying those assumptions that appear to be significant to the fair value measurement requires the exercise of judgment by management. The auditor focuses attention on significant assumptions. Generally, significant assumptions cover matters that materially affect the fair value measurement and may include those that are: a. sensitive to variation or uncertainty in amount or nature. For example, assumptions about short-term interest rates may be less susceptible to
significant variation compared to assumptions about long-term interest rates; b. 45. susceptible to misapplication or bias.
The auditor considers the sensitivity of the valuation to changes in significant assumptions, including market conditions that may affect the value. Where applicable, the auditor encourages management to use such techniques as sensitivity analysis to help identify particularly sensitive assumptions. In the absence of such management analysis, the auditor considers whether to employ such techniques. The auditor also considers whether the uncertainty associated with a fair value measurement, or the lack of objective data may make it incapable of reasonable estimation under the entity's financial reporting framework
Paragraphs 3751 of ISA 545 and AUS 526 Auditing Fair Value Measurements and Disclosures, the Australian Auditing and Assurance Standard, cover Testing Managements Significant Assumptions, the Valuation Model, and the Underlying Data and emphasize that it is crucial to be sure the underlying assumptions are still valid.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1760 Analysing the Projected Cash Flow / 9~1800 Ratio Analysis
9~1800
Ratio Analysis
Some of the ratios that may be useful when analysing projected financial statements are discussed in the section on financial analysis, in the chapter Review of Historic Accounts. It is important when comparing adjusted accounts that the results obtained from ratio analysis should either be consistent or any variations explainable. This will result in projections that are more likely to be of assistance when preparing a valuation.
ANALYSIS / 9~1000 Preparation and Review of Forecasts and Projections / 9~1850 References
9~1850 1.
References
Anderson, S 1999 Valuing High Technology Businesses Facts v. Fantasy, The Journal of Business Valuations Proceedings of the Fourth Joint Business Valuation Conference of the Canadian Institute of Business Valuators and the American Society of Appraisers, Ontario, Canada p. 115 Auditing & Assurance Standards Board and the Australian Accounting Research Foundation, Auditing and Assurance Guidance Statement AGS 1062, Reporting in Connection with Proposed Fundraisings Australian Securities & Investments Commission (ASIC), Policy Statement PS 170: Prospective Financial Information. Copies of this Policy Statement are available from ASICs commercial publisher, Thomson Legal & Regulatory Limited, at <www.cpd.com.au/asic> International Federation of Accountants (IFAC), International Standard on Auditing ISA 545 Auditing Fair Values Measurements and Disclosures. International Federation of Accountants (IFAC), International Standard on Auditing ISA 810 The Examination of Prospective Financial Information.
2.
3.
4. 5.
6.
Securities Institute of Australia, 2000, Applied Valuation E102, Course Notes, Australia, p. 32
VALUATION APPROACHES & METHODS
VALUATION APPROACHES & METHODS

VALUATION APPROACHES & METHODS / 10~1000 Income Approach
10~1000
Income Approach
This chapter and the following two discuss the three main valuation approaches encountered when performing a valuation: the income approach, market approach and asset approach. In later chapters we discuss: selecting an appropriate valuation method (market, asset); converting a business valuation into an entity valuation; valuing an entity without first valuing the underlying business; the valuations of other than 100% of the equity of a company; the valuation of goodwill; and updating valuations.
The valuation methods to be discussed build upon the theoretical, research and analytical issues which have been discussed in earlier chapters.
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1050 Introduction to Business Valuations
10~1050
Introduction to Business Valuations
The valuation of a closely-held business may be required for many reasons, including the sale of the business or the exit/entry of a stakeholder. However, obtaining relevant information to value closely-held businesses can be difficult. Firstly, public companies are usually not comparable because of their size and shareholding structure. Secondly, information on unlisted companies is harder to obtain and often there will be major differences between the operations of the business being valued and others in its industry. In the chapter Engagement and Documentation of Assignments which discussed the business v. the entity, we highlighted the importance of understanding what is being valued. We reproduce the diagram from that section as it is a useful aid in conceptualising the different components of an entity.
Conceptually the value of an entity is the aggregate value of each of the individual business units in that entity plus the value of any surplus assets less the value of any corporate debt. This can be represented diagrammatically as follows: Entity Valuation = Sum of the Values of each Business Unit + Value of Surplus Assets Value of Corporate Debt
In the circumstance where there is only one business unit and there are no surplus assets or corporate debt, then the value of the entity or company will be the same as the valuation of the business unit. It is also important to ensure all the assets used in the operations of the business are owned by the business and not by the owners individually. In the event there are assets held by the owners individually, the value of the business or company will need to be reduced by at least as much as it will cost to purchase or replace the assets. There are also a number of other valuation methodologies which are discussed in the chapter Other Methods and Considerations which include: rules of thumb; excess earnings; and comparable investment methods.
A comprehensive valuation will normally look at more than one valuation methodology in order to cross-check the valuations produced. It is also important to understand that the standard of value, the premise of value and the purpose of the valuation will not only affect the appropriate valuation methodology, but will also affect the value calculated.
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1120 Principle Supporting Income Approach Methods
10~1120
Principle Supporting Income Approach Methods
The income approach is based on the economic principle of anticipation (or expectation). Using this approach, the value of a business or intangible asset is based on the return, or economic income, expected to be generated by that asset in the future. Present value theory converts that future income stream into an equivalent current day amount or its present value. Given this theory, if one utilises a measure of income other than cash flow, there is an implicit assumption as to the relationship between the measure of income and cash flow.
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1140 When to use the Income Approach Methods
10~1140
When to use the Income Approach Methods
The income approach method of valuing a business is applicable in almost every situation. This is because the principle supporting the income approach is forward looking and is based on future cash generated. However it relies on the availability of accurate long-term earnings and cash forecasts.
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1160 Commonalities with the Market Approach
10~1160
Commonalities with the Market Approach
Throughout this chapter, the methodologies discussed will often refer to comparisons with listed companies. Such comparisons are the basis for the market approach to valuation, discussed in detail in the next chapter. It should therefore be borne in mind that when applying the income approach, there is a methodological similarity with the market approach if comparison is made to variables of other listed companies. Due to this, references to the income approach and market approach encountered outside of this text are sometimes intertwined.
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1180 Choosing the Appropriate Income Approach Method
10~1180
Choosing the Appropriate Income Approach Method
The main valuation methods within this approach are: discounted future cash flow; capitalisation of earnings; and owners discretionary cash flow.
The main differences between valuing earnings and cash flow revolve around: the amount of depreciation charged against earnings; the amount of capital required to be invested in working capital to fund the growth of the business; and the amount of capital required to be invested to maintain the level of real productive capacity.
Whether to base a valuation on earnings or cash flow will depend on the individual characteristics of
the company, specifically how depreciation and capital expenditure are dealt with. These factors must be considered on both an historic and projected basis.
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1180 Choosing the Appropriate Income Approach Method / 10~1200 Discounted Cash Flow (DCF)
10~1200
Discounted Cash Flow (DCF)
This text outlines several ways in which a closely-held business can be valued. The discounted cash flow approach is the main method used and it requires an assessment of the level of risk associated with the business, the consequent future cash flows and those then calculate the present day value of future net cash flows. This method has particular appeal in the following circumstances: start-up businesses where no history exists as to earnings potential, and cash flows will be irregular; cash flows can be reasonably estimated and/or are expected to be different from prior year cash flows; businesses in a high growth phase or facing large, irregular cash outflows to support fixed asset replacement programs; and limited-life ventures (e.g. a gold mine) or single-project businesses (e.g. a property development).
Entities with a profit profile such as the following example would apply the DCF methodology.
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1180 Choosing the Appropriate Income Approach Method / 10~1200 Discounted Cash Flow (DCF) / 10~1210 Key issues when valuing a business
using DCF methodology

10~1210
Key issues when valuing a business using DCF methodology
Some of the key elements for preparing a sound valuation using DCF methodology are discussed in the earlier chapter Net Present Value Fundamentals. These include: calculation of an appropriate discount rate to apply to the future maintainable earnings; selection of the appropriate discount point; and calculation of a realistic terminal value.
Some additional issues when applying the theory include: calculating the earnings and cash flows which can reasonably be expected to be earned by the organisation in the long term; converting the business valuation to an entity valuation; and valuing other than 100% of the equity of an entity.
Note that it is usual to discount future cash flows, but where future earnings approximate anticipated future cash flows, it is then possible to discount future earnings.
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1180 Choosing the Appropriate Income Approach Method / 10~1200 Discounted Cash Flow (DCF) / 10~1220 Future maintainable earnings
10~1220
Future maintainable earnings
The one thing we can be sure of with respect to forecasts is that they will be wrong the moment they are completed. This means that an assessment needs to be made on a range of probable future cash flows. There are two main ways of narrowing down the range of outcomes. These are: the use of a most likely or best estimate scenario and application of a risk adjusted discount rate; and the use of the alternative cash flow outcomes multiplied by a weighting using certainty equivalent factors to develop a weighted average cash flow profile.
The use of certainty equivalent factors has particular appeal where, for example, short-term cash flows are known with a high degree of certainty, e.g. by virtue of contracted arrangements, but latter years are highly uncertain. There is an element of subjectivity in either method. However, in most circumstances the use of a most likely scenario and a risk adjusted discount rate is the most practical solution. Two previous chapters should be considered when determining forecasts as they discuss adjustments that may be required to normalise and standardise historic and forecast accounts. Please refer to these chapters: Review of Historic Accounts; and Preparation and Review of Forecasts and Projections.
VALUATION APPROACHES & METHODS / 10~1000 Income Approach /

10~1180 Choosing the Appropriate Income Approach Method / 10~1200 Discounted Cash Flow (DCF) / 10~1230 Calculating an appropriate discount rate
10~1230
Calculating an appropriate discount rate
As explained previously, the discount rate represents two things: the risk associated with the business and the consequential future cash flows; and the return required from an investment to generate the future cash flows.
Thus it represents the rate at which those future cash flows are discounted in order to arrive at the present value of those cash flows. The discount rate or required rate of return is a combination of the opportunity cost (what an investor could earn from a risk-free investment such as a Government bond) plus a risk premium (a premium for the risk associated with obtaining the expected returns from the particular investment). When the discount rate incorporates an assessment of the probability of achieving the projected cash flows it is known as a risk adjusted discount rate. The discount rate will also vary depending on whether the cash flows are: real or nominal; pre- or post-tax; pre- or post-interest; or inclusive of risk or exclusive of risk adjustments.
There are alternative ways of determining the present value of cash flows including the use of single-period discount rates and the application of certainty equivalents. These are discussed in more detail in the section on alternative approaches to the risk adjustment of cash flows. In determining the appropriate rate to apply one should take into account the nature of the business, the risks involved and the stability or regularity of past and future cash flows. The determination and interpretation of discount rates is considered in detail in the chapter Discount Rates.
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1180 Choosing the Appropriate Income Approach Method / 10~1200 Discounted Cash Flow (DCF) / 10~1240 Summary of issues to consider when using DCF methodology
10~1240
Summary of issues to consider when using DCF methodology
There are a number of issues to consider when using the DCF method and these include: whether reliable long term forecasts (operating and capital) are capable of being developed; whether to use a most likely estimate of income or a probability weighted average cash flow; calculating the discount rate and whether a single discount rate is appropriate for all years; the timing of expected cash flows and selecting suitable discount points; and making a decision on whether the cash flows continue from a certain point into perpetuity without change (ongoing value) or whether it is preferable to assume an effective sale of the
business at that point in time (terminal value).
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1180 Choosing the Appropriate Income Approach Method / 10~1200 Discounted Cash Flow (DCF) / 10~1250 Adjustments required
10~1250
Adjustments required
A DCF analysis can produce different types of valuations depending on the adjustments made to the cash flows. If earnings have been normalised for owners discretionary expenditure the value produced is a marketable control value. If earnings have not been normalised for owners discretionary expenditure the value produced is a marketable minority interest value. Adjustments may be required for the following reasons: to convert the business valuation to an entity valuation; and to value other than 100% of the equity of an entity.
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1180 Choosing the Appropriate Income Approach Method / 10~1200 Discounted Cash Flow (DCF) / 10~1260 Discounted cash flow example
10~1260
Discounted cash flow example
Consider the following post-tax real cash flow stream attributable to a mining venture with an estimated 10 year life. Cash flows have been assumed to occur at the end of each year for simplicity (see section on discount points) and a post-tax real rate of return of 25% is considered appropriate.
Year 0 ($m) Post-tax Real Cash Flow Post-tax Real Discount Rate Present Value Cumulative Present Value Total Net Present Value (100.0) Year 1 ($m) (20.0) 25% (16.0) (116.0) Year 2 ($m) 0.0 25% 0.0 (116.0) Year 3 ($m) 20.0 25% 10.2 (105.8) Year 4 ($m) 60.0 25% 24.6 (81.2) Year 5 ($m) 100.0 25% 32.8 (48.4) Year 6 ($m) 100.0 25% 26.2 (22.2) Year 7 ($m) 100.0 25% 21.0 (1.2) Year 8 ($m) 100.0 25% 16.8 15.5 Year 9 ($m) 100.0 25% 13.4 29.0 Year 10 ($m) 120.0 25% 12.9 41.9
25% (100.0) (100.0)
41.9
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1180 Choosing the Appropriate Income Approach Method / 10~1200 Discounted Cash Flow (DCF) / 10~1260 Discounted cash flow example / 10~1265 Computations of value indicators example
10~1265
Computations of value indicators example
Click here to view the Computations for Template Valuation Indicators of Company Pty Ltd.
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1180 Choosing the Appropriate Income Approach Method / 10~1200 Discounted Cash Flow (DCF) / 10~1270 Sources of DCF models
10~1270
Sources of DCF models
Leadenhall periodically comes across valuation models produced by other organisations. Among these are: McKinsey DCF Valuation 2000 Model; Valuation Master 6.0 and ValueBase, available from NACVA; and Building a Discounted Cashflow Model Online, available from the Securities Institute (www.securities.edu.au).
There are many other DCF models available and the mention of those above is not an endorsement of these products.
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1180 Choosing the Appropriate Income Approach Method / 10~1280 Capitalisation of Earnings
10~1280
Capitalisation of Earnings
This valuation method involves dividing an estimate of the businesss annual future maintainable earnings (FME) by a market capitalisation rate. This rate represents the return an investor would expect to earn from investing in the business which is commensurate with the individual risks associated with the business. Similarly, the capitalisation rate can also be viewed as the rate of return achievable from investing in an alternate asset of similar risk profile to the business in question.
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1180 Choosing the Appropriate Income Approach Method / 10~1280 Capitalisation of Earnings / 10~1290 Key issues when valuing a business using capitalisation of earnings methodology
10~1290
Key issues when valuing a business using capitalisation of earnings methodology
The important issues to address when using this method of valuation are: estimating future maintainable earnings; calculating an appropriate rate of return; making assumptions as to ongoing real growth in earnings; converting the business valuation to an entity valuation; and valuing other than 100% of the equity of an entity.
This method assumes that all of the assets, tangible or intangible, are indistinguishable parts of the business and does not attempt to separate their individual values.
Whilst discounted cash flow analysis is a commonly misunderstood and misinterpreted form of valuation, people are often surprised to learn that the more familiar and readily understood capitalisation of earnings method is a derivative of the discounted cash flow methodology. This is perhaps not so surprising when one considers that, ultimately, it is the cash that a business can generate which is valuable. This applies whether the business is a property developer, restaurant, gold mine, pharmaceutical manufacturer or any other type of business. Because of the difficulties in obtaining detailed cash flow projections, the capitalisation of earnings method is a common valuation methodology. There are exceptions for particular industries and for businesses such as mining companies, limited life ventures (such as quarries) and single asset projects (e.g. property developments), where the DCF methodology is most common. A flaw of this method which often emerges is the extrapolation of bullish results and prices into the future without regard for the fact that those circumstances were a short-term aberration. This applies equally to extrapolations in recessionary times. In most cases, it is inappropriate to project forward without first considering the economic circumstances existing now and likely to exist in the future. An example of an earnings profile which could not be accurately capitalised is set out below:
Capitalisation of earnings is valid where: there are no unusual transactions in historic earnings (or they have been eliminated); the earnings stream is considered to be consistent, that is, at a more or less constant level of real earnings in perpetuity; there are no unusual transactions anticipated in future years; expected growth rates are predictable and moderate enough for relationships to hold on a long term basis; the business has been long established and has undergone all the necessary major capital expenditure (apart from ongoing maintenance);
there are no large capital expenditure requirements; and ongoing capital expenditure requirements approximate annual depreciation and amortisation charges. In other words the cash flow should be consistent (with the earnings).
A capitalisation of earnings method should be used with caution for businesses that are capital intensive. At a minimum, the value calculated should be cross checked against a value derived from the orderly realisation of the assets. For further discussion on what to include/exclude when using a capitalisation of earnings methodology, refer to what is being valued.
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1180 Choosing the Appropriate Income Approach Method / 10~1280 Capitalisation of Earnings / 10~1300 Future maintainable earnings
10~1300
Future maintainable earnings represent the expected level of after tax profits for the company, business or business segment which is expected to be generated consistently for at least a further five years (and in many cases, significantly longer). The starting point for the determination of future maintainable earnings is an assessment of historic earnings and budgeted earnings. In determining what constitutes future maintainable earnings it is necessary to adjust for any items which are not representative of the companys ongoing earning capacity. The objective in adjusting historic results is to arrive at a pro forma profit and loss account which is representative of future maintainable earnings under third party management. In developing the pro forma, consideration should be given as to whether some mix or weighting of prior results (either in total or on a line by line basis) is appropriate. However, it should always be borne in mind that historic results are only of use in so far as they provide a guide to the future and the reliability of budgets/projections. Great care must be taken in assuming that historic growth rates for profit or revenue will continue into the future, and using such growth rates to project forward. As earnings are a residual calculation (being revenues less costs) there is scope for a small variation in revenue or expenses to impact significantly upon profit. Accordingly, a sound understanding of historic profits and the reason for their growth must be gained before attempting to project historic results into the future. Accordingly, the period of review should be long enough to cover any cyclical fluctuations and should exclude any periods where conditions were substantially different from those at present and expected in the future. In other words, it is necessary to ascertain what period of analysis will produce a result that is representative of the companys ongoing maintainable earnings capacity. Two previous chapters should also be considered when determining FME as they discuss adjustments that may be required to normalise historic and projected accounts: Review of Historic Accounts; and
Preparation and Review of Forecasts and Projections.
A number of creative accounting techniques can be employed and these can distort earnings from year to year. It is important to look behind financial statements and ascertain, and adjust for, any creative accounting techniques which have been used. Often these can be identified through the application of ratio analysis and common sense after a physical inspection of the operation, and then relating these to the financial statements. It is also easy to assume that staff, customers and suppliers (especially for a small business) will continue under new management or ownership. In fact, many of these will change due to loyalties to prior owners. As a result, when conducting a valuation for the purpose of sale it is necessary to understand the level of continuity which can be expected for staff, managers, suppliers and customers. Similarly, if a business being valued has recently suffered some form of liquidity crisis, it is possible that suppliers will look to shorten credit terms and hence increase the amount of working capital which is required in the business. This should be accounted for in the valuation process by providing for additional working capital. In the case of most mining ventures, single project businesses and businesses undergoing significant structural change, it is inappropriate to use a future capitalisation of earnings methodology, instead a DCF methodology should be applied.
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1180 Choosing the Appropriate Income Approach Method / 10~1280 Capitalisation of Earnings / 10~1310 Calculating a capitalisation rate Relationship with price earnings ratios (PERs)
10~1310
Calculating a capitalisation rate Relationship with price earnings ratios (PERs)
The capitalisation rate is, to a degree, related to the price earnings ratio. It can be common practice to take the inverse of the PER witnessed in the market-place and apply this as the capitalisation rate or post-tax real rate of return. However, a complication arises given the historic nature of market-place PERs, that is, because current prices are related to past earnings the PER does not take into consideration real growth prospects in earnings. For this reason, an entitys PER and capitalisation rate are only comparable if the past years earnings equate to estimated future maintainable earnings. This equality will not hold if future growth in earnings is considered reasonable. Similarly, if the entity is in an early stage of its life cycle, last years earnings would not be representative of ongoing earning potential. When future earnings growth is considered reasonable, a simple adjustment can be made to convert the PER to an appropriate capitalisation rate (required rate of return). This is achieved by including the assumed real growth rate when calculating the inverse of the PER. The correlation between rates of return and PE ratios is discussed in more detail in the chapter Price Earnings Ratios. We can therefore express the figures at which future maintainable earnings are capitalised as per the following equations. Note that the assumptions inherent in this equation are that earnings equal cash flows and earnings grow at a constant rate.
r=
1 PER
+g
or PER = 1 (rg)
Where: PER = price earnings ratio r = capitalisation rate/required rate of return g = real earnings growth Thus Equals 1 (20%0%) PER of 5.0 OR 1 (20%2%) PER of 5.6
The first example depicts a scenario in which historic earnings can be safely assumed to approximate ongoing earnings. The second example incorporates the assumption of an ongoing annual real growth in earnings of 2%. The above examples highlight the need when selecting the multiple to be applied to estimated future maintainable earnings to consider both the rate of return required from the business and its expected earnings growth rate. Different views will be held as to the relative riskiness of businesses and the rates of return required thus a range of PERs is normally considered. It should also be noted that the assumption of real growth into perpetuity is somewhat fraught with danger. Care must be taken to ensure that such growth does not culminate in an unrealistic market share for the business, or even sales figures which exceed the total market size. A final issue to be borne in mind is that the rate of return witnessed in the market-place is generally a post-tax nominal rate of return. Incorporation of this rate into the above calculations will therefore introduce distortion as a result of differences in the bases of calculations, i.e. real earnings estimates coupled with nominal required rates of return. Attached is a sample PER/WACC Calculation template. The following table demonstrates how a post-tax nominal rate of return, either obtained from the market or calculated from first principles, can be converted to a post-tax real rate of return. The resulting post-tax real rate of return can then be converted to a PER. The underlying calculations are discussed in more detail in the chapter Price Earnings Ratios. Component of Discount Rate Calculation Risk-free Rate Market Premium Note 1 2 Rf RmRf Rates 5.15% 6.60%
Component of Discount Rate Calculation Beta Post-tax Nominal Nominal Earnings Growth Real Earnings Growth Implied Inflation Post-tax Real (Use Fisher Equation) Corporate Income Tax Pre-tax Real Pre-tax Nominal
Note 3 4 5 Calc KPostN
Rates 2.25 20.00% 7.50% 4.50%
Calc Calc KPostR
3.00% 16.50% 30.00%
Calc Calc 7
KPreR KPreN Check
23.58% 27.29% 27.29% 8.3
PER Equivalent = 1 / [Keg], where Ke = Post-Tax Real:
Notes 1. 2. 3. 4. Risk-free rate is based on the 10 year bond rate. Market premium is estimated. Beta is based on sector data. This should be compared with the nominal return for the local stock market Accumulation Index. These are post-tax nominal rates of return. These rates vary significantly depending on the time frame chosen. Calculated using the CAPM equation. 5. Nominal earnings growth of the company being valued. This Years EarningsLast Years Earnings Last Years Earnings
6. 7.
Implied inflation can be estimated as the nominal bond yield less yield on indexed bonds. Calculation checked via the alternative method of conversion i.e. KPostN to KPreN.
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1180 Choosing the Appropriate Income Approach Method / 10~1280 Capitalisation of Earnings / 10~1320 Summary of issues to consider when using capitalisation of earnings methodology
10~1320
Summary of issues to consider when using capitalisation of earnings methodology
The capitalisation of earnings methodology needs to be applied carefully for a number of reasons. These include: earnings do not equate to cash flows; the capitalisation rate is attempting to incorporate into one figure a number of factors which can
fundamentally affect the value of the business; no account is taken for additional capital expenditure requirements; and no account is taken for additional working capital required to fund the ongoing growth of the business.
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1180 Choosing the Appropriate Income Approach Method / 10~1280 Capitalisation of Earnings / 10~1330 Adjustments required
10~1330
A capitalisation of future earnings analysis can produce different types of valuations depending on the adjustments made to the cash flows. If earnings have been normalised for owners discretionary expenditure the value produced is a marketable control value. If earnings have not been normalised for owners discretionary expenditure the value produced is a marketable minority interest value. Adjustments may be required for the following reasons: to convert the business valuation to an entity valuation; or to value other than 100% of the equity of an entity.
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1180 Choosing the Appropriate Income Approach Method / 10~1350 Owners Discretionary Cash Flow Multiple
10~1350
Owners Discretionary Cash Flow Multiple
This ratio represents the multiple by which a companys earnings (post-interest and tax and owners discretionary expenditure) are capitalised to determine its value. It relies on the multiplication of estimated future maintainable cash flow by a multiple.
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1180 Choosing the Appropriate Income Approach Method / 10~1350 Owners Discretionary Cash Flow Multiple / 10~1360 Key issues when valuing a business using an owners discretionary cash flow multiple
10~1360
Key issues when valuing a business using an owners discretionary cash flow multiple
The important issues when using this method of valuation are: estimating future maintainable cash flow; calculating an appropriate multiple; converting the business valuation to an entity valuation; and valuing other than 100% of the equity of an entity.
Capitalisation of an owners discretionary cash flow is valid where:

the salary and benefits to the owner represents a significant amount of the benefits of ownership; the business is extremely small; reliable comparative transactions can be obtained; there are no unusual transactions in historic earnings (or they have been eliminated); the earnings stream is considered to be consistent, that is, at a more or less constant level of real earnings in perpetuity; there are no unusual transactions anticipated in future years; expected growth rates are predictable and moderate enough for relationships to hold; the business has been long established and has undergone all the necessary major capital expenditure (apart from ongoing maintenance); there are no large capital expenditure requirements; and ongoing capital expenditure requirements approximate annual depreciation and amortisation charges. In other words the cash flow should be consistent (with the earnings).
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1180 Choosing the Appropriate Income Approach Method / 10~1350 Owners Discretionary Cash Flow Multiple / 10~1370 Future maintainable earnings
10~1370
Future maintainable earnings represents the expected level of after tax profits for the company, business or business segment which is expected to be generated consistently for at least a further five years (and in many cases, significantly longer). The starting point for the determination of future maintainable earnings is an assessment of historic earnings and budgeted earnings. In determining what constitutes future maintainable earnings it is necessary to adjust for any items which are not representative of the companys ongoing earnings capacity. The objective in adjusting historic results is to arrive at a pro forma profit and loss account which is representative of future maintainable earnings under third party management. In developing the pro forma, consideration should be given as to whether some mix or weighting of prior results (either in total or on a line by line basis) is appropriate. However, it should always be borne in mind that historic results are only of use in so far as they provide a guide to the future and the reliability of budgets/projections. Great care must be taken in assuming that historic growth rates for profit or revenue will continue into the future, and using such growth rates to project forward. As earnings are a residual calculation (being revenues less costs) there is scope for a small variation in revenue or expenses to impact significantly upon profit. Accordingly, a sound understanding of historic profits and the reason for their growth must be gained before attempting to project historic results into the future. Accordingly, the period of review should be long enough to cover any cyclical fluctuations and should
exclude any periods where conditions were substantially different from those at present and expected. In other words, it is necessary to ascertain what period of analysis will produce a result that is representative of the companys ongoing maintainable earnings capacity. The types of adjustments commonly required are outlined in detail in these previous chapters: Review of Historic Accounts; and Preparation and Review of Forecasts and Projections.
A number of creative accounting techniques can be employed and these can distort earnings from year to year. It is important to look behind financial statements and ascertain, and adjust for, any creative accounting techniques which have been used. Often these can be identified through the application of ratio analysis and common sense after a physical inspection of the operation, and then relating these to the financial statements.
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1180 Choosing the Appropriate Income Approach Method / 10~1350 Owners Discretionary Cash Flow Multiple / 10~1380 Calculating an owners discretionary cash flow multiple
10~1380
Calculating an owners discretionary cash flow multiple
A suitable multiple can be calculated using the following formula: Business Value + Interest Bearing DebtExcess Funds on Hand Pre Tax Earnings + Interest ChargesInterest Income + Depreciation + Amortisation + Non Recurring Income & Expense + Owners Compensation We recommend using a table similar to the one used to calculate a PER from comparable listed companies in order to then calculate a weighted average EBITDA multiple.
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1180 Choosing the Appropriate Income Approach Method / 10~1350 Owners Discretionary Cash Flow Multiple / 10~1390 Summary of issues to consider when using owners discretionary cash flow multiples
10~1390
Summary of issues to consider when using owners discretionary cash flow multiples
This methodology needs to be applied carefully for a number of reasons. These reasons include: the methodology is only suitable for extremely small businesses, where salary and benefits represent a significant amount of the benefits of ownership; the method typically ignores asset values and does not provide for a reasonable compensation to the owner for working in the business; earnings do not equate to cash flows; the multiple is attempting to incorporate into one figure a number of factors which can fundamentally affect the value of the business; no account is taken for additional capital expenditure requirements; and
no account is taken of additional working capital required to fund the ongoing growth of the business.
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1180 Choosing the Appropriate Income Approach Method / 10~1350 Owners Discretionary Cash Flow Multiple / 10~1400 Adjustments required
10~1400
A valuation of owners discretionary cash flow produces a control value under an investment value standard. Adjustments may be required for the following reasons: to convert the business valuation to an entity valuation; or to value other than 100% of the equity of an entity.
VALUATION APPROACHES & METHODS / 10~1000 Income Approach / 10~1450 References

10~1450 1. 2. 3.
References
Reilly, R.F. 1992, Tackling a Common Appraisal Problem, Journal of Accountancy, October 1992, p 92. Scherf, Stephen J. 1999, Determining the Appropriate Valuation Method, NACVA Business Valuation Leaning Institute, August 1999 Securities Institute of Australia 2000, Topic 6 Capitalisation of Earnings and Other Methodologies, Applied Valuations E102 p. 67
VALUATION APPROACHES & METHODS / 11~1000 Market Approach

11~1000
Market Approach
This chapter discusses the market approach to valuation, the second of the three main valuation approaches. Situations in which this is best applied and the various categories of market based valuations are also addressed.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1050 Principle Supporting Market Approach Method
11~1050
Principle Supporting Market Approach Method
The market approach to value is based on the principle of substitution. In other words, substitute products should sell at the same price. This approach to value involves determining value multiples from comparative company data or market transactional data. (Scherf, Stephen J. 1999 p. 13)
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1100 When to use Market Approach Methods
11~1100
When to use Market Approach Methods
It is appropriate to use the market approach methods when: there is an adequate number of comparable companies or market transactions (at least five, preferably more); reliable data is available for both the subject business and the comparable companies; and the business has an expected steady earnings stream.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method
11~1150
Choosing the Appropriate Market Approach Method
The main valuation methods under this approach are: price/earnings; price/earnings before interest and tax (EBIT); price/earnings before interest, tax, depreciation and amortisation (EBITDA); price/cash flow; price/net asset value; and price/revenues.
The main issues to consider when selecting which market based valuation method to use include: 1. The requirements of the engagement, including: 2. the standard of value to be utilised; the premise of value to be utilised; and the purpose of the valuation.
Whether the measurement data is reasonably reflective of the economic benefits of ownership (i.e. economic benefits are most closely related to cash flow, then earnings, followed by revenue and finally asset backing). Whether the data to be used is available (and reliable) for both the company being valued and the comparison companies. Whether current earnings/cash flows are significantly positive for both the subject and comparable companies and are expected to approximate future earnings. Whether the selected value drivers can reasonably be compared with the market price (i.e. using net asset backing to compare the price of industrial companies would not be appropriate). Whether the selected value drivers will be affected by the treatment of debt of the two companies. Whether there are established valuation practices in the industry and what the value drivers for the industry are.
3. 4. 5. 6. 7.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1170 Price
Earnings Ratios (PERs)

11~1170
Price Earnings Ratios (PERs)
The price earnings ratio (PER) represents the multiple by which a businesss earnings is capitalised to determine its value. It relies on the multiplication of estimated annual post-tax future maintainable earnings (FME) by a PER. The chapter Price Earnings Ratios provides an in-depth discussion on the subject.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1180 Key issues when valuing a business using a PER
11~1180
Key issues when valuing a business using a PER
The important issues when using this method of valuation are: calculating the level of future maintainable earnings, which can reasonably be expected to be earned by the organisation in the long term; selecting an appropriate price earnings ratio, or multiple, to apply to the earnings estimate. This can be done by calculating a PER: based on the PERs of comparable listed companies; or based on PERs on sales of comparable companies;
converting the business valuation to an entity valuation; and valuing other than 100% of the equity of an entity.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1180 Key issues when valuing a business using a PER / 11~1190 Future maintainable earnings
11~1190
A PER is applied to the future maintainable earnings. Firstly, the level of maintainable earnings which can reasonably be expected to be earned must be established. Historic earnings are relevant only to the extent that they provide a guide as to the future. There are often significant differences between earnings and cash flow and the expected earnings may not be constant particularly in the short term. In these cases, judgement is required on the appropriate level of FME to be used. When determining FME, adjustments may be required to normalise and standardise historic and forecast accounts. Please refer to these earlier chapters: Review of Historic Accounts; and Preparation and Review of Forecasts and Projections.
It is normal practice to apply the PER to a range of FMEs.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach /

11~1150 Choosing the Appropriate Market Approach Method / 11~1200 Calculating a PER
11~1200
Calculating a PER
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1200 Calculating a PER / 11~1210 PERs of comparable listed companies
11~1210
PERs of comparable listed companies
Often, due to the lack of publicly available information on the sale of unlisted or private businesses we are forced to rely on two main sources of information regarding rates of return: 1. Historic price earnings ratios for publicly listed companies, adjusted for the many factors which make those rates of return lower than for private businesses (e.g. size of business, liquidity etc.). Rates of return from alternative investment instruments such as deposit rates, bond rates and yields on other fixed interest type investments, adjusted for estimated risk factors.
2.
In the case of a listed public company, a price earnings ratio can be found in the share market lists in the financial sections of newspapers. Here it represents a multiple upon which relatively small parcels of shares have been traded between buyers and sellers in the public market-place. The price earnings ratio represents the multiple which a purchaser is prepared to pay for a given level of earnings. It should be borne in mind that the price earnings ratios found in the public arena represent the multiple upon which historic earnings are traded in the current market-place, using investors expectations about the future. In undertaking a valuation we are usually concerned about the valuation of current or future earnings using a current or prospective price earnings ratio. The price earnings ratios found in the public arena are nevertheless a useful starting point in determining an appropriate ratio for the entity being valued. However, major sets of adjustments need to be made before the price earnings ratio of a publicly traded company can be used as a suitable surrogate. As the price earnings ratio represents the quantification of the risk/return relationship, care must be taken in drawing direct comparisons with similar companies due to varying risks within those companies. Once this initial comparison has been conducted (assuming relatively comparable companies exist) specific risks associated with the entity being valued must be considered. The PERs of comparable listed companies can be converted to a private company PER by: determining a weighted average PER for a publicly listed company; and then converting the PER from a weighted average public company PER to a private company PER. Attached is a sample PER Comparable Companies template. An example of how to build up a price earnings ratio from publicly available information is set out below. The first step is to determine the PERs of comparable listed companies.
An example of how to build up a price earnings ratio from publicly available information is set out below. The first step is to determine the PERs of comparable listed companies.
Company Normal Trading Volume Current After-tax Market Profit 20X0 Capitalisation ($m) ($m) Public Co 1 Public Co 2 Public Co 3 Public Co 4 Public Co 5 Weighted Average Yes Yes Yes Yes Yes 1,450 2,340 2,980 1,625 3,185 11,580 (Total) 100 150 200 125 175 750 (Total) 14.5 15.6 14.9 13.0 18.2 15.44 110 145 205 140 190 790 (Total) 13.2 16.1 14.5 11.6 16.76 14.66 PER based on 20XX Profit (x) After-tax Profit 20X1 ($m) PER based on 20X1 Profit (x)
The information needed to complete this table can be found in most daily newspapers and is also available from stockbrokers research reports. This data should correspond with the date on which the valuation is to be based. It is also worth collecting information on the industry sector and for the market as a whole as they provide useful reference points. The Securities Institute of Australia makes the point that a valuer should: not simply apply the average of the multiples from similar companies, but instead undertake detailed consideration of the individual characteristic of the company being valued and the comparable companies so as to assess where in the range the particular company should sit. The multiple of any particular company will reflect its own unique circumstances and attributes. The choice of an appropriate earnings multiple is therefore a matter of judgement rather than a mechanical process. Factors to be taken into consideration include: Growth opportunities for the business... The size of the business... The level of gearing... The general attributes of the company and its industry... The size of the free float of shares The asset backing of the business.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1200 Calculating a PER / 11~1220 PER based on the sales of comparable
businesses
11~1220
PER based on the sales of comparable businesses
The assessment of an appropriate capitalisation ratio will take into account comparable sales of similar businesses. In the United States, this is common practice, as comparable data is readily available from transactional databases. However, in many other countries there may be insufficient data from a reliable source. In addition what data is published (in newspapers, stockmarket reports and by business brokers) is typically: not of a comparable size; of a different market segment; for one-off transactions (which may not be a fair indication of the industry average); not indicative of special considerations included in the price; or not of a cash equivalent value.
Therefore, in many countries, a calculation of a PER based on the sale of comparable business can be fraught with danger and is not recommended.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1200 Calculating a PER / 11~1230 Summary of issues to consider when using PERs
11~1230
Summary of issues to consider when using PERs
Price earnings ratios need to be applied carefully for a number of reasons. These reasons include: quoted price earnings ratios are normally based on historic, not expected, earnings; earnings do not always equate to cash flows (gold production is a good example); or prices witnessed in the market-place reflect future earnings expectations whereas quoted price earnings ratios are calculated using historic earnings.
If the market is expecting an improved performance from an industry sector or company, the price of the stocks concerned will be bid up with a consequent increase in price earnings ratios on an historic earnings basis. However, if the current market prices are compared with projected earnings then one might see a slight fall or flattening out of the price earnings ratios. It is very important therefore when discussing price earnings ratios to be clear as to whether one is basing the ratio on the current share price against historic earnings or the current share price against prospective earnings. A word of caution needs to be sounded when selecting a possible price earnings ratio from an industry sector or individual company. It is quite common to find that there are few direct comparisons on the market and that each company has its own particular profile and mix of businesses. The answer lies in the fact that to be strictly comparable one should break down the various business units of a company and look at comparable price earnings ratios for each business unit. Comparability is less of a problem in price earnings ratios when dealing with relatively pure industries which are involved in one core activity, e.g. banks. It is important when selecting price earnings ratios that the ratios obtained are not distorted through
special trades that may have occurred in a companys stock or as a result of any market irregularities. It can be a useful cross-check to compare ratios of a company to the ratios of the industry and to the ASX All Industrial classification. Also, select points in time and ensure that any variations between the PERs can be explained. Likewise, price earnings ratios obtained from a very thin market-place (i.e. very little volume traded) may not be indicative of values. It is normal practice in a going concern valuation to define value as the amount which would be exchanged between a willing but not anxious buyer and a willing but not anxious seller. In an overheated market, or a depressed market, these fundamental assumptions of willing but not anxious must be considered very carefully. In an overheated market-place, there are often reluctant sellers but anxious buyers. Conversely, in a depressed market there can be many forced sales (anxious sellers) and very few buyers prepared to pay full value. Accordingly, the price earnings ratios obtained in such a marketplace can be distorted and should not be applied without careful consideration. This is particularly so given the adjustments required for the different business risks, application to future instead of historic earnings and whether there is a premium for control.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1200 Calculating a PER / 11~1240 Adjustments required
11~1240
As we generally rely on stock market data to calculate this multiple, the value produced from this calculation will be a marketable minority interest value and this determines what adjustments need to be made. If reliable comparative sales data is available and was relied on, the value produced is a marketable control value. Adjustments may be required for the following reasons: to convert the business valuation to an entity valuation; to convert the multiple from a public company PER into a private company PER; or to value other than 100% of the equity of an entity.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1200 Calculating a PER / 11~1250 PER example
11~1250
PER example
Consider the following data: Comparable weighted average PER = 14.66 Future maintainable earnings (after tax) = $150,000 In this example, the comparable weighted average PER has been derived from the earnings forecasts of the sample companies, not historic earnings. Applying this PER to our estimate of FME for the
subject business yields a value of: Valuation based on PER = 14.66 150,000 = $2,199,000 If the business being valued is not listed and a discount is considered appropriate to reflect its size and lack of liquidity, the following calculation would be required: Discount to be applied Resultant valuation = 10.00% = 2,199,000 x (1.00 0.10) = $1,979,100
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1270 EBIT Multiples
11~1270
EBIT Multiples
The earnings before interest and tax (EBIT) ratio represents the multiple by which a companys pre-interest and tax earnings are capitalised to determine its value. It relies on the multiplication of an estimated future maintainable earnings (FME) (pre-interest and tax) stream by a number or multiple. The multiple is the EBIT multiple.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1270 EBIT Multiples / 11~1280 Key issues when valuing a business using an EBIT multiple
11~1280
Key issues when valuing a business using an EBIT multiple
The important issues when using this method of valuation are: assessing the level of future maintainable earnings which can reasonably be expected to be earned by the organisation in the long term; calculating an appropriate EBIT multiple to apply to the earnings estimate; assessing an EBIT multiple in light of comparable company information; converting the business valuation to an entity valuation; and valuing other than 100% of the equity of an entity.
For further discussion on what to include or exclude when using an EBIT multiple, refer to what is being valued.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1270 EBIT Multiples / 11~1290 Future maintainable earnings (FME)
11~1290
Future maintainable earnings (FME)
An EBIT multiple is applied to FME on a before interest and tax basis. The key issues affecting the calculation of FME are discussed in the section on establishing future maintainable earnings as part of a PER calculation. Two previous chapters should also be considered when determining FME as they discuss adjustments that may be required to normalise and standardise historic and forecast accounts. Please refer to these earlier chapters: Review of Historic Accounts; and Preparation and Review of Forecasts and Projections.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1270 EBIT Multiples / 11~1300 Calculating an EBIT multiple
11~1300
Calculating an EBIT multiple
An EBIT multiple can be calculated using the following formula: Market Capitalisation + Interest Bearing Debt Excess Funds on Hand Pre-tax Earnings + Interest Charges Interest Income Set out below is an example of the adjustments and calculations for determining an EBIT multiple (as a surrogate for a PER). Using a table similar to the one used in calculating a PER from comparable listed companies will assist in calculating a weighted average EBIT multiple. As discussed in that section this should not be done as a mechanical process, because it requires judgement to decide where in the range of comparable company EBITs the business being valued should sit. Once a multiple based on comparable companies has been established, it may need to be adjusted to take into consideration the discounts affecting private companies. Refer to the section on converting a public company PER to a private company PER for some of the issues that may need to be considered. ALTERNATIVE METHOD FOR USING PRICE EARNINGS RATIO Pubco (Listed Company) Earnings before interest and tax Interest at 10.00% p.a. (Debt $300k) Profit before tax Income tax at 30.00% Profit after tax (earnings) Published P/E Ratio 12.0 Market capitalisation (price) Total Value of Assets
Valco (Valuation Company) $100 $0 $100 ($30) $70
$100 ($30) $70 ($21) $49
$588 $888
Pubco (Listed Company) Comprising: value of equity value of debt $588 $300 $888 8.8
Valco (Valuation Company)
Total value of assets Representing a multiple of EBIT Applying this multiple to Valco EBIT Multiple of EBIT Times EBIT Equals value of Valco total assets Comprising: equity debt
8.8 $100 $888
$888 $0 $888
Total value of Valco assets
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1270 EBIT Multiples / 11~1310 Summary of issues to consider when using EBIT multiples
11~1310
Summary of issues to consider when using EBIT multiples
Although valuations based on EBIT multiples are becoming increasingly popular there are a number of limitations with this methodology, including: EBIT does not necessarily approximate cash flow (as the necessary adjustments for depreciation, tax, working capital and capital expenditure are not reflected in EBIT); EBIT can be impacted by the age profile of the companys assets, recent capital expenditure programs, depreciation policies, revaluation of assets and whether the company has acquired businesses and capitalised goodwill which has to be written off; reliable information about PERs is more readily available than for EBIT multiples; by removing debt and interest from the EBIT calculation, one is only partially eliminating their effect on the multiple as the markets assessment of the financial risk and gearing is also factored into the share price. Thus where there are differing debt to equity ratios, an EBIT multiple will be distorted; and the level and type of debt may have an additional impact on an EBIT multiple due to the distortion of tax effective financing techniques and differences in the apparent fair market value of debt and its book value.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1270 EBIT Multiples / 11~1320 Adjustments required
11~1320
As we generally rely on stock market data to calculate this multiple, the value produced from this calculation will be a marketable minority interest value and this determines what adjustments need to be made. If reliable comparative sales data is available and was relied on, the value produced is a marketable control value. Adjustments may be required for the following reasons: to convert public data to private data; to convert the business valuation to an entity valuation; to value other than 100% of the equity of an entity.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1340 EBITDA Multiples
11~1340
EBITDA Multiples
This ratio represents the multiple by which a companys earnings (pre-interest, tax, depreciation and amortisation) are capitalised to determine its value. It relies on the multiplication of estimated future maintainable earnings (FME) (pre-interest, tax, depreciation and amortisation) stream by a number or multiple. The multiple is the EBITDA multiple.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1340 EBITDA Multiples / 11~1350 Key issues when valuing a business using an EBITDA multiple
11~1350
Key issues when valuing a business using an EBITDA multiple
The important issues when using this method of valuation are: assessing the level of future maintainable earnings, which can reasonably be expected to be earned by the organisation in the long term; calculating an appropriate EBITDA multiple to apply to the earnings estimate; converting the business valuation to an entity valuation; and valuing other than 100% of the equity of an entity.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1340 EBITDA Multiples / 11~1360 Future maintainable earnings
11~1360
An EBITDA multiple is applied to FME calculated on a before interest, tax, depreciation and amortisation basis. It is frequently used as an approximation of cash flow (although it ignores the effects of capital expenditure and working capital requirements). The key issues affecting the calculation of FME are discussed in the section on establishing future maintainable earnings as part of a PER calculation. Two previous chapters should also be considered when determining FME as they discuss adjustments that may be required to normalise and standardise historic and forecast accounts. Please refer to these earlier chapters: Review of Historic Accounts; and Preparation and Review of Forecasts and Projections.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1340 EBITDA Multiples / 11~1370 Calculating an EBITDA multiple
11~1370
Calculating an EBITDA multiple
An EBITDA multiple can be calculated using the following formula: Market Capitalisation + Interest Bearing Debt Excess Funds on Hand Pre-tax Earnings + Interest Charges Interest Income + Depreciation + Amortisation Using a table similar to the one used in calculating a PER from comparable listed companies will assist in calculating a weighted average EBITDA multiple. As discussed in that section this should not be done as a mechanical process because it requires judgement to decide where in the range of comparable company EBITDAs the business being valued should sit. Once a multiple based on comparable companies has been established, it may need to be adjusted to take into consideration the discounts affecting private companies. Refer to the section on converting a public company PER to a private company PER for some of the issues that may need to be considered.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1340 EBITDA Multiples / 11~1380 Summary of issues to consider when using EBITDA multiples
11~1380
Summary of issues to consider when using EBITDA multiples
Issues to consider when using EBITDA multiples are similar to those discussed under summary of issues to consider when using EBIT multiples. In addition, the inconsistent application and calculation of EBITDA (e.g. EBIT v. EBITDA v. EBITD v. EBTD) can cause problems when utilising this method.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach /

11~1150 Choosing the Appropriate Market Approach Method / 11~1340 EBITDA Multiples / 11~1390 Adjustments required
11~1390
As we generally rely on stock market data to calculate this multiple, the value produced from this calculation will be a marketable minority interest value and this determines what adjustments need to be made. If reliable comparative sales data is available and was relied on, the value produced is a marketable control value. Adjustments may be required for the following reasons: to convert public data to private data; to convert the business valuation to an entity valuation; and to value other than 100% of the equity of an entity.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1410 Cash Flow Multiples
11~1410
Cash Flow Multiples
This ratio represents the multiple by which a companys cash flow is capitalised to determine its value. It relies on the multiplication of estimated future maintainable cash flow by a number or multiple. The multiple is known as the cash flow multiple.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1410 Cash Flow Multiples / 11~1420 Key issues when valuing a business using a cash flow multiple
11~1420
Key issues when valuing a business using a cash flow multiple
The important issues when using this method of valuation are: assessing the level of future maintainable earnings which can reasonably be expected to be earned by the organisation in the long term and then determining, based on that, the future maintainable cash flows; calculating an appropriate cash flow multiple to apply to the cash flow estimate; converting the business valuation to an entity valuation; and valuing other than 100% of the equity of an entity.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1410 Cash Flow Multiples / 11~1430 Future maintainable cash flow
11~1430
Future maintainable cash flow
A cash flow multiple is applied to future maintainable cash flow. Cash flow is normally determined by first calculating FME and then adjusting this for non cash items.
These adjusted cash flows are also known as gross cash flows. The key issues affecting the calculation of FME are discussed in the section on establishing future maintainable earnings as part of a PER calculation. Two other chapters should also be considered as they discuss adjustments that may be required to normalise and standardise historic and forecast accounts. Please refer to these earlier chapters: Review of Historic Accounts; and Preparation and Review of Forecasts and Projections.
Additional adjustments may be required to the cash flow from operations to take into account the cash flow implications of changes in working capital and long term capital expenditure requirements.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1410 Cash Flow Multiples / 11~1440 Calculating a cash flow multiple
11~1440
Calculating a cash flow multiple
A cash flow multiple can be calculated using the following formula: Market Capitalisation Cash Flow from Operations Working Capital Requirements Capital Expenditure Requirements Using a table similar to the one used in calculating a PER from comparable listed companies will assist in calculating a weighted average cash flow multiple. As discussed in that section this should not be done as a mechanical process, because it requires judgement to decide where in the range of comparable company cash flow multiples the business being valued should sit. Once a multiple based on comparable companies has been established, it may need to be adjusted to take into consideration the discounts affecting private companies. Refer to the section on converting a public company PER to a private company PER for some of the issues that may need to be considered.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1410 Cash Flow Multiples / 11~1450 Summary of issues to consider when using cash flow multiples
11~1450
Summary of issues to consider when using cash flow multiples
Issues to consider when using cash flow multiples are similar to those discussed under summary of issues to consider when using EBIT multiples. In addition, the inconsistent application and calculation of cash flow from operations can cause problems when utilising this method.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1410 Cash Flow Multiples / 11~1460 Adjustments required
11~1460
As we generally rely on stock market data to calculate this multiple, the value produced from this calculation will be a marketable minority interest value and this determines what adjustments need to be made. If reliable comparative sales data is available and was relied on, the value produced is a marketable control value. Adjustments may be required for the following reasons: to convert public data to private data; to convert the business valuation to an entity valuation; or to value other than 100% of the equity of an entity.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1480 Net Asset Value Multiples
11~1480
Net Asset Value Multiples
This ratio represents the multiple by which a company adjusted net assets are capitalised to determine their fair market value. Application of net asset value multiples is common in the valuing of banks and other such financial institutions, and is generally done on a rule of thumb basis.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1480 Net Asset Value Multiples / 11~1490 Key issues when valuing a business using a net asset value multiple
11~1490
Key issues when valuing a business using a net asset value multiple
The important issues when using this method of valuation are: assessing the level of adjusted net assets and determining their appropriate fair market value (for both comparable businesses and the subject business); calculating an appropriate net asset value multiple to apply to the net assets of the subject business; converting the business valuation to an entity valuation; and valuing other than 100% of the equity of an entity.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1480 Net Asset Value Multiples / 11~1500 Assessing the level of adjusted net assets
11~1500
Assessing the level of adjusted net assets
The key issue when applying a net asset value multiple is recalculating the fair market value of the businesss assets rather than relying on their book value. This is necessary as assets may be recorded at values in excess of their recoverable amount (a common occurrence in smaller private
companies), or alternatively, they may be recorded at values less than their recoverable amount (due to say impairment or obsolescence). Adjustments to realign book value to fair market value are easily undertaken when the asset has a readily determinable market price, for example investments such as stocks and bonds. Revaluation of fixed assets such as plant and equipment is more involved and should be based on the estimated future levels of production for each asset.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1480 Net Asset Value Multiples / 11~1510 Calculating a net asset value multiple
11~1510
Calculating a net asset value multiple
A net asset value multiple can be calculated using the following formula: Market Capitalisation Adjusted Net Assets For a publicly listed entity, the net asset value multiple can be calculated directly by applying the above equation. This allows for comparison between entities of a similar nature. When valuing an unlisted business, net asset value multiples can be calculated for comparable listed entities and then applied to the subject business. Using a table similar to the one used in calculating a PER from comparable listed companies will assist in calculating a weighted average net asset value multiple. As discussed in that section, this should not be done as a mechanical process, because it requires judgement to decide where in the range of comparable company net asset value multiples the business being valued should sit. Once a multiple based on comparable comparisons has been established, it may need to be adjusted to take into consideration the discounts affecting private companies. Refer to the section on converting a public company PER to a private company PER for some of the issues that may need to be considered.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1480 Net Asset Value Multiples / 11~1520 Summary of issues to consider when using net asset value multiples
11~1520
Summary of issues to consider when using net asset value multiples
One of the major concerns with using this method is that net book value typically does not equal fair market value and that care and judgement is required to revalue the assets of both the comparable and subject companies.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1480 Net Asset Value Multiples / 11~1530 Adjustments required
11~1530
As we generally rely on stock market data to calculate comparable multiples, the value produced from
this calculation will be a marketable minority interest value and this determines what adjustments need to be made. If reliable comparative sales data is available and was relied on, the value produced is a marketable control value. Adjustments may be required for the following reasons: to convert public data to private data; to convert the business valuation to an entity valuation; or to value other than 100% of the equity of an entity.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1550 Revenue and Customer Multiples
11~1550
Revenue and Customer Multiples
Revenue multiples (and their derivative, customer multiples) represent the multiple by which a companys revenue is capitalised to determine its value. It relies on the multiplication of revenue by a number. The number is the revenue multiple.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1550 Revenue and Customer Multiples / 11~1560 Key issues when valuing a business using a revenue multiple
11~1560
Key issues when valuing a business using a revenue multiple
The important issues when using this method of valuation are: assessing the future maintainable revenue which can reasonably be expected to be earned by the organisation in the long term; calculating an appropriate revenue multiple to apply to the maintainable revenue; converting the business valuation to an entity valuation; and valuing other than 100% of the equity of an entity.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1550 Revenue and Customer Multiples / 11~1570 Future maintainable revenue
11~1570
Future maintainable revenue
A revenue multiple is applied to future maintainable revenue. The key issue affecting the calculation of maintainable revenue is determining the appropriate level of revenue. As discussed under long term growth rates, why do projections always seem to go upwards to the right? It is important to determine whether historic and current revenues are a reliable indication of future revenues. A number of articles have been written discussing the valuation of Internet stocks based on revenues expected in 5 or 10 years time! Two previous chapters should also be considered when determining revenue as they discuss
adjustments that may be required to normalise and standardise historic and forecast accounts. Please refer to these earlier chapters: Review of Historic Accounts; and Preparation and Review of Forecasts and Projections.
It is recommended that this method be used when revenue data is the most accurate available data.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1550 Revenue and Customer Multiples / 11~1580 Calculating a revenue multiple
11~1580
Calculating a revenue multiple
A revenue multiple can be calculated using the following formula: Market Capitalisation Revenue It is important to ensure similar definitions of revenue are being used between comparable companies. Is interest and other income either included in the revenue for both the comparable and subject companies or excluded from both? It would normally be better to ignore other income and undertake the valuation based on operating revenue. Using a table similar to the one used in calculating a PER from comparable listed companies will assist in calculating a weighted average revenue multiple. As discussed in that section this should not be done as a mechanical process, because it requires judgement to decide where in the range of comparable company revenue multiples the business being valued should sit. Once a multiple based on comparable companies has been established, it may need to be adjusted to take into consideration the discounts affecting private companies. Refer to the section on converting a public company PER to a private company PER for some of the issues that may need to be considered.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1550 Revenue and Customer Multiples / 11~1590 Summary of issues to consider when using revenue multiples
11~1590
Summary of issues to consider when using revenue multiples
Revenue multiples (and their derivative, customer multiples) are popular methods of valuing Internet stocks. They are also used in other industries where there is high revenue growth but a lack of earnings and assets. In many instances the broker analyst is not valuing Internet companies on a revenue multiple but comparing the market capitalisation of one company with another using one of the few common benchmarks available, namely revenue. The revenue to market capitalisation measure (and thus revenue multiple) is used in the absence of there being any other measure available. It is inherently dangerous to use multiples of this nature as revenues do not necessarily approximate cash flow in the short to medium term and the timing of those future cash flows will be very different
for each business. However, where there is insufficient data to undertake a discounted cash flow they can be used with caution for approximating the value of a business. Other major concerns with using this method are: the definitions of revenue used; and where operating revenue multiples have been used, adjusting that valuation for other revenue included in either the comparable or subject companys accounts.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1150 Choosing the Appropriate Market Approach Method / 11~1550 Revenue and Customer Multiples / 11~1600 Adjustments required
11~1600
As we generally rely on stock market data to calculate this multiple, the value produced from this calculation will be a marketable minority interest value and this determines what adjustments need to be made. If reliable comparative sales data is available and was relied on, the value produced is a marketable control value. Adjustments may be required for the following reasons: to convert public data to private data; to convert the business valuation to an entity valuation; or to value other than 100% of the equity of an entity.
VALUATION APPROACHES & METHODS / 11~1000 Market Approach / 11~1650 Reference

11~1650 1.
Reference
Scherf, Stephen J. 1999 Determining the Appropriate Valuation Method, NACVA Business Valuation Learning Institute, August 1999
VALUATION APPROACHES & METHODS / 12~1000 Asset Approach

12~1000
Asset Approach
This chapter discusses the asset approach to valuation, the last of the three main valuation approaches. Situations in which this is best applied and the various categories of asset based valuations are also addressed.
VALUATION APPROACHES & METHODS / 12~1000 Asset Approach / 12~1050 Asset Approach Overview
12~1050
Asset Approach Overview
The asset approach method of valuing a business means a valuer determines the amounts individual assets might realise, then after calculating the liabilities to be paid out (selling costs and any related taxes), the valuer can derive the net proceeds available to the owners of the business.
Assets are purchased primarily for their ability to generate income. Thus, unless there is a reason why the assets will not produce income in the future or there is a ready secondary market for the assets, it would normally be appropriate to value assets on their earnings ability rather than on their net realisability. It is incorrect to value assets on a going concern basis without considering the current and expected earnings to be generated from those assets. Valuers of specialised plant and equipment do not however value these assets on a going concern basis unless some reference has been made to the earnings ability of those assets either in the hands of the existing client or an alternative purchaser. Many businesses have assets with costs that exceed their current fair market value and that is because they have either been over-capitalised or market conditions have changed. This is, however, not a justification for valuing them at cost. This is probably best demonstrated by the fluctuations in the real estate market: properties are sold on a rental yield not on their cost of construction. A comprehensive valuation will normally look at more than one valuation methodology in order to cross-check the valuations produced. With real estate typically one looks not only at a rental yield but also comparable sales. For insurance purposes one looks at replacement cost. This highlights the importance of determining for whom and for what purpose the valuation is being undertaken. Therefore, unless the business has surplus assets or is closing down operations it is normally appropriate to value an asset by assessing its earnings ability.
VALUATION APPROACHES & METHODS / 12~1000 Asset Approach / 12~1100 Principle Supporting Asset Approach Methods
12~1100
Principle Supporting Asset Approach Methods
The asset approach to value is based on the theory that the current value of all assets (tangible and intangible) less the current value of the liabilities should equal the current value of the entity.
VALUATION APPROACHES & METHODS / 12~1000 Asset Approach / 12~1150 When to use Asset Approach Methods
12~1150
When to use Asset Approach Methods
These methods are generally not appropriate where assets are employed productively and earning more than the cost of capital, as the value of the business would be in excess of the calculation of the value of its net assets. Thus, the net asset method is used primarily for businesses that are making a low economic rate of return. Discounted cash flows or future maintainable earnings approaches are usually the most appropriate methods of valuing an ongoing business. This is particularly true for businesses that have a high proportion of intangible assets such as mastheads and goodwill. Accordingly, the orderly realisation of net assets is not an appropriate valuation basis in the circumstance where the business is a going concern. However, the net assets are often taken as a base figure and as a benchmark for comparison purposes. The following are situations where it may be appropriate to value a business using these methods:
the company has few intangible assets; the companys products or services add little to the value of the company; a controlling interest is being valued; the company is a start-up business; or future earnings are unpredictable.
VALUATION APPROACHES & METHODS / 12~1000 Asset Approach / 12~1200 Choosing the Appropriate Asset Approach Method
12~1200
Choosing the Appropriate Asset Approach Method
The main valuation methods under this approach are: adjusted net assets continuing business; orderly realisation of assets curtailed business; and liquidation value forced sale.
The appropriate approach to use for any engagement will be partially determined by the engagement conditions and particularly by the standard of value and the premise of value being used.
VALUATION APPROACHES & METHODS / 12~1000 Asset Approach / 12~1200 Choosing the Appropriate Asset Approach Method / 12~1220 Adjusted Net Assets
12~1220
Adjusted Net Assets
Unlike many of the other asset approach methods, this method is applicable when the business is expected to continue as a going concern. Its primary use is where the assets have a use or replacement cost. An example would be buying office space (with all the necessary infrastructure) from someone who has no particular interest in ceasing their employment. It is typically used to value start-up businesses and where the business has no predictable earnings capacity. In many respects it is an appraisal of a group of assets rather than a valuation of a business.
VALUATION APPROACHES & METHODS / 12~1000 Asset Approach / 12~1200 Choosing the Appropriate Asset Approach Method / 12~1220 Adjusted Net Assets / 12~1230 Key issues when valuing a business using an adjusted net assets methodology
12~1230
Key issues when valuing a business using an adjusted net assets methodology
The key issues when undertaking an adjusted net asset valuation include: identifying a complete listing of assets and liabilities to include in the valuation; determining the fair market value of each asset;
converting the business valuation to an entity valuation; and valuing other than 100% of the equity of an entity.
VALUATION APPROACHES & METHODS / 12~1000 Asset Approach / 12~1200 Choosing the Appropriate Asset Approach Method / 12~1220 Adjusted Net Assets / 12~1240 Identification of assets and liabilities
12~1240
Identification of assets and liabilities
Although the balance sheet provides an initial listing of assets and liabilities, additional sources of information will need to be reviewed. There may be assets not shown on the balance sheet such as assets not capitalised, assets fully depreciated, options or rights over other property etc. The following sources may provide additional information on the existence of assets and liabilities: an asset register; a register of lease liabilities (if leased assets are not capitalised); company policies on repairs, maintenance and R&D; a company register of the use of the company seal; contracts; supporting documentation to insurance policies; and enquiries of management.
As assets are the key valuation driver when using this methodology it is crucial that all assets are identified.
VALUATION APPROACHES & METHODS / 12~1000 Asset Approach / 12~1200 Choosing the Appropriate Asset Approach Method / 12~1220 Adjusted Net Assets / 12~1250 Fair market value of assets
12~1250
Fair market value of assets
This involves determining and adjusting the value of each asset to its fair market value. Adjustments to realign book value to fair market value are easily undertaken when the asset has a readily determinable market price, for example investments such as stocks and bonds. Revaluation of fixed assets such as plant and equipment is more involved and should be based on the estimated future levels of production for each asset. The adjusted net asset figure provides an estimate of the businesss value. If the valuer will be relying on other professionals for the valuation of certain assets, they should be made aware of the standard of value used for the appraisal.
VALUATION APPROACHES & METHODS / 12~1000 Asset Approach / 12~1200 Choosing the Appropriate Asset Approach Method / 12~1220 Adjusted Net Assets / 12~1260 Summary of issues to consider when using adjusted net assets
12~1260
Summary of issues to consider when using adjusted net assets
There are a number of limitations to this methodology, including: it is only suitable where the business has little in the way of intangible assets; the companys products and services (and their future potential) must add little to the value of the business; and it is only suitable if the business is a going concern but does not have a predictable earnings pattern.
VALUATION APPROACHES & METHODS / 12~1000 Asset Approach / 12~1200 Choosing the Appropriate Asset Approach Method / 12~1220 Adjusted Net Assets / 12~1270 Adjustments required
12~1270
The adjusted net asset method produces a marketable control value. Adjustments may be required for the following reasons: to convert the business valuation to an entity valuation; or to value other than 100% of the equity of an entity.
VALUATION APPROACHES & METHODS / 12~1000 Asset Approach / 12~1200 Choosing the Appropriate Asset Approach Method / 12~1290 Orderly Realisation of Assets and Liquidation Value
12~1290
Orderly Realisation of Assets and Liquidation Value
VALUATION APPROACHES & METHODS / 12~1000 Asset Approach / 12~1200 Choosing the Appropriate Asset Approach Method / 12~1290 Orderly Realisation of Assets and Liquidation Value / 12~1300 Orderly realisation of assets
12~1300
Orderly realisation of assets
Another valuation method that could be considered is that of orderly realisation (or current fair market value) of assets. This valuation method is best applied in the instance of a curtailed business. This asset valuation methodology uses a concept of breaking up the assets of the business, paying off the liabilities and returning whatever capital is left to the investors of the business. This process is assumed to occur in an orderly manner so as to maximise sale proceeds. Whilst often inappropriate for going concern entities, the methodology is useful for asset-based companies (e.g. cashboxes (companies with large cash reserves) or property and investment trusts) or where losses have been incurred consistently and liquidation is likely. For example, an entity with a profit profile similar to that shown in the following chart may be a candidate for an orderly realisation or asset based valuation methodology.
An asset based methodology should be considered when: the majority of the entitys value lies in readily marketable assets such as cash or near cash assets; or the company has been unable to demonstrate that it can trade profitably in the future and the only real prospect is a winding up or liquidation.
Arguably, an orderly realisation of assets by a going concern entity would result in an equivalent value as (say) an earnings or cash flow-based valuation (subject to realising intangible assets at their full value). Thus, for the same reasons that earnings-based valuations often differ from asset values, orderly realisation valuations may differ substantially from stated book value of assets.
VALUATION APPROACHES & METHODS / 12~1000 Asset Approach / 12~1200 Choosing the Appropriate Asset Approach Method / 12~1290 Orderly Realisation of Assets and Liquidation Value / 12~1310 Liquidation value
12~1310
Liquidation value
A liquidation valuation frequently arrives at a significantly lower value than a valuation on a going concern basis. The most simplistic way of viewing this concept is to consider that the individual items of plant, equipment, land and buildings involved in a business are incapable of producing the earnings which are available from all those assets employed together under good management. A liquidation value basis of valuation may be appropriate in a number of circumstances if it is intended to close the business: where the owners have mutually agreed they no longer wish to continue in the business; where the business is at the end of its useful life; where a buyer for the business as a going concern is not available; or
where the business has consistently incurred losses.
A liquidation value may also be used as a base or benchmark valuation when valuing a going concern, as the going concern value calculated using alternate methods should always exceed liquidation value. This is because the principle supporting going concern valuations is that the continuation of the business into the foreseeable future will generate future cash flows and earnings which will be valued more highly. Unless owners are likely to force a liquidation of the business, the value in most assets lies in their capacity to generate future cash flows and earnings and they should be valued accordingly. This is particularly true in the case of specialised assets which are not readily saleable on a stand alone basis.
VALUATION APPROACHES & METHODS / 12~1000 Asset Approach / 12~1200 Choosing the Appropriate Asset Approach Method / 12~1290 Orderly Realisation of Assets and Liquidation Value / 12~1320 Key issues when valuing a business using an orderly asset realisation methodology
12~1320
Key issues when valuing a business using an orderly asset realisation methodology
The key issues when undertaking an asset realisation valuation include: identifying a complete listing of assets and liabilities to include in the valuation; determining the value of each asset and the time required to realise that price; converting the business valuation to an entity valuation; and valuing other than 100% of the equity of an entity.
VALUATION APPROACHES & METHODS / 12~1000 Asset Approach / 12~1200 Choosing the Appropriate Asset Approach Method / 12~1290 Orderly Realisation of Assets and Liquidation Value / 12~1330 Identification of assets and liabilities
12~1330
Although the balance sheet provides an initial listing of assets and liabilities, additional sources of information will need to be reviewed. There may be assets not shown on the balance sheet such as assets not capitalised, assets fully depreciated, options or rights over other property etc. The following sources may provide additional information on the existence of assets and liabilities: an asset register (ensure this reconciles to the balance sheet); a register of lease liabilities (if leased assets are not capitalised); company policies on repairs, maintenance and R&D; a company register of the use of the company seal; contracts;
supporting documentation to insurance policies; and enquiries of management.
VALUATION APPROACHES & METHODS / 12~1000 Asset Approach / 12~1200 Choosing the Appropriate Asset Approach Method / 12~1290 Orderly Realisation of Assets and Liquidation Value / 12~1340 Fair market value of assets
12~1340
It is necessary to arrive at an appropriate fair market value and not rely on book values as these are often not indicative of the assets underlying value. If the valuer will be relying on other professionals for the valuation of certain assets, they should be made aware of the standard of value used for the appraisal. This methodology requires careful consideration of the prices assets might realise and the time taken to realise the prices. For this reason, a discount applied to particular assets should account for any significant time delay in realising the asset. A further discount may be applied if assets are to be sold on an individual basis. This is in contrast to the sale of a complement of assets in which additional value is obtained via their interaction in the production process. In addition, the realisable price should take into consideration any taxes that may arise on the sale of assets and this should be considered along with other transaction costs (e.g. auctioneer costs, stamp duty etc.). Depending on the time taken and how specialised the assets are, there may be significant costs associated with their disposal. These will need to be estimated and deducted from any anticipated proceeds of sale. Allowance will need to be made for tax on the assets sold. In the event of the assets recovering more than their written down book value there may be recouped depreciation (or capital gains tax) to pay on the surplus (if there are no offsetting losses). Issues such as site clearance, which can be significant in some situations, will need to be considered. The fact that distribution of the proceeds from a realisation may attract income tax in the hands of shareholders needs to be identified. The differential tax positions of shareholders should also be considered (although it may be difficult to report individual outcomes).
VALUATION APPROACHES & METHODS / 12~1000 Asset Approach / 12~1200 Choosing the Appropriate Asset Approach Method / 12~1290 Orderly Realisation of Assets and Liquidation Value / 12~1350 Summary of issues to consider when using an orderly asset realisation methodology
12~1350
Summary of issues to consider when using an orderly asset realisation methodology
There are a number of limitations to this methodology, including:

it is only suitable where the business has little in the way of intangible assets; the companys products and services (and their future potential) must add little to the value of the business; it is only suitable if the business is not a going concern, does not have a predictable earnings pattern or has a predictable earnings stream but not of the magnitude to warrant employment of the underlying assets; it requires an estimation of the time required and costs involved in selling the assets; and it requires substantial information on the costs of the assets and the tax consequences of disposing of them.
VALUATION APPROACHES & METHODS / 12~1000 Asset Approach / 12~1200 Choosing the Appropriate Asset Approach Method / 12~1290 Orderly Realisation of Assets and Liquidation Value / 12~1360 Adjustments required
12~1360
The orderly asset realisation methodology produces a marketable control value. Adjustments may be required for the following reasons: to convert the business valuation to an entity valuation; or to value other than 100% of the equity of an entity.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations

13~1000
Other Methods and Considerations
The previous three chapters have discussed the main valuation approaches commonly encountered, namely the income, market and asset approaches. When undertaking a valuation, there are however occasions when none of these approaches are appropriate, or, an alternative method of valuation is desirable for comparison purposes. This chapter considers the following alternative valuation methods: excess earnings; comparable investment method (justification of purchase); rules of thumb; and how to approach valuing goodwill.
These methods either represent a hybrid or combination of some of the methods previously discussed or rely on alternative methodologies for estimating a value.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods
13~1050
Other Valuation Methods
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1070 Excess Earnings Method
13~1070
Excess Earnings Method
The premise of this method is that the total estimated value of a business is the sum of the values of the adjusted net assets (as determined by the adjusted net assets method) and the value of the intangible assets. The value of the intangible assets is calculated by capitalising the earnings of the business which exceed a reasonable return on the adjusted net assets of the business. The excess earnings method is derived from what is often called the excess earnings return on assets method. This method is an income and asset based approach, and is often used in the valuation of professional practices where goodwill is being generated.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1070 Excess Earnings Method / 13~1080 Key issues when valuing a business using the excess earnings method
13~1080
Key issues when valuing a business using the excess earnings method
The key issues when undertaking an excess earnings valuation include: 1. 2. 3. 4. Determining the future maintainable earnings of the business. Determine the fair market value of the adjusted net tangible assets. This determination excludes goodwill and other intangible assets. Selecting a reasonable rate of return to apply to the assets employed. Multiplying the value of the tangible assets of the business determined at Point 2 by the rate of return determined in Point 3. The result is the proportion of the total earnings of the business attributable to a reasonable return on the adjusted asset values. Subtracting the earnings determined in Point 4 from the total earnings determined in Point 1. The difference is the excess earnings that are attributable to the intangible assets. Selecting a capitalisation rate for the business which corresponds to an appropriate rate for a safe return, adjusted accordingly to reflect the perceived level of risk associated with the company. Capitalising (dividing) the amount of excess earnings determined in Point 5 by the capitalisation rate determined in Point 6. The amount thus derived is the estimated total value of the intangible assets. Adding the value of the intangible assets (Point 7) to the adjusted net (tangible) assets determined in Point 2 to arrive at the value of the entire business.
5. 6.
7.
8.
In addition, the following factors may need to be considered: converting the business valuation to an entity valuation; or valuing other than 100% of the equity of an entity.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1070 Excess Earnings Method / 13~1090 Future maintainable earnings
13~1090
The key issue is to establish the level of anticipated future maintainable earnings to be obtained by the organisation in the long term. Historic earnings are relevant only to the extent that they provide a guide as to the future. There are often significant differences between earnings and cash flow and the expected earnings may not be constant particularly in the short term. In these cases, judgement is required as to the appropriate level of FME to be used. Two previous chapters should be considered when determining FME as they discuss adjustments that may be required to normalise and standardise historic and forecast accounts. Please refer to these earlier chapters: Review of Historic Accounts; Preparation and Review of Forecasts and Projections.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1070 Excess Earnings Method / 13~1100 Identification of assets and liabilities
13~1100
Although the balance sheet provides an initial listing of assets and liabilities, additional sources of information will need to be reviewed. The assets not capitalised may be assets fully depreciated, options or rights over other property etc. The following sources may provide additional information on the existence of assets and liabilities: an asset register; a register of lease liabilities (if leased assets are not capitalised); company policies on repairs, maintenance and R&D; a company register of the use of the company seal; contracts; supporting documentation to insurance policies; and enquiries of management.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1070 Excess Earnings Method / 13~1120 Fair market value of assets
13~1120
This involves determining and adjusting the value of each asset to its fair market value. If the valuer will be relying on other professionals for the valuation of certain assets, they should be made aware of the standard of value used for the appraisal.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1070 Excess Earnings Method / 13~1130 Selecting a reasonable rate of return for tangible assets
13~1130
Selecting a reasonable rate of return for tangible assets
The most appropriate rate of return is the average return on equities for comparable companies, or as determined from industry averages. Using a table and methodology similar to those used in calculating a PER from comparable listed companies will assist in calculating a weighted average reasonable rate of return. However, the return of comparable companies will incorporate a return on their intangible assets as well as their tangible ones. This may result in the reasonable return on the tangible assets being overstated. An alternative approach applies a safe rate of return to the adjusted net assets, where an appropriate safe rate is an intermediary Government bond. However this method implies that owning a business is no more risky than owning a Government bond.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1070 Excess Earnings Method / 13~1140 Selecting an appropriate capitalisation rate for the business
13~1140
Selecting an appropriate capitalisation rate for the business
Previously we determined a weighted average return on equities for comparable companies or from industry averages. This calculated return should now be amended to reflect the risks of this specific business. Many of the factors that need to be considered will be discussed in the section on converting the business valuation to an entity valuation.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1070 Excess Earnings Method / 13~1150 Summary of issues to consider when using the excess earnings method
13~1150
Summary of issues to consider when using the excess earnings method
This valuation method should be used when no other valuation method is appropriate or when required by law (as is required in some circumstances in the United States). It assumes the intangible assets can be separated from the business and a reasonable rate of return will still be earned on the assets owned by the business. It also assumes that the rate of return required on the assets of a business approaches the risk free rate or at the very least is less than the weighted average risk adjusted return for other industry
participants. Depending on the definition of future maintainable earnings, this methodology will typically overvalue cash-cow type businesses and undervalue growth businesses.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1070 Excess Earnings Method / 13~1160 Adjustments required
13~1160
As we generally rely on stock market data to calculate these multiples, the value produced from this calculation will be a marketable minority interest value and this determines what adjustments need to be made. If reliable comparative sales data is available and was relied on, the value produced is a marketable control value. Adjustments may be required for the following reasons: to convert the business valuation to an entity valuation; or to value other than 100% of the equity of an entity.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1180 Comparable Investment Method (Justification of Purchase)
13~1180
Comparable Investment Method (Justification of Purchase)
This method represents another check on the value calculated. It seeks to answer the question of whether or not a buyer of the business would be able to afford to buy at the estimated fair market value, given certain financing terms and minimum cash flow requirements.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1180 Comparable Investment Method (Justification of Purchase) / 13~1190 Key issues when valuing a business using the comparable investment method
13~1190
Key issues when valuing a business using the comparable investment method
The key issues when undertaking a comparable investment valuation include: calculating the vendors discretionary cash; determining reasonable financing terms (period, rate, down payment etc.); determining the buyers return on investment; determining a suitable living wage for the buyer; converting the business valuation to an entity valuation; and valuing other than 100% of the equity of an entity.
Example: Assumptions
Vendors discretionary cash Financing terms (months) Financing terms (interest rate) Down payment Buyers required return on investment Buyers living wage
125,000 36 10% 125,000 25% 60,000
Example: Calculation Vendors discretionary cash Less required ROI (125,000 x .25%) Less living wage Total available to service debt Total available to service debt (per month) Present value of monthly payments (at 10% for 36 months) Plus down payment Total available to service debt 125,000 31,250 60,000 33,750 2,813 87,163* 125,000 212,163
* Figure represents amount to be borrowed the maximum amount of debt which can be serviced from surplus cash flow (i.e. vendors discretionary cash less required return and living wage). Calculated as the net present value of $2,813 per month over 36 months, discounted at the monthly rate of 0.0083% (10%/12 months).
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1180 Comparable Investment Method (Justification of Purchase) / 13~1200 Vendors discretionary cash
13~1200
Vendors discretionary cash
Vendors discretionary cash represents the cash generated by the business which could be taken out of the business and directed towards non-business related transactions (without harming the ongoing operations of the business). The key issue is to establish the level of anticipated future maintainable earnings (and thus the cash flow) to be earned by the organisation in the long term. It is therefore necessary to add back any expenses (cash flows) made at the owners discretion, which were not directly attributable to the businesss operations. In doing so, a more accurate estimate of the businesss underlying profitability and cash generating ability is gauged, which in turn leads to a more meaningful valuation. There are often significant differences between earnings and cash flow and expected earnings may not be constant particularly in the short term. In these cases, judgement is required as to the appropriate level of FME to be used. Two previous chapters should be considered when determining FME as they discuss adjustments that
may be required to normalise and standardise historic and forecast accounts. Please refer to these earlier chapters: Review of Historic Accounts; and Preparation and Review of Forecasts and Projections.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1180 Comparable Investment Method (Justification of Purchase) / 13~1210 Financing terms and conditions
13~1210
Financing terms and conditions
Financing terms and conditions vary significantly. Some factors which can have an impact on the debt servicing cost and on the present value of the monthly payments include: the credit worthiness of the borrower; any external guarantees provided or other sources of income to support the debt; the current interest rate; future interest rates (if not a fixed rate loan); the period of the loan; any interest free periods; and any balloon (or terminal) payments.
To accurately calculate a value using this method it is necessary to understand the credit worthiness of the borrower and their preferred loan structure.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1180 Comparable Investment Method (Justification of Purchase) / 13~1220 Required return on investment
13~1220
Required return on investment
The rate of return required from an investment is discussed in the section on calculating a PER based on required return.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1180 Comparable Investment Method (Justification of Purchase) / 13~1230 Determining an appropriate living wage
13~1230
Determining an appropriate living wage
There are a number of alternatives for calculating the owners remuneration component to be used in this method. They include using: the minimum living wage; the owners forgone wage; or
the cost of an employee manager.
Using the minimum living wage will result in a larger cash flow being available to service debt and the value of the business is therefore maximised. However it effectively minimises the value to the owner. The second method may undervalue the business, in the circumstance where the owner has come from a high paying role. The final alternative is to determine a wage that would be appropriate for a employee manager. This would occur if an investor purchased the business and then employed someone to look after the day to day operations of the business. Conceptually, the final method is preferred. However, the other alternatives may be appropriate depending on certain circumstances. These issues are considered in greater detail in these earlier chapters: Review of Historic Accounts; and Preparation and Review of Forecasts and Projections.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1180 Comparable Investment Method (Justification of Purchase) / 13~1240 Summary of issues to consider when using the comparable investment method
13~1240
Summary of issues to consider when using the comparable investment method
The main issue is that this method should not be used as the primary valuation method. It should only be used as a sanity check. The value of the business will be fundamentally affected by the debt the business can support, the terms and conditions of the financing and the wage of the owner. This implies the business will have different values to different owners and as a result the value calculated could not be regarded as a fair market value.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1180 Comparable Investment Method (Justification of Purchase) / 13~1250 Adjustments required
13~1250
As we generally rely on stock market data to calculate these multiples, the value produced from this calculation will be a marketable minority interest value and this determines what adjustments need to be made. If reliable comparative sales data is available and was relied on, the value produced is a marketable control value. Adjustments may be required for the following reasons: to convert public data to private data;
to convert the business valuation to an entity valuation; or to value other than 100% of the equity of an entity.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1270 Rules of Thumb Method
13~1270
Rules of Thumb Method
Rules of thumb are often used as a quick assessment of a particular business, and sometimes take the place of a detailed analysis of financial results and the market-place in which the business operates. This is often to the detriment of the assessment. It is widely recognised that in some circumstances, using a rule of thumb can be a quick way of determining whether a price or value nominated by another party is in the ball park.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1270 Rules of Thumb Method / 13~1280 Key issues when valuing a business using a rules of thumb method
13~1280
Key issues when valuing a business using a rules of thumb method
A number of questions arise regarding rules of thumb, for example: What is the role of rules of thumb? Are they adequate surrogates for detailed analysis? Is it sufficient to rely upon a rule of thumb? Can you pay too much for a business valued using a rule of thumb?
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1270 Rules of Thumb Method / 13~1290 Rules of thumb pitfalls
13~1290
Rules of thumb pitfalls
A number of pitfalls can arise by using rules of thumb without backup information and analysis of financial statements and other key elements of the business (for example, supply or sale contracts, or key personnel arrangements). Some of the disadvantages of rules of thumb include: failure to take into consideration the future growth or decline of an individual business when applying an industry rate of return; employing a rule of thumb to an asset-rich business which is currently under-performing may result in a value lower than the realisable value of the underlying assets; employing a rule of thumb may result in acquiring a business at a price which results in a low rate of return particularly when taking into account the relative risks; where rules of thumb do not take into account business cycles or broader economic factors, prices and values can be inflated or deflated depending on the current state of the economy;
disparities in profitability levels for differing businesses within the same industry when relying on turnover rules of thumb; rules of thumb do not usually distinguish between businesses of different size (and, therefore, risk); cash flow and profitability expectations of the business in question may not be reflected in a rule of thumb valuation. For example, a kegs of beer rule of thumb for a hotel will not reflect a refurbishment program required to maintain current levels of patronage; competition from other similar businesses may require the business to increase expenditure on advertising, promotions and marketing. Declining gross margins may be another consequence; legislative requirements may impose (or remove) barriers to entry for new competitors; despite the existence of an industry specific rule of thumb, not all businesses are readily saleable for a variety of reasons specific factors may impede the sale of the subject business such as a restrictive covenant imposed by a previous owner on the current owner, or a proposed owner fails to meet a franchised systems minimum requirements (experience, financial position or other factors); the condition of plant and equipment employed in the business is not reflected in the rule of thumb if equipment is outdated or badly in need of repair, the business may be over-valued using a rule of thumb; and regional and location specific factors will significantly influence the applicability of rules of thumb. Many industry types are regulated on a differing basis from country to country (and even between states of the same country). Accordingly, a rule of thumb which is appropriate for businesses in one state may not be appropriate for the same business located in another state.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1270 Rules of Thumb Method / 13~1300 Survey outcomes
13~1300
Survey outcomes
In Australia in 1993 a survey was designed to provide answers to the questions raised in the section on key issues when valuing a business using a rule of thumb method, by gathering grass roots evidence of the various valuation rules of thumb employed by those undertaking business valuations. From this evidence, valuation outcomes determined by employing a rule of thumb can be contrasted with outcomes arrived at via detailed financial analysis to highlight the possible benefits and the dangers of using rules of thumb. The range of rate of return lay between 11% and 30% of those surveyed (95.7% of AVH subscribers, and 68.5% of South Australian CPAs). Rate of return refers to an acceptable rate of return calculated on a before interest and tax basis, after a fair owners wage has been subtracted. Although the rates of return have been calculated on a pre-interest basis it is important to understand the level of the risk free rate when the survey was conducted in 1993. While it is not known what inflation and tax assumptions respondents had made in the interim rate of return, the survey is assumed that the range is developed in the presence of no growth other than a
3% expected inflation rate and a 36% corporate tax rate. This range of rates of return is equivalent to capitalisation multiples in the range of 5.8 to 19.5 (i.e. 1/((0.3 0.03) 0.64) = 5.79; 1/((0.11 0.03) 0.64) = 19.53). Finally it is interesting to contrast the upper end of the average rate of return calculated using the rules of thumb (19.53) with the average price earnings ratio encountered in the Australian listed companies arena, at around 20 times historic (i.e. last year) earnings. Given the liquidity risk faced by smaller companies in the absence of a negotiable secondary market in which to buy and sell shares or interests in smaller businesses, it would appear that many practitioners encountering business valuations are either forecasting/expecting higher growth rates or are happy to accept what appears to be lower rates of returns compared with the traditional view of risks. These risks inherently include (depending on the nature of the business): lack of geographic diversification; dependence on one or a small number of key personnel; dependence on a small number of customers; dependence upon contract arrangements with suppliers; inability to negotiate with suppliers from a position of strength; and limited access to capital to facilitate growth or to overcome working capital shortfalls brought about by (for example) seasonal businesses.
Alternative views of current valuation practices could be that: little account is taken of the impact of taxation because of the ability of many small businesses to pass income on tax to their principal shareholders; or disclosed earnings of small businesses are a minimum and that the actual returns must be higher.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1270 Rules of Thumb Method / 13~1310 Rates of return by industry group
13~1310
Rates of return by industry group
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1270 Rules of Thumb Method / 13~1310 Rates of return by industry group / Professional business
Professional business
(e.g. accountancy/medical/lawyers) A generally agreed rule of thumb is to value the business at somewhere between 60% and 100% of fees. Medical practices gave rise to the biggest variances. While the method was still fee-based, the rule of thumb varied from 30% of gross fees to 250% of gross fees.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1270 Rules of Thumb Method / 13~1310 Rates of return by industry group / Small retail businesses
Small retail businesses

(e.g. milk bar/newsagency) Whilst rules of thumb varied, generally a profit or turnover basis was usually employed. A few of these rules of thumb were specifically related to the business, such as the number of papers delivered by a newsagency, but in the main the rules of thumb were generic and appeared to be applicable regardless of the industry under consideration.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1270 Rules of Thumb Method / 13~1310 Rates of return by industry group / Hotel/liquor stores/restaurants
Hotel/liquor stores/restaurants
There were basically three types of methods used: a method using licence fees as a base; capitalisation of excess earnings on assets; and capitalisation of turnover/profits.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1270 Rules of Thumb Method / 13~1310 Rates of return by industry group / Manufacturing/engineering
Manufacturing/engineering
Valuation methods varied markedly in this category. Two respondents indicated that establishment costs should be used as a basis, others used some form of profit or turnover basis while another believed a licensed valuer should be used. It appears that there is no generally accepted rule of thumb in this industry.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1270 Rules of Thumb Method / 13~1310 Rates of return by industry group / Supermarkets/wholesalers
Supermarkets/wholesalers
Rules of thumb varied. 33% of respondents believed an appropriate rule of thumb should be used as a capitalisation rate of profits plus assets. Another 33% believed it should be profit based while another 33% believed it should be turnover based.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1270 Rules of Thumb Method / 13~1310 Rates of return by industry group / Resorts/motels/nursing homes
Resorts/motels/nursing homes
There were three generally agreed methods for valuing this category. Firstly, there was a method relying upon a dollar amount per bed or occupancy. The second method was based on profit while the third method was a capitalisation of profits plus assets. Only the first method (bed or occupancy related) could be considered industry-specific.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1270 Rules of Thumb Method / 13~1310 Rates of return by industry group / Franchises
Franchises
While only a small category, there was some commonality in rules of thumb. Profit was used by all respondents. Note As only two of those surveyed actually gave a response for rate of return in this category, this is not an adequate sample from which to draw any conclusions. Minimum Return % Professional business Small retail business Hotel/liquor store/restaurant Manufacturing/engineering Supermarkets/wholesalers Resorts/motels/nursing homes Franchises (Note limited sample size) Total for all business 11.00 0.00 11.00 11.00 11.00 11.00 20.00 0.00 Weighted Average % 23.50 20.17 28.50 20.50 25.50 22.64 25.50 22.64 Maximum Return % 50.00 50.00 50.00 30.00 40.00 50.00 30.00 50.00
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1050 Other Valuation Methods / 13~1270 Rules of Thumb Method / 13~1320 Conclusion from survey
13~1320
Conclusion from survey
Other than for professional businesses, generally the rules of thumb nominated by the survey respondents were not industry specific. This suggests one of two possibilities: survey respondents have sufficient industry knowledge to value another professional practice other than (or including) their own, but lack industry specific knowledge; or survey respondents were more comfortable with general turnover/profit/asset based methods which are not complicated nor are they industry linked.
The overall outcome however, was the lack of consensus on rules of thumb, which leads to the conclusion and confirms, that business valuations should not be undertaken by merely employing rules of thumb.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1370 Valuation of Goodwill
13~1370
Valuation of Goodwill
This is not a valuation methodology as such, although the concept is frequently used by parties who are unaware that goodwill in fact only arises through earnings and assets. Goodwill is an intangible asset. Goodwill is difficult, and at times very difficult, to value. Its value grows and decreases as the prospects of the business increase or diminish. Goodwill should fall out of the valuation of the business as opposed to being a component which is added up to form part of the valuation. In other words, goodwill, as such, cannot be sold separately but is an integral part of the business. There are a number of rules of thumb which attempt to arrive at the value of goodwill independently of an assessment of earnings. These rules of thumb are frequently employed by banks, business brokers and industry participants but should not be used when undertaking a valuation or when buying or selling a business. A detailed discussion of the problems associated with using rules of thumb is discussed in an earlier section. Frequently, rules of thumb will relate to a multiple of revenue as a measure of the goodwill. Such rules of thumb are employed on the basis that all businesses in the industry will earn a comparable rate of return and therefore level of profits. Clearly, this is rarely the case. Such methods of valuing goodwill are useful only if the greater fool theory can be relied upon. The greater fool theory says that it does not really matter what price is paid for a business, providing that there is the capacity to on-sell the business at a greater price (to the greater fool). The greater fool theory is rarely seen other than in extremely bullish market-places where asset prices are rising significantly. In a relatively stable economy, asset prices are not rising at a rate which makes such speculation anything other than a gamble. Accordingly, goodwill should be related to the overall value of the business. Identifiable intangible assets can in some circumstances be divorced from the business. However, goodwill is one asset which cannot be divorced from the other components of the business and, for that reason, should not be viewed in isolation when undertaking the valuation. It is also important to note that not all of a businesss intangible assets will be represented by goodwill. Depending on the nature of the business, other identifiable intangible assets may exist such as brand names, trade marks, patents, rights to processes or intellectual property. The valuation of intangible assets is the subject of a separate section. Accordingly, when arriving at a valuation of a business, care must be taken to ensure that any excess value over net tangible assets is not simply aggregated and labelled goodwill. In all likelihood, the intangible assets (i.e. the excess value over net tangible assets) may include some of the other intangibles listed above.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1370 Valuation of Goodwill / 13~1390 Effects on Profitability of Goodwill
13~1390
Effects on Profitability of Goodwill
The treatment of goodwill in financial statements varies depending on the laws and accounting requirements of the country the company is incorporated in. However, in general, the purchase of a company for an amount which includes goodwill, requires the goodwill to be written off against income over a period of years. If there is a large goodwill component in the purchase price of the company, this will impact on profitability through the write-off. Alternatively, if the company being acquired has a large net tangible assets component and the assets acquired include land and buildings which are essentially non-depreciable or only depreciable at a nominal rate, the impact on the bottom line is lessened. If assets acquired include depreciable assets, the effect on profitability may be significant because of the shorter write-off period. However, the effect on the bottom line is mitigated both through the tax deductibility of depreciation and the residual value of the asset which may not apply in the case of goodwill. The negative impact on reported profit resulting from the purchase of a company which has a large dollar amount of goodwill may be substantially in excess of the situation where a company has low goodwill and high tangible assets. However, a decision to acquire a business with a large intangible asset component should not be revoked simply through fear of a large, and non tax deductible, amortisation expense. At the end of the day it is the cash flow which a business can generate which creates value. It should be noted that the purchase of a business comprising largely of intangibles such as goodwill may inhibit the purchasers ability to fund the acquisition. This is particularly so if part of the acquisition cost is going to be funded by debt. Bankers tend to rely on hard tangible assets for business lending and ignore goodwill and other intangibles for security purposes. This implies that there is some implicit risk associated with the purchase of goodwill. Indeed, a business comprised largely of intangibles is inherently riskier in the event that it ceases to be a going concern. As goodwill depends on the current and future profitability of a business, ceasing to be a going concern through a lack of profitability therefore suggests that the goodwill would then be worthless. The effect on risk of returns resulting from large intangible assets is difficult to quantify. However, the valuer should bear in mind that as a minimum, the ability to fund a business with significant intangible assets will be restricted due to the reliance upon equity funding.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1370 Valuation of Goodwill / 13~1410 Negative Goodwill
13~1410
Negative Goodwill
What is negative goodwill? There is, in fact, no such thing. However, where an earnings based valuation or DCF valuation determines a value which is less than the net tangible assets (NTA) of the entity (being careful to ensure that the NTA components are matched to the components that are being valued i.e. pre- or post-debt) one arrives at negative goodwill.
This is an indication that something has gone wrong in the valuation process. For this reason, a comparison at the conclusion of the valuation with the balance sheets NTA. Some of the errors which might have been made include: not adjusting capitalisation multiples or discount rates for debt influences; failing to account for the fact that divisions/products/operations have been disposed of subsequent to the balance date; failing to recognise the existence of assets surplus to the generation of the cash flows or earnings being valued; or choosing the wrong methodology (the earnings do not support the underlying assets therefore the valuation should have been conducted on a realisable value or net tangible assets basis).
However, there may in fact be no error at all and the conclusion that might be reached is that the asset values carried in the balance sheet are in excess of their earnings capacity. If a reconciliation is shown in the valuation between the value determined and the balance sheet, it would be necessary to ascribe this negative goodwill factor to a write-down in asset values.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1370 Valuation of Goodwill / 13~1430 Accounting Treatment of Goodwill
13~1430
Accounting Treatment of Goodwill
The treatment of goodwill in financial statements varies depending on the laws and accounting requirements of the country the company is incorporated in. In Australia the accounting treatment for goodwill is essentially governed by Accounting Standards AASB 3: Business Combinations and AASB 136: Impairment of Assets.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1480 Updating Valuations (Rolling Forward and Back)
13~1480
Updating Valuations (Rolling Forward and Back)
As discussed previously it is normally easiest to base the computation of a companys valuation on its normal year end date, as this allows historic data and future projections to be comparable without having to split and recompute annual figures. However, transactions do not always occur on balance date and therefore it is necessary to update i.e. roll forward or backwards the valuation calculated to the required valuation date. The methodology for updating the valuations to a later date varies according to the valuation methodology applied.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1480 Updating Valuations (Rolling Forward and Back) / 13~1500 Orderly Realisation of Net Assets
13~1500
Orderly Realisation of Net Assets
To update the valuation, one adds to that valuation any changes in the value of assets, including the
addition of profit after tax, from the date of the valuation to the new valuation date. This assumes in the period between preparing the valuation and updating it there has been no fundamental change to the value of the assets employed, of course new assets will need to be added and assets disposed of will need to be deducted at the value they were assumed to have realised.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1480 Updating Valuations (Rolling Forward and Back) / 13~1520 Discounted Cash Flow
13~1520
Discounted Cash Flow
There are two broad ways of updating a discounted cash flow valuation. The first methodology is to assume that the actual experience from the date of the old valuation to the date of the new valuation is in line with estimates and then the valuation can be rolled forward by calculating for x months a return on equity at the discount rate employed in calculating the net present value. The second methodology is to recast all projections from the new date of valuation and to add the amount of any net profits obtained since the last valuation. Both these methods assume the forecast prepared to support the original valuation remains valid and that the economic fundamentals have remained broadly consistent with when the original valuation was prepared.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1480 Updating Valuations (Rolling Forward and Back) / 13~1540 Capitalisation of Earnings
13~1540
A new later valuation date will provide greater information about the relative certainty of achieving earnings forecasts. Accordingly, greater confidence may be able to be placed in current and the immediate future years earnings. If this is so, then a greater case can be made for using not historic earnings but current or projected earnings as a base for FME.
VALUATION APPROACHES & METHODS / 13~1000 Other Methods and Considerations / 13~1480 Updating Valuations (Rolling Forward and Back) / 13~1560 General
13~1560
General
Any changes in the capital structure of the company since the original valuation (for example additional equity contributed, dividends paid out etc.), will affect the valuation and will require adjustments.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods

14~1000
Guidance on Appropriate Methods
The previous four chapters have discussed various valuation methodologies and the relevant merits of each. This chapter provides additional guidance on choosing between these valuation methods and the pertinent issues to be considered when doing so. Deciding on the most appropriate valuation approach or methodology requires an understanding of the scope of the assignment and what was agreed in the engagement letter, hence: the standard of value utilised; the premise of value utilised; and the purpose of the valuation.
These issues are discussed in detail in the chapter Scoping a Valuation Assignment. Once an understanding of the engagement has been achieved the business must be evaluated to: determine what data is available; and determine what are the common valuation practices in the industry and what are the industrys value drivers.
In addition, guidance on the appropriate method to use can be obtained from the following sources: legislation governing the conduct of companies; accounting standards; other government and regulatory bodies; and the court systems.
Assuming the business under consideration exhibits the following traits: it is a going concern; it has been in existence for a number of years; it is not undergoing any significant transformation; it is unlikely to experience significant growth or decline; it does not face technological obsolescence of its product(s); and it can reasonably be expected to continue into the future without significant change,
then the most appropriate methodology for valuing a business is likely to be either a discounted cash flow or as a derivation of that, a capitalisation of future maintainable earnings.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method
14~1050
Choosing an Appropriate Valuation Method
This section provides some general guidance regarding selecting valuation methods. Sometimes there may be exceptions, or cases where the choice of valuation method is not clear. Besides possible legal requirements, there are few, if any, absolute criteria for selecting valuation methods. Accordingly, the consultant must use judgement in weighing the relevant factors and selecting appropriate valuation methods.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate

Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1070 Diagrammatic Approach to Selecting Appropriate Valuation Approach
14~1070
Diagrammatic Approach to Selecting Appropriate Valuation Approach
The following diagram and accompanying text has been based on information extracted from Volume 2 of PPCs Guide to Business Valuations.
Having selected the appropriate valuation approach, it is important to use the most appropriate method. The following information will assist with determining the most appropriate valuation methods to use.
Income Approach Appropriate valuation method dependent on whether current operations and earnings are indicative of future operations and earnings. Valuation methods Market Approach Appropriate valuation method is the one that best approximates the expected future cash flow of the business depending on information available. Valuation methods Asset Approach Is the company a going concern or are the assets worth more individually? Other Approaches Useful methods for cross checking valuations to industry norms
Valuation methods
Valuation methods
Income Approach Discounted cash flow Capitalisation of earnings
Market Approach Price earnings ratios EBIT multiples EBITDA multiples Cash flow multiples Net asset multiples Revenue and customer multiples
Asset Approach Adjusted net assets Orderly realisation of assets
Other Approaches Excess earnings Comparable investments Rules of thumb Owners discretionary cash flow
For guidance on selecting the appropriate valuation methods 14~1220 14~1210 14~1200 14~1230
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1090 Are Any Approaches or Methods Required?
14~1090
Are Any Approaches or Methods Required?
A particular method may specified by: the engagement letter; the scope of the assignment; the standard premise or purpose of the valuation; the type of ownership interest; government regulations; legal precedence; company governing or constitutional documents; industry norms; company specific factors; or data availability.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1090 Are Any Approaches or Methods Required? / 14~1100 Effect purpose can have on the selection of approach
14~1100
Effect purpose can have on the selection of approach
Example of how the Purpose of the Engagement can Affect the Selection of Valuation Methods Purpose of the Engagement Estate and gift tax Definition of Value Fair market value Possible Effects on Selection of Valuation Methods Emphasis on methods using data derived from the market, especially comparative companies.
Example of how the Purpose of the Engagement can Affect the Selection of Valuation Methods Purpose of the Engagement Dissenting shareholder lawsuit Potential acquisition Marital dissolutions Definition of Value Fair value Possible Effects on Selection of Valuation Methods Selection of method depends on case law in appropriate jurisdiction and methods commonly used in the financial community. Emphasis on discounted cash flows. Selection of method depends on the definition of value, which may vary based on case law and applicable jurisdiction.
Investment value or fair market value Fair market value or other definition of value, depending on case law in the applicable jurisdiction
Extracted from Guide to Business Valuations p. 213
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1090 Are Any Approaches or Methods Required? / 14~1110 Effect ownership interest can have on selection of approach
14~1110
Effect ownership interest can have on selection of approach
Examples of how Controlling versus Minority Interests can Affect Valuation Methods Valuation Methods Price/earnings Controlling Interest Use control transactions or minority transactions, plus a control premium, where appropriate. Generally suitable for controlling interests Minority Interest Use minority transactions or control transactions, less a minority discount. Generally unsuitable for minority interests unless minority interests can cause the company to sell its assets (otherwise consider using the price/net asset value or price/book value method). Can be useful if it reflects the benefit stream currently received by the minority interest.
Net asset value
Discounted cash flow
Typically important to controlling shareholder, often reflecting benefit stream assuming exercise of control.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1090 Are Any Approaches or Methods Required? / 14~1120 Industry considerations
14~1120
Industry considerations
The Guide to Business Valuations at p. 214 makes the following comments regarding the effect
industry considerations have on the selection of a valuation approach. Some industries place emphasis on specific characteristics in determining value. For example, for accounting practices, the client base is an important consideration, and value is normally measured using parameters relating to the firms client base, such as multiples of revenues, etc. The use of certain methods tends to result from common characteristics of the industry and companies in it such as: a. b. c. d. e. f. g. h. the amount of current and potential competition (and ease of entry into the industry); degree of financial risk (including leverage) of companies in the industry; historical and expected profitability, considering both revenues and cost structures; growth and development trends; length of product life cycle, and the industrys current status within that cycle; effects of current and expected economic conditions; the markets perception of value based on a certain benefit stream or indicator; predicability of benefit streams.
The consultant should ascertain whether there are any standard practices for valuing businesses in the subject companys industry.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1090 Are Any Approaches or Methods Required? / 14~1130 Company factors
14~1130
Company factors
The Guide to Business Valuations at p. 215 makes the following comments regarding the effect company factors have on the selection of a valuation approach. While industry factors can help guide the consultant to certain approaches or methods, the actual selection of methods may depend more on the characteristics of the company being valued. Even companies in the same industry may differ with respect to factors such as: a. b. c. d. e. f. g. financial condition; earnings history and growth trends; competitive strengths; depth and quality of management; dependence on key managers, customers or suppliers; litigation or other contingencies; owner compensation arrangements.
Accordingly, the consultant generally needs an understanding of both the company and industry.

Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1150 Is an Asset or Earnings Approach Appropriate?
14~1150
Is an Asset or Earnings Approach Appropriate?
An earnings approach is generally appropriate where assets are employed productively and earning more than the cost of capital, as the value of the business would be in excess of the calculation of the value of its net assets. Examples of Some Conditions which may Influence the Degree of Emphasis on Earnings-based Versus Asset-based Valuation Methods Earnings-based Methods The companys future or normal operations can be estimated reliably. The company has a consistent, predictable customer base. The company has distinctive products, services or processes that might indicate intangible value. The companys assets are primarily production assets, such as machinery and equipment. Asset-based Methods The company has no earnings history, or its operations cannot be reliably estimated. The company depends heavily on competitive contract bids, and there is no consistent, predictable customer base. The company has little or no value from labour or intangible assets. A significant portion of the companys assets are composed of liquid assets or other investments (such as marketable securities, real estate investments, mineral rights etc). It is relatively easy to enter the industry. There is a significant chance of losing key personnel, which could have a substantial negative effect on the company.
There are significant barriers to entering the industry, such as high capital requirements. The company is likely to retain key personnel, or those individuals can be readily replaced without negatively affecting the business.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1170 Is Comparative Company Information Available and/or Appropriate?
14~1170
Is Comparative Company Information Available and/or Appropriate?
Comparative company information may not be available or appropriate: for start-up companies; for companies in unusual businesses; where a companys future operations are expected to differ significantly from current operations; where comparable transactions are not recent enough to provide meaningful comparison; where the companies differ in size or outlook; or where insufficient information is available.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1190 Approach to Selecting Appropriate Valuation Method
14~1190
Approach to Selecting Appropriate Valuation Method
Having selected the appropriate valuation approach, it is important to use the most appropriate method. The following information (when combined with the table used to select the most appropriate approach) will assist with determining the most appropriate methods: asset approach; market approach; income approach; and other approaches.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1190 Approach to Selecting Appropriate Valuation Method / 14~1200 Asset approach
14~1200
Asset approach
Having selected an asset based approach as an appropriate way of valuing the business or company the following text discusses more fully the factors indicating the suitability of an asset based approach before listing the various methods included under this approach and finally listing the key consideration when selecting between these methods.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1190 Approach to Selecting Appropriate Valuation Method / 14~1200 Asset approach / Factors indicating suitability of this approach
Factors indicating suitability of this approach
Generally, the smaller and less predictable the return on the owners investment, the more likely that the company has little goodwill value and the more likely that asset based methods are appropriate. An asset based approach is a suitable valuation method when: Assets are employed productively but earn less than the cost of capital. There are significant tangible assets and there are no significant intangible assets. * There is little or no value added to the companys products or services from labour. The balance sheet reflects all the companys tangible assets that still have value (that is the company has not expensed any tangible assets that continue to benefit the company). The ownership interest being valued is either a controlling interest or has the ability to cause the sale of the companys assets. * The business has no established cash flow or earnings history (or has a volatile history) or these amounts are projected to be negative or only marginally positive in the future.
A significant portion of the companys assets are composed of liquid assets or other investments (such as marketable securities, real estate investments, mining rights). The business depends heavily on competitive contract bids, or, for whatever reason, there is no reliable, predictable customer base. It is relatively easy to enter the industry (for example, small machine shops and retail establishments). The business is in the start-up phase of operations. The projected earnings or cash flow from continued operations are low in relation to net assets.
(Note that items marked with an asterisk (*) are factors that generally are required before the method can be used as a primary valuation method.) The above list has been extracted from the PPC Guide to Business Valuations pp. 248 and 249.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1190 Approach to Selecting Appropriate Valuation Method / 14~1200 Asset approach / Methods included in this approach
Methods included in this approach
This approach consists of the following methods: net asset value; or liquidation value.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1190 Approach to Selecting Appropriate Valuation Method / 14~1200 Asset approach / Key factors in determining appropriate method
Key factors in determining appropriate method
Key questions for selecting between these methods: Is the company likely to continue as a going concern? Does the plant and equipment consist of general purpose equipment (e.g. an office set up)? Is the company worth more as a going concern than in liquidation?
If all of the previous three questions were answered Yes then the net asset valuation method may be the most appropriate. Alternatively, if the answer to any of the above questions was No, then the liquidation valuation method should be considered. If the company is already in liquidation, or has recently been in liquidation, the liquidation valuation method will probably be the most appropriate.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1190 Approach to Selecting Appropriate Valuation Method / 14~1210 Market approach
14~1210
Market approach
Having selected a market based approach as an appropriate way of valuing the business or company the following text discusses more fully the factors indicating the suitability of a market based approach before listing the various methods included under this approach and finally listing the key considerations when selecting between these methods.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1190 Approach to Selecting Appropriate Valuation Method / 14~1210 Market approach / Factors indicating suitability of this approach
A market based approach is a suitable valuation method when: Comparative company information is available and appropriate to use. There is an adequate number of comparative companies and/or transactions to determine a value multiple. * If comparative public companies will be used, there is adequate data on the comparative companies to allow the consultant to make appropriate analysis and adjustments to arrive at a meaningful value multiple for the business being valued. * If comparative transactions will be used, there is adequate data (e.g. terms of sales, asset sales versus stock sales) on the comparatives to allow the consultant to make appropriate analysis and adjustments. * The company being valued is considering going public. The company being valued is sufficiently similar in size to the comparative companies to make comparison meaningful.
(Note that items marked with an asterisk (*) are factors that generally are required before the method can be used as a primary valuation method.) The above list has been extracted from the PPC Guide to Business Valuations p. 252.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1190 Approach to Selecting Appropriate Valuation Method / 14~1210 Market approach / Methods included in this approach
This approach consists of the following methods: price/earnings; price/cash flow; price/revenue; price/dividend; or price/net asset value.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1190 Approach to Selecting Appropriate Valuation Method / 14~1210 Market approach / Key factors in determining appropriate method
The key determinant for selecting an appropriate method is to ensure good quality comparative information is available and the benefit stream reasonably reflects the economic benefits of ownership. If Yes consider using the following method Is the valuation of a minority interest? Is sufficient reliable information available for both the company and the comparison companies to use price/earnings ratios? Is sufficient reliable information available for both the company and the comparison companies to use price/revenue ratios? Is sufficient reliable information available for both the company and the comparison companies to use price/net asset ratios? Price/Dividends Price/Earnings Price/Revenue Price/Net Asset
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1190 Approach to Selecting Appropriate Valuation Method / 14~1210 Market approach / Key factors in determining appropriate method / Price/earnings
Price/earnings This method is suitable when: Reliable earnings or cash flow data is available for the subject company and comparative companies. * Current earnings or cash flow are expected to approximate the future earnings or cash flow. * If valuing a controlling interest, owners benefits can be reasonably estimated (such benefits include compensation, personal expenses paid by company). Earnings or cash flow for the subject company and the comparative companies is significantly positive (that is, neither negative nor marginally positive). *
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1190 Approach to Selecting Appropriate Valuation Method / 14~1210 Market approach / Key factors in determining appropriate method / Price/revenue
Price/revenue This method is suitable when: Reliable company revenue data is available. * Some relationship can be established between revenue and profitability among comparative companies and the company being valued.* Revenue data is the only reliable income statement data available. The company has an erratic earnings history. The subject company is a service business or other business with low variable costs, and its industry is undergoing consolidation. Companies in the industry tend to have similar cost structures.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1190 Approach to Selecting Appropriate Valuation Method / 14~1210 Market approach / Key factors in determining appropriate method / Price/dividend
Price/dividend This method is suitable when either: the company being valued pays a dividend directly*; or the company pays dividends through excess compensation and the amount of those assumed dividends can be reasonably estimated. *
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1190 Approach to Selecting Appropriate Valuation Method / 14~1210 Market approach / Key factors in determining appropriate method / Price/net assets
Price/net assets This method is suitable when: Public information is available for comparative companies net assets values. * Net asset values for both the subject company and comparatives are expected to be significantly positive (that is, not negative or marginally positive). * A significant portion of the companys assets are composed of liquid assets or investments (such as marketable securities, real estate investments, mineral rights). The ownership interest being valued is a minority (non-controlling) interest, but the other
conditions for using the net asset value method are met. (Note that items marked with an asterisk (*) are factors that generally are required before the method can be used as a primary valuation method.) The above list has been extracted from the PPC Guide to Business Valuations p. 254.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1190 Approach to Selecting Appropriate Valuation Method / 14~1220 Income approach
14~1220
Income approach
Having selected an income based approach as an appropriate way of valuing the business or company the following text discusses more fully the factors indicating the suitability of an income based approach before listing the various methods included under this approach and finally listing the key consideration when selecting between these methods.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1190 Approach to Selecting Appropriate Valuation Method / 14~1220 Income approach / Factors indicating suitability of this approach
An income based approach is a suitable valuation method when: Assets are employed productively and expected to earn more than the cost of capital and comparative company information is not available and/or is not appropriate. Earnings or cash flow potential contributes significantly to the companys worth.* The company has significant intangible assets. If valuing a controlling interest, owners benefits can be reasonably estimated (such benefits include compensation, personal expenses paid by the company etc). * The company adds significant value to its products or services through the use of labour or intangible assets.
(Note that items marked with an asterisk (*) are factors that generally are required before the method can be used as a primary valuation method.) The above list has been extracted from the PPC Guide to Business Valuations pp. 250 and 251.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1190 Approach to Selecting Appropriate Valuation Method / 14~1220 Income approach / Methods included in this approach
This approach consists of the following methods: discounted net cash flow; or
capitalisation of earnings.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1190 Approach to Selecting Appropriate Valuation Method / 14~1220 Income approach / Key factors in determining appropriate method
The appropriate valuation method depends on whether current earnings or cash flow are indicative of future benefits of ownership. Key questions for selecting between these methods include: Are earnings considered a better indicator of value than net cash flow?* Are future earnings or cash flow expected to approximate current or historic earnings or cash flow.* Is enough reliable data available to reasonably estimate expected normal earnings? * Are earnings for the subject company significantly positive (that is neither negative nor marginally positive)? * Are expected growth rates modest and predictable? The company is not a start-up company. The company is not a potential acquisition. The company does not have a limited life.
(Note that items marked with an asterisk (*) are factors that generally are required before the method can be used as a primary valuation method.) The above list has been extracted from the PPC Guide to Business Valuations pp. 251 and 252. If all of the previous questions were answered Yes then a capitalisation of earnings valuation method may be the most appropriate. Alternatively, if the answer to any of the above questions was No, then a discounted cash flow valuation method would be preferable. The following factors would be reasons to consider not using the discounted net cash flow valuation method: The companys future net cash flow cannot be reliably estimated. The companys net cash flow in the terminal year is expected to be not significantly positive (that is, negative or marginally positive). The companys total net cash flow during the forecast period is expected to be negative.
In these circumstances an asset approach to valuation may be more appropriate.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1190 Approach to Selecting Appropriate Valuation Method / 14~1230 Other approaches
14~1230
Other approaches
The following has been extracted from pages 220 and 221 of the Guide to Business Valuations and provides some guidance as to when these methods may be appropriate. Very small businesses tend to have certain common characteristics. The following are some of the more important characteristics: a. The owners are usually the managers of the business. Therefore, the viability of proposed purchase of a very small business considers both return on labour (the owners salary) and return on capital. Absent any need for third-party review, the financial reporting emphasises minimisation of the businesss taxable income. Therefore, earnings may tend to be understated. Accounting records are generally on the cash basis and are typically not very detailed. The legal form of entity is relatively unimportant. Many very small businesses are sole proprietorships [or are structured with] ... a desire to limit liability or reduce taxes.
b.
c. d.
One of the most important distinguishing features of a very small business is that the owners are involved in the day-to-day operations of the business. Thus, the buyers of such businesses are often motivated by the desire to purchase a job or career. Since very small businesses involve buyers and sellers who are motivated by the purchase of a job, these owners/operators often measure their total return based on salary, benefits, and profits. Therefore, the purchase and sale of very small businesses have some of the following characteristics: a. b. c. d. The buyers perception of the businesss potential is a key factor in its marketability. These businesses are usually sold via an asset purchase. The terms of the sale and collateral are key components of the price eventually paid. Buyers and sellers may be ruled by emotion.
It should be evident that these businesses are risky. Many of these businesses fail within the first year of their existence. Some of the reasons are as follows: a. b. c. d. lack of capital poor management no business experience inadequate planning.
The following valuation methods could be considered when considering very small businesses: owners discretionary cash flow; excess earnings method; and comparable transactions.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1190 Approach to Selecting Appropriate Valuation Method / 14~1230 Other approaches / Owners discretionary cash flow
Owners discretionary cash flow
This method is also called multiple of discretionary earnings method. Page 221 of the Guide to Business Valuations states: The multiple of discretionary earnings method... is a valuation method that is often used to value very small businesses. This method may produce the investment value of the business rather than the fair market value. However, this method has been used so frequently to value very small businesses that it may constitute an industry norm. Page 256 of the Guide to Business Valuations states valuers should: consider using this method when: a. b. c. d. e. f. g. The companys value is derived primarily from its earnings/cash flow. * The company has an established earnings history. * The companys owner is a key employee who actively manages the company. * The owner/manager can be readily replaced without negatively affecting the business. Reliable earnings/cash flow data is available for the subject company and comparative companies. * Current earnings/cash flow is expected to approximate future earnings/cash flow. * Valuing a controlling interest if owners benefits can be reasonably estimated. (Such benefits include compensation, perquisites, personal expenses paid by company). * Earnings/cash flow for the subject company and comparative companies is significantly positive (that is, neither negative nor marginally positive).* The definition of value used in the assignment is intrinsic value. The business being valued is a very small business.
h. i. j.
(Note that items marked with an asterisk (*) are factors that generally are required before the method can be used as a primary valuation method.)
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1190 Approach to Selecting Appropriate Valuation Method / 14~1230 Other approaches / Excess earnings method
Excess earnings method
Page 221 of the Guide to Business Valuations states: The excess earnings method... is also frequently used to value very small businesses. It
may be considered a combination of an asset-based approach, in which an amount is paid for tangible assets of a business plus a negotiated amount for intangible assets based on capitalised excess earnings (if there are any). Page 255 of the Guide to Business Valuations states valuers should: consider using this method when: a. b. c. d. e. f. g. The companys value is derived primarily from its earnings. Applies to most companies.* The company has an established earnings history. * Enough reliable data is available to reasonably estimate expected normal earnings.* Current earnings are expected to approximate future earnings.* Earnings for the subject company are significantly positive (that is, neither negative nor marginally positive).* Expected growth rates are modest and predictable. * If valuing a controlling interest, owners benefits can be reasonably estimated. (Such benefits include compensation, perquisites, personal expenses paid by company.) * The business being valued is a very small business or professional practice.
h.
(Note that items marked with an asterisk (*) are factors that generally are required before the method can be used as a primary valuation method.)
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1190 Approach to Selecting Appropriate Valuation Method / 14~1230 Other approaches / Comparable transaction methods
Comparable transaction methods
Page 221 of the Guide to Business Valuations states: Valuation methods using comparable company data are also useful. In this sense, we are not referring to the price of comparative publicly traded enterprises, but sales of actual very small businesses. In this instance, the practitioner should contact business brokers, business owners, and other professionals in an effort to develop transaction information. Sometimes, this is reduced to a rule of thumb in the industry. Market valuation approaches are discussed in further detail in the chapter Market Approach. Rules of thumb are discussed in detail in an earlier chapter. There are significant dangers in using rules of thumb.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1050 Choosing an Appropriate Valuation Method / 14~1250 Choosing an Appropriate Benefit Stream to Value
14~1250
Choosing an Appropriate Benefit Stream to Value
The Guide to Business Valuations provides the following guidance on choosing a benefit stream (p. 218): Generally, for a benefit stream to be suitable for valuation purposes, it should meet the following criteria: a. It reasonably reflects the economic benefits of ownership. An important consideration for methods that use earnings or cash flows is that the owners economic benefits should be quantifiable, especially owners salary and perquisites. Some owners receive part of their ownership benefits through excess compensation or perquisites. When valuing controlling interests, failure to properly adjust for excess owners compensation can result in inappropriate value estimates... If there is inadequate data regarding owners compensation and perquisites, the consultant generally should consider another benefit stream instead of earnings or cash flow. b. It can be reliably estimated. Obviously, the consultant cannot use a benefit stream to value the business if the company data relating to it is known to be inaccurate. Thus, if earnings or cash flow cannot be reliably estimated, then another benefit stream (such as revenue) should be considered. c. It can be reasonably compared to market data. The consultant should be able to reasonably relate market rates of return and value multiples to the appropriate benefit stream. For example, to use revenue as the benefit stream, the consultant should be able to reasonably relate comparative company price/revenue data to the business being valued. Since most companies are sold assuming some level of profitability (or profit capacity), the consultant needs to be able to determine some relationship between revenue and profitability among the comparative companies and the businesses being valued before developing an appropriate value multiple. If that relationship cannot be determined, then other benefit streams may need to be considered or the valuation method may be given less weight in arriving at a final value estimate... d. The benefit stream is neither negative nor marginally positive for the company being valued or comparative companies. To develop and apply appropriate capitalisation rates or value multiples, the consultant needs a benefit stream that is neither negative nor marginally positive. Sometimes it may be appropriate to use average benefit streams for a period of years if the current period benefit stream is negative or marginal. However, in such cases the average cannot be negative or marginally positive. This guidance applies for both the company being valued and comparative companies.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1300 Company/Business Law Requirements
14~1300
Company/Business Law Requirements
Legislative guidance on appropriate valuation methods primarily comes from the Corporations Act 2001.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1300 Company/Business Law Requirements / 14~1320 Current Legislation
14~1320
Current Legislation
The Corporations Act 2001 as it currently stands provides limited guidance on the appropriate valuation methods to use. However, sections 296(1) and 295(4) of the Corporations Act 2001 require the preparation of accounts to be in compliance with Australian accounting standards and section 297 states that they must present a true and fair view of the companys state of affairs. The guidance that the accounting standards provide on appropriate valuation methodologies is discussed later in this chapter.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1300 Company/Business Law Requirements / 14~1340 Repealed Legislation
14~1340
Repealed Legislation
Section 294(4) of the Corporations Law (prior to 1 July 1998) has been repealed, as it was believed it duplicated similar requirements in the accounting standards. However, it is worthwhile reviewing the wording of this now repealed section, as it had a slightly different emphasis to the accounting standards. 294(4) [Non-current assets] The directors shall take reasonable steps: a. to find out whether the value of any non-current asset is shown in the companys accounting records at an amount that, having regard to the assets value to the company as a going concern, exceeds the amount that it would have been reasonable for the company to spend to acquire the asset as at the end of the financial year; and unless adequate provision for writing down the value of that asset is made to cause to be included in the accounts such information and explanations as will prevent the accounts from being misleading because of the overstatement of the value of that asset.
b.
It is interesting to note that the repealed section 294(4) referred to the amount that it would have been reasonable for the company to spend. It is undeniable that it would be unreasonable to spend the same to acquire an asset with a cash flow five years hence as it would be to acquire an asset with the same cash flow one year hence. To that extent there were strong regulatory reasons why net present value should be used in the revaluation of non-current assets.

Methods / 14~1390 Accounting Standards

14~1390
Accounting Standards
The following standards provide some guidance on appropriate valuation methodologies.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1390 Accounting Standards / 14~1400 AASB 3 Business Combinations
14~1400
AASB 3 Business Combinations
The business combinations standard requires that the cost of a business combination be measured at fair value. Paragraph 26 of the standard states: when settlement of all or any part of the cost of a business combination is deferred, the fair value of that deferred component shall be determined by discounting the amounts payable to their present value at the date of exchange, taking into account any premium or discount likely to be incurred in settlement.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1390 Accounting Standards / 14~1410 AASB 136 Impairment of Assets
14~1410
AASB 136 Impairment of Assets
This standard includes a definition for value in use, which is: The present value of the future cash flows expected to be derived from an asset or cash-generating unit. In addition, paragraph 14 of this standard, although not specifically mentioning discounted cash flow, does discuss and highlight the importance of future cashflows when assessing the potential impairment of an asset. However, the following paragraphs of AASB 136 clearly indicate a preference for the use of a discounted cash flow methodology: 30 The following elements shall be reflected in the calculation of an assets value in use: (a) (b) (c) (d) (e) an estimate of the future cash flows the entity expects to derive from the asset; expectations about possible variations in the amount or timing of those future cash flows; the time value of money, represented by the current market risk-free rate of interest; the price for bearing the uncertainty inherent in the asset; and other factors, such as illiquidity, that market participants would reflect in pricing the future cash flows the entity expects to derive from the asset.
31
Estimating the value in use of an asset involves the following steps: (a) (b) estimating the future cash inflows and outflows to be derived from continuing use of the asset and from its ultimate disposal; and applying the appropriate discount rate to those future cash flows.
32
...Whichever approach an entity adopts to reflect expectations about possible variations in the amount or timing of future cash flows, the result shall be to reflect the expected present value of the future cash flows.
Finally, Appendix A to AASB 136 provides guidance on the use of present value techniques in measuring fair value in use.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1390 Accounting Standards / 14~1420 AASB 138 Intangible Assets
14~1420
AASB 138 Intangible Assets

Quoted market prices in an active market provide the most reliable estimate of the fair value of an intangible assetThe appropriate market price is usually the current bid price. If current bid prices are unavailable, the price of the most recent similar transaction may provide a basis from which to estimate fair value, provided that there has not been a significant change in economic circumstances between the transaction date and the date at which the assets fair value is estimated. If no active market exists for an intangible asset, its fair value is the amount that the entity would have paid for the asset, at the acquisition date, in an arms-length transaction between knowledgeable and willing parties, on the basis of the best information available. In determining this amount, an entity considers the outcome of recent transactions for similar assets. Entities that are regularly involved in the purchase and sale of unique intangible assets may have developed techniques for estimating their fair values indirectly These techniques include, when appropriate: a) applying multiples reflecting current market transactions to indicators that drive the profitability of the asset (such as revenue, market shares and operating profit) or to the royalty stream that could be obtained from licensing the intangible asset to another party in an arm's-length transaction (as in the relief from royalty approach); or discounting estimated future net cash flows from the asset.
This standard on intangible assets provides a hierarchy of appropriate valuation methods. 39
40
41
b)
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1390 Accounting Standards / 14~1490 Other Authoritative Pronouncements by Accounting Organisations
14~1490
Other Authoritative Pronouncements by Accounting Organisations

Methods / 14~1390 Accounting Standards / 14~1490 Other Authoritative Pronouncements by Accounting Organisations / 14~1500 AASB Framework Definition of an Asset
14~1500
AASB Framework Definition of an Asset
Assets are defined in AASB: Framework for the Preparation and Presentation of Financial Statements, as follows (paragraph 49a): An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. Paragraph 89 states that the asset can be recognised when: it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably. Reliability of measurement is discussed in paragraph 86: The second criterion for the recognition of an item is that it possesses a cost or value that can be measured with reliability, as discussed in paragraphs 31 to 38 of this Framework. In many cases, cost or value must be estimated. The use of reasonable estimates is an essential part of the preparation of financial reports and does not undermine their reliability.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1390 Accounting Standards / 14~1490 Other Authoritative Pronouncements by Accounting Organisations / 14~1510 UIG abstract 1
14~1510
UIG abstract 1
The Urgent Issues Group has issued a number of abstracts which support the use of a discounted cash flow methodology. These include Abstract 1 Lease Accounting for Surplus Leased Space under a Non-cancellable Operating Lease. This abstract requires future payments for surplus space under a non-cancellable lease to be recognised as a liability and an expense. The abstract then states: 4. The amount recognised...shall be the total expected outlay relating to the surplus space as specified under the lease, discounted using the interest rate implicit in the lease or an estimate thereof.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1390 Accounting Standards / 14~1490 Other Authoritative Pronouncements by Accounting Organisations / 14~1520 AAG 10 Measurement of Monetary Assets and Liabilities
14~1520
AAG 10 Measurement of Monetary Assets and Liabilities
The Australian Accounting Standards Board has released Accounting Guidance Release AAG 10 Measurement of Monetary Assets and Liabilities. Paragraph 3 states: In Australia, the general principle underlying the measurement of interest bearing assets and liabilities is: Monetary assets and liabilities are to be measured at the present value of the cash flows
associated with their service and eventual payment, such present value being determined by discounting the cash flows at the rate of interest implicit in the original contract or other arrangement. This principle is reflected in Statement of Accounting Standard AAS 17 Accounting for Leases. Paragraph 4 states: Although arguments may be advanced for the use of the current rate of interest under other measurement systems, it is the effective rate of interest implicit in the original contract or other arrangement which is applied in the historical cost system as practised in Australia.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1390 Accounting Standards / 14~1490 Other Authoritative Pronouncements by Accounting Organisations / 14~1530 AAG 13 Determination of Discount Rates for Measuring Certain Liabilities at Present Value
14~1530
AAG 13 Determination of Discount Rates for Measuring Certain Liabilities at Present Value
The Australian Accounting Standards Board has also issued Accounting Guidance Release AAG 13 Determination of Discount Rates for Measuring Certain Liabilities at Present Value. At paragraph 6, that guidance release states: Where...a discount rate based on the anticipated rate of return on an entitys assets can be readily determined, it is appropriate to determine discount rates on that basis...In addition, the rate should be current, that is, it would need to be revised at each reporting date.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1590 Guidance from other Government or Regulatory Organisations
14~1590
Guidance from other Government or Regulatory Organisations
ASIC has issued a number of practice notes and policy statements that are authoritative guidance on appropriate valuation methods. Similarly, the Australian Prudential Regulation Authority (APRA) has issued: Prudential Standard GPS 210 Liability Valuation for General Insurers and its related Guidance Note GGN 210.1 Actuarial Opinions; reports on general insurance liabilities; and Guidance Note AGN 220.2 Security Valuation and Provisioning;
which give guidance on valuation methods and discount rates. The Life Insurance Actuarial Standards Board has released Actuarial Standard AS 1.03 Valuation of Policy Liabilities, which addresses methodologies for valuing the liabilities of life insurance companies.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1590 Guidance from other Government or Regulatory Organisations / 14~1630 ASIC Practice Note 43 Valuation Reports and Profit Forecasts
14~1630
ASIC Practice Note 43 Valuation Reports and Profit Forecasts
The most definitive statement on valuations by a regulatory body is ASICs Practice Note 43 (PN 43) . This practice note deals with the preparation of valuation reports and profit forecasts, and provides guidance on appropriate valuation methods, treatment of control premium, qualities of an expert and many other issues. With respect to valuation methodologies, PN 43 provides specific guidelines at clause 39: It is not the ASCs role or intention to limit the Experts exercise of skill and judgment in selecting the most appropriate method or methods of valuation. However, it is appropriate for the Expert to consider: a. b. the discounted cash flow method; the application of earnings multiples appropriate to the businesses or industries in which the company or its profit centres are engaged, to the estimated future maintainable earnings or cash flows of the company, added to the estimated realisable value of any surplus assets, on the basis that a controlling shareholder would seek to maximise the value of its investment; the amount which an alternative acquirer might be willing to offer if all the securities in the target company were available for purchase; the amount that would be distributed to shareholders on an orderly realisation of assets; the most recent quoted price of listed securities; or the current market value of the asset, securities or company.
c. d. e. f.
ASC does not suggest that this list is exhaustive or that the Expert should use all of the methods of valuation listed above. It can be seen from the practice note that reference is made to six principal valuation methods. It is interesting to note that PN 43 does not identify capitalisation of dividends as being one of the mainstays of the valuation methodologies. Historically PN 43 provides additional justification for the use of a discounted cash flow (or other forward looking valuation methods). Paragraph 47 states: Profit Forecasts/Cash Flow Projections 47. It is appropriate for this Practice Note on valuation reports to consider profit or profitability forecasts because the value of a company or an asset is frequently inextricably linked to its future profitability. Most of the guidelines in this Practice Note are equally applicable to valuation reports and profit forecasts.

Methods / 14~1590 Guidance from other Government or Regulatory Organisations / 14~1650 ASIC Policy Statement 163 Takeovers: Minimum Bid Price Principle Section 621
14~1650
ASIC Policy Statement 163 Takeovers: Minimum Bid Price Principle Section 621
Policy Statement 163 (PS 163) specifies that for quoted securities, non-cash consideration and pre-bid purchase consideration should be valued at: the volume weighted average market price of the securities in the ordinary course of trading during the two full trading days before each of: A. B. C. the time of the pre-bid purchase; the time as close as practical to when the bidder lodges its bidders statement; and the valuation time. (PS 163.25 (a))
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1590 Guidance from other Government or Regulatory Organisations / 14~1660 APRA Guidance Note AGN 220.2 Security Valuation and Provisioning
14~1660
APRA Guidance Note AGN 220.2 Security Valuation and Provisioning
APRA has issued Guidance Note AGN 220.2 Security Valuation and Provisioning for authorised deposit-taking institutions (ADIs) on valuation methods and discount rates. In particular, APRA has indicated that, where it may be difficult to determine the market value of property assets, for example, new properties that have not yet achieved a stable income or properties experiencing drastic fluctuations in income, a forecast of expected cash flows should be used to estimate the value of the property. In this circumstance: The discount rates used in calculating the value of the security should reflect the opportunity cost (determined by way of comparison with prevailing returns on competing investments) of holding the property, assuming a long term holding. Capitalisation rates should reflect reasonable expectations about the long-term rate of return investors require under normal, orderly and sustainable market conditions. (paragraph 4) For further information, refer to www.apra.gov.au.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1590 Guidance from other Government or Regulatory Organisations / 14~1670 APRA Prudential Standard GPS 210 Liability Valuation for General Insurers
14~1670
APRA Prudential Standard GPS 210 Liability Valuation for General Insurers
APRA has issued Prudential Standard GPS 210 Liability Valuation for General Insurers, which states, under Objectives and Key Requirements of this Standard, that: Insurance liabilities are to be valued on a discounted basis. The rate to be used in
discounting is the risk-free rate; ie the gross redemption yield of a portfolio of sovereign risk securities with a similar expected payment profile to the insurance liabilities for a given class (e.g. the yield on Commonwealth Government securities should be used for Australian dollar liabilities). Paragraph 19 specifies that: The central estimate will generally be measured as the present value of the future expected payments. This measurement process will involve prospective calculations and modelling techniques, and will require assumptions in respect of the expected future experience, taking into account all factors which are considered to be material to the calculation, including: a. b. c. d. discount rates (see paragraphs 2931); claims escalation; claims expenses; and the pattern of claims run-off.
This is equally applicable to the determination of the gross insurance liabilities and the estimation of reinsurance recoveries. Requirements for the discount rate are specified from Paragraph 2931: 29. The value of an insurers liabilities is typically independent of the value of the underlying assets. For this reason, a discount rate that is observable, market-based and objective is most appropriate. The rate to be used in discounting the expected future claims payments for a class of business is the gross redemption yield, as at the calculation date, of a portfolio of sovereign risk securities with a similar expected payment profile to the insurance liabilities for that class (e.g. Commonwealth Government securities for Australian dollar liabilities). Where the expected payment profile of the liabilities cannot be matched for example, because the duration is too long a discount rate regarded as consistent with the intention of this Standard should be assumed.
30.
31.
Guidance Note GGN 210.1 Actuarial Opinions and Reports on General Insurance Liabilities has been issued by APRA as preliminary guidance for insurers and actuaries when determining the value of general insurance liabilities under GPS 210 Liability Valuation for General Insurers. The Institute of Actuaries of Australia (IAAust) is developing a professional standard and guidance notes on this issue, and it is intended that this Guidance Note will be replaced by the standards of the IAAust as they are developed. GGN 210.1 comments on the valuation model to be used, in paragraphs 2627 as follows: 26. The actuary is responsible for the selection of an appropriate valuation model, having regard to the availability and reliability of the data and the key drivers of claim cost as revealed by the data analysis or consistent with the nature of the class of business. The actuary may investigate more than one valuation model for the estimation of insurance liabilities, then select one or blend the results from more than one as
27.
considered most appropriate. Determination of the discount rate is amplified in Paragraphs 3438 as follows: 34. For all Australian insurance liabilities, the fixed interest securities to be used are Commonwealth Government Treasury notes and bonds. It is acceptable to use either the average rate or a series of discount rates taken from the corresponding yield curve. Sovereign fixed interest securities are typically not available to exactly match projected payments. There are usually gaps in the maturity dates available and the longest dated such security may not be long enough. It is appropriate to smooth, interpolate and extrapolate from the observed yields in the sovereign bond market. If the actuary applies a sequence of discount rates for future periods, the corresponding average discount rate should be calculated for each class of business and stated in the report. The discounted mean term for each class of business should also be stated in the report. Where the value and timing of unclosed premiums have been projected, discounting should also be applied. Discounting may be disregarded where the effect of discounting does not materially change the resulting central estimate.
35.
36.
37. 38.
More information can be obtained at <www.apra.gov.au>.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1590 Guidance from other Government or Regulatory Organisations / 14~1675 Actuarial Standard 1.03 Valuation of Policy Liabilities
14~1675
Actuarial Standard 1.03 Valuation of Policy Liabilities
The Life Insurance Actuarial Standards Board has released Actuarial Standard 1.03 Valuation of Policy Liabilities which addresses methodologies for valuing the liabilities of life insurance companies. Further information can be obtained at <www.apra.gov.au>, but the following comment on the discount rate, from Paragraph 3.5 seems of interest: The gross rate used to discount expected future cash flows must reflect the expected investment earnings applicable to the assets backing the benefit being valued. This does not preclude the use of discount rates that make allowance for assumptions that are expressed as a percentage of the value of assets, rather than allowing for those assumptions explicitly in the projection. This practice may apply in respect of certain expenses, taxes or profit margins.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1680 Guidance from Courts on Valuation Issues
14~1680
Guidance from Courts on Valuation Issues
In litigation, the courts are often asked to gauge a fair price for a business or shares and to give orders that the court ruling be the basis of a transaction (often in retrospect).
This is at odds to the willing but not anxious vendor and purchaser concept as one or both parties may be willing to undertake a transaction but at different prices (hence the litigation). One of the parties may, in fact, be extremely unwilling to buy or sell, regardless of price. Undertaking a report for the courts as an independent expert requires an objective view of the circumstances. It is usually necessary to contrive a situation whereby the willing but not anxious concept can be created for the purpose of the report. It is partly because of the necessity to create a set of circumstances in which the valuation arises which distinguishes valuation reports for the courts from valuation reports for a purchase or sale in normal commercial circumstances. The courts have therefore spent considerable time considering the major issues of: the date of the valuation; the definitions of value and price; the bases or methodologies for valuing shares and businesses; and minority discounts and control premiums.
The following sections discuss a selection of legal cases which focus on these matters. This is not intended to be a legal digest which lists every precedent in valuation cases. However, the cases listed are useful references for further reading. A glossary of some of the key terms used in legal cases is set out below: Plaintiff: the aggrieved party bringing the action. Defendant: the party against whom the claim has been brought. Petition: the claim lodged with the court by the plaintiff against the defendant. Judgment: the decision of the court.
A useful paper for further background is The Measure of Damages for Economic Loss in Tort, Contract and for Misleading and Deceptive Conduct by Connery & Partners, which is available from the following web site, www.icaa.org.au, Technical Information, Specialist Groups, Forensic Accounting, Discussion Papers.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1680 Guidance from Courts on Valuation Issues / 14~1700 Price Must Reflect Fair Value
14~1700
Price Must Reflect Fair Value
The courts tend to support the view that the price of the shares should reflect their fair value, that is, the value which is fair to the parties in all the circumstances of the case. In re Bird Precision Bellows Ltd, Nourse J held that: although [the relevant UK Companies Act sections]are silent on the point, it is axiomatic that a price fixed by the court must be fair. ([1984] 3 All ER 444 at 449) In Scottish Co-operative Wholesale Society Ltd v. Meyer, Lord Denning held that: One of the most useful orders mentioned in [section 210 of the Companies Act 1948
(Eng)] which will enable the court to do justice to the injured shareholders is to order the oppressor to buy their shares at a fair price; and a fair price would be, I think, the value which the shares would have had at the date of the petition, if there had been no oppression. ([1959] AC 324 at 369) Similarly, in Diligenti v. RWMD Operations Kelowna Ltd (No. 2), Fulton J held that in fixing a price for shares in situations where a compulsory acquisition is ordered: what the court is concerned with is not the market value of the shares, but with the fair value or price to be set in the circumstances. ([1977] 4 BCLR 134 at 166) The definition of fair value was also considered in the case of Pauls Ltd v. Dwyer & Ors [2001] QSC 067, which considered how the compulsory acquisition laws allocate the benefits of 100% ownership. In this case Pauls Ltd sought approval of its acquisition of the remaining non-redeemable preference shares it did not already own in another company (PVL). These preference shares carried a 7% cumulative annual dividend, but very limited voting rights. The respondents sought to establish that PVL may be worth more to Pauls as a whole than to a third party and that this special value should be attributed to the preference shares not in Pauls control when assessing their valuation. The court found that the valuation of the shares had been done according to the procedures prescribed in Part 6A.2 of the Corporations Act 2001 and that no special value should have been included as section 667C(1)(c) used the words without allowing a premium in connection with the valuation. In a July 2002 minor thesis for a Master of Law, entitled How section 667C of the Corporations Act should be interpreted and its application to the various forms of compulsory acquisition, Allan Bulman considered, amongst other things, the question of how securities should be valued from a policy point of view for the purposes of compulsory acquisition. The paper included an analysis of valuation cases from the Supreme Court of Delaware. In considering cases concerning section 667C, there is a particular consideration as to whether special benefits should be included in determining fair value under section 667C. The paper can be accessed from <cclsr.law.unimelb.edu.au/research-papers/allan-bullman.html>.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1680 Guidance from Courts on Valuation Issues / 14~1720 Concept of Market Value
14~1720
Concept of Market Value
The concept of value accepted for statutory purposes and for many other purposes is the definition formulated by the High Court of Australia in Spencer v. The Commonwealth of Australia (1907) 5 CLR 418, when Griffith C. J., at page 432 applied the following test: In my judgment, the test of value of land is to be determined, not by inquiring what price a man desiring to sell could actually could have obtained for it on a given day, i.e. whether there was in fact, on that day, a willing buyer, but by enquiring: What would a man desiring to buy the land have to pay for it on that day to a vendor willing to sell it for a fair price but not desirous to sell.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1680 Guidance from Courts on Valuation Issues / 14~1740
Valuation Dependent on Future Earnings

14~1740
Valuation Dependent on Future Earnings
In Hepples, the Federal Commissioner of Taxation, McHugh J. said: Although Goodwill is commonly valued by capitalising expected future net profits or by estimating the worth of purchasing several years of the past profits of a business, it may exist even though the business has not made any profits and is unlikely to do so for some time. In the case of a new business, money expended on research, advertising and distribution networks for example, may have created sources of Goodwill which will ultimately generate future profits even though the business has not made any profit.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1680 Guidance from Courts on Valuation Issues / 14~1760 Valuation Conducted as if the Oppression has not Occurred
14~1760
Valuation Conducted as if the Oppression has not Occurred
As discussed above, the courts primary objective in carrying out a valuation is to determine the fair value of the companys shares. It follows that the valuation must disregard the adverse effects of the oppressive conduct if this conduct has reduced the value of the shares.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1680 Guidance from Courts on Valuation Issues / 14~1760 Valuation Conducted as if the Oppression has not Occurred / Scottish Co-operative Wholesale Society Ltd v. Meyer ([1959] AC 324)
Scottish Co-operative Wholesale Society Ltd v. Meyer ([1959] AC 324)
Key Point: The value placed upon the shares should be the value which they would have had, but for the effect of the oppression, at the date of presentation of the petition: per Lord Sorn.
A private company (called Newco in these notes) was formed by the majority shareholders of the company Scottish Co-operative Wholesale Society Ltd. The company was formed in order to enable the society to enter the rayon textile industry and to obtain licences to manufacture rayon cloth, the production of which was then controlled. At the time of its formation, Newco was dependent on the minority shareholders connections in the trade and on their technical experience and qualifications, and it was largely because of these connections and qualifications that licences were granted to the company by the controlling authority. The minority shareholders were joint managing directors, and three other directors were nominated by the society. The diagram below summarises the relationship of the parties:
For several years Newco traded successfully and earned substantial profits, but thereafter, following an unsuccessful attempt by the society to purchase the minority shareholders shares at less than their true value, the society embarked on a policy of diverting the societys trade to a new department within itself so as to destroy Newcos trade and depreciate the value of its shares. As a result of this policy Newcos business was brought virtually to a standstill and the value of its shares was greatly reduced. Consequently the minority shareholders sought to have the society purchase their shares at a price based on their value before the conduct complained of commenced, or at such other prices as the court might think fit. On this aspect of the case, Lord Sorn held that: the value placed upon the shares for the purpose of the Courts order to purchase should be the value which they would have had, but for the effect of the oppression, at the date of presentation of the petition. ([1957] SC 110 at 156) The trial judge found in favour of the minority shareholders. The parent company appealed to the House of Lords on the grounds that the value of the shares assessed by the court was excessive. The House dismissed the appeal. Lord Keith of Avonholm held that: It was contended that the value of 3 15s put upon the shares was excessive. I see no reason for altering this figure. Lord Sorn has, in my opinion, approached this matter on a correct principle, by considering what would have been the value of the shares at the commencement of the proceedings had it not been for the effect of the oppressive conduct of which complaint was made. ([1959] AC 324 at 364) Lord Denning also held that: a fair price would be, I think, the value which the shares would have had at the date of the petition, if there had been no oppression. ([1959] AC 324 at 369)
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1680 Guidance from Courts on Valuation Issues / 14~1780
Factors to be Considered in the Valuation of Shares

14~1780
Factors to be Considered in the Valuation of Shares
The factors to be considered in the valuation of shares were addressed in the decision of Geoffrey Alan & Anor v. Robert Hedley Cox (1997) handed down by the Supreme Court of NSW Court of Appeal. In that case, Mr Cox was engaged by Mr Holt as a consultant in a closely-held company, F P Leonard Advertising Pty Ltd, initially on a trial basis. Some three months later, as an incentive for Mr Cox to stay in the company, Mr Holt issued him with five A class shares. The shares had attached to them the right to appoint a director, the right to receive such dividends as may be declared by the directors from time to time, and the right on a winding up to receive 20% of any distribution of capital. In addition, the companys articles of association provided that, upon termination of his employment, the shares must be offered to the ordinary shareholders at a fair price determined by the company auditor. When Mr Coxs employment was terminated, under the capitalised future maintainable earnings method used by the auditor, Mr Coxs five A class shares were valued at $171. Mr Cox refused to go through with the sale on the grounds that the auditor failed to arrive at a fair price as required by the articles of association. The NSW Court of Appeal found for Mr Cox by two to one (Cole JA dissenting). The relevant points are as follows: The Court of Appeal upheld the reasoning process adopted by the auditor in arriving at the chosen valuation method. The Court of Appeal expressly agreed with the auditor that the most appropriate method for a particular valuation will depend on many factors, including the size of the parcel, and the special characteristics and nature of the shares being valued. The valuation method chosen must most accurately reflect the manner in which a willing but not anxious buyer would have approached the matter. The Court of Appeal found that the auditor failed to arrive at a fair price and subsequently undervalued the shares on the basis that insufficient weight had been placed on the prospects that the company would be wound up in the event that it could not be built up and sold. Any shared expectations of the parties are an important factor that should be taken into account in determining the fair price of the shares. The majority of the Court of Appeal was of the opinion that, whilst winding up was not imminent, it was a relevant consideration, and the possibility that it could eventuate should be given some weight and not simply ignored. The Court of Appeal agreed with the trial judge that a valuer should not apply a discount for the possibility that the directors might engage in profit stripping prior to winding up. Such a possibility is inconsistent with the notion of a fair price as it ignores the existence of fiduciary obligations that exist between the company and its shareholders. The Court also supported the trial judges view that in the case where there is no immediate prospect of sale and subsequent winding up of the company, the valuer should value the chance of sale and then determine the present value of 20% of the surplus assets of the company without taking into account any possibility of profit stripping. The valuer needed to value the prospect from the viewpoint of a willing but not anxious vendor who is forced to give up this prospect by selling.
While the Court of Appeal stated that it would be going too far to hold that this justified an additional premium to compensate for the forcible sale, the notion of a fair price in such circumstances of
appropriation requires the valuer, in having regard to what is equitable and just, to make an estimate on the liberal side in assessing that chance, within a range of possible values. Roessler v. Security Savings & Loan Co (72 NE 2d 259 (1974)) was concerned with the construction of the term fair cash value as used in the UK Companies Act. The Act provides, in part, that: if the court shall find and order that such shareholder [dissenting shareholder] is entitled to be paid the fair cash value of any number of shares, the court shall appoint three appraisers to determine the fair cash value of such number of shares as of a day to be named in such order, and said court shall instruct said appraisers respecting their duties in making such determination. Sohngen J. held that it is not possible for the court to list all of the possible factors to be considered in determining the fair cash value of the shares in question, but the court put forward the following factors to which consideration may be given: the business of the defendant and the prospects of its business for the future; the nature of its property; its financial condition; the value of its assets; the amount and nature of its actual and contingent liabilities; its earnings in the past and its prospects of earnings in the future; the dividends paid by it in the past and its prospects for paying dividends in the future; its management and reputation; the value of its goodwill (in this context, goodwill means the factors which contribute to the custom the business enjoys and not to a balance sheet concept); and the market value of its shares. (72 NE 2d at 260-1 (1974)).
Similarly in Commissioner of Succession Duties (SA) v. Executor Trustee and Agency Co. of South Australia Ltd ((1944) 69 CLR 1), Latham CJ and Rich and Williams JJ examined the matters to be considered in estimating the value of shares in the following passage: The main items to be taken into account in estimating the value of shares are the earning power of the company and the value of the capital assets in which the shareholders money is invested...[However], the more important item is the determination of the probable profit which the company may be reasonably expected to make in the future, because dividends can only be paid out of profits and a prudent purchaser would be interested mainly in the future dividends which he could reasonably expect to receive on his investment. Further, a prudent purchaser would reasonably expect to receive dividends which would be commensurate with the risk, so that the more speculative the class of business in which the company is engaged the greater the rate of dividend he would reasonably require. In order to estimate the probable future profits of a company it is necessary to examine its past history, particularly the accounts of those years which are most likely to afford a guide for this purpose.
In order to estimate the rate of dividend that a prudent purchaser could reasonably require on his investment it is necessary to examine the nature of the business and the risks involved and to seek the evidence of business men, particularly members of the stock exchange and experienced accountants, who can testify to the appropriate rate from the prices paid for shares in companies carrying on similar business listed on the stock exchange or from private sales of shares in such companies or from their general business experience. ((1947) 74 CLR at 362) Hence, according to Latham CJ and Rich and Williams JJ, the important factors to be considered in determining the value of shares are: the likely future earnings; the asset backing of the shares; the likely dividend flow from probable future profits; the riskiness of the operations which can significantly impact on the size of the expected dividends the greater the risks, the greater the returns; the history of the business which may be relevant to the determination of probable future profits; and to seek views on rates of return from experienced market participants.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1680 Guidance from Courts on Valuation Issues / 14~1780 Factors to be Considered in the Valuation of Shares / 14~1790 Method of valuation
14~1790
Method of valuation
The normal valuation methodologies which are appropriate for going concern businesses have also been accepted by the courts, as demonstrated in Lenehan v. Lenehan (1987) FLC 91.814 this case related to the valuation of a pharmacy business for property settlement purposes. The courts have held that there are essentially three methods which can be used in a court action for valuing shares in private companies. As mentioned earlier, the price of shares should be measured at their fair value, hence the method of valuation used should be the one which best achieves that objective in the circumstances of the case.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1680 Guidance from Courts on Valuation Issues / 14~1780 Factors to be Considered in the Valuation of Shares / 14~1790 Method of valuation / Net asset value/break up value
Net asset value/break up value
Net asset value/break up value is a method of valuation whereby shares are valued at what a companys assets could be sold for in the event of company liquidation, taking into account liabilities and prior claims against the companys assets. This method of valuation is appropriate where the companys principal activity is trading or holding real property or securities or where the company is insolvent or trading at a loss.
This was the approach adopted by the court in Re Dalkeith Investments Pty Ltd ((1984) 9 ACLR 247). In this case the parties in question were husband and wife. When they acquired their shares in the company they entered into an arrangement which constituted a partnership in corporate form. The arrangement was a family arrangement. After a bitter divorce, the parties were unable to work together, and so the company was dissolved. McPherson J. held that in the circumstances of the case, a minority shareholder was entitled to a winding up order on just and equitable grounds. The directors of Dalkeith Investments, with the acquiescence of a major shareholder, had behaved in a manner constituting oppression within the meaning of section 320 and the remedy envisaged by section 320 was an order that would effectively give relief to the petitioner from that oppression including an order for the purchase of the shares of any member, by the company or by the shareholders against whom the proceedings are brought. It was further suggested that the proper course in the case was to assess the value of the shares of the minority shareholder without reference to the matters that gave rise to the complaint of oppression. The companys primary assets were represented by a nursing home and a dwelling house and in valuing the assets McPherson J. held that the balance sheet as at the end of the most recent financial year would be an appropriate guide by which to act, provided that the most recent valuations were inserted in lieu of the value of fixed assets that appeared in the balance sheet.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1680 Guidance from Courts on Valuation Issues / 14~1780 Factors to be Considered in the Valuation of Shares / 14~1790 Method of valuation / Capitalisation of maintainable earnings
Capitalisation of maintainable earnings
The capitalisation of future maintainable earnings is a method of valuation which determines the capital value of future earnings. It is determined by applying the appropriate capitalisation rate to the future earnings of the company. The capitalisation of future maintainable earnings is the preferred method of valuation when the business is a going concern.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1680 Guidance from Courts on Valuation Issues / 14~1780 Factors to be Considered in the Valuation of Shares / 14~1790 Method of valuation / Buckingham v. Francis ([1986] 2 All ER 738)
Buckingham v. Francis ([1986] 2 All ER 738)
Key Points: The risk factor should be considered either in the assessment of the future profits or in the determination of a price earnings ratio but not in both. The assessment of future earnings can be made on a best-guess basis and a price earnings ratio can then be applied to the figure. On the other hand, the allowance for risk could be incorporated in the ratio rather than the profit figure or part of it in one and part in the other.
Until 24 March 1981 the plaintiff, Mr Buckingham, was a director of a company. He held 20 out of the
50 issued shares in the company. The other 30 shares were held as to 10 shares each by the defendants, Mr Francis, Mr Douglas and Mr Thompson. The primary business of the company was to supply the printing industry in East Anglia with materials and equipment. The defendants were interested, but Mr Buckingham was not, in other companies with similar names, which carried out the same trade in other parts of the country. On 24 March 1981 Mr Buckingham signed a written agreement which stated that he would offer his shares to the remaining shareholders at the issue price of 1 each. This action was brought: 1. 2. to declare that the agreement was void, illegal and of no effect; and to gain compensation for the shares transferred or the return of them.
By another action the company made certain claims against Mr Buckingham and others. On 9 December 1985 orders were made by consent dealing with all the issues in this litigation except one, namely, the value of the plaintiffs shares in the company as at 24 March 1981. The private company had a large income potential but few assets, so the earnings capitalisation method was chosen by Staughton J. as the preferred method of valuing the shares of the company. In estimating the future maintainable earnings of the company, Staughton J. took into account the difficult trading conditions at the relevant time, the loss of Mr Buckingham and the corresponding increase in competition from him. On the other hand, Staughton J also took into account the fact that there were reasonable grounds to expect that the company would prosper in the future. Staughton J. then arrived at a figure of 6,000 per annum. Staughton J. suggested that the risk factor is to be considered either in the assessment of the future profits or in the determination of a price earnings ratio but not in both. He further suggested that in order to avoid double counting, the assessment of future profits can be made on a best-guess basis, allowing for risks but without either undue caution or exaggeration and a price/earnings ratio can then be chosen on the basis that the figure for future profits is the probable answer. On the other hand, the allowance for risk could be incorporated in the ratio rather than the profit figure or part of it in one and part in the other. ([1986] 2 All ER at 741-2) Staughton J. rejected the use of 50% as the appropriate capitalisation rate. His Lordship came to the conclusion that a capitalisation rate of 25% was more appropriate on the basis that: the risk factor had already been incorporated in the profit figure and so a price/earnings ratio of 2 would contain a second unnecessary allowance for risk. ([1986] 2 All ER 738 at 743) It was then held that the value for the company was 6,000 x 4 or 24,000 and Mr Buckinghams shares, which represented two-fifths of the companys share capital, were worth 9,600.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1680 Guidance from Courts on Valuation Issues / 14~1780 Factors to be Considered in the Valuation of Shares / 14~1790 Method of
valuation / Capitalisation of expected dividends

Capitalisation of expected dividends
The method of valuation based on the capitalisation of expected dividends values a companys worth on the basis of what its shares would be valued on the open market if the company was listed and paid dividends on a commercial basis. In the case of Sanford v. Sanford Courier Services Pty Ltd & Ors ((1986) 10 ACLR 549), the plaintiff, Sanford, was an equal shareholder in the capital of Sanford Courier Services Pty Ltd & Ors, which was a courier company operating in NSW.
The other shareholders of the company became dissatisfied with the contribution of Sanford to the affairs of the business and on 11 February 1983 Sanford gave notice of his retirement, suggesting that his shares be acquired by the remaining shareholders at a value to be agreed upon. During the course of subsequent correspondence the value was not agreed upon and Sanford commenced proceedings after the company advised him that it would offer his shares to other shareholders at a value well below what Sanford considered to be the market value of the shares. It was then held that the shares should be valued at the time the proceedings commenced and the plaintiffs shares should be valued by capitalising the expected dividend stream as at December 1984 assuming that the emoluments provided for the remaining shareholders had been and would be on a commercial basis. According to Waddell CJ, what has to be arrived at is a value which is fair in all the circumstances, disregarding the effect of the oppressive conduct. Waddell CJ came to the conclusion that the capitalisation of expected dividends method was the appropriate method, in the circumstances, to arrive at the shares fair value. This is based on the fact that Sanford was a minority shareholder, that he was bound by the pre-emptive provisions of the articles and that he had no legal right to sell his shares without first offering them to other shareholders at the price which the auditor of the company might certify (pursuant to specific provisions in the companys articles). In addition, evidence did not establish that there had been, or was for the foreseeable future, any prospect of the business being sold. On the contrary, it was likely to be carried on as a family business
so the net asset value method of valuation was considered inappropriate in the circumstances.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1680 Guidance from Courts on Valuation Issues / 14~1780 Factors to be Considered in the Valuation of Shares / 14~1790 Method of valuation / Technology Valuations
Technology Valuations
In Re Zoffanies Pty Ltd v. Commissioner of Taxation, Administrative Appeals Tribunal, Taxation Appeals Division, No. NT 2001/70, Mr R P Handley noted that: While it seems the DCF methodology is the most widely accepted, the comparables and real options methodologies also have their advocates, and each has its limitations. Obviously, in the case of new technology requiring further R and D and commercialisation, where there is no clear market or income stream, no valuation can do more than estimate a range within which a particular valuation may reasonably lie. (Paragraph 135) For further information regarding technology valuations see the section on start-up and technology-based operations and the appropriate valuation methods for technology valuations.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1680 Guidance from Courts on Valuation Issues / 14~1780 Factors to be Considered in the Valuation of Shares / 14~1800 Date of valuation
14~1800
Date of valuation
There is no general rule regarding the date on which shares ought to be valued and this is confirmed by Nourse J. in Re London School of Electronics Ltd ([1985] 3 WLR 474 at 484) and Vinelott J. in Re a company No 002612 of 1984. However, certain dates have been held by reported cases as possible valuation dates. These include: the date of the presentation of the petition; the date of the occurrence of the oppressive conduct; the date of the courts judgment; and the date on which the valuation of the shares is completed by the court.
While there is no general rule on the selection of a valuation date, a main consideration for the court is that the date chosen must be such that the value of the shares is fair to all the parties involved in the circumstances of the case. Vinelott J. in Re a company No 002612 of 1984 suggested that the date of the petition is to be preferred. This was justified on the ground that: the date of the petition is the date on which the petitioner elects to treat the unfair conduct of the majority as in effect destroying the basis on which he agreed to continue to be a shareholder, and to look to his shares for his proper reward from participation in a joint undertaking. ((1986) 2 BCC 99453 at 99,492-99,493) This has also been the view adopted by the Australian courts. In Sanford v. Sanford Courier Service
Pty Ltd [see above], Waddell CJ held that the plaintiffs shares should be valued as at the time the proceedings were commenced. Similarly, in Re Bagot Well Pastoral Co Pty Ltd (which is discussed later), Cox J. held that: I think in all the circumstances Mrs Reids shares should be valued as at the time she lodged her petition. ((1992) 9 ACSR 129 at 146; affirmed on appeal (1993) 12 ACSR 197) However, the courts view that the relevant date for the valuation is the date of the petition poses some practical, commercial concerns for an aggrieved party. Whilst the courts (understandably) need a clearly defined occurrence at which time value and price can be determined, by the time legal action is contemplated the damage that the plaintiff is trying to overcome or be compensated for has probably already occurred. For example, in the case of oppression of minorities, by the time a minority shareholder is aware that the majority shareholder(s) is abusing their position possibly shifting value to another entity as was suggested in Re Bagot Well Pastoral Company the remedy offered by the courts may be too little, too late. This brings us back to a golden rule of litigation: avoid litigation wherever possible, negotiate a commercial settlement even when both parties appear to be at an impossible impasse and use formal dispute resolution processes in preference to court action. Litigation can often be an unknown quantity both in terms of the costs of undertaking the litigation and the outcome as litigants are unable to control the process as closely as commercial settlements.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1680 Guidance from Courts on Valuation Issues / 14~1780 Factors to be Considered in the Valuation of Shares / 14~1810 Discount rate
14~1810
Discount rate
The question is what would a hypothetical buyer be fairly expected to pay for the assigned interest. In other words, what rate of interest, having regard to all the risks and disadvantages of the business, would a buyer expect to receive in order to move him to buy. (Mr Justice Burt Reynolds the Commissioner of State Taxation 86 ATC 4528.)
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1680 Guidance from Courts on Valuation Issues / 14~1780 Factors to be Considered in the Valuation of Shares / 14~1820 Severability of goodwill
14~1820
Severability of goodwill
The proposition that goodwill cannot be separated from the business to which it relates has been subject to considerable legal opinion and a number of court decisions. Judge McHugh in Hepples v. Federal Commissioner of Taxation stated: Goodwill has no independent existence. It cannot subsist by itself. It must be attached to a business. Destroy the business, and the Goodwill will perish with it though elements remain which
may perhaps be gathered up and revived again. In the case of Geraghty v. Minter (1979) 142 CLR per Stephen J., at pages 190/191, said: Goodwill of a...business is an inseparable whole unless of course it consists in fact of a series of separate goodwill, each applicable to distinct areas in which the one business operates or to distinct business activities which the one business entity carries on. It appears that Stephen J. was referring to the principle that goodwill of the business carried on in several different places may be capable of being apportioned on a territorial basis and was referring to the possibility that there are, within a particular business activity, distinct businesses with their own separate goodwill being carried on in their respective places. This situation was referred to by Hope J. A. in Castlemaine Tooheys Limited and Anor v. Carlton & United Breweries Limited and Anor (1987) 10 NSWLR 468 at page 494, where he said: It is obvious that goodwill does not have any absolute inseverability. Thus suppose a company carries on the business of a general department store, selling products ranging from clothing to kitchenware. There is nothing in law from stopping the company from selling that part of the business and the associated goodwill, concerned with the sale of kitchenware to another company, retaining for itself, the balance of the business and associated goodwill.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1680 Guidance from Courts on Valuation Issues / 14~1780 Factors to be Considered in the Valuation of Shares / 14~1830 Minority discounts
14~1830
Minority discounts
When the petitioners shareholding represents a minority interest, the main issue is whether the petitioners shareholding should be valued on a pro rata basis or whether the pro rata value of the shares should be discounted to reflect the fact that they represent a minority interest. A summary of Australian cases involving minority discounts can be found in section 2.2 of Forsythes Family Law Value Handbook, and accessed from <www.forsythes.com.au>.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1680 Guidance from Courts on Valuation Issues / 14~1780 Factors to be Considered in the Valuation of Shares / 14~1830 Minority discounts / Re Bird Precision Bellows Ltd ([1984] 3 All ER 444 affd [1985] 3 All ER 523)
Re Bird Precision Bellows Ltd ([1984] 3 All ER 444 affd [1985] 3 All ER 523)
Key Points: There is no general rule for valuing shares in a private company. However, where the private company is conducted as a quasi-partnership, there is a general rule that the price of the shares should be fixed, pro rata, without any discount. However, the general rule does not apply where the minority shareholders conduct was such as to justify expulsion or where the minority shareholding was acquired for the purpose of
investment, and does not seek to take an active part in the companys affairs. The minority shareholders, who held 26% of the issued share capital of the company which was incorporated in 1975, alleged that the company was a quasi-partnership and that from the date of its incorporation there was an agreement that they would participate in the conduct of the companys affairs. That was challenged by the majority shareholders, who held the remaining 74% of the issued share capital. The minority shareholders were removed from office as directors in April 1981 and excluded from the companys business. In October 1981 they presented a petition under section 75 of the Companies Act 1980 alleging that the affairs of the company had been conducted in a manner unfairly prejudicial to their interests as members and sought an order under section 75(4)(d) of the same Act for the respondents to purchase their shares. At the first hearing of the petition on 23 November 1981 it was ordered by agreement that the majority purchase their shares at such a price as the court shall hereafter determine and the case then became concerned with the determination of the price. Nourse J held that there was no universal rule for valuing a minority interest in a private company. However, he was also of the view that a general rule did exist in the case of a private company conducted as a quasi-partnership. According to Nourse J, where the sale was being forced on the holder because of the unfairly prejudicial manner in which the affairs of the company were being conducted by the majority, it seems to me that it would not merely not be fair, but most unfair, that he should be bought out on the fictional basis applicable to a free election to sell his shares in accordance with the companys articles of association, or indeed on any other basis which involved a discounted price. In my judgment the correct course would be to fix the price pro rata according to the value of the shares as a whole and without any discount, as being the only fair method of compensating an unwilling vendor of the equivalent of a partnership share. ([1984] 3 All ER 444 affd [1985] 3 All ER 523 at 450) On the facts, it was held that the company was a quasi-partnership, since it had been set up on the understanding that the minority shareholders would participate in the conduct of its affairs and accordingly, it was appropriate that the price to be paid for their shares should be fixed on a pro rata basis without any discount to reflect the fact that the shares constituted a minority holding. However, Nourse J recognised that there may be circumstances where it may be inappropriate for a quasi-partners minority interest to be valued on a pro rata basis. Nourse J gave the examples of where: a minority shareholders conduct was such as to justify his exclusion ([1984] 3 All ER 444 affd [1985] 3 All ER 523 at 450) or where [he] acquired his minority shareholding for the purpose of investment, without seeking to take an active part in the companys affairs. ([1984] 3 All ER 444 affd [1985] 3 All ER 523 at 450) It was held that while the conduct of the minority shareholders was not beyond reproach, they had not in the circumstances acted so as to deserve their exclusion. Hence, no discount was given on that basis. The appeal to the Court of Appeal was dismissed and the decision of Nourse J still stands. No Australian authority has laid down a general rule regarding the application of a minority discount in
a court-ordered valuation under section 260 of the Corporations Law (now sections 232 and 233 of the Corporations Act 2001). Of the three main cases in which the issue of a minority discount was expressly raised, two were in favour of applying a discount. In Re M Dalley & Co Pty Ltd ((1968) 1 ACLR 489) the Master, who was responsible for valuing the shares, was specifically directed by the judge to take account of the fact that the petitioners shareholding was a minority interest in a private company. Similarly, in Sanford v. Sanford Courier Service Pty Ltd, Waddell CJ held that the plaintiffs status as a minority shareholder was to be taken into consideration in valuing his shares. On the other hand, the majority of the Full Court of the Supreme Court of Queensland in Re Golden Bread Pty Ltd ([1977] Qd R 44 at 64), accepted the trial judges decision to value the petitioners shares on a pro rata basis without applying a discount. However, none of the three authorities discuss the issue of minority discount in any detail and it remains to be seen whether the Australian courts will adopt the English position of confining the no discount rule to quasi-partnership cases or whether they will follow the Canadian courts in Diligenti v. RWMD Operations Kelowna Ltd where no distinction is made between quasi-partnerships and non-quasi-partnerships and the only test on when a minority discount would apply is to determine what price is fair in the circumstances. Another issue is whether a court is entitled to take account of the fact that the sale of a petitioners minority interest to the defendants will confer upon them either complete control or a majority interest.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1680 Guidance from Courts on Valuation Issues / 14~1780 Factors to be Considered in the Valuation of Shares / 14~1830 Minority discounts / Kummen v. Kummen Shipman Ltd ([1983] 2 WWR 577)
Kummen v. Kummen Shipman Ltd ([1983] 2 WWR 577)
Key Point: Where the defendant does not initially have a controlling interest but has acquired such an interest upon purchasing the petitioners minority shareholding, the court is entitled to take this into account in valuing the petitioners shares.
Two brothers each owned 49% of the shares in the respondent company, with their wives each owning one share. A falling-out occurred in 1970 with the result that the brothers salaries were frozen and no dividends paid since that time. An application was brought by one brother and his wife to liquidate and dissolve the company. At trial, it was ordered that the respondent brother had the option to purchase the applicant brothers shares; if he failed to do so, the applicant brother had a like option. In either event, the purchase price of the shares was to be 75% of the value established by the court as at the date of judgment. The decision was subsequently appealed. The appeal was successful. Monnin JA held that a discount rate is applicable to the purchase of shares when a person is buying into a minority position. The rationale for granting a discount is to give incentive to buy into a minority shareholder situation. However, where a person acquires a majority position by acquiring a minority shareholders interest, the rationale does not apply. Accordingly the purchase price of the shares should be the fair value, for otherwise the purchaser
would receive an unwarranted bonanza and at the same time a commensurate loss to the vendor which is not an equitable solution. ([1983] 2 WWR 577 at 580)
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1680 Guidance from Courts on Valuation Issues / 14~1780 Factors to be Considered in the Valuation of Shares / 14~1830 Minority discounts / Re Bagot Well Pastoral Company Ltd ((1992) 9 ASCR 129)
Re Bagot Well Pastoral Company Ltd ((1992) 9 ASCR 129)
Key Point: Where the compulsory acquisition gives the defendant absolute control of the company, that is a relevant factor to be considered in the valuation of the petitioners shares.
The case is concerned with a dispute between two shareholders in a family pastoral company, Bagot Well Pastoral Company Pty Ltd (BW). BW was a holding company for a partnership, Cambusdoon Proprietors. The share capital of BW was divided into different classes of shares. Mr Shannon held the only life governors share which gave him virtual control over directorial and managerial decisions, and allowed him to run BW as though he were the sole proprietor. Mrs Reid, who took an active interest in BW, had a number of complaints about the policies and management of the company. Over the years she had unsuccessfully attempted to obtain financial information about BWs affairs. The financial relationship between BW and Cambusdoon Proprietors, which was owned by Mr Shannon and his mother, suggested that Mr Shannon had, in effect, integrated the two businesses for the benefit of himself and his company. There was a dominant policy of building up the assets for the future benefit of Mr Shannons sons. In October 1985, Mrs Reid lodged a petition under section 320 of the Companies (SA) Code for an order that Mr Shannon or BW be required to purchase her shares at a price determined by the court. She argued that the affairs of BW had been conducted in a manner that was oppressive and unfairly prejudicial to, and discriminatory against her, and contrary to the interests of the members of the company as a whole. The court agreed with Mrs Reid that this had indeed been the case, and Mrs Reids shares should be valued as at the time she lodged her petition. As to deciding an appropriate value for the shares, Cox J held that the advantage to Mr Shannon of having complete control of the company in the future would be a relevant factor in the valuation of Mrs Reids shares ((1992) 9 ASCR 129 at 146). That is to say, the value of Mrs Reids shares should not be discounted as a normal minority holding as the acquisition concentrated control in the hands of Mr Shannon. Consequently, the Court appears to have suggested a pro rata valuation of Mrs Reids shares. In the case of multiple defendants where none of them held a controlling interest in the company, a courts order that each of them must acquire the petitioners shares in equal proportion or in the same proportion as their proportionate shareholding in the company could mean that after the purchase order is carried out, none of them will actually obtain a controlling interest. Whether this should also be
taken into account in the share valuation is another issue.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1680 Guidance from Courts on Valuation Issues / 14~1780 Factors to be Considered in the Valuation of Shares / 14~1830 Minority discounts / Diligenti v. RWMB Operations Kelowna Ltd (No 2) ((1977) 4 BCLR 134)
Diligenti v. RWMB Operations Kelowna Ltd (No 2) ((1977) 4 BCLR 134)
Key Point: The fact that the defendants have acquired the shares from another minority and have consolidated their minority shareholding will be a factor in determining the value of the shares, notwithstanding that they continue to be minority shareholders.
The petitioner, Mr Diligenti, and three other individuals (the defendants) each held 25% of the issued shares in a private company, and all four were appointed directors. The company was conducted as a quasi-partnership with each of the shareholders sharing equally in the management of the companys affairs. A dispute broke out amongst the shareholders which resulted in the defendants banding together and excluding Mr Diligenti from participating in the management of the company. Fulton J ordered that each of the defendants purchase Mr Diligentis interest in equal proportion so that after the compulsory acquisition was completed, each of the defendants would remain a minority shareholder with one third of the shares. In addition Fulton J granted Mr Diligenti relief by ordering the defendants to purchase the petitioners shares on a pro rata valuation without applying a minority discount. While Fulton J was aware that the defendants would continue to be minority shareholders, he was of the view that they were nevertheless in a different position to an outsider who acquires a minority interest in a company. The defendants relationship to each other as shareholders was unaffected and there was no justification for applying a minority discount. The circumstances existing in Diligentis case are quite common: that is, a company is formed with equal representation and ownership amongst the founders of the company. One of the key points established in Diligentis case was that the relationship between the remaining shareholders would remain substantially unchanged. As a consequence, each shareholder was, and would continue to be, a minority. However, as there was a mutuality in the decision-making, the relationship could be distinguished from that which might exist if a new minority shareholder invested in the company. Accordingly, the purchase price of a minority shareholding in such circumstances should reflect pro rata value rather than a discounted value. In a paper entitled Valuations and Price-Adjustment Clauses given at the 50th Annual Tax Conference of the Canadian Tax Foundation in 1998, Richard M Wise covered tax case law from Canada and the USA which dealt with the valuation of minority shareholdings and discounts for lack of control (minority discounts) and for lack of marketability or liquidity (marketability discounts). This paper can be
accessed via www.wbbusval.com.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1850 Guidance from Other Authoritative Organisations
14~1850
Guidance from Other Authoritative Organisations
The Australian Venture Capital Association (AVCAL) has issued revised valuation guidelines for unlisted investments for members to use from 1 January 2004. The starting point for these revised guidelines was the British Venture Capital Association (BVCA) Exposure Draft published in November 2002. This Exposure Draft has been replaced by Guidelines, which were endorsed by BVCAs Council on 11 June 2003. The AVCAL guidelines note (paragraph 1.2) that: In the event of inconsistency between these Guidelines and Accounting Standards, the requirements of the latter should take precedence in relation to statutory accounts reporting of the Funds. Business valuation methodologies are recommended and described in section 4 for the various stage investments, as follows: 4.2.1. Table 1 below recommends a number of methodologies for valuing businesses and indicates, for each methodology, whether it should be considered a primary or a secondary methodology. Table 1: Business Valuation Methodologies Stage of Investment Primary Methods Revenue multiple1 Price of recent investment Secondary Methods Price of recent investment Discounted cash flow Industry valuation benchmarks Net assets Price of recent investment Discounted cash flow Industry valuation benchmarks Net assets Discounted cash flow Industry valuation benchmarks Net assets Early Stage Investment Mid/Expansion Stage Investment Earnings multiple1 Revenue multiple1 Later Stage Investment Earnings multiple1
1. Taking into account the multiple applicable in any relevant recent investment transaction
4.2.2. The use of a secondary methodology is recommended as a cross-check of values produced using a primary methodology. However, a secondary methodology should only be considered for use as the main basis of estimating Fair Value if all the primary valuation methodologies are inappropriate in the particular circumstances. Where a secondary methodology is so used, that fact should be disclosed together with the rationale for its use.
The AVCAL guidelines, including detailed descriptions of the various methodologies, may be accessed via <www.avcal.com.au>.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1880 Industry Practice
14~1880
Industry Practice
In Australia there are many industry practices or rules of thumb used in valuing businesses in different industries. Some specify what value methods are appropriate (i.e. customer multiples for e-commerce businesses), while others suggest valuation rules (i.e. $ consideration per $ fees in the accounting industry). The problems with using such industry practices is that they do not necessarily accurately calculate the true value of the business concerned. Specifically, the valuation methods may not accurately reflect the future cash flow expected to be generated by a business. For additional information, please refer to the section on rules of thumb survey outcomes.
VALUATION APPROACHES & METHODS / 14~1000 Guidance on Appropriate Methods / 14~1930 References
14~1930 1.
References
Bulman, A How section 667C of the Corporations Act should be interpreted and its application to the various forms of compulsory acquisition, 2002, Minor Thesis for Master of Law, <www.cclsr.law.unimelb.edu.au/research-papers/allan-bullman.html>. Fishman, J E, Pratt, S P, Griffith, J C, Wilson, D K Guide to Business Valuations 1998, Practitioner Publishing Company, Fort Worth, Texas.
2.
VALUATION ISSUES
VALUATION ISSUES
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity
15~1000
Valuing 100% of an Entity
It is essential that the valuer understands exactly what it is that is being valued. For example, is a value to be ascribed to an individual business unit or is the corporate structure which encompasses that business unit to be valued? This chapter discusses those issues which need to be considered when valuing not only a business unit, but also the corporate entity to which that business unit belongs. In other words, we shall investigate valuing 100% of an entity. In this chapter we consider the methods of valuing a company by:
converting a business valuation into an entity valuation; and valuing an entity without first valuing the underlying business.
Later in this chapter we discuss converting the valuation to the valuation of a private entity. In the next chapter we consider the valuations of other than 100% of the equity of a company.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1050 Business Valuations Revisited
15~1050
Business Valuations Revisited
In the chapter Scoping a Valuation Assignment we discussed the importance of understanding what was being valued, the business v. the entity. In previous chapters we have considered the various methods of valuing a business. Those valuation methods are also applicable for the valuation of an entity, providing some additional factors are considered. As discussed previously, there are three general approaches or valuation methods: Market approach The market approach to value is based on the principle of substitution. In other words, substitute products should sell at the same price. This approach to value involves determining value multiples from comparative company data or market transactional data. Income approach The income approach to value is based upon discounted cash flow and present value theories. The value of an ongoing business is the present value of its estimated future stream of cash flows. Asset approach The asset approach to value is based on the theory that the current value of all assets (tangible and intangible) less the current value of the liabilities should equal the current value of the entity. There are also a variety of valuation methodologies which do not fit neatly in one of the above approaches and these are discussed in the chapter Other Methods and Considerations. It should be said that a comprehensive valuation will normally look at more than one valuation methodology in order to cross-check the valuations produced. It is also important to understand that the standard of value, premise of value and the purpose of the valuation will not only affect the appropriate valuation methodology, but will also affect the value calculated. When valuing private companies it is also important to identify all the assets used in the operations of the business that are owned by the business and not by the owners individually. In the event there are assets held by the owners individually, the value of the company will need to be reduced by at least as much as it will cost to purchase or replace those assets. It is important as the value of a companys shares should bear some resemblance to the sum of its parts. Where there is no apparent relationship between the sum of its parts and the value of the companys shares then questions must be asked as to why there is an apparent discrepancy.
In a large company group it is not uncommon to have separate valuations which are then aggregated to form a valuation of the whole. For example, a company may operate several subsidiaries and a multitude of businesses through the subsidiaries. It is important therefore that the valuer draws clear rings around the entities which are being valued and their inter-relationship in the group so that a clear picture is gained.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1100 Converting a Business Valuation to an Entity Valuation
15~1100
Converting a Business Valuation to an Entity Valuation
The following diagram is a useful aid in conceptualising the composition of a particular entity.
As a result, the valuation methods used for valuing a business are also applicable for valuing an entity, providing the following additional factors are considered: surplus assets; corporate debt; off balance sheet items; and treatment of debt.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1100 Converting a Business Valuation to an Entity Valuation / 15~1120 Surplus Assets
15~1120
Surplus Assets
Surplus assets are defined as: Assets which form part of a business entity or company but do not contribute to the earnings or cash flow generation capacity of that business or company. These are assets which, if sold, would not impact on the revenue or profit generating capacity of the entity. Typical examples may include:
cash; investments; land and buildings owned by the company and not used in operations; surplus inventories; surplus plant and equipment; or personal assets of shareholders (including works of art, antiques and luxury cars).
Consequently, a mismatch can occur between the earnings or cash flows being valued and the assets in the balance sheet as the surplus asset fails to generate any income or costs savings. Assets and liabilities which do not form part of the core business activity must be valued separately. Such assets are considered to be surplus to the main business undertaking, but nevertheless represent values which should be reflected in the overall value of the company as they could be sold separately and the cash added to the value of the business units. As an example, consider a company which holds 10 acres of vacant industrial land at a carrying value of $5 million. The fact that the land is vacant would indicate that it is not contributing to the profits or cash flows of the underlying business. If the land is not required for future activities then the land could be sold without any negative impact upon the future earnings or cash flows. By this definition, the asset is surplus and its value should be added to the valuation determined from profits or cash flows. We can take this example a step further and set out the following assumptions: Vacant industrial land: All other assets less liabilities: Net assets of entity: Capitalised value of earnings: $5,000,000 $5,000,000 $10,000,000 $6,000,000
This example appears to indicate that there is a negative goodwill amount of $4 million. However, this ignores the fact that the vacant industrial land is a surplus asset. Accordingly, the $5 million value of the vacant industrial land should be added to the earnings valuation of $6 million to arrive at a total valuation of all the companys assets of $11 million. Where the company being valued includes land and buildings that are used in the operations of the business, it may be worthwhile treating the land and buildings as separate assets. This requires valuing them separately and adding their value to the value of the business. (However to avoid double counting it is then necessary to reduce the maintainable earnings of the business by a notional third party rent, then add back ownership costs associated with the premises. This is to reflect the scenario of the land and buildings being sold separately and being leased back to the business.)
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1100 Converting a Business Valuation to an Entity Valuation / 15~1140 Treatment of Debt (Pre- or Post-Debt Valuation)
15~1140
Treatment of Debt (Pre- or Post-Debt Valuation)
As discussed in the chapter Scoping a Valuation Assignment, a distinction must be made at the outset of the valuation process as to whether the valuation is going to be of earnings/cash flows after interest,
or whether the valuation will be of earnings/cash flows before interest, with debt being deducted from the subsequent valuation. This concept is explained in more detail in the section on the treatment of debt when determining the appropriate cost of capital to use.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1100 Converting a Business Valuation to an Entity Valuation / 15~1160 Corporate Debt
15~1160
Corporate Debt
Corporate debt is that debt which is not related to, or included in, any individual business of the entity being valued, or is debt in excess of a businesss ability to support without outside guarantees. Where debt is to be held on an ongoing basis by a business unit, then the cost of that debt should be deducted from the related business (which will bear the ongoing interest charge). If the cost of the debt (i.e. interest) is not deducted in valuing an individual business, then the amount of the corporate debt should be deducted from the aggregate of the business values in determining the value of the entity. Debt guaranteed by an external party is not debt but equity and should be regarded as equity as it is beyond the ability of the business to sustain that level of debt, i.e. we must assume that debt funding would not have been approved without the support of guarantees. The parties providing the guarantee become exposed to the risks of the business and in effect bear an equity risk relating to the supported debt. From an accounting viewpoint debt guaranteed by external parties is not treated as equity, but a valuer, and indeed the individual(s) providing the guarantee, should treat the debt as equity and in turn calculate a commensurate rate of return. If a business is acquired (rather than the entity itself) and corporate debt remains behind in the entity for the vendor to extinguish with the proceeds from the sale, then this debt should be deducted from the value of the entity. The level of supportable debt is important in valuing a business as the higher the amount of debt a business can sustain in its own right, without outside guarantees, then the lower its weighted average cost of capital (WACC), up to a reasonable level of gearing. In a flow-on effect, a lower WACC (or discount rate) will result in a higher present value of future earnings or cash flow being calculated. Attached is a sample Supportable Debt and Maintainable Interest Cover Calculation template. The level of supportable debt can be calculated using the following table. Supportable Debt Calculation Asset Type Plant & equipment Trade debtors Inventory
Value ($) 150,000 20,000 15,000
Security (%) Note 1 65 50 33
Supportable Debt ($) 97,500 10,000 4,950
Supportable Debt Calculation Asset Type Total supportable debt based on security ratios Value ($) Security (%) Note 1 Supportable Debt ($) 112,450
Note 1: The security percentages have been obtained from banks and other financial institutions and are indicative of the level of security they place on hard assets. These rates will vary from business to business and country to country. This level of supportable debt can be confirmed via a maintainable interest cover calculation along the following lines: Maintainable Interest Cover Calculation Supportable debt as calculated Average interest rate Annual interest expense (calculated) Minimum interest cover (Note 2) Minimum required EBIT (calculated) Actual minimum EBIT (Yr 1, 0, +1, +2) 112,450 10 % 11,245 3 33,735 50,000
Note 2: The minimum interest cover multiple varies from industry to industry and from financier to financier. Where the actual EBIT for the last few years is greater than the minimum required EBIT (calculated) the business can support the level of debt ($112,440). If we assume the actual EBIT for the last few years was only $20,000, it is then less than the minimum required EBIT (calculated) and the business could not support the proposed level of debt ($112,440). The supportable level of debt can then be reverse calculated as follows: Supportable Interest Expense (based on Minimum EBIT) = Min EBIT Interest Cover 20,000 3 = 6,666
Supportable Debt (based on Minimum EBIT)
Supportable Interest Interest Rate
6,666 10%
= 66,660
If a companys current level of debt exceeds the level of supportable debt (as calculated above) the excess debt should be treated as corporate debt and deducted from the value of the entity (while the business valuation will include the supportable debt). Future debt levels and interest coverage should then be monitored with adjustments made to corporate debt as required. If adjustments are made to the businesss level of supportable debt, the interest expense included in
future maintainable earnings will also need to be recalculated.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1100 Converting a Business Valuation to an Entity Valuation / 15~1180 Off Balance Sheet Items
15~1180
Off Balance Sheet Items
It is important to realise that not all of the assets and liabilities of a business are recognised in the balance sheet. This is particularly the case in small private companies that may not comply with the requirements of the accounting standards and are not subject to independent audit. When valuing private entities it is also important to ensure all the assets used in the operations of the business are owned by the business and not by the owners individually. In the event there are assets held by the owners individually, the value of the business will need to be reduced by at least as much as it will cost to purchase or replace those assets. Following is a list of some of the more common off balance sheet items: leased assets and liabilities; contingent liabilities; interest rate caps and collars; foreign exchange cover; and tax losses.
These may need to be adjusted for when determining the value of a business.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1100 Converting a Business Valuation to an Entity Valuation / 15~1180 Off Balance Sheet Items / 15~1190 Leased assets and lease liabilities
15~1190
Leased assets and lease liabilities
It is not uncommon for assets financed by finance leases to not be capitalised and for the liabilities also to not be brought to account. This is despite the fact that: the practice is contrary to current accounting standards policy; there is a requirement for financial statements to present a true and fair view; and there is a requirement to prepare the accounts using a substance over form approach.
When this occurs it is worthwhile restating the accounts so as to recognise the assets and liabilities. This can have a number of effects including: increasing the amount of tangible assets; increasing the total return required by the company; increasing the current and non-current liabilities; and altering the values calculated in the ratio analysis of the financial statements.
It may even result in the company exceeding its supportable debt level.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1100 Converting a Business Valuation to an Entity Valuation / 15~1180 Off Balance Sheet Items / 15~1200 Contingent liabilities
15~1200
Contingent liabilities
These include unfunded superannuation commitments, golden parachutes or golden handcuffs for key executives and liabilities relating to litigation, product liability claims, employee claims over and above workers compensation insurance, environmental claims, income tax reassessments, unfunded warranty claims and product recalls. These liabilities can be a pitfall if they are not properly and fully identified in the research and evaluation phase of a valuation. While there is the obvious effect of overstating values through an understatement of liabilities, just as importantly is the effect that the incorrect (or even missed) treatment of such items can have on overstating the earnings stream this in turn will lead to an erroneous valuation.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1100 Converting a Business Valuation to an Entity Valuation / 15~1180 Off Balance Sheet Items / 15~1210 Interest rate caps and collars
15~1210
Interest rate caps and collars
Where a company has an interest rate cap or collar it is advisable to calculate the amount of protection or benefit created (or lost) by the contract and to consider incorporating the benefit (or loss) into the value of the company. The benefit can be calculated as follows: Average borrowings Contracted interest rate Current interest rate for the remaining term covered by the contract Benefit from interest rate cap ($5,000,000 (9.03% 8.00%)) $5,000,000 8.00% 9.03% $51,500 pa
If the contract has a further three years remaining, the value created over the next three years would need to be discounted back to its present value before being added to the value of the business. It is also possible for the interest rate collar to create a loss which would need to be deducted from the value calculated for the business.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1100 Converting a Business Valuation to an Entity Valuation / 15~1180 Off Balance Sheet Items / 15~1220 Foreign exchange cover
15~1220
Foreign exchange cover
Where a company has forward foreign exchange contracts it is advisable to calculate the amount of protection/benefit (or loss) created by the contract and to consider incorporating this benefit (or loss) into the valuation.
For example, a company has previously entered into forward exchange contracts but is now faced with different current spot forward rates. Forward Sell Date Amount of Cover US $ Exchange Rate at which Covered (Contract Rate) .5852 .5861 .5859 Current Forward Rate (for remaining Term) at June X0 .5700 .5950 .6120 Estimated Value Difference as at June X0 (68,353) 38,281 109,183 79,111
July X1 July X2 July X3 Total

1. 2. 3.
1,500,000 1,500,000 1,500,000
Based on US $1.5 million being converted into local currency equivalent. Exchange Rate expressed as 1A$ : xUS$ Line 1 is calculated as ((1,500,000 / .5852) (1,500,000 / .5700))
In the above scenario, the company has three future US dollar cash flows which will require conversion into Australian dollars. To avoid the uncertainties of Australian dollar receipts brought about via exchange rate fluctuations, the company has entered into forward contracts at the rates listed under exchange rate at which covered (contract rate). The company is now guaranteed the equivalent Australian dollar cash flows calculated at these applicable contract rates. As time passes, the spot exchange rate may appreciate or depreciate depending on wider market forces. Such fluctuations give rise to potential gains or losses in terms of Australian dollars to be received if these future cash flows had remained unhedged. These potential gains or losses can therefore be quantified by comparing the guaranteed cash receipt resulting from the hedge with the amount which would otherwise have been received if the cash flows had remained unhedged. For the July X1 cash flow, the US dollar has appreciated, meaning that conversion at the current spot forward rate (i.e. the new exchange rate which could be locked in for the remainder of the term) results in a larger Australian dollar cash inflow than that which results from conversion at the originally contracted exchange rate. In this instance, hedging the future cash flow has in fact cost the company additional cash inflows of $68,353 because of the appreciated US dollar. However, the current forward exchange rates for the X2 and X3 cash flows have moved in the companys favour (i.e. they are better off with the originally hedged exchange rate). Thus in the above example, in aggregate, the company transferring US dollars into Australian dollars is $79,111 better off than if they had not arranged to cover their forward foreign exchange transactions. If the nature, size and amount of these foreign exchange coverings is in the normal course of business, no specific adjustment needs to be made in the valuation for them. However, it will be important in any sale negotiations to ensure that the benefit of these foreign exchange covers are spelt out to a purchaser and that no deduction is made against the price because of their existence.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1100 Converting a Business Valuation to an Entity Valuation / 15~1180 Off Balance Sheet Items / 15~1230 Tax losses
15~1230
Tax losses
In some countries tax losses can be carried forward and offset against future taxable profits. Where this occurs there is potentially a benefit to the company which should be valued. Simplistically the value of the tax losses would be calculated as the present value of the benefit to be derived from the tax losses, taking into consideration their amount and the expected timing of tax. There is often uncertainty in using tax losses and a discount may need to be applied for this factor. In Australia there is an added complication of franking credits. If profits are to be transferred to shareholders then tax will be payable on those transfers (dividends). If there are franking credits available then the transfers are shielded through imputation. If there are no franking credits available (e.g. because no tax has been paid) then the tax saved through tax losses has an offsetting effect as there is no imputation credit available to the recipients of dividends. If a company has built up substantial franking credits, these might need to be valued. Their value will be as a result of the tax paid distributions to shareholders. Their value will be dependent upon: the companys ability to make sufficient profits to distribute; whether in doing so the company does not generate sufficient franking credits to cover these payments; and the ability of the shareholders to utilise the credits.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1100 Converting a Business Valuation to an Entity Valuation / 15~1180 Off Balance Sheet Items / 15~1240 Franking credits
15~1240
Franking credits
In Australia one of the specific off balance sheet items which may require adjustment and/or may affect the valuation of a company is the valuation of surplus franking credits. The following method demonstrates that the value of the franking credits is dependent upon the taxable status of the recipient of the dividend and on the companys ability to finance the payment of the dividend (and hence giving the taxpayer the ability to access the credits). An independent experts report, which was prepared as a result of a take-over offer for Laubman & Pank (L&P) by Hancock & Gore Ltd (HGL) states: The value of franking credits varies according to the nature of the tax position of the recipient of the dividends. The following example demonstrates this effect. (Note that at the time of the takeover offer (January 2001), the company tax rate was 34% and this is the rate used in the example). Assume Laubman & Pank pays a 25 cents per share dividend which is 100% franked. To assess the tax payable, the franked portion is grossed-up by the portion of tax paid using the following formula. Franked DPS Tax rate 1 Tax rate = Gross-up (and tax credit)
To assess the tax payable, the franked portion is grossed-up by the portion of tax paid using the following formula. Franked DPS Tax rate 1 Tax rate = Gross-up (and tax credit)
Table 1 Taxpayer Marginal Tax Rate 15% Fully Franked (FF) Dividend (25 x 100%) = 25 + = + = Gross-up FF x 34/(100 34) Grossed-up Franked Dividend Unfranked Dividend (25 FF) = 0 Taxable Dividend Tax Assessed (at marginal rate) Tax Credit (gross-up) = = Tax Payable (excess tax credit) After Tax Benefit of Dividend (assuming other income to offset credit or that credits are refundable) Decrease in Business Value as a result of increased debt (refer below) Combined value of extra dividend, franking credits and increased debt 25.00 12.88 37.88 0.00 37.88 5.68 12.88 (7.20) 34% 25.00 12.88 37.88 0.00 37.88 12.88 12.88 0.00 48% 25.00 12.88 37.88 0.00 37.88 18.18 12.88 5.30
32.20
25.00
19.70
(15.00)
(15.00)
(15.00)
17.20
10.00
4.70
As stated above the credits only have a value in the hands of the recipient, so the effect of paying the dividend on the financial structure of the company must also be evaluated and the following quote outlines the issues which need to be taken into consideration. As at 30 June 2000, L&P had a franking credit account of $12,765,000 (at 34% tax rate). (That is to say that the company could pay dividends with a gross value of $12.7 million carrying tax credits of $4.3 million.) The value of franking credits varies according to the nature of the tax position of the recipient of the dividends. For example, they have more value to a shareholder which is a superannuation fund than to an individual shareholder paying tax at the highest marginal rate. The value of franking credits also depends upon the ability of the company to liberate
these and pass them on to shareholders. The Board of L&P has considered alternatives for transferring some of the benefit of these franking credits to shareholders. The HGL Bidder Statement includes the comment that it is the intention to support the Laubman & Pank policy of distributing the available franking credits by special dividend. The gearing ratio of L&P is such that in addition to the normal dividends, the company could pay limited special dividends and stay within reasonable gearing limits, including continued compliance with lending covenants. For example, the payment of an additional dividend of 25 cents per share fully franked would result in a net cash outflow of $2.2 million. If this amount was debt funded this would increase the debt:equity ratio as at 31 December 2000 from 36.8% to 48.1% with interest bearing debt rising and shareholders funds falling. This effect is demonstrated in the following table: Table 2 30 June 2000 ($000) 31 December 2000 ($000) 31 December 2000 ($000) Pro Forma Debt Current Debt Non-Current Total Debt Less: Cash Balance Effective Net Debt Add: Assumed Debt Funding for Dividend Payment Adjusted Net Debt Total Shareholders Equity Less: Dividend Payment Adjusted Shareholders Equity Resultant Gearing Ratio 13,270 3.1% 16,251 36.8% 416 13,270 4,592 16,251 289 2,001 2,290 1,874 416 1,909 3,048 4,957 365 4,592 1,909 3,048 4,957 365 4,592 2,175 6,767 16,251 2,175 14,076 48.1%
The above calculated effect demonstrates the additional amount that could be liberated through increasing the gearing of the company. The value of the franking credits attaching to that additional dividend will be a function of the taxation position of individual shareholders. Paying a dividend as per the above example would create an offset to the future earnings capacity as the company would have the interest cost of the additional borrowings. The drop in value of the company as measured by the increased debt charge can be calculated broadly as follows:
Increased Debt Finance cost at, say, 8% Less: Tax effect on interest = Earnings Capacity Forgone Capitalise at multiple of, say, 11 Number of shares on issue Equivalent value per share
$2.175 $0.174 $0.059 $0.115 $1.265 8,698,591 15
(million)
(million)
cents
The effective surplus asset value of the franking credit/special dividend could thus be deemed to be in the order of 10 cents per share (dividend of 25 cents less 15 cents earnings capitalisation effect) to L&P (but potentially higher to a 100% acquirer). If HGL acquired 100% of L&P, they could distribute the franking credits to themselves by paying a dividend from L&P to HGL. If HGL acquires a significant interest but less than 100% control of L&P, HGL might still consider causing L&P to distribute franked dividends to its shareholders and, in turn, either reinvest the funds back into L&P under a dividend reinvestment scheme, lend money to L&P or pass on franking credits to shareholders. We are not aware of HGLs intentions in this regard but alert shareholders that there could be additional benefits to HGL in the franking credits. L&P is restricted in their ability to pass on all franking credits at present due to gearing and lending covenant ratios. The extent to which franking credits can be distributed is a function of the gearing ratio and requirement of funding for other purposes. In this regard we note that the company may consider there to be a better alternative use of funds than to use its borrowing capacity to make the payment of special dividends. The value of excess franking credits is a subject of some debate. The above methodology has been used to demonstrate a way of quantifying special dividends. There are some re-iterative calculations which could be done as an increased gearing ratio would increase the level of risk to the company which in turn would, in theory, be reflected in its capitalisation rate. However, when drawing comparable multiples from the market place that must be done in the context of the gearing ratios of the comparable companies and their ability to raise further funds and the risk profile of their businesses. Accordingly, the above calculations should not be seen as a precise science but rather as a method of estimating the approximate value of the amount of the franking credits which might be able to be liberated. The above method resulted in the increased dividends (and surplus franking credits) being included in the valuation report at an approximate value of 10 cents per share or $900,000. OPSM Protector Ltd subsequently made an offer for Laubman & Pank and their offer clearly demonstrated how surplus franking credits can be utilised to minimise the impact of CGT on consideration in a take-over situation. In their press release, OPSM Protector Ltd stated that: Under the terms of the revised and final offer, Laubman & Pank shareholders will
receive: $2.72 in cash for each share; fully franked interim dividend of 3 cents per share; fully franked special dividend of 25 cents per share; and further fully franked special dividend of 10 cents per share.
Imputation credits of $0.19 attached to the dividend increase the total value to the revised offer to $3.29 per share for shareholders able to use the imputation credits. This is at the top end of the independent experts valuation range of $2.96 $3.29 per share. In this situation, the $2.72 (less the cost base of the shares) would be subject to CGT, while the dividends of $0.38 would be treated as a franked dividend. If the calculations in Table 1 are repeated, based on a $0.38 fully franked dividend, the following after tax benefits are calculated: Table 3 Taxpayer Marginal Tax Rate 15% = Taxable Dividend (Grossed-up) Tax Assessed (at marginal rate) = = Tax Credit (gross-up) Tax Payable (excess tax credit) After Tax Benefit or Dividend (assuming other income to offset credit or that credits are refundable) Decrease in Business Value as a result of increased debt Combined value of extra dividend, franking credits and increased debt 57.58 8.64 19.58 (10.94) 57.58 19.58 19.58 0.00 57.58 27.64 19.58 8.06 34% 48%
48.94
38.00
29.94
Does not affect shareholders who sell as a result of the other
48.94
38.00
29.94
In addition, the impact of the capital consideration of $2.72 per share needs to be considered. For simplicity, we have only undertaken these calculations for the taxpayer on a 34% marginal tax rate. Table 4 Taxpayer with 34% Marginal Tax Rate Cost Base Assumption High Pre Sept 85 $2.72 3.00 High Post Sept 85 $2.72 3.00 Low Pre Sept 85 $2.72 1.50 Low Post Sept 85 $2.72 1.50
Capital Proceeds Assumed Cost Base

Table 4 Taxpayer with 34% Marginal Tax Rate Gain/(Loss) Tax Payable/(Claimable if there are gains to offset) After Tax Value of Capital Receipt After Tax Value of Dividend Received (from Table 3) = Combined value of capital gain, extra dividend and franking credits (0.28) N/A 2.72 0.38 (0.28) (0.10) 2.82 0.38 1.22 N/A 2.72 0.38 1.22 0.41 2.31 0.38
3.10
3.20
3.10
2.69
This compares to the following returns if the full $3.10 amount was distributed as consideration (with no franked dividend). Table 5 Taxpayer with 34% Marginal Tax Rate Cost Base Assumption High Pre Sept 85 $3.10 High Post Sept 85 $3.10 Low Pre Sept 85 $3.10 Low Post Sept 85 $3.10
Capital Proceeds Assumed Cost Base High Pre Sept 85 High Post Sept 85 Low Pre Sept 85 Low Post Sept 85
3.00 3.00 1.50 1.50 (0.10) N/A 3.10 (0.10) (0.03) 3.07 1.60 N/A 3.10 1.60 0.54 2.56
Gain/(Loss) Tax Payable/(Claimable if there are gains to offset) After Tax Value of Capital Receipt After Tax Value of Dividend Received = Combined value of capital gain, extra dividend and franking credits debt
No Dividend
3.10
3.07
3.10
2.56
The value difference between paying consideration partially by dividend versus all by capital proceeds is as follows. Table 6 Taxpayer with 34% Marginal Tax Rate
Table 6 Taxpayer with 34% Marginal Tax Rate Cost Base Assumption High Pre Sept 85 0.00 High Post Sept 85 0.13 Low Pre Sept 85 0.00 Low Post Sept 85 0.13
Increased After Tax Benefit for 34% Marginal Rate Taxpayers
As can be seen from the above table, the advantages of utilising franking credits in this manner can vary. In summary: The value of the franking credits is dependent upon the taxable status of the recipient of the dividend. If a companys level of debt is such that it cannot finance the payment of the additional dividends, the franking credits may have minimal value to the current shareholders. If a company does have the capacity to pay a dividend (and hence utilise the credits), the value of the increased dividends (and credits) will be partly offset by the increased level of debt required to pay that dividend or by the loss in earnings from the distribution of capital that could otherwise have been reinvested in the business. If the profitability and debt structure of the group will allow the distribution of the franking credits in a few years time or over a number of years, consideration will need to be given to discounting any benefit calculated to its present value. Take-over situations offer additional opportunities to structure the consideration offered and to utilise franking credits.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1280 Valuing an Entity without First Valuing the Underlying Business
15~1280
Valuing an Entity without First Valuing the Underlying Business
This is also referred to as valuing 100% of the share capital. As discussed previously, there are three approaches to valuing a business: the market approach; the income approach; and the asset approach.
When valuing an entity without first valuing the business there are additional methods to be considered: the market approach; and the income approach.
It is also important to understand that some of the issues discussed in the section on converting a business valuation into an entity valuation must also be considered when valuing the company directly. Issues like surplus assets and off balance sheet assets and liabilities must still be considered.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1280 Valuing an Entity without First Valuing the Underlying Business / 15~1300 Market Approach Methods
15~1300
Market Approach Methods
Details on the principle supporting the market approach methods have been discussed previously. In valuing an entity without first valuing the underlying business, there are some additional valuation methods that may be appropriate. These include: weighted average share price; and alternative acquirer.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1280 Valuing an Entity without First Valuing the Underlying Business / 15~1300 Market Approach Methods / 15~1310 Weighted average share price Key issues
15~1310
Weighted average share price Key issues
Weighted average share price is a method of pricing which can be used when a companys shares are quoted and traded on a stock exchange. The important issues when using this valuation method include: which share price to use; which period to consider; and what weighting to use.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1280 Valuing an Entity without First Valuing the Underlying Business / 15~1300 Market Approach Methods / 15~1320 Which share price to use
15~1320
Which share price to use
It is normal to use the closing share price of the stocks in question rather than the day high or low.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1280 Valuing an Entity without First Valuing the Underlying Business / 15~1300 Market Approach Methods / 15~1330 What period to consider
15~1330
What period to consider
We would normally consider that the pre-announcement (of an offer) share price would represent a reasonable measure of the fair market value of minority (or small) parcels of the companys shares, having considered the various influences of its major shareholders. The period should be extensive enough to provide a sufficient sample and consideration should also be given to eliminating any unusual transactions. For example, large transactions at an unusually high or low price may need to be eliminated. These might occur as a result of a single broker crossing a transaction at a high or low price (for tax
reasons) or as a result of a large shareholder selling and temporarily depressing the market.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1280 Valuing an Entity without First Valuing the Underlying Business / 15~1300 Market Approach Methods / 15~1340 What weighting to use
15~1340
What weighting to use
The weighting of the shares is normally undertaken based on the volume of shares traded for each day that a price has been obtained. In the circumstance of an upward or downward trend it may also be worthwhile considering a time weighted average price. If the data is available, the average weighted price can be obtained by valuing each trade over a period and then dividing by the total quantity for that period.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1280 Valuing an Entity without First Valuing the Underlying Business / 15~1300 Market Approach Methods / 15~1350 Summary of issues to consider
15~1350
Summary of issues to consider
Technically this is not a method of valuing a company, but rather a method of pricing minority holdings of the shares in a company. It is also important that trading of the companys shares is liquid, with reasonable trading volumes. It is important to understand that trading in stocks which have one or a few major shareholders may be examples of where the assumption of a liquid market may not be satisfied. An article in the 11 March 2000 edition of The Economist entitled Anorexia New Economy Shares included the following table which was based on data provided by Renaissance Capital and highlights the effect lack of liquidity can have on share prices. Less is More (Best and Worst Performing IPOs in the US) Company 724 Solutions WebMethods Quantum Effect Devices Diversa Avanex VarsityBooks.com VantageMed Beasley Broadcast Sawis Communications Pets.com Floating Shares as a % of Total 16 11 12 20 9 24 34 28 18 28 Total Returns % 731 700 521 520 516 -13 -17 -20 -22 -39
Data Source: Renaissance Capital
The article states that: the inescapable conclusion is that...price is being determined by a tiny trickle of shares that are being splashed back and forth between people with something of a zest for trading. The article also states that another important consideration is the date shares come out of escrow or have their selling restrictions removed, as this results in a significant increase in the number of shares that can be traded. Valuers should therefore be sure a liquid market exists before using this valuation method.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1280 Valuing an Entity without First Valuing the Underlying Business / 15~1300 Market Approach Methods / 15~1360 Adjustments required
15~1360
A premium for control may need to be added to the average weighted share price. This is relevant when assessing the price earnings ratios (PERs) to be used. By definition, minority parcels of shares are traded on the stock exchange. The prices exhibited, therefore, are those for minority parcels.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1280 Valuing an Entity without First Valuing the Underlying Business / 15~1300 Market Approach Methods / 15~1370 Alternative acquirer
15~1370
Alternative acquirer
The value of a business or company ultimately lies in the amount which one can obtain for that entity. One can do as much technical analysis as one likes but unless there is a buyer for the business then what is the true value of the entity? In considering a businesss value to an alternative acquirer, a distinction must be made between fair market value and investment value. Fair market value has been previously defined as: The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. The emphasis here in the context of an alternative acquirer is on the reference to a lack of compulsion to buy or sell. Investment value, however, has been previously defined as: The value to a particular investor based on individual investment requirements and expectations. The difference between these two terms highlights the possibility of an additional premium payable by an investor with a specific interest in the business. Such specific interests may include potential synergies with existing undertakings or access to particular assets of the business. The key issue to consider when using this valuation method is that the offer is reasonable but not fair.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1280 Valuing an Entity without First Valuing the Underlying Business / 15~1300 Market Approach Methods / 15~1380 Offer is reasonable but not fair
15~1380
Offer is reasonable but not fair
The basic premise for considering the amount that would be paid by an alternative acquirer is that the offer currently being made for shares may be reasonable but not fair. It may be reasonable, because the shareholders have little alternative, and because the current offeror may already have a substantial stake in the company, but the offer may not be fair because it undervalues the company.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1280 Valuing an Entity without First Valuing the Underlying Business / 15~1300 Market Approach Methods / 15~1390 Summary of issues to consider
15~1390
In making an assessment of what an alternative acquirer might pay, one has to make the assumption that all shares sought after would be available to the alternative acquirer. A number of experts have tried to avoid the issue of available shares by taking a line of reasoning that is too hypothetical, however it is an issue that should be considered. In making an assessment of an alternative acquirer, one normally uses the concept of willing but not anxious vendors and acquirers, an assumption that the acquirer is fully informed as to the state of affairs of the company and the industry in which it operates and that all shares sought after would be available to the alternative acquirer. It is important not to confuse the issues of price and value in this concept. The prices at which shares trade on the stock market are just that prices. They are not necessarily representative of the value of companies. The existence of an alternative acquirer is often influenced by the level and type of barriers to entry into the businesss market-place. The higher and more costly the barriers to entry, the more likely that an alternative acquirer will exist as the cost of building up a similar business from scratch is likely to be prohibitive. The alternative acquirer concept therefore is very much market driven. In certain instances it is considered to be too hypothetical but it can be an effective measure particularly when the entity being valued has a strategic significance in its market-place. A related concept to the alternative acquirer is that of the special purchaser. It is possible for a business to have a higher value to a special purchaser as aggregation or synergistic benefits to a special purchaser could far outweigh any additional price which must be paid to obtain that value. The value of the business to a special purchaser is not usually a valid methodology but it is worth bearing in mind that some purchasers may be prepared to pay considerably in excess of the value determined using other methodologies. If this is the case, it should be spelt out in the valuation report.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1280 Valuing an Entity without First Valuing the Underlying Business / 15~1300 Market Approach Methods / 15~1400 Adjustments required
15~1400
Often one sees references to premium for control being required in order to obtain control of a company and that the premium should be in the order of 20% to 30%. Statistical analysis shows that this may not be so and that no such broad, sweeping statement can be made about the premium for control required. The origins of the premium for control lay in the fact that the market typically reflects prices for relatively small portions of a companys shares; thus, in order to entice a substantial number of shareholders to sell their shares, an offeror would normally have to offer a price in excess of current market price. Typically that margin was believed to be in the order of 20% to 30% and hence a premium for control.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1280 Valuing an Entity without First Valuing the Underlying Business / 15~1420 Income Approach Methods
15~1420
Income Approach Methods
The principle supporting the income approach methods has been discussed previously. In valuing an entity without first valuing the underlying business, there are some additional valuation methods that may be appropriate. These include: capitalisation of dividends; and dividend paying capacity.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1280 Valuing an Entity without First Valuing the Underlying Business / 15~1420 Income Approach Methods / 15~1430 Capitalisation of dividends
15~1430
Capitalisation of dividends
It is normal practice to value a controlling shareholding by reference to total available earnings and minority shareholdings by reference to capitalisation of dividends. However this is based on the belief that investors purchase shares primarily for their dividend paying ability. This ignores the potential for capital growth inherent in the company employing those earnings at a rate of return higher than that which the investor might otherwise earn. The capitalisation of dividends method essentially relies on the existence of an identifiable and continuing flow of dividends which can be capitalised and valued in much the same way as one would value a property asset based on the rental income receivable from that property.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1280 Valuing an Entity without First Valuing the Underlying Business / 15~1420 Income Approach Methods / 15~1430 Capitalisation of dividends / Capitalisation of dividends calculation
Capitalisation of dividends calculation
The Gordon dividend growth model (described below) requires the following key elements:
the current dividend; the cost of equity; and an estimation of growth in earnings per share and dividends.
If it can be assumed in the particular circumstances that a constant level of earnings is retained out of the total earnings available for distribution, and that dividends grow at a constant rate over time, then the Gordon dividend growth model can be applied to the current dividend stream. Using the Gordon growth model a value for the minority interest can be calculated as follows: V = D1/(ke g) where: D1 = dividend at end of year one ke = cost of equity capital g = growth in earnings per share and dividends (assuming constant retention policy and constant rate of return on retained earnings) For example assume: Dividends per share at end of year one: Cost of equity capital Expected growth in dividends Gordon dividend growth model: value of share value of share = D1/(ke g) = 65/(20% 4%) = 65/(16%) = 406 cents D1 = 65 cents ke = 20% g = 4%
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1280 Valuing an Entity without First Valuing the Underlying Business / 15~1420 Income Approach Methods / 15~1430 Capitalisation of dividends / 15~1450 Summary of issues to consider
15~1450
The capitalisation of dividends requires a number of fundamental assumptions to be made about the dividend flow: that it is consistent and constant; that the retention policy remains constant; that the extent of franking attributable to the dividends is comparable amongst comparable
companies (franking refers to an investors ability to claim a tax credit on dividends received from profits which have been subject to corporate tax); and that retained earnings do not earn a lesser or greater rate of return than that which has been earned historically.
In combination, these assumptions can be unrealistic in practice. It is for this reason that capitalisation of dividends is usually abandoned in favour of capitalisation of earnings or discounting of cash flows. By contrast, capitalisation of earnings captures dividends and capital growth in the one number (i.e. earnings). Capitalisation of dividends becomes a particularly difficult argument to sustain in private companies where retention policy varies considerably from year to year or where the level of profit is dictated to a certain extent by the shareholders tax positions and the level of remuneration absorbed by shareholders.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1280 Valuing an Entity without First Valuing the Underlying Business / 15~1420 Income Approach Methods / 15~1460 Value produced from capitalisation of dividends
15~1460
Value produced from capitalisation of dividends
The value produced will be for a marketable minority interest.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1280 Valuing an Entity without First Valuing the Underlying Business / 15~1420 Income Approach Methods / 15~1470 Dividend paying capacity
15~1470
Dividend paying capacity
Actual dividends paid and the capacity to pay dividends may be two different things. This arises due to the fact that the entity has discretion over the level of dividends paid. Capitalisation of (expected future) dividends payable may be an appropriate method of valuing a minority interest in an entity, as a minority shareholder cannot exert influence over the entitys dividend stream. However, if a controlling interest in the entity is to be valued, capitalisation of the entitys capacity to pay dividends, as opposed to the actual level of dividends to be paid, is more appropriate. This stems from the controlling shareholders ability to influence dividend payments.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1280 Valuing an Entity without First Valuing the Underlying Business / 15~1420 Income Approach Methods / 15~1480 Calculation of future dividend paying capacity
15~1480
Calculation of future dividend paying capacity
The key element in applying this method relies on being able to calculate the entitys future dividend paying capacity. Estimations can be made by analysing comparable listed entities. For these entities, the amount of dividends paid can be gauged from reported dividend yields. The ratio of dividends paid to reported net income will give an indication of the comparable companies dividend paying capacities. Adjustments will then be required for the specific characteristics of the entity being valued.
Other factors such as liquidity must also be given due consideration. A relatively profitable entity may not have cash reserves if funds are needed for fixed assets and working capital. Once an appropriate level of dividend paying capacity has been estimated, the figure is capitalised to arrive at an indicative value for the entity. An example, which assumes no growth in dividends, follows: Future maintainable earnings Dividend paying capacity (ratio) Dividend paying capacity (level) Capitalisation rate Indicative value 500,000 25% 125,000 8% $1,562,500
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1280 Valuing an Entity without First Valuing the Underlying Business / 15~1420 Income Approach Methods / 15~1490 Adjustments required
15~1490
When valuing a small, privately held business, it is important to bear in mind that although there may be a capacity to pay dividends, profits may need to be retained for a number of reasons. For example, a smaller business faces restricted avenues of financing compared with those available to large, listed entities. Profits may therefore need to be retained to serve future financing requirements. In such an instance, the businesss dividend paying capacity should be reduced accordingly.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies
15~1540
Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies
This section contains some of the more pertinent factors to consider in valuing private companies. In giving an indication of price earnings ratios (PERs) it must be noted that numerous factors must be taken into account. It should be noted that the arguments applied to adjusting PERs could be applied to EBIT Multiples or EBITDA Multiples as well. For ease of reading, we have confined our discussion to PERs. Factors to consider include the following: the marketability of the shares or business; if the company is a private company, any plans it has to seek a stock exchange listing; whether there are any restrictions on the shares or shareholders within the companys governing articles or separate agreements; whether the company is in an expanding or contracting market and whether its market share is expanding or contracting; whether there are any extenuating circumstances which would indicate increases or decreases
in future profitability; the effective tax rate of the company and its effect on dividends; the fair market value of the companys assets as compared to the value shown in the companys financial statements (and any contingent tax liability albeit of a deferred nature); whether the assets of the company are tangible or intangible; effective add backs and deductions from the companys profit figures to take into account such things as remuneration of directors and interest payable on directors or shareholder loans which might not occur in differing circumstances; the ability to maintain future profit streams; the returns available on other investments at the time of the assessment; the PERs of other companies in the same industry that are listed on the stock exchange at the time of the assessment; where the information is available, the effective PER of any private company, in the same or similar industry, which has recently been sold or had a change in shareholding; and consideration as to the level (if any) of warranties and representations provided by the shareholders in a private company, as there may be numerous operational factors contingent on the involvement of particular shareholders (such as customer loyalty etc.). The value of the company would be considerably less in their absence.
It is generally accepted that the rate of return required on an investment in a private unlisted company is higher than an investment in a similar company which is publicly listed. The rationale for this is the generally held beliefs that private company shares are less negotiable than publicly listed shares and that smaller companies are more risky. These factors need to be incorporated into the valuation in the following manner: Lack of negotiability does not impact upon the underlying business risk of the operation. Consequently an adjustment is made by applying a discount to the value produced. For example: Future maintainable earnings Price earnings ratio Indicative value Discount for non-negotiability Adjusted value 500,000 10 5,000,000 10% 4,500,000
If the relatively small size has a direct impact upon the underlying business risk of the company, the discount rate should be increased to account for this additional risk. This will result in lower present values of future cash flows, in turn reducing the value determined for the company.
Other considerations in the public versus private debate include the ability to sell shares without significantly affecting the market. An attempt to sell on market a substantial line of stock in a listed public company could significantly depress the share price resulting in a lower than expected sale price. Other issues which affect the overall risk of a private company include:
the lack of audited results in some cases (and thus perceived higher risk); the cost of debt in some circumstances might be higher for a private company than a public company; and the availability of funding for expansion has (historically) been restricted for private companies, compared to the availability of funding for a publicly listed company. (The public fund raising environment has become increasingly prohibitive for smaller equity raisings and this has flowed on to the ability of publicly listed companies to raise debt funding.)
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1560 PER Conversion Table
15~1560
PER Conversion Table

High Low 18.4 (30%) (30%) (8%) (45%) 8.3
A table for calculating the effects of the various types of adjustments required is included below.
Price Earnings Ratio Deduction for strategic position (including lack of depth in management structure) Deduction for lack of geographic diversification and general business risk Deduction for assessment of prospective earnings versus historic earnings Total Adjustments SURROGATE PER Note: The adjustment is calculated as: (1 0.3)*(1 0.2)*(1 0.05) Attached is a sample PER Adjustments template.
18.4 (30%) (20%) (5%) (53%) 9.8
Once the surrogate PER has been applied to future maintainable earnings and an indicative value obtained, further consideration should be given to factors which do not impact upon the companys underlying business risk but which do impact upon value. Discounts may need to be applied to the indicative value for such factors as non-negotiability of a privately held company and elimination of minority interests.
The theory behind these adjustments is discussed briefly below.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER
15~1580
Theory for Converting the PER
To customise a PER for the valuation of a specific company, there are a number of adjustments that need to be made. Some of the adjustments need to be considered for all valuations, while others will only affect private company valuations: a premium for the purchase of a controlling shareholding; the purchase of a minority shareholding; the non-negotiability of shares; the strategic position relative to the industry and other industries; current versus prospective earnings; the growth expectations relative to the industry; the financial structure and dividend payout ratios; the nature and extent of the cost savings and revenue enhancement initiatives being pursued by the company and the additional risk associated with realising the benefit of these programs in the foreseeable future; and Australia specific adjustments.
In essence, the purpose of these adjustments is to reflect the differences in the risk of, and therefore return from, the subject company relative to the benchmark with which the analysis commenced. All the adjustments are subjective and require professional judgement and experience in determining the appropriate change.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER / 15~1590 Premium for control
15~1590
Premium for control
Premium for control has sometimes been described as the capacity to control or direct 100% of the earnings of a company from a shareholding position of less than 100%. An earnings-based valuation aims to value the entire company. Usually, a premium is paid by a buyer for a controlling interest in an earnings stream. This reflects the buyers ability to direct the way in which that earnings stream is employed or paid out. PERs documented on the stock exchange typically reflect trading in minority shareholdings. Only if takeover bids for controlling interests have occurred through on market cash offers does the public PER reflect any control premium. Accordingly, it is normal to adjust the PERs evidenced in the market-place upwards to reflect a premium for control. It is interesting to refer to the diagram below showing the relationship between a control premium, a minority interest discount and a discount for lack of marketability, which has been drawn from a US text by Dr. Shannon Pratt. This diagram also shows the steps of value between a non-marketable minority shareholding and a controlling shareholding.
A premium for control sometimes exists when access to assets or cash flows can be obtained without having to pay for 100% of the company. For example, if control of 100% of the assets of a company can be obtained by purchasing 51% of the shares, then it is likely that the buyer would be prepared to pay something more than 51% of the underlying value as they are gaining control of 100% of the assets. This premium for control usually relates to the amount of leverage resulting from the transaction. That is, there is no leverage if 100% of the company is purchased whereas there is considerable leverage if control resides in only (say) 40%. Accordingly, this premium for control reduces
proportionately as the percentage of the company which is required to be acquired increases, or if the acquirer already has effective control. The question here is the value of this premium for control and how is it to be measured in the absence of any market transactions which demonstrate its value. Some authors suggest that a fixed premium in the range of 20% to 30% can normally be ascribed as the additional price required for the acquisition of a controlling stake. However, it is difficult to generalise and substantiate such premiums in the market-place. In some circumstances a substantial premium (for example 50%) is paid over the underlying value of the shares, whereas in others no premium at all is paid. In calculating the valuation range, it is common to add a percentage premium to encompass a premium for control. This covers the likelihood that the PER adopted has been based on market multiples, and that the multiple in fact represents the price at which non-controlling parcels have changed hands. This is because it is rare for a controlling parcel to change hands on the stock market in the ordinary course of business. Alternatively, the earnings stream can be adjusted to reflect any increments which may result from holding a controlling stake. In this instance, the discount rate applied remains unchanged, while the underlying cash flows are increased, in turn increasing the value obtained. A fault which can occur is to value non-controlling parcels by applying a discount factor to the PER adopted particularly when that multiple has been drawn from the market in the first place. If a market multiple has been adopted in an earnings capitalisation valuation, then a premium must be added to arrive at the value of a controlling parcel and no adjustment need be made in the case of a non-controlling parcel. The valuation of a non-controlling parcel by the earnings capitalisation method may actually be inappropriate anyway, by virtue of this lack of control. A more appropriate method may in fact be dividend capitalisation. Another factor to be considered is whether the parcel being valued is in excess of 75% of the shares on issue, or in excess of 50% of the shares on issue. These points are significant in so much as a 75% shareholding can control special resolutions, whilst a 50% shareholding cannot, but can determine the constitution of the companys board of directors. Leadenhall undertook research in 1988 to establish the level of control premium being paid at that time in Australia. The results of the research suggested that the premium varied considerably due to a variety of factors. The overall range of premium relative to pre-bid market price was -20% to more than 60%. However, the arithmetic average was 10% and the majority of successful bids occurred at a premium to pre-bid price of 1% to 40%. A negative premium can occur if a bid is placed at below the current market price. A large shareholder may accept the offer because they may not be able to sell such a large stake on market. (Remember market price is normally for minority parcels.) It is important to note that the diagram at the start of this section has been modified and extended by Z Christopher Mercer in Leveling with you about the Levels of Value published in The E-Law Business Valuation Perspective, Issue 2001-10, 19 November 2001 (accessible on <www.mercercapital.com>)
by: reducing the gap between the control value financial buyer and the marketable minority. This was based on the argument that if a large gap existed, more takeover activity would occur as financial buyers bought up minority interests; adding a fourth level of value, control, considering strategic, synergistic and/or irrational elements of pricing, and a control/strategic premium. This was to recognise that some investors may be able to achieve synergies not available to a purely financial controlling shareholder.
The figure notes that it is necessary in many valuations to adjust market comparable multiples, due to differences in risk and expected growth between the comparable companies and the subject private companies, to a level applicable to the specific private companies to develop appropriate as-if-freely-tradable values. Reconciliation with Naths Level of Value Concept
Source: Mercer 1999
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER / 15~1600 Minority shareholding discount
15~1600
Minority shareholding discount
Ordinarily, a minority shareholding bears a discount because of the lack of control over cash flow, dividends and management of the company. This usually reflects the minoritys inability to block
special resolutions or to influence the composition of the board. A minority discount is the opposite of a control premium and this section should be reviewed for the new arguments that a large minority discount may not always be appropriate. This is discussed in articles entitled: Minority and Marketability Discount: A Present Value Approach to Determination in the September/October 2000 issue of The Valuation Examiner; Leveling with You About the Levels of Value by Z Christopher Mercer published in The E-Law Business Valuation Perspective, Issue 2001-10, 19 November 2001 (accessible on <www.mercercapital.com>); and The Integrated Theory of Business Valuation by Z Christopher Mercer, paper given to the ASA/CICBV 5th Annual Joint Business Valuation Conference, 26 October 2002 (accessible on <www.mercercapital.com>). Discounts for minority shareholdings are discussed further in the section on minority holdings of shares and convertible notes.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER / 15~1610 Non-negotiability of shares
15~1610
Non-negotiability of shares
A public listing of shares on the stock exchange is intended to provide a liquid secondary market in which the shares of a company may be traded. In practice, however, this occurs only for the larger listed companies. Large shareholders in smaller listed companies can suffer similar difficulties of non-negotiability as shareholders in unlisted companies due to the time required to locate potential acquirers of large holdings. The PERs documented in the market-place reflect the trading of all companies in the categories listed. Therefore, the PERs reflect trading both in large liquid stocks and small illiquid stocks. Trading in illiquid stocks frequently occurs at prices which already reflect a discount for non-negotiability. Accordingly, whilst it is reasonable to allow for non-negotiability, the discount should be tempered by the small company effect embedded in the benchmarks used. It is interesting to refer to the earlier diagram showing the relationship between a control premium, a minority interest discount and a discount for lack of marketability, which has been drawn from a US text by Dr. Shannon Pratt. This diagram also shows the steps of value between a non-marketable minority shareholding and a controlling shareholding. The discount for non-negotiability is variously described as being in the range of 10% to 30%. This is discussed in the article entitled Minority and Marketability Discount: A Present Value Approach to Determination in the September/October 2000 issue of The Valuation Examiner. Australian data on this topic comes from: AVCAL Valuation Guidelines 2003; commercial reports; and
case law.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER / 15~1610 Non-negotiability of shares / AVCAL Valuation Guidelines 2003
AVCAL Valuation Guidelines 2003
Paragraph 5.1.3.4 states: In determining the Marketability Discount appropriate in a particular situation for each individual financial instrument, the Valuer should consider all the relevant factors. As a guide, a discount rate in the range of 10% to 30% (in steps of 5%) should generally be applied against the gross value attributed to the relevant financial instrument used depending upon the particular circumstances. Paragraph 5.3.4 shows guideline levels of marketability discounts for quoted instruments: Number of days trading volume Up to 20 20 to 50 50 to 100 100+ % Discount 0 10 20 25
Number of days trading volume is determined by comparing the size of the holding with the normal trading volumes in that security: For example, an Investment of 100,000 shares in a company that trades an average of 10,000 shares per day would infer 10 days trading volume. (Paragraph 5.3.3). Leadenhall believes this table significantly under-estimates the impact of trading volume and believe that the table should be amended as follows: Number of days trading volume Up to 2 25 510 10+ % Discount 0 10 20 25
This table also needs to include a notation that once a substantial or controlling interest is held in an investment, a discount for lack of marketability may, in some circumstances, may be offset by a premium for control.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER / 15~1610
Non-negotiability of shares / Commercial reports

Commercial reports
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER / 15~1610 Non-negotiability of shares / Commercial reports / Indicative valuation of related party options on Vincorp Wineries Ltd
Indicative valuation of related party options on Vincorp Wineries Ltd In applying the Black Scholes Model in a 26 October 2001 indicative valuation of related party options, KPMG applied a marketability discount of 40% to the theoretical valuation of options to determine an indicative valuation for related party options. This discount was based on empirical studies in the US showing discounts for lack of marketability on restricted stocks of 25% to 40% and US court cases showing discounts in the area of 50%.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER / 15~1610 Non-negotiability of shares / Commercial reports / Cooper Energy NL
Cooper Energy NL In a 4 October 2002 Explanatory Statement to the Annual General Meeting, the directors commented: the valuation determined using the BSModel represents the maximum theoretical value for the Options. The terms of the Options do not allow the Options to be transferred. These restrictions are contrary to the assumptions underlying the BSModel. Although, due to these restrictive terms and the fact that the Options are not to be listed, it is often considered appropriate to apply a marketability discount to the value, the Directors have chosen not to do so in this instance.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER / 15~1610 Non-negotiability of shares / Commercial reports / Insolvency Management Fund Ltd
Insolvency Management Fund Ltd In valuing options for directors for a meeting held on 15 October 2002, a marketability discount of 15% was applied to the results of the Black Scholes model.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER / 15~1610 Non-negotiability of shares / Commercial reports / Xanadu Wines Ltd prospectus
Xanadu Wines Ltd prospectus The independent experts report, prepared by Hall Chadwick Corporate, included in the 11 March 2003 prospectus, used a marketability discount for the vinelots in the projects of approximately 25%. In leading up to this figure, the report referred to US studies suggesting a marketability discount of approximately 30% and a UK study suggesting a discount of approximately 25% but possibly up to 50%.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER / 15~1610 Non-negotiability of shares / Commercial reports / Sydney Futures Exchange Ltd
Sydney Futures Exchange Ltd In Grant Samuels independent experts report on Sydney Futures Exchange Ltd of 19 May 2000, a marketability discount of 5%15%, less than the normal discount for unlisted shares, is referred to. The factors that caused the use of the lower discount are then discussed.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER / 15~1610 Non-negotiability of shares / Case law
Case law
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER / 15~1610 Non-negotiability of shares / Case law / Dismin Investments Pty Ltd v. Federal Commissioner of Taxation [2000 FCA 1703]
Dismin Investments Pty Ltd v. Federal Commissioner of Taxation [2000 FCA 1703] A marketability discount on the market value of a 50% interest in the Molson partnership was proposed by Mr Stephen Scudamore of KPMG and Mr Gerard Dalbosco of Ernst & Young. As Heerey J allowed a discount for minority interest, he added back the marketability discount. His obiter included the statement that: there would be a double counting (or double discounting) since all discounts depend to a large degree on the same factors, namely lack of marketability and control.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER / 15~1610 Non-negotiability of shares / Case law / Brown v. Secretary, Department of Social Security No. T93/9 AAT No. 8886
Brown v. Secretary, Department of Social Security No. T93/9 AAT No. 8886
The Tribunal accepted a valuation by Cox Miller & Robinson for a 15% discount for lack of negotiability for shares in a family company.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER / 15~1610 Non-negotiability of shares / Case law / M T Associates Pty Ltd v. Aqua-Max Pty Ltd & Ors (No. 2) [2000] VSC 78 (14 March 2000)
M T Associates Pty Ltd v. Aqua-Max Pty Ltd & Ors (No. 2) [2000] VSC 78 (14 March 2000) Gillard J, when considering this case and the non-negotiability of shares in private companies, stated in obiter: In my opinion he should not have taken that into account. In the valuation process, having reached a valuation of shares based upon FME multiplied by the capitalisation rate, the fact that it is a private company may result in a discount of the total valuation. In my opinion it is not a factor relevant to the capitalisation rate.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER / 15~1610 Non-negotiability of shares / Case law / Holt v. Cox, Supreme Court of New South Wales, Court of Appeal, 4010/95, ED 3378/91
Holt v. Cox, Supreme Court of New South Wales, Court of Appeal, 4010/95, ED 3378/91 Mason J, Priestly J and Cole J accepted a company auditors valuation (Mr Adam), which included an allowance for lack of marketability of shares in a private company of 25%30%, compared with shares listed on the Australian Stock Exchange.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER / 15~1610 Non-negotiability of shares / Case law / Elmslie, Moore, Moyes & Valder v. Commissioner of Taxation, Federal Court, Federal Court of Australia, Nos. NG106, NG205, NG206 and NG207 of 1992 FED No. 826 Taxation (1993) 26 ATR 611 (1993) 93 ATC 4964 (1993) 118 ALR 357 (1993) 46 FCR 576
Elmslie, Moore, Moyes & Valder v. Commissioner of Taxation, Federal Court, Federal Court of Australia, Nos. NG106, NG205, NG206 and NG207 of 1992 FED No. 826 Taxation (1993) 26 ATR 611 (1993) 93 ATC 4964 (1993) 118 ALR 357 (1993) 46 FCR 576 Wilcox J rejected Mr Wayne Lonergans view that there should be a discount for non-negotiability of shares in a private company.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER / 15~1620 Strategic position
15~1620
Strategic position
This adjustment reflects a number of factors, including the relative risk of the business, barriers to entry in the market, technological advantages etc. A detailed review of the business is required before an assessment can be made on the appropriate adjustment. When valuing small private companies, one of the major issues that needs to be addressed is the lack of depth in the management structure and the company reliance on a few key individuals. This reliance exposes an investor to significantly higher risk than investing in a larger company and as a result an adjustment to the market PERs is required.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER / 15~1630 Current versus prospective earnings
15~1630
Current versus prospective earnings
PERs in the public market-place relate current prices to past earnings. Valuations relate PERs to future or current earnings. Thus an adjustment is required when using multiples from the public market-place. The adjustment relates to earnings growth (and inflationary effects) and to match the multiple to the earnings, i.e. historic earnings to historic PER, prospective earnings to prospective PER. Typically adjustments in the range of 4% to 15% might be considered. Such an adjustment incorporates a real growth element. This real growth element can only be determined after a detailed review of the companys prospects.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER / 15~1640 Growth expectation
15~1640
Growth expectation
Where the company being valued is expected to achieve earnings growth in excess of a general expectation for the market (from which the benchmark has been obtained), the multiple should be increased. For example, if the growth expectation is 5% greater than the expectation for the market, the multiple should be increased by 5%.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER / 15~1650 Financial structure
15~1650
Financial structure
If it is determined that the financial structure of the company under consideration differs considerably
from comparable companies in the same industry, the multiple should be adjusted. If the financial structure of the company demonstrates a level of debt funding that is significantly greater than the market as a whole, it is reasonable to expect that this will make the earnings of the company more volatile. Volatility translates into risk. Accordingly, the multiple should be decreased to reflect the increased volatility of earnings that will result. Furthermore when considering companies and entities in different countries, it is worth remembering that the financial structure of many companies differs substantially from their overseas counterparts.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER / 15~1660 Dividend payout ratios
15~1660
Dividend payout ratios
Similarly, when considering dividend levels it must be remembered that the dividend payout ratios of companies will vary considerably. This occurs both within industries and across national borders which in turn affects the comparability of companies.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER / 15~1670 Australia specific adjustments
15~1670
Australia specific adjustments
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER / 15~1670 Australia specific adjustments / Franking/imputation
Franking/imputation
Legislation relating to the imputation system has been effective from 1 July 1987. Under the imputation system, companies continue to pay corporate tax in the usual manner. When dividends are paid, however, calculations must be made to determine whether the dividends which have been paid are franked dividends or not. A franked dividend is, broadly speaking, one which has been paid from profits which have incurred tax after 1 July 1987 at the corporate tax rate. If franked dividends are paid to resident individual shareholders an imputation credit will be passed on to the shareholder to effectively remove the tax liability on the dividend, subject to the shareholders income tax rate. Non-qualifying or unfranked dividends, however, will be assessable (taxable) to the recipients with no imputation credit. Dividends paid to non-residents are exempt from dividend withholding tax to the extent that they are franked. The PERs documented in the public market-place result from trading between shareholder types of
differing tax status and in companies with differing levels of franking credits attaching to dividends. It is sometimes necessary to consider the extent to which the subject company is able to pass on franked dividends to its shareholders relative to the benchmark. If the dividends paid by the company are fully franked and are likely to remain so, a positive adjustment to the capitalisation multiple should be considered. The effects of imputation on the cost of capital are explored in more detail in another chapter.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1580 Theory for Converting the PER / 15~1680 Other adjustments
15~1680
Other adjustments
In assessing the strategic or competitive differences between listed companies and the company under consideration, the following additional factors should be addressed: management risk; specific business risk; geographic risk diversification; and other factors which impinge upon certainty of deriving future maintainable earnings (such as sustainability of contracted revenue).
The PER may vary considerably from one company to another within the same industry depending on factors such as the efficiency of the company, the nature of the assets employed, the location of the company, its capital and debt structure etc. Accordingly, the appropriate PER will depend on the subject companys earnings, growth prospects and its underlying risk factors.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1540 Specific Factors Affecting Price Earnings Ratios (and other Multiples) for Private Companies / 15~1690 Private PER: Public PER
15~1690
Private PER: Public PER
With long-term bond rates at approximately 7% (compared with cash rates of approximately 6.5%), after-tax returns on equity (overall average for the equity market) have traditionally been in the vicinity of 12%15%. Typically we find that small business transactions display a required rate of return of 30%45% before corporate tax. On an after corporate tax basis this equates to 20%30%. Compared with average market returns of 12%15% this represents a risk premium of 1.32.5 times the average market (listed equities) return. In part, this is a subjective assessment and so long as private companies data is absent from the market-place, it will remain so. However, given the many additional risks faced by the smaller private, unlisted businesses, such a risk premium is not unreasonable. A rule of thumb for converting public companies PERs to private companies PERs is as follows:
When private: At point of listing: On maturity*:
30%50% of PER. 60%80% of PER. 100% of PER.
* Maturity in this context means when performing like a public company and having established its maintainable earnings and profits as communicated to the market.
The required rate of return for a given investment is a complex issue. The application of a rule of thumb is dangerous without an understanding of the pitfalls and simplicity inherent in a rule of thumb.
VALUATION ISSUES / 15~1000 Valuing 100% of an Entity / 15~1740 References

15~1740 1.
References
Pratt, Dr. Shannon, Guide to Business Valuations, 2nd edition, July 1992, Practitioners Publishing Company, Fort Worth, Texas
VALUATION ISSUES / 16~1000 Valuing Minority Interests

16~1000
Valuing Minority Interests
This chapter contrasts to the previous, Valuing 100% of an Entity, as we now focus on the valuation issues which require consideration when analysing a minority interest. A minority interest is one which involves less than a 100% ownership in the company. There are various consequences of such an interest which, amongst others, include a lack of control over the direction of the company. These factors, and the subsequent impact they have on value, are the subject of this chapter.
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1050 Business Valuations Revisited
16~1050
Business Valuations Revisited
It is essential to ensure that the valuer understands exactly what is being valued. In the chapter Scoping a Valuation Assignment we discussed the importance of understanding what was being valued, the business v. the entity, and we reproduce the diagram from that section as it is a useful aid in conceptualising the composition of a particular entity.
Conceptually the value of an entity is the aggregate value of each of the individual business units in that entity plus the value of any surplus assets less the value of any corporate debt. This can be represented diagrammatically as follows: Entity Valuation = Sum of the Values of each Business Unit + Value of Surplus Assets Value of Corporate Debt
In the circumstance where there is only one business unit and there are no surplus assets or corporate debt, then the value of the entity or company will be the same as the valuation of the business unit. This is important as the value of a companys shares should bear some resemblance to the sum of its parts. Where there is no apparent relationship between the sum of its parts and the value of the companys shares then questions must be asked as to why there is an apparent discrepancy. In previous chapters we considered the methods of valuing a company by: converting a business valuation into an entity valuation; and valuing an entity without first valuing the underlying business.
In this chapter, and the following chapter, we consider the factors that affect the valuations of other than 100% of the equity of a company. Specifically we consider: minority holdings of shares; the valuation of options; and the valuation of convertible notes.
It is common to think of ordinary shares on issue as being the equity of a company and ascribing the value of a company to the ordinary shares; however, one should not overlook dilution effects that can occur through the conversion of convertible notes and the exercise of options. If there are convertible notes and options it may be appropriate to do two or more valuations, and be considered on both an undiluted and diluted basis. In determining whether to treat some securities as equity or as debt, any convertible securities (e.g.
convertible (redeemable) preference shares and convertible notes) on issue should be looked at and whether they are more in the nature of equity or debt. The principle of substance over form is important. In valuing investments held in another company it will be necessary to look at the nature of each investment and whether it confers any particular rights or benefits such as a board seat, whether it is a strategic parcel or a locked-in minority. When valuing a more than 50% interest in another company it is typically appropriate to value the underlying business of that investee company and then to apply a pro rata value. However, one should be aware of specific facts which can distort this result, for example, if the entity is incurring losses and the parent company has given a guarantee, then it is possible that the parent company may be covering more than its proportionate share of losses. In such a case a contingent liability must be evaluated. A minority interest in a listed company which is thinly traded may not be realisable quickly; the quoted price, therefore, should not be taken at face value without some enquiry as to shareholder spread, volumes traded, relative prices and the directions of those trades in the previous three to six months.
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1100 Minority Holdings of Shares and Convertible Notes
16~1100
Minority Holdings of Shares and Convertible Notes
This section addresses situations where the securities to be valued represent less than 100% of the total issued share capital of a company. Reference should be made to the section on company and securities valuations, as introductory and background remarks made in that chapter will add to the understanding of issues covered in this chapter. The valuation of such shareholdings requires particular consideration of a number of issues. In all cases where a proportion of the total issued capital is being valued, the following must be taken into account: whether the holding effectively controls the cash flows and management of the company; whether there is a discount for the absence of such control; and the ability of the holder to influence the level of cash flow receivable for the shareholding.
Often such a valuation needs to review the entitys memorandum and articles of association. In particular, private company articles often have clauses granting specific rights and obligations to minority shareholders. One such example is the typical pre-emptive rights contained in a private companys articles, which require that any offer for sale of the shareholdings must first be made to other (existing) shareholders before being offered to potential buyers outside the company. Traditional arguments for discounting the value of a minority shareholding must be carefully considered in each circumstance. Those traditional arguments state that a minority shareholding, due to its inability to influence the level of dividends, should be discounted as the dividend stream can be depressed by the controlling shareholders. However, it should be noted that any cash retained by the company is likely to be employed in one of three ways: the reduction of debt;
investment in additional entities or investments, plant, inventory, working capital items etc.; and/or placed on deposit.
In any event, the capital value of the shares on liquidation will reflect the underlying value of the companys assets. However, the minority shareholder may not be in a position to initiate a liquidation. Care should, however, be exercised in assuming that the rate of return which can be earned upon such retained cash equates to the rate of return on normal operations. If the cash is retained and, for example, placed on deposit, the rate of return which can be earned on such deposits is more than likely less than the expected return from continuing operations. Accordingly, there may be a need to discount the expected future capital value of the shareholding by virtue of the sub-optimal earning rate on the cash invested or to treat that cash as excess assets. In valuing any shareholding of less than 100% of a company the effect of other issued securities, such as convertible notes, options and other securities, needs to be considered to determine whether the conversion or exercise of such securities may further reduce or inhibit the rights of the minority shareholder. No hard and fast method and criteria can be applied to valuing a shareholding of less than 100% the circumstances must be considered in each case. For the purpose of discussion it is useful to consider holdings at or above each of the following levels of ownership of a company: 5%; 10%; 20%; 25%; 50%; 75%; and 90%.
The significance of each of these levels of ownership is discussed later. The essential difference between 100% ownership and something less than 100% ownership is that with 100% ownership the holder can unilaterally control: the dividends paid; the investment policy of the company; the utilisation of its cash flow; policies and procedures; the remuneration of executives and directors; and other factors which may be unique to the company.
With less than 100% ownership consideration has to be given to other shareholders in the company; where the ability to influence the course of affairs is limited there will be a need to take account of various factors in making and valuing the investment.
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1100 Minority Holdings of Shares and Convertible Notes / 16~1150 Established Practice
16~1150
Established Practice
Most valuers agree that the principal basis of valuing a minority shareholding should be the amount and timing of expected dividends, or increases in the underlying equity values, if no dividends are paid. However, and in keeping with other valuation principles, it is always worthwhile cross-checking a value determined by expected future dividends against: transactions relating to minority interests in the same entity (to the extent that any such transactions have occurred and sale price information can be obtained); the discounted proportionate share of the value of the company; and contractual buy or sell agreements.
Cross-checking a value against the discounted proportion of the share of the company value should only be used as a rough guide to the dividend valuation as it will only be in exceptional circumstances that a value based on expected future dividends will equate to the proportional share of the entitys value. The diagram set out below shows the relationship between a control premium, a minority interest discount and a discount for lack of marketability interest in the same company.
Evidence from the US (although not directly transferable to other countries) is that: minority interest discounts range from 20% to 40% with many valuers preferring a range of between 30% and 35%;
lack of marketability discounts range from 10% to 33.3% with many valuers preferring a range of between 20% and 25%; and restrictive agreement discounts range from 15% to 50% with many valuers preferring a range of between 30% and 35%.
Source: Supporting documentation to NACVAs Valuation Master 6.0 and ValueBase valuation software.
There appear to be no hard and fast rules on minority discounts in Australia. Generally, the courts seem to be less likely to allow a minority discount than those who value for commercial reasons. The discount ranges up to 66% in some cases.
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1100 Minority Holdings of Shares and Convertible Notes / 16~1150 Established Practice / Forsythes Family Law Value Handbook
Forsythes Family Law Value Handbook
On page 5 of the Handbook, it is stated: It is not uncommon for combined control and marketability discounts in excess of 50% to be applied in the valuation of closely held equity interests. The Handbook summarises court cases where a minority discount has been applied to a valuation and concludes minority discounts range from 5% to 66%.
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1100 Minority Holdings of Shares and Convertible Notes / 16~1170 Features of Minority Shareholdings
16~1170
Features of Minority Shareholdings
A number of features differentiate minority shareholdings from a controlling shareholder. For example, minority interest shareholders are generally subject to: a lack of board representation; an inability to carry motions at a general meeting; an inability to carry motions regarding winding-up; restrictions on access to information; and an inability to control the dividend distribution decision.
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1100 Minority Holdings of Shares and Convertible Notes / 16~1170 Features of Minority Shareholdings / 16~1180 Lack of board representation
16~1180
Lack of board representation
If a minority shareholder is represented on the board of directors, that representation usually continues at the discretion of the majority shareholder(s). Whilst a minimum voting shareholding may give rise to the right to call a general meeting of shareholders, appointment and removal of directors by shareholders is on the basis of a majority vote.
Accordingly, if a minority shareholder is represented on the board of directors, continued representation is at the discretion of the majority. If the minority shareholder seeks representation on the board, the appointment is also at the discretion of the majority.
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1100 Minority Holdings of Shares and Convertible Notes / 16~1170 Features of Minority Shareholdings / 16~1190 Inability to carry a motion at general meetings
16~1190
Inability to carry a motion at general meetings
Whilst a minority shareholder can put resolutions to a general meeting of shareholders by a minority, carrying the vote on such resolutions clearly falls in the hands of the majority, whether the majority is one shareholder or a group of shareholders with common aims.
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1100 Minority Holdings of Shares and Convertible Notes / 16~1170 Features of Minority Shareholdings / 16~1200 Inability to carry a motion on winding-up
16~1200
Inability to carry a motion on winding-up
While a minority shareholding may be able to call a general meeting at which a resolution to wind-up the company is moved by the minority shareholder, such a resolution may be defeated by a majority shareholder. Accordingly, a minority shareholder is not usually in a position to be able to effect a winding-up or liquidation unless legal action is taken.
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1100 Minority Holdings of Shares and Convertible Notes / 16~1170 Features of Minority Shareholdings / 16~1210 Restriction on access to information
16~1210
Restriction on access to information
In the absence of board representation, a minority shareholder is only entitled to receive an annual report from the company and any other information which is provided to other shareholders in their capacity as a shareholder, as opposed to their capacity as a director. In some circumstances minority shareholders may seek a direction from the courts to inspect the companys books if the minority shareholder can demonstrate to the courts that there is good reason to do so. A minority shareholder is not automatically entitled to attend directors meetings, review documents put before directors or participate in day-to-day decision making.
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1100 Minority Holdings of Shares and Convertible Notes / 16~1170 Features of Minority Shareholdings / 16~1220 Control over dividend distribution decisions
16~1220
Control over dividend distribution decisions
The laws in many countries specifically prohibit actions by a company that amount to the oppression of the rights of minorities. However, the failure to pay a dividend even when the company has the capacity to do so does not
constitute oppression if there is a demonstrated need for the company to retain earnings.
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1100 Minority Holdings of Shares and Convertible Notes / 16~1240 Levels of Ownership
16~1240
Levels of Ownership
An investor is concerned with risk return relationships. That is true whether the investment is 1% of the company or 100% of the company. Different levels of ownership bring with it differing degrees of ability to control events and thus this can change the risk return equation. The less control one has, the greater the risk there is of having events occur outside the control influence of the investment. With a higher risk, a higher rate of return is required and that can be obtained by either increasing the amount of the return or decreasing the price paid. Furthermore, a large investment in one company as opposed to several smaller investments in a number of different companies can create a different set of portfolio risks for the investor. The optimisation of a portfolio of investments is important for investors but is outside the scope of this manual. A number of leading financial texts deal with portfolio theory and optimising portfolio risk returns. We suggest they are referred to for further reading. This chapter is concerned primarily with an investment in a single company and the evaluation thereof. In discussing the levels of ownership, some of the thresholds are important from a legal viewpoint and an investor should be aware of the significance of these issues, in addition to the investment aspects. Reference should be made to the law for detailed guidance on precise definitions and applicability of provisions. The purpose of the following brief summary of some of the more important provisions of the Corporations Act 2001 is to highlight the relevance of the level of ownership to the ability of an investor to influence a companys course of action. Close attention must be paid to the terminology used and whether ownership entails voting rights or voting shares and which classes of shares are to be included in determining the relevant percentages. Minority shareholdings have differing features depending on the level of share ownership (and on the level of shareholding owned by the controlling shareholder). To assist in understanding how these features change, it is worthwhile considering these features for the following percentage holdings: 5%; 10%; 20%; 25%; 50%; 75%; and 90%.
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1100 Minority Holdings of Shares and Convertible Notes / 16~1240 Levels of Ownership / 16~1250 5%
16~1250
5%
Section 671B(1) requires that: A person must give the information referred to in subsection (3) to a listed company...if (a) (b) the person begins to have, or ceases to have, a substantial holding in the company or scheme; or the person has a substantial holding in the company or scheme and there is a movement of at least 1% in their holding....
Section 671B(3) defines the information to be given e.g. name, address, particulars of interest etc. Section 9 defines a substantial holding as: A person has a substantial holding in a body corporate...if: (a) The total votes attached to voting shares in the body...in which they or their associates: i) have relevant interests; ... is 5% or more of the total number of voting shares in the body... (b) the person has made a takeover bid for voting shares in the bodyand the bid period has started and not yet ended.
Where the voting shares are divided into two or more classes, then the requirement to disclose is brought into operation if the substantial shareholder has 5% or more of one of the classes, not aggregate of the classes. Section 249D(1) is often of great interest to a minority shareholder: The directors of a company must call and arrange a general meeting on the request of: (a) (b) members with at least 5% of the votes that may be cast at the general meeting; or at least 100 members who are entitled to vote at the general meeting.
Note that in this instance it is 5% of the total voting rights of all members and not 5% of a class. Also note that it is of voting rights not of voting shares different shares can have different voting rights. Those technicalities aside, the practical effect of section 249D(1) is that a disgruntled shareholder can, with 5% of the total voting rights, highlight issues and force a company to call an extraordinary general meeting. Furthermore, the costs of that meeting are covered by the company, not by the person calling the meeting. Whilst it is often difficult for a minority holder to force directors or other shareholders to adhere to their point of view, the ability to call a general meeting can be a very powerful tool in exercising a voice in the running of a company.
16~1260
10%
The power of a 10% holding is in many ways a negative power, as a shareholder with 10% or more
can stop a compulsory acquisition in the event of a take-over. Under the take-over provisions of the Corporations Act 2001, in certain circumstances, where an offeror is entitled to not less than 90% of the shares in a class, the offeror can proceed with compulsory acquisition of the balance. However, a holder of 10% or more of a class of shares can stop this compulsory acquisition. This can be a very powerful negotiating stance, particularly if the offeror requires 100% of the company in order to access particular benefits, e.g. accumulated tax losses.
16~1270
20%
The great significance of 20% is in relation to a take-over situation and applies to all companies with 50 or more members. Except in certain circumstances, a person shall not acquire shares in a company if they would, immediately after the acquisition, be entitled to more than the prescribed percentage of the voting shares in the company (section 606(1) of the Corporations Act 2001). The prescribed percentage is currently 20%. The certain circumstances permitted under the legislation relate to: an approval in a general meeting by shareholders; the operation of law; and a 3% creep provision every six months (section 611 table item 9).
The Corporations Act 2001 has extensive interpretative provisions relating to what entitlement means and the operation of the related term relevant interest. Section 608(3) defines a relevant interest at 20% or control. The word control is defined in section 608(4) in relation to whether the person has the capacity to determine the outcome of decisions about the body corporates financial and operating policies. The word control is used advisedly as there can be many instances where a shareholder has more than 20% of the shares of a class and has no control or influence at all over the affairs of a company. Similarly, the Corporations Act 2001 says that a relevant interest is created where a person has the power to vote in respect of a voting share in a body corporate. That power to vote is assumed where a holding of 20% or more is held in a body corporate. There are in turn tracing down provisions whereby if, for example, shareholder A has 21% of company B and company B has 50% of company C, A in turn is assumed to have the same relevant interest in company C that company B has. Australian Accounting Standard AASB 128: Investments in Associates requires that an investment in an associate generally be accounted for using the equity method. An associate is defined as being an entity over which the investor has a significant influence. The rule of thumb for determining whether significant influence exists is outlined in paragraph 6 of the standard, which states that an investor holding 20% or more of the issued capital of a company is presumed to have significant influence over the investee, unless it can be clearly demonstrated that this is not the case.
This does not mean that equity accounting should automatically be applied where an investor holds more than 20% of a companys issued capital, but the need for equity accounting must be considered, including the various subjective factors set out in the standard which determine whether or not significant influence exists, which include: the ability to control the board of directors; the extent of the voting power; and participation in the management of the investee company.
16~1280
25%
A number of proposed actions by a company must be passed by special resolution. A holder of 75% or more of a class of shares can ensure the passage of a special resolution of a class of shareholders. Thus, a holder of 25% or more can prevent such a resolution being passed. A number of unit trust deeds have similar provisions requiring 75% of the units to vote in favour (i.e. of those entitled to vote and voting). (Detailed reference should be made to individual trust deeds.)
16~1290
50%
50% is the normal threshold for control. Control in this instance is the ability to pass ordinary resolutions at meetings of shareholders. In the case of a company with a single class of shares all having the same voting rights and all paid to the same amount, then 50% or more of those ordinary shares would entitle the holder to control the general meetings of the company. It should be noted however that it would not enable the holder to pass special resolutions by themselves, or to act in an oppressive manner towards minority shareholders. Where 50% or more of the issued capital of a company is held by an investor, then that company would be consolidated in the accounts of the investor/holding company, which can have a significant impact on the reported results and the gearing ratios of the investor/holding company. One of the reasons that off balance sheet companies were so popular in Australia in the 1980s was the ability to remove, through technical (some would say artificial) arrangements, liabilities from being reported on the holding companys balance sheet. With changes in corporate thinking and definitions of consolidation, economic entity and control, there is a move (some would say return) to a substance over form situation, so that companies which are technically owned with less than 50% of all the shares, but where the benefits of ownership are more than 50%, will be consolidated. Reference should also be made to Accounting Standard AASB 127: Consolidated and Separate Financial Statements.
16~1300
75%
As discussed above under 25%, a 75% holding enables the shareholder to pass special resolutions.
16~1310
90%
As discussed above under 10%, the 90% threshold is important in order to proceed to compulsory acquisition.
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1100 Minority Holdings of Shares and Convertible Notes / 16~1330 Importance of Voting Rights
16~1330
Importance of Voting Rights
If all shares had the same rights to capital dividends and votes, the world would be much simpler. However, there can be differences and this can add a particular complexity when undertaking a valuation of a class of shares. The voting rights of a listed company may be governed by stock exchange listing rules, specific rules of the country of incorporation or the companys internal governing rules and regulations. It is important to determine the voting rights of different classes of shares, as in some parts of the world there may be specific rights attached to founders shares, which effectively prevent control being removed from the founder of the company, regardless of the extent of ownership interest. Some of the more normal classes of shares and their respective normal voting rights are detailed below: Ordinary shares one vote per share. Contributing shares: no liability company pro rata to the amount paid up; limited liability company if offered on a pro rata basis to members, on a one for one basis; and limited liability company if offered other than on a pro rata basis to members, pro rata to the proportion of the total issue price paid up.
Preference shares: when dividend is more than six months in arrears one vote per share; and at any meeting convened for the purpose of reducing the capital, winding-up, sanctioning a sale of the undertaking or where the proposition to be submitted to the meeting directly affects the rights and privileges of the preference shareholders one vote per share.
The number of votes which can be cast at a meeting can differ from the number of shares carrying
votes. For example, if a company has contributing (partly paid) shares and fully paid shares on issue, the following could occur on the basis that the shares paid to only 10 cents were issued other than on a pro rata basis to shareholders: Example 1 Number Ordinary $1 Shares: Fully Paid Paid to 10 cents 10,000,000 10,000,000 50% 50% 10,000,000 1,000,000 90.9% 9.1% % Voting Rights %
An interesting point which then arises is that there are 20,000,000 shares on issue which may carry the right to vote under stock exchange listing rules or the companys articles of association. Thus it could be possible to acquire 36.4% of the votes through holding only 20% of the total number of shares on issue by way of the ordinary fully paid shares. This can be illustrated as follows: Total Shares on Issue: 20% of Total Shares Voting Rights 20,000,000 = 4,000,000 (fully paid ordinary shares purchased) = (4,000,000/11,000,000) 100 = 36.4% Whilst one could normally assume that all listed shares have commonality of voting rights, one would be unwise to rely upon such an assumption without checking the companys memorandum and articles of association if there are shares paid up to different amounts or different classes of shares on issue. Another example (and one which parallels an actual case of a listed company) is given below: Example 2 Number Ordinary 20 cent shares: Fully Paid Paid to 3 cents 3,000,000 10,000,000 23.1% 76.9% 3,000,000 1,500,000 66.7% 33.3% % Voting Rights %
In this instance the issue of the shares paid to 3 cents were approved by a special meeting of shareholders. As can be seen, a quite different result occurs when comparing voting rights to the number of shares on issue. In fact, by acquiring 17.5% of the total number of shares on issue, i.e. 2,275,000 fully paid shares, in excess of 50% of the votes could be obtained. This has obvious issues in the building up of a stake in preparation for, or during, a take-over attempt. In such an instance normal valuation criteria can be overridden as parties jockey for position and special prices are paid for parcels of stock.
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1100 Minority Holdings of Shares and Convertible Notes / 16~1350 Importance of Trading Liquidity
16~1350
Importance of Trading Liquidity
There tends to be a distinction between the price earnings ratio (PER) of listed and unlisted companies. The thought process often goes that because a company is listed it has liquidity, therefore its shares may be traded and may be worth relatively more than an unlisted company. However, for some of the very thinly traded listed companies the liquidity of their shares in fact is often less than in large unlisted companies. It is therefore important to assess the size and spread of shareholdings when considering liquidity issues.
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1100 Minority Holdings of Shares and Convertible Notes / 16~1370 Valuation Principles Minority Shareholdings
16~1370
Valuation Principles Minority Shareholdings
It is not uncommon to find valuations of minority shareholdings prepared on the basis of a pro rata share of the value of the whole company (100% of the capital). However, where a minority shareholding clearly does not carry with it control of the board of the company in question (nor forms part of a shareholding block which controls), it should not be valued on the basis of a pro rata share of the value of the entire company. This is because: the minority can not influence the level of dividends paid (if any); and/or the minority can not commence winding-up or liquidation proceedings.
Both the determination of dividends and the commencement of winding-up or liquidation proceedings are matters which can be controlled by a majority shareholder or group of shareholders forming a majority. There are three basic methodologies available for valuing minority shareholdings: comparable transactions; present value of likely proceeds on sale or liquidation; and capitalisation of expected dividends.
A chart, entitled Levels of Value in Private Companies Based on Owners Options for Exit or Liquidity designed by Eric Nath, and sourced from Leveling with You About the Levels of Value published in The E-Law Business Valuation Perspective, Issue 2001-10, 19 November 2001 (accessible on <www.mercercapital.com>) and reproduced below, examines value from the perspective of a controlling owner and a minority owner and identifies options facing a minority shareholder. Nath 1995 and expanded 2001: Levels of Value in Private Companies Based on Owners Options for Exit or Liquidity
Source: Mercer 1999
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1100 Minority Holdings of Shares and Convertible Notes / 16~1370 Valuation Principles Minority Shareholdings / 16~1380 Sale to a third party
16~1380
Sale to a third party
Where there have been prior sales of shares in a company, or there is an identifiable and known buyer (who is not a special purchaser), the value of the minority shareholding may be determined by a potential sale value. This valuation methodology is of course inappropriate when there is no known or likely purchaser. In some countries it is unusual for a reliable source of information relating to comparable sales in other (unlisted) companies to be available. A gauge of value for any asset is the price other people are prepared to pay for that asset. This is best determined by referring to prices transacted in a deep secondary market. It is however, unusual for a deep secondary market to exist for private company shares. This valuation method is discussed in more detail in the chapter Market Approach.
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1100 Minority Holdings of Shares and Convertible Notes / 16~1370 Valuation Principles
Minority Shareholdings / 16~1390 Present value of likely proceeds on sale or liquidation

16~1390
Present value of likely proceeds on sale or liquidation
Where it is likely that a company will be liquidated at a definite point in time, the likely liquidation proceeds can be determined and a present value of the proceeds assessed as a value for the shareholding. However, as noted earlier, it is uncommon for a minority shareholder to be able to commence liquidation proceedings. An alternative approach which may be suitable for valuing minority interests as going concerns is discussed in the article Quantitative Support for Large Minority Discounts in Closely Held Corporations (John S Harper, Jr. and J Peter Lindquist, The Appraisal Journal, April 1983. Reprinted with permission from The Appraisal Journal (April 1983). 1983 and 2002 by the Appraisal Insitutute, Chicago, Illinois). This article states: Frequently, no market exists for minority interests in privately held companies except that market that may be created by an aggressive seller actively seeking prospective buyers. In this situation, the risks are unusually high compared to typical investments Some of the more important [reasons] are: A minority interest in a private corporation that does not have a market has no liquidity. A minority investor has no legal right to be a director, officer, or even an employee of the corporation and, thus, may have absolutely no say in the policies or practices of the company A minority investor has no say in how the company will be sold Finally, the minority shareholder has no say as to when the entire company should be sold
Because these risks are exceptionally high, a rational investor should seek a very high rate of return from a minority interest in a privately held company. Double, or even triple, the return expected from low-risk marketable investments, such as Treasury bonds The only return that many minority interest shareholders can expect is what is achieved internally. When no dividends are paid, their return results only from the appreciation of the stock and is only realized when the stock is sold. Moreover, when no market exists for the stock, the minority shareholder must usually wait until the majority shareholders decide to sell, so that the minority interest can be sold in conjunction with those majority shares To establish the price that one can afford to pay for minority shares when no market exists for them and when no external return is expected, a sophisticated buyer or business appraiser should take the following steps: Find todays value per share assuming a sale of 100% of all shares. Estimate the number of years before this investment will be liquidated at a fair price. Determine the future value (i.e. the probable value per share in the year of sale).
Select an annual rate of return commensurate with the risk associated with this investment. Discount the future value in the year of sale to present value using the selected internal rate of return.
...In determining the number of years until the sale is most likely to take place, the appraiser should consider the age, health, and motivation of the controlling stockholder. Of these three factors, usually age and health are of greatest importance when the owner is over fifty years old. Motivation is a stronger factor in an owner under fifty. To estimate the value of a share of stock at some future date, one must establish todays value, the year in which a sale of the business is most probable, and the annual rate of appreciation until that sale takes place. Having determined both todays value of a share and the probable year a sale will take place, the problem is how to determine the annual rate of appreciation. Generally, the best way to select this rate is to look for a trend in recent growth and to find out whether the growth rate has been accelerating or slowing over the past three years. Analyze the future growth prospects for the industry. Adjust for the companys market share increase or decrease. Adjust for the ability and motivation of the controlling owner/manager. Take into account known facts that will influence growth [like excessive distributions to controlling shareholders by way of non-market remuneration etc.]. When todays value per share, the number of years until sale, and the annual rate of appreciation of the stock are known, the future value per share can be calculated. Having selected a rate of return that is acceptable to a rational investor, the present value of the future selling price of a share of stock can be computed This present value of the future selling price represents what an investor can afford to pay for the stock today. The difference between todays value per share based on a sale of 100% of all outstanding shares and the present value of the future selling price per share represents the discount for minority interest in dollars We appreciate that many appraisers wish to explain their discounts in different words. It is of utmost importance, however, that all appraisers distinguish between a minority interest for which some market exists and a minority interest for which no market exists, other than that which is created by an aggressive seller actively seeking a prospective buyer. Further, to avoid the age-old confusion, it is critical that discounts be taken from the value per share at which 100% of the stock would be sold in a single transaction to a single buyer or buyer group Discounts of up to 75% or more might well be justified for a minority interest for which no market exists Because a minority investment in a private business that has no market for its stock is very high risk, the prudent investor should demand a rate of return that is between double and triple the rate possible in risk-free public investments that offer ready liquidity. The article also notes that in evaluating the rates of return, it should be recognised that typically external returns will be taxed at ordinary income tax rates, while internal returns will often be taxed at capital gains rates. The Subject Notes of the Securities Institute on Mergers and Acquisitions (E 142, pages 23) point out that the value of a minority interest in a non-listed company will normally have a lower value because it
is not so easily marketable as those in a listed company. Market evidence in Australia indicates that the premium for control (i.e. premium over pre-bid prices) has historically been around 30% to 35%. This valuation method is discussed in more detail in an earlier chapter, Asset Approach, and specifically under orderly realisation of net assets. A North American perspective can be found in a paper entitled Valuations and Price-Adjustment Clauses given at the 50th Annual Tax Conference of the Canadian Tax Foundation in 1998 by Richard M Wise. In particular, it refers to the results of a range of studies of minority discounts, which, although not directly comparable to other countries, may give an indication of the magnitude of discounts necessary: A. Joel Adelstein, former President of The Canadian Institute of Chartered Business Valuators, reviewed the various U.S. studies performed between 1970 and 1990 and concluded as follows: Based on the various studies relating to the question of marketability only, it would be hard to dispute as a minimum an average 35 percent discount. I believe greater discounts could be argued based on the fact that closely-held companies in general would be smaller in size than the average publicly-traded company and thus justify a higher discount. This theory seems to be supported by the data in the SEC Institutional Investor Study. Thus, a 35 percent marketability discount applied to a closely held company could, I believe, only be viewed as conservative. Combining the 30 percent adjustment from market to minority with the non-marketability discount of 35 percent, we arrive at an average total minority discount of approximately 65 percent, as established in the public marketplace. As suggested earlier, the average discount may be somewhat conservative, as I believe that the general circumstances surrounding the shares used to derive the two segments led to lesser discounts than would be appropriate for true minority shares of a typical closely held corporation. Applying the logic of the public market to the closely held corporation, it would appear that, on average and absent particular benefits to enhance marketability, a top down discount of, say 65 percent would not be unrealistic or unwarranted. Based on my reading, it would appear that the courts have allowed minority discounts in excess of 50 percent several times, but on the whole the courts still seem to be more comfortable with discounts in the 20 to 40 percent range. With the odd exception, it would appear that US courts have been reluctant to recognize a composite discount. In some situations, the status of the buyer has been used by the courts to justify a lower discount (controlling shareholder buying minority shares value to purchaser or family group, etc.), rather than fair market value Reconciliation Percentage Value of entity Minority market discount, say Hypothetical minority trading price Marketability discount Residual closely held minority interest, maximum
100 30 70 35 35
This reconciliation is supported by a number of the authors previously cited who have suggested total discounts of 75 percent or more Wise then summarised a number of restricted stock studies as per the table reproduced below: Study SEC, Overall Average a SEC, Nonreporting OTC Companies b Gelman b Trout c Moroney d Maher e Standard Research Consultants f Willamette Management Associates, Inc. g
a.
Years Covered in Study 19661969 19661969 19681970 19681972

h
Average Discount 25.8 32.6 33.0 33.5 i 35.6 35.4 45.0 i 31.2 i
19691973 19781982 19811984
From Discounts Involved in Purchasers of Common Stock (19661969), Institutional Investor Study Report of the Securities and Exchange Commission, H.R. Doc. No. 64, Part 5, 92nd Cong., 1st Sess. 1971, pp. 24442456.
b.
From Milton Gelman, An Economist-Financial Analysts Approach to Valuing Stock of a Closely Held Company, Journal of Taxation, June 1972, pp. 353354.
c.
From Robert R. Trout, Estimation of the Discount Associated with the Transfer of Restricted Securities, Taxes, June 1977, pp. 381385.
d. e.
From Robert E. Moroney, Most Courts Overvalue Closely Held Stocks, Taxes, March 1973, pp. 144154. From J. Michael Maher, Discounts for Lack of Marketability for Closely-Held Business Interests, Taxes, September 1976, pp. 562571.
f. g. h. i.
From Revenue Ruling 770287 Revisited SCR Quarterly Reports, Spring 1983, pp. 13. From Willamette Management Associates study (unpublished). Although the years covered in this study are likely to be 19691972, no years were given in the published account. Median discounts.
Wise further reports on studies of the price relationship between private, closely-held share transactions and subsequent initial public offerings (IPOs) of the same shares, as per the following table: Study # of IPO Prospectuses Reviewed # of Qualifying Transactions Discount
Mean 19921993 199019921 198919902

Median 44% 40% 40%
443 226 157
54 35 23
45% 42% 45%
Study
# of IPO Prospectuses Reviewed 98 130 97
# of Qualifying Transactions 27 21 13 173
Discount
198719893 198519864 198019815
45% 43% 60% 47%
45% 43% 66% 46%
1.
Emory, The Value of Marketability as Illustrated in Initial Public Offerings of Common Stock, Business Valuation Review, December 1992, pp. 208212.
2. 3. 4. 5.
December 1990, pp. 114116. June 1989, pp. 5557. December 1986, pp. 1214. September 1985, pp. 2124.
This paper by Wise can be accessed via www.wbbusval.com. For Australian data, refer to the section on established practice.
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1100 Minority Holdings of Shares and Convertible Notes / 16~1370 Valuation Principles Minority Shareholdings / 16~1400 Capitalisation of expected future dividends
16~1400
Capitalisation of expected future dividends
The appropriate methodology for valuing a minority shareholding is typically by capitalising future dividends. Where the only stream of cash flows likely to emerge for a minority shareholder is a dividend stream, it is appropriate to capitalise (or determine the present value of) the future dividends. Of necessity, this methodology requires: estimating the magnitude of likely future dividends; estimating the timing of likely future dividends (in the event that there is no clearly discernible dividend policy presently in place); and an assessment of an appropriate capitalisation rate or discount rate.
If the past dividend policy has been ad hoc or non-existent (due to, for example, the inability of the company to pay dividends), the assessment of likely future dividend policy is made difficult if not impossible. As the board of directors determines whether a dividend is recommended to shareholders, inability to influence or control board decisions places the minority shareholder in the hands of the board. Hence, where there is clearly a need to retain earnings in the company (for example, to reduce debt, to undertake capital expenditure programs or to create a more stable equity base), the company may choose not to pay dividends until such objectives are met and the minority could expect to receive no dividends.
If dividends do not flow to the minority shareholders, there can be no expected dividends to capitalise and the minority shareholding is technically worthless as it has no income stream. A minority shareholder could then offer the shareholding to fellow shareholders (and may, in fact, be required to do so first under pre-emptive rights provisions in the companys articles of association before an offer to external parties is made). There is however no compulsion for fellow shareholders to acquire the minority shareholders shareholding. If other shareholders do not take up the minority shareholders offer, the minority shareholder can offer the shareholding to third parties unrelated to the company. A third party investor unrelated to the company would look to the features of the holding to determine its worth. They would therefore look to the inability to control the board and/or the likelihood of future dividends as a basis for determining value. In the absence of board control or expected dividends, an external investor could draw the same conclusion as the shareholder, and view the shareholding as worthless. In other words, the capitalisation of dividends methodology could result in nil value due to the lack of dividends or an identifiable time period over which the dividends would flow. This valuation method is discussed in more detail in an earlier chapter, Income Approach, and specifically under capitalisation of dividends.
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1100 Minority Holdings of Shares and Convertible Notes / 16~1370 Valuation Principles Minority Shareholdings / 16~1410 Capitalisation of earnings per share
16~1410
Capitalisation of earnings per share
Additional consideration needs to be given to dilution effects which can occur in a variety of ways, including for example: the paying up of partly paid shares; the conversion of preference shares into ordinary shares; the conversion of convertible notes into ordinary shares; and the exercise of options into ordinary shares.
This is particularly important when basing calculations of dividends on earnings per share (EPS). Whilst the calculation and presentation of EPS deals mainly with past results, the principles to be applied are important when forecasting future earnings and dividends. It is these earnings and dividends which govern the value of shares. The key elements when calculating EPS are that: Basic earnings and diluted earnings per share should be calculated. Basic earnings per share are calculated by dividing earnings of the company by the weighted average number of ordinary shares of the company outstanding during the period being analysed. Earnings mean the companys operating profit or loss after income tax and abnormal items but before extraordinary items. Ordinary shares are expressed in fully paid terms.
Partly paid shares are included in the fully paid equivalents. Diluted earnings per share is the sum of the basic earnings plus the change in earnings which should occur as a result of the dilution effects. (The changes as a result of the dilution effects can include the ceasing of payment of dividends on convertible preference shares, the ceasing of payment of interest on convertible notes, the receipt of additional income as a result of paying up partly paid shares and/or the exercise of options.)
The increased income which may be received is calculated as the net after tax earnings. The calculations required to calculate EPS can become quite complex and reference should be made to a specific text or relevant accounting standard on the subject.
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1100 Minority Holdings of Shares and Convertible Notes / 16~1430 Specific Issues affecting Valuation of Minority Holdings
16~1430
Specific Issues affecting Valuation of Minority Holdings
In its simplest form, a corporate structure would have one class of ordinary shares with those shares all being fully paid. Variations can however be made and do occur for example, there can be differential voting rights but with equal rights to dividends, or shares can be paid to different amounts. The major differing types of shares that can occur include: ordinary shares fully paid; ordinary shares partly paid (contributing); and preference shares.
An essential difference is that a share which is not fully paid on its issue has an uncalled liability. To that extent it is said to be a contributing share or partly paid. In the case of limited companies, the holder of the partly paid share has a legal liability to pay the calls on the share as and when they are made. Holders, however, of partly paid or contributing shares in an Australian NL (no liability) company, which are typically used in the mining industry, can forfeit the shares if they do not pay the calls which are made. As a generalisation, the term partly paid is often used when describing shares in a limited company and contributing shares when discussing shares in an NL company. Preference shares are those which have some form of preference over ordinary shares, normally in respect of dividends. In return for this preference, the rights of the preference shareholders are in turn limited in some way, e.g. they may be redeemable only at the option of the company, or they can only participate in dividends up to a certain amount or have a fixed dividend. The particular considerations for valuing partly paid or contributing shares and preference shares are discussed later in this section. The valuation of options is discussed in a following chapter.
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1100 Minority Holdings of Shares and Convertible Notes / 16~1430 Specific Issues affecting
Valuation of Minority Holdings / 16~1440 Fully paid ordinary shares

16~1440
Fully paid ordinary shares
The basic calculation of the value of an ordinary share (assuming there are no complicating factors) is amply summed up by the Gordon dividend growth model which is discussed in the section capitalisation of dividends. The Gordon dividend growth model allows for a growth factor in dividends; it can be seen that if a constant growth factor is assumed then effectively the rate of capitalisation is reduced by that amount on a constant basis and thus the overall asset is worth more, than if no growth is assumed. The balance of this section demonstrates the effects that different structures have on share value. This is achieved by using a number of different scenarios each of which builds on the previous scenario. Scenario A Fully paid shares Consider Scenario A which assumes that a 12% pre-tax rate of return is obtainable from a comparable fixed interest-type investment account and that the investor is subject to tax at the same rate as the company. The following calculations can then occur. Scenario A Number of Ordinary Shares Issued Par Value Paid To BALANCE SHEET Assets Tangible Liabilities NET ASSETS Net Tangible Assets (NTA) NTA Per Share PROFIT & LOSS ACCOUNT Profit Pre Tax Less Tax at 30% Earnings (after tax) Earnings Per Share (EPS) DIVIDENDS Pay-out Ratio Dividends Per Share PRICE RELATED RATIOS Price (Per Share) Price Earnings Ratio Dividend Yield
Fully Paid Shares 1,000 $1 $1
$1,000 Nil $1,000 $1,000 $1
$120 $36 $84 $0.0840
100% $0.0840
$1.00 11.9 8.40%
Scenario A
Fully Paid Shares
Given the facts that: the EPS is 100% distributed in dividends; the EPS represents the same return as that which should be obtainable for a comparable fixed interest-type investment, ignoring the risk differences for the purposes of this example; and the net tangible assets (NTA) is the same as the par value of the shares,
one would value the shares at $1.00 on the assumption that if and when investors wanted to realise (sell) the shares, they could do so, i.e. that there is a liquid market for them and that the ongoing earnings and dividends will not be adversely affected by changes in company policies. It can be seen from this simple example that a number of potential risks confront the investor and there are obviously situations where a dollar may not be worth a dollar. Scenario B Fully paid shares and partly paid shares Scenario A can be extended to Scenario B by the inclusion of 1,000 shares paid to $0.10. Assuming everything else is pro rata, then the results are as shown in Scenario B. Scenario B Number of Ordinary Shares Issued Par Value Paid To Number of Equivalent Fully Paid Ordinary (EFPO) Shares BALANCE SHEET Assets Tangible Liabilities NET ASSETS Net Tangible Assets (NTA) NTA Per Share (EFPO) PROFIT & LOSS ACCOUNT Profit Pre Tax Less Tax at 30% Earnings (after tax) Earnings Per Share (EPS) DIVIDENDS Pay-out Ratio Dividends Per Share PRICE RELATED RATIOS
Fully Paid Shares 1,000 $1 $1 1,100
Partly Paid Shares 1,000 $1 $0.10
$1,100 Nil $1,100 $1,100 $1
$132 $40 $92 $0.0840
100% $0.0840
Scenario B Price (Per Share) Price Earnings Ratio Dividend Yield
Fully Paid Shares $1.00 11.9 8.40%
Partly Paid Shares
In this instance, it will be noted that it is necessary to calculate the number of equivalent fully paid ordinary (EFPO) shares. However, as in Scenario A, the value of the fully paid ordinary share would be $1.00, all other things being equal. It is important to think in terms of EFPO as the dividends payable per share are determined in the long run by the pay-out ratio and the earnings per share. If the earnings per share change, then sooner or later the dividends per share will be affected. An ordinary shareholder therefore, cannot ignore the dilution effects which can occur and must calculate the effect not only of the number of ordinary shares on issue, but the number of equivalent fully paid ordinary shares. Scenario C Fully paid shares with increased earnings In the above Scenarios A and B, it has been assumed that the earnings rate on the assets of 12% was that which might be obtainable on a comparable fixed interest-type investment and thus the value per share in terms of earnings was the same as the underlying net tangible assets per share. If the scenario changed (Scenario C), with the company earning 15% on its assets, new considerations arise. Scenario C Number of Ordinary Shares Issued Par Value Paid To Number of Equivalent Fully Paid Ordinary (EFPO) Shares BALANCE SHEET Assets Tangible Liabilities NET ASSETS Net Tangible Assets (NTA) NTA Per Share (EFPO) PROFIT & LOSS ACCOUNT Profit Pre Tax at 15% Less Tax at 30% Earnings (after tax) Earnings Per Share (EPS) DIVIDENDS
$800 Nil $800 $800 $0.80
$120 $36 $84 $0.0840
Scenario C Pay-out Ratio Dividends Per Share PRICE RELATED RATIOS Price (Per Share) Price Earnings Ratio Dividend Yield
Fully Paid Shares 100% $0.0840
$1.00 11.9 8.40%
The question that arises here is are the shares in Scenario C worth the same as those in Scenario A? The earnings per share and dividends per share are the same, however, the net tangible assets per share are different by 20%. If the alternative interest rates which could be obtained are still 12% then the shares in Scenario C are worth $1.00. However, the net tangible asset backing is $0.80, and on $0.80 a return of 15% pre tax is being earned (which is equivalent to 12% on $1.00 per share). If, however, external interest rates had changed and they were now 15%, then not only would one argue that the shares in Scenario C would only be worth $0.80 so as to provide a return (grossed up) of 15% on the amount invested, but also that the shares in Scenario A would be worth $0.80, despite the net tangible asset backing of $1.00. That immediately raises the question of whether the directors in Scenario A should change their investment policy or whether in fact the assets of the company in Scenario A should be liquidated and the capital returned to shareholders. If a shareholder is able to influence such a course of action, then there may well be a profit opportunity in paying something less than $1.00 for the shares and realising the assets. It is out of such scenarios that some of the take-over activity is initiated and, depending upon your point of view, terms such as asset stripping or redeployment of resources to better use come into use. This highlights the importance of control and whether or not the holding to be valued is a minority or controlling holding. Normally companies do not have their assets invested purely in cash, as shown above for the purpose of example, and there is some growth in the underlying business. Scenario D Fully paid shares with increased earnings but with reduced dividend pay-out ratio Scenario D Number of Ordinary Shares Issued Par Value Paid To Number of Equivalent Fully Paid Ordinary (EFPO) Shares BALANCE SHEET
Scenario D Assets Cash Liabilities NET ASSETS Net Tangible Assets (NTA) NTA Per Share (EFPO) PROFIT & LOSS ACCOUNT Profit Pre Tax Less Tax at 30% Earnings (after tax) Earnings Per Share (EPS) DIVIDENDS Pay-out Ratio Dividends Per Share PRICE RELATED RATIOS Price (Per Share) Price Earnings Ratio Dividend Yield
Fully Paid Shares $800 Nil $800 $800 $0.80
$120 $36 $84 $0.0840
75% $0.0630
$1.00 11.9 6.30%
Scenario D is in fact the same as Scenario C, with the exception that the dividend pay-out ratio has been changed from 100% to 75%. If the 25% retained is reinvested in the same assets and produces the same rate of return, then using a constant pay-out ratio, the dividends in years 2, 3, 4 etc. of Scenario D will be different from the dividends in year 1 of Scenario D. (Whereas in Scenario C, because there is 100% pay-out of EPS, the dividends would be the same in all years.) A different valuation will result as shown in Scenario D1: Scenario C Assets Reinvested Return Pre Tax Rate of Return Pre Tax Return Less Tax at 30% After Tax Return Earnings Per Share (EPS) Pay-out Ratio Dividend Per Share (DPS) Price (Per Share)
Scenario D1 $800 15% 15% $120 $36 $84 $0.0840 75% $0.0630 $1.00
$800 N/A 15% $120 $36 $84 $0.0840 100% $0.0840 $1.00
Scenario C Dividend Yield Price Earnings Ratio EPS Growth () EPS Growth (%) 8.40% 11.9 Nil Nil
Scenario D1 6.30% 11.9 0.22* 2.63%
Gordon dividend growth model Value = Value Dividend (Ke g) $0.0840 8.40% 0% $1.00 $0.0630 8.40% 2.63% $1.09
* Calculated by multiplying dividends per share retained ($0.021) by after tax return on equity (15% x (1 0.30) = $0.002205 = 0.22 cents.).
This shows that if the retained earnings can be reinvested to produce income at 15%, which is higher than the required rate of return of 8.4% post tax (12% pre tax), then the value of the shares rise from $1.00 to $1.09 each. If however the retained earnings can be reinvested to produce only 12% then the EPS growth is not 2.63% but 2.10% and thus the share value falls back to $1.00: Scenario C Assets Reinvested Return Pre Tax Return = Less Tax at 30% After Tax Return Earnings Per Share (EPS) Pay-out Ratio Dividend Per Share (DPS) Price (Per Share) Price Earnings Ratio EPS Growth () EPS Growth (%) 15% $120 $36 $84 $0.0840 100% 8.40% $1.00 11.9 $800 Scenario D1 $800 15% 15% $120 $36 $84 $0.0840 75% 6.30% $1.00 11.9 0.22 2.63% Scenario D2 $800 12% 15% $120 $36 $84 $0.0840 75% 6.30% $1.00 11.9 0.18 2.10%
Gordon dividend growth model
Dividend (Ke g) = Value $0.0840 8.40% 0% $1.00
$0.0630 8.40% 2.63% $0.0630 5.78% $1.09
$0.0630 8.40% 2.10% $0.0630 6.30% $1.00
Dilution effects can also be quite important. In Scenario B was an example where the number of EFPO shares was different from the number of ordinary shares fully paid. However, the effect of the change, as a result of the partly paid shares, was exactly proportional. This situation does not occur very often in practice. An example, again simplistic for ease of understanding of what can occur, is given in Scenario E below. Scenario E Number of Ordinary Shares Issued Par Value Paid To Equivalent Fully Paid Ordinary (EFPO) Shares Number: BALANCE SHEET Assets Tangible Liabilities NET ASSETS Net Tangible Assets (NTA) NTA Per Share (EFPO) PROFIT & LOSS Profit Pre Tax Less Tax at 30% Earnings (after tax) Earnings Per Share (EPS) DIVIDENDS Pay-out Ratio Dividends Per Share PRICE RELATED RATIOS Price (Per Share) Price Earnings Ratio Dividend Yield $1.00 6.5 11.45% $1.00 7.6 9.84% 75% $0.1145 75% $0.0984 $240 $72 $168 $0.1527 $135 $41 $95 $375 $113 $263 $0.1313 $2,000 Nil $2,000 $2,000 $1.82 $900 $2,900 Nil $2,900 $2,900 $1.45 1,100 900 2,000 Basic 1,000 $1 $1 Dilution Effects 1,000 $1 $0.10 Diluted
The column Dilution Effects shows the financial effects if the 90 cents outstanding on the partly paid shares is paid up so as to make all shares fully paid. Here it can be seen that the basic net tangible assets per share change from $1.82 to $1.45 and earnings per share change from $0.1527 to $0.1313. Furthermore, the dividends per share change by a similar margin. Assuming that a price of $1.00 is paid for a share then the dividend of $0.1145 equates to a yield of 11.45% based on current (basic) calculations. If, however, the partly paid shares are paid up in full and dividends are paid to those partly (now fully) paid shares, then the dividends payable per share would drop to $0.0984. This is despite the fact that the earnings rate on the assets from cash paid up for the partly paid shares may be at a greater rate (i.e. assume 15%) than the existing inherent earnings rate on existing assets (i.e. 12% as above). All other things being equal, the price per share, if it stays at $1.00, means that the dividend yield would drop.
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1100 Minority Holdings of Shares and Convertible Notes / 16~1430 Specific Issues affecting Valuation of Minority Holdings / 16~1450 Preference shares
16~1450
Preference shares
Preference shares, as the name implies, give the holder a preference over the holder of an ordinary share. That preference is normally related to dividends which may be fixed in amount and may be specified to be fully franked, partly franked or unfranked. As with partly paid shares, reference should be made to the companys articles of association for the particular terms of issue for these preference shares. Preference shares may be: paid as a fixed or variable dividend; cumulative or non-cumulative for dividends; voting or non-voting (or voting only in certain circumstances e.g. dividends in arrears); convertible into ordinary shares; and/or permanent or redeemable (if redeemable it is important to determine who can cause the redemption, when, and on what terms).
Preference shares have been used in the past as a financing mechanism. Often this is clearly evident from the terms of their issue, i.e. where shares are issued with a low nominal amount and a large premium, together with a fixed dividend, or a dividend related to a pre-determined interest rate, the chances are that the preference share issue is really in the nature of debt financing. The existence of a large premium on issue could suggest that the mechanism has been set up from the beginning for the redemption to occur (shares can only be redeemed out of a share premium account or out of a new issue of shares). A fixed date for redemption would also indicate that the shares issued were in the nature of a debt instrument. Preference shares however can, particularly in smaller companies, be genuinely in the nature of equity and be issued initially to shareholders who have a different risk return profile to the holders of ordinary shares. In this instance it is important to understand and appreciate the advantages and disadvantages for the preference shareholders over the ordinary shareholders if the valuation of the preference shares is to be logical and sound.
Subject to the terms of the issue of the preference shares and the current performance of the company, preference shares can thus be valued essentially on either a debt or equity basis. If they are valued in the nature of debt, then the valuation is of the income stream (including terminal value) discounted at the required rate of return required by an investor on investments with similar risk characteristics. If, however, the preference shares are in the nature of equity with no right of redemption, then the valuation should be based on the dividends to be received. In this case, however, the growth in those dividends could be limited and the scope for variations in valuation would be narrow. If there are conversion rights, then those conversion rights can be treated in the nature of an option and valued accordingly. In assessing preference shares, consideration should be given as to whether or not they can participate in new issues, as this can add value to the shares. Of fundamental importance in valuing preference shares is an assessment of the certainty of future dividends. In some instances, the existence of a preference share may indicate that the company had difficulty in issuing further ordinary shares because of uncertainty in future profits to service ongoing dividends to all ordinary shareholders. In recessionary times, this could in turn impact upon the payment of preference dividends. Conversely, some companies have issued preference shares as a low form cost of equity because their earnings are so strong that they can demonstrate a very high degree of confidence in paying preference dividends.
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1100 Minority Holdings of Shares and Convertible Notes / 16~1430 Specific Issues affecting Valuation of Minority Holdings / 16~1460 Partly paid/contributing shares
16~1460
Partly paid/contributing shares
Partly paid shares are normally issued in order to give the holders significant financial leverage. If there are 1,000 fully paid ordinary shares on issue paid to $1.00, then an investment of an additional $100 could be taken as either a further 100 shares of $1.00 or 1,000 shares of $1.00 paid to $0.10. The potential effects on issues such as control and locking into future value are dramatically different. If the fully paid shares subsequently rise to have a value of $2.00, then in the first instance the holder of 100 shares will have gained by $100 (100 shares x $1.00 increase in value of the share from $1.00 to $2.00) whereas in the second instance the investor of $100 will have seen an increase in their investment by $1,000 (1,000 shares x $1.00 increase in value of the share from $1.00 to $2.00 the uncalled liability of $0.90 per share being the same in both instances). (This ignores any differences in dilution effects because of the number of different shares on issue.) There are some obvious attractions in holding contributing shares. An obvious disadvantage is that in a limited liability company, the holder of contributing shares has an obligation to pay the calls as and when they are made and holders of partly paid shares can be pursued through the courts for their liabilities. Some attempts have been made to hold shares via interposed limited liability companies, however, some directors of interposed limited liability companies have been pursued on the basis that when the interposed company subscribed to the partly paid shares, the directors did not have reasonable grounds to believe that the interposed company could pay its debts as and when they fell due,
including the calls on partly paid shares. Not all these actions have been successful but they do point to an area of uncertainty and exposure. In the case of an Australian no liability (NL) company, if the calls are not paid then the shares are forfeited and the holder has no further liability. The dividend rights of partly paid shares are governed by the companys articles of association and these should be referred to in individual cases. Similarly, as discussed above, the voting rights should be carefully reviewed. Some companies will have a pre-defined call program, however, in many cases there is no set timetable for the partly paid shares to be paid up, and it is usually at the discretion of the directors. Not surprisingly, there are many instances of listed companies where the directors are the main holders of partly paid shares. Thus it can be seen that in some instances, contributing shares have option-like features, which can be called at the discretion of the directors (e.g. where there is no defined call program), and in other instances at the discretion of the contributing shareholders (e.g. as in the case of NL companies). An excellent article Valuing Contributing Shares by Robert L. Brown and Neville J. Hathaway appeared in the November 1991 issue of Accounting and Finance (the journal of the Accounting Association of Australia and New Zealand). This deals with the concept of contributing shares being in the nature of an option. The value of contributing shares is therefore dependent upon a number of factors, including, but not limited to: voting rights; rights entitlements; dividend rights; and the call program.
In addition, of course, the amount of the unpaid capital relative to the share price of the ordinary shares is of some importance. Where there is a pre-defined call program, the value of a partly paid share can be viewed as follows: Ordinary share price (i.e. for fully paid shares) less Net present value of calls to be made less Net present values of dividends forgone. Thus the holder of a partly paid share has the right to acquire a fully paid share in return for paying up the calls due, but must bear, in the meantime, the penalty of not receiving the same dividends as the fully paid shares. In some instances the amount of the dividend difference between an ordinary share and a fully paid share, particularly in mining companies, is very small. It can also be seen that if the call program is some distance into the future, or even undefined, that the net present value of the outstanding calls can be quite small. This is one of the reasons why the difference between the market prices of fully
paid shares and partly paid shares is much smaller than the amount of the unpaid capital between the two. A calculation of a valuation of partly paid shares follows: VALUATION OF PARTLY PAID SHARES IN A LIMITED COMPANY WITH A DEFINED CALL PROGRAM Cents Current Share Price as at 30 June 20x3 LESS Net Present Value of Calls to be Made Call due 31 December 20x3 Call due 31 December 20x4 Discounted at risk free rate of: Net Present Value of Calls to be Made LESS Net Present Value of Dividends Forgone Dividend due 30 November 20x3 Dividend due 31 May 20x4 Dividend due 30 November 20x4 Discounted at post-tax market rate applicable to similar equities: Net Present Value of Dividends Forgone VALUE OF PARTLY PAID SHARES 5 5 7 10% 16 143 50 50 7% 94 253
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1100 Minority Holdings of Shares and Convertible Notes / 16~1430 Specific Issues affecting Valuation of Minority Holdings / 16~1470 Convertible notes
16~1470
Convertible notes
As the valuation of a convertible note involves the valuation of an option, they are considered in a separate chapter, following the valuation of options.
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1520 References

16~1520 1. 2.
References
Brown, Robert L. and Hathaway, Neville J. Valuing Contributing Shares, November 1991, Accounting and Finance (the Journal of the Accounting Association Australia and New Zealand) Pratt, Dr. Shannon, Guide to Business Valuations, 2nd edition, July 1992, Practitioners Publishing Company, Fort Worth, Texas
VALUATION ISSUES / 16~1000 Valuing Minority Interests / 16~1520 References / Acknowledgment

Acknowledgment
Figure 4 from Levelling with You About the Levels of Value is reproduced with permission from Mercer Capital.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes

17~1000
Valuing Options and Convertible Notes
This chapter considers the value of options over unissued shares and sets out the fundamentals on which they are valued. Options over issued shares (exchange traded options ETOs) are not considered, although the basic premises apply. For an example, refer to the Independent Experts Report on eFinancial Capital Limited.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options
17~1050
An Introduction to Options
An option represents the right, but not the obligation, to acquire shares at a future date on known terms and conditions determined by the issuer of the option. An option has value because the option holder is able to exercise the option prior to or on expiration if circumstances are such that exercising the option would be more advantageous than allowing the option to lapse. Much of the discussion in this chapter can be applied (with minor modification) to securities such as convertible notes and warrants. Convertible notes can be viewed as a security comprising two components one component is a fixed interest security, the other component is an option (namely, the right, but not the obligation, to convert to shares). The principal differences between options and the underlying share are that an option does not bear interest or dividends until the right to acquire shares is exercised. Wherever there is an option embedded in a security there will be additional value. It is this additional value which is considered in this section. Options do not appear in the companys general ledger except in the circumstance where the options are issued for other than nil consideration (whereupon there will be an account styled along the lines of option premium reserve). Like convertible notes, options will, in all likelihood, have a value to the holder which is in excess of their intrinsic value. This additional value is likely to be in the form of time and volatility values. However, the time value and volatility value are affected by the following factors: the time to expiration of the options; the current riskless rate of return (e.g. 10 year bond rate); whether the underlying shares continue to be (or are) listed; and
underlying business factors affecting the volatility of share prices.
The ultimate intrinsic value will, to a large extent, determine the likelihood of the options being exercised. In turn, this will impact upon the valuation of the company. If the options are exercised, new cash will come into the company in return for additional scrip being issued. The additional scrip will have a dilution effect, but the new cash will increase the net asset backing and earnings capacity of the company. As with convertible notes, if there is uncertainty as to whether the options will be exercised it is best to consider the valuations as two scenarios with and without option exercise. Care should be taken when assessing a valuation based on the exercise of options as the new cash will either cause an increase in earnings (in the simplest scenario this will occur through interest receipt on the cash deposited) or debt reduction. Earnings and/or cash flow effects will flow through accordingly. Option valuation methods can also be employed to assess specific growth opportunities and alternatives available to a company. For example, if a new product is available to a pharmaceuticals company by expending $5 million on research and development, the present value of the resultant cash flows can be viewed as the underlying share price and the research and development expenditure as the exercise price. The cash flows associated with the new product can then be valued as a call option which the company may (or may not) exercise. Whilst this method has some appeal, it is infrequently used. For this reason we have focused on the methods for valuing options over unissued shares in this chapter. However, the concepts associated with the valuation of real options are beyond the scope of this text.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1070 Components of Option Value
17~1070
Components of Option Value
As mentioned above, an option represents the right, but not the obligation, to acquire shares at some predetermined future date on terms and conditions which have already been established at the time of acquiring the option. Thus, an option can be viewed as a contingent asset without any corresponding liability. To enable the valuation of an option to be followed through relatively easily, it is useful to break the valuation into component parts. The value of an option is principally determined by four factors: intrinsic value; time value; volatility value; and present value of dividends forgone.
A fresh options issue is often priced such that there is no intrinsic value (the difference between share price and exercise price) but significant time and/or volatility value arises from the deferral of the exercise to some future date. Simplistically, the value of an option could be looked at as:
Option Value = Share Price Exercise Price (Intrinsic Value) For example, the intrinsic value of an option with an exercise price of $1.00 and an underlying share price of $1.75 is: = $1.75 $1.00 = $0.75 However, this does not include the time value associated with the deferral of the purchase (exercise price). By applying the time value factor (discount factor) to the exercise price one has: Option Value = Share Price (Exercise Price x Discount Factor) (Time Value and Intrinsic Value) For example: at a discount rate of 10% p.a. and three years to expiry, the present value of the exercise price is $1.00/1.10^3 = $0.75. Thus, the time value of the option is $1.00 $0.75 = $0.25 and the value of the option is calculated as follows: = 1.75 (1.00/1.10^3) = 1.75 .75 = 1.00 Thus, the combined intrinsic and time value of the option ($1.00) can also be calculated by adding intrinsic value of $0.75 to the time value of $0.25. However, this does not allow for a value for the volatility in the share price of the underlying stock. To do this it is necessary to add volatility factors for the share price and the exercise price, namely: Option Value = (Share Price x N(d1)) (Exercise Price x (Discount Factor) x N (d2)) (Time, Intrinsic and Volatility Value) As this is a more detailed calculation we have set out an example in the section on option valuation methodologies. This is the basic premise of the Black-Scholes model for pricing options. The Black-Scholes model solves for d1 and d2. Option holders forgo the dividends that are payable to ordinary shareholders. Accordingly, the value of an option should be reduced by the present value of the likely dividends payable to shareholders over the life of the option. Hence: Option Value = Share Price x (d1) (Exercise Price x Discount Factor) x (d2) (Present Value of Dividends Forgone) (Time, Intrinsic and Volatility Value less Present Value of Dividends Forgone) The probability that the share price will exceed the exercise price of an option is related to each of the components.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1070 Components of Option Value / 17~1075 Accounting Standards
17~1075
Accounting Standards
Accounting standard AASB 2: Share-based Payments takes effect in Australia for periods beginning on or after 1 January 2005. This standard outlines the accounting treatment for share-based payment transactions (including shares and share options) in an entitys financial statements. Paragraph 17 states: If market prices are not available, the entity shall estimate the fair value of the equity instruments granted using a valuation technique to estimate what the price of those equity instruments would have been on the measurement date in an arms length transaction between knowledgeable, willing parties. The valuation technique shall be consistent with generally accepted valuation methodologies for pricing financial instruments, and shall incorporate all factors and assumptions that knowledgeable, willing market participants would consider in setting the price (subject to the requirements of paragraphs 1922). Further, Appendix B paragraph 6 states: All option pricing models take into account, as a minimum, the following factors: (a) (b) (c) (d) (e) (f) the exercise price of the option; the life of the option; the current price of the underlying shares; the expected volatility of the share price; the dividends expected on the shares (if appropriate); and the risk-free interest rate for the life of the option.
For further information, refer to <www.aasb.com.au>. On 30 June 2003, ASIC released final guidelines on how Australian listed companies should include the value of options as part of directors and executive officers emoluments in their annual directors reports for reporting years ending on or after 30 June 2003. As ASIC Media Release MR 03/202 notes: All listed companies are required to comply with their obligations under s 300A(1)(c) of the Corporations Act 2001 (Act). The guidelines cover the valuation methods to be applied, as well as when to include option values for the purpose of emolument disclosures. ASIC has drawn on the International Accounting Standards Boards Exposure Draft ED 2 Share based payment (ED 2), which provides an appropriate basis for valuing options and allocating their value over time.
The ASIC guidelines require the options to be valued at the time they are granted and then to have that value apportioned over the period from grant date to vesting date. The options must be valued at market if they are listed, or by a valuation method that meets the requirements of ED 2 and ED 108 and the method chosen should be disclosed in the directors report. The guidelines do not deal with the expensing of options or other share based-payments in the financial statements. This matter will be resolved by the issue of a final accounting standard by the Australian Accounting Standards Board. The disclosure in the directors report is a Corporations Act 2001 disclosure requirement that is not covered by Accounting Standards. The guidelines are available on ASICs website at <www.asic.gov.au>. An article by Michael Mileo, Senior Adviser at Leadenhall Australia Limited, entitled Establishing an appropriate fair value for executive options Disclose now, and plan for expensing, which was published in the August 2003 issue of The Finance and Treasury Professional, covers ASIC guidelines and the issues attached to them.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1070 Components of Option Value / 17~1080 Intrinsic value
17~1080
Intrinsic value
If an option can be exercised for less than the equivalent price of the underlying share, it has intrinsic value. For example, if an option has an exercise price of $1 and the underlying share is trading at $1.20, one would be prepared to pay up to 20 cents in order to exercise the option and thus gain a share with a value of $1.20 (assuming the option can be immediately exercised and the underlying share sold for $1.20). In calculating the intrinsic value, particular attention should be given to the exercise terms of the options. There may have been, for example, bonus issues of shares since the original issue of the options. The extent of the participation of the options in such a bonus issue needs to be determined and the underlying share price adjusted.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1070 Components of Option Value / 17~1090 Diagram Intrinsic value of an option
17~1090
Diagram Intrinsic value of an option
In calculating the intrinsic value, reference should be made to the share price and not the underlying value of the share which may be calculated by valuing the company as a whole and dividing it by the number of shares. This is because the value of an option is calculated by valuing the option as if it were converted into a share at the shares current price. Furthermore, the volatility calculations are related to the volatility of the share price, so it would be inconsistent to use volatility value related to share price and intrinsic value related to underlying value. Special considerations apply for unlisted shares. Similarly, any dilution of underlying value which may occur through the exercise of options is not allowed for. To the extent that the market is a perfect market, it can be argued that share prices make allowances for any dilution effects which can occur through the exercise of options. Furthermore, companies typically have relatively few options on issue relative to the number of ordinary shares on issue (although there are obviously some exceptions to this). The dilution effects (on value per share and dividends per share) are therefore typically relatively minor.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1070 Components of Option Value / 17~1100 Time value
17~1100
Time value
There are two parts to the time value of an option. The first part relates to the discounted value of the exercise price over time. Given that the exercise price is pushed further away in time then the cost of exercising becomes smaller in discounted terms. Therefore, the value of the option increases. As the name suggests, the time value of an option decays as the time to expiry advances. This is demonstrated in the following diagram.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1070 Components of Option Value / 17~1110 Diagram Time value of an option
17~1110
Diagram Time value of an option
Together, the intrinsic and time values of an option can be viewed as follows, with relevant data outlined in the table below.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1070 Components of Option Value / 17~1120 Diagram Time and intrinsic values of an option
17~1120
Diagram Time and intrinsic values of an option
Year 0 SHARE PRICE EXERCISE PRICE Intrinsic Value Time Value 7% Total Option Value 80 50 30 14.35 44.35
Year 1 72 50 22 11.86 33.86
Year 2 78 50 28 9.19 37.19
Year 3 76 50 26 6.33 32.33
Year 4 87 50 37 3.27 40.27
Year 5 89 50 39 0 39
Yr 0 Time Value = 50 (50/1.07^5) = 14.35 Yr 1 Time Value = 50 (50/1.07^4) = 11.86 Yr 2 Time Value = 50 (50/1.07^3) = 9.19
The second part relates to the volatility of the underlying share over time. The longer the term to expiration the greater the probability that a shares volatility will cause it to reach a high price.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1070 Components of Option Value / 17~1130 Volatility
17~1130
Volatility
Volatility value represents the amount which an option is worth purely by virtue of the probability that the share price will exceed the exercise price at some time over the options life. Shares which are not traded on the stock exchange do not give rise to a volatility value. Options over such shares have, therefore, only intrinsic and time values unless there is an active secondary market other than a stock exchange (e.g. an unlisted company where there is significant trading of the companys shares between members). The higher the variability in the price of the underlying share, the higher the value of the option. This is because there is a greater opportunity for the share price to exceed the exercise price more frequently during the life of the option. This gives the option holder greater opportunity to exercise the option (thereby acquiring the share), and realise the value of the underlying share profitability. Options over a high volatility share sell for more than options over a low volatility share (all other things being equal). Furthermore, it follows that the volatility and time value components of an options worth are interrelated: the longer the time to expiration, the greater the value of the option; and the higher the volatility, the greater the value of the option.
Accordingly, a short-dated option over a share with a high volatility will have less value than a long-dated option over the same share. Similarly, an option over a low volatility share will have a lesser value than an option over a high volatility share (assuming that both options are for the same period). The following chart shows the volatility value calculated using the Black-Scholes option pricing model. The key assumptions made are: an exercise price of 50 cents; a discount rate of 7% p.a. (fixed); share price volatility of 50% p.a. (fixed); and share prices of 80 cents (on issue), 72, 78, 76, 87 and 89 cents at the end of each year to expiry.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1070 Components of Option Value / 17~1140 Diagram Volatility value
17~1140
Diagram Volatility value
The intrinsic, time and volatility values can then be combined to form the following chart (using the same assumptions as previously).
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1070 Components of Option Value / 17~1150 Diagram Intrinsic, time and volatility value
17~1150
Diagram Intrinsic, time and volatility value
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1070 Components of Option Value /
17~1160 Diagram Effects of time and volatility on option price (days 0 60)
17~1160
Diagram Effects of time and volatility on option price (days 0 60)
To illustrate the determinants of time and volatility on the option price consider the following graphs which show a random walk (constrained to a price range of 25 to 80 cents) around a 50 cent share price.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1070 Components of Option Value / 17~1170 Diagram Effects of time and volatility on option price (days 40 60)
17~1170
Diagram Effects of time and volatility on option price (days 40 60)
(The graphs were generated using random number generating capabilities. The data was generated using the boundaries of 25 cents for the lower limit and 80 cents for the upper limit. The inclusion of the $1.00 figure was to illustrate a possible one-off increase in actively traded stocks.) The graphs clearly illustrate that the longer the time frame, the greater the probability that the exercise price will be exceeded by the share price.
In the first graph the volatility of the stock determines the swings in the share price. The longer the time frame the more swings there are and thus the higher the probability that the share price will exceed the exercise price, and accordingly the greater the option price. The second graph illustrates that with a reduction in time the probability of a high price declines, thus one would expect the option price to decline, all other things being equal. Another matter which must be taken into consideration is that share price volatility fluctuates over time due to the impact of market forces. By its very nature, the volatility of a share is not static over time. Numerous events can affect a share prices volatility. These include: the announcement of a take-over offer either for the company or by the company; the announcement of changes in business strategy or future direction by the company; the announcement of asset purchases or asset disposals; speculation by share traders; temporary suspension of the company from the stock exchange; or external influences such as currency volatility, commodity price volatility and stock market conditions generally.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1070 Components of Option Value / 17~1180 Present value of dividends forgone
17~1180
Present value of dividends forgone
As options do not (normally) attract any dividend rights or other income attributes (unlike a convertible note), the dividends forgone by an option holder reduce the value of the option. As a shareholder, you would become entitled to the dividends that are paid on those shares. As an option holder, no dividends are receivable. Accordingly, in considering an options value, the present value of all dividends forgone over the life of the option is deducted from the intrinsic, time and volatility value as previously calculated. Using the data from our previous charts but introducing dividends on the anniversary of the option issue date of 4, 5, 6, 7 and 8 cents, the value of the dividends forgone (discounted at 7%) is shown in the following chart.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1070 Components of Option Value / 17~1190 Diagram Value of dividends forgone
17~1190
Diagram Value of dividends forgone
When overlaid on the previous calculations of the time, intrinsic and volatility values, the option value is severely reduced, as demonstrated in the following diagram.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1070 Components of Option Value / 17~1200 Diagram Option value less dividends forgone
17~1200
Diagram Option value less dividends forgone
Note that no adjustment has been made to the underlying share price for fluctuations resulting from dividend expectations and payments. In reality, share prices build in future dividend expectations and fall by an amount approximating the dividend payment immediately upon dividend payment.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1070 Components of Option Value / 17~1200 Diagram Option value less dividends forgone / Discount rate
Discount rate
There is a school of thought which suggests that the discount rate applied to calculate the present
value of future dividends forgone should be the equivalent of the cost of equity capital for the company. The use of the cost of equity capital figure as the discount rate for this portion of the option valuation will increase the value by virtue of reducing the value of the dividends forgone. We favour the use of a risk-free discount rate for the following reasons: Exercising the option into the underlying share is reliant on having the necessary cash available to do so. This cash will be earning a rate closer to the risk-free rate than the equity rate. Hence, the opportunity cost of the funds used to exercise the option will be the risk-free rate. Empirical evidence suggests that the Black-Scholes option pricing model tends to over-value the majority of options over unissued shares and the use of an equity discount rate will serve to increase this over-valuation. Mercer Capital analyses seven factors which cause this over-valuation and modify the Black-Scholes model for their Mercer Capital option pricing model accordingly. These are: delayed vesting; longer maturity for the employee options; the possibility of forfeiture; non-transferability; dilution; volatility estimates; and whether the stock received upon exercise of the employee options is registered and subject to Rule 144 holding periods.
For more information, refer to The Mercer Capital Option Pricing Model by Jean E Harris, in Money For Nothing, Volume 2003, No. 03, 21 May 2003, which can be accessed on < www.mercercapital.com>. Adopting the risk-free rate as the basis of calculating the time value implies that the alternative return available to an investor is no greater than the risk-free rate. Utilising a higher discount rate would increase the time value of the option. However, use of the risk-free rate is commonly accepted. Investors also need to keep in mind that, like share price volatility, interest rates change over time. Accordingly, option values change depending on increases or decreases in the risk-free rate. It is commonly accepted practice to utilise a point-estimate of the risk-free rate in determining the time value of options.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1220 Option Terms and Conditions
17~1220
Option Terms and Conditions
Options are frequently structured with differing rights and entitlements which affect the value of the option. Of particular note are differing provisions relating to entitlements to bonus issues, rights issues, capital reconstructions and changes in the underlying value of the shares (anti-dilution provisions).
An option which contains extensive anti-dilution provisions will be worth more than an option which contains no such provisions in the event of a bonus, rights or other issue or capital reconstruction by the company.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1240 Valuations of Options over Unlisted Shares
17~1240
Valuations of Options over Unlisted Shares
Unlisted shares, by their definition, are not traded on a stock exchange and thus there will be relatively few references for prices where shares have changed hands. Thus whilst it can be argued that there should be a component of volatility in the valuation of an option, it is difficult (if not impossible) to calculate this value according to a standard formula. The volatility value therefore becomes a matter of judgement and each case will be determined on its individual circumstances. In addition, however, there will be the important considerations of: underlying value or value per share; and dilution effects.
In other words, if a share price does not incorporate reference to the above factors (i.e. intrinsic value, time value etc.) it is then critical to calculate the effects of these factors. The underlying value or value per share refers to calculating what the true intrinsic value might be. The method for determining a value per ordinary share into which the options can be exercised is set out in earlier chapters. Furthermore, in calculating the value per share, pre and post exercise of options, consideration needs to be given to the effects that other securities on issue might have upon the value per share. For example, if there are convertible notes on issue and they come up for conversion prior to the exercise of the options, then the dividend stream per share will be changed as well as the underlying value per share. The dilution calculations and adjustments to underlying value parallel those set out in the previous chapter on valuing minority shareholdings. Similarly, in determining the value per share to be derived, consideration needs to be given to the size of the holding and whether the resultant shares from the exercise of the option are to be considered a minority interest and valued accordingly, or will form part of a controlling stakeholding.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1260 Option Valuation Methodologies
17~1260
Option Valuation Methodologies
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1260 Option Valuation Methodologies / 17~1270 Present value method
17~1270
Present value method
The present value method of option valuation does not take into account volatility of the underlying share price or other matters raised earlier. It simply takes into account the intrinsic value and time value of the option. It is therefore of limited use, but can be useful as a broad estimate.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1260 Option Valuation Methodologies / 17~1280 Black-Scholes method
17~1280
Black-Scholes method
The Black-Scholes option pricing model (B-SOPM) takes into account the time value, intrinsic value and volatility value of the option. Mathematically it is represented as follows: C = SN(d1) Xe-rtN(d2) Where: d1 = ln(S/X) + (r + 2/2)T T
d2 = d1 T And where: C S X R T ln e = = = = = = = = Current option value Current stock price Exercise price Risk free interest rate Time to maturity of option in years Standard deviation of the annualised continuously compounded rate of return of the stock Natural logarithm function The base of the natural logarithm, or 2.71828 The probability that a random draw from a standard normal distribution will be less than d The appropriate discount factor for period T at rate r. Thus, Ce-rT is the present value of C.
N(d) = e-rT =
All of the above variables are largely contingent on external factors or the underlying share price with the qualifications set out in the section on components of option value kept in mind.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1260 Option Valuation Methodologies / 17~1280 Black-Scholes method / Utility of the B-SOPM
Utility of the B-SOPM
Empirical evidence suggests that the B-SOPM diverges from observed market prices where the option
is deep in the money or deep out of the money (i.e. very high or very low intrinsic values). Care should be taken in evaluating the outcome using the B-SOPM in such situations.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1260 Option Valuation Methodologies / 17~1280 Black-Scholes method / Critical assumptions underlying the B-SOPM
Critical assumptions underlying the B-SOPM
The B-SOPM was developed using some fundamental and critical assumptions. Whilst the model is reasonably robust in real world applications, acknowledgement of the assumptions is important in certain circumstances. The assumptions are: the option is only capable of exercise on expiry (this is a limiting factor on the value of the option); there are no margin requirements (not applicable to options over unissued shares), taxes or transaction costs; the underlying shares do not pay dividends during the life of the option; the risk-free interest rate does not change during the life of the option; there is continuous trading in the underlying shares; share prices approximate a log-normal distribution; and the underlying share price volatility remains constant during the life of the option.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1260 Option Valuation Methodologies / 17~1290 Binomial option pricing model
17~1290
Binomial option pricing model
In very simple terms, the Binomial option pricing model (BOPM) utilises probability theory to determine the value of an option based on likely share prices at the options expiry date. The BOPM can be seen to emulate potential share price movements in a manner similar to the share price variance or volatility approximations used in the B-SOPM. The BOPM utilises probability theories to replicate the random walk processes of a share price between the date of valuation and the expiry date. For shares not paying any dividends, the use of 18 30 periods in the BOPM produces prices that are within cents of the B-SOPM. The basic BOPM formula is as follows: Call (option) Value = (Discounted Value of Final Pay Offs) x (Hedging Probabilities) Whilst the BOPM does not require an estimate of the probability of likely movements in the share price, it does require a measure of the volatility of the share (as does the B-SOPM). Accordingly, the same inputs as are required for the B-SOPM are used in the BOPM, namely, current share price, standard deviation of the share price, exercise price of the option, the risk-free rate, timing and value
of expected dividends. Research indicates that the BOPM is rarely used in Australia and that, where a sophisticated model is used, it is commonly the B-SOPM.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1260 Option Valuation Methodologies / 17~1300 Empirical method
17~1300
Empirical method
A rough rule of thumb valuation method is to compare the value of options relative to the underlying shares with similar options and shares in other companies of a similar nature. This is normally conducted over a period of (say) 12 months share and option trading. It is important to compare like with like particularly key aspects such as time to expiry and exercise rights. It can often be difficult to find other options or shares with similar fundamental terms to those being valued. This method may only be used legitimately when there is significant trading on the stock market of both the companys shares and options over its unissued shares. In a market which is thinly traded or subject to any form of unusual activity or speculation, the empirical method of valuation should not be adopted.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1050 An Introduction to Options / 17~1320 Profitability and Cash Flows
17~1320
Profitability and Cash Flows
Ultimately, the value of a companys shares (and thus the options over unissued company shares) is determined according to the profitability and cash flows earned by the company. Where the profitability or the cash flow earning ability of the company is declining, the share market (by virtue of information provided by the company to the market) will systematically reduce the value of the companys shares to reflect the lower earnings capacity of the company. Correspondingly, the value of options over unissued company shares will reduce in value. Conversely, where the companys earnings power or cash flow earning ability is increasing, the share market will reflect this increased earning power in the share and option prices. This will also occur when the company announces changes in activities which will result in a likely increase in earnings or cash flow. A strategy which is sometimes adopted by take-over targets when the bidder has achieved control of the ordinary share capital, is to have a significant bonus or rights issue in order to dilute the option holder and to put pressure on the option holders to exercise their options. The purpose of such an issue is to increase the number of ordinary shares on issue whilst, at the same time, reducing the entitlement of the option holder and therefore the value of the underlying option. However, where the options have significant anti-dilution provisions (and many options do), a bonus or rights issue will not create the same reduction in value to the option holder.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes /

17~1370 Convertible Notes

17~1370
Convertible Notes
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1370 Convertible Notes / 17~1390 Nature of Convertible Notes
17~1390
Nature of Convertible Notes
A convertible note is a loan to a company with the right to convert that loan into other securities of the company. Convertible notes can be secured or unsecured, although normally they are unsecured. The conversion is normally into fully paid ordinary shares of the company. However, as with partly paid shares and preference shares, reference should be made to the specific terms of the convertible notes issue. The ability to convert into ordinary shares is at the discretion of the holder of the convertible note. Typically, in return for the right to convert into ordinary shares (and if not exercised a convertible note is paid out at maturity) the holder of a convertible note will usually take a lower interest rate than would be required for ordinary debt. Conversion is normally at pre-defined dates or upon maturity. Normally provisions also exist for conversions to occur if a take-over bid is made for the company. However, compulsory acquisition provisions and protections may apply to convertible notes so conversion does not necessarily have to occur in order to obtain any increased share price as a result of a take-over offer. There have been instances where convertible notes were issued with a high coupon (interest) rate; if a company has to issue such securities then, all other things being equal, there may be cause for concern about the financial stability of the company. Other factors relating to convertible notes (and also to options) include: as convertible notes are not voting shares, take-over bids do not need to include convertible notes (except in cases of compulsory acquisition); frequently, convertible notes have a value in excess of the intrinsic value, by virtue of time and volatility factors, thereby increasing their value to the holder; and taxation considerations across different types of taxpayer can affect shareholder investment choices between shares and convertible notes (e.g. charitable institution versus superannuation fund versus higher marginal taxpayer).
These issues relate principally to the position of individual note holders rather than the position of the company as a whole. In take-over situations, the likelihood of the conversion of convertible notes to gain voting shares in a company is often decreased by taxation and other considerations relating to notes and options.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1370 Convertible Notes / 17~1410 Components in the Valuation of Convertible Notes
17~1410
Components in the Valuation of Convertible Notes
A convertible note has two major components to it: a fixed interest component; and
an option component.
In valuing convertible notes, a valuation needs to be undertaken of the: cash flow stream receivable from interest income and redemption of the convertible note; and value of the option to convert into ordinary shares.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1370 Convertible Notes / 17~1430 Methods of Valuing Convertible Notes
17~1430
Methods of Valuing Convertible Notes
There are two methods of valuing convertible notes: assuming the note converts into shares; and component valuation method.
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1370 Convertible Notes / 17~1430 Methods of Valuing Convertible Notes / 17~1440 Conversion to shares method
17~1440
Conversion to shares method
Where conversion is bound to occur because the conversion terms are such that it would be disadvantageous to redeem the convertible note, either because the dividend income receivable is much greater than the interest income receivable (on an equivalent after tax basis) from the convertible note, and/or the resultant shares obtained from the notes conversion could be sold for more than the net present value of the cash flow from dividends plus redemption of the convertible note then it is more appropriate to value the convertible note on the basis of: the value of the shares into which the convertible note could be converted; plus the net present value of the interest payment (net after tax) receivable on the convertible note until conversion; less the net present value of the dividends (net after tax) which would be receivable on the shares into which the conversion notes could be converted until the conversion date.
The adjustments should be made to the income streams on a net after tax basis so as to compare like with like. This means that there can be differences between holders of convertible notes as to their preference to convert or not convert, depending on their tax position. The calculation of the net present value of the interest income and dividend streams needs to use the appropriate discount rates applicable to an investor investing in securities exhibiting similar risk characteristics. An example of a calculation of the valuation of convertible notes follows. It should be noted that a simplifying assumption is employed whereby redemption of the note occurs at expiration, and conversion into the underlying share can occur at any time. In practice this does not always occur (e.g. conversion sometimes occurs at half-yearly intervals).
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1370 Convertible Notes / 17~1430 Methods of Valuing Convertible Notes / 17~1450 Diagram Valuation of convertible notes
17~1450
Diagram Valuation of convertible notes
Valuation of a Convertible Note with a Coupon Rate of 10% (pre-tax), 1 for 1 Conversion and a Face Value of $3.80 Cents Value of Underlying Shares as at 30 June 20x3 PLUS Net Present Value of Interest Receivable (Post-Tax) Interest due 31 December 20x3 Interest due 31 December 20x4 Discounted at post-tax market rate applicable to similar debt securities: Net Present Value of Interest Receivable LESS Net Present Value of Dividends Forgone Dividend due 30 November 20x3 Dividend due 31 May 20x4 Dividend due 30 November 20x4 Discounted at post-tax market rate applicable to similar equities: Net Present Value of Dividends Forgone VALUE OF CONVERTIBLE NOTE 22 25 22 10% 63.27 402.5 22 22 5.36% 41.77 424.00
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1370 Convertible Notes / 17~1430 Methods of Valuing Convertible Notes / 17~1460 Component valuation method
17~1460
Component valuation method
The other method of valuation of convertible notes, normally called the component valuation method, is to value: the debt instrument; plus the conversion option.
The value of the debt instrument needs to take into account alternate market rates for a loan of the maturity and risk profile of the convertible note. It can be that if the convertible note was issued at, say, 10% for ten years and market rates have since moved to, say, 15% for ten years, then the value of the convertible note would have dropped
significantly below par so as to compensate the holder for the change in market rates. The value of the option to convert can be calculated in terms of a normal option. An example of the valuation of a convertible note using the component valuation method follows. Valuation of Convertible Note by Component Method using Black-Scholes Option Pricing Model for Option Component Valuation of Debt Instrument Interest receivable 31 December 20x3 Interest receivable 31 December 20x4 Principal receivable 31 December 20x4 Present value at after tax market rate for equivalent securities of Value of Debt Instrument = 347 cents Pre-tax Cents 33 33 330 Post-tax Cents 22 22 330 5.36%
Valuation of Option Black-Scholes formula: Value where d1 and d2 = = = pN(d1) se^rt.N(d2) (ln(p/s) + (r + (v^2)/2)t)/(v(t^0.5)) d1 v(t^0.5)
Inputs: p = share price net of present value of expected future dividends = share price less pv of future dividends p = net share price s = exercise price t = time to expiry r = risk-free rate v = volatility Thus, d1 = (ln(3.61/3.3) + (.08 + (.2^2)/2)1.5)/(.2(1.5^0.5)) d1 = 0.98 d2 = d1 .2(1.5^0.5) d2 = 0.73
424 cents
63 cents = = = = = 361 cents 330 cents 1.50 years 8.00% p.a. 20.00% p.a.
N(d1) = 0.8770 N(d2) = 0.8212 Therefore, Value = pN(d1) se^rtN(d2) Value = (361 x 0.8770) (330 x e^(.08 x 1.5) x 0.8212) Option value = 76.25 cents Total Value of Convertible Note: Debt instrument: Option: Total Value of Convertible Note 347 76 423
VALUATION ISSUES / 17~1000 Valuing Options and Convertible Notes / 17~1370 Convertible Notes / 17~1480 Effect of Convertible Notes on the Valuation of a Company
17~1480
Effect of Convertible Notes on the Valuation of a Company
Prior to conversion, the convertible note is a debt instrument and should be treated accordingly. However, as the prospect of conversion increases (i.e. the share price equivalent into which the note is convertible increases above the redemption value of the note), the convertible note can be treated as either debt or the equivalent value of equity. In many cases the valuer may be unable to assess the correct scenario (i.e. as to whether the notes should be treated as debt or equity) and should arrive at a valuation with two scenarios. In one case there will be an interest charge payable on convertible notes and in the alternative there will be no interest charge and no debt. This has implications for both capitalisation of earnings and discounted cash flow valuations. Not only does the number of shares on issue alter but the price earnings ratio or discount rate will change depending on whether the convertible note is treated as debt or equity.
VALUATION ISSUES / 18~1000 Particular Valuations

18~1000
Particular Valuations
Not all valuations neatly conform with the general requirements of valuation approaches discussed earlier in this text. This chapter deals with particular valuation assignments which may be considered different to those encountered on a more day to day basis and addresses the issues which require consideration in such circumstances. This chapter will discuss projects and resource valuations, start-up and technology based valuations and the valuation of intangible assets such as brand names and trade marks.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1050 Valuations for the Mining Industry
18~1050
Valuations for the Mining Industry
When asked to value a project or a resource activity, a key question that needs answering is how to regard site costs and sunk costs, i.e. those already expended. If one is working on a cash flow basis then past (sunk) costs are ignored as the value being determined is the net present value of future cash flows; if past costs have a value (realisable, resale or salvage) this will show as a cash inflow in the later stages of the project. If the project is to be considered on an earnings basis because of the very long project life then the capitalisation of earnings will embrace those sunk costs. Alternatively, if one is looking at a pioneering project which has incurred significant research and development costs and has the potential to be sold then the alternative offeror concept will embrace the sunk costs. Sunk costs and research and development expenditure become important when apportioning a valuation amongst its component parts. A parallel can be drawn between the methods which should be employed in valuing mineral resources and those employed in assessing the marketability and ultimate revenue generation of a new product. The process for determining the marketability and revenue generation capacity of a new product is to: assess the geographic and demographic qualities associated with the expected market of the product; determine the ultimate expected market penetration; determine the lead time to obtain that level of market penetration;
and so on, such that ultimately the dollar value of sales, expenditure and cash flow can be assessed. In many cases, valuers have little knowledge or expertise in terms of assessing the prospects of exploration tenements. For this reason, it is essential to obtain from a qualified geologist an assessment of a range of likely resource finds within the tenements being valued using a similar method to the market research method outlined above. This at least gives the valuer a basis upon which to assess the blue sky element of the mine, even if it involves a large variation between the lower and upper range of valuations.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1050 Valuations for the Mining Industry / 18~1090 Appropriate Valuation Methods
18~1090
Appropriate Valuation Methods
In previous chapters on business valuation methods, we have discussed that the most appropriate valuation method for projects and resource valuations is likely to be a discounted cash flow methodology. The reasons for this include: the projects do not have infinite lives; the projects typically involve significant initial capital expenditure;
the projects may have unstable income and profitability profiles; and the projects may involve significant capital expenditure towards the conclusion of the life of the project.
As always, the main constraint will be the availability of detailed long-term cash flow projections.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1050 Valuations for the Mining Industry / 18~1110 International Standards for Resource and Reserve Reporting
18~1110
International Standards for Resource and Reserve Reporting
On an international level there are increasing calls to produce international standards for the reporting and/or valuation of mineral resources and reserves. The article below summarises the progress that has been made in the development of such standards.
INTERNATIONAL ASPECTS OF RESOURCE AND RESERVE REPORTING STANDARDS

JEAN-MICHEL RENDU, Vice President, Resources and Mine Planning Newmont Mining Corporation, Member CMMI International Definitions Group Abstract International standards to estimate and report exploration information, mineral resources and mineral reserves, are an essential requirement for improved communications. A review of worldwide historical developments show that considerable progress has been made toward reaching such standards. However, much additional effort is needed to ensure that truly international standards are agreed on, and that such standards are accepted, followed, and understood by all entities that have a stake in the mining industry. Recommendations are made outlining steps to be taken to reach international agreement. Need for International Standards The mining industry has long recognised the need for international standards as a way to improve communications both within the industry and with stakeholders outside, but linked to the industry. Miners require significant capital to generate wealth from exploitation of mineral resources. Investors, who can make the necessary funds available, are looking for assurance of quality and the best opportunities. National and international organisations are concerned with the socio-economic and environmental impact of mining operations. Governmental agencies put in place and enforce rules and regulations to reach specific political or economic objectives. International standards are needed to create a common language, facilitate communications, and improve the quality of the information being released. Such standards are a minimum requirement if rational decisions are to be made on the basis of well-understood information. Miners need a means to describe what they have discovered, and the value of their discovery, while investors, community leaders, international agencies and regulators must understand the representation made by the miners, and must have reason to believe and have confidence in the information they are given. National standards have long existed. These limited standards were sufficient when mining companies based in a given country sought funds only from the same country, and the
international regulatory environment was somewhat more lenient than it is now. But internationalisation of the world mining industry has exponentially increased the need for effective means of communication. A mine located in Siberia may be operated by Russian geologists and engineers, managed by a mining company based in the United States, and funded by international banks from Germany and the United Kingdom, as well as investment banks representing mutual funds from Ireland and France and private investors from Australia. The same mine will be subject to Russian regulations while having to follow international environmental regulations, and being carefully monitored by a number of international nongovernmental agencies. Only if meaningful international standards are available and enforced can any of the parties involved make sound decisions concerning their participation in the project. Figure 1: Development of International Standards Historical Highlights Date September 1994 November 1996 Place Sun City, South Africa Geneva, Switzerland Event First Meeting of the CMMI International Resources/Reserves Definitions Group Publication of the United Nations International Framework Classification for Reserves/Resources Solid Fuels and Mineral Commodities Bre-X Scandal Second Meeting of the CMMI International Resources/Reserves Definitions Group The Denver Accord Third Meeting of the CMMI International Resources/Reserves Definitions Group, First Meeting with the UN-ECE Setting New Standards, Recommendations for Public Mineral Exploration and Mining Companies published by Toronto Stock Exchange and Ontario Securities Commission Fourth Meeting of the CMMI International Resources/Reserves Definitions Group, Second Meeting with the UN-ECE The Geneva Accord
March 1997 October 1997
Indonesia and Canada Denver, Colorado
October 1998
Geneva, Switzerland
January 1999
Toronto, Canada
November 1999
Geneva, Switzerland
J M RENDU, 2000, International Aspects of Resource and Reserve Reporting, in MICA, The Codes Forum, Sydney. Figure 2: Relationship between Exploration Information, Mineral Resources and Mineral Reserves
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1050 Valuations for the Mining Industry / 18~1130 Mineral Resources Reporting Standards
18~1130
Mineral Resources Reporting Standards
In Australia there are two codes to be considered in this area. the JORC Code; and the VALMIN Code.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1050 Valuations for the Mining Industry / 18~1130 Mineral Resources Reporting Standards / 18~1140 The JORC Code
18~1140
The JORC Code
The Australasian Code for Reporting of Identified Mineral Resources and Ore Reserves (otherwise known as the Jorc Code) is the governing legislation in this area. The Joint Ore Reserves Committee was established by the Australasian Institute of Mining and Metallurgy and the Australian Mining Industry Council in 1971 to consider and make recommendations on Australian Stock Exchange listing requirements for mining companies reporting ore reserves. Between 1972 and 1988, a number of reports were issued by the Joint Committee which made
recommendations on the classification and public reporting of ore reserves. The first version of the Australasian Code for Reporting of Identified Mineral Resources and Ore Reserves (the Code) was published in February 1989 and was incorporated into the Australian Stock Exchange Listing Rules in July 1989. The latest version of the Code was amended in September 1999. The Code has been adopted by the Australasian Institute of Mining and Metallurgy and the Australian Institute of Geoscientists and is therefore binding on members of those organisations. It is supported by the Minerals Council of Australia as a contribution to best practice. Because the Code has been incorporated into the Australian Stock Exchange Listing Rules, it is now mandatory for companies, when reporting exploration results, mineral resources and ore reserves to the Australian Stock Exchange, to abide by the Code. As from 1 July 1995, it is an Australian Stock Exchange requirement that such reports should also include the name(s) of the competent person(s) who compiled the information upon which public mineral resource or ore reserve statements are based. The Code can be found at: Appendix 5A of the ASX Listing Rules; and this web site address: www.ausimm.com.au
In 1995 ASIC withdrew NCSC Release 149 as its guide in examining mining experts reports. The JORC Code is now used as a source of reference by ASIC when reviewing mining and exploration prospectuses and take-over documents (ASIC Policy Statement 56.17).
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1050 Valuations for the Mining Industry / 18~1130 Mineral Resources Reporting Standards / 18~1150 The VALMIN Code
18~1150
The VALMIN Code
The Code for Technical Assessment and/or Valuations of Mineral and Petroleum Assets and Mineral and Petroleum Securities for Independent Expert Reports (otherwise referred to as the VALMIN Code) is also an important guide in this area. Although the code is binding on the members of the AusIMM when preparing independent experts reports as required by the Corporations Act 2001 concerning mineral and petroleum assets and securities, it is not recognised as law by ASIC or included in the Australian Stock Exchange Listing Rules. The code can be found at the following web site address: www.ausimm.com.au.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations
18~1200
Start-up and Technology-based Operations
How much do we ask for a share of our enterprise? What is 20% worth? Can we obtain the funding required and still keep control?
These questions cannot be answered in isolation. They must be viewed against the total business plan and structure in which the business operates. It is important to work through the layering of finance. The residual cash flow after satisfaction of outside debt charges is the amount of cash available to equity holders. What that equity is worth is a function of the amount of cash remaining after paying for debt. These calculations typically become reiterative. Different levels of debt and equity can be assessed and the cost of each type of debt varied according to the security offered. That in turn will provide for different valuations of equity assuming different rates of return for equity participants. Whilst it may seem logical, one should not value equity to start with and then layer in the debt. It is a question of assessing the financing needs of the business, working out a sensible (and sustainable) financing structuring and then determining what the resultant equity is worth. It is sometimes preferable to adopt a backwards methodology. This methodology considers the funding mix which the business can obtain by way of debt (including leasing, debentures, notes etc.) and equity, together with the rates of return which those forms of funding might reasonably expect. The balance of profitability remaining after paying for the debt and equity funding is attributable to the owners of the venture. Commonly the business seeks outside equity sources for funding the development and commercialisation of an invention or project.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1220 Principles and Concepts Involved in Valuation of Start-up Enterprises
18~1220
Principles and Concepts Involved in Valuation of Start-up Enterprises
Often, the purpose of valuing a start-up operation is to raise equity. In undertaking the valuation some questions must be asked: How much money is required? For how long? For what purpose?
If it can be demonstrated that a business has significant value beyond that which is readily apparent from its balance sheet and physical assets, both lenders and sources of equity capital tend to be more favourably disposed towards providing the financing. Profitability does not equal cash flow; it is possible (and often happens) that a business can be profitable but run out of cash. Cash is like the oil in an engine without it an engine will seize and so will a business. Careful attention must be given to the expected stages of an enterprise and the differing cash flow and profitability profiles of each stage. Unless, and until, the proponents of an enterprise fully appreciate the cash flow requirements, that enterprise runs the real risk of running out of cash. Thus a detailed budget and cash flow forecast should be prepared. A first pass at this can be done
before determining the sources of the cash and funding. Until one knows how much funding is required it is difficult to identify from where and at what price those funds are to be sourced. Some key concepts addressed in earlier chapters are revisited below to reinforce the fundamentals of valuing start-up enterprises. The valuation or appraisal of a business venture or company requires knowledge of a number of disciplines in order for the valuation to be carried out properly. It is important a clear understanding is obtained of: what is being valued; the date of the valuation; the standard, premise and purpose of the valuation; and for whom the valuation is being prepared.
The information required to assess the validity of cash flow projections is similar to the information required to conduct a valuation of any business the chapter Research and Data Collection includes an initial list of data required. It is also important that when attempting to value a start-up or technology based operation, the following key issues are addressed: the anticipated earnings upside; the risks; the capital required for development; the value of assets already in existence; the sources of possible finance and the level of debt; the rates of return required; and the appropriate valuation methods.
It is the value and extent of intellectual property which, in the absence of any history of the business or track record or buyer orders etc., must be measured using judgement and estimates. In February 2000, Salomon Smith Barney (SSB) published a research paper entitled E-commerce Strategy A Hitchhikers Guide to the Digital Planet. The publication included SSB Australias analytical checklist for Internet businesses, which we have reproduced below. SSB Australias Analytical Checklist for Internet Businesses Fig 19 SSB E-commerce Pg 50 1. 2. 3. 4. 5. 6. 7. Brand building strategy. First mover advantage. Competitive/barriers to entry. Large market opportunity/scaleable business model. Strong capital base and access to capital. Superior and adaptive management. Offers consumer choice and control (strong value proposition).
8. 9. 10. 11. 12.
Recurring revenue streams low customer churn rate. Reduced processing cost and time. Digital delivery of product or service. Exportable business model. Ownership of unique process, content, product.
SSB Australia also published checklists used by E-Venture and Ecorp for selecting successful Internet business. We have listed these below. Selection Criteria for Internet Businesses Fig 20 SSB E-commerce Pg 50 E-Ventures Criteria 1. 2. 3. 4. 5. 6. First mover advantage. Clear brand building strategy. Content-rich offering. Has sufficient capital to grow. Has consumer choice and control. Highly adaptive management. 3. 4. Ecorps Criteria 1. 2. Large market opportunities. High Internet value proposition: delivery is digital not physical; saves time and/or money.
High long term operating margin. Opportunity to be leading player.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1220 Principles and Concepts Involved in Valuation of Start-up Enterprises / 18~1230 Reliability of future earnings
18~1230
Reliability of future earnings
In times of economic uncertainty a business with an existing positive maintainable cash flow is more desirable than one with prospective future earnings. Similarly, in times of high economic optimism there will be greater demand for future stars and less demand for stable cash earners. A number of critical assumptions must often be made, including the existence or accuracy of: cash flow projections; market studies; technological/feasibility studies; corporate structure; patents/trade marks; and legal opinion.
In summary, predicting probable future earnings for any business is difficult. When one adds in the complications of a new business, with a concept product and a rapidly changing and developing market (in terms of customers, competitors and technology), it is even more difficult to predict future earnings with any degree of accuracy. However, best estimates must be prepared.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1220 Principles and Concepts Involved in Valuation of Start-up Enterprises / 18~1240 The anticipated earnings
18~1240
The anticipated earnings
The discounted cash flow method may be highly sensitive to a number of key variables. These are often: volume; price; market penetration; demand influences such as: seasonalities; relative cost of competitive products; statutory requirements; efficacy of invention; product differentiation; and
market constraints.
Valuation sensitivities should be performed for broad comparisons of cash flow profiles, debt and equity requirements, alternative sale methods and lead times. Detailed consideration should also be given to changing the timings of outlays and receipts. This is important both to understand the sensitivity of the proposal and to appreciate if the overall returns can be improved. It may be preferable to obtain some modest sales early before technical perfection is reached so that a cash flow is generated. In discussing improved returns, the key concepts to be concerned with are: increasing the rate of return for a given outlay (or decreasing the outlay for a given return); and speeding up the rate of return (i.e. obtaining cash flow sooner rather than later from sales and profits).
In addition, consideration should be given to whether returns could be improved by reducing risk. It is imperative therefore that the proponents of an enterprise clearly understand their total funding requirements, how these can be varied, and with what effect on, the proposed cash flow and returns. In assessing the funds required the possible alternative of joint-venture, licensing and strategic alliances should be considered.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1220 Principles and Concepts Involved in Valuation of Start-up Enterprises / 18~1250 The risk areas
18~1250
The risk areas
Set out below are a number of items which represent major assumptions and significant risk to the success of a project. The likelihood of some of these risks materialising is low, whereas others have a
reasonably high probability of occurring. The estimated future cash flows need to be viewed in the light of those risks which could impinge upon the planned development of a project. The risk areas identified may include: projections of demand; competitive pricing; patent protection; competitive products; acceptance/recommendation of product by wholesalers and retailers; alternative product delivery; technological change; price relativity of products; sales tax differentials; market size; component costs; and statutory requirements.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1220 Principles and Concepts Involved in Valuation of Start-up Enterprises / 18~1260 Capital required for development
18~1260
Capital required for development
One of the more significant factors affecting the valuation of start-up and technology businesses is the additional capital that must be outlaid up-front to develop the technology and/or bring the product or service to the attention of consumers. Because these outlays are required in the first few years, they can significantly impact on the value of any future income. As a result great care needs to be taken in determining an appropriate future capital development budget.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1220 Principles and Concepts Involved in Valuation of Start-up Enterprises / 18~1270 The value of assets already in existence
18~1270
The value of assets already in existence
The term start-up gives the impression of a firm with no history and no, or limited, tangible asset backing. However, there may be assets of value already within the business that can be used to attract backing. Common examples include: Management expertise The skills and experience of management can be crucial in obtaining finance for a new business.
Winning concept and protected key technology Businesses with winning concepts, proprietary technology and the necessary technical skills to complete the development are attractive to investors.
The backing of influential and knowledgeable investors and/or joint venture partners Companies that have been able to sell their concept to high profile investors or to appropriate funds that invest in that industry may find it easier then to attract additional funds.
Often a business will not have established a significant brand name or trade mark for the project. Furthermore the value of the projects intangibles may be interwoven into the proposed distribution of the product. Accordingly it may be inappropriate to attempt to value intangibles separately, instead the potential earnings and cash flow from the proposed business operations should be assessed. If there is not an identifiable intangible which could be sold separately from the business without devaluing the remainder of the business, then it is normally inappropriate to value that intangible as though it were a stand alone asset.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1220 Principles and Concepts Involved in Valuation of Start-up Enterprises / 18~1280 Sources of funding for start-up enterprises
18~1280
Sources of funding for start-up enterprises
A complication in the valuation of many start-up enterprises is the need to introduce substantial funding at the start to enable the enterprise to achieve its objectives. Thus, in determining the value of the enterprise, it is necessary to determine the amount of debt and equity required by the enterprise to succeed in the stated manner. This becomes a little circular as the enterprise can be shown to be more or less successful depending upon the level of debt and equity and the mix of these two types of funding. Some of the types of funding available include: ordinary shares; convertible preference shares; deferred shares; convertible notes; convertible bonds; subordinated debt; mortgage borrowings; bank overdraft; leasing; sale; and leaseback.
One should not overlook the importance of federal and state government assistance as a source of funding.
There are numerous techniques and instruments available that can maximise borrowing flexibility through the selective allocation of security and/or through credit enhancement techniques (e.g. priority of ranking of charges, unsecured borrowing with negative pledge, letters of credit and guarantees). It is useful, if not imperative in some cases, to test the sensitivity of projections to rises in interest rates. In recent years there has been a proliferation of financial techniques which can be used to minimise exchange rate and interest rate risks such as options, futures, swaps, caps, collars and forward rate agreements. Properly utilised, these can serve to limit debt funding risks. The raising of finance has not become any easier. A careful, studied approach is required of the entitys capacity, and ability to raise additional funds is crucial. The following table is a useful summary on sources of funding. Provider of Funds Venture Capitalists Development Capitalists Institutional Investors (superannuation and insurance funds) Mezzanine or Management Buy-out Funds Individual Investors Strategic Investors Stock Exchange Listing (incorporates all of the above investor types) Banks (Savings and Trading) Merchant Banks Finance Companies Floor-plan and Factoring Companies Government and related bodies Retained Profits (can become equity through dividend reinvestment) * * * * * * Equity * * * Quasi Equity * * * * * Long- term Debt Mediumterm Debt Short- term Debt * *
* * *
* * *
* *
* * *
* * * * * *
It is important to appreciate that different types of finance can be obtained against different types of assets, thus a layering process can be built up when identifying the debt and equity required. The chart below demonstrates the typical rates of return required from providers of debt, equity and
mezzanine (quasi-equity) finance.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1220 Principles and Concepts Involved in Valuation of Start-up Enterprises / 18~1290 The funding decision The level of debt
18~1290
The funding decision The level of debt
Typically the funding decision is related to maximising wealth creation, i.e. maximising the return on funds invested at an acceptable level of risk. When this objective is applied to the funding decision there are three important concerns: the first is the ratio of debt to equity a question of the capital structure; the second issue is the relative cost of debt and equity; and the third concerns the mixture of short-term and long-term liabilities in the total debt.
A major factor in determining the optimal debt to equity ratio is managements judgement of the ventures capacity to service debt. Such an assessment can be made by determining the debt servicing charges (interest and principal repayments) associated with a given level of debt, then assessing the ability of the ventures future income and cash flows to cover these charges in various scenarios.
This concept is discussed in more detail in the section on corporate debt. If a pessimistic assessment of the future shows that a given level of debt can be serviced, without prejudice to the return on investment, then management can accept such a level of debt as satisfactory. However, it should be pointed out that while the use of debt increases the return on funds invested at high levels of expected earnings, it also reduces the return on funds invested at low levels of earnings and may not provide sufficient funds to cover repayments of principal. Thus, it is necessary to accept that the increased earnings available from using debt are obtained at the cost of greater risk to the venture, increasing the possibility of not being able to service the debt, and receivership as a consequence. Furthermore the higher the relative level of debt the higher the return which will be required by equity holders because of the increased risk. Accordingly, the determination of how much debt to employ must be based on a detailed analysis of: various debt to equity ratios; the return on funds invested covering the most probable and pessimistic levels of earnings; and an assessment as to whether there is a risk of failure to meet legal obligations and required rates of return on investment and whether that risk is acceptable.
A prudent financial policy would not adopt more debt than can be handled under pessimistic conditions without causing jeopardy to the ventures existence. The mix of short and long-term debt is important. It is imprudent to finance long-term assets with short-term debt.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1220 Principles and Concepts Involved in Valuation of Start-up Enterprises / 18~1300 Rates of return required
18~1300
Rates of return required
The chapter Price Earnings Ratios examines the relationships between discount rates and price earnings multiples, while the chapter on Net Present Value Fundamentals discusses risk adjustment of cash flows. It is worth remembering that start-up or technology based businesses are inherently riskier than most. Accordingly, a discount rate of more than 30% is not uncommon. Additionally, the risk profile of start-up businesses usually decreases as the business matures. This is reflected in the rates of return expected by venture capital providers. Typical before tax rates of return required, are as follow: 100% per annum from seed capital investments (the first one to two years of the businesss existence); 50%+ per annum from start-up and early stage investments (two to four years); and 35%+ per annum from investments in businesses in an expansion phase (three plus years of success).
(The above rates are a combination of revenue return and capital gain on sale.) The 100% rate of return may be evidenced for only (say) the first 12 months of a businesss existence. Nevertheless, it reflects the extreme risks faced by a financial investor in a business which is devoid of
any record of success. This high rate of return also results in a restricted number of financial investors at this early stage both due to the inherent risks and the high cost to the proponents of the business. The maturity of a business and the corresponding reduction in underlying risks can be built into financial models by discounting early period cash flows at a higher discount rate. The discount rate reduces over time as the business develops and grows. This approach (whilst still subjective) places a more realistic weighting upon the importance of the seed capital introduced by the initial investors. However, the determination of the appropriate discount rates for the development stages and the assessment of when the business has moved from one development stage to the next still involves considerable commercial judgement and is not without difficulties.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1220 Principles and Concepts Involved in Valuation of Start-up Enterprises / 18~1310 Appropriate valuation methods
18~1310
Appropriate valuation methods
It is crucial that an appropriate valuation method is selected. As stated in previous chapters on business valuation methods, an appropriate value driver is one whose movement is closely correlated with cash. In this respect, the most appropriate valuation methodology is that of discounted cash flow, even though this necessitates the preparation of long-term cash flow projections. Conversely, valuation methods that are generally not appropriate include: multiples of revenue; multiples of subscribers; and even multiples of earnings (profits).
The valuation of earnings is appropriate in circumstances where the business is well established, not experiencing erratic growth, does not require significant or ad hoc capital expenditure and is expected to generate a relatively consistent level of earnings into the foreseeable future none of the typical characteristics of a start-up business. Start-up enterprises do not have an established earnings history and technology-based businesses typically enjoy a fast rise to stardom followed by a short-lived product life cycle due to obsolescence. It is generally accepted that in the absence of historic earnings or stable future earnings, the most appropriate method for valuing start-up enterprises is by using discounted cash flow analysis. To allow for the fact that substantial debt and equity is required in the development of the project, the valuation method should be able to calculate the amount of debt and equity required to achieve the cash flows and then deduct the present value of those amounts from the total present value of the project to determine the value of all the existing equity. This then enables the calculation of the percentage that the existing shareholders would hold in an entity which contains the new (introduced) debt and equity. The template used in the valuation should introduce the debt and equity required to fund the enterprise and calculate a rate of return payable to both the debt and equity holders. In this way the residual value (being the value of the existing equity) can be calculated.
In the preparation of discounted cash flow analyses, it is necessary to estimate all future cash flows. The use of an ongoing value in the valuation template encapsulates all cash flows after the final year. The ongoing value is calculated by multiplying the final years cash flow from operations by the inverse of the discount rate used (after deducting growth from the discount rate). This method can be likened to an earnings-based valuation of the final years cash flows using a price earnings ratio (PER). As mentioned earlier, Salomon Smith Barney (SSB) published a research paper entitled E-commerce Strategy A Hitchhikers Guide to the Digital Planet. SSB provided the following information regarding approaches to valuing technology companies: Valuation of New Age Companies No issue produces more questions, more scepticism, and at times more mirth, than the vexing issue of valuation of information age companies. To start discussion on the valuation of a New World company, we take some words from Ben Graham. Some Perceptions of the Father of Stock Valuation Ben Graham, co-author of Security Analysis (1934), wrote the following on valuing new, high growth technology companies. Unseasoned companies in new fields of activity...provide no sound basis for the determination of intrinsic value...analysts serve their discipline best by identifying such companies as highly speculative and not attempting to value them...The buyer of such securities is not making an investment but a bet on a new technology, a new market, a new service...Winning bets on such situations can produce very rich rewards, but they are in an odds setting rather than a valuation process. Below are the common valuation methods currently being used to value new age companies: 1. Discounted P/E This top down approach estimates market size, market share and possible net income margin to generate future earnings. It applies a future P/E multiple based on current multiples applying to firms which have today achieved similar market shares in similarly attractive markets. The resulting future value is discounted back at rates between 15% and 20% to a present value stock price. While the choice of discount rates is arbitrary, investors who believe in the Capital Asset Pricing Model could use the stocks present Beta to determine a discount rate. 2. Discount Cash Flow In this approach, assumptions are made on capital requirements, operating margins and terminal values to complete a more detailed 5 or 10 year cash flow analysis. In many cases, the end valuation is dominated by the choice of terminal value. 3. Comparative Company Analysis Here ranges of metrics are used to compare companies. Amongst Internet companies, price to last quarters sales and price to last quarters gross profits are emerging as popular metrics. Some of the key metrics now being used to distinguish between companies include:
4.
price/revenue multiples; customer acquisition costs; profit per customer; revenue per customer; revenue per page hit; customer retention/repeat business rates; cross-selling ratios; reach no. of unique visitors/total Internet users.
Probability Weighted Discounted Cash Flow McKinsey & Company recently outlined the following three step DCF-based approach to value new age ventures: Step 1: Start from the future. Rather than worrying about current performance, look forward to a time when you believe the industry may stabilise and extrapolate back. That is, attempt to project what the structure and earnings characteristics of an industry might be in say 10 years time. What is the total industry size, what market share might the company have, what margins will it make. Step 2: Weighting for probability. Because uncertainty is so high, rather than choosing one scenario, create a number of scenarios and assign probabilities to each. Step 3: Identify the key value and earnings drivers of the business and back this into each of your scenarios to see if they still make sense. This provides a sanity check for scenarios you created.
5.
Option-based Valuations In a theoretical sense, option valuation methods appear to fit the current situation extremely well. Much of the value credited to the new technology and Internet firms is based on real options for future success. The problem is that, although it is conceptually appealing to explain current valuations in terms of options, we have yet to see any credible way of translating this into numbers. Still, thinking about some of the companies in terms of options is useful if it helps to open ones mind to the potential that exists (and doesnt exist). Just as price volatility drives the value of trading company options, the volatility and potential outcomes of the business models of new age firms also create significant option value. A whole range of different technologies, processes and distribution models are emerging, and any number of these (but definitely not all) could be successful. Because we are at the beginning of this new information revolution, outcomes are highly uncertain, creating in some ways value for many new start-ups but as we move forward and outcomes begin to crystallise, the option values embedded in many firms will shrink.
Also of relevance in this area are the Guidelines for the Valuation and Disclosure of Venture Capital Portfolios issued by the British Venture Capital Association (BVCA), and available via its web site,
<www.bvca.co.uk>.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1330 Additional Disclaimer for Start-up Enterprises
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Additional Disclaimer for Start-up Enterprises
The start-up enterprise displays a number of characteristics which differ from the typical established business. In most instances, the success or otherwise of the venture cannot be predicted with any real certainty, and while the broad parameters of the environment within which the enterprise will operate may be definable, the extent and timing of its success may not be so easily definable. In preparing a valuation report on a start-up or technology-based company, an additional disclaimer should be considered along the following lines: DISCLAIMER The purpose of this document is to provide a framework and discussion relating to the valuation of the project and variations on structuring alternatives. It is not intended to be a valuation certificate. Compilation and preparation of this document involved making judgments which may be affected by unforeseen future events including wars, economic disruption, dislocations, business cycles, industrial relations, labour difficulties, political action and other factors, the effects of which are not capable of precise assessment. In many cases value judgements must be made based on material compiled by governmental agencies, scientific organisations, industrial, commercial and professional organisations and others. [Name of valuer] shall not be liable for any loss or damage which may be sustained by any person relying on the information contained in this document as a result of any negligence or alleged negligence on the part of LAL or of any such persons except such negligence as the statute law precludes LAL from contracting out of. This document has been prepared under the terms of our engagement letter of DD.MM.20XX. Part of those terms states that it is the responsibility of the client to ensure that all assumptions and supporting data provided to LAL are supported by fact or reputable opinion.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1340 Technology Valuations
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Technology Valuations
The valuation of technology has many challenges and imponderables. This section is concerned primarily with the valuation of technologies which have not yet been (fully) commercialised.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1340 Technology Valuations / Purpose of the valuation
Purpose of the valuation
We believe that it is far more important to understand the process by which a number (or preferably a range of numbers) is derived, rather than the derivation of the absolute number. Central to this process is an understanding of why the valuation is required and what is its purpose. The valuation process should inform and assist with decision making as well as (in most cases more importantly than) deriving a valuation range. A valuation of technology may be required for one or more of the following reasons: structuring a part or full disposal; as a measurement of value creation; to assist decision making on whether to proceed to the next phase of development; to rank alternatives in order to allocate capital resources; and for reporting purposes.
The information required and its treatment is different from circumstance to circumstance. It is better to focus on what decision needs to be made and how the valuation process can assist in that decision making rather than on deriving an absolute value number. Refer also to the purpose of the valuation.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1340 Technology Valuations / Similarities between business valuations and technology valuations
Similarities between business valuations and technology valuations
General valuation approaches can be classified under three headings: asset/cost; income; and market.
Similarly, the valuation of intangible assets can be conducted under the same three broad headings. Reference should be made to the IVSC Guidance Note 4 on intangible assets which sets out the considerations under the three approaches.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1340 Technology Valuations / Why are technology valuations different?
Why are technology valuations different?
There are a number of key areas where technology valuations require special consideration. They include: assumption of success; cost to replicate; project commitment; life cycle of technology; competition;
market dynamics; alternative transaction structures; and comparable transactions.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1340 Technology Valuations / Why are technology valuations different? / Assumption of success
Assumption of success A valuation of technology which assumes that the research and development of that technology will be a success (both technically and commercially) will normally create a misleading impression as to value. Technology which is yet to be fully commercialised has risks attached to it and explicit recognition of those risks needs to be made. Methods by which those risks can be recognised will depend on how far the technology has advanced towards its commercialisation, expected costs to complete the commercialisation, time to market, management, etc. In some instances, the milestones to be achieved or technical barriers to be overcome can be so fundamental that their critical nature can be masked by subsuming them into a valuation discount rate. It is better to separately consider the probability of success for each milestone. It is also important to note that commercial success does not automatically follow from technical success.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1340 Technology Valuations / Why are technology valuations different? / Cost to replicate
Cost to replicate When dealing with a generic asset such as a commercial building, the cost to replicate the asset can be informative. However, with technology, cost to replicate can be quite misleading and on occasions extremely difficult to quantify. This would raise, for example, the issue of whether one should bring into account all the costs of the blind alleys and/or the savings and benefits from other technical breakthroughs in other projects. In any event, the value of an asset is not its cost but the value of its future income stream or its disposal value.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1340 Technology Valuations / Why are technology valuations different? / Project commitment
Project commitment The valuation of many projects is undertaken on the basis that the project will go from A through to Z. Items are costed and income valued. With technology which has not been fully commercialised, there may not be an automatic commitment to all future phases. Some of those phases will be contingent upon other phases being successful, thus, in the event of technical and commercial success being achieved and future costs being undertaken or committed, a set of results may be derived. However, on the down side, it may not be
appropriate to bring to account all future potential costs because some of those may not be incurred if some phases are not successful. Obviously, each case depends on its individual circumstances, but the overall principle is that there needs to be a critical assessment of what is actually committed and at what date and the dependencies of other phases upon earlier phases.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1340 Technology Valuations / Why are technology valuations different? / Life cycle of technology
Life cycle of technology An income approach which capitalises into perpetuity can be quite inappropriate for a technology valuation. The life of the technology itself may be finite (and uncertain) depending upon other advances made in other technology. There is also the question of time to bring the technology to market and the length of life of that technology in the market and patent and other protections. The truncated effective income life from technology therefore may be dramatically different from the theoretical technical life. In reviewing the life of intellectual property, life can be evaluated under a number of headings, e.g. physical, functional, technological, economic, legal.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1340 Technology Valuations / Why are technology valuations different? / Competition
Competition With an established business, the existing effects of competition are known. For a technology which is yet to be commercialised, the actions and reactions of competitors are unknown. One of the ironies is that the greater the success of the technology, the likely a competitive reaction.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1340 Technology Valuations / Why are technology valuations different? / Market dynamics
Market dynamics The introduction of technologies into market-places can change those markets themselves. The market for the technology may be impacted not only by the technology and associated development but also by other technologies and changes taking place the existence of which may not be known.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1340 Technology Valuations / Why are technology valuations different? / Alternative transaction structures
Alternative transaction structures For technology developed for commercialisation, there are often a number of alternatives to a sale for cash. The intellectual property in the technology represents a bundle of rights which may be joint ventured, licensed with royalties and/or milestone payments. The number of alternatives open to
sharing in the commercialisation and benefits of the technology provide for innovative ways of sharing future costs, risks and returns. Where an organisation has a portfolio of technologies under development, the balance of the portfolio both in terms of the types and cost of projects being undertaken as well as in the way that those projects are commercialised can provide overall benefits in terms of the risk return of the overall portfolio. Technology can be dealt with in a variety of ways, e.g. outright sale, licence, franchise, joint venture (and maybe for specific products, markets or geographic areas). The licensing agreements can provide for a range of conditions on who contributes which costs, minimum/maximum royalties, frequency of payment, efforts to be made by respective parties, option for continuation/cancellation, co-venturing, sub-licensing.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1340 Technology Valuations / Why are technology valuations different? / Comparable market transactions
Comparable market transactions A market approach of comparing the price of one asset to derive the value of another is valid when there is a deep, unrestricted market and many assets of a similar nature, e.g. apartments, motor vehicles, etc. Technology by its very nature often has no direct comparable asset (because there is no other technology of the same nature or at the same stage of advancement). Similarly, there may not have been any comparable sales from which to derive market transactions. If sales of other technologies are taken into account (and that includes royalty arrangements), the issue then becomes one of whether full details are actually known of those transactions to establish a true, comparable database. For example: What was the length of the royalty period? Was it stepped? Were there threshold payments? What were the commitments for research and development expenditure? By whom? Over what period? Are milestone payments payable? By whom? Dependent on what events? How variable are they? If there are market transactions, to what extent were these driven by special circumstances? Do they reflect negotiating skills on behalf of one party or specific values to a special purchaser? It can be seen that comparable transactions may need considerable research and adjusting in order to be truly comparable. In boom stock market conditions, technology can appear to be very highly valued. Often a metric is quoted, such as market capitalisation to revenue. This is not a valuation metric at all but an outcome of an imperfect market process. It can so happen that there are relatively few common measures which can be applied across companies and their technology and, thus, imperfect ones are chosen to derive a measure. These metrics are an outcome of a market capitalisation, not an input as to how the market should value technology companies.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1340 Technology Valuations / A base case approach
A base case approach
The quantum of data imponderables and permutations of outcomes is often such that going through a process and attempting some quantification is in itself a benefit. There is a need to be objective but, at the same time, avoid paralysis by analysis. Some of the issues are obvious, while others may not have been thought about by the project participants. The areas to be considered include, but are by no means limited to: markets to be served; size of markets; expected date of entry; expected market share (based on what?); market share of others; take up rate; how many years to achieve ultimate market share percentage; cost to finalise development; cost to bring to market; cost to maintain technology; and cost to develop improvements.
In many instances, only broad estimates may be available and, in that instance, wide ranges may need to be used. The purpose of a base case is to draw a line in the sand so as to begin some quantification for major decision making. One knows that a forecast will be wrong (but not by how much or in which direction!), but that does not invalidate the need to make the forecast. The focus also needs to be on cost to complete, timing of commercialisation, as well as potential revenues. (As opposed to costs to date.) In many instances, the viability of the development of technology may be negated when a hard look is given at the length of time which may be required to commercialise it and particularly when compared to the projected life that such commercialised technology might have for generating income. By working through a matrix, a discipline can be developed of narrowing down potential outcomes and eschewing the end of range unlikely ones. The process also needs to focus on the bundle of rights associated with the technology and how and to whom income is to be generated. Typically, a linear approach may be taken to such a base case valuation approach using a discounted cash flow model. However, in doing so, the problems of using such linear models need to be kept in mind. Real option valuation theory approaches can be used. However, a word of caution, as these could turn essentially a subjective process into one of high sophistication such that the answer is believed due to the sophisticated method of calculation. In many instances, the management decisions which need to be made can be answered by a critical appraisal of a rigorous cash based DCF approach and it has the advantage of a methodology which is widely understood. This is not to say that real option theories do not have a place, they most certainly do. However, their sophistication is often much greater than the quality of the data fed into them.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1340 Technology Valuations / Risk return
Risk return
It is generally accepted, that the higher the risk of a project, the higher the return that is required. Refer to earlier text on the quantification of discount rates. In valuing technology there are two critical issues: the level of risk must be consistent with the discount rate; and a high discount rate should not be used as a substitute for management evaluation.
Discount rates represent both the time delay of the value of money and also the riskiness of receiving that money. Risk adjusted discount rates therefore need to be clearly understood as to which risks are included in the discount rate and which risks have been factored into the other variables before deriving the net cash flow. In some instances, it may be appropriate to discount the net cash flow at one rate and, in others, to discount the income at a higher rate and the expected expenditure at a very low discount rate. If the project expense is committed, then there is no risk of that expense being incurred. To bundle that expense in by deducting from future income, or using the same discount rate, would give a misleading answer, particularly if expenditure is to be incurred significantly ahead of expected income. Another fallacy is to evaluate a technology which has a sufficiently large market such that providing that only a small percentage of the market is achieved it will return a positive value even at a very high discount rate. This masks the decision criteria of whether the project is so risky fundamentally that it should not be undertaken.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1340 Technology Valuations / Value attributable to technology
Value attributable to technology
In many projects, there are a number of components which are required to make it successful. Technology may be a small component thereof and to attribute the whole of the value of the project to a technology can be quite misleading. A rigorous assessment therefore must be made of each project (into which the technology is to be put) and the requirements for success, both technically and commercially. In assessing the value of the technology, key questions need to be asked such as: Is the whole of the technology owned by one organisation? What other items are required to commercialise successfully the technology? Is this technology transferable? Is it enduring? For how long? Will the technology give some sustainable competitive advantage? What effects will the technology have on competitors?
Do other parties have any rights to this technology? Can part of the rights for technology be transferred or otherwise dealt with?
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1340 Technology Valuations / Implicit assumptions
Implicit assumptions
As part of the process of undertaking a base case analysis, it can be very worthwhile to stand back from the analysis and tabulate the implicit assumptions that are being made. What about competitors? Life of the technology? Technical success? Time to market? Actions of competitors? etc. The development of technology is one issue the commercialisation and success of the commercialisation of technology is quite another. Too many times we see valuations which assume technical success and, because of technical success, assume commercial success. A good idea does not equal cash flow. Pragmatism and reality are important and some scoping needs to be made of the timing issues which are likely to occur.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1340 Technology Valuations / Sensitivities
Sensitivities
Financial models have a tremendous capacity for testing sensitivities. What they do not have is a capacity to think about what are the critical sensitivities and how they might come into play. It is important that a critical review be made of the impacts of various sensitivities and their broad effect evaluated. This is not only to consider items such as cost increases or decreases by 10% but more fundamental issues such as overall delay in a program, partial technical success, changes in market dynamics and competitors.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1340 Technology Valuations / Technical valuation issues
Technical valuation issues
Pre-tax cash flows should be measured by using pre-tax discount rates and real discount rates applied to real projections (and nominal discount rates to projections in nominal terms). Equity discount rates should be used unless the technology is capable of bearing debt on its own account (normally this is not the case, particularly where the technology is in a research and development phase). The benefits of tax losses generated by the project should only be counted when income is generated by the project otherwise one is valuing the tax position of the entity undertaking the technology development.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1340 Technology Valuations / Management decisions
Management decisions
To be of most use, the technology valuation process should set out to answer specific management questions. Thus the process should be orientated towards examining the critical issues and the derivation of the technology valuation range will be a by-product. In most valuations, the valuation range is very dependent upon the assumptions made. In early stage technology, it is critical to understand what assumptions might be made and what would change if different assumptions were made. Projects are typically committed to on a stage by stage basis and the question that often needs to be asked is: Is it worthwhile going to the next stage? That then begs the question of: What is the added value of going to the next stage and what are the risks of that stage? Alternatively, if looking for a part disposal of technology on its commercialisation: What are the potentially large rewards and how can we capture those? or What are the potentially large risks and how can we lay off those risks?
In measuring value creation from period to period, it is important that the value shift is not masked by changes of financial assumptions. The methodology should be consistent from period to period and value changes be able to be reconciled. When ranking alternatives for the allocation of scarce resources, consistency of framework is important. However, the treatment of risk may also be usefully handled by some scoring attributes outside the valuation process itself. It would be misleading to believe that all risks can be bundled up into a valuation figure and the valuations ranked alongside each other in terms of size or some return on equity criteria. Valuations cannot be a simple answer for management decision making. Finally, one useful technique is to reverse engineer the decision; that is to say, what has to occur or what set of permutations have to occur in order for the decision to go the other way? In other words, rather than focusing on a finite value or a finite outcome, are there some circumstances that are so likely or so unlikely that the decision to proceed or not to proceed, to invest x or y becomes clearer.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1200 Start-up and Technology-based Operations / 18~1350 Summary
18~1350
Summary
The valuation of technology (particularly that which is yet to be successfully commercialised) is a complex area and one which is rewarded by having a methodical rigorous process. That process, however, is not a substitute for critical management evaluation of the attributes of the technology and its prospects, rather it is an input into the overall management decision making. Each valuation has its own requirements. The above is provided by way of thought starters and issues to consider. Given all of the factors which ultimately determine value, there will always be differing opinions on the weighting to be assigned to any given factor in any situation.
There will also be differences of opinion over the measurement of reasonable expectations for the various factors, such as earnings or values of assets, depending on different peoples degree of knowledge and their optimism or pessimism regarding the outlook for the economy, the industry and the businesss ability to compete favourably. Different levels of debt may be assumed in the ongoing operations. One investor may apply a higher cost of capital, resulting in a lower valuation; another investor, with a higher degree of confidence in a companys potential, may evaluate it on the basis of a lower cost of capital. The cost of capital used by different people in the valuation analysis may vary for reasons other than the risk inherent in the enterprise itself. The business, standing alone, may be considered to be highly risky and require a high cost of capital. On the other hand, a large company considering acquiring it may have a much lower cost of capital; it may use its own cost of capital in the valuation, assuming that the risk of the individual business unit will be reduced considerably as a result of it becoming a division or integral part of the larger company. A business may offer synergistic values to certain buyers, which it would not offer to other buyers. It may offer a company an important horizontal integration, such as entry into a key market area. This in turn is related to whether the business venture is seen as a pure financial investment meeting a required rate of return on capital invested, or whether it is seen as a strategic investment so as to obtain production or other end product benefits. In the latter case, because of the strategic value, it is not unreasonable to expect that the required return on funds invested would be lower than otherwise. All of the above points are important when negotiating the pricing and structuring of the introduction of a new equity investor.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets
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Intellectual Property and Intangible Assets
The following sections on the valuation of intellectual property were originally provided by Valuation Consulting, 97 Park Lane, London W1Y 3TA, Tel: 0207 499 5544 Fax: 0207 499 2266, email: valconsult@valconsulting.co.uk, web site: www.valuation-consulting.co.uk Valuation Consulting are dedicated specialists in the area of intellectual property valuation. Leadenhall wishes to thank them for permission to use this material as it is a good summary of the key issues affecting the valuation of intangible assets. Since the original version of this text, Leadenhall has amended and rewritten some of the sections provided by Valuation Consulting to take into account changes in legislation and the growing sophistication of many readers with the valuation of intangible assets.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1420 What is Intellectual Property and what are Intangible Assets
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What is Intellectual Property and what are Intangible Assets
Different organisations have different definitions of intellectual property and intangible assets.
Intellectual property commonly includes those assets traditionally protected by the legal system and specifically includes: patents; trade marks; copyright; designs; and brands.
The new International Accounting Standards define intangible assets for accounting purposes as: An intangible asset is an identifiable non-monetary asset without physical substance. Intangible assets include such things as: subscription lists; know-how and show-how; negative knowledge; research and development; trade secrets; proprietary technology; agreements; information; and the spectrum of creative thought.
AASB 3, the new Australian standard on business combinations contains an illustrative list of intangible assets.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1440 The Importance of Intangible Assets
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The Importance of Intangible Assets
Intangible assets may account for a significant proportion of the total value of a company. To give an indication of the importance of intangible assets to going concern businesses, we quote from an article entitled Hail the age of access : McKinsey estimates that in the US, the market to book value (share price versus the accounting value) for all public companies has risen from below two times in 1990 to 3.5 (it peaked at four in the bull market). This measure called Tobins Q, is a rough measure of the increasing importance of intangible assets (because book values tend not to have accurate estimates of intangible assets such as knowledge and brands), and the rising difference suggests that intangible assets are becoming more important to the value of listed companies. Stuckey says the trend has not been as extreme in Australia, but there has been a similar increase in the gap between book value and market value. He says the Tobins Q measure for the Australian stockmarket is now about 2.5.
(Source: Business Review Weekly 27 April 2001 page 91) Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1440 The Importance of Intangible Assets / 18~1450 The inefficient market and competitive advantage
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The inefficient market and competitive advantage
The efficient exploitation of their intellectual property assets is a key objective for business enterprises. Those that are able to manage these assets properly are poised to take commanding positions of economic power. It is no longer an exaggeration to say that the business world is dividing between those companies and corporations that possess intellectual capital and those who do not. The have-nots will tend to diminish in status and importance, unless they can gain access to items of intellectual capital such as patents or well regarded trade marks. Industrial muscle is no longer enough to ensure a future of growth and profitability. At the extreme, a manufacturing company lacking intellectual capital has two choices, manufacturing for other corporations in a sub-contract relationship, or the mass production of a commodity. In either case the likely result is poor growth and profits. This, coupled with the increasingly global nature of the market-place, is leading to a new form of international commercial activity that is transaction based, and involving the transfer, in one form or another, of intellectual property rather than the goods or services that the property supports. This commercial activity, whether taking the form of outright sale, joint ventures or licensing, is changing the face of international business. This has led to what has been described as a window of opportunity to obtain intellectual property at bargain prices or royalty rates, due to the current inefficient market in which intellectual property rights are bought, sold and licensed, and the fact that accurate economic values are not being attributed to these valuable assets. Those companies that have developed clear strategies, based on accurate appraisals of the strength and value of intellectual property rights, are out in the market-place enhancing their earning power, productivity, market share and harnessing home developed as well as acquired intellectual capital in their expansion.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1440 The Importance of Intangible Assets / 18~1460 Bundle of rights
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Bundle of rights
The ownership of intellectual property confers a number of separate privileges. The owner can sell the property, or give it away. They can lease, or license it, and there are many separate rights that can be licensed: the right to make, the right to use, to disclose, to lease, to sell etc. Each right deserves separate consideration in any valuation or licensing deal.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1440 The Importance of Intangible Assets / 18~1470 Highest and best use
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Highest and best use
The concept of highest and best use is an import from real estate valuation, where the valuer usually is able to assume that knowledgeable parties will know the potential uses of the land under
consideration and the particular use that will provide the highest economic return. This concept is crucial to the valuation of intellectual property. The various potential uses of any item of intellectual property should be considered in any appraisal or valuation of that property. Typically the highest and best use of intellectual property will be within a business. The ability to maximise the potential of the intellectual property is a key ingredient in its value. It should be noted however that this differs conceptually to the approach used in AASB 136: Impairment of Assets, which allows for the valuation of intangible assets on a value in use basis.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1440 The Importance of Intangible Assets / 18~1480 Intellectual property audit
18~1480
Intellectual property audit
The concept of an intellectual property audit is growing in importance and is being offered by a growing number of professional firms. During the process, typically a lawyer will establish what intellectual property and intangible assets are owned or used, and if those assets are effectively protected. Schedules of patents, trade marks and registered designs will be examined as well as applications pending. The nature and rights of licences will be reviewed. At every stage of the process the security of the rights is an essential question. Whilst the identification and protection of key intellectual property assets is clearly of crucial importance, the quantification of the returns earned from those assets is still not commonly undertaken. An intellectual property audit, in conjunction with a detailed appraisal of the assets identified by the audit, will provide a company with significantly more information about their intellectual property and may provide them with a competitive advantage. Intellectual property audits are now undertaken as part of most due diligence procedures and form an important source of information when undertaking a purchase price allocation and when assigning value to individual intangible assets, pursuant to AASB 3: Business Combinations.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1520 Need for Measuring and Monitoring Values
18~1520
Need for Measuring and Monitoring Values
A number of different professional groups now recognise that these valuable intangible assets need to be reliably and consistently valued. Valuations are needed, among other things, for the balance sheet, tax planning, licensing, litigation, lending, insurance purposes and management decision-making. The new accounting standards require that when a business combination or acquisition occurs, it is accounted for using the purchase method and that a purchase price allocation is undertaken. Specifically, AASB 3: Business Combinations requires: The dissection of the price paid for a business or company between the individual assets and liabilities of that entity. with goodwill being determined as: The remaining consideration after fair value has been allocated to all identifiable tangible and intangible net assets.
In addition, the new accounting standards require valuations so that intangible assets are tested for impairment on the following occasions: within the year of acquisition; annually thereafter at the same time each year; and whenever there is an indication that the cash generating unit or the intangible asset may be impaired.
The question is, how can these increasingly important intangible assets be valued?
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1540 Basics of Valuation Theory for Intellectual Property and Intangible Assets
18~1540
Basics of Valuation Theory for Intellectual Property and Intangible Assets
Any method developed for the valuation of intellectual property and intangibles, for example brand names and trade marks, should consider the marketing, financial and legal aspects of the brand or trade mark and it should follow the fundamental accounting concepts of prudence and consistency. We would add that it should also allow for revaluation on a regular basis, if required, and be suitable for both home grown and acquired brands. The starting point for any appraisal or valuation in this area is a recognition that the brand or trade mark provides some barrier to competition or a competitive advantage. Current valuation practice and theory also requires that the intangible asset is: separable; protected (or protectable); transferable; and relatively long-lived.
It is important to note that the new accounting standards have different criteria for recognition to that used historically: An asset meets the identifiability criterion in the definition of an intangible asset only if it: (a) (b) is separable; or arises from contractual or other legal rights (AASB 3, Paragraph 46).
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1540 Basics of Valuation Theory for Intellectual Property and Intangible Assets / 18~1550 Separability
18~1550
Separability
Valuation theory states that the value of any asset is determined by the expected future earnings or cash flows that can be obtained from the use, or resale, of that asset. If an asset is to be valued in the absence of an established market in comparable assets, the future economic benefits must be capable of reasonable estimation. Although this is also the case for any business valuation, increased difficulty results from the requirement to separate the future economic benefits deriving from the
individual asset being valued from those other net assets that comprise the business. In the past, the total difference between the acquisition price of the business and the value of the net tangible assets was classified as goodwill, without regard to the individual components that might have been separately valued. The professional valuer must therefore exercise proper judgement in allocating a composite intangible value between the separate identifiable intangible assets, the contractual intangible assets and the unidentifiable intangible assets.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1540 Basics of Valuation Theory for Intellectual Property and Intangible Assets / 18~1560 Protected (or capable of protection)
18~1560
Protected (or capable of protection)
In order for an asset to retain or increase its value it must have some form of protection. With brand names, there is generally protection by virtue of the trade mark and registered design legislation, in addition to protection under common law. Other forms of intellectual property receive differing types and extents of protection that may be limited to specific geographic areas. Protection may however be limited to a specific geographic area. The strength, duration and extent of this protection have to be carefully considered in placing a value on any brand name.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1540 Basics of Valuation Theory for Intellectual Property and Intangible Assets / 18~1570 Transferable
18~1570
Transferable
In order to be consistent with the standard definition of fair market value, the asset must be capable of being exchanged. In some instances, the asset itself may not be capable of direct sale, but may effectively be transferred by some other means, such as a licensing or franchise agreement. In the case of brand names, transfers are generally effected by either the sale of the entire business, including all tangible and intangible assets employed, or by means of a licensing arrangement with a third party. Any limitations on the transferability of the asset must be carefully considered and may limit the value that should be placed upon that intangible asset.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1540 Basics of Valuation Theory for Intellectual Property and Intangible Assets / 18~1580 Long lived or enduring
18~1580
Long lived or enduring
The characteristics of the asset should be such that it can properly be regarded as a capital asset rather than the carry-over effects of some recent expenditure. The greatest difficulty with this is, for example, separating the benefits of current expenditure from the value of the intangible assets. An indication of relative longevity is the continued success or dominance of a product in the absence
of high levels of supporting expenditure. It should be noted however than an assessment of the future economic benefits of the brand name should be net of the ongoing costs associated with the maintenance of the assets.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1540 Basics of Valuation Theory for Intellectual Property and Intangible Assets / 18~1590 Contractual recognition requirement
18~1590
Contractual recognition requirement
It is important to note that AASB 3: Business Combinations requires the recognition of a type of intangible asset that has previously always been regarded as goodwill. Criteria for recognition Contract based Not contract based Separable Intangible Intangible Not separable Intangible (prior to IAS = goodwill) Goodwill
As can be seen from the above table, AASB 3 effectively carves out a new category of intangible assets. AASB 3: Business Combinations contains an illustrative list of intangible assets.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1600 Valuation Methodologies
18~1600
Valuation Methodologies
It is a fundamental principle of valuation theory that the value of any asset is the present value of the future economic benefits that can be anticipated to accrue to the owner of that asset. However, whilst this principle is generally accepted by valuation professionals, there is no universally accepted valuation methodology. Valuation theory, in very broad terms, recognises three distinct approaches to the valuation of any asset, including intellectual property. These are usually described as the cost, market and income approaches.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1600 Valuation Methodologies / 18~1610 The asset or cost approach
18~1610
The asset or cost approach
The cost approach arrives at the value of the asset by ascertaining its cost of development and/or its replacement cost. The assumption underlying this approach is that the price of the new asset (or the cost of developing it) is commensurate with the economic value of the service that the new asset can provide during its life. The principal disadvantage of this method lies in its correlation of cost with value. This is a particular problem in technology companies. Commonly cited examples include:
the US Governments attempt to build a nuclear-powered aircraft in the 1950s. The costs of this ultimately abortive project would have amounted to many millions of dollars, yet the value of the aircraft, which wouldnt fly, was zero; and expensive product launches which have been a complete failure, or conversely, products which have become household names despite an extremely low cost advertising campaign.
Thus costs may bear no relation to value. Even in cases where the cost of replacement might reasonably be expected to provide a surrogate value there are additional complications: to capitalise costs incurred over a number of years ignores changes in the time value of money over that period of time and the effect of compound interest on those costs; an intangible asset, like most capital assets, requires on-going maintenance in order that its profitability (and hence value) does not diminish. Capitalising past costs may require a judgement on the extent to which expenditure relates to the development, or alternatively to the maintenance, of the asset; and the valuer has to quantify the necessary reduction from the brand new state of the replacement asset to the actual state of the asset under consideration, taking into account the physical, functional, economic and legal life of the asset.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1600 Valuation Methodologies / 18~1610 The asset or cost approach / Historic cost
Historic cost
It is possible to estimate the aggregate marketing costs of creating an intangible asset. However, much of the relevant information is unlikely to be available and spend levels need to be converted to a consistent current value with inflation and risk modelling. Even assuming that such an exercise was possible, historic expenditure is no guide to current value.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1600 Valuation Methodologies / 18~1610 The asset or cost approach / Replacement cost
Replacement cost
Estimating the likely marketing costs of creating a similar intangible asset is possible. However, while it may be possible to estimate the cost and time scale to achieve given levels of awareness, it is much more difficult to predict consumer loyalty and repeat buying patterns.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1600 Valuation Methodologies / 18~1620 The market approach
18~1620
The market approach
The market approach arrives at the value of an asset by obtaining a consensus of what others in the market-place have judged it to be. Problems here include the requirement for an active and public market, with a record of the exchange of comparable properties. Not surprisingly, perhaps, this is not
a common state of affairs for intellectual property. It is interesting to note that AASB 138: Intangible Assets states in paragraph 39: Quoted market prices in an active market provide the most reliable estimate of the fair value of an intangible asset the appropriate market price is usually the current bid price. If current bid prices are unavailable, the price of the most recent similar transaction may provide a basis from which to estimate fair value, provided that there has not been a sufficient change in economic circumstances between the transaction date and the date on which the assets fair value is estimated. Paragraph 40 then states: If no active market exists for an intangible asset, its fair value is the amount that the entity would have paid for the asset, at the acquisition date, in an arms-length transaction between knowledgeable and willing buyers, on the basis of the best information available. Note that, in this regard, an active market is assumed to be: A market in which the following conditions exist: (a) (b) (c) the items traded in the market are homogenous; willing buyers and sellers can normally be found at any time; and prices are available to the public.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1600 Valuation Methodologies / 18~1620 The market approach / Based on valuations of listed companies
Based on valuations of listed companies
Market valuations can be achieved by reviewing the market values of quoted companies with similar intangible assets and deducing an equivalent value for the intangible asset under review. However, quoted company values depend on a wide variety of factors including gearing and market sentiment. In most cases companies own many intangible assets and brands, making the segregation of value and the valuation of individual intangible assets difficult.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1600 Valuation Methodologies / 18~1620 The market approach / Comparable transactions
Comparable transactions
Alternatively, it is possible to identify transactions involving comparable intangible assets and then calculate values based on such benchmark prices. In an ideal situation, a valuer will always prefer to determine a fair market value by referring to comparable market transactions. In practice, this is difficult enough when valuing assets such as real estate, especially in todays climate, because it is rarely possible to find a transaction that is exactly comparable. However, in valuing an intangible asset, for example, finding a comparable market transaction becomes almost impossible. This is not only due to lack of comparability, but also because intangible assets are generally not
developed to be sold, and any sales are usually only a small part of a larger transaction and/or the details are kept extremely confidential. Comparable values are therefore difficult to arrive at. In addition, even if an apparently comparable transaction is evident, the following impediments limit the usefulness of this method: Above all, because intangible assets owe their value to their uniqueness, the concept of comparability is often flawed. There may be only one intangible asset of this kind in existence. Observed transactions will seldom represent the value the intangible assets has to the existing business, but reflect transactions where the assets are (or are deemed to be) much more valuable to the new owner, and such special values may not be reflective of fair market values. The implicit value placed upon identifiable intangible assets in the acquisition of a company may be based upon a limited level of knowledge of the underlying business, or the allocation between tangible and intangible assets is often driven by taxation or stamp duty considerations. Values placed on assets may vary as markets rise and fall in cycles. It is essential to eliminate the distorting effects of these peaks and troughs. The particular characteristics of intangible assets may differ both within and across industries. A direct comparison therefore may often not be possible.
In summary, whilst theoretically this method may be acceptable, it has practical difficulties. Accordingly, it should only be used after the valuer is satisfied that appropriate adjustments have been made in the valuation process to overcome the practical limitations of inadequate, specific and detailed information relating to the comparable transaction chosen.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1600 Valuation Methodologies / 18~1630 The income approach
18~1630
The income approach
The income approach looks at the income producing capability of the property to be valued. The future economic benefits are equated to the present value of the net cash flows anticipated to be derived from ownership of the property. The quantification of the future cash flows should take into account incremental fixed asset and working capital investments. The various methods based on estimates of future economic benefits include: capitalisation of earnings; gross margin differential; excess earnings; and relief from royalty.
Each of these methods attempts to measure the super profit being produced by the intangible asset over and above the profit that is generated by the tangible assets. The calculation of the present value of the cash flows is arrived at by utilising an appropriate discount value of the factor. This factor can be derived from a number of different rate of return models.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual

Property and Intangible Assets / 18~1600 Valuation Methodologies / 18~1630 The income approach / Capitalisation of earnings
Capitalisation of earnings
In essence, this method determines the value of an intangible asset by multiplying the core historic profitability of the business by a multiple that has been assessed after examining the relative strength of the intangible asset. This multiple is derived after assessing an intangible asset in the light of factors such as leadership, stability, market share, internationality, trend of profitability, brand support and protection. An intangible asset is then scored for each of these factors according to the weighting attributed to them and the resultant total is described as the brand strength score from which the resultant price earnings ratio or multiple may be derived. While this method recognises some of the factors that should be considered, its major shortcomings are: Being based upon the historic profitability of a business, this method does not take account of future profits growth or decline attributable to the intangible asset, nor the likely future effects of other key variables or alternative future uses of the intangible asset. Indeed, given that the fair market value of an asset is based on its future net economic benefits, this is a critical failing. There are numerous examples of intangible assets which have fallen from grace and would be overvalued on the basis of this method. Tangible assets fundamental to the generation of profits are not separately assessed, and with the use of total profits as a base for the valuation, this results in a significant over-valuation. The selection of the price earnings ratio is made without reference to the established markets for securities, and accordingly, this method will not allow any reconciliation to be made between the total value for the business and the values of its component parts, including industry intangible assets. This method fails to take account of the specific characteristics of the products that support the existence and valuation of intangible assets.
Furthermore the attribution of scores to the intangible asset in each of the various categories is a fundamentally subjective process. With the increasing importance of, and interest in, this area, it is of crucial importance that the impact of subjectively based judgements be minimised, not maximised as in this methodology.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1600 Valuation Methodologies / 18~1630 The income approach / Gross margin differential method
Gross margin differential method
This method is one of the most commonly used for trade marks and brand names. However, due to difficulties in defining the relevant components of gross margin, the actual method applied generally focuses upon sales price differentials (adjusted for differences in marketing costs). In this method, the difference between the margin of a branded product and an unbranded or generic product is utilised in the calculation of value. In determining the margin, both the prices and volumes need to be considered and full allowance needs to be made for the maintenance costs of the trade mark or brand names.
Despite a degree of sustainability from a theoretical point of view, in reality this method is almost impossible to apply with a high degree of reliability. Its major limitations can be identified as follows: The gross margin differential does not explicitly consider the net tangible assets employed and a reasonable required rate of return on those assets. The gross margin differential may principally be a reflection of factors other than the trade mark or brand name, such as cost efficiencies in production and/or distribution attributable to economies of scale. Information on cost, volumes and marketing expenditure of the other products may not be available or reliable. This may particularly be the case in circumstances where the products are sold through mass retailing outlets. It may be difficult to find a suitable non-branded or generic product available for comparison and even if there is a similar generic product, it may not be strictly comparable due to differences in quantity, quality and/or availability. It is rare, in practice, for there to be much (if any) empirical evidence on the price elasticity of the branded and generic product. No allowance is made for trends in relative market shares over time (e.g. a generic competitor may have only recently entered the market). Gross margin differential methods are inherently bias valuations in favour of industries with a lower proportion of variable costs to total costs.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1600 Valuation Methodologies / 18~1630 The income approach / Excess earnings method
In this method, the current market value of the net tangible assets employed is first calculated, then an estimated rate of return is utilised in order to calculate the profits that are required in order to induce investors into those net tangible assets. Any return over and above those profits is considered to be the excess return attributable to intangible assets. This return is then capitalised. However, care must be taken to allocate this capitalised amount between the individual identifiable components and any remaining unidentifiable component, which, by its nature, must represent goodwill. In essence, this method is a variation of the method of valuing the business as a whole and subtracting from that value the current market value of net tangible assets employed. In either case, one method should be reconciled to the other (i.e. the sum of the parts cannot exceed the total of the whole). Although this method theoretically relies on the pure economic benefits obtained from the use of the assets it has the following major limitations: The required rate of return may reflect risk and other factors which cannot be separately assessed with precision. The method itself does not differentiate between any constituent components (e.g. such as different brand names). The valuation of some of the tangible assets employed may also incorporate some of the
intangible value (i.e. plant and machinery may be valued on a going concern basis). Information about technological developments from potentially competitive products is generally not available and/or its impact is difficult to assess. The assets being valued may not be employed in the best possible manner (highest and best use). Asset values and reported profits may be calculated on different bases. Theoretically, any company with excess earnings will generally have that margin eroded over time by competitive pressures. Branded products, if successful, generally have the benefit of lower depreciation charges (because of fully depreciated assets or assets acquired at a lower historic cost base) and the benefit of the learning curve at all levels of operation. The required rate of return may be taken into account in setting the sales price of the product. This method ignores the potential earnings to be derived from alternative uses of the brand.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1600 Valuation Methodologies / 18~1630 The income approach / Relief from royalty method
Relief from royalty method
This approach is based on the theoretical assumption that if the brand had to be licensed from a third party there would be a royalty charge based on turnover, which would be levied for the privilege of using the brand. By owning the brand, royalties are avoided, hence the term royalty relief. The relief from royalty approach is similar to a sale and leaseback of real property. It assumes that the brand name is sold and then licensed back by its previous owner. The method calculates the maximum royalty the business could afford to pay for the licence, whilst still achieving an acceptable return on the assets remaining in the business, being its investment in plant, working capital and goodwill. Hence, the royalty is equivalent to the super profit component mentioned earlier. The royalty stream is then capitalised at an appropriate rate of return to produce the value of the rights to use the brand name or licence. The rate of return will need to reflect the risk/return relationship implicit in the investment in the brand name. The advantage that this method has over those previously mentioned is that the notional royalty rate used in the valuation can be compared to the royalty rates actually being paid in the market for similar brand names. Also, the approach specifically considers the profitability of the brand and takes into account factors such as the number of times the royalty is covered by profit. Some of the problems associated with the relief from royalty approach are: There may be no separation of the other intangible components that may be implicitly included in the determination of a prevailing royalty rate. Therefore, the licensee will, in addition to the brand name, pay for the geographic goodwill or monopoly that may be a component of the business. Rates also often incorporate payments for the use of patents, copyrights or shared marketing costs. The selection of a comparable royalty rate has the following practical difficulties:
the reference rates may be out of date and may not properly reflect the current economic conditions; the normalised rates are established with respect to an average of a number of transactions about which detailed information may not be available; and the licensing arrangement may preclude the alternative uses to which the intangible asset may be put.
The relief from royalty approach does have some conceptual problems but it is probably the best we have to work with and certainly provides the soundest starting point. The article entitled Using Royalty Rates as Valuation Benchmarks by David G Weiler provides further discussion on caution in the use of the relief from royalty method and can be accessed via <www.royaltysource.com>.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1650 Preferred Valuation Methodology and Key Valuation Issues
18~1650
Preferred Valuation Methodology and Key Valuation Issues
For all the reasons outlined above, economic use valuations based on discounted cash flows, are the most widely recognised approach to brand valuation. Such valuations consider the economic value of the brand to the current owner in its current use. They do not consider the value of the brand in use by a different owner or any hope value based on new uses of the brand. Most valuers value companies on the basis of free cash flows, discounted back to a net present value. This avoids the distortions of accounting adjustments which bear no relationship to the underlying economic facts. A similar approach is used for valuing brands. Just as business valuations now focus on the sustainable cash flows from the business and put a value on that cash stream, so too brand valuations consider sustainable cash flows from the brand and put a value on them. Broadly speaking, therefore, it is preferable to prepare a intellectual and intangible assets valuation based on the economic use method. A valuation using this method comprises the following elements: quantification of the remaining life; development of a financial forecast; identification of the intellectual property and intangible asset earnings; and determining an appropriate discount rate.
On the basis of these analyses, the value of the brand can be calculated. An intellectual property and intangible asset valuation typically includes sensitivity analysis, based on alternative scenarios using different price and growth assumptions, different marketing support profiles and different discount rates.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1650 Preferred Valuation Methodology and Key Valuation Issues / 18~1660 Remaining life
18~1660
Remaining life
Quantification of the remaining useful life and decay rate associated with the use of the intangible asset is vital. The remaining useful life analysis will quantify the shortest of the following: physical life; functional life; technological life; economic life; and legal life.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1650 Preferred Valuation Methodology and Key Valuation Issues / 18~1670 A financial forecast
18~1670
A financial forecast
This involves a review of both internal and external data, and a review of historic data relationships and trends. A detailed brand audit identifies how the brand to be valued stands in relation to its competitors, and how market share and margins will trend in the future. The objective is to identify a reliable set of assumptions and a range of business earnings flowing from the branded business as a whole. Characteristics that need to be looked at include: market shares; possible extensions; advertising spends; profitability and premium prices; and possibly commissioned market research indicators of consumer recognition.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1650 Preferred Valuation Methodology and Key Valuation Issues / 18~1680 Identifying intellectual property and intangible asset earnings
18~1680
Identifying intellectual property and intangible asset earnings
A detailed review of the market, intellectual property and intangible assets is used to apportion total business earnings between all the intellectual property and intangible assets employed by the business, for example, recipes, formulae, copyrights and patents may be more important than brands in particular industries. Some brands are profitable because of non-brand related factors, for example, a patent or design, that was present to begin with or developed later. Other factors could be management, marketing effort and advertising, sub-brand names or the trade mark. This income allocation is essentially a judgemental process but is based on all available market research about what drives consumer purchases and loyalty patterns.

Property and Intangible Assets / 18~1650 Preferred Valuation Methodology and Key Valuation Issues / 18~1690 Discount rate determination
18~1690
Discount rate determination
Determination of the appropriate discount rate or capitalisation rate to capitalise the incremental economic benefits associated with the intangible asset should consider the following cumulative: current yield on short-term, risk-free or money market instruments; inflation risk premium; term to maturity premium, based upon the current term structure of interest rates; illiquidity risk premium; lack of marketability risk premium; premium for the systematic risk factors associated with a comparable investment; Beta factors for the market as a whole and for the intellectual property and intangible assets in particular. These Beta factors are determined by reference to standard industry risk analysis supplemented by specific risk analysis; premium for the non-systematic risk factors associated with the specific technology or intangible asset; and strength of the intellectual property and intangible assets. Strong intellectual property and intangible assets would attract a lower rate reflecting lower risk to associated earnings. Weak intellectual property and intangible assets would attract a commensurably higher rate, other modelling being equal.
This fair rate of return could be based on the capital asset pricing model, a risk or return analysis or similar methodology.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1710 Exploitation
18~1710
Exploitation
The successful exploitation of intellectual property requires the employment of additional, often substantial, resources. In broad terms the exploitation of intellectual property can be either direct or indirect. In the direct form, the intellectual property is employed by its inventor or developer, with the business or individual retaining all the various rights. This option is adopted for the following reasons. These would typically include the view that the intellectual property was in the mainstream of the enterprises activities, the availability of the necessary resources to exploit it successfully or the fact that the potential royalties might not be economically worthwhile. A typical example of direct exploitation would be a pharmaceutical company developing a drug in-house and then exploiting it and reaping the benefits from the marketing and sale of that drug. Indirect exploitation, by contrast, involves the owner transferring all or part of the bundle of rights in return for some share in the economic returns. Indirect exploitation typically involves one or other of the following: outright sale, licensing, joint ventures or franchising. Outright sale is the simplest method of indirect exploitation, where the owner, in exchange for some form of consideration, transfers all interest in, or at least control of, the intellectual property. The
consideration can be structured in a number of ways including a one-off payment or deferred or contingent payments. Licensing involves a licensor, the owner of the intellectual capital or intellectual property right, availing another, the licensee, of some form of permission to use one or more rights associated with the property, which the licensee would not otherwise have access to, in exchange for some form of consideration.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1730 Types of Intangible Assets and Valuation Methodologies for Specific Intangible Assets
18~1730
Types of Intangible Assets and Valuation Methodologies for Specific Intangible Assets
AASB 3: Business Combinations contains an illustrative list of intangible assets. Below we have summarised the intangibles included in that illustrative list. In the following list assets designated by the symbol: (#) are those that would be recognised apart from goodwill because they meet the contractual-legal criterion. These intangible assets also might meet the separability criterion. However, separability is not a necessary condition for an asset to meet the contractual-legal criterion. do not arise from contractual or other legal rights, but shall nonetheless be recognised apart from goodwill because they meet the separability criterion.
(*)
Below we have also identified the valuation methodologies that may be appropriate to value some of those intangible assets. Depending on the circumstances/reasons for the valuation, the following approaches may be worthwhile considering when undertaking the valuation of specific intangible assets. The reasons for undertaking the valuation may determine the most appropriate valuation methodology. It is also important to ensure that the results of the various methodologies used to value a particular intangible asset are reconciled or a clear explanation is provided as to why a particular methodology provides a more appropriate estimate of value. (Note: The valuation of intangible assets is a complex area involving specialised and separate study. Interested readers should study suitable specialist texts such as Valuing Intangible Assets (Reilly & Schweihs).)
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1730 Types of Intangible Assets and Valuation Methodologies for Specific Intangible Assets / Marketing-related intangible assets
Marketing-related intangible assets
AASB 3: Business Combinations contains the following list of illustrative examples. The standard also provides additional commentary on these broad categories: trade marks, trade names, service marks, collective marks, certification marks#;
Internet domain names#; trade dress (unique color, shape, or package design)#; newspaper mastheads#; and non-competition agreements#.
Appropriate valuation methodologies for valuing trade marks and non-competition agreements are discussed below.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1730 Types of Intangible Assets and Valuation Methodologies for Specific Intangible Assets / Marketing-related intangible assets / Trade marks
Trade marks Cost approach The cost approach is normally the least applicable approach and will generally understate the value of a trade mark. However, it is sometimes possible to review the costs of developing or acquiring a trade mark, e.g. advertising and promotion expenditures, legal costs and registration fees. These can be used as a guide to the current cost or value of recreating the trade mark. The profit split method can be used to estimate the value of a trade mark. This involves determining the income the product generates and splitting the profit between all applicable capital charges associated with generating that income. The most common market approach method is the relief from royalty method or the capitalised royalty income method. Guidance can be obtained from market transactions involving comparable trade marks.
Income approach
Market approach
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1730 Types of Intangible Assets and Valuation Methodologies for Specific Intangible Assets / Marketing-related intangible assets / Non-competition agreements
Non-competition agreements Cost approach This approach is rarely used in estimating the value of non-competition agreements as the cost of negotiating such an agreement is normally included in the cost of buying a business and the cost of negotiation would be significantly less than the value of the non-competition agreement. This is the most common methodology used to estimate the value of a non-competition agreement and involves the estimation of the value of the business with the covenant, less the value of the subject business without the covenant. Transactions involving the sale of non-competition agreements do not frequently occur in isolation from other assets and, accordingly, it is normally not possible to apply the market approach.
Income approach
Market approach

Property and Intangible Assets / 18~1730 Types of Intangible Assets and Valuation Methodologies for Specific Intangible Assets / Customer-related intangible assets
Customer-related intangible assets
AASB 3: Business Combinations contains the following list of illustrative examples. The standard also provides additional commentary on these broad categories: customer lists*; order or production backlog#; customer contracts and related customer relationships#; and non-contractual customer relationships*.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1730 Types of Intangible Assets and Valuation Methodologies for Specific Intangible Assets / Artistic-related intangible assets
Artistic-related intangible assets
AASB 3: Business Combinations contains the following list of illustrative examples. The standard also provides additional commentary on these broad categories: plays, operas, ballets#; books, magazines, newspapers, other literary works#; musical works such as compositions, song lyrics and advertising jingles#; pictures and photographs#; and video and audiovisual material, including films, music videos and television programs#.
Appropriate valuation methodologies for valuing copyright are discussed below.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1730 Types of Intangible Assets and Valuation Methodologies for Specific Intangible Assets / Artistic-related intangible assets / Copyright intangible assets
Copyright intangible assets Cost approach Replacement or recreation cost can often be used to provide an estimate of the minimum or lower bound estimate of value for a copyright intangible asset. If this method is utilised, it should include developers profit. There are two methodologies that utilise the income approach to estimate the value of copyright intangible assets: incremental analysis attempts to identify the additional revenue and profit as a result of owning a copyright intangible asset; and a profit split methodology that involves estimating appropriate portions of revenue to allocate to the different types of intangible assets.
Income approach
Market approach
Although there is an active market for items subject to copyright, it is often difficult to find a product that is truly comparable. In addition, transaction details, including pricing, are often not disclosed and it is conceptually difficult to calculate an appropriate unit of comparison. However, royalty rate analysis is the most common market approach applied.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1730 Types of Intangible Assets and Valuation Methodologies for Specific Intangible Assets / Contract-based intangible assets
Contract-based intangible assets
AASB 3: Business Combinations contains the following list of illustrative examples. The standard also provides additional commentary on these broad categories: licensing, royalty and standstill agreements#; advertising, construction, management, service or supply contracts#; lease agreements#; construction permits#; franchise agreements#; operating and broadcast rights#; use rights such as drilling, water, air, mineral, timber cutting, and route authorities#; servicing contracts such as mortgage servicing contracts#; and employment contracts#.
Appropriate valuation methodologies for valuing supplier contracts, lease agreements and employment contracts are discussed below.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1730 Types of Intangible Assets and Valuation Methodologies for Specific Intangible Assets / Contract-based intangible assets / Favourable supplier contracts
Favourable supplier contracts A favourable supplier contract should be evaluated using all three approaches. Cost approach The cost approach could be applied by estimating the total costs required to identify and evaluate the reliability of suppliers and to negotiate, draft and consummate a contract. This cost should include both the direct and indirect costs. The benefit from favourable supplier contracts can be calculated by estimating the future cost savings expected to be realised over the remaining term of the contract, including expected renewal periods, discounted to present value. This approach is difficult to apply as no market exists for the transfer of contract intangible assets or supplier contracts.
Income approach
Market approach
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1730 Types of Intangible Assets and Valuation Methodologies for Specific Intangible Assets / Contract-based intangible assets / Lease agreements
Lease agreements Cost approach The cost approach is not often used. However, it may be used if each of the following components are analysed: Income approach direct cost; indirect cost; developers profit; and entrepreneurial incentive.
An income approach can be utilised to evaluate a lease agreement. The methodologies often involve the estimation of incremental income less incremental costs and less capital costs associated with the establishment of a suitable leasehold. This approach is often used and normally involves either the analysis of property sales data (comparable transactions) or the analysis of comparable leases. Where the above analysis indicates the current lease is below the market rate, an intangible asset may exist.
Market approach
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1730 Types of Intangible Assets and Valuation Methodologies for Specific Intangible Assets / Contract-based intangible assets / Employment contracts
Employment contracts Cost approach The replacement cost method is frequently used to estimate the value of an employment contract or an assembled workforce. The costs include the cost to recruit, hire and train a replacement and should include the direct and indirect costs. The income approach is rarely used to estimate the value of an employment contract or an assembled workforce. The market approach is normally not used in the valuation of an employment contract or an assembled workforce because transactions involving the transfer of employees individually or collectively are not common.
Income approach Market approach
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1730 Types of Intangible Assets and Valuation Methodologies for Specific Intangible Assets / Technology-based intangible assets
Technology-based intangible assets
AASB 3: Business Combinations contains the following list of illustrative examples. The standard also provides additional commentary on these broad categories: patented technology#; computer software and mask works#; unpatented technology*; databases*; and trade secrets such as secret formulas, processes or recipes#.
Appropriate valuation methodologies for valuing patents and computer software are discussed below.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1730 Types of Intangible Assets and Valuation Methodologies for Specific Intangible Assets / Technology-based intangible assets / Patented technology
Patented technology Cost approach Although reproduction cost and/or replacement cost methodologies are sometimes used to value patents as there is no correlation between cost in value, the use of the cost approach is problematic at best. The income approach is often the most appropriate approach for valuing a patent. The chosen methods often involve either: Market approach methods that quantify the incremental sales or profit; or methods based on a relief from royalty methodology.
Income approach
It is often difficult to apply the market approach when valuing items such as patents as: by its very nature, a patent is unique and, accordingly, it is difficult to find similar technologies to compare it with; even if a comparable technology is identified, that comparable technology, i.e. patent, must have been included in a transaction where no other assets, e.g. know how, were transferred; and sufficient information about the comparable transaction needs to be available to allow a meaningful comparison to be made.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1730 Types of Intangible Assets and Valuation Methodologies for Specific Intangible Assets / Technology-based intangible assets / Computer software and mask works
Computer software and mask works Cost approach The cost approach can involve the calculation of the reproduction cost of the software or the replacement cost. Trended historical cost and the software engineering model method can both be used to estimate the value of computer software.
Income approach
A discounted cash flow methodology can be used where there is an identifiable income stream associated with the intangible asset, i.e. where the software generates income through sale or licence. It is sometimes possible to use market approaches in the valuation of computer software. Three common methodologies are: market transaction method (where information about sales of software as opposed to the businesses that own the software is available); relief from royalty method using a market derived royalty rate; and market replacement cost method where off the shelf software packages are used to provide an indication of the possible value of competitive products.
Market approach
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1760 Legislation Affecting the Valuation of Intangible Assets
18~1760
Legislation Affecting the Valuation of Intangible Assets
Various countries have issued legislation or guidance on what intangible assets can be valued and the methods that can be used. The International Valuation Standards Committee (IVSC) has issued a guidance note on intangible assets, which is reproduced in full in the chapter Reports. The valuation of intangible assets may be required for accounting purposes (particularly in the following circumstances): on the purchase or restructuring of a business; and when testing for the impairment of intangible assets.
The accounting standards governing the recognition and carrying value of intangible assets in each of these situations is discussed in detail in the chapter on Scoping a Valuation Assignment. There are a number of alternative circumstances where the valuation of intangibles and goodwill may be an issue: management of internally generated intangible assets and goodwill; litigation to protect intangible assets; and licensing and purchasing of intangible assets and goodwill.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1400 Intellectual Property and Intangible Assets / 18~1760 Legislation Affecting the Valuation of Intangible Assets / 18~1770 Internally Generated Intangible Assets and Goodwill
18~1770
Internally Generated Intangible Assets and Goodwill
With regard to internally generated intangible assets, International Accounting Standard IAS 38 Intangible Assets: currently allows the recognition of internally generated intangible assets arising from the development phase under certain conditions (IAS 38, paragraphs 45-50); but
currently does not allow the recognition of internally generated intangible assets arising from the research phase (IAS 38, paragraphs 42-44); and currently does not allow the recognition of internally generated brands, mastheads, publishing titles, customer lists and items similar in substance (IAS 38, paragraphs 51-52).
As discussed below, IAS 38 is currently being reviewed as part of the IASBs high priority project on business combinations and purchased intangibles, but the revised standard is expected to retain the prohibition on the recognition of internally generated goodwill and on internally generated intangible assets. In the USA Paragraph 10 of SFAS 142 (Goodwill and other intangibles) does not permit internally generated goodwill to be recognised, and neither do the UK standards. However, the IASB (IAS 36, paragraph 109) and UK (FRS 10, paragraph 44) do require the reversal of an impairment loss for goodwill if it is clear that the effect of the specific external event giving rise to that impairment loss has been reversed.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1810 Vendor Securities (Restricted Stock)
18~1810
Vendor Securities (Restricted Stock)
The following article on the valuation of restricted stock has been extracted from the Canadian Institute of Chartered Business Valuators newsletter entitled Business Valuation Digest. We thank them and James DeBresser of Marmer Penner Inc for permission to reproduce this article.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1810 Vendor Securities (Restricted Stock) / 18~1830 Introduction
18~1830
Introduction
Executives of companies who hold restricted shares are faced with difficult valuation problems if and when it becomes necessary to value those shares. This has become a reality for many executives in recent years as a result of the popularity of stock and option awards in executive remuneration packages. In the 1970s, a typical executive received a simple base salary. In the last 20 years, annual stock and option awards as components of executive remuneration became trendy. This trend continues today. Typically, the stock and option awards of key employees within an organisation vest over a long period of time in order to foster long-term loyalty to the organisation. Before vesting, holders of these stock and option awards are restricted from selling or exercising them. Occasionally, these employees are faced with circumstances where it becomes necessary to value restricted stock awards prior to them having vested, for example, on the occasion of a marital breakdown or for purposes of a wrongful dismissal claim against a former employer. In addition, merger and acquisition transactions between two companies often involve the issuance of restricted stock, typically by the acquiring company, in exchange for the stock of the company being acquired. It becomes very important for business valuers and other advisers involved in corporate finance activities to recognise occasions where restricted stock is a significant component of a merger and acquisition transaction. Faulty valuation conclusions will result if proper consideration is not given to the risks associated with holding restricted securities.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1810 Vendor Securities (Restricted Stock) / 18~1850 Empirical Evidence from the Public Markets of Restricted Stock Discounts
18~1850
Empirical Evidence from the Public Markets of Restricted Stock Discounts
Much research has been done to support the existence and magnitude of restricted stock discounts. Valuers typically cite the research from restricted stock studies and pre-IPO studies to support these discounts. Overall, these studies suggest an average restricted stock discount somewhere between 25% and 40% of the gross value. While these studies are useful for making general conclusions about restricted stock discounts, they fall short in their ability to pinpoint a narrower range for the discount in a particular transaction or notional situation. Because the 25% to 40% rule of thumb for these transactions represents only the average of those restricted stock discounts encountered in the studies, wide ranges in the studies were experienced. In the summary of restricted stock studies shown in Figure 1, the discounts were as high as 91% and as low as -30% (i.e. a premium was actually paid to acquire a block of restricted stock). Similarly, wide fluctuations are seen in the summary of preIPO studies as shown in Figure 2. FIGURE 1 Range Author of Study SEC Institutional Investor Study Gelman Study1 Moroney Study2 Maher Study3 Trout Study4 Stryker/Pittock Study5 Williamette Management Assoc.6 Silber Study Hall/Polacek Study
1.
Year(s) Completed 1969 19681970 19681972 c.19681972 19691973 19781982 19811984 Median 24% 33% 34% 33% na 45% 31% Mean 26% 33% 35% 35% 34% na na Low (15%) <15% (30%) 3% na 7% na
Discount High 80% >40% 90% 76% na 91% na
19811988 19691992
na na
34% 23%
(13%) na
84% na
Getman, Milton, An Economist-Financial Analysts Approach to Valuing Stock of a Closely Held Company, Journal of Taxation, June 1972, p. 353.
2.
Moroney, Robert E., Most Courts Overvalue Closely Held Stocks, Taxes The Tax Magazine, March 1973, pp. 144155.
3.
Maher, J. Michael, Discounts for Lack of Marketability for Closely Held Business Interests, Taxes The Tax Magazine, September 1976, pp. 562571.
4.
Trout, Robert R., Estimation of the Discount Associated with the Transfer of Restricted Securities, Taxes, June 1977, pp. 381385.
5.
Pittock, William F. and Stryker, Charles H., Revenue Ruling 77-287 Revisited, SRC Quarterly Reports, Spring 1983, pp. 13.
6.
Reported in Pratt, Shannon P, Reilly, Robert F, and Schweihs, Robert P, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, Third Edition (Chicago, IL, Irwin Professional Publishing 1996), pp. 344348.
FIGURE 2 Years Completed 19851986 19871989 19891990 19901992 19921993 19941995 Number of IPOs 21 27 23 35 54 46 Median 43% 45% 40% 40% 44% 45% Mean 43% 45% 45% 42% 45% 45% Discount Low 3% 4% 6% -6% -4% 6% Range High 83% 82% 94% 94% 90% 76%
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1810 Vendor Securities (Restricted Stock) / 18~1870 Restricted Stock Studies
18~1870
Restricted Stock Studies
The first restricted stock studies were completed in the United States during the 1960s and 1970s. These studies were based on the acquisitions of large blocks of actively traded securities by mutual funds and other institutional investors. Under Rule 144 of the Securities and Exchange Act of 1934 (Rule 144), the investors in these large blocks of stock were faced with a minimum two-year holding period in order to protect the interests of average investors. Following the expiry of the two-year period, Rule 144 allowed for the gradual liquidation of the block of stock on the public market. Typically, the total restriction was for a period of two to three years following the acquisition of the block. These investors were required to disclose the discounted prices they paid for large blocks of stock that were subject to the Rule 144 restriction and the quoted market price on the date of acquisition. Accordingly, implied restricted stock discounts were reported over several years and a reasonably good population of data was available to analyse until the mid 1970s. Although some studies were completed as late as 1992, the studies completed after the mid 1970s were based on much smaller populations. As shown in Figure 1 above, the studies suggest an average restricted stock discount in the range of 23% to 45%. The largest restricted stock study of its kind was performed by the Security Exchange Commission in the United States and was completed in 1969. The SEC Institutional Investor Study7 (SEC study) analysed a total of 398 transactions. In addition to simply reporting the results of the study, the SEC took its analysis one step further and made several general conclusions about the size of the restricted stock discounts it encountered in the population based on several common factors among the transactions in the population. The SEC study noted that the size of the restricted stock discount for a particular transaction was dependent on several factors. Subsequent studies, including the Silber8 study and the Hall/Polacek9 study supported the general conclusions of the SEC study.
Some of the important factors highlighted by the SEC study were: a. The size of the transaction The larger the dollar value of the transaction, the smaller the restricted stock discount encountered. b. The revenues of the company The larger the revenues of the company, the smaller the restricted stock discount encountered. c. The earnings of the company Companies with higher levels of earnings tended to have smaller discounts associated with them. d. The exchange that the company traded on Companies that traded on the New York Stock Exchange and American Stock Exchange tended to have smaller discounts associated with them while companies whose shares traded on over-the-counter exchanges had larger discounts associated with them.
7. Institutional Investor Study Report of the Securities and Exchange Commission (Washington DC: US Government Printing Office, March 10, 1971) 8. Silber, William L. Discounts on Restricted Stock: The Impact of Illiquidity on Stock Prices Financial Analysts Journal, JulyAugust 1991, pp. 6064 9. Hall, Lance S. and Polacek, Timothy C. Strategies for Obtaining the Largest Valuation Discounts Estate Planning, JanuaryFebruary 1994, pp. 3844
FIGURE 3 Factors Identified in SEC Study Smaller Transactions Lower Revenues Lower Revenues The exchange on which the company trades Volatility Tends To Be Higher Higher Higher Higher for over-the-counter, lower for larger exchanges such as the NYSE
Although the general conclusions reached in the SEC study and others are useful, a more rigorous approach to the quantification of restricted stock discounts is needed. Although the restricted stock studies identified several factors that were common with larger discounts, these studies failed to identify the one main variable that was the driver for the magnitude of the restricted stock discount. Once the main driver is identified, an approach to the quantification of restricted stuck discounts can be more easily understood.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1810 Vendor Securities (Restricted Stock) / 18~1890 Pre-IPO Studies
18~1890
Pre-IPO Studies
The types of transactions on which the restricted stock studies were based in the 1960s and 1970s decreased significantly by the mid 1970s. Accordingly, few transactions are available after this time on
which more current restricted stock studies can be based. An additional disadvantage therefore of relying on the restricted stock studies for supporting restricted stock discounts is that these studies are now almost 30 years old. An additional public market phenomenon became more prevalent in the mid 1970s that provided further evidence for restricted stock discounts. Studies based on this phenomenon are known as the pre-IPO studies. The pre-IPO studies were based on transactions that took place prior to the initial public offering of a stock on a public exchange. Typically, these transactions were private placements between large investors and insiders. These investors were restricted from selling their shares, not only until the company went public, but also for the two to three year period pursuant to Rule 144 after the initial public offering. These studies analysed the price difference between blocks of shares acquired as private placements by investors before the initial public offering of those shares vis-a-vis the initial public offering price once the shares first came onto the market. This difference is known as the pre-IPO discount and has been used to support the existence of restricted stock discounts. The most comprehensive studies on pre-IPO transactions were performed by Emory in the United States10. Emory worked for the large investment bank Robert W Baird & Company, and as such, was privy to many pre-IPO transactions in the course of his employment. Emorys first study was completed in 1985 and included 13 transactions. Since that time, Emory has published six updates of his original study. For each of the updates, Emory took the price at which the pre-IPO transaction took place and compared it with the price on the public market immediately after the initial public offering. A summary of the results of Emorys studies are shown in Figure 2.
10. Emory, John., The Value of Marketability as illustrated in Initial Public Offerings of Common Stock, Business Valuation News, September 1985, pp. 2124; Business Valuation Review, December 1986, pp. 1215; June 1989 pp. 5557; December 1990, pp. 114116; December 1992, pp. 208212; March 1994, pp. 37; and December 1995, pp. 150160.
These results suggest an average discount in the range of 40% to 45%. However, like the restricted stock studies, wide ranges of observations were noted. An additional criticism of the pre-IPO studies is that the discount encountered in these transactions is dependent on other factors other than the restriction on the stock and it is difficult, if not impossible, to separate out the components of the discount in order to derive the pure restricted stock discount. Discussion of the other factors that impact the pre-IPO discount is beyond the scope of this text, however other authors including Mercer11 discuss how the pre-IPO discount is affected by factors other than the restrictive nature of the block of stock.
11. Mercer, Christopher Z. Quantifying Marketability Discounts (Memphis, Tennessee: Peabody Publishing, LP, 1997)
Many transactions were reviewed by Emory in his studies, all of which support the existence of a restricted stock discount. However, the wide dispersion of discounts and the difficulties with being able to separate out the impact resulting from restrictions as opposed to the impact of other factors make it difficult to use the pre-IPO studies to determine restricted stock discounts in actual transactions or notional situations.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1810 Vendor Securities (Restricted Stock) / 18~1910 Restricted Stock Discounts The Main Drivers
18~1910
Restricted Stock Discounts The Main Drivers
As discussed above, the restricted stock and pre-IPO studies identified factors that tended to cause
larger restricted stock discounts. However, they failed to identify the one variable common to all the transactions that would have allowed for a more rigorous quantification of a particular restricted stock discount: volatility. Volatility is simply the tendency of the share price to rise and fall. This fact does not change the earlier findings of the restricted stock studies, rather it is in complete harmony with them. Take for example the common factors associated with large restricted stock discounts reported by the SEC study completed 30 years ago. Once identified as the main driver, volatility can be used to assist with narrowing in on a range for a particular restricted stock discount. It is important to realise that the volatility of a stock is a unique characteristic of the stock at a certain point in time, however it is constantly changing. In many cases, the volatility can be obtained from investor services such as Bloomberg, or it can be calculated using available public market data.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1810 Vendor Securities (Restricted Stock) / 18~1930 The Quantification of Restricted Stock Discounts The Mercer Approach
18~1930
The Quantification of Restricted Stock Discounts The Mercer Approach
An approach to the quantification of restricted stock discounts described by Mercer12 equates the quantum of the restricted stock discount to the cost of hedging the restricted stock during the restriction period and is directly related to the volatility of the stock at the day the restricted stock holding is required to be valued. The rationale for this approach is based on the premise that the risk related to holding restricted stock (and therefore the discount that should be afforded to a notional investor who is acquiring a block of restricted stock) is directly related to the risk that the stock price may decline during the restriction period after all, if there was a guarantee issued with restricted stock that the price of the stock will not decline during the restriction period, holding restricted stock would be risk-free, except for the time value of money forgone during the restriction period. Therefore, the restricted stock discount should equal the cost of providing the price guarantee during the restriction period. This is best illustrated by the example described in Figure 4, that calculates the discount for a hypothetical single share of stock in CIBC.
12. Mercer, Christopher Z. Quantifying Marketability Discounts (Memphis, Tennessee: Peabody Publishing, LP, 1997, pp. 409411)
FIGURE 4 Assume an investor is provided with an opportunity to purchase a single share in CIBC, whose stock closed recently on the TSE at about $30, but was not allowed to trade the stock for four months following the purchase. There is risk that in the four months following the purchase, the stock price could drop below $30, and because of the restriction, the investor would be prevented from minimising his loss, even if the stock price continued to drop. How much should an investor be willing to pay for this opportunity? The investor could purchase the share at its gross price of $30, and at the same time, insure against the risk associated with a price decline by purchasing a single put option on the TSE at an exercise price of $30 that expires in four months. A put option in CIBC provides the investor with the right, but not the obligation, to sell the CIBC stock at the specified $30, called the exercise or strike price on or before the expiration date. This way, even if the stock price dropped, the investor could exercise the option to sell the share at $30 and protect himself completely from a drop in the stock price. A single
CIBC put option with these terms (i.e. exercise price of $30 and an expiry date in four months) recently traded at $1.95. Therefore, the maximum that the investor should be willing to pay for the opportunity described by this example is the $30 stock price less the $1.95 cost of the put option, or $28.05. Expressed as a restricted stock discount, =1 Gross Value Cost of Insurance to Guarantee Gross Value Gross Value
=1 =1 =1
$30 $1.95 $30 $28.05 $30 0.935
Under the circumstances described in Figure 4, the opportunity provided to the investor had a 6.5% restricted stock discount associated with it. The discount can be expressed in the general form shown in Figure 5. FIGURE 5 Discount = 1 Gross Value Cost of Insurance to Guarantee Gross Value Gross Value
In the real world, investors acquire insurance against declines in stock prices by purchasing put options in the stock they hold. Buying and selling of put options is commonplace on North American public markets.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1810 Vendor Securities (Restricted Stock) / 18~1950 Valuing a Block of Restricted Stock Using the Mercer Approach
18~1950
Valuing a Block of Restricted Stock Using the Mercer Approach
The above example can be extended for almost any holding of restricted stock. This is illustrated by the example illustrated in Figure 6. FIGURE 6 Assume that an executive holds 20,000 shares of restricted stock in the company by whom he is employed. The shareholding is only a small percentage of the total outstanding stock in the company, and the average daily trading volume of the stock is large enough to absorb the block entirely when it ultimately gets sold by the executive following the lifting of the restriction period13. The executive becomes separated from his spouse and it becomes necessary to value all of his assets under family law in the province in which he resides. On the date of separation from his spouse, the 20,000 shares of stock have not vested to him; the stock ownership agreement with his company indicates that the restrictions on his holding get lifted over a four year period such that in
each of the next four years, 25% of his shares may be sold. Assume further that the stock closed at $120 on the date that the executive became separated from his spouse, and that the stock does not pay dividends14, and that the volatility of the stock, from published market data, is 40%.
13. If the size of the block is very large, a price concession may be required in order to cause the block to be immediately liquidated. In these circumstances, an additional discount for blockage may be appropriate. Although arising from different circumstances, a discount for blockage can be estimated using similar techniques and is described in detail in Quantifying Marketability Discounts, by Christopher Z. Mercer 1997. 14. If the stock pays dividends, adjustments to the input variables of the Black-Scholes formula are required, a discussion of which is beyond the scope of this paper.
In the example illustrated in Figure 6, which is more typical of real life restricted share problems, the value of a series of put options that hedges the entire holding is calculated with a range of expiry dates between one and four years. Unlike the example from Figure 5 however, published market prices are typically not available for the series of put options required to hedge the entire shareholding. It is therefore necessary to calculate all possible put option prices for different combinations of exercise prices and expiry dates. This ability is accomplished by making use of two fundamental equations from corporate finance.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1810 Vendor Securities (Restricted Stock) / 18~1970 Put Call Parity and the Black-Scholes Formula
18~1970
Put Call Parity and the Black-Scholes Formula
In order to calculate the value of any put option, one must first understand that the value of a put option is related mathematically to the value of a call option having the same terms by the equation from corporate finance known as put call parity. The put call parity equation simply states the mathematical relationship between a put option and a call option having the same terms, as illustrated in Figure 7. FIGURE 7 Call option value Put option value = Stock Price Present value of Strike Price Moving the terms around using simple algebra, one can solve for the value of the put option: Put option value = Call option value Stock Price + Present value of Strike Price From the put call parity equation, the stock price and the present value of the strike price are easily obtained. The call option value is determined by using the Black-Scholes equation derived by Professors Fisher Black and Myron Scholes in 197215, which is shown in Figure 8. This equation calculates the value of a call option for a non-dividend paying stock.
15. Black, Fischer and Scholes, Myron, The pricing of options and corporate liabilities, Journal of Political Economy, MayJune 1973
FIGURE 8 C = SN(d1) Xe-rtN(d2) where:

d1 = d2 = d1 T
ln(S/X) + (r + (2/2)T T
and where: C S X r T ln e = = = = = = = = Current option value Current stock price Exercise price Risk-free interest rate Time to maturity of option in years Standard deviation of the annualised continuously compounded rate of return of the stock Natural logarithm function the base of the natural logarithm, or 2.71828 The probability that a random draw from a standard normal distribution will be less than d The appropriate discount factor for period T at rate r. Thus, Ce-rT is the present value of C.
N(d) = e-rT =
If the stock under consideration pays dividends, adjustments to the model are required to account for the dividend paying nature of the stock. The Black-Scholes formula provides the last of the three unknowns contained in the formula for the value of the put option given in Figure 7. By substituting these terms into the equation given in Figure 7, a valuer can then proceed to determine the restricted stock discount for the executives restricted stock holding from Figure 6, as illustrated in Figure 9. FIGURE 9 Number of Shares 5,000 5,000 5,000 5,000 20,000 Restriction Period (years) 1 2 3 4 Risk-free Interest Rate 6.00% 6.25% 6.50% 6.75% Exercise Price of Put Value of Value of Put Call per per Put Call Black-Scholes Parity $19.11 $27.06 $33.26 $38.59 $19.11 $26.65 $31.97 $35.95 Total Cost of Hedging Strategy 95,549 133,233 159,848 179,735 568,365 2,400,000 24%
$127.20 $135.00 $143.40 $152.40
Total cost of hedging strategy Total value of portfolio, but for restricted nature Restricted Stock Discount
VALUATION ISSUES / 18~1000 Particular Valuations / 18~1810 Vendor Securities (Restricted Stock) / 18~1990 Conclusion
18~1990
Conclusion
When calculating the restricted stock discount for a particular shareholding, it is important to have all the facts, as underlying circumstances can render the approach discussed above inappropriate. A careful review of the circumstances surrounding the restricted stock holding as well as knowledge of the other shareholders are necessary. In certain circumstances, a restricted stock discount is not appropriate to take at all. However, where a restricted stock discount is appropriate, the approach discussed in this paper provides a method to establish a supportable range. It is not appropriate to apply an arbitrary 25% to 40% discount except in the most general of circumstances. Particularly in litigation, a supportable approach to the quantification of restricted stock discounts like the one discussed above is necessary.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~2040 References

18~2040 1.
References
AusIMM, 1998 Codes and Guidelines for the Technical Assessment and/or Valuation of Mineral and Petroleum Assets and Mineral and Petroleum Securities for Independent Experts Reports (The VALMIN Code) www.ausimm.com.au Debresser, A.J., 1999 Valuing Restricted Stock Canadian Institute of Chartered Business Valuers Business Valuation Digest, Volume 5, Issue 2. E-commerce Strategy A Hitchhikers Guide to the Digital Planet, February 2000, Salomon Smith Barney. Joint Ore Reserves Committee of the Australasian Institute of Mining and Metallurgy, Australian Institute of Geoscientists and Minerals Council of Australia 1999 Australasian Code for Reporting of Mineral Resources and Ore Reserves (The JORC Code) http://www.ausimm.com.au Rendu, J. 2000 International Aspects of Resource & Reserve Reporting Standards, a paper presented at The Codes Forum: The VALMIN and JORC Codes The 2000 AusIMM Annual Conference.
2. 3. 4.
5.
VALUATION ISSUES / 18~1000 Particular Valuations / 18~2040 References / Acknowledgements

Acknowledgements
Extracts from the Project Summary Business (Phase 1) Combinations, Keith Alfredsons speech Moving towards the implementation of 2005 International Accoundting Standards, and ED 109 are reproduced with permission from the AASB ( 2002 Australian Accounting Standards Board).
VALUATION ISSUES / 19~1000 Taxation
19~1000
Taxation
All countries in the world have a variety of different taxation legislation that needs to be considered when valuing a business and when planning the purchase or disposal of a business. Some of the taxes that may need to be considered include: income taxes; capital gains taxes; goods and services taxes or consumption taxes; stamp duty or asset transfer taxes; and taxes on transfers of funds between countries.
Taxation is very country specific, and in some cases state specific. This chapter provides some general commentary on the types of taxes that may need to be considered when valuing or transferring businesses.
VALUATION ISSUES / 19~1000 Taxation / 19~1050 Income Tax

19~1050
Income Tax
Where a valuation is being undertaken it is important to consider the impact of income tax. In Australia the type of legal entity which owns the business (or is going to purchase the business) affects the rate of tax that should be applied to the future earnings. A company will be taxed at the relevant company tax rate and a business owned by a trust or partnership may not be taxed directly. Company income tax rates are included in the chapter Reference Material. Furthermore, should profits be distributed by way of franked dividends the after tax effect to the individual shareholder may vary considerably, depending on their personal marginal tax rate. Additional considerations may include: the availability of any surplus franking credits and the purchasing companys ability to distribute them; and the ability of an entity to utilise or transfer carried forward tax losses.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax

19~1100
Capital Gains Tax
Capital gains tax is an important issue to consider before the sale of a business. The purpose of the following commentary is to give you a basic guide to the operation of the CGT regime in relation to the sale of a business. We recommend that taxation advice is sought from a taxation expert prior to entering a business sale.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1120 Background
19~1120
Background
A taxpayer can only make a capital gain or loss if a CGT event occurs in relation to a CGT asset that the taxpayer owns. This transactional approach to CGT enables CGT liability, and related issues such as the amount of the gain or loss and the time it arises, to be readily determined.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1140 Commencement Date
19~1140
Commencement Date
The CGT event approach to CGT applies from 1 July 1998, subject to certain transitional provisions.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1160 CGT Events
19~1160
CGT Events
There are over 50 CGT events and they are listed in Division 104. As a general rule, a capital gain arises if the capital proceeds of the asset from the CGT event is more than its cost base (or expenditure incurred). A capital loss arises if the opposite occurs. Capital gains and losses are usually disregarded if the asset was acquired before 20 September 1985. Capital proceeds are generally: those moneys that the taxpayer received, or was entitled to receive, on the occurrence of the event; and/or the market value of any other property the taxpayer has received, or is entitled to receive, for the event occurring.
There are also special modifications that apply in particular circumstances, e.g. the market value substitution rule. The cost base has five elements: The money paid, or required to be paid, for the asset and the market value of any other property given, or required to be given, for the asset. Any non-deductible incidental costs incurred in relation to the asset. The non-deductible non-capital costs of ownership. Capital expenditure incurred to increase the assets value. Capital expenditure incurred to establish, preserve or defend the asset.
The cost base includes indexation (if applicable), except for incidental costs. Those rules are contained in section 11025. The list of CGT events is divided up into 12 Subdivisions. Each Subdivision deals with a different type of CGT event and is lettered in alphabetical order.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1180 CGT Events Table
19~1180
CGT Events Table
of CGT event and is lettered in alphabetical order. 19~1180
CGT Events Table

Time of event is: when disposal contract is entered into or, if none, when entity stops being assets owner when other entity first obtains use and enjoyment of the asset when compensation is first received or, if none, when loss discovered or destruction occurred when contract ending asset is entered into or, if none, when asset ends when option ends Capital gain is: capital proceeds from disposal less assets cost base capital proceeds from agreement less assets cost base capital proceeds from loss or destruction less assets cost base Capital loss is: assets reduced cost base less capital proceeds assets reduced cost base less capital proceeds from agreement assets reduced cost base less capital proceeds from loss or destruction assets reduced cost base less capital proceeds from ending expenditure in granting option less capital proceeds from granting option incidental costs of creating right less capital proceeds from creating right expenditure to grant option less capital proceeds from grant expenditure to grant right less capital proceeds from grant reduced cost base apportioned to the covenant less capital proceeds from covenant assets reduced cost base less capital proceeds from creating trust assets reduced cost base less capital proceeds from transfer
Event number and description A1 Disposal of a CGT asset
B1 Use and enjoyment before title passes
C1 Loss or destruction of a CGT asset
C2 Cancellation, surrender and similar endings C3 End of option to acquire shares, etc.
capital proceeds from ending less assets cost base capital proceeds from granting option less expenditure in granting it capital proceeds from creating right less incidental costs of creating it capital proceeds from grant less expenditure to grant it capital proceeds from grant of right less expenditure to grant it capital proceeds from covenant less cost base apportioned to the covenant capital proceeds from creating trust less assets cost base capital proceeds from transfer less assets cost base
D1 Creating contractual or other rights in another entity D2 Granting, renewing or extending an option D3 Granting a right to income from mining D4 Granting of conservation covenant
when contract is entered into or right is created when option is granted, renewed or extended when contract is entered into or, if none, when right is granted when conservation covenant is entered into by landowner
E1 Creating a trust over a CGT asset
when trust is created
E2 Transferring a CGT asset to a trust
when asset is transferred
Event number and description E3 Converting a trust to a unit trust
Time of event is: when trust is converted
Capital gain is: market value of asset at time trust is converted less its cost base non-assessable part of the payment less cost base of the trust interest reduction in cost base of unit or interest for trustee market value of CGT asset at that time less its cost base; for beneficiary that market value less cost base of beneficiarys capital interest for trustee market value of CGT asset at that time less its cost base; for beneficiary that market value less cost base of beneficiarys right to income for trustee market value of CGT asset at that time less its cost base; for beneficiary that market value less cost base of beneficiarys capital interest capital proceeds less appropriate proportion of the trusts net assets
Capital loss is: assets reduced cost base less that market value at time trust is converted no capital loss
E4 Capital payment from trust on trust interest
immediately before the end of the income year when trustee makes payment
E5 Beneficiary becoming entitled to a trust asset
when beneficiary becomes absolutely entitled to trust asset
for trustee reduced cost base of CGT asset at that time less that market value; for beneficiary reduced cost base of beneficiarys capital interest less that market value for trustee reduced cost base of CGT asset at that time less that market value; for beneficiary reduced cost base of beneficiarys right to income less that market value for trustee reduced cost base of CGT asset at that time less that market value; for beneficiary reduced cost base of beneficiarys capital interest less that market value appropriate proportion of the trusts net assets less capital proceeds
E6 Disposal to beneficiary to end income right
the time of the disposal
E7 Disposal to beneficiary to end capital interest
the time of the disposal
E8 Disposal by beneficiary of capital interest
when disposal contract entered into or, if none, when beneficiary ceases to own CGT asset when entity makes agreement
E9 Creating a trust over future property
market value of the property (as if it existed when agreement made) less incidental costs in making agreement
incidental costs in making agreement less market value of the property (as if it existed when agreement made)
Event number and description F1 Granting, renewing or extending a lease
Time of event is: for grant of lease when entity enters into lease contract or, if none, at start of lease; for lease renewal or extension at start of renewal or extension for grant of lease when lessor grants lease; for lease renewal or extension at start of renewal or extension when lease term is varied or waived when lease term is varied or waived when lease term is varied or waived when company pays non-assessable amount when liquidator makes declaration when deposit is forfeited
Capital gain is: capital proceeds less expenditure on grant, renewal or extension
Capital loss is: expenditure on grant, renewal or extension less capital proceeds
F2 Granting, renewing or extending a long-term lease
capital proceeds from grant, renewal or extension less cost base of leased property
reduced cost base of leased property less capital proceeds from grant, renewal or extension amount of expenditure incurred in getting lessees agreement no capital loss
F3 Lessor pays lessee to get lease changed F4 Lessee receives payment for changing lease F5 Lessor receives payment for changing lease G1 Capital payment from company to shareholder G3 Liquidator declares shares or financial instruments worthless H1 Forfeiture of a deposit
no capital gain
capital proceeds less cost base of lease capital proceeds less expenditure in relation to variation or waiver payment less cost base of shares plus cost base reduction to share no capital gain
expenditure in relation to variation or waiver less capital proceeds no capital loss
shares reduced cost base plus cost base modification to share expenditure in connection with prospective sale less deposit Incidental costs less capital proceeds for each CGT asset the person owns, its reduced cost base less its market value for each CGT asset the trustee owns, its reduced cost base less its market value
deposit less expenditure in connection with prospective sale capital proceeds less incidental costs for each CGT asset the person owns, its market value less its cost base for each CGT asset the trustee owns, its market value of asset less its cost base
H2 Receipt for event relating to a CGT asset I1 Individual or company stops being resident I2 Trust stops being a resident trust
when act, transaction or event occurred when individual or company stops being Australian resident when trust ceases to be resident trust for CGT purposes
Event number and description J1 Company stops being member of wholly owned group after rollover J2 Change in status of a CGT asset that was a replacement asset in a rollover under Subdivision 152E (small business rollover) J3 Change of circumstances where a share in a company or an interest in a trust was a replacement asset in a rollover under Subdivision 152E J4 Reversal of trust to company rollover
Time of event is: when the company stops being a 100% subsidiary of relevant ultimate holding company of the group when the change in status of the asset happens
Capital gain is: market value of asset at the break-up time less its cost base
Capital loss is: reduced cost base of asset less that market value
the amount of the capital gain that was previously disregarded under Subdivision 152E with respect to the replacement asset that changed status the amount of the capital gain that was previously disregarded under Subdivision 152E for the share or unit
no capital loss
when the change in circumstances happens
no capital loss
at the end of the six-month period (or at end of any extended period granted by the Commissioner) when payment in respect of debt is made immediately prior to death when taxpayer starts holding asset as trading stock when CGT event A1, C2 or E8 happens to shares in the company, or an interest in the trust, that owns the collectable
market value of asset at time company acquired it from the trust less assets cost base no capital gain
reduced cost base of asset less assets market value at that time so much of payment as relates to denied part of a net capital loss reduced cost base of asset less that market value reduced cost base of asset less its market value market value of the shares or interest (as if the collectable had not fallen in market value) less the capital proceeds from CGT event A1, C2 or E8
K2 Bankrupt pays amount in relation to debt K3 Asset passing on death to tax-advantaged entity K4 CGT asset starts being trading stock K5 Special capital loss from collectable that has fallen in market value
market value of asset at death less its cost base market value of asset less its cost base no capital gain
Event number and description K6 Pre-CGT shares or trust interest
Time of event is: when another CGT event involving the shares or interest happens
Capital gain is: capital proceeds from the shares or trust interest (so far as attributable to post-CGT assets owned by the company or trust) less the assets cost bases termination value less cost times fraction
Capital loss is: no capital loss
K7 Balancing adjustment events depreciable assets
when balancing adjustment event calculated under Subdivision 40D occurs when the decrease in market value happens for the relevant interest when manager becomes entitled to receive payment in terms of relevant partnership agreement when the forex realisation event happens i.e. when the right to receive the foreign currency ceases when the forex realisation event happens just before the end of the income year in which the capital loss under section 83050(2)(b) or section 83050(3)(b) occurs just after entity becomes subsidiary member of the group
cost less termination value times fraction
K8 Direct value shifts affecting your equity or loan interests in a company or trust K9 Entitlement of venture capital managers to receive payment of a carried interest K10 Short-term forex realisation gain covered by item 1 of the table in subsection 77570(1) K11 Short-term forex realisation loss covered by item 1 of the table in subsection 77575(1) K12 Partner in a foreign hybrid makes a capital loss under section 83050(2)(b) or section 83050(3)(b) L1 Reduction under section 70557 in tax cost setting amount of assets of entity becoming subsidiary member of consolidated group or MEC group
the gain worked out under section 725365
no capital loss
capital proceeds (including the giving of any property) from the event the forex realisation gain calculated under forex realisation event 2
no capital loss
no capital loss
no capital gain
the forex realisation loss calculated under forex realisation event 2 partners available loss exposure amount less carried forward capital losses available to a foreign hybrid amount of reduction which is spread over five years
no capital gain
no capital gain
Event number and description L2 Amount remaining after step 3A etc. of joining allocable cost amount is negative L3 Tax cost setting amounts for retained cost base assets exceed joining allocable cost amount L4 No reset cost base assets against which to apply excess of net allocable cost amount on joining L5 Amount remaining after step 4 of leaving allocable cost amount is negative L6 Error in calculation of tax cost setting amount for joining entitys assets L7 Discharged amount of liability differs from amount for allocable cost amount purposes
Time of event is: just after entity becomes subsidiary member of the group just after entity becomes subsidiary member of the group
Capital gain is: amount remaining
Capital loss is: no capital loss
amount of excess
no capital loss
just after entity becomes subsidiary member of the group
no capital gain
amount of excess
when entity ceases to be subsidiary member of the group start of the income year when the Commissioner becomes aware of the errors start of the income year in which the liability is discharged
amount remaining
no capital loss
the net overstated amount resulting from the errors, or a portion of that amount allocable cost amount less what it would have been had the correct amount for the liability been used no capital gain
the net understated amount resulting from the errors, or a portion of that amount what the allocable cost amount would have been had the correct amount for the liability been used less the allocable cost amount amount of reduction that cannot be allocated
L8 Reduction in tax cost setting amount for reset cost base assets on joining cannot be allocated
just after entity becomes subsidiary member of the group
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1200 Subdivision 108A: What a CGT asset is
19~1200
Subdivision 108A: What a CGT asset is
CGT assets are any kind of property or a legal or equitable right that is not property. A CGT asset may be part of, or an interest in, an asset. Goodwill is a CGT asset according to subsection 1085(2)(b). A CGT asset may comprise an interest in a partnership or an interest in an asset of a partnership. If a CGT asset is owned as a joint tenant, this will be treated as though a separate asset is owned that equals the taxpayers share in the asset.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1220 Section 10410: Disposal of a CGT asset: CGT event A1
19~1220
Section 10410: Disposal of a CGT asset: CGT event A1
This is the main CGT event, which occurs if a taxpayer disposes of an asset. An asset is disposed of if a change of ownership occurs from one entity to another entity whether by act, event or operation of law. A change of ownership does not occur: if a taxpayer stops being the legal owner of the asset, but continues to be the beneficial owner; or because of a change of trustee.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1220 Section 10410: Disposal of a CGT asset: CGT event A1 / When?
When?
The time of CGT event A1 is either: when a contract is entered into for the disposal; or if no contract, when the change of ownership occurs.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1220 Section 10410: Disposal of a CGT asset: CGT event A1 / How?
How?
A capital gain is made if the capital proceeds from the disposal are more than the assets cost base. A capital loss is made if the capital proceeds are less than the assets reduced cost base. Example: Sale of a business In June 2004, a contract of sale is entered into, which settles in October 2004. When incidental costs are taken into account, a capital gain of $50,000 is made. Timing is important. Does the capital gain fall in the 2003/04 or the 2004/05 income year? Section 10410 states that the time of the event is when the contract is entered into and not when it is settled. Therefore, the capital gain must be included in the tax return for the 2003/04 income year. Note: A taxpayer may be entitled to the small business relief under Division 152 which may eliminate or reduce the capital gain on the disposal of the assets of a small business.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1220 Section 10410: Disposal of a CGT asset: CGT event A1 / Exceptions
Exceptions
A capital gain or loss can be disregarded: if the asset was acquired before 20 September 1985;
if a lease was granted before 20 September 1985; or in the case of a renewed or extended lease, if the start of the last renewal or extension occurred before 20 September 1985.
Section 10410 also gives details of timing for CGT purposes in relation to compulsory acquisition. This event will not occur if the asset is disposed of in order to provide or redeem a security.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1240 Division 114 Indexation of Cost Base
19~1240
Division 114 Indexation of Cost Base
This Division contains: indexing elements of a cost base; when indexation is relevant; a requirement for 12 months ownership; cost base modifications; and when expenditure is incurred for rollovers.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1240 Division 114 Indexation of Cost Base / 19~1250 Section 1141: Indexing elements of cost base
19~1250
Section 1141: Indexing elements of cost base
In working out the cost base of a CGT asset acquired at or before 11:45 am (by legal time in the Australian Capital Territory) on 21 September 1999, expenditure incurred at or before that time in each element is indexed. (The expenditure can include giving property.) Subdivision 960M shows taxpayers how to index amounts. The indexation does not take account of inflation after 30 September 1999. All five elements of the cost base of a CGT asset are indexed, except element three non-capital costs of ownership. Indexation is not relevant to expenditure incurred after 21 September 1999 or any expenditure relating to a CGT asset acquired after that time. As of 21 September 1999 certain taxpayers are entitled to a 50% discount on the amount of a capital gain. Indexation is not available if a taxpayer utilises the 50% discount capital gain concession (refer section 11520).
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1240 Division 114 Indexation of Cost Base / 19~1260 Section 1145: When indexation is relevant
19~1260
Section 1145: When indexation is relevant
Indexation is only relevant if the cost base of a CGT asset is relevant to a CGT event. Indexation is not relevant to the reduced cost base of a CGT asset. Indexation is not relevant to the capital gain of individuals, complying superannuation entities, trusts or listed investment companies from a CGT event occurring after 21 September 1999, unless the
relevant entity has chosen that the cost base includes indexation for the purposes of section 11025.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1240 Division 114 Indexation of Cost Base / 19~1270 Section 11410: Requirement for 12 month ownership
19~1270
Section 11410: Requirement for 12 month ownership
Expenditure is only indexed in the cost base of a CGT asset or a CGT event occurring in relation to the asset if the entity whose cost base is being worked out, acquired the asset at or before 21 September 1999, and at least 12 months before the time of the CGT event. There are, however, five main exceptions: CGT event E8 (disposal by beneficiary of capital interest) In this circumstance, the beneficiary may only index the cost base of the trust assets if they acquired the interest in the trust capital at least 12 months before disposing of it. Replacement asset or same asset rollover The 12 month rule will only be satisfied if the period of the entitys ownership of the original asset and the replacement asset, when combined, is at least 12 months. This exception will also apply to an unbroken chain of rollovers. Deceased estates When a taxpayer dies and a CGT asset is left to a legal personal representative or beneficiary, the 12 month rule is measured from the time that the taxpayer acquired the asset. Surviving joint tenant If a taxpayer owns a CGT asset with another as a joint tenant and the taxpayer dies, the 12 month rule will apply to the surviving joint tenant as if that tenant had acquired the taxpayers interest when they acquired it. CGT event J1 (company stops being member of wholly owned group after rollover) When a company stops being a member of a wholly owned group after a rollover and a CGT asset has occurred, the company that owns the rollover asset ignores, for the purpose of indexation, the acquisition rule contained in subsection 104175(8).
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1240 Division 114 Indexation of Cost Base / 19~1280 Section 11415: Cost base modifications
19~1280
Section 11415: Cost base modifications
Section 11415 notes that a number of modifications to the cost base of a CGT asset are contained within ITAA 1997. These modifications are contained in sections 11220, 11235 and Subdivisions 112B, 112C and 112D. The main way in which the cost base of an asset is modified is by substituting the market value of an asset for the first element of the cost base. Section 11220 provides that market value of an asset, at the time of its acquisition, is substituted, if:
no expenditure is incurred in acquiring the asset (e.g. a gift), except where the acquisition arose by way of CGT event D1 or where it results from another entity doing something which did not amount to a CGT event; or some or all of the expenditure incurred in acquiring the asset cannot be valued; or the parties were not dealing with each other at arms length in connection with the acquisition.
If an element of a cost base of a CGT asset is modified, you must also index the modified element as if expenditure equal to the amount had been incurred in the quarter in which the modification occurred.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1240 Division 114 Indexation of Cost Base / 19~1290 Section 11420: When expenditure is incurred for rollovers
19~1290
Section 11420: When expenditure is incurred for rollovers
If there is a rollover and the first element of the assets cost base is the whole of the cost base of the original asset, you must index that element as if expenditure equal to the amount in that element had been incurred at the same time as the rollover.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1240 Division 114 Indexation of Cost Base / 19~1300 Section 960280: Index number
19~1300
Section 960280: Index number
The cost base may be indexed (if available) to take into account the effects of inflation. Indexation occurs only where the asset has been held for 12 months or more. The indexation factor is determined by dividing the index number of the quarter in which the asset was disposed of by the index number of the quarter in which the asset was acquired. Note: Assets acquired on or after 21 September 1999 cannot be indexed. Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 March 74.4 81.4 87.0 92.9 100.9 105.8 107.6 108.9 110.4 114.7 119.0 120.5 June 75.6 82.6 88.5 95.2 102.5 106.0 107.3 109.3 111.2 116.2 119.8 120.2 September 71.3 77.6 84.0 90.2 97.4 103.3 106.6 107.4 109.8 111.9 117.6 120.1 119.7 December 72.7 79.8 85.5 92.0 99.2 106.0 107.6 107.9 110.0 112.8 118.5 120.3 120.0
Year 1998 1999
March 120.3 121.8
June 121.0 122.3
September 121.3 123.4
December 121.9
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1320 Division 115 Discount Concessions for Capital Gains by Individuals and some other Entities
19~1320
Division 115 Discount Concessions for Capital Gains by Individuals and some other Entities
Division 115 sets out how taxpayers can reduce their capital gains by a discount percentage in certain circumstances. Concessional rules apply to working out the net capital gain of certain entities if: the CGT event occurred after 11:45 am on 21 September 1999; the CGT asset was acquired at least 12 months before the CGT event that caused the capital gain; and the taxpayer must have chosen not to include indexation in the cost base of the asset for working out the capital gain (refer section 11520).
Only the following entities are entitled to the CGT discount concession: individuals; complying superannuation entities; trusts; and life insurance companies or registered organisations before 1 July 2000, in certain circumstances.
Note: Companies are not entitled to the 50% discount concession on capital gains made by them.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1320 Division 115 Discount Concessions for Capital Gains by Individuals and some other Entities / 19~1330 CGT events eligible for the discount
19~1330
CGT events eligible for the discount
Not all CGT events are eligible for the CGT discount concession. Section 11525(3) lists those CGT events for which the CGT discount concession is not available. The CGT discount concession may be used for all other CGT events.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1320 Division 115 Discount Concessions for Capital Gains by Individuals and some other Entities / 19~1340 CGT events that do not qualify for the CGT discount
19~1340
CGT events that do not qualify for the CGT discount
Where the following events occur in relation to a CGT asset, the taxpayer will not be able to claim the CGT discount concession: CGT event D1: Creating contractual or other rights. CGT event D2: Granting an option. CGT event D3: Granting a right to income from mining. CGT event E9: Creating a trust over future property. CGT event F1: Granting a lease. CGT event F2: Granting a long-term lease. CGT event F5: Lessor receives payment for changing lease. CGT event H2: Receipt for event relating to a CGT asset. CGT event J2: Small business rollover change in status of replacement asset. CGT event J3: Small business rollover shares or units as replacement assets. CGT event K10: Short-term forex realisation gain.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1320 Division 115 Discount Concessions for Capital Gains by Individuals and some other Entities / 19~1350 Indexation and the CGT discount concession
19~1350
Indexation and the CGT discount concession
Prior to the introduction of the CGT discount concession taxpayers could use indexation to calculate a capital gain. This allowed for the effect of inflation so that the capital gain was the gain in value above inflation. Section 11520 provides that the discount capital gain must not have an indexed cost base. To be a discount capital gain the capital gain must have been worked out by reference to a cost base whose elements have not been indexed. A taxpayer can choose to apply one method or the other for working out the capital gain depending on the time of acquisition of the CGT asset and the time of the CGT event. In summary these particular rules are: If both the time of acquisition and the CGT event occurred prior to 11:45 am 21 September 1999, then a CGT discount concession is not available. Indexation can be used. If the time of acquisition was before 11:45 am 21 September 1999 and the CGT event occurred after 11:45 am 21 September 1999, then the taxpayer can choose either method to calculate the CGT liability. If both the time of acquisition and the CGT event occurred after 11:45 am 21 September 1999, then a taxpayer may only use the CGT discount concession.
Note however: Indexation is not available after the end of the September 1999 quarter.
The method of calculation of the capital gain is different depending upon which method is used. The rules for this calculation are set out in Division 102. Section 1023 provides that the CGT discount concession is calculated in such a way that the net capital gain includes only part of the amount of the discount capital gain left after applying current year capital losses and net capital losses from earlier years. Reference must be made to section 1025 which contains the operative provisions for calculating assessable income that includes a net capital gain.
In summary the rules are: If the capital gain has had the benefit of indexation then the indexed capital gain is calculated and this amount is then offset by the capital loss. If the CGT discount concession provisions are being used then the capital gain is offset by the capital loss and then that amount is discounted by the 50% discount concession.
This will lead to differences in the effect of the application of the capital loss and gives rise to a different result depending on whether indexation or the CGT discount concession is applied. Example 1 A taxpayer acquires a CGT asset for $100,000. Its indexed cost base at the date of sale is $110,000. The CGT asset is sold for $200,000. There is no capital loss to apply. If the taxpayer is entitled to use indexation then the method to work out the net capital gain is: $200,000 $110,000 $90,000 Realisation Amount Indexed Cost Base Net Capital Gain
If the CGT discount concession is used then the calculation would be: $200,000 $100,000 = $100,000 2 = $50,000 (Net Capital Gain)
In this case the CGT discount concession is the preferable method. Example 2 Assume that the taxpayer has a capital loss of $50,000, then the respective calculations would be as follows. Using the indexation method the calculations would be: $200,000 $110,000 $90,000 $50,000 = $40,000 Realisation Amount Indexed Cost Base Net Capital Gain Capital Loss Net Capital Gain
Using the CGT discount concession method the calculations would be: $200,000 $100,000 Realisation Amount Cost Base
$100,000 $50,000 $50,000 = $25,000
Capital Gain before discount concession Capital Loss 2 (50% Discount) Net Capital Gain
In this case the CGT discount concession is the preferable method. Example 3 If the capital loss was $85,000, then the respective calculations would be: Using the indexation method: $200,000 $110,000 $90,000 $85,000 = $5,000 Capital Loss Net Capital Gain Realisation Amount Indexed Cost Base
Using the CGT discount concession method: $200,000 $100,000 $100,000 $85,000 $15,000 = $7,500 Realisation Amount Cost Base Capital Gain before discount concession Capital Loss 2 (50% Discount) Net Capital Gain
In this case the indexation method produces the better result for the taxpayer. It would seem that the greater the capital loss the more favourable one method is over the other.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1320 Division 115 Discount Concessions for Capital Gains by Individuals and some other Entities / 19~1360 The 12 month holding requirement
19~1360
The 12 month holding requirement
To qualify for the CGT discount, a CGT asset must have been owned by the taxpayer for at least 12 months at the time of the CGT event.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1320 Division 115 Discount Concessions for Capital Gains by Individuals and some other Entities / 19~1360 The 12 month holding requirement / How does this rule apply in cases where rollover relief is being
utilised or the asset has devolved from a deceased person?

How does this rule apply in cases where rollover relief is being utilised or the asset has devolved from a deceased person?
Certain assets acquired under the same asset or replacement asset rollover provisions or under the rules applying to deceased persons will be treated as having been owned for at least 12 months, if the collective period of ownership is at least 12 months. This effective ownership rule is only for the purposes of claiming the CGT discount.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1320 Division 115 Discount Concessions for Capital Gains by Individuals and some other Entities / 19~1360 The 12 month holding requirement / Section 11540: Rules against artificial extension of ownership period to 12 months
Section 11540: Rules against artificial extension of ownership period to 12 months
A capital gain arising from an agreement made within a year of acquisition is not a discount capital gain. Section 11540 states that a capital gain from a CGT event will not be discounted if the CGT event occurred in an agreement made within 12 months of acquiring the asset (e.g. put and call option agreements). This rule will prevent taxpayers inappropriately taking advantage of the CGT discount by seeking to artificially extend the period of ownership of the asset that produces the capital gain.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1320 Division 115 Discount Concessions for Capital Gains by Individuals and some other Entities / 19~1360 The 12 month holding requirement / Sections 11545 and 11550: Capital gains from sale of shares in a company or an interest in a trust
Sections 11545 and 11550: Capital gains from sale of shares in a company or an interest in a trust
Section 11545 provides that the CGT discount is not available for capital gains arising from CGT events happening to shares in a company with less than 300 members or interests in a fixed trust with less than 300 members unless at least one of the following conditions is satisfied: the taxpayer (including associates) has less than 10% equity in the entity before the CGT event; or the sum of the cost base of the assets held for less than 12 months by the entity just before the CGT event is not more than 50% of the cost base of all the assets of the entity; or the notional net capital gain made on assets held by the entity for less than 12 months just before the CGT event is not more than 50% than the notional net capital gain on all assets held by the entity at that time.
This rule prevents a capital gain from an equity interest in an entity with newly acquired assets from being a discount capital gain, unless relevant ratios are satisfied.
Section 11550 provides that where the company or unit trust has more than 300 members this rule does not apply, unless the entity is subject to concentrated ownership (i.e. where up to 20 individuals own interests between them which give them at least 75% control of the entity in terms of voting rights, income and capital or the variation of rights can result in this).
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1320 Division 115 Discount Concessions for Capital Gains by Individuals and some other Entities / 19~1370 Subdivision 115B: Discount percentage
19~1370
Subdivision 115B: Discount percentage
Section 115100 states that the discount percentage for a discounted capital gain is: 50% if the gain is made by an individual or a trust that is not a complying superannuation entity; or 331/3% if the gain is made by a complying superannuation entity or life insurance company.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1320 Division 115 Discount Concessions for Capital Gains by Individuals and some other Entities / 19~1380 Application to individuals
19~1380
Application to individuals
If an individual makes a capital gain from a CGT event occurring after 21 September 1999 to a CGT asset acquired after that time, the individual will be taxed on one half of the gain, without indexation applying to the cost base. The CGT asset must be acquired by the taxpayer at least 12 months before the CGT event that caused the capital gain. The gain before the CGT discount is applied is defined as the discount capital gain. The CGT discount is determined by the discount percentage. Example Sarah acquires listed public company shares in November 1999, for $15 each. She sells the shares in December 2000 for $27 each. She must include in assessable income a discounted gain of $6 for each share, being half of the realised nominal gain of $12. If an individual makes a capital gain from a CGT event occurring after 21 September 1999 to a CGT asset acquired at or before that date and owned for at least 12 months, the individual may choose to include in their taxable capital gain: one half of the capital gain without indexation of the cost base; or the whole of the gain between the realised price of the asset and its cost base, including indexation frozen at 30 September 1999.
Example Sandra acquired shares in a listed public company in 1995 for $20 each and sells these shares in May 2000 for $38 each. At the date of sale, the frozen indexation amount would increase the cost base to $22, based on indexation frozen at 30 September 1999. Sandra may choose to calculate the capital gain for each share in either of the following ways:
the excess of disposal proceeds ($38) over index cost base ($22) giving a capital gain of $16; or half of the realised gain, being the excess of the capital proceeds ($38) over the cost base without any indexation ($20), the nominal gain being $18 and half of that gain being $9.
Given this outcome, Sandra chooses to claim the CGT discount of 50%.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1320 Division 115 Discount Concessions for Capital Gains by Individuals and some other Entities / 19~1390 Application to complying superannuation entities
19~1390
Application to complying superannuation entities
If a complying superannuation entity makes a capital gain from a CGT event occurring after 21 September 1999 to a CGT asset acquired after that time, the complying superannuation entity will be taxed on two-thirds of the gain, without any indexation applying to the cost base. The CGT asset must have been acquired by the complying superannuation entity at least 12 months before the CGT event occurs. After 21 September 1999, if a complying superannuation entity makes a capital gain from a CGT event occurring to a CGT asset it acquired at or before that time and owned for at least 12 months, it may choose to include in its assessable income: two-thirds of the capital gain calculated without any indexation of the cost base; or the whole of the capital gain calculated with the index cost base frozen at 30 September 1999.
A complying superannuation entity is: a complying superannuation fund; a complying approved deposit fund; or a pooled superannuation trust.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1320 Division 115 Discount Concessions for Capital Gains by Individuals and some other Entities / 19~1400 Application to trusts and beneficiaries
19~1400
Application to trusts and beneficiaries
If a trust makes a capital gain from a CGT event happening after 21 September 1999 a CGT asset acquired after that time, the net income of the trust will include one half of the gain, without any indexation applying to the cost base. The CGT asset must have been acquired by the trust at least 12 months before the CGT event that caused the capital gain. If a trust makes a capital gain from a CGT event on a CGT asset it acquired at or before 21 September 1999 and it has owned the asset for at least 12 months, the trustee of the trust may choose the CGT discount or frozen indexation option. The net income of the trust will include the discounted capital gain or indexation gain depending on the trustees choice. The beneficiary will need to know what proportion of their entitlement to the net income of the trust is attributable to capital gains and what proportion of that capital gain amount is
attributable to a discounted capital gain. The beneficiary of a trust must gross-up their part of the net income of the trust that is attributable to a discounted capital gain by applying a gross-up factor of 100%. This amount is treated as a capital gain of the beneficiary for the purposes of calculating the net capital gain for the year. This gross-up factor allows the beneficiary to appropriately apply any capital losses against the trusts capital gains before applying the CGT discount that is appropriate for that beneficiary. No discount is allowed for a trustee assessed under subsection 98(3) or section 99A of the ITAA 1936. That part of the beneficiarys share of the net income of the trust that is treated as a capital gain is deducted from their assessable income for the income year. This ensures that the capital gains component is not taxed twice. Example A fixed trust makes a capital gain of $1,000 following the disposal of a CGT asset owned for two years. In calculating the capital gain the trustee of the trust chooses the CGT discount, leaving a net income of $500 in terms of section 95 of ITAA 1936. There is a single beneficiary who is an individual and who is presently entitled to the net income of the trust. The beneficiary also has personal current year capital losses available of $400. In calculating his net capital gain for the year, the beneficiary must gross up the trust gain to $1,000 before applying his personal capital losses of $400, leaving a discount capital gain of $600, with a net capital gain of $300 after the 50% CGT discount has been applied. Example A fixed trust makes a capital gain of $1,000 as a result of an A1 event occurring to a CGT asset that the trustee has owned for more than 12 months. In calculating the net income under section 95 of the ITAA 1936, the trustee chooses to claim the CGT discount, resulting in a net income for the trust of $2,500, including the discounted capital gain of $500. There is one beneficiary, a company, that is presently entitled to the net income of the trust. The company will gross-up the discounted capital gain component to $1,000. The company is not eligible to apply the CGT discount to that grossed-up capital gain. This means that the company will include in its assessable income for the year the net trust distribution of $2,000, and that capital gain amount of $1,000.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1320 Division 115 Discount Concessions for Capital Gains by Individuals and some other Entities / 19~1400 Application to trusts and beneficiaries / 19~1410 Can a company use indexation to calculate a capital gain?
19~1410
Can a company use indexation to calculate a capital gain?
If a company acquires an asset after 21 September 1999, indexation of its cost base is not available. If a company acquired an asset at or before 21 September 1999, indexation of its cost base, frozen at 30 September 1999, is used to calculate a capital gain, providing the asset was owned for at least 12 months at the time that the CGT event occurs.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax /

19~1530 Division 122 Rollover for the Disposal of Assets to, or the Creation of Assets in, a Wholly-owned Company
19~1530
Division 122 Rollover for the Disposal of Assets to, or the Creation of Assets in, a Wholly-owned Company
Rollover relief is the deferral of CGT liability. This Division contains special rules governing rollover relief in the following situations: where assets are transferred to a wholly-owned company (i.e. a company in which an individual owns all the shares); where partners dispose of partnership property to a wholly-owned company; where an asset is created in a wholly-owned company; and where partners create an asset in a wholly-owned company.
Example 1 Joe owns a small plumbing business. Joe decides to incorporate and rollover the business assets to a new company. Joe owns all the shares in the company he creates. Example 2 Rachel and her two brothers operate the family farm in partnership. They all agree to incorporate the business. All the farm property and business assets are rolled over into a company. Rachel and her two brothers hold all the shares in the company.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1550 Subdivision 122A: Disposal or Creation of Assets by an Individual to a Wholly-owned Company
19~1550
Subdivision 122A: Disposal or Creation of Assets by an Individual to a Wholly-owned Company
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1550 Subdivision 122A: Disposal or Creation of Assets by an Individual to a Wholly-owned Company / 19~1560 Section 12215: When can a CGT liability be deferred by means of a rollover?
19~1560
Section 12215: When can a CGT liability be deferred by means of a rollover?
If a CGT asset or all of the assets of a business are disposed of to a wholly-owned company. If contractual or other rights are created in the company. If an option is granted to the company. If the company is granted a right to income from mining. If a lease is granted to the company, or a lease is renewed or extended.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1550 Subdivision 122A: Disposal or Creation of Assets by an Individual to
a Wholly-owned Company / 19~1570 Section 12220: What must be received in exchange for the disposal or creation of the asset?
19~1570
Section 12220: What must be received in exchange for the disposal or creation of the asset?
A taxpayer must only receive: non-redeemable shares in the company; or where existing assets are transferred to the company, non-redeemable company shares and the company undertaking to discharge liabilities for the assets.
The market value of the shares received must be substantially the same as: the market value of the assets transferred minus any liabilities the company undertakes to discharge in respect of the assets, where existing assets are transferred to the company; the market value of the asset, where assets are created.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1550 Subdivision 122A: Disposal or Creation of Assets by an Individual to a Wholly-owned Company / 19~1580 Section 12225: When is rollover relief not available?
19~1580
Section 12225: When is rollover relief not available?
Where a CGT asset in the company is disposed of or created in relation to: a collectable or personal-use asset; a decoration awarded for valour or brave conduct (unless it was bought); a precluded asset: OR Where all the assets of a business are disposed of to the company in relation to: a collectable or personal-use asset; a decoration awarded for valour or brave conduct (unless it was bought); or an asset that becomes trading stock of the company just after the disposal (unless it was the taxpayers trading stock when it was disposed of). a depreciating asset; trading stock; an interest in the copyright of a film dealt with under section 11830; a right to mine referred to in section 11845; or
an asset that becomes trading stock of the company just after its disposal or creation.
Where the income of the company is exempt from income tax because of Division 50 (Division 50 deals with exempt income and exempt entities) for the particular income year, the asset cannot be rolled over. Note: If the asset to be rolled over is a right, an option or a convertible note, the company cannot acquire trading stock by exercising the right or option or converting the convertible note.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1550 Subdivision 122A: Disposal or Creation of Assets by an Individual to a Wholly-owned Company / 19~1590 Residency
19~1590
Residency
If either the transferor or the company are not Australian residents, each rollover asset must have a necessary connection with Australia. The requirements for fulfilment of this connection are contained in section 13625.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1550 Subdivision 122A: Disposal or Creation of Assets by an Individual to a Wholly-owned Company / 19~1600 Special rules
19~1600
Special rules
Section 12235 sets out special rules where the company to which the CGT asset or asset of a business is being disposed respectively undertakes to discharge one or more liabilities for either of those assets. In either case the market value or the cost base of an asset is worked out when it is disposed of. Under subsection 12235(1) the following applies: What amount the liabilities cannot exceed Item 1 2 In this situation: You acquired the asset on or after 20 September 1985 You acquired the asset before 20 September 1985 the liabilities cannot exceed: The cost base of the asset The market value of the asset
Note: There are rules for working out what the liabilities are for an asset (refer section 12237). Subsection 12235(2) applies to the disposal of all the assets of a business and the following applies: What amount the liabilities cannot exceed Item 1 In this situation: You acquired all the assets on or after 20 September 1985 You acquired all the assets before 20 September 1985 You acquired at least one asset on or after 20 September 1985 and at least one before that day the liabilities cannot exceed: The sum of the market values of the precluded assets and the cost bases of the other assets The sum of the market values of the assets For liabilities in respect of assets acquired on or after that day the sum of the market values of the precluded assets and the cost bases of the other assets; For liabilities in respect of assets acquired before that day the sum of the market values of those assets
2 3
Section 12237 sets out the rules for working out what a liability for an asset is: A liability incurred for the purposes of a business that is not a liability for a specific asset or assets of the business is taken to be a liability for all the assets of the business (e.g. a bank overdraft would be such a liability). If a liability is for two or more assets, the proportion of the liability that is for any one of those assets is equal to: the market value of the asset the total of the market values of all the assets the liability is for
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1550 Subdivision 122A: Disposal or Creation of Assets by an Individual to a Wholly-owned Company / 19~1610 Section 12240: What happens if you rollover a CGT asset?
19~1610
Section 12240: What happens if you rollover a CGT asset?
Any capital gain or loss made is disregarded. If the asset was acquired on or after 20 September 1985, the cost base or reduced cost base of the shares received in exchange for the asset equals the cost base or reduced cost base of the asset when it was disposed of, minus any liabilities the company undertakes to discharge.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1550 Subdivision 122A: Disposal or Creation of Assets by an Individual to a Wholly-owned Company / 19~1620 Section 12245: What happens if you rollover all the assets of a business?
19~1620
Section 12245: What happens if you rollover all the assets of a business?
Any capital gains or losses made from each of the assets are disregarded. If the assets were acquired on or after 20 September 1985, the cost base or reduced cost base equals the market value of any precluded assets plus the cost base or reduced cost base of the other assets minus any liabilities the company undertakes to discharge. If all or some of the assets were acquired prior to 20 September 1985 (except precluded assets) then some of the shares received in consideration may be taken to be pre-CGT shares.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1550 Subdivision 122A: Disposal or Creation of Assets by an Individual to a Wholly-owned Company / 19~1630 Section 12265: Replacement asset rollover for a creation case
19~1630
Section 12265: Replacement asset rollover for a creation case
Any capital gain or loss can be disregarded. The costs incurred in creating the asset will equal the cost base or reduced cost base of the shares.
Example Bill grants a licence (CGT event D1) to Tiffin Pty Ltd (a company he owns). The company issues him with two additional shares. He incurs legal expenses of $1,000 to grant the licence. Bills cost base for each of the shares is $500.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1550 Subdivision 122A: Disposal or Creation of Assets by an Individual to a Wholly-owned Company / 19~1640 Section 12270: What are the consequences for the company?
19~1640
Section 12270: What are the consequences for the company?
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1550 Subdivision 122A: Disposal or Creation of Assets by an Individual to a Wholly-owned Company / 19~1640 Section 12270: What are the consequences for the company? / If a non-precluded asset is disposed of
If a non-precluded asset is disposed of
If an individual acquired the asset prior to 20 September 1985, the company is also deemed to have acquired it prior to that date. If an individual acquired the asset on or after 20 September 1985, the cost base or reduced cost base of the asset in the hands of the company is the same as the cost base in the taxpayers hands when they disposed of it.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1550 Subdivision 122A: Disposal or Creation of Assets by an Individual to a Wholly-owned Company / 19~1640 Section 12270: What are the consequences for the company? / If a non-precluded asset in the company is created
If a non-precluded asset in the company is created
The costs incurred in creating the asset will equal the assets cost base or reduced cost base in the hands of the company.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1660 Division 152 Small Business Relief
19~1660
Division 152 Small Business Relief
This Division sets out a number of CGT concessions available on the disposal of assets by a small business. They are as follows: the small business 15-year exemption; the small business 50% active asset reduction; the small business retirement exemption; and the small business rollover relief.
The concessions are available to CGT events occurring from 21 September 1999. Note: The former 50% goodwill concession available under former Subdivision 118C has been subsumed by the Division 152 small business concessions. For details of how the goodwill concession applied to CGT events occurring before 21 September 1999, see Taxation Ruling TR 1999/16. The Tax Office has issued an addendum to TR 1999/16, which states that capital gains attributable to goodwill may now qualify for the small business CGT concessions in Division 152. They may be eligible because goodwill is considered to be an active asset and also an intangible asset that is inherently connected with that business.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1660 Division 152 Small Business Relief / 19~1670 Section 15210: Basic conditions for relief
19~1670
Section 15210: Basic conditions for relief
Section 15210 sets out the basic conditions for relief that are common to each of the four small business concessions: A CGT event occurs in relation to a taxpayer owned CGT asset. The CGT event would give rise to a capital gain. The taxpayer satisfies the maximum net asset value test. The CGT asset satisfies the active asset test.
In addition, subsection 15210(2) provides two further conditions where the active asset is a share or an interest in a trust: The company or trust must satisfy the controlling individual test. The taxpayer must be a CGT concession stakeholder in the company or trust.
It should be noted that there may be additional conditions which may also need to be satisfied in the Subdivisions.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1660 Division 152 Small Business Relief / 19~1680 Sections 15250 and 15255: What is a controlling individual?
19~1680
Sections 15250 and 15255: What is a controlling individual?
A company or trust will satisfy the controlling individual test if there is at least one controlling individual of the company or trust just before the CGT event occurs to the active asset.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1660 Division 152 Small Business Relief / 19~1680 Sections 15250 and 15255: What is a controlling individual? / For a company
For a company
An individual will be a controlling individual of a company where the individual holds the legal and equitable interest in shares that carry between them, the right to exercise at least 50% of the voting power of the company and the right to receive at least 50% of any distribution of income and capital
that the company may make.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1660 Division 152 Small Business Relief / 19~1680 Sections 15250 and 15255: What is a controlling individual? / For a fixed trust
For a fixed trust
An individual will be a controlling individual of a trust where the individual is beneficially entitled to at least 50% of the income and capital of the trust.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1660 Division 152 Small Business Relief / 19~1680 Sections 15250 and 15255: What is a controlling individual? / For a discretionary trust
For a discretionary trust
An individual will be a controlling individual of a discretionary trust where: the trust makes a distribution of income or capital or both in the year of income; and the individual was beneficially entitled to at least 50% of the total of the distributions of income and the total distribution of capital made by the trust in that year.
Note: The controlling individual test is modified for the small business 15-year exemption to take into account circumstances that a trust may not have made any distributions in a particular year because of losses.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1660 Division 152 Small Business Relief / 19~1690 Section 15260: What is a CGT concession stakeholder?
19~1690
Section 15260: What is a CGT concession stakeholder?
A CGT concession stakeholder of a company or trust is: a controlling individual of the company or trust; or in the case of a company a spouse of a controlling individual of the company, if the spouse holds the legal and equitable interests in the shares; or in the case of a trust or discretionary trust a spouse of a controlling individual of the trust, if the spouse is beneficially entitled to any income or capital of the trust.
Example Ann and her spouse Brett carry on a business through a company in which Ann owns 40% of the shares and Brett 60%. Ann sells her shares and wants to claim the small business concession. The relevant conditions are satisfied because Bretts 60% makes him a controlling individual of the company, and because Ann is a CGT concession stakeholder in the company, in that Ann owned some shares just before the CGT event and was the spouse of a controlling individual (Brett) at that time.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1660 Division 152 Small Business Relief / 19~1700 Satisfying the net
asset value test

19~1700
Satisfying the net asset value test
As noted, the taxpayer must satisfy the net asset value test. This test is satisfied if a small business taxpayers net asset position does not exceed $5 million. Section 15215 provides that the test will be satisfied where the sum of the following amounts does not exceed $5 million: the net value of the taxpayers CGT assets; the net value of the CGT assets of any entities connected with the small business taxpayer; and the net value of the CGT assets of any small business CGT affiliate of the small business taxpayer, or entities connected with the small business taxpayers CGT affiliates (not including those already counted).
Where the taxpayer is a partner in a partnership and the CGT event occurs in relation to a CGT asset of the partnership the net value of the CGT assets of the partnership must not exceed $5 million.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1660 Division 152 Small Business Relief / 19~1710 Section 15240: What is an active asset?
19~1710
Section 15240: What is an active asset?
A CGT asset is an active asset at a given time if, at that time, the taxpayer owns it and: uses it, or holds it ready for use, in the course of carrying on a business; or it is an intangible asset that is inherently connected with a business that the taxpayer carries on (for example, goodwill or the benefit of a restrictive covenant); or it is used, or held ready for use, in the course of carrying on a business by a small business CGT affiliate or another entity connected to the taxpayer.
In addition, subsection 15240(3) provides that a CGT asset is also an active asset at a given time if, at that time, the taxpayer owns it and: it is either a share in a company that is an Australian resident or an interest in a trust that is a resident trust for CGT purposes for the income year in which that time occurs; and the total of the market values of the active assets of the company or trust and any capital proceeds that the company or trust received during the two years before that time, from CGT events happening to its active assets and that the company or trust holds in the form of cash or debt pending the acquisition of new active assets, is 80% or more of the market value of all of the assets of the company or trust.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1660 Division 152 Small Business Relief / 19~1720 Section 15235: General conditions to be satisfied
19~1720
Section 15235: General conditions to be satisfied
To satisfy the active asset test under section 15235, the CGT asset must be an active asset of the small business seeking the concession just before the earlier of:
the CGT event; and if the relevant business ceased to be carried on in the last 12 months or any longer period that the Commissioner allows the cessation of the business; and
during at least half the period beginning the later of: when the taxpayer acquired the asset; and 15 years before the CGT event and ending at the time of the CGT event or the small business ceasing.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1660 Division 152 Small Business Relief / 19~1740 What is not an active asset?
19~1740
What is not an active asset?
The following assets are not active assets: share units or other interests in an entity connected with the taxpayer: assets solely for the personal use and enjoyment of the individual or a small business CGT affiliate; rights to capital amounts payable out of a superannuation fund or an approved deposit fund; rights to an asset of a superannuation fund or an approved deposit fund; and life insurance policies.
Note: A private dwelling may be included in the maximum net asset valuation test, if it is partially used for non-private (i.e. income producing) purposes.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1660 Division 152 Small Business Relief / 19~1750 Section 15225: What is a small business CGT affiliate?
19~1750
Section 15225: What is a small business CGT affiliate?
A small business CGT affiliate is: a taxpayers spouse; a taxpayers child under 18; or an entity that: acts or could reasonably be expected to act, in accordance with the taxpayers directions or wishes; or acts, or could reasonably be expected to act, in concert with the taxpayer.
Note: A partner in a partnership for which the taxpayer is also a partner is not a small business CGT affiliate of the taxpayer merely because the partner acts, or could reasonably be expected to act, in concert with the taxpayer.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1660 Division 152 Small Business Relief / 19~1760 Section 15230:
What is an entity connected with a small business entity?

19~1760
Section 15230: What is an entity connected with a small business entity?
Section 15230 covers the basic definitions of connected with, which depend upon the definitions of control. An entity will be connected with the small business entity, in the case of a company or trust, if: the small business entity controls the company or trust; the company or trust controls the small business entity; or both the company or trust and the small business entity are controlled by a third party.
Controls means: except where the other entity is a discretionary trust beneficially owning or having the right to beneficially acquire ownership of interests in another entity that give the right to receive at least 40% of any income or capital distribution by the other entity; or if the other entity is a company beneficially owning, or having the right to beneficially acquire, ownership of shares in a company that gives at least 40% of the voting power in the company.
In terms of when a beneficiary will be considered to control a discretionary trust, subsection 15230(5) provides that a beneficiary will only be considered to control the trust if the beneficiary satisfies a pattern of distributions test. Under this test, a beneficiary (and/or their small business CGT associates) must receive at least 40% of total distributions of the trust in at least one of the four preceeding years before the relevant CGT event in order for control to exist. In the absence of this requirement, it would be possible for control to exist in any or all of the beneficiaries of a discretionary trust regardless of whether or not they actually received a distribution.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1780 Subdivision 152B: Small Business 15-Year Exemption
19~1780
Subdivision 152B: Small Business 15-Year Exemption
The small business 15-year exemption provides CGT relief where a CGT asset is held by a small business taxpayer for at least 15 years and certain conditions are met. Capital losses are not affected. The main conditions are: the basic conditions for relief under Subdivision 152A are satisfied; the entity continuously owned the asset for the 15-year period leading up to the CGT event; if the entity is an individual, the individual retires or is permanently incapacitated; and if the entity is a company or trust, the entity had a controlling individual throughout the period of ownership and the individual who was the controlling individual just before the CGT event retires or is permanently incapacitated.
The Subdivision also allows time periods to continue to run if there has been a rollover because of marriage breakdown or compulsory acquisition. Example Ruth and Geoff are partners in a partnership that conducts a farming business on land they purchased
in 1986, and have owned continuously since that time. The net value of the CGT assets of the partnership is less than $5 million. Ruth and Geoff wish to retire as they are both over 60 years of age. As they have no children, they decide to sell the farming business, and do so in 2002, for a total capital gain of $100,000. Both Ruth and Geoff qualify for the small business 15-year exemption in relation to the capital gain.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1780 Subdivision 152B: Small Business 15-Year Exemption / 19~1800 Section 152105: Conditions to be met by an individual to obtain the 15-year exemption
19~1800
Section 152105: Conditions to be met by an individual to obtain the 15-year exemption
For the exemption to apply to an individual, the following conditions need to be satisfied: the basic conditions for CGT small business relief as contained in Subdivision 152A; the CGT asset has been held continuously for a 15-year period just before the CGT event; if the CGT asset is a company share or interest in a trust, there must have been a controlling individual during the whole ownership period (even if it was not the same controlling individual during the whole period); and either: the individual must be 55 or over and the disposal of the CGT asset must be in connection with the individuals retirement; or the individual is permanently incapacitated at the time of the relevant CGT event.
Where the basic and additional conditions are met, the exemption is automatic.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1780 Subdivision 152B: Small Business 15-Year Exemption / 19~1810 Section 152110: Conditions to be met by a company or trust to obtain the 15-year exemption
19~1810
Section 152110: Conditions to be met by a company or trust to obtain the 15-year exemption
For the exemption to apply to a company or trust, the following conditions need to be satisfied: the basic conditions for CGT small business relief as contained in Subdivision 152A are met; the CGT asset has been held continuously for a 15-year period just before the CGT event; at all times during which the entity owned the asset, the entity had a controlling individual (as defined in sections 15250 and 15255), even if it was not the same controlling individual during the whole period; the controlling individual of the company or trust just before the CGT event either: was 55 or over at the time and the event happened in connection with the individuals retirement; or was permanently incapacitated at that time.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1780 Subdivision 152B: Small Business 15-Year Exemption / 19~1820 Section 152115: Continuing time period where there is an involuntary disposal
19~1820
Section 152115: Continuing time period where there is an involuntary disposal
Where assets have been acquired under rollover relief in terms of assets compulsorily acquired, lost or destroyed, or marriage breakdown, these intervening events will be ignored in determining whether the 15-year test has been satisfied.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1780 Subdivision 152B: Small Business 15-Year Exemption / 19~1820 Section 152115: Continuing time period where there is an involuntary disposal / Rules where asset compulsorily acquired, lost or destroyed
Rules where asset compulsorily acquired, lost or destroyed
For the purposes of the 15-year exemption, the replacement asset will be treated as if it had been: acquired when the original asset was acquired; and used in the same way as the original asset was used from the time the original asset was acquired.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1780 Subdivision 152B: Small Business 15-Year Exemption / 19~1820 Section 152115: Continuing time period where there is an involuntary disposal / Rules where an asset has been transferred as a result of marriage breakdown
Rules where an asset has been transferred as a result of marriage breakdown
Where a small business individual has an asset transferred to them as a result of marriage breakdown under a Subdivision 126A rollover, the individual may choose: to include the ownership and active asset periods of their former spouse; or to commence new ownership and active asset periods from the time that the asset was transferred to them.
Where the former is chosen, the small business individual will be treated as though they had always owned the asset and used it in the same manner as the persons former spouse used it. Example Cameron and Therese were married. During the 10 years they were married, Cameron owned a farm on which he operated a dairy business. Since their divorce five years ago, Therese has owned the farm and operated the dairy business. Therese is able to sell the farm and obtain the 15-year exemption if she chooses to adopt Camerons ownership and active asset periods.

19~1780 Subdivision 152B: Small Business 15-Year Exemption / 19~1830 Section 152120: Special rules for a controlling individual of a discretionary trust
19~1830
Section 152120: Special rules for a controlling individual of a discretionary trust
There is no requirement for a controlling individual under sections 152105 and 152110, where there is no trust distribution of income or capital, due to the presence of a loss.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1780 Subdivision 152B: Small Business 15-Year Exemption / 19~1840 Section 152125: Distributing the disregarded capital gain by a company or trust to a CGT concession stakeholder
19~1840
Section 152125: Distributing the disregarded capital gain by a company or trust to a CGT concession stakeholder
Where the capital gain made by a company or trust qualifies for the 15-year exemption, this amount may be distributed to a CGT concession stakeholder (as defined in section 15260) as an exempt amount, providing the following conditions are met: the company or trust makes the payment within two years of the CGT event that resulted in the gain; the payment must be made to a person who was a CGT concession stakeholder just before the CGT event; and the payment must not exceed an amount determined by multiplying the CGT concession stakeholders control percentage by the exempt capital gain.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1780 Subdivision 152B: Small Business 15-Year Exemption / 19~1840 Section 152125: Distributing the disregarded capital gain by a company or trust to a CGT concession stakeholder / Working out the CGT concession stakeholders percentage
Working out the CGT concession stakeholders percentage
The CGT concession stakeholders control percentage is worked out as follows: for a company the percentage of the legal and equitable interests in shares in the company; for a fixed trust the percentage of the income and capital of the trust, to which the beneficiary is entitled; and for a non-fixed trust 100% if there is one CGT concession stakeholder or 50% each if there are two CGT concession stakeholders.
Example Joe is a controlling individual of Company X, owning 60% of the shares in the company. Joes wife, Anne, owns the remaining 40% of the shares in the company. The company makes a capital gain of $10,000 and is able to disregard that capital gain under the small business 15-year exemption as both Joe and Anne are planning to retire. Six months after the CGT event, the company distributes the
amount of the exempt capital gain to the shareholders. As CGT concession stakeholders, Joe and Anne both qualify for the small business 15-year distribution exemption. The amount that is exempt is calculated as follows: For Joe: 60% of $10,000 = $6,000 For Anne: 40% of $10,000 = $4,000 If it is decided to distribute $8,000 each to Joe and Anne, they can exclude from their assessable incomes for the income year an amount of $6,000 and $4,000 respectively.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1850 Subdivision 152C: Small Business 50% Active Asset Reduction
19~1850
Subdivision 152C: Small Business 50% Active Asset Reduction
The small business 50% active asset reduction provides for a 50% reduction on the capital gains made by a small business where the basic conditions of Subdivision 152A are satisfied. This Subdivision will apply, and reduce a small business taxpayers gain, where: the small business has capital gains; current and prior year capital losses have been deducted from that gain; the remaining gain has been further reduced by any discount capital gain that may apply under Division 115: 50% if the gain is made by an individual or trust; 33.33% if the gain is made by a complying superannuation entity; and the basic conditions under Subdivision 152A are satisfied.
Therefore, a taxpayer may obtain the discount capital gain and the small business 50% active asset reduction together. In this instance only 25% of the gain is assessed. Example Mary operates a small manufacturing business and disposes of a CGT asset that she has owned for three years, and has used as an active asset of the business. Mary makes a capital gain of $17,000 from the CGT event, and qualifies for the CGT discount and for the small business 50% reduction. Mary also has a capital loss in the income year of $3,000 from the sale of another asset. Mary calculates her net capital gain for the year as follows: $17,000 $3,000 = $14,000 $14,000 (50% x $14,000) = $7,000 $7,000 (50% x $7,000) = $3,500 (under step 1 of the method statement in section 1025) (under step 3 of the method statement in section 1025) (under step 4 of the method statement in section 1025)
Her net capital gain for the year is $3,500.

19~1850 Subdivision 152C: Small Business 50% Active Asset Reduction / 19~1860 Section 152205: Getting the small business 50% reduction in addition to any discount percentage that may be available
19~1860
Section 152205: Getting the small business 50% reduction in addition to any discount percentage that may be available
Taxpayers will be eligible for the small business 50% reduction in addition to any discount percentage that may apply under step 3 of the method statement in section 1025, providing the basic conditions of Subdivision 152A are satisfied. These conditions are: that a CGT event occurs in relation to a CGT asset owned by the taxpayer; the CGT event would give rise to a capital gain; the taxpayer satisfies the maximum net asset value test; and the CGT asset satisfies the active asset test.
Where the active asset is a share or interest in a trust: the company or trust must satisfy the controlling individual test; and the taxpayer must be a CGT concession stakeholder in the company or trust.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1850 Subdivision 152C: Small Business 50% Active Asset Reduction / 19~1870 Section 152210: Getting the small business retirement exemption and small business rollover relief in addition to the small business 50% reduction
19~1870
Section 152210: Getting the small business retirement exemption and small business rollover relief in addition to the small business 50% reduction
A capital gain that is reduced under section 152210 may also qualify for further reduction, under either: the small business retirement exemption, as contained in Subdivision 152D; or the small business rollover, as contained in Subdivision 152E; or both.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1850 Subdivision 152C: Small Business 50% Active Asset Reduction / 19~1880 Section 152215: 15-year rule has priority
19~1880
Section 152215: 15-year rule has priority
Where the 15-year exemption applies under Subdivision 152B, Subdivisions 152D (small business retirement exemption) and 152E (small business rollover) do not apply.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1850 Subdivision 152C: Small Business 50% Active Asset Reduction / 19~1880 Section 152215: 15-year rule has priority / Order of relief general
Order of relief general

First apply any applicable CGT percentage discount to any capital gain, where the entity is an individual, trust or complying superannuation fund. Second apply the small business 15-year exemption. Third where the 15-year small business exemption does not apply, apply the 50% small business exemption. Fourth apply the small business rollover or retirement exemption.
Note: Capital gains eligible for the retirement concession and/or the small business rollover relief do not need to be automatically reduced by the 50% small business reduction before applying the other concessions. This choice allows a company or trust to make larger tax-free ETPs under the retirement exemption (subject to the $500,000 and RBL limits).
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1890 Subdivision 152D: Small Business Retirement Exemption
19~1890
Subdivision 152D: Small Business Retirement Exemption
The small business retirement exemption basically disregards a capital gain from a CGT event that occurs to a CGT asset of the taxpayers small business, where the capital proceeds from the event are used in connection with the taxpayers retirement. There is a lifetime maximum of $500,000 and it does not matter how old the taxpayer is when they retire. However, where the taxpayer is under 55, the capital proceeds from the relevant CGT event must be rolled over into a superannuation fund or approved deposit fund.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1890 Subdivision 152D: Small Business Retirement Exemption / 19~1900 Section 152305: Choosing the exemption
19~1900
Section 152305: Choosing the exemption
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1890 Subdivision 152D: Small Business Retirement Exemption / 19~1900 Section 152305: Choosing the exemption / For an individual
For an individual
A small business individual can disregard a capital gain if: the basic conditions in Subdivision 152A are satisfied; and the capital proceeds from the CGT event are used for the purposes of retirement.
Note: Where the taxpayer is aged under 55, the exempt amount which is in the form of an eligible termination payment, must be rolled over into a superannuation fund or approved deposit fund, otherwise the exempt amount is regarded as an assessable capital gain.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1890 Subdivision 152D: Small Business Retirement Exemption / 19~1900
Section 152305: Choosing the exemption / For a company or trust

For a company or trust
A small business company or trust can disregard a capital gain if: the basic conditions of Subdivision 152A are satisfied; the entity has a controlling individual; and the company and trust conditions of section 152325 are satisfied.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1890 Subdivision 152D: Small Business Retirement Exemption / 19~1910 Making an election for the small business retirement exemption
19~1910
Making an election for the small business retirement exemption
In both instances the taxpayer must prepare and maintain a written election for the assets subject to this exemption. The election must specify the CGT exempt amount relating to each asset.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1890 Subdivision 152D: Small Business Retirement Exemption / 19~1920 Section 152310: Consequences of choice
19~1920
Section 152310: Consequences of choice
If the individual, company or trust chooses to disregard all or part of their capital gain, by choosing the retirement exemption, then that amount will be exempt from CGT.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1890 Subdivision 152D: Small Business Retirement Exemption / 19~1920 Section 152310: Consequences of choice / Additional requirements for an individual
Additional requirements for an individual
Where the taxpayer is an individual, the exempt capital proceeds from the CGT event are deemed to be paid to the individual as an eligible termination payment. Such an ETP must be paid to the individual at the later of: the time the individual made the choice for the exemption to apply; or the time the ETP was received by the individual.
Where the individual is under 55, this ETP must be paid into a complying superannuation fund or approved deposit fund. Such an ETP is also non-deductible to the individual. In working out the capital proceeds from the event, the taxpayer must disregard the market value substitution rule.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1890 Subdivision 152D: Small Business Retirement Exemption / 19~1930 Section 152315: Choosing the amount to disregard
19~1930
Section 152315: Choosing the amount to disregard
The taxpayer may choose to disregard all or part of each capital gain to which Subdivision 152D applies. That choice must be made in a way that ensures that the CGT retirement exemption limit is not exceeded. This exempt amount is known as the CGT exempt amount and this must be specified in writing. Where the taxpayer is a company or trust, the entity must stipulate the CGT exempt amount which is allocated for each CGT concession stakeholder, where there is more than one. Example Daryl is a controlling individual of a company. The company specifies 90% control for Daryl under subsection (5) (which means that the percentage specified for the other stakeholder must be 10%). Daryls retirement exemption limit is $500,000. To determine whether subsection (2) is complied with, Daryl would take 90% of the assets CGT exempt amount, add that to amounts previously specified in choices made by or for him under this subdivision and see whether the total exceeds $500,000.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1890 Subdivision 152D: Small Business Retirement Exemption / 19~1940 Section 152320: Meaning of CGT retirement exemption limit
19~1940
Section 152320: Meaning of CGT retirement exemption limit
An individuals CGT retirement exemption limit is $500,000, reduced by any previous exemptions the individual has received under these rules, or the earlier rules as contained in the old Division 118F.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1890 Subdivision 152D: Small Business Retirement Exemption / 19~1950 Section 152325: Company or trust conditions
19~1950
Section 152325: Company or trust conditions
Where a company or trust makes a choice under Subdivision 152D to treat the disposal proceeds it receives as a CGT exempt amount, these capital proceeds must be paid to the CGT concession stakeholders as an ETP. Where there are two CGT concession stakeholders, the ETP must be paid by reference to each CGT concession stakeholders percentage of the relevant CGT exempt amount (see section 152315). The ETP must be paid by the later of: seven days after the taxpayer makes the choice; or seven days after the taxpayer receives an amount of capital proceeds from the CGT event.
The ETP must be equal to the lesser of: the amount of the capital proceeds; or the relevant CGT exempt amount.

19~1960 Subdivision 152E: Small Business Rollover

19~1960
Subdivision 152E: Small Business Rollover
The small business rollover allows a taxpayer to defer the making of a capital gain from a CGT event happening in relation to one or more small business assets, if the taxpayer acquires replacement assets. This exemption applies after the small business 50% reduction contained in Subdivision 152C.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1960 Subdivision 152E: Small Business Rollover / 19~1970 Section 152405: Basic principles for the small business rollover
19~1970
Section 152405: Basic principles for the small business rollover
The following conditions must be met by the taxpayer to obtain the small business rollover: the basic conditions in Subdivision 152A must be satisfied; the replacement asset is acquired by the taxpayer between one year before, to two years after, the CGT event in the year in which the taxpayer claims the small business rollover; the form of the rollover is that the capital gain is disregarded to the extent that it does not exceed the cost base of the replacement asset; and a capital gain will arise where the replacement asset is eventually disposed of or its status changes.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1960 Subdivision 152E: Small Business Rollover / 19~1980 Section 152410: When the rollover can be obtained
19~1980
Section 152410: When the rollover can be obtained
A rollover can be obtained when the above conditions are met by the taxpayer, and the replacement asset satisfies the conditions in section 152420.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1960 Subdivision 152E: Small Business Rollover / 19~1990 Section 152415: What the rollover consists of
19~1990
Section 152415: What the rollover consists of
To the extent that the rollover conditions are met, the capital gain can be rolled over to the extent that it does not exceed: the acquisition consideration of the replacement asset; and any incidental costs associated with that acquisition.
Otherwise, any excess is assessable as a capital gain.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1960 Subdivision 152E: Small Business Rollover / 19~2000 Section 152420: Replacement asset conditions
19~2000
Section 152420: Replacement asset conditions
For the replacement asset to qualify under the rollover, the following conditions must be met: The replacement asset must be acquired during the period starting one year before, and ending two years after, the last CGT event in the income year has occurred for which the taxpayer claims the small business asset rollover. This time limit may be extended at the discretion of the Commissioner. The acquired replacement asset must be an active asset immediately, or by the end of two years, after the last CGT event during the year in which the rollover is chosen. Where the replacement asset is a share in a company or an interest in a trust, the taxpayer, or an entity connected with the taxpayer, must be a controlling individual of the company or trust just after the taxpayer acquired the share or interest.
If the replacement asset ceases to be an active asset, or the taxpayer ceases to be a controlling individual of the company or trust in respect of which the replacement share or interest is issued, then a CGT event will be automatically triggered. In this case, a capital gain will accrue equal to the gain ignored under the concession. This gain may itself be the subject of further CGT small business relief.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~1960 Subdivision 152E: Small Business Rollover / 19~2010 Section 152425: Special rules where the individual who obtained the rollover dies
19~2010 Where: a person dies after they acquired a replacement asset under the small business rollover; that asset forms part of the persons deceased estate; and the asset passes to the legal personal representative of the deceased person;
Section 152425: Special rules where the individual who obtained the rollover dies
then the legal personal representative is treated, for the purposes of this rollover, as if they had undertaken any actions taken by the person before they passed away. However, this rule does not apply if the person who died had done anything that would have triggered CGT Events J2 and J3. The same concept applies to a beneficiary of a deceased estate where the replacement asset passes to the beneficiary.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~2030 Division 165 Income Tax Consequences of Changing Ownership or Control of a Company
19~2030
Division 165 Income Tax Consequences of Changing Ownership or Control of a Company
This Division includes: Subdivision 165CA: Applying net capital losses of earlier income years; and Subdivision 165CB: Working out the net capital gain and the net capital loss for the income
year of the change.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~2030 Division 165 Income Tax Consequences of Changing Ownership or Control of a Company / CGT consequences of a change of a companys ownership
CGT consequences of a change of a companys ownership
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~2040 Subdivision 165CA: Applying Net Capital Losses of Earlier Income
Years
19~2040
Subdivision 165CA: Applying Net Capital Losses of Earlier Income Years
Section 16596 states that when working out CGT liability for a financial year, a company cannot apply a net capital loss from an earlier year: if Subdivision 165A would prevent it from deducting the loss; and if section 16520 were disregarded.
Subdivision 165A provides that a company may not deduct a tax loss from an earlier income year if there has been a change in the ownership or control of the company from the start of the loss year to the end of the income year or it satisfies the same business test. Section 16520 sets out when a company can deduct part of a tax loss and it can only do that if that part of the loss meets the same ownership rule or the same business rule for the whole of the loss year in accordance with sections 16510, 16512 and 16513.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~2050 Subdivision 165CB: Working out the Net Capital Gain and the Net Capital Loss for the Income Year of the Change
19~2050
Subdivision 165CB: Working out the Net Capital Gain and the Net Capital Loss for the Income Year of the Change
If a company has changed ownership or control during the income year and cannot satisfy the same business test, its net capital gain or loss will have to be worked out under this Subdivision.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~2050 Subdivision 165CB: Working out the Net Capital Gain and the Net Capital Loss for the Income Year of the Change / 19~2060 Section 165102: On a change of ownership, or of control of voting power, unless the company carries on the same business
19~2060
Section 165102: On a change of ownership, or of control of voting power, unless the company carries on the same business
A company must calculate its CGT liability under this provision if it must calculate its taxable income or tax loss under Subdivision 165B or alternatively, it did not calculate them under that subdivision due to subsection 16550(3). If the company in question is a widely held or eligible Division 166 company and if it so chooses, Subdivision 166B will modify the operation of this subdivision.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~2050 Subdivision 165CB: Working out the Net Capital Gain and the Net Capital Loss for the Income Year of the Change / 19~2070 Section 165105: Divide the income year into periods
19~2070
Section 165105: Divide the income year into periods
The first step is to divide the income year into periods according to section 16545 which requires a
division of the income year into the first period which starts at the beginning of the income year with each later period starting immediately after the end of the previous period. The last period ends at the end of the income year. Each period except the last period ends at the earlier of: the latest time that would result in persons having more than a 50% stake in the company during the whole of the period; or the earliest time when a person begins to control, or becomes able to control, the voting power in the company (whether directly, or indirectly through one or more interposed entities) for the purpose, or for purposes including the purpose, of: getting some benefit or advantage to do with how ITAA 1997 applies; or getting such benefit or advantage for someone else.
The next step is the calculation of the notional net capital gain or notional net capital loss.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~2050 Subdivision 165CB: Working out the Net Capital Gain and the Net Capital Loss for the Income Year of the Change / 19~2080 Subsection 165108(1): Notional net capital gain
19~2080
Subsection 165108(1): Notional net capital gain
The notional net capital gain for a period is the difference between the total capital gains made during the period minus the net capital losses made during that period.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~2050 Subdivision 165CB: Working out the Net Capital Gain and the Net Capital Loss for the Income Year of the Change / 19~2090 Subsection 165108(2): Notional net capital loss
19~2090
Subsection 165108(2): Notional net capital loss
If the total capital losses exceed the total capital gains during that period, then any excess will be the notional net capital loss.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~2050 Subdivision 165CB: Working out the Net Capital Gain and the Net Capital Loss for the Income Year of the Change / 19~2100 Subsection 165108(3): No notional net capital loss
19~2100
Subsection 165108(3): No notional net capital loss
If the company has a notional net capital loss for none of the periods in the income year, the companys net capital gain for the income year is calculated in the usual way (refer to section 1025).
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~2050 Subdivision 165CB: Working out the Net Capital Gain and the Net Capital Loss for the Income Year of the Change / 19~2110 Subsection 165108(4): Trusts capital gain attributed to company beneficiary
19~2110
Subsection 165108(4): Trusts capital gain attributed to company
beneficiary
If some or all of an amount included in the companys assessable income for the income year, under either section 97 or 98A of ITAA 1936, is attributable to a capital gain the trust made during the period, this section will apply to that amount as though it were a capital gain made by the company at that time.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~2050 Subdivision 165CB: Working out the Net Capital Gain and the Net Capital Loss for the Income Year of the Change / 19~2120 Section 165111: How to work out the companys net capital gain
19~2120
Section 165111: How to work out the companys net capital gain
The companys net capital gain is worked out in the following way: Add up the notional net capital gains worked out under section 165108. Add to this as much of each amount included in the companys assessable income for the financial year under sections 97 and 98A of ITAA 1936, as is attributable to a capital gain that the trust made outside the income year. If this amount is more than zero, subtract any unapplied net capital losses from previous years. If this reduces it to zero, the company has made no net capital gain for the income year. If it is more than zero, this amount is the companys net capital gain.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~2050 Subdivision 165CB: Working out the Net Capital Gain and the Net Capital Loss for the Income Year of the Change / 19~2120 Section 165111: How to work out the companys net capital gain / Working out a companys net capital gain
Working out a companys net capital gain
Note: For exceptions and modifications to this rule, see section 10230.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~2050 Subdivision 165CB: Working out the Net Capital Gain and the Net Capital Loss for the Income Year of the Change / 19~2130 Section 165114: How to work out the companys net capital loss
19~2130
Section 165114: How to work out the companys net capital loss
The companys net capital loss is worked out in the following way: Add up the notional net capital losses of a company worked out under section 165108. If this amount is greater than zero, this amount is the companys net capital loss. This amount may be deferred and offset against any future capital losses.
VALUATION ISSUES / 19~1000 Taxation / 19~1100 Capital Gains Tax / 19~2050 Subdivision 165CB: Working out the Net Capital Gain and the Net Capital Loss for the Income Year of the Change / 19~2130 Section 165114:
How to work out the companys net capital loss / Working out a companys net capital loss
Working out a companys net capital loss
Note: For exceptions and modifications to this rule, see section 10230.
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business
19~2180
Goods and Services Tax Buying and Selling a Business
At the outset it is important to remember that the buying or selling of a business should not be confused with the buying or selling of an entity; for GST purposes these are entirely different supplies. Under the GST legislation business is one aspect of the general concept of enterprise, while under the same legislation entity has its own detailed definition. The GST legislation describes an enterprise as an activity or series of activities something that is done or undertaken, usually in the form of a business or trade (though not limited to this, as such things as charitable and religious institutions are specifically included), whereas an entity is a being that could have its own legal status (such as a company). Other forms of entities include partnerships, trusts and individuals. In respect of entities, the buying or selling of shares in a company is a financial supply and is input taxed (no GST); as is the buying or selling of an interest in a partnership or the units in a unit trust. These supplies are not the buying or selling of a business but instead relate to the transfer of ownership in an entity.
Example A company, ABC Pty Ltd, operates three distinct divisions one division manufactures furniture, another manufactures textiles and the third retails both furniture and cloth to the general public. For GST purposes there is one entity (ABC Pty Ltd) and three enterprises (furniture manufacturing, textile manufacturing and furniture/cloth retailing). ABC Pty Ltd may decide to sell the retail arm and concentrate on manufacturing; this will be the sale of an enterprise. On the other hand, if ABC Pty Ltd consists of 10 shares, owned by two people (five each), and those shares are sold, this means the ownership of the entity has changed via the sale of those shares. This is despite the fact that the two people who sold the shares may continue to operate the manufacturing and retail businesses within a partnership, i.e. the enterprises are retained and operated via a new entity. For the purposes of this text we have limited our discussion to the GST implications of buying or selling a business or enterprise. Issues such as whether or not a change in the membership of a partnership constitutes the creation of a new partnership, whilst also important from a GST perspective, are not considered here. Below are the issues that will require some thought of the GST implications when either buying or selling a business. Note: For the purposes of this discussion any general reference to the GST legislation encompasses: A New Tax System (Goods & Services Tax) Act 1999; A New Tax System (Goods & Services Tax Transition) Act 1999; and all regulations, rulings and determinations made on GST.
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business / 19~2200 Going Concern
19~2200
Going Concern
Perhaps the most important GST issue surrounding the buying and selling of a business is the concept of going concern. Under the GST legislation the supply of a going concern is GST-free, that is, the supplier does not have a GST liability for the supply. Firstly though, it must be determined whether or not an arrangement entered into is for the supply of a going concern. An arrangement will be for the supply of a going concern where the supplier: supplies to the recipient all of the things that are necessary for the continued operation of an enterprise; and carries on the enterprise until the day of the supply.
Once the supply of a going concern is established, three criteria must be satisfied before the GST-free status is attained, namely: the supply of the going concern must be for consideration; and the recipient of the going concern is registered (or required to be registered) for GST purposes; and
the supplier and recipient of the going concern agree in writing that the supply is that of a going concern.
The above requirements highlight that any GST risk associated with the supply of a going concern belongs to the supplier. This is because if a GST-free supply is found to be a taxable supply, it is possible the supplier will lose 1/11th of the consideration received. Example D sells F a business for consideration of $1,000,000. D and F decide the business is the supply of a going concern and hence agree not to add GST to the consideration. A contract of sale is drawn up accordingly. Upon review the Australian Taxation Office (Tax Office) determined that the supply is not that of a going concern as D was considered to have ceased operations one month prior to the supply. The Tax Office requires D to pay GST of $90,909.10; this effectively reduces Ds proceeds from the supply of the business by this amount. In addition, if F becomes aware of the determination a tax invoice can be requested and an input tax credit claimed; this will effectively reduce Fs payment for the business. The above scenario may be protected to some degree with the inclusion of a GST clause in the sale contract. Such a clause would stipulate that if any GST was to become payable on the supply of the business the vendor can recover an amount equal to the GST from the purchaser, in addition the clause may need to address the issue of any penalties imposed for an incorrect going concern assessment. The point to note from the above is the requirement for both parties to agree in writing that the supply is that of a going concern. Whilst this does not guarantee that the supply will ultimately be treated as such, it does make the intended GST position clear to all parties.
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business / 19~2200 Going Concern / 19~2210 When is there an arrangement for the supply of a going concern?
19~2210
When is there an arrangement for the supply of a going concern?
This can often be a difficult question and much case law has developed in other GST jurisdictions specifically relating to this issue. Looking at the first criterion relating to establishing the supply as that of a going concern it is obvious that it is the sale of an enterprise or business, as opposed to an entity, that is contemplated. To satisfy the legislative criterion all things that are necessary for the continued operation of an enterprise (our emphasis) must be supplied. In a very simple sense this establishes a going concern, that is, the concern still goes (or continues) regardless of the entity operating the business. Example As a simple example, if XYZ Pty Ltd owns a building and operates a sausage manufacturing plant from that building, the sale of a going concern will exist where the sausage manufacturing enterprise is sold to Mr. Banger. This will still be the case even if XYZ Pty Ltd retains ownership of the building but leases it to Mr. Banger to operate the manufacturing business. Therefore, supplying all things necessary for the continued operation of an enterprise does not
necessitate a sale in every instance. In this example the building used to conduct the business from has been leased to the acquirer of the business. Note: In some cases it may be enough to merely attempt to supply all things necessary for the continued operation of an enterprise. For example, certain licences may not be assignable to the acquirer, however, surrendering the licence so that the acquirer can apply for its own licence will be sufficient. What if, in the above example XYZ Pty Ltd sells the building, is this the supply of a going concern? Probably not, given the building merely facilitates the operation of the sausage manufacturing enterprise and is not an enterprise in itself. However, if XYZ Pty Ltd sells the building together with the enterprise it can be included in the supply of a going concern. If the building was used to derive rental income then it could be supplied as a going concern in its own right the enterprise being the rental business. In the above example the renting of the building to Mr. Banger following the sale of the business would constitute a new enterprise being carried on by XYZ Pty Ltd. The need for the supplier to carry on the business up to the day of the supply is also consistent with the concept of a going concern. That is, if there is a hiatus in operations resulting from the transfer of ownership the enterprise will not be considered to be going or continuing. This will usually include situations where the supplier ceases operations prior to the sale of the business as well as where the acquirer does not continue operations from the date of the acquisition. For example, a New Zealand case found that the sale of a motel was not a going concern where the supplier, prior to the supply, had ceased to accept clientele and had taken no future bookings. Essentially, it was considered that the sale was for the land and buildings. Another New Zealand case deemed that there was no supply of a going concern where the acquirer did not accept restaurant patrons until the premises had been renovated. The business effectively closed for a period and hence did not continue. A further possible application of the going concern concept relates to franchises. The supply of an existing franchise is more likely to be a going concern than the supply of a newly created franchise. The supply of the franchise agreement is important in these instances as it is necessary for continued operation.
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business / 19~2200 Going Concern / 19~2220 Sale of business assets Going concern?
19~2220
Sale of business assets Going concern?
Whilst a 1998 New Zealand judgment held that the sale of business assets was not the supply of a going concern, each circumstance should be considered in the light of its own facts. The New Zealand decision centred on the issue that there was no transfer of the business activity, only the land, buildings and plant. Items mentioned as important in denoting a going concern in relation to the sale of business assets were: goodwill; stock;
books of account; customer records; work in progress; restraint of trade provisions; and a transfer of name.
The decision appears logical with reference to the Australian legislation, given that such things as goodwill, stock and business names will usually be considered as assets and integral to the continued operation of the business as a going concern. When examining the GST treatment of the sale of business assets it is probably safest to work on the premise that the assets will be a taxable supply. Obviously, this will not always be the case, however, where input tax credits are available the net GST effect will be zero (leaving aside the cash flow and stamp duty implications).
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business / 19~2200 Going Concern / 19~2230 Timing and/or funding issue
19~2230
Timing and/or funding issue
Basically, the going concern issue can be simply avoided by the vendor selling the business as a taxable supply, with the acquirer claiming an input tax credit, thereby leaving a neutral GST result on the transaction. Naturally, the problems that may be attached to this approach are the timing of the input tax credit in comparison to the requirement to make the GST-inclusive payment, and the funding of the GST component of the price. If these are not huge problems for the acquirer this may be the safest approach to deal with the transaction.
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business / 19~2200 Going Concern / 19~2240 Australian Tax Office Ruling on the supply of going concerns
19~2240
Australian Tax Office Ruling on the supply of going concerns
In October 2002 the Australian Tax Office issued a final ruling relating to the supply of going concerns (GSTR 2002/5). It is a lengthy and detailed ruling and contains many examples of the operation of the going concern concession.
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business / 19~2250 Sale of a Business that is not Registered for GST
19~2250
Sale of a Business that is not Registered for GST
If a business that is not registered for GST is supplied, the consideration received for the sale of the enterprise does not form part of the calculation of turnover for the entity operating the business. This avoids the potential need to register for GST solely because of the sale of the business.
The acquirer of the business will still need to assess whether they are required to register.
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business / 19~2270 Taxable Supply (No Going Concern)
19~2270
Taxable Supply (No Going Concern)
When a business is not supplied as a going concern it will be a taxable supply if the following criteria are met: 1. 2. 3. 4. the supply is for consideration; and the supply is made in the course of carrying on an enterprise; and the supply is connected with Australia; and the supplier is registered (or required to be registered).
The first and fourth criteria are reasonably straightforward; it is the second and third criteria that require some discussion.
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business / 19~2270 Taxable Supply (No Going Concern) / Course of carrying on an enterprise
Course of carrying on an enterprise
It might be argued that if the enterprise itself is being supplied then this cannot be in the course of carrying on that enterprise. There are probably two counter arguments: Under the GST legislation the definition of carrying on an enterprise includes anything done in the course of terminating the enterprise. The supply of the enterprise is in itself an enterprise, albeit a one-off activity.
We consider the first argument is more conceivable and the one that would bring the supply of a business within the realms of this criterion. However, it is possible that the Tax Office holds a contrary view.
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business / 19~2270 Taxable Supply (No Going Concern) / Connected with Australia
Connected with Australia
A supply of anything, other than goods or real property, will be connected with Australia where the supply occurs in Australia or is supplied through an enterprise carried on in Australia. This will generally mean, according to the Tax Office, that if a sale of business agreement is signed in Australia then it will be connected with Australia. However, it is hard to extrapolate this view to a situation where the business being supplied is not being carried on in Australia (if this contingency indeed eventuates).
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business / 19~2270 Taxable Supply (No Going Concern)
/ 19~2280 The margin scheme

19~2280
The margin scheme
Where a business is sold as a taxable supply and includes the sale of land and buildings, it may be worthwhile separating the supply of the business from the supply of the land and buildings. Doing this creates an option to use the margin scheme to calculate the GST for the land and buildings. If the margin scheme is adopted the amount of GST on supply is 1/11th of the margin. The margin is calculated as the amount by which consideration for the supply exceeds the consideration for the acquisition of the interest in the property. Where the property was acquired before 1 July 2000 valuations as at that date are required to use the margin scheme. Example J acquired land and buildings on 1 January 2000 for $5,000,000. On 1 July 2000 the land and buildings were valued at $5,500,000. On 1 December 2000 J sold the land and buildings as a taxable supply to Z for a total consideration of $5,750,000. If the margin scheme were not used the GST payable by J would be 1/11th of $5,750,000, that is $522,727. If the margin scheme is used the GST payable by J would be 1/11th of the margin, i.e. $5,750,000 $5,500,000 = $22,727. Had J purchased the land and buildings on 1 September 2000 for $5,600,000 (and the margin scheme was used to calculate the GST liability), there is no requirement for a valuation and the margin is $5,750,000 $5,600,000. One drawback with the margin scheme is that the purchaser of the property will not be entitled to claim an input tax credit. In the above example this would mean Z pays a total consideration of $5,750,000 for the land and buildings, rather than a net consideration of $5,227,273 (after the $522,727 input tax credit). Accordingly, the best scenario for all parties to the transaction will be where the margin is zero and no GST is applicable. In the above example this would occur if the valuation as at 1 July 2000 was $5,750,000 (same as the total consideration to be paid). This result would also save on the stamp duty payable where GST would otherwise be added to the consideration. It must be remembered that the margin is GST-inclusive and therefore it is vital that all parties are aware of the consequences and outcomes of any proposed transaction. In addition, it should be noted the margin scheme cannot be used where the property was originally acquired through a taxable supply and the GST was calculated without applying the margin scheme.
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business / 19~2300 Price (No Going Concern)
19~2300
Price (No Going Concern)
In the absence of any reference to GST, the agreed or negotiated price of a business will be deemed inclusive of GST. It is therefore vital that all parties are aware (and accept) the status of the consideration to be paid when negotiations are conducted and also when any contract of sale is drawn
up.
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business / 19~2320 Administration
19~2320
Administration
Below are GST related issues that may be of interest to the buyer or seller of a business.
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business / 19~2320 Administration / 19~2330 Due diligence
19~2330
Due diligence
Where a business is being acquired it is advisable to conduct a due diligence exercise to ensure current compliance with GST legislation. Whilst any past errors/liabilities may be in the hands of the entity making the supply in the first instance, as a new owner of the business, it would be preferable to ensure full compliance takes place on a prospective basis. In addition, any identified problems may influence the consideration paid for the business.
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business / 19~2320 Administration / 19~2340 Registration
19~2340
Registration
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business / 19~2320 Administration / 19~2340 Registration / Supplier
Supplier
The supply of a business may necessitate cancellation of the GST registration; this will be mandatory where the supplier conducts no other enterprise. Where the supplier is conducting another enterprise a re-assessment of turnover may be necessary to ascertain if GST registration is still mandatory. The registration turnover thresholds are $100,000 for non-profit entities and $50,000 for all other entities. These thresholds are subject to change.
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business / 19~2320 Administration / 19~2340 Registration / Acquirer
Acquirer
1. Not currently registered The first decision to make is what vehicle (type of entity) will be used to operate the business, will it be a company, partnership, sole trader, trust or other? Secondly, the acquirer will need to determine the turnover of the enterprise to ascertain whether or not registration of the entity operating the enterprise is mandatory. If registration is mandatory
application should be made for both an Australian Business Number and a GST registration (both assigned to the entity, not the enterprise). Where registration is optional the following should be taken into consideration before making the decision to register or not: Clientele: Can clients claim input tax credits if the business was to charge GST? If so, GST registration is more attractive because in doing so the GST the business pays on acquisitions can be claimed back (in most cases). Administration: Will the costs of administering a GST registration outweigh the benefits? Competitors: Are the businesss competitors registered? Whether or not competitors are registered may affect the price that can ultimately be charged (whether GST-inclusive or not). Image: The business may be perceived as small and insignificant if not registered. 2. Currently registered Where the acquirer of a business already has a GST registration, will the acquired enterprise also be operated out of this entity? If yes, no further registration formalities are necessary and the supplies and acquisitions of that enterprise are included in the Business Activity Statement of the entity. The only further consideration is the possibility of establishing GST branches, to perhaps distinguish between locations or different activities carried on. If a new entity is to be used the same issues discussed earlier need to be considered. GST branching can be achieved where an entity either carries on multiple enterprises, each from a different location, or one enterprise from multiple locations. In order for a GST branch to be established the following criteria must be satisfied: the Commissioner of Taxation is satisfied that the branch maintains an independent system of accounting; and the branch can be separately identified by reference to the nature of the activities carried on or the location of the branch; and the Commissioner of Taxation is satisfied the registered entity is conducting an enterprise through the branch.
Branching effectively allows an entity to devolve its GST responsibilities, as each branch will complete its own Business Activity Statement.
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business / 19~2320 Administration / 19~2340 Registration / Other registration issues
Other registration issues
A few other issues require consideration upon registration. 1. Cash v. accruals (method of accounting) In order for an entity to ascertain its net amount for a particular tax period it is necessary to correctly attribute or identify the GST charged on taxable supplies and the available input tax credits for GST paid on acquisitions. The two methods of attribution are the accruals method and the cash method. The cash
method can be used where: annual turnover does not exceed the cash accounting turnover threshold (currently $1 million); or for income tax purposes the entity uses the receipts method; or the Commissioner of Taxation has determined the entity can use the cash method.
Taxable supplies (accruals basis) The GST payable on a taxable supply is attributable to the earlier of the tax period in which any of the consideration is received, or the tax period in which an invoice is issued. Taxable supplies (cash basis) Where the business accounts on a cash basis, the GST payable on any supply is to the extent that the consideration is received (either none, part or whole). Creditable acquisitions (accruals basis) The input tax credit available on a creditable acquisition is attributable to the earlier of the tax period in which any of the consideration is provided, or the tax period in which an invoice is received. Creditable acquisitions (cash basis) Where the business accounts on a cash basis the input tax credit available on any creditable acquisition is to the extent the consideration is provided (either none, part or whole). When a GST return is lodged for a particular tax period, a tax invoice must be held for creditable acquisitions in order to claim the input tax credits. 2. Monthly or quarterly returns The general rule is three month tax periods will apply, ending 31 March, 30 June, 30 September and 31 December. An entity may, however, apply to have one month tax periods. One month tax periods will automatically apply where: An entity has a turnover of $20 million or more (subject to change by regulation). The Commissioner is satisfied the entity will be carrying on an enterprise for less than three months. The Commissioner is satisfied the entity has a history of failing to comply with its taxation obligations.
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business / 19~2320 Administration / 19~2350 Debts
19~2350
Debts
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business / 19~2320 Administration / 19~2350 Debts / Bad debt adjustments
Bad debt adjustments
Where the sale of a business includes the debts owed to that business, the ability of the acquirer to make an adjustment for a bad debt disappears. This problem emanates from the difference between acquiring an enterprise and an entity. Generally, an entity that accounts for GST on an accruals basis can make an adjustment for a bad debt either after writing the debt off as bad or after 12 months from the due date. However, where the debts owed are sold as part of a business the entity now operating that enterprise was not the original supplier to which the bad debt relates and the ability to make a GST adjustment is frustrated. This is because the first criterion relating to the making of a bad debt adjustment is not satisfied you make a taxable supply. Under the GST legislation the term you refers to entities and therefore must contemplate that it is the original supplier that must make any available bad debt adjustment.
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business / 19~2320 Administration / 19~2350 Debts / Supply of debts as part of a taxable supply
Supply of debts as part of a taxable supply
Under normal circumstances the sale of debts owed will be a financial supply and input taxed. Accordingly, when a business is sold as a taxable supply, and includes debts owing, the part of the supply relating to the debts is not a taxable supply and therefore GST should not be exactly 1/11th of the price of the supply. Given the above, careful consideration should be given to the GST ramifications of trading debts when connected with the buying and selling of a business.
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business / 19~2320 Administration / 19~2360 Adjustments for supply of a going concern
19~2360
Adjustments for supply of a going concern
Where an entity acquires a GST-free going concern an increasing adjustment is required if any part of that going concern is used either for private purposes or to make input taxed supplies. In other words, an amount of GST becomes payable for the going concern and the GST-free status is compromised.
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business / 19~2320 Administration / 19~2370 Notional input tax credits for second-hand goods
19~2370
Notional input tax credits for second-hand goods
In some instances an entity will be able to claim input tax credits for the acquisition of second-hand goods (acquired for the purpose of sale or exchange in the ordinary course of business), even though GST was not payable on the supply. The notional input tax credit is not available where the: supply of the goods to the entity was a taxable supply (normal input tax credit rules apply) or GST free; or goods were imported; or supply was by way of hire; or
goods are divided by the acquiring entity for re-supply; or entity that acquired the second-hand goods subsequently makes a supply of those goods that is not a taxable supply.
Therefore, where an entity acquires second-hand goods as a part of acquiring a business, the otherwise available notional input tax credits will be lost as the supply of the business (including the second-hand goods) will either be a taxable or GST-free supply. That is, the first exclusion above is invoked. Accordingly, the consideration for the second-hand goods may be influenced by the potential loss of the notional input tax credits in the hands of the acquiring entity.
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business / 19~2320 Administration / 19~2380 Pre-establishment costs
19~2380
Pre-establishment costs
The GST legislation provides, in certain circumstances, for the claiming of input tax credits prior to the establishment of a company (the section does not refer to any other type of entity). Accordingly, where it is anticipated a business will be acquired and a company structure established to operate the business, the GST contained in some expenses can be claimed back even though the company does not exist yet and is not registered for GST. A pre-establishment cost is a creditable acquisition where: the acquisition is not applied to any other use other than for the company not yet in existence; and the company comes into existence and is registered for GST within six months after the acquisition; and the acquirer becomes a member, officer or employee of the company; and the acquirer is reimbursed by the company for the acquisition; and the acquirer is not entitled to an input tax credit in their own right; and the acquisition is a creditable acquisition and a tax invoice is held.
By way of note, an acquisition will be creditable if it is acquired for the purposes of bringing the company into existence.
VALUATION ISSUES / 19~1000 Taxation / 19~2180 Goods and Services Tax Buying and Selling a Business / 19~2320 Administration / 19~2390 Assignment of leases/agreements
19~2390
Assignment of leases/agreements
A lease or agreement that is GST-free because of the transitional provisions will maintain its GST-free status if assigned to another entity. For the GST-free status to apply there must not be any review or opportunity to review the consideration payable under the lease or agreement, that is, only the parties to the lease or agreement should change.
VALUATION ISSUES / 19~1000 Taxation / 19~2440 Stamp Duty or Asset Transfer Taxes
19~2440
Stamp Duty or Asset Transfer Taxes
Where a valuation is being undertaken as part of a transfer of a business (or the legal entity that owns the business) it may be important for the purchaser to consider the stamp duty payable under the various State Acts. (Stamp duty is generally paid by the purchaser and is calculated on the GST-inclusive value.) This is a complex area of law, with some States exempting transfers of assets between wholly owned subsidiaries and specialist legal advice should be sought prior to finalising any agreement. Details of the rates of stamp duty payable are included in the chapter Reference Materials.
REFERENCES
REFERENCES
REFERENCES / 20~1000 Reference Materials
20~1000
Reference Materials
As discussed in earlier chapters, there are a number of ways to value companies, all of which are reliant on some data external to the company. In this chapter, we draw together the data and data sources required to enable appropriate analysis of the general economy and on an industry level, and its application to the company through the calculation of discount rates and capitalisation multiples. We continue this chapter with the price earnings ratios (PERs) achieved by Australian listed companies, before considering the rates of return available on world and Australian markets. We also include details on the cost of equity and the betas of various industries based on data from the Australian Graduate School of Management. The table below shows the external data requirements of the common valuation methods. VALUATION METHOD Market Approach Price Earnings Ratios (PERs) DATA REQUIRED PER of the market PER of the industry PERs of comparable public listed companies
VALUATION METHOD Income Approach Discounted Cash Flow (DCF)
DATA REQUIRED Economy growth rate Industry growth rate Inflation rate Cost of capital 1. 2. Market premium Beta
PER from first principles Risk-free rate Market premium Beta Economy growth rate Industry growth rate Inflation rate Taxation rate
PER from required rate of return Industry rate of return
REFERENCES / 20~1000 Reference Materials / 20~1020 Valuation Information

20~1020
Valuation Information
Some useful sources of additional information on valuation approaches can be located on the following websites. Some data from these sites is free, while some is available for purchase.
ORGANISATION American Capital Strategies Australasian Legal Information Institute Business Valuation Update CBIZ RELEVANT INFORMATION Valuation methodologies Australian legislation and case law database Articles on valuation issues, including court cases Newsletters and papers on valuation issues Industry research, valuation software and valuation multiples WEBSITE <www.americancapital.com> <www.austlii.edu.au> COUNTRY USA Australia & World
<www.bvlibrary.com>
USA
<www.cbiz.com>
USA
Companyvalue.com
<www.companyvalue.com>
USA
ORGANISATION Damodaran, Aswath Associate Professor, Leonard N Stern School of Business, New York University Federal Court of Australia Fisher College of Business, The Ohio State University, Finance Department Global-Investor.com Goetz, Charles J Virginia Law School
RELEVANT INFORMATION Valuation methodologies, spreadsheets, models
WEBSITE <www.stern.nyu.edu/~adamodar>
COUNTRY USA
Fully searchable text of judgments US and international finance journals, working papers and databases Definitions of finance terms Reports/expert testimony and problems associated with graphs Articles on business and finance Articles Valuation newsletter Definitions and research reports Industry surveys and other business and financial information
<www.fedcourt.gov.au> <www.cob.ohio-state.edu/dept/fin/journal/jof.htm>
Australia USA & World
<www.finance-glossary.com> <www.people.virginia.edu/~cjg4t/>
World USA
Harvard Business Review McKinsey Mercer Capital Motley Fool Standard & Poors
<www.hbsp.harvard.edu> <www.mckinseyquarterly.com> <www.mercercapital.com> <www.bizval.com> <www.fool.com> <www.standardandpoors.com>
USA World USA & World World USA
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information

20~1050
Economic Information
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1070 World Economies (in Summary)
20~1070
World Economies (in Summary)
Some useful sources of global economic information can be located on the following web sites. Some data from these sites is free, while some is available for purchase.
ORGANISATION American Economic Association Asian University of Science and Technology (Faculty of Business) RELEVANT INFORMATION US and world economic and financial data Links to world-wide financial, business and economic research resources WEB SITE <www.vanderbilt.edu/AEA> COUNTRY USA
<www.asianust.ac.th/Academics/business/resource.html Thailand
ORGANISATION Bank One
RELEVANT INFORMATION Overview from leading economists, European quarterly spotlight, Americas quarterly spotlight Global business research US economic time series data US economic and financial data, surveys, reports, studies, working papers and articles Economic information Extensive economic research, by country Current and historic currency rates Economic information World economic and financial data Stock market indices data for various countries
WEB SITE <www.bankone.com>
COUNTRY Europe & Americas
Bis Shrapnel Economagic.com Federal Reserve Board
<www.bis.com.au/> <www.economagic.com> <www.federalreserve.gov>
Australia USA USA
Finfacts International Monetary Fund OANDA Office of National Statistics Organisation for Economic Cooperation & Development World Federation of Exchanges
<www.finfacts.com> <www.imf.org> <www.oanda.com> <www.statistics.gov.uk> <www.oecd.org>
Ireland World World United Kingdom World
www.world-exchanges.org
World
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1090 Australian Economy
20~1090
Australian Economy
Some useful sources of Australian economic information can be located on the following websites. Some data from these sites is free, while some is available for purchase.
ORGANISATION ACIL Tasman Australian Bureau of Agricultural and Resource Economics Australian Bureau of Statistics Australian Business Ltd IBIS World RELEVANT INFORMATION Market analysis and provision of economic and commercial advice Economic papers and data on agricultural and resource commodities Australian statistics Review of the Australian economy, updated daily Detailed economic reports WEBSITE <www.aciltasman.com.au> <http://abare.gov.au>
<www.abs.gov.au> <www.australianbusiness.com.au> <www.ibisworld.com.au>
ORGANISATION Sensis Productivity Commission
RELEVANT INFORMATION Yellow Pages Small Business Indicators Reports, research and other publications on the Australian economy and industries RBA Bulletin articles and statistics, financial and economic reports, statements and other publications Australian and APEC economic data
WEBSITE <www.sensis.com.au> <www.pc.gov.au/publications/index.html>
Reserve Bank of Australia
<www.rba.gov.au>
The Treasury
<www.treasury.gov.au>
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1090 Australian Economy / 20~1100 Economy growth rate
20~1100
Economy growth rate
The following data has been obtained from the Reserve Bank of Australias Bulletin, Table G10 and can be updated from its web site (refer <www.rba.gov.au/Statistics/Bulletin/index.html#table_g>). The table lists annual GDP and the corresponding growth rate, which is used as a surrogate measure of economic growth.
YEAR Q1 SEP ($ million) 132,239 131,345 134,529 138,838 147,992 153,063 159,113 165,756 174,084 180,945 188,000 191,909 200,332 205,794 212,449 217,919 Q2 DEC ($ million) 132,578 131,601 136,709 141,813 148,512 154,158 160,881 167,723 177,235 183,970 186,274 194,155 200,761 209,488 213,244 Q3 MAR ($ million) 131,845 132,867 138,310 144,492 149,586 156,708 160,966 170,078 178,296 185,519 188,281 196,178 202,479 211,001 214,835 Q4 JUN ($ million) 131,397 132,957 139,096 146,240 150,863 157,614 165,040 171,375 180,251 187,690 189,879 198,575 202,589 211,967 217,591 TOTAL % CHANGE
1990/91 1991/92 1992/93 1993/94 1994/95 1995/96 1996/97 1997/98 1998/99 1999/2000
531,128 528,059 528,770 548,644 571,383 596,953 621,543 646,000 674,932 709,866 738,124 752,434 780,817 806,161 838,250
-0.58% 0.13% 3.76% 4.14% 4.48% 4.12% 3.93% 4.48% 5.18% 3.98% 1.94% 3.77% 3.25% 3.98% 2.37%
2000/01 2001/02 2002/03 2003/04 2004/05 2005/06
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1090 Australian Economy / 20~1110 Interest rates
20~1110
Interest rates
The following table provides 3-, 5- and 10-year treasury bond yields which are often used as a surrogate for the risk-free interest rate for the term applicable to each bond. The data has been obtained from the Reserve Bank of Australias Bulletin, Table F2 and can be updated from its website (refer <www.rba.gov.au/Statistics/Bulletin/index.html#table_g>). A graphical display of this data is provided below. YEAR ENDING 31 DECEMBER Dec 1989 Dec 1990 Dec 1991 Dec 1992 Dec 1993 Dec 1994 Dec 1995 Dec 1996 Dec 1997 Dec 1998 Dec 1999 Dec 2000 Dec 2001 Dec 2002 Dec 2003 Dec 2004 Dec 2005 7.74 5.87 10.07 7.44 6.58 5.49 4.64 6.47 5.27 5.10 4.55 5.39 5.10 5.21 3-YEAR BONDS (% P.A.) 5-YEAR BONDS (% P.A.) 13.45 11.99 8.22 8.24 6.17 10.06 7.78 6.96 5.72 4.77 6.70 5.34 5.47 4.79 5.55 5.22 5.22 10-YEAR BONDS (% P.A.) 12.90 12.07 9.39 8.94 6.68 10.04 8.18 7.37 6.05 5.01 6.96 5.46 6.01 5.16 5.60 5.33 5.20
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1090 Australian Economy / 20~1120 Diagram Annual treasury bond yields
20~1120
Diagram Annual treasury bond yields
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1090 Australian Economy / 20~1130 Inflation rate
20~1130
Inflation rate
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1090 Australian Economy / 20~1130 Inflation rate / Historical inflation
Historical inflation
The common measure of inflation in Australia is the Consumer Price Index (CPI), published by the Australian Bureau of Statistics. The following CPI data is also found in the Reserve Bank of Australias Bulletin, Table G2 and can be updated from its web site (refer <www.rba.gov.au/Statistics/Bulletin/index.html#table_g>). (1989/90 = 100) YEAR 1989 1990 1991 1992 1993 1994 1995 1996 MAR 92.9 100.9 105.8 107.6 108.9 110.4 114.7 119.0 JUNE 95.2 102.5 106.0 107.3 109.3 111.2 116.2 119.8 SEPT 97.4 103.3 106.6 107.4 109.8 111.9 117.6 120.1 DEC 99.2 106.0 107.6 107.9 110.0 112.8 118.5 120.3
YEAR 1997 1998 1999 2000 2001 2002 2003 2004 2005
MAR 120.5 120.3 121.8 125.2 132.7 136.6 141.3 144.1 147.5
JUNE 120.2 121.0 122.3 126.2 133.8 137.6 141.3 144.8 148.4
SEPT 119.7 121.3 123.4 130.9 134.2 138.5 142.1 145.4 149.8
DEC 120.0 121.9 124.1 131.3 135.4 139.5 142.8 146.5 150.6
Perhaps of greater importance is the percentage change in the year end All Groups Consumer Price Index. The following CPI data is also found in the Reserve Bank of Australias Bulletin, Table G1 and can be updated from its web site (refer <www.rba.gov.au/Statistics/Bulletin/index.html#table_g>). YEAR 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 MAR 6.8 8.6 4.9 1.7 1.2 1.4 3.9 3.7 1.3 -0.2 1.2 2.8 6.0 2.9 3.4 2.0 2.4 JUNE 7.6 7.7 3.4 1.2 1.9 1.7 4.5 3.1 0.3 0.7 1.1 3.2 6.0 2.8 2.7 2.5 2.5 SEPT 8.0 6.1 3.2 0.8 2.2 1.9 5.1 2.1 -0.3 1.3 1.7 6.1 2.5 3.2 2.6 2.3 3.0 DEC 7.8 6.9 1.5 0.3 1.9 2.5 5.1 1.5 -0.2 1.6 1.8 5.8 3.1 3.0 2.4 2.6 2.8
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1090 Australian Economy / 20~1140 Diagram Annualised quarterly CPI figures
20~1140
Diagram Annualised quarterly CPI figures
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1090 Australian Economy / 20~1140 Diagram Annualised quarterly CPI figures / Implied inflation
Implied inflation
The following chart and data show the difference between nominal and indexed bonds since 1989. Indexed bond yield data is located in the Reserve Bank of Australias Bulletin, Table F2 and can be updated from its web site (refer <www.rba.gov.au/Statistics/Bulletin/index.html#table_f>). The difference between these two yields can be used as a proxy for the level of inflation. The table shows that implied inflation has been in the range of 1.59% to 8.10% for the period analysed. These inflation expectations should be compared with actual, 10-year data. NOMINAL 10-YEAR YIELD (% P.A.) 12.90 12.07 9.39 8.94 6.68 IMPLIED INFLATION (% P.A.) 8.10 6.57 3.89 4.36 3.08 ACTUAL INFLATION(1) (% P.A.) 7.83 6.85 1.51 0.28 1.95
YEAR ENDING 31 DECEMBER Dec 1989 Dec 1990 Dec 1991 Dec 1992 Dec 1993
INDEXED YIELD (% P.A.) 4.80 5.50 5.50 4.58 3.60
YEAR ENDING 31 DECEMBER Dec 1994 Dec 1995 Dec 1996 Dec 1997 Dec 1998 Dec 1999 Dec 2000 Dec 2001 Dec 2002 Dec 2003 Dec 2004 Dec 2005
NOMINAL 10-YEAR YIELD (% P.A.) 10.04 8.18 7.37 6.05 5.01 6.96 5.46 6.01 5.16 5.60 5.33 5.20
INDEXED YIELD (% P.A.) 5.47 4.62 4.23 4.05 3.42 3.78 3.31 3.52 3.22 3.52 2.76 2.20
IMPLIED INFLATION (% P.A.) 4.57 3.56 3.14 2.00 1.59 3.18 2.15 2.49 1.94 2.08 2.57 3.00
ACTUAL INFLATION(1) (% P.A.) 2.55 5.05 1.52 -0.25 1.58 1.80 5.80 3.12 3.03 2.37 2.59 2.80
Note 1: Calculated as the percentage change in the Consumer Price Index over the preceding year.
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1090 Australian Economy / 20~1150 Diagram Nominal v. real yields and inflation
20~1150
Diagram Nominal v. real yields and inflation
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1090 Australian Economy / 20~1160 Taxation rate
20~1160
Taxation rate
The following table provides company tax rates back to the 1989/90 financial year. Updated company tax rate information can be found in The Accountants Manual published by Thomson Legal & Regulatory Limited. YEAR 1989/90 1990/91 1991/92 1992/93 1993/94 1994/95 1995/96 1996/97 1997/98 1998/99 1999/2000 2000/01 TAX RATE 39% 39% 39% 39% 33% 33% 36% 36% 36% 36% 36% 34%
YEAR 2001/02 2002/03 2003/04 2004/05 2005/06
TAX RATE 30% 30% 30% 30% 30%
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1180 Industry and Company Specific Information
20~1180
Industry and Company Specific Information
Detailed information on the industry in which a company operates and on any companies selected as comparison companies is crucial in preparing a thorough valuation. Below we have listed some of the possible sources for such information.
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1180 Industry and Company Specific Information / 20~1190 Industry information
20~1190
Industry information
The information sources included in the following table may be useful to all practitioners when preparing valuations. Some data from these websites is free, while some is available for purchase.
ORGANISATION ABIX: Australian Business Intelligence RELEVANT INFORMATION Industry, company and business information in Australia and New Zealand Royalty and licensing data from the US Beta and risk measurement information on all Australian listed companies Example data and order instructions Industry cost models and average costs of operating businesses in a variety of industries Global business research and market forecasting services WEBSITE <www.abix.com.au> COUNTRY Australia
AUS Consultants Australian Graduate School of Management
<www.royaltysource.com> <www.agsm.edu.au>
USA Australia
Benchmarking Partners
<www.surgency.com>
USA
Bis Shrapnel
<www.bis.com.au/>
Australia
ORGANISATION CCH Benchmarking (formerly FMRC Benchmarking)
RELEVANT INFORMATION Industry cost models and average costs of operating businesses in a variety of industries Information on chemical industries Industry information and studies US industry cost of capital Industry information Example data and order instructions Industry information Industry reports Global business intelligence Economic indicators relating to international and domestic property markets Information services for the polymer industry and industries using plastics and rubber in any component, product or production process
WEBSITE <www.fmrcbenchmarking.com.au>
COUNTRY Australia
ChemTec Publishing Freedonia Ibbotson Associates Cost of Capital Center IBISWorld
<www.chemtec.org> <www.freedoniagroup.com> <www.ibbotson.com> <www.ibisworld.com.au>
Canada USA USA Australia
IBISWorld Industry Research MarketResearch.com Property Council of Australia
<www.ibisworld.com> <www.industrysearch.com.au> <www.marketresearch.com> <www.propertyoz.com.au>
USA Australia USA Australia
Rapra Technology
<www.rapra.net>
United Kingdom
ResearchandMarkets.comData on international and regional markets, key industries, the top companies, new products and the latest trends Royaltystat Database of royalty rates and license agreements compiled from the US Securities and Exchange Commission (SEC) Edgar Archive Research service dealing with: companies; trends; people; markets; and products.
<www.researchandmarkets.com>
Ireland
<www.royaltystat.com>
USA
Tell Me Now
<www.tellmenow.com.au>
Australia
ORGANISATION The Center for Economic & Industry Research The Financial Valuation Group
RELEVANT INFORMATION Data on US public companies, discount rates, industry reports Intellectual property transactions database
WEBSITE <www.c-e-i-r.com>
COUNTRY USA
<www.fvginternational.com/ipdatabase/ ipdatabase.html>
USA
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1180 Industry and Company Specific Information / 20~1195 Australian Graduate School of Management (AGSM)
20~1195
Australian Graduate School of Management (AGSM)
The Australian Graduate School of Management is Australias premier management school. Since its inception in 1975 the AGSM has been at the forefront of introducing leading management skills and the introduction and development of modern finance theory to Australias business and academic communities. A school of both the University of New South Wales and the University of Sydney, the AGSM continues to develop and teach theories on a wide range of topics important to modern managers. AGSMs achievements have earned it the highest ranking among graduate business schools in Asia (Financial Times (UK)) and a position comfortably among the top 50 schools worldwide. Academics associated with the School have conducted many of the studies concerned with the applicability of modern finance theory in Australia, and many of these studies have been published in the Schools journal, the Australian Journal of Management. The Risk Measurement Service (RMS) produced by the Centre for Research in Finance (CRIF) builds on the experience of the AGSM faculty and research officers. It is an essential information source for investors seeking to analyse the risks of an individual stock or equity portfolio. The RMS provides a comprehensive listing of risk measures for all fully paid ordinary stocks listed on the ASX, with sufficient trading histories, and is widely accepted by Australias investment community as the reliable provider of risk measures for the Australian equity market. The RMS enables: an analysis of portfolio risk and selection of securities which match individual (or clients) requirements; use of risk estimates to measure ex-post performance of portfolios; and estimates of the cost of equity capital for individual companies or industry groups.
The following sections cover: the benefits of using AGSMs Beta information (including an example report); the industries covered; and order instructions.
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1180 Industry and Company Specific Information / 20~1195 Australian Graduate School of Management (AGSM) / Benefits of using AGSM Beta information
Benefits of using AGSM Beta information

AGSMs Risk Measurement Service provides the information valuers require to analyse the risks of an individual company or industry group. AGSM provides risk measurements and associated data for all companies with fully paid shares listed on the Australian Stock Exchange and at least 21 months of trading. As explained elsewhere in this text, information from the Risk Measurement Service can be used to estimate the cost of equity for individual companies or industry groups. The AGSM data is regularly updated to keep information current and new estimates are available each quarter. The attached document is an example report. The attached document discusses the concept of risk management and answers questions frequently asked about the AGSM data.
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1180 Industry and Company Specific Information / 20~1195 Australian Graduate School of Management (AGSM) / Industries covered
Industries covered
Up to and including the September 2002 quarter, AGSM data was available for the following major industry groups: Industry Group 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 Industry Name Gold Other Metals Diversified Resources Energy Infrastructure and Utilities Developers and Contractors Building Materials Alcohol and Tobacco Food and Household Goods Chemicals Engineering Paper and Packaging Retail Transport Media Banks and Finance Insurance Telecommunications Investment and Financial Services
Industry Group 20 21 22 23 24
Industry Name Property Trusts Health Care and Biotechnology Miscellaneous Industrials Diversified Industrials Tourism and Leisure
Because of the introduction by Standard & Poors of the Global Industry Classification System (GICS) from 1 July 2002, AGSM's Risk Measurement Service for September 2002 was the last issue to use the ASX industry classifications. The December 2002 issue onwards reports industry classifications based on GICS. AGSM CLASS now defines industry portfolios while GICS gives finer classifications within each CLASS. The relationship is shown in the tables below. Risk Measurement Service Industry Classes
GICS Sector Name 10 Energy 1 15 Materials 2 3 4 5 6 7 8 20 Industrials 9 10 11 12 13 14 25 Consumer Discretionary 15 automobile & components 25101010 25101020 25102010 25102020 building products construction & engineering machinery conglomerates & other capital goods commercial services & supplies transportation 20102010 20103010 20106010 20106020 20101010 20104010 20104020 20105010 20107010 20201010 20201020 20201030 20201040 20201050 20201060 20301010 20302010 20303010 20304010 20304020 20305010 20305020 20305030 chemicals construction materials diversified metals & mining* gold* precious metals & minerals* steel & aluminium* paper & forest products & packaging 15101010 15101020 15101030 15101040 15101050 15102010 15104020 15104030 15104040 15104050 15104010 15103010 15103020 15105010 15105020 energy* 10101010 10101020 10102010 10102020 10102030 AGSM RMS CLASS Code Name Standard & Poors Global Industry Classification System (GICS) Codes
GICS Sector Name 16
AGSM RMS CLASS Code Name consumer durables & apparel hotels restaurants & leisure media retailing
Standard & Poors Global Industry Classification System (GICS) Codes 25201010 25201020 25201030 25201040 25201050 25202010 25202020 25203010 25203020 25203030 25301010 25301020 25301030 25301040 25401010 25401020 25401030 25401040 25501010 25502010 25502020 25503010 25503020 25504010 25504020 25504030 25504040
17 18 19
30
Consumer Staple 20 21 22 food & drug retailing beverages food & other products & tobacco 30101010 30101020 30101030 30201010 30201020 30201030 30202010 30202020 30202030 30203010 30301010 30302010
35
Health Care 23 24 25 health care equipment & supplies health care providers & services pharmaceutical & biotechnology 35101010 35101020 35102010 35102020 35102030 35201010 35202010
40
Financials 26 27 28 29 30 banks diversified financials insurance real estate investment trusts real estate management & development 40101010 40201010 40201020 40201030 40301010 40301020 40301030 40301040 40301050 40401010 40401020
45
Information Technology 31 32 33 34 Internet software & services IT consulting & services software technology hardware & equipment 45101010 45102010 45103010 45103020 45201010 45201020 45202010 45202020 45203010 45204010 45205010 45205020
50
Telecommunications 35 telecommunications 50101010 50101020 50102010
55
Utilities 36 GICS Not Defined 37 GICS not defined utilities 55101010 55102010 55103010 55104010
* Not all industrials
Risk Measurement Service Industry Classes: GICS to RMS

Standard & Poors Global Industry Classification System (GICS) Sector Energy Energy Energy Equipment & Services Oil & Gas Drilling Oil & Gas Equipment & Services Oil & Gas Integrated Oil & Gas Oil & Gas Exploration & Production Oil & Gas Refining & Marketing Materials Materials Chemicals Commodity Chemicals Diversified Chemicals Fertilisers & Agricultural Chemicals Industrial Gases Speciality Chemicals Construction Materials Construction Materials Containers & Packaging Metal & Glass Containers Paper Packaging Metals & Mining Aluminium Diversified Metals & Mining Gold Precious Metals & Minerals Steel Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited 15104010 15104020 15104030 15104040 15104050 7 4 5 6 7 steel & aluminium diversified metals & mining gold precious metals & minerals steel & aluminium 15103010 15103020 8 8 paper & forest products & packaging 15102010 3 construction materials 15101010 15101020 15101030 15101040 15101050 2 2 2 2 2 chemicals 10102010 10102020 10102030 1 1 1 10101010 10101020 1 1 energy Group Industry Sub-Industry GICS Code Code Name
Standard & Poors Global Industry Classification System (GICS) Sector Group Industry Sub-Industry GICS Code Code Name
Paper & Forest Products Forest Products Paper Products Industrials Capital Goods Aerospace & Defence Aerospace & Defence Building Products Building Products Construction & Engineering Construction & Engineering Electrical Equipment Electrical Components & Equipment Heavy Electrical Equipment Industrial Conglomerates Industrial Conglomerates Machinery Construction & Farm Machinery Industrial Machinery Trading Companies & Distributors Trading Companies & Distributors Commercial Services & Supplies Commercial Services & Supplies Commercial Printing Data Processing Services Diversified Commercial Services Employment Services Environmental Services Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited 20201010 20201020 20201030 20201040 20201050 13 13 13 13 13 commercial services & supplies 20107010 12 conglomerates & other capital goods 20106010 20106020 11 11 machinery 20105010 12 20104010 20104020 12 12 conglomerates & other capital goods 20103010 10 construction and engineering 20102010 9 building products 20101010 12 conglomerates & other capital goods 15105010 15105020 8 8 paper & forest products & packaging
Standard & Poors Global Industry Classification System (GICS) Sector Group Industry Sub-Industry Office Services & Supplies Transportation Air Freight & Couriers Air Freight & Couriers Airlines Airlines Marine Marine Road & Rail Railroads Trucking Transportation Infrastructure Airport Services Highways & Railtracks Marine Ports & Services Consumer Discretionary Automobile & Components Auto Components Auto Parts & Equipment Tyres & Rubbers Automobiles Automobile Manufacturers Motorcycle Manufacturers Consumer Durables & Apparel Household Durables Consumer Electronics Home Furnishings Homebuilding Household Appliances Housewares & Specialties Leisure Equipment & Products Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited 25201010 25201020 25201030 25201040 25201050 16 16 16 16 16 consumer durables & apparel 25102010 25102020 15 15 25101010 25101020 15 15 automobile & components 20305010 20305020 20305030 14 14 14 20304010 20304020 14 14 20303010 14 20302010 14 20301010 14 transportation GICS Code 20201060 Code Name 13
Standard & Poors Global Industry Classification System (GICS) Sector Group Industry Sub-Industry Leisure Products Photographic Products Textiles & Apparel Apparel & Accessories Footwear Textiles Hotels Restaurants & Leisure Hotels Restaurants & Leisure Casinos & Gaming Hotels Leisure Facilities Restaurants Media Media Advertising Broadcasting & Cable TV Movies & Entertainment Publishing & Printing Retailing Distributors Distributors Internet & Catalogue Retail Catalogue Retail Internet Retail Multiline Retail Department Stores General Merchandise Stores Specialty Retail Apparel Retail Computer & Electronics Retail Home Improvement Retail 25504010 25504020 25504030 19 19 19 25503010 25503020 19 19 25502010 25502020 19 19 25501010 19 retailing 25401010 25401020 25401030 25401040 18 18 18 18 media 25301010 25301020 25301030 25301040 17 17 17 17 hotels restaurants & leisure 25203010 25203020 25203030 16 16 16 GICS Code 25202010 25202020 Code Name 16 16
Standard & Poors Global Industry Classification System (GICS) Sector Group Industry Sub-Industry Specialty Stores Consumer Staple Food & Drug Retailing Food & Drug Retailing Drug Retail Food Distributors Food Retail Food Beverage & Tobacco Beverages Brewers Distillers & Vintners Soft Drinks Food Products Agricultural Products Meat Poultry & Fish Packaged Foods Tobacco Tobacco Household & Personal Products Household Products Household Products Personal Products Personal Products Health Care Health Care Equipment & Supplies Health Care Equipment & Services Health Care Equipment Health Care Supplies Health Care Providers & Services Health Care Distributors & Services Health Care Facilities Managed Health Care Pharmaceuticals and Biotechnology Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited 35102010 35102020 35102030 24 24 24 health care providers & services 35101010 35101020 23 23 health care equipment & supplies 30302010 22 30301010 22 30203010 22 30202010 30202020 30202030 22 22 22 food & other products & tobacco 30201010 30201020 30201030 21 21 21 beverages 30101010 30101020 30101030 20 20 20 food & drug retailing GICS Code 25504040 Code Name 19
Standard & Poors Global Industry Classification System (GICS) Sector Group Industry Sub-Industry GICS Code Code Name
Biotechnology Biotechnology Pharmaceuticals Pharmaceuticals Financials Banks Banks Banks Diversified Financials Diversified Financials Consumer Finance Diversified Financial Services Multi-Sector Holdings Insurance Insurance Insurance Brokers Life & Health Insurance Multi-line Insurance Property & Casualty Insurance Reinsurance Real Estate Real Estate Real Estate Investment Trusts Real Estate Management & Development Information Technology Software & Services Internet Software & Services Internet Software & Services IT Consulting & Services IT Consulting & Services Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited 45102010 32 it consulting & services 45101010 31 internet software & services 40401010 40401020 29 30 real estate investment trusts real estate management & development 40301010 40301020 40301030 40301040 40301050 28 28 28 28 28 insurance 40201010 40201020 40201030 27 27 27 diversified financials 40101010 26 banks 35202010 25 35201010 25 pharmaceuticals & biotechnology
Standard & Poors Global Industry Classification System (GICS) Sector Group Industry Software Application Software Systems Software Technology Hardware & Equipment Communications Equipment Networking Equipment Telecommunications Equipment Computer & Peripherals Computer Hardware Computer Storage & Peripherals Electronic Equipment & Instruments Electronic Equipment & Instruments Office Electronics Office Electronics Semiconductor Equipment & Products Semiconductor Equipment Semiconductors Telecommunications Telecommunication Services Diversified Telecommunication Services Alternative Carriers Integrated Telecommunication Services Wireless Telecommunication Services Wireless Telecommunication Services Utilities Utilities Electric Utilities Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited 50102010 35 50101010 50101020 35 35 telecommunications 45205010 45205020 34 34 45204010 34 45203010 34 45202010 45202020 34 34 45201010 45201020 34 34 technology hardware & equipment 45103010 45103020 33 33 software Sub-Industry GICS Code Code Name
Standard & Poors Global Industry Classification System (GICS) Sector Group Industry Sub-Industry Electric Utilities Gas Utilities Gas Utilities Multi-Utilities Multi-Utilities Water Utilities Water Utilities 55104010 36 55103010 36 55102010 36 GICS Code 55101010 Code Name 36 utilities
GICS industry membership for individual companies is available from: the Australian Stock Exchanges web site <www.asx.com.au>; and the Trading Room <www.tradingroom.com.au>.
Purchasing the data for a particular industry or sector also includes details on all the companies included in that sector.
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1180 Industry and Company Specific Information / 20~1195 Australian Graduate School of Management (AGSM) / Order instructions
Order instructions
AGSMs Beta data can be purchased as a complete set (containing all sectors and companies listed on the ASX), at a cost of approximately $250 from: Centre for Research in Finance Australian Graduate School of Management The University of New South Wales UNSW Sydney NSW 2052 Tel: (02) 9931 9281 and (02) 9931 5276 CRIF@AGSM.edu.au
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1180 Industry and Company Specific Information / 20~1205 IBISWorld
20~1205
IBISWorld
IBISWorld is fast becoming a world leading strategic business information provider, offering a wealth of uniquely comprehensive and powerful information on all industries and the major enterprises that drive each economy, together with the business environment in which they operate. The following sections cover: the benefits of using IBISWorld information;
the products and services offered by IBISWorld (including example reports); the industries analysed; the enterprises analysed; and order instructions.
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1180 Industry and Company Specific Information / 20~1205 IBISWorld / Benefits of using IBISWorld information
Benefits of using IBISWorld information
The more a valuer understands a businesss market, competitors and industry sector, the better they will understand the opportunities and risks inherent in that business. Evaluating the strategic position of a company depends heavily on the quality, timeliness and comprehensiveness of the business information used. With IBISWorld online (at www.ibisworld.com.au), a valuer can assess the necessary information from a reliable source in a timely and cost effective manner.
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1180 Industry and Company Specific Information / 20~1205 IBISWorld / Products and services offered by IBISWorld
Products and services offered by IBISWorld
IBISWorld is a leading Australian business information provider, with over 30 years experience providing strategic information to Australias largest companies. IBISWorld can provide instant access to the most comprehensive business information available, such as: Statistics, forecasts and analysis in 12 reports, with consideration of over 500 key economic and demographic variables. Statistics, analysis and forecasts on every industry in Australia. A sample industry report has been included. Detailed information on Australias top 2,000 companies. A sample company report has been included.
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1180 Industry and Company Specific Information / 20~1205 IBISWorld / Industry and market research reports
Industry and market research reports
IBISWorld produces information on 479 industries in Australias economy as well as 17 division overview reports. For details of industries covered, refer <www.ibisworld.com.au>.
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1180 Industry and Company Specific Information / 20~1205 IBISWorld / Company profile reports
Company profile reports
IBISWorld reports contain key information on the top 2,000 companies in Australia, including public,
private, foreign owned and government organisations. For the list of companies covered, refer <www.ibisworld.com.au>
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1180 Industry and Company Specific Information / 20~1205 IBISWorld / Order instructions
Order instructions
IBISWorld reports can only be purchased online, directly from the IBISWorld website.
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1180 Industry and Company Specific Information / 20~1240 Specific company information
20~1240
Specific company information
The information sources included in the following table may be useful to practitioners when preparing valuations. Some data from these websites is free, while some is available for purchase.
ORGANISATION Aspect Financial RELEVANT INFORMATION Listed company information: brokers reports; forecast consensus earnings; and forecast PERs. Australian Stock Exchange Australian securities information, including annual reports, ASX announcements, etc. Data on US public companies, discount rates, industry reports Information and analysis on Australian listed companies Access to US SEC corporate filing US industry cost of capital Company data Search articles from newspapers in UK, Australia and New Zealand <www.asx.com.au> Australia WEBSITE <www.aspectfinancial.com.au> COUNTRY Australia
Business Valuation Research Institute Connect 4
<www.bvri.com>
USA
<www.connect4.com.au>
Australia
EDGAR Online Ibbotson Associates Cost of Capital Center Kompass News Limited
<www.edgar-online.com> <www.valuation.ibbotson.com> <www.kompass.com> <www.newstext.com.au>
USA USA World Australia, UK & New Zealand
ORGANISATION Shares
RELEVANT INFORMATION Research, trends, charting, access to Shares magazine archives Research service dealing with: companies; trends; people; markets; and products.
WEBSITE <www.sharesdaily.com.au>
COUNTRY Australia
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Australia
The Centre for InterFirm Comparison Trading Room
Benchmarking and interfirm comparison Australian securities information, including annual reports, ASX announcements etc. Scanned images of company reports, prospectuses, media releases etc. for public companies
<www.cifc.co.uk> <www.tradingroom.com.au>
UK Australia
TransData Corporation
<www.webreports.net>
Australia, New Zealand, Hong Kong, Singapore, Taiwan, Indonesia, The Philippines, Malaysia and China
REFERENCES / 20~1000 Reference Materials / 20~1050 Economic Information / 20~1180 Industry and Company Specific Information / 20~1240 Specific company information / PERs of comparable public listed companies
PERs of comparable public listed companies
When undertaking valuation assignments specific companies within the Australian Stock Exchange (ASX) classification which most closely represent the activities of the subject business need to be identified. Space prohibits publication of the PER or annual TSR for all the listed companies. This data can be obtained from a number of sources, including the ASX, Australian Graduate School of Management, The Australian Financial Review, Stock Exchange Journal and broker research. The Trading Room web site, which can be accessed at <www.tradingroom.com.au>, provides lists of companies within each industry group.
Sector 10 Energy Industry Group 1010 Energy Industry 101010 Energy Equipment & Services Sub-Industry 10101010 Oil & Gas Drilling Oil & Gas Equipment & Services
10101020
Sector
Industry Group
Industry 101020 Oil & Gas
Sub-Industry 10102010 10102020 Integrated Oil & Gas Oil & Gas Exploration & Products Oil & Gas Refining & Marketing & Transportation Commodity Chemicals Diversified Chemicals Fertilisers & Agricultural Chemicals Industrial Gases Speciality Chemicals Construction Materials Metal & Glass Containers Paper Packaging Aluminium Diversified Metals & Mining Gold Precious Metals & Minerals Steel Forest Products Paper Products Aerospace & Defence Building Products Construction & Engineering Electrical Components & Equipment Heavy Electrical Equipment
10102030
15
Materials
1510
Materials
151010
Chemicals
15101010 15101020 15101030
15101040 15101050 151020 151030 Construction Materials Containers & Packaging 15102010 15103010 15103020 151040 Metals & Mining 15104010 15104020 15104030 15104040 15104050 151050 Paper & Forest Products 15105010 15105020 20 Industrials 2010 Capital Goods 201010 201020 201030 201040 Aerospace & Defence Building Products Construction & Engineering Electrical Equipment 20101010 20102010 20103010 20104010
20104020
Sector
Industry Group
Industry 201050 Industrial Conglomerates Machinery
Sub-Industry 20105010 Industrial Conglomerates Construction & Farm Machinery & Heavy Trucks Industrial Machinery Trading Companies & Distributors Commercial Printing Data Processing Services (Discontinued, effective 30/4/2003) Diversified Commercial Service Employment Service Environmental Services Office Services & Supplies Air Freight & Logistics Airlines Marine Railroads Trucking Airport Services
201060
20106010
20106020 201070 Trading Companies & Distributors Commercial Services & Supplies 20107010
2020
Commercial Services & Supplies
202010
20201010
20201020
20201030
20201040 20201050 20201060 2030 Transportation 203010 203020 203030 203040 Air Freight & Logistics Airlines Marine Road & Rail 20301010 20302010 20303010 20304010 20304020 203050 Transportation Infrastructure 20305010
20305020 20305030 25 Consumer Discretionary 2510 Automobiles & Components 251010 Auto Components 25101010
Highways & Railtracks Marine Ports & Services Auto Parts & Equipment Tyres & Rubber Automobile Manufacturers
25101020 251020 Automobiles 25102010
Sector
Industry Group
Industry
Sub-Industry 25102020 Motorcycle Manufacturers Consumer Electronics Home Furnishings Homebuilding Household Appliances Housewares & Specialities Leisure Products Photographic Products Apparel, Accessories & Luxury Goods Footwear Textiles Casinos & Gaming Hotels, Resorts & Cruise Lines Leisure Facilities Restaurants Advertising Broadcasting & Cable TV Movies & Entertainment Publishing Distributors Catalogue Retail Internet Retail Department Stores
2520
Consumer Durables & Apparel
252010
Household Durables
25201010
25201020 25201030 25201040 25201050 252020 Leisure Equipment & Products 25202010
25202020 252030 Textiles, Apparel & Luxury Goods 25202010
25202020 25203030 2530 Hotels, Restaurants & Leisure 253010 Hotels, Restaurants & Leisure 25301010
25301020 25301030 25301040 2540 Media 254010 Media 25401010 25401020 25401030
25401040 2550 Retailing 255010 255020 Distributors Internet & Catalogue Retail 25501010 25502010
25502020 255030 Multi-line Retail 25503010
Sector
Industry Group
Industry
Sub-Industry 25503020 General Merchandise Stores Apparel Retail Computer & Electronics Retail Home Improvement Retail Specialty Stores Drug Retail Food Distributors Food Retail Hypermarkets & Super Centres Brewers Distillers & Vintners Soft Drinks Agricultural Products Meat, Poultry & Fish (Discontinued, effective March 2002) Packaged Foods & Meats Tobacco Household Products Personal Products Health Care Equipment Health Care Supplies Health Care Distributors
255040
Specialty Retail
25504010 25504020
25504030
25504040 30 Consumer Staples 3010 Food & Staples Retailing 301010 Food & Staples Retailing 30101010 30101020 30101030 30101040
3020
Food, Beverage & Tobacco
302010
Beverages
30201010 30201020 30201030
302020
Food Products
30202010 30202020
30202030 302030 3030 Household & Personal Products 303010 Tobacco Household Products Personal Products Health Care Equipment & Supplies 30203010 30301010
303020 35 Health Care 3510 Health Care Equipment & Services 351010
30302010 35101010
35101020 351020 Health Care Providers & Services 35102010
Sector
Industry Group
Industry
Sub-Industry 35102015 35102020 35102030 Health Care Services Health Care Facilities Managed Health Care Biotechnology
3520
Pharmaceuticals & Biotechnology
352010
Biotechnology
35201010
352020 40 Financials 4010 Banks 401010
Pharmaceuticals Commercial Banks
35202010 40101010 40101015
Pharmaceuticals Diversified Banks Regional Banks Thrifts & Mortgage Finance Consumer Finance (Discontinued, effective 30 April 2003) Other Diversified Financial Services Multi-Sector Holdings Specialised Finance Consumer Finance Asset Management & Custody Banks Investment Banking & Brokerage Diversified Capital Markets Insurance Brokers Life & Health Insurance Multi-line Insurance
401020
Thrifts & Mortgage Finance Diversified Financial Services
40102010
4020
Diversified Financials
402010
40201010
40201020
40201030 40201040 402020 402030 Consumer Finance Capital Markets 40202010 40203010
40203020
40203030 4030 Insurance 403010 Insurance 40301010 40301020 40301030
Sector
Industry Group
Industry
Sub-Industry 40301040 Property & Casualty Insurance Reinsurance Real Estate Investment Trusts Real Estate Management & Development Internet Software & Services IT Consulting & Other Services Data Processing & Outsourced Services Application Software Systems Software Home Entertainment Software Communications Equipment Networking Equipment (Discontinued, effective 30 April 2003) Telecommunications Equipment (Discontinued, effective 30 April 2003) Computer Hardware Computer Storage & Peripherals Electronic Equipment Manufacturers Electronic Manufacturing Services
40301050 4040 Real Estate 404010 Real Estate 40401010
40401020
45
Information Technology
4510
Software & Services
451010
Internet Software & Services IT Services
45101010
451020
45102010 45102020
451030
Software
45103010 45103020 45103030
4520
Technology Hardware & Equipment
452010
Communications Equipment
45201020
45201010
45201020
452020
Computers & Peripherals
45202010 45202020
452030
Electronic Equipment & Instruments
45203010
45203020
Sector
Industry Group
Industry
Sub-Industry 45203030 Technology Distributors Office Electronics Semiconductor Equipment (Discontinued, effective 30 April 2003) Semiconductors (Discontinued, effective 30 April 2003) Semiconductor Equipment
452040 452050
Office Electronics Semiconductor Equipment & Products (Discontinued, effective 30 April 2003)
45204010 45205010
45205020
4530
Semiconductors & Semiconductor Equipment
453010
Semiconductors & Semiconductor Equipment
45301010
45301020 50 Telecommunication Services 5010 Telecommunication Services 501010 Diversified Telecommunication Services 50101010
Semiconductors Alternative Carriers
50101020
Integrated Telecommunication Services Wireless Telecommunication Services Electric Utilities Gas Utilities MultiUtilities & Unregulated Power Water Utilities
501020
Wireless Telecommunication Services Electric Utilities Gas Utilities MultiUtilities & Unregulated Power Water Utilities
50102010
55
Utilities
5510
Utilities
551010 551020 551030
55101010 55102010 55103010
551040
55104010
REFERENCES / 20~1000 Reference Materials / 20~1250 Price Earnings Ratios

20~1250
Price Earnings Ratios
In the following sections we provide information on: PERs by industry sector on an annual basis; PERs by industry sector on a monthly basis;
where PERs of comparable listed companies can be obtained; and the effect of company size on PERs.
As outlined in Australian Stock Exchange indices, the ASX has changed industry classifications to the Global Industry Classification Standard (GICS). As a result, for the industry classifications listed later, there is no data prior to 30 June 2002 using this data series. Earlier versions of AVH have produced data and graphs for different data series. The data in the attached tables has been extracted from the Monday editions of The Australian Financial Review and is based on the PERs reported (which are for the last Tuesday of the month not the last day of the month). Data for each component of a GICS code (industry sub sector) is available in the tables of Shares magazine or from the Shares web site.
REFERENCES / 20~1000 Reference Materials / 20~1250 Price Earnings Ratios / 20~1270 Price Earnings Ratios by Industry Sector (Annual)
20~1270
Sector All Ordinaries S&P/ASX 20 S&P/ASX 50 S&P/ASX 100 S&P/ASX 200 S&P/ASX 300 S&P/ASX Midcap 50 S&P/ASX Small Ords Cons Discretionary Consumer Staples Energy Financials Financial-x-Property Health Care Industrials Info Technology Materials Property Trusts Telecommunications Utilities
Price Earnings Ratios by Industry Sector (Annual)

Jun-02 19.24 21.49 20.57 20.14 19.69 19.57 17.98 15.21 22.60 18.48 10.67 18.01 19.40 28.91 31.70 17.31 26.39 13.54 15.45 17.85 Dec-02 15.11 16.12 15.39 15.43 15.21 15.19 15.70 13.03 19.04 16.64 14.20 13.91 13.85 22.87 15.45 14.64 16.17 14.10 15.47 16.87 Jun-03 15.45 18.61 15.81 15.87 15.56 15.54 16.23 12.88 17.97 18.14 10.10 16.11 16.57 29.50 12.09 20.46 13.05 14.55 20.84 15.89 Dec-03 16.40 18.56 16.91 17.07 16.93 16.85 18.18 14.83 25.60 18.59 15.44 14.28 14.24 40.74 17.12 47.07 18.97 14.41 15.19 17.21 Jun-04 15.78 17.04 16.87 16.74 15.95 15.90 15.91 10.46 25.48 16.41 17.08 13.95 13.53 33.98 15.61 28.16 15.57 15.76 13.23 16.32 Dec-04 16.42 16.34 16.44 16.66 16.56 16.53 17.91 15.61 19.03 21.17 13.87 15.37 15.40 28.65 15.87 37.53 16.96 15.24 15.36 14.69 Jun-05 15.22 16.03 15.41 15.35 15.13 15.10 15.00 13.06 17.99 14.87 16.15 14.41 14.55 27.55 14.89 34.43 15.42 13.63 15.16 8.71 Dec-05 15.80 15.72 15.73 16.08 15.86 15.86 18.49 14.00 19.91 14.48 19.82 14.88 14.54 27.06 15.26 32.24 17.30 17.31 11.52 11.58
REFERENCES / 20~1000 Reference Materials / 20~1250 Price Earnings Ratios / 20~1270 Price Earnings Ratios by Industry Sector (Annual) / 20~1290 All Ordinaries
20~1290
Year 2002/03 2003/04 2004/05 2005/06
All Ordinaries
July Aug Sept Oct Nov Dec Jan Feb March April May June
18.33 18.50 17.12 16.04 15.29 15.11 14.98 14.46 14.87 15.62 15.02 15.45 15.71 16.54 16.11 16.54 16.20 16.40 16.31 15.32 15.04 15.11 14.92 15.78 15.52 14.98 15.27 15.44 16.01 16.42 16.54 15.85 14.86 14.48 14.29 15.22 15.62 15.95 16.02 15.26 15.49 15.80 16.48
REFERENCES / 20~1000 Reference Materials / 20~1250 Price Earnings Ratios / 20~1270 Price Earnings Ratios by Industry Sector (Annual) / 20~1300 S&P/ASX 20
20~1300
Year 2002/03 2003/04 2004/05 2005/06
S&P/ASX 20
20.38 21.07 20.30 17.97 16.51 16.12 15.86 15.51 16.44 17.99 17.97 18.61 18.26 19.37 19.19 19.38 19.05 18.56 18.51 16.05 17.13 16.54 16.03 17.04 16.33 15.31 15.82 15.85 16.04 16.34 16.30 16.01 15.73 15.46 15.51 16.03 16.44 16.73 16.22 15.73 15.69 15.72 16.69
20~1310
Year 2002/03 2003/04 2004/05 2005/06
S&P/ASX 50
19.60 19.68 18.27 16.65 15.59 15.39 15.11 14.74 15.40 16.41 15.38 15.81 15.91 16.99 16.67 17.12 16.92 16.91 16.88 15.17 15.77 15.63 15.87 16.87 16.42 15.15 15.62 15.68 16.02 16.44 16.46 15.80 14.90 14.60 14.40 15.41 15.80 16.07 15.77 15.22 15.31 15.73 16.54
20~1320
Year 2002/03 2003/04 2004/05 2005/06
S&P/ASX 100
19.22 19.48 17.95 16.46 15.53 15.43 15.23 14.78 15.29 16.17 15.44 15.87 15.98 16.89 16.79 17.26 17.05 17.07 16.97 15.46 15.75 15.68 15.79 16.74 16.41 15.14 15.52 15.68 16.26 16.66 16.69 16.00 14.94 14.59 14.39 15.35 15.73 16.14 16.09 15.50 15.68 16.08 16.84
20~1330
Year 2002/03 2003/04 2004/05 2005/06
S&P/ASX 200
18.82 18.92 17.50 16.20 15.30 15.21 15.02 14.51 14.95 15.82 15.19 15.56 15.77 16.62 16.57 17.02 16.78 16.93 16.83 15.46 15.71 15.65 15.71 15.95 15.66 15.09 15.46 15.64 16.18 16.56 16.63 15.80 14.79 14.43 14.20 15.13 15.52 15.92 15.90 15.30 15.50 15.86 16.57
20~1340
Year 2002/03 2003/04 2004/05 2005/06
S&P/ASX 300
18.72 18.83 17.43 16.15 15.28 15.19 15.00 14.49 14.92 15.77 15.17 15.54 15.74 16.60 16.48 16.93 16.68 16.85 16.76 15.40 15.68 15.61 15.66 15.90 15.63 15.04 15.42 15.58 16.16 16.53 16.62 15.78 14.77 14.39 14.18 15.10 15.49 15.90 15.90 15.31 15.51 15.86 16.58
REFERENCES / 20~1000 Reference Materials / 20~1250 Price Earnings Ratios / 20~1270 Price Earnings Ratios by Industry Sector (Annual) / 20~1350 S&P/ASX Midcap 50
20~1350
Year 2002/03 2003/04 2004/05 2005/06
S&P/ASX Midcap 50
17.30 18.45 16.34 15.33 15.18 15.70 15.90 15.01 14.71 14.97 15.77 16.23 16.43 16.31 17.52 18.15 17.88 18.18 17.58 17.63 15.60 16.06 15.32 15.91 16.34 15.12 14.88 15.70 17.70 17.91 18.02 17.30 15.11 14.56 14.32 15.00 15.37 16.61 18.07 17.25 18.09 18.49 18.90
REFERENCES / 20~1000 Reference Materials / 20~1250 Price Earnings Ratios / 20~1270 Price Earnings Ratios by Industry Sector (Annual) / 20~1360 S&P/ASX Small ords
20~1360
Year 2002/03 2003/04 2004/05 2005/06
S&P/ASX Small ords

14.85 14.47 13.66 13.71 12.93 13.03 13.12 12.15 12.17 12.73 12.89 12.88 13.73 14.17 13.87 14.17 13.57 14.83 14.83 14.93 15.28 15.10 14.37 10.46 10.63 14.21 14.59 14.82 15.76 15.61 15.99 14.02 13.46 12.80 12.45 13.06 13.48 13.77 14.39 13.71 14.12 14.00 14.40
REFERENCES / 20~1000 Reference Materials / 20~1250 Price Earnings Ratios / 20~1270 Price Earnings Ratios by Industry Sector (Annual) / 20~1370 Consumer discretionary
20~1370
Year 2002/03 2003/04 2004/05 2005/06
Consumer discretionary
21.13 19.72 19.08 18.83 18.74 19.04 18.65 16.49 15.67 17.02 17.25 17.97 18.78 19.55 24.67 25.57 24.42 25.60 25.87 22.05 21.46 23.52 23.16 25.48 24.75 22.65 22.54 22.47 18.23 19.03 18.76 18.29 18.14 17.05 17.54 17.99 18.65 24.34 20.81 19.70 19.95 19.91 19.74
REFERENCES / 20~1000 Reference Materials / 20~1250 Price Earnings Ratios / 20~1270 Price Earnings Ratios by Industry Sector (Annual) / 20~1380 Consumer staples
20~1380
Year 2002/03 2003/04 2004/05 2005/06
Consumer staples
17.96 19.32 18.43 16.91 16.52 16.64 16.93 16.02 17.61 18.27 18.07 18.14 17.72 18.42 18.21 17.97 18.01 18.59 17.09 15.18 16.00 16.29 16.28 16.41 16.74 18.50 18.73 19.16 20.37 21.17 20.40 15.85 16.01 15.63 15.01 14.87 15.09 14.63 15.13 14.90 14.39 14.48 14.50
REFERENCES / 20~1000 Reference Materials / 20~1250 Price Earnings Ratios / 20~1270 Price Earnings Ratios by Industry Sector (Annual) / 20~1390 Energy
20~1390
Year 2002/03 2003/04 2004/05 2005/06
Energy
July Aug Sept Oct Nov Dec Jan Feb March April 10.19 May 9.95 June 10.10
10.44 15.62 14.45 13.95 13.89 14.20 13.76 12.90
9.59
10.79 10.96 11.03 11.61 11.96 15.44 16.02 16.50 16.62 17.16 16.79 17.08 17.82 12.05 12.75 13.40 14.05 13.87 14.30 14.15 13.73 13.45 14.18 16.15 16.75 18.10 19.12 17.53 18.83 19.82 22.01
REFERENCES / 20~1000 Reference Materials / 20~1250 Price Earnings Ratios / 20~1270 Price Earnings Ratios by Industry Sector (Annual) / 20~1400 Financials
20~1400
Year 2002/03 2003/04 2004/05 2005/06
Financials
16.69 16.80 16.63 15.58 14.26 13.91 13.89 13.71 14.45 15.27 15.57 16.11 15.84 15.91 15.20 15.36 15.03 14.28 14.44 14.04 14.33 14.07 13.60 13.95 13.10 13.01 13.40 13.76 14.97 15.37 15.41 15.29 14.41 14.29 13.93 14.41 14.68 14.47 15.22 14.80 14.76 14.88 15.42
REFERENCES / 20~1000 Reference Materials / 20~1250 Price Earnings Ratios / 20~1270 Price Earnings Ratios by Industry Sector (Annual) / 20~1410 Financial-x-property
20~1410
Year 2002/03 2003/04 2004/05 2005/06
Financial-x-property
17.82 17.84 17.55 16.11 14.31 13.85 13.84 13.79 14.57 15.62 15.82 16.57 16.38 16.44 15.62 15.76 15.31 14.24 14.37 13.91 14.04 13.81 13.17 13.53 12.55 12.86 13.17 13.53 14.86 15.40 15.38 15.37 14.50 14.36 14.34 14.55 14.86 14.11 14.87 14.49 14.39 14.54 15.14
REFERENCES / 20~1000 Reference Materials / 20~1250 Price Earnings Ratios / 20~1270 Price Earnings Ratios by Industry Sector (Annual) / 20~1420 Health care
20~1420
Year 2002/03 2003/04 2004/05 2005/06
Health care
27.38 26.09 23.83 23.09 22.45 22.87 21.52 18.89 29.27 30.03 29.03 29.50 31.18 48.37 41.83 41.74 41.18 40.74 30.17 30.99 31.95 34.19 33.20 33.98 34.20 25.68 27.08 26.74 27.62 28.65 29.02 28.76 25.02 24.54 24.81 27.55 28.25 26.86 30.81 25.93 26.23 27.06 28.83
REFERENCES / 20~1000 Reference Materials / 20~1250 Price Earnings Ratios / 20~1270 Price Earnings Ratios by Industry Sector (Annual) / 20~1430 Industrials
20~1430
Year 2002/03 2003/04 2004/05 2005/06
Industrials
30.92 29.09 16.45 15.78 15.12 15.45 15.41 13.12 11.43 12.00 11.87 12.09 12.11 13.29 16.69 17.42 17.09 17.12 16.15 15.20 15.44 15.44 15.26 15.61 15.79 13.65 14.43 14.93 15.16 15.87 16.29 16.00 14.89 14.57 14.35 14.89 15.21 16.00 15.61 15.03 15.09 15.26 15.59
REFERENCES / 20~1000 Reference Materials / 20~1250 Price Earnings Ratios / 20~1270 Price Earnings Ratios by Industry Sector (Annual) / 20~1440 Info technology
20~1440
Year 2002/03 2003/04 2004/05 2005/06
Info technology
14.76 15.24 15.72 16.55 14.75 14.64 16.01 14.10 18.33 18.69 19.27 20.46 22.93 21.35 42.69 50.99 46.31 47.07 47.25 50.79 28.07 28.59 26.26 28.16 27.34 22.32 25.85 30.35 32.12 37.53 38.00 33.02 35.18 31.13 33.30 34.43 36.73 32.08 33.34 32.24 33.57 32.24 32.89
REFERENCES / 20~1000 Reference Materials / 20~1250 Price Earnings Ratios / 20~1270 Price Earnings Ratios by Industry Sector (Annual) / 20~1450 Materials
20~1450
Year 2002/03 2003/04 2004/05 2005/06
Materials
26.33 22.61 20.97 16.46 16.19 16.17 15.22 15.84 15.92 17.30 12.96 13.05 14.35 18.00 16.01 17.49 17.45 18.97 18.23 15.96 15.94 15.87 18.59 15.57 15.71 15.17 15.39 15.13 16.88 16.96 17.41 15.02 14.14 13.48 13.15 15.42 16.20 14.45 16.41 15.74 16.39 17.30 19.08
REFERENCES / 20~1000 Reference Materials / 20~1250 Price Earnings Ratios / 20~1270 Price Earnings Ratios by Industry Sector (Annual) / 20~1460 Property trusts
20~1460
Year 2002/03 2003/04 2004/05 2005/06
Property trusts
13.11 13.44 13.59 13.82 14.06 14.10 14.08 13.46 14.04 14.12 14.75 14.55 14.06 14.12 13.72 13.95 14.05 14.41 14.67 14.52 15.09 15.18 15.45 15.76 16.57 13.79 14.66 15.08 15.53 15.24 15.55 14.86 13.94 13.88 11.81 13.63 13.66 16.91 17.55 16.90 17.34 17.31 17.40
REFERENCES / 20~1000 Reference Materials / 20~1250 Price Earnings Ratios / 20~1270 Price Earnings Ratios by Industry Sector (Annual) / 20~1470 Telecommunications
20~1470
Year 2002/03 2003/04 2004/05 2005/06
Telecommunications
16.32 17.36 16.23 16.70 15.37 15.47 16.04 14.14 18.50 19.58 20.65 20.84 21.87 17.11 15.31 14.68 15.22 15.19 15.59 12.22 12.09 12.27 12.16 13.23 13.19 14.83 14.64 14.56 15.30 15.36 15.26 15.84 15.27 15.10 15.12 15.16 15.49 13.14 11.78 12.10 11.40 11.52 11.42
REFERENCES / 20~1000 Reference Materials / 20~1250 Price Earnings Ratios / 20~1270 Price Earnings Ratios by Industry Sector (Annual) / 20~1480 Utilities
20~1480
Year 2002/03 2003/04 2004/05 2005/06
Utilities
18.36 14.42 13.39 16.52 16.21 16.87 16.90 15.19 14.68 15.67 15.89 15.89 15.07 15.84 16.79 16.62 16.38 17.21 17.23 17.21 16.12 15.59 15.60 16.32 16.81 13.91 14.04 13.81 14.03 14.69 15.25 15.77 10.40 10.64 10.82 11.28 11.58 11.90
8.46
8.27
8.57
8.71
8.58
REFERENCES / 20~1000 Reference Materials / 20~1250 Price Earnings Ratios / 20~1580 Effect of Company Size on PERs
20~1580
Effect of Company Size on PERs
Small companies do not enjoy the same high rating as large companies for capitalisation multiples. This small company effect has been well documented in the US market and some evidence can be drawn from the Australian market on its impact. This size discount can be attributed to the additional risk inherent in smaller companies, reflecting predominantly a lack of geographic diversification and depth in management.
REFERENCES / 20~1000 Reference Materials / 20~1250 Price Earnings Ratios / 20~1580 Effect of Company Size on PERs / Analysis of index data
Analysis of index data
The chart below compares the various S&P/ASX indices and the approximate percentage their market capitalisation is of the total market capitalisation of all companies on the ASX. The chart shows data for only the largest 500 companies, as: the S&P/ASX 50 comprises the 50 largest stocks by market capitalisation; the S&P/ASX 100 comprises 100 stocks selected by the S&P Australian Index Committee; the S&P/ASX MidCap 50 comprises the S&P/ASX 100 but not those in the S&P/ASX 50; the S&P/ASX 200 comprises the S&P/ASX 100 plus an additional 100 stocks; the S&P/ASX 300 comprises the S&P/ASX 200 plus up to an additional 100 small-cap stocks; the S&P/ASX Small Ordinaries comprises the S&P/ASX 300 but not those in the S&P/ASX 100; and the All Ordinaries Index represents the largest 500 companies on the ASX.
There are over 1,550 companies with equities quoted on the ASX. As can be seen, the weighted average PERs decline as smaller companies are included. From the ASX data on the number of companies included in each index and the weighted average PE ratio for companies in each index, we have estimated the implied PE ratios by company categories sorted in order of market capitalisation. This is shown in the chart below for the financial years ending 30 June 2002, 2003 and 2004. A logarithmic trend line has been fitted to the data in each respective year. Implied PER by company categories sorted in order of market capitalisation
The analysis in the above graph is somewhat problematic, predominantly due to the limited number of observations. However, the analysis is broadly supportive of the proposition that lower PE ratios are applied to small companies. These results are supported by other studies from around the world, particularly Ibbotson data from the USA. It should be noted that the horizontal axis on the above graph is scaled in order of market capitalisation, relative to other ASX listed companies, and not market capitalisation itself. For this reason, and the limited number of observations, the graph should be taken as support for the size effect on company valuation, and not an exact guide to the extent of any particular discount or premium that should be applied
REFERENCES / 20~1000 Reference Materials / 20~1250 Price Earnings Ratios / 20~1580 Effect of Company Size on PERs / Review of Australian data on smaller public companies
Review of Australian data on smaller public companies
Leadenhall conducted a review of ASX data on PE ratios by market capitalisation as at 30 June 2003, 2004 and 2005, focusing on small public companies. All companies chosen displayed the following characteristics: positive earnings; trading operations (i.e. resource and investment companies were eliminated); price earnings multiples between 0 and 30; and market capitalisations of up to $40 million.
No two companies are exactly the same, either from a growth viewpoint or from a risk viewpoint, be it financial risk or business risk. The individual companies selected are not directly comparable, but the sample overall is relevant as a comparable surrogate for multiples applied to smaller companies.
REFERENCES / 20~1000 Reference Materials / 20~1250 Price Earnings Ratios / 20~1580 Effect of Company Size on PERs / Results for smaller public companies
Results for smaller public companies
Our analysis shows that average PERs for smaller companies are significantly lower than the average for all companies included in the All Ordinaries Index. The table below shows the weighted average multiples for a selection of companies at different levels of market capitalisation as at 30 June 2003, 2004 and 2005 and compares these multiples with those of the All Ordinaries. Select Market Capitalisation $ million 0 to 10 10 to 20 20 to 30 30 to 40 0 to 40 All Ordinaries 30 June 2003 9.9 10.3 10.4 13.6 10.7 15.4 Sample Price Earnings Multiple Ranges 0 to 30 30 June 2004 5.1 7.9 9.4 8.0 7.8 15.8 30 June 2005 8.7 11.5 12.1 9.1 10.6 15.2 30 June 2003 10.3 9.9 9.7 12.6 10.4 15.4 5 to 20 30 June 2004 8.7 9.6 12.2 8.3 9.6 15.8 30 June 2005 10.7 9.8 10.4 9.1 9.9 15.2
Removing companies with PE multiples outside of the 520 range removes much of the variance in the data and provides for more meaningful output. That is, companies with a historic PE multiple outside that range would almost certainly have had a significantly different historic earnings result
compared to their prospective earnings. From this study, it can be seen that: the PE multiples for companies with smaller capitalisation are at a considerable discount to the average for companies included in the All Ordinaries; at 30 June 2003, the average PE multiple for companies with market capitalisation of $040 million and PE multiples between 5 and 20 was 10.4, compared with the All Ordinaries of 15.4 (i.e. a discount of over 30%); at 30 June 2004, the average PE multiple for companies with market capitalisation of $040 million and PE multiples between 5 and 20 was 9.6, compared with the All Ordinaries of 15.8 (i.e. a discount of almost 40%); and at 30 June 2005, the average PE multiple for companies with market capitalisation of $040 million and PE multiples between 5 and 20 was 9.9, compared with the All Ordinaries of 15.2 (i.e. a discount of 35%).
This data is consistent with the trend lines in the earlier chart that support the size effect for those companies included in the various ASX indices.
REFERENCES / 20~1000 Reference Materials / 20~1610 Required Rates of Returns (International)

20~1610
Required Rates of Returns (International)
Below information has been provided on price and accumulation indices for a number of different world markets. These will allow readers to judge the comparative returns required from different markets.
REFERENCES / 20~1000 Reference Materials / 20~1610 Required Rates of Returns (International) / 20~1630 Price Indices
20~1630
Price Indices
There are problems associated with price indices. These are discussed in the section on accumulation indices. The variability in returns is not unique to the Australian marketplace. A comparison of average share price volatility (from capital growth only i.e. a price index) for the three years to December 2005 from Australia and nine overseas markets is set out below. COUNTRIES (PRICE INDICES) Taiwan Weighted South Korea Composite Europe Dow Jones Euro STOXX 300 Singapore Straits Times Hong Kong Hang Seng United States S&P 500 United Kingdom FTSE 100
ANNUALISED SHARE PRICE VOLATILITY 20% 21% 13% 10% 15% 9% 10%
COUNTRIES (PRICE INDICES) Japan TOPIX New Zealand NZSE 50 Australia S&P/ASX 200
ANNUALISED SHARE PRICE VOLATILITY 14% 11% 9%
REFERENCES / 20~1000 Reference Materials / 20~1610 Required Rates of Returns (International) / 20~1630 Price Indices / World Price Indices
World Price Indices
Source: Reserve Bank of Australia, <www.rba.gov.au/Statistics/> Table F8
WORLD STOCK EXCHANGES (PRICE INDICES) 31 December 2005 Australia S&P/ASX 200 Europe Dow Jones Euro STOXX 300 Hong Kong Hang Seng Japan TOPIX New Zealand NZSE 50
COMPOUND ANNUAL RETURNS Last 1 Year 17.6% 23.0% 4.5% 43.6% 10.0% Last 2 Years 20.2% 16.3% 8.8% 25.8% 17.3% Last 5 Years 8.2% -3.4% -0.3% 5.2% 13.0%
WORLD STOCK EXCHANGES (PRICE INDICES) 31 December 2005 Singapore Straits Times South Korea Composite Taiwan Weighted United Kingdom FTSE 100 United States S&P 500
COMPOUND ANNUAL RETURNS Last 1 Year 13.6% 54.0% 6.6% 16.7% 3.0% Last 2 Years 15.3% 30.4% 5.4% 12.0% 6.0% Last 5 Years 4.0% 22.3% 6.7% -2.0% -1.1%
Source: derived from Reserve Bank of Australia, <www.rba.gov.au/Statistics/>, Table F8
Of note is the average variability in returns for each of the markets. Australia is usually referred to as being a relatively volatile market. However, when compared with the South Korean and Taiwanese markets, it can be seen that Australian market prices are significantly less volatile. In fact, from the sample of markets analysed, the annualised log-normal returns from Australian shares have been the least volatile over the three years to 31 December 2005. The following table compares capital growth in sharemarkets in Australia, Germany, Hong Kong, Japan, New Zealand, Singapore, South Korea, United Kingdom and the United States. Annual capital growth 2000 Australia S&P/ASX 200 Germany Dow Jones Euro STOXX 300 Hong Kong Hang Seng Japan TOPIX New Zealand NZSE 50 Singapore Straits Times South Korea Composite Taiwan Weighted United Kingdom FTSE 100 United States S&P 500 1.7% 2001 6.7% 2002 -12.1% 2003 9.7% 2004 22.8% 2005 17.6%
-5.9% -11.0% -25.5% -13.8% -22.3% -50.9% -43.9% -10.2% -10.1%
-19.7% -24.5% -19.6% 8.0% -15.7% 37.5% 17.1% -16.2% -13.0%
-34.5% -18.2% -18.3% -1.2% -17.4% -9.5% -19.8% -24.5% -23.4%
18.1% 34.9% 23.9% 25.6% 31.6% 29.2% 32.2% 13.7% 26.4%
9.9% 13.2% 10.1% 25.1% 17.1% 10.5% 4.2% 7.5% 9.0%
23.0% 4.5% 43.6% 10.0% 13.6% 54.0% 6.6% 16.7% 3.0%
REFERENCES / 20~1000 Reference Materials / 20~1610 Required Rates of Returns (International) / 20~1650 Accumulation Indices
20~1650
Accumulation Indices
The following table and chart highlight total investor returns for a range of asset classes.
REFERENCES / 20~1000 Reference Materials / 20~1610 Required Rates of Returns (International) / 20~1650 Accumulation Indices / 20~1660 Total investor returns dividends and capital growth
20~1660
Total investor returns dividends and capital growth
Historical rates of return for asset classes

International bonds (measured in AUD) (b) 29.2% 17.6% 12.5% 16.3% 13.1% 15.3% 15.8% 14.7% 2.1% 13.1% 11.2% 12.1% 11.0% 5.5% 5.0% 9.0% 8.0% 12.2% International shares as measured Unlisted in AUD (d) Property (e) 55.2% 32.6% -10.0% 18.1% 1.9% -2.0% 7.1% 31.8% 0.0% 14.2% 6.7% 28.6% 42.2% 8.2% 23.8% -6.0% -23.5% -18.5% 14.8% 18.2% 28.5% 23.7% 13.2% -9.9% -9.0% -7.3% 8.5% 9.9% 6.6% 6.3% 10.2% 9.4% 10.9% 10.4% 9.9% 0.5%
Year 30-Jun 86 30-Jun 87 30-Jun 88 30-Jun 89 30-Jun 90 30-Jun 91 30-Jun 92 30-Jun 93 30-Jun 94 30-Jun 95 30-Jun 96 30-Jun 97 30-Jun 98 30-Jun 99 30-Jun 00 30-Jun 01 30-Jun 02 30-Jun 03
Australian bonds (a) 15.7% 13.7% 15.8% 7.4% 14.0% 20.7% 18.0% 13.3% -0.4% 10.5% 9.9% 14.8% 11.7% 2.4% 5.9% 6.1% 5.9% 9.5%
Australian shares (c) 42.5% 54.0% -8.6% 3.5% 4.1% 5.9% 13.3% 9.9% 18.5% 5.7% 15.8% 26.6% 1.6% 15.3% 15.5% 9.1% -4.7% -1.7%
Listed Property (f) 23.8% 41.3% -2.8% -1.1% 15.2% 7.7% 14.7% 17.1% 9.8% 7.9% 3.6% 28.5% 10.0% 4.3% 12.1% 14.1% 15.5% 12.1%
Cash (g) 18.3% 17.3% 12.5% 15.7% 18.5% 13.5% 9.0% 5.9% 4.9% 7.1% 7.8% 6.8% 5.1% 5.0% 5.6% 6.1% 4.7% 5.0%
Compound rate of growth per annum 1 year 5 years 10 years 15 years 9.5% 5.9% 7.5% 9.8% 12.2% 7.9% 8.9% 10.9% -1.7% 6.4% 9.8% 8.9% -18.5% -4.7% 5.8% 7.4% 0.5% 8.1% 8.2% 5.8% 12.1% 11.6% 11.6% 11.2% 5.0% 5.3% 5.8% 8.0%
Year 20 years
Australian bonds (a) 11.3%
International bonds (measured in AUD) (b) 11.0%
Australian shares (c) 12.8%
International shares as measured Unlisted in AUD (d) Property (e) 11.6% 8.8%
Listed Property (f) 13.6%
Cash (g) 9.7%
a. b. c. d. e. f. g.
10 Year Bond Accumulation Index SSB World Government Bond Index (Australian dollar hedged) S&P/ASX 200 Accumulation Index MSCI World ex Australia Accumulation Index Mercer Unlisted Property Funds Index S&P/ASX Listed Property Trust Accumulation Index UBS Warburg Australia Bank Bill Accumulation Index
From the table and the chart below, it can clearly be seen that returns from shares and listed property vary more from year to year than returns from the other asset classes.
REFERENCES / 20~1000 Reference Materials / 20~1710 Required Rates of Return (Australia)

20~1710
Required Rates of Return (Australia)
The annual rates of return and average annual compound rates of return are effectively a total shareholder return (TSR). The estimated cost of equity is a long-run concept and when valuing businesses it is usual to refer to the long-run average returns which are expected. The long-run average may be quite different from the short-run expectations particularly if restructuring is required or the business is highly cyclical. In the following sections we provide information on: how accumulation indices are calculated; the problems with calculating a Beta in some markets; the market risk premium; and a comparison of the rate of return from different types of investments.
Below is a list of abbreviations and terms used in the tables and graphs that follow. Total Shareholder Return (TSR): This is the total annual percentage rate of return (from dividends and capital growth) received by shareholders in the company. To avoid measurement difficulties arising through differing investor tax rates, the dividend component is usually calculated on the basis of the cash dividend only. Four-year average compound return: This is the average annual TSR which, when compounded over the analysis period, results in the total return evidenced by shareholders from the fluctuating annual returns (akin to a line of best fit). Ke: Estimated cost of equity capital (% per annum). Usually measured as a post-corporate tax rate of return. Market risk premium: The long-run expected premium for investing in risky assets. Risk-free rate: Long-run estimate of returns from riskless assets (Commonwealth bonds), assuming a buy and hold to maturity strategy. ASX code: Refers to the industry classification allocated by the Australian Stock Exchange (e.g. oil and gas). S-W Beta: This is a measure of the relative riskiness of the investment. S-W Beta is the Scholes-Williams adjusted measure of the Beta factor obtained from share price movements relative to the overall market. OLS Beta: Ordinary least squares Beta is the slope coefficient from a simple linear regression of the company equity rate of return on that of the market index, where both are measured as deviations from the risk-free rate.
REFERENCES / 20~1000 Reference Materials / 20~1710 Required Rates of Return (Australia) / 20~1730 Explanation of Accumulation Indices
20~1730
Explanation of Accumulation Indices
One of the common errors in measuring market rates of return is to use a price index as a measure of historic returns.
Price indices reflect only the movement in capital value and exclude the impact of dividends and their reinvestment on returns. Historical data on Australian accumulation indices is available from a number of sources, including the ASX Fact Book, which can be downloaded from the Australian Stock Exchange web site at <www.asx.com.au>. This publication contains data on price indices for the last 10 years for each sector. The following sections detail the basis of calculation of the Australian Stock Exchange accumulation indices.
REFERENCES / 20~1000 Reference Materials / 20~1710 Required Rates of Return (Australia) / 20~1730 Explanation of Accumulation Indices / 20~1740 The Australian Stock Exchange indices
20~1740
The Australian Stock Exchange indices
The Australian Stock Exchange (ASX) share price indices summarise movements in share values resulting from equity trading on the ASX. Indices serve to indicate current trends, provide performance benchmarks and record sharemarket cycles and reactions to various events and economic situations. The calculation and dissemination of the ASX indices contribute to an informed market and fair trading while providing a base for derivatives. Whilst price indices measure movements in capital value, the matching set of ASX accumulation indices indicate the total return from investments in listed shares after reinvesting 100% of dividends at the 16:00 hours EST market price ex-dividend rate. Comparisons can then be made between sharemarket returns and the returns from other investments offering high income (e.g. bonds) or capital gains only (e.g. gold). The ASX accumulation indices make no allowance for tax, dividend franking or reinvestment at a discount, although specific requirements can be catered for upon request. The Australian Stock Exchange indices were introduced in January 1980. For 12 months they ran in parallel with older Sydney and Melbourne series of indices, which were discontinued on 31 December 1980. The Sydney and Melbourne indices were calculated daily from 1958 and 1960 respectively, while earlier retrospective calculations record monthly share market movements back to 1875. A wall chart of monthly index data from 1875 to date is available from all ASX investor centres. The All Ordinaries Index (AOI) is designed to meet the needs of a broad range of interested parties. Movements in the index are commonly reported in the media as good or bad trading days for investors. In the past, the AOI has been the most commonly used benchmark for assessing the performance of fund managers investments in the Australian sharemarket. The introduction of sub-indices added a further dimension to assessing performance as they encompassed characteristics of different portfolios. These indices allow ready identification of whether a managers skills are adding value to the investment portfolio relative to the markets performance in general. From the close of business on Friday 5 April 2002, Standard & Poors Inc, the key provider of equity indices in Australia, began the transition of the S&P/ASX indices to the Global Industry Classification Standard (GICS). The 24 sector indices of the All Ordinaries Index, as well as various industrial and resources indices, will no longer be disseminated on a real-time basis and have reverted to an end of day dissemination only. Those indices that have been discontinued or made available on an end of day only basis include the gold and many other specific sector indices, as well as the widely quoted
S&P/ASX resources and industrials indices. The final stage of the GICS transition occurred at the close of business on 5 July 2002. At that date the calculation of the 24 sector indices included in the All Ordinaries, as well as the calculation of those indices included in the S&P/ASX 200 and S&P/ASX 300 has been discontinued. No values for these indices will be published beyond this date. Since 25 June 2001, companies in the S&P/ASX 200 and S&P/ASX 300 indices have been classified under both the ASX classification system as well as the new GICS system. Integrated with this change is a shift to a free float methodology in index calculation both locally and globally. Free float is defined as the percentage of a companys shares that is freely available for purchase. A fully free floated company has an investible weight factor (IWF) of 100%. Standard & Poors adjust the IWF downwards to reflect the exclusion of any of the following holdings of greater than 5%: government and government agencies; controlling and strategic shareholders or partners; entities or individuals holdings more than 5% (excluding insurance companies, securities companies, finance companies and investment funds); and other restricted holdings such as treasury stock.
The adoption of the free float method does not make the existing methodology redundant. Standard & Poors has integrated free float adjustments to the successful elements of the current S&P/ASX methodology. The existing relative liquidity measure will remain one of the key determinants for index inclusion. Use of the free float method will then determine a stocks index weight. Further information is available from <www.standardandpoors.com>.
REFERENCES / 20~1000 Reference Materials / 20~1710 Required Rates of Return (Australia) / 20~1730 Explanation of Accumulation Indices / 20~1750 How the ASX price indices work
20~1750
How the ASX price indices work
The ASX price indices summarise price movements on the ASX by following the changes in the aggregate market values (AMV) of the companies covered by each index. The individual company market value (or market capitalisation) is the number of listed shares/units multiplied by their market price. These company market values are added to obtain the AMV for each index portfolio and the price indices are calculated as follows: Yesterdays Closing Price Index Todays Closing AMV Todays Start-of-Day AMV = Todays Closing Price Index
The value of each security in the AMV calculation is the last sale price recorded on the Stock Exchange Automated Trading System (SEATS), modified by any subsequent higher bid or lower offer made before normal trading ends at 16:00 hours EST. The start-of-day AMV is the previous days closing AMV adjusted for any overnight changes in the index portfolio, such as delistings, additions, new issues and capital reconstructions. These overnight
adjustments to the share numbers and prices making up the index portfolio do not move the indices. The indices are designed solely to reflect price movements resulting from share trading between 10:00 and 16:00 hours each day. Some comparable overseas market capitalisation weighted indices are the Standard & Poors 500 and the New York Stock Exchange Composite Indices (USA), the Financial Times Actuaries Indices (UK), the Toronto 300 Composite (Canada) and the Topic Index (Japan). It is important to note that price indices do not retain dividends, they are only a measure of capital gain or loss from investing in the stock market. To incorporate the effects of dividends on investment returns we turn to accumulation indices.
REFERENCES / 20~1000 Reference Materials / 20~1710 Required Rates of Return (Australia) / 20~1730 Explanation of Accumulation Indices / 20~1760 How the ASX accumulation indices work
20~1760
How the ASX accumulation indices work
The gross return (capital plus dividend income before tax) from share investment is indicated by a matching series of ASX accumulation indices. Dividends are reinvested in the appropriate indices on the ex-dividend date, consequently no fall attributable to the loss of dividend entitlement will occur on this date. The accumulation indices are calculated once daily after the close of trading using the following formula: Yesterdays Closing Accumulation Index Todays Closing AMV + Todays Dividends Todays Start-of-Day AMV = Todays Closing Accumulation Index
Over time accumulation indices will rise faster (or fall less) than their equivalent price indices, especially when they cover shares or units with a high dividend yield (e.g. property trusts). The closing AMVs and start-of-day AMVs are identical to those used in calculating the price indices. Accumulation indices can also be compiled for individual companies, fixed interest securities, property and other investments where the total pre-tax return on different investments needs to be compared. More sophisticated accumulation indices adjusted for tax, transaction costs, other expenses, dividend imputation and reinvestment at discounted prices are also possible and can be calculated by the ASX index office upon request.
REFERENCES / 20~1000 Reference Materials / 20~1710 Required Rates of Return (Australia) / 20~1730 Explanation of Accumulation Indices / 20~1770 April 2002 changes to the ASX indices
20~1770
April 2002 changes to the ASX indices
As mentioned earlier, from the close of business on Friday 5 April 2002, Standard & Poors Inc began the transition of the S&P/ASX indices to the Global Industry Classification Standard (GICS). The 24 sector indices of the All Ordinaries Index, as well as various industrial and resources indices, are no longer used.
The table below details those indices that are disseminated on a real-time basis for the Australian market post 5 July 2002. Index Code XTO XTL XAO XFL XMD XSO XJO XKO XEJ XMJ XNJ XDJ XSJ XHJ XFJ XIJ XTJ XUJ XPJ XXJ Index Number 25 26 30 31 34 38 51 52 710 715 720 725 730 735 740 745 750 755 760 765 Index Name S&P/ASX 100 S&P/ASX 20 All Ordinaries S&P/ASX 50 S&P/ASX Midcap 50 S&P/ASX Small Ordinaries S&P/ASX 200 S&P/ASX 300 S&P/ASX 200 Energy (GIC) S&P/ASX 200 Materials (GIC) S&P/ASX 200 Industrials (GIC) S&P/ASX 200 Consumer Discretionary (GIC) S&P/ASX 200 Consumer Staples (GIC) S&P/ASX 200 Health Care (GIC) S&P/ASX 200 Financials (GIC) S&P/ASX 200 Information Technology (GIC) S&P/ASX 200 Telecommunication Services (GIC) S&P/ASX 200 Utilities (GIC) S&P/ASX 200 Property Trusts (GIC) S&P/ASX 200 Financials-x-Property Trusts (GIC)
Mapping stocks that were previously classified in 24 different industry groups (the existing system) into the 10 new economic sectors (GICS) does not result in a direct mapping translation. The table below, reproduced from Understanding GICS (accessible <www.standardandpoors.com.au>) represents an approximate mapping outline. ASX Industry Sectors Gold Other Metals Diversified Resources Energy Infrastructure & Utilities Developers & Contractors Building Materials
through
Energy
Materials 100% 100% 1% 99% 11% 99% 1%
Industrials
37% 15% 100%
ASX Industry Sectors Alcohol & Tobacco Food & Household Chemicals Engineering Paper & Packaging Retail Transport Media Banks Insurance Telecommunications Investment & Fin. Services Property Health & Biotechnology Miscellaneous Industrials Diversified Industrials Tourism
Energy
Materials
Industrials
100% 100% 100%
100%
2%
38%
5% 6%
47% 78%
ASX Industry Sectors Gold Other Metals Diversified Resources Energy Infrastructure & Utilities Developers & Contractors Building Materials Alcohol & Tobacco Food & Household Chemicals Engineering Paper & Packaging Retail Transport Media
Consumer Discretionary
Consumer Staples
Health Care
100% 100%
21%
79%
100%
ASX Industry Sectors Banks Insurance Telecommunications Investment & Fin. Services Property Health & Biotechnology Miscellaneous Industrials Diversified Industrials Tourism
Consumer Discretionary
Consumer Staples
Health Care
100% 3% 4% 100% 12%
ASX Industry Sectors Property Trusts Gold Other Metals Diversified Resources Energy Infrastructure & Utilities Developers & Contractors Building Materials Alcohol & Tobacco Food & Household Chemicals Engineering Paper & Packaging Retail Transport Media Banks Insurance Telecommunications Investment & Fin. Services Property Health & Biotechnology Miscellaneous Industrials
Financials-xProperty
2% 85%
100% 100% 1% 60% 100%
45%
ASX Industry Sectors Property Trusts Diversified Industrials Tourism
Financials-xProperty
ASX Industry Sectors Gold Other Metals Diversified Resources Energy Infrastructure & Utilities Developers & Contractors Building Materials Alcohol & Tobacco Food & Household Chemicals Engineering Paper & Packaging Retail Transport Media Banks Insurance Telecommunications Investment & Fin. Services Property Health & Biotechnology Miscellaneous Industrials Diversified Industrials Tourism
Telecommunication Services
Utilities
50%
99%
As at March 31, 2002. Mapping as a % of market capitalisation. It should be noted that there are outliers within each industry group, which do not map perfectly. All Ordinaries Index (AOI) This is considered the headline index of the ASX and to which most reference is made in the press
from day to day. The construction of the AOI has two main determinants: Inclusion in the index is based solely on market capitalisation with no restrictions imposed on the liquidity (i.e. lack thereof) of a stock, with the exception of foreign domiciled companies. The size of the AOI is fixed at 500 stocks, weighted in terms of market capitalisation.
Prior to 3 April 2000, eligibility for inclusion in the AOI was based on a number of criteria. These included: a market capitalisation of 0.02% of the markets total capitalisation; liquidity requirements ensuring a certain volume of trade relative to the markets average liquidity; and various saleability requirements based on legislation and ASX regulation.
From 3 April 2000, the AOI has been much broader with capitalisation of the stocks included in the index constituting 99% of the Australian market at 30 November 2002. This figure compares with approximately 90% under the previous AOI construction. Additionally, whereas the minimum capitalisation required for inclusion was previously approximately $130 million, this figure reduced to approximately $20 million for the revised index. As noted in the Standard & Poors publication Understanding Indices: Index governance for the S&P/ASX indices is conducted by the S&P Australian Index Committee. The committee comprises five members representing Standard & Poor's and the ASX, and is responsible for setting policy, determining index composition, and administering the indices in accordance with the S&P/ASX index methodology. The committee may add, remove, or by-pass any company or security during the selection process. Index constituents are deleted for the following reasons: Acquisition The acquisition of a company by takeover or scheme of arrangement; Insufficient market capitalisation; Insufficient liquidity; Liquidation A company becomes insolvent or is placed under voluntary administration; and Company restructuring The restructured company and any spin-offs are reviewed for potential index inclusion or exclusion.
The need for an addition to the index is triggered only by a deletion from the index. Companies added to the S&P/ASX indices need to be selected by the S&P Australian Index Committee. Index additions are made according to the company's market size and liquidity. Initial public offerings (IPO) may be eligible for inclusion prior to six months of data being available. An IPO will be added to the index only if an appropriate vacancy occurs, and, if in the view of the S&P Australian Index Committee, its size, trading volume, and free float justify its inclusion.
Quarterly Reviews The S&P/ASX indices are reviewed quarterly and on an as-needed basis when significant corporate events occur. Each benchmark index is reviewed by the S&P Australian Index Committee on a constituent-by-constituent basis. Quarterly reviews analyse the previous six months' market capitalisation and liquidity for all companies. Quarterly reviews may result in index deletions and index additions. Quarterly reviews occur at the end of February, May, August, and November. Announcements of changes are made on the 15th of March, June, September, and December, becoming effective on the first business day of the following quarter. Announcement of intra-quarter changes Announcement of index deletions and additions outside of the quarterly review are made five business days in advance. Changes to IWFs as a result of a significant corporate action are announced as soon as practicable. Index Calculation Calculations for all S&P/ASX indices are based on stock prices taken from the ASX. The official daily index close for price and accumulation indices are calculated after the market closes and are based on the last traded price for each constituent. A range of sub-indices are also reported which provide useful information for varying purposes. These indices are classified numerically to indicate the number of companies included. The AOI has not been affected by the 5 April 2002 free float changes.
REFERENCES / 20~1000 Reference Materials / 20~1710 Required Rates of Return (Australia) / 20~1730 Explanation of Accumulation Indices / 20~1770 April 2002 changes to the ASX indices / Comparison between the existing methodology and the indices post-5 April 2002
Comparison between the existing methodology and the indices post-5 April 2002
Integration of the free float method into the existing methodology has affected all of the S&P/ASX indices except the AOI. It is important to recognise that the existing S&P/ASX index methodology already looked at free float when determining a stock's index eligibility and also liquidity factors as a proxy for free float when determining a stock's index weight. Standard & Poors has taken these provisions one step further by bringing the methodology in line with global practices. Outlined below are comparisons between the pre-5 April 2002 methodology and the post-5 April 2002 processes of determining index eligibility and index weight.
REFERENCES / 20~1000 Reference Materials / 20~1710 Required Rates of Return (Australia) / 20~1730 Explanation of Accumulation Indices / 20~1770 April 2002 changes to the ASX indices / Comparison between the existing methodology and the indices post-5 April 2002 / Index eligibility
Index eligibility
The previous methodology looked at the following free float provisions when determining index eligibility: 1. 2. 3. companies with a free float of less than 15% were ineligible for the index; IPOs with less than 50% free float could only join the index at a 50% liquidity factor; and a company being taken over was eligible to be removed or downweighted once the free float falls below 25%.
Under the current methodology there is a minimum free float threshold of 30%, unless it is deemed that the size of the float is large enough to warrant index inclusion. This replaces points 1 and 2 above. Take-over treatment is determined on a case-by-case basis; however it is also expected that a company under takeover will be eligible for removal once the free float drops below 30%. Relative liquidity is an effective measure for determining index eligibility. This process did not change.
REFERENCES / 20~1000 Reference Materials / 20~1710 Required Rates of Return (Australia) / 20~1730 Explanation of Accumulation Indices / 20~1770 April 2002 changes to the ASX indices / Comparison between the existing methodology and the indices post-5 April 2002 / Index weighting
Index weighting The previous methodology used a liquidity factor to adjust a stocks index weight. Liquidity factors were determined by trading volumes, moved in 25% band widths and were reviewed quarterly. Under the post 5 April 2002 methodology, the liquidity factor is replaced with an investable weight factor (IWF). IWFs are based on free float, are calculated to the nearest percentage and are reviewed annually (unless a major shift in the free float occurs of more than 5%). In addition, secondary securities are assessed individually for index inclusion. Previous practice was to aggregate secondary stock issues as part of the overall analysis. Consequently the index will now cover 200 stocks as opposed to 200 companies. Further details can be obtained from <www.standardandpoors.com>.
REFERENCES / 20~1000 Reference Materials / 20~1710 Required Rates of Return (Australia) / 20~1730 Explanation of Accumulation Indices / 20~1770 April 2002 changes to the ASX indices / S&P/ASX 20 and S&P/ASX 50 indices
S&P/ASX 20 and S&P/ASX 50 indices
These indices were previously known as the Top 20 and Top 50 leaders respectively and, as the previous names suggest, comprise the top 20 and 50 market leaders based on market capitalisation. These indices are considered useful for targeted investment strategies. At 30 November 2002, the S&P/ASX 20 represented 56% of the market capitalisation of domestic equities, while the S&P/ASX 50 represented 75% of the market capitalisation of domestic equities listed on the ASX.
REFERENCES / 20~1000 Reference Materials / 20~1710 Required Rates of Return (Australia) / 20~1730 Explanation of Accumulation Indices / 20~1770 April 2002 changes to the ASX indices / S&P/ASX 100 index
S&P/ASX 100 index
This index is comprised of 100 stocks selected by the S&P Australian Index Committee. The index provides a benchmark for large active managers whose emphasis is on having a portfolio with strong liquidity. It essentially covers large-cap and mid-cap stocks evaluated for liquidity and size. The index represented approximately 85% of the total market capitalisation of the Australian market at 30 November 2002.
REFERENCES / 20~1000 Reference Materials / 20~1710 Required Rates of Return (Australia) / 20~1730 Explanation of Accumulation Indices / 20~1770 April 2002 changes to the ASX indices / ASX 200 index
ASX 200 index
This index comprises those stocks included in the ASX 100, plus an additional 100 stocks. The index addresses the needs of investment managers to benchmark against a portfolio characterised by sufficient size and liquidity. The S&P/ASX 200 represented approximately 90% of the total market capitalisation of the Australian market at 30 November 2002.
REFERENCES / 20~1000 Reference Materials / 20~1710 Required Rates of Return (Australia) / 20~1730 Explanation of Accumulation Indices / 20~1770 April 2002 changes to the ASX indices / S&P/ASX 300 index
S&P/ASX 300 index
The ASX 300 index comprises those stocks included in the ASX 200, as well as an additional 100 small-cap companies. This provides a broad benchmark for fund managers who are exposed to smaller stocks but still require liquidity to maintain their portfolios. The index may not always contain 300 companies. It represented 91% of the Australian market at 30 November 2002.
REFERENCES / 20~1000 Reference Materials / 20~1710 Required Rates of Return (Australia) / 20~1730 Explanation of Accumulation Indices / 20~1770 April 2002 changes to the ASX indices / S&P/ASX Small ordinaries index
S&P/ASX Small ordinaries index
This is an index for those investing in smaller size stocks. The index comprises those stocks included in the ASX 300 but excludes those in the ASX 100. It represented approximately 6% of the total market capitalisation of the Australian market at 30 November 2002.
REFERENCES / 20~1000 Reference Materials / 20~1710 Required Rates of Return (Australia) / 20~1730 Explanation of Accumulation Indices / 20~1770 April 2002 changes to the ASX indices / S&P/ASX MidCap 50 Index
S&P/ASX MidCap 50 Index
The S&P/ASX MidCap 50 index is comprised of companies within the S&P/ASX 100, but not those included in the S&P/ASX 50. The index provides a benchmark for large active managers where the emphasis is on having a portfolio with sufficient liquidity. The index represented approximately 10% of the total market capitalisation of the Australian market at 30 November 2002.
REFERENCES / 20~1000 Reference Materials / 20~1710 Required Rates of

Return (Australia) / 20~1730 Explanation of Accumulation Indices / 20~1770 April 2002 changes to the ASX indices / S&P Asia Pacific 100 Index
S&P Asia Pacific 100 Index
The S&P Asia Pacific 100 index measures the performance of the most liquid companies in South East Asia and Oceania, covering approximately 70% of market capitalisation for the region. The seven countries the index covers are Australia, Hong Kong, Malaysia, New Zealand, Singapore, Korea, and Taiwan. The S&P Asia Pacific 100 index forms part of the S&P Global 1200 index. For further information regarding the structure of the above indices, visit the Australian Stock Exchange web site at <www.asx.com.au>. The ASX has also calculated retrospective data for these indices for the period July 1992 to March 1999. This information is available upon request.
REFERENCES / 20~1000 Reference Materials / 20~1710 Required Rates of Return (Australia) / 20~1730 Explanation of Accumulation Indices / 20~1770 April 2002 changes to the ASX indices / Index based derivatives
Index based derivatives
ASX derivatives (ASXD) introduced index options in 1985. Currently options are traded based on the currently the S&P/ASX 200 Index and the S&P/ASX 200 Property Trusts Index. ASXD index option contracts are based on the price index, multiplied by $10. The option may be exercised (European style) on the last day of the contract. SPI futures based on the All Ordinaries Index are traded on the Sydney Futures Exchange.
REFERENCES / 20~1000 Reference Materials / 20~1710 Required Rates of Return (Australia) / 20~1730 Explanation of Accumulation Indices / 20~1780 The problems with Beta
20~1780
The problems with Beta
The Australian sharemarket is known for its thinness in volumes of trading. For this reason, care must be taken with the Beta factors obtained for companies that trade infrequently or have been subject to dramatic price movements as a result of take-over activity or unfounded speculation. Beta factors obtained by the Scholes-Williams method will normally provide a better estimate than ordinary least squares (OLS) Beta factors due to the inherent smoothing of the Scholes-Williams method. However, it should be noted that the Australian Graduate School of Management (AGSM) Centre for Research in Finance (CRIF) noted, in Risk Measurement Service of December 2002 that: In view of the characteristics of each estimation procedure, another strategy for choosing between BETA estimates is to always use the OLS estimate unless the conditions required for OLS are not satisfied. In practice, it seems that OLS requirements are frequently satisfied, even though some companies are thinly traded. When these conditions are not satisfied, the Scholes-Williams BETA method is likely to produce more reliable BETA estimates. This is why we recommend using OLS unless the LM statistic is under 0.05. When the LM statistic [a statistic which reports on the likelihood that assumptions required for the OLS procedure are reasonable, or, more technically, the p-value in a test for first order serial correlation of OLS residuals] is under 0.05 the Scholes-Williams method is recommended.
Rapid increases in share prices and in the share of the market held by the telecom, media and technology sectors in the late 1990s distorted metrics, such as Betas, that relied on historical data. An article by Andr Annema and Marc H Goedhart, entitled A Better Beta in The McKinsey Quarterly, No. 1, 2003, proposed the exclusion of the bubble years from their calculations of Beta. The article can be accessed via <www.mckinseyquarterly.com>. If the Beta factor of a company (and therefore its cost of equity capital) is substantially out of line compared with its competitors, and this is not readily explainable by debt/equity effects, in all likelihood there have been market price fluctuations which have affected the calculation of the Beta factor. Often, these market price fluctuations will not be explained by normal fluctuations in operational cash flows. In estimating the cost of capital we need to sift through this noise to determine the appropriate signal.
REFERENCES / 20~1000 Reference Materials / 20~1710 Required Rates of Return (Australia) / 20~1800 Market Risk Premium
20~1800
Market Risk Premium
Analyses of long-run returns from equity investments in the Australian market usually conclude that there is a market risk premium (MRP) for investing in risky assets of between 6% and 8%. This premium is in effect the reward sought by investors for accepting the higher level of risk associated with equity investments. It is added to the risk-free rate to arrive at the required rate of return for the asset in question. Alternatively, this market risk premium reflects the additional returns which are required in the good years to compensate for the likelihood that there will be bad years where returns fail to meet risk-free equivalents. To place the concept of longer-term rates of return in perspective, the following spreadsheet shows the annual rates of return generated from the Australian stock market as measured by the ASX All Ordinaries Accumulation Index (usually accepted as a surrogate for returns from all risky assets) over the last 30 years. The analysis also compares returns from equities with returns from government bonds over the same period. A bond accumulation index has been constructed via a portfolio of ten 10-year government bonds. Returns for the portfolio incorporate both changes in its market value and coupon payments received. By allowing bond returns to proxy for the risk-free rate the overall market risk premium can then be estimated. A bond accumulation index can be constructed by: establishing a revolving portfolio of ten 10-year bonds, each maturing at different times (i.e. 10 years to maturity, nine years to maturity etc.); calculating total coupon income using the 10-year yield at the time of issue as the coupon rate applicable to each bond (i.e. it is assumed each bond is issued at par); calculating the market value of the portfolio based on the market value of each individual bond; comparing this to the previous years portfolio market value to enable calculation of the capital gain or loss for the past year; adding the capital gain or loss to the coupon income to arrive at total income; dividing total income for a given period by the opening market value of the portfolio to give the portfolios return; and this in turn can proxy for the discount rate applicable to fixed interest securities.
Of particular note in the following analysis is the variability in returns from year to year. This highlights the need to consider the long-run expected returns from the business being valued, as there will undoubtedly be years when returns are in excess of the benchmark and there will be years when returns fail to meet the benchmark. S&P/ASX 200 Accumulation Index Year Index* (31 December 1979 = 1000) 568 540 404 402 537 554 637 781 1,287 1,490 1,057 1,424 1,616 2,206 3,143 4,841 4,424 4,580 4,767 5,047 5,720 6,287 7,448 7,873 9,119 11,541 11,731 13,530 -4.85% -25.16% -0.69% 33.79% 3.02% 15.01% 22.69% 64.78% 15.77% -29.06% 34.72% 13.48% 36.51% 42.48% 54.02% -8.61% 3.53% 4.08% 5.87% 13.33% 9.91% 18.47% 5.71% 15.83% 26.56% 1.65% 15.34% % change 10-Year Bond Accumulation Index Index (31 June 1959 = 100) 190 196 190 210 228 249 289 307 321 347 361 448 532 613 709 806 933 1,002 1,142 1,378 1,627 1,843 1,836 2,030 2,230 2,559 2,859 2,927 2.83% -2.68% 10.33% 8.43% 9.26% 15.90% 6.41% 4.60% 8.14% 4.03% 24.07% 18.70% 15.12% 15.68% 13.66% 15.84% 7.36% 14.01% 20.66% 18.05% 13.31% -0.39% 10.55% 9.86% 14.79% 11.68% 2.40% -7.68% -22.48% -11.03% 25.36% -6.24% -0.89% 16.28% 60.18% 7.64% -33.09% 10.65% -5.21% 21.39% 26.80% 40.36% -24.45% -3.83% -9.92% -14.78% -4.71% -3.39% 18.86% -4.84% 5.97% 11.77% -10.04% 12.93% % change Market Risk Premium
30 Jun 72 30 Jun 73 30 Jun 74 30 Jun 75 30 Jun 76 30 Jun 77 30 Jun 78 30 Jun 79 30 Jun 80 30 Jun 81 30 Jun 82 30 Jun 83 30 Jun 84 30 Jun 85 30 Jun 86 30 Jun 87 30 Jun 88 30 Jun 89 30 Jun 90 30 Jun 91 30 Jun 92 30 Jun 93 30 Jun 94 30 Jun 95 30 Jun 96 30 Jun 97 30 Jun 98 30 Jun 99
S&P/ASX 200 Accumulation Index Year Index* (31 December 1979 = 1000) 15,628 17,045 16,245 15,967 19,417 24,534 % change
10-Year Bond Accumulation Index Index (31 June 1959 = 100) 3,100 3,288 3,482 3,811 3,866 4,189 % change Market Risk Premium
30 Jun 00 30 Jun 01 30 Jun 02 30 Jun 03 30 Jun 04 30 Jun 05
15.51% 9.07% -4.69% -1.71% 21.61% 26.36%
5.91% 6.05% 5.90% 9.44% 1.45% 8.36%
9.60% 3.02% -10.59% -11.16% 20.16% 17.99%
Equities Average rates last 10 years Arithmetic Mean: Geometric Mean: Average rates last 25 years Arithmetic Mean: Geometric Mean:
*
Bonds
MRP
12.55% 12.04%
7.58% 7.51%
4.97%
13.83% 12.51%
10.98% 10.82%
2.84%
The early part of the data series has since been superseded by the S&P/ASX200 and the data re-cast to conform with the current series.
The market risk premium is by convention calculated using the arithmetic mean. This provides consistency given the additive nature of the capital asset pricing model. The Independent Pricing and Regulatory Tribunal of New South Wales (IPART), in a Discussion Paper entitled Weighted Average Cost of Capital (Discussion Paper D56), review studies of the market risk premium from various sources: In the last rounds of electricity and gas reviews over the period of 19972000, the Tribunal adopted a MRP of 5.06.0 per cent. This was after considering various market studies and submissions. In the recent determinations of ACCC, ESC, QCA and Ofgar, a MRP of 6 per cent was used in the calculations. In the current Victorian Gas reviews, Envestra and Multinet have proposed a MRP of 7.3 and 7.0 per cent MRP, respectively. They support their proposal by citing new studies by Welch and Dimson, Marsh and Staunton. TXU has maintained a MRP of 6 per cent. In its draft decision, ESC has maintained a 6 per cent MRP, after having regard to various studies and practitioner surveys. Various studies have tried to estimate the MRP in the Australian market, these studies are summarised in the table below. Table 7 MRP studies
are summarised in the table below. Table 7 MRP studies Study Officer (1989) Time period of study 19821987 MRP 7.9% 6.6% Officer (1989) Updated 19821997 7.1% 5.7% Hathaway (1996) Hathaway (1996) Centre for Research in Finance (1999) 19821991 19471991 19741998 7.7% 6.6% 4.8% 2.8% Centre for Research in Finance (1999) excluding Oct 1987 19741998 6.4% 4.9% Ibbotson Associates (1999) Dimson, Marsh and Staunton (2000) 19701998 19002000 3.4% 7.6% (nominal) 6.5% (real) Welch (Survey 2000) Welch (Survey 2001) Graham & Harvey (2001) Mercer Investment Consulting (2002) Oct 1998 late 1998 Aug 2001 June 2000 Sep 2001 May 2002 7.1% 5.5% 3.64.7% 3.0%* 4.0% (incl franking credits) 3.06.0% Arithmetic Arithmetic Survey of 1107 CFO Arithmetic Method of averaging Arithmetic Geometric Arithmetic Geometric Arithmetic Arithmetic Arithmetic Geometric Arithmetic Geometric Arithmetic Geometric
Broker survey
* This value reflects that used by Mercer Investment Consulting in its asset allocation advice to institutional investors. In addition, Mercer Investment Consulting also surveyed various brokers on their assumptions of the equity risk premium. This discussion paper can be acccessed on <www.ipart.nsw.gov.au>.
The ACCC, in its 2003 Discussion Paper Review of the Draft Statement of Principles for the Regulation of Transmission Revenues, comments in section 8.6.2: Regulatory decisions in Australia have used an historical MRP (ex-post measure) of between 57% per annum representing the long run average return on Australian stocks. Decisions in the UK have used an historical MRP of 3.5%. The rationale for such differences is that there are segmented stock markets, and investors require a higher risk premium to invest in the Australian market.
There is evidence that the MRP moves inversely with government interest rates suggesting that in times of low inflation and expected inflation (reflected by lower long term interest rates), the MRP is higher. Arguments for a lower MRP stem from the fact that the economy as a whole is much less risky than the stock market. Households typically receive income from wages and salaries and other sources that resemble aggregate returns, rather than simply returns on the stock market. Risk can be diversified away using households other sources of income, thus a lower MRP would seem more plausible than experienced in the past. There is often comment made that historical estimates of the MRP have been calculated as some historical average of the actual market return over a long term risk free rate. Typically the risk free rate used is a 10 year government bond rate. Therefore, the assertion is made that if these estimates of the MRP are to be used in CAPM, consistency requires that a long term bond be used as the risk free rate. However, according to Davis, a number of arguments can be advanced against that position. Further undermining this consistency rationale is the fact that in beta estimation, short term interest rates (i.e. 90 day bank bills) are frequently used. The Commission currently adopts a figure of 6% per annum for the MRP, which reflects the long run historical return on the Australian stock market. This is consistent with a comprehensive study by Lally for the Commission, which recommended a MRP of 6% as reasonable. The ACCC paper can be found at <www.accc.gov.au>. Robert G Bowman, in an article entitled Estimating market risk premium in the Spring 2001 issue of JASSA (pp.1013), believes that historical evidence in Australia indicates a post MRP slightly below 7.0%. However, historical estimates may not be appropriate for incorporation in CAPM as CAPM is a forward looking concept, based on expectations of the future. He suggests that: Australia use an approach based upon using the US MRP as a benchmark. The forward-looking US MRP is estimated to be 6% to 9% with a point estimate of 7.5%There are a number of issues that can be considered to adjust the US benchmark. I believe that on balance they support an adjustment of at least +0/3% (+1.7% for a short horizon MRP). In my opinion the appropriate MRP to use for Australia is 7.8% (9.2% for a short horizon MRP). (page 13) The following graph plots the calculated market risk premiums. A line of best fit has also been plotted highlighting the estimated value of the market risk premium based on simple regression analysis.
Dimson, Marsh and Staunton (2000), in their study Triumph of the Optimists, estimated a global historical average equity premium of 4.6 percentage points. Their study was based on indices of total returns for 16 countries using data going back to 1900.
REFERENCES / 20~1000 Reference Materials / 20~1710 Required Rates of Return (Australia) / 20~1840 Required Rates of Return
20~1840
Required Rates of Return
The annual rates of return and average annual compound rates of return are effectively a total shareholder return (TSR). That is, the combined capital growth and dividend return are captured in these calculations. The annual returns are referred to as TSR as this is the common terminology for benchmark returns. The following table shows estimates of the expected total shareholder returns (Ke%) in the various GICS sector indices for the year beginning 1 January 2006, calculated using the CAPM. These are compared to the annual compound total shareholder returns that have been realised over the four years to 31 December 2005. Market Premium % 4.97% 4.97% 4.97% 4.97% 4.97% 4.97% Ke% (based on OLS Beta) 11.06% 12.21% 10.47% 11.41% 8.18% 14.30% TSR over 4 years (% per annum) 32.22% 24.83% 10.48% 2.04% 11.42% 3.32%
Industry Energy Materials Industrials Consumer Discretionary Consumer Staples Health Care
OLS Beta 1.18 1.41 1.06 1.25 0.60 1.31
S-W Beta 1.16 1.28 1.32 1.17 0.66 1.83
Rf % 5.20% 5.20% 5.20% 5.20% 5.20% 5.20%
Industry Financials Information Technology Telecommunications Services Utilities

Risk Measurement Service.
OLS Beta 0.82 1.49 0.37 0.30
S-W Beta 0.79 2.37 0.62 0.05
Rf % 5.20% 5.20% 5.20% 5.20%
Market Premium % 4.97% 4.97% 4.97% 4.97%
Ke% (based on OLS Beta) 9.28% 12.61% 7.04% 6.69%
TSR over 4 years (% per annum) 13.07% -2.50% -0.48% 22.03%
Note: This data is not current. It is recommended that the most recent data be used for current valuations. Refer to the AGSM
Sources: Betas from AGSM Risk Measurement Service, December 2005. AGSM advocates that the S-W Beta is likely to be more reliable than the OLS Beta when the LM statistic (which is a measure of thin trading) is less than 0.05. Consequently, the S-W Beta has been used above for the health care industry, while the standard OLS Beta has been used for all other industries. Risk-free rate is the 10-year Government bond rate at 31 December 2005 accessed from <www.rba.gov.au> statistical table F2. Market premium is the arithmetic mean over 10 years. TSR over four years has been calculated from Standard & Poors S&P/ASX Accumulation Index Returns December 2004 and December 2005, accessed on <www2.standardandpoors.com>.
The estimated cost of equity is a long-term concept and when valuing businesses it is usual to refer to the long-term average returns which are expected. Short-term returns can exhibit significantly higher volatility than long-term returns. The long-term average return may be quite different to the short-term returns particularly if restructuring is required or the business is highly cyclical. The expected long-run average return can be calculated using the capital asset pricing model (CAPM). A key component of CAPM is the Beta of a given investment. Surrogate Betas can be obtained from industry Betas.
REFERENCES / 20~1000 Reference Materials / 20~1710 Required Rates of Return (Australia) / 20~1840 Required Rates of Return / 20~1850 Industry Betas
20~1850
Industry Betas
The industry Beta data in the table below is extracted from AGSM Risk Measurement Service, December 2005: OLS Beta is the slope coefficient from a simple linear regression of the company equity rate of return on that of the market index, where both are measured as deviations from the risk-free rate. S-W Beta has been calculated by modifying for the effects of thin trading using the
Scholes-Williams technique. AGSM advocates that the S-W Beta is likely to be more reliable than the OLS Beta when the LM statistic (which is a measure of thin trading) is less than 0.05.
Warning: This data is not current. It is recommended that the most recent available data be used for current valuations. Refer to the AGSM Risk Measurement Service.
CLASS
CLASS NAME
OLS BETA LM 0.187 0.428 0.488 0.798 0.431 0.379 0.611 0.323 0.095 0.626 0.053 0.240 0.506 0.273 0.381 0.029 0.302 0.840 0.946 0.315 0.527 0.770 0.384 0.912 0.286 0.510 0.033 0.737
S-W BETA 1.16 1.06 0.79 0.45 1.47 1.39 1.71 1.08 0.86 2.05 1.01 1.17 1.26 0.76 0.62 1.36 2.76 0.51 1.39 1.94 1.49 0.30 2.47 2.01 0.62 0.05 0.46 0.91
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27
energy chemicals construction materials paper & forest products + containers & packaging metals & mining capital goods commercial services & supplies transportation automobile & components consumer durables & apparel consumer services media retailing food & drug retailing + household & personal products food beverage & tobacco health care equipment & services pharmaceuticals & biotechnology banks diversified financials insurance real estate excluding investment trusts real estate investment trusts software & services technology hardware & equipment telecommunication services utilities gics not defined
1.18 1.56 1.14 0.93 1.50 1.12 1.17 0.98 0.90 1.47 0.91 1.41 1.03 0.62 0.57 1.17 1.59 0.70 1.23 1.57 1.04 0.34 1.66 1.06 0.37 0.30 0.46 0.88
2-4,6-26 all industrials

CLASS
CLASS NAME
OLS BETA LM
S-W BETA
AGSMs Risk Measurement Service, including Beta data can be purchased as a complete set (containing all sectors and companies listed on the ASX), at a cost of approximately $250 from: Centre for Research in Finance Australian Graduate School of Management The University of New South Wales UNSW Sydney NSW 2052 Tel: (02) 9931 9281 and (02) 9931 5276 CRIF@AGSM.edu.au
REFERENCES / 20~1000 Reference Materials / 20~1710 Required Rates of Return (Australia) / 20~2060 Required Rate of Return (Non-listed Property)
20~2060
Required Rate of Return (Non-listed Property)
The following data comes from the Mercer Australian Unlisted Property Index and has been obtained from the W M Mercer web site located at <www.merceric.com>. As the index is of unlisted property it is not influenced by general stock market conditions and provides a more accurate insight into property market returns. YEAR (TO 31 DECEMBER) 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995
INDEX VALUE 382.83 462.81 523.38 611.88 699.85 815.10 1012.47 1280.69 1515.72 1531.96 1333.19 1240.01 1208.29 1382.32 1489.08
ANNUAL RETURN (Pre Tax) 18.43% 20.89% 13.09% 16.91% 14.38% 16.47% 24.21% 26.49% 18.35% 1.07% -12.97% -6.99% -2.56% 14.4% 7.72%
YEAR (TO 31 DECEMBER) 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
INDEX VALUE 1607.25 1716.11 1881.27 2065.47 2298.80 2524.30 2793.65 3127.46 3500.33 3988.80
ANNUAL RETURN (Pre Tax) 7.94% 6.77% 9.62% 9.79% 11.30% 9.81% 10.67% 11.95% 11.92% 13.95%
REFERENCES / 20~1000 Reference Materials / 20~2110 Stamp Duty Rates

20~2110
Stamp Duty Rates
Stamp duty is a state and territory tax controlled by eight separate legislatures and imposed either as a fixed rate or at an ad valorem rate on the value of the transaction involved. The problems with determining the duty payable include: the complexity of the legislations;
the extra-territorial operation of the various legislations; the lack of harmony between the various state and territory Acts; the land rich provisions contained in all Acts; and the inclusion of rollover provisions in the Acts of some states.
It is important to note the term property is applied in a very wide sense and may include such things as goodwill. The following rates are included to assist practitioners when providing advice to clients on the comparative costs of: buying shares in a company; or buying assets held by a business.
These rates can be accessed via the links in the Stamp Duty Tax topics explained section of <www.ato.gov.au>.
REFERENCES / 20~1000 Reference Materials / 20~2110 Stamp Duty Rates / 20~2130 Transfer of Shares
20~2130
Transfer of Shares
REFERENCES / 20~1000 Reference Materials / 20~2110 Stamp Duty Rates / 20~2130 Transfer of Shares / 20~2140 Northern Territory
20~2140
Northern Territory
30 per $100 (or part thereof) 60 per $100 (or part thereof)
Listed Shares Unlisted Shares
REFERENCES / 20~1000 Reference Materials / 20~2110 Stamp Duty Rates / 20~2130 Transfer of Shares / 20~2145 Australian Capital Territory, New South Wales, Queensland, South Australia and Tasmania
20~2145
Australian Capital Territory, New South Wales, Queensland, South Australia and Tasmania
Not payable 60 per $100 (or part thereof)
Listed Shares Unlisted Shares
Note 1 The ACT legislation imposes a minimum duty payable of $20. Note 2 The NSW legislation imposes a minimum duty payable of $10 (on unlisted shares).
REFERENCES / 20~1000 Reference Materials / 20~2110 Stamp Duty Rates / 20~2130 Transfer of Shares / 20~2150 Victoria and Western Australia
20~2150
Victoria and Western Australia

Nil
Listed and Unlisted Shares
REFERENCES / 20~1000 Reference Materials / 20~2110 Stamp Duty Rates / 20~2180 Conveyance of Property
20~2180
Conveyance of Property
REFERENCES / 20~1000 Reference Materials / 20~2110 Stamp Duty Rates / 20~2180 Conveyance of Property / 20~2190 Australian Capital Territory
20~2190
Australian Capital Territory

Duty Payable $0 $2,000 $5,500 $9,500 $20,500 $49,250 plus $2.00 per $100 or part thereof ($20 minimum) plus $3.50 per $100 or part thereof of value in excess of $100,001 plus $4.00 per $100 or part thereof of value in excess of $200,001 plus $5.50 per $100 or part thereof of value in excess of $300,001 plus $5.75 per $100 or part thereof of value in excess of $500,001 plus $6.75 per $100 or part thereof of value in excess of $1,000,000
Value of Property Up to $100,000 $100,001 to $200,000 $200,001 to $300,000 $300,001 to $500,000 $500,001 to $1,000,000 $1,000,001 and over
REFERENCES / 20~1000 Reference Materials / 20~2110 Stamp Duty Rates / 20~2180 Conveyance of Property / 20~2200 New South Wales
20~2200
New South Wales

Duty Payable $0 $175 $415 $1,290 $8,990 $40,490 plus $1.25 per $100 or part thereof plus $1.50 per $100 or part thereof of value in excess of $14,000 plus $1.75 per $100 or part thereof of value in excess of $30,000 plus $3.50 per $100 or part thereof of value in excess of $80,000 plus $4.50 per $100 or part thereof of value in excess of $300,000 plus $5.50 per $100 or part thereof of value in excess of $1,000,000
Value of Property Up to $14,000 $14,001 to $30,000 $30,001 to $80,000 $80,001 to $300,000 $300,001 to $1,000,000 $1,000,001 and over
REFERENCES / 20~1000 Reference Materials / 20~2110 Stamp Duty Rates / 20~2180 Conveyance of Property / 20~2210 Northern Territory
20~2210
Northern Territory
Duty Payable See formula below 5.4% of amount of unencumbered value
Value of Property $0 $500,000 $500,001 and over D = (0.065 * V2) + 21V Where: D = the duty payable in $; and V = the value/1,000
REFERENCES / 20~1000 Reference Materials / 20~2110 Stamp Duty Rates / 20~2180 Conveyance of Property / 20~2220 Queensland
20~2220
Queensland
Duty Payable $0 $300 $975 $2,350 $7,225 $15,975 plus $1.50 per $100 or part thereof plus $2.25 per $100 or part thereof of value in excess of $20,000 plus $2.75 per $100 or part thereof of value in excess of $50,000 plus $3.25 per $100 or part thereof of value in excess of $100,000 plus $3.50 per $100 or part thereof of value in excess of $250,000 plus $3.75 per $100 or part thereof of value in excess of $500,000
Value of Property Up to $20,000 $20,001 to $50,000 $50,001 to $100,000 $100,001 to $250,000 $250,001 to $500,000 $500,001 and over
Note: Queensland stamp duty on the conveyance of property with the value of $500,001 and over will increase from 1 July 2006. See <www.osr.qld.gov.au> for more details.
REFERENCES / 20~1000 Reference Materials / 20~2110 Stamp Duty Rates / 20~2180 Conveyance of Property / 20~2230 South Australia
20~2230
South Australia
Duty Payable $0 $120 $480 plus $1.00 per $100 or part thereof plus $2.00 per $100 or part thereof of value in excess of $12,000 plus $3.00 per $100 or part thereof of value in excess of $30,000
Value of Property Up to $12,000 $12,001 to $30,000 $30,001 to $50,000
Value of Property $50,001 to $100,000 $100,001 to $200,000 $200,001 to $250,000 $250,001 to $300,000 $300,001 to $500,000 $500,001 and over $1,080 $2,830 $6,830 $8,955 $11,330 $21,330
Duty Payable plus $3.50 per $100 or part thereof of value in excess of $50,000 plus $4.00 per $100 or part thereof of value in excess of $100,000 plus $4.25 per $100 or part thereof of value in excess of $200,000 plus $4.75 per $100 or part thereof of value in excess of $250,000 plus $5.00 per $100 or part thereof of value in excess of $300,000 plus $5.50 per $100 or part thereof of value in excess of $500,000
REFERENCES / 20~1000 Reference Materials / 20~2110 Stamp Duty Rates / 20~2180 Conveyance of Property / 20~2240 Tasmania
20~2240
Tasmania
Duty Payable $20 $20 $150 $550 $1,675 $3,925 $6,550 plus 1.5% of excess over $1,300 plus 2.0% of excess over $10,000 plus 2.5% of excess over $30,000 plus 3.0% of excess over $75,000 plus 3.5% of excess over $150,000 plus 4.0% of excess over $225,000
Value of Property Up to $1,300 $1,301 to $10,000 $10,001 to $30,000 $30,001 to $75,000 $75,001 to $150,000 $150,001 to $225,000 $225,001 and over
REFERENCES / 20~1000 Reference Materials / 20~2110 Stamp Duty Rates / 20~2180 Conveyance of Property / 20~2250 Victoria
20~2250
Victoria
Duty Payable $0 $280 $2,560 $0 plus 1.4% of the value plus 2.4% of value in excess of $20,000 plus 6.0% of value in excess of $115,000 plus 5.5% of the value
Value of Property Up to $20,000 $20,001 to $115,000 $115,001 to $870,000 $870,001 and over
REFERENCES / 20~1000 Reference Materials / 20~2110 Stamp Duty Rates / 20~2180 Conveyance of Property / 20~2260 Western Australia
20~2260
Western Australia
Duty Payable $0 $1,600 $2,200 $8,200 $20,700 plus $2.00 per $100 or part thereof plus $3.00 per $100 or part thereof of value in excess of $80,000 plus $4.00 per $100 or part thereof of value in excess of $100,000 plus $5.00 per $100 or part thereof of value in excess of $250,000 plus $5.40 per $100 or part thereof of value in excess of $500,000
Value of Property Up to $80,000 $80,001 to $100,000 $100,001 to $250,000 $250,001 to $500,000 $500,001 and over
REFERENCES / 21~1000 Glossary and Abbreviations

21~1000
Glossary and Abbreviations
A number of definitions and abbreviations are used in this text, and to avoid the necessity of having to define or footnote them throughout the text, we have set out below the most common abbreviations and meanings. Please note the following symbol: # means that the definition has been quoted directly from the International Glossary of Business Valuation Terms which has been developed and adopted by the following organisations: A M the American Institute of Certified Public Accountants; the American Society of Appraisers; the Canadian Institute of Chartered Business Valuators; the National Association of Certified Valuation Analysts; and The Institute of Business Appraisers. B N C O D P E R F S G T H U I V K W L
REFERENCES / 21~1000 Glossary and Abbreviations / A

A TERM AARF AAS AASB DEFINITION Australian Accounting Research Foundation. Australian Accounting Standard. Australian Accounting Standards Board (previously Accounting Standards Review Board).
TERM Abnormal items
DEFINITION Items of revenue and expense, and other gains and losses, brought to account in the period, which although attributable to the ordinary operations of the entity are considered abnormal by reason of their size and effect on the results for the period. In relation to financial reporting, means the responsibility to provide information so that users can make informed judgments about the financial status, performance and compliance of the authority. Method of adjusting accounts to provide for expenditure incurred but not paid for and revenue earned but not received. Basis of levying stamp duty or tax as a percentage of the value of the item that is dutiable or taxable. The value that results after one or more asset or liability amounts are added, deleted, or changed from their respective financial statement amounts.
# International Glossary of Business Valuation Terms
Accountability
Accrual basis of accounting Ad valorem Adjusted book value
AGSM AICPA All Ordinaries Index
Australian Graduate School of Management (University of New South Wales, Australia). American Institute of Certified Public Accountants. Composite index of the share prices of all ordinary shares listed on the Australian Stock Exchange related to a base index of 1,000. Care should be taken that the All Ordinaries Price Index is not confused with the All Ordinaries Accumulation Index. The latter index includes the value of all dividends paid by the shares included in the index. The accumulation indices provide a better estimate of value over time as they effectively eliminate effects such as the introduction of imputation from the underlying price index. Terms and conditions of options and other instruments which provide protection against the dilution of the securities interest in the company by events such as bonus issues, reconstructions and other events. See Valuation. See Valuation approach. See Valuation date. See Valuation method. See Valuation procedure. American Society of Appraisers. A resource owned or controlled by an enterprise as a result of past events and from which some future economic benefit(s) can be expected to flow to the enterprise
International Valuation Standards, Glossary of Terms, 2001 International Accounting Standard Framework 49(a) IAS 16, Property, Plant and Equipment, Para 16.7
Anti-dilution provisions
Appraisal Appraisal approach Appraisal date Appraisal method Appraisal procedure ASA Asset
TERM Asset (asset-based) approach
DEFINITION A general way of determining a value indication of a business, business ownership interest, or security by using one or more methods based on the value of the assets of that business net of liabilities.
Asset based approach
An approach to value that examines the balance sheet of the business that reports all assets, tangible and intangible, and all liabilities at market value, or an appropriate carrying amount. When an asset based approach is used in assignments involving operating businesses valued as going concerns, the value estimate obtained should be considered together with the value estimates from (an)other approach(es).
International Valuation Standards, Glossary of Terms, 2001, GN 6, 6.7
ASIC ASC Asset strip acquisition
Australian Securities & Investments Commission (successor of ASC). Australian Securities Commission (successor of NCSC). Opportunistic acquisition, the objective of which is to realise more from the sale of the entitys individual assets than from the earnings that the business might otherwise earn. Total assets less assets under construction. Physical assets which (a) were not used in the latest completed accounting period and (b) have been specifically identified as surplus to the future needs of the operation. Suppositions taken to be true. Assumptions involve facts, conditions, or situations affecting the subject of, or approach to, a valuation but which may not be capable or worthy of verification. They are matters that, once declared, are to be accepted in understanding the valuation. All assumptions underlying a valuation should be reasonable.
International Valuation Standards, Glossary of Terms, 2001, Code of Conduct, 3.1
Assets-in-service (operating assets) Assets not in use
Assumptions
ASX ASX code Average compound return
Australian Stock Exchange Limited (and its State subsidiaries). The code allocated by the Australian Stock Exchange to identify specific securities and derivatives listed on the exchange. This is the average annual total shareholder return (TSR) which, when compounded over the analysis period, results in the total return evidenced by shareholders from the fluctuating annual returns (akin to a line of best fit). This is usually synonymous with liquidation value as it represents the amount that might be realised from the sale of individual assets divorced from the business in a distressed sale manner.
Auction value
REFERENCES / 21~1000 Glossary and Abbreviations / B

B TERM
DEFINITION
TERM Back door listing Balance sheet
DEFINITION Method of obtaining stock exchange listing by the reverse take-over (refer separate entry) of a business by an existing listed company. Australia is in the process of changing the name of its financial statements. It is intended to call a balance sheet (old name) a statement of financial position (new name). Applies to financial years commencing on or after 1 July 2000.
Benefit stream
Any level of income, cash flow or earnings generated by an asset, group of assets, or business enterprise. When the term is used, it should be supplemented by a definition of exactly what it means in the given valuation context.
Beta
A measure of systematic risk of a security; the tendency of a securitys returns to correlate with swings in the broad market.
Blockage discount
An amount or percentage deducted from the current market price of a publicly traded security to reflect the decrease in the per share value of a block of those securities that is of a size that could not be sold in a reasonable period of time given normal trading volume.
Blue sky
The potential for growth/profit etc. which cannot be reasonably estimated based on the facts to hand. Often the blue sky potential of a project or invention is dependent upon a number of fundamental occurrences, the likelihood of which is often dubious. The combination of rights associated with the ownership of real property. The bundle-of-rights concept likens property ownership to a bundle of sticks with each stick representing a distinct and separate right of the property owner, e.g., the right to use, to sell, to lease, to give away, or to choose to exercise all or none of these rights.
International Valuation Standards, Glossary of Terms, 2001, Concepts/Principles, 2.3; Property Types 2.2
Bundle of rights
Business Business enterprise
See Business enterprise. A commercial, industrial, service or investment entity, or a combination thereof, pursuing an economic activity.
A commercial, industrial, service or investment entity pursuing an economic activity; generally a profit-making enterprise. A business enterprise may be unincorporated (sole proprietorships, partnerships) or incorporated (closely-held or publicly held), or take the form of trust arrangements or multiple entities. The ownership interest in a business may be undivided, divided among shareholders and/or involve a majority interest and minority interest.
International Valuation Standards, Glossary of Terms, 2001, Property Types 4.1, 4.2, 4.7, 4.8; GN 6, 3.5
TERM Business valuation
DEFINITION The act or process of determining the value of a business enterprise or ownership interest therein.
REFERENCES / 21~1000 Glossary and Abbreviations / C

C TERM Capacity DEFINITION In relation to an asset, means its physical ability to yield service to the business, such ability being generally measured in terms of units of production or services in a given period. A model in which the cost of capital for any security or portfolio of securities equals a risk-free rate plus a risk premium that is proportionate to the systematic risk of the security or portfolio.
Capital asset pricing model (CAPM)
Capitalisation
A conversion of a single period stream of benefits into value.

At a given date the conversion into the equivalent capital value of net income or a series of net receipts, actual or estimated, over a period.
International Valuation Standards, Glossary of Terms, 2001
Capitalisation factor
Any multiple or divisor used to convert anticipated benefits into value.

Any multiple or divisor used to convert income into value.

International Valuation Standards, Glossary of Terms, 2001, GN 4, 3.4; GN 6, 3.8
Capitalisation multiple Capitalisation rate (all risks yield)
See Capitalisation factor. Any divisor (usually expressed as a percentage) used to convert anticipated benefits into value.
Any divisor (usually expressed as a percentage) that is used to convert income into value. The interest rate or yield at which the annual net income from an investment is capitalised to ascertain its capital value at a given date.
Capital structure
The composition of the invested capital of a business enterprise; the mix of debt and equity financing.
CAPM CASA
See Capital asset pricing model. Companies (Acquisitions of Shares) Code; predecessor of Corporations Law.
TERM Cash flow
DEFINITION Cash that is generated over a period of time by an asset, group of assets or business enterprise. It may be used in a general sense to encompass various levels of specifically defined cash flows. When the term is used, it should be supplemented by a qualifier (for example, discretionary or operating) and a definition of exactly what it means in the given valuation context.
The actual or estimated periodic net income produced by the revenues and expenditures/outgoings in the operation and ultimate resale of an income-producing property. See also Gross cash flow, Equity net cash flow and Invested capital net cash flow. Commercialisation Commercialisation of intellectual property relates to the development of an idea through business planning, intellectual property protection, marketing, distribution and sale. An activity undertaken at the direction of government by a public sector entity which would not be undertaken on a commercial basis or would only be undertaken on a commercial basis at higher prices. Data generally used in the valuation analysis to develop value estimates; comparable data relates to properties that have characteristics similar to the property being valued. Such data include sale prices, rents and expenses.
Community service obligations Comparable data
Comparable sales method (market method or direct market comparison method)
A valuation procedure using sales prices or rentals of assets similar to the subject asset as a basis for estimating its market value for sale or rent. The underlying assumption is that an investor will pay no more for a property than he or she would have to pay for a similar property of comparable utility. Also called sales comparison approach.
Compliance
Adherence to statutory requirements, or any regulations, rules or directives of a financial nature governing a companys operations which fall within the scope, and relate to the objectives, of financial reporting. The power to direct the management and policies of a business enterprise.
Control
The power to direct the management and policies of a business.

Control premium
An amount (expressed in either dollar or percentage form) by which the pro rata value of a controlling interest exceeds the pro rata value of a non-controlling interest in a business enterprise, that reflects the power of control.
TERM
DEFINITION The additional value inherent in the control interest that reflects its power of control, as contrasted to a minority interest. See also Discount for lack of control.
Convertible note
A debt instrument issued by a company (usually under the terms of a trust deed for which a reputable trustee holds responsibility). Usually a fixed interest security, which offers the holder the opportunity to convert their debt instrument into equity in the company on specific terms at specific times. Corporate or surplus debt relates to that debt which is not related to or included in any individual business unit of the entity being valued. A general way of estimating a value indication of an individual asset by quantifying the amount of money that would be required to replace the future service capability of that asset.
Corporate debt Cost approach (method)
A comparative approach to the value of property or another asset that considers as a substitute for the purchase of a given property, the possibility of constructing another property that is a replica of the original or one that could furnish equal utility with no undue cost due to delay. The valuers estimate is based on the reproduction or replacement cost of the subject property or asset, less total (accrued) depreciation, plus the value of the land to which an estimate of entrepreneurial incentive or developers profit/loss is commonly added.
International Valuation Standards, Glossary of Terms, 2001, Concepts/Principles 9.3.1; Property Types 2.7.1; GN 1, 5.11
Cost of capital
The expected rate of return (discount rate) that the market requires in order to attract funds to a particular investment.
Copyright
Protects the original expression of ideas, not the ideas themselves. It is free and automatically safeguards original works of art, literature, music, film, broadcasts and computer programs from copying and unauthorised usage. Consumer price index. See Community service obligations. A system of accounting which is designed to reflect in the determination of the profit and loss account and in the balance sheet the impact of the changes in the input prices of goods and services used by the business.
CPI CSO Current cost accounting
TERM Current cost of conversion 1.
DEFINITION In relation to inventories, means: the current cost of direct labour (including any charges directly incurred in connection with the employment of such labour) and of sub-contracted work; and other current production costs ascertained in accordance with historic accounting principles for production cost allocation. Production costs exclude expenses which relate to general administration, finance, marketing, selling and distribution to customers.
2.
Current cost of purchase
In relation to inventories, means the current market buying price plus duties and taxes, inwards transport costs and any other directly attributable costs of acquisition, less discounts (other than settlement discounts), rebates and subsidies whether immediate or deferred. The current cost less accumulated depreciation, calculated on the basis of such cost to reflect the already consumed or expired service potential of the asset.
Current written down cost
REFERENCES / 21~1000 Glossary and Abbreviations / D

D TERM Debt/equity ratio DEFINITION Financial debt (including finance leases but excluding trade creditors and provisions) divided by equity (shareholder funds less minority interests, preference shares and intangible assets). The amount of the adjustment required in order to express in end-of-period current costs the aggregate of: 1. 2. Deprival value the opening balance of accumulated depreciation; and the periods current cost depreciation charge.
Depreciation backlog
The amount that a business would need to expend to replace the remaining service potential embodied in an asset if the business was deprived of the asset. A reduction in value or the act of reducing value.
Discount
Discounted cash flow (DCF) analysis
The procedure used to calculate the present value of future cash flow benefits. The most widely used applications of DCF analysis are the internal rate of return (IRR) and net present value (NPV). The techniques may be used for the valuation of land and investments and the ranking of projects.
TERM Discount for lack of control
DEFINITION An amount or percentage deducted from a pro-rata share of the value of 100 per cent of an equity interest in a business, to reflect the absence of some or all of the powers of control. See also Control premium.
Discount for lack of marketability
An amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability.
Discount rate
A rate of return (cost of capital) used to convert a monetary sum, payable or receivable in the future, into present value.
A rate of return used to convert a monetary sum, payable or receivable in the future into present value.
Due diligence
An activity which is conducted for the purpose of independently verifying representations made and the key assumptions made by a lender, buyer etc, to the extent to which information is independent and verifiable.
REFERENCES / 21~1000 Glossary and Abbreviations / E

E TERM Economic life DEFINITION The period of time over which property may generate economic benefits.
i)
The number of years over which assets are expected to render services of economic value, i.e. the time remaining for the asset to earn profits. The period over which an asset is expected to be economically usable by one or more users or the number of production or similar units expected to be obtained from the asset by one or more users.
ii)
International Valuation Standards, Glossary of Terms, 2001 International Accounting Standard IAS 17.3
Effective date Elements of comparison
See Valuation date. Specific characteristics of properties and transactions that cause the prices paid for real estate to vary. Elements of comparison include property rights conveyed, financing terms, conditions of sale, market conditions, location and physical and economic characteristics.
TERM Enterprise Equity net cash flows See Business enterprise.
DEFINITION
Those cash flows available to pay out to equity holders (in the form of dividends) after funding operations of the business enterprise, making necessary capital investments, and reflecting increases or decreases in debt financing.
Equity risk premium
A rate of return in addition to a risk-free rate to compensate for investing in equity instruments because they have a higher degree of probable risk than risk-free instruments (a component of the cost of equity capital or equity discount rate).
Excess earnings
That amount of anticipated benefits that exceeds a fair rate of return on the value of a selected asset base (often net tangible assets) used to generate those anticipated benefits.
A specific way of determining a value indication of a business, business ownership interest, or security determined as the sum of a) the value of the assets obtained by capitalising excess earnings and b) the value of the selected asset base. Also frequently used to value intangible assets. See Excess earnings.
Excess rent
A rental that is more than market rent; such rentals, if considered, at all, is commonly capitalised at a higher discount rate because of the higher risk and potential uncertainties
International Valuation Standards, Glossary of Terms, 2001, GN 2, 3.1.10
Extraordinary items
Items of revenue and expense, and other gains and losses, brought into account in the period which are attributable to events or transactions outside the ordinary operations of the entity.
REFERENCES / 21~1000 Glossary and Abbreviations / F

F TERM Fair market value DEFINITION The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. (Note: in Canada, the term price should be replaced with the term highest price.)
TERM Fair value i)
DEFINITION The amount for which an asset could be exchanged, or a liability settled, between knowledgeable willing parties in an arms-length transaction. In accounting, fair value anticipates a sale which may occur in differing circumstances and in conditions other than those prevailing in the (open) market for the normal, orderly disposition of assets. These include the possibility of a sale under short-term distress situations or other circumstances not contemplated in the market value definition. However, in these situations where a valuer concludes that the fair value and market value of a real estate asset are equivalent, the valuer should indicate that the value estimate satisfies both definitions. ii) The term fair value is also used in legal actions to derive a settlement in disputes between parties, the circumstances of which may not meet the definition of market value. Hence, fair value is not synonymous with market value.
International Valuation Standards, Glossary of Terms, 2001 International Accounting Standards, 16.6, 17.3
iii)
Fair value may represent the service potential of an asset, i.e., the future economic benefits embodied in the asset in terms of its potential to contribute, directly or indirectly, to the flow of cash and cash equivalents to the entity.
International Valuation Standards, Glossary of Terms, 2001, IVA 1, A6.4
The Australian Accounting Standards use the following definition: the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arms length transaction.
AASB 116 Paragraph 6 Definitions
The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.
Appendix F of SFAS 142
FME Forced sale (liquidation) value
See Future maintainable earnings. Liquidation value at which the asset or assets are sold as quickly as possible, such as at an auction.
TERM i)
DEFINITION Market value, with a proviso that the vendor has imposed a time limit for completion of the sale which cannot be regarded as a reasonable time period, taking into account the nature of the asset, its location and the state of the market. The amount which may reasonably be received from the sale of a property within a time frame too short to meet the marketing time frame of the market value definition. In some States forced sale value in particular may also involve an unwilling seller and a buyer or buyers who buy with knowledge of the disadvantage of the seller.
ii)
International Valuation Standards, Glossary of Terms, 2001, IVS 2, 3.10
Forecast
Prospective financial information prepared on the basis of assumptions as to future events which management expect to take place and the actions management expects to take as of the date information is prepared (best estimate assumption).
International Standards on Auditing paper entitled The Examination of Prospective Financial Information the ISA paper
Any published estimate of financial results made: a. b. c. In advance of completion of financial statements up to publication standard for any expired accounting period; For a current (or expired) accounting period; For a future accounting period.
Institute of Chartered Accountants in England and Wales statement 908 entitled Accountants Reports on Profit Forecasts
prospective financial information prepared on the basis of assumptions as to future events which management expects to take place and the actions management expects to take as of the date the information is prepared;
ASIC Policy Statement PS 170 Prospective Financial Information
prospective financial information prepared on the basis of assumptions as to future events which management expects to take place, and the actions management expects to take as of the date the information is prepared (best-estimate assumptions)....Forecasts are generally prepared by management on a comparable basis to the historical information...Forecasts may also be estimated actual forecasts that combine historical information over part of a reporting period, with forecast information over the remainder of the period.
AGS 1062 Reporting in connection with proposed Fundraisings at .04(g)
The amount which is expected to be generated as profit after tax attributable to ordinary shareholders into the foreseeable future.
REFERENCES / 21~1000 Glossary and Abbreviations / G

G TERM GAVP DEFINITION Generally accepted valuation principles; best practice in the valuation profession.
Gearing Going concern
Synonymous with leverage; the extent to which a company is funded by debt. An ongoing operating business enterprise.
The financial statements are normally prepared on the assumption that an enterprise is a going concern and will continue in operation for the foreseeable future. Hence, it is assumed that the enterprise has neither the intention nor the need to liquidate or curtail materially the scale of its operations; if such an intention or need exists, the financial statements may have to be prepared on a different basis and, if so, the basis used is disclosed.
An operating business.
International Valuation Standards, Glossary of Terms, 2001, GN 4, 3.11; GN 6, 3.19.1
Going concern value
The value of a business enterprise that is expected to continue to operate into the future. The intangible elements of going concern value result from factors such as having a trained work force, an operational plant, and the necessary licences, systems and procedures in place.
The value of a business as a whole, subject to adequate potential profitability or service potential of the enterprise, with all its assets and liabilities, goodwill and potentialities.
International Valuation Standards, Glossary of Terms, 2001, IVS 2, 3.5, 6.4
The value of a business, or an interest therein, as an operating business.

International Valuation Standards, Glossary of Terms, 2001, GN 4, 3.12.1, 3.12.2; GN 6, 3.20.1
Intangible elements of value in a business enterprise resulting from factors such as having a trained workforce, an operational plant and the necessary licences, systems and procedures in place.
International Valuation Standards, Glossary of Terms, 2001, GN 6, 3.20.2
Goodwill
That intangible asset arising as a result of name, reputation, customer loyalty, location, products and similar factors not separately identified.
TERM i)
DEFINITION This is an intangible but marketable asset based on the probability that customers will continue to resort to the same premises where the business is carried on under a particular name, or where goods are sold or services provided under a trade name, with the result that there is likely to be continuing prospects of earning an acceptable profit... That intangible asset that arises as a result of name, reputation, customer patronage, location, products and similar factors that have not been separately identified and/or valued but which generate economic benefits. ii Any excess of the cost of acquisition over the acquirers interest in the fair value of the identifiable assets and liabilities acquired as at the date of the exchange transaction.
Goodwill value
The value attributable to goodwill.

Gross service potential
The total benefit expected to be derived when the asset was first acquired, and also the benefit from any subsequent upgradings.
REFERENCES / 21~1000 Glossary and Abbreviations / H

H TERM Highest and best use DEFINITION The most probable use of an asset which is physically possible, appropriately justified, legally permissible, financially feasible and which results in the highest value of the asset being valued. See also Market value.
International Valuation Standards Committee (IVSC) Par 6.3 of the statement of General Valuation Concepts & Principles
Historical cost Historical written down cost
Original cost of the assets. Original cost less accumulated depreciation.
REFERENCES / 21~1000 Glossary and Abbreviations / I

I TERM IBA DEFINITION Institute of Business Appraisers.
TERM Improvements
DEFINITION For the purpose of ascertaining the current cost of land means all work actually done or material used on and for the benefit of the land, but only insofar as the effect of such work done or material used increases the value of the land and the benefit thereof is unexhausted at the time of the valuation, but does not include improvements comprising 1. 2. 3. the removal or destruction of vegetation or the removal of timber, rocks, stones or earth; or the draining or filling of the land or any retaining walls or other works pertinent to such draining or filling; or the arresting or elimination of erosion or the changing or improving of any watercourse on or through the land.
Income (capitalisation approach)
A comparative approach to value that considers income and expense data relating to the property being valued and estimates value through a capitalisation process. Capitalisation relates income (usually net income) and a defined value type by converting an income amount into a value estimate. This process may consider direct relationships (whereby an overall capitalisation rate or all risks yield is applied to a single years income), yield or discount rates (reflecting measures of return on investment) applied to a series of incomes over a projected period, or both. The income approach reflects the principle of anticipation.
Income (income-based) approach
A general way of determining a value indication of a business, business ownership interest, security or intangible asset using one or more methods that convert anticipated benefits into a present single amount.
Intangible assets
Non-physical assets (such as franchises, trade marks, patents, copyrights, goodwill, equities, mineral rights, securities and contracts as distinguished from physical assets) that grant rights, privileges and have economic benefits for the owner.
Assets that manifest themselves by their economic properties; they do not have physical substance; they grant rights and privileges to their owner; and usually generate income for their owner. Intangible assets can be categorised as arising from: rights; relationships; grouped intangibles; or intellectual property. In general, the accounting profession limits the recognition of individual intangible assets to those that are: commonly recognisable; have a statutory or contractual remaining life; and/or must be individually transferable and separable from the business.
Intangible property
The rights and privileges granted to the owner of intangible assets.

TERM Intellectual property (IP)
DEFINITION Property of the mind or intellect. Types of IP include: design and typography; confidential information such as processes and techniques; client lists; and databases. Registrations possible to protect IP include patents, trade marks and design registration. In relation to an asset, means goods or other property and services: 1. 2. 3. held for sale in the ordinary course of business; in the process of production for such sale; or to be used up in the production of goods, other property or services for sale including consumable stores and supplies,
Inventories
but excludes depreciable assets. Invested capital The sum of equity and debt in a business enterprise. Debt is typically a) long-term liabilities or b) the sum of short-term interest bearing debt and long-term liabilities. When the term is used, it should be supplemented by a definition of exactly what it means in the given valuation context.
Invested capital net cash flows
Those cash flows available to pay out to equity holders (in the form of dividends) and debt investors (in the form of principal and interest) after funding operations of the business enterprise and making necessary capital investments.
Investment
i)
Using a capital sum to acquire an asset which is expected to produce an acceptable flow of income and/or appreciate in capital value...
Investment method
A valuation procedure that capitalises expected future income or utility as a basis for estimating the market value of the subject asset. The underlying assumption is that the investor will pay no more for the subject asset then would have to be paid for another asset with an income stream of comparable amount, duration and certainty. See also Income approach.
Investment risk
The degree of uncertainty as to the realisation of expected returns.

Investment value
The value to a particular investor based on individual investment requirements and expectations. (Note: in Canada, the term used is value to the owner.)
REFERENCES / 21~1000 Glossary and Abbreviations / K

K TERM Ke Key person discount DEFINITION Cost of equity capital (% per annum); usually measured as a post-corporate tax rate of return. An amount or percentage deducted from the value of an ownership interest to reflect the reduction in value resulting from the actual or potential loss of a key person in a business enterprise.
REFERENCES / 21~1000 Glossary and Abbreviations / L

L TERM Levered Beta DEFINITION The Beta reflecting a capital structure that includes debt.
Liquidity
The ability to quickly convert property to cash or pay a liability.

Liquidation
The net amount that can be realised if the business is terminated and the assets are sold piecemeal. Liquidation can be either orderly or forced.
Liquidation value
See Liquidation.
REFERENCES / 21~1000 Glossary and Abbreviations / M

M TERM Majority control DEFINITION The degree of control provided by a majority position.
Majority interest
An ownership interest greater than 50% of the voting interest in a business enterprise.
Ownership position greater than 50% of the voting interest in a business.

Market approach
Any approach to value based upon the use of data that reflects market transactions and reasoning that corresponds to the thinking of market participants.
TERM
DEFINITION A general way of estimating a value indication for an asset using one or more methods that compare the subject to similar assets that have been sold.
Market (market-based) approach
A general way of determining a value indication of a business, business ownership interest, security or intangible asset by using one or more methods that compare the subject to similar businesses, business ownership interests, securities or intangible assets that have been sold.
Market risk premium
The additional return above that received from a risk-free asset (Government bond) required by investors to invest in a well diversified portfolio of assets, known as the market portfolio. The premium compensates for undiversifiable risk factors associated with the market portfolios assets. The estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arms-length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently and without compulsion. The concept of market value reflects the collective perceptions and actions of a market and is the basis for valuing most resources in market-based economies. The professionally derived market value is an objective valuation of identified ownership rights to specific property as of a given date. See also Highest and best use and Non-market bases of value.
Market value
Business valuers in Australia typically define market value as: The price that would be negotiated in an open and unrestricted market between a knowledgable, willing but not anxious buyer and a knowledgable, willing but not anxious seller acting at arms length. In the context of consolidation and setting the costs of an asset brought into the consolidated group by a joining entity, the task of establishing the market value of an asset is approached with the typical definition in mind. For this reason, it is reasonable to focus on the price a willing purchaser would have to offer a willing seller in order to persuade them to sell for a fair price. Consequently, to determine an assets market value, the question to be asked is what price would the head company be willing to offer in order to acquire the assets of the joining entity? It would usually be expected that the head company would pay no more for the asset than the value it would add to the consolidated group given the continuation of its existing use.
Australian Taxation Office Consolidation Reference Manual
Marketability
The ability to quickly convert property to cash at minimal cost.

TERM Marketability discount
DEFINITION An amount or percentage deducted from an equity interest to reflect lack of marketability.
Minority discount
A discount for lack of control applicable to a minority interest.

Minority interest
An ownership interest of less than 50% of the voting interest in a business enterprise.
Ownership position of less than 50% of the voting interest in a business.

Monetary liabilities/assets MRP
Those liabilities or assets which do not alter in amount as a direct consequence of changes in prices. See Market risk premium.
REFERENCES / 21~1000 Glossary and Abbreviations / N

N TERM NACVA Net book value DEFINITION National Association of Certified Valuation Analysts. With respect to a business enterprise, the difference between total assets (net of accumulated depreciation, depletion and amortisation) and total liabilities of a business enterprise as they appear on the balance sheet (synonymous with shareholders equity); with respect to an intangible asset, the capitalised cost of an intangible asset less accumulated amortisation as it appears on the books of account of the business enterprise.
Net cash flow
A form of cash flow. When the term is used, it should be supplemented by a qualifier (for example, equity or invested capital) and a definition of exactly what it means in the given valuation context.
Net present value (NPV)
The difference between the present value of all inflows and all outflows of cash associated with a business or property, calculated by discounting each at a required rate of return or targeted yield. NPV is a measure of financial return, the calculation of which is based upon DCF analysis. This application is sometimes referred to as the NPV method.
Net realisable value
The actual or estimated selling price of an asset less costs of marketing, selling and distribution.
TERM Net tangible assets (NTA) per share
DEFINITION Ordinary shareholders funds less intangible assets divided by equivalent fully paid ordinary shares at year end. NTA per share is normally calculated on a fully diluted year end basis after adjusting for convertible notes, convertible preference shares, options and partly paid shares. The value of the business enterprises tangible assets (excluding excess assets and non-operating assets) minus the value of its liabilities. (Note: in Canada, tangible assets also include identifiable intangible assets.)
Net tangible asset value
Nominal interest rate Non-current asset
The cost of borrowings expressed as the actual rate of interest charged. An asset which: 1. 2. is held for the purpose of deriving future benefits through their use in the business; and has a useful economic life of more than one accounting period but excludes assets held for resale in the ordinary course of business.
Non-market basis of value
Valuations of property may be based on considerations of the economic utility or functions of a property other than its ability to be bought and sold by market participants, or the effects of unusual or atypical market conditions.
International Valuation Standards, Glossary of Terms, 2001, Introduction to IVS 1 and IVS 2, 4.2.1
Non-monetary liabilities/assets Non-operating assets
Those liabilities or assets which alter in amount as a direct consequence of changes in prices. Assets not necessary to ongoing operations of the business enterprise. (Note: in Canada, the term used is redundant assets.)
NPV
See Net present value.
REFERENCES / 21~1000 Glossary and Abbreviations / O

O TERM Optimised deprival value DEFINITION The amount that a business would need to expend to replace the remaining service potential embodied in an asset if the business was deprived of the asset optimised for over/under-capacity, over/under-engineering, reconfiguration, etc. See also Deprival value. The right, but not the obligation, to purchase an asset at a future date on known terms and conditions determined by the issuer of the option.
Option
TERM Orderly liquidation value
DEFINITION Liquidation value at which the asset or assets are sold over a reasonable period of time to maximise proceeds received.
Other monetary assets Other monetary liabilities
Includes cash, deposits with banks and other financial institutions and prepayments. Includes bank overdrafts, trade creditors and accrued expenses.
REFERENCES / 21~1000 Glossary and Abbreviations / P

P TERM Patent DEFINITION A right granted for any device, substance, method or process which is new, innovative or useful. A patent granted in Australia provides the owner with exclusive rights to prohibit others from manufacturing, using and or selling a invention. Patent protection is not automatic, it must be registered and can be protected internationally with an international patent application. See Price earnings ratio. The total period over which the asset is physically capable of continuing to operate. Publicly listed company (UK). An amount or percentage that may be deducted from the value of a business enterprise to reflect the fact that it owns dissimilar operations or assets that may not fit well together.
PER Physical life of a depreciable fixed asset PLC Portfolio discount
Practical capacity
The capacity at which the business would expect to use an asset under normal conditions of full usage after allowing for a normal amount of downtime. A right conferred normally in the memorandum and articles of association of a proprietary company which provides for the shareholders of the company to be first offered the shares of a fellow shareholder in the event of sale. An assumption regarding the most likely set of transactional circumstances that may be applicable to the subject valuation e.g. going concern, liquidation.
Pre-emptive rights
Premise of value
Premium for control
Amount which would be payable over and above the fair value of a shareholding when the acquisition of that shareholding confers control over the board, management and cash flows. The current monetary value of future cash flows.
Present value
TERM Present value of future cash flows Price earnings ratio (PER)
DEFINITION Projected future cash flows including salvage values discounted to the current day and using an appropriate discount rate. Market price divided by earnings per share. Earnings per share refers to the amount of profit attributable to ordinary shareholders after deducting preference dividends and adjusting for the effects of options and convertible notes (i.e. on a fully diluted basis). Value is created by the expectation of future benefits.
International Valuation Standards, Glossary of Terms, 2001, Property Types 2.7.3
Principle of anticipation
Principle of substitution
A prudent person will not pay more for a good or service than the cost of acquiring an equally satisfactory substitute good or service, in the absence of the complicating factors of time, greater risk or inconvenience. The lowest cost of the best alternative, whether a substitute or the original, tends to establish market value. This principle is fundamental to the three approaches to market value.
International Valuation Standards, Glossary of Terms, 2001, Concepts/Principles 9.2
Principle of supply and demand
The price of a good, service or commodity varies inversely with the supply of the item and directly with the demand for the item.
International Valuation Standards, Glossary of Terms, 2001, Introduction to IVS 1 and IVS 2, 2.1
Profit and loss statement
Australia has changed the name of its financial statements. A profit and loss statement (old name) is now a statement of financial performance (new name). Applied to financial years commencing on or after 1 July 2000.
Projection
Prospective financial information prepared on the basis of: a. hypothetical assumptions about future events and management actions which are not necessarily expected to take place, such as when some entities are in a start-up phase or are considering a major change in the nature of operations; or a mixture of best estimate and hypothetical assumptions.
b.
Prospective financial information in respect of a future period which the directors are reasonably confident (but not reasonably certain) will be achieved.
Institute of Chartered Accountants in England and Wales statement 908 entitled Accountants Reports on Profit Forecasts
Prospective financial information prepared on the basis of: a. b. hypothetical assumptions about future events and management actions which are not necessarily expected to take place; or a mixture of assumptions management expects to take place and hypothetical assumptions.
ASIC Policy Statement PS 170 Prospective Financial Information Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited
TERM i.
DEFINITION Prospective financial information prepared on the basis of: hypothetical assumptions about future events and management actions which are not necessarily expected to take place. This may include circumstances when entities are in a start-up phase or are considering a major change in the nature of operations; or a mixture of best-estimate and hypothetical assumptions.
ii.
Such information illustrates the possible consequences, as of the date the information is prepared, if the events and actions were to occur (a what-if scenario). A projection will not usually have reasonable grounds.
Australia in AGS 1062 Reporting in connection with proposed Fundraisings at .04(h)
Proprietorial benefits
Amounts received by proprietors (shareholders) in the form of cash and non-cash benefits including, for example, salary, directors fees, car, school fees, medical health insurance, superannuation, holidays and travel, expense accounts, entertainment allowances, low or interest-free loans, etc. Financial information based on assumptions about events that may occur in the future and possible actions by an entity. It is highly subjective in nature and its preparation requires the exercise of considerable judgment. Prospective financial information can be in the form of a forecast, a projection or a combination of both, for example, a one year forecast plus a five year projection.
Prospective financial information
Financial information of a predictive character based on assumptions about events that may occur in the future and on possible actions by an entity.
ASIC Policy Statement PS 170 Prospective Financial Information
Financial information based on assumptions about events that may occur in the future and on possible actions by the client entity. It is highly subjective in nature and its preparation requires the exercise of considerable judgment. Prospective financial information can be in the form of a forecast, or a projection, or a combination of both. For example, a one-year forecast plus a projection for several years.
Australian AGS 1062 Reporting in connection with proposed fundraisings at 04(e).
Prospective financial information in respect of a financial period which has not yet been completed and which the directors are reasonably certain will be achieved. The only factors likely to affect the outcome would be those outside the control of the entity or its management. Although usually limited to the current financial period, this need not be the case where the necessary degree of confidence exists for later periods.
United Kingdoms Auditing Practice Board in a discussion paper in April 1988
Pty Ltd
Proprietary limited company.
TERM Public float
DEFINITION Issue of shares in a company to the public. Usually used to describe the first major issue by a company prior to it obtaining stock exchange listing. See Present value of future cash flows.
PV
REFERENCES / 21~1000 Glossary and Abbreviations / R

R TERM Rate of return DEFINITION An amount of income (loss) and/or change in value realised or anticipated on an investment, expressed as a percentage of that investment.
An amount of income (loss) and/or change in value realised or anticipated on an investment, expressed as a percentage of that investment.
Real interest rate Real interest expenses Recoverable amount Redundant assets Reference asset
The nominal interest rate adjusted for changes in price levels. Nominal (actual) interest charges incurred less holding gains on interest bearing liabilities. The greater of the present value of net future cash flows from continued use of the asset or its net realisable value. (Note: in Canada, see non-operating assets.) An asset, the current market buying price or current construction cost of which is referred to in order to determine the current cost of an asset held by the company. (A reference asset, whether it is similar to the asset held or the most appropriate modern facility, must at least carry out the same function as the asset held.) In relation to an asset, means the cost per unit of service potential of the most appropriate modern facility, established by reference to the current market buying price of an identical or equivalent item. The current cost of a similar new property having the nearest equivalent utility to the property being valued.
Replacement cost
Replacement cost new
Replacement value
This usually means the total current replacement cost of an asset of equivalent technology and capacity and with a similar remaining useful life. The date conclusions are transmitted to the client.
Report date
The date of the valuation report. May be the same or different from the valuation date.
International Valuation Standards, Glossary of Terms, 2001, GN 4, 3.22; GN 6, 3.38 Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited
TERM Reproduction cost Reproduction cost new
DEFINITION In relation to an asset, means the cost per unit of service potential of reproducing (replicating) the existing asset. The current cost of an identical new property.
Residual value
The prospective value as of the end of the discrete projection period in a discounted benefit streams model.
Retention policy Reverse take-over
Company policy as to the proportion of earnings which are retained (i.e. not paid out as dividends) for future business expansion. Process by which one entity (Company A) encourages the take-over of Company A by another company (Company B). The purpose Is usually to gain board or management control of Company B by way of scrip exchange between the two companies. Possibility of loss or injury. Generally, uncertainty of realising expected future returns on an Investment. Risk is often seen as synonymous with volatility of returns. The rate of return available in the market on an investment free of default risk.
Risk
Risk-free rate
Riskless rate Risk premium
Long-run estimate of returns from riskless assets (e.g. Government bonds), assuming a buy and hold to maturity strategy. A rate of return in addition to a risk-free rate to compensate the investor for accepting risk.
ROA RRR Rule of thumb
Return on assets. Rate of return reporting. A mathematical relationship between or among variables based on experience, observation, hearsay or a combination of these, usually applicable to a specific industry.
REFERENCES / 21~1000 Glossary and Abbreviations / S

S TERM Scrip exchange DEFINITION Purchase of shares in consideration for shares. For example, Company A purchases Company B shares in return for issuing shares in Company A. Securities Exchange Commission.
SEC
TERM Service potential
DEFINITION The future economic benefits embodied in the asset in terms of its potential to contribute, directly or indirectly, to the flow of cash and cash equivalents to the entity. Service potential is measured as the level of productive capacity that would have to be replaced if the entity were deprived of the asset.
International Valuation Standards, Glossary of Terms, 2001, IVA 1, A6.4; IFAC ED Standard 14, 11
Share buy-back
Acquisition of a companys shares by the company. Often regulated by specific provisions and, in some cases, subject to shareholder approval and various declarations of solvency etc. Acquirers who believe they can enjoy post-acquisition economies of scale, synergies or strategic advantages by combining the acquired business interest with their own.
Special interest purchasers
Standard of value
The identification of the type of value being utilised in a specific engagement e.g. fair market value, fair value, investment value.
Statement of financial performance
Australia changed the name of its financial statements. A profit and loss statement (old name) is now a statement of financial performance (new name). Applies to financial years commencing on or after 1 July 2000.
Statement of financial position
Australia changed the name of its financial statements. A balance sheet (old name) is now a statement of financial position (new name). Applies to financial years commencing on or after 1 July 2000.
SKU Surplus asset
Stock keeping unit. An asset that is owned by an entity such as a corporation but considered superfluous to the operations of that entity. A surplus asset is not considered necessary to the production of the good or service the entity produces. It is held for investment, development or disposal, or used as security for a loan or some other commercial purpose unrelated to the operation of the entity. The market value of a surplus asset is determined by its highest and best use.
Sustaining capital reinvestment
The periodic capital outlay required to maintain operations at existing levels, net of the tax shield available from such outlays.
S-W Beta
This is a measure of the relative riskiness of the investment. S-W Beta is the Scholes Williams adjusted measure of the Beta factor obtained from share price movements relative to the overall market. A benefit or gain which is obtained by combining two operations which would otherwise not have been obtained, i.e. 2 + 2 = something more than 4.
Synergy
TERM Systematic risk
DEFINITION The risk that is common to all risky securities and cannot be eliminated through diversification. When using the capital asset pricing model, systematic risk is measured by beta.
REFERENCES / 21~1000 Glossary and Abbreviations / T

T TERM Take-over premium Technological obsolescence Terminal value Total shareholder return Trade creditors Trade debtors DEFINITION Amount in excess of market price paid by a bidder (offeror) pursuant to a take-over bid. Process, product or machine which is made obsolete or significantly inefficient by virtue of a new technology, process or product. See Residual value. This is the total annual percentage rate of return (from dividends and capital growth) received by shareholders in the company. Includes monetary liabilities arising from the purchase on credit of commodities and services in the ordinary course of business. Includes monetary assets arising from the sale on credit of commodities and services in the ordinary course of business, less provisions for doubtful debts. Can take the form of a letter, number, word or phrase, sound, smell, shape, logo, picture, packaging aspect or combination of these. A trade mark is a sign which is used to distinguish goods and services of one trader from another. While registration is not compulsory for usage of the sign, it is advisable. The can be applied to registered trade marks. The can be used regardless of registration. Total shareholder return.
Trade mark
TSR
REFERENCES / 21~1000 Glossary and Abbreviations / U

U TERM Undiluted DEFINITION Prior to the exercise or conversion of options, convertible notes and other securities outstanding which have the capacity of becoming fully paid ordinary shares with full voting rights, capital entitlements and dividend entitlements. The Beta reflecting a capital structure without debt.
Unlevered Beta
TERM Unsystematic risk
DEFINITION The portion of total risk specific to an individual security that can be avoided through diversification.
Useful life
In relation to a depreciable asset, means the estimated total period, from the date of acquisition, over which the service potential of the asset is expected to be used by the business.
REFERENCES / 21~1000 Glossary and Abbreviations / V

V TERM Valuation DEFINITION The act or process of determining the value of a business, business ownership interest, security or intangible asset.
The process of estimating value.

Valuation approach
A general way of determining a value indication of a business, business ownership interest, security or intangible asset using one or more valuation methods.
A generally accepted analytical methodology for estimating value that employs one or more specific valuation procedures. All market-based valuation approaches apply the principle of substitution.
International Valuation Standards, Glossary of Terms, 2001, Concepts/Principles 9.1; GN 4, 3.25; GN 6, 3.40
Valuation date
The specific point in time as of which the valuators opinion of value applies (also referred to as effective date or appraisal date).
The date as of which the valuers opinion of value applies. Also referred to as effective date and/or as of date.
International Valuation Standards, Glossary of Terms, July 2000
Valuation method
Within approaches, a specific way to determine value.

Within the valuation approaches, a specific way to estimate a value.

Valuation procedure
The act, manner and technique of performing the steps of an appraisal method.
TERM Valuation ratio
DEFINITION A fraction in which a value or price serves as the numerator and financial, operating, or physical data serve as the denominator.
Valuation report
This report describes the results of the analysis leading to an opinion of value. There are codes of practice which a valuer must follow when preparing a valuation report.
International Valuation Standards, Glossary of Terms, July 2000
Value
The price most likely to [be] concluded by the buyers and sellers of a good or service that is available for purchase. Value establishes the hypothetical or notional price that buyers and sellers are most likely to conclude for the good or service. Value is not a fact, but an estimate of the likely price to be paid for a good or service at a given time in accordance with a particular definition of value.
International Valuation Standards, Glossary of Terms, 2001, Concepts/Principles 4.5; Introduction to IVS 1 and IVS 2, 3.3
Value in exchange
i)
It is the value as recognised by a marketplace in which exchange of asset ownership notionally takes place. The IVSC definition of market value for appropriate financial reporting is based upon the principle of value in exchange. The value, in terms of cash, of a property which is bartered for another asset or assets. Cash being the yardstick by which the comparative value of each can be assessed.
ii)
International Valuation Standards, Glossary of Terms, 2001, IVS 2, 6.1, 6.2
Value in use
i)
It is the value a specific property has for a specific use to a specific user and is therefore non-market related.
ii)
This value type focuses on the value that specific property contributes to the enterprise of which it is a part, without regard to the propertys highest and best use or the monetary amount that might be realised upon its sale. The present value of estimated future cash flows expected to arise from the continuing use of an asset and from its disposal at the end of its useful life.
iii)
International Valuation Standards, Glossary of Terms, 2001, IAS 36.5; IVA 1, A6.3.4.1
Value to the owner
(Note: in Canada, see investment value.)
REFERENCES / 21~1000 Glossary and Abbreviations / W

W
W TERM WACC WDRC Weighted average cost of capital (WACC) DEFINITION See Weighted average cost of capital. Written down replacement cost. The cost of capital (discount rate) determined by the weighted average, at market value, of the cost of all financing sources in the business enterprises capital structure.
Working capital
Short-term items required for the everyday conduct of the business such as debtors and inventory. Calculated as current assets less current liabilities. In relation to an asset, means its current cost less, where applicable, depreciation calculated on the basis of such cost to reflect the already consumed or expired service potential of the asset.
Written-down current cost
REFERENCES / 22~1000 Additional Reading and Training

22~1000
Additional Reading and Training
REFERENCES / 22~1000 Additional Reading and Training / 22~1050 Chapter 1 Scoping a Valuation Assignment
22~1050
Chapter 1 Scoping a Valuation Assignment
REFERENCES / 22~1000 Additional Reading and Training / 22~1050 Chapter 1 Scoping a Valuation Assignment / 22~1070 Additional Reading
22~1070
Additional Reading
The following recommended reading expands on the concepts raised in this chapter: 1. 2. Damodaran, A Damodaran on Valuation, John Wiley & Sons, 1994. Available to order from NACVA. Pratt, S, Reilly, R & Schweihs, R Valuing a Business, The Analysis and Appraisal of Closely Held Companies, 4th edition, McGraw-Hill-Irwin, 2000. Available to order from NACVA.
REFERENCES / 22~1000 Additional Reading and Training / 22~1050 Chapter 1 Scoping a Valuation Assignment / 22~1090 Training
22~1090
Training
The following organisations have training courses specifically addressing the topics considered in this section. ORGANISATION NACVA SUBJECT Understanding and Using Business Valuations (PowerPoint presentation)
ORGANISATION NACVA NACVA NACVA Securities Institute of Australia
SUBJECT Levels of Value Valuation Methods The Business of Business Valuations Financial Analysis and Valuation
REFERENCES / 22~1000 Additional Reading and Training / 22~1140 Chapter 2 Engagement and Documentation of Assignments
22~1140
Chapter 2 Engagement and Documentation of Assignments
REFERENCES / 22~1000 Additional Reading and Training / 22~1140 Chapter 2 Engagement and Documentation of Assignments / 22~1160 Additional Reading
22~1160
Additional Reading
The following recommended reading expands on the concepts raised in this chapter: 1. Fishman, J Guide to Business Valuations, 3-volume set, PPC, 1996. Available to order from NACVA.
REFERENCES / 22~1000 Additional Reading and Training / 22~1140 Chapter 2 Engagement and Documentation of Assignments / 22~1180 Training
22~1180
Training
The following organisation has training courses specifically addressing the topics considered in this section. ORGANISATION NACVA SUBJECT The Business of Business Valuations
REFERENCES / 22~1000 Additional Reading and Training / 22~1230 Chapter 3 Reports

22~1230
Chapter 3 Reports
REFERENCES / 22~1000 Additional Reading and Training / 22~1230 Chapter 3 Reports / 22~1250 Additional Reading
22~1250
Additional Reading
The following recommended reading expands on the concepts raised in this chapter: 1. Green & Burkert, Case Analysis, NACVA TC Course, 2000. Available to order from NACVA.
REFERENCES / 22~1000 Additional Reading and Training / 22~1230 Chapter 3 Reports / 22~1270 Training
22~1270
Training
The following organisations have training courses specifically addressing the topics considered in this section. ORGANISATION NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA Securities Institute of Australia SUBJECT Planning and Preparing for the Examination of the Valuation Expert (PowerPoint presentation) Forensic Accounting Fundamentals Forensic Accounting Advanced Application Alternative Dispute Resolutions Litigation Support Economic Theory and Modelling Litigation Support Statistical Analysis Litigation Support Commercial Damages, Legal Theory and Case Law Litigation Support Speciality Areas of Litigation Litigation Support Calculating Personal and Business Losses Litigation Support Legal and Economic Foundations of Litigation Litigation Support The Financial Expert as a Litigation Strategist, Expert and Consultant Litigation Support Report Writing and the Experts Role In Discovery Litigation Support Rules of Evidence: Disposition Theory, Practice and Strategy Litigation Support Negotiation, Settlement Conferences and Mediation Litigation Support The Dynamics of Trial Litigation Support Understanding the Intellectual Property Law Environment (Patents, Trademarks, Copyrights, Trade Secrets) Litigation Support Basic Economic Principles of Damage Analysis in Intellectual Property Cases Litigation Support Economic and Statistics and their Application in Intellectual Property Cases Litigation Support Nuts and Bolts 1: How to Calculate Damages in Patent Infringement Cases Litigation Support Nuts and Bolts 2: How to Calculate Damages in Trademark, Copyright and Trade Secret Cases Applied Valuations
REFERENCES / 22~1000 Additional Reading and Training / 22~1320 Chapter 4 Net Present Value Fundamentals
22~1320
Chapter 4 Net Present Value Fundamentals
REFERENCES / 22~1000 Additional Reading and Training / 22~1320 Chapter 4 Net Present Value Fundamentals / 22~1360 Training
22~1360
Training
The following organisations have training courses specifically addressing the topics considered in this section. ORGANISATION NACVA NACVA NACVA Securities Institute of Australia SUBJECT Advanced Finance, Valuation Theory and Applications Capitalisation/Discount Rates Valuation Discounts and Premiums Financial Analysis and Valuation
REFERENCES / 22~1000 Additional Reading and Training / 22~1410 Chapter 5 Discount Rates
22~1410
Chapter 5 Discount Rates
REFERENCES / 22~1000 Additional Reading and Training / 22~1410 Chapter 5 Discount Rates / 22~1430 Additional Reading
22~1430
Additional Reading
The following recommended reading expands on the concepts raised in this chapter: 1. 2. 3. Ibbotson Associates, Stocks Bonds Bills Inflation (SBBI) Valuation Edition, Ibbotson Associates, 2000. Available to order from NACVA. Ibbotson Associates, Cost of Capital Quarterly and Yearbook, Ibbotson Associates, 2000. Available to order from NACVA. Pratt, S Cost of Capital, McGraw-Hill-Irwin, 1998. Available to order from NACVA.
REFERENCES / 22~1000 Additional Reading and Training / 22~1410 Chapter 5 Discount Rates / 22~1450 Training
22~1450
Training
The following organisations have training courses specifically addressing the topics considered in this section. ORGANISATION NACVA SUBJECT Advanced Finance, Valuation Theory and Applications
ORGANISATION NACVA Securities Institute of Australia Securities Institute of Australia Securities Institute of Australia
SUBJECT Capitalisation/Discount Rates Interest Rate Markets and Risk Management Applied Valuations Corporate and Structured Finance
REFERENCES / 22~1000 Additional Reading and Training / 22~1500 Chapter 6 Price Earnings Ratios
22~1500
Chapter 6 Price Earnings Ratios
REFERENCES / 22~1000 Additional Reading and Training / 22~1500 Chapter 6 Price Earnings Ratios / 22~1520 Additional Reading
22~1520
Additional Reading
The following recommended reading expands on the concepts raised in this chapter: 1. Pratt, S Cost of Capital, McGraw-Hill-Irwin, 1998. Available to order from NACVA.
REFERENCES / 22~1000 Additional Reading and Training / 22~1500 Chapter 6 Price Earnings Ratios / 22~1540 Training
22~1540
Training
The following organisations have training courses specifically addressing the topics considered in this section. ORGANISATION NACVA NACVA Securities Institute of Australia Securities Institute of Australia Securities Institute of Australia SUBJECT Advanced Finance, Valuation Theory and Applications Capitalisation/Discount Rates Interest Rate Markets and Risk Management Applied Valuations Corporate and Structured Finance
REFERENCES / 22~1000 Additional Reading and Training / 22~1590 Chapter 7 Research and Data Collection
22~1590
Chapter 7 Research and Data Collection
REFERENCES / 22~1000 Additional Reading and Training / 22~1590 Chapter 7 Research and Data Collection / 22~1610 Additional Reading
22~1610
Additional Reading
The following recommended reading expands on the concepts raised in this chapter: 1. 2. 3. 4. 5. Business Research Handbook: Methods & Sources for Lawyers and Business Professionals, Aspen Law, 1996. Available to order from NACVA. Gale City & Metro Rankings Reporter, various editions, The Gale Group, 1996 and forward. Available to order from NACVA. Lavin, M R Business Information: How to Find It, How to Use It, 2nd Edition, Oryx Press, 1992. Available to order from NACVA. Mercer, C Organising Principals of Business Valuation: The Grapes of Value, Mercer Capitals E-Law Newsletter, www.bizval.com, Issue 9911, 1999. Pratt, S Cost of Capital, McGraw-Hill-Irwin, 1998. Available to order from NACVA.
REFERENCES / 22~1000 Additional Reading and Training / 22~1590 Chapter 7 Research and Data Collection / 22~1630 Training
22~1630
Training
The following organisations have training courses specifically addressing the topics considered in this section. ORGANISATION NACVA NACVA NACVA NACVA Securities Institute of Australia Securities Institute of Australia SUBJECT Research: Economic, Industry, Legal and Internet Litigation Support Economic Theory and Modelling Litigation Support Statistical Analysis Litigation Support Legal and Economic Foundations of Litigation Financial Markets and Economics Applied Valuations
REFERENCES / 22~1000 Additional Reading and Training / 22~1680 Chapter 8 Review of Historic Accounts
22~1680
Chapter 8 Review of Historic Accounts
REFERENCES / 22~1000 Additional Reading and Training / 22~1680 Chapter 8 Review of Historic Accounts / 22~1700 Additional Reading
22~1700
Additional Reading
The following recommended reading expands on the concepts raised in this chapter:
1. 2. 3. 4.
Fridson, M S Finanical Statement Analysis: A Practitioners Guide, John Wiley & Sons, 1995. Available to order from NACVA. The Institute of Chartered Accountants in Australia and the Australian Society of CPAs, 1995, Auditing Standard AUS 512 Analytical Procedures Pratt, S, Reilly, R & Schweihs, R Valuing a Business, The Analysis and Appraisal of Closely Held Companies, 4th edition, McGraw-Hill-Irwin, 2000. Available to order from NACVA. Walsh, C Key Management Ratios, How to analyse, compare and control the figures that drive company value; Pitman Publishing, 1996. Available to order from NACVA.
REFERENCES / 22~1000 Additional Reading and Training / 22~1680 Chapter 8 Review of Historic Accounts / 22~1720 Training
22~1720
Training
The following organisations have training courses specifically addressing the topics considered in this section. ORGANISATION NACVA NACVA NACVA NACVA Securities Institute of Australia SUBJECT Normalising and then Projecting Earnings Valuation Issues in Family Owned Businesses Forensic Accounting Fundamentals Forensic Accounting Advanced Application Financial Analysis and Valuation
REFERENCES / 22~1000 Additional Reading and Training / 22~1770 Chapter 9 Preparation and Review of Projections and Forecasts
22~1770
Chapter 9 Preparation and Review of Projections and Forecasts
REFERENCES / 22~1000 Additional Reading and Training / 22~1770 Chapter 9 Preparation and Review of Projections and Forecasts / 22~1790 Additional Reading
22~1790
Additional Reading
The following recommended reading expands on the concepts raised in this chapter: 1. Breen. T., 1993, chapter titled Guidelines for the Estimation of Revenues in the Planning and Assessment of Industrial Mineral Projects in the Cost Estimation Handbook for the Australian Mining Industry, Australasian Institute of Mining & Metallurgy. CFI ProService, Financial Profiles of the Small Business, Halcyon, 1998. Available to order from NACVA. Copeland, T, Koller, T & Murrin, J Valuation, Measuring and Managing the Value of Companies, Wiley, 2000. Available to order from NACVA.
2. 3.
4. 5. 6. 7. 8. 9. 10. 11. 12.
De Heer, M & Koller, T Valuing Cyclical Companies The McKinsey Quarterly, 2000 Number 2. <www.mckinseyquarterly.com>. Dun & Bradstreet, Industry Norms and Key Business Ratios, Annual. Available to order from NACVA. Fridson, M S Finanical Statement Analysis: A Practitioners Guide, John Wiley & Sons, 1995. Available to order from NACVA. The Institute of Chartered Accountants in Australia and the Australian Society of CPAs, 1995, Auditing Standard AUS 512 Analytical Procedures. Internal Revenue Service, Revenue Ruling 5960 (valuing closely held stock). Parker, C & Porter, B Australian GAAP 2001, available from ICA Bookshop. Pratt, P P, Reilly, R F & Schweihs, R P Valuing Small Businesses and Professional Practices, 3rd edition, McGraw-Hill, 1998. Available to order from NACVA. Pratt, P P, Reilly, R F & Schweihs, R P Valuing a Business, The Analysis and Appraisal of Closely Held Companies, 4th edition, McGraw-Hill-Irwin, 2000. Available to order from NACVA. Walsh, C Key Management Ratios, How to analyse, compare and control the figures that drive company value, Pitman Publishing, 1996. Available to order from NACVA.
The following web site and reference are useful for sources of additional information on business valuation issues: Organisation Judges & Lawyers Business Valuation Updated Relevant Material US case law and other articles to assist independent experts Web Address www.bvlibrary.com
REFERENCES / 22~1000 Additional Reading and Training / 22~1770 Chapter 9 Preparation and Review of Projections and Forecasts / 22~1810 Training
22~1810
Training
The following organisations have training courses specifically addressing the topics considered in this section. ORGANISATION NACVA NACVA NACVA NACVA Securities Institute of Australia Securities Institute of Australia SUBJECT Normalising and then Projecting Earnings Valuation Issues in Family Owned Businesses Forensic Accounting Fundamentals Forensic Accounting Advanced Application Financial Analysis and Valuation Applied Valuations
REFERENCES / 22~1000 Additional Reading and Training / 22~1860 Chapter 10 Income Approach
22~1860
Chapter 10 Income Approach
REFERENCES / 22~1000 Additional Reading and Training / 22~1860 Chapter 10 Income Approach / 22~1880 Additional Reading
22~1880
Additional Reading
The following recommended reading expands on the concepts raised in this chapter: 1. 2. Cornell, B Corporate Valuation, Tools for Effective Appraisal and Decision Making, McGraw-Hill, 1994. Available to order from NACVA. Pratt, S, Reilly, R & Schweihs, R Valuing a Business, The Analysis and Appraisal of Closely Held Companies, 4th edition, McGraw-Hill-Irwin, 2000. Available to order from NACVA.
REFERENCES / 22~1000 Additional Reading and Training / 22~1860 Chapter 10 Income Approach / 22~1900 Training
22~1900
Training
The following organisations have training courses specifically addressing the topics considered in this section. ORGANISATION NACVA NACVA NACVA NACVA NACVA Securities Institute of Australia Securities Institute of Australia SUBJECT Understanding and Using Business Valuations (PowerPoint presentation) Levels of Value Valuation Issues in Family Owned Businesses Valuation Methods Determining the Appropriate Valuation Method Financial Analysis and Valuation Applied Valuations
REFERENCES / 22~1000 Additional Reading and Training / 22~1950 Chapter 11 Market Approach
22~1950
Chapter 11 Market Approach
REFERENCES / 22~1000 Additional Reading and Training / 22~1950 Chapter 11 Market Approach / 22~1970 Additional Reading
22~1970
Additional Reading
The following recommended reading expands on the concepts raised in this chapter: 1. 2. 3. 4. Cornell, B Corporate Valuation, Tools for Effective Appraisal and Decision Making, McGraw-Hill, 1994. Available to order from NACVA. Pratt, S, Reilly, R & Schweihs, R Valuing a Business, The Analysis and Appraisal of Closely Held Companies, 4th edition, McGraw-Hill-Irwin, 2000. Available to order from NACVA. Wisehart, D The Market Method, NACVA TC course, 2000. .Available to order from NACVA. Zamucen, S How to Value over 100 Closely Held Companies (Rules of Thumb), National Alliance of Valuers and Consultants, 2000. Available to order from NACVA.
REFERENCES / 22~1000 Additional Reading and Training / 22~1950 Chapter 11 Market Approach / 22~1990 Training
22~1990
Training
The following organisations have training courses specifically addressing the topics considered in this section. ORGANISATION NACVA NACVA NACVA NACVA NACVA NACVA NACVA Securities Institute of Australia Securities Institute of Australia SUBJECT Understanding and Using Business Valuations (PowerPoint presentation) Levels of Value Using Guideline Companies in Valuations Valuation Discounts and Premiums Valuation Issues in Family Owned Businesses Valuation Methods Determining the Appropriate Valuation Method Financial Analysis and Valuation Applied Valuations
REFERENCES / 22~1000 Additional Reading and Training / 22~2040 Chapter 12 Asset Approach
22~2040
Chapter 12 Asset Approach
REFERENCES / 22~1000 Additional Reading and Training / 22~2040 Chapter 12 Asset Approach / 22~2060 Additional Reading
22~2060
Additional Reading
The following recommended reading expands on the concepts raised in this chapter: 1. Cornell, B Corporate Valuation, Tools for Effective Appraisal and Decision Making, McGraw-Hill, 1994. Available to order from NACVA.
2. 3.
Pratt, S, Reilly, R & Schweihs, R Valuing a Business, The Analysis and Appraisal of Closely Held Companies, 4th edition, McGraw-Hill-Irwin, 2000. Available to order from NACVA. Zamucen, S How to Value over 100 Closely Held Companies (Rules of Thumb), National Alliance of Valuers and Consultants, 2000. Available to order from NACVA.
REFERENCES / 22~1000 Additional Reading and Training / 22~2040 Chapter 12 Asset Approach / 22~2080 Training
22~2080
Training
REFERENCES / 22~1000 Additional Reading and Training / 22~2130 Chapter 13 Other Methods and Considerations
22~2130
Chapter 13 Other Methods and Considerations
REFERENCES / 22~1000 Additional Reading and Training / 22~2130 Chapter 13 Other Methods and Considerations / 22~2150 Additional Reading
22~2150
Additional Reading
The following recommended reading expands on the concepts raised in this chapter: 1. 2. Mercer, C Z Quantifying Marketability Discounts, Mercer Capital, 1997. Zamucen, S How to Value over 100 Closely Held Companies (Rules of Thumb), National Alliance of Valuers and Consultants, 2000. Available to order from NACVA.
REFERENCES / 22~1000 Additional Reading and Training / 22~2130 Chapter 13 Other Methods and Considerations / 22~2170 Training
22~2170
Training
REFERENCES / 22~1000 Additional Reading and Training / 22~2220 Chapter 14 Guidance on Appropriate Methods
22~2220
Chapter 14 Guidance on Appropriate Methods
REFERENCES / 22~1000 Additional Reading and Training / 22~2220 Chapter 14 Guidance on Appropriate Methods / 22~2240 Additional Reading
22~2240
Additional Reading
The following recommended reading expands on the concepts raised in this chapter: 1. 2. Abraham, M Valuation Issues and Case Law Update, A Reference (updated regularly). Available to order from NACVA. Zamucen, S How to Value over 100 Closely Held Companies (Rules of Thumb), National Alliance of Valuers and Consultants, 2000. Available to order from NACVA.
REFERENCES / 22~1000 Additional Reading and Training / 22~2220 Chapter 14 Guidance on Appropriate Methods / 22~2260 Training
22~2260
Training
The following organisations have training courses specifically addressing the topics considered in this section. ORGANISATION NACVA SUBJECT Understanding and Using Business Valuations (PowerPoint presentation)
ORGANISATION NACVA NACVA NACVA NACVA NACVA NACVA Securities Institute of Australia Securities Institute of Australia
SUBJECT Levels of Value Using Guideline Companies in Valuations Valuation Discounts and Premiums Valuation Issues in Family Owned Businesses Valuation Methods Determining the Appropriate Valuation Method Financial Analysis and Valuation Applied Valuations
REFERENCES / 22~1000 Additional Reading and Training / 22~2310 Chapter 15 Valuing 100% of an Entity
22~2310
Chapter 15 Valuing 100% of an Entity
REFERENCES / 22~1000 Additional Reading and Training / 22~2310 Chapter 15 Valuing 100% of an Entity / 22~2330 Additional Reading
22~2330
Additional Reading
The following recommended reading expands on the concepts raised in this chapter: 1. Pratt, S, Reilly R & Schweihs, R Valuing a Business, The Analysis and Appraisal of Closely Held Companies, 4th edition, McGraw-Hill-Irwin, 2000. Available to order from NACVA.
REFERENCES / 22~1000 Additional Reading and Training / 22~2310 Chapter 15 Valuing 100% of an Entity / 22~2350 Training
22~2350
Training
The following organisations have training courses specifically addressing the topics considered in this section. ORGANISATION NACVA Securities Institute of Australia Securities Institute of Australia Securities Institute of Australia SUBJECT Valuing Public Securities Applied Valuations Industrial Equity Analysis Mining Investment Analysis
REFERENCES / 22~1000 Additional Reading and Training / 22~2400 Chapter

16 Valuing Minority Interests

22~2400
Chapter 16 Valuing Minority Interests
REFERENCES / 22~1000 Additional Reading and Training / 22~2400 Chapter 16 Valuing Minority Interests / 22~2420 Additional Reading
22~2420
Additional Reading
The following recommended readings expands on the concepts raised in this chapter: 1. 2. Mercer, C Z Quantifying Marketability Discounts, Mercer Capital, 1997. Pratt, S, Reilly, R & Schweihs, R Valuing a Business, The Analysis and Appraisal of Closely Held Companies, 4th edition, McGraw-Hill-Irwin, 2000. Available to order from NACVA.
REFERENCES / 22~1000 Additional Reading and Training / 22~2400 Chapter 16 Valuing Minority Interests / 22~2440 Training
22~2440
Training
The following organisations have training courses specifically addressing the topics considered in this section. ORGANISATION NACVA NACVA NACVA Securities Institute of Australia Securities Institute of Australia Securities Institute of Australia SUBJECT Valuing Preferred Stock Valuing Public Securities Valuing Options and Warrants Applied Valuations Futures Markets and Trading Options Markets and Trading
REFERENCES / 22~1000 Additional Reading and Training / 22~2490 Chapter 17 Valuing Options and Convertible Notes
22~2490
Chapter 17 Valuing Options and Convertible Notes
REFERENCES / 22~1000 Additional Reading and Training / 22~2490 Chapter 17 Valuing Options and Convertible Notes / 22~2510 Additional Reading
22~2510
Additional Reading
The following recommended reading expands on the concepts raised in this chapter: 1. Pratt, S, Reilly, R & Schweihs, R Valuing a Business, The Analysis and Appraisal of Closely Held Companies, 4th edition, McGraw-Hill-Irwin, 2000. Available to order from NACVA.
REFERENCES / 22~1000 Additional Reading and Training / 22~2490 Chapter 17 Valuing Options and Convertible Notes / 22~2530 Training
22~2530
Training
The following organisation has training courses specifically addressing the topics considered in this section. ORGANISATION NACVA SUBJECT Determining The Appropriate Valuation Method
REFERENCES / 22~1000 Additional Reading and Training / 22~2580 Chapter 18 Particular Valuations
22~2580
Chapter 18 Particular Valuations
REFERENCES / 22~1000 Additional Reading and Training / 22~2580 Chapter 18 Particular Valuations / 22~2600 Additional Reading
22~2600
Additional Reading
The following recommended readings expand on the concepts raised in this chapter: 1. 2. 3. 4. Abraham, M Valuation Issues and Case Law Update, A Reference (updated regularly). Available to order from NACVA. Desmet, D, Francis, T, Hu, A, Koller, TM and Riedel, GA .com What are they worth? Mckinsey Quarterly & Business Review Weekly, 28 January 2000. Isom, T A Asset Financing Strategies, Dana Commercial Credit Corporation, 1995. Available to order from NACVA. Joint Committee of The Australasian Institute of Mining and Metallurgy, Australian Institute of Geoscientists and Minerals Council of Australia, 1999. Australasian Code for Reporting of Identified Mineral Resources and Ore Reserves (The JORC Code) www.ausimm.com.au Joint Committee of The Australasian Institute of Mining and Metallurgy, Australian Institute of Geoscientists and Minerals Council of Australia, 1999. Code and Guidelines for Technical Assessment and/or Valuation of Mineral and Petroleum Assets and Mineral and Petroleum Securities for Independent Experts Reports (The Valmin Code) www.ausimm.com.au Mauboussin, M & Hiler, B Cash Flow.com Cash Economics in the New Economy Credit Suisse First Boston, Frontiers of Finance Volume 9 March 1999. Smith, G V Trademark Valuations, John Wiley & Sons, 1996. Available to order from NACVA. Trevillion, K & Perrier, R Brand Valuation A Practical Guide, Institute of Chartered Accountants in England & Wales, Accountants Digest, Issue 405, March 1999. Valuation Counsellors, An Insiders Guide to Valuing Start-Up and Development Stage Companies High Tech Mergers & Acquisitions Journal www.valuco.com/majournal Valuation Counsellors, Intellectual Capital (IC) What is IC in a high tech company and how do you value it High Tech Mergers & Acquisitions Journal www.valuco.com/majournal
5.
6. 7. 8. 9. 10.
11.
White, M The Valuation of Newly-Formed Technology Companies White & Lee Lawyers. www.whiteandlee.com
REFERENCES / 22~1000 Additional Reading and Training / 22~2580 Chapter 18 Particular Valuations / 22~2620 Training
22~2620
Training
The following organisations have training courses specifically addressing the topics considered in this section. ORGANISATION NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA NACVA Securities Institute of Australia SUBJECT How to value Professional Practices (PowerPoint presentation) Finding and Valuing Intangible Assets Valuation Issues in Family Owned Businesses Forensic Accounting Fundamentals Forensic Accounting Advanced Application Valuations in Bankruptcy Valuing .com Companies Valuing Auto Dealerships Valuing Banks and Financial Institutions Valuing Software Companies Valuing CPA Firms Valuing Fast Food Establishments Valuing Law Firms Valuing Leases Valuing Medical Practices Valuing Retail Stores Valuing Service Organisations Litigation Support Understanding the Intellectual Property Law Environment (Patents, Trademarks, Copyrights, Trade Secrets) Litigation Support Basic Economic Principles of Damage Analysis in Intellectual Property Cases Litigation Support Economic and Statistics and their Application in Intellectual Property Cases Litigation Support Nuts and Bolts 1: How to Calculate Damages in Patent Infringement Cases Litigation Support Nuts and Bolts 2: How to Calculate Damages in Trademark, Copyright and Trade Secret Cases Industrial Equity Analysis
ORGANISATION Securities Institute of Australia
SUBJECT Mining Investment Analysis
REFERENCES / 22~1000 Additional Reading and Training / 22~2670 Chapter 19 Taxation

22~2670
Chapter 19 Taxation
REFERENCES / 22~1000 Additional Reading and Training / 22~2670 Chapter 19 Taxation / 22~2690 Additional Reading
22~2690
Additional Reading
The following recommended reading expands on the concepts raised in this chapter: 1. 2. Howitt, I Federal Tax Valuation Digest, 1999/2000, Warren, Gorham & Lamont, 1999. Available to order from NACVA. Moores Stephen HF, The Accountants Manual. Available to order from Thomson Legal & Regulatory Limited.
REFERENCES / 22~1000 Additional Reading and Training / 22~2670 Chapter 19 Taxation / 22~2710 Training
22~2710
Training
The following organisation has training courses specifically addressing the topics considered in this section. ORGANISATION Securities Institute of Australia SUBJECT Securities Law and Ethics
REFERENCES / 22~1000 Additional Reading and Training / 22~2760 Chapter 20 Reference Material
22~2760
Chapter 20 Reference Material
REFERENCES / 22~1000 Additional Reading and Training / 22~2760 Chapter 20 Reference Material / 22~2780 Additional Reading
22~2780
Additional Reading
The following recommended reading expands on the concepts raised in this chapter: 1. 2. Ibbotson Associates, Stocks Bonds Bills Inflation (SBBI) Valuation Edition, Ibbotson Associates, 2000. Available to order from NACVA. Ibbotson Associates, Cost of Capital Quarterly and Yearbook, Ibbotson Associates, 2000. Available to order from NACVA.
REFERENCES / 22~1000 Additional Reading and Training / 22~2760 Chapter 20 Reference Material / 22~2800 Training
22~2800
Training
The following organisation has training courses specifically addressing the topics considered in this section. ORGANISATION NACVA SUBJECT Research: Economic, Industry, Legal And Internet
TEMPLATES
TEMPLATES
Australian Valuation Handbook contains sample templates formatted to an A4 size, ready for use within your organisation. The template documents provided are designed to be used within standard programs i.e. Microsoft Word and Excel. To use any of the documents, you should check the table below to identify the name of the file you wish to use, then doubleclick the title to immediately open the file in your Microsoft program. When one of the template documents is opened in a word processing application, it may be changed and reformatted to accommodate the special requirements of your organisation. These templates have been designed to save time.
TEMPLATES / List of Template Documents:
List of Template Documents:

Paragraph Number Title of Document File Name
Chapter 2 Engagement and Documentation of Assignments 2~1160 2~1180 2~1200 2~1220 2~1240 2~1260 2~1280 2~1300 Summary Workplan Overview Engagement and General Preliminary Reading and Identification of Key Value Drivers The Market The Product The Expected Income The Costs The Capital Expenditure Requirements 2_1160.doc 2_1180.doc 2_1200.doc 2_1220.doc 2_1240.doc 2_1260.doc 2_1280.doc 2_1300.doc
Paragraph Number 2~1320 2~1340 2~1360 2~1380 2~1400 2~1470 2~1500 2~1510 2~1580 2~1650
Title of Document The Working Capital Requirements The Impact of Taxation The Discount Rate and Points The Valuation Report to Client Confidentiality of Information Agreement Conflict of Interest Declaration Instructions to Staff Conflict of Interest Declaration Staff Disclosure Engagement Letter General Conditions of Business Consulting
File Name 2_1320.doc 2_1340.doc 2_1360.doc 2_1380.doc 2_1400.doc 2_1470.doc 2_1500.doc 2_1510.doc 2_1580.doc 2_1650.doc
Chapter 3 Reports 3~1610 Checklist for Business Valuation Report Reviews 3_1610.doc
Chapter 5 Discount Rates 5~1590 Discount Rate Conversion 5_1590.xls
Chapter 7 Research and Data Collection 7~1570 List of Information Required 7_1570.doc
Chapter 8 Review of Historic Accounts 8~1490 Statement Adjustment 8_1490_9_1480.xls
Chapter 9 Preparation and Review of Forecasts and Projections 9~1480 9~1550 9~1610 Statement Adjustment Revenue Projections Gross Profit Projections 8_1490_9_1480.xls 9_1550.xls 9_1610.xls
Chapter 10 Income Approach 10~1265 10~1310 Computations for Template Valuation Indicators of Company Pty Ltd PER/WACC Calculation 10_1265.xls 10_1310.xls
Chapter 11 Market Approach 11~1210 PER Comparable Companies 11_1210.xls
Chapter 15 Valuing 100% of an Entity 15~1160 15~1560 Supportable Debt and Maintainable Interest Cover Calculation PER Adjustments 15_1160.xls 15_1560.xls

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MAIN MENU JUNE 2006 UPDATE #5

MAIN MENU JUNE 2006 UPDATE #5

MAIN MENU JUNE 2006 UPDATE #5 / Preface

MAIN MENU JUNE 2006 UPDATE #5 / Preface / About the Authors

About the Authors

Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited

Gary Cornelius, B.Ec (Hons), FCT, FAICD Dip

MAIN MENU JUNE 2006 UPDATE #5 / Preface / About the Publisher

About the Publisher

Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited

MAIN MENU JUNE 2006 UPDATE #5 / Preface / Major Contributors

C Donald Smith III, MBA, CFE, CPA, CVA, President

Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited

BS, MBA, CPA, CVA, CFA, President

David Mensel, CPA, CFE, CVA, BA in Economics, President

Emanuel Gerstein, CPA, CVA, President Sole Shareholder

Laura J Tindall, PhD, CPA, ABV, BVAL, MCBA, Principal

Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited

Esq., CPA, CVA, Mediator, President

Mel H Abraham, CPA, CVA, ABV, ASA, Partner

Nancy Gault, CPA, CVA, Partner

Richard Berning, CPA/ABV, CBA, CVA, CFP, CMA, President

Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited

CPA, CVA, President

Rod P Burket, CPA/ABV, CVA, MBA, Partner

Stephen Scherf, CPA/ABV, CFE, CVA, DABFA, Principal

MAIN MENU JUNE 2006 UPDATE #5 / Preface / Acknowledgments

MAIN MENU JUNE 2006 UPDATE #5 / Preface / Disclaimer

MAIN MENU JUNE 2006 UPDATE #5 / Preface / Need More Help?

Need More Help?

Website: www.leadenhall.com.au Email: office@leadenhall.com.au

MAIN MENU JUNE 2006 UPDATE #5 / Preface / Key Questions

Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited

MAIN MENU JUNE 2006 UPDATE #5 / Preface / Checklists

MAIN MENU JUNE 2006 UPDATE #5 / Preface / Conclusion

MAIN MENU JUNE 2006 UPDATE #5 / Preface / Other Organisations

International USA USA Australia

www.ivsc.org www.nacva.com www.sec.gov www.thomson.com.au

MAIN MENU JUNE 2006 UPDATE #5 / Preface / Trademarks, Licence and

Trademarks, Licence and Copyright Information

Scoping a Valuation Assignment

Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited

the report format and type.

What is Being Valued

The Business v. The Entity

Diagram Company v. business valuation

Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited

The Effect of Multiple Entities

valuations which are part of a cohesive whole.

Controlling Interest v. Minority Interest

Date of the Valuation

Importance of Valuation Date

Practicality when Preparing a Valuation

ASSIGNMENT MANAGEMENT / 1~1000 Scoping a Valuation Assignment / 1~1260 Standard of Value

Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited

Fair Market Value

Australian Valuation Handbook Copyright 2006 Leadenhall Australia Limited

both parties have the ability to complete the transaction.

Intrinsic or Fundamental Value

Fair or Compensatory Value

Other Standards of Value

Refer to the section on references.

Comparison of Key Assumptions