V I E W

Determining Enterprise Values -

Methods and Challenges in the Middle East Context

Introduction subtract cash and investments (also on the balance sheet).

The estimation of Enterprise Value (EV) is an art and not a
science. Often experts on valuations have disagreed on
enterprise values and subsequently the prices to be paid for
shares. However, the best that can be achieved is to arrive
at a value within a range which is a fair indication of the
price. The key lies in understanding not only what the value
is but also in understanding the sources of the value namely
the value drivers.
The EV of any asset can be assessed, but some assets are
easier to value than others and the details of valuation will
vary from case to case. There is undeniably uncertainty
associated with valuation. Often that uncertainty comes
from the asset being valued, though the valuation model
may add to that uncertainty. The Middle East region faces a
further challenge in that the valuation concepts and
benchmarks that are often taken for granted in developed
markets are still evolving in the markets in the region.
What is Enterprise Value?
Market capitalization (the current stock price multiplied by
the number of shares outstanding) in normal layman's
parlance is what serves as a company's price tag. But market
cap ignores debt, and with some companies, debt is
substantial enough to change the picture significantly. EV, on
the other hand, is a modification of market cap that
incorporates debt.
To calculate enterprise value, start with a company's market
cap, add debt (found on a company's balance sheet), and
To get total debt, add together long- and short-term debt.
Market cap = current share price * total shares outstanding
Debt = long-term debt + short-term debt
Enterprise Value = market capitalization - cash and
equivalents + debt
Approaches to determining Enterprise Value and
Challenges
There are three basic approaches to determining Enterprise
Value:
1. Asset based (Adjusted net asset, Liquidation)
2. Income (Discounted cash flows, Income capitalization)
3. Market (Similar transaction, Public company market
multiple)
1) Asset Based Approach
The asset based approach considers the value of the
company's assets and liabilities as the primary source of
information. The current (usually as of the valuation date)
market prices of the assets and the liabilities are ascertained
and the net realizable value of the assets and the liabilities
are worked out. This approach is based on the assets and
liabilities of the entity appearing in the financial statements
as on the valuation date and does not consider the earnings
potential, or the future business prospects of the company
or possible hidden goodwill if any. The asset based 2) Income Based Approach
techniques are:
Income based approaches consider the historic earnings, and
• Liquidation value cash flows and, more importantly, the future earnings and
cash flows. This approach is more appropriate for a going
• Adjusted net equity concern where the entity is presumed to operate for an
indefinite period and recognizes the incomes generated out
Challenges in the Middle East context of the assets as a basis rather than the assets themselves.
The income based approach techniques are:
Following are the challenges while adopting an Asset Based
Approach: • The discounted cash flow

• Quality of financial statements and reporting not of • Income capitalization

the highest standard - Unlike the developed countries
which have stringent norms, the norms and regulations in
the Middle East as far as financial reporting
is concerned is not very demanding. This in
turn affects the quality of financial Forecasted Free Cash Free Cash Flow at end of Net Realizable Value of
Flow Flora Finite Finite Period, Increased for Redundant Assets at
statements and since the asset based Number of Years Future Growth rate Valuation Date

approach relies heavily on the

financial statements, value determination is Discount Rate, which includes
nominal risk, Free Rate Application of
not very accurate. Industry Risk, Business Risk Terminal Factor

• Lack of specialist appraisers - In order t o

Present Value of Terminal Value/ Net Redundant
calculate liquidation value, it is often Free Cash Flow PLUS Residual Value PLUS Assets

necessary to rely on a qualified real estate,

equipment or other specialist appraiser in
Discounted
order to properly determine a gross selling Valuation

price for certain assets such as land,

buildings, equipment, patents, etc. These
appraised asset values will be adopted in
order to adjust the most recent financial s t a t e m e n t s t o Challenges in the Middle East context
reflect the estimated market value (or gross realization
value) that each asset would bring if exposed for sale in Following are the challenges while adopting an Income
the open market. Such specialist appraisers are in short Based Approach and they relate mainly to the elements for
supply in the Middle East. calculating discount rate:

• Nascent factoring industry - In developed countries,
ongoing liquidation costs may be minimized by the sale of
trade receivables en bloc to a factoring company. The
factoring industry is a very nascent industry in the Middle
East and hence estimating liquidation costs are difficult.
• Estimation of risk free rate is difficult - In developed
countries the risk free rate is assumed to be the coupon
on government bonds (refer table below for US
government bonds coupons). In the Middle East, both the
number and variety of government bonds issued are
 limited; hence government bonds coupons cannot be extended time periods (the table below shows the
used as a proxy for the risk free rate. historical estimates from various sources). However, they
yield poor estimates for both the beta and the risk
Table 1 US Bonds premium in the Middle East, where the equity markets
represent a small proportion of the overall economy and
US Bonds Coupon Maturity Date the historical returns can be reliably estimated only for
short periods.
2-Year 4.875 5/31/2008
3-Year 4.875 5/15/2009
3) Market Based Approach
5-Year 4.875 5/31/2011
10-Year 5.125 5/15/2016
Market based approach involves applying public market
30-Year 4.5 2/15/2036
multiples taken from the stock market to private
Source: Bloomberg
corporation valuations. Under this approach one selects a
group of comparable publicly quoted companies and
• Estimation of beta and equity risk premium is difficult calculates the average multiple (P/E, EV/ Sales, EV/ EBITDA
In developed countries, the beta of an asset is estimated etc). The average would be applied to the relevant metric
relative to the local stock market index and the equity risk (Earnings/ Sales/ EBITDA etc) of the target company to
premium is estimated by looking at the historical premium arrive at an estimate of the value of the company.
earned by stocks over default-free securities over long
time periods. These approaches yield reasonable
Challenges in the Middle East context
estimates in markets like the United States, with a large
and diversified stock market and a long history of returns
Following are the challenges while adopting a Market Based
on both stocks and government bonds. A number of
Approach:
studies have calculated the U.S. equity risk premium over

• Lack of comparable-
Table 2 US Equity Premium
companies In the Middle East,
the number of publicly quoted
companies are limited in
number. The New York Stock
Exchange (NYSE) has
around 2,700 companies listed
while the Dubai Financial
Market (DFM) has around 36
companies listed on it (a
ratio of 75: 1)

• Limited information sharing

and transparency - Given the
restricted nature of information
sharing in the Middle East,
* The compound, annualized rate of return (geometric mean) on equities minus the compound, obtaining data on comparable
annualized return of short-term government debt.
Source: “Risk Management Perspectives, April 2003” Analytics Investor transactions is an onerous task.
 Recommended Approach
An Income based approach is recommended as most of the
challenges can be overcome by applying some relevant
assumptions pertaining to the Middle East region.
• Average risk free rate - The risk free rate for the
region can be derived by averaging the yield on 30-year
US Treasury Bonds (refer Table 1) and the yield on a 30-
year Qatar sovereign bond. In late June 2000, the
Government of Qatar launched a US $ 1.4 billion
sovereign Eurobonds. These bonds are of thirty-year
maturity due on June 29, 2030 and carry a semi-annual
coupon of 9.75%. This average yield can serve as a proxy
for the risk free rate for the Middle East region
(refer Table 2). And, the ratings assigned to a country's
debt by a rating agency (S&P, Moody's) to measure default
risk can be used as a proxy for the country premium. For
e.g. Moody's assigns a risk spread of 0.9% to UAE and
1.35% for Saudi Arabia as of January 2006. These risk
spreads can be used as the values for country premium.
Determining Enterprise Value in the Middle East context
requires application of the above approaches keeping in
mind the challenges unique to the region and avoiding a one
shoe fits all prescription. “Value lies in the eyes of the
beholder but the approach lies in the hand of the valuer.”

• Modified Equity risk premium - The risk premium in

any equity market can be modified as Equity Risk
Premium = Base Premium for Mature Equity Market + Article contributed by Thomas K Jacob,
Engagement Manager, Cedar Management
Country Premium. The US equity risk premium can be a
Consulting International
proxy for the base premium for a mature equity market

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