, a fair value measurement aims to estimate the price (e.g. exit price) at which an orderly transaction to sell an asset or to transfer a liability between market participants would take place at the measurement date based on current market conditions. To determine fair value, a professional valuation should be carried out, normally by a Chartered Valuer or Appraiser (CVA).\u00a0\u00a0<\/span><\/p>\nA qualified valuer would take into account:<\/span><\/p>\n\n- the valuation approach that makes the least subjective adjustments to the inputs used (i.e., it makes best use of relevant observable inputs and minimises the use of unobservable inputs);<\/span><\/li>\n
- In addition to a) ranges of values indicated by the method used and whether they overlap;<\/span><\/li>\n
- the reasons for the difference in value resulting from applying different approaches.<\/span><\/li>\n<\/ol>\n
There is judgment not only in applying a valuation approach, but also in selecting the appropriate valuation approach based on the circumstances.<\/span><\/p>\n\u00a0<\/span>The following factors should be considered when choosing the most appropriate valuation approach:<\/span><\/p>\n\n- Information that is reasonably available;<\/span><\/li>\n
- Market conditions (such as covid-19);<\/span><\/li>\n
- The investment horizon and investment type (i.e., market sentiment is likely to be better reflected by some valuation techniques than others);<\/span><\/li>\n
- An investment’s life cycle (i.e., different valuation techniques may capture value at various stages of an investment’s life cycle better than others);<\/span><\/li>\n
- The nature of an investee’s business (a volatile or cyclical business may be better captured by certain valuation techniques than by others); and<\/span><\/li>\n
- Industry in which the investee operates<\/span><\/li>\n<\/ul>\n
Valuation techniques are based on <\/span>three widely<\/b> used valuation approaches<\/b>:<\/span><\/p>\n\n\n\n| Approach<\/span><\/th>\n | Techniques for valuing unquoted shares<\/span><\/th>\n<\/tr>\n\n\n\n- Market approach\u00a0<\/span><\/li>\n<\/ul>\n<\/td>\n
By using market transactions involving identical or comparable assets<\/span><\/p>\n\n- Guideline publicly traded company method<\/span><\/li>\n
- Guideline merged and acquired company method<\/span><\/li>\n<\/ul>\n<\/td>\n<\/tr>\n
\n\n\n- Income approach<\/span><\/li>\n<\/ul>\n<\/td>\n
Converts future amounts (e.g. cash flows or income and expenses) to a single current amount after discounting\u00a0<\/span><\/p>\n\n- Discounted cash flow (DCF) method\u00a0<\/span><\/li>\n
- Dividend discount model\u00a0<\/span><\/li>\n
- Option pricing model\u00a0<\/span><\/li>\n<\/ul>\n<\/td>\n<\/tr>\n
\n\n\n- Cost\/asset approach<\/span><\/li>\n<\/ul>\n<\/td>\n
Reflects the amount of the net assets at fair market value\u00a0<\/span><\/p>\n\n- Adjusted net assets method<\/span><\/li>\n<\/ul>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n
\nIn addition to selecting the appropriate valuation method and technique, there are two specific adjustments to be made when valuing unquoted shares;<\/span><\/p>\n\n- Discount for lack of control; and<\/span><\/li>\n
- Discount for lack of marketability.<\/span><\/li>\n<\/ol>\n
Discount for lack of control (DLOC)\u00a0<\/span><\/p>\nDLOCs result from minority interests held by investors, who do not have control of the investee’s affairs, which is why the minority interest value will be lower.<\/span><\/p>\nThe limitation caused by the lack of control could be as follows:\u00a0<\/span><\/p>\n\n- Election and appointment of directors and officers<\/span><\/li>\n
- Declaration and distribution of dividends<\/span><\/li>\n
- Raising debt or equity capital\u00a0<\/span><\/li>\n
- Investment or divestment of assets<\/span><\/li>\n<\/ul>\n
Discount for lack of marketability (DLOM)<\/span><\/p>\nDLOM occurs because there is insufficient liquidity when selling investments which results in a price reduction for shares that are unquoted. It is often the case for private companies whose shares do not have an active market to sell. Moreover, it may be exacerbated if there is a specific clause\/condition for selling the shares in the company’s constitution or shareholder\u2019s agreement.<\/span><\/p>\nAlong with the above adjustments (DLOC & DLOM), covid-19 will also have to be taken into account when valuing unquoted shares. When preparing a financial forecast based on the discounted cash flow method, the following factors should be considered:<\/span><\/p>\n\n- Impact of pandemic on the business operations, revenue, cost, etc\u00a0<\/span><\/li>\n
- Measures to mitigate the impact and their effectiveness<\/span><\/li>\n
- Additional capital expenditure in technology\u00a0<\/span><\/li>\n
- Options for fundraising\/borrowings<\/span><\/li>\n
- Likelihood of default on debts\u00a0<\/span><\/li>\n
- Different scenario analysis with probability given the uncertainties\u00a0\u00a0<\/span><\/li>\n<\/ul>\n
DCF discount rates are unlikely to be lower than before covid-19. This is because the level of risk in investments is generally higher during uncertain times. Credit rating plays a major role in determining the cost of debt and equity risk premium.<\/span><\/p>\nIf the valuation is based on a market approach, we must specifically consider whether revenue or earnings based on pre-covid-19 historical performance should be adjusted for the impact of covid-19, as the market multiples based on such revenue and earnings would affect the valuation directly.<\/span><\/p>\nIn order to perform a proper valuation of unquoted shares, there would be judgement required, and the inputs (including assumptions) for the valuation must be reasonable and justifiable.\u00a0\u00a0<\/span><\/p>\nWe will discuss other valuation-related topics in our next article.<\/span><\/p>\nLet SC Mohan PAC help you navigate the valuation requirements for your business today.<\/span><\/p>\nDisclaimer: The information provided here is general in nature and is not intended to be used as professional advice. The information contained in this blog was collected October 2021.\u00a0<\/span><\/p>\nOptional information which may not be necessary:<\/span><\/p>\nTypically, valuation consists of the following steps:<\/span><\/p>\n\n\n\n| Getting a clear understanding of the engagement<\/span><\/td>\n | Describe the purpose, client, interest, report type, and date of the report<\/span><\/td>\n<\/tr>\n\n| First meeting, purpose, and discussion<\/span><\/td>\n | Understanding of requirements, limitations, laws, regulations, and professional standards<\/span><\/td>\n<\/tr>\n\n| Proposal, fee quotation, engagement letter\u00a0<\/span><\/td>\n | Agree on terms of engagement<\/span><\/td>\n<\/tr>\n\n| Data gathering \/ company and industry analysis<\/span><\/td>\n | Global \/ national \/ local analysis via Internet \/ websites \/ trade publications \/ reliability of information<\/span><\/td>\n<\/tr>\n\n | | | |
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