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FAIR ACCOUNTING VALUE AND BUSINESS VALUATION
Since the earliest times, people have done business. As no man is an island[1], humans have always needed their fellow humans to obtain all the goods they need to survive. When they needed these goods, it was natural for men to trade with each other. For, often, the surplus that man obtained from a certain activity, hunting, v.g, needed to be traded with other members of the community who had surpluses of other things. It is intuitive that men, from the earliest times, seek an efficient allocation of the resources at their disposal.
Thus, even before the beginning of trade, it was necessary to assign value to things, because even in a society that practiced bartering, there was always a need to assign value to things. To seek this efficient allocation of resources, man has always needed to assign value to things.
It turns out that the notion of value depends on the perspective of the person who assigns it. Take, for example, a bottle of mineral water and a Ferrari. In Manhattan, for example, you will certainly need to own a few thousand bottles of water to be able to buy a Ferrari with the same value attributed to both things. Now, in the Sahara Desert, and in front of a rich traveler lost in the desert for two days, you will certainly be able to exchange a single bottle of water for the Italian machine and perhaps even receive something extra for it.
Therefore, the notion of value has always been an enigma difficult for man to solve. Even more so, if we talk about, more than finding the value of things, finding their fair value. Meanwhile, with the complexity of social relations and more specifically in the business area, it is important to know the fair value of a company.
Therefore, we have to obey the accounting standards in force in order to answer this question.
I- Market Value
The International Valuation Standards Council defines market value as:
The estimated value for which an asset or liability should be exchanged on the valuation date between a willing buyer and a willing seller in an arm's length transaction, after proper marketing and where the parties have acted knowledgeably, prudently and without compulsion.
Suppose I want to sell you a vehicle that is being traded on the market for R$ 100,000 and I know it's worth that. However, you do not have this knowledge. Under these conditions, this value is market value, but it is not fair. This type of value occurs when the people involved are knowledgeable about the components of a transaction[2]
The term market value is the price that the market assigns to a certain good or service. However, as already said, this is not the fair value, because, for example, if in the summer a sunscreen can be sold for a price even above the market, in the winter this price can fall to less than the cost price, if the product is close to expiration.
Furthermore, there is another problem in the definition of market value, as it does not take into account other market participants. Thus, in a transaction a product may have been sold for R$ 1 million to a certain buyer. But, it may be that no one else in the market buys this product for that price. So, for the definition of market value, the R$ 1 million would be sufficient, but in terms of fair value, the number would certainly have to be lower until another possible buyer is found in the market.
II- Fair Value
CPC 46 defines the concept of fair value: "It is the price that would be received for the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date."
A-Elements of Fair Value
a.1 Orderly transaction
Fair value will only be obtained if the participants were free to decide and arbitrate its content. You cannot work with the notion of fair value in cases of forced sale, such as those that anticipate or avoid the liquidation of companies or even when there is any problem that prevents the correct valuation of prices, such as coercion, for example.
a.2 Main market
With regard to the main market in which the transaction occurs, we have to ask whether or not that is the main market. To determine fair value, the value in the main market must be determined. If it does not exist, you should inquire about the most advantageous market for the asset or liability.
a.3 Exit Price
As Gelbcke and Others[3] rightly said, "fair value is a price and, therefore, is part of exit value measurements, as opposed to cost, which is part of entry value measurements."
a.4 Market participants
This is a big difference between the concept of market fair value and fair value. Because we will only be able to determine the fair value if another market participant is willing to pay the same amount. As KING[4] teaches us, in the example of the auction of a painting that was sold for US$ 30 million, two bidders reached US$ 29 million, but only one of them paid the US$ 30 million for the painting. Thus, the fair value would be at most US$ 29 million, as at this level there would be more than one interested party in the market able to buy that asset.
B- Subjectivity of fair value
To arrive at fair value, even if we strictly follow accounting standards and procedures, it is crucial that the assessment of the value of something will depend, in one way or another, on evaluation. And then, even if the concepts are well tied and defined, a certain degree of subjectivism will always prevail. Even experienced appraisers placed face to face with the same problem will end up having different views and will arbitrate different prices, sometimes with up to 10% (ten percent) difference.
III- Methods for Obtaining the Fair Value of a Company
Obtaining the fair value of a company, as we have seen, is not an easy task, especially because we have seen that there is a certain degree of subjectivity in the assessment of a company's set of assets and rights. In any case, there are some methods developed by accounting science to show us the value of a company.
The three main methodologies for valuing companies are[5]: discounted cash flow, market multiples and equity value. Each of these has its particularities and importance for each phase of the company or the negotiation that is intended to be carried out.
a. Discounted Cash Flow
The most used method today in valuation is discounted cash flow. In short, discounted cash flow would be the value of the cash flows projected for the future, discounted to the present at a rate that represents the risk. This risk is necessarily linked to the type of company exercised. The greater the risk of the activity, the greater the rate that represents that risk. On the other hand, often the risk of the activity compensates for the realization of the business, because often the secret of success in the negotiation is precisely in assuming this greater degree of risk.
The necessary information is: the projected cash flow (revenue, expenses, costs, etc), the expected growth (market expectations), discount rate (how much will be discounted from the cash month to month, taking into account a risk premium).
Finally, it is worth mentioning the perpetuity that would be an estimated value for the company after it reaches its peak of growth and reaches a degree of stability for some years. This period must be projected and is part of the valuation by the discounted cash flow method.
a.1 Positive and Negative Aspects
Although it is the most used model in the valuation of companies, some criticisms are made to this method, among them the fact that it requires great understanding and study of the business to be acquired in addition to the calculation assumptions can be manipulated, especially those that concern market information and the future of the company. Finally, there is a high degree of uncertainty because much of the evaluation is based on future and uncertain events.
b. Market Multiples
Another of the methods of valuation of companies widely used is the market multiples. There are several commonly used multiples, but the most important are: EBITDA multiple and profit multiple, or PE.[6]
This method of valuation takes into account how the market prices companies with similar activities. In general, it seems a more simplified evaluation like that of a car or a property. However, evaluating a company is not as simple as these other evaluations.
The first difficulty is to find a company similar to the one to be evaluated, because companies, even if similar, have characteristics that individualize them.
Moreover, another complicating factor is the choice of the valuation multiple to be used as EBITDA, EBIT etc. Below, a link to a table of Prof. Damodaran[7] that stipulates multiples for large players in the market. http://www.stern.nyu.edu/~adamodar/pc/datasets/betas.xls
1
Profit Multiple
It is the use of the company's monthly profit in the measurement of its value. It is the most used method in the acquisition of small and medium-sized companies. It is a simpler method using the comparison with other companies in the industry through the market sales value / company profit reaching a multiple.
2
EBIT Multiple
It is the abbreviation of the English earnings before interest and taxes. Profit before payment of interest and fees. This method is used for companies that when buying the company pay off any loans contracted and, therefore, get rid of the interest to be paid to the capital provider. Also, with regard to fees, often the buyer is a company in a different tax regime, being necessary to purge the calculation of taxes that in the larger company will be accounted for and paid differently.
Therefore, to arrive at the fair value of the company it is necessary to purge interest and taxes that would be paid differently by the companies participating in the business.
3
EBITDA Multiple
It is the abbreviation of the English earnings before interest, taxes, depreciation and amortization. Profit before payment of interest, fees, depreciation and amortization.
This methodology consists of multiplying the EBITDA or the net profit of the company by the number of times that other companies are being traded. Market multiples are especially used in the negotiation of sale of companies in installments, where it is determined that part of the value to be paid will be linked to the future performance of the company.
4
Revenue Multiple, Book Value and Net Worth
There are other methods, however, they are not the most used. They consist, in short, in finding the monthly revenue, the book value or the net worth of the company and calculating its value by a market multiple based on these vectors.
b.5 Positive and Negative Aspects
The multiple methods are simpler than the discounted cash flow in the valuation of companies. However, like some inputs of the DCF method, here some information can be manipulated. In addition, a certain sector may be going through an upward or downward bias, which may end up influencing the valuation of the market multiple. This contaminating bias is not detected in the valuation by the multiple and may end up under or overestimating a company.
c. Net Worth
The last company valuation methodology addressed in this text is net worth. This company valuation methodology basically consists of estimating its value by its net worth. It is a methodology based on accounting, little used in negotiations, but important in cases of liquidation of the company in which its future or eventual market multiples will not be projected.
Easy method of calculating the value, as it is already carved into the company's balance sheet.
These are the main company valuation methodologies. Each has its purpose and all are important in different phases of negotiation or the life of the company.
IV- Conclusion
As we have seen, finding the fair value of a company is not an easy task, because although we are in the field of accounting science, many of the inputs or information to be used in calculating the value of a company come from a perspective with a certain degree of subjectivity. For this, there are varied evaluation methods, some of which were seen en passant in this small study, all with the objective of creating a technicality and reducing speculation.
The method to be used will depend, among other factors, on the economic or legal situation of the company, the type of activity carried out, its revenue, the type of business to be celebrated, the size of the buyer, etc.
In any case, no matter how good the appraiser is and how appropriate the valuation method carried out is, it is important to emphasize that no valuation is the same as another, as a certain margin of subjectivity will always permeate the appraiser in his study.
Footnotes:
[1] No man is an island, entire of itself; every man is a piece of the continent, a part of the main. If a clod be washed away by the sea, Europe is the less, as well as if a promontory were. as well as if a manor of thy friend's or of thine own were. Any man's death diminishes me, because I am involved in mankind; and therefore never send to know for whom the bell tolls; it tolls for thee. – John Donne, Meditations VII.
[3] Corporate Accounting Manual, Ed. Atlas, 3rd edition.
[4] Fair Value Concepts, Alfred E. KING, in Catty, James P. IFRS: fair value application guide. Porto Alegre. Bookman, 2013.pag. 11-28.
[7] Aswath Damodaran is a professor of finance at the Stern School of Business at New York University, where he teaches corporate finance and equity valuation. He is best known as the author of several academic and practical texts on valuation, corporate finance, and investment management.