Valuation Volcano

By Charles Hattingh CA(SA) Chartered Financial Analyst

When company managers base published earnings on valuations, one can expect those earnings to be manipulated or, at best, to be unreliable. When taxpayers base their tax returns on valuations, I leave it to your imagination what can be expected.

In an article published in the December 2003 issue of this journal I looked into some aspects of deceit, carelessness and ignorance in the performance of valuations for Capital Gains Tax (CGT) purposes. The purpose of this article is to anticipate some of the problems SARS can expect from valuations presented to them for CGT, donations tax and estate duty tax purposes. SARS will have to ask four basic questions when assessing the validity of such valuations:

  1. To what extent was the result “stretched” to suit the taxpayer, i.e. increased to arrive at the base value for capital gains tax or decreased for estate duty, donations tax or capital gains tax subsequent to the base date?
  2. Was the valuation based on sufficient and reliable evidence?
  3. Was the model used valid?
  4. Were the detailed calculations technically correct and accurate?

The concept of the value of an equity interest for fiscal purposes is “what it will fetch in the open market”. In the absence of a price quoted on an active market, a valuation will have to be performed. The conceptually sound basis for arriving at value is to discount the projected cash flows at a fair rate of return (the DCF model). In the case of a controlling interest, the value is the higher of the value arrived at using the DCF model and the value arrived at assuming that the entity is wound up (the liquidation model).

To assess the extent to which values have been “stretched”, SARS will have to apply benchmarks against which to compare the views used in the calculations.

To assess whether or not the valuation was based on sufficient and reliable evidence, SARS will have to examine the scope paragraph of the valuation report to determine the extent to which the valuation was based on factual evidence. SARS will have the advantage of hindsight when assessing the validity of the projections used in the valuation. The valuer, on the other hand,may not use hindsight in arriving at these projections according to case law but should provide evidence at the valuation date of these expectations.

Methodologies using price earnings ratios and factors multiplied by sales should be rejected outright by SARS. Such methods can be used as reality checks but are not valid methods for professional valuations. A method used by some auditing firms is to multiply the earnings of the entity by a price earnings ratio and then to add the result to the equity of the entity to get the value of the equity interest!

The model I developed for fiscal valuations is now widely adopted. The science behind the model is 100% accurate and valid – it is based on the DCF approach. However, as the old saying goes: “Garbage in, garbage out”. SARS will have to be especially vigilant when checking the details. Here is a small sample of issues they will have to watch out for:

  1. Most small entities use practice note 19 issued by SARS to measure depreciation. I have seen cases where assets such as trucks have been written off to R1 but still have a useful life of 10 years. Clearly in such cases, the assets and depreciation should be adjusted before commencing the valuation process.
  2. When projecting replacements of property, plant and equipment, one should account for the current costs of replacement. Many entities make good returns on historical values of assets and these returns are then projected into the future thereby overstating the sustainable growth rate of future earnings and the valuation.
  3. It is not possible to perform a sound valuation if all the resources used by the entity are not recognised on the balance sheet. The valuer should reinstate derecognised receivables that were factored or securitised and items of property plant and equipment held as “operating” leases. This is necessary to be able to assess the true utilisation of assets and gearing.
  4. As part of the valuation process, the valuer should perform a scientific analysis of the company’s past performance. I have seen cases where historical analyses reflect poor past results but when projecting the future these returns are magically transformed into super profits.
  5. One of the most important aspects of a valuation is reinvestment risk, i.e. what the entity will do with the cash generated by the business that is not required to fund on-going activities. One cannot assume that this cash will generate after-tax returnspresently achieved by the entity as this would assume that the entity is to invest in new businesses that do not exist at the valuation date. Although one could argue that there is an option value attached to new businesses in an existing entity, one cannot pretend that the business is operational when it does not exist. If a valuation of a minority interest is being performed, at best one can assume that the cash not declared by way of a dividend will be used to redeem debt.
  6. Secondary tax on companies is a fact of life. When valuing a share in a company or a close corporation, one cannot value the assets of the entity and call it the value of the equity interest in the entity. To get the value to the members the entity must pay STC to the extent that it does not have STC credits. The model I developed takes this into account. However, I have seen many valuations that ignore this aspect.
  7. Many valuers value the entity assuming that the owner of the interest controls the entity. (It is fascinating to see them do this based on PE ratios of listed companies, which are minority based!) They then attempt to convert the value to a minority value by applying a discount. To my mind, this is incorrect. The approachesused to value majority interests and minority interests are totally different, with different risks applied to discounting future cash flows. A majority holder has the ability to withdraw the cash flows after providing for the entity’s needs, so this is the “free” cash flow that should be projected when doing a majority valuation. A minority holder, on the other hand, is at the mercy of the dividend policy of the controlling shareholder so it is this cash flow (dividends) that should be projected when doing a minority valuation. There is, I am afraid, no magic adjusting discount between a majority and a minority value. Two valuations should be performed.
  8. One of the difficulties valuers experience is deciding on the balance sheet to use as the basis for the valuation. Most SMEs in RSA have February year-ends. Some valuers use the February 2001 balance sheet and forget to take the value forward to 1 October 2001. Others use the balance sheet at 1 October 2001 based on estimates and management reports. And yet others use the balance sheet at February 2002 and backdate the valuation, which is not permitted in common law. A fiscal valuation should reflect foresight and not hindsight.
  9. How does one account for deferred capital gains tax on the revaluation of an asset above the tax base when performing the valuation of a majority share in an entity after 1 October 2001? Clearly a buyer of an entity will want to be compensated for this “liability”, just as he or she will want to be compensated for the unrecognised STC “liability” on the reserves at the date of the valuation. In an actual transaction, this will be negotiated between the buyer and the seller. However, this does not help the valuer and SARS as they have to visualise hypothetical buyers and sellers. In my opinion, the valuer will have to take a view as to when this tax will be paid and SARS will have to determine whether or not this view is reasonable, e.g. if the window period for discounting cash flows is five years, the STC and CGT could be discounted at the fair rate of return in five years. My model automatically does this.
  10. There are still some valuers who are discounting after tax cash flows at before tax discount rates. I find it amazing that they still carrying this convoluted baggage from their informative years.

Does this scare you? It should. As my word count is way over the limit I will leave the other scary ideas for a later article.