Valuations - Horses for Courses - 3rd February 2022

Many areas of litigation require valuations of businesses and corporate structures.

These notes not only relate to business and corporate valuations but I will make some observations about real estate valuations which may have an effect on those valuations.

The area of law which appears to have the greatest requirement for these valuations is family law but valuations can also be required in estates, compensation, contractual disputes and insolvency.

The parties to these proceedings can have a completely different view of a valuation which is driven by their individual requirements and both could be justified.

Real Estate

Valuation of real estate must typically be performed by a licenced real estate valuer.

A decision has to be made as to how one would typify the land in question e.g., is it farm land or development land? A real estate valuer will typically go with highest and best use, which may not be the requirement for all the parties.  This conundrum is very real in the far outer metropolitan area and some growing country centres.

It should also be noted, in my experience, even when valuers are asked to assess market value rather than mortgage value, they still seem to revert back to mortgage value which is inevitably lower than market. I guess it is an insurance issue. The instruction have to be very clear and authoritative.

I will discuss business plans latter in these notes but for certain types of land a business plan would be helpful to guide the valuer and assist in obtaining the correct result.

Public Company Shareholdings

To set the scene for some really strange valuation conundrums you only have to look at shares in a listed public company. A company with a market capitalisation of say one billion dollars can have its value set on a day by a trade of ten thousand dollars in shares. Someone on the other side of the country dry coughs and you get a change of 5% in the market capitalisation of the company the following day.

An offer can be received for a takeover of that company which is higher than the market capitalisation at, say $1.2 billion. Why would you make this offer if it is above market capitalisation?

If the bid was less than market cap the directors/shareholders would ignore it as they already have a market value which is higher even though if all the shareholders tried to sell their shares at the same time the company’s share value would likely be trashed. The takeover company, if it wants to succeed, has to get most shareholders and directors on side and therefore has to make the offer appealing. Forget what is the true value.

Buying into this company in small parcels will make a takeover much cheaper but past a point is not allowed by ASIC.

The takeover company may well be happy to pay extra for the target as it may assist the merged entity to be even more profitable than the sum of the parts and thus it recovers the premium paid.

So where does that leave the shareholder who has a small, but not insignificant, strategic 2% shareholding in that example company on current market capitalisation worth $2 million. If the holding were to be sold on one day or over a short period it may realise less than that amount. If it is held for strategic purposes, it may be worth more depending on the strategy. How do you value that shareholding? The underlying value may be more but the share market value may be less.

Many public companies could be typified as large private companies for valuation purposes as one person or group of persons control the company. It may be more appropriate to do a full valuation rather than rely on the share price.

The market share value of a large and diverse public company such as a big 4 bank will not vary significantly around the market value but once you start contemplating resource and tech companies the variation could be incredibly wide.

We are generally not privy to what due diligence a takeover company does over the target but a valuation would be a difficult undertaking without an open book and may result in a lesser value.  The takeover company would have to pay the extra on either known other circumstances or gut feel. Whichever way there is a risk.

Privately Owned Businesses

Privately owned businesses can be held in companies, small public companies, trusts, partnerships and by sole traders.

I have included small public companies in this discussion as many are so tightly controlled that they could be private companies with a spread of outside shareholders to just comply with listing requirements. That control can be exercised by one or a few parties but the result is the same. The share price in these circumstances may never reflect the actual value and therefor a valuation may be appropriate.

Party’s different reasons for the valuation requirements of the entity can result in widely different values.   

Where the parties have a similar requirement of the business, such as partners in an accountant’s office, then the difference may not be all that much but where one party sees the business as an asset to generate cash and the other their livelihood then totally different methods may be employed by each party’s advisers/expert.

You can have even more vexing issues such as a business that is worth nothing but has a cash flow. This could be a personal service business which relies on one person to provide a service but may have some employees and assets to assist with that task. This can happen from a cleaner to a barrister. If they tried to sell the business it would be worth nothing, but it is a cash flow as long as the party wants to continue in that occupation. You cannot use a capitalised earning calc in this case and there is no market information about how much people are paying in the dollar for the income.

Do you value the cash flow which could cease tomorrow at the whim of the service provider or attempt a valuation of an underlying asset for which you have no evidence?

In a family law matter, one party may be looking for a cash flow to sustain them and the other is attempting to minimise financial disruption so that their livelihood can continue. Each is looking for a cash flow but from a totally different view point.

For a party seeking a cash flow the lump sum to generate that cash flow would be usually calculated by the use of a discounted cash flow to calculate a net present value.

Once a cash flow requirement is determined a discount factor is used to obtain the opening lump sum. That discount rate will have a significant effect on the amount of the lump sum. The discount rate is a combination of different factors including current and future expected returns, inflation and risk. Inflation can be taken out of the calculation by the way you look at the required cash flow but the two others are fundamental. One question is whose risk should you look at, the recipient’s future risk on the investment or the risk level of the party that still holds the business and has to take on increased risk from additional borrowings to fund the payment of the lump sum?

The valuation of the business for a continuing owner is far more complex. What method do you use, capitalisation of earnings, sum of the parts or maybe a discounted cash flow based on a projection of earnings over how many years? How do you take into account inflation, future of the business, re-investment, borrowings, changing business circumstances, government assistance, mergers, carve ups, other owners? The list goes on and each business has its own quirks.

Needless to say, there is no one formula that suits all circumstances and the business valuer must both know all the alternatives and also have a reasonable insight into the industry so that they know which is appropriate.

What can make the valuation task easier is a business plan prepared by the controller and detailed financial accounts for the business which clearly show abnormalities to normal trading. These can stop arguments at the front gate and lead to more productive discussion about the valuation.

Accountants have been advising businesses for years to invest in these documents but unfortunately much of business is operated by the seat of the pants or by a bid to save money. A business plan written at the lead up to a valuation or after an event leading to the valuation has occurred is far less valuable than one written a few years before.

Corporate structures

A corporate structure could include one or many businesses. In some cases, some divisions/subsidiaries may be profitable and others not. Each could be in a different part of a life cycle or their results are part of a strategic purpose.

Do you just value the corporate structure as a whole or do you look at it as the sum of different parts? Each may require a different methodology.

A business plan is helpful in providing guidance for the valuation methodology. Also, good quality segmented accounts are vital to obtain an accurate and defendable result.

Balance Sheet Adjustments

I will write a separate paper regarding this subject as it is a broad area and is full of pitfalls.

This paper is by no means a full explanation of what matters are to be considered for business/corporate valuations but just to indicate that there is no fixed methodology and the valuer must adapt to get it right.

BI Claims Update - 2nd November 2021

On the 6th September 2021 the second test cases commenced in the Federal Court. The Federal Court issued a ruling on the 8th October 2021. The upshot is that the court ruled in favour of the insurer in 8 of the 9 claims presented. In respect of the successful claim proof is required of whether there was business interruption.

The parties to this second test case are reviewing the ruling and decide whether an appeal is appropriate. The Federal Court has set aside time in November 2021 to hear any appeal.

Insurers are still encouraging insured to lodge a claim although they will not be dealt with until at least December 2021 after all appeals are finalised.