Valuation Report Quality and Reliability in Egypt

A valuation report is not just any report which offers a number. It is an opinion of an expert who bases his or her opinion on financial data, market data, expectations about the business and professional judgment to come up with a value which can be relied on by investors, shareholders, regulators, banks and other stakeholders in the transaction. This is why the quality of valuation should not be measured only in terms of whether the number that emerges out of the process looks reasonable, but also whether the process itself was technically, independently, professionally and objectively sound. The report of valuation may thus end up being unreliable despite having used an advanced financial model to generate the number if the underlying data, assumptions, methodology and professional judgment cannot be objectively supported.

It is not the question of whether another valuation specialist would arrive at the exact same number when evaluating any valuation report. It should be noted that valuation is a subjective process and, therefore, there may be differences in opinions of two equally qualified valuation specialists depending on the way the information was analyzed and the assumptions made about the future. However, what matters is whether these differences were due to sound professional judgment or poor valuation process. The problem is that if there are serious flaws in the report that make the resultant opinion worthless for the reasonable user, the report will be deemed inadequate.

The Importance of Valuation Report Quality

It is important that a proper valuation report should draw a strong connection between the purpose of valuation, the asset being valued, the valuation date, the valuation basis, the data used, the methodology of valuation adopted, the assumptions involved and the conclusion arrived at. It should be possible for one to follow the valuation process right from the data through the assumptions and the methodology to the conclusion.

Without such a connection, the valuation would be difficult to challenge, to replicate and to understand.

The valuation report is even more important when the valuation is intended to be used in relation to an Initial Public Offering, mergers and acquisitions, fundraising, stock transactions, business reorganization, accountancy or any other transaction which would have economic ramifications for the valuation conclusion arrived at. In such a case, what is needed is not just a figure which looks reasonable but a figure backed up by evidence and sound professional judgment.

When Should a Valuation Report Be Rejected?

If there is an issue in the report that is too serious to allow for the readers to use the conclusions from the report as a reasonable basis, then the report must be rejected or significantly modified prior to using it. The issues that can lead to rejecting a report are the lack of financial data or its unreasonableness, unreliable management forecasts, incorrect method for valuing the company, omission of risks in the analysis, as well as technical mistakes in the valuation model. The report may also be rejected due to the absence of professional experience, independence, registration, and other qualifications necessary for preparing the report or undertaking the regulated task.

However, rejection is not the solution to all possible flaws that emerge during the report assessment procedure. In particular, there are certain flaws that can be eliminated through further disclosure, provision of evidence, modelling and explanation of assumptions. It is extremely important to understand the difference between the process of revising a report and rejecting it. Although certain inconsistencies of wording of the report can be easily corrected, a serious technical flaw may necessitate calculation of the valuation model and conclusion once again. However, the methodology used is fundamentally wrong, there is no independence in performing the evaluation, certain material information is omitted or the professional performing the task is not qualified enough for official purposes, then the report cannot be used.

Reasonable Judgment Versus a Defective Valuation

There is another key principle that should be considered in relation to valuations. It is important to remember that just because people disagree does not always mean that they make a mistake. The valuation of a firm at different prices by two professionals could be quite justified if one of them thinks that the growth of a company is going to be sustainable or if the second uses a different peer group or makes a different decision concerning risk premium.

Importance of the difference is evident when it turns out that the assumptions behind the calculations are not backed up with facts, or the methodology chosen appears to be selected with the only goal in mind to achieve the predetermined outcome. For example, a high growth rate projection of revenues does not mean that it is wrong just because it is greater than historical growth of the revenues. Indeed, if there were changes in the business, such as new agreements, production capacity increase, entering a new market, higher prices or increased market share, the high growth projection may be justified. However, what makes the valuation incorrect is the absence of reasonable explanation and factual support for the forecast which differs significantly from historical experience and market data.

When Can a Valuation Report Be Defended?

Valuation report may withstand scrutiny where the critical underlying assumptions used are reasonable, backed by data, consistent, and relevant within the context of the information available as at the time of valuation. The assumptions need not necessarily turn out to be true. Projections are prone to errors since the actual outcome may deviate from the projected figures due to changes in the economic environment, market conditions, regulatory requirements, competitive environment, and other factors surrounding the company. Such deviation does not necessarily imply that the valuation conducted was not adequate.

There will be enough documentation in the report to show how the key assumptions have been formulated. Assumptions concerning inflation, interest, exchange rates, industry growth, pricing, volume, margin, working capital, capital expenditure, taxation, discount rate, terminal growth, and comparable companies should be based on data available as of the valuation date. The more substantiation there is for a key assumption, the more easily it can be proven that the assumption was a reasonable professional judgement rather than a mere unsupported estimate.

On the other hand, the valuation process should not take anything for granted and question management’s assumptions. There should be a logical progression of the valuation process from past performance to current market environment, the company’s budget, management’s projections, industry expectations, and other evidence from the marketplace. Management’s projections should therefore be compared to historical performance, the current market evidence, and the company’s production capabilities.

Errors in Valuation Modelling

One of the most obvious technical bases for rejecting or substantially revising a valuation report is a modeling mistake, which may involve revenues, margins, working capital, capital spending, taxes, debt, cash, discount periods, terminal value, and enterprise to equity value reconciliation. While even the final value may appear reasonable, technical problems will greatly affect its accuracy because the reasonableness of conclusions will not affect the modeling problem itself.

The danger that such a problem poses becomes especially serious in case of the discounted cash flow method because even minor discrepancies in the projections of cash flows, discount rates, and terminal values have an extremely strong impact on the value obtained. Major mistakes in the DCF analysis include double counting of debt or cash, incorrect taxation, incorrect free cash flow calculation, wrong assumptions about the forecast period, and the wrong choice of the discount rate in relation to cash flow being valued. The problem of terminal value calculation may pose a particular threat because terminal value makes up a considerable part of enterprise value.

Another major aspect associated with technical modeling is model consistency. In other words, the cash flows, inflation assumptions, discount rate, terminal growth, and currency assumed in the model must be consistent from an economic standpoint with one another. For instance, if one assumes that the valuation is based on nominal cash flows in Egyptian Pounds (EGP), then the discount rate and the terminal growth assumptions must be consistent with the inflation assumptions built into the cash flows. If cash flows are in a foreign currency, then the discount and terminal assumptions must be consistent with the foreign currency.

Errors in Valuation Report Wording and Presentation

However, the valuation report could still be flawed despite lack of any mathematical inaccuracies. When it comes to terms used in the valuation report, inconsistencies in their definition and interpretation, ambiguities, material omissions, contradictions – all these factors can prevent users from properly understanding the value stated in the valuation report. The report should clearly outline the date of valuation, objective of valuation, nature of subject interest, the basis of value, scope of assignment, sources of information used for valuation, methods of valuation, assumptions, limitations and conclusions.

Contradictions among various parts of the report are extremely hazardous for the user. For example, the executive summary of the report includes equity value whereas the main part of the report has enterprise value, or different valuation dates are indicated in the report and in the model. It should also be noted that providing conclusions in the form of “fair value” without further clarifications on the basis of value might be misleading for the reader of the report.

The Impact on the Income Approach

The income approach is very dependent on the underlying assumptions made about the future economic benefits of the business. In the case of a discounted cash flow analysis, the final result will depend on future income projections, profits, capital investment, working capital requirements, assumptions related to tax rates, discount rates, and terminal values. Hence, when using an income approach in a report, it should be carefully examined from the point of view of unsupported assumptions, incorrect cash flow calculations, and inaccurate discount rates.

The discount rate that is applied during valuation must have clarity and must be able to demonstrate the validity of each element of that rate, including the risk-free rate, equity risk premium, country risk, beta, peer group, capital structure, cost of debt, and any specific risk premiums.

Moreover, the analyst must make sure that there is an alignment between the discount rate and the currency and inflation rate assumptions applied in the calculations. Valuation is highly sensitive where there are nominal cash flows in EGP combined with different assumptions of the discount rate or terminal growth.

Foreign exchange rate assumptions become highly significant in the Egyptian environment. In cases where the company holds foreign currency cash flows, expenses, or revenue, the valuation must indicate how the foreign exchange assumptions are formulated and how any change in exchange rates will impact the future cash flows of the company and the final valuation result.

The Impact on the Market Approach

The market approach relies on market data; hence the selection and analysis of comparable companies and transactions play a critical role in making the conclusions of the study valid. A red flag should always be raised on valuation reports where the selection of comparable firms seems to be driven by the desirable multiples they offer but overlooks the underlying economic considerations like the differences in size, location, growth prospects, profitability, leverage, liquidity, diversification, or riskiness of the firms.

The use of international or regional comparables in calculating valuation multiples does not automatically mean that the valuation itself is inappropriate due to the lack of sufficient local comparables from Egypt. There are times when local valuators will have no option but to analyze EGX-listed firms, MENA comparables, emerging markets companies, or even international firms to calculate the right multiples for the subject company. What matters most is whether the report highlights economic comparability between the subject firm and its competitors.

Furthermore, it is crucial to ensure that consistency is maintained between the numerator and denominator used to determine the multiple. In other words, when enterprise value is being considered, it is vital to use an equivalent operating indicator such as EBITDA or EBIT, and when equity value is being used, it should be matched with an equivalent equity indicator such as net income or book value of equity.

The Impact on the Asset Approach

This approach might prove more applicable in cases of asset-intensive businesses, holding companies, investment companies, and some types of real estate and restructuring deals. The applicability of this approach is based on the accurate determination of the underlying assets and liabilities according to the particular valuation basis.

The report proves unreliable when there are any significant assets recorded in the books on old accounting basis, when there are no underlying liabilities taken into account, when any contingent liabilities are ignored, and when any important intangible assets are left out of consideration. For instance, the value of a property-owning business might prove substantially different from the accounting values of the properties due to changes in their market values. In turn, in an investment holding company, it is important that the correct market value of the underlying investments was considered during the valuation of the business according to the applicable valuation basis.

The asset approach does not mean that the valuation professional just subtracts total liabilities from the total assets from the balance sheet. The valuation professional has to determine whether the underlying assets and liabilities appropriately correspond to the particular valuation approach and make any needed adjustments.

Valuation Reports and Their Applications in Egypt

Whether a valuation report needs to be accepted, revised, or rejected is particularly important in Egypt considering the widespread application of valuations in mergers and acquisitions, capital increases, shareholder transactions, corporate reorganizations, accounting, investment decision-making, financing, and capital market transactions. Based on the intended use of the valuation engagement, it can be evaluated by the parties such as the shareholders, boards of directors, investors, audit committees, creditors, transaction advisors, and others.

For situations where valuations have been done according to the Egyptian regulations pertaining to capital market transactions, the appropriate Egyptian criteria need to play a prominent role in the evaluation process. The Financial Regulatory Authority has established Egyptian criteria and requirements related to financial valuation services, and whenever a valuation assignment falls under the jurisdiction of those criteria, the FRA-licensed financial advisory companies and valuation experts must conform to the criteria relevant to the particular assignment. Consequently, when evaluating an Egyptian valuation, it cannot be based solely on the general international practices but it must also comply with the appropriate Egyptian criteria and regulations as well.

Another crucial question of professional standing of the valuation provider is covered in the Egyptian regulation. Appropriate professional specialization can also depend on the type of asset being evaluated and the regulatory purpose of the evaluation. It is especially relevant in Egypt, as financial valuation services, real estate valuation, and asset revaluation require separate regulations. Therefore, even if the valuation is done by a technically competent professional, if he does not possess certain qualifications and registrations required for the valuation of the given asset or the completion of the particular assignment, the valuation will still be considered inappropriate.

Moreover, valuation professionals have issues connected with the economic environment of Egypt. Inflation rate, interest rate, exchange rate, country risk, cost of capital, as well as the difference between publicly-held and privately-held companies can affect the assumptions made during the valuation process. Thus, a proper evaluation of an asset in Egypt should disclose the factors considered and differentiate information known at the time of valuation from the information obtained afterwards. Moreover, a change in economic circumstances following the valuation process cannot automatically affect the validity of the valuation, unless the conclusion made during the valuation process was unreasonable.

Can the Valuation Professional’s Qualifications Affect Acceptance of the Report?

The competence of qualifications of the valuation expert would have a considerable effect on the reliability and quality of the report of the valuation, especially in the cases where the assignment is regulated. The first consideration is regulatory eligibility. In the case where the assignment is within the scope of one of the regulated activities in the relevant FRA jurisdiction, the professional or firm needs to be registered, licensed, or otherwise authorized in accordance with the relevant regulations. This is quite a different thing from the technical competence in valuation on behalf of the individual professional.

The second consideration is technical competence. A technically competent valuation expert would have competence in the DCF method, FCFF/FCFE, WACC/CAPM, comparable companies/precedent transactions approach, asset valuation, financial statement analysis, and sensitivity/scenario analysis. More important still, the individual would be able to explain why the methodology has been selected and also reconcile various methodologies.

Technical competence within that particular industry sector is just as vital. The valuation of banks, insurers, real estate developers, hotel chains, healthcare companies, manufacturers, fintech, infrastructure companies, startups, and tech firms, many of which are industries that typically include a lot of intangible assets, requires understanding various business drivers, regulation, capital structure, margins, KPIs, and risk factors. Hence, a technically competent generalist may not necessarily possess enough industry-specific competence to undertake all valuations, especially those with unique business features.

The Role of the Valuation Analyst

Valuation analysts need to be essential to the process of determining the ability of the valuation to withstand testing. Valuation analysts are supposed to do more than input financial information and generate valuations. They are required to establish the accuracy and credibility of the information entered into the model, challenge management assumptions, make decisions on the right methodologies and techniques to use, incorporate market information, assess the risks, examine important assumptions, conduct sensitivity and scenario analysis, and provide limitations of the analysis.

The competent valuation analyst needs to be able to provide clear reasons for adopting a certain methodology and projections, selecting particular comparative firms, employing a specific discount rate, having market information at the time of valuation, considering alternative assumptions, and examining the sensitivity of the conclusion to changes in assumptions. It is precisely this capacity of explaining all these things based on relevant evidence that turns a regular valuation into a professional opinion.

Another requirement is that of maintaining independence and objectivity on the part of the analyst. The valuation exercise should not be aimed at ensuring that the price offered for the business deal is justified or that the expectations of any of the parties concerned are satisfied. In case of aggressive management projections, it becomes incumbent upon the analyst to examine the basis of the projections and the validity of the estimates made in that context.

Conclusion

In case there is an opposite point of view and/or the results received do not correspond to those expected from the valuation report due to some later factors, it does not mean that the entire process of valuation is to be considered rejected. The valuation is rather subjective matter, and opinions of various professionals, based on their own knowledge and experience, may differ due to various factors, including the interpretation of the market data, approach used and expected future results of the company’s work.

The most essential part is having a logical and justified ground for drawing such conclusions. The grounds for rejecting the valuation include material weaknesses of the process of valuation, including flaws of the model used for valuation, insufficient or inadequate information, unreasonable assumptions, incorrect methodology used, cash flow and discount rate issues, inappropriate comparables used, lack of disclosure, lack of independence and lack of qualifications.

For instance, in Egypt, the defensibility of the valuation must be assessed based on the economic and regulatory circumstances prevailing at the time of valuation. Inflation rates, interest rates, movements in exchange rates, country risk, financial considerations, and lack of comparables in the local market could make a significant impact on the outcome. The ultimate test for the valuation report is not the reasonableness of the final figure in the valuation report. More important is the defensibility of the entire process that leads to the outcome of the valuation.

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