Business Valuation and Professional Judgment in Egypt

A conclusion reached during valuation seems like an outcome of a financial model; however, the financial model does not establish the value of a business. The conclusion depends on data available, assumptions used, methodology applied, market evidence considered and the judgements made during the valuation exercise. This brings us to another critical question: who in fact drives the valuation?

It is not the valuation analyst alone because management has significant control over the data and forecasts that constitute the basis of analysis. It could be the shareholders or parties involved in the transaction who would want certain expectations from the valuation. The market provides observable evidence through prices and transaction multiples while the valuation analyst makes judgements about inputs. The regulator can impose restrictions as well on certain types of valuation assignments.

It is therefore vital to understand the difference between influence and control over the valuation process. The valuation expert has to take into account the data supplied by management and other parties involved, yet cannot accept them as long as they confirm a certain price at which the deal should be done. The quality of the valuation process is defined by whether the assumptions made can be justified.

The Information Behind the Valuation

Valuation starts with gathering data. Historical financial performance of the firm, its budgeting, business plan, operations, market data, and managerial forecasts all affect the result of the valuation. On the other hand, the person providing the information or controlling the source of information has significant power in affecting the valuation result.

Managers usually have the most information about the firm’s operations and future plans. This information could be related to the number of sales, pricing, contract signing, growth strategies, investment in fixed assets, working capital requirements, and financing strategy. The information is very useful for valuations performed via the income approach, where future projections are the main factor.

This, however, is not a guarantee of the reliability of the forecasts themselves. It is necessary for a valuation analyst to analyze the data on which the forecasts were based, compare the performance projections with the past performance and current situation in the market, and question the adequacy of the company’s capacity and financing needs in order to sustain its growth projections.

For instance, it may be the case that the company projects significant revenue growth due to the plans to access a new market or increase the production capacity. This projection then should be verified in relation to the company’s ability to finance the growth, availability of necessary resources, projected working capital needs and any proof of the increased demand assumption. The issue is not whether the projection is conservative or optimistic, but whether the projection is reasonable based on the facts available at the date of the valuation.

The valuator holds a distinct role from management as well as from all parties to the transaction. The valuator neither holds ownership interest in the company nor determines the strategy of the firm or the transaction price. Rather, his role lies in the assessment of the information available to him using proper valuation techniques and arriving at an independently verified conclusion.

This involves more than mere input of the financial data into a valuation model. The valuator must determine the reliability of the source data, the manner in which the management has arrived at the forecast figures, the feasibility of operations based on these forecasts and the ability of the firm to fund these operations. Also, the valuator must check whether the valuation technique used is appropriate, whether the firms chosen for comparison are objective and whether the major assumptions made are self-consistent.

Professional judgment plays a critical role where differing assumptions could lead to significantly differing outcomes. The valuator may have to identify the right peer group, assess the importance of past performance, analyze the risks associated with the particular country and firm, the discount rate and the assumptions regarding terminal value.

It is also not just about absence of conflict of interest. Rather, it involves professional judgment in case there are expectations from management, shareholders or parties involved in the transaction. An assumption or conclusion that is not based on proper evidence should not be accepted just because it gives the desired valuation result.

Who Controls the Income Approach?

The income approach is an excellent example of how various parties can impact a valuation without one of those parties controlling the result of the analysis.

In the case of a discounted cash flow, the projections made by the company’s management will define the basis for revenue growth, margin, capital expenditure, and working capital. Then the valuation specialist evaluates these projections and defines how they will fit the model. In addition, the discount rate is another critical area where judgments are required to be made, while terminal growth and terminal value can also significantly influence the enterprise value.

It is especially important how these projections interact with each other. Higher revenue growth projections may lead to higher cash flows, while higher discount rate may decrease their present value. At the same time, a slight change in the terminal growth and discount rate can also significantly impact the terminal value and, thus, the whole valuation.

This is because the person in charge of the spreadsheet does not have to control the valuation itself. The valuation will be determined by the set of assumptions, both operating and financial, the market information and professional judgement.

The expert must integrate the different factors in the model, instead of looking at each assumption separately. The revenue growth must be compatible with the operating capacity and market potential of the company; the margins can be assessed in comparison with the historical and industry trends; the capital expenditures must be adequate for the projected operations; and the working capital and financing needs must be consistent with the growth projections.

The same holds true for the discount rate. The components of the discount rate must be consistent with the risk of the business, market information, capital structure and currency and inflation assumptions underlying the cash flow.

Who Controls the Market Approach?

There are additional factors that come into play here since there is a heavy reliance on actual market data for this type of analysis.

The choice of comparable companies is arguably one of the key decisions involved in this analysis. The decision to use certain companies as comparables is not because of the attractive multiple, but because of the similarities in terms of size, growth, earnings, financial structure, risk, liquidity, and location among others.

The valuation analyst needs to be able to justify his selection of each of the material comparables and demonstrate why his choice compares favorably to that of the subject company. If the information available is limited, then the analyst should be able to highlight the limitation instead of treating the resulting multiple as an easily observable and comparable one.

This holds true even when considering precedent transactions. The precedent transaction involving a business that operates in a different environment cannot be considered a precedent just because it is in the same industry.

The application of regional or international comparables doesn’t necessarily imply the appropriateness of a valuation. It becomes necessary when there aren’t enough comparable firms in the local market. The important thing is to identify if the factors that distinguish the markets from each other as far as size, liquidity, growth, leverage, and risk are concerned have been duly taken into account.

The consistency of the numerator and the denominator of the multiples used for valuation is equally important. For instance, enterprise value must be compared against an operating metric like EBITDA or EBIT, whereas equity value must be matched against an equity metric like earnings.

Who Controls the Asset Approach?

The asset-based approach is yet another type of judgment. Initially, the asset-based approach might seem to be more objective, since it relies upon the assets and liabilities of the business. Yet, the assessment of the right value of those assets and liabilities could prove to be quite subjective and would require certain professional judgment.

The accounting values of the assets and liabilities might not correspond to their market values. It is especially true when it comes to property-owning business, investment holding company and business with substantial amounts of specialized and intangible assets.

Consequently, the valuation procedure might involve the analysis of the economic value of the properties, investments, equipment, intellectual property and other assets of the business, as well as the liabilities, contingent liabilities and other claims that might impact the value of the equity.

Hence, the asset approach is not about simple subtraction of total liabilities from total assets according to the balance sheet. Rather, it is about the proper identification and valuation of the assets and liabilities according to the chosen basis of valuation.

It is also necessary for the expert to assess if any critical information has been overlooked in this analysis. A contingent liability not accounted for, an out-of-date value of the property, or an intangible asset can have a significant impact on the result. The accuracy of the approach thus depends on both the calculation and the available information.

The Egyptian Context

Who influences the valuation then becomes an important question in the Egyptian context, as there are economic factors which may impact different elements of the valuation simultaneously.

Inflation, interest rates and foreign exchange fluctuations are interconnected factors. Depreciation of the Egyptian Pound, for instance, could both raise the value of the export revenues of an export company in Egyptian Pound terms, as well as increase the cost of imported material, machinery or other inputs. In addition, if the company had foreign currency-denominated debt, the depreciation of the Egyptian pound would both increase the value of such debt and change the company’s financing situation.

In that case, the exchange rate cannot be treated as an independent assumption. The professional valuator should consider the implications of currency fluctuations on revenue, costs, working capital, capital expenditure and debt obligations, as well as the consistency of these cash flows with other economic assumptions in the valuation.

There can also be a similar kind of relationship in the case of inflation. While inflation may have implications for selling price and nominal revenue, it will also impact operational costs, working capital and capital expenditure requirements. In addition, the changes in inflation and interest rates will impact the discount rate of projected cash flows.

This will be especially true for valuing the business through a DCF approach in Egyptian Pound. Nominal cash flows need to be discounted at a nominal discount rate while assuming appropriate levels of inflation. When a business earns its cash flow in a foreign currency, the denominations of cash flows as well as discounting assumptions need to be considered together.

Thus, the valuing of business needs to clearly show how these economic assumptions interact together rather than just state each one of them separately. The more a business interacts with inflation, exchange rates and cost of finance, the more relevant it becomes to assess this relationship between these factors.

The Regulatory Dimension in Egypt

Another aspect is related to the regulatory framework in terms of how and in what way valuation is influenced by the respective regulations. The Egyptian Standards for Financial Valuation of Enterprises have been released by the Financial Regulatory Authority in Egypt. The current framework is a result of amendments to the existing standards for financial valuation. These standards deal with issues related to conduct, competence, scope of work, procedures, assumptions, methodologies, and financial valuation reporting.

Nevertheless, it is important to understand that the scope of valuation from a regulatory perspective needs to be determined depending on the purpose of the valuation assignment itself. Not all valuations made in Egypt have to comply with FRA registration, reporting and other requirements. Whenever the specific valuation assignment is related to some regulated transactions and activities, one needs to identify the appropriate Egyptian requirements, which include requirements for the eligibility and registration of the valuation providers.

It should be noted that regulation does not imply that the regulator will determine the commercial value of the company in question. Rather, there are certain requirements to the way particular valuation assignments are made.

In this context, it is important for a valuation expert to ascertain the legal environment pertinent to the valuation task at hand, instead of making an assumption that the same set of legal provisions apply to all valuations. This includes considering the reason behind the valuation, the nature of the transaction, the asset or business to be valued, and the Egyptian laws that apply to it.

When Does Influence Become a Valuation Risk?

It should be noted that stakeholder influence on the valuation is not a bad thing by itself. There are always assumptions within any valuation, and assumptions will always incorporate judgments on future prospects. But what matters is when there is no way for the expert to make his own professional judgment because of stakeholder influence.

A shareholder might have certain expectations regarding the value of a company. Management might have a grandiose development strategy. A buyer might have a certain price at which the deal is to be closed. All of these factors by themselves do not make the valuation invalid.

The problem is when the entire process of valuation is conducted in such a way as to achieve a predetermined goal rather than to make objective conclusions based on the available data.

Therefore, suitable precautions need to be taken. Material assumptions must be backed by evidence, material changes suggested by management and/or transacting parties need to be made known and accounted for, and sensitivity analysis needs to be carried out when the conclusion reached is highly dependent on uncertain assumptions. Unresolved limitations need to be reported instead of being hidden behind the precision of the valuation number.

Documentation is especially critical when disputes arise while performing valuations. A record of the information that has been taken into consideration, the assumptions that have been questioned, the suggested changes and the reasons for agreeing to or rejecting them is evidence that the conclusion reached was arrived at through professional opinion and not stakeholder guidance.

When the evidence available does not support a particular conclusion, the expert needs to take a stand and not support an otherwise commercially favorable conclusion.

The Role of the Valuation Professional

The valuation professional plays a crucial role in ensuring discipline in the valuation process. The expert must be able to separate facts from assumptions, the management’s expectations from independent evidence, and market data from professional judgment.

An experienced expert would be capable of explaining the basis for the verification of the source data, testing the management’s forecast, determining if the firm had the capability and the finance to meet the targets set by management, reasons why particular comparable firms were used, and how the main assumptions were reconciled in the valuation model.

The expert could also explore other assumptions that can be used and the sensitivity of the result to changes in the main valuation driver. The issue becomes more relevant if there is high uncertainty in exchange rates, interest rate, commodity prices, margins, or future growth of the business.

Maintaining independence would be much easier if such judgments are recorded at the time of the valuation. When management or transaction parties ask for modification of any of the assumptions, the expert would have to understand the rationale and record it.

It is not the job of the expert to control the value in the way that determining the number would be done. The expert is responsible for controlling the discipline of the process, including testing the data, questioning the assumptions, choosing and using the methodologies, harmonizing the model, and revealing material constraints.

Conclusion

Who truly controls the valuation?

There is no entity that can rightfully dictate the value of a business. While management is responsible for most of the inputs and projections, expectations might exist from shareholders and involved parties regarding the end result, there are data from the markets available and requirements set by the regulators for specific cases. All of these entities might be able to impact the valuation process, but impact does not equate to the power to control the result.

It is the job of the valuation expert to come up with a tested, documented and defendable conclusion. The expert’s responsibility is to check the quality of the data provided as the input, to evaluate management’s projections compared to practical needs of operation and finance, to choose the comparable businesses in an objective way and to reconcile the assumptions in the model.

In the Egyptian case this is especially critical as the variables such as inflation, exchange rate movement, interest rates and access to local market data might interact and significantly affect the business value. Any change in any economic assumption might have positive and negative consequences for the different aspects of the business.

In the end, the outcome is computed in the spreadsheet; however, it is the professional judgment that decides whether this outcome can hold up under the scrutiny. The true test for any valuation is not how much anyone affected the outcome, but how the expert can prove that the decision was made in an unbiased manner based on the facts and in accordance with the corresponding valuation concept.

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