The Influence of Stakeholders on Business Valuation

Audio

Valuations are often considered to be exercises that involve figures obtained from financial statements, market figures, projections, and standard methods like the DCF method, market multiple methods, and asset methods. But the figures used in these methods are not independent of the people behind them. Management, investors, shareholders, and deal makers can affect the assumptions involved in valuations without actually affecting the method of valuation.

The above becomes particularly relevant in transactions concerning private businesses, takeovers, capital injections, restructuring, and other businesses where past financial success does not necessarily translate to future economic prospects. Sales growth, profitability, capital investment, working capital needs, discount rates, terminal growth rates, and even the choice of comparable firms are all influenced by the expectations and motivations of the stakeholders involved.

However, recognizing these effects is not meant to lead us towards subjectivity in valuations. Instead, it shows us the significance of drawing the distinction between the value derived from the financial model and the underlying assumptions and motivations behind the model. Thus, good valuations need not just modeling abilities but also skepticism and understanding of the environment within which the valuation is carried out.

Management’s Influence on Business Valuation

The role of management is likely to be most influential on valuation since management generally prepares the business plan, budget, and forecasts for the enterprise. The forecasts used in the DCF valuation will play an important part in the valuation results obtained. Even a slight change in forecasted growth rate or EBITDA margin can lead to a big difference in enterprise value.

The involvement of management is not necessarily inappropriate or even deliberate. Management usually has more information about its business operations, clients, manufacturing capabilities, pipeline, pricing policy, and investment plan than an external valuer. Nonetheless, there might also be other interests of management that determine the assumptions used. For instance, sellers might want to show their future performance to be better, while management seeking funding or capital raising might focus on the growth prospects of the company.

It is for this reason that the valuer’s function is not merely to take the forecast made by management at face value but to examine the rationale and underlying reasons for management’s forecast. Factors such as historical performance, industry trends, capacity, customer contracts, competition, capital needs, and macroeconomic factors need to be taken into account in doing so.

The Difference Between Management Forecasts and Valuation Assumptions

One of the key differences between the two in valuation is that a management forecast does not equate itself to a valuation forecast. The management might make a business plan considering certain strategic considerations, internal considerations, or even just on the basis of a positive assumption, while the valuation needs to be made on the basis of realistic assumptions.

As an example, the management of the firm may project revenue growth at a rate of 25% annually due to the fact that the firm plans to expand its market reach. It is important for the valuer to understand whether the firm has the necessary production capacity, distribution system, consumer demand, working capital, and investment necessary for realizing that projection.

This becomes even more crucial when the result of valuation is extremely sensitive to a few assumptions only. For that matter, a professional valuation must make it clear where the assumptions are coming from management, where they are independently arrived at, and where they are modified according to market experience.

The Role of Investor Expectations in Business Valuation

Valuation is affected by the perception of risk and return on the part of investors. For example, even two investors with the same set of information about the firm can reach different valuations due to differences in investment horizon, financing power, strategies, or risk tolerance.

The financial investor might be most interested in cash flows, exit multiples, leverage, and internal rate of returns. In contrast, the strategic investor may perceive some extra values resulting from the acquisition of the firm such as economies of scale, customer base, market expansion, technology, or vertical integration. These values could be different from the standpoint of one buyer compared to that of another.

It is vital to distinguish among the three since they are not always the same. The strategic buyer is usually ready to pay more compared to a financial buyer since the firm being purchased will provide extra value within the context of the buyer’s own company. However, the presence of such strategic value does not necessarily have to be incorporated in an ordinary valuation.

Dealmakers and the Negotiation Effect

It can be argued that the investment bankers, M&A advisors, brokers, and others involved in the deals have considerable power over the value of the deals since they determine the way in which the deal will be presented to the potential purchasers and the way in which the negotiations will be carried out. This power is not only limited to bringing together the buyer and seller but also extends much further.

The price at which the deal closes in competitive transactions may be affected by certain things which do not necessarily affect a valuation model. Competition created by more than one buyer can create competition for the asset while having fewer bidders can undermine the negotiating power of the seller. The timing and significance of the target can affect the agreed price.

Therefore, the actual transaction price cannot be assumed to be proof that the enterprise being sold was objectively worth that much. Rather, it could be the product of a particular negotiation conducted by particular individuals in particular conditions.

The Hidden Influence of Incentives

The power of incentives is among the most significant yet invisible forces in the valuation process. There could be very different motivations behind what seems to be talking about the same number.

It is likely that the seller has the interest of extracting maximum from the headline deal price in mind. The management may have the interest in maintaining control, job security, or receiving bonuses. The buyer may have the interest in the synergies or reduction in the first time cash flow expenditure in mind. The interests of the existing shareholders will vary according to whether they are exiting or will remain invested.

These interests may affect the assumptions, bargaining positions, and even the form of the transaction. In case of dispute over the values, the problem may be solved through the means of earn-outs, contingencies, deferred payments, and other means, rather than through the modification in headline valuation.

In this regard, the valuer must consider not only the numerical results but also the reasons for such interests of the parties.

Comparable Companies

It may seem that the comparable companies analysis is the market-based method of company valuation and hence quite an objective one. Nevertheless, the selection of comparable companies is quite a subjective task requiring much professionalism.

A company may be benchmarked against other firms working in the same industry as it, but differing from it in geography, size, growth rate, profitability, debt load, customer concentration, and business model. By selecting firms having high trading multiples, we can receive a higher valuation and vice versa by choosing firms having low multiples.

The problem under discussion does not mean at all that the comparable companies valuation approach is subjective or unreliable. On the contrary, it illustrates the need for the explanation of the criteria for selecting and not selecting the comparable companies.

Forecasts Can Be Influenced Without Changing the Numbers

The influence is not always exerted through any overt manipulation of numbers. It can be done through the assumptions on which these numbers are based.

In such situations, the management may come out with a revenue forecast that sounds plausible enough, but it will rely upon unusually quick improvements in collection periods, lesser inventory needs, minimal capex, and/or widening of margins. Individually, each of these assumptions might seem defensible, but collectively, they result in a biased valuation.

That is why valuation must examine the consistency of assumptions. The growth in revenues should be consistent with the capacity and demand for it; margins must be reflective of the competitive landscape; the working capital requirement must fit into the operating philosophy of the firm; and capex should be in sync with expected growth.

Deal Structure Can Change the Perception of Value

The mechanics of a transaction could hide the economic substance of what is being exchanged. Transactions could include cash payment, stocks, earn outs, seller financing, debt assumption, or any other forms of contractual obligations. The focus on the headline acquisition price could fail to fully grasp the economics of the deal.

For instance, the buyer could agree to pay more in headline price but delay the consideration or make part of it contingent on future performance. Or the headline price could be lower, with a corresponding assumption of significant debt or other liabilities.

It is critical for a valuation expert to be able to separate enterprise value from equity value and consideration for shareholders. The proper understanding of the transaction mechanics is key in assessing whether the price quoted is truly comparable to the valuation approach adopted.

Egyptian Market Localization

The influence of the stakeholders is especially relevant when valuing an Egyptian company due to the possible influence of inflation, exchange-rate fluctuations, interest rates, availability of foreign currency, import dependence, and working capital needs on the valuation assumptions.

When dealing with an Egyptian company that depends on imported raw materials or equipment, for instance, an exchange-rate fluctuation will affect the company’s revenue, cost of goods sold, capital expenditure, and working capital at the same time. This way, the management’s forecast of stable margins not taking into account the foreign currency exposure of the business may be unrealistic.

In addition, interest rates can have a material impact on the valuation. The increase in financing expenses will affect debt repayment, investments, working capital, and ultimately the free cash flow. Changes in the inflation rate and monetary policy can affect the risk-free rate and equity risk premium in the discount rate.

In order for the currency of valuation to be appropriate, it must be consistent with the cash flows being valued. If a valuation has been performed using the EGP as its currency, then all of the assumptions must reflect this, whereas if the valuation uses US dollars as its currency of valuation, the discount rate applied to the valuation must be consistent with the cash flows in US dollars. Furthermore, it is important to understand the difference between country risk and the real risk exposure that the company faces from its foreign currency, inflation, import costs, and foreign currency needs.

This may be particularly important when dealing with transactions in Egypt where expansion plans are overly optimistic, where capital raises have occurred, where acquisitions have taken place, or where changes have been made to the company’s financing structure. Expansion plans that look good on paper, but which require foreign currency funding or changes to working capital that are not accounted for in the projections, or related party transactions, can be examples of such cases.

The difference between listed and privately held firms is also significant. It is possible that listed firms in Egypt would enjoy market prices and information that are publicly available, while their market prices are still influenced by liquidity and the state of the markets. Private firms will tend to depend on management information, which implies that there will be less transparency in market information.

In the case of Egypt, it is necessary to take into account the existing legal environment as well. This environment is represented by the Egyptian Standards for Financial Valuation of Enterprises, while the Financial Regulatory Authority recognizes these standards as mandatory for valuation activities carried out pursuant to capital-market laws and regulations. Thus, the valuer should define the purpose, legal environment, and basis of value before choosing an appropriate approach and assumptions.

The Valuer’s Role

This should not be taken to imply that the valuer can ignore the information supplied by the parties. In many instances, the most reliable source of information regarding future business operations of the company is management. What needs to be done is to treat this information critically and objectively.

The task of the valuer, thus, is not to replace management’s knowledge with his own subjective opinion, but rather to question, validate and, if necessary, modify the management’s assumptions. This can be done through benchmarking the forecasts with actual performance of the company and the industry, market data, capacity limitations, peer companies, etc.

Independence in valuation does not equate to lack of any assumptions. Every valuation includes assumptions. What needs to be done is to make sure that such assumptions are explicit, internally consistent and proper for the given valuation purpose and basis.

Skills Required of a Modern Valuation Expert

The role of the valuation practitioner goes far beyond creating financial models. Modelling skills remain critical, yet professional scepticism, source verification, due diligence, management of conflicts of interest, documentation, and communication of uncertainty are required for a good valuation.

Professional scepticism is especially crucial when evaluating management’s forecast or deal information. The valuation practitioner needs to be ready to challenge the assumptions that do not look reasonable against historical experience, market environment, financing possibilities, production capacity, and any other external indicators. It does not mean that management is wrong. It just means that key assumptions need to have proper support.

Source verification is another area that is critical for a good valuation. Management accounts, audited accounts, market data, contracts, technical reports, forecasts, studies of industry and competitors, and many other sources can be used during the process of valuation. The valuer should know their pros and cons and keep proper documentation regarding the way how critical input data was gathered and evaluated.

Managing conflicts of interest is yet another vital professional skill. The valuer must be able to detect potential influences on independence or objectivity and ensure adherence to relevant professional and regulatory rules in this area. Proper communication is just as important. All stakeholders must understand which assumptions were provided by management, which were independently developed, which remain uncertain, and how those uncertainties impact the valuation process.

The valuation expert working in Egypt must also be familiar with the applicable Egyptian requirements and rules for financial valuation. Specifically, the FRA provides for licensing and professional competency rules for the conduct of financial valuations, as well as registration rules for financial valuation firms carrying out financial valuations and fair value studies. In other words, technical skills should be supplemented by the knowledge of the regulatory rules for the relevant task.

Knowledge of local market and sector characteristics is especially important in valuation. The valuation expert in Egypt may need to take into account the influence of inflation, changes in exchange rates, foreign currency risks, financing limitations, liquidity issues, dependency on imports, working capital needs, and the availability and reliability of comparables data.

The practice of valuation internationally also recognizes the quality of information and assumptions used, proper documentation, and disclosure. These values emphasize that the process of valuation should not just be an exercise of calculations but the process of arriving at a well-supported conclusion.

Ultimately, a good valuation is not one that generates a value. It is a valuation that gives clear explanation as to why the value arrived at was such.

A professional valuer ought to be able to determine the assumptions that have more influence on value and determine if they are reasonable or not.

For example, in a discounted cash flow analysis, the critical assumptions are often revenues growth, EBITDA margins, working capital, capital expenditure, WACC and terminal growth. In a market valuation, the important assumptions are often the choice of comparable firms and the multiples used. In an asset-based analysis, it could be the values for each of the assets and liabilities.

This approach makes sensitivity and scenario analysis very useful since rather than give just one result for the valuation, the impact of change in the key assumptions could be shown.

Conclusion

Valuation is first and foremost a process of financial analysis, but it is also a process that is inherently driven by people. The management drives the estimates, the investors drive the expectations, the stockholders drive the objectives, and the deal-makers drive the negotiation process. Such influences may well be legitimate and financially significant, but they may also give rise to motivations that must be identified and assessed carefully.

A valid valuation process must thus always start with identifying the reason for the valuation and the associated basis of value, followed by a review of the material assumptions, their underlying evidence, and any stakeholder influence. Any material conflicts must be identified and recorded, the key assumptions validated against independent evidence, and any material uncertainties presented in sensitivity and scenario analyses.

For the purposes of the Egyptian market, however, the above process also has to take into account inflation, changes in the exchange rate, changes in the interest rates, foreign currency exposure, financing issues, market liquidity, and the Egyptian requirements concerning valuation.

It is also worth noting that the best valuations are not those that are done by the most complex models. The best valuations are the ones in which there is clarity about the purpose and the basis of value, where the assumptions are transparent, the evidence has been evaluated correctly, there is a disclosure of conflicts, there is an identification of uncertainties, and the interests of different parties have been identified and properly considered.

Frequently Asked Questions

Add Andersen in Egypt to Google Preferred Sources

Make us your preferred source to ensure you always get accurate information. Access our peer-reviewed, highly reputable, and unique research directly through Google.

Add

To find out more, please fill out the form or email us at: info@eg.Andersen.com

Contact Us