Open market value
Valuing an asset has never been an easy business. But at least until a year or two ago there was one assumption that would have rarely been questioned: values should continue to steadily head up.
Now that has changed, a lot of corporate clients could be holding assets worth less than their purchase price. And with the triggers of corporate failure, fraud, extraordinary write-offs, financial misstatement or plain tax planning, the issue that legal counsels may have to dispute or defend on behalf of investors, directors and auditors is: was this 'new' market value fair or distressed?
Let's take a simplified example where investors own the equity of a listed company that they bought for £10m two years ago. The original price was based on £5m of physical assets and £5m in goodwill and intangible assets.
Now the business has been written down to £8m in the books but the market is valuing it at £6m. Which is right? Technically, if the original valuation was based on open market value then the 'new' market valuation should now be relied on.
But then again, it is also the case that the market can overshoot or undershoot 'true' value when at a peak or a trough. The problem is that any over or under-pricing only becomes apparent with hindsight. So the situation going forward is hardly clear-cut.
And, more importantly for legal professionals, in the event the company failed, how would you defend a £8m value as reasonable when the market was saying £6m at the time?
Well, first let us be clear about what financial reporting standards are trying to do with valuations in the books of companies. The goal is that valuations tell the public about the cash flows and risks of those investments. If this is done objectively, then market discipline and efficiency have a platform to work from.
The eye of the beholder
So what arguments might win out when a conflict arises from a difference between the market and a company's accounts?
One way is to argue the higher value is correct based on an analysis of the underlying cash flows of the business and their inherent risk. If these have been adjusted to take account of the new market conditions, there is a case that the discount rate can stay roughly the same as it has been in the past. To adjust both for the one factor might result in double-discounting the value.
If you can demonstrate that customer demand, supplier and employee arrangements and so on have largely been unaffected, it could go a long way to support the case that the market is undervaluing the business on this occasion. When all is said and done, fair value results when the rewards are commensurate with the risks.
Another source of support is to look at what is happening to the market capitalisations of other companies in the sector.
If, for example, comparable companies are also reporting net assets that are above their market caps, then you won't be alone in suggesting that negative sentiment rather than fundamentals are causing the difference.
A further possible defence is that, as the International Valuation Standards Committee points out, value is not the same as price. (Or, to quote US investor Warren Buffett: 'Price is what you pay. Value is what you get.')
However, demonstrating that can be a tricky matter, as many have found to their cost that you can't beat the market.
The technical arguments
The bottom line is that if it was difficult to justify a valuation previously, it is even more so now – unless your technical arguments are strong and logical. The main factors that can come under fire are:
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The economic drivers of the business, both macro and micro
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The inherent difficulty of forecasting cash flows
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Determining the discount rate
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Determining the long-term growth rate
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What discounts and premiums might be relevant to equity values
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Factoring in the business cycle (i.e. the possible impact of the next financial surge or crisis)
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Distinguishing between market sentiment and fundamentals
Whichever side of the fence you find yourself, it goes without saying that winning a valuation dispute is very difficult without a detailed and up-to-date knowledge of the subject. This is a matter where expert input is practically indispensable.
To discuss this article or valuation issues in general, contact Trevor Slack on trevor.slack@bdo.co.uk or 020 7893 3698.
