PwC – Market uncertainty drives investors back to the basics

12 April 2010 PricewaterhouseCoopers (PwC)

In its continued drive to provide insights into the valuation methodologies, assumptions and parameters used by South African analysts and corporate financiers, PricewaterhouseCoopers (PwC) is pleased to present the fifth edition of its biennial Valuation Methodology Survey.

The publication titled “Signs of the times: Valuation Methodology Survey 2009/2010” reflects the views of 27 South African financial analysts and corporate financiers. Fair value has taken centre stage in the wake of the recent global economic crisis and respondents to the survey could provide unique insights into the impact of the crisis on corporate valuation principles in South Africa.

Jan Groenewald, Valuation & Strategy Leader: PwC Corporate Finance says, “There was a noticeable increase in the number of comments and questions received from participants compared to the previous years. This could be reflective of the focus on fair value and its underlying assumptions and principles in a post-crisis environment. It also provides us with assurance that the survey is meeting its objective of stimulating debate among valuation practitioners in the South African market.”

Specific questions addressed in this edition of the survey relate to the elements of valuation most frequently discussed during the crisis. These include among others:

· Thoughts around the length of the downturn and the likely recovery;

  • Changes in the equity market risk premium and risk premiums demanded by equity investors in a post-crisis environment; and
  • The general impact of the crisis on cost of capital with specific reference to the impact of the decline in equity markets and a perceived increase in the cost of debt.

As turmoil, loss of value and market uncertainty drive investors back to the basics of the valuation process, the application of solid theory backed by an astute analysis of the economy, the industry and company drivers has become more important. Groenewald continues, “This survey not only provides an insight into post-crisis thinking but also provides an update of the basic valuation inputs, assumptions and methodology issues surveyed in previous editions.”

How long will difficult trading conditions last?

The analysis of company budgets and forecasts plays an important role in valuing a business. Valuation practitioners are therefore in a unique position to gauge market sentiment. According to the survey, South African companies are generally forecasting a return to “business as usual” during the course of 2011. 71% of market participants expect an end to the economic downturn in the first half of 2011 but a sizeable minority expect difficult trading conditions to persist into the second half of 2011. 18% of respondents were more optimistic, and expected trading conditions to improve during 2010.

The shape of the recession (U, W or V) is often debated amongst economists, the financial press and the public. 70% of respondents believe that we can expect a U-shaped or protracted recession with no immediate upturn.

We also wanted to assess respondents’ perceptions regarding the impact of the crisis on South Africa versus developed and developing markets. 74% of respondents believed that South Africa was less affected than developed markets. In terms of developing markets 49% of respondents felt that South Africa was equally affected and 44% felt South Africa was again less affected.

How has the economic crisis influenced perceptions of market risk?

Equity market risk premiums are a key indicator of the level of perceived risk in equity investments and any increase in the risk premium would provide an indication of increased levels of perceived risk, which would lead to lower equity values over the longer term. Respondents were asked if they changed their view of the equity market risk premium as a result of the current economic downturn. 66% made no changes, although a sizeable minority increased their market risk premium.

However, one third of respondents are including specific risk premiums in the discount rate to reflect current economic uncertainty. This indicates that a number of respondents are pricing additional risk in the discount rates they apply. However, most respondents are taking a longer term view of equity markets and have not changed their outlook for market risk premium.

There is little consensus amongst respondents on how widening debt margins should be addressed in valuations. Some respondents take a longer-term view and do not make adjustments, while others commented that the adjustment would be based on the nature of the company and the industry in which it operates.

The findings suggest that there is a strong consensus in the market for the use of a long-term, normalised data for the purposes of evaluating market valuation assumptions.

How do companies address cross border risks?

South African companies are increasingly expanding their global profile and are investigating opportunities in the rest of Africa. In a cross border mergers and acquisitions (M&A) process, it is critical that a prospective investor asses and quantify the risks inherent to investing in different sovereign territories.

Whether we should add a country risk premium and use a higher equity risk premium in certain markets is an important question in the realm of international investments. Although it appears to be intuitive to require a higher risk premium in emerging markets than developed markets, there are some arguments that favour a global equity risk premium.

The survey indicates that country risk differentials are recognised mainly through adjusting local discount rates with a country risk premium.

Groenewald concludes, “It is clear from the results of the survey and our recent market experience that more market uncertainty requires financial analysts and corporate financiers to expand and deepen any valuation analysis they perform. In addition the increased focus on fair value in both corporate actions and corporate financial reporting will increase scrutiny on assessments of fair value made by companies. As a result, companies are likely to benefit from the involvement of experienced valuators in their transaction or corporate governance processes. ”

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