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Business Valuations
Ensuring all the valuer’s ducks are in a row

(Published in the De Rebus Magazine – 2013)

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An attorney often needs to liaise with or refer his or her clients to an independent valuer to determine the value of a business, whether owned by a legal entity, an individual or a partnership. This may be to assist a client wishing to sell a business to determine the value thereof, to determine value for purposes of resolving shareholders’ disputes, to comply with the Companies Act 71 of 2008, for objecting to property valuations, or for a myriad other reasons.

Valuations have increasingly become a specialised field and care should be taken when appointing a valuer to ensure that he or she will be capable of defending his or her valuation if it becomes necessary to do so, whether in the course of negotiations, legal proceedings or at any other time. This increased specialisation is due mainly to technical developments that have taken place in regard to various valuation methodologies coupled with arguments that have developed around the applicability of different methodologies, the correct application of different models and the underlying assumptions used in connection with the valuation.

Accordingly, whenever a party scrutinises a valuation, a range of areas should be probed to ensure that the value can be defended, including –

the reason for having chosen the particular valuation methodology;
the applicability of the methodology;
whether the valuation model has been correctly applied;
the quality and reliability of the information used; and
the underlying assumptions applied in connection with the valuation.

This article elaborates on some of these aspects.

Areas that need to be probed when scrutinising a valuation

Below are brief commentaries on some of the areas that need to be probed when scrutinising a valuation.

General principles

First and foremost, the underlying principles applied by the valuer must be sound, particularly if the valuation may need to be defended. These include:

Frameworks and standards: All valuations should be based on a sound framework and an acceptable standard. For instance, the International Valuation Standard Council’s international valuation framework (IVF) and valuation standards are recognised as international generally accepted standards for supporting valuations (also by various professional bodies in South Africa).

The definition of ‘market value’: According to the IVF, the definition of ‘market value’ is: ‘The estimated amount for which an asset should exchange on the valuation date between a willing buyer and a willing seller in an arm’s length transaction, after proper marketing and where the parties had each acted knowledgeable, prudently and without compulsion’.

This definition should form the basis of any valuation of market value.

Whatever the valuation model applied, the valuation process will entail estimates, scenarios, judgements and assumptions by the valuer. It is up to the valuer to decide how these elements will be incorporated during the valuation process and to what degree they will influence the value. More often than not, a financial forecast will also form part of the valuation and here too different forecasting techniques can be used. Consequently, there is scope for differences of opinion on numerous levels.

The valuer must be able to justify his or her estimations and assumptions and be able to demonstrate their influence on value under different scenarios. This will give clarity on how the valuation will change when possible differences of opinion are applied to the model or where circumstances change significantly.

Importance of information used

The information furnished to a valuer for purposes of the valuation determines the valuation methodology that will be applied and the underlying assumptions that will be made, and will show up potential areas requiring more research or additional information. The reliability of information is of critical importance.

It should be clear from the valuation itself that the valuer has applied his or her mind to the quality and applicability of the information used. In this regard, independent verification always remains an option.

Impact of different degrees of ownership on valuations

The value of an interest in a business is significantly influenced not only by the weight of the shareholding being valued but also by the actual rights that attach to the shareholding.

In theory, the more influence a shareholder has on the business, the higher the value (control premium) and vice versa (minority discount), assuming that the shareholder has the best interests of the business at heart and is a competent decision-maker.

The factors influencing a value and the degree to which those factors influence the value form part of the valuer’s judgement. A clear understanding of the valuer’s thought process and reasoning is thus essential when scrutinising a valuation.

Exposure to risks

Different businesses are exposed to different risks. Consequently, these risks first need to be identified and, secondly, the impact of the risks needs to be factored into the value. The principle is that the higher the risk, the higher the required return, which in turn influences the value, since a higher required return will lead to a lower value.

Risks can be categorised as systematic risks (all businesses are exposed to these risks although on different levels, eg, inflation risk, interest rate risk, foreign exchange risk, etc) or specific risks (specific to the business, eg, dependence on key management, one key customer or supplier, start-ups, etc). Technically, these risks are dealt with differently in different valuation models.

In addition, the marketability of shares in an unlisted company should be taken into account.

Again, it is in the discretion of the valuer to determine the applicability of the risks influencing value and the degree to which those risks do so. Once more, a clear understanding of the valuer’s thought process and reasoning is essential when scrutinising the valuation.

Applicability of valuation methodologies

The choice of valuation model will most probably have the biggest influence on the final value determined by the valuer.

There are several theoretical valuation methodologies available to value a business. These include Gordon’s dividend growth model, market approaches, income approaches, for example, discounted cash-flow models (free-cash-flow-to-firm and free-cash-flow-to-equity models), the net asset value approach and the economic value-added (EVA) approach.
As the application of a particular model is in the discretion of the valuer, the reasons for having chosen a particular model and the applicability thereof should also be apparent from the valuation itself.

Conclusion

The calculation of the value of an interest in a business is a process in which various building blocks are used, information is analysed and different methodologies are available for application.

The credibility of a valuation ultimately lies in the ability to support the value and to be able to substantiate and verify the reasoning behind the chosen methodology and the underlying assumptions. This is, more often than not, dependent on a complete theoretical understanding of the various valuation methodologies, an ability to apply financial modelling techniques (eg, forecasting and discounting techniques), experience in incorporating assumptions, being abreast of market conditions and the ability to evaluate applicable risk factors.

To ensure that a valuation is able to withstand scrutiny, a party to the valuation must ensure that, at the very least, the matters raised in this article have been dealt with.


 
Christiaan Vorster CA (SA) is a business adviser at Business Growth Africa in Cape Town.
Contact: christiaan@businessgrowthafrica.com
www.businessgrowthafrica.com


Engaging a Financial Expert
Put it all in the Brief

(Published in the Without Prejudice Magazine – 2013)

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I was recently contacted by an attorney to act as an independent financial expert in a valuation matter. I was given a short telephonic brief that I interpreted as being to assess someone else’s business valuation from the perspective of the majority shareholder with a controlling interest in and an extensive knowledge of the industry in which the company being valued operates. After I had spent some time on the assignment and raised some pertinent questions, the answers I received from the instructing attorney revealed that, in fact, they are acting for a minority shareholder without a controlling interest. This obviously had a major influence on the assessment of the original valuation!

Miscommunications such as this can easily happen and ultimately result in loss of valuable time and extra costs. Which brings me to the importance of the brief. Although the items I highlight below appear to be straightforward and matters of common sense, it is prudent once again to revisit the contents of a brief to a financial expert.

From a financial expert’s point of view, the following items, amongst others, should be considered when preparing a brief:

The brief should be in writing

Even though the brief may be given at a meeting, the contents of all meetings or telephone calls should be confirmed in writing. This will ensure that any misunderstandings are cleared up immediately.

Background to the assignment should be complete

A detailed background to the assignment, the reasons for engaging the expert, the parties to the matter and the process leading up to contacting the expert need to be included in the brief. If the assignment relates to a legal matter, the facts of the matter should also be included.

The scope of the assignment

Exactly what it is that is required from the expert should be clearly spelt out. For example:
   - an independent opinion (i.e. on value);
   - advice on whether accepted standards have been adhered to (e.g. International Valuation Standards);
   - advice on the proper financial model which should be used (e.g. a valuation model or forecast).

Information available

The expert should have firsthand knowledge of all information and information sources available for the assignment. That way the expert can assess if additional information is required before commencing with the assignment.

The timeline for issuing feedback regarding the assignment should be included in the brief

The format of the feedback required should be stated.
For example:
   - a valuation report, or
   - an independent opinion.

Any future potential engagements in connection with the assignment should be indicated.
If the assignment forms part of a current legal matter, potential dates for arbitration, appeals, court appearances, etc. should be stipulated.

Ensuring that the brief is accurate will help greatly in eliminating possible misunderstanding and ultimately save time and costs for all parties involved.




 
Vorster, CA (SA), heads up the business advisory Business Growth Africa.
christiaan@businessgrowthafrica.com.


Facilitating Expansion Decisions
Guidelines for evaluating potential growth projects.

(Published on the Entrepreneur Magazine’s website – 2012)

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Introduction

Businesses continuously have to make important investment decisions relating to the question of whether they should invest in new projects or other expansion opportunities with the aim to grow the business. These investments generally require a large capital commitment upfront (in the form of the acquisition of various assets such as plant and/or equipment) that will consequently tie up available capital for a period of time. The correct decisions are thus crucial to the long-term growth potential of any business.

Analysis of Potential Expansion Projects

Long-term investment proposals should be analysed and selected based on sound capital budgeting and capital investment principles.

Listed below are the core principles and steps that would help any business in their decision-making process:


All medium and long term investment proposals should be consistent with the business’s strategic goals (linked to its mission, vision and objectives). A business should continuously review its strategic objectives through a logical strategic planning process with all potential investments reviewed on a relative basis for their consistency with the defined strategy of the business.

The financing cost of the “money” or capital that will be invested in a project should be taken into account when evaluating a potential investment. The lower the cost, the higher the net return on any investment. The cost of capital can be calculated as a weighted average of the cost of all sources of financing, be it either from equity or debt based instruments. It is advisable that a business work with a target Weighted Average Cost of Capital (WACC) based on its optimal capital structure, meaning the optimal mix of equity (shareholder funds) and debt financing, where the “average” cost of financing is the lowest from the business’s point of view. Practically a business would then also strive to at all times finance its assets at the optimal mix. The WACC is thus the minimum required return of any project.

Estimates, projections and forecasts of the potential future cash flows that are a direct result of the project under review should be calculated/ determined.
   - The focus should be on the after tax cash flows and not on accounting profit,
   - The life of the potential project should be taken into account,
   - The period in which the cash flows are expected to be generated should be clearly recognised,
   - Adjustments for inflation and potential extraordinary risks should be taken into account.

The cash flows would then be discounted at the Weighted Average Cost of Capital in order to calculate the present value of the cash flow streams that are projected to be generated by any potential project. A potential project will be analysed at a specific point in time, thus the information relating to a project should be relevant to that point in time, hence future cash flows are discounted to their present values.

The Net Present Value technique, highlighted above, is one of the most commonly used project appraisal techniques in industry.

Other project appraisal techniques include:
- Payback Period (time it takes to recoup initial investment),
- Discounted Payback Period (same as Payback Period, except that cash flows are discounted before the Payback Period is calculated)
- Internal Rate of Return (the IRR indicates the compound annual rate of return on a project, given its up-front investment and subsequent cash flows)

Conclusion
Potential investment proposals should be analysed and selected based on sound capital budgeting and capital investment principles and techniques. The Net Present Value (NPV) techniques is one of the techniques that will lead businesses to make the correct decisions when resources are allocated to potential projects, cognisant that the projects are in line with the strategic objectives of a business.


 
Christiaan Vorster CA (SA) is a financial management consultant and heads up the business advisory Business Growth Africa (www.businessgrowthafrica.com). He focuses on the SME sector, specialising in business valuations, strategic planning and budgeting and forecasting. He also facilitates numerous executive courses in South Africa, Europe, Africa, and the Middle East. E-mail Christiaan at Christiaan@businessgrowthafrica.com.


The Basics of Strategic Planning
A logical approach to strategic planning that will help a business reach its full potential.

(Published on the Entrepreneur Magazine’s website – 2012)

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Introduction
What is value?

Strategic Planning is a comprehensive process for determining what a business should become and how it can best achieve those objectives or goals.

Strategic Planning appraises the full potential of a business and explicitly links the business’s objectives to the actions and resources required to achieve them. It offers a systematic process to ask and answer the most critical questions confronting a management team – especially large, irrevocable resource commitment questions.

Steps in Strategic Planning
The pathway to successful strategic planning lies in the following steps:

1. The Creation of a Mission Statement for the Business
The Mission Statement of a Business is a Statement of the purpose of the business which is intended to unify the business to focus towards one common page. A well worded Mission Statement will put all stakeholders (from management to employees to shareholders) “on the same page” and will get all stakeholders thinking along the same lines.

2. Creating a Vision for the Business
A Vision is a realistic dream for the business for the future. With the Mission Statement in mind, a Vision needs to be created and all stakeholders need to “buy into” the Vision. A Vision is normally focussed on the long term and paints the picture of where a business should be heading to or what should a business look like in the long term in a near perfect environment.

3. Translating the Vision for the Business into Short-term and Long-tem Objectives
The next step is to set short-term and long-term measurable and obtainable targets that would ultimately lead the business to its Vision as set out for the business. By linking the objectives to the Vision, the business will focus on achieving the “future realistic dream” it set out for itself.

For strategic objectives to be measurable and obtainable, it should be set out in a structured way, such as measuring each objective against the SMART objectives framework.
SMART objectives:
S – Specific (What exactly are we going to do, with or for whom?)
M – Measurable (Is it measurable and are we able to measure it?)
A – Attainable (Can we get it done in the timeframe, in the climate, with the amount of money?)
R – Relevant (Will this objective lead to the desired result?)
T – Time-bound (When will we accomplish, achieve the result?)

Once objectives have been set in this way, these will be evaluated and re-evaluated on a continuous basis to establish if the business is realising the objectives on its way to its Vision.

4. Putting strategies into place to achieve the objectives

At this stage various possible practical actions plans will be analysed and decided upon to achieve the strategic objectives. Core to the decision on which action plans to be implemented are the following:
- What are the different possible plans available to achieve the objectives?
- Who will implement the plans?
- With what will the plan be implemented (what resources are needed and are the resources readily available)?
- By when will the plan be implemented?

These plans will be business and industry specific and a detailed analysis of each environment will have to be done before a decision on the course of action is taken. Once the course of action is decided upon, a budget can be drawn up. Theoretically a budget is an expression, in financial terms, of the strategic and operation plans of an organisation, for a forthcoming period of time.

Items to be taken into account during the strategic planning process
Various items should be taken into account during the process as mentioned above, especially after the Mission and Vision have been created, preferable on a yearly basis. An analysis of these items will help in setting the measurable and obtainable objectives, as well as deciding on the correct action plans to achieve the objectives.

Listed below are some items to take into account:
- The current Economic Cycle
The economic cycle refers to the fluctuations of economic activity (business fluctuations) around its long-tem growth trend. The cycle involves shifts over time between periods of relatively rapid growth of output (recovery and prosperity) and periods of relative stagnation of decline (contraction or recession).

- The stage in the life cycle of the business’s products
All firms and products have a life cycle. The length of the cycle can vary enormously from business to business. The stages in the life cycle are: Introduction in the market, Growth, Maturity, Saturation and decline. A business needs to analyse where in the life cycle it is to be able to establish its way forward.

- SWOT analysis of the business
Each business should be aware of its Strengths, Weaknesses (Internal Environment) and its Opportunities and Threats (External Environment) to be able to plan for its future.

- PESTEL environment analysis

For Strategic Planning purposes a business needs to know the environment in which it is operating as it will directly influence the course of action. Factors to take into account are Political, Economical, Social, Technological, Environmental and Legal environmental analysis.

- Industry Analysis
Understanding the industry will help in setting the correct plans. The following factors should be analysed:
o How big is the industry?
o Market Characteristics
o Industry Conditions
o Key Competitors
o Industry Performance
o Industry Outlook

- Competitive Analysis
A continuous process of comparing a business’s strategies, products or processes with those of “best-in-the-class” organisations. Such benchmarking will help a business in closing any gaps that might be existing relative to the industry leaders.

Conclusion
Strategic Planning is a comprehensive process for determining what a business should become and how it can best achieve those objectives or goals. It should be done in a logical way with a process approach to enable a business to reach its full potential.

The financial objective of a business, to create wealth by adding value to providers of capital, lies at the core of the whole strategic planning process. All planning activities should ultimately also be weighed against this objective.


 
Christiaan Vorster CA (SA) is a financial management consultant and heads up the business advisory Business Growth Africa (www.businessgrowthafrica.com). He focuses on the SME sector, specialising in business valuations, strategic planning and budgeting and forecasting. He also facilitates numerous executive courses in South Africa, Europe, Africa, and the Middle East. E-mail Christiaan at Christiaan@businessgrowthafrica.com.


Principles in Business Valuations
Essential valuation information for SME owners considering buying or selling a business

(Published on the Entrepreneur Magazine’s website – 2012)

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When embarking on the valuation of a non-listed business, be it for the purpose of buying a stake in a business, selling an existing holding, buying out another shareholder or needing an indication of value for any other purpose, there are some basic guidelines that you should understand and follow. These basic concepts are applicable across any business operating in any industry, be it in manufacturing, agriculture, FMCG or a service based industry.

Valuation basics
What is value?

According to the International Valuation Standard Council (IVSC) the definition of market value is: “The estimated amount for which a property should change hands on the date of the valuation between a willing buyer and a willing seller in an arm’s length transaction after proper marketing wherein both parties had each acted knowledgeably, prudently and without compulsion”.

In a broader context, value arises when a choice is made between alternatives. This choice is necessitated as the principle of scarcity applies to all resources, whether they be natural or economic. Whenever a choice is made amongst possible alternatives, one is foregone. Such a concept is best illustrated with an example:

When investing in a business at a certain cost, the opportunity to invest in another business at the same cost is foregone assuming that the investee has limited investment resources. The potential benefit gained from investing in ‘another business’ may be defined as the “opportunity cost” of investing in the first business i.e. the benefit forgone of the best available alternative.

Alternatively, the seller would assess the opportunity cost of selling his/her share relative to not owning a share in the business in the future. The actual transaction price or exchange value would ultimately be dependent on the opportunity cost of both parties to the transaction, where there is a mutual interest, in particular circumstances, at a particular time.

The impact of different degrees of ownership on valuation

The value of an interest in a business is significantly influenced by the underlying weight of the shareholding being valued within the business.

The rights attached to a majority shareholding (51% or more) can include amongst others the right to sell or issue shares, the ability to determine salaries and bonuses and the decision to pay dividends. When acquiring a majority interest in a company, the investor often pays a control premium for these privileges.

Alternatively, a minority shareholder (less than 51%) is far more reactive, and can generally only voice concern and is more often than not reliant on decisions taken by Management such as the level of dividend payouts to be received. The impact of the lack of control should be taken into account during any valuation exercise, as the power to alter the course of the business and to direct resources will ultimately have an influence on the estimation of value.

In theory, the more influence a shareholder has on the business, the higher the value and visa versa assuming that shareholder has the best interests of the business at heart and is a competent decision maker.

Relying on the valuation of an expert

Where no open market exists for the shares of a business (e.g. being traded on a stock exchange) an expert’s valuation could form the basis of an indication of value at a given point in time.

One should remember that a valuation completed by any expert is merely the expert’s opinion of value at a specific point in time. In determining a reasonable valuation, the expert will apply various estimates, judgements and assumptions. This by no means implies that you are bound by the valuation, except if it has been agreed upon by the relevant parties that an independent expert will value the business and that that value will be taken as the value for future references.

One should always remember that a valuation is inherently dynamic and changeable and wherever alternative estimates, judgements and assumptions are applied it will have an influence on the estimation of value. Furthermore, a valuation is merely an indication of value and not by any means a price. A valuation only becomes a price when two willing parties agree to transact at the generated valuation. Negotiation sits between a valuation and a transaction price.

Valuation models

There are several theoretical valuation models available to value a business. Highlighted below are three models commonly used by valuation experts to determine an estimation of value of a business.

Earnings Multiple based valuation approaches

This methodology involves the application of an earnings multiple to the earnings of the business being valued to derive a value for the business. A multiple can be applied to an earnings base (commonly used P/E multiple); EBIT (Earnings before interest and Tax) or EBITA (EBIT before amortization) to estimate the value of a business.

When applying a Price /Earnings (P/E) multiple, the general practise is to first identify a Price/Earnings (P/E) ratio of a comparable listed company or the average P/E ratio of the sector in which the business operates (these P/E ratios are commonly reported). The rationale behind this is that listed businesses’ have a reported market value “at all times” which can be used as an indicator of the value of similar unlisted businesses.

This market-based approach assumes that listed businesses are correctly valued by the market and that comparable companies or the sector as a whole are in fact truly similar to the unlisted company being valued.

As it is extremely difficult to identify listed companies that are completely similar, the identified earnings multiple is often adjusted (with a discount or premium) for points of difference between the comparable company or sector and the business being valued.

These adjustments are intended to take into account the various influencing factors such as the relative risk of the business compared to the risk of the comparable business or sector, including the size and diversity of the business, the rate of growth, the diversity of product ranges, the level of borrowings and the risk arising from the lack of marketability of the shares.

The adjusted earnings multiple is then applied to a reasonable estimate of maintainable earnings of a business to derive at an estimation of value. A reasonable estimate of maintainable earnings is generally calculated by taking the historical earnings figures (or reliable forecast earnings figures) and adjusting it for exceptional or non-recurring items.

If, for example, an EBIT multiple is used, the same rationale will be followed, an applicable EBIT multiple will be identified, the EBIT of the business will be adjusted if needed (for non-recurring, non-operating items, etc) and a value will be calculated. The value as determined by the above calculation will in turn be adjusted for business specific circumstances and risks to get an estimation of value.

Discounted Cash Flow

This methodology involves deriving the value of a business by calculating the present value of the expected future cash flows of the company. In other words, the expected cash flows generated by the business are discounted at a fair rate of return to calculate an estimation of value at the current valuation date. The sum of these present values and a terminal value forms the basis of an estimate of value of the business. The terminal value is the projected value of the business at the end of the businesses lifespan.

The Discounted Cash Flow (“DCF”) technique consists of two distinct parts. Firstly, an estimation must be made of the amount and timing of all cash flows during the likely period or future lifespan of the business. The likely lifespan will differ from business to business and amongst different industries.

The basic information required to determine the projected cash flows would include, amongst other things, the estimates of earnings, depreciation and tax payable, net movements in working capital year-on-year, net realisable value of all surplus assets and estimations of the likely delay in selling them and the amount and timing of capital expenditure, all on an annual basis over the forecast period.

Secondly, a discount rate must be selected and applied to the cash flows to convert them into the present value. Generally the discount rate will be based either on the Weighted Average Cost of Capital of the business, adjusted for specific factors or it will be determined taking a holistic view on the required rate of return for the business (taking into account the systematic and unsystematic risk factors applicable to the business).

The estimation of the enterprise value will then be calculated by discounting the estimation of cash flows by the calculated discount rate. To get an estimation of value for a shareholding, total debt will be deducted from the calculation above.

Net Asset Value approach

This methodology indicates the value of a business by adjusting the business’s assets and liabilities to their market value equivalents. This model is most applicable for the valuation of businesses that derives its value from investments.

For all other businesses, it is advisable, under certain circumstances, to only apply this method if the business is on the verge of liquidation or split-up, or as a sense check of other valuation methodologies.

Judgements and assumptions

Throughout any valuation process, whatever the valuation model, the valuation expert will have to make his/her own estimations, judgements and assumptions based on information at his/her disposal. Because valuations entail many difficult estimates, scenarios, judgements and assumptions, there is scope for differences of opinion. A valuation can never be a precise figure, it is rather an indication of value which is often portrayed as a range of values. As mentioned, if there is a difference of opinion, you are by no means bound to a transaction by a valuation expert’s estimate of value, except if it has been agreed upon beforehand by the relevant parties.

Understanding the valuation model, estimates, assumptions and their implications

When using the services of a valuation expert, on presentation of the valuation report by the expert, you as the client should interrogate the expert with reference to the choice of model applied. Further to this, the expert should explain all possible deviations from the chosen model and explain its implementation in detail so that you the client/business owner have the same understanding of the underlying model as the valuation expert.

Furthermore, you the client should also question the valuation expert on the estimations and assumptions that he/she has made and the associated influence of these assumptions on his/her valuation, so that you are able to fully understand the impact of changing macro and microeconomic circumstances. This will allow you to see how the valuation will change when differences in opinion are applied to the model or where market circumstances change significantly.

Information

All applicable information needs to be taken into account during the valuation process, from an industry analysis, to financial information (financial statements and management accounts), risk analysis to all relevant legal documents. The quality of information going into the valuation process will influence which model will be used, the estimates, assumptions and ultimately the quality of the estimation of value. Care should be taken that all applicable and necessary information should be taken into account when calculating an estimation of value.

The same holds true should the valuation be performed by an expert – the quality of information given to the expert will determine the quality of the estimation of value. Garbage in equals garbage out.

Conclusion

The calculation of the estimation of value of an interest in a business is a process where various building blocks are used, information analysed, with different models available for application. The answer is always an indication of value and at best an informed estimation of value.

Ultimately, it is always still up to the potential buyer or seller to negotiate the final price and terms and conditions of a potential transfer of interest.


  References:





Valuation of Unquoted Companies, Fifth Edition (2009), Christopher Glover. Wolters Kluwer (UK) Ltd.
Financial Management, 6th Edition (2007), Correia et al. Juta & Co. (SA)
International Private Equity and Venture Capital Valuation Guidelines (September 2009). IPEV Board. www.privateequityvaluation.com
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Implementing a Forecasting Model
Practical advice when considering the implementation of a forecasting model to enhance your business’s financial management.

(Published on the Entrepreneur Magazine’s website – 2012)

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The aim of implementing a forecasting model is to enhance the financial management and decision making capabilities of any business, especially if the forecast is updated on a regular basis and a future rolling component is added during each updating period. For example, a twelve month rolling forecast implies that after each month the forecast will be updated and another month will be added to the forecasting period. Thus, at any point in time, the business will have a twelve month forecast. The update could also be quarterly or even six monthly, depending on the business’s needs.

Listed below are a number of recommendations to take into account during the design of a forecasting model. However, before the design and implementation of any forecasting model, a number of financial planning principles have to be highlighted:

The relationship between Budgeting and Forecasting

The relationship between Budgeting and Forecasting needs to be clearly understood by all relevant parties. The definition of a budget is an expression, in financial terms, of the strategic and operational plans of an organisation for a forthcoming period of time. A budget is generally goal orientated and based on future strategies and plans.

Theoretically, some of the main purposes of a budget are:
- Resource allocation (linked to the strategic plan)
- Putting performance targets in place
- Control and measurement
- Putting everybody on the “same page”
- Focus on the end result for the budget period (setting overall defined financial goals).

A forecast is an expectation, based on all available information at a point in time, of what the near term future may in reality look like. It is based on actual expectations of the future without any influences (e.g. goals or targets).

Theoretically, some of the main purposes of a forecast are:

- Enhancement of management decision making processes, based on a reaction to near term future expectations,
- Ongoing value creation activities and continuous improvement of activities and processes
- Continuous improvement of the accuracy of forecasting and management information
- Behaviour changes from defensive (reactive) to offensive (proactive)

Forecasting is a planning discipline of facing reality; it aims to show the latest reality. It should be highlighted that Forecasting is a management tool in its own right based on foreseen reality and not a rolling budget based on updated goals or targets.

Responsibility and Ownership of Financial Planning

The responsibility for all financial planning, including budgeting and forecasting, lies within the operational functions of a business, where the financial function plays only a supporting role.

Operational Heads should thus be responsible and accountable for revenues, costs and capital expenditure which fall under their sphere of responsibility. Furthermore, operational heads should only be responsible for items that can be influenced by them. The finance function’s role in financial planning is a support function to assist operational employees to compile their financial plans and forecasts according to set guidelines.

Listed below are 6 practical items to assist in the design and implementation of any forecasting model:

1. Forecasting horizon

The forecasting horizon of any business should be driven by the future visibility of the functions of the business. It is pointless to forecast beyond a certain point in time, as one of the main purposes of forecasting is to enhance near term decision making capabilities of operational employees. After a certain point in time, it will be better to extrapolate the remainder of the forecast rather than to predict an uncertain future.

Seeing that one of the longer-term goals of forecasting is the continuous improvement of forecasting accuracy, it is recommended that a phased approached to the forecasting horizon be implemented, always starting with a short-term focussed view (dependent on the business a one, two or three month horizon, with the rest of the period extrapolated). Thereafter, as forecasting accuracy increases, the focused forecasting horizon will increase.

2. Introducing Probabilities

Due to the difficulty to predict the future, it is preferred that forecasting should always make use of probabilities. This will enhance the overall relevance of the information gained through the forecasting process. Over time forecasting ability will improve. It is advisable to start with an option of three probabilities, each with its own % likelihood (e.g. definite, confident and possibly) for example:

  Amount Estimated Likelihood
Definitely Rxxx 95%
Confident Rxxx 80%
Possibly Rxxx 65%
  Rxxx  

3. Frequency of Forecasting

Realities change every day and subsequently the forecast of a business should be updated as often as possible. It will be beneficial if a forecast can be done every month on a rolling 12 month forecasting basis. As mentioned in 1. above, the forecasting horizon will determine for how many months the forecast will be focussed, whereas the remainder will be extrapolated.

4. Forecasting detail

Forecasts should focus only on the key value drivers and key limiting factors and should not be drawn up in the same detail as budgets and management accounts. Accuracy and relevance of information should be weighed up against the time it takes to draw up management information.

For each “budget line” a separate detailed analysis should be performed of what level of detail should go into the forecast.
Two methods can be applied to assist with this analysis:
- 80/20 principle, which implies that 80% of effects come from 20% of the causes.
- Putting a 10% selection criterion in place: If an item has less than a 10% impact, it is clustered together.

5. Visibility and user friendliness of reports

Usually budget and forecasts are shown in numbers and percentages. It is recommended that graphs be incorporated in the forecasting model showing the following relationships:

Overall view:
- Actual
- Prior year actual
- Budget
- Actual plus forecast
Forecast Accuracy view:
- Prior Forecast
- Actual

Conclusion

More often than not the same assumptions, methods and models that are used during the budgeting process are used during the forecasting process, which should not be the case. Due to the different nature of budgets and forecasts, different assumptions, methods and models should be used.

As mentioned before, forecasting is a management tool and not a rolling budget, thus a separate detailed analysis should be performed to evaluate the assumptions and techniques needed for improved forecasting.