8 UkraineBusiness insight February/March 2012

FINANCE

8 UkraineBusiness insight March/April 2013

One half of a potential deal is that of the current owner of a business, who has to make a decision whether to keep or sell it. This may be the case when an owner has received an offer from a potential buyer and wants to determine whether to accept the price. The owner compares the compensation offered with the subjective value of the business, based on expected future economic benefits (cash flows) should it be kept.

The other half of a potential deal is that there is a prospective buyer who has to make a decision whether to invest in an asset and define the maximum price they are prepared to pay. In this case, the subjective value of a business for the potential buyer is based on their investment requirements and particular circumstances. This value may, for example, reflect a potential buyer’s synergies with their existing activities, other motivations or their required rate of return on invested capital.

The two parties could refer to an objective

market value of the business to reach common ground. This value does not reflect their specific considerations, but shows the price paid for an asset by an ‘average’ investor, or in other words, the assessment of an asset by the whole investment community.

One should always have in mind what kind of value is relevant. This particularly influences the decision as to which valuation approach is used and how the valuation parameters (or ‘value drivers’) are determined. Compared with other countries, these decisions are more complex in Ukraine.

APPROACHES TO BUSINESS VALUATIONThe most commonly used business valuation approaches are market and income.1 As in any other country, both approaches are generally applicable in Ukraine too. The market approach is based on the prices paid for comparable companies, which can

be seen on the stock market or by noting prices paid historically in transactions for similar companies. 2It is achieved through an estimate of so called ‘multiples’ i.e. the ratios of price-to-value of financial or operational parameters of a comparable business (e.g. price-to-earnings ratio). The income approach is based on the future economic benefits expected to be generated by the subject business, and discounted as of the valuation date.

Unlike in developed countries, the market valuation approach is of quite limited use when applied in Ukraine: among the primary reasons for this is an underdeveloped and illiquid stock market, which does not provide a reliable indication of true value.

Another reason is that normally in Ukraine,

How do you value a business in Ukraine?There are many reasons for undertaking a business valuation: among the most important is the

sale or purchase of a business. We should begin by distinguishing what elements of a business to

evaluate for this purpose, what criteria to take into account and by whom

1 For more details please refer e.g. to Pratt / Niculita, Valuing a Business – The Analysis and Appraisal of Closely Held Companies, 2008, p. 62-64.

2 For example cf. Damodaran, Investment Valuation, 2002, p. 11 and 18.

March/April 2013 UkraineBusiness insight 9

Valuation

the data needed on M&A transactions to perform a reliable value analysis is either completely unavailable, insufficient or not reliable enough to base a valuation upon. For example, prices paid for shares in privatised state enterprises could hardly be said to be market prices, as many were thought to be sold below their true market value. As an alternative, trading or transaction multiples for comparable businesses operating in other CIS or emerging countries could be used. The main challenge here is poor comparability of foreign businesses to those in Ukraine.

So the market approach for business valuation in Ukraine may be used only in a very limited number of cases, e.g. for high level estimating of an indicative market value range for transaction purposes. Furthermore, it might be used to validate the valuation resulting from the income approach; if reliable comparables can be found; such an approach may indicate if the computed value seems reasonable.

THE CHALLENGES OF THE INCOME APPROACH WHEN VALUING A BUSINESS IN UKRAINEThe limitations inherent to the application of the market approach to business valuation in Ukraine, partly described above, increase the importance of the income approach and the Discounted Cash Flow (DCF) method in particular. 3 The two components of the DCF are the numerator, i.e. the expected cash flow, and the denominator, i.e. the discount rate.4

THE COMPONENTS OF THE DCF fig.1It is obvious that (future) cash flow will not necessarily equal the expected ones. Thus, the discussion about expected cash flow as one of the two big value drivers is always part of any valuation, especially the one performed for M&A transactions. In Ukraine, these discussions are escalated by uncertainties in the development of the economy, its high dependence on what happens in world commodity markets, devaluation expectations, unpredictability of changes in the regulatory environment, and other factors inherent in emerging countries. Furthermore, the question remains as to when the ‘steady state’ of the economy and business itself will be achieved; a subject widely and regularly discussed, but a question without an answer.

Another challenge worth mentioning here relates to the peculiarities of the application of the DCF method during an economic crisis. In such a crisis, the actual financial figures – as the basis for the planning – may be below their historical average and show declining revenues and profit. I It should therefore be verified whether this decline will have a long-term, or purely temporary

influence on a company’s outlook. It is possible that a current owner may have a different view to that of a potential buyer, especially when negotiating a potential sale price. In this case, an objective estimate of market value could help the parties reach common ground.

The Weighted Average Cost of Capital (WACC) is commonly used as a discount rate when the DCF method is applied for business valuations. It takes into account the cost of equity as well as the cost of debt, and “weights” both components with their (market) values (see example in figure 3)5. As the cost of debt is not normally a parameter which is intensively discussed, the cost of equity should be considered in greater detail here.

This component of the WACC is commonly derived within the Capital Asset

Pricing Model (CAPM). The CAPM is a risk-return model, which assumes that the rate of return on the shareholder’s equity is estimated, based on a risk-free rate, a market risk premium (MRP) reflecting the available investment opportunities of the market (portfolio), and beta (ß) representing the risk of a particular investment.6

THE COMPONENTS OF THE COST OF EQUITY UNDER THE CAPM fig.2In the example given, the cost of equity is estimated in US$ as a very first step. The main reason for this is that the risk-free rate is commonly based on yields to maturity (YTMs) of US treasury bonds denominated in US$. The MRP is often assumed to be 5% but might also be up to 6.5%. The beta is normally derived based on the betas of comparable public companies. So, as with the market approach, the so-called ‘peer group’ is also required for estimating a discount rate; though its impact on the resulting value seems less material.

As YTMs of US treasury bonds are used to determine the risk-free rate to estimate the cost of equity for a business operating in Ukraine, the sovereign (country) risk premium (Sov.RP) should be added.

3 Regarding the importance of the DCF method in practice cf. Brealy/Myers/Allen, 2006, Corporate Finance, p. 508.

4 Cf. Damodaran, Investment Valuation, 2002, p. 14.5 Cf. Pratt / Niculita, Valuing a Business – The Analysis and Appraisal

of Closely Held Companies, 2008, p. 216-217.6 Cf. Damodaran, Investment Valuation, 2002, p. 69-71.

Expected future businesscash flows (E(CF)) are uncertain and thus

are subject to discounting

The discount rate (k) containsrisk premiums. The EACC is commonly

used as an estimate of k

PresentValue =n

∑t=0

E(CF)t

(1+k)t

R = r + ß x MRP + SovRPUS$ US$ US$ US$ US$E rf Stock, Index Index

Risk free rate,e.g. determind by YTMs of sovereign bonds ofAAA rated countries (e.g. the U.S.)

Beat, e.g. determindby comparablepublic companies

Market portfolio:reflects availableinvestmentopportunities(e.g. local vs. global)

Sovereign (Country)risk premium

Expected future businesscash flows (E(CF)) are uncertain and thus

are subject to discounting

The discount rate (k) containsrisk premiums. The EACC is commonly

used as an estimate of k

PresentValue =n

∑t=0

E(CF)t

(1+k)t

R = r + ß x MRP + SovRPUS$ US$ US$ US$ US$E rf Stock, Index Index

Risk free rate,e.g. determind by YTMs of sovereign bonds ofAAA rated countries (e.g. the U.S.)

Beat, e.g. determindby comparablepublic companies

Market portfolio:reflects availableinvestmentopportunities(e.g. local vs. global)

Sovereign (Country)risk premium

Figure 1: The components of the DCF

Figure 2: THE COMPONENTS OF THE COST OF EQUITY UNDER THE CAPM

It could be derived by taking the difference between the YTMs of US treasury notes and Ukrainian Eurobonds denominated in US$ with a similar maturity.

Though it seems obvious, nonetheless, it should be stated that the two components of the DCF (the expected cash flows and the discount rate) should always be consistent. This is one of the most common mistakes in business valuations and it is completely independent from its purpose. For example, it means that if the expected cash flows are denominated in UAH, then the discount rate (e.g. the WACC) should be estimated in UAH as well.

The cost of equity estimated in US$ could be converted into UAH using the inflation rate differential, which in itself is based on the forecast inflation rates in the United States and Ukraine. If the cost of debt is also derived in US$ or another currency, then the inflation rate differentials could be used to transfer this component of the WACC into UAH too.

The example shows the indicative calculation of the WACC. Of course the different parameters have to be derived and discussed individually for each valuation, i.e. they should not simply be taken from the sample table.

SUMMARYAs reliable multiples are rarely available in Ukraine, this significantly limits the opportunity to conduct market valuation approaches, thus the income approach and the DCF method in particular, can hardly be avoided when valuing a business in Ukraine, regardless of the purpose of the valuation. The market approach might be used to validate the valuation results derived from the income approach, but the comparables have to be carefully derived.

A sound derivation of all valuation parameters is fundamental, especially in cases where an objective market value is needed. When using the DCF method, one of the most challenging discussions is about the assumptions underlying the highly uncertain future cash flows. Furthermore, the DCF method requires a reliable derivation of the cost of equity, which in most cases, is very subjective.

Please note that the views expressed in this article are those of the authors and are not necessarily endorsed by UBI.

AuthorsAndreas Pfeil, PwC Senior Manager at Advisory Deals, Corporate Finance / Valuation & Strategy

Igor Iaremchuk, PwC Assistant Manager at Advisory Deals, Corporate Finance / Valuation & Strategy

FINANCE

10 UkraineBusiness insight March/April 2013

Parameter 2013 20X Y Abbreviation Comments

Risk-free rate, US$ 2.6% 2.6% Rrf Yield to maturity of 20y US Treasury bonds (sample assumption)

Market risk premium 5.0% 5.0% MRP Best practice

Unlevered Beta 0.51 0.51 ß uni Research data for the identified peer group (sample assumption

Debt-to-Equity ratio 71.2% 71.2% D/E Research data for the identified peer group (sample assumption

Relevered Beta 0.81 0.82 ß rel ß unl * (1 + D/E * (1 – T)

YTM of Ukraine Eurobonds 7.9% 7.9% YTM UA YTM of Ukrainian US$ Eurobonds with maturity in November 2022 (sample assumption)

YTM of US Treasury notes 1.8% 1.8% YTM US YTM of 10y US Treasury notes (sample assumption)

Sovereign risk of Ukraine 5.9% 5.9% Sov. RP (1 + YTM UA) / (1 + YTM US) – 1

Cost of equity, US$ 12.6% 12.6% Re US$ Rrf + MRP * ß rel + Sov. RP

Forecasted inflation in Ukraine 7.8% 5.0% CPI UA Sample assumption

Forecasted inflation in the USA 2.4% 2.0% CPI US Sample assumption

Cost of equity, UAH 18.5% 15.9% Re UAH (1 + Re US$) * (1 + CPI UA) / (1 + CPI US) – 1

Weight of equity 58.4% 58.4% We 1/ (D/E + 1)

Weight of Debt 41.6% 41.6% Wd 1 – We

Cost of debt, UAH 14.0% 14.0% Rd UAH Weighted average effective interest rate for the company’s debt ( sample assumption)

Effective income tax rate 19.0% 16.0% T Corporate income tax rate according to the Tax Code of Ukraine

Weighted average cost of capital

15.53% 14.20% WACC UAH Re UAH * We + Rd UAH * Wd * (1 – T)

Figure 3: Example of the WACC computation for the DCF based valuation of a Ukrainian business (sample figures)

“The most commonly used business valuation approaches are market and income, but in Ukraine market values – comparison of similar sales –can only be applied in a very limited number of cases, and (future) cash flow predictions are hit by uncertainties in the development of the economy”