For any company, business owner, lender or investor looking at an M&A deal one of the main questions thrown up by the EU referendum vote is how this affects business valuations.
After initial plunges, all of the main listed company indices – the FTSE 100, FTSE 250, and FT All Share Index – are now higher than before the referendum vote. The 0.25% cut in the base rate in August and the continuing downward pressure on gilt yields would imply a fall in the risk-free rate and hence a reduction in the discount rate used for discounted cash flow analysis leading to a rise in business valuations. But does this make sense in the context of the Brexit decision?
Price v value
Share prices are relative and largely reflect supply and demand, which can fluctuate significantly based on external events, investor sentiment, liquidity, and a host of other factors. In contrast, value is specific to the asset and is a function of a company’s cash flows, growth, and risk. For this reason we would never use quoted company prices alone as a benchmark when valuing a private company.
Generally, our preferred approaches are to evaluate comparable transaction data (another relative pricing measure) and undertake a discounted cash flow analysis (a way to determine intrinsic value). Under either approach, care must now be taken with the key inputs to the valuation method.
Sector specific transaction multiples are likely to move post-Brexit, but even if we assume no change there may will be an impact on the company’s profits and cash flows. While many companies may have experienced little immediate impact from the referendum vote, consideration needs to be given to the short to medium term impact on regional, global, and industry growth which will ultimately impact the business. This could well lead to an adjustment to the underlying profit figures used in the valuation analysis.
The discount rate puzzle
A further complication arises for DCF models in how the discount rate is calculated. It could be argued that a risk-free rate based on a historically low base rate of 0.25% is a quirk and does not reflect long-term levels and so should be “normalised”. But, that is what many valuers said in 2009 when the rate went down to 0.5% and seven years later it is even lower! The other approach is to increase the Equity Risk Premium for the UK, which intuitively sounds attractive but runs counter to the fact that current monetary policy inflates asset prices and reduces the variability of returns. Aswath Damodaran’s recently updated spreadsheet of ERPs only increases the UK level to 6.88% from the pre-Brexit level of 6.82% based on ratings agency data (although the rise was greater using CDS spreads with the ERP increasing from 6.29% to 6.82%).
While some arbitrary Brexit premium could be added to the discount rate it may be difficult to support this with empirical data at the moment, other than if we do see a direct impact on liquidity and financing risks. So, our preference would be to revise cash flow forecasts to take into account post-referendum changes such as revisions to GDP, sector specific issues, exchange rates, and tax, and including the use of multiple sensitivity and “what if” scenarios.
The buoyant stock market and recent announcements of major deals, such as the acquisition of ARM Holdings by Japan’s Softbank and the South African retailer Steinhoff’s bid for Poundland could lead to the conclusion that the impact of the Brexit vote on the valuation of UK businesses is not as great as might have been feared before 23 June. However, it is worth remembering that a large proportion of the investors in UK companies are from overseas. While here in the UK we may not yet notice a significant impact on valuations, for overseas buyers and investors the depreciation of Sterling makes the price of acquisitions cheaper, potentially offsetting any fundamental decline in intrinsic value, at least in the short-term. It is noticeable that amongst the currencies against which Sterling has fallen the most are the Japanese Yen and the South African Rand.
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