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From the Slide Rule to the BlackBerry.

Business Valuation in Colombia and Latin America: My Personal View

Ignacio Vélez-Pareja

Moscow, December 11, 2008

First of all I wish to thank the Russian Society of Appraisers for the invitation to

participate in this Conference as a guest speaker. It is a privilege to exchange ideas with so

selected and qualified audience.

Before I move forward, allow me please, to read a quotation attributed to one of

your great compatriots: “I know that most men, including those at ease with problems of

the greatest complexity, can seldom accept even the simplest and most obvious truth if it be

such as would oblige them to admit the falsity conclusions which they have delighted

explaining to colleagues, which they have proudly taught to others, and which they have

woven, thread by thread, into the fabric of their lives”. (Lev Tolstoy, (1828-1910). What Is Art and

Essays on Art, Quoted by physicist Joseph Ford in Chaotic Dynamics and Fractals (1985) edited by Michael

Fielding Barnsley and Stephen G. Demko).

Is Business Valuation an Art?

It is not an art. I think that some practitioners prefer to give the impression that there

is something secret on it or it is a kind of alchemy, just to protect them. It is a methodical

and systematic approach to valuating cash flows for an ongoing concern. You have to look

for information, need criteria to select proper inputs, have to construct a financial model,

have to assess the economic environment, etc. It is not a precise science, although it might

give the impression of precision. Usually numbers give the false impression of exactitude

and precision. We should keep in mind the fact that we work with estimates. Estimates are

just that. Estimates can differ from one analyst to another one. The relevant issues are first,

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to use systematic and correct approaches to business valuation; second, we should always

remind the golden GIGO rule: Garbage In, Garbage Out. We have to make our best effort

to grant that we are introducing in our model the best information we have in order to get

the best results we can.

Let me go over the idea of a financial model for valuation and value management.

A Financial Model for Cash Flow Valuation and Value Management

Why is it so important to have a financial model for the firm? This is an imperative

for the management because it gives a powerful tool to grasp a vision of the firms’ future.

This is mandatory for the management because it could give the manager a future vision for

the performance of the firm. It is of major importance to develop strategies in order to

overcome difficulties, such as the actual global economic crisis we are witnessing these

days. This financial model is critical for management to keep control on the value creation

process.

Traditionally valuation exercises for those non-public firms are used only for selling

or purchasing a firm or even for merging firms. I deeply disagree with this approach.

Almost 100% of the firms and projects, at a world level, are not traded, including

developed markets. In the U.S. 99.87% of the firms are not traded. They do not have the

value on a daily basis. For this reasons typical valuation tools are in fact designed for non

traded firms. In general, if you trust the market it makes no sense to “calculate” the value of

a traded firm because you can find it in the price the market fixes every day.

How do these firms manage the value creation process? They do it just by hunching

and by intuition. They do not have the possibility public traded firms have of looking and

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estimating their value everyday or even every minute through the price traded in the

market.

Non traded firms should keep an updated model to measure value permanently

through the estimation of their market price and see before hand, the effect on value of

future decisions. Firms should have an instrument for prospective financial management

and not for doing necropsies. A good value based management can be done using an

appropriate forward looking financial model.

With a proper financial model the firm can estimate cash flows and value them.

When valuing cash flows we have to keep on mind that the relevant issue is value, not

return. If the firm creates value it will have an acceptable return, however, the contrary is

not true: maximizing return is not equivalent to maximizing value. A firm should keep a

model to measure value and estimate the effect of future decisions on it. Even public firms

could profit from a model like this one. Just as an example look around and answer the

question if the market price reflects the fair value of a firm. Here I am assuming that the

market shows more than the price. Price might be different of value and this fact makes the

model highly valuable even for them.

How is the typical financial analysis taught at our Business Schools? Usually what

we do is to teach how to see what happened and answer questions like: Did the firm have

high or low liquidity last year? How was the financial (capital structure) decision? How

much was financed using long or short term debt? Was it profitable? How did the firm

spend the funds?

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What is the purpose to know that? Management should be more interested on what

is going to happen, rather than on what happened. Of course history could give us some

clues to forecast the near future, but not much more. Management has to make plans and

establish future policies and should have tools for following up that those policies are put in

practice. Moreover, management has to make decisions to “recover” any value lost because

of variables not under management control (exogenous variables such as inflation), have an

adverse behavior. With a financial model those plans and policies are designed in advance

and are aimed toward value creation. With this approach we cannot expect to know the

future, but to mold and design it.

Using a financial model we can estimate and assess different risks that might impair

the firm value, for instance,

Political risk

Rate of exchange risk

Inflation risk

Operating risk and

Financial risk.

We can use the model to examine the financial and economic effects of a decision

prior to implementing it. All this can be done using several types of sensitivity analysis:

one and two variables tables, scenarios and Monte Carlo Simulation. It is interesting that

these tools are available at very low cost (or even free of charge) in a spreadsheet.

In addition of all the previous reasons to develop a financial model, we can use it for

other purposes:

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1. When planning to raise funds for a new or an ongoing firm.

2. When planning to sell or merge a firm.

3. When planning to issue public debt (bonds).

4. When planning a financial strategy (bond issues, or an approach to a institutional

lender)

In practice my proposal consists in looking valuation as a permanent exercise and

not only used as an ad hoc approach, say to sell or buy a firm. It is a proposal for changing

the use of business valuation. It is a management tool for value creation control and risk

analysis.

I propose a model with traditional financial statements, such as the Income

Statement, Balance Sheet and a kind of cash flow statement I call Cash Budget. Let me

explain a little bit the Cash Budget. It has five modules:  

Operating module

Capital Expenditures Capex

External financing,

Transactions with owners and

Discretionary transactions.

Each module has a Net Cash Balance. The Operating module gives information

useful in determining short term deficit/surplus and hence short term financing. The Capex

module lists the capital investment schedule The External Financing module allows us to

define short and long term financing, including the share equity might have in long term

financing. The Transactions with the owners module lists the new equity investment and

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dividends and repurchase of stock. The Discretionary transactions module allows us to

define cash surpluses to be invested in marketable securities. The added NCB for the first

two modules gives a measure of the maximum debt capacity of the firm in the period. From

financing and transactions with owners’ modules we can derive the relevant cash flows for

valuing the firm/project.

This is a consistent and integral financial model based on one simple and well

known principle: The Double Entry Principle, DEP. This is the basic concept of current

accounting practice. It has many advantages. One of them is that arithmetic mistakes (in the

accounting process) or modeling errors are easily identified. It is simple: total credits

should be identical to total debits. If this does not match, something is wrong. Mentioning

that the model is based upon the DEP might be seen naïve and self evident. However, it is

not. What practitioners and authors do is to assume they have done every step in the model

construction correctly and close (match) the Balance Sheet with plugs. It is like sweeping

the dust under the carpet. And I can assure you there are lots of mistakes (even evident and

elemental mistakes) that are done even by most experienced model builders.

Some additional features are:

It has disaggregated inputs: inflation, real growth, real prices, policies, etc.

The Cash Budget allows us to define short term and long term (by equity and/or

debt) financing and cash excess for ST investment.

It allows the analyst to calculate the maximum debt capacity the firm could

acquire for a given period of time

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Allows the analyst to derive cash flows directly for investment valuation reducing

the probability of mistakes.

The financial model (when used integrally, this is, when used to valuate the

investment) considers the proper working capital calculation. I mean by this that what is

called liquid assets are not considered as cash flows (because they are listed in the BS) as

Damodaran and others include as cash flows (they include as CFs items that are listed in the

BS).

Given the disaggregation of inputs it allows a proper sensitivity analysis included

Monte Carlo Simulation. This is interesting because we can examine and assess the risks of

cash flows directly examining and sensitizing their basic components as proposed in several

of my papers and suggested by Galasyuk and Galasyuk in their paper “Consideration of

Economic Risks …” (Sept. 2007).

Given item 1, it is possible (as I have done in different versions) to include

several degrees of complexity, for instance, price-demand elasticity, large scale economies,

inclusion of financial distress costs in the cash flows (WACC has enough problems to

include additional like different classes of risk, financial distress costs, etcetera), effect of

accounts receivables policies on growth, exchange rates effects and any other you can need

and/or imagine.

The proposal is integral in the sense that the financial model is just a means to

conduct forward looking financial analysis and value management. I think that apart from

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the technicalities involved in the previous items, this is the most relevant feature of the

proposal.

Some advantages of using a financial model like the one I propose are:

With the financial model we work a forward looking financial management. Not

necropsies.

A financial model should allow managers to assess what effect a change in input

variables will have on the firm value. In that case we can answer questions such as

will an increase or decrease in a given input (exogenous or endogenous) creates or

destroys value? If an exogenous variable changes and destroys value, what can be

done to offset it? Will a change in a given policy destroy or create value? That is

what Economics, Business Administration, Engineers and similar professions aim

at: to increase value. That is the name of the game: to create value.

This position does not mean that we should not value history. Although I insist in a

looking forward exercise, historical data are useful in several ways:

a. When defining policies for the firm. It is usual to find that one thing is what

the manager says the firm does (wishful thinking) and another one is what in

reality happens. Looking past performance might give light upon the

implicit policies the firm has.

b. When comparing immediate results with expected ones. The bottom line

about creating/destroying value is when we compare what was expected

with the actual results.

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Some History and Business Valuation in Colombia and Latin America

Asset valuation has a long history. People traded goods since the beginning of

Humankind and there was a need to know their value. This gave rise to an ability to assign

value to those assets. However, Business Valuation as we know it today is relatively recent.

Professional Valuation main activity is focused toward “pricing of exchanges with

non-standard assets (real property, non-public companies and interests in them, intangible

assets and other assets exchanged on inactive markets”. (Artemenkov, Mikerin, and

Artemenkov, 2007).

Let me make some emphasis on the valuation of non-public companies.

My first exposure to the subject of business valuation was through my college

course on Time Value of Money with the classical text “Principles of Engineering

Economy” by Grant and Ireson in 1963. From that date to today there has been lots of

changes.

At that time computing resources were very limited and scarce. We had to work

with pre calculated tables (the PV of $1 and similar) and slide rule! And now we are in the

era of the real portable computing: the iPhone and the Blackberry.

Project appraisal was very popular. At that time the current practice was to draw

cash flow trends by extrapolating them given some initial cash flow; working capital was

calculated as a percent of investment and little effort was done in relating cash flows with

financial statements and the discount rate was picked out from the thin air. Social project

appraisal (economic appraisal) was the norm. Constant prices approach was and is today a

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current practice. Discount rate for cash flows was, as it is today, pulled from the thin air.

Nobody knows why it is 12% or 8% or whatever.

We have to recall that the work of Modigliani & Miller was completed near 1963,

Harry M. Markowitz, (1952-1959), James Tobin, (1958), William F. Sharpe, (1963-1964),

John Lintner, (1965), and Robert S. Hamada, (1969), were scarcely writing on the issue of

risk and return, CAPM and the like and there was a time lag between theory and practice.

In the 70’s large scale computers, mainframes, started to appear for academic and

official use. In the late 70’s rudimentary PCs gave their first steps, but still, many

computing for project appraisal was done by hand with the help of the slide rule and at the

very end of the decade, using financial calculators. Basically, at least in our countries, the

valuation or appraisal approach was the same.

In the 80’s less expensive and more efficient computing resources started to appear

and we could build some “sophisticated” models for project appraisal. That was a double

edged sword. I remember when we used a spreadsheet for the first time (in 1982) and

submitted a work to some firm that contracted us to appraise a large scale project. The

customer was impressed with our work and suggested a change in one or two variables. We

went back to the office and made the changes and in 30 minutes we had the results in the

desk of our customer. He was stunned. The problem was when we submitted the invoice for

our services. Our customer said, how come you are charging that much for something that

could be done in half an hour? Discount rates were estimated with not more detail than

before. Perhaps we started to think on an average discount rated based on the cost of debt

and the cost of equity. Although we taught at Engineering and Business Schools a kind of

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science fiction called Simulation, we had to wait for the next decade to start doing it in an

easy and not as expensive way.

From the 80’s to today the Business Valuation professional has been more aware of

the use of relatively more sophisticated methods such as the above mentioned.

In the mid 90’s authors started to link the basic concept of time value of money (as

in Grant & Ireson’s classic textbook) with the issue of value creation and cash flow

valuation. Financial models started to flourish. CAPM was an issue in the academic world

and was taught in our business schools. Practitioners timidly started to use it.

In the 2000’s we have seen a flourish of improved valuation techniques, mainly due

to the availability of cheap and efficient computing resources. We have moved from

methods based on accounting data to others based on profitability. I have to say that even

today, many do not understand the implications and limitations behind the betas for CAPM

and yet they use them blindly and mechanically. Damodaran website is the mine of data for

many. They add to the model all the risk premia you can imagine. Even adjustments to find

the optimal capital structure that everybody talks about but I am sure that nobody has seen.

As I have proposed elsewhere, we should try to include as much as possible in the cash

flows (via a financial model), what could happen to a firm (including financial stress costs).

Another example is in the Markovitz portfolio analysis that has been a subject taught since

the 90’s, but until recent date neither students nor their teachers knew what to do with an

elaborated efficient frontier they learned to construct. Many authors and teachers ignore the

work done by Black (1972), Merton (1973) and presented later by Levy and Sarnat (1982),

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Elton and Gruber (1995) and Benninga (1997) where they show a simple way to identify

the optimal portfolio.

The most usual accounting methods were (and surprisingly still they are, mainly in

small and medium size firms) the book value, book value with net assets adjusted to the

commercial price, reposition value and liquidation value. These methods are relatively easy

to use, but they have serious drawbacks. Some associate these methods with what is called

the cost approach and generally applies to liquidation analyses.

On the other hand, the profitability methods take into account the capacity of the

firm to create value in the future. The most popular are multiples of comparables, value of

traded stock and discounted cash flow. From the later ones, the most popular is the

discounted cash flow, DCF. The profitability methods are associated with the income and

market value and these approaches are typically used for "going concern" business

valuations.

How is the valuation practice in our countries?

Large firms prefer to contract the big boys of the U. S. for business valuation:

Boston Consulting Group, McKinsey, The Monitor Group and others. In addition,

practitioners heavily rely on Damodaran (who, as far as I know, is not a member of any

Association of Appraisers) data and common knowledge approaches.

In the Business Valuation area the professional activity (consulting) uses the

discounted cash flow and multiples of comparables approaches which include shortcuts of

doubtful correctness. My concern with this is not the proper procedures by themselves, but

the fact that it is not necessary to make Olympic assumptions or to use practical shortcuts.

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With the computational resources we have today, it makes no sense to use approaches and

solutions that were good in the sixties and seventies. Some of the improper procedures have

to do with the construction of financial statements using plugs and circularity to match

them as already mentioned. When deriving cash flows, considering as cash flows amounts

that are listed in the BS; double counting the risk when using premia for taking into account

different classes of risks; wrong use of formulas for the cost of capital; improper models for

terminal or continuing value (perpetuities are a Pandora’s Box); inconsistent results in

methods that should show consistency; blindly use of models like CAPM that gives the

illusion of precision; dealing with inflation with constant instead of nominal prices; using

as cost of debt the wrong rate of interest; wrong application of M&M findings and the like.

A mea culpa. I should recognize that in some of my papers and works I use the

CAPM, however, it is out of the necessity to teach and explain it as part of the academic

activity. You need to know (the CAPM, for instance) what you disregard because you get

disappointed or convinced that it should not be applied in every case. As mentioned above,

our concern as users of Professional Valuation is the illiquid firms understanding by that

more than 99% of the firms in the world. Our concern is the many firms owned by non

diversified investors where ideal models like CAPM do not apply. I think it is valid to

estimate the cost of equity subjectively. Subjectivity is not wrong by definition. It is

different from arbitrariness. Arbitrariness has no bases. Subjectivity captures and is based

upon a lot of information and experience the decision maker has. I wonder what is more

arbitrary (or “subjective”) if some cost (of equity) estimated subjectively (see the

Analytical Hierarchical Process by Thomas L. Saaty) or a “precise” estimation (you can

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calculate it with as many decimals as you wish) based on a method like CAPM with “N”

risk premia.

However, even now, it seems that many practitioners and teachers are anchored to

the past and still work with models as if they have computing restrictions as we had in the

sixties. On the other hand, some are in the frontier of knowledge trying to solve very

complex issues with sophisticated tools. Right now I am engaged with my colleague Rauf

Ibragimov, in working a series of papers we have untitled Return to Fundamentals or

Return to Basics with the hope that practitioners, teachers and authors realize that there are

many basic and simple issues to be mastered with the use of available technological

resources before they move forward to those sophisticated tools such as Econometrics.

Today, to be a respectable scholar you need to use it. I am not saying that we should not try

to be in the frontier of the state of the art, no. What I say is that there should be a clear

understanding of basics concepts and ideas before approaching to complex ideas and

concepts handled with complex tools. At this point I would like to cite a couple of

quotations: the first one is from Edward Leamer: “There are two things you are better off

not watching in the making: sausages and econometric estimates” and the other is related to

those "[...] practitioners [that] are often accused of doing, [what] is called data mining,

fishing, grubbing or number-crunching. This methodology is described eloquently by

[Ronald Harry] Coase: if you torture the data long enough, Nature will confess" (Author not

identified).

Business Valuation has no formality in Latin America and in particular in countries

such as Argentina, Brazil, Colombia, México, Peru and Venezuela. There are guilds or

associations for appraisers mainly for real estate and machinery and vehicles or as noted

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above, on “pricing of exchanges with non-standard assets (real property, […] intangible

assets and other assets exchanged on inactive markets” (Artemenkov, Mikerin, and

Artemenkov, 2007). One of the reasons business appraisers are neither associated nor

regulated might be the professions of the former. Appraisers for real estate and machinery

are lawyers, architects and engineers. Business appraisers are usually accountants,

economists, business administrators and engineers. Most of them are financial consultants.

It is interesting to note that in The American Society of Appraisers

(http://www.bvappraisers.org/) we find individuals, not consulting firms. The same happens

in the International Valuation Standards Committee (IVSC, http://www.ivsc.org/) where

Professor Igor Artemenkov is a member of The Professional Board. Perhaps it is time to

stimulate the participation of consultants (Business Valuation professionals) in these

organizations.

A Summary

I have tried to communicate my opinions on business valuation in general and what

I see in Colombia and Latin America as a current practice of the valuation activity. In

summary, I could say that many scholars try to keep up with the state of the art in the

valuation approach and this is very good, but many still have basic conceptual deficiencies.

This sounds paradoxical, but it is true. I have found that many propose, handle and design

complex mathematical and econometrical models to analyze very sophisticated approaches

to risk assessment, for instance, but they are surprised because firms obtain tax savings

from any deductible expense and create value from it.

On the other hand, practitioners disregard theoretical precisions under the

assumption that they are unnecessary and the differences in results are negligible or due to

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“rounding” errors but they vanished when spreadsheets arrived. It is not the point. The

point is that if you do not have a consistent and correct valuation approach you will never

know if the estimation of value is reasonable. I agree that valuation is not a cold

mathematical exercise. It has many subjectively estimated inputs and the value we suggest

(better, the range of values) is the starting point for a negotiation process between buyer

and seller (in the case of a situation of selling and buying a firm or project), but this starting

point should be a consistent and reliable one. In short, valuation relies upon forecasts that

by themselves are debatable, why should we add sources of errors to something that has

implicit a given degree of error? We should minimize the total error once we have

identified the source. It is not reasonable to increase error because we use a tool that has

inherently a degree of error. In short, when you question whatever the “holy cows” do, they

dismiss you and to put in Artemenkov, Mikerin and Artemenkov (2007) words, “… those

who attempt to spot cracks in [their work …] are regarded as being unreasonable hair-

splitters”. I would tell these authors, please, include me in the exceptions.

Finally, the most relevant issue in business valuation is to give management a tool

for controlling value creation. This could even be a very interesting source of income for

practitioners and consultants. They could offer non traded firms not only the consulting in

Business Valuation, but the service to keep the value estimation updated every time

exogenous variables change and/or the sensitivity analysis option to test future decisions in

terms of value creation/destruction.

I invite this selected audience to think about basics. Return to basics and consolidate

that knowledge before we introduce sophisticated tools for financial analysis and value

management.

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Thank you very much for your kind attention.