The Critical Question

The Critical Question During a valuations workshop after the introduction of capital gains tax a delegate asked: “How will SARS know when my client developed his business plan?” His client had developed a business plan for a new operation, which he had valued for capital gains tax purposes at R20 million. I asked: “What did he value?” He responded: “The future cash flows.” I asked: “What asset or thing is generating these future cash flows?” He said: “The future business.” I said: “But there is no business now so what are you valuing now?” He said: “The business plan.” A business plan is worth R20 million? We would all be millionaires if we could document and sell our dreams. During the IT bubble, I was having lunch with the accounting staff at an IT company. They showed me their plans for a new product – revenue growing at 30% p.a. in perpetuity. I felt like a real kill-joy asking them where they were going to find the sales people to sell the product, the customers to buy the product and the technicians to service the product. The market price of the share on the day was R3 per share. Based on their projections the market price should have been more like R300. Fortunately I did not allow myself to get caught up in their tide of enthusiasm. The company is no longer in existence. In this case no product, infrastructure or market had been created to generate these projected cash flows. Their projections were pie in the sky. But the accountants were radiating dollar signs from their eyes. This is what happened in the IT bubble. People lost touch with valuation fundamentals. The first question to ask when performing a valuation is: “Exactly what am I valuing?” Here are some examples: Investment property: You value the land and the buildings (including the equipment in the buildings) by either capitalising rental or discounting future cash flows. You do not value the future cash flows or the rental stream. You value the property based on the rental or cash flows that the property generates. If you said to a reasonable person: “I am dreaming of buying a property in three years time. The future cash flow expected from this property is . . . . The present value of that cash flow is R10m. I will offer this property to you today for R9m.” Would this reasonable person be a taker? There may very well be the odd taker. And that is when the scam artists move in. A sports shop: You value the inventory, receivables, furniture and fittings, vehicles, favourable lease agreement, customer loyalty, etc. You use dividends, earnings or cash flows as a basis to value the sports shop assets. You are not valuing the dividends, earnings or cash flows. If you bought a sports shop valued on a discounted cash flow basis and you arrive on your first day of trading to find that the seller has walked off with all the assets and the customer list, would you quite happily say: “Well I did not buy the assets, I bought the cash flows so it really doesn’t matter.”? A minority share in a listed company: You value the share certificate (now in electronic format) entitling the holder to dividends and capital proceeds at the end of the holding period. If the company has no history and no assets but a wildly optimistic business plan, I wonder how many investors would fall over themselves to pay good money for these shares, especially after experiencing the IT bubble. The JSE would hopefully protect the investors from themselves in such cases. So the key question to ask when valuing an asset is: “Exactly what am I valuing?” If the cupboard is bare, there cannot be any value. IFRS only allows one to recognise the cost (not future cost) of an internally generated intangible asset if it meets the definition of an intangible asset and meets certain criteria, e.g. it must be controlled by the entity as a result of past events from which future benefits are expected to flow. It must be separable, i.e. capable of being sold, transferred, licensed, rented or exchanged or have arisen from contractual rights. IFRS does not permit intangible assets to be measured at fair value unless it is quoted on an active market where items of the same kind are traded with willing buyers and sellers to be found at any time and prices being available to the public. This eliminates about 99% of intangible assets. These constraints are there for a reason. They avoid the creation and recognition of illusions and fiction. We cannot allow illusions and fiction to boost the financial strength of a balance sheet. Similarly, we cannot allow illusions and fiction to create tax allowances. Dear Uncle Charlie, In your article “So this is IFRS” the company lent the employees R2m to acquire shares in the company, to be paid out of future dividends of the company. The shares were to be held in trust and the employees had the option to sell the shares back to the trust at the net asset value or the issue price, whichever is the higher. You debited the loan and credited share capital and share premium. I quote from the August issue of IRIC Update: “Under many (employee benefit plans share loan plans) employees are enabled to acquire shares by means of a loan from the issuer with recourse only to the shares. The IFRIC indicated that such an arrangement was in substance a share option plan in which options were exercised on the date or dates when the loan was repaid. The IFRIC decided not to take this item onto its agenda because there was insufficient evidence of emerging diversity in practice.” Just thought you would like to know that your article is not IFRS. Dear Just Thought, Thank you so much for this. I only read the IFRIC Update after the article was published. What I find fascinating is that one must pretend that the shares were not issued and pretend that the company is not owed the money. What do we do with the interest received? Pretend it is not received? Do we pretend that we do not pay tax on the interest received and pretend that we do not pay STC on the dividends? It gets weirder by the day. A big thank you to Glynnis Carthy for pointing this out to me. Charles Hattingh CA (SA) Chartered Financial Analyst and Honorary Professor at the University of the Free State