Key Stages of Privatisation

2. Pre-sale Considerations

e) Pre-sale valuation and pricing

The pre-sale valuation is an extremely important step in the process of privatisation, because it provides the vendor with a good idea about the value of their enterprise, and thus puts them in a strong position from which to assess how reasonable the various bids for it are later on, and to negotiate with bidders.

The valuation is an assessment and estimate of the value of the enterprise, and pricing is the estimate of what is a reasonable price at which it can be sold. Pricing is somewhat different from valuation, in that it must take account of the context in which the enterprise is to be sold, whereas valuation considers the value of the enterprise rather than how much someone would be prepared to pay for it in that situation. They should be conducted by an authority who is independent of both the vendor and any of the bidders to ensure that they are fair, and be based on the accepted principles of business valuation. Importantly, they should also be carried out before the enterprise is marketed, so that the vendor can have this useful knowledge about the enterprise’s value before they start appraising the bids.

It is advisable that after being provided with the information about the value of the enterprise and the price it should sell at, the vendor sets a floor price, beneath which the enterprise will not be sold.

There are various methods for carrying out valuation. In a privatisation, the enterprise is most often sold as a going concern, which means that it will continue to operate indefinitely after its sale, and is not breaking up. Methods of valuation for enterprises sold as a going concern are:

Price earnings: the price earnings ratio is the share price of a business divided by its earnings per share from annual profits, after tax. This method is normally used to value businesses with an established, profitable history. State enterprises do not, of course, have shares, and so when applying this process to a state enterprise the standard practice is to take the appropriate data from comparable companies which are operating in the same sector in the local stock market, or in other countries (with adjusted averages to suit the local market), and assume that the enterprise being valued would have similar financial ratios if it was listed on the stock market. In selecting comparable companies, not only should the businesses of the companies be similar but also their accounting practices. Only if the businesses are truly comparable can the process provide a reasonable estimate, and the data must be applied with care and interpreted effectively in order to provide meaningful information. In valuing an enterprise which is soon to be privatized, its value is estimated based on a particular multiple of the actual or projected post-tax annual profits of the comparable companies. The multiple will be higher where forecasted growth is higher (i.e. higher forecasted growth = higher price earnings ratio and vice versa).

Discounted cash flow: This method projects a business’s present cash flows into the future, indicating the timing and level of returns to investors. A discount factor is applied to streams of forecasted cash flows to find their present value. The discount factor is applied to approximate an investor’s rate of return. An expected value can be worked out by taking averages of the data from comparable companies. This method of valuation is heavily dependent on assumptions about long-term business conditions, but the further the cash flow is projected into the future the greater is the level of perceived risk. It has often been used in countries with formerly planned economies, because past profitability was difficult to assess as there had been no market competition.

The valuation may be estimated at several different amounts according to different methods used, but this is a positive rather than negative thing as it allows the vendor to have a more rounded idea of the value than if it had only been calculated on one way. The process of comparing the results from several different methods of valuation is called triangulation. The vendor may even wish to take valuations from more than one independent source, so as to acquire a range of views.

The valuation should not be conducted by anyone who may have a conflict of interest regarding the outcome of the privatisation. That includes the managers of the business, even if they are not themselves bidding for it. But the valuation may properly use information supplied by the managers and verified by an independent authority, if this is appropriate. In some cases, the vendor may need to get the valuation checked by an independent party, for instance when the valuation is carried out by the vendor’s financial advisors and these financial advisors are entitled to receive a sale completion fee based on the extent to which sale proceeds exceed the valuation. In such a case the advisors have an interest in the valuation being low, and so it is a good idea to have their valuation checked again by an authority which has no stake to benefit from it.

If any reforms or restructuring have been carried out, it is best to do the valuation after they are complete, and if the valuation was first done before these reforms it is advisable to revise it afterwards to take their effects into account.

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