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Finding true value

November 2017


Earlier this year, the Securities and Futures Commission issued a guidance note after being increasingly concerned that some listed companies are acquiring assets at unreasonably high prices or selling assets that are undervalued. CPAs explain to Nicky Burridge the challenges in business valuation

Illustrations by Simone Altamura



A Hong Kong-listed company managed to lose HK$125 million through a string of disastrous acquisitions and disposals over a three-year period. Despite its core business involving advertising and marketing services, Inno-Tech Holdings decided to acquire three hotels and a gold mine in Mainland China, only to dispose of them around 18 months later.

At the heart of the loss was not poor timing, a market downturn or even simple bad luck, but rather a failure to ensure the assets were correctly valued and the purchase price justified.

A subsequent investigation by the Securities and Futures Commission (SFC) led to four of Inno-Tech’s directors being disqualified and pursued for compensation.

The case, while an extreme example, is by no means an isolated one, with the SFC saying it was seeing far too many transactions announced with unusual valuations.

Its concern about the issue became so great that in May this year it issued guidance on corporate transactions and valuations, reminding directors of their responsibilities to ensure acquisition targets were properly considered and assessed.

“The details of some transactions announced by companies suggested that the directors did not appear to have acted properly when assessing targets or disposals,” says Michael Duignan, Senior Director, Corporate Finance, at the SFC. “Large sums were being paid for apparently poor-quality assets or businesses, and the value of these assets was being written off in the subsequent annual accounts.”

He adds that when the SFC raised enquiries about some transactions, the justification given for the purchase price often included a report giving a valuation. But, he explains, it was described as being a “calculation report” rather than a valuation report. “The valuations set out in the report were often based on unquestioned, unverified and often wildly ambitious assertions about future performance, which was in stark contrast to the actual historical performance achieved by the target,” Duignan says.

He adds that the assertions upon which they were based were often made by the vendors, who were somewhat self-interested, with this valuation then used by the acquiring company as justification for the transaction.


 

Uncritical acceptance

In the case of Inno-Tech, the HK$99.5 million purchase price for a 81.5 percent share in a gold mine was based on a feasibility study report provided by the vendor stating that the maximum mining capacity was 1,200 tons per day.

In its investigation, the SFC noted that there was no indication that the vendor was asked to justify the figure, even though a separate feasibility study put the capacity significantly lower at just 150 tons per day.

Despite their lack of previous experience in mining, there was no documentary evidence that the directors of Inno-Tech had made any site visits or had meetings or telephone conferences with geologists, accounting experts, technical mining specialists or mining operators.

Instead, the SFC concluded the directors relied “uncritically” on the valuation provided by the vendor. Inno-Tech sold its stake in the mine 17 months later at a HK$84.5 million loss.

Duignan says in some cases reviewed by the SFC, the companies being acquired had never made a profit, had only been in existence for two years or less, and had no assets.

“It was also unlikely to be a coincidence that when the SFC raised enquiries in relation to such transactions, the timetable for the transaction was often extended, and as the enquiries became more detailed, the transactions were cancelled,” he says.

In its guidance note, the SFC emphasized that directors should not blindly and unquestioningly accept financial forecasts, assumptions or business plans provided to them, typically by a vendor or the management of the target, but must carry out independent due diligence.

It also warned financial advisors appointed by listed companies to conduct their own assessments and verify the reasonableness of the forecasts, assumptions, qualifications and methodologies of any valuation.

The note added that if any forecasts or assumptions appeared to be unrealistic, financial advisers should bring this to the attention of the directors.



 

Valuation challenges

The reasons why companies may be overpaying for acquisitions are many and varied. Duignan says there is a tendency for some companies in Hong Kong to try to expand their way out of difficulties by starting a completely new line of business. “We saw a rash of companies buying coal mines and writing off the value within a year after deciding it wasn’t worth what they paid for it,” he says.

But he adds that in other cases: “The suspicion is that the directors were in some way going to benefit from the process, that there is some connection between the vendors and the buyers.”

Raymond Cheng, Managing Director of HLB Hodgson Impey Cheng, points out that a significant number of listed companies in Hong Kong are characterized by high concentrations of shareholdings, providing opportunities for abuse. “A small minority of companies are buying high and selling low to the detriment of their minority shareholders, while benefiting their controlling shareholders,” says Cheng, a Council member of the Hong Kong Institute of CPAs.


“You are looking at the future of sales and profitability and the market, therefore the challenge will be what support can you find to substantiate and back up those assumptions as the input into the valuations.”

But even when company directors do carry out due diligence, valuations are not always straightforward. Eugene Liu, Managing Partner and Head of Consulting at RSM Hong Kong, points out that valuation is both a science and an art, and values should be thought of as being reasonable rather than correct. He adds that there are technical difficulties involved in valuing certain types of assets, such as mining or biological ones, or structured financial products with complex terms and conditions.

Different valuation methods can also sometimes give significantly different results, while what is considered a reasonable assumption or interpretation of an assumption is likely to vary from valuer to valuer. But Liu, a member of the Institute and the National Association of Certified Valuation Analysts, adds: “The valuer’s ethical standards, independence, and the extent to which the valuer is susceptible to being influenced by management is also a factor.”

Wiley Pun, Associate Director, Business and Financial Instrument Valuation, at Savills, agrees that a “lack of professional scepticism” on the business valuer’s side is an issue, as is adopting the forecasts provided by the target’s management without question.

“Another possible cause is the lack of thorough technical understanding of the coherence of the valuation approaches and parameters, which would lead to erroneous conclusions,” says Pun, an Institute member.

An extreme example, he adds, would be a “pure textbook follower,” where all the calculations may be technically correct, but do not make commercial sense.

The fact that many business valuations involve forecasts, which are inherently uncertain, is also an obstacle. “You are looking at the future of sales and profitability and the market, therefore the challenge will be what support can you find to substantiate and back up those assumptions as the input into the valuations,” says Cheng.

He adds that in many instances information may not be available and the valuer will have to study historical analysis and comparable companies to form an opinion.

Pun points out that if a valuer was using a market approach, they would have to carefully select comparable companies for the derivation of implied valuation multiples, such as price to earnings, but sometimes there may be a lack of comparable companies.

Janet Cheung, Partner and Head of Valuation Services, KPMG in China, notes that sometimes when merger and acquisition activity is high, it becomes a sellers’ market, leading to pricing being higher than normal. But Duignan at the SFC says: “There are transactions where those factors are in play, but they are less likely to be the sort of transactions we have big concerns about.”



 

Low entry barrier

Aside from the technical difficulties involved in valuations, the low entry barrier to become a valuer is also an issue.

Liu says that in recent years a number of valuation firms have emerged in Hong Kong that are hiring graduates without appropriate qualifications and experience to carry out complicated valuations, competing on ever-lower fees.

He suggests the way forward would be for a regulatory body to create a licensing system and enforceable valuation standards to ensure valuers are technically qualified and fulfilling the requirements to be independent and ethical.

He points out that auditors and accountants are supervised by the Financial Reporting Council and Hong Kong Institute of CPAs, while surveyors fall under the Hong Kong Institute of Surveyors or Royal Institution of Chartered Surveyors, but there is no comparable body for valuers.

Pun agrees that one major problem with the business valuation industry in Hong Kong is the lack of regulation and entry barriers. “Unscrupulous companies may engage an unscrupulous valuer to sign off a valuation report that may under or over value the target as the company requested,” he says.

He adds that in Mainland China, valuation firms have to be registered and they are reprimanded if they fail to comply with standards set by the China Appraisal Society, China’s professional valuation organization, but there is no similar system in Hong Kong.

In an interview with the Malaysian Institute of Accountants in September, Sir David Tweedie, Chairman of the International Valuation Standards Council, suggested that the entry requirements for valuers need to be as rigorous as they are for accountants. He would like to see professional bodies set up for valuers that would only admit people with the right qualifications, experience and ethics, and would discipline members who failed to live up to these standards. He has also called for the introduction of global valuation standards, which all valuers would use.

Some in the industry are making changes to their operating models. William Yuen, Director at Ascent Partners Valuation Service, explains that his firm has taken a number of steps to ensure its valuations are accurate.

He says: “We have developed automated valuation tools which not only increase work efficiency but also reduce inadvertent human errors. All valuation works also have to go through three levels of reviews before being sent out to clients and other professional parties.” These reviews include a peer review and a final review by a supervisor or manager, and aim to ensure that valuations are rational and stand up to criticism.


 

The role of CPAs

CPAs have a role to play in helping to ensure valuations are correct. Cheung at KPMG points out that CPAs are increasingly being involved in valuations, in particular because of the financial reporting requirement of IFRS 13 Fair Value Measurement.

Pun agrees. “CPAs understand businesses from the inside out,” he says, “they can help to make sure a valuation is accurate.”

He adds that professional scepticism and business acumen are built into the DNA of CPAs, which make the CPA qualification a suitable designation for business valuers. “CPAs have been evaluating the truth and fairness of financial statements and the health of businesses for decades in the capacity of an auditor. For those of us who are business valuers as well as CPAs, we can help ensure valuations are reasonable right from the start.”

 


“In July, accountants and brokers urged Hong Kong’s Securities and Futures Commission to issue standards for qualifying the value of non-property assets, reported South China Morning Post. “The financial statements of some companies contain valuation reports of their investment assets. The valuations of these assets affect their financial performance, but then there’s no standard for valuation. It’ll be great if valuations can follow a similar standard [as with global accounting],” Clement Chan, past president of the Institute, and Managing Director of BDO Hong Kong, told SCMP.”