Valuing privately–owned companies in South Africa : adjusting for unsystematic risk
Erasmus, Hendrik Philippus
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Business valuations have been an integral part of business for many years, and will stay an important part of business, as valuations are required for multiple reasons. The majority of businesses in South Africa (and the rest of the world) consist of privately-owned companies. A business valuation in general is a complex exercise that can be described as an inexact science. When the business valuation of a privately-owned company is added to the equation, the level of uncertainty is increased with another notch. The valuations of privately-owned companies are therefore a relevant topic. As unsystematic risk in privately-owned companies is difficult to eliminate or mitigate by diversification, this study sets the goal to determine if the advisory departments of the big four audit, tax and advisory firms in South Africa (Ernst & Young, PwC, KPMG and Deloitte & Touch) consider and incorporate unsystematic risk into valuations of privately-owned companies and if it is taken into account, whether it is done objectively. This study firstly focussed on the literature of privately-owned company valuations. The most frequently used approaches are found to be the market approach and the income approach. The asset approach is used to determine the minimum value of a company (the liquidation value). The topic of unsystematic risk is perceived as very much subjective and therefore receptive of manipulation. The second part of the study uses the mixed method approach to collect empirical data, using survey questionnaires and follow-up interviews (which are based on the literature review). It was found that the preferred valuation approaches used by the participants are indeed the income approach followed by the market approach. It seems that these two approaches are used in conjunction with one another. Incorporating unsystematic risk is done in line with what the literature proposes, but as professional judgement is needed, the process is never entirely objective. Participants tend to agree that the identification and quantification of unsystematic risk are not entirely objective and that it is possible to use unsystematic risk as a device to bring the final results of a valuation in line with the clients‟ objective. This study recommends that a professional valuation body should be formed to regulate valuations in South Africa. This body should set valuation standards. It is furthermore recommended that the asset approach is used as a reasonableness test when going concern companies are valued, and to consider the use of CAPM variants (e.g. modified CAPM, the local CAPM, the Build-up method etc.) and non-CAPM variants (Estrada model and the EHV model) to determine the cost of equity when the income approach is followed, as is suggested by the literature. The practical implication of the study is that the research can be used as starting point by role-players in the valuations sector to open the discussion on the topic formally so that valuation practitioners can engage with one another and work towards a professional valuation body and valuation standards. The limitations of the study are that only top-level employees were used as the representatives of firms and the population only includes the big four audit, advisory and taxation firms. Areas for further research include extending the population to three strata, viz. big four firms, medium-sized firms and small-sized firms. Comparative valuations on a case study can be performed by the different approaches of each stratum using unsystematic risk as the only variable (if themes are identified in strata). Conclusions can be made based on the outcomes of the valuations to determine the impact when different approaches are followed.