An Emerging Market Perspective on Key Value Drivers in the Valuation of Cross-Border Transactions into South Africa

ABSTRACT.This paper investigates the valuation performance of 16 individual value drivers, from five different value driver categories, in relation to the South African equity market for the period 2001-2010. The research results revealed, among other findings, that headline earnings is by far the most accurate value driver and that, contrary to popular belief, earnings before interest, tax, depreciation and amortization and earnings before interest and tax are only fourth and fifth best alternatives. The evidence also suggests that, when employing multiples to perform equity valuations, a careful selection of value drivers could increase valuation accuracy by as much as 50.03%. JEL codes: G11; G12; G32; 016Keywords: equity valuation; JSE; multiples; valuation accuracy; value drivers(ProQuest: . denotes formulae omitted.)1. IntroductionClosing deals in emerging markets is inherently riskier than in developed markets. Factors such as currency volatility, unreliable market measures and accounting differences come into play, all of which complicate valuations in emerging markets (Damodaran, 2009). Despite these challenges, a significant number of valuations are performed for cross-border transaction purposes into Africa, with international interest from the United States of America (USA), the United Kingdom (UK) and European investors (PwC, 2012). However, the most prominent deal breaker in this regard is the inability of buyers and sellers to agree on valuations. The large gap in buyer and seller expectations can be traced to uncertainty regarding the magnitude of future growth, the availability of few comparable companies and strong competition for emerging market assets. In a recent study by PwC (2012), in which 240 failed transactions in emerging markets were analyzed, the range of potential outcomes was found to be significantly wider than for equivalent transactions in developed markets. The wider range is a reflection of the magnitude of the divide between the expectations of willing buyers and willing sellers.One of the most popular valuation approaches, that is used extensively in practice, is multiples (PwC, 2012; Dellinger, 2010; Nel, 2010; Minjina, 2008; Roosenboom, 2007; Damodaran, 2006b; Asquith, Mikhail and Au, 2005; Bhojraj and Lee, 2002; Liu, Nissim and Thomas, 2002b). For example, in a study of 550 equity research reports from USA-, UK- and Asia-based investment banks in 2001, Damodaran found that multiples outnumbered discounted cash flow valuations by ten to one. A multiples-based approach, based on observable market data rather than assumption-driven modeling, is particularly popular among private equity and venture capitalist practitioners (International Private Equity and Venture Capital Guidelines, 2010). Consequently, multiples typically find their way into analysts' reports and investment bankers' opinions (Schreiner, 2007). Despite the popularity thereof, limited empirical guidance is available for constructing optimal multiples for equity valuation purposes in emerging markets. Value drivers, on which this paper focuses, play a key role in the construction of multiples. Consequently, this paper investigates the valuation performance of 16 value drivers, from five different value driver categories, for the period 2001-2010.Section 2 offers a review of the relevant literature. Sections 3 and 4 present the dataset and the research design. The empirical research findings are discussed in section 5 and final remarks are offered in the last section.2. Review of the LiteratureWhen employing multiples to perform equity valuations, analysts determine the actual value of a company's shares by scaling a specific market price variable by an appropriate value driver, thereby creating a multiple, which is then multiplied with a specific value driver of the target company. Value drivers are gleaned from different sections in the statement of comprehensive income, the statement of financial position or the cash flow statement. …