The latest 2020 edition of the International Valuation Standards (IVS) marks an important milestone towards harmonising valuation practice worldwide.
Valtech has been closely following the development of IVS. IVS is applicable in many of our valuation engagements looking for consistency and transparency for potential investment decisions.
We pay a lot of attention in the updates of IVS 200 Business and Business Interests as this standard is frequently referred in business valuation. We can see that the major updates are relate to Capital Structure Considerations. Traditionally, equity is frequently derived by the formula of enterprise value minus debt plus free cash. Under IVS 200, two important issues have been raised.
IVS 200 put additional requirements on valuers to consider the capital structure in valuing equity (especially common equity). In many cases, the value of a particular class of equity cannot be derived directly. So enterprise value is usually first derived and then allocated to different classes of equity.
For simple capital structures that include only common stock and simple debt structures (such as bonds, loans and overdrafts), it may be possible to estimate the value of all of the common stock within the enterprise by directly estimating the value of debt, subtracting that value from the enterprise value, then allocating the residual equity value pro rata to all of the common stock. This method is not appropriate for all companies with simple capital structures, for example it may not be appropriate for distressed or highly leveraged companies.
To solve for the equity value, three methods are mentioned in IVS 200 which may be applied in different circumstances. The three methods are namely Current Value Method (CVM), Option Pricing Method (OPM) and Probability-Weighted Expected Return Method (PWERM). In the three methods introduced, OPM can be considered as more general and forward looking to value the payoffs of different equity classes.
The major updates of IVS 200 put higher weight on knowledge and background in corporate finance and option pricing on top of traditional valuation skills of building discount cash flow models and market approach analysis.
The concepts of dividend or preferred dividend rights, liquidation preferences, voting rights, redemption rights, conversion rights, participation rights, anti-dilution rights, registration rights, and put and/or call rights are usually covered in corporate finance courses or the CFA curriculum. Practical application and valuation are usually covered in advanced courses. Valuers need to be ready for market expectation on more sophisticated valuation models on valuation of common equity especially when it is more common globally to have complex capital structures for growth companies.