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Working out the Kinks in Firm Valuations

One of the greatest challenges for private firms operating in China is how to derive a respective valuation. The problems involved are both theoretical and practical.

On the theoretical front, because China is still in the process of transitioning from a command to market-based economy, how does one value assets that have never been valued in the past by market players? Chinese accounting practices tend to value assets based on historical costs. But Western valuation practices favour forward-looking models such as Discounted Cash Flow (DCF). How is it possible to even consider finding a middle ground when such views are so diametrically opposed?

On the practical front, private firms are known to have looser accounting standards than publicly listed firms; this has allowed many owners to intermingle their personal funds with those of the company. Because there is little historical information about comparable firms in the industry, relative valuation modelling is extremely difficult. The long lead time in selling all or part of a firm also results in an illiquidity discount.

At the macroeconomic level, the absence of free-floating renminbi interest rates for a suitable range of maturities suggests further challenges in calculating the costs of capital and the costs of debt, the prime components in calculating a firm's weighted average cost of capital (WACC), the discount rate used to assess a firm's riskiness. Figure 1 summarizes one commonly used valuation model used in the West, the DCF model. Can this popular western formula work in China or is this another area where the Chinese can insist they have another way to do it?

Figure 1: One "straight-forward" way to value a firm, the DCF model

The upshot is that many compromises are inevitable and the real driving factor is how eager each side is for a deal. Nonetheless, sellers and buyers looking to value a firm in China should consider the following:

•    Move towards IFRS. Beginning in January 2005, nearly 100 countries, including China, began using the process of presenting their financial statements according to global accounting standards, not surprisingly called the International Financial Reporting Standards (IFRS). These standards are set by the International Accounting Standards Board (IASB), which is the standard-setting body of the International Accounting Standards Committee (IASC) Foundation. While these initials might sound a bit "ivory towerish," the creation of a universal accounting language could only accelerate investment activity related to China.

•    Set your goals before you set your price. Given the complexities of the valuation process, the benefits of what you are trying to accomplish must outweigh the costs. Hence, just knowing a firm's value is not enough. You must see if you can create shareholder wealth from such an exercise.

•    Consider ranges of values rather than sticking to one number. Remember what happened to Google in August 2004? It cut its IPO price from a range of US$108-$135 to US$85-$95, knocking off about US$10 billion from its market capitalization to US$26 billion. Even its ranges had ranges! Such is the life of emerging companies, whether they reside in the West or in China.

Writing on finance and economics for the last 18 years, David Seto, CFA splits his time between Hong Kong and Beijing where he reads Chinese Classics and tries to revive his defunct band, Scarbelly. Any comments on his columns can be sent to dseto@btmbeijing.com.

Bank Governor Pledges Reform

The governor of China's central bank defended the necessity of early public offerings for the Bank of China (BOC) and China Construction Bank (CCB) on May 13, pledging to press ahead with reform.

Speaking at the release of the 2005 Bluebook of Finance in China, People's Bank of China (PBOC) Governor Zhou Xiaochuan chided sceptics who insist there should be no haste in listing the banks and that the focus should lie on internal reforms and control instead.

"The next stages in the reform of State-owned banks, joint-stock restructuring, the ushering in of strategic investors, and stock market listings, are key steps and important milestones of reform," said Zhou.

China is accelerating reform of its four State-owned commercial banks, which still dominate the local banking system.

Authorities picked the BOC and CCB more than a year ago for pilot joint-stock restructuring programmes and recapitalized the two with a combined US$45 billion.

The two banks are now both planning initial public offerings in overseas stock markets and are talking with potential overseas strategic investors.

The Industrial and Commercial Bank of China also won a US$15 billion capital infusion in April.

But the Financial Times reported on May 12 that the BOC's share offering will be delayed until next year because its restructuring and search for a foreign strategic investor have yet to be completed.

Some analysts have expressed pessimism about the pilots, saying little concrete progress has been made. But, according to Zhou, a public stock offering will substantially push ahead key reforms such as building efficient incentive systems and ending administrative interference.

"The reform of large State-owned enterprises showed that, in the process of joint-stock reform, particularly in becoming listed companies, all the reforms were very much accelerated," Zhou said.