Approaches to valuation for unquoted equity instruments

The three valuation approaches and techniques described in IFRS 13 are:

IFRS 13  does not prescribe a specific valuation technique, but encourages the use of professional judgment together with consideration of all facts and circumstances surrounding the measurement. These three different valuation approaches could be applied in determining the fair value of an unquoted equity instrument. However, regardless of the valuation technique used, the fair value measurement of those equity instruments must reflect market conditions at the investor’s reporting date.

Market approach

The market approach uses prices and other relevant information generated by market transactions involving identical or comparable (i.e. similar) assets. The following valuation techniques may be used under the market approach:

  1. Transaction price paid for an identical or a similar instrument in an investee,
  2. Comparable company valuation multiples.

a) Transaction price paid for an identical or a similar instrument in an investee

If an investor has recently acquired an investment in another equity instrument that is identical or similar to the unquoted equity instrument being valued, then the price for that transaction might be a reasonable starting point for measuring fair value.

  1. Identical instrument: If the equity instrument that was recently acquired is identical to the unquoted equity instrument being valued, the investor should assess whether factors or events that have occurred after the purchase date that could affect the fair value of the unquoted equity instrument at measurement date. If so, the investor should adjust the transaction price for those factors. Factors could include changes in market conditions that have affected the investee’s growth prospects or expected milestones, or internal matters such as fraud, commercial disputes, changes in management or strategy,
  2. Similar instrument: If the equity instrument that was recently acquired is similar to the unquoted equity instrument being valued, the investor needs to understand, and make adjustments for, any differences between the two equity instruments. Differences might include different economic rights (e.g. dividend rights, priority upon liquidation etc) and control rights (i.e. control premium in a controlling interest vs. a non-controlling interest).

b) Comparable company valuation multiples

This technique assumes that the value of an unquoted asset can be measured by comparing that asset to similar assets where market prices are available. Information can usually be sourced from quoted prices and/or observable data from transaction such as mergers and acquisitions. This technique involves the following four steps:

  • Step one: Identify comparable company peers.
  • Step two:
    1. Select the performance measure that is most relevant to assessing the value of the investee (earnings, equity book value or revenue)
    2. Once selected, derive and analyse possible valuation multiples and select the most appropriate one (e.g. EBIT, EBITA, EBITDA, or P/E for earnings, P/B for book value)
    3. Adjust the relevant multiple as appropriate for general qualitative differences between the investee and its company peers (e.g. size in terms of revenues or assets, level and rate of growth of earnings, diversity of product range, diversity and quality of customer base, leverage location, lack of liquidity).
  • Step three: Apply the appropriate valuation multiple to the relevant performance measure of the investee to obtain an indicated fair value of the investee’s equity or the enterprise value. Note: for the purposes of the educational material, enterprise value is the fair value of all financial claims attributable to all capital providers (i.e. debt and equity holders).
  • Step four: Make appropriate adjustments for differences that are directly related to the characteristics of equity instruments being valued (e.g. non-controlling interest discount, lack of liquidity).

Income approach

The valuation techniques under the income approach convert future amounts to a single current (i.e. discounted) amount. The following valuation techniques are described in the document:

  1. Discounted cash flow method
  2. Dividend discount model
  3. Constant growth dividend discounted model
  4. Capitalisation model.

a) Discounted cash flow method

Under this method, the investor would discount the expected cash flows amounts to a present value at a rate of return that represents the time value of money and the relative risks of the investment. Equity instruments can be valued directly using ‘free cash flow to equity’ (i.e. an equity valuation), or indirectly, by obtaining the enterprise value using ‘free cash flow to firm’ and then subtracting the fair value of the investee’s debt net of cash.

b) Dividend discount model

This model assumes that the price of the equity instrument equals the present value of all its expected future dividends in perpetuity. It is often used when the investee pays dividends consistently.

c) Constant-growth dividend discount model

This model determines the fair value of the equity instrument by referring to a forecast of growing dividend streams. This model is sensitive to the assumptions about the growth rate. The model is best suited for investments that both:

  • Are growing at a rate that is equal to or lower than the nominal growth rate in the economy
  • Have a well established dividend payout policy that the investee intends to continue into the future.

d) Capitalisation model

This model applies a rate to an amount that represents a measure of economic income (e.g. free cash flows to firm or free cash flows to equity) to arrive at an estimate of present value. The model is useful as a cross-check when other approaches have been used.

Adjusted net asset method

The adjusted net asset method is a combination of the market and income approach. It involves directly measuring the fair value of the recognised and unrecognised assets and liabilities of the investee. This method is likely to be appropriate for entities that derive value from holding assets (such as property holding companies or investment entities) and may also be appropriate for entities in their early stages that have little financial history and may not yet have developed products.

Typically, the adjusted net asset method involves making adjustments to the balance sheet carrying amounts of assets and liabilities. Items that are commonly subject to adjustments include:

Once an equity valuation has been derived, the investor would also need to consider making the following adjustments for its share of the investee’s equity instruments held:

  • Non controlling interest
  • Lack of liquidity
  • The passage of time that could have an effect on the changes in fair value of the assets and liabilities or any additions/ disposals
  • Any other contractual agreements specific to the equity instruments held etc.

Use of judgement

When determining a price that is most representative of the fair value, an investor needs to consider:

  • Which valuation technique makes the least adjustment to the inputs used (and, consequently, which technique maximises the use of relevant observable inputs, which is the valuation approach that IFRS requires)
  • The range of values indicated by the techniques used and whether they overlap
  • The reasons for the differences in value under different techniques.

Depending on the circumstances, one valuation technique might be more appropriate than another. Some of the factors that need to be considered when selecting the most appropriate valuation technique include:

  • Information that is reasonably available to an investor
  • The market conditions (i.e. bullish or bearish markets might require an investor to consider different valuation techniques)
  • The investment horizon and the type of investment
  • The life cycle of the investee (some valuation techniques are better at capturing the market sentiment when measuring the fair value of a short-term financial investment)
  • The nature of an investee’s business (some valuation techniques are better at capturing the volatile or cyclical nature of an investee’s business)
  • The industry in which the investee operates.

Judgement needs to be applied both in the application of a particular valuation technique and in the selection of the valuation technique. For example, an investor is likely to place more emphasis on the comparable company valuation multiples techniques, where there is a sufficient number of comparable peers.

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