Date posted: 8/11/2018 4 min read

Valuations – art or science?

The ‘crazy’ valuation of technology stocks is highlighting valuation fundamentals.

In Brief

  • Technology stock valuations have become ‘crazy’
  • Key fundamentals provide a guide to sound valuations
  • The level of valuation art and science depends on asset lifecycle

Simon Dalgarno, Managing Director and Shareholder, Leadenhall Corporate Advisory Pty Ltd
Rajeev Shah, Managing Director and Chief Executive Officer, RBSA Advisors

Leading valuers say the current 'crazy' valuation of technology stocks highlights the importance of valuation fundamentals.

"When we look at the world today, some of us feel the world has gone crazy," says Rajeev Shah, Managing Director and Chief Executive Officer, RBSA Advisors. "The valuations of FANG stocks and technology stocks are just astounding."

Shah says the surge in tech valuations is triggering questions about whether the valuations are correct, and whether is there a science or art to valuing.

Simon Dalgarno FCA

Simon Dalgarno FCA, Managing Director and Shareholder - Leadenhall Corporate Advisory Pty Ltd.

Simon Dalgarno, Managing Director and Shareholder, Leadenhall Corporate Advisory, says Silicon Valley valuations rely on the "greater fool theory" where a buyer believes a "greater fool" will pay a higher price for a share.

"It has nothing to do with valuation, it is driven by speculation," he says. "It is not true valuation. The only thing that generates value – true value – is the cash generated by the business, the profitability."

He says he is sceptical about companies that have billion-dollar valuations but no prospects of creating positive cash flow.

When we look at the world today, some of us feel the world has gone crazy.
Rajeev Shah Managing Director and Chief Executive Officer, RGSA Advisors.

But amid this volatility, Shah says there are a number of fundamentals of valuation that never change and must be established to generate a sound valuation.

1. Date

"Defining your date is quite critical," says Dalgarno. "It depends on the circumstances of the case, but often it is the date of the valuation. You should take into account only information which comes into existence as at that date."

2. Purpose

Dalgarno says the valuation could change for different purposes, including valuation, accounting or a transaction.

3. Standard

What is the valuation standard? Is it market value, investment value or fair value? Dalgarno says, for example, the fair value used for accounting purpose is different from that could be used in court.

4. What is being valued

Dalgarno says valuers also need to be careful about exactly what is being valued. He cites the case of the sale in 1969 of London Bridge, where the buyer thought they were buying another bridge across the Thames. "Being careful about what you want us to value is critical," he says.

Dalgarno says his firm calculates equity valuation from adding enterprise value (EV) and surplus assets and deducting debt.

5. Valuer's role

The valuer must also clarify their role. "We don't always need to be engaged as an independent basis," Dalgarno says.

Australian accountants must specify whether their valuation is being prepared independently. "We must specify if our valuation is not independent," he says. "If I am working on a transaction and I'm going to get a success fee, then I am not independent."

Art and science

But, ultimately, valuation in most cases is a combination of art and science and depends on the asset and its lifecycle, Shah says.

"An early stage company will involve a lot of art; for a late-stage developed listed company there will be more science to it," he says.

Rajeev Shah

Rajeev Shah, Managing Director and Chief Executive Officer - RBSA Advisors.

The 'art' element of valuation involves factors such as sales forecasts, economic outlook and capitalisation/discount rate determination.

"Over the lifecycle of a company, the valuation approaches change, the thinking changes; and from predominantly art, it moves to predominantly science," Shah says.

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