International Valuation Newsletter October 20 kpmg.ch/dealadvisory
Dear reader Strong growth in Central and Eastern Europe and unprecedented political instability in the US have produced further economic uncertainties. However, capital markets appear to have their own view of the future. In our third International Valuation Newsletter of 20, we share an update on recent capital market data that are highly pertinent to any valuation analysis in these times, where disruption is one of the main themes: Major stock market performances: Continued positive performance EURO STOXX 600 sector multiples: Stable in Q3 20 Current risk-free rates for major currencies: The rise of interest rates Recent country risk premiums and inflation forecasts for the BRIC countries: Lowest for China (among the BRIC countries) We also provide our insights into the following topics that are relevant to valuation practitioners: What (and what not) to reflect in real estate valuations The growing reach of country risks in valuation practice We wish you a pleasant pre-christmas period and look forward to discussing with you any questions you might have regarding valuation trends and practices. Yours faithfully Johannes Post Partner, Deal Advisory Valuation / Financial Modelling EMEA Head of Valuation Rolf Langenegger Director, Deal Advisory Valuation / Financial Modelling
What (and what not) to reflect in real estate valuations A reliable, detailed property valuation may be necessary for a wide range of corporate needs, including transactions, financing, accounting, taxation, legal disputes and foreclosures. But take care when valuing real estate compared to companies. Significant differences can exist between the subjective values of owners and investors, financing banks and leasing companies, tax authorities, owner-occupiers and tenants regarding a given property. This is where an independent, objective appraisal can help. Put simply, a property s market value is the value that a wellinformed third party would be prepared to pay without external pressure. Determining this figure is rather less simple, however. A property appraisal is usually based on value concepts set out by international professional associations such as RICS (Red Book), TEGoVA (Blue Book) and IVSC (White Book). Three main ways to determine property values Based on the normal income and expenses of the valuation subject the income/present value method takes into account future market expectations. The most frequently used technique for investment properties is the discounted cash flow (DCF) method, which is based on Anglo-Saxon principles and has its origins in company valuation practice. The DCF method uses forecast income and expenses that are capitalized at a discount rate derived from current market conditions. By contrast, the depreciated replacement cost method is based on the restoration cost, taking into account a value reduction due to depreciation. This method is suitable for owner-occupied residential properties, public infrastructure buildings or particular manufacturing properties, among others. It lacks direct reference to the market, though there will be a final market-based adjustment to determine the value. The third valuation method is the comparable transaction method. This is based on transaction prices, which can be adjusted where necessary to make them comparable. A sufficient number of comparable transactions must be available for this method to be used. rental space and type of use, actual rents, building regulations and characteristics that are specific to the object. ket-related parameters include normal market rents and capitalization rates, among other factors. The parameters are ascertained as part of an intensive analysis of the property and the regional real estate market. In particular, this includes an inspection of the property and its environment as well as detailed market research. Avoid double (or more) counting Whichever valuation method is applied, all facts and propertyspecific characteristics must be considered if they may influence the value. Care should be taken, however, to ensure their effects are not duplicated. For example, it may be necessary to deduct an existing maintenance backlog from the valuation, but this same factor should not also be reflected by applying a reduced remaining useful life, lower market rent or a surcharge in the capitalization interest rate. It is also critical that all parameters and inputs included in the valuation are free of subjective influence. In addition the evaluation should be based only on data that is not influenced by unusual or personal circumstances. Standard market data (e.g. for operating costs, administrative costs, maintenance costs and rental loss risks) should be used to develop a typical forecast that does not reflect the subjective views of an owner or asset manager. A significant difference between valuing real estate and the companies that hold it is that the company valuation incorporates company-specific issues via corporate planning. The company s non-real estate-related revenues and costs are taken into account, such as corporate management costs, administrative expenses and corporate taxes. In other words, while company valuation methods may be used to value a company that holds real estate, valuation of the real estate itself should always focus specifically on the Which factors might influence the valuation? Like company valuations, real estate is valued as of a certain date the valuation date. The individual parameters used in a valuation can be divided into two groups: Object-related parameters can include, among others, an object s macro and micro-location, property size, size of the land and buildings, free of corporate-specific considerations. International Valuation Newsletter October 20 3
The growing reach of country risks in valuation practice For the purpose of valuation practice and corporate investment decisions, country risks have historically been relevant mainly in relation to emerging and developing markets. Since the financial and sovereign debt crises of 2007 to 2011, however, greater country risks can be observed also in the Eurozone. The need to take them into account in valuation calculations has therefore never been more pressing. A basic principle of forward looking company valuation is the risk equivalence between the expected future cash flows of an enterprise and the capitalization rates or discount rates applied to determine the present value. Such discount rates usually include the risk-free basic interest rate and adjustments to reflect operational risks and financing risks to be borne by the investor (risk premium method). When valuing companies in an international context, operational risks often include additional country and exchange rate risks on which the cash flows are based. What are country risks? For valuation purposes, country risks cover general political, regulatory, macroeconomic, legal and/or tax risks to which investors may be exposed in the respective country. It also includes risks that are inadequately diversified from a risk perspective due to the interdependence of international capital markets. An extreme example is expropriation by foreign investors or the imposition of transfer moratoria for corporate profits or dividends generated in a country. No longer an issue only in emerging markets The recent financial and debt crises mean country risks have become more significant in the Eurozone. Country risk premiums in Europe currently range from 0 percent for Germany and Switzerland to 8.3 percent for Greece. In fact, the premium for some European countries is higher than that of some emerging markets for example, 3.4 percent and 1.0 percent for Brazil and China respectively. Where and when to apply the country risk premium A country risk premium generally distinguishes between: Primary country risks resulting from a company's direct contractual or trading relationships with the corresponding public sector that is at risk of default; and Derivative country risks that affect a company's future earnings prospects through general economic development and fiscal policy measures. Country risks are generally taken into account when planning and analyzing future cash flows and determining cost of capital. When using the Capital Asset Pricing Model (CAPM), country risks form part of the risk premium produced when calculating the cost of capital. Often, the market risk premium cannot be measured empirically in emerging and developing countries or in countries undergoing significant structural change, such as the Eurozone s crisis-hit states. In these instances, country risks are often taken into account in a separate country risk premium in addition to a general market risk premium for established capital markets. One transparent way of deriving country risk premiums is by analyzing differences in yields (so-called spreads) between government bonds of the same currency and maturity in the same country and a comparatively safe benchmark (for example, German or US government bonds). The assumed analogy between sovereign risks (government bonds) and risks for companies operating in the country in question is controversial, though. It must also be kept in mind that different sectors are exposed to country risk in different ways. For example, International Valuation Newsletter October 20 4
mining or tobacco consumption might be affected quite differently by natural disaster, conflicts, or riots than retail, business services or the financial sector. Country risks derived by government bonds cannot reflect those sector specific risks and an analysis of the individual facts and circumstances is needed. In addition, the analysis of government bonds must also take into account the impact of capital market intervention. To support companies in their cross-border valuation efforts, KPMG began publishing up-to-date country risk premiums for selected countries in this International Valuation Newsletter at the start of 20. In the following article Capital market data: Latest updates we introduce a table that contains recent country risk premiums. Other essential considerations Exchange rate risks, on the other hand, should be taken into account separately from other country risks when determining cash flows (by using forward rates) or in the capitalization interest rate. Consider the difference in expected inflation between two countries when using spot rates, for example. When determining the cost of capital, it is vital to ensure that the individual parameters of the cost of capital are combined and that risks are not taken into account twice. Double counting may involve applying a base interest rate based on a risky local government bond as well as including a country risk premium based on government bond spreads. Country risk premium graph Additional alpha factor β x MRP Country risk premium Operating risk Discount rate (cost of equity) Risk-free rate Source: KPMG analysis Note: MRP stands for market risk premium International Valuation Newsletter October 20 5
Capital market data: Latest updates The February 20 edition of this newsletter introduced a selection of key financial market data. We now provide the second of our periodic updates, covering: Comparison of major stock market performances for the 12 months ending tember 20 EURO STOXX 600 sector multiples Risk-free rates for major currencies Country risk premiums and inflation forecasts for the BRIC countries Continued positive performance of major stock market indices Stock markets have proved extremely resilient over the past twelve months, weathering such events as the Brexit referendum and the recent interest rate hike by the US Federal Reserve. Between Q3 20 and Q3 20, outstanding performances were noted from the Nikkei 225 (+23.7 percent), technology-driven NASDAQ (+22.3 percent), DAX (+22.1 percent), France s CAC 40 (+19.8 percent) and MSCI Emerging kets Index (+19.7 percent). The MSCI Emerging kets Index outperformed its peers with a growth rate of 7.0 percent on a quarterly basis (in Q3 20), closely followed by NASDAQ s growth of 5.8 percent. The only major index to perform negatively in Q3 20 was the Ibex 35 index at minus 0.6 percent although it posted an impressive annual increase of 18.2 percent. The FTSE 100 came under pressure as a result of Brexit, and lost momentum and declined to 6.9 percent from 18.6 percent on an annual basis. Performance of leading indices tember 20 tember 20 22.1% 22.3% 23.7% 19.7% 19.8% 18.2% 15.9%.2% 13.2% 12.5% Index performance (%) 4.4% 7.0% 2.3% 0.8% 6.9% 4.1% 4.1% 4.0% 2.8% 5.8% 1.6% (0.6)% MSCI World MSCI Emerging kets STOXX Europe 600 FTSE 100 DAX CAC 40 Ibex 35 SMI S&P 500 NASDAQ Nikkei 225 QoQ YoY Source: Capital IQ, KPMG analysis International Valuation Newsletter October 20 6
EURO STOXX 600 sector multiples The enterprise value (EV) multiple states the market value of the business in relation to an appropriate base metric. Commonly used EV multiples are revenue and EBITDA. The numerator (EV) and denominator (revenue, EBITDA) represent all investor claims on the business The Euro STOXX 600 sector overview of trading multiples showed no significant outliers or other extremes based on EV/revenue and in Q3 20 compared to Q2 20. Only the energy (oil and gas) sector (where the EV/ EBITDA multiple fell from 9.0 x in Q1 to 6.8x in Q2 and then rose to 7.5x in Q3) moved noticeably in 20. Consumer Discretionary Median Consumer Staples Median 12.8x 12.6x 12.9x 13.1x 11.1x 10.9x 10.5x 10.4x 1.9x 1.8x 1.7x 1.8x 2.0x 2.1x 2.2x 2.1x Energy (Oil and Gas) Median Financials Median 1 10.3x 6.8x 7.5x 2.0x 1.0x 1.4x 1.4x 1.4x 1.7x 1.1x 1.1x 1.1x 1.2x 1.4x 1.2x 1.0x 1.1x z P/BV Healthcare Median Industrials Median 15.4x 15.5x.1x 15.7x 11.4x 11.8x 11.8x 12.3x 3.7x 3.8x 4.1x 3.9x 1.4x 1.5x 1.5x 1.6x International Valuation Newsletter October 20 7
Information Technology Median Materials Median 14.5x 15.5x 15.8x.0x 10.3x 9.7x 9.9x 10.3x 3.9x 4.6x 4.5x 4.4x 1.8x 1.9x 1.6x 1.7x Telecommunication Services Median Utilities Median 8.2x 8.4x 8.4x 8.8x 8.2x 1 1 9.9x 2.3x 2.4x 2.2x 2.3x 1.7x 1.8x 1.6x 1.6x Source: Capital IQ, KPMG analysis Note: 1 Financial services companies differ from many other companies in how they operate. For those companies, debt acts more like raw material than operational capital. A common valuation metric used by analysts evaluating such firms is the price to book (P/B) ratio. Risk-free rates: The rise of interest rates The risk-free rate (or base rate) can generally be broken down into two key components that seek to compensate the investor: the first for expected inflation and the second for deferred consumption. The base rate is considered to be free of risks except for risks embedded in the underlying currency and risks related to investments in the particular country (including general political, legal, regulatory and tax risks, as well as the risk of a moratorium). As no investment is truly risk free, the risk-free rate is typically approximated by reference to the yield on long-term debt instruments issued by presumably financially healthy governments. The historical risk-free rates for Germany, the Eurozone, the US, the UK and Switzerland are below. A slight upward movement in risk-free rates was observed in Q3 compared to Q2 in 20. The US Federal Reserve s decisions to raise the interest rates in 20 and in 20 resulted in a slight incrase of the US risk-free rate. Risk-free rates rounded Euro-countries Germany UK Switzerland USA Date EUR EUR GBP CHF USD /3/2013 /6/2013 /9/2013 /12/2013 /3/2014 /6/2014 /9/2014 /12/2014 /3/2015 /6/2015 /9/2015 /12/2015 /3/20 /6/20 /9/20 /12/20 /03/20 /06/20 /09/20 2.50% 2.74% 2.71% 2.88% 2.53% 2.28% 1.92% 1.46% 0.69% 1.79% 1.51% 1.70% 1.03% 0.46% 0.53% 0.97% 1.25% 1.39% 1.40% 2.24% 2.51% 2.62% 2.81% 2.51% 2.26% 1.97% 1.56% 0.70% 1.65% 1.38% 1.55% 0.90% 0.49% 0.47% 0.95% 1.24% 1.33% 1.38% 3.23% 3.60% 3.57% 3.72% 3.58% 3.49% 3.12% 2.58% 2.39% 2.80% 2.58% 2.77% 2.39% 1.85% 1.61% 2.03% 1.88% 2.02% 2.05% 1.34% 1.60% 1.74% 1.93% 1.65% 1.56% 1.28% 0.80% 0.43% 0.79% 0.81% 0.70% 0.25% (0.03)% (0.06)% 0.35% 0.32% 0.39% 0.45% 3.% 3.56% 3.81% 4.06% 3.67% 3.44% 3.% 2.85% 2.66% 3.% 3.06% 3.% 2.81% 2.50% 2.48% 3.06% 3.27% 3.04% 3.04% Source: KPMG analysis Approach: Determination of a present value-equivalent uniform interest rate based on the yield curve of the specific central bank International Valuation Newsletter October 20 8
Country risk premium: Lowest for China (among the BRIC countries) The country risk premium is a measure of risk faced by businesses when investing in sovereign states. It reflects a number of risks including economic, financial, political and institutional. The country risk premium is effectively the risk of low probability, high impact events that could lead to significant losses in investment values. These types of risk are at the forefront of many investors thinking now more than ever due to a number of major economic and geopolitical events such as the Eurozone sovereign debt crisis and events in the Middle East and North Africa, all of which have led to previously stable countries becoming much riskier. KPMG s Valuation practice has been analyzing and measuring country risk for 15 years and covers more than 150 sovereign states in a proprietary KPMG analyst model. The country risk premiums for Brazil, Russia, India and China are set out below as of tember 20 for an investment period of between 0.5 and 2 years. The country risk premium for China is substantially lower than that for Brazil, Russia or India. This is driven chiefly by political and institutional uncertainties in Brazil for various investment horizons. Country risk premium 0.5 year 1.0 year 2.0 year Brazil 2.4% 2.6% 3.3% Russia 1.8% 2.0% 2.6% India 1.7% 1.9% 2.1% China 1.1% 1.0% 1.1% Source: KPMG CRP study Growth rates Growth rates are a major component of the terminal value calculation for the discounted value method and are based on country-specific inflation forecasts. The growth rates for Brazil, Russia, India and China are based on the International Monetary Fund Economist Intelligence Unit inflation forecast for the years 2018 to 2022. Brazil, Russia and India demonstrate high growth rates for 2018 as well as stable growth over the long term. A more moderate growth rate development is expected for China in 2018 and 2019, rising from 2020 onwards. Inflation forecast 2018 2019 2020 2021 2022 Brazil 4.3% 4.5% 4.5% 4.5% 4.5% Russia 4.2% 4.0% 4.0% 4.0% 4.0% India 5.1% 5.0% 4.9% 4.9% 5.0% China 2.3% 2.6% 3.0% 3.0% 3.0% Source: IMF International Valuation Newsletter October 20 9
Contacts KPMG AG Badenerstrasse 2 PO Box CH-8036 Zurich kpmg.ch/dealadvisory Johannes Post Partner, Deal Advisory EMEA Head of Valuation +41 58 249 35 92 jpost@kpmg.com Rolf Langenegger Director, Deal Advisory Valuation / Financial Modelling +41 58 249 42 71 rlangenegger@kpmg.com The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received, or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. The scope of any potential collaboration with audit clients is defined by regulatory requirements governing auditor independence. 20 KPMG AG is a subsidiary of KPMG Holding AG, which is a member of the KPMG network of independent firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss legal entity. All rights reserved.