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'What's the value of this thing?' (valuation of Eastern European businesses)(Chairman's Agenda: Acquiring in Eastern Europe)

Some practical considerations in coping with the uncertainties of East Bloc business valuation.

Most business people would throw up their hands if asked to value a company operating amidst the accelerating political, economic, and social changes in Eastern Europe. Valuing Eastern European companies poses unique challenges compared with valuing Western firms; nevertheless, the same general concepts and approaches apply. As the move toward capitalism continues, the need for valuation expertise grows daily. Foreign capital is essential to privatization and allows companies to invest in more competitive and efficient technologies. In addition, public policy requires that these investments occur at fair values. Potential investors, government agencies, and company management must have access to reasonable valuations to facilitate the transition to market economies.

Valuation Methods

Business valuation focuses on two general approaches: market multiples and discounted cash flow. The market multiple approach capitalizes a normalized, or sustainable, level of earnings or cash flow with a multiple developed from analyzing trading prices or change-of-control transactions for similar public companies. The discounted cash flow method first projects company cash flows for three to 10 years, then calculated a present value using a discount rate that incorporates the risks of achieving the forecasts. These approaches can be applied to Eastern European firms as long as the important differences with Western companies are considered.

Due Diligence and Historical Financial Analysis

Performing due diligence and obtaining data in Eastern Europe has the same goals as in the West -- a thorough understanding of the business, including historical performance, current competitive and financial situation, operating and strategic plans, and future prospects. Obtaining this information is quite a different story.

Financial statements from Eastern European companies do not compare with those in the West. Local accounting practices typically have changed from year to year, making historical trend analysis difficult. Fortunately, many companies are turning to outside accountants to restate their results in U.S. Generally Accepted Accounting Principals (GAAP) or similar standards.

In many cases, management may be unfamiliar with, or even uncomfortable, discussing performance in terms of cash flow and profitability. State-owned enterprises were often judged and managed on the basis of unit volume. Cash flow forecasts are practically nonexistent. Since such projections are essential to the valuation, the company's outside financial adviser normally assists with their preparation.


Even consistent financial statements may not be useful in assessing future performance, because of the magnitude of changes affecting every aspect of a company. Political and legal developments alone have dramatically altered the business operating environment.

The move to a market economy with unregulated prices, unrestricted imports, and convertible currencies means that most domestic firms will face international competition for the first time in decades. Intracountry competition will also increase as companies are free to sell any product, not just goods that are centrally mandated. The collapse of the Soviet Union's economy, coupled with limited hard currency convertibility for the ruble, eliminates the major Eastern European trading partner. The recent curtailment and eventual elimination of Soviet energy supplies at below-market prices has not yet affected the national budget deficits or company results.

The business environment in each country is nowhere near equilibrium. This uncertainty translates into increased risk and must be incorporated in selecting market multiples and discount rates. The discounted cash flow approach must include a sensitivity analysis of all key variables.

Projected performance will also significantly depart from the past where new foreign capital and management talent come into the firm. Investments in new technology, changes in product mix, and the availability of the foreign investor's marketing channels make financial forecasts much more relevant than historical results.

Segmented Markets

Underlying a valuation is the fundamental premise that investors can freely diversify their portfolios internationally. Investors then require a return from a given security or business that reflects the risk that cannot be diversified. This means companies that have similar risk characteristics will be valued similarly. This allows us to develop multiples and discount rates from similar companies that trade on exchanges in other countries, as long as capital can flow freely into and out of the country.

If a country restricts capital flow or limits currency convertibility, then we cannot directly use proxy companies from other countries' markets. A firm that operates in unrestricted capital markets whose investors can fully diversify will face lower capital costs than an identical firm whose investors have fewer opportunities to diversify. The former firm will be valued more highly because it has the same cash flow but lower required returns to investors. The lack of domestic capital markets in Eastern Europe forces us to incorporate a subjective discount to reflect constraints on capital and currency. As a practical matter, however, countries in which privatization is a priority also moving simultaneously to reduce restrictions on capital flows and currency convertibility.

Cost Structure Issues

Social welfare expenses -- such as ownership and maintenance of temporary apartments for workers, and supplementary retirement payments -- comprise an important part of historical financial results. Full employment policies have left firms overstaffed. Companies now have much greater latitude to modify their work force and benefit plans.

Future tax payments will be affected by companies with foreign investors. Available tax benefits may create substantial value for profitable firms.

Valuation advisers to Eastern European businesses can learn and benefit from extensive Western experience. Limited availability of financial data from companies and the rapid economic changes result in a higher level of uncertainty. Generally investors do not shy away from start-up ventures or companies in turnaround situations in the West, despite the variability of future performance. Opportunities in Eastern European companies may represent a similar combination of risk and return.

Jeffrey R. Greene is a Managing Director, and Edward P. Krawitt is an Associate, of Houlihan, Lokey, Howard & Zukin, a Los Angeles-based, full-service financial advisory firm.
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Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Author:Krawitt, Edward P.; Greene, Jeffrey R.
Publication:Directors & Boards
Date:Jan 1, 1991
Previous Article:From the bizarre to the merely complex: a legal perspective on the changing rules of the game in investing in Eastern Europe.
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