Business valuation in the privatization process: The case o

Multinational Business Review, Spring 1994 by Jermakowicz, Eva K, Jermakowicz, Walter W

Business valuation is an attempt to calculate a price that may be paid for an entity by a willing buyer to a willing seller when neither party is under duress for the transaction. On the demand side, the business valuation gives a solid basis for investors making an investment in privatized companies. It mirrors the thought process that they experience in analyzing businesses before making their decisions. The valuation report provides an external and objective appraisal of the company's value and future potential. It gives investors greater security in the decision to become owners and assume a risk they have to face.

On the seller's side, it has to be remembered, as stressed by Lipton and Sachs [1991], that the seller i.e. the Ministry of Privatization (MoP) is not a commercial organization, and it is not exposed to the risks inherent in any market economy. Moreover, the employees of the MoP lack a motivating direct personal stake in ensuring the price is fair. At the same time, the state wants to control the objectivity of the transactions and desires evidence that the price demanded for state-owned enterprises is fair. The objective business valuation provided by consulting firms working for the MoP is essential to avoid potential scandals or the perception of corruption in the privatization process. A proper valuation can eliminate the deals which should not be struck and generate public support for those which are valid.

Therefore, the process of valuing a company does much more than just determine the firm's fair market value. Properly done, the business valuation process and report can facilitate a company's transformation, prepare it for survival in competitive markets, and build public support for the new market system.

OBJECTIVITY VS. SUBJECTIVITY

Scholars have often noted that reliable and objectively prepared business valuation is a prerequisite for the success of privatization through initial public offering, where companies are sold to the public case by case (Frydman, Rapaczynski 1992; Lipton, Sachs 1991). Given the conditions prevalent in Poland, the determination of an "objective" value for a business entity constitutes, however, one of the most difficult problems. There are many reasons for that.

Poland suffers the absence of capital markets. The lack of these markets makes it impossible to establish any reliable benchmarks against which the value of an enterprise can be measured or to reason the value by analogy with other enterprises of the same type (Dietl 1992, Frydman, Rapaczynski 1990).

Polish enterprises lack data from the past. Records gleaned from the last five years, when the enterprises functioned within the regime of a command economy, tell nearly nothing about a firm's present value. Given no reliable track record, it is impossible to make even informed guesses about how a given firm would do under the conditions of a free market economy(1) (Lipton, Sachs 1991).

The existence of the institution of "interfirm credit," the chain of mutual indebtedness among the companies along the vertical production process, introduces an additional element of uncertainty. As Frydman and Rapaczynski (1990) write, in Poland around 40 percent of the book value of companies being prepared for privatization resides in the form of funds to be collected from other enterprises (receivables). It is very difficult to predict what portion of these funds will ever be recovered(2).

Poland is exposed to high political, financial and economic risk. The political risk includes factors like frequent government changes, militant trade unions and still very strong pro-socialist sentiments. The financial risk is based on the high likelihood of losses from exchange rate controls and loan defaults. The economic risk takes into account such factors as very high inflation and debt service costs. The ratings of Poland among 129 countries shows the following numbers: political risk 62.0; financial risk 29.0, economic risk 31.0 and composite risk 62.0. Poland was rated in 57th place among 129 countries (The Wall Street Journal 1991).

The disruption of exports to the former Soviet Union and other East European countries creates a situation of uncertainty concerning future sale possibilities. The export conditions to the West continually change, and it is difficult to predict the state of the whole economy or even of its particular segments a few months ahead. The problems related to forecasting of future cash-flows are fundamental problems, which form the substance of business value. At this time it is difficult to make predictions about interest rates and tax policies, and little can be said about the future development of special business sectors regarding market trends or penetration of foreign suppliers. This makes cash-flow forecasting and business valuation extremely insecure (Accounting 1991).

The enterprises in Poland are also exposed to high inflation rates and a high unpredictability in long-term interest rates. In the process of valuation, some assumptions about long-term interest rates are necessary to calculate the present value of future streams of income. In Poland, this is still simply set by the state in response to high inflation. Relatively small variations in the interest rate may radically affect the estimated value of an enterprise.