Valuing an East European Company

Valuing an East European Company Stephen P. Ferris, Yash P. Joshi and Anil K. Makhija

A CONSEQUENCE AND PART OF privatization plans, former Soviet bloc countries are dismantling state systems of loans and subsidies to enterprises. With limited alternative domestic sources of financing, it is hoped that the privatization of former state-owned enterprises (SOEs) will be accompanied by a growth in foreign investment, particularly through joint ventures. Foreign capital cannot only underwrite the modernization of the industrial base, it can be the mechanism for introducing modern business practices and technologies. This need for foreign investment has been widely recognized in East-Central Europe and has led to the passage of liberal joint venture laws. The 1990 Joint Venture Act in Czechoslovakia, for example, contains several attractive features: foreigners can own any fraction of the venture, there are minimal controls on the repatriation of profits and capital, enterprises with foreign participation are entitled to negotiate a 'tax holiday' for up to two years with a possibility of further concessions, and the tax rate on corporate profit is reduced from fifty per cent to forty per cent if the level of foreign participation exceeds thirty per cent. These financial incentives, coupled with the possibilities for profit in markets where domestic firms in many sectors are not competitive in price and quality, was intended to generate large inflows of foreign capital. This, however, did not O c c u r . 1 By the middle of 1991, over 2500 joint ventures with foreigners had been approved in Czechoslovakia, 2 but only ten per cent had commenced activities. Moreover, the amount of capital involved was small, since the majority of these ventures were in small privately-owned businesses, such as restaurants. Indeed, large firms attracted very little interest. Of the nearly one thousand large firms undergoing privatization in the first round in the Czech Republic where foreign interest had been expected to be greater AS

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especially in anticipation of the split of Czechoslovakia into the Czech and Slovak republics in January 1993, fewer than fifty reported any foreign ownership. 3 Long Range Planning, Vol. 28, No. 6, pp. 48 to 60, 1995 Copyright © 1995 Elsevier Science Ltd Printed in Great Britain. All rights reserved 0024-6301/95 $9.50+.00

There may be several reasons behind this reluctance of foreign firms to expand into these new markets, including the recession in the West during the last few years or the continuing political instability in the region. Moreover, as noted recently by Auerbach and Stone, the time it takes to transfer economic and managerial knowledge, as well as the ingrained nature of socialist management styles, represent further impediments to foreign investment in Eastern Europe. 4 In this article, we examine a more business-related 'stumbling block' that has not received adequate attention--difficulties in striking a deal because of problems in valuing assets in a transition economy. Although business valuation is never a mechanical process, it poses special challenges in transition economies. 5 The purpose of this article is to highlight the unique issues that surround business valuation in East-Central Europe through illustrations from the case of the Czech and Slovak republics. These republics are among the first of the East-Central European nations to make substantial progress towards privatization, and the lessons learned from this experience will be valuable elsewhere. Valuation of business in a transition economy can entail uncertainties that may deter many potential investors. Some of these uncertainties are especially serious since they are magnified by the wide range of possibilities for future activities and plans of these firms. Foreign investors who are interested in joint ventures in the former Soviet bloc countries face several difficulties in evaluating their stakes. The absence of capital markets and use of socialist-styled accounting data represent basic challenges to standard firm valuation. This article, while recognizing these problems, addresses a more fundamental valuation problem that arises from the condition of the assets of the typical former state-owned enterprise. Because of historic under-investment and neglect, the value of existing assets is often small compared to the value of the firm if it can be successfully reorganized and modernized. This means that firm value is primarily driven by the future course or strategy of the firm rather than its current activities. Although future growth is always an issue in valuation, in East-Central Europe it is likely to be an unusually large component of firm value; the investor is chiefly buying an option for future growth rather than currently profitable physical assets. Alternative strategies, with their accompanying future risk and growth implications, can differ widely depending on the resources that the foreign firm possesses. Firm value and strategy (foreign firm commitment) are inextricably related and in this sense the basic issues of this paper extend beyond the mechanical application of valuation techniques. Emphasizing the value from future growth, we discusses the merits of alternative valuation pro-

cedures--book value, replacement and liquidation values, comparative value, and discounted cash flow value--in the context of the practices prevalent in the Czech and Slovak republics prior to the privatization of large firms. These lessons are relevant for most other ex-Soviet bloc countries today, since they lag in the implementation of their privatization plans. This analysis also continues to be useful for the Czech and Slovak republics, since privatization has not yet resulted in many meaningfully restructured firms or capital markets. Moreover, the economies of both these nations are now at a crossroads, poised either to enter a growth mode resulting in Western European living standards or to continue their long recessions. Processes which facilitate foreign investment will allow these governments to make the switch from stabilization to growth-oriented policies. Although the discounted cash flow valuation technique is most appealing to many investors because it allows for the expected risk and growth of alternative strategies to be explicitly included, an illustration with a Czech firm highlights both the importance and difficulties in properly accounting for expected cash flow, risk and growth. For example, the most pessimistic growth outlook yields a discounted cash flow value of equity that is nearly four times the book value of the firm as a whole. A wide range of firm values results, from the discounted cash flow analysis, however, driven by widely differing strategic assumptions regarding the growth that is possible in the region. Clearly, firm valuation is best undertaken by an insider under these circumstances; but, the common practice in the Czech republic is to hire external consultants because of local managers' lack of familiarity with valuation procedures. 6 The remainder of the article is devoted to a discussion of the applicability of the different techniques in the Czech and Slovak republics prior to large firm privatization. We focus on this period since it best illustrates the nature of the valuation problem, even though privatization has not yet produced reliable market prices. Consequently, we begin with a description of the Czech and Slovak situation in the years 1991 and 1992.

Developments in the Czech and Slovak Republics Privatization in the Czech and Slovak republics refers to the process of reducing the state sector of the economy through an expansion of the private sector's domain. This is accomplished by the establishment of new enterprises as well as the transfer to private ownership of existing state assets. In this section we briefly review the progress of privatization as it has proceeded in these new republics. This provides Long Range Planning Vol. 28

December 1995

the context for our discussion of the valuation procedures. The economic objective of privatization is the enhancement of economic efficiency with which privatized firms will operate. In order to emphasize the stand-alone value of firms in the future, it is interesting to note that the Ministry of Finance, in its information booklet on privatization, recognizes that increased system-wide economic efficiency can result from firm failures as well. The Ministry indicates that, 'from the point of view of the state, any enterprise that is going bankrupt is making the necessary space for the creation of new companies or the growth of enterprises that prosper'. 7 The privatization process is planned to occur in 'waves'. The first wave, consisting of the largest firms, has been in progress since mid-1992. 8 A second wave is now underway. Presently, the Czech Republic is anticipating completion of its programme of privatizations and transformation to a market economy by end-1995, by which time the alloted stocks will have been distributed to investors. In all, approximately 3500 firms will be privatized. Since few securities have traded so far, valuations accomplished to-date have been done largely without the benefit of market prices of comparable securities. 9 A lack of pre-existing capital markets creates a 'chicken or egg' type of situation, making it difficult to argue whether valuation or the securities exchanges should come first. The lessons are instructive for other former Soviet-bloc countries, since the development of market economies in the region remains immature. The basic approach to privatization involves the preparation of a privatization plan. Although anyone can legally propose a privatization plan, limited access to information has meant that overwhelmingly it is the managers and related parties who have developed the plans. The plan is a description of the new ownership structure, financing proposal, disposition of assets, employment targets, and treatment of environmental problems. On average two to three plans were submitted for each of the approximately one thousand Czech firms undergoing initial privatization. From the viewpoint of the foreign investor, the privatization plan may specify some preparation of the firm available for sale or joint venture. The amount to be paid will be negotiated with the Ministry of Privatization, which typically has hired Western consultants to value the firm in question. Privatization plans consist of four major sections. 1° The first involves the identification of assets scheduled for privatization. This typically requires selected balance sheet and income statement entries, employment and wage statistics, and a description of the firm's organizational and physical plant structures. It should be noted that this represents the required financial disclosure that is available to the public. Even though mandated detailed income and balance Valuing an East European Company

sheet data were filed by state-owned enterprises, there is no historic tradition of distributing annual reports to the public. The second section of the privatization plan is a determination of the restitution claims of rightful persons for property nationalized by the Communists in 1948. A statute of limitations for claims by former owners has been enacted and restitution is limited to land and structures. Restitution can be either in cash, shares, or the return of the actual property. The third section is an identification of those assets which are unsuitable for entrepreneurial purposes and which may be liquidated through public auction prior to the privatization of the firms. The last section establishes those units of business which will be independently privatized. This section allows for the possibility that a single state-owned firm may actually be privatized into a number of independent, individually-owned businesses. Those units which are neither privatized nor liquidated will remain in state hands. It is the privatized portion, either the whole enterprise or its components, that is of further interest to us. This is the portion which can be sold to foreigners or is made available for bidding in the voucher scheme. Both involve valuations. In the case of sales to foreigners, the price paid by the foreign firm is settled through negotiations and, in principle, is driven by the valuation estimate. A number of parties can be involved in these negotiations. As a common pattern of ownership in the region, the enterprises 'belonged' to specific ministries. These ministries take an active role in negotiations. In addition, all foreign deals are routed through the Czech Ministry of Privatization. Given the shortage of skilled Czech business analysts, in many cases foreign buyers sit across the table and negotiate with other foreigners who have been hired by the government. It is such a valuation situation that we are primarily examining. This resembles the circumstances prevailing in many of the other former socialist countries. When privatization through voucher or another public ownership scheme is completed and markets become active, market prices will change the valuation problem. Until such time, however, valuations 'negotiated across the table' will be necessary.

Analytical Framework: Incorporating Growth Opportunities On a conceptual level, placing a 'price' on a business simply requires a determination of the value of the estimated inflows that it will generate, net of investment outlays. The future inflows, based on revenues minus costs, result from: 1. existing assets in place and 2. from new assets that will be acquired in the

future. Thus we can express the value of a business as follows: Value = Value of Assets in Place + Value of Future Growth Opportunities Existing assets are obviously easier to value, since their technology and products are observable and some historic information on their performance may be available. In contrast, future assets are considerably harder to value. They are the result of likely future decisions to expand existing product lines or perhaps to move into new technologies and products. For some industries such as utilities existing assets can frequently provide an indication of likely future assets. In other industries such as computers, changes are rapid, and existing assets (cashflows) are not reliable predictors of future cashflows. In such circumstances, valuing future assets amounts to assessing an option that will be exercised at a later date. The value of such an option is largely dependent on the posture and abilities of the firm at that time--that is, the performance of existing assets is meaningful only because it tells us about the access to future markets and the state of the people and organization that will exploit those opportunities. The value of these growth opportunities is particularly important to business valuation in East-Central Europe. The former state-owned enterprise is selling not only a portion of its existing assets, but also provides the foreign firm with access to the option created by future growth opportunities. Two generalizations can be made about the assets of most former SOEs in East-Central Europe. First, after years of underinvestment and neglect and consequent use of obsolete technology, the value of existing assets is small relative to the value of future assets if modernization is undertaken. 11 Second, primary predictors of the value of future assets are the capital, personnel, and technological resources that the foreign joint venture partners are willing to bring to the deal. The situation is depicted in Figure 1. Two items--'value of assets' and 'value of growth opportunities'--determine the value of the business. The issues related to the two items, however, are quite different, as seen in the Figure 1: the primary determinant of growth opportunities is strategy. This is shown to depend on a host of environment and decision variables. On the other hand, the value of existing assets is determined straightforwardly by usual factors such as asset lives, depreciation, and cost of capital. The characteristics of the existing assets are taken to be fixed, resulting in some expected level of cashflows with known risk and growth expectations. In the case of growth opportunities however the cashflows depend upon resourceswcapital, personnel, and technological--that are yet to be decided. The alter-

native choices for exploiting opportunities, along with the corresponding commitment of resources, represent the set of possible strategies. The selection of a strategy from this set will become critical to the firm's ultimate success. Csath argues that the development and implementation of strategic initiatives is essential if firms are to survive in the dynamic and uncertain environment of Eastern Europe. 12The value generated by future growth opportunities may itself be the basis of financing additional future investments within the enterprise. Choice among alternative strategies presents the former SOEs and their foreign joint venture partners with some dilemmas, however, since the commitment of greater resources, at least up to a point, usually results in larger cashflows (better returns) and greater firm value. For the same share in the partnership, the foreign partner can be tempted to choose a smaller commitment; justifying it, for example, with a familiarity with superior technology. The domestic partner, unable fully to evaluate the alternative strategies, may look for other means of determining value. Given the proximity to Western Europe, one appealing procedure is to compare the value of the subject firm with that of a similar business elsewhere. In fact, the domestic partner may be tempted to argue that local opportunities should be exploited to provide comparable returns on investment, if not more, since in the near future there is likely to be relatively little local competition. In many East-Central European industries such profitability may be overly-optimistic, however, given the constraints imposed by the limited purchasing power of the population, scarcity of skilled manpower, relatively poor infrastructure and government regulations. Indeed, Woodward and Liu report that similar infrastructure deficiencies and lack of a trained managerial cadre are major obstacles for Western investors in China's liberalizing economy. 13 In most cases, the upper bound on the value of the business is the value of a similar business in the West after some discount.14

Methods of Valuation Finance managers of former state-owned enterprises, bank officers, local and foreign valuation experts, staff in various ministries, and academics were interviewed for our research regarding valuation practices in use in Czechoslovakia during 1991-1993. These sources included employees of the Czech Ministry of Privatization, Slovak Ministry of Privatization, Czech Ministry of Industry, Slovak Ministry of Industry, Federal Ministry of Finance, Price Waterhouse, Harvard Capital and Consulting (investment fund), Prague School of Economics, Czechoslovak Management Centre, Strojimport (import/export firm), Gumarne Barum (tires), Prvni Investicni (investment Long Range Planning Vol. 28

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New investment and its cost according to risk of strategy

Capital Technology Personnnel

Strategy

VALUE OF GROWTH OPPORTUNITIES

Period of competitive advantage which determines growth rate

Original asset Cashflows

VALUE OF BUSINESS

Period of asset decay

Current asset Cashflows VALUE OF EXISTING ASSETS Cost of capital

Project risk

fund), Ekogrobanka (small loans), Tatra Bank, Investicni Bank, Obchodni Bank, Spolana (Chemicals), Kovohute (metals), Kauck~ (Chemicals), and ZTS Dubonica (armaments). Forty-five years of state ownership of industry has left management unfamiliar with a profit orientation. Valuing an East European Company

Many Czech and Slovak managers were unfamiliar with valuation terms and corresponding Czech/Slovak words did not exist. Short of trained personnel, most companies planned to rely on external consultants. A summary of our interviews and related discussions follows.

Book Value

Replacement and Liquidation Values

The Czech and Slovak governments have made widespread use of the book value approach to asset and firm valuation. Indeed, the subscription price for the shares of the privatized firms are set in book value terms rather than current market values. Also, it seems that most managers feel comfortable with book values since they reflect the historical cost of the assets and do not require an assessment of either current or projected market conditions. In the past, this method was likely to have been useful because inflation was kept at very low levels and detailed bookkeeping for preparing the equivalent of income and balance sheets had been well-established, although the need for business valuation was clearly limited. There are a number of problems with using this method in the new economic environment. For instance, the price level is highly uncertain, with inflation for 1993 exceeding 18% (Wodd Economic Survey, 1993/94). Indeed, government schedules for land prices have been revised upwards by over 300% in the three years after the Revolution, reflecting problems with historic values. But these problems with book value are common in the West as well. Another limitation with the book value of assets drawn from accounting data is unique to the former socialist countries. The accounting practices still in use (firms are adopting Western systems now) do not recognize land values. ~5 Adjusting for land prices is problematic because a credible real estate market is still emerging. 16 A second important item deals with accounts receivable/payable. During the socialist regime, firms generally satisfied their accounts payable within a stipulated fifteen-day period, the eventual transfer of funds being managed and guaranteed by the common 'owner', the state. Currently, the fifteen-day period is not being met by many enterprises who have had financial difficulties during the transition. Indeed, it is because of these aging receivables that the first cases of bankruptcy are expected to be filed. The value of these growing payables is highly uncertain. A third item worth highlighting deals with depreciation. The depreciation rate on plant and equipment which is calculated on a straight-line basis over a very long economic life results in an underreporting of the depreciation chargeable to an asset. Accounting for land results in an under-reporting of firm worth, while the true value of receivables is likely to be overstated. Later, using an illustration of an actual Czech firm's accounting statements, we find that the book value of the firm's assets is barely onefourth of the least favorable estimate from the discounted cashflow method. Finally, our framework suggests that even if the book value were a fair estimate of the value of existing assets it would ignore the most important c o m p o n e n t - - t h e value of growth opportunities.

Replacement value is the cost of replacing all the physical assets of the firm. The firm's value becomes equivalent to the cost of replacing its assets. This approach had an intuitive appeal in the republics because the Czechoslovakian Ministry of Finance historically produced cost schedules for land, buildings, etc. But the schedules have rapidly lost any congruence with current market prices. For example, real estate schedules represent uniform rates for large areas and are unadjusted for the growing disparity in prices based on location. At any rate, the p r o c e d u r e - apparently popular during the socialist admini s t r a t i o n - i s cumbersome because it necessitates extensive asset itemization and has almost prohibitively costly information requirements. While there are considerable estimation problems in calculating true replacement costs for various assets, there is a more serious conceptual deficiency in the replacement cost method of firm valuation. This method ignores that component of firm value attributable to future growth opportunities. A viable firm is more than its visible physical assets, and thus its value will have a worth m u c h greater than simply the sum of its visible physical assets because of the value of intangibles such as its distribution system, customer brand awareness and loyalty, perceived product quality, firm reputation and growth opportunities. In terms of our framework, replacement cost procedures understate the values of the firms not only because they ignore the values of future growth opportunities but also because they do not include the income (cashflow) generated by the existing assets. By similar arguments, the value of a non-viable firm might be less than the cost of its physical assets if it does not produce sufficient cash inflows. A related valuation method may be more relevant in some cases. The liquidation value of the firm represents the potential sale price of the firm's assets on a piecemeal basis. In this sense, it represents a m i n i m u m value, for if the going concern value is less, then the shareholders' wealth is maximized by liquidating the firm and distributing the proceeds. This may in fact apply to many of Slovakia's industries which are characterized by obsolete technologies and a declining demand for their products. As we have argued above, this may be the appropriate approach for a nonviable firm. Non-viable firms, however, are unlikely partners in joint ventures. Discussion with consultants and managers suggests that neither the liquidation value nor the replacement value methods are applied in practice. The information requirements make these procedures difficult to implement. They are, nevertheless, intuitively invoked to justify other firm valuation estimates.

Comparative Method The comparative method of estimating firm value is based on the notion that two assets that are 'essenLong Range Planning Voh 28

December 1995

tially identical' should sell for 'essentially identical' prices; otherwise, arbitrage opportunities will become available and eventually dissipate the difference. This method has an intuitive appeal in the region. Application of this method in the Czech and Slovak republics typically involves identifying an industry counterpart in either a former Soviet-bloc country such as Hungary, Poland, or Romania, or in a West European nation. Among the latter group, German firms appear to be the most frequently chosen, perhaps because many (nearly 30%) of the joint ventures are with German firms. Indeed, in 1993 Germany was the largest single investor in the Czech Republic, accounting for 37% of total foreign investment. As our framework w o u l d suggest, use of a comparable West European firm is justified by Czech or Slovak partners with the argument that the foreign buyer will employ the assets in such a manner as to generate higher asset yields. Yet this comparison is questionable because of differences in infrastructure, technology, management, consumer incomes, etc. Many of the large accounting firms operating in the republics maintain proprietary lists of comparable West European firms to be used in valuation contracts. Typically, a discount is applied to the value of the Western firm and this figure then serves as the basis for the estimate. Ad hoc adjustments to West European firm values to control for these economy-wide factors are necessarily subjective and result in valuation estimates subject to considerable debate. The use of comparable firms located in formerly socialist countries has its own limitations. Many of these firms themselves suffer from a lack of readily available market prices because, even in the few cases where they have been privatized, the capital markets are still immature and unreliable. As an alternative, one German transportation and electrical systems manufacturer has elected to use the data from Spain, Portugal, and Greece after their joining the European Community. One may argue that another set of comparable firms can be found in South American or Southeast Asian firms. Many countries in these regions have limited capital markets, with a small group of actively traded stocks. It is likely that the planned Czech and Slovak stock markets (Prague and Bratislava) will follow these models, at least initially. 17 Moreover, some of these regions are also characterized by a weak infrastructure and a low per capita income as in the Czech and Slovak republics. Besides problems with identifying a comparable firm, establishing its value, and determining an appropriate discount rate, it is necessary to scale the value according to the size of the Czech or Slovak firm. Possibilities include the units of output or some adjusted or unadjusted earnings measure. In terms of our framework, the value of assets in place and the value of growth opportunities is jointly captured in the value of the comparable firm. The problem is that Valuing an East European Company

full comparability may not be possible and a discount may be necessary. It is unclear h o w such a discount should be estimated. One may argue that the discount largely reflects the ability to capture value in growth opportunities relative to another firm. No explicit mechanism to do so has been recognized in the literature. Rather, as described in the following method, growth can be directly taken into account.

Discounted Cash Flow The discounted cashflow approach arrives at an estimate of firm worth by discounting the projected cashflows, net of equipment outlays, at an appropriate risk-adjusted rate. Three items are required for its implementation: 1. the firm's cashflows net of investments, or free cashflow, 2. the rate of growth of these cashflows, and 3. the discount rate. We note that the focus of this method is on the value of the equity. This is a correct emphasis since some fraction of this equity value will represent the stake of the foreign firm.

Accounting Statement Translation The first problem in applying this method to the Czech or Slovak firms is that the socialist accounting systems in use are production-oriented rather than income-oriented. Consequently, the financial statements must first be translated into a Western format, which in turn must be analysed to obtain estimates of free cashflow. Historically, Czechoslovak enterprises produced monthly profit and loss statements, with a number of accounts that have no direct counterparts in Western accounting. The accounting statements were used to show compliance with production quotas. In Table I we list some of the notable features of the Czechoslovak accounting system. Later in Table 3 we show h o w a Czech accounting statement can be converted into an American-style financial statement. The translation of theses domestic financial statements into a Western format will be a generic problem for all transitional economies in the region. The practice in the Czech and Slovak republics is that private consulting and accounting firms develop their own procedures (proprietary algorithms) for the translation of financial statements. Because many accounts do not have a clear correspondence with Western systems, an element of judgement is involved and the algorithms differ across users.

Incorporation of Value from Future Growth The next step in the application of the cashflow approach is an estimate of the growth rate in future cashflows. Most valuation firms in Czechoslovakia arrived at this rate after interviewing management and an analysis of the firm's entrepreneurial plans over the ensuing 5-7 years. Others estimated growth rates on a more ad hoc basis, using comparable West-

Item

Characteristic

A. Income Statement Sales Sales of material and fixed assets reported net of selling costs Cost of Sales No tie-in to inventory valuation Aggregate wages reported Aggregate overhead reported Depreciation Low depreciation rates Offset by high repair and maintenance expenditures Wages Excludes free housing, recreation and other items provided by the company. Housing costs are included Materials, Repair and Maintenance, etc. Often on Cash Basis Interest Expense B. Balance Sheet Inventory

Fixed Assets

Securities Debt

Finished Goods and Work-inProgress valued at fully allocated price. Semi-durable assets should be included in fixed assets Seven classes with different depreciation rates within each class10-30% of assets fully depreciated Accounted for at historical price Foreign currency debt usually not revalued

ern European industry rates, and then adjusting them downwards. Users of this approach were understandably vague about adjustments, with typical growth rates adjusted down by 25% to 50%. In a few cases, forecasters project a negative growth rate in cashflows as unprofitable lines are eliminated. Estimation of the rate of growth of future cashflows is critical to the valuation of a firm. Without a detailed analysis of the company's business plan and likely market conditions, the value of future growth opportunities cannot be properly addressed. An external valuation appraiser may improperly assess growth opportunities for firms in transitional economies because of the difficulty in securing the necessary information.

Risk Analysis The value of growth opportunities can not be separated from the discount rate. The nature and extent of future earnings prospects determines the riskiness of a firm's cashflows. As a result, another critical variable in the exercise of discounted cashflow analysis is the estimation of an appropriate discount rate. Approaches currently in use in the republics vary from use of a single hurdle rate based upon a subjectively determined return on investment 'grossed up' by an expected inflation premium to a more soph-

isticated application of the Capital Asset Pricing Model (CAPM). TM As transitional economies relax price controls and permit commodity prices to reflect world market conditions, inflation will quickly become a concern. 19 Thus, one must consider the impact of inflation upon cash flow projection and resulting firm valuation. In the next section, we illustrate the use of the discounted cash flow method. The existing cash flow reflects the value of assets in place. H o w it grows depends on the value of future opportunities. Similarly, the riskiness and corresponding discount rate which is applied to the cash flows depends on the projected assets.

An Illustration of Firm Valuation In Table 2, we provide an example of a monthly profit and loss statement for a Czech metal products manufacturer located north of Prague that produces bars, tubes, wires and copper alloys. For purposes of this illustration, we use the accounting conversion package developed by Price Waterhouse described in Table 3. The Czech statement is then easily recast into an American-style income statement that is provided in Table 4. From this income statement we obtain our estimate of free cashflow that will become the focus of our illustration. Note that we estimate free cashflow since it represents the total after-tax cashflow generated by the firm net of investment outlays and is available as returns to the supplier of capital. Since free cashflow is net of investment outlay, it is also important in terms of our valuation framework. The investment outlay is of great concern to the domestic partner since it affects the value of growth opportunities that can be realized. This will then influence the valuation estimate calculated for the firm. As can be seen from Table 2, the socialist financial statements are quite elaborate. They are, however, not organized with a profit orientation. Rather, they are designed to satisfy control purposes. Using Table 3 to convert the profit and loss statement of the Czech metal manufacturer to an American-style statement, we observe that the socialist sales figure includes goods produced and placed in inventory as well as deliveries to customers. In Table 4 we find that the American-style income statement implies a free cashflow of $31,220, reflecting flows to equity from assets in place. The growth rate of this cashflow will depend upon future investment and market opportunities. As we examine the rate of growth in the following step, we should recognize that in the first several years following privatization a firm may undergo an adjustment period before attaining a stable growth rate. In this particular valuation, we w o u l d assume that Long Range Planning Vol. 28

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Line No.

Account

Value

Line No.

Account

Value

21 22 24 25 26 27 28 29 30 31 32

Materials Fuel Material and Fuel Price Change Power Repair and Maintenance Communication Other Services Depreciation--Semi Durables Non-material Services Material Price Differences Subtotal (21-31)

1,610,452 12,451 56,351 44,740 8,060 400 2,940 15,660 11,324 (6,223) 1,756,155

33

Depreciation--Fixed Assets

22,900

37 38 39 43

Wages Interest Wages Voluntary Tax Other Financial Costs

30,419 32,900 17,850 846

51 52 53 101 102 103

Total Costs Profit/Loss of the Period Turnover Profit/Loss of the Period State Subsidy for losses Undistributed Profit

1,861,070 131,200 1,992,270 131,200 0 131,200

61 62 63 67 70 73 75 131 132 133 135 136 137 138 110 119 120 121 122 123 127

Sales Revenue--Production Sales Revenue--Trade Sales Revenue--Other Material for Own Consumption Revenues from Sale of Stock Change in Work in Progress Earnings Materials Fuel Semi-durable Fixed Assets Sub-deliveries WIP Finished Goods Kitchen Stocks Tax Entertainment and Gifts Other uses of Economic Results Contribution to funds Contribution to Funds Contribution to Funds 110-123

1,969,539 600 2,200 1,355 445 18,131 1,992,270 107,945 5 16,000 2,000 70,000 30,000 50 72,160 26 49,454 715 2,960 5,885 131,200

Czech or Slovak Format

Line No.

Account Name

67 73 75 21 31 37 39 29 33 38 110 22 24 25 26 27 28 30 43

Material for Own Consumption Change in WlP Earnings Materials Material Prime Differences Wages Wages Voluntary Tax Depreciation-Semi Durables Depreciation-Fixed Assets Interest Tax Fuel Material and Fuel Price Change Power Repair and Maintenance Communication Other Services Non-Material Services Other Financial Costs

Western Format

Account Name

Sales

75-73-67

Cost of Goods Sold

21+31

Salary and Wages

37+39

Depreciation Expense Interest Expense Tax Expense

29+33 38 110

OtherExpenses

22+24+25+26+27+28+30+43

initial growth rates are unlikely to exceed those of Western Europe, given the difficulties in retooling, the significant retraining requirements and the inadequate infrastructure. A realistic business plan might project a real growth rate of approximately 2%. Higher growth rates four to five years in the future Valuing an East European Company

could then be projected, possibly exceeding those of comparable Western firms. Justification for such estimates will focus on projected foreign investment, a retrained labour force and access to n e w markets. We provide, in Table 5, valuation estimates across a number of growth rates. The choice of growth rate should

A. Annualized Czech Firm Profit and Loss Statement Converted into a Western Style Income Statement (in US$) Sales Revenue Cost of Goods Gross Profit Salaries and Wages Depreciation Other Total Operating Expenses Operating Profit Interest Expense Profit Before Tax Tax Profit After Tax

$816,324 $663,819 $152,505 $19,973 $15,956 $56,736 $92,665 $59,840 $13,614 $46,226 $29,859 $16,367

B. Estimation of Free Cashflow Free Cashflow = Profit After Tax + Depreciation Change in Investment =$16,367+ $15,956 - $1,103 = $31,220 Notes: 1. Changes in Investment represents changes in the Working Capital and Fixed Asset accounts. 2. These changes can be obtained from a comparison with the previous period balance sheets or approximated from the historical variability of these data. 3. Czech crowns were converted into American dollars at the rate of 29 korunas to the dollar.

come only after considerable analysis. The growth rates chosen here are a conservative representation of the range of possibilities recognized by the management of the Czech metals manufacturer. This is not a high growth industry in either the United States or Western Europe. As pointed out above, another important parameter in performing a firm valuation is estimation of the discount rate. A discount rate captures the risk associated with a cashflow and is the means by which future

cashflows are translated into present value equivalents. Because both Czech and Slovak firms are facing the uncertainties of a competitive marketplace for the first time, it is difficult to determine their true riskiness. Consequently, there is significant divergence of opinion concerning the most appropriate method of generating a discount rate. One method currently in use involves the application of a discount rate for a Western European firm 'grossed up' by an additional risk premium of between 10 to 15%.2° This exphdns the large discount rates used in Table 5. Again, this represents a conservative approach to firm valuation. In Table 5 we present our valuation results for the metals producer, using a variety of growth rates and discount rates.There is a substantial variation in equity value, ranging form a minimum of $101,462 to a maximum of $715,419. This table indicates the sensitivity of equity value to assumptions regarding the discount rate and the growth rate in cashflows. The highest equity values are associated with low discount rates by investors and high projected rates of futm:e cashflow growth. For comparative purposes, we present the Western translated balance sheet of the metals producer in Table 6. 21 We observe a current book value for the firm of $25,958. This represents only 3.5% of the most favorable estimate using a discounted cashflow approach and 24.7% of Table 5's least favorable estimate. Indeed, the book value of equity is only $13,216. Such low figures for the firm's worth reveals the critical shortcoming of the book value approach. Because it ignores the importance of future growth opportunities, a balance sheet method for firm valuation will underestimate true economic worth. The divergence between the two methods may be reduced by inclusion of land values. This, however, is practically difficult since there does not currently exist a credible real estate market.

Discount rate

Growth rate of cashflows for the next four years

10%

--2% 0% 2%

2% 345,107 370,837 398,052

4% 435,253 468,570 503,841

6% 615,554 664,036 715,419

20%

--2% 0% 2%

155,903 166,136 176,912

167,475 178,683 190,493

182,354 194,814 207,954

30%

-- 2% 0% 2%

101,462 107,449 113,729

105,063 111,353 117,955

109,264 115,908 122,885

Growth rate of cashflows for years 5 and hereafter

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December 1995

Assets

Claims against Assets

Accounts Receivable Inventories Total Current Assets Gross Fixed Assets Less: Accumulated Depreciation Net Fixed Assets

11,774 5,729 17,488 20,886 12,433 8,452

Accounts Payable Bank Loans and Other Creditors Accruals Total Current Liabilities Long Term Liabilities Shareholders' Equity

6,527 5,227 986 12,742

Total Assets

25,958

Total Liabilities and Equity

25,958

Conclusion A number of factors complicate the valuation process in East-Central Europe. Besides the bureaucratic negotiations over the value of the firm with various ministries, the obvious absence of credible capital market prices for most firms contributes to the difficulties in obtaining a valuation. The Czech and Slovak accounting systems akin to that in other countries in the region, also makes it difficult to identify the necessary information to calculate asset values. Furthermore, this study suggests a more fundamental problem inherent in the valuation of state-owned enterprises within the former Soviet-bloc. The existing assets of a firm, which are relatively easy to value, are likely to represent only a small fraction of the firm if it is reorganized and modernized by the foreign joint venture partner. The bulk of the value of the revitalized firm--value attached to its future activities or future risk and growth possibilities--depends on the strategy (investments) that the foreign investor will bring to the enterprise. This relationship between firm value and strategy makes it difficult to implement traditional valuation procedures mechanically. To an extent, this resembles the difficulties inherent in the valuation of high growth potential firms, such as initial public offerings of high tech Western firms. One important difference is that American firms are priced in an active capital market. In East-Central Europe traditional firms encounter the same pricing problems as high tech American firms, but without the benefit of a well developed capital market.

In this study, the problems of valuation are illustrated with data on a Czech metals manufacturer, beginning with its socialist-styled accounting data. A number of traditional valuation methods such as book value, liquidation and replacement value, and comparative value do not take future strategy (expected risk and growth) into account. Alternatively, another traditional method, the discounted cashflow procedure, explicitly incorporates risk and growth. The importance as well as problems of incorporating growth are seen in the results from the discounted cashflow method. The least favorable risk and growth strategy produces an equity value that is nearly four times the book value of the firm's assets. Moreover, the value estimates have a large range for a reasonable set of growth rates. This underscores the crucial role of firm strategy in the determination of firm value in a transitional economy.

We are grateful to a large number of individuals who have helped us in this study. We would to particularly like acknowledgethe contributions madeby Dan Fogel(Universityof Pittsburgh), Walter Howes (Price Waterhouse), Raymond Betler, (President, AEG Transportation Systems). Petra Wendelova (Harvard Capital and Consulting), and Ms Eva Klvacova, special assistant to the Czech Minister for Privatization. We would like to thank the staff of the Czech ManagementCentre for arrangingthe interviews and translations without which this study would not have been possible. At the time this study was undertaken,YashP. Joshiwas on the faculty of Northeastern University.The views expressed in this paper do not necessarily represent the positions of the organizations with whom the authors are affiliated.

References 1. As in any transitional economy, there exist a number of risks to the foreign investor, regardless how liberal the tax laws and regulatory oversight. V.H. Kirpalani, K.C. Mun and M. Hui argue that investors in emerging markets should constrain the amount of investment initially at risk while striving to improve operational effectiveness. They further note that financial risk can be reduced by following a 'foothold' market entry strategy. See V.H. Kirpalani, K.C. Mun and M. Hui, Hong Kong and China: Strategic options for investors, LongRangePlanning25 (2), 44-51 (1992). 2. Price-Waterhouse Information Guide, Doing Business in Czechoslovakia, August (1991).

Valuing an East European Company

0 13,216

3. This is based on the data submitted to the Czechoslovakian Ministry for Privatization by large Czech firms which participated in the first wave of privatization. On 1 January 1993, Czechoslovakia was split into the independent Czech and Slovak Republics. The discussion in this article applies to either of these republics. Because of its greater industrialization and more developed relationship with Western European economies, analysts anticipate that privatization will proceed more rapidly in the Czech Republic. 4. P. Auerbach and M. Stone, Developing the new capitalism in eastern Europe--how the west can help, Long Range Planning 24 (1), 58-65 (1991). 5. See, for example, T. Copeland, Tim Koller and Jack Murrin, Valuation: Measuring the Value of Companies, 2nd edn, J. Wiley and Sons, New York (1993). 6. This discussion also has implications with regard to negotiating the terms of a joint venture, but that subject is not explored in detail here. 7. Information Booklet: Voucher Privatization, p. 3, Ministry of Finance, CFSR, Prague, (1991). 8. Privatization of these large firms, however, has proceeded much slower in both the Czech and Slovak Republics than for corresponding smaller businesses. P. Aghion and R. Burgess note that a number of factors account for this, including ill-defined property rights, administrative bottlenecks, labour reorganization, operational restructuring, inadequate domestic savings and a scarcity of managerial talent. See P. Aghion and R. Burgess, Financing in Eastern Europe and the Former Soviet Union, In D.K. Das, International Finance: Contemporary Issues, pp. 101-124, New York, Routledge (1993). 9. Bythe end of 1992 no equities had been traded, while by late 1994, only a small number of securities were trading. These stocks, however, were experiencing unexpectedly thin markets.

10. Mandatory Format of Privatization Projects, Financier Credit Suisse-First Boston, Prague (1991).

11. H. Barton et al. contend that even these existing assets are strategic in the sense that they still have a significant impact on the firm's operations and have the potential to affect its long-term performance. See H. Barton, D. Brown, J. Cound, P. Marsh and K. Willey, Does top management add value to investment decisions, Long Range Planning 25 (5), 43-48 (1992). 12. M. Csath, Corporate planning in Hungarian companies, Long Range Planning 22 (4), 8997 (1989). 13. D.G. Woodward and B. Liu, Investing in China: guidelines for success, Long Range Planning 26 (1), 83-89 (1993). 14. Although the negotiation process between the foreign investor and the state is not discussed in this study, it is expected that the process should terminate with the foreign partner's agreement to commit those resources necessary to achieve the highest potential firm value. 15. To date, the particular Western accounting system has not yet been mandated. 16. Another problem associated with land valuation in the Czech and Slovak Republics is the uncertainty in actual ownership due to the residual rights of the pre-1948 owners. 17. An alternative model for emerging stock markets as noted by H.R. Stoll is for these exchanges to expand their listings by including stocks from around the world. Stocks could be traded either directly or through a Depositary Receipt procedure as is used in the United States. See Hans R. Stoll, The Shape of World Equity Markets, In Hans R. Stoll (ed.), International Finance and Financial Policy, pp. 219-226, Quorum Books, New York (1990).

18. E. Jermakowicz and W. Jermakowicz, Business valuation in the privatization process: the case of Poland, Multinational Business Week Review, 28-37, (1993).

19. Earlier inflation rates in Czechoslovakia were quite high, for instance 1991's inflation rate approached 60%. Estimates for 1994, however, are more moderate, centring around an annualized rate of 10% according to the World Economic Survey 1994/95.

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20. Some consultants did apply more sophisticated techniques, such as the Capital Asset Pricing Model to estimate the discount rate for the Western firm. Yet the next step which involves 'grossing up' the risk premium is nevertheless highly subjective. 21. The actual translation of the Czech balance sheet into a Western style equivalent was accomplished using another of the Price-Waterhouse accounting algorithms. For reasons of economy of space, we do not reproduce them in this study.

Valuing an East European Company