Each month, bizval co-founder and finance specialist The Finance Ghost shares his learnings from listed companies and how they can be applied to private companies.
Success in succession
The valuation of a company goes beyond the numbers. Although Artificial Intelligence (AI) is growing at an almost alarming rate, we aren’t at the point where computers can run companies. Not yet, at least.
Until that day comes (and hopefully it never will because Arnold Schwarzenegger is now 75 years old and probably can’t save us), the management team is an important part of any investment decision. For founder-led companies, this becomes an even more significant area of focus in a valuation and due diligence process. The first passing of the baton is also the hardest one, as founders take the gigantic step of allowing professional management to take the reins. Once that succession journey has been cemented, the next handover to a professional CEO is easier.
In public markets, a well-telegraphed succession plan makes investors comfortable. On the Johannesburg Stock Exchange (JSE), we’ve seen two such recent examples. Dis-Chem was a great example of a handover from the founding family to a professional management team, while Momentum Metropolitan saw a seamless transition from CEO to deputy CEO. Globally, Netflix founder Reed Hastings stepped down as co-CEO at the start of 2023 and got out of the way of two other co-CEOs who are now running the company.
The concept of a “co-CEO” isn’t great of course, but it’s a step in the right direction for the group.
If enormous, listed companies struggle with succession planning and life-after-founder issues, it’s not hard to see why buyers of private companies tend to knock down the valuation substantially where there is little evidence of succession.
One of the best ways to increase the value of a company and to lower the discount rate applied to the cash flows is to reduce risk through having a well-considered succession plan.
It’s not easy, we know.
Country risk is a real thing
Like it or not, where you build makes a big difference. All else being equal, a company in the US will typically trade on a higher multiple than a company in South Africa. Likewise, a company in South Africa will trade on a higher multiple than a company in Nigeria or Angola.
Macroeconomic stability is one of the most sensitive inputs in a valuation model. This is hugely frustrating for founders, as geopolitical issues are well outside of their control. Life isn’t fair and neither is business, sadly.
Country risk is measured by the “risk-free” rate for a particular region, which is usually the yield on 10-year bonds. We’ve been through an exceptionally volatile period over the past couple of years, with a spectacular rise in yields across the globe as inflation has taken hold.
The Bank of England didn’t change base rates at all between March 2009 and August 2016. They only adjusted rates once in 2017 and once in 2018. Then along came a pandemic and a major drop in rates down to a base rate of just 0.1% in the UK in March 2020. It’s been one-way traffic since then, with twelve hikes in a row to take the base rate to 4.5%. The hawkishness of central banks has been sensational to watch.
UK 10-year yields are now at 4.3%, a level last seen in 2008 at the top of the bull market before the Global Financial Crisis. This is effectively the “risk-free” rate that is used in valuing companies in the UK, with an equity risk premium added on to reflect the return required from a company rather than the government. For contrast, the 10-year yield in South Africa is currently over 11% and the equivalent yield in Nigeria is 14.5%.
Put differently, the return required from the government of Nigeria is considerably higher than the return required from companies in the UK even after adding a substantial equity risk premium to the UK rate. This is why valuations in emerging and frontier markets are well below valuations in developed markets.
If this feels unfair, take a look at this excerpt from recent results at Nampak showing how profits from countries like Nigeria are whittled down to almost nothing once foreign exchange losses are taken into account:
Investors require compensation for the risk they are taking on and country risk is perhaps the biggest risk of all. This is why it simply isn’t appropriate to take examples of transactions in a country like the US and apply those multiples to businesses in South Africa.
Did you miss our April edition of Technical Toolbox?