Audit and Valuation Partner
Let's start by mentioning the number of listed companies in Azerbaijan. Besides commercial banks and a few financial institutions, how many listed companies can you count? Just a few! When a company's shares are not publicly traded, the accuracy of its financial statements is of interest to only a limited group of readers and users, typically including the following:
Before starting to discuss the reliability coefficient of financials received from aforementioned groups and to what extent you could rely on them let's explain why we need accurate financials.
The market capitalization of the target company is essential for the acquirer or for synergy purposes in terms of:
Ensuring Fair Value: As an acquirer, you are interested in not paying more than the target company's real market value. This helps in making sure that the investment is justified and that you are not overpaying for the acquisition.
Assessing Financial Health: For synergy purposes, the parties should be comfortable that your company is financially healthy and that the synergy will bring its benefits. This confidence is crucial for achieving the anticipated cost savings, revenue enhancements, and overall efficiency improvements.
To be comfortable with the above points, you should have accurate financial information, which is summarized and reflected in the financial statements prepared for the corresponding period. More precisely, I would replace the word "accurate" above with the word "audited" as, at least in this context, I believe they are synonyms.
Most likely, your consultants will choose one of the two valuation methods: either income-based or asset-based. Regardless of which method they choose, they will need precise elements from the financial statements (net profit, costs, fixed assets, inventories, cash flow, etc.) to employ a comprehensive valuation approach.
Tax Authorities - The primary users of financial statements for all registered companies in Azerbaijan are the tax authorities. The reason for this is straightforward: they are responsible for implementing the Tax Code and collecting taxes from entities operating in Azerbaijan. Therefore, all entities must complete their tax returns, showing elements such as net profit, turnover, assets, etc., which are subject to relevant taxes. Financial statements are prepared in accordance with the Tax Code of Azerbaijan, following rule-based accounting treatments. So, can we rely on the financials of a target company when we intend to acquire it? The answer to this question may seem subjective and depends on your risk tolerance.
Here are some points to consider in forming your own answer:
Existing Shareholders - In the Azerbaijani business environment, shareholders are often the founders of the business. Therefore, they believe they know every small detail about their business, including its financial structure and operational health. They often have special-purpose financial reports that are usually inappropriate for M&A purposes.
As an investor with sufficient funds, I would avoid relying solely on tax returns and special-purpose financial statements prepared for shareholders to analyze the financial health of a target company.
Since the asset-based valuation approach is not widely used and selecting appropriate multiples for publicly listed companies has proven ineffective for us, we will focus on the key elements of the flow-based valuation approach (DDM, RIVM, DCF), which is the most reliable method in our context.(We are not going to analyze and discuss the estimation of discount rates such as CoE and WACC, as the articulation between discount rates and accurate accounting figures is a topic with a broad scope and warrants a separate article)
Dividends: Although accurate dividend payments can be used to obtain a reliable intrinsic value for a target company, if we employ the same ratio that we have for our audit and valuation portfolio (excluding companies partially owned by the government), we find that approximately 70% of Azerbaijani companies either do not pay dividends or have an unstable dividend payment trend, making future dividend projections unreliable. Therefore, I believe we could exclude the Discounted Dividend Model from the flow-based valuation approach as well.
Net income: After a comprehensive external audit, you can be confident about the net profits of your target company, and your consultants can implement the Residual Income Valuation model to determine its intrinsic value. However, considering the shareholders' awareness of the determined return rate on capital employed, your consultants will barely be able to obtain the required rate of return for the capital employed during the corresponding period to generate residual incomes. In simple terms, to determine the residual incomes, the cost of capital (capital invested multiplied by the required rate of return) is deducted from the net profits. This flow-based valuation model is considered one of the more reliable ones, but obtaining a precise required rate of return can be challenging. Moreover, using the book value of equity to generate residual income could also have some negative points. But anyway, net profit is what we need ultimately, and it will be used for the next flow-based valuation model as well.
FCF = Net Income + Depreciation and Amortization − Changes in Working Capital − Capital Expenditures.
Since Free Cash Flow (FCF) represents the actual amount that can be paid to shareholders, it is considered a very reliable input for determining the market value of the target company. It is also an alternative to dividends for assessing the company’s value.
So, it is crucial to have all the above elements accurate to ensure they do not affect the market value of the target company and deviate from its real value.
Although this article does not include sample sizes, there are numerous articles in this field that affirm the crucial role of accounting figures in determining the market value of a company.
In summary, obtaining accurate and audited financial statements is crucial for a reliable valuation of a target company, especially in a market like Azerbaijan where financial transparency can be limited. The choice of valuation methods, whether flow-based models like the Residual Income Valuation Model (RIVM) or the Discounted Cash Flow (DCF) model, relies heavily on the precision of these financial elements. By ensuring the integrity and accuracy of net income, depreciation and amortization, changes in working capital, and capital expenditures, investors can make well-informed decisions and accurately determine the market value of their target companies. Reliable financial data not only ensures fair value assessments and sound investment decisions but also supports the confidence needed for successful mergers, acquisitions, and strategic partnerships.