The latest revisions to the IVSC’s International Valuation Standards, having completed the lengthy public comment and review process, become effective 1 January 2020. BVWire—UK has covered important components of the extensive update, which replaces IVS 2017, in previous issues (for example, here’s our analysis of the new complex financial structure section).
New Sections 50.34-40 are worthy of review by anyone preparing business valuations: Most of the new guidance will be familiar to BVWire—UK subscribers, but the detail expands the standard to (hopefully) increase uniform practices globally. Common sources of discount rates include Duff & Phelps and BVR’s Cost of Capital Professional.
For the first time, in section 50.34, the IVS will require documentation of both the method used and the inputs selected to derive discount rates:
50.34. In developing a discount rate, the valuer must:
(a) document the method used for developing the discount rate and support its use,
(b) provide evidence for the derivation of the discount rate, including the identification of the significant inputs and support for their derivation or source.
The IVS update also requires careful balancing of the quality of the forecasted cash flow with the selection of the appropriate discount rate. This new guidance confirms what’s obvious in practice but not always documented by analysts.
50.36. Valuers must consider the risk of achieving the forecast cash flow of the asset when developing the discount rate. Specifically, the valuer must evaluate whether the risk underlying the forecast cash flow assumptions are captured in the discount rate.
This section is combined with the new section 50.37, which lists the methods a valuer might employ to identify key components of risk in the cash flow analysis (historical performance, economic growth rates for the country and industry, etc.). If these elements indicate that the enterprise’s forecast does not capture risk appropriately, the new section 50.38 now requires an adjustment in either forecast or the discount rate:
50.38. If the valuer determines that certain risks included in the forecast cash flow for the asset have not been captured in the discount rate, the valuer must 1) adjust the forecast, or 2) adjust the discount rate to account for those risks not already captured.
(a) When adjusting the cash flow forecast, the valuer should provide the rationale for why the adjustments were necessary, undertake quantitative procedures to support the adjustments, and document the nature and amount of the adjustments,
(b) When adjusting the discount rate, the valuer should document why it was not appropriate or possible to adjust the cash flow forecast, provide the rationale for why such risks are not otherwise captured in the discount rate, undertake quantitative and qualitative procedures to support the adjustments, and document the nature and amount of the adjustment. The use of quantitative procedures does not necessarily entail quantitative derivation of the adjustment to the discount rate. A valuer need not conduct an exhaustive quantitative process but should take into account all the information that is reasonably available.