Paul Short: The Rational Investor

Share valuations are always challenging, particularly those involving the valuation of a minority share interest and each set of circumstances is different.

Even so, one finds that many valuers adopt a mechanical and formulaic approach to this process.

One selects a multiple of earnings to establish a whole business valuation and then applies a predetermined discount to value the shareholding.

There are the usual checks to make sure that a higher valuation is not reached by looking at the balance sheet value or the dividend basis. The multiple of earnings will be reached by using a respected or recommended published index.

HMRC certainly tend to follow this approach slavishly, in my experience.

I always feel that not enough attention is perhaps paid to the specific environment in which the shareholding in question is placed. There is the industry or sector setting to take account of. There is then the actual performance specifics of the company.

Finally there is the shareholder dynamics to take into account.

What I try and do when I go through the valuation process is to step back at the end of it and say “would I pay this sum to acquire this shareholding?”

I am trying to be what used to be known in the past as “the man on the Clapham omnibus” that is the ordinary chap in the street.

Solicitors will know that I often refer copiously in my Reports to the rational independent investor. This person:

• Has limited funds.
• Has other investment opportunities competing for those funds.
• Is broadly risk averse but prepared to back his judgment if he sees a good thing.
• Has full knowledge of the investment opportunity presented to him. This will include the industry, circumstances of the disposal, the dynamics of the business and the shareholder relationships.

The rational independent investor should be distinguished from the special buyer who is prepared to a premium because of the specific benefits he will receive from the acquisition.

I would regard myself as a rational independent investor. I certainly have limited funds.

I, therefore, step back at the end of the valuation and say “what I would pay for this investment?”

That to me is the acid test. If I couldn’t justify the investment at that price, then I would consider that my valuation is misjudged.

I do just wonder whether some other valuers do take this step. Indeed that would always be my challenge to HMRC or other valuers “Would you pay the price you have determined for this particular investment? Well, would you?”

The HMRC officer, in particular, is unlikely to have any practical experience of being involved in business and investing in private companies.

It can be a challenging question to answer.

Posted by Paul Short