Thanks for the comments. I like the dialogue. You don’t have to read all the 78 pages of the circular (!) just the 6 pages of the valuation opinion. I’ll email you the Word docs of both this lastest and then also the previous 1 done last year by the same person for the first leg of the transaction.

I also use CTRL-F a lot these days , but what I have also found the review/compare function in Word especially helpful in seeing how their valuation opinion changed in only 1 year !

For example:

1. They changed the forecast period from 2016 – 2059, to 2017 – 2022 ( no explanation why )
2. Changed R/$ exchange rate range: from R14.73 – R16.59, to R12.20 – R14.90) ( no explanation why )
3. Chnaged the fore castcoal export price range : US$79.84 to US$90.25 for 2016 to 2059, to $59.29/ton – $72.46/ton for 2017 to 2022 ( no explanation why and notwhitstanding that coal export prices traded above the high forcast value at the time of the valuation ! )

Minor point, it could imply a ERP above 6%, or factor in a Beta higher than 1 or some other adjustments. I could’t muster the enthusiasm to read all 78 pages, but a CTRL-F didn’t reveal much in the way of justification for the discount rate, where I think you are I have agreed in the past would be informatie.
What it did reveal was an odd section:

we stress tested the discount rate of 14.30% by assuming a rate 1% higher and 1% lower than the base case. In addition, we stress tested the R/$ exchange rate of R13.55 by assuming a rate 10% higher and 10% lower than the base case

1. Although recognising the implicit uncertainty and subjectivity is better than nothing, that is an entirely arbitrary stress test in the discount rate.
2. I’m really not convinced that the second most important stress test is on an objective market observable input like exchange rate. Maybe I’m being overly harsh and focussed on semantics. A sensitivity showing how sensitive the value is to the exchange rate, so that fluctuations in the exchange rate over time can be approximately factored into a ZAR valuation might be helpful. But it doesn’t talk to inherent uncertainty in the valuation itself and appears to diminish other, far more important, sources of valuation uncertainty.

I don’t usually read much sell side research, but I do look at Fairness Opinions quite a lot, and I especially look at and study appraisal court opinions where it’s a battle of the experts !

But you can have a look at today’s issued IE fairness opinion by KPMG for the Exxaro BEE buyback where they use a discount rate of 14.30% . – http://www.exxaro.com/wp-content/uploads/2017/10/Job014425-Exxaro-Circular-Combined.pdf

That sounds exessive for such a big market cap listed company and would imply using a ERP of above 6% .

Thanks for the comment!

• Selection of the discount rate is inevitably somewhat subjective – but yes it is absolutely good practice to disclose and communicate why it was chosen and how it was built up from subcomponents.
• If the company is listed, then many of the reasons for a specific risk premium fall away. Not all though, depending on the specifics of the company and depending on how “best estimate” the cash flows are.
• Volatility is not the only measure of risk, and not necessarily the best. However, it can act as a reasonable second-order taylor approximation approximation to other risk measures. In practice, other risk measures often don’t give as different results as you might expect. I always try to keep in mind that, despite it’s flaws, the outcomes are not always poor.
• I can’t recall if I posted on Beta estimation before – I’ve done it plenty of times for various purposes and the conclusion is inevitably that it is a highly sensitive result to estimate. I think that’s partly why a Beta of 1 is so often used – as an a priori estimate it should be unbiased and might be better than one estimated poorly from market data. There are definitely better and worse ways of doing this.

Have you taken a look at what sell side analysts use as their discount rate in their DCF models of individual stocks?

Thanks for your post !

I agree with you that if one would have to do a valuation for a single concentrated investment into an unlisted company, there might be justification for adding such a high company specific risk premium of 4%. Especially if, as you mentioned, there is uncertainty in the future cash flow predictions which was not already accounted for with a discount factor or probability model. However, if the valuation is for a listed company where an investor can diversify away his specific company risk, then the justification for using it becomes very difficult, if not impossible. It becomes even more untenable if the valuer does not disclose, explain or justify his use for including such discount. Isn’t the function of Beta exactly that, to try and predict (based on volatility) ( a flawed approach imho, as volatility is not risk ) what extra discount to place on a single company compared to the market as a whole ?