1. STATISTICS DEPARTMENT VALUATION OF SHARES AND OTHER EQUITY IN THE FINANCIAL ACCOUNTS OF THE SPANISH ECONOMY (FASE). The discounted value of future profits Begoña Gutiérrez del Olmo Moreda Central Balance Sheet Data Office Specialist WORKING PARTY OF FINANCIAL STATISTICS-OCDE Paris, 3 November 2009

2. Statistics Department 2 VALUATION OF UNQUOTED SHARES AND OTHER EQUITY IN THE FASE. The discounted value of future profits  Introduction to the Spanish valuation methods: Description and aggregates  Issues of resident units  Issues of non-resident units held by residents  Discounted value of future profits (method D): Conceptual framework  References to the method in the reviewed SNA  Reasons for applying method D as an alternative to method C  Requirements for applying method D  Description of method D  Components of the discount factor (d q )  Process of grossing up Contents

3. Statistics Department 3 INTRODUCTION TO SPANISH VALUATION METHODS: DESCRIPTION AND AGGREGATES Issues of residents General criteria Specific criteria (method) Aggregates Market valuation in strict sense Market capitalisation (A)Quoted public limited companies (Non-financial and banks) Net asset value (B)Mutual Funds Approximations to market valuation Capitalisation / Own funds ratio (C) Unquoted banks Discounted value of future profits (D) Unquoted non-financial public limited companies Book valueOwn funds (E) Unquoted public limited companies (Financial except banks) Other legal forms (Other equity)

4. Statistics Department 4 INTRODUCTION TO SPANISH VALUATION METHODS: DESCRIPTION AND AGGREGATES Issues of non-residents held by residents (F) Valuation methods based on: –Market value: In case of quoted shares –International Investment Position Statistics: In other cases

5. Statistics Department 5 VALUATION OF UNQUOTED SHARES AND OTHER EQUITY IN THE FASE. The discounted value of future profits  Introduction to Spanish valuation methods: Description and aggregates  Issues of resident units  Issues of non-resident units held by residents  Discounted value of future profits (method D): Conceptual framework  References to the method in the Reviewed SNA  Reasons for applying method D as an alternative to method C  Requirements for applying method D  Description of method D  Components of the discount factor (d q )  Process of grossing up Contents

6. Statistics Department 6 DISCOUNTED VALUE OF FUTURE PROFITS (METHOD D): CONCEPTUAL FRAMEWORK  Reviewed SNA: –13.70 When actual market values are not available, an estimate is required. Alternative methods of approximating market value of shareholders’ equity in a direct investment enterprise follow. These are not ranked according to preference, and each would need to be assessed according to the circumstances and the plausibility of results: … c. Present value/price to earnings ratios. The present value of unlisted equity can be estimated by discounting the forecast future profits. At its simplest, this method can be approximated by applying a market or industry price-to-earnings ratio to the (smoothed) recent past earnings of the unlisted enterprise to calculate a price. This method is most appropriate where there is a paucity of balance sheet information but earnings data are more readily available References to the method in the reviewed SNA

7. Statistics Department 7 Why does Spain use an alternative method? –are much more larger than unquoted ones –usually have a different financial structure from unquoted companies –are concentrated among particular economic activities which usually demand a larger volume of funds –The number of quoted public limited companies is very small relative to the total  Unquoted non-financial public limited companies are not well represented by quoted ones because quoted public limited companies, DISCOUNTED VALUE OF FUTURE PROFITS (METHOD D): CONCEPTUAL FRAMEWORK Reasons for applying method D ( as an alternative to method C )  Only in case of banks are unquoted companies well represented by quoted ones

8. Statistics Department 8  Method D is well considered by Accounting standard setters: IASB. Draft about Fair Value Measurement and Valuation techniques:  Paragraph 38 b): “The income approach uses valuation techniques to convert futures amounts to a single present (discounted) amount. The fair value measurement is determined on the basis of the value indicated by current market expectations about those future amounts”  Paragraph 44: “… A fair value measurement developed using a present value technique might be categorised within Level 2 or Level 3, depending on the inputs that are significant to the entire measurement and the level in the fair value hierarchy within which those inputs are categorised”. DISCOUNTED VALUE OF FUTURE PROFITS (METHOD D): CONCEPTUAL FRAMEWORK Reasons for applying method D ( as an alternative to method C )  Method D is the most commonly used by financial analysts Where Level 2 o 3 could mean inactive markets. Financial crisis reducing so much liquidity as to have listed but iliquidity corporations could be an example of this situation.

9. Statistics Department 9 DISCOUNTED VALUE OF FUTURE PROFITS (METHOD D): CONCEPTUAL FRAMEWORK Some figures to measure the problem Reasons for applying method D ( as an alternative to method C )

10. Statistics Department 10 DISCOUNTED VALUE OF FUTURE PROFITS (METHOD D): CONCEPTUAL FRAMEWORK The problems of using multi-country ratios Additional limitations arise when trying to use multi-country ratio data because of the differences between countries’ financial structures 1. Some of these differences are:  The amount and the structure of assets  Revaluation criteria  Financing practice in each country  Relationships between firms and banks  Tax systems  Guarantees offered to lenders  Pensions  Bankruptcy law insolvency rules Reasons for applying method D ( as an alternative to method C ) (1) According to the conclusions of the Own funds Working Group of the European Committee of Central Balance Sheet Data Offices set out in one of its studies: “Corporate Finance in Europe from 1986 to 1996

11. Statistics Department 11 1. A quality data source for non-financial companies’ profit and loss accounts to estimate future profits to be discounted 2. A market reference to estimate the discounting rate 3. Demographic statistics for non-financial companies  In Spain the information comes from:  Central Balance Sheet Data Office Database: Accounting information and a conversion table to go from business accounting to National accounts  National demographic statistics for corporations: DIRCE from National Institute of Statistics DISCOUNTED VALUE OF FUTURE PROFITS (METHOD D): CONCEPTUAL FRAMEWORK Requirements of the method  The application of this method requires:

12. Statistics Department 12 VALUATION OF UNQUOTED SHARES AND OTHER EQUITY IN THE FASE. The discounted value of future profits  Introduction to Spanish valuation methods: Description and aggregates  Issues of resident units  Issues of non-resident units held by residents  Discounted value of future profits (Method D): Conceptual framework  References to the method in the reviewed SNA  Reasons for applying method D as an alternative to method C  Requirements for applying method D  Description of method D  Components of the discount factor (d q )  Process of grossing up Contents

13. Statistics Department 13  The method is based on the fact that the market value of quoted firms can be obtained by dividing their expected profits by a discount factor DISCOUNTED VALUE OF FUTURE PROFITS (METHOD D): DESCRIPTION OF THE METHOD  Underlying this method is the hypothesis that the profits generated by such firms are considered to be perpetual. Risk-free interest rate Risk premium Expected growth rate of profits Components of the discount factor (d q )  This method estimates the market value of shares issued by unquoted firms by calculating the present value of the future profits generated by such firms

14. Statistics Department 14 DISCOUNTED VALUE OF FUTURE PROFITS (METHOD D): DESCRIPTION OF THE METHOD  About ONPq (Ordinary Net Profit):  It’s to be the expected profit for the following year. Failing that, it is used the average of last five years  Calculated as Gross Value Added at factor cost minus personnel costs, net financial charges and operating depreciation and provisions  About d q:  It’s to be the implicit discount factor or Internal Rate of Return of quoted companies: Capitalization/ONPq  Three components of d q:  Risk free interest rate  Risk premium  Expected growth rate of profits Components of the discount factor (d q )

15. Statistics Department 15 COMPARED EVOLUTION OF THE COMPONENTS OF dq : Risk-free interest rate, risk premium, expected growth rate of profits and discounted rate Components of the discount factor (d q ) 0 3 6 9 12 1995199619971998199920002001200220032004200520062007 Discount factorExpected growth rate of profits Risk-free interest rateRisk Premium

16. Statistics Department 16 DISCOUNTED VALUE OF FUTURE PROFITS (METHOD D): DESCRIPTION OF THE METHOD  Likewise, the following expression can be deduced for unquoted shares: Where 0,03 is the illiquidity premium: This premium should consider not only the illiquidity but, also, the possibility that unquoted public limited companies’ profits are not as perpetual as those of quoted ones. Therefore, an increase in the discount rate, because of the different time horizons, must be considered The level of this premium has been quantified according to theoretical analysis of the gap between perpetual income and temporary income Components of the discount factor (d q )

17. Statistics Department 17 DISCOUNTED VALUE OF FUTURE PROFITS (METHOD D): DESCRIPTION OF THE METHOD  d q is calculated as the median of the discount rates of all the quoted non- financial corporations traded on the continuous market, which means excluding floor-traded companies  Extremely volatile corporations are stripped out of the aggregate by means of the trust interval, which is defined as the average plus/minus twice the standard deviation.  Sector differentiation is only applied in the case of the electricity sector because of its specific features Components of the discount factor (d q )

18. Statistics Department 18 DISCOUNTED VALUE OF FUTURE PROFITS (METHOD D): DESCRIPTION OF THE METHOD  The Central Balance Sheet Data Office Database provides information on approximately 30,000 unquoted public limited companies  Using the conversion table which allows one to go from business accounting to National Accounts, a full chart of accounts, including those relating to other changes in volume and revaluation, is prepared.  There must be a process of grossing up, from the original aggregate to the whole unquoted non-financial public limited corporations aggregate.  Finally, whole unquoted non-financial public limited corporations’ estimated values by this way is used, with several adjustments coming from other Institutional Sectors, for preparing Financial Accounts of the Spanish Economy. Process of grossing up

19. Statistics Department 19 COMPARED EVOLUTION OF REVALUATION RATES: Quoted and unquoted shares Process of grossing up -30% -20% -10% 0% 10% 20% 30% 40% 2001200220032004200520062007 Quoted FASE Unquoted MENFUnquoted FASE

20. Statistics Department 20 COMPARED EVOLUTION OF UNQUOTED SHARES REVALUATION RATES COMPONENTS: ONPnq and discount factor Definitions -20 -10 0 10 20 30 40 1995199619971998199920002001200220032004200520062007 Ordinary Net Profit (nq) Discount factor

21. Statistics Department 21 BEGOÑA GUTIÉRREZ DEL OLMO THANK YOU FOR LISTENING