1. ECONOMICS, STATISTICS AND RESEARCH VALUATION OF SHARES AND OTHER EQUITY IN THE FINANCIAL ACCOUNTS OF THE SPANISH ECONOMY (FASE). The use of discounted value of future profits for unquoted non-financial public limited companies Begoña Gutiérrez del Olmo Moreda Statistics and Central Balance Sheet Data Office Department Specialist TASK FORCE ON THE VALUATION AND MEASUREMENT OF EQUITY (TFVME) Ottawa, Canada 13 April 2005

2. Economics, Statistics and Research Department 2 VALUATION OF SHARES AND OTHER EQUITY IN THE FASE. The use of discounted value of future profits for unquoted non-financial public limited companies  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 SNA 1993 and in the ESA 95  Reasons for applying method D as an alternative to method C  Requirements for applying method D  Description of method D  Definitions  Process of grossing up  A particular case: Companies systematically reporting losses Contents

3. Economics, Statistics and Research Department 3 INTRODUCTION TO SPANISH VALUATION METHODS: DESCRIPTION AND AGGREGATES Issues of residents General criteriaSpecific criteriaAggregates 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. Economics, Statistics and Research 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. Economics, Statistics and Research Department 5 VALUATION OF SHARES AND OTHER EQUITY IN THE FASE. The use of discounted value of future profits for unquoted non-financial public limited companies  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 SNA 1993 and in the ESA 95  Reasons for applying method D as an alternative to method C  Requirements for applying method D  Description of method D  Definitions  Process of grossing up  A particular case: Companies systematically reporting losses Contents

6. Economics, Statistics and Research Department 6 DISCOUNTED VALUE OF FUTURE PROFITS (METHOD D): CONCEPTUAL FRAMEWORK  1993 SNA: –(13.28): “…market prices may be approximated by the present, or discounted, value of future economic benefits expected from a given asset; this is the case for a number of financial assets, natural assets and intangible assets…” –(13.34): “…although normal prices are used to value the ultimate output, a rate of discount must, in addition, be used to compute the present value of the expected future returns…”  ESA 95: – (7.27): “…In addition to prices observed on markets or estimated from observed prices or costs incurred, current prices may be approximated for balance sheet valuation by: a)… b) the present, or discounted, value of future returns” References to the method in the 1993 SNA and in the ESA 95

7. Economics, Statistics and Research Department 7 Why does Spain use an alternative method? –are usually 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  Only in the case of banks are unquoted companies well represented by quoted ones  Method D is the most commonly used by financial analysts  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 )

8. Economics, Statistics and Research Department 8 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 )

9. Economics, Statistics and Research Department 9 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

10. Economics, Statistics and Research Department 10 DISCOUNTED VALUE OF FUTURE PROFITS (METHOD D): CONCEPTUAL FRAMEWORK Quoted and unquoted companies: Some European figures Reasons for applying method D ( as an alternative to method C )

11. Economics, Statistics and Research 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. Economics, Statistics and Research Department 12 VALUATION OF SHARES AND OTHER EQUITY IN THE FASE. The use of discounted value of future profits for unquoted non-financial public limited companies  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 SNA 1993 and in the ESA 95  Reasons for applying method D as an alternative to method C  Requirements for applying method D  Description of method D  Definitions  Process of grossing up  A particular case: Companies systematically reporting losses Contents

13. Economics, Statistics and Research Department 13  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 Where RONc is the expected profit for the following year, and d c is the implicit discount factor  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

14. Economics, Statistics and Research Department 14 DISCOUNTED VALUE OF FUTURE PROFITS (METHOD D): DESCRIPTION OF THE METHOD  Likewise, the following expression can be deduced for unquoted shares:

15. Economics, Statistics and Research Department 15 DISCOUNTED VALUE OF FUTURE PROFITS (METHOD D): DESCRIPTION OF THE METHOD  Ordinary Net Profit is defined as: Definitions RON (Ordinary Net Profit)

16. Economics, Statistics and Research Department 16 DISCOUNTED VALUE OF FUTURE PROFITS (METHOD D): DESCRIPTION OF THE METHOD  RONnc is calculated, company by company in the database, as the weighted average of the ordinary net profit over the last five years, as follows: Definitions RON (Ordinary Net Profit)

17. Economics, Statistics and Research Department 17 DISCOUNTED VALUE OF FUTURE PROFITS (METHOD D): DESCRIPTION OF THE METHOD  d nc is defined as : Where, –d c is the discount rate associated with quoted shares –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 Definitions: d nc

18. Economics, Statistics and Research Department 18 DISCOUNTED VALUE OF FUTURE PROFITS (METHOD D): DESCRIPTION OF THE METHOD  d c 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 Definitions: d nc

19. Economics, Statistics and Research Department 19 DISCOUNTED VALUE OF FUTURE PROFITS (METHOD D): DESCRIPTION OF THE METHOD  The discount factor obtained by this method is as follows: Definitions: d nc

20. Economics, Statistics and Research Department 20 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.  Finally, there must be a process of grossing up, from the original aggregate to the whole unquoted non-financial public limited corporations aggregate. Process of grossing up

21. Economics, Statistics and Research Department 21 DISCOUNTED VALUE OF FUTURE PROFITS (METHOD D): DESCRIPTION OF THE METHOD Unquoted public limited companies systematically reporting losses  A weighted average RON nc below zero implies a negative market value when using method D. That is not possible in legal and economic terms, so, therefore, an alternative method is necessary for these specific cases  Since –Shareholders of a limited company are never liable to third parties for more than their capital contribution –Quoted corporations reporting systematic losses never trade on the market below their share capital –Spanish laws lays down minimum limits for net worth the criterion adopted for these cases is to value their shares at their nominal capital A particular case

22. Economics, Statistics and Research Department 22 DISCOUNTED VALUE OF FUTURE PROFITS (METHOD D): DESCRIPTION OF THE METHOD  The final revaluation rates for the quoted and unquoted shares of non- financial public limited corporations, resulting from the whole process, are as follows: Process of grossing up Quoted and Unquoted share revaluation rates in the FASE -100% -75% -50% -25% 0% 25% 50% 75% 100% 19961997199819992000200120022003 Quoted shares Unquoted shares

23. Economics, Statistics and Research Department 23 BEGOÑA GUTIÉRREZ DEL OLMO THANK YOU FOR LISTENING