Privatization: Valuation

The value of an enterprise yet to be privatized is subject to considerable uncertainty.  Government bureaucrats and private consultants are a poor substitute for capital markets in determine a market price for shares.  Nonetheless, some prior knowledge of the likely value of a company is important to privatization planning.  Valuation analysis can indicate the need for financial restructuring prior to privatization and can play a role in the design of the privatization plan.  In a private placement, valuation analysis can provide a means for assessing the reasonableness of a bid and help to address charges that assets are being sold too cheaply.  In an initial public offering, valuation information is crucial for setting the offer price. 

The offer price for an initial public offering has important implications for the outcome of that offering.   If the offer price is too high, sufficient buyer interest will not materialize and the offering will fail.  If the offer price is too low, the offer will be oversubscribed.  Oversubscription has two implications.  First, the government has left "cash on the table" that it could have collected if it had privatized the enterprise for a higher price.  Second, given the excess demand for shares, the government has to develop an administrative scheme for allocating shares.  In doing so it is in effect distributing surplus value from the offering.

Governments may be tempted to inflate the demand for shares by offering credit, either directly or on concessional terms, for the purchase of shares. Such a strategy does not change the value of shares; it merely combines a privatization program with the creation of a new public credit program. Making such a link is often a poor policy choice. Moreover, public credit programs or state-owned banks share many of the weakness of other state-owned enterprises. Establishing such institutions in the context of a privatization program suggests a potentially dangerous inconsistency in government policy.

A typical, but not particularly useful, starting point for valuing a company is book value.  Book value is  based on the value of the company's assets and liabilities as recorded on its balance sheet.  Book value of assets can often differ significantly from their market value.  In the case of Kenya Airways, the book value of the company's assets was KShs. 5.19 per share. Using pro-forma assessed market values raised the net asset value per share to KShs. 16.18.  In terms of privatization, the value that could be realized by closing the company and liquidating its assets provides a lower bound for bids.  Note that sales costs, taxes, and severance pay would reduce the liquidated value below the book value, even after the later has been adjusted to reflect the market value of assets.  Moreover, an expressed goal of the Kenya Airways privatization was to have Kenya Airways continue as the Kenyan national flag carrier.  Thus liquidation was not an option for potential bidders.

Discounted cash flow analysis offers a more theoretically sound means for valuing a company.   The value of a company is the net present value of its future free cash flows.  In practice, one might construct a financial model for the company over a reasonable time horizon.  Summing the appropriately discounted dividends paid under the model as well as the terminal value of the company gives an estimate of net present value.  Such an approach is most fruitful for a company with a stable operating environment, well-known technology, and well-established products.  The airline industry is subject to considerable earnings volatility, which creates significant uncertainty in financial planning.  Nonetheless, one could imagine constructing a five year financial plan for Kenya Airways in order to estimate its current market value.

Only a few parameters are required for a highly simplified financial model.  The share value, P, is:

P = EPS ( 1/R + RFGO)
where EPS is the long-run earnings per share for the core (no growth) business, R is the market capitalization (discount) rate,  and RFGO is the net present value of future growth opportunities, expressed relative to EPS.  Thus, for example, RFGO=5 means that future growth opportunities are worth 5 times core earnings.  For the year ending 31 March 1995, Kenya Airways earnings per share before unrealized exchange gains were KShs. 1.92.  If one assumes that R=.15 and RFGO=2, then the share value P= KShs. 16.64.  You can consider the effect of other parameter values in the interactive model below.
Simplified Financial Model
core earnings per share (EPS)
market capitalization rate (R)
relative value of future growth opportunities (RFGO)
value of share (P)

The market capitalization rate R plays a key role in determining share value.  The market capitalization rate depends on company, country, and industry risk factors such as risks of corrupt practices, unfavorable exchange rate movements, or macroeconomic instability.  Various investment consulting services provide assessments of such risks.  See, for example, an analysis of the effect of risk based on the International Country Risk Guide, a commercial risk evaluation product.  In principle, only risks that investors cannot diversify away affect the value of R. A higher level of non-diversifiable risk raises R.

The Kenya Airway initial public offering closed on April 19, 1996.  A total of 235 million shares (51% of the company) were offered at KShs 11.25 per share. The offering was oversubscribed in aggregate by 94%.   The Board of Kenya Airways made the following decisions for allocating shares among the investors who sought them:

In early June 1996, Kenya Airways traded between KShs. 13.25 and KShs 13.90.  Shares subsequently began to decline in value, falling to KShs. 8.5 at the end of January, 1997. They have subsequently gradually drifted towards KShs 7.  For the most recent price quotation for Kenya Airways, see the Nairobi Stock Exchange.

Questions for discussion
  1. Was the initial public offering price for Kenya Airways too low? Too high?

  3. If the price of shares drops after the initial public offering, has the public been cheated?

  5. How would you assess Kenya Airways' future growth opportunities?

Go to Kenya Airways: Case Study in Privatization

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