As investors, we rely on the professional opinion of various sources to make informed investment decisions. One of these sources, especially as REIT / property investors, are from independent valuation reports completed by professional valuers. These valuation reports have a huge impact on the valuation of REITs and property stocks as it affects a important ratio: the Price to Book ratio. This ratio is computed using the following formula:
Price to Book = Price / Book Value
Since investment properties are carried on the books at fair value, increasing value will increase book value and reduce PB ratio. The vice versa applies if there’s a decrease in valuation.
Most REIT investors use this ratio as a important guide to determine if a REIT is over or undervalued. As such, it is important to understand how these valuation reports are created.
More importantly, you should know why you cannot totally trust these reports.
True Value or Fairy Dust?
I have been closely following the Hyflux restructuring saga and this post was actually inspired by it.
Hyflux recently reported an impairment charge of S$916m for its Tuaspring project and other assets. The asset was carried on its balance sheet for roughly S$1.3b according to Olivia Lum. This charge represents a over 70% loss in value.
The article mentioned that the valuation was based on a recent market study conducted by K4K Training and Advisory. This was the same consultant that provided the market study to support Hyflux’s 2016 valuation of Tuaspring.
So how did an asset reportedly worth S$1.3b lose 70% of its value of a short span of 3 years?
One reason could be that the electricity market in Singapore deteriorated significantly since 2016, resulting in a deterioration of value. This reason touches on the general problem with valuations: Valuations are essentially best guesses at value.
The other reason could be far more sinister. The professional consultancy industry is inherently designed to have a conflict of interest between client and consultant.
Valuations are Guesstimates
To understand why valuation reports are guesstimates, let me explain the valuation process and methods typically used by professional property valuers to determine value. There are typically 3 methods to valuations: The Income approach, the Market approach and the Cost Approach.
The Income Approach essentially refers to the Discounted Cash Flow method of valuation. Project a stream of future cash flows and discount them back to present value to determine the asset’s valuation.
If you are familiar with DCFs, the whole exercise is a whole bunch of estimates. The list of estimates include Revenue growth rate, Expense growth rate, Discount rate, Terminal growth rate, etc etc. Each estimate can be adjusted and justified by the valuer based on his professional opinion. This method also usually relies a lot on past performance being an good indicator of future performance.
This approach is best when the asset has very clear visibility of future cash flows like bonds. Unfortunately, not many assets are able to give you such clarity. As such, there is much estimation involved in the determination of valuation.
The Market Approach refers to valuation based what the market is willing to pay for a similar asset. A common example is from the residential market; You estimate the value a 5 room flat in Tampines based on recent similar sales transactions in Tampines.
This approach is best when the asset is non-unique and has frequent similar transactions in the market to reference to. Even so, your valuation is very much dependent on current sentiment in the market. Are buyers rational in valuing the property they are purchasing? Or are they FOMO-ing (Fear Of Missing Out) and recklessly driving the price up?
Another problem for this approach is that unique and specialised properties have almost no similar market transactions. As such, for an asset like Tuaspring, this approach might not be applicable.
The Cost Approach, or the Replacement Cost method, values a property based on the cost to build an asset of similar utility. This usually involves reviewing and adjusting the construction cost incurred by the company to reflect current market conditions.
Of the 3 approaches, this approach is one of the more perplexing approaches to me. You are essentially arriving at market valuation using historical cost given some small adjustment. While this valuation inputs are highly reliable, as cost are real figures, I doubt the usefulness of this method as it does not look at the potential returns from the asset.
This method implies that the move I spend to make the asset, the more valuable it is. If you overestimate the return on investment of the asset, this approach is potentially useless.
How valuers use these methods to arrive at a valuation
Having evaluated these valuation reports in my previous life as an external auditor, I can tell you with some certainty how these valuations are arrived at. I’ll illustrate this with my guess on how they valued the Tuaspring plant. Please note that this is my guess and may not be a true reflection of what actually happened. Figures used are only for illustrative purposes only.
The valuers start by trying to come up with a valuation based on the 3 methods available to them. The valuations may be as follows:
This is a very typical scenario for an newly built asset of a specialised nature. The Income Approach will give a horrible valuation, as the asset only has 1-3 years of operations under its belt and it is still working through all its teething problems. Market Approach will draw a blank due to lack of similar assets, while the Cost Approach simply returns a value very close to cost.
Faced with this scenario, it is likely that the valuers dismissed the Income Approach, as it is “way too low” (yes, I’ve heard that as an explanation from a valuer before) and go with the Cost approach valuation of $1.3b instead.
Want me to blow your mind even further? In the case where you are able to split the asset into separate parts to be valued independently, the valuer can value each part using a different approach and then add it all back together to arrive at an abomination of value.
What does this mean?
To come up with a valuation, you use a bunch of estimates to come up with up to 3 different estimates. Using your “professional judgment” you choose / mix & match the estimates to arrive at a estimated final value. There is so much opinion / judgment / uncertainty over a valuation that you can only say that a valuation is a reasoned guess at value.
But that’s not all…
Part of the problem with the professional services industry is the inherent conflict of interest in the industry.
Companies pay these professionals to value / audit / advise them on various issues. This results in these professionals at least being slightly beholden to their client’s interests.
“Valuation too low? Pump it up or I’ll take my business elsewhere. Adverse audit opinion? Change it or I’ll sack you and hire another auditor.” You get the idea.
This pressure is ever present and more or less will affect the valuable to some extent. The good ones are able to thread the fine line between Client Service and Professionalism well. The more shady consultants might be more flexible in their professional judgment. Ultimately, its up to you the investor to try and call bullshit when you see it.
We as investors have to place some trust in independent valuation reports as a indicator of an asset’s value. However, ultimately we need to realise that these reports are guided by judgment and estimation, not fact. Use them as a guide but learn to form your own views and outlook before making a investment decision. It might save you some losses in the process.
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