With reference to a guidance document issued by the China Appraisal Society (“CAS”) in relation to discount rate calculation, the China Securities Regulatory Commission (“CSRC”) launched the Regulatory Guidance - Valuation (the “Guidance”) in January 2021 to standardize the parameters of discount rate calculation in the income approach.
 
The Guidance provides specific requirements for the parameters in Capital Asset Pricing Model (“CAPM”) and Weighted Average Cost of Capital (“WACC”), including risk-free rate, market risk premium, beta, capital structure, specific risk premium and expected return of debt.
 
With AVISTA’s experience in business valuation, the key points of the Guidance for the discount rate calculation are outlined below.
 
Background and Objective 
 
The discrepancies for the current valuation practices in the income approach have been prevailing among valuation entities (“Entities”), ranging from sample selection, parameters’ determination and calculation methodology. Meanwhile, the valuation process may also be influenced by complicated and subjective judgment, which would impact the reliability of company’s financial data and valuation result.
 
Accordingly, the CSRC formulates the Guidance in order to standardize the discount rate calculation, thereby enhancing the regulations in the valuation industry.
 
Fundamental Requirements 
 
The Guidance enumerates 3 fundamental requirements to the Entities highlighting the consistency and reasonableness in the discount rate calculation.
 
<ol>
<li>The Entities must formulate a set of consistent principles and methods for discount rate calculation. Upon formulation, the principles and methods could not be revised at discretion afterward to ensure the consistency of valuation projects. </li>
<li>The Entities must ensure the reasonableness of discount rate calculation on multiple valuation dates. The Entities should clarify any significant changes of parameters from the previous valuation date in the valuation report. </li>
<li>The Entities must ensure the alignment between discount rate and expected return, which requires CAPM in line with the Free Cash Flow to the Equity (“FCFE”) and WACC in line with the Free Cash Flow to the Firm (“FCFF”). </li>
</ol>
Instructions on Parameters
 
The Guidance provides instructions for 6 parameters typically used in the discount rate calculation. In general, the Guidance requires the Entities to disclose parameter-related methods, analytical processes and data sources in the valuation reports. The details of the instructions to each parameter are specified below.
 
<ol>
<li>Risk-free rate
<ul style="list-style-type: square;">
<li>China 10-year or above government bond and its yield to maturity should be adopted under the assumption of going concern. </li>
</ul>
</li>
<li>Market risk premium
<ul style="list-style-type: square;">
<li>If the primary business of the target company to be valued (the “Target”) is within China’s territory, the historical risk premium data of China Securities Market index should be adopted as a priority. </li>
</ul>
</li>
<li>Beta
<ul style="list-style-type: square;">
<li>The Entities should take into account the enterprise size, profitability, growth, etc. in their consideration of comparability of comparable company to determine the beta, as well as select the beta with the appropriate time horizon. </li>
</ul>
</li>
<li> Capital structure 
<ul style="list-style-type: square;">
<li>The Entities must conduct analysis for the discrepancies between the Target and comparable company as well as the development stage of the Target with reference to the adopted capital structure, alongside disclosure and clarification. </li>
<li>The debt-to-equity ratio should be measured by market value. Clarification should be provided in the valuation report if book value is used. </li>
</ul>
</li>
<li>Specific risk premium 
<ul style="list-style-type: square;">
<li>The Entities must evaluate the Target’s risk characteristics, enterprise size, core competitiveness, etc. when determining the specific risk premium. </li>
</ul>
</li>
<li>Expected return of debt 
<ul style="list-style-type: square;">
<li>The Entities must assess the Target’s operating performance, capital structure, credit risk, etc. if Loan Prime Rate (“LPR”) is taken as reference. </li>
<li>The Entities must assess the Target’s financing options, cost of debt, solvency, etc. if non-market interest rates are adopted. </li>
</ul>
</li>
</ol>
To read the full Regulatory Guidance released by CSRC, please click <a href="http://www.csrc.gov.cn/pub/newsite/ztzl/jggzsyzy/202101/t20210122_391113.html" target="_blank" rel="noopener">here</a>. (Available in Chinese version only) 
AVISTA’s Professional Services for Business Valuation
 
As a professional valuation and financial advisory firm, AVISTA provides reliable business valuation services and accommodates the valuation needs in various transactions, including merger and restructuring. Our valuation experts are ready to advise you on asset valuation in compliance with the latest regulatory guidance.
 
For further information or enquiries regarding the potential valuation impact of the CSRC’s regulatory guidance on discount rate calculation, please feel free to contact us.

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CSRC Regulatory Guidance on Discount Rate Calculation in Income Approach

A growing concern of sustainability has been emerging in the investment community over the past decade. It was an old thought that considering sustainability for society implied sacrificing financial returns of investment. The development of Environmental, Social, Governance (ESG) investing, however, has demonstrated a different story.
 
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A growing attention to the Biotech sector has been shown in the accelerating investments by Venture Capital funds and IPOs, as well as the expectation of innovative therapies amidst Covid-19. This article, therefore, provides a guide on Biotech investment analysis with highlighting the “3H” characteristics of Biotech industry—High inputs in R&amp;D, High Rewards, and High Risks, and demonstrating related valuation approaches for quantitative analysis.
 
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The International Valuation Standards Council (“IVSC”) Financial Instruments Board (“FI Board”) has published the Exposure Draft (the “Draft”) with proposals to improve the valuations of financial instruments outlined in IVS 500 Financial Instruments (“IVS 500”). The IVSC FI Board has launched the consultation to invite comments on the proposals in the Draft, which covers (1) Standards objectives and agenda, (2) Guidance on governance around valuation process, and (3) Principles of data taxonomy and control. As a professional valuation advisory firm, AVISTA has outlined the key points in the Draft for the latest proposals of improvements of financial instruments valuation.
 
Standards Objectives and Agenda
 
In review of IVS 500, the FI Board aims to establish the principles that will enable entities to develop fit-for-purpose valuations of financial instruments adaptable to varying market conditions or circumstances and to different reporting purposes, including financial, tax, and regulatory reporting. The proposals made by the FI Board are principles-based guidance requiring valuation processes in line with the concepts outlined in IVS 500. Meanwhile, considering the potential conflicts with the requirements in other International Valuation Standards (“IVS”), the Standards Review Board is also proposing consequential amendments to IVS 101 Scope of Work to IVS 105 Valuation Approaches and Methods.
 
The improvements to IVS 500 will be considered in stages, where the Draft firstly focuses on the areas of Governance and Data. The two remaining areas of Methods and Models, and Controls and Reporting will be considered and published in subsequent documents that will also contain revised proposals on Governance and Data based on received comments for the Draft. This practice is to address the interdependencies among different areas and facilitate the comments from the stakeholders on the proposals.
 
Guidance on Governance around Valuation Process 
 
The Draft proposes the guidance over the valuation processes that entities should follow to ensure adequate governance around financial instrument valuations. A valuation process should be (a) systemic, (b) consistently applied, (c) economically sound, and (d) controlled. To be specific, the governance around valuation process requires the valuation of financial instrument with similar portfolios, financial principles and market practice to be developed consistently, with end-to-end documentation and controls’ implementation.
 
The Draft, in the meantime, also highlights a series of principles covering the governance and controls over financial instruments valuation, including (a) ownership, (b) accountability, (c) transparency, (d) consistency, (e) review and challenge, (f) diversity, (g) documentation. In general, the principles emphasize clear responsibility for execution among different functions and individuals, transparent documentation for consistent valuation methods, as well as independent and diverse assessment for valuation processes.
 
Principles of Data Taxonomy and Control
 
The Draft highlights the importance of data as inputs to the valuation process to derive fit-for-purpose valuation. The quality of data adopted in the valuation process should ensure the objectivity and the effective communications of the valuation decisions.
 
The Draft proposes a data taxonomy differentiating static data and dynamic data to establish the standardized best practice for participants both within and across the entities involved in the valuation processes. It is not mandatory to adopt the taxonomy outlined in the Draft, but any taxonomy developed and adopted by an entity should be consistent with the principles proposed in the Draft.
 
In addition, the Draft requires the policies and processes in place to control the identification, assessment, aggregation and management of outsourced and internally generated data. In particular, the policies and processes should ensure (a) accuracy and integrity, (b) completeness, (c) adaptability, (d) timeliness, (e) transparency and (f) proportionality.
 
<a href="https://www.ivsc.org/files/file/view/id/1890" target="_blank" rel="noopener"><img src="../../../../../uploads/cover_586d37e853.jpeg" width="200" /></a>
 
To read the full Exposure Draft released by IVSC, please click <a href="https://www.ivsc.org/files/file/view/id/1890" target="_blank" rel="noopener">here</a>.
 
AVISTA’s Professional Services for Financial Instruments Valuation
 
As a corporate member of IVSC, AVISTA provides professional valuation and financial advisory services on financial instruments. The knowledge and experience of AVISTA can facilitate the most appropriate valuation service ensuring IVS-compliant valuation processes and reporting.
 
We are closely monitoring the latest development of IVSC consultation for valuations of financial instruments. For further information or enquiry regarding the Exposure Draft, please feel free to contact us.

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In this publication, AVISTA Research has covered the outlook of the Hong Kong office market and its Q3 2020’s performance in the unstable environments and insights on the tender cancellation of Tung Chung commercial site and the development of Tung Chung New Town Extension Project as well as the global co-working and remote working trends.
 
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