Key lies in handling writedowns
As we approach the period of new corporate results for the Gulf and other regions, expectation is centred on the extent of asset writedowns for corporates, construction companies, investment houses and banks. Valuation writedowns are likely to play a critical role in the bottom line results for many companies.
The global financial and liquidity crisis has reduced market and fair value valuations of assets across all economic sectors, from real estate to equities to bonds to companies. Valuations are likely to be cut significantly, reflecting sharply lower multiples as well as weaker liquidity.
Much onus will be on company boards as well as auditors in determining the extent of the fall in the values of assets on companies' balance sheets and the impact on accounts from the financial crisis.
Fair market value calculation, that is the cash price an asset would sell for between two willing parties, remains an opaque area and subject to estimation. Financial statements prepared in accordance with generally accepted accounting principles often show the values of assets at their historic costs rather than at their current market values. A real estate company's balance sheet will usually show the value of land it owns at what the company paid for it rather than at its current market value.
Difficult to value areas, particularly assets held by private equity firms, also present problems. Often the method in unquoted privately-held investments is determined by observing the prices of similar companies that sold in the market. The observed prices serve as valuation benchmarks. From the prices, one calculates price multiples such as the price-to-earnings or price-to-book value ratios. However, as volatility has been so severe over the last year together with very few market sales, valuation will be difficult.
Accurate mark-to-market valuations are needed for a trading operation, particularly when your creditors can, and do, force you to liquidate loss positions. On the other hand, it is not so relevant when you intend to hold an illiquid asset to its maturity, and when you have the financial stability to do so. In these situations where there is no real market for the asset, marking to market can be misleading. The problem at the moment is that many companies are under financial pressure and stress and do not have the ability or capacity to hold assets to maturity
Construction and real estate companies will need to assess the values of current properties, projects under construction and planned, and infrastructure assets. The ability of real estate companies to sell to end owners, both in the Gulf and elsewhere, has fallen due to a lack of funding. Companies and contractors in the Middle East have billions of dollars of contracts at risk of deferral or cancellation.
It is not only regional companies which face the prospect of asset writedowns but international companies with exposure to the region. The Middle East is weakening – although still remains stronger than many global markets – with oil and property prices falling in the UAE and the continued global shortage of credit. Some construction contracts have already been cancelled, deferred or renegotiated, even contracts with government entities.
Net profit for many companies will likely be sharply lower following writedowns and investment valuations. Key will be to assess the underlying performance of companies following the removal of investment writedowns in order to see the strength of profit at the operating level.
Some companies may take the option of impairment charges as opposed to marking assets to market. Writedowns following the latter process are usually higher.
Companies, especially investment houses and banks, will be hit by their listed equity investment portfolios as share prices have fallen dramatically, particularly in many Gulf markets. Companies will need to write down their investments.
Unlisted investments will face writedowns due to the poor performance and the need for downgrade. The erosion of investment value in franchises and subsidiaries will also need to be recognised.
Companies and banks which hold the bulk of their investments and securities in their held to maturity portfolio will have greater flexibility around mark-to-market methods. This includes basing valuations on recent sale prices. This may yield a price higher than the current share price and waiting for a prolonged period of impairment before marking to the actual share price.
Asset management firms, investment houses and banks will incur write downs when they mark the value of listed funds and investments to market value. Mark-to-market valuation write-downs are likely to have been particularly severe over the last couple of months of 2008.
The debate about the merits of marking-to-market will continue, especially over the coming few months as corporate results are released. There are likely to be many surprises and writedowns in assets but the severity of the crisis will be clearly evident.
- The author is a US-based commentator on business issues
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