This is the speech delivered by Ignacio Velez Pareja at Moscow Business Valuation Conference 2008

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From the Slide Rule to the BlackBerry.
Business Valuation in Colombia and Latin America: My Personal View
Ignacio Vélez-Pareja
Moscow, December 11, 2008
First of all I wish to thank the Russian Society of Appraisers for the invitation to
participate in this Conference as a guest speaker. It is a privilege to exchange ideas with so
selected and qualified audience.
Before I move forward, allow me please, to read a quotation attributed to one of
your great compatriots: “I know that most men, including those at ease with problems of
the greatest complexity, can seldom accept even the simplest and most obvious truth if it be
such as would oblige them to admit the falsity conclusions which they have delighted
explaining to colleagues, which they have proudly taught to others, and which they have
woven, thread by thread, into the fabric of their lives”. (Lev Tolstoy, (1828-1910). What Is Art and
Essays on Art, Quoted by physicist Joseph Ford in Chaotic Dynamics and Fractals (1985) edited by Michael
Fielding Barnsley and Stephen G. Demko).
Is Business Valuation an Art?
It is not an art. I think that some practitioners prefer to give the impression that there
is something secret on it or it is a kind of alchemy, just to protect them. It is a methodical
and systematic approach to valuating cash flows for an ongoing concern. You have to look
for information, need criteria to select proper inputs, have to construct a financial model,
have to assess the economic environment, etc. It is not a precise science, although it might
give the impression of precision. Usually numbers give the false impression of exactitude
and precision. We should keep in mind the fact that we work with estimates. Estimates are
just that. Estimates can differ from one analyst to another one. The relevant issues are first,

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to use systematic and correct approaches to business valuation; second, we should always
remind the golden GIGO rule: Garbage In, Garbage Out. We have to make our best effort
to grant that we are introducing in our model the best information we have in order to get
the best results we can.
Let me go over the idea of a financial model for valuation and value management.
A Financial Model for Cash Flow Valuation and Value Management
Why is it so important to have a financial model for the firm? This is an imperative
for the management because it gives a powerful tool to grasp a vision of the firms’ future.
This is mandatory for the management because it could give the manager a future vision for
the performance of the firm. It is of major importance to develop strategies in order to
overcome difficulties, such as the actual global economic crisis we are witnessing these
days. This financial model is critical for management to keep control on the value creation
process.
Traditionally valuation exercises for those non-public firms are used only for selling
or purchasing a firm or even for merging firms. I deeply disagree with this approach.
Almost 100% of the firms and projects, at a world level, are not traded, including
developed markets. In the U.S. 99.87% of the firms are not traded. They do not have the
value on a daily basis. For this reasons typical valuation tools are in fact designed for non
traded firms. In general, if you trust the market it makes no sense to “calculate” the value of
a traded firm because you can find it in the price the market fixes every day.
How do these firms manage the value creation process? They do it just by hunching
and by intuition. They do not have the possibility public traded firms have of looking and

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estimating their value everyday or even every minute through the price traded in the
market.
Non traded firms should keep an updated model to measure value permanently
through the estimation of their market price and see before hand, the effect on value of
future decisions. Firms should have an instrument for prospective financial management
and not for doing necropsies. A good value based management can be done using an
appropriate forward looking financial model.
With a proper financial model the firm can estimate cash flows and value them.
When valuing cash flows we have to keep on mind that the relevant issue is value, not
return. If the firm creates value it will have an acceptable return, however, the contrary is
not true: maximizing return is not equivalent to maximizing value. A firm should keep a
model to measure value and estimate the effect of future decisions on it. Even public firms
could profit from a model like this one. Just as an example look around and answer the
question if the market price reflects the fair value of a firm. Here I am assuming that the
market shows more than the price. Price might be different of value and this fact makes the
model highly valuable even for them.
How is the typical financial analysis taught at our Business Schools? Usually what
we do is to teach how to see what happened and answer questions like: Did the firm have
high or low liquidity last year? How was the financial (capital structure) decision? How
much was financed using long or short term debt? Was it profitable? How did the firm
spend the funds?

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What is the purpose to know that? Management should be more interested on what
is going to happen, rather than on what happened. Of course history could give us some
clues to forecast the near future, but not much more. Management has to make plans and
establish future policies and should have tools for following up that those policies are put in
practice. Moreover, management has to make decisions to “recover” any value lost because
of variables not under management control (exogenous variables such as inflation), have an
adverse behavior. With a financial model those plans and policies are designed in advance
and are aimed toward value creation. With this approach we cannot expect to know the
future, but to mold and design it.
Using a financial model we can estimate and assess different risks that might impair
the firm value, for instance,
 Political risk
 Rate of exchange risk
 Inflation risk
 Operating risk and
 Financial risk.
We can use the model to examine the financial and economic effects of a decision
prior to implementing it. All this can be done using several types of sensitivity analysis:
one and two variables tables, scenarios and Monte Carlo Simulation. It is interesting that
these tools are available at very low cost (or even free of charge) in a spreadsheet.
In addition of all the previous reasons to develop a financial model, we can use it for
other purposes:

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1. When planning to raise funds for a new or an ongoing firm.
2. When planning to sell or merge a firm.
3. When planning to issue public debt (bonds).
4. When planning a financial strategy (bond issues, or an approach to a institutional
lender)
In practice my proposal consists in looking valuation as a permanent exercise and
not only used as an ad hoc approach, say to sell or buy a firm. It is a proposal for changing
the use of business valuation. It is a management tool for value creation control and risk
analysis.
I propose a model with traditional financial statements, such as the Income
Statement, Balance Sheet and a kind of cash flow statement I call Cash Budget. Let me
explain a little bit the Cash Budget. It has five modules:
 Operating module
 Capital Expenditures Capex
 External financing,
 Transactions with owners and
 Discretionary transactions.
Each module has a Net Cash Balance. The Operating module gives information
useful in determining short term deficit/surplus and hence short term financing. The Capex
module lists the capital investment schedule The External Financing module allows us to
define short and long term financing, including the share equity might have in long term
financing. The Transactions with the owners module lists the new equity investment and

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dividends and repurchase of stock. The Discretionary transactions module allows us to
define cash surpluses to be invested in marketable securities. The added NCB for the first
two modules gives a measure of the maximum debt capacity of the firm in the period. From
financing and transactions with owners’ modules we can derive the relevant cash flows for
valuing the firm/project.
This is a consistent and integral financial model based on one simple and well
known principle: The Double Entry Principle, DEP. This is the basic concept of current
accounting practice. It has many advantages. One of them is that arithmetic mistakes (in the
accounting process) or modeling errors are easily identified. It is simple: total credits
should be identical to total debits. If this does not match, something is wrong. Mentioning
that the model is based upon the DEP might be seen naïve and self evident. However, it is
not. What practitioners and authors do is to assume they have done every step in the model
construction correctly and close (match) the Balance Sheet with plugs. It is like sweeping
the dust under the carpet. And I can assure you there are lots of mistakes (even evident and
elemental mistakes) that are done even by most experienced model builders.
Some additional features are:
 It has disaggregated inputs: inflation, real growth, real prices, policies, etc.
 The Cash Budget allows us to define short term and long term (by equity and/or
debt) financing and cash excess for ST investment.
 It allows the analyst to calculate the maximum debt capacity the firm could
acquire for a given period of time

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 Allows the analyst to derive cash flows directly for investment valuation reducing
the probability of mistakes.
 The financial model (when used integrally, this is, when used to valuate the
investment) considers the proper working capital calculation. I mean by this that what is
called liquid assets are not considered as cash flows (because they are listed in the BS) as
Damodaran and others include as cash flows (they include as CFs items that are listed in the
BS).
 Given the disaggregation of inputs it allows a proper sensitivity analysis included
Monte Carlo Simulation. This is interesting because we can examine and assess the risks of
cash flows directly examining and sensitizing their basic components as proposed in several
of my papers and suggested by Galasyuk and Galasyuk in their paper “Consideration of
Economic Risks …” (Sept. 2007).
 Given item 1, it is possible (as I have done in different versions) to include
several degrees of complexity, for instance, price-demand elasticity, large scale economies,
inclusion of financial distress costs in the cash flows (WACC has enough problems to
include additional like different classes of risk, financial distress costs, etcetera), effect of
accounts receivables policies on growth, exchange rates effects and any other you can need
and/or imagine.
 The proposal is integral in the sense that the financial model is just a means to
conduct forward looking financial analysis and value management. I think that apart from

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the technicalities involved in the previous items, this is the most relevant feature of the
proposal.
Some advantages of using a financial model like the one I propose are:
 With the financial model we work a forward looking financial management. Not
necropsies.
 A financial model should allow managers to assess what effect a change in input
variables will have on the firm value. In that case we can answer questions such as
will an increase or decrease in a given input (exogenous or endogenous) creates or
destroys value? If an exogenous variable changes and destroys value, what can be
done to offset it? Will a change in a given policy destroy or create value? That is
what Economics, Business Administration, Engineers and similar professions aim
at: to increase value. That is the name of the game: to create value.
This position does not mean that we should not value history. Although I insist in a
looking forward exercise, historical data are useful in several ways:
a. When defining policies for the firm. It is usual to find that one thing is what
the manager says the firm does (wishful thinking) and another one is what in
reality happens. Looking past performance might give light upon the
implicit policies the firm has.
b. When comparing immediate results with expected ones. The bottom line
about creating/destroying value is when we compare what was expected
with the actual results.

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Some History and Business Valuation in Colombia and Latin America
Asset valuation has a long history. People traded goods since the beginning of
Humankind and there was a need to know their value. This gave rise to an ability to assign
value to those assets. However, Business Valuation as we know it today is relatively recent.
Professional Valuation main activity is focused toward “pricing of exchanges with
non-standard assets (real property, non-public companies and interests in them, intangible
assets and other assets exchanged on inactive markets”. (Artemenkov, Mikerin, and
Artemenkov, 2007).
Let me make some emphasis on the valuation of non-public companies.
My first exposure to the subject of business valuation was through my college
course on Time Value of Money with the classical text “Principles of Engineering
Economy” by Grant and Ireson in 1963. From that date to today there has been lots of
changes.
At that time computing resources were very limited and scarce. We had to work
with pre calculated tables (the PV of $1 and similar) and slide rule! And now we are in the
era of the real portable computing: the iPhone and the Blackberry.
Project appraisal was very popular. At that time the current practice was to draw
cash flow trends by extrapolating them given some initial cash flow; working capital was
calculated as a percent of investment and little effort was done in relating cash flows with
financial statements and the discount rate was picked out from the thin air. Social project
appraisal (economic appraisal) was the norm. Constant prices approach was and is today a

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current practice. Discount rate for cash flows was, as it is today, pulled from the thin air.
Nobody knows why it is 12% or 8% or whatever.
We have to recall that the work of Modigliani & Miller was completed near 1963,
Harry M. Markowitz, (1952-1959), James Tobin, (1958), William F. Sharpe, (1963-1964),
John Lintner, (1965), and Robert S. Hamada, (1969), were scarcely writing on the issue of
risk and return, CAPM and the like and there was a time lag between theory and practice.
In the 70’s large scale computers, mainframes, started to appear for academic and
official use. In the late 70’s rudimentary PCs gave their first steps, but still, many
computing for project appraisal was done by hand with the help of the slide rule and at the
very end of the decade, using financial calculators. Basically, at least in our countries, the
valuation or appraisal approach was the same.
In the 80’s less expensive and more efficient computing resources started to appear
and we could build some “sophisticated” models for project appraisal. That was a double
edged sword. I remember when we used a spreadsheet for the first time (in 1982) and
submitted a work to some firm that contracted us to appraise a large scale project. The
customer was impressed with our work and suggested a change in one or two variables. We
went back to the office and made the changes and in 30 minutes we had the results in the
desk of our customer. He was stunned. The problem was when we submitted the invoice for
our services. Our customer said, how come you are charging that much for something that
could be done in half an hour? Discount rates were estimated with not more detail than
before. Perhaps we started to think on an average discount rated based on the cost of debt
and the cost of equity. Although we taught at Engineering and Business Schools a kind of

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science fiction called Simulation, we had to wait for the next decade to start doing it in an
easy and not as expensive way.
From the 80’s to today the Business Valuation professional has been more aware of
the use of relatively more sophisticated methods such as the above mentioned.
In the mid 90’s authors started to link the basic concept of time value of money (as
in Grant & Ireson’s classic textbook) with the issue of value creation and cash flow
valuation. Financial models started to flourish. CAPM was an issue in the academic world
and was taught in our business schools. Practitioners timidly started to use it.
In the 2000’s we have seen a flourish of improved valuation techniques, mainly due
to the availability of cheap and efficient computing resources. We have moved from
methods based on accounting data to others based on profitability. I have to say that even
today, many do not understand the implications and limitations behind the betas for CAPM
and yet they use them blindly and mechanically. Damodaran website is the mine of data for
many. They add to the model all the risk premia you can imagine. Even adjustments to find
the optimal capital structure that everybody talks about but I am sure that nobody has seen.
As I have proposed elsewhere, we should try to include as much as possible in the cash
flows (via a financial model), what could happen to a firm (including financial stress costs).
Another example is in the Markovitz portfolio analysis that has been a subject taught since
the 90’s, but until recent date neither students nor their teachers knew what to do with an
elaborated efficient frontier they learned to construct. Many authors and teachers ignore the
work done by Black (1972), Merton (1973) and presented later by Levy and Sarnat (1982),

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Elton and Gruber (1995) and Benninga (1997) where they show a simple way to identify
the optimal portfolio.
The most usual accounting methods were (and surprisingly still they are, mainly in
small and medium size firms) the book value, book value with net assets adjusted to the
commercial price, reposition value and liquidation value. These methods are relatively easy
to use, but they have serious drawbacks. Some associate these methods with what is called
the cost approach and generally applies to liquidation analyses.
On the other hand, the profitability methods take into account the capacity of the
firm to create value in the future. The most popular are multiples of comparables, value of
traded stock and discounted cash flow. From the later ones, the most popular is the
discounted cash flow, DCF. The profitability methods are associated with the income and
market value and these approaches are typically used for "going concern" business
valuations.
How is the valuation practice in our countries?
Large firms prefer to contract the big boys of the U. S. for business valuation:
Boston Consulting Group, McKinsey, The Monitor Group and others. In addition,
practitioners heavily rely on Damodaran (who, as far as I know, is not a member of any
Association of Appraisers) data and common knowledge approaches.
In the Business Valuation area the professional activity (consulting) uses the
discounted cash flow and multiples of comparables approaches which include shortcuts of
doubtful correctness. My concern with this is not the proper procedures by themselves, but
the fact that it is not necessary to make Olympic assumptions or to use practical shortcuts.

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With the computational resources we have today, it makes no sense to use approaches and
solutions that were good in the sixties and seventies. Some of the improper procedures have
to do with the construction of financial statements using plugs and circularity to match
them as already mentioned. When deriving cash flows, considering as cash flows amounts
that are listed in the BS; double counting the risk when using premia for taking into account
different classes of risks; wrong use of formulas for the cost of capital; improper models for
terminal or continuing value (perpetuities are a Pandora’s Box); inconsistent results in
methods that should show consistency; blindly use of models like CAPM that gives the
illusion of precision; dealing with inflation with constant instead of nominal prices; using
as cost of debt the wrong rate of interest; wrong application of M&M findings and the like.
A mea culpa. I should recognize that in some of my papers and works I use the
CAPM, however, it is out of the necessity to teach and explain it as part of the academic
activity. You need to know (the CAPM, for instance) what you disregard because you get
disappointed or convinced that it should not be applied in every case. As mentioned above,
our concern as users of Professional Valuation is the illiquid firms understanding by that
more than 99% of the firms in the world. Our concern is the many firms owned by non
diversified investors where ideal models like CAPM do not apply. I think it is valid to
estimate the cost of equity subjectively. Subjectivity is not wrong by definition. It is
different from arbitrariness. Arbitrariness has no bases. Subjectivity captures and is based
upon a lot of information and experience the decision maker has. I wonder what is more
arbitrary (or “subjective”) if some cost (of equity) estimated subjectively (see the
Analytical Hierarchical Process by Thomas L. Saaty) or a “precise” estimation (you can

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calculate it with as many decimals as you wish) based on a method like CAPM with “N”
risk premia.
However, even now, it seems that many practitioners and teachers are anchored to
the past and still work with models as if they have computing restrictions as we had in the
sixties. On the other hand, some are in the frontier of knowledge trying to solve very
complex issues with sophisticated tools. Right now I am engaged with my colleague Rauf
Ibragimov, in working a series of papers we have untitled Return to Fundamentals or
Return to Basics with the hope that practitioners, teachers and authors realize that there are
many basic and simple issues to be mastered with the use of available technological
resources before they move forward to those sophisticated tools such as Econometrics.
Today, to be a respectable scholar you need to use it. I am not saying that we should not try
to be in the frontier of the state of the art, no. What I say is that there should be a clear
understanding of basics concepts and ideas before approaching to complex ideas and
concepts handled with complex tools. At this point I would like to cite a couple of
quotations: the first one is from Edward Leamer: “There are two things you are better off
not watching in the making: sausages and econometric estimates” and the other is related to
those "[...] practitioners [that] are often accused of doing, [what] is called data mining,
fishing, grubbing or number-crunching. This methodology is described eloquently by
[Ronald Harry] Coase: if you torture the data long enough, Nature will confess" (Author not
identified).
Business Valuation has no formality in Latin America and in particular in countries
such as Argentina, Brazil, Colombia, México, Peru and Venezuela. There are guilds or
associations for appraisers mainly for real estate and machinery and vehicles or as noted

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above, on “pricing of exchanges with non-standard assets (real property, […] intangible
assets and other assets exchanged on inactive markets” (Artemenkov, Mikerin, and
Artemenkov, 2007). One of the reasons business appraisers are neither associated nor
regulated might be the professions of the former. Appraisers for real estate and machinery
are lawyers, architects and engineers. Business appraisers are usually accountants,
economists, business administrators and engineers. Most of them are financial consultants.
It is interesting to note that in The American Society of Appraisers
(http://www.bvappraisers.org/) we find individuals, not consulting firms. The same happens
in the International Valuation Standards Committee (IVSC, http://www.ivsc.org/) where
Professor Igor Artemenkov is a member of The Professional Board. Perhaps it is time to
stimulate the participation of consultants (Business Valuation professionals) in these
organizations.
A Summary
I have tried to communicate my opinions on business valuation in general and what
I see in Colombia and Latin America as a current practice of the valuation activity. In
summary, I could say that many scholars try to keep up with the state of the art in the
valuation approach and this is very good, but many still have basic conceptual deficiencies.
This sounds paradoxical, but it is true. I have found that many propose, handle and design
complex mathematical and econometrical models to analyze very sophisticated approaches
to risk assessment, for instance, but they are surprised because firms obtain tax savings
from any deductible expense and create value from it.
On the other hand, practitioners disregard theoretical precisions under the
assumption that they are unnecessary and the differences in results are negligible or due to

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“rounding” errors but they vanished when spreadsheets arrived. It is not the point. The
point is that if you do not have a consistent and correct valuation approach you will never
know if the estimation of value is reasonable. I agree that valuation is not a cold
mathematical exercise. It has many subjectively estimated inputs and the value we suggest
(better, the range of values) is the starting point for a negotiation process between buyer
and seller (in the case of a situation of selling and buying a firm or project), but this starting
point should be a consistent and reliable one. In short, valuation relies upon forecasts that
by themselves are debatable, why should we add sources of errors to something that has
implicit a given degree of error? We should minimize the total error once we have
identified the source. It is not reasonable to increase error because we use a tool that has
inherently a degree of error. In short, when you question whatever the “holy cows” do, they
dismiss you and to put in Artemenkov, Mikerin and Artemenkov (2007) words, “… those
who attempt to spot cracks in [their work …] are regarded as being unreasonable hair-
splitters”. I would tell these authors, please, include me in the exceptions.
Finally, the most relevant issue in business valuation is to give management a tool
for controlling value creation. This could even be a very interesting source of income for
practitioners and consultants. They could offer non traded firms not only the consulting in
Business Valuation, but the service to keep the value estimation updated every time
exogenous variables change and/or the sensitivity analysis option to test future decisions in
terms of value creation/destruction.
I invite this selected audience to think about basics. Return to basics and consolidate
that knowledge before we introduce sophisticated tools for financial analysis and value
management.

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Thank you very much for your kind attention.