There are many reasons for this, and one of the big ones is definitely the (sometimes catastrophic) misjudging of the value proposition itself that this post underscores in detail. In income statement terms, this translates into getting the top-line sales figure wrong, which renders everything else that goes on in the valuation analysis irrelevant.

Without taking anything away from that point, I would argue that another big way to get it wrong that is only slightly less lethal than misjudging the market is misunderstanding the underlying operation itself. The amount of analysis and thoughtfulness that goes into a valuation varies dramatically from instance to instance. I have seen preposterously lazy attempts to apply a developed-market sales, cash or EBITDA multiple, arbitrarily adjusted “for China risk” (or even adjusted upwards “for China opportunity”!) without any attempt to understand the “guts” of the business or how reported cash and EBITDA were arrived at. This can certainly yield a number in just minutes, but it is one that will mean nothing, even if you got your top-line right. These and other less-extreme labor-saving approaches carry with them both upside and downside risk—they may fail to reflect an operational Achilles’ heel or allow an opportunity to add value to the transaction by tweaking the operation remain hidden.

The more I conduct valuations, the more I feel that it is absolutely crucial to build a bottom-up model, starting with the basic operation (which will already reflect many of the opportunities and drawbacks associated with being in China), using this model to recalculate the financials, then applying various valuation methods based on these financials. Such an exercise certainly involves more time and expertise, but it yields a robust figure that is defensible in front of investors. It also greatly expands the number of variables according to which you can stress-test. Essentially, the steps are: (1) due diligence; (2) model and stress-test; (3) valuation.

The list of common pitfalls to look out for at the due diligence step is long (see my other posts), but failure to consider, for example, vulnerability of intellectual property (and the importance of IP to the success of the particular transaction), compliance issues such as back taxes, or the presence of a hidden subsidy/ a local protector (See Jay’s law of Guangxi) (advantages that are generally not transferable to the post-transaction business) can also scupper the value proposition of the contemplated deal.

Jay