VALUATION CONCEPTS AND

METHODS
INSTRUCTIONAL MATERIALS

HERBERT C. BARON
ANDREW TIMOTHY L. CACHERO
MARVIN V. LASCANO
LUZVIMINDA S. PAYONGAYONG
MARIA LUISA U. OLIVEROS
 Module 1 – Introduction on Valuation Concepts
and Methods

Overview:
There is no doubt that the “value” is the defining measurement of any market in the
economy of today. Value is all about how much something is worth, whether in an
estimate or exact amount. When somebody invest, they expect the “value” of their
investment to increase by an amout that is acceptable to them or sufficient enough to
compensate the risk or sacrifice they took, incorporating the time value of money. As we
say, in everything we do, we need to sacrifice. That sacrifice has value, giving away
something that is valuable to him expecting another value, the return or profits he is willing
to accept given the value of his sacrifice.

Therefore, knowing how to measure value or how to create value is an essential tool
for everybody to be able to make a decision, wise decisions.

Module Objectives:
After successful completion of this module, you should be able to:

• Discuss the importance of valuation in accountancy profession

• Discuss why people needs to apply valuation techniques
• Identify the appropriate valuation techniques

Course Materials:
• Foundations of value

There is no doubt that the “value” is the defining measurement of any

market in the economy of today. Value is all about how much something is worth,
whether in an estimate or exact amount. When somebody invest, they expect the
“value” of their investment to increase by an amout that is acceptable to them or
sufficient enough to compensate the risk or sacrifice they took, incorporating the
time value of money. As we say, in everything we do, we need to sacrifice. That
sacrifice has value, giving away something that is valuable to him expecting
another value, the return or profits he is willing to accept given the value of his
sacrifice.

Therefore, knowing how to measure value or how to create value is an

essential tool for everybody to be able to make a decision, wise decisions.

• Definition of valuation
 Valuation is the analytical (quantitative) process of determing the current
or projected worth (value) of an asset or something. There are several techniques
or methods available to be used in doing valuation. Each of these methods may
give different results or value, what matter is how this will be used in the decisions
why such valuation activity is being done.

Valuation determines the economic value of a business, asset or company.

• Frameworks for valuation

Conceptual frameworks of valuation is about the issue of what affects or

what drives the value to change. A company’s value is driven by its ability to earn
a good or healthy return on invested capital (ROIC) and by its ability to grow.
Healthy rates of return and growth result in high cash flows, the ultimate source of
value. Discussions on this will be done in detail in the topic, step by step process
of valuation.

• Concepts of valuation

Valuation is based on economic factors, industry variables, and on the

analysis of financial statements and the entire outlook of the firm. Valuation
process will determine the long-run fundamental economic value of its common
stock or preferred stock. Different concepts of valuation are based on the
following:
1. Going concern value
2. Liquidation value
3. Market value
4. Book value
5. Intrinsic value

Details of the above concepts will be discussed in the respective topics.

When dealing with the valuation process, it is important to get as many

facts as possible with clear goals on what is the purpose of this valuation.
1. Why are you valuing?
2. What are you trying to accomplish with this valuation?

• Objectives/uses of valuation

Valuation is useful when we are trying to determine the fair value of an

asset. Fair value is the amount which is determined by what is the buyer willing to
pay and the seller is willing to sell under the conditions that both parties are willing
or voluntarily enter in the exchage transaction.

• Importance/Rationale of valuation
 Business valuation is an important exercise since it can help in improving
the company. Here are some of the reasons why is there a need to perform a
business valuation.

Although the goal of valuation is to determine the fair market value, there
is no one way to be certain of the ultimate price paid. Typically, it depends on many
factors including industry, sector, valuation method and the economic conditions.
You can also count on a fact, you can have your business valued by two
professionals and you will come up with two different answers

Various reasons for performing a business valuation

• Litigation

In a court case, such as an injury case, divorce, or where there is an

issue with the value of the business, someone may need to provide proof of
company’s worth that could be the basis of claims for any damages, or be
based on the actual worth of your businesses and not inflated figures estimated
by a lawyer.

• Exit strategy planning

In cases where there is a plan to sell a business, it is wise to come up

with a base value for the company and then come up with a strategy to enhance
the company’s profitability so as to increase its value as an exit strategy. Your
business exit strategy needs to start early enough before the exit, addressing
both involuntary and voluntary transfers.

A valuation with annual updates will keep the business ready for
unexpected and expected sale. It will also ensure that you have correct
information on the company fair market value and prevent capital loss due to
lack of clarity or inaccuracies.

• Buying a business

Sellers and buyers of business usually have different opinions on the

worth of the business. However, the real business value is what the buyers
are willing to pay. A sound business valuation should consider market
conditions, potential income, and other similar concerns to ensure that the
investment being done is viable. Business buyers must exercise prudence by
normally hiring a business broker who can help you with the process.

• Selling a business

As mentioned, sellers and buyers usually have different opinions on the

worth of the business. The sellers, however, would want to be certain that they
are getting what it is worth, thus they may have to perform their valuation
process as well.
 • Strategic planning

The true value of assets may not necessarily be reflected on the assets
schedule, and if there has been no adjustment of the balance sheet for various
possible changes, it may be risky. Having a current valuation of the business
will give you good information that will help you make better business
decisions. As in the financial reporting standards, the use of current value
accounting is more evident.

• Funding

Bankers, financing companies or any potential investors require an

objective valuation when someone is negotiating or applying for credits, loans
or any funding requirements. Professional documentation of your company’s
worth is usually required since it enhances your credibility to the lenders or
potential investors.

• Selling a share in a business

For business owners, proper business valuation enables you to know

the worth of your shares and be ready when you want to sell them. Just like
during the sale of the business, you ought to ensure you get good value from
your share.

Business valuation is a critical financial analysis that needs to be done

by a valuation expert who has appropriate qualifications. Business owners are
able to negotiate a tactical sale of their entity, plan an exit strategy, acquire
financing, and reduce the financial risk during litigation.

• Fundamental principles of valuation or value creation

Business valuation involves the determination of the fair economic value of

a company or business for various reasons as mentioned earlier.

Key Principles of Business Valuation

The following are the key principles of business valuation that business
owners who want to create value in their business must know.

• The value of a business is defined only at a specific point in time.

The value of a business usually experiences changes every single day.

The earnings, cash position, working capital, and market conditions of a
business are always changing. The valuation made by business owners a
months or years ago may not reflect the true current value of the business.
The value of a business requires consistent and regular monitoring. This
 valuation principle helps business owners to understand the significance of the
date of valuation in the process of business valuation.

• Value primarily varies in accordance with the capacity of a business to

generate future cash flow

A company’s valuation is essentially a function of its future cash flows

except in in unusual situations where net asset liquidation may lead to a higher
value.

The consideration here is the term “future.” It implies that historical

results of the company’s earnings before the date of valuation are useful in
predicting the future results of the business under certain conditions. Another
consideration is the term “cash flow.” It is because cash flow, which takes into
account capital investments, working capital changes, and taxes, is the true
determinant of business value. Business owners should aim at building a
comprehensive estimate of future cash flows for their companies. Even though
making estimates is a subjective undertaking, it is vital that the value of the
business is validated. Reliable historical information will help in supporting the
assumptions that the forecasts will use.

• The market commands what the proper rate of return for investors

Market forces are usually in a state of flux, and they guide the rate of
return that is needed by potential buyers in a particular marketplace. Market
forces include the type of industry, financial costs, and the general economic
conditions. Market rates of return offer significant benchmark indicators at a
specific point in time. They influence the rates of return wanted by investors
over the long term. Business owners need to be wary or concerned of the
market forces in order to know the right time to exit that will maximize value.

• The value of a business may be impacted by underlying net tangible assets

Business valuation measures of the relationship between the

operational value of a company and its net tangible value. Theoretically, a
company with a higher underlying net tangible asset value has higher going
concern value. It is because of the availability of more security to finance the
acquisition and lower risk of investment since there are more assets to be
liquidated in case of bankruptcy. Business owners need to build an asset base.
For industries that are not capital intensive, the owners need to find means to
support the valuation of their goodwill.

• Value is influenced by transferability of future cash flows

How transferable the cash flows of the business are to a potential

acquirer will impact the value of the company. Valuable businesses usually
operate without the control of the owner. If the business owner exerts a huge
control over the delivery of service, revenue growth, maintenance of customer
 relationships, etc., then the owner will secure the goodwill and not the
business. Such a kind of personal goodwill provides very little or no commercial
value and is not transferable.

In such a case, the total value of the business to an acquirer may be

limited to the value of the company’s tangible assets in case the business
owner does not want to stay. Business owners need to build a strong
management team so that the business is capable of running efficiently even
if they left the company for a long period of time. They can build a stronger and
better management team through enhanced corporate alignment, training, and
even through hiring.

• Value is impacted by liquidity

This principle functions based on the theory of demand and supply. If

the marketplace has many potential buyers, but there are a few quality
acquisition targets, there will be a rise in valuation multiples and vice versa. In
both open market and notional valuation contexts, more business interest
liquidity translates into more business interest value. Business owners need
to get the best potential purchasers to the negotiating table to maximize price.
It can be achieved through a controlled auction process.

Although they are technical valuation concepts, the basics of the

valuation principles need to understood by business owners to help them
increase the valuation of their businesses.

Read:

Books, published materials and references on Corporate Valuation, Valuation Concepts,

Tools for Valuation

Activities/Assessments:
1. Essay. Answer the following questions using what you’ve learned in this module.
Use diagrams, if needed:
a. Why we need to value value?
b. Why valuation matters to business people?
c. Why do people perform valuations?
d. How and when to apply valuation principles?
 Module 2 – Asset Based Valuation for Going
Concern Opportunities Part 1
Overview:
Asset is defined as transactions that will yield future economic benefits brought
about by past events. Given the definition, valuation should be observed to address the
determination of the amount of returns that will be earned or generated from the
transactions. The challenge is determining the factors that will affect the value of the
assets.
Valuation concepts are geared towards determining the price of equity based on
the value of its assets. The higher the value of the assets or investment represents the
higher the projected returns to be generated. Valuation approach is different depending
on the investment opportunity available. This module shall focus on asset based
valuation approached for going concern opportunities.

Module Objectives:
After successful Completion of this module, you should be able to:

• Compare and contrast the different asset-based valuation methods for going concern
• Justify the reasonableness of the value based on the methods

Course Materials:
There are several business opportunities in various industry. In Management
Accounting, capital budgeting techniques are very useful in determining which among
the alternative opportunities is the most economic and would be a better choice. In order
to determine the value, information is the key. The best and most relevant information
must be factored in. For going concern business opportunities, there are different
approaches that can be used, the most popular are: discounted cash flows or DCF
analysis, comparable companies analysis, and economic value added.

Discounted Cash Flows Analysis

In Financial Management, it has been discussed that a way to determine the

value of an investment opportunity is by determining the actual cash generated by a
particular asset. Recall that discounted cash flows analysis can be done by determining
the net present value of the free cash flows of the investment opportunity. In Conceptual
Framework and Accounting Standards, it was discussed the that the cash flows are
presented and analyzed based on their sources and activities which are categorized as
operating, investing and financing. The free cash flows are the amounts of cash
available for distribution to both debt and equity claim from the business or asset. This is
calculated from the net cash generated from operations and for investment over time.
Since this is a going concern opportunity, certain risk and returns are inherent this is
quantified in the form of terminal cash flows. Terminal cash flows can be computed by
estimating the perpetual value of cash to be generated by the opportunity or in some
cases these represents the salvage value of the opportunity.

The net present value of the free cash flows represents the value of the assets. It
may be recalled further that the assets are financed by debt and equity. Hence, these
are the claims which are presented at the right side of the Statement of Financial
Position, under an account form of reporting.

Same principle applies that the best opportunity is the one that will yield the
highest net present value or solely if the opportunity will result into a positive amount it
should be accepted. Conservatively, the total outstanding liabilities must be considered
and deducted versus the asset value to determine the amount appropriated to the equity
shareholders. This is called the equity value. The opportunity that will result to the
highest equity value is considered.

DCF Analysis is most applicable to use when the following are available:

• Validated Operational and Financial Information

• Reasonable appropriated cost of capital or required rate of return
• New quantifiable information

Supposed PUP Company is projected to generate Php10 Million every year for
the next 5 years and beyond. The estimated terminal value is Php50 Million. The
required return is 10%. It was noted further that there is an outstanding loan of Php50
Million. If you are going to purchase 50% of PUP, how much would you be willing to
pay?

in million pesos
Year 1 2 3 4 5
Free Cash Flows from the Firm 10.00 10.00 10.00 10.00 10.00
Terminal cash flows 50.00
Free Cash Flows - Firm 10.00 10.00 10.00 10.00 60.00
NPV @ 7% 76.65
Less: Outstanding Loans 50.00
Free Cash Flows to Equity 26.65

Based on the foregoing information, the value of PUP’s equity is Php26.65

Million. If the amount at stake is only 50% then the amount to be paid is Php13.33 Million
(Php26.65 x 50%).

Comparable Company Analysis

In Financial Management, financial ratios are used as tools to assess and

analyze business results. Recall that one of these purposes can be used to determine
the value. These financial ratios are P/E Ratio, Book to Market Ratio, Earnings Per
Share, Dividend Per Share. Multiples can also be used in comparative company
analysis. The beauty of the ratios is that it creates better and relevant comparison
knowing that opportunities or investments have distinct drivers of their performance.

The following are the consideration for doing a comparable company analysis:

• Total and absolute values should not be compared

• Variables used in determining the ratios must be the same
• Period of observation must be comparable
• Non quantitative factors must also be considered

Economic Value Added

The most conventional way to determine the value of the asset is through its
economic value added. In Economics and Financial Management, economic value
added (EVA) is the convenient for this is assessing the ability of the firm to support its
cost of capital with its earnings. EVA is the excess of the earnings after deducting the
cost of capital. The assumption is that the excess shall be accumulated for the firm the
higher the excess the better.

The elements that must be considered in using EVA are:

• Reasonableness of earnings or returns

• Appropriate cost of capital

Other factors to be considered in Valuation

Once the value of the asset has been established, there are factors that can be
considered to properly value the asset. These are the earning accretion or dilution,
equity control premium and precedent transactions.

Earning accretion are additional value inputted in the calculation that would
account for the increase in value of the firm due to other quantifiable attributes like
potential growth, increase in prices, and even operating efficiencies. Earnings dilution
works differently. But in both cases, these should also be considered in the sensitivity
analysis.

Equity Control premium is the amount that is added to the value of the firm in
order to gain control of it. Precedent transactions, on the other hand, are experiences,
usually similar with the opportunities available. These transactions are considered risks
that may affect further the ability to realize the projected earnings.

Read:

Books and related literature on Corporate and Asset Valuation

Activities/Assessments:
1. XYZ Company is exploring two mutually exclusive opportunity. There are two
available opportunities for XYZ with the following information:
a. ABC Company has projected annual returns of Php7 Billion and
outstanding liabilities of Php5 Billion.
b. DEF Company has projected annual returns of Php12 Billion and
outstanding liabilities of Php20 Billion.
c. Both companies has terminal value of Php100 Billion.
If you will assess the company for five years with the required rate of return of
10%, which company will you recommend purchasing and how much? Why?
2. Using the information in No. 1, which is a better choice if the initial investment for
ABC Company and DEF Company is Php50 Billion and Php110 Billion,
respectively. The cost of capital for the two companies are 10%.

3. XYZ Company is offered to purchase ABC Company with EPS of Php12 and P/E
ratio of 5; while DEF Company has EPS of Php15 and P/E ratio of 4. What is the
value of the two companies? Which one is a better? Why?
 Module 3 – Asset Based Valuation for Going
Concern Opportunities Part 2
Overview:
In valuing companies, there are a lot of methodologies that are available.
DCF Analysis are is a sanitary and conservative approach to determine the
value. The challenge is that in the fast-changing world the need to be agile in
terms of making decision is imperative. The information available today will be
different later hence the basis for the decision may no longer be relevant.
The tools available to assess the value of the going concern business
could be in the form of ratios and multiple. But more conservative tool is the use
of a financial model designed to represent all quantitative information and
converted into financial terms. This module will discuss how financial model
works and used in the valuation exercise.

Module Objectives:
After successful Completion of this module, you should be able to:

• Prepare a financial model that will be used for the valuation decision
• Assess projects or investment opportunity with the use of financial models

Course Materials:
Financial Modelling is a valuation activity that enable the analyst or investor to
determine the value of an asset or opportunity. This incorporates all factors that may
affect the value. A financial model must clear and auditable. Financial models were
created to aid in coming up with a recommended decision and at the same time can be
used to validate the assumptions made.

Financial models are similar to budgets and Financial modelling is similar to

financial planning. The difference is that financial models are usually longer in terms of
the period, more conservative and designed to determine the value not the cash needed
of the firm in the short to medium term. Financial Models are done using spreadsheets.
Best is with the use of electronic spreadsheets; nowadays electronic spreadsheets are
considered manual still. There are financial models which are designed electronically or
programmed in an application.
What are the steps in doing a financial model for going concern opportunities?

Gather historical information and references

Historical information must be made available before the financial model is to be

constructed. Historical information may be generated from, but not limited to the
following: audited financial statements, corporate disclosures, contracts, and peer
information.

Audited Financial Statements are the most ideal reference for the historical
performance of the company. The components of the Audited Financial Statements
enable the analyst or the financial modeler to assess the future of the company based on
its past performance. Statement of Income are used to determine the historical financial
performance, Statement of Financial Position is used to determine the book value of the
assets and the disclosed stakes of the debt and equity financiers, Statement of Cash
Flows illustrate how the company historically financing its operations and investments.
Statement of Changes in Stockholder’s Equity provides the information on how much is
the claim and dividend background of the company. One of the most important
components of the financial statements are the Notes to the Financial Statements. It
provides the summary of important disclosure that should be considered in the valuation.
The financial modeler must be able to quantify these disclosures and more importantly
the risks involved.

Establish drivers for growth and assumptions

Once the historical information are gathered and validated, drivers and
assumptions can be established by conducting financial analysis. Again, in this part,
financial ratios may be used as tools to determine the growth drivers and assumptions.
Trend analysis will also help you establish the trajectory of growth pattern. The financial
modeler must assess whether the company can sustain the pattern otherwise it is
conservative to assume a less aggressive growth. To illustrate, if the sales volume grows
in the last 5 years at the rate of 15% per year. It must be assess whether the average
year on year growth will be sustained or may be surpassed. In here, skills of scenario
analysis will be required. Scenario analysis as discussed in Financial Management will
require to determine different scenarios and incorporates the probability of occurrence.
Normally the weighted growth pattern will be considered in the long term financial
perspective.

PUP Company’s historical production grows 10% per year. It is expected that in
the next five years the probability are as follows:

Scenario Rate Probabilty

A 5% 10%
B 10% 40%
C 15% 50%
With the given information, the weighted average growth rate to be used is 12%.
Determine the reasonable cost of capital

In determining the reasonable cost of capital, the financial modeler must be able
to use the appropriate parameters for the company. Generally, cost of debt and cost of
equity are weighted to determine the cost of capital reasonable for the valuation. For
cost of debt, the prevailing market interest rates are used. While for the cost of equity,
industry average can be conveniently used or internally assess the cost of equity using
the Capital Asset Pricing Model.

Calculate for the Value using Valuation Methods

Normally in Financial Modelling, DCF is used to calculate for the value. Since
most information are already available in Financial model, it can be easier to use other
capital budgeting techniques like Internal Rate of Return, Profitability Index etc.

Illustration. HIJ Company’s last EBITDA reported is Php50 Million. Historically, their
sales grew by 12% every year. The scenarios were built based on the plan of the
company to purchase an asset within the year with the cost of Php150 Million. Terminal
cash flows were estimated to be Php250 Million. The company reported total liabilities of
Php100 Million. Using the financial model and with the given facts the value of the equity
is Php70.01 Million.

in million pesos
Year 1 2 3 4 5
EBITDA, base 50.00 56.00 62.72 70.25 78.68
Multiply: (1 + Growth Rate) 112% 112% 112% 112% 112%
EBITDA, adjusted 56.00 62.72 70.25 78.68 88.12
Less: Interest Payments 5.00 5.00 5.00 5.00 5.00
Less: Corporate Income Taxes 18.30 20.32 22.57 25.10 27.94
Free Cash Flows from the Firm 32.70 37.40 42.67 48.57 55.18
Less: Additional Asset 150.00
Terminal cash flows 250.00
Free Cash Flows - Firm - 117.30 37.40 42.67 48.57 305.18
Discount Factor @ 10% 0.91 0.83 0.75 0.68 0.62
Discounted Cash Flows - 106.64 30.91 32.06 33.18 189.49
Value to the Firm 179.01
Less: Outstanding Loans 100.00
Value to the Equity Stockholders 79.01

Read:

Other reference materials on Financial Forecasting, Corporate Valuation

and Financial Modelling
Activities/Assessments:

1. Secure a copy of an annual report of the any publicly listed company in the
Philippines. Calculate the growth rate of its EBITDA in the last 3 years. Using the
growth rate apply it to project the EBITDA for the next 5 years. All things remain
constant. Assume weighted average cost of capital to be 10%, 12% and 15%.
Prepare a financial model. How much is the value of that firm? Would you
recommend buying the company to be part of your asset?

2. Using your financial model developed in No.1, use the total value of the
Noncurrent Assets of the company as the terminal cash flows, would your
recommendation change? Why?

3. Using your financial model developed in No.1, create a scenario where:

a. growth rate is 0%;
b. growth rate is half of what they have historically but purchase new asset
based on 20% of the net book value of the property, plant and equipment;
and
c. growth rate is 1.5x of what they have historically but purchase new asset
based on 25% of the net book value of the property, plant and equipment.
How much is the value of the asset under three scenarios? What is you
recommendation? Why?
Module 4 – Asset Based Valuation for Liquidation
Overview:
There are instances when different circumstances create doubt that going-concern
assumption is still attainable for businesses. These circumstances may include economic
downturn, bankruptcy, financial distress, unfavorable regulatory environment, depletion of
limited resources (e.g. granite, quarry) as source of business. As a result, it might not be
appropriate to use going-concern techniques when valuing businesses facing these. An
alternative approach is the use of liquidation value. This module describes liquidation
value, its uses for business valuation and decision making and relevant concepts for
calculation of liquidation value
.
Module Objectives:
After successful completion of this module, you should be able to:

• Understand liquidation value and its importance to business decision making

• Apply liquidation value appropriately when surrounding circumstances require it

Course Materials:
Liquidation value refers to the value of a company if it were dissolved and its assets
sold individually. Liquidation value represents the net amount that can be gathered if the
business is shut down and its assets are sold piecemeal. For example, if a restaurant
closes, the assets such as the kitchen equipment, tables and chairs, and so on can be
sold separately. The liquidation value indicates the present value of the sums that can be
obtained through the disposal of the assets of the firm in the most appropriate way, net of
the sums set aside for the repayment of the debts and for the termination of legal
obligations, and net of the tax charges related to the transaction and the costs of the
process of liquidation itself. Liquidation value is the most conservative valuation approach.
Liquidation value can be used for businesses who are closing, are closed, are in
bankruptcy, are in industries that are in irreversible trouble, or going concern firms that
isn’t putting its assets to good use and may be better off closing down and selling the
assets. For distressed companies, the liquidation value conveys relevant information as it
is typically the lower bound of the valuation range.

General concepts considered in liquidation value are as follows:

• If the liquidation value is above income approach valuation (based on going-concern

principle) and liquidation comes into consideration, liquidation value should be used.
• If the nature of the business implies limited lifetime (e.g. a quarry, gravel, fixed-term
company etc.), the terminal value must be based on liquidation.
• Non-operating assets should be valued by liquidation method as the market value
reduced by costs of sale and taxes. If such result is higher than net present value of
cash-flows from operating the asset, the liquidation value should be used.
• Liquidation valuation must be used if the business continuity is dependent on
contemporary management that will not stay.

For most companies, the value generated by assets working together and by
human capital applied to managing those assets makes estimated going - concern value
greater than liquidation value. If we exclude the synergies generated by assets working
together or by applying managerial skill to those assets, the value of a company would
likely change depending on the time frame available for liquidating them. For example, the
value of perishable inventory that had to be immediately liquidated would typically be lower
than the value of inventory that could be sold during a longer period of time.
Identifying the type of liquidation that will happen is important because it affects
the costs connected with liquidation of the property, including commissions for those
facilitating the liquidation (lawyers, accountants, auditors) and taxes at the end of the
transaction. That entire outflow affects the final value of the business. Here are the
gradations of liquidation value:
• Orderly liquidation: Assets are sold strategically over an orderly period of time to
attract the most money for the assets
• Forced liquidation: Usually, creditors have sued or a bankruptcy. Filed that calls
for immediate liquidation, so everything gets sold on the market in a hurry
fetching lower prices.

Calculation for liquidation value is somewhat like the book value calculation, except
the value assumes a forced or orderly liquidation of assets rather than book value. In
practice, the liabilities of the business are deducted from the liquidation value of the assets
to determine the liquidation value of the business. The overall value of a business that
uses this method should be lower than a valuation. In calculating the present value of a
business or property on a liquidation basis, discount the estimated net proceeds at a rate
that reflects the risk involved back to the date of the original valuation. Liquidation value
can replace the terminal cash flow (based on going concern) in a DCF calculation in order
to compute firm value in case there are years that the firm will still be operational.

Illustrative Example

Gourmet Company showed below balances from its accounting records. Gourmet
Company has 500,000 outstanding shares.

Assets
Cash 200,000
Accounts Receivable (A/R) – Net 1,000,000
Inventories 4,000,000
Prepaid Expenses 100,000
Property, Plant and Equipment (PPE) – Net 5,000,000
Total Assets 10,300,000

Liabilities
Notes Payable 1,500,000
Other Liabilities 1,000,000
 Total Liabilities 2,500,000

Gourmet Company is undergoing financial distress and management would want

determine the liquidation value to decide on the next steps to take for the business. If
assets will be sold/realized, they will only realize based on below table. To computed for
the adjusted value of the assets, the current book values should be multiplied by the
assumed realizable value if they are liquidated. Next, the liabilities should be deducted
from these to arrive at the liquidation value (or net asset value).

Asset Valued Asset Book Value Valued Asset

At At Adjusted
Value
Cash 100% Cash 200,000 100% 200,000
A/R – Net 85% Accounts 1,000,000 85% 850,000
Receivable –
Net
Inventories 60% Inventories 4,000,000 60% 2,400,000
Prepaid 25% Prepaid 100,000 25% 25,000
Expenses Expenses
PPE - Net 60% Property, Plant 5,000,000 60% 3,000,000
and Equipment
– Net
Total Assets 10,300,000 6,475,000

Asset Adjusted Value 6,475,000

Less: Total liabilities to be settled 2,500,000
Liquidation Value – Gourmet Company 3,975,000
Number of Outstanding Shares 500,000
Liquidation Value per Share 7.95

Liquidation value per share should be considered together with other quantitative (e.g.
current share price, going concern DCF) and qualitative metrics to justify business
decisions to be made.

Uses of Liquidation Value Method

For analysts, liquidation value method can be used for making investment
decisions. If the company is profitable and industry is growing too, the company’s
liquidation value will normally be much lower than the share price, since share price factors
growth aspect which liquidation value does not.

For companies going through a decline phase or if the industry is dying, the share
price may be lower than the liquidation value; this would logically mean that the company
should shut business. To have arbitrage benefits, smart corporate raiders usually are on
a lookout for these kinds of companies. Since the liquidation value is higher than the
market share price, they can buy out the company stock at a lower price and then sell off
the company to make risk-free arbitrage profit.

Limitations of Liquidation Value

Summing up the concept, liquidation value reflects the base price for the company.
However, this may not be a very wise tool to measure a profitable company as it ignores
the future growth potential. Nonetheless, this method can be considered to evaluate a
dying company as a potential takeover and sell down for profit making.

For companies with proprietorship or partnership model; there may be a high

dependence of profitability on the partners. It may be because of the key partners (their
skill, ability, knowledge, network, etc.) that the business enjoys profitability; and their
liquidation value may not reflect true value unless we value the impact of these key
personnel on business profitability. This leads to a need to calculate the goodwill impact
which is built up by the key personnel to arrive at fair liquidation value. This is model of
valuation is suitable only for such special cases where liquidation is the motive. However,
it is to be noted that this method is far more realistic compared to the book value method.

Other reference materials on Financial Forecasting, Corporate Valuation

and Financial Modelling

Activities/Assessments:

1. Why is liquidation value method considered the most conservative valuation

approach?
2. Explain instances when liquidation value should be used in valuation and why it
should be used over going concern valuation techniques.
 Module 5 – Earnings Value Approach
Overview:
There are various business valuation methods. This module will discuss the way
to determine value of company using Earnings Value Approach. This is another common
method of valuation and is based on the idea that the actual value of a business lies
in the ability to produce revenue in the future. There are a lot of methods of valuation
under the earning value approach, but the most common two is capitalizing past
earnings and discounted future earnings.
Capitalization of Past Earnings is a method of establishing the value of a company
which uses the formula is Net Present Value (NPV) divided by Capitalization rate. To
properly apply the formula requires a strong understanding of the business being
reviewed.
Discounted future earnings is a method of valuing a firm's value based on
forecasted future earnings. The model takes earnings for each period, as well as the firm's
terminal value, and discounts them back to the present to arrive at a value. The model
relies on several assumptions that make it less than useful in practice, including the level
of those future earnings and terminal value, as well as the appropriate discount rate.

Module Objectives:
After successful Completion of this module, you should be able to:

• Compare and contrast the different earnings value approach

• Justify the reasonableness of the value based on the methods

Course Materials:

Earning Value Approaches

An earning value approach is based on the idea that a business's value lies in its
ability to produce wealth in the future.

• Capitalizing Past Earning determines an expected level of cash flow for the
company using a company's record of past earnings, normalizes them for unusual
revenue or expenses, and multiplies the expected normalized cash flows by a
capitalization factor. The capitalization factor is a reflection of what rate of return a
reasonable purchaser would expect on the investment, as well as a measure of
the risk that the expected earnings will not be achieved.
• Discounted Future Earnings is another earning value approach to business
valuation where instead of an average of past earnings, an average of the trend of
predicted future earnings is used and divided by the capitalization factor.

Capitalizing Past Earnings Approach

 Capitalization of earnings is determined by calculating the NPV (Net present value)
of the expected future cash flows or profits. The estimate here is found by taking the future
earnings of the company and dividing them by a cap rate (capitalization rate). In short, this
is an income-valuation approach that lets us know the value of a company by analyzing
the annual rate of return, the current cash flow and the expected value of the business.
This approach of the capitalization of earnings, being one of the conventional methods of
valuation, helps investors figure out the possible risks and return of acquiring a company.

Let’s take an example of a company that for the last ten years, has earned and
had cash flows of about P500,000 every year. As per the predictions of the company’s
earnings, the same cash flow would continue for the foreseeable future. The expenses for
the business every year is about P100,000 only. Hence, the company makes an income
of P400,000 every year.

To figure out the value of the business, an investor analyses other risk investments
that have the same kind of cash flows. The investor now recognizes a P4 million Treasury
bond that returns about 10% annually, or P400,000. From this, the investor can determine
that the value of the business is around P4,000,000. This is because it is a similar
investment concerning risks and rewards. This would be a method in determining similar
investments for the value of a company.

Limitation. There isn’t one perfect method to determine a company’s value, which
is why assessing a company’s future earnings has some drawbacks. At first, the method
used to predict the future earnings might give an inaccurate figure, which would eventually
result in less than expected generated profits.

In addition to this, exceptional circumstances can occur that eventually

compromises the earnings, and affect the valuation of the investment. Further, a business
that has just entered the market might lack adequate information for finding out an
accurate valuation of the company.

The buyer has to know all about the desired ROI and the acceptable risks, as the
capitalization rate has to be reflected in the risk tolerance, market characteristics of the
buyer, and the expected growth factor of the business. For instance, if a buyer is not aware
of the targeted rate, he might pass on a more suitable investment or overpay for an
investment.

Discounting Future Earnings Approach

Discounted future earnings is a valuation method used to estimate a firm's worth

based on earnings forecasts. The discounted future earnings method uses these forecasts
for the earnings of a firm and the firm's estimated terminal value at a future date, and
discounts these back to the present using an appropriate discount rate. The sum of the
discounted future earnings and discounted terminal value equals the estimated value of
the firm.
 As with any estimate based on forecasts, the estimated value of the firm using the
discounted future earnings method is only as good as the inputs – the future earnings,
terminal value, and the discount rate. While these may be based on rigorous research and
analysis, the problem is that even small changes in the inputs can give rise to widely
differing estimated values.

The discount rate used in this method is one of the most critical inputs. It can either
be based on the firm's weighted average cost of capital or it can be estimated on the basis
of a risk premium added to the risk-free interest rate. The greater the perceived risk of the
firm, the higher the discount rate that should be used.

The terminal value of a firm also needs to be estimated using one of several
methods. There are three primary methods for estimating terminal value:

• The first is known as the liquidation value model. This method requires figuring the
asset's earning power with an appropriate discount rate, then adjusting for the
estimated value of outstanding debt.
• The multiples approach uses the approximate sales revenues of a firm during the
last year of a discounted cash flow model, then uses a multiple of that figure to
arrive at the terminal value. For example, a firm with a projected $200 million in
sales and a multiple of 3 would have a value of $600 million in the terminal year.
There is no discounting in this version.
• The last method is the stable growth model. Unlike the liquidation values model,
stable growth does not assume that the firm will be liquidated after the terminal
year. Instead, it assumes that cash flows are reinvested and that the firm can
grow at a constant rate in perpetuity.

For example, consider a firm that expects to generate the following earnings
stream over the next five years. The terminal value in Year 5 is based on a multiple of 10
times that year's earnings.

Year 1 P50,000

Year 2 P60,000

Year 3 P65,000

Year 4 P70,000

Year 5 P750,000 (terminal value)

Using a discount rate of 10%, the present value of the firm is P657,378.72.

What if the discount rate is changed to 12%? In this case, the present value of
the firm is P608.796.61
 What if the terminal value is based on 11 times Year 5 earnings? In that case, at
a discount rate of 10% and a terminal value of P825,000, the present value of the firm
would be P703,947.82.

Thus, small changes in the underlying inputs can lead to a significant difference
in estimated firm value.

Limitation. The main limitation of discounting future earnings is that it requires

making many assumptions. For one, an investor or analyst would have to correctly
estimate the future earnings streams from an investment. The future, of course, would
be based on a variety of factors that could easily change, such as market demand, the
status of the economy, unforeseen obstacles, and more. Estimating future earnings too
high could result in choosing an investment that might not pay off in the future, hurting
profits. Estimating them too low, making an investment appear costly, could result in
missed opportunities. Choosing a discount rate for the model is also a key assumption
and would have to be estimated correctly for the model to be worthwhile.

Read:

Books and related literature on Corporate and Asset Valuation

Activities/Assessments:
1. Essay: Among the company valuation method, how do you see Earnings Value
Approaches compared to other methods?
2. Discuss in class the factors affecting Earning Value Approaches. What are the
decision factors that needs to be considered?
 Module 6 – Market Value Approach
Overview:

The idea behind the market approach is that the value of the business can be
determined by reference to reasonably comparable guideline companies for which
transaction values are known. The values may be known because these companies are
publicly traded or because they were recently sold and the terms of the transaction were
disclosed.

This approach is commonly used especially in contexts where the user(s) of the
analyst’s report do not have specialized business valuation knowledge. There is an
obvious parallel in a lay person’s mind consulting with a real estate agent prior to listing
your home for sale to find out for what amount similar homes in your neighborhood have
sold. The market approach is the most common approach employed by real estate
appraisers. Real estate appraisers generally have from several to even hundreds of
companies from which to choose.

For a business valuation professional, a good set of companies may be as many

as two or three – and sometimes no comparable company data can be found. (The
objective of analyzing these components is to determine if the comparable company has
a similar risk profile.) There are three sources of comparable company transaction data:

• Public company transactions

• Private company transactions
• Prior transaction of the subject company

Module Objectives:

After successful Completion of this module, you should be able to:

• Enumerate the advantages and disadvantages of Market Based Approach in

valuation.
• Describe the different market-based approaches.

Course Materials:
Advantages and Disadvantages
1. Advantages
a. It is “user friendly.”
b. It uses actual data.
c. It is relatively simple to apply.
d. It does not rely on explicit forecasts.
2. Disadvantages
a. Sometimes, no recent comparable company data can be found.
 b. The standard of value may be unclear.
c. Most of the important assumptions are hidden.
d. It is a costly approach.
e. It is not as flexible or adaptable as other approaches.
f. Reliability of the transaction data is questionable.

B. Basic Implementation

The basic format is :

Value = (Price/Parameter)company X ParameterSubject

(For invested capital multiples, debt should be subtracted)

Where:
Price is the price measure of the guideline company
Parameter is the financial statement parameter that scales the value of
the company

C. Sources of Guideline Company Data

1. Private Company Transactions

A number of publications collect and disseminate information on

transactions. Most publications make their databases accessible on the
Internet for free on a per-use basis or annual subscription access.
Among the most widely used are:

a. Institute of Business Appraisers (IBA)

b. BIZCOMPS®
c. Pratt’s Stats™
d. Done Deal™
e. Mid Market Comps™ (ValueSource)
f. Mergerstat®

2. Public Company Transactions

Publicly traded companies are required to file their financial

statement electronically with the Securities and Exchange Commission
(SEC). These filing are public information and are available on the SEC
website at https://www.sec.gov.ph

D. Parameters

The second part of the pricing multiple is the denominator, the

financial statement parameter that scales the value of the company.

Some specific common measures include:

 1 Revenues
2 Gross Profit
3 EBITDA
4 EBIT
5 Debt-free net income (net income plus after-tax interest
expense)
6 Debt-free cash flow (debt-free net income plus
depreciation/amortization)
7 Pretax Income
8 Net after-tax income
9 Cash flows
10 Asset related
11 Tangible assets
12 Book value of equity
13 Book value of invested capital (book value of equity plus debt)
14 Tangible book value of invested capital (book value of equity,
less intangible assets, plus book value of debt)
15 Number of employees

E. Matching Price to Parameter

“Price” should be matched to the appropriate parameter based on

which providers of capital in the numerator will be paid with the money
given in the denominator. For example, in Price/EBIT, price is the market
value of invested capital (MVIC), since the earnings before interest
payments and taxes will be paid to both the debt and equity holders. In
price/net income, price, is the market value of equity (MVEq) only, since
net income is after interest payment to debt holders and represents amount
potentially available to shareholders. Any denominators that exclude
interest (e.g. EBIT or EBITDA) should usually be matched with
corresponding numerator (e.g.MVIC).

MVIC is usually the numerator paired with:

1 Revenues
2 EBITDA
3 EBIT
4 Debt-free net income
5 Debt-free cash flows
6 Assets
7 Tangible book value of invested capital

MVEq is usually the numerator paired with:

1 Pretax Income
2 Net Income
3 Cash flow
 4 Book value of equity

F. Basic Financial Indicators

Finally, when determining whether you have found comparable company

data, some financial measures that should be included in an analysis for both
guideline and subject companies include:

1 Size Measures

2 Historical Growth Rates

3 Activity and Other Ratios
4 Measures of Profitability and Cash Flow
5 Profit Margins
6 Capital Structure
7 Other measures

G. Market Approach: Dividend Paying Capacity Method

The dividend paying Capacity Method, sometimes referred to as the

Dividend Payout Method, is an income-oriented method but is considered a market
approach as it is based on market data. It is similar to the capitalization of earnings
method. The difference between this method and the capitalization of earnings
method lies in the difference in the type of earnings used in the calculations and
the source of the capitalization rate. This method of valuation is based on the
future estimated dividends to be paid out or the capacity to pay out. It then
capitalizes these dividends with a five-year weighted average of dividend yields of
five comparable companies. In the U. S., per Revenue Ruling 59-60, this method
must be considered for estate and gift tax purposes.

1. Description
This method expresses a relationship between the following:
a. Estimated future amount of dividends to be paid out (or capacity to
pay out)
b. Weighted average “comparable” company dividend yields of
comparable companies, further weighted by degree of
comparability each year using a sufficient number of comparable
companies, generally more than three
c. Estimated value of the business
This method is particularly useful for estimating the value of
businesses that are relatively large and businesses that have had a
history of paying dividends to shareholders. It is highly regarded
because it utilizes market comparisons.

Similar to the Price/Earnings Ratio or other methods relying on

market data, this method may not be appropriate for valuing most small
businesses because they do not have comparable counterparts in the
publicly traded area. Another problem with this method is that most
 closely held businesses avoid paying dividends. For tax reasons,
compensation is usually the preferred method of disbursing funds.

In determining dividend-paying ability, liquidity is an important

consideration. A relatively profitable company may be illiquid, as funds
are needed for fixed assets and working capital.

Example (Pre-Tax Basis)

A Company has a five-year history of weighted average profits

of Php 250,000. Its weighted average dividend payout percentage over
the last five years has been 30 percent.

Dividend Payout Ratio = Php 250,000 x 30%

Amount of Dividend = Php 75,000

The weighted average dividend yield rate of five comparable

companies over the last five years is 7.5 percent. Therefore, the value
of A Company under the dividend payout method is as follows:

Php 75,000/.075 = Php 1,000,000

H. COST BASED APPROACH

The cost approach to valuation is the one method that is not

dependent upon an active market for similar properties. Instead, the cost
approach estimates the property value as the value of its components, the
underlying land, and the depreciated value of the improvements.

The Cost Approach Formula

Although the details are more complicated, the basic formula for
valuing a property using the cost approach is:

Property Value = Land Value + (Cost new – Accumulated Depreciation)

The cost approach is based on the economic belief that informed

buyers will not pay any more for a product than they would for the cost of
producing a similar product that has the same level of utility. The sot
approach to valuation is easy to use when the property is new and
represents the highest and best use of the property. In this case, cost new
is known because the improvements were just built. In addition, there
should be a negligible amount of accumulated depreciation. Since the cost
approach does not rely on comparables, it is also useful when valuing a
special use property or a property with unique components.
I. BASE STOCK METHOD

The Base Stock method is a valuation technique for the inventory

asset, where the minimum amount of inventory needed to maintain
operations is recorded at its acquisition cost, while the LIFO method is
applied to all additional inventory. This approach is not acceptable under
generally accepted accounting principles.

Under this method, it is assumed that every firm has to maintain a

certain minimum amount of inventory (in the form of raw materials, work-
in-progress and finished goods) throughout the year. The same will have
to be maintained for meeting emergency needs, such as undue delay in
supply of raw materials, excessive consumption etc.

This minimum level of inventory goes by the name of Base Stock or

Safety Stock. ‘Base Stock’ serves as the signal below which the inventory
level of a firm is nevel allowed to fall. (Therefore inventory, to the extent of
‘Base Stock’, though basically a class falling within the category of current
assets, assumes , for all practical purposes, the character of fixed assets.)

Generally, there may not be any wide variation between the volume
of closing and opening inventory unless there is a remarkable change in
the scale of operation and other factors. The Base-Stock’ level is usually
created out of the first lot of the materials purchased or goods
manufactured at the beginning of the period and, as such, it is valued at the
cost price of the first lot.

Therefore, under this method, closing inventories are generally

taken to be equal to the ‘Base-Stock’ level and, hence, they are valued at
the values allotted to the respective ‘Base-Stock.’ However, if there is any
excess (over base stock level) the same should be valued either on the
basis of FIFO or LIFO methods.

It should be remembered that this method is generally used with

FIFO or LIFO method. There is, however difference of opinion among the
accountants as to the principles to be followed for valuation of inventories
when this method is adopted.

Advantages:
1 This method is simple to understand and easy to operate
2 This technique serves the valuation of closing stock easily.
3 This method practically renders the profit and loss most conservative.
4 It is particularly applicable where a certain quantity of basic materials is
needed in process for a long time.
5 All the advantage of FIFO and LIFO method will also be applicable in
this method

Disadvantages:
 1 The disadvantages appearing in FIFO and LIFO may also apply in this
method.
2 Sometimes ‘Base-Stock’ may appear in Balance Sheet at most
unreliable price, and as such, the owners/shareholders maybe cheated.
3 Since ‘Base-Stock’ is apart of stock of materials (i.e., a part of current
assets) can it be treated as a fixed asset which appears at cost in the
Balance Sheet?

J. STANDARD COST METHOD

Standard costing is the practice of substituting an expected cost for an

actual cost in the accounting records. Subsequently, variances are recorded to
show the difference between the expected and actual costs. This approach
represents a simplified alternative to cost layering systems, such as the FIFO and
LIFO methods, where large amounts of historical cost information must be
maintained for inventory items held in stock.

Standard costing involves the creation of estimated (i.e., standard) cost for
some or all activities within a company. The core reason for using standard costs
is that there are a number of applications where it is too time-consuming to collect
actual costs, so standard costs are used as a close approximation to actual costs.

Since standard costs are usually slightly different from actual cost, the cost
accountant periodically calculates variances that break out diff erences caused by
such factors as labor rate changes and the cost of materials. The cost accountant
may periodically change the standard cost to bring them into closer alignment with
actual costs.

Uses of Standard Costs:

1 Budgeting
2 Inventory costing
3 Overhead application
4 Price formulation

Problem areas:
1 Cost-plus contracts where standard costing is not allowed
2 Drives inappropriate activities to create favorable variances
3 Fast-paced environment may result to standard cost that is out-of-date
within a month or two
4 Slow feedback
5 Unable to provide Unit-level information since variance calculations are
accumulated in aggregate for a company’s entire production department.

Read:
Books on Valuation and Property Assessments
Visit websites of www.propertymetrics.com, accountingtools.com, National Association
of Certified Valuators and Analyst

Activities/Assessments:
1. Essay
a. What are the market based approaches in valuation. Describe each.
b. What are the advantages and disadvantages of the Market Based
approaches?
2. Financial Modelling Exercise
a. Secure an audited financial statement of a Philippine Listed company
b. Develop a financial model using electronic or manual spreadsheet, use
assumptions based on their Notes to Financial Statements, information
available in the market, or given information from your instructor.
c. Calculate for the following values:
i. Net Present Value of Free Cash flows available from the project
with scenarios on discount rate
ii. Net Present Value of Free Cash flows available to the Equity
shareholders
iii. Projected Market Value assuming the average P/E ratio in the
audited FS
iv. May apply market value based approach
 REFERENCES
BBA Lectures.com
Corporate Finance Institute
National Association of Certified Valuators and Analyst
Oreilly.com
Philippine Securities and Exchange Commission
Strategic CFO.com