CHAPTER 1: FUNDAMENTAL PRINCIPLES OF VALUATION

FUNDAMENTALS PRINCIPLES OF VALUATION 

Assets, individually or collectively, has value. Generally, value pertains to the worth of an object in
another person's point of view. Any kind of asset can be valued, though the degree of effort needed may
vary on a case-to-case basis. Methods to value for real estate can may be different on how to value an
entire business. 

Businesses treat capital as a scarce resource that they should compete to obtain and efficiently manage.
Since capital is scarce, capital providers require users to ensure that they will be able to maximize
shareholder returns to justify providing capital to them. Otherwise, capital providers will look and bring
money to other investment opportunities that are more attractive, Hence, the most fundamental
principle for all investments and business is to maximize shareholder value. Maximizing value for
businesses Consequently result in a domino impact to the economy. Growing companies provide long.
term sustainability to the economy by yielding higher economic output, better productivity gains,
employment growth and higher salaries. Placing scarce resources in their most productive use best
serves the interest of different stakeholders in the country. 

The fundamental point behind success in investments is understanding what is the prevailing value and
the key drivers that influence this value. Increase in value may imply that shareholder capital is
maximized, hence, fulfilling the promise to capital providers. This is where valuation steps in. 

According to the CFA Institute, valuation is the estimation of an asset’s value based on variables
perceived to be related to future investment returns, on comparisons with similar assets, or, when
relevant, on estimates of immediate liquidation proceeds. Valuation includes the use of forecasts to
come up with reasonable estimate of value of an entity’s assets or its equity. At varying levels, decisions
done within a firm entails valuation implicitly. For example, capital budgeting analysis usually considers
how pursuing a specific project will affect entity value. Valuation techniques may differ across different
assets, but all follow similar fundamental principles that drive the core of these approaches. 

Valuation places great emphasis on the professional judgment that are associated in the exercise. As
valuation mostly deals with projections about future events, analysts should hone their ability to
balance and evaluate different assumptions used in each phase of the valuation exercise, assess validity
of available empirical evidence and come up with rational choices that align with the ultimate objective
of the valuation activity. 

Interpreting Different Concepts of Value

In the corporate setting, the fundamental equation of value is grounded on the principle that Alfred
Marshall popularized - a company creates value if and only if the return on capital invested exceed the
cost of acquiring capital. Value, in the point of view of corporate shareholders, relates to the difference
between cash inflows generated by an investment and the cost associated with the capital invested
which captures both time value of money and risk premium. 

The value of a business can be basically linked to three major factors: 

 Current operations — how is the operating performance of the firm in recent year? 
 Future prospects — what is the long-term, strategic direction of the company? 
  Embedded risk — what are the business risks involved in running the business? 

These factors are solid concepts; however, the quick turnover of technologies and rapid globalization
make the business environment more dynamic. As a result, defining value and identifying relevant
drivers became more arduous as time passes by. As firms continue to quickly evolve and adapt to new
technologies, valuation of current operations becomes more difficult as compared to the past.
Projecting future macroeconomic indicators also is harder because of constant changes in the economic
environment and the continuous innovation of market players. New risks and competition also surface
which makes determining uncertainties a critical ingredient to success. 

The definition of value may also vary depending on the context and objective of the valuation exercise. 

 Intrinsic value 
Intrinsic value refers to the value of any asset based on the assumption that there is a
hypothetical complete understanding of its investment characteristics. Intrinsic value is the
value that an investor considers, on the basis of an evaluation of available facts, to be the "true"
or "real" value that will become the market value when other investors reach the same
conclusion. As obtaining complete information about the asset is impractical, investors normally
estimate intrinsic value based on their view of the real worth of the asset. If the assumption is
that the true value of asset is dictated by the market, then intrinsic value equals its market
price. 

Unfortunately, this is not always the case. The Grossman - Stiglitz paradox states that if the
market prices, which can be obtained freely, perfectly reflect the intrinsic value of an asset, then
a rational investor will not spend to gather data to validate the value of a stock. If this is the
case, then investors will not analyze information about stocks anymore. Consequently, how will
the market price suggest the intrinsic price if this process does not happen? The rational
efficient markets formulation of Grossman and Stiglitz acknowledges that investors will not
rationally spend to gather more information about an asset unless they expect that there is
potential reward in exchange of the effort. 

As a result, market price often does not approximate an asset's intrinsic value. Securities
analysts often try to look for stocks which are mispriced in the market and base their buy or sell
recommendations based on these analyses. Intrinsic value is highly relevant in valuing public
shares. 

Most of the approaches that will be discussed in this book deal with finding out the intrinsic
value of assets. Financial analysts should be able to come up with accurate forecasts and
determine the right valuation model that will yield a good estimate of a firm’s intrinsic value.
The quality of the forecast, including the reasonableness of assumptions used, is very critical in
coming up with the right valuation that influences the investment decision. 
  Going Concern Value 

Firm value is determined under the going concern assumption. The going concern assumption
believes that the entity will continue to do its business activities into the foreseeable future. It is
assumed that the entity will realize assets and pay obligations in the normal course of business. 

 Liquidation Value 

The net amount that would be realized if the business is terminated and the assets are sold
piecemeal. Firm value is computed based on the assumption that entity will be dissolved, and its
assets will be sold individually + hence, the liquidation process. Liquidation value is particularly
relevant for companies who are experiencing severe financial distress. Normally, there is greater
value generated when assets working together are combined with the application of human
capital (unless the business is continuously unprofitable) which is the case for going-concern
assumption. If liquidation occurs, value often declines because the assets no longer work
together, and human intervention is absent. 

 Fair Market Value 

The price, expressed in terms of cash, at which property would change hands between a
hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s
length in an open and unrestricted market, when neither is under compulsion to buy or sell and
when both have reasonable knowledge of the relevant facts. Both parties should voluntarily
agree with the price of the transaction and are not under threat of compulsion. Fair value
assumes that both parties are informed of all material characteristics about the investment that
might influence their decision. Fair value is often used in valuation exercises involving tax
assessments. 

Roles of Valuation in Business 

Portfolio Management 

The relevance of valuation in portfolio management largely depends on the investment objectives of the
investors or financial managers managing the investment portfolio. Passive investors tend to be
disinterested in understanding valuation, but active investors may want to understand valuation in order
to participate intelligently in the stock market. 

 Fundamental analysts - These are persons who are interested in understanding and measuring
the intrinsic value of a firm. Fundamentals refer to the characteristics of an entity related to its
financial strength, profitability or risk appetite. For fundamental analysts, the true value of a
firm can be estimated by looking at its financial characteristics, its growth prospects, cash flows
and risk profile. Any noted variance between the stock’s market price versus its fundamental
value indicates that it might be overvalued or undervalued. 

Typically, fundamental analysts lean towards long-term investment Strategies which

encapsulate the following principles:
 o Relationship between value and underlying factors can be reliably measured.
o Above relationship is stable over an extended period
o Any deviations from the above relationship can be corrected within a reasonable time 

Fundamental analysts can be either value or growth investors. Value investors tend to be mostly
interested in purchasing shares that are existing and priced at less than their true value. On the
other hand, growth investors lean towards growth assets (businesses that might not be
profitable now but has high expected value in future years) and purchasing these at a discount. 

Security and investments analysts use valuation techniques to support the buy / sell
recommendations that they provide to their clients. Analysts often infer market conditions
implied by the market price by assessing this against his own expectations. This allows them to
assess reasonableness and adjust future estimates. Market expectations regarding
fundamentals of one firm can be used as benchmark for other companies which exhibit the
same characteristics. 

 Activist investors - Activist investors tend to look for companies with good growth prospects that
have poor management. Activist investors usually do “takeovers” — they use their equity
holdings to push old management out of the company and change the way the company is run.
In the minds of activist investors, it is not about the current value of the company but its
potential value once it is run properly. Knowledge about valuation is critical for activist investors
so they can reliably pinpoint which firms will create additional value if management is changed.
To do this, activist investors should have a good understanding of the company’s business model
and how implementing changes in investment, dividend and financing policies can affect its
value. 

 Chartists — Chartists relies on the concept that stock prices are significantly influenced by how
investors think and act. Chartists rely on available trading KPls such as price movements, trading
volume, and short sales when making their investment decisions. They believe that these
metrics imply investor psychology and will predict future movements in stock prices. Chartists
assume that stock price changes and follow predictable patterns since investors make decisions
based on their emotions than by rational analysis. Valuation does not play a huge role in
charting, but it is helpful when plotting support and resistance lines. 

 Information Traders — Traders that react based on new information about firms that are
revealed to the stock market. The underlying belief is that information traders are more adept in
guessing or gating new information about firms and they can mako predict how the market will
react based on this. Hence, information traders correlate value and how information will affect
this value. Valuation is important to information traders since they buy or sell shares based on
their assessment on how new information will affect stock price. 
Under portfolio management, the following activities can be performed through the use of valuation
techniques: 

 Stock selection - Is a particular asset fairly priced, overpriced, or underpriced in relation to its
prevailing computed intrinsic value and prices of comparable assets? 
 Deducing market expectations — Which estimates of a firm’s future performance are in line
with the prevailing market price of its stocks? Are there assumptions about fundamentals that
will justify the prevailing price? 

Typically, investors do not have a lot of time to scour all available information in order to make
investment decisions. Instead, they seek the help of professionals to come up with information that they
can use to decide their investments. 

Sell-side analysts that work in the brokerage department of investment firms issue valuation judgment
that are contained in research reports that are disseminated widely to current and potential clients.
Buy-side analysts, on the other hand, look at specific investment options and make valuation analysis on
these and report to a portfolio manager or investment committee. Buy-side analysts tend to perform
more in-depth analysis of a firm and engage in more rigorous stock selection methodologies. 

In general, financial analysts assist clients to realize their investment goals by providing them
information that will help them make the right decision whether to buy or sell. They also play a
significant role in the financial markets by providing the right information to investors which enable the
latter to buy or sell shares. As a result, market prices of shares usually better reflect its real value. Since
analysts often take a holistic look on businesses, they somewhat serve a monitoring role for the
management to ensure that they make decision that are in line with the creating value for
shareholders. 

Analysis of Business Transactions / Deals 

Valuation plays a very big role when analyzing potential deals. Potential acquirers use relevant valuation
techniques (whichever is applicable) to estimate value of target firms they are planning to purchase and
understand the synergies they can take advantage from the purchase. They also use valuation
techniques in the negotiation process to set the deal price. 

Business deals include the following corporate events: 

 Acquisition - An acquisition usually has two parties: the buying firm and the selling firm. The
buying firm needs to determine the fair value of the target company prior to offering a bid price.
On the other hand, the selling firm (or sometimes, the target company) should have a sense of
its firm value to gauge reasonableness of bid offers. Selling firms use this information to guide
which bid offers to accept or reject. On the downside, bias may be a significant concern in
acquisition analyses. Target firms may show very optimistic projections to push the price higher
or pressure may exist to make resulting valuation analysis favorable if target firm is certain to be
purchased as a result of strategic decision. 

 Merger — General term which describes the transaction wherein two companies had their
assets combined to form a wholly new entity. 
  Divestiture — Sale of a major component or segment of a business (e.g. brand or product line)
to another company. 

 Spin-off - Separating a segment or component business and transforming this into a separate
legal entity.

 Leveraged buyout — Acquisition of another business by using significant debt which uses the
acquired business as a collateral. 

Valuation in deals analysis considers two important, unique factors: synergy and control. 

 Synergy — potential increase in firm value that can be generated once two firms merge with
each other. Synergy assumes that the combined value of two firms will be greater than the sum
of separate firms. Synergy can be attributable to more efficient operations, cost reductions,
increased revenues, combined products/markets or cross-disciplinary talents of the combined
organization. 
 Control — change in people managing the organization brought about by the acquisition. Any
impact to firm value resulting from the change in management and restructuring of the target
company should be included in the valuation exercise. This is usually an important matter for
hostile takeovers. 

Corporate Finance 

Corporate finance involves managing the firm’s capital structure, including funding sources and
strategies that the business should pursue to maximize firm value. Corporate finance deals with
prioritizing and distributing financial resources to activities that increases firm value. The ultimate goal
of corporate finance is to maximize the firm value by appropriate planning and implementation of
resources, while balancing profitability and risk appetite. 

Small private businesses that need additional money to expand use valuation concepts when
approaching private equity investors and venture capital providers to show the promise of the business.
The ownership stake that these capital providers will ask from the business in exchange of the money
that they will put in will be based on the estimated value of the small private business. 

Larger companies who wish to obtain additional funds by offering their shares to the public also need
valuation to estimate the price they are going to fetch in the stock market. Afterwards, decision
regarding which projects to invest in, amount to be borrowed and dividend declarations to shareholders
are influenced by company valuation. 

Corporate finance ensures that financial outcomes and corporate strategy drives maximization of firm
value. Current business conditions push business leaders to focus on value enhancement by looking at
the business holistically and focus on key levers affecting value in order to provide some level of return
to shareholders. 

Firms that are focused on maximizing shareholder value uses valuation concepts to assess impact of
various strategies to company value. Valuation methodologies also enable communication about
significant corporate matters between management, shareholders, consultants and investment
analysts. 

Legal and Tax Purposes 

Valuation is also important to businesses because of legal and tax purposes. For example, if a new
partner will join a partnership or an old partner will retire, the whole partnership should be valued to
identify how much should be the buy-in or sell-out. This is also the case for businesses that are dissolved
or liquidated when owners decide so. Firms are also valued for estate tax purposes if the owner passes
away. 

Other Purposes 

 Issuance of a fairness opinion for valuations provided by third party (e.g. investment bank) 
 Basis for assessment of potential lending activities by financial institutions 
 Share-based payment/compensation 

Valuation Process

Generally, the valuation process considers these five steps:

Understanding of the business 

Understanding the business includes performing industry and competitive analysis and analysis of
publicly available financial information and corporate disclosures. Understanding the business is very
important as these give analysts and investors the idea about the following factors: economic
conditions, industry peculiarities, company strategy and company’s historical performance. The
understanding phase enables analysts to come up with appropriate assumptions which reasonably
capture the business realities affecting the firm and its value. 

Frameworks which capture industry and competitive analysis already exist and are very useful for
analysts. These frameworks are more than a template that should be filled out: analysts should use
these frameworks to organize their thoughts about the industry and the competitive environment and
how these relates to the performance of the firm they are valuing. The industry and competitive
analyses should emphasize which factors affecting business will be most challenging and how should
these be factored in the valuation model. 

Industry structure refers to the inherent technical and economic characteristics of an industry and the
trends that may affect this structure. industry characteristics means that these are true to most, if not
all, market players participating in that industry. Porter’s Five Forces is the most common tool used to
encapsulate industry structure. 

Refers to the nature and intensity of rivalry

between market players in the industry. Rivalry is
less intense if there is lower number of market
Industry rivalry players or competitors Industry rivalry (i.e. higher
concentration) which means higher potential for
industry profitability. This considers
concentration of market players, degree of
 differentiation, switching costs, information and
government restraint.
Refers to the barriers to entry to industry by new
market players. If there are relatively high entry
costs, this means there are fewer new entrants,
New Entrants thus, lesser competition New Entrants j which
improves profitability potential. New entrants
include entry costs, speed of adjustment,
economies of scale, reputation, switching costs,
sunk costs and government restraints.
This refers to the relationships between
interrelated products and services in the industry.
Availability of substitute products (products that
Substitutes and can replace the sale of an existing product) or
complementary complements products (products
Complements that can be used together with another product)
affects industry profitability. This consider prices
of substitute products/services, complement
products/services and government limitations.
Supplier power refers to how suppliers can
negotiate better terms in their favor. When there
is strong supplier power, this tends to make
industry profits lower. Strong supplier power
exists if there are few suppliers that can supply a
Supplier Power specific input. Supplier power, also considers
supplier concentration, prices of alternative
inputs, relationship-specific investments, supplier
switching costs and governmental regulations.

Buyer power pertains to how custom negotiate

better terms in their favor for the
products/services they purchase. Typically buying
power is low if customers are fragmented and
concentration is low. This means that market
players are not dependent to few customers to
survive Low buyer power tends to improve
Buyer Power industry profits since buyers cannot Significantly
negotiate to lower price of the product. Other
factors considered in buyer power include buyer
concentration, value of substitute products that
buyers can purchase, customer switching costs
and government restraints. 

Competitive position refers to how the products, services and the company itself is set apart from other
competing market players. Competitive position is typically gauged using the prevailing market share
level that the company enjoys. Generally, a firm’s value is higher if it can consistently sustain its
competitive advantage against its competitors. According to Michael Porter, there are generic corporate
strategies to achieve competitive advantage: 

 Cost leadership 

It relates to the incurrence of the lowest cost among market players with quality that is
comparable to competitors allow the firm to price products around the industry average. 

 Differentiation 

Firms tend to offer differentiated or unique product or service characteristics that customers are
willing to pay for an additional premium. 

 Focus

Firms are identifying specific demographic segment or category segment to focus on by using

cost leadership strategy (cost focus) or differentiation strategy (differentiation focus) 

Aside from industry and competitive landscape, understanding the company’s business model is also
important. Business model pertains to the method how the company makes money what are the
products or services they offer, how they deliver and provide these to customers and their target
customers. Knowing the business model allows analysts to capture the right performance drivers that
should be included in the valuation model. 

The results of execution of aforementioned strategies will ultimately be reflected in the company
performance results contained in the financial statements. Analysts look at the historical financial
statements to get a sense of how the company performed. There is no hard rule on how long the
historical analysis should be done. Typically, historical financial statements analysis can be done for the
last two years up to ten years prior — as long as there is available information. Looking at the past ten
years may give an idea how resilient the company in the past and how they reacted to problems they
encountered along the way. 

Analysis of historical financial reports typically use horizontal, vertical and ratio analysis. More than the
computation, these numbers should be related year-on-year to give a sense on how the company
performed over the years. These can be benchmarked against other market players or the industry
average to understand how the firm fared. Some information can also be compared against stated
objectives of the organization — such as sales growth, gross margin ratios or profit targets. 

Typical sources of information about companies can be found in government mandated disclosures like
audited financial statements. If the firm is publicly listed, regulatory filings, company press releases and
financial statements can be easily accessed in the stock exchange. Investor relation materials that
companies issue can also be accessed in their websites. Other acceptable sources of information include
news articles, reports from industry organization, reports from regulatory agencies and industry
researches done by independent firms such as Nielsen or Euromonitor. Ethically, analysts should only
use information that are made publicly available (via government filings of press releases). Analysts
should avoid using material inside information as this gives undue disadvantage to other investors that
do not have access to the information. 

In analyzing historical financial information, focus is afforded in looking at quality of earnings. Quality of
earnings analysis pertain to the detailed review of financial statements and accompanying notes to
assess sustainability of company performance and validate accuracy of financial information versus
economic reality. During analysis, transactions that are nonrecurring such as financial impact of litigation
settlements, temporary tax reliefs or gains/losses on sales of nonoperating assets might need to be
adjusted to arrive at the performance of the firm's core business. 

Quality of earnings analysis also compares net income against Operating Cash flow to make sure
reported earnings are actually realizable to cash ang are not padded through significant accrual entries.
Typical observations that analysts can derive from financial statements are listed below: 

Line Item Possible Observation Possible Interpretation

Revenues and gain Early recognition of Accelerated
revenue revenues (e.g. bill-and-
recognition improves hold sales,
sales recognition prior to
installation and acceptance
performance of customer)
Accelerated revenue
recognition improves income
and can be used to hide
declining performance

Inclusion of nonoperating non- Non-recurring gains do not

Expenses and losses
operating gains income or gains
as part of operating income
Recognition of too high or too
little reserves losses too little
reserves (e.g. may improve
current restructuring, bad
debts)
Deferral of expenses such as
customer acquisition or product
development costs by
capitalization.
Aggressive assumptions such as
long useful lives, lower asset
impairment, high assumed
discount rate for pension
liabilities or high expected
return on plan assets.
relate to operating performance
may hide declining
performance.
Too little reserves may improve
current year income but might
affect future income (vice versa)
May improve current income
but will reduce future income.
May hide
declining performance.
Aggressive estimates may imply
that there are steps taken to
improve current year income.
Sudden changes in estimates
may indicate masking of
potential problems in operating
performance.

Balance sheet items
Off balance sheet financing Asset/liabilities mays not be
(those not reflected in the face fairly reflected.
of the balance sheet) like
leasing or securitizing
receivables 
 Operating Cash flows Increase in bank overdraft as Potential artificial inflation in
operating cash flow operating cash flow.
Based on AICPA guidance, other red flags that may indicate aggressive accounting include the following: 

 Poor quality of accounting disclosures, such as segment information, acquisitions, accounting

policies and assumptions, and a lack of discussion of negative factors. 
 Existence of related - party transactions or excessive officer, employee, or director loans. 
 Reported (through regulatory filings) disputes with and/or changes in auditors. 
 Material non-audit services performed by audit firm. 
 Management and/or directors’ compensation tied to profitability or stock price (through
ownership or compensation plans) 
 Economic, industry, or company - specific pressures on profitability, such as loss of market share
or declining margins. 
 High management or director turnover. 
 Excessive pressure on company personnel to make revenue or earnings targets, particularly
when management team is aggressive 
 Management pressure to meet debt covenants or earnings expectations. 
 A history of securities law violations, reporting violations, or persistent late filings. 

Forecasting financial performance 

After understanding how the business operates and analyzing historical financial statements, forecasting
financial performance is the next step. Forecasting financial performance can be looked at two lenses:
(a) on a macro perspective viewing the economic environment and industry where the firm operates in
and (b) on a micro perspective focusing in the firm's financial and operating characteristics.

Forecasting summarizes the future-looking view which results from the assessment of industry and
competitive landscape, business strategy and historical financials. This can be summarized in two
approaches: 

 Top-down forecasting approach - Forecast starts from international or national macroeconomic

projections with utmost consideration to industry specific forecasts. From here, analysts select
which are relevant to the firm and then applies this to the firm and asset forecast. In top-down
forecasting approach, the most common variables include GDP forecast, consumption forecasts,
inflation projections, foreign exchange currency rates, industry sales and market share. A result
of top-down forecasting approach is the forecasted sales volume of the company. Revenue
forecast will be built from this combined with the company-set sales prices. 

 Bottom-up forecasting approach = Forecast starts from the lower levels of the firm and is
completed as it captures what will happen to the company based on the inputs of its segments /
units. For example, store expansions and increase in product availability is collated and revenues
resulting from these are calculated. Inputs from various segments are consolidated until
company-level revenues is determined. 

Insights compiled during the industry, competitive and business strategy analysis about the firm should
be considered in this phase when forecasting for the firm’s sales, operating income and cash flows.
Comprehensive understanding of these items is critical to forecast reasonable numbers. Qualitative
factors, albeit subjective, are considered in the forecasting process in order to make valuation

approximate the true reality of the firm. Assumptions should be driven by informed judgment based on
the understanding of the business. 

Forecasting should be done comprehensively and should include earnings, cash flow and balance sheet
forecast. Comprehensive forecasting approach prevents any inconsistent figures between the
prospective financial statements and unrealistic assumptions. The approach considers that analysis
should done per line item as each item can be influenced by a different business driver. Similar with
short-term budgeting, forecasting process starts with the determining sales growth and revenue
projections of the business. 

Forecasting process should also consider industry financial ratios as this gives an idea how the industry is
operating. From this, analysts should be able to explain reasons why firm-specific ratios will deviate from
this. Knowledge of historical financial trends is also important as this can give guidance how prospective
trends will look like. Similarly, any deviations from noted historical trends should be carefully explained
to ensure reasonableness. 

Typically, sales and profit numbers should consistently move in the future based on current trends if
there is no significant information that will prove otherwise. 

The results of forecasts should be compared with the dynamics of the industry where the business
operates and its competitive position to make sure that the numbers make sense and reflect the most
reliable view of how the business operates. Even though general economic and market trends can be
used as reliable benchmark, analysts should consider that there might be unique factors that affect
company prospects that can be used as guidance in the forecasting process. 

Typically, forecasts are done on annual basis as most publicly available financial information are
interpreted on an annual basis. Where applicable, forecasts can be better done on a quarterly basis to
account for seasonality. Seasonality affects sales and earnings of almost all industry. For example, airline
companies tend to have peak sales during summer season and holiday seasons while lean sales during
rainy months. Developing earnings forecast while considering seasonality can give a more reasonable
estimate. 

Selecting the right valuation model 

The appropriate valuation model will depend on the context of the valuation and the inherent
characteristics of the company being valued. Details of these valuation models and the circumstances
when they should be used will be discussed in succeeding chapters. 

Preparing valuation model based on forecasts 

Once the valuation model is decided, the forecasts should now be inputted and converted to the chosen
valuation model. This step is not only about manually encoding the forecast to the model to estimate
the value (which is the job of Microsoft Excel). More so, analysts should consider whether the resulting
value from this process makes sense based on their knowledge about the business. To do this, two
aspects should be considered: 
Sensitivity analysis 

It is a common methodology in valuation exercises wherein multiple analyses are done to understand
how changes in an input or variable will affect the outcome (i.e. firm value). Assumptions that are
commonly used as an input for sensitivity analysis exercises are sales growth, gross margin rates and
discount rates. Aside from these, other variables (like market share, advertising expense, discounts,
differentiated feature, etc.) can also be used depending on the valuation problem and context at hand. 

Situational adjustments or Scenario Modelling 

For firm-specific issues that affect firm value that should be adjusted by analysts. In some instances,
there are factors that do not affect value per se when analysts only look at core business Operations but
will still influence value regardless. This includes control premium, absence of marketability discounts
and illiquidity discounts. Control premium refers to additional value considered in a stock investment if
acquiring it will give controlling power to the investor. Lack of marketability discount means that the
stock cannot be easily sold as there is no ready market for it (e.g. non-publicly traded discount).
Illiquidity discount should be considered when the price of particular shares has less depth or generally
considered less liquid compared to other active publicly traded share. Illiquidity discounts can also be
considered if an investor will sell large portion of stock that is significant compared to the trading
volume of the stock. Both lack of marketability discount and iliquidity discount drive down share value. 

Applying valuation conclusions and providing recommendation

Once the value is calculated based on all assumptions considered, the analysts and investors use the
results to provide recommendations or make decisions that suits their investment objective. 

Key Principles in Valuation 

I. The Value of a Business is Defined Only at a specific point in time 

Business value tend to change every day as transactions happen. Different circumstances that
occur on a daily basis affect earnings, cash position, working capital and market conditions.
Valuation made a year ago may not hold true and not reflect the prevailing firm value today. As
a result, it is important to give perspective to users of the information that firm value is based
on a specific date. 

II. Value varies based on the ability of business to generate future cash flows 

General concepts for most valuation techniques put emphasis on future cash flows except for
some circumstances where value can be better derived from asset liquidation.

The relevant item for valuation is the potential of the business to generate value in the future
which is in the form of cash flows. Future cash flows can be projected based on historical results
considering future events that may improve or reduce cash flows. 
 Cash flows is more relevant in valuation as compared to accounting profits as shareholders are
more interested in receiving cash at the end of the day. Cash flows include cash generated from
operations and reductions that are related to capital investments, working capital and taxes.
Cash flows will depend on the estimates of future performance of the business and strategies in
place to support this growth. Historical information can provide be a good starting point when
projecting future cash flows. 

III. Market dictates the appropriate rate of return for investors 

Market forces are constantly changing, and they normally provide guidance of what rate of
return should investors expect from different investment vehicles in the market. Interaction of
market forces may differ based on type of industry and general economic conditions.
Understanding the rate of return dictated by the market is important for investors so they can
capture the right discount rate to be used for valuation. This can influence their decision to buy
or sell investments. 

IV. Firm value can be impacted by underlying net tangible assets 

Business valuation principles look at the relationship between operational value of an entity and
net tangible of its assets. Theoretically, firms with higher underlying net tangible asset value are
more stable and results in higher going concern value. This is the result of presence of more
assets that can be used as security during financing acquisitions or even liquidation proceedings
in case bankruptcy occurs. Presence of sufficient net tangible assets can also support the
forecasts on future operating plans of the business. 

V. Value is influenced by transferability of future cash flows 

Transferability of future cash flows is also important especially to potential acquirers. Business
with good value can operate even without owner intervention. If a firm’s survival depends on
owner's influence (e.g. owner maintains customer relationship or provides certain services), this
value might not be transferred to the buyer, hence, this will reduce firm value. In such cases,
value will only be limited to net tangible assets that can be transferred to the buyer. 

VI. Value is impacted by liquidity 

This principle is mainly dictated by the theory of demand and supply. If there are many potential
buyers with less acquisition targets, value of the target firms may rise since the buyers will
express more interest to buy the business. Sellers should be able to attract and negotiate
potential purchases to maximize value they can realize from the transaction. 

Risks in Valuation 

In all valuation exercises, uncertainty will be consistently present. Uncertainty refers to the possible
range of values where the real firm value lies. When performing any valuation method, analysts will
never be sure if they have accounted and included all potential risks that may affect price of assets.
Some valuation methods also use future estimates which bear the risk that what will actually happen
may be significantly different from the estimate.

Value consequently may be different based on new circumstances. Uncertainty is captured in valuation
models through cost of capital or discount rate. 

Another aspect that contributes to uncertainty is that analysts use their judgments to ascertain
assumptions based on current available facts. Even if risk adjustments are made, this cannot 100%
ascertain the value will be perfectly estimated. Constant changes in market conditions may hinder the
investor from realizing any expected value based on the valuation methodology. 

Performance of each industry can also be characterized by varying degrees of predictability which
ultimately fuels uncertainty. Depending on the industry, they can be very sensitive to changes in
macroeconomic climate (investment goods, luxury products) or not at all (food and pharmaceutical). 

Innovations and entry of new businesses may also bring uncertainty to established and traditional
companies. It does not mean that a business that has operated for 100 years will continue to have stable
value. If a new company arrives and provides a better product that customers will patronize, this can
mean trouble. Typically, businesses manage uncertainty to take advantage of possible opportunities and
minimize impact of unfavorable events. This influences management style, reaction to changes in
economic environment and adoption of innovative approaches to doing business. Consequently, these
dynamic approaches also contribute to the uncertainty to all players in the economy.