Chapter 4 Py NVM d 09 | Woy VALUATIONFUNDAMENTALS PRINCIPLES OF VALUATION Assets, individually or collectively, hhas valle) Generally, value pertains to how much a particular object is worth toa particular set of eyes. 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 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, most fundamental principle for all investments and business is to maximize shareholder value. Maximizing value for businesses consequently résult 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 infl ence this value. Increase in value may imply that shareholder capital is max zed>hence, fulfilling the promise to capital providers. This is where valuation steps in VALUATION According to the CFA Institute, valuatiois 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 follows similar fundamental principles that drives 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 evaluationOras Nate ualaeed eer] eae tions used in e le empirical evidel fe objective of se of the valuation exercise, assess in each pha 7 apt ae and come up with rational choices that different assump! f the valuation activity. validity of available aligns with the ultimat |G DIFFERENT CONCEPTS. quation of value is grounded on the — a company creates value if and hthe cost of acquiring_capital, holders, relates to the difference tment and the cost associated 1e of money and risk E INTERPRETIN OF VALU In the corporate setting, the fundamental e principle that Alfred Marshall) popularized only if tl > return_on_capital invested Xx Value, in the point of view of corporate sharel between cash inflows generated by an invest with the capital invested which captures both time valu premium. The value of a businesses can be basically linked to three major factors: * Current-operations — how is the operating performance of the firm in recent year? a + Future prospects — ‘company? Embedded risk — what are the business risks involved in running the business? what is the long-term, strategic direction of the These factors are solid concepts; however, the quick turnover of technologies. and rapid globalization make the business environment more dynamio. 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 change in the economic environment and the continuous innovation of market players. New risks and competitions 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. lue — refers to the value of any_asset_based_on-the assumption assuming there is a hypothetically _complete ding of its investment characteristics. Intrinsic value is the estor_considers, on_the basis of an evaluation or value that an i available facts; to be the {true? or "feal) 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 Unfortunately, this is not 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 no investors 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 based their buy or sell recommendations based on these analyses. Intrinsic value is highly relevant in pricing public shares. Most of the approaches that will be discussed in this book deals 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. Chapters 2 and 3 focus on valuation methodologies dealing with a firm's going concern value. 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 willbe 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freeroll fetee] TT wien hace sets OO capital (u! forking together are combined with the 7 nless the business is continuously i jing-concern assumption se in the going-Co} It the an declines because of the assets not ind the absence of human intervention, enerated whet soplication of human unprofitable) which e i liquidation occurs, valu : working together anymore essed in terms of cash equivalents, Fair Market Value ~ the pice, e>fands between a hypothetical viling at which el hypothetical willing and able seller, acting at arwfsion imate and unrestricted market, when neither is under arm's lengtt aie or sell and when both have reasonable knowledge eral rt ts Both parties should voluntarily agree with the price of the : nd are not under threat of compulsion. Fair rice of the transaction a : aie 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 Profile. Any noted variance between the stock's market price versus its fundamental value indicates th: lat undervalued. it might be overvalued or Typically, fundamental anal ee lysts lean towai 1 t strategies which encapsulate the fo rds long-term investment © Relationship between valu reliably measured, llowing Principles: le and underlying factors can be[eel VALUATION CONCEPTS AND METHODOLOGIES © Above relationship is stable over an extended period Any deviations from the above relationship can be corrected within a reasonable time ° eerie may include value and growth investors. Value si nd to be mostly interested in purchasing shares that are ently existing and priced at less than their true value. On the other hand, growth investors lean towards growth assets (expected value that future investments can create) 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 him fo assess reasonableness and adjust future estimates. Market expectations regarding fundamentals of one firm can be used as benchmark for other companies which exhibits the same characteristics. * Activist investors — Activist investors tend to look for companies with good growth prospects that have poor management. Activities investors usually do “takeovers” — they use their equity holdings to push old management out of the company and change the way the company is being 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, activities 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. relies on the concept that stock prices are by how investors think and act. Chartists rely on available trading KPIs such as price movements, trading volume, 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. * Chartists — Chartists significantly influencedthat react based on new information Information Traders ;, t aero the stock market. ne underlying belies about irs that f° FENCES more adept in guessing or geting ney is that information tf2ceT™ | can make predict how the market wii information about fit ence, information traders correlate value ang react based on ts. HENCE: alue. Valuation is important tg how information Wi" ce they buy oF sell shares based on thei, information trace sin nformation wil affect stock price assessment on ho\ inder portfolio management he following activities can be perfor : Under lio manags through the use of valuation cular asset fairly priced, overpriced, or ion - arti Pau + Stock selection -'6 3 Pet its prevailing computed intrinsic value to it underpriced in relation F \d prices of comparable assets : . pees 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 their 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 clien ts to re iri providing them information that alize their investment goals by will help them make the right decision whether , Marke ete * prices of shares usually better reflect its real somewhat serves a Monitori be ing r decision that are in line with 19 role to mang the agement to ensure that they make © creating value for shareholders.[ieee PSPs Analysis of Business Transactions / Deals Valuation plays a very big role when analyzing potential deals. Potential acquirers typically use relevant valuation techniques (whichever is applicable) éctimate value of target firms they are planning to purchase and understand the synergies they can take advantage from the purchase. They also use vstuation 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 bid price. On the other hand, the selling firm (or sometimes, the target company) should have a sense of its firm value as well to gauge reasonableness of bid offers. Selling firms also 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 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 wo companies combined to form a wholly new entity. An example is the merger of * 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 whose ownership will be transferred to shareholders. « Leveraged buyout — Acquisition of another business by using significant debt which uses the acquired business as a collateral. Valuation in deals analysis also 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areca can be attributable to more ns, increased revenues, ¢o, disciplinary talents of the Coy ficiany nt Mbineg Mbingg yneray reductio! erations, cl " productsimarkets or cross organization. . : ore the on — change in peop! es * Control rel scauiston ‘Any impact to firm value resultin about by ent and restructuring of the i managem' tre cere uld ratincluded in the valuation exercise, 7 compat sually an important matter for hostile takeovers. u $) rate firms. sepal st 9 from tar his ig Corporate Finance ce mainly involves managing the firm's capital Structure, See ana aie 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 ang implementation of resources, while balancing profitability and risk appetite. Small private businesses that need additional money to expand uses 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 their 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 be offered 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, valuation valuation corporate tment Fi fam ia are focused on maximizing shareholder value useS mathedolog a ess impact of various strategies to company value gies also enable communication about significant matters between analysts. Management, shareholders, consultants and inve(eee METHODOLOGIES Legal and Tax Purposes Valuation is also important to businesses because of legal and tax purposes. For example, if anew 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 fiquidated 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 that affect the business: 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 exists and are very useful for analysts. These frameworks are more than a template that should be filled out: analysts should use these framework 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.the inherent technical and conom:. F Ea and the trends that may affect ne istics means that these are true to most ticipating in that industry. Porter's Five on tool used to encapsulate Ndustry Industry structure ae ‘ characteristics of an indu: structure. Industry character if not all, market players Pal Forces is the most comm structure. a aor pe ine nature and intensity of rivalry between market players Industry rivalry | ne industry. Rivalry is less intense if there is lower number of markat payers or competitors (i.e. higher concentration) which means higher Fotential for industry profitability, This considers concentration of Prarket players, degree of differentiation, switching costs, information and government restraint. Refers to the barriers to entry to industry by new market players ir] there is relatively high entry costs, this means there are fewer ney entrants, thus, lesser competition which improves profitability potential New entrants include entry costs, speed of adjustment, economies of scale, reputation, switching costs, sunk costs and govemment New Entrants restraints, Substitutes and | This refers to the relationships between interrelated products and Complements services in the industry. Availability of substitute products (products Which can replace the sale of an existing product) or complementary products (products which 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 | 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 specific input. Supplier power also considers supplier concentration, prices of altemative inputs, relationship-specific investments, supplier switching costs and governmental regulations, Buyer Power Buyer power pertains to how customers can negotiate better terms in their favor for the products/services they purchase. Typically, buying Pricer 's low if customers are fragmented and concentration is Ion to sume nat market players are not dependent to few customers ikea 've. Low buyer power tends to improve industry profits since race annot significantly negotiate for the price of the product. Other es rs considered in buyer power include buyer concentration, value Substitute products that buyers can purchase, customer switching Costs and govemment restraints : Competiti a omectitive position refers how the products, services and the apart from other competing market players: Ba 'ypically gauged using the prevailing MaKe" © company enjoys, Generally, a firm’s value is hight ustain its competitive advantage against ' Company itself is set Competitive Position is share level th; if it can Consistently sicompetitors. Accordin, strategies to achieve ig to Michael Porter, there are generic corporate competitive advantage: Cost leadership — players with quality firm to be price pro: incurring the lowest cost among market that is comparable to competitors allow the fie ducts around the industry average ferentiation — offering differentiated or unique product or service characteristics that customers are willing to i vay for an additional premium ae Focus — 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 which is reflected in the financial statements. Analysts typically 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’ from up to ten years prior — as long as available information is available. Looking at the past ten years may give an idea how resilient the company in the past and how they reacted to the 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 i be compared against stated fare. Some information can also ; objectives of the organization — such as sales growth, gross margin ratios or bottom line targets Typical sources of information government-mand: about companies can be found in ated disclosures like audited financial statements.ny press releases ; filings, comPANY P” lily listed, regula easily accessed in the stock statements Js that can company Issues can and financial ‘stor relation materia’ Other acceptable sources of e. Inve ebsites. ne ori accessed in their oes reports from industry organization, atormation include news artes and industry researches done by i agencies an dj reports from ropualor a rsen ae uromonitor. eticaly, ana independent firms su tion that are made publicly avail y firms should only use informe ). Analysts should avoid using leases, nt Sere a er gives undue disadvantage to.other terial inside information ea imeeers that do not have access to the inform: rmation, focus is given to look at it arnings. Quality of earnings analysis pertain to the Taare all financial statements and accompanying notes to assess sustainability of company performance and validate accuracy of financial information versus economic reality. During the 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. In analyzing historical financial info Quality of earnings analysis also compares net income against operating cash flow to make sure reported earnings are actually realizable to cash and are not padded only because of significant accrual entries. Typical observations that analysts can derive from financial statements and should be critical of are listed below: Pe ES Possible Interpretation Revenues and gain Early recognition — of | Accelerated revenue uel fe 9. bill-and- | recognition improves ee a Sales | income and can be used to un to | hide declining and | performance acceptance of customer) income or sen ooerating Nonrecurring gains that do operating ineoeges Pato! | not relate to operating Performance may hide declining performance. Too little reserves may improve current year income but might affect future income (and vice Expenses and losses Recognition of too high or too little reserves (e. restructuring, bad debts) versa)Leer le Observation Possible Interpretation Deferral” of expenses | May improve current Such as customer | income but will reduce Bcquisition or product | future income. May hide Gevelopment costs by | declining performance. capitalization Aggressive assumptions | Aggressive estimates may Such as long useful lives, | imply that there are steps lower asset impairment, | taken to improve current high assumed discount | year income. Sudden Fate for pension liabilities | changes in estimates may or high expected return | indicate masking of on plan assets potential problems in ‘operating performance. Balance sheetitems | Off-balance sheet | Assetsiliabilities may not financing (those not | be fairly reflected. reflected in the face of the balance sheet) like leasing or securitizing receivables Operating cash flows | Increase in bank | Potential artificial inflation overdraft as operating | in operating cash flow. 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 nonaudit 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.curities !aW violations, reporting Violations i of se Hs ‘ston q A hist iate filing: persisten' inancial performance 11, Forecasting fi standing ho’ nts, for 5 operates and analysis of hj recasting financial performance is the Next ste cial performance can be looked at two lenses ona ‘tive viewing the economic environment and ingye macro perspe’ erates in and on amore micro perspective focusing in where the firm a and operating characteristics. Forecastin the firm's het ture-looking view which resulted from the aSSessmen summarizes the fu tive landscape assessment, business strateg and competi reed financials. This can be summarized in two approaches: w the busines: a After undet financial stateme! Forecasting finan * 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. Usually, one result of top-down forecasting approach is the forecasted sales volume for 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 builds the forecast as it captures what will happen to the company. For example, store expnasion will be captured and its corresponding impact to revenues will be computed until company-level revenues is calculated ae compiled during the industry, competitive and business Aine Benes about the fim should be considered inthis atest fone, Coasting forthe firms sales, operating income and oat reasonable’ nn oe understanding of these is critical to forecee considered in Meet Qualitative factors, albeit subjective. % approximate the rae casting process in order to make valuate” Dy informed yn ealty Of the firm, Assumptions should be v2" Judgment based on the understanding of the business:eT rT Ned pe ona Forecasting should be done c earning, cash flow and bala forecasting approach prevents prospective financial statement nce sheet forecast. Comprehensive any inconsistent figures between the tS and unrealistic assumpti approach considers that analysis should done per line em a5 each i a. item can influenced by a different business: driver. Similar with short- term budgeting, forecastin 5 19 process starts with the determi growth and revenue projections of the business. en Praeceeen process should also consider industry financial ratios as gives an idea how the industry is operating. From this, analysts should be able to explain the 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. On the other hand, return on investments will move closer to cost of capital as competition comes in to play 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 estimate of how the business operates. Even though general economic and market trends can be used as reliable benchmark, analysts should consider that unique factors that affect company prospects as guidance in the forecasting process. Typically, forecasts are done on annual basis as most publicly | information are interpreted on an annual basis. available financial s 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 using seasonality te can give a more reasonable estimate the right valuation model | will depend on the context of the of the company being Selecting ration mode iate valu: ‘ The appropri herent characteristics valuation and the ineee is erento send the ereumstances When uation in succeeding chapters. ode! i val ; vate sae ted ‘il pe aiscussed | ts it uation model based on forecas! we forecasts should now be jon more aluation model. This step is not am forecast to the model to estimate coding ft Excel). Moreso, analysts should from this process makes sense 5. To do this, two aspects a we led, the Once the valuat inputted and converte’ only about manually ene i jo the value (which is thej ng value ul consider whether the res ae based on the knowledge about the bus' should be considered is — common methodology in valuation Itiple other analyses are done to s in an input or variable will affect ie. firm value). Assumptions that are Se eta as an input for sensitivity analysis exercises are sales growth, gfoss 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 — firm-specific issues that affects firm value that should be adjusted by analysts since these are events that are not quantified if analysts only look at core business operations. This includes control premium, absence of marketability discounts and _illiquidity discounts. Control premium refers to additional value Sarit My ae if acquiring it. will give discount means that re investor. Lack of marketability there is no ready mere for ee ce eee discount). Lack of mark ee i fo oneal share value. Iliquidity a ‘ability discount drives down the price of particular scount should be considered when considered less liquid comp: po ess cena oy gsnerely traded share. liquidity ae ene ce rheelive) Puc unts can also be considered if an investor wil a will Sell large portion of stock that is significant fo the trading volume Of the stock. ° «Sensitivity analyst exercises wherein mu understand how change!Appl PPlving valuation conclusions and providin Once the value is Calculated base the a du d on all assumptions considere recommencstionn , investors use the resus to fprovde objective Make decisions that Suits their investment ig fecommendation KEY PRINCIPLES IN VALUATION a. Th is defi © value of a business is defined only at a specific point in time a pad ago may not hold true and not reflect the current firm value today. As a result, this is important to give perspective to users of the information that firm value is based on a specific date. vaue 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 taking into account future events that may improve or reduce cash flows. Cash flows is also more relevant in valuation as compared to accounting profits as shareholders are more interested in receiving cash at the end the day. Cash flows include cash generated from operations and reductions that are related to capital Luecslbsdn working capital and taxes. Cash flows will depend on the estimates of future performance of the business and strategies in place Ee support this growth. Historical information can provide be a good starting ps when projecting future cash flows.. Value is int changing and they normayy Pry ita onstantly i com return should investors expect from are et forces of i Mamence O what a the market nee Of market forces guitment venice austry and general economic conaiig differ bas ate of return dictated by the market jg in, ns ing the f° apture the right discount rate to be it tors their decision to BUY OF Sell inven can influenc tenis valuation. This van be impacted by underlying net tangible assets value ¢ Firm 7 look at the relationship p, uation principles eh Busine a valle of an entity and net tangible of its assay operation: firms with higher underlying net tangible asset Value are retically, a aban results in higher going concern value. This is a regu, that can be used as security q sence of more assets con uring ae acquisitions or even liquidation proceedings in case bankruptcy occurs. Presence of sufficient net tangible assets can alg, support the forecasts on future operating plans of the business, fuenced 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 owners influence (e.g. owner maintains customer relationship or provides certain services), this value might not be transfer 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. Value is impacted by liquidity Te Principle is mainly dictated by the theory of demand and svPPi i ieee any Potential buyers with less acquisition targets. Si Pa gaat fms may rise since the buyers wil express moe eal transite nates. Generally, more business interest liuidl) : © more business value, Sellers should be able to atvaci tial purchases to maximize value they can realize Negotiate potent the transaction,Rete ess AE aioe ore = Uncertainty in Valu: ion In all valuation exercises, uncertain refers to the possible range of val performing any valuation method, iy will be consistently present. Uncertaint lues pas the real firm value lies. When a i" accounted and included! al potential risks that may afet rice wt cones 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 Die is captured in valuation models through cost of capital or discount ti 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 has operated for 100 years will continue to have stable value. If a new company suddenly arrived and provide 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ret anand [Ree n asset's value based on variables Perceived t returns, on comparisons with similar assets immediate liquidation proceeds. Definition the context. Different definitions of Value ern value, liquidation value and fair Market Valuation is the estimation of al to be related to future investmen or, when relevant, on estimates of of value may vary depending on include intrinsic value, going conc’ value Je in the business world with respect to portfolio Valuation plays significant ro! actions or deals, corporate finance, legal and tax management, business trans: purposes. Generally, valuation process involves these five steps: understanding of the business, forecasting financial performance, selecting right valuation model, preparing valuation model based on forecasts and applying conclusions and providing recommendations. Key principles in valuation includes the following: «Value is defined at a specific point in time Value varies based on ability of business to generate future cash flows Market dictates appropriate rate of return for investors «Value can be impacted by underlying net tangible assets Value is influenced by transferability of future cash flows Value is impact by liquidityEXERCISES True or False. Write TRUE if the Statement is true and the word FALSE if you find the statement inconsistent with the truth. poe Buel ea Value pertains to how much a particular object is worth to a particular set of eyes. 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. 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 fo come up with reasonable estimate of value of an entity's assets or its equity Valuation techniques may differ across different assets, but all follows similar fundamental principles that drives the core of these approaches. As valuation mostly deals with projections about future events, analysts should hone their ability to balance and evaluation different assumptions used in each phase of the valuation exercise, assess validity of available empirical evidence and come up with rational choices that aligns with the ultimate objective of the valuation activit 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, 10. Intrinsic value refers to the value of any asset based on the assumption assuming there is a hypothetically complete understanding of its investment characteristics.STATEMENT rn firm value is cetera the Going conern assumption. The going ; ; going concen lieves that the entity will continue to do eee activities into the foreseeable future. its business ac is the net amount that would be 12. Seer business is terminated and the assets ae sold piecemeal. ir is the price, expressed in terms of ® es 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, 14. Fundamental analysts are persons who are interested in understanding and measuring the intrinsic value of a firm. 15. Fundamentals refer to the characteristics of an entity related to its financial strength, Profitability or risk appetite. 16. Activities investors usually do “takeovers” — they use their equity holdings to push old management out of the company and change the way the company is being run. 17. Chartists relies on the coni cept that stock Prices are significantly influenced by how investors think and act, Chartists rely on available trading KPIs such as price Movements, trading volume, short Sales - when Making their investment decisions. the market will react ba: ‘N acquisition usually has two Parties: the buying firm and the Selling firm. T determine the fair val Offering a bid rice. Merger is the general term which describes _ transaction two companie: S fo form a ——feweniy, “ mpanies combined t ad he buying firm needs to . ue of the target company prior to_| / i | | 7 4 |LUATION CONCEPTS AND METHODOLC ane STATEMENT Divestiture is the sale of a major component or: Segment of a business (e.g. brand or product line) to another company Spin-off is separating a segment or component business and transforming this into a ‘separate legal entity whose ownership will be transferred to shareholders. Leveraged buyout is the acquisition of another business by using significant debt which uses the acquired business as a collateral Synergy can be attributable to more efficient operations, cost reductions, increased revenues, combined products/markets or cross-disciplinary talents of the combined organization. Corporate finance mainly involves managing the firm's capital structure, including funding sources and strategies that the business should pursue to maximize firm value. Valuation is also important to businesses because of legal and tax purposes. Top-down forecasting approach — Forecast starts from international or national macroeconomic projections with utmost consideration to industry specific forecasts. 28. Bottom-up forecasting approach — Forecast starts from the lower levels of the firm and builds the forecast as it captures what will happen to the company. 29. Sensitivity analysis is the common methodology in valuation exercises wherein multiple other analyses are done to understand how changes in an input or variable will affect the outcome (i.e. firm value). 30. Uncertainty is captured in valuation models through cost of capital or discount rate. 31. Uncertainty is captured in valuation models through cost of capital or discount rate. 32. 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. 33. Definition of value may vary depending on the context. | Different definitions of value include intrinsic value, going concern value, liquidation value and fair mar value.= role in the busi lays significant me wirectoct i portfolio management, business transactions or deals, corporate finance, lega| a, lly, valuation process involves these five ste 38. cnlerstending of the business, forecasting financighs performance, selecting right valuation model, Preparing, valuation model based on forecasts and appiying b). conclusions and providing recommendations. a 36.__Value is defined at a specific point in time 37. Value varies based on ability of business to generate future cash flows 38. Market dictates appropriate rate of return for investors 39. Value is influenced by transferability of future cash flows 40. Value is impact by liquidityATEN Ree) tae Pca Lelesedsncuie ia MULTIPLE CHOICE THEORY. Write the letter of the best angwer before the number of the question or statement being answered. 1._____ pertains to how much a particular object is worth to a particular set of eyes. a. Price b, Value ©. Cost d. Fundamentals 2. According to the CFA Institute, 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. a. Valuation D. Price Estimation c. Fundamentals d. Appraisal 3. Valuation places great emphasis on the that are associated in the exercise. ‘a. Professional judgment b, Human reasoning c. Professional Skepticism d. Due diligence 4. The value of a businesses can be basically linked to three major factors, except a. Current Operations b.Future Prospects 9, c, Embedded Risks fon d. Alll of the above 5. One major factors linked to the value of business that shows how is the operating performance of the firm in the recent. . | | | a_Current Operations b. Future Prospects c. Embedded Risks d. Alll of the above‘or factors linkes is ie fong-term and st ‘a, Current Operations . Future Prospects ¢. Embedded Risks above 7 eae linked to the value of business that shows what are the business risks involved in running the business. ‘a. Current Operations b. Future Prospects c, Embedded Risks @.All of the above 8. refers to the value of any asset based on the assumption assuming there is a hypothetically complete understanding of its investment characteristics. a. Going concern value b. Liquidation Value ¢. Intrinsic Value d. Fair Market Value 9. particularly relevant for companies who are experiencing severe financial distress. a. Going concern value b Liquidation Value c. Intrinsic Value d. Fair Market Value 10. Value is determined under the going concern assumption a. Going concern value b. Liquidation Value c. Intrinsic Value d. Fair Market Value 11.The price, expressed in terms of cash equivalents, 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. 3 a. Going concern valueWTOP TORTS b. Liquidation Value ¢. Intrinsic Value g. Fair Market Value 12. The relevance of valuation in the investr oer maely oe rea oR ER a-PRortfolio Management b. Fundamental Management c. Financial Management d. Investment Management 13. These are persons who are interested in understanding and measuring the intrinsic value of a firm. a, Fundamental Analysts b. Activist Investors c. Chartists d. Information Traders 4. refer to the characteristics of an entity related to 14. its fnancial strength, profitability or risk appetite. a. Intrinsic Value 'b, Fundamentals c. Technical Characteristics d. Financial Value id to look for companies with good growth ten anagement. 15. prospects that have poor m: ental Analysts Fundam Activist Investors P c. Chartists d. Information Traders » ieve that these metrics imply investor psychology and prices. movements In stock ntal Analysts ors 16. They bel will predict future a, Fundame b. Activist Invest & Chartists d. Information TradersPSone sf about firms and th ting new information about firms and the predict row he matel will react based on this. Hence, 4 correlate value and how information will affect th value. a, Fundamental Analysts b. Activist Investors ¢. Chartists d. Information Traders 18. Under portfolio management, the following activities can b performed through the use of valuation techniques, except a. Stock Selection b. Deducing Market Expectation Both can be performed d. None of the above 19. Separating a Segment or component business and t 9. S 7 Transform this into a separate legal entity whose Ownership will a to shareholders, est 'sferreg. | a. Mergers b. Acquisitions SC. Divestiture @ Spin-off 20. Sale of a major com) brand or product line) to a. Mergers b. Acquisitions (©)Divestiture d. Spin-off Ponent or segment of a business (e. 9. another company 21. General term which describes the transaction two companies combined to form a wholly new entity @ Mergers b. Acquisitions c. Divestiture d. Spin-offSR Sea VALUATION CONCEPTS AND METHODOLO& I ? usually has two parties: the buyi selling fim, The buying frm needs to determine the fa value of th target company prior to offering a bid price. On the other hand, the selling firm (or sometimes, the target company) should have a sansa of its firm value as well to gauge reasonableness of bid offers. a. Mergers ® Acquisitions c. Divestiture d. Spin-off 23. Acquisition of another business by using significant debt which uses the acquired business as a collateral. a. Mergers b. Acquisitions c. Divestiture d, Leveraged buy-out 24. assumes that the combined value of two firms will be greater than the sum of separate firms. can be attributable to more efficient operations, cost reductions, increased revenues, combined products/markets or cross-disciplinary talents of the combined organization. a. Synergy b. Control c. Synergy and Control d. None of the above 25. deals with prioritizing and distributing financial resources to activitiés that increases firm value. The ultimate goal is to maximize the firm value by appropriate planning and implementation of resources, while balancing profitability and risk appetite. a. Financial Management b. Corporate Finance c. Risk Management d. Portfolio Management 26. Generally, the valuation process considers these steps, except ‘a. Understanding the Business ] b. Forecasting Financial Performance v d. Preparing Valuation model based on forecasts J27 Which key principles in valuati a. The value of a business future cash flows ¢. Firm value can be impacted by underlying net tangible assets 28. refers to the possible range of values where the real firm value lies. a. risk of the unknown b. volatility ¢.uncertainty d. None of the above to change every day as transaction happens? e b. Value varies based on the al d. Market dictates the appropriate rate of return for Investors ion refers to Business value tend is defined only at a specific poin bility of business to Generate 29. Which key principles in valuation refers to 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? a. The value of a business i time b. Value varies based on th future cash flows c. Firm value can be impacted by underlying net tangible assets d. Market dictates the appropriate rate of return for investor 30. Which key principles in valuati 's defined only at a specific pointin, @ ability of business to generate rs | j ion refers to 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? . Value varies based on the ability of business to generate future cash flows c. Firm value can be impact assets d. Market dictates the appropriate rate of return for investors, led by underlying net tangibleChapter 2 GOING CONCERN ASSET BASED VALUATIONfrees Ge Tees poe ASSET-BASED VALUATION ities available in the ma ea lot of opportuni market In business, ee eand Their porfolio by securing More Acquisition, Investors are eager ne estment to mitigate the risk and improve stment in various and improving their basket of i their inve: their returns. Most investors diversify opportunities, but the challenge is ‘determining the value on how much they are willing to acquire it. ed by the industry as transactions that woulg Asset has been defin' yield future economic benefits as a result of past transactions. Hence, the value of investment opportunities is highly dependent on the value that the future. The value should also include asset will generate from now until the ful all cash flows that will be generated until the disposal of the asset. In practice, observe valuation as a sensitive and confidential activity in their portfolio management. Valuation should be kept confidential to allow the company to negotiate a better position for them to acquire an opportunity. Since the value of the assets will depend on its ability to generate economic benefits. It is more challenging to determine the value a green field investment since all shall be based on purely estimate than brown field. Recall, the green field investments are those started from scratch while brown field investment are those opportunities that either partially or fully operational. Brown field investments are those already in the going concern state, as most business are in the optimistic perspective that they will grow in the future. Therefore, they can also be considered as going concern business opportunities (GCBOs). Going concern business opportunities are those businesses that has a long term into infinite operational period The beauty of GCBOs is that we already have a reference for their performance either on similar nature of business or from its historical performance. With this, the risk indicators can be identified easily and therefore can be quantified accordingly. The Committee of Sponsoring Organization of the Treadway Commission (COSO) suggests that risk management principles must be observed as well in doing businesses and determining its value. It was noted in their report that the benefits of having a sound Enterprise-wide Risk Management allows for the company to: (1) increase the opportunities (2) facilitates the m: . i ier anaee business et and identification of the risk factorsMe cae) METHODOLOGIES (3) identify or create ici cost-efficient opportunities (4) manages the performance variability; (5) improve mani i entered’ Management and distribution of resources across the (6) make the business more resilient to abrupt changes. Pima identtying the risk is to enable the investors to quantify eee tens and/or the cost of managing these risks. Theoretically, hiner itis more on the economic benefits valuation to determine lue, the pertinent and anticipated outflows must be included. an pe critical part in valuing an opportunity is determining is value as for the investor or the enterprise. For GCBOs, there are different approaches that can be used, the most popular are: discounted cash flows or ocr analysis and comparable companies analysis, and economic value 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 Net Cash Flows of the investment opportunity. In Conceptual Framework and ‘Accounting Standards, it was discussed the that the cash flows are d and analyzed based on their sources and activities which are Categorized as operating, investing and financing. In determining the value of an asset, the cash flows are important reference or inputs. Note that in determining the value of the asset what should be included are the amount Gf cash that will be available for the claims of the equity owners presente are the amounts of cash available for quity claim from the business or asset. This is calculated from the net cash generated from operations and for investment ver time, For GCBO, the net cash flows generated will be based on the cash flows from operating and investing activities, since this represents already the amount earned or will be earned from the business and the mount that is required for you to infuse in the operations to generate more profit. Theoretically, it can be equated as: The Net Cash Flows distribution to both debt and eD rare Ra Free Cash Flows ope = Revenue — OPE fa tal Expenditures rating Expenditures — Taxes = Capi is cash flows based. For accounting Id consider that the operating 5 to those above the EBITDA level of reciation and Amortization. This wij s Before Interest, Dept Beason to determine the eee eae based a the e tit economically generated less advantage of EBITDA is that it already excludes interest that 9 the cost of financing the asset, taxes you Pay to the goverme i, en this should be accounted separately, and depreciation and amortization which ig part of the capital expenditures which will be deducted separately as wel) ou earn from the sales enables the EBITDA Margin or the level of earnings y' > investor to have an overview of the opportunity they are going to realized among others. mind that this ! majors and professionals, you a expenditures mentioned here pe! Let's bear in There are two levels of Net Cash Flows: (1) Net Cash Flows to the Firm; and (2) Net Cash Flows to Equity. The Net Cash Flows to the Firm represents the cash flows which was described in the preceding paragraph This is the amount made available to both debt and equity claims against the company. The Net Cash Flows to Equity represents the amount of cash flows made available to the equity stockholders after deducting the net debt or the outstanding liabilities to the creditors less available cash balance of the company. Since GCBOs is assumed to operates in a long period of time to almost perpetuity. The risk and returns are inherent to the opportunity should also be quantified. Furthermore, the economic value that will be generated by the assets is expected to stable after some point in time, since the projections are reliant on certain assumptions made. The challenge for the determination of the value of the asset is to also account for the economic returns that it will generate in perpetuity, This is addressed by the Terminal Value. Terminal Value represents the value of the company In perpetuity or in 2 going concer environment. The convenient way to terminal value or terminal cash flows is through this equation