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.
CHAPTER 1: FUNDAMENTAL PRINCIPLES OF VALUATION

• 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.
CHAPTER 1: FUNDAMENTAL PRINCIPLES OF VALUATION

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.
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• 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.
CHAPTER 1: FUNDAMENTAL PRINCIPLES OF VALUATION

• 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:

CHAPTER 1: FUNDAMENTAL PRINCIPLES OF VALUATION

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
CHAPTER 1: FUNDAMENTAL PRINCIPLES OF VALUATION

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
CHAPTER 1: FUNDAMENTAL PRINCIPLES OF VALUATION

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

Inclusion of nonoperating non- Non-recurring gains do not

Expenses and losses
operating gains income or gains relate to operating performance
as part of operating income may hide declining
performance.
Recognition of too high or too Too little reserves may improve
little reserves losses too little current year income but might
reserves (e.g. may improve affect future income (vice versa)
current restructuring, bad
debts)
Deferral of expenses such as May improve current income
customer acquisition or product but will reduce future income.
development costs by May hide
capitalization. declining performance.
Aggressive assumptions such as Aggressive estimates may imply
long useful lives, lower asset that there are steps taken to
impairment, high assumed improve current year income.
discount rate for pension Sudden changes in estimates
liabilities or high expected may indicate masking of
return on plan assets. potential problems in operating
performance.
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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
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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
CHAPTER 1: FUNDAMENTAL PRINCIPLES OF VALUATION

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

CHAPTER 1: FUNDAMENTAL PRINCIPLES OF VALUATION

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.