Module 5:

Fundamental
Principles of
Valuation
Source: Valuation Concepts and
Methodologies by Lascano et., al.
Topics
❑ Fundamental Principles of Valuation
❑ Valuation
❑ Interpreting Different Concepts of Value
❑ Roles of Valuation in Business
❑ Valuation Process
❑ Key Principles in Valuation
❑ Summary
Fundamental
Principles of
Valuation
Fundamental Principles of Valuation
Assets, individually or collectively, has value. Generally, value
pertains to how much a particular object is worth to a 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.
Fundamental Principles of Valuation
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.
Valuation
Valuation
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 follows similar
fundamental principles that drives the core of these approaches.
Valuation
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 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 activity.
Interpreting Different
Concepts of Value
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 businesses 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?
Interpreting Different Concepts of
Value
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 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.
Interpreting Different Concepts of
Value
Intrinsic value - refers to the value any asset based on the
assumption assuming there is a hypothetically complete
understanding of its investment characteristics. Intrinsic value is the
value that an investor considers, on the basis of an evaluation or
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.
Interpreting Different Concepts of
Value
❑ 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.
Interpreting Different Concepts of
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 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 in the going-concern assumption. If liquidation occurs,
value often declines because of the assets not working together
anymore and the absence of human intervention.
Interpreting Different Concepts of
Value
❑ Fair Market Value - 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. Both parties should voluntarily agree with the price of the
transaction and are not under threat of compulsion. Fair value
assumes that both parties are informed of all material
characteristics about the investment that might influence their
decision. Fair value is often used in valuation exercises involving
tax assessments.
Roles of Valuation in
Business
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.
Roles of Valuation in Business
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 and 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:
❑ Relationship between value and underlying factors can be reliably measured.
❑ Above relationship is stable over an extended period
❑ Any deviations from the above relationship can be corrected within a
reasonable time
Roles of Valuation in Business
❑ 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 f0r 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.
Roles of Valuation in Business
❑ 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, 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.
Roles of Valuation in Business
❑ 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 getting new information about firms and they can
make 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.
Roles of Valuation in Business
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
under-priced 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?
Roles of Valuation in Business
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) 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 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 farms 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.
Roles of Valuation in Business
❑ Merger - General term which describes the transaction two
companies 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 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.
Roles of Valuation in Business
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 two separate firms.
Synergy can be attributable to more effective operations, cost
reductions, increased revenues, combined products/markets or cross-
disciplinary talents of the combined organization.
❑ Control - change in people managing the organization for 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.
Roles of Valuation in Business
Corporate Finance
Corporate finance mainly 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.
Roles of Valuation in Business
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.
Roles of Valuation in Business
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
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.
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.
Valuation Process
PORTER'S FIVE FORCES
Industry rivalry 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 players or
competitors (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.
New Entrants Refers to barriers to entry to industry by new market
players. If there is relatively high entry costs, this
means there are fewer new 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 government restraints.
Substitutes This refers to the relationships between interrelated
and products and services in the industry. Availability of
Complements 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 Supplier power refers to how suppliers can
Power 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 alternative
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 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
industry profits since they cannot significantly
negotiate for the 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.
Valuation Process
Competitive position refers 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 - incurring the lowest cost among market players with quality
that is comparable to competitors allow the firm to be price products around
the industry average
❑ Differentiation - offering differentiated or unique product or service
characteristics that customers are willing to pay for an additional premium
❑ Focus - identifying specific demographic segment or category segment to
focus on by using cost leadership strategy (cost focus) or differentiation
strategy (differentiation focus)
Valuation Process
In analyzing historical financial information, focus is given to look at the
quality of earnings. Quality of earnings analysis pertain to the detailed
review of 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 non-
operating 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
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:
Valuation Process
Line Item Possible Observation Possible Interpretation
Revenues and gain Early recognition of revenues (e.g., bill- Accelerated revenue recognition
and-hold sales, sales recognition prior to improves income and can be used to
installation and acceptance of customer) hide declining performance.

Inclusion of non-operating income or Non-recurring gains that do not relate to

gains as part of operating income. operating performance may hide
declining performance.
Expenses and losses Recognition of too high or too little Too little reserves may improve current
reserves (e.g., restructuring, bad debts) year income but might affect future
income (vice versa)
Deferral of expenses such as customer May improve current income but will
acquisition or product development costs reduce future income. May hide
by capitalization. declining performance.
Aggressive assumptions such as long Aggressive estimates may imply that there
useful lives, lower asset impairment, high are steps taken to improve current year
assumed discount rate for pension income. Sudden changes in estimates
liabilities or high expected rate of return may indicate masking of potential
on plan assets. problems in operating performance.
Balance sheet items Off-balance sheet financing (those not Assets/liabilities may not be fairly
reflected in the face of the balance reflected.
sheet) like leasing or securitizing
receivable.
Operating cash flows Increase in bank overdraft as operating Potential artificial inflation in operating
cash flow. cash flow.
Valuation Process
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.
Valuation Process
❑ 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, persistent late
filings.
Valuation Process
Forecasting financial performance
After understanding how the business operates and analysis of
historical financial statements, forecasting financial performance is
the next step. Forecasting financial performance can be looked at
two lenses: a macro perspective viewing the economic
environment and industry where the firm operates in and on a
more micro perspective focusing in the firm's financial and
operating characteristics. Forecasting summarizes the future-
looking view which resulted from the assessment of industry and
competitive landscape assessment, business strategy and historical
financials. This can be summarized in two approaches:
Valuation Process
❑ 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 expansion will be captured and its
corresponding impact to revenues will be computed until company-
level revenues is calculated.
Valuation Process
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 lectures.
Valuation Process
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). Moreso, analysts should consider whether the resulting
value from this process makes sense based on the knowledge about the
business. To do this, two aspects should be considered:
❑ Sensitivity analysis - 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). 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.
Valuation Process
❑ 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 central premium, absence of marketability discounts and
liquidity discounts.
▪ Control premium refers to additional value considered in a stack 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). Lack of
marketability discount drives down snare value.
▪ Illiquidity discount should be considered when the price of particular shares
has less depth or generally considered 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.
Valuation Process
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
Key Principles in Valuation
The value of a business is defined only at a specific point in time
Business value tend to change every day as transaction happens.
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 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.
Key Principles in Valuation
Value varies based on Me 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 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 grown. Historical information can provide be a good starting point
when projecting future cash flows.
Key Principles in Valuation
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
Key Principles in Valuation
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 a
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.
Key Principles in Valuation
Value is influenced by transferability of future cash flows
Transferability of future cash flows is also important especially to
potential acquirers. Business with good value can operate even
without owner intervention. If a firm's survival depends on 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.
Key Principles in Valuation
Value is impacted by liquidity
This principle is mainly dictated by the theory of demand and
supply. If there are many potential layers 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.
Uncertainty 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 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 rated.
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 he investor from realizing any expected value based on the
valuation methodology.
Uncertainty in Valuation
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.
Summary
Summary
Valuation is the estimation of an asset's value based on variables
perceived to be related to future investment returns, on comparisons
with similar asset or, when relevant, on estimates of immediate liquidation
proceeds. Definitions of value may vary depending on the context.
Different definitions of value include intrinsic value, going concern value,
liquidation value and fair market value.
Valuation plays significant role in the business world with respect to
portfolio management, business transactions or deals, corporate finance,
legal and tax 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.
Summary
Key principles in valuation includes the following:
❑ Value is defined at a specific point in time
❑ Value varies based an 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.

Summary