Module 1 Introduction on Valuation Concepts and Methods Concepts of valuation
Value is all about how much something is worth, whether in an estimate or exact
amount. When somebody invest, they expect the “value” of their investment to increase by an
amount that is acceptable to them or sufficient enough to compensate the risk or sacrifice they
took, incorporating the time value of money. As we say, in everything we do, we need to
sacrifice. That sacrifice has value, giving away something that is valuable to him expecting
another value, the return or profits he is willing to accept given the value of his sacrifice.
Therefore, knowing how to measure value or how to create value is an essential tool
for everybody to be able to make a decision, wise decisions.
Foundations of value
There is no doubt that the “value” is the defining measurement of any market in the
economy of today. Value is all about how much something is worth, whether in an estimate or
exact amount. When somebody invest, they expect the “value” of their investment to increase
by an amount that is acceptable to them or sufficient enough to compensate the risk or sacrifice
they took, incorporating the time value of money. As we say, in everything we do, we need to
sacrifice. That sacrifice has value, giving away something that is valuable to him expecting
another value, the return or profits he is willing to accept given the value of his sacrifice.
Therefore, knowing how to measure value or how to create value is an essential tool
for everybody to be able to make a decision, wise decisions.
Definition of valuation
Valuation is the analytical (quantitative) process of determining the current or
projected worth (value) of an asset or something. There are several techniques or methods
available to be used in doing valuation. Each of these methods may give different results or
value, what matter is how this will be used in the decisions why such valuation activity is being
done.
Valuation determines the economic value of a business, asset or company.
Frameworks for valuation
Conceptual frameworks of valuation is about the issue of what affects or what drives
the value to change. A company’s value is driven by its ability to earn a good or healthy return
on invested capital (ROIC) and by its ability to grow. Healthy rates of return and growth result
in high cash flows, the ultimate source of value. Discussions on this will be done in detail in
the topic, step by step process of valuation.
Valuation is based on economic factors, industry variables, and on the analysis of
financial statements and the entire outlook of the firm. Valuation process will determine the
long-run fundamental economic value of its common stock or preferred stock. Different
concepts of valuation are based on the following:
1. Going concern value
2. Liquidation value
3. Market value
4. Book value
5. Intrinsic value
When dealing with the valuation process, it is important to get as many facts as possible
with clear goals on what is the purpose of this valuation.
1. Why are you valuing?
2. What are you trying to accomplish with this valuation?
Objectives/uses of valuation
Valuation is useful when we are trying to determine the fair value of an asset. Fair
value is the amount which is determined by what is the buyer willing to pay and the seller is
willing to sell under the conditions that both parties are willing or voluntarily enter in the
exchange transaction.
Importance/Rationale of valuation
Business valuation is an important exercise since it can help in improving the company.
Here are some of the reasons why is there a need to perform a business valuation.
Although the goal of valuation is to determine the fair market value, there is no one
way to be certain of the ultimate price paid. Typically, it depends on many factors including
industry, sector, valuation method and the economic conditions. You can also count on a fact;
you can have your business valued by two professionals and you will come up with two
different answers.
Various reasons for performing a business valuation
- Litigation
In a court case, such as an injury case, divorce, or where there is an issue with the value
of the business, someone may need to provide proof of company’s worth that could be the basis
of claims for any damages, or be based on the actual worth of your businesses and not inflated
figures estimated by a lawyer.
- Exit strategy planning
In cases where there is a plan to sell a business, it is wise to come up with a base value
for the company and then come up with a strategy to enhance the company’s profitability so as
to increase its value as an exit strategy. Your business exit strategy needs to start early enough
before the exit, addressing both involuntary and voluntary transfers.
A valuation with annual updates will keep the business ready for unexpected and
expected sale. It will also ensure that you have correct information on the company fair market
value and prevent capital loss due to lack of clarity or inaccuracies.
- Buying a business
Sellers and buyers of business usually have different opinions on the worth of the
business. However, the real business value is what the buyers are willing to pay. A sound
business valuation should consider market conditions, potential income, and other similar
concerns to ensure that the investment being done is viable. Business buyers must exercise
prudence by normally hiring a business broker who can help you with the process.
- Selling a business
As mentioned, sellers and buyers usually have different opinions on the worth of the
business. The sellers, however, would want to be certain that they are getting what it is worth,
thus they may have to perform their valuation process as well.
- Strategic planning
The true value of assets may not necessarily be reflected on the assets schedule, and if there
has been no adjustment of the balance sheet for various possible changes, it may be risky.
Having a current valuation of the business will give you good information that will help you
make better business decisions. As in the financial reporting standards, the use of current value
accounting is more evident.
- Funding
Bankers, financing companies or any potential investors require an objective valuation
when someone is negotiating or applying for credits, loans or any funding requirements.
Professional documentation of your company’s worth is usually required since it enhances your
credibility to the lenders or potential investors.
- Selling a share in a business
For business owners, proper business valuation enables you to know the worth of your
shares and be ready when you want to sell them. Just like during the sale of the business, you
ought to ensure you get good value from your share.
Business valuation is a critical financial analysis that needs to be done by a valuation expert
who has appropriate qualifications. Business owners are able to negotiate a tactical sale of their
entity, plan an exit strategy, acquire financing, and reduce the financial risk during litigation.
Fundamental principles of valuation or value creation
Business valuation involves the determination of the fair economic value of a company
or business for various reasons as mentioned earlier.
Key Principles of Business Valuation
The following are the key principles of business valuation that business owners who
want to create value in their business must know.
The value of a business is defined only at a specific point in time.
The value of a business usually experience changes every single day. The earnings, cash
position, working capital, and market conditions of a business are always changing. The
valuation made by business owners a month or years ago may not reflect the true current value
of the business. The value of a business requires consistent and regular monitoring. This
valuation principle helps business owners to understand the significance of the date of valuation
in the process of business valuation.
Value primarily varies in accordance with the capacity of a business to generate future cash
flow
A company’s valuation is essentially a function of its future cash flows except in in
unusual situations where net asset liquidation may lead to a higher value.
The consideration here is the term “future”. It implies that historical results of the
company’s earnings before the date of valuation are useful in predicting the future results of
the business under certain conditions. Another consideration is the term “cash flow”. It is
because cash flow, which takes into account capital investments, working capital changes, and
taxes, is the true determinant of business value. Business owners should aim at building a
comprehensive estimate of future cash flows for their companies. Even though making
estimates is a subjective undertaking, it is vital that the value of the business is validated.
Reliable historical information will help in supporting the assumptions that the forecasts will
use.
The market commands what the proper rate of return for investors get the best potential purchasers to the negotiating table to maximize price. It can be achieved
through a controlled auction process.
Market forces are usually in a state of flux, and they guide the rate of return that is
needed by potential buyers in a particular marketplace. Market forces include the type of Although they are technical valuation concepts, the basics of the valuation principles
industry, financial costs, and the general economic conditions. Market rates of return offer need to understood by business owners to help them increase the valuation of their businesses.
significant benchmark indicators at a specific point in time. They influence the rates of return
wanted by investors over the long term. Business owners need to be wary or concerned of the
market forces in order to know the right time to exit that will maximize value.

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

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

Value is influenced by transferability of future cash flows

How transferable the cash flows of the business are to a potential acquirer will impact
the value of the company. Valuable businesses usually operate without the control of the owner.
If the business owner exerts a huge control over the delivery of service, revenue growth,
maintenance of customer relationships, etc., then the owner will secure the goodwill and not
the business. Such a kind of personal goodwill provides very little or no commercial value and
is not transferable.
In such a case, the total value of the business to an acquirer may be limited to the value
of the company’s tangible assets in case the business owner does not want to stay. Business
owners need to build a strong management team so that the business is capable of running
efficiently even if they left the company for a long period of time. They can build a stronger
and better management team through enhanced corporate alignment, training, and even through
hiring.

Value is impacted by liquidity

This principle functions based on the theory of demand and supply. If the marketplace
has many potential buyers, but there are a few quality acquisition targets, there will be a rise in
valuation multiples and vice versa. In both open market and notional valuation contexts, more
business interest liquidity translates into more business interest value. Business owners need to
 Chapter 1 Fundamental 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 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 entail’s valuation implicitly. For example, capital
budgeting analysis usually considers how pursuing a specific project will affect entity value.
Valuation techniques may differ across different assets but all follow similar fundamental
principles that drive the core of these approaches.
Valuation places great emphasis on the professional judgment that are associated in the
exercise. As valuation mostly deals with projections about future events, analysts should hone
their ability to balance and evaluate different assumptions used in each phase of the valuation
exercise, assess validity of available empirical evidence and come up with rational choices that
align with the ultimate objective of the valuation activity.
Interpreting Different Concepts of Value
In the corporate setting the fundamental equation of value is grounded on the principle that
Alfred Marshall popularized - a company creates value if and only if the return on capital
invested exceed the cost of acquiring capital. Value, in the point of view of corporate
shareholders, relates to the difference between cash inflows generated by an investment and
the cost associated with the capital invested which captures both time value of money and risk
premium.
The value of a business can be basically linked to three major factors
• Current operations - how is the operating performance of the firm in recent year?
• Future prospects - what is the long-term, strategic direction of the company?
• Embedded risk - what are the business risks involved in running the business?
These factors are solid concepts; however, the quick turnover of technologies and rapid
globalization make the business environment more dynamic. As a result, defining value and
identifying relevant drivers became more arduous as time passes by. As firms continue to
quickly evolve and adapt to new technologies, valuation of current operations becomes more
difficult as compared to the past. Projecting future macroeconomic indicators also is harder
because of constant changes in the economic environment and the continuous innovation of
market players. New risks and competition also surface which makes determining uncertainties
a critical ingredient to success.
The definition of value may also vary depending on the context and objective of the valuation
exercise.
• Intrinsic value
Intrinsic value refers to the value of any asset based on the assumption that there is a
hypothetical complete understanding of its investment characteristics. Intrinsic value is the
value that an investor considers, on the basis of an evaluation of available facts, to be the "true"
or "real" value that will become the market value when other investors reach the same
conclusion. As obtaining complete information about the asset is impractical, investors
normally estimate intrinsic value based on their view of the real worth of the asset. If the
assumption is that the true value of asset is dictated by the market, then intrinsic value equals
its market price.
Unfortunately, this is not always the case. The Grossman - Stiglitz paradox states that
if the market prices, which can be obtained freely, perfectly reflect the intrinsic value of an
asset, then a rational investor will not spend to gather data to validate the value of a stock. If
this is the case, then investors will not analyze information about stocks anymore.
Consequently, how will the market price suggest the intrinsic price if this process does not
happen? The rational efficient markets formulation of Grossman and Stiglitz acknowledges
that investors will not rationally spend to gather more information about an asset unless they
expect that there is potential reward in exchange of the effort.
As a result, market price often does not approximate an asset's intrinsic value.
Securities analysts often try to look for stocks which are mispriced in the market and base their
buy or sell recommendations based on these analyses. Intrinsic value is highly relevant in
valuing public shares.
Most of the approaches that will be discussed in this book deal with finding out the
intrinsic value of assets. Financial analysts should be able to come up with accurate forecasts
and determine the right valuation model that will yield a good estimate of a firm's intrinsic
value. The quality of the forecast, including the reasonableness of assumptions used, is very
critical in coming up with the right valuation that influences the investment decision.
• Going Concern Value
Firm value is determined under the going concern assumption. The going concern
assumption believes that the entity will continue to do its business activities into the foreseeable
future. It is assumed that the entity will realize assets and pay obligations in the normal course
of business.
• Liquidation Value
The net amount that would be realized if the business is terminated and the assets are
sold piecemeal. Firm value is computed based on the assumption that entity will be dissolved,
and its assets will be sold individually - hence, the liquidation process. Liquidation value is
particularly relevant for companies who are experiencing severe financial distress. Normally,
there is greater value generated when assets working together are combined with the application
of human capital (unless the business is continuously unprofitable) which is the case for going-
concern assumption. If liquidation occurs, value often declines because the assets no longer
work together, and human intervention is absent.
• Fair Market Value
The price, expressed in terms of cash, at which property would change hands between
a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm's
length in an open and unrestricted market, when neither is under compulsion to buy or sell and
when both have reasonable knowledge of the relevant facts. Both parties should voluntarily
agree with the price of the transaction and are not under threat of compulsion. Fair value
assumes that both parties are informed of all material characteristics about the investment that
might influence their decision. Fair value is often used in valuation exercises involving tax
assessments.
Roles of Valuation in Business
Portfolio Management
The relevance of valuation in portfolio management largely depends on the investment
objectives of the investors or financial managers managing the investment portfolio. Passive
investors tend to be disinterested in understanding valuation, but active investors may want to
understand valuation in order to participate intelligently in the stock market.
• Fundamental analysts - These are persons who are interested in understanding and
measuring the intrinsic value of a firm. Fundamentals refer to the characteristics of an entity
related to its financial strength, profitability or risk appetite. For fundamental analysts, the true
value of a firm can be estimated by looking at its financial characteristics, its growth prospects,
cash flows and risk profile. Any noted variance between the stock's market price versus its
fundamental value indicates that it might be overvalued or undervalued.
Typically, fundamental analysts lean towards long-term investment strategies which
encapsulate the following principles:
o Relationship between value and underlying factors can be reliably measured
o Above relationship is stable over an extended period
o Any deviations from the above relationship can be corrected within a reasonable time
Fundamental analysts can be either value or growth investors. Value investors tend to
be mostly interested in purchasing shares that are existing and priced at less than their true
value. On the other hand, growth investors lean towards growth assets (businesses that might
not be profitable now but has high expected value in future years) and purchasing these at a
discount.
Security and investments analysts use valuation techniques to support the buy / sell
recommendations that they provide to their clients. Analysts often infer market conditions
implied by the market price by assessing this against his own expectations. This allows them
to assess reasonableness and adjust future estimates. Market expectations regarding
fundamentals of one firm can be used as benchmark for other companies which exhibit the
same characteristics.
• Activist investors - Activist investors tend to look for companies with good growth prospects
that have poor management. Activist investors usually do "takeovers" - they use their equity
holdings to push old management out of the company and change the way the company is run.
In the minds of activist investors, it is not about the current value of the company but its
potential value once it is run properly. Knowledge about valuation is critical for activist
investors so they can reliably pinpoint which firms will create additional value if management
is changed. To do this, activist investors should have a good understanding of the company's
business model and how implementing changes in investment, dividend and financing policies
can affect its value.
• Chartists - Chartists relies on the concept that stock prices are significantly influenced by
how investors think and act. Chartists rely on available trading KPIS such as price movements,
trading volume, and short sales when making their investment decisions. They believe that
these metrics imply investor psychology and will predict future movements in stock prices.
Chartists assume that stock price changes and follow predictable patterns since investors make
decisions based on their emotions than by rational analysis. Valuation does not play a huge role
in charting, but it is helpful when plotting support and resistance lines.
• Information Traders - Traders that react based on new information about firms that are
revealed to the stock market. The underlying belief is that information traders are more adept
in guessing or 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.
Under portfolio management, the following activities can be performed through the
use of valuation techniques:
• Stock selection - Is a particular asset fairly priced, overpriced, or underpriced in relation to
its prevailing computed intrinsic value and prices of comparable assets?
• Deducing market expectations - Which estimates of a firm's future performance are in line
with the prevailing market price of its stocks? Are there assumptions about fundamentals that
will justify the prevailing price?
Typically, investors do not have a lot of time to scour all available information in order
to make investment decisions. Instead, they seek the help of professionals to come up with
information that they can use to decide their investments
Sell-side analysts that work in the brokerage department of investment firms issue
valuation judgment that are contained in research reports that are disseminated widely to
current and potential clients. Buy-side analysts, on the other hand, look at specific investment
options and make valuation analysis on these and report to a portfolio manager or investment
committee. Buy-side analysts tend to perform more in-depth analysis of a firm and engage in
more rigorous stock selection methodologies.
In general, financial analysts assist clients to realize their investment goals by
providing them information that will help them make the right decision whether to buy or sell.
They also play a significant role in the financial markets by providing the right information to
investors which enable the latter to buy or sell shares. As a result, market prices of shares
usually better reflect its real value. Since analysts often take a holistic look on businesses, they
somewhat serve a monitoring role for the management to ensure that they make decision that
are in line with the creating value for shareholders.
Analysis of Business Transactions / Deals
Valuation plays a very big role when analyzing potential deals. Potential acquirers use
relevant valuation techniques (whichever is applicable) to estimate value of target firms they
are planning to purchase and understand the synergies they can take advantage from the
purchase. They also use valuation techniques in the negotiation process to set the deal price.
Business deals include the following corporate events:
• Acquisition - An acquisition usually has two parties: the buying firm and the selling firm.
The buying firm needs to determine the fair value of the target company prior to offering a bid
price. On the other hand, the selling firm (or sometimes, the target company) should have a
sense of its firm value to gauge reasonableness of bid offers. Selling firms use this information
to guide which bid offers to accept or reject. On the downside, bias may be a significant concern
in acquisition analyses. Target firms may show very optimistic projections to push the price
higher or pressure may exist to make resulting valuation analysis favorable if target firm is
certain to be purchased as a result of strategic decision.
• Merger - General term which describes the transaction wherein two companies had their
assets combined to form a wholly new entity
• Divestiture - Sale of a major component or segment of a business (e.g., brand or product
line) to another company
• Spin-off - Separating a segment or component business and transforming this into a separate
legal entity.
• Leveraged buyout - Acquisition of another business by using significant debt which uses the
acquired business as a collateral.
Valuation in deals analysis considers two important, unique factors: synergy and control.
• Synergy - potential increase in firm value that can be generated once two firms merge with
each other. Synergy assumes that the combined value of two firms will be greater than the sum
of separate firms. Synergy can be attributable to more efficient operations, cost reductions,
increased revenues, combined products/markets or cross-disciplinary talents of the combined
organization.
• Control - change in people managing the organization brought about by the acquisition. Any
impact to firm value resulting from the change in management and restructuring of the target
company should be included in the valuation exercise. This is usually an important matter for
hostile takeovers.
Corporate Finance
Corporate finance involves managing the firm's capital structure, including funding
sources and strategies that the business should pursue to maximize firm value. Corporate
finance deals with prioritizing and distributing financial resources to activities that increases
firm value. The ultimate goal of corporate finance is to maximize the firm value by appropriate
planning and implementation of resources, while balancing profitability and risk appetite.
 Small private businesses that need additional money to expand use valuation concepts
when approaching private equity investors and venture capital providers to show the promise
of the business. The ownership stake that these capital providers will ask from the business in
exchange of the money that they will put in will be based on the estimated value of the small
private business.
Larger companies who wish to obtain additional funds by offering their shares to the
public also need valuation to estimate the price they are going to fetch in the stock market.
Afterwards, decision regarding which projects to invest in, amount to be borrowed and dividend
declarations to shareholders are influenced by company valuation.
Corporate finance ensures that financial outcomes and corporate strategy drives
maximization of firm value. Current business conditions push business leaders to focus on
value enhancement by looking at the business holistically and focus on key levers affecting
value in order to provide some level of return to shareholders.
Firms that are focused on maximizing shareholder value uses valuation concepts to
assess impact of various strategies to company value. Valuation methodologies also enable
communication about significant corporate matters between management, shareholders,
consultants and investment analysts.
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.

Legal and Tax Purposes

Valuation is also important to businesses because of legal and tax purposes. For
example, if a new partner will join a partnership or an old partner will retire, the whole
partnership should be valued to identify how much should be the buy-in or sell-out. This is also
the case for businesses that are dissolved or liquidated when owners decide so. Firms are also
valued for estate tax purposes if the owner passes away.
Other Purposes
• Issuance of a fairness opinion for valuations provided by third party (e.g., investment bank)
• Basis for assessment of potential lending activities by financial institutions
• Share-based payment/compensation

Valuation Process
Generally, the valuation process considers these five steps:
Understanding of the business
Understanding the business includes performing industry and competitive analysis and
analysis of publicly available financial information and corporate disclosures. Understanding
the business is very important as these give analysts and investors the idea about the following

Competitive position refers to how the products, services and the company itself is set apart
from other competing market players. Competitive position is typically gauged using the
prevailing market share level that the company enjoys. Generally, a firm's value is higher if it
can consistently sustain its competitive advantage against its competitors. According to
Michael Porter, there are generic corporate strategies to achieve competitive advantage:
• Cost leadership
It relates to the incurrence of the lowest cost among market players with quality that is
comparable to competitors allow the firm to price products around the industry average.
• Differentiation
Firms tend to offer differentiated or unique product or service characteristics that
customers are willing to pay for an additional premium.
• Focus
Firms are identifying specific demographic segment or category segment to focus on
by using cost leadership strategy (cost focus) or differentiation strategy (differentiation focus).
Aside from industry and competitive landscape, understanding the company's business model
is also important. Business model pertains to the method how the company makes money -
what are the products or services they offer how they deliver and provide these to customers
and their target customers. Knowing the business model allows analysts to capture the right
performance drivers that should be included in the valuation model.
The results of execution of aforementioned strategies will ultimately be reflected in the
company performance results contained in the financial statements. Analysts look at the
historical financial statements to get a sense of how the company performed. There is no hard
rule on how long the historical analysis should be done. Typically, historical financial
statements analysis can be done for the last two years up to ten years prior - as long as there is
available information Looking at the past ten years may give an idea how resilient the company
in the past and how they reacted to problems they encountered along the way.
Analysis of historical financial reports typically use horizontal, vertical and ratio analysis. More
than the computation, these numbers should be related year-on-year to give a sense on how the
company performed over the years These can be benchmarked against other market players or
the industry average to understand how the firm fared. Some information can also be compared
against stated objectives of the organization - such as sales growth, gross margin ratios or profit
targets.
Typical sources of information about companies can be found in government-mandated
disclosures like audited financial statements. If the firm is publicly listed, regulatory filings,
company press releases and financial statements can be easily accessed in the stock exchange.
Investor relation materials that company 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 or 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 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 through significant accrual entries. Typical observations that analysts can derive
from financial statements are listed below:

Based on AICPA guidance, other red flags that may indicate aggressive accounting include the
following:
• Poor quality of accounting disclosures, such as segment information, acquisitions, accounting
policies and assumptions, and a lack of discussion of negative factors.
• Existence of related-party transactions or excessive officer, employee, or director loans.
• Reported (through regulatory filings) disputes with and/or changes in auditors.
• Material non-audit services performed by audit firm.
• Management and/or directors' compensation tied to profitability or stock price (through
ownership or compensation plans)
• Economic, industry, or company-specific pressures on profitability, such as loss of market
share or declining margins.
• High management or director turnover.
• Excessive pressure on company personnel to make revenue or earnings targets, particularly
when management team is aggressive
• Management pressure to meet debt covenants or earnings expectations.
• A history of securities law violations, reporting violations, or persistent late filings.
Forecasting financial performance
After understanding how the business operates and analyzing historical financial
statements, forecasting financial performance is the next step. Forecasting financial
performance can be looked at two lenses: (a) on a macro perspective viewing the economic
environment and industry where the firm operates in and (b) on a micro perspective focusing
in the firm's financial and operating characteristics. Forecasting summarizes the future-looking
view which results from the assessment of industry and competitive landscape, business
strategy and historical financials. This can be summarized in two approaches:
• Top-down forecasting approach - Forecast starts from international or national
macroeconomic projections with utmost consideration to industry-specific forecasts. From
here, analysts select which are relevant to the firm and then applies this to the firm and asset
forecast. In top-down forecasting approach, the most common variables include GDP forecast,
consumption forecasts, inflation projections, foreign exchange currency rates, industry sales
and market share. A result of top-down forecasting approach is the forecasted sales volume of
the company. Revenue forecast will be built from this combined with the company-set sales
prices.
• Bottom-up forecasting approach - Forecast starts from the lower levels of the firm
and is completed as it captures what will happen to the company based on the inputs of its
segments/units. For example, store expansions and increase in product availability is collated
and revenues resulting from these are calculated. Inputs from various segments are consolidated
until company-level revenues is determined.
Insights compiled during the industry, competitive and business strategy analysis about the firm
should be considered in this phase when forecasting for the firm's sales, operating income and
cash flows. Comprehensive understanding of these items is critical to forecast reasonable
numbers. Qualitative factors, albeit subjective, are considered in the forecasting process in
order to make valuation approximate the true reality of the firm. Assumptions should be driven
by informed judgment based on the understanding of the business.
Forecasting should be done comprehensively and should include earnings, cash flow and
balance sheet forecast. Comprehensive forecasting approach prevents any inconsistent figures
between the prospective financial statements and unrealistic assumptions. The approach
considers that analysis should done per line item as each item can be influenced by a different
business driver. Similar with short-term budgeting, forecasting process starts with the
determining sales growth and revenue projections of the business.
Forecasting process should also consider industry financial ratios as this gives an idea how the
industry is operating. From this, analysts should be able to explain reasons why firm-specific
ratios will deviate from this. Knowledge of historical financial trends is also important as this
can give guidance how prospective trends will look like. Similarly, any deviations from noted
historical trends should be carefully explained to ensure reasonableness.
Typically, sales and profit numbers should consistently move in the future based on current
trends if there is no significant information that will prove otherwise.
The results of forecasts should be compared with the dynamics of the industry where the
business operates and its competitive position to make sure that the numbers make sense and
reflect the most reliable view of how the business operates. Even though general economic and
market trends can be used as reliable benchmark, analysts should consider that there might be
unique factors that affect company prospects that can be used as guidance in the forecasting
process
Typically, forecasts are done on annual basis as most publicly available financial information
are interpreted on an annual basis. Where applicable, forecasts can be better done on a quarterly
basis to account for seasonality. Seasonality affects sales and earnings of almost all industry.
For example, airline companies tend to have peak sales during summer season and holiday
seasons while lean sales during rainy months. Developing earnings forecast while considering
seasonality can give a more reasonable estimate.
Selecting the right valuation model
The appropriate valuation model will depend on the context of the valuation and the
inherent characteristics of the company being valued. Details of these valuation models and the
circumstances when they should be used will be discussed in succeeding chapters.
Preparing valuation model based on forecasts
Once the valuation model is decided, the forecasts should now be inputted and
converted to the chosen valuation model. This step is not only about manually encoding the
forecast to the model to estimate the value (which is the job of Microsoft Excel). More so,
analysts should consider whether the resulting value from this process makes sense based on
their knowledge about the business. To do this, two aspects should be considered:
• Sensitivity analysis
It is a common methodology in valuation exercises wherein multiple analyses are done
to understand how changes in an input or variable will affect the outcome (i.e., firm value).
Assumptions that are commonly used as an input for sensitivity analysis exercises are sales
growth, gross margin rates and discount rates. Aside from these, other variables (like market
share, advertising expense, discounts, differentiated feature, etc.) can also be used depending
on the valuation problem and context at hand.
• Situational adjustments or Scenario Modelling
For firm-specific issues that affect firm value that should be adjusted by analysts. In
some instances, there are factors that do not affect value per se when analysts only look at core
business operations but will still influence value regardless. This includes control premium,
absence of marketability discounts and illiquidity discounts. Control premium refers to
additional value considered in a stock investment if acquiring it will give controlling power to
the investor. Lack of marketability discount means that the stock cannot be easily sold as there
is no ready market for it (e.g., non publicly traded discount). Illiquidity discount should be
considered when the price of particular shares has less depth or generally considered less liquid
compared to other active publicly traded share. Illiquidity discounts can also be considered if
an investor will sell large portion of stock that is significant compared to the trading volume of
the stock. Both lack of marketability discount and illiquidity 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 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 future cash flows
Transferability of future cash flows is also important especially to potential
acquirers. Business with good value can operate even without owner intervention.
If a firm's survival depends on owner's influence (e.g., owner maintains customer
relationship or provides certain services), this value might not be transferred to the
buyer, hence, this will reduce firm value. In such cases, value will only be limited
to net tangible assets that can be transferred to the buyer VI. Value is impacted by
liquidity This principle is mainly dictated by the theory of demand and supply. If
there are many potential buyers with less acquisition targets, value of the target
firms may rise since the buyers will express more interest to buy the business.
Sellers should be able to attract and negotiate potential purchases to maximize
value they can realize from the transaction.
Risks in Valuation
In all valuation exercises, uncertainty will be consistently present Uncertainty refers to
the possible range of values where the real firm value lies. When performing any valuation
method, analysts will never be sure if they have accounted and included all potential risks that
may affect price of assets Some valuation methods also use future estimates which bear the risk
that what will actually happen may be significantly different from the estimate.
Value consequently may be different based on new circumstances. Uncertainty is
captured in valuation models through cost of capital or discount rate.
Another aspect that contributes to uncertainty is that analysts use their judgments to
ascertain assumptions based on current available facts. Even if risk adjustments are made, this
cannot 100% ascertain the value will be perfectly estimated. Constant changes in market
conditions may hinder the investor from realizing any expected value based on the valuation
methodology.
Performance of each industry can also be characterized by varying degrees of
predictability which ultimately fuels uncertainty. Depending on the industry, they can be very
sensitive to changes in macroeconomic climate (investment goods, luxury products) or not at
all (food and pharmaceutical).
Innovations and entry of new businesses may also bring uncertainty to established and
traditional companies. It does not mean that a business that has operated for 100 years will
continue to have stable value. If a new company arrives and provides a better product that
customers will patronize, this can mean trouble. Typically, businesses manage uncertainty to
take advantage of possible opportunities and minimize impact of unfavorable events. This
influences management style, reaction to changes in economic environment and adoption of
innovative approaches to doing business. Consequently, these dynamic approaches also
contribute to the uncertainty to all players in the economy.