lOMoARcPSD|17961778

Chapter 1 Fundamental Principles of Valuation

Auditing Theory (Centre For Accounting Studies)

StuDocu is not sponsored or endorsed by any college or university

Downloaded by Mae ann Lomugda (maeann2929@gmail.com)
 lOMoARcPSD|17961778

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 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

Downloaded by Mae ann Lomugda (maeann2929@gmail.com)

 lOMoARcPSD|17961778

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

Downloaded by Mae ann Lomugda (maeann2929@gmail.com)

 lOMoARcPSD|17961778

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

Downloaded by Mae ann Lomugda (maeann2929@gmail.com)

 lOMoARcPSD|17961778

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

Downloaded by Mae ann Lomugda (maeann2929@gmail.com)

 lOMoARcPSD|17961778

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.

Downloaded by Mae ann Lomugda (maeann2929@gmail.com)

 lOMoARcPSD|17961778

Legal and Tax Purposes

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

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

Valuation Process

Generally, the valuation process considers these five steps:

Understanding of the business

Understanding the business includes performing industry and competitive analysis and analysis of publicly
available financial information and corporate disclosures. Understanding the business is very important as
these give analysts and investors the idea about the following factors: economic conditions, industry
peculiarities, company strategy and company's historical performance. The understanding phase enables
analysts to come up with appropriate assumptions which reasonably capture the business realities affecting
the firm and its value.
Frameworks which capture industry and competitive analysis already exist and are very useful for analysts.
These frameworks are more than a template that should be filled out: analysts should use these
frameworks to organize their thoughts about the industry and the competitive environment and how these
relates to the performance of the firm they are valuing. The industry and competitive analyses should
emphasize which factors affecting business will be most challenging and how should these be factored in
the valuation model.
Industry structure refers to the inherent technical and economic characteristics of an industry and the
trends that may affect this structure. Industry characteristics means that these are true to most, if not all,
market players participating in that industry. Porter's Five Forces is the most common tool used to
encapsulate industry structure.

Downloaded by Mae ann Lomugda (maeann2929@gmail.com)

 lOMoARcPSD|17961778

PORTER’S FIVE FORCES

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 (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 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

Substitutes and Complements
products and services in the industry. Availability of
substitute products (products that can replace the
sale of an existing product) or complementary
products (products 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
Supplier Power 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 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
Buyer Power players are not dependent to few customers to
survive. Low buyer power tends to improve
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.

Downloaded by Mae ann Lomugda (maeann2929@gmail.com)

 lOMoARcPSD|17961778

Competitive position refers to how the products, services and the company itself is set apart from other
competing market players. Competitive position is typically gauged using the prevailing market share level
that the company enjoys. Generally, a firm's value is higher if it can consistently sustain its competitive
advantage against its competitors. According to Michael Porter, there are generic corporate strategies to
achieve competitive advantage:
 Cost leadership
It relates to the incurrence of the lowest cost among market players with quality that is comparable
to competitors allow the firm to price products around the industry average.
 Differentiation
Firms tend to offer differentiated or unique product or service characteristics that customers are
willing to pay for an additional premium.
 Focus
Firms are identifying specific demographic segment or category segment to focus on by using cost
leadership strategy (cost focus) or differentiation strategy (differentiation focus).

Aside from industry and competitive landscape, understanding the company's business model is also
important. Business model pertains to the method how the company makes money - what are the products
or services they offer how they deliver and provide these to customers and their target customers. Knowing
the business model allows analysts to capture the right performance drivers that should be included in the
valuation model.
The results of execution of aforementioned strategies will ultimately be reflected in the company
performance results contained in the financial statements. Analysts look at the historical financial
statements to get a sense of how the company performed. There is no hard rule on how long the historical
analysis should be done. Typically, historical financial statements analysis can be done for the last two
years up to ten years prior - as long as there is available information Looking at the past ten years may give
an idea how resilient the company in the past and how they reacted to problems they encountered along
the way.
Analysis of historical financial reports typically use horizontal, vertical and ratio analysis. More than the
computation, these numbers should be related year-on-year to give a sense on how the company
performed over the years These can be benchmarked against other market players or the industry average
to understand how the firm fared. Some information can also be compared against stated objectives of the
organization - such as sales growth, gross margin ratios or profit targets.

Typical sources of information about companies can be found in government-mandated disclosures like
audited financial statements. If the firm is publicly listed, regulatory filings, company press releases and
financial statements can be easily accessed in the stock exchange. Investor relation materials that
companies issue can also be accessed in their websites. Other acceptable sources of information include
news articles, reports from industry organization, reports from regulatory agencies and industry researches
done by independent firms such as Nielsen or Euromonitor Ethically, analysts should only use information
that are made publicly available (via government filings 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,

Downloaded by Mae ann Lomugda (maeann2929@gmail.com)

 lOMoARcPSD|17961778

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:

Line Item Possible Observation Possible Interpretation

Early recognition of revenues Accelerated revenue recognition

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

Inclusion of nonoperating income Nonrecurring gains that do not

or gains as part of operating relate to operating performance
income may hide declining performance.

Recognition of too high or too Too little reserves may improve

little reserves (e.g. restructuring, current year income but might
bad debts) affect future income (and vice
versa)

Deferral of expenses such as May improve current income but

customer acquisition or product will reduce future income. May
Expenses and Losses development costs by hide declining performance.
capitalization

Aggressive assumptions such as Aggressive estimates may imply

long useful lives, lower asset
impairment, high assumed
discount rate for pension
liabilities or high expected return
on plan assets
that there are steps taken to
improve current year income.
Sudden changes in estimates
may indicate masking of potential
problems in operating
performance.

Off-balance sheet financing Assets/liabilities may not be fairly

Balance sheet items (those not reflected in the face of reflected.
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.

Downloaded by Mae ann Lomugda (maeann2929@gmail.com)

 lOMoARcPSD|17961778

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.

Downloaded by Mae ann Lomugda (maeann2929@gmail.com)

 lOMoARcPSD|17961778

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.

Downloaded by Mae ann Lomugda (maeann2929@gmail.com)

 lOMoARcPSD|17961778

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.

Downloaded by Mae ann Lomugda (maeann2929@gmail.com)

 lOMoARcPSD|17961778

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

Downloaded by Mae ann Lomugda (maeann2929@gmail.com)