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 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.
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.

ORTER’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 players or
Industry
competitors (i.e. higher concentration) which means higher potential for
rivalry
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, thus,
New
lesser competition which improves profitability potential. New entrants
Entrants
include entry costs, speed of adjustment, economies of scale, reputation
switching costs, sunk costs and government restraints.

This refers to the relationships between interrelated products and services

Substitut in the industry. Availability of substitute products (products that can replace
es and the sale of an existing product) or complementary products (products that
Comple can be used together with another product) affects industry profitability. This
ments consider prices of substitute products/services, complement
products/services and government limitations.

Supplier Supplier power refers to how suppliers can negotiate better terms in their
Power favor. When there is strong supplier power, this tends to make industry
 profits lower. Strong supplier power exists if there are few suppliers that can
supply a specific input. Supplier power also considers supplier
concentration, prices of alternative inputs, relationship-specific investments,
supplier switching costs and governmental regulations.

Buyer power 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
Buyer market players are not dependent to few customers to survive. Low buyer
Power 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.

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, 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
Possible Observation Possible Interpretation
Item

Early recognition of revenues

Accelerated revenue recognition
 (e.g. bill-and-hold sales, sales improves income and can be used to
Reve
recognition prior to installation and hide declining performance
nues
acceptance of customer)
and
gain Nonrecurring gains that do not relate to
Inclusion of nonoperating income or
operating performance may hide
gains as part of operating income
declining performance.

Expe Recognition of too high or too little Too little reserves may improve current
nses reserves (e.g. restructuring, bad year income but might affect future
and debts) income (and vice versa)
 Deferral of expenses such as May improve current income but will
customer acquisition or product reduce future income. May hide declining
development costs by capitalization performance.

Losse Aggressive estimates may imply that

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

Balan Off-balance sheet financing (those

ce not reflected in the face of the Assets/liabilities may not be fairly
sheet balance sheet) like leasing or reflected.
items securitizing receivables

Oper
ating Increase in bank overdraft as Potential artificial inflation in operating
cash operating cash flow cash flow.
flows

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