FUNDAMENTALS PRINCIPLES OF VALUATION
cash inflows generated by an investment and the cost associated with the
Assets, individually or collectively has value.
Value - pertains to the worth of an object in another person's point of view.
Any kind of asset can be valued, though the degree of effort needed may vary on
a case-to-case basis Methods to value for real estate can may be different on how
to value an entire business.
• Businesses treat capital as a scarce resource that they should Compete to
obtain and efficiently manage.
• Since capital is scarce, capital providers require users to ensure that they will
be able to maximize shareholder returns to justify providing capital to them.
Otherwise, capital providers will look and bring money to other investment
opportunities that are more attractive.
• Hence, the most fundamental principle for all investments and business is to
maximize shareholder value.
• Maximizing value for businesses consequently result in a domino impact to the
economy. Growing companies provide long term sustainability to the economy
by yielding higher economic output, better productivity gains, employment
growth and higher salaries. Placing scarce resources in their most productive
use best serves the interest of different stakeholders in the country.
• The fundamental point behind success in investments is understanding what is
the prevailing value and the key drivers that influence this value.
• Increase in value may imply that shareholder capital is maximized, hence,
fulfilling the promise to capital providers. This is where valuation steps in.
Valuation - According to the CFA institute, 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.
- 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.
- 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
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 -
- refers to the value of any asset based on the assumption that there is a hypothetical
complete understanding of its investment characteristics.
- 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 not rationally
spend to gather more information about an asset unless they expect that there js
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.
- 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 analysis
- These are persons who are interested in understanding and measuring the intrinsic
value of a firm. Fundamentals re er o e 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:
✓ Relationship between value and underlying factors can be reliably measured.
✓ Above relationship is stable over an extended period.
✓ Any deviations from the above relationship can be Corrected within a reasonable
time.
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.
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.
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
- tend to look for companies with good growth prospects that have poor 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
- relies on the concept that stock prices are significantly influenced by how
investors think and act.
- 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.
 - 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.
- 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.
- 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
- involves managing the firm's capital structure, including funding sources and
strategies that the business should pursue to maximize firm value.
- 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
- includes performing industry and competitive analysis and analysis of publicly
available financial information and corporate disclosures.
- 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. Porters Five Forces is the most common tool used to
encapsulate industry structure.
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 players or competitors (i.e., higher
Industry rivalry 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, thus, lesser competition which improves
New Entrants
profitability potential. New entrants include entry costs, speed
of adjustment, economies of scale, reputation, switching costs,
sunk costs and government restraints.
This refers to the relationships between interrelated products
and services in the industry. Availability of substitute
products (products that can replace the sale of an existing
Substitutes and
product) or complementary products (products that can be used
Complements
together with another product) affects industry profitability. This
considers 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
Supplier Power 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, Analysis of historical financial reports typically use horizontal, vertical and ratio
supplier switching costs and governmental regulations. analysis. More than the computation, these numbers should be related year-on-year
Buyer power better pertains terms to in how their customers to give a sense on how the company performed over the years. These can be
favor for can the negotiate products/services they purchase. benchmarked against other market players or the industry average to understand
Typically buying power is low if customers are fragmented and how the firm fared. Some information can also be compared against stated objectives
concentration is low This means that market players are not of the organization — such as sales growth, gross margin ratios or profit targets.
dependent to few customers to survive Low buyer power tends
Buyer Power Typical sources of information about companies can be found in government
to improve industry; negotiate profits since to buyers cannot of
the significantly product lower price other factors considered in mandated disclosures like audited financial statements. If the firm is publicly listed,
buyer power include buyer concentration, value of substitute regulatory filings, company press releases and financial statements can be easily
products that buyers can purchase, customer switching costs accessed in the stock exchange. Investor relation materials that company issue can
and government restraints. also be accessed in their websites. Other acceptable sources of information include
news articles, reports from industry organization, reports from regulatory agencies and
Competitive position industry researches done by independent firms such as Nielsen or Euromonitor.
- refers to how the products, services and the Company itself is set apart from other Ethically, analysts should only use information that are made publicly available (via
competing market players. government filings or press releases). Analysts should avoid using material inside
- is typically gauged using the prevailing market share level that the company enjoys. information as this gives undue disadvantage to other investors that do not have
Generally, a firm's value is higher if it can consistently sustain its competitive access to the information.
advantage against its competitors. According to Michael Porter, there are generic
corporate strategies to achieve competitive advantage: 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
• Cost leadership statements and accompanying notes to assess sustainability of company
- It relates to the incurrence of the lowest cost among market players with quality that performance and validate accuracy of financial information versus economic reality.
is comparable to competitors allow the firm to price products around the industry During analysis, transactions that are nonrecurring such as financial impact of
average. litigation settlements, temporary tax reliefs or gains/losses on sales of nonoperating
assets might need to be adjusted to arrive at performance of the firm's core
• Differentiation business.
- Firms tend to offer differentiated or unique product or service characteristics that
customers are willing to pay for an additional premium. Quality of earnings analysis also compares net income against operating cash flow
to make sure reported earnings are actually realizable to cash are not padded
through significant accrual entries. Typical observations analysts can derive from
• Focus
financial statements are listed below:
- Firms are identifying specific demographic segment or category segment to focus
on by using cost leadership strategy (cost focus) or differentiation strategy
(differentiation focus)
Line item Possible observation Possible
interpretation
Aside from industry and competitive landscape. understanding the company's
Early recognition of revenue Accelerated revenue
business model is also important. Business model pertains to the method how the
(e.g. bill-and-hold sales, recognition improves
company makes money what are the products or services they offer, how they
sales recognition prior to income and can be used
deliver and provide these to customers and their target customers. Knowing the
installation and acceptance to hide declining
business model allows analysts to capture the right performance drivers that should
Revenues of customer) performance
be included in the valuation model.
and gains Nonrecurring gains that
The results of execution of aforementioned strategies will ultimately be reflected in Inclusion of nonoperating do not relate to operating
the company performance results contained in the financial statements Analysts income or gains as part of performance may hide
look at the historical financial statements to get a sense of how the company operating income declining performance.
performed. There is no hard rule on how long the historical analysis should be done.
Recognition of too high or Too little reserves may
Typically, historical financial statements analysis can be done for the last two
too little reserves fosses too improve current year
years up to ten years prior — as long as there is available information, looking at the Expenses
little reserves (e.g. may income but might affect
past ten years may give an idea how resilient the company in the past and how they and losses
improve current future income (and vice
reacted to problems they encountered along the way.
restructuring, bad debts) versa)
 Deferral of expenses such
as customer acquisition or
product development costs
by capitalization
Aggressive assumptions
such as long useful lives,
lower asset impairment, high
assumed discount rate for
pension liabilities. or high
expected return on plan
assets.
Off-balance sheet financing
(those not reflected in the
Balance
face of the balance sheet)
sheet items
like leasing or securitizing
receivables
Operating Increase in bank overdraft
cash flows as operating cash flow
Based on AICPA guidance, other red flags that may indicate aggressive accounting
include the following:
May improve current
income but will reduce
future income. May hide
declining performance.
Aggressive estimates
may imply that there are
steps taken to improve
current year income.
Sudden changes in
estimates may indicate
masking of potential
problems in operating
performance.
Assets/liabilities may not
be fairly reflected.
Potential artificial inflation
in operating cash flow.
(b) on a micro perspective focusing in the firm's and operating which results
characteristics from the Forecasting assessment summarizes of industry the
and 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 [t 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-lever revenues is determined.

• 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
- can be looked at two lenses:
(a) on a macro perspective viewing the economic environment and industry
where the firm operates in and
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 safes,
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 fine 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 mode/ 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 (which is the job of Microsoft
resulting value from this 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,
context etc.) can at hand. Also be used depending on the valuation problem and
• 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.
- 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.
- include cash generated from operations and reductions that are related to
capital investments, working capital and taxes.
- will depend on the estimates of future performance of the business and strategies in
place to support this growth. Historical information can provide be a good starting
point when projecting future cash flows.
III. Market dictates the appropriate rate of return for investors
Market forces are constantly changing, and they normally provide guidance of
what rate of return should investors expect from different investment vehicles in
the market. Interaction of market forces may differ based on type of industry and
general economic conditions. Understanding the rate of return dictated by the
 market so they can capture the right discount rate to be used for valuation. This
can influence their decision buy or sell investments.
IV. Firm value can be impacted by underlying net tangible assets
Business valuation principles look at the relationship between operational value
of an entity and net tangible of its assets Theoretically, firms with higher underlying
net tangible asset value are more stable and results in higher going concern value.
This is the result of presence of more assets that can be used as security during
financing acquisitions or even liquidation proceedings in case bankruptcy occurs.
Presence of sufficient net tangible assets can also support the forecasts on future
operating plans of the business.
V. Value is influenced by transferability of future cash flows
Transferability of future cash flows is also important especially to potential
acquirers. Business with good value can operate even without owner intervention.
If a firm's survival depends on owners influence (e.g. owner maintains customer
relationship or provides certain services). this value might not be 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.
Risk in Valuation
- In all valuation exercises, uncertainty will be consistently present. Uncertainty 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 and included all potential
risks that may affect price of assets. valuation methods also use future estimates
which bear the risk that 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.
SUMMARY
Valuation is the estimation of an asset's value based on variables perceived to be
related to future investment returns, on comparisons with similar assets or, when
relevant, on estimates of immediate liquidation proceeds. Definition of value may
vary depending on the context. Different definitions of value include intrinsic value,
going concern value, liquidation value and fair market value.
Valuation plays significant role in the business world with respect to portfolio
management, business transactions or deals, corporate finance, legal and tax
purposes.
Generally, valuation process involves these five steps:
1. understanding of the business,
2. forecasting financial performance,
3. selecting right valuation model preparing valuation model based on forecasts
and,
4. applying conclusions and,
5. providing recommendations.
Key principles in valuation includes the following:
• Value is defined at a specific point in time
• Value varies based on ability of business to generate future cash flows
• Market dictates appropriate rate of return for investors
• Value can be impacted by underlying net tangible assets
• Value is influenced by transferability of future cash flows
• Value is impacted by liquidity