Overview of Valuation stocks and bonds; tangible assets like

Valuation refers to the process of determining buildings and equipment; or intangible assets
the present value of a company or an asset. It like brands, trademarks or patents.
can be done using a number of techniques.
Analysts that want to place value on a Equity Valuation
company normally look at the management of Equity valuation is a general term which is
the business, the prospective future earnings, used to refer to all tools and techniques used
the market value of the company’s assets, and by investors to find out the true value of a
its capital structure composition. company’s equity.
“Price is what you get, value is what you It is often seen as the most crucial element of a
get.” – Warren Buffet successful investment decision. Every
participant in the stock market either directly or
Valuation Used in Securities indirectly makes use of equity valuation while
Valuation may also be used in determining a making investment decisions.
security’s fair value, which depends on the The users of equity valuation are the small
amount that a buyer is ready to pay a seller, individual investors who make up the vast
with the assumption that both parties will enter majority of stock market investors, the
the transaction. government and institutional investors and
During the trade of a security on an exchange, entities that hedge funds.
sellers and buyers will dictate the market value
of a bond or stock. However, intrinsic value is a Maximizing Shareholder Value
concept that refers to a security’s perceived Shareholder value increases when a company
value on the basis of future earnings or other earns a higher return in its invested capital
attributes of the entity that are not related to a than the capital's cost, creating profit.
security’s market value.
Therefore, the work of analysts when doing
valuation is to know if an asset or a company is
undervalued or overvalued by the market.

Uses of Valuation
Valuations can be performed on assets or on
liabilities such as company bonds.
They are required for a number of reasons
including merger and acquisition transactions,
capital budgeting, investment analysis,
litigation, and financial reporting.
Earnings Per Share (EPS)
Asset Valuation Earnings per share demonstrate how profitable
This pertains to the value assigned to a a company is by measuring the net income for
specific property when a company or asset is each outstanding share of the company. For
to be sold, insured, or taken over. The assets shareholders, EPS is an indication of how well
may be categorized into tangible and intangible a company is performing as it represents the
assets. bottom line of a company on a per-share basis.
Asset valuation is the process of determining The EPS figure does not reflect the cash that
the fair market or present value of assets, shareholders receive, however. It is only an
using book values, absolute valuation models accounting figure.
or comparables. The assets may include
investments in marketable securities like
 businesses that have recently been sold or
acquired in the same industry.
These transaction values include the take-over
premium included in the price for which they
were acquired.

Valuation Methods Leverage Buyout

When valuing a company as a going concern, A leveraged buyout model, or an LBO, is a
there are three main valuation methods used type of company acquisition where total
by industry practitioners: acquisition proceeds are financed with a
1. DCF analysis substantial portion of borrowed funds. There
2. Comparable company analysis are two parties involved in a leveraged buyout
3. Precedent transactions – the buyer company & the target company.
In LBO, the acquiring company finance the
acquisition with a mix of equity (usually the
down payment) and debt (for the remaining
balance). The target company’s assets serve
as security or collateral for the debt.

Discounted Cash Flow Analysis

Discounted Cash Flow (DCF) analysis is an
intrinsic value approach where one forecasts
the future business free cash flow and
discounts it back at present day.
It is the most detailed of the three approaches,
requires the most assumptions, and often
produces the highest value which also often
result in the most accurate valuation.

Comparable Company Analysis

Comparable company analysis, also called
trading multiples or public market multiples, is
a relative valuation method in which you
compare the current value of a business to
other similar businesses by looking at trading
multiples like P/E, EV/EBITDA, or other ratios.
Multiples of EBITDA are the most common
valuation method. This is the most widely used
approach, as they are easy to calculate and
always current.

Precedent Transactions
Precedent transactions analysis is where you
compare the subject company to other
 Standards of Value and Research that is, other than in a forced or
liquidation sale.
Purpose of Valuation
Premise of Value
Businesses or their assets
An assumption regarding the most likely set of
• Mergers and acquisitions, financial
transactional circumstances that may be
reporting, reorganizations and
applicable to the subject valuation.
bankruptcies, marital dissolution
There are two premises of value:
Types of businesses
1. Going concern value
• General partnerships, corporations, sole
The value of a business enterprise that
proprietorships
is expected to continue to operate into
Types of interest within each of the
the future.
organizational structures
The intangible elements of going
• 100 percent controlling interest, majority
concern value result from factors such
interests that possess control
as having a trained work force, an
operational plant, and the necessary
Standards of Value
licenses, systems, and procedures in
There are four standards of value:
place.
1. Fair market value (FMV)
2. Liquidation value
 The price at which the property
There are two types of liquidation value,
would change hands between a
orderly liquidation and forced liquidation.
willing buyer and a willing seller,
• Liquidation value at which the asset or
neither being under any compulsion
assets are sold over a reasonable
to buy or to sell and both having
period of time to maximize proceeds
reasonable knowledge of relevant
received.
facts.
• Liquidation value at which the asset or
2. Investment value assets are sold as quickly as possible,
 The value to a particular investor such as at an auction.
based on individual investment
requirements and expectations. Valuation Date
The specific point in time as of which the
3. Intrinsic value valuator’s opinion of value applies (also
 Future dividends are derived from referred to as ‘Effective Date’ or ‘Appraisal
earnings forecasts and then Date’).
discounted to the present, thereby
establishing a present value for the Price and Cost
stock. Price and cost refer to an amount of money
• If a stock is trading at a price asked or actually paid for a property, and this
lower than this calculation, it is a may be more or less than its value.
‘buy’ Furthermore, value is future looking. Although
• If the market price is higher than historical information can be used to set a
the intrinsic value, the stock is a value, the expectation of future economic
‘sell’ benefits is the primary value driver.
4. Fair value (financial reporting)
 The amount at which an asset (or Approaches to Value
liability) could be bought (or incurred) There are only three approaches to value any
or sold (or settled) in a current asset, business or business interest:
transaction between willing parties,
 1. The income approach or some of the company’s operations and by
• Discounted cash flow method or interviewing management.
capitalized cash flow method
2. The market approach
• Apply guideline public company
multiples or multiples
3. The asset approach
• Valuing just tangible assets,
individual intangible assets or all
intangible assets as a collective
group.

Company Valuation Data

Economic Data
Internal Information
Economic data includes information on national
Internal information is generated by the subject
economic conditions and local market
company and includes items such as budgets,
conditions. It encompasses the entire
marketing plans, and projections.
macroeconomic environment, including
Information gathered and prepared by an
demographic and social trends, technological
outside firm specifically for and about the
issues, and the political/regulatory
company is also considered to be internal
environment.
information.
This information may include financial
Economic Research
statements, audit reports, and market
The purpose of economic research is to
analyses.
understand the effects of economic conditions
on the subject company both at the national
External Information
level and at the company’s market level. These
External information is generated by sources
macroeconomic forces are factors over which
outside the subject company, such as trade
the company has no control.
associations, newspapers, and magazines.
Analysts must consider the key external factors
An example of external information would be a
that affect value, such as interest rates,
trade journal article about trends in the subject
inflation, technological changes, dependence
company’s industry.
on natural resources, and legislation.
Obtaining Internal Information
Industry Data
Most valuation engagements begin with the
Industry data should focus on the competitive
collection of data from the subject company.
structure of the industry and its prospects for
Typically, analysts gather information on the
growth. The relative position or market share of
company by reviewing documents, visiting all
the subject company in the market area and
the subject company’s financial performance
as compared to industry standards are
important considerations.

Industry Research
The industry analysis should provide a picture
of where the industry is going and how the
subject company fits in.
Look at historical and projected growth in the
industry, the number and respective market
shares of competitors, and prospects for
consolidation.

Guideline Publicly Traded Company and

Guideline Company Transaction Data
Guideline information is important to
understanding the subject company’s relative
performance. Collecting guideline information
involves identifying companies similar to the
subject company, locating pricing and financial
data, and identifying, if appropriate,
transactions involving the sales of controlling
interests in similar companies.

Evaluate Information
The amount of information available on the
Internet is staggering, and it varies widely in its
accuracy, reliability, and value.
Warning signs include:
• Numbers or statistics presented without an
identified source
• Information you cannot corroborate with other
sources
• Extremist language or sweeping
generalizations
• Conflict of interest between the source and
the material presented
• Undated information or old dates on
information known to change rapidly
 Valuation Analysis • To facilitate a comparison of a given
A well-reasoned valuation analysis includes company to itself, to other companies
certain critical elements: within the same industry, or to an
• An estimation of the amount of future accepted industry standard
economic benefits (normalization and • To compare the debt and/or capital
projection of future cash flows) structure of the company to that of its
• An assessment of the probability that competition or peers
the projected future economic benefits • To compare compensation with industry
will be realized norms

Financial Statement Analysis Normalization of Financial Statements

The process of financial statement analysis, The objective of normalizing historical financial
generally considered to be five steps: statements is to present the data on a basis
1. Spreading historical financial statements comparable to that of other companies in the
in columnar format industry, thereby allowing the analyst to form
2. Normalizing historical financial conclusions as to the strength or weakness of
statements the subject company relative to its peers.
3. Common-sizing normalized historical It can also reflect what a willing buyer would
financial statements expect the operating results to be.
4. Performing ratio analysis on the
normalized historical financial Unusual, Nonrecurring, Extraordinary Items
statements
5. Subjecting normalized historical Unusual items. Events or transactions that
financial statements to industry possess a high degree of abnormality and are
comparison of a type clearly unrelated to, or only
incidentally related to, the ordinary and typical
Adjustments to Financial Statements activities of the entity, taking into account the
An adjustment to historical financial statements environment in which the entity operates.
should be made if the effect of the adjustment Nonrecurring items. Events or transactions
will present more accurately the true operating that are not reasonably expected to recur in the
performance of the enterprise. foreseeable future, taking into account the
Therefore, all appropriate adjustments should environment in which the entity operates.
be made, regardless of whether they reflect Extraordinary items. Events or transactions
positively on the company. Since adjustments that are distinguished by their unusual nature
that are appropriate for one valuation may be and by the infrequency of their occurrence.
inappropriate for another, it is important to Thus, for an item to be classified as an
disclose the key assumptions underlying all extraordinary item, the item must be both an
adjustments. unusual item and a nonrecurring item.
Financial statement adjustments are made for
a variety of reasons, some of which are: Extraordinary Items
• To develop historical earnings from Items representative of the type of adjustments
which to predict future earnings made to historical financial statements for
• To present historical financial unusual, nonrecurring, and extraordinary items
information on a normalized basis, that include:
is, under normal operating conditions • Strikes and other types of work
• To adjust for accounting practices that stoppages (unless common for the
are a departure from industry or GAAP industry)
Standards • Litigation expenses or recoveries
 • Uninsured losses due to unforeseen treatment that minimizes earnings and, hence,
disasters such as fire or flood the corporate tax burden.
• One-time realization of revenues or These choices may mean that, if the financial
expenses due to nonrecurring contracts statements of a private company have not
• Gain or loss on the sale of a business been audited or reviewed, the accounting
unit or business assets practices adopted by management may not be
• Discontinuation of operations in compliance with GAAP.

Nonoperating Items Normalization Adjustments – Balance Sheet

Common examples of nonoperating items 1. Unusual and Nonrecurring Items – None
include: 2. Nonoperating Items
• Excess cash Adjustment #1—Based upon analytical
• Marketable securities (if in excess of review, including comparisons to financial ratio
reasonable needs of the business) benchmark data, it was determined that the
• Real estate (if not used in business Company has excess marketable securities
operations, or, in some situations, if the that exceed the Company’s working capital
business could operate in rented requirements.
facilities) 3. Nonconformance With GAAP
• Private planes, entertainment or sports Adjustment #2—Based upon
facilities (hunting lodge, transferable discussions with management, it was
season ticket contracts, skyboxes, etc.) discovered that the company has not properly
• Antiques, private collections, etc. written off obsolete inventory.
4. Control Adjustment
Change in Accounting Principle Adjustment #3—Based upon appraisals
A change in accounting principle results from of the Company’s land, buildings, and fixed
the adoption of a generally accepted assets, an adjustment has been made to
accounting principle different from the one restate the Company’s fixed assets to reflect
used previously for financial reporting their fair market value.
purposes. Note: Some analysts do not make this
The term “principle” includes not only principles adjustment for comparison purposes since the
and practices but also methods of applying benchmark data that subject companies are
them. compared to do not usually have this
• A change in the method of pricing adjustment made. This is a decision each
inventory, such as LIFO (last in, first out) analyst must make. Also, some analysts make
to FIFO (first in, first out) or FIFO to tax adjustments to the asset values.
LIFO
• A change in the method of depreciating Normalization Adjustments – Income
previously recorded assets, such as Statement
from 1. Unusual and Nonrecurring Items
• straight-line method to accelerated Adjustment #1—Based upon
method or from accelerated method to discussions with management, it was
• straight-line method discovered that the Company was involved in a
lawsuit in 2001 that was determined to be
Nonconformance with GAAP nonrecurring in nature.
Public companies tend to choose accounting 2. Nonoperating Items
treatments that please shareholders with Adjustment #2—Based upon analytical
higher reported earnings. Most closely-held review, it was determined that the Company
business owners tend to elect an accounting has excess marketable securities that exceed
the Company’s working capital requirements. Time series analysis (commonly known as
Income and gains/losses attributable to the trend analysis) compares the company’s ratios
excess marketable securities have been over a specified historical time period and
removed from the income statement. identifies trends that might indicate financial
3. Nonconformance With GAAP – None performance improvement or deterioration.
4. Control Adjustments
Adjustment #3—Based upon Cross-sectional Analysis
discussions with management, it was Cross-sectional analysis compares a specified
discovered that family members of the company’s ratios to other companies or to
Company’s owner were using Company gas industry standards/norms. It is most useful
cards for the purchase and use of gas in their when the companies analyzed are reasonably
personal vehicles for nonbusiness related comparable, i.e., business type, revenue size,
travel. product mix, degree of diversification, asset
Adjustment #4—Based upon size, capital structure, markets served,
discussions with management, it was geographic location, and the use of similar
discovered that country club dues for the accounting methods. It is important to exercise
company’s owner were being paid by the professional judgment in determining which
Company, even though no business meetings ratios to select in analyzing a given company.
were ever conducted at the country club.
Adjustment #5—Based upon analytical
review and discussions with management,
adjustments were made to officers’
compensation, salaries, and payroll taxes in
order to (1) provide for a reasonable level of
compensation for officers, (2) remove payroll
received by the family members of the
Company’s owner who performed no services
for the Company, and (3) remove the payroll
taxes associated with such adjustments.
Adjustment #6—Based upon analytical
review and discussions with management, it
was determined that above market rent was
being paid by the Company for the rental of a
building owned by a related party.

Ratio Analysis
Financial ratios allow the analyst to assess and
analyze the strengths and weaknesses of a
given company with regard to such measures
as liquidity, performance, profitability, leverage
and growth, on an absolute basis and by
comparison to other companies in its industry
or to an industry standard.
Two common types of ratio analyses exist:
time series analysis and cross-sectional
analysis.

Time Series Analysis