VALUATION CONCEPT AND

METHODOLOGIES

Jammilon A. Montila
BSA – 3rd Year

1. ROLES OF VALUATION IN BUSINESS

Portfolio Management
The investment goals of the investors or financial managers managing the investment
portfolio heavily influence the value of valuation in portfolio management. Active investors
might desire to understand valuation in order to engage wisely in the stock market,
whereas passive investors typically have little interest in doing so.

 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:
- 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. 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. 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 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,
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 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.

2. PORTER’S FIVE FORCES

Refers to the nature and intensity
of rivalry between market players
in the industry. Rivalry is less
INDUSTRY RIVALRY intense if there is lower number of
market players or competitors (1.e.
higher concentration) which
means higher potential for
industry profitability. This
considers concentration of market
players, degree of differentiation,
switching costs, information and
restraint.
Refers to the barriers to entry to
industry by new market players. If
there are relatively high entry
costs, this means there are fewer
 NEW ENTRANTS new entrants, thus, lesser
competition which improves
profitability potential. New
entrants include entry costs,
speed of adjustment, economies of
scale, reputation, switching costs,
sunk costs. and government
restraints.
This refers to the relationships
between interrelated products and
services in the industry.
Availability of substitute products
(products that can replace the sale
SUBSTITUES AND COMPLEMENTS of an existing product)
complementary or products
(products that can be used
together with another product)
affects industry profitability. This
consider prices of substitute
products/services, complement
products/services and government
limitations.
Supplier power refers to how
suppliers can negotiate better
terms in their favor. When there is
SUPPLIER POWER 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
BUYER POWER products/services they purchase.
Typically, buying power is low if
customers are fragmented and
concentration is low. This means
that market players are not
dependent to few customers to
survive. Low buyer power tends to
improve industry profits since
buyers cannot significantly
negotiate to lower price of the
product. Other factors considered
 in buyer power include buyer
concentration, value of substitute
products that buyers can
purchase, customer switching
costs and government restraints.

3. KEY PRINCIPLES OF VALUATION

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 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 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 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
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.
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.