Chapter 1AZAEU ile) Ree) tate METHODOLOGIES FUNDAMENTALS 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 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 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 Teasonable 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. RTVALUATION CONCEPTS AND METHODOLOGIES Interpreting Different Concepts of Value > in the corporate setting, the fundamental e principle that Alfred Marshall popularized only if the return on capital invested ex, Value, in the point of view of corporate sh; between cash inflows generated by an i with the capital invested which captures premium. ‘quation of value is grounded on the ~ 4 company creates value if and Ceed the cost of acquiring capital. 'areholders, relates to the difference Investment and the cost associated both time value of money and risk 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 bee “true” or "real" value that will become the market value when es ie investors reach the same conclusion. As es ee information about the asset is impractical, investors es Tae intrinsic value based on their view of the real worth of theSmaneeeros ALUATION CONCEPTS A he true value of asset is dictated by the Market, hat the assumption Se equals its market price. then intrinsic val s the case. The Grossman - Stiglitz Unfortunately. ms f et prices, which can be obtained freely, paradox sialon te intrinsic value of an asset, then a rational investor perfectly refer Paes data to validate the value of a stock. If this is eae Ses will not analyze information about Stocks ee, sonsequently, how will the market price suggest the intrinsic Sea on cess does not happen? The rational efficient Markets, read fo aa and Stiglitz acknowledges that investors will or raionaly 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 hi public shares. ighly relevant in valuing 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 assum) tion 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 and the assets are 5. the assumption that individually Particularly would be realized if the business is terminated Old piecemeal. Firm value is computed based 0" entity will be dissolved, and its assets will be sold ~ hence, the liquidation Process. Liquidation value , relevant for compar who are experi sever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, ex hands _betwe hypothetical and unrestri ‘pressed in terms of cash, at which property would change ‘een a hypothetical willing and able buyer and a willing and able seller, acting at arm’s length in an open icted 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 fong-term investment strategies which encapsulate the following principles:jonship between value and underlying factors o Relation: i sured. reliably ationship is stable over an extended Period ° par aman from the above relationship can be correcteg 1 ° wathin a reasonable time Can be in be either value or growth investors, Value See interested in purchasing shares that are investors ind priced at less than their true value. On the other hand, ee lean towards growth assets (businesses that might ee be profitable now but has high expected value in future years) ang purchasing these at a discount. Security and investments analysts use valuation techniques to Support the buy / sell recommendations that they Provide to their cients. Analysts often infer market conditions implied by the market price by assessing this against his own ©xpectations. 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 Tun. In the minds of activist investors, it is not about the current value Of the company but its potenti it is Knowledge about Valuation is critical for activi 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 aking 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 a by rational analysis. Valuation does not playEPTS AND METHODOLOGIES huge role in Charting, but it is helpful when plotting support and Fesistance lines, Information Traders — Traders that react based on new information about firms th: ‘at 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 feact 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 portfol lio Management, the following activities can be Performed through the u: ‘Se Of valuation techniques: Stock selection - 's a particular asset fairly priced, Overpriced, or underpriced in rel; lation to its Prevailing computed intrinsic value and prices of comparable assets? Deducing market exper Performance are in [i Stocks? Are there ass the Prevailing price? tations — Which estimates of a firm’s future ine with the Prevailing market Price of its ‘umptions about fundamentals that will justify Professionals to come up with information that they investments. Sell-side analysts that work in the brokerage department of investment firms issue valuation judgment that are contained in fesearch 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-si ide analysts tend to perform more in-depth analysis of a firm and engage in more rigorous stock selection methodologies. ial analysts assist clients to realize their investment goals by Se ee reais tel acne este Tight decision whether Providing them They also play a significant role in the financial markets by to ae or i a ight information to investors which enable the latter to buy or providing i flect its real irket prices of shares usually better ret = es a eee take a holistic look on businesses, they somewhat Mees ae srs for the management to ensure that they make decision itorit 7 : ti stare in tine with the creating value for shareholders. alND METHODOLOGIES Analysis of Business Transactions / Deals role when analyzing potential deals. Pote, ti Vauaton pays @ very vauation techniques (whichever is applicable) acquirers use of target firms they are planning to purchase and understang estimate ae can take advantage from the purchase. They also Use ee niques 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 concer 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 fine) 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 ma combined value of two firms will be greater than the sum 7 Separate firms. Synergy can be attributable to more effiOperations, cost reductions, increased revenues, combined Products/markets or cross-disciplinary talents of the com organization. —_ fe * Control — change in people managing the organization broug| abor ut 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 fi 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. im’s capital structure, including ‘Small private businesses that Need additional Money to expand use valuation concepts when @pproaching private equity investors and venture capital low the promise of the business. The Ownership stake that it roviders 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 ensure: drives maximization of fi leaders to focus on val and focus on key lever: to shareholders. 'S that financial outcomes and Corporate strategy im value. Current business Conditions push business lue enhancement by looking at the business holistically 'S affecting value in order to Provide some level of return Firms that are focused on maximizi concepts to assess im Methodologies also Matters between mar analysts. ing shareholder value uses valuation pact Of various strategies to company value. Valuation enable communication about significant corporate inagement, shareholders, consultants and investment|ODOLOGIES Legal and Tax Purposes i f legal and tax purposes, ion is important to businesses because of ] ; ean aa new partner will join a partnership or an old partner will Tetire, 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 fuidated when owners decide so. Firms are also valued for estate tax purposes if the owner passes away. Other Purposes «Issuance of a faimess 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 Teasonably capture the business realities affecting the firm and its value. Frameworks which capture ind and are very useful for anal that should be filled out: a their thoughts about the i these relates to the Perforr Competitive analyses sho be most challenging and lustry and competitive analysis already exist lysts. These frameworks are more than a template inalysts should use these frameworks to organize industry and the competitive environment and how mance of the firm they are valuing. The industry and uld emphasize which factors affecting business how should these be factored in the valuation model. Industry structure refers to the inhere ical e S inherent technical and ec Industry characterist | industry and the trends that may affect this struc ics means that these are true to most, if not all, markIndustry Tivalry Players participating in that industi ry. Porter’ tool used to encapsulate industry ‘structure. 'S Five Forces is the most common PORTER'S FIVE T= Refers to the nature and intensity of Tivalry Players in the industry. intense if there is lower Number of market Players or competitors (i.e. higher concentration) which means higher potential for industry profitability This considers Concentration of market Players, degree of differentiation, ‘switching costs, information and government restraint. between market Rivalry is less j New Entrants Refers to the barriers to entry to industry by . If there are relatively 5 Means there are fewer 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, Substitutes and Complements This refers to the rel interrelated Products industry. Availability of substitute Products (Products that can Teplace the sale of an existing Product) or lationships between and services in the complementary Products (products that can be used together with another Product) affects industry profitability. This Consider prices of substitute Products/services, complement Products/services and government limitations. Supplier Power Supplier power refers to how ‘suppliers can Negotiate better terms in their favor. When there is strong supplier power, this tends to make industry profits lower. Strong ‘supplier Power exists if there are few suppliers that can supply a specific input. Supplier Power also considers supplier concentration, prices of alternative inputs, relationship- specific investments, supplier switching costs and governmental regulations.Buyer power pertains to how customers can negotiate better terms in their favor for the products/services they purchase. Typically buying power is low if customers are fragmented and concentration is low. This means that market 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. Buyer Power 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 Itrelates 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 identi Segment to focus on by oF differentiation strat ifying specific demographic segment or nets using cost leadership strategy (cost fou" egy (differentiation focus)DN Nsar eo seers 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 feports typically use horizontal, vertical and Tatio 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 firm fared. Some information can also be compared against stated objecti ives 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, Tegulatory filings, company press releases and financial statements canbe 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 dustry researches done In analyzing historical fi quality of earnings. Quai Of financial statements company performance economic reality. Durit nancial information, focus is afforded in looking at lity Of earnings analysis pertain to the detailed review and accompanying notes to assess sustainability of and validate accuracy of financial information versus ing analysis, transactions that are nonrecurring such asroiianermeass ; liefs Or gains/losg, financial impact of litigation settlements, temporary tax reliefs a sales of nonoperating assets might need to be adjusted to arriy, es performance of the firm’s core business. net income against operat i ings analysis also compares oer aks sure reported earnings are actually realizable to cash ang a not padded through significant accrual entries. Typical observations that analysts can derive from financial statements are listed below: ble Obs: fi Poss' ye Item Po: ry pretation Revenues and gain | Early recognition of Accelera led revenue revenues (e.g. bill-and- recognition improves hold sales, sales income and can be recognition prior to used to hide declining installation and acceptance | performance of customer) Inclusion of nonoperating Nonrecurring gains income or gains as part of | that do not relate to operating income operating performance may hide declining performance. Expenses and | Recognition of too high or | Too little reserves losses too little reserves (e.g. may improve current restructuring, bad debts) year income but might affect future income (and vice versa) Deferral of expenses such May improve current as customer acquisition or | income but will reduce product development costs | future income. May by capitalization hide declining performance. Aggressive assumptions Aggressive estimates Such as long useful lives, | may imply that there lower asset impairment, are steps taken to high assumed discount improve current year fate for pension liabilities income. Sudden or high expected return on | changes in estimates plan assets may indicate masking of potential problems in operating performance. =PAO reared METHODOLOGIES eT eRe) ar) rely eesti) Balance sheet | Off-balance sheet Assetsiliabilities may items financing (those not not be fairly reflected. reflected in the face of the balance sheet) like leasing or securitizing receivables Increase in bank overdraft | Potential artificial as operating cash flow inflation in operating cash flow. Operating cash 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yuan ra 5 in and (b) on a micro perspective focusing in the firm's financial characteristics. Forecasting summarizes the future-looking a the assessment of industry and competitive landscape, business strategy and historical financials. This can be la : / summarized in two approaches: firm operate: and operatin: view which results from « 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. aie ae be done comprehensively and should include eamings. prevents any ——— forecast. Comprehensive forecasting approach statements snd aonsetent figures between the prospective financial analysis should d ee assumptions. The approach considers lone per line item as each item can be influenced by different busine: on y Process starts aaa driver. Similar with short-term budgeting, forecasting the business, th the determining sales growth and revenue projections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 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:Mace ess VALUATION CONC ueE « 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 oss margin rates and discount rates, exercises are sales growth, gr 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 os Value is calculated based on all assumptions considered, the - llysts and investors use the results to provide recommendations or lecisions that suits their investment objective. makeReon aU at Key Principles Valuation ML The Value of a Business is Defined Only at a Specific point in ti in time Business value tend to change every day a: i Different circumstances that occur on a oa bossa cash position, working capital and market conditions. Valuation made a year ago may not hold true and not reflect the eras firm value today. As a result, it is important to give perspective t2 users of the information that firm value is based on a ‘specific ate. 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. 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sed for valuation. This can influence their decision, t io rate to be u: 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. Vv. 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. VL 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 a= valuation exercises, uncertainty will be consistently present. Uncertainty sete te the possible fange of values where the real firm value lies. When cmd any a method, analysts will never be sure if they have eee incl moat all potential risks that may affect price of assets. sick i cet Methods also use future estimates which bear the risk ly happen may be significantly different from the estimale-VALUATION CONCEPTS AND METHODO! selei9 Value conse Uncertainty is rate. quently may be different based on new circumstances. captured in valuation models through cost of capital or discount Another aspect that contributes to uncertainty is that analysts use their judgments to ascertain assumptions based on current available facts. Even if tisk adjustments are made, this cannot 100% ascertain the value will be Perfectly estimated. Constant changes in market Conditions may hinder the investor from reali izing 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 does not mean that a business that le. Typically, advantage of Possible opportuniti events. This influences Managem environment and adoption of ini Consequently, these dynamic ap) to all players in the economy. businesses Manage uncertainty to take les and minimize impact of unfavorable ent style, reaction to changes in economic Inovative approaches to doing business. proaches also contribute to the uncertaintythe estimation of an asset's value based on variables perceiveg future investment returns, on comparisons with similar assets, imates of immediate liquidation proceeds. Definition ding on the context. Different definitions of vaiug include intrinsic value, going concern value, liquidation value and fair Market Valuation is to be related to re or, when relevant, on esti of value may vary depen 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: understanding of the business, forecasting financial performance, selecting right valuation model, preparing valuation model based on forecasts and applying conclusions and 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 ee ee