Chapter 1 FUNDAMENTAL PRINCIPLES OF VALUATIONEPTS AND 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- sustainability to the economy by yielding higher economic output, better gains, employment growth and higher salaries. Placing scarce resources in their most productive use best serves the interest of different stakeholders in the country. The fundamental point behind success in investments is understanding what is the prevailing value and the key drivers that influence this value. Increase in value may imply that shareholder capital is maximized, hence, fulfilling the promise to capital providers. This is where valuation steps in. According to the CFA Institute, valuation is the estimation of an asset's value based on variables perceived to be related to future investment returns, on comparisons with similar assets, or, when relevant, on estimates of immediate liquidation proceeds. Valuation includes the use of forecasts to come up with reasonable estimate of value of an entity's assets or its equity. At varying levels, decisions done within a firm entails valuation implicitly. For example, capital budgeting analysis usually considers how pursuing a specific project will affect entity value. Valuation techniques may differ across different assets, but all follow similar fundamental principles that drive the core of these approaches. Valuation places great emphasis on the professional judgment that are associated in the exercise. As valuation mostly deals with projections about future events, analysts should hone their ability to balance and evaluate different assumptions used in each phase of the valuation exercise, assess validity of available empirical evidence and come up with rational choices that align with the ultimate objective of the valuation activity.VALUATION CONCEPTS AND METHODOLOGIES “®erpreting Different Concepts of Value “# Me corporate setting, the fundamental equation of value is grounded on the ‘WPeols that Alfred Marshall popularized — a company creates value if and “= =the return on capital invested exceed the cost of acquiring capital. Se 5 the point of view of corporate shareholders, relates to the difference cash inflows generated by an investment and the cost associated "© = capital invested which captures both time value of money and risk _ = eStve 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? ‘actors are solid concepts; however, the quick turnover of technologies "2c globalization make the business environment more dynamic. As a defining value and identifying relevant drivers became more arduous. ‘m= passes by. As firms continue to quickly evolve and adapt to new valuation of current operations becomes more difficult as = to the past. Projecting future macroeconomic indicators also is Secause of constant changes in the economic environment and the innovation of market players. New risks and competition also which makes determining uncertainties a critical ingredient to ‘Sefton of value may also vary depending on the context and objective weluation exercise. = litinsic value ermsic value refers to the value of any asset based on the essumption that there is a hypothetical complete understanding of its vestment characteristics. Intrinsic value is the value that an investor considers, on the basis of an evaluation of available facts, to be the "sus" or "real" value that will become the market value when other mvestors reach the same conclusion. As obtaining complete formation about the asset is impractical, investors normally estimate innsic value based on their view of the real worth of the asset. If theVALUATION CONCEPTS AND METHODOL( SS Fi assumption is that the true value of asset is dictated by the market, then intrinsic value equals its market price. Unfortunately, this is not always the case. The Grossman - Stiglitz paradox states that if the market prices, which can be obtained freely, perfectly reflect the intrinsic value of an asset, then a rational investor will not spend to gather data to validate the value of a stock. If this is the case, then investors will not analyze information about stocks anymore. Consequently, how will the market price suggest the intrinsic price if this process does not happen? The rational efficient markets formulation of Grossman and Stiglitz acknowledges that investors will not rationally spend to gather more information about an asset unless they expect that there is potential reward in exchange of the effort. As a result, market price often does not approximate an asset's intrinsic value. Securities analysts often try to look for stocks which are mispriced in the market and base their buy or sell recommendations based on these analyses. Intrinsic value is highly relevant in valuing public shares. Most of the approaches that will be discussed in this book deal with finding out the intrinsic value of assets. Financial analysts should be able to come up with accurate forecasts and determine the right valuation model that will yield a good estimate of a firm's intrinsic value. The quality of the forecast, including the reasonableness of assumptions used, is very critical in coming up with the right valuation that influences the investment decision. * Going Concern Value Firm value is determined under the going concern assumption. The going concern assumption believes that the entity will continue to do its business activities into the foreseeable future. It is assumed that the entity will realize assets and pay obligations in the normal course of business. Liquidation Value The net amount that would be realized if the business is terminated and the assets are sold piecemeal. Firm value is computed based on the assumption that entity will be dissolved, and its assets will be sold individually — hence, the liquidation process. Liquidation value is particularly relevant for companies who are experiencing severeVALUATION CONCEPTS AND METHODOLOGIES 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 n valuation exercises involving tax assessments. ‘ees of Valuation in Business Paolo Management Te vance of valuation in portfolio management largely depends on the ‘Syes™ent objectives of the investors or financial managers managing the nt portfolio. Passive investors tend to be disinterested in ding valuation, but active investors may want to understand in order to participate intelligently in the stock market. Fundamental analysts — These are persons who are interested in derstanding and measuring the intrinsic value of a firm. indamentals refer to the characteristics of an entity related to its nancial strength, profitability or risk appetite. For fundamental nalysts, the true value of a firm can be estimated by looking at its nancial characteristics, its growth prospects, cash flows and risk profile. Any noted variance between the stock’s market price versus *s fundamental value indicates that it might be overvalued or undervalued. ically, fundamental analysts lean towards long-term investment trategies which encapsulate the following principles:ene au ae © Relationship between value and underlying factors can be reliably measured. © Above relationship is stable over an extended period o Any deviations from the above relationship can be corrected within a reasonable time Fundamental analysts can be either value or growth investors. Value investors tend to be mostly interested in purchasing shares that are existing and priced at less than their true value. On the other hand, growth investors lean towards growth assets (businesses that might not be profitable now but has high expected value in future years) and purchasing these at a discount. Security and investments analysts use valuation techniques to support the buy / sell recommendations that they provide to their clients. Analysts often infer market conditions implied by the market price by assessing this against his own expectations. This allows them to assess reasonableness and adjust future estimates. Market expectations regarding fundamentals of one firm can be used as benchmark for other companies which exhibit the same characteristics * Activist investors — Activist investors tend to look for companies with good growth prospects that have poor management. Activist investors usually do “takeovers” — they use their equity holdings to push old management out of the company and change the way the company is tun. 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VALUATION CON! 'S AND METHODOLOGIES 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 nformation 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. “weer portfolio management, the following activities can be performed ‘ough 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? = ©2"y. investors do not have a lot of time to scour all available information to make investment decisions. Instead, they seek the help of Sonals to come up with information that they can use to decide their analysts that work in the brokerage department of investment firms ‘ee salvation judgment that are contained in research reports that are ‘Seen nated widely to current and potential clients. Buy-side analysts, on the " Panc, look at specific investment options and make valuation analysis and report to a portfolio manager or investment committee. Buy-side - nd to perform more in-depth analysis of a firm and engage in more suS stock selection methodologies. ‘nancial analysts assist clients to realize their investment goals by 2em information that will help them make the right decision whether sell. They also play a significant role in the financial markets by right information to investors which enable the latter to buy or As a result, market prices of shares usually better reflect its real analysts often take a holistic look on businesses, they somewhat "= 2 monitoring role for the management to ensure that they make decision "© © = line with the creating value for shareholders.VALUATION 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 (eg. 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VALUATION CONCEPTS AND METHODOLOGIES 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. Finance “rporate finance involves managing the firm’s capital structure, including “sping sources and strategies that the business should pursue to maximize ‘= elue. Corporate finance deals with prioritizing and distributing financial Sources to activities that increases firm value. The ultimate goal of corporate ‘erce is to maximize the firm value by appropriate planning and “N@ementation of resources, while balancing profitability and risk appetite. ‘Sme! private businesses that need additional money to expand use valuation ‘Seecects when approaching private equity investors and venture capital ao to show the promise of the business. The ownership stake that “Yeee capital providers will ask from the business in exchange of the money rae will put in will be based on the estimated value of the small private Gusress per companies who wish to obtain additional funds by offering their shares ) Me oublic also need valuation to estimate the price they are going to fetch ) Me stock market. Afterwards, decision regarding which projects to invest "» @meunt to be borrowed and dividend declarations to shareholders are by company valuation. finance ensures that financial outcomes and corporate strategy _ == ~=amization of firm value. Current business conditions push business "Wears ® focus on value enhancement by looking at the business holistically Secus on key levers affecting value in order to provide some level of return larshoiders. ors Set are focused on maximizing shareholder value uses valuation to assess impact of various strategies to company value. Valuation gies also enable communication about significant corporate setween management, shareholders, consultants and investment ssREM kestrel Legal and Tax Purposes Valuation is also important to businesses because of legal and tax purposes. For example, if a new partner will join a partnership or an old partner will retire, the whole partnership should be valued to identify how much should be the buy-in or sell-out. This is also the case for businesses that are dissolved or liquidated when owners decide so. Firms are also valued for estate tax purposes if the owner passes away. Other Purposes ¢ Issuance of a fairness opinion for valuations provided by third party (e.g. investment bank) * Basis for assessment of potential lending activities by financial institutions * Share-based payment/compensation Valuation Process Generally, the valuation process considers these five steps: Understanding of the business Understanding the business includes performing industry and competitive analysis and analysis of publicly available financial information and corporate disclosures. Understanding the business is very important as these give analysts and investors the idea about the following factors: economic conditions, industry peculiarities, company strategy and company’s historical performance. The understanding phase enables analysts to come up with appropriate assumptions which reasonably capture the business realities affecting the firm and its value. Frameworks which capture industry and competitive analysis already exist and are very useful for analysts. These frameworks are more than a template that should be filled out: analysts should use these frameworks to organize their thoughts about the industry and the competitive environment and how these relates to the performance of the firm they are valuing. The industry and competitive analyses should emphasize which factors affecting business will be most challenging and how should these be factored in the valuation model. Industry structure refers to the inherent technical and economic characteristics of an industry and the trends that may affect this structure. Industry characteristics means that these are true to most, if not all, marketVALUATION CONCEPTS AND METHODOLOGIES participating in that industry. Porter's Five Forces is the most common to encapsulate industry structure. iis 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 industry rivalry | (ie. higher 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 | New Entrants 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 2 (products that can replace the sale of an Substitutes and existing product) or complementary Complements 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 strong supplier power, this tends to make industry profits lower. Strong supplier Supplier Power 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. |Mende nora anes PORTER’S FIVE FORCES 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 Buyer Power purchase, customer switching costs and jovernment restraints. Competitive position refers to how the products, services and the company itself is set apart from other competing market players. Competitive position is typically gauged using the prevailing market share level that the company enjoys. Generally, a firm's value is higher if it can consistently sustain its competitive advantage against its competitors. According to Michael Porter, there are generic corporate strategies to achieve competitive advantage: « Cost leadership It relates to the incurrence of the lowest cost among market players with quality that is comparable to competitors allow the firm to price products around the industry average. Differentiation Firms tend to offer differentiated or unique product or service characteristics that customers are willing to pay for an additional premium. * Focus Firms are identifying specific demographic segment or category segment to focus on by using cost leadership strategy (cost focus) or differentiation strategy (differentiation focus)VALUATION CONCEPTS AND METHODOLOGIES “See “rom industry and competitive landscape, understanding the company’s “SeSress model is also important. Business model pertains to the method how “e company makes money — what are the products or services they offer, _@» "ey deliver and provide these to customers and their target customers. "S9@rng the business model allows analysts to capture the right performance _ vers that should be included in the valuation model. “= sults of execution of aforementioned strategies will ultimately be “Wieced in the company performance results contained in the financial _ Seemenis. Analysts look at the historical financial statements to get a sense = *© the company performed. There is no hard rule on how long the _) rca! analysis should be done. Typically, historical financial statements “Wess can be done for the last two years up to ten years prior — as long as "See 5 available information. Looking at the past ten years may give an idea 4 ‘esilient the company in the past and how they reacted to problems they "WiSeuntered along the way. »=s of historical financial reports typically use horizontal, vertical and enalysis. More than the computation, these numbers should be related ~on-year to give a sense on how the company performed over the years. se can be benchmarked against other market players or the industry 0 understand how the firm fared. Some information can also be ed against stated objectives of the organization - such as sales gross margin ratios or profit targets. sources of information about companies can be found in government- =¢ disclosures like audited financial statements. If the firm is publicly regulatory filings, company press releases and financial statements b= easily accessed in the stock exchange. Investor relation materials that @anes issue can also be accessed in their websites. Other acceptable of information include news articles, reports from industry ation, reports from regulatory agencies and industry researches done ‘e@eoendent firms such as Nielsen or Euromonitor. Ethically, analysts only use information that are made publicly available (via government or press releases). Analysts should avoid using material inside mon as this gives undue disadvantage to other investors that do not =ccess to the information. ‘@@)2ing historical financial information, focus is afforded in looking at earnings. Quality of earnings analysis pertain to the detailed review al statements and accompanying notes to assess sustainability of y performance and validate accuracy of financial information versus reality. During analysis, transactions that are nonrecurring such as[ARN w aes financial impact of litigation settlements, temporary tax reliefs or gains/losses on sales of nonoperating assets might need to be adjusted to arrive at the performance of the firm’s core business Quality of earnings analysis also compares net income against operating cash flow to make sure reported earnings are actually realizable to cash and are not padded through significant accrual entries. Typical observations that analysts can derive from financial statements are listed below: Line Item Revenues and gain Leto BO) are) Early recognition of revenues (€.g. bill-and- hold sales, sales recognition prior to installation and acceptance of customer) Le) Interpretation Accelerated revenue recognition improves income and can be used to hide declining performance Inclusion of nonoperating income or gains as part of Nonrecurring gains 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 as customer acquisition or product development costs by capitalization May improve current income but will reduce future income. May hide declining performance. Aggressive assumptions ‘such as long useful lives, lower asset impairment, high assumed discount rate for pension liabilities or high expected return on plan assets 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.esr Peace ince sheet Assets/liabilities may financing (these not not be fairly reflected reflected in the face of the | balance sheet) like leasing or securitizing receivables Increase in bank overdraft | Potential artificial @s operating cash flow inflation in operating cash flow. Sesed on AICPA guidance, other red flags that may indicate @gg°essive accounting include the following: = Poor quality of accounting disclosures, such as segment mformation, 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 eamings expectations. * Ahistory of securities law violations, reporting violations, or persistent late filings. esting financial performance understanding how the business operates and analyzing historical statements, forecasting financial performance is the next step. ing financial performance can be looked at two lenses: (a) on a perspective viewing the economic environment and industry where theVALUATION CONCEPTS AND Mi IODOLOGIES firm operates in and (b) on a micro perspective focusing in the firm’s financial and operating characteristics. Forecasting summarizes the future-looking view which results from the assessment of industry and competitive landscape, business strategy and historical financials. This can be ‘summarized in two approaches: * Top-down forecasting approach. — Forecast starts from international or national macroeconomic projections with utmost consideration to industry specific forecasts. From here, analysts select which are relevant to the firm and then applies this to the firm and asset forecast. In top-down forecasting approach, the most common variables include GDP forecast, consumption forecasts, inflation projections, foreign exchange currency rates, industry sales and market share. A result of top-down forecasting approach is the forecasted sales volume of the company. Revenue forecast will be built from this combined with the company-set sales prices. * Bottom-up forecasting approach — Forecast starts from the lower levels of the firm and is completed as it captures what will happen to the company based on the inputs of its segments / units. For example, store expansions and increase in product availability is collated and revenues resulting from these are calculated. Inputs from various segments are consolidated until company-level revenues is determined. Insights compiled during the industry, competitive and business strategy analysis about the firm should be considered in this phase when forecasting for the firm's sales, operating income and cash flows. Comprehensive understanding of these items is critical to forecast reasonable numbers. Qualitative factors, albeit subjective, are considered in the forecasting process in order to make valuation approximate the true reality of the firm. Assumptions should be driven by informed judgment based on the understanding of the business. Forecasting should be done comprehensively and should include earnings, cash flow and balance sheet forecast. Comprehensive forecasting approach prevents any inconsistent figures between the prospective financial statements and unrealistic assumptions. The approach considers that analysis should done per line item as each item can be influenced by a different business driver. Similar with short-term budgeting, forecasting process starts with the determining sales growth and revenue projections of the business.VALUATION CONCEPTS AND METH erecesting process should also consider industry financial ratios as this | gees an idea how the industry is operating. From this, analysts should be | @ *© explain reasons why firm-specific ratios will deviate from this. Spewiledge of historical financial trends is also important as this can give ‘Peeance how prospective trends will look like. Similarly, any deviations from "etec historical trends should be carefully explained to ensure "esonableness. "7 ecaily, sales and profit numbers should consistently move in the future ‘Qesec on current trends if there is no significant information that will prove arewse. He results of forecasts should be compared with the dynamics of the industry ‘where the business operates and its competitive position to make sure that ‘Se sumbers make sense and reflect the most reliable view of how the “SeSmess operates. Even though general economic and market trends can be “se2 2s reliable benchmark, analysts should consider that there might be “shaue factors that affect company prospects that can be used as guidance ® He ‘orecasting process. ‘)pesily. forecasts are done on annual basis as most publicly available "ence! information are interpreted on an annual basis. Where applicable, “Syecests can be better done on a quarterly basis to account for seasonality. _Se®eonality affects sales and earnings of almost all industry. For example, “@hime companies tend to have peak sales during summer season and holiday _sessons while lean sales during rainy months. Developing earnings forecast “whe considering seasonality can give a more reasonable estimate. “eecing the right valuation model "= sepropriate valuation model will depend on the context of the valuation ‘He herent characteristics of the company being valued. Details of these "semen models and the circumstances when they should be used will be “@eeessed in succeeding chapters. “Peeerrg valuation model based on forecasts Seee he valuation model is decided, the forecasts should now be inputted = werted to the chosen valuation model. This step is not only about "Seeeelly encoding the forecast to the model to estimate the value (which is ‘ @0 of Microsoft Excel). More so, analysts should consider whether the "secre value from this process makes sense based on their knowledge the business. To do this, two aspects should be considered:IN CONCEPTS AND METHODOLOGIES Kf Sensitivity analysis It is a common methodology in valuation exercises wherein multiple analyses are done to understand how changes in an input or variable will affect the outcome (i.e. firm value). Assumptions that are commonly used as an input for sensitivity analysis exercises are sales growth, gross margin rates and discount rates. Aside from these, other variables (like market share, advertising expense, discounts, differentiated feature; etc.) can also be used depending on the valuation problem and context at hand. Situational adjustments or Scenario Modelling For firm-specific issues that affect firm value that should be adjusted by analysts. In some instances, there are factors that do not affect value per se when analysts only look at core business operations but will still influence value regardless. This includes control premium, absence of marketability discounts and illiquidity discounts. Control premium refers to additional value considered in a stock investment if acquiring it will give controlling power to the investor. Lack of marketability discount means that the stock cannot be easily sold as there is no ready market for it (e.g. non- publicly traded discount). Illiquidity discount should be considered when the price of particular shares has less depth or generally considered less liquid compared to other active publicly traded share. Illiquidity discounts can also be considered if an investor will sell large portion of stock that is significant compared to the trading volume of the stock. Both lack of marketability discount and illiquidity discount drive down share value. Applying valuation conclusions and providing recommendation Once the value is calculated based on all assumptions considered, the analysts and investors use the results to provide recommendations or make decisions that suits their investment objective.err Peeciples in Valuation The Value of a Business is Defined Only at a specific point in time ness value tend to change every day as transactions happen. rent circumstances that occur on a daily basis affect earnings, cash position, working capital and market conditions. Valuation made 2 year ago may not hold true and not reflect the prevailing ®rm 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. 2lue varies based on the ability of business to generate future cash flows General concepts for most valuation techniques put emphasis on € cash flows except for some circumstances where value can better derived from asset liquidation. The relevant item for valuation is the potential of the business to rate value in the future which is in the form of cash flows. uture cash flows can be projected based on historical results considering future events that may improve or reduce cash flows. S 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 formation can provide be a good starting point when projecting ‘uture 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VALUATION CONCEPTS AN! rate to be used for valuation. This can influence their decision to buy or sell investments. Iv. Firm value can be impacted by underlying net tangible assets Business valuation principles look at the relationship between Operational value of an entity and net tangible of its assets. Theoretically, firms with higher underlying net tangible asset value are more stable and results in higher going concern value. This is the result of presence of more assets that can be used as security during financing acquisitions or even liquidation proceedings in case bankruptcy occurs. Presence of sufficient net tangible assets can also support the forecasts on future operating plans of the business. 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. Vi. Value is impacted by liquidity This principle is mainly dictated by the theory of demand and supply. If there are many potential buyers with less acquisition targets, value of the target firms may rise since the buyers will express more interest to buy the business. Sellers should be able to attract and negotiate potential purchases to maximize value they can realize from the transaction. Risks in Valuation In all valuation exercises, uncertainty will be consistently present. Uncertainty refers to the possible range of values where the real firm value lies. When performing any valuation method, analysts will never be sure if they have accounted and included all potential risks that may affect price of assets. Some valuation methods also use future estimates which bear the risk that what will actually happen may be significantly different from the estimate.VALUATION CONCEPTS AND METHODOLOGIES consequently may be different based on new circumstances. tainty is captured in valuation models through cost of capital or discount “a aspect that contributes to uncertainty is that analysts use their to ascertain assumptions based on current available facts. Even if sjustments are made, this cannot 100% ascertain the value will be pee estimated. Constant changes in market conditions may hinder the from realizing any expected value based on the valuation rer gy. Perormance of each industry can also be characterized by varying degrees bility which ultimately fuels uncertainty. Depending on the industry, ‘De can be very sensitive to changes in macroeconomic climate (investment gees luxury products) or not at all (food and pharmaceutical). 's and entry of new businesses may also bring uncertainty to d and traditional companies. It does not mean that a business that rated for 100 years will continue to have stable value. If a new y arrives and provides a better product that customers will patronize, mean trouble. Typically, businesses manage uncertainty to take of possible opportunities and minimize impact of unfavorable influences management style, reaction to changes in economic nt and adoption of innovative approaches to doing business. ly, these dynamic approaches also contribute to the uncertainty rs in the economy.