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The document outlines various concepts and methodologies of valuation, emphasizing the importance of understanding intrinsic value, market value, and liquidation value in business contexts. It discusses the roles of valuation in different scenarios, including mergers, acquisitions, and financial management, highlighting the need for accurate forecasts and professional judgment. Additionally, it explores the impact of valuation on investment decisions and the significance of maximizing shareholder value for economic growth.
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0% found this document useful (0 votes)
69 views218 pagesACCTG 8 by MV Lascano
The document outlines various concepts and methodologies of valuation, emphasizing the importance of understanding intrinsic value, market value, and liquidation value in business contexts. It discusses the roles of valuation in different scenarios, including mergers, acquisitions, and financial management, highlighting the need for accurate forecasts and professional judgment. Additionally, it explores the impact of valuation on investment decisions and the significance of maximizing shareholder value for economic growth.
Uploaded by
Cristan MiguelCopyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF or read online on Scribd
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ION CONCEPTS AND METHODOLOGIES
TABLE OF CONTENTS
FUNDAMENTALS PRINCIPLES OF VALUATION...
Interpreting Different Concepts of Value
Roles of Valuation in Business ..
Valuation Process...
Key Principles in Valuation .
Risks in Valuation...
ASSET-BASED VALUATION...
Book Value Method...
Replacement Value Method.
Reproduction Value Method
Liquidation Value Method
Liquidation value....... = 60
Situations to Consider Liquidation Value...
General Principles on Liquidation Value .........cs:oeese-suentnennesnne 83
Types of Liquidation ...
Calculating Liquidation Value.........
‘COME BASED VALUATION...
Economic Value Added
2
Capitalization of Earnings Method
Discounted Cash Flows Method
DISCOUNTED CASH FLOWS METHOD....
Net Cash Flow to the Firm...
Net Cash Flow to Equity...
Terminal Value...
Financial Models in Discounted Cash Fiows Analysis... ane AEE,
Components of Financial Model... Penne ese an kes
MARKET VALUE APPROACH
Empirical / Statistical Approach.
Comparable Company Analysis......
Heuristic pricing rules method.......
OTHER VALUATION CONCEPTS AND TECHNIQUES...
Due Diligence...
Mergers and Acquisitions.
Divestiture.
Other Valuation Techniques...
REFERENCES
APPENDIX Chapter 1
FUNDAMENTAL PRINCIPLES OF
VALUATION NZ TMeP Are Mes) ese hbase nek
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 abie 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
cult in a domino impact to the economy. Growing companies provide long-
sability to the economy by yielding higher economic output, better
ns, employment growth and higher salaries. Placing scarce
most productive use best serves the interest of different
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 Mi
ting Different Concepts of Value
porate setting, the fundamental equation of value is grounded on the
‘hat Alfred Marshall popularized — a company creates value if and
return on capital invested exceed the cost of acquiring capital.
= the point of view of corperate 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
© Of a business can be basically linked to three major factors:
ent operations — how is the operating performance of the firm in
year?
ture prospects — what is the long-term, strategic direction of the
mpany?
edded risk — what are the business risks involved in running the
business?
‘s are solid concepts; however, the quick turnover of technologies
= globalization make the business environment more dynamic. As a
= ng value and identifying relevant drivers became more arduous
2 ses by. As fitms continue to quickly evolve and adapt to new
Sreoges, valuation of current operations becomes more difficult as
= the past. Projecting future macroeconomic indicators also is
ause of constant changes in the economic environment and the
mnovation of market players. New risks and competition also
ich makes determining uncemtainties a critical ingredient to
ton of value may also vary depending on the context and objective
vation exercise.
= Stinsic value
ic value refers to the value of any asset based on the
mption that there is a hypothetical complete understanding of its
iment characteristics. Intrinsic value is the value that an investor
ders, on the basis of an evaluation of available facts, to be the
or "real" value that will become the market value when other
rs reach the same conclusion. As obtaining complete
‘mation about the asset is impractical, investors normally estimate
value based on their view of the real worth of the asset. If the VALUATION CONCEPTS AND Mi
assumption is that the true value of asset is dicteted 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 vaiuing
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 ¢ 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 foreseeabie 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 reelized 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 asseis 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
ypothetical 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
arties are informed of all material characteristics about the
avestment that might influence their decision. Fair value is often used
9 valuation exercises involving tax assessments.
*@es of Valuation in Business
Management
vance of valuation in portfolio management largely depends on the
it objectives of the investors or financial managers managing the
% 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
standing and measuring the intrinsic value of a_ firm.
undamentals refer to the characteristics of an entity related to its
Seancial strength, profitability or risk appetite. For fundamental
nalysts, the true value of 2 firm can be estimated by looking at its
cial characteristics, its growth prospects, cash flows and risk
le. Any noted variance between the stock’s market price versus
‘undamental value indicates that it might be overvalued or
undervalued.
ically, fundamental analysts lean towards long-term investment
strategies which encapsulate the following principles: © Relationship between value and underlying factors can be
feliably 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 mode! 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
istance lines_
‘formation Traders — Traders that react based on new information
about firms that are revealed to the stock market. The underlying belief
's that information traders are more adept in guessing or getting new
nformation about firms and they can make predict how the market will
ct based on this. Hence, information traders correlate value and
how information will affect this value, Valuation is important to
nformation traders since they buy or sell shares based on their
assessment on how new information will affect stock price
portfolio management, the following activities can be performed
he 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 ils
stocks? Are there assumptions about fundamentals that will justify
the prevailing price?
nvestors do not nave a lot of time to scour all available information
make investment decisions. Instead, they seek the help of
s to come up with information that they can use to decide their
valysts that work in the brokerage department of investment firms
‘ion judgment that are contained in research reports that are
ed widely to current and potential clients. Buy-side analysts, on the
look at specific investment options and make valuation analysis
report to a portfolio manager or investment commitiee. Buy-side
to perform more in-depth analysis of a firm and engage in more
stock selection methodologies.
financial analysts assist clients to realize their investment goals by
m information that will help them make the right decision whether
They also play a significant role in the financial markets by
right information to investors which enable the latter to buy or
;. AS @ result, market prices of shares usually better reflect its real
analysts often take a holistic look on businesses, they somewhat
™onitoring role for the managementto ensure that they make decision
ine with the creating value for sharehoiders. Parga
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 incluced in the valuation exercise. This is
usually an important matter for hostile takeovers.
Finance
finance involves managing the firm’s capital structure, including
sources and strategies that the business should pursue to maximize
Corporate finance deals with prioritizing and distributing financial
to activities that increases firm value. The ultimate goal of corporate
~ is to maximize the firm value by appropriate planning and
ion of resources, while balancing profitability and risk appotite.
ite businesses that need additional money to expand use valuation
Ss when approeching private equity investors and venture capital
show the promise of the business. The ownership stake that
pital providers will ask from the business in exchange of the money
vill put in will be based on the estimated value of the small private
anies who wish to obtain additional funds by offering their shares
dlic also need valuation to esiimate the price they are going to fetch
market. Afterwards, decision regarding which projects to invest
it to be borrowed and dividend declarations to shareholders are
y company valuation.
finance ensures that financial outcomes and corporate strategy
~aximization of firm value. Current business conditions push business
© focus on value enhancement by looking at the business holistically
key levers affecting value in order to provide some level of return
are focused on maximizing shareholder value uses valuation
oes #0 assess impact of various strategies to company value. Valuation
2s also enable communication about significant corporate
ween management, shareholders, consultants and investment VALUATION CO!
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
» {ssuance of a fairness opinion for valuations provided by third party
(eg. 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:
Undersianding 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
apprepriate assumptions which reasonably capture the business realities
affecting the firm and its value.
Frameworks which capture industry and competitive analysis already exist
anc 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
cherecteristics 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
rticipating in that industry. Porter’s Five Forces is the most common
€ to encapsulate Industry structure.
PORTER’S FIVE FORCES
industry rivalry
Refers to the nature and intensity of rivalry
between market players in the industry.
Rivalry is less intense if there is lower
number of market players or competitors
(i. higher concentration) which means
higher potential for industry profitability.
This considers concentration of market
players, degree of differentiation, switching
costs, information and government
restraint.
New Entrants
Refers to the barriers to eniry to industry by
new market players. if there are relatively
high entry costs, this means there are fewer
new entrants, thus, lesser competition
which improves profitability potential. New
entrants include entry costs, speed of
adjustment, economies of scale, reputation,
switching costs, sunk costs and
government restraints.
Substitutes and
Complements
Supplier Power
This refers to the relationships between
interrelated products and services in the
industry. Availability of substitute products
(products that can replace the sale of an
existing product) or complementary
products (preducts that can be used
together with another product) affects
industry profitability. This consider prices of
substitute products/services, complement
products/services and government
limitations ie oe rel
‘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. JATION CONCEPTS AND METHODOLOGIES _
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
Gependent 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 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
» <= Tom industry and competitive landscape, understanding the company's
eeness model is also important. Business model pertains to the method how
pany makes money — what are the products or services they offer,
deliver and provide these to customers and their target customers.
-g the business model allows analysts to capture the right performance
es that should be included in the valuation model.
ults of execution of aforementioned strategies will ultimately be
the company performance results contained in the financial
's. Analysts look at the historical financial statements to get a sense
"é company performed. There is no hard rule on how long the
analysis should be done. Typically, historical financial statements
eyes can be done for the last two years up to ten years prior — as long as
available information. Looking al the past ten years may give an idea
esient the company in the past and how they reacted to problems they
ed along the way
# historical financial reports typically use horizontal, vertical and
ysis. More than the computation, these numbers should be related
ear to give a sense on how the company performed over the years.
‘9 understand how the firm fared. Some information can also be
against stated objectives of the organization - such as sales
cross margin ratios or profit targets.
rces of information about companies can be found in government-
disclosures like audited financial statements. If the firm is publicly
tory filings, company press releases and financial statements
sily accessed in the stock exchange. Investor relation materials that
issue can also be accessed in their websites. Other acceptable
information include news articles, reports from industry
on, reports from regulatory agencies and industry researches done
dent firms such as Nielsen or Euromonitor. Ethically, analysts
y use information that are made publicly available (via government
press releases). Analysts should avoid using material inside
as this gives undue disadvantage to other investors that do not
to the information
= zing historical financial information, focus is afforded in Jooking at
rings. Quality of earnings analysis pertain to the detailed review
cal statements and accompanying notes to assess sustainability of
performance and validate accuracy of financial information versus
> reality. During analysis, transactions that are nonrecurring such as
12
BAN ed I VALUATION CONCEPTS AND METHODOLOGIES
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 eamings analysis also compares net income against operating
cash flow to make sure reported earnings are actually realizable to cash and
are noi padded through significant accrual entries. Tygical observations that
anelysts can derive from financial statements are listed below:
Line Item
Revenues and gain
ee 3S
Early recognition of
revenues (€.g. bill-and-
hold sales, sales
recognition prior to
installation and acceptance
of customer)
Accelerated revenue
recognition improves
income and can be
used to hide declining
performance
Inclusion of nonoperating
income or gains as part of
operating income
Nonrecurring gains
that do not relate to
operating
performance may
hide declining
performance.
Expenses and
losses
Recognition of too high or
too little reserves (2.9.
restructuring, bad debts)
‘Too little reserves
may improve current
year income but might
affect future income
(and vice versa)
Deferral of expenses such
@s 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. sr
Cosy eee
oe sheet
inancing (those not not be fairly reflected.
reflected in the face of the
balance sheet) like leasing
sritizing receivables
increase in bank overdraft | Potential artificial
as operating cash flow infiation in operating
cash flow.
2 AICPA guidance, other red flags that may indicate
=ggressive accounting include the following:
+ Poor quality of accounting disclosures, such as segment
formation, acquisitions, accounting policies and
essumptions, 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 io
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 targels, 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.
fnancial performance
—-cesianding how the business operates and analyzing historical
# Statements, forecasting financial performance is the next step.
ng financial performance can be iooked at two lenses: (a) on a
Serspective viewing the economic environment and industry where the [eaters
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 agproximate 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
prevenis 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 shori-term budgeting, forecasting
process starts with the determining sales growth and revenue projections of
the business. VALUATION CONCEPTS AND METHODOLOGIES
ting process should also consider industry financial ratios as this
an idea how the industry is operating. From this, analysts should be
to explain reasons why firm-specific ratios will deviate from this
‘edge of historical financial trends is also important as this can give
ce how prospective trends will look like. Similarly, any deviations from
historical trends should be carefully explained to ensure
bleness.
y, sales and profit numbers should consistently move in the future
current trends if there is no significant information that will prove
its of forecasts should be compared with the dynamics of the industry
he business operates and its competitive position to make sure that
numbers make sense and reflect the most reliable view of how the
Ss operates. Even though general economic and market trends can be
= 2s reliable benchmark, analysts should consider that there might be
tors that affect company prospects that can be used as guidance
‘Orecasting process.
y. forecasts are done on annual basis as most publicly available
information are interpreted on an annual basis. Where applicable,
an be better done on a quarterly basis to account for seasonality.
ity affects sales and eamings of almost all industry. For example,
companies tend to have peak sales during summer season and holiday
'S while lean sales during rainy months. Developing earnings forecast
‘sidering seasonality can give a more reasonable estimate.
s
g the right valuation model
opriate valuation model will depend on the context of the valuation
herent characteristics of the compeny being valued. Details of these
mm models and the circumstances when they should be used will be
in succeeding chapters.
ng valuation model based on forecasts
valuation model is decided, the forecasts should now be inputted
erted to the chosen valuation model. This step is not only about
y encoding the forecast to the model to estimate the value (which is
licrosoft Excel). More so, analysts should consider whether the
value from this process makes sense based on their knowedge
business. To do this, two aspects should be considered: Leeroy
« Sensitivity analysis
It is @ 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 acjustments 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 es there is no ready market for it (¢.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. Sep Pewciples in Valuation
ue of a Business is Ds
¢ Only at @ specific point in time:
ss value tend to change every day as transactions happen.
circumstances ‘hat occur ona daily basis affect eamings,
position, working capital and market conditions. Valuation
i@ 2 year ago may not hold true and not reflect the prevailing
alue today. As a result, it is important to give perspective to
the information that firm value is based on a specific date.
¢ varies based on the ability of business to generate future
concepts for most valuation techniques put emphasis on
= cash flows except for some circumstances where value can
ter derived from asset liquidation.
relevant item for valuation is the potential of the business to
te value in the future which is in the form of cash flows.
cash flows can be projected based on historical results
considering future events that may improve or reduce cash flows.
flows is more relevant in valuation as compared to
inting profits as shareholders are more interested in
ing cash at the end of the day. Cash flows include cash
‘atod from operations and reductions that are related to
‘al investments, working capital and taxes. Cash flows will
end on the estimates of future performance of the business
strategies in place to support this growth. Historical
formation can provide be a good starting point when projecting
€ 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 LRN
vi
rate to be used for valuation. This can influence their decision to
buy or sell investments.
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.
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. Ifa 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.
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 METHODOL
consequently may be different based on new circumstances.
nty is captured in valuation models through cost of capital or discount
aspect that contributes to uncertainty is that analysts use their
to ascertain assumptions based on current available facts. Even if
iments are made, this cannot 100% ascertain the value will be
estimated. Constant changes in market conditions may hinder the
from realizing any expected value based on the valuation
gy.
¢ of each industry can also be characterized by varying degrees
bility which ultimately fuels uncertainty. Depending on the industry,
be very sensitive to changes in macroeconomic climate (investment
wxury preducts) ar not at all (food and pharmaceutical)
's and entry of new businesses may also bring uncertainty to
d and traditional companies. Ht does not mean thet a business that
