Chapter 1: Valuation Concepts and Definition of Value may also vary depending on the

Methodologies Context and Objective of the Valuation Exercise:

 Assets, individually or collectively, has value. a. Intrinsic Value
 Value pertains to the worth of an object in another  Value of any asset based on the assumption
person’s POV. that there is a hypothetical complete
 Methods to value for real estate can may be understanding of its investment
different on how to value an entire business. characteristics.
 Business treat capital as scarce. Capital Providers  Value an investor considers, “true” or “real”
require users to ensure that they will be able to value that will become the market value when
maximize shareholders returns to justify providing other investors reach the same conclusion.
capital to them.  Investors normally estimate based on their
 Most fundamental principle for all investments and view of the real worth of the asset.
business and business is to maximize shareholder  “Intrinsic Value equals the Market Price.” – not
value. always the case. The Grossman -Stiglitz
 Fundamental point behind success in investments is paradox states that if the market prices
understanding what is the prevailing value and the perfectly reflect intrinsic value then a rational
key drivers that influence this value. investor will not spend to gather data to
 Increase in value may imply that shareholder capital validate the value of stock.
is maximized, hence, fulfilling the promise to capital  Market Price often does not approximate an
providers. asset’s value.
According to CFA Institute, valuation is the estimation
b. Going Concern Value
of an asset’s value based on variables perceived to be
 Firm value is determined under Going Concern
related to future investment returns, on comparisons
Assumption.
with similar assets, or, when relevant, on estimates of
 Believes that the entity will continue to its
immediate liquidation proceeds.
business activities into the foreseeable future.
 Includes use of forecasts
 Decisions done within a firm entails valuation c. Liquidation Value
implicitly.  Net amount that would be realized if the
 Valuation techniques may differ across different business is terminated and the net assets are
assets but all follow similar fundamental sold piecemeal.
principles.  Firm value is computed based on the
 Places great emphasis on the professional assumption that the entity will be dissolved,
judgement and its asset will be sold individually.
 If liquidation occurs, value often declines
Alfred Marshall – a company creates value if and only
because the assets no longer work together,
if the return on capital invested exceed the cost of
and human intervention is absent.
acquiring capital.

The value of a business can be basically linked to three d. Fair Market Value
major factors:  Price, express in terms of cash, at which
property would change hands between a
1. Current Operations – How is the operating hypothetical willing and able buyer and a
performance of the firm in recent year? hypothetical willing and able seller, acting at
2. Future Prospects – What is the long-term, strategic arm’s length in an open and unrestricted
direction of the company? market, when neither is under compulsion to
3. Embedded Risk – What are the business risks buy or sell and both have reasonable
involved in running the business? knowledge about relevant facts.
 Often used in valuation exercises involving tax
assessments.
Roles of Valuation in Business expected value in future years) and purchasing these at
a discount.
1.PORTFOLIO MANAGEMENT
2.ANALYSIS OF BUSINESS TRANSACTION/DEALS Security and Investments Analysts – use valuation
3.CORPORATE FINANCE techniques to support/sell recommendations that they
4.LEGAL AND TAX PURPOSES provide to their clients.
5.OTHER PURPOSES
2. Activist Investors – tend to look for companies with
 Issuance of a fairness opinion for valuations
good growth prospects that have poor
provided by third party (investment bank)
management.
 Basis for assessment of potential lending
 Activist Investors usually do “takeovers” – they
activities by financial institutions.
use their equity holdings to push old
 Share-based payment/compensation
management out of the company and change
the way the company is run.
PORTFOLIO MANAGEMENT – largely depends on the  It is not about the current value of the company
investment objectives of the investors or financial but its potential value once it is run properly.
managers managing the investment portfolio.  Activist Investors should have a good
understanding of the company’s business model
 Passive Investors tend to be disinterested in
and how implementing changes in investment,
understanding valuation
dividend and financing policies can affect its
 Active Investors may want to understand
value.
valuation in order to participate intelligently in
the stock market.
3. Chartists – relies on the concept that stock prices
are significantly influenced by how investors think
1. Fundamental Analysts – persons who are
and act (on available KPIs such as price movements,
interested in understanding and measuring intrinsic
trading volume and short sales when making their
value of a firm.
investment decisions) these metrics imply investor
 Fundamentals refers to the characteristics
psychology and will predict future movements in
of an entity related to its financial strength,
stock prices.
profitability or risk appetite.
 Assume that stock price changes and follow
 For Fundamental Analyst, the true value of
predictable patterns since investors make
a firm can be estimated by looking at its
decisions based on their emotions than
financial characteristics, its growth
rational analysis.
prospects, cash flow and risk profile.
 Valuation does not play a huge role in
Typically, they lean towards long-term investment charting, but it is helpful when plotting
strategies which encapsulate the following support and resistance lines.
principles:
4. Information Traders – traders that react based on
 Relationship between value and underlying
new information about firms that are revealed in
factors can be reliably measured.
stock market.
 Above relationship is stable over an
 More adept in guessing or getting new
extended period.
information about firms and they can make
 Any deviations from the above relationship
predict on how the market will react based
can be corrected within a reasonable time.
on this.
Value Investors – tend to be mostly interested in
Under the portfolio management, the following
purchasing shares that are existing and priced at less
activities can be performed through the use of
than their true value.
valuation techniques:
Growth Investors – lean towards growth assets
 Stock Selection – is a particular asset fairly priced,
(business that might not be profitable now but has high
overpriced or underpriced in relation to its
 prevailing computed intrinsic value and prices of  More efficient operations, cost reductions,
comparable assets? increased revenues, combined product/markets
 Deducting market expectations – which estimates of or cross-disciplinary talents of the combined
a firm’s future performance are in line with the organization.
prevailing market price of its stocks? Are there
assumptions about fundamentals that will justify 2. Control – change in people managing the
the prevailing price? organization brought about the acquisition.
 Any impact to firm value resulting from the
ANALYSIS OF BUSINESS TRANSACTION/DEALS
change in management and restructuring of the
 Potential acquirers use relevant valuation target company should be included in the
techniques (whichever is applicable) to estimate valuation exercise.
value of target firms they are planning to
CORPORATE FINANCE
purchase and understand the synergies they
can take advantage from the purchase.  Involves managing the firm’s capital structure,
 Also use valuation techniques in the negotiation including funding sources and strategies that
process to set the deal price. the business should pursue to maximize firm
value.
Business deals include the following corporate events:
 Deals with prioritizing and distributing financial
1. Acquisition – usually has two parties: the buying resources to activities that increases firm value.
firm and the selling firm.  Ultimate goal is to maximize the firm value by
 Buying firm needs to determine the fair value appropriate planning and implementation of
of the target company prior to offering a bid resources, while balancing profitability and risk
price. appetite.
 Selling firm (the target company) should have a  Small private businesses that need additional
sense of its firm value to gauge reasonableness money to expand use valuation concepts when
of bid offers. approaching private equity investors and
venture capital providers to show the promise
2. Merger – two companies had their assets combined of the business.
to form a wholly new entity.  Large companies who wish to obtain additional
funds by offering their shares to public also
3. Divestiture – sale of a major component or segment need valuation to estimate the price they are
of a business (brand or product line) to another going to fetch in the stock market.
company.  Corporate finance ensures that financial
outcomes and corporate strategy drives
4. Spin-off – separating a segment or component maximization of firm value.
business and transforming this into a separate legal
LEGAL AND TAX PURPOSES
entity.
 Important to business, for example, if a new
5. Leveraged buyout – acquisition of another business partner will join a partnership or an old partner
by using significant debt which uses the acquired will retire, the whole partnership should be
business as collateral. valued to identify how much should be the buy-
in or sell-out.
Valuation in deals analysis considers two important,
 Firms are also valued for estate tax purposes if
unique factors: SYNERGY and CONTROL.
the owner passes away.
1. Synergy – potential increase in firm value that can
OTHER PURPOSES
be generated once two firms merge with each
other.  Issuance of a fairness opinion for valuations
 Assumes that the combined value of two firms provided by third party (investment bank)
will be greater than the sum of separate firms.
  Basis for assessment of potential lending - Availability of substitute products
activities by financial institutions. (products that can replace the sale
 Share-based payment/compensation of an existing product) or
complementary products (products
VALUATION PROCESS
that can be used together with
1. Understanding the business – it includes another product) affects industry
performing industry, competitive analysis and profitability.
analysis of publicly available financial - Considers prices of substitute
information and corporate disclosures. products/services and government
 Give analysts and investors the idea limitations.
about the following factors: economic 4. Supplier Power – how suppliers can negotiate
conditions, industry peculiarities, better terms in favor.
company strategy and company’s - When there is strong supplier
historical value. power, this tends to make industry
 An investor should be able to profits lower.
encapsulate the industry structure. One - Strong supplier power exists if there
of the most common tools used in are few suppliers that can supply a
encapsulating industry is Porter’s Five specific output.
Forces. - Considers supplier concentration,
prices of alternative inputs,
Porter’s Five Forces relationship-specific investments,
1. Industry Rivalry – refers to the nature and supplier switching costs and
intensity of rivalry between market payers in governmental regulations.
the industry. 5. Buyer Power – how customers can negotiate
- Rivalry is less intense if there is better terms in their favor for the
lower number of market players or products/services they purchase.
competitors (i.e higher - Typically, buying power is low if
concentration) which means higher customers are fragmented and
potential for industry profitability. concentration is low. This means that
- Considers concentration of market market players are not dependent to
players, degree of differentiation, few customers to survive.
switching costs, information and - Low buyer power tends to improve
government restraint. industry profits since buyer cannot
2. New Entrants – refers to the barriers to entry to significantly negotiate to lower price of
industry by new market players. the product.
- If there are relatively high entry - Considers buyer concentration, value of
costs, this means there are fewer substitute products that buyers can
new entrants, thus, lesser purchase, customer switching costs and
competition which improves government restraints.
profitability potential. Competitive position – how the products, services and
- New entrants include entry costs, the company itself is set apart from the competing
speed of adjustment, economies of market players.
scale, reputation, switching costs,
sunk costs and government - Gauged with the prevailing market
restraints. share level that the company enjoys.
3. Substitutes and Complements – refers to the - Firm’s value is higher if it can
relationship between interrelated products and consistently sustain its competitive
services in the industry. advantage against competitor.
 Generic Corporate Strategies to Achieve  Bottom-Up Forecasting Approach – forecast
Competitive Advantage according to Michael Porter starts from the lower levels of the firm and
builds the forecast as it captures what will
 Cost Leadership –incurrence of the lowest cost
happen to the company.
among market players with quality that is
comparable to competitors allow the firm to be
3. Selecting the right valuation model – it depends on
price products around the industry average.
the context of the valuation and the inherent
 Differentiation – offer differentiated or unique
characteristics of the company being valued.
product or service characteristics that
customers are willing to pay for an additional
4. Preparing valuation based on forecasts – there are
premium.
two aspects to be considered:
 Focus – identifying specific demographic
segment or category segment to focus on by
 Sensitivity Analysis – common methodology in
using cost leadership strategy or differentiation
valuation exercises wherein multiple other
strategy.
analysis is done to understand how changes in
Business model pertains to the method how the an input or variable will affect the outcome.
company makes money – what are the products or  Assumptions that are
services they offer, how they deliver and provide these commonly used as an input:
to customers and their target customers. sales growth, gross margin rates
and discount rates.
Quality of earnings analysis pertain to the detailed  Situational Adjustments – firm specific issues
review of financial statements and accompanying notes that affects firm value that should be adjusted
to assess sustainability of company performance and by analysts.
validate accuracy of financial information versus
economic reality. There are factors that do not affect value per se
when analysts only look at core business operations
- Compares net income against operating cash but will still influence value.
flow to make sure reported earnings are
actually realizable to cash not padded through 1. Control Premium – additional value considered
significant accrual entries in stock investment if acquiring it will give
controlling power to the investor
2. Forecasting Financial Performance – can be looked 2. Lack of marketability discount – the stock
at two perspectives: cannot be easily sols as there is no ready market
 on a macro perspective viewing the economic for it.
environment and industry where the firm 3. Illiquidity discount should be considered when
operated and price of particular shares has less depth or
 in micro perspective focusing on the firm’s generally considered less liquid compared to
financial and operating characteristics. other active publicly traded share.

Forecasting summarizes the future-looking view which BOTH LACK OF MARKETABILITY DISCOUNT AND
results from the assessment of industry and competitive ILLIQUIDITY DISCOUNT DRIVE DOWN SHARE.
landscape, business strategy and historical financials.
This can be summarized into two approaches
5. Applying valuation conclusions and providing
recommendations.
 Top-Down Forecasting Approach – forecast
Key Principles in Valuation
starts from international or national
macroeconomic projection with the utmost  The value of a business is defined only at a specific
consideration to industry’s specific point in time. – Business value tend to change ever
forecasts. day as transactions happens.
 Value varies based on the ability of business to - Sellers should be able to attract and negotiate
generate future cash flows. – General concepts for potential purchases to maximize value they can
most valuation techniques put emphasis on future realize from the transaction.
cash flows except for some circumstances where
Risk in Valuation
value can be better derived from asset liquidation.
- Future Cash flows can be projected based on  In all valuation exercises, uncertainty will be
historical results considering future events that consistently present.
may improve or reduce cash flows.  Uncertainty refers to the possible range of
- Includes cash generated from operations and values where the real firm value lies.
reductions that are related to capital  Uncertainty is captured in valuation models
investments, working capital and taxes. through cost of capital or discount rate.
- Depend on estimates of future performance of  Another aspect that contributes to uncertainty
the business and strategies in place to support is that analysts use their judgement to ascertain
this growth. assumptions based on current available facts.
- Historical information can provide a good  Influences management style, reaction to
starting point when projecting future cash changes in economic environment and adoption
flows. of innovative approaches to doing business.
 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.
 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.
- Firms with higher underlying net tangible asset
value are more stable and results in higher
going concern value.
 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, this value might not be transferred to
buyer.
 Value is impacted by liquidity. – This principle
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.
No, getting bigger does not always translate into
creating a firm’s value. The value of a firm does not
solely depend upon “growth” as a significant driver.
There are three significant value drivers we should
consider. First cash flow, the greater the cash flow
generation, the greater is the value of the firm. Second
is growth, the greater is the growth rate, the greater is
the value of the firm. Lastly is risk which relates the two
factors, the lesser the uncertainty regarding future cash
flows, the greater the growth of the firm. This means
that the impact of growth simply does not create value
because it can be influence by several factors. By means
of growth, what creates value is the cash flows
generated for investors, rather than revenue or the
earnings growth. As Alfred Marshall principle states that
a company creates value if and only if the return on
capital invested exceeds the cost of acquiring capital.

We can conclude that other factors like risk and cash

flow generation play a major role in creating value of
the firm. Generally, the relationship between growth
and the firm’s value is not linear, even when the
expected growth rate in cash flows goes up, the firm's
value does not change correspondingly.