VALUATION CONCEPTS AND METHODS- - Embedded risk

Fundamental Principles of Valuation • Because of major developments of

technologies and rapid globalization- it makes
Fundamental Principes of Valuation:
the business more dynamic and new risks and
• Assets, individually or collectively, has value. competition also surface which makes
Value pertains to the worth of an object in determining uncertainties a critical ingredient
another’s person’s point of view to success
• Business treat capital as a scarce resource-
Different Kinds of Values:
capital providers require users to ensure that
they will be able to maximize shareholder - Intrinsic Value- value of an asset based on the
returns to justify capital to them (or will look for assumption that there is a hypothetical
more attractive) complete understanding of its investment
• The fundamental principle for all investments characteristics
and business is to “maximize shareholder “True or Real” Value in which the value that
value” in which growing companies provide long an investor considers, on basis of an evaluation
term sustainability to the economy by: of available facts.
- Yielding economic output Market price can be an intrinsic value but
- Better productivity gains not often.
- Employment growth and higher salaries - Going Concern Value- firm is determined
• Success in investment comes from under the going concern assumption
understanding what is the prevailing value and - Liquidation Value- firm value is computed
the key drivers that influence value- this is based on the assumption that the entity will
where valuation occurs. dissolve, and its assets will be sold individually
Particularly relevant for companies who are
What is Valuation? experiencing severe financial distress.
• Valuation is the estimation of an asset’s value Value declines since the assets no longer
based on the variables perceived to be related work together and human intervention is
to the future investment returns, on absent.
comparisons to similar assets, or, when - Fair Market Value- it assumes that both parties
relevant, on estimates of immediate liquidation are informed from all material characteristics
proceeds about the investment that might influence their
• It includes the use of forecasts decision.
It often used in valuation exercises involving
• It places great emphasis on the “professional
tax assessments.
judgment”
• Analysts should hone their ability to balance Roles of Valuation in Business:
and evaluate different assumptions used in
each phase of the valuation exercise, assess Portfolio Management- it depends on the
validity of available empirical evidence and objectives of the investors or financial managers
come up with rational choices that align with managing the investment portfolio.
objectivity of the valuation exercise. Passive investors tend to be disinterested in
Interpreting Different Concepts of Value: understanding valuation while active investors
doing otherwise.
• The fundamental equation of value is grounded
- Fundamental analysts-interested in
in the principle that “a company creates value if
understanding the intrinsic value of a firm.
and only if the return on capital invested exceed
Which believes that any noted variant between
the cost of acquiring capital”
the stock’s market price versus the
• It captures both time value of money and risk
fundamental value indicates that it might be
premium
overvalued or undervalued
• The value of business can be basically link to
Typically, fundamental analysts lean
three major factors:
towards long-term investment strategies which
- Current operations
encapsulates the following principles:
- Future Prospects
 ➢ Relationship between value and underlying report to a portfolio manager or investment
factors can be reliably measured committee.
➢ Above relationship is stable over the
Analysis of Business Transactions/Deals-
extended period
estimate value of target firms they are planning to
➢ Any deviations from the above relationship
purchase and understand the synergies they can
can be corrected within a reasonable time
take advantage from the purchase- also in the
They can either value or growth investors- negotiation process to set the deal price.
“Value investors”- purchasing shares that are
Business deals include the ff. corporate events:
priced lower than their true value. “Growth
investors”- assets not profitable now but has - Acquisition- buying and selling firms- BF needs
high expected value in the future. to determine the FV of the target company prior
to offering bid price while SF should gave a
Security and investments analysts use
sense of its firm value to gauge reasonableness
valuation techniques to support buy/ sell
of bud offers
recommendations that they provide to their
- Merger- two companies had their assets
clients.
combined to form a wholly or new entity
- Activist investors- they look for the good - Divestiture- sale of a major component or
growth prospects that have poor management- segment of a business to another company
usually do “takeovers” it is not the current value - Spin-off- separating a segment or component
but it’s potential value when managed properly business and transforming this into a separate
They should have: legal entity
➢ Good understanding of the company’ - Leverage buyout- acquisition of another
business model business by using significant debt which uses
➢ How implementing changes investments, the acquired business as collateral
dividend and financing policies can affect its
Valuation in deals analysis considers two
value
important, unique factors:
- Chartists- stock prices are heavily influenced
by how investors think and act- which means - Synergy- potential increase in firm value that
investor psychology will predict movements in can be generated once two firms merge with
stock prices than rational analysis which helps each other
us derived from the fact where valuation does - Control- change in people managing the
not play a huge role in charting. organization brought about by the acquisition
KPIs such as price movements, trading
volume, and short sales makes their investment Corporate Finance- managing capital firm’s
decisions structure- including funding sources and strategies
- Information Traders- they react based on new that the business should pursue to maximize firm
information about the firms that are revealed to value. Valuation methodologies also enable
the stock market- they correlate value and how communication about significant corporate
information affects this value. matters between management, shareholders,
consultants, and investment analysts.
The following activities can be performed using
valuation techniques: PM Small private businesses that need
additional money to expand use valuation concepts
- Stock selection- UN, OV, FV when approaching private equity investors and
- Deducing market expectations- firm’s future venture capital providers to show the promise of
performance = prevailing market price the business.
Sell-side analysts that work in the brokerage Larger companies who wish to obtain
department of investment firms issue valuation additional funds by offering their shares to the
judgment that are contained in research reports public need valuation to estimate the price they are
and disseminated to current and potential clients. going to fetch in the stock market.
Buy-side analysts- look at specific investment Legal and Tax Purposes- it is important in this area
options and make valuation analysis on these and too.
Other Purposes- value of substitute products that buyers can
purchase, customer switching costs, and
- Issuance of a fairness opinion for valuations
government restraints
provided by the third party
- Basis for assessment of potential lending Strategies to achieve competitive advantage:
activities by the financial institutions
- Cost leadership
- Share-based payment/compensation
- Differentiation
Valuation Process: 5 steps - Focus- use Cost leadership strategy (cost
focus) or differentiation strategy (differentiation
#1 Understanding of the Business- to form
focus)
assumption about the business
Understanding business model is also
Performing industry and competitive analysis
important- to have an idea how it business pertains
and analysis of publicly available financial
the method of how the company makes money.
information and corporate disclosures.
Analyst also look for FS to have an idea how
It gives ideas to the following factors: economic
resilient the company in the past and how they
conditions, industry peculiarities, company
reacted problems they encountered along the way.
strategy and company’s historical performance.
To assess they uses horizontal, vertical, and ratio
Industry structure refers to the inherent analysis.
technical and economic characteristics of an
Typical sources of information should come
industry and the trends that may affect this
from publicly available information- like audited FS,
structure.
news articles, reports from industry organizations,
Porter’s Five Forces: Industry and Competitive reports from regulatory agencies, and industry
Landscape research done by independent firms.

- Industry Rivalry- nature and intensity of rivalry Quality of earning analysis compares net
between market players in the industry. This income against operating cash flow to make sure
considers concentration of market players, reporting earning are actually realizable to cash and
degree of differentiation, switching costs, are not padded through significant accrual entries.
information and government restraint.
Typical observations:
- New Entrants- barriers to entry to industry by
new market players. It includes- entry costs, Line Item Possible Observation
speed of adjustment, economies of scale, Revenues and Gain - Early recognition of
reputation, switching cost, sunk costs and revenues
government restraints - Inclusion of
- Substitutes and Complements- refers to the nonoperating
relationships between interrelated products income or gains as
and services in the industry. It includes- prices part of OE
Expenses and losses - Recognition of too
of substitute products/services, complement
high or too little
products/services, and government limitations
reserves
- Supplier Power- refers to how suppliers can - Deferral of
negotiate better terms in their favor. HSP>Lower expenses such as
industry profits (few suppliers). It considers- customer
supplier concentration, prices of alternative acquisition or
inputs, relationship-specific investments, product
supplier switching costs, and governmental development costs
regulations by capitalization
- Buyer Power- pertains to how customers can - Aggressive
negotiate better terms in their favor for assumptions such
products/services they purchase. LBP<More as long useful lives,
industry profits. Other factors considered in lower asset
impairment, high
buyer power include- buyer concentration,
assumed discount
 rate for pension Forecasts are done on annual basis as most
liabilities or high publicly available financial information are
expected return on interpreted in annual basis- where applicable, can
plan assets be better done on a quarterly basis to account for
Balance sheet items - Off balance sheet seasonality.
like leasing or
securitizing #3 Selecting Right Valuation Model- will depend
receivables on the context of the valuation and the inherent
Operating cash flows - Increase in bank characteristics of the company being valued
overdraft as
operating cash flow #4 Preparing Valuation Model based on
Other red flags that indicate aggressive accounting: Forecasts-input and convert

- Poor quality of accounting disclosures Consider whether the resulting value from this
- Existence of related party transactions or process makes sense- two aspects should be
excessive officer, employee, or director loans considered:
- Reported disputes with and/or changes in - Sensitivity Analysis- multiple analyses are
auditors done to understand how change in an input or
- Material non-audit services performed by an variable will affect the outcome- (sales growth,
audit firm gross margin rates, discount rates, market
- Management and/or directors’ compensation share, advertising expense, discounts,
ties to profitability or stock price differentiated feature)
- Economic, industry, or company- specific - Situational adjustments or Scenario
pressures on profitability Modelling- issues that affect firm value that
- High management/ director turnover should be adjusted by analysts
- Excessive pressure on company personnel to ➢ Control premium- addtnl. value considered
make revenue or earning targets in a stock investment if acquiring it will give
- Management pressure to meet debt covenants controlling power to the investor
or earnings expectations ➢ Lack of marketability discount (stock cannot
- A history of securities law violations, reporting be easily sold) and Illiquidity discount (price
violations, or persistent late filings is less depth, less liquid thank other
#2 Forecasting Financial Performance- can be SP)=drive down share value
looked at two lenses: #5 Applying valuation conclusions and providing
- On a macro perspective viewing the economic recommendations- that suits their investment
environment and industry where the firm objective
operates in Key Principles in Valuation:
- On micro perspective focusing on the firm’s
financial and operating characteristics - The Value of a Business is Defined Only at a
specific point in time
Forecasting can be summarized in two approaches: - Value varies based on the ability of business to
- Top-down forecasting approach- GDP generate future cash flows
Forecast, consumption forecasts, inflation - Market dictates the appropriate rate of return to
projections, forex currency rates, industry sales investors
and market share (starts from - Firm value can be impacted by underlying net
international/national macroeconomic tangible assets
projections in consideration to industry specific - Value is influenced by transferability of future
forecasts) cash flows
- Botton-up forecasting approach- store - Value is impacted by liquidity
expansions and increase in product availability Risks in Valuation:
is collated and revenues resulting from these
are calculated (starts from the lower levels of - Value may be different based in new
the firm) circumstances- Uncertainty is captured in
 valuation models through cost of capital or
discount rate
- Analysts use their judgments on current
available facts which may be different from the
perfectly estimations.
- Performance of each industry varies degrees of
predictability which fuels uncertainty
- Innovations and entry of new businesses may
also bring uncertainty to the establish and
traditional companies- your value now does not
equal to stable value in the future.
VALUATION CONCEPTS AND METHODS- Asset - The advantage of this method is that it provides
Based Valuation a more transparent view on firm value and is
more verifiable since this is based in the figures
Asset Valuation:
in FS- the downside is that it is historical which
- The value of an asset should include all cash may not reflect the real value of the business
flows that will be generated until the disposal of currently.
an asset (2) Replacement Value Method- value of
- Valuation is sensitive and confidential activity in individual assets shall be adjusted ton reflect
the portfolio management the relative value or cost equivalent to replace
that asset.
Green Field Investments- investments that started
from scratch Factors that affect the replacement value of an
asset:
Brown Field Investments- already in a going
concern state – Going Concern Business - Age of the asset
Opportunities (GCBOs) - Size of the assets
- Competitive advantage of the asset
GFI is a lot more challenging in determining its
value than BFI. Formula:

- Advantage of GCBOs we already have reference

from its historical performance or an existing
business with similar nature
- Compute for the Adjusted amounts of Non-
COSO noted in their report the benefits of having Current Assets
sound Enterprise-wide Risk Management which - Add back the unadjusted amounts which
allows the company to: equals Total Assets-Replacement Value
- Apply the Replacement Value Formula
- Increase the opportunities
(3) Reproduction Value Method- is an estimate of
- Facilitate management and identification of the
cost of reproducing, creating, developing or
risk factors that affect business
manufacturing a similar asset.
- Identify or create cost-efficient opportunities
- Manage performance variably Steps in determining the equity value using the
- Improve management and distribution of reproduction value method are as follows:
resources across to enterprise
- Conduct reproduction costs analysis on all
- Make business more resilient to abrupt changes
assets (NCA x % of affected item) the remaining
Information required for asset-based valuation is the goodwill and already in its proper value
includes: - Adjust the BV to reproduction cost values
(similar as replacement value)
- Total value of the assets
- Apply the replacement value formula using the
- Financing structure
figures calculated in the preceding step
- Classes of equity and other sources of funding
Formula:
Methods:
Reproduction Value= Net Book Value +_
(1) Book value method- value recorded in the Reproduction adjustment/ Outstanding shares
accounting records of a company (audited FS)
(4) Liquidation Value Method- considers the
- Assets and Liabilities are required to be
salvage value as the value of the asset
categorized by current and non-current
(piecemeal)- also known as “net asset value”
Formula:
-Liquidation value- base price or the floor price for
any firm valuation exercise

Situations to Consider Liquidation Value:

- Business Failures- commonly bankruptcy, Less: PV of Tax charges for the (xx)
business failures can be driven by different transactions and other liquidation costs
internal factors such as:
➢ Mismanagement Liquidation Value xx
➢ Poor financial evaluation and decisions Case 1- Steps
➢ Failure to execute strategic plans - Compute for the adjusted value of the assets,
➢ Inadequate cash flow planning current BVs should be multiplied by assumed
➢ Failure to manage working capital realizable value if they are liquidated.
These external factors that would attribute - Compute for Liquidation Value/ Liquidation
to business failure may take the form of, but is Value per share
not limited to the ff:
➢ Severe economic down-turn Asset Adjusted Value xx
➢ Dynamic consumer preferences Less: Total liabilities to be settled (xx)
➢ Material adverse governmental action or Liquidation value xx
regulation Divided by OS xx
➢ Occurrence of natural disasters or Liquidation value per share Pxx
calamities Case 2- Steps
➢ Occurrence of pandemic or general health - Compute PV od the Cash Inflows during years
hazards in operation (per year)
- Corporate or Project End of Life PV of Annual NCF= Net Cash Flow x PV Factor
- Depletion of scarce resources of %
General Principles on Liquidation Value: LVM is - Compute Liquidation Value:
the most conservative valuation approach PV sale of asset xx
General concepts considered in liquidation value Less: PV of cost for termination and (xx)
are as follows: settlement of Liabilities
Less: PV of Tax charges for transactions (xx)
- If liquidation value is above the income and other liquidation costs
approach and liquidation comes into Liquidation value xx
consideration- use LV approach - Compute for the Value of company:
- If the nature of the business implies limited Value of the Company= PV of Cash Inflows
lifetime- terminal value must be based on during years of operation + Liquidation value
liquidation. All costs necessary to close the
Case 3- Steps
operations should be factored in and deducted
to arrive at the liquidation value - Compute for Liquidation value:
- Non-operating assets should be valued by Liquidation value= Sale of assets upon
liquidation method liquidation – Payment of Liabilities-
- Liquidation valuation must be used if the Liquidation Costs
business continuity is dependent on current - Compute for Liquidation value per share:
management will not stay Liquidation value per share= Liquidation
value/ No. of OS ordinary
Types of Liquidation:

- Orderly liquidation- assets are sold

strategically over an orderly period to attract
and generate most money for the assets
- Forced Liquidation- assets are sold as quickly
as possible, such as at auction

Calculating Liquidation Value:

Present Value of Sale of Asset xx

Less: PV of Cost for termination and
settlement for Liabilities (xx)
VALUATION CONCEPTS AND METHODS- Income
Based Valuation
Income based valuation- investors consider two
(2) opposing theories:
Dividend Irrelevance Theory- stock prices are not
affected by dividends or returns on the stock but
more on the ability and sustainability of the asset or Economic Value Added:
company - The most conventional way to determine value
Bird-in-hand Theory (Dividend Relevance of an asset
Theory)- dividend or capital gains has an impact on - It is the excess of the company earnings after
the price of the stock deducting the cost of capital
Certain factors that can be considered to properly The elements that must be considered in using
value the asset: EVA:
- Earning accretion- additional value inputted in - Reasonableness of earnings or returns
the calculation that would account for the - Appropriate cost of capital
increase in value of firm dure to other Formula:
quantifiable attributes like (potential growth,
increase in prices, and operating efficiencies)
- Equity control premium- amount added to the
value of the firm in order to gain control Capitalization of Earnings Method:
- Precedent transactions - the value of the asset or investment is
Key Driver of this method is the cost of capital and determined using anticipated earnings of the
cost of capital can be computes through: company divided by the capitalization rate
(a) Weighted Average Cost of Capital- weighting - this method provides for the relationship of the
the portion of the asset funded through equity 1. Estimated earnings of the company
and debt 2. Expected yield or required rate of return
3. Estimated equity value
Formula:

- If earnings are fixed in the future- it will be

applied directly.
WACC may also include other sources of
- If earnings are not constant: average all the
financing like Preferred Stock and Retained
variable net cash flows in the given period
Earnings
- If there is an “idle asset”- it is added to the
Steps:
calculated capitalized earnings
- Compute for Ke or cost of equity
Limitations:
- Find We or weight of equity financing
- This does not fully account for future earnings
- Compute for Cost of debt for Kd
or cash flows thereby resulting to over or
- Compute for cost of debt after tax (1-%)
undervaluation
- Input the percentage without tax
- Inability to incorporate contingencies
- Add all
- Assumptions used to determine the cashflows
(b) Capital Asset Pricing Model
may not hold true since the projections are
based on a limited time horizon

The cost of debt formula: