ACCT 041
Reference:
Valuation VALUATION
Concepts and Methodologies
2021 edition
Concepts and Lacsano • Baron • Cachero
Methodologies
Chapter 1
FUNDAMENTALS
PRINCIPLES OF
VALUATION
Prepared by: MARIVEL B. NEGRANA
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, through the degree
of effort needed may vary on a case to case
basis. Methods to value for real estate can may
be different on hoe 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 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 investment and business is to maximize
shareholder value.
Maximizing value for businesses consequently result
in a domino impact to the economy. Growing
companies provide long-term sustainability to the
company by yielding higher economic output, better
productivity gains , employment growth and higher
salaries. Placing scarce resources in their most
productive use best serves the interest of different
stakeholders in the country.
The fundamental point behind success in
investments is understanding what is the
prevailing and the key drivers that influence this
value. Increase in the 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
asset or its equity. At varying levels, decisions done within a
firm entails valuation implicitly.
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.
Interpreting Different
Concepts of Value
In the corporate setting, the fundamental equation of
value is grounded on the principle that Alfred Marshall
popularized – a company creates value if and only if the
return on capital invested exceed the cost of acquiring
capital. Value, in the point of view of corporate
shareholders, relates to the difference between cash
inflows generated by an investment and the cost
associated with the capital invested which captures
both time value of money and risk premium.
The value of a business can be basically linked to
three major factors:
• Current operation – how is the operating
performance of the firm in recent year?
• Future prospects – what is the long-term,
strategic direction of the company?
• Embedded risk – what are the business risks
involved in running the business?
These factors are solid concepts; however, the quick turnover of
technologies and rapid globalization make the business
environment more dynamic. As a result, defining value and
identifying relevant drivers became more arduous as time passes
by. As firms continue to quickly evolve and adapt to new
technologies, valuation of current operations becomes more
difficult as compared to the past. Projecting future macroeconomic
indicators also is harder because of constant changes in the
economic environment and the continuous innovation of market
players. New risks and competition also surface which makes
determining uncertainties a critical ingredient to success.
The definition of value may also vary depending on the context and
objective of the valuation exercise.
• Intrinsic Value
Intrinsic value refers to the value of any asset based on the
assumption that there is a hypothetical complete understanding of its
investment characteristics. Intrinsic value is the value that an investor
considers, on the basis of an evaluation of available facts, to be the
“true” or “real” value that will become the market value when other
investors reach the same conclusion. As obtaining complete information
about the asset is impractical, investors normally estimate intrinsic value
based on the their view of the real worth of the asset.
• 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 the 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 financial distress.
• 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 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
assumed that both parties are informed of all material characteristics
about the investment that might influence their decision. Fair value is
often used in valuation exercises involving tax assessments.
Roles of Valuation
in Business
Portfolio Management
Analysis of Business Transactions/Deals
Corporate Finance
Legal and Tax Purposes
Other Purposes
The relevance of valuation in the portfolio management
largely depends on the investment objectives of the
investors or financial managers managing the
investment portfolio. Passive investors tend to be
disinterested in understanding valuation, but active
investors may want to understand valuation in order to
participate intelligently in the stock market.
Fundamental Analyst – These are persons who are interested in
understanding and measuring the intrinsic value of a firm.
Activist Investors – Activist investors tend to look for companies with good
growth prospects that have poor management.
Chartists – Chartists relies on the concept that stock prices are
significantly influenced by how investors think and act.
Information Traders – Traders that react based on new information about
firms that are revealed to the stock market. Information traders correlate
value and how information will affect its value.
Portfolio Management
Under portfolio management , the following activities can be
performed through 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 expectation – 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?
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.
Analysis of Business Transactions/Deals
Business deals include the following corporate events:
1. 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.
Analysis of Business Transactions/Deals
2. Merger – General term which describes the transaction
wherein two companies had their assets combined to form
a wholly new entity.
3. Divestiture – Sale of a major component or segment of a
business (e.g. brand or product line) to another company.
4. Spin-off – Separating a segment or component business and
transforming this into a separate legal entity.
5. Leveraged buyout – Acquisition of another business by
using significant debt which uses the acquired business as a
collateral.
Analysis of Business Transactions/Deals
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 organizations.
Analysis of Business Transactions/Deals
• 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.
Corporate Finance
Corporate finance involves managing the
firm’s capital structure, including funding
sources and strategies that the business
should pursue to maximize firm value.
Corporate finance deals with prioritizing and
distributing financial resources to activities
that increases firm value. The ultimate goal
of corporate finance maximize the firm
value by appropriate planning and
implementation of resources, while
balancing profitability and risk appetite.
Legal and Tax Purposes
Valuation is 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
decides so. Firms are also valued for estate tax purposes
if the owner passes away.
Issuance of a fairness opinion for
valuations provided by third party
(e.g. investment bank)
Other Basis for assessment of
potential lending activities by
Purposes financial institutions.
Share-based
payment/compensation
Valuation Process
Generally, the valuation process considers these five
steps:
Forecasting Selecting the
Understanding
of the business
financial right valuation
performance model
Preparing valuation Applying valuation
model based on conclusions and providing
forecasts recommendation
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 analyst 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 exists 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 players
participating in that industry. Porter’s five forces
is the most common tool used to encapsulate
industry structure.
Industry
New Entrants
Rivalry
PORTER’S
Substitutes
and
Complements
Supplier
Power FIVE
FORCES
Buyer Power
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.e.
higher concentration) which
Industry Rivalry 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
entry to industry by new market
players. If there are relatively high
entry cost, this means there are
fewer new entrants, thus lesser
competition which improves
New Entrants 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 or
Substitutes complementary products affects
industry profitability. This consider
and prices of substitute
Complements products/services, complement
product/services and government
limitations.
Supplier power refers to how
suppliers can negotiate better terms
in their favor. When there is strong
supply power, this tends to make
Supplier industry profits lower. Strong supply
Power power exists if there are few
suppliers that can supply a specific
input.
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
Buyer Power concentration is low. This means that
market players are not dependent to
few customer to survive. Low buyer
power tends to improve industry
profits since buyers cannot
significantly negotiate to lower price
of the product.
Competitive position refers to how the
products , services and the company
itself is set apart from other competing
market players. According to Michael
Porter, there are generic corporate
strategies to achieve competitive
advantage:
• Cost leadership
• Differentiation
• Focus `
Cost leadership
Differentiation
Focus
Forecasting financial performance
Forecasting summarizes the future-looking view which
results from the assessment of industry and competitive
landscape, business strategies and historical financials. This
can be summarized in two approaches:
Top-down forecasting approach
Bottom-up forecasting approach
1. Top-down forecasting approach
Forecast starts from international or national
macroeconomic projections with utmost consideration to
industry specific forecasts.
2. Bottom-up forecasting approach
Forecasts 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.
Selecting the right valuation
model
The appropriate valuation model will depend
on the context of valuation and the inherent
characteristics of the company being valued.
Details of these valuation models and the
circumstances when they should be used will
be discussed in the succeeding chapters.
Preparing valuation model based
on forecasts
Once the valuation model is decided, the
forecasts should now be inputted and
converted to the chosen valuation model.
Analysts should consider whether the resulting
value from this process makes sense based on
their knowledge about the business. To do this,
two aspects should be considered:
1. Sensitivity analysis;
2. Situational adjustments or Scenario
Modeling.
• Sensitivity analysis
Multiple analyses are done to understand how
changes in an input or variable will affect the outcome.
• Situational adjustments or Scenario Modeling
For firm-specific issues that affect firm value that
should be adjusted by analysts.
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 objectives.
Key principles in Valuation
The value of a business is defined only at a specific point in time.
Value varies based on the ability of business to generate future cash flows.
Market dictates the appropriate rate of return for investors.
Firm value can be impacted by underlying net tangible assets.
Value is influenced by transferability of future cash flows.
Value is impacted by liquidity.
Risks in Valuation
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. Value consequently may be
different based on new circumstances. Uncertainty is captured
in valuation models through cost of capital or discount rate.
END OF CHAPTER 1
