PRE 6: Valuation Methods
LESSON 1: FUNDAMENTALS PRINCIPLES OF VALUATION
BSMA Fourth Year, Second Semester
Assets, individually or collectively, has value. Generally, value pertains to the worth of an object in another
person's point of view. Any kind of asset can be valued, though the degree of effort needed may vary on a
case-to-case basis. Methods to value for real estate can may be different on how to value an entire
business.
Businesses treat capital as a scarce resource that they should compete to obtain and efficiently manage.
Since capital is scarce, capital providers require users to ensure that they will be able to maximize
shareholder returns to justify providing capital to them. Hence, the most fundamental principle for all
investments and business is to maximize shareholder value. Maximizing value for businesses consequently
result in a domino impact to the economy. Placing scarce resources in their most productive use best
serves the interest of different stakeholders in the country.
The fundamental point behind success in investments is understanding what is the prevailing value and the
key drivers that influence this value.
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.
Valuation places great emphasis on the professional judgment that are associated in the exercise as
valuation mostly deals with projections about future events.
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:
1. Current operations
2. Future prospects
3. Embedded risk
The definition of value may also vary depending on the context and objective of the valuation exercise.
1. Intrinsic value- refers to the value of any asset based on the assumption that there is a hypothetical
complete understanding of its investment characteristics.
2. 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.
3. Liquidation Value- The net amount that would be realized if the business is terminated and the
assets are sold piecemeal. Firm value is computed based on the assumption that entity will be
dissolved, and its assets will be sold individually hence, the liquidation process.
4. 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.
Analysis of Business Transactions / Deals
Valuation plays a very big role when analyzing potential deals.
Business deals include the following corporate events:
● Acquisition - An acquisition usually has two parties: the buying firm and the selling firm.
● 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.
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● 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.
● Control - change in people managing the organization brought about by the acquisition.
Valuation Process
Generally, the valuation process considers these five steps:
1. Understanding of the business
Understanding the business includes performing industry and competitive analysis and analysis of publicly
available financial information and corporate disclosures.
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.
PORTER’S FIVE FORCES
Industry rivalry Refers to the nature and intensity of rivalry
between market players in the industry.
New Entrants Refers to the barriers to entry to industry by
new market players.
Substitutes and This refers to the relationships between
Complements interrelated products and services in the
industry.
Supplier Power Supplier power refers to how suppliers can
negotiate better terms in their favor.
Buyer Power Buyer power pertains to how customers can
negotiate better terms in their favor for the
products/services they purchase.
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
It relates to the incurrence of the lowest cost among market players with quality that is comparable
to competitors allow the firm to price products around the industry average.
● Differentiation
Firms tend to offer differentiated or unique product or service characteristics that customers are
willing to pay for an additional premium.
● Focus
Firms are identifying specific demographic segment or category segment to focus on by using cost
leadership strategy (cost focus) or differentiation strategy (differentiation focus).
2. Forecasting financial performance
After understanding how the business operates and analyzing historical financial statements, forecasting
financial performance is the next step.
This can be summarized in two approaches:
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● Top-down forecasting approach
● Bottom-up forecasting approach
3. Selecting the right valuation model
The appropriate valuation model will depend on the context of the 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 succeeding chapters.
4. 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. To do this, two aspects should be considered:
● Sensitivity analysis
It is a common methodology in valuation exercises wherein multiple analyses are done to
understand how changes in an input or variable will affect the outcome (i.e. firm value).
● Situational adjustments or Scenario Modelling
For firm-specific issues that affect firm value that should be adjusted by analysts. In some instances,
there are factors that do not affect value per se when analysts only look at core business operations
but will still influence value regardless.
5. 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.
Key Principles in Valuation
1. The Value of a Business is Defined Only at a specific point in time
Business value tend to change every day as transactions happen. Different circumstances that occur on a
daily basis affect earnings, cash position, working capital and market conditions.
2. Value varies based on the ability of business to generate future cash flows
General concepts for most valuation techniques put emphasis on future cash flows except for some
circumstances where value can be better derived from asset liquidation.
3. 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
4. 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.
5. 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.
6. Value is impacted by liquidity
This principle is mainly dictated by the theory of demand and supply.
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.
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Innovations and entry of new businesses may also bring uncertainty to established and traditional
companies. It does not mean that a business that has operated for 100 years will continue to have stable
value..
