MA413 (Valuation Concepts and Methods)

Lesson 1 – OVERVIEW OF VALUATION CONCEPTS AND METHODS

Foundation and Concepts of Valuation

Overview:

The fundamental point behind success investments is understanding what is the prevailing value and the
key drivers that influence this value. In this lesson, the valuation and the processes in valuation will be
discussed.

Learning Objectives:
After successful completion of this lesson, you should be able to:
1. Describe the use and importance of valuation
2. Illustrate Porter’s Five Forces
3. Enumerate the principles and processes in creating value

Course Materials:

Valuation

It is the estimation of an asset’s value based on variables perceived to be related to future investment
returns, on comparison with similar assets, or when relevant, on estimates of immediate liquidation
proceeds, says CFA Institute.

OBJECTIVE OF THE VALUATION EXERCISE

1. Intrinsic Value – refers to the value of any asset based on the assumption assuming there is a
hypothetically complete understanding of its investment characteristics. It is the value that an investor
considers, on the basis of an evaluation or available facts, to be the “true” or “real” value that will
become the market value when other investors reach the same conclusion.

2. Going Concern Value – 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. It is particularly relevant for companies who are experiencing severe financial
distress.

4. Fair Market Value – the price, expressed in terms of cash equivalents, 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 have reasonable knowledge of the relevant facts.

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ROLES OF VALUATION IN BUSINESS

Portfolio Management

o Fundamental Analyst – these are persons who are interested in understanding and measuring
the intrinsic value of a firm. Fundamentals refer to the characteristics of an entity related to its financial
strength, profitability or risk appetite.

o 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 being run.

o Chartists – they rely on the concept that stock prices are significantly influenced by how
investors think and act and on available trading KPIs such as price movements, trading volume, short
sales – when making their investment decisions.

o Information Traders – they react based on new information about firms that are revealed to
the stock market. The underlying belief is that information traders are more adept in guessing or getting
new information about firms and they can make predict how the market will react based on this.

Valuation Techniques in Portfolio Management

∙ Stock selection
∙ Deducing market expectations

Business Deals for Analysis

 Acquisition – an acquisition usually has two parties: the buying firm that needs to determine the
fair value of the target company prior to offering a bid price and the selling firm who gauge
reasonableness of bid offers.
 Merger – transaction of two companies’ combined to form a wholly new entity.
 Divestiture – sale of a major component or segment of a business to another company.
 Spin-off – separating a segment or component business and transforming this into a separate
legal entity whose ownership will be transferred to shareholders.
 Leverage buyout – acquisition of another business by using significant debt which uses the
acquired business as a collateral.

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VALUATION PROCESS

1. Understanding the business – it includes performing industry and competitive analysis and analysis of
publicly available financial information and corporate disclosures. An investor should be able to
encapsulate the industry structure. One of the most common tools used in encapsulating industry is
Porter’s Five Forces:

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Generic Corporate Strategies to achieve Competitive Advantage

- Cost leadership – incurring the lowest cost among market players with quality that is
comparable to competitors allow the firm to be price products around the industry average.

- Differentiation – offering differentiated or unique product or service characteristics that

customers are willing to pay for an additional premium.

- Focus – identifying specific demographic segment or category segment to focus on by using

cost leadership strategy or differentiation strategy.

2. Forecasting financial performance – can be looked at two perspectives: on a macro perspective

viewing the economic environment and industry where the firm operates in and micro perspective
focusing in the firm’s financial and operating characteristics.

Two Approaches of Forecast Financial Performance

o Top down forecasting approach – international or national macroeconomic projections with

utmost consideration to industry specific forecasts.

o Bottom-up forecasting approach – forecast starts from the lower levels of the firm and builds
the forecast as it captures what will happen to the company.

3. Selecting the right valuation model – it depends on the context of the valuation and the inherent
characteristics of the company being valued.

4. Preparing valuation model based on forecasts – there are two aspects to be considered:

- Sensitivity analysis – common methodology in valuation exercises wherein multiple other

analyses are done to understand how changes in an input or variable will affect the outcome.

- Situational adjustments – firm specific issues that affects firm value that should be adjusted by
analysts since these are events that are not quantified if analysts only look at core business
operations.

5. Applying valuation conclusions and providing recommendation

KEY PRINCIPLES IN VALUATION

o The value of a business is defined only at a specific point in time.

o Value varies based on the ability of business to generate future cash flows.
o Market dictates the appropriate rate of return for investors.
o Firm value can be impacted by underlying net tangible assets.
o Value is influenced by transferability of future cash flows.
o Value is impacted by liquidity.