CHAPTER 1 FUNDAMENTAL PRINCIPLES OF VALUATION willing and able seller, acting at arm’s length in an open and

unrestricted market, not under compulsion and both have

Value reasonable knowledge of the relevant facts
- pertains to the worth of an object in another person’s point - Both parties should voluntarily agree with the price and not
of view. under threat of compulison
- Value, in the point of view of corporate shareholders, - Often used in valuation excercises involving tax
relates to the difference between cash inflows generated by assessment
an investment and the cost associated with the capital
invested which captures both time value of money and risk ROLES OF VALUATION IN BUSINESS
premium. Portfolio Management
- Depends on the investment objectives of the investors or
Valuation financial managers managing the investment portfolio
- the estimation of an asset’s value based on variables - Under this, the ff activities can be performed through the
perceived to be related to future investment returns, on use of valuation techniques: Stock Selection and Deducing
comparisons with similar assets, or, when relevant, on Market Expectation
estimates of immediate liquidation proceeds
- It includes the use of forecasts to come up with reasonable ● Fundamental Analysts
estimate of value of an entity’s asset or its equity. - interested in the understanding and measuring the
intrinsic value of a firm
● The fundamental equation of value is grounded on the - For them, the true value of a firm can be estimated
principle that Alfred Marshall popularized - a company by looking at its financial characteristics, its growth
creates value if and only if the return on capital invested prospects, cash flows and risk profile
exceed the cost of acquiring capital. - They lean towards long-term investment strategies
which encapsulate the ff principles:
a. Relationship between value and
Three major factors that can be linked to the value of a underlying factors can be reliably
business: measured
1. Current operations (how is the operating performance of b. Above relationship is stable over an
the firm in recent year?) extended period
2. Future prospects (what is the long-term, strategic direction c. Any deviations from the above
of the company?) relationship can be corrected within
3. Embedded risk (what are the business risks involved in reasonable time.
running the business?) - They can be either value or growth investors:
● Value Investors - interested in purvhasing
Intrinsic Value shares that are existing and priced at less
- Refers to the value of any asset based on the assumption than their true value
that there is a hypothetical complete understanding of its ● Growth Investors - lean towards growth
investment characteristics assets(businesses that might not be
- It is the value that an investor considers, on the basis of the profitable now but has high expected
evaluation of available facts, to be the ‘’true’ or ‘’real’’ value value in future) and purchasing these at a
that will become the market value when other investors discount
reach the same conclusion
- Estimate intrinsic value based on their view of the real ● Activist Investors
worth of the asset - tend to look for companies with good growth
- If the assumption is that the true value of asset is dictated prospects that have poor management
by the market, intrinsic value equals is market price - Usually do ‘’takeovers’’-they use their equity
holdings to push old management out of the
Going Concern Value company and change the way the company is run
- Going concern assumption believes that the entity will - For them, it not about the current value of the
continue its business activities into the foreseeable future. company but its potential value once it is run
- It is assumed that the entity will realized assets and pay properly
obligation in the normal course of business
● Chartists
Liquidation Value - Relies on the concpet that stock prices are
- It is the net amount that would be realized if the business is significantly influenced by how investors think and
terminated and the assets are sold piecemeal act
- Firm value is computed based on the assumption that entity - They rely on available trading KPIs such as price
will be disolved adn its assets will be sold individually movement, trading volume, and short sales when
making their investment decisions
Fair Market Value
- The price, expressed in terms of cash, at which property ● Information Traders
would change hand between willing and able buyer and
 - Traders that react based on new information about VALUATION PROCESS
firms that are revealed to the stock market 1. Understanding of the Business
- They are more adept in guessing or getting new - It includes performing industry and competitive
information about firms and they can make predic analysis and analysis of publicly available financial
how the market will react based in this information and corporate disclosures
- It is very important as these give analysts and
Sell-side Analysts - issue valuation judgement that are investors the idea about the ff factors:
contained in research reports that are dissimenated widely a. Economic conditions
to current and potential clients b. Industry peculiarities
Buy-sed Analysts - look at specific investment options and c. Company strategy
make valuation analysis on theses and report to portfolio d. Company’s historical performance
manager or investment committee
Industry Structure - refers to the inherent technical adn economic
Analysis of Business Transactions/Deals characteristics of an industry and the trends that may affect this
Business deals include the ff corporate events: structure
a. Acquisition ● PORTER’S FIVE FORCES is the most common tool used
- Usually has two parties: the buying firm and the to encapsulate industry structure
selling firm
- The buying firm, needs to determine the fair value a. Industry Rivalry
of the target company prior to offerinf a bid price - Refers to the nature and intensity of rivalry
- The selling firm, should have a sense of its firm between market plaers in the industry
value to gauge reasonableness of bid offers - Rivalry is less intense if lower in number of market
b. Merger - two comapnies had their assets combined to form players wich means high potential for profitability
a wholly new entity b. New Entrants
c. Divestiture - sale of a major component or segment of a - Refers to the barriers to entry to industry by new
business to another company market players
d. Spin-off - separating a segment or component business - High entry costs, fewer new entrants, lesser
and transforming this into a separate legal entity competition which improves profitability potential
e. Leveraged Buyout - acquisition of another business by c. Substitutes and Complements
using significant debt which uses the acquired business as - Refers to the relationship between interelated
a collateral products and services in the industry
- Substitute products, products that can be replace
Two important factors of valuation in deals: the sale of an existing product
1. Synergy - Potential increase in firm value that can be - Complementary products, products that can be
generated once two firms merge with each other used together with another product
2. Control - change in people managing the organization d. Supplier Power
brought by the acquisition - Refers to how suppliers can negotiate better terms
in their favor
Corporate Finance - Strong supplier power, make industry profit lower
Corporate Finance e. Buyer Power
- It involves managing the firm’s capital structure, including - Pertains to how customers can negotiate better
funding sources and strategies that tge business should terms in their favor for products/services they
pursue to maximize firm value purchase
- Deals with prioritizing and distributing financial resources to - Buying power is low if customers are fragmented
activities that incresing firm value and concentration is low
- The ultimate goal of this is to maximize the firm value by - Low buyer power tends toimprove industry profit
appropriate planning and implementation of resources,
while balancing profitability and risk appetite Competitive Position - refers to how the products, services and the
company itself is set apart from other competing market players
Legal and Tax Purposes
- Valuation is also important to businesses because of legak According to Michael Porter these are the generic corporate
and tax purposes strategies to achieve competitive advantage:
● Cost Leadership - refers to the incurrence of lowest cost
Other Purposes among market players with quality that is comparable to
- Issuance of fairness opinion for valuations provided by third competitors allow the firm to price products around the
party industry average
- Basis for assessment of potential lending activities by ● Differetiation - firms tend to offer unique product or service
financial institutions characteristics that customer are willing to pay for and
- Share-based payement/compensation additional permium
● Focus - firms are identfying specific demographic segment
or category segment to focus on by using cost leadership
 strategy (cost focus) or differentiation strategy
(differentiation focus)

Business Model - pertains to the method how the company makes

money

Quality of Earnings Analysis - pertain to the detailed review of

financial statements and accompanying notes to assess
sustainability of company performance and validate accuracy of
financial information verus economic relity

2. Forecasting Financial Performance

- Forecasting financial performance can be looked
at two lenses:
a. On a macro perspective viewing the
economic environment and industry
where the firm operates in
b. On a micro perspective focusing in the
firm’s financial and operating
characteristics
- These can be summarize in two approaches:
a. Top-down Forecasting Approach -
forecasts start
b. Bottom-up Forecasting Approach
3. Selecting the Right Valuation Model
4. Preparing Valuation Model based on Forecasts
5. Applying Valuation Conclusions and Providing
Recommendation