VALUATION CONCEPTS AND METHODOLOGIES

Valuation
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
includes the use of forecasts to come up with reasonable estimate

Alfred Marshall popularized, "a company creates value if and only if the return on capital invested exceed the
cost of acquiring capital".

Value of a company:

Current operations Future prospects Embedded risks

Intrinsic Value
based on assumption that there is a hypothetical complete understanding of its investment
characteristics
value that investor considers based on available facts

Grossman-Stiglitz paradox states, "if market prices, which can be obtained freely, perfectly reflect
the instrinsic value of an asset, then a rational investor will not spend to gather data to validate
the value of a stock".

As a result, market price does not often approximate an asset's intrinsic value. Intrinsic value is
highly relevant in valuing public shares.

Going Concern Value

it believes that the entity will continue to do its business activities into the foreseeable future
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
relevant for companies who are experiencing severe financial distress
value often declines

Fair Market Value

price, in terms of cash, at which property would change hands, when neither is under compulsion
to buy or sells and when both have reasonable knowledge of the relevant facts
often used in valuation exercises involving tax assessments

Rules of Valuation
Portfolio Management
depends on investment objectives
 Fundamental analysts
persons interested in understanding and measuring intrinsic value
true value of a firm can be estimated by looking at its financial characteristics, its
growth prospects, cash flows and risk profile
any noted variance between stock's market price versus its fundamental value indicates
that it might be overvalued or undervalued
lean towards long-term investment strategies:
relationship between value and underlying factors can be reliably measured
above relationship is stable over an extended period
any deviations from the above relationship can be corrected within a
reasonable time
either value or growth
value investors are mostly interested in purchasing shares that are existing
and priced at less than their true value
growth investors lean towards growth assets and purchasing these at a
discount

Activitist investors
look for companies with good growth prospects that have poor management
do "takeovers" - use equity holdings to push old management out of the company
about the potential value once it is run properly
understanding of the business model and how implementing changes in investment,
dividend and financing policies can affect its value

Chartists
stock prices are significantly influenced by how investors think and act
rely on available trading KPIs (Key Performance Indicators)
stock prices changes and follows predictable patterns
valuation does not play a huge role in charting

Information traders
react based on new information about firms that are revealed to the stock market
valuation is important since they buy or sell shares based on their assessment on how
new information will affect stock price

The following activities can be performed under portfolio management:

Stock selection
Deducing market expectations

Sell-side analysts
issue valuation judgment that are contained in research reports that are disseminated
Buy-side analysts
look at specific investment options and make valuation analysis
tend to perform more in-depth analysis

Analysis of Business Transactions/Deals

 Acquisition
two parties: buying and selling firm
bias may be a significant concern

Merger
two companies had their assets combined to form a wholly new entity

Divestiture
sale of a major component to another company

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

Valuation considers two important factors:

Synergy potential increase in firm value once two firms merge with each other
Control change in management brought by acquisition

Corporate Finance
managing firm's capital structure including funding sources and strategies
deals with prioritizing and distributing financial resources to activities that increases firm value

Legal and Tax Purposes

dissolution, liquidation, estate tax, etc.

Other Purposes
issuance of a fairness opinion for valuations provided by third party
basis for assessment of potential lending activities by financial institutions
share-based payment/compensation

Valuation Process

Understanding the business

Porter's Five Forces

considers concentration of market players, degree of differentiation,
Industry rivalry
switching costs, information and government restraint
barriers to entry to industry by new market players. It includes entry costs,
New entrants speed of adjustment, economies of scale, reputation, switching costs, sunk
costs and government restraints
Substitutes and refers to the relationships between interrelated products and services in
complements the industry. Their availability affects industry profitability
Supplier power negotiation of better terms in their favor
 Buyer power low tends to improve industry power

Competitive position refers to how products, services and the company itself is set apart from
other competing market players.

Michael Porter's Generic Corporate Strategies to Gain Advantage

incurrence of the lowest cost among market players while quality is

Cost Leadership
comparable to competitors
Differentiation offering unique product or service
identifies specific demographic category segment to focus on by using cost
Focus
leadership strategy and differentiation strategy

Business model pertains to the method of how company makes money.

In analyzing bistorical financial information, focus is afforded in looking at quality of earnings.

Quality of earnings analysis pertain to the detailed review of financial statemets and notes to
assess sustainability of company perfformance and validate accuracy of financial information.

Forecasting financial performance

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

Two Approaches:
Top-down Forecasting Approach
starts from international or national macroeconomic projections
GDP forecast, consumption forecasts, inflation projections, foreign
exchange currency rates, industry sales and market share

Bottom-up Forecasting Approach

starts from lower levels of the firm

Comprehensive Forecasting Approach

prevents any inconsistent figures between the prospective financial
statements and unrealistic assumptions
analysis should be done per line items as each item can be influenced by a
different business driver

Selecting the right valuation model

Preparing valuation model based on forecasts

two aspects must be considered:
Sensitivity Analysis
Situational Adjustments or Scenario Modelling
Control premium is the additional value considered in a stock
investment if acquiring it will give controlling power to investor
 Applying valuation conclusions and providing recommendation

Key Principles in Valuation

Value is defined at a specific point in time
Value varies based on ability of business to generate future cash flows
Market dictates appropriate rate of return for investors
Value can be impacted by underlying net tangible assets
Value is influenced by transferability of future cash flows
Value is impacted by liquidity

ASSET BASED VALUATION

It is more challenging to determine the value of a green field investment since value shall be based on pure
estimates compared to brown field investment.
Green field investment starts from scratch
Brown field investments are already in the going concern state

Asset-based valuation can be used if the basis of the value is concretely established and complete.
Information required include total value of assets, financing structure, classes of equity and sources of fund.

Book Value Method

book value is highly dependent on the value of the assets declared in the audited financial
statement

Total Assets - Total Liabilities

Net Book Value of Assets =
Number of Outstanding Shares

advantage: it provides more transparent view on firm value and is more verifiable
limitation: it only reflects historical value

Replacement Value Method

replacement cost is the cost of similar assets that have the nearest equivalent value as of the
evaluation date
value of individual assets shall be adjusted to reflect the relative value or cost equivalent
factors that can affect replacement value:
Age of asset
Size of asset
Competitive advantage of asset

Net Book Value ± Replacement Adjustment

Replacement Value per Share =
Outstanding Shares

Reproduction Value Method

an estimate of cost of reproducing, creating, developing or manufacturing a similar asset
required reproduction cost analysis which is internally done
limitation: the ability to validate the reasonableness of the value calculated since there are
only limited sources of comparators
 Steps in determining the equity value:
Conduct reproduction cost analysis on all assets
Adjust the book values to reproduction costs values
Apply the replacement value formula using the figures calculated in the preceding step

Liquidation Value Method

equity valuation approach that considers the salvage value as the value of the asset
limitation: future value is not fully incorporated in the calculated equity value

LIQUIDATION BASED VALUATION

Liquidation value
also known as net asset value
base price for any firm valuation exercise
does not consider growth prospects of the business
most conservative as it considers the realizable value of the asset if it is sold now based on
current conditions
unique callout is under a proprietorship or partnership because it is dependent on skills of owner
or partners hence they should consider valuing separately the goodwill attributed to these
partner-specific qualities as this may not reflect true value of assets

Situations to Consider Liquidation Value

Business Failures
Corporate or Project End of Life
Depletion of Scarce Resources

Liquidation Value Should be Used:

When liquidation value is greater than going concern value
When business has finite life
To value non-operating assets
If business continuity is dependent on current management who will not stay

Calculation of Liquidation Value

considers the present value of the sums that can be obtained through the disposal of assets
of the firm in the most appropriate wat, net of the sums set aside for the closure costs, repayment
of the debts and settlements of all liabilities, and net of the tax charges related to the transaction
and the costs of the process of liquidation itself

computed on a per share basis by dividing total liquidation value by outstanding ordinary shares

Present Value of Sale of Asset xx

Less: PV of Cost for Termination and Settlement for Liabilities (xx)
Less: PV of Tax Charges for Transactions and other Liquidation Costs (xx)
Liquidation Cost xx

Liquidation Value should be based on potential earning capacity when sold to the buying party
instead of the original capital invested in the assets.
 PV of Cash Inflows during Years in Operation xx
Add: Liquidation Value xx
Value of Company xx

INCOME BASED VALUATION

Investors consider two opposing theories:

Dividend Irrelevance Theory
Modigliani and Miller
stock prices are not affected by dividends or the returns on the stock but more on the
ability and sustainability of the asset or company
Bird-In-Hand Theory
dividend relevance theory
Myron Gordon and John Lintner
dividend or capital gains has an impact on the price of stock

Factors to consider to properly value the asset:

Earning accretion or dilution
additional value inputted in the calculation that would account for the increase in the
value of the firm due to quantifiable attributes
Equity control premium
amount that is added to the value of the firm in order to gain control of it
Precedent transactions
previous deals or experiences that can be similar with the investment being evaluated

Key Drivers:
Cost of the capital or required return for a venture

Weighted Average Cost of Capital Capital Asset pricing Model

WACC = (kₑ x wₑ) + (k d x w d) kₑ ​= Rf​ +β(Rm​−Rf​)

kₑ = cost of equity Rf = risk free rate

wₑ = weight of the equity financing β = beta
kd = cost of debt after tax Rm = market return
wd = weight of the debt financing
Cost of Debt
it may also include other source
of financing like Preferred Stock kd = R f + DM
& Retained Earnings
Rf = risk free rate
DM = debt margin
Economic Value Added
most conventional way to determine the value of asset
convenient metric in evaluating investment as it quickly measures the ability of the firm to support
its cost of capital using its earnings
 excess of the company earnings after deducting the cost of capital

Elements that must be considered:

Reasonableness of earnings or returns
Appropriate cost of capital

EVA = Earnings - Cost of Capital

Cost of Capital = Investment value x Rate of Cost of Capital

EVA = EAT - (WACC x Capital)

Capitalization of Earnings Method

value of asset or investment is determined using the anticipated earnings of the company
divided by the capitalization rate
provides for the relationship of the:
estimated earnings of the company
expected yield or the required rate of return
estimated equity value

Future Earnings
Equity Value =
Required Return

if earnings are fixed in the future, the capitalization rate will be applied directly to the projected
fixed earnings
limitations:
does not fully account for the future earnings or cash flows
inability to incorporate contingencies
assumptions may not hold true since projections are based on a limited time horizon

If future earnings are not constant and vary every year, it is suggested to average the earnings.

Discounted Cash Flows Method

most popular method
generally used by investors, valuators and analyst because of sophisticated approach in
determining the corporate value
determines equity value by calculating the present value of the expected duture net cash flows

DISCOUNTED CASH FLOWS METHOD

Net Cash Flows is preferred as basis of evaluation if any of the following conditions are present:
Company does not pay dividends
Company pays dividends but the amount paid out significantly differs from its capcity to pay
dividends
Net Cash Flows and profits are aligned within a reasonable forecast period
Investor has a control perspective

Using net cash flows is more advantageous since it can be directly used as input to a Discounted Cash Flow
 model. This is not the case as EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization),
EBIT, net income and cash flow from operations.

Two Levels of Net Cash Flow

To the firm cash flow available to the parties who supplied capital after paying all
operating expenses, including taxes, and investing in capital expenditures
and working capital
cash flow generated from operating activities

A. Based from Net Income (Indirect Approach)

Net Income available to common shareholders
Add: Non-cash charges (net)
Add: Interest expense (net of axes)
Add/Less: Adjustment in working capital
Less: Net investment in fixed capital (purchases - sales of fixed capital inv)
Net Cash Flows to the Firm

Non-Cash Charges
Depreciation and amortization
Restructuring charges
Provisions for doubtful accounts

B. Based from Statement of Cash Flows

Cash flows from operating activities
Add: Interest expenses (net of taxes-only id deducted from operations)
Less: Cash flows from investing activities
Net Cash Flows to the Firm

C. From EBITDA
EBITDA, net of taxes
Add: Tax savings on noncash charges
Add/Less: Working capital adjustments
Less: Investment in fixed capital
Net Cash Flows to the Firm

To equity level of available cash that a business can freely declare as dividends to
its common shareholders

Net Cash Flows to the Firm

Add: Proceeds from Borrowings
Less: Debt Service
Add: Proceeds from Preferred Shares Issuance
Less: Dividends on Preferred Shares
Net Cash Flows to the Equity

Terminal Value
value of company in perpetuity or in a going concern environment
 basis:
Liquidation value
Estimated perpetual value
using the farthest cash flows you can estimate divide by the cost of capital
less the growth rate

CFn+1 CFn+1 = farthest net cash flows

TV =
r-g r= cost of capital
g= growth rate
Constant growth
Scientific estimates

MARKET APPROACH VALUATION

It follows the concept that the value of the business can be determined by reference to reasonably
comparable guideline companies for which transaction values are known.

Business Valuation Methods

Comparative transaction method/comparative private company sale data method
Guideline publicly traded company method
Use of expert opinions of professional practitioners

Empirical/Statistical Approach
uses research and database processing in order to come up with conclusion and recommendation
requires references and evidences
information may take the form of Sales Data, Financial Performance and other historical info

Comparative Private Company Sales Data

guideline transaction method
finding out prior transactions of comparable companies
a majority stake should be valued relative to either:
prior transaction of the same company involving a majority stake
guideline transactions representing a majority stake involving a comparable
company
a minority stake should be valued using the guideline public company method after
applying prooper discounts and adjustments
advantage: source of data is reliable and comparable
disadvantage: there is insufficient market evidence

Guideline Public Company Data

identifying a comparable company and obtaining the stock price for the company's
listed securities
advantage: availability of large set of recent data
disadvantage: not appropriate in valuing early-stage or small businesses

Prior Transactions Method

looking up historical transactions in securities of the business undervaluation
additional considerations include selecting timeline of the transaction, economic
 situation, etc.
advantage: a good reference for valuation if data is available
disadvantage: absence of good data may not enable this approach to produce reliable
results

Comparable Company Analysis

comparators must be at least with the similar industry
total or absolute values should not be compared
variables used in determining the ratios must be the same
period of observation must be comparable
non quantitative factors must also be considered

Price-Earnings Ratio
represents the relationship of market value per share and earnings per share

Market Value Per Share

Earnings Per Share

Book-to-Market Ratio
determine the appreciation of the market to value of the company as compared to
the value it reported under its SFP

Net Book Value Per Share

Market Value Per Share

Dividend Yield Ratio

relationship between the dividends received per share and the appreciation of the
market on the price of the company

Dividend Per Share

Market Value Per Share

EBITDA Multiple
Earnings Before Interest, Taxes, Depreciation and Amortization
net amount of revenue after deducting operating expenses and before deducting
financial fixed costs, taxes and non-cash expenses

Market Value per Share

EBITDA per Share

Heuristic Pricing Rules Method

analysts use business pricing formulas that are developed based on the expert opinion of
professionals involves in business sales
advantage: based on expert opinion and pricing formulas are often relied upon both by
practitioners and their client business owners and buyers
disadvantage: pricing multiples may not be sufficiently backed by rigorous statistical analysis
 OTHER CONCEPTS AND VALUATION TECHNIQUES
Due Diligence
process of validating the representations made by a seller
team is composed of lawyers, auditors and technical experts

According to Executor:
Corporate Due Diligence
comissions external experts
part of the cost of investment of the company
Private Due Diligence
facilitated by individual or gew individual investors but not yet incorporated
normally done by investors themselves
Government Due Diligence
for the protection of public

According to Subject:
Hard Due Diligence
focuses on data and hard evidential information
focuses on EBITDA, aging of receivables and payables, cash flow and
capital expenditures
prone to unrealistic and biased interpretations by eager salespeople
EX: Review and audit of FS
Validation of the projections for future performance
Analysis of the market or industry
Review of ooperational policies, process and procedures
Review of potential or ongoing litigation
Review of antitrust considerations
Assessment of subcontractor and other third part relationships
Soft Due Diligence
focuses on internal affairs
validate qualitative factors
concerned with employee motivation and compensation packages
EX: Organizational review including succession plans
Competency assessment
Quality assurance on customer services
Quality assurance on processes
On the ground interview and examination
Combined Due Diligence

Factors To Be Considered:
1. Market Capitalization
provides an indication on how volatile the value of the company in the market
2. Performance/Profitability Trend Analysis
3. External Environment Analysis
4. Management and Share Ownership
5. Financial Statements
6. Stock Price History
 7. Stock Dilution Possibilities
8. Market Expectations
9. Long and Short-term Risks

Mergers and Acquisitions

combining assets to another company or to acquire another company
popular strategy to expand and for others to save from distress

Top reasons why companies entered into M&As:

Manage the cost of capital
Expansion and growth
Economies of scale
Diversify for expanded market coverage
Widen access in the industry
Technological advancement
Tax management strategies
Legal strategies
Control over supply chain

According to Form:
Absorption
company takes over another company, normally latter are in disadvantage
Consolidation
two companies combined its assets and restructure their debt profile

According to Economic Perspective:

Horizontal
Vertical
Conglomerate

Based on Legal Perspective

Short-form M&As
parent purchase more interest from subsidiary
Statutory M&As
company combines with another where the acquirer retains its name
Subsidiary M&As
consolidation of subsidiaries of a holding or parent company

Five Stages of M&A

1. Pre-acquisition Review - conduct internal evaluation with regards to business opportunity
2. Investment Opportunity Scanning - gathering risks
3. Valuation of Target Investment
4. Negotiation
5. Integration

Reasons for Failure of M&A

1. Poor Strategic Fit - failure to align mission, vision and goals
 2. Poorly executed and ill managed integration phase
3. Inadequate Due Diligence
4. Too Aggressive Projections and Estimates

Major Valuation Methods Used

Discounted Cash Flow Method
based on projected cash flow with appropriate discount
Comparable Company Analysis
relative valuation metric for public companies are used to determine the
value of the target
Comparable Transaction Analysis
valuation metrics for past comparable transactions in the industry are used

Divestiture
disposal of assets of an entity or segment via sale to third party
sale of any assets that the company owns but is also used as a term to describe sale of a non-core
business segment
enable companies to improve cash flows, discontinue operating segments that are not aligned
with the strategic direction and create additional shareholder value

Rationale:
Sell non-core business segment
Generate additional funds
Take advantage of resale value of non-performing segments instead of incurring losses
Ensure business stability
Adapt to regulatory environment
Lack of internal talent
Take advantage of opportunistic offer from third party

Types:
Partial sell-offs
Equity Carve-out
occurs when initial public offering is performed for up to 20% ownership
of a subsidiary
companies often need additional cash and often faces uncertainty
about how much a subsidiary is worth
Spin-off
Split-off
shareholders are offered the option to exchange parent company shares for
the new company shares

Impact:
Divestiture Value = Going concern value no impact in selling company's value
Divestiture Value > Going concern value increase value of selling company
Divestiture Value < Going concern value decrease value of selling company