VALUATION CONCEPTS AND METHODOLOGIES

CHAPTER 1 : FUNDAMENTAL PRINCIPLES OF VALUATION

According to CFA Institute, valuation is the estimation of investor will not spend to gather data to validate the
an asset’s value based on variables perceived to be related value of a stock.
to future investment returns, on comparisons with similar
assets, or, when relevant on estimates of immediate The rational efficient markets formulation of Grossman
liquidation proceeds. and Stiglitz acknowledges that investors will not
rationally spend to gather more information about an
●​ It includes the use of forecasts to come up with asset unless they expect that there is potential reward in
reasonable estimates of value of an entity’s assets exchange for the effort.
or its equity.
2.​ Going Concern Value - Firm value is
INTERPRETING DIFFERENT CONCEPTS OF determined under the going concern assumption. The
VALUE going concern value believes that the entity will
continue to do its business activities into the foreseeable
Alfred Marshall - a company creates value if and only if future.
the return on capital invested exceeds the cost of
acquiring capital. 3.​ Liquidation Value - The net amount that would
be realized if the business is terminated and the assets
VALUE OF BUSINESS LINKED TO 3 MAJOR are sold piecemeal.
FACTORS: -​ Liquidation Value is particularly relevant for
1.​ Current Operation - how is the operating companies who are experiencing severe financial
performance of the firm in recent years? distress.
2.​ Future Prospects - what is the long term, -​ If liquidation occurs, value often declines
strategic direction of the company? because the assets no longer work together, and human
3.​ Embedded Risk - what are the business risks intervention is absent.
involved in running the business?
4.​ Fair Market Value - the price, expressed in
DEFINITIONS OF VALUE cash, at which properly would change hands between
1.​ Intrinsic Value - the value of any asset based on hypothetical willing and able buyer and a hypothetical
the assumption that there is a hypothetical willing and able seller
complete understanding of its investment -​ Fair value assumes that both parties are informed
characteristics. of all material characteristics about the investment that
-​ True or real value might influence their decision.
-​ If the assumption is that the true value of an asset -​ Fair value is often used in valuation exercises
is dictated by the market, then intrinsic value involving tax assessments.
equals its market price.
RULES OF VALUATION IN BUSINESS
Grossman-Stiglitz paradox states that if the market Portfolio Management
prices, which can be obtained freely, perfectly reflect the - The relevance of valuation in PM largely depends on
intrinsic value of an asset, then a rational investor will the investment objectives of the investors or financial
not spend to gather data to an asset, then a rational managers managing the investment portfolio.
- Passive investors - tend to be disinterested in UNDER PORTFOLIO MANAGEMENT, THE FF
understanding valuation. ACTIVITIES CAN BE PERFORMED:
- Active investors - may want to understand valuation Stock selection - is a particular asset fairly
priced…
1.​ FUNDAMENTAL ANALYSTS - persons who Deducing market expectations - which
are interested in understanding and measuring estimates of a firm’s future…
the intrinsic value of a firm. It can be either SELL-SIDE ANALYSTS - work in the brokerage
value or growth investors. department of investment firm use valuation judgments
Fundamentals - the characteristics of an entity related that are contained in research reports that are
to its financial strength, profitability or risk appetite. disseminated widely to current and potential clients.
-​ Typically, FA lean towards long-term investment
strategies which encapsulate the following BUY-SIDE ANALYSTS - look at specific investment
principles: options and make valuation analysis on these and report
-​ Relationship between value and to a portfolio manager or investment committee. It tends
underlying factors can be reliably to perform more in-depth analysis of a firm.
measured.
-​ Above relationship is stable over an In general, FINANCIAL ANALYSTS assist clients to
extended period. realize their investment goals by providing them
-​ Any deviations from the above information that will help them make the right decision
relationship can be corrected within a whether to buy or sell.
reasonable time.
Value Investors - tend to be mostly interested in ANALYSIS OF BUSINESS TRANSACTIONS
purchasing shares that are existing and priced at less /DEALS
than their true value. Corporate events:
Growth Investors - lean towards growth assets and Acquisitions - usually has 2 parties: the buying firm and
purchasing these at a discount. the selling firm.
Security and investments analysts use valuation The buying firm needs to determine the fair
techniques to support the buy/sell recommendations. value of the target company prior to offering a
bid price.
2.​ ACTIVIST INVESTORS - tend to look for The selling firm (target company) should have a
companies with good growth prospects that have sense of its firm value to gauge reasonableness
poor management. They usually do “takeovers” - of bid offers.
they use their equity holdings to push old Mergers - two companies had their assets combined to
management out of the company and change the form a wholly new entity
way the company is run. Divestiture - sale of a major component or segment of a
business to another company.
3.​ CHARTISTS - relies on the concept that stock Spin-Off - separating a segment or component business
prices are significantly influenced by how and transforming this into a separate legal entity.
investors think and act. They rely on available Leveraged buyout - acquisition of another business by
trading KPI such as price movements. using significant debt which uses the acquired business
Information Traders - traders that react based on new as a collateral
information about firms that are revealed to the stock
markets.
Valuation in deals analysis considers 2 important, unique c.​ Substitutes and Complements - refers to the
factors: synergy and control relationships between interrelated products and
Synergy - potential increase in firm value can be services in the industry.
generated once two firms merge with each other. d.​ Supplier Power - refers to how suppliers can
Control - change in people managing the negotiate better terms in their favor.
organization brought about by the acquisition. e.​ Buyer Power - pertains to how customers can
negotiate better terms in their favor for the
Corporate Finance - involves managing the firm’s products/services they purchase.
capital structure, including funding sources and
strategies that the business should pursue to maximize Competitive positions - refers to how the products,
firm value. services and the company itself is set apart from other
ULTIMATE GOAL: to maximize the firm value by competing market players.
appropriate planning and implementation of resources,
while balancing profitability and risk appetite. According to Michael Porter, there are generic corporate
strategies to achieve competitive advantage:
LEGAL AND TAX PURPOSES ●​ Cost Leadership - relates to the incurrence of
Other Purposes: the lowest cost among market players.
-​ Issuance of a fairness opinion for valuations ●​ Differentiation - firm tends to offer
provided by third party (investment bank) differentiated or unique product or service
-​ Basis for assessment of potential lending characteristics
activities by financial institutions ●​ Focus - firms are identifying specific
-​ Share-based payment/compensation demographic segment or category segment
Quality of earnings analysis - pertains to the detailed
VALUATION PROCESS review of financial statements
FIVE STEPS: Typical observations that analysts can derive from
1.​ Understanding of the business - includes financial statements are listed below:
performing industry and competitive analysis -​ Revenues and gain
and analysis of publicly available financial -​ Expenses and losses
information and corporate disclosures. -​ Balance sheet items
INDUSTRY STRUCTURE - the inherent -​ Operating cash flows
technical and economic characteristics of an
industry and the trends that may affect this 2.​ Forecasting financial performance - After
structure. understanding how the business operates and
INDUSTRY CHARACTERISTICS - these are analyzing historical financial statements,
true to most, if not all, market players forecasting financial performance is the next
participating in that industry. step.
Forecasting financial performance can be
PORTER’S 5 FORCES looked at two lenses: (a) on a macro perspective
a.​ Industry Rivalry - refers to the nature and viewing the economic environment and industry
intensity of rivalry between market players in the where the firm operates in and (b) on a micro
industry. perspective focusing in the firm’s financial and
b.​ New Entrants - refers to the barriers to entry to operating characteristics.
industry by new market players.
Two Approaches: based on all assumptions considered, the analysts
●​ Top-down forecasting approach - forecast stars and investors use the results to provide
from international or national macroeconomic recommendations or make decisions that suits
projections with utmost considerations to their investment objective.
industry specific forecasts.
●​ Bottom-up forecasting approach - forecast Key Principles in Valuation
starts from the lower levels of the firm and is 1.​ The Value of a Business is Defined only at a
completed as it captures what will happen to the specific point in time
company based on the inputs of its segments / 2.​ Value varies based on the ability of business to
units. generate future cash flows
3.​ Market dictates the appropriate rate of return for
3.​ Selecting the right valuation model - The investors
appropriate valuation model will depend on the 4.​ Firm value can be impacted by underlying net
context of the valuation and the inherent tangible assets
characteristics of the company being valued. 5.​ Value is influenced by transferability of future
cash flows
4.​ Preparing valuation model based on forecast - 6.​ Value is impacted by liquidity
Once the valuation model is decided, the
forecasts should now be inputted and converted Risks in Valuation
to the chosen valuation model. Two aspects In all valuation exercises, uncertainty will be
should be considered: consistently present.
Sensitivity Analysis - a common methodology in
valuation exercises wherein multiple analyses are done Uncertainty refers to the possible range of values where
to understand how changes in an input or variable will the real firm values lies.
affect the outcome.
Situational Adjustments or Scenario Modelling - for Valuation - the estimation of an asset’s value based on
firm-specific issues that affect firm value firm value that variables perceived to be related to future investment
should be adjusted by analysts. returns, on comparisons with similar assets, or, when
relevant, on estimates of immediate liquidation
5.​ Applying valuation conclusions and providing proceeds.
recommendation - once the value is calculated

CHAPTER 2 : ASSET BASED VALUATION

Asset has been defined by the industry as transaction Green Field Investments - started from scratch
that would yield future economic benefits as a result of Brown Field Investments - opportunities that can be
past transactions. either partially or fully operational. BFI are those
already in the going concern state. They can be
The value of assets will depend on its ability to generate considered as “Going Concern Business
economic benefits, it is more challenging to determine Opportunities” (GCBOs)
the value of a green field investment since value shall
be based on pure estimates compared to brown field “Going Concern Business Opportunities” (GCBOs)
investments. are those businesses that have a long term to infinite
operational period.
The Committee of Sponsoring Organization of the -​ The advantage: it provides a more transparent
Treadway Commission (COSO) suggests that risk view on firm value and is more verifiable since
management principles must be observed in doing this is based on the figures reflected in the
business and determining its value. financial statements.
-​ Book Value only reflects historical value (only
It was noted in their report that the benefits of based on what is recorded in the accounting
having a sound Enterprise-wide Risk Management books) and might not reflect the real value of the
allows the company to: business now.
1.​ Increase the opportunities
2.​ Facilitate management and identification of the BVM FORMULA:
risk factors that affect the business;
3.​ Identify or create cost efficient opportunities
4.​ Manage performance variability
5.​ Improve management and distribution of Example:
resources across the enterprise; and
6.​ Make the business more resilient to abrupt
changes

The importance of identifying risks is to enable

investors to quantify the impact of the risk and/or the
cost of managing these risks.
Asset value is dependent on the economic benefits it
gives
In asset-based valuation, familiarity with the generally
accepted accounting principles (GAAP) is a key
attribute for an analyst to enable them to establish the
value.
Asset-based valuation can be used if the basis of the
value is concretely established and complete.

POPULAR METHOD TO DETERMINE THE 2.​ REPLACEMENT VALUE METHOD

VALUE USING ASSETS -​ The National Association of Valuators and
1.​ Book Value Method (BVM) Analysts has defined replacement value method
2.​ Replacement Value Method (ReplVM) as the cost of similar assets that have the nearest
3.​ Reproduction Value Method (ReprVM) equivalent value as of the valuation date.
4.​ Liquidation Value Method (LVM) -​ The value of assets shall be adjusted to reflect
the relative value or cost equivalent to replace
1.​ BOOK VALUE METHOD that asset.
-​ Defined as the value recorded in the accounting Factors that can affect the replacement value of an asset:
records of a company. 1.​ Age of the Asset
-​ It is highly dependent on the value of the assets 2.​ Size of the Assets
-​ In the book value method, the value of the 3.​ Competitive advantage of the Assets
enterprise is based on the book value of the asset
less all non-equity claims against it.
ReplVM FORMULA -​ Useful when calculating the value of new or
start-up businesses.
-​ The challenge: the ability to validate the
reasonableness of the value calculated since
there are only limited sources of comparators and
benchmark information that can be used.
Example:
Steps in determining the equity value using
reproduction value method are as follows:
1.​ Conduct reproduction costs analysis on all assets
2.​ Adjust the book values to reproduction costs
values (similar as replacement value)
3.​ Apply the replacement value formula using the
figure calculated in the preceding step.

Example:

3. REPRODUCTION VALUE METHOD

-​ Is an estimate of cost reproducing, creating,
developing or manufacturing a similar asset.
-​ It requires reproduction cost analysis which is
internally done by companies especially if the
assets are internally developed. 4.​ LIQUIDATION VALUE METHOD
-​ Is an equity valuation approach that considers the
salvage value as the value of the asse
 CHAPTER 3 : LIQUIDATION BASED VALUATION

LIQUIDATION VALUE -​ liquidation value is the value of a company if it

According to the CFA Institute, were dissolved and its assets are sold
individually.
-​ It represents the net amount that can be gathered 3.​ Material adverse governmental action or
if the business is shut down and its assets are regulation
sold piecemeal. 4.​ Occurrence of natural disaster or calamities
-​ It is also known as “Net Asset Value” 5.​ Occurrence of pandemic or general health
-​ It is the base price or the floor price for any firm hazards
valuation exercise.
-​ It should not be used to value profitable or 2. Corporate or Project End of Life - Most
growing companies as this approach does not corporations only have a finite number of years to
consider growth prospects of the business. operate as stated in their Article of Incorporation. Once
-​ It should be used for dying or losing companies the date arrives and life is not extended, due process
where liquidation is imminent to check whether takes place to end the life of the corporation and start the
profits can still be realized upon sale of the asset liquidation process. If the corporate end of life is already
owned. certain, it is more appropriate to compute terminal value
-​ A unique callout for liquidation value is if the using liquidation value.
firm is operating under a proprietor or a
partnership model. 3. Depletion of scarce resources - In some industries
like mining and oil, availability of scarce resources
SITUATIONS TO CONSIDER LIQUIDATION significantly influences firm value.
VALUE
1.​ Business Failures - the most common reason GENERAL PRINCIPLES ON LIQUIDATION
why businesses close or liquidate. Early VALUE
symptoms: low or negative returns. Liquidation value is the most conservative valuation
a.​ Insolvency - happens when a company approach among all as it considers the realizable value
cannot pay liabilities as they come due. of the asset if it is sold now based on current conditions.
b.​ Bankruptcy - the most serious type of
business failure as this happens when
liabilities become greater than asset
balance.
Internal Factors:
1.​ Mismanagement
2.​ Poor financial evaluation and decisions
3.​ Failure to execute strategic plans
4.​ Inadequate cash flows planning
5.​ Failure to manage working capital
TYPES OF LIQUIDATION
Orderly Liquidation - Assets are sold strategically.
Forced Liquidation - Assets are sold as quickly as
External Factors: possible such as an auction.
1.​ Severe economic down-turn
2.​ Dynamic consumer preferences CALCULATING LIQUIDATION VALUE
 -​ Book Value should not be used as liquidation of
assets
-​ Liquidation value can be obtained based on the
potential sales price
-​ It is far more realistic as compared to the book
value method.

EXAMPLE: