VA LUATION CONCEPTS AND METHODOLOGIES

FUNDAMENTALSPRINCIPLES OF VALUATION
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 differenton how to value an entire
business.

Businesses treat capitalas a scarce resource that they should competeto

obtain and efficientlymanage. 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. Othervyise, capital providers will look and
bring money to other investmentopportunitiesthat are more attractive.
Hence, the most fundamental principle for all investments and business is to
maximize shareholdervalue. Maximizingvalue for businesses consequently
result in a domino impact to the economy. Growing companies provide long-
term sustainability to the economy by yielding higher economic-output, better
productivitygains, employmentgrowthand higher salaries. Placing scarce
resources in theirmost productiveuse best serves the interestof 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. Increase
in value may imply that shareholder capital is maximized, hence, fulfilling the
promise to capital providers. This is where valuation steps in.

According to the CFA Institute, valuation is the estimation of an asset's value

based on variables perceivedto be relatedto future investmentreturns,on
comparisons with similar assets, or, when relevant, on estimates of immediate
liquidationproceeds. Valuation includes the use of forecasts to come up with
reasonable estimateof value of an entity'sassets or its equity.At varying
levels, decisions done within a firm entails valuation implicitly. For example,
capital budgetinganalysis usually considers how pursuinga specific project
will affect entity value. Valuation techniques may differacross differentassets,
but all follow similar fundamentalprinciples that drive the core of these
approaches.

Valuation places great emphasis on the professionaljudgmentthat are

associated in the exercise. As valuation mostly deals with projections about
futureevents, analysts should hone their abilityto balance and evaluate
differentassumptionsused in each phase of the valuationexercise, assess
validity of available empirical evidence and come up with rational choices that
align with the ultimate objective of the valuation activity.

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I VALUATION CONCEPTSAND METHODOiÖGi€S¯

—erpreting DifferentConcepts of Value

•re corporate setting, the fundamental equation of value is grounded on the
that Alfred Marshall popularized —a company creates value if and
the returnon capital invested exceed the cost of acquiringcapital.
n the pointof view of corporate shareholders, relates to the difference
—een cash inflowsgenerated by an investmentand the cost associated
capital invested which captures both time value of money and risk

.aiue of a business can be basically linked to three major factors:

Current operations —how is the operating performance of the firm in

recent year?
• Future prospects —what is the long-term,strategic directionof the
oompany?
• Embedded risk —what are the business risks involved in running the
business?

factors are solid concepts; however, the quick tumover of technologies

•u•d globalization make the business environment more dynamic. As a
defining value and identifying relevant drivers became more arduous
passes by. As firms continueto quicklyevolve and adapt to new
valuation of current operations becomes more difficult as
—c.ee to the past. Projecting future macroeconomicindicatorsalso is
*cause of constantchanges in the economicenvironmentand the
—-a-cus innovationof market players. New risks and competitionalso
which makes determining uncertainties a critical ingredient to

of value may also vary depending on the context and objective

vauationexercise.

tnrnsic value
•-mnsic value refers to the value of any asset based on the
assumption that there is a hypothetical complete understanding of its
nvestment characteristics. Intrinsic value is the value that an investor
considers, on the basis of an evaluationof availablefacts, to be the
Yue" or "real"value that will become the market value when other
nvestors reach the same conclusion. As obtaining complete
nformation about the asset is impractical, investors normally estimate
rnnsic value based on their view of the real worth of the asset. If the
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 VALUATION CONCEPTS AND METHODOLOGIES

assumption is that the true value of asset is dictated by the market,

then intrinsic value equals its market price.

Unfortunately,this is not always the case. The Grossman - Stiglitz

paradox states that if the market prices, which can be obtained freely,
perfectly reflect the intrinsic value of an asset, then a rational investor
Will not spend to gather data to validate the value Of a stock. If this is
the case, then investors will not analyze informationabout stocks
anymore. Consequently, how will the market price suggest the intrinsic
price if this process does not happen? The rational efficient markets
formulation of Grossman and Stiglitz acknowledges that investors will
not rationally spend to gather more information about an asset unless
they expect that there is potential reward in exchange of the effort.

As a result, market price often does not approximatean asset's

intrinsic value. Securities analysts often try to look for stocks which are
mispriced in the market and base their buy or sell recommendations
based on these analyses. Intrinsic value is highly relevant in valuing
public shares.

Most of the approaches that will be discussed in this book deal with
finding out the intrinsic value of assets. Financial analysts should be
able to come up with accurate forecasts and determinethe right
valuationmodel that will yield a good estimateof a firm's intrinsic
value. The quality of the forecast, including the reasonableness of
assumptions used, is very critical in coming up with the right valuation
that influences the investment decision.

Going Concern Value

Firm value is determinedunder the going concem assumption.The

going concern assumption believes that the entity will continue to do
its business activities into the foreseeable future. It is assumed that
the entity will realize assets and pay obligations in the normal course
of business.

• LiquidationValue

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. Liquidation value is
particularly relevant for companies who are experiencing severe
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 VALUATION CONCEPTS AND METHODOLOGIES

financial distress. Normally, there is greater value generated when

assets working togetherare combinedwiththe applicationof human
capital(unless the business is continuouslyunprofitable)which is the
case for going-concern assumption. If liquidationoccurs, value often
declines because the assets no longer work together,and human
intervention is absent.

Fair MarketValue

The price, expressed in terms of cash, at which propertywould change

hands between a hypothetical willing and able buyer and a
hypotheticalwillingand able seller, acting at arm's length in an open
and unrestrictedmarket,when neitheris under compulsionto buy or
sell and when both have reasonable knowledgeof the relevantfacts.
Both parties should voluntarily agree with the price of the transaction
and are not underthreatof compulsion.Fair value assumes that both
parties are informed of all material characteristics about the
investment that might influence their decision. Fair value is often used
in valuationexercises involvingtax assessments.

ees of Valuation in Business

Management

reevance of valuationin portfoliomanagementlargely depends on the

•etnent objectives of the investors or financial managers managing the
•«ament portfolio. Passive investors tend to be disinterested in
.oerstanding valuation, but active investors may want to understand
in order to participate intelligently in the stock market.

• Fundamentalanalysts —These are persons who are interestedin

understanding and measuring the intrinsic value of a firm.
Fundamentalsrefer to the characteristicsof an entity related to its
financial strength, profitabilityor risk appetite. For fundamental
analysts, the true value of a firm can be estimatedby lookingat its
fnancial characteristics,its growth prospects, cash flows and risk
profile.Any notedvariance betweenthe stock's market price versus
ts fundamental value indicates that it might be overvalued or
undervalued.

Typically, fundamentalanalysts lean towards long-term investment

strategies which encapsulate the following principles:

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VALUATION CONCEPTS AND METHODOLOGIES

Relationship between value and underlyingfactors can be

reliably measured.
o Above relationshipis stable over an extended period
o Any deviationsfrom the above relationshipcan be corrected
within a reasonable time

Fundamentalanalysts can be eithervalue or growthinvestors. Value

investors tend to be mostly interestedin purchasing shares that are
existing and priced at less than theirtrue value. On the other hand,
growth investors lean towards growth assets (businesses that might
not be profitable now but has high expected value in future years) and
purchasing these at a discount.

Security and investments analysts use valuation techniques to

supportthe buy I sell recommendationsthat they provide to their
clients. Analysts often infer market conditionsimplied by the market
price by assessing this against his own expectations. This allows them
to assess reasonableness and adjust future estimates. Market
expectationsregardingfundamentalsof one firm can be used as
benchmark for other companies which exhibit the same
characteristics.

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
run. In the minds of activist investors, it is not about the current value
of the company but its potentialvalue once it is run properly.
Knowledge about valuation is critical for activist investors so they can
reliably pinpointwhich firms will create additional value if management
is changed. To do this, activist investors should have a good
understanding of the company's business model and how
implementingchanges in investment,dividendand financing policies
can affect its value.

Chartists — Chartists relies on the concept that stock prices are

significantlyinfluencedby how investors thinkand act. Chartists rely
on available trading KPIs such as price movements,trading volume,
and short sales when making theirinvestmentdecisions. They believe
that these metrics imply investor psychology and will predict future
movements in stock prices. Chartists assume that stock price changes
and followpredictablepattems since investors make decisions based
on theiremotionsthan by rationalanalysis. Valuationdoes not play a
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 VALUATION CONCEPTS AND METHODOLOGIES

huge role in charting, but it is helpful when plottingsupport and

resistance lines.
InformationTraders —Traders that react based on new information
about firms that are revealed to the stock market. The underlying belief
is that informationtraders are more adept in guessing or getting new
informationabout firms and they can make predict how the market will
react based on this. Hence, informationtraders correlatevalue and
how informationwill affect this value. Valuation is importantto
informationtraders since they buy or sell shares based on their
assessment on how new informationwill affect stock price.

portfolio management, the following activities can be performed

the use of valuation techniques:
Stock selection - Is a particular asset fairly priced, overpriced, or
underpriced in relation to its prevailing computed intrinsic value
and prices of comparable assets?
Deducing market expectations —Which estimates of a firm's future
performanceare in line with the prevailingmarket price of its
stocks? Are there assumptions about fundamentals that will justify
the prevailing price?
'e*y, investors do not have a lot of time to scour all available information
to make investmentdecisions. Instead, they seek the help of
to come up with informationthat they can use to decide their

E--s.ce analysts that work in the brokerage department of investment firms

valuationjudgment that are contained in research reports that are
—•ue•n.nated widely to current and potential clients. Buy-side analysts, on the
look at specific investment options and make valuation analysis
rese and report to a portfoliomanager or investment committee. Buy-side
•—•.•ststend to perform more in-depth analysis of a firm and engage in more
stock selection methodologies.
—-eral, financial analysts assist clients to realize their investment goals by
them informationthat will help them make the right decision whether
sell. They also play a significantrole in the financialmarkets by
—cn,g the right informationto investors which enable the latter to buy or
g-•es. As a result, market prices of shares usually better reflect its real
...e Sanceanalysts often take a holistic look on businesses, they somewhat
a monitoringrole for the management to ensure that they make decision
•e line with the creating value for shareholders.

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 VALUATION CONCEPTS AND METHODOLOGIES

Analysis of Business Transactions / Deals

Valuation plays a very big role when analyzing potentialdeals. Potential

acquirers use relevant valuation techniques (whichever is applicable) to
estimate value of target firms they are planning to purchase and understand
the synergies they can take advantage from the purchase. They also use
valuation techniques in the negotiation process to set the deal price.

Business deals include the following corporate events:

Acquisition- An acquisitionusually has two parties:the buying

firm and the selling firm. The buying firm needs to determine the
fair value Ofthe target company priorto offering a bid price. On
the other hand, the selling firm (or sometimes, the target
company) should have a sense of its firm value to gauge
reasonablenessof bid offers. Selling firms use this informationto
guide which bid offers to accept or reject. On the downside, bias
may be a significantconcern in acquisitionanalyses. Target firms
may show very optimistic projections to push the price higher or
pressure may exist to make resulting valuation analysis favorable
if targetfirm is certain to be purchased as a result of strategic
decision.

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.

Spin-off — Separating a segment or componentbusiness and

transformingthis intoa separate legal entity.

• Leveraged buyout —Acquisitionof another business by using

significantdebtwhich uses the acquired business as a collateral.

Valuationin deals analysis considers two important,uniquefactors: synergy

and control.

• Synergy —potentialincrease 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. Synergy can be attributableto more efficient
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operations, cost reductions, increased revenues, combined

products/marketsor cross-disciplinary talents of the combined
organization.
Control —change in people managing the organizationbrought
about by the acquisition. Any impact to firm value resulting from
the change in managementand restructuringof the target
companyshould be includedin the valuationexercise. This is
usually an importantmatter for hostile takeovers.

C.zrporateFinance

Cay—oratefinance involves managing the firm's capital structure, including

sources and strategies that the business should pursue to maximize
value. Corporate finance deals with prioritizing and distributingfinancial
•es:turces to activities that increases firm value. The ultimate goal of corporate
is to maximize the firm value by appropriate planning and
mc.ementation of resources, while balancing profitabilityand risk appetite.

private businesses that need additional money to expand use valuation

etcects when approaching private equity investors and venture capital
to show the promiseof the business. The ownershipstake that
••ese capital providers will ask from the business in exchange of the money
will put in will be based on the estimated value of the small private

companies who wish to obtain additional funds by offering their shares

•e public also need valuation to estimate the price they are going to fetch
• •ne stock market. Afterwards, decision regarding which projects to invest
—-cunt to be borrowedand dividenddeclarationsto shareholdersare
As-ced by company valuation.

finance ensures that financial outcomes and corporatestrategy

maximization of firm value. Current business conditions push business
to focus on value enhancement by looking at the business holistically
on key levers affecting value in order to provide some level of retum
•ereholders.
tat are focused on maximizingshareholdervalue uses valuation
to assess impact of various strategies to company value. Valuation
—•ccoeogies also enable communication about significant corporate
between management, shareholders, consultants and investment

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Legal and Tax Purposes

Valuationis also importantto businesses because of legal and tax purposes

For example, if a new partner will join a partnership or an old partner will retire,
the whole partnershipshould be valued to identiWhow much should be the
buy-in or sell-out.This is also the case for businesses that are dissolved or
liquidatedwhen owners decide so. Firms are also valued for estate tax
purposes if the owner passes away.

Other Purposes

• Issuance of a faimess opinionfor valuations providedby third party

(e.g. investment bank)
• Basis for assessment of potentiallending activities by financial
institutions
• Share-based payment'compensation

Valuation Process

Generally, the valuationprocess considers these five steps:

Understanding of the business

Understandingthe business includes performingindustry and competitive

analysis and analysis of publicly available financial informationand corporate
disclosures. Understandingthe business is very importantas these give
analysts and investors the idea about the following factors: economic
conditions, industry peculiarities, company strategy and company's historical
performance.The understandingphase enables analysts to come up with
appropriateassumptions which reasonably capture the business realities
affecting the firm and its value.

Frameworks which capture industry and competitiveanalysis already exist

and are very useful for analysts. These frameworks are more than a template
that should be filled out: analysts should use these frameworks to organize
their thoughts about the industry and the competitive environment and how
these relates to the performance of the firm they are valuing. The industry and
competitiveanalyses should emphasize which factors affecting business will
be most challenging and how should these be factored in the valuation model.

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
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 VALUATION CONCEPTSAND METHODOLOGIES

participatingin that industry. Porter's Five Forces is the most common

•z used to encapsulate industry structure.

PORTER'S FIVE FORCES

Refers to the nature and intensity of rivalry
between market players in the industry.
Rivalry is less intense if there is lower
number of market players or competitors
Industry rivalry (i.e. higher concentration) which means
higher potential for industry profitability.
This considers concentrationof market
players, degree of differentiation,switching
costs, information and govemment
restraint.
Refers to the barriers to entry to industry by
new market players. If there are relatively
high entry costs, this means there are fewer
new entrants, thus, lesser competition
New Entrants which improves profitability potential. New
entrants include entry costs, speed of
adjustment,economies of scale, reputation,
switching costs, sunk costs and
overnmentrestraints.
This refers to the relationshipsbetween
interrelatedproducts and services in the
industry. Availability of substitute products
(productsthat can replacethe sale of an
Substitutes and existing product) or complementary
Complements products (products that can be used
together with another product) affects
industryprofitability.This consider prices of
substitute products/services, complement
products/services and government
limitations.
Supplier powerrefers to how suppliers can
negotiate better terms in their favor. When
there is strong supplier power, this tends to
make industry profits lower. Strong supplier
Supplier Power powerexists if there are few suppliers that
can supply a specific input.Supplier power
also considers supplier concentration,
prices of alternative inputs, relationship-
specific investments, supplier switching
costs and overnmentalre ulations.

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 VALUATION CONCEPTSAND METHODOLOGIES

PORTER'S FIVE FORCES

Buyer power pertains to how customers can
negotiate better terms in their favor for the
products/servicesthey purchase. Typically,
buying power is low if customers are
fragmented and concentrationis low. This
means that market players are not
dependent to few customers to survive.
Buyer Power Low buyer power tends to improve industry
profits since buyers .cannot significantly
negotiate to lower price of the product.
Other factors considered in buyer power
include buyer concentration, value of
substitute products that buyers can
purchase, customer switching costs and
overnment restraints.

Competitive position refers to how the products, services and the company
itself is set apartfrom othercompetingmarket players. Competitiveposition
is typically gauged using the prevailing market share level that the company
enjoys. Generally, a firm's value is higher if it can consistentlysustain its
competitive advantage against its competitors. 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 differentiatedor unique product or service

characteristics that customers are willingto pay for an additional
premium.

Focus

Firms are identifyingspecific demographicsegment or category

segment to focus on by using cost leadershipstrategy (cost focus)
or differentiationstrategy (differentiationfocus)

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