VALUATION CONCEPTS AN ASSET-BASED VALUATION Asset has been defined by the industry as transactions that would yield future economic benefits as a result of past transactions. Hence, the value of investment opportunities is highly dependent on the value that the asset will generate from now until the future. The value should also include all cash flows that will be generated until the disposal of the asset. In practice, valuation is a sensitive and confidential activity in their portfolio management. Valuation should be kept confidential to allow the company to negotiate a better position for them to acquire an opportunity. Since the value of assets will depend on its ability to generate economic benefits, 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 investments are investments that started from scratch while brown field investments are those opportunities that can be either partially or fully operational. Brown field investments are those already in the going concern state, as most businesses are in the optimistic perspective that they will grow in the future. Therefore, they can be considered as going concem business opportunities (GCBOs). Going concern business opportunities are those businesses that has a long term to infinite operational period. The advantage of GCBOs is that we already have a reference for their performance - from its historical performance or an existing business with a similar nature. With this, the risk indicators can be identified easily and can be quantified accordingly. The Committee of Sponsoring Organization of the Treadway Commission (COSO) suggests that risk management principles must be observed in doing businesses and determining its value. It was noted in their report that the benefits of having a sound Enterprise-wide Risk Management allows the company to: increase the opportunities; facilitate management and identification of the risk factors that affect the business; identify or create cost-efficient opportunities manage performance variability; improve management and distribution of resources across the enterprise; and 6. make the business more resilient to abrupt changes. no BPo The importance of identifying risks is to enable investors to quantify the impact of the risk and/or the cost of managing these risks. Theoretically, asset value is dependent on the economic benefits (i.e. cash flows) it gives. _ ——_VALUATION CON PTS AND METHODOLOGIES Since the entire company is driven by its asset base, the value of the company can be best attributed to the value of its assets. The advantage of using this approach is it enables the analyst to validate the firm value through the value of its assets. Some approaches may rely on the ability of the asset to generate more revenues. However, this only focuses on the current and historical value of the assets and will disregard the value it can generate in the future and may not fully represent the true value of the assets. In asset-based valuation, familiarity with the generally accepted accounting principles 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. Information required for asset-based valuation include total value of the assets, the financing structure (i.e. total liabilities and total equity), classes of equity and other sources of funding. Among the popular methods used to determine the value using assets as its bases are: (1) book value method; (2) replacement value method; (3) reproduction value method; and (4) liquidation value method. Book Value Method Book value can be defined as the value recorded in the accounting records of a company. The book value is highly dependent on the value of the assets as declared in the audited financial statements, particularly the balance sheet or the statement of financial position. International Accounting Standard No. 1 requires that the statement of financial position to summarize the total value of its assets, liabilities and equity of a firm. The assets are required to be categorized into current and non-current assets. Current assets are those expected to be realized within the company’s normal operating cycle, expected to be realized within 12 months after these transactions were reported, or held primarily for the purpose of trading. Cash and cash equivalents may also be included only if it is not restricted. On the other hand, assets wherein benefits can be realized in more than 12 months are known as non-current assets. On the other hand, liabilities is also categorized as current and non-current. Current liabilities are expected to be settled within the entity's normal operating cycle, due to be settled within 12 months, held for the purpose of trading or if the company does not have ability to settle beyond 12 months. Non-current liabilities are liabilities which are due to be settled longer than 12 months.Ne eee TARY Wun elere tele In the book value method, the value of the enterprise is based on the book value of the assets less all non-equity claims against it. Hence, the formula is as follows: Total Assets — Total Liabilities Net Book Value of Assets = 77 her of Outstanding Shares To illustrate, Grape and Vines Corp. in the Year 20xx presented their statement of financial position with the following balances: Current Assets is Php500 Million; Non-current Assets is Php1 Billion; Current Liabilities is Php200 Million; Non-current Liabilities is Php700 Million and the Outstanding shares is 1 Million. With the given information, the net book value of the assets is Php600 per share computed as follows: Current Assets Php 500,000,000 Non-current Assets 1,000,000,000 Total Assets php 1,500,000,000 Current Liabilities Php 200,000,000 Non-current Liabilities 700,000,000 Total Liabilities Php 900,000,000 NBV of Assets = Php1,500,000,000 — Php900,000,000 1,000,000 shares Php600 Million NBY of Assets = —1P000 Million 1 Million shares NBV of Assets = php 600 / share The advantage of using book value method is that it provides a more transparent view on firm value and is more verifiable since this is based in the figures reflected in the financial statements. However, the book value only reflects historical value (only based on what is recorded in the accounting books) and might not reflect the real value of the business now. ”VALUATION CONCEPTS AND METH! OGIES Replacement Value Method While the book value method offers convenient determination of the company jue, the limitation of the book value method is that it does not account for the full value of the net assets now that would result for overage or understatement of value of the net assets recorded in the books. The National Association of Valuators and Analysts has defined the replacement cost as the cost of similar assets that have the nearest equivalent value as of the valuation date. Under the replacement value method, the value of the individual assets shall be adjusted to reflect the relative value or cost equivalent to replace that asset. The following are the factors that can affect the replacement value of an asset: * Age of the asset - It is important to know how old the asset is. This will enable the valuator to determine the costs related in order to upkeep a similarly aged asset and whether assets with similar engineering design are still available in the market. Size of the assets - This is important for fixed assets particularly real Property where assets of the similar size will be compared. Some analysts find that the assets can produce the same volume for the assets of the same size. Competitive advantage of the asset - Assets which have distinct characteristics are hard to replace. However, the characteristics and capabilities of the distinct asset might be found in similar, separate assets. Some valuators combine the value of the similar, separate assets that can perform the function of the distinct asset being valued. There is a specific discipline in determining the replacement value. Appraisers have their own technique to determine the replacement value. Insurance companies use the replacement value in determining the appropriate insurance premium to be charged to their clients. For instance, a company owns a building with a book value of Php 5 Million, and the estimated replacement cost is Php6 Million. The insurer can offer a premium to cover the insurance at Php6 Million. This is the most prudent approach for a company. However, if the company opted to get a coverage lower than its replacement value, for example Php4 Million, the insurer will only reimburse the amount cover and the company will be the one to cover for the Php2 Million difference. Note that value that will be shouldered is not Php 1 Million [ Php5 Million less Php4 Million] but instead Php2 Million since the asset can no longer be replaced now at Php 5 Million.VALUATION CONCEPTS AI The value of the equity using the replacement value method is computed using the formula Net Book Value + replacement adjustment Replacement Value per share = Outstanding Shares To illustrate, following through the given information for Grapes and Vines Corp., suppose that 50% of the non-current assets has an estimated teplacement value of 150% of its recorded net book value while the remaining half has estimated replacement value of 75% of their recorded net book value, With the given information, the equity value is adjusted: 1. Calculate the replacement value of the affected items. Since the values presented are the one presented in the statement Of financial position, it is assumed that it is the net book value of the non-current assets. 50% of Non-current Assets - 150% of the net book value Non-current Assets Php 1,000,000,000 % of affected item 50% 50% of the Non-current Assets Php 500,000,000 Premium on Replacement 150% Adjusted Non-Current Assets (A) Php 750,000,000 50% of Non-current Assets is 75% of the net book value Non-current Assets Php 1,000,000,000 % of affected item 50% 50% of the Non-current Assets Php 500,000,000 Discount on Replacement 75% Adjusted Non-Current Assets (B) Php 375,000,000 Total Adjusted Non-current Assets Adjusted Non-Current Assets (A) Php 750,000,000 Adjusted Non-Current Assets (B) i 375,000,000 Total Adjusted Non-current Assets Php1,1 25,000,000 2 2VALUATION CONCEPTS AND METHODOLOGIES 2. Add back the unadjusted components Total Adjusted Non-current Assets Php1,125,000,000 Add: Current Assets 500,000,000 Total Assets — Replacement Value Php1,625,000,000 3. Apply the Replacement Value Formula Php1,625,000,000 — Php900,000,000 Repl tValue = eee 1,000,000 shares Php725,000,000 R * “7,000,000 ‘eplacement Value 1,000,000 Replacement Value = Php725 per share Reproduction Value Method In some instances, no external information is available that can serve as basis for replacement cost of assets that are highly specialized in nature. In this case, reproduction value is used instead. Reproduction value is an estimate of cost of reproducing, creating, developing or manufacturing a similar asset. For example, the firm has an internally constructed equipment costing Php 4 Million that processes 500 tons of inventory. After few years of using the equipment, the firm estimated that developing another asset with similar capability i.e. to generate 500 tons of inventory will cost Php 1.3 Million. The reproduction value method requires reproduction cost analysis which is internally done by companies especially if the assets are internally developed. Hence, this method is useful when calculating the value of new or start-up businesses, ventures that use specialized equipment or assets, firms that are heavily dependent on intangible assets and those with limited market information. While this is a convenient approach, the challenge of using reproduction value method is 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.VALUATION CONCEPTS A\ Steps in determining the equity value using the 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 figures calculated in the preceding step. To illustrate using the information of Grapes and Vines Corp., supposed that it was noted that the 80% of the total noncurrent assets are cheaper by 90% of the book value when reproduced. 20% of the total noncurrent assets are comprised of goodwill which upon testing was proven to be valued correctly. 1. Conduct reproduction cost analysis to all assets 80% of the Total Noncurrent Assets if reproduced is equal to 90% of its value Non-current Assets Php 1,000,000,000 % of affected item 80% —Ehp 800,000,000 y> Since the remaining 20% or Php 200 Million is goodwill and already in its proper value, it will not be adjusted. 2. Adjust the book value to reproduction costs Non-current Assets Php 800,000,000 Reproduction Cost Estimate % 90% Reproduction Cost Php 720,000,000 Non-Current Assets — Reproduction Cost PhP 720,000,000 Add: Goodwill 200,000,000 Total Non-current Assets Php 920,000,000 Add: Current Assets 500,000,000 Total Assets Php1,420,000,000 3. Apply the replacement value formula using the figures calculated in the preceding step- Php1,420,000,000 — Php900,000,000 1,000,000 shares Reproduction Value =VALUATION CONCEPTS AND METHODOLOGIES Php5S20,000,000 Reproduction Value = P%P520,000,000 E on Value = +500,000 shares Reproduction Value = Php 520 / share Liquidation Value Method Liquidation value method is an equity valuation approach that considers the salvage value as the value of the asset. This assumes that the reasonable value for the company to be purchased is the amount which the investors will realize in the end of its life or the value of the when it is terminated. While the value it provides is the most conservative, the limitation of this approach is that the future value is not fully incorporated in the calculated equity value. This method will be further discussed in the next chapter.