ELEC2 - Module 1 - Fundamentals Principles of Valuation

CHAPTER 1
FUNDAMENTALS
PRINCIPLES OF
VALUATION
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Department of Accountancy – MGT7A-Financial Management

LEARNING OUTCOME
• Define Valuation.
• Identify the role of valuation in the business
world.
• Enumerate the Key principles in Valuation.
Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Source: Valuation Concepts and Methodologies
By: Marvin V. Lascano, Herbert C. Baron and Andrew Timothy L. Cachero
LEARNING CONTENTS
• Fundamentals Principles of Valuation
• Interpreting different Concepts of Value
• Roles of Valuation in Business
• Valuation Process
• Key principles in Valuation
• Risks in Valuation

FUNDAMENTALS PRINCIPLES OF VALUATION
• Valuation is the estimation of an asset’s value based

on variables perceived to be related to future
investment returns, on comparison with similar assets
or, when relevant, on estimates of immediate
liquidation proceeds. (CFA)
• Includes the use of forecasts to come up with
reasonable estimate of value of an entity’s assets or its
equity.

• Valuation techniques may differ across different

assets, but all follow similar fundamentals principles
that drive the core of these approaches.
• Valuation places great emphasis on the professional
judgment that are associated in the exercise.

• Valuation mostly deals with projections about future

events, analysts should hone their ability to balance
and evaluate different assumptions used in each phase
of the valuation exercise, assess validity of available
empirical evidence and come up with rational choices
that align with the ultimate objective of the valuation
activity.

INTERPRETING DIFFERENT CONCEPTS OF VALUATION
• In corporate setting, the fundamental equation of value is

grounded on that principle as popularized by Alfred Marshall:
• A company creates value if and only if the return on invested
capital exceed the cost of acquiring capital.
• Value in the point of view of the corporate shareholders, relates to
the difference between cash inflows generated by an investment
and the cost associated with the capital invested which captures
both time value of money and risk premium.

INTERPRETING DIFFERENT CONCEPTS OF VALUATION
The value 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 direction of the
company?
• Embedded risk – what are the business risks involved in running
the business?

OBJECTIVE OF THE VALUATION EXERCISE
Intrinsic Value – refers to the value of any asset based on the
assumption assuming there is a hypothetically complete
understanding of its investment characteristics. It is the
value that an investor considers, on the basis of an
evaluation or available facts, to be the “true” or “real” value
that will become the market value when other investors
reach the same conclusion.
Going Concern Value – the going concern assumption believes
that the entity will continue to do its business activities into
the foreseeable future.
OBJECTIVE OF THE VALUATION EXERCISE
Liquidation Value – the net amount that would be realized if
the business is terminated and the assets are sold
piecemeal. It is particularly relevant for companies who are
experiencing severe financial distress.
Fair Market Value – the price, expressed in terms of cash
equivalents, at which property would change hands
between a hypothetical willing and able buyer and a
hypothetical willing and able seller, acting at arm’s length in
an open and unrestricted market, when neither is under
compulsion to buy or sell and when both have reasonable
knowledge of the relevant facts

ROLES OF VALUATION IN BUSINESS
Portfolio Management
• Fundamental Analysts – these are persons who are interested in

understanding and measuring the intrinsic value of a firm.
Fundamentals refer to the characteristics of an entity related to its
financial strength, profitability or risk appetite.
• 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 being run.
• Chartists – they rely on the concept that stock prices are

significantly influenced by how investors think and act and on
available trading KPIs such as price movements, trading volume,
short sales – when making their investment decisions.
• Information Traders – they react based on new information about
firms that are revealed to the stock market. The underlying belief
is that information traders are more adept in guessing or getting
new information about firms and they can make predict how the
market will react based on this.
Activities can be performed through 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
performance are in line with the prevailing market price of its
stocks? Are there assumptions about fundamentals that will justify
the prevailing price?

Analysis of Business Transactions/Deals
• Acquisition – an acquisition usually has two parties: the

buying firm that needs to determine the fair value of the
target company prior to offering a bid price and the selling
firm who gauge reasonableness of bid offers.
• Merger – transaction of two companies combined to form
a wholly new entity.
• Divestiture – sale of a major component or segment of a
business to another company.

• Spin-off – separating a segment or component business

and transforming this into a separate legal entity whose
ownership will be transferred to shareholders.
• Leverage buyout – acquisition of another business by
using significant debt which uses the acquired business as
a collateral.

Two important unique factors:

• Synergy – potential increase in firm value that can be
generated once two firms merge with each other.
• Control – change in people managing the organization
brought about by the acquisition.

Corporate finance involves managing the firm’s structure, including
funding sources and strategies that the business should pursue to
maximize firm value.
Legal and Tax Purposes. Valuation is also important to businesses
because of tax and legal purposes.
Other Purposes
• Issuance of a fairness opinion for valuations provided by third
party.
• Basis for assessment of potential lending activities by financial
institutions.
• Shared-based payment/compensation.
VALUATION PROCESS
• 5 steps in the valuation process
• Understanding the business – it includes performing industry and
competitive analysis and analysis of publicly available financial
information and corporate disclosures. An investor should be able to
encapsulate the industry structure. One of the most common tools used
in encapsulating industry is Porter’s Five Forces:
➢Industry Rivalry refers to the nature and intensity of rivalry between
market players in the industry.(market players, degree of differentiation,
switching costs, information and government restraints)
➢New Entrants refers to the barriers to entry to industry by new
entrants. (entry costs, speed adjustment, economies of scale,
reputation, switching costs, sunk costs and government restraints.
VALUATION PROCESS
Porter’s Five Forces:
➢Substitutes and Complements – this refers to the relationships
between interrelated products and services in the industry. (prices of
substitute products/services, complement products/services and
government limitations.
➢Supplier Power – refers to how suppliers can negotiate better terms in
their favor. ( supplier concentration, prices of alternative inputs,
relationship-specific investments, supplier switching costs and
government regulations
➢Buyer Power –pertains to how customers can negotiate better terms in
their favor for products/services they purchase. (buyer concentration,
value of substitute products, customer switching costs and government
restraints.

VALUATION PROCESS
Competitive position refers to how the products, services and the
company itself is set apart from other competing market players.
Generic Corporate Strategies to achieve Competitive Advantage
• Cost leadership – incurring the lowest cost among market players
with quality that is comparable to competitors allow the firm to be
price products around the industry average.
• Differentiation – offering differentiated or unique product or
service characteristics that customers are willing to pay for an
additional premium.
• Focus – identifying specific demographic segment or category
segment to focus on by using cost leadership strategy or
differentiation strategy.
VALUATION PROCESS
Understanding company’s business model – business model
pertains to the method how the company makes money – what are
products or services they offer, how they deliver and provide these
to customers and their target customers.
The results of execution of aforementioned strategies will ultimately
be reflected in the company performance results contained in the
financial statements.
Analysis of historical financial reports typically use horizontal,
vertical and ratio analysis.
Typical sources of information about companies can be found in
government-mandated disclosures like audited financial statements.
VALUATION PROCESS
In analyzing historical financial information, focus is afforded in
looking at quality of earnings.
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 versus economic reality.
During analysis, transactions that are nonrecurring such as financial
impact of litigation settlements, temporary tax reliefs or gains/losses
on sales of nonoperating assets might need to be adjusted to arrive
at the performance of the firm’s core business.

VALUATION PROCESS
Quality of earnings analysis also compares net income against operating cash
flow to make sure reported earnings are actually realizable to cash and are not
padded through significant accrual entries. Typical observations that analysts
can derive from financial statements are listed below:
Line item Possible Observation Possible Interpretation
Revenues and gain Early recognition of revenues Accelerated revenue recognition
(e.g. bill-and-hold sales, sales improves income and can be
recognition prior to installation used to hide declining
and acceptance of customer performance
Inclusion of nonoperating Nonrecurring gains that do not
income or gains as part of relate to operating performance
operating income may hide declining
performance.

VALUATION PROCESS
Expenses and Recognition of too high little Too little reserves may improve
losses reserves (e.g. restructuring, bad current year income but might affect
debts) future income (and vice versa)
Deferral of expenses such as May improve current income but will
customer acquisition or product reduce future income. May hide
development costs by declining performance.
capitalization.
Aggressive assumptions such as Aggressive estimates may imply that
long useful lives, lower asset there are steps taken to improve
impairment, high assumed current year income. Sudden
discount rate for pension liabilities changes in estimates may indicate
or high expected return on plan masking of potential problems in
assets. operating performance.

VALUATION PROCESS

Balance sheet Off-balance sheet financing (those Assets/liabilities may not be fairly
items not reflected in the face of the reflected
balance sheet) like leasing or
securitizing receivables.
Operating cash Increase in bank overdraft as Potential artificial inflation in
flows operating cash flow operating cash flow.

VALUATION PROCESS
• Forecasting financial performance – can be looked at two
perspectives: on a macro perspective viewing the economic
environment and industry where the firm operates in and micro
perspective focusing in the firm’s financial and operating
characteristics.
• Two Approaches of Forecast Financial Performance
➢Top down forecasting approach – international or national
macroeconomic projections with utmost consideration to industry
specific forecasts.
➢Bottom-up forecasting approach – forecast starts from the lower
levels of the firm and builds the forecast as it captures what will
happen to the company based on the inputs of its segments/units

VALUATION PROCESS
• Selecting the right valuation model – it depends on the context
of the valuation and the inherent characteristics of the company
being valued.
• Preparing valuation model based on forecasts – there are two
aspects to be considered:
➢Sensitivity analysis – common methodology in valuation exercises
wherein multiple other analyses are done to understand how
changes in an input or variable will affect the outcome.
➢Situational adjustments – firm specific issues that affects firm
value that should be adjusted by analysts since these are events
that are not quantified if analysts only look at core business
operations.

VALUATION PROCESS
• Applying valuation conclusions and providing
recommendations
Once the value is calculated based on all assumptions
considered, the analysts and investors use the results to
provide recommendations or make decisions thar suits
their investment objectives

KEY PRINCIPLES IN VALUATION
• The value of a business is defined only at a specific point in time.
Business value tend to change every day as transactions happens.
• Value varies based on the ability of business to generate future
cash flows.
General concepts for most valuation techniques put emphasis
future cash flows except for some circumstances where value can
be better derived from asset liquidation
• Market dictates the appropriate rate of return for investors.
Market forces are constantly changing, and they normally provide
guidance of what rate of return should investors expect from
different investment vehicles in the market.

KEY PRINCIPLES IN VALUATION
• Firm value can be impacted by underlying net tangible assets.
Business valuation principles look at the relationship between
operational value of an entity and net tangible of its assets.
• Value is influenced by transferability of future cash flows.
Transferability of future cash flows is also important especially to
potential acquirers
• Value is impacted by liquidity.
This principle is mainly dictated by the theory of demand and
supply.

RISKS IN VALUATION
Uncertainty refers to the possible range of values where the real
firm lies. When performing any valuation method, analysts will
never be sure if they have accounted and included all potential risks
that may affect price of assets.
Aspects that contributes uncertainty
• Future estimates
• Use of judgment
• Business performance
• Innovations and entry of new businesses

THANK YOU
STAY SAFE
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Department of Accountancy – ELEC2

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CHAPTER 1

This Photo by Unknown Author is licensed under CC BY-SA

Department of Accountancy – MGT7A-Financial Management

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

• Valuation is the estimation of an asset’s value based

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

• Valuation techniques may differ across different

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

• Valuation mostly deals with projections about future

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

• In corporate setting, the fundamental equation of value is

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

The value of a business can be basically linked to three major

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

• Fundamental Analysts – these are persons who are interested in

• Chartists – they rely on the concept that stock prices are

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

• Acquisition – an acquisition usually has two parties: the

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

• Spin-off – separating a segment or component business

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Two important unique factors:

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Line item Possible Observation Possible Interpretation

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

This Photo by Unknown Author is licensed under CC BY-SA

Department of Accountancy – ELEC2

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