Bachelor of Business Administration

Semester VII

Business Valuations (FIN 4239)

Introduction to Business Valuation

(Session 01)

S E N A N I T H E N U WA R A
D E PA R T M E N T O F F I N A N C E
FA C U LT Y O F M A N A G E M E N T A N D F I N A N C E
UNIVERSITY OF COLOMBO
 Content
▪Introduction
▪Generalities about valuation
▪Objectives of valuation
▪Why valuations are not perfect?
▪Information required for valuation and sources
▪Business Valuation vs firm valuation
▪Different valuation approaches
 Introduction to Valuation
Valuation is the process of determining the value of an asset (Tangible
or intangible), liability or a firm as a whole.

Value is the monetary worth of a certain thing.

Business valuation requires the knowledge an expertise in varies

aspects ; professional judgment, experience, knowledge on purpose of
valuation, value drivers, industry and the competition, economic
factors, application of valuation techniques.
 Generalities about Valuation
▪ Valuation is objective – use of quantitative models

▪Valuation is timeless

▪Valuations provides precise estimates

▪Better the model better the valuation

▪Assumptions on market efficiency

▪Value matters and process does not

 Objectives of corporate
valuation
▪Decision on acceptable purchase consideration

▪Arbitrator - in settling a dispute among parties

▪Lender – to quantify the collateral against a loan to be granted.

▪Decisions on application of stamp duty

 Objectives of corporate
valuation
▪Deciding the values to be included in financial statements

▪Loss claim assessment

▪Management buyout or levered buyout assessment

 Why valuations are not perfect
all times?
▪Market imperfection

▪Subjectivity involved in assessments

▪Forecasts made on assumptions

▪Risk

It is not a science but it requires inherent subjectivity.

 Characteristics of a good
valuation
▪Value should be realistic and acceptable
▪Application of convincing methods in valuation
▪Transparent process
▪Realistic estimate and consideration of factors
▪Unbiased considerations
▪Ability to validate
▪Application of knowledge in different fields; accounting, finance,
investment banking, economics etc.
 Information required for
valuation
▪Industry and its competition

▪Business operations

▪Entity’s sales and marketing

▪Strength of human resources

▪Financial performance

▪Financial projections
 Sources of information for
valuation
▪Annual reports of companies

▪Managements accounts companies

▪Reports of future prospects

▪Economic review reports, industry related reports

▪Stock market statistics

▪Press releases

▪Industry journals, surveys etc.

 Value of a business
Present value of future benefits to be derived from the business.

How benefits are to be defined?

How to forecast future benefits? (risk and uncertainty)
What DF to be applied?
 Perspectives on valuation
How much
How much Hoe much I would it
the should pay cost to
company for a share? acquire the
worth? company?
 Principles of Valuation
▪Focus on a point in time

▪Based on ability to generate future CFs

▪Required rate of return is derived by the market forces

▪Impact of net tangible assets

▪Impact of liquidity
 Ethical principles of valuation
▪Fairness and integrity

▪Objectivity

▪Professional competency

▪Confidentiality

▪Professional behaviour
Approaches to Valuation
▪Intrinsic valuation (Main approach)

▪Relative valuation

▪Contingent claim valuation

 Intrinsic valuation
▪ Foundation of all supplementary valuations
▪ Focus on the present value

Value of an asset = PV value of expected CFs

▪

n= life of the asset

CFt = Cashflow in period t
r = discount rate

▪CFs can vary based on the asset (stock –dividends, bonds – face
value and the coupon rate, real project- after tax CFs)
 Intrinsic valuation
▪ Inputs required ;
▪ estimated life of the asset
▪ estimated the cash flows
▪ estimated the discount rate
▪ Two main paths
Equity Valuation

Firm Valuation

▪Balance Sheet approach – finance perspective

▪Value of equity – CFs related to equity discounted at Ke
▪Value of firm – CFs related to firm discounted at cost of capital
▪Should not be mismatched
 Value of equity
Dividend Discount model

Source: Damodaran, A. (2012)., Investment Valuation; Tools and Techniques for Determining the Value of Any Asset

Note: Dividend Discount model - Special case of equity valuation

 Value of firm

Source: Damodaran, A. (2012)., Investment Valuation; Tools and Techniques for Determining the Value of Any Asset
Value of equity vs Value of firm

Be cautious of
Mismatching
 Limitations of Intrinsic
valuation
▪ Distressed firms with negative CFs

▪ CFs of cyclical forms tends to move with the economy

▪Existence of underutilized assets

▪Require more explicit inputs and information than other valuation

approaches
▪Inputs and information are not only but difficult to estimate
The quality of the analysis can be manipulated by the analyst yst
 Limitations of Intrinsic
valuation
▪ Firms with patents or product options

▪Firms under restructuring

▪ Acquisition firms

▪Valuing Private firms

 When DCF Valuation works
best
▪Approach is designed for use for assets (firms) that derive their value

from their capacity to generate cash flows in the future.

▪It works best for investors who either

▪ have a long time horizon, allowing the market time to correct its valuation

Mistakes and for price to revert to true value or

▪ are capable of providing the catalyst needed to move price to value

 Relative valuation
▪ Most valuations are relative valuation

▪Valuation based on how similar assets are priced

▪ Value is derived from pricing of comparable assets and standardized using

a common variable ( earning, CFs, book value , revenue)
Eg: use an industry average PE ratio to value a firm
▪ Assume that market is right (assume market prices stocks correctly on
average but makes errors in pricing stock individually)

▪Assume comparison of market multiples will allow to identity errors and

correct over time
 Relative valuation
▪Information Needed:

▪ an identical asset, or a group of comparable or similar assets

▪ a standardized measure of value

▪ if the assets are not perfectly comparable, variables to control for the
differences

▪ Required less explicit information

▪It mostly reflects market expectations and moods

 Limitations of Relative
valuation
▪Difficult to use with no obvious comparable

▪Easy to misuse and manipulate

 When does relative valuation
works best?
▪This is east to use;

▪ When large number of comparable assets are there

▪ The assets are priced

▪ Existence of a common variable to standardize the price

▪Good for short time horizons

▪When judgements are based on relative benchmarking

▪ when can take advantages of relative mispricing

 Contingent Claim Approach
▪Options have several features

▪ They derive their value from an underlying asset

▪ The payoff occurs - if the value of the underlying asset is greater (lesser)

than an exercise price specified at the time the option is created.

▪ If this contingency does not occur, the option is worthless.

▪ They have a fixed life

▪ If these features absence- option worthless

Thank You