ACCELE2 – Professional Elective 2
rate increased, many could no longer afford the
Module 1: Fundamental Principles of Valuation
Let us understand why we need to value "value"
by looking unto the consequences of not
valuing value...
When managers, boards of directors, and investors
have forgotten these simple truths, the
consequences have been disastrous. The rise and
fall of business conglomerates in the 1970s, hostile
takeovers in the United States in the 1980s, the
collapse of Japan’s bubble economy in the 1990s,
the Southeast Asian crisis in 1998, the Internet
bubble, and the economic crisis starting in 2007—
all of these can be traced to a misunderstanding or
misapplication of the cornerstones. During the
Internet bubble, for instance, managers and
investors lost sight of what drives ROIC, and many
even forgot its importance entirely.
Between 1995 and 2000, more than 4,700
companies went public in the United States and
Europe, many with billion-dollar-plus market
capitalizations. Some of the companies born in this
era, including Amazon, eBay, and Yahoo!, have
created and are likely to continue creating
substantial profits and value. But for every solid,
innovative new business idea, there were dozens of
that couldn’t similarly generate revenue or cash flow
in either the short or long term. The initial stock
market success of these companies represented a
triumph of hype over experience.
Ignoring the cornerstones also underlies financial
crises, such as the one that began in 2007. When
banks and investors forgot the conservation-of-
value principle, they took on a level of risk that was
unsustainable.
First, homeowners and speculators bought homes
—essentially illiquid assets. They took out
mortgages with interest set at artificially low teaser
rates for the first few years, but then those rates
rose substantially. Both the lenders and buyers
knew that buyers couldn’t afford the mortgage
payments after the teaser period. But both assumed
that either the buyer’s income would grow by
enough to make the new payments, or the house
value would increase enough to induce a new
lender to refinance the mortgage at similarly low
teaser rates. Banks packaged these high-risk debts
into long-term securities and sold them to investors.
The securities, too, were not very liquid, but the
investors who bought them, typically hedge funds
and other banks, used short-term debt to finance
the purchase, thus creating a long-term risk for
those who lent the money.
When the interest on the homebuyers’ adjustable
payments. Reflecting their distress, the real estate
market crashed, pushing the value of many homes
below the value of loans taken out to buy them. At
that point, homeowners could neither make the
required payments nor sell their houses. Seeing
this, the banks that had issued short-term loans to
investors in securities backed by mortgages
became unwilling to roll those loans over, prompting
all the investors to sell their securities at once.
The value of the securities plummeted. Finally,
many of the large banks themselves had these
securities on their books, which they, of course, had
also financed with short-term debt that they could
no longer roll over.
This story reveals two fundamental flaws in the
decisions taken by participants in the securitized
mortgage market. First, they all assumed that
securitizing risky home loans made them more
valuable because it reduced the risk of the assets—
but this violates the conservation of-value rule. The
aggregated cash flows of the home loans were not
increased by securitization, so no value was
created and the initial risks remained.
Securitizing the assets simply enabled risks to be
passed on to other owners; some investors,
somewhere, had to be holding them. After the
housing market turned, financial service companies
feared that any of their counterparties could be
holding massive risks and almost ceased to do
business with one another. This was the start of the
credit crunch that triggered a protracted recession
in the real economy.
The second flaw in thinking made by decision
makers during the past economic crisis, was in
believing that using leverage to make an investment
in itself creates value. It doesn’t because, according
to the conservation-of-value principle, leverage
doesn’t increase the cash flows from an investment.
Many banks, for example, used large amounts of
short-term debt to fund their illiquid long-term
assets. This debt didn’t create long-term value for
shareholders in those banks. On the contrary, it
increased the risks of holding their equity.
What does it mean to create shareholder value?
Particularly at this time of reflection on the virtues
and vices of capitalism, it’s critical that managers
and board directors have a clear
understanding of what value creation means. For
value-minded executives, creating value cannot be
limited to simply maximizing
today’s share price. Rather, the evidence points to a
better objective: maximizing a company’s collective
value to its shareholders, now and in the future.
If investors knew as much about a company as its
managers do, maximizing its current share price
might be equivalent to maximizing
its value over time. But in the real world, investors
have only a company’s published financial results
and their own assessment of the
quality and integrity of its management team. For
large companies, it’s difficult even for insiders to
know how financial results are generated.
Investors in most companies don’t know what’s
really going on inside a company or what decisions
managers are making. They can’t know, for
example, whether the company is improving its
margins by finding more efficient ways to work or by
skimping on product development, resource
management, maintenance, or marketing.
Since investors don’t have complete information,
companies can easily pump up their share price in
the short term or even longer. One global consumer
products company consistently generated annual
growth in earnings per share (EPS) between 11
percent and 16 percent for seven years. Managers
attributed the company’s success to improved
efficiency. Impressed, investors pushed the
company’s share price above those of its peers—
unaware that the company was shortchanging its
investment in product development and brand
building to inflate short-term profits, even as
revenue growth declined. Finally, managers had to
admit what they’d done. Not surprisingly, the
company went through a painful period of
rebuilding. Its stock price took years to recover.
It would be a mistake, however, to conclude that the
stock market is not “efficient” in the academic sense
that it incorporates all public
information. Markets do a great job with public
information, but markets are not omniscient.
Markets cannot price information they
don’t have. Think about the analogy of selling an
older house. The seller may know that the boiler
makes a weird sound every once in a
while or that some of the windows are a bit drafty.
Unless the seller discloses those facts, a potential
buyer may have great difficulty
detecting them, even with the help of a professional
house inspector.
Despite such challenges, the evidence strongly
suggests that companies with a long strategic
horizon create more value than those
run with a short-term mindset. Banks that had the
insight and courage to forgo short-term profits
during the last decade’s real-estate bubble, for
example, earned much better total shareholder
returns (TSR) over the longer term. In fact, when we
studied the patterns of investment, growth, earnings
quality, and earnings management of hundreds of
companies across multiple industries between 2001
and 2014, we found that companies whose focus
was more on the long term generated superior TSR,
with a 50 percent greater likelihood of being in the
top decile or top quartile by the end of that 14-year
period. In separate research, we’ve found that long-
term revenue growth—particularly organic revenue
growth—is the most important driver of shareholder
returns for companies with high returns on capital.
What’s more, investments in research and
development (R&D) correlate powerfully with long-
term TSR.
Managers who create value for the long term do not
take actions to increase today’s share price if those
actions will damage the company down the road.
For example, they don’t shortchange product
development, reduce product quality, or skimp on
safety. When
considering investments, they take into account
likely future changes in regulation or consumer
behavior, especially with regard to
environmental and health issues. Today’s
managers face volatile markets, rapid executive
turnover, and intense performance pressures,
so making long-term value-creating decisions
requires courage. But the fundamental task of
management and the board is to demonstrate that
courage, despite the short-term consequences, in
the name of value creation for the collective
interests of shareholders, now and in the future.
Overview of Valuation Concepts and Methods
WHAT and WHY?
The fundamental point behind successful
investments is understanding what is the prevailing
value and the key drivers that influence this value.
In this lesson, the valuation and the processes in
valuation will be discussed.
According to the CFA Institute, 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. It includes the use of forecasts to come
up with reasonable estimate of value of an entity's
assets or its equity.
Valuation places great emphasis on the
professional judgment that are associated in the
exercise. As 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.
Key Principles in Valuation
- The value of a business is defined only at
a specific point in time.
- Value varies based on the ability of
business to generate future cash flows.
- Market dictates the appropriate rate of
return for investors.
- Firm value can be impacted by underlying
net tangible assets.
- Value is influenced by transferability of
future cash flows.
- Value is impacted by liquidity.
Risks in Valuation
In all valuation exercises, uncertainty will
be consistently present. Uncertainty refers to the
possible range of values where the real firm value
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. Some valuation methods also use future
estimates which bear the risk that what will actually
happen may be significantly different from the
estimate.
Objective of the Valuation Exercise
The definition of value may vary depending on the
context and objective of the valuation exercise.
1. 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.
2. Going Concern Value – the going concern
assumption believes that the entity will continue
to do its business activities into the foreseeable
future.
3. 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.
4. 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
Valuation is an essential tool for business owners to
assess both opportunities and opportunity
costs associated with the business resources. It
helps them manage the business because they are
able to track the effectiveness of the decision-
making process and provide them the ability to track
performance in terms of estimated change in value,
not just in revenue.
I. Portfolio Management
1. Fundamental Analyst – 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.
2. 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.
3. 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.
4. 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.
Valuation Techniques in Portfolio Management
∙ Stock selection
∙ Deducing market expectations
II. Business Deals for Analysis
 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.
The Valuation Process
Generally, the valuation process considers five
steps.
1. 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:
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.
Other ways to understand a business include
the following:
a. understanding the company's business model
which pertains to the method on how the company
makes money.
b. analysis of historical and financial reports which
use horizontal, vertical, and ratio analysis and their
interpretations.
c. analysis of quality earnings which 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.
2. 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 Limitation: Only reflects historical value (only based
Performance on what is recorded in the accounting books) and
- Top down forecasting approach: international or might not reflect the real value of the business now.
national macroeconomic projections with utmost
consideration to industry specific forecasts. Your Task:
- Bottom-up forecasting approach: forecast starts
Assuming you are the accountant of Green Tea
from the lower levels of the firm and builds the
Company who looks at the different account
forecast as it captures what will happen to the
balances in the company records. You are asked to
company.
provide preliminary valuation numbers for an
3. Selecting the right valuation model – it upcoming management discussion. The following
depends on the context of the valuation and the account balances were generated from the records:
inherent characteristics of the company being
Accounts payable
valued.
20,000
4. Preparing valuation model based on forecasts
Accounts receivable
there are two aspects to be considered:
70,000
- Sensitivity analysis: common methodology in
valuation exercises wherein multiple other analyses Accrued liabilities 1,000
are done to understand how changes in an input or
variable will affect the outcome. Cash
50,000
- Situational adjustments: firm specific issues that
affects firm value that should be adjusted by Intangible Assets 70,000
analysts since these are events that are not
quantified if analysts only look at core business Inventory
operations. 52,000

5. Applying valuation conclusions and providing Long-term investments

recommendation. 150,000

Long-term liabilities 125,000

Module 2: Asset-Based and Liquidation-Based Marketable securities 46,000

Valuation
Notes payable (short-term) 25,000
Book Value Method
Property, plant and equipment 705,000
Book value is total assets minus total liabilities and
Prepaid expenses 3,000
is commonly known as net worth. 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 Compute the following:
financial position.
1. Total current assets =
The assets are required to be categorized into
current and non-current assets. On the other hand, 2. Total non-current assets =
liabilities is also categorized as current and non-
3. Total current liabilities =
current. In the book value method, the value of the
enterprise is based on the book value of the assets 4. Total noncurrent liabilities =
less all non-equity claims against it and is computed
as follows: 5. Book value of Green Tea Company =

Net Book Value of Assets = (Total Assets - Total 6. Book value per share =
Liabilities) / No. of Outstanding Shares

Advantage: It provides a more transparent view on

firm value and is more verifiable since this is based Replacement Value Method
in the figures reflected in the financial statements.
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:

1. age of the asset: It is important to know how

old the asset is. This will enable the evaluator 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.

2. size of the asset: 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.

3. 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 no specific discipline in determining the

replacement value. Appraisers have their own
technique to determine the replacement value.

The value of the equity using the replacement

value method is computed using the formula:

Replacement value per share = (Net Book Value +/-

replacement adjustments) / Outstanding Shares
Your Task:

Caramel Company showed the following balances

To illustrate, Fabulous Company in the year 20XX in its balance sheet as at year-end:
presented its statement of financial position with the
following balances: Current Assets is Php500 Current Assets Php
Million; Non-Current Assets is Php1 Billion; Current 450,000
Liabilities is Php200 Million; Non-Current Liabilities
Non-Current Assets
is Php700 Million and the outstanding shares is P1
1,150,000
Million. Suppose that 50% of the non-current
assets has an estimated replacement value of Current Liabilities
150% of its recorded net book value while the 300,000
remaining half has estimated replacement value of
75% of their recorded net book value. Non-Current Liabilities
900,000
With the given information, the equity value is
adjusted: Weighted Average of outstanding shares
120,000 shares
According to the appraiser, 60% of the non-current noncurrent assets are comprised of goodwill which
assets can be replaced at 150% of their reported upon testing was proven to be valued correctly.
book value while the remaining balance of the non-
current assets has replacement value of 65%.
Reported balance of other items approximates their
replacement value. Compute the replacement
value of Caramel Company at year-end.

Reproduction Value Method

In some instances, no external information is

available that can serve as basis for replacement
costs of assets that are highly specialized in
nature. In this case, reproduction value is used
instead.

Reproduction value is an estimate of cost

reproducing, creating, developing or manufacturing
a similar asset. 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 Your Task:
reproduction value method is the ability to validate
the reasonableness of the value calculated since Samsan Company, a start-up company which
there are only limited sources of comparators and developed its own data imaging algorithm, is trying
benchmark information that can be used. to estimate the value of their company. Their latest
financial statement showed the following
Steps in determining the equity value using the information:
reproduction value method are as follows:
Current Assets 1,250,000
1. Conduct reproduction costs analysis on all
assets. Non-Current Assets
4,000,000
2. Adjust the book values to reproduction costs
values (similar as replacement value) Current Liabilities 850,000

3. Apply the replacement value formula using the Non-Current Liabilities

figures calculated in the preceding step. 250,000

Part of their non-current assets is a patent for the

To illustrate, using the information of Fabulous
Company:
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 P1 Million.
technology they developed which has a recorded
balance of P2,500,000. An equity investor is
looking at buying the company. Samsan Company
tried to trace back the costs of developing the
patent and determined that the reproduction cost of
that particular patent is P3,000,000. What is the
reproductive value of Samsan Company?

Suppose 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
Liquidation Value Method