Cee arenes FUNDAMENTALS PRINCIPLES OF VALUATION Assets, individually or collectively, has value. Generally, value pertains to how much a particular object is worth to a particular set of eyes. 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 different on how to value an entire business. Businesses treat capital as a scarce resource that they should compete to ‘obtain and efficiently manage. Since capital is scarce, capital providers require users to ensure that will be able to maximize shareholder returns to justify providing capital to them. Otherwise, capital providers will look and bring money to other investment opportunities that are more attractive. Hence, most fundamental principle for all investments and business is to maximize shareholder value. Maximizing value 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 productivity gains, employment growth and higher salaries. Placing scarce resources in their most productive use best serves the interest of 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, fulfiling the promise to capital providers. This is where valuation steps in. VALUATION 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 ‘comparisons with similar assets, or, when relevant, on estimates of immediate liquidation proceeds. Valuation includes the use of forecasts to come up with reasonable estimate of value of an entity's assets or its equity. At varying levels, decisions done within a firm entails valuation implicitly. For example, capital budgeting analysis usually considers how pursuing a specific project will affect entity value. Valuation techniques may differ across different assets, but all follows similar fundamental principles that drives the core of these approaches. 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 evaluation Re aes VALUATION CONCEPTS AND METHODOLOGIES different assumptions used in each phas phase of the valuation exer: validity of available empirical evidence and come up with rational chennnesS aligns with the ultimate objective of the valuation activity id INTERPRETING DIFFERENT CONCEPTS OF VALUE In the corporate setting, the fundamental equation of value is grounded oy principe that Alfred Marshall popularized — a company creates vale ft oi only if the return on capital invested exceed the cost of acquiring ca wa | Vale, in the point of view of corporate shareholders, relates tothe 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. The value of a businesses 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? ‘These factors are solid concepts; however, the quick turnover of technologies and rapid globalization make the business environment more dynamic. As a result, defining value and identifying relevant drivers became more arduous as time passes by. AS firms continue to quickly evolve and adapt to new technologies, valuation of current operations becomes more dificut 2s compared to the past. Projecting future macroeconomic indicators also is harder because of constant change in the economic environment and the ‘continuous innovation of market players. New risks and competitions also surface which makes determining uncertainties a critical ingredient to success, ‘The definition of value may also vary depending on the context and 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. Intrinsic value is the value that an investor considers, on the basis of an evaluation of available facts, to be the "true" or “real” value that will become the market value when other investors reach the same conclusion. AS 2 —RU eens Obtaining complete information about the asset is impractical, investors normally estimate intrinsic value based on their view of the real worth of the asset. f the assumption is that the true value of asset is dictated by the market, then intrinsic value equals its market price. Unfortunately, this is not 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 no investors analyze information about 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 approximate an asset's intrinsic value. Securities analysts often try to 100k for stocks which are ‘mispriced in the market and based their buy or sell ecommendations based on these analyses, Intrinsic value is highly relevant in pricing public shares Most of the approaches that will be discussed in this book deals with finding out the intrinsic value of assets. Financial analysts should be able to come up with accurate forecasts and determine the right valuation model that will yield a good estimate of 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 determined under the going ‘concern 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. Chapters 2 and 3 focus on valuation methodologies dealing with a firm's going concern value. ‘+ Liquidation Value - 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 financial distress. Normally, there is greater valueae Rk eaar en master sy Generated when assets working together are combined with ine application of human capital (unless the business is continuow unprofitable) which is the case in the going-concern assumption liquidation occurs, value often declines because of the assets ot working together anymore and the absence of human intervention * 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. Both parties should voluntarily agree with the Price of the transaction and are not under threat of 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 valuation exercises involving tax assessments, ROLES OF VALUATION IN BUSINESS Portfolio Management The relevance of valuation in portfolio management largely depends on the investment objectives of the investors or financial managers managing the investment portfolio. Passive investors tend to be disinterested in understanding valuation, but active investors may want to understand valuation in order to participate intelligently in the stock market. * 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. For fundamental analysts, the true value of a firm can be estimated by looking at its financial characteristics, its growth prospects, cash flows and isk Profile. Any noted variance between the stock's market price versus its fundamental value indicates that it might be overvalued of undervalued, Typically, fundamental analysts lean towards long: strategies which encapsulate the following principle © Relationship between valu liably measured.Nero aneeered Above relationship is stable over an extended period ‘Any deviations from the above relationship can be corrected within a reasonable time | Fundamental analysts may include value and growth investors. Value | investors tend to be mostly interested in purchasing shares that are | Currently existing and priced at less than their true value. On the other hand, growth investors lean towards growth assets (expected value that future investments can create) and purchasing these at a discount. Security and investments analysts use valuation techniques to Support the buy / sell recommendations that they provide to their clients. Analysts often infer market conditions implied by the market rice by assessing this against his own expectations. This allows him to assess reasonableness and adjust future estimates. Market expectations regarding fundamentals of one fim can be used as benchmark for other companies which exhibits the same characteristics, * Activist investors ~ Activist investors tend to look for companies with good growth prospects that have poor management. Activities 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. In the minds of activist investors, itis not about the current value of the company but its potential value once itis run properly. Knowledge about valuation is critical for activist investors so they can reliably pinpoint which firms will create additional value if ‘management is changed. To do this, activities investors should have ‘@ good understanding of the company’s business model and how implementing changes in investment, dividend and financing policies can affect its value. + Chartists - Chattists relies on the concept that stock prices are significantly influenced by how investors think and act. Chartists rely on available trading KPIs such as price movements, trading volume, short sales - when making their investment decisions. They believe that these metrics imply investor psychology and will predict future ‘movements in stock prices. Chartists assume that stock price changes and follow predictable patterns since investors make decisions based ‘on their emotions than by rational analysis. Valuation does not play a huge ‘ole in charting, but it is helpful when plotting support and resistance lines,“ erature eae kets} Information Traders ~ Traders that react based on new injgy about firms that are revealed to the stock market. The underiyiny 2% is that information traders are more adept in guessing or geri information about firms and they can make predict how the Tarra react based on this. Hence, information traders correlate vaiye how information will affect this value. Valuation is importa information traders since they buy or sell shares based on assessment on how new information will affect stock price, “* Under portfolio management, the following activities can be performey through the use of valuation techniques: + Stock selection - Is a particular asset fairly priced, overpriced, g underpriced in relation to its prevailing computed intrinsic vaiye and prices of comparable assets? ‘+ Deducing market expectations ~ Which estimates of a firm's futue performance are in line with the prevailing market price of is stocks? Are there assumptions about fundamentals that wil juts, the prevailing price? Typically, investors do not have a lot of time to scour all available information in order to make investment decisions. Instead, they seek the help of professionals to come up with information that they can use to decide ther investments. Sell-side analysts that work in the brokerage department of investment fms issue valuation judgment that are contained in research reports that ae disseminated widely to their current and potential clients. Buy-side analysis, on the other hand, look at specific investment options and make valuatin analysis on these and report to a portfolio manager or investment committee. Buy-side analysts tend to perform more in-depth analysis of a firm and engage in more rigorous stock selection methodologies. In general, financial analysts assist clients to realize their investment goals by providing them information that will help them make the right decision whether to buy or sell. They also play a significant role in the financial markets by Providing the right information to investors which enable the latter to buy 0” sell shares. As a result, market prices of shares usually better reflect its rea! values. Since analysts often take a holistic look on businesses, these somewhat serves a monitoring role to management to ensure that they make decision that are in line with the creating value for shareholders. imi ceVALUATY eres Analysis of Business Transactions / Deals Valuation plays @ very big role when analyzing potential deals. Potential acquirers typically use relevant valuation techniques (whichever is applicable) 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 acquisition usually has two parties: the buying firm and the selling firm. The buying firm needs to determine the fair value of the target company prior to offering a bid price. On the other hand, the selling firm (or sometimes, the target Company) should have a sense of its firm value as well to gauge reasonableness of bid offers. Selling fims also use this information to guide which bid offers to accept or reject. On the downside, bias may be a significant concern in acquisition analyses. Target firms may show very optimistic projections to Push the price higher or pressure to make resulting valuation analysis favorable if target firm is certain to be purchased as a result of strategic decision. + Merger ~ General term which describes the transaction two companies combined to form a wholly new entity. An example is the merger of ‘+ 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 component business and transforming this into a separate legal entity whose ownership will be transferred to shareholders. Leveraged buyout - Acquisition of another business by using significant debt which uses the acquired business as a collateral Valuation in deals analysis also considers two important, unique factors: synergy and control ‘+ Synergy ~ potential increase 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Reta uaa eres) separate firms. Synergy can be attributable to more d oy ‘operations, cost reductions, increased revenues, combin Producismatkets or coss-scininary teens ofthe gor bt organization. ned * Control - change in people managing the organization bye, about by the acquisition, Any impact to firm value resuting gat the change in management and resmctuing ofthe eh company should be included in the valuation exercise. Thy usually an important matter for hostile takeovers, 5 Corporate Finance Corporate finance mainly involves managing the firm's capital struct including funding sources and strategies that the business should pursue g maximize firm value. Corporate finance deals with priontizing and distrbuti financial resources to activities that increases firm value. The utimate goai¢ comporate finance is to maximize the firm value by appropriate planning ang implementation of resources, while balancing profitability and risk appetite ‘Small private businesses that need additional money to expand uses valuation concepts when approaching private equity investors and ventu capital providers to show the promise of the business. The ownership stake that these capital providers will ask from the business in exchange of the money that they will put in will be based on their estimated value of the smal private business, Larger companies who wish to obtain additional funds by offering their shares. to the public also need valuation to estimate the price they are going to be offered in the stock market. Afterwards, decision regarding which projects to invest in, amount to be borrowed and dividend declarations to shareholders are influenced by company valuation. Corporate finance ensures that financial outcomes and corporate strategy drives maximization of firm value. Current business conditions push business leaders to focus on value enhancement by looking at the business holistically and focus on key levers affecting value in order to provide some level of return to shareholders, Firms that are focused on maximizing shareholder value uses valuation concepts to assess impact of various strategies to company value. Valuation methodologies also enable communication about significant corporate matters between management, shareholders, consultants and investment analysts.Mees. uaneecsd Legal and Tax Purposes Valuation is also important to businesses because of legal and tax purposes. For example, if anew partner will join a partnership or an old partner will retire, the whole partnership should be valued to identify how much should be the buy-in oF sell-out. This is also the case for businesses that are dissolved or liquidated when owners decide so. Firms are also valued for estate tax purposes if the owner passes away. Other Purposes (e.g. investment bank) + Basis for assessment of potential lending activities by financial institutions * Share-based paymenticompensation VALUATION PROCESS Generally, the valuation process considers these five steps: |. Understanding of the business Understanding the business includes performing industry and competitive analysis and analysis of publicly available financial information and corporate disclosures. Understanding the business is very important as these give analysts and investors the idea about the following factors that affect the business: economic conditions, industry peculiarities, company strategy and company's historical performance. The understanding phase enables analysts to come up with appropriate assumptions which reasonably capture the business realities affecting the firm and its value | | | + Issuance of a fainess opinion for valuations provided by third party Frameworks which capture industry and competitive analysis already exists and are very useful for analysts. These frameworks are more than @ template that should be filled out: analysts should use these framework 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 competitive analyses should emphasize which factors affecting business will be most challenging and how should these be factored in the valuation model.Wien cae ean to the inherent technical and ecan Industy structure refers ’ pd des ‘of an industry and the bial may affect th Structure, Industry characteristics means that these are true to m not al, market players participating in that industry. Porter Fores is the most common tool used to encapsulate indus structure restraints. ‘Substitutes and | This refers to the relationships beeen interrelated produ ap | Complements | services in the industry. Availabilty of substitute products (produce which can replace the sae ofan existing procuct) or comptes Broducts (products which can be used together wth another praes | Btfects industy prottabity. This consicer press of suse) | procuctslservices, complement productsisenices and’ govemnet| | limitations. \ Supplier Power [Supple power reer Te fw suppers can regolate Baty Tema} ther favor. When there is strong supplier power, this tends te rae industy prfts lower, Svong supplier power exists there ae fer suppliers that can suppiy a spectic input. Supplier poner ass censiders suppier concenttaton, prices of atlematve inpus telatonship-specfic_ investments, supplier swiching cots ans governmental equations, | Buyer Power] Buyer power perains to how customers Can negotiate beter TaEw/ thet favor fr the productsiservces they purchase. Typiealy, buy | power is low if customers are fragmented and concentaion oe | This means tht market players are not dependent to few customer to survive. Low buyer power tends to improve industy profs see they cannot signfcanty negotate for the pnce of the produt. Oe fectors considered in buyer power include buyer coneervaton, abe Of substitute products that buyers can purchase, customer sulting cosls and goverment restraints. Competitive position refers how the Products, services and the company itself is set apart from other competing market players. Competitive position is typically gauged using the prevailing market share level that the company enjoys. Generally, a firm's value ishighet iT it can consistently sustain its competitive advantage against fs ee SSK Nee |RU eae bees competitors. According to Michael Porter, there are 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 (cost focus) or differentiation strategy (differentiation focus) Aside from industry and competitive landscape, understanding the company’s business models also important. Business model pertains to the method how the company makes money - what are the products or services they offer, how they deliver and provide these to customers and their target customers. Knowing the business model allows analysts to capture the right performance drivers that should be included in the valuation model The results of execution of aforementioned strategies will ultimately be reflected in the company performance results which is reflected in the financial statements. Analysts typically look at the historical financial statements to get a sense of how the company performed, There is no hard rule on how long the historical analysis should be done. Typically, historical financial statements analysis can be done for the last two years from up to ten years prior as long as available information is available. Looking at the past ten years may give an idea how resilient the company in the past and how they reacted to the problems they encountered along the way. ‘Analysis of historical financial reports typically use horizontal, vertical ‘and ratio analysis. More than the computation, these numbers should be related year-on-year to give a sense on how the company performed over the years. These can be benchmarked against other ‘market players or the industry average to understand how the firm fare. Some information can also be compared against stated objectives of the organization — such as sales growth, gross margin ratios or bottom line targets. government-mandated disclosures like audited financial statements, | Typical sources of information about companies can be found ina ™~ Rote esau mae ofc) Ifthe fm is publicly listed, regulatory flings, company press reeag, and financial statements can be easily accessed in the at exchange. Investor relation materials that can company issues also be accessed in their ovin websites. Other acceptable sourcac™™ information include news articles, reports from industry OFganization reports from regulatory agencies and industry researches done independent fms such as Ne'sen or Euromonitor. Ethcalyanay¢! should only use information that are made publicly availabe by ne (via government flings or press releases), Analysts should avoid uss material inside information as this gives undue disadvantage to othe, investors that do not have access to the information og, In analyzing historical financial information, focus is given to look the quality of earings. Quality of earnings analysis pertain to the detailed review of all financial statements and accompanying notes ts assess sustainability of company performance and validate accura, of financial information versus economic reality. During the analysis transactions that are nonrecurring such as financial impact of ltigatin settiements, temporary tax reliefs or gainsilosses on sales of nonoperating assets might need to be adjusted to arrive at the performance of the firm's core business. Quality of earnings analysis also compares net income against operating cash flow to make sure reported earnings are actualy realizable to cash and are not padded only because of significant accrual entries. Typical observations that analysts can derive fom financial statements and should be critical of are listed below: rie Revenues and gain ESS Early recognition of revenues (e.g. billand- hold sales, sales | recognition prior to installation and ‘acceptance of customer) [inclusion of nonoperating | income or gains as part of | operating income | Possible Interpretatio Accelerated revenue | recognition improves income and can be used to hide decining performance | Nonrecurring gains that 60 not relate to operating Performance may hide declining performance. Expenses and losses Recognition of too high or too ttle reserves (e.g, restructuring, bad debts) Too litle reserves may improve current yest income but might attest) future income (and we® | versa) 4cea ame) wo aad Possible Observation __ Possible Interpretation Deferal of expenses | May improve current suchas customer | income but will reduce acquisition or produc | future income. May hide development costs by | decining performance | capitaizaton ‘Aggressive assumptions | Aggressive estimates m such as long usefl lives, | imply that there are steps | lower asset impairment, | taken to improve current | high assumed ciscount | year income, Sudden rate for pension labites | changes in estimates may or high expected return | indicate masking of on plan assets potential problems in operating performance. Balance sheetitems | Offbalance Sheat | Assetsiliabilties may not financing (those not | be fairy reflected. reflected in the face of the | balance sheet) _ lke | leasing or securitizing receivables Operating cashflows [Increase in bank | Potential arifcial inflation ‘overdraft as operating | in operating cash flow. cash flow Based on AICPA guidance, other red flags that may indicate aggressive accounting include the following: * Poor quality of accounting cisclosures, such as segment information, acquisitions, accounting policies and assumptions, and a lack of discussion of negative factors. + Existence of related - party transactions or excessive officer, employee, or director loans. + Reported (through regulatory flings) disputes with andlor changes in auditors. + Material nonauit services performed by aucit frm. + Management andlor directors ' compensation | profitability or stock price (through ownership or compensation plans) + Economic, industry, or company - specific pressures on proftailty, such as loss of market share or declining margins. + High management or director turnover + Excessive pressure on company personnel to make revenue of earnings targets, particularly when management team is aggressive + Management pressure to meet debt covenants or earnings expectations: xd toy RUN eae yn eels} A history of secures law violations, reporting Volatong persistent late filings , Il Forecasting financial performance After understancing how the business operates and analysis of itn financial statements, forecasting financial performance isthe next ge: Forecasting financial performance can be looked at two lenses, ons macro perspective viewing the economic environment and indy where the firm operates in and on a more micro perspective focusne the firm's financial and operating characteristics. Forecaghs summarizes the future-ooking view which resuite ftom the assesanc? Of industry and competitive landscape assessment, business stratey, and historical financials. This can be surimarized in two approaches * Top-down forecasting approach - Forecast starts ftom international or national macroeconomic projections with utmos consideration to industry specific forecasts. From here, analysis select which are relevant to the firm and then applies this to the firm and asset forecast. In top-down forecasting approach, the most common variables include GDP forecast, consumption forecasts, inflation projections, foreign exchange currency rates, industry sales and market share. Usually, one result of top-down forecasting approach is the forecasted sales volume for the company. Revenue forecast will be built from this combined with the company-set sales prices ‘+ Bottom-up forecasting approach — Forecast starts from the lower levels of the firm and builds the forecast as it captures what wil happen to the company. For example, store expnasion will be captured and its corresponding impact to revenues will be computed until company-level revenues is calculated. Insights compiled during the industry, competitive and business strategy analysis about the firm should be considered in this phase while forecasting for the firm's sales, operating income and cash flows. Comprehensive understanding of these is critical to forecast reasonable numbers. Qualitative factors, albeit subjective, 3° considered in the forecasting process in order to make valuation approximate the true reality of the firm. Assumptions should be drve" by informed judgment based on the understanding of the business TE _Neyo moaned Forecasting should be done comprehensively and should include earning, cash flow and balance sheet forecast. Comprehensive forecasting approach prevents any inconsistent figures between the Prospective financial statements and unrealistic assumptions. The proach considers that analysis should done per line item as each ‘tem can influenced by a different business driver. Similar with short- term budgeting, forecasting process starts with the determining sales grows growth and revenue projections of the business. Forecasting process should also consider industry financial ratios as this gives an idea how the industry is operating. From this, analysts should be able to explain the reasons why firm-specific ratios will deviate from this. Knowledge of historical financial trends is also important as this can give guidance how prospective trends will look like. Similarly, any deviations from noted historical trends should be carefully explained to ensure reasonableness. Typically, sales and profit numbers should consistently move in the future based on current trends if there is no significant information that will prove otherwise. On the other hand, return on investments will move closer to cost of capital as competition comes in to play. The results of forecasts should be compared with the dynamics of the industry where the business operates and its competitive position to make sure that the numbers make sense and reflect the most reliable estimate of how the business operates. Even though general economic and market trends can be used as reliable benchmark, analysts should consider that unique factors that affect company prospects as guidance in the forecasting process. Typically, forecasts are done on annual basis as most publicly available financial information are interpreted on an annual basis. Where applicable, forecasts can be better done on a quarterly basis to account for seasonality. Seasonality affects sales and earings of almost all industry. For example, airline companies tend to have peak sales during summer season and holiday seasons while lean sales during rainy months. Developing earnings forecast using seasonality can give a more reasonable estimate. Selecting the right valuation mode! ‘The appropriate valuation model will depend on the context of the valuation and the inherent characteristics of the company being Pn eariarern seats——— valued, Details of these valuation models and the circumstance they should be used will be discussed in succeeding chapters Rol S When IV. Preparing valuation model based on forecasts Once the valuation model is decided, the forecasts should ny, inputted and converted to the chosen valuation model. This step sr cnly about manually encoding the forecast to the model to esting the value (whichis the ob of Microsoft Excel). Moreso, analysts shou consider whether the resulting value from this process makes senge based on the knowledge about the business. To do this, two agpecs should be considered: Sensitivity analysis — common methodology in valuation exercises wherein multiple other analyses are done ty understand how changes in an input or variable will afec the outcome (ie. firm value). Assumptions that are commonly used as an input for sensitivity analysis exercises are sales growth, gross margin rates ang discount rates. Aside from these, other variables (ite market share, advertising expense, discounts differentiated feature, etc.) can also be used depending or the valuation problem and context at hand, Situational adjustments — firm-specific issues that affecs firm value that should be adjusted by analysts since these are events that are not quantified if analysts only look at core business operations. This includes control premium, absence of marketability discounts and liquidity discounts. Control premium refers to additional valve considered in a stock investment if acquiring it will ge controlling power to the investor. Lack of marketabiliy discount means that the stock cannot be easily sold a there is no ready market for it (e.g. non-publicly traded discount). Lack of marketability discount drives down share value. liquidity discount should be considered when the price of particular shares has less depth or generally considered less liquid compared to other active publioy traded share. llliquidity discounts can also be considered an investor will sell large portion of stock that is significant compared to the trading volume of the stock. iiiMea ees Vv, Applying valuation conclusions and providing recommendation Once the value is calculated based on all assumptions considered, the analysts and investors use the results to provide recommendations or make decisions that suits their investment objective, KEY PRINCIPLES IN VALUATION a. The value of a business is defined only at a specific point in time Business value tend to change every day as transaction happens. Different circumstances that occur on a daily basis affect earnings, cash position, working capital and market conditions. Valuation made a year ago may not hold true and not reflect the current firm value today. As a result, this is important to give perspective to users of the information that firm value is based on a specific date. b. Value varies based on the abilty of business to generate future cash flows General concepts for most valuation techniques put emphasis on future cash flows except for some circumstances where value can be better derived from asset liquidation The relevant item for valuation is the potential of the business to generate value in the future which is in the form of cash flows. Future cash flows can be projected based on historical results taking into account future events that may improve or reduce cash flows. Cash flows is also more relevant in valuation as compared to ‘accounting profits as shareholders are more interested in receiving cash at the end the day. Cash flows include cash generated from operations and reductions that are related to capital investments, working capital and taxes. Cash flows will depend on the estimates of future performance of the business and strategies in place to support this growth. Historical information can provide be a good starting point when projecting future cash flows.ee ~ STITT oases cMarket dictates the appropriate rate of return for investors Market forces are constantly changing and they normally proyg, Guidance of what rate of return should investors expect from dite investment vehicles in the market. Interaction of market forces ma differ based on type of industry and general economic concitions Understanding the rate of return dictated by the market is importa for investors so they can capture the right discount rate to be used jg, valuation. This can influence their decision to buy or sell investmens d. 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 Theoretically, firms with higher underlying net tangible asset value ae more stable and results in higher going concern value. This is a resut of presence of more assets that can be used as security during financing acquisitions or even liquidation proceedings in case bankruptcy occurs. Presence of sufficient net tangible assets can also ‘support the forecasts on future operating plans of the business. e. Value is influenced by transferability of future cash flows Transferability of future cash flows is also important especially to potential acquirers. Business with good value can operate even without owner intervention. If a firm's survival depends on owners influence (e.g. owner maintains customer relationship or provides certain services), this value might not be transfer to the buyer, hence, this will reduce firm value. In such cases, value will only be limited 19 net tangible assets that can be transferred to the buyer. f. Value is impacted by liquidity This principle is mainly dictated by the theory of demand and supply If there are many potential buyers with less acquisition targets, valve of the target firms may rise since the buyers will express more interest to buy the business. Generally, more business interest liquidity ¢@" translate to more business value. Sellers should be able to attract and negotiate potential purchases to maximize value they can realize fo™ the transaction.Cerra uareced Uncertainty 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. Value consequently may be different based on new circumstances. Uncertainty is captured in valuation models through cost of capital or discount rate. Another aspect that contributes to uncertainty is that analysts use their judgments to ascertain assumptions based on current available facts. Even if risk adjustments are made, this cannot 100% ascertain the value will be Perfectly estimated. Constant changes in market conditions may hinder the investor from realizing any expected value based on the valuation methodology. Performance of each industry can also be characterized by varying degrees of predictability which ultimately fuels uncertainty. Depending on the industry, they can be very sensitive to changes in macroeconomic climate (investment goods, luxury products) or not at all (food and pharmaceutical) Innovations and entry of new businesses may also bring uncertainty to established and traditional companies. It does not mean that a business has operated for 100 years will continue to have stable value. If a new company suddenly arrived and provide a better product that customers will patronize, this can mean trouble. Typically, businesses manage uncertainty to take advantage of possible opportunities and minimize impact of unfavorable events. This influences management style, reaction to changes in economic environment and adoption of innovative approaches to doing business. Consequently, these dynamic approaches also contribute to the uncertainty to all players in the economy.RT saad uals ' Valuation isthe estimation ofan asses value based on varabes pera, tobe relate tofture investment reurs, on comparisons vith sions oF, when relevant, on estimates of immediate liquication proceeds, Degit® of value may vary depending on the contex. Different defntions of mi incuce inns value, ging concer value, iuidaton value and far mn value Valuation plays significant role in the business world with respect to portoig management, business transactions or deals, corporate finance, legal angi purposes. Generally, valuation process involves these five steps: understanding of he business, forecasting financial performance, selecting right valuation mage Preparing valuation model based on forecasts and applying conclusions ang providing recommendations. Key principles in valuation includes the following: Value is defined at a specific point in time Value varies based on ability of business to generate future cash fows Market dictates appropriate rate of return for investors Value can be impacted by underlying net tangible assets | Value is influenced by transferability of future cash flows Value is impact by liquidity