Value

 Worth of object in another person’s point of view

 Increase > shareholder capital is maximized > fulfill promise to capital providers
 Cash inflows by the investment - cost of capital invested (captures time value of money and risk premium)

Capital
 Scarce resource

Maximize shareholder value

 Fundamental principle for investments and business
 Domino impact to economy (higher economic output, better productivity gains, employment growth, higher
salaries)

Valuation
 CFA Institute: estimation of asset’s value based on future investment return, comparisons with similar assets, or
estimates of immediate liquidation proceeds
 Use of forecasts to come up with reasonable estimate
 Emphasis on professional judgment (analysts should hone their ability to evaluate assumptions, assess validity of
evidence, and come up with rational choices)

Alfred Marshall
 Fundamental equation of value: company creates value if and only if the return on capital invested exceed the
cost of acquiring capital

FACTORS OF THE VALUE OF BUSINESS

1. Current operations - operating performance
2. Future prospects - long term, strategic direction
3. Embedded risk - business risks

Defining value and identifying relevant drivers became more arduous

 As firms continue to evolve and adapt to new technologies, valuation becomes more difficult
 Harder to project future macroeconomic indicators (constant changes in economic environment and innovation)
 New risks and competition

CONTEXT AND OBJEJCTIVE OF VALUATION EXERCISE

1. Intrinsic value
 Value of asset based on hypothetical complete understanding of its investment characteristics
 Value that investor considers
o Estimated based on their view of the real worth
 True or real value > market value (when other investors reach the same conclusion)
o True value is dictated by market: intrinsic value = market price
 Grossman-Stiglitz paradox
 If market prices, obtained freely, perfectly reflect the intrinsic value of asset, then a
rational investor will not spend to gather data to validate the value of stock
 Investors will not spend to gather more information unless there is potential reward in
exchange
 Market price often does not approximate intrinsic value
 Analysts look for stocks which are mispriced in the market and base their recommendations based on analysis
 Highly relevant in valuing public shares

2. Going concern value

 Firm value is determined under the going concern assumption
 Going concern: entity will continue to do business activities into the foreseeable future
 Greater value when assets working together are combined with application of human capital

3. Liquidation value
 Realized net amount when business is terminated and assets are sold
 Computed based on the assumption that entity will be dissolved and assets will be sold individually
 Relevant for companies under severe financial distress
 Value declines because assets no longer work together and human intervention is absent

4. Fair market value

 Price at which property would change hands between willing and able buyer and seller in open and unrestricted
market, when neither is under compulsion to buy or sell and both have reasonable knowledge of facts
 Assumed that both parties are informed of material characteristics that might influence decision
 Often used in valuation exercises involving tax assessments

ROLES OF VALUATION IN BUSINESS

1. Portfolio management
 Depends on investment objectives
 Passive investors: disinterested in understanding valuation
 Active investors: want to understand valuation to participate intelligently in stock market
a. Fundamental analysts
 Interested in understanding and measuring intrinsic value of firm
 Fundamentals: characteristics of entity related to financial strength, profitability, or risk appetite
 Overvalued/undervalued: variance between stock’s market price and fundamental value
 Can be value or growth investors
o Value investors - interested in purchasing existing shares priced at less than true value
o Growth investors - purchasing growth assets (businesses not profitable now but has high
expected value in future) at a discount
 Use valuation to support buy/sell recommendations to clients
b. Activist investors
 Look for companies with good growth prospects that have poor management
 Do takeovers (use equity holdings to push old management out and change the way the company run)
 Not about the current but potential value once run properly
 Use valuation to pinpoint which firms will create additional value if management is changed
c. Chartists
 Relies on concept that stock prices are influenced by how investors think and act
 Rely on available trading KPIs when making decisions
 Assume that stock prices changes and follows predictable patterns
 Valuation does not play a huge role but is helpful when plotting support and resistance lines
d. Information traders
 React based on new information about firms revealed to stock market
 Correlate value and how information will affect its value
 Use valuation to buy/sell shares based on assessment on how new information will affect stock price
 Activities performed: stock selection and deducing market expectations
 Sell-side analysts: work in brokerage department of investment firms that issue valuation judgment to current
and potential clients
 Buy-side analysts: look at investment options, make valuation analysis, and report to portfolio manager
2. Analysis of business transactions/deals
 Use valuation techniques to estimate value of target firms planning to purchase and understand its advantages
 FACTORS
a. Synergy - potential increase in firm value once two firms merge (greater than the sum of separate)
b. Control - change in people managing the organization brought by acquisition
 CORPORATE EVENTS
a. Acquisition - buying and selling firm
 Buying firm - determine fair value of target company prior to offering bid price
 Selling firm - should have a sense of its value to gauge reasonableness of bid offers
c. Merger - two companies combine assets to form a wholly new entity
d. Divestiture - sale of major component or segment of business to another company
e. Spin-off - separating segment or component business and transforming it into a separate legal entity
f. Leveraged buyout - acquisition of another business by using significant debt (acquired business = collateral)
3. Corporate finance
 Managing capital structure (funding sources and strategies to maximize firm value)
 Ensures financial outcomes and corporate strategy drives maximization
4. Legal and tax purposes
 Joining a new partnership, old partner retiring, dissolution, liquidation, estate tax
5. Other purposes
 Issuance of fairness opinion by third party, basis for assessment of potential lending activities by financial
institutions, and share-based compensation

VALUATION PROCESS
1. Understanding of the business
 Performing industry and competitive analysis of publicly available financial information and corporate disclosure
 Idea about economic conditions, industry peculiarities, company strategy, and historical performance
 Industry and competitive analyses: emphasize most challenging factors
 Industry structure: technical and economic characteristics of industry and trends that affect the structure
 Industry characteristics: market players participating in industry
 Porter’s Five Forces: most common tool for industry structure
o Industry rivalry - nature and intensity of rivalry between market players
 Less intense = lower number of market players (higher concentration and profitability)
 Considers market players, degree of differentiation, switching costs, information, and
government restraint
o New entrants - barriers to entry by new market players
 High entry costs = fewer new entrants = lesser competition and improved profitability potential
  Include entry costs, speed of adjustment, economies of scale, reputation, switching costs, sunk
costs, and government restraints
o Substitutes and complements - relationships between interrelated products and services
 Substitute products: can replace the sale of an existing product
 Complementary products: can be used together with another product
 Considers prices of substitutes, complements, and government limitations
o Supplier power - how suppliers can negotiate better terms in their favor
 Strong supplier power: exists if there are few suppliers that can supply an input (= lower
industry profits)
 Considers supplier concentration, prices of alternative inputs, relationship-specific investments,
supplier switching costs, and governmental regulations
o Buyer power - how customers can negotiate better terms in their favor for their purchase
 Low buying power: customers are fragmented and concentration is low (market players are not
dependent to few customers to survive), improve industry profits (buyers cannot negotiate to
lower price)
 Considers buyer concentrations, value of substitute products that buyers can purchase,
customer switching costs, and government restraints
 Competitive position: how products, services, and the company is set apart from other competing market
players
 GENERIC CORPORATE STRATEGIES TO ACHIEVE COMPETITIVE ADVANTAGE
o Cost leadership - incurrence of lowest cost with quality comparable to competitors
o Differentiation - offer unique product or service for additional premium
o Focus - identify demographic segment or category segment by using cost leadership strategy or
differentiation strategy
 Business model: method how the company makes money (what and how)
 Historical financial statements analysis: can be done for the last 2 years up to 10 years prior
 Historical financial reports: use horizontal, vertical, and ratio analysis
 Quality of earning analysis
o Detailed review of financial statements and accompanying notes to assess sustainability of company
performance and validate accuracy of financial information vs economic reality
o Nonrecurring transactions need to be adjusted
o Compares net income against operating cash flow (ensure reported earnings are realizable to cash)
2. Forecasting financial performance
 Macro perspective viewing economic environment and industry where the firm operates
 Micro perspective focusing in firm’s financial and operating characteristics
 Forecasting: summarizes the future-looking view from assessment of industry and competitive landscape,
business strategy, and historical financials
 APPROACHES IN FORECASTING
o Top-down forecasting approach
 Starts from international or national macroeconomic projections to industry specific forecasts
 Select which are relevant to firm and apply it to firm and asset forecast
 Variables: GDP forecast, consumption forecast, inflation projections, foreign exchange currency
rates, industry sales, and market share
 Result: forecasted sales volume (+ company-set sales price = revenue forecast)
o Bottom-up forecasting approach
 Starts from lower levels and completed when it captures what will happen to company based on
inputs of its segments/units
 Results of forecasts should be compared with the dynamics of industry where the business operates and its
competitive position
 Typically done on annual basis, better done on quarterly basis (to account for seasonality: affects sales and
earnings of all industry)
3. Selecting the right valuation model
 Depend on the context of valuation and inherent characteristics of company being valued
4. Preparing valuation model based on forecasts
 Input and convert forecast to chosen valuation model
 ASPECTS TO CONSIDER
o Sensitivity analysis - multiple analyses are done to understand how changes in input will affect outcome
o Situational adjustments/scenario modelling - for firm-specific issues affecting firm value is adjusted
 Control premium - additional value in stock investment if acquiring it will give controlling power
to investor
 Lack of marketability discounts - stock cannot be easily sold as there is no ready market, drive
down share value
 Illiquidity discounts - price of shares has less depth or less liquid compared to other, investor will
sell large portion of stock that is significant compared to trading volume of stock, drive down
share value
5. Applying valuation conclusions and providing recommendation

KEY PRINCIPLES IN VALUATION

1. The value of a business is defined only at a specific point in time
 Business value change every day as transactions happen
 Valuation made a year ago may not hold true and not reflect the prevailing firm value today
2. Value varies based on the ability of business to generate future cash flows
 Future cash flows can be projected based on historical results considering future events that may improve or
reduce cash flows
 Cash flows: cash generated from operations and reductions related to capital investments, working capital, and
taxes
3. Market dictates the appropriate rate of return for investors
 Market forces: constantly changing, provide guidance of what rate of return should investors expect
 Capture the right discount rate to be used for valuation
4. Firm value can be impacted by underlying net tangible assets
 Valuation look at the relationship between operational value and net tangible assets
 Higher underlying net tangible asset value = more stable and higher going concern value
5. Value is influenced by transferability of future cash flows
 Value will only be limited to net tangible assets that can be transferred to buyer
6. Value is impacted by liquidity
 Dictated by theory of demand and supply
 Many potential buyers with less acquisition targets = higher firm value

Risks in valuation
 Uncertainty: possible range of values where the real firm value lies
 Include all potential risks
 Future estimates may be different from what will actually happen
 Ascertain assumptions based on current available facts (cannot 100% ascertain value to be perfectly estimated)
 Innovations and entry of new businesses

Asset
 Transactions that would yield future economic benefits as a result of past transaction
 Value it generates from now until future and all cash flows generated until disposal

Green field investments

 Investments started from scratch
 More challenging to determine (value based on pure estimates)

Brown field investments

 Opportunities that can be either partially or fully operational
 Already in the going concern state (GCBO)

Going concern business opportunities

 Businesses that has long-term to infinite operational period
 Advantage: reference for performance (historical performance or existing business with similar nature)

Asset-based valuation
 More commonly used since asset is the best representation of what the company currently has less the non-
equity claim against assets
 Enables analyst to validate firm value through value of its assets
 Focuses on current and historical value of assets and disregard the value it can generate in the future and may
not fully represent the true value of assets
 Used if the basis of value is concretely established and complete
 METHODS: book value method, replacement value method, reproduction value method, and liquidation value
method

Book value method

 Book value: value recorded in accounting records of a company
 Highly dependent on value of assets as declared in the audited financial statements (balance sheet)
 International Accounting Standard No. 1: requires that the statement of financial position to summarize the total
value of its assets, liabilities, and equity
o Current assets - realized within normal operating cycle, 12 months after they were reported, or held for
trading; unrestricted cash
o Non-current assets - benefits can be realized in more than 12 months
o Current liabilities - settled within normal operating cycle, due to be settled within 12 months, held for
trading, or company does not have ability to settle beyond 12 months
o Non-current liabilities - due to be settled longer than 12 months
 Net book value = (total assets - total liabilities) / number of outstanding shares
 Provides a more transparent view on firm value and is more verifiable (based on figures)

Replacement value method

  Replacement cost: cost of similar assets that have the nearest equivalent value as of valuation date (National
Association of Valuators and Analysts)
 FACTORS THAT CAN AFFECT REPLACEMENT VALUE
o Age of the asset
o Size of the asset
o Competitive advantage of the asset
 Replacement value per share = (net book value +- replacement adjustment) / outstanding shares

Reproduction value method

 Used when no external information is available
 Reproduction value: estimate of cost of reproducing, creating, developing, or manufacturing a similar asset
 Requires reproduction cost analysis, internally done by companies especially if assets are internally developed
 Useful when calculating 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 marketing information
 Challenge to validate reasonableness of value calculated

Liquidation value method

 Considers the salvage value as value of asset
 Reasonable value for company to be purchased is the amount which investors will realize in the end of its life
 Most conservative
 Limitation: future value is not fully incorporated in the calculated equity value