FUNDAMENTALS PRINCIPLES OF VALUATION

Assets, individually or collectively, has value. Generally, value pertains to the

worth of an object in another person's point of view. 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 they 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, the 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, fulfilling
the promise to capital providers. This is where valuation steps in.

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 follow similar fundamental principles that
drive 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 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 Value

In the corporate setting, the fundamental equation of value is grounded on

the principle that Alfred Marshall popularized - a company creates value if
and only if the return on capital invested exceed the cost of acquiring capital.
Value in the point of view of 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.

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?

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 difficult as
compared to the past. Projecting future macroeconomic indicators also is
harder because of constant changes in the economic environment and the
continuoue innovation of market players. New risks and competition also
rurface which makes determining uncertainties a critical ingredient to
ruccess.

The definition of value may also vary depending on the context and objective
of the valuation exercise.

 Intrinsic value

Intrinsic value refers to the value of any asset based on the assumption
that there is a hypothetical 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 obtaining complete information about the asset is
impractical, investors normally estimate intrinsic value based on their
view of the real worth of the asset. If 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 always 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 investors will not 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 look for stocks which are mispriced in the market and
base their buy or sell recommendations based on these analyses. Intrinsic
value is highly relevant in valuing public shares. Most of the approaches
that will be discussed in this book deal 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.

 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 generated when assets working
together are combined with the application of human capital (unless the
business is continuously unprofitable) which is the case for going-concern
assumption. If liquidation occurs, value often declines because the assets
no longer work together, and human intervention is absent.

 Fair Market Value

The price, expressed in terms of cash, 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
inancial characteristics, its growth prospects, cash flows and risk
profile. Any noted variance between the stock's market price versus is
fundamental value indicates that it might be overvalued or
undervalued.
Typically, fundamental analysts lean towards long-term investment
strategies which encapsulate the following principles:
  Relationship between value and underlying factors can be
reliably measured.
 Above relationship is stable over an extended period
 Any deviations from the above relationship can be corrected
within a reasonable time

Fundamental analysts can be either value or growth investors. Value

investors tend to be mostly interested in purchasing shares that are
existing and priced at less than their true value. On the other hand,
growth investors lean towards growth assets (businesses that might
not be profitable now but has high expected value in future years) 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 price by
assessing this against his own expectations. This allows them to assess
reasonableness and adjust future estimates. Market expectations
regarding fundamentals of one firm can be used as benchmark for
other companies which exhibit the same characteristics.

 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
run. In the minds of activist investors, it is not about the current value
of the company but its potential value once it is 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, activist investors should have a good
understanding of the company's business model and how
implementing changes in investment, dividend and financing policies
can affect its value.
 Chartists - Chartists 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,
and 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 role in charting, but it is helpful when plotting support and
resistance lines.
 Information Traders - Traders that 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. Hence, information traders correlate
value and how information will affect this value. Valuation is important
to information traders since they buy or sell shares based on their
assessment on how new information will affect stock price.

Under portfolio management, the following 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?

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 their
investments.

Sell-side analysts that work in the brokerage department of investment firms

valuation judgment that are contained in research reports that are
disseminated widely to current and potential clients. Buy-side analysts, on
the other hand, look at specific investment options and make valuation
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 s 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 or sell
shares. As a result, market prices of shares usually better reflect its real
value. Since analysts often take a holistic look on businesses, they somewhat
serve a monitoring role for the management to ensure that they make
decision that are in line with the creating value for shareholders. Analysis of
Business Transactions / Deals Valuation plays a very big role when analyzing
potential deals. Potential acquirers use relevant valuation techniques
(whichever is applicable) to 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 to gauge reasonableness of bid offers. Selling
firms 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 may exist 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 wherein two

companies had their assets combined to form a wholly new entity.

• 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.

• Leveraged buyout - Acquisition of another business by using

significant debt which uses the acquired business as a collateral.