Valuation Concepts and Methodologies

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Fundamentals of Valuation

Module 002 Fundamentals of Valuation

At the end of this module, you are expected to:
1. Cognitive: Describe the nature of Financial Valuation
2. Cognitive: Identify significant concepts in Valuation
3. Affective: Develop critical thinking in identifying and explaining the roles
of valuation in business
4. Psychomotor: Assess the capability to discuss the valuation process

Fundamentals of Valuation

Every asset in a sole proprietorship, partnership or corporation can be valued. Its value
depends on numerous factors such as, but not limited to, nature of the specific asset, supply
and demand in the market, company’s financial earnings or performance and many more.
Valuation of an asset is important since it gives stakeholders a perspective on the value of a
business’ entirety.
Most businesses look at its capital as a resource which is scarce. Being a scarce resource,
investors or those who provide capital to a business are very cautious on which business
they will venture into. The capability of a business to maximize its return is one of the major
factors a capital provider will look into. The capability of a business to maximize its return
results in maximizing the shareholders’ value. That is why investors are very much
interested in businesses who can attain this objective. Interestingly, when investors are able
to put their capital in the right businesses it creates as well as huge economic implication, it
provides productivity gains, lowered unemployment rates, higher salaries and higher
economic outputs.
Valuation comes into play in knowing the prevailing value of one’s business in order that
investors or other stakeholders may have a better, sound, and informed financial decision.
The Chartered Financial Institute (CFA) Institute defines valuation as the estimation of an
asset’s value based on either variables perceived to be related to future investment returns
or comparisons with closely similar assets. Since valuation is but a mere estimation of an
asset’s value, it primarily deals with projections and estimates of future events which will
have an impact to the asset’s value.

Different Concepts of Value

Alfred Marshall, a notable figure in the field of economics, believed that a company
only creates value once the return on capital exceeds the costs of its acquisition.
Indirectly, Marshall implies that a business which is surviving on pure costs without
any return on its capital does not have a value. The value of a business has three major
factors:

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(1) Current Operations

Current operations of a business is an indicator of how good a company is performing.
An increasing performance in current operations as compared to its previous
performance is indicative of an increasing value of a business;

(2) Prospective Goal

The long run objectives of a company can also be used in estimating its value. For
example, plans for business expansion, additional capital investments, and reduction
of unnecessary expenses in the future are factors in arriving at the present value of a
business.

(3) Inherent risks

Building a business entail risks. This is what we called business risks which are already
embedded to a business. One concept in business risk is that it is directly proportional
with return in capital. Meaning, the higher the risk, the higher the return. Stated
inversely, the lower the risk, the lower the return. Mitigating these business risks
through proper internal controls and safeguards would add value to a business and
will help investors in trusting more their capital to the business.

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Different definitions of value depending on its objective

(1) Intrinsic value – is the value of an asset which is data and facts driven. It represents
the amount of an asset which is based on the idea that all relevant facts are
gathered to arrive to its value. Once a financial analyst, has gathered all relevant
facts, he will then evaluate the asset based on these presented data and he will
consider it as its “true” or “real value.

(2) Going Concern Value – Just like the concept of going concern in accounting. Going
concern value is the value of an asset under the assumption the business will not
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halt its operations in the future. It is the value of the business after considering
that assets will be realized and contractual obligations will be complied with in
good faith as they fall due.

(3) Liquidation Value – As compared with the going concern value, liquidation value
of a business is evaluated on the assumption that the business will no longer
continue. In this assumption, financial analysts, computes the value of business by
assuming that assets will be sold individually during its liquidation process. Most
companies which use this value are those companies which have seen unfavorable
figures and are in distress.

(4) Fair Market Value – This is the value in the market where a willing buyer and a
willing seller commonly agrees to the value of an asset under the assumption that
they both know all the factors in considering the value of the subject asset.

Roles of Valuation in Business

We have already discussed why valuation is important in a Business and in the

economy. Now, we go to the specific roles of valuation in the business.

(1) Portfolio Management

Investopedia defines portfolio management as the building and overseeing a selection

of investments that will meet long-term financial goals and risk tolerance of a client, a
company, or an institution.
The job of portfolio management usually belongs to a fundamental analyst. As a
fundamental analyst, his or her main job is to check the fundamentals of various
companies. The fundamentals of a company may refer to its liquidity, profitability,
associated business risks and more. After a careful deliberation of the fundamentals,
the fundamental analyst will now decide the portfolio of a business. The portfolio may
or may not include different companies on which a person, company or institution will
invest depending on their risk appetite.
Portfolio management may also belong to activist investors. Activist investors are
those people who scout for companies which are, management wise, financially
distressed. These people see this as an opportunity for growth and investment. They
are of the belief that with proper management, growth, profitability, and sustainability
will necessarily follow. This is the reason that they invest or include these types of
company in their portfolio.
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Chartists or Technical investors are also helpful in portfolio management. Their

investment decisions rely on charts or historical prices or trade volumes. This concept
is very much common for those who are trading in the stock market using technical
indicators. Under this concept, it is believed that participants in the market tend to
behave the same way overtime. It provides investors basis on the next move of stock
prices based on a rational analysis of the historical price movements and volume over
time. Some of the popular technical indicators are the following:

(a) Moving Average Convergence Divergence (MACD);

(b) Relative Strength Index;
(c) Bollinger Bands;
(d) Simple Moving Averages
(e) Fibonacci Retracements
In summary, portfolio management, through the use of valuation techniques and
methodologies, simplify the selection of the right stock to invest in depending on one’s
risk appetite and deduce market expectations

(2) Analysis of Business Transactions and potential deals

Valuation is also important in potential business deals of a company or institution. It

can provide you insights on whether it is a good buy or not. In addition, it sets price
expectations which can be helpful in the negotiation process.
Some of the business deals where valuation could be helpful:

(a) Acquisition – it is the buying out of a company’s entire assets including the
assumption of its existing liabilities. In the point of view of the buyer, valuation
comes into play in determining and assessing the fair market value of a company it
intends to buy. On the side of the seller, valuating its own assets is also important
to assess whether the offer price is sufficient to sell its business.
(b) Merger – This deal happens when two companies decide to pool their assets and
assume their liabilities together while forming a new business entity.
(c) Divestiture – Pertains to the sale of a major component of a business such as its
subsidiary, product line, branch, etc.
(d) Spin-off – Pertains to the separation of segments within one entity to form an
entirely different business entity.
(e) Leveraged buyout - occurs when the buyer of a company takes on a significant
amount of debt as part of the purchase.

(3) Corporate Finance

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As defined by Investopedia, corporate finance deals with how companies address

funding sources, capital structuring, accounting, and investment decisions. It involves
maximizing the firm’s value in the most economical way alongside with the aim of
increasing the shareholders’ value. Valuation is used in arriving at the best corporate
strategy to maximize the firm’s value. This strategy may include, among others,
dropping of unprofitable segment, increasing productivity of profitable segments and
implementing other financial strategies whilst taking into account the risk appetite of
the business.

(4) Legal and Tax purposes

Valuation can also be helpful in statutory requirements especially in estimating future

legal disputes when a company is at risk to incur one. Likewise, valuation can be used
in tax avoidance too help the business in minimizing its tax liabilities.

Valuation Process

The following are the five steps in the valuation process:

(1) Understanding the Business

As discussed in the preceding sections, valuation will depend on different factors
which include, among others, the nature of the business, characteristic of the asset
being evaluated and the embedded business risks. Understanding the business is a
preliminary step in ascertaining which methodology is best in terms of valuation. It
gives the analyst the opportunity to prepare material facts, appropriate assumptions
and other factors that can best give the reasonable value of a business.

The Porter’s Five Forces model is a tool used by most analysts in understanding one’s
business:

(1) Competition in the Industry -this pertains to the rivalry among market players in
the industry. The intensity of rivalry is directly proportional to the number of
market players. Meaning, the higher the number of market players, the higher the
intensity of rivalry is. Stated inversely, the lower the number of market players, the
lower the intensity of rivalry.
(2) New Entrants in the industry – New entrants in the industry is a barrier to the
profitability of a company belonging to the same industry. However, this barrier is
reduced by entry costs entailed to new entrants and will lessen the competition in
the industry.

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(3) Power of Suppliers – Suppliers drive up input costs and lessens the potential of
profitability to companies. It includes, among others, prices of alternative inputs,
relationship-specific investments, supplier concentration, supplier switching costs
and more.
(4) Power of Customers – As compared to the preceding number, this refers to the
demand of your product or service in the market. The higher the demand for your
product or service, the more profitable your company or business become.
(5) Threat of substitutes and opportunity for complements – Substitutes are products
that can be used to replace an existing one. This can be considered as a threat since
it can drive the profitability down should the price of the substitute is more
attractive to the market. On the other hand, complements are products that can be
used together with another one. This can be considered as an opportunity in
increasing a company’s profitability since the sale on the complementary product
may be used to offset unnecessary or high costs of the main product.

(2) Forecasting Financial Performance

The second stage in the valuation process is forecasting financial performance. It is
the process of estimating, predicting or evaluating the value of the business in the
foreseeable future. The following are the two approaches normally used in forecasting
financial performance:

(1) Top-down approach – This approach starts on a macro level perspective. In

performing the forecasting of financial performance, analysts generally look first
in a pool of companies on a specific industry then breaks it down into a more
specific pool which comprises only of those relevant to the business. In this kind of
approach, analysts normally look into inflation projections, GDP performance,
foreign exchanges rates and more. As an end result, analysts will come up with a
sales or revenue forecast for the business.
(2) Bottom-up approach- The second approach is the bottom-up approach. In this
forecasting strategy, analysts normally look into different revenue producing
segments of the business and analyze which of the following will provide more or
less profitability for the business in the future.

(3) Selecting the appropriate valuation model

The next step in the valuation process is selecting the right valuation model for the
business. This step highly depends on the nature, characteristic, risks and other
relevant factors which may affect the value of one’s business.

(4) Preparation of Valuation Model

After deciding which valuation model is appropriate, analysts are now incorporate its
forecasts to the selected valuation model. Analysts consider sensitivity analysis and
situational adjustments or scenario modeling.
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Fundamentals of Valuation

Sensitivity analysis refers to the determination on how target variables will be affected
by the input variables. Simply stated, it is the processing of various assumptions by
considering different variables which may affect the forecasted data.
Situational adjustments or scenario modeling, on the other hand, pertains to the
process of predicting the value outcome of one variable after having experienced
changes in market conditions.

(5) Applying valuation conclusions and providing recommendations.

The last step in the valuation process is presenting to management the computed
value, after considering different scenarios or assumptions, to top management. This
will help them to have an informed decision which will cater to the company’s success.

Guide Questions:
Answer the following to check what you learned from the discussions so far. Check your
answers from the provided answer key at the end of this module. There is no need to
submit your answers to OEd.
1. What is the valuation process?
2. What are the two approaches in financial forecasting?

Answers to the Guide Questions

1. The Valuation process includes the following, understanding the business,

forecasting financial performance, selecting the appropriate valuation
model, preparation of valuation model, and applying valuation conclusions
and recommendations
2. The two approaches in financial forecasting are top-down and bottom-up
approach.

References and Supplementary Materials

Books and Journals

1. Lascano, Marvin V., Baron, Herbert C., Cachero, Andrew Timothy L. (2021). Valuation
Concepts and Methodologies
2. Brigham, Eugene F., Houston, Joel F., Jun-Ming, Hsu, Kee, Kong Yoon, Bany-Ariffin A.N
(2019). Essentials of Financial Management
3. Brigham, Eugene F., Houston, Joel F. (2019). Essentials of Financial Management
Online Supplementary Reading Materials

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Fundamentals of Valuation

1. Valuation Methods;
https://corporatefinanceinstitute.com/resources/knowledge/valuation/valuation-
methods/; Accessed 1 May 2022.
2. Valuation Concepts – 5 Most Important Valuation Concepts;
https://www.bbalectures.com/valuation-concepts/; Accessed 1 May 2022.
3. Accounting and Business Valuation Methods;
https://www.elsevier.com/books/accounting-and-business-valuation-
methods/howard/978-0-7506-8468-2; Accessed 1 May 2022.
4. Edey. (2014). Business Valuation, Goodwill and the Super-Profit Method*. In H. C.
Edey, Routledge Library Editions: Accounting Vol. 27. Accounting Queries (pp. 97-
113).
Routledge. https://link.gale.com/apps/doc/CX3614800017/GVRL?u=phama&sid=
bookmark-GVRL&xid=33210a32. Accessed 1 May 2022.
5. "Porter's Five-Forces Model." Encyclopedia of Management, 8th ed., vol. 2, Gale,
2019, pp. 876-880. Gale
eBooks, link.gale.com/apps/doc/CX7617900250/GVRL?u=phama&sid=bookmark-
GVRL&xid=761e58f0. Accessed 1 May 2022.
6. "Portfolio Management and Optimization." Gale Business Insights Handbook of
Innovation Management, edited by Miranda Herbert Ferrara, Gale, 2013, pp. 93-
101. Gale Business Insights. Gale
eBooks, link.gale.com/apps/doc/CX2759500017/GVRL?u=phama&sid=bookmark-
GVRL&xid=eab55455. Accessed 1 May 2022.
Online Instructional Videos

1. Valuation Methods; https://www.youtube.com/watch?v=cVWpVKvX0BQ; May 1,

2022
2. Session 1: Introduction to Valuation;
https://www.youtube.com/watch?v=znmQ7oMiQrM; May 1, 2022
3. Top 5 Portfolio Management Techniques;
https://www.youtube.com/watch?v=ornAXWzIgxE; May 1, 2022