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.
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. 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.

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.

Valuation places great emphasis on the professional judgment that are associated in
the exercise as valuation mostly deals with projections about future events.

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:

1. Current operations
2. Future prospects
3. Embedded risk

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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.
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.
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.
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.

Analysis of Business Transactions / Deals

Valuation plays a very big role when analyzing potential deals.

Business deals include the following corporate events:

● Acquisition - An acquisition usually has two parties: the buying firm and the
selling firm.
● 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.

Valuation in deals analysis 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 separate firms.

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 ● Control - change in people managing the organization brought about by the
acquisition.

Valuation Process
Generally, the valuation process considers these five steps:
1. Understanding of the business
Understanding the business includes performing industry and competitive analysis and
analysis of publicly available financial information and corporate disclosures.
Industry structure refers to the inherent technical and economic characteristics of an
industry and the trends that may affect this structure. Industry characteristics means
that these are true to most, if not all, market players participating in that industry.
Porter's Five Forces is the most common tool used to encapsulate industry structure.
PORTER’S FIVE FORCES
Industry rivalry Refers to the nature and intensity of rivalry between
market players in the industry.
New Entrants Refers to the barriers to entry to industry by new market
players.
Substitutes and This refers to the relationships between interrelated
Complements products and services in the industry.
Supplier Power Supplier power refers to how suppliers can negotiate
better terms in their favor.
Buyer Power Buyer power pertains to how customers can negotiate
better terms in their favor for the products/services they
purchase.

Competitive position refers to how the products, services and the company itself is set
apart from other competing market players.
According to Michael Porter, there are generic corporate strategies to achieve
competitive advantage:

● Cost leadership
It relates to the incurrence of the lowest cost among market players with quality
that is comparable to competitors allow the firm to price products around the
industry average.
● Differentiation
Firms tend to offer differentiated or unique product or service characteristics that
customers are willing to pay for an additional premium.
● Focus

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 Firms are identifying specific demographic segment or category segment to focus
on by using cost leadership strategy (cost focus) or differentiation strategy
(differentiation focus).

2. Forecasting financial performance

After understanding how the business operates and analyzing historical financial
statements, forecasting financial performance is the next step.
This can be summarized in two approaches:

● Top-down forecasting approach

● Bottom-up forecasting approach

3. Selecting the right valuation model

The appropriate valuation model will depend on the context of the valuation and the
inherent characteristics of the company being valued. Details of these valuation models
and the circumstances when they should be used will be discussed in succeeding
chapters.
4. Preparing valuation model based on forecasts
Once the valuation model is decided, the forecasts should now be inputted and
converted to the chosen valuation model. To do this, two aspects should be considered:

● Sensitivity analysis
It is a common methodology in valuation exercises wherein multiple analyses are
done to understand how changes in an input or variable will affect the outcome
(i.e. firm value).
● Situational adjustments or Scenario Modelling
For firm-specific issues that affect firm value that should be adjusted by analysts.
In some instances, there are factors that do not affect value per se when analysts
only look at core business operations but will still influence value regardless.
5. 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

1. The Value of a Business is Defined Only at a specific point in time
Business value tend to change every day as transactions happen. Different
circumstances that occur on a daily basis affect earnings, cash position, working capital
and market conditions.
2. Value varies based on the ability of business to generate future cash flows

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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.
3. Market dictates the appropriate rate of return for investors
Market forces are constantly changing, and they normally provide guidance of what rate
of return should investors expect from different investment vehicles in the market
4. 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 are more stable and results in higher going concern value.
5. 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.
6. Value is impacted by liquidity
This principle is mainly dictated by the theory of demand and supply.

Risks in Valuation
In all valuation exercises, uncertainty will be consistently present. Uncertainty refers to
the possible range of values where the real firm value lies.

Innovations and entry of new businesses may also bring uncertainty to established and
traditional companies. It does not mean that a business that has operated for 100 years
will continue to have stable value..