iLINK College of Science and Technology

Valuation Methods and Concepts

Midsayap, Cotabato

Lesson 1

Overview of Valuation Techniques

Overview

The fundamental point behind success investments is understanding what is the prevailing
value and the key drivers that influence this value. In this lesson, the valuation, the types, and the
processes in valuation will be discussed.

Learning Objectives

After successful completion of this lesson, you should be able to:

1. Describe the use and importance of valuation

2. Illustrate Porter’s Five Forces
3. Enumerate the principles and processes in creating value

Valuation

It is the estimation of an asset’s value based on variables perceived to be related to future

investment returns, on comparison with similar assets, or when relevant, on estimates of
immediate liquidation proceeds (CFA Institute).

The term “value” can mean the following:

1. Intrinsic Value – is the present value of all expected future cash flows, discounted at
the appropriate discount rate. It is determined by means of an objective calculation or
complex financial model, rather than using the currently trading market price of that
asset.

2. Going Concern Value – the going concern assumption believes that the entity will
continue to do its business activities into the foreseeable future.

3. Liquidation Value – the net amount that would be realized if the business is
terminated and the assets are sold piecemeal. It is particularly relevant for companies
who are experiencing severe financial distress.

4. 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

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 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.

Objective/Purpose of the Valuation

Valuations are useful in making effective and informed business decisions. They also help
monitor the performance level of your investments, not just in revenue but also in value. Valuation
allows an investor to take a general look at businesses, to help make a more profitable investment
decision. As an investor, it’s essential to compare different stock or security values and weigh
your investment options before investing.

• Desire to sell the business due to retirement, divorce, or health or family reasons
• Need for debt or equity financing to underwrite expansion or address cash flow
issues
• Addition of new partners or LLC members
• Sale of a share of the business by a partner or member
• Calculation of value for tax purposes

The reason for performing the valuation will establish the scope of the valuation analysis—
is it for establishing real property value for real estate tax purposes, or is it for determining the
value of the business for sale purposes? The reason for the valuation will provide a necessary
data point for the best valuation analysis methods to use.

Roles of Valuation in Business

Valuation is useful in a wide range of tasks. The role it plays, however, is different in different
arenas. The following section lays out the relevance of valuation in portfolio management, in
acquisition analysis, in corporate finance, and for legal and tax purposes.

Valuation in Portfolio Management

The role that valuation plays in portfolio management is determined in large part by
the investment philosophy of the investor. Valuation plays a minimal role in portfolio
management for a passive investor, whereas it plays a larger role for an active investor.

Even among active investors, the nature and the role of valuation is different for
different types of active investment. Market timers use valuation much less than investors
who pick stocks, and the focus is on market valuation rather than on firm-specific valuation.
Among security selectors, valuation plays a central role in portfolio management for
fundamental analysts, and a peripheral role for technical analysts.

- Fundamental Analyst – these are persons who are interested in understanding

and measuring the intrinsic value of a firm. Fundamentals refer to the

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 characteristics of an entity related to its financial strength, profitability or risk
appetite.

- 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 being run.

- Chartists – they rely on the concept that stock prices are significantly influenced
by how investors think and act and on available trading KPIs such as price
movements, trading volume, short sales – when making their investment
decisions.

- Information Traders – they 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.

Valuation in Acquisition Analysis

Valuation should play a central part of acquisition analysis. The bidding firm or
individual has to decide on a fair value for the target firm before making a bid, and the target
firm has to determine a reasonable value for itself before deciding to accept or reject the
offer.

There are special factors to consider in takeover valuation. First, there is synergy, the
increase in value that many managers foresee as occurring after mergers because the
combined firm is able to accomplish things that the individual firms could not. The effects
of synergy on the combined value of the two firms (target plus bidding firm) have to be
considered before a decision is made on the bid. Second, the value of control, which
measures the effects on value of changing management and restructuring the target firm,
will have to be taken into account in deciding on a fair price. This is of particular concern in
hostile takeovers.

There is a significant problem with bias in takeover valuations. Target firms may be
over-optimistic in estimating value, especially when the takeover is hostile, and they are
trying to convince their stockholders that the offer price is too low. Similarly, if the bidding
firm has decided, for strategic reasons, to do an acquisition, there may be strong pressure
on the analyst to come up with an estimate of value that backs up the acquisition.

Valuation in Corporate Finance

There is a role for valuation at every stage of a firm’s life cycle. For small private
businesses thinking about expanding, valuation plays a key role when they approach

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 venture capital and private equity investors for more capital. The share of a firm that a
venture capitalist will demand in exchange for a capital infusion will depend upon the value
she estimates for the firm. As the companies get larger and decide to go public, valuations
determine the prices at which they are offered to the market in the public offering. Once
established, decisions on where to invest, how much to borrow and how much to return to
the owners will be all decisions that are affected by valuation. If the objective in corporate
finance is to maximize firm value, the relationship between financial decisions, corporate
strategy and firm value has to be delineated.

As a final note, value enhancement has become the mantra of management

consultants and CEOs who want to keep stockholders happy, and doing it right requires an
understanding of the levers of value. In fact, many consulting firms have come up with their
own measures of value (EVA and CFROI, for instance) that they contend facilitate value
enhancement.

Valuation for Legal and Tax Purposes

Mundane though it may seem, most valuations, especially of private companies, are
done for legal or tax reasons. A partnership has to be valued, whenever a new partner is
taken on or an old one retires, and businesses that are jointly owned have to be valued
when the owners decide to break up. Businesses have to be valued for estate tax purposes
when the owner dies, and for divorce proceedings when couples break up. While the
principles of valuation may not be different when valuing a business for legal proceedings,
the objective often becomes providing a valuation that the court will accept rather than the
right valuation.

Business Deals for Analysis

1. Acquisition – an acquisition usually has two parties: the buying firm that needs to
determine the fair value of the target company prior to offering a bid price and the
selling firm who gauge reasonableness of bid offers.

2. Merger – transaction of two companies’ combined to form a wholly new entity. ∙

3. Divestiture – sale of a major component or segment of a business to another

company.

4. Spin-off – separating a segment or component business and transforming this into a

separate legal entity whose ownership will be transferred to shareholders.

5. Leverage buyout – acquisition of another business by using significant debt which

uses the acquired business as collateral.

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Valuation Process

1. Understanding the business – it includes performing industry and competitive

analysis and analysis of publicly available financial information and corporate
disclosures. An investor should be able to encapsulate the industry structure. One of
the most common tools used in encapsulating industry is Porter’s Five Forces:

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 or differentiation strategy.

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2. Forecasting financial performance – can be looked at two perspectives: on a macro
perspective viewing the economic environment and industry where the firm operates
in and micro perspective focus in the firm’s financial and operating characteristics.

Two Approaches of Forecast Financial Performance

- Top down forecasting approach – international or national macroeconomic

projections with utmost consideration to industry specific forecasts.

- Bottom-up forecasting approach – forecast starts from the lower levels of the
firm and builds the forecast as it captures what will happen to the company.

3. Selecting the right valuation model – it depends on the context of the valuation and
the inherent characteristics of the company being valued.

One type of valuation classification

• Cost approach
• Market approach
• Discounted cash flow

Another type of valuation classification

Asset-based approach
Income approach

4. Preparing valuation model based on forecasts – there are two aspects to be

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 considered:

- Sensitivity analysis – common methodology in valuation exercises wherein

multiple other analyses are done to understand how changes in an input or
variable will affect the outcome.
- Situational adjustments – firm specific issues that affects firm value that
should be adjusted by analysts since these are events that are not quantified if
analysts only look at core business operations.

5. Applying valuation conclusions and providing recommendation

Key Principles in Valuation

The value of a business is defined only at a specific point in time.

Varies based on the ability of business to generate future cash flows.
Market dictates the appropriate rate of return for investors.
Firm value can be impacted by underlying net tangible assets.
Value is influenced by transferability of future cash flows.
Value is impacted by liquidity.