Chapter 1: Fundamental Principles of Valuation PDF

**CHAPTER 1: FUNDAMENTAL 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 ca...

**CHAPTER 1: FUNDAMENTAL 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. **Example:** Methods to value real estate may be different on how to value the entire business **Business treat capital as a scarce resource** that they should compete to obtain and efficiently manage. Since capital is scarce, **capital provider requires users to ensure that they will able to maximize shareholders return** to justify providing capital to them. The fundamental point behind **success in investment** is **understanding what is the prevailing value** and the key **drivers that influence this value.** **Increase in value may imply that shareholder capital is maximize**, hence, **fulfilling the promise to capital providers.** 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 comparison with similar assets or when relevant, on estimates of immediate liquidation proceeds. Valuation includes the **use of forecast** to come up with a reasonable estimate of value of an entity's assets or equity. **Valuation may differ across different assets but all follow similar fundamental principles** that drive the core of these approaches. **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 the return on capital invested exceed the cost of acquiring capital.** **The value of a business can be basically linked in three major factors:** - **Current Operation** = operating performance of the firm in the recent year - **Future Prospects** = long term plan - **Embedded Risk** = business risk involved **Intrinsic Value** - Refers to the value of any **asset based on the assumption** that there is a hypothetical complete understanding of its investment characteristics. - Market value - Available facts/info - Value based on what business competitive position **Going Concern Value** - Firm value is determined under the going concern assumption that **entity will continue to do its business activities in the foreseeable future.** - Value of the business based on their capability to generate profit **Liquidation Value** - The **amount** that would **realized if the business is terminated** and the assets are sold piecemeal. - Computed based on the assumption that entity will be dissolved, and its asset will be sold individually. **Fair Market Value** - The price, expressed in terms of cash, at which property would change hand between a willing hypothetical willing and able buyer. - Both parties agreed **ANALYSIS OF BUSINESS TRANSACTIONS/ DEALS** Valuation plays a very big role when analyzing potential deals. It is used 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** determines the fair value of the target company prior to offering the bid price. - On the other hand, **selling firm** should have sense of its firm value to gauge reasonableness of bid offer. **Merger** - General term which describes the transaction where in **two companies had their assets combined to form a wholly new entity**. - A + B = C or A + B = A/B **Divestiture** - **Sale of a major component or segment of business** ( ex. Product line) to another company **Spin-off** - **Separating a segment** or component business and **transforming this into a separate entity** **Leverage buyout** - Acquisition of another business by using significant debt which uses the acquired business as collateral. - Ex. Company A wants to buy Company B but Company A doesn't have money. With that, Company A borrowed money to buy Company B. And, if Company A can't pay the loan Company B will serve as collateral. Valuation in deals analysis consider two important, unique factors; synergy and control **Synergy** - Potential increase in **firm value** that can be **generated once two firms merge** with each other. **Control** - Change in people managing the organization brought about by the acquisition. Any impact to firm value resulting from **change in management and restructuring of the target company should be included in the valuation.** **Valuation Process** Generally, the valuation process considers these five steps; 1. **UNDERSTANDING OF THE BUSINESS** - Understanding the business includes performing industry and competitive analysis of publicly available financial information and corporate disclosures. - Understanding present, past, future prospects of the business **Industry structure** - Refers to the inherent technical and economic **characteristic of an industry and the trends that may affect this structure.** **Porter's Five Forces** - Most common tool to encapsulate industry structure. 1. **Industry Rivalry** - Refers to the nature and intensity of rivalry between market players in the industry 2. **New Entrants** - Refers to the barrier to entry to industry by new market players. - High entry cost, low number of new entrants which improves profitability 3. **Substitutes and Complements** - This refers to the relationships between interrelated products and services in the industry. 4. **Supplier Power** - Refers to how suppliers can negotiate better terms in their favor. - Strong supplier power can reduce industry profit 5. **Buyer Power** - Pertains to how customer can negotiate better terms in their favor for products/services they purchase. **Competitive Position** - Refers to how the products, services and the company itself is set apart from other competing market players. **Cost Leadership** - It relates to the occurrence of the **lowest cost among market player with quality** that is comparable to competitors allow the firm to price products around the industry average. **Differentiation** - Firm tends to **offer differentiated or unique product or service** characteristic that customers are willing to pay for an additional premium. **Focus** - 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 statements, forecasting financial performance is the next step. This can be summarized in two approaches: **Top-down forecasting approach** - Forecast starts from international or national macroeconomic projections with utmost consideration to industry specific forecasts. **Bottom-up forecasting approach** - Forecast starts with lower level of the firm and is completed as it captures what will happen to the company based on inputs of its segment. 3. **SELECTING THE RIGHT VALUATION MODEL** - Appropriate valuation model will **depend on the context of the valuation** and the inherent **characteristics of the company being valued.** 4. **PREPARING VALUATION MODEL BASED ON FORECASTS** - Once the valuation model is decided, the forecast should now be inputted and converted to the chosen valuation model. **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). - Assessing **how changes in key variables or assumptions impact financial outcomes** **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. - Modifying plans or forecast based on changes in the business environment or unforeseen circumstances. 5. **APPLYING VALUATION CONCLUSIONS AND PROVIDING RECOMMENDATION** - Once the value is based on all assumptions considered, the analyst and investors use the results to provide recommendations are make decision 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, and working capital land market conditions. 2. **Value varies based on the ability of business to generate future cash flows** - 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.