Valuation Concepts and Methodologies 2021 PDF

ACCT 041 Reference: Valuation VALUATION Concepts and Methodologies 2021 edition Concepts and Lacsano Baron Cachero Methodologies Chapter 1 FUNDAMENTALS PRINCIPLES O...

ACCT 041 Reference: Valuation VALUATION Concepts and Methodologies 2021 edition Concepts and Lacsano Baron Cachero Methodologies Chapter 1 FUNDAMENTALS PRINCIPLES OF VALUATION Prepared by: MARIVEL B. NEGRANA 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, through the degree of effort needed may vary on a case to case basis. Methods to value for real estate can may be different on hoe 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 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 investment 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 company 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 and the key drivers that influence this value. Increase in the 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 asset or its equity. At varying levels, decisions done within a firm entails valuation implicitly. 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 operation – 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 continuous innovation of market players. New risks and competition also surface which makes determining uncertainties a critical ingredient to success. 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 the their view of the real worth of the asset.  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 the 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.  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 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 assumed 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 Analysis of Business Transactions/Deals Corporate Finance Legal and Tax Purposes Other Purposes The relevance of valuation in the 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 Analyst – These are persons who are interested in understanding and measuring the intrinsic value of a firm. Activist Investors – Activist investors tend to look for companies with good growth prospects that have poor management. Chartists – Chartists relies on the concept that stock prices are significantly influenced by how investors think and act. Information Traders – Traders that react based on new information about firms that are revealed to the stock market. Information traders correlate value and how information will affect its value. Portfolio Management 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 expectation – 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? 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. Analysis of Business Transactions/Deals Business deals include the following corporate events: 1. 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. Analysis of Business Transactions/Deals 2. Merger – General term which describes the transaction wherein two companies had their assets combined to form a wholly new entity. 3. Divestiture – Sale of a major component or segment of a business (e.g. brand or product line) to another company. 4. Spin-off – Separating a segment or component business and transforming this into a separate legal entity. 5. Leveraged buyout – Acquisition of another business by using significant debt which uses the acquired business as a collateral. Analysis of Business Transactions/Deals 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. Synergy can be attributable to more efficient operations, cost reductions, increased revenues, combined products/markets or cross-disciplinary talents of the combined organizations. Analysis of Business Transactions/Deals Control – change in people managing the organization brought about by the acquisition. Any impact to firm value resulting from the change in management and restructuring of the target company should be included in the valuation exercise. This is usually an important matter for hostile takeovers. Corporate Finance Corporate finance involves managing the firm’s capital structure, including funding sources and strategies that the business should pursue to maximize firm value. Corporate finance deals with prioritizing and distributing financial resources to activities that increases firm value. The ultimate goal of corporate finance maximize the firm value by appropriate planning and implementation of resources, while balancing profitability and risk appetite. Legal and Tax Purposes Valuation is important to businesses because of legal and tax purposes. For example, if a new partner will join a partnership or an old partner will retire, the whole partnership should be valued to identify how much should be the buy-in or sell-out. This is also the case for businesses that are dissolved or liquidated when owners decides so. Firms are also valued for estate tax purposes if the owner passes away.  Issuance of a fairness opinion for valuations provided by third party (e.g. investment bank) Other Basis for assessment of potential lending activities by Purposes financial institutions. Share-based payment/compensation Valuation Process Generally, the valuation process considers these five steps: Forecasting Selecting the Understanding of the business financial right valuation performance model Preparing valuation Applying valuation model based on conclusions and providing forecasts recommendation  Understanding of the Business Understanding the business includes performing industry and competitive analysis and analysis of publicly available financial information and corporate disclosures. Understanding the business is very important as these give analyst and investors the idea about the following factors: economic conditions, industry peculiarities, company strategy and company’s historical performance. The understanding phase enables analysts to come up with appropriate assumptions which reasonably capture the business realities affecting the firm and its value. Frameworks which capture industry and competitive analysis already exists and are very useful for analysts. These frameworks are more than a template that should be filled out: analysts should use these frameworks to organize their thoughts about the industry and the competitive environment and how these relates to the performance of the firm they are valuing. The industry and competitive analyses should emphasize which factors affecting business will be most challenging and how should these be factored in the valuation model. 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.  Industry New Entrants Rivalry PORTER’S Substitutes and Complements Supplier Power FIVE FORCES Buyer Power  Refers to the nature and intensity of rivalry between market players in the industry. Rivalry is less intense if there is lower number of market players or competitors (i.e. higher concentration) which Industry Rivalry means higher potential for industry profitability. This considers concentration of market players, degree of differentiation, switching costs, information and government restraint.  Refers to the barriers to entry to entry to industry by new market players. If there are relatively high entry cost, this means there are fewer new entrants, thus lesser competition which improves New Entrants profitability potential. New entrants include entry costs, speed of adjustment, economies of scale, reputation, switching costs, sunk costs and government restraints.  This refers to the relationships between interrelated products and services in the industry. Availability of substitute products or Substitutes complementary products affects industry profitability. This consider and prices of substitute Complements products/services, complement product/services and government limitations.  Supplier power refers to how suppliers can negotiate better terms in their favor. When there is strong supply power, this tends to make Supplier industry profits lower. Strong supply Power power exists if there are few suppliers that can supply a specific input.  Buyer power pertains to how customers can negotiate better terms in their favor for the products/services they purchase. Typically, buying power is low if customers are fragmented and Buyer Power concentration is low. This means that market players are not dependent to few customer to survive. Low buyer power tends to improve industry profits since buyers cannot significantly negotiate to lower price of the product. 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 Differentiation Focus ` Cost leadership Differentiation Focus  Forecasting financial performance Forecasting summarizes the future-looking view which results from the assessment of industry and competitive landscape, business strategies and historical financials. This can be summarized in two approaches: Top-down forecasting approach Bottom-up forecasting approach 1. Top-down forecasting approach Forecast starts from international or national macroeconomic projections with utmost consideration to industry specific forecasts. 2. Bottom-up forecasting approach Forecasts starts from the lower levels of the firm and is completed as it captures what will happen to the company based on the inputs of its segments/units. Selecting the right valuation model The appropriate valuation model will depend on the context of 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 the succeeding chapters. 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. Analysts should consider whether the resulting value from this process makes sense based on their knowledge about the business. To do this, two aspects should be considered: 1. Sensitivity analysis; 2. Situational adjustments or Scenario Modeling.  Sensitivity analysis Multiple analyses are done to understand how changes in an input or variable will affect the outcome. Situational adjustments or Scenario Modeling For firm-specific issues that affect firm value that should be adjusted by analysts. 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 objectives. Key principles in Valuation The value of a business is defined only at a specific point in time. Value 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. Risks in Valuation Uncertainty refers to the possible range of values where the real firm value lies. When performing any valuation method, analysts will never be sure if they have accounted and included all potential risks that may affect price of assets. Some valuation methods also use future estimates which bear the risk that what will actually happen may be significantly different from the estimate. Value consequently may be different based on new circumstances. Uncertainty is captured in valuation models through cost of capital or discount rate. END OF CHAPTER 1