Chapter 1 FUNDAMENTAL PRINCIPLES OF VALUATIONMuieakceh aa PEO ere FUNDAMENTALS PRINCIPLES OF VALUATION Assets, individually or collectively, has value, Generally, value per worth of an object in another person's point of view, Any kind of ag, valued, though the degree of effort needed may vary on a cas: Methods to value for real estate can may be different on how t business. tains to Set can hy e © to case base ‘0 value an ents Businesses treat capital as a scarce resource that they should c obtain and efficiently manage. Since capital is scarce, capital Provide require users to ensure that they will be able to maximize shareholder retune to justify providing capital to them. Otherwise, capital providers wil look ang bring money to other investment opportunities that are more attractive Hence, the most fundamental principle for all investments and business is to maximize shareholder value. Maximizing value for businesses consequent result in a domino impact to the economy. Growing companies provide long. term sustainability to the economy 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. compete to The fundamental point behind success in investments is understanding what is the prevailing value and the key drivers that influence this value. Increase in 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, 0 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. At varying levels, decisions done within a firm entails valuation implicitly. For exareis capital budgeting analysis usually considers how pursuing a specific La will affect entity value, Valuation techniques may differ across different as5*"" but all follow similar fundamental principles that drive the core of the approaches, Valuation places great emphasis on the professional judgment that ee associated in the exercise, As valuation mostly deals with projections uate future events, analysts should hone their ability to balance and @vf Gifferent assumptions used in each phase of the valuation exercis®, 2° 1 validity of available empirical evidence and come up with rational choice align with the ultimate objective of the valuation activitVALUATION CONCEPTS AND METHODOLOGIES 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 operations — 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 their view of the real worth of the asset. If theCORIEn eras jon is that the true value of asset is dictated by ti . ane quals its market price. ‘he tari then intrinsic value et Unfortunately, this is not always the case. The Grossman . paradox states that if the market prices, which can be obtai perfectly reflect the intrinsic value of an asset, then a rationa investor will not spend to gather data to validate the value of a stock It thisig the case, then investors will not analyze information about st 3 anymore. Consequently, how will the market price suggest the in price if this process does not happen? The rational efficient Markets formulation of Grossman and Stiglitz acknowledges that investors will not rationally spend to gather more information about an asset unless they expect that there is potential reward in exchange of the effort, Stigit ined freak. S rinsig As a result, market price often does not approximate an assets intrinsic value. Securities analysts often try to look for stocks which are mispriced in the market and base their buy or sell recommendations based on these analyses. Intrinsic value is highly relevant in valuing public shares. Most of the approaches that will be discussed in this book deal with finding out the intrinsic value of assets. Financial analysts should be able to come up with accurate forecasts and determine the right valuation model that will yield a good estimate of a firm's intrinsic value. The quality of the forecast, including the reasonableness of assumptions used, is very critical in coming up with the right valuation that influences the investment decision. Going Concern Value Firm value is determined under the going concern assumption. The going concern assumption believes that the entity will continue to 4° its business activities into the foreseeable future. It is assumed that the entity will realize assets and pay obligations in the normal cours? f business. Liquidation Value Th ' The nat amount that would be realized if the business is teninalet the ascumant® 212 Sold piecemeal. Firm value is computed based 4 : ‘umption that entity will be dissolved, and its assets will be 30 individually — jy is ‘ — her iauik alue Particularly roleceee gt liudation process. Liquidation VaWN ie t for companies who are experiencing 5° Ni aVALUATION CONCEPTS AND METHODOLOGIES financial distress. Normally, there is greater value generated when assets working together are combined with the application of human capital (unless the business is continuously unprofitable) which is the case for going-concern assumption. If liquidation occurs, value often declines because the assets no longer work together, and human intervention is absent. «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 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 assumes 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 The relevance of valuation in 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 analysts — These are persons who are interested in understanding and measuring the intrinsic value of a firm. Fundamentals refer to the characteristics of an entity related to its financial strength, profitability or risk appetite. For fundamental analysts, the true value of a firm can be estimated by looking at its financial characteristics, its growth prospects, cash flows and risk profile. Any noted variance between the stock’s market price versus its fundamental value indicates that it might be overvalued or undervalued. Typically, fundamental analysts lean towards long-term investment Strategies which encapsulate the following principles: Lea aE(SS ee a o Relationship between value and underlying factors can be reliably measured. o Above relationship is stable over an extended period o Any deviations from the above relationship can be corrected within a reasonable time Fundamental analysts can be either value or growth investors. Value investors tend to be mostly interested in purchasing shares that are existing and priced at less than their true value. On the other hand, growth investors lean towards growth assets (businesses that might not be profitable now but has high expected value in future years) and purchasing these at a discount. Security and investments analysts use valuation techniques to support the buy / sell recommendations that they provide to their clients. Analysts often infer market conditions implied by the market price by assessing this against his own expectations. This allows them to assess reasonableness and adjust future estimates. Market expectations regarding fundamentals of one firm can be used as benchmark for other companies which exhibit the same characteristics. 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 tun. In the minds of activist investors, it is not about the current value of the company but its potential value once it is run properly. Knowledge about valuation is critical for activist investors so they can reliably pinpoint which firms will create additional value if management is changed. To do this, activist investors should have a good understanding of the company’s business model and how implementing changes in investment, dividend and financing policies can affect its value. Chartists - Chartists relies on the concept that stock prices are significantly influenced by how investors think and act. Chartists rely on available trading KPIs such as price movements, trading volume, and short sales when making their investment decisions. They believe that these metrics imply investor psychology and will predict future movements in stock prices. Chartists assume that stock price changes and follow predictable patterns since investors make decisions based on their emotions than by rational analysis, Valuation does not play @ LAR Ee ER1 VALUATION CONCEPTS AND METHODOLOGI huge role in charting, but it is helpful when plotting support and resistance lines. + Information Traders — Traders that 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. Hence, information traders correlate value and how information will affect this value. Valuation is important to information traders since they buy or sell shares based on their assessment on how new information will affect stock price, 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 expectations — 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? Typically, investors do not have a lot of time in order to make investment decisions. Professionals to come up with information investments. to scour all available information Instead, they seek the help of that they can use to decide their Sell-side analysts that work in the brokerage department of investment firms issue valuation judgment that are contained in research reports that are disseminated widely to current and potential clients. Buy-side analysts, on the other hand, look at specific investment options and make valuation analysis on these and report to a portfolio manager or investment committee. Buy-side analysts tend to perform more in-depth analysis of a firm and engage in more rigorous stock selection methodologies In general, financial analysts assist clients to realize their investment goals by Providing them information that will help them make the right decision whether {o buy or sell. They also play a significant role in the financial markets by Providing the right information to investors which enable the latter to buy or Sell shares. As a result, market prices of shares usually better reflect its real value. Since analysts often take a holistic look on businesses, they somewhat S21Ve 2 monitoring role for the management to ensure that they make decision ‘hat are in line with the creating value for shareholders. RE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. Business deals include the following corporate events: * 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. * 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. Synergy can be attributable to more efficientMET Ne Kee) Nest PO cata se) neaciasd operations, cost reductions, increased revenues, combined products/markets or cross-disciplinary talents of the combined organization. + 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 is to maximize the firm value by appropriate planning and implementation of resources, while balancing profitability and risk appetite. Small private businesses that need additional money to expand use valuation concepts when approaching private equity investors and venture capital providers to show the promise of the business. The ownership stake that these capital providers will ask from the business in exchange of the money that they will put in will be based on the estimated value of the smalll private business. Larger companies who wish to obtain additional funds by offering their shares to the public also need valuation to estimate the price they are going to fetch in the stock market. Afterwards, decision regarding which projects to invest in, amount to be borrowed and dividend declarations to shareholders are influenced by company valuation. Corporate finance ensures that financial outcomes and corporate strategy drives maximization of firm value. Current business conditions push business leaders to focus on value enhancement by looking at the business holistically and focus on key levers affecting value in order to provide some level of return to shareholders. Firms that are focused on maximizing shareholder value uses valuation concepts to assess impact of various strategies to company value. Valuation methodologies also enable communication about significant corporate matters between management, shareholders, consultants and investment analysts.