Valuation Concepts and Methods

Introduction to Valuation

MODULE 1
Introduction to Valuation

Reference: Investment Valuation (Second Edition) by Aswath Damodaran

INTRODUCTION
Every asset, financial as well as real, has a value. The key to successfully investing in
and managing these assets lies in understanding not only what value is but also the sources of
the value. Any asset can be valued, but some assets are easier to value than others and the
details of valuation will vary from case to case. Thus, the valuation of a share of a real estate
property will require different information and follow a different format than the valuation of a
publicly traded stock. What is surprising, however, is not the differences in valuation techniques
across assets, but the degree of similarity in basic principles. There is undeniably uncertainty
associated with valuation. Often that uncertainty comes from the asset being valued, though the
valuation model may add to that uncertainty.

Learning Outcomes:
After completing this module, students should be able to:

1. Discuss the basic concepts of valuation

2. Identify the philosophical basis for valuation, as well as examine the myths that come
with it.
3. Discuss the role of valuation.

 Philosophical Basis for Valuation

 A postulate of sound investing is that, an investor does not pay more for an asset than its
worth.
Investors do not and should not buy most assets for aesthetic or emotional reasons;
financial assets are acquired for the cashflows expected on them. Consequently,
perceptions of value have to be backed up by reality, which implies that the price paid for
any asset should reflect the cashflows that it is expected to generate.

 Myths About Valuation

 Since valuation models are quantitative, valuation is objective.
The models that we use in valuation may be quantitative, but the inputs leave plenty of
room for subjective judgments. Thus, the final value that we obtain from these models is
colored by the bias that we bring into the process. In fact, in many valuations, the price
gets set first and the valuation follows.
There are two ways of reducing the bias in the process. The first is to avoid taking strong
public positions on the value of a firm before the valuation is complete. The second is to
minimize the stake we have in whether the firm is under or overvalued, prior to the
valuation.

 A well-researched and well-done valuation is timeless.

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The value obtained from any valuation model is affected by firm-specific as well as
market-wide information. As a consequence, the value will change as new information is
revealed. Given the constant flow of information into financial markets, a valuation done
on a firm ages quickly, and has to be updated to reflect current information. This
information may be specific to the firm, affect an entire sector or alter expectations for all
firms in the market. The most common example of firm-specific information is an
earnings report that contains news not only about a firm’s performance in the most
recent time period but, more importantly, about the business model that the firm has
adopted.

 A good valuation provides a precise estimate of value.

Even at the end of the most careful and detailed valuation, there will be uncertainty
about the final numbers, colored as they are by the assumptions that we make about the
future of the company and the economy. It is unrealistic to expect or demand absolute
certainty in valuation, since cash flows and discount rates are estimated with error.
The degree of precision in valuations is likely to vary widely across investments. The
valuation of a large and mature company, with a long financial history, will usually be
more precise than the valuation of a young company, in a sector that is in turmoil. If this
company happens to operate in an emerging market, with additional disagreement about
the future of the market thrown into the mix, the uncertainty is magnified. The problems
are not with the valuation models we use, though, but with the difficulties we run into in
making estimates for the future.

 The more quantitative a model is, the better the valuation.

As models become more complex, the number of inputs needed to value a firm
increases, bringing with it the potential for input errors. All too often the blame gets
attached to the model rather than the analyst when a valuation fails.

 To make money on valuation, you have to assume that markets are inefficient.
It is not clear how markets would become efficient in the first place, if investors did not
attempt to find under and overvalued stocks and trade on these valuations. In other
words, a pre-condition for market inefficiency seems to be the existence of millions of
investors who believe that markets are not. The view of markets leads us to the following
conclusions: 1. If something looks too good to be true – a stock looks obviously under or
overvalued – it is probably not true. 2. When the value from an analysis is significantly
different from the market price, we start from the presumption that the market is correct
and we have to convince ourselves that this is not the case before we conclude that
something is over or undervalued.

 The Role of Valuation

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 Valuation and Portfolio Management

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.

Fundamental analysts. The underlying theme is that the true value of the firm can be
related to its financial characteristics – growth prospects, risk profile and cash flows. Any
deviation from this true value is a sign that a stock is under or overvalued. It Is a long-
term investment strategy, and the underlying assumptions are:
a. The relationship between value and the underlying financial factors can be
measured.
b. The relationship is stable over time.
c. Deviations from the relationship are corrected in a reasonable time period.

Franchise buyer. The philosophy of a franchise buyer is best expressed by Warren

Buffett: “We try to stick to businesses we believe we understand. That means, they must
be relatively simple and stable in character. If a business is complex and subject to
constant change, we’re not smart enough to predict future cash flows.” As a long-term
strategy, the underlying assumptions are that:
a. Investors who understand a business well are in a better position to value it
correctly.
b. These undervalued businesses can be acquired without driving the price above
the true value.

Chartists. Chartists believe that prices are driven as much by investor psychology as by
any underlying financial variables. The information available from trading – price
movements, trading volume, short sales, etc. – gives an indication of investor
psychology and future price movements. The assumptions here are that prices move in
predictable patterns, that there are not enough marginal investors taking advantage of
these patterns to eliminate them, and that the average investor in the market is driven
more by emotion rather than by rational analysis.

Information traders. Information traders attempt to trade in advance of new information

or shortly after it is revealed to financial markets, buying on good news and selling on
bad. The underlying assumption is that these traders can anticipate information
announcements and gauge the market reaction to them better than the average investor
in the market.
For an information trader, the focus is on the relationship between information and
changes in value, rather than on value, per se. Thus, an information trader may buy an
‘overvalued’ firm if he believes that the next information announcement is going to cause
the price to go up, because it contains better than expected news.
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Market timers. Market timers note, with some legitimacy, that the payoff to calling turns
in markets is much greater than the returns from stock picking. They argue that it is
easier to predict market movements than to select stocks and that these predictions can
be based upon factors that are observable.
While valuation of individual stocks may not be of any use to a market timer, market
timing strategies can use valuation in at least two ways:
a. The overall market itself can be valued and compared to the current level.
b. A valuation model can be used to value all stocks, and the results from the cross-
section can be used to determine whether the market is over or undervalued.

Efficient marketers. Efficient marketers believe that the market price at any point in
time represents the best estimate of the true value of the firm, and that any attempt to
exploit perceived market efficiencies will cost more than it will make in excess profits.
They assume that markets aggregate information quickly and accurately, that marginal
investors promptly exploit any inefficiencies and that any inefficiencies in the market are
caused by friction, such as transaction costs, and cannot be arbitraged away.
For efficient marketers, valuation is a useful exercise to determine why a stock sells for
the price that it does. Since the underlying assumption is that the market price is the best
estimate of the true value of the company, the objective becomes determining what
assumptions about growth and risk are implied in this market price, rather than on finding
under or overvalued firms.

 Valuation in Acquisition Analysis

The following are the special factors to consider in takeover valuation:
a. The effects of synergy on the combined value of the two firms (target plus bidding
firm)
b. 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 (hostile takeovers)

 Valuation in Corporate Finance

If the objective in corporate finance is the maximization of firm value, the relationship
among financial decisions, corporate strategy and firm value has to be delineated. In
recent years, management consulting firms have started to offer advice on how to
increase value.
The value of the firm can be directly related to decisions that it makes – on which
projects it takes, on how it finances them and on its dividend policy. Understanding this
relationship is key to making value-increasing decisions and to sensible financial
restructuring.
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Introduction to Valuation

 Conclusion
Valuation plays a key role in many areas of finance – corporate finance, mergers and
acquisitions and portfolio management. Valuation is not an objective exercise; and any
preconceptions and biases that an analyst brings to the process will find its way into the
value.

Introduction to Valuation
• Every asset has value, regardless of type
• Any asset can be valued, but some assets are easier to value than others and the
details of valuation will vary from case to case.
• Not all are uniformly measured
• Uncertainty is always present

Philosophical Basis of Valuation

▸ A postulate of sound investing is that, an investor does not pay more for an asset than
its worth.
▸ The price paid for any asset should reflect the cashflows that it is expected to generate.

Myths About Valuation

Myth:
▸ Since valuations are quantitative, valuation is objective.
Truth:
▸ All valuations are biased. The only questions are how much and in which direction.
▸ The direction and magnitude of the bias in your valuation is directly proportional to who
pays you and how much you are paid.

Myth:
▸ A well-researched and well-done valuation is timeless.
Truth:
▸ A valuation done on a firm ages quickly, and has to be updated to reflect current
information.
Myth:
▸ A good valuation provides a precise estimate of value.
Truth:
▸ There are no precise valuations.
▸ The payoff to valuation is greatest when valuation is least precise.
Myth:
▸ The more quantitative a model is, the better the valuation.
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Introduction to Valuation

Truth:
▸ One’s understanding of a valuation model is inversely proportional to the number of
inputs required for the model.
▸ Simpler valuation models do much better than complex ones.
Myth:
▸ To make money on valuation, you have to assume that markets are inefficient.
Truth:
▸ We start from the presumption that the market is correct and we have to convince
ourselves that this is not the case before we conclude that something is over or
undervalued.

Role of Valuation
Valuation and Portfolio Management
▸ Passive investor (long-term profitability) – minimal role
▸ Active investor (short-term gains) – larger role

Fundamental analysts
• Underlying theme: true value of the firm can be related to its financial characteristics –
growth prospects, risk profile and cash flows
• long-term investment strategy
• Assumptions are:
■ The relationship between value and the underlying financial factors can
be measured.
■ The relationship is stable over time.
■ Deviations from the relationship are corrected in a reasonable time
period.
Franchise buyer
▸ “We try to stick to businesses we believe we understand. That means, they must be
relatively simple and stable in character.”
▸ long-term strategy
▸ underlying assumptions are:
▹ Investors who understand a business well are in a better position to value it
correctly.
▹ These undervalued businesses can be acquired without driving the price above
the true value.
Chartists
▸ prices are driven as much by investor psychology
▸ Assumptions here are:
▹ prices move in predictable patterns
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▹ there are not enough marginal investors taking advantage of these patterns to
eliminate them
▹ the average investor in the market is driven more by emotion rather than by
rational analysis.
Information traders
▸ Information traders attempt to trade in advance of new information or shortly after it is
revealed to financial markets, buying on good news and selling on bad
▸ Underlying assumption:
▹ traders can anticipate information announcements and gauge the market
reaction to them better than the average investor in the market.

Market timers
▸ Market timers argue that it is easier to predict market movements than to select stocks
and that these predictions can be based upon factors that are observable.
▸ Market timing strategies can use valuation in at least two ways:
▹ The overall market itself can be valued and compared to the current level.
▹ A valuation model can be used to value all stocks, and the results from the cross-
section can be used to determine whether the market is over or undervalued.
Efficient marketers
▸ Efficient marketers believe that the market price at any point in time represents the best
estimate of the true value of the firm, and that any attempt to exploit perceived market
efficiencies will cost more than it will make in excess profits.
▸ For efficient marketers, valuation is a useful exercise to determine why a stock sells for
the price that it does.

Role of Valuation

Valuation in Acquisition Analysis

The following are the special factors to consider in takeover valuation:
▸ The effects of synergy on the combined value of the two firms (target plus bidding firm)
▸ 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 (hostile takeovers)
Valuation in Corporate Finance
▸ If the objective in corporate finance is the maximization of firm value, the relationship
among financial decisions, corporate strategy and firm value has to be delineated. In
recent years, management consulting firms have started to offer advice on how to
increase value.
▸ The value of the firm can be directly related to decisions that it makes – on which
projects it takes, on how it finances them and on its dividend policy. Understanding this
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Introduction to Valuation

relationship is key to making value-increasing decisions and to sensible financial

restructuring.

▸ “It’s hard to beat a person who never gives up.” – Babe Ruth

MODULE 2
The Basics of Risk

Reference:
 Investment Valuation (Second Edition) by Aswath Damodaran
 investopedia.com

INTRODUCTION
Risk, for most of us, refers to the likelihood that in life’s games of chance, we will receive
an outcome that we will not like. For example, the risk of driving a car too fast is getting a
speeding ticket, or worse still, getting into an accident. Webster’s dictionary, in fact, defines risk
as “exposing to danger or hazard”. Thus, risk is perceived almost entirely in negative terms. In
finance, an investor’s personality, lifestyle, and age are some of the top factors to consider for
individual investment management and risk purposes. Each investor has a unique risk profile
that determines their willingness and ability to withstand risk. In general, as investment risks rise,
investors expect higher returns to compensate for taking those risks.

Learning Outcomes:
After completing this module, students should be able to:

4. Discuss risk and its relevance in valuation.

5. Identify the components of risk.
6. Explain the types of financial risk.

 What is risk?
Risk is defined in financial terms as the chance that an outcome or investment’s actual
gains will differ from an expected outcome or return. Risk includes the possibility of
losing some or all of an original investment.

Overall, it is possible and prudent to manage investing risks by understanding the basics
of risk and how it is measured. Learning the risks that can apply to different scenarios
and some of the ways to manage them holistically will help all types of investors and
business managers to avoid unnecessary and costly losses.

 Components of Risk

Firm-specific risk. When an investor buys stock or takes an equity position in a firm, he
or she is exposed to many risks. Some risk may affect only one or a few firms.

Project risk. This is the risk that a firm may have misjudged the demand for a product
from its customers.
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Competitive risk. This risk arises from competitors proving to be stronger or weaker than
anticipated.

Sector risk. This risk may affect an entire sector but is restricted to that sector.

Market risk. It is much more pervasive and affects many if not all investments. For
instance, when interest rates increase, all investments are negatively affected, albeit to
different degrees. Similarly, when the economy weakens, all firms feel the effects,
though cyclical firms (such as automobiles, steel and housing) may feel it more.

It is important to note that, what is common across the project, competitive and sector
risk, is that they affect only a small sub-set of firms.

 Types of Financial Risk

2 Broad Types:
 Systematic Risk/Market Risk
o Risk that can affect an entire economic market overall or a large
percentage of the total market.
o Risk of losing investments due to factors such as political risk and
macroeconomic risk
o Cannot be easily mitigated through portfolio diversification
o Examples include: interest rate risk, inflation risk, currency risk, liquidity
risk, country risk and sociopolitical risk

 Unsystematic Risk/Specific Risk/Idiosyncratic Risk

o Risk that only affects an industry or a particular company.
o Risk of losing an investment due to company or industry-specific hazard
o Examples include: change in management, product recall, regulatory
change that could drive down company sales, and a new competitor in
the marketplace with the potential to take away market share from a
company.
o Investors often use diversification to manage unsystematic risk by
investing in a variety of assets

Specific Types:
 Business Risk
o Basic viability of a business (the question of whether a company will be
able to make sufficient sales and generate sufficient revenues to cover its
operational expenses and make a profit
o is concerned with all the other expenses a business must cover to remain
operational and functioning.
o is influenced by factors such as the cost of goods, profit margins,
competition, and the overall level of demand for the products or services
that it sells

 Credit/Default Risk
o risk that a borrower will be unable to pay the contractual interest or
principal on its debt obligation
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Introduction to Valuation

o is particularly concerning to investors who hold bonds in their portfolios

o least amount of default risk and lowest returns: government bonds
o highest amount of default risk and highest interest rates: corporate bonds
o bonds with a lower chance of default: investment grade
o bonds with higher chances of default: high yield or junk bonds

 Country Risk
o risk that a country won't be able to honor its financial commitments
o When a country defaults on its obligations, it can harm the performance of
all other financial instruments in that country – as well as other countries it
has relations with
o applies to stocks, bonds, mutual funds, options, and futures that are
issued within a particular country
o most often seen in emerging markets or countries that have a severe
deficit

 Foreign Exchange Risk

o applies to all financial instruments that are in a currency other than your
domestic currency

 Interest Rate Risk

o risk that an investment's value will change due to a change in the absolute
level of interest rates, the spread between two rates, in the shape of the
yield curve, or in any other interest rate relationship
o affects the value of bonds more directly than stocks and is a significant
risk to all bondholders

 Political Risk
o risk an investment’s returns could suffer because of political instability or
changes in a country
o can stem from a change in government, legislative bodies, other foreign
policy makers, or military control

 Counterparty Risk
o likelihood or probability that one of those involved in a transaction might
default on its contractual obligation
o can exist in credit, investment, and trading transactions, especially for
those occurring in over-the-counter (OTC) markets

 Liquidity Risk
o associated with an investor’s ability to transact their investment for cash

Risk-Reward Tradeoff
 balance between the desire for the lowest possible risk and the highest possible returns
 In general, low levels of risk are associated with low potential returns and high levels of
risk are associated with high potential returns.
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 Each investor must decide how much risk they’re willing and able to accept for a desired
return.

It’s important to keep in mind that higher risk doesn’t automatically equate to higher returns. The
risk-return tradeoff only indicates that higher risk investments have the possibility of higher
returns—but there are no guarantees. On the lower-risk side of the spectrum is the risk-free rate
of return—the theoretical rate of return of an investment with zero risk. It represents the interest
you would expect from an absolutely risk-free investment over a specific period of time. In
theory, the risk-free rate of return is the minimum return you would expect for any investment
because you wouldn’t accept additional risk unless the potential rate of return is greater than the
risk-free rate.

Risk and Diversification

The most basic – and effective – strategy for minimizing risk is diversification. Diversification is
based heavily on the concepts of correlation and risk. A well-diversified portfolio will consist of
different types of securities from diverse industries that have varying degrees of risk and
correlation with each other’s returns.

While most investment professionals agree that diversification can’t guarantee against a loss, it
is the most important component to helping an investor reach long-range financial goals, while
minimizing risk.

There are several ways to plan for and ensure adequate diversification including:
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Introduction to Valuation

1. Spread your portfolio among many different investment vehicles – including cash,
stocks, bonds, mutual funds, ETFs and other funds. Look for assets whose returns
haven’t historically moved in the same direction and to the same degree. That way, if
part of your portfolio is declining, the rest may still be growing.

2. Stay diversified within each type of investment. Include securities that vary
by sector, industry, region, and market capitalization. It’s also a good idea to mix styles
too, such as growth, income, and value. The same goes for bonds: consider varying
maturities and credit qualities.

3. Include securities that vary in risk. You're not restricted to picking only blue-chip stocks.
In fact, the opposite is true. Picking different investments with different rates of return will
ensure that large gains offset losses in other areas.

Keep in mind that portfolio diversification is not a one-time task. Investors and businesses
perform regular “check-ups” or rebalancing to make sure their portfolios have a risk level that’s
consistent with their financial strategy and goals.

MODULE 3
Level 1 Investments

Reference:
 PSE
 Investopedia
 Bloomberg

INTRODUCTION
Investments, for them to be valued, has to be assessed as to what level they belong.
Different levels call for different valuation basis and method. For this lesson, we will focus on the
level 1 investments.

Learning Outcomes:
After completing this module, students should be able to:

7. Be familiar of the common financial terms used.

8. To know more about the level 1 investments and how they are valued.

COMMON FINANCIAL TERMS:

 Trade date
o The date that a contractual obligation to buy or sell the instrument is made

 Settlement date
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Introduction to Valuation

o The date that cash transfers to settle a buy or sell transaction

 Mark-to-Market
o An adjustment to the value of a financial instrument from the previous value to
the current value.

 Bid price
o The price which buyers are willing to pay for a particular financial instrument

 Ask price
o The price that sellers are willing to sell a particular financial instrument

 Mid price
o In between the bid and ask prices

 Last trade price

o The final price at which a security is traded on a given trading day
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 What Are Level 1 Assets?

Level 1 assets include listed stocks, bonds, funds, or any assets that have a
regular mark-to-market mechanism for setting a fair market value. These assets are
considered to have a readily observable, transparent prices, and therefore a reliable
fair market value.
 Level 1 assets are liquids financial assets and liabilities, such as stocks or
bonds, that experience regular market pricing.
 Level 1 assets are the top classification based on their transparency and
how reliably their fair market value can be calculated.
 Level 2 and 3 assets are less liquid and more difficult to quickly and
correctly ascertain their fair value.

 Understanding Level 1 Assets

Publicly traded companies must classify all of their assets based on the ease that
they can be valued, with Level 1 assets being the easiest. A big part of valuing
assets comes from market depth and liquidity. For developed markets, robust
market activity acts as a natural price discovery mechanism. This, in turn, is a core
element to market liquidity, which is a related gauge measuring a market’s ability to
purchase or sell an asset without causing a significant change in the asset’s price.

 Advantages of Level 1 Assets

Level 1 assets are one way to measure the strength and reliability of an entity’s
balance sheet. Because the valuation of Level 1 assets is dependable, certain
businesses can enjoy incremental benefits relative to another business with fewer
Level 1 assets. For example, banks, investors, and regulators look favorably on an
entity with a majority of assets that have a market-based valuation because they can
rely on supplied financial statements. If a business heavily uses derivatives and a
majority of its assets fall into the Level 2 or 3 category, then interested parties are
less comfortable with the valuation of these assets.

The issue with assets outside Level 1 is best displayed during times of distress.
Naturally, during a volatile market, liquidity and market depth erode and many
assets will not enjoy a reasonable price discovery mechanism. These assets then
need to be valued by appraisals or according to a model. Both of these are less than
perfect methods, so investors and creditors often lose confidence in reported
valuations. During periods of peak uncertainty, such as during the depths of
the Great Recession, Level 3 assets are especially scrutinized—with pundits
calling mark-to-model methods more like mark-to-myth.
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 Valuing Level 1 Assets

o For Philippine setup, the Philippine Stock Exchange (PSE) is one of the
primary sources of fair value.

We have to input the company name in the “Search Company or Symbol”

portion. Let’s take Jollibee as an example.

All the relevant stocks and warrants concerning Jollibee will appear, included
those which are delisted already.
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Introduction to Valuation

When we try to choose the one that is still listed, all the information relating to it
will appear. If we want to access the names of the current Board of Directors, we may access
the “Profile” tab. The historical data portion, on the other hand, shows all the previous prices.

o For the international setup, the Bloomberg is one of the primary sources of fair
value.
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Introduction to Valuation

In the “Quote Search” portion, we will just input the investment that we want to
value. For example, VanEck Vectors Semiconductor ETF (exchange-traded fund).

Just like in the PSE, you will also find the essential details of the fund when you search in the
Bloomberg website.
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 Conclusion
We can indeed utilize the internet to know the prices of investments and
funds and use the data obtained to either make investment-related decisions, or just to simply
know how the industry has been performing.