Overview of Valuation Concepts and Methods

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Module 1 –Overview of Valuation Concepts and Methods

What is Valuation?
Valuation refers to the process of determining the present value of a company or an asset.
It can be done using a number of techniques. Analysts that want to place value on a company
normally look at the management of the business, the prospective future earnings, the market
value of the company’s assets, and its capital structure composition.

Valuation may also be used in determining a security’s fair value, which depends on the
amount that a buyer is ready to pay a seller, with the assumption that both parties will enter the
transaction.

During the trade of a security on an exchange, sellers and buyers will dictate the market
value of a bond or stock. However, intrinsic value is a concept that refers to a security’s perceived
value on the basis of future earnings or other attributes of the entity that are not related to a
security’s market value. Therefore, the work of analysts when doing valuation is to know if an
asset or a company is undervalued or overvalued by the market.

Valuations can be performed on assets or on liabilities such as company bonds. They are
required for a number of reasons including merger and acquisition transactions, capital budgeting,
investment analysis, litigation, and financial reporting.

OVERVIEW …

There is no doubt that the “value” is the defining measurement of any market in the economy of
today. Value is all about how much something is worth, whether in an estimate or exact amount.
When somebody invest, they expect the “value” of their investment to increase by an amount that
is acceptable to them or sufficient enough to compensate the risk or sacrifice they took,
incorporating the time value of money. As we say, in everything we do, we need to sacrifice. That
sacrifice has value, giving away something that is valuable to him expecting another value, the
return or profits he is willing to accept given the value of his sacrifice.

Therefore, knowing how to measure value or how to create value is an essential tool for everybody
to be able to make a decision, wise decisions.
Basic Principles of Accounting

NOTE:
In performing valuations, one should be equipped with analytical skills. These skills should not
only be on intelligence and reasonable ideas, good recommendations and excellent analysis. It
should also be anchored with the principles that guide accountants to provide ethical practices for
decision making.
Just a quick recap ….

The accounting principles are concepts that serve as basis in preparing and interpreting the
financial statements. These are the basic foundations that guide prepares into presenting the
financial reports to the users and the users to be confident of what they read.

The Conceptual Framework of Accounting specifically mentions the underlying assumption of


going concern which contemplate the realization of assets and settlement of liabilities in the
normal course of business.

The basic concepts or principles of accounting are:

Going Concern Assumption


The going concern principle, also known as continuity assumption, means that a business entity
will continue to operate for at least another accounting period. This principle is the reason why
assets are generally presented in the balance sheet at cost rather that at fair market value and
long-term assets are included in the books until they are fully utilized and retired.

Accrual Basis of Accounting


The accrual basis of accounting means that the financial statements are prepared where income
and expenses must be recognized in the accounting periods to which these are incurred. This
means that revenue or income is recognized when earned regardless of when payment is
received and expenses are recognized when incurred regardless of when these are paid.

Examples:
a. XYZ Company rendered repair services to a client on October 10, 2019. The client
paid after 90 days which is January 9,2020. The income will be recognized when the
service has already been rendered. Hence, the income should be recognized in
October, 2019 even if it has not yet been collected as of that date.

b. Burgis Company received its electricity bill for the month of December, 2019 on
January 5, 2020 and paid it on January 31,2020. When should the electricity expense
be recorded? The electricity expense shall be recorded in December, 2019 even if the
bill has been paid and received in January, 2020 because electricity consumption
pertains to the month of December, 2019.

Accounting Entity Concept


The accounting entity concept recognizes a specific business enterprise as one accounting entity,
separate and distinct from the owners. In other words, a company has its own identity set apart
from its owners and can represent its own self.

For example, if JXY Company buys a vehicle to be used as delivery equipment, then it is
considered a transaction of the business entity and not by the owner even if the owner is the
signatory of the transaction. However, if Mr. Ben, owner of JXY Company, buys a car for personal
use using his own money, that transaction is not recorded in the company's accounting books
because it is not a transaction of the company. If the money used to buy the car is company’s
funds, then the payment will be treated as company advances to the owner which can be
deducted from owner’s future dividends or share in profits.
Time Period
The time period assumption, also known as periodicity assumption, means that the life of an
enterprise is subdivided into time periods (accounting periods), which are usually of equal length,
for the purpose of preparing the financial statements. An accounting period is usually a 12-month
period – either calendar or fiscal. A calendar year refers to a 12-month period ending December
31 and fiscal year is a 12-month period ending in any day of the year except December 31.

Monetary Unit Assumption


This means that transactions and events when recorded in the books of accounts should be
measured in monetary terms.

The monetary unit assumption has two characteristics – quantifiability and stability of the
currency. Quantifiability means that records should be stated usually in the currency of the country
where the financial statements are prepared and stability means that the purchasing power of the
said currency is stable or constant and that any insignificant effect of inflation is ignored.

There are other principles derived from the above concepts, like: matching principle, revenue or
expense recognition principle, historical cost principle, consistency, materiality, neutrality or
completeness. The financial statements should possess the above attributes or concepts so that
these can be reliable to decision makers.

• Foundations of value

There is no doubt that the “value” is the defining measurement of any market in
the economy of today. Value is all about how much something is worth, whether in an
estimate or exact amount. When somebody invest, they expect the “value” of their investment
to increase by an amount that is acceptable to them or sufficient enough to compensate the
risk or sacrifice they took, incorporating the time value of money. As we say, in everything
we do, we need to sacrifice. That sacrifice has value, giving away something that is valuable
to him expecting another value, the return or profits he is willing to accept given the value
of his sacrifice .
Therefore, knowing how to measure value or how to create value is an essential tool
for everybody to be able to make a decision, wise decisions.

• Definition of valuation

Valuation is the analytical (quantitative) process of determining the current or projected


worth (value) of an asset or something. There are several techniques or methods available
to be used in doing valuation. Each of these methods may give different results or value,
what matter is how this will be used in the decisions why such valuation activity is being
done.
Valuation determines the economic value of a business, asset or company.

• Frameworks for valuation

Conceptual frameworks of valuation is about the issue of what affects or what drives
the value to change. A company’s value is driven by its ability to earn a good or healthy
return on invested capital (ROIC) and by its ability to grow. Healthy rates of return and
growth result in high cash flows, the ultimate source of value. Discussions on this will be done
in detail in the topic, step by step process o f valuation.

• Concepts of valuation

Valuation is based on economic factors, industry variables, and on the analysis of


financial statements and the entire outlook of the firm. Valuation process will determine
the long-run fundamental economic value of its common stock or preferred stock. Different
concepts of valuation are based on the following:

1. Going concern value


2. Liquidation value
3. Market value
4. Book value
5. Intrinsic value

Details of the above concepts will be discussed in the respective topics.

When dealing with the valuation process, it is important to get as many facts as possible
with clear goals on what is the purpose of this valuation.

1. Why are you valuing?


2. What are you trying to accomplish with this valuation?

• Objectives/uses of valuation

Valuation is useful when we are trying to determine the fair value of an asset. Fair
value is the amount which is determined by what is the buyer willing to pay and the seller is
willing to sell under the conditions that both parties are willing o r voluntarily enter in the
exchange transaction.

• Importance/Rationale of valuation

Business valuation is an important exercise since it can help in improving the


company. Here are some of the reasons why is there a need to perform a b u s i n e s s
valuation.

Although the goal of valuation is to determine the fair market value, there is no one
way to be certain of the ultimate price paid. Typically, it depends on many factors including
industry, sector, valuation method and the economic conditions. You can also count on a
fact; you can have your business valued by two p ro f ess i ona ls and you will come up with two
different answers
Various reasons for performing a business valuation

• Litigation

In a court case, such as an injury case, divorce, or where there is an issue with the
value of the business, someone may need to provide proof of company’s worth that could be
the basis of claims for any damages, or be based on the actual worth of your businesses
and not inflated figures estimated by a lawyer.

• Exit strategy planning

In cases where there is a plan to sell a business, it is wise to come up with a base
value for the company and then come up with a strategy to enhance the company’s profitability
so as to increase its value as an exit strategy. Your business exit strategy needs to start
early enough before the exit, addressing b o t h involuntary and voluntary transfers.

A valuation with annual updates will keep the business ready for unexpected and
expected sale. It will also ensure that you have correct information on the company fair
market value and prevent capital loss due to lack of clarity or inaccuracies.

• Buying a business

Sellers and buyers of business usually have different opinions on the worth of the
business. However, the real business value is what the buyers are willing to pay. A sound
business valuation should consider market conditions, potential income, and other similar
concerns to ensure that the investment being done is viable. Business buyers must exercise
prudence by normally hiring a business broker who can help you with the process.

• Selling a business

As mentioned, sellers and buyers usually have different opinions on the worth of the
business. The sellers, however, would want to be certain that they are getting what it is
worth, thus they may have to perform their valuation p r o c e ss as well.

• Strategic planning

The true value of assets may not necessarily be reflected on the assets schedule,
and if there has been no adjustment of the balance sheet for various possible changes, it
may be risky. Having a current valuation of the business will give you good information that
will help you make better business decisions. As in the financial reporting standards, the use
of current value a c c o u n t i n g is more evident.

• Funding

Bankers, financing companies or any potential investors require an objective valuation


when someone is negotiating or applying for credits, loans or any funding requirements.
Professional documentation of your company’s worth is usually required since it enhances
your credibility to the lenders or p o t e n t i a l investors.
• Selling a share in a business

For business owners, proper business valuation enables you to know the worth of your
shares and be ready when you want to sell them. Just like during the sale of the business,
you ought to ensure you get good value from your share.

Business valuation is a critical financial analysis that needs to be done by a valuation


expert who has appropriate qualifications. Business owners are able to negotiate a tactical
sale of their entity, plan an exit strategy, acquire f i n a n c i n g , and reduce the financial risk
during litigation.

• Fundamental principles of valuation or value creation

Business valuation involves the determination of the fair economic value of a company
or business for various reasons as mentioned earlier.

Key Principles of Business Valuation

The following are the key principles of business valuation that business owners who
want to create value in their business must know.

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

The value of a business usually experiences change every single day. The earnings,
cash position, working capital, and market conditions of a b u s i n e s s are always changing.
The valuation made by business owners a month or years ago may not reflect the true current
value of the business. The value of a business requires consistent and regular monitoring.
This valuation principle helps business owners to understand the significance of the da te of
valuation in the process of business valuation.

• Value primarily varies in accordance with the capacity of a business to generate future
cash flow

A company’s valuation is essentially a function of its future cash flows except in in


unusual situations where net asset liquidation may lead to a higher value .

The consideration here is the term “future.” It implies that historical results of the
company’s earnings before the date of valuation are useful in predicting the future results of
the business under certain conditions. Another consideration is the term “cash flow.” It is
because cash flow, which takes into account capital investments, working capital changes, and
taxes, is the true determinant of business value. Business owners should aim at building a
comprehensive estimate of future cash flows for their companies. Even though making
estimates is a subjective undertaking, it is vital that the value of the business is validated.
Reliable historical information will help in supporting the a s s u m p t i o n s that the forecasts will
use.

• The market commands what the proper rate of return for investors

Market forces are usually in a state of flux, and they guide the rate of return that is
needed by potential buyers in a particular marketplace. Market forces include the type of
industry, financial costs, and the general economic conditions. Market rates of return offer
significant benchmark indicators at a specific point in time. They influence the rates of return
wanted by investors over the long term. Business owners need to be wary or concerned of
the market forces in order to know the right time to exit that will maximize value.

• The value of a business may be impacted by underlying net tangible assets

Business valuation measures of the relationship between t h e operational value of a


company and its net tangible value. Theoretically, accompany with a higher underlying net
tangible asset value has higher going concern value. It is because of the availability of more
security to finance the acquisition and lower risk of investment since there are more assets
to be liquidated in case of bankruptcy. Business owners need to build an asset base. For
industries that are not capital intensive, the owners need to find means to s upp o r t the
valuation of their goodwill.

• Value is influenced by transferability of future cash flows

How transferable the cash flows of the business are to a potential acquirer will impact
the value of the company. Valuable businesses usually operate without the control of the
owner. If the business owner exerts a huge control over the delivery of service, revenue
growth, maintenance of customer
relationships, etc., then the owner will secure the goodwill and not the business. Such a kind
of personal goodwill provides very little or no commercial v a l u e and is not transferable.

In such a case, the total value of the business to an acquirer may be limited to the
value of the company’s tangible assets in case the business owner does not want to stay.
Business owners need to build a strong management team so that the business is capable of
running efficiently even if they left the company for a long period of time. They can build a
stronger and better management team through enhanced corporate alignment, training, and
e v e n through hiring.

• Value is impacted by liquidity

This principal function based on the theory of demand and supply. If the marketplace
has many potential buyers, but there are a few quality acquisition targets, there will be a rise
in valuation multiples and vice versa. In both open market and notional valuation contexts, more
business interest liquidity translates into more business interest value. Business owners need
to get the best potential purchasers to the negotiating table to maximize price. It can be
achieved through a controlled auction process.
Although they are technical valuation concepts, the basics of the valuation principles
need to understood by business owners to help them increase the valuation of their
businesses.

REFERENCE:

(source: corporatefinanceinstitute.com)

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