CHAPTER 1 FUNDAMENTAL PRINCIPLES OF VALUATION willing and able seller, acting at arm’s length in an open and

unrestricted market, not under compulsion and both have

Value reasonable knowledge of the relevant facts
- pertains to the worth of an object in another person’s point - Both parties should voluntarily agree with the price and not
of view. under threat of compulsion
- Value, in the point of view of corporate shareholders, - Often used in valuation exercises involving tax assessment
relates to the difference between cash inflows generated by
an investment and the cost associated with the capital ROLES OF VALUATION IN BUSINESS
invested which captures both time value of money and risk Portfolio Management
premium. - Depends on the investment objectives of the investors or
financial managers managing the investment portfolio
Valuation - Under this, the ff activities can be performed through the
- the estimation of an asset’s value based on variables use of valuation techniques: Stock Selection and Deducing
perceived to be related to future investment returns, on Market Expectation
comparisons with similar assets, or, when relevant, on
estimates of immediate liquidation proceeds ● Fundamental Analysts
- It includes the use of forecasts to come up with reasonable - interested in the understanding and measuring the
estimates of value of an entity’s asset or its equity. intrinsic value of a firm
- For them, the true value of a firm can be estimated
● The fundamental equation of value is grounded on the by looking at its financial characteristics, its growth
principle that Alfred Marshall popularized - a company prospects, cash flows and risk profile
creates value if and only if the return on capital invested - They lean towards long-term investment strategies
exceeds the cost of acquiring capital. which encapsulate the ff principles:
a. Relationship between value and
underlying factors can be reliably
Three major factors that can be linked to the value of a measured
business: b. Above relationship is stable over an
1. Current operations (how is the operating performance of extended period
the firm in recent year?) c. Any deviations from the above
2. Future prospects (what is the long-term, strategic direction relationship can be corrected within
of the company?) reasonable time.
3. Embedded risk (what are the business risks involved in - They can be either value or growth investors:
running the business?) ● Value Investors - interested in purchasing
shares that are existing and priced at less
Intrinsic Value than their true value
- Refers to the value of any asset based on the assumption ● Growth Investors - lean towards growth
that there is a hypothetical complete understanding of its assets(businesses that might not be
investment characteristics profitable now but has high expected
- It is the value that an investor considers, on the basis of the value in future) and purchasing these at a
evaluation of available facts, to be the ‘’true’ or ‘’real’’ value discount
that will become the market value when other investors
reach the same conclusion ● Activist Investors
- Estimate intrinsic value based on their view of the real - tend to look for companies with good growth
worth of the asset prospects that have poor management
- If the assumption is that the true value of asset is dictated - Usually do ‘’takeovers’’-they use their equity
by the market, intrinsic value equals is market price holdings to push old management out of the
company and change the way the company is run
Going Concern Value - For them, it not about the current value of the
- Going concern assumption believes that the entity will company but its potential value once it is run
continue its business activities into the foreseeable future. properly
- It is assumed that the entity will realized assets and pay
obligation in the normal course of business ● Chartists
- Relies on the concept that stock prices are
Liquidation Value significantly influenced by how investors think and
- It is the net amount that would be realized if the business is act
terminated and the assets are sold piecemeal - They rely on available trading KPIs such as price
- Firm value is computed based on the assumption that entity movement, trading volume, and short sales when
will be dissolved and its assets will be sold individually making their investment decisions

Fair Market Value ● Information Traders

- The price, expressed in terms of cash, at which property - Traders that react based on new information about
would change hand between willing and able buyer and firms that are revealed to the stock market
 - They are more adept in guessing or getting new - It includes performing industry and competitive
information about firms and they can make predict analysis and analysis of publicly available financial
how the market will react based in this information and corporate disclosures
- It is very important as these give analysts and
Sell-side Analysts - issue valuation judgment that are investors the idea about the ff factors:
contained in research reports that are disseminated widely a. Economic conditions
to current and potential clients b. Industry peculiarities
Buy-sed Analysts - look at specific investment options and c. Company strategy
make valuation analysis on theses and report to portfolio d. Company’s historical performance
manager or investment committee
Industry Structure - refers to the inherent technical and economic
Analysis of Business Transactions/Deals characteristics of an industry and the trends that may affect this
Business deals include the ff corporate events: structure
a. Acquisition ● PORTER’S FIVE FORCES is the most common tool used
- Usually has two parties: the buying firm and the to encapsulate industry structure
selling firm
- The buying firm, needs to determine the fair value a. Industry Rivalry
of the target company prior to offering a bid price - Refers to the nature and intensity of rivalry
- The selling firm, should have a sense of its firm between market players in the industry
value to gauge reasonableness of bid offers - Rivalry is less intense if lower in number of market
b. Merger - two companies had their assets combined to form players which means high potential for profitability
a wholly new entity b. New Entrants
c. Divestiture - sale of a major component or segment of a - Refers to the barriers to entry to industry by new
business to another company market players
d. Spin-off - separating a segment or component business - High entry costs, fewer new entrants, lesser
and transforming this into a separate legal entity competition which improves profitability potential
e. Leveraged Buyout - acquisition of another business by c. Substitutes and Complements
using significant debt which uses the acquired business as - Refers to the relationship between interrelated
a collateral products and services in the industry
- Substitute products, products that can be replace
Two important factors of valuation in deals: the sale of an existing product
1. Synergy - Potential increase in firm value that can be - Complementary products, products that can be
generated once two firms merge with each other used together with another product
2. Control - change in people managing the organization d. Supplier Power
brought by the acquisition - Refers to how suppliers can negotiate better terms
in their favor
Corporate Finance - Strong supplier power, make industry profit lower
Corporate Finance e. Buyer Power
- It involves managing the firm’s capital structure, including - Pertains to how customers can negotiate better
funding sources and strategies that the business should terms in their favor for products/services they
pursue to maximize firm value purchase
- Deals with prioritizing and distributing financial resources to - Buying power is low if customers are fragmented
activities that increasing firm value and concentration is low
- The ultimate goal of this is to maximize the firm value by - Low buyer power tends to improve industry profit
appropriate planning and implementation of resources,
while balancing profitability and risk appetite Competitive Position - refers to how the products, services and the
company itself is set apart from other competing market players
Legal and Tax Purposes
- Valuation is also important to businesses because of legal According to Michael Porter these are the generic corporate
and tax purposes strategies to achieve competitive advantage:
● Cost Leadership - refers to the incurrence of lowest cost
Other Purposes among market players with quality that is comparable to
- Issuance of fairness opinion for valuations provided by third competitors allow the firm to price products around the
party industry average
- Basis for assessment of potential lending activities by ● Differentiation - firms tend to offer unique product or service
financial institutions characteristics that customer are willing to pay for and
- Share-based payment/compensation 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
VALUATION PROCESS (differentiation focus)
1. Understanding of the Business
Business Model - pertains to the method how the company makes when the price of
money particular shares has
less depth or generally
Quality of Earnings Analysis - pertain to the detailed review of considered less liquid
financial statements and accompanying notes to assess compared to other
sustainability of company performance and validate accuracy of active publicly traded
financial information versus economic reality share

2. Forecasting Financial Performance 5. Applying Valuation Conclusions and Providing

- Forecasting financial performance can be looked Recommendation
at two lenses: - The analysts and investors use the result to
a. On a macro perspective viewing the provide recommendations or make decisions that
economic environment and industry suits their investment objective
where the firm operates in
b. On a micro perspective focusing in the Key Principles in Valuation
firm’s financial and operating 1. The value of a business is defined only at a specific point in
characteristics time
- These can be summarize in two approaches: 2. Value varies based on the ability of business to generate
a. Top-down Forecasting Approach - future cash flows
forecasts start from international or 3. Market dictates the appropriate rate of return for investors
national macroeconomic projections with 4. Firm value can be impacted by underlying net tangible
utmost consideration to industry specific assets
forecasts 5. Value is influenced by transferability of future cash flows
b. Bottom-up Forecasting Approach - 6. Value is impacted by liquidity
forecasts start from the lower levels of
the firm andis completed as it captures Risk in Valuation
what will happen to the company based Uncertainty- the possible range of values where real firm value lies
on the inputs of its segments/units
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 forecasts
should now be inputted and converted to the
chosen valuation model
● SENSITIVITY ANALYSIS - multiple
analyses are done to understand how
changes in an input or variable will affect
the outcome

● SITUATIONAL ADJUSTMENTS OR
SCENARIO MODELLING - for
firm-specific issues that affect firm value
that should be adjusted by analysts
- Factors that do not affect value
per se when analysts only look
at core business operations but
still influence value regardless:
● Control premium -
additional value
considered in a stock
investment if acquiring
it will give controlling
power to the investor
● Absence of
marketability discount -
the stock cannot easily
old as there is no ready
market for it
● Illiquidity discount –
should be considered