VALUATION METHODS AND METHODOLOGIES
Fundamental Principles of Valuation
Principles of Valuation
Concept of Value
● Value represents the worth of an asset from another person’s perspective.
● Value is subjective; what one investor values highly, another may not.
● Assets can be valued individually (like a car, building) or collectively (like a business or portfolio).
Role of Capital in Business
● Capital is Scarce: Businesses compete to obtain and allocate capital efficiently.
● Investors demand maximized returns to justify providing funds. If returns are insufficient, capital flows to other
opportunities.
● Maximizing shareholder value is the cornerstone of all business investments.
● Allocating scarce resources efficiently benefits all stakeholders in the economy.
● Economic Impact of Value Maximization:
1. Sustains long-term business growth.
2. Increases economic output.
3. Enhances productivity.
4. Promotes employment growth and higher wages.
Understanding Value in Investments
● Investment Success: Determined by understanding:
1. The current prevailing value of the asset.
2. The key drivers influencing its future value.
● An increase in asset value signals that shareholder capital is being maximized, fulfilling obligations to investors.
Definition of Valuation (CFA Institute)
● Valuation is the estimation of an asset's value based on variables related to future investment returns, comparisons with
similar assets, or, when relevant, immediate liquidation proceeds.
● Key Aspects:
1. Uses forecasts for estimating future asset or equity value.
2. Implicit in many corporate decisions
Role of Professional Judgment
● Required Skills for Analysts:
○ Balancing assumptions: Consider multiple scenarios and drivers.
○ Evaluating empirical evidence: Use historical and market data to justify assumptions.
○ Making rational choices: Align choices with the ultimate objective—accurate estimation of value.
Interpreting Different Concepts of Value
Alfred Marshall
● Core Principle: A company creates value if and only if the return on invested capital exceeds the cost of acquiring that
capital.
● Value is determined by the difference between cash inflows generated by an investment and the capital costs.
● Capital cost reflects:
○ Time value of money – the opportunity cost of investing capital now rather than elsewhere.
○ Risk premium – compensation for the uncertainty of returns.
Key Factors Determining Business Value
1. Current Operations
● How has the firm performed recently?
● Measures operating efficiency, profitability, and cash flows.
2. Future Prospects
● What is the company’s long-term strategy?
● Considers growth opportunities, market positioning, and expansion plans.
3. Embedded Risk
● What are the risks inherent in the business?
● Includes industry risks, competition, regulatory changes, and operational uncertainty.
Dynamic Business Environment
● Rapid technological change and globalization make valuation more complex:
1. Current operations are harder to assess accurately due to evolving technologies.
2. Future macroeconomic projections are less predictable because of constant market shifts.
3. Emerging risks and competition increase uncertainty, requiring careful consideration in valuation.
Different Concepts of Value
1. Intrinsic Value
● Intrinsic value is the value of an asset based on a hypothetical complete understanding of its investment
characteristics.
● Key Characteristics
a. Derived from evaluating: Cash flow, Growth potential, Risk level and Economic and industry conditions
b. Different investors may estimate different intrinsic values because of different assumptions.
c. Investors compare intrinsic value with market price:
Intrinsic value > Market price → Undervalued → Buy
Intrinsic value < Market price → Overvalued → Sell
● Intrinsic value is highly relevant in:
a. Stock valuation
b. Investment analysis
c. Equity research
d. Buy/sell recommendations
2. Going Concern Value
● Going concern value is the value of a firm assuming it will continue operating into the foreseeable future.
● It assumes the company will:
a. Continue business operations
b. Use its assets productively
c. Pay obligations normally
● Most business valuations use the going concern assumption because businesses are normally expected to continue
operating.
3. Liquidation Value
● Liquidation value is the net amount realized if the business is dissolved and its assets are sold individually.
● Key Characteristics
a. Assumes business will cease operations
b. Assets sold separately (piecemeal)
c. Human capital and operational synergy are lost
d. Usually lower than going concern value
4. Fair Market Value
● Fair market value is the price at which property would be exchanged between a willing buyer and willing seller,
acting freely and knowledgeably, without compulsion.
● Fair market value assumes:
a. Willing buyer
b. Willing seller
c. No compulsion
d. Arm’s length transaction
e. Both parties have reasonable knowledge
f. Open and unrestricted market
Roles of Valuation in Business
Portfolio management
● Process of selecting, managing, and monitoring a collection of investments to achieve the investor’s financial objectives
while balancing risk and return.
● Valuation plays a crucial role because it helps investors determine if assets are fairly priced, overpriced, or underpriced.
Role of Valuation Based on Investor Type
1. Passive Investors
● Passive investors invest without actively trying to outperform the market.
● Characteristics
○ Follow market indexes (e.g., index funds)
○ Do not actively analyze intrinsic value
○ Assume market prices reflect fair value
○ Limited reliance on valuation
2. Active Investors
● Active investors actively evaluate securities to outperform the market.
● Characteristics:
○ Use valuation techniques extensively
○ Identify undervalued and overvalued stock
○ Aim to earn abnormal returns
Types of Investors
1. Fundamental Analysts
● They estimate the intrinsic value of a firm by analyzing its financial and economic characteristics.
● Assumptions
○ Relationship between value and fundamentals can be measured reliably
○ This relationship remains stable over time
○ Market deviations correct themselves eventually
● Types of Fundamental Investors
○ Value Investors
➔ Investors who buy stocks selling below intrinsic value.
➔ Characteristics:
○ Seek undervalued stocks
○ Prefer stable companies
○ Long-term investment horizon
○ Growth Investors
➔ Investors who focus on companies with high future growth potential.
➔ Characteristics:
○ Invest in companies with strong expected growth
○ May accept lower current profitability
○ Focus on future earnings potential
2. Activist Investors
● Activist investors invest in companies to influence management decisions and improve company value.
● They target companies with:
○ Good growth potential
○ Poor management performance
● Activist investors may:
○ Acquire significant ownership
○ Replace management
○ Change business strategy
○ Improve operations
3. Chartists (Technical Analysts)
● Chartists analyze stock price movements and trading patterns to predict future prices.
● They rely on:
○ Price trends and Market patterns
○ Trading volume
○ Investor psychology
● Key Belief: Stock prices follow predictable patterns due to investor behavior.
4. Information Traders
● Information traders trade based on new information released to the market.
● Key Belief: New information affects stock value and price.
● They attempt to:
○ Predict how new information affects value
○ Buy or sell before the market fully adjusts
Role of Valuation in Portfolio Management Activities
1. Stock Selection
● Determining whether a stock is:
○ Fairly valued
○ Undervalued
○ Overvalued
● Based on:
○ Intrinsic value
○ Market price
○ Comparable assets
2. Deducing Market Expectations
● Determining what assumptions about future performance are reflected in current stock price.
Types of Financial Analysts
1. Sell-Side Analysts
● Analysts working for brokerage firms.
2. Buy-Side Analysts
● Analysts working for investment firms, mutual funds, or asset managers.
Importance of Valuation in Financial Markets
Valuation helps:
1. Investors make informed decisions
2. Analysts provide recommendations
3. Markets reflect fair value
4. Improve capital allocation efficiency
5. Monitor management performance
Analysis of Business Transactions/Deals
Importance of Valuation in Business Deals
● Valuation is essential in analyzing business transactions because it helps determine:
○ Fair value of target firms
○ Appropriate deal price
○ Potential benefits from acquisition (synergies)
○ Reasonableness of offers
○ Impact of management changes on firm value
Purpose of Valution For Each Party
1. Buying Firm
● Estimate intrinsic value of the target firm
● Determine maximum price willing to pay
● Identify potential synergies
● Avoid overpaying
2. Selling Firm
● Determine its fair value
● Evaluate bid offers
● Accept or reject acquisition proposals
● Negotiate better deal terms
Potential Bias in Valuation
● Optimistic projections by target company
● Pressure to justify acquisition decision
● Strategic motivations overriding objective analysis
Types of Business Transactions
1. Acquisition
● An acquisition occurs when one company purchases another company.
● Purpose:
○ Expand operations
○ Increase market share
○ Achieve synergies
○ Improve profitability
2. Merger
● A merger occurs when two companies combine to form a new entity.
● Key Characteristics
○ Both companies cease to exist separately
○ New company is created
○ Assets and operations are combined
3. Divestiture
● Divestiture is the sale of a business segment, division, or product line.
4. Spin-Off
● A spin-off occurs when a company separates a segment into a new independent company.
5. Leveraged Buyout (LBO)
● A leveraged buyout is the acquisition of a company using significant debt.
Critical Factors in Business Deals
1. Synergy
● Synergy is the additional value created when two firms combine.
● e.g. Two companies merging may reduce administrative costs.
2. Control
● Control refers to the value created from changing management or restructuring operations.
● Hostile takeovers occur when acquisition happens without management approval.
● Control becomes valuable because new management may improve performance.
Corporate Finance
Definition
● Corporate finance is the area of finance concerned with managing a firm’s capital structure, funding sources, and
investment decisions to maximize firm value.
● The primary objective of corporate finance is: Maximization of firm value (shareholder value)
Application of Valuation in Businesses
● Small Businesses
○ Use of Valuation: Seeking of Funds
○ Helps determine:
a. How much the business is worth
b. Ownership percentage given to investors
● Large Companies
○ Use of Valuation: Issuing shares
○ Helps determine:
a. Stock offering price
b. Market value of company
Value Maximization
● Companies focus on key value drivers such as:
○ Revenue growth
○ Cost efficiency
○ Risk management
○ Capital efficiency
Importance of Valuation
● Valuation helps management:
○ Evaluate business performance
○ Assess impact of strategic decisions
○ Identify value-creating opportunities
○ Communicate value to stakeholders
Legal Taxes
Legal and Tax Situations Requiring Valuations:
1. Admission of a New Partner
2. Retirement or Withdrawal of a Partner
3. Dissolution and Liquidation of Business
4. Valuation: Estate tax, Donor’s tax, Capital gains tax, Property Tax
Other Purposes
● Issuance of a fairness opinion for valuations provided by third party
● Basis for assessment of potential lending activities by financial institutions
● Share-based payments/compensation
Valuation Process
1.Understanding of the business
Porter’s Five Forces
a. Industry Rivalry
b. New Entrants
c. Substitutes and Compliments
d. Supplier Power
e. Buyer Power
Strategies to Achieve Competitive Advantage
a. Cost Leadership
b. Differentiation
c. Focus
Analyzing Financial Information
● Revenues and Gain
● Expenses and losses
● Balance sheet items
● Operating cash flows
2.Forecasting financial performance
Forecasting Financial Performance
● Top-down forecasting approach
● Bottom-up forecasting approach
3.Selecting the right valuation model
● The appropriate valuation method will depend on the context of the valuation and the inherent characteristics
of the company being valued
4.Preparing valuation model based on forecast
Once the valuation model is decided, the forecasts should now be inputted and converted to the chosen valuation
model
● Sensitivity analysis
● Situational adjustments or Scenario modelling
5.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 suit their investment objectives
Key Principles in Valuation
1. The value of a business is defined only at a specific point in time
2. Value varies based on the ability of business to generate future cash flows
3. Market dictates the appropriate rate of return for investors
4. Firm value can be impacted by underlying net tangible assets
5. Value is influenced by transferability of future cash flows
6. Value is impacted by liquidity
Risks in Valuation
● Analysts will never be sure if they have accounted and included all potential risks that may affect price of asst
● Analysts use their judgments to ascertain assumptions based on current available facts
● Depending on the industry, they can be very sensitive to changes in macro-economic climate
● Innovations and entry of new businesses may also bring uncertainty to established and traditional companies
Asset-Based Valuation
Book Value Method
● Value recorded in the accounting records of a company
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡 − 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝑁𝑒𝑡 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐴𝑠𝑠𝑒𝑡 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑆ℎ𝑎𝑟𝑒𝑠
Replacement Value Method
● Value of the individual assets shall be adjusted to reflect the relative value or cost equivalent to replace that asset
𝑁𝑒𝑡 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 ± 𝑅𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡 𝐴𝑑𝑗𝑢𝑠𝑡𝑚𝑒𝑛𝑡
𝑅𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 = 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑆ℎ𝑎𝑟𝑒𝑠
Reproduction Value Method
● This method is useful when calculating the value of new or start-up businesses, ventures that use specialized equipment or
assets
𝑁𝑒𝑡 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 ±𝑅𝑒𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝐶𝑜𝑠𝑡𝑠
𝑅𝑒𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑣𝑎𝑙𝑢𝑒 = 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑆ℎ𝑎𝑟𝑒𝑠
Liquidation Value Method
● Assumes that the reasonable value for the company to be purchased is the amount which the investors will realize in the end
of its life or the value when it is terminated
Liquidation Value
● Value of a company if it were dissolved and its assets are sold individually
Situations to Consider Liquidation Value
● Business failures
● Corporate or Project End of Life
● Depletion of Scarce Resources
General principles on Liquidation Value
●
Types of Liquidation
● Orderly Liquidation
● Forced Liquidation
Calculating Liquidation Value
Present Value of Sale of Asset
Less: Present Value of Cost for Termination and Settlement for Liabilities
Less: Present Value of Tax CHarges for the Transactios and Other Liquidation Costs
Liquidation Value