VALUATION CONCEPTS

AND METHODS
ASET-BASED VALUATION:
DISCOUNTED CASH FLOW
ANALYSIS AND COMPARABLE
COMPANY ANALYSIS
 Objectives
 Differentiate the valuation methods.
 Describe the going concern and liquidation
concern asset based approach.
 Illustrate the capitalizing and discounted
future earnings.
 Define the financial ratios to compare
company performance.
 Describe the use of financial ratios in
estimating entity value and investments.
 Apply the financial ratios in decision making.
 INTRODUCTION
In this module, we will discuss the
different valuation methods particularly
discounted cash flow analysis and
comparable company analysis. These
valuation methods are used when the
company is valued as a going concern. The
uses and procedures on how to use these
methods, and other related topics are
presented in this module.
 INTRODUCTION
Different financial ratios as a tool will
also be discussed and illustrated to help
students assess the relationship of each
drivers and show the how these tools could
actually simplify the decision making of
investors.
 DISCOUNTED CASH FLOW
ANALYSIS
Discounted cash flow (DCF) is an
analysis method used to value investment
by discounting the estimated future cash
flows. DCF analysis can be applied to value
a stock, company, project, and many other
assets or activities, and thus is widely used
in both the investment industry and
corporate finance management.

(www.corporatefinanceinstitute.com)
 DISCOUNTED CASH FLOW
ANALYSIS
Discounted cash flow (DCF) is a valuation
method used to estimate the value of an investment
based on its expected future cash flows. DCF
analysis attempts to figure out the value of an
investment today, based on projections of how
much money it will generate in the future. This
applies to the decisions of investors in companies or
securities, such as acquiring a company or buying a
stock, and for business owners and managers
looking to make capital budgeting or operating
expenditures decisions.

(www.investopedia.com)
 DISCOUNTED CASH FLOW
ANALYSIS
 Discounted cash flow can be done by determining the
net present of the free cash flows of the investment
opportunity.
 Based on Conceptual Frameworks and Accounting
Standards (CFAS), cash flows are presented and
analyzed based on their sources and activities:
operating, investing and financing.
 The free cash flows are the amount are the amount of
cash available for distribution to both debt and equity
claim from the business or asset. Free cash flows can
be computed as:

Free Cash Flows = Revenue – Operating Expenditures –

Taxes – Capital Expenditures
 DISCOUNTED CASH FLOW
ANALYSIS
 Two Levels of Net Cash Flows
 Net Cash Flows to the Firm – represents the
amount of cash made available to both debt and
equity claims against the company.
 Net Cash Flows to Equity – represents the
amount of cash flows made available to the equity
stockholders after deducting the net debt or the
outstanding liabilities to the creditors less available
cash balance of the company.
 Terminal cash flows represents the value of
the company in perpetuity or in a going
concern environment. This can be computed
as:
DISCOUNTED CASH FLOW
ANALYSIS

TV
 DISCOUNTED CASH FLOW
ANALYSIS
Accordingly:
Valuation is the estimation of an
asset’s value based on variables perceived to
be related to future investment returns, on
comparisons with similar assets, or, when
relevant, on estimates of immediate
liquidation proceeds. Skill in valuation is a
very important element of success in
investing.

Source: www.cfainstitute.org
 DISCOUNTED CASH FLOW
ANALYSIS
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.
 DISCOUNTED CASH FLOW
ANALYSIS
A valuation can be useful when trying
to determine the fair value of a security,
which is determined by what a buyer is
willing to pay a seller, assuming both
parties enter the transaction willingly. When
a security trades on an exchange, buyers
and sellers determine the market value of a
stock or bond.

Source: www.investopedia.com
 DISCOUNTED CASH FLOW
ANALYSIS
Valuation is the process of determining
the present value of a company or an asset
using a number of techniques that analysts
used by looking at the management of the
business, the prospective future earnings,
the market value of the company’s assets,
and its capital structure composition.
 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. Intrinsic Value – refers to the value of any asset based on

the assumption assuming there is a hypothetically complete
understanding of its investment characteristics. It is the
value that an investor considers, on the basis of an
evaluation or available facts, to be the “true” or “real” value
that will become the market value when other investors
reach the same conclusion.

2. Going Concern Value – the going concern assumption

believes that the entity will continue to do its business
activities into the foreseeable future.
 CONCEPTS OF VALUATION
3. Liquidation Value – the net amount that would
be realized if the business is terminated and the
assets are sold piecemeal. It is particularly
relevant for companies who are experiencing
severe financial distress.

4. Fair Market Value – the price, expressed in

terms of cash equivalents, 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.
 ROLES OF VALUATION IN
BUSINESS
A. Portfolio Management
The role that valuation plays in portfolio
management is determined in large part by the
investment philosophy of the investor. 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. Market timers
use valuation much less than investors who pick
stocks, and the focus is on market valuation rather
than on firm-specific valuation. Among stock pickers,
valuation plays a central role in portfolio
management for the following:
 ROLES OF VALUATION IN
BUSINESS
 Fundamental Analyst – 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.

 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
being run.
 ROLES OF VALUATION IN
BUSINESS
 Chartists – they rely on the concept that stock
prices are significantly influenced by how
investors think and act and on available trading
KPIs such as price movements, trading volume,
short sales – when making their investment
decisions.

 Information Traders – they 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.
 ROLES OF VALUATION IN
BUSINESS
B. Business Deals for Analysis
The following are some corporate transactions that
is used in business expansion and investments that
signifies valuation in businesses.

 An acquisition of a company occurs when all or part

of a company is purchased by another company.
Sometimes an acquisition takes the form of a sale of
a company's assets. At other times, the shareholders
of a target company sell their shares to a buyer. The
assets or shares of a target company may be
purchased directly by another company. In other
instances, the buyer creates a subsidiary for the
purpose of acquiring the shares or assets of the
target.
 ROLES OF VALUATION IN
BUSINESS
 A merger is a form of an acquisition that is
structured by combining the target company
with the acquirer (or its acquisition
subsidiary) into one legal entity. Sometimes
the target merges with the acquirer or its
subsidiary, and the target is the surviving
legal entity. In other cases, the acquirer or its
acquisition subsidiary is the surviving legal
entity in a merger. Whether or not the deal is
structured as a tax-free reorganization will
affect the tax treatment of any new shares of
the acquirer's stock that you receive in
exchange for your old shares.
 ROLES OF VALUATION IN
BUSINESS
 A divestiture can be any among a broad
range of transactions that result in a
portion of a company, such as a
subsidiary, a division, or a line of
business, being sold to another party.

 A spinoff is a type of divestiture in which

the divested unit becomes an
independent company (perhaps through
an IPO) instead of being sold to a third
party.
 ROLES OF VALUATION IN
BUSINESS
 A leveraged buyout (LBO) is the
acquisition of another company using a
significant amount of borrowed money to
meet the cost of acquisition. The assets
of the company being acquired are often
used as collateral for the loans, along
with the assets of the acquiring company.
VALUATION PROCESS
 VALUATION PROCESS
1. Understanding the Business.
It includes evaluation of industry
prospects, competitive position, and
corporate strategies–all of which contribute
to making more accurate forecasts. It also
involves analysis of financial reports,
including evaluating the quality of a
company’s earnings. An investor should be
able to encapsulate the industry structure.
Common tools used in encapsulating
industry is Porter’s Five Forces:
 VALUATION PROCESS

PORTER’S FIVE FORCES OF COMPETITIVE POSITION ANALYSIS

Buyer Power Supplier Power Substitutes/Complements Competition New Entrants

 Purchasing power  Better terms offered  Availability of  Market player  Cost to enter
 Buyer concentration  Price of alternative substitute/complement  Degree of  Speed of adjustment
 Value substitute puts products differentiation  Economies of scale
products  Relationship-specific  Price of substitute/  Switching costs  Reputation
 Customer Switching investments complement products  Info and gov’t  Switching costs
cost  Supplier switching restraints  Sunk cost
 Gov’t restraints cost  Gov’t restraints
 Gov’t regulations
 VALUATION PROCESS
Generic Corporate Strategies to Achieve
Competitive Advantage
 Cost leadership – incurring the lowest cost among
market players with quality that is comparable to
competitors allow the firm to be price products
around the industry average.
 Differentiation – offering differentiated or unique
product or service characteristics that customers are
willing to pay for an additional premium.
 Focus – identifying specific demographic segment
or category segment to focus on by using cost
leadership strategy or differentiation strategy.
 VALUATION PROCESS
2. Forecasting Financial Performance
This can be looked at two perspectives: on a
macro-perspective viewing the economic environment
and industry where the firm operates in and micro-
perspective focusing in the firm’s financial and
operating characteristics.

Approaches of Forecast Financial Performance

 Top down forecasting approach – international or
national macroeconomic projections with utmost
consideration to industry specific forecasts.
 Bottom-up forecasting approach – forecast starts from
the lower levels of the firm and builds the forecast as it
captures what will happen to the company.
 VALUATION PROCESS
3. Selecting the Right Valuation Model
It means choosing an approach that is:
 consistent with the characteristics of the
company being valued;
 appropriate given the availability and quality
of the data; and
 consistent with the analyst’s valuation
purpose and perspective
 VALUATION PROCESS
There are two main categories of valuation models:
absolute valuation model and relative valuation
model.
1. Absolute valuation models attempt to
find the intrinsic or "true" value of an investment
based only on fundamentals. Looking at
fundamentals simply means you would only focus
on such things as dividends, cash flow, and the
growth rate for a single company, and not worry
about any other companies. Valuation models that
fall into this category include the dividend discount
model, discounted cash flow model, residual income
model, and asset-based model.
 VALUATION PROCESS
2. Relative valuation models, in contrast,
operate by comparing the company in question to
other similar companies. These methods involve
calculating multiples and ratios, such as the price-to-
earnings multiple, and comparing them to the
multiples of similar companies. For example, if the
P/E of a company is lower than the P/E multiple of a
comparable company, the original company might
be considered undervalued. Typically, the relative
valuation model is a lot easier and quicker to
calculate than the absolute valuation model, which is
why many investors and analysts begin their
analysis with this model.
 VALUATION PROCESS
4. Preparing Valuation Model Based on Forecasts
There are two aspects to be considered:
A. Sensitivity analysis – common methodology in
valuation exercises wherein multiple other analyses are done to
understand how changes in an input or variable will affect the
outcome.

B. Situational adjustments – firm specific issues

that affects firm value that should be adjusted by analysts since
these are events that are not quantified if analysts only look at
core business operations. This includes control premiums
(premiums for a controlling interest in the company), discounts for
lack of marketability (discounts reflecting the lack of a public
market for the company’s shares), and illiquidity discounts
(discounts reflecting the lack of a liquid market for the company’s
shares).
 VALUATION PROCESS
5. Applying Valuation Conclusions and Providing
Recommendations
Applying valuation conclusions depends on the purpose of the
valuation.

In performing valuations, analysts must hold themselves accountable to

both standards of competence and standards of conduct.

An effective research report:

 contains timely information;
 is written in clear, incisive language;
 is objective and well researched, with key assumptions clearly identified;
 distinguishes clearly between facts and opinions;
 contains analysis, forecasts, valuation, and a recommendation that are
internally consistent;
 presents sufficient information that the reader can critique the valuation;
 states the risk factors for an investment in the company; and
 discloses any potential conflicts of interest faced by the analyst
KEY PRINCIPLES OF VALUATION
The following are the key principles of business valuation that
business owners who want to create value in their business must
know.

1. The value of a business is defined only at a specific point

in time.
The value of a privately-held business usually experiences
changes every single day. The earnings, cash position, working
capital, and market conditions of a business are always changing.
The valuation prepared by business owners a few months 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 date of valuation in the process
of business valuation.
KEY PRINCIPLES OF VALUATION

2. 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 flow except in rare
situations where net asset liquidation leads to a
higher value. The first key takeaway in the
second principle is “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.
KEY PRINCIPLES OF VALUATION

The second key in this principle is “cash flow.” It is

because cash flow, which takes into account capital
expenditures, 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 assumptions that the forecasts
will use.
KEY PRINCIPLES OF VALUATION
3. The market commands what the proper rate of
return for acquirers is
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. Some of the 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 individual company buyers
over the long term. Business owners need to be wary of
the market forces in order to know the right time to exit
that will maximize value.
KEY PRINCIPLES OF VALUATION
4. The value of a business may be impacted by
underlying net tangible assets
This principle of business valuation measures of the
relationship between the operational value of a company
and its net tangible value. Theoretically, a company with a
higher underlying net tangible asset value has higher
going concern value. It is due to 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 support the valuation of their goodwill.
KEY PRINCIPLES OF VALUATION

5. 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 value and is not transferable.
KEY PRINCIPLES OF VALUATION

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 even through hiring.
KEY PRINCIPLES OF VALUATION

6.Value is impacted by liquidity

This principle functions 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.
KEY PRINCIPLES OF VALUATION

The above are fundamental business

valuation principles that determine the value of a
business. The value of any business is usually
determined at a specific point in time and is
impacted by the company’s capacity to generate
future cash flow, market forces, underlying net
tangible assets, transferability of future cash
flows, and liquidity.
Although they are technical valuation
concepts, the basics of the valuation principles
need to be understood by business owners to help
them increase the valuation of their businesses.
Thank You!