Chapter 1 - Fundamentals Principles of Valuation

-kemch-

value

pertains to the worth of an object in another person’s point of view

maximize shareholder value

most fundamental principle for all investments and businesses

valuation

-       estimation of an asset’s value based on variables perceived to be related to future investment returns investment returns, on comparison with similar assets, or, when relevant, on estimates of immediate liquidation proceeds.

-       includes the use of forecasts to come up with reasonable estimate of value of an entity’s assets or its equity

-       places great emphasis on the professional judgement that are associated in the exercise

-       mostly deals with projections about future events

current operations

how is the operating performance of the firm in recent year?

future prospects

what is the long-term, strategic direction of the company?

embedded risk

what are the business risks involved in running the business?

intrinsic value

- based on the assumption that there is a hypothetical complete understanding of its investment characteristics

- value that an investor considers, based on an evaluation of available facts, to be the “true” or “real” value that will become the market value when other investors reach the same conclusion

going concern value

-firm value

- believes that the entity will continue to do its business activities into the foreseeable future

-assumed that the entity will realize assets and pay obligations in the normal course of business

liquidation value

-net amount that would be realized if the business is terminated and the assets are sold piecemeal

-computed based on the assumption that the entity will be dissolved

-particularly relevant for companies who are experiencing severe financial distress

fair market value

-expressed in terms of cash, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller

fundamental analysts

-persons who are interested in understanding and measuring the intrinsic value of a firm

-for them, the true value of a firm can be estimated by looking at its financial characteristics, growth prospects, cash flows, and risk profile

-lean towards long-term investment strategies which encapsulate

o relationship between value and underlying factors can be reliably measured

o    above relationship is stable over an extended period

any deviations from the above relationship can be corrected within a reasonable time

fundamentals

characteristics of an entity related to its financial strength, profitability, or risk appetite

value investors

tend to be mostly interested in purchasing shares that are existing and priced less than their true fair value

growth investors

lean towards growth assets (businesses that might not be profitable now but has high expected value in future years) and purchasing these at a discount

security and investments analysts

use valuation techniques to support the buy/sell recommendations that they provide to their clients

market expectations

regarding fundamentals of one firm can be used as benchmark for other companies which exhibit the same characteristics

activist investors

-tend to look for companies with good growth prospects that have poor management

-do “takeovers”, using their equity holdings to push old management out of the company and change the way the company is running

-potential value once it is run properly by them

-knowledge about valuation is critical for them so they can reliably pinpoint which firms will create additional value if management is changed

-they should have good understanding of the company’s business model and how implementing changes in investment, dividend, and financing policies can affect its value

chartists

-relies on the concept that stock prices are significantly influenced by how investors think and act

-rely on available tracking KPIs such as price movements, trading volume, and short sales when making their investment decisions

-assume that stock price changes and follow predictable patterns since investors make decisions based on their emotions than by rational analysis

-they do not rely on valuations, but this is helpful for them when plotting support and resistance lines

information traders

-react based on new information about firms that are revealed to the stock market

-more adept in guessing or getting new information about firms and they can make predict how the market will react based on this

-correlate value and how information will affect his value

-valuation is important to them since they buy/sell shares based on their assessment on how new information will affect stock price

stock selection

particular asset priced, overpriced or underpriced in relation to its prevailing computed intrinsic value and prices of comparable assets?

deducting market expectations

which estimates of a firm’s future performance are in line with the prevailing market price of its stocks? are there assumptions about fundamentals that will justify the prevailing price?

sell-side analysts

(work in the brokerage department of investment firms) issue valuation judgement that are contained in research reports that are disseminated widely to current and potential clients

buy-side analysts

-look at specific investment options and make valuation analysis on these and report to a portfolio manager or investment committee

-they also tend to perform more in-depth analysis of a firm and engage in more rigorous stock selection and methodologies

financial analysts

-assist clients to realize their investment goals by providing them information that will help them make the right decision whether to buy/sell

-play a significant role by providing the right information to investors which enable the latter to buy/sell shares

acquisition

-Buying firm needs to determine the fair value of the target company prior to offering a bid price

-Selling firm (target company) should have a sense of its firm value to gauge reasonableness of bid offers

-bias may be a significant concern in this event

merger

two companies had their assets combined to form a wholly new entity

divestiture

sale of a major component or segment of a business to another company

spin-off

separating a segment or component business and transforming this into a separate legal entity

leveraged buyout

acquisition of another business by using significant debt which uses the acquired business as a collateral

synergy

-potential increase in firm value that can be generated once two firms merge with each other

-assumes that the combined value of two firms will be greater than the sum of separate firms

-can be attributable to more efficient operations, cost reductions, increased revenues, combined products/markets, or cross-disciplinary talents of the combined organization

control

change in people managing the organization brought about by the acquisition

corporate finance

-involves managing the firm’s capital structure, including funding sources and strategies that the business should pursue to maximize firm value

-deals with prioritizing and distributing financial resources to activities that increases firm value

-goal is to maximize the firm value by appropriate planning and implementation of resources, while balancing profitability and risk appetite

-ensures that financial outcomes and corporate strategy drives maximization of firm value

legal and tax purposes

- valuation is also important to businesses because of this

other purposes of valuation

-issuance of a fairness opinion for valuations provided by third party

-basis for assessment of potential lending activities by financial institutions

-share-based payment/compensation

understanding the business

o    includes performing industry and competitive analysis and analysis of publicly available financial information and corporate disclosures

o    very important as these give analysts and investors the idea about the following factors:

§  economic conditions

§  industry peculiarities

§  company strategy

§  company’s historical performance

frameworks

capture industry and competitive analysis already exist and are very useful for analysts and are more than a template that should be filled out

industry structure

inherent technical and economic characteristics of an industry and the trends that may affect this structure

industry rivalry

- nature and intensity of rivalry between market players

- rivalry is less intense if there is lower number of market players or competitors which means higher potential for industry profitability

- considers concentration of the market players, degree of differentiation, switching costs, information, and government restraint

new entrants

-barriers to entry to industry by new market players

-if there are relatively high entry costs, this means there are fewer new entrants thus, lesser competition which improves profitability potential

-new entrants include entry costs, speed of adjustment, economies of scale, reputation, switching costs, sunk costs, and government restraints

substitutes and complements

-relationships between interrelated products and services in the industry

-availability of substitute products or complementary products affects industry profitability

-consider prices of substitute products/services, complements and government limitations

supplier power

-how suppliers can negotiate better terms in their favor

-when there is strong supplier power, this tends to make industry profits lower

-strong supplier power exists if there are few suppliers that can supply a specific input

-also considers supplier concentration, prices of alternative inputs, relationship-specific investments, supplier switching costs and governmental regulations

buyer power

-how customers can negotiate better terms in their favor for the products/services they purchase

-low if customers are fragmented and concentration is low

-low buyer power tends to improve industry profits since buyers cannot significantly negotiate to lower price of the product

-other factors considered: buyer concentration value of substitute products that buyers can purchase, customer switching costs and government restraints

competitive position

-how the products, services, and the company itself is set apart from other competing market players

-typically gauged using the prevailing market share level that the company enjoys

cost leadership

relates to the incurrence of the lowest cost among market players with quality that is comparable to competitors allow the firm to price products around the industry average

differentiation

firms tend to offer differentiated or unique product or service characteristics that customers are wiling to pay for an 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 (differentiation focus)

business model

method how the company makes money – what are the products or services they offer, how they deliver and provide these to customers and their target customers

quality of earning analysis

-detailed review of financial statements and accompanying notes to assess sustainability of company performance and validate accuracy of financial information versus economic reality

-also compares net income against operating cash flow to make sure reported earnings are realizable to cash and are not padded through significant accrual entries

forecasting financial performance

ocan be looked at two lenses: (a) on a macro perspective viewing the economic environment and industry where the firm operates in and (b) on a micro perspective focusing on the firm’s financial and operating characteristic

forecasting

osummarizes the future-looking view which results from the assessment of industry and competitive landscape, business strategy and historical financials

top-down forecasting approach

starts from international or national macroeconomic projections with utmost consideration to industry specific forecasts

bottom-up forecasting approach

starts from the lower levels of the firm and is completed as it captures what will happen to the company based on the inputs of its segments/units

comprehensive forecasting approach

prevents any inconsistent figures between the prospective financial statements and unrealistic assumptions

detecting the right valuation model

appropriate valuation model will depend on the context of the valuation and inherent characteristics of the company being valued

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

-this step is not only about manually encoding the forecast to the model to estimate the value

sensitivity analysis

common methodology in valuation exercises wherein multiple analyses is 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, and these are the factors that do not affect value per se when analysts only look at core business operations but will still influence value regardless

control premium

additional value considered in a stock investment if acquiring it will give controlling power to the investor

lack of marketability discount

stock cannot be easily sold as there is no ready market for it

illiquidity discount

should be considered when the price of shares has less depth or generally considered less liquid compared to other active publicly traded share

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 suits their investment objective

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

-business value tends to change every day as transactions happen

-different circumstances that occur daily affect earnings, cash position, working capital, and market conditions

-valuation made a year ago may not hold true and not reflect the prevailing firm value today

-it is important to give perspective to users of the information that firm value is based on a specific date

value varies based on the ability of business to generate future cash flows

• general concepts for most valuation techniques put emphasis on future cash flows except for some circumstances where value can be better derived from asset liquidation

• relevant item for valuation is the potential of the business to generate value in the future which is in the form of cash flows

cash flows

more relevant in valuation as compared to accounting profits as shareholders are more interested in receiving cash at the end of the day

market dictates the appropriate rate of return for investors

• market forces are constantly changing, and they normally provide guidance of what rate of return should investors expect from different investment vehicles in the market

• understanding the rate of return dictated by the market is important for investors so they can capture the right discount rate to be used for valuation

firm value can be impacted by undelting net tangible assets

• business valuation principles look at the relationship between operational value of an entity and net tangible of its assets

• firms with higher underlying net tangible asset value are more stable and results in higher going concern value

• presence of sufficient net tangible assets can also support the forecasts on future operating plans of the business

value is influenced by transferability of future cash flows

• important especially to potential acquirers

• business with good value can operate even without owner intervention

• if a firm’s survival depends on owner’s influence, this value might not be transferred to the buyer, hence, this will reduce firm value

• value will only be limited to net tangible assets that can be transferred to the buyer

value is impacted by liquidity

• principle is mainly dictated by the theory of demand and supply

• if there are many potential buyers with less acquisition targets, value of the target firms may rise since the buyers will express more interest to buy the business

• seller should be able to attract and negotiate potential purchases to maximize value they can realize from the transaction

risk in valuation

-uncertainty will be consistently present

-analysts will never be sure if they have accounted and included all potential risks that may affect price of assets

uncertainty

• possible range of values where the real firm value lies

• some valuation methods use future estimates which bear the risk that what will happen may be significantly different from the estimate

three major factors of determining the value of a business

• current operations

• future prospects

• embedded risk

key concepts used to determine the true worth of a business based on its fundamentals

• intrinsic value

• going concern value

• liquidation value

• fair market value

roles of valuation in business

• portfolio management

• analysis of business management

• corporate finance

• legal and tax purposes

portfolio management

• fundamental analysts

• activist investors

• chartists

• sell-side/buy-side analysts

• information traders

analysis of business transaction

• acquisition

• merger

• divestiture

• spin-off

• leverage buy-out

valuation process

1. understanding the business

2. forecasting financial performance

3. selecting the right valuation model

4. preparing the valuation model based on forecasts

5. applying evaluation conclusions and providing recommendations

porter’s five forces

• rivalry of competition

• potential of new entrants

• bargaining power of suppliers

• bargaining power of buyers

• potential for substitutes

forecasting financial performance approach

• top-down forecasting approach

• bottom-up approach

key principles in valuation

1. 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