Unit 1 –Fundamentals Principles of Valuation-(Elec 1)

Lecture Guide B

Valuation Process

Five steps – Understanding of the business, forecasting financial performance, selecting right valuation
model, preparing valuation model based on forecasts and applying conclusion and providing
recommendation.

Understanding of the business

Understanding of the business includes performing industry and competitive analysis and analysis of
publicly available financial information and corporate disclossure. Understanding the business is very
important as these give analysts and investors the idea about the following factors. Economic conditions,
industry peculiarities, company strategy and company historical performance. The understanding phases
enable analysts to come up with appropriate assumptions which reasonably capture the business
realities affecting the firm and its value.

Industry structure refers to the inherent technical and economic characteristic of an industry and the
trends that may effect this structure. Porter’s Five Forces is the most common tool used to encapsulate
industry structure.

Porter Five Forces:

1.​ Industry Rivalry – refers to the nature and intensity of rivalry between market player in the
industry.
2.​ New Entrants – refers to the barrier entry to industry by new market player.
3.​ Substitutes and complements – refers to the relationship between interrelated products and
servcies in the industry. This consider prices of subsitute product/servces, complement
product/services and government limitation
4.​ Supplier Power – refers how supplier can negotiate better term in their favor. It consider supplier
concentration, prices of alternative inputs, relationship- specific investments, supplier switching
costs and government regulations.
5.​ Buyer Power pertain how customer can negotiate better term in their favor for the
product/service they purchase.

Competitive position refers how the products, services and the company itself is set apart from other
competitive market player. Competitive position is typically gauged using the prevailing market share
level that the company enjoy. According to Michael Porter, there are generic corporate strategies to
achieve competitive advantage.

●​ Cost leadership – it relate to the incurrence of the lowest cost among market players with
quality that is comparable to competitors allow the firm to price product around the industry
average.
●​ Differentiation – firm tend to offer differentiated or unique product or service characteristic
that customer are willing to pay for an additional premium
●​ Focus Firm are identifying specific demographic segment or category segment to focus on by
using cost leadership (cost focus) or diffentiation strategy (differentiation focus)
Business model pertain to the method how the company makes money- what are the product or services
they offer, how they deliver and provide these to customer and their target customer. Knowing the
business model allow analysts to capture the right performance drivers that should be included in the
valuation model.

Forecasting Financial performance​

Forecasting financial performance can be looked at two lenses (a) on a macro perspective viewing the
economic environment and industry where the firm operate in ans (b) on a micro perspective focusing in
the firm’s financial and operating characteristic. Forecasting summarize the future –looking view which
result from the the assessment of industry and competitive landscape, business strategy and historial
financials. This can be summarizes in two approaches:

●​ Top-down forecasting approach –Forecast start form international or national macroeconomic

projection with utmost consideration to industry specific forecasts. From here, analysts select
which are relevant to the firm and applies this to firm and asset forecast. In top-down
forecasting approach the most common variables include GDP forecast, consumption forecasts,
inflation projections foreign exchange currency rates, industry sales and market share. A result of
top-down forecasting approach is the forecasted sales volume of the company. Revenue forecast
will be built from this combined with the company set sales prices.
●​ Bottom –up forecasting approach – Forecast 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. Inputs from various segments are consolidated until company-level revenue is
determined.

Forecasting should be done comprehensively and should include earnings,cash flow and balance sheet
forecast. Comprehensive forecasting approach prevents any inconsistent figures between the
prospective financial statements and unrealistic assumptions. The approach considers that analysis
should done per line item as each item can be influenced by different business driver. Similar with short
–term budgeting, forecasting process starts with the determining sales growth and revenue projections
of the business.

Forecasting process should also consider industry financial ratios as this gives an idea how the industry is
operating. From this, analysts should be able to explain reasons why firm-specific ratios will deviate from
this. Knowledge of historical financial trends will look like. Similarly, any deviations from noted historical
trends should be carefully explainded to ensure reasonableness.

The result of forecasts should be compared with the dynamics of the industry where the business
operates and its competitive position to make sure that the number make sense and reflect the most
reliable view of how the business operates. Even through general economic and market trends can be
used as reliable benchmark, analysts should consider that there might be unique factors that affect
company prospects that can be used as guidance in the forecasting process.

Selecting the right valuation model

The appropriate valuation model will depend on the context of the valuation and the 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. More so analyst should consider whether the resulting value from this process makes sense based
on their knowledge about the business. Two aspect should be considered:

●​ Sensitivity analysis
It is common methodology in valuation exercises wherein multiple analyses are done to
understand how changes in an input or variable will affect the outcome(i.e. firm value).
Assumptions that are commonly used as an input for sensitivity analysis exercise are sales
growth, gross margin rates and discounts rates. Aside from these, other variable (like market
share, advertising expense, discounts, differentiated feature, etc) can also be used depending on
the valuation problem and context at hand.
●​ Situational adjustments or Scenario Modeling
For firm –specific issues that affect firm value that should be adjusted by analysts. In some
instances, these are factor that do not affect value per se when analysts only look at core
business operations but will still influence value regardless. This includes control premium,
absence of marketability discounts and illiquidity discounts. Control premium refers to additional
value considered in a stock investment if acquiring it will give controlling power to the investor.
Lack of marketabilility discount means that the stock cannot be easily sold as there is no ready
market for it ( e.g.non-publicly traded discount) . illiquidity discount should be considered when
the price of particular shares has less depth or generally considered less liquid compared to
other active public traded share. Illiquidity discounts can also be considered if an investor will
sell large portion of stock that is significant compared to the trading volume of the stock. Both
lack of marketability discount and illiquidity discount drive down share value.
Applying valuation conclusion and providing recommendation

Once the value is calculated based on all assumptions considered. The analysts and investors use the
results to provide recommendation or make decisions that suits their investment objective.

Key Principle in Valuation

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

Business value tend to change every day as transation happen . it is important to give
perspective to users of the information that firm value is based on a specific date.

2.​ Value varies based on the ability of busiess to generate future cash flows
The relevant item for valuation is the potential of the business to generate value in the future
which is in the form of cash flows.
3.​ 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 vehicle in the market. Understanding
 the rate of return dictated by the market is important for investors do they can capture the right
discount rate to be used for valuation. This can influence their decision to buy and sell
investments.
4.​ Firm value can be impacted by underlying net tangible assets
Business valuation principles look at the relationship between operational value of an entity and
net tangible of its assets. Theoretically firm with higher underlying net tangible asset value are
more stable and results in higher going concern value. This is the result of presence of more
assets that can be used as security during financing acquisitions or even liquidation proceedings
in case bankruptcy occurs. Presence of sufficient net tangible asset can also support the forecast
on future operating plans of the business.
5.​ Value is influenced by transferability of future cash flows
Transferability of future cash flow is also 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 (e.g. owner maintains customer relationship or provides certain services), this
value might not be transferred to the buyer, this will reduce firm value. In such cases, value will
only be limited to net tangible assets that can be transfered to the buyer.
6.​ Value is impacted by liquidity

This 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. Sellers should be able to attract and negotiate
potential purchases to maximize value they can realize from the tranction.

Risk in Valuation

In all valuation exercise, uncertainty will be consistently present. Uncertainty refers to the possible range
of values where the real firm value lies. When performing any valuation method. Analyst will never be
sure if they have accounted and included all potential risks that may affect price of assets.

Some valuation methods also use future estimates which bear the risk that what will actually happen
may be significantly different from the estimate.

Business manage uncertainty to take advantage of possible opportunities and minimize impact of
unfavorable events. This influences management style, reaction to changes in economic environment
and adoption of innovative approaches to doing business, these dynamic approaches also contribute to
the uncertainty to all players in the economy.

Learning Resources
 ●​ Lascano,Marvin 2021. Valuation concept and Methodologies, copyright 2021
●​ Timbang, Ferdinand 2015, Financial Management Part 11,C& E Publishing Inc.
●​ Carmilleri, Emanuel 2017, Accounting for Financial instrument, Routledge

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