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VCM_CH1_FUNDAMENTALS-PRINCIPLE-OF-VALUATION

The document outlines the fundamentals of asset valuation, emphasizing the estimation of value based on future investment returns, comparisons with similar assets, and professional judgment. It details various definitions of value, including intrinsic value, going concern value, liquidation value, and fair market value, as well as the valuation process involving understanding the business, forecasting financial performance, and selecting appropriate valuation models. Key principles highlight that value is time-specific, influenced by future cash flow generation, and affected by market conditions and liquidity.

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Karen Revadona
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Download as PDF, TXT or read online on Scribd
2 views

VCM_CH1_FUNDAMENTALS-PRINCIPLE-OF-VALUATION

The document outlines the fundamentals of asset valuation, emphasizing the estimation of value based on future investment returns, comparisons with similar assets, and professional judgment. It details various definitions of value, including intrinsic value, going concern value, liquidation value, and fair market value, as well as the valuation process involving understanding the business, forecasting financial performance, and selecting appropriate valuation models. Key principles highlight that value is time-specific, influenced by future cash flow generation, and affected by market conditions and liquidity.

Uploaded by

Karen Revadona
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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FUNDAMENTALS PRINCIPLE OF VALUATION

Valuations

➔ 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.
➔ Use of forecast
➔ Places great emphasis on the professional judgement

Three Major Factors

1. Current operations
2. Future prospects
3. Embedded risk

Different definitions of value

Intrinsic Value

- The value of any asset based on the assumption that there is a hypothetical
complete understanding of its investment characteristics.
- True or real value
- If true value of asset is dictated by the market then, intrinsic value = market price

Going Concern Value

- Firm value is determined under the GCV.

Liquidation Value

- Net amount that would be realized if the business is terminated

Fair Market Value

- Price (cash) at which property would change hands between hypothetical willing
and able buyer, same is true on the seller, acting at arm’s length and in an open
and unrestricted market
- Ofter used in valuation exercises involving tax assessments

Business deals that use valuation

1. Acquisition – buy and sell


2. Merger - new entity
3. Divestiture -sale of major component
4. Spin-off – separate legal entity
5. Leveraged buyout – acquisition by debt, acquired business is the collateral

Unique Factors

- Synergy – potential increase in firm value


- Control - change in management

Valuation Process

1. Understanding of the business


Porter’s Five Forces
a. Industry rivalry
b. New entrants
c. Substitutes and complements
d. Supplier power
e. Buyer power
- Competitive position – how the products, services and company is set apart
- Firm value is higher if it can consistently sustain it competitive adgavatages
- Historical fs analysis can be done for the last 2 years up to 10 years prior to
- Historical FS analysis, uses horizontal, vertical and ratioa analysis
- Quality of earnings analysis pertain to the detailed review of fs (sustainability,
accuracy, vs economic reality)
o Also compare net income against operating cash flow

Revenues and Gains

Possible Observation Possible Interpretation


Early recognition of revenues (e.g., bill- Accelerated revenue boosts income
and-hold sales, recognition before and may hide poor performance
delivery)
Inclusion of nonoperating income as part Nonrecurring gains inflate operating
of operating income performance, may hide declining
results

Expenses and Losses

Possible Observation Possible Interpretation

Recognition of too high or too little Affects current income; might distort
reserves (e.g., restructuring, bad debts) future income (and vice versa)
Deferral of expenses via capitalization Improves current income, reduces
(e.g., customer acquisition, R&D costs) future income; may hide declining
performance

Aggressive assumptions (e.g., long useful May signal efforts to boost income;
lives, low impairments, high pension could indicate hidden performance
returns) issues

Valuation Concepts and Methodologies

Line Item Possible Observation Possible Interpretation

Balance Off-balance sheet financing not reflected Assets/liabilities may not


Sheet (e.g., leasing, securitizing receivables) be fairly reflected

Operating Increase in bank overdraft as operating Potential warning of cash


Cash cash flow flow issues

2. Forecasting financial performance


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

Two Approaches

1. Top-down forecasting approach


- forecast starts from international or national macroeconomic projections
- most common variables includes GDP forecast , consumption forecasts, inflation
projections, foreign exchange currency rates, industry sales and market share.
- Result: forecasted sales volume
2. Bottom-up forcasting approach
- Forecast starts from the lower levels, and completed based on the inputs of its
segments/units.
- E.g, store expansions, increase in product availability
- Inputs from various segments are consolidated until company-level revenues is
determined.

3. Selecting the right valuation model


4. Preparing valuation model based on forecasts
Sensitivity Analysis
- Wherein multiple analysis are don to understand how changes in an input or
variable will affect the outcome.

Situational Adjustments or Scenario Modelling


- E.g., control premium (lack of marketability discount – stock cannot be easily sold
as there is no ready market for it)
- Illiquidity discount – less liquid than other active publicly traded share
- Lack of marketability discount and illiquidity discount drive down share value.
5. Applying valuation conclusions and providing recommendations

Key Principles in Valuation

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


2. Value varies based in the ability of business to generate future cashflows
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

Risk in Valuation

Uncertainty is captured in valuation models through cost of capital or discount rate.

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