Financial Management: Intro to Financial Valuation

Question 1

Valuation and Value Defined:

Answer 1

1. Valuation: Process of assigning worth or value to something.
2. Financial Valuation: Process of estimating the fair value of an asset, liability, or an entire business.
3. Accounting Fair Value: Price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.
   
   • Also called: Exit Price

Question 2

Valuation Uses:

Answer 2

Valuation is used in many circumstances:

• Recognition of assets, liab, and equity items
• Investment analysis
• Capital budgeting
• Business mergers and acquisitions
• Assessment of closely-held businesses
• Tax determinations
• Buy/Sell agreements
• Etc.

Question 3

Characteristics of Valuation Process:

Answer 3

1. Most valuation has elements of both science (objective characteristics) and art (subjective characteristics):
   
   • Science: Use of quantitative data - analytical and software;
   • Art: Incorporates a qualitative dimension and use of professional judgment to:
     
     • Understand purpose and context of valuation
     • Select appropriate quantitative techniques and data
     • Assign value
2. Value is measured in MONEY. It is determined for specific item:
   
   • Separate asset, liab, or equity item
   • Group of assets, liab, or entire business.
3. The following factors must be considered in assigning value:
   • The specific item or items (asset, liability, equity, etc.) being valued;
   • The condition of the item(s);
   • The location of the item(s);
   • The time at which the valuation is occurring;
   • The economic environment in which the valuation is occurring.

Question 4

Fair Value Framework (Hierarchy of Inputs)

Answer 4

• US GAAP provides a framework for ranking quality of assumptions and inputs on assessing fair value:
• US GAAP Hierarchy of Inputs:
  
  • Level 1 Inputs: Unadjusted quoted prices obtained at the measurement date in active markets for assets and liab identical to those being valued. (Observable)
    
    • These inputs are the most reliable evidence of FV.
      
      • Quoted price in active market
    • Should be used when available.
  • Level 2 Inputs: Observable for the item being valued, either directly or indirectly, but are other than quoted prices described in Level 1; including the following 4 categories:
    
    1. Quoted prices for similar, but not identical, item in active market
    2. Quoted prices for identical or similar item in market that is NOT active.
    3. Inputs other than quoted prices that are observable for the item being valued, including:
       
       • Interest rates
       • Yield curve rates
       • Credit risk
       • Default rates
    4. Inputs derived principally from, or corroborated by, observable market data by correlation or other means.
  • Level 3 Inputs: Unobservable for items being valued.
    
    • Entity’s assumptions used
    • Entity’s internal data
    • Use only when observable imputs not available

Question 5

Fair Value Framework (3 Approaches):

Answer 5

• US GAAP also provides 3 approaches to developing FV:
  
  1. Market Approach (also Sales Comparison Approach): Uses prices and other relevant info generated by market transactions for items identical or comparable to item being valued.
     
     • Example: common is establishing value of pre-existing house or building.
  2. Income Approach: Uses valuation techniques to convert future amounts of economic benefits or sacrifices of econ benefits to determine what the future amounts are worth at valuation date.
     
     • Techniques include:
       
       • Discounted cash flows
       • Option pricing models
       • Earnings capitalization models
  3. Cost Approach: Uses valuation techniques to determine the amount required to acquire or construct a substitute item.
     
     • Also called:
       
       • Replacement cost approach
       • Reproduction cost approach
     • More limited than market approach or income approach
       
       • Especially useful for specialized items