Fundamentals Principles of Valuation Flashcards
What has value?
Assets
Worth of an object in another person’s point of view.
Value
Scarce resource that should be competed to obtain and efficiently manage.
Capital
Most fundamental principle for all investments and businesses
Maximize shareholder value
Fundamental point behind success investments
Understanding what the prevailing value and the key drivers that influence this value
Estimation of an asset’s value based on variables perceived to be related to future investment returns, on comparison with similar assets, or, when relevant, on estimates of immediate liquidation proceeds.
Valuation
What is the fundamental equation of value?
A company creates value if and only if the return on capital invested exceed the cost of acquiring capital.
Who popularized the fundamental equation of value?
Alfred Marshall
What are the three major factors that the value of a business can be basically linked to?
Current operations
Future prospects
Embedded risk
Value of any asset based on the assumption that there is a hypothetical complete understanding of its investment characteristics.
Intrinsic Value
Value that an investor considers to be the “true” or “real” value that will become the market value when other investors reach the same conclusion.
Intrinsic Value
If dictated by the market, what is intrinsic value?
Market Price
The entity will realize assets and pay obligations in the normal course of business.
Going Concern Value
What is going concern value?
Firm value is determined under the going concern assumption.
What is the going concern assumption?
The entity will continue to do its business activities into the foreseeable future.
The net amount that would be realized if the business is terminated and the assets are sold piecemeal.
Liquidation Value
The price (expressed in terms of cash) at which property would change hands between a buyer and a seller.
Fair Market Value
What are the roles of valuation in business?
Portfolio Management
Analysis of Business Transactions / Details
Corporate Finance
Legal and Tax Purposes
Other Purposes
What are the 2 types of investors?
Passive investors
Active investors
Investors that are disinterested in understanding valuation.
Passive Investors
Investors that want to understand valuation to participate intelligently in the stock market.
Active Investors
Who manages the investment portfolio?
Fundamental analysts
Activist investors
Chartists
Information traders
Interested in understanding and measuring the intrinsic value of a firm, estimated by looking at its financial characteristics, growth prospects, cash flows and risk profile.
Fundamental Analysts
Which principles do fundamental analysts lean towards in terms of long-term investment strategies?
- Relationship between value and underlying factors can be reliably measured.
- Relationship is stable over an extended period.
- Any deviations can be corrected within a reasonable time.
What are the 2 types of fundamental analysts?
Value investors
Growth investors
Investors mostly interested in purchasing shares that are existing and priced at less than their true value.
Value Investors
Investors that lean towards growth assets and purchasing these at a discount.
Growth Investors
What are growth assets?
Businesses that might not be profitable now but has high expected value in future years.
They look for companies with good growth prospects that have poor management.
They usually do “takeovers.”
Activist Investors
They look for the potential value of a business once it is run properly, rather than its current value.
Activist Investors
What does “takeover” mean for an activist investor?
Activist investors use their equity holdings to push old management out of the company and change the way the company is run.
They rely on concept that stock prices are significantly influenced by how investors think and act.
Chartists
They rely on available trading KPIs such as price movements, trading volume, and short sales when making their investment decisions.
Chartists
Traders that react based on new information about firms that are revealed to the stock market.
Information Traders
They are more adept in guessing or getting new information about firms and they can predict how market will react based on this.
They correlate value and how information will affect this value.
Information Traders
They buy or sell shares based on their assessment on how new information will affect stock price.
Information Traders
What are the activities that can be performed through the use of valuation techniques under portfolio management?
Stock selection
Deducing market expectations
Concerns whether a particular asset is fairly priced, overpriced, or underpriced in relation to its prevailing computed intrinsic value and prices of comparable assets.
Stock Selection
Concerns whether the estimates of a firm’s future performance are in line with the prevailing market price of its stocks.
Deducing Market Expectations
What are the following corporate events that are included in business deals?
Acquisition
Merger
Divestiture
Spin-Off
Leveraged Buyout
This corporate event usually has two parties: the buying firm and the selling firm.
Acquisition
What are the usual two parties of acquisition?
Buying Firm
Selling Firm (Target Firm)
This party needs to determine the fair value of the target company prior to offering a bid price.
Buying Firm
This party should have a sense of its firm value to gauge reasonableness of bid offers. They use this information to guide which bid offers to accept or reject.
Selling Firm (Target Firm)
General term which describes the transaction wherein two companies had their assets combined to form a wholly new entity.
Merger
Sale of a major component or segment of a business to another company.
Divestiture
Separating a segment or component business and transforming this into a separate legal entity.
Spin-Off
Acquisition of another business by using significant debt which uses the acquired business as a collateral.
Leverage Buyout
What are the two important unique factors that valuation in deals analysis consider?
Synergy
Control
The potential increase in firm value that can be generated once two firms merge with each other.
Synergy
The change in people managing the organization brought about by the acquisition. Any impact to firm value resulting from the change in management and restructuring of the target company should be included in the valuation exercise.
Control
This involves managing the firm’s capital structure, including funding sources and strategies that the business should pursue to maximize firm value.
Corporate Finance
It deals with prioritizing and distributing financial resources to activities that increases firm value. Its ultimate goal is to maximize the firm value by appropriate planning and implementation of resources, while balancing profitability and risk appetite.
Corporate Finance
What are the other purposes of valuation in business?
- Issuance of a fairness opinion for valuations provided by third party
- Basis for assessment of potential lending activities by financial institutions
3, Share-based payment/compensation
What are the 5 steps of the valuation process?
- Understanding the business
- Forecasting financial performance
- Selecting the right valuation model
- Preparing valuation model based on forecasts
- Applying valuation conclusions and providing recommendation
This step in valuation process included performing industry and competitive analysis and analysis of publicly available financial information and corporate disclosures
Understanding the business
This phase enables analysts to come up with appropriate assumptions which reasonably capture the business realities affecting the firm and its value.
Understanding the business
These capture industry and competitive analysis are very useful for analysis.
They are more than a template that should be filled out by analysts to organize their thoughts about the industry and the competitive environment and how these relates to the performance of the firm they are valuing.
Frameworks
This refers to the inherent technical and economic characteristics of an industry and the trends that may affect this structure.
Industry Structure
These are true to most, if not all, market players participating in the industry.
Industry Characteristics
The most common tool used to encapsulate industry structure.
Porter’s Five Forces
The nature and intensity of rivalry between market players in the industry.
This considers concentration of market players, degree of differentiation, switching costs, information and government restraint.
Industry Rivalry
The barriers to entry to industry by new market players.
Include entry costs, speed of adjustment, economies of scale, reputation, switching costs, sunk costs and government restraints.
New Entrants
The relationships between interrelated products and services in the industry.
This considers prices of substitute products/services, complement products/services and government limitations.
Substitutes and Complements
Products that can replace the sale of an existing product.
Substitute Products
Products that can be used together with another product.
Complementary Products
Refers to how suppliers can negotiate better terms in their favor.
Considers supplier concentration, prices of alternative inputs, relationship specific investments, supplier switching costs and governmental reguations.
Supplier Power
Pertains to how customers can negotiate better terms in their favor for the products/services they purchase.
Other factors considered include buyer concentration, value of substitute products that buyers can purchase, customer switching costs and government restraints.
Buyer Power
Refers to how the products, services and the company itself is set apart from other competing market players. It is typically gauged using the prevailing market share level that the company enjoys.
Competitive Position
Generic corporate strategies to achieve competitive advantage according to Michael Porter.
Cost Leadership
Differentiation
Focus
It 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.
Cost Leadership
Firms tend to offer differentiated or unique product or service characteristics that customers are willing to pay for an additional premium.
Differentiation
Firms are identifying specific demographic segment or category segment to focus on by using cost leadership strategy or differentiation strategy.
Focus
Using cost leadership strategy to identify specific demographic or category segment to focus on
Cost Focus
Using differentiation strategy to identify specific demographic or category segment to focus on
Differentiation Focus
Pertains to the 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.
Business Model
Three methods used in the analysis of historical financial reports.
Horizontal Analysis
Vertical Analysis
Ratio Analysis
Typical sources of information about companies.
Government-mandated disclosures
Audited financial statements
Regulatory fillings
Company press releases
Financial statements
Investor relation materials
Other acceptable sources of information about companies.
News articles
Reports from industry organization
Reports from regulatory agencies
Industry researches done by independent firms
The detailed review of financial statements and accompanying notes to assess sustainability of company performance and validate accuracy of financial information versus economic reality.
Quality of earnings analysis
Compares net income against operating cash flow to make sure reported earnings are actually realizable to cash and are not padded through significant accrual entries.
Quality of earnings analysis
Based on AICPA guidance, other red flags that may indicate aggressive accounting include:
Poor quality of accounting disclosures
Existence of related-party transactions
Reported disputes with and/or changes in auditors
Material non-audit services performed by audit firm
Management/Directors’ compensation tied to profitability or stock price
Economic, industry, or company-specific pressures on profitability
High management/director turnover
Excessive pressure on company personnel to make revenue or earnings targets
Management pressure to meet debt covenants or earnings expectations
A history of securities law violations, reporting violations, or persistent late filings
This step can be looked at two lenses:
(a) on a macro perspective viewing the economic environment and industry where the firm operates in,
(b) on a micro perspective focusing in the firm’s financial and operating characteristics.
Forecasting Financial Performance
It summarizes the future-looking view which results from the assessment of industry and competitive landscape, business strategy and historical financials.
Forecasting
Forecasting is summarized in two approaches:
Top-down forecasting approach
Bottom-up forecasting approach
Forecast starts from international or national macroeconomic projections with utmost consideration to industry specific forecasts.
Top-down forecasting approach
In this forecasting approach, the most common variables include GDP forecast, consumption forecasts, inflation projections, foreign exchange currency rates, industry sales and market share.
Top-down forecasting approach
The result of this forecasting approach is the forecasted sales volume of the company. Revenue forecast will be built from this combined with the company-set sales prices.
Top-down 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.
Bottom-up forecasting approach
Store expansions and increase in product availability is collated in this forecasting approach and revenues resulting from these are calculated.
Bottom-up forecasting approach
Analysts should consider whether the resulting value from preparing valuation model based on forecasts makes sense based on their knowledge about the business using two aspects:
Sensitivity analysis
Situational adjustments or Scenario Modelling
A common methodology used in valuation exercises wherein multiple analyses are done to understand how changes in an input or variable will affect the outcome.
Sensitivity analysis
Assumptions that are commonly used as an input for sensitivity analysis:
Sales growth
Gross margin rates
Discount rates
Market share
Advertising expense
Discounts
Differentiated feature
For firm-specific issues that affect firm value that should be adjusted by analysts.
Situational adjustments or Scenario Modelling
Factors that do not affect value per se but will still influence value regardless:
Control premium
Absence of marketability discounts
Illiquidity discounts
Additional value considered in a stock investment if acquiring it will give controlling power to the investor.
Control premium
The stock cannot be easily sold as there is no ready market for it (e.g. non-publicly traded discount).
Lack of marketability discount
This discount should be considered when the price of particular shares has less depth or generally considered less liquid compared to other active publicly traded share.
Illiquidity discounts
Discounts considered if an investor will sell large portion of stock that is significant compared to the trading volume of the stock.
Illiquidity discount
Both of these discounts drive down share value.
Lack of marketability discount
Illiquidity discount
6 Key Principles in Valuation
- The value of a business is defined ony at a specific point in time.
- Value varies based on the ability of business to generate future cash flows.
- Market dictates the appropriate rate of return for investors.
- Firm value can be impacted by underlying net tangible assets.
- Value is influenced by transferability of future cash flows.
- Value is impacted by liquidity.
The possible range of values where the real firm value lies.
Captured in valuation models through cost of capital or discount rate.
Uncertainty
