ACCELE2 – Professional Elective 2 When the interest on the homebuyers’ adjustable

rate increased, many could no longer afford the

Module 1: Fundamental Principles of Valuation payments. Reflecting their distress, the real estate
Let us understand why we need to value "value" market crashed, pushing the value of many homes
by looking unto the consequences of not below the value of loans taken out to buy them. At
valuing value... that point, homeowners could neither make the
required payments nor sell their houses. Seeing
When managers, boards of directors, and investors this, the banks that had issued short-term loans to
have forgotten these simple truths, the investors in securities backed by mortgages
consequences have been disastrous. The rise and became unwilling to roll those loans over, prompting
fall of business conglomerates in the 1970s, hostile all the investors to sell their securities at once.
takeovers in the United States in the 1980s, the
collapse of Japan’s bubble economy in the 1990s, The value of the securities plummeted. Finally,
the Southeast Asian crisis in 1998, the Internet many of the large banks themselves had these
bubble, and the economic crisis starting in 2007— securities on their books, which they, of course, had
all of these can be traced to a misunderstanding or also financed with short-term debt that they could
misapplication of the cornerstones. During the no longer roll over.
Internet bubble, for instance, managers and
This story reveals two fundamental flaws in the
investors lost sight of what drives ROIC, and many
decisions taken by participants in the securitized
even forgot its importance entirely.
mortgage market. First, they all assumed that
Between 1995 and 2000, more than 4,700 securitizing risky home loans made them more
companies went public in the United States and valuable because it reduced the risk of the assets—
Europe, many with billion-dollar-plus market but this violates the conservation of-value rule. The
capitalizations. Some of the companies born in this aggregated cash flows of the home loans were not
era, including Amazon, eBay, and Yahoo!, have increased by securitization, so no value was
created and are likely to continue creating created and the initial risks remained.
substantial profits and value. But for every solid,
Securitizing the assets simply enabled risks to be
innovative new business idea, there were dozens of
passed on to other owners; some investors,
that couldn’t similarly generate revenue or cash flow
somewhere, had to be holding them. After the
in either the short or long term. The initial stock
housing market turned, financial service companies
market success of these companies represented a
feared that any of their counterparties could be
triumph of hype over experience.
holding massive risks and almost ceased to do
Ignoring the cornerstones also underlies financial business with one another. This was the start of the
crises, such as the one that began in 2007. When credit crunch that triggered a protracted recession
banks and investors forgot the conservation-of- in the real economy.
value principle, they took on a level of risk that was
The second flaw in thinking made by decision
unsustainable.
makers during the past economic crisis, was in
First, homeowners and speculators bought homes believing that using leverage to make an investment
—essentially illiquid assets. They took out in itself creates value. It doesn’t because, according
mortgages with interest set at artificially low teaser to the conservation-of-value principle, leverage
rates for the first few years, but then those rates doesn’t increase the cash flows from an investment.
rose substantially. Both the lenders and buyers Many banks, for example, used large amounts of
knew that buyers couldn’t afford the mortgage short-term debt to fund their illiquid long-term
payments after the teaser period. But both assumed assets. This debt didn’t create long-term value for
that either the buyer’s income would grow by shareholders in those banks. On the contrary, it
enough to make the new payments, or the house increased the risks of holding their equity.
value would increase enough to induce a new
lender to refinance the mortgage at similarly low
teaser rates. Banks packaged these high-risk debts
into long-term securities and sold them to investors.
The securities, too, were not very liquid, but the
investors who bought them, typically hedge funds
and other banks, used short-term debt to finance
the purchase, thus creating a long-term risk for
those who lent the money.
What does it mean to create shareholder value? detecting them, even with the help of a professional
house inspector.
Particularly at this time of reflection on the virtues
and vices of capitalism, it’s critical that managers Despite such challenges, the evidence strongly
and board directors have a clear suggests that companies with a long strategic
understanding of what value creation means. For horizon create more value than those
value-minded executives, creating value cannot be run with a short-term mindset. Banks that had the
limited to simply maximizing insight and courage to forgo short-term profits
today’s share price. Rather, the evidence points to a during the last decade’s real-estate bubble, for
better objective: maximizing a company’s collective example, earned much better total shareholder
value to its shareholders, now and in the future. returns (TSR) over the longer term. In fact, when we
studied the patterns of investment, growth, earnings
If investors knew as much about a company as its quality, and earnings management of hundreds of
managers do, maximizing its current share price companies across multiple industries between 2001
might be equivalent to maximizing and 2014, we found that companies whose focus
its value over time. But in the real world, investors was more on the long term generated superior TSR,
have only a company’s published financial results with a 50 percent greater likelihood of being in the
and their own assessment of the top decile or top quartile by the end of that 14-year
quality and integrity of its management team. For period. In separate research, we’ve found that long-
large companies, it’s difficult even for insiders to term revenue growth—particularly organic revenue
know how financial results are generated. growth—is the most important driver of shareholder
returns for companies with high returns on capital.
Investors in most companies don’t know what’s
What’s more, investments in research and
really going on inside a company or what decisions
development (R&D) correlate powerfully with long-
managers are making. They can’t know, for
term TSR.
example, whether the company is improving its
margins by finding more efficient ways to work or by Managers who create value for the long term do not
skimping on product development, resource take actions to increase today’s share price if those
management, maintenance, or marketing. actions will damage the company down the road.
For example, they don’t shortchange product
Since investors don’t have complete information,
development, reduce product quality, or skimp on
companies can easily pump up their share price in
safety. When
the short term or even longer. One global consumer
considering investments, they take into account
products company consistently generated annual
likely future changes in regulation or consumer
growth in earnings per share (EPS) between 11
behavior, especially with regard to
percent and 16 percent for seven years. Managers
environmental and health issues. Today’s
attributed the company’s success to improved
managers face volatile markets, rapid executive
efficiency. Impressed, investors pushed the
turnover, and intense performance pressures,
company’s share price above those of its peers—
so making long-term value-creating decisions
unaware that the company was shortchanging its
requires courage. But the fundamental task of
investment in product development and brand
management and the board is to demonstrate that
building to inflate short-term profits, even as
courage, despite the short-term consequences, in
revenue growth declined. Finally, managers had to
the name of value creation for the collective
admit what they’d done. Not surprisingly, the
interests of shareholders, now and in the future.
company went through a painful period of
rebuilding. Its stock price took years to recover.

It would be a mistake, however, to conclude that the Overview of Valuation Concepts and Methods
stock market is not “efficient” in the academic sense
that it incorporates all public WHAT and WHY?
information. Markets do a great job with public
information, but markets are not omniscient. The fundamental point behind successful
Markets cannot price information they investments is understanding what is the prevailing
don’t have. Think about the analogy of selling an value and the key drivers that influence this value.
older house. The seller may know that the boiler In this lesson, the valuation and the processes in
makes a weird sound every once in a valuation will be discussed.
while or that some of the windows are a bit drafty.
According to the CFA Institute, valuation is the
Unless the seller discloses those facts, a potential
estimation of an asset's value based on variables
buyer may have great difficulty
perceived to be related to future investment returns,
on comparison with similar assets, or when that will become the market value when other
relevant, on estimates of immediate liquidation investors reach the same conclusion.
proceeds. It includes the use of forecasts to come
up with reasonable estimate of value of an entity's
assets or its equity. 2. Going Concern Value – the going concern
assumption believes that the entity will continue
Valuation places great emphasis on the to do its business activities into the foreseeable
professional judgment that are associated in the future.
exercise. As valuation mostly deals with projections
about future events, analysts should hone their
ability to balance and evaluate different 3. Liquidation Value – the net amount that would
assumptions used in each phase of the valuation be realized if the business is terminated and the
exercise, assess validity of available empirical assets are sold piecemeal. It is particularly relevant
evidence and come up with rational choices that for companies who are experiencing severe
align with the ultimate objective of the valuation financial distress.
activity.

4. Fair Market Value – the price, expressed in

terms of cash equivalents, at which property
Key Principles in Valuation would change hands between a hypothetical
willing and able buyer and a hypothetical willing
- The value of a business is defined only at and able seller, acting at arm’s length in an open
a specific point in time. and unrestricted market, when
- Value varies based on the ability of neither is under compulsion to buy or sell and when
business to generate future cash flows. both have reasonable knowledge of the relevant
- Market dictates the appropriate rate of facts.
return for investors.
- Firm value can be impacted by underlying
net tangible assets.
- Value is influenced by transferability of Roles of Valuation in Business
future cash flows.
Valuation is an essential tool for business owners to
- Value is impacted by liquidity.
assess both opportunities and opportunity
costs associated with the business resources. It
helps them manage the business because they are
Risks in Valuation able to track the effectiveness of the decision-
making process and provide them the ability to track
In all valuation exercises, uncertainty will performance in terms of estimated change in value,
be consistently present. Uncertainty refers to the not just in revenue.
possible range of values where the real firm value
lies. When performing any valuation method, I. Portfolio Management
analysts will never be sure if they have accounted 1. Fundamental Analyst – these are persons who
and included all potential risks that may affect price are interested in understanding and measuring the
of assets. Some valuation methods also use future intrinsic value of a firm. Fundamentals refer to the
estimates which bear the risk that what will actually characteristics of an entity related to its financial
happen may be significantly different from the strength, profitability or risk appetite.
estimate.
2. Activist Investors – activist investors tend to
look for companies with good growth prospects that
have poor management. Activist investors usually
Objective of the Valuation Exercise do “takeovers” – they use their equity holdings to
push old management out of the company and
The definition of value may vary depending on the
change the way the company is being run.
context and objective of the valuation exercise.
3. Chartists – they rely on the concept that stock
1. Intrinsic Value – refers to the value of any asset
prices are significantly influenced by how investors
based on the assumption assuming there is a
think and act and on available trading KPIs such as
hypothetically complete understanding of its
price movements, trading volume, short sales –
investment characteristics. It is the value that an
when making their investment decisions.
investor considers, on the basis of an evaluation or
available facts, to be the “true” or “real” value
4. Information Traders – they react based on new 1. Understanding the business – it includes
information about firms that are revealed to the performing industry and competitive analysis and
stock market. The underlying belief is that analysis of publicly available financial information
information traders are more adept in guessing or and corporate disclosures. An investor should be
getting new information about firms and they can able to encapsulate the industry structure. One of
make predict how the market will react based on the most common tools used in encapsulating
this. industry is Porter’s Five Forces:

Valuation Techniques in Portfolio Management

∙ Stock selection
∙ Deducing market expectations

II. Business Deals for Analysis

 Acquisition – an acquisition usually

has two parties: the buying firm that
needs to determine the fair value of
the target company prior to offering a
bid price and the selling firm who Generic Corporate Strategies to achieve
gauge reasonableness of bid offers. Competitive Advantage
 Merger – transaction of two - Cost leadership: incurring the lowest cost among
companies’ combined to form a wholly market players with quality that is comparable to
new entity. competitors allow the firm to be price products
 Divestiture – sale of a major around the industry average.
component or segment of a business - Differentiation: offering differentiated or unique
to another company. product or service characteristics that customers
 Spin-off – separating a segment or are willing to pay for an additional premium.
component business and transforming - Focus: identifying specific demographic segment
this into a separate legal entity whose or category segment to focus on by using cost
ownership will be transferred to leadership strategy or differentiation strategy.
shareholders.
Other ways to understand a business include
 Leverage buyout – acquisition of
the following:
another business by using significant
debt which uses the acquired a. understanding the company's business model
business as a collateral. which pertains to the method on how the company
makes money.

b. analysis of historical and financial reports which

The Valuation Process use horizontal, vertical, and ratio analysis and their
interpretations.
Generally, the valuation process considers five
steps. c. analysis of quality earnings which pertain to the
detailed review of financial statements and
accompanying notes to assess sustainability of
company performance and validate accuracy of
financial information versus economic reality.

2. Forecasting financial performance – can be

looked at two perspectives: on a macro perspective
viewing the economic environment and industry
where the firm operates in and micro perspective
focusing in the firm’s financial and operating
characteristics.
Two Approaches of Forecast Financial Limitation: Only reflects historical value (only based
Performance on what is recorded in the accounting books) and
- Top down forecasting approach: international or might not reflect the real value of the business now.
national macroeconomic projections with utmost
consideration to industry specific forecasts. Your Task:
- Bottom-up forecasting approach: forecast starts
Assuming you are the accountant of Green Tea
from the lower levels of the firm and builds the
Company who looks at the different account
forecast as it captures what will happen to the
balances in the company records. You are asked to
company.
provide preliminary valuation numbers for an
3. Selecting the right valuation model – it upcoming management discussion. The following
depends on the context of the valuation and the account balances were generated from the records:
inherent characteristics of the company being
Accounts payable
valued.
20,000
4. Preparing valuation model based on forecasts
Accounts receivable
there are two aspects to be considered:
70,000
- Sensitivity analysis: common methodology in
valuation exercises wherein multiple other analyses Accrued liabilities 1,000
are done to understand how changes in an input or
variable will affect the outcome. Cash
50,000
- Situational adjustments: firm specific issues that
affects firm value that should be adjusted by Intangible Assets 70,000
analysts since these are events that are not
quantified if analysts only look at core business Inventory
operations. 52,000

5. Applying valuation conclusions and providing Long-term investments

recommendation. 150,000

Long-term liabilities 125,000

Module 2: Asset-Based and Liquidation-Based Marketable securities 46,000

Valuation
Notes payable (short-term) 25,000
Book Value Method
Property, plant and equipment 705,000
Book value is total assets minus total liabilities and
Prepaid expenses 3,000
is commonly known as net worth. The book value
is highly dependent on the value of the assets as
declared in the audited financial statements,
particularly the balance sheet or the statement of Compute the following:
financial position.
1. Total current assets =
The assets are required to be categorized into
current and non-current assets. On the other hand, 2. Total non-current assets =
liabilities is also categorized as current and non-
3. Total current liabilities =
current. In the book value method, the value of the
enterprise is based on the book value of the assets 4. Total noncurrent liabilities =
less all non-equity claims against it and is computed
as follows: 5. Book value of Green Tea Company =

Net Book Value of Assets = (Total Assets - Total 6. Book value per share =
Liabilities) / No. of Outstanding Shares

Advantage: It provides a more transparent view on

firm value and is more verifiable since this is based Replacement Value Method
in the figures reflected in the financial statements.
Under the replacement value method, the value of
the individual assets shall be adjusted to reflect the
relative value or cost equivalent to replace that
asset. The following are the factors that can affect
the replacement value of an asset:

1. age of the asset: It is important to know how

old the asset is. This will enable the evaluator to
determine the costs related in order to upkeep a
similarly aged asset and whether assets with similar
engineering design are still available in the market.

2. size of the asset: This is important for fixed

assets particularly real property where assets of the
similar size will be compared. Some analysts find
that the assets can produce the same volume for
the assets of the same size.

3. competitive advantage of the asset: Assets

which have distinct characteristics are hard to
replace. However, the characteristics and
capabilities of the distinct asset might be found in
similar, separate assets. Some valuators combine
the value of the similar, separate assets that can
perform the function of the distinct asset being
valued.

*There is no specific discipline in determining the

replacement value. Appraisers have their own
technique to determine the replacement value.

The value of the equity using the replacement

value method is computed using the formula:

Replacement value per share = (Net Book Value +/-

replacement adjustments) / Outstanding Shares
Your Task:

Caramel Company showed the following balances

To illustrate, Fabulous Company in the year 20XX in its balance sheet as at year-end:
presented its statement of financial position with the
following balances: Current Assets is Php500 Current Assets Php
Million; Non-Current Assets is Php1 Billion; Current 450,000
Liabilities is Php200 Million; Non-Current Liabilities
Non-Current Assets
is Php700 Million and the outstanding shares is P1
1,150,000
Million. Suppose that 50% of the non-current
assets has an estimated replacement value of Current Liabilities
150% of its recorded net book value while the 300,000
remaining half has estimated replacement value of
75% of their recorded net book value. Non-Current Liabilities
900,000
With the given information, the equity value is
adjusted: Weighted Average of outstanding shares
120,000 shares
According to the appraiser, 60% of the non-current noncurrent assets are comprised of goodwill which
assets can be replaced at 150% of their reported upon testing was proven to be valued correctly.
book value while the remaining balance of the non-
current assets has replacement value of 65%.
Reported balance of other items approximates their
replacement value. Compute the replacement
value of Caramel Company at year-end.

Reproduction Value Method

In some instances, no external information is

available that can serve as basis for replacement
costs of assets that are highly specialized in
nature. In this case, reproduction value is used
instead.

Reproduction value is an estimate of cost

reproducing, creating, developing or manufacturing
a similar asset. The reproduction value method
requires reproduction cost analysis which is
internally done by companies especially if the
assets are internally developed. Hence, this
method is useful when calculating the value of new
or start-up businesses, ventures that use
specialized equipment or assets, firms that are
heavily dependent on intangible assets and those
with limited market information. While this is a
convenient approach, the challenge of using Your Task:
reproduction value method is the ability to validate
the reasonableness of the value calculated since Samsan Company, a start-up company which
there are only limited sources of comparators and developed its own data imaging algorithm, is trying
benchmark information that can be used. to estimate the value of their company. Their latest
financial statement showed the following
Steps in determining the equity value using the information:
reproduction value method are as follows:
Current Assets 1,250,000
1. Conduct reproduction costs analysis on all
assets. Non-Current Assets
4,000,000
2. Adjust the book values to reproduction costs
values (similar as replacement value) Current Liabilities 850,000

3. Apply the replacement value formula using the Non-Current Liabilities

figures calculated in the preceding step. 250,000

Part of their non-current assets is a patent for the

technology they developed which has a recorded
To illustrate, using the information of Fabulous balance of P2,500,000. An equity investor is
Company: looking at buying the company. Samsan Company
tried to trace back the costs of developing the
Current Assets is Php500 Million; Non-Current
patent and determined that the reproduction cost of
Assets is Php1 Billion; Current Liabilities is Php200
that particular patent is P3,000,000. What is the
Million; Non-Current Liabilities is Php700 Million and
reproductive value of Samsan Company?
the outstanding shares is P1 Million.

Suppose that it was noted that the 80% of the total

noncurrent assets are cheaper by 90% of the book
value when reproduced. 20% of the total
Liquidation Value Method