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Valuation Research

Foundations of Valuation
Every day, businesses face decision choices. For example, should a bank choose to expand
organically by opening new branches, or should it expand by acquiring another bank with its own
network of branches. Or, should a technology company release a new version of a product line
now, and thereby cannibalize sales of its existing product line, or should it wait a year at the risk
of giving its competitors time to catch up. The key to success in business is to make sound, or
value-creating, business decisions. Every choice a business manager can potentially make has risk
associated with it. In turn, every choice also has some upside, or positive return, associated with
it. A sound decision is one that balances this risk and return to create value for the owners of the
business, whether those are public shareholders or a private ownership group. However, to make
value-creating business decisions, a manager needs to be able to first quantify, or measure, the risk
and return inherent in each of the decision choices he is facing, and then convert these risk-return
combinations into ex-ante measures of value creation. This is where the topic of valuation comes
into play. Valuation is simply the conversion of risk and return into monetary value. The value
could be of intangible assets like ideas or potential projects, or it could be of tangible assets like a
manufacturing plant or the shares of a business. The common theme underlying valuation,
however, is that it allows managers to make better business decisions by quantifying into a single
metric the risk and return inherent in all business decision choices.
Every decision that a business faces can be conceptualized as a node on a decision tree, as
shown in Figure 1.1. A manager facing a decision is trying to decide which of multiple paths
emanating from this node he wants to take for the business. The figure illustrates the example of a
manager deciding whether to build a manufacturing plant. The two possible paths are to build the
plant or to not build the plant. Once the initial decision to build or not build is made, the decision
tree branches off again into the capacity of the plant and again to the number of assembly lines.
Each of the branches represents a set of possible outcomes that could occur. The role of valuation,
then, is to quantify the value created (or destroyed) by deciding to head down a specific path. For
example, the value created by building a plant with a 100,000 unit capacity containing one large
assembly line would need to be quantified, as would the value created by not building a plant at
Note, however, that this path is only a decision path; it is not an outcome path. While a
manager may decide to take a particular path, the result from taking the path is uncertain, and it
might take many years before it becomes a known quantity. A more quantitative way to state this
is that there is a probability distribution of possible results from the decision to take a path.
Therefore, the process of valuation must take into account this probability distribution of outcomes
(or risk) involved in taking a specific path.
*Chacko G., & Evans C., Valuation: Methods and Models in Applied Corporate Finance.
Retrieved from
Definitions of valuation
Valuation means finding out correct value of the assets on a particular date. It is an act of
determining the value of assets and critical examination of these values on the basis of normally
accepted accounting standard. Valuation of assets is to be made by the authorized officer and the
duty of auditor is to see whether they have been properly valued or not. For ensuring the proper
valuation, auditor should obtain the certificates of professionals, approved values and other
competent persons. Valuation is the primary duty of company officials. Auditor can rely upon the
valuation of concerned officer but it must be clearly stated in the report because an auditor is not
a technical person. Without valuation, verification of assets is not possible.
If the valuation of assets is not correct, both the financial statements such as Balance Sheet
and Profit and Loss Account cannot be correct. Hence, the auditor must take utmost care while
valuing the assets to show true and fair view of the state of affairs of the financial position of the
*Retrieved from http://www.brainkart.com/article/Valuation--Meaning,-Definition,Objectives,-Methods_37599/
Valuation is the analytical process of determining the current (or projected) worth
of an asset or a company. There are many techniques used for doing a valuation. An analyst
placing a value on a company looks at the business's management, the composition of
its capital structure, the prospect of future earnings, and the market value of its assets,
among other metrics.
Simply, valuation is a quantitative process of determining the fair value of an asset
or a firm.
*Retrieved from https://www.investopedia.com/terms/v/valuation.asp#:~:text=
Frameworks for valuation
Target price of a security is the fair price usually expected to be met within a 12-month
investment horizon (if not state otherwise) derived by employing either absolute valuation tools &
methods such as Discounted Cash-Flow model (DCF), Discounted Dividend model (DDM),
Residual income (RI), sum-of-parts method or relative models such as peer group multiples.
All valuation methods are based on either top-down or bottom-up integrated models for
every stock included in AFR coverage universe and imply a minimum 5-year period of detailed
forecasts (Income Statement, Balance Sheet, Cash Flow Statement) constructed based on a
comprehensive analysis of all relevant publicly available information and analyst’s best judgment
at the date of the report. Frequently used assumptions refer to (and are by no means exhaustive)
earnings KPIs (prices/tariffs, volumes, market positioning, sector evolution, investment plans,
working capital needs etc.) which may differ depending on the companies’ specifics. However, by
using Excel standardized modeling tools we ensure consistency and comparability within our
coverage and peer group. Valuation conclusions are not disclosed prior to the public issuance of
AFR research reports.
Most commonly used valuation methods
1. Discounted Cash-flow Model (DCF)
DCF valuation tool is used to derive the value of a firm and asses the attractiveness of the
investment. The tool takes into consideration time value of money and, thus, discounts future cash
flow projections using an appropriate discount factor – usually the weighted average cost of capital
(WACC)- to arrive at a present value, frequently compared to the cost of an immediate investment.
Should fair value of the firm be higher than current cost of the investment, it may prove to be a
good investment opportunity.
As a standard model, we use a Free Cash Flow to Firm (FCFF) model. FCFFs are modeled
based on financial theoretical guidelines:
Free Cash Flow = NOPLAT + Depreciation & Amortization - gross investment in PPE &
Intangibles +/- change in Working Capital +/- change in long-term provisions
Net operating profit less adjusted taxes (NOPLAT) is a financial metric that refers to total
operating profits generated by the company's core operations after adjusting for income taxes
related to those operations.
We compute terminal value as: Terminal value (TV) = Last explicitly forecast
FCFF*(1+sustainable earnings growth)/(WACC – sustainable earnings growth).
The discount factor is based on the cost of capital, most specifically on the cost of each
component weighted by its relative market value (Weighted Average Cost of Capital – WACC).
Please note that the company may choose to finance its operations via either own capital or a mix
of equity and debt.
For modeling the company’s cost of debt, we usually consider the market rate that it
currently pays on its long-term debt and base our longer-term assumptions on the underlying yield
Cost of equity, on the other hand, is based on the Capital Asset Pricing Model (CAPM), a
model that describes the relationship between systematic risk (Beta) and expected returns of the
stocks. Based on CAPM guidelines, we add to our risk-free rate assumption an equity market
premium adjusted with the company’s levered beta. Risk free rates used reflect Romanian
benchmark government bond yield curve at the time of the report. Furthermore, we base our beta
(β) assumption on a Blume-adjusted two-year weekly benchmarked-to-BET assessment. Levered
beta is adjusted for the company’s specific financing structure.
An alternative to Free Cash Flow to the Firm model is Free Cash Flow to Equity. This version
discounts all future cash flow projections available to equity holders at the cost of equity (not
weighted average cost of capital).
2. Dividend Discounted Model (DDM)
DDM is a valuation tool based on the general principle that the value of the stock should be
the present value of expected dividends. The model requires two basic inputs – expected dividends
and cost of equity used as discount factor. Projected dividends rely on assumptions of future
earnings’ growth rates and payout ratios whereas the cost of equity is based on CAPM model.
Furthermore, we estimate terminal values (after our explicitly forecast period) based on Gordon
Growth Model:
Terminal value (TV) = Last explicitly forecast DPS*(1+ sustainable earnings growth)/(cost of
equity – sustainable earnings growth).
3. Sum-of-parts valuation method
The sum-of-parts valuation method is the process of valuing the company by aggregating the
standalone value of its business units/divisions/lines in order to determine a single total enterprise
value (EV) which is afterwards adjusted for net debt, other nonoperating assets and minorities.
Each division can be separately valued using a different valuation model/method. The method is
recommended for conglomerates comprised of business units in different industries or performing
different core operations. It can be used as a defense tool against a hostile takeover by highlighting
that the company’s value exceeds its sum-of-parts value due to presence of synergies and
economies of scale.
4. Relative valuation
Relative valuation method uses current valuation ratios of comparable companies (in terms of size,
financing structure, operations etc.) to derive a fair value estimate for a company. Most frequently,
valuation ratios refer to trading multiples which are compared with those of the peer group. Peer
group companies are listed companies which analysts see as a comparable proxy of the company
under review. Usually companies from the same industry are seen as peers although there can be
a wide range of criteria used in the selection process: size, growth prospects, financing structure,
similar end-customer markets etc.
Price multiples
Price multiples refer to any ratio that uses the share price of the company in conjunction with any
other per-share financial metric. Most frequently used price multiples are P/E (Price-to-earnings),
P/B (Price-to-book), P/S (Price-to-sales), P/CF (Price-to-CashFlow).
Price-to-Earnings (P/E) is a valuation ratio comparing the stock price of a company to its earnings
per share, underscoring how much investors are willing to pay for the company’s earnings. The
fair value per share is derived by multiplying the estimated earnings per share by the peer group
P/E (average peers’ P/E).
Price-to-Book (P/B) is a valuation ratio comparing the price stock of a company to its book value
per share, indicating how much investors are willing to pay for the book value of a company. The
fair value per share is derived by multiplying the estimated book value per share by the peer group
P/B. Enterprise Value (EV) multiples Enterprise Value multiples consider the impact of a
company’s financing structure (leverage). Most frequently used Enterprise Value (EV) multiples
are EV/Sales (Enterprise Value-to-Sales), EV/EBITDA (Enterprise value-to-Earnings before
Interest, Tax, Depreciation and Amortization) or EV/EBIT (Enterprise Value-to- Earnings before
Interest and Tax). The multiples are computed by dividing Enterprise Value by the respective
Sales, EBIDTA and EBIT figures and indicate how many times an investor are willing to pay for
the company’s sales, EBITDA and EBIT. In any of the three cases, the fair value per share is
derived by multiplying the estimated Sales, EBITDA or EBIT by the respective peer group EV
multiple (deducting the market value of net debt, minority interests and other adjustments) and
dividing by the total number of shares outstanding.
*Retrieved from https://www.alphafinance.ro/upload/files/Concepts_Methods.pdf
Concepts of valuation
Estimating the worth of an asset or a security or a business is termed as "valuation". Any
investor would be interested in knowing the value of a business before purchasing a major portion
of the assets or a security. The task of valuation involves not only the estimating the values of the
existing plant and equipment, machinery, furniture & fittings etc., but also of intangible assets like
patents, copyrights, good will etc. The process of valuation would also include any unrecorded
contingent liabilities so that the purchaser is totally aware of the entire business assets and
liabilities as on a particular date. The valuation process is thus influenced and affected by
subjective considerations. The following concepts of valuation are generally used to help the
finance manager arrive at a more accurate valuation, reducing the element of subjectivity to the
maximum possible extent.
Book value - Book value is the accounting record value of assets that is shown in the
balance sheet. It is usually the purchase cost of an asset less the accumulated depreciation on it. It
may not reflect the sale value or the fair value of the asset. This valuation is based on the going
concern principle of accounting. It is the total book value of all the assets that are valuable
excluding the fictitious assets, minus the external liabilities. It is otherwise known as the net worth.
Market value - Market value is the value at which an asset or a security of a company can
be sold in the market. Market value can be applied to tangible assets only because intangible assets
cannot be sold generally. The total market value of all the outstanding equity shares as quoted in
the stock market can be referred as the market value of a business. Market value can be ascertained
for listed corporates only.
Intrinsic/Economic value - The present value of all the incremental future cash flows can
be termed as the intrinsic value. The present value is arrived by discounting the incremental cash
flows at an appropriate discount rate. The maximum price at which a business can be acquired is
the economic value.
Liquidation value - This represents the price at which each individual asset can be sold in
the event of liquidation of business. It is valued after subtracting all the external liabilities. The
liquidation value would generally be the least.
Replacement value - It is the cost of purchasing or replacing a new asset which is of equal
utility to the business. It is generally applied to tangible assets like equipment, plant etc.
Salvage value - Salvage value, also called as the scrap or residual value is the sale value
of an old asset after its usage.
Valuation of goodwill - Valuation of goodwill is one of the toughest as goodwill is nonmonetary. A business is said to have a real goodwill if it can earn a higher rate of return on an
investment when compared with its competitor having the same risk. When the firm earns super
profits, goodwill results. It can be valued as the present value of all the future expected super
profits for ‘n’ number of years. It is very useful in merger and acquisition decisions.
Fair value - fair value is based on all of the valuations explained above. Particularly, it is
the average of the market value, book value and the intrinsic value.
Objectives/uses of valuation
To assess the correct financial position of the concern.
To enquire about the mode of investment of the capital of the concern.
To assess the goodwill of the concern.
To evaluate the differences in the value of the asset as on the date of purchase and on the
date of Balance Sheet.
*Retrieved from http://www.brainkart.com/article/Valuation--Meaning,-Definition,Objectives,-Methods_37599/
The standard measure that delivers the expected value created by a business decision,
incorporating the full probability distribution of possible results, or payoffs, is present value.
Importance/rationale of valuation
Valuation for Mergers, Acquisitions & Sales
Interested parties during a merger, acquisition, or sale need to obtain the best fair
market price of the business entity. They need to look at their return on their
investment. (your company is their capital being deployed). This will ultimately be negotiated
between the buyer and the seller.
In buy-sell agreements, you transfer equity or assets between partners and/or shareholders.
Valuation for Estate & Gifting
Death is a fact that everyone is going to face. But the timing of that event varies for different
people. If your business is part of your estate, you need to conduct a valuation of your business.
This can be done either prior to estate planning, gifting of interests, or after the death of the owner.
The IRS also requires this type of valuation for charitable donations.
Valuation for Disputes (Shareholder)
Occasionally, a breakup of the company is in the shareholder’s best interests. This could also occur
when shareholders are withdrawing and need to transfer their shares.
Valuation for Financing
Banks hate risk. As a result, they need to validate their investment in your company before they
provide capital. At this point, they request for a business appraisal of your assets.
*Retrieved from https://strategiccfo.com/why-valuation-matters/
1. Better Knowledge of Company Assets
It is significantly important to obtain an accurate business valuation assessment. Estimates
are not acceptable as it is a generalization.
Specific numbers need to be gained from valuation processes so that business owners can
obtain proper insurance coverage, know how much to reinvest into the company, and how much
to sell your company for so that you still make a profit.
2. Understanding of Company Resale Value
If you are contemplating selling your company, knowing its true value is necessary. This
process should be started far before the business goes up for sale on the open market because you
will have an opportunity to take more time to increase the company's value to achieve a higher
selling price. As a business owner, you should know what your company's valuation is.
You also need to be aware of what your company's resale value really is in order to
negotiate a higher selling price. Use black and white statistics, provided by a valuation firm, to
solidify your stance on the higher selling price.
A. Neumann & Associates, LLC CEO Achim Neumann said, "We are approached by
business owners to have the value of their business determined two to four years prior to its
contemplated sale."
3. Obtain a True Company Value
You may have a general idea of what your business is worth, based upon simple data such
as stock market value, total asset value and company bank account balances. But, there is much
more to business valuations than those simple factors. Work with a reputable valuations company
to ensure that the correct numbers are provided.
Knowing the true value of your company is often a deciding factor if selling the business
becomes a possibility. It also helps to show company income and valuation growth over the course
of the previous five years. Potential buyers like to see that a company has seen regular, consistent
growth as it ages.
4. Better During Mergers/Acquisitions
If a major company asks about purchasing your company, you have to be able to show
them what the value is as a whole, what its asset withholdings are, how it has grown, and how it
can continue to grow. Major corporations will attempt to acquire your business or merge with it
for as little money as possible.
When you know what your business valuation really is, you are able to negotiate your way
to the appraised valuation numbers provided by a well-known and reputable valuation
determination service.
If you are offered less for your company than it is shown to be worth, reject the deal or
offer to enter negotiation mediation. It will help both sides come to a comfortable agreement.
5. Access to More Investors
When you seek additional investors to fund company growth or save it from financial
disaster, the investor is going to want to see a full company valuation report. You should also
provide potential investors with a valuation projection based upon their provided funding.
Investors like to see where their money is going and how it is going to provide them with a return
on the investment.
You are more likely to gain the attention of a potential investor when they can see that their
funds will carry the company to the next level, increase its value, and put more money back into
their own products.
*Retrieved from https://www.inc.com/chirag-kulkarni/5-benefits-of-getting-a-businessvaluation.html
Fundamental principles of valuation or value creation
1. Future Profitability
Future profitability is the only thing that determines the current value. The price should be
based on what a buyer can expect in future earnings, not how the business performed in the
past. Past revenue tells us about business momentum but we are more focused on what’s left over
after all the expenses of running the business have been paid.
2. Cash Flow
Insurance or financial service businesses don’t have many tangible assets, so the real value
is in the cash flow generated through clients (specifically the cash flow over and above the cost of
running the business).
3. Potential Risk
Simply put, less risk is rewarded with a higher price. The more risk a buyer must assume,
the less they’re willing to pay. The greater the certainty that a percentage of cash flow comes from
recurring cash flow and the sustainability of recurring cash flow will decrease the risk and increase
the valuation price.
4. Objectivity vs Subjectivity
There is a mix of art and science that goes into valuing a book of business. There’s an
objective review of revenue, expenses but then there’s the subjective view on understanding what
might make one book more valuable than another (even if they generate the same revenue). The
subjective side might include looking at the deal itself; terms of payment, guarantees, claw-back
clauses and the seller’s involvement in the transition.
5. Motivation and Determination
At the end of the day, it doesn’t matter how accurate or realistic the valuation put on a
business. The final price will be determined by the two parties involved and how motivated and
determined they are to complete the deal. The best outcome is when both the seller and buyer feel
that they’ve met a fair price.
*Retrieved from https://blog.findbob.io/5-basic-principles-of-valuation