CHMSC-VALCOM 2nd sem. AY2021-2022
MODULE 1. OVERVIEW OF VALUATION TECHNIQUES
Learning Objectives:
After successful completion of this module, you should be able to:
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Identify the relevance Of your accounting skills in valuation
Define Valuation and understand the different valuation techniques
Describe the asset and equity valuation
Identify what and when to use the valuation methods appropriately
Distinguish absolute versus relative valuation
What is Valuation?
(source: corporatefinanceinstitute.com)
Valuation refers to the process Of the present value Of a company Or an asset. It can be done using a
number Of techniques. Analysts that want to place value On a company normally look at the
management of the business, the prospective future earnings, the market value of the company's assets,
and its capital structure composition.
Valuation may also be used in determining a security's fair value, which depends on the amount that a
buyer is ready to pay a seller, with the assumption that both parties will enter the transaction
During the trade of a security on an exchange, sellers and buyers will dictate the market value of a bond
or stock. However, intrinsic value is a concept that refers to a security's perceived value on the basis of
future earnings other attributes of the entity that are not related to a security's market value. Therefore,
the work of analysts when doing valuation is to know if an asset or a company is undervalued or
overvalued by the market.
Valuations can be performed on assets or on liabilities such as company bonds. They are required for a
number of reasons including merger and acquisition transactions, capital budgeting, investment analysis,
litigation, and financial reporting.
Basic Principles of Accounting
In performing valuations, one should be equipped with analytical skills. These skills should not
only be on intelligence and reasonable ideas, good recommendations and excellent analysis. It should
also be anchored with the principles that guide accountants to provide ethical practices for decision
making.
The accounting principles are concepts that serve as basis in preparing and interpreting the financial
statements. These are the basic foundations that guide prepares into the financial reports to the users
and the users to be confident of what they read.
The Conceptual Framework Of Accounting specifically mentions the underlying assumption Of going
concern Which contemplate the realization Of assets and settlement Of liabilities in the normal course of
business.
The basic concepts or principles of accounting are:
Going Concern Assumption
The going concern principle, also known as continuity assumption. means that a business entity will
continue to operate for at least another accounting period - This principle is the reason why assets are
generally presented in the balance sheet at cost rather that at fair market value and long-term assets are
included in the books until they are fully utilized and retired.
Accrual Basis of Accounting
The accrual basis or accounting means that the financial statements are prepared where income and
expenses must be recognized in the accounting periods to which these are incurred. This means that
revenue or income is recognized when earned regardless of when payment is received and expenses are
recognized when incurred regardless of when these are paid.
Examples:
a. XYZ Cornpany rendered repair services to a client on October 10, 2019. The client paid after 90
days which is January 9 ,2020. The income will be recognized when the service has already been
rendered. Hence, the income should be recognized in October 2019 even if it has not yet been
collected as of that date.
b. Burgis Cornpany received its electricity bill for the month Of December, 2019 on January 5, 2020
and paid it on January 31 ,2020. When should the electricity expense be recorded? The electricity
expense Shall be recorded in December. 2019 even if the bill has been paid and received in
January. 2020 because electricity consumption pertains to the month of December, 2019.
Accounting Entity Concept
The accounting entity concept recognizes a specific business enterprise as One accounting entity,
separate and distinct from the owners. In other words, a company has its own identity set apart from its
owners and can represent its own self.
For example. if Naruto Company buys a vehicle to be used as delivery equipment, then it is considered a
transaction Of the business entity and not by the owner even if the owner is the signatory Of the
transaction. However. if Mr. Zen, owner Of Naruto Company, buys a car for personal use using his Own
money, that transaction is not recorded in the company's accounting books because it is not a
transaction Of the company. If the money used to buy the car is company’ s funds, then the payment will
be treated as company advances to the owner which can be deducted from owners future dividends or
share in profits
.
Time Period
The time period assumption also known as periodicity assumption, means that the life of an enterprise is
subdivided into time periods (accounting periods), which are usually of equal length, for the purpose of
preparing the financial statements. An accounting period is usually a 12-month period — either calendar
or fiscal. A calendar year refers to a 12-month period ending December 31 and fiscal year is a 12-month
period ending in any day of the year except December 31.
Monetary Unit Assumption
This means that transactions and events when recorded in the books of accounts should be measured in
monetary terms.
The monetary unit assumption has two characteristics — quantifiability and stability of the currency.
Quantifiability means that records should be stated usually in the currency of the country where the
financial statements are prepared and stability means that the purchasing power of the said currency is
stable or constant and that any insignificant effect of inflation is ignored.
There are other principles derived from the above concepts, like: matching principle, revenue Or expense
recognition principle, historical cost principle, consistency, materiality, neutrality Or completeness. The
financial statements should possess the above attributes or concepts so that these can be reliable to
decision makers.
Asset and Equity Valuation
Valuations can and should be used as a powerful driver Of how you manage yoourbusiness. The
purpose of a valuation is to track the effectiveness Of your strategic decision making and provide the
ability to track performance in terms of estimated change in value, not just in revenue. There are two
common valuations: ( 1 ) Asset valuation. and (2) Equity valuation
What is Asset Valuation?
This pertains to the value assigned to a specific property when a company or asset is to be sold, insured.
or taken over. The assets may be categorized into tangible and intangible assets.
Asset valuation is the process of determining the fair market or present value of assets, using book
values., absolute valuation models or comparables. The assets may include investments in marketable
securities like stocks and bonds: tangible assets like buildings and equipment: or intangible assets like
brands, trademarks or patents.
What is Equity Valuation?
Equity valuation is a general term which is used to refer to all tools and techniques used by investors to
find out the true value of a company's equity. It is often seen as he most crucial element of a successful
investment decision. Every participant in the stock market either directly or indirectly makes use of equity
valuation while making investment decisions. The users of equity valuation are the small individual
investors who make up the vast majority of stock market investors, the government and institutional
investors and entities that hedge funds.
Valuation Methods
When valuing a company as a going concern, there are three main valuation methods used by industry
practitioners: (1) DCF analysis, (2) comparable company analysis, and (3) precedent transactions.
As shown in the diagram above, when valuing a business or asset, there are three broad
categories that each contain their own methods. The Cost Approach looks at what it costs to build
something and this method is not frequently used by finance professionals to a company as a going
concern. Next is the Market Approach, this is a form of relative valuation and frequently used in the
industry. It includes Comparable Analysis Precedent Transactions. Finally, the discounted cash flow
(DCF) approach is a form of intrinsic valuation and is the most detailed and thorough approach to
valuation modeling (source:https://corporatefinanceinstitute.com/)
DCF Analysis
Discounted Cash Flow (DCF) analysis is an intrinsic value approach where one forecasts the future
business free cash flow and discounts it back at present day. It is the most detailed of the three
approaches, requires the most assumptions. and often produces the highest value which also often result
in the most accurate valuation.
Comparable Analysis
Comparable company analysis. also called trading multiples or public market multiples , is a relative
valuation method in which you compare the current value of a business to other similar businesses by
looking at trading multiples like P/E, EV/EBITDA, or other ratios. Multiples of EBITDA are the most
common valuation method. This is the most widely used approach, as they are easy to calculate and
always current.
Example of Comparable Table
(source:
Precedent Transactions
Precedent transactions analysis is where you compare the subject company to other businesses that
have recently been sold or acquired in the same industry. These transaction values include the take-over
premium included the price for which they were acquired.
Example of Transaction Analysis (source: https://corporatefinanceinstitute.com/)
Leveraged Buyout (LBO)
A leveraged buyout model, or an LBO, is a type Of company acquisition where total proceeds are
financed with a substantial portion Of borrowed funds. There are two parties involved in a leveraged
buyout — buyer company & the target company. In LBO, the acquiring company finance the acquisition
with a mix of equity (usually the down payment) and debt (for the remaining balance), The target
company's assets serve as security or collateral for the debt.
In LBO. the acquiring company usually targets companies that are in trouble but have valuable market.
maybe financially or have incurred heavy losses. After the buyout, the acquiring company channels the
management and technical expertise and funds to the target company. Sometimes, employees are
allowed to participate in the LBO through an employee ownership plan, which may provide tax
advantages improve employee productivity.
Example:
Barbers Corp. wants to buy Gupit Corp without investing a lot of capital. The value of Gupit Corp is
Php2,000. Barbers Corp. invests Php200 of its own equity and for the remaining Php 1,800 it borrows at
an interest rate Of 5% per annum.
In the first year Of operations, Barbers Corp earns Php200 (10%) from the cash flow Of Gupit Corp. Now
the total value Of Gupit Corp. is Php2,200. Barbers Corp. repays its interest on debt for Php90 ( 5% of
Php 1,800) which is an expense to the company, Thus Barbers Corp is left with Php110 available for
equity shareholders. Barbers Corp eams Phpl 10 on its original investment of Php200.OO which is 55%
return on equity on this transaction (Php110/Php200).
How much retum Barbers Corp. would have earned had it financed the entire transaction by equity? To
acquire Gupit Corp, Barbers Corp. has to invest Php2,000. In the next one year, Barbers Corp. earned
Php200 from the cash flow of Gupit Corp. thus, its total return is only 10% (Php 200/Php2,000)
We can therefore say that the returns on leveraged buyout are much higher than financing the buyout by
equity alone.
Absolute and Relative Valuation
There are two basic methods Of valuing equity Stock: (1 ) the absolute evaluation and (2) relative
evaluation, These methods have its Own advantages and disadvantages so One has to make wise
decisions what techniques to use for asset valuation.
There two general approaches in valuation techniques: the discounted cash flow valuation techniques,
where the value of the stock is estimated based upon the present value Of some measure of cash now,
including dividends, operating cash flow, and free cash flow; and (b) the relative valuation techniques,
where the value of a stock is estimated based upon its current price relative to variables considered to be
significant to valuation, such as earnings, cash flow, value, or sales.
These approaches and all Of these valuation techniques have several Common factors: (1 ) all Of them
are Significantly affected by the investor's required rate Of return on the Stock, (2) all valuation
approaches are Affected by the estimated growth rate Of the variable used in the valuation technique like
dividends, earnings, cash flow, or sales
Absolute Valuation Techniques
Discounted Dividends
The most straightforward measure Of cash flow is dividends because these are clearly cash flows that go
directly to the investor. However, this dividend technique is difficult to apply to firms that do not pay
dividends during periods Of high growth. or that currently pay limited dividends because they have high
rate Of return Of investment.
Discounted Residual Income
This cash flow measure is the operating free cash now, which is generally described as cash flows after
direct costs and before any payments to capital suppliers are made. The discount rate employed is the
company’s weighted average cost of capital (WACC).
Discounted Free Cash Flow
Another cash flow measure is free cash flow to equity, which is a measure Of cash flows
available to the equity holder after payments to debt holders and after allowing for expenditures
to maintain the company's asset base, Since these are cash flows available to equity owners,
the appropriate discount rate is the company's cost Of equity,
Relative Valuation Techniques
A possible problem with the discounted cash flow valuation models is that it is possible to derive
intrinsic values that are substantially above or below prevailing prices. The relative valuation
techniques advantage over discounted cash flow valuation is that they provide information about
how the market is currently valuing stock at several levels that is. the aggregate market,
alternative industries, and individuals stocks within industries
The relative valuation techniques are appropriately considered under two conditions: (1) there
are good set Of comparable entities Wherein comparable companies are Similar in terms Of
industry. size. and risk. and (2) the aggregate market and the company's industry are not at a
valuation extreme where they are not either undervalued or overvalued.
ACTIVITIES/ ASSESSMENTS
Answer the following Exercises
Exercise No. Mod 1-1 (Essay)
"The Conceptual Framework of Accounting specifically mentions the underlying assumption of
going concern which contemplate the realization of assets and settlement of liabilities in the
normal course Of business.”
Exercise NO. Mod 1-2 (Essay)
Explain why the "Accrual Entity Concept" is more adopted by companies than the “Cash Basis
Concept"?
Exercise NO. Mod 1-3 (Essay)
Why is Accounting Entity Concept an important principle of accounting that a business should
follow especially if it is a sole-proprietorship business?
Exercise NO. Mod 1-4 (Essay)
What is preferable at the point Of View Of an investor?
a. TO value the business using the Asset Valuation method: or
b. To value the business using the Equity Valuation method.
Exercise No. Mod 1-5 (Essay)
Why is financing of a capital expenditure (e.g. acquisition of machineries or plant expansion)
through Leveraged Buy Out (LBO) model preferred over financing through Equity alone?
Prepare an example to compare the two models in terms of cash now and return of investment
(ROI).
Exercise No. Mod 1-6 (Problem Solving LBO vs Equity )
Assume that ABC Enterprise, with long-term capitalization consisting entirely Of 5 million
shares, wants to raise P2 million for the acquisition Of special equipment by:
1. Selling 40,000 Ordinary shares at P50 each
2. Selling bonds at 10% interest
3. Issuing preference Shares with an 8% dividend.
The present EBIT is P1,000,000, the income tax rate is at 50%, and 100,000 shares of ordinary
shares outstanding,
Compute: (a) the earnings available to ordinary shareholders and
(b) EPS, showing a comparative using the assumptions (items# 1-3)
End of Module 1
(taken from the compilation of Mr.Benjamin A. Abarquez, Jr.}