WHY VALUE VALUE?
When managers, boards of directors, and investors have forgotten these simple truths, the
consequences have been disastrous. The rise and fall of business conglomerates in the 1970s,
hostile takeovers in the United States in the 1980s, the collapse of Japan’s bubble economy
in the 1990s, the Southeast Asian crisis in 1998, the Internet bubble, and the economic crisis
starting in 2007—all of these can be traced to a misunderstanding or misapplication of the
cornerstones. During the Internet bubble, for instance, managers and investors lost sight of
what drives ROIC, and many even forgot its importance entirely.
Between 1995 and 2000, more than 4,700 companies went public in the United States and
Europe, many with billion-dollar-plus market capitalizations. Some of the companies born
in this era, including Amazon, eBay, and Yahoo!, have created and are likely to continue
creating substantial profits and value. But for every solid, innovative new business idea, there
were dozens of that couldn’t similarly generate revenue or cash flow in either the short or
long term. The initial stock market success of these companies represented a triumph of hype
over experience.
Ignoring the cornerstones also underlies financial crises, such as the one that began in 2007.
When banks and investors forgot the conservation-of-value principle, they took on a level of
risk that was unsustainable.
First, homeowners and speculators bought homes—essentially illiquid assets. They took out
mortgages with interest set at artificially low teaser rates for the first few years, but then
those rates rose substantially. Both the lenders and buyers knew that buyers couldn’t afford
the mortgage payments after the teaser period. But both assumed that either the buyer’s
income would grow by enough to make the new payments, or the house 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 longterm risk for those who lent the money.
When the interest on the homebuyers’ adjustable rate increased, many could no longer afford
the payments. Reflecting their distress, the real estate market crashed, pushing the value of
many homes below the value of loans taken out to buy them. At that point, homeowners
could neither make the required payments nor sell their houses. Seeing this, the banks that
had issued short-term loans to investors in securities backed by mortgages became unwilling
to roll those loans over, prompting all the investors to sell their securities at once.
The value of the securities plummeted. Finally, many of the large banks themselves had these
securities on their books, which they, of course, had also financed with short-term debt that
they could no longer roll over.
This story reveals two fundamental flaws in the decisions taken by participants in the
securitized mortgage market. First, they all assumed that securitizing risky home loans made
them more valuable because it reduced the risk of the assets—but this violates the
conservation of-value rule. The aggregated cash flows of the home loans were not increased
by securitization, so no value was created and the initial risks remained.
Securitizing the assets simply enabled risks to be passed on to other owners; some investors,
somewhere, had to be holding them. After the housing market turned, financial service
companies feared that any of their counterparties could be holding massive risks and almost
ceased to do business with one another. This was the start of the credit crunch that triggered
a protracted recession in the real economy.
The second flaw in thinking made by decision makers during the past economic crisis, was
in believing that using leverage to make an investment in itself creates value. It doesn’t
because, according to the conservation-of-value principle, leverage doesn’t increase the cash
flows from an investment. Many banks, for example, used large amounts of short-term debt
to fund their illiquid long-term assets. This debt didn’t create long-term value for
shareholders in those banks. On the contrary, it increased the risks of holding their equity.
WHAT DOES IT MEAN TO CREATE SHAREHOLDER VALUE?
Particularly at this time of reflection on the virtues and vices of capitalism, it’s critical that
managers and board directors have a clear understanding of what value creation means. For
value-minded executives, creating value cannot be limited to simply maximizing today’s
share price. Rather, the evidence points to a better objective: maximizing a company’s
collective value to its shareholders, now and in the future.
If investors knew as much about a company as its managers do, maximizing its current share
price might be equivalent to maximizing its value over time. But in the real world, investors
have only a company’s published financial results and their own assessment of the quality
and integrity of its management team. For large companies, it’s difficult even for insiders to
know how financial results are generated.
Investors in most companies don’t know what’s really going on inside a company or what
decisions managers are making. They can’t know, for example, whether the company is
improving its margins by finding more efficient ways to work or by skimping on product
development, resource management, maintenance, or marketing.
Since investors don’t have complete information, companies can easily pump up their share
price in the short term or even longer. One global consumer products company consistently
generated annual growth in earnings per share (EPS) between 11 percent and 16 percent for
seven years. Managers attributed the company’s success to improved efficiency. Impressed,
investors pushed the company’s share price above those of its peers—unaware that the
company was shortchanging its investment in product development and brand
building to inflate short-term profits, even as revenue growth declined. Finally, managers
had to admit what they’d done. Not surprisingly, the 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 stock market is not “efficient” in the
academic sense that it incorporates all public information. Markets do a great job with public
information, but markets are not omniscient. Markets cannot price information they don’t
have. Think about the analogy of selling an older house. The seller may know that the boiler
makes a weird sound every once in a while or that some of the windows are a bit drafty.
Unless the seller discloses those facts, a potential buyer may have great difficulty detecting
them, even with the help of a professional house inspector.
Despite such challenges, the evidence strongly suggests that companies with a long strategic
horizon create more value than those run with a short-term mindset. Banks that had the
insight and courage to forgo short-term profits during the last decade’s real-estate bubble,
for example, earned much better total shareholder returns (TSR) over the longer term. In fact,
when we studied the patterns of investment, growth, earnings quality, and earnings
management of hundreds of companies across multiple industries between 2001 and 2014,
we found that companies whose focus was more on the long term generated superior TSR,
with a 50 percent greater likelihood of being in the top decile or top quartile by the end of
that 14-year period. In separate research, we’ve found that long-term revenue growth—
particularly organic revenue growth—is the most important driver of shareholder returns for
companies with high returns on capital. What’s more, investments in research and
development (R&D) correlate powerfully with long-term TSR.
Managers who create value for the long term do not take actions to increase today’s share
price if those actions will damage the company down the road. For example, they don’t
shortchange product development, reduce product quality, or skimp on safety. When
considering investments, they take into account likely future changes in regulation or
consumer behavior, especially with regard to environmental and health issues. Today’s
managers face volatile markets, rapid executive turnover, and intense performance pressures,
so making long-term value-creating decisions requires courage. But the fundamental task of
management and the board is to demonstrate that courage, despite the short-term
consequences, in the name of value creation for the collective interests of shareholders, now
and in the future.
OVERVIEW OF VALUATION CONCEPTS AND METHODS
The fundamental point behind successful investments is understanding what is the prevailing
value and the key drivers that influence this value. In this lesson, the valuation and the
processes in valuation will be discussed.
According to the CFA Institute, valuation is the 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. It includes the use
of forecasts to come up with reasonable estimate of value of an entity's assets or its equity.
Valuation places great emphasis on the professional judgment that are associated in the
exercise. As valuation mostly deals with projections about future events, analysts should
hone their ability to balance and evaluate different assumptions used in each phase of the
valuation exercise, assess validity of available empirical evidence and come up with rational
choices that align with the ultimate objective of the valuation activity.
Key Principles in Valuation






The value of a business is defined only 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.
Risks in Valuation
In all valuation exercises, uncertainty will be consistently present. Uncertainty refers to the
possible range of values where the real firm value lies. When performing any valuation
method, analysts will never be sure if they have accounted and included all potential risks
that may affect price of assets. Some valuation methods also use future estimates which bear
the risk that what will actually happen may be significantly different from the estimate.
OBJECTIVE OF THE VALUATION EXERCISE
The definition of value may vary depending on the context and objective of the valuation
exercise.
1. Intrinsic Value – refers to the value of any asset based on the assumption assuming there
is a hypothetically complete understanding of its investment characteristics. It is the value
that an investor considers, on the basis of an evaluation or available facts, to be the “true”
or “real” value that will become the market value when other investors reach the same
conclusion.
2. Going Concern Value – the going concern assumption believes that the entity will
continue to do its business activities into the foreseeable future.
II. Business Deals for Analysis
3. Liquidation Value – the net amount that would be realized if the business is
terminated and the assets are sold piecemeal. It is particularly relevant for companies who
are experiencing severe financial distress.
4. Fair Market Value – the price, expressed in terms of cash equivalents, at which property
would change hands between a hypothetical willing and able buyer and a hypothetical
willing and able seller, acting at arm’s length in an open and unrestricted market, when
neither is under compulsion to buy or sell and when both have reasonable knowledge of the
relevant facts.





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 gauge reasonableness of bid offers.
Merger – transaction of two companies’ combined to form a wholly new entity.
Divestiture – sale of a major component or segment of a business to another company.
Spin-off – separating a segment or component business and transforming this into a
separate legal entity whose ownership will be transferred to shareholders.
Leverage buyout – acquisition of another business by using significant debt which uses
the acquired business as a collateral.
ROLES OF VALUATION IN BUSINESS
Valuation is an essential tool for business owners to assess both opportunities and
opportunity costs associated with the business resources. It helps them manage the business
because they are able to track the effectiveness of the decision-making process and provide
them the ability to track performance in terms of estimated change in value, not just in
revenue.
I. Portfolio Management
Fundamental Analyst – these are persons who are interested in understanding and
measuring the intrinsic value of a firm. Fundamentals refer to the characteristics of an
entity related to its financial strength, profitability or risk appetite.
Activist Investors – activist investors tend to look for companies with good growth
prospects that have poor management. Activist investors usually do “takeovers” – they use
their equity holdings to push old management out of the company and change the way the
company is being run.
Chartists – they rely on the concept that stock prices are significantly influenced by how
investors think and act and on available trading KPIs such as price movements, trading
volume, short sales – when making their investment decisions.
Information Traders – they react based on new information about firms that are revealed
to the stock market. The underlying belief is that information traders are more adept in
guessing or getting new information about firms and they can make predict how the market
will react based on this.
Valuation Techniques in Portfolio Management
∙ Stock selection
∙ Deducing market expectations
THE VALUATION PROCESS
1. Understanding the business – it includes performing industry and competitive analysis
and analysis of publicly available financial information and corporate disclosures. An
investor should be able to encapsulate the industry structure. One of the most common tools
used in encapsulating industry is Porter’s Five Forces:
Generic Corporate Strategies to achieve Competitive Advantage
- Cost leadership – incurring the lowest cost among market players with quality that is
comparable to competitors allow the firm to be price products around the industry average.
- Differentiation – offering differentiated or unique product or service characteristics that
customers are willing to pay for an additional premium.
- Focus – identifying specific demographic segment or category segment to focus on by using
cost leadership strategy or differentiation strategy.
Other ways to understand a business include the following:
a. understanding the company's business model which pertains to the method on how the
company makes money.
b. analysis of historical and financial reports which use horizontal, vertical, and ratio analysis
and their interpretations.
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 Performance
o Top down forecasting approach – international or national macroeconomic projections with
utmost consideration to industry specific forecasts.
o Bottom-up forecasting approach – forecast starts from the lower levels of the firm and
builds the forecast as it captures what will happen to the company.
3. Selecting the right valuation model – it depends on the context of the valuation and the
inherent characteristics of the company being valued.
4. Preparing valuation model based on forecasts – there are two aspects to be considered:
- Sensitivity analysis – common methodology in valuation exercises wherein multiple other
analyses are done to understand how changes in an input or variable will affect the outcome.
- Situational adjustments – firm specific issues that affects firm value that should be adjusted
by analysts since these are events that are not quantified if analysts only look at core business
operations.
5. Applying valuation conclusions and providing recommendation.