Fundamental Principles of Valuation
Assets, individually or collectively, have value.
❖ Generally, value pertains to the worth of an object from another person's point of
view.
❖ Any kind of asset can be valued, though the degree of effort needed may vary on a
case-to-case basis.
❖ Methods to value real estate can be different from how to value an entire business.
❖ Businesses treat capital as a scarce resource that they should compete to obtain and
efficiently manage.
Since capital is scarce, capital providers require users to ensure that they will be able to
maximize shareholder returns to justify providing to them. Otherwise, capital providers will look
and bring money to other investment opportunities that are more attractive. Hence, the most
fundamental principle for all investments and businesses is to maximize shareholder value.
Maximizing value for businesses consequently results in a domino impact on the economy.
Growing companies provide long-term sustainability to the economy by yielding:
● higher economic output,
● better productivity gains,
● employment growth, and
● higher salaries.
Placing scarce resources in their most productive use best serves the interest of different
stakeholders in the country.
The fundamental point behind success in investments is understanding what is the prevailing
value and the key drivers that influence this value. An increase in value may imply that
shareholder capital is maximized, hence, fulfilling the promise to capital providers. This is where
valuation steps in.
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 comparisons with similar assets, or, when relevant,
● on estimates of immediate liquidation proceeds.
❖ The valuation includes the use of forecasts to come up with a reasonable estimate of the
value of an entity's assets or equity.
❖ At varying levels, decisions done within a firm entail valuation implicitly. For example,
capital budgeting analysis usually considers how pursuing a specific project will affect
entity value.
❖ Valuation techniques may differ across different assets but all follow similar
fundamental principles that drive the core of these approaches.
Valuation places great emphasis on the professional judgment that is associated with 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 the validity of available empirical evidence and come up with rational choices
that align with the ultimate objective of the valuation activity.
Interpreting Different Concepts of Value
In the corporate setting, the fundamental equation of value is grounded on the principle that
Alfred Marshall popularized - a company creates value if and only if the return on capital
invested exceeds the cost of acquiring capital.
Value, in the point of view of corporate shareholders, relates to the difference between cash
inflows generated by investment and the cost associated with the capital invested which
captures both the time value of money and risk premium.
Three major factors of the value of a business:
● Current operations - how is the operating performance of the firm been in recent years?
● Future prospects - what is the long-term, strategic direction of the company?
● Embedded risk - what are the business risks involved in running the business?
These factors are solid concepts; however, the quick turnover of technologies and rapid
globalization make the business environment more dynamic. As a result, defining value and
identifying relevant drivers became more arduous as time passes by.
As firms continue to quickly evolve and adapt to new technologies, the valuation of current
operations becomes more difficult as compared to the past. Projecting future macroeconomic
indicators also is harder because of constant changes in the economic environment and the
continuous innovation of market players. New risks and competition also surface which makes
determining uncertainties a critical ingredient to success.
The definition of value may also vary depending on the context and objective of the valuation
exercise.
❖ Intrinsic value
➢ value of any asset based on the assumption that there is a hypothetical
complete understanding of its investment characteristics.
➢ the value that an investor considers, on the basis of an evaluation of available
facts, to be the "true" or "real" value that will become the market value when other
investors reach the same conclusion.
➢ As obtaining complete information about the asset is impractical, investors
normally estimate intrinsic value based on their view of the real worth of the asset.
➢ If the assumption is that the true value of an asset is dictated by the market, then
intrinsic value equals its market price.
➢ Unfortunately, this is not always the case.
➢ The Grossman - Stiglitz paradox states that if the market prices, which can be
obtained freely, perfectly reflect the intrinsic value of an asset, then a rational
investor will not spend to gather data to validate the value of a stock.
➢ If this is the case, then investors will not analyze information about stocks
anymore. Consequently, how will the market price suggest the intrinsic price if this
process does not happen?
➢ The rational efficient markets formulation of Grossman and Stiglitz acknowledges
that investors will not rationally spend to gather more information about an asset
unless they expect that there is a potential reward in exchange for the effort.
Assets, individually or collectively, have value.
❖ Generally, value pertains to the worth of an object from another person's point of
view.
❖ Any kind of asset can be valued, though the degree of effort needed may vary on a
case-to-case basis.
❖ Methods to value real estate can be different from how to value an entire business.
❖ Businesses treat capital as a scarce resource that they should compete to obtain and
efficiently manage.
Since capital is scarce, capital providers require users to ensure that they will be able to
maximize shareholder returns to justify providing to them. Otherwise, capital providers will look
and bring money to other investment opportunities that are more attractive. Hence, the most
fundamental principle for all investments and businesses is to maximize shareholder value.
Maximizing value for businesses consequently results in a domino impact on the economy.
Growing companies provide long-term sustainability to the economy by yielding:
● higher economic output,
● better productivity gains,
● employment growth, and
● higher salaries.
Placing scarce resources in their most productive use best serves the interest of different
stakeholders in the country.
The fundamental point behind success in investments is understanding what is the prevailing
value and the key drivers that influence this value. An increase in value may imply that
shareholder capital is maximized, hence, fulfilling the promise to capital providers. This is where
valuation steps in.
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 comparisons with similar assets, or, when relevant,
● on estimates of immediate liquidation proceeds.
❖ The valuation includes the use of forecasts to come up with a reasonable estimate of the
value of an entity's assets or equity.
❖ At varying levels, decisions done within a firm entail valuation implicitly. For example,
capital budgeting analysis usually considers how pursuing a specific project will affect
entity value.
❖ Valuation techniques may differ across different assets but all follow similar
fundamental principles that drive the core of these approaches.
Valuation places great emphasis on the professional judgment that is associated with 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 the validity of available empirical evidence and come up with rational choices
that align with the ultimate objective of the valuation activity.
Interpreting Different Concepts of Value
In the corporate setting, the fundamental equation of value is grounded on the principle that
Alfred Marshall popularized - a company creates value if and only if the return on capital
invested exceeds the cost of acquiring capital.
Value, in the point of view of corporate shareholders, relates to the difference between cash
inflows generated by investment and the cost associated with the capital invested which
captures both the time value of money and risk premium.
Three major factors of the value of a business:
● Current operations - how is the operating performance of the firm been in recent years?
● Future prospects - what is the long-term, strategic direction of the company?
● Embedded risk - what are the business risks involved in running the business?
These factors are solid concepts; however, the quick turnover of technologies and rapid
globalization make the business environment more dynamic. As a result, defining value and
identifying relevant drivers became more arduous as time passes by.
As firms continue to quickly evolve and adapt to new technologies, the valuation of current
operations becomes more difficult as compared to the past. Projecting future macroeconomic
indicators also is harder because of constant changes in the economic environment and the
continuous innovation of market players. New risks and competition also surface which makes
determining uncertainties a critical ingredient to success.
The definition of value may also vary depending on the context and objective of the valuation
exercise.
❖ Intrinsic value
➢ value of any asset based on the assumption that there is a hypothetical
complete understanding of its investment characteristics.
➢ the value that an investor considers, on the basis of an evaluation of available
facts, to be the "true" or "real" value that will become the market value when other
investors reach the same conclusion.
➢ As obtaining complete information about the asset is impractical, investors
normally estimate intrinsic value based on their view of the real worth of the asset.
➢ If the assumption is that the true value of an asset is dictated by the market, then
intrinsic value equals its market price.
➢ Unfortunately, this is not always the case.
➢ The Grossman - Stiglitz paradox states that if the market prices, which can be
obtained freely, perfectly reflect the intrinsic value of an asset, then a rational
investor will not spend to gather data to validate the value of a stock.
➢ If this is the case, then investors will not analyze information about stocks
anymore. Consequently, how will the market price suggest the intrinsic price if this
process does not happen?
➢ The rational efficient markets formulation of Grossman and Stiglitz acknowledges
that investors will not rationally spend to gather more information about an asset
unless they expect that there is a potential reward in exchange for the effort.
