Introduction to Valuation

Concept of valuation
Valuation involves establishing what an asset is

fundamentally worth
To produce estimates of unobservable true (or fair) values
To provide essential knowledge for prospective sellers or buyers

Different terms of value

Book value: shown in balance-sheet numbers
Market value (market capitalization): based on market prices
Fair market value or intrinsic value: what we need to estimate

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Introduction to Valuation
The role of valuation
Many aspects of finance draw upon valuation methods, therefore
the materials in this course is applicable to many areas, including
the following:

Portfolio management (e.g., fundamental analysts, technical

analysts, )
IPO valuation (investment banks)

Corporate project valuation (corporate managers)

Acquisition analysis (investment banks)

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Introduction to Valuation
Financial market efficiency
There are three different forms (levels) of market efficiency, which
have different implications regarding the extent to which security
prices reflect information.
Strong-form market efficiency: Prices reflect all information,

including both public and private information

Semistrong-form market efficiency: Prices reflect all publicly

available information, Including all trading information, annual

reports, press releases, etc.
Weak-form market efficiency: Market prices reflect all past

market information, including price and trading volume.

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Introduction to Valuation

Introduction to Valuation 4

Introduction to Valuation
Market efficiency and valuation
How useful is valuation analysis if the market is efficient?
With strong-form market efficiency, investors can not earn

abnormal returns regardless of the information they possess.

With semistrong-form market efficiency, fundamental analysis

(that use all publically available information) will not lead to

abnormal returns.
With weak-form market efficiency, technical analysis (that use

historical price and trading information) will not lead to abnormal

returns.

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Introduction to Valuation

Market Efficiency

Valuation Analysis useful?

Strong

Semi-strong

Weak

Fundamental
analysis

Technical
analysis

Large, public firms

No

Yes

No

Small, public firms

No

No

Yes

Yes

No

Private firms
& divisions/projects

N.A.

N.A.

N.A.

Yes

N.A

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Introduction to Valuation
Valuation approaches
A range of methods and tools are available for valuing assets,

each with their own benefits and disadvantages

Despite using quantitative models, valuation is not objective.

Valuation result can vary greatly between different methods,

depending on the assumptions, inputs, and tools used.
Uncertainty makes valuation difficult.

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Introduction to Valuation
There are generally three approaches to valuation
Discounted cash flow (DCF) valuation: calculating the present
value of expected future cash flows, discounted at a rate which
reflects the riskiness of those cash flows.
Relative valuation: drawing upon the pricing of similar assets in
the market, and then standardising by some common variable
such as earnings.
Contingent claim valuation: an approach which may be used to
value assets with option like features.

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Approaches to Valuation
DCF valuation
This approach assumes that the value of an asset is the present

value of the expected cash flows generated by using the asset.

Valuation formula
=

=
=1

1+

To use DCF valuation, you need the following information:

Life of the asset

Cash flows during the life of the asset
Discount rate to apply to these cash flows
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Approaches to Valuation
Advantages
Based upon an assets fundamentals, it is not seriously exposed to
market moods and perceptions.
It forces you to think about the underlying characteristics of the firm,
and understand its business.
Convenient for performing sensitivity analysis

Disadvantages
Requires far more explicit inputs and information than other valuation
approaches.
These inputs and information are not only noisy (and thus leading to
imprecise valuation result), but can be manipulated by the analyst to
provide the conclusion he or she wants.

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Approaches to Valuation
Relative valuation
Assumption: the value of an asset can be estimated by looking

at how the market prices similar or comparable assets.

To do a relative valuation, you need the following information:
A group of similar (comparable) assets.
A standardised measure of value market value divided by certain
financial variable (e.g., P/E ratio)
P/E ratio: 19.3 for Microsoft
12.7 for JP Morgan
58.5 for Alibaba

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Approaches to Valuation
Advantages
More likely to reflect market perceptions and moods than DCF
Requires much less explicit information than DCF
Easy to use

Disadvantages
Works well only when markets are correct in the aggregate
Often difficult to find closely comparable assets
Does not help understand fundamentals; difficult to perform a
sensitivity analysis

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Approaches to Valuation
Contingent claim (option) valuation
How to value an asset when its cash flows are contingent on

the occurrence or non-occurrence of an event?

Apply option valuation models to real options (which include

natural resource options and the product patents)

Disadvantages
The option value derives from the value of the underlying asset, so
you first need to value the asset.
For real options, many of the inputs for the valuation model are
difficult to obtain.

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