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BUSINESS ANALYSIS AND VALUATION: AN

OVERVIEW
Objectives:
INTRODUCTION TO
To learn a logical framework to analyze and value a
BUSINESS ANALYSIS & business by understanding relations with business
environment, industry structure, business strategy
VALUATION and the economic value of the firm.

Valuations approaches and models are discussed in


detail.
MBA 617 Business Analysis and Valuation
MBA in Finance
Postgraduate and Mid-career Development Unit
Faculty of Management & Finance 2
University of Colombo

VALUATION APPROACHES INTRINSIC VALUATION (ABSOLUTE


VALUE MODELS)
Intrinsic Valuation (Absolute value models) – main relates the value of an asset to its intrinsic
approach characteristics: its capacity to generate cash flows and
the risk in the cash flows.
Relative Valuation – supplementary
Establish through comparative standards/measures. In it’s most common form, intrinsic value is computed
with a discounted cash flow valuation, with the value of
an asset being the present value of expected future cash
Contingent Claim Valuation (Option pricing models) flows on that asset.
– supplementary

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BASIS FOR ALL VALUATION
RELATIVE VALUATION APPROACHES
Relative valuation, estimates the value of an asset by The use of valuation models in investment
looking at the pricing of 'comparable' assets relative to decisions (i.e., in decisions on which assets are
a common variable like earnings, cash flows, book value under valued and which are over valued) are
or sales.
based upon

a perception that markets are inefficient and
CONTINGENT CLAIM VALUATION make mistakes in assessing value
an assumption about how and when these
Contingent claim valuation, uses option pricing models inefficiencies will get corrected
to measure the value of assets that share option
characteristics.

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BASIS FOR ALL VALUATION DISCOUNTED CASH FLOW VALUATION


APPROACHES (CONT.…)
In an efficient market, the market price is the What is it:
best estimate of value. The purpose of any
valuation model is then the justification of this In discounted cash flow valuation, the value of an
value. asset is the present value of the expected cash
flows on the asset.

Philosophical Basis:
Every asset has an intrinsic value that can be
estimated, based upon its characteristics in terms
of cash flows, growth and risk.
 
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DISCOUNTED CASH FLOW VALUATION ADVANTAGES OF DCF VALUATION!

Since DCF valuation, done right, is based upon


Information Needed: an asset’s fundamentals, it should be less
To use discounted cash flow valuation, you need exposed to market moods and perceptions.
•  to estimate the life of the asset
•  to estimate the cash flows during the life of the If good investors buy businesses, rather than
asset stocks (the Warren Buffet), discounted cash flow
•  to estimate the discount rate to apply to these valuation is the right way to think about
cash flows to get present value what you are getting when you buy an asset.

Market Inefficiency: Markets are assumed to DCF valuation forces you to think about the
make mistakes in pricing assets across time, and underlying characteristics of the firm, and
are assumed to correct themselves over time, as understand its business. If nothing else, it brings
new information comes out about assets. 3
you face to face with the assumptions you are
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making when you pay a given price for an asset.

RELATIVE VALUATION RELATIVE VALUATION

What is it?: Information Needed:


The value of any asset can be estimated by looking To do a relative valuation, you need
at how the market prices “similar” or ‘comparable” •  an identical asset, or a group of comparable or
assets. similar assets
•  a standardized measure of value (in equity, this
  Philosophical Basis: is obtained by dividing the price by a common
variable, such as earnings or book value)
The intrinsic value of an asset is impossible (or
•  and if the assets are not perfectly comparable,
close to impossible) to estimate. The value of an
asset is whatever the market is willing to pay for it variables to control for the differences
(based upon its characteristics)
Market Inefficiency:
Pricing errors made across similar or comparable
4 assets are easier to spot, easier to exploit and are 4

much more quickly corrected.


ADVANTAGES OF RELATIVE VALUATION ADVANTAGES OF RELATIVE VALUATION (CONT..)

Relative valuation is much more likely to reflect


market perceptions and moods than discounted
Relative valuation generally requires less explicit
cash flow valuation. This can be an advantage
information than discounted cash flow valuation.
when it is important that the price reflect these
perceptions as is the case when
•  the objective is to sell an asset at that price
today (IPO, M&A)
•  investing on “momentum” based strategies
With relative valuation, there will always be a
significant proportion of securities that are under
valued and over valued. Since portfolio managers
are judged based upon how they perform on
a relative basis relative valuation is more
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tailored to their needs

DISADVANTAGES OF RELATIVE VALUATION DISADVANTAGES OF RELATIVE VALUATION


(CONT….)
A portfolio that is composed of stocks which are Relative valuation may require less information
under valued on a relative basis may still be in the way in which most analysts and portfolio
overvalued, even if the analysts’ judgments managers use it. However, this is because
are right. It is just less overvalued than other implicit assumptions are made about other
securities in the market. variables (that would have been required in a
discounted cash flow valuation). To the extent
Relative valuation is built on the assumption that these implicit assumptions are wrong the
that markets are correct in the aggregate, but relative valuation will also be wrong.
make mistakes on individual securities. To the
degree that markets can be over or under valued
in the aggregate, relative valuation will fail

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WHEN RELATIVE VALUATION WORKS BEST CONTINGENT CLAIM (OPTION) VALUATION!

This approach is easiest to use when


•  there are a large number of assets comparable Options have several features
to the one being valued •  They derive their value from an underlying
•  these assets are priced in a market asset, which has value
•  there exists some common variable that can be •  The payoff on a call (put) option occurs only if
used to standardize the price the value of the underlying asset is greater
This approach tends to work best for investors (lesser) than an exercise price that is specified at
•  who have relatively short time horizons the time the option is created. If this contingency
•  are judged based upon a relative benchmark does not occur, the option is worthless.
(the market, other portfolio managers following •  They have a fixed life
the same investment style etc.) Any security that shares these features can be
•  can take actions that can take advantage of the valued as an option
relative mispricing; 4 4

ADVANTAGES OF USING OPTION PRICING


MODELS!

Option pricing models allow us to value assets


that we otherwise would not be able to value. For
instance, equity in deeply troubled firms are
difficult to value using discounted cash flow
approaches or with multiples. They can be valued
using option pricing.

Option pricing models provide us fresh insights Priyantha Hearth
into the drivers of value. In cases where an asset B.Sc, MBA, FCA, ACMA

is deriving it value from its option Email: herathpriyantha1@gmail.com


characteristics. Phone: 0773047772

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