St.

Ferdinand College
College of Accountancy
Valuation Concept & Methods

Lecture 4
Asset Based Valuation for Going Concern Opportunities Part 1
Overview:

Asset is defined as transactions that will yield future economic benefits brought about by past events.
Given the definition, valuation should be observed to address the determination of the amount of
returns that will be earned or generated from the transactions. The challenge is determining the factors
that will affect the value of the assets.

Valuation concepts are geared towards determining the price of equity based on the value of its assets.
The higher the value of the assets or investment represents the higher the projected returns to be
generated. Valuation approach is different depending on the investment opportunity available. This
module shall focus on asset based valuation approached for going concern opportunities.

Module Objectives:
After successful Completion of this module, you should be able to:
• Compare and contrast the different asset-based valuation methods for going concern
• Justify the reasonableness of the value based on the methods

Course Materials:
There are several business opportunities in various industry. In Management Accounting, capital
budgeting techniques are very useful in determining which among the alternative opportunities is the
most economic and would be a better choice. In order to determine the value, information is the key.
The best and most relevant information must be factored in. For going concern business opportunities,
there are different approaches that can be used, the most popular are: discounted cash flows or DCF
analysis, comparable companies analysis, and economic value added.

Discounted Cash Flows Analysis

In Financial Management, it has been discussed that a way to determine the value of an investment
opportunity is by determining the actual cash generated by a particular asset. Recall that discounted
cash flows analysis can be done by determining the net present value of the free cash flows of the
investment opportunity.

In Conceptual Framework and Accounting Standards, it was discussed the that the cash flows are
presented and analyzed based on their sources and activities which are categorized as operating,
investing and financing. The free cash flows are the amounts of cash available for distribution to both
debt and equity claim from the business or asset. This is calculated from the net cash generated from
operations and for investment over time.

Since this is a going concern opportunity, certain risk and returns are inherent this is quantified in the
form of terminal cash flows. Terminal cash flows can be computed by estimating the perpetual value of
cash to be generated by the opportunity or in some cases these represents the salvage value of the
opportunity.
The net present value of the free cash flows represents the value of the assets. It may be recalled
further that the assets are financed by debt and equity. Hence, these are the claims which are presented
at the right side of the Statement of Financial Position, under an account form of reporting.

Same principle applies that the best opportunity is the one that will yield the highest net present
value or solely if the opportunity will result into a positive amount it should be accepted. Conservatively,
the total outstanding liabilities must be considered and deducted versus the asset value to determine
the amount appropriated to the equity shareholders. This is called the equity value. The opportunity
that will result to the highest equity value is considered.

DCF Analysis is most applicable to use when the following are available:
• Validated Operational and Financial Information
• Reasonable appropriated cost of capital or required rate of return
• New quantifiable information

Supposed PUP Company is projected to generate Php10 Million every year for the next 5 years and
beyond. The estimated terminal value is Php50 Million. The required return is 10%. It was noted further
that there is an outstanding loan of Php50 Million. If you are going to purchase 50% of PUP, how much
would you be willing to pay?

in million pesos
Year 1 2 3 4 5
Free cash flows from the firm 10 10 10 10 10
Terminal cash flows 50
Free Cash Flows – Firm 10 10 10 10 60
NPV @ 7% 76.65
Less: Outstanding loans 50.00
Free Cash Flows to Equity 26.65

Based on the foregoing information, the value of PUP9s equity is Php26.65 Million. If the amount at
stake is only 50% then the amount to be paid is Php13.33 Million (Php26.65 x 50%).

Comparable Company Analysis

In Financial Management, financial ratios are used as tools to assess and analyze business results.
Recall that one of these purposes can be used to determine the value. These financial ratios are P/E
Ratio, Book to Market Ratio, Earnings Per Share, Dividend Per Share. Multiples can also be used in
comparative company analysis. The beauty of the ratios is that it creates better and relevant comparison
knowing that opportunities or investments have distinct drivers of their performance.

The following are the consideration for doing a comparable company analysis:
• Total and absolute values should not be compared
• Variables used in determining the ratios must be the same
• Period of observation must be comparable
• Non quantitative factors must also be considered Economic Value Added
 The most conventional way to determine the value of the asset is through its economic value added. In
Economics and Financial Management, economic value added (EVA) is the convenient for this is
assessing the ability of the firm to support its cost of capital with its earnings. EVA is the excess of the
earnings after deducting the cost of capital. The assumption is that the excess shall be accumulated for
the firm the
higher the excess the better.

The elements that must be considered in using EVA are:

• Reasonableness of earnings or returns
• Appropriate cost of capital

Other factors to be considered in Valuation

Once the value of the asset has been established, there are factors that can be considered to properly
value the asset. These are the earning accretion or dilution, equity control premium and precedent
transactions.

Earning accretion are additional value inputted in the calculation that would account for the increase in
value of the firm due to other quantifiable attributes like potential growth, increase in prices, and even
operating efficiencies. Earnings dilution works differently. But in both cases, these should also be
considered in the sensitivity analysis.

Equity Control premium is the amount that is added to the value of the firm in order to gain control of
it. Precedent transactions, on the other hand, are experiences, usually similar with the opportunities
available. These transactions are considered risks that may affect further the ability to realize the
projected earnings.

Activities/Assessments:
1. XYZ Company is exploring
two mutually exclusive
opportunity. There are two
available opportunities for XYZ
with the following information:
a. ABC Company has projected
annual returns of Php7 Billion and
outstanding liabilities of Php5
Billion.
b. DEF Company has projected
annual returns of Php12 Billion
and
outstanding liabilities of Php20
Billion.
c. Both companies has terminal
value of Php100 Billion.
If you will assess the company for
five years with the required rate of
return of
10%, which company will you
recommend purchasing and how
much? Why?
2. Using the information in No. 1,
which is a better choice if the
initial investment for
ABC Company and DEF Company
is Php50 Billion and Php110
Billion,
respectively. The cost of capital for
the two companies are 10%.
3. XYZ Company is offered to
purchase ABC Company with EPS
of Php12 and P/E
ratio of 5; while DEF Company
has EPS of Php15 and P/E ratio of
4. What is the
value of the two companies?
Which one is a better? Why?
Activities/Assessments:
1. XYZ Company is exploring two mutually exclusive opportunity. There are two available opportunities
for XYZ with the following information:
a. ABC Company has projected annual returns of Php7 Billion and outstanding liabilities of Php5 Billion.
b. DEF Company has projected annual returns of Php12 Billion and outstanding liabilities of Php20
Billion.
c. Both companies has terminal value of Php100 Billion.

If you will assess the company for five years with the required rate of return of 10%, which company will
you recommend purchasing and how much? Why?
2. Using the information in No. 1, which is a better choice if the initial investment for ABC Company and
DEF Company is Php50 Billion and Php110 Billion, respectively. The cost of capital for the two companies
are 10%.

3. XYZ Company is offered to purchase ABC Company with EPS of Php12 and P/E ratio of 5; while DEF
Company has EPS of Php15 and P/E ratio of 4. What is the value of the two companies? Which one is a
better? Why?