TOPIC 11 – Valuation Hierarchy

ISSUE 11  – DATE 9 August 2015

INTRODUCTION AND OBJECTIVE

Often in times, we notice that there are many valuation techniques being used and we also noted that the outcome of the fair values is affected by the technique chosen.  Some of the techniques chosen require an analyst to use assumptions that are subjective in nature and this causes potential subjective views of an analyst being translated into the fair values derived. This may be aggravated if “data mining” is adopted in a valuation report, to achieve a desired fair value. Data mining is a form of bias in ascribing fair value. by selecting inputs that meets the desired fair value such as amending the growth rate, cost of equity, weighted average cost of capital, any other inputs, i.e. in simple term it is  a manipulation of the inputs which are subjective in nature.

Hence, in this article, I intend to share some guidance issued by Global Investment Performance Standards (GIPS), that provides guidelines on choosing a suitable method to be used based on following emphasis:-

  • Using objective inputs – to reduce the use of subjective inputs by an analyst.
  • Observable inputs – Using inputs which are observable in market place.
  • Inputs used are from active markets as opposed to inactive traded markets.

Appended in a summarized table for reference.  It is noted that the highest hierarchy in the valuation method is based on objective and observable inputs obtained from active markets and the lowest hierarchy have attributes which are the opposites. It should be noted that the guidelines are for reference guidance only and one cannot claim compliance with GIPS unless one adopt in full the GIPS guidelines which covers a broad range of areas in guiding the performance reporting of funds.

HIERARCHY OF VALUATION

Reference is made to guidance recommendations set up by Global Investment Performance Standards (GIPS), on guidelines to be adopted in conducting fair valuation. The spirit of the emphasis is the following:-

  • Objective
  • Observable
  • Unadjusted quoted market price in an active market.

Objective – as far as possible, analyst should avoid / reduce  using subjective interpretations / assumptions
Observable – use source of inputs that are observable
Active – analyst should ensure that source of valuation metrics used are from active market and avoid using data from an illiquid market which does not reflect the fair price.

t11Click TABLE to enlarge


THANKS FOR READING 

This article is prepared by Ong Tee Chin, CFA, FRM, and represents the view of the author. He can be contacted at ong@atlantiscapital.org for any further enquiries on the contents of this article. The author wishes to declare that this article is not sponsored by any party and it is solely prepared of the author with aim to share knowledge with readers having common interest.

The information contained in this article is provided for reference and informational purpose only and does not constitute any investment advice. Investors are advised to seek independent advice before making any investment decision. Past performance is not indicative of future performance. Also, this article is written by the author for educational purpose based on author’s analysis of public information.

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CERTIFICATION

Chartered Financial Analyst
CFA Institute



Financial Risk Manager
Global Association of Risk Professionals (GARP)

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