Valuation: Closing Thoughts

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Valuation Closing Thoughts

• Aswath Damodaran

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Do you have your life vests on?
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Truths about Valuation

• Truth 1 All valuations are biased.
• Truth 2. There are no precise valuations.
• Truth 3 Complexity comes with a cost More
  information is not always better than less
  information.

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Approaches to Valuation

• Discounted cashflow valuation, where we try
  (sometimes desperately) to estimate the intrinsic
  value of an asset by using a mix of theory,
  guesswork and prayer.
• Relative valuation, where we pick a group of
  assets, attach the name comparable to them and
  tell a story.
• Contingent claim valuation, where we take the
  valuation that we did in the DCF valuation and
  divvy it up between the potential thieves of
  value (equity) and the potential victims of this
  crime (lenders)

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Basis for all valuation approaches

• We all believe market are inefficient, and that
  we can find under and over valued assets because
  of our superior intellect, models, information or
  some combination of all three.
• Some Sobering facts
• 70-80 of portfolio managers under perform market
  indices.
• The Vanguard 500 Index fund is poised to overtake
  the Fidelity Magellan fund as the largest mutual
  fund in the United States. In the last 5 years,
  it has been the best performing large mutual fund
  in the United States.
• The more people trade, the more they seem to
  lose.
• A study of mutual fund portfolios discovered that
  they would have made a higher return, if they had
  frozen their portfolios on January 1.
• A study of individual investors by Terrence
  ODean also noted a negative correlation between
  returns earned and transactions volume (and this
  is before trading costs)

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Discounted Cash Flow Valuation

• What is it In discounted cash flow valuation,
  the value of an 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.
• Information Needed To use discounted cash flow
  valuation, you need
• to estimate the life of the asset
• to estimate the cash flows during the life of the
  asset
• to estimate the discount rate to apply to these
  cash flows to get present value
• Market Inefficiency Markets are assumed to make
  mistakes in pricing assets across time, and are
  assumed to correct themselves over time, as new
  information comes out about assets.

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Relative Valuation

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

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The Four Steps to Understanding Multiples

• Define the multiple
• In use, the same multiple can be defined in
  different ways by different users. When comparing
  and using multiples, estimated by someone else,
  it is critical that we understand how the
  multiples have been estimated
• Describe the multiple
• Too many people who use a multiple have no idea
  what its cross sectional distribution is. If you
  do not know what the cross sectional distribution
  of a multiple is, it is difficult to look at a
  number and pass judgment on whether it is too
  high or low.
• Analyze the multiple
• It is critical that we understand the
  fundamentals that drive each multiple, and the
  nature of the relationship between the multiple
  and each variable.
• Apply the multiple
• Defining the comparable universe and controlling
  for differences is far more difficult in practice
  than it is in theory.

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Estimating a Multiple

• Use comparable firms, compute the average
  multiple and adjust subjectively for differences
• Use comparable firms, run a regression of
  multiple against fundamentals and estimate
  predicted multiple for firm
• Use market, run a regression of multiple against
  fundamentals and estimate a predicted multiple
  for firm

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What approach would work for you?

• As an investor, given your investment philosophy,
  time horizon and beliefs about markets (that you
  will be investing in), which of the the
  approaches to valuation would you choose?
• Discounted Cash Flow Valuation
• Relative Valuation
• Neither. I believe that markets are efficient.

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Contingent Claim (Option) Valuation

• Options have several features
• They derive their value from an underlying asset,
  which has value
• The payoff on a call (put) option occurs only if
  the value of the underlying asset is greater
  (lesser) than an exercise price that is specified
  at the time the option is created. If this
  contingency does not occur, the option is
  worthless.
• They have a fixed life
• Any security that shares these features can be
  valued as an option.

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Indirect Examples of Options

• Equity in a deeply troubled firm - a firm with
  negative earnings and high leverage - can be
  viewed as an option to liquidate that is held by
  the stockholders of the firm. Viewed as such, it
  is a call option on the assets of the firm.
• The reserves owned by natural resource firms can
  be viewed as call options on the underlying
  resource, since the firm can decide whether and
  how much of the resource to extract from the
  reserve,
• The patent owned by a firm or an exclusive
  license issued to a firm can be viewed as an
  option on the underlying product (project). The
  firm owns this option for the duration of the
  patent.

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Value Enhancement

• For an action to create value, it has to
• Increase cash flows from assets in place
• Increase the expected growth rate
• Increase the length of the growth period
• Reduce the cost of capital
• The value enhancement measures that have been
  widely promoted as new and different are neither.
  
• EVA and CFROI have their roots in traditional
  discounted cash flow models
• Measures (like EVA and CFROI) do not create
  value managers do.

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Some Not Very Profound Advice

• Its all in the fundamentals
• Focus on the big picture dont let the details
  trip you up.
• Keep your perspective it is only a valuation.

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Or maybe you can fly.