Website: damodaran.

com
Blog: http://aswathdamodaran.blogspot.com/
Twitter: @AswathDamodaran
Email: adamodar@stern.nyu.edu

THEBERMUDATRIANGLEOF
VALUATION:
BIAS,UNCERTAINTYANDCOMPLEXITY
AswathDamodaran

TheBermudaTriangleofValuation

Valuation First
Principles &
Good Sense

Uncertainty & the Unknown

2

I.ValuationBias

Preconceptionsandpriors:Whenyoustartonthe
valuationofacompany,youalmostneverstartwitha
blankslate.Instead,yourvaluationisshapedbyyour
priorviewsofthecompanyinquestion.

Corollary1:Themoreyouknowaboutacompany,themore
likelyitisthatyouwillbebiased,whenvaluingthecompany.
Corollary2:Thecloseryougettothemanagement/ownersof
acompany,themorebiasedyourvaluationofthecompanywill
become.

Valuefirst,valuationtofollow:Inprinciple,youshould
doyourvaluationfirstbeforeyoudecidehowmuchto
payforanasset.Inpractice,peopleoftendecidewhatto
payanddothevaluationafterwards.
3

Sourcesofbias

Thepowerofthesubconscious:Wearehuman,afterall,andasa
consequencearesusceptibleto

Herdbehavior:Forinstance,thereisthemarketpricemagnetinvaluation,where
estimatesofintrinsicvaluemovetowardsthemarketpricewitheachiteration.
Hindsightbias:Ifyouknowtheoutcomeofasequenceofevents,itwillaffectyour
valuation.(Thatiswhyteachingvaluationwithcasesisanexerciseinfutility)

Thepowerofsuggestion:Hearingwhatothersthinkacompanyisworth
willcoloryourthinking,andifyouviewthoseothersasmore
informed/smarterthanyouare,youwillbeinfluencedevenmore.
Thepowerofmoney:Ifyouhaveaneconomicstakeintheoutcomeofa
valuation,biaswillalmostalwaysfollow.

Corollary1:Yourbiasinavaluationwillbedirectlyproportionaltowhopaysyouto
dothevaluationandhowmuchyougetpaid.
Corollary2:Youwillbemorebiasedwhenvaluingacompanywhereyoualready
haveaposition(longorshort)inthecompany.

Biasing a DCF valuation: A template of "tricks"

If you want higher (lower) value, you can
1. Augment (haircut) earnings
2. Reduce(increase) effective tax rate
3. Ignore (Count in) unconventional cap ex
4. Narrow (Broaden) definition of working capital
Free Cashflow to Firm
EBIT (1- tax rate)
- (Cap Ex - Depreciation)
- Change in non-cash WC
= Free Cashflow to firm

If you want to increase (decrease) value, you can

1. Use higher (lower) growth rates
2. Assume less (more) reinvestment with the
same growth rate, thus raising (lowering) the
quality and value of growth.

Expected Growth in FCFF during

high growth

If you want to increase (decrease) value, you can

1. Assume a longer (shorter) growth period
2. Assume more (less) excess returns over the growth period
Value of Operating Assets today
+ Cash & non-operating assets
- Debt
Value of equity
If you want to increase
(decrease) value, you can
add (subtract) premiums
(discounts) for things you
like (dislike) about the
company.
Premiums: Control,
Synergy, liquidity
Discounts: Illiquidity,
private company

Length of high growth period: PV of FCFF during high

Cost of Capital
Weighted average of cost of equity & cost of debt

If you want to increase (decrease) value, you can

1. Assume a higher (lower) debt ratio, with the same costs of debt & equity.
You may be able to accomplish this by using book (market) value debt
ratios.
2. Use a lower (higher) equity risk premium for equity and a lower (higher)
default spread for debt.
3. Find a "lower" ("higher") beta for your stock.
4. Don't add (add) other premiums to the cost of equity (small cap?)

Stable Growth
When operating income and
FCFF grow at constant rate
forever.
If you want to increase value, you can
1. Use stable growth rates that are economically
impossible (higher than the growth rate of the
economy)
2. Allow this growth to be accompanied by high
positive excess returns (low reinvestment)
If you want to decrease value, you can
1. Use lower growth rates in perpetuity
2. Accompany this growth with high negative excess
returns

BiasTools1a:TheCashFlowPloy
Item

The unbiasedsolution

Biasup

Biasdown

EBIT/ Earnings

Removeallextraordinary
items&normalizetherest
(withearningsgoingupor
down)onlyifnecessary.

Remove only
extraordinarylosses&
normalizetopush
earningsup

Removeonly
extraordinary income
&normalizetopush
earningsdown

Taxrate

You canstartwiththe
Useeffectivetax(if
effectivetaxratebut
lessthanmarginal)
changeovertimetowards forever.
marginalrate.

NetCapEx

Countinall investments
Ignoreunusual capex Count unusualcapex
(R&D,acquisitions)made (acquisitions)while
whileignoringgrowth
forgrowth&allowforthe countinggrowthin.
generated.
resultinggrowth.

Working Capital

Use historicorindustry
averagesofworking
capitaltoestimate
changes

Ignoreworkingcapital
or usenegative
workingcapitalas
sourceofcash.

Usemarginaltaxrate
(ifhigherthan
effective)forever.

Usechange in
workingcapital,ifitis
alargedrainoncash
flow.

BiasTools1b:TaxMismatching

Unbiased:Ifyourcashflowsareafter(no,corporate,corporate+individual)taxes,
yourdiscountratehastoreflect(no,corporate,corporate+individual)taxes

Entity

Entitytaxes

Investor taxes

Valuation approaches

MLPs,REITs,
Partnerships,Sole
proprietorships

Notaxes

1.

Income taxedas
ordinaryincome
Valueappreciation
taxedascapitalgains

1.
2.

Valuepretax incomeatapretaxdiscountrate
Valuepostpersonaltaxincomeatpost
personaltaxdiscountrate.

Corporations

Income
taxedat
corporate
taxrate

Dividendstaxed when
paid
Priceappreciation
taxedwhenstocksold

1.

Valuecashflows,postcorporate butpre
personaltaxes,atadiscountratethatispost
corporatebutprepersonal.
Valuecashflows,postcorporate&post
personaltaxes,atadiscountratethatispost
corporateandpostpersonal

2.
1.
2.

2.

Biasup:Usepretax(personal,personal&corporate)whilediscountingatan
aftertax(personal,personal&corporate)discountrate.

Biasdown:Useaftertaxtax(personal,personal&corporate)whilediscountingat
apretax(personal,personal&corporate)discountrate.
7

BiasTools2:TheGrowthTrick
Unbiased

Biasup

Biasdown

Scaling upof
growth

Reducegrowth
Continue withhigh Scale downgrowth
ratesascompany
revenuegrowth,as tooquickly.
scalesup,butallow youscaleup.
forexceptions.

TargetOperating
Margin

Move towards
marginsofmature
companiesin
industry

Move wellabove
marginsofmature
companiesin
industry

Move wellbelow
typicalmarginsin
industry

Reinvestment

Enough
reinvestmentto
allowforgrowth

Noorlittle
reinvestment,as
growth continues

Disproportionately
largereinvestment,
givengrowth.

Imputed ROC

Trends down
towardsindustry
averageandcostof
capital.

Trendsupaway
fromindustry
average&costof
capital.

Trends downbelow
theindustry
average&costof
capital
8

BiasTools3a:TheMacroGame Riskfreerate
Unbiased

Bias Up

BiasDown

Normalization

Usethecurrent
riskfreerate.

Usetherisk freeratetoday,
ifitislow,butreplacewith
anaveragerateovertime,
ifthecurrentrateishigh.

Usetheaverage
rateovertime,if
thecurrentrateis
loworthecurrent
rate,ifitishigh.

Government
default risk

Remove the
defaultriskfrom
thegovernment
bondratetoget
toriskfreerate.

Useariskfreerateina
lowerinflationcurrency,
withadefaultfree
government(butleave
cashflowsinlocal
currency).

Usethe
governmentbond
rateastheriskfree
rate.

BiasTools3b:EquityRiskPremiums

1928-2012
1962-2012
2002-2012

Arithmetic Average
Geometric Average
Stocks - T. Bills Stocks - T. Bonds Stocks - T. Bills Stocks - T. Bonds
7.65%
5.88%
5.74%
4.20%
2.20%
2.33%
5.93%
3.91%
4.60%
2.93%
2.38%
2.66%
7.06%
3.08%
5.38%
1.71%
5.82%
8.11%

Historical
premium

10

Bias Tools 3c: Country

Risk

Canada

0.00%

5.75%

UnitedStates

0.00%

5.75%

0.00%

5.75%

NorthAmerica

Argentina
Belize
Bolivia
Brazil
Chile
Colombia
CostaRica
Ecuador
ElSalvador
Guatemala
Honduras
Mexico
Nicaragua
Panama
Paraguay
Peru
Suriname
Uruguay
Venezuela

10.13%
14.25%
5.40%
3.00%
1.20%
3.38%
3.38%
12.00%
5.40%
4.13%
8.25%
2.55%
10.13%
3.00%
5.40%
3.00%
5.40%
3.38%
6.75%

15.88%
20.00%
11.15%
8.75%
6.95%
9.13%
9.13%
17.75%
11.15%
9.88%
14.00%
8.30%
15.88%
8.75%
11.15%
8.75%
11.15%
9.13%
12.50%

LatinAmerica

3.94%

9.69%

Andorra
Austria
Belgium
Cyprus
Denmark
Finland
France
Germany
Greece
Iceland
Ireland
IsleofMan
Italy
Liechtenstein
Luxembourg
Malta
Netherlands
Norway
Portugal
Spain
Sweden
Switzerland
Turkey
UK

1.95%
0.00%
1.20%
16.50%
0.00%
0.00%
0.45%
0.00%
10.13%
3.38%
4.13%
0.00%
3.00%
0.00%
0.00%
1.95%
0.00%
0.00%
5.40%
3.38%
0.00%
0.00%
3.38%
0.45%

7.70%
5.75%
6.95%
22.25%
5.75%
5.75%
6.20%
5.75%
15.88%
9.13%
9.88%
5.75%
8.75%
5.75%
5.75%
7.70%
5.75%
5.75%
11.15%
9.13%
5.75%
5.75%
9.13%
6.20%

W.Europe

1,.22%

6.97%

Angola
Benin
Botswana
BurkinaFaso
Cameroon
CapeVerde
Egypt
Gabon
Ghana
Kenya
Morocco
Mozambique
Namibia
Nigeria
Rwanda
Senegal
SouthAfrica
Tunisia
Zambia

5.40%
8.25%
1.65%
8.25%
8.25%
6.75%
12.00%
5.40%
6.75%
6.75%
4.13%
6.75%
3.38%
5.40%
8.25%
6.75%
2.55%
4.73%
6.75%

11.15%
14.00%
7.40%
14.00%
14.00%
12.50%
17.75%
11.15%
12.50%
12.50%
9.88%
12.50%
9.13%
11.15%
14.00%
12.50%
8.30%
10.48%
12.50%

Africa

5.90%

11.65%

Albania
Armenia
Azerbaijan
Belarus
Bosnia
Bulgaria
Croatia
CzechRepublic
Estonia
Georgia
Hungary
Kazakhstan
Latvia
Lithuania
Macedonia
Moldova
Montenegro
Poland
Romania
Russia
Serbia
Slovakia
Slovenia
Uganda
Ukraine

6.75%
4.73%
3.38%
10.13%
10.13%
3.00%
4.13%
1.43%
1.43%
5.40%
4.13%
3.00%
3.00%
2.55%
5.40%
10.13%
5.40%
1.65%
3.38%
2.55%
5.40%
1.65%
4.13%
6.75%
10.13%

12.50%
10.48%
9.13%
15.88%
15.88%
8.75%
9.88%
7.18%
7.18%
11.15%
9.88%
8.75%
8.75%
8.30%
11.15%
15.88%
11.15%
7.40%
9.13%
8.30%
11.15%
7.40%
9.88%
12.50%
15.88%

E.Europe/Russia

3.13%

8.88%

Bahrain
Israel
Jordan
Kuwait
Lebanon
Oman
Qatar
SaudiArabia
UAE

2.55%
1.43%
6.75%
0.90%
6.75%
1.43%
0.90%
1.20%
0.90%

8.30%
7.18%
12.50%
6.65%
12.50%
7.18%
6.65%
6.95%
6.65%

MiddleEast

1.38%

7.13%

Bangladesh
Cambodia
China
Fiji
HongKong
India
Indonesia
Japan
Korea
Macao
Malaysia
Mauritius
Mongolia
Pakistan
PapuaNG
Philippines
Singapore
SriLanka
Taiwan
Thailand
Vietnam

5.40%
8.25%
1.20%
6.75%
0.45%
3.38%
3.38%
1.20%
1.20%
1.20%
1.95%
2.55%
6.75%
12.00%
6.75%
4.13%
0.00%
6.75%
1.20%
2.55%
8.25%

11.15%
14.00%
6.95%
12.50%
6.20%
9.13%
9.13%
6.95%
6.95%
6.95%
7.70%
8.30%
12.50%
17.75%
12.50%
9.88%
5.75%
12.50%
6.95%
8.30%
14.00%

Asia

1.77%

7.52%

Australia

0.00%

5.75%

CookIslands

6.75%

12.50%

NewZealand

Australia &NZ

0.00%

5.75%

0.00%

5.75%

Black #: Total ERP

Red #: Country risk premium
AVG: GDP weighted average

11

BiasTools3d:Adjustthediscountrate

Unbiased:Ifyoufeelthatyourriskadjustmentmetric(e.g.,Beta)is
notcapturingequityriskadequately,thinkaboutbetterwaysof
measuringthatrisk.
Biasup:Reduceyourdiscountratetoreflectimaginarysavingsor
perceivedsafety.

Somevalueinvestorsarguethatthemoretheyknowaboutafirm,the
lowertheriskofthefirm,andthatalowerdiscountrate(eventheriskfree
rate)canbeused.
Inacquisitions,yousometimesseeanalystsreducingdiscountratesto
reflecttheriskreductionfromdiversification.
Asimplewaytoreduceyourcostofcapitalistoincreasethedebtratio
youuse,whilekeepingyourcostofequity&debtfixed.

Biasdown:Addonpremiumstoyourdiscountrate(forsize,
liquidity,privatecompanyrisk,survival)topushupyourdiscount
rateandpushdownvalue.
12

BiasTools4:TerminalValueMagic
Unbiased: Move towards a marginal tax rate
Bias up: Leave at effective tax rate
Bias down: Use tax rate > marginal tax rate

Terminal Value n =

Unbiased: Assume ROIC is equal to or

just above cost of capital. RR= g/ROC
Bias up: Assume no or very low
reinvestment & high ROIC
Bias down: Assume ROIC < Cost of
capital in perpetuity.

EBITn+1 (1 - tax rate) (1 - Reinvestment Rate)

Cost of capital - Expected growth
rate

Unbiased: Move towards mature

company WACC
Bias up: Move below mature
company WACC
Bias down: Leave at current
WACC (especially if it is high risk
company)

Unbiased: g risk free rate

Bias up: g > risk free rate
Bias down: Depends on ROIC

13

BiasTools5:Fromfirmtoequityvalue
Unbiased

Biasup

BiasDown

Cash

Treatasneutral,unlessthereis Addapremiumtothe Discountthecash

evidencethatthemarketis
cash,arguingthat it
substantially, arguing
discountingit.
makesthecompany
thatitearnsalow
safer.
rateofreturn.

Cross
holdings

Trytoestimate theintrinsic
valueoftheseholdings.

OtherAssets

Addonthevalueofonlythose Addonassetsthat
assets thatarenotcountedin youhavealready
yourcashflows.
counted inyourcash
flows(realestate).

Ignoreallotherassets

Goodwill

Ignore value

Addontovalue

Ignore goodwillbut
reduceearningsfor
impairment.

Debt

Includealldebt countedin
yourcostofcapital.

Usealowerdebt
number thanyou
usedincostofcapital.

Count inother
liabilitiesasdebt.

Usebookvalue,
Ignore crossholdings.
especiallyifhigher
thanintrinsicvalue,or
letmanagers specify
value.

14

BiasTools6:Postvaluationgarnishing

Unbiased:Followtheitproposition:Itcanhavevalueonlyifitaffectsthecashflowsof
anassetoritsrisk,anditcanbevaluedexplicitly.

Biasup:Lookforpremiumstoaddtovalue

Controlpremium:Isitreallyalways20%?

Synergypremium:Dontknowwhatitis,butitisworthalot.

Liquiditypremium:Ifanassetisliquid,youaddapremium.

Biasdown:Lookfordiscounts

Minoritydiscount:Ifyougetlessthan50%,youhavetodiscountvalue.

Illiquiditydiscount:Ifitisilliquid,youneedtodiscountitsvalue.

15

Facebook IPO: May 17, 2012

This year
Last year
$ 3,711.00 $ 1,974.00
Revenues
Starting numbers
$ 1,032.00
Operating inco $1,695.00
Invested Capit $ 4,216.11 $
694.00
Tax rate
40.00%
Operating mar
45.68%
Return on cap 146.54%
Sales/Capital
88.02%

Operating assets
+ Cash
- Debt
Value of equity
- Options
Value in stock
Value/share

62,053
1,512
1,219
62,350
3,088
59,262
$25.39

Year
Revenues
Operating margin
EBIT
EBIT (1-t)
- Reinvestment
FCFF

Revenue
growth of 40% a
year for 5 years,
tapering down
to 2% in year 10

Stable Growth
g = 2%; Beta = 1.00;
Cost of capital = 8%
ROC= 12%;
Reinvestment Rate=2%/12% = 16.67%

Sales to
capital ratio of
1.50 for
incremental
sales

Pre-tax
operating
margin declines
to 35% in year
10

Terminal Value 10 = 7,713/(.08-.02) = 128,546

1
$ 5,195
44.61%
$ 2,318
$ 1,391
$ 990
$ 401

2
$ 7,274
43.54%
$ 3,167
$ 1,900
$ 1,385
$ 515

3
$ 10,183
42.47%
$ 4,325
$ 2,595
$ 1,940
$ 655

4
$ 14,256
41.41%
$ 5,903
$ 3,542
$ 2,715
$ 826

5
$ 19,959
40.34%
$ 8,051
$ 4,830
$ 3,802
$ 1,029

6
$ 26,425
39.27%
$ 10,377
$ 6,226
$ 4,311
$ 1,915

7
$ 32,979
38.20%
$ 12,599
$ 7,559
$ 4,369
$ 3,190

8
$ 38,651
37.14%
$ 14,353
$ 8,612
$ 3,782
$ 4,830

9
$ 42,362
36.07%
$ 15,279
$ 9,167
$ 2,474
$ 6,694

Cost of capital = 11.19% (.988) + 1.59% (.012) = 11.07%

Cost of Equity
11.19%

Riskfree Rate:
Riskfree rate = 2%

Cost of Debt
(2%+0.65%)(1-.40)
= 1.59%

Beta
1.53

Unlevered Beta for

Sectors: 1.52

Weights
E = 98.8% D = 1.2%

10
$ 43,209
35.00%
$ 15,123
$ 9,074
$ 565
$ 8,509

Term yr
EBIT (1-t)
9255
- Reinv
1543
FCFF
7713

Cost of capital decreases to

8% from years 6-10

At 4.00 pm, May 17,

the offering was
priced at $38/share

Risk Premium
6%

D/E=1.21%

16

17

Bias Down: Facebook IPO: May 17, 2012

This year
Last year
$ 3,711.00 $ 1,974.00
Revenues
Starting numbers
$ 1,032.00
Operating inco $1,695.00
Invested Capit $ 4,216.11 $
694.00
Tax rate
40.00%
Operating mar
45.68%
Return on cap 146.54%
Sales/Capital
88.02%

Operating assets
+ Cash
- Debt
Value of equity
- Options
Value in stock
Value/share

35,408
1,512
1,219
35,705
3,088
32,616
$13.97

Year
Revenues
Operating margin
EBIT
EBIT (1-t)
- Reinvestment
FCFF

Revenue
growth of 40% a
year for 5 years,
tapering down
to 2% in year 10

Pre-tax
operating
margin drops to
31% over the
next 10 years

Stable Growth
g = 2%; Beta = 1.00;
Cost of capital = 8%
ROC= 8%;
Reinvestment Rate=2%/20% = 10%

Sales to
capital ratio
stays at 0.75

Terminal Value 10 = 6,148/(.08-.02) = 102,469

1
$ 5,195
44.21%
$ 2,297
$ 1,378
$ 1,979
$ (601)

2
$ 7,274
42.74%
$ 3,109
$ 1,865
$ 2,771
$ (906)

3
$ 10,183
41.27%
$ 4,203
$ 2,522
$ 3,879
$ (1,358)

4
$ 14,256
39.81%
$ 5,675
$ 3,405
$ 5,431
$ (2,026)

5
$ 19,959
38.34%
$ 7,652
$ 4,591
$ 7,603
$ (3,012)

6
$ 26,425
36.87%
$ 9,743
$ 5,846
$ 8,622
$ (2,776)

7
$ 32,979
35.40%
$ 11,675
$ 7,005
$ 8,738
$ (1,733)

8
$ 38,651
33.94%
$ 13,116
$ 7,870
$ 7,563
$
307

Cost of capital = 11.19% (.988) + 1.59% (.012) = 11.07%

Cost of Equity
11.19%

Riskfree Rate:
Riskfree rate = 2%

Cost of Debt
(2%+0.65%)(1-.40)
= 1.59%

Beta
1.53

Unlevered Beta for

Sectors: 1.52

Weights
E = 98.8% D = 1.2%

9
$ 42,362
32.47%
$ 13,754
$ 8,252
$ 4,947
$ 3,305

10
$ 43,209
31.00%
$ 13,395
$ 8,037
$ 1,130
$ 6,907

Term yr
EBIT (1-t)
8198
- Reinv
2049
FCFF
6148

Cost of capital decreases to

8% from years 6-10

At 4.00 pm, May 17,

the offering was
priced at $38/share

Risk Premium
6%

D/E=1.21%

18

RelativeValuationBias

Choosea
multiple

Pick
comparable
firms
Spin/Tell
yourstory

19

Biastool1a:Pickthemultiple

20

BiasTool1b:Pickyourscalingvariable
Twitter: Revenues =$550 m, Users = 230 m, Employees = 1250, EBITDA and Net
Income were negative.
Company
EV
Market Cap EV/Sales EV/EBITDA PE
Market Cap/User Market Cap/Employee
Facebook, Inc. (NasdaqGS:FB)
$100,017
$107,909
16.35
36.20
193.73
$97.22
$20.36
Google Inc. (NasdaqGS:GOOG)
$248,856
$296,078
4.46
14.64
25.45
$270.89
$6.61
LinkedIn Corporation (NYSE:LNKD)
$28,449
$29,322
22.87
179.26
729.40
$130.32
$6.91
Netlfix
$13,959
$14,539
3.54
81.20
304.80
$403.86
$7.11
OpenTable, Inc. (NasdaqGS:OPEN)
$1,642
$1,734
9.45
30.35
59.99
$15.34
$3.02
Pandora Media, Inc. (NYSE:P)
$4,163
$4,232
7.89
NA
NA
$21.16
$5.72
RetailMeNot
$1,724
$1,715
10.20
34.20
64.96
$147.84
$4.60
Trulia, Inc. (NYSE:TRLA)
$1,647
$1,853
17.75
NA
NA
$59.02
$3.57
Yelp, Inc. (NYSE:YELP)
$4,006
$4,103
22.42
NA
NA
$41.03
$2.67
Zillow, Inc. (NasdaqGS:Z)
$3,420
$3,590
22.48
NA
NA
$78.20
$5.22
Yahoo! Inc. (NasdaqGS:YHOO)
$27,263
$29,855
5.65
21.24
7.19
$106.24
$2.55
Groupon
$5,857
$7,039
2.42
44.04
NA
$168.80
$0.62
Travelzoo Inc. (NasdaqGS:TZOO)
$347
$421
2.23
12.81
23.39
$16.20
$0.95
Aggregate
$441,350
$502,389
5.82
20.43
30.76
$151.57
$5.96
Median
8.67
32.27 59.99
101.73
4.91
Average

10.97

47.44 159.96

121.98

5.42

If you wanted to show me that Twitter is cheap at $10 billion, which scaling
variable would you use?
21

BiasTools1c:Choosethetimingofyourvariable

Unbiased:Noparticularpreferencebutyoustayconsistentwiththat
choiceacrosscompaniesandacrosstime.

Biasup:Useforwardestimatesforyourcompanywhilestickingwith
trailingorcurrentvaluesforthecomparablefirms.

Biasdown:Usetrailingorcurrentvaluesforyourcompanywhile
projectingforwardvaluesforyourcomparablefirms.

22

BiasTool2:Pruneyourcomparablefirms

Unbiased:Havepresetcriteriaforchoosingcomparablefirms,butonce
selected,yougenerallydonotprunethatlist.(Evenifyouhaveoutliers,
youremovefirmssymmetrically)

Biasup:Removethecheapestfirmsinyourcomparablefirmlist,basedon
whatevermetricormultipleyouareusinginyourvaluation..

Biasdown:Removethemostexpensivefirmsinyourcomparablefirmlist,
basedonwhatevermetricormultipleyouareusinginyourvaluation.

23

BiasTools3:Spinyourstory

Unbiased:Onceyouhavethemultiplescomputedforyoursample,you
controlfordifferencesinallofthefundamentalvariables,measuringrisk,
cashflowsandgrowthbetweenyourfirmandthecomparablefirms.

Biasup:Youpickthefundamentalvariablethatyourfirmlooksbetter
thanthecomparablefirmsonandignoretherest.

Biasdown:Youpickthefundamentalvariablethatyourfirmlooksworse
thanthecomparablefirmsonandignoretherest.

24

Dealingwithbias:Thebadways

Iamnotacrook:Youdonthavetobecrookedtobebiased.Itis
easytodeludeyourselfintobelievingthatyouarejustbeing
objective.
Iuseonlynumbers:Theeasiestdefenseistoarguethatyouare
onlyusingnumbersandthatbiasrequiressubjectivejudgments.
Iamaprofessional:Valuationprofessionalspointtothe
requirementsoftheirprofessionalgroups(CPA,CFA,CVA,etc.)that
theybeunbiased.
Itisafairvalue(withmylawyer/accountantsimprimatur):The
mostcommonresponsetobiasistoaddlegaloraccountingcover.

Legalfairvalue:Inmostcountries,investmentbankershavetosignalegal
documentthattheirvalueisafairvalue.
Accountingfairvalue:Accountantshavejumpedintothemixandhaveset
upstandardsforfairvalue.

25

Healthyresponsestobias
1.

2.

3.

4.

Buildprocessesthatminimizebias,notmaximizeit:Tothedegreethata
significantportionofbiascomesfromreward/punishmentmechanisms,
weneedtobuildprocessesthatdisassociatethevaluationoutcome
fromcompensation.
Behonest(atleastwithyourself):Evenifyoumaynotwanttoreveal
yourbiasestoyourclients,youshouldatleastbehonestwithyourself.
Bayesianvaluation:Itmaybeagoodideatorequireanyonevaluinga
companytostatewhattheybelievethattheywillfindinthevaluation,
beforetheyactuallydothevaluation.Anyoneusingthevaluation
shouldthenhaveaccesstoboththeanalystspriorsandthevaluation.
Transparencyaboutmotives:Allvaluationsshouldbeaccompaniedwith
fulldetailsofwhoispayingforthevaluationandhowmuch,aswellas
anyotherstakesintheoutcomeofthevaluation.

26

II.ValuationUncertainty

27

28

29

30

31

Thesourcesofuncertainty

EstimationversusEconomicuncertainty

MicrouncertaintyversusMacrouncertainty

Estimationuncertaintyreflectsthepossibilitythatyoucouldhavethewrong
modelorestimatedinputsincorrectlywithinthismodel.
Economicuncertaintycomesthefactthatmarketsandeconomiescanchangeover
timeandthateventhebestmodelswillfailtocapturetheseunexpectedchanges.
Microuncertaintyreferstouncertaintyaboutthepotentialmarketforafirms
products,thecompetitionitwillfaceandthequalityofitsmanagementteam.
Macrouncertaintyreflectstherealitythatyourfirmsfortunescanbeaffectedby
changesinthemacroeconomicenvironment.

Discreteversuscontinuousuncertainty

Discreterisk:Risksthatliedormantforperiodsbutshowupatpointsintime.
(Examples:AdrugworkingitswaythroughtheFDApipelinemayfailatsomestage
oftheapprovalprocessoracompanyinVenezuelamaybenationalized)
Continuousrisk:Riskschangesininterestratesoreconomicgrowthoccur
continuouslyandaffectvalueastheyhappen.

32

Unhealthywaysofdealingwithuncertainty
1.

2.

3.

4.

Paralysis&Denial:Whenfacedwithuncertainty,someofusget
paralyzed.Accompanyingtheparalysisisthehopethatifyou
closeyoureyestoit,theuncertaintywillgoaway
Mentalshortcuts(rulesofthumb):Behavioraleconomistsnote
thatinvestorsfacedwithuncertaintyadoptmentalshortcutsthat
havenobasisinreality.Andhereistheclincher.Moreintelligent
peoplearemorelikelytobepronetothis.
Herding:Whenindoubt,itissafesttogowiththecrowd.The
herdinginstinctisdeeplyengrainedandverydifficulttofight.
Outsourcing:Assumingthatthereareexpertsouttherewhohave
theanswersdoestakeaweightoffyourshoulders,evenifthose
expertshavenoideaofwhattheyaretalkingabout.

33

Healthyresponsestouncertainty
1.
2.
3.
4.

5.

6.

Lessismore.
Buildininternalchecksonreasonableness.
Dontsweatthediscountrate
Usetheoffsettingprinciple(riskfreerates&
inflationatTataMotors)
Drawoneconomicfirstprinciples(Terminalvalue
atallthecompanies)
Confrontuncertainty,ifyoucan.

34

1.Lessismore
Revenues&MarginsforTwitter,preIPO
Put intermediate numbers on
autopilot
Year

Revenue growth rate

Base

Revenues

Operating Margin

EBIT

$534.46

1.44%

$7.67

EBIT (1-t)

51.50%

$809.71

3.79%

$30.70

$30.70

51.50%

$1,226.71

6.15%

$75.42

$75.42

51.50%

$1,858.47

8.50%

$158.06

$158.06

51.50%

$2,815.58

10.86%

$305.81

$294.22

51.50%

$4,265.60

13.22%

$563.82

$394.67

41.70%

$6,044.35

15.57%

$941.36

$648.60

31.90%

$7,972.50

17.93%

$1,429.53

$969.22

22.10%

$9,734.43

20.29%

$1,974.84

$1,317.22

12.30%

$10,931.76

22.64%

$2,475.34

$1,623.82

10

2.50%

$11,205.05

25.00%

$2,801.26

$1,806.81

TY

2.50%

$11,485.18

25.00%

$2,871.29

$1,851.99

The NOLs are

embedded in
the taxes and
cash flows.

Be parsimonious: Estimate the big numbers (revenues and margin in year 10)

35

RevenueJudgment:Theexistingplayers

36

TheTotalAdvertisingMarketin2013

37

TheOnlineAdmarketin2023

38

Andmarginjudgments

39

2.Buildininternalchecks
ReinvestmentandReturnonCapital

Comfortable with ROC = 22.39% in year 10?

- Check against cost of capital
- Check against industry average
40

SalestoInvestedCapital

41

3.Dontsweatoverthediscountrate:
Twitterscostofcapital

42

4.Justbeconsistentonmacrovariables
TataMotors:InRupeesandUSdollars

(1.125)*(1.01/1.04)-1 = .0925

Equity versus Firm: If cash flows are post-debt

and to equity, you should discount at the cost
of equity. Pre-debt cash flows should be
discounted at the cost of capital.

Currency: The currency in which the cash

flows are estimated should also be the
currency in which the discount rate is
estimated.

43

5.DrawonEcon101andMath101;
Theterminalvaluelimits
Stablegrowthrate

3M

TataMotors

Amazon

Twitter

0%

$70,409

$26,390

$23,111

1%

$70,409

435,686
435,686

$28,263

$24,212

2%

$70,409

$30,595

$25,679

3%

$70,409

435,686
435,686
435,686
435,686

$37,618

4%
5%

$33,594
$43,334
$52,148

Riskfreerate

3.72%

5%

6.60%

2.70%

ROIC

6.76%

10.39%

20%

12.00%

Costofcapital

6.76%

10.39%

9.61%

8.00%

44

Andthemarketsharecannot>100%

45

6.Confrontuncertainty,ifyoucan
RevisitingtheTwittervaluation

46

Withtheconsequencesforequityvalue

47

III.Complexityinvaluation

48

Sourcesofcomplexity

Globalization:Ascompaniesglobalize,valuationsaregetting
morecomplexforanumberofreasons:

Riskassessmenthastofactorinwhereacompanyoperatesandnot
whereitisincorporated.
Currencychoicesproliferate,sinceacompanycanbevaluedinanyofa
halfadozencurrencies(oftentovaluedifferentlistings)

Shiftingandvolatilemacroeconomicriskshavecreated
changingriskpremiumsandstrangeinterestrate/exchange
rateenvironments.
Morecomplexaccountingstandardshavecreatedlonger,
morecomplicated,moredifficulttoreadfinancialstatements.
Morecomplicatedholdingstructures(crossholdings,shares
withdifferentvotingrights),motivatedbytaxandcontrol
reasons,makevaluationsmoredifficult.
49

Manifestationsofcomplexity
1.

2.

3.

Mysteriousterms/acronyms:Afeatureofcomplex
valuationislineitemsortermsthatsound
sophisticatedbutyoudonotknoworarenotsure
whattheymeanormeasure.(Foranaddedlayerof
intimidation,makethemGreekalphabets)
Longer,moredetailedvaluations:Thelevelofdetail
thatyouseeinvaluations,withhundredsoflineitems
anddozensofinputs,isstaggering(andscary).
Whatifandscenarioanalysis:Whilethereisaplacefor
askingwhatifquestionsandscenarioanalysisin
valuation,theeasewithwhichitcanbedonehas
openedthedoortoabuse,withtheprimaryobjective
becomingcover,nomatterwhathappens.
50

Unhealthyresponsestocomplexity
1.

2.

3.

Inputfatigue:Analystswhoarecalledupontoestimate
dozensanddozensofinputs,oftenwithlittleinformationto
doso,willgiveupatsomepointandinputnumbersjust
togetdone.Itisgarbagein,garbageout
Blackboxmodels:Themodelsbecomesocomplicatedthat
whathappensinsidethemodelbecomesamysterytothose
outside.Consequently,analystsessentiallyclaimno
ownershiporresponsibilityfortheoutputfromthemodel.
Themodeldiditbecomestherefrain.
Suspensionofcommonsense:Thedependenceonmodels
becomessocompletethatanalystslosesightofcommon
senseandmanglethevaluationofthesimplestassets.
51

Healthyresponsestocomplexity
1.

2.

3.

Parsimoniousvaluations:Neverestimatemoreinputs
thanyouabsolutelyhaveto.Lessismore.Whenfaced
withthequestionofaddingmoredetail/complexity,
askyourselfwhetheritwillmakeyourvaluationmore
precise(orjustmakeitlookmoreprecise).
Gobacktofirstprinciples:Thefundamentalsof
valuationdontchange,justbecauseyouarefacedwith
complexity.Alwaysfallbackonfirstprinciples.
Focusonkeylevers:Evenwhentherearedozensof
inputsinavaluation,thevaluationitselfisafunctionof
threeorfourkeyvaluedrivers(whichmaybedifferent
fordifferentcompanies).Keepyourfocusonthose
variables
52

Inclosing

Theproblemwithvaluationpracticeisnotthatwedo
nothaveaccesstoenoughdataorthatourmodelsare
notgoodenoughorthatwedontunderstandvaluation.
Theperilstogoodvaluationlieinthreeveryhuman
failings:

Wearebiasedandwedontliketoadmitwearebiased.Instead,
wedeludeourselvesintobelievingthatwearebeingfairand
objective.
Wefearuncertaintyandtrytoevadeitorhidefromit.
Wethinkthatbiggerandmoresophisticatedmodelswillmake
thebigchoicesforusandspareusthepainofhavingtodoit
ourselves.
53