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M1 - Introduction To Valuation Handout
M1 - Introduction To Valuation Handout
WHAT IS VALUATION?
How?
TYPES OF VALUATION:
Closure Value
All good things come to an end. How we bring things
together at the end. conditions, determine stock prices and thus investor’s
returns.
1.1 Liquidation value: Liquidation value is the amount
of money that a firm would realize by selling its assets Second Box: differentiates what we call “true
and paying off its liabilities expected returns” and “true risk” from “perceived”
returns and “perceived” risk.
1.2 Going concern value: represents the amount that
can be realized if the firm is sold as a continuing Third Box: shows that each stock has an intrinsic
operating entity. (Terminal value) value, which is an estimate of the stock’s “true” value
as calculated by a competent analyst who has the
Book value: best available risk and return data, and a market
price, which is the actual market price based on
*BV of an asset is equal to the historical cost of the perceived but possibly incorrect information
asset less accumulated depreciation or amortization
as the case may be. Bottom Box: Equilibrium
*BV of a firm’s equity is equal to the book value of its Market Inefficiency: Markets are assumed to make
assets minus the book value of its liabilities. mistakes in pricing assets across time, and are
assumed to correct themselves over time, as new
Market value information comes out about assets.
The price that the owner can receive from selling an Management’s goal should be to take actions
asset in the market place. The key determinant of designed to maximize the firm’s intrinsic value, not its
market value is supply and demand for the asset. current market price. Note, though, that maximizing
the intrinsic value will maximize the average price
Intrinsic value over the long run but not necessarily the current price
at each point in time.
Or Fundamental value, is the estimate “actual” or
“true” value of some financial assets.
IMPORTANCE OF VALUATION
*To estimate the price that their firms are likely to DCF is a valuation method used to estimate the value
receive when issuing bonds or shares of common or of an investment based on its expected future cash
preferred stock. flows. It attempts to figure the present value of the
investment based on how much money it will generate
*To understand how corporate decisions may affect in the future.
the value of their firm’s outstanding securities,
especially common stock. Basis:
To know if they would consider buying the asset/entity You need long time horizon because market can make
or not. mistakes, they can find those mistakes but there is no
guarantee that those mistakes will get corrected in the next
months, or year. The longer time horizon the better off you are
If the estimate of intrinsic value exceeds an asset’s using this kind of cash flow valuation
market value (price), investors would consider buying
the asset.
ii. the cash flows during the life of the
If the market value (price) exceeds the estimated asset,
intrinsic value, investors would not consider buying the
asset (or would consider selling if they own it). iii. and the discount rate
Assumption:
Advantage:
In valuing a company:
*Discounted cash flow valuation is the right way to
You can value the equity or the total assets
think about what you are getting when you buy an
asset
DISCOUNTED CASH FLOW VALUATION
(most common tool used to measure intrinsic
valuation)
MODULE 1 – INTRODUCTION TO VALUATION
* DCF valuation forces you to think about the 3 ingredients to get the relative value: (IMC)
underlying characteristics of the firm, and understand
its business i. Identify comparable assets and obtain
market value for these assets
When to use:
Advantages:
* Relative valuation is built on the assumption that *Value first, valuation to follow: In principle, you
markets are correct in the aggregate, but make should do your valuation first before you decide how
mistakes on individual securities. To the degree that much to pay for an asset. In practice, people often
markets can be over or under valued in the decide what to pay and do the valuation afterwards
aggregate, relative valuation will fail.
II. THE SOURCES
* Relative valuation may require less information in the
way in which most analysts and portfolio managers use The power of the subconscious: We are human,
it. However, this is because implicit assumptions are after all, and as a consequence are susceptible to
made about other variables (that would have been bias.
required in a discounted cash flow valuation). To the
extent that these implicit assumptions are wrong the The power of suggestion: Hearing what others think
relative valuation will also be wrong. a company is worth will color your thinking, and if you
view those others as more informed/smarter than you
are, you will be influenced even more.
When to use:
The power of money: If you have an economic stake
This approach is easiest to use when in the outcome of a valuation, bias will almost always
follow.
¤ there are a large number of assets comparable to
the one being valued ¤ Corollary 1: Your bias in a valuation will be
directly proportional to who pays you to do the
¤ these assets are priced in a market valuation and how much you get paid.
¤ there exists some common variable that can be ¤ Corollary 2: You will be more biased when
used to standardize the price ¨ valuing a company where you already have a
position (long or short) in the company
This approach tends to work best for investors
iii. No pre-commitments: Decision makers should b. Firm-specific Uncertainty: The path that we envision
avoid taking strong public positions on the value of a for a firm can prove to be hopelessly wrong. The firm
firm before the valuation is complete. may do much better or much worse than we expected
it to perform, and the resulting earnings and cash flows
iv. Self-Awareness: The best antidote to bias is will be very different from our estimates.
awareness. An analyst who is aware of the biases he
or she brings to the valuation process so she can either c. Macroeconomic Uncertainty: Even if a firm evolves
actively try to confront these biases when making input exactly the way we expected it to, the macro-economic
choices or open the process up to more objective environment can change in unpredictable ways.
points of view. Interest rates can go up or down and the economy can
do much better or worse than expected. These macro-
v. Honest reporting: The analyst should reveal their economic changes will affect value.
priors (Biases) before they present their results from an
analysis so that the person reviewing the study can
then factory that bias in while looking at the
conclusions.
Responses of Uncertainty
2. IMPRECISION AND UNCERTAINTY i. Valuation Ranges: A few analysts recognize that the
When valuing an asset at any point in time, we make value that they obtain for a business is an estimate
forecasts for the future. Since none of us possess
and try to quantify a range on the estimate. Some use
crystal balls, we have to make our best estimates,
given the information that we have at the time of the simulations and others derive expected, best-case
valuation.
and worst-case estimates of value. The output that
Our estimates of value can be wrong for a number of they provide therefore yields both their estimates of
reasons, and we can categorize these reasons into value and their uncertainty about that value.
three groups.
ii.Probabilistic Statements: Some analysts couch their
a. Estimation Uncertainty: Even if our information valuations in probabilistic terms to reflect the
sources are impeccable, we have to convert raw uncertainty that they feel. Thus, an analyst who
information into inputs and use these inputs in models. estimates a value of $ 30 for a stock which is trading
Any mistakes or mis-assessments that we make at at $ 25 will state that there is a 60 or 70% probability
either stage of this process will cause estimation error. that the stock is undervalued rather than make the
categorical statement that it is undervalued. Here
again, the probabilities that accompany the
MODULE 1 – INTRODUCTION TO VALUATION
statements provide insight into the uncertainty that the In the physical sciences, the principle of parsimony
analyst perceives in the valuation. dictates that we try the simplest possible explanation
for a phenomenon before we move on to more
iii.Building better models and accessing superior complicated ones.
information When valuing an asset, we want to use the simplest