MODULE 1 – INTRODUCTION TO VALUATION

WHAT IS VALUATION?

Valuation is an analytical process that links risk and

return to estimate the current (or projected) worth of
an asset or a company.

How?

In placing a value on a company, an analyst looks at:

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(a) The business’s management

(b) The composition of its capital structure
(c) Prospect of future earnings
(d) Market value of the assets

TYPES OF VALUATION:

 Closure Value
All good things come to an end. How we bring things
together at the end.
1.1 Liquidation value: Liquidation value is the amount
of money that a firm would realize by selling its assets
and paying off its liabilities
1.2 Going concern value: represents the amount that
can be realized if the firm is sold as a continuing
operating entity. (Terminal value)
 Book value:
*BV of an asset is equal to the historical cost of the
asset less accumulated depreciation or amortization
as the case may be.
conditions, determine stock prices and thus investor’s
returns.
Second Box: differentiates what we call “true
expected returns” and “true risk” from “perceived”
returns and “perceived” risk.
Third Box: shows that each stock has an intrinsic
value, which is an estimate of the stock’s “true” value
as calculated by a competent analyst who has the
best available risk and return data, and a market
price, which is the actual market price based on
perceived but possibly incorrect information
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
asset in the market place. The key determinant of
market value is supply and demand for the asset.
 Intrinsic value
Or Fundamental value, is the estimate “actual” or
“true” value of some financial assets.
Management’s goal should be to take actions
designed to maximize the firm’s intrinsic value, not its
current market price. Note, though, that maximizing
the intrinsic value will maximize the average price
over the long run but not necessarily the current price
at each point in time.

IMPORTANCE OF VALUATION

 Corporate managers, (especially financial

Top Box: Indicates that managerial actions, managers)
combined with the economy, taxes, and political
 MODULE 1 – INTRODUCTION TO VALUATION
*Determine if the market properly prices these assets
*To estimate the price that their firms are likely to
receive when issuing bonds or shares of common or
preferred stock.
*To understand how corporate decisions may affect
the value of their firm’s outstanding securities,
especially common stock.
 Analysts:
To help their clients (in a merger, acquisition
transaction, capital budgeting, investment analysis,
litigation and financial reporting). It is their work to
know if an asset or a company is undervalued or
overvalued by the market.
 Investors:
To know if they would consider buying the asset/entity
or not.
If the estimate of intrinsic value exceeds an asset’s
market value (price), investors would consider buying
the asset.
If the market value (price) exceeds the estimated
intrinsic value, investors would not consider buying the
asset (or would consider selling if they own it).
STANDARD APPROACHES IN VALUATION
In valuing a company:
You can value the equity or the total assets
 DISCOUNTED CASH FLOW VALUATION
(most common tool used to measure intrinsic
valuation)
What?
DCF is a valuation method used to estimate the value
of an investment based on its expected future cash
flows. It attempts to figure the present value of the
investment based on how much money it will generate
in the future.
Basis:
Every asset has an intrinsic value that can be
estimated, based upon its characteristics in terms of
cash flows, growth and risk.
3 ingredients to get the present value (LCD)
i. life of the asset, (when your business
will mature, I cannot estimate cash flows
forever, much preferred- long time
horizon)
You need long time horizon because market can make
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
using this kind of cash flow valuation
ii. the cash flows during the life of the
asset,
iii. and the discount rate
Assumption:
Market makes mistakes in valuing individual
companies and that they are correct these mistakes
over time.
Advantage:
*It should be less exposed to market moods and
perceptions. (if you don’t trust crowd to make the
judgement, intrinsic valuation is for you)
*Discounted cash flow valuation is the right way to
think about what you are getting when you buy an
asset
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* 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

Disadvantage: ii. Create price multiples: Convert market

values into standardized values, since
*It is difficult to estimate the absolute prices cannot be
compared.
*It can be manipulated by the analyst to provide the
conclusion that he or she wants

When to use:

*This approach is designed for use for assets (firms)

that derive their value from their capacity to generate
cash flows in the future.
* Investors with a long-time horizon, allowing the
market time to correct its valuation mistakes and for
price to revert to “true” value

DCF Things to Remember:

1. IT Proposition: If it does not affect the cash
flows or alter risk (thus changing discount
rate) it cannot affect the value.
2. DUH proposition: For an asset to have value,
the expected cash flows have to be positive
some time over the life of the asset.
3. DON’T FREAK OUT Proposition: Assets can
generate negative cash flows for the first
years especially start-ups.
iii. Compare multiples of the asset being
analyzed to the multiples for comparable
assets and control any differences
between the firms to judge if the asset is
under value or over value
Assumption:
Assume that markets are right on average but that
they’re wrong in individual companies and that those
mistakes will get corrected sooner rather than later.

Advantages:

* In sync with the market: Relative valuation is much

more likely to reflect market perceptions and moods
than discounted cash flow valuation. This can be an
 RELATIVE VALUATION: advantage when it is important that the price reflect
these perceptions as is the case when

¤ the objective is to sell an asset at that price

What?
The value of any asset can be estimated by looking at today (IPO, M&A)
how the market prices “similar” or ‘comparable” assets
¤ investing on “momentum” based strategies
Basis: The intrinsic value of an asset is impossible (or
close to impossible) to estimate. The price of an asset *Relative valuation generally requires less explicit
information than discounted cash flow valuation
is whatever the market is willing to pay for it (based
upon its characteristics)
Disadvantages:
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* Relative valuation is built on the assumption that
markets are correct in the aggregate, but make
mistakes on individual securities. To the degree that
markets can be over or under valued in the
aggregate, relative valuation will fail.
* Relative valuation may require less information in the
way in which most analysts and portfolio managers use
it. However, this is because implicit assumptions are
made about other variables (that would have been
required in a discounted cash flow valuation). To the
extent that these implicit assumptions are wrong the
relative valuation will also be wrong.
When to use:
This approach is easiest to use when
¤ there are a large number of assets comparable to
the one being valued
¤ these assets are priced in a market
¤ there exists some common variable that can be
used to standardize the price ¨
This approach tends to work best for investors
¤ who have relatively short time horizons
LIMITATIONS IN VALUATION
Bermuda triangles of valuations. The three big
reasons why valuations fail.
1. BIAS
I: EFFECT
* Preconceptions and priors: When you start on the
valuation of a company, you almost never start with a
blank slate. Instead, your valuation is shaped by your
prior views of the company in question.
¤ Corollary 1: The more you know about a company,
the more likely it is that you will be biased, when
valuing the company.
¤ Corollary 2: The “closer” you get to the
management/owners of a company, the more biased
your valuation of the company will become.
*Value first, valuation to follow: In principle, you
should do your valuation first before you decide how
much to pay for an asset. In practice, people often
decide what to pay and do the valuation afterwards
II. THE SOURCES
The power of the subconscious: We are human,
after all, and as a consequence are susceptible to
bias.
The power of suggestion: Hearing what others think
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.
The power of money: If you have an economic stake
in the outcome of a valuation, bias will almost always
follow.
¤ Corollary 1: Your bias in a valuation will be
directly proportional to who pays you to do the
valuation and how much you get paid.
¤ Corollary 2: You will be more biased when
valuing a company where you already have a
position (long or short) in the company
III. WHAT TO DO ABOUT BIAS
Bias cannot be regulated or legislated out of
existence. Analysts are human and bring their biases
to the table. However, there are ways in which we can
mitigate the effects of bias on valuation:
i. Reduce institutional pressures: Sources of bias
had to grapple with the demand from their employers.
Institution should want honest sell-side or buy-side
valuation.
ii. De-link valuations from reward/punishment: Any
valuation process where the reward or punishment is
conditioned on the outcome of the valuation will result
in biased valuations.
 MODULE 1 – INTRODUCTION TO VALUATION
iii. No pre-commitments: Decision makers should
avoid taking strong public positions on the value of a
firm before the valuation is complete.
iv. Self-Awareness: The best antidote to bias is
awareness. An analyst who is aware of the biases he
or she brings to the valuation process so she can either
actively try to confront these biases when making input
choices or open the process up to more objective
points of view.
v. Honest reporting: The analyst should reveal their
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.
2. IMPRECISION AND UNCERTAINTY
When valuing an asset at any point in time, we make
forecasts for the future. Since none of us possess
crystal balls, we have to make our best estimates,
given the information that we have at the time of the
valuation.
Our estimates of value can be wrong for a number of
reasons, and we can categorize these reasons into
three groups.
a. Estimation Uncertainty: Even if our information
sources are impeccable, we have to convert raw
information into inputs and use these inputs in models.
Any mistakes or mis-assessments that we make at
either stage of this process will cause estimation error.
b. Firm-specific Uncertainty: The path that we envision
for a firm can prove to be hopelessly wrong. The firm
may do much better or much worse than we expected
it to perform, and the resulting earnings and cash flows
will be very different from our estimates.
c. Macroeconomic Uncertainty: Even if a firm evolves
exactly the way we expected it to, the macro-economic
environment can change in unpredictable ways.
Interest rates can go up or down and the economy can
do much better or worse than expected. These macro-
economic changes will affect value.
Responses of Uncertainty
i. Valuation Ranges: A few analysts recognize that the
value that they obtain for a business is an estimate
and try to quantify a range on the estimate. Some use
simulations and others derive expected, best-case
and worst-case estimates of value. The output that
they provide therefore yields both their estimates of
value and their uncertainty about that value.
ii.Probabilistic Statements: Some analysts couch their
valuations in probabilistic terms to reflect the
uncertainty that they feel. Thus, an analyst who
estimates a value of $ 30 for a stock which is trading
at $ 25 will state that there is a 60 or 70% probability
that the stock is undervalued rather than make the
categorical statement that it is undervalued. Here
again, the probabilities that accompany the
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statements provide insight into the uncertainty that the
analyst perceives in the valuation.
iii.Building better models and accessing superior
information
In the physical sciences, the principle of parsimony
dictates that we try the simplest possible explanation
for a phenomenon before we move on to more
complicated ones.
When valuing an asset, we want to use the simplest

3. COMPLEXITY model we can get away with. In other words, if we can

value an asset with three inputs, we should not be
We live in the complex world, with complex data and
complex model and sometimes that gets in the way in using five. If we can value a company with 3 years of
the simplicity that is core of valuation.
cashflow forecasts, forecasting ten years of cash flows
is asking for trouble.
The Cost of Complexity

There are clear costs that we pay as models become

more complex and require more information.

Information Overload: More information does not

always lead to better valuations. In fact, analysts can
become overwhelmed when faced with vast amounts
of conflicting information and this can lead to poor input
choices. The problem happened by the fact that
analysts often operate under time pressure when
valuing companies.

Black Box Syndrome: The models become so

complicated that the analysts using them no longer
understand their inner workings. They feed inputs into
the model’s black box and the box spits out a value.

The Principle of Parsimony

What do I mean by that? If you can value a company

with three inputs don’t go looking for five. If you can
value a company with three years of forecasts don’t do
10, less is more.