Approaches to Valuation

Before we begin, let us burst a few general myths about Valuation

 

Myth 1: A Valuation is an objective search for “true value”

Truth: All valuations are biased. The only questions are how much and in which direction.

 

Myth 2: A good Valuation provides a precise estimate of value

Truth: There are no precise valuations. In fact, the payoff to valuation is greatest when valuation is least precise.

 

Myth 3: The more quantitative the model, the better the Value

Truth: One’s understanding of a valuation model is inversely proportional to the number of inputs required for the model. Simpler valuation models do much better than complex ones.

 

With that behind us, there are broadly 2 approaches to Valuation of Securities

 

1.      Discounted cashflow valuation, relates the value of an asset to the present value of expected future cashflows on that asset.

2.      Relative valuation, estimates the value of an asset by looking at the pricing of 'comparable' assets relative to a common variable like earnings, cashflows, book value or sales.

 

The use of valuation models in investment decisions (i.e., in decisions on which assets are under valued and which are over valued) are based upon:

 

1.      a perception that markets are inefficient  and make mistakes in assessing value

2.      an assumption about how and when  these inefficiencies will get corrected

 

In an efficient market, the market price is the best estimate of value. The purpose of any valuation model is then the justification of this value.

 

Discounted Cash Flow Valuation

 

In discounted cash flow valuation, the value of an asset is the present value of the expected cash flows on the asset. Every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash flows, growth and risk. To use discounted cash flow valuation, you need

1.      to estimate the life of the asset

2.      to estimate the cash flows  during the life of the asset

3.      to estimate the discount rate  to apply to these cash flows to get present value

 

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. Since DCF valuation, done right, is based upon an asset's fundamentals, it should be less exposed to market moods and perceptions. If good investors buy businesses, rather than stocks (the Warren Buffet adage), discounted cash flow valuation is the right way to think about what you are getting when you buy an asset. DCF valuation forces you to think about the underlying characteristics of the firm, and understand its business. If nothing else, it brings you face to face with the assumptions you are making when you pay a given price for an asset.

 

Since it is an attempt to estimate intrinsic value, it requires far more inputs and information than other valuation approaches. These inputs and information are not only noisy (and difficult to estimate), but can be manipulated by the savvy analyst to provide the conclusion he or she wants. In an intrinsic valuation model, there is no guarantee that anything will emerge as under or over valued. Thus, it is possible in a DCF valuation model, to find every stock in a market to be over valued. This can be a problem for (1) equity research analysts, whose job it is to follow sectors and make recommendations on the most under and over valued stocks in that sector and (2) equity portfolio managers, who have to be fully (or close to fully) invested in equities

 

This approach is designed for use for assets (firms) that derive their value from their capacity to generate cash flows in the future. It does make your job easier, if the company has a history that can be used in estimating future cash flows. It works best for investors who either have a long time horizon, allowing the market time to correct its valuation mistakes and for price to revert to "true" value or are capable of providing the catalyst needed to move price to value, as would be the case if you were an activist investor or a potential acquirer of the whole firm.

 

Relative Valuation

 

The value of any asset can be estimated by looking at how the market prices "similar" or 'comparable" assets. 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). To do a relative valuation, you need

1.      an identical asset, or a group of comparable or similar assets 

2.      a standardized measure of value (in equity, this is obtained by dividing the price by a common variable, such as earnings or book value)

3.      and if the assets are not perfectly comparable, variables to control for the  differences 

 

Pricing errors made across similar or comparable assets are easier to spot, easier to exploit and are much more quickly corrected. Relative valuation is much more likely to reflect market perceptions and moods than discounted cash flow valuation. This can be an advantage when it is important that the price reflect these perceptions as is the case when the objective is to sell a security at that price today (as in the case of an IPO) and investing on "momentum" based strategies. With relative valuation, there will always be a significant proportion of securities that are under valued and over valued. Since portfolio managers are judged based upon how they perform on a relative basis (to the market and other money managers), relative valuation is more tailored to their needs. Relative valuation generally requires less information than discounted cash flow valuation (especially when multiples are used as screens).

 

A portfolio that is composed of stocks which are under valued on a relative basis may still be overvalued, even if the analysts' judgments are right. It is just less overvalued than other securities in the market. 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.

 

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, and 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, are judged based upon a relative benchmark (the market, other portfolio managers following the same investment style etc.), and can take actions that can take advantage of the relative mispricing; for instance, a hedge fund can buy the under valued and sell the over valued assets.