I told you guys last month that I signed up and paid money like a sucker to do a semester long Valuation course through NYU with Aswath Damodaran. Why a sucker? Because Damodaran provides all of this courses and materials through his website for anyone to take for free. Honestly, follow the link and you can take any course he teaches entirely for free. It’s an incredible resource. However, like most people, I never got around to doing the Valuation course available for free because… it’s free. When things are free, they tend to constantly get shifted down in the priority list of things to do because you reason that you can do it anytime because… it’s free. That’s a recipe for never doing anything. So I paid up to motivate myself to actually go through with learning this material. Since my first quiz is coming up, I figured I would do a brain dump of the topics covered so far for my own review. If you find it interesting, great.
Introduction to Valuation
Here is the link to the entire Valuation course, with links to videos and lecture slides. Kudos if you have the discipline to go through this entire free resource.
I would recommend watching Damodaran’s first video in the course series on the Introduction to Valuation:
A big concept to immediately realize is that valuation is a series of assumptions. The components of the discount rate are made up through a series of assumptions. Therefore, there is no absolute right or wrong, just degrees of right and wrong. While the valuation process is a series of assumptions, just like when I talked about models, it is far better to create a model and make explicit assumptions that you can revisit if the model turns out to be right or wrong, than to make implicit assumptions.
Why? Because when you don’t make your assumptions explicit and open to inquiry, it is psychologically far too easy for the human mind to conduct some fancy mental gymnastics to either revise poor thinking to make it not seem so bad in hindsight or just completely forget about errors because it is emotionally too painful.
Myths of Valuation
However, again, just like when I talked about the pros and cons of models, you also need to be aware of some myths when it comes to intrinsic valuation:
Myth #1 – Valuation is an Objective Search for “True” Value
- Since all valuation is based on a series of assumptions, this is not true.
- There are biases when it comes to making valuation: i.e. if you are getting paid to make a valuation, your biases will affect the inputs you use to come up with a “value”.
Myth #2 – A Good Valuation Provides a Precise Estimate of Value
- There are no precise valuations, again because it is based on a series of assumptions.
- Counter-intuitively, the payoff to valuation is greatest when valuation is least precise. A company like Amazon has a greater range of potential payoffs (and loss) than a company like Wal-Mart.
Myth #3 – The More Quantitative a Model, the Better the Valuation
- Again, since valuation is based on a series of assumptions, you can’t just bring in more and more higher level math and make your model more and more complex to get a more and more precise valuation. There are times for complexity and times for simplicity.
- Typically, simpler valuation models do much better than complex ones. Buffett and Munger have been repeating for decades that their models for buying companies/stocks is rather very elementary and simple.
So, while it is important to create a model to value a company based on a series of explicit assumptions you make, it is also important to not get carried away with hubris thinking that making your model unnecessarily complex and adding additional decimal points to your figures is going to somehow unveil the “Truth” because capital T “Truth” does not exist.
Three Valuation Methods
When it comes to approaches to valuation, there are 3 main approaches:
1. Intrinsic Valuation
- This is the approach we are interested in and will be focusing on, which is the idea that the value of a company is the capacity for a company to generate cash flows and the risk in those cash flows. You discount the cash flows to the present to find an estimation of the present value of expected future cash flows of an asset.
2. Relative Valuation
- This method estimates the value of an asset (company) by looking at the pricing of “comparable” assets (companies) to a common variable like earnings, cash flows, book value, revenue, etc. For example, you would look at something like the entire industrial sector, find the average P/E of that sector, and then find companies that deviate from that average ratio. You are relying on reversion to the mean to close the gap between the average ratio and the ratio of the company you buy.
3. Contingent Claim Valuation
- This one uses option pricing models to measure the value of assets that share option-like characteristics. For example, if a company owns an asset that has contingent cash flows – meaning that the asset will only have value if something happens – the company’s value will depend on whether those contingent cash flows truly become an asset. For example, if you are a pharmaceutical company with a patent working its way through the pipeline, that patent (or potential asset) only has value once it gains FDA approval and can turn into an asset that generates cash flows.
Each of these 3 approaches assume that markets make mistakes. Therefore, if you believe markets are efficient, you should just buy an index and forget about doing valuation of any sort because in an efficient market, the market price is the best estimate of value.
All 3 are important to understand in order to truly grasp valuation – there is a time and place for each approach and knowing when to use each one is a key part in mastering valuation
Intrinsic and Relative Valuation are what dominate most valuations, and for our purposes, we will be focusing on Intrinsic Valuation, which is based on discounted cash flows.
To reiterate, discounted cash flows assumes that the value of an asset is the present value of the expected cash flows from that asset. In its most basic form, this is the valuation method perferred by value investors like Warren Buffett, Seth Klarman, Joel Greenblatt, etc.
The assumption you are making when you choose to use discounted cash flows is that you believe every asset has an intrinsic value that can be estimated based upon 3 characteristics:
- Cash Flows
In order to use discounted cash flows, you need 3 estimates:
- Estimated Life of the Asset
- Estimated Cash Flows during the Life of the Asset
- Estimated Discount Rate to Apply to the Cash Flows to get a Present Value
Additionally, you are making an assumption that markets make mistakes in pricing assets across time and that markets will correct themselves over time as new information comes out about assets.
While we focus on discounted cash flows, Relative Valuation and Contingent Claim Valuation are also important and integral tools to have in our toolbox for being able to make the most accurate assumptions possible.
I keep repeating this ad nauseam because I think this is the most important takeaway: valuation is based on a series of assumptions.
There is no “Truth” when conducting valuation. There are closer degrees of truth based on better data and analysis, but anything that is forecasting into the future is inherently volatile.
If you are looking for absolute certainty, you will not find it in valuation.