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ANINTRODUCTIONTOVALUATIONSpring2017AswathDamodaran
Aswath Damodaran 1
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Valuationwon’tmakeyourational.Youareahumanbeingwithlemmingitis!¨ "Onehundredthousandlemmingscannotbewrong"
Graffiti
We thought we were in the top of the eighth inning, when we were in the bottom of the ninth.. Stanley
DruckenmillerAswath Damodaran
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MisconceptionsaboutValuation
¨ Myth1:Avaluationisanobjectivesearchfor“true” value¤ Truth1.1:Allvaluationsarebiased.Theonlyquestionsare“howmuch”
andinwhichdirection.¤ Truth1.2:Thedirectionandmagnitudeofthebiasinyourvaluationis
directlyproportionaltowhopaysyouandhowmuchyouarepaid.¨ Myth2.:Agoodvaluationprovidesapreciseestimateofvalue
¤ Truth2.1:Therearenoprecisevaluations.¤ Truth2.2:Thepayofftovaluationisgreatestwhenvaluationisleast
precise.¨ Myth3:.Themorequantitativeamodel,thebetterthevaluation
¤ Truth3.1:One’sunderstandingofavaluationmodelisinverselyproportionaltothenumberofinputsrequiredforthemodel.
¤ Truth3.2:Simplervaluationmodelsdomuchbetterthancomplexones.
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TheBermudaTriangleofValuation
Valuation First Principles & Good Sense
Uncertainty & the Unknown- Paralysis- Outsourcing- Herding- Mental accounting
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ApproachestoValuation
1. Intrinsicvaluation,relatesthevalueofanassettoitsintrinsiccharacteristics:itscapacitytogeneratecashflowsandtheriskinthecashflows.Init’smostcommonform,intrinsicvalueiscomputedwithadiscountedcashflowvaluation,withthevalueofanassetbeingthepresentvalueofexpectedfuturecashflowsonthatasset.
2. RelativevaluationorPricing,estimatesthevalueofanassetbylookingatthepricingof'comparable'assetsrelativetoacommonvariablelikeearnings,cashflows,bookvalueorsales.
3. Contingentclaimvaluation,usesoptionpricingmodelstomeasurethevalueofassetsthatshareoptioncharacteristics.
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Basisforallvaluationapproaches
¨ Theuseofvaluationmodelsininvestmentdecisions(i.e.,indecisionsonwhichassetsareundervaluedandwhichareovervalued)arebasedupon¤ aperceptionthatmarketsareinefficientandmakemistakesinassessingvalue
¤ anassumptionabouthowandwhentheseinefficiencieswillgetcorrected
¨ Inanefficientmarket,themarketpriceisthebestestimateofvalue.Thepurposeofanyvaluationmodelisthenthejustificationofthisvalue.
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DiscountedCashflowValuation(DCF)
¨ Whatisit:Indiscountedcashflowvaluation,thevalueofanassetisthepresentvalueoftheexpectedcashflowsontheasset.
¨ PhilosophicalBasis:Everyassethasanintrinsicvaluethatcanbeestimated,baseduponitscharacteristicsintermsofcashflows,growthandrisk.
¨ InformationNeeded:Tousediscountedcashflowvaluation,youneed¤ toestimatethelifeoftheasset¤ toestimatethecashflowsduringthelifeoftheasset¤ toestimatethediscountratetoapplytothesecashflowstogetpresent
value¨ MarketInefficiency:Marketsareassumedtomakemistakesin
pricingassetsacrosstime,andareassumedtocorrectthemselvesovertime,asnewinformationcomesoutaboutassets.
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AdvantagesofDCFValuation
¨ SinceDCFvaluation,doneright,isbaseduponanasset’sfundamentals,itshouldbelessexposedtomarketmoodsandperceptions.
¨ Ifgoodinvestorsbuybusinesses,ratherthanstocks(theWarrenBuffetadage),discountedcashflowvaluationistherightwaytothinkaboutwhatyouaregettingwhenyoubuyanasset.
¨ DCFvaluationforcesyoutothinkabouttheunderlyingcharacteristicsofthefirm,andunderstanditsbusiness.Ifnothingelse,itbringsyoufacetofacewiththeassumptionsyouaremakingwhenyoupayagivenpriceforanasset.
¨ Ifyoubuyintothenotionofvaluebeingdrivenbyacompany’scashflows,youareimmunized(totheextentthatyouhavealongtimehorizon)fromwhatthemarketthinksaboutyourinvestment..
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DisadvantagesofDCFvaluation
¨ Sinceitisanattempttoestimateintrinsicvalue,itrequiresfarmoreexplicitinputsandinformationthanothervaluationapproaches
¨ Theseinputsandinformationarenotonlynoisy (anddifficulttoestimate),butcanbemanipulatedbytheanalysttoprovidetheconclusionheorshewants.Thequalityoftheanalystthenbecomesafunctionofhowwellheorshecanhidethemanipulation.
¨ Inanintrinsicvaluationmodel,thereisnoguaranteethatanythingwillemergeasunderorovervalued.Thus,itispossibleinaDCFvaluationmodel,tofindeverystockinamarkettobeovervalued.Thiscanbeaproblemfor¤ equityresearchanalysts,whosejobitistofollowsectorsandmake
recommendationsonthemostunderandovervaluedstocksinthatsector¤ equityportfoliomanagers,whohavetobefully(orclosetofully)investedin
equities
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WhenDCFValuationworksbest
¨ Attheriskofstatingtheobvious,thisapproachisdesignedforuseforassets(firms)thatderivetheirvaluefromtheircapacitytogeneratecashflowsinthefuture.
¨ Itworksbestforinvestorswho¤ havealongtimehorizon,allowingthemarkettimetocorrectitsvaluationmistakesandforpricetorevertto“true” valueor
¤ arecapableofprovidingthecatalystneededtomovepricetovalue,aswouldbethecaseifyouwereanactivistinvestororapotentialacquirerofthewholefirm
¤ arenoteasilyswayedoraffectedbymarketmovementsthatarecontrarytotheir“value”views
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RelativeValuation(Pricing)
¨ Whatisit?:Thevalueofanyassetcanbeestimatedbylookingathowthemarketprices“similar” or‘comparable” assets.
¨ PhilosophicalBasis:Theintrinsicvalueofanassetisimpossible(orclosetoimpossible)toestimate.Thepriceofanassetiswhateverthemarketiswillingtopayforit(baseduponitscharacteristics)
¨ InformationNeeded:Todoarelativevaluation,youneed¤ anidenticalasset,oragroupofcomparableorsimilarassets¤ astandardizedmeasureofvalue(inequity,thisisobtainedbydividingthe
pricebyacommonvariable,suchasearningsorbookvalue)¤ andiftheassetsarenotperfectlycomparable,variablestocontrolforthe
differences¨ MarketInefficiency:Pricingerrorsmadeacrosssimilaror
comparableassetsareeasiertospot,easiertoexploitandaremuchmorequicklycorrected.
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AdvantagesofRelativeValuation
¨ Insyncwiththemarket:Relativevaluationismuchmorelikelytoreflectmarketperceptionsandmoodsthandiscountedcashflowvaluation.Thiscanbeanadvantagewhenitisimportantthatthepricereflecttheseperceptionsasisthecasewhen¤ theobjectiveistosellanassetatthatpricetoday(IPO,M&A)¤ investingon“momentum” basedstrategies
¨ Withrelativevaluation,therewillalwaysbeasignificantproportionofsecurities thatareundervaluedandovervalued.Sinceportfoliomanagersarejudgedbaseduponhowtheyperformonarelativebasis(tothemarketandothermoneymanagers),relativevaluationismoretailoredtotheirneeds
¨ Relativevaluationgenerallyrequireslessexplicitinformationthandiscountedcashflowvaluation.
¨ Inrelativevaluation,youareplayingthe“incremental”game,whereyouhopetomakemoneybygettingthenextincrement(earningsreport,newsstoryetc.)right.
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DisadvantagesofRelativeValuation
¨ Aportfoliothatiscomposedofstockswhichareundervaluedonarelativebasismaystillbeovervalued,eveniftheanalysts’judgmentsareright.Itisjustlessovervaluedthanothersecuritiesinthemarket.
¨ Relativevaluationisbuiltontheassumptionthatmarketsarecorrectintheaggregate,butmakemistakesonindividualsecurities.Tothedegreethatmarketscanbeoverorundervaluedintheaggregate,relativevaluationwillfail
¨ Relativevaluationmayrequirelessinformationinthewayinwhichmostanalystsandportfoliomanagersuseit.However,thisisbecauseimplicitassumptionsaremadeaboutothervariables(thatwouldhavebeenrequiredinadiscountedcashflowvaluation).Totheextentthattheseimplicitassumptionsarewrongtherelativevaluationwillalsobewrong.
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Whenrelativevaluationworksbest..
¨ Thisapproachiseasiesttousewhen¤ therearealargenumberofassetscomparabletotheonebeingvalued
¤ theseassetsarepricedinamarket¤ thereexistssomecommonvariablethatcanbeusedtostandardizetheprice
¨ Thisapproachtendstoworkbestforinvestors¤ whohaverelativelyshorttimehorizons¤ arejudgedbaseduponarelativebenchmark(themarket,otherportfoliomanagersfollowingthesameinvestmentstyleetc.)
¤ cantakeactionsthatcantakeadvantageoftherelativemispricing;forinstance,ahedgefundcanbuytheundervaluedandselltheovervaluedassets
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AssetBasedValuation:ADetour
¨ Incontrasttovaluingabusinessasagoingconcern(basedoncashflows)orbylookingathowotherbusinessesthatlookitarepriced(relativevaluation),yousometimesmayvalueabusinessbyvaluingitsassets.
¨ Assetbasedvaluationmaybeusedinthecontextof¤ Liquidationvaluation,whereyouarevaluingtheassetsforsale¤ Accountingvaluation,whereyouarevaluingindividualassetsfor
accountingreasons(fairvalueorgoodwillestimation¤ Sumofthepartsvaluation,toeitherseeifacompanyischeapasan
investmentoragoodtargetforacquisition/restructuring¨ Tovaluetheindividualassets,though,youhavetoeitheruse
expectedcashflows(intrinsicvaluation)orbaseitonthepricingofsimilarassets(relativevaluation).
¨ Assetbasedvaluationiseasiesttodowhenassetsareseparableandhavestandaloneearnings/cashflows.
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Whatapproachwouldworkforyou?
¨ Asaninvestor,givenyourinvestmentphilosophy,timehorizonandbeliefsaboutmarkets(thatyouwillbeinvestingin),whichofthetheapproachestovaluationwouldyouchoose?a. DiscountedCashFlowValuationb. RelativeValuationc. Neither.Ibelievethatmarketsareefficient.
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ContingentClaim(Option)Valuation
¨ Optionshaveseveralfeatures¤ Theyderivetheirvaluefromanunderlyingasset,whichhasvalue
¤ Thepayoffonacall(put)optionoccursonlyifthevalueoftheunderlyingassetisgreater(lesser)thananexercisepricethatisspecifiedatthetimetheoptioniscreated.Ifthiscontingencydoesnotoccur,theoptionisworthless.
¤ Theyhaveafixedlife
¨ Anysecuritythatsharesthesefeaturescanbevaluedasanoption.
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OptionPayoffDiagrams
Value of AssetStrike Price
Call OptionPut Option
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DirectExamplesofOptions
¨ Listedoptions,whichareoptionsontradedassets,thatareissuedby,listedonandtradedonanoptionexchange.
¨ Warrants,whicharecalloptionsontradedstocks,thatareissuedbythecompany.Theproceedsfromthewarrantissuegotothecompany,andthewarrantsareoftentradedonthemarket.
¨ ContingentValueRights,whichareputoptionsontradedstocks,thatarealsoissuedbythefirm.TheproceedsfromtheCVRissuealsogotothecompany
¨ ScoresandLEAPs,arelongtermcalloptionsontradedstocks,whicharetradedontheexchanges.
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IndirectExamplesofOptions
¨ Equityinadeeplytroubledfirm - afirmwithnegativeearningsandhighleverage- canbeviewedasanoptiontoliquidatethatisheldbythestockholdersofthefirm.Viewedassuch,itisacalloptionontheassetsofthefirm.
¨ Thereservesownedbynaturalresourcefirmscanbeviewedascalloptionsontheunderlyingresource,sincethefirmcandecidewhetherandhowmuchoftheresourcetoextractfromthereserve,
¨ Thepatentownedbyafirmoranexclusivelicense issuedtoafirmcanbeviewedasanoptionontheunderlyingproduct(project).Thefirmownsthisoptionforthedurationofthepatent.
¨ Therightspossessedbyafirmtoexpand anexistinginvestmentintonewmarketsornewproducts.
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AdvantagesofUsingOptionPricingModels
¨ Optionpricingmodelsallowustovalueassetsthatweotherwisewouldnotbeabletovalue. Forinstance,equityindeeplytroubledfirmsandthestockofasmall,bio-technologyfirm(withnorevenuesandprofits)aredifficulttovalueusingdiscountedcashflowapproachesorwithmultiples.Theycanbevaluedusingoptionpricing.
¨ Optionpricingmodelsprovideusfreshinsightsintothedriversofvalue.Incaseswhereanassetisderivingitvaluefromitsoptioncharacteristics,forinstance,moreriskorvariabilitycanincreasevalueratherthandecreaseit.
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DisadvantagesofOptionPricingModels
¨ Whenrealoptions(whichincludesthenaturalresourceoptionsandtheproductpatents)arevalued,manyoftheinputsfortheoptionpricingmodelaredifficulttoobtain.Forinstance,projectsdonottradeandthusgettingacurrentvalueforaprojectoravariancemaybeadauntingtask.
¨ Theoptionpricingmodelsderivetheirvaluefromanunderlyingasset.Thus,todooptionpricing,youfirstneedtovaluetheassets.Itisthereforeanapproachthatisanaddendumtoanothervaluationapproach.
¨ Finally,thereisthedangerofdoublecountingassets.Thus,ananalystwhousesahighergrowthrateindiscountedcashflowvaluationforapharmaceuticalfirmbecauseithasvaluablepatentswouldbedoublecountingthepatentsifhevaluesthepatentsasoptionsandaddsthemontohisdiscountedcashflowvalue.
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Insummary…
¨ Whiletherearehundredsofvaluationmodelsandmetricsaround,thereareonlythreevaluationapproaches:¤ Intrinsicvaluation(usually,butnotalwaysaDCFvaluation)¤ Relativevaluation¤ Contingentclaimvaluation
¨ Thethreeapproachescanyielddifferentestimatesofvalueforthesameassetatthesamepointintime.
¨ Totrulygraspvaluation,youhavetobeabletounderstandanduseallthreeapproaches.Thereisatimeandaplaceforeachapproach,andknowingwhentouseeachoneisakeypartofmasteringvaluation.
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