Tell me something about the philosophy of valuation.
There have always been investors in financial markets who have argued that market prices are determined by the perceptions (and misperceptions) of buyers and sellers, and not by anything as down to earth as cashflows or earnings
* Perceptions matter, but they cannot be all that matters
* Asset prices cannot be justified by merely using the “bigger fool” theory
Why is this a Myth? : A valuation is an objective search for “true” value
- Truth 1: All valuations are biased. The only questions are how much and in which direction
- Truth 2: The direction and magnitude of the bias in valuation is often directly proportional to who pays for it and how much is paid
Name 3 examples of manifestation of biases in valuation
- Inputs to the valuation: Our assumptions about margins, returns on capital, growth and risk are influenced by our biases
- Post-valuation tinkering: The most obvious manifestation of bias occurs after we finish the valuation when we add premiums (synergy, control) and assess discounts (illiquidity) for various factors.
- Qualitative factors: When we run out of all other choices, we tend to explain away the difference between the price we are paying and the value obtained by giving it a name (strategic considerations…)
Why is this a Myth? 2: A good valuation provides a precise estimate of value
- Truth 1: There are no precise valuations
- Truth 2: The payoff to valuation is greatest when valuation is least precise
Why is this a Myth 3? : The more elaborate a model, the better the valuation
- Truth 1: One’s understanding of a valuation model is inversely proportional to the number of inputs required for the model
- Truth 2: Simpler valuation models do much better than complex ones
What is the basic principle of Parsimony?
- When valuing an asset, we want to use the simplest model we can get away with.
- Don’t go looking for trouble and estimate inputs that you do not have to. You can mangle simple assets using complicated valuation models.
- All-in-one valuation models that try to value all companies, by definition, will be far more complicated than they need to be, since they have to be built for the most complex company that you will run into.
Name 3 approaches of valuation
Discounted Cash Flow (DCF) –
* Estimate based off expected future cashflows on that asset
Relative valuation (multiples) – Estimate based off pricing of ‘comparable’ assets
Contingent claim (not covered in this course)
* Estimate based off option pricing models
What is the philosophical basis of a DCF?
Every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash flows, growth and risk
What (3) information points do we need to do a DCF Valuation?
- to estimate the life of the asset
- to estimate the cash flows during the life of the asset including growth
- to estimate the discount rate (risk) to apply to these cash flows to get present value
Name (3) advantages of the DCF
- Based upon an asset’s fundamentals: Less exposed to market moods and perceptions
- If investors buy businesses rather than stocks (the Warren Buffet philosophy), 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
Name (3) disadvantages of a DCF
- Requires far more inputs and information than other valuation approaches
- Inputs are noisy, difficult to estimate and can be manipulated
- No guarantee that anything will emerge as under or over valued. Every stock can be over valued. Can be a problem if you have to make recommendations (equity research analysts) or manage an equity portfolio (equity portfolio managers)
Wolf Cola expects a cash flow of €400k next year which it expects will grow annually by 6% afterwards forever. If the discount rate is 10%, what is the value of Wolf Cola’s business?
10 mln
Now suppose Wolf Cola expands into energy drinks (Fight Milk), which it will support for 25 years. During this time, Fight Milk is expected to generate cash flows of €350k at a discount rate of 10%. What is the present value of the Fight Milk project?
3177k
Wolf Cola is looking to acquire a PR-firm, Paddy’s Publishers. From this acquisition, it expects increased cash flows of €100k next year, which will grow by 40% in years 2 and 3, after which the cash flow will grow at a steady pace of 4% forever. If the discount rate is 9%, what is the value of acquiring Paddy’s Publishers?
3509
What is the beta of a Risk-free asset & Beta of market? And what is typically the beta of luxury goods?
- Beta of a risk-free asset = 0
- Beta of the market portfolio = 1
Typically:
* Luxury goods tend to have a larger beta, necessities tend to have a smaller beta
Negative beta
* Can exist (but rarely found in practice. E.g. Debt collection agency)
