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Investment
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Founded in 1807, John Wiley & Sons is the oldest independent publishing company in theUnited States. With offices in North America, Europe, Australia, and Asia, Wiley is glob-ally committed to developing and marketing print and electronic products and services forour customers’ professional and personal knowledge and understanding.
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For a list of available titles, please visit our Web site at www.WileyFinance.com.
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Investment
ValuationTools and Techniques for
Determining the Value of Any Asset
Third Edition
ASWATH DAMODARANwww.damodaran.com
WILEYJohn Wiley & Sons, Inc.
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Copyright © 2012 by Aswath Damodaran. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.
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Library of Congress Cataloging-in-Publication Data:
Damodaran, Aswath.Investment valuation : tools and techniques for determining the value of any asset / Aswath
Damodaran.—3rd ed.p. cm.—(Wiley finance series)
Includes bibliographical references and index.ISBN 978-1-118-01152-2 (cloth); ISBN 978-1-118-20654-6 (ebk);ISBN 978-1-118-20655-3 (ebk); ISBN 978-1-118-20656-0 (ebk)ISBN 978-1-118-13073-5 (paper); ISBN 978-1-118-20657-7 (ebk);ISBN 978-1-118-20658-4 (ebk); ISBN 978-1-118-20659-1 (ebk)1. Corporations—Valuation—Mathematical models. I. Title.
HG4028.V3 D353 2012658.15—dc23 2011052858
10 9 8 7 6 5 4 3 2 1
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I would like to dedicate this book to Michele, whose patienceand support made it possible, and to my four children—
Ryan, Brendan, Kendra, and Kiran—who provided the inspiration.
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Preface to the Third Edition
This is a book about valuation—the valuation of stocks, bonds, options, futuresand real assets. It is a fundamental precept of this book that any asset can be val-
ued, albeit imprecisely in some cases. I have attempted to provide a sense of notonly the differences between the models used to value different types of assets, butalso the common elements in these models.
The past decade has been an eventful one for those interested in valuation forseveral reasons. First, the growth of Asian and Latin American markets broughtemerging market companies into the forefront, and you will see the increased focuson these companies in this edition. Second, we saw the havoc wreaked by macro-economic factors on company valuations during the bank crisis of 2008, and a blur-ring of the lines between developed and emerging markets. The lessons I learnedabout financial fundamentals during the crisis about risk-free rates, risk premiumsand cash flow estimation are incorporated into the text. Third, the past year has seenthe influx of social media companies, with small revenues and outsized market capi-talizations, in an eerie replay of the dot-com boom from the late 1990s. More thanever, it made clear that the more things change, the more they stay the same. Finally,the entry of new players into equity markets (hedge funds, private equity investorsand high-frequency traders) has changed markets and investing dramatically. Witheach shift, the perennial question arises: “Is valuation still relevant in this market?”and my answer remains unchanged, “Absolutely and more than ever.”
As technology increasingly makes the printed page an anachronism, I have triedto adapt in many ways. First, this book will be available in e-book format, andhopefully will be just as useful as the print edition (if not more so). Second, everyvaluation in this book will be put on the web site that will accompany this book(www.damodaran.com), as will a significant number of datasets and spreadsheets.In fact, the valuations in the book will be updated online, allowing the book to havea much closer link to real-time valuations.
In the process of presenting and discussing the various aspects of valuation, Ihave tried to adhere to four basic principles. First, I have attempted to be as com-prehensive as possible in covering the range of valuation models that are availableto an analyst doing a valuation, while presenting the common elements in thesemodels and providing a framework that can be used to pick the right model for anyvaluation scenario. Second, the models are presented with real-world examples,warts and all, so as to capture some of the problems inherent in applying thesemodels. There is the obvious danger that some of these valuations will appear to behopelessly wrong in hindsight, but this cost is well worth the benefits. Third, inkeeping with my belief that valuation models are universal and not market-specific,illustrations from markets outside the United States are interspersed throughout thebook. Finally, I have tried to make the book as modular as possible, enabling areader to pick and choose sections of the book to read, without a significant loss ofcontinuity.
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Contents
CHAPTER 1
Introduction to Valuation 1
A Philosophical Basis for Valuation 1Generalities about Valuation 2The Role of Valuation 6Conclusion 9Questions and Short Problems 9
CHAPTER 2
Approaches to Valuation 11
Discounted Cash Flow Valuation 11Relative Valuation 19Contingent Claim Valuation 23Conclusion 25Questions and Short Problems 25
CHAPTER 3
Understanding Financial Statements 27
The Basic Accounting Statements 27Asset Measurement and Valuation 29Measuring Financing Mix 36Measuring Earnings and Profitability 42Measuring Risk 47Other Issues in Analyzing Financial Statements 53Conclusion 55Questions and Short Problems 55
CHAPTER 4
The Basics of Risk 58
What is Risk? 58Equity Risk and Expected Return 59Alternative Models for Equity Risk 71A Comparative Analysis of Equity Risk Models 76Models of Default Risk 77Conclusion 81Questions and Short Problems 82
CHAPTER 5
Option Pricing Theory and Models 87
Basics of Option Pricing 87Determinants of Option Value 89
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Option Pricing Models 90Extensions of Option Pricing 107Conclusion 109Questions and Short Problems 109
CHAPTER 6
Market Efficiency—Definition, Tests, and Evidence 111
Market Efficiency and Investment Valuation 111What Is an Efficient Market? 112Implications of Market Efficiency 112Necessary Conditions for Market Efficiency 114Propositions about Market Efficiency 114Testing Market Efficiency 116Cardinal Sins in Testing Market Efficiency 120Some Lesser Sins That Can Be a Problem 121Evidence on Market Efficiency 122Time Series Properties of Price Changes 122Market Reaction to Information Events 130Market Anomalies 134Evidence on Insiders and Investment Professionals 142Conclusion 149Questions and Short Problems 150
CHAPTER 7
Riskless Rates and Risk Premiums 154
The Risk-Free Rate 154Equity Risk Premium 159Default Spreads on Bonds 177Conclusion 180Questions and Short Problems 180
CHAPTER 8
Estimating Risk Parameters and Costs of Financing 182
The Cost of Equity and Capital 182Cost of Equity 183From Cost of Equity to Cost of Capital 210Best Practices at Firms 221Conclusion 222Questions and Short Problems 223
CHAPTER 9
Measuring Earnings 229
Accounting versus Financial Balance Sheets 229Adjusting Earnings 230Conclusion 247Questions and Short Problems 249
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CHAPTER 10
From Earnings to Cash Flows 250
The Tax Effect 250Reinvestment Needs 258Conclusion 268Questions and Short Problems 269
CHAPTER 11
Estimating Growth 271
The Importance of Growth 272Historical Growth 272Analyst Estimates of Growth 282Fundamental Determinants of Growth 285Qualitative Aspects of Growth 301Conclusion 302Questions and Short Problems 302
CHAPTER 12
Closure in Valuation: Estimating Terminal Value 304
Closure in Valuation 304The Survival Issue 318Closing Thoughts on Terminal Value 320Conclusion 321Questions and Short Problems 321
CHAPTER 13
Dividend Discount Models 323
The General Model 323Versions of the Model 324Issues in Using the Dividend Discount Model 344Tests of the Dividend Discount Model 345Conclusion 348Questions and Short Problems 349
CHAPTER 14
Free Cash Flow to Equity Discount Models 351
Measuring What Firms Can Return to Their Stockholders 351FCFE Valuation Models 357FCFE Valuation versus Dividend Discount Model Valuation 372Conclusion 376Questions and Short Problems 376
CHAPTER 15
Firm Valuation: Cost of Capital and Adjusted Present Value Approaches 380
Free Cash flow to the Firm 380Firm Valuation: The Cost of Capital Approach 383
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Firm Valuation: The Adjusted Present Value Approach 398Effect of Leverage on Firm Value 402Adjusted Present Value and Financial Leverage 415Conclusion 419Questions and Short Problems 419
CHAPTER 16
Estimating Equity Value per Share 423
Value of Nonoperating Assets 423Firm Value and Equity Value 440Management and Employee Options 442Value per Share When Voting Rights Vary 448Conclusion 450Questions and Short Problems 451
CHAPTER 17
Fundamental Principles of Relative Valuation 453
Use of Relative Valuation 453Standardized Values and Multiples 454Four Basic Steps to Using Multiples 456Reconciling Relative and Discounted Cash Flow Valuations 466Conclusion 467Questions and Short Problems 467
CHAPTER 18
Earnings Multiples 468
Price-Earnings Ratio 468The PEG Ratio 487Other Variants on the PE Ratio 497Enterprise Value to EBITDA Multiple 500Conclusion 508Questions and Short Problems 508
CHAPTER 19
Book Value Multiples 511
Price-to-Book Equity 511Applications of Price–Book Value Ratios 521Use in Investment Strategies 530Value-to-Book Ratios 532Tobin’s Q: Market Value/Replacement Cost 537Conclusion 539Questions and Short Problems 539
CHAPTER 20
Revenue Multiples and Sector-Specific Multiples 542
Revenue Multiples 542Sector-Specific Multiples 571
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Conclusion 577Questions and Short Problems 577
CHAPTER 21
Valuing Financial Service Firms 581
Categories of Financial Service Firms 581What is Unique about Financial Service Firms? 582General Framework for Valuation 583Discounted Cash Flow Valuation 584Asset-Based Valuation 599Relative Valuation 599Issues in Valuing Financial Service Firms 605Conclusion 607Questions and Short Problems 608
CHAPTER 22
Valuing Firms with Negative or Abnormal Earnings 611
Negative Earnings: Consequences and Causes 611Valuing Negative Earnings Firms 615Conclusion 639Questions and Short Problems 639
CHAPTER 23
Valuing Young or Start-Up Firms 643
Information Constraints 643New Paradigms or Old Principles:
A Life Cycle Perspective 644Venture Capital Valuation 646General Framework for Analysis 648Value Drivers 659Estimation Noise 661Implications for Investors 662Implications for Managers 663The Expectations Game 663Conclusion 665Questions and Short Problems 666
CHAPTER 24
Valuing Private Firms 667
What Makes Private Firms Different? 667Estimating Valuation Inputs at Private Firms 668Valuation Motives and Value Estimates 688Valuing Venture Capital and Private Equity Stakes 693Relative Valuation of Private Businesses 695Conclusion 699Questions and Short Problems 699
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CHAPTER 25
Aquisitions and Takeovers 702
Background on Acquisitions 702Empirical Evidence on the Value Effects of Takeovers 705Steps in an Acquisition 705Takeover Valuation: Biases and Common Errors 724Structuring the Acquisition 725Analyzing Management and Leveraged Buyouts 730Conclusion 734Questions and Short Problems 735
CHAPTER 26
Valuing Real Estate 739
Real versus Financial Assets 739Discounted Cash Flow Valuation 740Comparable/Relative Valuation 759Valuing Real Estate Businesses 761Conclusion 763Questions and Short Problems 763
CHAPTER 27
Valuing Other Assets 766
Cash-Flow-Producing Assets 766Non-Cash-Flow-Producing Assets 775Assets with Option Characteristics 777Conclusion 778Questions and Short Problems 779
CHAPTER 28
The Option to Delay and Valuation Implications 781
The Option to Delay a Project 781Valuing a Patent 789Natural Resource Options 796Other Applications 802Conclusion 802Questions and Short Problems 803
CHAPTER 29
The Options to Expand and to Abandon: Valuation Implications 805
The Option to Expand 805When Are Expansion Options Valuable? 812Valuing a Firm with the Option to Expand 815Value of Financial Flexibility 817The Option to Abandon 820Reconciling Net Present Value and Real Option Valuations 823Conclusion 823Questions and Short Problems 824
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CHAPTER 30
Valuing Equity in Distressed Firms 826
Equity in Highly Levered Distressed Firms 826Implications of Viewing Equity as an Option 828Estimating the Value of Equity as an Option 831Consequences for Decision Making 836Conclusion 839Questions and Short Problems 839
CHAPTER 31
Value Enhancement: A Discounted Cash Flow Valuation Framework 841
Value-Creating and Value-Neutral Actions 841Ways of Increasing Value 842Value Enhancement Chain 859Closing Thoughts on Value Enhancement 864Conclusion 865Questions and Short Problems 865
CHAPTER 32
Value Enhancement: Economic Value Added, Cash Flow Return on Investment,
and Other Tools 869
Economic Value Added 870Cash Flow Return on Investment 884A Postscript on Value Enhancement 890Conclusion 891Questions and Short Problems 891
CHAPTER 33
Probabilistic Approaches in Valuation: Scenario Analysis, Decision Trees,
and Simulations 894
Scenario Analysis 894Decision Trees 899Simulations 908An Overall Assessment of Probabilistic Risk-Assessment Approaches 919Conclusion 921Questions and Short Problems 921
CHAPTER 34
Overview and Conclusion 925
Choices in Valuation Models 925Which Approach Should You Use? 926Choosing the Right Discounted Cash Flow Model 929Choosing the Right Relative Valuation Model 933When Should You Use the Option Pricing Models? 937Conclusion 938
References 939
Index 954
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CHAPTER 1Introduction to Valuation
Every asset, financial as well as real, has a value. The key to successfully investingin and managing these assets lies in understanding not only what the value is, but
the sources of the value. Every asset can be valued, but some assets are easier tovalue than others, and the details of valuation will vary from case to case. Thus,valuing of a real estate property will require different information and follow a dif-ferent format than valuing a publicly traded stock. What is surprising, however, isnot the differences in techniques across assets, but the degree of similarity in thebasic principles of valuation. There is uncertainty associated with valuation. Oftenthat uncertainty comes from the asset being valued, though the valuation modelmay add to that uncertainty.
This chapter lays out a philosophical basis for valuation, together with a discus-sion of how valuation is or can be used in a variety of frameworks, from portfoliomanagement to corporate finance.
A PHILOSOPHICAL BASIS FOR VALUATION
It was Oscar Wilde who described a cynic as one who “knows the price of every-thing, but the value of nothing.” He could very well have been describing some ana-lysts and many investors, a surprising number of whom subscribe to the “biggerfool” theory of investing, which argues that the value of an asset is irrelevant as longas there is a “bigger fool” around willing to buy the asset from them. While this mayprovide a basis for some profits, it is a dangerous game to play, since there is no guar-antee that such an investor will still be around when the time to sell comes.
A postulate of sound investing is that an investor does not pay more for an assetthan it’s worth. This statement may seem logical and obvious, but it is forgotten andrediscovered at some time in every generation and in every market. There are thosewho are disingenuous enough to argue that value is in the eye of the beholder, andthat any price can be justified if there are other investors willing to pay that price.That is patently absurd. Perceptions may be all that matter when the asset is apainting or a sculpture, but investors do not (and should not) buy most assets foraesthetic or emotional reasons; financial assets are acquired for the cash flows ex-pected on them. Consequently, perceptions of value have to be backed up by reality,which implies that the price that is paid for any asset should reflect the cash flows itis expected to generate. The models of valuation described in this book attempt torelate value to the level and expected growth of these cash flows.
There are many areas in valuation where there is room for disagreement, includinghow to estimate true value and how long it will take for prices to adjust to true value.
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But there is one point on which there can be no disagreement: Asset prices cannot bejustified by merely using the argument that there will be other investors around willingto pay those prices.
GENERALITIES ABOUT VALUATION
Like all analytical disciplines, valuation has developed its own set of myths overtime. This section examines and debunks some of these myths.
Myth 1: Since valuation models are quantitative, valuation
is objective.
Valuation is neither the science that some of its proponents make it out to be northe objective search for true value that idealists would like it to become. The mod-els that we use in valuation may be quantitative, but the inputs leave plenty ofroom for subjective judgments. Thus, the final value that we obtain from thesemodels is colored by the bias that we bring into the process. In fact, in many valua-tions, the price gets set first and the valuation follows.
The obvious solution is to eliminate all bias before starting on a valuation,but this is easier said than done. Given the exposure we have to external informa-tion, analyses, and opinions about a firm, it is unlikely that we embark on mostvaluations without some bias. There are two ways of reducing the bias in theprocess. The first is to avoid taking strong public positions on the value of a firmbefore the valuation is complete. In far too many cases, the decision on whether afirm is under- or overvalued precedes the actual valuation,1 leading to seriouslybiased analyses. The second is to minimize, prior to the valuation, the stake wehave in whether the firm is under- or overvalued.
Institutional concerns also play a role in determining the extent of bias in valu-ation. For instance, it is an acknowledged fact that equity research analysts aremore likely to issue buy rather than sell recommendations2 (i.e., they are morelikely to find firms to be undervalued than overvalued). This can be traced partly tothe difficulties analysts face in obtaining access and collecting information on firmsthat they have issued sell recommendations on, and partly to pressure that they facefrom portfolio managers, some of whom might have large positions in the stock. Inrecent years, this trend has been exacerbated by the pressure on equity research an-alysts to deliver investment banking business.
When using a valuation done by a third party, the biases of the analyst(s)should be considered before decisions are made on its basis. For instance, a self-valuation done by a target firm in a takeover is likely to be positively biased. Whilethis does not make the valuation worthless, it suggests that the analysis should beviewed with skepticism.
2 INTRODUCTION TO VALUATION
1This is most visible in takeovers, where the decision to acquire a firm often seems to precedethe valuation of the firm. It should come as no surprise, therefore, that the analysis almostinvariably supports the decision.2In most years buy recommendations outnumber sell recommendations by a margin of 10 to1. In recent years this trend has become even stronger.
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Myth 2: A well-researched and well-done valuation
is timeless.
The value obtained from any valuation model is affected by firm-specific as well asmarketwide information. As a consequence, the value will change as new informa-tion is revealed. Given the constant flow of information into financial markets, avaluation done on a firm ages quickly and has to be updated to reflect current in-formation. This information may be specific to the firm, affect an entire sector, oralter expectations for all firms in the market.
The most common example of firm-specific information is an earnings reportthat contains news not only about a firm’s performance in the most recent time pe-riod but, even more importantly, about the business model that the firm hasadopted. The dramatic drop in value of many new economy stocks from 1999 to2001 can be traced, at least partially, to the realization that these firms had businessmodels that might deliver customers but not earnings, even in the long term. Wehave seen social media companies like Linkedin and Zynga received enthusiasticmarket responses in 2010, and it will be interesting to see if history repeats itself.
Generalities about Valuation 3
BIAS IN EQUITY RESEARCH
The lines between equity research and salesmanship blur most in periods thatare characterized by “irrational exuberance.” In the late 1990s, the extraordi-nary surge of market values in the companies that comprised the new econ-omy saw a large number of equity research analysts, especially on the sell side,step out of their roles as analysts and become cheerleaders for these stocks.While these analysts might have been well-meaning in their recommendations,the fact that the investment banks that they worked for were leading thecharge on initial public offerings from these firms exposed them to charges ofbias and worse.
In 2001, the crash in the market values of new economy stocks and the an-guished cries of investors who had lost wealth in the crash created a firestorm ofcontroversy. There were congressional hearings where legislators demanded toknow what analysts knew about the companies they recommended and whenthe knew it, statements from the Securities and Exchange Commision (SEC)about the need for impartiality in equity research, and decisions taken by someinvestment banks to create at least the appearance of objectivity. Investmentbanks even created Chinese walls to separate their investment bankers from theirequity research analysts. While that technical separation has helped, the realsource of bias—the intermingling of banking business, trading, and investmentadvice—has not been touched.
Should there be government regulation of equity research? It would notbe wise, since regulation tends to be heavy-handed and creates side costs thatseem quickly to exceed the benefits. A much more effective response can bedelivered by portfolio managers and investors. Equity research that creates thepotential for bias should be discounted or, in egregious cases, even ignored.Alternatively, new equity research firms that deliver only investment advicecan meet a need for unbiased valuations.
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These companies offer tremendous promise because of their large member bases,but they are still in the nascent stages of commercializing that promise.
In some cases, new information can affect the valuations of all firms in a sector.Thus, financial service companies that were valued highly in early 2008, on the as-sumption that the high growth and returns from the prior years would continueinto the future, were valued much less in early 2009, as the banking crisis of 2008laid bare the weaknesses and hidden risks in their businesses.
Finally, information about the state of the economy and the level of interestrates affects all valuations in an economy. A weakening in the economy can lead toa reassessment of growth rates across the board, though the effect on earnings islikely to be largest at cyclical firms. Similarly, an increase in interest rates will affectall investments, though to varying degrees.
When analysts change their valuations, they will undoubtedly be asked to jus-tify them, and in some cases the fact that valuations change over time is viewed as aproblem. The best response is the one that John Maynard Keynes gave when hewas criticized for changing his position on a major economic issue: “When the factschange, I change my mind. And what do you do, sir?”
Myth 3: A good valuation provides a precise estimate
of value.
Even at the end of the most careful and detailed valuation, there will be uncertaintyabout the final numbers, colored as they are by assumptions that we make aboutthe future of the company and the economy. It is unrealistic to expect or demandabsolute certainty in valuation, since cash flows and discount rates are estimated.This also means that analysts have to give themselves a reasonable margin for errorin making recommendations on the basis of valuations.
The degree of precision in valuations is likely to vary widely across investments.The valuation of a large and mature company with a long financial history will usu-ally be much more precise than the valuation of a young company in a sector in tur-moil. If this latter company happens to operate in an emerging market, withadditional disagreement about the future of the market thrown into the mix, the un-certainty is magnified. Later in this book, in Chapter 23, we argue that the difficultiesassociated with valuation can be related to where a firm is in the life cycle. Maturefirms tend to be easier to value than growth firms, and young start-up companies aremore difficult to value than companies with established products and markets. Theproblems are not with the valuation models we use, though, but with the difficultieswe run into in making estimates for the future. Many investors and analysts use theuncertainty about the future or the absence of information to justify not doing full-fledged valuations. In reality, though, the payoff to valuation is greatest in these firms.
Myth 4: The more quantitative a model, the better
the valuation.
It may seem obvious that making a model more complete and complex should yieldbetter valuations; but it is not necessarily so. As models become more complex, thenumber of inputs needed to value a firm tends to increase, bringing with it the po-tential for input errors. These problems are compounded when models become so
4 INTRODUCTION TO VALUATION
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complex that they become “black boxes” where analysts feed in numbers at oneend and valuations emerge from the other. All too often when a valuation fails, theblame gets attached to the model rather than the analyst. The refrain becomes “Itwas not my fault. The model did it.”
There are three important points that need to be made about all valuation. Thefirst is to adhere to the principle of parsimony, which essentially states that you donot use more inputs than you absolutely need to value an asset. The second is to rec-ognize that there is a trade-off between the additional benefits of building in moredetail and the estimation costs (and error) with providing the detail. The third is tounderstand that models don’t value companies—you do. In a world where the prob-lem that you often face in valuations is not too little information but too much, andseparating the information that matters from the information that does not is almostas important as the valuation models and techniques that you use to value a firm.
Myth 5: To make money on valuation, you have to assume that
markets are inefficient (but that they will become efficient).
Implicit in the act of valuation is the assumption that markets make mistakes andthat we can find these mistakes, often using information that tens of thousands ofother investors have access to. Thus, it seems reasonable to say that those who be-lieve that markets are inefficient should spend their time and resources on valuationwhereas those who believe that markets are efficient should take the market priceas the best estimate of value.
This statement, though, does not reflect the internal contradictions in both po-sitions. Those who believe that markets are efficient may still feel that valuation hassomething to contribute, especially when they are called on to value the effect of achange in the way a firm is run or to understand why market prices change overtime. Furthermore, it is not clear how markets would become efficient in the firstplace if investors did not attempt to find under- and over-valued stocks and tradeon these valuations. In other words, a precondition for market efficiency seems tobe the existence of millions of investors who believe that markets are not efficient.
On the other hand, those who believe that markets make mistakes and buy orsell stocks on that basis must believe that ultimately markets will correct these mis-takes (i.e., become efficient), because that is how they make their money. This istherefore a fairly self-serving definition of inefficiency—markets are inefficient untilyou take a large position in the stock that you believe to be mispriced, but they be-come efficient after you take the position.
It is best to approach the issue of market efficiency as a skeptic. Recognizethat on the one hand markets make mistakes but, on the other, finding these mis-takes requires a combination of skill and luck. This view of markets leads to thefollowing conclusions: First, if something looks too good to be true—a stock looksobviously undervalued or overvalued—it is probably not true. Second, when thevalue from an analysis is significantly different from the market price, start offwith the presumption that the market is correct; then you have to convince your-self that this is not the case before you conclude that something is over- or under-valued. This higher standard may lead you to be more cautious in followingthrough on valuations, but given the difficulty of beating the market, this is not anundesirable outcome.
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Myth 6: The product of valuation (i.e., the value) is what
matters; the process of valuation is not important.
As valuation models are introduced in this book, there is the risk of focusing exclu-sively on the outcome (i.e., the value of the company and whether it is under- orovervalued), and missing some valuable insights that can be obtained from theprocess of the valuation. The process can tell us a great deal about the determinantsof value and help us answer some fundamental questions: What is the appropriateprice to pay for high growth? What is a brand name worth? How important is it toimprove returns on projects? What is the effect of profit margins on value? Sincethe process is so informative, even those who believe that markets are efficient (andthat the market price is therefore the best estimate of value) should be able to findsome use for valuation models.
THE ROLE OF VALUATION
Valuation is useful in a wide range of tasks. The role it plays, however, is differentin different arenas. The following section lays out the relevance of valuation inportfolio management, in acquisition analysis, and in corporate finance.
Valuation in Portfolio Management
The role that valuation plays in portfolio management is determined in large partby the investment philosophy of the investor. Valuation plays a minimal role inportfolio management for a passive investor, whereas it plays a larger role for anactive investor. Even among active investors, the nature and the role of valuationare different for different types of active investment. Market timers should use val-uation much less than investors who pick stocks for the long term, and their focusis on market valuation rather than on firm-specific valuation. Among stock pickersvaluation plays a central role in portfolio management for fundamental analystsand a peripheral role for technical analysts.
Fundamental Analysts The underlying theme in fundamental analysis is that thetrue value of the firm can be related to its financial characteristics—its growthprospects, risk profile, and cash flows. Any deviation from this true value is a signthat a stock is under- or overvalued. It is a long-term investment strategy, and theassumptions underlying it are:
■ The relationship between value and the underlying financial factors can bemeasured.
■ The relationship is stable over time.■ Deviations from the relationship are corrected in a reasonable time period.
Valuation is the central focus in fundamental analysis. Some analysts use dis-counted cash flow models to value firms, while others use multiples such as theprice-earnings and price–book value ratios. Since investors using this approachhold a large number of undervalued stocks in their portfolios, their hope is that, onaverage, these portfolios will do better than the market.
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Franchise Buyers The philosophy of a franchise buyer is best expressed by aninvestor who has been very successful at it—Warren Buffett. “We try to stick tobusinesses we believe we understand,” Mr. Buffett writes.3 “That means theymust be relatively simple and stable in character. If a business is complex andsubject to constant change, we’re not smart enough to predict future cashflows.” Franchise buyers concentrate on a few businesses they understand welland attempt to acquire undervalued firms. Often, as in the case of Mr. Buffett,franchise buyers wield influence on the management of these firms and canchange financial and investment policy. As a long-term strategy, the underlyingassumptions are that:
■ Investors who understand a business well are in a better position to value itcorrectly.
■ These undervalued businesses can be acquired without driving the price abovethe true value and sometimes at a bargain.
Valuation plays a key role in this philosophy, since franchise buyers are at-tracted to a particular business because they believe it is undervalued. They are alsointerested in how much additional value they can create by restructuring the busi-ness and running it right.
Chartists Chartists believe that prices are driven as much by investor psychology asby any underlying financial variables. The information available from trading—price movements, trading volume, short sales, and so forth—gives an indication ofinvestor psychology and future price movements. The assumptions here are thatprices move in predictable patterns, that there are not enough marginal investorstaking advantage of these patterns to eliminate them, and that the average investorin the market is driven more by emotion than by rational analysis.
While valuation does not play much of a role in charting, there are ways inwhich an enterprising chartist can incorporate it into analysis. For instance, valua-tion can be used to determine support and resistance lines4 on price charts.
Information Traders Prices move on information about the firm. Informationtraders attempt to trade in advance of new information or shortly after it is re-vealed to financial markets, buying on good news and selling on bad. The underly-ing assumption is that these traders can anticipate information announcements andgauge the market reaction to them better than the average investor in the market.
For an information trader, the focus is on the relationship between informationand changes in value, rather than on value per se. Thus an information trader may
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3This is extracted from Mr. Buffett’s letter to stockholders in Berkshire Hathaway for 1993.4On a chart, the support line usually refers to a lower bound below which prices are unlikelyto move, and the resistance line refers to the upper bound above which prices are unlikely toventure. While these levels are usually estimated using past prices, the range of values ob-tained from a valuation model can be used to determine these levels (i.e., the maximum valuewill become the resistance line and the minimum value will become the support line).
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buy stock in even an overvalued firm if he or she believes that the next informationannouncement is going to cause the price to go up because it contains better thanexpected news. If there is a relationship between how undervalued or overvalued acompany is and how its stock price reacts to new information, then valuation couldplay a role in investing for an information trader.
Market Timers Market timers note, with some legitimacy, that the payoff to call-ing turns in markets is much greater than the returns from stock picking. They ar-gue that it is easier to predict market movements than to select stocks and thatthese predictions can be based on factors that are observable.
While valuation of individual stocks may not be of any use to a market timer,market timing strategies can use valuation in at least two ways:
1. The overall market itself can be valued and compared to the current level.2. A valuation model can be used to value all stocks, and the results from the
across all stocks be used to determine whether the market is over- or underval-ued. For example, as the number of stocks that are overvalued, using a dis-counted cash flow model, increases relative to the number that are undervalued,there may be reason to believe that the market is overvalued.
Efficient Marketers Efficient marketers believe that the market price at any point in timerepresents the best estimate of the true value of the firm, and that any attempt to ex-ploit perceived market efficiencies will cost more than it will make in excess profits.They assume that markets aggregate information quickly and accurately, that marginalinvestors promptly exploit any inefficiencies, and that any inefficiencies in the marketare caused by friction, such as transaction costs, and cannot be arbitraged away.
For efficient marketers, valuation is a useful exercise to determine why a stocksells for the price that it does. Since the underlying assumption is that the marketprice is the best estimate of the true value of the company, the objective becomesdetermining what assumptions about growth and risk are implied in this marketprice, rather than on finding under- or overvalued firms.
Valuation in Acquisition Analysis
Valuation should play a central part in acquisition analysis. The bidding firm or in-dividual has to decide on a fair value for the target firm before making a bid, andthe target firm has to determine a reasonable value for itself before deciding to ac-cept or reject the offer.
There are also special factors to consider in takeover valuation. First, the ef-fects of synergy on the combined value of the two firms (target plus bidding firm)have to be considered before a decision is made on the bid. Those who suggest thatsynergy is impossible to value and should not be considered in quantitative termsare wrong. Second, the effects on value of changing management and restructuringthe target firm will have to be taken into account in deciding on a fair price. This isof particular concern in hostile takeovers.
Finally, there is a significant problem with bias in takeover valuations. Targetfirms may be overly optimistic in estimating value, especially when the takeoversare hostile and they are trying to convince their stockholders that the offer prices
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are too low. Similarly, if the bidding firm has decided for strategic reasons to do anacquisition, there may be strong pressure on the analyst to come up with an esti-mate of value that backs up the acquisition.
Valuation in Corporate Finance
If the objective in corporate finance is the maximization of firm value,5 the relation-ship between financial decisions, corporate strategy, and firm value has to be delin-eated. In recent years, management consulting firms have started offering companiesadvice on how to increase value.6 Their suggestions have often provided the basis forthe restructuring of these firms.
The value of a firm can be directly related to decisions that it makes—on whichprojects it takes, on how it finances them, and on its dividend policy. Understand-ing this relationship is key to making value-increasing decisions and to sensiblefinancial restructuring.
CONCLUSION
Valuation plays a key role in many areas of finance—in corporate finance, in mergersand acquisitions, and in portfolio management. The models presented in this bookwill provide a range of tools that analysts in each of these areas will find of use, but thecautionary note sounded in this chapter bears repeating. Valuation is not an objectiveexercise, and any preconceptions and biases that an analyst brings to the process willfind their way into the value. And even the very best valuation will yield an estimate ofthe value, with a substantial likelihood of you being wrong in your assessment.
QUESTIONS AND SHORT PROBLEMS
In the problems following, use an equity risk premium of 5.5 percent if none isspecified.
1. The value of an investment is:a. The present value of the cash flows on the investment.b. Determined by investor perceptions about it.c. Determined by demand and supply.d. Often a subjective estimate, colored by the bias of the analyst.e. All of the above.
2. There are many who claim that value is based on investor perceptions, and per-ceptions alone, and that cash flows and earnings do not matter. This argument isflawed because:a. Value is determined by earnings and cash flows, and investor perceptions do
not matter.b. Perceptions do matter, but they can change. Value must be based on some-
thing more substantial.
Questions and Short Problems 9
5Most corporate financial theory is constructed on this premise.6The motivation for this has been the fear of hostile takeovers. Companies have increasinglyturned to “value consultants” to tell them how to restructure, increase value, and avoid be-ing taken over.
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c. Investors are irrational. Therefore, their perceptions should not determinevalue.
d. Value is determined by investor perceptions, but it is also determined by theunderlying earnings and cash flows. Perceptions must be based on reality.
3. You use a valuation model to arrive at a value of $15 for a stock. The marketprice of the stock is $25. The difference may be explained by:a. A market inefficiency; the market is overvaluing the stock.b. The use of the wrong valuation model to value the stock.c. Errors in the inputs to the valuation model.d. All of the above.
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