Investment Valuation

Tools and Techniques for Determining the Value of any Asset, University Edition

Aswath Damodaran

• Publisher: Wiley
• Year: 2012
• ISBN:
  9781118206591
• Edition: 3
• Topic: Business
• Subtopic: Valutazione
• Index: Business

The definitive source of information on all topics related to investment valuation tools and techniques

Valuation is at the heart of any investment decision, whether that decision is buy, sell or hold. But the pricing of many assets has become a more complex task in modern markets, especially after the recent financial crisis. In order to be successful at this endeavor, you must have a firm understanding of the proper valuation techniques. One valuation book stands out as withstanding the test of time among students of financial markets and investors, Aswath Damodaran's Investment Valuation.

Now completely revised and updated to reflect changing market conditions, this third edition comprehensively introduces students and investment professionals to the range of valuation models available and how to chose the right model for any given asset valuation scenario. This edition includes valuation techniques for a whole host of real options, start-up firms, unconventional assets, distressed companies and private equity, and real estate. All examples have been updated and new material has been added.

• An expansion of ancillaries include updated online databases, spreadsheets, and other educational support tools
• Fully revised to incorporate valuation lessons learned from the last five years, from the market crisis and emerging markets to new types of equity investments
• Revised examples of company valuations such as companies from Eastern Europe and Africa, which stress the global nature of modern valuation
• Author Aswath Damodaran is regarded as one of the best educators and thinkers on the topic of investment valuation

This indispensable guide is a must read for students wishing to gain a better understanding of investment valuation and its methods. With it, you can take the insights and advice of a recognized authority on the valuation process and immediately put them to work for you.

CHAPTER 1

Introduction to Valuation

Every asset, financial as well as real, has a value. The key to successfully investing in 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 to value 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 different format than valuing a publicly traded stock. What is surprising, however, is not the differences in techniques across assets, but the degree of similarity in the basic principles of valuation. There is uncertainty associated with valuation. Often that uncertainty comes from the asset being valued, though the valuation model may add to that uncertainty.

This chapter lays out a philosophical basis for valuation, together with a discussion of how valuation is or can be used in a variety of frameworks, from portfolio management to corporate finance.

A PHILOSOPHICAL BASIS FOR VALUATION

It was Oscar Wilde who described a cynic as one who “knows the price of everything, but the value of nothing.” He could very well have been describing some analysts and many investors, a surprising number of whom subscribe to the “bigger fool” theory of investing, which argues that the value of an asset is irrelevant as long as there is a “bigger fool” around willing to buy the asset from them. While this may provide a basis for some profits, it is a dangerous game to play, since there is no guarantee 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 asset than it's worth. This statement may seem logical and obvious, but it is forgotten and rediscovered at some time in every generation and in every market. There are those who are disingenuous enough to argue that value is in the eye of the beholder, and that 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 a painting or a sculpture, but investors do not (and should not) buy most assets for aesthetic or emotional reasons; financial assets are acquired for the cash flows expected 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 it is expected to generate. The models of valuation described in this book attempt to relate value to the level and expected growth of these cash flows.

There are many areas in valuation where there is room for disagreement, including how to estimate true value and how long it will take for prices to adjust to true value. But there is one point on which there can be no disagreement: Asset prices cannot be justified by merely using the argument that there will be other investors around willing to pay those prices.

GENERALITIES ABOUT VALUATION

Like all analytical disciplines, valuation has developed its own set of myths over time. 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 nor the objective search for true value that idealists would like it to become. The models that we use in valuation may be quantitative, but the inputs leave plenty of room for subjective judgments. Thus, the final value that we obtain from these models is colored by the bias that we bring into the process. In fact, in many valuations, 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 information, analyses, and opinions about a firm, it is unlikely that we embark on most valuations without some bias. There are two ways of reducing the bias in the process. The first is to avoid taking strong public positions on the value of a firm before the valuation is complete. In far too many cases, the decision on whether a firm is under- or overvalued precedes the actual valuation,1 leading to seriously biased analyses. The second is to minimize, prior to the valuation, the stake we have in whether the firm is under- or overvalued.

Institutional concerns also play a role in determining the extent of bias in valuation. For instance, it is an acknowledged fact that equity research analysts are more likely to issue buy rather than sell recommendations2 (i.e., they are more likely to find firms to be undervalued than overvalued). This can be traced partly to the difficulties analysts face in obtaining access and collecting information on firms that they have issued sell recommendations on, and partly to pressure that they face from portfolio managers, some of whom might have large positions in the stock. In recent years, this trend has been exacerbated by the pressure on equity research analysts 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. While this does not make the valuation worthless, it suggests that the analysis should be viewed with skepticism.

BIAS IN EQUITY RESEARCH

The lines between equity research and salesmanship blur most in periods that are characterized by “irrational exuberance.” In the late 1990s, the extraordinary surge of market values in the companies that comprised the new economy 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 the charge on initial public offerings from these firms exposed them to charges of bias and worse.

In 2001, the crash in the market values of new economy stocks and the anguished cries of investors who had lost wealth in the crash created a firestorm of controversy. There were congressional hearings where legislators demanded to know what analysts knew about the companies they recommended and when the knew it, statements from the Securities and Exchange Commision (SEC) about the need for impartiality in equity research, and decisions taken by some investment banks to create at least the appearance of objectivity. Investment banks even created Chinese walls to separate their investment bankers from their equity research analysts. While that technical separation has helped, the real source of bias—the intermingling of banking business, trading, and investment advice—has not been touched.

Should there be government regulation of equity research? It would not be wise, since regulation tends to be heavy-handed and creates side costs that seem quickly to exceed the benefits. A much more effective response can be delivered by portfolio managers and investors. Equity research that creates the potential for bias should be discounted or, in egregious cases, even ignored. Alternatively, new equity research firms that deliver only investment advice can meet a need for unbiased valuations.

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 as marketwide information. As a consequence, the value will change as new information is revealed. Given the constant flow of information into financial markets, a valuation done on a firm ages quickly and has to be updated to reflect current information. This information may be specific to the firm, affect an entire sector, or alter expectations for all firms in the market.

The most common example of firm-specific information is an earnings report that contains news not only about a firm's performance in the most recent time period but, even more importantly, about the business model that the firm has adopted. The dramatic drop in value of many new economy stocks from 1999 to 2001 can be traced, at least partially, to the realization that these firms had business models that might deliver customers but not earnings, even in the long term. We have seen social media companies like Linkedin and Zynga received enthusiastic market responses in 2010, and it will be interesting to see if history repeats itself. 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 assumption that the high growth and returns from the prior years would continue into the future, were valued much less in early 2009, as the banking crisis of 2008 laid bare the weaknesses and hidden risks in their businesses.

Finally, information about the state of the economy and the level of interest rates affects all valuations in an economy. A weakening in the economy can lead to a reassessment of growth rates across the board, though the effect on earnings is likely to be largest at cyclical firms. Similarly, an increase in interest rates will affect all investments, though to varying degrees.

When analysts change their valuations, they will undoubtedly be asked to justify them, and in some cases the fact that valuations change over time is viewed as a problem. The best response is the one that John Maynard Keynes gave when he was criticized for changing his position on a major economic issue: “When the facts change, 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 uncertainty about the final numbers, colored as they are by assumptions that we make about the future of the company and the economy. It is unrealistic to expect or demand absolute certainty in valuation, since cash flows and discount rates are estimated. This also means that analysts have to give themselves a reasonable margin for error in 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 usually be much more precise than the valuation of a young company in a sector in turmoil. If this latter company happens to operate in an emerging market, with additional disagreement about the future of the market thrown into the mix, the uncertainty is magnified. Later in this book, in Chapter 23, we argue that the difficulties associated with valuation can be related to where a firm is in the life cycle. Mature firms tend to be easier to value than growth firms, and young start-up companies are more difficult to value than companies with established products and markets. The problems are not with the valuation models we use, though, but with the difficulties we run into in making estimates for the future. Many investors and analysts use the uncertainty 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 bett...