# Equity Valuation Class: Approaches to Valuation

I hope everyone who has signed up for the study group received my email yesterday. I discuss some of the logistics of our study group in that email. Please contact me if you didn’t get the message.

We are now on session two of Equity Instruments. The lecture starts off by following the Introduction to Valuation presentation slides. This session start with slide 4 on “Misconceptions about Valuation”.

Bias in equity valuation is the first topic covered. Professor Damodaran lays out two scenarios. First, an investment banker in a friendly merger will be tempted to raise their valuation to justify the price being offered in a merger. They might change the growth rate higher, lower the discount rate, improve margins, increase cash flows, reduce reinvestment, and add an arbitrary control premium. As a user of equity valuations, you need to ask the right questions.

The second scenario is a private business owner asking for a valuation for estate tax purposes. The bias will be to lower the price for appraisal valuations. They apply discounts for liquidity, etc.

**Key questions to ask about a valuation:**

- Who is doing the valuation?
- What are the potential biases?

Remember: Don’t lie to yourself in your valuations!

Professor Damodaran makes a good point about the main misconception about valuation. That is if I do valuation right, I will get the right answer. However, we just don’t know what the right answer is. If you cannot handle this kind of uncertainty, don’t get into stocks.

Damodaran also notes that the payoff is often best for equities you are most uncomfortable valuing. I don’t agree that we should always try to value the incredibly uncertain situations with some businesses. I remember a Buffett quote, “If I was teaching a course in business school, I’d ask the students to value an Internet company for the final. Anyone who turns in any number for valuation, will fail the class.” I share Buffett’s feelings on valuing highly uncertain businesses. I think Damodaran pushes a techniques a bit too far in their ability to value highly uncertain situations.

I laughed when I heard, “If I make my model bigger, it will get better.” This is another misconception about valuation that Damodaran points out. I think we should be all leary of complex valuation models. Two things result from overly complex models:

**Input fatigue**– You end up inputting a random number after input number twelve according to Damodaran. (Hehe.) With more details, your assumptions end up hiding in all the information.**The model becomes a black box**– You have no idea what makes the model work. If you ever read, “The model valued the company at $x,” watch out. This likely means the analyst doesn’t know how it works and/or doesn’t believe in the results of the model. The professor doesn’t ever want to hear us say the Damodaran spreadsheet came up with it.

Don’t try to value cash! Don’t estimate items you can simply measure the value.

Only new concept in valuation in recent time is real option model valuation. The rest, discounted cash flows and relative valuation, have always been around.

**Discounted Cash Flow Valuation**

I think the professor made a good point in reminding us that every valuation approach assumes markets make mistakes. What are we trying to do with discounted cash flow valuation? We are trying to estimate the intrinsic value or “true” value of an asset.

**DCF Assumptions:**

- We need to assume that markets make mistakes.
- We need to assume you can find the mistakes using your discounted cash flow model.

Here’s the unfair part of investing based on valuation; you can do everything right and go bankrupt. The market can be wrong longer than you can wait. This is why long term investing is so important.

The biggest advantage of discounted cash flow (DCF) valuation is that the valuation is disconnected from the market. If you are valuing businesses like Buffett according to Damodaran, then discounted cash flow valuation is tailor made for you. You are forced to understand how businesses work. However, those advantages are also the disadvantages of DCF valuation. Yikes!

An important point is that the whole market could end up looking overvalued with DCF. We need to remember that investing is like a no strikes called baseball game. We don’t have to invest in stocks when the market is overvalued. I actually try to wait for the *fat pitches* before I take any big swings at a stock.

Another disadvantage is that it takes a lot more time and resources to do discounted cash flows valuations versus relative valuation. However, I believe the advantages of DCF outweigh the additional costs of time and resources if you truly want to outperform the market.

**Relative Valuation**

With relative valuation, you value an asset based on how similar assets are priced. Most valuations are relative valuations. There are three main information needs for relative valuation:

- Set of comperable assets
- Standardized prices – multiples
- Variables to control for differences

With relative valuation, you think on average markets are efficient, but on occassion prices are mispriced and stick out. It assumes mispricing assets are relatively rare.

It is not surprising that relative valuation is used if you as an analyst are judged on your relative performance versus absolute performance. You see this with all the mutual and even hedge fund managers. However, since I work for myself, I am only concerned about absolute performance. I try to avoid using relative valuation.

What if all of the stocks are expensive? With relative valuations, you’ll end up just buying the cheaper of overvalued assets. You can’t expect to make money in these type of situations. You just hope to loose less than the market.

Another danager the professor indicates is that you tend to make implicit assumptions with relative valuations that you might not realize. I didn’t quite follow this point, so I’d be interested to hear your take on what this actually means.

Relative valuation works best when the comparable assets are similar. It is very challenging with stocks, since they are never really that similar to each other.

**What approach would work for you?**

- Discounted cash flow valuation or
- Relative valuation

List your choice in the comments section now and then we will revisit this question in the last session again to see if your position has changed at all.

**Option Valuation**

Also know as contingent valuation. You can use option price model for stocks when these three following features line up:

- There is an underlying asset which has value.
- The payoff on the option occurs only if the value of the underlying asset is greater than the excercise price.
- There is a fixed life

Examples include a patent held by a biotech company, unexploited reserves held by a natural resource company and Delta Airlines stock. With Delta Airlines stock, there is the hope that something good will happen. 95% of the time, nothing good happens.

Options valuation is the fall back position for convential valuation. Things get flipped around in option valuation. As risk increases, options become more valuable. Weird!

Option valuation can get you into trouble if you are not careful. The inputs are difficult to get for real options.

**Discounted Cashflow Valuation**

After this introduction to valuation, Professor Damodaran moves to the Discounted Cashflows Valuation presentation. He discusses the equation that drives discounted cash flows valuation.

Cash flows have to be positive in some point in time for DCF. Valuation can be for the whole business or just the equity of the business. Dividend discount model is the most strict cash flows to equity valuation model.

**What debt to subtract out to get from the value of the firm to the value of the equity?** That’s a great question that I have often had. The debt you use in your cost of capital is a starting point.

The professor uses the example of Merck (MRK). For a discounted cashflows to firm valuation you should really subtract out cost of the contingent liability for the Vioxx litigation. The liability makes equity less valuable.

The weekly challenge is to value the same company twice; once a discounted cashflow to the firm and then to equity? We should be able to value of equity the same with both methods. The professor asks, “What are the asumptions that make the valuations converge?” You should try to figure this out and discuss it in the comments section below.

*Full Disclosure*: I own shares of Merck.

If you want to watch these videos from Damodaran, I would suggest skipping classes 3-5. No offense to Damodaran, but most of what he says in these is BS. I watched some of class 3, and it is mostly (other than the very beginning) useless information about estimating cost of capital using betas and country risk premiums. If you DO watch these, you’ll know exactly how Warren Buffett and others can make so much money without their strategies being closely followed.

Take for example near the middle of Session 3, where Damodaran talks about how the Price/Book (which can be seen as Price/Value) of a stock affects its beta. According to this reasoning, and Damodaran’s calculation of “Value” through a DCF model, he is saying that: Price/Value determines Beta, Beta determines Cost of Capital, and Cost of Capital determines Value. This just doesn’t make any sense, as stated many times by Warren Buffett. “To a man with a hammer, everything looks like a nail.”

This is perfect and straight to the point, because I had a problem with understanding the relative valuation.

Sibusiso,

I’m glad you found this discussion useful.

Max,

You make some great points to keep in mind while listening to classes 3-5. I’m going to watch these videos in order to better understand the weaknesses of CAPM.

Hey I’m going through these webcasts, they’re really informative. I’m also doing the weekly challenges that the Prof hands out with the lectures. I’ve done most of the 1st week apart from section e).

So I peeked at the answers!

But I can’t for the life of me still figure out how he comes up with the value of the firm when it has a 3% growth rate…

For example, how does he calculate the WACC/cost of capital at 10.6%?

it all seems really circuitous.

I can get the equity value from using the FCFE model and then using to figure out the inputs that go into the FCFF model,including the WACC, that would match the two up but that feels a little bit like cheating!

In regard to your question about the implicit assumptions… If you use relative valuation, you’re not required to figure out the growth rate or discount rate. It basically ties into the idea that the entire sector can be overvalued. The company you’re looking at may seem relatively undervalued, but you might be assuming a growth rate of 80% without realizing it by simply comparing it to the other similar companies. If you backed the number out and realized what you were assuming the growth rate at, you might second guess using the relative valuation method.

I think that’s what he meant, but that’s just my opinion.

I’m 3 years too late, but here’s my take on Max’s comment –

Use the bottom-up approach to determine a firm’s beta. Find comparable firms and note down their betas and Debt-Equity Ratios. Compute the average beta for the sector and the average D-E ratio. Then find the unlevered beta of the sector using the average (levered) beta and the average D-E ratio. Finally lever this unlevered beta using the firm’s own D-E ratio.

Once you get the beta, find the COE using the CAPM approach. Cost of Debt (COD) can be approximated using the interest coverage ratio of the firm or by looking at recent bond issues. COE and COD combined give you the Cost of Capital (COC). COC is the discount factor used when discounting the value of future cash flows.

So to summarize, beta determines COE, COE and COD determine COE and COE determines value. Obviously growth and ROE are also important factors.

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