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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 ...
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 investors and students of financial markets, Aswath Damodaran'sInvestment Valuation.
Now completely revised and updated to reflect changing market conditions, this third edition comprehensively introduces investment professionals and students 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.
This indispensable guide is a must read for anyone 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.
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. Any 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, the valuation of a real estate property will require different information and follow a different format than the valuation of a publicly traded stock. What is surprising, however, is not the differences in techniques across assets, but the degree of similarity in basic principles. 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 cashflows 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 a higher price in the future.
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, 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 make buy rather than sell recommendations (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) doing the valuation 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.
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 not only contains news about a firm's performance in the most recent time period but, 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.
In some cases, new information can affect the valuations of all firms in a sector. Thus, pharmaceutical companies that were valued highly in early 1992, on the assumption that the high growth from the 1980s would continue into the future, were valued much less in early 1993, as the prospects of health reform and price controls dimmed future prospects. With the benefit of hindsight, the valuations of these companies (and the analyst recommendations) made in 1992 can be criticized, but they were reasonable given the information available at that time.
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 may be 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 will 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 better the valuation.
It may seem obvious that making a model more complete and complex should yield better valuations; but it is not necessarily so. As models become more complex, the number of inputs needed to value a firm tends to increase, bringing with it the potential for input errors. These problems are compounded when models become so complex that they become "black boxes" where analysts feed in numbers at one end and valuations emerge from the other. All too often when a valuation fails, the blame gets attached to the model rather than the analyst. The refrain becomes "It was not my fault. The model did it."
There are three important points on all valuation. The first is the principle of parsimony, which essentially states that you do not use more inputs than you absolutely need to value an asset. The second is that there is a trade-off between the additional benefits of building in more detail and the estimation costs (and error) with providing the detail. The third is that the models don't value companies-you do. In a world where the problem that we often face in valuations is not too little information but too much, separating the information that matters from the information that does not is almost as 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.
Implicit in the act of valuation is the assumption that markets make mistakes and that we can find these mistakes, often using information that tens of thousands of other investors have access to. Thus, it seems reasonable to say that those who believe that markets are inefficient should spend their time and resources on valuation whereas those who believe that markets are efficient should take the market price as the best estimate of value.
This statement, though, does not reflect the internal contradictions in both positions. Those who believe that markets are efficient may still feel that valuation has something to contribute, especially when they are called on to value the effect of a change in the way a firm is run or to understand why market prices change over time. Furthermore, it is not clear how markets would become efficient in the first place if investors did not attempt to find under- and over-valued stocks and trade on these valuations. In other words, a precondition for market efficiency seems to be 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 or sell stocks on that basis must believe that ultimately markets will correct these mistakes (i.e., become efficient), because that is how they make their money. This is a fairly self-serving definition of inefficiency-markets are inefficient until you take a large position in the stock that you believe to be mispriced, but they become efficient after you take the position.
It is best to approach the issue of market efficiency as a wary skeptic. Recognize that on the one hand markets make mistakes but, on the other, finding these mistakes requires a combination of skill and luck. This view of markets leads to the following conclusions: First, if something looks too good to be true-a stock looks obviously undervalued or overvalued-it is probably not true. Second, when the value from an analysis is significantly different from the market price, start off with the presumption that the market is correct; then you have to convince yourself that this is not the case before you conclude that something is over- or undervalued. This higher standard may lead you to be more cautious in following through on valuations, but given the difficulty of beating the market, this is not an undesirable outcome.
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 exclusively on the outcome (i.e., the value of the company and whether it is under- or overvalued), and missing some valuable insights that can be obtained from the process of the valuation. The process can tell us a great deal about the determinants of value and help us answer some fundamental questions: What is the appropriate price to pay for high growth? What is a brand name worth? How important is it to improve returns on projects? What is the effect of profit margins on value? Since the process is so informative, even those who believe that markets are efficient (and that the market price is therefore the best estimate of value) should be able to find some use for valuation models.
THE ROLE OF VALUATION
Valuation is useful in a wide range of tasks. The role it plays, however, is different in different arenas. The following section lays out the relevance of valuation in portfolio management, in acquisition analysis, and in corporate finance.
Valuation in Portfolio Management
The role that valuation plays in portfolio management is determined in large part by the investment philosophy of the investor. Valuation plays a minimal role in portfolio management for a passive investor, whereas it plays a larger role for an active investor. Even among active investors, the nature and the role of valuation are different for different types of active investment.
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A Philosophical Basis for Valuation 1
Generalities about Valuation 2
The Role of Valuation 6
Questions and Short Problems 9
CHAPTER 2 Approaches to Valuation 11
Discounted Cash Flow Valuation 11
Relative Valuation 19
Contingent Claim Valuation 23
Questions and Short Problems 25
CHAPTER 3 Understanding Financial Statements 27
The Basic Accounting Statements 27
Asset Measurement and Valuation 29
Measuring Financing Mix 36
Measuring Earnings and Profitability 42
Measuring Risk 47
Other Issues in Analyzing Financial Statements 53
Questions and Short Problems 55
CHAPTER 4 The Basics of Risk 58
What is Risk? 58
Equity Risk and Expected Return 59
Alternative Models for Equity Risk 71
A Comparative Analysis of Equity Risk Models 76
Models of Default Risk 77
Questions and Short Problems 82
CHAPTER 5 Option Pricing Theory and Models 87
Basics of Option Pricing 87
Determinants of Option Value 89
Option Pricing Models 90
Extensions of Option Pricing 107
Questions and Short Problems 109
CHAPTER 6 Market Efficiency—Definition, Tests, and Evidence 111
Market Efficiency and Investment Valuation 111
What Is an Efficient Market? 112
Implications of Market Efficiency 112
Necessary Conditions for Market Efficiency 114
Propositions about Market Efficiency 114
Testing Market Efficiency 116
Cardinal Sins in Testing Market Efficiency 120
Some Lesser Sins That Can Be a Problem 121
Evidence on Market Efficiency 122
Time Series Properties of Price Changes 122
Market Reaction to Information Events 130
Market Anomalies 134
Evidence on Insiders and Investment Professionals 142
Questions and Short Problems 150
CHAPTER 7 Riskless Rates and Risk Premiums 154
The Risk-Free Rate 154
Equity Risk Premium 159
Default Spreads on Bonds 177
Questions and Short Problems 180
CHAPTER 8 Estimating Risk Parameters and Costs of Financing 182
The Cost of Equity and Capital 182
Cost of Equity 183
From Cost of Equity to Cost of Capital 210
Best Practices at Firms 221
Questions and Short Problems 223
CHAPTER 9 Measuring Earnings 229
Accounting versus Financial Balance Sheets 229
Adjusting Earnings 230
Questions and Short Problems 249
CHAPTER 10 From Earnings to Cash Flows 250
The Tax Effect 250
Reinvestment Needs 258
Questions and Short Problems 269
CHAPTER 11 Estimating Growth 271
The Importance of Growth 272
Historical Growth 272
Analyst Estimates of Growth 282
Fundamental Determinants of Growth 285
Qualitative Aspects of Growth 301
Questions and Short Problems 302
CHAPTER 12 Closure in Valuation: Estimating Terminal Value 304
Closure in Valuation 304
The Survival Issue 318
Closing Thoughts on Terminal Value 320
Questions and Short Problems 321
CHAPTER 13 Dividend Discount Models 323
The General Model 323
Versions of the Model 324
Issues in Using the Dividend Discount Model 344
Tests of the Dividend Discount Model 345
Questions and Short Problems 349
CHAPTER 14 Free Cash Flow to Equity Discount Models 351
Measuring What Firms Can Return to Their Stockholders 351
FCFE Valuation Models 357
FCFE Valuation versus Dividend Discount Model Valuation 372
Questions and Short Problems 376
CHAPTER 15 Firm Valuation: Cost of Capital and Adjusted Present Value Approaches 380
Free Cash flow to the Firm 380
Firm Valuation: The Cost of Capital Approach 383
Firm Valuation: The Adjusted Present Value Approach 398
Effect of Leverage on Firm Value 402
Adjusted Present Value and Financial Leverage 415
Questions and Short Problems 419
CHAPTER 16 Estimating Equity Value per Share 423
Value of Nonoperating Assets 423
Firm Value and Equity Value 440
Management and Employee Options 442
Value per Share When Voting Rights Vary 448
Questions and Short Problems 451
CHAPTER 17 Fundamental Principles of Relative Valuation 453
Use of Relative Valuation 453
Standardized Values and Multiples 454
Four Basic Steps to Using Multiples 456
Reconciling Relative and Discounted Cash Flow Valuations 466
Questions and Short Problems 467
CHAPTER 18 Earnings Multiples 468
Price-Earnings Ratio 468
The PEG Ratio 487
Other Variants on the PE Ratio 497
Enterprise Value to EBITDA Multiple 500
Questions and Short Problems 508
CHAPTER 19 Book Value Multiples 511
Price-to-Book Equity 511
Applications of Price–Book Value Ratios 521
Use in Investment Strategies 530
Value-to-Book Ratios 532
Tobin’s Q: Market Value/Replacement Cost 537
Questions and Short Problems 539
CHAPTER 20 Revenue Multiples and Sector-Specific Multiples 542
Revenue Multiples 542
Sector-Specific Multiples 571
Questions and Short Problems 577
CHAPTER 21 Valuing Financial Service Firms 581
Categories of Financial Service Firms 581
What is Unique about Financial Service Firms? 582
General Framework for Valuation 583
Discounted Cash Flow Valuation 584
Asset-Based Valuation 599
Relative Valuation 599
Issues in Valuing Financial Service Firms 605
Questions and Short Problems 608
CHAPTER 22 Valuing Firms with Negative or Abnormal Earnings 611
Negative Earnings: Consequences and Causes 611
Valuing Negative Earnings Firms 615
Questions and Short Problems 639
CHAPTER 23 Valuing Young or Start-Up Firms 643
Information Constraints 643
New Paradigms or Old Principles: A Life Cycle Perspective 644
Venture Capital Valuation 646
General Framework for Analysis 648
Value Drivers 659
Estimation Noise 661
Implications for Investors 662
Implications for Managers 663
The Expectations Game 663
Questions and Short Problems 666
CHAPTER 24 Valuing Private Firms 667
What Makes Private Firms Different? 667
Estimating Valuation Inputs at Private Firms 668
Valuation Motives and Value Estimates 688
Valuing Venture Capital and Private Equity Stakes 693
Relative Valuation of Private Businesses 695
Questions and Short Problems 699
CHAPTER 25 Aquisitions and Takeovers 702
Background on Acquisitions 702
Empirical Evidence on the Value Effects of Takeovers 705
Steps in an Acquisition 705
Takeover Valuation: Biases and Common Errors 724
Structuring the Acquisition 725
Analyzing Management and Leveraged Buyouts 730
Questions and Short Problems 735
CHAPTER 26 Valuing Real Estate 739
Real versus Financial Assets 739
Discounted Cash Flow Valuation 740
Comparable/Relative Valuation 759
Valuing Real Estate Businesses 761
Questions and Short Problems 763
CHAPTER 27 Valuing Other Assets 766
Cash-Flow-Producing Assets 766
Non-Cash-Flow-Producing Assets 775
Assets with Option Characteristics 777
Questions and Short Problems 779
CHAPTER 28 The Option to Delay and Valuation Implications 781
The Option to Delay a Project 781
Valuing a Patent 789
Natural Resource Options 796
Other Applications 802
Questions and Short Problems 803
CHAPTER 29 The Options to Expand and to Abandon: Valuation Implications 805
The Option to Expand 805
When Are Expansion Options Valuable? 812
Valuing a Firm with the Option to Expand 815
Value of Financial Flexibility 817
The Option to Abandon 820
Reconciling Net Present Value and Real Option Valuations 823
Questions and Short Problems 824
CHAPTER 30 Valuing Equity in Distressed Firms 826
Equity in Highly Levered Distressed Firms 826
Implications of Viewing Equity as an Option 828
Estimating the Value of Equity as an Option 831
Consequences for Decision Making 836
Questions and Short Problems 839
CHAPTER 31 Value Enhancement: A Discounted Cash Flow Valuation Framework 841
Value-Creating and Value-Neutral Actions 841
Ways of Increasing Value 842
Value Enhancement Chain 859
Closing Thoughts on Value Enhancement 864
Questions and Short Problems 865
CHAPTER 32 Value Enhancement: Economic Value Added, Cash Flow Return on Investment, and Other Tools 869
Economic Value Added 870
Cash Flow Return on Investment 884
A Postscript on Value Enhancement 890
Questions and Short Problems 891
CHAPTER 33 Probabilistic Approaches in Valuation: Scenario Analysis, Decision Trees, and Simulations 894
Scenario Analysis 894
Decision Trees 899
An Overall Assessment of Probabilistic Risk-Assessment Approaches 919
Questions and Short Problems 921
CHAPTER 34 Overview and Conclusion 925
Choices in Valuation Models 925
Which Approach Should You Use? 926
Choosing the Right Discounted Cash Flow Model 929
Choosing the Right Relative Valuation Model 933
When Should You Use the Option Pricing Models? 937
Posted March 31, 2010
Investment Valuation covers a broad range of valuation topics, from the theoretical to the practical. The most useful and attractive feature of this book is the multitude of examples. Some of the concepts in valuation are very arcane in the abstract, but examples illuminate them. Every example is clear, structured and well explained.
The book also comes with a very helpful support website, where readers can download Excel spreadsheets from the book. The author also provides abundant related material.
While the book does cover CAPM and option-pricing, it definitely does not intend to be a comprehensive book on financial theory. However, I highly recommend it as a practical valuation book.