Session 1: Introduction to Valuation

this is the first in a series of sessions about valuation now when I say the word valuation most of you think about models and numbers and you're right there are lots of models and lots of numbers but there are three broad themes I hope to establish in these coming sessions the first is that valuation is simple we choose to make it complex the second is every valuation even though it's about numbers has a story a narrative behind it a good valuation is more about the story than about the numbers and third when valuations go bad

it's not because of the numbers it's because of three big problems I see in valuation the first is bias you come in with preconceptions and they find their way into evaluation the second is uncertainty we're not very good about dealing with uncertainty and the third is complexity we live in a complex world with complex data and complex models and sometimes that gets in the way of the Simplicity that should be at the core of valuation that's what I hope to bring through in the next few sessions this is a first in a series of sessions

about valuation valuation of what you might ask of just about any business you can think of small or large public or private emerging or developed market and here's my objective by the end of this class I would like you to be able to Value just about any asset let's see if we can get there when I first started teaching valuation 26 years ago at NYU I made the mistake of assuming that everybody else was as interested in valuation as I was in hindsight that was a bad mistake most people don't believe in valuation by most

people I include most people who do valuation for a living but they do it they do it to cover their rear end they do it because it's their jobs so let me start off by explaining why I do valuation before I start delving into the details I do valuation to fight the leming in me now you probably heard about Lemmings right they became famous and Infamous about 50 years ago when National Geographic fill the most amazing site thousands of big ugly rat-like creatures that's what lemmings look like gathered together on a cliff ran right off

the cliff into an ocean and ever since one of the big questions has been why did they do it why did they go off that Cliff why did they commit Collective suicide I don't know the answer to the question but let's do some collective imagery you can see why the first leming did it right it was going too fast he couldn't stop he went right off the cliff into an ocean what about the second guy he was going too close to the first guy same fate but put yourself in the shoes of the very last

leming in that group you're going as fast as you can towards a cliff you've seen an entire tribe disappear off that Cliff I would assume you had have second thoughts about what you were planning to do your right brain left brain whatever part of you is rational saying stop don't do it but then you have this voice in the back of your head you know what it's saying they must know something that you don't remember those seven words they're the seven most deadly words in investing you know when you hear them you value a company

say you come up with a value of $50 per share let's give the company a name let's suppose it's Amazon stocks trading at 278 one of the great stocks of the last decade you've come up with 50 your rational side saying don't buy that stock it's expensive but then you hear this voice in the back of your head saying they must know something that you don't and when you hear that voice magical things start happening to your valuation your cash flows increase your growth rates go up your discount rates go down 50 becomes 100 100

becomes 150 and before you know it guess what you're at 275 300 justifying your need to buy in fact you can divide all investors into three groups of lemmings the first group I call proud lemings I'm a leming and I'm proud to be a leming who am I talking about they call themselves momentum investors but that's pretty much what they do right they look for a crowd they join in you're buying I'm buying you're selling I'm selling why are you buying I don't care the second group of lemmings I call Yogi Bear lemings have you

ever seen Yogi Bear cartoons or or maybe even that ill- fated movie that came out remember his most f f famous expression he said smarter than the average bear Yogi Bear lemings think they're smarter than the average leming what do they want to do they want to run with the crowd to the very edge of the cliff and at the last moment we are away if you can pull it off that's great you get all the upside of momentum and none of the downside now I'm afraid I cannot be a proud leming I don't have

the stomach to be a yogi B leming I have no idea where the cliff is coming if you ask me to describe myself you you can pretty much see where I'm going I'm a leming with a life firstest that's all valuation is valuation gives you a life vest it gives you something to hold on to when everybody else changes their mind and goes in the other direction it's not going to stop you from doing really stupid things if you really really really want to buy something you're going to find a way to buy it if

you really want to sell something you're going to find a way to sell it valuation slows the process down gives your rational side a chance to mount an argument that's why we do valuation so having laid that Foundation let me actually go on and talk about what I call the Bermuda Triangle valuation the three big reasons why valuations fail and it's not about the numbers it's not about the models it's not about the metrics here's the first and biggest problem in valuation most people when they sit down to value a company or a business already

have a preconception of what they expect to see as the value it's very difficult not to we almost never start with a blank slate when you value a company everything you've read about the company everything you know about the company is going to become part of that preconception the great irony is the more you know about a company the stronger those preconceptions are and when those preconceptions get said your valuation follows so if I think a company is a great company guess what my valuation is going to deliver a high value in fact let me

add to that proposition you tell me who pays you to do a valuation how much you get paid I'll tell you which direction the bias is going to be and how much the bias is going to be this is I think one of the fundamental rules in valuation when I see a valuation cross my desk before I look at the numbers and the assumptions I ask two questions who did this valuation who paid them to do this valuation because your biases are going to be preset by what your mission is if you're an investment banker

and I come to you for valuation of a Target company and I really want to take over the target company remember your mission is to get the deal done you're going to find a way to justify that value not surprisingly your valuation deliver exactly the result I hope to see that this company is a bargain second big misconception about valuation that valuation is somehow a science you know what feeds into this you sit in front of computers with models and you enter numbers and after a while you tell yourself well I'm being objective all I'm

doing is using numbers well don't be deceived even though you might be using numbers those numbers numbers are estimates and when you think about those estimates those estimates are going to come with a great deal of uncertainty and uncertainty scares people so when you do evaluation one of the tests you ask yourself is am I comfortable am I certain about these numbers and especially if you come from a quantitative background you're going to look at those numbers and say well I'm really uncomfortable these numbers could be wrong well guess what they're always going to be

wrong because you're forecasting the future and one of the great ironies in valuation is the more uncomfortable you feel valuing a company the greater the payoff to doing a valuation that sounds strange right you're valuing a technology company with a lot of growth potential you are going to be more uncomfortable than when you value a stable company where everything is pretty much set but those technology companies with growth potential those are exactly the companies where should persevere make your best estimates and remember that most people give up on these companies and here's the third misconception

about valuation if you make a model bigger it's going to get better and it's so easy to build big models now as you build these big models in Excel or whatever your tool of choice is remember you have to make those assumptions those inputs that drive these models and as these models get really complex two things happen one is these models become black boxes after a while it's not clear who's running whom are you running the model is a model running you the other is your have input fatigue at some point in time as you

start entering those numbers it becomes garbage in garbage out so here's a message I hope to deliver as you look at valuations one of the first things you should try to do is be parsimonious what do I mean by that if you can value a company with three inputs don't go looking for five if you can value a company with three years of forecast don't do 10 less is more so having laid the table for valuation let's look at the three broad approaches that there are to valuing a business and there are only three the

first I'm going to call intrinsic valuation in intrinsic valuation you value a business you value a company based on its fundamentals its cash flows its growth its risk discounted cash flow valuation is the most common tool used for estimated intrinsic value but it's not the only one but the key in intrinsic valuation is it's all about the business the second approach to valuation I call relative valuation and as I describe it it's going to sound familiar to Value an asset and relative valuation you look at what similar assets are being priced at by the market

right now and once you find them you use that as your basis for valuing this asset think about it if you look at an equity research report what do you see you see a multiple right price earnings EV to haveit up Price to Book and you see a bunch of companies and what the analyst is saying is look at these companies and look at this one based on how these other companies are being valued I think this company is cheap or expensive those two approaches to valuation by far dominate all valuation and we talk about

which one is dominant but there's a third and Final Approach to valuation the third approach to valuation and this is perhaps the only new and perhaps sophisticated aspect that's new to valuation is applying option pricing models in the context of valuing these assets that have contingent cash flows what are contingent cash flows well this asset will have value only if something happens so if you're a biotechnology company you have a patent working its way through the pipeline it'll have value only if you get FDA approval you're an undeveloped oil Reserve company those oil reserves will

have value only if oil prices go up Beyond a certain level so collectively you can take valuation approaches and break them down into these three basic approaches underlying each approach though is an assumption about how markets work or better still how they don't work each of these approaches assumes that markets make mistakes saying why do we need that assumption if markets never made mistakes there would be no point to valuing publicly traded companies right the market price of the company would be the best estimate of the value of the company so every one of these

approaches makes an assumption about Market mistakes but they all make different assumptions about how markets make mistakes and how those mistakes get corrected so to set the table on these different approaches let me give you a very quick introduction into each of these approaches let's start with discounted cash flow valuation or intrinsic valuation what is it in discounted cash flow valuation the value of an asset is the present value of the expected cash flows in the asset nothing more nothing less you're trying to estimate the intrinsic value of a business based on its cash flows

and if you break down a discounted cash flow model it has three ingredients you'll see cash flows you'll see a discount rate that reflects the risk in those cash flows and You' see a life for the asset you're valuing which could be 5 years 10 years it could be forever and when you use discounted cash flow valuation you are assuming that markets make mistakes in valuing individual companies and that they correct these mistakes over time so if you ask me what the hidden ingredient for using discounted cash flow valuation is you need a long time

Horizon because markets can make mistakes you can find those mistakes but there is no guarantee that those mistakes will get corrected in the next 3 months or 6 months or even a year the longer your time Horizon the better off you are using discounted cash flow valuation the second approach to valuation is relative valuation in relative valuation you value an asset based on how similar assets are priced you've given up an intrinsic valuation when you do relative valuation you say I don't know what the intrinsic value is I'm going to let the market tell me

and if you break down relative valuation here's what you're going to see you're going to see a scale measure of price what do I mean by that you might not be able to compare the values of individual companies because some are smaller some are larger but if you divide that value by earnings or Book value in other words you use a multiple you are essentially comparing numbers which are comparable the second ingredient you need for relative valuation is you need to find other Investments that look just like yours that might be easy in some cases

it's difficult when you when you're talking about companies find me a company that's similar to Microsoft or apple it's tough to do right so what you will often find is analysts defining something as comparable then waving their hands and saying you know what they're probably not that comparable which brings me to the third step you need to control for differences across these Investments growth and risk and cash flows so find a multiple scaled version of a value look for comparables control for differences what kind of mistakes do you assume markets make when you use relative

valuation you actually assume that markets are right on average but that they're wrong on individual companies and if they're wrong in individual companies that those mistakes will get corrected sooner rather than later which brings me to the third and Final Approach to valuation which is using option pricing in the context of valuation as I said option pricing models have been around a long time what we're talking about though is using those option pricing models to Value businesses or assets that have option like characteristics what are those options derive their value from an underlying asset they

have a contingent payoff and they have a limited life so here are some very generic examples of option like examples in valuation that we might try to find a use for the first as I pointed out is a natural resource company with undeveloped reserves an oil an oil company with undeveloped oil reserves a gold mining company with gold reserves there the option is those undeveloped reserves that the company can choose to develop but will do so only if the price is right the second is is a biotechnology pharmaceutical company with a patent could be any

technology company with a patent that's not viable right now but potentially could be viable in the future and the third example and this is fairly unusual is if you buy stock in a deeply troubled company a money losing company with a lot of debt I'm going to argue that you're effectively buying an option so those are potentially places where we might be able to find uses for option pricing that pretty much covers what I want to do in this session so in summary we're looking at different approaches to valuation in the future session we're going

to flesh these approaches out and look at ways in which we can actually value companies with these approaches