Foundations of Valuation

 Banks, insurance companies and other financial service firms pose particular challenges for an
analyst attempting to value them for two reasons.
1. The first is the nature of their businesses makes it difficult to define both debt and
reinvestment, making the estimation of cash flows much more difficult.
2. The other is that they tend to be heavily regulated and the effects of regulatory
requirements on value have to be considered.
 When valuing private firms, the motive for the valuation matters and can affect the value.
 In particular, the value that is attached to a publicly traded firm may be different awhen it is
being valued for sale to an individual, for sale to a publicly traded firm or for an initial public
offering.
 In particular, whether there should be a discount on value for illiquidity and non-diversifiable
risk or a premium for control will depend upon the motive for the valuation.
(Investment Valuation: 2nd Edition by Aswath Damodaran)

Definition of Valuation

 Value is the defining dimension of measurement in a market economy.

 People invest in the expectation that when they sell, the value of each investment will have
grown by a sufficient amount above its cost to compensate them for the risk they took.
 This is true for all types of investments, be they bonds, derivatives, bank accounts, or company
shares.
(Valuation: Measuring and Managing the Value of Companies 5 th Edition by Koller, Tim et. al)
 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 also 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.
(Investment Valuation: 2nd Edition by Aswath Damodaran)

Objectives/ Uses of Valuation

 Value, in contrast, is relevant to all stakeholders, because according to a growing body of
research, companies that maximize value for their shareholders in the long term also create
more employment, treat their current and former employees better, give their customers more
satisfaction, and shoulder a greater burden of corporate responsibility than more shortsighted
rivals.
(Valuation: Measuring and Managing the Value of Companies 5 th Edition by Koller, Tim et. al)

 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 is different for different types
of active investment.
 (Investment Valuation: 2nd Edition by Aswath Damodaran)

Importance/ Rationale of Valuation

 The value of a firm can be directly related to decisions that it makes -- on which projects it takes,
on how it finances them and on its dividend policy.
 Understanding this relationship is key to making value-increasing decisions and to sensible
financial restructuring.
 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:
(a) The overall market itself can be valued and compared to the current level.
(b) A valuation model can be used to value all stocks, and the results from the cross-section can
be used to determine whether the market is over or under valued.
(Investment Valuation: 2nd Edition by Aswath Damodaran)

Frameworks for Valuation

Model Measure Discount Factor Assessment

Enterprise Works best for projects, business units, and

Weighted Average
Discounted Free Cash Flow companies that manage their capital structure
cost of Capital
Cash Flow to a target level

Discounted
Weighted Average Explicitly highlights when a company creates
Economic Economic Profit
cost of Capital value.
Profit

Adjusted Unlevered cost of Highlights changing capital structure more

Free Cash Flow
Present Value Equity easily than WACC-based models.

Compresses free cash flow and the interest tax

Capital Cash Unlevered cost of shield in one number, making it difficult to
Capital Cash Flow
Flow Equity compare operating performance among
companies and over time.

Difficult to implement correctly because capital

Equity Cash Cash Flow to
Levered Cost of Equity structure is embedded within the cash flow.
Flow Equity
Best used when valuing financial institutions.

(Valuation: Measuring and Managing the Value of Companies 5 th Edition by Koller, Tim et. al)

Concepts of Valuation
  Like all analytical disciplines, valuation has developed its own set of myths over time.
Myth 1: Since valuation models are quantitative, valuation is objective.
Myth 2: A well-researched and well-done valuation is timeless.
Myth 3: A good valuation provides a precise estimate of value.
Myth 4: The more quantitative a model, the better the valuation.
Myth 5: To make money on valuation, you have to assume that markets are inefficient.
Myth 6: The product of valuation (i.e., the value) is what matters; The process of
valuation is not important.
(Investment Valuation: 2nd Edition by Aswath Damodaran)

Fundamental Principles of Valuation or Value Creation

 A company’s primary task is to generate cash flows at rates of return on invested capital greater
than the cost of capital.
 Following these principles helps managers decide which investments will create the most value
for shareholders in the long term.
 The principles also help investors assess the potential value of alternative investments.
 A corollary of this principle is the conservation of value: any action that doesn’t increase cash
flows doesn’t create value.
(Valuation: Measuring and Managing the Value of Companies 5 th Edition by Koller, Tim et. al)