Jieya Kylah D.

Casiple BSMA 4-B

1. Valuation is a process by which analysts determine the present or expected worth of

a stock, company, or asset. The purpose of valuation is to appraise a security and
compare the calculated value to the current market price in order to find
attractive investment candidates. While the current market price is said to reflect all
variables (including irrational behavior), valuation models will only factor in a few
variables—this is why there are so many different methods of valuation. If you have a
business and seek funding from investors, they will need to know how much your
enterprise is worth. This is achieved through a valuation – an estimate of your
company’s overall worth.

2. Misconceptions about Valuation

Myth 1: A valuation is an objective search for “true” value
¤ Truth 1.1: All valuations are biased. The only questions are “how much” and in
which direction.
¤ Truth 1.2: The direction and magnitude of the bias in your valuation is directly
proportional to who pays you and how much you are paid.

Myth 2.: A good valuation provides a precise estimate of value

¤ Truth 2.1: There are no precise valuations.
¤ Truth 2.2: The payoff to valuation is greatest when valuation is least precise.

Myth 3: . The more quantitative a model, the better the valuation

¤ Truth 3.1: One’s understanding of a valuation model is inversely proportional
to the number of inputs required for the model.
¤ Truth 3.2: Simpler valuation models do much better than complex ones.

3. The Bermuda Triangle of Valuation

Bias

In an ideal valuation, you would start with no preconceptions about the companies that
you are analyzing and then make your best judgments on how much value to attach to
them. In practice, you almost never start with a clean slate, as everything that you have
read or heard about a company will have already created perceptions about it that will
affect your valuation. Ironically, the more you learn about a company and the more
exposure you have to its management, the more entrenched the bias becomes. This
bias is made worse if you are being paid to do the valuation as an appraiser, banker or
expert witness, since the client paying for the service often has a “value” in mind that he
or she would like to see, and you will feel pressure, either implicitly or explicitly, to
deliver that value. At the risk of stating the obvious, all valuations are biased, with the
only questions being to what degree and in which direction.

There are many tools to reflect bias in value, and one test of your valuation expertise is
in how well you can hide bias in your inputs. Thus, if your intent is to lower (higher)
value, you can find ways to under (over) estimate cash flows, skew growth rates
(higher), push up discount rates or attach large discounts (premiums) to your end value
to arrive at your final number. While bias is perhaps impossible to escape in valuation,
analysts often deny its existence, express outrage when confronted about it or try to
counter it by getting stamps of approval from accountants or lawyers. It would be much
healthier if analysts were more transparent about their motives, open about their biases
and worked at minimizing their impact on value, rather than acting like they do not
exist.

Uncertainty

Uncertainty is a feature in valuation, not a bug, and it rises to the surface, especially
when valuing young start-ups and companies in transition. It comes from many sources,
from both within and without the firm, and analysts are often paralyzed in its presence,
therefore they seek out mental short cuts (use simple pricing multiples) or try to
outsource the problem (call in consultants and experts).

Rather than run away from uncertainty, analysts will be better served if they faced up to
it in healthier ways. One technique that has stood me in good stead is to replace the
conventional base case valuation, where you use single estimates for each input to
derive a base case value, with a simulation, where you estimate probability distributions
for the inputs to generate a distribution of values. When all is said and done, though, a
little humility will benefit us all. After all, no matter how good your valuation skills are
and how well you have brought them to bear when valuing a young start-up, you will be
wrong and often dramatically so, through no fault of your own.

Complexity

There are multiple forces that are converging to make valuations more complex. First, as
companies globalize, analysts increasingly have to confront country risk and currency
estimation choices when valuing even U.S.-incorporated companies. Second, as
accounting standards become more complex and corporate holding structures get more
complicated, analysts are facing the spillover effects. Third, easy access to data and to
modeling tools allows analysts to build complex models quickly and at low cost.
 These complex models, with multiple moving pieces and mysterious acronyms, become
black boxes, where analysts suspend common sense and stop taking responsibility for
their own valuations. It is time to go back to first principles, accept the proposition that
less is more and build more parsimonious models that we understand and can use more
effectively.

The Bottom Line

At valuation conferences and in valuation treatises, we spend our time immersed in

valuation details including how best to estimate cash flows, discount rates and deal with
valuation loose ends, but we seldom talk about the bias, uncertainty and complexity.
Valuation practice will be better served if we had an honest and open discussion of how
we deal with these structural problems, because they remain the biggest barriers to
good valuations.

4. Common valuation techniques

Comparable Analysis (“Comps”)

Comparable company analysis (also called “trading multiples” or “peer group analysis”
or “equity comps” or “public market multiples”) is a relative valuation method in which
you compare the current value of a business to other similar businesses by looking at
trading multiples like P/E, EV/EBITDA, or other ratios. Multiples of EBITDA are the most
common valuation method.

The “comps” valuation method provides an observable value for the business, based on
what other comparable companies are currently worth. Comps are the most widely
used approach, as they are easy to calculate and always current.

Precedent Transactions

Precedent transactions analysis is another form of relative valuation where you

compare the company in question to other businesses that have recently been sold or
acquired in the same industry. These transaction values include the take-over premium
included in the price for which they were acquired.

The values represent the en bloc value of a business. They are useful for M&A
transactions but can easily become stale-dated and no longer reflective of the current
market as time passes. They are less commonly used than Comps or market trading
multiples.

DCF Analysis
Discounted Cash Flow (DCF) analysis is an intrinsic value approach where an analyst
forecasts the business’ unlevered free cash flow into the future and discounts it back to
today at the firm’s Weighted Average Cost of Capital (WACC).

A DCF analysis is performed by building a financial model in Excel and requires an

extensive amount of detail and analysis. It is the most detailed of the three approaches
and requires the most estimates and assumptions. However, the effort required for
preparing a DCF model will also often result in the most accurate valuation. A DCF
model allows the analyst to forecast value based on different scenarios and even
perform a sensitivity analysis.