Methods of Valuation

There are three broad themes to look at valuation:

 Valuation is simple
 Every valuation even if it is about numbers has a story
When our valuation goes bad its not about the number but the problems such as
1) Bias towards the company (preconception if we have prior knowledge about the
company)
2) Uncertainty of the market
3) Complexity (Misconception that bigger the model the better)
There are three broad approaches to value a business/company.
1) Intrinsic valuation: Here we value a company based on its fundamentals, its cash flows,
its growth, its risks. Discounted cash flow model is a common tool for Intrinsic valuation
2) Relative valuation: Here we look at the price of similar assets by the market right now
and use that as a basis for our valuation. We use various multiples like price to sales,
price to earnings, price to book value, etc.
3) Option pricing models: Here we apply option pricing model in the context of valuing an
asset that have contingent cash flows
Why do we need valuation?
The underlying of each of the above approaches is an assumption about how market works. Each
of these approaches assumes that market makes mistake, saying “why do we need that
assumption?”. If markets never made mistakes there would be no point in valuing publicly traded
companies, the market price of the company would be the best estimated 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.
Now we will look at each of them in detail
1)Discount cash flow model:
In DCF the value of an asset is based on the present value of future cash flows
Breakdown of DCF model;
 Cash flows
 Discount rate: This reflects the risk in those cash flows
 Life of an asset you are valuing
Assumption of markets mistakes: Markets have made mistakes valuing an individual
company and that they will correct these mistakes over time
 Assumptions to be made about: Various cost inputs such as Sales quantity, sales price,
growth rate, revenue annual growth rate for 5 or 10 years
Terminal value, terminal growth rate
Time: There is no guarantee whether the mistakes get corrected in 3 months or 6 months or
even a year. The longer the time horizon the better off you are using DCF valuation
The downside is that over the long period it’s difficult to make assumptions, so it can go
wrong most of the times.
2) Relative Valuation:
In relative valuation the value of an asset is based on how the similar assets are priced
Breakdown of Relative Valuation;
 Scale measure of price: Price to earnings, price to sales, price to book value etc.
 Other investments which look like yours
 Control for differences across these investments: Growth, risks and cash flows
Assumption of markets mistakes: The markets are correct on average but wrong on individual
companies and it will get corrected sooner rather than later
3)Option pricing model:
Option pricing models are used to value businesses/assets that have options like characteristics,
as option s derive their value from an underlying asset, they have a contingent payoff and they
have a limited life.
Examples where option pricing models can be used
 Natural resource company with undeveloped reserves: Depending on the value of the
natural resource.
Example: If you are an undeveloped oil reserve company those oil reserves will have
value only if the oil prices go up beyond the certain level. Factors such as how much oil
the company is able to take out and what value it holds in the current market are also
considered
 Biotechnology or any technology company with a patent that’s not viable right now but
potentially could be viable in the future
Example: If you are a biotechnology company and you have a patent working its way
through the pipeline, it will have value only if you get FDA approval.
 It is also used in buying and selling the derivatives in the stock market
 Black Scholes model is used in option pricing
Cost basis