You are on page 1of 31

Introduction to

Business Valuation
Dr. Chhavi Mehta
How You Differentiate?

VALUE
&
PRICE
Valuation
• Beauty Lies in the eyes of beholder

• Valuation lies in the eyes of the analyst


Basis for Valuation
• Financial Assets – Financial assets need to be valued on
some logical basis

• In many areas analysts may disagree


Knowing what an asset is worth and what determines that
value is a pre-requisite for intelligent decision making
– Aswath Damodaran
Importance of Valuation
• Key to successful investing
– Know the value
– Sources of value

• Every asset can be valued – Some are easier than others

• Techniques across assets can differ but basic principles of valuation


are similar
Remember Three Things about Valuation
• Valuation is simple, we make it complex

• Valuation has a story behind it, a good valuation is about story than
about numbers

• When valuation fail, they are not because of the numbers but
because of other factors
What are these Factors?
• Bias – preconceived notions

• Uncertainty – we are not good at dealing with this

• Complexity – we live in a complex world and make simple


things complex
Bias in Valuation
Bias in Valuation
• We almost never start valuing a company with a blank slate

• Views on a company being over- or under-valued are formed before


we start inputting the numbers into the models  Conclusions tend
to reflect these biases
Reduction of Biases
• First:
– Avoid taking strong public positions on the value of a firm before the
valuation is complete
– In many cases decision a firm being over- or under-valued precedes the
actual valuation leading to seriously biased analyses

• Second:
– Minimise the stake in firm being over- and under-valued (institutional
investors concerns)
Institutional Investors’ Concerns
 Equity research analysts are likely to issue ‘buy’ rather than ‘sell’
recommendation – they are more likely to find firms to be
undervalued than overvalued

 Reasons
a. If information about the companies is difficult to get – sell
b. Pressure form portfolio managers and from their own investment banking
arm – some of them have large positions in the stock and have profitable
relationship with the firms in question
Imprecision and Uncertainty
in Valuation
Imprecision and Uncertainty in Valuation
• Valuation requires using forecasted numbers – They are only estimates

• There will always be uncertainty associated with valuations, and even


the best valuations come with a substantial margin for error.
Why Our Estimated Value May be Wrong?
1. Estimation Uncertainty  Even if our information sources are impeccable, we
have to convert raw information into inputs and use these inputs in models. Any
mistake that we make at either stage of this process will cause estimation error.

2. Firm-specific Uncertainty  The path that we envision for a firm could prove to
be hopelessly wrong. The firm may do much better or much worse than we
expected it to perform, and the resulting earnings and cash flows will be very
different from our estimates.

3. Macroeconomic Uncertainty  Even if a firm evolves exactly the way we


expected it to, the macro economic environment can change in unpredictable
ways. Interest rates can go up or down and the economy can do much better or
worse than expected. These macro economic changes will affect value.
Responses of Uncertainty
 Better Valuation Models  Build better valuation models that use more of the
information that is available at the time of the valuation. But remember that even
the best-constructed models may reduce estimation uncertainty but they cannot
reduce or eliminate the very real uncertainties associated with the future.

 Valuation Ranges  Since value is an estimate, try to quantify a range on the


estimates. Use simulations or derive expected, best-case and worst-case
estimates of value

 Probabilistic Statements  Value in probabilistic terms to provide insight into the


uncertainty i.e. value of Rs.30 for a stock which is trading at Rs.25, state that there
is a 60-70% probability that the stock is under valued rather than make the
categorical statement that it is under valued.
Complexity
Are Complex Models Better?
More Details or Less Details?
• Gross working capital vs. Net working capital vs. Individual
components of working capital
– Cash
– Accounts receivables
– Inventories
– Accounts receivables
Cost of Complexity
• Information Overload  More complex models require more
information but how much? GIGO

• Black Box Syndrome  Not aware of the inner working of the


model you use.

• Big versus Small Assumptions  Single growth vs. two-stages vs.


multiple-stages growth model?
Myths of Valuation
• Myth 1 – Since valuation models are quantitative so valuation is
objective
• Myth 2 – A well-research 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
the markets are inefficient and they will become efficient
• Myth 6 – The product of valuation is what matters (the value), the
process of valuation is not important
Myth 1
Since valuation models are quantitative so valuation is objective

• Remember:
– Valuation – Art and science both; more of art and than science
– Valuation models may be quantitative but the inputs are based on
qualitative assessment, so lot of scope for subjective judgement
– Final value we obtain from these models gets affected by various biases
Myth 2
A well-research and well done valuation is timeless

• Remember:
– Value of a firm = f(firm specific information, industry specific information,
market specific information)  Value will change as new information is
revealed
– Give the constant flow of information into financial market, a valuation
done ages quickly and need to be updated continuously
Myth 3
A good valuation provides a precise estimate of value

• Remember:
– As valuation is based on the future estimated of the company (cash flows
and discount rates), there will always be uncertainty about the final
numbers
– Degree of precision is likely to vary across companies  Valuation of large
and mature companies versus valuation of young companies; magnified
uncertainty due to emerging market
– Difficulties associated with valuation can be related to where the firm is in
the life cycle
– Problem arises not because of the model but because of the estimates, still
doing valuation is better than not doing it; keep a margin of errors
Myth 4
The more quantitative a model, the better the valuation

• Remember:
– As models become more complex, number of inputs needed to value a firm
tends to increase resulting in a possibility of more estimation errors
– As a valuation fails, the blame on the model instead of analyst
– Three things to remember:
• Adhere to the principle of parsimony
• Trade off between additional benefits of building a more complex model
and estimation cost
• You do the valuation not the models  Problem of excess information,
so segregate between important and unimportant information
Myth 5
To make money on valuation, you have to assume that the markets
are inefficient and they will become efficient
• Remember:
– Some believe that markets are inefficient so they spend their time and
resources on valuation; some believe that markets are efficient should take
the market price as best estimate of value
– Approach the issue of market efficiency as a skeptic  Recognize that on
one hand markets make mistakes but, on the other, finding these mistakes
requires a combination of skill and luck
– If something looks too good to be true, it is not probably so
– When a value from analysis is significantly from the market price, start off
with the presumption that market is correct
Myth 6
The product of valuation is what matters (the value), the process of
valuation is not important

• Remember:
– Risk in focusing exclusively on the outcome  You might miss on some
valuable insights that can be obtained from the process of valuation
– Process can tell us great deal about the determinants of value and help us
answer some fundamental questions i.e.:
• What is the appropriate price to pay for high growth?
• What is the effect of profit margins on value?
Role of Valuation
• Valuation in Portfolio Management  Valuation is the central focus
in fundamental analysis.

• Valuation in Acquisition Analysis  Bidding firm and Target firm


both do valuation and then negotiate a price.

• Valuation in Corporate Finance  If the objective in corporate


finance is maximization of firm value, firms must understand what
derives value. Take value increasing decisions.
REMEMBER
Valuation is not an objective exercise and any preconception
and biases that an analyst brings to the process will find their
way into the value, with a substantial likelihood of you being
wrong in your assessment.