ANINTRODUCTIONTOVALUATIONSpring2017AswathDamodaran

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Valuationwon’tmakeyourational.Youareahumanbeingwithlemmingitis!¨ "Onehundredthousandlemmingscannotbewrong"

Graffiti

We thought we were in the top of the eighth inning, when we were in the bottom of the ninth.. Stanley

DruckenmillerAswath Damodaran

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MisconceptionsaboutValuation

¨ Myth1:Avaluationisanobjectivesearchfor“true” value¤ Truth1.1:Allvaluationsarebiased.Theonlyquestionsare“howmuch”

andinwhichdirection.¤ Truth1.2:Thedirectionandmagnitudeofthebiasinyourvaluationis

directlyproportionaltowhopaysyouandhowmuchyouarepaid.¨ Myth2.:Agoodvaluationprovidesapreciseestimateofvalue

¤ Truth2.1:Therearenoprecisevaluations.¤ Truth2.2:Thepayofftovaluationisgreatestwhenvaluationisleast

precise.¨ Myth3:.Themorequantitativeamodel,thebetterthevaluation

¤ Truth3.1:One’sunderstandingofavaluationmodelisinverselyproportionaltothenumberofinputsrequiredforthemodel.

¤ Truth3.2:Simplervaluationmodelsdomuchbetterthancomplexones.

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TheBermudaTriangleofValuation

Valuation First Principles & Good Sense

Uncertainty & the Unknown- Paralysis- Outsourcing- Herding- Mental accounting

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ApproachestoValuation

1. Intrinsicvaluation,relatesthevalueofanassettoitsintrinsiccharacteristics:itscapacitytogeneratecashflowsandtheriskinthecashflows.Init’smostcommonform,intrinsicvalueiscomputedwithadiscountedcashflowvaluation,withthevalueofanassetbeingthepresentvalueofexpectedfuturecashflowsonthatasset.

2. RelativevaluationorPricing,estimatesthevalueofanassetbylookingatthepricingof'comparable'assetsrelativetoacommonvariablelikeearnings,cashflows,bookvalueorsales.

3. Contingentclaimvaluation,usesoptionpricingmodelstomeasurethevalueofassetsthatshareoptioncharacteristics.

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Basisforallvaluationapproaches

¨ Theuseofvaluationmodelsininvestmentdecisions(i.e.,indecisionsonwhichassetsareundervaluedandwhichareovervalued)arebasedupon¤ aperceptionthatmarketsareinefficientandmakemistakesinassessingvalue

¤ anassumptionabouthowandwhentheseinefficiencieswillgetcorrected

¨ Inanefficientmarket,themarketpriceisthebestestimateofvalue.Thepurposeofanyvaluationmodelisthenthejustificationofthisvalue.

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DiscountedCashflowValuation(DCF)

¨ Whatisit:Indiscountedcashflowvaluation,thevalueofanassetisthepresentvalueoftheexpectedcashflowsontheasset.

¨ PhilosophicalBasis:Everyassethasanintrinsicvaluethatcanbeestimated,baseduponitscharacteristicsintermsofcashflows,growthandrisk.

¨ InformationNeeded:Tousediscountedcashflowvaluation,youneed¤ toestimatethelifeoftheasset¤ toestimatethecashflowsduringthelifeoftheasset¤ toestimatethediscountratetoapplytothesecashflowstogetpresent

value¨ MarketInefficiency:Marketsareassumedtomakemistakesin

pricingassetsacrosstime,andareassumedtocorrectthemselvesovertime,asnewinformationcomesoutaboutassets.

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AdvantagesofDCFValuation

¨ SinceDCFvaluation,doneright,isbaseduponanasset’sfundamentals,itshouldbelessexposedtomarketmoodsandperceptions.

¨ Ifgoodinvestorsbuybusinesses,ratherthanstocks(theWarrenBuffetadage),discountedcashflowvaluationistherightwaytothinkaboutwhatyouaregettingwhenyoubuyanasset.

¨ DCFvaluationforcesyoutothinkabouttheunderlyingcharacteristicsofthefirm,andunderstanditsbusiness.Ifnothingelse,itbringsyoufacetofacewiththeassumptionsyouaremakingwhenyoupayagivenpriceforanasset.

¨ Ifyoubuyintothenotionofvaluebeingdrivenbyacompany’scashflows,youareimmunized(totheextentthatyouhavealongtimehorizon)fromwhatthemarketthinksaboutyourinvestment..

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DisadvantagesofDCFvaluation

¨ Sinceitisanattempttoestimateintrinsicvalue,itrequiresfarmoreexplicitinputsandinformationthanothervaluationapproaches

¨ Theseinputsandinformationarenotonlynoisy (anddifficulttoestimate),butcanbemanipulatedbytheanalysttoprovidetheconclusionheorshewants.Thequalityoftheanalystthenbecomesafunctionofhowwellheorshecanhidethemanipulation.

¨ Inanintrinsicvaluationmodel,thereisnoguaranteethatanythingwillemergeasunderorovervalued.Thus,itispossibleinaDCFvaluationmodel,tofindeverystockinamarkettobeovervalued.Thiscanbeaproblemfor¤ equityresearchanalysts,whosejobitistofollowsectorsandmake

recommendationsonthemostunderandovervaluedstocksinthatsector¤ equityportfoliomanagers,whohavetobefully(orclosetofully)investedin

equities

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WhenDCFValuationworksbest

¨ Attheriskofstatingtheobvious,thisapproachisdesignedforuseforassets(firms)thatderivetheirvaluefromtheircapacitytogeneratecashflowsinthefuture.

¨ Itworksbestforinvestorswho¤ havealongtimehorizon,allowingthemarkettimetocorrectitsvaluationmistakesandforpricetorevertto“true” valueor

¤ arecapableofprovidingthecatalystneededtomovepricetovalue,aswouldbethecaseifyouwereanactivistinvestororapotentialacquirerofthewholefirm

¤ arenoteasilyswayedoraffectedbymarketmovementsthatarecontrarytotheir“value”views

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RelativeValuation(Pricing)

¨ Whatisit?:Thevalueofanyassetcanbeestimatedbylookingathowthemarketprices“similar” or‘comparable” assets.

¨ PhilosophicalBasis:Theintrinsicvalueofanassetisimpossible(orclosetoimpossible)toestimate.Thepriceofanassetiswhateverthemarketiswillingtopayforit(baseduponitscharacteristics)

¨ InformationNeeded:Todoarelativevaluation,youneed¤ anidenticalasset,oragroupofcomparableorsimilarassets¤ astandardizedmeasureofvalue(inequity,thisisobtainedbydividingthe

pricebyacommonvariable,suchasearningsorbookvalue)¤ andiftheassetsarenotperfectlycomparable,variablestocontrolforthe

differences¨ MarketInefficiency:Pricingerrorsmadeacrosssimilaror

comparableassetsareeasiertospot,easiertoexploitandaremuchmorequicklycorrected.

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AdvantagesofRelativeValuation

¨ Insyncwiththemarket:Relativevaluationismuchmorelikelytoreflectmarketperceptionsandmoodsthandiscountedcashflowvaluation.Thiscanbeanadvantagewhenitisimportantthatthepricereflecttheseperceptionsasisthecasewhen¤ theobjectiveistosellanassetatthatpricetoday(IPO,M&A)¤ investingon“momentum” basedstrategies

¨ Withrelativevaluation,therewillalwaysbeasignificantproportionofsecurities thatareundervaluedandovervalued.Sinceportfoliomanagersarejudgedbaseduponhowtheyperformonarelativebasis(tothemarketandothermoneymanagers),relativevaluationismoretailoredtotheirneeds

¨ Relativevaluationgenerallyrequireslessexplicitinformationthandiscountedcashflowvaluation.

¨ Inrelativevaluation,youareplayingthe“incremental”game,whereyouhopetomakemoneybygettingthenextincrement(earningsreport,newsstoryetc.)right.

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DisadvantagesofRelativeValuation

¨ Aportfoliothatiscomposedofstockswhichareundervaluedonarelativebasismaystillbeovervalued,eveniftheanalysts’judgmentsareright.Itisjustlessovervaluedthanothersecuritiesinthemarket.

¨ Relativevaluationisbuiltontheassumptionthatmarketsarecorrectintheaggregate,butmakemistakesonindividualsecurities.Tothedegreethatmarketscanbeoverorundervaluedintheaggregate,relativevaluationwillfail

¨ Relativevaluationmayrequirelessinformationinthewayinwhichmostanalystsandportfoliomanagersuseit.However,thisisbecauseimplicitassumptionsaremadeaboutothervariables(thatwouldhavebeenrequiredinadiscountedcashflowvaluation).Totheextentthattheseimplicitassumptionsarewrongtherelativevaluationwillalsobewrong.

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Whenrelativevaluationworksbest..

¨ Thisapproachiseasiesttousewhen¤ therearealargenumberofassetscomparabletotheonebeingvalued

¤ theseassetsarepricedinamarket¤ thereexistssomecommonvariablethatcanbeusedtostandardizetheprice

¨ Thisapproachtendstoworkbestforinvestors¤ whohaverelativelyshorttimehorizons¤ arejudgedbaseduponarelativebenchmark(themarket,otherportfoliomanagersfollowingthesameinvestmentstyleetc.)

¤ cantakeactionsthatcantakeadvantageoftherelativemispricing;forinstance,ahedgefundcanbuytheundervaluedandselltheovervaluedassets

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AssetBasedValuation:ADetour

¨ Incontrasttovaluingabusinessasagoingconcern(basedoncashflows)orbylookingathowotherbusinessesthatlookitarepriced(relativevaluation),yousometimesmayvalueabusinessbyvaluingitsassets.

¨ Assetbasedvaluationmaybeusedinthecontextof¤ Liquidationvaluation,whereyouarevaluingtheassetsforsale¤ Accountingvaluation,whereyouarevaluingindividualassetsfor

accountingreasons(fairvalueorgoodwillestimation¤ Sumofthepartsvaluation,toeitherseeifacompanyischeapasan

investmentoragoodtargetforacquisition/restructuring¨ Tovaluetheindividualassets,though,youhavetoeitheruse

expectedcashflows(intrinsicvaluation)orbaseitonthepricingofsimilarassets(relativevaluation).

¨ Assetbasedvaluationiseasiesttodowhenassetsareseparableandhavestandaloneearnings/cashflows.

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Whatapproachwouldworkforyou?

¨ Asaninvestor,givenyourinvestmentphilosophy,timehorizonandbeliefsaboutmarkets(thatyouwillbeinvestingin),whichofthetheapproachestovaluationwouldyouchoose?a. DiscountedCashFlowValuationb. RelativeValuationc. Neither.Ibelievethatmarketsareefficient.

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ContingentClaim(Option)Valuation

¨ Optionshaveseveralfeatures¤ Theyderivetheirvaluefromanunderlyingasset,whichhasvalue

¤ Thepayoffonacall(put)optionoccursonlyifthevalueoftheunderlyingassetisgreater(lesser)thananexercisepricethatisspecifiedatthetimetheoptioniscreated.Ifthiscontingencydoesnotoccur,theoptionisworthless.

¤ Theyhaveafixedlife

¨ Anysecuritythatsharesthesefeaturescanbevaluedasanoption.

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OptionPayoffDiagrams

Value of AssetStrike Price

Call OptionPut Option

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DirectExamplesofOptions

¨ Listedoptions,whichareoptionsontradedassets,thatareissuedby,listedonandtradedonanoptionexchange.

¨ Warrants,whicharecalloptionsontradedstocks,thatareissuedbythecompany.Theproceedsfromthewarrantissuegotothecompany,andthewarrantsareoftentradedonthemarket.

¨ ContingentValueRights,whichareputoptionsontradedstocks,thatarealsoissuedbythefirm.TheproceedsfromtheCVRissuealsogotothecompany

¨ ScoresandLEAPs,arelongtermcalloptionsontradedstocks,whicharetradedontheexchanges.

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IndirectExamplesofOptions

¨ Equityinadeeplytroubledfirm - afirmwithnegativeearningsandhighleverage- canbeviewedasanoptiontoliquidatethatisheldbythestockholdersofthefirm.Viewedassuch,itisacalloptionontheassetsofthefirm.

¨ Thereservesownedbynaturalresourcefirmscanbeviewedascalloptionsontheunderlyingresource,sincethefirmcandecidewhetherandhowmuchoftheresourcetoextractfromthereserve,

¨ Thepatentownedbyafirmoranexclusivelicense issuedtoafirmcanbeviewedasanoptionontheunderlyingproduct(project).Thefirmownsthisoptionforthedurationofthepatent.

¨ Therightspossessedbyafirmtoexpand anexistinginvestmentintonewmarketsornewproducts.

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AdvantagesofUsingOptionPricingModels

¨ Optionpricingmodelsallowustovalueassetsthatweotherwisewouldnotbeabletovalue. Forinstance,equityindeeplytroubledfirmsandthestockofasmall,bio-technologyfirm(withnorevenuesandprofits)aredifficulttovalueusingdiscountedcashflowapproachesorwithmultiples.Theycanbevaluedusingoptionpricing.

¨ Optionpricingmodelsprovideusfreshinsightsintothedriversofvalue.Incaseswhereanassetisderivingitvaluefromitsoptioncharacteristics,forinstance,moreriskorvariabilitycanincreasevalueratherthandecreaseit.

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DisadvantagesofOptionPricingModels

¨ Whenrealoptions(whichincludesthenaturalresourceoptionsandtheproductpatents)arevalued,manyoftheinputsfortheoptionpricingmodelaredifficulttoobtain.Forinstance,projectsdonottradeandthusgettingacurrentvalueforaprojectoravariancemaybeadauntingtask.

¨ Theoptionpricingmodelsderivetheirvaluefromanunderlyingasset.Thus,todooptionpricing,youfirstneedtovaluetheassets.Itisthereforeanapproachthatisanaddendumtoanothervaluationapproach.

¨ Finally,thereisthedangerofdoublecountingassets.Thus,ananalystwhousesahighergrowthrateindiscountedcashflowvaluationforapharmaceuticalfirmbecauseithasvaluablepatentswouldbedoublecountingthepatentsifhevaluesthepatentsasoptionsandaddsthemontohisdiscountedcashflowvalue.

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Insummary…

¨ Whiletherearehundredsofvaluationmodelsandmetricsaround,thereareonlythreevaluationapproaches:¤ Intrinsicvaluation(usually,butnotalwaysaDCFvaluation)¤ Relativevaluation¤ Contingentclaimvaluation

¨ Thethreeapproachescanyielddifferentestimatesofvalueforthesameassetatthesamepointintime.

¨ Totrulygraspvaluation,youhavetobeabletounderstandanduseallthreeapproaches.Thereisatimeandaplaceforeachapproach,andknowingwhentouseeachoneisakeypartofmasteringvaluation.

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