An Introduction to Valuation

AswathDamodaran

Aswath Damodaran

Some Initial Thoughts

"Onehundredthousandlemmingscannotbewrong"

Wethoughtwewereinthetopoftheeighthinning,
whenwewereinthebottomoftheninth..
Stanley
Druckenmiller

Aswath Damodaran

Graffiti

A philosophical basis for Valuation

Valuationisoftennotahelpfultoolindeterminingwhentosell
hypergrowthstocks,HenryBlodget,MerrillLynchEquity
ResearchAnalystinJanuary2000,inareportonInternetCapital
Group,whichwastradingat$174then.
Therehavealwaysbeeninvestorsinfinancialmarketswhohave
arguedthatmarketpricesaredeterminedbytheperceptions(and
misperceptions)ofbuyersandsellers,andnotbyanythingasprosaic
ascashflowsorearnings.
Perceptionsmatter,buttheycannotbeallthematter.
Assetpricescannotbejustifiedbymerelyusingthebiggerfool
theory.
Postscript:InternetCapitalGroupwastradingat$3inJanuary2001.

Aswath Damodaran

Misconceptions about Valuation

Myth1:Avaluationisanobjectivesearchfortruevalue
Truth1.1:Allvaluationsarebiased.Theonlyquestionsarehowmuchand
inwhichdirection.
Truth1.2:Thedirectionandmagnitudeofthebiasinyourvaluationis
directlyproportionaltowhopaysyouandhowmuchyouarepaid.

Myth2.:Agoodvaluationprovidesapreciseestimateofvalue
Truth2.1:Therearenoprecisevaluations
Truth2.2:Thepayofftovaluationisgreatestwhenvaluationisleast
precise.

Myth3:.Themorequantitativeamodel,thebetterthevaluation
Truth3.1:Onesunderstandingofavaluationmodelisinversely
proportionaltothenumberofinputsrequiredforthemodel.
Truth3.2:Simplervaluationmodelsdomuchbetterthancomplexones.

Aswath Damodaran

The Role of Valuation

Valuationisusefulinawiderangeoftasks.
Theroleitplays,however,isdifferentin
differentarenas.Thefollowingsectionlays
outtherelevanceofvaluationin:
Portfoliomanagement
Acquisitionanalysis
Corporatefinance

Aswath Damodaran

Approaches to Valuation

Discountedcashflowvaluation,relatesthevalueofanassettothe
presentvalueofexpectedfuturecashflowsonthatasset.
Relativevaluation,estimatesthevalueofanassetbylookingatthe
pricingof'comparable'assetsrelativetoacommonvariablelike
earnings,cashflows,bookvalueorsales.
Contingentclaimvaluation,usesoptionpricingmodelstomeasure
thevalueofassetsthatshareoptioncharacteristics.

Aswath Damodaran

Basis for all valuation approaches

Theuseofvaluationmodelsininvestmentdecisions(i.e.,indecisions
onwhichassetsareundervaluedandwhichareovervalued)arebased
upon
aperceptionthatmarketsareinefficientandmakemistakesinassessing
value
anassumptionabouthowandwhentheseinefficiencieswillgetcorrected

Inanefficientmarket,themarketpriceisthebestestimateofvalue.
Thepurposeofanyvaluationmodelisthenthejustificationofthis
value.

Aswath Damodaran

Discounted Cash Flow Valuation

Whatisit:Indiscountedcashflowvaluation,thevalueofanassetis
thepresentvalueoftheexpectedcashflowsontheasset.
PhilosophicalBasis:Everyassethasanintrinsicvaluethatcanbe
estimated,baseduponitscharacteristicsintermsofcashflows,growth
andrisk.
InformationNeeded:Tousediscountedcashflowvaluation,youneed
toestimatethelifeoftheasset
toestimatethecashflowsduringthelifeoftheasset
toestimatethediscountratetoapplytothesecashflowstogetpresentvalue

MarketInefficiency:Marketsareassumedtomakemistakesinpricing
assetsacrosstime,andareassumedtocorrectthemselvesovertime,as
newinformationcomesoutaboutassets.

Aswath Damodaran

Advantages of DCF Valuation

SinceDCFvaluation,doneright,isbaseduponanassets
fundamentals,itshouldbelessexposedtomarketmoodsand
perceptions.
Ifgoodinvestorsbuybusinesses,ratherthanstocks(theWarren
Buffetadage),discountedcashflowvaluationistherightwaytothink
aboutwhatyouaregettingwhenyoubuyanasset.
DCFvaluationforcesyoutothinkabouttheunderlyingcharacteristics
ofthefirm,andunderstanditsbusiness.Ifnothingelse,itbringsyou
facetofacewiththeassumptionsyouaremakingwhenyoupaya
givenpriceforanasset.

Aswath Damodaran

Disadvantages of DCF valuation

Sinceitisanattempttoestimateintrinsicvalue,itrequiresfarmore
inputsandinformationthanothervaluationapproaches
Theseinputsandinformationarenotonlynoisy(anddifficultto
estimate),butcanbemanipulatedbythesavvyanalysttoprovidethe
conclusionheorshewants.
Inanintrinsicvaluationmodel,thereisnoguaranteethatanythingwill
emergeasunderorovervalued.Thus,itispossibleinaDCFvaluation
model,tofindeverystockinamarkettobeovervalued.Thiscanbea
problemfor
equityresearchanalysts,whosejobitistofollowsectorsandmake
recommendationsonthemostunderandovervaluedstocksinthatsector
equityportfoliomanagers,whohavetobefully(orclosetofully)invested
inequities

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When DCF Valuation works best

Thisapproachiseasiesttouseforassets(firms)whose
cashflowsarecurrentlypositiveand
canbeestimatedwithsomereliabilityforfutureperiods,and
whereaproxyforriskthatcanbeusedtoobtaindiscountratesis
available.

Itworksbestforinvestorswhoeither
havealongtimehorizon,allowingthemarkettimetocorrectitsvaluation
mistakesandforpricetoreverttotruevalueor
arecapableofprovidingthecatalystneededtomovepricetovalue,as
wouldbethecaseifyouwereanactivistinvestororapotentialacquirer
ofthewholefirm

Aswath Damodaran

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Relative Valuation

Whatisit?:Thevalueofanyassetcanbeestimatedbylookingathowthe
marketpricessimilarorcomparableassets.
PhilosophicalBasis:Theintrinsicvalueofanassetisimpossible(orcloseto
impossible)toestimate.Thevalueofanassetiswhateverthemarketis
willingtopayforit(baseduponitscharacteristics)
InformationNeeded:Todoarelativevaluation,youneed
anidenticalasset,oragroupofcomparableorsimilarassets
astandardizedmeasureofvalue(inequity,thisisobtainedbydividingtheprice
byacommonvariable,suchasearningsorbookvalue)
andiftheassetsarenotperfectlycomparable,variablestocontrolforthe
differences

MarketInefficiency:Pricingerrorsmadeacrosssimilarorcomparable
assetsareeasiertospot,easiertoexploitandaremuchmorequickly
corrected.

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Advantages of Relative Valuation

Relativevaluationismuchmorelikelytoreflectmarketperceptionsand
moodsthandiscountedcashflowvaluation.Thiscanbeanadvantage
whenitisimportantthatthepricereflecttheseperceptionsasisthecase
when
theobjectiveistosellasecurityatthatpricetoday(asinthecaseofanIPO)
investingonmomentumbasedstrategies

Withrelativevaluation,therewillalwaysbeasignificantproportionof
securitiesthatareundervaluedandovervalued.
Sinceportfoliomanagersarejudgedbaseduponhowtheyperformona
relativebasis(tothemarketandothermoneymanagers),relative
valuationismoretailoredtotheirneeds
Relativevaluationgenerallyrequireslessinformationthandiscounted
cashflowvaluation(especiallywhenmultiplesareusedasscreens)

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Disadvantages of Relative Valuation

Aportfoliothatiscomposedofstockswhichareundervaluedona
relativebasismaystillbeovervalued,eveniftheanalystsjudgments
areright.Itisjustlessovervaluedthanothersecuritiesinthemarket.
Relativevaluationisbuiltontheassumptionthatmarketsarecorrectin
theaggregate,butmakemistakesonindividualsecurities.Tothe
degreethatmarketscanbeoverorundervaluedintheaggregate,
relativevaluationwillfail
Relativevaluationmayrequirelessinformationinthewayinwhich
mostanalystsandportfoliomanagersuseit.However,thisisbecause
implicitassumptionsaremadeaboutothervariables(thatwouldhave
beenrequiredinadiscountedcashflowvaluation).Totheextentthat
theseimplicitassumptionsarewrongtherelativevaluationwillalsobe
wrong.

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When relative valuation works best..

Thisapproachiseasiesttousewhen
therearealargenumberofassetscomparabletotheonebeingvalued
theseassetsarepricedinamarket
thereexistssomecommonvariablethatcanbeusedtostandardizethe
price

Thisapproachtendstoworkbestforinvestors
whohaverelativelyshorttimehorizons
arejudgedbaseduponarelativebenchmark(themarket,otherportfolio
managersfollowingthesameinvestmentstyleetc.)
cantakeactionsthatcantakeadvantageoftherelativemispricing;for
instance,ahedgefundcanbuytheundervaluedandselltheovervalued
assets

Aswath Damodaran

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