Chapter Outlines and overheads: These are saved as pdf files, and you need Web Casts: These are webcasts of the lectures from the valuation class that I. Damodaran. Basis for all valuation approaches. □ The use of valuation models in investment decisions (i.e., in decisions on which assets are under valued. Part I: Discounted Cash Flow Valuation; Part II: Relative Valuation; Part III Damodaran on Valuation: Security Analysis for Investment and.
|Language:||English, Spanish, Dutch|
|ePub File Size:||21.89 MB|
|PDF File Size:||11.76 MB|
|Distribution:||Free* [*Sign up for free]|
Chapter Closure in Valuation: Estimating Terminal Value. equity research analysts and many investors, a surprising number of whom subscribe to . Equity Valuation: Models from Leading Investment Banks Aswath Damodaran INVESTMENT VALUATION Real Estate Market Valuation and portal7.info pdf. Ebook Investment Valuation 3rd Aswath Damodaran. Pages . Library of Congress Cataloging-in-Publication Data: Damodaran, Aswath. Investment.
To estimate cash flows, we usually begin with a measure of earnings. Free cash flows to the firm, for in- stance, are based on after-tax operating earnings. Free cash flow to equity estimates, in constrast, commence with net income. While we obtain and use measures of op- erating and net income from accounting statements, the accounting earnings for many firms bear little or no resemblance to the true earnings of the firms. We con- sider how the earnings of a firm, at least as measured by accountants, have to be ad- justed to get a measure of earnings that is more appropriate for valuation. To get from earnings to cash flows, we also need estimates of how much firms reinvest back to generate future growth. Since the accounting definitions of working capital and capital expenditures are often too narrow for purposes of computing cash flows, we consider more expansive definitions of both items.
Why should we care?
Investors come to the market with a wide range of investment philosophies. Some are market timers, while others believe in picking stocks. Some pore over price charts and classify themselves as technicians, whereas others compute financial ratios and swear by fundamental analysis. Some invest for short-term profits and other for long term gains. We believe that knowing how to value assets is useful to all of these investors, though its place in the process will vary. The Market timer Market timers note, with some legitimacy, that the payoff to calling turns in markets is much greater than the returns from stock picking.
They argue that it is easier to predict market movements than to select stocks and that these predictions can be based upon factors that are observable. While valuation of individual stocks may not be of much direct use to a market timer, market-timing strategies can use valuation in one of at least two ways: a The overall market itself can be valued, either on an intrinsic or relative basis, and compared to the current level.
For example, as the number of stocks that are overvalued, using the valuation model, increases relative to the number that are undervalued, there may be reason to believe that the market is overvalued. In effect, market timers can use valuation models to determine when to enter a market stocks, bonds, real estate and how much of their portfolio to allocate to an asset class. Stock pickers believe that while timing the market is a fruitless exercise, picking the right stocks to invest in can generate profits over the long term, especially when the choices are based upon fundamentals.
The underlying theme in fundamental stock picking is that the true value of the firm can be related to its financial characteristics -- its growth prospects, its risk profile and its cashflows. Any deviation from this true value is a sign that a stock is under or overvalued. Fundamental analysts can include both value and growth investors. The key difference between the two is in where the valuation focus lies. Value investors are primarily interested in valuing a firms existing asset base and acquiring it at less than its true value.
Growth investors, on the other hand, are far more focused on valuing a firms growth potential and downloading these growth assets at a discount. While valuation is the central focus in fundamental analysis, some analysts use discounted cashflow models to value firms, while others use multiples and comparable firms. Chartists believe that prices are driven as much by investor psychology as by any underlying financial variables. The information available from trading measures -- price movements, trading volume, short sales and other indicators -- gives an indication of investor psychology and future price movements.
The assumptions here are that prices move in predictable patterns and that the average investor in the market is driven more by emotion than by rational analysis. While valuation does not play as much of a role in charting as it does in fundamental analysis, there are ways in which an enterprising chartist can incorporate valuation views into analysis.
For instance, valuation can be used to determine support and resistance lines on price charts. The information trader Prices move on information about the firm. Information traders attempt to trade in advance of new information or shortly after it is revealed to financial markets. The underlying assumption is that these traders can anticipate information announcements and gauge the market reaction to them better than the average investor in the market.
For an information trader, the focus is on the relationship between information and changes in value, rather than on value, per se.
Thus an information trader may download an 'overvalued' firm if he believes that the next 1 On a chart, the support line usually refers to a lower bound below which prices are unlikely to move and the resistance line refers to the upper bound above which prices are unlikely to venture.
While these levels are usually estimated using past prices, the range of values obtained from a valuation model can be used to determine these levels, i. If there is a relationship between how undervalued or overvalued a company is, and how its stock price reacts to new information, then valuation could play a role in investing for an information trader. The corporate manager There is a role for valuation at every stage of a firms life cycle.
For small private businesses thinking about expanding, valuation plays a key role when they approach venture capital and private equity investors for more capital.
The share of a firm that a venture capitalist will demand in exchange for a capital infusion will depend upon the value she estimates for the firm.
As the companies get larger and decide to go public, valuations determine the prices at which they are offered to the market in the public offering. Once established, decisions on where to invest, how much to borrow and how much to return to the owners will be all decisions that are affected by valuation.
If the objective in corporate finance is to maximize firm value2, the relationship between financial decisions, corporate strategy and firm value has to be delineated. The most significant trend in accounting standards globally is the shift towards fair value accounting, where assets are valued on balance sheets at their fair values rather than at their original cost. This shift, which we view with trepidation, has required accountants to hone their valuation skills, as they are charged with valuing brand name, customer lists and other intangible assets.
In addition, both US and international accounting standards now require that acquisitions be followed immediately by a reassessment of the values of the assets of the target company and evaluation of goodwill impairment in future periods; the latter task requires that the target company be revalued on a continuing basis, with any decline in value below the original download price being recorded as impairment.
Some truths about valuation Before you delve into some of the details of valuation, it is worth noting some truths about valuation in general that will not only provide you with perspective when looking at valuations done by others but also some comfort, when doing your own.
All valuations are biased You almost never start valuing a company with a blank slate. All too often, uour views on a company are formed before you start inputting the numbers into the models and metrics that you use and not surprisingly, your conclusions tend to reflect your biases. The sources of the biases can be manifold: a. The bias in valuation starts with the companies you choose to value. These choices are almost never random, and how you make them can start laying the foundation for bias.
It may be that you have read something in the press good or bad about the company or heard from an expert that it was under or over valued. Thus, you already begin with a perception about the company that you are about to value. You add to the bias when you collect the information you need to value the firm. The annual report and other financial statements include not only the accounting numbers but also management discussions of performance, often putting the best possible spin on the numbers.
With many larger companies, it is easy to access what other analysts following the stock think about these companies. Finally, you have the markets own estimate of the value of the company- the market price adding to the mix. Valuations that stray too far from this number make investors uncomfortable. There are institutional factors that add to this already substantial bias. For instance, it is an acknowledged fact that equity research analysts are more likely to issue download rather than sell recommendations, i.
The reward and punishment structure associated with finding companies to be under and over valued is also a contributor to bias. An analyst whose compensation is dependent upon whether she finds a firm is under or over valued will be biased in her conclusions.
This should explain why acquisition valuations are so often biased upwards.
The analysis of the deal, which is usually done by the acquiring firms investment banker, who also happens to be responsible for carrying the deal to its successful conclusion, can come to one of two conclusions. One is to find that the deal is seriously over priced and recommend rejection, in which case the analyst receives the eternal gratitude of the stockholders of the acquiring firm but little else.
The other is to find that the deal makes sense no matter what the price and to reap the ample financial windfall from getting the deal done. There are three ways in which your views on a company and the biases we have can manifest themselves in value.
The first is in the inputs that you use in the valuation. When you value companies, you constantly come to forks in the road where you have to make assumptions to move on. They generally include industry averages for key variables and represent updates on many of the tables in the book. Web Casts: These are webcasts of the lectures from the valuation class that I teach at Stern. You can use the lecture notes and the text book to follow the lectures. You can read the preface to the book by clicking here.
If you are an instructor using this book, click here. Since this is the first printing of this edition, there will undoubtedly be typos that have crept in. The corrections can be found here.
Our estimates of value can be wrong for a number of reasons, and you can categorize these reasons into three groups. Estimation Uncertainty: Even if our information sources are impeccable, you have to convert raw information into inputs and use these inputs in models. Any mistakes that we make at either stage of this process will cause estimation error. Firm-specific Uncertainty: The path that you envision for a firm can prove to be hopelessly wrong.
The firm may do much better or much worse than you expected it to perform, and the resulting earnings and cash flows will be very different from your estimates. Macroeconomic Uncertainty: Even if a firm evolves exactly the way you 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. The contribution of each type of uncertainty to the overall uncertainty associated with a valuation can vary across companies. When valuing a mature cyclical or commodity company, it may be macroeconomic uncertainty that is the biggest factor causing actual numbers to deviate from expectations.
Valuing a young technology company can expose you to far more estimation and firm-specific uncertainty. Even if you feel comfortable with your estimates of an assets values at any point in time, that value itself will change over time, as a consequence of new information that comes out both about the firm and about the overall market.. Given the constant flow of information into financial markets, a valuation done on a firm ages quickly, and has to be updated to reflect current information.
Thus, technology companies that were valued highly in late , on the assumption that the high growth from the nineties would continue into the future, would have been valued much less in early , as the prospects of future growth dimmed.
With the benefit of hindsight, the valuations of these companies and the analyst recommendations made in can be criticized, but they may well have been reasonable, given the information available at that time.
The advantage of breaking uncertainty down into estimation uncertainty, firm-specific and macroeconomic uncertainty is that it gives us a window on what you can manage, what you can control and what you should just let pass through into the valuation.
Building better models and accessing superior information will reduce estimation uncertainty but will do little to reduce exposure to firm-specific or macro-economic risk.
Even the best-constructed model will be susceptible to these uncertainties. More detail and complexity does not always result in better valuations Valuation models have become more and more complex over the last two decades, as a consequence of two developments.
On the one side, computers and calculators have become far more powerful and accessible in the last few decades. With technology as our ally, tasks that would have taken us days in the pre- computer days can be accomplished in minutes.
On the other side, information is both more plentiful, and easier to access and use. We can download detailed historical data on thousands of companies and use them as we see fit.
The complexity, though, has come at a cost. A fundamental question that we all face when doing valuations is how much detail we should break a valuation down into. There are some who believe that more detail is always better than less detail and that the resulting valuations are more precise.
We disagree. The trade off on adding detail is a simple one. On the one hand, more detail gives you a chance to use specific information to make better forecasts on each individual item. On the other hand, more detail creates the need for more inputs, with the potential for error on each one, and generates more complicated models. In the physical sciences, the principle of parsimony dictates that we try the simplest possible explanation for a phenomenon before we move on to more complicated ones.
We would be well served adopting a similar principle in valuation. When valuing an asset, use the simplest model that you can get away with. In other words, if you can value an asset with three inputs, you should not be using five.
If you can value a company with 3 years of cash flow forecasts, forecasting ten years of cash flows is asking for trouble. Conclusion When faced with the question of whether to invest in a stock, a bond or any asset, you can either choose to make your decisions based upon the actions or recommendations of others that you view as more informed or make your own assessment of value.
Most investors choose not to do the latter and offer a variety of excuses: that valuation models are too complex, that there is insufficient information or that there is too much uncertainty about the future. While all of these reasons have a core of truth to them, there is no reason why they should stop you from valuing assets. Valuation models can be simplified, you can make do with the information that you have rather than wish you had and you can make your best estimates about an uncertain future.
Will you be wrong? Of course, but so will everyone else. Success in investing comes not from being right but from being less wrong than everyone else playing the game. Section 1: Laying the groundwork Chapter 2: The Tools of the trade There are a few basic tools that should be part of every valuation toolkit. While all of these tools have common sense underpinnings, they can take complex forms in some analyses. In this chapter, we will navigate our way through the basics of these tools, while steering away from the complexities that may or may not improve valuations at the margin.
Valuation Tools: An overview Before we start looking at valuation models and metrics, there are four tools that we focus on as essential for our pursuit: a.
Estimating time value of money: An investment generates cash flows over many years and a dollar today is worth more than a dollar in the future. True, but to convert this common sense proposition to value, we have to first understand why time has value and then develop ways in which we can make this notion specific. Measuring risk and estimating expected return: When investing, we face uncertainty about future cash flows.
The basic principle that more risky or uncertainty cash flows should be worth less than less risky cash flows is intuitive.
To put this principle to work in valuation, we need to be clear about what comprises risk, how to measure that risk and how we adjust value for that risk. Making sense of accounting data: When valuing companies, much of the information that we use comes from financial statements. To the extent that this data is misread, our valuations will run off course.
We look at the questions that we would like accounting statements to address and how we might be able to eke out answers from the numbers. Understanding relationships between data: The biggest problem that we face in investing today is not that we have too little information but that we have too much. The data is often contradictory and pulls us in different directions on whether an asset is under or over valued. Statistical measures such as standard deviation can help us consolidate data and understand relationships.
The Time Value of Money The simplest tools in finance are often the most powerful. The notion that a dollar today is preferable to a dollar some time in the future is intuitive enough for most people to grasp without the use of models and mathematics.
The principles of present value enable us to calculate exactly how much a dollar some time in the future is worth in todays dollars and to move cash flows across time. Why money has time value There are three reasons why a cash flow in the future is worth less than a similar cash flow today. Individuals prefer present consumption to future consumption. People would have to be offered more in the future to give up present consumption.
If the preference for current consumption increases, individuals will have to be offered much more in terms of future consumption to give up current consumption, a trade-off that is captured by a high real rate of return or discount rate.