Session 1: Introduction to Valuation

Introduction to Valuation

In this section, the speaker introduces the concept of valuation and outlines three broad themes that will be covered in the coming sessions.

Three Broad Themes of Valuation

• Valuation is simple, but we choose to make it complex.

• Every valuation has a story behind it, and a good valuation is more about the story than about the numbers.

• When valuations go bad, it's not because of the numbers. It's because of bias, uncertainty, and complexity.

Objectives of This Class

• By the end of this class, students should be able to value just about any asset.

Why Do Valuation?

• The speaker explains that he does valuation to fight against his own tendency to follow the crowd (like lemmings).

• He uses an analogy with lemmings running off a cliff to illustrate how people can get caught up in momentum investing.

• The speaker identifies three groups of investors: proud lemmings who embrace momentum investing; Yogi Bear lemmings who try to time their exit from momentum investing; and those who use valuation as a life vest to protect themselves from following the crowd blindly.

Valuation Misconceptions

In this section, the speaker discusses three common misconceptions about valuation.

Preconceptions and Bias

• When valuing a company, preconceptions based on what you know about the company will influence your valuation.

• The more you know about a company, the stronger those preconceptions become.

• Who pays for the valuation can also bias the results.

Valuation is Not Science

• Although numbers are used in valuation, they are estimates and come with uncertainty.

• Uncertainty should be considered when evaluating a company's value.

Less is More

• A simpler model with fewer inputs can be better than a complex one with many inputs.

• The goal is to make accurate estimates without input fatigue or garbage-in data.

Three Approaches to Valuing a Business

In this section, the speaker describes three approaches to valuing a business.

Intrinsic Valuation

• This approach values a business based on its fundamentals such as cash flows, growth potential, and risk.

• Discounted cash flow (DCF) valuation is commonly used for intrinsic valuation.

Relative Valuation

• This approach values an asset by comparing it to similar assets that are currently priced by the market.

• Equity research reports often use multiples such as price-to-book or price-to-sales ratios for relative valuation.

Option Pricing Models

• This approach applies option pricing models to assets that have contingent cash flows.

Valuation Approaches

In this section, the speaker introduces three basic approaches to valuation and explains that each approach assumes that markets make mistakes.

Cash Flow Valuation or Intrinsic Valuation

• Discounted cash flow valuation is used to estimate the intrinsic value of a business based on its cash flows.

• The model has three ingredients - cash flows, a discount rate that reflects the risk in those cash flows, and a life for the asset being valued.

• This approach assumes that markets make mistakes in valuing individual companies and correct these mistakes over time.

• A long time horizon is needed when using this kind of cash flow valuation because there is no guarantee that market mistakes will get corrected in the short term.

Relative Valuation

• In relative valuation, an asset is valued based on how similar assets are priced.

• This approach uses a multiple to compare numbers which are comparable.

• Finding other investments that look just like yours can be difficult when talking about companies. Analysts often define something as comparable then control for differences across these investments such as growth and risk.

• This approach assumes that markets are right on average but wrong in individual companies. It also assumes that market mistakes will get corrected sooner rather than later.

Option Pricing

• Option pricing models can be used to value businesses or assets with option-like characteristics.

• Examples of option-like characteristics include natural resource companies with undeveloped reserves, biotechnology or pharmaceutical companies with patents, and deeply troubled companies with a lot of debt.

• This approach assumes that markets make mistakes in valuing assets with option-like characteristics.

Conclusion

In this section, the speaker summarizes the three approaches to valuation and mentions that they will be fleshed out in future sessions.

• The three approaches to valuation are cash flow valuation or intrinsic valuation, relative valuation, and option pricing.

• Future sessions will explore these approaches in more detail.