Ch. 1 Introduction to Valuation Questions and Answers

Ch. 1 Introduction to Valuation Questions and Answers Perceptions of Value... ...have to be baked up by reality, which implies that the price that is paid for any asset should reflect the cash flows it is expected to generate. Myth 1: Since valuation models are quantitative, valuation is objective. The models used may be quantitative, but the inputs leave plenty of room for subjective judgments. 2 ways to reduce bias: 1) Avoid taking strong public positions on the value of a firm before the valuation is complete. 2) Minimize, prior to the valuation, the stake we have in whether the firm is under- or overvalued. Myth 2: A well-researched and well-done valuation is timeless. The value obtained from any valuation model is affected by firm-specific as well as market-wide information. As a consequence, the value will change as new information is revealed. Examples of new information: Business models that deliver customers, but not earnings. New information in a sector. The state of the economy. Myth 3: A good valuation provides a precise estimate of value. It is unrealistic to expect or demand absolute certainty in valuation, since cash flows and discount rates are estimated. Analysts have to give themselves a reasonable margin of error. Myth 4: The more quantitative a model, the better the valuation. As models become more complex, the numbers of inputs needed to value a firm tends to increase, bringing with it the potential for input errors. 3 important points that need to be made about all valuation: 1) Adhere to the principle of parsimony, which essentially states that you do not use more inputs than you absolutely need to value an asset. 2) Recognize that there is a trade-off between the additional benefits of building in more detail and the estimation costs (and error) with providing the detail. 3) Understand that models don't value companies - YOU do. Myth 5: To make money on valuation, you have to assume that markets are inefficient (but that they will become efficient). Implicit in the act of valuation is the assumption that markets make mistakes and that we can find these mistakes, often using information that tens of thousand of other investors have access to. Those who believe that markets are inefficient should spend their time and resources on valuation, whereas those who believe that markets are efficient should take the market price as the best estimate of the value. Inefficiency markets are inefficient until you take a large position in the stock that you believe to be mispriced, but they become efficient after you take the position. It is best to approach the issue of market efficiency as a skeptic: 1) If something looks too good to be true (a stock looks obviously under- or overvalued) it is probably NOT true. 2) When the value from analysis is significantly different from the market price, start off with the presumption that the market is correct; then you have to convince yourself that this is not the case before concluding that something is under- or overvalued. Myth 6: The product of valuation (i.e., the value) is what matters; the process of valuation is not important. Don't focus exclusively on the outcome. The process can tell us a great deal about the determinants of value and help us answer some fundamental questions. Examples: What is the appropriate price to pay for high growth? What is a brand name worth? How important is it to improve returns on projects? What is the effect of profit margins on value? Valuation in Portfolio Management Valuation plays a minimal role in portfolio management for a passive investor, whereas it plays a larger role for an active investor. Valuation in Fundamental Analysis The true value of a firm can be related to its financial characteristics. Methods: discounted cash flow models or price-earnings/price-book ratios. Valuation in Franchise Buying - Investors who understand a business well are in a better position to value it correctly. -These undervalued businesses can be acquired without driving the price above the true value and sometimes at a bargain. Valuation in Charting Not a big role. Chartists believe that prices are driven as much by investor psychology as by any underlying financial variables. Valuation in Information Trading Information traders focus on the relationship between information and changes in value, rather than on value alone. They attempt to trade in advance of new information or shortly after it is revealed to financial markets, buying on good and selling on bad. Valuation in Market Timing The overall market can be valued. Valuation of individual stocks is not of any use to market timers. Valuation in Efficient Marketing Valuation is a useful exercise to determine why a stock sells for the price that it does. They believe that the market price represents the best estimate of true value of a firm. Valuation in Acquisition Analysis Valuation plays a central role. There is a significant problem with boas in takeover valuations. Special factors to consider: 1) The effects of synergy on the combined value of the two firms. 2) The effects on value of changing management and restructuring the target firm. Valuation in Corporate Finance If the objective in corporate finance is the maximization of firm value, the relationship between financial decisions, corporate strategy, and firm value has to be delineated.