VALUATION
Overview of Valuation
- Valuation involves models and numbers, but it is fundamentally simple; complexity is often self-
imposed.
- A good valuation emphasizes the narrative behind the numbers rather than the numbers
themselves.
Common Pitfalls in Valuation
- Bias: Preconceptions can skew valuations; individuals often start with an expected value based on
prior knowledge.
- Uncertainty: Valuators struggle with uncertainty, which is inherent in forecasting future cash
flows.
- Complexity: Overly complex models can obscure understanding and lead to poor valuations.
Approaches to Valuation
1. Intrinsic Valuation:
- Focuses on a business's fundamentals, including cash flows, growth, and risk.
- Discounted cash flow (DCF) is a common method, calculating the present value of expected cash
flows.
2. Relative Valuation:
- Values an asset based on the pricing of similar assets in the market.
- Analysts often use multiples (e.g., price-to-earnings) to compare companies.
3. Option Pricing Models:
- Useful for valuing assets with contingent cash flows, such as patents or undeveloped resources.
- These models account for the uncertainty and potential future value of options.
Market Assumptions
- All valuation approaches assume that markets make mistakes, which is crucial for justifying the
need for valuation.
- Each method has different assumptions about how these market mistakes occur and are corrected.
Conclusion
- The session sets the foundation for understanding valuation, emphasizing the importance of
simplicity, awareness of biases, and the different approaches to valuing assets.
, 2. INTRINSIC VALUE FOUNDATIONS
Intrinsic Valuation Overview
- Intrinsic valuation is a method for valuing a business based on its expected “cash flows”, “growth”,
and “risk”.
- It is fundamental to valuation practices and can be applied to either the “equity” of a business or
the “entire business”.
Key Concepts of Intrinsic Value
- The essence of intrinsic value lies in valuing a business based on its “cash flows”, “growth”, and
“risk”, with “discounted cash flow (DCF)” valuation being a primary tool.
- Intrinsic value is specifically designed for “cash flow generating assets”, making it unsuitable for
non-cash flow assets like art or gold.
Discounted Cash Flow Valuation
- The core equation for DCF valuation states that the value of an asset is the “present value of
expected cash flows”.
- DCF valuation involves estimating cash flows and adjusting for risk, which can be done in two ways:
- Adjusting the “discount rate” for risk.
- Adjusting the “cash flows” for risk, leading to what is known as “certainty equivalent cash flows”.
Conditions for Valuation
- For an asset to have value, its expected cash flows must be “positive” at some point.
- Young companies may have negative cash flows initially but must show “disproportionately large
positive cash flows” in the future to be valued.
Financial Balance Sheet Framework
- A “financial balance sheet” simplifies valuation by focusing on two asset types: “investments in
place” and “growth assets”.
- The liabilities side consists of “debt” and “equity”, representing the two funding sources for a
business.
Valuing Equity vs. Entire Business
- When valuing “equity”, focus on cash flows available to equity investors after all obligations.
- Valuing the “entire business” considers cash flows available to both equity investors and lenders,
using the “weighted average cost of capital” as the discount rate.
- It is crucial to maintain consistency in cash flows and discount rates to avoid valuation errors.
- Summary Takeaways
- Intrinsic valuation is about assessing companies based on their unique characteristics.
- DCF valuation is a key tool for estimating intrinsic value, requiring careful estimation of cash flows
and risk adjustments.
- The choice between valuing equity or the entire business influences cash flow estimation and
discount rate selection.
3 RISK FREE RATE
- Understanding the Risk-Free Rate
- The “risk-free rate” is essential for valuing assets and is typically derived from government bond
rates, such as the US Treasury bond rate.
, - Estimating a risk-free rate requires ensuring that the issuing entity has “no default risk”, which can
be challenging in certain regions.
- Discount Rates in Valuation
- Discount rates are crucial in “discounted cash flow (DCF)” valuation, but analysts often focus
excessively on them rather than on estimating cash flows.
- Consistency in valuation is key; for cash flows to equity, use the “cost of equity”, and for business
cash flows, use the “cost of capital”.
- Nominal vs. Real Cash Flows
- Valuation can be conducted in “nominal” or “real terms”; real cash flows ignore inflation, while
nominal cash flows account for it.
- The currency used for cash flows must match the currency of the discount rate, particularly for
nominal cash flows.
- Measuring Risk
- The cost of equity should be higher for riskier investments, but measuring risk often relies on
statistical measures like “standard deviation” and “volatility”.
- When assessing risk, consider the perspective of “marginal investors”, who typically hold
significant shares and influence stock prices.
- Risk and Return Models
- Traditional finance models, such as the “Capital Asset Pricing Model (CAPM)”, assess risk based on
its contribution to a diversified portfolio.
- Alternative models like the “Arbitrage Pricing Model” and “multifactor models” offer different
approaches to measuring market risk.
- Characteristics of a Risk-Free Rate
- A true risk-free rate must have no default risk and no reinvestment risk, and it should match the
cash flow duration.
- The risk-free rate is typically derived from long-term government bond rates, but not all
governments are considered default-free.
- Estimating Risk-Free Rates
- For US dollar valuations, the “10-year government bond rate” is often preferred due to its balance
of availability and relevance.
- In other currencies, such as Euros or Brazilian Reais, the selection of a risk-free rate involves
identifying government bonds with the least perceived default risk.
- Default Spread Calculation
- To convert a government bond rate into a risk-free rate, one must account for the “default
spread”, which can be estimated using various methods, including comparing dollar-denominated
bonds or using credit default swap (CDS) spreads.
- If no direct measures are available, sovereign ratings can provide a basis for estimating default
spreads.
- Conclusion
- The risk-free rate is a foundational element in calculating expected returns and discount rates
across various currencies, necessitating careful estimation to ensure accuracy in valuations.
Overview of Valuation
- Valuation involves models and numbers, but it is fundamentally simple; complexity is often self-
imposed.
- A good valuation emphasizes the narrative behind the numbers rather than the numbers
themselves.
Common Pitfalls in Valuation
- Bias: Preconceptions can skew valuations; individuals often start with an expected value based on
prior knowledge.
- Uncertainty: Valuators struggle with uncertainty, which is inherent in forecasting future cash
flows.
- Complexity: Overly complex models can obscure understanding and lead to poor valuations.
Approaches to Valuation
1. Intrinsic Valuation:
- Focuses on a business's fundamentals, including cash flows, growth, and risk.
- Discounted cash flow (DCF) is a common method, calculating the present value of expected cash
flows.
2. Relative Valuation:
- Values an asset based on the pricing of similar assets in the market.
- Analysts often use multiples (e.g., price-to-earnings) to compare companies.
3. Option Pricing Models:
- Useful for valuing assets with contingent cash flows, such as patents or undeveloped resources.
- These models account for the uncertainty and potential future value of options.
Market Assumptions
- All valuation approaches assume that markets make mistakes, which is crucial for justifying the
need for valuation.
- Each method has different assumptions about how these market mistakes occur and are corrected.
Conclusion
- The session sets the foundation for understanding valuation, emphasizing the importance of
simplicity, awareness of biases, and the different approaches to valuing assets.
, 2. INTRINSIC VALUE FOUNDATIONS
Intrinsic Valuation Overview
- Intrinsic valuation is a method for valuing a business based on its expected “cash flows”, “growth”,
and “risk”.
- It is fundamental to valuation practices and can be applied to either the “equity” of a business or
the “entire business”.
Key Concepts of Intrinsic Value
- The essence of intrinsic value lies in valuing a business based on its “cash flows”, “growth”, and
“risk”, with “discounted cash flow (DCF)” valuation being a primary tool.
- Intrinsic value is specifically designed for “cash flow generating assets”, making it unsuitable for
non-cash flow assets like art or gold.
Discounted Cash Flow Valuation
- The core equation for DCF valuation states that the value of an asset is the “present value of
expected cash flows”.
- DCF valuation involves estimating cash flows and adjusting for risk, which can be done in two ways:
- Adjusting the “discount rate” for risk.
- Adjusting the “cash flows” for risk, leading to what is known as “certainty equivalent cash flows”.
Conditions for Valuation
- For an asset to have value, its expected cash flows must be “positive” at some point.
- Young companies may have negative cash flows initially but must show “disproportionately large
positive cash flows” in the future to be valued.
Financial Balance Sheet Framework
- A “financial balance sheet” simplifies valuation by focusing on two asset types: “investments in
place” and “growth assets”.
- The liabilities side consists of “debt” and “equity”, representing the two funding sources for a
business.
Valuing Equity vs. Entire Business
- When valuing “equity”, focus on cash flows available to equity investors after all obligations.
- Valuing the “entire business” considers cash flows available to both equity investors and lenders,
using the “weighted average cost of capital” as the discount rate.
- It is crucial to maintain consistency in cash flows and discount rates to avoid valuation errors.
- Summary Takeaways
- Intrinsic valuation is about assessing companies based on their unique characteristics.
- DCF valuation is a key tool for estimating intrinsic value, requiring careful estimation of cash flows
and risk adjustments.
- The choice between valuing equity or the entire business influences cash flow estimation and
discount rate selection.
3 RISK FREE RATE
- Understanding the Risk-Free Rate
- The “risk-free rate” is essential for valuing assets and is typically derived from government bond
rates, such as the US Treasury bond rate.
, - Estimating a risk-free rate requires ensuring that the issuing entity has “no default risk”, which can
be challenging in certain regions.
- Discount Rates in Valuation
- Discount rates are crucial in “discounted cash flow (DCF)” valuation, but analysts often focus
excessively on them rather than on estimating cash flows.
- Consistency in valuation is key; for cash flows to equity, use the “cost of equity”, and for business
cash flows, use the “cost of capital”.
- Nominal vs. Real Cash Flows
- Valuation can be conducted in “nominal” or “real terms”; real cash flows ignore inflation, while
nominal cash flows account for it.
- The currency used for cash flows must match the currency of the discount rate, particularly for
nominal cash flows.
- Measuring Risk
- The cost of equity should be higher for riskier investments, but measuring risk often relies on
statistical measures like “standard deviation” and “volatility”.
- When assessing risk, consider the perspective of “marginal investors”, who typically hold
significant shares and influence stock prices.
- Risk and Return Models
- Traditional finance models, such as the “Capital Asset Pricing Model (CAPM)”, assess risk based on
its contribution to a diversified portfolio.
- Alternative models like the “Arbitrage Pricing Model” and “multifactor models” offer different
approaches to measuring market risk.
- Characteristics of a Risk-Free Rate
- A true risk-free rate must have no default risk and no reinvestment risk, and it should match the
cash flow duration.
- The risk-free rate is typically derived from long-term government bond rates, but not all
governments are considered default-free.
- Estimating Risk-Free Rates
- For US dollar valuations, the “10-year government bond rate” is often preferred due to its balance
of availability and relevance.
- In other currencies, such as Euros or Brazilian Reais, the selection of a risk-free rate involves
identifying government bonds with the least perceived default risk.
- Default Spread Calculation
- To convert a government bond rate into a risk-free rate, one must account for the “default
spread”, which can be estimated using various methods, including comparing dollar-denominated
bonds or using credit default swap (CDS) spreads.
- If no direct measures are available, sovereign ratings can provide a basis for estimating default
spreads.
- Conclusion
- The risk-free rate is a foundational element in calculating expected returns and discount rates
across various currencies, necessitating careful estimation to ensure accuracy in valuations.
