Session 1: Introduction to Valuation

This is the first in a series of

session

s on

valuation

. Now, when I say the word

valuation

, most of you think of models and numbers, and you're right, there are many models and many numbers, but there are three broad themes that I hope to establish. In these next

session

s, the first is that the valuation is simple, we choose to make it complex, the second is that each valuation, although it is about numbers, has a story, a narrative behind it, a good valuation has more to do with the story than with the numbers, and the third, when the evaluations go wrong it is not because of the numbers but because of three big problems that I see in the evaluation: the first is bias, you arrive with preconceived ideas and these find their way into the evaluation, the second The third is complexity: we live in a complex world with complex data and models and sometimes that gets in the way of the simplicity that should be at the core. of the valuation.

That's what I hope to show in the next sessions. This is the first time in a series of sessions on valuation valuation that you could ask about any business you can imagine, small or large, public or private, emerging in a developed market and this is my goal at the end of this class. I wish you could value just on any asset, let's see how we can get there when I started teaching valuation 26 years ago at New York University. I made the mistake of assuming that everyone else was as interested in valuation as I was, which in retrospect was a serious mistake that most people don't believe. in valuation, but most people include most people who make a living doing valuations, but they do it, they do it to cover their ass, they do it because it's their job, so let me start by explaining why I do assessments before we start digging into the details I do assessments to fight the lemming in me by now you've probably heard of lemmings, right?

They became famous or infamous about 50 years ago when National Geographic for the most amazing sight, thousands of big, ugly rat-like creatures, this is what lemmings look like gathered on a cliff ran straight off the cliff into an ocean and since then , the big questions have been why they do it, why they fall off that cliff, why they commit collective Susa. I don't know the answer to the question, but come on. Take some collective images and you can see why the first lemming did well. I was going too fast. He couldn't stop. He fell off the cliff into the ocean.

What about the second guy that's going to shut down the first guy? The same, but put yourself. The shoes of the last lemming of that group. You go as fast as you can towards a cliff. You've seen an entire tribe disappear from that cliff. I would assume you have doubts about what you were planning to do. You're right brain, left brain, whatever part of you is rational says "stop, don't do it," but then you have this voice in the back of your head, you know what it is, they must know something that You don't remember those seven words. are the seven deadliest words in investing, you know, when you hear them, you value a company, so you get a value of 50 dollars per share, let's give the company a name, let's say it's Amazon stock trading at 278 , one of the big stocks of the last decade, your rational side comes to you saying don't buy that stock, it's expensive, but then you have this voice in the back of your head saying they must know something you don't know and when you know it Morrie's magical things start to happen to his valuation his cash flows increase his growth rates increase his discount rates go down 50 becomes 100 100 becomes 150 and before you know it guess what it becomes You find 275,300 justifying your need to buy, in fact you can divide all investors into three groups of lemmings.

I call the first group proud lemmings. I am a lemming and I am proud to be a lemming. Who am I talking about? They call themselves momentum investors, but that's pretty much what they do well and go for. a crowd come together you're buying I'm buying you're selling I'm selling why you're buying I don't care about the second group of lemmings I call Yogi Bear lemmings have you ever seen Yogi Bear cartoons or maybe even that unfortunate movie that came out remember his most famous expression he said smarter than the average bear Yogi Bear's lemmings think they are smarter than the average lemming what they want to do they want to run with the crowd to the very edge of the cliff and at the last moment we are far away, yeah you make it, that's great, you'll get all the advantages of the boost and none of the disadvantages now.

I'm afraid I can't be a proud lemming. I don't have the stomach to be a Yogi Bear Lemming. I have no idea which way the cliff is coming from. If you ask me to describe myself, you can see where I'm going. I'm a lemming in a life jacket, that's all valuation is valuation gives you a life jacket gives you something to hold on to when everyone else changes their mind and goes the other direction, that won't stop you from doing really stupid things, If you really really want to buy something you're going to find a way to buy it if you really want to sell something you're going to find a way to sell it Valuation slows down the process it gives your rational side a chance to make an argument that's why we do ratings, so after I've laid that foundation, let me go ahead and talk about it. what I call the Bermuda Triangle assessment, the three big reasons valuations fail and it's not about the numbers, it's not about the models, it's not about the metrics, this is the first and biggest. problem in valuation that most people when they sit down to value a company or a Companies already have a preconceived idea of ​​what they expect to see as value, it is very difficult not to do so.

We almost never start with a blank slate when valuing a company, everything you've read about the company, everything you know about the company will become part of that preconceived idea, the great irony is that the more you know about a company , the stronger those preconceptions are and when those preconceptions are established, your valuation follows, so if I think a company is a great company, guess what my valuation will be that will offer high value. In fact, let me add to that proposition, tell me who pays you to do a valuation, how much they pay you, I will tell you which direction the buyer is going to be and how much the bias is going to be, this is, I think, one of the fundamental rules in valuation when I see a valuation cross my desk before I look at the numbers and the assumptions as to the questions who made this valuation who paid them to do this valuation because their biases will be pre-established by what their mission is If you are an investment banker and I come to you asking for a valuation of a target company and I really want to take over the target company, remember your mission is to close the deal, you will find a way to justify that value.

No wonder your valuation provides exactly the result. I hope to see this company be a bargain. Second big misconception about valuation is that valuation is somehow science, you know what fuels this. You sit in front of computers with models, you enter numbers and after a while you say to yourself, well, I'm being objective, all I'm doing is using numbers, well, don't be fooled, even though you may be using numbers, those Numbers are estimates and when you think about those estimates, those estimates will come with a There is a lot of uncertainty and uncertainty scares people, so when you do an evaluation, one of the tests, you ask your service.

I feel comfortable? Am I sure about these numbers? Especially if we come from a quantitative background, you can look at those numbers and say, “Well, I am.” really uncomfortable these numbers could be wrong, I guess they are always going to be wrong because you are forecasting the future and one of the great ironies in valuation is that the more uncomfortable you are valuing a company, the greater the reward for making that evaluation. It sounds strange, right, you are valuing a technology company with a lot of growth potential, you will feel more uncomfortable than when you value a stable company where everything is practically established but those technology companies would have growth potential, those are exactly the companies we should persevere , do your best estimates and remember that most people give up on these companies and here is the third misconception about valuation: if you make a larger model, it will get better and it is very easy to build large models now as you you build these big models in Excel. or whatever your tool of choice is, remember that you have to make those assumptions, those inputs that drive these models and as these models get really complex, two things happen: one is that these models become black boxes after one time, it is not clear who is running, who is running the The model is a model that runs it, the other is your input fatigue at some point, when you start entering those numbers, it becomes garbage, so here is a message which I hope to convey by looking at the reviews, one of the first things you should try.

What you have to do is be parsimonious, what do I mean by that? If you can value a company with three inputs, don't look for five. If you can value a company with three years of forecasts, don't do ten less, it's more. So, having put the valuation table, let's see the results. three general approaches that exist to value a company and there are only three: the first I will call intrinsic valuation in intrinsic valuation you value a business you value a company based on its fundamentals, its cash flows its growth its risk the discounted cash flow valuation It is the most common tool used to estimate intrinsic value but it is not the only one but the key in intrinsic valuation is that everything has to do with the business the second evaluation approach I call relative valuation and as I describe it You will be familiar with valuing a asset and its relative valuation: you look at the prices of similar assets that the market has at the moment and, once you find them, you use them as a basis to value this asset.

Think about it if you look at an equity research report, what do you see? You see multiple earnings at the right prices to have at our price to book and you see a group of companies and what the analyst says is look at these companies and look at this one. depending on how these others work. Companies are being valued. I think this company is cheap or expensive. Those two valuation approaches by far dominate all evaluations and we will talk about which one is dominant, but there is a third and final evaluation approach, the third evaluation approach, and this is perhaps the only new and perhaps sophisticated aspect that cannot be Evaluating is the application of option pricing models in the context of the value of these assets that have contingent cash flows.

It has a pattern working its way through the pipeline, it will have value only if it gets FDA approval, it is an undeveloped oil reserves company, those oil reserves will have value, only oil prices rise beyond a certain level, so they can collectively make an assessment. approaches and break them down into these three basic approaches, although behind each approach is an assumption about how markets work or, better yet, how they don't work, each of these approaches assumes that markets make mistakes, so why do we need that assumption if markets never made them? errors it would not make sense to value publicly traded companies, true, the market price of the company would be the best estimate of the value of the company, so each of these approaches starts from an assumption about market errors, but They all make different assumptions about how markets make mistakes and how those mistakes are corrected, so to lay the foundation for these different approaches, let me give you a very quick

introduction

to each of these approaches.

Let's start with this type of cash flow valuation or intrinsic valuation, what is discounted cash flow? valuation the value of an asset is the present value of the expected cash flows in the asset nothing more nothing less you are trying to estimate the intrinsic value of a business based on its cash flows and whether it is broken down into this type of cash flow cash model, it has three ingredients, you will see cash flows, you will see a discount rate that reflects the risk in those cash flows and you will see a life for the asset that you are valuing, which could be five years, ten years, it could be for As long as discounted cash flow valuation is used, you are assuming that markets make mistakes and value individual companies and that they correct these errors over time, so if you ask me what is the hidden ingredient to using this type of valuation? cash flow, you need a long time horizon because markets can If you make mistakes, you may find them, but there is no guarantee that those mistakes will becorrect in the next three months, six months or even a year.

The longer the time horizon, the better off you are using this type of cash flow valuation. The second approach to valuation is a relative valuation in a relative valuation you value an asset based on the price of similar assets, you have given up an intrinsic valuation when you do a relative valuation so I don't know what the intrinsic value is. I'm going to tell the market. I and if you break down the relative valuation, this is what you'll see, you'll see a price scale measure, what do I mean by that? You may not be able to compare the values ​​of individual companies because some are smaller. are larger, but if you divide that value by earnings or book value, what you use is a multiple, you're essentially comparing numbers that are comparable.

The second necessary ingredient for a relative valuation is that you need to find other investments that look similar to yours and may be easy to obtain. In some cases it's difficult when you look when you talk about companies, find a company similar to Microsoft or Apple it's difficult to do well, so what you will often find is that analysts define that something is comparable and then they wave their hands and say you know what. which probably aren't all that comparable, which brings me to the third step that you need to monitor to spot the differences between them.

These investments grow, take risks, and flow cash, so find a multi-scale version of a security Look for comparables Monitor differences What kinds of mistakes you think markets make Would you use relative valuation You actually assume markets are right on average , but that they are not wrong on individual companies and that they are wrong on individual companies, that those errors will be corrected sooner rather than later, which brings me to the third and final valuation approach, which is to use option valuation in the context of valuation, as I said, option valuation models. They've been around for a long time, what we're talking about is using those option pricing models to value businesses or assets that have options-like characteristics, what are those options?

They derive value from an underlying asset, have a contingent payment and have a limited duration. life, so here are some very generic examples of options, as valuation examples, that we could try to find a use for the first one, as I pointed out: a natural resources company with undeveloped oil reserves an oil company with undeveloped oil reserves Developed a gold mining company with gold reserves, the option are those undeveloped reserves that the company can choose to develop, but loses only if the price is right. The second is a biotechnology pharmaceutical company with a patent. It could be any technology company with a patent that is not viable. right now, but it could potentially be viable in the future and the third example, and this is quite unusual, is if you buy shares in a company with serious problems, a company that is losing money and has a lot of debt.

I'm going to argue that your effect is to buy an option, so those are potentially places where we could find uses for options pricing that largely covers what I want to do in this session, so in summary, we're looking at different valuation approaches in the future session we are going to Develop these approaches and look for ways in which we can actually value companies with these approaches.