Welcome to Valuations: The Different Forms
Lecture 1 has sought to provide a broad introduction to valuations. Valuation analysis is an exercise in discovering what "true value" is. True value is something that is generally unobservable but in attempting to capture it (via some worked analysis) we give ourselves a chance to make relatively informed investment (or otherwise) decisions. Efficient resource allocation can only occur when prices reflect rational values. Attempting to figure out what these rational values are is however, where the difficulty lies.There are hundreds of different valuation models used in practice to value companies, property, investments, funds, antiques etc... Many of these valuation models have similar underlying characteristics and for this reason we can normally track back there existence to one of three frameworks:
1. Absolute (Intrinsic) valuation - An absolute or intrinsic valuation is one that relies on identifying a firm's future cash flows, the risk incurred in earning those cash flows and the relative growth to be experienced in them.An absolute valuation exercise does not rely on the market price, in fact it is premised on the fact that market may make errors over time. For this reason it is not unheard of to have significant deviations between an intrinsic valuation and the current market price. One should therefore not alter the assumptions (given that they were reasonable to begin with) of their model to reflect the movements in the current stock price.
The major advantages of such a model are therefore quite clear. By focusing on firm accounting numbers, cash flows you are not as exposed to market sentiment as some other valuation model. Such valuation analysis also requires you to understand a firm (asset) before trying to model it. The disadvantages revolve around the complexity of such models (which is generally dependent on the person conducting the analysis).Trying to over model a valuation, for example by trying to work out changes in inventory, accounts receivable/ payable, may bring about more trouble that worth.
2. Relative valuation - The idea here is that we work out the value of an asset based on the value of comparable assets. While the concept of intrinsic valuation is important for rational decision making, it can possibly lead to inaction which is also in itself an unfavourable outcome. Think about how many acquisitions of companies would not have happened if we simply relied on intrinsic valuation analysis. This concept of relative valuation is used ubiquitously in real estate, art, commodities, currency etc... Why? Its appeal is simple. If i wanted to work out what i could sell my house for then i could work out the size of my property and the proportion of it that i could lease, work out for every square metre what i could earn, undertake a DCF type analysis, factoring in some growth rate and level of risk on those cash flows which will give me the sale price. Alternatively, i can look at the houses sold recently in my area, with similar characteristics (like no. of bedrooms, bathrooms, garage spots etc...). It is likely in this domain that my valuation (or sale price) will be more relevant and a lot less complex to determine.
As an investment choice, relative valuation will tell you whether something is over or undervalued. This is generally harder to interpret with an intrinsic valuation. The simplicity of such an analysis, however, is where the problems in this model exist. In fact, one can re-engineer a relative valuation back to an intrinsic valuation. What this says is that relative and intrinsic valuation are from the same tree, the only difference is that the assumptions for the latter are implicit.
3. Contingent claims valuation - This valuation method is used in select situations where assets begin to share similar qualities to options. It is normally used in internal valuations of start-up firms, distressed firms and options on investments. Where do option-like characteristics come from? Typically, as the risk profile of a company increases shareholder value is negatively affected due to the impact on future cash flows. The negative impact of risk on a stable public company, however, is not shared by a distressed firm where the equity of the firm is in danger of becoming worthless. In this situation risk is a positive attribute (for shareholders, not debtholders) because if equity is virtually worthless and the company takes great risks, there is an improved probability that shareholders will finish "in-the-money" or better off. The problem with this model however, is largely to do with its limited applicability and the types of inputs required to operationalise it.
This covers lecture 1.
1. Absolute (Intrinsic) valuation - An absolute or intrinsic valuation is one that relies on identifying a firm's future cash flows, the risk incurred in earning those cash flows and the relative growth to be experienced in them.An absolute valuation exercise does not rely on the market price, in fact it is premised on the fact that market may make errors over time. For this reason it is not unheard of to have significant deviations between an intrinsic valuation and the current market price. One should therefore not alter the assumptions (given that they were reasonable to begin with) of their model to reflect the movements in the current stock price.
The major advantages of such a model are therefore quite clear. By focusing on firm accounting numbers, cash flows you are not as exposed to market sentiment as some other valuation model. Such valuation analysis also requires you to understand a firm (asset) before trying to model it. The disadvantages revolve around the complexity of such models (which is generally dependent on the person conducting the analysis).Trying to over model a valuation, for example by trying to work out changes in inventory, accounts receivable/ payable, may bring about more trouble that worth.
2. Relative valuation - The idea here is that we work out the value of an asset based on the value of comparable assets. While the concept of intrinsic valuation is important for rational decision making, it can possibly lead to inaction which is also in itself an unfavourable outcome. Think about how many acquisitions of companies would not have happened if we simply relied on intrinsic valuation analysis. This concept of relative valuation is used ubiquitously in real estate, art, commodities, currency etc... Why? Its appeal is simple. If i wanted to work out what i could sell my house for then i could work out the size of my property and the proportion of it that i could lease, work out for every square metre what i could earn, undertake a DCF type analysis, factoring in some growth rate and level of risk on those cash flows which will give me the sale price. Alternatively, i can look at the houses sold recently in my area, with similar characteristics (like no. of bedrooms, bathrooms, garage spots etc...). It is likely in this domain that my valuation (or sale price) will be more relevant and a lot less complex to determine.
As an investment choice, relative valuation will tell you whether something is over or undervalued. This is generally harder to interpret with an intrinsic valuation. The simplicity of such an analysis, however, is where the problems in this model exist. In fact, one can re-engineer a relative valuation back to an intrinsic valuation. What this says is that relative and intrinsic valuation are from the same tree, the only difference is that the assumptions for the latter are implicit.
3. Contingent claims valuation - This valuation method is used in select situations where assets begin to share similar qualities to options. It is normally used in internal valuations of start-up firms, distressed firms and options on investments. Where do option-like characteristics come from? Typically, as the risk profile of a company increases shareholder value is negatively affected due to the impact on future cash flows. The negative impact of risk on a stable public company, however, is not shared by a distressed firm where the equity of the firm is in danger of becoming worthless. In this situation risk is a positive attribute (for shareholders, not debtholders) because if equity is virtually worthless and the company takes great risks, there is an improved probability that shareholders will finish "in-the-money" or better off. The problem with this model however, is largely to do with its limited applicability and the types of inputs required to operationalise it.
This covers lecture 1.
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