Valuation Lecture Notes

Introduction to Valuation

• Series of sessions on valuation.
• Common perception: Valuation is about models and numbers.
• Three broad themes:
  1. Valuation is simple; complexity is chosen.
  2. Every valuation has a story/narrative.
  3. Valuation failures arise from three problems:
     • Bias
     • Uncertainty
     • Complexity

Objectives of the Session

• Ability to value any asset by the end of the class.
• Personal experience: 26 years of teaching valuation.
• Many people do not believe in valuation, even those working in the field.

Personal Motivation for Valuation

• Valuation helps mitigate the instinct to follow the crowd (like lemmings).
• Example of lemmings: Collective behavior leading to poor decisions.
• Valuation serves as a rational process to slow down decision-making.

The Bermuda Triangle of Valuation Errors

• Bias: Preconceptions affect valuation outcomes.
  • Knowledge of the company can strengthen biases.
  • Example: Valuing a company based on who paid for the valuation (e.g., investment bank).
• Uncertainty: Valuation relies on estimates with inherent uncertainty.
  • Comfort with numbers is misleading; uncertainty always exists.
• Complexity: Bigger models ≠ better results.
  • Avoid overcomplicating models; simpler is often better.

Approaches to Valuation

1. Intrinsic Valuation:

   • Based on fundamentals: cash flows, growth, risk.
   • Common tool: Discounted cash flow (DCF) valuation.
   • Key elements: Cash flows, discount rate, asset life.
   • Assumes markets make mistakes over time.

2. Relative Valuation:

   • Value based on pricing of similar assets in the market.
   • Commonly uses multiples (P/E, EV/EBITDA, etc.).
   • Requires finding comparable assets and controlling for differences.
   • Assumes markets are right on average but may misprice individual companies.

3. Option Pricing Models:

   • Used for valuing assets with contingent payoffs.
   • Examples:
     • Undeveloped natural resource reserves.
     • Biotech patents with uncertain future viability.
     • Stock in distressed companies as options.

Conclusion

• Future sessions will explore these approaches in detail.
• Emphasis on understanding how different valuation methods work and their applications.