Transcription
This is the first in a series of sessions about valuation. Now, when I say the word valuation, most of you think about models and numbers. And you're right. There are lots of models and lots of numbers. But there are three broad themes I hope to establish in these coming sessions.
The first is that valuation is simple. We choose to make it complex. The second is every valuation, even though it's about numbers, has a story, a narrative behind it. A good valuation is more about the story than about the numbers. And third, when valuations go bad, it's not because of the numbers. It's because of three big problems I see in valuation. The first is bias. You come in with preconceptions, and they find their way into your valuation. The second is uncertainty. We're not very good about dealing with uncertainty. And the third is complexity. We live in a complex world with complex data and complex models, and sometimes that gets in the way of the simplicity that should be at the core of valuation. That's what I hope to bring through in the next few sessions.
This is a first in a series of sessions about valuation. Valuation of what, you might ask? Of just about any business you can think of, small or large, public or private, emerging or developed market. And here's my objective. By the end of this class, I would like you to be able to value just about any asset. Let's see if we can get there.
When I first started teaching valuation 26 years ago at NYU, I made the mistake of assuming that everybody else was as interested in valuation as I was. In hindsight, that was a bad mistake. Most people don't believe in valuation. By most people, I include most people who do valuation for a living. But they do it. They do it to cover their rear end. They do it because it's their jobs. So let me start off by explaining why I do valuation before I start delving into the details.
I do valuation to fight the lemming in me. Now, you probably heard about lemmings, right? They became famous or infamous about 50 years ago when National Geographic filmed the most amazing sight. Thousands of big, ugly, rat-like creatures. That's what lemmings look like. Gathered together on a cliff, ran right off the cliff into an ocean. And ever since, one of the big questions has been, why did they do it? Why did they go off that cliff? Why do they commit collective suicide? I don't know the answer to the question, but let's do some collective imagery. You can see why the first lemming did it, right? He was going too fast. He couldn't stop. He went right off the cliff into an ocean. What about the second guy? He was going too close to the first guy. Same fate. But put yourself in the shoes of the very last lemming in that group. You're going as fast as you can towards a cliff. You've seen an entire tribe disappear off that cliff. I would assume you have second thoughts about what you were planning to do. Your right brain, left brain, whatever part of you is rational, saying, "Stop. Don't do it." But then you have this voice in the back of your head. You know what it's saying? "They must know something that you don't."
Remember those seven words? They're the seven most deadly words in investing. You know when you'll hear them? You value a company. So you come up with a value of $50 per share. Let's give the company a name. Let's suppose it's Amazon. Stock's trading at 278, one of the great stocks of the last decade. You come up with 50. Your rational side saying, "Don't buy that stock. It's expensive." But then you hear this voice in the back of your head saying, "They must know something that you don't." And when you hear that voice, magical things start happening to your valuation. Your cash flows increase. Your growth rates go up. Your discount rates go down. 50 becomes 100. 100 becomes 150. And before you know it, guess what? You're at 275, 300, justifying your need to buy.
In fact, you can divide all investors into three groups of lemmings. The first group I call proud lemmings. "I'm a lemming, and I'm proud to be a lemming." Who am I talking about? They call themselves momentum investors. But that's pretty much what they do, right? They look for a crowd. They join in. You're buying. I'm buying. You're selling. I'm selling. Why are you buying? I don't care.
The second group of lemmings I call Yogi Bear Lemmings. Have you ever seen Yogi Bear cartoons, or or maybe even that ill-fated movie that came out? Remember his most famous expression? He said, "Smarter than the average bear." Yogi Bear lemmings think they're smarter than the average lemming. What do they want to do? They want to run with the crowd till the very edge of the cliff and at the last moment veer away. If you can pull it off, that's great. You get all the upside of momentum and none of the downside.
Now, I'm afraid I cannot be a proud lemming. I don't have the stomach to be a Yogi Bear lemming. I have no idea where the cliff is coming. If you ask me to describe myself, you you can pretty much see where I'm going. I'm a lemming with a life vest. That's all valuation is. Valuation gives you a life vest. It gives you something to hold on to when everybody else changes their mind and goes in the other direction. It's not going to stop you from doing really stupid things. If you really, 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 the process down. Gives your rational side a chance to mount an argument. That's why we do valuation.
So, having laid that foundation, let me actually go on and talk about what I call the Bermuda Triangle of valuation. The three big reasons why valuations fail. And it's not about the numbers. It's not about the models. It's not about the metrics.
Here's the first and biggest problem in valuation. Most people, when they sit down to value a company or a business, already have a preconception of what they expect to see as the value. It's very difficult not to. You almost never start with a blank slate when you value a company. Everything you've read about the company, everything you know about the company, is going to become part of that preconception. The great irony is the more you know about a company, the stronger those preconceptions are, and when those preconceptions get set, your valuation follows. So if I think a company is a great company, guess what my valuation is going to deliver? A high value. In fact, let me add to that proposition. You tell me who pays you to do a valuation, how much you get paid. I'll tell you which direction the bias 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, I ask two questions: Who did this valuation? Who paid them to do this valuation? 'Cause your biases are going to be preset by what your mission is. If you're an investment banker, and I come to you for a valuation of a target company, and I really want to take over the target company, remember, your mission is to get the deal done. You're going to find a way to justify that value. Not surprisingly, your valuation will deliver exactly the result I hope to see, that this company is a bargain.
Second big misconception about valuation, that valuation is somehow a science. You know what feeds into this? You sit in front of computers with models, and you enter numbers, and after a while, you tell yourself, "Well, I'm being objective. All I'm doing is using numbers." Well, don't be deceived. Even though you might be using numbers, those numbers are estimates. And when you think about those estimates, those estimates are going to come with a great deal of uncertainty. And uncertainty scares people. So when you do evaluation, one of the tests you ask yourself is, "Am I comfortable? Am I certain about these numbers?" And especially if you come from a quantitative background, you're going to look at those numbers and say, "Well, I'm really uncomfortable. These numbers could be wrong." Well, guess what? They're always going to be wrong because you're forecasting the future. And one of the great ironies in valuation is the more uncomfortable you feel valuing a company, the greater the payoff to doing a valuation. That sounds strange, right? You're valuing a technology company with a lot of growth potential, you are going to be more uncomfortable than when you value a stable company where everything is pretty much set. But those technology companies with growth potential, those are exactly the companies where you should persevere. Make your best estimates and remember that most people give up on these companies.
And here's the third misconception about valuation. If you make a model bigger, it's going to get better. And it's so easy to build big models. Now, as you build these big models in Excel or whatever your tool of choice is, remember, you have to make those assumptions, those inputs that drive these models. And as these models get really complex, two things happen. One is these models become black boxes. After a while, it's not clear who's running whom. Are you running the model? Is a model running you? The other is you have input fatigue. At some point in time, as you start entering those numbers, it becomes garbage in, garbage out. So here's a message I hope to deliver. As you look at valuations, one of the first things you should try to do is be parsimonious. What do I mean by that? If you can value a company with three inputs, don't go looking for five. If you can value a company with three years of forecast, don't do 10. Less is more.
So, having laid the table for valuation, let's look at the three broad approaches that there are to valuing a business. And there are only three. The first I'm going to 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. Discounted cash flow valuation is the most common tool used for estimating intrinsic value, but it's not the only one. But the key in intrinsic valuation is it's all about the business.
The second approach to valuation I call relative valuation. And as I describe it, it's going to sound familiar. To value an asset in relative valuation, you look at what similar assets are being priced at by the market right now. And once you find them, you use that as your basis for valuing this asset. Think about it. If you look at an equity research report, what do you see? You see a multiple, right? Price earnings, EV to EBITDA, price to book, and you see a bunch of companies. And what the analyst is saying is, look at these companies and look at this one. Based on how these other companies are being valued, I think this company is cheap or expensive.
Those two approaches to valuation by far dominate all of valuation. And we'll talk about which one is dominant. But there's a third and final approach to valuation. The third approach to valuation, and this is perhaps the only new and perhaps sophisticated aspect that's new to valuation, is applying option pricing models in the context of valuing these assets that have contingent cash flows. What are contingent cash flows? Well, this asset will have value only if something happens. So, if you're a biotechnology company, you have a patent working its way through the pipeline, it'll have value only if you get FDA approval. You're an undeveloped oil reserve company. Those oil reserves will have value only if oil prices go up beyond a certain level. So collectively, you can take valuation approaches and break them down into these three basic approaches.
Underlying each approach, though, is an assumption about how markets work, or better still, how they don't work. Each of these approaches assumes that markets make mistakes. Saying, why do we need that assumption? If markets never made mistakes, there would be no point to valuing publicly traded companies, right? The market price of the company would be the best estimate of the value of the company. So, every one of these approaches makes an assumption about market mistakes, but they all make different assumptions about how markets make mistakes and how those mistakes get corrected.
So, to set the table on these different approaches, let me give you a very quick introduction into each of these approaches. Let's start with discounted cash flow valuation, or intrinsic valuation. What is it? In 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're trying to estimate the intrinsic value of a business based on its cash flows. And if you break down a discounted cash flow model, it has three ingredients. You'll see cash flows. You'll see a discount rate that reflects a risk in those cash flows. And you'll see a life for the asset you're valuing, which could be 5 years, 10 years, it could be forever. And when you use discounted cash flow valuation, you are assuming that markets make mistakes in valuing individual companies and that they correct these mistakes over time. So if you ask me what the hidden ingredient for using discounted cash flow valuation is, you need a long time horizon because markets can make mistakes. You can find those mistakes, but there is no guarantee that those mistakes will get corrected in the next three months or six months or even a year. The longer your time horizon, the better off you are using discounted cash flow valuation.
The second approach to valuation is relative valuation. In relative valuation, you value an asset based on how similar assets are priced. You've given up intrinsic valuation when you do relative valuation. Say, "I don't know what the intrinsic value is. I'm going to let the market tell me." And if you break down relative valuation, here's what you're going to see. You're going to see a scale measure of price. What do I mean by that? You might not be able to compare the values of individual companies because some are smaller, some are larger. But if you divide that value by earnings or book value. In other words, you use a multiple. You are essentially comparing numbers which are comparable. The second ingredient you need for relative valuation is you need to find other investments that look just like yours. That might be easy in some cases. It's difficult when you're when you're talking about companies. Find me a company that's similar to Microsoft or Apple. It's tough to do, right? So, what you will often find is analysts defining something as comparable, then waving their hands and saying, "You know what, they're probably not that comparable." Which brings me to the third step. You need to control for differences across these investments: growth and risk and cash flows. So, find a multiple scaled version of a value. Look for comparables. Control for differences. What kind of mistakes do you assume markets make when you use relative valuation? You actually assume that markets are right on average, but that they're wrong in individual companies. And that they're wrong in individual companies, that those mistakes will get corrected sooner rather than later.
Which brings me to the third and final approach to valuation, which is using option pricing in the context of valuation. As I said, option pricing models have been around a long time. What we're talking about, though, is using those option pricing models to value businesses or assets that have option-like characteristics. What are those? Options derive their value from an underlying asset. They have a contingent payoff and they have a limited life. So here are some very generic examples of option-like examples in valuation that we might try to find a use for. The first, as I pointed out, is a natural resource company with undeveloped reserves. An oil company with undeveloped oil reserves. A gold mining company with gold reserves. There, the option is those undeveloped reserves that the company can choose to develop, but will do so only if the price is right. The second is a biotechnology pharmaceutical company with a patent. Could be any technology company with a patent that's not viable right now, but potentially could be viable in the future. And the third example, and this is fairly unusual, is if you buy stock in a deeply troubled company, a money-losing company with a lot of debt, I'm going to argue that you're effectively buying an option. So those are potentially places where we might be able to find uses for option pricing.
That pretty much covers what I want to do in this session. So, in summary, we're looking at different approaches to valuation. And in future sessions, we're going to flesh these approaches out and look at ways in which we can actually value companies with these approaches.