Some Methodology Behind how to Value A Company
Why do valuations fail?
Problem 1: Most people when they value a company have a perception on how to value a company. This includes everything they've ready, heard, and prior knowledge. The most obvious irony to this is that the MORE that individual knows, the stronger the preconceptions. This naturally leads to a high value being placed on companies with strong existing pre perceptions by the investors.
Here's proof: If you tell me who is paying you to evaluate a company, and how much they get paid, I can without a doubt in my mind tell you youu which direction the bias will be and how much. This is fundamental. When a valuation comes across our desks, there needs to be two questions.
Who did this valuation?
1) How much did they get paid? and WHO paid them to do this valuation. If an investment banker comes to you with an valuation based on his hidden agenda to take the company over, his value of the company will obvious be suited.
2) Computers, models, indicators, all allow us to feel like we're using numbers that will tell the future. This isn't the truth. Valuations involve quantitative numbers, and need to be internally valued by your own bias. The best ironic part of a valuation, is that the more you are unsure about the valuation of a company, the higher the chance that company will deliver upside returns that outperform competitors in the same market sectors.
If you make a model bigger, it get's better. As models are built, remember that the inputs are human made. Two things happen when a model becomes to complex. After a certain point, the model runs you. You also get input fatigue, and more or less just noise.
If you can value a company with just 3 metrics, stick with that--less IS more.
In each approach , it assumes that market makes mistakes. If market never makes mistakes, there would be no value for us as traders, because it would mean that all asset classes are set to their true equilibrium, which as we know is not possible. However, the key takeaway is that each of these approaches makes different assumptions about how and why the market has made these mistakes.
3 approaches to valuation.
Intrinsic valuation: a company being based on discounted cash flow estimation (not the only one). Put simple: the value of this asset is derived from free cash flow, nothing more. The key though is this phase is all about the business. You're trying to simply value a business based on its cash flows. Cash flows, discount rate reflecting the risk in these cash-flows, and then the life of the asset. You assume markets make mistakes and that these mistakes are corrected over time. This means that using this valuation technique means that you need a longerterm-horizon.
Relative valuation: comparing similarly priced assets, that can then be used as a benchmark. For example., "based on how B is doing, we can assume company A has value. If you break down relative valuation here's what we see: a scale measure of price. This being said, finding something that is comparable is key. You need to control for differences (scale down multiples, look for comparables, scale the difference). make sure you are comparing similar companies within the same subject of an individual industry.
The last method (and the one I use) is applying option pricing models with valuation models using contingent cash flows. This means that value within the valuation is taken collectively. You assume that the market is right among most of the companies in an asset classes excluding minor outliers, and that time will correct that assets price, similar to above. Using these models to value businesses with option like characteristics. Options derive there value from a contract with a limited life. For example, an oil company with undeveloped reserves. There is an option for the company to choose to do so or not, but only if the price is right.
This includes companies with viable patents in the future, or a company in a money losing company, this would be arguable that you are buying an asset based on the optional pricing method.
Problem 1: Most people when they value a company have a perception on how to value a company. This includes everything they've ready, heard, and prior knowledge. The most obvious irony to this is that the MORE that individual knows, the stronger the preconceptions. This naturally leads to a high value being placed on companies with strong existing pre perceptions by the investors.
Here's proof: If you tell me who is paying you to evaluate a company, and how much they get paid, I can without a doubt in my mind tell you youu which direction the bias will be and how much. This is fundamental. When a valuation comes across our desks, there needs to be two questions.
Who did this valuation?
1) How much did they get paid? and WHO paid them to do this valuation. If an investment banker comes to you with an valuation based on his hidden agenda to take the company over, his value of the company will obvious be suited.
2) Computers, models, indicators, all allow us to feel like we're using numbers that will tell the future. This isn't the truth. Valuations involve quantitative numbers, and need to be internally valued by your own bias. The best ironic part of a valuation, is that the more you are unsure about the valuation of a company, the higher the chance that company will deliver upside returns that outperform competitors in the same market sectors.
If you make a model bigger, it get's better. As models are built, remember that the inputs are human made. Two things happen when a model becomes to complex. After a certain point, the model runs you. You also get input fatigue, and more or less just noise.
If you can value a company with just 3 metrics, stick with that--less IS more.
In each approach , it assumes that market makes mistakes. If market never makes mistakes, there would be no value for us as traders, because it would mean that all asset classes are set to their true equilibrium, which as we know is not possible. However, the key takeaway is that each of these approaches makes different assumptions about how and why the market has made these mistakes.
3 approaches to valuation.
Intrinsic valuation: a company being based on discounted cash flow estimation (not the only one). Put simple: the value of this asset is derived from free cash flow, nothing more. The key though is this phase is all about the business. You're trying to simply value a business based on its cash flows. Cash flows, discount rate reflecting the risk in these cash-flows, and then the life of the asset. You assume markets make mistakes and that these mistakes are corrected over time. This means that using this valuation technique means that you need a longerterm-horizon.
Relative valuation: comparing similarly priced assets, that can then be used as a benchmark. For example., "based on how B is doing, we can assume company A has value. If you break down relative valuation here's what we see: a scale measure of price. This being said, finding something that is comparable is key. You need to control for differences (scale down multiples, look for comparables, scale the difference). make sure you are comparing similar companies within the same subject of an individual industry.
The last method (and the one I use) is applying option pricing models with valuation models using contingent cash flows. This means that value within the valuation is taken collectively. You assume that the market is right among most of the companies in an asset classes excluding minor outliers, and that time will correct that assets price, similar to above. Using these models to value businesses with option like characteristics. Options derive there value from a contract with a limited life. For example, an oil company with undeveloped reserves. There is an option for the company to choose to do so or not, but only if the price is right.
This includes companies with viable patents in the future, or a company in a money losing company, this would be arguable that you are buying an asset based on the optional pricing method.
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