Sunday, September 27, 2009

The dangers of relative valuation

In my last post on Twitter, I hypothesized that the valuation of Twitter was based upon what investors had assigned as a value for Facebook a few months earlier. I want to make clear that I am not suggesting that this is a good way to value businesses but that it is the status quo.

With relative valuation, the dangers of a bad initial valuation cascading into subsequent valuations is high and they get worse when the initial valuation is of a large company (Facebook is large, by the standards of networking sites) and done by what is viewed as a reputable source (private equity investors have an ill deserved reputation for valuation expertise and a big investment banking name helps..) In fact, this may be one reason for pricing bubbles in sectors.

I can carry the relative valuation lessons here to an absurd limit. I have 15,000 + members on the mailing list for my website ( I would argue that this is a fairly valuable potential list for anyone with an investment or valuation product. Applying the $32.5/member to each member (a bargain, given the selection bias), my site should be worth half a million. Any takers? Better still, why not just your add your name to my mailing list and increase my value $32.5 by doing so? (The incentives for sites to seek out new members, even if they are idle and do nothing, is extremely high...)

I am kidding here, since I have no intent of making my site commercial. I have always argued that relative valuation, at least as it is practiced, is a sign of laziness because analysts are not only sloppy but throw out much of the data that they have access to. Relative valuation, done right, where you use not just the averages, but also look at the differences in valuations across companies to draw lessons about how the market values assets, can be a very useful tool in valuation.



Dear Professor

Your website have a lot of value! But I believe that you take out value of your website by diffusion of your approaches on valuation. I think You are applying the Economics of Networks principle (Varian, The Information Economy).

Congratulations! I thank for keep your website up.

Marcelo Arantes Alvim (Valuation professor, from Brazil.)

wesc said...

Relative valuation reminds me of the Larry Summers quote about "proving" market efficiency by showing that two quart bottles of ketchup always sell for twice the price of one quart bottles.

For some users, Twitter is a replacement for Facebook, even though Facebook encompasses a much larger feature set than Twitter. I doubt Facebook and Twitter can both exist and compete for the same users at the same valuation per user.

Immortal said...

what a nice receipe to cook a billion dollar simple as Tweeting on Twitter...take a relatively FAT business to compare..bring in few renowned IB bnkers n give them a simple excel sheet to turn your business into Billion dollars...Simply amazing!!!!


Destiny said...

I think the entire valuation aspect of facebook/twitter is keeping scalability in perspective. As also these websites have a better "recall" value when a netizen logs on to the internet as companred to a non-fun site. $32.5/login id may not be an efficient basis for valuation, PEs are tempted by the thought of having $32.5/registered user. I believe te frequency of loggin-in onto these sites can be a useful tool for the PEs to ascertain the true potential of these sites.

RPL (MBA student from India)

Johnny said...

Hi, can somebody help me on this simple question.

I'm confused in PE multiple i read in one of article, it said that the problem with PE multiple is when the company overestimated its growth. This made a NPV method useless as growth exceeds its rate of return in the formula (r-g).

My question is what's the explanation of why growth exceeds rate of return created such a problem aside the formula (r-g)?

Fiadon said...

Dear Mr. Damodaran

Your website and content has been a really great value (theoretical and practical) addition to anybody who knows basics of finance. You are inspiration for a lot of students and if someday I meet you I am just going to bow down to you(=your work). You are simply superb.

Thanks and Regards,
One of your fans

accounting said...

Warren Buffet called it the Monalisa effect I believe. since one man bought it, it must be worth something! :)

And as long as someone else is there to take it off you at a higher price, you are a "smart guy".