Sunday, June 20, 2010

Valuation Approaches...

I have always believed that valuation is simple at its core and that we choose to make it complex. Furthermore, the determinants of value have not changed through the ages; all that has changed are the estimation practices. One of my pet peeves relating to valuation is when an entity (usually a consultant, academic or an appraiser) takes a standard valuation equation, does some algebra, moves terms around and then claims to have discovered a new and "better" valuation model.

Each consulting firm has its own proprietary value measure, with a fancy name and acronym (Economic value added (EVA), Cash Flow Return on Investment (CFROI), Cash Return on Capital Invested (CROCI) etc.) that it markets to its clients as the magic bullet for value creation. To make themselves indispensable, consultants usually add computational twists that require their presence. To get a sense of how these measures are marketed, you can check out books on each (usually written by the measure's developers):
CFROI
EVA
CROCI
All of these models share two themes. First, they relate the value of a business to excess returns (returns earned over and above the cost of capital or equity). Second, each claims to be easier to use, more intuitive and better than the other models out there.

With analysts, the search for a better valuation approach usually takes the form of concocting new multiples or modifying existing ones. Consider the PEG ratio, a favored tool of analysts following high tech (and growth) companies. The PEG ratio is obtained by dividing the PE ratio by the expected growth rate in earnings per share, and companies that trade at low PEG ratios are considered cheap. It is viewed as a less time-intensive and assumption-free substitute for intrinsic valuation.

As analysts and consultants push their favored approaches to the forefront, it is no surprise that most of us feel overwhelmed by the choices that we face. Which of these dozens of approaches will yield the right value? How do I pick? At the risk of being simplistic, let me offer a solution. Pick the approach that you feel most comfortable with and use it correctly. The value you obtain will be identical to the value you would have obtained using any alternate approach. I have an extended survey paper that I wrote on valuation approaches (and their history) in 2005 that can be downloaded online, if you are interested:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1625010
Valuation is not rocket science. Valuing companies may not be easy but the challenges we face are not in valuation theory but in estimation practice. Put another way, we know exactly how to value companies. What we do not have a handle on is how best to estimate growth, risk and cash flows. So, let's stop concocting new models and theories and start thinking more seriously about how best to estimate cash flows for a cyclical firm, risk for a regulated company and growth for young start-up firm. The second edition of one of my books, The Dark Side of Valuation, is dedicated to this concept. You may not like or agree with some of the solutions that I have to estimation challenges, but I hope it will start you thinking about how best to deal with these challenges.

14 comments:

Karen said...

i concur. BUT lets keep in mind this is business afterall. These companies have all the freedom they want to help undecided investors via these models/valuation approaches they packaged. Otherwise we wouldnt be in a capitalistic/global economy we are in today. But then again, you never know... sometimes repackaging something might just land you something unique and new.

perpetual wonderer said...

Good one prof. Well put. As a student of finance, I always felt like researchers and financial engineers were sometimes too academic in their approach and complicated things that could have been left simpler. However, looking at it from the other side, sometimes simplifying things leaves them subject to the risk of them being applied haphazardly and wrongly. Not that complex tools are any less prone to abuse or confusion, but the caveat with simplistic and common sense tools is that they NEED to applied wisely. That risk is amplified even more when they deal with critical topics such as firm valuation. Simplistic tools and concepts have a way of getting abused out in the real world when every person in the street feels like he has a grip on the concept (for example, a lot of people who feel they know ‘exactly’ what compound interest and compounding means, often find themselves surprised at how hard it can hit them. I feel this is largely because the gravity of the power of compounding is lost because it is ‘just another’ concept that is taught since highschool. That concept ought to have some more complexity attached to it because right now, too many people feel like they ‘know it’ when they actually don’t). And that can have consequences that are just as disastrous as complex tools, techniques, products and concepts being concocted by large consultancy firms and analysts going wrong.

As with a lot of things, I think it eventually boils down to what the tool is being used for. If the tool is being used simply to value a firm fairly, like you said, we really only need to focus on any one technique that we are comfortable with and apply it wisely. On the other hand, if the tool is being used to create an exit barrier for the client to ensure repeat business, then the more complex the tool, the better. And I am sure most firms getting themselves valuated are aware of this too. It’s just about them being comfortable with things as they are rather than taking a stand and questioning the basic approach that our financial system stands (albeit shakily) on today.

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Vipul said...

Totally concur; Very well said Sir

tequilainmycutting said...

I believe the reason consulting firms tend to stress on proprietary valuation approaches (EVA/SVA/CFROI/CROCI) are more based in marketing than in finance. A prop model helps the consulting firm present itself as a thought leader and if it can successfully propagate it, then get universal recall. e.g. EVA for Stern Stewart, and (a better but non-fin example) of BCG matrix for BCG.

It is also an easier tool to pitch to a board of directors than educate them on, what are for them, the nitty-gritty of valuations - risk, growth & cash flows.

Anyway, in most actual implementations, these three key parameters are usually used more as levers to arrive at the desired valuation than as drivers of the real valuation.

shub11 said...

Hi Prof. Damodaran
I am a student of finance from India
as a part of my curriculum I am writing an equity research report ,
But I am stuck on forward earnings projection part. I do not know how to project the future earnings of a company. Please help me out

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