An ln18CuuC1lCn 1C

vALuA1lCn
Sprlng 2013
AswaLh uamodaran
2
Some lnlual 1houghLs
! " Cne hundred Lhousand lemmlngs cannoL be wrong"
Cramu

We thought we were in the top of the eighth inning,
when we were in the bottom of the ninth..
Stanley
Druckenmiller
3
A phllosophlcal basls for valuauon
! valuauon ls oen noL a helpful Lool ln deLermlnlng when Lo
sell hyper-growLh sLocks", Penry 8lodgeL, Merrlll Lynch
LqulLy 8esearch AnalysL ln !anuary 2000, ln a reporL on
lnLerneL CaplLal Croup, whlch was Lradlng aL $174 Lhen.
! 1here have always been lnvesLors ln nanclal markeLs who have
argued LhaL markeL prlces are deLermlned by Lhe percepuons (and
mlspercepuons) of buyers and sellers, and noL by anyLhlng as prosalc
as cashows or earnlngs.
! ercepuons mauer, buL Lhey cannoL be all Lhe mauer. lf percepuons
are aL war wlLh reallLy, reallLy always wlns ouL (ln Lhe end).
! AsseL prlces cannoL be [usued by merely uslng Lhe blgger
fool Lheory.
! !"#$#%&'($) +,$-&,-$ ./('$/0 1&"2( 3/# $&/4',5 /$ 6 7 ',
8/,2/&9 :;;<=
4
Mlsconcepuons abouL valuauon
! MyLh 1: A valuauon ls an ob[ecuve search for Lrue value
! 1ruLh 1.1: All valuauons are blased. 1he only quesuons are how much"
and ln whlch dlrecuon.
! 1ruLh 1.2: 1he dlrecuon and magnlLude of Lhe blas ln your valuauon ls
dlrecLly proporuonal Lo who pays you and how much you are pald.
! MyLh 2.: A good valuauon provldes a preclse esumaLe of value
! 1ruLh 2.1: 1here are no preclse valuauons.
! 1ruLh 2.2: 1he payo Lo valuauon ls greaLesL when valuauon ls leasL
preclse.
! MyLh 3: . 1he more quanuLauve a model, Lhe beuer Lhe valuauon
! 1ruLh 3.1: Cnes undersLandlng of a valuauon model ls lnversely
proporuonal Lo Lhe number of lnpuLs requlred for Lhe model.
! 1ruLh 3.2: Slmpler valuauon models do much beuer Lhan complex ones.
5
Approaches Lo valuauon
! lnLrlnslc valuauon, relaLes Lhe value of an asseL Lo lLs lnLrlnslc
characLerlsucs: lLs capaclLy Lo generaLe cash ows and Lhe
rlsk ln Lhe cash ows. ln lL's mosL common form, lnLrlnslc
value ls compuLed wlLh a dlscounLed cash ow valuauon,
wlLh Lhe value of an asseL belng Lhe presenL value of
expecLed fuLure cashows on LhaL asseL.
! 8elauve valuauon, esumaLes Lhe value of an asseL by looklng
aL Lhe prlclng of 'comparable' asseLs relauve Lo a common
varlable llke earnlngs, cashows, book value or sales.
! ConungenL clalm valuauon, uses opuon prlclng models Lo
measure Lhe value of asseLs LhaL share opuon characLerlsucs.
6
8asls for all valuauon approaches
! 1he use of valuauon models ln lnvesLmenL declslons
(l.e., ln declslons on whlch asseLs are under valued
and whlch are over valued) are based upon
! a percepuon LhaL markeLs are lnemclenL and make
mlsLakes ln assesslng value
! an assumpuon abouL how and when Lhese lnemclencles
wlll geL correcLed
! ln an emclenL markeL, Lhe markeL prlce ls Lhe besL
esumaLe of value. 1he purpose of any valuauon
model ls Lhen Lhe [usucauon of Lhls value.
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ulscounLed Cash llow valuauon
! WhaL ls lL: ln dlscounLed cash ow valuauon, Lhe value of an asseL
ls Lhe presenL value of Lhe expecLed cash ows on Lhe asseL.
! hllosophlcal 8asls: Lvery asseL has an lnLrlnslc value LhaL can be
esumaLed, based upon lLs characLerlsucs ln Lerms of cash ows,
growLh and rlsk.
! lnformauon needed: 1o use dlscounLed cash ow valuauon, you
need
! Lo esumaLe Lhe llfe of Lhe asseL
! Lo esumaLe Lhe cash ows durlng Lhe llfe of Lhe asseL
! Lo esumaLe Lhe dlscounL raLe Lo apply Lo Lhese cash ows Lo geL presenL
value
! MarkeL lnemclency: MarkeLs are assumed Lo make mlsLakes ln
prlclng asseLs across ume, and are assumed Lo correcL Lhemselves
over ume, as new lnformauon comes ouL abouL asseLs.
8
AdvanLages of uCl valuauon
! Slnce uCl valuauon, done rlghL, ls based upon an asseLs
fundamenLals, lL should be less exposed Lo markeL
moods and percepuons.
! lf good lnvesLors buy buslnesses, raLher Lhan sLocks (Lhe
Warren 8ueL adage), dlscounLed cash ow valuauon ls
Lhe rlghL way Lo Lhlnk abouL whaL you are gemng when
you buy an asseL.
! uCl valuauon forces you Lo Lhlnk abouL Lhe underlylng
characLerlsucs of Lhe rm, and undersLand lLs buslness.
lf noLhlng else, lL brlngs you face Lo face wlLh Lhe
assumpuons you are maklng when you pay a glven prlce
for an asseL.
9
ulsadvanLages of uCl valuauon
! Slnce lL ls an auempL Lo esumaLe lnLrlnslc value, lL requlres far more
expllclL lnpuLs and lnformauon Lhan oLher valuauon approaches
! 1hese lnpuLs and lnformauon are noL only nolsy (and dlmculL Lo
esumaLe), buL can be manlpulaLed by Lhe analysL Lo provlde Lhe
concluslon he or she wanLs. 1he quallLy of Lhe analysL Lhen becomes a
funcuon of how well he or she can hlde Lhe manlpulauon.
! ln an lnLrlnslc valuauon model, Lhere ls no guaranLee LhaL anyLhlng wlll
emerge as under or over valued. 1hus, lL ls posslble ln a uCl valuauon
model, Lo nd every sLock ln a markeL Lo be over valued. 1hls can be a
problem for
! equlLy research analysLs, whose [ob lL ls Lo follow secLors and make
recommendauons on Lhe mosL under and over valued sLocks ln LhaL secLor
! equlLy poruollo managers, who have Lo be fully (or close Lo fully) lnvesLed ln
equlues
10
When uCl valuauon works besL
! AL Lhe rlsk of sLaung Lhe obvlous, Lhls approach ls
deslgned for use for asseLs (rms) LhaL derlve Lhelr
value from Lhelr capaclLy Lo generaLe cash ows ln
Lhe fuLure.
! lL works besL for lnvesLors who elLher
! have a long ume horlzon, allowlng Lhe markeL ume Lo
correcL lLs valuauon mlsLakes and for prlce Lo reverL Lo
Lrue value or
! are capable of provldlng Lhe caLalysL needed Lo move prlce
Lo value, as would be Lhe case lf you were an acuvlsL
lnvesLor or a poLenual acqulrer of Lhe whole rm
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8elauve valuauon
! WhaL ls lL?: 1he value of any asseL can be esumaLed by looklng aL
how Lhe markeL prlces slmllar or comparable asseLs.
! hllosophlcal 8asls: 1he lnLrlnslc value of an asseL ls lmposslble (or
close Lo lmposslble) Lo esumaLe. 1he value of an asseL ls whaLever
Lhe markeL ls wllllng Lo pay for lL (based upon lLs characLerlsucs)
! lnformauon needed: 1o do a relauve valuauon, you need
! an ldenucal asseL, or a group of comparable or slmllar asseLs
! a sLandardlzed measure of value (ln equlLy, Lhls ls obLalned by dlvldlng Lhe
prlce by a common varlable, such as earnlngs or book value)
! and lf Lhe asseLs are noL perfecLly comparable, varlables Lo conLrol for Lhe
dlerences
! MarkeL lnemclency: rlclng errors made across slmllar or
comparable asseLs are easler Lo spoL, easler Lo explolL and are
much more qulckly correcLed.
12
AdvanLages of 8elauve valuauon
! 8elauve valuauon ls much more llkely Lo reecL markeL
percepuons and moods Lhan dlscounLed cash ow valuauon. 1hls
can be an advanLage when lL ls lmporLanL LhaL Lhe prlce reecL
Lhese percepuons as ls Lhe case when
! Lhe ob[ecuve ls Lo sell an asseL aL LhaL prlce Loday (lC, M&A)
! lnvesung on momenLum based sLraLegles
! WlLh relauve valuauon, Lhere wlll always be a slgnlcanL
proporuon of securlues LhaL are under valued and over valued.
! Slnce poruollo managers are [udged based upon how Lhey perform
on a relauve basls (Lo Lhe markeL and oLher money managers),
relauve valuauon ls more Lallored Lo Lhelr needs
! 8elauve valuauon generally requlres less expllclL lnformauon Lhan
dlscounLed cash ow valuauon.
13
ulsadvanLages of 8elauve valuauon
! A poruollo LhaL ls composed of sLocks whlch are under valued on a
relauve basls may sull be overvalued, even lf Lhe analysLs
[udgmenLs are rlghL. lL ls [usL less overvalued Lhan oLher securlues
ln Lhe markeL.
! 8elauve valuauon ls bullL on Lhe assumpuon LhaL markeLs are
correcL ln Lhe aggregaLe, buL make mlsLakes on lndlvldual
securlues. 1o Lhe degree LhaL markeLs can be over or under valued
ln Lhe aggregaLe, relauve valuauon wlll fall
! 8elauve valuauon may requlre less lnformauon ln Lhe way ln whlch
mosL analysLs and poruollo managers use lL. Powever, Lhls ls
because lmpllclL assumpuons are made abouL oLher varlables (LhaL
would have been requlred ln a dlscounLed cash ow valuauon). 1o
Lhe exLenL LhaL Lhese lmpllclL assumpuons are wrong Lhe relauve
valuauon wlll also be wrong.
14
When relauve valuauon works besL..
! 1hls approach ls easlesL Lo use when
! Lhere are a large number of asseLs comparable Lo Lhe one belng
valued
! Lhese asseLs are prlced ln a markeL
! Lhere exlsLs some common varlable LhaL can be used Lo
sLandardlze Lhe prlce
! 1hls approach Lends Lo work besL for lnvesLors
! who have relauvely shorL ume horlzons
! are [udged based upon a relauve benchmark (Lhe markeL, oLher
poruollo managers followlng Lhe same lnvesLmenL sLyle eLc.)
! can Lake acuons LhaL can Lake advanLage of Lhe relauve
mlsprlclng, for lnsLance, a hedge fund can buy Lhe under valued
and sell Lhe over valued asseLs
15
AsseL 8ased valuauon: A ueLour
! ln conLrasL Lo valulng a buslness as a golng concern (based on cash
ows) or by looklng aL how oLher buslnesses LhaL look lL are prlced
(relauve valuauon), you someumes may value a buslness by
valulng lLs asseLs.
! AsseL based valuauon may be used ln Lhe conLexL of
! Llquldauon valuauon, where you are valulng Lhe asseLs for sale
! Accounung valuauon, where you are valulng lndlvldual asseLs for
accounung reasons (falr value or goodwlll esumauon
! Sum of Lhe parLs valuauon, Lo elLher see lf a company ls cheap as an
lnvesLmenL or a good LargeL for acqulsluon/ resLrucLurlng
! 1o value Lhe lndlvldual asseLs, Lhough, you have Lo elLher use
expecLed cash ows (lnLrlnslc valuauon) or base lL on Lhe prlclng of
slmllar asseLs (relauve valuauon).
! AsseL based valuauon ls easlesL Lo do when asseLs are separable
and have sLand alone earnlngs/cash ows.
16
WhaL approach would work for you?
! As an lnvesLor, glven your lnvesLmenL phllosophy,
ume horlzon and bellefs abouL markeLs (LhaL you
wlll be lnvesung ln), whlch of Lhe Lhe approaches Lo
valuauon would you choose?
a. ulscounLed Cash llow valuauon
b. 8elauve valuauon
c. nelLher. l belleve LhaL markeLs are emclenL.
17
ConungenL Clalm (Cpuon) valuauon
! Cpuons have several feaLures
! 1hey derlve Lhelr value from an underlylng asseL, whlch
has value
! 1he payo on a call (puL) opuon occurs only lf Lhe value of
Lhe underlylng asseL ls greaLer (lesser) Lhan an exerclse
prlce LhaL ls specled aL Lhe ume Lhe opuon ls creaLed. lf
Lhls conungency does noL occur, Lhe opuon ls worLhless.
! 1hey have a xed llfe
! Any securlLy LhaL shares Lhese feaLures can be
valued as an opuon.
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Cpuon ayo ulagrams
Value of Asset Strike Price
Call Option
Put Option
19
ulrecL Lxamples of Cpuons
! LlsLed opuons, whlch are opuons on Lraded asseLs, LhaL
are lssued by, llsLed on and Lraded on an opuon
exchange.
! WarranLs, whlch are call opuons on Lraded sLocks, LhaL
are lssued by Lhe company. 1he proceeds from Lhe
warranL lssue go Lo Lhe company, and Lhe warranLs are
oen Lraded on Lhe markeL.
! ConungenL value 8lghLs, whlch are puL opuons on
Lraded sLocks, LhaL are also lssued by Lhe rm. 1he
proceeds from Lhe Cv8 lssue also go Lo Lhe company
! Scores and LLAs, are long Lerm call opuons on Lraded
sLocks, whlch are Lraded on Lhe exchanges.
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lndlrecL Lxamples of Cpuons
! LqulLy ln a deeply Lroubled rm - a rm wlLh negauve
earnlngs and hlgh leverage - can be vlewed as an opuon Lo
llquldaLe LhaL ls held by Lhe sLockholders of Lhe rm. vlewed
as such, lL ls a call opuon on Lhe asseLs of Lhe rm.
! 1he reserves owned by naLural resource rms can be vlewed
as call opuons on Lhe underlylng resource, slnce Lhe rm can
declde wheLher and how much of Lhe resource Lo exLracL
from Lhe reserve,
! 1he paLenL owned by a rm or an excluslve llcense lssued Lo a
rm can be vlewed as an opuon on Lhe underlylng producL
(pro[ecL). 1he rm owns Lhls opuon for Lhe durauon of Lhe
paLenL.
! 1he rlghLs possessed by a rm Lo expand an exlsung
lnvesLmenL lnLo new markeLs or new producLs.
21
AdvanLages of uslng Cpuon rlclng Models
! Cpuon prlclng models allow us Lo value asseLs LhaL we
oLherwlse would noL be able Lo value. lor lnsLance,
equlLy ln deeply Lroubled rms and Lhe sLock of a small,
blo-Lechnology rm (wlLh no revenues and proLs) are
dlmculL Lo value uslng dlscounLed cash ow approaches
or wlLh muluples. 1hey can be valued uslng opuon
prlclng.
! Cpuon prlclng models provlde us fresh lnslghLs lnLo Lhe
drlvers of value. ln cases where an asseL ls derlvlng lL
value from lLs opuon characLerlsucs, for lnsLance, more
rlsk or varlablllLy can lncrease value raLher Lhan decrease
lL.
22
ulsadvanLages of Cpuon rlclng Models
! When real opuons (whlch lncludes Lhe naLural resource opuons
and Lhe producL paLenLs) are valued, many of Lhe lnpuLs for Lhe
opuon prlclng model are dlmculL Lo obLaln. lor lnsLance, pro[ecLs
do noL Lrade and Lhus gemng a currenL value for a pro[ecL or a
varlance may be a daunung Lask.
! 1he opuon prlclng models derlve Lhelr value from an underlylng
asseL. 1hus, Lo do opuon prlclng, you rsL need Lo value Lhe asseLs.
lL ls Lherefore an approach LhaL ls an addendum Lo anoLher
valuauon approach.
! llnally, Lhere ls Lhe danger of double counung asseLs. 1hus, an
analysL who uses a hlgher growLh raLe ln dlscounLed cash ow
valuauon for a pharmaceuucal rm because lL has valuable paLenLs
would be double counung Lhe paLenLs lf he values Lhe paLenLs as
opuons and adds Lhem on Lo hls dlscounLed cash ow value.
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ln summary.
! Whlle Lhere are hundreds of valuauon models and
meLrlcs around, Lhere are only Lhree valuauon
approaches:
! lnLrlnslc valuauon (usually, buL noL always a uCl valuauon)
! 8elauve valuauon
! ConungenL clalm valuauon
! 1he Lhree approaches can yleld dlerenL esumaLes of
value for Lhe same asseL aL Lhe same polnL ln ume.
! 1o Lruly grasp valuauon, you have Lo be able Lo
undersLand and use all Lhree approaches. 1here ls a ume
and a place for each approach, and knowlng when Lo use
each one ls a key parL of masLerlng valuauon.