For the full free YouTube course, see below (would recommend you watch this one):
Notes:
Foundational Tenets:
- Simplicity vs Complexity: Valuation is fundamentally simple, but it's often convoluted by over-analysis. Also, every solid valuation is underpinned by a coherent story.
- Common Pitfalls: Valuation inaccuracies commonly stem from inherent biases, unforeseen variables, and needless complexities.
The Threefold Path to Valuation:
- Intrinsic Valuation:
- Premise: It's all about estimating an asset's value based on its expected cashflows.
- DCF Analysis: The cornerstone. It demands careful projection of cash flows, the right discount rate, and a clearly defined asset lifespan.
- Time Horizon: A long-term perspective is vital to unlock the true potential of this approach.
- Relative Valuation:
- Premise: This method involves comparing an asset against its peers.
- Key Metrics: Metrics such as Price-to-Book (P/B) and EV/EBITDA come into play, offering valuable insights.
- Option Pricing Valuation:
- Premise: Ideal for assets that are option-like in nature.
- Real-life Examples: Patents, which can be commercialized when economic conditions become favorable.
A Deep Dive into Intrinsic Valuation
- DCF Nuances:
- Equity vs. Firm Valuation: Choose between assessing the entire company or solely its equity. An essential reminder: Always match the right cash flows with the correct discount rate.
- Positive Cashflows: An asset's true value hinges on its potential to generate positive cash flows in the future. Earlier inflows are always more valuable. Durability of cash flows is valued.
- Asset & Liability Dynamics:
- Asset Types: They can either be growth-oriented or current.
- Liabilities & Equity: Companies have two main avenues - debt or equity financing.
- Risk-free Rate (Rf) & Discounting:
- Significance: Rf is a cornerstone concept in valuation.
- Real vs Nominal: Depending on whether you adjust cash flows for inflation (real) or not (nominal), the Rf and discount rate will differ.
- Determinants: Currency choice and bond maturity are key considerations. For instance, using a 10-year bond issue might be more practical than a 30-year one due to data availability. To determine Rf across different currencies, government-issued 10-year bonds are a go-to. However, adjustments for default risk, possibly through credit default swaps or country debt ratings, are essential.
Risk Assessment & Cost Calculations
- Risk Quantification:
- Marginal Investor's Role: These influential players, who actively trade sizable holdings, predominantly determine stock prices.
- Diversification Assumption: Most models assume that the marginal investor has a diversified portfolio, making an asset's unique risk less relevant.
- Risk/Return Models:
- CAPM: Highlights the market risk premium using a beta relative to the market.
- Advanced Models: The Arbitrage Pricing Model and multifactor models consider multiple risk sources, with the former focusing on statistical nuances and the latter on macroeconomic factors.
- Debt & Equity Costs:
- Equity Cost: Termed as the cost of equity, it represents the return equity investors expect.
- Debt Cost: The rate at which a company can borrow long-term, reflecting its default risk. This can be estimated using the yield on a long-term bond issued by the company, or by assessing the default spread based on credit ratings. Unrated companies can be evaluated using interest coverage ratios.
- Cost of Capital: A weighted average of the cost of equity and debt, vital for accurate DCF analysis.
Projecting Cash Flows & Growth Potential
- Earnings Estimates:
- Preferred: Market typically prefers NTM numbers for valuation.
- Adjustments: Can adjust earnings to reflect genuine operating performance, getting normalized figures.
- Growth Projections:
- Beyond Historical Data: While past trends offer insights, growth is more intricately tied to the quality and magnitude of reinvestment.
- Metrics Matter: For equity, the retention ratio and Return on Equity (ROE) are pivotal. For the firm, the reinvestment rate and Return on Invested Capital (ROIC) hold the key.
Concluding the Valuation & Enhancing Value
- Terminal Value:
- Necessity: At some point, cash flows need a definitive end. Stable growth models, where growth rates align with economic growth rates, are popular.
- Value Augmentation Techniques:
- Product & Market Strategies: Innovations and market expansions can notably boost a firm's value. Conversely, acquisitions often dilute value due to the premiums involved.
Equity Valuation Subtleties
- Influencing Factors:
- Cash & Cross Holdings: Elements like cash reserves, cross holdings, potential lawsuits, and other tangible or intangible assets/liabilities can swing a firm's equity value.
Synergy, Governance, and Complexity
- Synergy's Role:
- Operational & Financial Synergies: These can add notable value post-mergers or acquisitions, though they might take time to realize fully.
- Control Value:
- Potential value addition by new management can sway valuation, especially if the new team can drive better performance.
- Complexity's Downside:
- Overly intricate firms might require a discount, given the challenges they present. This can be quantified. For example a conglomerate discount.
Private Companies & Special Valuation Scenarios (continued):
- Asset-Based Valuation:
- When & Why: This method shines during liquidation or acquisition scenarios. It's also valuable for "fair value" accounting.
- Methodology: Each asset on the balance sheet is valued either through intrinsic, relative, or accounting value methods. For instance, during liquidation, relative valuation is pivotal as it reflects the market's willingness to pay.
- Private Company Challenges:
- Valuation Nuances: The absence of a market value and varied accounting standards can make private company valuations intricate.
- Private-to-Private Transactions: Such deals must consider factors like the total beta (since buyers are typically not diversified) and potential illiquidity discounts.
- Private-to-Public Transactions: Here, conventional valuation methods can be employed, but the public company's bargaining power and different tax implications must be considered.
- Private-to-IPO: Control implications, allocation of IPO proceeds, and the valuation of options/warrants need attention. Also, the price guarantees offered by investment banks may introduce discounts.
Relative Valuation Highlights:
- The Essence: This method hinges on valuing assets by comparing them to their peers.
- Multiples: They offer insights into what you're paying versus what you're getting. Examples include Price-to-Earnings (P/E), EV/EBITDA, and Price-to-Book (P/B).
- PE Ratios: Here, earnings per share (EPS) can vary based on timing (current, trailing, forward) and other factors like dilution or extraordinary items.
- EV/EBITDA: A more robust metric than Price-to-Sales (P/S), it considers the entire value of the company, minus cash.
- Price/Book Ratio: Focuses on the relationship between the market value of equity and its book value.
- Revenue Multiples: These are less influenced by accounting choices and can be useful for sectors where profitability is yet to be achieved.
Option-Based Valuation Insights:
- The Premise: Useful when assets manifest option-like characteristics.
- Real Options: For an option to hold tangible value, there must be exclusivity in its usage. Also, the option's key attributes, like an underlying asset, contingent payoff, and limited life, are crucial.
- Option Valuation in Distressed Scenarios: For companies on the brink of bankruptcy, equity can be seen as a call option on the firm's assets. This perspective can offer a more realistic valuation in dire circumstances.