Chapter One

Value-More than a?Number!: Understanding the?Terrain

OSCAR WILDE DEFINED A CYNIC AS ONE WHO "knows the price of everything and the value of nothing." The same can be said of many investors who regard investing as a game and define winning as staying ahead of the pack.

A postulate of sound investing is that an investor does not pay more for an asset than it is worth. If you accept this proposition, it follows that you must at least try to value whatever you are buying before buying it. I know there are those who argue that value is in the eyes of the beholder and that any price can be justified if there are other investors who perceive an investment to be worth that amount. That is patently absurd. Perceptions may be all that matter when the asset is a painting or a sculpture, but you buy financial assets for the cash flows that you expect to receive. The price of a stock cannot be justified by merely using the argument that there will be other investors around who will pay a higher price in the future. That is the equivalent of playing an expensive game of musical chairs, and the question becomes: Where will you be when the music stops?

Two Approaches to?Valuation

Ultimately, there are dozens of valuation models but only two valuation approaches: intrinsic and relative. In intrinsic valuation, we begin with a simple proposition: the intrinsic value of an asset is determined by the cash flows you expect that asset to generate over its life and how uncertain you feel about these cash flows. Assets with high and stable cash flows should be worth more than assets with low and volatile cash flows. You should pay more for a property that has long-term renters paying a high rent than for a more speculative property with not only lower rental income but more variable vacancy rates from period to period.

While the focus in principle should be on intrinsic valuation, most assets are valued on a relative basis. In relative valuation, assets are valued by looking at how the market prices similar assets. Thus, when determining what to pay for a house, you would look at what similar houses in the neighbourhood sold for. With a stock, that means comparing its pricing to similar stocks, usually in its "peer group." Thus, Exxon Mobil will be viewed as a stock to buy if it is trading at 8 times earnings while other oil companies trade at 12 times earnings. Since this approach to putting a number on a business or asset is philosophically different from intrinsic valuation and determined less by fundamentals and more by what other people are willing to pay, we will use the term "pricing" to describe relative valuation.

Intrinsic valuation provides a fuller picture of what drives the value of a business or stock, but there are times when pricing will yield a more realistic estimate of what you can get for that business or stock in the market today. While nothing stops you from using both approaches to put a number on the same investment, it is imperative that you understand whether your mission is to value an asset or to price it, since the tool kit that you will need is different.

Why Should You?Care?

Investors come to the market with a wide range of investment philosophies. Some are market timers looking to buy before market upturns while others believe in picking stocks based on growth and future earnings potential.

Some pore over price charts and classify themselves as technicians, whereas others compute financial ratios and swear by fundamental analysis, in which they drill down on the specific cash flows that a company can generate and derive a value based on these cash flows. Some invest for short-term profits and others for long-term gains. Knowing how to value assets is useful to all these investors, though its place in the process will vary. Market timers can use valuation or pricing tools at the start of the process to determine whether a group or class of assets (stocks, bonds, or real estate) is under- or overvalued, while stock pickers can draw on valuations of individual companies to decide which stocks are cheap and which ones are expensive. Even technical analysts (including chartists) can use valuations to detect shifts in momentum when a stock on an upward path changes course and starts going down or vice versa.

Increasingly, though, the need to assess value and price has moved beyond investments and portfolio management. There is a role for valuation and pricing at every stage of a firm's life cycle. For small private businesses thinking about expanding, pricing and valuation play a key role when they approach venture capital and private equity investors for more capital. The share of a firm that venture capitalists will demand in exchange for a capital infusion will depend on the value (pricing) they estimate for the firm. As the companies get larger and decide to go public, your assessments of what it is worth will determine the prices at which they are offered to the market in the public offering. Once established, decisions on where to invest, how much to borrow, and how much to return to the owners will all be affected by perceptions of their impact on value. Even accounting is not immune. The most significant global trend in accounting standards is a shift toward fair value accounting, where assets are valued on balance sheets at their fair values rather than at their original cost. Thus, even a casual perusal of financial statements requires an understanding of valuation fundamentals and pricing basics.

Some Truths about Valuation

Before delving into the details of valuation, it is worth noting some general truths about valuation that will provide you not only with perspective when looking at valuations done by others but also with some comfort when doing your own.

All Valuations Are Biased

You almost never start valuing a company or stock with a blank slate. All too often, your views on a company or stock are formed before you start inputting the numbers into the models and metrics that you use and, not surprisingly, your conclusions tend to reflect your biases.

The bias in the process starts with the companies you choose to value. These choices are not random. It may be that you have read something in the press (good or bad) about the company or heard from a talking head that a particular company was under- or overvalued. It continues when you collect the information you need to value the firm. The annual report and other financial statements include not only the accounting numbers but also management discussions of performance, often putting the best possible spin on the numbers.

With professional analysts, there are institutional factors that add to this already substantial bias. Equity research analysts, for instance, issue more buy than sell recommendations because they need to maintain good relations with the companies they follow and because of the pressures that they face from their own employers, who generate other business from these companies. To these institutional factors, add the reward and punishment structure associated with finding companies to be under- and overvalued. Analysts whose compensation is dependent on whether they find a firm to be cheap or expensive will be biased in that direction.

The inputs that you use in the valuation will reflect your optimistic or pessimistic bent; thus, you are more likely to use higher growth rates and see less risk in companies that you are predisposed to like. There is also post-valuation garnishing, where you increase your estimated value by adding premiums for the good stuff (synergy, control, and management quality) or reduce your estimated value by netting out discounts for the bad stuff (illiquidity and risk).

Always be honest about your biases: Why did you pick this company to value? Do you like or dislike the company's management? Do you already own stock in the company? Put these biases down on paper, if possible, before you start. In addition, confine your background research on the company to information sources rather than opinion sources; in other words, spend more time looking at a company's financial statements than reading equity research reports about the company. If you are looking at someone else's valuation of a company, always consider the reasons for the valuation and the potential biases that may affect the analyst's judgments. Generally, the more bias there is in the process, the less weight you should attach to the valuation judgment.

Valuations (Even Good Ones) Are Wrong

Starting early in life, you are taught that if you follow the right steps and use the right models, you will get the correct answer and that if the answer is imprecise, you must have done something wrong. While precision is a good measure of process quality in mathematics or physics, it is a poor measure of quality in valuation. Your best estimates for the future will not match up to the actual numbers for several reasons. First, even if your information sources are impeccable, you must convert raw information into forecasts, and any mistakes that you make at this stage will cause estimation error. Next, the path that you envision for a firm can prove to be hopelessly off. The firm may do much better or much worse than you expected it to perform, and the resulting earnings and cash flows will be different from your estimates; consider this...