Post 1 in the valuation series
The idea behind valuation is to understand an asset and try to identify the sources that gives the value to the asset and measure the value with close approximation.
A common attribute observed in most of the assets is that every asset is different from one another and hence there is no ‘one size fits all’ technique that can be applied to value all the assets. Thereby it is imperative to understand every asset thoroughly and identify where the asset derives its value from intuitively.
Valuation is not an approach with only formulas and models that gives a value automatically when the inputs are provided, but should be seen as a set of principles, which once understood provides meaning and sense to the models and formulas that we use in practice. Now let’s look at some general Ideas that needs to be kept in mind while performing valuation:
1. Independence
While valuing an asset we will come across many situations where we would have to make assumptions or choose a model out of many that are available to value an asset. Such situations are dependent on our judgements and our personal decisions, hence it is very important to remain independent of any biases.
The most important thing about independence is to be able to identify the biases we have already developed about an asset and to not let that affect us decision.
2. Valuation is time dependent
Since valuation is dependent on lot of assumptions made on the future prospect of the firm or economy, we should understand that the value that we have arrived at is dependent on lot of factors which keep on changing with time. Hence the value obatined at a point of time is not the final value and needs to be updated based on the most recent information.
3. Uncertainty
Even with sophisticated models there is always some uncertainty associated with valuation. Since valuation is dependent on the judgements and assumptions made by an individual.
4. Myth: The more complex the model the better the valuation
It is often a prevalent thought that the more complex a model the higher is it’s accuracy and better is it’s ability to value. But it often turns out that with complex models even a small error can get compounded resulting in a valuation that is no where close to it’s actual value. So it is advised to always keep the models simple and only include factor in only a reasonable number of factor assess the value.
The role of valuation:
Valuation is useful for people from different backgrounds and in different scenarios:
1. Portfolio Management
Valuation plays a significant role in portfolio management but it’s significance differs based on the type investor that employs it. Investors are broadly of two types, passive and active investors. While active investors might have to make frequent use of valuation it is not the same case for passive investors, who rarely have to use it. Even among active investor it may not be very useful for investors who utilise strategies based on market timing and chart patterns.
2. Franchise buyers
Acquiring businesses that are undervalued has always been a smart and a prudent investment. But it is important to understand the business before acquiring a stake in a business and in such cases valuation techniques are very useful to arrive at a fair value at which it can be bought helping us to avoid overpaying.
3. Fundamental analysts
Fundamental analysis is basically determining the value using fundamental factors such as the firm’s growth prospects, investment strategy, etc. Valuation is very important for fundamental analysts, purchase undervalued assets hoping that the current difference between the asset’s market price and it’s fair value will be corrected over time.
4. Corporate finance
In corporate finance the focus has always been on firm value maximisation, so every action that is taken by the firm is aimed at increaing the firm’s value. Imagine a firm as machine with a lot of levers, Understanding the where the firm derives it’s value will help in optimising the levers in such a way that the value of the firm increases. An example would be making decisions on the firm’s dividend policy or on it’s capital structure.
In conclusion, valuation plays an important role in many areas of finance, such as corporate finance, mergers and acquisition, investment and portfolio management, etc. Valuation is a process that is highly subjective and is based on few guiding principles, hence when valuing a company we should be wary of these words which are “The market must know something that I don’t” which is usually a conception that we develop when there seems to be very little relation between the market price and the value that we have determined. At such times it is always advised to recheck our valuation models and make sure that they stick to the fundamental principles that govern valuation.