The Dark Side of Valuation – Third Edition
The idea for this book was born at the end of 1999, towards the end of the Dot-com boom and was triggered by two phenomena; the seeming inability of traditional valuation models to explain stratospheric stock prices for technology (especially new technology) companies and the willingness of analysts to abandon traditional valuation metrics and go over to the “dark side” of valuation, where prices were justified using a mix of new metrics and story telling. The publication of the first edition coincided with the bursting of that bubble. The second edition came ten years later, just after the 2008 crisis, precipitated by a housing bubble bursting, and banks behaving badly. With that crisis came the realization that the dark side of valuation beckons any time analysts have trouble fitting companies into traditional models and metrics, and the book reflected that broader perspective. Rather than focus on just young, high-tech (internet) companies as I did in the first edition, I expanded the discussion to companies that are difficult to value across the spectrum including distressed companies, commodity firms and banks.
In the eight years since the second edition was published, there are three macro phenomena that have confounded analysts trying to value companies. The first is that interest rates around the world, and especially so in developed markets, have not only hit historic lows but have become negative in some parts of the world. That has resulted in some analysts giving up on valuation, arguing that it does not work when rates are this low or negative. The second is that global market crises have become almost an annual occurrence, with each year bringing a fresh outbreak in a different part of the world, making risk premiums much more volatile in all markets. Finally, the journey to globalization, which a decade ago seemed unstoppable, has been not only slowed but perhaps even been pushed back in some parts of the world. In the third edition of this book, I plan to look at how best to deal with low interest rates, volatile equity risk premiums and political risk in valuation.
The structure of the book will be largely unchanged. The first part of the book will review the basic tools that you have available in valuation. In particular, it will provide, in compressed format, a summary of conventional discounted cash flow models, probabilistic models (simulations, decision trees etc), relative valuation models and real options. Much of what will be included in this section has already been said in my other books on valuation.
The second part of the book will examine some of the estimation questions and issues surrounding macro inputs that affect all inputs. The first chapter in this section will look at risk free rates, the building block for all other inputs, and examine the reasons for low interest rates and the consequences for value. The second chapter will examine equity risk premiums and how best to estimate risk premiums in the midst of crises and economic shocks. The third chapter puts the focus on other macro economic assumptions that are often implicit in valuations about growth in the real economy, exchange rates and inflation and how inconsistencies in these valuations affect the conclusions that we draw.
The third part of the book will look at valuation challenges across a firm’s life cycle. In pictorial format, these are the challenges:
The first two chapters in this section will review the valuation challenges faced in valuing young and “idea” businesses, where there an interesting idea for a product or service but no tangible commercial product yet. It will also consider the baby steps involved as the idea evolves into a commercial product, albeit with very limited revenues and evidence of market success. In effect, this chapter is designed to look at the challenges faced in the very first stages of entrepreneurial valuation. It is the challenge that venture capitalists have faced for decades when providing “angel financing” to small companies. The third chapter will climb the life cycle ladder to look at young growth companies, whose products and services have found a market and where revenues are growing fast. This chapter will also examine the valuation implications of going public as opposed to staying private and the sustainability of growth The fourth chapter will look at the growth companies that have survived the venture capital cycle and gone public. These companies have a well-established track record of growth, but the size of the company is working against it. The fifth chapter will look at “mature companies”, where growth is in the past, and the efforts that they go to increase value including acquisitions, operating restructuring and financial restructuring. In the process, we will also consider how a private equity investor may view value in a “mature” company in the context of a leveraged buyout and the value of control in this company. In the closing chapter in this section, we will consider firms in decline, where growth can be negative, and the potential for distress and bankruptcy may be substantial.
The final part of the book will look at specific types of firms that have proved difficult to value for a variety of reasons. We will begin by looking at two broad classes of firms – commodity companies (oil, gold etc) and cyclical companies – where volatile earnings driven by external factors (commodity prices, state of the economy) have made projections difficult to do. The special challenges associated with financial service firms – banks, insurance companies and investment banks – are examined in the subsequent chapter, with an emphasis on how regulatory changes can affect value. We will follow up by looking at companies that are heavily dependent on intangible assets: patents, technological prowess and human capital. The nature of the assets in these firms combined with flaws in the accounting standards that cover them make them challenging from a valuation perspective. The next chapter looks at companies that operate in volatile and young economies (emerging markets) and how best to estimate value. The fourth chapter looks at companies in multiple businesses that operate in many countries and how best to deal with the interactions between the different pieces within these companies. The fifth chapter is a catch-all for how best to value unusual entities, from infrastructure investments to sports franchises to cryptocurrencies.
In summary, I hope to make the third edition of the Dark Side of Valuation a book for today’s markets, where investors have to be willing to deal with uncertainty head on rather than hiding from it, where having too much data is as much of a concern as having too little and where models sometimes have more complexity and power than their users can handle.
Changes from second edition
1 The Dark Side of Valuation
Enlightenment: The Tools
2 Intrinsic Valuation
3 Probabilistic Valuation: Scenario Analysis, Decision Trees & Simulations
4 Relative Valuation
5 Option Valuation
The Dark Side of Macro Inputs
6 A Shaky Base: A Risky Risk free Rate
7 Risky Ventures: Assessing the Price of Risk
8 Macro Matters: The Real Economy
The Dark Side across the Life Cycle
9 Baby Steps - Valuing start-ups
10 Off the School – Valuing young companies
11 Shooting Stars - Valuing growth companies
12 Not so staid - Valuing mature companies
13 The inevitable end - Valuing companies in distress and decline
The Dark Side across company types
14 Ups and Down: Valuing Cyclical and Commodity companies
15 Mark to Market: Valuing Financial Service companies
16 Invisible Investments: Valuing firms with intangible assets
17 Volatility Rules: Valuing Emerging Market companies
18 The Octopus: Valuing Multi-business, global companies
19 Puzzle Palace: Valuing the Unusual
20 Lighting the Way: Vanquishing the Dark Side