"There is nothing so dangerous as the pursuit
of a rational investment policy in an irrational world." John Maynard
Keynes
Lord Keynes was not alone in believing that the pursuit of 'true value'
based upon financial fundamentals is a fruitless one in markets where prices
often seem to have little to do with value. There have always been investors
in financial markets who have argued that market prices are determined by
the perceptions (and misperceptions) of buyers and sellers, and not by anything
as prosaic as cashflows or earnings. I do not disagree with them that investor
perceptions matter, but I do disagree with the notion that they are all
the matter. It is a fundamental precept of this book that it is possible
to estimate value from financial fundamentals, albeit with error, for most
assets, and that the market price cannot deviate from this value, in the
long term. From the tulip bulb craze in Holland in the middle ages to the
South Sea Bubble in England in the eighteen hundreds to the stock markets
of the present, markets have shown the capacity to correct themselves, often
at the expense of those who believed that the day of reckoning would never
come.
In the process of presenting and discussing the various models available
for valuation, I have tried to adhere to four basic principles . First,
I have attempted to be as comprehensive as possible in covering the range
of valuation models that are available to an analyst doing a valuation,
while presenting the common elements in these models and providing a framework
that can be used to pick the right model for any valuation scenario. Second,
the models are presented with real world examples, warts and all, so as
to capture some of the problems inherent in applying these models. There
is the obvious danger that some of these valuations will appear to be hopelessly
wrong in hindsight, but this cost is well worth the benefits. Third, in
keeping with my belief that valuation models are universal and not market-specific,
illustrations from markets outside the United States are interspersed through
the book. Finally, I have tried to make the book as modular as possible,
enabling a reader to pick and choose sections of the book to read, without
a significant loss of continuity.
In applying valuation models to real world examples in this book, I have
used the capital asset pricing model (CAPM) as my model for risk, and beta
as my measure of risk, throughout this book. I am well aware of the controversy
surrounding the CAPM, and have discussed its limitations as well as alternative
models in the chapter on estimating discount rates. There are four reasons
for my dependence on the CAPM in this book. First, the estimation of the
cost of equity, which is where I have used the CAPM, is just one component
of valuation. The valuation models described in this book require a cost
of equity, and any model that provides one can be used instead of the CAPM,
without any loss of generality. Second, the data that is available often
determines usage. The betas of both domestic and foreign firms are estimated
by a number of information services, and are easily accessible. I could
have attempted to estimate the parameters of an alternative model for the
stocks that I have valued, but that would have diverted me from my primary
focus, which was valuation. Third, the CAPM provides a convenient forum
for discussing more general issues that are important in valuation, such
as the effects of financial leverage on risk and the relationship between
risk and growth opportunities. Finally, in spite of all the criticism of
the CAPM, I am not convinced that alternative models do much better in predicting
expected returns, though there is evidence that they do better at explaining
past returns.
Outline of the Book
The first chapter of this book examines the general basis for valuation
models and the role that valuation plays in different investment philosophies.
The second chapter provides an overview to the three basic approaches to
valuation - discounted cashflow valuation, relative valuation and contingent
claim valuation. The rest of the book delves into the details of using these
models.
Discounted Cashflow Valuation Models
The first section of the book presents different discounted cashflow models
to value both equity and the firm. Chapter 3 examines different approaches
for dealing with risk and estimating the cost of equity, and for calculating
the weighted average cost of capital. Chapter 4 provides a background on
financial statements and cashflow calculation, and distinguishes between
cashflow to equity and cashflow to the firm. Chapter 5 explores the process
of estimating future growth in earnings and cashflows, starting off with
a discussion of the relationship between past growth and future growth,
and proceeding with an examination of how analysts estimate growth, how
accurate their predictions are and how best to use analyst forecasts of
growth in valuation. It also discusses the relationship between growth and
financial fundamentals - how good or bad the firm's projects are, how much
leverage the firm has and its dividend policy.
Chapter 6 describes the basis dividend discount model and its variants.
First, the Gordon Growth Model, which assumes steady state growth, is described
and applied. Next, the two-stage and three-stage dividend discount models
are developed and contrasted, and the value of extraordinary growth is separated
from the value of assets in place. The information requirements for each
model are summarized, in conjunction with a description of the firms on
which these models work best. Finally, the results of past studies on the
efficacy of the dividend discount model in estimating value and finding
undervalued and overvalued stocks are presented.
Chapter 7 starts off with a discussion of why free cashflows to equity (FCFE)
are different from dividends for most firms. The two-stage and three-stage
FCFE discounted cashflow models are described and applied to high growth
firms which do not pay dividends. Chapter 8 examines the alternative of
valuing the firm by discounting free cashflows to the firm at the weighted
average cost of capital. The advantages of this approach are discussed together
with caveats on its usage.
Chapter 9 is dedicated to the valuation of those firms which do not fit
easily into traditional discounted cashflow models. In particular, the problems
in valuing cyclical and troubled firms are discussed, and possible solutions
are suggested. Chapter 13 examines the issues associated with valuing firms
that are in the process of being restructured, and provides a framework
for analyzing the valuation effects of the many dimensions of restructuring
- realigning of assets, changes in financial leverage and shifts in dividend
policy. Chapter 14 analyzes the key issues that arise in takeover valuation
- the value of synergy and the value of control. It lays out the sources
of synergy and shows how it can be valued explicitly, and also provides
the theoretical basis and an analytical framework for valuing a control
premium.
Relative Valuation Models
The section on relative valuation covers three chapters. Chapter 10 discusses
the use and misuse of price-earnings (PE) and price-cashflow ratios, beginning
with an examination of the determinants of price-earnings ratios, and continuing
with an analysis of why PE ratios change over time and why earnings multiples
are different across industries and countries. It also talks about the estimation
of PE ratios for firms using the information in the cross-section and the
empirical evidence on the relationship between PE ratios and excess returns.
Finally, the use of price-earnings multiples for pricing initial public
offerings is examined, with an application.
Chapter 11 explores the relationship between price and book value, and attempts
to clear misconceptions about the relationship. The determinants of Price/Book
Value ratios are examined and a rationale is presented for why some firms
sell for less than book value while others sell for more. Finally, there
is a discussion of how to use price-book value ratios sensibly in investing.
Chapter 12 examines the price to sales ratio and reasons for differences
across firms and industries on this multiple. The price to sales ratios
is also a useful tool to use to examine the value of a brand name and the
effects of changes in corporate strategy.
Contingent Claim Valuation Models
The section on contingent claim valuation is presented in two chapters.
Chapter 15 develops the basis concepts of option pricing. It describes the
payoff diagrams on call and put options and provides the rationale for option
pricing models. The Binomial and the Black-Scholes model are presented and
contrasted, and extensions on these models and their limitations are described.
Chapter 16 applies these models in the pricing of a number of contingent
claim securities such as warrants, and explores the use of option pricing
models in pricing assets which have option-like features such as equity
in a firm, natural resource rights and product patents.
Choosing the right model
The problem in valuation is not that there are not enough models for valuation;
it is that there are too many. Consequently, the final chapter, Chapter
17, may be the most important one in this book. It provides a framework
for picking the right model for any occasion, based upon the characteristics
of the asset being valued.
