Week 1: Valuation Basics

Question 1

Main Valuation Approaches

Answer 1

1. Fundamental Valuation-
   The value of a firm is determined by the present value of its future cash flows.
2. Relative Valuation-
   The value of a firm is determined by looking at the value of comparable firms. (Multiples approach)
3. Contingent Claim Valuation (“real option valuation”)-
   The value of a firm is determined by
   using option pricing techniques (e.g., Black-Scholes model).

Question 2

Fundamental Valuation and its Approaches

Answer 2

Firm value= PV of future CFs discounted at the riskiness of CFs (r)

Valuation approaches:
− Enterprise value:
− Cost of capital approach (DCF-WACC)
− Adjusted present value approach (APV)
− Equity value:
− Dividend discount model (DDM)
− Free cash flow to equity model (FCFE)

Question 3

Relative valuation

Answer 3

Firm value= using multiples
3 main steps:
1) Identification of comparable firms
2) Standardization of firm value → Multiples
3) Comparison of multiples and controlling for any remaining differences between firms

Relative valuation only works if comparable firms are fairly priced!

Question 4

Which valuation approach do analysts use more?

Answer 4

-> Relative valuation
“Football field”, meaning that DCF-WACC can result in more overvalued firm.

Question 5

3 Main problems of valuation

Answer 5

*Bias:
Myth 1: A valuation is an objective search for the “true” value.
Truth 1: All valuations are biased.
*Uncertainty:
Myth 2: A good valuation provides a precise estimate of the value.
Truth 2: There are no precise valuations.
*Complexity:
Myth 3: The more quantitative a model, the better the valuation.
Truth 3: Simpler valuation models typically do much better than more complex ones.

Question 6

Problem of Biases

Answer 6

*Sources:
− Information available (e.g., annual reports, newspaper articles, stock prices)
− Institutional setting
− Compensation structure
*Consequences:
− Biased inputs
− Post-valuation tinkering
− Use of premiums/discounts for justification (e.g., synergies in mergers)
*What to do about it?
− Self-awareness
− Reduce institutional pressure (e.g., independent research firms)
− De-link valuation from compensation

Question 7

What is a sell-side analyst?

Answer 7

− Sell-side analysts work for banks and other financial intermediaries.
− They value stocks and other securities.
− Based on these valuations, they issue target prices for stocks and other securities and investment
recommendations, typically termed “buy”, “hold”, or “sell”.
− These target prices and investment recommendations are then offered to clients (e.g., retail investors).

Buy-slide analysts work for asset managers (e.g., mutual funds, hedge funds).
They perform the same tasks as sell-side analysts but exclusively for the asset manager.

Question 8

Problem of Uncertainty

Answer 8

*Sources of uncertainty:
− Model uncertainty
− Firm-specific uncertainty
− Macroeconomic uncertainty
*Consequences:
− Wrong (point) estimates
− Reliance on forecasts of others (e.g., star analysts)
− Giving up on fundamental valuation (e.g., focusing on relative valuation)
*What to do about it:
− Familiarize with models, firm, and macroeconomic environment
− Use valuation ranges (e.g., best case, worst case)

Question 9

Problem of Complexity

Answer 9

*Sources of complexity:
− Information available (e.g., Internet, financial data providers)
− Computation power (e.g., powerful computers, Microsoft Excel, “ready-to-use valuation models”)
*Consequences:
− Information overload
− Complex models = black box
− Big assumptions vs. small assumptions
*What to do about it:
− Use simplest model possible
− Do not estimate inputs you do not have to
− Do not use “all-in-one valuation models”