Valuation
Summary of the Lectures
University of Amsterdam
MSc Finance
2022
,Introduction
What is valuation?
Method to determine how much an asset is worth, based on future cash flows it might produce
● Can be used to determine whether assets are priced correctly
○ Aids in deciding which assets to purchase or sell
○ Commonly used to determine whether stocks are over/underpriced, but method can
also be applied to other assets (even whole firms!)
● Important tool for achieving finance’s ultimate purpose: to generate highest return for savers,
and allocate capital to most efficient users
Who uses valuation?
Finance industry:
● Buy-side: Mutual funds, private equity firms, venture capital funds
● Sell-side: Equity research analysts, investment bankers that provide advisory services (e.g.,
M&A bankers)
Consulting:
● Management consultants provide corporations with advice on how to increase value
● Liquidation specialists in bankruptcy value reorganization plans
Corporate sector:
● CFOs decide how to raise financing and pay back investors
● Managers decide which projects to pursue when allocating resources
You, potentially:
● Provides foundation for personal investing strategy
● Useful for entrepreneurs when developing business model
Some people who typically don’t use valuation:
● Technical analysts
● Many types of traders (e.g., fixed income, commodities)
● Quant or arbitrage funds
● Speculators
What valuation is not
1. Way to forecast prices in short term
2. Scientific process that can guarantee a correct answer
3. Reliable method to quickly make money from investing
4. Objective analysis that overcomes investors’ inherent biases
More on these points throughout the course!
Price vs. value
● Valuation models an asset’s long-term value, based on future cashflows
● Asset’s price is whatever an investor is willing to pay for it today
○ If investors are rational and forward-looking, then price = value
○ But if markets not fully efficient, prices can deviate from value in short term (and
sometimes even longer)
● Sometimes goal is to maximize asset price, and valuation less useful here
○ Adviser to firm undertaking IPO seeks investors who will pay highest price, even if
above market value
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,Importance of growth assets
Apple has a market cap of $1.96T but its total assets are $339B. What is driving the higher market
value?
Valuation considers both existing assets and growth opportunities that firm is expected to pursue in
future
● Current prices reflect value of these investment opportunities
● If investors believe growth will slow in future, stock price falls today
Key to achieving growth is to invest in positive NPV projects
Valuation and market efficiency
When valuation models are used to make investment decisions, two implicit assumptions are:
● Markets are inefficient and make mistakes in assessing value
● One can predict when inefficiencies will get corrected
When investor states that asset is under/over-valued, they are assuming that price is inefficient
● To earn money, must hold asset until price reverts to correct value
If market is efficient, then purpose of valuation is to understand what drives firm’s value
Approaches to valuation
● Discounted cash flow valuation: relates asset’s value to present value of its expected future
cash flows
● Relative valuation: looks at pricing of ‘comparable’ assets using common variable like
earnings, cash flows, etc.
Discounted cash flow valuation
● Philosophical Basis: Every asset has intrinsic value that can be estimated, using cash flows,
growth and risk.
● Information Needed:
○ life of asset
○ cash flows during life of asset
○ discount rate to apply to cash flows to get present value
● Market Inefficiency: Markets assumed to make mistakes in pricing assets, but correct
themselves over time as new information comes out
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,Discounted Cash Flow (DCF) valuation: Basis for approach
● CFt = the expected cash flow in period t
● r = the discount rate
● n = the life of the asset
Assets generating cash flows early will be worth more than those generating cash flows late.
● But the latter may have higher growth -> explains why many young, unprofitable firms have
high valuations.
When DCF valuation works best
1. Cashflows are currently positive, and
2. Can be estimated with some reliability for future periods, and
3. A proxy for risk can be used to calculate discount rates
It works best for investors who either:
● have a long time horizon, allowing the market time for price to revert to “true” value, or
● are capable of moving price toward correct value (e.g., activist investor or potential acquirer)
Relative valuation
● Philosophical Basis: Intrinsic value of an asset is impossible to estimate. An asset’s value is
whatever market is willing to pay for it.
● Information Needed:
○ a group of similar, comparable assets
○ a standardized measure of value to use in comparison
○ if assets are not perfectly comparable, variables to control for the differences
● Market Inefficiency: Pricing errors made across similar or comparable assets are easier to spot
and exploit
● Common measures used as multiples: Price/Earnings Ratio, Enterprise Value/EBITDA,
Price/Book Value
When relative valuation works best
This approach is easiest to use when:
● many assets comparable to the one being valued
● these assets are priced in a market
● there exists some common variable to standardize the price
This approach tends to work best for investors:
● who have relatively short time horizons
● who are judged based upon a relative benchmark (the market, other portfolio managers with
the same investment style, etc.)
● who can take advantage of the relative mispricing, e.g., by short selling overvalued assets
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,Recall: What valuation is not
1. Scientific process that can guarantee a correct answer
a. Key challenge is forecasting future cash flows—no “correct” answer
b. Valuation formulas are only as good as their inputs
2. Reliable method to quickly make money from investing
a. Prices can diverge from fundamental value for long time periods
3. Objective analysis that overcomes investors’ inherent biases
a. All valuations require subjective decisions affected by personal biases
b. Information provided by management/analysts is slanted
Online Appendix: Bias in valuation
● Information always skewed by biases of those who provide it
○ E.g., annual reports represent management’s spin on events
● Institutional factors can affect our biases and skew valuation outcomes
○ Firm may reward you for finding under- or over-valued assets
● Common manifestations of bias:
○ assumptions about valuation inputs
○ post-valuation tinkering: adding premiums (synergy, control) or discounts (illiquidity)
to achieve desired result
○ qualitative factors: explain difference between price and value with abstract terms
(e.g., “strategic considerations”)
Week 1 (Estimating Cashflows)
DCF and NPV Formula
Recall: NPV formula is basis of DCF valuation
● Today’s goal is to estimate inputs for numerator (firm’s cash flows)
Two challenges:
● Firm financials do not accurately reflect current cash flows
● Value relies largely on future cash flows that must be estimated
Steps in Estimating Cash Flows
1. Collect current data from firm’s most recent financial statements (10K and 10Q)
a. If valuing entire firm, start with operating earnings after taxes (but before interest
payments)
b. If valuing equity, use net income (earnings after interest)
2. Adjust earnings for various accounting conventions
a. E.g., some investments misclassified as ordinary business costs
3. Calculate firm’s net investment spending
a. Firm can not grow if the firm never reinvests
b. net capital expenditure = everything the firm invests in capital - depreciation
4. Convert earnings into cash flows
a. Subtract investment spending as money left firm, add back depreciation as money did
not leave the firm
b. For equity, also add cash flows from issuing/repaying debt
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,Measuring Cash Flows (IMPORTANT)
● All claimholders: if all the investment and debt needs are satisfied
● Equity investors also get dividends and profit from buybacks.
From Reported to Actual Earnings
● Operating leases are not expenses (in accounting it is) but you need to convert it into debt
● You need to convert R&D expenses into assets because you create income with these
expenses eventually
1. Collect current data
Annual financial statements are often outdated
● Partly reflect firms’ conditions from a year ago
Updating matters most for firms that have changed recently
● Smaller/volatile firms
● Firms that have undergone significant restructuring
Update using trailing data from past 12 months, constructed from quarterly earnings reports
● All you need is one 10K and one 10Q
● Trailing 12-month revenue = Annual revenues (in last 10K) - Revenues from first 3 quarters
of last year (in 10Q) + Revenues from first 3 quarters of this year (in 10Q)
● Example of this on the next page!
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,Example: Google
2. Adjusting Accounting Earnings
● Make sure no financial expenses are mixed in with operating expenses
○ Financial expense: Any commitment that is tax deductible and must be paid, or else
you lose control of the business.
○ Example: Operating Leases are treated by accounting rules as business expense, but
really should be reclassified as financial expense
● Make sure investment is not classified as operating expenses
○ Any spending that is expected to generate benefits over multiple periods is investment
○ R&D is investment, but accounting rules classify as operating expense
The Magnitude of Operating Leases
● For some industries, operating lease expenses are big and more important.
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,2a. Adjusting Lease Expenses
● Goal: Treat leases as any other type of debt
○ Add leases to total debt on balance sheet
○ Re-calculate operating earnings without lease costs
● To capitalize lease expenses:
○ collect data on current and future lease commitments from 10-Ks
○ calculate present value of future commitments, discounting at pretax cost of debt
○ sum up present values to obtain debt value of operating leases
● Add debt value to balance sheet as liability, create asset of same value
○ Adjusted Operating Earnings = Operating Earnings + Operating Lease Expenses -
Depreciation on Leased Asset
○ As an approximation, you can use Operating Earnings + Pre-tax cost of Debt × PV of
Operating Leases!
Example: Operating Leases at The Gap
For the exam important to understand what will change in comparison to conventional accounting.
You can see that the ROC is lower when you treat operating leases as debt.
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,The Magnitude of R&D Expenses
● For some industries (also pharma), operating lease expenses are big and more important.
2b. Adjusting R&D expenses
● Goal: Treat R&D the same as capital expenditures
○ Add value of R&D asset to balance sheet
○ Calculate earnings without subtracting net R&D spending
■ amortization (depreciation of intangible assets) of R&D is similar to
depreciation of tangible asset
● To capitalize R&D investment:
○ specify an amortizable life for R&D (~2 - 10 years)
○ collect past R&D expenses over amortizable life (from past 10-Ks)
○ calculate amount of past R&D that has not yet amortized
○ sum up unamortized past R&D to obtain value of R&D asset
○ calculate amount of past R&D that is amortized in current year
● Adjust operating earnings by adding back current R&D expense, and subtracting amount
amortized in current year
○ also need to add back ignored tax benefit of expensing R&D
Example: Capitalizing R&D Expenses of SAP
In the current year (2016) nothing has been amortized because all the R&D expenses contribute to the
value of the asset as the research is very recent
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, For the exam important to understand what will change in comparison to conventional accounting
You can see that the ROC is lower when you treat R&D as capital expenditure.
You can also see how much a firm reinvests as R&D is treated as capital expenditure.
2c. One-Time and Non-recurring Charges
● A firm reports a loss of $500 million due to a one-time charge of $1 billion. What earnings
would you use in your valuation? A loss of $500 million or a profit of $500 million (i.e.,
ignoring the write-off)? Would your answer be any different if the firm had reported one-time
losses like these once every five years?
● My advice: Ignore losses or gains that actually occur only once, but incorporate recurring
charges. You can subtract average loss over five years from earnings.
2d. Accounting Malfeasance
● Some firms push accounting standards more than others in order to show higher earnings
● You likely cannot catch outright fraud, but look for warning sign in financial statements and
correct for them:
○ Income from unspecified sources, e.g., off-balance-sheet holdings in other businesses
or special purpose vehicles
○ Income from asset sales or financial transactions (for non-financial firm)
○ Sudden changes in standard expense items, e.g., a big drop in SG&A or R&D
expenses as a percentage of revenues
○ Significant changes to asset lifespan used for depreciation
○ Frequent accounting restatements
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