Website: damodaran.com Blog: http://aswathdamodaran.blogspot.com/ Twitter: @AswathDamodaran Email: adamodar@stern.nyu.

edu

THEBERMUDATRIANGLEOF VALUATION: BIAS,UNCERTAINTYANDCOMPLEXITY

AswathDamodaran

TheBermudaTriangleofValuation

Valuation First Principles & Good Sense

Uncertainty & the Unknown

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I.ValuationBias

Preconceptionsandpriors:Whenyoustartonthe valuationofacompany,youalmostneverstartwitha blankslate.Instead,yourvaluationisshapedbyyour priorviewsofthecompanyinquestion.

Corollary1:Themoreyouknowaboutacompany,themore likelyitisthatyouwillbebiased,whenvaluingthecompany. Corollary2:Thecloseryougettothemanagement/ownersof acompany,themorebiasedyourvaluationofthecompanywill become.

Valuefirst,valuationtofollow:Inprinciple,youshould doyourvaluationfirstbeforeyoudecidehowmuchto payforanasset.Inpractice,peopleoftendecidewhatto payanddothevaluationafterwards.

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Sourcesofbias

Thepowerofthesubconscious:Wearehuman,afterall,andasa consequencearesusceptibleto

Herdbehavior:Forinstance,thereisthemarketpricemagnetinvaluation,where estimatesofintrinsicvaluemovetowardsthemarketpricewitheachiteration. Hindsightbias:Ifyouknowtheoutcomeofasequenceofevents,itwillaffectyour valuation.(Thatiswhyteachingvaluationwithcasesisanexerciseinfutility)

Thepowerofsuggestion:Hearingwhatothersthinkacompanyisworth willcoloryourthinking,andifyouviewthoseothersasmore informed/smarterthanyouare,youwillbeinfluencedevenmore. Thepowerofmoney:Ifyouhaveaneconomicstakeintheoutcomeofa valuation,biaswillalmostalwaysfollow.

Corollary1:Yourbiasinavaluationwillbedirectlyproportionaltowhopaysyouto dothevaluationandhowmuchyougetpaid. Corollary2:Youwillbemorebiasedwhenvaluingacompanywhereyoualready haveaposition(longorshort)inthecompany.

Biasing a DCF valuation: A template of "tricks"

If you want higher (lower) value, you can 1. Augment (haircut) earnings 2. Reduce(increase) effective tax rate 3. Ignore (Count in) unconventional cap ex 4. Narrow (Broaden) denition of working capital Free Cashow to Firm EBIT (1- tax rate) - (Cap Ex - Depreciation) - Change in non-cash WC = Free Cashow to rm If you want to increase (decrease) value, you can 1. Use higher (lower) growth rates 2. Assume less (more) reinvestment with the same growth rate, thus raising (lowering) the quality and value of growth.

Expected Growth in FCFF during high growth

If you want to increase (decrease) value, you can 1. Assume a longer (shorter) growth period 2. Assume more (less) excess returns over the growth period Value of Operating Assets today + Cash & non-operating assets - Debt Value of equity If you want to increase (decrease) value, you can add (subtract) premiums (discounts) for things you like (dislike) about the company. Premiums: Control, Synergy, liquidity Discounts: Illiquidity, private company Length of high growth period: PV of FCFF during high Stable Growth When operating income and FCFF grow at constant rate forever. If you want to increase value, you can 1. Use stable growth rates that are economically impossible (higher than the growth rate of the economy) 2. Allow this growth to be accompanied by high positive excess returns (low reinvestment) If you want to decrease value, you can 1. Use lower growth rates in perpetuity 2. Accompany this growth with high negative excess returns

Cost of Capital Weighted average of cost of equity & cost of debt

If you want to increase (decrease) value, you can 1. Assume a higher (lower) debt ratio, with the same costs of debt & equity. You may be able to accomplish this by using book (market) value debt ratios. 2. Use a lower (higher) equity risk premium for equity and a lower (higher) default spread for debt. 3. Find a "lower" ("higher") beta for your stock. 4. Don't add (add) other premiums to the cost of equity (small cap?)

BiasTools1a:TheCashFlowPloy
Item EBIT/ Earnings The unbiasedsolution Removeallextraordinary items&normalizetherest (withearningsgoingupor down)onlyifnecessary. Biasup Remove only extraordinarylosses& normalizetopush earningsup Biasdown Removeonly extraordinary income &normalizetopush earningsdown Usemarginaltaxrate (ifhigherthan effective)forever.

Taxrate

You canstartwiththe Useeffectivetax(if effectivetaxratebut lessthanmarginal) changeovertimetowards forever. marginalrate.

NetCapEx

Countinall investments Ignoreunusual capex Count unusualcapex (R&D,acquisitions)made (acquisitions)while whileignoringgrowth forgrowth&allowforthe countinggrowthin. generated. resultinggrowth. Use historicorindustry averagesofworking capitaltoestimate changes Ignoreworkingcapital or usenegative workingcapitalas sourceofcash. Usechange in workingcapital,ifitis alargedrainoncash flow.

Working Capital

BiasTools1b:TaxMismatching

Unbiased:Ifyourcashflowsareafter(no,corporate,corporate+individual)taxes, yourdiscountratehastoreflect(no,corporate,corporate+individual)taxes
Entitytaxes Notaxes Investor taxes 1. 2. Income taxedat corporate taxrate 1. 2. Income taxedas ordinaryincome Valueappreciation taxedascapitalgains Dividendstaxed when paid Priceappreciation taxedwhenstocksold Valuation approaches 1. 2. Valuepretax incomeatapretaxdiscountrate Valuepostpersonaltaxincomeatpost personaltaxdiscountrate. Valuecashflows,postcorporate butpre personaltaxes,atadiscountratethatispost corporatebutprepersonal. Valuecashflows,postcorporate&post personaltaxes,atadiscountratethatispost corporateandpostpersonal

Entity MLPs,REITs, Partnerships,Sole proprietorships Corporations

1.

2.

Biasup:Usepretax(personal,personal&corporate)whilediscountingatan aftertax(personal,personal&corporate)discountrate. Biasdown:Useaftertaxtax(personal,personal&corporate)whilediscountingat apretax(personal,personal&corporate)discountrate.

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BiasTools2:TheGrowthTrick
Unbiased Scaling upof growth Biasup Biasdown Reducegrowth Continue withhigh Scale downgrowth ratesascompany revenuegrowth,as tooquickly. scalesup,butallow youscaleup. forexceptions. Move towards marginsofmature companiesin industry Enough reinvestmentto allowforgrowth Trends down towardsindustry averageandcostof capital. Move wellabove marginsofmature companiesin industry Noorlittle reinvestment,as growth continues Trendsupaway fromindustry average&costof capital. Move wellbelow typicalmarginsin industry Disproportionately largereinvestment, givengrowth. Trends downbelow theindustry average&costof capital
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TargetOperating Margin

Reinvestment

Imputed ROC

BiasTools3a:TheMacroGame Riskfreerate
Unbiased Normalization Usethecurrent riskfreerate. Bias Up Usetherisk freeratetoday, ifitislow,butreplacewith anaveragerateovertime, ifthecurrentrateishigh. Useariskfreerateina lowerinflationcurrency, withadefaultfree government(butleave cashflowsinlocal currency). BiasDown Usetheaverage rateovertime,if thecurrentrateis loworthecurrent rate,ifitishigh. Usethe governmentbond rateastheriskfree rate.

Government default risk

Remove the defaultriskfrom thegovernment bondratetoget toriskfreerate.

BiasTools3b:EquityRiskPremiums

1928-2012 1962-2012 2002-2012 Arithmetic Average Geometric Average Stocks - T. Bills Stocks - T. Bonds Stocks - T. Bills Stocks - T. Bonds 7.65% 5.88% 5.74% 4.20% 2.20% 2.33% 5.93% 3.91% 4.60% 2.93% 2.38% 2.66% 7.06% 3.08% 5.38% 1.71% 5.82% 8.11%

Historical premium

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Bias Tools 3c: Country Risk

Canada UnitedStates

0.00% 0.00%

5.75% 5.75%

NorthAmerica

0.00%

5.75%

Argentina Belize Bolivia Brazil Chile Colombia CostaRica Ecuador ElSalvador Guatemala Honduras Mexico Nicaragua Panama Paraguay Peru Suriname Uruguay Venezuela

10.13% 14.25% 5.40% 3.00% 1.20% 3.38% 3.38% 12.00% 5.40% 4.13% 8.25% 2.55% 10.13% 3.00% 5.40% 3.00% 5.40% 3.38% 6.75%

15.88% 20.00% 11.15% 8.75% 6.95% 9.13% 9.13% 17.75% 11.15% 9.88% 14.00% 8.30% 15.88% 8.75% 11.15% 8.75% 11.15% 9.13% 12.50%

Andorra Austria Belgium Cyprus Denmark Finland France Germany Greece Iceland Ireland IsleofMan Italy Liechtenstein Luxembourg Malta Netherlands Norway Portugal Spain Sweden Switzerland Turkey UK

1.95% 0.00% 1.20% 16.50% 0.00% 0.00% 0.45% 0.00% 10.13% 3.38% 4.13% 0.00% 3.00% 0.00% 0.00% 1.95% 0.00% 0.00% 5.40% 3.38% 0.00% 0.00% 3.38% 0.45%

7.70% 5.75% 6.95% 22.25% 5.75% 5.75% 6.20% 5.75% 15.88% 9.13% 9.88% 5.75% 8.75% 5.75% 5.75% 7.70% 5.75% 5.75% 11.15% 9.13% 5.75% 5.75% 9.13% 6.20%

W.Europe
Angola Benin Botswana BurkinaFaso Cameroon CapeVerde Egypt Gabon Ghana Kenya Morocco Mozambique Namibia Nigeria Rwanda Senegal SouthAfrica Tunisia Zambia

1,.22%
5.40% 8.25% 1.65% 8.25% 8.25% 6.75% 12.00% 5.40% 6.75% 6.75% 4.13% 6.75% 3.38% 5.40% 8.25% 6.75% 2.55% 4.73% 6.75%

6.97%
11.15% 14.00% 7.40% 14.00% 14.00% 12.50% 17.75% 11.15% 12.50% 12.50% 9.88% 12.50% 9.13% 11.15% 14.00% 12.50% 8.30% 10.48% 12.50%

Albania Armenia Azerbaijan Belarus Bosnia Bulgaria Croatia CzechRepublic Estonia Georgia Hungary Kazakhstan Latvia Lithuania Macedonia Moldova Montenegro Poland Romania Russia Serbia Slovakia Slovenia Uganda Ukraine

6.75% 4.73% 3.38% 10.13% 10.13% 3.00% 4.13% 1.43% 1.43% 5.40% 4.13% 3.00% 3.00% 2.55% 5.40% 10.13% 5.40% 1.65% 3.38% 2.55% 5.40% 1.65% 4.13% 6.75% 10.13%

12.50% 10.48% 9.13% 15.88% 15.88% 8.75% 9.88% 7.18% 7.18% 11.15% 9.88% 8.75% 8.75% 8.30% 11.15% 15.88% 11.15% 7.40% 9.13% 8.30% 11.15% 7.40% 9.88% 12.50% 15.88%

E.Europe/Russia
Bahrain Israel Jordan Kuwait Lebanon Oman Qatar SaudiArabia UAE

3.13%
2.55% 1.43% 6.75% 0.90% 6.75% 1.43% 0.90% 1.20% 0.90%

8.88%
8.30% 7.18% 12.50% 6.65% 12.50% 7.18% 6.65% 6.95% 6.65%

Bangladesh Cambodia China Fiji HongKong India Indonesia Japan Korea Macao Malaysia Mauritius Mongolia Pakistan PapuaNG Philippines Singapore SriLanka Taiwan Thailand Vietnam

5.40% 8.25% 1.20% 6.75% 0.45% 3.38% 3.38% 1.20% 1.20% 1.20% 1.95% 2.55% 6.75% 12.00% 6.75% 4.13% 0.00% 6.75% 1.20% 2.55% 8.25%

11.15% 14.00% 6.95% 12.50% 6.20% 9.13% 9.13% 6.95% 6.95% 6.95% 7.70% 8.30% 12.50% 17.75% 12.50% 9.88% 5.75% 12.50% 6.95% 8.30% 14.00%

Asia

1.77%

7.52%

Australia CookIslands NewZealand

0.00% 6.75% 0.00%

5.75% 12.50% 5.75%

Australia &NZ

0.00%

5.75%

MiddleEast

1.38%

7.13%

LatinAmerica

3.94%

9.69%

Black #: Total ERP Red #: Country risk premium AVG: GDP weighted average

Africa

5.90%

11.65%

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BiasTools3d:Adjustthediscountrate

Unbiased:Ifyoufeelthatyourriskadjustmentmetric(e.g.,Beta)is notcapturingequityriskadequately,thinkaboutbetterwaysof measuringthatrisk. Biasup:Reduceyourdiscountratetoreflectimaginarysavingsor perceivedsafety.

Somevalueinvestorsarguethatthemoretheyknowaboutafirm,the lowertheriskofthefirm,andthatalowerdiscountrate(eventheriskfree rate)canbeused. Inacquisitions,yousometimesseeanalystsreducingdiscountratesto reflecttheriskreductionfromdiversification. Asimplewaytoreduceyourcostofcapitalistoincreasethedebtratio youuse,whilekeepingyourcostofequity&debtfixed.

Biasdown:Addonpremiumstoyourdiscountrate(forsize, liquidity,privatecompanyrisk,survival)topushupyourdiscount rateandpushdownvalue.

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BiasTools4:TerminalValueMagic
Unbiased: Move towards a marginal tax rate Bias up: Leave at effective tax rate Bias down: Use tax rate > marginal tax rate Unbiased: Assume ROIC is equal to or just above cost of capital. RR= g/ROC Bias up: Assume no or very low reinvestment & high ROIC Bias down: Assume ROIC < Cost of capital in perpetuity.

Terminal Value n =

EBITn+1 (1 - tax rate) (1 - Reinvestment Rate) Cost of capital - Expected growth rate Unbiased: g risk free rate Bias up: g > risk free rate Bias down: Depends on ROIC

Unbiased: Move towards mature company WACC Bias up: Move below mature company WACC Bias down: Leave at current WACC (especially if it is high risk company)

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BiasTools5:Fromfirmtoequityvalue
Unbiased Cash Biasup BiasDown Discountthecash substantially, arguing thatitearnsalow rateofreturn. Treatasneutral,unlessthereis Addapremiumtothe evidencethatthemarketis cash,arguingthat it discountingit. makesthecompany safer. Trytoestimate theintrinsic valueoftheseholdings.

Cross holdings

Usebookvalue, Ignore crossholdings. especiallyifhigher thanintrinsicvalue,or letmanagers specify value. Ignoreallotherassets

OtherAssets

Addonthevalueofonlythose Addonassetsthat assets thatarenotcountedin youhavealready yourcashflows. counted inyourcash flows(realestate). Ignore value Addontovalue

Goodwill

Ignore goodwillbut reduceearningsfor impairment. Count inother liabilitiesasdebt. 14

Debt

Includealldebt countedin yourcostofcapital.

Usealowerdebt number thanyou usedincostofcapital.

BiasTools6:Postvaluationgarnishing

Unbiased:Followtheitproposition:Itcanhavevalueonlyifitaffectsthecashflowsof anassetoritsrisk,anditcanbevaluedexplicitly. Biasup:Lookforpremiumstoaddtovalue

Controlpremium:Isitreallyalways20%? Synergypremium:Dontknowwhatitis,butitisworthalot. Liquiditypremium:Ifanassetisliquid,youaddapremium. Minoritydiscount:Ifyougetlessthan50%,youhavetodiscountvalue. Illiquiditydiscount:Ifitisilliquid,youneedtodiscountitsvalue.

Biasdown:Lookfordiscounts

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Facebook IPO: May 17, 2012

This year Last year $ 3,711.00 $ 1,974.00 Revenues Starting numbers $ 1,032.00 Operating inco $1,695.00 Invested Capit $ 4,216.11 $ 694.00 Tax rate 40.00% Operating mar 45.68% Return on cap 146.54% Sales/Capital 88.02%

Revenue growth of 40% a year for 5 years, tapering down to 2% in year 10

Pre-tax operating margin declines to 35% in year 10

Sales to capital ratio of 1.50 for incremental sales

Stable Growth g = 2%; Beta = 1.00; Cost of capital = 8% ROC= 12%; Reinvestment Rate=2%/12% = 16.67% Terminal Value 10 = 7,713/(.08-.02) = 128,546

Operating assets + Cash - Debt Value of equity - Options Value in stock Value/share

62,053 1,512 1,219 62,350 3,088 59,262 $25.39

Year Revenues Operating margin EBIT EBIT (1-t) - Reinvestment FCFF

1 $ 5,195 44.61% $ 2,318 $ 1,391 $ 990 $ 401

2 $ 7,274 43.54% $ 3,167 $ 1,900 $ 1,385 $ 515

3 $ 10,183 42.47% $ 4,325 $ 2,595 $ 1,940 $ 655

4 $ 14,256 41.41% $ 5,903 $ 3,542 $ 2,715 $ 826

5 $ 19,959 40.34% $ 8,051 $ 4,830 $ 3,802 $ 1,029

6 $ 26,425 39.27% $ 10,377 $ 6,226 $ 4,311 $ 1,915

7 $ 32,979 38.20% $ 12,599 $ 7,559 $ 4,369 $ 3,190

8 $ 38,651 37.14% $ 14,353 $ 8,612 $ 3,782 $ 4,830

9 $ 42,362 36.07% $ 15,279 $ 9,167 $ 2,474 $ 6,694

10 $ 43,209 35.00% $ 15,123 $ 9,074 $ 565 $ 8,509

Term yr EBIT (1-t) 9255 - Reinv 1543 FCFF 7713

Cost of capital = 11.19% (.988) + 1.59% (.012) = 11.07%

Cost of capital decreases to 8% from years 6-10

Cost of Equity 11.19%

Cost of Debt (2%+0.65%)(1-.40) = 1.59%

Weights E = 98.8% D = 1.2%

At 4.00 pm, May 17, the offering was priced at $38/share

Riskfree Rate : Riskfree rate = 2%

Beta 1.53

Risk Premium 6%

Unlevered Beta for Sectors: 1.52

D/E=1.21%

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Bias Down: Facebook IPO: May 17, 2012

This year Last year $ 3,711.00 $ 1,974.00 Revenues Starting numbers $ 1,032.00 Operating inco $1,695.00 Invested Capit $ 4,216.11 $ 694.00 Tax rate 40.00% Operating mar 45.68% Return on cap 146.54% Sales/Capital 88.02%

Revenue growth of 40% a year for 5 years, tapering down to 2% in year 10

Pre-tax operating margin drops to 31% over the next 10 years

Sales to capital ratio stays at 0.75

Stable Growth g = 2%; Beta = 1.00; Cost of capital = 8% ROC= 8 %; Reinvestment Rate=2%/20% = 10% Terminal Value 10 = 6,148/(.08-.02) = 102,469

Operating assets + Cash - Debt Value of equity - Options Value in stock Value/share

35,408 1,512 1,219 35,705 3,088 32,616 $13.97

Year Revenues Operating margin EBIT EBIT (1-t) - Reinvestment FCFF

1 $ 5,195 44.21% $ 2,297 $ 1,378 $ 1,979 $ (601)

2 $ 7,274 42.74% $ 3,109 $ 1,865 $ 2,771 $ (906)

3 $ 10,183 41.27% $ 4,203 $ 2,522 $ 3,879 $ (1,358)

4 $ 14,256 39.81% $ 5,675 $ 3,405 $ 5,431 $ (2,026)

5 $ 19,959 38.34% $ 7,652 $ 4,591 $ 7,603 $ (3,012)

6 $ 26,425 36.87% $ 9,743 $ 5,846 $ 8,622 $ (2,776)

7 $ 32,979 35.40% $ 11,675 $ 7,005 $ 8,738 $ (1,733)

8 $ 38,651 33.94% $ 13,116 $ 7,870 $ 7,563 $ 307

9 $ 42,362 32.47% $ 13,754 $ 8,252 $ 4,947 $ 3,305

10 $ 43,209 31.00% $ 13,395 $ 8,037 $ 1,130 $ 6,907

Term yr EBIT (1-t) 8198 - Reinv 2049 FCFF 6148

Cost of capital = 11.19% (.988) + 1.59% (.012) = 11.07%

Cost of capital decreases to 8% from years 6-10

Cost of Equity 11.19%

Cost of Debt (2%+0.65%)(1-.40) = 1.59%

Weights E = 98.8% D = 1.2%

At 4.00 pm, May 17, the offering was priced at $38/share

Riskfree Rate : Riskfree rate = 2%

Beta 1.53

Risk Premium 6%

Unlevered Beta for Sectors: 1.52

D/E=1.21%

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RelativeValuationBias

Choosea multiple

Pick comparable firms Spin/Tell yourstory

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Biastool1a:Pickthemultiple

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BiasTool1b:Pickyourscalingvariable
Twitter: Revenues =$550 m, Users = 230 m, Employees = 1250, EBITDA and Net Income were negative.
Company EV Market Cap EV/Sales EV/EBITDA PE Market Cap/User Market Cap/Employee Facebook, Inc. (NasdaqGS:FB) $100,017 $107,909 16.35 36.20 193.73 $97.22 $20.36 Google Inc. (NasdaqGS:GOOG) $248,856 $296,078 4.46 14.64 25.45 $270.89 $6.61 LinkedIn Corporation (NYSE:LNKD) $28,449 $29,322 22.87 179.26 729.40 $130.32 $6.91 Netlfix $13,959 $14,539 3.54 81.20 304.80 $403.86 $7.11 OpenTable, Inc. (NasdaqGS:OPEN) $1,642 $1,734 9.45 30.35 59.99 $15.34 $3.02 Pandora Media, Inc. (NYSE:P) $4,163 $4,232 7.89 NA NA $21.16 $5.72 RetailMeNot $1,724 $1,715 10.20 34.20 64.96 $147.84 $4.60 Trulia, Inc. (NYSE:TRLA) $1,647 $1,853 17.75 NA NA $59.02 $3.57 Yelp, Inc. (NYSE:YELP) $4,006 $4,103 22.42 NA NA $41.03 $2.67 Zillow, Inc. (NasdaqGS:Z) $3,420 $3,590 22.48 NA NA $78.20 $5.22 Yahoo! Inc. (NasdaqGS:YHOO) $27,263 $29,855 5.65 21.24 7.19 $106.24 $2.55 Groupon $5,857 $7,039 2.42 44.04 NA $168.80 $0.62 Travelzoo Inc. (NasdaqGS:TZOO) $347 $421 2.23 12.81 23.39 $16.20 $0.95 Aggregate $441,350 $502,389 5.82 20.43 30.76 $151.57 $5.96 Median 8.67 32.27 59.99 101.73 4.91 Average 10.97 47.44 159.96 121.98 5.42

If you wanted to show me that Twitter is cheap at $10 billion, which scaling variable would you use? 21

BiasTools1c:Choosethetimingofyourvariable

Unbiased:Noparticularpreferencebutyoustayconsistentwiththat choiceacrosscompaniesandacrosstime. Biasup:Useforwardestimatesforyourcompanywhilestickingwith trailingorcurrentvaluesforthecomparablefirms. Biasdown:Usetrailingorcurrentvaluesforyourcompanywhile projectingforwardvaluesforyourcomparablefirms.

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BiasTool2:Pruneyourcomparablefirms

Unbiased:Havepresetcriteriaforchoosingcomparablefirms,butonce selected,yougenerallydonotprunethatlist.(Evenifyouhaveoutliers, youremovefirmssymmetrically) Biasup:Removethecheapestfirmsinyourcomparablefirmlist,basedon whatevermetricormultipleyouareusinginyourvaluation.. Biasdown:Removethemostexpensivefirmsinyourcomparablefirmlist, basedonwhatevermetricormultipleyouareusinginyourvaluation.

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BiasTools3:Spinyourstory

Unbiased:Onceyouhavethemultiplescomputedforyoursample,you controlfordifferencesinallofthefundamentalvariables,measuringrisk, cashflowsandgrowthbetweenyourfirmandthecomparablefirms. Biasup:Youpickthefundamentalvariablethatyourfirmlooksbetter thanthecomparablefirmsonandignoretherest. Biasdown:Youpickthefundamentalvariablethatyourfirmlooksworse thanthecomparablefirmsonandignoretherest.

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Dealingwithbias:Thebadways

Iamnotacrook:Youdonthavetobecrookedtobebiased.Itis easytodeludeyourselfintobelievingthatyouarejustbeing objective. Iuseonlynumbers:Theeasiestdefenseistoarguethatyouare onlyusingnumbersandthatbiasrequiressubjectivejudgments. Iamaprofessional:Valuationprofessionalspointtothe requirementsoftheirprofessionalgroups(CPA,CFA,CVA,etc.)that theybeunbiased. Itisafairvalue(withmylawyer/accountantsimprimatur):The mostcommonresponsetobiasistoaddlegaloraccountingcover.

Legalfairvalue:Inmostcountries,investmentbankershavetosignalegal documentthattheirvalueisafairvalue. Accountingfairvalue:Accountantshavejumpedintothemixandhaveset upstandardsforfairvalue.

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Healthyresponsestobias
1.

2.

3.

4.

Buildprocessesthatminimizebias,notmaximizeit:Tothedegreethata significantportionofbiascomesfromreward/punishmentmechanisms, weneedtobuildprocessesthatdisassociatethevaluationoutcome fromcompensation. Behonest(atleastwithyourself):Evenifyoumaynotwanttoreveal yourbiasestoyourclients,youshouldatleastbehonestwithyourself. Bayesianvaluation:Itmaybeagoodideatorequireanyonevaluinga companytostatewhattheybelievethattheywillfindinthevaluation, beforetheyactuallydothevaluation.Anyoneusingthevaluation shouldthenhaveaccesstoboththeanalystspriorsandthevaluation. Transparencyaboutmotives:Allvaluationsshouldbeaccompaniedwith fulldetailsofwhoispayingforthevaluationandhowmuch,aswellas anyotherstakesintheoutcomeofthevaluation.

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II.ValuationUncertainty

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Thesourcesofuncertainty

EstimationversusEconomicuncertainty

Estimationuncertaintyreflectsthepossibilitythatyoucouldhavethewrong modelorestimatedinputsincorrectlywithinthismodel. Economicuncertaintycomesthefactthatmarketsandeconomiescanchangeover timeandthateventhebestmodelswillfailtocapturetheseunexpectedchanges. Microuncertaintyreferstouncertaintyaboutthepotentialmarketforafirms products,thecompetitionitwillfaceandthequalityofitsmanagementteam. Macrouncertaintyreflectstherealitythatyourfirmsfortunescanbeaffectedby changesinthemacroeconomicenvironment. Discreterisk:Risksthatliedormantforperiodsbutshowupatpointsintime. (Examples:AdrugworkingitswaythroughtheFDApipelinemayfailatsomestage oftheapprovalprocessoracompanyinVenezuelamaybenationalized) Continuousrisk:Riskschangesininterestratesoreconomicgrowthoccur continuouslyandaffectvalueastheyhappen.

MicrouncertaintyversusMacrouncertainty

Discreteversuscontinuousuncertainty

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Unhealthywaysofdealingwithuncertainty
1.

2.

3.

4.

Paralysis&Denial:Whenfacedwithuncertainty,someofusget paralyzed.Accompanyingtheparalysisisthehopethatifyou closeyoureyestoit,theuncertaintywillgoaway Mentalshortcuts(rulesofthumb):Behavioraleconomistsnote thatinvestorsfacedwithuncertaintyadoptmentalshortcutsthat havenobasisinreality.Andhereistheclincher.Moreintelligent peoplearemorelikelytobepronetothis. Herding:Whenindoubt,itissafesttogowiththecrowd.The herdinginstinctisdeeplyengrainedandverydifficulttofight. Outsourcing:Assumingthatthereareexpertsouttherewhohave theanswersdoestakeaweightoffyourshoulders,evenifthose expertshavenoideaofwhattheyaretalkingabout.

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Healthyresponsestouncertainty
1. 2. 3. 4.

5.

6.

Lessismore. Buildininternalchecksonreasonableness. Dontsweatthediscountrate Usetheoffsettingprinciple(riskfreerates& inflationatTataMotors) Drawoneconomicfirstprinciples(Terminalvalue atallthecompanies) Confrontuncertainty,ifyoucan.

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1.Lessismore Revenues&MarginsforTwitter,preIPO
Put intermediate numbers on autopilot
Year Base 1 2 3 4 5 6 7 8 9 10 TY 51.50% 51.50% 51.50% 51.50% 51.50% 41.70% 31.90% 22.10% 12.30% 2.50% 2.50% Revenue growth rate Revenues $534.46 $809.71 $1,226.71 $1,858.47 $2,815.58 $4,265.60 $6,044.35 $7,972.50 $9,734.43 $10,931.76 $11,205.05 $11,485.18 Operating Margin 1.44% 3.79% 6.15% 8.50% 10.86% 13.22% 15.57% 17.93% 20.29% 22.64% 25.00% 25.00% EBIT $7.67 $30.70 $75.42 $158.06 $305.81 $563.82 $941.36 $1,429.53 $1,974.84 $2,475.34 $2,801.26 $2,871.29 $30.70 $75.42 $158.06 $294.22 $394.67 $648.60 $969.22 $1,317.22 $1,623.82 $1,806.81 $1,851.99 EBIT (1-t)

The NOLs are embedded in the taxes and cash flows.

Be parsimonious: Estimate the big numbers (revenues and margin in year 10)

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RevenueJudgment:Theexistingplayers

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TheTotalAdvertisingMarketin2013

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TheOnlineAdmarketin2023

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Andmarginjudgments

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2.Buildininternalchecks ReinvestmentandReturnonCapital

Comfortable with ROC = 22.39% in year 10? - Check against cost of capital - Check against industry average 40

SalestoInvestedCapital

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3.Dontsweatoverthediscountrate: Twitterscostofcapital

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4.Justbeconsistentonmacrovariables TataMotors:InRupeesandUSdollars

(1.125)*(1.01/1.04)-1 = .0925

Equity versus Firm: If cash flows are post-debt and to equity, you should discount at the cost of equity. Pre-debt cash flows should be discounted at the cost of capital.

Currency: The currency in which the cash flows are estimated should also be the currency in which the discount rate is estimated.

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5.DrawonEcon101andMath101; Theterminalvaluelimits
Stablegrowthrate 0% 1% 2% 3% 4% 5% Riskfreerate ROIC Costofcapital 3.72% 6.76% 6.76% 3M $70,409 $70,409 $70,409 $70,409 TataMotors 435,686 435,686 435,686 435,686 435,686 435,686 5% 10.39% 10.39% Amazon $26,390 $28,263 $30,595 $33,594 $37,618 $43,334 $52,148 6.60% 20% 9.61% 2.70% 12.00% 8.00% Twitter $23,111 $24,212 $25,679

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Andthemarketsharecannot>100%

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6.Confrontuncertainty,ifyoucan RevisitingtheTwittervaluation

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Withtheconsequencesforequityvalue

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III.Complexityinvaluation

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Sourcesofcomplexity

Globalization:Ascompaniesglobalize,valuationsaregetting morecomplexforanumberofreasons:

Riskassessmenthastofactorinwhereacompanyoperatesandnot whereitisincorporated. Currencychoicesproliferate,sinceacompanycanbevaluedinanyofa halfadozencurrencies(oftentovaluedifferentlistings)

Shiftingandvolatilemacroeconomicriskshavecreated changingriskpremiumsandstrangeinterestrate/exchange rateenvironments. Morecomplexaccountingstandardshavecreatedlonger, morecomplicated,moredifficulttoreadfinancialstatements. Morecomplicatedholdingstructures(crossholdings,shares withdifferentvotingrights),motivatedbytaxandcontrol reasons,makevaluationsmoredifficult.

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Manifestationsofcomplexity
1.

2.

3.

Mysteriousterms/acronyms:Afeatureofcomplex valuationislineitemsortermsthatsound sophisticatedbutyoudonotknoworarenotsure whattheymeanormeasure.(Foranaddedlayerof intimidation,makethemGreekalphabets) Longer,moredetailedvaluations:Thelevelofdetail thatyouseeinvaluations,withhundredsoflineitems anddozensofinputs,isstaggering(andscary). Whatifandscenarioanalysis:Whilethereisaplacefor askingwhatifquestionsandscenarioanalysisin valuation,theeasewithwhichitcanbedonehas openedthedoortoabuse,withtheprimaryobjective becomingcover,nomatterwhathappens.
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Unhealthyresponsestocomplexity
1.

2.

3.

Inputfatigue:Analystswhoarecalledupontoestimate dozensanddozensofinputs,oftenwithlittleinformationto doso,willgiveupatsomepointandinputnumbersjust togetdone.Itisgarbagein,garbageout Blackboxmodels:Themodelsbecomesocomplicatedthat whathappensinsidethemodelbecomesamysterytothose outside.Consequently,analystsessentiallyclaimno ownershiporresponsibilityfortheoutputfromthemodel. Themodeldiditbecomestherefrain. Suspensionofcommonsense:Thedependenceonmodels becomessocompletethatanalystslosesightofcommon senseandmanglethevaluationofthesimplestassets.
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Healthyresponsestocomplexity
1.

2.

3.

Parsimoniousvaluations:Neverestimatemoreinputs thanyouabsolutelyhaveto.Lessismore.Whenfaced withthequestionofaddingmoredetail/complexity, askyourselfwhetheritwillmakeyourvaluationmore precise(orjustmakeitlookmoreprecise). Gobacktofirstprinciples:Thefundamentalsof valuationdontchange,justbecauseyouarefacedwith complexity.Alwaysfallbackonfirstprinciples. Focusonkeylevers:Evenwhentherearedozensof inputsinavaluation,thevaluationitselfisafunctionof threeorfourkeyvaluedrivers(whichmaybedifferent fordifferentcompanies).Keepyourfocusonthose variables
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Inclosing

Theproblemwithvaluationpracticeisnotthatwedo nothaveaccesstoenoughdataorthatourmodelsare notgoodenoughorthatwedontunderstandvaluation. Theperilstogoodvaluationlieinthreeveryhuman failings:

Wearebiasedandwedontliketoadmitwearebiased.Instead, wedeludeourselvesintobelievingthatwearebeingfairand objective. Wefearuncertaintyandtrytoevadeitorhidefromit. Wethinkthatbiggerandmoresophisticatedmodelswillmake thebigchoicesforusandspareusthepainofhavingtodoit ourselves.

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