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Intro
1. Basic themes in valuation
a. Not just about numbers/models, narratives/stories
b. Simple, we chose to make it complex
2. Why valuations go bad
a. Preconceptions/biases about value. Be honest about
biases
b. Unhealthy responses to uncertainty. Confront
uncertainty
c. Complexity (in models, in data). Keep it simple
3. Three approaches to valuation
a. Intrinsic: Value an asset based on its characteristics
and there are only three: cash flows, growth and risk
b. Relative: Value an asset based on how similar assets
are priced
c. Contingent Claim valuation: Value an asset, whose
cash flows are contingent on something happening.
VALUATION IS SIMPLE AND THE APPROACHES ARE CLEARLY
LAID OUT. THE BIGGEST ENEMIES OF VALUATION ARE WITHIN
EACH OF US: HOW MUCH BIAS WE BRING INTO THE
VALUATION, HOW WE DEAL WITH UNCERTAINTY AND WHAT
EFFECT COMPLEXITY HAS ON US.
1. Essence of intrinsic value: Look at the characteristics of an
asset to value it, rather than look at the outside.
2. DCF is a tool for estimating intrinsic value, but not the only
one
3. In DCF, the value of an asset is the PV of expected cash
flows, with the risk adjustment showing up either as lower
cash flows or a higher discount rate
4. In valuing a business, there are two ways you can
approach DCF. You can where blinders and focus on just
the equity investors, look at their cash flows and discount
at a rate of return that reflects their risk or you can value
the entire business, discounting collective cash flows to
both debt and equity investors at a composite discount
rate.
5. Ultimately, when you strip a DCF model down, all of the
inputs can be categorized into four groups: (a) cash flows
from existing assets, (b) the growth in these cash flows, (c)
the risk in these cash flows and (d) closure assumptions.
To value any asset, especially one with risk associated with it,
you need to be able to answer a fundamental question: how
much return can you expect to make on a guaranteed
investment? That is the risk free rate and it is always easy or
simple to estimate.

For an investment to be risk free, there can be no default risk

in the investment. While we tend to use government bond
rates as risk free, that is built on the presumption that
governments are default free.
But what if they are not? We need to be able to strip out the
default risk to get to a risk free rate and understand why risk
free rates are different in different currencies.
Assume that you can make 2% risklessly on your existing
investment? How much more would I need to offer you to
move your money into stocks? The answer to that question is
the equity risk premium and it will vary among investors,
because they have different risk aversion, and across time,
because the risk you see in equities will change over time.
Estimating this time varying ERP is a challenge. Some people
use historical premiums, but stock returns are very noisy.
You need a forward looking, dynamic number that changes as
the market changes and you also need a way of extending the
approach to younger, emerging markets where there may not
be much historical data. Ultimately, if you use too low or too
high an ERP, you are going to bias your valuations.
Assume that you have a risk free rate and have estimated
what you would demand as a premium for an average risk
investment. To value a risky asset, you now need to make one
final extension and estimate how risky that asset is relative to
the average. That is the role played by beta. While modern
portfolio theory argues for a beta estimated by looking at how
an asset (stock) moves with the market, thinking of beta in
statistical terms misses the mark. If you truly dislike beta,
there are alternative approaches that are based upon
accounting numbers or even qualitative judgments that can
take that place.
Risk free rate, ERP and beta all feed into an estimate of cost
of equity, i.e, what it costs you to raise equity to finance a
business. The other source of financing is debt and there are
two questions that you need to address:
(a) What is debt? First, not everything that accountants
classify as liabilities is debt. Second, not everything that is
debt shows up as a liability on the balance sheet
(b) The cost of debt is not the rate at which you borrowed
money in the past.
Once you have a cost of debt, you can then bring it together
with the cost of equity and the appropriate weights to get to
a cost of capital, which is the overall cost of funding the
business.
While analysts spend the bulk of the time estimating and
finessing discount rates, they miss a key truth, which is that

the big mistakes in valuation are on the cash flows, not the
discount rates. Estimating cash flows is a four step process,
starting with fine tuning earnings to make sure that they
measure what they are supposed to, netting out the right
amount in taxes, subtracting out what you need to reinvest to
grow and if you are estimating cash flows to equity investors,
incorporating the cash flows to or from debt.
When estimating cash flows for last year, you have a crutch of
accounting statements. When estimating growth for the
future, you should start getting uncomfortable because I am
asking you to play God. There are generically three ways of
estimating growth. One is to look at past growth and
extrapolate. The second is to outsource the estimate and use
those made by analysts and managers. The third is to tie the
growth estimate to fundamentals of the firm: how much and
how well it reinvests. If you are doing intrinsic valuation, I see
the third way as the most consistent.