Myths and Approaches to Valuation

Myth 1: A valuation is an objective search for “true” value

This is an absolute lie. All valuations are biased. The only questions are “how much” and in which direction. A basic example would be a person who prefers Apple products over other brands. He will be biased towards telling the real value of that Apple product. Psychology has a lot to play when you are doing valuation. Not just that, the direction and magnitude of the bias in your valuation is directly proportional to who pays you and how much you are paid. We all are human and we are susceptible to herd behaviour. For instance, there is the “market price” magnet in valuation, you will observe that your estimated value will always move towards the market price with every iteration.

Myth 2: A good valuation provides a precise estimate of value.

There are no precise valuations. The payoff to valuation is greatest when valuation is least precise. One should prefer to be imprecisely right than be precisely wrong because one can’t make money being precisely wrong.

Myth 3: The more quantitative a model, the better the valuation

Your understanding of a valuation model is inversely proportional to the number of inputs required for the model. Simpler valuation models do much better than complex ones. As I said earlier, valuation is a blend of a good story and numbers.

Approaches to Valuation

1. Intrinsic Valuation relates the value of an asset to its capacity to generate cash flows and the risk in these cash flows. In its most common form, intrinsic value is computed with a discounted cash flow valuation, with the value of an asset being the present value of expected future cash flows on that asset.
2. Relative Valuation or Pricing estimates how much to pay for an asset by looking at what others are paying for ‘comparable’ assets, scaled to a common metric that they all share(earnings, revenues, subscribers). The “value” of any asset can be estimated by looking at how the market prices “similar” or ‘comparable” assets. The intrinsic value of an asset is impossible (or close to impossible) to estimate. The price of an asset is whatever the market is willing to pay for it (based upon its characteristics).
3. Contingent claim (or real option) valuation, augments the value of assets, whose cash flows are contingent on an event happening.