Valuations : The Final Destination

[Equity Section]

I'll discuss the topic of Valuation in breaks as its a huge topic to cover.

I'll use Benjamin Graham's most famous words that Investment is most intelligent when its most business-like. Ideally, an investment makes sense when you don't pay more than the worth for an asset, in fact, less is welcome. But, often, in stock markets, this rule is flouted leading to bubbles. History has been full of such bubbles starting from tulip bubble in Amsterdam to housing bubble in 2008 in USA.

Now, question arises that why do we make investments.One makes an investment in expectation that it'll generate future cash-flows. So, one shall pay attention to the prediction of future cash-flows while making investments.

There're two extreme views of the valuation process - one, that Valuation, if done in a strict scientific way has little room for error. Second is that Valuation is an art and that analysts can manipulate to get whatever results they want. But, the truth lies in between the two. Even if strictly scientific, there's ample space for the the analyst's bias because of the uncertainty the analyst faces when it comes to predicting things.

[Equity Section]

Bias can start from the inputs which we use for evaluating companies. Inputs are often based on assumptions and assumptions can be either pessimistic or optimistic. And the end result at which we'll arrive will reflect the pessimistic or optimistic assumption. For example, for a company which has high operating margins, one view can be that competition will creep in and its margins'll fall. This is pessimistic assumption. Another view will be that it will continue its growth trajectory as it is. This is optimistic assumption.

Also, most of the times, even after achieving neutral value estimates, in bull run periods, analysts tend to justify higher prices and are ready to give premiums. Similarly, in bear periods, they again justify lower prices than their estimates and ignore the discounts.

[Equity Section]

To come at the correct price i.e. the correct Valuation, is an ideal situation. Even the best valuations come with substantial space for errors. Also, Valuations are not static. They hold true for only that point of time and it gets affected over the course of time with new information pouring in regarding a particular business. Thus, an analyst must give himself reasonable room for error while arriving at valuations.

[Equity Section]

There are quiet a few approaches to valuation : Discounted Cash Flow valuation, Relative Valuation & Contingent Claim Valuation.

Discounted Cash Flow Valuation : As per this valuation, we buy assets in the expectation that they'll generate future cash flows. So, the value of an asset is not its present worth. The value of an asset is the function of the expected cash flows on that asset.

[neha]

One thing I'll like to quote is why suddenly the conversation has been stopped by you.....It was shaping into a brilliant argument. I have read Aswath & I must say that bulk of it has been squeezed from there......I'll really love you to continue further the Valuation thing....

[Equity Section]

Yes..you're corect about Aswath Damodaran

Nov 10, 2011 16:12:54 GMT 5.5 neha said:

One thing I'll like to quote is why suddenly the conversation has been stopped by you.....It was shaping into a brilliant argument. I have read Aswath & I must say that bulk of it has been squeezed from there......I'll really love you to continue further the Valuation thing....

[A. D. Sharma]

This section needs to be carried forward...It can become a very strong section here.....