Session 1: Introduction to Valuation

Valuation is inherently simple, yet it often appears complex due to an overemphasis on models and numbers. A credible valuation uncovers a compelling narrative behind the figures, revealing the true financial story. Pitfalls in valuation typically arise from biased thinking, uncertainty in assumptions, and unnecessary complexity that obscures the underlying simplicity.

The goal is to master the skill of asset valuation across various businesses with clear, objective analysis. Many professionals perform valuations merely as a procedural task, lacking the genuine belief in disciplined methods. A vivid analogy compares irrational group behavior to lemmings, where following the crowd distorts realistic estimates by inflating growth and cash flow projections, highlighting the need for rigorous, independent evaluation.

Investor Herding and the Lifesaving Role of Valuation Investor behavior is depicted through vivid analogies that separate momentum followers from risk-taking contrarians, highlighting the pitfalls of blindly joining market trends. Some investors join the momentum without critical thought while others try to outsmart the crowd at the last minute, courting danger. A rational approach to valuation is presented as a life vest that slows the decision process and counteracts impulsive, herd-driven actions.

Preconceived Bias and Its Impact on Valuation Valuation is shown to be inherently flawed when preconceptions shaped by prior knowledge dictate the perceived value of a company. Familiarity with a company strengthens these preconceived notions, which in turn skew the outcome of the valuation process. The source of the valuation and the entity commissioning it can further bias results to support a pre-determined aim. This dynamic underscores the challenges in achieving an unbiased, objective assessment of true value.

Valuation is not a precise science, as numerical models rely on estimates that forecast the future with inherent uncertainty. Numbers serve as projections rather than absolute truths, making discomfort with these estimates an expected part of the process. When evaluating technology companies with high growth potential, the inability to reach complete certainty signals the opportunity for significant rewards. Embracing this discomfort transforms it into a guide for discovering undervalued prospects.

Complex valuation models can become counterproductive when they evolve into inscrutable black boxes and suffer from input fatigue. Relying on a few well-chosen inputs instead of an overload of assumptions ensures that the outputs remain reliable and manageable. Business valuation methods boil down to assessing fundamentals such as cash flows, growth, and risk through intrinsic approaches, or comparing similar assets using market multiples. Maintaining a parsimonious approach highlights that less is often more when accurately gauging a company's value.

Companies are typically assessed by comparing them with peers or simply evaluating if they are cheap or expensive, but a more advanced method uses option pricing models. These models are applied to assets with contingent cash flows, meaning the asset only holds value if certain conditions are met, such as FDA approval for a biotech patent or a surge in oil prices for undeveloped reserves. Each valuation approach rests on the belief that markets are imperfect and prone to mistakes, leading to different assumptions that justify uncovering intrinsic value beyond market price.

Intrinsic and Relative Valuation Fundamentals Discounted cash flow valuation calculates an asset’s intrinsic value by determining the present value of its expected cash flows, using cash flows, a discount rate, and the asset's lifetime as key ingredients. It assumes that market mispricing exists and requires a long-term horizon for corrections to materialize. Relative valuation, on the other hand, compares an asset's price against similar investments using multiples like earnings or book value while controlling for differences in growth, risk, and cash flows. This approach banks on market efficiency at an aggregate level even when individual companies are mispriced.

Option-Based Valuation for Assets with Contingent Payoffs Option pricing models are applied to value assets that exhibit option-like characteristics, including contingent payoffs, dependence on an underlying asset, and a finite life. This method finds use in natural resource companies with undeveloped reserves, technology or biotech firms holding unproven patents, and distressed companies where equity behaves like an option. It harnesses the flexibility and potential embedded within these assets to assess value under conditions of uncertainty.