The Hindu Business Line : Escaping the clutches of valuation myths

Valuation is a tricky subject, and successful investors escape the associated myths to generate immense wealth for themselves and the community at large.

Equity investing, in its simplest avatar, is about understanding businesses, valuing them and then figuring out which ones are available at a price substantially lower than their intrinsic value. The essence of successful investing is to appreciate that the former is the collective opinion of market participants and the latter, an individualistic view.

Institutional investors, retail investors, speculators, traders and the like vote with their money in the market by either buying or selling stocks, thereby determining the stock's price at that time. This is essentially the `price discovery' mechanism in action. At the same time, each participant has a view on the value of the business which is arrived at independently using various valuation techniques, the more popular of them being discounted cash flow (DCF), relative valuation, sum of parts, etc. Value, it can be said, lies in the eye of the beholder.

A simplistic view of the market is to view it like a game and ask yourself: "Should I play this game and wager real money even if I don't completely understand the workings of the game?" I'm sure the answer is a resounding `NO'. I view investors who lack a firm sense of valuation and investing discipline as having answered `Yes'. Wise investors, on the other hand, have a firm grasp of the market's mechanism and are conscious of their knowledge or the lack of it. This is essentially what differentiates the men from the boys.

The stock market is a platform where investors come with different strategies and views and participate in a market-making mechanism that results in fluctuating prices that we see on an ongoing basis.

Valuation, the fulcrum of it all, is a tricky subject and one where you can spend a lifetime grappling with issues and still not claim to know all that is to be known. Let's focus today on a few myths that surround the holy grail of valuation.

Valuation myths

The first notion I'd like shattered is that valuation is an "objective search for true value". Nothing can be far from the truth. Any analyst will tell you the kind of subjective inputs he has to deal with when using any of the techniques mentioned above, more so if they use the most popular DCF. The truth is that all valuations are biased and the only question is how much and in what direction.

We live in a real world and it is but obvious that the bias in any valuation is determined by who pays the analyst and how much. If you are a sell-side analyst, chances are that your performance is measured by the commission dollars your recommendation earns for the firm. If you are an entrepreneur, you want to have as high a valuation as you can justify. If you are a venture capital or private equity investor, you would want to demonstrate as low a valuation as possible.

This is followed by an even more ridiculous notion that a detailed valuation exercise provides us a "precise estimate of value". Given the subjective nature of assumptions required to complete a valuation exercise, we would be stretching our imagination a lot if we expect any precise answer to result.

I've seen seasoned investors who understand this and use valuation models only as a guide and I've met novices who are ruled by their models and fail to grasp this and want a single magical number to result from their efforts. Every time I see a research report with a target price, I pity investors who'd treat that number as sacrosanct.

The next one that I hear commonly is "more quantitative a model, better the valuation". MS Excel is the wonder drug in the world of valuations. I've seen models run into numerous sheets and each sheet would be hundreds of rows and columns. My view on this is that a highly quantitative model implies a greater number of assumptions.

Any layman would agree that the more assumptions we make, higher the amount of error that creeps into our valuation. I think it will be a big help to the world at large, if analysts narrow down on a few key parameters required to value a business and focus all their energies in getting them right, to the extent possible, than trying to estimate a host of parameters which they have no way of being masters of.

While I'm advocating that simpler models do a much better job then complex ones, one must bear in mind the pitfall of over-simplification. As Einstein said, "Things should be as simple as possible, but no simpler."

Last, but not the least, is the belief that "well-researched and well-done valuation is timeless". We live in a world dynamically changing so fast it would outstrip your most vivid imagination. Nothing is static and timeless including our valuation models. We have to continuously keep abreast of various changes taking place anywhere on this planet and update our models to reflect the expected reality incorporating the impact of these changes. Successful investors smartly slip from the clutches of these myths and generate immense wealth for themselves and the community at large. Warren Buffett is a good example of that and the billions of dollars of charity he does is its testimony. Happy Investing!!

(The author is with Emerging Markets Group of Franklin Templeton Investments. The views are personal.)

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