To Buy, sell or hold is at heart of any valution process. Trying to find the diferrent between market price and intrinsic value at the end of the research process is the aim of any investment process. At the end, numbers and the story need to make the securitie a buy, sell or hold. I will try to sumarize the well-know book “The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit” by Aswath Damodaran. Notes: chapter 1, 2 and 3.
Notes Chapter 1:
- You buy a financial assets for the cash flows that you expect to receive in the future (dividends).
- Two approaches to valuation: intrinsic and relative.
- Intrinsic: is determined by the cash flows you expect that asset to generate over its life and how uncertantain (sometimes called RISK) you feel about these cash flows.
- Relative: assets are valued by looking at how the market prices similar aassets (“peer group”). Quite useful for real state purposes.
- Relative’s example: Exxon Mobil will be viewed as a stock to buy if it is trading at 8 times earning while other oil companies trade at 12 earning.
- There is a role for valuation at every stage of a firm’s life cycle.
- Some truths about valuation:
- All valuations are biased
- Most valuations (even good ones) are wrong. Reasons:
- Raw information into forecasts–> estimation error.
- Uncertainty.
- Simpler can be better.
Notes Chapter 2:
- Time is money. Finance 101, present value vs future value. Do you prefer a dollar today or next year? Three reasons why a cash flow in the future is worth less than a similar cash flow today:
- People prefer consuming today instead of consume in the future.
- Inflation decreases the purchasing power of cash over time.
- A promised cash flow in the future may not be delivered. RISK!
- Discounting future value, discounting rate, real return, expected inflation and premium interest.
- Simple cash flow: CF in the future / (1+ discount rate) ^ time period.
- Annuity : constant casf flow that occurs at regular intervals for a fixed period of time. Annual cash flow ((1 – 1/(1+discount rate) ^numbers of periods)/ discount rate)
- Example: You can buy a car, $10,000, cash down or paying installments of $3,000 a year, for 5 years. Discount rate: 12%. $3,000((1-1/(1.12)^5/12%) = $10,814. The economical option is to pay the car today instead of paying installments.
- Growing annuity: cash flow that grows that grows at a constant rate for a specified period of time.
- Example: You have the rights to a gold mine that generated $1.5 million in cash flos last year. For the next 20 years, 3% a year and a discount rate of 10% to reflect your uncertainty. Cash flow*(1+g)[1- (1+g)^n/(1+r)^n / (r-g)]
- Perpetuity: is a constant cash flo at regular intervals forever. Cash flow / discount rate.
- Growing perpetuity: is a cash flow that is expected to grow at a constrant rate forever. Expected cash flow next year / (discount rate – Expected growth rate)
- Risk: diversification, CAPM…the risk of any asset then becomes the risk added to this “market portfolio”, which is measured with a beta. Beta is a relative risk measure and it is standardized around one. Beta > 1 = more exposed to market risk than the average stock (market). Expected return on the investment = Risk Free rate + Beta.
- CAPM is based on unrealistic assumptions.
- Alternatives: multi-beta models and proxy models.
- All these models are flawed:
- risk matters:
- some investments are riskier than others:
- the price of risk affects value
- Accounting 101:
- Balance sheet
- Income Statement
- Cash flow statement
- Fixed and LT assets: value = originally paid for the asset (historical cost) and reduce that value for the aging of the asset (depreciation or amortization).
- ST assets: amenable to the use of an updated or market value.
- To principles underlie the measurement of accounting earnings and profitablity.
- 1st, accrual accounting: the revenue from selling a good or service is recognized in the period in which the good is sold or the service is performed, same for expenses.
- 2nd, is the categorization of expenses into operating, financing, and capital expenses.
- Operating margin = operating income / sales
- Net marging = Net income / sales
- Capital invested in the firm = Book value ( debt and equity, net of cash, and marketable securities.
- After- tax ROC = (operating income (1-tax rate) / BV of debt + BV of equity – Cash
- ROE = Net Income / BV of common equity
- Financial BS vs Accounting BS
Notes Chapter 3:
- Determining intrinsic value. DCF: discount expected cash flow at a risk-adjusted rate.
- Valuing a company: value the entire BUSINESS or just the EQUITY.
- Assets in place + growth assets = value of business–> to value the entire business, discount the casf flows before debt payments (cash flow to the firm) by overall cost of financing, including both debt and equity (cost of capital).
- Assets in place + growth assets = value of business – Debt = VALUE OF EQUITY.
- Inputs to intrinsic valuation:
- cash flow from existing assets
- expected growth in these cash flows for a forecast period
- cost of financing the assets
- estimate of what the firm will be worth at the end of the forecast period
- Cash flows: dividends paid or stock buybacks. Augmented dividends = dividends + stock buybacks.
- Free Cash Flow to Equity = the cash left over after taxes, reinvestment needs, and debt cash flows have been met.
- Free Cash Flow to Firm = After-tax operating income – (Net Capital expenditures + Change in non-cash orking capital).
- Reinvestment rate = (Net Capital expenditure + Change in non-cash WC) / after-tax operating income
- FCFF = After-tax operating income (1- Reinvestment rate).
- Risk:
- Business: risk in firm’s operations
- Equity: at the risk in the equity investment in this business
- Risk captured in the cost of capital.
- Cost of equity: a risk-free and a price for risk to use across all investments, as well as a measure of relative risk:
- Risk-free rate.
- Equity risk remium.
- Relative risk or beta.
- Cost of equity = RFR + Beta * ERP
- Interest coverage ratio = Operating income / Interest expenses
- Terminal value: to ays of estimating terminal value are to estimate a liquidation value for the assets of the firm or to estimate a going concern value.
- Terminal value in year n = Cash Flow in year (n + 1) / Discount rate – perpetual growth rate
- Three constraints that shold be imosed on its estimation:
- No firm can grow forever at a rate higher than the growth rate of the economy in which it operates.
- Firms move from high growth to stable growth,
- Discounted dividends or free cash flows to equity on a per-share bassi at the cost of equity:
- add back the cash balance of the firm
- adjust for cross holding
- subtract other potential liabilities
- subtract the value of management options
- Market price vs value:
- You have made erroneous or unrealistic assumptions about a company’s future groth potential or riskiness
- That you have made incorrect assessments of risk premiums for the entire market
- The market price is rong and that you are right in your value assessment.
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