THE TRUTH BEHIND VALUATIONS -

Valuation by definition is –

“The process of deriving the intrinsic value of any asset “

Be it a stock, bond, business, a machine or real estate – all of these assets have an intrinsic value. The intrinsic value comes from the ability of these assets to generate future cash flows.

“The intrinsic value of any asset is defined as what any investor with having all the possible information relating to that asset would be willing to pay for it. “

Let’s ask some questions –

Who has all the information about a business?

The management of a company technically should have spent the maximum amount of time in the business. The management knows the business's customers, suppliers, employees and itself. So, if anyone were to know the intrinsic value – our most likely candidate is the management of the company itself.

Does the management know the intrinsic value?

If the management was to know the intrinsic value of their company, then in theory they should never make any wrong decisions relating to the business. All the businesses should be performing at their absolute best in that case.

But as we all know that it’s not the case. Managements make mistakes all the time. There is enough evidence of a management taking unsuitable debt, unsuitable growth strategies, hiring unsuitable employees all of which affect the stability of the business.

So it is very logical to comment that even after being ahead of everyone in the market it’s impossible even for the internal corporate finance teams to always derive the perfect intrinsic value of each and every decision.

What’s the reason behind these biased valuations and decisions?

A business cannot be done in an isolated environment. Businesses interact with all kinds of other businesses, consumers and the government. Even the management, regardless of the best quality information about their own businesses would not have the best quality of information of the other businesses they interact with.

The management would know the economics of their own business very well and still might miserably fail because of lack of information on politics, government policies, their supplier’s business etc. In the end valuations are just a result of the best guesses made by a large consensus of people .

So what can be said about Valuation then?

“ ALL VALUATIONS ARE BIASED “

You almost never start valuing a company or stock with a blank slate. Almost every time when we start evaluating a company, our views are formed way before we have started inputting the numbers in our models and metrics.

And it doesn’t take a genius to now know that these are going to be reflecting all our biases.

The Bias in the process start with the companies you choose to value. These choices are not random by nature. Maybe you read something, maybe you heard someone talking, maybe you watched a video or maybe you observed consumer behaviour.

This bias then continues when you start collecting data for the valuation process. The annual reports are designed to put the best possible spin to the actual numbers; management discussion will always also be highly biased.

The data that you might get from secondary sources might be best estimates and not factual. If you look at other analyst’s valuation you have already most probably doubled your biases.

Equity research professionals issue more buy than sell recommendations because they need to maintain good relations with the companies that are paying them. In a market like India where most portfolios are long only and the incentives of these professional depends on going long on undervalued stock might further push the valuations down.

There is also post valuation garnishing where you increase these valuations for the impossible to measurable good and bad stuff like synergies or liquidity risk.

Why do the valuations despite all these biases?

Business is just so much more than numbers. It is the people who make these numbers and not the numbers that have made these people. Valuations are not your absolute decision making tools. Valuation according to me is just the process to ask more relevant questions and to come at not the most precise but to come at more accurate conclusions.

Valuation is not a one time activity. It needs to keep happening again and again. It needs to be tweaked again and again. We don’t need an absolute answer but rather just the direction towards a right one.

We don’t need to know the intrinsic value because no one actually does. In the end investing is not a game of always being right but it’s just about being right more often than others. As and when we keep refining our valuation process we can be more and more right more often than the others.

Prices are just a common weighted average opinion of the consensus and –

References used - Ashwath Damodaram