It’s a core belief of many investors that assets can be valued in some kind of systematic fashion. The exact methods used may vary, but by and large most investors agree that it is theoretically possible to accurately value a business.
And yet, there are many myths that continue to surround the practice of valuation. In his book, "Investment Valuation," NYU Stern School of Business Professor Aswath Damodaran breaks down three such misconceptions.
Myth #1: All valuation is objective
Over the last few decades, economics in general, and valuation in particular, have become more quantitative. Valuation has come to lean much more heavily on complex models, and it is often assumed that mathematical rigour is synonymous with accuracy. However, just because the methods used to arrive at an estimate for intrinsic value are rigorous and complicated doesn’t mean that the end result of those calculations will be correct.
Damodaran says that the final value that is obtained from these models is influenced by our own biases. Institutional analysts in particular have incentives to be more bullish than bearish, as it is difficult to get access to company management if you are known for being a "harsh grader." To make matters worse, sell-side analysts often face pressure to butter up corporate boards when courting their business for securities offerings and bond issuance.
Myth #2: A well-researched and well-done valuation is timeless
Just because something has been true in the past does not mean that it will continue being true in the future. The value of an asset can and will fluctuate over time, and it is therefore important for the analyst to periodically update their models. Earnings reports, market assumptions and changes in macroeconomic conditions will all have a significant effect on the present value of future cash flows of a business. The important things is to have the mental flexibility to change your mind:
“When analysts change their valuations, they will undoubtedly be asked to justify them, and in some cases the fact that valuations change over time is viewed as a problem. The best response is the one that John Maynard Keynes gave when he was criticized for changing his position on a major economic issue: 'When the facts change, I change my mind. And what do you do, sir?'”
Myth #3: A good valuation provides a precise estimate of value
Damodaran says that at the end of the day, it’s important to bear in mind that even the most rigorous and well-practiced analysis can only give you an approximate range for the true value of a business. To be sure, bigger businesses can usually be valued more accurately than smaller ones, and there are other factors that can affect how wide the valuation range is. For example, whether the business operates overseas and whether it is a new company or a more mature one both have an effect. The best analysts always remember that their attempts at valuation are - at best - highly educated guesses and leave themselves a wide margin for error.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Bill Ackman Reflects on J.C. Penney Failure
- Seth Klarman: Investors Are Like Relief Pitchers
- Seth Klarman: How to Balance Risk and Reward
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
