Previously, I wrote on the process of valuing financial firms, looking at the work of professor Aswath Damodaran, who teaches corporate finance and valuation at the Stern School of Business at New York University.
Damodaran's work on valuing companies is second to none. His presentations and lectures are hugely valuable for any investors who want to improve their valuation process or learn more about the professor's work.
Damodaran concentrates on valuing businesses according to their cash flows. A great deal of his work is devoted to analyzing the various inputs required for a discount cash flow analysis of a business. The professor of finance believes it's important to distinguish between the equity valuation of a business and the valuation of the whole firm.
Equity vs. firm
These two different concepts have a substantial impact on the eventual outcome of the valuation process. Valuing the equity of a business involves valuing the equity claim of the company. Valuing the firm takes into account the value of the whole business, including assets and liabilities. The resulting present value is the value of the entire firm, reflecting the value of all claims on the business.
There are two main differences in these methods of valuation. The first is the calculation of the discount rate. When valuing the firm as a whole, Damodaran believes the discount rate should reflect the cost of raising both debt and equity financing in proportion to their use. However, when valuing just the equity, the discount rate should reflect only the cost of raising equity financing.
The second is the treatment of cash flows. When evaluating the equity, Damodaran has said cash flows considered in the firm valuation should be "cash flows from assets prior to any debt payments, after a firm has reinvested to create growth assets." Meanwhile, when valuing the equity claims on the business, investors should look at the "cash flows from assets after making debt payments and after making reinvestments needed for future growth."
Different business, different method
Damodaran argued that these two different methods should be used for different businesses. For example, in my last article, I noted that the professor of evaluation believes financial firms should be valued on the equity cash flows basis, because it is so difficult to calculate and estimate the cost, as well as quantity of debt financial firms have to use in their businesses and the amount of money they reinvest to grow. As a result, he argued, it is better to value only the cash flows investors will receive, i.e., dividends, rather than try to estimate firm cash flows. Estimating the firm cash flows will likely result in a misleading outcome because there are so many unknown variables to consider.
On the other hand, the firm method of valuation might be more suitable for fast-growing businesses that are using a substantial amount of debt. This could give a more accurate reflection of the business's post-growth potential while taking into account all liabilities.
The margin of safety
The method most suitable for evaluation will differ company by company, and vary according to the information at hand. There is no correct process for valuation. Some methods are certainly more suitable for certain businesses than others. No one model fits all, and trying to make a single model work for different sectors and industries will lead to unreliable outcomes.
One thing that should always be a constant in the valuation process, however, is making sure the figures used are reliable and that there is a substantial margin of safety embedded into the numbers to try and provide compensation for mistakes made as part of the valuation process. Deciding whether it is appropriate to value the firm as a whole, or just the equity claim of the business, is just one step in the valuation process.
Disclosure: The author owns no share mentioned.
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Warren Buffett: Looking for Businesses We Can Be Sure AboutÂ
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Joel Greenblatt's Views on Concentrated InvestingÂ
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