Introduction to Valuation - Inside The Valuation Process

Question

Why does the annual report has bias?

Answer 1

They include not only the accounting numbers, but also management discussions on performance, often putting the best possible spin on numbers.

Answer 2

The markets own estimate of the company, the market price. Valuations that stray too far from this number make analysts uncomfortable, since they may reflect large valuation errors (rather than market mistakes).

Answer 3

1. Harder to get information on a company they issued a sell recommendation. 2. Pressure from portfolio managers who have large positions in the stock. 3. The companies own investment banking arms, who have other profitable relationships with the company in question.

Answer 4

Analysts can be compensated finding over or undervalued firms. This explains why aquisition valuation have an upward bias. The analyst can find the deal is overpriced, no deal, happy shareholders. Or, whatever the price, finds it is a good price, and reaps the financial windfall that comes with the deal.

Answer 5

We have to make assumptions while valuing a company, they can be pessimistic or optimistic.

Answer 6

An analyst may revisit assumptions after a valuation to get closer to they had expected when starting off.

Answer 7

Analysts leave the value for what it is, but make use of quality factors such as synergy and strategy to justify differnces in the market price and their calculated value.

Answer 8

1. Estimation uncertainty

2. Firm-specific uncertainty

3. Macro-economic uncertainty

Answer 9

1. Better valuation models (reducing estimation uncertainty but not future uncertainties)

2. Valuation ranges (simulations, worst/best case scenarios)

3. Probabilistic statements (70% stock is undervalued)

Answer 10

1. Passing the buck (using numbers of other analysts, take credit when right, blame others when wrong)

2. Giving up on fundametals (fall back to more simplistic ways, comparables, multiples. Or stating valuation is pointless, and fall back to reading charts and gauging market perception)

Answer 11

It is not how precise a valuation is that determines its usefullness but how precise the value is relative to the estimates of other investors trying to value the same company.

Answer 12

More detail gives analysts a change to use specific information to make better forecasts on each individual item, on the other hand more detail creates the need for more inputs, with potential error in each one and generates more complicated models.

Answer 13

1. Information overload (Analyst face conflicting information, time pressure, bad choices. Garbage in, garbage out)

2. Black Box Syndrome (Analyst does not understand model anymore)

3. Big versus small assumptions (a big assumption with big impact has to compete with a small assumption with little impact)

Answer 14

The principle of parsimony dictates one should use the simplest possible explanation for a phenomenon before one moves to more complex ones. In valuation: use the simplest model you can get away with.