Class 2 Valuation: Bias, Uncertainty & Complexity
Class 2 Valuation: Bias, Uncertainty & Complexity
If you want to be a lemming, be the last lemming.
Story of the lemmings
Prof. Aswath Damodaran do valuation to fight the lemmings. In a 1958 documentary titled the White Wilderness, a large group of lemmings are found to be mass migrating and appeared to be jumping off a cliff into the Artic Ocean akin to committing suicide (a controversial myth actually).
But the moral of the story is that you want to understand why the first lemming jumped. Maybe it was running too fast and couldn’t stop, slipped into the sea, can’t swim, and drown. Second lemming was too close to the first, also slipped & drowned.
Imagine you are the last lemming, and you see an entire tribe just jumped into the sea. A voice echoed in your head and said:
“They must know something that I don’t. The 7 most deadly words in investment.”
Tesla’s price 4x in a year during the pandemic. When you are valuing Tesla, you will then start to adjust growth rate to be higher, discount rate lower, etc. so that your value is close to the price. You think, they must know something that you don’t.
There are 3 groups of lemmings:
Momentum lemmings, if you are buying, I’m buying type.
Yogi Bear lemmings, smarter than momentum lemmings, they will attempt to stop before they fall.
Lemming with a life vest, this is what describe Prof. He does valuation to slow down, since he can’t be objective/rational, just like any other human. Valuation allows you to slow down, it gives you a chance to process things. Better to have life vest and jump then jumping without a life vest and drown.
Bias
Power of subconscious: when you a pick a company, you already have some point of view on the company. Sometimes you don’t even realise it. For e.g. Prof always find Microsoft to be overvalued because he’s an avid user of Apple products since 1981.
Power of suggestion: if you hear a number from someone, the number mentioned is already anchored, especially from someone authoritative.
Power of money: if you are being paid to value, then there’s no objectivity, at least be honest upfront, and say that you are bias!
About 30 years ago, AT&T had an option to buy Link Cable (unsure of actual company name’s spelling). Opportunity to exercise the option comes about, AT&T hired Morgan Stanley (buy-side banker) to value 51% of Link Cable so that AT&T can buy it. Link Cable went and hired Lehman Brothers (sell-side vendor) to assess the same 51% value.
Morgan Stanley comes back with a $105/share valuation, and Lehman Brothers comes back with a $155/share valuation. The difference is so large, a third investment bank - Wasserstein Perella was called in, who couldn’t value anything in the 80s & 90s. It came back with a $127.50/share value, right in the middle.
Same set of financials, 3 different valuations.
Hint: never come back with a round number, a 2 decimal points number looks more convincing.
Skin-in-the-game is also an important bias where you can’t be objective.
Below are some real-life examples on whether you are bias-up (high value) or bias-down (low value):
You are a founder of your own company, valuing it for a third party for a sale. High value
You are a VC, valuing the same business for an investment, especially with a 50% discount rate. Low value
You are valuing the same business for a divorce court where half of the business will go to your soon to be ex-spouse. Zero value, of course.
You are an appraisal for the owner, valuing a business for tax purposes. Low value.
You are the IRS, valuing the same business for tax purposes. Very high value.
You are a sell-side analyst, valuing a company with the intention of putting a buy or sell recommendation. Usually high value or they will lose business of the company (on the investment bank side) they are valuing. Or even losing out access to the management. Chinese/Ethical walls can be climbed over. If a sell is needed to recommend, usually is in multitude of “buy” (i.e. Strong buy, buy, weak buy or hold)
You are a buy-side analyst, valuing a company whom the fund already owns 1 million stocks of it. High value, for re-affirmation from your superior.
Same scenario as above but instead the fund is shorting 1 million stocks. Low value, same re-affirmation reason.
A friendly takeover, you’re the buy-side M&A analyst, i.e. client is being acquired. Offer price is high and as long as transaction goes through with an advisory fee bring paid.
A friendly takeover, you’re the sell-side M&A analyst, i.e. client is doing the acquisition. There’s a lot of synergy on the target and as long as it goes through with a fee paid.
Same analysts but in a hostile takeover. Valuation becomes a strategic tool to negotiate, number is either meaningless or there will be many numbers. And of course, as long as fees being paid.
Biases appear at everywhere on everyone, every time.
Misconception
No true value. Since we agreed that there’s bias, then there is no objectivity or a “true” value. A simple test is if you are valuing Tesla and the question being asked is, what do you think of Elon Musk? You either love him or hate him. Bias is part of valuation especially if you are paid to do it.
No accurate/precise value. There’s no right answer even with the right inputs. Equity valuation only give you an estimate. In fact, the greatest value or payoff from valuation is when valuation is the least precise (i.e. inefficient market hypotheses).
Lyft vs Levi’s Strauss - you would think you can value Levi’s Strauss precisely, but which company do you think will give you the biggest payoff if your valuation is correct? Uncertainty is a feature in valuation and not a bug.
However, precise value exists in fixed income valuation.
Complex model doesn’t produce good valuation. Is easy to build detailed 3-statement model in Excel but it still doesn’t mean you can value. You only need 6 numbers, not 496 lines. There’s something called input fatigue where you worked tirelessly past midnight on an in-house valuation model, to a point where you just insert random numbers. Easy to hide garbage in complex models.
Lastly, are you running the model or the model running you? Modelling can be outsourced now too. Prof. also never breakdown working capital as he is incapable of forecasting days receivable.
When in doubt, aggregate, which is better than breaking down.
We need to be honest to ourselves, do we want to push up or push down that number? How do we get that number?
3 ways to get that number.
Intrinsic valuation - must be cash flow driven.
Relative valuation, or pricing - looking at what other is paying for similar things (all P/E, EV/EBITDA or similar valuation metrics).
Contingent claim (or real option) - i.e. FDA approval on a new drug, oil reserves, etc.
All valuation method is based on the fact that market is inefficient. If you believe market is efficient, then there’s no need to value.
Markets make mistakes but they also must self-correct.
Intrinsic valuation pre-dates discounted cash flow (“DCF”). Like searching for the holy grail, this is an exercise to keep searching.
How do you find market mistakes?
Reversing the question would be how much does an active portfolio manager beats the market each year? 1.5% on average less than the market. This is like a plumber starting a business called “Flood-r-us”.
Say you are 1-in-a-million and is able to find a market mistake & valued Facebook at $200/share and price now is $120/share. You go and buy a million share. Do you make any profits yet? No.
Here comes the second part - market must also self-correct. You can only have faith, buy, pray and hope that it will hit $200.
I - Intrinsic Valuation
The best use case of intrinsic valuation is having the mindset of buying a piece of the business, like Warren Buffett. Not affected by noises of markets & price.
This forces you to think all the elements that would affect a business, i.e. what would affect cash flow & risks involved.
The disadvantage of DCF is not only it being tedious, but also biases and the fact that 99% of the time things are under/overvalued. Imagine being a tech investor that practices intrinsic valuation, where do you find value for the past decade (before 2022)?
It is also better to have a longer time-horizon and to know when or how a catalyst is to happen. Activist investors like Carl Ichan are their own catalyst to begin a correction, or you obtain control of the company to initialise the catalyst.
You can figure out what kind of catalyst by doing scenarios of potential events, e.g. surprise news like aging CEO that is going to retire/die, potential takeover target, etc.
1 last preparation to being intrinsic valuation is that you are usually always against the crowd. This is natural to some people (esp. if you are a weird kid in the classroom at your younger days) but not all mostly. Don’t underestimate the psychological effect of intrinsic valuation have on you.
II - Pricing
How do you find a company or a group of companies that look exactly like your company? Very hard. But if you do, and tried, you will use their price to divide by some metrics to standardise across the companies.
You assume the market or sector is right on average but is getting individual companies wrong. So, you find a “cheap” stock to buy.
There’s always something that is cheap while not everything is undervalued every time.
Fund managers are also judged on pricing, i.e. how well they fare with (index) benchmarks.
Say you find something “cheap”, and the market corrects. Your only consolation is that the sell-off on your stock is less than the others. This is similar to having high cholesterol and still think you are fine when compared to someone who have died of heart attack. This is pricing.
Implicitly, you are also making cash flow & growth assumptions when you do pricing, hence doing a version of intrinsic valuation. When Tesla was at $1 trillion market cap, intrinsically Tesla will also need to generate $1 trillion revenue. No companies have ever achieved that.
Pricing works best when you have a lot of similar companies/assets out there, have a shorter time horizon, judged based on a relative benchmark or is able to take advantage of mispricing (short sell a high price stock & long a low-price stock like a hedge fund).
Currencies cannot be value but is priced against another currency. Commodities can be valued but mostly priced due to lagging economic data. Where is Bitcoin? Is it a currency? A collectible?
“Before you begin to value, make sure you know you are to either value or to price.”
Asset-based valuation - either intrinsic or pricing
Basis of valuation is to assume business as a going concern, but sometimes you need to value the underlying asset of a business, i.e. the pieces of the company. It can be:
Liquidation
Fair Value Accounting
Sum-of-parts
You will still use either intrinsic or pricing. i.e. to value 5 pieces of real-estate, you’ll use pricing.
III - Options
Options is having an underlying asset that you can leech on. It’s a derivative.
The unique feature is limited losses, with potential unlimited profits. Remember and forget about this concept as the purpose for us is to understand Real Option, i.e. oil reserves, patents, deeply troubled company where equity is zero.
Most airline shares during pandemic are an option not because of their cash flows or dividends but due to their potential upside in share price while current price is already beaten down to ground level (pun intended).
When you do a DCF and you increase the risk, the value should fall due to higher discount rate. When you do pricing, a higher risk is reflected in lower price, or lower P/E ratio.
Generally, high risk equals to low value or price.
But when you look at an asset as an Option and you increase risk, the value actually increases.
“When you think about risk, only downside risk is what you are worried about, not upside risk. In option, your downside risk is limited, and this is a deep insight.”
When you buy a deeply troubled airline stock in a pandemic, you know exactly how much you are going to lose but the payoff will be huge if it “turns around” (pun intended).
Conclusion: Know all 3 approaches.
Really understand between valuing and pricing. When you use P/E or EV/EBITDA, you are not valuing but pricing.
No 1 method is better than the other, each have its own time & purpose. To truly master valuation, you will need to learn all 3 approaches of Valuation, Pricing & Options.
// Class 2 of Valuation ends