There is great information to be found and some of it is on You Tube – today will be some takeaways from Aswath Damodaran who teaches Business Valuation. If you have not seen the You Tube they are worth the time to watch and learn.

Mr. Damodaran gave a talk to Google Talks on 4 Lessons To Take Away on Valuation

1. Valuation is a Simple

Similar to all things, as long as you start with the fundamentals, it can be simple. Valuation is not accounting.

Accountants look backwards to what has been done. They are necessary for that, the numbers they end up with is used for analysis and accounting works best for mature companies.

Valuation is forward looking – what could happen in the future? Which means it deals with unknowns.

A Balance Sheet works best for companies with tangible assets. The problem for young companies is Goodwill – the difference between what a company is worth and what it paid for on the asset side. On the liability side Shareholders Equity only increases if you have bought a company. If the growth is organic, then low shareholders equity.

Most of the tools for valuing companies are based on mature companies for  the estimates are relatively easy to make and involve less risk. Mr. Damodaran and a partner have a tool  on iTunes called You Value – plug in the numbers and you have a valuation.

Evaluation Balance Sheet

Assets in Place – what are they?                                           /            Debt

Growth Assets – expectations for the future                  /               Equity

Key question to ask – what are you buying when you buy this company.

Growth companies finance themselves through equity as it is tough to payback a loan based on the good ideas of the people in the company. Mature companies generate cash and do either equity or debt – whatever is more advantageous at the time.

2. Do not mistake modeling for Valuation

Valuation is about the cash flows:

1. What is the cash flow from existing operations?
2. What is the value created by growth?
3. How risky is the cash flow?
4. When will the company become mature? ideally it is going to be in business in the future. All companies go through the cycle.

95% of you research should be on the cash flow; 5% on which discount rate to use.

To answer the above questions regarding cash flows, you have to determine a story for the company. The narrative of the story will tell you what the company is and what the company is not – then the numbers reflect the storyline.

Rule: whatever number you come up with – the offer for the company should be less.

Analyst Reports are an important part of the sales business, however they must be read with a grain of salt. For sometimes they are meant to justify the client rather than justify the price offered. Mr. Damodaran calls buzz words Weapons of Mass Distraction – control; synery; brand name; strategic considerations; China or BRIC.

Remember:

1. If it does not affect the cash flow or alter risk, it can not affect the value.
2. For an asset to have value the Expected Cash Flows have to be positive sometime before the life of the asset
3. Assets that generate cash flow early in their life will be worth more than assets that generate cash flow later – they have to financed.

How to value Growth Companies?

Mr. Damodaran uses a program called Crystal Ball which attaches to his excel sheets. The program allows for a distribution model or you can say there is a 90% probability the results will fall with the parameter, 10% chance they will not. Remember the only time you have perfect information is looking back, you are trying to look forward.

3. Much of what passes as Evaluation is a Pricing Model

In his talk, Mr. Damodaran uses the example of house price listing. How does the number come up? The agent typically looks for comparable past sales, adjusts the price for special features and comes up with a number. That is the pricing model.

Price is based on supply and demand or mood and momentum

Valuation is based on cash flow, growth and risk.

In his talk, Mr. Damodaran discusses why price and value can diverge. It is often what the market is paying for. It used to website visits were worth something; at the present time it is the number of members ($100). Take the number of members x 100 equals the price of company. The problem is the market is fickle and one day will say – how do you make money from the members? what percentage do that? what would could that normally grow to?  The price might be different.

4. Do not mistake luck for skill

In the investment world, when you make money all is forgiven. There is no smart money there is stupid money and less stupid money.

Buying a company at the right price is good; buying it at the wrong price no matter how good the buzz words are the result will be losses in the future. Similar to all negotiations, they only work if you are willing to walk away from the table if you do not get your price.

Linking to dividend paying stocks, these tend to be the mature companies and the existing models work terrifically for them. The issue might be what price are you paying for the valuation when a tool such as You Value is in the marketplace. There is fewer reasons to discuss the estimates and how they are made. For growth companies there is need to focus on the story which allows you to focus on what the assumptions are made about cash flow, growth and risk.

There are more questions than answers, till the next time – to raising questions.