Principles of Valuation and Analysis - Fundamental Framework

Introduction

Valuation is an area that produces more debate and controversy in financial markets than almost any other subject. Calculating the “correct” value for a company’s shares is the holy grail of the investment and investment banking community, the rewards for getting a valuation right (or penalties for getting it wrong) can be enormous. Academic theory suggests that valuation matters, but probably only in the long run. Research shows that for an investment horizon over 12-24 years, valuation is the key driver of value, accounting for up to 50%+ of returns1. Over shorter periods, liquidity, technical factors and even fear/greed can drive markets and valuation becomes almost irrelevant; the TMT bubble at the end of the 1990s was a prime example of greed driving share price movements. In addition, different valuation metrics can have varying importance at different stages of an economic or market cycle and creative analysts or companies can always find new valuation metrics to explain share price movements. As a result, the approach that is taken throughout this manual is a pragmatic one, although a fundamental approach to valuing a company using corporate finance theory is the cornerstone of the approach. A fundamental approach assumes that the value of a company is the discounted present value of the cash flows generated by the company. However, a pragmatic approach also recognises that other  aluation methodologies can be equally important, price/earnings and dividend yield in particular have been proved to have strong correlations with share price returns2. Two of the greatest ever investors, Benjamin Graham and his famous pupil, Warren Buffett, have commented up the subject of valuation as follows:

 

A summary of these comments might be that it should be recognised that valuing a company is both a science and an art. Anyone attempting to value a company should be prepared to adopt a pragmatic approach, realising that whatever valuation is produced will depend on the assumptions used and will be at best only partially accurate. The comments by Warren Buffett above are very apposite. In particular the fact that over the short term, issues such as sentiment are important (“the market is a voting machine”), but in the long term, fundamental valuation will drive share prices  (“the market is a weighing machine”). Buffett’s investment style mirrors this fact; he takes large stakes in undervalued businesses that he holds for a time period he describes as “forever”. Over such a time period, valuation will drive the returns generated from an investment.

1 Standard Life Investments

2 Basu (1977), Basu (1983)

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