Conclusion
Rules for the Road
The more things change, the more they stay the same. As we employed both intrinsic and relative valuation techniques to value firms across the life cycle from Evergreen Solar, a young growth company, to Sears, a company whose best days are behind it, we followed a familiar script. The enduring theme is that value rests on standard ingredients: cash flows, growth, and risk, though the effects of each can vary across companies and across time.
No matter what type of company you are valuing, you have to decide whether you are valuing just equity or the entire business, the approach you will use to estimate value (intrinsic versus relative valuation), and the key components of value.
When valuing a business, you can choose to value the equity in the business or you can value the entire business. If you value the business, you can get to the value of equity by adding back assets that you have not valued yet (cash and cross holdings) and subtracting out what you owe (debt). The choice matters because all of your inputs—cash flows, growth, and risk—have to be defined consistently. For most of the companies that we have valued in this book, we have valued the businesses and backed into the value of equity. With financial service firms, our inability to define debt and estimate cash flows did push us into using equity valuation models.
You can also value a business based on its fundamentals, which is the intrinsic value, or you can value it by looking at how the market prices similar firms in the market. While both approaches yield estimates of value, they answer different questions. With intrinsic valuation, the question we are answering is: Given this company’s cash flows and risk, it is under- or overvalued? With relative valuation, the question being answered is: Is this company cheap or expensive, given how the market is pricing other companies just like this one? With the example of Under Armour in Chapter 6, the intrinsic valuation approach led us to conclude that the company was undervalued, whereas the relative valuation would have led us to conclude that the stock is overvalued.
In both intrinsic and relative valuation, the value of a company rests on three ingredients: cash flows from existing assets, the expected growth in these cash flows, and the discount rate that reflects the risk in those cash flows. In intrinsic valuation, we are explicit about our estimates for these inputs. In relative valuation, we try to control for differences across firms on these inputs, when comparing how they are priced.
The models and approaches used are identical for all companies, but the choices we make and the emphasis we put on inputs varied across companies. As illustrated in Table 12.1, the value drivers that were highlighted in each chapter reflect the shifts in focus, as firms move through the life cycle and across sectors.
Table 12.1 Value Drivers across the Life Cycle and Sectors
| Category | Value Drivers |
| Young growth companies | Revenue growth, target margin, survival probability |
| Growth companies | Scaling growth, margin sustainability |
| Mature companies | Operating slack, financial slack, probability of management change |
| Declining companies | Going concern value, default probability, default consequences |
| Financial service firms | Equity risk, quality of growth (return on equity), regulatory capital buffers |
| Commodity and cyclical companies | Normalized earnings, excess returns, Long-term growth |
| Intangible asset companies | Nature of intangible assets, efficiency of investments in intangible assets |
These value drivers are useful not only to investors who want to determine what companies offer the best investment odds, but also to managers in these firms, in terms of where they should be focusing their attention to increase value.
Can you make money on your valuations? The answer depends on three variables. The first is the quality of your valuation. Well done valuations based upon better information should generate better returns than shoddy valuations based upon rumor or worse. The second is market feedback. To make money on even the best-done valuation, the market has to correct its mistakes. The payoff to valuation is likely to be speedier and more lucrative in smoothly functioning markets. In more selfish terms, you want the market to be efficient for the most part, with pockets of inefficiency that you can exploit. The third and final factor is luck. While this will violate your sense of fairness, luck can overwhelm good valuation skills. While you cannot depend on good luck, you can reduce the impact of luck on your returns by spreading your bets across many companies that you have found to be undervalued. Diversification still pays!
Do not let experts and investment professionals intimidate you. All too often, they are using the same information that you are and their understanding of valuation is no deeper than yours. Do not be afraid to make mistakes. I hope that even if not all of your investments are winners, the process of analyzing investments and assessing value brings you as much joy as it has brought me.
10 Rules for the Road
1. Feel free to abandon models, but do not budge on first principles.
2. Pay heed to markets, but do not let them determine what you do.
3. Risk affects value.
4. Growth is not free and is not always good for value.
5. All good things, including growth, come to an end. Nothing is forever.
6. Watch out for truncation risk; many firms do not make it.
7. Look at the past, but think about the future.
8. Remember the law of large numbers. An average is better than a single number.
9. Accept uncertainty, face up to it and deal with it.
10. Convert stories to numbers.