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Valuations
CA Yash Jain

The Wall Street School

Index
01 Basics

02 Misconception about valuations

03 Bermuda Triangle of valuations

04 Principle of parsimony

05 Approaches to valuation

06
“
Philosophy behind valuation
“Valuation is like a stick of blind man crossing the road”

He don’t know what might hit him from sideways but he uses his
stick to check whether he have any obstruction in front of him.
 
We all are like blind man in this world of every changing data
which gets reflected in investors perception and ultimately in
stock prices.

This stick called “valuation” gives me confidence to hold the

“
stock for substantial period of time, move ahead with confidence
and ultimately cross the road (earn profits)
Valuations
CA Yash Jain
 Basics
Chapter 1

1.Forms of market

Efficient Market Hypothesis Definition

The Efficient Market Hypothesis (EMH) essentially says that all known information about investment securities,
such as stocks, is already factored into the prices of those securities.
Therefore, assuming this is true, no amount of analysis can give an investor an edge over other investors, collectively known
as "the market.“

That’s why we see Active managers are not able to beat the market in general over the period of time

EMH does not require that investors be rational; it says that individual investors will act randomly, but as a whole,
the market is always "right."

In simple terms, "efficient" implies "normal."    Efficient Normal

For example, an unusual reaction to unusual information is normal. If a crowd suddenly starts running in one direction,
it's normal for you to run in that direction as well, even if there isn't a rational reason for doing so.

2.Forms of EMH
Weak Form EMH:  Semi Strong Form EMH:
The weak form suggests that
today’s stock prices reflect all the
data of past prices and that no
form of technical analysis can be
effectively utilized to aid investors
in making trading decisions.
Advocates for the weak form
efficiency theory believe that
if fundamental analysis is used,
undervalued and overvalued stocks
can be determined, and investors
can research companies' financial
statements to increase their
chances of making higher-than-
market-average profits.
Basics
Chapter 1
The semi-strong form efficiency
theory follows the belief that
because all information that is
public is used in the calculation of a
stock's current price, investors
cannot utilize either technical or
fundamental analysis to gain higher
returns in the market. Those who
subscribe to this version of the
theory believe that only information
that is not readily available to the
public can help investors boost their
returns to a performance level above
that of the general market.
Strong Form EMH: 
Strong Form version of the efficient
market hypothesis states that all
information – both the information
available to the public and any
information not publicly known – is
completely accounted for in current
stock prices, and there is no type of
information that can give an investor
an advantage on the market.
Advocates for this degree of the
theory suggest that investors cannot
make returns on investments that
exceed normal market returns,
regardless of information retrieved
or research conducted.
 Basics
Chapter 1

3.Anamolies

There are anomalies that the efficient market theory cannot explain and that may even flatly contradict the theory. For example,
the price/earnings (P/E) ratio shows that firms trading at lower P/E multiples are often responsible for generating higher returns. The  neglected
firm effect suggests that companies that are not covered extensively by market analysts are sometimes priced incorrectly in relation to their true
value and offer investors the opportunity to pick stocks with hidden potential.

Though the efficient market hypothesis is an important pillar of modern financial theories and has a large backing, primarily in the academic
community, it also has a large number of critics. The theory remains controversial, and investors continue attempting to outperform market
averages with their stock selections.

Investors can outperform the market; it says that there are outliers that can beat the market averages; however, there are also outliers that
dramatically lose to the market. The majority is closer to the median. Those who "win" are lucky and those who "lose" are unlucky. 
 
 
Source:
1.https://www.thebalance.com/efficient-markets-hypothesis-emh-2466619
2.
https://www.investopedia.com/ask/answers/032615/what-are-differences-between-weak-strong-and-semistrong-versions-efficient-market-hyp
othesis.asp
Valuations
CA Yash Jain
 Misconception about valuations
Chapter 2

MYTHS TRUTHS

All valuations are biased. The only questions are how

A valuation is an objective search for “true” value
much and in which direction.

•The direction and magnitude of the bias in your valuation is directly

cproportional to who pays you and how much you are paid.
A good valuation provides a precise estimate of value There are no precise valuations
•The payoff to valuation is greatest when valuation is least precise.

The more quantitative a model, the better the Simpler valuation models do much better than complex
valuation
•One’s understanding of a valuation model is inversely proportional to
the number of inputs required for the model.
Valuations
CA Yash Jain
 Bermuda Triangle of valuations
Chapter 3

Reasons why valuations go bad:

Co
mp
s
Bia

lex
iti
es
Uncertainties
 Bermuda Triangle of valuations
Chapter 3

1. Manifestations of Bias in valuation:

A. Inputs to the valuation: Our assumptions about margins, returns on capital, growth and risk are influenced by our biases.

B. Post-valuation tinkering: The most obvious manifestation of bias occurs after we finish the valuation when we add premiums (synergy,
control) and assess discounts (illiquidity) for various factors. If we are biased towards higher values, we tend to use premiums; if biased towards
lower values, we discount.

C. Qualitative factors: When we run out of all other choices, we tend to explain away the difference between the price we are paying and the
value obtained by giving it a name (strategic considerations…)
 Bermuda Triangle of valuations
Chapter 3

What to do about bias…

1. Reduce institutional pressures: Institutions that want honest sell-side equity research should protect their equity research analysts who issue
sell recommendations on companies, not only from irate companies but also from their own sales people and portfolio managers.

2. De-link valuations from reward/punishment: Any valuation process where the reward or punishment is conditioned on the outcome of the
valuation will result in biased valuations.

3. No pre-commitments: Decision makers should avoid taking strong public positions on the value of a firm before the valuation is complete.

4. Self-Awareness: The best antidote to bias is awareness. An analyst who is aware of the biases he or she brings to the valuation process can
either actively try to confront these biases when making input choices or open the process up to more objective points of view about a
company’s future

 
 Bermuda Triangle of valuations
Chapter 3

2. Uncertainties

Even if our information sources are impeccable, we have to convert raw information into inputs and use these inputs in
models. Any mistakes or mis-assessments that we make at either stage of this process will cause estimation error.
Real Uncertainty:

• Firm-specific Uncertainty: The path that we envision for a firm can prove to be hopelessly wrong. The firm may do much
better or much worse than we expected it to perform, and the resulting earnings and cash flows will be very different from our estimates.

• Macroeconomic Uncertainty: Even if a firm evolves exactly the way we expected it to, the macro economic environment
can change in unpredictable ways. Interest rates can go up or down and the economy can do much better or worse than expected. These macro
economic changes will affect value.
 Bermuda Triangle of valuations
Chapter 3

Responses of Uncertainty: The healthy ones..

1.Better Valuation Models: Building better valuation models that use more of the information that is available at the time of the valuation is
one way of attacking the uncertainty problem. Even the best-constructed models may reduce estimation uncertainty but they cannot reduce or
eliminate the very real uncertainties associated with the future.

2.Valuation Ranges: A few analysts recognize that the value that they obtain for a business is an estimate and try to
quantify a range on the estimate. Some use simulations and others derive expected, best-case and worst-case estimates of value.

3.Probabilistic Statements: Some analysts couch their valuations in probabilistic terms to reflect the uncertainty that they feel. Thus, an analyst
who estimates a value of $ 30 for a stock which is trading at $ 25 will state that there is a 60 or 70% probability that the stock is under valued
rather than make the categorical statement that it is under valued.
 Bermuda Triangle of valuations
Chapter 3

Responses to uncertainty: Unhealthy ones..

1. Passing the buck: Some analysts try to pass on responsibility for the estimates by using other people’s numbers in the valuation. If the
valuation turns out to be right, they can claim credit for it, and if it turns out wrong, they can blame others (management, other analysts,
accountants) for leading them down the garden path.

2. Giving up on fundamentals: A significant number of analysts give up, especially on full-fledged valuation models, unable to confront
uncertainty and deal with it. All too often, they fall back on more simplistic ways of valuing companies (multiples and comparables, for example)
that do not require explicit assumptions about the future. A few decide that valuation itself is pointless and resort to reading charts and gauging
market perception.

What to do about uncertainty..

You can reduce estimation uncertainty but you cannot do much about real uncertainty (other than treat it as risk and build it into your discount
rates) In general, analysts should try to focus on making their best estimates of firm-specific information – how long will the firm be able to
maintain high growth? How fast will earnings grow during that period? What type of excess returns will the firm earn?– and steer away from
bringing in their views on macro economic variables.

 
 Bermuda Triangle of valuations
Chapter 3

Complexity :
Sources of Complexity
1.The tools are more accessible: Computers and calculators have become far more powerful and accessible in the last few decades. With
technology as our ally, tasks that would have taken us days in the pre-computer days can be accomplished in minutes.

2. There is more information for us to work with: On the other side, information is both more plentiful, and easier to access and use. We can
download detailed historical data on thousands of companies and use them as we see fit.
 Bermuda Triangle of valuations
Chapter 3

Cost of complexity
1. Information Overload: More information does not always lead to better valuations. In fact, analysts can become overwhelmed when faced
with vast amounts of conflicting information and this can lead to poor input choices. The problem is exacerbated by the fact that analysts often
operate under time pressure when valuing companies.

2.Black Box Syndrome: The models become so complicated that the analysts using them no longer understand their inner workings. They feed
inputs into the model’s black box and the box spits out a value. In effect, the refrain from analysts becomes “The model valued the company at $
30 a share” rather than “We valued the company at $ 30 a share”.

3.Big versus Small Assumptions: Complex models often generate voluminous and detailed output and it becomes very difficult to separate the
big assumptions from the small assumptions.
 The principle of parsimony
Chapter 3

The basic principle:

When valuing an asset, we want to use the simplest model we can get away with.

Don’t go looking for trouble and estimate inputs that you do not have to. You can mangle simple assets using complicated
valuation models.

All-in-one valuation models that try to value all companies, by definition, will be far more complicated than they need to be, since they have
to be built for the more complex company that you will run into.
 Approaches to Valuation
Chapter 4

The basic principle:

When valuing an asset, we want to use the simplest model we can get away with.

Don’t go looking for trouble and estimate inputs that you do not have to. You can mangle simple assets using complicated
valuation models.

All-in-one valuation models that try to value all companies, by definition, will be far more complicated than they need to be, since they have
to be built for the more complex company that you will run into.
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