Valuing a potential investment -- doesn't the thought of that just make you tingle a little inside? Valuing assets was once a task for only the smartest and most astute investment professionals. They would labor away deciphering financial statements, scouring SEC filings, and calling management to confirm statistics. It was indeed a noble profession. We still consider typical asset classes, such as stocks, bonds, real estate, etc. However, the methods of attaining a value are somewhat different than they were in the past.
Determining the implied valuation for an asset can be as simple or as complicated as you care to make it. And in this field, the more complicated the method doesn't necessarily imply the most accuracy. The value of an asset in its simplest form is what someone else is willing to pay for it. This notion is used every day in the public markets at current prices. However, these current prices don't necessarily mean that is the correct value of the asset.
Reaching an appropriate valuation can be a game between a buyer and seller. If you've ever played poker, then you understand it isn't a good thing for the other players to know your hand. For example, consider the trader for a large asset management firm. He regularly faces the challenge of acquiring or disposing of large quantities of a single asset. Does he push the entire lot onto the market at the current price? Of course not. He calls his buddies at the firms that are active in the security, and develops an indication of interest that these players are willing to take concerning the potential trade. He then uses astute negotiation skills in the conversation, taking special care to not give away his hand. If the guys on the other end of the line knew his size, they would be inclined to increase or decrease their bid or offer accordingly.
To find the true-value-to-you of an asset intended for a personal investment will take research and a decent amount of work. You may be saying: "Wait a minute now, with today's technology, valuation should require no more than a plug-and-play method. All that work is in the past, right?" Sure, you can input the necessary parameters into an Excel-linked Bloomberg Terminal and it'll spit out values based on DCF, comparables, transactions, along with many more than you care to see. That would look something like this:
But what's the fun in that? Valuing an asset with the investment horizon over years requires desire, passion, and the excitement to intimately know its deepest secrets. To begin, let's assume (that's a fun word) that you would like to buy a large stake in IBM Corp. (NYSE:IBM). You feel that the recent sell-off is overdone, but would like to know an appropriate value for its equity. First, begin by asking yourself what type of company IBM is. Is it a technology company? How about a services company? Maybe it's a software company? You get the point. IBM, along with most large corporations, is comprised of multiple segments. IBM is a multi-national business and technology services company that operates in 175 countries. I'm not sure you can get that from a calculation in Excel, but I am now a little more familiar with my future investment.
Let's next examine that fun word: assumption. In any valuation approach, various assumptions are necessary. In the past, and still today when determining the appropriate static assumptions to use in a valuation analysis, a professional would use the prevailing trend in factors such as growth rates of various lines of the company's financial statements, required return, treasury bond rates, beta in some instances, and future market conditions. One of the most common methods used to determine the required return is the Capital Asset Pricing Model (CAPM). As useful as it is in determining the required return, every factor is an assumption.
It also uses Beta as a multiple to the assumption for market risk premium. Beta, in effect, is a random number used to compare the risk of the asset to the overall market. Wait a minute, I believe I just offended statisticians around the world! Beta is calculated as the covariance of the asset and market as a percentage of the variance of the asset, which I suppose is a logical multiple for determining the risk of the asset in relation to the risk of the market. So in effect, if you were to choose a discounted cash flow valuation, you may choose current earnings, earnings projections, a growth rate, estimated static risk-free rate for the estimated holding period, beta, and an estimated market risk premium.
If you didn't notice, most of these inputs are assumptions. The only piece that isn't an assumption is current earnings, which should be rigorously analyzed to determine if the figure is an accurate representation of the company's performance. Are you understanding yet how valuation is an art rather than a science?
Even with all the fun and excitement of the previous static assumptions, there were several who felt left out, specifically the statisticians. Therefore, they assimilated statistical models into asset valuation. What a wonderful achievement! Asset valuation now incorporates neat phrases such as Monte Carlo simulation, Martingale Pricing, Brownian and Jump Diffusion models. What is important is that these advances in valuation methods have enhanced our models to somewhat solve the problem of static assumptions by giving us new assumptions based on randomness, continuous stochastic process, and probability.
To master the art of valuation, you will need to become successful in the following methods:
You must become proficient at data gathering and manipulation. Many services such as Bloomberg and FactSet will allow quick collection and dissection of data. Compile the data into a program such as Excel in preparation of customized valuation and statistical analysis. However, this data oftentimes requires adjustments. If available, study the company's 10-K thoroughly, taking special care to keep an eye out for anything suspicious in the MD&A and notes.
Organize the Data With a Purpose
We use 34 Bloomberg-linked Excel workbooks that perform specific functions across many different asset classes. Organize your work in a purposeful manner, in order to achieve the intended result without wasting valuable time.
Make Use of Statistical Programs
Excel is a powerful source for the most common statistical calculations necessary for valuation. Become familiar with the solver add-in, and get to work on developing dynamic inputs. Excel can be linked to many investment-related programs providing updates for your models. Utilize this tool, and you will have the capability to become continuously aware of the changing value of your current or soon-to-be investments. There are also a variety of rather expensive solutions available. Choose the one that best fits your needs.
Analyze the Data Using Multiple Methods
Value the asset using multiple methods and consolidate the results. For example, perform a DCF, Residual Income, Multiple Derivation, Transactional if available, and a Comparable Company approach. Each of these methods will provide different results. Test the analysis against several scenarios using the Excel solver function or a program such as Crystal Ball from Oracle.
It is not possible to avoid assumptions in asset valuation. There must be informed guesses in order to predict a true-value-to-you. Once you master the art of valuation, you will become ever more confident in your investment decisions.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.