Introduction to Valuation

 Introduction to Valuation

           

         Valuation is based on lots of models and lots of numbers. Valuation is not that hard. We used to make that complex. Every valuation even though it’s about numbers has a story. A good valuation is a combination of both. There are three main reasons for valuations go bad.

1. Preconception – you come up with a preconception of the company/Asset
2. Uncertainty – Humans are not good at dealing with uncertainty.
3. Complexity – We use complex data and complex models for valuation.

A valuation can be used for just about any business you can think of, Small or large, public or private, emerging or developed market.

• Intrinsic Valuation

Intrinsic valuation is the value of a business as a function of its expected cash flows, growth, and risk. Intrinsic valuation is the fundamental way of thinking about valuation and it lies at the core of almost everything in valuation. There are main 2 methods to do Intrinsic valuation.

1. Value the equity in the business
2. Value the entire business

"Discounted cash flow is one way of finding Intrinsic value"

A lot of people in finance misunderstand that discounted cash flow is always intrinsic value & intrinsic value is always discounted cash flow valuation. And another main thing is intrinsic value is generated for cash flow generating assets. We can use intrinsic valuation for businesses, start-ups, stocks, or growth companies. We cant use intrinsic valuation for gold or art because those are not generating any cash flows. intrinsic valuation is a technique for cash flow generating assets.

“The intrinsic valuation value will be a function of the magnitude of the expected cash flows on the asset over its lifetime and the uncertainty about receiving those cash flows”

• Two Faces of Discounted Cash Flow Valuation

The more common way of doing this is to get the expected cash flow on an asset or a business over time. If you do true discounted cash flow valuation you have to look at all possible good & bad outcomes. Expected cash flow is not risk-adjusted. The discount rate is where you adjust for risk. Riskier assets have higher discount rates than safer assets.

Rather than adjusting the discount rate, you can adjust the cash flow for risk. I will explain this with an example cause a lot of people don’t quite understand this.

Let’s assume you have 100$ of expected cash flow for next year. But you are uncertain about those cash flows. Your risk-adjusted cash flow will not be 100$. It will be whatever you’d take as a replacement for the 100$ as a guaranteed cash flow.

If you are risk-averse and I offered you a choice of 100$ of risky cash flows or some other number that’s safe cash flow. You probably settle for a lesser number (90,95,93 ). That’s called certainty equivalent cash flow.

Those are the two things in risk adjusting discounted cash flows.

 

Risk is Not Purely Bad

 Risk is Not Purely Bad

        The risk just can’t be viewed as a negative. If the risk is just a negative the way should respond to risk is by avoiding it. So the best risk management strategies would be risk avoidance strategies. And that’s not a way to invest or build a business. In fact, if you look at great businesses and you think about how they became great not by avoiding risk but by seeking out risk. Not seeking out every risk but seeking out the right kind of risk. to me, that’s the essence of risk management to understand that risk is both positive and negative, and good risk-taking is you’re weighing the trade-off and you are taking those risks where the good outweighs the bad. No guarantees, but that’s the essence of risk-taking.

         As human beings, we’re risk averse. People became more experts the more expertise they had and the less risk-averse they became. Take the example of some traders out there. Traders as they trade longer and longer become less risk averse because they either learn more about the market or worse they think they’ve learned more about the market. Another example is young versus old people. Young people are less risk-averse than older people. People are more willing to take big risky bets with other people’s money than with their own money. That’s something that comes from within. If you come into a casino and I handed you 50,000$ at the door even though it’s now your money the fact that I handed you the money rather than it being money that you earned makes a difference in how you bet with that money.

        And finally here’s the interesting point, when people lose money on bets or when they lose money in casinos it looks like they get less risk averse and try to get back to break even. In other words, they start taking bigger and bigger risks just to get back to breakeven. It’s something that every casino knows but something to keep in mind. These are things that go against classic economics in terms of risk aversion but this is what behavioral finances brought to the table. Recognizing risk will helps you to understand why people behave the way they do. And sometimes why they behave strangely.

 

Type of Stocks to Avoid

Type of Stocks to Avoid

    If I could avoid a single stock it would be the hottest stock in the hottest industry. the one that gets the most favorable publicity, the one that every investor hears about in the carpool or on the commuter train- and succumbing to the social pressure, often buys. Hot stocks can go up fast, usually out of sight of any of the known landmarks of value, But since there's nothing but hope and thin air to support them, they fall just as quickly, If you aren't clever at selling hot stocks, you will soon see your profits turn into losses, because when the where you jumped on, price falls, it's not going to fall slowly, nor is it likely to stop at the level look at the chart for Softlogic life insurance. A recent hot stock in the hot insurance industry, which in 5 months went from Rs. 30 to Rs.240 back to 36/-. That was terrific for the people who said goodbye at 240, but what about the people who said hello at 240/- 

If you had to live off the profits from investing in the hottest stocks in each successive hot industry, soon you'd be on welfare .. High growth and hot industries attract a brilliant crowd that wants to get into the business. Entrepreneurs and venture capitalists stay awake nights trying to figure out how to get into the act as quickly as possible.  when you find a stock under these conditions it’s better to stay away.

Foundation of Finance

Foundation of Finance

Finance is the heart of a business. And finance is all about money. No matter what aspect of a business you are looking about strategy, marketing, human relations, or public relations it’s always about the money. In corporate finance you are looking at a business inside out, you are looking at financial decision-making within a business how to run a business well and how do you create value in the business.

There are 6 building blocks in finance you should understand. These are my subjective judgment there might be others who believe there are other building blocks.

1. The Concept and Structure of Business

(Forward-looking, Not backward-looking)

Finance is a very simple and at the same time very complex way of looking at businesses. You’ve got assets and liabilities here. This part is not what you’ve already put into business but what we expect you to make from these assets in the future. It’s always about the future.    

        2. Cash Flows

Finance is all about cash flows. As supposed to accounting, earnings, and book value of assets it’s always about cash flows. Understanding what drives cash flows, why they are different from earnings the different types of cash flows is central to understanding finance.   

        3. Risk

It’s a definition and measuring the risk. And it’s the notion the driving force of risk everything in finance it’s better on measuring risk and making sure you are earning a return that is sufficient given the risk you’ve taken on. In this process you have to define risk, come up with measuring of risk and you have to come up with perspectives on risk.

        4. Time Value of Money

This one is the fourth big idea in finance. A dollar today is worth more than a dollar year from now. Understanding intuition of time values centered also understand why currencies matter and why the time value of money itself might shift across time. 

        5. The Basics of Valuation

This part describes how you value a cash set of cash flows. What are those cash flows contractually set? What if their residual cash flows? what are their contingent cash flows? Understand the basics of valuation.    

        6. Trading Fundamentals

Understand trading is central to finance. In fact, every trader likes to make money without taking any risk and in fact, you’d like to invest no money take no risk and make money that’s called arbitrage. Understanding what makes arbitrage so difficult in markets is again central to thinking about finance.

Current Liabilities

  Current Liabilities

Current liabilities are the debts and obligations that the company owes that is coming due within one year. They are found on the balance sheet under the headings of Accounts Payable, Accrued Expenses, Short-Term debt, Long-Term debt coming due, and other current liabilities. Typically current liabilities are settled using current assets, which are assets that are used for one year.

 

Dive into Liquidity Ratios

 

Current assets include cash, cash equivalent, and account receivables. Which is money owned by customers. The ratio of current assets to current liabilities is an important one in determining a company's ongoing ability to pay its debts as they are due.

 

Accounts payable is typically one of the most significant current liability accounts on a company's financial statements, representing unpaid amounts for suppliers. Companies try to match payment dates so that their accounts receivables are collected before the accounts payables are due to suppliers.

 

For example, a company might have 60-day terms for money owed to their supplier, which results in requiring their customers to pay within a 30-day term. Current liabilities can also be settled by creating a new current liability, such as a new short-term debt obligation.

Financial analysts and creditors often use the current ratio. This current ratio measures a company's capacity to pay its short-term financial debts or obligations. The ratio, which is calculated by dividing current assets by current liabilities, shows how well a company manages its balance sheet to pay off the company’s short-term debt. It shows investors and financial analysts whether a company has enough current assets on its balance sheet to satisfy or pay off its current debt and other payables.

 

And the most important liquidity ratio is the quick ratio. The quick ratio is the same formula as the current ratio, except it subtracts the value of total inventories beforehand. The quick ratio is a more conservative one for liquidity since it only includes the current assets that can be immediately converted to cash to pay off current liabilities.

 

A number higher than one is ideal for both the current and quick ratios since it demonstrates there are more current assets to pay current short-term debts. However, if the number is too high, it could mean the company is not leveraging its assets as well as it otherwise could be.

 

Good Management and Leadership Practice

  Good Management and Leadership Practice

 

        One of the main components of a successful business is often the presence of good management. Good management practices involve managing people and improving their strengths, weaknesses, and needs. We can describe management as the practice of handling people and organizational tasks. Good managers implement management strategies that benefit the entire company. Good management knows how to allocate an employee to maximize their potential and best utilize their unique skills. Good managers can improve employee satisfaction and development by getting to know the employees personally, consequently promoting greater success and productivity with the rest of the company.

 

Most managers discover strengths and weaknesses through conversation and observation. For example, talking to individual employees about their skills and their goals often helps managers understand the areas in which they work well. Once a manager is aware of each employee’s strengths and weaknesses, they can distribute tasks, assign responsibilities, and form teams to promote productivity and eliminate conflict, boredom, or demoralization. 

 

Managers are responsible for providing guidance and ongoing development and training to employees during their careers. Good management means being able to adjust one’s teaching style to suit how each employee learns. For example, some employees learn best through spoken instruction or written directions. Others learn skills through practice and need time to perform well. Good managers can adapt these learning styles to each employee’s needs.

 

A good manager encourages employees to speak up when they have insight, concerns, or questions. If a manager neglects to listen to either positive or negative feedback from their employees, they may inhibit their decision-making abilities.

 

It’s important to recognize the success of employees. If an employee has a relatively meaningful achievement, an employer can recognize their success with tokens of appreciation such as verbal recognition, bonuses, and other rewards. When employees feel recognized and appreciated, they become more confident and enthusiastic about their work. Employees should trust that their manager has the best information and knowledge to lead a successful team.

 

Motivating employees to perform well and achieve their goals is an important task for a manager. One of the overarching goals of good management is to instill employees with the ability to work autonomously and take ownership of their roles. Employees often have unique motivational drivers, so it’s important to individualize your motivational approach. Some are driven by a desire for recognition and may benefit from rewards like employee of the month or employee sales competitions. Others may be driven by financial stability and respond best to monetary motivators or promotions. Managers should understand these factors when dealing with their employees. Combining all these factors can lead to the success of the business.  

 

 

What Is a Great Company

 What Is a Great Company

 

        What we want is a company with a durable competitive advantage. The world’s greatest investor Warren Buffet has figured out that these super companies come in three basic business models: They sell either a unique product or a unique service, or they are the low-cost buyer and seller of a product or service that the public consistently needs. 

Let's take a good look at each of them. Selling a unique product: This is the world of Coca-Cola, Apple, Wrigley, Pepsi, Budweiser, Coors, Kraft, The Washington Post, Procter & Gamble, and Philip Morris. Through the process of customer need and experience, and advertising promotion, the producers of these products have placed the stories of their products in our minds and in doing so have induced us to think of their products when we go to satisfy a need. Want to have a phone? You think of apples. Want to chew some gum? You think of Wrigley, Feel like having a cold beer after a hot day on the job? You think of Budweiser. And things do go better with Coke. 

Top-level investors like to think of these companies as owning a piece of the consumer's mind, and when a company owns a piece of the consumer's mind, it never has to change its products. The company also gets to charge higher prices and sell more of its products, creating all kinds of wonderful economic events that show up on the company's financial statements.

 Selling a unique service: This is the world of Moody's Corp., H & R Block Inc., American Express Co., The Service Master Co., and Wells Fargo & Co. Like lawyers or doctors, these companies sell services that people need and are willing to pay for - but unlike lawyers and doctors, these companies are institutional specific as opposed to people specific. When you think of getting your taxes done you think of H & R Block, you don't think of Jack the guy at H & R Block who does your taxes. When Warren buffet bought into Salomon Brothers, an investment bank ( now part of Citigroup ), which he later sold, he thought he was buying an institution. But when top talent started to leave the firm with the firm's biggest clients, he realized it was people specific. In people-specific firms, workers can demand and get a large part of the firm's profits, which leaves a much smaller pot for the firm's owners/shareholders. And getting the smaller pot is not how best investors get rich. 

The economics of selling a unique service can be phenomenal. A company doesn't have to spend a lot of money on redesigning its products, nor does it have to spend a fortune building a production plant and warehousing its wares(CAPEX), Firms selling unique services that own a piece of the consumer's mind can produce better margins than firms selling products. 

Being the low-cost buyer and seller of a product or service that the public has an ongoing need for: This is the world of Wal - Mart, Costco, Nebraska Furniture Mart, Borsheim's Jewelers, and the Burlington Northern Santa Fe Railway. Here, big margins are traded for volume, with the increase in volume more than making up for the decrease in margins. The key is to be both the low-cost buyer and the low-cost seller, which allows you to get your margins higher than your competitor's and still be the low-cost seller of a product or service. The story of being the best price in town becomes part of the consumer's story of where to shop. In Omaha, if you need a new stove for your home, you go to the Nebraska Furniture Mart for the best selection and the best price. Want to ship your goods cross-country? The Burlington Northern Santa Fe Railway can give you the best deal for your money. Live in a small town and want the best selection with the best prices? You go to Wal - Mart.

After combining all these factors you can come up with a decision that great companies are made up of all factors like Durable competitive advantage, honest management, customer mind share, low CAPEX requirement, pricing power, and brand loyalty.