Val closing propositions

Val closing propositions - 1 GOING OVER TO THE LIGHT:...

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1 GOING OVER TO THE LIGHT: VANQUISHING THE DARK SIDE Through this book, we have emphasized the importance of first principles in valuation and how they should guide us, when faced with questions. The dark side of valuation, as we have described it, takes different forms with different types of firms and the remedies we offer have also varied with each type. In this chapter, we pull together some of the core ideas that can allow us to combat the pull of the dark side. In the process, we will very quickly review the foundations of what we would like to portray as the right “light” side of valuation. Enlightening Propositions When confronted by uncertainty or missing information, we are tempted to adopt loosed-backed rules of thumb and make inconsistent assumptions about growth, risk and cash flows. In this section, we will outline a few propositions that can guide us in making better judgments, when challenged, and result in better valuations. Proposition 1: First principles matter There are a few basic principles in valuation that we should never compromise on, no matter what the counter arguments are. An analyst who argues that firms can grow forever without reinvesting is violating a first principle, as is one who says that risk does not matter in determining value. Lest this be seen as a sign of rigidity, we would hasten to add that we should always be willing to compromise on and accept better tools, and be open to alternative estimates for inputs into value. Thus, the capital asset pricing model is a tool for estimating risk, which we should be willing to adapt, modify or even abandon, if the data so directs us. The beta that we come up with for a firm, in the context of measuring risk, is an estimate and there should be no one approach that dominates. In summary, then, we will remain steadfast in our belief that risk should affect value, open to new developments when it comes to models for estimating that risk and always be on the lookout for better and more consistent estimates of beta or other risk parameters. Proposition 2: Pay heed to markets but don’t let markets determine your valuations. Many of the companies that we are called upon to value are traded in financial markets and have a market price. Without making any judgments about markets or their
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2 efficiency, we believe that there is valuable information in how the market is pricing assets. In fact, our estimates of riskfree rates, in chapter 6, and equity risk premiums, in chapter 7, came from financial markets – the pricing of the treasury bond for the first and the level of the equity indices in the latter. When valuing a company, it therefore behooves us to pay attention to the market price for three reasons: 1. The information we extract from markets on implied growth rates, risk and cash flows can be used to improve our valuation. 2.
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Val closing propositions - 1 GOING OVER TO THE LIGHT:...

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