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.
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