Chapter2
Business valuation analysis
What Is Valuation Analysis?
Valuation analysis is a process to estimate the approximate value or worth of an
asset, whether it's a business, equity, fixed income security, commodity, real
estate, or other assets.
 The analyst may use different approaches to valuation analysis for different
types of assets, but the common thread will be looking at the underlying
fundamentals of the asset.
 Valuation analysis is important for investors to estimate the intrinsic values of
company shares in order to make better-informed investment decisions.
 Fair values of bonds do not deviate much, if at all, from intrinsic values, but
opportunities do arise once in a while in the case of the financial stress of a
heavily indebted company.
Valuation analysis is a useful tool for:
1- Comparing companies within the same sector
2- Estimating a return on an investment over a given time period.
Investing and Herd Mentality
Herd mentality bias refers to investors’ tendency to follow and copy what other
investors are doing.
 They are largely influenced by emotion and instinct, rather than by their own
independent analysis.
 This guide provides examples of how investors may give in to herd bias, as
part of behavioral finance theory.
 Many investors react to market conditions like lemmings “Stampeding up the
high mountain when markets are rising and down into the deep sea when
markets are falling!” But, Why does it happen?
 Because investors often get into the market too late and get out too early! “So
you should never let emotions cloud your trading judgment. But you can turn
the crowd’s fear and greed to your advantage!”
1
Mr. Ahmed Elmowafy
 To Damodaran, all investors can be categorized as belonging to one of three
categories of lemming:
Lemming #1 - The Proud Lemming
 This lemming is proud to be part of the crowd, as they go along with whatever
is getting the herd excited. This type of herd behavior is in line with the fear of
missing out (FOMO), where this lemming will do whatever to be included in
the herd.
 Fundamentals are damned (hateful) with this type of lemming. All they care
about is what the crowd is doing and mimic what is being bought and sold by
the crowd.
"One hundred thousand lemmings cannot be wrong" Damodaran
Lemming #2 - The Yogi Bear Lemming
 This lemming thinks it can get out in front of the crowd. Yogi Bear's famous
slogan was that he was "smarter than the average bear," and this lemming
thinks he's smarter than the crowd as well - able to get out in front of the
market before price bumps and able to jump ship before crashes.
 Just as Yogi Bear often looks like a fool in his cartoons, this lemming seldom
outsmarts the crowd and ends up going over the cliff anyway.
2
Mr. Ahmed Elmowafy
Lemming #3: The Lemming With A Life Vest
 A lemming with a life vest is a lemming that thinks a little bit differently than
the crowd. They're still part of the crowd but typically don't go all-in with the
crowd and can sometimes survive the herd going over the cliff because they
have a life vest.
 For example: The value of equity markets grew exponentially during the
dotcom bubble, with the Nasdaq rising from under 1,000 to more than 5,000
between 1995 and 2000. The bubble burst in 2001. The Nasdaq, which rose
five-fold between 1995 and 2000, saw an almost 77% drop, resulting in a loss
of billions of dollars.
3
Mr. Ahmed Elmowafy
 During the dot com bubble, Warren Buffett was a lemming with a life vest. He
was still part of the herd - still investing in the stock market - but he didn't go
all-in with the crowd.
 Buffett knew that dot com stocks were overvalued in 2000 and stuck to his
guns. While the media vilified him and called him "old," Buffett didn't bend
and was spared the major losses the herd took when the bubble burst.
Misconceptions about Valuation
Myth 1: A valuation is an objective search for “true” value.
 Truth 1.1: All valuations are biased. The only questions are how much and in
which direction.
 Truth 1.2: The direction and magnitude of the bias in your valuation are
directly proportional to who pays you and how much you are paid.
Damodaran Justification
 To expand on this myth, he gave an example of a recent company
acquisition.
 According to him, the buyer hired a valuation firm to determine the value of
the intended acquisition while the seller hired their own firm to do the
same thing.
4
Mr. Ahmed Elmowafy
 When the two firms came back they presented significantly different
results. In the end, a third party was brought in and conveniently landed
with a number right in the middle of the first firms' numbers.
Myth 2: A good valuation provides a precise estimate of the value.
 Truth 2.1: There are no precise valuations.
 Truth 2.2: The payoff to valuation is greatest when valuation is least precise.
Damodaran Justification
 Value estimates are projected with “everything is going to go as planned” in
mind.
 There is no way to predict whether an outside event will affect value three
years down the road.
 There will always be a level of uncertainty so valuation professionals, even
if completely off on their initial values, are never really “wrong” with their
assessments.
Myth 3: The more quantitative a model, the better the valuation.
 Truth 3.1: One’s understanding of a valuation model is inversely proportional
to the number of inputs required for the model.
 Truth 3.2: Simpler valuation models do much better than complex ones.
Damodaran Justification
 Damodaran says less is more. Complex models can lead to input fatigue and
cause problems with the value outcome.
 He advises other professionals to aggregate and consolidate in order to
make much more simple models to follow.
5
Mr. Ahmed Elmowafy
Approaches to Valuation
Fundamental valuation/Discounted cashflow valuation
 This technique relates the value of an asset to the present value of the
expected future cash flows on that asset.
Relative valuation
 This technique estimates the value of an asset by looking at the pricing of
'comparable' assets relative to a common variable like earnings, cash-flows,
book value, or sales.
Contingent Claim Valuation/Option pricing model
 This technique uses option pricing models to measure the value of assets
that share option characteristics.
6
Mr. Ahmed Elmowafy