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VALUATION:CLOSINGTHOUGHTSFall2016“Itain’t overtillitsover”
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Backtotheverybeginning:ApproachestoValuation
¨ DiscountedCashflowValuation,wherewetry(sometimesdesperately)toestimatetheintrinsicvalueofanassetbyusingamixoftheory,guessworkandprayer.
¨ Relativevaluation,wherewepickagroupofassets,attachthename“comparable” tothemandtellastory.
¨ Contingentclaimvaluation,wherewetakethevaluationthatwedidintheDCFvaluationanddivvyitupbetweenthepotentialthieves(equity)andthevictimsofthiscrime(lenders)
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IntrinsicValuation:Thesetup
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DantemeetsDCF:Ninelayersofvaluationhell..Andabonuslayer..
Base year and accounitng fixaiton
Death and taxes
High growth for how long?
Whatʼs in your disocunt rate?
The terminal value: Itʼs not an ATM
Are you paying for growth?
Debt ratios change, donʼt they?
No garnishing allowed!!
From aggregate to per share value?
The Wasserstein-Perella bonus layer
5
Layer1:BaseYearfixation….
¨ YouarevaluingExxonMobil,usingthefinancialstatementsofthefirmfrom2008.Thefollowingprovidesthekeynumbers:Revenues $477billionEBIT(1-t) $58billionNetCapEx $3billionChg WC $1billionFCFF $54billion
¨ Thecostofcapitalforthefirmis8%andyouuseaveryconservativestablegrowthrateof2%tovaluethefirm.Themarketcapforthefirmis$373billionandithas$10billionindebtoutstanding.a.Howunderorovervaluedistheequityinthefirm?b.Wouldyoubuythestockbasedonthisvaluation?Whyorwhynot?
Base year and accounitng fixaiton
Death and taxes
High growth for how long?
Whatʼs in your disocunt rate?
The terminal value: Itʼs not an ATM
Are you paying for growth?
Debt ratios change, donʼt they?
No garnishing allowed!!
From aggregate to per share value?
The Wasserstein-Perella bonus layer
6
Layer2:TaxesandValue
¨ Assumethatyouhavebeenaskedtovalueacompanyandhavebeenprovidedwiththemostrecentyear’sfinancialstatements:
¨ EBITDA 140¨ - DA 40¨ EBIT 100¨ Interestexp 20¨ Taxableincome 80¨ Taxes 32¨ NetIncome 48¨ Assumealsothatcashflowswillbeconstantandthatthereisnogrowthinperpetuity.Whatisthe
freecashflowtothefirm?a. 88million(Netincome+Depreciation)b. 108million(EBIT– taxes+Depreciation)c. 100million(EBIT(1-taxrate)+Depreciation)d. 60million(EBIT(1- taxrate))e. 48million(NetIncome)f. 68million(EBIT– Taxes)
Free Cash flow to firmEBIT (1- tax rate)-(Cap Ex – Depreciation)- Change in non-cash WC=FCFF
Base year and accounitng fixaiton
Death and taxes
High growth for how long?
Whatʼs in your disocunt rate?
The terminal value: Itʼs not an ATM
Are you paying for growth?
Debt ratios change, donʼt they?
No garnishing allowed!!
From aggregate to per share value?
The Wasserstein-Perella bonus layer
7
Layer3:HighGrowthforhowlong…
¨ Assumethatyouarevaluingayoung,highgrowthfirmwithgreatpotential,justafteritsinitialpublicoffering.Howlongwouldyousetyourhighgrowthperiod?
¨ <5years¨ 5years¨ 10years¨ >10years
Base year and accounitng fixaiton
Death and taxes
High growth for how long?
Whatʼs in your disocunt rate?
The terminal value: Itʼs not an ATM
Are you paying for growth?
Debt ratios change, donʼt they?
No garnishing allowed!!
From aggregate to per share value?
The Wasserstein-Perella bonus layer
8
Layer4:TheCostofCapital
¨ ThecostofcapitalforChippewaTechnologies,aUStechnologyfirmwith20%ofitsrevenuesfromBrazil,hasbeencomputedusingthefollowinginputs:
Cost of equity = Riskfree Rate + Beta (ERP) + Small firm premium = 5% + 1.20 (5%) + 3% = 14%
Replaced current T.Bond rate of 3% with normalized rate of 5%
“Adjusted” Beta from Bloomberg
Both from Ibbotson data base, derived from 1926-2008 dataERP: Stocks - T.Bonds (Arithmetic average)Small firm: Smal stocks - Overall market
Cost of capital = Cost of equity (Equity/ (Debt + Equity)) + Cost of debt (1- tax rate) (Debt/ (Debt + Equity)= 14% (1000/2000) + 3% (1-.30) (1000/2000) = 8.05%
From above
Used market value of equity
Company is not rated and has no bonds. Used book interest rate = Int exp/ BV of debt
Used effective tax rate of 30%
To be conservative, counted all liabilities, other than equity, as debt and used book value.
Base year and accounitng fixaiton
Death and taxes
High growth for how long?
Whatʼs in your disocunt rate?
The terminal value: Itʼs not an ATM
Are you paying for growth?
Debt ratios change, donʼt they?
No garnishing allowed!!
From aggregate to per share value?
The Wasserstein-Perella bonus layer
9
TheCorrectCostofCapitalforChippewa
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Layer5:Thepriceofgrowth..
¨ Youarelookingattheprojectedcashflowsprovidedbythemanagementofthefirm,foruseinvaluation
¨ Whatquestionswouldyouraiseabouttheforecasts?
Base year and accounitng fixaiton
Death and taxes
High growth for how long?
Whatʼs in your disocunt rate?
The terminal value: Itʼs not an ATM
Are you paying for growth?
Debt ratios change, donʼt they?
No garnishing allowed!!
From aggregate to per share value?
The Wasserstein-Perella bonus layer
11
Layer6:The“fixeddebtratio” assumption
¨ YouhavebeenaskedtovalueHormelFoods,afirmwhichcurrentlyhasthefollowingcostofcapital:¤ Costofcapital=7.31%(.9)+2.36%(.1)=6.8%
¨ Youbelievethatthetargetdebtratioforthisfirmshouldbe30%.Whatwillthecostofcapitalbeatthetargetdebtratio?
¨ Whichdebtratio(andcostofcapital)shouldyouuseinvaluingthiscompany?
Base year and accounitng fixaiton
Death and taxes
High growth for how long?
Whatʼs in your disocunt rate?
The terminal value: Itʼs not an ATM
Are you paying for growth?
Debt ratios change, donʼt they?
No garnishing allowed!!
From aggregate to per share value?
The Wasserstein-Perella bonus layer
12
Layer7:TheTerminalValue
¨ Thebestwaytocomputeterminalvalueistoa. Useastablegrowthmodelandassumecashflowsgrowatafixed
rateforeverb. UseamultipleofEBITDAorrevenuesintheterminalyearc. Usetheestimatedliquidationvalueoftheassets¨ Youhavebeenaskedtovalueabusiness.Thebusinessexpectsto$
120millioninafter-taxearnings(andcashflow)nextyearandtocontinuegeneratingtheseearningsinperpetuity.Thefirmisallequityfundedandthecostofequityis10%;theriskfreerateis3%andtheERPis7%.Whatisthevalueofthebusiness?
¨ Assumenowthatyouweretoldthatthefirmcangrowearningsat2%ayearforever.Estimatethevalueofthebusiness.
Base year and accounitng fixaiton
Death and taxes
High growth for how long?
Whatʼs in your disocunt rate?
The terminal value: Itʼs not an ATM
Are you paying for growth?
Debt ratios change, donʼt they?
No garnishing allowed!!
From aggregate to per share value?
The Wasserstein-Perella bonus layer
13
Layer8.Fromfirmvaluetoequityvalue:TheGarnishingEffect…
¨ Forafirmwithconsolidatedfinancialstatements,youhavediscountedfreecashflows tothefirmatthecostofcapitaltoarriveatafirmvalueof$100million.Thefirmhas¤ Acashbalanceof$15million¤ Debtoutstandingof$20million¤ A5%holdinginanothercompany:thebookvalueofthisholdingis$5
million.(Marketvalueofequityinthiscompanyis$200million)¤ Minorityinterestsof$10milliononthebalancesheet
¨ Whatisthevalueofequityinthisfirm?
¨ Howwouldyouranswerchangeifyouknewthatthefirmwasthetargetofalawsuititislikelytowinbutwherethepotentialpayoutcouldbe$100millionifitloses?
Base year and accounitng fixaiton
Death and taxes
High growth for how long?
Whatʼs in your disocunt rate?
The terminal value: Itʼs not an ATM
Are you paying for growth?
Debt ratios change, donʼt they?
No garnishing allowed!!
From aggregate to per share value?
The Wasserstein-Perella bonus layer
14
Layer9.Fromequityvaluetoequityvaluepershare
¨ Youhavevaluedtheequityinafirmat$200million.Estimatethevalueofequitypershareifthereare10millionsharesoutstanding..
¨ Howwouldyouranswerchangeifyouweretoldthatthereare2millionemployeeoptionsoutstanding,withastrikepriceof$20ashareand5yearslefttoexpiration?
Base year and accounitng fixaiton
Death and taxes
High growth for how long?
Whatʼs in your disocunt rate?
The terminal value: Itʼs not an ATM
Are you paying for growth?
Debt ratios change, donʼt they?
No garnishing allowed!!
From aggregate to per share value?
The Wasserstein-Perella bonus layer
15
Layer10.Thefinalcircleofhell…
Cost of Equity Cost of Capital
Kennecott Corp (Acquirer) 13.0% 10.5%
Carborandum (Target) 16.5% 12.5%
Base year and accounitng fixaiton
Death and taxes
High growth for how long?
Whatʼs in your disocunt rate?
The terminal value: Itʼs not an ATM
Are you paying for growth?
Debt ratios change, donʼt they?
No garnishing allowed!!
From aggregate to per share value?
The Wasserstein-Perella bonus layer
YOURNUMBERS/FINDINGS
“Thetruthshallsetyoufree”.
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TheModelsYouUsedinDCFValuation
DividendDiscount5% FCFE
5%
FCFF
90%
Modelused
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TheMostValuedCompany(Companies)..
FacebookPrice DCFvalue Pricing Recommendation
Facebook $121.38 $111.18 $159.53 SellFacebook $120.31 $75.74 $59.60 SellFacebook $117.77 $155.43 $158.89 BuyFacebook 120.31 87.42 95.43 SellFacebook $120.31 $162.58 $142.36 BuyFacebook 119.68 177.05 190.11 Buy
UnderArmour,Inc.UnderArmour $32.26 26.83 23.53 SellUnderArmour $27.61 $34.15 $15.13 BuyUnderArmour $32.36 $26.00 $16.00 SELLUnderArmour $32.26 $36.43 $27.41 BUYUnderArmour $32.20 $18.28 $19.77 SellUnderArmour $30.94 $26.71 $28.48 Buy
TeslaTeslaMotors $198.15 $147.64 $100.70 SellTeslaMotors $198.00 $116.00 $87.00 SellTeslaMotors $192.43 $208.94 $50.92 BuyTeslaMotors $192.18 $345.73 $207.71 BuyTeslaMotors $184.52 $137.84 $139.61 HoldTeslaMotors $198.88 $150.81 $147.18 Sell
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Whatyoufound…
0.
10.
20.
30.
40.
50.
60.
70.
80.
Undervaluedmorethan50%
Undervalued33-50%
Undervalued10-33%
Undervalued0-10%
Overvalued0-10%
Overvalued10-50%
Overvalued50-100%
Overvaluedmorethan100%
AxisTitle
AxisTitle
DCFValuevsMarketPrice
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Themostundervaluedstocks…
CompanyName Price DCFValue RelativeValue Recommendation%Underor
over
KajimaCorporation $818.00 $1,656.00 $1,004.00 Buy -50.60% YGEntertainment KRW28,900.00 KRW56,799.00 KRW30,206.00 Buy -49.12% QOL ¥1,454.00 ¥2,710.67 ¥4,658.73 Buy -46.36% TeslaMotors 192.18 345.73 207.71 Buy -44.41% JD.com 181.4 315.80 974.2 Buy -42.56% EdreamsOdigeo(EUR) 2.92 5.08 8.47 Buy -42.52% Li&Fung $0.46 $0.77 $0.60 Buy -40.26% PlanetFitness $20.70 $33.96 $32.82 Buy -39.05% Square,Inc. $13.85 $21.96 $15.20 Buy -36.93% Chipotle $377.50 $582.93 $485.88 Buy -35.24% LIGNex1 $69.84 $104.87 $114.06 Buy -33.40% Facebook 119.68 177.05 190.11 BUY -32.40% HCAHoldings,Inc. $73.25 $108.21 $180.11 Buy -32.31% ZTECorporation 15.56 22.89 3.82 Buy -32.02%
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TheMostOvervaluedstocksare...
CompanyName Price DCFValue RelativeValue OptionValue Recommendation%Underor
over
TowerInsurance $2.50 $0.15 $6.42 Buy 1566.67% AquaVenture Holdings $23.91 2.95 $18.29 Sell 710.51% ColumbiaPipelineGroup $25.50 3.79 $11.85 Sell 572.82% Groupon $3.74 $0.78 $3.43 0.31 Sell 379.49%
MGMResorts $29.19 $6.69 $25.29 $12.85 Sell 336.32% RegalEntertainmentGroup 21.57 6.05 15.21 Sell 256.53% Kronos $11.95 $3.64 $12.77 $1.19 Buy 228.30% Twitter $19.37 $6.10 $15.41 Hold 217.54%MakeMyTrip $24.25 $7.81 24.6 Sell 210.50% WholeFoodsMarket $31.04 $10.04 $25.62 Sell 209.16%
Zillow $33.87 $11.58 $7.38 Sell 192.49% JCPenney 10.51 3.71 5.19 17.60 Buy 183.29% Intrexon $28.79 $10.30 $19.38 Sell 179.51% Salesforce 71.17 29.98 65.3 Sell 137.39% TripAdvisor $48.71 $20.69 $55.47 Sell 135.43%
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Theultimatetest…Didundervaluedstocksmakemoney?
!5.00%&
0.00%&
5.00%&
10.00%&
15.00%&
20.00%&
Spring&1995& Spring&1997& Spring&1999& Spring&2001& Spring&2003& Spring&2005&
Performance*of**Recommenda-ons*
Buy&&
S&P&500&
Sell&
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Moreonthewinners...
¨ Onaverage,right:About60%ofallbuyrecommendationsmakemoney;about45%ofsellrecommendationsbeatthemarket.Theaveragereturnonbuyrecommendationswasabout4%higher,onanannualizedbasis,thantheaveragereturnonsellrecommendations.
¨ Moresoonsome:Theexcessreturnsonbuyrecommendationsonsmallcapandemergingmarketcompaniesishigherthantheexcessreturnsonlargemarketcapcompanies,withhighermistakesinbothdirectionsontheformer.
¨ Skewedpayoffs:Therearetwoorthreebigwinnersineachperiod,butthepayoffwasnotalwaysimmediate.BuyingApplein1999wouldhaveledtonegativereturnsforayearormore,beforetheturnaroundoccurred.
¨ Doublewhammy:StocksthatareundervaluedonbothaDCFandrelativevaluationbasisdobetterthanstocksthatareundervaluedononlyoneapproach.
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RelativeValuation:TheFourStepstoUnderstandingMultiples
¨ AnnaKournikovaknowsPE….Ordoesshe?¤ Inuse,thesamemultiplecanbedefinedindifferentwaysbydifferent
users.Whencomparingandusingmultiples,estimatedbysomeoneelse,itiscriticalthatweunderstandhowthemultipleshavebeenestimated
¨ 8timesEBITDAisnotalwayscheap…¤ Toomanypeoplewhouseamultiplehavenoideawhatitscrosssectional
distributionis.Ifyoudonotknowwhatthecrosssectionaldistributionofamultipleis,itisdifficulttolookatanumberandpassjudgmentonwhetheritistoohighorlow.
¨ Youcannotgetawaywithoutmakingassumptions¤ Itiscriticalthatweunderstandthefundamentalsthatdriveeachmultiple,
andthenatureoftherelationshipbetweenthemultipleandeachvariable.¨ Therearenoperfectcomparables
¤ Definingthecomparableuniverseandcontrollingfordifferencesisfarmoredifficultinpracticethanitisintheory.
Value of Stock = DPS 1/(ke - g)
PE=Payout Ratio (1+g)/(r-g)
PEG=Payout ratio (1+g)/g(r-g)
PBV=ROE (Payout ratio) (1+g)/(r-g)
PS= Net Margin (Payout ratio)(1+g)/(r-g)
Value of Firm = FCFF 1/(WACC -g)
Value/FCFF=(1+g)/(WACC-g)
Value/EBIT(1-t) = (1+g) (1- RIR)/(WACC-g)
Value/EBIT=(1+g)(1-RiR)/(1-t)(WACC-g)
VS= Oper Margin (1-RIR) (1+g)/(WACC-g)
Equity Multiples
Firm Multiples
PE=f(g, payout, risk) PEG=f(g, payout, risk) PBV=f(ROE,payout, g, risk) PS=f(Net Mgn, payout, g, risk)
V/FCFF=f(g, WACC) V/EBIT(1-t)=f(g, RIR, WACC) V/EBIT=f(g, RIR, WACC, t) VS=f(Oper Mgn, RIR, g, WACC)
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TheMultiplesyouusedwere...
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DCFvsRelativeValuation
0.
10.
20.
30.
40.
50.
60.
200% DCFasfractionofRelativeValue
DCFas%ofRelativeValue
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Mostunderpricedonarelativebasis…
CompanyName Price DCFValue RelativeValue Recommendation %UnderorOver:RelativeJD.com 181.4 315.80 974.2 Buy -81.38% QOL ¥1,454.00 ¥2,710.67 ¥4,658.73 Buy -68.79% EdreamsOdigeo(EUR) 2.92 5.08 8.47 Buy -65.53% JustoRodero&Hijos(USD) 3.95 3.95 11.34 Buy -65.17% EnphaseEnergy,Inc. $1.27 $0.96 $3.45 Sell -63.19% UniversalMedical ¥6.64 9.49 ¥17.70 Buy -62.49% JD.com $26.16 $30.01 $69.06 Buy -62.12% WholeFoods $31.04 38.72 80.48 Buy -61.43% TowerInsurance $2.50 $0.15 $6.42 Buy -61.05% PandoraMedia $13.48 11.25 $34.29 Hold -60.69% HCAHoldings,Inc. $73.25 $108.21 $180.11 Buy -59.33% Fitbit $7.98 6.54 19.17 Sell -58.37% Chegg,Inc. $7.99 $10.00 $18.70 Buy -57.27% Chegg,Inc. 7.99 10.00 18.70 Buy -57.27% BebeStores $5.74 $6.10 $13.43 Sell -57.26%
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Mostoverpricedonarelativebasis…
CompanyName Price DCFValue RelativeValue Recommendation%UnderorOver:
Relative
Twitter $18.98 $(19.77) $2.08 Sell 812.50% iKang HealthcareGroup $16.06 8.63 $3.20 Sell 401.88% Zillow $33.87 $11.58 $7.38 Sell 358.94% Twilio 29.23 26.83 6.57 Sell 344.90% Barnes&Noble,Inc. 13.10 11.65 3.16 Sell 314.56% ZTECorporation 15.56 22.89 3.82 Buy 307.33% TeslaMotors $192.43 $208.94 $50.92 Buy 277.91% BakerHughes $66.20 $33.59 $19.27 Sell 243.54% Fibria $31.61 $27.42 $10.48 Sell 201.62%Kroger $34.19 $36.44 $13.50 Sell 153.26% Netflix $120.81 $74.53 $48.40 Sell 149.61%J.C.Penney $9.92 $8.54 $3.99 Sell 148.62% Nathan'sFamous 63.65 54.10 26.45 Hold 140.64% CWCP(privatecompany) 34.722 34.722 14.893 Buy 133.14% Priceline $1,536.71 $1,325.00 $679.00 Sell 126.32%
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ContingentClaim(Option)Valuation
¨ Optionshaveseveralfeatures¤ Theyderivetheirvaluefromanunderlyingasset,whichhasvalue¤ Thepayoffonacall(put)optionoccursonlyifthevalueofthe
underlyingassetisgreater(lesser)thananexercisepricethatisspecifiedatthetimetheoptioniscreated.Ifthiscontingencydoesnotoccur,theoptionisworthless.
¤ Theyhaveafixedlife
¨ Anysecuritythatsharesthesefeaturescanbevaluedasanoption.
¨ Numberoffirmsvaluedusingoptionmodels=12¨ MedianPercentincreaseinvalueoverDCFvalue=117.38%
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ValueEnhancement…Youtoocandoit!
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ValueEnhancementShortCuts:Theycomewithacost¨ Oldwineinanewbottle:Alldiscountedcashflowmodels(costofcapital,
APV,EVA,Excessreturnmodels)areallvariantsofthesamemodeland,doneright,shouldyieldthesamevalue.
¨ Nomagicbullets:Valueenhancementishardwork.Thereareno“shortcuts” andadoptingEVA,CFROIoranyothermeasurewillnotincreasevalue.
¨ Tyingcompensationsystemstoameasureisarecipeforgameplaying:IfyoutiemanagementcompensationtoEVA,forinstance,canleadto:¤ TheGrowthtradeoffgame:Managersmaygiveupvaluablegrowthopportunities
inthefuturetodeliverhigherEVAinthecurrentyear.¤ TheRiskgame:ManagersmaybeabletodeliverahigherdollarEVAbutinriskier
businesses.ThevalueofthebusinessisthepresentvalueofEVAovertimeandtheriskeffectmaydominatetheincreasedEVA.
¤ Thecapitalinvestedgame:ThekeytodeliveringpositiveEVAistomakeinvestmentsthatdonotshowupaspartofcapitalinvested.Thatway,youroperatingincomewillincreasewhilecapitalinvestedwilldecrease.
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Actingonvaluation:Itisnotjustanacademicexercise
a. Iamnotsureyet:Uncertaintyisnotashieldagainstaction.Ifyouwaituntilyoufeel“certain”aboutyourvaluation,youwillneveract.
b. Allbelieversnow?Ultimately,youhavetobelieveinsomemodicumofmarketefficiency.Marketshavetocorrecttheirmistakesforyourvaluationstopayoff.
c. Thelawoflargenumbers:Assumingyourvaluationscarryheft,youarefarmorelikelytoberightacrossmanycompaniesthanonanyindividualone.
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Yourrecommendationswereto..
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Pickingyourvaluationapproach
¨ Assetcharacteristics¤ Marketability¤ Cashflowgeneratingcapacity¤ Uniqueness
¨ Yourcharacteristics¤ Timehorizon¤ Reasonsfordoingthevaluation¤ Beliefsaboutmarkets
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Whatapproachwouldworkforyou?
¨ Asaninvestor,givenyourinvestmentphilosophy,timehorizonandbeliefsaboutmarkets(thatyouwillbeinvestingin),whichofthetheapproachestovaluationwouldyouchoose?
a. DiscountedCashFlowValuationb. RelativeValuationc. Neither.Ibelievethatmarketsareefficient.
37
StoryTellers?NumberCrunchers?
¨ Ifyouareastoryteller,Ihopethatyouhave¤ Moreconfidenceinyournumbercrunching¤ Moredisciplineinyourstories¤ Lessintimidation,whenconfrontedwithnumbercrunchers
¨ Ifyouareanumbercruncher,Ihopethatyouhave¤ Morewillingnesstoputstoriesbehindyournumbers¤ Moreimaginationinyournumbercrunching¤ Moreunderstanding,whenconfrontedwithstorytelling
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SomeNotVeryProfoundAdvice
1. Itsallinthefundamentals.2. Focusonthebigpicture.Don’tsweatthesmall
stuffanddon’tgetdistracted.3. Anecdotesmeanlittleandexperiencedoesnot
equalknowledge.4. Keepyourperspective.Itisonlyavaluation.5. Ininvesting,luckdominatesskillandknowledge.DonotforgettodoyourCFEs.Yourabilitytocheckyourgrade
restsonit.
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