Session 26: Closing Thoughts (and a discourse of the value of control)

Key Concepts

Intrinsic Valuation: Estimating an asset's value based on its future cash flows, growth, margins, and reinvestment.
Pricing (Relative Valuation): Determining an asset's value by comparing it to similar assets in the market.
Option Pricing: Valuing assets with optionality, typically used for companies with significant debt and money-losing operations.
Value of Control: The additional value derived from the ability to change a company's management and operations.
Valuation Triangle: A framework for assessing companies based on growth, profitability, risk, and reinvestment.
Economic Value Added (EVA): A profitability metric that measures a company's economic profit.
Cash Flow Return on Investment (CF ROI): A metric that measures the return on invested capital based on cash flows.
Minority Discount: A reduction in value applied to a stake in a private company when the owner does not have control.
Peer Group: A set of comparable companies used for relative valuation.
Market Regression: A statistical method used to determine how the market prices companies based on certain variables.

Summary

This YouTube video transcript provides a comprehensive review of valuation methodologies, student project outcomes, and the concept of the "value of control." The instructor emphasizes the foundational principles of valuation while also discussing practical applications and common pitfalls.

Project Submissions and Initial Review

The session begins with administrative announcements regarding the final project submission deadline and grading. The instructor then outlines the day's agenda: using student-submitted numbers to illustrate valuation concepts and completing the discussion on the "value of control."

Three Ways to Value an Asset

The instructor reiterates the three primary approaches to valuing an asset:

Intrinsic Valuation: This method involves making educated guesses about future growth, margins, and reinvestment to estimate a company's intrinsic value. It requires a deep understanding of the business and its cash flows.
Pricing (Relative Valuation): This approach involves looking at what similar assets are trading for in the market. The instructor notes the challenge of defining a "pure peer group" and how this can lead to mispricing.
Option Pricing: This method is selectively used for companies with optionality, such as biotech or natural resource firms, where future events can significantly increase cash flows. It's not applicable to most companies.

Intrinsic Valuation: The Core Equation and Drivers

The fundamental equation of intrinsic valuation is presented: Value of an asset = Present value of expected cash flows. The process involves:

Cash Flows from Existing Assets: Derived from current financials, more significant for mature companies like Coca-Cola.
Estimating Future Cash Flows: This is the "no man's land" where best estimates for growth, margins, and reinvestment are crucial.
- Growth: Can add, destroy, or have no impact on value depending on reinvestment.
- Risk: Incorporated through the discount rate.
Terminal Value: Calculated using perpetual growth models, finite growth annuities, or liquidation values.

The four key drivers of value in intrinsic valuation are:

Revenue Growth: The rate at which a company's sales increase.
Margins: The profitability of a company's sales (e.g., operating margin).
Reinvestment: The capital a company invests back into its business to generate growth.
Cost of Capital (Discount Rate): Reflects the risk of the company's operations, often using betas and risk premiums.

A critical point is made about failure risk, which is often deliberately ignored in DCF but needs explicit consideration, especially for younger companies with high debt. The instructor argues that increasing the discount rate to account for failure risk is problematic as it can approach infinity, making it an ineffective tool. Venture capitalists' high discount rates are cited as an example of a poor attempt to incorporate failure risk.

The Valuation Triangle

A "valuation triangle" is introduced to assess companies:

Growth: Desired to be high.
Profitability (Margins): Desired to be high.
Risk: Desired to be low.
Reinvestment: The amount needed to achieve growth.

Great companies are characterized by high growth, high margins, low reinvestment, and low risk. However, business involves trade-offs; higher growth often comes at the expense of margins or increased risk.

Student Project Analysis: Company Valuations

The instructor analyzes the companies students valued, noting popular choices like Palantir, Netflix, Boeing, and Starbucks. The variation in stock prices for the same company is attributed to different valuation dates.

Palantir: Shows significant disagreement among students, with most classifying it as a "sell" or "hold."
DCF vs. Market Price: The median company in the class was found to be overvalued by approximately 28% based on DCF valuations. 35% of companies were undervalued, and 65% were overvalued. This contradicts the notion that intrinsic valuation is always conservative.
Most Undervalued Companies: BSON and Kepler Weber are highlighted, with a student explaining their rationale for Kepler Weber as a manufacturing company providing logistics solutions.
Most Overvalued Companies: Philip and Madison Square Garden are mentioned.

The instructor shares historical data on the performance of student-identified undervalued and overvalued stocks, indicating that buys generally outperformed sells and the market, though acknowledging the absence of transaction costs. The analysis suggests that excess returns often come from one or two significant winners, emphasizing the importance of holding onto these big winners.

Value of Control: A Deeper Dive

The discussion shifts to the "value of control," building on the concept of valuing a company twice:

Status Quo Value: The value of the company as currently managed.
Optimal Value: The value if the company were run differently and more effectively.

The potential to change value lies in altering the inputs to valuation:

Increasing Cash Flows from Existing Assets: Through cost-cutting, efficiency improvements, and reduced maintenance capex.
Managing Growth: Reinvesting more in good businesses, less in bad ones.
Lowering Cost of Capital: Through debt/equity mix optimization and asset-debt matching.
Corporate Strategy: Lengthening growth periods and excess return durations.

The instructor argues that the value of control is embedded in publicly traded stock prices, influencing acquisitions, and the pricing of voting versus non-voting shares.

Factors influencing the likelihood of management change and thus the value of control:

Restrictions on Takeovers: Hostile acquisitions are a key mechanism for management change.
Voting Rights: Different classes of shares affect the ability to influence management.
Access to Capital: Crucial for activist investors.
Company Size: Easier to change management in smaller companies.

Scenarios where the value of control is evident:

Publicly Traded Stock Prices: Market prices reflect assumptions about potential management changes.
Hostile Acquisitions: The premium paid reflects the potential to unlock value through control.
Voting vs. Non-Voting Shares: Voting shares typically trade at a premium due to the control they offer. The Embraer case study illustrates how voting shares can command a significant premium, especially when management change is possible. The divergence in prices between voting and non-voting shares (e.g., Facebook, Google) can signal market perceptions of management quality.
Private Company Valuation (Minority Discount): Owning less than 51% of a private company results in a lower valuation (minority discount) because control remains with existing owners. This is the flip side of a control premium.

Critiques of Simplistic Valuation Metrics

The instructor criticizes consulting firms for creating complex acronyms (like EVA and CF ROI) that oversimplify valuation and can be gamed.

Economic Value Added (EVA): Defined as the difference between return on capital and cost of capital, multiplied by capital invested. The instructor demonstrates how EVA can be manipulated through accounting games, short-term focus, and by altering the cost of capital, potentially making a company less valuable while increasing EVA.
Cash Flow Return on Investment (CF ROI): Presented as an analogy to IRR, this metric can be misleading as it often uses gross cash flow and can ignore crucial factors like capex and taxes.

The core message is that there are no shortcuts in valuation; the basics of cash flows, growth, and risk remain paramount.

Pricing: Multiples and Peer Groups

The discussion returns to pricing and multiples, emphasizing the need for consistency and careful definition of terms (e.g., EV/EBITDA).

Four Steps for Pricing:
1. Define Multiples Consistently: Ensure numerator and denominator are properly matched.
2. Use Data: Leverage available data to avoid rules of thumb.
3. Control for Variables: Understand what drives multiples by referencing valuation models.
4. Select Peer Group Carefully: The choice of peer group significantly impacts pricing.

The instructor notes the shift towards EV multiples over P/E ratios, driven by the prevalence of money-losing growth companies. While Warren Buffett focuses on mature companies and equity multiples, growth companies necessitate EV multiples.

The analysis of student pricing results shows that, on average, pricing resulted in a smaller overvaluation (5%) compared to DCF (26%). This is because pricing is a relative measure.

Most Underpriced Stocks (Pricing): A mix of companies, some with mixed signals from DCF.
Most Overpriced Stocks (Pricing): Palantir appears again.

Option Pricing in Valuation

A subset of students attempted option pricing for companies with significant debt and money-losing operations. This method yielded an average premium of 45% over intrinsic value, highlighting its potential for companies with real optionality.

Decision Making in Valuation

The instructor addresses student uncertainty about making buy/sell/hold decisions:

Embrace Uncertainty: Acknowledge that complete resolution is impossible; collect more information but don't let it paralyze decision-making.
Consider Index Funds: For those finding active investing difficult, index funds offer a prudent base.
Portfolio Approach: Adding investments to a portfolio reduces the stress of being right on every single decision.

The breakdown of student recommendations shows a significant bias towards "sell" (68 sells vs. 35 buys), contrasting with typical equity research analyst recommendations.

The Right Way to Value an Asset

The instructor concludes by emphasizing that the "right" valuation approach depends on:

Cash Flows: Intrinsic valuation is unsuitable for assets without cash flows (e.g., Bitcoin).
Marketability: Pricing is more relevant for liquid assets.
Personal Beliefs: Time horizon, risk tolerance, and beliefs about market efficiency play a role.
Job Function: M&A professionals often focus on pricing.

The instructor stresses the importance of understanding market mistakes and developing an investment philosophy based on this understanding.

Storytellers vs. Number Crunchers

The class is divided into "storytellers" and "number crunchers."

Storytellers: Encouraged to be more disciplined with their narratives, understanding margins and returns on capital, and not being intimidated by bankers.
Number Crunchers: Advised to embrace being wrong, use imagination, and have patience with storytellers.

Final Takeaways and Advice

The instructor offers several key pieces of advice:

Back to Basics: Revenue growth, margins, reinvestment, and risk are fundamental.
Look at the Big Picture: Focus on what truly matters and avoid getting lost in minor details.
Challenge Experience: Experience doesn't always guarantee an advantage; be open to new ideas.
Cultivate Imagination: Creativity and imagination are scarce and valuable in investing.
Keep Perspective: Valuation is important, but it's not life or death.
Embrace Luck: While skills are important, luck plays a significant role in investment success.

The session concludes with administrative reminders about course evaluations and final exam logistics. The instructor also addresses the reason for the prevalence of overvalued companies in student valuations, attributing it to the recent market rally rather than a flaw in valuation methodology.