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A Few Notes on The Dark Side of Valuation

| | Posted in: Fundamental Valuation

In the 2009 second edition of his book, The Dark Side of Valuation: Valuing Young, Distressed, and Complex Businesses, Professor of Finance Aswath Damodaran, investigates and offers remedies for “dark practices and flawed methods in valuation.” He emphasizes “the importance of first principles in valuation and how they should guide us when we’re faced with estimation questions and issues.” As summarized in the closing chapter, the key enlightening propositions of the book are:

The basic principles of valuation on which one should never compromise include: “(a) that an asset derives its value from its capacity to generate cash flows in the future, (b) that risk affects value, (c) that growth has to be earned (not endowed), and (d) that the laws of demand and supply cannot be repealed.” However, one should always be in search of and open to better ways of modeling risk.

“…[T]he areas where you choose to accept market wisdom and the points at which you deviate depend on…the competitive advantages you see yourself having as an analyst and where you think these advantages will generate the biggest payoff.

“As investors, we can invest in bonds, assets, stocks, and in domestic or foreign markets. Therefore, we need to use the same rules when assessing expected returns across asset classes and markets.”

“Ultimately, the expected growth in a company’s earnings and cash flows must come from either new investments or improved efficiency. The latter is finite…whereas new investment growth can be for the long term…[G]rowth by itself is not always a plus for a company, since the value added by growth is a function of the quality of the investments that generated the growth. That is why we [focus] so intensely on…comparing the return on capital to the cost of capital, or the return on equity to the cost of equity.”

“As companies get bigger, it becomes more and more difficult for them to keep delivering the excess returns and growth rates they did in the past… When firms are successful, they attract attention, which in turn leads to imitation and competition…the new competitors will inevitably chip away at profitability and growth.”

“When we use historical data to make estimates, we are assuming that mean reversion exists… While mean reversion has strong empirical support, two dangers are associated with assuming it will happen. The first is that there can sometimes be significant breaks in history, where the circumstances change so much that the numbers are unlikely to revert for a very long period to past averages… The second danger is that there is no consensus on what exactly the norm is for most variables.”

The “push toward larger sample sizes permeates much of what we have done…to combat bad practices.”

“Accept uncertainty as a given, understanding that no matter how carefully we construct models, we cannot make uncertainty go away…adding more detail to models or making models more complicated…often does little to alleviate the problem and may make it worse.”

“Every number in a…valuation should have a good economic rationale, a good economic story behind it… On the flip side, every solid economic story should find a place in the numbers…the tendency toward storytelling sometimes overwhelms the numbers.”

In summary, The Dark Side of Valuation presents quantitative approaches to modeling the worth of companies for which valuation is especially complex and/or judgmental.

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