A Review of Valuation, 5th Edition

March 13, 2014
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If I were teaching a course on value investing, Valuation: Measuring and Managing the Value of Companies, 5th Edition, would be the main textbook that I would use. The authors are all current or former consultants of McKinsey & Company, the renowned management consultancy. When the book was originally published more than 20 years ago it was meant to be a handbook for McKinsey consultants. As the name implies the book teaches you how to value companies based on the principles of discounted cash flow analysis. Value investors in my opinion generally follow two distinct approaches to investing: the Graham “cigar butt” strategy or Buffett’s quality at a discount. If you’re looking for a book on how to find and assess a net-net stock, this book isn’t for you. If on the other hand, you focus on finding “wide-moat” companies and holding them over the long-term this book will help you value companies better. In the 1989 Berkshire Hathaway annual report, Buffett stated the following:

What counts, however, is intrinsic value – the figure indicating what all of our constituent businesses are rationally worth. With perfect foresight, this number can be calculated by taking all future cash flows of a business – in and out – and discounting them at prevailing interest rates. So valued, all businesses, from manufacturers of buggy whips to operators of cellular phones, become economic equals.

I think the biggest mistake that most investors make is that they don’t know how to correctly assess intrinsic value through discounted cash flow analysis. Valuation will teach how to correctly analyze past performance, forecast free cash flows, estimate the cost of capital and interpret the results of a valuation analysis. After reading this book and understanding it you’ll probably be able to value a company better than 99% of retail investors and maybe some institutional investors.

The book is categorized into six parts. Part one focuses on value creation and how managers create value by generating returns on invested capital that are above a company’s cost of capital. Chapter 2, titled Fundamental Principles of Value Creation, is probably the best explanation I have ever seen of why ROIC (Return On Invested Capital) is the key value driver for any business from both a theoretical and mathematical perspective.

Anyone that has taken a corporate finance course will be familiar with the well-known cash flow perpetuity formula:

Most financial analysts use some form of this formula when deriving terminal values in a typical valuation exercise. The authors then use the cash flow perpetuity formula to derive the key value driver formula, which they reverently have named the “Tao of corporate finance.”

The key value driver formula relates a company’s fundamental drivers to growth, ROIC and the cost of capital. I would concur with the authors that “this formula represents all there is to valuation. Everything else is mere detail.”

If you’ve read a few a books on value investing they all inevitably begin to sound the same. It’s rare when you come across a book that actually improves your overall investment process. By incorporating the key driver formula into my terminal value calculations, I can honestly say that reading Valuation improved my investment process.

Part two of the book is basically a self-taught course on discounted cash flow (DCF) analysis. If you’ve never done a DCF, I think it would be difficult to learn how to do it simply by reading the book. However, for experienced practitioners it will serve as a good refresher course.

Part three of the book provides empirical evidence of why stock prices reflect long-term value creation as described in the book. I think most value investors intuitively believe that stock prices should reflect value creation over time. However, it’s always helpful to see empirical confirmation of this belief. The authors also tackle market bubbles in this section of the book. Given the widespread belief in market efficiency it’s always refreshing to see academically oriented writing reflect the fact that mispricing does occur in equity markets. Investors can be swept up in emotions such as greed and fear, which means market prices don’t always reflect underlying fundamentals. The authors take the practical view that mispricings do occur in the market and are eventually corrected.

Part four of the book is written primarily for managers. It deals with the process of value creation when running a company. As a former investment banker, I can testify to the inability of most management teams of publicly traded companies to generate value through acquisitions. The “institutional imperative” as defined by Buffett is too powerful for many CEOs to overcome. For a great explanation of the institutional imperative you should read Robert Hagstrom’s The Warren Buffett Way. Essentially, most CEOs end up focusing on revenue and earnings per share growth when return on invested capital and cash flow generation should be their focus. As a result, most CEOs end up overpaying when acquiring businesses and returns to shareholders are negatively impacted. This section of the book is an attempt to help corporate managers implement a framework to evaluate corporate portfolio strategy. The individual investor probably won’t get much out of this section of the book. However, it will help to identify managers that are focused on creating shareholder value rather than simply growing their fiefdom.

Part five of the book deals with advanced valuation techniques and deals with more complex issues such as taxes, pension reserves, inflation and foreign currencies. If you’re a professional equity analyst, you’ve probably come across these thorny valuation issues at some point in your career. This part of the book serves as a good source of reference for these issues. Part six of the book is focused on special situation analysis such as valuing high growth companies, companies in emerging markets, cyclical companies and banks. Although I found the bank valuation chapter helpful, I think professor Aswath Damodaran’s book The Dark Side of Valuation does a better job of laying out the intricacies of valuing high growth and start-up companies.

Overall, I think it’s a good book and is written primarily for corporate finance practitioners. I think the book may be a too technical for a novice investor. However, I think any investor would benefit from reading part one and part two of the book to understand why ROIC is the key driver of long-term value creation for any business. If you’re a novice investor, I would recommend starting with Pat Dorsey’s The Little Book That Builds Wealth. You can read my review of the book here. If you’re a professional investor or corporate finance professional, Valuation should be in your library. It’s a practitioner’s handbook that has the rare ability to combine theoretical analysis with practical advice.


Written by Ankur Shah

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