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1. Why Learn About Valuation
Investment valuation is a great skill to have in both your personal and professional life. In this lesson, we introduce some basic theory and rules for valuation.
What is valuation?
- Valuation is the process of estimating the value of an asset
- Assets are anything of value that can be converted into cash
Why learn about valuation?
- Investment decisions are among the most important we'll make in our personal lives
- Almost all managers and senior executives will need to make investment decisions
- Understanding how to value assets makes these decisions far less daunting
Some simple rules for valuation
1 Valuation is hard, due to uncertainty about the future
2 Some assets are harder to value than others
3 Some investors are better positioned to value an asset than others
Valuation is simply the process of estimating the value of an asset.
And an asset is anything of value that can be converted into cash. This includes investments, property, jewelry, stocks, bonds, and even vehicles.
So why learn about valuation? On a personal level, many of the investment decisions we make are some of the most important in our lives. For example, buying our first home. From a professional perspective, almost all managers and senior executives will need to make investment decisions at some point and understanding valuation will make these decisions a lot less daunting. In this course we'll assume that you have little or no prior knowledge of valuation, so let's start with some simple rules. The first rule is that valuation is hard and it's hard because of uncertainty. When valuing assets at a point in time, you make forecasts and assumptions about the future. These forecast and assumptions will almost always be wrong and they will be wrong due to uncertainty. How wrong you are will determine how much money you make. I tend to divide uncertainty into three different types. The first type is asset specific uncertainty, related only to the individual asset we want to buy. A good example of this would be a planning application for a plot of land. The risk associated with the planning application is only relevant to this particular land asset.
Market-specific uncertainty on the other hand, relates to trends and changes within an individual market. A well known example of market-specific uncertainty was the impact of smartphones on incumbent mobile phone players such as Nokia. The uncertainty created by the introduction of smartphones was related to the mobile phone market as a whole, and affected every player within that market.
The last type of uncertainty is macroeconomic, and this relates to the entire economy. During the downturn in 2008 all stocks were affected by the downturn and as a result the S&P 500 as a whole dropped 21%.
When valuing an asset it's important to understand the exposure of that asset to each type of uncertainty, which brings us to our second rule, some assets are harder to value than others. As an example, let's take two investment opportunities on the same downtown street. The first is a building for sale that currently houses an insurance company. The company has signed a 15-year lease on the building, generates sizable profits every year from a stable customer base, and should have very little problem paying off the rent for the remainder of the lease. As a result this project has lower risk and hence is easier to value. The second is a plot of land further down the street. The land has been zoned for office use and is currently vacant. The buyer of this asset would first have to submit a planning application to the town council then hire a construction firm to build the project, and finally get tenants for the new building. As you can imagine, your valuation of the first asset is likely to be a lot easier than your valuation of the second asset which is going to be higher risk, but with a higher potential return.
If the risky asset did not offer a higher rate of return then all investors would simply invest in the safer asset. Our third and final rule of valuation is that some investors are better positioned to value an asset than others. Investors should always stay within their circle of competence, regardless of how small or large that is. To illustrate this point we'll return again to our plot of land that's currently for sale.
The first bidder is a wealthy technology entrepreneur who's dabbling in the property market for the first time. The second is a seasoned developer who has developed over 15 properties in the local area over the past 10 years. Clearly, bidder number two is in a much better position to gauge the risk and value of this asset. Bidder number one, on the other hand, is much more likely to make an investment error, given this asset is outside his circle of competence. Now that we have these three basic rules out of the way let's explore the different methods of valuation in the next lesson.