How's my Luck now?

Reflections, views and descriptions during my stay at IIM Lucknow from July 2004 to March 2006

Location: India

Monday, July 18, 2005

Crystal-ball gazing

I just completed one assignment each in Investment Management and Corporate Valuation. They were related - we were projecting the future cash flows of an Indian IT services company and in the case of IM, were valuing the stock of the company in order to find if it was over- or under-valued with respect to economic fundamentals. This 'standard' exercise and the recent classes in CorVal have left me a bit flustered.

For most (or all) companies, the future is risky and uncertain, with the degree of risk and uncertainty varying. Valuing a company today for what it might become in the future is itself a risky job. But investment bankers and others do it day-in and day-out. The problem is: not many of these valuations match. A company is a complex entity, and then it is placed in an uncertain environment, which creates a combinatorial explosion of alternative scenarios for the future. The performance of equity researchers who value stocks is then measured by their past reports and their variance from the actual scenario (not for their normal performance appraisal perhaps, but definitely for their future credibility).

If future uncertainty was the only reason for mismatched valuations, however, it could still be pardoned. The problem is: the methodology used for valuation is often suspect - illogical or biased. We had a case study in class in which we saw that a reputed investment banking firm used a strange hotch-potch of valuation techniques to value a diversified firm, and a merger decision was based on that valuation. Another survey of US and European analysts showed that most analyst recommendations were 'buy/hold', as compared to 'sell'. And I also read about the kind of fantastic measures used to value dot-coms and Internet companies. Having done some part of a valuation exercise, I must say that the temptation to manipulate figures to suit assumptions is high :).


Blogger Samrat said...

Well said Ted. I always remember the Jesus quote regarding technical analysis. i.e." I see triangles in the charts whereas one may see a picture of Jesus in that".

Also since valuation is such an important component, it is essential to know it. But definitely the current techniques available: DCF, Relative,Option pricing are way too inadequate and subjective.
and millions of dollars depends on them.
infact damodaran has written a book called "Dark side Of Valuation" . Maybe we will also switch over to that and become Darth Vaders.

2:30 PM  

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