Damodaran on Valuation

18.6. TEN STEPS TO BETTER VALUATIONS

At the risk of repeating much of what we have already said in earlier chapters, we can now summarize some general propositions about how we can improve the quality of valuations.

1. Minimize bias in the valuation process. In Chapter 1, we argued that the problem with most valuations is the bias that permeates the process. Analysts who bring strong prior views about a company's standing as under- or overvalued or have their compensation tied to the valuation results are likely to generate valuations reflecting their biases. Improving valuation models will do little to improve the process under these circumstances.

2. Use parsimonious models. While technology and the availability of data have made more complex valuation models more feasible, there is much to be said in favor of simpler models that require fewer inputs.

3. Respect the basic laws of economics. The most egregious mistakes in valuation arise when analysts ignore the basic laws of economics. For instance, while there is absolutely no way to justify the assumption that the firm can grow at a rate higher than the economy forever, many analysts continue to make that assumption.

4. Match cash flows to discount rates. The key to good valuations is to ensure that you don't mismatch cash flows and discount rates. Using the cost of equity to discount cash flows to the firm, a nominal rate to discount real cash flows, or a dollar discount rate on peso cash flows will always yield incorrect estimates of value. ...