Equity and debt analysts evaluate and price securities, as part of an investment process. The product of their work is a stand-alone written recommendation or part of an investment memorandum. The valuation is then used by the investment manager to reach a conclusion regarding the attractiveness of a deal. But, should the decision-maker regard the valuation as gospel truth? How should she treat the product of the analyst’s work?
The goal of this article is to improve the communication between analysts and decision-makers who use the analyst’s work. I hope it will help improve the credibility and usability of valuations. From the perspective of the investment manager, what should she ask and take into account when receiving the input from the analyst? And from the analyst’s side, how can he communicate his conclusions to the investment manager and what should he include in his report?
The article is divided into two sections – process and conclusion. The process part deals with questions related to the analysis process – potential biases and assumptions made by the analyst. The conclusion part talks about the presentation of the valuation’s result and its confidence level. Both sections include a list of questions that should be answered by the analyst, the reasoning for those questions and a “best practices” recommendation for the analyst.
Read time: ~ 10 minutes
Process related questions:
Process related questions serve two main purposes:
- Understand the methods and assumptions used: There are several methods to perform a valuation (DCF, NAV, Multiples, etc…) and a lot of assumptions made by the analyst (profitability margins, growth rates, discount rates, and much more). While the investment manager does not need to know every small detail of the valuation model, she should be familiar with the main assumptions and the methods used. Additionally, a possible benefit of the exchange of ideas with the analyst is that she will feel that she contributed to the analysis. This will improve the accountability of the analysis in her eyes. She will also be confident that the work performed answers the question of the investment thesis. For example, if the investment thesis is to buy a company and IPO some of its subsidiaries, the investment manager should know that the valuation used current market multiples to price those subsidiaries.
- Understand the bias of the analysis: All analysts are subject to bias. Although we cannot create a completely objective analysis, we can try to discern biases and account for them while examining the investment. I love the example given by Prof. Damodaran in the intro to his lectures on valuation: a valuation of Apple performed by an analyst who uses and loves the company’s products will, most likely, be higher than a valuation performed by an analyst who prefers Android devices.
Methods and Assumptions related questions:
As previously noted, the user of the analysis should be familiar with the major drivers of the analysis, both in order to know if the assumptions used align with his own and to make sure that the analysis performed serves its purpose and supports the investment thesis. Even if all of the information is included in the valuation report, the investment manager should converse with the analyst and ask questions. It will improve her understanding of the thought process of the analyst and let her make suggestions and express her views. This has a major psychological benefit – it will make her feel that she was part of the analysis process and increase its credibility in her eyes. Following are some examples of questions which can be used in the discussion with the analyst:
- What are the main assumptions, most material to the outcome of the analysis?
- Why did you assume those assumptions? What checks were performed to verify them?
- What assumptions you think might be controversial, and why?
- Did you use the same assumptions in other recent work you’ve performed?
- What method/s were used to perform the analysis?
- What is the purpose of the analysis? How do the methods used align with this purpose?
Best Practice for the analyst:
- Before starting the analysis, make sure you know its purpose, and choose the methods and assumptions accordingly.
- Before completing the analysis, review the main assumptions and rethink if they are valid and make sense. Then, make a list of the main assumptions, their sources and the reasons for using them, and include it in your report.
- If you’re analyzing several companies in the same industry:
- Create a separate file with the assumptions relevant to all those companies, like macro forecasts, and use this file as the data source for the individual valuation model files.
- Create a file that compares individual assumptions used for each company, for example, gross profit margins, or write-off ratios. This file will help you check if you’re being consistent in your assumptions for each company. Also, this file can include a comparison of various financial ratios from the forecasts of those companies. This will help you see that the outcome of the model is consistent with the assumptions used.
Bias related questions:
Bias against/for the analyzed company:
The investment manager should be familiar with the bias of the analyst against/for the industry, company and management. This bias will, more likely than not, affect the valuation’s result. Of course, negative/positive opinions might very well be justified. Additionally, a negative view will much improve the credibility of a high valuation, and vice versa. Here are a few questions that can help reveal such bias:
- What do you think about the industry?
- What do you think about the company and its products?
- What do you think about the way the management acts?
- Do you think management is reliable?
- How long are you familiar with the company? What is your experience with it?
Bias due to striving for consistency:
It is extremely important to us, as human beings, to be consistent in our decisions and actions. This phenomenon is reinforced once these decisions or actions are known to others. Consistency is usually a good thing, but sometimes this psychological phenomenon makes it hard for the analyst to change his previous recommendation, or to reexamine the assumptions which led to the recommendation. The investment manager should try to understand if such a bias exists, what measures were taken to try to mitigate it, is it possible it affected the outcome and how. Here are some questions that will help reveal this type of bias:
- Have you previously analyzed this company? What were the results and when was the analysis performed?
- What changed since the last analysis, and how has that been reflected in the current analysis?
- Did the analyst check the value before completing the analysis? If so, did he change some of the assumptions afterward, and why?
Best Practice for the analyst:
- Talk with the recipient of your work about potential biases you might have, and how they might have influenced your analysis. Before doing so, consider if you have especially positive or negative feelings towards the company and its management.
- When performing an analysis of a company you’ve analyzed before, take some extra time to go through the major assumptions and consider if they have changed. If so, you have a concrete foundation to receive a completely different value/recommendation compared to the previous result.
- As you build the valuation model of a company, the actual calculation of the value should be the very last thing you do. If you receive a value which doesn’t make sense to you and you want to change some of the assumptions, try to perform a more thorough analysis of those assumptions.
Conclusion related questions
Conclusion related questions help the decision-maker to gain confidence in the outcome of the analysis. This section of the article is also divided into two parts – the credibility of the valuation and insight from additional analysis.
The credibility of the outcome of the valuation
It doesn’t matter how good the work the analyst has done is, the ability to forecast the performance of a company varies between industries and companies, and also depends on the time, data resources and information available. For that reason, it is important to receive the analyst’s input regarding his confidence level in the outcome and his perception of the “probable range” of possible outcomes. Also, the analyst should provide sensitivity tables that will objectively show the possible variance of the outcome, which is a good measure of certainty. The questions you should ask the analyst are:
- How confident are you with the result of the analysis?
- What would you change if you had more time/data/resources? Do you think this might have a substantial impact on the result?
- Do you think the main assumptions can be forecasted with a good level of confidence?
- What is your impression of the forecast provided by the management of the company?
- Do you think management can reliably forecast the results of the company? For what time period?
The analysis report should include sensitivity tables for the main assumptions used. The magnitude of change in the outcome, relative to the magnitude of change in the assumptions, shows how confident you should be in the outcome. Of course, this should correlate with the cost of capital used. For example, if a very small change in one of the assumptions makes a substantial impact on the result, you will probably demand a high margin of safety, resulting in a high cost of capital. This is the result of high uncertainty or high leverage, financial or operational.
Best Practice for the analyst:
- Tell the user of the report your level of confidence in the analysis performed, what were the measures taken to forecast the various assumptions, what is your impression with the forecasts provided by management, etc…
- Create sensitivity tables for the main assumptions.
A second opinion always contributes to decision making, so it’s important to look at additional input. A “second opinion” from the same analyst may be received in two ways:
- Valuation of the same company using a different method.
- Valuation of a similar public company using the same method, while comparing the result to the market price.
Ideally, the valuation will be performed using several methods, like DCF (discounted cash flow valuation) of the cash flow to the firm and cash flow to the equity, Relative Valuation by using pricing multiples (earnings, cash flow and other), EVA (economic value added), and more. Additionally, a comparison to the pricing of public companies or recent transactions is of high importance. If the analyst receives a substantially different result, the assumptions should be reconsidered, this time more thoroughly. Ideally, in this case, you would be able to explain why the pricing in the market differs from your conclusion.
Of course, these “second opinions” require time, but their contribution to the credibility of the result is substantial. The caveat here is that the analyst will be psychologically inclined to receive a similar result, which can be minimized using the following best practice recommendations:
Best Practice for the analyst:
DCF of a similar company:
- Use the same assumptions you used in the original valuation. If you receive a “strange” result, or think that the assumptions do not fit the similar company well, reconsider using them in the original valuation.
- Estimate the discount rate and perpetual growth rates before completing the valuation. You should estimate those very subjective parameters without the bias of knowing the end result they yield.
- When looking for comparable companies, set the screening criteria and perform any adjustments you think are necessary before viewing the results.