Chapter 3 – Valuation
Chapter Three
Valuation
OVERVIEW
Chapter 3 describes how managers and analysts might not use textbook valuation
techniques in practice, but instead rely on particular valuation heuristics. In turn these
heuristics often lead to valuation biases. Moreover, even when managers and analysts
The chapter focuses on the use of four heuristics and three discounted cash flow
(DCF) techniques. The four heuristics are as follows:
1. P/E heuristic
3. price-to-sales heuristic
The DCF techniques are as follows:
1. Free cash flow (FCF)
3. (net) present value of growth opportunities
Chapter 3 – Valuation
In order to make the ideas in the chapter concrete, the chapter text focuses on the
case of one particular firm, the Internet auction firm eBay. In this respect, the discussion
eBay, dated April 2003. This report serves to illustrate some of the major points
discussed in the chapter. The eBay case was originally written for the first edition of the
book. An important feature of the second edition is that it focuses on the subsequent ten
years more than ten years, thereby providing a sense of how to judge the behavioral
assessment made in the first edition.
The discussion of biases inevitably raises questions about market efficiency. At
this stage, discussions of market efficiency should be limited. What instructors should
stress in the present chapter, first and foremost, is the degree to which managers and
the valuations associated with textbook techniques. Instructors should be careful to be
clear about the benchmark used to assess bias, and whether the variable under discussion
is a current price, the forecast of a future price, or the forecast of a future return.
The discussion of bias in respect to returns will touch on whether managers or
Chapter 3 – Valuation
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classroom. No reproduction or further distribution permitted without the prior written consent of
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3
mispricing, and less on whether the stock is indeed overvalued, undervalued, or correctly
valued, the latter issue being the subject of chapter 5 in the text.
The discussion takes place in two phases. The first phase pertains to biases in
hindsight, based only on information that was available at the time that forecasts and
LEARNING OBJECTIVES
The main objective of this chapter is for students to demonstrate that they can identify
how heuristics and framing affect the way managers and analysts value firms. After
completing this chapter students will be able to:
1. Explain why some financial executives and analysts rely on valuation heuristics
instead of textbook techniques that emphasize intrinsic value.
3. Identify the biases that arise in connection with the use of valuation heuristics.
4. Identify the biases that arise in connection with the use of traditional textboo
techniques that emphasize intrinsic value.
Chapter 3 – Valuation
CHAPTER OUTLINE
Traditional Approach to Valuation
The traditional approach to valuation is based on discounting expected cash flows
at a rate that reflects the riskiness of those flows. Instructors might begin the discussion
of behavioral valuation by reminding students that this principle applies to the valuation
One of the important issues in Chapter 3 is the issue of what determines a firm’s
P/E ratio. Instructors might want to remind students that the growth opportunities
valuation formula provides insight into the ratio of a firm’s fundamental (or intrinsic)
value to its expected future expected earnings. This ratio, viewed as a price-to-earnings
Valuation Heuristics
This section introduces three of the four valuation heuristics described in Chapter
3. All three are based on identities, one for P/E, one for PEG, and one for price-to-sales.
Most students will already be familiar with P/E. PEG is not a variable that receives much
attention in traditional textbooks. PEG is a ratio of P/E to an expected annual growth rate.
Chapter 3 – Valuation
PEG is commonly used as a valuation metric, and its value is reported regularly, for
example on Yahoo Finance. Similar remarks apply to the ratio of price-to-sales.
A CFO’s Reliance on Valuation Heuristics
This section describes how the financial executives at eBay approached the
question of whether in April 2003their firm was fairly valued by the market. In this
respect, consider what they did and what they did not do. What they did was to begin
Instructors might raise with their students the question of whether this is a
sensible approach. In this respect, instructors can seek to stimulate a discussion about
both the pluses and minuses of relying on PEG instead of following an approach that is
Chapter 3 – Valuation
How Analysts Value Firms: an Illustrative Example
This section provides a historical introduction to Mary Meeker, the analyst who
led the Morgan Stanley team following eBay, whose April 2003 report is described in the
chapter. The section explains how the Morgan Stanley team arrived at their target price
Biases in Foresight
Taking both the required return of 12 percent and the April 2003 stock price as
given benchmarks, most, if not all, of the four target valuations for eBay in the Morgan
Stanley team’s April 2003 report on eBay appear to be biased. Instructors might ask
students to consider whether they would judge that the valuation targets based upon PEG
and P/E are downwardly biased relative to the 12 percent discount rate. Instructors might
The valuation procedure based on FCF is the only one of the techniques upon
which the Morgan Stanley team relies that is based on DCF. The key bias associated with
the FCF computation relates to excessive optimism in respect to the terminal growth rate.
The bias is called growth opportunities bias, and it can be identified with a simple ratio
Chapter 3 – Valuation
©2018 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the
classroom. No reproduction or further distribution permitted without the prior written consent of
McGraw-Hill Education.
7
test that compares g/k to the reinvestment rate. An appropriate estimate of free cash
flow, with the g/k condition satisfied, results in much lower values.
Other Sources of Bias in Foresight
Growth opportunities and high earnings growth are not equivalent concepts. Yet
many investors and managers believe they are equivalent concepts. There is little
The 1/n heuristic is a simple rule that stipulates that when faced with a choice in
respect to n items, the chooser accords each item equal weight. Mary Meeker applied the
1/n heuristic to establishing a target price for eBay by taking an unweighted average of
the valuations associated with P/E, PEG, price-to-sales, and FCF-based DCF. The use of
The Morgan Stanley team intentionally overweighted their upside case relative to
her base case, thereby creating an optimistic forecast of eBay’s future revenue stream. At
the time, The Wall Street Journal pointed out that hers was the most optimistic among all
Chapter 3 – Valuation
his recommendation, at which time he stated that eBay’s stock was “priced for
perfection.” Instructors might ask students for their thoughts about excessive optimism in
The Morgan Stanley team used the CAPM to arrive at the discount rate used in
their DCF analysis. The discussion on page 72 includes a series of issues about potential
Biases in Hindsight
Section 3.6 beginning on page 72 contains a discussion about biases in hindsight.
After presenting information about the history of eBay’s revenues and free cash flows for
There are several issues that should be part of the discussion. These issues arise in
connection with Exhibits 3-5, 3-6, and 3-7. Instructors can reinforce the earlier discussion
about growth opportunities bias by focusing on the distinction between accuracy in
respect to the short term and accuracy in respect to the long term. The discussion can also
Section 3.7 discusses the traditional textbook formula for free cash flow. At issue
is whether this formula, while acceptable for pedagogic purposes, can be misleading
Chapter 3 – Valuation
when used to value real firms. A good point for instructors to emphasize in the discussion
involves the rationale for using free cash flows as the basis for intrinsic valuation. The
Agency Conflicts
In order to acquire information and investment banking business for their firms,
analysts have an incentive to curry favor with managers by issuing favorable
TEACHING TIPS FOR POWERPOINT SLIDES
Before showing the first PowerPoint slide, instructors might ask students to keep
in mind that traditional textbook valuation techniques based on discounted dividends or
At various points in the discussion, some students might express surprise at the
suggestion that both managers and analysts who earn several million dollars a year
commit major errors. If this occurs, instructors might ask students why they are surprised,
Chapter 3 – Valuation
whether they concur with the contention that the Morgan Stanley team’s analysis is
flawed, or whether they believe that the team’s analysis is correct, and the argument in
the text is flawed.
Below are suggestions for notes in respect to select slides.
Slide 3
Slide 3 describes the equations associated with three heuristics upon which
managers and analysts rely. The heuristics are respectively associated with P/E, PEG, and
price-to-sales. For P/E, the slide displays two forms of the equation, the first for current
valuation and the second for target valuation. To limit slide clutter, only the current
Slide 5
Slide 5 deals with the manner in which managers at eBay think about whether the
equity of their firm is fairly priced in the market. Notably, eBay’s managers rely on PEG.
In April 2003, they noted that on a P/E basis, eBay’s stock appeared to be about three
Instructors might ask students if they believe that this approach is the same as
using DCF to analyze whether eBay’s stock was fairly priced in April 2003. The answer
is no, the approach is not the same, as far as process is concerned, in that DCF requires a
Chapter 3 – Valuation
forecast of future cash flows, and PEG computations only feature future cash flows
indirectly through forecasted earnings growth.
Instructors might ask students if they believe that Wal-Mart stock was overpriced
relative to eBay stock, as suggested by eBay’s chief financial officer (CFO). Some
students might suggest that this was the case, justifying their contention in terms of the
Finally, instructors might ask students whether they believe that it is reasonable to
Slide 7
Slide 7 introduces Mary Meeker, the most well known analyst covering eBay,
who coined the phrase “the Wal–Marting of the Web.” The information on the slide
describes two important to keep in mind about Mary Meeker. First, in being dubbed