Anyone who has done valuation for very long, whether discounted cash flow models or comparables, realizes that there are a host of assumptions behind the mechanics of the analysis. Some of these are based on straightforward economic logic. For example, if the returns we expect on our investment exceed our opportunity cost of capital (i.e., what we could have earned doing the next best thing), then we have created economic value for ourselves (which can easily be expressed as a positive NPV). If not, we have misallocated our capital. Or, for example: the less uncertainty we bear with regard to receiving our returns (i.e., higher probability of receiving the cash flows), all else being equal, the more highly we will value them (i.e., we will discount them less); thus debt has a lower “cost” than equity for the same firm.
But economic logic only takes us so far. When it comes to many of the assumptions in our models (e.g., the DCF), we look to historical data, either from the capital markets or the economy as a whole. Common examples: Using the historical nominal GDP growth as a proxy for terminal growth rate. Calculating a firm’s current market capitalization/total capitalization as a proxy for its future capital structure for the purpose of estimating WACC. Finally, using market prices to estimate a firm’s “cost” of equity (i.e., the CAPM).
Naturally, these latter assumptions, all of which rely on empirical and historical data from the markets, prompt us to ask: how reliable are those data as benchmarks for valuation? The question of whether markets are “efficient” or not is not merely an academic discussion.
I recently had an interesting correspondence with Michael Rozeff, Professor Emeritus of Finance at the University at Buffalo, on some of these very issues. He shared with me a paper he published online critiquing the Efficient Market Hypothesis (EMH) and offering an alternative view, called the Market Pricing Maxim (MPM). I wanted to share it here with our readers:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=906564
Over the next several weeks, I plan to further discuss the concepts behind many of our assumptions (particularly with regard to the cost of capital), unpacking the logic behind them and asking how it lines up with economic reality, in the same spirit that Professor Rozeff does in his paper on efficient markets. In the meantime, enjoy the paper!
