May 2022 | 

The Art and Science of Corporate Valuation

The Art and Science of Corporate Valuation

Wharton@Work recently met with Professor Vincent Glode, who is joining Wharton Executive Education’s Corporate Valuation program as an instructor, to discuss the importance of valuation, who needs to understand it, and how to balance the art and science required to value a firm.

Wharton@Work: Who do you think should learn valuation?

Vincent Glode: Valuation is an applied skill that’s important for all business people. It uses the basic principles from finance and accounting in order to translate a set of financial statements, an understanding of the products of a firm, an assessment of the quality of the management team, and many other things of that nature into a value for the firm. Corporate valuation requires transforming qualitative hunches about a company into a quantitative estimation of its intrinsic value.

As an instructor, my goal is to prepare people to make their own forecasts about the future of a company rather than solely relying on those done by other people. When analysts pitch that a company is a buy recommendation, they may be overly optimistic. Similarly, insiders talk about their own firm optimistically, because they want to raise capital. You can listen to these experts and learn something, but ultimately, if you really want to make money valuing firms you need to be able to come up with your own forecasts.

Moreover, even when they don't value companies as part of their job, most managers need to know how the valuation process works. If you're a CFO of a company, you might not go through all the computations that bankers will go through. But if you’re planning to take your firm public, for example, you need to have a good idea of what these bankers will be doing when they value your firm and assess how much capital you will be able to raise.

Here’s another example: if you’re in marketing, you're going to make a lot of decisions about how to advertise your firm’s products. You need to understand the valuation framework in order to assess how your marketing decisions will affect your revenues, profit margins, risk, and, ultimately, the overall value of your firm. That’s also true of decisions in every other area of the business.

W@W: You have been teaching the popular Valuation class to Wharton undergraduate and MBA students since you came to Wharton in 2009. Now you will be teaching it to executives. How do you expect it to be different?

Vincent Glode: I'm excited about teaching in Executive Education because the students will have a lot of industry experience, and they'll be sharing that with me and the class throughout our discussions and interactions. I expect to benefit from these interactions. In Executive Education, we will be able to explore the same concepts I have been covering since 2009 but focusing on things that program participants deal with in their everyday operations.

Another difference is that current executives don't have as much time to value companies as most of my full-time students will have when they start working in investment banks or in hedge funds. Executives might have to take shortcuts or use rules of thumb, but I want them to be able to know the costs and the benefits of the available shortcuts so that when it's time to decide what to skip and what to spend time on, they have a good idea of what the tradeoffs are.

W@W: Are there any common misconceptions about valuation?

VG: Definitely. Even though it is based on principles of finance and accounting, valuation is part art, part science. It’s an art to be able to forecast the future of a company based on the knowledge that you acquire by seeing a lot of other companies that, at one point in time, were similar to the one you're currently valuing. It’s a science to be able to properly mix theoretical concepts and the data from empirical studies written by finance researchers like me. You can gather a lot of data about the past of a company and an industry, but at some point, you have to make a subjective prediction about what will happen in the future. I think in Executive Education, the participants will bring a lot more of this artistic side to the classroom than I'm used to. It should make for interesting discussions, and I’m looking forward to that.

W@W: Is one side more important than the other?

VG: No — you need both the art and the science. If you have a good idea of what will happen to your company, but you cannot translate it into a price, then that artistic side is not useful. Similarly, if you're able to translate any set of predictions into a valuation, but you don't know how to forecast — you don't know where the firm will go — it's not going to work. Corporate valuation can help experienced managers — who are typically very good at the artistic side — to master the technical side. It then allows them to use their industry knowledge in an effective way.

Having said that, there's also a lot you can learn about the science of forecasting, including what works well, and what people have done in the past to be successful. No one is born with that gut feeling of whether a company will be good or not. You need to acquire experience, and the more experience you acquire the better. Then you can add that to the science, i.e., the concepts and the data, to inform your gut feeling.

W@W: Clearly, there is a lot of uncertainty involved. What, if anything, can you do to reduce it?

VG: In business, you're almost always forecasting under uncertainty, so you never want to be too confident that one scenario will happen. In my undergraduate and MBA classes I often get the question, "Should we account for X, Y, and Z?" The answer is always yes, you should account for everything! Never say, "I'm going to value this company omitting X, Y, and Z, which are all possible and important." If you omit possibilities, you're leaving in too much uncertainty, and not really valuing the company. That's part of the game. A lot of complexities will affect what happens with these companies we’re looking at. When I teach, this is always important to me. I want my students to have the skills to be able to see something they have never seen before and be able to make the best decisions.

The way that I found best to help them do this is by going through different types of problems with actual companies. We'll go through their financial statements. We'll see something that doesn't fit perfectly into the basic conceptual framework of valuation. We'll get our hands dirty and try to solve problems. But while trying to solve those problems, I'll make sure that my students understand the tradeoffs that we're facing and we'll make a decision together. Once they have gone through a few of these decisions for different types of problems, my hope is that they will be able to apply what they learned to new problems that might arise but that we didn’t cover.

W@W: If you went back to your classroom in the fall of 2019, one of those new problems might have been, “How well is this company going to deal with a global pandemic? Are they agile enough to keep most of their workforce working?” How does a situation like that play into forecasting?

VG: That's a good question. The goal is not to forecast everything perfectly. Whether it's a pandemic or a financial crisis, you should forecast the possibility of bad-case scenarios that your firm has to react to. There might be some precision lost by not knowing specifically whether it's going to be a health or a financial crisis, but you greatly improve your valuation by at least thinking through those scenarios and forecasting how your firm should be able to react in these different environments.

What's the cost structure? How are the operations? How can we adjust the operations in case of lower demand or supply shortage? All these things are elements of a good valuation. Even though we don't necessarily know in advance which kind of shock will lead to a decrease in demand or a shortage in supply, we still need to adjust our valuation for the fact that these events might happen.