Library / Investment Tools

Date of review: January 2022
Book author: McKinsey & Company
Вook published: 1990

Valuation: Measuring and Managing the Value of Companies by McKinsey & Company (1990)

Foundational book with the best analytical tools for estimating the value of a company.
I would not recommend it for learning about the basic concepts such as the NPV, IRR, discount factor, time value of money etc. But it should definitely be the next book to read after learning the basic ideas. I know many people praise Aswath Damodaran's books. I prefer the McKinsey book as it appears to be more straight to the point and presents the key concepts and tools better (in my subjective view, of course).

Unlike other books on Valuation, this one makes an important point on cross-checking Profit & Loss estimates against returns on capital. Way too many novice investors/analysts focus too much on projecting future revenue growth and profit margins without considering how future profits would correspond to returns on capital. As a result, a typical mistake is to forecast constantly rising ROIC, whereas, in reality, it often declines to an industry-average level of about 10% (matching a typical cost of capital).

Another useful point is the sensitivity analysis. Many books recommend running different valuation scenarios for various discount rates (WACC) to reflect a range of potential risks. McKinsey, however, recommends keeping WACC estimate constant for all scenarios but reflecting potential risks through probability factors and a different range of profit/cashflow estimates. So, instead of discounting cash flow in Year 5 of $100m at 8%, 10% and 12%, it is better to apply a single 10% WACC to a range of cash flow estimates for Year 5 ($50m/$100m/$150m).

Finally, I found a section on evaluating international businesses and taking into account currency risk to be quite helpful.

The only drawback of this book, in my opinion, is that it is so detailed that it creates the illusion of knowledge. After reading the book, you feel that you can forecast everything in great detail. A fundamental issue of randomness and uncertainty is not emphasised enough in this book.

In general, I consider this book a must-read for anyone who wants to learn practical valuation tools. Just remember the caution above.

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