Behavioural Finance and Business Valuation: Course Outline

Uploaded the outline for my course on Behavioural Finance and Business Valuation. It can be downloaded from here.

A nine-year old dreams up a M&A Deal

Last night, over dinner, I was telling my family about Adidas' plans to buy Reebok.

Gauri, my younger daughter who is nine years old thought about what I had said and then blurted:

"I think Subway should buy Big Chill (her favourite restaurant in Khan Market, New Delhi)".

Highly amused, I asked Gauri, "Tell me three reasons why Subway and Big Chill should merge."

Gauri is highly familiar with the term "merge" because when we play Monopoly, two players often merge when they find synergies (complimentary properties, cash and properties combo etc.)

Its extremely fascinating to discuss stuff like this over the dinner table with kiddos.

Gauri thought about my question for a while and then giggled, in substance, the following reasons:

1. Subway Sandwich outlets have awesome smell and if Subway merges with Big Chill, then more customers will come to eat in the merged entity;
2. Big Chill makes the best desserts in the world and Subway makes the best sandwiches in the world, and therefore, if the best of both are offered under the same roof, the revenues of the combined entity will be more than the revenues of the two outlets on a stand-alone basis; and
3. People who can't eat subway sandwiches (like Gauri's elder sister Garima, because she got braces installed recently) can eat the Big Chill food, while other members of the family freak out over both. So, there will be more reasons for such families to visit the combined entity.

Not bad at all!

Keep it up Gauri, you've all the hallmarks of becoming a fundoo M&A player...

When the promoter goes to jail, the projections go out of the window

In June 2005, Provogue came out with an IPO priced at Rs 150 per share. The IPO was subscribed 67 times (social proof, deprival super-reaction) the number of shares offered. The stock opened for trading at Rs 250 and closed at Rs 205 on 2 August.

At Rs 205, the company's market cap comes to Rs 331 cr. Add debt of Rs 33 cr. and the enterprise value comes to Rs 364 cr. Is this valuation justified by the current fundamentals (the future will be hazy now, isnt it?)?

For FY 2004-05, the company reported revenues of Rs 115 cr., EBITDA of Rs 14 cr., and PAT of Rs 7.2 cr. So, the current enterprise value of Rs 364 cr. is 3.2 times revenues and 26 times EBITDA. The P/E comes to 46 times. Nifty's P/E is 14.58 times.

Sadly, the stock is not traded on futures and options. Sigh...

One interesting aspect of the IPO is the innovative application of Mr. Munger's "backward thinking" wherein the seller of shares approaches the intermediaries and tells them "I want Rs xyz per share, for selling z% of my company and now its up to you to justify this valuation by making projections about the future of my company." And so, given the nature of competition in the intermediateries market, there are strong incentives to apply backward thinking by taking the price being asked as correct, and working backward to figure out what the future of the company should be (on paper, of course), to justify that price.

When the promoter goes to jail, the projections go out of the window. Remember MS Shoes' Pavan Sachdeva and Mesco's Rita Singh? Where are their companies?

How can it be otherwise?

After all, pavlovian association works both ways. Fardeen Khan, who endorses the company's brand, and popular retail chains like Shoppers' Stop, Westside, Pyramyd, Pantaloon, and Lifestyle who sell Provogue apparel, will be doing some very serious thinking.

It will be interesting to watch what the insiders do with their stock.


Models:
Social Proof
Deprival Super Reaction
Incentives
Pavlovian Association

Mental Trick:
Backward Thinking

Here's looking at you kid!

Why should a 40-year old finance professor cum investment professional draw inspiration from an undergrad finance student roughly half his age?

Well, why not?

Shai Dardashti is 21 years old and is doing a wonderful job on his new blog.

All Grahamites should bookmark Shai's blog.

Drawing inspiration from Shai, I will be a bit more active on my blog now!