Precisely right, or roughly wrong?

I had the pleasure of taking a Valuation course as part of the investment banking course for an institute for a couple of years. In one of my introductory classes, when I asked students to assume the approximate cost of capital between 12%-15% for their companies which they were supposed to value, they looked at me surprised and dismayed. Soon, I found out that they wanted to actually calculate Beta / cost of capital mathematically and were unhappy because they were not asked to do so. They wanted to be “precisely right, rather than roughly wrong”.

Well, we did finally calculate Beta and cost of capital (My rough wrong guess of cost of capital for companies being in the range of 12% to 15% was equal to their precisely right calculations). The false sense of having calculated a precise number gave the students an innate amount of confidence about their financial abilities and their excel models, thereof. The focus on precision however did not let the students realize that while they could get their financial models looking sexy, they could be proven wrong in a BIG way.

After all, you need not calculate the net worth of Bill Gates precisely to know that he is a rich man; even if you are roughly wrong by a few thousands, rather millions in this case; you would still figure out that he is a rich man.

Focus on being precisely right is one of the key reasons for being short-sighted as well. Some of the “sector experts” who precisely predict the next quarter earnings estimates of the companies often fail to understand the long-term dynamics of the industry. Does it make sense to be precisely right in an airline industry, when the long-term economics of the business is bound to produce losers?

As the famous saying goes: How to become a millionaire? You start as a billionaire, invest in an airline and you will land up becoming a millionaire. You stay put for a long time and you will go bankrupt.

This can further be accentuated by the fact that many telecom analysts during 2004-07 who were busy predicting the next quarter earnings precisely failed miserably to realize that that the telecom industry had started to witness the emergence of more than 10 players, thereby declining ARPUs, revenues and profitability eminent.

Hence, rather than focusing on figuring out precise numbers, it is important to incorporate a range of outcomes, including the possibility of improbable outcomes.

Thinking about investments this way would not only make you not only a better investor, but also would enable you to avoid a lot of miseries in life.

 

Disclaimer: Please note that these are my personal views. I am NOT a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014. All investors are advised to conduct their own independent research into individual stocks or industries before making any decision. In addition, investors are advised that past stock performance is not indicative of future price action.

 

 

 

 

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