When making an assumption on the expected return of an asset, one is making an implicit call on the valuation of that asset. There are several textbooks written on valuation, and smart individuals have built successful careers on sophisticated valuation methodologies. However, valuing an asset is hard, and is not a science.

Valuation is important, as illustrated by this excerpt from the noted asset manager GMO:

For an individual or an asset allocator, the valuation of an asset has a direct relationship with the return that they can expect when making an investment. It might therefore be helpful to understand the drivers of value, and then determine whether you believe the assumptions on those drivers of value are reasonable.

All complexity around valuation can be distilled into three factors: cash flow/yield, multiple and perceived value.

1. Cash Flow/yield : This is the traditional textbook basis of valuation. In any Finance 101 class we learn that the value of an asset is the Present Value of future cash flows, and in most cases, that is the fundamental value of an asset. For a bond, it is the interest earned. For an infrastructure project, its the expected cash flows from the power plant or airport. For a rental apartment in New York, its the net rental income, etc. Quite simply, you acquire an asset today with the expectation of earning these cash flows over a period of time. These cash flows may be “risk-free” such as a government bond, or “risky” such as a corporate bond, or uncertain, such as the free cash flow of a company. The cash flows may be enhanced by “structure” such as a CDO, or by “effort”, e.g. infrastructure. However, they still represent a stream of cash flows that a holder of the asset can expect to receive.

2. Multiple : The value of a series of cash flows is quite simply the multiple of the cash flows that someone is willing to pay for these cash flows. The multiple contains several moving parts that drive value. For example, the multiple may reflect uncertainty around the likelihood of the future cash flows materializing, such as in the case of a corporate bond. Mathematically, you might determine this using the discount rate for the cash flows. Therefore, the riskier the cash flows, the lower the multiple of cash flows.

Alternatively, the multiple might reflect other factors such as a liquidity, uncertainty, scarcity, fear, mania, etc.

Multiples play a key role in determining the potential return you can expect from an investment. If the multiples are relatively stable between when you acquire and when you plan to dispose an asset, then the return you expect can approximate the cash flow/yield. However, more often than not, we see that expected returns are determined based on assumptions on changes in multiple. For example, if equity yields are 2-4% but if you assume a P/E multiple expansion (as the equity analysts like calling it), then you might find yourself believing that returns could be higher than what yields imply. Sometimes that multiple expansion can be justified – for example, if there is an expectation of growth that could drive an increase in future cash flows.

In addition to expectations, multiples can also change based on human behavior – for example, in times of crisis, people are willing to pay a greater multiple for the certainty afforded by US government securities.

Relying on multiple expansion for future returns can be a risky game, but unfortunately, its hard to find assets where you can justify their current expected return assumptions based on cash flows alone.

3. Perceived Value : This third aspect of valuation is where we move further away from mathematical and financial principles into the realm of human behavior. There are assets that have little or no fundamental cash flows, yet not only have value, but actually increase in value because of the way they are perceived. Gold is the “gold standard” of this type of value, where there aren’t necessarily major fundamental drivers for the value of Gold. Some forms of New York real estate fit the bill as well, where their perceived “safety” and “exclusivity” make them a store of value.

Sometimes value can be created by design – the classic example is the one of Black Pearls, described in Dan Ariely’s book “Predictably Irrational”. By positioning black pearls as something exclusive and desirable, they gained value to the point where they became more valuable than white pearls.

Perception of the person valuing the asset also plays a role determining the value of the asset. Unfortunately, this feels more in the realm of quantum physics (where the experimenter can impact the outcome just by virtue of the fact that he/she is observing) rather than corporate finance where the value of a firm/stream of cash flows should be independent of the person valuing it. The example of Facebook and WhatsApp provides an illustration of this effect – On a standalone basis, even making “steady state” cash flow assumptions for WhatsApp, and applying a generous multiple to these cash flows, the valuation is likely to fall short of the $19 Billion that Facebook paid for it. However, when you look at the value from Facebook’s perspective, and change the currency for $ to % of Facebook’s value, it might actually make sense – The cost to Facebook was around 5% of its market value, and in exchange Facebook secured a customer base and removed a potential threat to its existing business.

The fallacy in valuation would be to extrapolate from this one instance and start applying the same perceived value to all social media assets.

It might be better to think of asset allocation for assets that are primarily driven by perceived value to be outside any mean-variance type asset allocation framework.

For assets with a high degree of perceived value and uncertainty such as precious metals, startup ventures, etc. investment consultants and professionals often try to estimate annual expected returns and volatilities for assets, so that they can fit neatly within a mean-variance type optimization framework for their clients. While there might be certain fundamental drivers of perceived value that might be modeled (similar to multiple expansion in times of crisis), imputing a “return” or “yield” based on an expansion of perceived value can affect the quality of an asset allocation process.