Aswath Damodaran - Valuation
Valuation is not a science. Valuation is not an art. Valuation is a craft. The more you do it, the better you get at it.
Value <> Price
Drivers of value:
- Cashflow of existing assets
- Growth in cash flows
- Quality of Growth Drivers of price:
- Market moods and momentum
- Stories about fundamentals Good Valuation = Story + Fundamentals; Numbers + Narrative
To act on your valuations, you have to have faith in:
- Your own valuation judgments
- Markets: that prices will move towards your value estimates. That faith will have to be earned
- All valuations are biased. The direction and magnitude of the bias in your valuation is directly proportional to who pays you and how much you are paid.
- There are no precise valuations
- Simpler valuation models do much better than complex ones
Free Cash Flow to the Firm (FCFF): This is a pre-debt cash flow that will be shared by lenders (as interest & principal payments) and by equity investors (as dividends & buybacks)
How do you measure company complexity?
- multiple businesses
- one time income and expenses
- income from unspecified sources
- volatile items in income statement
- income from multiple locales
- headquarters in tax havens
- volatile capital expenditures
- frequent and large acquisitions
- Is your firm's ROC much higher than industry average?
- Does the firm have shares with different voting rights?
Intangibles
Brand name, great management, superb product, loyal workforce, technological prowess
Dangers: For some assets, the value may already be in your value and adding a premium will be double counting. For other assets, the value may be ignored but incorporating it will not be easy.
Macro Views
When you are asked to value a company, you should keep your focus on what drives that value. If you bring in your specific macro views into the valuation, the value that you obtain for a company will be a joint result of what you think about the company and your macro views. (e.g. Shell and oil prices)
Narrative
Every valuation starts with a narrative, a story that you see unfolding for your company in the future. You will be making assessments of:
- Your company (its products, its management and its history)
- The market or markets that you see it growing in
- The competition it faces and will face
- The macro environment in which it operates
Corporate Life Cycle
- Start-up: Have an idea for a business that meets an unmet need in the market
- Young growth: Create a business model that converts ideas into potential revenue and earnings
- High growth: Build the business, convert potential into revenue
- Mature growth: Grow your business, shifting from losses to profits
- Mature stable: Defend your business from new competitiors and find new markets
- Decline: Scale down your business as market shrinks
Tech companies are able to climb the growth ladder faster because their growth requires less investment and their products are more likely to be accepted quickly by consumers.
Tech companies don't have long "mature" periods, where they get to live off the fat, because disruption is always around the corner.
Tech companies also have more precipitous declines from grace, for the same reason that they climbed so fast, i.e, new companies rise faster to take their business.
Non-tech companies take longer to grow, partly because they need more investment to grow and partly because consumer inertia (attachment to existing products) is more deeply set.
Non-tech companies get longer "mature " period, where they get to milk their cash cows.
Non-tech companies decline over long periods and may even find ways to live on as smaller, more focused versions of their original selves.
Determinants of price
- Mood and Momentum: Behavioral factors (panic, fear, greed)
- Liquidity & Trading Ease: While the value of an asset may not change much from period to period, liquidity and ease of trading can, and as it does, so will the price.
- Incremental information: Since you make money on price changes, not price levels, the focus is on incremental information (news stories, rumors, gossip) and how it measures up, relative to expectations
- Group Think: To the extent that pricing is about gauging what other investors will do, the price can be determined by the "herd".
Multiples and Comparables
- Pick a multiple
- Pick comparable firms: Sector/business, market cap, country/region, other subjective criteria
- Tell a story: Risk, growth, quality of growth
Classifying Investments
- Cash flow generating assets: Generate cash flows now or are expected to do so in the future. Can be valued based upon expected cashflows. Can be priced against similar assets
- Commodities: Used as raw material to meet another need (energy, food etc.). Can be valued, based upon utilitarian demand and supply, but with long lags in both. Can be priced against its own history (normalized price over time)
- Currencies: Measure of cash flows, medium of exchange or store of value. Cannot be valued. Can be priced against other currencies, with greater acceptance & more stable purchasing power = higher price.
- Collectibles: May have aesthetic or emotional value but derives its pricing from its scarcity (supply) and the perception of others that it is wanted. Cannot be valued. Can be priced based upon scarcity and desirability.
A Crisis Plan for Investor
- Do you want to bet on a market, sector or company level pricing mistake?
- Market: Value the market using DCF or use a pricing indicator (PE or variants). If Price < Value increase equity exposure
- Sector/Company: Look at sectors where pricing has been least or most affected during the crisis and gauge whether effect reflects fundamentals
Active Investor Road Map
- Have an investment philosophy that fits you: The best investment philosophy for you is the one that best fits you as an investor, in sync not only with your views about markets but with your personal makeup (in terms of patience, liquidity needs and skill sets)
- Balance faith with feedback: Investing requires balancing faith with feedback, faith in your core market beliefs with enough of an acceptance that you can be wrong on the details, to allow for feedback that can modify your investing decisions
- Find your investing edge: Drawing on the language of competitive advantages and moats, what sets you apart does not have to be uniquebut it does have to be scarce and not easily replicable
- If choosing a money manager or hedge fund, look for humility. Humble investors are less likely to overpromise and overcommit
https://pages.stern.nyu.edu/~adamodar/pdfiles/country/valintroExtended2020.pdf