In his forward to “The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit,” Michael J. Mauboussin wrote:
“Valuation is at the core of the economic activity in a free economy. As a consequence, a working knowledge of valuation’s broad concepts as well as its ins and outs is of great utility. Aswath Damodaran has done more to bring these ideas to life than anyone I know. I hope that you enjoy The Little Book of Valuation and profit from its lessons.”
Aswath Damodaran is indeed the author of that 2011 book, one we will summarize and review, chapter by chapter, in coming days. It is at the “core of economic activity,” as Mauboussin has written, and also at the core of value investing.
Damodaran wrote that too many investors think valuing an asset is too complex and complicated to master; as a result, they leave valuation to others, or simply ignore it. Yet, he argues, “I believe that valuation, at its core, is simple, and anyone who is willing to spend time collecting and analyzing information can do it.” That’s very helpful, he adds, because anyone who understands the value drivers of a business will also be able to identify “value plays.”
In chapter 1, he introduced two broad valuation models:
- Intrinsic valuation.
- Relative valuation.
Intrinsic value is based on the cash flows that an asset is expected to generate over its lifespan. More specifically, assets with high and stable cash flows will normally be worth more than assets that exhibit low and volatile cash flows.
When choosing among assets, relative valuations come to the fore. This refers to differences among similar stocks or to a stock’s “peer group.” Damodaran offers this simple example: If Exxon Mobil (XOM, Financial) trades at 8 times earnings while other major oil companies trade at 12 times, then Exxon would be the more attractive.
Both types, intrinsic and relative, have their uses, he wrote, despite some purists who claim the other approach is useless. Intrinsic gives investors a fuller picture of the drivers for a particular stock or business but when looking for stocks to buy, knowing the relative value can help you invest more effectively.
In response to a rhetorical “Who cares?” question, Damodaran said all types of investors can use valuation techniques, whether they are fundamentalists, technicians or market timers. In addition, all companies require valuations at all stages of their life cycle:
- Small businesses need valuations before approaching venture capitalists.
- Valuations will be the basis for companies planning to go public.
- Once publicly held, companies need valuations on questions such as borrowing, where to invest next and how much to return to shareholders as dividends.
He adds that even accounting now demands valuations, as their standards move away from original cost and toward fair value accounting.
Next, Damodaran turned to what he calls “some truths” about investing.
All valuations are biased. When we begin the valuation process, we begin with views that are formed before the calculations begin. For example:
- The companies you select to value.
- What you’ve read and heard about the companies.
- Management discussions and annual reports that emphasize the positive.
There are also the biases, or institutional factors, encountered by professional analysts:
- Equity analysts typically issue more buy than sell recommendations.
- There is a reward and punishment structure, when an analyst’s compensation depends on his or her findings.
- Post-valuation garnishing, which involves increasing estimates with premiums for factors such as synergy and management quality.
So beware of your own biases and the biases of others who do valuations. The more suspected bias, the less weight the analysis should receive.
Even good valuations are wrong. Damodaran said, “While precision is a good measure of process in mathematics or physics, it is a poor measure of quality in valuation. Your best estimates for the future will not match up to the actual numbers for several reasons.”
- Converting data, even when using impeccable sources, into forecasts could lead to estimation errors.
- The firm may do better or worse than expected, which is known as firm-specific uncertainty. He added, “When valuing Cisco in 2001, for instance, I seriously underestimated how difficult it would be for the company to maintain its acquisition-driven growth in the future, and I overvalued the company as a consequence.”
- Interest rates and other macroeconomic factors may change. The author concedes his valuation of Goldman Sachs (GS, Financial) in August 2008 looked hopelessly optimistic in hindsight, since he didn't foresee the damage that would be caused by the banking crisis.
What’s to be done in the face of these traps? Damodaran recommended that analyses be simplified if possible. He said the abundance of information now available, combined with the computing power available to almost everyone, can lead investors and analysts astray. Each new element or detail introduced into the analysis is another potential error.
The author then referenced the physical sciences to surface the idea of simplicity: “If you can value an asset with three inputs, don’t use five. If you can value a company with three years of forecasts, forecasting 10 years of cash flows is asking for trouble. Less is more.”
While there are obviously hazards in doing valuations, author Damodaran urged investors to tackle them anyway. Use simplified models and the information on hand; you may be wrong sometimes, but that doesn’t matter:
He wrapped up the chapter with this piece of wisdom that might have come from Warren Buffett (Trades, Portfolio), the Sage of Omaha: “Success in investing comes not from being right but from being wrong less often than everyone else.”
The author: Aswath Damodaran is the author of three books on valuation and is a professor of finance and the David Margolis teaching fellow at the Stern School of Business at New York University. There he teaches corporate finance and equity valuation courses in the MBA program. His research interests lie in valuation, portfolio management and applied corporate finance.
This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.
Disclosure: I do not own shares in any company listed and do not expect to buy any in the next 72 hours.
