In chapter two of "The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit," Aswath Damodaran aims to provide investors with what he calls the “Power Tools of the Trade,” with “trade” referring to the practice of valuing stocks.
Time value
The first of those tools are cash flows and present value, with the latter referring to how much a dollar earned in the future is worth today. Cash flows in the future are always worth less in the future, for three main reasons:
- Preference for consuming today.
- Inflation reduces purchasing power over time.
- Promised cash flows might not appear in the future.
The process of adjusting the original cash flow to account for these potential reductions is called discounting, and the “magnitude of these factors” shows in the discount rate. A related term is real return, which refers to what an investor receives after consideration of the three factors.
Damodaran wrote there are five types of cash flows:
- A simple cash flow.
- An annuity: Constant cash flow at regular intervals for a fixed period.
- A growing annuity: Cash flow grows at a constant rate for specified period.
- A perpetuity: Constant cash flow at regular intervals forever.
- A growing perpetuity: A cash flow expected to grow at a constant rate forever (growth rate has to be less than the discount rate).
He calls these cash flows “the essential building blocks for virtually every financial asset.” And Damodaran added that if you can discount these cash flows, you can value practically every type of financial assets.
The risk factor
The management of risk became more sophisticated in the early 1950s when Harry Markowitz, a doctoral student at the University of Chicago, discovered that portfolio risk could be reduced by including securities that responded differently to outside stimuli. If some securities move up and others move down at the same time, the portfolio will be safer than a portfolio of individual stocks that all move in the same direction more or less simultaneously.
Damodaran wrote, “The risks that affect one or a few firms will get averaged out in your portfolio: For every company where something worse than expected happens, there will be another company where something better than expected will happen.”
Still, there will remain some residual risk from companies that cannot be diversified away, and this is called market risk. It can be quantified with beta, a measure in which a stock is measured against the broader market: A stock with a beta of exactly 1.0 is considered to be exactly as volatile as the market, while a stock with a beta of less than 1.0 is less volatile and a stock with a beta of more than 1.0 is more volatile. Consequently, the expected return of an investment will equal the risk-free rate plus beta.
Damodaran next turns to the ways in which accountants look at valuations. He lists and defines many terms and tools commonly found and used in both accounting and investing. Among them are the following:
- Net income: Revenue minus operating expenses and depreciation (or amortization).
- Net or operating margin: Net income divided by sales, or operating income divided by sales.
- Return on capital (ROC) and return on invested capital (ROIC): Divide after-tax, net operating profit by operating capital.
- Return on equity (ROE) is similar to ROC but is a narrower metric since it includes only equity and not debt.
Where do investors find this information? They can all be found in the financial statements:
- Balance sheet: Summarizes the assets, their value and the equity and debt needed to buy them.
- Income statement: Summarizes the source of a company’s revenues, its operations and its profitability.
- Statement of cash flows: Shows where the cash originated and where it went (operating, financing and investing activities).
Statistics
Having assessed time values and risk metrics, an investor is ready to pull these strands of data into a whole, into something that is actionable. To do this, the investor will need the help of statistics. The author writes, “Finally, given the sheer quantity of information that we have to access, statistical measures that compress the data and provide a sense of the relationships between data items can provide invaluable insight.”
These statistical measures include:
- Averages: Across all the data.
- Standard deviation: Shows the amount of variation around an average.
- Frequency distribution: A more robust format than averages, frequency distribution involves assigning individual data to ranges of values, producing the well-known bell curve.
- Correlation: Refers to the interaction between two variables, such as inflation and interest rates. The more these variables move together, the greater the correlation and vice versa.
- Simple regression: A more involved correlation exercise, in which a regression line is fit (drawn) between scatterplots for the variables. This exercise provides deeper insight into the relationship between the two variables.
Damodaran refers to this set of tools—time value, risk and statistics—as his valuation tools, and will begin applying them in the coming chapters. Next up, determining intrinsic value.
The author: 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.
