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5 Key Valuation Lessons by NYU Professor Aswath Damodaran
Aswath Damodaran is a luminary in the field of Valuation and famously known as the Dean of Valuation. His famous Valuation Class was viewed by millions of people online.
1. The Bermuda Triangle of Valuation
There are three things that will ruin your valuation from the get-go.
1.1 Perception of Value Beforehand:
If you already have a number/price in mind when you start the valuation process, you’re primed to conduct your research and the following valuation in a way that fits your existing belief.
Since there’s no clear right or wrong in investing, there’s a lot of room for interpretation. That’s why our mind can easily interpret all the evidence to confirm our prior idea of value.
Now, it’s almost impossible not to get in contact with an idea of value when you look at a stock. After all, the current price is difficult to ignore when conducting your research.
Yet, being aware of this error makes you more likely to ignore the current price as an anchor. Because you’re intentionally thinking about this possibility, and it’s not happening unconsciously and unnoticed in the back of your head.
1.2 Thinking of Valuation as a Science:
Whenever numbers are involved, we feel like there should be a right or wrong solution, as if it is a science. Charlie Munger calls this phenomenon in economics “physics envy.” This describes the craving for a false precision. The wanting of a formula for all the problems in economics. But this won’t happen. Economics is too complex.
The same can be said about valuation. It’s not a science, and no formula will give you the precise value of a company.
Valuation combines numbers and stories. You make assumptions that suit the story you want to tell and come up with numbers. These assumptions will be wrong.
The question is, by how much? And can you buy the company at a price that you’re doing okay even if you’re wrong and the numbers turn out a little worse?
1.3 Preferring Complex Models:
There is something exciting in complexity. A complex model creates a (false) sense of security. After all, you have thought of all possible influencing factors and taken every possibility into account, right?
Well, what you do with complex models is make more and more assumptions. Assumptions that make the model vulnerable.
The more unknowable inputs a model consists of, the higher the chance you won’t be wrong slightly but by a wide margin. This makes planning with a margin of safety impossible.
Less is more. Your goal is to keep the valuation as simple as possible.
“Pluralitas non est ponenda sine necessitate.” “Plurality should not be posited without necessity.”
2. Number People vs. Story People
We generally belong to one of these groups. Some of us prefer the number side of valuation, others the story side. Neither one is working without the other.
The Story People:
Story people believe that valuation and investing are really about great narratives and that estimating unknowable and almost certainly incorrect numbers is useless.
The Numbers People:
Numbers people believe that everything is quantifiable and that narratives or stories only lead to irrationalities and wrong decisions.
As always, the truth lies somewhere in the middle. Staying on one side will weaken your valuation and leave out important factors determining the real intrinsic value.
No matter which group you feel you belong to, make a special effort to pay attention to the other side during your next valuation. The combination of both factors will always lead to a better result.
A Short Announcement on my behalf:
Starting in October, this Newsletter will have additional content and new features.
The additional features will be:
Monthly Deep Dives/Valuations of Companies
A Comparative Intrinsic Value Sheet with all analyzed Companies
A Community Portfolio starting with $1,000
Free Access to all the Products I’ll release (Starting with my Investing Checklist System)
Direct E-Mail Access to Me
These features will be available to all Paid Subscribers at $17/Month.
All current Paid Subscribers will stay at the current pricing level ($7/Month). (The same goes for everyone subscribing before October)
3. The 3-P’s: Possible? Plausible? Probable?
The 3-P’s are a way to set boundaries for our creativity regarding stories and narratives.
Look at the company’s history and industry and determine whether the story you tell about the company’s future is in line with the 3-P’s.
You can start with the products the company wants to introduce to the market and their estimated impact on the financials. Further, you can look at historical multiples and assess whether they will be similar, higher, or lower in the future.
The multiples that investors are willing to pay in the future are a crucial factor for the success of your investment. Even when earnings go up, If the multiple that investors assign to those earnings drops, your investment can turn out to be a loser, although the company grew and became more profitable.
Take Company A, with current earnings of $2 per share and a P/E multiple of 25. You’ll get to a share price of $50.
Now, imagine the company increasing its earnings by 50% to $3. That’s a considerable increase. However, investors believe this growth will not continue, and the company has matured. They aren’t willing to pay a multiple of 25 anymore.
Instead, they only pay a multiple of 15. Now, you have $3 in earnings and a multiple of 15, resulting in a share price of $45.
Although the company saw massive growth in earnings, you’ve lost money on your investment.
Make conservative assumptions in your story and your numbers. Answer the 3-P’s.
4. Focus on Value Drivers
It has never been so easy to get lost in details. The frequency of news and headlines about the markets, industries, and companies is as high as ever.
But details that do not affect the company’s ability to generate cash, its risk profile, or growth prospects shouldn’t matter to your valuation.
Focus on these value drivers, and you’ll get a clear picture of what direction the company is heading.
Now, you might ask, how do you know what affects these value drivers? The rule of thumb is: Everything that impacts the company’s financials.
Soft factors like brand name or quality of management are so-called intangible competitive advantages. If you believe your company has such intangible advantages, they would show up in the financials.
A strong brand name, for example, increases the willingness to pay. Thus, the margins should be higher than those of the competition. The superiority of management can show up in various ways. They might be great at improving efficiency, resulting in lower costs. Or they are great at allocating capital.
The point is, in your analysis of the financials, you’ll see what impacts the company’s cash flow, risk, and growth prospects.
5. The Difference of Pricing and Valuation
Many investors confuse pricing and valuation, but they are two entirely different things. Prices are set by supply and demand. In bull markets, stocks go up because they go up. In bear markets, this reverses. That’s the case because a rising (or falling) stock creates fear of missing out (or panic) which drives demand up (or down).
The price only tells you what market participants are willing to pay for a stock. So, the price is based on the logic of supply and demand. In many cases, there’s a great diversion to the underlying company’s value. Most of the time that is due to market moods and/or momentum.
Bull and bear markets are symbolic of this because of their self-reinforcing nature.
Valuation, on the other hand, is completely detached from the supply and demand logic. The only thing that matters is what the underlying company should cost based on cash-generating potential and its assets.
Here’s a free PDF of Aswath Damodaran’s famous Valuation Class that you can also find on YouTube:
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