The Little Book of Valuation

the-little-book-of-valuation

The Little Book of Valuation: How to Value a Company, Pick a Stock, and Profit

by Aswath Damodaran

How do you determine if a stock is overpriced or a bargain? NYU finance professor Aswath Damodaran explains.

“There are dozens of valuation models but only two valuation approaches: intrinsic and relative… The intrinsic value of an asset is determined by the cash flows you expect that asset to generate over its life and how uncertain you feel about these cash flows. Assets with high and stable cash flows should be worth more than assets with low and volatile cash flows… In relative valuation, assets are valued by looking at how the market prices similar assets.”

“In discounted cash flow valuation, you discount expected cash flows back at a risk-adjusted rate. When applied in the context of valuing a company, one approach is to value the entire business, with both existing investments and growth assets; this is often termed firm or enterprise valuation. The other is to focus on valuing just the equity in the business.”

“The simplest and most direct measure of the cash flow you get from the company for buying its shares is dividends paid… One limitation of focusing on dividends is that many companies have shifted from dividends to stock buybacks as their mechanism for returning cash to stockholders. One simple way of adjusting for this is to augment the dividend with stock buybacks and look at the cumulative cash returned to stockholders. Augmented dividends = Dividends + Stock buybacks. Unlike dividends, stock buybacks can spike in some years and may need to be averaged across a few years to arrive at more reasonable annualized numbers.”

“In conventional discounted cash flow valuation models, we use higher discount rates on riskier cash flows and lower discount rates on safer cash flows… As firms move from high growth to stable growth, we need to give them characteristics of stable growth firms; as a general rule, their risk levels should move towards the market (beta of one) and debt ratios should increase to industry norms.”

“You can buy stocks that you believe are undervalued and find [they] become more undervalued over time. That is why a long time horizon is almost a prerequisite for using intrinsic valuation models. Giving the market more time (say three to five years) to fix its mistakes provides better odds than hoping that it will happen in the next quarter or the next six months.”

In one example, “the intrinsic value per share of $86.95 that we derived for 3M in September 2008 was higher than the stock price of $80 at the time. While the stock looks undervalued, the degree of undervaluation (less than 10 percent) is well within the margin of error in the valuation. Hence, I did not feel the urge to buy at the time.”

“Relative valuation can be done with less information and more quickly than intrinsic valuation and is more likely to reflect the market mood of the moment. Not surprisingly, most valuations that you see are relative… Every multiple, whether it is of earnings, revenues, or book value, is a function of the same three variables—risk, growth, and cash flow generating potential. Intuitively, firms with higher growth rates, less risk, and greater cash flow generating potential should trade at higher multiples than firms with lower growth, higher risk, and less cash flow potential.”

Part Two includes chapters on valuing companies at different stages of the life cycle:

  • Young Companies — “You want to invest in young companies with tough-to-imitate products that have huge potential markets, are working at keeping expenses under control, and have access to capital. Not easy to do, but done right, it is a high risk, high return proposition.”
  • Growth Companies — “Great growth companies can be bad investments at the wrong price.” Look for low PEG ratios. “Time can be your ally. Even the most worthy growth company will disappoint investors at some point, delivering earnings that do not match up to lofty expectations. When that happens, there will be investors who overreact, dumping their shares, and embarking on their search for the next great story. The drop in price will offer you an opportunity to pick up the company at the right price.”
  • Mature Companies — “Focus on firms where there is a catalyst for management change: an aging CEO, a new investor on the board of directors, or a change in the corporate charter. If you are right in your assessment, you don’t have to wait for the management change to happen. The payoff on your investment will occur when the rest of the market recognizes that change is likely and push up the stock price to reflect that change.”
  • Declining Companies — “Investors with long time horizons and strong stomachs can use two strategies with declining companies. The first is to invest in declining companies, where the decline is inevitable and management recognizes that fact. While there will be little price appreciation from your equity investments, you will get large cash flows, as assets are divested and the cash used for dividends and stock buybacks. In effect, your stock will behave like a high-yield bond. The second is to make a turnaround play, where you invest in declining or distressed companies with the hope that they revert back to health and, in the process, deliver substantial upside.”

Part Three addresses valuation considerations in various sectors including financial services, commodity, cyclical, technology, and pharmaceutical companies.

“The most significant capital expenditures made by technology and pharmaceutical firms is in R&D, by consumer product companies in brand name advertising, and by consulting firms in training and recruiting personnel. Using the argument that the benefits are too uncertain, accountants have treated these expenses as operating expenses. As a consequence, earnings and capital expenditures tend to be understated at these firms.”

Damodaran argues that to value companies with intangible assets, the financial statements need to be restated. “Once we make those corrections, these companies look very much like the companies in other sectors and can be valued using the same metrics.” I am receptive to the argument about capitalizing R&D. I am not convinced about capitalizing advertising, recruiting, and training.

The author also addresses the use of stock options as a form of compensation in technology firms.

Valuation is an inexact science. Damodaran cautions: all valuations are biased, most valuations are wrong, and simpler is better. To put things in perspective, he also notes that “success in investing comes not from being right but from being wrong less often than everyone else.”

“To make money on even the best-done valuation, the market has to correct its mistakes. The payoff to valuation is likely to be speedier and more lucrative in smoothly functioning markets. In more selfish terms, you want the market to be efficient for the most part, with pockets of inefficiency that you can exploit.”

Damodaran has written several other books including Narrative and Numbers: The Value of Stories in Business.

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Damodaran, Aswath. The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit. Hoboken, NJ: John Wiley & Sons, 2011. Buy from Amazon.com

 

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