In a podcast, Aswath Damodaran, the ‘Dean of Valuation,’ shared valuable insights on valuation. He explained the hidden traps in growth forecasting, how to think about discount rates and argued why mimicking other investors is silly.
Here are some of the key insights shared in the interview:
The 5 variables of business valuation
Aswath Damodaran throws light on the three pivotal dimensions of business valuation:
(1) revenue growth,
(2) profitability (i.e. margins),
(3) reinvestment efficiency,
(4) discount rate, and
(5) failure risk
Growth, he stresses, is neither inherently good nor bad. It’s only value-additive when it’s achieved efficiently, without excessive reinvestment, as illustrated by Meta’s controversial Metaverse investment.
Deciphering the Noise
The world today is awash with information, making effective data interpretation a necessity for accurate business valuation. Damodaran simplifies the process by circling back to these 3 key variables of business valuation.
(1) revenue growth,
(2) profitability (i.e. margins),
(3) reinvestment efficiency
He cautions against getting lost in buzzwords like ESG, where many argue that it will increase the intrinsic value of businesses.
Ask yourself:
– Is it going to make the business grow faster?
– Is it going to make the business more profitable?
– Is it providing more opportunities for reinvestment?
For ESG, it’s likely a resounding no for all three.
The Trap of Overestimating Growth and Profitability
Damodaran argues that investors tend to overestimate growth rates in silos, ignoring the dynamics and behaviors of other market participants. People get excited when they hear about automated driving and how it will benefit ride-sharing companies like Uber. Perhaps it will be beneficial if Uber does it, but its competition won’t sit back and watch.
It is necessary to incorporate game theory into our analysis to take into account market dynamics as well as our competitors’ actions.
Furthermore, he took a shot at the “Kathy Wood Delusion”, highlighting the need to focus on a company’s unique competitive advantage rather than the overall growth potential of the industry.
Decoding the Science of Discount Rates
Damodaran sheds some light on the often-confusing area of discount rates. These rates should reflect market expectations, not an investor’s desired returns. Using a constant desired return as a discount rate overlooks the market’s collective perspective, he says.
The intrinsic value of a company is determined by what investors collectively deem the right price to be. If the market settles for a 6% return, but an investor wants 10%, the company’s value will reflect the market consensus of 6%.
The purpose of intrinsic valuation is to figure out the fair market value of a company, taking into account the market’s risk price. By taking this approach, we acknowledge the market’s diverse nature, dominated by big institutions like BlackRock, State Street, Fidelity, and Vanguard.
Your Forecast Horizon Depends on The Business Lifecycle
Aswath Damodaran says that the optimal forecasting period for company cash flows heavily depends on the maturity of the company rather than the investor’s comfort or uncertainty level. If the company is mature, meaning it’s growing at a predictable rate, shorter forecasting periods are likely sufficient. He uses Coca-Cola as an example, stating that a two-year forecast might be adequate due to its steady state of growth and predictable performance.
However, for younger, less stable companies still defining their business model, like Peloton, longer forecasting periods are necessary. Until these companies settle on their core operations and growth strategies, they cannot be put into a steady-state model.
Hence, when valuing a company, Damodaran advises focusing on the company’s characteristics rather than the investor’s personal inclinations or comfort levels.
Why ‘hold forever’ is silly
Aswath Damodaran challenges the old ‘hold forever’ approach often attributed to Warren Buffett. Value investing involves buying stocks when they’re undervalued and, logically, should extend to selling them when they’re overvalued. To Damodaran, it’s inconsistent to be diligent in buying but indifferent when selling.
He recommends reevaluating every investment in a portfolio annually, arguing that each investment must justify its place each year. Damodaran also points out that ‘buy and hold’ is perceived as successful because of selection bias. He emphasizes the fact that even Warren Buffett’s recent investments do not necessarily support the buy-and-hold approach.
Uncertainty is a feature, not a bug
Aswath Damodaran stresses that uncertainty is an intrinsic part of valuation, a discipline grounded in predicting the future. In an uncertain world, aiming for precision could be viewed as overconfidence, since we’re not omniscient. Complex Excel spreadsheets can’t erase uncertainties, nobody can accurately compute the probability of future pandemics and wars.
Accept and embrace uncertainty in valuation. He warns against investment concentration and insists it is more dangerous now than decades ago due to the high level of uncertainty. Investing heavily in a few companies, confident that their price will reflect their value, disregards the myriad of macro, micro, technological, and disruptive uncertainties.
It’s important for investors to diversify their investments. Damodaran’s guiding principle is clear: being wrong on an investment can be disastrous if it makes up a large chunk of your portfolio. Therefore, diversifying your portfolio serves as a buffer against markets’ inherent unpredictability.
How does he begin his process when a company comes onto his radar?
According to Aswath Damodaran, there are two triggers for starting a valuation. The first is a dramatic drop in stock price, which makes him wonder if it’s justified. Using Facebook as an example, Damodaran incorporated the worst possible scenario, like assuming that big investments into the metaverse will be wasted. Interestingly, the value he got was higher than the plummeting stock price, suggesting the company may be undervalued.
The second trigger is Damodaran’s personal interest in a company, largely influenced by his admiration for its management. He cites Amazon as an instance where, despite his consistent fondness for the company since 1997, it wasn’t until 2001 after the dot com crash that his valuation deemed the company undervalued.
However, Damodaran emphasizes that liking a company doesn’t guarantee a good investment if the price is too high. Despite the fact that it may take years, as Amazon did, patience is paramount.
The problem with mimicking super investors blindly
According to Aswath Damodaran, crafting one’s investment strategy involves more than mimicking the successful figures in the industry. Although these figures, such as Warren Buffet, offer valuable lessons, they are not the ultimate guide to success. Their strategies are products of their times, their individual personalities, and the markets they navigated, which may be drastically different from the current climate.
Investing requires self-awareness and developing a philosophy that suits one’s strengths, weaknesses, triggers, and personal makeup. Investing isn’t about mimicking Buffett or Peter Lynch; it’s about understanding oneself as a person and as an investor. Even though these investment luminaries provide inspiration, it’s important to remember that the strategies they used were specific to their time.
Graham’s success in the 1940s and 1950s was attributed to a laborious manual data collection process which served as a competitive advantage, but such strategies are no longer useful in the digital age.
Investing is a dynamic process. Without considering contextual nuances and personal psychological compatibility, replicating other investors strategies can lead to disappointing results. As a result, investors should cultivate their unique philosophies rooted in self-understanding and adaptability.
Conclusion
Damodaran’s lessons underline the importance of strategic and objective valuation, warning against biases and blind emulation of successful investors. He emphasizes the need for personal investment philosophies that consider market dynamics, individual strengths, and the rapidly evolving investment landscape.
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