Corporate and Equity Valuation:
Every Valuation Tells a Story
Aswath Damodaran, NYU
Aswath's website (has links to pdfs of his courses and books)
Aswath's YouTube channel where you can take his courses
Abstract:
This talk will address the process of valuing companies and financial equities by weaving together narrative and numbers.
The Key Questions of valuation are:
What are the cash flows from existing assets?
Equity: Cash flows after debt payments
Firm: Cash flows before debt payments
What is the value added by growth assets?
Equity: Growth in equity earnings/ cash flows
Firm: Growth in operating earnings/cash flows
How risky are the cash flows from both existing assets and growth assets?
Equity: Risk in equity in the company
Firm: Risk in the firm’s operations
When will the firm become a mature firm, and what are the potential roadblocks?
Bio:
My name is Aswath Damodaran. I am a Professor of Finance at the Stern School of Business at New York University. I teach the corporate finance and valuation courses in the MBA program as well as occasional short-term classes around the world on both topics. I received my MBA and Ph.D degrees from the University of California at Los Angeles. My research interests lie in valuation, portfolio management and applied corporate finance. My papers have been published in the Journal of Financial and Quantitative Analysis, the Journal of Finance, the Journal of Financial Economics and the Review of Financial Studies, though I am sure that the list of people who have read these articles is a short one.
I do like to write. I have written four books on equity valuation (Damodaran on Valuation, Investment Valuation, The Dark Side of Valuation, The Little Book of Valuation) and two on corporate finance (Corporate Finance: Theory and Practice, Applied Corporate Finance: A User’s Manual). I also co-edited a book on investment management with Peter Bernstein (Investment Management) and I have two books on portfolio management - one on investment philosophies (Investment Philosophies) and one titled Investment Fables. I also have a book, titled Strategic Risk Taking, which is an exploration of how we think about risk and the implications for risk management. My newest book, Narrative and Numbers, was published in January 2017.
If you asked me to describe what I do, I am first and foremost a teacher - not an academic, a professor or an authority on any topic. I learned to teach when I was a visiting lecturer at the University of California, Berkeley, from 1984 to 1986, where I received the Earl Cheit Outstanding Teaching Award in 1985. I have been at NYU since 1986, received the Stern School of Business Excellence in Teaching Award (awarded by the graduating class) in 1988, 1991, 1992, 1999, 2001, 2007 and 2008, 2012 and 2016, and was the youngest winner of the University-wide Distinguished Teaching Award (in 1990). I was profiled in Business Week as one of the top twelve business school professors in the United States in 1994, a testimonial to weak competition. Not recognizing the error of their ways, Business Week did a poll of MBAs in 2011 that named me the most popular business school professor in the country (globe, universe.. who knows?). Needless to say, I love teaching and I hope it shows.
Summary:
The Key Questions of valuation are:
What are the cash flows from existing assets?
Equity: Cash flows after debt payments
Firm: Cash flows before debt payments
What is the value added by growth assets?
Equity: Growth in equity earnings/ cash flows
Firm: Growth in operating earnings/cash flows
How risky are the cash flows from both existing assets and growth assets?
Equity: Risk in equity in the company
Firm: Risk in the firm’s operations
When will the firm become a mature firm, and what are the potential roadblocks?
Mature: grows at the same rate as the economy
Makes it possible to forecast corporate value for firms that never die
Short-term growth is modeled directly, and
Long-term behavior is infinite time series = the economy
Value drivers of the economy
Business model
Revenue growth
Google: advertising growth is slowing down
Operating margins
Google: advertising and software have high profit margins
Car companies: 5-7% profit margins
Growth/Investment Efficiency
Google: relatively little investment to get growth
Car companies: very investment-intensive
Risk
Google is unlikely to die unless the government targets it as a threat
Cost of risk relevant for cost of
Equity (sell stock)
Debt (borrow: loans or bonds)
Challenges of Valuation
Bias due to preconceptions about the company
People’s prior conceptions have very strong impact on results
Bankers who benefit from a deal will use assumptions or estimates that make the deal more attractive
There are many ways to measure the same thing (e.g. growth, effective tax rate) and analyst can choose the one they like
Possibility for ML/Alphabet
Generate long time series
Compute distributions of datasets
Crowd sourcing predictions from experts
Uncertainty/Unknown
Monte carlo estimation is a good tool for estimating uncertainty and its impact on results
Complexity of analysis
Models are often unnecessarily complicated
Too many details with no real data behind them
Engineers must remember that being wrong about valuations is completely possible in this environment
Valuation = Stories + Numbers
Every number in valuation has to have stories behind them (why this number, why this way of computing it).
Every story has to have numbers to back them up.
Analysts tend to play to their strong side
Best valuation combines stories and numbers
The Steps
Tell story about the company, what it does, who the competition is
Test story to test whether it is plausible
Convert story into drivers of value
Connect drivers to a valuation
Keep feedback loop open (listen to people who disagree with you; need very different opinions)
Challenge
Today’s markets focus on pricing rather than value
Build up a bunch of indicators of value (e.g. users) that raise the price people will pay for the company, then sell the company even though there’s no way to convert indicators to profit
Observation
A given equity is a good buy at the right price
It doesn’t matter if a company is good or bad
If a good company is too expensive (> your valuation), don’t buy it
If a bad company is cheap enough (< your valuation), buy it