Aswath Damodaran is one of the world’s premier experts in the field of equity valuation. He has written several books like Damodaran on Valuation, Investment Fables, The Dark Side of Valuation and most recently The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit, on the subject. He is a Professor of Finance at the Stern School of Business at New York University where he teaches corporate finance and equity valuation. . In this interview he speaks to Vivek Kaul.
How did you get into the field of valuation?
I started in finance as a general area and then I got interested in valuation when I started teaching. Valuation is a piece of almost everything you do and I was surprised how ill developed it was as a field of thought. It was almost random and not much thinking had gone into thinking about how to do it systematically.
A lot of valuation is basically compound interest when you discount the expected cash flows. So how much of it is math and how much of it is art?
Much of it is not the compound interest or the discount factor it is really the cashflows you have to estimate. So most of it is actually is in the numerator. It is about figuring out what business you are in. Figuring out how you make money. Figuring out what the margins are. What the competition is going to be. So numerator is where all the action is and it is actually very little to do with mathematics. It is more an understanding of business and actually getting it into numbers.
Can you give us an example?
So if you are trying to value Facebook getting the discount rate for Facebook is trivial. It is easy. It is about 11.5%. It is about the 80th percentile in terms of riskiness of companies. The trouble with Facebook is figuring out, first what business they are going to be in, because they haven’t figured it out themselves. How are they going to convert a billion users into revenues and income? And second, if they even manage to do it, how much those revenues will be, what will the margins etc. And those are all functions where you cannot think just Facebook standing alone. It is going to compete against Google. It is going compete against Apple. It is going to compete against other social media companies. So you have to make judgement calls of how it is all going to play out. It is numbers but the numbers come from understanding business. Understanding strategy. Understanding competition. Understanding all the things that kind of come into play.
You just mentioned that the discounting rate for expected cash flows from Facebook was at 11.5%. How did you arrive at that?
I have the cost of capital for by every sector in the US.
So this is the cost of capital for dotcoms?
This is actually the cost of capital for risky technology capitals. So basically I am saying is that I could sit there and try to finesse it and say is it 11.8% or is it 11.2%. But it doesn’t really matter. Getting the revenues and margins is more critical than getting the discount rate narrowed down.
This 11.5% would be from a combination of equity and debt?
For a young growth company it is almost going to be all equity. You don’t borrow money if you are that small and when you are in a high growth phase it is not worth it. It is almost all equity.
I recently read a blog of yours where you said that you have sold Apple shares even though they were undervalued. Why did you do that?
There are two parts to the investment process. One is the value part to the process. And the other is the pricing part to the process. To make money you need to be comfortable with both parts. You want to feel comfortable with value and you have to feel comfortable that price is going to converge on the value. In the case of Apple for 15 years I was comfortable with my estimate of value and I was comfortable that the price would converge on value. In the last year the Apple stockholder base has had a fairly dramatic change. There has been influx of a lot of institutional investors who have coming in as herd investors and momentum investors who go wherever the price is hottest. You have also got a lot of dividend investors who came in last year because they expected Apple to start paying dividends.
What happened because of that?
So you got this influx of new investors with very different ideas of what they expect Apple to do in the future. They are all in there. And right now they are okay for the moment because Apple is able to keep them all reasonably happy. But I think this is a game where I have lost control of the pricing process because those investors turn on a dot. Like they did, when the stock went from $640 to $530 for no reason at all. You look at any news that came out. Nothing came out. So why is the stock worth $640 and eight weeks later $530? But that’s the nature of momentums stocks. It is not news that drives the price anymore, it’s the herd. Basically if it moves in one direction, prices are going to go up $20. If it moves in the other direction, it is going to go down $30. And I looked at the pricing process and said I have lost control of this part of the process. I am comfortable with the value still. But I am leaving not forever. If these guys keep pushing it down, sooner or later they are going to push it to a point where these guys leave and then I can step in buy the stock. So it’s not permanent but I think at the moment it has become a momentum stock.
You have talked about the danger of purely relying on stories while investing. But that’s how most investors invest. What are the problems with that?
Even momentum investors want a crutch. Basically stories give them a crutch. You have decided to buy the stock anyway because everyone else is doing it. You don’t want to tell people because that doesn’t sound good so you look for a story to convince yourself that you area really doing this for a good reason. The power of the story is very strong, I am not denying it. But I am saying that if there is a story my job is to bring it into the numbers and see if that story holds up to scrutiny.
You can talk about user base. Facebook the story is that they have lots of users. My job is to take those billion users and talk about what that might mean in revenues and margins and operating income and cash flows. And not just say that there are lot of users therefore the company must be worth a lot. If a Chinese company says we are going to be valued. There are a billion Chinese. Okay. What does that mean? You have a billion Chinese but how much will be you able to sell? How much will they buy your product? So I think you need to get past the macro big story telling because it is easy to fall into saying that hey this company is worth a lot.
Can smaller investors make money by piggybacking on investment decisions of big investors?
If you look at institutional investors they do things so badly why do you want to piggyback on them.
Someone like a Warren Buffett and Rakesh Jhunjhunwala in the Indian context?
You could but I think by the time you get the information it is usually too late. It is not like you are the only one who finds out that Warren Buffett has bought a stock. Half the world has found out. So when you get to lineup to buy the stock, everyone else is buying the stock and price has already moved up.
George Soros once said that most money is made by entering a bubble early. What are your views on that?
Everybody is guilty of hyperbole when it comes to bubbles and Soros is no exception. Soros has never been a great micro investor. He has made his money on macro bets. He has always been. He has never been a great stock picker. For him it is got to be massive macro bubbles, an asset class that gets overpriced or underpriced. You’re right if you can call macro bubbles you can make a lot of money. John Paulson called the housing bubble made a few billion dollars. So he is right and he is wrong. He is right because if you can call a macro bubble you can make a lot of money. He is wrong because if you make your investment philosophy calling macro bubbles, you better get lucky, because everybody is calling macro bubbles and most of them are going to be wrong.
You have talked about buying the 35worst stocks in the market and holding that investment and making money on it. How does that work?
It’s called the classic contrarian investment strategy where you buy the biggest holders and you hold them for a long period. There is evidence that if you hold them for a long period that they tend to be the best investments. But it comes with caveats. One is that if you buy the 35 biggest losers they often tend to be low priced stocks because they have gone down so much which increases the transaction cost of your trading. The other is that it is very dependant on your time horizon. It turns out that if you buy the lowest price stocks for the first 18 months they actually underperform. It is only after that they turnaround. This means that if you buy these stocks you are going to get about 18 months of heart burn and stomach aches. And for many people they don’t have the patience to stay in. So they often buy the worst stocks after reading these studies. About 12 months in they lose patience they sell it. It is very dependant on both those pieces of puzzle falling in.
How much role does media play in influencing investment decisions of people?
Media and analysts are followers. None of the media told us last week that Facebook was going to collapse. Now of course everybody is talking about it. So basically when I see in the media news stories I see a reflection of what has already happened. It is a lagging indicator. It is not a leading indicator. I have never ever found a good investment by reading a news story. But I have heard about why an investment was good in hindsight by reading a news story about it.
I am not a great believer that I can find good investments in the media. That’s not their job anyway.
(The interview was originally published in the Daily News and Analysis(DNA) on June 2,2012. http://www.dnaindia.com/money/interview_ive-never-found-a-good-pick-by-reading-a-news-story_1696935)
(Vivek Kaul is a writer and can be reached at [email protected])