SUMMARY OF THE LITTLE BOOK OF VALUATION - BY ASWATH DAMODARAN

Summarizing My Mentor Aswath Damodaran

(SUMMARY OF THE LITTLE BOOK OF VALUATION - BY ASWATH DAMODARAN)

 

How do you know how much a share in Amazon or AT & Tor Exxon Mobil is worth?

 Unlike they say that beauty of any painting is in the eyes of beholder, the value of a stock market company is not in the eyes of the beholder.

 So, if you're one of those people who have always thought that the price of a stock doesn't matter as long as someone else is willing to pay more for it, think again.

 This "greater fool theory" as it is referred to, can be a really expensive game to play.

As the investing community collectively proved during the dot-com bubble, and also one that is totally unnecessary.

 Why?

 Because, at its fundamental, valuing a company is essentially humble, and in this Article, I'll show you how?

 This is a important 5 take-out of "The Little Book of Valuation", written by Aswath Damodaran, and this is Engineer Ability All about start up and growth analysis of company.


Take-out 1: Two valuation approaches; relative and intrinsic value. Valuing a stock market company can be done using two major approaches; the relative and the intrinsic value approaches.

 





 The relative value approach is based on a single premise.

 That is everybody prefers to pay as little as possible for equal value perceived assets.

 The intrinsic approach is based on two major grounds; everyone prefers money today over money tomorrow and everyone prefers a sure stake over a chancy one.

 Roughly people favor one system over the other one, but I think that both are useful,

and there's you should confirm your investment decisions using both of them.

 My own investing strategy consists of first using a relative approach to filter companies and later use an intrinsic tactic to choose if the individual business is worthy of my cash.

 With that said, let's dive deeper into both of these.


Take Out number two: A quick guide to relative valuation.

What would you favor? Purchasing a house for $200,000 or purchasing the neighboring house for $300,000?

 This is the foundation for relative valuation; you compare an asset with another one that is as similar as possible and simply pick the inexpensive substitute.

 In the stock market, it is never as clear-cut as in this example, but the idea is still the same.


There are three essential steps for relative valuations;


1.      Find comparable assets.

Fair Comparison should be done with apples to apples and oranges to oranges.

If we take the companies that I talked about in the commencement of this Articles, it's cooler to find comparisons for AT&T, and for ExxonMobil, while it's more difficult for Amazon. Walmart comes to mind but their stores are physical and not online.

 Honestly, no one even comes close to the online sales of Amazon who has about Fifty Percentage of the total online retail market in the U.S.


2.      Use a homogenous variable.

 To be able to compare these companies with each other, we cannot just look at the prices of the businesses and pick the cheapest ones.

 We must gauge the price to additional variable.

Scaling price to earnings by using the so-called Price to Earnings or P/E multiple is

a good place to start.


3.      Adjust for differences.

 To begin with Walmart over Amazon just because its P/E is lower doesn't make much sense. Usually, a company trades at a lower multiple than another one because its earnings growth is expected to be lower in the future.

 Though historic earnings growth isn't in any way a guarantee for growth in the future,

it can be used as an estimate, and to find thought-provoking predictions to dig deeper

into.

 Further looking into Verizon and Royal Dutch Shell are equally cheaper and have experienced a stronger growth in earnings than their similar level companies, which makes them exciting gears for additional analysis.

 In our relative valuation, we adopt that the market is correct on average, but wrong

on an individual company level.

 But it wouldn’t have made much sense to pick one of the dot-com companies in 1999 at a P/E of 100 just because it seemed cheap relative to its competitors that had P/Es of 200.

 Hence, this postulation may be faulty and relative valuations, in my opinion, should always be go together with by intrinsic ones.

 



Take-out number three: A quick guide to intrinsic valuation.

 

 Do you prefer? $10,000 today or $1,000 per year for the next 10 years?

 So, then we have recognized our first belief; everyone prefers cash today over cash tomorrow.

 Two of the important reason this is the case is for instant

gratification and inflation.

 Now, think about this one; what would you prefer?

I'll give you a thousand bucks or you'll have to flip a coin...

Heads, you get 2,000 bucks, tails you get nothing at all?

 Excellent!

 Now we have recognized our successive principle too; everyone prefers a sure bet over a risky one.

Collectively, these two grounds help us in considerate the utmost significant variable in an intrinsic valuation, often referred to as a discounted cash flow analysis elsewhere by the way, and that is the so called "discount rate".

The discount rate governs how much less a future revenue is value to you, and the rate should be higher the more uncertain you think that income is.


If you use a 15% discount rate, you fundamentally say that $1000 the next year is worth only $870 today.

 $1000 in 3 years is only $658, and in 10 years it will be worth only $247.

The discount rate can be observed as yearly return that you claim for

that asset.

 Now, let’s see how we apply this into stock market?

 Firstly, do you recall what a share in a company is.

 A share in a corporation is a claim against a sure slice of the future earnings of

the same company.

 For example, if you grasp one portion in Amazon, you are authorized to 1 out of 504,000,000 of the future earnings of Amazon.

 Technically, we are actually not interested in net income, but rather something like Warren Buffett's owner's earnings.


If one could inevitability say what the proprietors’ incomes would be from this day to infinity and use our formerly gritty discount rate to explain the incomes into today's value, we say what the equity in a business true price is.

 If we divide that with the amount of shares remaining, we could say what a single share is worth.

 If the price of the share is lower than the value that we came up with, we would buy the stock and vice versa.

 Calculating anything from now to infinity sounds like a daunting task.

 So, we generally only guesstimate the owners’ earnings for the first 10 years or so, and then compute approximately called "a going concern value".

 The possessors’ incomes for the 1st 10 years plus the going concern value determines the whole worth of the business.

 Recollect that you are not watching over a stock that your approximation is worth something like 10% extra to the price.

 

You want what Benjamin Graham stated to as "a margin of safety" here.

 Using the discount rate that you require your investments, about 15% and then making sure that intrinsic value calculation is at least something like 40% undervalued.

 Whilst, calculating the intrinsic value of the stock is modest, but not easy.

Approximating 10 years of proprietor’s incomes comprises a lot of assumptions.

 Like, how fast will the income be able to raise through these years, how high

return yields can the business sustain, and how much capital expenditures will be compulsory to provision this.

Results might surprise you from this valuation technique will be no better than those fundamental traditions.


Take-out number 4: Truths about valuations.

 Even a combination of a relative valuation and intrinsic one comes with its flaws.

By being aware of these flaws, you can improve your odds of picking the right stocks.

All valuations are biased; why did you estimate a 20% revenue growth per year for the next ten years for Amazon and not 10%?

 Selections like these will have major impacts on the valuations that you make, and you want to be sure that you are as rational as possible in your assumptions.

Odds are that you have at least single motive of being prejudiced; maybe you like the character of Jeff Bezos, maybe you already own stocks in the company, or maybe a friend of yours is on the Amazon hype train.

 Be aware of this and question your assumptions one more time if you know that you're at risk. Most valuations are wrong, unfortunately.

 But this shouldn't stop you because relative and intrinsic valuations are the two best

tools that we have, and all investors are facing the same uncertainty.

 Also, sometimes it doesn't matter if your valuation is off by say 30% because the stock

is so clearly undervalued anyways.

 As Benjamin Graham famously said "it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age, or that a man is heavier than he should be without knowing his exact weight".

 Less is sometimes more!

 Take the approximation of coming revenue growth as an example.

There are so many variables that could go into this, but be careful not include to make it clumsy in your analysis, too many variables will distort the overall picture.

 Focus on just a few of the most important ones; perhaps competition, quality of management and the potential size of the market and leave the others aside.

Including too many variables will often cause you to miss the forest for the trees.


Take-out number 5: Context matters: Growth, decline and cyclicals.

 Depending on what type of company that you are dealing with, you'll have to change your relative and intrinsic analysis.

For instance, valuing Amazon as a growth company, AT&T as a corporation in weakening and ExxonMobil as a highly cyclic product company will present different complications.

Amazon, the growth company. Defining how scalable the revenue growth is will be of chief status.

 As suggested before, it starts at evaluating competition, quality of management and the

size of the overall market. Future profit margins are another concern, and typically, they will increase as the company matures.

 Having margins scaled from the current level and to that of an industry average over time is probably a good idea.

 Don't wait too long before putting the company into the stable growth used for the going concern value.

 A sturdy growth company will not be able to grow like it did previously.

 The absolute size of itself will be a problematic, as will competition.

 AT&T, the company in decline. Be careful great wealth expenditures.

 You don't want the business to toss good cash after bad.

 As Warren Buffett says "should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks".

 A fascinating possession of businesses in decline is that the risk for bankruptcy probabilistically increases.

 In your valuations, you must take this into account.

 Administrate a value for the business if it continues collectively with the value of the business if it defaults, and assign likelihoods to both of these results. If the business defaults, it probably has a lot of possessions that can be traded off. The balance sheet consequently converts much more significant for the valuation of a business in failure then for instance, the growth company.

 ExxonMobil, the cyclical product company. Results vary a lot over a standard operational/business cycle. One fascinating theory is that they have is that they often seem the highest undervalued at the top of a market cycle, or at the top of product prices and the most overestimated at the bottommost.

 But in realism, just the reverse is accurate.

 For these businesses, it becomes important to standardize incomes to be able to make fair judgements and intrinsic valuations.

 For a product company, you can use the normal price of the product of the past 10 years for instance to see how it impacts revenues and net earnings. For an industrial company, you can use the average profit models over a whole business

cycle.

Ajmal Muhammad 可汗

I am Open-Source Advocate, Cloud Consultant, I have experience in Digital Transformation, Security, Data Analytics, ML/AI, PMO, Product Managment focused on Growth Strategies and enhanced customer experience and Experience design. I’m passionate about creating usable digital products. I have worked with incredibly talented people across different companies. Skilled in Entrepreneurship, Startup, Open Source, Digital Transformation, Cloud, Security, Data Analytics, AI/ML Consulting, Investment Valuation, Seed Capital, Board of Directors and Advisory. Strong business growth professional with a Postgraduate Diploma focused on International Business from University of Cambridge. |► Connect with me on | linkedin

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