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.
