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

How do you know how much a share in Amazon is worth?

How about one in AT&T?

Or one in ExxonMobil for that matter?

Unlike for instance a painting or a sculpture, 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 core, valuing a company is actually simple, and in this video, I'll show

you how.

This is a top 5 takeaway summary of "The Little Book of Valuation", written by Aswath Damodaran,

and this is The Swedish investor, bringing you the best tips and tools to reach financial

freedom through stock market investing.

Takeaway number 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 approach.

The relative value approach is based on a single premise.

I told you this was simple...

Which is that, everyone prefers to pay as little as possible for identical assets.

The intrinsic approach is based on two major premises; everyone prefers money today over

money tomorrow and everyone prefers a sure bet over a risky one.

Some people may favor one method over the other one, but I think that both are useful,

and there's no reason not to confirm your investment decisions using both of them.

My own investing strategy consists of first using a relative approach to screen for companies

and later use an intrinsic approach to decide if the individual company is worthy of my

money.

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

Takeaway number two: A quick guide to relative valuation.

What would you prefer?

Buying a house for $200,000 or buying the neighboring house for $300,000?

Silly question perhaps, but this is the basis for relative valuation; you compare an asset

with another one that is as similar as possible and simply pick the cheaper alternative.

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

the same.

There are three essential steps for relative valuations;

1. Find comparable assets.

We must compare apples to apples and oranges to oranges.

If we take the companies that I talked about in the beginning of this video, it's easier

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.

Frankly, no one even comes close to the online sales of Amazon who has about 50% of the total

online retail market in the U.S.

2. Use a standardized 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 scale the price to another 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.

We're not quite there yet though.

To pick 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.

While historical earnings growth isn't in any way a guarantee for growth in the future,

it can be used as an approximation, and to find interesting prospects to dive deeper

into.

As we can see, Verizon and Royal Dutch Shell are both cheaper and have experienced a stronger

growth in earnings than their peers, which makes them interesting cases for further analysis.

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

on an individual company level.

But, it didn't make 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.

Therefore, this assumption may be flawed and relative valuations, in my opinion, should

always be accompanied by intrinsic ones.

Takeaway number three: A quick guide to intrinsic valuation.

What would you prefer?

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

All right, perfect.

So then we have established our first principle; everyone prefers money today over money tomorrow.

There are plenty of reasons for this, but two of the more important ones are 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!

Then we have established our second principle too; everyone prefers a sure bet over a risky

one.

Combined, these two premises help us in understanding the most important 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 determines how much less a future income is worth to you, and the rate

should be higher the more uncertain you think that income is.

If you use a 15% discount rate, you essentially say that $1000 the next year is worth only

$870 today.

$1000 in three years is only $658, and in ten years it will be worth only $247.

The discount rate could also be viewed as how much yearly return that you demand for

that asset.

Now, how do we apply this in the stock market?

Well?

First and foremost, we must remember what a share in a company is.

A share in a company is a claim against a certain portion of the future earnings of

the same company.

For instance, if you hold one share in Amazon, you are entitled to 1 out of 504,000,000 of

the future earnings of Amazon.

To get a little bit technical, we are actually not interested in net income, but rather something

like Warren Buffett's owner's earnings.

If we could say with certainty what the owners earnings would be from this day to infinity

and use our previously determined discount rate to translate the earnings into today's

value, we could say what the equity in a company is truly worth.

If we divide that with the number of shares outstanding, 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 usually only estimate the owners earnings for the first ten years or so, and then calculate

something called "a going concern value".

The owners earnings for the first ten years plus the going concern value determines the

total value of the company.

Remember that you are not looking for a stock that your estimate is worth something like

10% more than the price.

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

Use the discount rate that you require for your investments, say 15% and then make sure

that your intrinsic value calculation is at least something like 40% undervalued.

As you can see, calculating the intrinsic value of the stock is simple, but not easy.

Estimating 10 years of owners earnings involves a lot of assumptions.

For instance, how fast will the revenue be able to grow during these years, how high

profit margins can the company maintain, and how much capital expenses will be required

to support this.

Your results from this valuation technique will be no better than those underlying assumptions.

Therefore, in takeaway number 5, I will give you some guidelines for three common situations.

Takeaway 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%?

Choices 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.

Chances are that you have at least one reason of being biased; maybe you like the personality

of Jeff Bezos, maybe you already owns stocks in the company, or maybe a friend of yours

is on the Amazon hypetrain.

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 estimation of future revenue growth as an example.

There are so many variables that could go into this, but you have to be careful not

to include too many of them in your analysis.

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 other ones out.

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

Takeaway number 5: Context matters: Growth, decline and cyclicals.

Depending on what type of company that you are dealing with, you'll have to adjust your

relative and intrinsic analysis.

For example, valuing Amazon as a growth company, AT&T as a company in decline and ExxonMobil

as a highly cyclical commodity company will present different difficulties.

Amazon, the growth company.

Determining how scalable the revenue growth is will be of major importance.

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

The sheer size of itself will be a problem, as will competition.

AT&T, the company in decline.

Beware large capital expenses.

You don't want the company to throw good money 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".

An interesting property of companies in decline is that the risk for bankruptcy increases

a lot.

In your valuations, you must take this into account.

Determine a value for the company if it survives together with the value of the company if

it defaults, and attach probabilities to both of these outcomes.

If the company defaults, it probably has a lot of assets that can be sold off.

The balance sheet therefore becomes much more important for the valuation of a company in

decline then for instance, the growth company.

ExxonMobil, the cyclical commodity company.

For cyclical companies, results vary a lot over a normal business cycle.

One of the most interesting properties that they have is that they often seem the most

undervalued at the top of a market cycle, or at the top of commodity prices and the

most overvalued at the bottom.

But in reality, just the opposite is true.

For these companies, it becomes important to normalize earnings to be able to make fair

comparisons and intrinsic valuations.

For a commodity company, you can use the average price of the commodity of the past ten 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.

If you want to dig deeper into how you can determine the fair value of a stock market

company, I've created a playlist of videos on that subject for you.

Check it out...

Cheers guys!