Tips from the celebrated finance professor, including why uncertainty isn't a bug of the valuation system but rather a feature of it, and why your own story about investing in a company like Tesla is more important than Elon Musk's story about it.
Just click the player below to stream their conversation. Prefer to read? There's a transcript below.
17 minutes
Transcript
Rana Pritanjali: Hi everyone, this is Rana Pritanjali, your analyst for Inside Value. Today I'm fortunate to be joined by professor Aswath Damodaran. He's a professor of finance at the Stern School of Business at NYU. I think the best way to introduce him is, if you ever get stuck in a valuation question, you should just Google a paper or an article by him, and there's a good chance you'll get an answer. In fact, in 2016, the CFA Society added a chapter on Probabilistic Approach written by him in the Level II course. Thanks, professor, for joining us today.
Aswath Damodaran: You're welcome.
Rana Pritanjali: Can you please tell our members a little more about yourself?
Aswath Damodaran: I'm a teacher first and foremost. To me, that's the way I would characterize myself. I know I teach because it's the way I feel that ... It's my passion. Finance happens to be what I teach. If you ask me what I am, I'm a teacher who happens to teach finance. Valuation happens to be one of those things that interests me. It fascinates me.
Rana Pritanjali: Great. I'm a huge fan of your work in the field of valuation. Let me start the conversation by asking you: When you evaluate a company, how much time do you spend on understanding the business versus doing the valuation work? I understand the first feeds into the second, but has there been a notable shift in giving more value to one or another?
Aswath Damodaran: Not really, because that's really a very company-specific factor. In some companies, you really don't need to know much about the business. If you're valuing Coca-Cola as a company, who cares what the beverage business looks like? It's a company with a long history with an established way of doing business that's worked. If you're valuing a company like Uber, which is in a business which is evolving, you might need to understand the business first before you value the company.
Rather than put myself in a position where I'm always doing the same thing, which in valuation never works, I have to be flexible. Depending on the company, I would spend some ... I do spend some time assessing the competitive landscape simply because it's good to know what a high margin is or a low margin is; what a high return on capital is or ... Without having a sense of what those numbers look like, but that's not really that much work. With today's databases, getting a sense of what the sector looks like is a 30-minute job or a 45-minute job. It's well worth doing in the context of doing a valuation.
Rana Pritanjali: Right. Coming to the Coca-Cola example, yes, you're right. There is going to be less chance of an operational failure, but what do you think of projecting how consistent the business is going to look like? It was probably easier 20 years ago. Do you think that's still the case, even in today's world, where people change habits so quickly?
Aswath Damodaran: So what, right? The way I see it is so what if it's difficult. It's difficult for everybody. Everything is relative. I actually think I have a better shot at valuation now than I did 20 years ago, simply because if there's a lot of uncertainty, people give up. That's why I think it's kind of pointless to value companies like Procter & Gamble and Coca-Cola. If, in fact, the world is so settled that you can value a company without making big assumptions, why are you wasting your time? Anybody can do the same thing. A 10-year-old could probably do it.
View uncertainty not as a bug in the system, but a feature of the system. It's part of the process. Accept the fact the fact that you have to make assumptions. Accept the fact that you're going to be wrong a lot of the time and be OK with it, because that's, in fact, the only way you can celebrate investing.
Rana Pritanjali: What do you think investors mean when they say that "This is a value company now"?
Aswath Damodaran: You know, what I hear is that they probably found that the P/E ratio is less than 10. Another aspect of the laziness that characterizes so much of old-time value investing. When I hear the word "value stock," what I usually hear is that you looked at the P/E ratio for the stock. It's lower than the average, so you've decided to call it a value stock, or it has a big dividend yield, therefore it's a value stock. If that's your definition of a good value, I think you're in serious trouble.
Rana Pritanjali: What is your definition of "discount rate?"
Aswath Damodaran: Discount rate is what you need to make to break even, so it's as simple as that. When you invest in something risky, you need to make a higher return [than] a risk-free rate. That's all it is. How we get to a discount rate, we can debate — whether you use one model or another, one set of investors as opposed to the rest — but the definition of a discount rate is what you need to break even on an investment.
Rana Pritanjali: Since the Fed decided not to increase interest rates even before this whole episode of Brexit happened, given we are in an eight-year bull market, does the Fed's decision imply that investors should lower the discount rate permanently, or to your definition, that my required rate of return should be lowered, practically speaking?
Aswath Damodaran: Unlike most people, I don't think the Fed has had much influence in interest rates. Fed doesn't set a single rate. All it sets is the Fed's Funds Rate, [at] which banks borrow [from] one another. The only reason rates are low now is because inflation is slow and real growth is slow. The Fed almost latches on to something that is already happening and says, "Look, we did it." It's like The Wizard of Oz. The notion that the Fed has somehow kept rates low, I think, is almost comical, because the flip side of that is it could make rates go to 4.5%. It's not going to happen. We don't live in that kind of world anymore. We live in a world where for much of the world, we have low real growth and low inflation. If those two things are in place, interest rates are going to stay low, whether the Fed wants it or not.
We are, I think, in a very different market environment with lower risk-free rates, but higher risk premiums. The cost of equity for stocks has not changed since 2007. It's about 8%. What's changed is, the composition of that number used to be 4% risk-free rate and 4% risk premium in 2008. Today, it's 2% risk-free rate, and 6% risk premium. This notion that discount rates have somehow gone down over the last 10 years, and that's why the value of equity has gone up, I don't see the evidence of that. I don't see the basis for that statement, because that's not what I see when I look at the numbers.
Rana Pritanjali: Do you think market, in general, perceives equity investing as riskier than what it used to for the past 10 years?
Aswath Damodaran: Absolutely, and they have a good basis for their perception. Notice there's a crisis every year? This year, it's Brexit. Last year, it was China, and the year before, it was Greece. At some point, you've got to stop and ask, "Is this an accident or is this the way ...?" This is, I think, a direct consequence of globalization. Globalization has, in a sense, brought down the real growth of the developed parts of the world — the U.S. and western Europe. It's connected us at the hip, so everybody's problem is everybody else's problem. Guess what? Collective, globally, equities have become riskier. They have become risky. You have to demand a higher risk premium.
It's not just a market perception. They're reflecting the reality that we live in a much riskier world as investors. We no longer have those nice [safe] enclaves. We say, "Let me go back and just hold this nice dividend paying you [a given percentage] stock, and just hide from the risk until it goes away." There is no safe spot anymore. Everybody is impacted by everybody else, and I think that's why risk premiums are higher.
Rana Pritanjali: Let's say there's company A that has a long operating history and has shown very steady results — above 15% ROE, consistent sales growth, expanding margin — and there's a company B that is relatively new. Its performance has been irregular and its industry is cyclical. As a person who's keen on doing valuation, how do you differentiate between these two companies in your valuation approach?
Aswath Damodaran: The company that's more volatile probably is going to have a higher discount rate, but ultimately, why even worry about valuation? Ultimately, what drives your decision is not what the value of the company is, but what the value is, relative to the price. Let's say the value of the riskier, younger, more volatile company is lower than the value of the more stable company. That tells you absolutely nothing, right? It depends on what market price is being attached to the company. It is entirely possible that your better bargain is actually the younger, more cyclical, less valuable company because the price is even lower. Everything is relative to price.
You have to value the company, and the value will be lower for the riskier company with a lot more risk attached to it. It's a natural consequence of having more risk and more uncertainty, but that by itself is neither here nor there. After you come up with the value, you still have to say, "What is the market doing to this company?" Those same factors that made you uncomfortable valuing the second company are exactly the factors that'll make the market price even lower.
I never compare my valuations across companies. I value probably a company a week, and I range a spectrum — emerging market, developed market, mature emerging market. I never compare a valuation I do in a week to a valuation I did of a different company in a previous week, because it really tells me absolutely nothing. To me, I'm focused on valuing that company in that week and comparing it to the price attached to that company in that week because that's all that drives my investment decision.
To me, if there's risk, you bring it in to your discount rate, you value the company and then you let go, because you've got to compare to the price and make your investment decision. I'm not going to skew my investment decision because of how uncomfortable I felt during the process of doing valuation. In other words, if my risky, young company is undervalued by 20%, why should I treat it any differently than if my safe company with the long history is undervalued by 20%? What difference does it make?
Rana Pritanjali: Right. This is related to the previous question. Do you believe in paying up for quality? What I mean by this is, when you value a company, and this is true for most of the value investors that they put a terminal rate after 10 years, but there are some companies which have proven to grow above their terminal rate for almost decades, so how do you ...?
Aswath Damodaran: Why do these people even bother doing valuations? That's my question. In fact, most people who claim to be value investors have no faith in valuation. They just have these little qualitative factors about great managers and stable businesses, and valuation is just what they like to talk about after they've made their decision. It's a very dangerous place to be. Don't make decisions based on quality or what you think about management first, and then do valuation afterwards. If you do valuation and you have all those things that you think are good about the company, bring it into the valuation, and if that value is still lower then the price, guess what? It could be the greatest company on the face of the earth, Warren Buffet could run the company, he could be investing [in] the company, but you shouldn't care, because if you've done your job right, your valuation should reflect all those good things already.
Don't let your priors drive your decision. In my view, that's a big problem; when you start talking about quality companies with great stuff ... you're saying, "Look, I couldn't get into the value, but I think this is a really great company, and I want it in my portfolio so I'm going to find a way to buy it no matter what." Don't bend your valuations because you have too strong a prior on the company.
Rana Pritanjali: That can also mean that I might be wrong about the way I am projecting that company.
Aswath Damodaran: You're always going to be wrong. In fact, it's not might — you will be wrong.
As long as you're not ... I can take make mistakes; I can't take bias. If you're going to make a mistake, mistakes average out. If you're going to be biased, which is what you get with this quality issue or bringing in factors, bias doesn't average out. I'd much rather have a group of 20 analysts who screw up all the time than 20 analysts who screw up less but are biased all the time. Bias doesn't average out, and a lot of value investing has become so hopelessly biased toward these things that are viewed as good, as high-quality, that they've lost sight of what drives value.
Rana Pritanjali: Interesting. The next question is, do you think that investing in a company that even an idiot can run, or can be a part of the sleep-well portfolio, is still valid today? That that whole concept is still valid today?
Aswath Damodaran: Company that can be put on autopilot?
Rana Pritanjali: Yes.
Aswath Damodaran: Sure, and if it exists, the market also puts it on autopilot. The price would reflect it as well. Again, it's a game of differential advantages. What you'd like to find is a company that runs on autopilot, but the market thinks is a very risky company, is very difficult to run. It's mismatches between what you think about a company and what the market thinks about the company that [you] can exploit to make money. We all agree that a company is such a great company, it can run on its own, that you don't really need great managers to run the company, but if everybody believes that, the price is going to reflect it and your value is going to reflect it. What's the differential advantage you bring to the game?
What you're looking for are shifts in the marketplace or a company that used to be a great, high-quality company, that's become not that high-quality, and the market's not recognizing it, or vice-versa. You make money as an investor by detecting those shifts a little faster than the market. If you are able to look at value in 2014 and say, "You know what? This is a company that [goes through] acquisitions, I don't think its numbers are going to hold up." Everybody thinks it's a great company, but it's really a very average company that is used to acquisitions to cover up a lot of crap. You can make a lot of money, but if you came to that recognition in December of 2015, everybody kind of knew it by then; there's no money to be made. If you're thinking about investing, it's not about what you think about the company, it's what you think about the company versus the rest of the world thinking about the company. The more you think like the rest of the world, the less chance you have of making money.
Rana Pritanjali: Mm-hmm (affirmative) — interesting. My next question is, when you value a high-growth company which has a growth rate of above 20%, as you said, there are so many moving pieces that if you want to invest, you have to buy the story and have some faith in management.
Aswath Damodaran: You don't have buy their story; you have to have a story of your own that you buy into. You can't buy into the management story. That's their story. That's the first thing in investing: You can't buy other peoples stories. If you're buying Tesla, don't buy it because you like Elon Musk's story. You have to buy Tesla because you have a story for Tesla that you believe in, that you're willing to invest on. There are lots of moving pieces, so you're going to be wrong a lot of the time. Guess what? If the rule in diversification is, "You should spread your bet," it becomes even more incumbent on you to follow that rule with young growth companies. You can not put your money in five young growth companies. That's a height of danger. You've got to spread your bets, and this notion again from old-time value investing of having concentrated investing is horrible advice, and especially horrible advice when you're thinking about investing in young growth companies where there's a lot of uncertainty.
I think that in the world that we live in, I think anybody [who] owns four, or five, or six companies in their portfolio, is begging to be taken to the cleaners. Not a question of whether, it's a question of when it's going to happen. I think don't make diversification the enemy of value investing. You could be a value investor and diversified at the same time, and we live in a world where you have to spread your bets.
Rana Pritanjali: An ideal situation is that you diversify more when you're investing on a high-growth company because it's sort of very hard to ... Even if you're unbiased and you don't want to buy into management's story, since there are so many moving pieces, it's hard to put a valuation number with some degree of confidence.
Aswath Damodaran: Absolutely. That's exactly my point is, maybe you can get away with five or six companies if you own old-time value companies, but the more you enter these new spaces where there's lots of uncertainty, the more you have to spread your bets.
Rana Pritanjali: Right. Well, thank you so much, Professor Damodaran, for talking with me today. It was a pleasure having you with us today.
Aswath Damodaran: You're welcome.
Rana Pritanjali: Thank you so much.
