The Little Book of Valuation, Aswath Damodaran, 2011 - If there’s one book that has taught me the most about the markets, it is this one. There isn’t anything else as lucid, well structured and also exhaustive while being so concise and precise. It covers everything from the basic precepts of valuation, different types of cash flows, different types of valuation, valuing growth companies, mature companies, startups and dying businesses and special situations all the while keeping to the coherent whole of what drives intrinsic value of something, where does uncertainty and risk come from and how to discount for it
My notes -
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One who knows the price of everything but the value of nothing - Oscar Wilde
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Price of a stock cannot be justified by just using the argument that there will be other investors who will be willing to pay a higher price in the future
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Assets with high and stable cash flows should be worth more than ones with low and volatile cash flows - Intuition - You will be willing to pay higher for a property with higher and increasing rents than to a property with lower rents and variable vacancy rates
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Most assets are valued on a relative basis than based on intrinsic value (what’s another house in the same neighborhood worth?)
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Intrinsic value provides full picture but relative valuation is also a realistic estimate of value - find the middle-ground or find stocks undervalued on both to increase odds
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All valuations are biased - bias starts with companies chosen to be valued, continues with management inputs that put best spin, institutional factors (analysts want to maintain cordial relations with company), predisposition (see less risk to higher growth rates for businesses you like), post-valuation garnishing (adding premiums to synergy, management quality etc.) - more bias, less accuracy
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Confine your research to information sources (financial statements), rather than opinion sources (analyst reports)
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Most valuations are wrong due to information sources, estimation errors and firm-specific uncertainty (young growth companies specially)
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Value an asset with the simplest possible model (dont be misled by computational power and informational abundance)
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Success in investing comes not from being right but by being wrong less often
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Present value - how much is a dollar in the future worth today? The adjustment factor is simply the discount rate (If $100 next year is worth $80 today to you, your discount rate is 20%)
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Why discount? 1. Consumption today vs tomorrow 2. Inflation 3. Uncertainty in the promise to delivery value in the future (Note how subjective, rather than objective these are)
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Five types of cash flows - simple cash flows, annuities, growing annuities, perpetuities, and growing perpetuities
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Simple cash flow - Cash flow in future / (1 + Discount rate)^Time Period. Say you are to receive $1000 in 10 yrs its value will be - 1000/(1+0.08)^10 = $463.19 ($500.25 if 9 yrs, $857.34 after 2 yrs, $926 after a year and so on). Intuition - Longer the period, lesser your willingness to wait and higher the uncertainty and so lesser the value - notice how for 10 yrs at 8% discount rate, the value is less than half of actual cash flow at 8%. What happens when you discount at 15%? Its worth only $247 today vs $463 at 8%! (This follows the exponential discounting curve - as part of intuition get this curve into your head so you can discount at 8% vs 12% vs 15% intuitively)
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Annuity - Constant cash flow in regular interval for a fixed time period - Say you receive $1000 every year for 10 yrs - You can discount them for each year as in simple cash flow above and add them up - or you can use the formula Annual Cash flow ( (1 - (1/ (1 + Discount Rate)^ Time Period )) / Discount Rate ). Say a $3000 cash flow every year for 5 yrs will be worth $10,814 today, discounted at 12% - see how its 3.6x instead of 5x annual cash flow (Summing up present value of individual cash flows for 5 separate years is more intuitive than the formula). If done for 10 yrs, the value is $16950 or ~6x (The low P/E for businesses without growth in terminal industries should be intuitive now)
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Growing Annuity - Grows at a constant rate for a specific period of time. A gold mine that generates $1.5m in current year and expected to grow at 3% a year, for next 20 years, discounted at 10% will have a present value of $16.15m (or roughly 10x current year earnings). A growth of 10%, discounted at 15% will be ~20x earnings. Formula is straight-forward to look-up but a year-wise cashflow discounted back and added provides the intuition to the sensitivity to growth and discount rates (Plugging in g=0 in this formula makes it same as Annuity of course)
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Perpetuity - A constant cash flow at regular intervals forever (console bonds). Calculated as Cash flow / discount rate A $60 every year till perpetuity, discounted at 9% is $60/0.09 will have a value of $667. This can be very unintuitive that something that pays till perpetuity has such a finite value and that too at just 11x yearly cash flow. Intuition - That’s how less cash-flows far into the future are worth that it tapers down drastically and adds up to a finite value
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Growing Perpetuity - A cash flow that’s expected to grow at a constant rate, forever. Calculated as Cash flow / (discount rate - growth rate). Note how growth rate has to be lower than discount rate. Also this growth rate has to be lower than the growth rate of the economy (remember this is perpetual growth). Also note how growth rate being 0 in this formula simply makes this same as present value of a perpetuity above. The formula is also exact same as the one we use in Dividend discount model - like a $2 dividend this year, expected to grow at 2% a year, discounted at 8% will give us $2 / (0.08 - 0.02) will give us the value of share as $34. Can also be used to calculate value of a property with rent
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The price of risk affects value. (Risk isn’t beta and CAPM isn’t the right way to model risk IMO)
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Goodwill is the most common intangible asset that rises mostly from acquisition - price paid over and above price of assets is recorded as Goodwill - when value of target company drops, this goodwill is decreased or impaired
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Accrual accounting - Revenue is recognised in the period in which good is sold or service is performed (cash comes later)
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Operating, financial and capital expenses - Operating provide benefits only in the current period. Financial - interest cost. Capital - benefits over multiple periods. Netting operating expenses and depreciation yields operating income. Post interest and taxes, the net income
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Post tax RoCE = Operating Income (1 - tax rate) / BV of debt + BV of equity - Cash. RoE = Net Income / BV of equity
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Financial Balance Sheet - Reflects fair-value accounting. Value of business is value of current assets already invested (at fair-value) and value of growth assets (what’s to be invested in the future)
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Valuation can be done be valuing entire business and subtracting the debt or valuing the equity directly based on net income and adjusting for risk. Ideally both should yield similar value
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Dividends would be a good way to calculate value but unfortunately not all businesses pay dividends, so judging the potential for dividend or free cash flow to equity (FCFE) is one way to go about it (I think this is absurd since it includes net debt issued in FCFE or potential dividend)
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Buffett uses FCFF or free-cash flow to firm which ignores the debt issues and uses owner’s earnings adjusted for capital and working capital expenditures (One I personally use)
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Discount rates are lower for stable cash flows and higher for volatile ones. When valuing equity, risk is part of business operations as well as in use of debt. Debt investors will have to look at the cash flows (operating income to interest or interest coverage ratio) and default risk - cost of equity and cost of debt and cost of capital to firm varies accordingly (again, the intuition more important than formulas)
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Relationship between past and future growth for most companies is a weak one. Neither managers, nor analysts can be objective about the future.
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A firm can grow by managing its existing investments better (efficiency) or make new investments (capex)
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While valuing a firm, value cash flows at a reasonable time period (say 10 yrs for most businesses or 20 yrs for some) and work on terminal value - estimated by liquidation value or a going concern value (valued as a perpetuity with same cash flow as nth year or with small growth rate and appropriate discount rate)
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If your est of fair value disagrees with the market, 1. your assumptions could be wrong 2. your risk premiums could be off 3. market is valuing business incorrectly - #3 is rare and should be treated as such. It is no guarantee that market will agree with you in the near future (cheap can get cheaper)
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Relative valuation can be done more quickly and with less information and is most often used. Comparing P/E or P/B or EV/EBITDA across companies or across time for same company while accounting for differences qualitatively - these multiples are easy to use and also easy to misuse, so exercise caution
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Relative valuations have short shelf life as market perceptions of risk vary wildly across time. For eg. lower interest rates 5 yrs back could have led to higher P/E multiples which may not apply anymore
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Key determinants of P/E - 1. Expected growth rate 2. Cost of equity 3. Payout ratio (Value of Equity = Expected Dividends / (Cost of Equity - Expected growth rate) and P/E = Value of Equity / Net Income which is nothing but Dividend Payout Ratio / (Cost of Equity - Expected Growth Rate)). All else remaining same, higher growth, lower risk and higher payout ratio firms will trade at higher P/E ratios (All market movement boils down to these 3 in some way if you think about it deeply)
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Key determinants of P/B - In addition to determinants of P/E, RoE also affects P/B (P/B = Value of Equity / BV of Equity = RoE * P/E. Looking at P/B as RoE x P/E is a tremendously useful way of thinking).
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Typical valuation mismatches - 1. Low P/E coupled with higher expected growth rate 2. Low P/B coupled with higher trending RoE 3. Low P/S with increasing net margin 4. Low EV/EBITDA with lower re-investment needs (This was the key takeaway for me from this book in 2017 and the one I have benefitted from the most)
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In young idea companies without cash flows, we often rely on compelling stories to justify investment decisions - instead focus on 1. Big potential market 2. Expense tracking and controls 3. Access to capital 4. Key-man risk 5. Exclusivity - So tough-to-imitate products, with a large potential market, keeping expenses under control and great access to capital get valued higher
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Growth firms get more of their value from investments they expect to make in the future and less from ones already made
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Quality of growth - measured in terms of excess returns - returns on the assets relative to the cost of capital
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A company that has posted 80% growth for last 5 yrs is now 18x its size and is unlikely to grow at that rate - growth crimps growth by attracting competition (or market shrinks)
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Level of growth affects value, as does the length of growth period and the excess returns that accompany that growth rate (Larger potential markets with less aggressive competition and better management can maintain high revenue growth for longer periods)
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As firms grow large, they have to diversify their product offerings for wider customer base to continue growth - focus on managements that enable this
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Mature companies - 1. Revenue growth approaching growth rate of economy 2. Margins are stable 3. Competitive advantages may be squandered (Nokia) or retained (Coca-cola) 4. Have good debt-servicing capability but not many avenues for growth 5. Generate more cash from ops. than they need which must be paid out or they will accumulate in balance sheet 6. Sometimes grow by acquisitions as growth stagnates and cash grows (could be often value-destructive)
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Mature companies may increase value by changes in operations, changes in financial structure or changes in non-operating assets (cash and marketable securities)
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Since interest expenses are tax deductible while cash flows to equity are not, debt becomes attractive when marginal tax rate rises (never thought of this before)
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As debt increases, so does the probability of bankruptcy and along with the cost of bankruptcy - aside from legal fees and court costs, your customers may stop buying your products and your suppliers may expect payments upfront and your employees abandon ship (Classic case with Vodafone)
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Changing mix of debt and equity and also type of debt can change value
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Value of management change = Optimal value - status quo values (Estimate value assuming management changes vs stays same - Classic case is Zee Ent at present or CG Power in the recent past)
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In declining companies, book values can be eroded with continued operations (Suzlon for eg. in the past)
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Most declining and distressed firms dont make it back to health
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Key metric in valuing banks is not dividends, earnings or expected growth but what it will earn as RoE in the long-term
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Banks with regulatory capital shortfalls should be valued less than ones that have safety buffers, since the former will have to reinvest more to get the capital ratios back up
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P/B for financial firms will vary based on growth rate, payout, lower cost of equity and higher returns on equity with RoE being the dominant variable (Risk matters too, higher leverage, lower the P/B)
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Valuing cyclicals & commodity companies - 1. Absolute avg. over time (Mean reversion in revenues) 2. Relative avg over time (Mean reversion in margins) 3. Sector averages 4. Firm’s value at normalised value of underlying commodity 5. Option value of unutilised resources (say mines or oil resources)
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Intangible assets - human capital, technology, brand, loyalty of workforce. Accounting for these isn’t consistent as in physical assets. For eg. R&D is expensed due to uncertainty of future revenues in current year though there may be benefits in future - this can understate earnings (Tech startups with large TAM spend a lot on brands upfront which is expensed as well and is similar - must consider value carefully instead of looking only at PnL)
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10 Rules for the road 1. Abandon models but dont budge on first principles 2. Don’t let market determine what you do 3. Risk affects value 4. Growth is not free and is not always value-accretive 5. All good things comes to an end, incl. growth 6. Consider truncation risk 7. Look at past but think about future 8. An avg. is better than a single number 9. Accept uncertainty and deal with it 10. Convert narratives to numbers
You dont have to read this book so you can learn to do DCF. That is not the objective of this book though I feel it is mostly misunderstood as such. You have to understand the machinery that is a business, understand the various parts and their interaction, the design, the problems that might arise and its fixes and the way in which it can be efficiently run by its operator. To develop the intuition of what something is worth quickly is the most invaluable skill we can have. This book or his lecture are great places to start and having read Graham and John Burr Williams, I can safely say this is the easiest and most practical of the lot. 11/10