The Little Book Of Valuation by Aswath Damodaran

Summary

Provides relative and intrinsic valuation methods for stocks of businesses in all stages of their lifecycle. A very in-depth explanation. Also includes business drivers for each type of business. Beware that this is just one man’s way of valuing businesses.

Key Takeaways

• You buy financial assets for the cash flows that you expect to receive.
• You can improve your odds by investing in stocks that are undervalued not only on an intrinsic basis but also on a relative one.
• Four basic inputs that we need for a value estimate:
  • Cash flows from existing assets (net of reinvestment needs and taxes).
  • Expected growth in these cash flows for a forecast period.
  • The cost of financing the assets.
  • An estimate of what the firm will be worth at the end of the forecast period.
• Free cash flow to equity: it measures the cash left over after tax, reinvestment needs, and debt cash flows have been met.
• When estimating market value, you have three choices:
  • Market value of equity: the price per share or market capitalization.
  • Market value of firm: the sum of the market values of both debt and equity.
  • Market value of operating assets or enterprise value: the sums of the market values of debt and equity, but with cash netted out of the value.
• Various valuation methods (see different business types below) and business drivers (see “conclusion” at the bottom).

What I got out of it

The Little Book of Valuation by Aswath Damodaran covers intrinsic and relative valuation principles and formulas for all kinds of businesses, ranging from recently IPO’d startups to established and declining giants.

One of the most in-depth valuation books I’ve come across, rich in formulas and mathematical formulas. It appears daunting at first, but you quickly realize that the same formulas are applied over and over again and have been mentioned in other investment books (e.g. Beating The Street, The Acquirer’s Multiple, Security Analysis).

While the formulas are standard fare, I had to remind myself that Damodaran’s valuation approach is just one way to value a company. That being said, I appreciate adding his perspective to my valuation toolkit.

Summary Notes

Introduction

If you understand the value drivers of a business, you can also start to identify value plays – stocks that are investment bargains.

Understanding The Terrain

Perceptions may be all that matter when the asset is a painting or a sculpture, but you buy financial assets for the cash flows that you expect to receive.

You can improve your odds by investing in stocks that are undervalued not only on an intrinsic basis but also on a relative one.

The inputs that you use in the valuation will reflect your optimistic or pessimistic bent; thus, you are more likely to use higher growth rates and see less risk in companies that you are predisposed to like. There is also post-valuation garnishing, where you increase your estimated value by adding premiums for the good stuff (synergy, control, and management quality) or reduce your estimated value by netting out discounts for the bad stuff (illiquidity and risk).

When valuing an asset, use the simplest model that you can. If you can value an asset with three inputs, don’t use five. If you can value a company with three years of forecasts, forecasting 10 years of cash flows is asking for trouble. Less is more.

Success in investing comes not from being right but from being wrong less often than everyone else.

Time Value, Risk, and Statistics

The principles of present value enable us to calculate exactly how much a dollar sometime in the future is worth in today’s terms, and to compare cash flows across time.
There are three reasons why a cash flow in the future is worth less than a similar cash flow today.

1. People prefer consuming today to consuming in the future.
2. Inflation decreases the purchasing power of cash over time. A dollar in the future will buy less than a dollar would today.
3. A promised cash flow in the future may not be delivered. There is risk in waiting.

There are five types of cash flows – simple cash flows, annuities, growing annuities, perpetuities, and growing perpetuities.

An annuity is a constant cash flow that occurs at regular intervals for a fixed period of time.

A perpetuity is a constant cash flow at regular intervals forever and the present value is obtained by dividing the cash flow by the discount rate.

• Risk matters. Even if you don’t agree with portfolio theory, you cannot ignore risk while investing.
• Some investments are riskier than others. If you don’t use beta as a measure of relative risk, you have to come up with an alternative measure of relative risk.
• The price of risk affects value, and markets set this price.

Two principles underlie the measurement of accounting earnings and profitability.

1. Accrual accounting, where the revenue from selling a good or service is recognized in the period in which the good is sold or the service is performed (in whole or substantially), and a corresponding effort is made to match expenses incurred to generate revenue.
2. The categorization of expenses into operating, financing, and capital expenses.

An accounting balance sheet is useful because it provides us with information about a firm’s history of investing and raising capital, but it is backward looking. To provide a more forward-looking picture, consider an alternative, the financial balance sheet, as below:

• Assets in place: value of investments already, updated to reflect their current cash flow potential.
• ADD growth assets: value of investments the company is expected to make in the future (this rests on perceptions of growth opportunities).
• EQUALS value of business: the value of a business is the sum of assets in place and growth assets.
• MINUS debt: lenders get first claim on cash flows, during operations, and cash proceeds, in liquidation.
• EQUALS value of equity: equity investors get whatever is left over after debt payments.

Determining Intrinsic Value

In discounted cash flow valuation, you discount expected cash flows back at a risk-adjusted rate. When applied in the context of valuing a company, one approach is to value the entire business, with both existing investments and growth assets; this is often termed firm or enterprise valuation.

You can value 3M as a business and subtract out the debt the company owes to get to the value of its shares. Or, you can value the equity in the company directly, by focusing on the cash flows 3M has left over after debt payments and adjusting for the risk in the stock. Done right, both approaches should yield similar estimates of value per share.

There are four basic inputs that we need for a value estimate:

• Cash flows from existing assets (net of reinvestment needs and taxes).
• Expected growth in these cash flows for a forecast period.
• The cost of financing the assets.
• An estimate of what the firm will be worth at the end of the forecast period.

The simplest and most direct measure of the cash flow you get from the company for buying its shares is dividends paid. One limitation of focusing on dividends is that many companies have shifted from dividends to stock buybacks as their mechanism for returning cash to stockholders. One simple way of adjusting for this is to augment the dividend with stock buybacks and look at the cumulative cash returned to stockholders.

Augmented dividends = Dividends + Stock buybacks

Free cash flow to equity: it measures the cash left over after tax, reinvestment needs, and debt cash flows have been met.

From net income to potential dividend (or free cash flow to equity):

• Net income: earnings to equity investors, after taxes and interest expenses.
• PLUS depreciation: accounting expense (reduced earnings), but not a cash expense.
• MINUS capital expenditures: not an accounting expense, but still a cash outflow.
• MINUS change in noncash working capital: increases in inventory and accounts receivable reduce cash flows, and increases in accounts payable increase cash flows. If working capital increases, cash flow decreases.
• MINUS (principal repaid – new debt issued): principal repayments are cash outflows but new debt generates cash inflows. The net change affects cash flows to equity.
• EQUALS potential dividend, or FCFE: this is the cash left over after all needs are met. If it is positive, it represents a potential dividend. If it is negative, it is a cash shortfall that has to be covered with new equity infusions.

To measure reinvestment, we will first subtract depreciation from capital expenditures; the resulting net capital expenditures represents investment in long-term assets. To measure what a firm is reinvesting in ints short-term assets (inventory, accounts receivable, etc.), we look at the change in noncash working capital. Adding the net capital expenditures to the change in noncash working capital yields the total reinvestment. This reinvestment reduces cash flow to equity investors, but it provides a payoff in terms of future growth.

A more conservative version of cash flows to equity, which Warren Buffett calls “owners earnings,” ignores the net cash flow from debt.

Free cash flow to firm (FCFF) = After-tax operating income – (net capital expenditures + change in noncash working capital)

Both FCFE and FCFF are after taxes and reinvestment and both can be negative, either because a firm has negative earnings or because it has reinvestment needs that exceed income. The key difference is that the FCFE is after debt cash flows and the FCFF is before.

Cash flows that are riskier should be assessed at a lower value than more stable cash flows.

When valuing equity, you look at the risk in the equity investment in this business, which is partly determined by the risk of the business the firm is in and partly by its choice of how much debt to use to fund that business.

There are three inputs needed to estimate a cost of equity:

• A risk-free rate
• A price for risk (equity risk premium) to use across all investments
• A measure of relative risk (beta) in individual investments

Lenders add a default spread to the riskless rate when they lend money to firms; the greater the perceived risk of default, the greater the default spread and the cost of debt.
To estimate this default spread:

• Use a bond rating for the company (S&P or Moody’s)
• Estimate a “synthetic” rating for the firm, based on the ratio of operating income to interest expenses (interest coverage ratio)

The final input needed to estimate the cost of debt is the tax rate.

After-tax cost of debt = (Risk-free rate + default spread) x (1 – marginal tax rate)

Studies indicate that the relationship between past and future growth for most companies is a very weak one.

Studies indicate that analyst and management estimates of future growth, especially for the long-term, seem just as flawed as historical growth rates.

For a firm to grow, it has to either manage its existing investments better (efficiency growth) or make new investments (new investment growth).

• To capture efficiency growth, you want to measure the potential for cost cutting and improved profitability. It can generate substantial growth in the near term, especially for poorly run mature firms, but not forever.
• To measure the growth rate from new investments, you should look at how much of its earnings a firm is reinvesting back in the business and the return on these investments. 

While reinvestment and return on investment are generic terms, the way in which we define them will depend upon whether we are looking at equity earnings or operating income. 

• Equity earnings: measure reinvestment as the portion of net income not paid out as dividends (retention ratio) and use the return on equity to measure the quality of the investment.
• Operating income: measure reinvestment as the reinvestment rate and use the return on capital to measure investment quality.

The two legitimate ways of estimating terminal value:

• Estimate a liquidation value for the assets of the firm, assuming that the assets are sold in the terminal year.
• Estimate a going concern value, assuming that the firm’s operations continue.

Simple rules of thumb:

1. The stable growth rate is that it should not exceed the risk-free rate used in the valuation; the risk-free rate is composed of expected inflation and a real interest rate, which should equate to the nominal growth rate of the economy in the long term.
2. As firms move from high growth to stable growth, we need to give them the characteristics of stable growth firms; as a general rule, their risk levels should move towards the market (beta of one) and debt ratios should increase to industry norms. 
3. A stable growth firm should reinvest enough to sustain the assumed growth rate.

The key assumption in the terminal value composition is not what growth rate you use in the valuation, but what excess returns accompany that growth rate.

If you discounted cash flows to the firm, you have four adjustments to make to get to value per share:

• Add back the cash balance of the firm.
• Adjust for cross holdings.
• Subtract other potential liabilities.
• Subtract the value of management options.

What if the intrinsic value that you derive, from your estimates of cash flows and risk, is very different from the market price? There are three possible explanations:

• You have made erroneous or unrealistic assumptions about a company’s future growth potential or riskiness.
• Related: you have made incorrect assessments of risk premiums for the entire market.
• The market price is wrong and you are right in your value assessment.

Even in the last scenario, there is no guarantee that you can make money from your valuations.

A long time horizon is almost a prerequisite for using intrinsic valuation models. Giving the market more time (say three to five years) to fix its mistakes provides better odds.

The intrinsic value of a company reflects its fundamentals. Estimates of cash flows, growth, and risk are all embedded in that value, and it should have baked into it all of the other qualitative factors that are often linked to high value, such as a great management team, superior technology, and a long-standing brand name.

Determining Relative Value

The three essential steps in relative valuation are:

1. Find comparable assets that are priced by the market.
2. Scale the market prices to a common variable to generate standardized prices that are comparable across assets.
3. Adjust for differences across assets when comparing their standardized values.

Relative valuation can be done with less information and more quickly than intrinsic valuation and is more likely to reflect the market mood of the moment.

When estimating market value, you have three choices:

1. Market value of equity: the price per share or market capitalization.
2. Market value of firm: the sum of the market values of both debt and equity.
3. Market value of operating assets or enterprise value: the sums of the market values of debt and equity, but with cash netted out of the value.

The first test to run on a multiple is to examine whether the numerator and denominator are defined consistently.

When using multiples to value companies, we generally lack a sense of what comprises a high or low value with that multiple. To get this perspective, start with the summary statistics. It makes far more sense to focus on the median.

As a general rule, you should be sceptical about any multiple that results in a significant reduction in the number of firms being analyzed.

The common practice of branding a market to be under or overvalued based upon comparing the PE ratio today to past PE ratios will lead to misleading judgments when interest rates are higher or lower than historical norms.

Every multiple, whether it is of earnings, revenues, or book value, is a function of the same three variables – risk, growth and cash flow generating potential.

Mismatch indicator for an undervalued company

• PE ratio – expected growth – low PE ratio with a high expected growth rate in earnings per share.
• P/BV ratio – ROE – low P/BV ratio with high ROE.
• P/S ratio – net margin – low P/S ratio with high net profit margin.
• EV/EBITDA – reinvestment rate – low EV/EBITDA ratio with low reinvestment needs.
• EV/Capital – return on capital – low EV/Capital ratio with high return on capital.
• EV/Sales – after-tax operating margin – low EV/sales with high after-tax operating margin.

No matter how carefully we construct our list of comparable firms, we will end up with firms that are different from the firm we are valuing. How to control for these differences:

• Compare the multiple a firm trades at to the average compound for the sectors; if it is significantly different, you can make a judgment about whether the firm’s individual characteristics (growth, risk, or cash flows) may explain the difference. Weakness: judgments are often based upon little more than guesswork.
• Modify the multiple to take into account the most important variable determining it – the companion variable.
• When there is more than one variable to adjust for, when comparing across companies, there are statistical techniques that offer promise.

The differences in value between discounted cash flow valuation and relative valuation come from different views of market efficiency or inefficiency.

In relative valuation, we assume that while markets make mistakes on individual stocks, they are correct on average.

Valuing Young Growth Companies

Key numbers in forecasting future cash flows:

• Revenue growth, which can be obtained by either extrapolating from the recent past or by estimating the total market for a product or service and an expected market share.
  • Estimate the share of the market that will be captured by the firm. Consider both the quality of the products and management and the resources that the company can draw on.
• Estimate the operating expenses associated with delivering the projected revenues.
  • Estimate the target operating margin when the firm becomes mature.
  • Look at how the margin will evolve over time.

Two problems in estimating discount rates for young companies:

1. Market history is too short and volatile to yield reliable estimates of beta or cost of debt.
2. Cost of capital can be expected to change over time as the company matures.

To deal with the risk of failure in a young firm, try a two-step approach:

1. Value the firm on the assumption that it survives and makes it to financial health.
2. Bring in the likelihood that the firm will not survive. The probability of failure can be assessed, most simply, by using sector averages.

To assess a key person discount in valuations, first value the firm with the status quo and then value it again with the loss of these individuals built into revenues, earnings, and expected cash flows.

Valuing Growth Companies

Growth firms get more of their value from investments they expect to make in the future and less from investments already made.

The value of growth assets is a function of not only how much growth is anticipated but also the quality of that growth, measured in terms of excess returns: returns on the invested capital in these assets, relative to the cost of capital.

One of 3 paths to estimate reinvestment:

1. Most general approach: estimate the reinvestment using the change in revenue and a sales-to-capital ratio, estimated using either historical data for the firm or industry averages.
2. For growth firms that have a more established record of earnings and reinvestment, estimate the growth rate as a product of the reinvestment rate and the return on capital on these investments.
3. Growth firms that have already invested in capacity for future years: forecast capacity usage to determine how long the investment holiday will last and when the firm will have to reinvest again.

Voting shares trade at a premium over nonvoting shares; studies indicate that the premium is about 5 to 10 percent at U.S. companies.

Valuing Mature Companies

If growth companies get the bulk of their value from growth assets, mature companies must get the bulk of their value from existing investments.

Not all mature companies are large companies. Many small companies reach their growth ceiling quickly and essentially stay on as small mature firms.

With mature firms, the problem we face is not that we cannot estimate a relative value but that there are too many values to pick from.

If the key to valuing mature companies is assessing the potential increase in value from changing the way they are run, changes can be categorized broadly into three groups:

• Changes in operations
• Changes in financial structure
• Changes in nonoperating assets

The cost of capital approach relies on sustainable cash flow to determine the optimal debt ratio. The more stable and predictable a company’s cash flow and the greater the magnitude of these cash flows – as a percentage of enterprise value – the higher the company’s optimal debt ratio can be.

If we estimate a value for the firm, assuming that existing management practices continue, we can call this a status quo value and reestimate the value of the same firm, assuming that it is optimally managed, and call this the optimal value, the value of changing management can be written as:

Value of management change = Optimal firm value – Status quo value

There are two value plays with mature companies:

1. Passive value: invest in well-managed companies that deliver solid earnings and reasonable growth, but which investors have turned sour on, either in reaction to a recent news event (earnings report) or because these firms are not the flavour of the moment or are boring.
2. Look for those firms that are poorly managed but could be worth more under better management.

Valuing Declining Companies

To value the effects of distress, first value the firm as a going concern, and then estimate the cumulative probability that the firm will become distressed over the forecast period, and the proceeds you expect to get from the sale.

A simple approach to estimating the probability of distress is to use the bond rating for a firm and the history of default rates of firms in that rating class.

The most practical way of estimating distress sale proceeds is to consider them as a percent of book value of assets, based upon the experience of other distressed firms.

Investors with long time horizons and strong stomachs can use two strategies with declining companies:

1. Invest in declining companies, where the decline is inevitable and management recognizes that fact.
2. Make a turnaround play, where you invest in declining or distressed companies with the hope that they revert back to health and, in the process, deliver substantial upside.

Valuing Financial Service Companies

Dividend discount model: adapt the free cash flow to equity measure to define reinvestment as the increased regulatory capital required to sustain growth. Focus on what financial service firms generate as a return on equity, relative to the cost of equity, and value these excess returns.

The key number in valuing a bank is not dividends, earnings, or expected growth, but what we believe it will earn as return on equity in the long term.

To estimate the reinvestment in regulatory capital, we need to define the target book equity capital ratio that the bank aspires to reach.

An issue that is specific to financial service firms is the use of provisions for expected expenses. 

Another consideration in the use of earnings multiples is the diversification of financial service firms into multiple businesses.

Invest in financial service firms that not only deliver high dividends but also generate high returns on equity from relatively safe investments.

Valuing Cyclical and Commodity Companies

There are usually 3 standard techniques that are employed for normalizing earnings and cash flows of cyclical companies:

1. Absolute average over time. The typical economic cycle in the US lasts 5 to 10 years.
2. Relative average over time.
3. Sector averages.

What is a normalized price for oil? Or gold? There are two ways of answering:

1. Look at the average price of the commodity over time, adjusted for inflation.
2. Determine a fair value for the commodity, given the demand and supply for that commodity.

Valuing Companies With Intangible Assets

Accounting for intangible assets is not consistent with its treatment of physical assets. Earnings and capital expenditures tend to be understated at these firms.

Firms with intangible assets are bigger users of options to compensate management than firms in other businesses.

To value firms with intangible assets, we have to deal with two big problems:

• Clean up the financial statements (income statement and balance sheet) and recategorize operating and capital expenses.
• Deal more effectively with management options – the ones that have been granted in the past as well as the ones that we expect to be granted in the future.

Adjust book value of equity = Stated book value of equity + Capital invested in R&D

Adjust operating income = Stated operating income + R&D expenses – R&D amortization

Technology or pharmaceutical firms that want to continue to grow have to keep investing in R&D while ensuring that these investments, at least collectively, generate high returns for the firm.

Firms that pay managers and others with equity options are giving away some of the stockholders’ equity to these people. To deal with the resulting loss in value to common stockholders, there are three approaches that are employed in intrinsic valuation:

1. Diluted shares approach: simple, but leads to low estimate of value per share because it fails to reflect the proceeds from option exercise.
2. Treasury stock approach: will yield too high a value per share, because the approach ignores the time premium on the option; an option trading at or out of the money may have no exercise value but it still has option value.
3. Estimate the value of the options today, given today’s value per share and the time premium on the option: most work, but the right way to deal with options.

Conclusion

Value rests on standard ingredients: cash flows, growth, and risk, though the effects of each can vary across companies and across time.

Value drivers across the life cycle and sectors

• Young growth companies
  • Revenue growth
  • Target margin
  • Survival probability
• Growth companies
  • Scaling growth
  • Margin sustainability
• Mature companies
  • Operating slack
  • Financial slack
  • Probability of management change
• Declining companies
  • Going concern value
  • Default probability
  • Default consequences
• Financial service firms
  • Equity risk
  • Quality of growth (return on equity)
  • Regulatory capital buffers
• Commodity and cyclical companies
  • Normalized earnings
  • Excess returns
  • Long-term growth
• Intangible asset companies
  • Nature of intangible assets
  • Efficiency of investments in intangible assets