Aswath Damodaran’s Three Need-To-Know Valuation Lessons

Aswath Damodaran’s Three Need-To-Know Valuation Lessons
Reda Farran, CFA

over 2 years ago6 mins

  • Investment opportunities arise when a stock’s price is below its value, with a catalyst on the horizon that could narrow that gap.

  • You can work out its value with a simplified discounted cash flow model, which you can build using the four key drivers of value: revenue growth, profit margins, investment efficiency, and riskiness.

  • A good valuation isn’t just based on numbers, it also has a story – so make sure you embed a narrative into your valuation model.

Investment opportunities arise when a stock’s price is below its value, with a catalyst on the horizon that could narrow that gap.

You can work out its value with a simplified discounted cash flow model, which you can build using the four key drivers of value: revenue growth, profit margins, investment efficiency, and riskiness.

A good valuation isn’t just based on numbers, it also has a story – so make sure you embed a narrative into your valuation model.

Mentioned in story

Aswath Damodaran is known the world over as one of the leading valuation experts, and there are three simple lessons he swears by whenever he comes to assess a company. And if you get to grips with them for yourself, you’ll be able to value any company just as well as the legend himself…

Lesson 1: Valuing a stock isn’t the same as pricing a stock

As Warren Buffett once said, “Price is what you pay. Value is what you get.”

In its simplest form, the value of a stock is the sum of all its expected future cash flows, discounted back to today at a rate that reflects the riskiness of the company. Value is driven by factors like revenue growth, profit margins, investment efficiency, and so on (more on that in a second). If you’re trying to value a stock as opposed to price it, building a discounted cash flow (DCF) model on the company is a more theoretically sound way to go.

The price of a stock, on the other hand, is driven by factors like momentum, news, investors’ moods, market swings, and behavioral biases, and a lot more. If you’re looking at a company and you multiply its profits by a price-to-earnings (P/E) ratio taken from a stock in the same sector, you’re basically pricing it. That’s because the P/E ratio of a similar stock captures all the aforementioned factors. Tech stocks, for example, traded at lofty P/E ratios during the dotcom bubble, while bank stocks traded at depressed levels right after the 2008 financial crisis – in each instance reflecting investors’ moods and big market swings.

So it’s important to see if there’s a gap between value and price when you invest. Ideally, you want to buy a stock when its price is below its value. And if you can also foresee some “catalyst” – the company being acquired, say, or launching a share buyback program – that would cause the gap between price and value to narrow, all the better.

Lesson 2: There are four key drivers of value

DCF models are the preferred valuation method, sure, but they have a reputation for being complicated and time-consuming to build. Only, they don’t have to be if you simplify them to solely focus on the key drivers of value.

Recall we said that the value of a company is the sum of all its expected future cash flows, discounted back to today at a rate that reflects the riskiness of the company. You can see that in the equation below:

Equation to calculate the value of a company. Source: Damodaran
Equation to calculate the value of a company. Source: Damodaran

Damodaran has used this equation to highlight four key drivers of value:

  • Revenue growth (faster = higher company valuation)
  • Profit margin (bigger = higher company valuation)
  • Riskiness (lower = higher company valuation)
  • Investment efficiency (better = higher company valuation)

The first three of these drivers are relatively straightforward to understand. As for investment efficiency, just know that in order for companies to grow revenues, they need to invest in things like equipment, software, research and development, raw materials, and so on. Companies that are more investment efficient generate more revenue for every dollar of capital they invest, and they’re rewarded with higher valuations. You can measure investment efficiency using the sales-to-invested-capital ratio (revenue / ).

“Riskiness”, meanwhile, has two dimensions. First, the operating risk of the business. This is basically the uncertainty around the firm’s future cash flows and is captured by the company’s cost of capital (which is also the rate used to discount those cash flows to the present). A higher cost of capital leads to lower company value. Second, there’s also the risk that the company won’t actually survive. This is called risk of failure, with a higher risk of failure leading to lower company value.

How the four drivers impact the value of a company. Source: Damodaran
How the four drivers impact the value of a company. Source: Damodaran

So how can you actually put this into practice to build a quick DCF model? Take a look at a simple example below. Note that cells highlighted in yellow are assumptions I’ve made about this hypothetical company, based on my narrative explaining how I see the business evolving over time (more on that later).

Simplified DCF model
Simplified DCF model

With this simple model, you can forecast a company’s future free cash flows (FCFs) using three of the four value drivers (revenue growth, profit margin, and investment efficiency). The fourth (riskiness) is captured when you discount the forecasted future FCFs by the company’s cost of capital, where the higher the company’s risk, the higher the cost of capital used.

Lastly, don’t forget to calculate the company’s terminal value: this is the value of the company at the end of the forecast period (year 5 in our example), which basically captures all its future FCFs beyond that point. The formula below shows how to calculate the terminal value:

Formula to calculate terminal value
Formula to calculate terminal value

Note that you can capture the company’s risk of failure by simply changing the cost of capital used when calculating terminal value, where the higher the risk of failure, the higher the cost of capital. This would lower the company’s terminal value to reflect its higher risk of failure.

Once you’ve done all of the above, add the discounted value of each future cash flow to the company’s discounted terminal value. That’ll give you the total value of the entire company. To arrive at equity value per share, simply subtract net debt (debt minus cash) from total firm value and divide the result by the total number of shares outstanding.

Lesson 3: Capture a narrative in your model

A good valuation isn’t just based on numbers, it has a story. When you’re trying to value a business, work out how you see the business evolving over time, and then ask yourself if it’s possible, plausible, and probable. There are lots of possible narratives, but not all of them are plausible and only a few of them are probable.

Then you’ll want to convert the narrative into drivers of value. So take the narrative apart and look at how you can apply it to arrive at valuation inputs using the four drivers discussed above. By the time you’re done, each part of the narrative should have a place in your numbers, and each number should be backed up by a portion of your story. That allows you to create a valuation model that captures the narrative, similar to the simple DCF one shown earlier.

Here’s a great example using Uber from Damodaran himself:

Connecting Uber’s narrative to the key drivers of value. Source: Damodaran
Connecting Uber’s narrative to the key drivers of value. Source: Damodaran

Lastly, it’s important to constantly fine-tune – or, if necessary, overhaul – your narrative. So keep a feedback loop open, where you constantly try to listen to people who know the business better than you do, or who have a completely different opinion to yours. Even Damodaran has made the point that Tesla “bulls” could learn a lot from talking to Tesla “bears”, and vice versa.

At the end of the day, you’re in the investing game to make money, not to prove you got everything right the first time…

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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