Damodaran on Valuation: Security Analysis for Investment and Corporate Finance

by Aswath Damodaran

Damondaran on Valuation will not only convince you of the vitality of the many valuation models available to you, it will help ensure that you develop the acumen needed to select the right model for any valuation scenario.

Written by a gifted teacher and respected valuation authority, Damodaran on Valuation offers systematic examination of the three basic approaches to valuation - discounted cash-flow valuation, relative valuation, and contingent claim valuation - and the various models within these broad categories.

Using numerous real-world examples involving both US and International firms, the book illuminates the purpose of each particular model, its advantages and limitatations, the step-by-step process involved in putting the model to work, and the kinds of firms to which it is best applied. Among the tools presented are designed
* Estimate the cost of equity - including the capital asset pricing model and arbitrage pricing model
* Estimate growth rates - with coverage of how to arrive at a weighted average of growth rates by blending three separate approaches
* Value equity - focusing on the Gordon Growth Model and the two-and three-stage dividend discount model
* Measure free cash flow to equity - cash flows that are carefully delineated from the dividends of most firms
* Value firms - including free cash flow to firm models, which are especially suited to highly leveraged firms
* Estimate the value of assets by looking at the pricing of comparable assets - with insight into the use and misuse of price/earning and price/book value ratios, and underutilized price-to-sales ratios
* Measure the value of assets that share option characteristics - including a comparative look at the classic Black-Scholes and simpler binomial models.

Supported by an optional IBM-compatible disk, which consists of spreadsheet programs designed to help users apply the models highlighted in the book, Damodaran on Valuation provides practitioners involved in securities analysis, portfolio management, M&A, and corporate finance with the knowledge they need to value any asset.

Genres: Finance, Business, Economics, Nonfiction, Textbooks, Money, Reference

464 pages, Hardcover

First published October 21, 1994

About the author

Aswath Damodaran is a Professor of Finance at the Stern School of Business at New York University (Kerschner Family Chair in Finance Education). He is well known as the author of several widely used academic and practitioner texts on Valuation, Corporate Finance and Investment Management; as well as a provider of comprehensive data for valuation purposes.

Reviews

[Nasos Chatzilaidis · Rating 4 out of 5]

It is a great introductory book on security analysis (mainly stocks and options of any economy and not US only) and I believe that anyone can perfectly follow it with no prior background on finance. The author explains most of the topics thoroughly, expecting that you don't know them and rarely skips explanations.

If you find that you don't understand something, I believe a google search will, or an investopedia visit will prove sufficient.

The reason I am not giving it 5 stars, is because as of today (12/2/2019) it is really aged. There have been a lot of new models, new ideas and tools that are obviously not introduced. This doesn't lower the quality of the book though. The methods explained in the book are the building blocks to the world of firm valuation (as far as I know).

Bonus point. I love that the author is scholastic and always pin points the strengths and possible weaknesses of everything. He will not introduce a model as if it is the holy grail of all models.

[Liquidlasagna · Rating 3 out of 5]

The more I read about him the angrier i get

He says some of the strangest shit about NVidia and the valuation of Technology stocks, and strange assumptions about its growth, and his track record isn't very good to be quite honest.

More unforgivable is his touchy defense of Fama and the Efficient Markets Hypothesis

and his petty shitkicking of Buffet and Munger for being dinosaurs with some of their views

Damodaran has made comments that it's pretty much par for the course that 20% of all valuations don't get it right. Which isn't a very good track record if you dismiss the 'easy valuations' out there...

I just think the more i read the bigger a black cloud there is over his head, and the less i trust his judgement on plenty of things with economics and stocks.

.........

Here is something on his blog about Buffett and Munger, i think it's sorta petty and snippy

........

Damorian's blog going after Buffet like a loon
Buffett and Munger... Shock value!

Berkshire Hathaway is having its annual meeting and the financial press is falling all over itself reporting what the sage from Omaha has to say about investing. Let me say at the outset that I have expressed my admiration for what Warren Buffet does well - the fact that he has a core philosophy that he does not deviate from and his instinct for going against the grain. Over time, he and Charlie Munger, who has operated at his right hand for decades, also say things for shock value to indicate how separated they are from both academics and other portfolio managers. Here is a listing of quotes and my responses to them.

1 Mr. Buffett: “There is so much that’s false and nutty in modern investing practice and modern investment banking, that if you just reduced the nonsense, that’s a goal you should reasonably hope for.”

I agree entirely. There is much that is done in portfolio management and corporate finance that does not pass the common sense test. Layering complexity on stupid ideas - that leverage always increases value, that securitization can make you a more valuable company - do not make them any less stupid.

2 Mr. Buffett said he was once asked by a student from the University of Chicago, a hub of modern portfolio theory, “What are we learning that’s most wrong?” To which Charlie Munger quipped, “How do you handle that in one session?”

My question to Mr. Buffett would be a simple one: What exactly is your understanding of Modern Portfolio Theory? I would wager that he would come back with Markowtiz portfolios and the CAPM. If you define modern as circa 1964, he would be right. If not, he has a lot of catching up to do.

3 Mr. Buffett on the efficient market hypothesis, the idea that all information is instantly priced into the market: “There’s this holy writ, the efficient market theory. How do you teach your students everything is priced properly? What do you do for the rest of the hour?”

Mr. Buffett probably does not realize this but the efficient market hypothesis is really a warning to those portfolio managers who try to trade on information - earnings announcements and acquisitions, for isntance - and day traders. To be honest, 99% of investors would be saved a lot of money, if they followed the suggestions of efficient market theorists. Let's face reality. If you define an efficient market as one where investors cannot easily take advantage of market imperfections, markets are efficient to most investors on most assets most of the time... One reason that Mr. Buffett continues to generate excess returns is that he is able to strike inside deals with managers... Do you think you or I would have been able to get the deal he got from Goldman?

4 Mr. Buffett on complex calculations used to value purchases: “If you need to use a computer or a calculator to make the calculation, you shouldn’t buy it.”

Spoken like a Luddite... How about an abacus, Mr. Buffett? Maybe a slide rule?

5 Mr. Buffett on the use of higher-order math in finance: “The more symbols they could work into their writing the more they were revered.”

Actually, I do share Mr. Buffett's concern that common sense is sometimes overwhelmed by mathematics. However, the people who are most revered in finance - Harry Markowtiz, Merton Miller and Gene Fama- are surprisingly down to earth in explaining their ideas.

6 Mr. Munger on the same theme: “Some of the worst business decisions I’ve ever seen are those with future projections and discounts back. It seems like the higher mathematics with more false precision should help you but it doesn’t. They teach that in business schools because, well, they’ve got to do something. ”

What would Mr. Munger do instead? Look backwards and discount forward? What part of forecasting does he think is pointless? And does he not agree with the proposition that a dollar today is worth than a dollar in year? If not, he should be sentenced to spend a year in a high inflation economy (say Zimbabwe)...

7 Mr. Buffett adds: “If you stand up in front of a business class and say a bird in the hand is worth two in the bush, you won’t get tenure…. Higher mathematics my be dangerous and lead you down pathways that are better left untrod.”

Depends upon your chances of getting the birds in the bush, right? If you feel that you have a 60% chance of getting the birds in the bush, is it not worth the trade off? No wait. Talking about probabilities probably is higher mathematics and I should not do it... My bad...

8 Mr. Buffett on the persistence of bad ideas in finance: “The famous physicist Max Planck was talking about the resistance of the human mind, even the bright human mind, to new ideas…. And he said science advances one funeral at a time, and I think there’s a lot of truth to that and it’s certainly been true in finance.”

It is true. In any discipline, for every three ideas you come up with, only one will move forward. But the solution to this is not to stop having new ideas but to churn out more...

.........

I'm not terribly impressed.

Damodoran: However, the people who are most revered in finance - Harry Markowtiz, Merton Miller and Gene Fama- are surprisingly down to earth in explaining their ideas.

Markowitz's Doctoral advisor was Milton Friedman
Fama's Doctoral advisor was Merton Miller

........

Here's a quote

"After the stock market crash (in 1987), they rewarded two theoreticians, Harry Markowitz and William Sharpe, who built beautifully Platonic models on a Gaussian base, contributing to what is called Modern Portfolio Theory. Simply, if you remove their Gaussian assumptions and treat prices as scalable, you are left with hot air. The Nobel Committee could have tested the Sharpe and Markowitz models—they work like quack remedies sold on the Internet—but nobody in Stockholm seems to have thought about it."

 Nassim Taleb, The Black Swan: The Impact of the Highly Improbable, page 277

Contrarian investors and value investors typically do not subscribe to Modern Portfolio Theory.

One objection is that the MPT relies on the efficient-market hypothesis and uses fluctuations in share price as a substitute for risk.

John Templeton believed in diversification as a concept, but also felt the theoretical foundations of MPT were questionable, and concluded (as described by a biographer):

"the notion that building portfolios on the basis of unreliable and irrelevant statistical inputs, such as historical volatility, was doomed to failure."

.........

I just think if he's siding more with Fama, and a critic of Buffet and Munger, it should give you some pause, especially with Damodaran's peculiar views on Hardware/Software/Semiconductor Technology Stocks.....

I know there's a lot to question about NVidia with price or growth and sustainability, but i find his arguments sorta shallow and sigh, i think though i've overused the word peculiar, it's the best way to encapsulate his strangeness with his opinions on stocks.

Here are some of the comments I question...

I'm not a fan of the hype with Artificial Intelligence, where the changes will be slow and gradual, yet people will rely on the 'unreliable' with fact-checking and quality writing and well-thought out arguments go out the window with the ChatGPI goofball. I've got more faith in Weizenbaum's ELIZA from the 70s for depth...

Dam: So, where does AI fall on this spectrum from revolutionary to incremental to minimalist change? A year ago, I would have put it in the incremental column, but ChatGPT has changed my perspective. That was not because ChatGPT was at the cutting edge of AI technology, which it is not, but because it made AI relatable to everyone. As I watched my wife, who teaches fifth grade, grapple with students using ChatGPT to do homework assignments. and with my own students asking ChatGPT questions about valuation that they would have asked me directly, the potential for AI to upend life and work is visible, though it is difficult to separate hype from reality.

Dam: On the specific questions of how AI will affect investing, in general, and active investing, in specific, I believe that if it is used as a tool, it can enrich valuation and investing, and I look forward to being able to develop valuation narratives and numbers, with its aid. For those who are active investors, individuals as well as institutions, I believe that AI will make a difficult game (delivering excess returns or alpha from investing) even more so. Any edge you have as an active investor will be more quickly replicated in an AI world, and to the extent that AI tools will be accessible and available to every investor, by itself, AI will not be a sustainable edge for any active investor.

I think what exists for Investing websites is fine, and if people want to embrace the 'new fads' with all the incredibly risks of investing, well let the lemmings fly off the damn cliff to their AI deaths! People use lots of well designed sites for figuring out Financial Strength, Growth, Profitability and Fair Value for stocks for years now....

And I just think Damordian is full of meaningless hot air, like it's a new question that needs that answer. If there's some new software or websites that have 'better results' or 'lousy information' the proof is in using it, rather than blathering about generalities.

Dam: As you look at NVIDIA's growth and success in the last decade, and its recent ascent into the rarefied air of "trillion dollar market cap" companies, there are two impulses that come into play. One is to extrapolate the past and assume that assume that the company will continue to not just succeed in the future, but do so in a way that beats the market's expectations for it. The other is to argue that the outsized success of the past has raised investors expectations so much that it will be difficult for the company to meet them. In my story, I will draw on both impulses, and try to thread the needle on the company.

Sigh, either you find it cheap or you don't....
Either the growth looks good, or there's warning signs showing up... [sometimes when it's almost too late]

Dam: At the risk of stating the obvious, I am making assumptions about market growth and market share that you may or even should take issue with. In the interests of examining how value varies as a function of the assumptions, I fell back on an approach that I find helps me deal with estimation uncertainty, which is a simulation. I built the simulation around the key inputs, including....

Dam: (1) Revenues: In my base case valuation, incorporating high growth in the AI and Auto Chip businesses, and giving NVIDIA a dominant share of the first and a significant share of the second resulted in revenues of $267 billion in 2033. However, this is built on assumptions about the future for both markets that can be wrong, in either direction, and that uncertainty is incorporated into the simulation as distributions for each of the three segments of NVIDIA's revenues: As these distributions play out, there are simulations where NVIDIA's revenues exceed $600 billion and some where it is less than $100 billion, in 2033.

I think you look at growth every 90 days or maybe yearly, but to look a decade ahead with all his 'assumptions' i think is, well, something close to wild speculation.

Dam: (2) Operating Margin: In my base case story, I increase NVIDIA's R&D adjusted margin to 35% next year, and target an operating margin of 40% in 2027, that it maintains in perpetuity after that. While I provide my justifications for those assumptions, it is entirely possible that I am being too optimistic, in raising margins that are already above industry-average levels to even higher values, or that I am being pessimistic, and not factoring in NVIDIA's higher pricing power in the AI and Auto businesses. I capture that uncertainty in my (triangular) distribution for the target operating margin in 2027 (and beyond), where I set the upper end of the range at 50%, which would be a significant premium over NVIDIA's own past margins, and the lower end at 30%, which would put them closer to their peer group.

i might be optimistic, i might even be pessimistic, i might be hedging my bets with more hot air....

Dam: (3) Reinvestment: The input that drives reinvestment is the sales to capital ratio, and while I set NVIDIA's sales to capital ratio at 1.15, the semiconductor industry average, it is possible that the company may continue to reinvest at closer to its historic average of 0.65 (leading to more reinvestment). Alternatively, it is also conceivable that the company's investments over the last decade, especially in its AI chips, will put it on a glide path to reinvesting a lot less in the next decade (a sales to capital ratio closer to 1.94, the 75th percentile of the semiconductor business.

Dam: (4) Risk: Ruling out failure risk, and focusing on the cost of capital, I center my estimates on 12.21%, the industry average that I used in the base case, but allow for the possibility that a growing AI business may reduce the cyclicality of revenues, lowering the cost of capital towards the market-average of 8.85%) or conversely, increase uncertainty and uncertainty, raising the cost of capital towards 15%, the 90th percentile of global companies)

His conclusions?

Dam: With these estimates in place, the simulated value per share is shown below: To the question of whether NVIDIA could be worth $400 a share or more, the answer is yes, but the odds, at least based on my estimates, are low. In fact, the current stock price is pushing towards the 95th percentile of my value distribution.

Dam: An alternative look at what has to happen for NVIDIA's intrinsic value to exceed $400, I looked at the two key variables that determine its value: revenues in year 10 and operating margins: This table reinforces the findings in the simulation, insofar as it shows that there are plausible paths that lead to the current price being a fair value or under value, but these paths require a daunting combination of extraordinary revenue growth and super-normal margins. In my view, a target margin of 50% is pushing the limits of possibility, in the semiconductor business, and if NVIDIA finds a way to deliver value that justifies current pricing, it has to be through explosive revenue growth. Put simply, you need another market or two, with potential similar to the AI market, where NVIDIA can wield a dominant market share to justify its pricing.

Dam: I have written many posts about the divide between investing and trading, arguing that the two are philosophically different.. Thus, even if you believe that NVIDIA's value is well below its price, you may buy NVIDIA on the expectation that the stock will continue to rise, borne upwards by momentum or incremental information. Given the strength of momentum as a market-driver, you may very well generate high returns over the next weeks, months or even years, and you should not let "value scolds" get in the way of your enjoyment of your winnings.

Dam: My only pushback would be against those who argue that momentum can carry a stock forward forever, since it is the gift that both gives and takes away. The strength of momentum in the rise in NVIDIA's stock price will be played out in the the opposite direction, when (not if) momentum shifts, and if you are trading NVIDIA, you should be working on indicators that give you early warning of those shifts, not worrying about value.

Dam: The Bottom Line - As we hear the relentless pitches for AI, and how it will change our live and affect our investments, there are lessons, to draw on, from the other big changes that we have seen over our lifetime. The first is that even if you buy into the argument that AI will change the ways that we work and play, it does not necessarily follow that investing in AI-related companies will yield returns. In other words, you can get the macro story right, but you need to also consider how that story plays out across companies to be able to generate returns.

Dam: The second, is that refusing to make estimates or judgments about how AI will affect the fundamentals (cash flows, growth and risk) in a business, just because you face significant uncertainty, will not make that uncertainty go away. Instead, it will create a vacuum that will be filled by arbitrary AI premiums and make us more exposed to scams and wannabes.

Dam: The third is that, as a society, it is unclear whether adding AI to the mix will make us better or worse off, since every big technological change seems to bring with it unintended consequences.

Dam: To end, I was considering asking ChatGPT to write this post for me, using my own language and history, and I am open to the possibility that it could do a better job than I have.

sigh

way too much blathering about AI, and not enough substance on value or growth, talking about technicals, merely just look at my simulation, or look at my data, and 'make your own conclusions'....

///////

I still have a bone to pick wth Damodaran, he's been critical of value investing, saying that it wasn't working as well in the 2010s, and people questioned when he like did that essay in October 2020.

Stranger was this year when he was valuing NVidia extremely low, thinking it was only worth $150 as a fair value, and well, it should be in the low $400 range.

He seems to have a real disbelief in the potential growth that others see in the numbers and in the technology industry.

Even odder is he thinks 'oh the ONLY way' NVidia can get this 'growth' is that it needs to totally wipe the floor with the AI Industry!

really!?

[James Hull · Rating 3 out of 5]

Great reference!

[Ning-Jia Ong · Rating 5 out of 5]

A practical book on valuation. Needed some immediate advice on the topic and was recommended to look up Damodaran. This was one of the first books that I found from Damodaran and its chapters were very well structured from the more academic and theory side, all the way to very practical views on biases and empirical studies.

[Affad Shaikh · Rating 4 out of 5]

Can't go wrong with this book. Its comprehensive. However, you need someone to help you deploy many of the things covered in a way that is practical - Excel spreadsheet aesthetics being a key to understanding what your doing from the book.

[Yousuf · Rating 5 out of 5]

This book is dense, but its contents are valuable. They provide a comprehensive reservoir of knowledge for anyone who is deeply interested in the mechanics and the theoretical underpinning of the science and art of valuation.

[Vitaliy Karaba · Rating 5 out of 5]

One of the best book to study for valuation and perhaps, the best resource you will come across for learning the basics of this subject.

[Pradeep Kumar · Rating 4 out of 5]

Tough one to read and understand

[Mumtaza Rizky Iswanda · Rating 5 out of 5]

Practical and easy to read

[Melyssa Wolf · Rating 3 out of 5]

Damodaran is the King of valuation. Too bad I’m the lonely peasant sitting among the dense pages of this text.

[Autumn Skitzki · Rating 4 out of 5]

one of the best in the market. but price is high

[Senthil Nathan · Rating 5 out of 5]

This is an excellent book on Security Analysis.It covers the different valuation models DCF , Relative , Option Pricing in depth and application areas of the models

[Trần Tùng · Rating 4 out of 5]

Excellent in valuation method. KIS - a wonderful mix of practical simplicity adding some mathematical seasonings.

[Murali Podile · Rating 5 out of 5]

Must have for everyone involved in portfolio management etc.