The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit (Little Books. Big Profits)

by Aswath Damodaran

A postulate of sound investing is that an investor does not pay more for an asset than it is worth.

I know there are those who argue that value is in the eyes of the beholder, and that any price can be justified if there are other investors who perceive an investment to be worth that amount. That is patently absurd. 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.

The price of a stock cannot be justified by merely using the argument that there will be other investors around who will pay a higher price in the future.

The intrinsic value of an asset is determined by the cash flows you expect that asset to generate over its life and how uncertain you feel about these cash flows.

In relative valuation, assets are valued by looking at how the market prices similar assets.

others believe in picking stocks based on growth and future earnings potential.

For small private businesses thinking about expanding, valuation plays a key role when they approach venture capital and private equity investors for more capital.

The most significant global trend in accounting standards is a shift toward fair value accounting, where assets are valued on balance sheets at their fair values rather than at their original cost.

First, even if your information sources are impeccable, you have to convert raw information into forecasts, and any mistakes that you make at this stage will cause estimation error.

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

Rising interest rates or an economic recession will put a dent in the profitability of all companies.

In the special case where the holding comprises more than 50 percent of the value of another company (subsidiary), the firm has to record all of the subsidiary’s assets and liabilities on its balance sheet (this is called consolidation), with a minority interest item capturing the percentage of the subsidiary that does not belong to it.

Finally, you have what are loosely categorized as intangible assets. While you would normally consider items such as brand names, customer loyalty, and a well-trained work force as intangible assets, the most commonly encountered intangible asset in accounting is goodwill.

The first is 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 revenues.

Consider, for instance, two widely followed variables, inflation and interest rates, and assume that you want to analyze how they move together.

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; and an estimate of what the firm will be worth at the end of the forecast period.

Adding the net capital expenditures to the change in non-cash working capital yields the total reinvestment.

The key difference is that the FCFE is after debt cash flows and the FCFF is before.

In January 2011, the implied equity risk premium in the United States was approximately 5 percent.

Once you have estimated the costs of debt and equity, you estimate the weights for each, based on market values (rather than book value).

Worse still, studies indicate that the relationship between past and future growth for most companies is a very weak one, with growth dropping off significantly as companies grow and revealing significant volatility from period to period.

managers are likely to overestimate their capacity to generate growth and analysts have their own biases.

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

To capture efficiency growth, you want to measure the potential for cost cutting and improved profitability.

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.

The two legitimate ways of estimating terminal value are to estimate a liquidation value for the assets of the firm, assuming that the assets are sold in the terminal year, or to estimate a going concern value, assuming that the firm’s operations continue.

cash flows to equity,

the discount rate will be the cost of equity for the first two

First, no firm can grow forever at a rate higher than the growth rate of the economy in which it operates.

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.

In fact, you can buy stocks that you believe are undervalued and find them become more undervalued over time.

Giving the market more time (say three to five years) to fix its mistakes provides better odds than hoping that it will happen in the next quarter or the next six months.

Thus, earnings per share and net income are earnings to equity, whereas operating income measures earnings to the firm.

There are four basic steps to using multiples wisely and detecting misuse in the hands of others, starting with making sure that they are defined consistently, and then moving on to looking at their distributional characteristics and the variables that determine their values, and concluding with using them in comparisons across firms.

A PE ratio for a company can be computed using earnings from the last fiscal year (current PE), the last four quarters (trailing PE), or the next four quarters (forward), yielding very different estimates.

So is the enterprise value to EBITDA multiple, since the numerator and denominator are both measures of operating assets; the enterprise value measures the market value of the operating assets of a company and the EBITDA is the cash flow generated by the operating assets.

The key lesson from this distribution should be that using the average as a comparison measure can be dangerous with any multiple. It makes far more sense to focus on the median.

Why should this matter when the sample is large? The fact that the firms that are taken out of the sample are the firms losing money implies that the average PE ratio for the group will be biased because of the elimination of these firms. As a general rule, you should be skeptical about any multiple that results in a significant reduction in the number of firms being analyzed.

Why do multiples change over time? Some of the change can be attributed to fundamentals. As interest rates and economic growth shift over time, the pricing of stocks will change to reflect these shifts; lower interest rates, for instance, played a key role in the rise of PE ratios through the 1990s. Some of the change, though, comes from changes in market perception of risk. As investors become more risk averse, which tends to happen during recessions, multiples paid for stocks will decrease.

For instance, 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.

A stock may look cheap relative to comparable companies today, but that assessment can shift dramatically over the next few months.

In the intrinsic valuation chapter, we observed that the value of a firm is a function of three variables—its capacity to generate cash flows, its expected growth in these cash flows, and the uncertainty associated with these cash flows.

Intuitively, firms with higher growth rates, less risk, and greater cash flow generating potential should trade at higher multiples than firms with lower growth, higher risk, and less cash flow potential.

A comparable firm is one with cash flows, growth potential, and risk similar to the firm being valued.

If, in the judgment of the analyst, the difference in PE cannot be explained by fundamentals (low growth or high risk), the firm will be viewed as undervalued.

Thus, technology companies in the United States are treated as growth companies, whereas steel companies are considered mature.

Others categorize companies trading at high PE ratios as growth companies, trusting markets to make the distinction.

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

Use of debt: Growth firms in any business will tend to carry less debt, relative to their value (intrinsic or market), than more stable firms in the same business, simply because they do not have the cash flows from existing assets to support more debt.

a dependence on equity funding,