How to counter your biggest valuation enemy – with Aswath Damodaran
According to our latest podcast guest Professor Aswath Damodaran of New York University’s Stern School of Business, the biggest challenge to an objective valuation of any business can be staring you in the face
In Beware the ‘multiple personality company’, our most recent guest on The Value Perspective podcast –Professor Aswath Damodaran of New York University’s Stern School of Business – argues that investors should strive to build a consistent picture when they value a company. As he goes on to warn, however, when doing so, they face a major challenge that at times can literally be staring them in the face.
“Your biggest enemy looks at you in the mirror every morning when you get up and brush your teeth,” he explains. “The biggest problems in valuation are not mechanical – they are human.” Alongside the human instincts to introduce unnecessary complexity into proceedings and to refuse to acknowledge the role uncertainty plays in life, personal bias makes up what Damodaran calls “the Bermuda Triangle of valuation”.
“When you sit down to value a company, you bring along your preconceptions and your biases,” he continues. “The stronger those preconceptions and biases, the less point there is to doing valuation – to the extent that, if you asked me to teach valuation to a team of M&A analysts at an investment bank, I would say it was pointless. It’s not that they don’t know how to value companies – there’s just too much bias in their process.
“Why? As an M&A banker, you make money from deals going through, which means you need high values, which means you’re already starting at ‘end up with a high value, otherwise I don’t get paid’. I can teach that team everything there is to teach about how to come up with discount rates, how to bring in country risk, how to incorporate cashflows – it does not matter because they will always find a way to get to that high value.”
Conflict of interest
How then can investors counter this enemy within? First of all, says Damodaran, you avoid creating processes that amplify existing biases. “To continue our M&A example, the biggest problem is the dealmaker is also the deal analyst,” he continues. “You have a conflict of interest right there. To be facetious, asking an M&A banker if a deal make sense is like asking a plastic surgeon if there is something wrong with your face.
“What sort of answer are you going to get? So you need to take the bias out and yet, in equity research, even subtle things you do can create bias. Say you are a portfolio manager and you ask your buy-side analyst to value a company – but then, as a throwaway line, you tell them you already own a million shares in that business. You might not mean to but that is going to create bias.
“The analyst knows what will make you happy so they will come back with a valuation of a great company you should continue to hold. You need to be careful and, if you want to minimise bias, try to give people as clean a slate as possible. They will still bring their own biases but the only way to expose that is for them to be open about them – and for somebody to push back.”
In short, somebody needs to play devil’s advocate. “You need somebody who is not just asking mechanical questions but understands enough about the business that they can push back,” says Damodaran. “So if the analyst is assuming $600bn [£468bn] in revenues for Tesla, it would help to point out Volkswagen, the largest automobile company in the world, generates $300bn in revenues. So where is the extra $300bn coming from?
“And if they suggest ‘software’, you know they haven’t thought things through because Microsoft, the largest software company in the world, ‘only’ makes $130bn in revenues. Put them on the spot and focus on the year 10 numbers. Say – you have created this magical company with $600bn in revenues, 20% margins and a return on capital of 50% by year 10 ... how is that happening?
“That is when you start thinking about where this story is really going. What kind of story would I need to justify it? And if you are a good analyst, you will have thought through these stories. That is why it is good to have meetings where people put out their ideas. Don’t push back on mechanics – that is the wrong fight. Push back on the story and the story’s connection to the numbers. That is how the bias goes away.”
Here on The Value Perspective, in articles such as End of story, we have argued that adding ‘narrative gloss’ to investment scenarios risks clouding an objective analysis of the available facts. That is why, as we wrote in Power your investment case, we work so hard to set out the detailed results of our research on every company clearly, concisely, objectively and in a set template so it has the potential to retain its value for years to come.
Juan Torres Rodriguez
Fund Manager, Equity Value
I joined Schroders in January 2017 as a member of the Global Value Investment team. Prior to joining Schroders I worked for the Global Emerging Markets value and income funds at Pictet Asset Management with responsibility over different sectors, among those Consumer, Telecoms and Utilities. Before joining Pictet I was a member of the Customs Solution Group at HOLT Credit Suisse.
The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.
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