Valuers must beware the ‘multiple-personality company’ – with Aswath Damodaran
Investors can never hope to arrive at a perfect valuation of a business, warns our latest podcast guest Professor Aswath Damodaran, but they should strive to achieve a consistent one
“Valuing companies is a craft,” says Professor Aswath Damodaran when he joins us on the latest episode of The Value Perspective podcast. “It’s like cooking – you have to keep working at it. When you start cooking, you might only be able to cook eggs but from there you can expand your arsenal. But if you say, look, I’m really good at cooking eggs so that’s all I’m going to do, then eggs is all you will ever be really good at.
“You have to accept you are never going to master valuation completely – you just keep working at your craft. That is what I do. I enjoy valuation. I am not an expert. I am not a researcher. I don’t write for academic journals. I basically do valuation because I am interested in it I and I keep learning new things every time I value a company.”
Here on The Value Perspective, we suspect the professor is being a little modest. If he is not an expert in valuing companies, he is the next best thing, having taught corporate finance and valuation at New York University’s Stern School of Business since 1986 and written a dozen or so books on his specialist subjects, including our personal favourite Narrative and Numbers (2017).
How then does he suggest investors give themselves the best chance of maintaining their discipline when valuing a business and limit – or, better still, prevent – the temptation to take shortcuts? “The first thing to understand is that you can never check a valuation for correctness.” Damodaran begins. “Why? Because we do not know what the future will bring.
“The future is going to bring its own surprises and valuations are going to be wrong 100% of the time. So it would be hubris on my part to look at your valuation and tell you it is wrong. But what I can do is look at your valuation and check for what I call ‘internal consistency’. In other words, I can tell you whether you are at war with yourself – not with me, but with yourself.”
Damodaran offers the example of a valuation of a business that is built on a high growth rate and high and increasing margins. “Clearly, with that valuation, you like the company and you like its market,” he says. “Usually, though, when a company wants to grow its revenues, it has got to sell more – but in this case, you not only have it selling more, you have it raising prices at the same time.
“So I am going to push back and ask you, what kind of competition does this company face? Is it the sole player in a market where it enjoys complete pricing power? And if you have not even thought about the answer to that question, I will doubt I can buy into the story because it is a story where you haven’t checked the competition. Is this a market where companies have pricing power?
“Still, say I get beyond your growth and margins – because you tell me a convincing story – then next I look at what you’re setting aside to create the growth. Growth is not magical – it does not happen on its own. So, in your valuation, you might have line item after line item – capital expenditure, depreciation, working capital, acquisition and so on – but the net effect is it is taking away from earnings and reducing your cashflows.
A different story
“So I might look at the company’s collective reinvestment and say, you told me a story about high growth but the reinvestment tells a different story. Tell me again what this company has done – and maybe have a convincing story. But if you don’t have an answer, I will suggest maybe you need to think about how your story is a growth story but your reinvestment numbers reflect a very different company.
“If you have a ‘multiple-personality company’ wandering through your valuation – in other words, one that is a growth company in its revenues, a company with no competition in its margins and a company that behaves like a mature business when it comes to reinvestment – then you have to make up your mind which of these three personalities you want to latch onto. Make a valuation that is consistent.”
This way, argues Damodaran, checking for consistency comes down to a relatively simple spreadsheet. “I will not impose one on you but, whatever spreadsheet you use, consider these questions in just one page. What am I assuming about growth? What am I assuming about margins? What am I assuming about reinvestment? Then it will just jump out to you if those numbers don’t go together and you need to revisit them.”
Here on The Value Perspective, we are certainly aware of the importance of maintaining as consistent an approach as possible across every aspect of investment. That is why we have worked so hard to embed investment ‘edges’ – in essence, the difference between skill and luck – within the informational, analytical, behavioural and organisational elements of our own process.
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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