1/
Get a cup of coffee.
In this thread, I'll walk you through the art and science of valuing a company.
The Goal: We want to figure out how much a company is worth -- so we know what's a good price to pay for its shares.
Get a cup of coffee.
In this thread, I'll walk you through the art and science of valuing a company.
The Goal: We want to figure out how much a company is worth -- so we know what's a good price to pay for its shares.
2/
Warren Buffett often says that ALL intelligent investing is value investing.
What exactly is value investing?
Many people think value investing means buying companies at low P/E (Price To Earnings) ratios, or low P/B (Price To Book) ratios, or high dividend yields.
Warren Buffett often says that ALL intelligent investing is value investing.
What exactly is value investing?
Many people think value investing means buying companies at low P/E (Price To Earnings) ratios, or low P/B (Price To Book) ratios, or high dividend yields.
3/
But that's NOT how Buffett looks at it.
To Buffett, value investing simply means buying a company for LESS than what it's worth.
Or buying *shares* of a company at a *price* that's *lower* than their *value*.
But that's NOT how Buffett looks at it.
To Buffett, value investing simply means buying a company for LESS than what it's worth.
Or buying *shares* of a company at a *price* that's *lower* than their *value*.
4/
But wait a minute.
Isn't a company's *value* exactly equal to what someone will *pay* for its shares?
For example, isn't the *value* of 1 share of Apple exactly equal to $163.17 -- the latest *price* that someone paid for it?
The answer is NO.
But wait a minute.
Isn't a company's *value* exactly equal to what someone will *pay* for its shares?
For example, isn't the *value* of 1 share of Apple exactly equal to $163.17 -- the latest *price* that someone paid for it?
The answer is NO.
5/
*Price* and *value* are 2 different things.
Buffett sums it up this way:
*Price* is what we *pay*. *Value* is what we *get*.
So, the *price* of 1 share of Apple is $163.17.
But its *value*? That depends on what we'll *get* from owning that share -- ie, future *dividends*.
*Price* and *value* are 2 different things.
Buffett sums it up this way:
*Price* is what we *pay*. *Value* is what we *get*.
So, the *price* of 1 share of Apple is $163.17.
But its *value*? That depends on what we'll *get* from owning that share -- ie, future *dividends*.
6/
For example, suppose that share of Apple gives us $4 in dividends next year.
And every year after that, the dividends grow 10%.
So, in Year 1, we get $4.
In Year 2, we get $4 * 1.1 = $4.40.
In Year 3, we get $4 * 1.1^2 = $4.84.
And so on.
For example, suppose that share of Apple gives us $4 in dividends next year.
And every year after that, the dividends grow 10%.
So, in Year 1, we get $4.
In Year 2, we get $4 * 1.1 = $4.40.
In Year 3, we get $4 * 1.1^2 = $4.84.
And so on.
7/
The question now is: are we willing to *pay* $163.17 *today* to *get* this stream of dividends in the *future*?
That's the *price* vs *value* trade-off.
What we *pay* vs what we *get*.
The question now is: are we willing to *pay* $163.17 *today* to *get* this stream of dividends in the *future*?
That's the *price* vs *value* trade-off.
What we *pay* vs what we *get*.
8/
In finance and investing, the standard way to answer this question is through a Discounted Cash Flow (DCF) analysis.
Here's the idea:
Suppose we want a 15%/year return from buying a share of Apple.
Then, we *discount* our future dividends at 15% and add them up.
Like so:
In finance and investing, the standard way to answer this question is through a Discounted Cash Flow (DCF) analysis.
Here's the idea:
Suppose we want a 15%/year return from buying a share of Apple.
Then, we *discount* our future dividends at 15% and add them up.
Like so:
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This tells us that the *value* of 1 Apple share to us is $80.
That is, if we want our 15%/year return, we can't pay more than $80/share for Apple.
But that share is *priced* at $163.17.
So, *price* exceeds *value*.
The trade-off does NOT work for us.
We don't buy Apple.
This tells us that the *value* of 1 Apple share to us is $80.
That is, if we want our 15%/year return, we can't pay more than $80/share for Apple.
But that share is *priced* at $163.17.
So, *price* exceeds *value*.
The trade-off does NOT work for us.
We don't buy Apple.
10/
But suppose we're willing to settle for a 12%/year return from Apple.
That is, we're no longer demanding 15%/year.
Then, we can pay up to $200/share for Apple.
Now, *value* ($200/share) exceeds *price* ($163.17/share).
The trade-off works.
We can buy Apple.
But suppose we're willing to settle for a 12%/year return from Apple.
That is, we're no longer demanding 15%/year.
Then, we can pay up to $200/share for Apple.
Now, *value* ($200/share) exceeds *price* ($163.17/share).
The trade-off works.
We can buy Apple.
11/
What we just did is called a *valuation* of Apple.
We estimated the *future cash flows* (ie, dividends) from an Apple share.
We *discounted* those cash flows using our target rate of return as the discount rate.
What we just did is called a *valuation* of Apple.
We estimated the *future cash flows* (ie, dividends) from an Apple share.
We *discounted* those cash flows using our target rate of return as the discount rate.
12/
This gave us a *value* for Apple -- the maximum price we can *pay* for an Apple share IF we want to *get* our target return.
That's essentially what valuation is:
Figuring out how much a share of a company is worth -- so we can tell whether its market price is reasonable.
This gave us a *value* for Apple -- the maximum price we can *pay* for an Apple share IF we want to *get* our target return.
That's essentially what valuation is:
Figuring out how much a share of a company is worth -- so we can tell whether its market price is reasonable.
13/
Our valuation above was rather simplistic.
We just assumed Apple will grow per share dividends at 10%/year.
How exactly will Apple achieve that? Will it grow revenues? Will it improve margins? Will it become more capital efficient?
We didn't really get into those details.
Our valuation above was rather simplistic.
We just assumed Apple will grow per share dividends at 10%/year.
How exactly will Apple achieve that? Will it grow revenues? Will it improve margins? Will it become more capital efficient?
We didn't really get into those details.
14/
Also, we just assumed a target rate of return and used that to discount our cash flows.
But is this target reasonable?
That would depend on future interest rates, inflation, etc.
We didn't get into those details either.
Also, we just assumed a target rate of return and used that to discount our cash flows.
But is this target reasonable?
That would depend on future interest rates, inflation, etc.
We didn't get into those details either.
15/
So, what if we wanted our valuation to NOT be as simplistic?
What if we wanted to explicitly account for things like Apple's future revenues, margins, future interest rates, etc.?
Well, getting from our simplistic model to one that includes all this is NOT a small step.
So, what if we wanted our valuation to NOT be as simplistic?
What if we wanted to explicitly account for things like Apple's future revenues, margins, future interest rates, etc.?
Well, getting from our simplistic model to one that includes all this is NOT a small step.
16/
We have to think long and hard about Apple's current and future economic characteristics.
We have to understand the *business* -- how much capital it currently uses, what it earns on that capital, how fast it will grow, how much capital that growth will require, etc.
We have to think long and hard about Apple's current and future economic characteristics.
We have to understand the *business* -- how much capital it currently uses, what it earns on that capital, how fast it will grow, how much capital that growth will require, etc.
17/
Once we understand the business, we have to predict the macro environment it will operate in: future interest rates, inflation, etc.
These factors will directly impact future cash flows.
*And* they'll decide how those cash flows should be *discounted*.
Once we understand the business, we have to predict the macro environment it will operate in: future interest rates, inflation, etc.
These factors will directly impact future cash flows.
*And* they'll decide how those cash flows should be *discounted*.
18/
That's why valuation is both *art* and *science*.
Deciding how much detail to include, coming up with a narrative of how the future will look at that level of detail, translating this narrative into numbers -- there's a LOT of *art* there.
That's why valuation is both *art* and *science*.
Deciding how much detail to include, coming up with a narrative of how the future will look at that level of detail, translating this narrative into numbers -- there's a LOT of *art* there.
19/
To become good at the art and science of valuation, we must familiarize ourselves with many key concepts.
Thankfully, we have Professor Aswath Damodaran (@AswathDamodaran) -- who has made it his life's work to teach these concepts to millions of people around the world.
To become good at the art and science of valuation, we must familiarize ourselves with many key concepts.
Thankfully, we have Professor Aswath Damodaran (@AswathDamodaran) -- who has made it his life's work to teach these concepts to millions of people around the world.
20/
Every now and then, Prof. Damodaran values a company and shows us how he did it.
Studying these valuations is a great way to learn the key concepts underneath.
The same key concepts apply to valuing many different kinds of companies.
Every now and then, Prof. Damodaran values a company and shows us how he did it.
Studying these valuations is a great way to learn the key concepts underneath.
The same key concepts apply to valuing many different kinds of companies.
21/
For example, Prof. Damodaran recently valued the 6 FANGAM companies: Facebook, Apple, Netflix, Google, Amazon, and Microsoft.
Of these 6 companies, he concluded that Facebook is the most undervalued (*value* = $322.50, *price* = $219.55 per share).
For example, Prof. Damodaran recently valued the 6 FANGAM companies: Facebook, Apple, Netflix, Google, Amazon, and Microsoft.
Of these 6 companies, he concluded that Facebook is the most undervalued (*value* = $322.50, *price* = $219.55 per share).
https://twitter.com/AswathDamodaran/status/1492639822393061376
22/
So, let's dissect Prof. Damodaran's valuation of Facebook, and see what key concepts we can learn from it.
Here's the spreadsheet that Prof. Damodaran used to value Facebook: stern.nyu.edu/~adamodar/pc/b…
At first glance, it looks complex.
So, let's dissect Prof. Damodaran's valuation of Facebook, and see what key concepts we can learn from it.
Here's the spreadsheet that Prof. Damodaran used to value Facebook: stern.nyu.edu/~adamodar/pc/b…
At first glance, it looks complex.
23/
But once we familiarize ourselves with 5 Key Concepts, this valuation -- and many others! -- become a lot easier to understand.
So, let's dive in!
But once we familiarize ourselves with 5 Key Concepts, this valuation -- and many others! -- become a lot easier to understand.
So, let's dive in!
24/
Key Concept #1: How Businesses Work
Businesses have *capital*.
They earn *profits* using this capital.
They *re-invest* part of these profits back into themselves -- so they can *grow*.
The rest of the profits can be *returned* to owners.
Key Concept #1: How Businesses Work
Businesses have *capital*.
They earn *profits* using this capital.
They *re-invest* part of these profits back into themselves -- so they can *grow*.
The rest of the profits can be *returned* to owners.
25/
Key Concept #2
To understand how much capital a business needs, we may need to go beyond its Balance Sheet.
Modern businesses invest through their *Income Statements* as well (sales and marketing, R&D).
We have to *adjust* Balance Sheet numbers to account for this.
Key Concept #2
To understand how much capital a business needs, we may need to go beyond its Balance Sheet.
Modern businesses invest through their *Income Statements* as well (sales and marketing, R&D).
We have to *adjust* Balance Sheet numbers to account for this.
26/
For example, Facebook spends billions of dollars each year on R&D.
Much of this spend is an *investment* -- to build new products, to add new features to existing products that will result in growing revenues and profits, etc.
For example, Facebook spends billions of dollars each year on R&D.
Much of this spend is an *investment* -- to build new products, to add new features to existing products that will result in growing revenues and profits, etc.
27/
But the accounting rules do not allow Facebook to treat such R&D spend as an *investment*. There's no Balance Sheet asset to be depreciated over the useful life of such R&D efforts.
Instead, the entire R&D spend is treated as an *expense* on the Income Statement.
But the accounting rules do not allow Facebook to treat such R&D spend as an *investment*. There's no Balance Sheet asset to be depreciated over the useful life of such R&D efforts.
Instead, the entire R&D spend is treated as an *expense* on the Income Statement.
28/
This has 2 effects:
(i) *Reported* Operating Income is understated relative to *true* earning power, and
(ii) *Reported* Balance Sheet assets are understated relative to the *true* capital invested into the business.
This can mess up our valuation of Facebook.
This has 2 effects:
(i) *Reported* Operating Income is understated relative to *true* earning power, and
(ii) *Reported* Balance Sheet assets are understated relative to the *true* capital invested into the business.
This can mess up our valuation of Facebook.
29/
So, Prof. Damodaran makes *adjustments* to both the Income Statement and the Balance Sheet, and uses the *adjusted* numbers rather than the *reported* numbers for his valuation.
Like so:
So, Prof. Damodaran makes *adjustments* to both the Income Statement and the Balance Sheet, and uses the *adjusted* numbers rather than the *reported* numbers for his valuation.
Like so:
30/
Key Concept #3
As businesses grow and mature, their size tends to act as an anchor on further growth.
So, sales growth becomes slower. Operating margins and returns on invested capital tend to shrink.
The business tends to gravitate towards its industry's "base rate".
Key Concept #3
As businesses grow and mature, their size tends to act as an anchor on further growth.
So, sales growth becomes slower. Operating margins and returns on invested capital tend to shrink.
The business tends to gravitate towards its industry's "base rate".
31/
This plays a big role in valuation.
For example, suppose a business's sales have been growing at 30%/year for 3 years.
Our valuation shouldn't just extrapolate this for the next 50 years. Realistically, how many businesses in history have grown that fast for 50 years?
This plays a big role in valuation.
For example, suppose a business's sales have been growing at 30%/year for 3 years.
Our valuation shouldn't just extrapolate this for the next 50 years. Realistically, how many businesses in history have grown that fast for 50 years?
32/
To be conservative, we have to assume that growth will slow sooner or later.
Margins and returns may worsen over time, etc.
Here are some of Prof. Damodaran's conservative assumptions for Facebook:
To be conservative, we have to assume that growth will slow sooner or later.
Margins and returns may worsen over time, etc.
Here are some of Prof. Damodaran's conservative assumptions for Facebook:
33/
Key Concept #4
Trees don't grow to the sky. And neither do companies.
DCFs usually handle this by introducing a "terminal" stage -- where growth is slow (or even negative) and return on capital is low.
This ensures that the DCF "converges" and does not go off to infinity.
Key Concept #4
Trees don't grow to the sky. And neither do companies.
DCFs usually handle this by introducing a "terminal" stage -- where growth is slow (or even negative) and return on capital is low.
This ensures that the DCF "converges" and does not go off to infinity.
34/
For example, in Prof. Damodaran's Facebook valuation, this terminal stage starts in Year 11.
By that time, growth has slowed to just 3% per year.
*And* in this terminal stage, Return On Invested Capital takes a permanent hit; it falls from ~27% to ~15%, never to recover.
For example, in Prof. Damodaran's Facebook valuation, this terminal stage starts in Year 11.
By that time, growth has slowed to just 3% per year.
*And* in this terminal stage, Return On Invested Capital takes a permanent hit; it falls from ~27% to ~15%, never to recover.
35/
Key Concept #5: Different Discount Rates For Different Years
During the course of our DCF, interest rates may change. Or our company's "risk premium" may decrease as it matures.
This means our DCF discount rate will change from year to year.
Here's how we handle that:
Key Concept #5: Different Discount Rates For Different Years
During the course of our DCF, interest rates may change. Or our company's "risk premium" may decrease as it matures.
This means our DCF discount rate will change from year to year.
Here's how we handle that:
36/
Finally, here's the overall flow that Prof. Damodaran used to do his Facebook valuation.
As you can see, all 5 Key Concepts above played a role:
Finally, here's the overall flow that Prof. Damodaran used to do his Facebook valuation.
As you can see, all 5 Key Concepts above played a role:
37/
I hope you found this exercise useful.
It's so great that Prof. Damodaran shares his valuations with us.
By dissecting them with a keen eye, we can learn so many fundamental concepts -- that we can then apply to other companies as well.
Thank you, Professor!
I hope you found this exercise useful.
It's so great that Prof. Damodaran shares his valuations with us.
By dissecting them with a keen eye, we can learn so many fundamental concepts -- that we can then apply to other companies as well.
Thank you, Professor!
38/
Prof. Damodaran has also graciously agreed to appear on Money Concepts later today.
When: Today (Sun, Mar 6), at 1pm ET
Where: callin.com/link/xcqSgBJvrr
Don't miss this episode. It's a unique opportunity to learn from the very best!
Prof. Damodaran has also graciously agreed to appear on Money Concepts later today.
When: Today (Sun, Mar 6), at 1pm ET
Where: callin.com/link/xcqSgBJvrr
Don't miss this episode. It's a unique opportunity to learn from the very best!
39/
About Money Concepts
We're a virtual investing club. Our goal is to help each other become better investors.
We meet Sundays at 1pm ET via @getcallin, to discuss all things investing.
Join us. Get the app. Subscribe. Tell your friends.
It's FREE.
callin.com/show/money-con…
About Money Concepts
We're a virtual investing club. Our goal is to help each other become better investors.
We meet Sundays at 1pm ET via @getcallin, to discuss all things investing.
Join us. Get the app. Subscribe. Tell your friends.
It's FREE.
callin.com/show/money-con…
40/
Thank you very much for patiently reading all the way to the end. I appreciate it.
Please stay safe. Enjoy your weekend!
/End
Thank you very much for patiently reading all the way to the end. I appreciate it.
Please stay safe. Enjoy your weekend!
/End
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