Odd Lots - The World's Foremost Expert Explains How To Value Stock

Episode Date: November 20, 2017

In this age of algorithms and quants, you hear less and less about good old stock picking. You know, like the style of investing associated with Warren Buffet or Benjamin Graham. But that doesn't mean you can't still dive into a balance sheet or cash flow statement in order to divine a stock's true worth. On this week's Odd Lots we speak to Aswath Damodaran, a professor at NYU's Stern School of Business, and the foremost expert on stock valuation. He explains his general approach to valuing stocks, and how he might use that framework on companies like GE, Tesla, and Uber.See omnystudio.com/listener for privacy information.

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Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg Television, radio, and wherever you get your podcasts. Oh, and welcome to another episode of the Odd Lots podcast. I'm Joe Wisenthal. And I'm Tracy Allaway. One of the things that I like about this podcast is that we can ask the really dumb questions that, you know, everyone sort of takes it for granted and we don't talk about them.

But I feel like we can just ask the really simple questions of finance. I thought you were going to say you enjoy spending 30 minutes on the phone with me every week. But, you know, you like asking dumb questions. I always thought that what you said before kind of goes without saying because I hope it comes through. And all of our conversations that this is my favorite half an hour of the week. Because, of course, that's true. But you know what I'm saying? Like last week, we talked to a currency trader.

We're like, how do you pick what currencies to buy or sell? It's just like the really basic stuff. Yeah, it's like a remedial course for people who are in the market, day in and day out. but it kind of gives us a chance to step back from the stuff that we take for granted, I guess, and actually dig into what exactly it is that we're talking about. It's kind of funny because I kind of like to think we're having a sophisticated conversation here, and yet you just described this as a remedial course. Sorry.

Sorry. No, I think that's fair. I think we can do both. Yeah, I think so. Okay, so what basic pillar of markets or finance are we going to learn about today? So today we're going to go to the heart of investing, sort of the simplest, most basic thing that people will think about when they think about what investing is, and that is thinking about what stocks are worth. Oh, now, okay, so I guess this is kind of a simple topic, but it's definitely a really timely one because I'm pretty sure I just saw a headline go by about a record number. of investors who think stocks are overvalued in the U.S. market.

And, of course, the notion of things being overvalued, not just stocks, that's a pretty prominent theme in markets right now. It absolutely is. And, of course, you know, a few weeks ago that we had another episode with a pair of accounting professors talking about new ideas in stock market valuation. But, like, I think when people learn about investing, they think about Warren Buffett, and they think about Benjamin Graham and Dodd. security analysis and reading income statements and just like trying to put a number on the stock

and then looking to stock and saying, well, should it go up or down from here? And that simplicity there is just incredibly important thing. But how do you do it? I don't, you know, I don't think most people really know how to even go about the process. No, I guess we throw around words like PE ratios and forward earnings and things like that. But let's dig into it a little bit more. So who do we have. So we have the best possible guest for this subject. He is considered to be the foremost expert on the subject of valuing stocks. He is Oswath Damodaran, a professor at the Stern School of Business at New York University. He teaches about the topics of corporate finance and equity valuation. He runs a great blog where he discusses how he values certain companies. He's come on

TV on Bloomberg TV several times to discuss it. So Professor Damodaran, thank you very much for joining the Oddlaws podcast. Thank you, Joe. Before I start, though, I'm going to bash a few groups that I always start the bashing with. First, don't ask accountants about value. I mean, I think it's a wrong group to ask because realistically, I think accountants have their job to do in valuation is not one of those jobs. Second, anybody tells you there's something new in valuation is lying. Everything in valuation is old and tested. Now, it's old wine and a new bottle. Third, and I think this is, this will set the table for the entire discussion. Value and price are two different things. You can either value a stock or you can price a stock. Tracy mentioned

price earnings ratios and forward earnings. That's a classic analyst technique. It's for pricing a stock. And here's the contrast. The price of a stock is determined by demand and supply, mood and momentum. So when you use price earnings ratios and comparable firms and future earnings, you're pricing a company. To value a company, you've got to go back to basics. The value of a company is built on three pillars. It's cash flows, it's growth and its risk. We can dance around those three as much as we want, but those are the three driving forces that drive the value of a company. I love that how you just came out swinging at the top of our podcast.

I think that's a very auspicious start. start by bashing two of our previous guests, start by bashing some of the way we talked about this. So now I'm very excited about the conversation. So let's get right into it. When we talk about valuing a stock, how do you begin, you know, what do you tell your students on day one of classes about what they need to understand about this process? I take them back about 70 years. And I talk about people buying stock 70 years ago, bought them for a cash flow. The cash flow is the difference.

dividends. Companies were mature companies. They paid out what they could afford to in dividends. And he essentially said, what I'm paying for a stock is the present value of those dividends. That present value term might sound like a fancy term, but what you're saying is dividends in the future have to be brought back to the present. And to bring them back to the present, you've got to factor in two things. One is, what can I make elsewhere with my money now? What are interest rates at? Where can I invest money? And the other is how much risk is there in that dividend. In a sense, it's good to start with a very simple dividend discount model because it moors your entire analysis. It says, let's not get fancy. Ultimately, you buy stocks for the cash flow.

And if the only cash flow you're going to get as a dividend, what you'll pay for a stock is the present value of those dividends. So think of that as the Ben Graham, the old value investing ideology, which says buy stocks with big and stable dividends. They're worth more than stocks that don't pay dividends. Do you think that purpose is still relevant? Because nowadays, you know, the notion of buying stocks for dividends for a lot of people is going to sound almost quaint. Like a lot of people are buying stocks just to see the appreciation in value in the market and then just sell them onwards at a later date. Three things have changed. One is in the 1930s, 1940s, even into the 1950s, when you look at companies that were listed in the stock market, they tended to be mature

companies. If you're a growth company, you stayed private and you were funded by venture capitalists till very late in the process. The second is companies that had excess cash flows, cash flows that they did not have a use for, paid them out as dividends. There were no stock buybacks. Essentially dividends were the only way of game in town. And the third was investors, in a sense, were buying stocks for the long term. They were buying stocks to hold them for the next 10, 15, 25 years. In fact, many of them had no intention of even selling these stocks. They were holding them for the dividends.

The world has changed. Today, look at the market. You look at the top 10 stocks. Maybe 7, 8 are growth companies, not mature companies. And in fact, many companies are entering the market at stages. They would never even have thought about entering the market even 25 years ago. You take a company like Snap. It's a startup pretty much.

It would be a company that would be invested in, venture capital is for another five or six years before it was ready for the market. So the composition of the market has changed. So if you're trying to value a company like Facebook with dividends, here's the problem we're going to run into. The first is the company, even if it can afford to pay dividends, doesn't pay dividends. It accumulates the cash. Second, when it does decide to return the cash, it returns a cash in the form of stock

buybacks. So increasingly what we've had to move away from is not that we still want, you know, We still want cash flows, but the way we're getting the cash flows now are different. They take the form of buybacks more often than dividends, and you might have to wait to get your cash flows if you're buying a young growth company. So it's not that the focus of what we're doing changes, but the kinds of markets and companies we're trying to value has become very different. So, you know, in the beginning, you said anyone who tells you that there's something new in the world in valuation is lying. But of course, as you've just said, the nature of the companies has changed such that, you know, strict dividend analysis or even strict buyback analysis isn't going to be the right frame because they're

not in that business right now. Is the idea then that you sort of project forward what they could theoretically pay back in dividends or could theoretically do in buybacks or sort of how do you take this sort of Graham and Dodd approach that everybody knows and apply it to a Facebook or a snap. You've nailed down valuation. That's exactly what you do. Instead of taking the actual dividends, you try to estimate potential dividends. Sounds fancy.

But if you run a business, think of the cash that you can take out of the business. It's a cash left over after you've met every conceivable need, which includes what you put in for future growth and you pay taxes. If there's any cash left in the till and you're the business owner, you can take it out of the business. That is your potential dividend. And it's easy to estimate that for a company, because if you look at the statement of cash flows for a company, they tell you what they're putting back into the business. They tell you what they're using to make debt payments. So you can actually take a Facebook and estimate how much they could have paid in dividends

last year. That then becomes your basis. So it's essentially what we're doing is instead of using the actual dividends to value the stock, we're using potential dividends. That's really the innovation of the last 70 years, we can even call it that, because the rest of the process stays the same. You make it sound really easy, but, you know, estimating future cash flow versus cash needs, there are all sorts of things that must go into that forecast, right? So, for instance, do you attempt to assign probabilities to certain scenarios? Do you worry about one-off, you know, sort of tail-risk events?

What are you actually looking at when you do that? The first thing to do in valuation is to adopt what I call the karmic pose. The karmic pose is basically there are lots of things you don't control. So stop worrying about them. You're valuing an oil company. The oil price could change tomorrow. You could have a crisis in the Middle East. Those are things you can worry about them, but there's nothing you can do about them.

What you have to do is take the information you have and make your best estimates. And sometimes that requires using statistics, property, distribution. You're vowing a biotechnology company with a blockbuster drug working its way through the pipeline. You might not like to do it, but you have to assess a probability that that drug will make it through the pipeline. The process is easy, but estimation can be difficult for some companies. You ask me to value SNAP? I'm making judgments based on very little historical data, and that's really the big difference when you have to value growth companies. it's not that the process is different, but you have fewer crutches.

Because when you have a lot of historical data that you can project off, you feel better. Even if that is completely misplaced, you just feel more comfortable. What you have is an absence of comfort, and for people valuing, especially the kinds of companies that are increasingly entering the market, you've got to learn to live with being uncomfortable, with making estimates and being hopelessly wrong and saying, hey, you know what, that wasn't my fault. It really wasn't your fault. If you did not forecast cloud computing coming out of nowhere and essentially becoming a big part of Amazon's business, you can only estimate what you can. And then when you're done, you've got to step back and say, I've done what I can. I valued a company. I could be very wrong, but this is my best estimate of

value. You know, in addition to the fact that you don't have a lot of historical data on these companies, is we live, it feels like we live in an age of novel business model. So I imagine that if you sort of value, you know, if we were in the 1980s and you wanted to value shares of the New York Times, that the business model of the New York Times was not that different from the business model of newspapers, you know, going back for decades before that. But, you know, take a look at Snap today. You know, you could, is this a media company?

Is it a tech company? is it a camera company, is it an apps company? You know, it seems how does that, is it true that you're coming across more business models that don't have good historical analogs? And if so, how does that complicate the task of valuing a company? I'll give you an example of what I think is shift the most in business as I see it. When I look at companies like Facebook and Snap, what I see are what are called user-based models, which is, if you look at what they boast about the most,

is the number of users, the number of subscribers. I mean, take a look at Netflix's last annual report and look at how much they emphasize the number of subscribers going up. We've increasingly shifted from a top-down approach where companies boast about their overall revenues growing to a bottom-up approach where they boast about how many customers, users they have. And it's not just new companies.

If you look at Microsoft and Adobe, The way they used to grow 10 years ago, 20 years ago, is they used to update their software and try to sell them more. Today, look at Microsoft and Adobe. Their crown jewels are actually their subscription-based models, Office 365 for Microsoft and Creative Crowd for Adobe. Adobe, in fact, doesn't even sell its software in regular channels anymore. So increasingly, I've tried to think about what the value of a user is,

value of a subscriber. And you know what? The basics of valuation still work to, more actually I'm going to deliver the keynote speech at the CFA conference where I'm going to value an Uber user. I'm going to value an Amazon Prime member and I'm going to value Netflix subscriber. Because to me, that's become the way I think about the values of the companies is they essentially are trying to pump up their values of users, subscribers, members. And that then multiplies by 100 million in the case of Facebook, 1.7 billion. Got these astronomically high values.

So to me, that's one thing that shifted in the way I think about companies, because rather than start with revenues and work down to cash flows, the way I've always to approach valuation. With these companies, I've increasingly started thinking about those unit-based valuations. And here's the problem I ran into. The information you need to value a user is not being made available to us by the companies that boast about how many users they have. If I were writing information disclosure laws, this is something that. that I think needs to be fixed is as these companies increasingly shift to user-based models, so I'd like to know what the renewal rates are and much more specificity than they reveal it now. I'd like to know what the distribution is of revenues across users.

Do 10% of Uber users account for 90% of its revenues? That's the kind of information that companies have that they're not sharing with us. And if they're going to ask us to invest in them because they have tens of millions of users, it's their obligation, I think, then to provide the information that will allow us to value them better. I'm Francine Lacqua, an award-winning journalist, and I've got a new podcast, leaders with Francine Lacqua from Bloomberg Podcasts. I've interviewed everyone from Heads of State to fashion icons about the news of the moment. But I've always been curious, who are these people as leaders? I don't think there's one right way to be a leader.

Make decisions. A poor decision is always better than not. decision? Listen to new episodes every other Monday. Follow leaders with Francine Lacquois wherever you get your podcasts. I have a potentially slightly weird question, but we're talking about a lot of high growth stocks, which you could also call story stocks, right? Like if you buy in to Tesla or Uber, you buy into this idea that both those companies are going to be revolutionary in various ways for the transport industry. When you attempt to value a company nowadays, do you give any credence to that sort of narrative? Do you buy into some of that hype?

And, you know, some of that hype, it sounds silly, but we do see that reflected, you know, in intangible assets like brand value and things like that. So I'm just curious if you factor any of that in. Every valuation tells a story, right? I mean, any analyst who puts up a spreadsheet and says, this is my value for a company, whether he likes it or not, is actually telling a story about a company.

I'm a firm believer that every good valuation is a story behind it. The question you're asking is a different one. Does that story have to be the story that manages in the company, are pushing for the company? And the answer is absolutely not. If you're an investor, you have to take ownership of your own story, which means you can listen to Elon Musk. You can admire Elon Musk.

You can listen to his story about Tesla. But if you're valuing Tesla, you better have your own story about Tesla. So that's true. Every, there is, these are stories talks, but ultimately every company is a story. The GE story is just a horror story right now. So basically some stories are fun stories, some stories are uplifting stories. Some stories are not. So in a sense, sometimes you have to look at the story, but then you've got to make that story your own and then convert that story into numbers and valuation. In fact, that's my latest book. It's called narrative and numbers about how to both connect stories to numbers and how to detect when a story is not going to hold up.

Because I see a lot of impossible stories being told sometimes by CEOs of companies or implausible stories. And my job is to say, that's not going to work. That violates the laws of economics. And then adapt the story to make it my story and my valuation. I love that. I want to get to like a little speed round where we talk about some of these stories and Tesla and GE and Uber real quickly. But before we do, I have one last question just sort of on a framework. At the very beginning, you talked about the importance of distinguishing between valuation and price and price being a function of supply and demand. So how do you then, as an investor, because ultimately what

people want to do is pick stocks that are going to make them money, how do you sort of, once you establish the valuation, then think about entering the market given various pricing factors? So first you've got to decide whether you want to be an investor or a trader. And this is my distinction. Investors buy stocks for less than the value that they add to the stocks. And then they hope and pray that the price adjust to value. So investing requires faith. Faith in your own valuation and faith that markets will correct that value.

And you know what? Most people don't have faith. And if you don't have faith, you can try to be an investor, but you're not going to hang in there. You're going to give up. So I tell people be realistic. you have no faith in value, even though you might know how to mechanically how to value a company, you're not going to be able to invest. You're going to be a trader. And if you're going to be a trader, might as well be honest about the fact that in trading, the game is to buy at a low price,

sell at a high price. Why the price goes up is none of your business. You really don't even care. It's not an intellectual exercise. It's a money-making exercise. So the first decision you got to make is do you have enough faith to be an investor. If you do have faith, then here's what you need to need to value companies and hopefully the value is higher than the price. And then you have to look for a catalyst, something that will cause the price to move to value because you can be right about value and go bankrupt being right. I mean, you've had the old saying,

the market can be rational longer than you can be liquid. So in a sense, or solvent. So I think you have to, when you look at an undervalued company, a company with a price is less than value, you're looking for some kind of catalyst. That catalysts might be. be a management changed. It might be an activist investor stepping in. It might be a, it might even be,

you know, it might even be something small, a competitor trying to essentially take over the company. But you're trying to look for something that will cause the market to shake up, because there's nothing that shakes up the market. Nothing's going to change. And that effectively is one of the most frustrating things about being an investor, is you can value a company, feel very convinced that you got the right value and see the price go in the opposite direction, not just for days, not just for weeks, but for years. And you've got to be okay with it. You've got to be, if you get frustrated and you get angry about the fact that the market

is not doing the right thing, then you set yourself up to do really stupid things. Okay, okay, speed round. Let's start with, shall we do GE? Because this kind of gets some of the shake-up stuff that you were talking about. So when you see a sharp repricing in a company's market value, what do you think? Well, the first thing I think is the story change. Sometimes the repricing comes about because people were buying into an unrealistic story before, and some things kick them in the face saying that story is not going to happen.

The classic example is you buy a stock with what you think is a high growth rate. You give it a price earnings ratio of 35. Then an earnings report comes out where the revenues are flat. and the company comes up with all kinds of excuses, but it's very clear that revenues are not growing. That's the world kicking you in the face saying, you thought you bought a growth stock, now rethink. So the first thing that happens when you were repricing is either the story could have changed.

The story changes, the new value has to change. So it's not that the market is making a mistake before, is that the value was reflecting a different story. The second is when you have a pure pricing stock, and there are lots of companies there where there are no investors in that market. It's all traders buying and selling from each other. It's based on mood and momentum. And momentum and mood can shift in a moment.

Look at how quickly Bitcoin goes from being, you know, everything's great to everything's awful. That's the nature of pure pricing stocks. And there are some stocks out there that there are pure pricing stocks. As a value investor is an investor who cares about value. I avoid those stocks like the play because things happen on those stocks and there's really no good reason why it happens. is the mood shifted. So sometimes we try to attach really strong economic reasons to things for which there are no good reasons. And sometimes it's better to look and say, thank God I wasn't in that stock when that happened. So Tracy asked about GE. So what is your 30 second take on what, on the story there?

Oh, GE has a problem. It's an old, I mean, I have this one of my favorite devices in my classes is to call, is to talk about what's called the corporate life cycle. The corporate life cycle, you have startups that became teenage companies, think over than growth companies, the peak of your life, and you become mature companies, and then you go into decline. GE has been a company in decline now for 15 years. The problem for GE is it's an old company with lots of old businesses. There is no good story you can tell that will allow GE to come out of this as a growth company. The best they can hope for is that they don't become decrepit. So in a sense, I would not envy the top management of GE right now.

They're trying to get rid of old businesses which others are not going to pay a high price for. They're trying to kind of set up investors to accept the fact that this is the way it's going to be, that things are not going to change. So they're doing the right thing in a sense by being open about it, but that doesn't mean it's going to be any less painful. Now, growing old is hard to do. and watching GE, you realize how difficult it is for a company that was an American institution to accept that, you know what, the best days are way behind them. And now it's a question of winding down. I mean, I only half-jokingly say that, you know, the right CEO for a company depends on

where it is in the life cycle. If you're a startup, it's got to be Steve the visionary who's running you. But if you're a declining company, you need Larry the liquidator. So maybe Danny DeVito might want to come and play one last role here, G. Very bleak. All right. Real quickly, Tesla, one of the most controversial stocks in the world right now. How do you think about that one?

You know what I said? Remember, I said that every company is driven by the story that you see in the company. The problem with Tesla is Elon Musk. The advantage in Tesla is Elon Musk. This guy, I mean, when companies wish for a visionary CEO, they have visual. of Elon Musk because this guy is not just visionary, he's over visionary. And what I mean by that is every day he wakes up with a bigger vision. And sometimes you've got to stop and say, you know, slow down. I think my real concern with GE is not that they're not, I think they're an

incredible company. And if you've talked to anybody with a Tesla, you know that they love their cars. This is a company that is super loyal customers. My problem with Tesla is that they have a supply chain problem. They have a problem of execution. They've always had an execution problem. You can go back and look at every quarter's earnings announcements at Tesla and it's almost like reading the same script over and over again. Promise to deliver 40,000 cards, deliver 32,000. Promise to deliver 60,000, delivered 45,000. But as long as they were a small company with lots of potential, people overlooked that execution problem. I think we're approaching a serious moment for Tesla now because the middle of, I think with June of 2018, they promised to deliver about half a million Tesla 3s.

This is a big moment and they need to get their execution done. And my concern is that this is a prom from the top down. It's not an execution problem that's just to the factory floor. it comes from the fact that Elon Musk is not that interested in supply chains and inventory and assembly lines. He's much more interested in making a big vision and telling a story. What he needs is what Steve Jobs had in his second round as a visionary CEO. The first round, he almost destroyed Apple. In his second round, he had Tim Cook at his side.

What Elon Musk needs is his own Tim Cook, a chief operating officer who makes the trains run on time. who gets the supply chain going. Because I think of Tesla, I can get its execution problems behind it. I think I don't have a problem with the value that's attached to the company. But with those execution prompts, I wouldn't pay the price

that they're paying for Tesla right now. Okay, this is the important one. The entire stock market, is it overvalued? Given where risk-free rates are right now, no, I don't think it's overvalued, but your one leg of that table falling off before the whole thing collapses. So earnings growth has to stay high.

The tax reform package has to pass, and interest rates have to stay low. And if you can keep that trifecta going, then I don't see this market as being overvalued. Oswath Delmadarin, fascinating conversation. I absolutely loved it. Really appreciate you coming on. We could talk forever, but that was great. Thanks for joining the Outlodge podcast. Thank you.

So Tracy, I really enjoyed that one. I think I've mentioned on a few episodes in the past, you know, that when I first got into finance, that it was actually kind of this stuff, looking at stocks, buy-side research on equities. And it's kind of nice just that someone makes the case that, you know what, yeah, the economy is changing. Yeah, there's all this stuff. But the old ideas basically still apply. You just have to think about how to correctly use them. Yeah, it is nice to see that bit of continuity. But I have to say, I kind of, I wish we could have done the speed round for another 60 minutes or something, because I just want to throw out all these companies.

You know, not just Tesla, but he could have done Bitcoin, Uber, Amazon. I would love to know his opinion on something like Saudi Aramco, which is kind of an old company, but it's new in the sense that it's coming to the market for the first time, and we don't have a lot of historical data about it. I just, I love to see his ideas actually translated to real-life examples. Tracy, you should have them on your show on Bloomberg TV for Saudi Aramco Block. Oh, we totally should. I'm glad you thought of that because I would very much like to see that segment.

Yeah, that'd be fun. In the meantime, I recommend if you're curious about Oswath stuff, you should check out his blog, azwathdamadaran.blogspot.com. Just a great resource where he really dives deep into this stuff and really shows his work on all these. companies that you mentioned, Amazon, Tesla, Uber, all this stuff. Bitcoin. His latest post is even about Bitcoin. So great stuff there.

All right. So we leave it there? Let's leave it there. This has been another edition of the Athotts podcast. I'm Tracy Allaway. You can follow me on Twitter at Tracy Allo. And I'm Joe Wisenthall. You can follow me on Twitter at the stalwart. And you can follow Oswath on Twitter at Oswath Damadarin. And you should definitely check out his blog musings on markets. And don't forget to follow our producer, Sarah Patterson, at Sarah Pat with two T's. Thanks for listening. You can get the news whenever you want it with Bloomberg News Now.

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