We Study Billionaires - The Investor’s Podcast Network - TIP515: The Little Book of Valuation by Aswath Damodaran

Starting point is 00:00:00 You're listening to TIP. Hey everyone, welcome to the investors' podcast. I'm your host, Clay Fink, and on today's episode, I'm going to be giving an overview of Azwath Demodran's great book called The Little Book Evaluation. During this episode, I will cover Azwath's two primary methods to valuing a company, some general truths about valuation that investors should understand, the foremost basic inputs to valuing a company, how we can go about setting an appropriate growth rate in our valuations, the differences between

Starting point is 00:00:33 valuing a growth company and valuing a more mature company, as well as the adjustments that we need to make when valuing a company with a lot of intangible assets like many technology companies today. At the end of the episode, I'll be touching on William Sonoma and why I have started a position in this company. So be sure to stick around until the end to hear that pitch. If you're a stock investor, learning how to value a company is a critical skill in achieving good returns. I found a ton of value reading through Azwath's book, no pun intended, as he is often referred to as the dean of valuation, and he has written so much about how to properly value a company. William Green actually had Azwath on his podcast back on episode RWH005 on the

Starting point is 00:01:20 podcast feed you're on back in April of 2022. If you tune into that episode, you know that Azwath is a very intelligent and gifted teacher, as he has taught finance at NYU since the 1980s. Additionally, Azwath made all of his courses free online. I can assure you that there is probably no one better to learn from when it comes to learning how to properly value a company. With that, I hope you enjoy today's episode covering Azwath Demodaran's book, The Little Book of Valuation.

Starting point is 00:01:56 You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. All right, diving right into the book. Michael Mobison wrote the forward to Aswas book. He was the chief investment strategist at Leg Mason Capital Management and adjunct professor at Columbia Business School. In the forward, he mentions that stock exchanges provide a service that seems pretty miraculous. One can go to the exchange and put down money today for a claim on a stream of future cash flows of a company. In other words, you can defer consumption now in order to consume more in the future. Alternatively, you can go to the market and sell your claim on future free cash flows for a certain sum today.

Starting point is 00:02:55 valuation is the mechanism behind this incredible ability to trade cash for claims. And if you want to invest thoughtfully, you must learn how to value these cash flows. He then goes on to say that Azwath is the best teacher of valuation he has ever encountered, and that if you're looking to learn about valuation from the master, then you've come to the right place. And when I was recently looking through Azwas analysis on meta or Facebook during my episode a few weeks back on TIP 508. I was going through his site and seeing all the books he's written, the articles he's done, and it becomes clear fairly quickly that this guy has an immense passion and just a gift for teaching. Aswas book addresses the challenges of valuing companies that are completely different

Starting point is 00:03:43 from each other, whether that be different points in their life cycle, whether it be a commodity company or a company that's just pouring capital into R&D with little to show for it. The book is relatively short, only around 170 pages, and it has 11 chapters. In the intro, Aswath rightly points out that most investors see valuing an asset as a daunting task that is just too complex and complicated for their skill sets. So they either leave it to the professionals or just ignore it entirely. He believes that valuation is in fact simple, and anyone who is willing to spend the time collecting and analyzing the information can do it. He says that sound investing is when the investor does not pay more for an asset than what it is worth. And he acknowledges that there are some

Starting point is 00:04:29 who believe 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. When it comes to financial assets, he believes this idea is absurd because people purchase financial assets for the cash flows they expect to receive and he isn't referring to assets that don't produce cash flows such as a painting or a sculpture. This means that purchasing a company based on the argument that other investors will be willing to pay a higher price in the future is not a sound investment strategy. He says that this is the equivalent of playing an expensive game of musical chairs. And the question becomes, where will you be when the music stops? Aswath points out that there are dozens of valuation models,

Starting point is 00:05:14 but only two valuation approaches, intrinsic valuation and relative valuation. Intrinsic valuation is based on the cash flows you expect an asset to generate over its life and how certain you feel about those cash flows. High and stable cash flows should have more value than low and volatile cash flows. While the focus should be put on the intrinsic value, most assets are valued actually on a relative basis. For relative valuation, an asset's value is determined by looking at the market prices of similar assets.

Starting point is 00:05:48 Like when you determine the fair value of a home, you look at similar homes that have recently sold in the neighborhood. Or to help determine a reasonable multiple for Coca-Cola, you might look at the valuation of Pepsi. Both methods can be used as tools, and there's no reason to just rely on one of these methods, whether it be the intrinsic value method or the relative value method. Before diving into the specifics of how to calculate these values, Aswath presents some general truths about valuation that we should really be mindful of.

Starting point is 00:06:18 The first is that all valuations are biased. It's very rare for someone to value a company based on a blank slate. We all have our own views or opinions on a company before we start valuing it, whether that be our own personal experience with that company, a newspaper headline we've read, or maybe we are just biased because we heard some other person's view on the company. Institutional analysts tend to issue more buy than sell recommendations because they need to maintain good relations with the companies they follow, and also because of the pressures that they face from their own employers.

Starting point is 00:06:54 If you are biased towards a company having a positive future, then it's likely that you will use optimistic and higher growth rates and probably see less risk when comparing to other companies you aren't as biased towards. It's super important to be aware and honest with ourselves about these biases and consider why you're valuing the company you are. what you like about it, what you dislike about the company, the company's management, and whether you own shares in the company you're valuing, because if you own shares, then you're probably biased towards being overly optimistic rather than overly pessimistic.

Starting point is 00:07:29 The second general truth he mentions is that most valuations are wrong. In school, we're taught that if we follow a systematic approach, then we will come up with the correct answer. And if the answer is imprecise, then we must have done something wrong. The reality is that you can value a company using the very best data and very best information, but valuations require forecasting. Oftentimes, we can be certain about a company's future over the coming years, but the reality is that we will run into occurrences where the future plays out much different than we expect.

Starting point is 00:08:02 Azwath uses the example of Cisco in 2001, and he severely underestimated how difficult it would be for them to continue their acquisition-driven growth. This led him to overvaluing Cisco at the time in 2001. You should expect to be wrong in your valuations from time to time, and success in investing comes from being wrong less often than everyone else. The third general truth is that the simpler can be better. These large institutions that buy and sell stocks oftentimes use very complicated models. The tradeoff here is that more detail in your valuation gives you the chance to potentially make a lot of money. better forecasts, but it also creates the need for more inputs, thus more potential for

Starting point is 00:08:47 more mistakes in your judgment. Aswas general rule is that you should use the simplest model you can with the most relevant variables to the company's value. Moving along, in order to understand how to value an asset, you need to understand the time value of money. A dollar today is worth more than a dollar sometime in the future for three reasons. First, people prefer to consume today rather than consuming at some point in the future. Two, inflation decreases the purchasing power of cash over time, so in other words, a dollar

Starting point is 00:09:21 in the future will buy less than a dollar would today. And three, a promised cash flow in the future may not be delivered, so there is risk in waiting. So if we expect to receive $1 in the future, we have to discount that dollar back to today while taking all three of these items into consideration. So first is people would prefer to consume today rather than in the future. Second is inflation, and the third is the risk of actually being paid that dollar. We want to be compensated for delaying consumption.

Starting point is 00:09:53 We want to not lose purchasing power due to inflation. And we want to be compensated for the risks taken because there is a chance we may not receive the cash lows we would expect to receive. This is where the discount rate comes into play in our valuation, which is the interest rate in which the future free cash flows are discounted to today. So essentially, the discount rate is used to take cash flows we expect to receive in the future and convert those cash flows into today's dollars. So with the discount of, say, 10%, $100 one year from now is worth roughly $91 today. $100, 10 years from now is worth roughly $38 today using that 10% discount rate.

Starting point is 00:10:34 So the further out into the future we expect the cash flows, the lower the present value of those cash flows. This is why growth companies are much more sensitive to increases in interest rates relative to value companies at least. It's because a lot of those cash flows for a value stock are in the near term, while a lot of the cash flows for a growth stock are further out into the future. Aswath also touches on some of the basics of accounting, one of which I wanted to highlight is two important accounting principles that underlie the measurement of accounting earnings

Starting point is 00:11:06 and profitability. The first being accrual accounting, where the revenue and expenses from selling a product or service are recognized based on when the sale took place to help match the actual expenses that are associated with the sale of that products or service. The second principle is how expenses like operating, financing, and capital expenses are categorized for a company. Operating expenses, in theory, are not a company. Operating expenses, in theory, are not a company. intended to only provide benefits during the current period, whether that be from raw materials that were purchased or the labor costs. Financing expenses are incurred from capital raised through non-equity financing. The most common example here is your interest expenses.

Starting point is 00:11:47 Then the capital expenses are the company's longer-term investments such as a building or a manufacturing plant. The company receives benefits from a capital expense over many accounting periods, and not just one period like we see in the operating expenses section. Now that accountants can put expenses into three different categories, they can calculate the operating income by subtracting the operating expenses and depreciation from the revenue. Then the net income is the operating income minus interest and taxes. Finally, we can use these items like operating income, net income, and return on invested capital to compare one business to another. Accounting is really important to understand because in order to determine an appropriate measure of a company's future-free cash

Starting point is 00:12:34 flows, we'll want to start with the cash flows the company is producing today, which is what we get from the financial statements. Aswa states that the four most basic inputs we need to calculate the intrinsic value of a company is the cash flow from existing assets, the expected growth rate of those cash flows, the cost of financing the assets, and an estimate for what the company will be worth at the end of our forecasting period. Now, to calculate the free cash flow, we need to take the net income and make the necessary adjustments to turn that net income amount into a free cash flow that could be paid out to the shareholders. Luckily, nowadays, free cash flow is calculated for us so we don't have to sift through the numbers and calculate it ourselves.

Starting point is 00:13:18 But for those interested in learning how it's calculated, free cash flow is the net income, plus depreciation since depreciation is not a cash expense, it's more so just an accounting expense, then you can subtract capital expenditures, add the change in non-cash working capital, subtract the principal repaid on the debt, and add new debt issued. To measure how the firm is investing in longer-term assets, you can compare the capital expenditures to the depreciation in amortization expenses. If CapEx is well above depreciation and amortization, then that tells me that the company is continuing to make long-term investments to help fuel that future growth. He also points out that Warren Buffett's calculation of owner's earnings does not factor in the net

Starting point is 00:14:04 cash flow from debt. So if the net cash flow from debt was, say, $1 billion, and ASWASC calculation of free cash flow to equity holders was $4 billion, then Warren Buffett's owner's earnings figure would be $3 billion since he doesn't want to include the issuing of new debt as a figure for earnings. After determining the free cash flow for the business, we'll want to determine what sort of discount rate we want to use. Businesses that are riskier should warrant a higher discount rate, all else equal. Let's take a quick break and hear from today's sponsors. All right, I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every

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Starting point is 00:18:53 Second is the equity risk premium, which is the premium investors put on owning stocks since they are riskier than owning bonds. Between 1928 through 2010, stocks generated a 4.3% higher return than bonds. And then you have the relative risk or the beta. The relative risks should be taken into consideration because the more risky a company is, the more uncertain we are of the company's future-free cash flows. The future-free cash flows for a company like Coca-Cola are much easier to predict than a company like Tesla.

Starting point is 00:19:25 In the book, he calculates the cost of capital by taking a weighted average of the cost of of equity and the cost of debt. He uses an example of a company called 3M in the book. The majority of the cost of capital is weighted towards the cost of equity. I personally try not to get too technical or too cute with the discount rate, and I typically just use a discount rate of 10% in my own intrinsic value calculations. Next, we need to determine the expected growth rate of the company. It's common to look back at history to predict where this company is trending and where those free cash flows are trending into the future. However, he mentions the relationship between the past and future growth rates is fairly

Starting point is 00:20:07 weak for a lot of companies. It reminds me of Charlie Munger saying that less than 2% of companies in the S&B 500 will be better businesses in five years, which really shows just how difficult it is to predict which companies will continue to grow and be in a better competitive position in five years or so. To better understand potential future growth rates, you could also look into expectations set by Wall Street, as well as expectations set by management of the firm. There's a good chance that these types of sources have access to other information, but we should also be mindful that they may have an incentive to overestimate or maybe be too optimistic in their projections for future growth.

Starting point is 00:20:49 In order for a firm to grow, it will need to manage its existing investments better or successfully make new investments. The higher the rate of reinvestment back into the company and the higher the return on equity, the more we can expect a company to continue to grow into the future. The fourth key piece of the valuation process is the value of the business at the end of the forecasting period, which is also called the terminal value. Having some sort of end date can help make our intrinsic value calculations much more accurate because although a business can in theory produce cash flows into perpetuity, it's much

Starting point is 00:21:28 easier to estimate the cash flows for the next, say, five or 10 years than it is for the next 50 years. There are two ways of going about estimating the terminal value. The first would be to estimate the liquidation value if the firm were to sell all of their assets, pay off their debts, and send the remainder of the money back to shareholders. The second method would be to come up with an estimate of what you believe the firm would be worth if the operations were to continue. A simple example of this would be to take a relatively stable company like Apple, project out their future free cash flows for, say, 10 years,

Starting point is 00:22:03 and put a conservative multiple on the business at year 10. I would say a multiple of 15 is pretty conservative in this case for a company like Apple for its terminal value, assuming that you believe that they will maintain their competitive position over that time frame. Then you can discount that terminal value back to today rather than trying to estimate the cash flows from that point forward. After you've calculated the present value of the future free cash flows of the business, as well as that terminal value, there are a number of adjustments you might want to consider as well. The first would be adding back the cash and cash equivalence because the cash, of course, has a real value. The second adjustment,

Starting point is 00:22:43 would be for minority interests or non-controlling interests, which is an ownership interest of less than 50% of a company. Since minority interests aren't part of the company's core operations, the minority interest, revenue, and expenses do not flow through the company's income statement. So adjustments need to be made to account for this. For example, if Berkshire Hathaway owned 100% ownership in a business, then this company's operations would flow through Berkshire's income statement. But if Berkshire only owned 10% of a private business, then it wouldn't flow through Berkshire's income statement if it is privately owned and not a publicly traded company. The third adjustment is to consider the company's potential liabilities such as any debt or any underfunded pension or healthcare plan. In the fourth and final adjustment to consider

Starting point is 00:23:34 is to subtract the value of management options. Aswa says that the right approach to handle this is to reduce the value of the equity by the value of the options since those options are owned by the management. Sometimes when you calculate the intrinsic value of a company, your estimation will be far different than the market value of the company. Common mistakes people make is to make unrealistic assumptions about a company's future growth potential or the riskiness of a company. A second mistake is to misassess the overall risk premium attached to the stock market. If your estimations of these are truly correct, then you may have found a company that is severely undervalued or overvalued. Chapter 4 of Aswas' book covers relative valuation. Relative valuation

Starting point is 00:24:22 is essentially just looking at the market prices of similar companies and comparing it to the company you're analyzing. So to get an idea of the valuation of, say, GM, you want to consider the valuation of Ford. When considering the relative valuation, you'll also want to adjust the values to normalize your comparison between the two. For example, if company A is growing at 20% per year and company B is growing at 10% per year, then you'll want to factor that end to your relative valuations. When performing a relative valuation, oftentimes multiples are used, and multiples are easy to misinterpret when comparing two companies.

Starting point is 00:24:59 Price to earnings and enterprise value to EBITA are common metrics when performing relative evaluations. I'd be careful with using price to sales and price to EBITA, as any company with a high debt burden can actually appear to be cheap. At the time of this recording, the PE ratio of the S&P 500 is around 20. This can give us a reference point to how any company compares to the overall U.S. market. In looking at the overall market, there are so many factors that determine the PE ratio. There's market sentiment, interest rates, economic growth, and inflation. These all play a major role. Because all these factors change so much from year to year, the PE ratio of the market overall can shift really quickly. For example, Azwath shows in his book that the median

Starting point is 00:25:47 PE in 2000 was 24, and that number dropped to just under 15 one year later. In 2005, the median PE was 23, and in 2009, it dropped below 10. I think it's also important to mention that there is a huge difference between the average PE of the market and the median. The average can be highly skewed by a number of companies that have little to no earnings, whereas the median is historically much lower because it's looking at your typical company and is not skewed by the outliers near as much. For example, in 2005, when the median PE was 23, the average PE of the market was 48. When performing relative valuations, the key to finding an undervalued company is to find a valuation mismatch, such as a company with a relatively low PE and a higher growth rate in its earnings per share.

Starting point is 00:26:43 Every single company's value is based fundamentally on its cash flows, the growth potential of those cash flows, and the risk associated with the business. So if company A has a PE of 5 and company B has a P.E. of 10 that doesn't necessarily make company A cheap and it doesn't necessarily make company B expensive. It all really depends on your assessment of the intrinsic value of the company and how that compares to the market price. However, using relative valuation can be helpful in determining whether a stock is under or overvalued to help increase your conviction in the company and further understand, you know, its true value. In Chapter 5, Aswath covers the challenge of valuing a young growth company. Valuing these types of companies can be extremely difficult

Starting point is 00:27:33 because there is practically no historical data to rely on. They have little to know revenues, negative earnings, and most young companies end up failing. Because there is little historical information to rely on, if the founders want to pitch their company to investors, then they need to have a convincing story of how the company will be successful at some point in the future. There's no easy solution to valuing young growth companies, but to try and get a good idea, you still have to try and estimate the future-free cash flows. To do so, you can look at the market potential of the company and consider its total addressable market oftentimes called TAM. From there, you can guesstimate what percent of the market share the company will

Starting point is 00:28:15 capture and by what year. Then you will also want to determine. what sort of margins the company will have once it's profitable. Then when you project out the future free cash flows, the reinvestment back into the company will also need to be considered, which further complicates determining the intrinsic value. I think the most important piece when valuing a young company is to really consider the level of risk with such a purchase. It's really easy to get excited about a company's potential and overlook the actual risk that is associated since most of these companies end up failing and not being a good investment at all. Warren Buffett's first rule of investing is to not lose money.

Starting point is 00:28:56 And that's why you see most value investors simply stay away from these young growth companies. But from Aswath's perspective, every single company has some sort of value to it. And if you take into consideration all of the risks and properly estimate a reasonable intrinsic value, then it may be the case that he purchases a young growth company if the price, is appealing enough. When valuing growth companies, one should also consider the potential for optionality. For example, Apple's iPod helps lay the foundation for the iPhone and the iPad, so sometimes it pays to put weight on the management team and their ability to execute on their vision, as sometimes you don't really know what products might come in the future. Aswath concludes

Starting point is 00:29:40 this section by stating that you want to invest in young companies with tough to imitate products that have a huge total addressable market, and the company's disciplined about keeping their costs under control, and they have access to capital to help fuel their growth. It's not easy to do, but when it's done right, it is a high-risk, high-return proposition. Once a company has some operating history and has gotten off the ground, eventually it reaches the status of a growth company rather than a young startup. Growth companies tend to be those that have high revenue in earnings growth, as well as a market valuation that is typically much higher than the book value of the company.

Starting point is 00:30:20 The tricky part of valuing a growth company is determining how long the growth can persist because eventually the growth has to slow down as the company matures and is operating from a higher base, and the growth tends to attract a lot of competition as well. Azwatth uses the example of Under Armour in his book, which by the way was written all the way back in 2011. And he uses Under Armour as an example of how he would project forward the future free cash flows for this company. He starts with their revenues projecting out a higher revenue growth rate in year 1 at 35%. And then that tapers down to 10% growth in year 5 and 3% growth in year 10. So higher growth rates in the first five years and lower growth rates in the

Starting point is 00:31:04 remainder of his projection. Then he also includes the company's operating margins and operating income, after-tax operating income, the required reinvestment each year, and finally, the free cash flow each year as well. The first few years have negative free cash flows in his example for Under Armour, then it turns positive and increases each year beyond that as the company scales up and less reinvestment is needed each year. As with any company, great growth companies can be bad investments if you pay the wrong price. Most growth companies will eventually disappoint investors at some point, delivering earnings that don't match up to the lofty expectations. When that happens, there will be investors that overreact, dumping their shares and embarking on their search for

Starting point is 00:31:50 the next growth story. Sometimes these sort of price drops will give investors the opportunity to pick up the company when it hits the right price. This brings us to mature companies, which are much easier to value than young growth companies and your typical growth company because their future earnings are much more predictable, giving us much more certainty in the range of future potential outcomes. Common characteristics of a mature company is that their revenue growth is approaching the growth rate of the economy, say 2 to 3 percent annually. The company's margins are stable, with the exception of commodity and cyclical companies. These companies have strong competitive advantages to maintain their market position. They tend to have excess cash so they're

Starting point is 00:32:35 able to pay dividends and buyback shares, and oftentimes mature companies have their growth fueled by acquisitions. Coca-Cola is a perfect example of a mature company. The acquisitions piece specifically can be pretty difficult for individual investors to judge because it can be hard for investors to assess the success of an acquisition relative to just judging the business's internal metrics over time. Companies can also play with leverage to do share repurchases, so it's important to be mindful of a company's debt levels when you're valuing a company or doing a relative valuation of one company versus another. I think a lot of people would gravitate towards the Buffett style of value investing and buying a well-managed mature company, but Azwhath also

Starting point is 00:33:21 discusses the strategy of purchasing a company that is a bet on the management. For example, a mature company that has been run poorly, but has a new management team coming in or has an activist investors stepping in and pushing for management to make changes within the business. In Chapter 8, Aswat touches on valuing a declining company, which are in the final phase of their life cycle. And he argues that these may offer lucrative investment opportunities for long-term investors with strong stomachs. Declining companies tend to be those with stagnant or declining revenues, shrinking or negative margins. They might be selling off in liquidating parts of the business that are no longer profitable.

Starting point is 00:34:03 They may also have large dividend payouts or stock buybacks. And debt might be a big issue because their business hasn't played out as well as they might have expected. I didn't want to dive too much into valuing a declining company because there can be so much nuance with these, whether it be the assets they're selling off, the likelihood that bankruptcy comes into fruition and so on. Let's take a quick break and hear from today's sponsors. No, it's not your imagination.

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Starting point is 00:37:16 income fund in just minutes. The fund's total return in 2025 was 8%, and the average annual total return since inception is 7.8%. Past performance does not guarantee future results, current distribution rate as of 1231, 2025. Carefully consider the investment material before investing, including objectives, risks, charges, and expenses. This and other information can be found in the income fund fund's prospectus at fundrise.com slash income. This is a paid advertisement. All right, back to the show. The final chapter of his book covers valuing companies with intangible assets, which is becoming more and more important today.

Starting point is 00:37:56 I recently read a stat that intangible assets consist of 68% of the value in companies in the S&P 500 in 1995, and that amount has increased to 90% in 2020. This is why more and more investors have shifted away from relying on book value when valuing a company because it's much harder to value something like the brand of Google or the intangible value of Google search from an accounting perspective. Many companies in the previous century required investments and physical assets that from an accounting perspective were treated as capital expenses because those investments were considered to produce a benefit for many years. Nowadays, many companies are making large investments in intangible assets such as brand name

Starting point is 00:38:44 advertising or the development of a specific type of software technology. However, oftentimes with intangible assets, accountants tend to treat these investments as operating expenses, and as a result, earnings and capital expenditures tend to be understated when looking at financial statements of these companies. Technology companies and other companies investing in intangible assets also tend to be bigger users of options to compensate management. Thus, Aswatz says that accounting measures such as book value, earnings, and capital expenditures for firms with intangible assets are all misleading and aren't comparable to the same items for a manufacturing company. Therefore, adjustments need to be made to these companies in order to value them correctly. So the first step in making these adjustments

Starting point is 00:39:35 is that the investments in intangible assets should be capitalized, and we need to make an assumption for how long it takes for these investments on average to be converted into something that is of value to the company. And we need to make an assumption for how long it takes for these investments on average to be converted into something that is of value to the company. This is referred to as the amortizable life of these assets. After the amortizable life has been estimated, then we need to collect data. on past years and estimate how those investments are amortized each year. Then in order to adjust the operating income and net income, you take what is in the accounting

Starting point is 00:40:15 statements, add back to capitalize expenses towards intangible assets, and subtract out your amortization amount. These sorts of things probably weren't considered back in the 2000s when everyone said that Amazon was totally overvalued and unprofitable. actually was a profitable company, they were just making investments in intangible assets that were considered operating expenses. So a lot of investors were looking at operating income numbers that weren't a true reflection of what was actually happening within the real business. Aswath also rightly points out that consumer product companies like Coca-Cola could make a case

Starting point is 00:40:55 to have a portion of their advertising expenses to be treated as capital expenses, because these are designed to augment brand name value. And for a consulting firm, the cost of recruiting and training its employees could be considered a capital expense since the consultants who emerge are likely to be the heart of a firm's value and provide benefits for the company for many years. However, we still want to be careful about capitalizing some expenses and be sure there is evidence that these investments actually turn into real benefits for the company over time. I think another important consideration here is that your return on invested capital is also adjusted when you add back to the capital expenses.

Starting point is 00:41:39 Because some of these companies are incorrectly placed in the operating expenses category, accountants are understating how much the company is investing in intangible assets, thus they are likely overstating the return on invested capital as well. So you can't always take the return on invested capital at face value. The final piece I will mention in regards to intangible investments is that these adjustments only work well if the investments in intangible assets generate value and earn high returns. So look for a firm with intangible assets that have a competitive advantage and are difficult for competitors to replicate.

Starting point is 00:42:19 I don't believe Aswath mentioned storytelling in his book, but I think this is a really important piece of how he explains valuation in his classes and on his. website. He says that in order to value a company, you need to be able to tell a story, and that valuation is a bridge between stories and numbers. When you're projecting out growing revenues for a company, you need to be able to explain why those revenues will grow at the rate that you're projecting. Is the company operating in a growing market? Do they offer a superior product that gives them a competitive advantage? Are they at the forefront of a new industry? In order to develop a story for the company, you'll need to develop a good understanding of the

Starting point is 00:43:04 company, what they do, the markets they operate in, the competition they face, as well as the macro environment in the really big picture. Without a strong foundation and a good understanding of the company, you can't tell a good story. And once Azwhath has developed his story, he then wants to ensure the company passes what he calls the 3P test. Is it possible? is it plausible and is it probable? First, is it possible? The first one is a pretty low bar. I might ask you if it's possible that your favorite team is going to win the Super Bowl.

Starting point is 00:43:40 For some teams, it might not even be possible because it's towards the end of the season and some teams just aren't eligible for playoffs. The second question is, is it plausible? If something is plausible, you could argue with reason that something may happen, but it isn't necessarily certain. The third question, is it probable? This is when you're much more certain that something will play out in a certain way, and you have strong evidence to back that claim up.

Starting point is 00:44:08 I might say that the Kansas City Chiefs making it to the Super Bowl is probable. Given that they're in the top two in the power rankings, they've been to the Super Bowl multiple times in recent years, and if everyone stays healthy, then they probably have a good shot. A lot of companies can show the possibility of something happening, but not near as many have a bright future that is probable. In thinking about stories, I think Tesla is a perfect example to use here. Many people have their own opinions on what the story is of the company.

Starting point is 00:44:41 The investors who say Tesla is far too overvalued might have a story that says something like Tesla is a company who makes the majority of its revenue from cars, and cars historically are a very difficult business to be in. Even if the world goes to fully electric vehicles and Tesla captures 100% of the market, Tesla's valuation is not justified today. On the other side, the Tesla bull is telling an entirely different story. They might say Tesla is an incredible company, and Elon Musk is setting them up to be one of the world's most powerful technology companies.

Starting point is 00:45:18 Rather than Tesla being limited to only being a car company, they are a technology company, just like how Amazon wasn't limited to retail, they expanded into other businesses that made sense for them, such as online advertising and AWS. Tesla will be able to monetize other business units such as their battery technology, self-driving tech, car insurance, the list goes on. I honestly don't know which story will end up playing out, but you want to look at the facts and the research that shows which story is based on reality. I think that's a really important point. You want research that shows your story is based on reality and not based on how you want the future to look. This also reminds me of Howard Marks and how he talks about second level thinking. Your average

Starting point is 00:46:06 investor might look at Tesla or whatever high growth company and see their massive sales growth and say, this company's doing something right. I ought to own shares in this company. Second level thinking says that Tesla is a great company, but the market is pricing it as if it's going to be one of the greatest companies in the world. So I'm going to sell it because there is just too much risk. So you need to figure out your story that makes the most sense to you based on the objective data and facts and then run the numbers yourself. So let's talk about a story and weave it into the valuation of a company. One company I was quite intrigued by when I started researching it was William Sonoma. I first discovered this stock when Tobias Carlisle pitched it in Q1 of 2022

Starting point is 00:46:55 in the mastermind meeting during episode TIP 418. And in my mind, this is just your classic value purchase. Back when Tobias pitched it in early 2022, the stock was trading at around $150, $50 per share, and at the time of this recording, it sits at around $116 per share. This is a 24% decline, while the business fundamentals have held up quite well, in my opinion. It's not a glamorous growth story, and it's not going to make you rich overnight, but I think it's a company that has strong, stable, and growing free cash flows, and the company is trading at a pretty attractive multiple. Their EV to EBIT is under 7, and their free cash flow year.

Starting point is 00:47:40 yield is nearly 12%. The stock is even trading at a historically low multiple, even slightly lower than March 2020. William Sonoma is a leading consumer retail company that is most well known for selling kitchenware and home furnishings, and this is all under eight different brands within their business. They adjusted quite well post-COVID and they've accelerated their growth and revenue and earnings ever since. The business has grown every single year for the past decade as well. Their revenue growth over the past 10 years is 7.4% per year, while the growth in their free cash flow per share has increased by 25% per year, which again, really accelerated from 2020 through 2022. Their average return on invested capital over the past five years is

Starting point is 00:48:29 24%, which is really good to see. I also like that the company is positioning themselves to benefit from the trend to online shopping as 66% of their business is done online. Their e-commerce sales have gradually increased over time, which is another thing I like to see as it's not a dying physical retail company. They did $8.7 billion in sales in the trailing 12 months in a total addressable market of over $800 billion. So they have a 1% market share of a highly fragmented market, meaning that there's a lot of room for potential growth. Additionally, none of their competitors have more than 5% share of the overall market. Management is shooting to grow their annual revenue to $10 billion by 2024.

Starting point is 00:49:17 The relatively cheap price for the company today gives investors quite a bit of downside protection, I believe. Of course, earnings could decrease with the recession in 2023, but I don't expect the decrease to be permanent. So for anyone that is able to hold on for, say, five plus years, I think they will do quite well holding the stock when it's bought at today's price of around $116. In fact, I would expect the company's business and stock to really pull back if there, in fact, is a recession, and it's as bad as some people are anticipating.

Starting point is 00:49:52 The company's stock actually declined by 90% during the great financial crisis, but I don't think this business is going anywhere because they're a retailer that's adapted to the age of online shopping and they understand where retail is trending. William Sonoma also has an interesting executive compensation model where the compensation is partially determined by the return on invested capital, which really aligns the shareholder interest with that of the executives. I also really like that management is taking advantage of the stock's decline in 2022 as they aggressively bought back shares. And over the past four quarters, they've allocated over $1 billion to share repurchases, which is quite substantial for a company that's worth just shy of $8 billion.

Starting point is 00:50:38 Earlier in 2022, they announced that they would be allocating $1.5 billion to share repurchases, and they announced they'd be increasing their dividend by 10% stating that these actions reflect our commitment to execution in the resulting return of value to our shareholders. Now let's talk about the valuation. I'm going to keep the valuation fairly simple doing a base case and then a case where the company does worse than I would expect. And I'm simply going to project out the future free cash flows using our TIP finance tool to give me a rough idea of the intrinsic value of the company.

Starting point is 00:51:14 This reminds me of two quotes. The first being from Albert Einstein, everything should be made as simple as possible, but not simpler. Now I'm going to take that approach here and only use the free cash flows. rather than pulling in the projected revenue, operating margins, and such. The other quote is by John Keynes is one that I think refers to modeling in general, and that's, it is better to be roughly right than precisely wrong. I'm not trying to get the exact value of Williams Anoma.

Starting point is 00:51:44 I just want to get a general idea and factor in a margin of safety as well. So turning to the valuation, I'll be using our TIP finance tool again, which is a tool that TIP created that allows anyone to analyze a company and calculate its intrinsic value or expect a return. The future free cash flow for the trailing 12 months for William Sonoma is $851 million that is already down from fiscal year 2022 of $1.1 billion. For my base case, I'm going to assume that the free cash flows declined by 20% to $681 million due to the recession and macro factors, and then I'm going to assume that those cash flows grow on average by 9% per year for the next 10 years. In putting these numbers into our TIP finance tool on our website,

Starting point is 00:52:34 the expected internal rate of return under the scenario is 14.2%. This is quite good even when you assume the decline in earnings. In a more bearish scenario, let's say the earnings declined by 50%, which might seem somewhat crazy, but it's important to remember that that the decline in earnings. the free cash flows more than doubled from 2020 to 2021. So if we see free cash flows cut in half and we project just 5% growth going forward, the expected rate of return is still 6.6%. So unless something catastrophic happens to the economy or Amazon totally disrupts William Sonoma's business all of a sudden, I'd expect investors to at least earn a decent return from this pick. To put the story simply for William Sonoma, I think it's a high-quality business with

Starting point is 00:53:23 durable revenues long-term, a strong brand and competitive advantage, and consistently high returns on capital. They have a strong balance sheet with no debt outside of their leasing obligations, so they will really be able to weather through any type of economic downturn just fine, I believe. Since they operate in a large market and they're well-positioned, I believe management will be able to hit their targeted revenue growth of mid to high single digits while also continuing to return capital back to shareholders through dividends and sharey purchases. Rather than finding a turnaround business that is trading for cheap, I believe that William Sonoma is a great business that is currently trading at a cheap to fair price.

Starting point is 00:54:07 To round out the discussion on William Sonoma, I think this is also a good opportunity to mention our policy, The Investors Podcast, Network has around trading stocks we discuss on the show. To avoid any conflict of interest, I am not able to buy or sell any stock that has been mentioned on the show for the first two weeks that the episode has been released. There have been times in the past where we've talked about smaller companies and the stock has moved substantially after the episode was released. So I just want to make it clear that I will not be buying or selling any stock that I mention on the show for the first two weeks after any episode of mine is released. For full transparency,

Starting point is 00:54:49 I have started a small starter position in William Sonoma and I purchased it at a price of around $116. I've for the most part been on the sidelines lately building more cash in my portfolio and I'm really seeing how these macro factors end up playing out with high inflation and higher interest rates. Again, I'm not able to purchase any more shares in William Sonoma for the first two weeks that the episode is out to avoid any conflict of interest and to be fully transparent. But if the stock trades lower throughout 2023, I will definitely consider increasing my position gradually. All right, that wraps up today's episode. If you don't already, be sure to click follow on the podcast app you're on so you can get notified of all of our future episodes coming out.

Starting point is 00:55:35 Also, if you have any comments or questions about Aswas Book or William Sonoma, feel free to tweet at me letting me know or shooting me a DM. I would really love to hear from you. My username is at Clay underscore Fink, C-L-A-Y-U-N-C-K. If you're interested in connecting with me there. With that, thank you so much for tuning in to today's episode, and I hope to see you again next week. Thank you for listening to TIP. Make sure to subscribe to millennial investing by the Investors Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only.

Starting point is 00:56:21 Before making any decision consult a professional, this show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP515: The Little Book of Valuation by Aswath Damodaran

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