Aswath Damodaran has taught tens of thousands of students at New York University’s Stern School of Business how to value stocks. Outside of the classroom, he is one of the best-known experts on valuation, and is often the go-to source when reporters are trying to understand how a hot new company can have metrics that seem to defy conventional analysis.
The professor, 62, received his master’s degree and doctorate from the University of California, Los Angeles. He is the author of four books on equity valuation.
Barron’s recently talked with Damodaran, who is unafraid to challenge assumptions about controversial stocks. His voice is as important as any other when it comes to determining what a stock is worth. An edited version of the conversation follows:
Barron’s: Tell us about teaching stock valuation.
Aswath Damodaran: Everything I know about valuation I’ve learned in the process of teaching that class. I remember October 1987, the one-day collapse of the
index, down 22%. The next day, I’d go back to class and talk to people about how can the market change 22%? And you still believe in value? And the 1990s dot-com boom and bust. I had to talk about
[ticker: AMZN], whether I wanted to or not in 1997. How can a company with very little revenues, and everything in the future, be worth what it is? There was nothing on valuing young companies in 1997. I had to improvise what I’ve known about valuation.
And improvise is the key word. It’s how I’ve finagled my way to where I am today, by improvising. Because every time I run into something I’ve never seen before, I go back to basics, and amazingly there’s so much give in the basics that I can stretch them to meet just about any requirement that I need, any conditions I face. But to me, every crisis is a crucible. It tests my faith. It checks my philosophy. And it teaches me new things.
What are the basics?
Cash flow, growth, and risk. I tell people about a Venetian glassmaker in the 1400s; when he sold his business, people didn’t check earnings reports. They checked what’s cash in, cash out. How stable are these numbers? And they did their own version of a discounted cash flow valuation. All we’ve done is taken those basics and added layers and layers, sometimes too many layers. Whenever I’m in doubt, I go back to those basics.
You said valuation was uninteresting in the 1980s. How so?
I think the biggest difference of the 1990s was public markets encroaching into what used to be the private market space. In the initial public offerings of the 1970s and 1980s, whether
[MSFT], the company is almost fully formed. Even if it wasn’t making money, it was very close to making money. What the dot-com boom changed, and permanently changed, is that you could have companies that used to stay in the private space for longer, have the capacity to go public. The old metrics—price/earnings ratios, price-to-book ratios, enterprise value to Ebitda—are all designed for companies that are pretty established companies. You take those metrics, and you try to price a young company that’s still building a business model. I think of a company like
[UBER] as a company that fits that description. Nothing’s going to work.
And when that happens, people react in strange ways. They then say, oh, these people are crazy. They’re irrational. They must be shallow. And that, I think, is something I’ve found to be very troubling about old-time value investors. They use metrics they looked up, applied these metrics to a
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[ZM] or a
[Z], and they say, well, these people are crazy. And I say, look, maybe those people aren’t crazy. Maybe you’re just using a mechanism that is not right for measuring value at these companies. It’s still about cash flows, growth, and risk. But those cash flows, growth, and risk are all in the future. You’ve got to deal with estimating it.
At Barron’s, we often default to P/E ratios. What is the best way to update a value investor’s “cheat sheet?”
I think one of the problems with finance is it was developed primarily in the U.S. in the second half of the 20th century. The U.S. economy in the second half of the 20th century was the most stable, mean-reverting economy of all time. If you look at traditional old-time value, that’s low P/E stocks. The reason it works is that low P/E stocks revert back to the average, and you make your money. Mean reversion works until it doesn’t.
What do you mean?
The U.S. was the largest economy in the world, but it wasn’t the global economy. So, since 2008, we are pushing back against the Shiller P/E and the CAPE [cyclically adjusted P/E] ratios because there are a lot of very lazy arguments being made for stocks being overvalued because a normal P/E for the S&P is about 16. Where do you get that? Well, the Shiller data are from 1871 to 2009. Come on.
Standard valuation measures must have some value?
I’m not an academic. I’m a pragmatist. I don’t believe that markets are efficient, but I also don’t believe that much of active investing, at least as practiced now, has a prayer at finding and exploiting these inefficiencies for profit. But I do think that markets always convey messages. And if you ignore those messages, or you think you’re bigger than the market, the market’s going to take you down several notches. So I think that is my overriding message—get away from static to dynamic, from backward-looking to forward-looking. And that scares people.
So how can investors move from static to dynamic?
We don’t like to be wrong. And I think that the reason we use historical data is not even that they give us better predictions, but because if something goes wrong, you have something to blame. You can say, look, I just used past earnings. It’s not my fault. So, the first thing we need to do is abandon the need for it. The historical data become a crutch. The second is, and I tell people this, look, you don’t need to be smart, but you need to accept the fact that you’re going to be wrong. And you’ve got to be willing to change how you do things when you’re wrong. There is this deeply held view that there is smart money on Wall Street. I’m looking for humble money.
What are your thoughts on today’s most-talked-about stocks?
At the wrong price, I don’t care how great the company is. It’s not a great investment.
[FB] and Apple are in my portfolio. Amazon has been in the past. I’ve never owned Google [
; GOOGL]. I have to confess, Google is one of those companies where I have consistently underestimated the capacity of that little search box.
I like Facebook because I think it will continue to deliver those advertising revenues, because it’s the way the world is evolving. We get our news from social media. We get our entertainment from social media. And when you’ve got two billion users who spend an hour every day on your platform—and I’m not even counting the WhatsApp revenues that are going to come in the future—I think you have a money machine.
I like Apple, not because it’s ever going to become a growth company. I’m a realist on Apple. It is a mature company with low growth, but it’s the greatest cash machine in history.
What about some of the gig-economy companies?
I’m a little skeptical on Uber. I’ve told people for a long time that I love Uber as a growth machine, but not its business model. It was designed in such a way that it allowed it to scale up really fast but was very difficult to make money. It comes with almost no barriers to entry. In 2019, for the first time in Uber’s history, CEO Dara Khosrowshahi said, hey, we have to figure out how to make money. My response was, thank you, God. I bought Uber in September of last year. My value’s about $28 to $30. Basically, it’s going to be car service as a business, dominated by two companies, Uber and
What about Tesla?
[TSLA] at the start of this year. I bought it in the middle of last year because I thought the price was right at $180. I got incredibly lucky. I think in a strange way, this crisis has made Tesla a much more powerful company in the automobile space, because it’s capital-light relative to its competition. The fact that CEO Elon Musk made cars in a tent actually is going to work in his favor. The one thing that always scares me about valuing Tesla is that it draws the crazies.
What do you think of the current rally?
This is going to be a terrible year. We all agree with that. Now, we can debate whether earnings are going to be down 30% or 40%, but they’re going to be down a ton. The real debate should be about what will happen over the next three, four, five years. How much of this damage is permanent? And how much is transitory? That’s a healthy discussion to have. And when you have the discussion, what happens is, you discover that there are some businesses where the damage is permanent. The cruise-line business. It’s never going to go back to a pre-crisis valuation for good reason. But I’ll make it broader. I think infrastructure businesses [airlines and telecommunications], especially ones with a lot of debt, are going to be permanently marked down after this crisis because people have learned that these companies are very fragile. They are not designed to live through a crisis like this one.
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