Coming To Grips With Valuations

Foreword from ShareInvestor

This article “Coming To Grips With Valuations” by Teh Hooi Ling was first published in The Business Times Weekend on 25-26 May 2013 and is reproduced in this blog in its entirety.

The price of stocks and their value are two different things

WHEN I was studying for my CFA exams back in early 2000s, I found Aswath Damodaran, Professor of Finance at the Stern School of Business at NYU, to be one of the most lucid authors. He made stock valuation seem too easy.

This week, Prof Damodaran was in Singapore as a speaker at the 66th CFA Institute Annual conference. His extended session was entitled “Living with Noise Valuation in the Face of Uncertainty”.

He provided a lot of good reminders and pointers in his presentation that analysts and investors who are trying to do fundamental analysis will find useful.

First off, he said, the value of a stock that emerges from using a discounted cashflow model is imprecise. “But one just has to be less wrong than the market (to make money),” quipped Prof Damodaran.

For example, he valued Amazon at US$35.08 back in January 2000 while the market price for the stock was US$84. By January 2001, Amazon’s share price had collapsed to US$14. He updated his analysis and found the stock to have a value of US$20.83.

In May 17, 2012, his valuation of Facebook came out to US$25.39. The Wall Street investment banks – Morgan Stanley, Goldman Sachs, among others – which took Facebook public, sold its shares at US$38 apiece. In its first two trading days, Facebook plunged 19 per cent.

Prof Damodaran said he was asked by CNBC how the investment banks could get their valuation so wrong. His answer was: “They are pricing the issue, they are not valuing the shares.”

In his presentation, he reminded the audience that in intrinsic valuation you value an asset based upon its intrinsic characteristics. For cashflow, the intrinsic value will be a function of the magnitude of the expected cashflows on the asset over its lifetime and the uncertainty about receiving those cashflows.

Discounted cashflow valuation is a tool for estimating intrinsic value, where the expected value of an asset is written as the present value of the expected cashflows on the asset, with either the cashflows or the discount rate adjusted to reflect the risk.

He outlined three basic propositions for risk-adjusted value. One, if “it” does not affect the cashflow or alter risk (thus changing discount rates), “it” cannot affect value.

Two, for an asset to have value, the expected cashflows have to be positive for some time over the life of the asset.

Three, assets that generate cashflows early in their life will be worth more than assets that generate cashflows later; the latter may, however, have greater growth and higher cashflows to compensate.

Here’s how you ascertain the fundamental determinants of the value of a company. First determine what are the cashflows from existing assets. If you are valuing the equity, it’s the cashflows after debt payments that you must look at. If you are valuing the firm, then you take cashflows before debt payments.

Second, determine what is the value added by the firm’s growth assets. In valuing equity, you look at growth in equity earnings/cashflows. For firms, you look at growth in operating earnings/cashflows.

Third, determine how risky the cashflows are, from both existing assets and growth assets. For equity, it’s the risk in the equity in the firm and, for firm, it’s risk in the firm’s operations.

Finally, determine when the firm will become mature, and the potential road blocks.

In doing all of the above, there are numerous uncertainties. First, there is the estimation versus economic uncertainty. Estimation uncertainty reflects the possibility that you could have the “wrong model” or estimated inputs incorrectly within the model. Economic uncertainty comes from real sources: the fact that markets and economies can change over time and that even the best models will fail to capture these unexpected changes.

Estimation uncertainty can be mitigated by doing your homework, collecting more data or building better models, said Prof Damodaran. But economic uncertainty is here to stay.

Next there is micro versus macro uncertainty. I think this is quite similar to the uncertainty mentioned above. But here’s how Prof Damodaran defined it: Micro uncertainty refers to uncertainty about the firm you are valuing and its business model – the potential market or markets for its products, the competition it will face and the quality of its management team. Macro uncertainty reflects the reality that the firm’s fortunes can be affected by changes in the macro economic environment, such as the strength of the economy, the level of interest rates and the price of risk (for equity and debt).

Micro uncertainty can be mitigated or even eliminated by diversifying across companies, but macro uncertainty will remain even in the most diversified portfolio, said Prof Damodaran.

And then there is discrete versus continuous uncertainty. Some events that you are uncertain about are discrete. So a biotechnology firm with a new drug working its way through the US Food and Drug Administration pipeline may see the drug fail at some stage of the approval process. In the same vein, a company in Venezuela or Argentina may worry about nationalisation risk.

Most uncertainties, though, are continuous. Thus changes in interest rates or economic growth occur continuously and affect value as they happen.

In valuation, we are better at dealing with continuous risks than with discrete risks, said Prof Damodaran. In fact, discount rate risk adjustment models are designed for continuous risk.

The unhealthy responses to uncertainty are paralysis and denial; resorting to mental short cuts or rules of thumb, herd behaviour and outsourcing to “experts”.

Some suggestions for dealing with uncertainty are: one, keeping the forecasting simple, when trying to forecast the cashflows of a new company, take a look at the trajectory of previous similar companies. For example, Prof Damodaran modelled Facebook’s growth trajectory after Google’s.

Two, build in internal checks on reasonableness. For example, the market share cannot exceed 100 per cent of market size. Three, use consistency tests, for example the currency in which cashflows are estimated should also be the currency in which the discount rate is estimated. Four, draw on economics first principles and mathematical limits. For example, a stable growth rate cannot exceed the growth rate of the economy. Five, use the market as a crutch, when trying to estimate, say the equity risk premium. Six, draw on the law of large numbers. For example, when trying to estimate beta (or volatility), take the beta of the industry and adjust for the debt level of the company you are analysing. Other suggestions include confronting uncertainty by coming up with a probability distribution, constantly adjusting and adapting your model as new information comes out. Finally, accept that you can make mistakes, but keep the biases out. “If you are ‘biased’ about individual company valuations, your mistakes will not average out, no matter how diversified you get.”

There are three ways to view the value/pricing gap. One, if you believe in efficient market theory, then you’d think that the gaps between price and value, if they do occur, are random. Then you’d go for index funds.

If you are a “value extremist”, then you’d view market participants who collectively price the stock as dilettantes who will move from fad to fad. Eventually the price will converge on value. If you are in this camp, then you’d buy and hold stocks where the value exceeds the price.

For the pricing extremists, they think value is only in the heads of the “eggheads”. Even if it exists, prices may never converge to value. So what they do is to look for mispriced securities and try to get ahead of shifts in demand and momentum.

The dilemmas of “pricers” are that they don’t have an anchor on where a security should be and are, therefore, pushed back and forth as the price moves from high to low; they are reactive; and they face the difficulty of trying to read where the crowd is going to move to next.

The valuers’ dilemmas are that they are not sure about the magnitude of the value/price gap, and they are uncertain when the gap will close. They can mitigate that uncertainty by lengthening their holding time horizon, and by providing or looking for a catalyst that will cause the gap to close. Prof Damodaran’s study of Apple showed that the value/price gap for the company would close by 80 per cent if the holding period is 5 years. That goes up to 90 per cent for a holding period of 10 years.

And, finally, here’s a tip for Apple fans from Prof Damodaran. According to his study, there is a 90 per cent chance of the company being undervalued at its current price of about US$440 per share.