Monday, November 18, 2013

Valuation Myths: Young companies cannot be valued

Twitter is now officially a publicly traded company, and I am glad that we no longer have to debate the IPO price and what will happen in the aftermath. While the opening may have veered a little off script, to the extent the price popped a little more than “desirable”, I am sure that the bankers, the preferred clients who were able to get the shares at $26/share and even the owners who left money on the table (just over a billion dollars) are all happy with the outcome, at least so far. While they may be tempted to claim “mission accomplished”, I think that there are a few more rounds to go before we make that judgment.

In an earlier post, I noted the divergence between investors, who trade based on value, and traders, who make judgments about price movements, and how they often talk past each other. If you have been following the conversation about Twitter online or in the financial media, the last week has also brought reminders about enduring myths about the valuing and pricing of young, growth companies that both sides seem to hold dear. At the risk of irking both groups, I would like to argue that they are holding on to preconceptions that are not only shaky and self serving, but also damaging to their portfolios.

Investor Myths
Let’s start with the three misconceptions that some “value” investors have about young, growth companies.
  1. Young, growth companies cannot be valued: How often have you heard someone say that young companies cannot be valued because there is too much uncertainty about the future? This rationale is used by value investors not only to avoid entire segments of the market but as a shield against even discussing the value of young, growth companies. While it is true that there is more uncertainty about the future prospects of a young company than for a mature business, you can still make estimates of expected earnings and cash flows into the future and value the company, as I tried to do in these spreadsheets to value Tesla and Twitter. You can and should take issue with my assumptions and come up with your own values for both companies but you cannot argue that these companies cannot be valued.
  2. Even if you can value companies, that value will change significantly over time (making it pointless): As you learn more about a new company, from its early operating successes and failures, you will reassess value and your estimates will change, often significantly over time.I know that bothers some value investors, because they have been taught (wrongly in my view) that intrinsic value is stable and should not change over time. I am not bothered by the volatility in my value estimate, since the information that causes my estimate of value to change will also cause the price to change, and generally by far more. As an illustration, let me point to Facebook, a company that I have valued a half dozen times since its initial public offering in March 2012. My initial estimate of value for the company on the day of the offering was $27.07, well below the offering price of $38. A few months later, after a disappointing earnings report that suggested that their mobile advertising revenues may be lagging, I re-estimated the value of Facebook to be $23.94, a drop of approximately 13%, but the stock was trading at just under $19 (a drop of 50%). In fact, my value for Facebook has ranged from $24 to $30, while the price has fluctuated from $18 to $51. If your payoff in value investing is in finding mispriced stocks, I think that your odds are much better with stocks like Facebook and Twitter, where both your estimates of value and the market prices are subject to change, than in mature companies like Exxon Mobil or Coca Cola, where there is more consensus about the future, and fewer uncertainties.
  3. Young, growth companies are always over valued. This is an insidious myth that can be attributed to one of two forces. The first is that some value investors are born pessimists, who seem to believe that making bets on the future is a sign of weakness. The second is that some value investors rely on approaches for estimating value that are not only outdated, but simplistic. If your measure of value is to apply a constant PE (say 12) to next year’s earnings or to use a stable growth dividend discount model to value equity, you will never find a young, growth company to be a bargain. If you are creative in estimating value, willing to make assumptions about the future, persistent in tracking that value and patient in terms of timing (your buying and selling), there is no reason why you should not find growth companies to be bargains. I did not like Facebook at $38/share in March 2012 but I loved it at $18/share in September 2012, and while I would not touch Twitter today at $42/share, I would be interested at $15/share.
Trader Myths
On the trading side, there are two broad misconceptions about “value” that are just as misplaced and as dangerous as the three myths that value investors hold on to.
  1. With young growth companies, value does not matter. This is, of course, the mirror image of the value investors’ lament that a young growth company cannot be valued. While value investors use it as a reason to not invest in the company, traders use it as a reason to ignore value, arguing that if no one can value a company, its price is entirely a function of what the market thinks it is, rather than fundamentals. Perception may be all that matters if you are pricing a piece of art (like this one that just sold for $142 million), but it cannot be with a share of a publicly traded business. After all, no matter what the promise or potential of a company, the stories eventually have to show up as numbers (revenues and earnings), and if perception is at odds with reality, it is perception (price) that will change, not reality.
  2. Even if value does matter, it is best determined by focusing on the short term, where you have a chance of estimating numbers, rather than on the long term. With young, growth companies, analysts seem to prefer that the focus stay on the short term – next quarter, next year or perhaps two years out, using the excuse that going beyond that is an exercise in speculation. Ironically, it is the end game (the long term) that determines the value of young companies, rather than the near-term results. Put differently, it is not how Twitter does in 2014 that will be the arbiter of its value, but how the choices it makes in 2014 affect its long-term growth path. 
I know that you are probably still skeptical about whether you can value young, growth companies and I empathize. I have struggled with young company valuations both technically (in coming up with cash flows, growth rates and discount rate) and psychologically (in fighting the instinct to flee from uncertainty) and I know that I will never quite master the process. However, each time I value one of these companies, I learn something new that I can incorporate into my tool kit. I have taken some of these lessons and put them into this paper on dealing with uncertainty that you are welcome to read (or ignore). Better still, pick a company that you are convinced cannot be valued and try valuing it. You may find it difficult, the first time around, but I promise you that it will only get easier. And it is so much more fun that valuing a utility or a bank!

31 comments:

Tahir Chad said...

It's because some people won't make a difference between the concepts of Price and Value. If one's was omniscient (even of future events), Price would be Value. We never really compute a "valuation", but just a subjective estimation. The latter is then compared to the transaction price of the stock. So basically there is 3 things : The intrinsic value, our actual estimation of it, and the actual price.

QI said...

Excellent article/explanation but it is fear of losing money which forced value investor to make distance from this kind of companies. But I am 100% agree the pay off will be huge if your entry is right.

Anonymous said...

Myth: "Young, growth companies cannot be valued"

Perhaps the problem should be approached from the other end: how well did the valuations turn out?

What I would really like to know is how well you did out of your student picks, and if there was any overall lesson that you could learn in hindsight. You must be sitting on a wealth of data, Professor, and analysing it should be illuminating in itself.

Mark

Aswath Damodaran said...

Mark,
Good point but who would we look at? Value investors almost never even try to value young, growth companies and those who trade young, growth companies are traders (who don't care about value). Anecdotal evidence is pretty useless. But I agree with you, in principle. This is about results, not theory.

Anonymous said...

Prof,

Why do you use Free cash flows = EBIT (1-t) * (1-Reinvestment rate)?

Reinvestment rate includes positive effect of depreciation also because Reinvestment = Capex – Depreciation + Change in working capital.

Since EBIT is calculated after depreciation which is a positive cash flow, wouldn’t doing EBIT (1-t) * (1-Reinvestment rate) to get FCF will make FCF lower, i.e. effect of depreciation not considered?

-SP

Anonymous said...

Prof Damodaran: "Good point but who would we look at?"

That's easy: your own work, and that of your students. You have the potential to build a database like no other. After all, don't your courses teach students how to value exactly these types of situations?

Do they systemmatically undervalue or overvalue companies, for example? Do they do better in some areas compared to others. e.g. cyclicals versus small growth companies, or option-like environments?

Mark

Anonymous said...

Blog posts, now are not being delivered to my email - is there anything that needs to be done?

UniverseofRisks said...

isn't valuation done on an "as is" basis? which means with any additional information my assumptions about,and the value of a company can dramatically transform. This is especially true for companies in distress and young companies. People also usually shift between being traders and investors based on their beliefs and how their portfolio is performing relative to their opinions.It's all convenience!

mhayon said...

I am curious which text states that intrinsic value is static? Even Graham was very careful around this issue. I am pretty sure Buffett, Graham, Dodd, Munger, et al don't believe that is true...

A value investor isn't just looking for a bargain, he is looking for a bargain with a substantial margin of safety... something you can build a confidence interval around. Now when value investors claim they "don't understand" or "don't invest in" technology-- does that mean they are dumber than the rest of us? They just don't get it? No, it just means they can't build in a margin of safety in a confidence interval they are comfortable with. And anyone who says they can predict Facebook's next 5-10 years with confidence (with greater certainty than Exxon Mobil or Coca Cola) is lying or dumb.

A value investor is looking for an investment that he can hold while going to a remote island for a decade and not have to worry about it.

Mohnish Pabrai says there are 4 types of investments: low risk, low uncertainty; low risk, high uncertainty; high risk, low uncertainty; and high risk high uncertainty. His Dhando Investor is about the pursuit of these low risk, high uncertainty investments.

Or take it from the Munger angle-- similar to the pari-mutuel bet at the race track: "It's like looking for a horse that pays 50/50 and has a 3-to-1 chance of winning."

mhayon said...

I am curious which text states that intrinsic value is static? Even Graham was very careful around this issue. I am pretty sure Buffett, Graham, Dodd, Munger, et al don't believe that is true...

A value investor isn't just looking for a bargain, he is looking for a bargain with a substantial margin of safety... something you can build a confidence interval around. Now when value investors claim they "don't understand" or "don't invest in" technology-- does that mean they are dumber than the rest of us? They just don't get it? No, it just means they can't build in a margin of safety in a confidence interval they are comfortable with. And anyone who says they can predict Facebook's next 5-10 years with confidence (with greater certainty than Exxon Mobil or Coca Cola) is lying or dumb.

A value investor is looking for an investment that he can hold while going to a remote island for a decade and not have to worry about it.

Mohnish Pabrai says there are 4 types of investments: low risk, low uncertainty; low risk, high uncertainty; high risk, low uncertainty; and high risk high uncertainty. His Dhando Investor is about the pursuit of these low risk, high uncertainty investments.

Or take it from the Munger angle-- similar to the pari-mutuel bet at the race track: "It's like looking for a horse that pays 50/50 and has a 3-to-1 chance of winning."

mhayon said...

I am curious which text states that intrinsic value is static? Even Graham was very careful around this issue. I am pretty sure Buffett, Graham, Dodd, Munger, et al don't believe that is true...

A value investor isn't just looking for a bargain, he is looking for a bargain with a substantial margin of safety... something you can build a confidence interval around. Now when value investors claim they "don't understand" or "don't invest in" technology-- does that mean they are dumber than the rest of us? They just don't get it? No, it just means they can't build in a margin of safety in a confidence interval they are comfortable with. And anyone who says they can predict Facebook's next 5-10 years with confidence (with greater certainty than Exxon Mobil or Coca Cola) is lying or dumb.

A value investor is looking for an investment that he can hold while going to a remote island for a decade and not have to worry about it.

Mohnish Pabrai says there are 4 types of investments: low risk, low uncertainty; low risk, high uncertainty; high risk, low uncertainty; and high risk high uncertainty. His Dhando Investor is about the pursuit of these low risk, high uncertainty investments.

Or take it from the Munger angle-- similar to the pari-mutuel bet at the race track: "It's like looking for a horse that pays 50/50 and has a 3-to-1 chance of winning."

Laszlo said...

A good post, thank you for that!
And I also liked the model used for evaluating Tesla and Twitter.

I would though have a question regarding the calculus behind.
Where are the finance cost and equity impact of the losses for the 9 years taken into account?

You were calculating with negative cash-flow for both businesses for 9-10 years. These losses will have to be financed either by equity or by debt at the companies, both of them would mean less equity for present owners and maybe additional costs. Is it taken into account?

Thank you!

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Kemorwale said...

Rule No. 1 : Do not lose money
Rule No. 2: Remember rule 1

Buffett isn't trying to be the smartest guy in the room. He isn't interested in showcasing his valuation prowess, and he probably doesn't believer he has it. He is a fool, and he knows spots, and he sticks to spots.

He doesn't know technology companies. He knows insurance (it was explained to him by GEICO VP when WB was a young lad), he knows consumer companies, old technology like railways and brick and mortar technology companies like IBM.

And I don't think Value Investors say its impossible to value young companies. They just said its hard for them, if smart people like you can then good, less competition for you to make money...

Actually, Charlie Munger has said that if he was a young man, he would "get them young."

P.S. I follow your blog religiously. You're doing an awesome job educating the public outside the classroom. Kudos

Anonymous said...

Rule No. 1 : Do not lose money
Rule No. 2: Remember rule 1

Buffett isn't trying to be the smartest guy in the room. He isn't interested in showcasing his valuation prowess, and he probably doesn't believer he has it. He is a fool, and he knows spots, and he sticks to spots.

He doesn't know technology companies. He knows insurance (it was explained to him by GEICO VP when WB was a young lad), he knows consumer companies, old technology like railways and brick and mortar technology companies like IBM.

And I don't think Value Investors say its impossible to value young companies. They just said its hard for them, if smart people like you can then good, less competition for you to make money...

Actually, Charlie Munger has said that if he was a young man, he would "get them young."

P.S. I follow your blog religiously. You're doing an awesome job educating the public outside the classroom. Kudos

Anonymous said...

Rule No. 1 : Do not lose money
Rule No. 2: Remember rule 1

Buffett isn't trying to be the smartest guy in the room. He isn't interested in showcasing his valuation prowess, and he probably doesn't believer he has it. He is a fool, and he knows spots, and he sticks to spots.

He doesn't know technology companies. He knows insurance (it was explained to him by GEICO VP when WB was a young lad), he knows consumer companies, old technology like railways and brick and mortar technology companies like IBM.

And I don't think Value Investors say its impossible to value young companies. They just said its hard for them, if smart people like you can then good, less competition for you to make money...

Actually, Charlie Munger has said that if he was a young man, he would "get them young."

P.S. I follow your blog religiously. You're doing an awesome job educating the public outside the classroom. Kudos

Anonymous said...

Rule No. 1 : Do not lose money
Rule No. 2: Remember rule 1

Buffett isn't trying to be the smartest guy in the room. He isn't interested in showcasing his valuation prowess, and he probably doesn't believer he has it. He is a fool, and he knows spots, and he sticks to spots.

He doesn't know technology companies. He knows insurance (it was explained to him by GEICO VP when WB was a young lad), he knows consumer companies, old technology like railways and brick and mortar technology companies like IBM.

And I don't think Value Investors say its impossible to value young companies. They just said its hard for them, if smart people like you can then good, less competition for you to make money...

Actually, Charlie Munger has said that if he was a young man, he would "get them young."

P.S. I follow your blog religiously. You're doing an awesome job educating the public outside the classroom. Kudos

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Abhishek Sinha said...

I believe it is about picking stocks which have more certainty around them rather than knowing how to value a particular stock. Traditionally, young companies have a lot more to prove than a matured company which has walked the talk. It is not just about quantifying future expectations; it also is about management's ability to deliver. So in case of a company which is yet to prove it's ability to manage; "risk" taken demands higher expected return which again may be difficult to quantify while valuing.

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Sepatu Running said...

Namaste Prof. Damodaran,
I want to know why did you divide the terminal FCF with risk premium percentage and then discounted it to present value?

Anonymous said...

Sepatu,

That calculation is the Gordon Growth Model that is used to project a consistent cash flow into perpetuity, which then needs to be discounted back to the present value.

The Contrarian Individual Investor said...

Value investors fail at this because they attempt to determine a 'value' for the company rather than a range of values and the scenarios which drive the various elements of that range. Lulled by the sell and buy side research that touts an absolute value, price target or 'Fair Value' amount they forget that markets and companies are dynamic and a valuation is only a starting point for giving you the information you need to understand information about your investment as time elapses.

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