Tuesday, November 19, 2013

Value in the eye of the storm: Why you should welcome uncertainty!

One of the responses to my last post on valuing young companies was that even if you can value companies early in the life cycle, you cannot do so with any degree of confidence. I concede that point, but that is exactly why I would try to value them! I know that statement makes little sense, but to solidify my argument, take a look at the following list of five assets/entities and rank them on the basis of the confidence you will feel in valuing each one (I have provided my rankings and the reasons in the table).
Valuation Setting Your precision ranking My precision ranking My reasons
$20 in an envelope

(1) Absolute  Nothing to forecast & no risk to adjust for.
A mature, money making company in a stable macroeconomic environment

(2) Very high You can use both company & macroeconomic history in making forecasts.
A mature, money making company in an unpredictable macroeconomic environment

(3) Average While company is stable, macroeconomic shifts can cause earnings/cash flows to change.
A young, money losing company in a stable macroeconomic environment

(4) Low You have no history and know little about market. Lots of unknowns, at least at the company level.
A young, money losing company in an unpredictable macroeconomic environment

(5) Very little The uncertainties you face at the company level are multiplied by uncertainties about interest rates and economic growth.
My guess is that your rankings will match closely to mine. Cash in an envelope is easier to value than an ongoing business, an ongoing stable business is easier to value than a young, growing business and valuations in general are easier when interest rates and economic growth are stable/predictable than when they are not.

Now that we have dispensed with that formality, I think it is worth asking a more complex question. If valuation is designed to find investment bargains, what is the payoff to doing valuation in each of these settings? Note that the game is now different, since your advantage does not come from the precision of your valuation but in its relative precision: How much more precise is your estimate of value for a given asset is than the estimates of others valuing exactly the same asset? Here is my attempt to look at my potential differential advantages (and I would encourage you to do the same).
Valuation Setting
Differential Precision
$20 in an envelope
(5) None.
A mature, money making company in a stable macroeconomic environment (4) Very little (unless I cheat and use inside information, which would of course bring the SEC's wrath to bear on me). The estimates come from historical data and are unlikely to shift very much, since the macroeconomic setting is stable. Valuation modeling is trivial and you can use historical PE ratios or stable growth cash flow discount models to value the company.
A mature, money making company in an unpredictable macroeconomic environment (3) Your differential advantages can come from being able to incorporate the macroeconomic uncertainty into company forecasts and valuing the company. If the macroeconomic uncertainty is large enough (say, at crisis levels), other investors may stop trying to value even mature companies (remember late 2008), essentially conceding the game to you.
A young, money losing company in a stable macroeconomic environment (2) Your differential advantage comes from researching the business the company is in, understanding the company's products and being willing to make forecasts (knowing that you are going to be wrong). Again, with enough uncertainty, other investors will not even try to value these companies , focusing instead on rules of thumb, unusual value metrics (value per user) or short term numbers (earnings next quarter).
A young, money losing company in an unpredictable macroeconomic environment (1) Your differential advantage will come from just trying to make estimates, in the face of immense uncertainty, when everyone else has long since given up any attempt to estimate value.
My motto is that you don’t have to be right to make money, but just less wrong than everyone else in the market. That makes my odds best in exactly those environments where I am uncomfortable and uncertainty is overwhelming.

Wielding Ben Graham’s tome on security analysis as a weapon, old-time value investors will probably take issue with this argument, pointing to the efficacy of the time-tested value investing conventions, where you are told to stay focused on companies with solid earnings and cash flows, with superior management. I would be inclined to concede the argument, if active value investing, as practiced today, actually worked, but there is little evidence that it does, at least in the aggregate, as I argued in this paper. In fact, there is evidence, albeit weak, that the average active growth investor beats a growth index more frequently and by more than the average active value investors beats a value index. That does not surprise me in the least, since it is in keeping with my thesis that the best investment opportunities are in the volatile, growth sectors.

I think that Ben Graham, if he were writing his book today, would be much less rigid in his view of value than the classicists. The real lesson that I get from reading Graham’s writings is that value is determined by fundamentals and that markets sometimes misread or ignore those fundamentals. My addendum is that investors are more likely to misread and/or ignore fundamentals, when they are faced with large uncertainties than with small ones.

In closing, there are three general propositions about valuation that flow from my view of uncertainty.
  1. The more comfortable you are in valuing a company, the less point there is to doing that valuation. After all, the factors that comfort you are just as likely to comfort others valuing that company.
  2. If you wait for the uncertainties to resolve themselves before you value a company, it is too late for a valuation. In the midst of crises or uncertainty, it is human nature to want to wait, until there is resolution, before committing to valuation or investing. It is precisely at the moment of crisis, though, that your valuation skill set will provide the biggest payoff, if employed. So, you should have been valuing banks in November 2008, Greek companies in 2009 and 2010 and emerging market companies earlier this year. Using a specific example, many global investors are holding back on investing in India, waiting for the election that is scheduled next year, making me more interested in valuing Indian companies today, and especially those that are more likely to be affected by the election results.
  3. If most investors contend that something cannot be valued, you should try to value it. As I noted in my last post, I think that the status quo (where young companies are not valued) suits both investors and traders, the former, because they can stay above the fray, attributing any profits to be made in in these companies to gambling, and the latter, because they feel no obligation to even pay lip service to fundamentals.
If you have found conventional valuation to be an extension of accounting and therefore boring (I am sorry! My biases are showing!), you should try valuing young, growth companies instead, to see how much fun it can be to connect stories to numbers and narratives to value. So, rather than value 3M or Coca Cola for the hundredth time, why not try valuing Tesla, Yelp or Pandora? And if in the process, you make some money, that is just icing on the cake, right?


Anonymous said...

As always, Professor, very interesting, and a view that I have some favour with.

I am reminded of the story by Joel Greenblatt, who got a grade A on his Shakespeare exams. He admitted not having a clue about Shakespeare. As it turned out, neither did anyone else; thus leading him to earn a high grade.

I think there is an extra angle on it, though. Misvaluations are of two sorts: undervaluations, and overvaluations. By refusing to value small growth companies, the "value" investor is saying tacitly that small loss-making companies tend to attract the traders (or "gamblers") who systemmatically overvalue them. IPOs are notorious for providing bad returns, for instance, so value investors eschew them on the basis that they're the wrong hole to fish in.

Of course, it's never that simple. There are plenty of companies that might be termed "defensive" which suddenly drop a clanger. Tesco - which is about as stable a company as you could hope for - saw its prices drop 20% in Jan 2012. So an investor is in kind of a dilemma with regards to defensives: he is often investing with limited upside, some downside, and the occasional black swan.

One stupendous short-term performer for me was when I invested in a "life assistance" business which was under investigation. There was some news which suggested that the company was not quite the gonner everyone thought it was. I reckoned that the market had essentially mispriced the odds, and was able to benefit accordingly. It certainly makes your head swim investing in these kind of events, though.

I think that investors might be able to develop their own special situations, trying to exploit certain systemmatic biases in the markets. One are that springs to mind, for example, is where there is some kind of debacle, and management institute some kind of independent external review. Investors will uniformly shun these kinds of situations, although from my limited experience, the findings are far far less severe than people worry about. So there's opportunity to buy on the certainty and sell when the dust has settled.


Anonymous said...


Would you relink your paper on the efficacy, or lack thereof, of value investing? I clicked, and it suggested that there was an error.


Gaurav Mehta said...

i would just say...excellent thoughts put together in a comprehensive manner.

If you are supposed to be making money in the market, one should be investing on bottoms or near bottoms when all investors/traders have given up on the market/stock and the underlying uncertainty at that point in time will be maximum, but the pay off on the up move greatest.

I have always believed that and have used that in investing. The example about India is extremely valid as a lot of people are holding back where as investors should have started valuing PSU Banks and other beaten down sectors ect for the last 3 months which is exactly what i have been doing for my clients and myself.

Valuation will only yield maximum results when uncertainty is at its peak or else you can buy mature high quality stocks for that 10 % move a year.

Gaurav Mehta said...

Also it would be interesting to see some of your Indian Valuations given that the last time i saw your valuations of

Tata Motors - valued at around 700 to 800 by you in 2010 before split (i didn't agree on your valuation as i believed JLR story would play out better than you expected at that point in time)...I have held this stock since 2009 at 260 pre split along with

Tata Steel - which you again valued around 800-900 (agreed with your valuation in fact i expected a higher valuation assuming the Corus acquisition would play out better) but that story played out badly and the stock went back to its 2009 levels of 200 currently at 384,... although my valuation still suggests higher levels given that steel down cycle may be finally ending with better Chinese data.

If you plan to value these companies would be interesting to see your valuation. Also if you could add a valuation set of Emerging Market Companies and those spread sheets can be put together as and when you value them will be great.

Apart from that thanks for all my finance that i have learnt from you even without attending NYU...just through your lectures and website over the last 5 yrs.

Anonymous said...

Great insights. Agree totally. I value biotech companies in early stages where there are greater zones of uncertainty and the price discovery mechanism is more tricky and there in lies the 'unrealised/uncertain' value. I guess this is the most fun part of valuation the challenge of finding value and waiting or convincing others to realise this.

... said...


Have you ever tested your valuation methods using Portfolio123 or something similar? I mean it's sort of like...instead of trying to be the greatest policeman you can possibly be, wouldn't it be better to build RoboCop if you have all the tools to do it?

-Eric Simpson

BGaates said...

Thank you professor. One of your best post. At least from my perspective. As an investor, I always struggled with the Graham school of investing and it's relation to mature companies. You just addressed all the issues bothering me - almost like writing directly to me. Thank you once again.

Anonymous said...

A very benign analysis. My addendum ( If I may use you jargon).the "invisible hand",is everywhere in Today's market.

As of India it is suicidal to project any serious Investment Prior of after the election. The "fundamentals" are just not there . India is lacking TRUST, sine qua non condition for any business venture.It is Simply an economy that needs to self collapse and start all over again.

Anonymous said...

Why don't you try to value Reliance Industries which you have never done before?

It is in an interesting phase - getting into uncertain sectors such as telecom and retail; hitting a low point on oil and gas; lots of excess cash - whether pay off on cash deployment in telecom and retail is wise or not.

Your analysis would be great; see if you can do it - especially, how you look at risk-free rate, ERP and country premiums for India at this stage and cost of capital specific to the firm in 5 businesses.

Anonymous said...

I am just putting in some contrary views - despite your great post.

Would appreciate your thoughts on the below particularly because I consider you as a value investor rather than a price seeker.

1) In case of - A young, money losing company in a stable macroeconomic environment – what you are actually doing is competing with price chasers not value seekers. This is because, in such cases as you correctly presumed value investors will not want to value and so they keep off, but speculators and traders will, again as you correctly presumed, will abandon value and try to set prices. In this scenario, where is the pay off for you who is attempting a value (which is not close to the fundamentals due to intelligent guesswork) and trying to be more correct than others? Your value is competing with traders’ price all the time. Until at least there is some basis for value, i.e. increased comfort in cash flows, valuation is not likely to be credible. The key point here is that neither value nor price is catching up with the fundamentals because the fundamentals keep changing by the quarter. In other words, although the model is alright in terms of integrity, the inputs are hardly comfortable since they are essentially a high-level guesswork.
2) Now in case of - A mature, money making company in an unpredictable macroeconomic environment – Here, there is basis for value because the fundamentals have not changed. The speculators and traders will still try to set prices ignoring value. Value investors will try to value and since sooner or later prices catch up with the fundamentals (and this is the key), they will be able to make money with relatively lower risk.
3) A mature, money making company in a stable macroeconomic environment – could also help make money for a value investor if there is a price-value mismatch which might be only occasional.
4) A young, money losing company in an unpredictable macroeconomic environment – is speculators’ paradise.


VKgujrati said...

Dear Sir,

I really like your thought process. We don't know each other still I consider you my professional Guru and Ideal.

You rightly said that about uncertainties. uncertainties always give chance to add quality business at bargained price. On the basis of your valuation approached I picked Indian companies like Bayer Crop Scince, Swaraj Engines, Page Industries, MRF, Oracle Finance, Sundaram Finance etc...... list is long...the best part with these companies that companies management does not interact so no broking or sell side analyst cover these companies. These companies has given 2x to 4x kind of return in last 2-3 years when overall market was under pressure. I am working as a Mid Cap research analyst in indian broking companies. I am very thankful for your support thru continuous knowledge sharing.

Anonymous said...

Dear Prof. Damodaran -

If you were offered to buy equity in a gold mine (not producing but with proved reserves) and the company was well capitalized i.e. didn't need any cash for two years or so and could sit out the current slump in gold prices, how would you value your offer price?

By using an option pricing model? If so, how would you come up with the right inputs for

1. Strike price
2. current underlying price (current price of the metal?)
3. life of the option
4. Variance (I assume this will be gold price variance?)
4. Risk free rate


Anonymous said...

Slightly off topic, but some day I would really like your opinion on bitcoin.

Moneycontrol said...

The annual headline inflation is expected to moderate to near 5 percent as there was reasonable price stability in some major commodities, the finance minister said on Thursday.
P. Chidambaram made the comment in a lecture at the National University of Singapore.
India's wholesale price index based headline inflation rose to an eight-month high in October at 7 percent, driven by costlier fuel and manufactured goods, raising the prospect of a fresh interest rate hike.

Unknown said...

Dear Professor,

In a young company that loses money, a lot boils down to the quality of the management team.

The team's experience, its ability to innovate and understand its market are critical factors. Governance appears to be critical as well.

Can these "soft" factors be captured in a quantitative model? It certainly appears challenging.

Aswath Damodaran said...

Soft factors have to be captured in the numbers. If not, all you have is the story telling and little more.

Anonymous said...

Good points, Professor. However, I thought the whole Grahamian argument of investment vs. speculation is to focus on quality assets and only buy when market is selling them at a discount. So yes, Graham leans toward valuing something that can be valued, but he does not recommend buying unless Mr. Market is offering them at a discount. Somehow, I think your posts did not underscore the latter point about Mr. Market's sloppiness in offering good things at a discount.

The recurring crises tells us forecasting anything is fool's errand. I am reminded of an example in Prof. Bruce Greenwald's book on value investing. He uses a DCF example where if your forecast for discount rate r or perpetual growth rate g is wrong by even 1% in either direction (in calculating terminal value), the resulting TV multiple will vary from 16x to 50x making such exercise next to meaningless in any valuation.

So yes, while one can try and predict future performance of young companies, I struggle to understand why such an exercise would be any different than gambling. There will be some wins, but that would be pure speculation as opposed to buying stronger companies with (what we hope is) temporary hiccups and resulting market overreaction.

ThinkBox said...

Hello Professor,

Is any of your valuation of a company in unpredictable macroeconomic environment available on your website or blogger? I would like to go through it from learning perspective. Also, can you please give example of companies which are more likely to be affected by election results? And, how do we factor in the uncertainty of election results into our forecasts? I would appreciate your answer to these as it will help me in learning.

Santosh Gupta

Jamie said...

The whole purpose of evaluation is to identify uncertainties and manage them to a comfort level. If there are no uncertainties in the first place there won't be a chance to purchase below valuation. As an Investor, we should also invest when the asset is below valuation.

Only by doing this can we make a consistent profit. I agree with you Professor that we must keep an eye and the search for values during a time of uncertainties.

ThinkBox said...

Janie, any example of your work on valuation during uncertain times? and, how did you model it?

Anonymous said...

OK.. But, can you please define an 'uncertain macroeconomic environment'. Like, are we in one right now? Were we in one in 2007? What about 2004? What about 1999?

Anonymous said...

I would like to hear the uncertainties of bitcoin.
Visit the free market

Anonymous said...

Dear Professor ! Can you please write an Article/Post on your version of Altman Z-Score. I will be thankful to you.

Thank you

Apprentice of Agamas said...

Dear Prof,

Stop fighting it. You know you want to opine on Bitcoin but you've held out too long. Lesser people and institutions are of course galloping away with their thoughts (Greenspan-->"bubble", BofA-->"major means of payment", etc)
Your audience eagerly awaits.... :)

*gets popcorn and mind ready for a good, nay a great analysis*

Anonymous said...

When you say you can value tell the value of $20 with absolute certainty, does that mean you really know the real value of $20 now? or you are just talking about the nominal values here? I think valuing cash is a pretty difficult exercise that depends on the future fed actions, US economy, unemployment, inflation, and trade with the rest of the world.

Anonymous said...

When you say you can value tell the value of $20 with absolute certainty, does that mean you really know the real value of $20 now? or you are just talking about the nominal values here? I think valuing cash is a pretty difficult exercise that depends on the future fed actions, US economy, unemployment, inflation, and trade with the rest of the world.

Anonymous said...

Volatility in market pricing is an interesting topic to me because of the recent Bitcoin phenomenon. This is potentially something that can dominate the culture, but has nothing backing it up. Yet it continues to generally rise in price.

In general, fairly valuing something is really hard. For instance one of the biggest IPOs in the last few years was from Facebook and they had to prop up the stock price even on day 1 to avoid embarassment. Facebook had everything going for them from mass public usage, big brands promoting their pages in their Super Bowl ads, lots of small brands listed at BuyLikesReviews that do nothing other than promote businesses, and a weak field of competitors and still had problems initially keeping their stock price high. If Facebook has some risk and uncertainty even given all of their advantages, you just know its hard to accurately price anything out.

Where there's uncertainty, there's a gamble, but its where people can use their skills, knowledge, intuition, and judgement to take a leap.

Aki Suomela said...

These are the points small businesses should look at to not lose everything they've worked hard for over the years just because of one misfortune.

Anonymous said...

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EnlightenedBanker said...

Dear Professor/Aswath(do you have a preference? I recall in one of your lectures, you said you hated being called 'Professor!').
Back on topic – in your post you had said that “The real lesson that I get from reading Graham’s writings is that value is determined by fundamentals and that markets sometimes misread or ignore those fundamentals. My addendum is that investors are more likely to misread and/or ignore fundamentals, when they are faced with large uncertainties than with small ones.”

I’m trying to get an understanding of this statement (and the post in general). Is this accurate?

(1) General Hypothesis on what determines “value” and “price”:

1(a) Value is determined by fundamentals (whether you are a young, growth company or a mature company with predictable cash flows)

1(b) Markets sometimes misread or ignore fundamentals leading to valuation errors which cause price to deviate from underlying value

1(b.1) Valuation errors can include:

1(b.1.1) Error 1: general reluctance to engage in valuation based on fundamentals [this is the focus of this post];

1(b.1.2) Error 2: assumptions/projections that deviate from fundamentals (i.e. unrealistic growth assumptions that come out of “nowhere”, overly pessimistic views of company future, etc.) [not necessarily the main focus of this post];

1(b.1.3) others errors??

(2) “Uncertainty” is, but one, trigger for markets misreading/ignoring fundamentals (are there others?)

2(a) Markets are more likely to misread and/or ignore fundamentals when faced with uncertainties.

2(b) Uncertainties exist in both young, growth companies and established companies with predictable cash flows.

2(c) Defining “uncertainties”:

2(c.1) With respect to young, growth companies – uncertainties stem from the difficulty in making future estimates (i.e. due to lack of information and operational history), and therefore the valuation exercise itself.

2(c.2) With respect to established companies with predictable cash flow – uncertainties are less likely to stem from the valuation exercise itself, but rather, misreading/ignoring fundamentals when faced with some kind of crisis that is specific to the company (i.e. American Express salad oil scandal, maybe even Lululemon this year?)

2(c.3) With respect to both established and growth companies – uncertainties also arise from macroeconomic factors and large-scale crises (i.e. financial crisis in 2008).

(3) Uncertainties can lead to Error 1, defined above (and Error 2 as a by-product) – which creates opportunity

3(a) Error 1: With respect to all of the above mentioned uncertainties, investors will have a general reluctance to value companies based on fundamental analysis. Instead, they turn to whacky valuation metrics, waiting for uncertainties to resolve themselves, momentum trading, “gut-checks”, and blindly listening to management/analyst projections when determining market “value”.

3(b) Error 2: Because investors deviate from fundamental analysis when determining price, Error 2 will likely be built into their valuation as well. However, the assumptions themselves are not the cause of mis-valuation (they are by-product of error 1).

3(c) Based on this, “differential advantage” comes from valuing companies in “high uncertainty” situations, because others have given up on trying to value based on fundamental analysis, which leads to price deviating from underlying value.


Your insights would be greatly appreciated as I’m trying to trace the logic throughout.

Apologies in advance for the extremely lengthy post.

Moneycontrol said...

The Indian stock market has slipped into the red after opening notably higher this morning. Profit taking after Wednesday's gains and a weak rupee have dragged down stock prices.Bank, capital goods and oil stocks are trading lower.

Aki Suomela said...

One way to look at it also is by preparing for uncertainty because you value your company.

Apprentice of Agamas said...
This comment has been removed by the author.
Apprentice of Agamas said...

Prof, what would you propose about a certain viewpoint that calculating free cash flow (for use in valuation via dcf) is perverse because cash from operations minus cash investment is used.
The implication being, the investment a company does reduces free cash flow (and thus would affect the valuation negatively) whereas liquidation would increase free cash flow (and thus positively impact valuation)?

Anonymous said...

I enjoyed your last two articles sir, I will re-read them many times.

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Investors will uniformly shun these kinds of situations, although from my limited experience, the findings are far far less severe than people worry about. So there's opportunity to buy on the certainty and sell when the dust has settled.

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