The World's Foremost Expert Explains How To Value Stock

I always thought that that what you said before kind of goes without saying because comes through all of our conversations that this is my favorite half an hour of the week. Because of course that's true. But you know what I'm saying, Like last week we're like we talked to a currency trader, or like how do you pick what currencies to buy ourselves? It's just like just the really basic stuff. Yeah, it's like a remedial course for people who are in the market to day in and

day out. But it kind of gives us a chance to step back from the stuff that we take for granted, I guess, and actually dig into what exactly it is that we're talking about. It's kind of funny because I kind of like to think we're having a sophisticated conversation here, and yet you just described this as a remedial course. Sorry. Sorry, I think that's fair. I think like I think we can do both. Yeah, I think so. So okay, so what basic pillar of markets or finance are we going

to learn about today? So today we're going to go to like the heart of investing, sort of the simplest, most basic thing that people will think about when they think about what investing is, and that is thinking about

what stocks are worth. Now, Okay, so I guess this is kind of a simple topic, but it's definitely a really timely one because I'm pretty sure I just saw a headline go by about a record number of investors who think stocks are overvalued in the US market, And of course, the notion of things being overvalued, not just stocks, that's a pretty prominent theme in markets right now. It

absolutely is. And of course, you know a few weeks ago that we had another episode with a pair of accounting professors talking about new ideas and stock market valuation. But like I think, when people learn about investing, they think about Warren Buffett, and they think about Benjamin Graham and dot and security analysis and reading income statements and just like trying to put a number on the stock and then looking the stock and saying, well should it

go up or down from here? And that's simple. That simplicity there is, you know, just incredibly important thing. But we don't. But how do you do it? I don't, you know. I don't think most people really know how to even go about the process. No. I guess we throw around words like pe ratios and forward earnings and things like that. But let's dig into it a little bit more. So, who do we have so we have

the best possible guest for the subject. He is considered to be the foremost expert on the subject of valuing stocks. He is Oswath Damodarin, a professor at the Stern School of Business at New York University. He teaches about the topics of corporate finance and equity valuation. He runs a great blog where he discusses how he values certain companies. He's come on TV on Bloomberg TV several times to discuss it. So Professor Damodarin, thank you very much for

joining the Odd Loaves podcast. Thank you, Joe. I Before I start, I'm going to bash a few few groups that I always start to bash with. Soles. Don't ask the contents about value. I mean, I think it's the wrong group to ask, because realistically, I think accountants that the job to do invaluation is not one of those jobs. Second, anybody tells you there's something new, evaluation is lying. Everything invaluation is old and tested. Now it's all old wine in a new bottle. Third, and I think this is

this will set the table for the entire discussion. Value and price are two different things. You can either value a stock or you can price the stock. Tracy mentioned price earnings ratios and forward earnings. That's a classic analyst technique. It's for pricing a stock. And here's the contrast. The price of the stock is determined by demand and supply, mood and momentum. And so when you use price earnings ratios and comparable firms and future earnings, you're pricing a company.

To value a company, you've got to go back to basics. The value of company is built on three pillars. It's cash flows, it's growth, and its risk. We can dance around those three as much as we want, But those are the three driving forces that drive the value of a company. I love that how you just came out swinging at the top of our podcast. I think that's a very auspicious start. Start by bashing two of our previous guests. Start by bashing some of the way we

talked about this. So now I'm very exciting about the conversation. So let's get right into it. When we talk about valuing a stock, how do you begin? You know, what do you tell your students on day one of classes about what they need to understand about this process. I take them back about seventy years and I talked about people buying stock seventy years ago, bought them for a

cash for the cash flow is the dividend. Companies were mature companies, They paid out what they could afford to individends, and you essentially said, what I'm paying for stock is the present value of those dividends. That present value term might sound like a fancy tumb but what he's saying is dividends in the future have to be brought back to the president. To bring them back to the president, you've got a factor in two things. One is what can I make elsewhere with my money? Now what what

our interest rates at? Where can I invest money? And the other is how much risk is there in that dividend. In a sense, it's good to start with a very simple dividend discount model because it it mores your entire analysis. It says, let's not get fancy. Ultimately, you buy stocks for the cash flow, and if the only cash flow you're going to get as a dividend, what you pay for a stock is the present value of those dividends.

So think of that as the Ben Graham, the old value investing ideology would says, buy stocks with big and stable dividends, they're worth more than stocks that don't pay dividends. Do you think that purpose is still relevant, because nowadays, you know, the notion of buying stocks for dividends for a lot of people is going to sound almost coint like a lot of people are buying stocks just to see the appreciation in value in the market and then just sell them onwards at a later day. Three things

have changed. One is, in the nineteen thirties, nineteen forties, even into the nineteen fifties, when you look at companies that were listed in the stock market, they tended to be mature companies. If you're a growth company, you stayed private and you were funded by venture capitalists, still very late in the process. The second is companies that had excess cash flows, cash flows that they did not have

used for paid them out as dividends. There were no stock buybacks, so essentially dividends were the only way game in town. And the third investors in a sense, we're buying stocks for the long term. They were buying stocks to hold them for the next ten, fifteen, twenty five years. In fact, many of them have had no had no intention of even selling these stocks. They were holding them for the dividends. The world has changed today. Look at the market and you look at the top ten stocks,

maybe seven eight are growth companies, not mature companies. And in fact, many companies are entering the market at stages they would never even have thought about entering the market even twenty five years ago. You take a couple like Snap, it's a startup. Pretty much it will been a company that will been invested in by venture capitalists for another five or six years before it was ready for the market.

So the composition of the market has changed. So if you're trying to value a company like Facebook with dividends. Here's the problem'm gonna run into. The first is the company, even if it can afford to pay dividends, doesn't pay dividends. It accumulates the cash. Second, when it does decide to return to cash, it turn cash in the form of stock buy backs. So increasingly what we've had to move away from is not that we still want to you know, we still want cash flows, but the way we're getting

the cash flows now are different. They take the form of buy backs more often than dividends, and you might have to wait to get your cash flows if you're buying a young growth company. So it's not that the focus of what we're doing changes, but the kinds of markets and companies were trying to value has become very different. So, you know, obviously in the beginning you said, anyone who tells you that there's something new in the world invaluation

is lying. But of course, as you've just said, the nature of the companies has changed such that you know, strict dividend and LSS or even strict buy back analysis isn't going to be the right frame because they're not

in that business right now. Is the idea then that you sort of reject forward what they could theoretically pay back in dividends or could theoretically do in buy backs or sort of how do you take this sort of Graham and Dot approach that everybody knows and apply it to a Facebook or a Snap you nailed down valuation. That's exactly what you do. Instead of taking the actual dividends, you try to estimate potential dividends. Sounds fancy, but if you run a business, think of the cash that you

can take out of the business. The cash left over after you've met every conceivable need, which includes what you put in for future growth and you pay taxes. If there's any cash left in the till and you're the business owner, you can take it out of the business. That is your potential dividend. And it's easy to estimate that for a company because if you look at the statement of cash flows for a company, they tell you what they're putting back into the business. They tell you

what they're using to make debt payments. So you can actually take a Facebook and estimate how much they could have paid in dividends last year. The that then becomes your basis. So It's essentially what we're doing is instead of using the actual dividends to value the stock, we're using potential dividends. That's really the innovation of the last seven years, if we can even call it that, because

the rest of the process stays the same. You make it sound really easy, but you know, estimating um future cash flow versus cash needs, there are all sorts of things that must go into that forecast, right, So for for instance, do you attempt to assign probabilities to certain scenarios. Do you worry about one off, you know, sort of tail risk events. What are you actually looking at when you do that? The first thing to do in valuation

is to adopt what I call the karmic post. The karmic post is basically, there are lots of things you don't control, so stop worrying about them. You're valuing an oil company. The oil press could change tomorrow. You could have a crisis in the Middle East. Those are things you You can worry about them, but there's nothing you

can do about them. What you have to do is take the information you have and make your best estimates, and sometimes that requires using statistics, probabity distributions, you're having a bio technology company with a blockbuster drug working its way through the pipeline. You might not like to do it, but you have to assess a probability that that drug will make it through the pipeline. The process is easy,

but estimation can be difficult for some companies. You asked me to value Snap, I'm making judgments based on very little historical data. And that's really the big difference when you have to value growth companies. It's not that the process is different, but we have a fewer crutches because when you have a lot of historical data that you can project off, you feel better. Even if you if that that that is completely misplaced, you just feel more comfortable.

What you have is an absence of comfort. And for people valuing, especially the kinds of companies that are increasingly entering the market, you've got learned to live with being uncomfortable with making a as and it's in being hopelessly wrong and saying, you know what, that wasn't my fault.

It really wasn't your fault. If you did not forecast cloud computing coming coming out of nowhere and essentially becoming a big part of Amazon's business, you can only estimate what you can, and then when you're done, you've got to step back and say, I've done what I can. I valued the company. I could be very wrong, but

this is my best estimate of value. You know, in addition to the fact that you don't have a lot of historical data on these companies we live, it feels like we live in an age of novel business models. So I imagine that if you sort of value you know, if we were in the nineteen eighties and you wanted to value shares of the New York Times, that the business model of the New York Times was not that different from the business model of newspapers, you know, going

back for decades before that. But you know, take a look at Snap today. You know you could is this a media company? Is a tech company? Is it a camera company? Is an apps company? You know, it seems how does that? Is it true that you're coming across more business models that don't have good historical analogs, And if so, how does that complicate the task of valuing a company. I'll give you an example of what I think is shift the most in business as I see it,

when I look at companies like Facebook, and snap. What I see on what I called user based models, which is if you look at what they boast about the most is the number of users, the number of subscribers. I mean, take a look at Netflix's last annual report and look at how much they emphasize the number of subscribers going up. We've increasingly shifted from a top down approach where companies boast about their overall revenues growing, to a bottom up approach where they boast about how many

customers users they have. And it's not just new companies. If you look at Microsoft in Adobe, the way they used to grow ten years ago, twenty years ago is they used to update their software and try to sell them more. Today, look at Microsoft Adobe, their crown jewels are actually their subscription based models. Offers three sixty Microsoft and Creative crowd for Adobe. Adobe, in fact doesn't even

sell it software in regular channels anymore. So increasingly I've tried to think about what the value of a user is, value of a subscriber, and you know what, the basics of valuations still work. Tomorrow. Actually, I'm going to deliver the keynote speech at the c f A conference where

I'm going to value a noble user. I'm going to value an Amazon Prime member, and I'm going to value Netflix subscriber because to me, that's become the way I think about the values of the companies is they essentially are trying to pump up their values of users, subscribers, members, and that then multiplies by a hundred million, in the case of Facebook one point seven billion, You've got these

astronomically high values. So to me, that is that's one thing that shifted in the way I think about companies because rather than start with revenues and work down to cash flows the way I've always approached valuation with these companies have increasingly started thinking about those unit based valuations. And here's the problem. Right into the information you need to value a user is not being made available to us by the companies that boast about how many users

they have if I were writing information disclosure laws. This is something that I think needs to be fixed as these companies increasingly shift to user based models. So I'd like to know what the renewal rates are, and much more specificity than they reveal it now. I'd like to know what the distribution is of revenues across users to ten percent of ooper users account for ninety percent of its revenues. That's the kind of information that companies have

that they're not sharing with us. And if they're going to ask us to invest in them because they have tens of millions of users, it's their obligation, I think, and to provide the information that will allow us to value them better. But I have a potentially slightly weird question. But we're talking about a lot of high growth stocks, which you could also call story stocks, right, Like if you buy in to Tesla or Uber, you buy into this idea that both those companies are going to be

revolutionary in various ways for the transport industry. When you attempt to value a company nowadays, do you give any credence to that sort of narrative? Do you buy into some of that hype um and you know, some of that hype It sounds silly, but we do see that reflected, you know, in intangible assets like brand value and things

like that. So I'm just curious if you factor any of that in every valuation tells a story, right, I mean, any analysts who puts up a spreadsheet and says, this is my value for a company whether he likes it or not, is actually telling a story about a company. I'm a firm leaver that every good valuation is a story behind it. The question you're asking is a different one. Does that story you have to be the story that manages in the company of pushing for the company, And

the answer is absolutely not. If you're an investor, you have to take ownership of your own story, which means you can listen to Elon Musk. You can admire Elon Musk, you can listen to his story about Tesla, but if you're valuing Tesla, you better have your own story about Tesla. So that's true every there is, These are stories, talks, but ultimately every company is a story. The g story is just a horror story right now. So basically, some

stories are fun stories, some stories are uplifting stories. Some stories are not so in a sense, sometimes you have to look at the story, but then you've got to make that story your own and then convert that story into numbers and valuation. In fact, that's my latest book.

It's called Narrative and Numbers, about how to both connect storage to numbers and how to detect when a story is not going to hold up because I see a lot of impossible stories being told, sometimes by CEOs of companies, are implausible stories, and my job is to say that's not going to work, that violates the laws of economics, and then adapt the story to make it my story

and my valuation. I love that. I want to get to like a little speed round where we talk about some of these stories and Tesla and g E and Uber real quickly. But before we do, I have one last question, just sort of on a framework. At the very beginning, you talked about the importance of distinguishing between valuation and price, and price being a function of supply and demand. So how do you then as an investor, because ultimately what people want to do is pick stocks

that are going to make them money. How do you sort of once you establish the valuation, then think about entering the market given various pricing factors. So first you've got to decide whether you want to be an investor or a trader. And this is my distinction. Investors buy stocks for less than the value that they adact to the stocks, and then they hope and pray that the

price suggests to value. So investing requires faith, faith in your own valuation and faith that markets will correct that value. And you know what, most people don't have faith. And if you don't have faith, you can try to be an investor, but you're not going to hang in there. You're going to give up. So I tell people be realistic. If you have no faith in value, even though you might know how to mechanically how to value a company, you're not going to be able to invest. You're going

to be a trader. And you're going to be a trader, might as well be honest about the fact that in trading, the game is to buy the low price sell at a high price. Why the price goes up is none of your business. You really don't even care. It's not an intellectual exercise. It's a money making exerciss So the first decision you've got to make is do you have enough faith to be an investor. If you do have faith,

then here's what you need to do. Need to value companies and hopefully the value is higher than the price. And then you have to look for a catalyst, something that will cause the price to move to value. Because you can be right about value and go bankrupt being right.

I mean, you've got the old saying the market can be rational longer than you can be liquid, so in a sense or solving, so, I think you have to when you look, when you look at an undervalued company, a company with the price is less than value, looking for some kind of catalyst. That catalyst might be a management changed, It might be an activist investor stepping in. It might be it might even be there, you know, it might even be something small, a competitor trying to

essentially take over the company. But you're trying to look for something that will caused the market to shake up. Because there is nothing that shakes up the market. Nothing's going to change, and that effectively is one of the most frustrating things about being an investor is you can value a company, feel very convinced that you've got the right value, and see the price go in the opposite direction, not just for days, not just for weeks, but for years.

And you've got to be okay with it. You've got to be if you get frustrated and you get angry about the fact that the market is not doing the right thing, then you set yourself up to do really stupid things. Okay, okay, speed round. Let's start with shall we do g E because this kind of gets some of the shake up stuff that you're talking about. So when you see a sharp repricing in the company's um market value, what you think, Well, the first thing I

think is the story change. Sometimes the repricing comes about because people were buying into an unrealistic story before and some things kicked them in the face saying that story is not going to happen. The classic example is you buy a stock with with with with what you think is a high growth three. You give it a price on its ratio of thirty five. The learnings report comes out with the revenues are flat, and the company comes up with all kinds of excuses, but it's very clear

that revenues and not growing. That's the world kicking you in the face. Thing you thought about a growth stop now readthing. So the first thing that happens we reprice thing is the story could have changed. The story changes, then your value has to change. So it's not that the market is making a mistake before, is that that

the value is reflecting a different story. The second is when you have a pure pricing stock and there are lots of companies there where there are no investors in that market, it's all traders buying and selling from each other. It's based on mood and momentum, and momentum and mood can shift in a moment. Look at how quickly bitcoin goes from being you know seven, now everything is great to everything's awful. That's the nature of pure pricing stocks.

And there are some stocks out that there are pure pricing stocks. As a value investors, an investor cares about value, I avoid those stocks like the Play because things happen on those docks, and there's really no good reason why it happens. Is the mood shifted. So sometimes we try to attach really strong economic reasons to things, but use there are no good reasons, and sometimes it's better to look and said, thank god, I wasn't in that stock when that happened. So Tracy asked about Ge, So what

is your thirty second take on what on the story there? Well? Gee, as a problem, it's an old I mean, this is one of my favorite devices in my classes is to call it is to talk about what's called the corporate life cycle, the corporate life cycle of startups that became teenage companies think oh, but then growth companies the peak of your life and become mature companies, and then you go into decline. G has been a company and decline now for fifteen years. The prompt GY is it's an

old company with lots of old businesses. There is no good story you can tell that will allow you to come out of this as a growth company. The best they can hope for is that they don't become decrepit. So in a sense, I would not envy the top management of Genie right now. They're trying to get rid of old businesses which others are not going to pay a high price for. They're trying to kind of set up investors to accept the fact that this is the way it's going to be, that things are not going

to change. So they're doing the right thing in a sense by being open about it. But that doesn't mean it's going to be any less painful. Now. Growing old is hard to do, and watching G you realize how how difficult it is for a company that was an American institution to accept that, you know what, the best days away behind them, and now it's a question of winding down. I mean I only half jokingly say that you know the right CEO for a company depends on

where it is in the life cycle. If you're a startup, it's got to be Steve the visionary who's running you. But if you're a declining company, you need Larry the liquidator. So maybe Danny DeVito might want to come and play one last role here, g very bleak. All right, real quickly. Tesla one of the most controversial stocks in the world right now, how do you think about that one? You know what I said? I remember I said that every company is driven by the story that that you see

in the company. The promin test lavel is you know, Musk. The advantage in Tesla is Elon Muks, this guy. I mean when companies wish for a visionary CEO, their visions of Elon Musk, because this guy is not just visionary, he's over visionary. And what I mean by that is every day he wakes up with a bigger vision. And sometimes you've got to stop and say, you know, slow down now. I think that my real Concernaty is not

that they're not I think they're an incredible company. And if you've talked to anybody with a Tesla, you know that they love their cards. Then this is this is a company that as super oil customers. My problem Tesla is that they have a supply chain problem. They have a problem of execution. They've always had an execution problems. You can go back and look at every quarters earnings announcements of Tesla and the court and it's almost like

reading the same script over and over again. Promised to deliver forty cards, deliver thirty two, promised to deliver a sixty deliver at But as long as they were a small company with lots of potential, people overlooked that execution problem. I think we're approaching a serious moment for Tesla now because the middle I think with June of two thousand and eighteen, they've promised to deliver about half a million Tesla threes. This is a big moment and they need

to get their execution done. And my concern is that that this is a problem from the top down. It's not an execution problem, that's just the factory floor. It comes from the fact that Elon Musk is not that interested in supply chains and inventory and assembly lines. He's much more interested in making a big vision and telling a story. What he what he needs is what Steve Jobs had in his second round as a visionary CEO. The first round he almost destroyed Apple. In his second round,

he had Tim Cook at his side. What Elon Musk needs is his own Tim Cook, a chief operating officer who makes the trains round on time, who gets the supply chain going. Because I think of tests, I can get its execution problems behind it. I think I I don't have a problem with the value that's attached the company, but with those execution problems, I wouldn't pay the price that they're paying for Tesla right now. Okay, this is the important one. The entire stock market. Is it over

valued given where risk free rates are right now? No, I didn't think it's over value. But you're one leg of that table falling off before the whole thing collapses. So earnings protest to stay high, the tax reform package has to pass, and interest rates have to still stay low. And if you can keep that that trifecta going, then I don't see this market as being overvalued. As walked Alma, darn fascinating conversation. I absolutely loved it. Really appreciate you

coming on. We could talk forever, but that was great. Thanks for joining the out launched podcast. Thank you so, Tracy. I really enjoyed that one. I think I've mentioned on a few episodes in the past. Um, you know that when I first got into finance that it was actually kind of this stuff looking at stocks by side research on equities, And it's kind of nice just that someone makes the case that, you know what you have, the economy is changing. Yeah, there's all this stuff, but the

old ideas basically still apply. You just have to think about how to correctly use them. Yeah, it is nice to see that bit of continuity. But I have to say I kind of I wish we could have done the speed round for another sixty minutes or something, because I just wanted to throw out all these companies, you know, not just Tesla, but he could have done Bitcoin, uber, Amazon.

I would love to know his opinion on something like Saudi Aramco, which is kind of an old company but it's new in the sense that it's coming to the market for the first time and we don't have a lot of historical data about it. I just I love to see his ideas actually translated to real life examples. Racy, you should have him on your show on Bloomberg TV. For a Saudia Aroundcode blog. Oh, we totally should. I'm glad you thought of that because I would very much

like to see that that that segment. Yeah. That. In the meantime, I recommend if you're curious about Oswald stuff, you should check out his blog Oswave Domadaran dot blogspot dot com. Just a great resource where he really dives deep into this stuff and really shows his work on all these companies that you mentioned, Amazon, test Uber, all this coin, Bitcoin. His latest post is even about bitcoin, So great stuff there. All right, son, we leave it there,

Let's leave it there. This has been another edition of the Thoughts Podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway, and I'm Joe Wisn't Thought. You can follow me on Twitter at the Stalwart. And you can follow Oswath on Twitter at Aswath Damodarin And you should definitely check out his blog Musings on Markets, And don't forget to follow our producer, Sarah Patterson at Sarah patt with Two Teas. Thanks for listening.