Premium Value Investing NewsletterDownload Free Issue

2 Bitter Truths of Stock Valuation…and How You Can Avoid Them

If you have been a reader of security analysis and business valuations, you must have heard about or read Aswath Damodaran.

Damodaran is a Professor of Finance at the Stern School of Business at New York University, where he teaches corporate finance and equity valuation. He is widely quoted on the subject of valuation, with “a great reputation as a teacher and authority”.

In other words, Damodaran is to business valuations what Peter Drucker was to business strategy.

I recently picked up his Little Book of Valuation. The first chapter reiterates an important fact about “value” – that it’s more than a number, and that understanding it well is a way to stay ahead of the pack.

I’ve met a lot of investors over the years who’ve been good students of businesses, but when it came to valuations, they argued that value lies in the eyes of the beholder…and that any price can be justified if there are other investors who perceive an investment to be worth that amount.

This is obviously absurd. But then this is the way valuations are treated – with the aim of looking for a bigger fool who will pay a higher value in the future!

Surprisingly, not just unqualified investors, this is also the way the smart and qualified analysts set targets on the stocks they recommend – that they will be able to find people who will get fooled by the glamorous returns the recommended stock promises by way of its target price.

Anyways, the idea of this post is not to discuss the authenticity of stock market analysts and their valuation skills. Instead, the core idea of this post is to share with you what Damodaran writes in his book on some truths about valuations.

The reason I call these as bitter truths is because these are something that we as investors rarely realize in our busyness of calculating a stock’s intrinsic value. More importantly, knowing these truths can keep us grounded and not get obsessed about the numbers that our valuation models throw up.

So what are these truths?

1. All Valuations are Biased
However hard we try to remove biases – those leaks in our brains – we are prone to fall in love with our ideas. A leading theory of romantic love is that it functions to make one feel committed to one’s beloved, as well as to signal this commitment to the beloved.

Stock analysis is no different. We first like an idea (a business), and only then we study it deeper. Then, once we start to like what we study of the business, the likeness turns to our love for the stock. And before we could know it, we are committed to it. This commitment creates a bias when we are working on estimating the stock’s intrinsic value.

“How could the intrinsic value be so low as compared to the current price?” I would tend to ask myself on finding that a “company I’ve started loving” is selling expensive in the stock market.

The next reaction is – “Let me raise the free cash flow growth rate a bit and then see. Ah! Instead of 8%, if I assume a growth of 12%, then the intrinsic value is almost around the current stock price.”

And then – “If this company has grown its FCF at 15% over the past 10 years, a 12% growth over the next 10 years isn’t impossible. So let me keep it at 12%.”

Notice the love getting deeper…and deeper.

As Damodaran writes…

The inputs that you use in the valuation will reflect your optimistic or pessimistic bent; thus, you are more likely to use higher growth rates and see less risk in companies that you are predisposed to like.

What he writes after this is comical…

There is also “post-valuation garnishing”, where you increase your estimated value by adding premiums for the good stuff (synergy, control, and management quality)…

There you are! In taking care of all the other biases in the world – confirmation, anchoring, herding, vividness etc. – you forget to remove the “I love this company” bias, and this shows in your valuations for the stock.

So how can you remove this bias, if at all? Damodaran suggests putting all your thoughts on the company on paper even before you start calculating its intrinsic value.

In addition, he suggests you to confine your background research on the company to “information sources” i.e., company’s financial statements, rather than “opinion sources” i.e., equity research reports about the company.

Damodaran concludes…

As a general rule, the more bias there is in the process, the less weight you should attach to the valuation judgment.

Just consider the moat stories surrounding a lot of stocks these days. It’s easy for an investor to fall in love with such stories. Now, while the only reason to fall in love with such stocks for most investors is their rising stock prices, it is garbed under the veil of stuff like – great management, good business, wonderful growth prospects, etc. etc. (which may also be true, but not truer than the beautiful stock price chart). 🙂

2. Most Valuations are Wrong
Now this can be shocking to you if you spend a lot of time arriving at that magical number (intrinsic value) that helps you ascertain whether you must buy a stock or not.

Damodaran talks about three kinds of errors that cause most valuations – even the ones meticulously calculated – to go wrong:

  1. Estimation error…that occurs while converting raw information into forecasts.
  2. Firm-specific uncertainty…as the firm may do much better or worse than you expected it to perform, resulting in earnings and cash flows to be quite different from your estimates.
  3. Macro uncertainty…which can be a result of drastic shifts in the macro-economic conditions that can also impact your company.

The year 2008 is one classic example when most valuations – even the good ones – went horribly wrong owing to the last two factors – firm-specific and macro uncertainties.

As I remember now, my careful 2007 valuations, for instance, of stocks like GE Shipping, NTPC, and Crompton Greaves, look hopelessly optimistic, in hindsight, simply because I underestimated the damage brought about by the 2008 crisis.

As Damodaran writes…

While precision is a good measure of process in mathematics or physics, it is a poor measure of quality in valuation.

So, To Value or Not Value?
Knowing that your valuation could be wrong (and in most cases, it would be) despite any kind of precision you employ in your calculations, it should not lead you to a refusal to value a business at all.

This makes no sense, since everyone else looking at the business faces the same uncertainty.

Instead what you must do to increase the probability of getting your valuations reasonably (not perfectly) right is…

  1. Stay within your circle of competence and study businesses you understand. Simply exclude everything that you can’t understand in 30 minutes.
  2. Write down your initial view on the business – what you like and not like about it – even before you start your analysis. This should help you in dealing with the “I love this company” bias.
  3. Run your analysis through your investment checklist. A checklist saves life…during surgery and in investing.
  4. Avoid analysis paralysis. If you are looking for a lot of reasons to support your argument for the company, you are anyways suffering from the bias mentioned above.
  5. Estimate intrinsic values using simple models, and avoid using too many input variables. In fact, use the simplest model that you can while valuing a stock. If you can value a stock with three inputs, don’t use five. Remember, less is more.
  6. Use the most important concept in value investing – ‘margin of safety’. Without this, any valuation calculation you perform will be useless.

At the end of it, Damodaran writes…

Will you be wrong sometimes? Of course, but so will everyone else. Success in investing comes not from being right but from being wrong less often than everyone else.

So don’t justify the purchase of a company just because it fits your valuation. Don’t fool yourself into believing that every cheap stock will yield good returns. A bad company is a bad investment no matter what price it is.

I love how Charlie Munger explains that – “a piece of turd in a bowl of raisins is still a piece of turd”…and…“there is no greater fool than yourself, and you are the easiest person to fool.”

So, get going on valuing stocks…but when you find that the business is bad, exercise your options. Not a call or a put option, but a “No” option. 🙂

Print Friendly
About the Author

Vishal Khandelwal is the founder of Safal Niveshak. He works with small investors to help them become smart and independent in their stock market investing decisions. He is a SEBI registered Research Analyst. Connect with Vishal on Twitter.

Comments

  1. karthik says:

    A Good morning lesson vishal.. Seems mee to suffering from the bias on infosys ….. but iam finding a good number like me in the forums.. but i have not yet taken a call…

  2. sanjeevbhatia says:

    Great Perspective.

    Bias is quit visible at all times, especially if you have spent quite some time over it. Fortunately, learnt and still learning to be objective at all times. Its almost like what they say in meditation – “Let the thoughts come, observe your thoughts as if you are somebody else. In essence, be outside your body mentally”. I don’t know if I am able to convey exactly what I mean, but being aloof really helps.

    Understanding ones biases and trying to be as objective as possible is probably the first and foremost step to get your valuations right.

    • Your meditation analogy is very appropriate not just to investing but to life and situations well.

    • Thanks for the analogy Sanjeev! Indeed it is this aloofness that has made people like Buffett and Munger as great investors. First they always listen to their inner voice, especially the one coming from the gut, and then they also stay far away from places where the nose decibel levels are the highest (like NY in US and Mumbai in India). Sometimes I think that staying away from this financial centre can help you think more rationally…thus cutting out certain biases straightaway.

  3. sanjeevbhatia says:

    Number of instances where despite my “Love” with the company, didnot buy as was not comfortable with valuation of stock as well as broader direction of market. BHEL (we have spent a great deal of time over it, got a full post on me for this, thanks for the dubious honour Vishal :D), Thermax, Symphony, Clariant (which was covered later in Stock Talk) etc.

    Thanks

  4. Reni George says:

    Good Morning Vishal
    As i have said in the forum and here also in previous post,biases are natural to be crept in,we always love what we have.Regarding Infosys in the forum,that’s why i started with let us first put out all the negative aspects that can hamper the company’s growth.As per your last sentence that have you ever not purchased a stock that you loved,but desisted due to valuation parameters.There are many, the first and the foremost that comes to my mind is Educomp,i loved their idea of smart class,the love would have due to a factor that i used to teach children from class 1 to 10,and somewhere down the line,i found the decades old teaching style not up to the mark.But i desisted,firstly the market was at an absurd level at that time and everyone was thinking of Educomp,as a game changing company and it had become too hot to handle.The other thing that i disliked about the company was the billing structure and the contract structure with the schools that it operated,as i had good contacts in nearly all the good schools of baroda,i came to know that the charges for the basic smartclass was different for all the schools, that means somewhere down the line, they were conniving with some management guys of the schools,to operated their product.So I thought let me wait for some time and let more data come onto the forefront.Maybe that decision to postpone the purchase,turned out to be a blessing in disguise, the market crashed and then all negatives of Educomp started coming out,now its a full no for EDUCOMP.But i had my share of love also,Kesoram Industries, i check out all the data and fell in love,but i don’t believe in love per Se,so i committed myself to just 10 % of buy,that i intended to do and that was at a price of 365,which was the intrinsic value calculated by me at that time,look right now where it is,but i accumulated little bit more also,because now in that period of three years since my last purchase,i valued all the negatives also.So the Moral is when in love,do not commit yourself,let some time pass through.

    Thanks and Regards
    Happ Investing
    Reni George

    • Thanks for your inputs on Educomp, Reni! Well, the moral – “When in love, do not commit yourself, let some time pass through” goes against the very grain of how we humans behave. In most cases, just togetherness brings commitment, and love happens much later 🙂

      So we need to be extra careful in handling this bias. Thanks anyways for sharing your experience.

  5. I met a batchmate of mine after many years, who narrated what a experienced old time investor in the stock market mentioned to him ‘those who need money for education or marriage or buying a house, are the ones who make money in the share bazaar”.
    The lesson is if you have a defined objective and it is met, exit.
    The improbables are just too many. Apply all learnings, controls but remember to exit as well.

    • sanjeevbhatia says:

      That is true to some extent Sudhir. That is what we imply by Financial Goal Setting, be it your child’s marriage, you house, vehicle, vacation etc. The problem is, you can’t have a well defined goal in terms of duration and quantum every time. Take Retirement corpus, for example. Since it is too long a duration, there are too many improbables as you have pointed out and at the end of the day, you can’t really be sure if the corpus will suffice for your sunset years or not as even life expectancy can’t be specified exactly. If it is well defined objective, yes – you can and should exit but otherwise you just have to monitor and let the wealth compound. The other way can be through periodic rebalancing and shifting of assets as you are nearing your goals.

      Thanks.

    • Yes Sudhir, having clearly defined life goals is a must…but also as Sanjeev mentions, a periodic rebalancing and shifting of assets is required. I also believe that the exit from stock markets has to be 1-2 years prior to the actual goal date as you would not want to lose out due to a big correction in stocks in the last year. Thanks anyways for sharing the idea.

  6. Manish Sharma says:

    Vishal, this post and the picture you posted on facebook about the Ashwath Damodaran book has inspired me to read it 😛

    And since, you have also written on your wall about McDonald, i must say – I m luving it 😀

  7. Manish Sharma says:

    The little book, Sanjeev!! And, I must say every one should read it…

    However, I got it 3-4 months ago for around Rs 700 and today I checked it’s avaliable for Rs 210 🙁 And guess what, I haven’t opened it at all in these months 🙁 🙁

  8. Manish Sharma says:

    Yeaah Vishal why not :)…there is one urdu couplet – “Dil behlaane ko gaalib, yeh khyaal achcha hai”

    But, come to think of it, in stock market this is one bias that is always affecting us. We are always unsure at what price we should take position in a particular stock. Something about which Sanjeev also wrote a few days ago…

    And, yes for the now the complete focus is to improve my topline 😀

  9. Manish Sharma says:

    But, I must say that Vishal’s update and Sanjeev’s (inadvertent )query on the forum 😉 has woken me up from my slumber and pick this book finally. Thanks guys !! 🙂
    I now intend to find the intrinsic value of infy by using the little book methods 😛

  10. shankar says:

    That was a really good article Vishal…:)
    I will also buy the book as soon as I can…:)

  11. Varun Panaskar says:

    I am avoiding buying NESCO as I write, its still 21% higher than my intrinsic value.

Trackbacks

  1. […] Damodaran shares two bitter truths of stock valuation, and how you can avoid […]

Speak Your Mind

*