Aswath Damodaran On The ‘Dark Side Of Valuation’

[Music] Abdul's one is I never wear a tie ever and the second is I don't stand behind podiums I absolutely hate them so I thought about what I would say evening sessions are always difficult because but especially if you've been said 637 you're fighting two things one is you're hungry you want to get to the dinner and the second is you're tired so I'm going to keep this basic I want to keep this big picture I'm not going to get into details I'll give you a little bit of history I came to NYU New York University in 1986 as an assistant professor and when I was hired as an assistant professor I was given a class to teach the class I was going to teach was called security analysis for those of you have never heard of this class the class that is a long and hoary tradition in the 1950s it would start at Columbia University by a guy called Ben Graham whose most famous student of course was Warren Buffett so 1986 I show up at NYU they say this is the class you're teaching I took one look and said I'm not teaching this guy's most boring class ever the collection of topics is for weeks and starts in three weeks and bonds in two weeks and futures and options and five weeks and institutional detail listing requirements for this listing requirements for that and I said I'm not going to eat something it's boring not a great attitude if you've just been hired as an assistant professor so I went to the head of my department ed I don't want to teach this class it's a good guy though he said what would you like to teach instead I said I'd like to teach a valuation class he said don't do it there isn't enough stuff in valuation to fill a class you know what it was absolutely right in 1986 there wasn't enough stuff in valuation to fill a class but I really really really wanted to teach this class and I learned very early in my academic life that if you want to get anything dine at a university the best way to do it is to do it subversively you try to get official permission to do something you know what had happened a committee would be formed years of experience with committees being formed you know what happens in committees get formed their baby committees they call them sub committees and sub sub committees they report to each other and take them about 35 years to get down in 35 years later they'd come back to me say you can teach the class I'd be too old to teach the class so I said okay I'll teach you security analysis class and I walked in and taught evaluation class they have no idea what I do in a classroom anyway you know how long it took them to catch on in 2008 I get a call from the dean's office they said well yeah we hear you're teaching evaluation class I said yes I've been doing it for 22 years they said we don't see it anywhere on the schedule and I said that's very easy to explain I've been hijacking all these other classes you've been giving me and teaching valuation instead they said that's not right we should call it valuation I said you're right call it valuation so if you look at the NYU course schedule evaluation shows up for the first time in 2008 but this is the class that I've been teaching since 1986 and last spring spring up 2019 I taught this class for the 55th semester and I'll say something about this guy's no no claps need no applause needed I've just survived survival should never get dissed applause right that's minimalist requirement but I'm going to say something about this class that encapsulates how I think about valuation everything I know about valuation I've learned in the course of teaching this class notice how I said I didn't know it when I walked in I've learned in the course I've changed over the last 33 years as I've taught this class I've had to learn and as I thought about what I would do there I thought about compressing everything I've learned over 33 years of talking about valuation thinking about valuation I actually don't do valuation for a living I've never been paid to do evaluation and never want to be paid to do evaluation I have the luxury of talking about somebody would just practices valuation and what I did so I thought about taking my lessons I'm kind of compressing them and presenting them in about an hour maybe a little more than an hour to do it and presenting them as a series of big lessons I picked my favorite movie fact when Rajiv asked what title should I give I said look you know we take ourselves far too seriously in this profession we're really not rocket scientist we can add subtract multiply and divide you can do valuation so I said let's call it the Jedi guide to valuation Star Wars friends if you can you switch the slides please okay you see what that title says you know who I'm channeling when I say my valuation journey have faith you must what Star Wars character is that come on you've seen Star Wars right if you haven't seen Star Wars we're pretty much dead in the water right now right that's your da right have faith you must so let's take what I see is the legends evaluation and kind of compress them and go through them it started the first one I usually get the B MBA I did my typical classes forded MBA side teaching and amphitheater and I usually get them after the in the second semester of their MBA class and their walk when they walk in an MBA class a very diverse people who come into MBAs now have you know literature backgrounds history background somewhere scientist summer museum directors so often for many of them their first exposure to what they think is finance is an accounting class that they take in the first semester and that makes my life really difficult because the first thing I tell them is accounting is not finance let me explain I'm going to say some very mean things about accountants right now so don't take it personally for an accountant let's think about how accountants think about the world let's take the accountants favorite financial statement a balance sheet it kind of encapsulate how accountants think about the work first accountants like to put things in boxes there's fixed assets as financial assets as current assets there's intangible assets and the rules they follow are not consistent across the different boxes when you have fixed assets how do you record them in an accounting mataji you look at what you originally paid for the asset you play this new dances little dance about how much value it's lost you call it depreciation and you come up with a Book value so if I bought some land in Mumbai in 1955 and it's still in my balance sheet um it's worth nothing if I believed you I'd be giving away my business for nothing then I have current assets inventory accounts receivable and your the rules are different they reflect what I paid recently and it's not because you were trying but because my inventories not been sitting around for 30 years you're not financial assets investments and other companies and here your roots are all over the place if I'm holding it for training you market to market if I hold it for strategic reasons God helped me I have no idea what you do and you show a number and then you come to intangible assets let's step back from the accounting precipice is it true that a large chunk of value for many companies now comes from intangible assets in fact if you take that ten largest companies in the world every single company's value comes predominantly from assets you cannot see it apples value comes from the technology it's styling it so I mean so it's very easy to see that see that intangible asset they're a big chunk of that you think this is good accountants are waking up to reality but here's the problem 85% of intangible assets and accounting balance sheets come from one item the most ridiculous and absurd item ever created in accounting you know what it is good it's an absurdity it's a nonentity shouldn't even be treated as an acid it shows up that and here's what I mean about it being an absurdity for Goodwill to manifest itself on an accounting balance sheet what does the company have to do it has to do an acquisition so let's not even pass judgement on paying more paying less so if you grow entirely with internal investments there is no goodwill on your balance sheet take a look at Apple's biology there is almost no good well you know why because they've grown almost entirely with internal investments their biggest acquisition is a tiny acquisition that they did six years ago the minute I do an acquisition account it becomes oh my god that's good we'll learn your biology let's take a look at how accountants measure good I do an acquisition goodwill pops up and what is it it's a difference between two numbers what is it what are the two numbers the first is what you pay for the company and the other is let's see how much brainwashing you've gone through it's not fair value it's it's book bad and you know why accountants have a problem until yesterday what were they telling you the companies were two million the company oh my god it's worth ten million there's an eight million dollar mistake I've got to explain away so I'm going to call it goodwill and pop it on my balance sheet and I need to do it for a very simple reason balance sheets have this very unpleasant requirement which is they have to balance there is only one reason for good world to exist which is without it my balance sheet doesn't balance so I put it I call it you know what the problem with goodwill is it sounds good and when something sounds good you feel the urge to pay for it you'd be amazed at how many emails I get every week from people saying I'm valuing the company that's 15 billion dollars and good well how much should I pay for good a little too much my responses it's a plug variable there's nothing behind it every year I said the suggestion to the Accounting Standards Board they never seem to take my suggestions so been eight years ago I sent a suggestion I said let's rename good work in algebra you have two numbers don't do that don't equate it's very easy to make the McQuade you just went plus X so I said let's call Goodwin X you open up a ballot G so X or 15 you never feel the urge to pay for it right it is a plug variable is nothing behind me now let's move to the other side of the balance sheet all those inconsistencies accountants have with how assets get recorded manifests themselves on the library side as well when you have current library the accounts payable supply credit deferred taxes they recorded it close to current values when you have long term libraries bank closed corporate bonds they get recorded off in AD book value what you raised at the time of the loan that's what you see there even though you might be doing distress and you might only had 30 percent chance of paying off the loan and at the bottom of the e-library side you have the shareholders equity portion you know what goes into it when I look at a company I mean I'm really me ITC tomorrow's file as one of the one of the companies in my seminar when I look at ITC's balance sheet and I look at shareholders equity in the balance sheet what goes into it everything that ITC has done over its history isn't that right from the time they went public and raise capital to every respect mathematically the shareholders equity at a in an accounting balance sheet is a summation of every retained earnings of the company over its lifetime so here's what I would say about accounting vanishing the first is there backward-looking accountants are historians and there's nothing bad about them they record the past the second is accounting is rule driven what do accountants do when there's a problem they write more rules have you noticed this you open up GAAP you open up IFRS it's about you can't do that you can't do that don't even think about doing that that's not love accounting is for 6 euros it's about rules that you can so counting is backward-looking and rule driven as opposed to what in valuation I use a balance sheet but it's a very different balance the way I look at the companies I don't care whether your assets are fixed of financial or tangible or intangible I basically ask the question how much of your value comes from investments you've already made as a company I call these assets in place and as I said those assets can be tangible or intangible and how much of your value comes from growth assets you're saying what I growth assets these are investments I expect you to make in the future I'm giving you credit for investments you haven't even thought about yet you think you're not allowed to do that I'm allowed to do whatever I want you can be a growth company where does the bulk of my value come from it comes from expectations about the future I can't bring that under onto an accounting balance sheet but in a financial balance sheet those are part of my values new bow in public this year right 45 billion dollar worth more than that 75 billion dollar value even on a good day investments they've already made a word probably 10 min in the rest of the values for what expectations of the future you think that speculation who are we to pass judgment and what's investing in what speculation it's a line that's a very gray line and in financial balance sheets rather than look backwards I look forward rather than look at rules and look at principles I am I'm very queasy about valuation rule books because I think they aren't that good valuations eventually valuation should have based principles and those based principles should drive how we think about valuation and the more rules we write the worse evaluations become that's my problem with with GAAP and IFRS trying I mean account fair value accounting is an oxymoron you got to make up your mind do you want to do accounting or do you want to do valuation you can't tread both you know it's impossible to do it's going to screw up our accounting balance sheets and it's not going to be very good valuation that replaces so I told you I was gonna insult you as an accountant don't worry they're a banker I'll insult you two so a whole bunch of people I'll insert by the end of the day so let's talk about the second big lesson one of the things were taught in valuation is discounted we like to act like we've reinvented the world so as many of you know I value companies on my blog I'm very high tech very very caught up in the 21st century basically whatever I write I put on there people comment on and so I valued beyond meat four weeks ago this is a meatless meat company and uber eight weeks ago and Tesla six weeks ago value the company I put it on and often people don't like my value for a company they disagree with which is absolutely okay and some of them become downright insulting and one of their favorite insults is that I'm a theorist I I'm a practitioner you're a theorist and after laughs because I know how little Theory there is in my entire valuation class my evaluation class last fifteen weeks and twenty six sessions you know how much Theory there is it's one equation the value of an asset is the present value of the expected cash flows that's it that's it that's one the entire class is about coming up with better estimates of the cash flows and better adjustments to come up with a discount rate on those cash flows in fact I do anything when I when I do my regular valuation class I walk in with an envelope and I put a $20 bill in it act like I have an envelope at the $20 bill I hold it up and say how much would you pay for this envelope go along with me act like there's an envelope to $20 bill how much my paper if you pay $20 for an envelope with $20 what do you end up with an envelope because all you do is swap the $20 so the first rule in valuation is if you know the value of something don't start your bidding at that number there's nothing left for you right so started a dog you don't know what disease I have maybe I don't read numbers of course it's asking for too much even a bank can screw up a $20 bill in a envelope so at the end of that auction you're probably going to end up with $20 then I take a three by five card act like I have a $20 envelope with envelope with $20 we've got two $20 now I take a three by five card and I write a word of it let's make it control I put it in the envelope with you and ask you how much would you pay for this envelope now you know a $20 plus control Cola how much would you pay for that envelope now still 20 when I put control in there I thought control is what like 20% isn't that the case in the rule of thumb you will never make it as an M&A banker that's a good thing right because I tried exactly this experiment of Goldman Sachs I'm in a six months ago it was for a re-education camp that they had for their bankers you know why it's a reaction camp these were experienced bankers had forgotten that basic they say can you come in and do a session so I didn't hold up the I'll put $20 put control a bank of beds $25 you know what I did I sold him the envelope he said I didn't mean he said now that your old money you feel the pain right and think of what he did he paid five dollars for a three by five card which I stole and wrote the word control on and then I continued I write take my second three by five card and I write the word synergy that's a good thing right I put in the how much would you pay for this envelope now brand-name put it in that straight whiny darlin it's just three by five cards with nice sounding words I call these weapons of mass distraction you know why I call them weapons of mass distraction because you finish evaluation what do people do so what about my brand name what about the fact that we're great management what about this what what they want they want you to add a premium on your valuation because they have a word that sounds good so I'm going to stay the proposition that I call the it proposition it's a deep breath it's a deep proposition and here's what it says if it does not affect the cash flows and it does not affect risk it cannot affect value let me go back to those words I threw out there what's the value of control don't think in terms of a bank or twenty percent premium what's the value of control the true bad you get to run the company into the existing management right so the value control what do I have to do I have to value the company twice once with the existing management running it and once with you running it and presumably if you can do a better job what will I fight you will get a higher value with you running it that the existing management that difference is the value of control could it be worth 20% yeah could it be what nothing absolutely we have a company it's already perfectly managing perfectly run and could it be what a hundred percent if you have a company that's really badly managed and badly run it could be what the hundred percent I don't know where these rules of thumb come from I don't believe a single one of them what's a value of synergy what in fact what is synergy we use this word all the time right I don't see the word use what is synergy two companies coming together are able to do something that they could not have done as standalone companies right so the value synergy what do I need to do first I need to value the two companies standing alone yeah you can never value synergy by just telling the target company it's impossible to do so when a banker claims or an analyst claims he's done that it's not doable you got to value the acquiring company and the target company is standalone company didn't you know what you need to do you need to take the combined company and put in the specifics of synergy higher revenue growth lower cost and value the combined company and guess what synergy could be worth a lot or if we work very little in most M&A deals do you think people do that they talk about synergy but they don't want to give you specifics you know why because they want to get away paying whatever they want to pay and call the difference synergy it becomes a plug variable again and we close up with the value of a brand name what's the value of a brand name every Indian company claims have a brand name right the longer they've been around the bigger their brand name value supposedly is what's the essence of a brand name is you get to charge a higher price for exactly the same product that is true brand name power I tell people to walk into a pharmacy walk to the painkiller section no one does it's true an Indian but you walk into any part of the world you'd see Bayer Aspirin and right next door do you see a generic aspirin exactly the same aspirin trust me aspirins been off patent like a hundred years but the Bayer Aspirin would sell for twice the generic aspirin and there will be people who buy the Bayer Aspirin why they feel that they take the Bayer Aspirin the headache goes away sooner that's what brand name it plays games with your mind should've a new brand name what do I need to do I need to look at your profit margins if you truly have brand name what should be true your margin should be much higher than the competition the next time a company or a management or founder or a promoter says where is my brand name value you might look at the mind say what brand name value it's gone so but I've spent lots of money in advertising I don't care that's your mistake I can't give you a brand name I'll leave you threw money into advertising name nothing to show for it the it proposition basically says don't let words drive value look for what's behind those words second the proposition I'm named after my daughter she's 23 my four kids they're all grown up none of them are kids anymore but with each of them I noticed a very disquieting trend around the age of two or three they thought I knew everything on the face of the earth they'd come to me with questions like what's the meaning of the universe dad and I'd make up stuff and they believed it because they thought I knew the answer to everything and sometimes in the age of two and three they'd go to bed one night and I noticed something insidious happening the next morning when they woke up I knew less and just downhill from that my son my three sons around the age of 11 or 12 became so self-centered they forgot I even existed so they'd stop thinking about me but my daughter was obsessive about tracking how stupid I was getting and letting me know like stupider and stupider and stupider and I think there was a day when she was turned 16 when she came to me said dad I have to tell you this but you've officially become the stupidest person on the face of the earth and I had the misfortune or dinner sitting across the table from her for dinner and the topic of conversation come where I think I'd something to could tribute I'd opened my mouth and my daughter look across the table said dad yeah they might have contempt that who started the board would say I stopped talking for like two years the good news is around the age of 18 I started climbing up the ranks again I was no longer the same the ten stupidest and the 25th and I'm still in the top 500 stupidest people but I'm kind of rising in the ranks so here's what the dur proposition is for every week I get a few emails from people and I'm banning a money-losing company I expected to lose money forever which of your valuation models do you think I can use to put a value on this company which you feel like slapping the person around the phasing wake up you have a money-losing company expected to lose money forever why are you thinking of paying them they should be paying you if any of you thinking of buying jet airways they should be paying you rather than the other way around it's basically it is the reality if you're in a bad business and there's no I mean there's no light at the end of the tunnel the business is worth nothing which brings me read third and most interesting proposition you sit down to value company and you project out the cash flows next year and then- what's your first reaction this is terrible my company is negative cash flow don't give up yet if your company is negative cash flows upfront it can still be a valuable company if it can give you disproportionately large positive cash flows in the future you know what types of companies you're going to run into but this is going to be true negative cash flows are pressure what types of companies will tend up negative cash flows are project startups and why do they have negative cash flows because they're right now not making money and they're to reinvest huge amounts of money to get growth in the future so you look at NOLA flip card even on a good day I think I can't have cash flows that are negative as far as the eye can see but you got to hope and pray that the cash flows turn positive to deliver that offsetting life when you see the valuation of young startups do not be surprised to see me cash flows a friend in fact if you see the valuation of a start-up with positive cash flows and you'll want somebody's life either this is not a startup or you don't know how to compute cash flow either way I should be terrified of what you're doing to me and step away very basic propositions but let's step back from what discounted cash flow evaluations are increasingly become I'll tell you one of the things I find troubling is let me ask you a couple of questions do you think we have access to more data now than we did 30 years ago absolutely I still remember the first time I value the company the early 1980s I had to write to the company to get an annual report and to collect companies and numbers and other companies I had to go by hand into the library get data's and other companies and put them into what no Excel spreadsheets I put them on a ledger sheet and I was going to say an abacus I'm not that old no but I used to calculate it to compute every single number so we have access to more data than we did 30 years ago and we have access to more powerful models than we did 30 years ago so now comes the big question do you think valuations today are therefore better than the valuations 30 years ago should I do more data you're better models you should have better valuations I don't think so and that to me is the great contradiction with what we have we feed more data we have more powerful models and one of the reasons I think it's happened is increasingly in valuation class have become Excel Microsoft Excel classes you become an Excel ninja right you know which buttons way to make every alternate or different color and in the process I think we've lost control of valuation when I look at valuing a company I don't look at a spreadsheet I look at answers to four questions these are four questions you need answered no matter what type of company about it first is what are the cash flows are making from my existing investments right you've already made some investments in yarn I need to know what those cash flows are and do I those questions I look at your income statement your balance sheet the statement of cash flows everything you give me from last year that's an easy question to answer because I can get them from the financials here comes a more difficult question how much value are you creating from future growth notice how I phrased the question and asking what's your future growth because growth by itself is a mixed blessing it gives you good stuff and bad some good stuff is it makes your earnings become a larger number the bad stuff is to create that growth here to reinvest the net effect from growth can be positive it can be zero it can be negative third how risky are your cash flows why because you get riskier more on certain cash flows the value should be lower and finally when will the good times end when will you be a mature company ok I have a math problem and let me show you what my math promised the previous space I said the value of an asset is the present value the expected cash flows on that asset over its lifetime right so if I give you a 10 year asset you project cash flows the next 10 years you discount them back you got a value for the answer if you ask me to value a publicly traded company what's the life of a publicly traded company there's a corporate charter that tells you when the company is founded when is it only the company is going to be wound up oh it doesn't mention it at least in theory what can be true that company can go on forever and that means the value this company I have to estimate cash flows forever it's an Excel spreadsheet that never ends that's my vision of Hell your intro 16,000 318 you're still projecting cash flows so in the real world what's it did the question can I stop now how about right now and I can give you an answer as to when you and you were not going to like it you can stop if you're willing to assume that beyond that point in time your cash flows grow at a constant rate forever you know what that buys you it buys you an infinite series in mathematics and 200 years ago mathematician saw all for the value that series we stole that equation from mathematics and we act like we invented this but this is of course terminal value equation you see in valuation at the end of every valuation it comes from that madam but for that series to hold your growth rate has to be constant forever now let me get back to the question as said when will your company be a mature company in order to mature companies a mature company is one that grows at a rate less than or equal to that of the economy why do I need to know that because if you're going to be able to do that then I can assume your cash flows are at a constant rate forever and I can put closure come up with the terminal value bring it back so when I think about valuation I think about add Cisco's for questions and to me a discounted cash flow valuation model is just a way of putting in my answers in to the model my base your cash flows reflect what you're making from existing assets my value of growth I shown two places one in the growth rate that I use that's a good news then in the reinvestment that I put in to get that growth rate which is the bad news the net effect is going to determine where the growth adds value does nothing for value reduces right my risk shows up in my discount rate and when you tell me your company will become a mature company I put the closure in the terminal dies discounted cash flow valuation allow me to answer questions in a structured way and bring them all in for that I'm not going to have a chance to go to the specifics of discarded cash flow valuation but I'm going to throw out a few cautionary notes that I find increasingly problematic in this kind of cash flow valuation I don't know what this is becoming part of the process in India but around the world one of the prompted appraisers and analyst faces they could no longer just stay in their local currency 20 years ago view said look I'm an Indian appraiser all I care about is rupee valuation so what do I care about dollars a yen or pesos or or your right go ahead just the reality is when we talk about valuation now often we're talking about other currencies coming so I want to talk a little bit about why currencies matter and why they actually should not this graph it's a graph that I do every six months I'm going to do the update in a couple of for I estimate risk-free rates in different currency risk reread is a base from which you build everything on and in some markets you can get by just looking at a government bond rate in the US for instance you ask me what a dollar is created so I use the t bond rate and Europe you ask murder risk-free rate is I use the German euro bond rate in Switzerland you at Muller is free rate is I use the Swiss franc force breathing that but when I do that what am i assuming governments have no to fortress is that a safe assumption may I ask you a different question can governments default and usually people that well that's because you don't have enough dollars to pay off the bonds I know right now you had this little mini debate about wishing sovereign bonds or not so if you shoe boards in a different currency that can of course open you up to it but people often struggle with the notion of why would a government default in a local currency bond because there's an easy way to pay the bond right which is front the printing presses a little faster what's the big deal so the argument is usually I'm looking for a repeater screen rate I can use the Indian government ten-year rupee bond rate and the Indian government will never default in rupees because I can run the printing presses faster you know that half of all sovereign defaults in the last 30 years have been local currency to 53 percent of sovereign defaults in the last 30 years have been local currency born it's true you could print run the printing machines faster and pay off your debt by running but if you do that what happens your currency you're going to debase your cards you're caught between a rock and a hard place do you want in default or do you want in the base your currency and you know what coming back from default is actually easier than coming back from the base in your cards I go to Latin America which is in a sense the centerpiece for the sovereign default this is the continent that says look we're the Masters of sovereign default they do it over and over again so I remember the first time I went to Brazil was in 1997 this was five years after they'd gone through hyperinflation you know what not a single Brazilian company would issue bonds in Brazilian reais because nobody would buy a reai denominated bond because I didn't trust the currency anymore and the Brazilian government would not issue bonds injury ID because nobody would buy their bonds they had to issue bonds in dollars so the reason Brazil started issuing sovereign bonds was not because they had a well thought through process because they had no choice nobody trusted the local currency they had to issue bonds in US dollars it took Brazil 14 years before the Brazilian government was able to issue Brazil entry I bought a local currency bond because that's how long it took for people to get trusted you know how often Argentina has defaulted in the last last 15 years this is like every four years there's another in any just world nobody should ever lend money to Argentina ever again but in 2015 I was in Argentina it was the second coming of Argentine or the third coming every portfolio management award was there they were ready to forgive and forget you know where I'm going next right the assumption that governments don't default in the local currency is just not true which means if you give me an Indonesian Rupiah government bond I cannot use it as my risk-free rate because if that some portion of that bond is for default risk I'm actually double counting country risk once through what I use as what I call my government bond risk free rate and once with the risk premium that I attach to the country so I do a little cleaning up and some people don't like what I do but it's what I do in any country where I perceive default risk in the government I take the government bond rate and I subtract from the government bond rate the portion of the bond that I think is due to the fortress and I'm a little sloppy about how I do this I'm open about admitting it I get that measure of default risk in one of two ways one is I look at your sovereign rating as a country and I'll admit ratings agencies are not the sharpest knives in the drawer they're always late to the party but let's face it they'd known on average they do tend to capture the fortress so if you're a B Double A to rated country and you have a government barn I'm going to take the default spread that goes with the B Double A to rating and subtract it from your government bond rate saying I want to screen rate in rupees or create and repeal so see this red portion on the part that is my risk free rate in different currencies so let's start with an observation risk-free rates vary across currency some currencies are much lower the screen rates and others in this case for instance the risk-free rate in Nigerian naira or Turkish lira is much higher than the risk rooted in Indian rupees which is much higher than the risk-free rate in u.s. dollars which is much higher than the risk-free rate in Swiss francs or Japanese yen in fact the risk free rate in Japanese yen in Swiss franc is actually negative kind of a mind-boggling concept right I mean you know the Danish homeowners last year when they borrowed money to buy houses note the banks had to do they made them a check every month you borrow money and they mail you a check this sounds like a great deal right it's a mixed blessing but it's what it is so I'm going to ask you a question this is going to go to the heart of what I call cracking the currency corn why don't we screen rates vary across currency if they're truly risk free we know why government bond rates vary across currency some governments are risky some are safe but if I've cleaned up for risk why do risk-free rates vary across currencies its inflation that's it high inflation currencies will end up with high risk-free rates low inflation currencies will end up with low risk credits and deflationary currencies could end up with what negative risk readings three years ago I wrote a piece of my blog on negative risk rates and the row I wrote it because I got so many emails from people around the world especially in Europe saying I'm valuing companies the risk-free rate my currency has gone negative what do I do so no heart friendly I mean I do a whole world that ended for them I said let it go it's okay negative risk free rates are unusual but naturally if you have deflation and negative growth you should expect it's not a good thing right the fact that the euro is created is third negative is a very bad message for European growth in the future but in terms of doing a risk-free rate it is what it is I think what I call the karmic for you andris creates you know what that is it is what it is I can tell you what I wish the T bond rate should be but it's not mine to control it is what it is I'm going to build it it and if you are consistent in how you treat currencies your valuation should be currency invariant you know what I mean by currency invariant if I value Infosys in rupees and I come up with the value per share and then I valued a gain in US Dollars and come up with a value per share I should get exactly the same value per share and that strikes people as how can that be the cost of capital foreign forces in US dollars is going to be much lower than the cost of capital in Indian rupees right you're saying so how can the values be the same what else is going to change when I value in forces in Indian rupees the growth rate I need to use as an Indian rupee growth rate with an Indian inflation rate but it but if I value in forces entirely in US dollars the growth rate there should be using should be a dollar growth rate which reflects a lower inflation what one hand gives you the other hand would take away you know what gets us into trouble is when you do your discount rate in dollars and your cash flows and rupees and expect your valuation actually makes sense but it can happen so easily I remember a student of mine call me about two years ago he's the CFO of a very large US company and is very proud of himself he just bought an Indian company and he wanted to call me to tell me how carefully big so he calls and he says I just we just acquired an Indian company we I remembered everything from your class and I did everything right I said tell me what you did he said we validate need company in US dollars because that's we think adore you that's okay right and I said you can value any company in any currency that's a choice to make that's fine he said to get the dollar cost to capital we start with the dollar is created the t bond rate we built up country risk premium and then he went through the pros and he said okay that sounds right and he said i we got the good the last year's financial statements sure and rupees we converted to dollars so that we're doing dollar cash flows and then we put a growth rate on and I said where do you get the growth rate he said we talked to our the managers of the Indian company and we asked them what they thought the earnings would grow at and we think they were pretty they were you know they were pretty be unbiased and they gave us a girl train we plugged in it so I asked him the question you know what question asked him did you ask the Indian managers what cards they would think you ask an Indian manatee about growth what's your frame of reference if you're in India man you think in rupee terms the growth rate that God was they were not being no they were not being deceptive they were just giving the growth rate in the car we tend to think in the currencies we work so my recommendation to you is increasingly be explicit about currencies especially we talk to companies which have multiple cars it was wrong when you talk about an interest rate we talk about a growth rate and somebody says I borrowed money at 6% ask them in what currency because it makes a big difference when you borrow the money at 6% in u.s. dollars and 6% in repeat terms because it's so easy to mismatch second so much of what we do comes from looking at the pass rate for instance when you talk about risk premiums where I would start to estimate equity risk brings to the price of risk in the equity market it's look backwards I can understand why we do that because there's no forward-looking number that's out there that's obvious we look backwards and in the u.s. that data goes back a long times you feel the sense of comfort because you all this data backing you up so you asked me what they equity risk rating for the u.s. is I can go all the way back to 1928 and say the risk premium is four point seven seven percent and it looks pretty good right ninety years of data but when I do that there are two things I forget one is when I use original risk premium for the last 90 years as my risk cream for the future what am i assuming about the future I would assume the future looks like the past it's called mean reversion is that a good assumption it's a good assumption as long as I'm working with the structural model that hasn't shifted so much of what we do in finance and valuation they come from the US and the second half of the last century and the u.s. in the second half of the last century had the most mean reverting stable predictable economy of all time you see where I'm going this trust in the past comes from a market where trusting the past work post 2008 I think we're in very dangerous ground making that assumption I have not used historical risk premiums in valuation probably 12 15 years and 2004 2008 I've never used because to me 2008 was a break from the past it said look the model has changed you can believe in whatever means reversion you want but you don't know what the mean is going to be so what do I do instead I look at a forward-looking estimate I won't go through the specifics but it start of every month in my website I compute a forward-looking risk premium for the S&P 500 sounds fancy but have you ever computed the year to maturity on a bond you know how you do that you take the price of the bond you take the cash flow as you saw for an internal rate of return I do that with stocks to start of every month and take the S&P 500 project cash flows and solve for what rate of return investors are demanded it's not your job or my job to tell what the right price of risk is this is a market set number and that number goes up and down and started this month it was five point six seven percent every company I've valued in July that's a premium of used as my us refrain then what are you going to use in August I don't know yet on August first I'll read in the numbers and I'll update the premium talk about globalization another library of becoming globalized is even if your value just Indian companies the reality is you're exposed to country this you have an Indian company that has operations in Africa you've got to bring in the risk of that African market into your investment so one of the things I've been doing for the last 25 years at the start of every year I estimate risk premiums for every country I don't do it for you I actually do it for me because the value companies for the rest of the earth I need to know what the risk premium is in Nigeria if I want to value BP British Petroleum not Bharat Petroleum no but basically for every company that is XO I go through this process and I cut to the chase of how I do it because there's no mystery in how I do it I start with the us risk premium on January 1st 2019 we started this year that number was five point nine six percent that becomes my base number then for every country in the world which has a sovereign rating I look up that local currency sovereign rating and Moody's I think rates 132 countries S&P does so basically I combined all the way I create if and so I'll do the rated countries so if you have a triple-a rating I take the easy way out Germany Australia Singapore I classify all Triple A rated countries as mature markets and I give them the US recipe so Germany Australian see five point nine six percent if you're not triple-a rated I look at the default spread when we talked about the faults which taken out of the risk-free rate I take your rating I come up with the default spread and then I apply a final adjustment the default spread is what I would charge for buying a bond issued by a country but I'm not interested in buying bonds I want to buy equities or equities riskier than bonds is safer than what's the riskier so what I do is I apply a scaling multiple to it I say look equities are riskier to compute how much riskier I look at how much the standard deviation of all eternity of equities is relative to government bonds across all emerging markets so here's how it what five point nine six percent is my risk premium let's say the default script for India is one point seven seven percent I multiply one point seven seven percent by one point two three I get an extra premium I add that to my five point nine six percent I now have a risk green for India I do this for every country and when I'm done I have a picture this is my January 2019 picture my july 2019 will show up in a couple of days on my blog this is my picture of the world as I see it with wrist cream so let's focus on Asia there you look across Asia you see across all of Asia the weighted average risk premium is is seven point four three percent but you can see the wide differences in equity risk premiums across different countries India for instance has an equity risk of eight point six percent across all of Asia Singapore has the lowest because its triple-a rated you could see how risk premium change this is the most downloaded data set on my website thank if you look at the top spots those are what I call my frontier markets what a frontier market Dena market that are so scary that the ratings agencies don't send anybody there they have no rating markets like what Syria Sudan North Korea until about two years ago I did not estimate risk cream for those markets until I got an email from a Syrian business person there's actually one guy left in Syria I think running a business and he said I need hearted rates to take projects I was looking on your website for an equity risk for Syria how come there's none and I told him look there's no sovereign rating for Syria there's no sovereign rating and he said so how do you expect me to take projects no I don't know you know maybe get out of the country altogether no but I said yeah I said you have a point let me try in fact starting two years ago I used these political risk scores you know like numerical scores for four countries and you have them for North Korea and Syria I look up other countries with similar scores on which there's a rating and then I attach the same risk premium to the country I know it's very sloppy back-of-the-envelope and I think I pretty much the whole world here it's by far as I said the most heavily downloaded dataset of nowhere and it gets used to the strangest places I don't control how it's used I've given up on it and I get emails from people using and most of the time its technical I remember getting an email from the New Zealand milk port I didn't even know there was a milk board in New Zealand til I got this email saying well using your country risk premiums to set milk prices for New Zealand farmers keep selling the milk to Zimbabwe how do you come up with the risk prints and I have a little PDF file upgrade said this is how I do it's no rocket science but once in a while I do get an email I don't know how to respond I remember in April of 2009 I get an email from a Lebanese businessperson I open it up and I'm very excited I don't get that many emails my valuation in the Middle East and here's how the email begins you have destroyed Lebanon after 30 years of civil war in his bowl ah I'm the guy who destroyed Lebanon so what did I do yeah and the Lebanese businessperson had had his business appraised and the business appraiser had used the risk premium for Lebanon from my website to value the copper do you think so what take a look at Lebanon fourteen that number was seventeen and a half percent in April of 2009 you put in a seventeen and a half percent risk premium what happened in this country it's going to go through the roof your discard rate goes up what happens to your value it collapses this guy felt he'd been gypped it was all my fault my reaction was hey you paid your appraiser you didn't pay me take it up with him but then I remember the email was from Lebanon so I decided to be a little careful about how I answered I said it's not my fault you see whose fault it is what do I do I start with the US premium then I look up your rating on Moody's and if your rating is in the toilet guess what you're going to the toilet with it and I said it's not my fault it's Moody's if you want to put having a dress to put in your GPS here it is it's got nothing to do with me it's basically a reflection of the fact that your rating has collapsed there's no intellectual firepower behind these numbers but the reason I need them is to value a company I need to have the entire schedule No so if you do get forces I did a valuation in 2017 the last time I was here Infosys is an Indian company but guess where it gets its revenues it gets almost if you look at the percentage 62% of its revenues and not in Northern Europe 22% in Europe 12 in the rest of the world and 3.1 9% it's an Indian company with not valuing forces I have to remember that it's an Indian company with its exposure in the rest of the world when I used to value in forces that was the equity risk premium my birthday imaginarily coca-cola Coca Cola's US company and name its headquarters in Atlanta but 65% of its revenues come from emerging markets risk doesn't come from where you're incorporated it comes from where you do business and this is my way of bringing that into the valuation find a point about valuation then I'll move on to the next topic when I look at valuation and we'll look at a lot of them I've used what I call my my valuation triangle to check for consistency let me explain what I mean by that there are three sides of the triangle there's growth there's reinvestment this risk sounds fancy but let's say you said to DCF to me said can you take a look at I'm first going to check your growth rate what are the three possibilities you could be estimating high growth low growth or no growth and I'm not going to fight you on it your company you know what more about the company than I just have you put in high growth okay hydro then I'm going to go check your cash flows to see how much you reinvested in plant and equipment and whatever you need reinvested if you have high growth what should I expect to see in reinvestment high reinvestment low reinvestment and all reinvestment I just expect to see high reinvestment and generally when I look at risk I should expect see iris hi-hi-hi makes that lololo makes sense hi Lolo I'm going to push back tell me how is it that your company can grow fast without reinvesting very much give me a good story I'd step back but this is my way of checking valuations for consistency because without consistency valuations kind of fall apart point about growth that I want to re-emphasize growth by itself does not create value you can grow and add value crow and destroy value and grow and do nothing for that we pay I think we pay how much to growth too much and let me explain why I'm so cynical about growth start of every year the way I create my data sets come up with Industrial Average they download the data every publicly traded company in the world so last this January when I did this though 43,000 publicly traded companies in my sample it's a gigantic Excel spreadsheet then I compute two numbers for every company the cost of capital for every company and I do everything in US dollar terms I can Kia stay consistent so have the cost to capture every company and I also compute the return and invested capital at every company don't fall too much into the trap of the specific return investment cabbages measures what you make on the Kapiti of investment company and what do you need what what's a rule in in businesses and it's a very simple simple common-sense rule if you're costly capital is nine percent what should you try to do earn more than nine percent that's right every good business person through time has known that so I could be the return capital and cost of capital every country you know why I do this I want to see what percentage of companies globally create value and they grow how many destroy value as they grow and how many do nothing just run in place and the numbers to me are frankly depressing see these green numbers those are the companies globally that create value do they have a return on capital greater than the cost of capital so about 22 percent plus sir but 30 percent companies rounded up have a return on capital higher than the cost Akash about 12% of company's pretty much run in place they earn roughly their Casta kappa 58% of companies globally last year as they grew destroyed bad the reason I say that is in markets like India and China why did the big sales pitches the companies make is where a growth market growth is a worker to grow to which my response is that's nice but should I be running for the exit doors when you say we're going to grow because you can grow and destroy value as you grow fact yesterday when I was on the flight from Chennai to here have been a big growth in the airline business [Music] obviously right so if I graphed our number of airline passengers revenues from the airlines it's all this huge the line looks like it's a huge growth line now it's going to follow-up question how many great money-making airlines are there in India you can have growth and have businesses not able to make money off that road and the sooner we start separating the two the healthier growth becomes not all growth is created equal so this is my cautionary note don't think of growth is a good thing in some company and they say I want to grow you should be sake dope you're better off not growing and finally on the cost of capital one of the things I try to do to keep perspective is I compute the cost of capital every one of those 43,000 companies and I put in a histogram remember histograms from Statistics basic I just count the number of companies caustic Apple to do so the reason I do this is actually at the end of the process can tell you what the cost to capital for a typical company would be in a global market in a mature market and it's what I used to gain perspective so and you should send me a valuation of an Indian company if I see a 5% cost to capital I am wary because the median cost to cap for an Indian company in rupees is closer to 12% what I used this histogram for is when I look at evaluation to make a judgement is that cost of capital in numbered looks okay given how to cost the capital a distributor and I tell me one other thing in valuation I think we spent far too much time on discount rate and hard to little time on cash flows spend more time and the revenues the growth the cash flows because that's where the big mistakes in valuation get me finally don't let your macro view climate you know what I mean by microwaves what do you think will happen interest rates what do you think gonna happen oil prices you're gonna be tempted but it's better to keep your macro views out of the valuation I'll give you a very simple example when you sit down to value an oil company let's say it's Royal Dutch you know what to keep driver a valued royal Duchess what happens to oil prices so you're going to be tempted to project our oil prices so let's say you are an optimist and oil price and you think they will double over the next five years if you put in that projection into your Royal that's valuation what are you gonna find companies what tonight you think so what then if you ask me to buy the company I'm not sure what you're asking me to buy the company because you like the company or because you think oil prices will double you think why should I care if you're really telling me to buy royal that because you take oil pressure double I was really something there's a much easier way for me to make money and buying Royal Dutch which is to do what go buy all price futures if you're that good at forecasting oil prices what the heck are you doing value Royal Dutch in the first place and that's I think part of the problems when an analyst start to bring in their views and interest rates and exchange rates and commodity prices into valuations what you end up with is a strange mishmash in the valuation not quite sure what to do with it so let's talk a little so to I was going to I just show you my ITC valuation that I'm going to show in my class tomorrow don't do anything crazy about it I know very you know I'm staying at the ITC Murata while I'm doing the valuation so I'm afraid of what will happen the day after no because I don't like the company to me this is a company if there anybody from ITC don't take this personally I just don't like the cover it is a cigarette company no matter what your frame you think but their hotels they have consumer products this is a company that gets the bulk of its cash flows from cigarettes the problem they have is the cigarette business is stagnant thank God for that because I don't want any more cigarette smoke blown across my face it's that and the company has taken the cash flow through the cigarette business and directed into hotels into consumer products and the reality is none of those other businesses create value this is a great business feed so that's what I see in the company and my valuation reflects its story so the growth you see that comes almost entirely from them trying to grow it out the business where the margins are much lower than in the cigarette business and that's going to show up over time to Marilee from evaluation like one of the points I'm going to make is every valuation tells a story and my story for ITC is not enough beat story but it's not my fault it is what it is it's a cigarette company trying desperately to get growth and that growth is coming from businesses that don't have the kinds of margins and returns the basic cigarette businesses I'm not saying it's going to go bankrupt or be in distress it's going to be a company that's around but it's not a company where there's gonna be much upside from growth because the growth is being in is happening in businesses where their competitive advantages don't kick in I a few years ago by four years ago I wrote a post on what I call dysfunctional DCF so we get a chance you can read it basically it's about all those terrible DCF that I see and I put them into the in the Hall of shape of baddies yet so I won't go too specific but one of my favorites what I call the Kabuki this year what a kabuki deceive us this is what valuation we start with the number you want to see and then you reverse engineer into that number let's face it most fair value accounting valuations the Kabuki valuations you're not trying to search for the truth you have a number and say how do I get that your dreamscapes valuation what those are these are companies can exist only in your dreams or in spreadsheets I can create some amazing companies and spreadsheets your robot DCF Robo DCFS and DCF or you're not sure who's running you who are you running the model as a model running you it's like you know you have muted DCF and I few months ago I got an email and multiple quotes from somebody that he valued the Indian market and found it to be massively undervalue he done it DCF visa and here's what he had done if you're in the room don't identify yourself I don't want to know he took the earnings for Indian companies in May and discounted them first what do we need say earnings are not cash flows because you can't pay or entire and exact how the heck are you gonna grow he put a 20% growth in earnings forever and he put a 7% discounted I'm amazed he ended up with a positive value because seven minus 20 is negative your terminal value should have blown up but just because you discount the number doesn't make it a discounted cash flow valuation you discounted the wrong number you discounted earning sensitive cash flows you made up a discount rate and then you tell me that stocks are massively overvalued there's nothing behind what you've just said but again people think that if they discount a number and they come up with a value that they've done a discounted cash flow valuation I know I'm running out of time so let me kind of cut to the chase on the other lessons I hope to break through I mean as I said one of the things that troubles me is is the fact that we've increasingly become spreadsheet driven in valuation one of the questions I asked my class started the class I said no no I asked and I can throw this question out to you if I ask you to describe yourself as a person would you more naturally think of yourself as a storyteller or in number cruncher think about it for just a moment what comes more easily to you working with numbers a telling story because each of us has a strength I'll tell you what - I'm a number cruncher naturally and when I first started teaching valuation I thought it as a number cruncher that focus on numbers equations mortars and I discovered very quickly that this wasn't taking me very far because if all you have are numbers in a spreadsheet you don't have evaluation of numbers in a spreadsheet if all you have a stories you don't have evaluations in step stories a good valuation is a bridge between stories and numbers you know I mean my bridge you show me a valuation of a company and I point to revenues in your 10 so why are your revenues 2 billion I don't want your answer to be I used to thirty percent growth rate for the next five years and ten percent that doesn't answer my question I need to know your story for the company that justifies the revenue in a good valuation every number will have a story attached to it and every story you told me about the company will have a number attached to it and I've struggled with this because I'd teach myself storytelling I think I'm better at doing this now than I used to be but it's been a struggle I've had to learn storytelling this is an example about by the way I do this in fact when I think about is I go through a five step process you give me a company to value your the five steps I go through first step is I try to tell a story about the company no that's a step one I don't open an Excel spreadsheet and I have a story for the company second step I make sure the story I've told you is not is possible I'm not totally a fairy tale it's plausible which is a higher standard and probable I call this the 3p test I basically pass it through the time third step I take the story and I break it into numbers that become input system evaluation every story you tell can become numbers and once I do that step four does itself I have a value for the company because those inputs give me that and then comes a step that most of us don't want to take but it's well worth take when you finish a valuation show to other people what do you want them to tell you amazing job this is exactly how I value the company - right and if you hang out with people who think just like you who read the same book see dead follow the same rules you do guess what you're all going to Pat each other in the back thing this is amazing we all agree with each other my advice to you is when you're done with evaluation seek out people who think least like you present your evaluation to them and learn from the feedback you know and it requires a thick skid because they're going to tell you that everything you did was wrong and it's probably not wrong but listening to people would make your story better so I I do a session actually on narrative and numbers connecting stories numbers where I go through this process with two companies uber in June of 2014 I explain how I valued uber and Ferrari in October of 2015 at the time that I feel the case of uber I valued them as basically the story I told about uber well and in June of 2014 which there were an urban car service company that attracted new users into the business and essentially continue to do things the way they did which didn't own the cars and hide the drivers and kept 20% of fare my valuation reflected that story in fact every single input I have I tell you what part of the story back then it so when you see my valuation you can go to the input but then each input is started this is the story I'm telling about the inputs because without it all I have is a collection of numbers you know I valued uber every year since in fact to me at the time of the IPO a few months ago I valued them again and in that valuation I kind of gave you my updated story for uber a very different story than the story in June of 2014 because the company has changed the market has changed the word is one final point about stories there's some companies that I called story stocks and here are the characteristics of the story stock the first is it's usually a young company young company in a big market why it's going after the big and in its it has a storyteller and a storyteller was a great storyteller young company in a big market with a storyteller becomes a story stock and one of my favorite examples for this this Tesla the company I valued every single year for the set last seven years it's a stock that's fascinating everybody's familiar with Tesla right I mean this is of course Elon Musk's vehicle it's a company that morphs every day the store you're not sure what the story is one day it's a car company the next day it's a battery company and an energy company that a boring come who knows what will be tomorrow so the story shifts not so but two years ago I decided to value Tesla and I looked at the possible storage first I said what business is the company maybe it's an automobile company maybe it's a technology company maybe it's a clean energy company then I said what's it's focused on the high end of the marketers in a mass-market company third I said what's its competitive edge is it because they were there first they produced the first viable electric cars because of the style and the brand or is it because they have superior technology and I said when they invest are they investing like a manufacturing company like a typical automobile company or can they get away investing like a typical technology company and finally is there risk going to reflect the risk of an automobile company or the risk of a technology and you can say given the choice I make I can come up with very different stories for the company and those very different stories essentially going to pay artists very different inputs and very different values for company in fact I ended up at the table that that reflected given my choices what the value of the company would be and they range from minus $60 which means the company is going to go bankrupt the $316 depending on how I framed the story for the company I'm a great believer in starting with stories because without stories all you have are collections of numbers and those numbers in a sense would play out in your final valuation in fact they're my ITT stories right up there and as I said it's not enough Beach story it's a story about an aging company that is using its cash flows from a business that is stagnant to try to grow and I think that doesn't that that story has never ended well in any part of the world right because you keep stretching into businesses you're not that good at those cash flows eventually start to dry up and my valuations reflect that end game let's close off a few more lessons would you rather be precise would you rather be accurate I'll give you the difference being precise and accurate you've ever played dart precision basically means that you get all your darts in the same spot accuracy means you get your dots close to the center so of course you'd like to be precise and accurate that's the first one the second one you're precise but you're all off the center you're getting all your dots in the same place the third place you're accurate but not precise and the fourth place you're neither but let's pick these two do you rather be precise od rather be accurate in valuation what's your end game would you rather be precise with me rather be accurate I'd rather be accurate and here's where I think you've got to be careful about how you write rules and valuation rules and valuation are driven by precision not by accuracy they're driven so you get the same result over and over again even though it's a wrong result it's actually shows up especially when you value on companies right because young companies the the reality is when you sit down to value your company with lots of unknowns it's like everything is unknown and most people just give up this and you can't value young companies why because it's too much uncertainty that's not true you can value them but you're going to you can even value them accurately but you cannot value them precisely it requires that you make your best judgment I'm going to cut to the chase here I think that the payoff to valuing companies when you feel most uncertain is greater than the payoff to valuing companies where you know all the facts sounds weird right and I'll give you my simplest way of explaining why let's say that you decide to become a weather forecaster why are you bored of this appraisal business who wants to work with spreadsheets you decide to become a weather forecaster I'm going to give you two cities and I'm going to give these cities from the US and I'll give you some background you can see why your first put tential job is to go work at the weather forecaster in Honolulu Hawaii and your second potential job is to become the weather forecaster in Epping North Dakota I know you've never been tapping I've never been there I don't want to go there Peck so why do you pick those two cities here's what the contrast is Honolulu Hawaii has the most predictable weather in the United States the least variation in temperature and the least variation in yesterday's rain tomorrow's going to rain as well see so if you go to Honolulu Hawaii as the weather forecast you're going to be right a lot of the time because it's very predictable weather epping not the code as the least predictable weather in the United States of whether the temperature shifts dramatically you go from rainy days to dry days very quickly so your job as a weather forecaster is to be right where would you rather be a weather forecaster we're gonna be in Honolulu Hawaii to be if you want to be right if you want to be noticed the reality is who cares what the weather forecast the things in Honolulu why it's going to be sunny and 83 degrees tomorrow it always is I mean it's like being the weather forecast Mumbai and saying it's going to rain tomorrow I know it rains every day it's always 83 degrees and raining there's not much payoff to listening to the weather forecast here the payoff to being a weather forecaster people listen to you when there's the most uncertainty about the world and I think my valuation the same way I know you can value coca-cola more precisely than uber why you have a lot of history you know what they do they have a business model it's easy to value but guess what nobody cares what you value coca-cola is because everybody else can value coca-cola precisely as well it's companies like the ubers and Beyond meets the world where there's a lot of uncertainty did the payoff to doing valuation is greater so we don't valuation don't stick with nice mature company you might feel comfortable doing what you're doing but those are exactly the companies we are very little to add to the process go where it's darkest that sounds like a weird to say go whether it's the most uncertainty value company in the middle of crises because that's where the payoff to doing valuation is greatest one final point and then we'll end for the day how many of you do valuation is part that you live it what is part of your jobs your an appraisal you think your job is to value companies right I'm gonna throw two words that you're now after I've thrown the two words I'm gonna ask you the same question as before we know what drives value what drives value is cash flows growth and risk you can dress it up at the discounted cash flow model intrinsic value driven by cash flows growth and risk what drives price demand and supply what drives demand and supplied car only knows it could be mood it could be momentum it could be any number of things value price you know that most of your valuation jobs are early pricing jobs you really your mission is to actually price things you're using a discounted cash flow model you're actually using the wrong tool how do you price something you look at what other people are willing to pay for similar assets out there the starting proposition is why would the if you know the value of a company's 100 why would people pay 300 for it or 50 for it because the pricing process can lead to a very different number than the value process in valuation you can focus on cash flows growth and risk and value the company in pricing you're looking at demand and supply so we use multiples and comparables uzv to Abbott down 15 companies out there you are pricing a company not valuing it and you're doing it not because it's better or worse but because that's your job so the next time somebody comes say I want a number for my company ask them do you want me to value your company or do you want me to price your company they'll have no idea what you're talking about but if you want to sell your company what do you want you want a pricing or evaluation you want a pricing the thing is they don't know the difference so when they when you show them the value and it's too low they said that's not right I can make 50% more than that it's being wrong they're saying I want a pricing they just know how to ask you that question so the next valuation mission job you have step back from and says it's my job to value the companies at the prices because it'll make your job a lot easier if you know exactly what you're required to do so think of all those lessons as we go through and as I said valuation is you know the other thing I wanted to said this is something that I believe truly is the valuation is not a science it can never be a science valuation is not art you can't make up stuff as you go along valuation is a craft you know the essence of a character it's like cooking how do you master cooking you could do what my daughter does she watches cooking shows on TV all the time she can't cook a lick tell you in the abstract how to make a souffle she's seen in 20 times on TV but you don't learn cooking by watching TV you don't learn cooking by reading cookbooks you learn cooking by cooking and the first time you cook what happens fire alarms go off disaster strikes and you probably eat out that evening I remember the first time I scrambled eggs nobody told me I was supposed to spray the pan I scramble the eggs they look good but they were stuck to the pan eggs and pan went to the trash you learned a very important lesson valuation is a craft in the essence of a craft is you get better by doing more of it I mean 35 years into this process I'm still learning and I have to remember that the door is never closed you're never master of a crack you might be able to do a particular dish really well as a cook but there are other dishes you don't know and that's something I have to remind myself because there are times when I think I've got this and then I said no you haven't caught this and I'll give you how this plays out about two years ago I remember I valued uber and I just as I value who by the way with traditional value companies project our total revenues total income total cash flows disk on the back comes with the value first and I got some pushback some people didn't like my growth rate but one of the pushback zygarde was from somebody I respect it said you using 20th century technology to value a 21st century company and what he was talking about is the fact that I was using a discounted cash flow model to value companies that derive their value from users or subscribers or members let's face it the big successful companies of today if you add some why is successful the numbers they point to are not revenues cash flows it's hummin look at how many users I have Facebook's most impressive number is not their revenues and their margins it's the fact that they have 2.3 billion users that's mind-boggling Apple there are more than a billion people of using Apple devices so his point was you using 20th century technology to value these companies and derive the value and I thought my initial response is what the heck do you know about valuation but then I thought about saying you have a point but the problem you have is not with discounted cash flow valuation it's with me because what is this kind of cash flow valuation said the value of an asset is the present value the expected cash flows in the acid right could I value a Netflix subscriber with a discounted cash flow model or let me phrase it differently how would our value Netflix subscribe within this kind of cash flow model I'd first have to ask me at how many years you would stay on a subscriber then what do I have to do project out how much you will pay a subscription revenues next tracked out the expenses I will have to incur to keep you as a customer and then discount it back at a discard rate that reflects the uncertainty I feel about those subscription revenue you know what I can Don your Netflix can I'm gonna take every month how much you will pay but I can value a writer a subscriber member so I wrote back to him and said you're promised not with this kind of cash flow valuation it's with me I can value users of rabid and he responded one word right piss me off now end because what was the subject you can talk about it but you cannot do it so I spent the next two weeks developing a framework for valuing uber rider and I'll tell you what it was the most productive two weeks that I spent that year because I use that framework that the value Netflix subscriber an Amazon Prime member as part applies driver and I still use it to this day anytime you give me a user based company what's the value a user a subscriber a customer I now have the frame of prevailing an individual user a subscriber remember in fact it's not it's now going to become my next book I'm supposed to write it over the next few months but I haven't started yet but I'll get there but my point is I was able to do it because I was willing to listen and that's something as long as you keep the door open saying there's more to learn there are things we can do better this process can move forward that's why I don't want you to get enshrined in a set of rules because you know what's gonna happen those rules are going to become outdated sooner rather than later and we're still going to be driven by their rules a lot of valuations around the world I checkbox valuations we basically I fall in the rule I follow the rule look it's all it's following every rule but it might be a terrible valuation so I'm gonna leave you with a couple of final thoughts neither of which I should be throwing out an evaluation session but I'll do it anyway don't take any of this stuff too seriously just reminders of it's only money if your reaction is what else is there in life you need some spiritual counseling but I'm in no position together I remember about six years ago and or what my evaluation class the second year MBA counselor she was a history major who usually history major you take what I call the strategic MBA route which means you pick classes with the word strategic in their name and you can go two years without ever seeing a number but she ended up a mistake in my evaluation class turned out to be pretty good at it so the end of the class she comes to me and says I never thought this would happen but I have a job as a sell-side I could've research analyst I said congresso condole my condolences and then I said oh no my congratulations I say that I'm really scared they said why are you so scared she's and what if I make a mistake that's a big lad you're not a brain surgeon a brain surgeon makes a mistake somebody dies on the table you make a mistake what's the worst that's gonna happen somebody gets a little richer somebody else gets a little poorer think like a Marxist you move some wealth around the world just make sure that somebody's getting a little poor is not you that's the only condition we gotta be think like a Marxist just let it go nothing in valuation is worth sleep losing sleep over I don't I don't understand people get angry in valuation what's wrong with you nobody's dying no but I mean you want to use a different cost of capital go ahead I'm not going to stop you this is not the end of the world final part if you're ever given a choice between knowing everything there is no but valuation and being lucky which one should you pick being lucky I hate to let you in on this but I will anyway this is a business when luck is the dominant paradigm if you're lucky all is forgiven you can do really stupid things and get away with it if you're not you're completely and totally screwed okay how much you know the art evaluation every valuation you do is going to go down so be superstitious which I don't have say you're in India everything is in order there's a time right is it and I don't fight it anymore I used to find it incredibly frustrating that he wouldn't start a business through 9:30 in a particular day because that was the right time that he got I just say okay that's what makes you a lucky person go for it because luck is the dominant paradigm in this business so maybe you should visit a shrine tomorrow and offer the role around the evaluations turned out to be right or you know a mosque or whatever you need to do to get that you you want to be on the right side of lucky because that's such a dominant factor in what ends up happening that you don't control it but that's about it thank you very much for for being your head [Applause] [Music]

Channel: BloombergQuint

Views: 85,052

Rating: 4.9293375 out of 5

Keywords: Bloomberg, BloombergQuint, Business, India, News, Aswath Damodaran

Id: 3DtpkMOjH7s

Length: 89min 7sec (5347 seconds)

Published: Thu Aug 01 2019