How do you know how much a share in Amazon
is worth? How about one in AT&T? Or one in ExxonMobil for that matter? Unlike for instance a painting or a sculpture,
the value of a stock market company is not in the eyes of the beholder. So, if you're one of those people who have
always thought that the price of a stock doesn't matter as long as someone else is willing
to pay more for it, think again. This "greater fool theory" as it is referred
to, can be a really expensive game to play. As the investing community collectively proved
during the dot-com bubble, and also one that is totally unnecessary. Why? Because, at its core, valuing a company is
actually simple, and in this video, I'll show you how. This is a top 5 takeaway summary of "The Little
Book of Valuation", written by Aswath Damodaran, and this is The Swedish investor, bringing
you the best tips and tools to reach financial freedom through stock market investing. Takeaway number 1: Two valuation approaches;
relative and intrinsic value. Valuing a stock market company can be done
using two major approaches; the relative and the intrinsic value approach. The relative value approach is based on a
single premise. I told you this was simple... Which is that, everyone prefers to pay as
little as possible for identical assets. The intrinsic approach is based on two major
premises; everyone prefers money today over money tomorrow and everyone prefers a sure
bet over a risky one. Some people may favor one method over the
other one, but I think that both are useful, and there's no reason not to confirm your
investment decisions using both of them. My own investing strategy consists of first
using a relative approach to screen for companies and later use an intrinsic approach to decide
if the individual company is worthy of my money. With that said, let's dive deeper into both
of these. Takeaway number two: A quick guide to relative
valuation. What would you prefer? Buying a house for $200,000 or buying the
neighboring house for $300,000? Silly question perhaps, but this is the basis
for relative valuation; you compare an asset with another one that is as similar as possible
and simply pick the cheaper alternative. In the stock market, it is never as clear-cut
as in this example, but the premise is still the same. There are three essential steps for relative
valuations; 1. Find comparable assets. We must compare apples to apples and oranges
to oranges. If we take the companies that I talked about
in the beginning of this video, it's easier to find comparisons for AT&T, and for ExxonMobil,
while it's more difficult for Amazon. Walmart comes to mind but their stores are
physical and not online. Frankly, no one even comes close to the online
sales of Amazon who has about 50% of the total online retail market in the U.S. 2. Use a standardized variable. To be able to compare these companies with
each other, we cannot just look at the prices of the businesses and pick the cheapest ones. We must scale the price to another variable. Scaling price to earnings by using the so
called Price to Earnings or P/E multiple is a good place to start. 3. Adjust for differences. We're not quite there yet though. To pick Walmart over Amazon just because its
P/E is lower doesn't make much sense. Usually, a company trades at a lower multiple
than another one because its earnings growth is expected to be lower in the future. While historical earnings growth isn't in
any way a guarantee for growth in the future, it can be used as an approximation, and to
find interesting prospects to dive deeper into. As we can see, Verizon and Royal Dutch Shell
are both cheaper and have experienced a stronger growth in earnings than their peers, which
makes them interesting cases for further analysis. In our relative valuation, we assume that
the market is correct on average, but wrong on an individual company level. But, it didn't make much sense to pick one
of the dot-com companies in 1999 at a P/E of 100 just because it seemed cheap relative
to its competitors that had P/Es of 200. Therefore, this assumption may be flawed and
relative valuations, in my opinion, should always be accompanied by intrinsic ones. Takeaway number three: A quick guide to intrinsic
valuation. What would you prefer? $10,000 today or $1,000 per year for the next
10 years? All right, perfect. So then we have established our first principle;
everyone prefers money today over money tomorrow. There are plenty of reasons for this, but
two of the more important ones are instant gratification and inflation. Now, think about this one; what would you
prefer? I'll give you a thousand bucks or you'll have
to flip a coin... Heads, you get 2,000 bucks, tails you get
nothing at all? Excellent! Then we have established our second principle
too; everyone prefers a sure bet over a risky one. Combined, these two premises help us in understanding
the most important variable in an intrinsic valuation, often referred to as a discounted
cash flow analysis elsewhere by the way, and that is the so called "discount rate". The discount rate determines how much less
a future income is worth to you, and the rate should be higher the more uncertain you think
that income is. If you use a 15% discount rate, you essentially
say that $1000 the next year is worth only $870 today. $1000 in three years is only $658, and in
ten years it will be worth only $247. The discount rate could also be viewed as
how much yearly return that you demand for that asset. Now, how do we apply this in the stock market? Well? First and foremost, we must remember what
a share in a company is. A share in a company is a claim against a
certain portion of the future earnings of the same company. For instance, if you hold one share in Amazon,
you are entitled to 1 out of 504,000,000 of the future earnings of Amazon. To get a little bit technical, we are actually
not interested in net income, but rather something like Warren Buffett's owner's earnings. If we could say with certainty what the owners
earnings would be from this day to infinity and use our previously determined discount
rate to translate the earnings into today's value, we could say what the equity in a company
is truly worth. If we divide that with the number of shares
outstanding, we could say what a single share is worth. If the price of the share is lower than the
value that we came up with, we would buy the stock and vice versa. Calculating anything from now to infinity
sounds like a daunting task. So we usually only estimate the owners earnings
for the first ten years or so, and then calculate something called "a going concern value". The owners earnings for the first ten years
plus the going concern value determines the total value of the company. Remember that you are not looking for a stock
that your estimate is worth something like 10% more than the price. You want what Benjamin Graham referred to
as "a margin of safety" here. Use the discount rate that you require for
your investments, say 15% and then make sure that your intrinsic value calculation is at
least something like 40% undervalued. As you can see, calculating the intrinsic
value of the stock is simple, but not easy. Estimating 10 years of owners earnings involves
a lot of assumptions. For instance, how fast will the revenue be
able to grow during these years, how high profit margins can the company maintain, and
how much capital expenses will be required to support this. Your results from this valuation technique
will be no better than those underlying assumptions. Therefore, in takeaway number 5, I will give
you some guidelines for three common situations. Takeaway number 4: Truths about valuations. Even a combination of a relative valuation
and intrinsic one comes with its flaws. By being aware of these flaws, you can improve
your odds of picking the right stocks. All valuations are biased; why did you estimate
a 20% revenue growth per year for the next ten years for Amazon and not 10%? Choices like these will have major impacts
on the valuations that you make, and you want to be sure that you are as rational as possible
in your assumptions. Chances are that you have at least one reason
of being biased; maybe you like the personality of Jeff Bezos, maybe you already owns stocks
in the company, or maybe a friend of yours is on the Amazon hypetrain. Be aware of this and question your assumptions
one more time if you know that you're at risk. Most valuations are wrong, unfortunately. But this shouldn't stop you because relative
and intrinsic valuations are the two best tools that we have, and all investors are
facing the same uncertainty. Also, sometimes it doesn't matter if your
valuation is off by say 30% because the stock is so clearly undervalued anyways. As Benjamin Graham famously said "it is quite
possible to decide by inspection that a woman is old enough to vote without knowing her
age, or that a man is heavier than he should be without knowing his exact weight". Less is sometimes more! Take the estimation of future revenue growth
as an example. There are so many variables that could go
into this, but you have to be careful not to include too many of them in your analysis. Focus on just a few of the most important
ones; perhaps competition, quality of management and the potential size of the market and leave
the other ones out. Including too many variables will often cause
you to miss the forest for the trees. Takeaway number 5: Context matters: Growth,
decline and cyclicals. Depending on what type of company that you
are dealing with, you'll have to adjust your relative and intrinsic analysis. For example, valuing Amazon as a growth company,
AT&T as a company in decline and ExxonMobil as a highly cyclical commodity company will
present different difficulties. Amazon, the growth company. Determining how scalable the revenue growth
is will be of major importance. As suggested before, it starts at evaluating
competition, quality of management and the size of the overall market. Future profit margins are another concern,
and typically, they will increase as the company matures. Having margins scaled from the current level
and to that of an industry average over time is probably a good idea. Don't wait too long before putting the company
into the stable growth used for the going concern value. A strong growth company will not be able to
grow like it did previously. The sheer size of itself will be a problem,
as will competition. AT&T, the company in decline. Beware large capital expenses. You don't want the company to throw good money
after bad. As Warren Buffett says "should you find yourself
in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive
than energy devoted to patching leaks". An interesting property of companies in decline
is that the risk for bankruptcy increases a lot. In your valuations, you must take this into
account. Determine a value for the company if it survives
together with the value of the company if it defaults, and attach probabilities to both
of these outcomes. If the company defaults, it probably has a
lot of assets that can be sold off. The balance sheet therefore becomes much more
important for the valuation of a company in decline then for instance, the growth company. ExxonMobil, the cyclical commodity company. For cyclical companies, results vary a lot
over a normal business cycle. One of the most interesting properties that
they have is that they often seem the most undervalued at the top of a market cycle,
or at the top of commodity prices and the most overvalued at the bottom. But in reality, just the opposite is true. For these companies, it becomes important
to normalize earnings to be able to make fair comparisons and intrinsic valuations. For a commodity company, you can use the average
price of the commodity of the past ten years for instance to see how it impacts revenues
and net earnings. For an industrial company, you can use the
average profit models over a whole business cycle. If you want to dig deeper into how you can
determine the fair value of a stock market company, I've created a playlist of videos
on that subject for you. Check it out... Cheers guys!
