I read this book at a really interesting time. In a market that has supposedly forgotten the word ‘valuations’, I think this book is a good read as a reminder for investors like me in a market where it seems that the majority of the crowd has come to a consensus that ‘valuations don’t matter. So, here is a refreshing little book on the art of valuation. Aswath Damodaran has written this book with utmost simplicity such that it’s extremely easy to understand.
Valuations can be a tricky area for investors. Rarely do investors come to a consensus regarding the valuation of a stock. And that is what makes the market. Different perspectives and expectations often fuel different narratives regarding a business or a stock. So, Valuations are often estimations that often change with time as the future is many times uncertain and unpredictable.
Valuations are also extremely prone to incentives and biases. One thing I have learned about valuations over the years is that investors can easily manufacture any well-sounding explanation to justify whether low or extremely high valuations.
My two most important insights from this book are:
- The most important factors in the valuation of a firm are its ability to generate cash flows in the future and the uncertainty regarding those cash flows. Firms with the ability to generate higher cash flows in the future will be valued more highly, as is the nature of the market to value growth companies at higher multiples.
The firms can be intrinsically or relatively.
The most common method to assess the intrinsic value of an asset is Discounted Cash flow (DCF) analysis where the sum of all cash flows in the lifetime of the company are estimated and summed up and discounted back to the present day.
Relative valuations are influenced by the way similar assets are priced.
So, this book briefly explains how the cost of capital, growth rates, and cash flows can be estimated to calculate the intrinsic value of a firm. And all these calculations are subject to assumptions. So, they are great tools to use but one should be aware of their shortcomings and limitations. - The second takeaway from the book is that one should not use the same hammer to value different types of companies.
This is a very common error most investors make. This book analyses companies in different sectors and different stages of their lifecycle. It’s probably not wise to value a loss-making company that is yet to exploit its market potential the same way one would analyze a multi-billion-dollar giant. There is no one size that fits all. So, growth companies should be subject to different valuation metrics than mature and stable firms. As Charlie Munger states, ‘there should be different checklists for different type of companies.
Similarly, it’s also not wise to compare the valuations of companies in different industries with similar valuation metrics. For example, A financial services company is exposed to more risk than an IT/Internet company. Banks can blow upon an entire century of profits in a quarter due to bad lending practices which are difficult to replicate in most other types of businesses. All Businesses are exposed to their own unique industry-specific risk, thus they should be valued accordingly. And this is what makes investing extremely exciting as every investment opportunity can be viewed from multiple perspectives.
This book wonderfully gives a brief overview and some good perspectives over different ways to view a cyclical, growth, mature, declining, loss-making, leveraged, and commodity firms.
I could have written a lot more, but the book has done a good job of explaining most concepts.
As it can be made out from the title, this is a little book that doesn’t take much of your time. It is a great crash course for someone who wants to understand the art of valuations and factors that influence valuations. But everything written should probably be not taken too literally as investing and the business world is far more uncertain than most people imagine and the points stated are just good perspectives to have at your disposal.