Aswath Damodaran : How to approach valuations and markets
Among the best known experts on valuations with several books on the topic to his credit, Aswath Damodaran is a professor of finance and the David Margolis Teaching Fellow at the Stern School of Business at New York University.
Damodaran’s major works on equities include Investment Valuation, The Dark Side of Valuation and Damodaran on Valuation while books on corporate finance are Corporate Finance: Theory and Practice and Applied Corporate Finance: A User’s Manual. in an interview with Jitendra Kumar Gupta, Damodaran talks about the Indian economy, stock picking and factors investors need to watch out for before committing their money to the markets.
Do you believe that India’s long term growth story remains intact?
Yes, but with one caveat. The long-term growth story was never as rosy as it was made out to be nor was it sustainable.
In other words, those who thought that the Indian economy could grow at double digit rates forever were living in a fantasy world. Growth is almost never linear. It is two steps forward, one step back. Note that after this you are still one step ahead.
What is your assessment of the current Indian equity markets in the context of various domestic and global concerns? How long could the pain last?
The longer the party, the more severe the hang over is likely to be. The gain lasted a long time. The pain will last awhile as well. In some ways, the pain will have to last long enough for the excesses of the last few years to be washed away.
Will picking defensive/value stocks work in the Indian context in current circumstances?
Depends on what you are trying to accomplish. If you want to preserve principal and derive cash flows, there are no safe stocks. Even the safest sectors will see volatility in stock prices.
If you have a longer time horizon and are willing to bear ‘paper losses’ in the short term, a strategy to adopt would be to buy mature companies with solid cash flows, good management, significant competitive advantages and reasonable market prices.
What are the lessons to learn from the current meltdown in equity markets, including India?
Humility …No one is bigger than the market or smarter than the rest of the world. Risk is upside and downside… What goes up can come down. Models are only as good as the inputs that go into them.
How relevant is the valuation of the broader market when valuing a particular stock?
A fair amount… After all, the way the entire market is valued tells us something about the risk aversion of investors, risk premiums and the level of interest rates. Those are all key inputs into the valuation of an individual company.
What are the important tools of valuations, which could be used by a layman to pick stocks?
I think assuming that the average investor is incapable or unwilling to use the tools of professional investors is elitist. There are two tools for valuation – you can value a company based upon its expected cash flows and risk (discounted cash flow valuation) or you can value it based on similar companies are priced (multiples and comparables).
Every investor should be able to use the fundamental tools of valuation – looking at cash flows, comparing how stocks are priced.
The data is accessible, the tools are simple and all you need is some time and a willingness to apply yourself.
What are the simple and most effective ways of assessing portfolio risk?
Look at how much your portfolio varies across time and how it moves with the market. If your portfolio seems to be moving too much or is out of synch with the market, you are not diversified sufficiently.
How would you value a company which is aggressively investing in capacity expansion and has a long gestation period? Should investors pay a premium for the future?
Depends on whether the investment in capacity is a sensible investment or not. There is nothing inherently good about investing for the future, if the investments you are making will be delivering sub-standard returns.
In the case of loss making companies with potential to break even in the due course of time, what tools should be used to arrive at valuations?
Why would you need different tools for valuing money-losing companies? In fact, your tools for valuing all companies should be fundamentally the same. You cannot create new sets of rules/models/principles for different classes of stock.
Commodity stocks tend to attract high valuations during the peak of commodity cycle and correct significantly when the cycle turns down. How does one capture the risk of cyclicality of the business?
Commodity stocks are more driven by commodity prices than by business cycles. In the current cycle, the two have moved together. If you look historically, that has not been true.
In the 1990s, for instance, real economies grew but oil prices stagnated. If you have a cyclical company, it will be affected by economic cycles. The only thing you can do to capture the risk of cyclicality is to demand a higher return on these investments.
What are the valuations tools that one should use to determine the selling point for a particular equity investment?
The same tools that you used to decide what and when to buy – cash flows, comparables – should be the tools that you decide to use when to sell.
What are the possible signs of ascertaining a turnaround or a company moving towards default?
When everyone else around you has given up on the company… And the management of the company is moving past denial (where it is denying it is in trouble) and is dealing forcefully with its problems.
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