Latest / Masters in Business / At the Money: Valuation Is an Exercise in Faith

Transcript

At the Money: Valuation Is an Exercise in Faith · Masters in Business

• 0:02
  Speaker 1: Bloomberg Audio Studios, podcasts, radio news because I gotta have fame.
• 0:18
  Speaker 1: Oscar Wilde once described a cynic as a man who
• 0:22
  Speaker 1: knows the price of everything, but the value of nothing.
• 0:27
  Speaker 1: Nowhere is understanding value more important than in the stock market. Sure,
• 0:32
  Speaker 1: prices get quoted every second, every tick, but value that's
• 0:37
  Speaker 1: a much more challenging problem. Whether you're buying broad indices
• 0:42
  Speaker 1: or purchasing specific stocks, it pays to not be a
• 0:46
  Speaker 1: cynic and understand both price and value of your investments.
• 0:52
  Speaker 1: I'm Barry Ritolts, and on today's edition of At the Money,
• 0:56
  Speaker 1: we're going to explain how to become more savvy about
• 1:00
  Speaker 1: understanding equity values. The value you pay for your investment
• 1:04
  Speaker 1: has an outsized impact on your long term returns. To
• 1:09
  Speaker 1: help us unpack all of this and what it means
• 1:11
  Speaker 1: for your portfolio, let's bring in Professor Aswath Damaduran of
• 1:15
  Speaker 1: NYU's School of Business. He is often referred to as
• 1:19
  Speaker 1: the Dean of valuation for his extensive work in the area.
• 1:24
  Speaker 1: He's written numerous books on the subject, including Damadoran on Valuation,
• 1:29
  Speaker 1: Narrative and Numbers, and the textbook Investment Valuation Tools and Techniques.
• 1:36
  Speaker 1: For determining the value of any asset. So, Professor, let's
• 1:40
  Speaker 1: just start with the basic question, why are valuations so
• 1:44
  Speaker 1: important when it comes to equities.
• 1:47
  Speaker 2: I'm going to give you a cynical answer. They're not
• 1:49
  Speaker 2: important if you're a trader. Traders live on pricing. In
• 1:52
  Speaker 2: the essence of pricing is you buy at a low price,
• 1:54
  Speaker 2: you set at a high price, and it doesn't really
• 1:56
  Speaker 2: matter why the price changes if you get the direction drive,
• 2:00
  Speaker 2: value matters if you're an investor. To me, the definition
• 2:03
  Speaker 2: of an investor is you buy something for less than
• 2:06
  Speaker 2: what it's worth. And the essence of values, you're trying
• 2:08
  Speaker 2: to estimate what something is worth. But most as I said,
• 2:12
  Speaker 2: it depends on the philosophy you bring in. Are you
• 2:14
  Speaker 2: an investor or your trader, because that's going to dry
• 2:16
  Speaker 2: whether value matters to you.
• 2:18
  Speaker 1: So let's talk about identifying that intrinsic value of what
• 2:23
  Speaker 1: something is worth with any specific company. How can you
• 2:26
  Speaker 1: determine that valuation.
• 2:29
  Speaker 2: It's as old as time that Venetian glass maker is
• 2:32
  Speaker 2: sold as business in the Middle Ages. Probably sold it
• 2:35
  Speaker 2: to somebody bought it because of the cash flows he generated,
• 2:39
  Speaker 2: the risk in those cash flows, and how much those
• 2:42
  Speaker 2: cash flows are going to grow. It's cash flows, growth
• 2:44
  Speaker 2: and risk. That's the essence of value. That's always been true.
• 2:48
  Speaker 2: We act like we invented valuation in the last century
• 2:51
  Speaker 2: in finance because we came up with all these neat
• 2:54
  Speaker 2: little models and metrics to measure risk and bring it
• 2:57
  Speaker 2: into what you need to make. But always been driven
• 3:00
  Speaker 2: by cash flows, growth and risk. And how you get
• 3:03
  Speaker 2: to that value can come from different pathways. I use
• 3:07
  Speaker 2: intrinsic valuation, you know, in that sense as capturing anybody
• 3:13
  Speaker 2: who thinks about those fundamentals.
• 3:14
  Speaker 1: So let's dive into that intrinsic valuation based on cash flow,
• 3:20
  Speaker 1: growth and risk. What different ways are there to measure
• 3:23
  Speaker 1: the fundamental value of a company? And how do these
• 3:27
  Speaker 1: different valuations reveal intrinsic value?
• 3:30
  Speaker 2: I mean, ultimately, cash flows, growth and risk are not
• 3:33
  Speaker 2: going to be different for different people. The way we
• 3:35
  Speaker 2: think about risk, though, can differ depending on who you
• 3:38
  Speaker 2: are as an investor and what do you think matters.
• 3:40
  Speaker 3: I mean, I'll give you an example.
• 3:42
  Speaker 2: In traditional finance, we think about risk by looking at
• 3:45
  Speaker 2: how prices move for a stock relative to the market.
• 3:48
  Speaker 3: But there are intrinsic value.
• 3:50
  Speaker 2: People argue that true measure of risk is what happens
• 3:52
  Speaker 2: to your earnings. Your revenues are operating metrics. So even
• 3:56
  Speaker 2: within people who believe in intrinsic value, we can have
• 3:58
  Speaker 2: disagreements about how to measure risk, what is the right
• 4:02
  Speaker 2: cash flow to look at, and what's the growth rate
• 4:06
  Speaker 2: that you think about over what periods. So while we
• 4:09
  Speaker 2: might have twenty people in a room, all of whom
• 4:12
  Speaker 2: buy into intrinsic value, we can come up with twenty
• 4:14
  Speaker 2: different estimates of intrinsic value for the same company at
• 4:17
  Speaker 2: the same point in time.
• 4:19
  Speaker 1: So we always hear about price to sales, price to book,
• 4:23
  Speaker 1: price to earnings. Are these all that different, They're just
• 4:26
  Speaker 1: variations on fundamentals, or are they very different ways of
• 4:30
  Speaker 1: looking at the same company.
• 4:32
  Speaker 2: Philosophically, they're very different because when you compute the price
• 4:35
  Speaker 2: earnings or the ev Tabidov price to book for a company,
• 4:38
  Speaker 2: what you do is you compare to other companies out there,
• 4:41
  Speaker 2: and you make a judgment and saying, in this company
• 4:44
  Speaker 2: trades at ten times earnings, other companies like it, and
• 4:47
  Speaker 2: I'm going to put quotes on like it trade at
• 4:50
  Speaker 2: fifteen times earnings. Therefore as cheap, that's a pricing judgment.
• 4:53
  Speaker 2: There's nothing value in here, there's no intrinsic value judgment.
• 4:57
  Speaker 2: That's why all of seal side equity research, I would argue,
• 5:00
  Speaker 2: is all about pricing.
• 5:01
  Speaker 3: It's not about valuation.
• 5:03
  Speaker 2: Nothing wrong with it, but we should be honest about
• 5:06
  Speaker 2: what we're doing. So when you use ratios, it's because
• 5:09
  Speaker 2: you want to find something cheap by comparing it to
• 5:12
  Speaker 2: other things out there that are being traded right now,
• 5:15
  Speaker 2: and you're looking at what other people are paying, so.
• 5:17
  Speaker 1: You're looking at price. When people look at stocks that way,
• 5:21
  Speaker 1: they're looking at price and relative valuation, non intrinsic value.
• 5:26
  Speaker 1: Let's talk about some of the things you've explained in
• 5:29
  Speaker 1: your books. Valuation requires a deeper understanding of the business,
• 5:34
  Speaker 1: including how it makes money and its future prospects. Give
• 5:38
  Speaker 1: us a little more detail on that.
• 5:40
  Speaker 2: I'll give you an example, and it's a personal example.
• 5:43
  Speaker 2: I bought in Media purely by luck in two thousand
• 5:46
  Speaker 2: and eighty. I didn't see AI coming, none of this stuff.
• 5:49
  Speaker 2: So sometimes your best investments happened by accident. So last
• 5:53
  Speaker 2: year I had to revalue in Vidia for a simple reason.
• 5:57
  Speaker 2: I mean I bought it at twenty seven dollars per Yeah,
• 6:00
  Speaker 2: the stock was trading at eight hundred dollars per share,
• 6:03
  Speaker 2: and I had to decide is it time to leave?
• 6:06
  Speaker 2: So as I sat down to value VideA, I started
• 6:08
  Speaker 2: with a presumption that was a computer chip company that
• 6:11
  Speaker 2: had made chips and sold them, and I had to
• 6:13
  Speaker 2: estimate cash flows based on that. It's only as I
• 6:16
  Speaker 2: started digging a little deeper that I realized that they're
• 6:19
  Speaker 2: not a chip maker, They're a chip designer. Every Invidia
• 6:23
  Speaker 2: chip is made by TSMC, which basically changes the way
• 6:27
  Speaker 2: you think about the business. If you're doing pricing, you
• 6:30
  Speaker 2: might be able to gloss over it, it doesn't matter
• 6:32
  Speaker 2: that they do it, but if you're doing intrinsic valuation,
• 6:35
  Speaker 2: because I have to estimate cash flows, I have to
• 6:38
  Speaker 2: think about what is it that they spend to create
• 6:41
  Speaker 2: these revenues, and that requires an understanding of how they
• 6:44
  Speaker 2: conduct their business. I mean Warren Buffett a famous saying
• 6:48
  Speaker 2: that he doesn't buy stocks, he buys shares of businesses. That,
• 6:52
  Speaker 2: to me, in essence, is what you're doing in intrinsic valuation.
• 6:55
  Speaker 2: You're not buying a share of Apple or a share
• 6:57
  Speaker 2: of Amazon. You're buying a slice of those businesses. That's
• 7:01
  Speaker 2: what you're doing. You better understand what you're buying before
• 7:04
  Speaker 2: you pay a price.
• 7:05
  Speaker 1: So can we apply the same theory of valuation to
• 7:08
  Speaker 1: broad indices as opposed to just individual stocks.
• 7:13
  Speaker 2: Absolutely, I mean it's cash flows, growth and risk drive
• 7:15
  Speaker 2: the value of Invidia. Cash flows, growth and risk, because
• 7:18
  Speaker 2: what drives the value the S and P five hundred
• 7:20
  Speaker 2: or the nasdat. In fact, that's the process I use
• 7:23
  Speaker 2: at the start of every month to come up with
• 7:26
  Speaker 2: an estimate or what investors are pricing in the S
• 7:29
  Speaker 2: and P five hundred and what they can expect to
• 7:31
  Speaker 2: earn given the cash flow. It's a very intrinsic value
• 7:34
  Speaker 2: view of what can you expect to make as a
• 7:37
  Speaker 2: rate of return on an index.
• 7:39
  Speaker 1: So that raises, you know, the real important question, what
• 7:45
  Speaker 1: do these measures of evaluations mean for future expected returns?
• 7:50
  Speaker 2: The more you pay for something, let's cut away from
• 7:52
  Speaker 2: all of the noise in this process, The more you
• 7:57
  Speaker 2: pay for something upfront, the low you're expected returns are
• 8:01
  Speaker 2: going to be. Because if you pay more upfront, and
• 8:03
  Speaker 2: that's just common sense. So when you buy the S
• 8:07
  Speaker 2: and P five hundred at fifty three hundred, you can
• 8:11
  Speaker 2: expect to earn a lower return than if you bought.
• 8:13
  Speaker 3: It at fifty one hundred.
• 8:15
  Speaker 2: So if you bought it last week, your expected denerve
• 8:18
  Speaker 2: was lower than if you bought it today.
• 8:20
  Speaker 3: And that's at the basis of intrinsic value.
• 8:23
  Speaker 2: It's about paying the right price for something upfront.
• 8:27
  Speaker 3: Is the most critical decision you make.
• 8:29
  Speaker 1: So you consistently in all your books emphasize that value
• 8:34
  Speaker 1: is not price. So how should investors think about the
• 8:38
  Speaker 1: difference between the quoted fluctuated price we see every day,
• 8:44
  Speaker 1: the quoted fluctuating price that we see every moment on
• 8:48
  Speaker 1: the market, and that deep intrinsic value.
• 8:51
  Speaker 2: Recognize there are two different processes. Nothing makes one better
• 8:54
  Speaker 2: than the other. Different processes. Values driven by changes in
• 8:58
  Speaker 2: your earnings, cash flows, growth risk, and that's captured by
• 9:02
  Speaker 2: changing value over time. So I'm not saying intrinsic value
• 9:06
  Speaker 2: somehow stable stagnant number. The intrinsic value in radio doubled
• 9:10
  Speaker 2: because of its entry into AI. Intrinsic value can change.
• 9:14
  Speaker 2: Price is driven by demand and supply, driven by mood
• 9:18
  Speaker 2: and momentum, and I think one of the best indicators
• 9:21
  Speaker 2: you can take a mood and momentum is when the
• 9:23
  Speaker 2: momentum is good All news is good news. In fact,
• 9:27
  Speaker 2: there's a whole segment of finance called behavioral finance, and
• 9:31
  Speaker 2: behavioral finance tries to explain why price can not only
• 9:35
  Speaker 2: deviate from value but stay different for long periods. There
• 9:40
  Speaker 2: this inherent belief that value investors have that price will
• 9:43
  Speaker 2: move towards value and it will happen quickly. That's not true.
• 9:47
  Speaker 2: Price can deviate from value. It can stay separated from
• 9:50
  Speaker 2: value for long periods, which means if you're an intrinsic
• 9:54
  Speaker 2: value investor, you're going to get incredibly frustrated because you
• 9:57
  Speaker 2: think you got.
• 9:57
  Speaker 3: It right, but you keep losing money.
• 10:00
  Speaker 1: So you're referring to mean reversion. The expectation is that
• 10:03
  Speaker 1: pricey things eventually come back down to fair value, and
• 10:08
  Speaker 1: inexpensive things will eventually be recognized and return to fair value.
• 10:14
  Speaker 1: How long does this process take? Is it guaranteed to happen?
• 10:18
  Speaker 1: Does that mean reversion always occur?
• 10:21
  Speaker 2: It's not just mean reversion, it's assumption that values what
• 10:25
  Speaker 2: matters in the long term.
• 10:26
  Speaker 3: I mean that's almost ill. I mean when I.
• 10:30
  Speaker 2: Start my valuation class, I started the question do you
• 10:32
  Speaker 2: have faith? My students look at me, say it's evaluation class.
• 10:35
  Speaker 2: What are you talking about? I said, the essence of
• 10:37
  Speaker 2: investing is faith. Faith that your estimated value is the
• 10:41
  Speaker 2: right value, and faith that the price will move to value.
• 10:45
  Speaker 3: And the essence of faith.
• 10:46
  Speaker 2: If you asked me to prove it, and if you
• 10:48
  Speaker 2: told me, tell me what will cause it to.
• 10:50
  Speaker 3: Happen, my answer is, I don't know. It's a mystery.
• 10:53
  Speaker 3: I mean, it's like.
• 10:54
  Speaker 2: Going to church and going up to your pastor or
• 10:56
  Speaker 2: your rabbi and saying, can you give me some proof
• 10:58
  Speaker 2: that God exists?
• 10:59
  Speaker 3: I keep coming back every you know, every week.
• 11:02
  Speaker 2: Because I and if that rabbi, a priest or you
• 11:06
  Speaker 2: know is telling you the truth, they should say look enough.
• 11:08
  Speaker 3: I can't give you that proof. It's faith.
• 11:11
  Speaker 2: And I think that's what makes investing so difficult is
• 11:14
  Speaker 2: it's driven by faith rather than by proof. So if
• 11:17
  Speaker 2: you ask me, you know, if I bought something undervalued,
• 11:20
  Speaker 2: am I guaranteed to make money in the long term?
• 11:23
  Speaker 3: Absolutely not. And you have to be okay with it.
• 11:25
  Speaker 2: If you're not okay with it buying a text file,
• 11:29
  Speaker 2: don't invest or be a trader. The essence of investing
• 11:32
  Speaker 2: is you can do everything right and I have nothing
• 11:35
  Speaker 2: to show for it, and you have to be okay
• 11:36
  Speaker 2: with that.
• 11:37
  Speaker 1: Wow, So, professor, bottom line it for us when we
• 11:41
  Speaker 1: think about valuation, when investors look at equities, what should
• 11:45
  Speaker 1: be foremost in their minds before deploying capital?
• 11:51
  Speaker 3: Pwice.
• 11:51
  Speaker 2: Be honest with yourself, Now, what is the game you're playing?
• 11:55
  Speaker 2: If you're playing the trading game, don't lie to yourself
• 11:57
  Speaker 2: about caring about fundamentals and earning and cash flows.
• 12:01
  Speaker 3: Just play the trading game.
• 12:02
  Speaker 2: Look at charts, look at technical indicators, look at mood
• 12:05
  Speaker 2: and momentum, because that's what you're playing. If you want
• 12:08
  Speaker 2: to be an investor, you need to do your homework.
• 12:10
  Speaker 2: You can't hide behind the fact of I've never done
• 12:13
  Speaker 2: an accounting or evaluation classet or understand these financial statements.
• 12:17
  Speaker 3: The essence of investing.
• 12:19
  Speaker 2: Is you've got to be able to look through those
• 12:22
  Speaker 2: financial statements and be able to gauge the value of
• 12:25
  Speaker 2: a company. You might not want to use the full
• 12:27
  Speaker 2: technology of intrinsic valuation, but you need to start thinking
• 12:31
  Speaker 2: about businesses and value in a much more in a
• 12:34
  Speaker 2: much deeper way than you're doing right now. If that's
• 12:37
  Speaker 2: not your thing, that's fine. There are lots of people
• 12:40
  Speaker 2: who get richest traders, and there's nothing wrong with trading.
• 12:43
  Speaker 3: Just play that game well.
• 12:45
  Speaker 1: So to wrap up, investors who have a long term
• 12:48
  Speaker 1: time horizon should be very aware of the variations in valuations.
• 12:54
  Speaker 1: The more you pay for a given stock or a
• 12:57
  Speaker 1: given market index, the lower your future expected returns are.
• 13:02
  Speaker 1: Understand that there are no guarantees in the market, and
• 13:06
  Speaker 1: merely buying cheap stocks is no guarantee that you're going
• 13:10
  Speaker 1: to outperform or even market perform in the future. I'm
• 13:14
  Speaker 1: Barry Retults and this is Bloomberg's at the money.
• 13:17
  Speaker 3: I gotta have