Aswath Damodaran, professor of finance at NYU’s Stern School of Business, has written extensively on valuation. In "The Little Book of Valuation" (Wiley, 2011) he makes the process accessible to any individual investor who can—to quote one of his “rules for the road”—convert stories to numbers.
The math in this book is elementary; for the most part it requires no more than a junior high school education or, barring that, a calculator. Naturally, the concepts are more sophisticated.
Damodaran begins by differentiating between intrinsic and relative valuation. Intrinsic valuation looks inward, to the properties of cash flows (e.g., high/low, stable/volatile). Relative valuation looks outward, to how the market prices similar assets. There’s no compelling reason to use a single model and discard the other. “In truth, you can improve your odds by investing in stocks that are undervalued not only on an intrinsic basis but also on a relative one.” (p. 5)
Frequently the outputs of the two models are quite different. The explanation for this disparity lies in their “different views of market efficiency or inefficiency. In discounted cash flow valuation, we assume that markets make mistakes, that they correct these mistakes over time, and that these mistakes can often occur across entire sectors or even the entire market. In relative valuation, we assume that while markets make mistakes on individual stocks, they are correct on average.” (p. 78) Any investor who went through the dot.com bust should realize how tenuous relative valuation can be. An Internet company that was undervalued in relation to its radically overvalued sector could still be, and probably was, intrinsically overvalued.
After explaining the essential steps involved in statically valuing stocks according to each model, the author introduces a more dynamic “cradle to grave” scenario. Companies have life cycles, and there are valuation issues at every phase in these cycles. For instance, how do you value young companies that may be losing money and whose survival is not assured? How do you value companies that are suffering from growing pains? Even mature companies, which might seem easy to value, can present challenges. “The biggest challenge in valuing mature companies is complacency. When valuing these companies, investors are often lulled into believing that the numbers from the past … are reasonable estimates of what existing assets will continue to generate in the future.” (p. 128) And what about companies in decline, which can still be profitable investments?
Finally, the author addresses special situations in valuation—financial service companies, cyclical and commodity companies, and companies with intangible assets. All this in a 5” x 7” book of 230 pages.
For the investor who wants to use fundamental analysis to help unearth opportunities in the market, "The Little Book of Valuation" is a gem. Damodaran provides the reader with the essential tools of valuation without overtaxing his brain. Even more important, he challenges (and helps) the reader to go beyond the formulaic and ask the kinds of questions that can make all the difference between an essentially useless valuation and one that is a truly valuable input to an investment decision. Hats off to Damodaran and to the “little book” series.