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Notes from Workshop (Prof Aswath Damodaran on valuation)

How many of you all like number crunching and How many likes story telling?
Usually bankers are number crunchers & VC's are story tellers
So what is exactly valuation?
Valuation is a bridge between numbers and story
Story leads --> Numbers leads --> Valuation
With world is changing value of young companies keeps on changing
Don’t mistake modelling for valuation (Not a spreadsheet to enter numbers)

Step 0 --> Survey the landscape


Step 1 --> Develop a narratieve for the business that you are valuing
Step2 --> Test the narrative to see if it is possible, plausibel, and probable
Step 3 --> convert the narrative into drivers of value
Step 4 ---> Connect the drivers of value to valuation
Step 5 --> Keep the feedback loop open

Every valuation starts with a narrative, a story that you see unfolding for your company in future
In developing this narrative, you will be making assetmnets of
-Your company its products, management and its history
-Market that you see as growing
-Competition it fcaes
-Macro environment in which it operates

For eg: Auto business is bad business --> low margin business, have low growth, require high and inc reinvestmnets
Now here what makes Ferrari different ?
Ferrari sold only 7,255 cars in all in 2014
Had a profit margins of 18%, partly because of sky high prices and partly coz it spends very less on advertising
Ferrari sales have grown very little in tha last decadeand have been stable
Ferrair have not invested in new plants

Aslo in 2009 after financial crises it sold 7,200 cars


sells to rich class of people , who don’t care of economy
Belongs to exclusive club --> so reflected in valuations

Shell company
Oil company --> riskly business --> valuation differ
Clean energy --> tech company --> valuation differ
Tech to deliver energy at lower cost and higher output
So valuation diifers with differnet story

Ferrari narrative at the time of its IPO in Oct 2015


Ferrari will stay an exclusive auto club, deriving its allure fromscarcity and the fcat that only few owns ferrraris
By staying exclusive , the company get three benfits
-It can continue to charge nose bleed prices for its cars and sell them wih lesse advertising
-It does not need to invest in new plants since it does not plan to ramp up its production
-It only sells to super rich who are unaffected by overall economic conditions or market crisis
Shell narrative in 2016
3 different stories , 3 different outcomes
What business is Shell in? Oil/ Energy
Competitive advantages ? How strong are they? How sustainavble are they?
How do you see the company evolving? Shrinking, growing, holding (If so , How?)

Ashwath damodarn Uber valuations in June 2014 ---> 6 bn dollar


VC valuations --> 17 bn $ ( VC don’t value they price)

Uber narrative in 2014


-Urban car service company
-Would expand business moderately
-Local networking benfits --> If it becomes large enough in any city, it will quickly become larger, but that will of little help w
city Eg Ola in Mumbai,
-Maintain its 20% revenues sharing system
-Asset light model

Uber Gurley Pushback


-Uber not just a car service company, it’s a logistic compay
-Will expand susbstancially
-Not just urban
-Global networking benefits - by linking tech nad credit card companies
-Value for Uber --> 17 bn $

2nd narrative --> Will have dominant market share, by reding margins to 10%
Valutions --> 28 bn

The real world intrududes --> Be ready to modify narrative as events unfold

How do you value or research a company?


Financial statements may be google search
Instead you should talk to people working there why they like working , why people buy products
You should research at ground level instead of talking to management
Step from your class - circle and discuss with other groups of people
Then come on to valuation of a company

Ashwath damodaran's Uber's story in his own words


He Converted entire story into numbers and came to a valuation of 6bn $
June 2014 I firsts heard about uber , they have raised 3bn dollar from VC and valued at 17 bn, Like I have said VC value noth
see how many similar companies are there and accordingly they price the company.
I saw my credit card statement of last 3 months, with most UBER in that, somehow it was my son using that. I thought he w
classes but later learned about uber from my niece that its a ride sharing company and then I downloaded the app and ma
happening on my smartphone, saw car driving on my smartphone. Driver aks' where do you want to go Sir!' This has never
in a yellow cab, I said I want to go on a ride for 30 mins and would like to ask you a few questions. Ok Sir! Get inside. This is
driving ? No, this is my car. Are you a Uber employee? No. I do a regular job, I already own this car & pays for insurance an
my secondary source of income. In New York city it is legal to pick up people from streets and Uber connects me with them
is linked with your credit card and Ubers pays me 80% of it. What about remaining 20%? I dont know Sir and he leaves. The
are you using Uber when you already have your own car. He replies, On Fri & Sat night UBER is an ease. Do they charge hig
No, instead they are cheaper and faster.

-connects with customer


-This becomes second source of income
-Cheaper & faster than cab
-20 % of income from fare
-Good business by not owning any car
-Networking fatser with technology --> will make company big
This is how I look at companies
What would I get by looking at numbers and valuations of a private company

When you read Annual reports they are more accoutant driven stuff and you get caught in trap od accounting
Your job as an investor is looking for specific set of numbers
Like where is the capital getting reinvested, what is the cost of capital, what growth are we getting on that invested capital,
invested capital giving growth

Don’t shy away from negative cashflows if a company has --> Look where the new capital is invested

Younger companies will have faster revenue growth and should have higher re investment and lower margins. So they get n
say after 1,2 or 3 years later these companies have have the ability to create disproportionate postive cashflows for the ea
cashflows
Mature companies will have lower revenue growth and lower re investment and higher margins
But a company with higher revenue growth and lower re investmnents with growing margins --> Looks absurd

How a financial balance sheet should be made: Different from accounting balance sheet
Investments already made -Existing investments generate cashflows today
Investments yet to be made - Expected value that will be created with future investments
Debt -Borrowed money
Equity - Owner's funds

There can be two variants:


Variant 1 --> You estimate the values of assets
Variant 2 --> You let the market estimate it for you

Accouting statements gets less and less useful if you are looking earlier in the life cycle
As companies age, balance sheets mean more but they also become more cluttered
Balance sheet based valuation, which is what most accounting valuation is useless in young companies. It is most useful in
without accounting clutter
Companies where accounting miscategorizes expenses, balance sheet get even more meaningless
Fair value accounting is destined for failure, because accountants cannot be imaginative or creative

Life cycle of company


Growth stage:
Startup --> Young growth --> High growth --> Mature growth --> Mature stable --> Decline

- At mature stage --> defend your business from new competitors and find new markets
-On decline scale down your business as the market shrinks

Operating profits:

Large op. losses--> Op. losses narrow--> Op. profits turn positive--> Op. profits grows quickly--> Op. profits level off--> Op. p

Reinvestments:
Very high--> High--> Remains large, but scale down as percent of firm--> decrease --> scale down further --> Divestment

FCF to firm:
Negative --> Negative--> Cross over to positive territory--> Positive and growing--> Positibe and stable--> Positive and dropp

Investing :
Option investing (Go for the upside)--> Growth investing (Maximize value from growth) --> Scaling investing (Scale up grow
investing (Protect your competitive advantage) --> Maintenance investing (Preserve your value) --> Divesting

Financing:
All equity (usually pvt)--> All equity (shift to public)--> First signs of debt capacity, but benefits are small --> Debt capacity e
cautionary notes --> Benefits of borrowing significantly exceeds costs---> Pay down debt as assets are sold

Dividend:
Need cash from equity investors--> Cash needs multiply (beyong pvt mkt)--> Move towards sufficiency (cash flow meet inve
Internal cash flows exceed investment needs--> Significant excess free cash flows--> Internal cashflows decline

Biggest concerns:

Lack of capital--> Allocating limited capital across competiting investments--> Balance existing investments with new ventu
with less attractive investments --> Too much capital chasing too few investments --> Deciding which investment to pull cap

Investment Technique:
Options models, all about upside--> Maximizing IRR--> Profitability index(NPV as % of investments --> NPV as capital constr
and excess returns models --> Divesiture and Liquidation Analysis

Stage 1 --> Organic investments


Stage 2 & 3 --> Acquisitions for potential growth
Stage 4 & 5 --> Acquisitions for current growth
Stage 6 --> Divestitures

Profits and cash flows:

Large losses & neg cashflows --> losses narrow but cashflows still negative--> Profits turns positive but reinvestments make
low/negative --> Cashflows turn positive as profits grows & reinvestment drops --> Cashflows continues to rise, as earnings
profits decline but divestitures add to cashflow
Tax benefits
None --> None --> Low as NOLS shelter income --> Rising as NOLS expire --> High --> Positive, but dropping

Debt capacity
Non existent --> Very low--> Low--> Rising --> High --> High but dropping

Debt
No debt -->No debt --> Low debt --> Medium debt --> High debt --> Retiring debt

Narrative drivers
How big is the narrative--> How plausibkle is the narrative--> How profitable is the narrative?--> How scalable is the narrati
happy ending?

Top managements job

Tell a compelling and plausible story with potential of huge profits --> Stay consistent with words and actions to story --> St
numbers to back up the story --> Keep your narrative in sync with your numbers --> Adjust your narrative to reflect where y
cycle

Pricing metrics
EV/market, cash burn ratio--> EV/user--->EV/ sales--> PEG--> PE, EV/EBIDTA ---> Price to Book, EV/Invested Cap

Using a metric that is designed for one stage in the life cycle to price companies in different stage will yield results that can
to catastrophic
-Old time value investors who use PE ratios will always find young companies to be over priced, no matter what their pricin
-Growth investors who uses revenue multiples will find mature companies look like bargains at all times

Drawing line between Tech and Non Tech companies is getting more & more difficult
Equity research analysts work into sectors silos
Now where a company like Amozon is placed can make a difference in how it is analysed
Is a retail, tech, ecom?
Pricing is often done relative to the sectors that investors decide to put a company into

Characteristics of the tech business


Scaling up is easy --> Up front investment is minimal and scaling up is easy
Holding on is tough --> Once tech companies mature, their competitive advantages are fleeting and quickly deplete
Decline is rapid --> Same forces that alllows them to quickly scale up also makes them vulnerale to new entrants
And there is little left in the end game --> Unlike other business which accumulate physical assets as they grow and thus ha
potential where tech companies fall back

Tech companies don’t have long mature periods, because disruption is alwasys around the corner. Non tech companies hav
periods where they get to milk their cashflows

Tech companies climb the growth ladder faster because their grwoth requires less investments and products are quickky ac
consumers. Non tech companies take longer tio grow, because their growth requires high reinvestments and partly becaus
is more deeply set
Tech companies also have a faster decline as their growth where as non tech companies declineover long periods and may
live on as smaller and more focussed versisons of their original shelves
The Big Picture
3 decisions maximizes the value of the business (firm)
Investment decision - Invest in assets that earn return higher than min acceptabe hurrdle rate
Financing decision - Find righ kind if debt for your firm & right mix of debt and equity to fund your operations
Dividend decision - If you can dinf investments that make your minimum acceptable rate, return the cash to owners of you
-How you choose to return cash to the owner will depend on whether they are pref div or buybacks

Whats different about a young start up companies? Estimation issues


What is the value added by growth assets?
What are the cashflows from existing assets?
How risky are the cashflows from both existing assets and growth assets?
What is the value of equity in firm?
When will the firm become a mature firm and what are the potential road blocks?

Price Vs Value
Drivers of intrinsic value
-Casflows from existing assets
-Growth in cashflows
-Quality of growth

Drives of price
-Market moods and momentum
-Surface stories about fundamentals

Determinants of price
Mood (behavioural factors) and Momentum
Liquidity and trading ease
Incremental information
Group Think

Twitter had 240 mn users at the time of its IPO? What price would you attcah to the company
The most imp variable in 2013 in determing market value and price in tis sector (Social media) is the no of users that comp
Looking at comparable firms , it looks like the market is paying about 100 $ per user in social media space
Enterprice value --> 240 * 100 = $24 bn

DCF as tool for intrinsic valuation


Expected cashflow in year (t) = Expected earnings in year (t) - Reinvestment needed for the growth
Risk in investement is captured in the discount rate as beta in the cost of equity and the default spread in the cost of debt

To get to the cashflows:


Op earnings - Taxes - Reinvestment = FCF to the firm
Interest not subtracted --> Cost of capital is considered while discounting so that there inno double counting

Reinvest a lot and reinvest well for company to grow


% of inc ---> that you are not paying as dividend

It is easier to grow but difficult to get quality growth


1. High reinvestmnet
2.High ROCE
You can grow while destroying value at the same time

The Terminal Value --> Can hijack valuations

Terminal Value = EBIT (1- tax rate) (1- reinvestment rate)/ Cost of capital - Expected growth
This is a mature company equation not applicable for young growth companies
-Move towards marginal tax rate
-Are you reinvesting enough to sustain your stable growth rate?
-This is a mature company. Its cost of capiatl should reflect that
-This growth rate should be less than the nominal growth rate of the economy
-Mature companies assume consostent growth rate but lesser than the economy
-High growth companies --> high risk --> cost of cap high as compared to mature compnies
-When you reach steady state you have to reinvest perpetual

The government bond rate is not always the risk free rate
-Not all govt bonds are deafult free
-Almost half of all the sovereign defaults in the lst 30 years have been in the local currency
What currency are you using for assumong growth rate ? Ask first
-To value infosys in rupees , you need a risk free rate in rate ( this is imp when you are valueing company, when you are valu
US dollars, you cannot take indian growth or indian discount rate), ypu are should use US
-The indian rupee govt bond was yielding 7.33% on March 28,2018. The bond rating for India is Baa2, with a default spread
risk free rate of 5.38%
RFR --> bond yield - default spread
Also it is easier for country to deafault in bonds , than devalue currency coz these defaults can be recovered easily
Are you consistent with assumptions and calc --> inflationaty rates and discounts

High inflationary currency --> high risk free rate


Low iflationary currency --> Low risk free rate
Defaltionary --> Negative

While valuations you can forecast only thigs which are under your control, now you cannot forecast what will be the inte
this is not under your control. Be consistent with those calculations

If you use betas , don’t use regression betas


Break down companies into busienss
Beta for software business by data from all soft companies
For steel, chem, tech companies --> all public companies
unlever beta by removing debt
Take wt avg
-Replace one regression beta = avg of 100 betas
-10 times more precise than one regression Beta

Globalization is a buzz word


As companies get globalised, the valuations that we do have to reflect that globalisation. In particular we have to be wary a
-currency mismatches
-Beta gaming
-Equity risk premiums
Value triangle
Is your risk reflective of how much, how and where are you growing?
Are you reinvsting enough, given your growth rate?
Is your risk consistent withyour reinvestment strategy?

Revenes growth, margins wrong ---> valuation messed up


Cost of capital --> taken as 80% of companies that use the same---> valuations wont be affectd much
Keep macros thing away while valuation Eg. interest rates are out of control
You should be macro neutralas you can bw, in your company valuations

Are you pricing or valuing a company


Both are different things
To be a better pricer, here are four suggestions
Check your multiple or consistency/uniformity
-In use , the same multiples can be defined in different ways by different users. When comparing and using multiples, estim
else, it is critical that we understand how the multiples have been estimated

Look at all the data, not just the key statistics


Too many people, who use multiple have no idea what its cross setional distribution is . If you do not know what the cross s
of a multiple is, it is difficukt to look at a number and pass judgement on whether it is too high or low

Don’t forget the fundamnetals ultimately matter


It is critical that we understand the fundamentals tat drive each multiple, and the nature of the relationship btween the mu
variable

Don’t define comparables based only on sector


Define the comparable universe and controllling difference is far more difficult in practice than it is in theory

Amazon --> a distrtuption machine


Follows a business model of
"If you build (revenues), they (profits) will come"
You should pray that amazon doesn’t enter your business, because if it enters it will erode your business and you will get im
term
Amazon prime members have shipping cost of 350 $ but it provides service at 99$, with loss of 251$ behind every custome
But as the customer base has picked up, its shipping cost are coming down and it some point of time this will cross over
Prime members ---> growing faster
Shipping cost --> coming down
Fedex --> Nervous , Amazon coming after their shipping business
Flipkart is thankful to Walmart, it would not sustain against amazon in the long run
Recently amazon bought wholefoods business with 500 distribution centers
Later , they started sending mail to prime members 'Would you like to have home prepared food?
Blue April, company with same business got affected --> young company with lots of potential
Amazon is a potential disruptor in every business

US oil company in early 90s --> charged high to create monopoly


Amazon --> gave away to create monopoly
Always changes as the company gets big
15 years back I heard Microsoft is going to take over the world
Fb had 3.2 bn users greater than China's Population

Netflix is over valued


2012 started as video rental company --> regional model
2013 --> started with their own content --> orange is new black, House of cards
This has become a time bomb
Subscriobers are growing but also the content cost is growing
Same business is 50% more expensive than it was 2 years ago
Even if your subscribers grows ad contebt cost are not kept under control --> this will become time bomb
As they grow they will lower the content cost --> that’s a different story to tell
No of shows increases every quarter and analyst are focussed on subscribers growth

CIO's discussion
Pricing and valuations two different things
Avoid not good business and high valuations
Vakrangee, PCJ, Gitanjali gems --> no mutual funds invested
Always invest in good business and by looking at peers

Radhakrishnan Damani --> continuosly boughht HDFC stock and became single largest owner post IPO
If I was there I would have asked him why are you buying HDFC bank 10 times the book value when other large banks are a
valuations

He replied "Dekh beta Dharavi mein rehene ka toh dharavi ka price dene ka , peter road pe rehene ka hai toh peter road ka
So with quality --> there comes price
Always go for quality

last decade retail sector was expected to outperform with lots of investment happening but later slowed down
Last 3-4 years, no one wanted to buy retail
After IPO of Dmart this has changed
Lot of businesses start with higher valuations and then come to lower Eg retail
Lot of business have been built on not tested model or copied model, they may take 10 - 15 years to come to growth
Model correcting happeing now --> which were US copied models
In new business , you either catch it faster than the market or be very skeptical and wait for maturity

Prof Ashwat
Portfolio managers play pricing game and that is difficult to win
If you miss big momentum stocks , no matter how fast you are you will lag
In S&P, 4 out of 500 stocks , in the periods were responsible for growth
If you dint had these 4 stocks you were out of the performance game
These 4 stocks --> very difficult to find the intrinsic value
Portfiolio mangers say they do value investing and when I see their portfolio stock they have momentum stocks

Investment banks --> works by deaal, pricing game, here dcf is not needed

Why facebook bought whatsapp for 19 bn


This has been the most read on my blog
Whatsapp --> 450 mn uses
FB --> 350 mn users very unique to f
35 bn --> f valuation
with 19 bn --> they bought 450 mn

CIO
Price today will become EPS of company later not feasible
In 2013, bought pharma, paper, fin played well
-how at twice PE bought earlier
-You should develop your own rules
-even if it has 10 -15 years sustainability
-buying cheap, half of book value

Active fund mangers perspective


Alpha created by 3 things
1. Market timings
2. Stock selectioin
3. Weight

What is the risk reward for that stock against benchmark


Understand wt of benchmark opponent if you want to beat
Style and process of investing differs with every fund manger

Prof Aswath
Stick to investment philosophy which is right for you, avoid which you are not comfortable with
Failure --> when you try to be someone else (Warren buffett, Peter Lynch)
We spend more time on reading but not on thinking
More time spent on google search than on thinking
Go back and reinvest yourself, you cant be doing the same thing always
Market are reminders you are not the best
People stuck with core philosophies are the winners in the long run

CIO
Which fund had 10% stake in Infosys post IPO
Ent bank mutual funds
Does not exist now
If holded that it would have been 3 bn dollars

Tempelton banglore based engg coompany ---> sudden losses


wrote 100 cr --> tecg degradation
Those days we dint had quarterly results
In fact, these 100 cr were provisions for tech companies
Some FII sold 5%, we bought 2.5% and another marquee investor bought 2.5%
That stock has moved and treendous weath was created
Marquee investor still holds 2.5%

Satyam --> we dint own single stock


stick to our conviction
Focus on quality

Prof Ashwath
How many stocks should we have in our portfolio?
Certainty of valuations , price will adjust to valuations
All you need is one stock

More uncertain ---> more stocks


small company --> risky --> more stocks will be needed

Qualities of succesful investors --> Patience, serenity, calm


They don’t overthink, panic
Stage 1 -Start up
Stage 2 -Young growth
Stage 3 -High growth
Stage 4 -Mature growth
Stage 5 -Mature stable
Stage 6 -Decline

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