July 7, 2015 – Investment Summary Highlights on Aswath Damodaran’s Book “Investment Valuation” Chapter 1 (1 of 20)

Highlights : Aswath Damodaran, Investment Valuation

1.) Perceptions may be all that matter when the asset is a painting or a sculpture, but investors do not (and should not) buy most assets for aesthetic or emotional reasons, financial assets are acquired for the cash flows expected on them.    Asset prices cannot be justified by merely using the argument that there will be other investors around willing to pay a higher price in the future.

2.) Analysis should be viewed with skepticism.

3.) Values  will change as new information is revealed. Given the constant flow of information into financial markets, a valuation done on a firm ages quickly, and has to be updated to reflect current information.

4.) Prospects :  A weakening in the economy can lead to a reassessment of growth rates across the board, though the effect on earnings are likely to be largest at cyclical firms. Similarly, an increase in interest rates will affect all investments, though to varying degrees.

5.) Even at the end of the most careful and detailed valuation, there will be uncertainty about the final numbers, colored as they are by the assumptions that we make about the future of the company and the economy. It is unrealistic to expect or demand absolute certainty in valuation, since cash flows and discount rates are estimated with error. This also means that you have to give yourself a reasonable margin for error in making recommendations on the basis of valuations.

6.) The valuation of a large and mature company, with a long financial history, will usually be much more precise than the valuation of a young company, in a sector that is in turmoil. If this company happens to operate in an emerging market, with additional disagreement about the future of the market thrown into the mix, the uncertainty is magnified. Later in this book, we will argue that the difficulties associated with valuation can be related to where a firm is in the life cycle. Mature firms tend to be easier to value than growth firms, and young start-up companies are more difficult to value than companies with established produces and markets.

7.) separating the information that matters from the information that does not is almost as important as the valuation models and techniques that you use to value a firm.

8.) The process can tell us a great deal about the determinants of value and help us answer some fundamental questions — What is the appropriate price to pay for high growth? What is a brand name worth? How important is it to improve returns on projects? What is the effect of profit margins on value?

9.) Fundamental Analysts: The underlying theme in fundamental analysis is that the true value of the firm can be related to its financial characteristics — its growth prospects, risk profile and cashflows. Any deviation from this true value is a sign that a stock is under or overvalued. It is a long term investment strategy, and the assumptions underlying it are: (a) the relationship between value and the underlying financial factors can be measured. (b) the relationship is stable over time. (c) deviations from the relationship are corrected in a reasonable time period. Valuation is the central focus in fundamental analysis. Some analysts use discounted cashflow models to value firms, while others use multiples such as the priceearnings and price-book value ratios. Since investors using this approach hold a large number of ‘undervalued’ stocks in their portfolios, their hope is that, on average, these portfolios will do better than the market.

10. Franchise Buyer: The philosophy of a franchise buyer is best expressed by an investor who has been very successful at it — Warren Buffett. “We try to stick to businesses we believe we understand,” Mr. Buffett writes3. “That means they must be relatively simple and stable in character. If a business is complex and subject to constant change, we’re not smart enough to predict future cash flows.” Franchise buyers concentrate on a few businesses they understand well, and attempt to acquire undervalued firms. Often, as in the case of Mr. Buffett, franchise buyers wield influence on the management of these firms and can change financial and investment policy. As a long term strategy, the underlying assumptions are that : (a) Investors who understand a business well are in a better position to value it correctly. (b) These undervalued businesses can be acquired without driving the price above the true value


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