Aswath Damodaran, Professor of Finance at the Stern School of Business at New York University, has been called a modern-day Benjamin Graham, thanks to his disciplined approach to company valuation and knowledge of value investing. His blog Musings on Markets is one of the most informative financial blogs online and interviews with Aswath are always highly informative.

Aswath Damodaran: Tesla’s Value More Justified Than Amazon

The July 28 issue of Goldman Sachs’ Fortnightly Thoughts magazine contains one such interview. In the interview, Aswath discusses how he approaches company valuation, and the traits he looks for in companies when he’s trying to establish if they have a competitive advantage.

These are the highlights of the interview, which was first published in December 2015.

Aswath Damodaran
Aswath Damodaran: Diversify to beat disruption

Aswath Damodaran: Diversify to beat disruption

Optionality is almost impossible to value yet understanding the value of optionality and how it will affect a company’s valuation is critical to the valuation process.

Aswath Damodaran Session 27 (Undergraduate): Valuation

Aswath points out that when making an investment decision, an investor needs to understand what other people are pricing into the stock, this includes the value of optionality (where the success of a company in one market allows them to enter another), a dynamic concept that traditional valuation methods fail to capture. Trying to place a value on this optionality turns the traditional valuation methods, usually used by those who follow the school of value investing, on their head as Aswath explains:

Aswath Damodaran – Session 24 (MBA): Dividend Analysis and First Steps on Valuation

“Twitter..I value at around US$26 per share…I place a buy limit at US$27 – is that inconsistent with my principle of buying companies where my valuation is greater than the price? It isn’t, because, unlike CocaCola, where the upside is constrained due to its maturity, Twitter has a far longer tail of upside scenarios…they could enter the retail market, the news market or the data market…By noting that these various options exist, I would be more willing to invest in a company like Twitter, even if it is fairly valued. And that’s how I conceptualize option value; it shows up more in the timing of my investment decision than as an explicit add on to my valuation.”

Aswath goes on to say that the companies with the greatest scope to create optionality are those who have an exclusive product, not the largest companies in the space. In an era where there are many businesses all competing for our attention, the value and exclusivity of certain products are very quickly being eroded.

“Now I see the nature of competitive advantage changing with the ubiquity of technology. The life expectancy of competitive advantage is declining, and that’s because technology means that it is much easier, both in terms of time and cost, to replicate business models and processes. Just look at how Google caught up with and surpassed Yahoo’s search engine; competitive advantage is becoming far more transient. This has implications for the entire life cycle of companies. Historically, companies would start off small and low value, over time becoming larger and higher value. It took time to build infrastructure and it took time to build new markets. New technology companies on the other hand seem to jump right through this; they can go from nothing to valuations of billions of dollars in a short period of time.”

This poses a huge risk to traditional valuation models. In fact, Aswath argues that some tech companies may deserve a low valuation because there is a greater risk a new player may enter the market and extract market share. Investors can no longer assume competitive advantages will last forever. This risk of disruption is now becoming a huge problem for investors, with company lifespans becoming shorter and shorter, buy and hold forever strategies are becoming less and less efficient.

Aswath Damodaran On Valeant, Accounting And Valuation

So what’s the answer? Aswath believes the only way to protect your portfolio from this trend is to diversify across sectors and corporate life cycles to capture both the mature and disrupting companies.

“Diversification shouldn’t just be across sectors, it should also be across corporate life cycles. So, if you’re buying mature stocks with price to earnings ratios less than 10x, because they look cheap relative to new players like Netflix, your portfolio is not diversified because you’re ignoring younger, higher priced disruptive companies. In fact by focusing on cheap mature companies your portfolio is more susceptible to disruption and that should make any value investor uncomfortable. And for growth investors it means investing in companies that are viewed as being in bad businesses that may disappear with time.”

Even the tech industry’s biggest players aren’t immune to disruption. Aswath notes that Google and Facebook are the internet’s to main advertising groups, but Google’s pre-tax operating margins are 25% while Facebook’s are around 32% in this particular business line. Therefore, at some point, it’s inevitable that they will start competing and when this happens these companies will fall out of the fast growth category into the mature business category and are likely to be rewarded and lower valuation by the market as a result.

Something for investors to watch out for.