Value Investing

Aswath Damodaran: Where is “Value” In Value Investing

Aswath Damodaran: Where is “Value” In Value Investing via DD D, Slide Share

Who is a value investor?

value investing

Three faces of value investing…

  • Passive Screeners: Following in the Ben Graham tradition, you screen for stocks that have characteristics that you believe identify under valued stocks.
  • Contrarian Investors: These are investors who invest in companies that others have given up on, either because they have done badly in the past or because their future prospects look bleak.
  • Activist Value Investors: These are investors who invest in poorly managed and poorly run ?rms but then try to change the way the companies are run.

The three biggest Rs of value investing

  • Rigid: The strategies that have come to characterize a great deal of value investing reveal an astonishing faith in accounting numbers and an equally stunning lack of faith in markets getting anything right. Value investors may be the last believers in book value. The rigidity extends to the types of companies that you buy (avoiding entire sectors…)
  • Righteous: Value investors have convinced themselves that they are better people than other investors. Index fund investors are viewed as “academic stooges”, growth investors are considered to be “dilettantes” and momentum investors are “lemmings”. Value investors consider themselves to be the grown ups in the investing game.
  • Ritualistic: Modern day value investing has a whole menu of rituals that investors have to perform to meet be “value investors”. The rituals range from the benign (claim to have read “Security Analysis” by Ben Graham and every Berkshire Hathaway annual report) to the not-so-benign…

Myth 1: DCF valuation is an academic exercise…

The value of an asset is the present value of the expected cash ?ows on that asset, over its expected life:

value investing

  • Proposition 1: If “it” does not affect the cash ?ows or alter risk (thus changing discount rates), “it” cannot affect value.
  • Proposition 2: For an asset to have value, the expected cash ?ows have to be positive some time over the life of the asset.
  • Proposition 3: Assets that generate cash ?ows early in their life will be worth more than assets that generate cash ?ows later; the latter may however have greater growth and higher cash ?ows to compensate.

Here is what the value of a business rests on… in DCF valuation

value investing

Myth 2: Beta is greek from geeks… and essential to DCF valuation

  • Dispensing with all of the noise, here are the underpinnings for using beta as a measure of risk:
    • Risk is measured in volatility in asset prices
    • The risk in an individual investment is the risk that it adds to the investor’s portfolio
    • That risk can be measured with a beta (CAPM) or with multiple betas (in the APM or Multi-factor models)
  1. Beta is a measure of relative risk: Beta is a way of scaled risk, with the scaling around one. Thus, a beta of 1.50 is an indication that a stock is 1.50 times as risky as the average stock, with risk measured as risk added to a portfolio.
  2. Beta measures exposure to macroeconomic risk: Risk that is specific individual companies will get averaged out (some companies do better than expected and others do worse). The only risk that you cannot diversify away is exposure to macroeconomic risk, which cuts across most or all investments.

If you don’t like betas, here are your alternatives

  • Market price based alternatives
    •  Relative volatility: The ratio of a company’s standard deviation to standard deviation of average company in market
    • Implied costs of equity and capital: Backed out of current stock prices…
    • If you don’t like betas because they are based on stock prices, you won’t like these alternatives either.
  • Accounting information based alternatives
    • Accounting earnings volatility: The ratio of the stability in earnings in your company, relative to other companies.
    • Accounting ratios: Ratios that capture ?nancial leverage (debt ratios) and liquidity of assets (current ratios).
    • Accountants are better at measuring default risk than equity risk.
  •  Proxies for risk
    • Dividend Yield: Higher dividend yields -> Less risk
    • Sector: Technology is risky, consumer product companies are not…
    • Company size: Small companies are risky, big companies are not…

See full presentation below.