Stock valuation can be extremely complex or simple. The fight is between two worlds: the academic world and the stock market investing practitioners (Damodaran vs Munger and Warren Buffett). 99% of people who invest are academics because that is what you learned at school. Only the 1% are practitioners who have constantly beaten the market over the last 5 decades.
Stock Valuation - Do You Need Complex Math?
Good for investors today we're going to talk about stock market valuation in a recent video about Facebook. I made a simple model for analyzing Facebook stock and giving it a value. And there are very complex models as we will analyze from Professor the mother. So the topics for today are stock market valuation and input parameters. Complex or common sense stock valuation formulas and methods of stock valuation equity risk premium and how to do stock valuation properly to get good investing returns not academic titles or grades. To quote Warren Buffett there is so much that's false and not in modern investing practice and modern investment banking that if you just reduce the nonsense that's a goal you should reasonably hope for just reducing the nonsense. So what is stock valuation. For example I recently analyzed Facebook's stock and my earnings model looks like this. The parameters used are the growth rate the discount rate. That is my required return rate not something the market tells me to use a price to earnings ratio of 10 for the termini value which all lead to one present value that I compare to the stock. You can see more about that in the Facebook video. All other factors are qualitative and not quantitative where I have to estimate their future growth based on their management base or their intentions based on their short term or long term objectives. Monetization whatever and I don't believe anyone can put those into numbers hold those qualitative factors. It's funny to compare my model with professors. The mother on Smallville from the Stern School of Business at the New York University.
This is 50 percent of the first excel sheet of Professor Dumol they're on stage. There are inputs inputs inputs discussions and then we come to some very important inputs that consider market numbers. That is the risk free rate and the initial cost of capital. So all normal things and then something you use from the market where the market tells you what is the real value. We'll discuss later a bit more about the initial cost of capital but let's quote Mongar some of the worst business decisions I've seen came with detailed analysis. The higher math was false precision. They do that in business schools because they've got to do something. So we can listen to Mongar or academics stock valuation formulas can be simple or complex. Let's go to the initial cost of capital. If you don't know what your firm's cost of capital is you can't compute it in a sheet like the following from Professor Domm other and of course this shows you more in detail what is required. So you have levered beta or beat the risk free rate. Equity risk premium used in the cost of equity. So all things Briski rate from the market equity risk premium depending where what's the market to analyze depending on what the risk free on what market et cetera et cetera. So a lot of complexities a lot of things that really don't have so much in relation to the business you might be analyzing. So you're basing your investment decision on the risk free rate. Okay. But then also on the beat coefficient best equity premium. And here is where academics and protection are strongly disagreed.
To quote Mongar again using a stock's volatility as a measure of risk is nuts. So on the methods of stock valuation I always like to use the same simple example of Luigi who has a restaurant in Venice. Does he care about the risk free rate. Does he care about the equity premium. Does he care about the volatility of the prices of his restaurant. No he just cares about how many tourists will come there how to improve his.