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Speaker 1: Oscar Wilde once described a cynic as a man who
Speaker 1: knows the price of everything, but the value of nothing.
Speaker 1: Nowhere is understanding value more important than in the stock market. Sure,
Speaker 1: prices get quoted every second, every tick, but value that's
Speaker 1: a much more challenging problem. Whether you're buying broad indices
Speaker 1: or purchasing specific stocks, it pays to not be a
Speaker 1: cynic and understand both price and value of your investments.
Speaker 1: I'm Barry Ritolts, and on today's edition of At the Money,
Speaker 1: we're going to explain how to become more savvy about
Speaker 1: understanding equity values. The value you pay for your investment
Speaker 1: has an outsized impact on your long term returns. To
Speaker 1: help us unpack all of this and what it means
Speaker 1: for your portfolio, let's bring in Professor Aswath Damaduran of
Speaker 1: NYU's School of Business. He is often referred to as
Speaker 1: the Dean of valuation for his extensive work in the area.
Speaker 1: He's written numerous books on the subject, including Damadoran on Valuation,
Speaker 1: Narrative and Numbers, and the textbook Investment Valuation Tools and
Speaker 1: Techniques for determining the value of any asset. So, Professor,
Speaker 1: let's just start with the basic question, why are valuations
Speaker 1: so important when it comes to equities.
Speaker 3: I'm going to give you a cynical answer. They're not
Speaker 3: important if you're a trader. Traders live on pricing. In
Speaker 3: the essence of pricing is you buy at a low price,
Speaker 3: you set at a high price, and it doesn't really
Speaker 3: matter why the price changes if you get the direction dright,
Speaker 3: value matters if you're an investor. To me, the definition
Speaker 3: of an investor is you buy something for less than.
Speaker 2: What it's worth.
Speaker 3: And the essence of values, you're trying to estimate what
Speaker 3: something is worth. But most as I said, it depends
Speaker 3: on the philosophy you bring in. Are you an investor
Speaker 3: or your trader, because that's going to dry whether value
Speaker 3: matters to you.
Speaker 1: So let's talk about identifying that intrinsic value of what
Speaker 1: something is worth with any specific company. How can you
Speaker 1: determine that valuation.
Speaker 2: It's as old as time.
Speaker 3: That Venetian glass maker is sold at business in the
Speaker 3: Middle Ages. Probably sold it to somebody bought it because
Speaker 3: of the cash flows he generated, the risk in those
Speaker 3: cash flows, and how much those cash flows are going
Speaker 3: to grow. It's cash flows, growth and risk. That's the
Speaker 3: essence of value. That's always been true. We act like
Speaker 3: we invented valuation in the last century in finance because
Speaker 3: we came up with all these neat little models and
Speaker 3: metrics to measure risk and bring it into what you
Speaker 3: need to make. But always been driven by cash flows,
Speaker 3: growth and risk. And how you get to that value
Speaker 3: can come from different pathways. I use intrinsic valuation, you know,
Speaker 3: in that sense as capturing anybody who thinks about those fundamentals.
Speaker 1: So let's dive into that intrinsic valuation based on cash flow,
Speaker 1: growth and risk. What different ways are there to measure
Speaker 1: the fundamental value of a company? And how do these
Speaker 1: different valuations reveal intrinsic value?
Speaker 3: I mean, ultimately, cash flows, growth and risk are not
Speaker 3: going to be different for different people. The way we
Speaker 3: think about risk, though, can differ depending on who you
Speaker 3: are as an investor and what do you think matters.
Speaker 2: I mean, I'll give you an example.
Speaker 3: In traditional finance, we think about risk by looking at
Speaker 3: how prices move for a stock relative to the market.
Speaker 2: But there are intrinsic value.
Speaker 3: People argue that true measure of risk is what happens
Speaker 3: to your earnings. Your revenues are operating metrics. So even
Speaker 3: within people who believe in intrinsic value, we can have
Speaker 3: disagreements about how to measure risk, what is the right
Speaker 3: cash flow to look at, and what's the growth rate
Speaker 3: that you think about over what periods. So while we
Speaker 3: might have twenty people in a room, all of whom
Speaker 3: buy into intrinsic value, we can come up with twenty
Speaker 3: different estimates of intrinsic value for the same company at
Speaker 3: the same point in time.
Speaker 1: So we always hear about price to sales, price to book,
Speaker 1: price to earnings. Are these all that different, They're just
Speaker 1: variations on fundamentals, or are they very different ways of
Speaker 1: looking at the same company.
Speaker 3: Philosophically, they're very different because when you compute the price
Speaker 3: earnings or the ev Tabidov price to book for a company,
Speaker 3: what you do is you compare to other companies out there,
Speaker 3: and you make a judgment and saying, in this company
Speaker 3: trades at ten times earnings, other companies like it, and
Speaker 3: I'm going to put quotes on like it trade at
Speaker 3: fifteen times earnings. Therefore a cheap that's a pricing judgment.
Speaker 3: There's nothing value in here, there's no intrinsic value judgment.
Speaker 3: That's why all of seal side equity research, i would argue,
Speaker 3: is all about pricing.
Speaker 2: It's not about valuation.
Speaker 3: Nothing wrong with it, but we should be honest about
Speaker 3: what we're doing. So when you use ratios, it's because
Speaker 3: you want to find something cheap by comparing it to
Speaker 3: other things out there that are being traded right now,
Speaker 3: and you're looking at what other people are.
Speaker 1: Paying, so you're looking at price. When people look at
Speaker 1: stocks that way, they're looking at price and relative valuation,
Speaker 1: non intrinsic value. Let's talk about some of the things
Speaker 1: you've explained in your books. Valuation requires a deeper understanding
Speaker 1: of the business, including how it makes money and its
Speaker 1: future prospects. Give us a little more detail on that.
Speaker 3: I'll give you an example, and it's a personal example.
Speaker 3: I bought in Verdia purely by luck.
Speaker 2: In two thousand and eighty. I didn't see AI coming,
Speaker 2: none of this stuff.
Speaker 3: So sometimes your best investments happened by accident. So last
Speaker 3: year I had to revalue in Vidio for a simple reason.
Speaker 3: I mean I bought it at twenty seven dollars per sit. Yeah,
Speaker 3: the stock was trading at eight hundred dollars per share,
Speaker 3: and I had to decide is it time to leave?
Speaker 3: So as I sat down to value in Vidia, I
Speaker 3: started with a presumption that was a computer check company
Speaker 3: that had made chips and sold them, and I had
Speaker 3: to estimate cash flows based on that.
Speaker 2: It's only as I started.
Speaker 3: Digging a little deeper that I realized that they're not
Speaker 3: a chip maker, They're a chip designer. Every Nvidia chip
Speaker 3: is made by TSMC, which basically changes the way you
Speaker 3: think about the business. If you're doing pricing, you might
Speaker 3: be able to gloss over it, it doesn't matter.
Speaker 2: That they do it.
Speaker 3: But if we're doing intrinsic valuation, because I have to
Speaker 3: estimate cash flows, I have to think about what is
Speaker 3: it that they spend to create these revenues, and that
Speaker 3: requires an understanding of how they conduct their business. I
Speaker 3: mean Warren Buffett and a famous saying that he doesn't
Speaker 3: buy stocks, he buys shares of businesses. That, to me,
Speaker 3: in essence, is what you're doing in intrinsic valuation. You're
Speaker 3: not buying a share of Apple or a share of Amazon.
Speaker 3: You're buying a slice of those businesses is that's what
Speaker 3: you're doing. You better understand what you're buying before you
Speaker 3: pay a price.
Speaker 1: So can we apply the same theory of valuation to
Speaker 1: broad indices as opposed to just individual stocks.
Speaker 3: Absolutely, I mean it's cash flows, growth and risk drive
Speaker 3: the value of Invidia. Cash flows, growth and risk, because
Speaker 3: what drives the value the S and P five hundred
Speaker 3: or the Nasdaq. In fact, that's the process I use
Speaker 3: at the start of every month to come up with
Speaker 3: an estimate or what investors are pricing in the S
Speaker 3: and P five hundred and what they can expect to
Speaker 3: earn given the cash flow. It's a very intrinsic value
Speaker 3: view of what can you expect to make as a
Speaker 3: rate of return on an index?
Speaker 1: So that raises, you know, the real important question, what
Speaker 1: do these measures of evaluations mean for future expected returns?
Speaker 3: The more you pay for something, let's cut away from
Speaker 3: all of the noise in this process. The more you
Speaker 3: pay for something upfront, the lower your expected returns are
Speaker 3: going to be.
Speaker 2: Because if you.
Speaker 3: Pay more upfront, and that's just common sense. So when
Speaker 3: you buy the S and P five hundred at fifty
Speaker 3: three hundred, you can expect to earn a lower return
Speaker 3: than if you bought it.
Speaker 2: At fifty one hundred.
Speaker 3: So if you bought it last week, your expected denerves
Speaker 3: lower than if you bought it today. And that's at
Speaker 3: the basis of intrinsic value. It's about paying the right
Speaker 3: price for something upfront.
Speaker 2: Is the most critical decision you make.
Speaker 1: So you consistently in all your books emphasize that value
Speaker 1: is not price. So how should investors think about the
Speaker 1: difference between the quoted fluctuated price we see every day,
Speaker 1: the quoted fluctuating price that we see every moment on
Speaker 1: the market, and that deep intrinsic value.
Speaker 3: Recognize that are two different processes. Nothing makes one better
Speaker 3: than the other. Different processes. Values driven by changes in
Speaker 3: your earnings, cash flows, growth, risk, and that's captured by
Speaker 3: changing value over time. So I'm not saying intrinsic value
Speaker 3: somehow stable stagnant number. The intrinsic value in radio doubled
Speaker 3: because of its entry into AI. Intrinsic value can change.
Speaker 3: Price is driven by demand and supply, driven by mood
Speaker 3: and momentum, and I think one of the best indicators
Speaker 3: you can take a mood and momentum is when the
Speaker 3: momentum is good.
Speaker 2: All news is good news.
Speaker 3: In fact, there's a whole segment of finance called behavioral finance,
Speaker 3: and behavioral finance tries to explain why price can not
Speaker 3: only deviate from value but stay different for long periods.
Speaker 3: There is this inherent belief that value investors have that
Speaker 3: price will move towards value and it will happen quickly.
Speaker 3: That's not true. Price can deviate from value. It can
Speaker 3: stay separated from value for long periods, which means, if
Speaker 3: you're an intrinsic value investor, you're going to get incredibly
Speaker 3: frustrated because you think you got it right, but you
Speaker 3: keep losing money.
Speaker 1: So you're referring to mean reversion. The expectation is that
Speaker 1: pricey things eventually be come back down to fair value,
Speaker 1: and inexpensive things will eventually be recognized and return to
Speaker 1: fair value. How long does this process take? Is it
Speaker 1: guaranteed to happen? Does that mean reversion always occur?
Speaker 3: It's not just mean reversion, it's assumption that values what
Speaker 3: matters in the long term. I mean that's almost I
Speaker 3: mean when I start my valuation class, I started the
Speaker 3: question do you have faith? My students look at me say,
Speaker 3: it's evaluation class.
Speaker 2: What are you talking about?
Speaker 3: I said, the essence of investing is faith. Faith that
Speaker 3: your estimated value is the right value, and faith that
Speaker 3: the price will move to value. And the essence of faith.
Speaker 3: If you asked me to prove it, and if you
Speaker 3: told me, tell me what will cause it to happen,
Speaker 3: my answer is, I don't know. It's a mystery. I mean,
Speaker 3: it's like going to church and going up to your
Speaker 3: pastor or your rabbi and saying, can you give me.
Speaker 2: Some proof that God exists?
Speaker 3: I keep coming back every you know, every week because
Speaker 3: I and if that rabbi, a priest or you know,
Speaker 3: is telling you the truth, they should say look enough.
Speaker 2: I can't give you that proof. It's faith. And I
Speaker 2: think that's what makes investing.
Speaker 3: So difficult is it's driven by faith rather than by proof.
Speaker 3: So if you ask me, you know, if I bought
Speaker 3: something undervalued, am I guaranteed to make money in the
Speaker 3: long term?
Speaker 2: Absolutely not. And you have to be okay with it.
Speaker 3: If you're not okay with it buying a text file,
Speaker 3: don't invest or be a trader. The essence of investing
Speaker 3: is you can do everything right and have nothing to
Speaker 3: show for it, and you have to be okay with that.
Speaker 1: Wow, So, professor, bottom line it for us when we
Speaker 1: think about valuation, when investors look at equities, what should
Speaker 1: be foremost in their minds before deploying capital.
Speaker 2: Leys be honest with yourself. Now, what is the game
Speaker 2: you're playing?
Speaker 3: If you're playing the trading game, don't lie to yourself
Speaker 3: about caring about fundamentals and earnings and cash flows.
Speaker 2: Just play the trading game.
Speaker 3: Look at charts, look at technical indicators, look at mood
Speaker 3: and momentum, because that's what you're playing. If you want
Speaker 3: to be an investor, you need to do your homework.
Speaker 3: You can't hide behind the fact of I've never done
Speaker 3: an accounting or evaluation closet or understand these financial statements.
Speaker 2: The essence of investing.
Speaker 3: Is you've got to be able to look through those
Speaker 3: financial statements and be able to gauge the value of
Speaker 3: a company. You might not want to use the full
Speaker 3: technology of intrinsic valuation, but you need to start thinking
Speaker 3: about businesses and value in a much more in a
Speaker 3: much deeper way than you're doing right now.
Speaker 2: If that's not your thing, that's fine.
Speaker 3: There are lots of people who get richest traders and
Speaker 3: there's nothing wrong with trading. Just play that game well.
Speaker 1: So to wrap up, investors who have a long term
Speaker 1: time horizon should be very aware of the variations in valuations.
Speaker 1: The more you pay for a given stock or a
Speaker 1: given market index, the lower you future expected returns are.
Speaker 1: Understand that there are no guarantees in the market, and
Speaker 1: merely buying cheap stocks is no guarantee that you're gonna
Speaker 1: outperform or even market perform in the future. I'm Barry
Speaker 1: Retults and this is Bloomberg's at the Money