Great notes from Market Folly.
To Buy, sell or hold is at heart of any valution process. Trying to find the diferrent between market price and intrinsic value at the end of the research process is the aim of any investment process. At the end, numbers and the story need to make the securitie a buy, sell or hold. I will try to sumarize the well-know book “The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit” by Aswath Damodaran. Notes: chapter 1, 2 and 3.
Notes Chapter 1:
- You buy a financial assets for the cash flows that you expect to receive in the future (dividends).
- Two approaches to valuation: intrinsic and relative.
- Intrinsic: is determined by the cash flows you expect that asset to generate over its life and how uncertantain (sometimes called RISK) you feel about these cash flows.
- Relative: assets are valued by looking at how the market prices similar aassets (“peer group”). Quite useful for real state purposes.
- Relative’s example: Exxon Mobil will be viewed as a stock to buy if it is trading at 8 times earning while other oil companies trade at 12 earning.
- There is a role for valuation at every stage of a firm’s life cycle.
- Some truths about valuation:
- All valuations are biased
- Most valuations (even good ones) are wrong. Reasons:
- Raw information into forecasts–> estimation error.
- Simpler can be better.
Notes Chapter 2:
- Time is money. Finance 101, present value vs future value. Do you prefer a dollar today or next year? Three reasons why a cash flow in the future is worth less than a similar cash flow today:
- People prefer consuming today instead of consume in the future.
- Inflation decreases the purchasing power of cash over time.
- A promised cash flow in the future may not be delivered. RISK!
- Discounting future value, discounting rate, real return, expected inflation and premium interest.
- Simple cash flow: CF in the future / (1+ discount rate) ^ time period.
- Annuity : constant casf flow that occurs at regular intervals for a fixed period of time. Annual cash flow ((1 – 1/(1+discount rate) ^numbers of periods)/ discount rate)
- Example: You can buy a car, $10,000, cash down or paying installments of $3,000 a year, for 5 years. Discount rate: 12%. $3,000((1-1/(1.12)^5/12%) = $10,814. The economical option is to pay the car today instead of paying installments.
- Growing annuity: cash flow that grows that grows at a constant rate for a specified period of time.
- Example: You have the rights to a gold mine that generated $1.5 million in cash flos last year. For the next 20 years, 3% a year and a discount rate of 10% to reflect your uncertainty. Cash flow*(1+g)[1- (1+g)^n/(1+r)^n / (r-g)]
- Perpetuity: is a constant cash flo at regular intervals forever. Cash flow / discount rate.
- Growing perpetuity: is a cash flow that is expected to grow at a constrant rate forever. Expected cash flow next year / (discount rate – Expected growth rate)
- Risk: diversification, CAPM…the risk of any asset then becomes the risk added to this “market portfolio”, which is measured with a beta. Beta is a relative risk measure and it is standardized around one. Beta > 1 = more exposed to market risk than the average stock (market). Expected return on the investment = Risk Free rate + Beta.
- CAPM is based on unrealistic assumptions.
- Alternatives: multi-beta models and proxy models.
- All these models are flawed:
- risk matters:
- some investments are riskier than others:
- the price of risk affects value
- Accounting 101:
- Balance sheet
- Income Statement
- Cash flow statement
- Fixed and LT assets: value = originally paid for the asset (historical cost) and reduce that value for the aging of the asset (depreciation or amortization).
- ST assets: amenable to the use of an updated or market value.
- To principles underlie the measurement of accounting earnings and profitablity.
- 1st, accrual accounting: the revenue from selling a good or service is recognized in the period in which the good is sold or the service is performed, same for expenses.
- 2nd, is the categorization of expenses into operating, financing, and capital expenses.
- Operating margin = operating income / sales
- Net marging = Net income / sales
- Capital invested in the firm = Book value ( debt and equity, net of cash, and marketable securities.
- After- tax ROC = (operating income (1-tax rate) / BV of debt + BV of equity – Cash
- ROE = Net Income / BV of common equity
- Financial BS vs Accounting BS
Notes Chapter 3:
- Determining intrinsic value. DCF: discount expected cash flow at a risk-adjusted rate.
- Valuing a company: value the entire BUSINESS or just the EQUITY.
- Assets in place + growth assets = value of business–> to value the entire business, discount the casf flows before debt payments (cash flow to the firm) by overall cost of financing, including both debt and equity (cost of capital).
- Assets in place + growth assets = value of business – Debt = VALUE OF EQUITY.
- Inputs to intrinsic valuation:
- cash flow from existing assets
- expected growth in these cash flows for a forecast period
- cost of financing the assets
- estimate of what the firm will be worth at the end of the forecast period
- Cash flows: dividends paid or stock buybacks. Augmented dividends = dividends + stock buybacks.
- Free Cash Flow to Equity = the cash left over after taxes, reinvestment needs, and debt cash flows have been met.
- Free Cash Flow to Firm = After-tax operating income – (Net Capital expenditures + Change in non-cash orking capital).
- Reinvestment rate = (Net Capital expenditure + Change in non-cash WC) / after-tax operating income
- FCFF = After-tax operating income (1- Reinvestment rate).
- Business: risk in firm’s operations
- Equity: at the risk in the equity investment in this business
- Risk captured in the cost of capital.
- Cost of equity: a risk-free and a price for risk to use across all investments, as well as a measure of relative risk:
- Risk-free rate.
- Equity risk remium.
- Relative risk or beta.
- Cost of equity = RFR + Beta * ERP
- Interest coverage ratio = Operating income / Interest expenses
- Terminal value: to ays of estimating terminal value are to estimate a liquidation value for the assets of the firm or to estimate a going concern value.
- Terminal value in year n = Cash Flow in year (n + 1) / Discount rate – perpetual growth rate
- Three constraints that shold be imosed on its estimation:
- No firm can grow forever at a rate higher than the growth rate of the economy in which it operates.
- Firms move from high growth to stable growth,
- Discounted dividends or free cash flows to equity on a per-share bassi at the cost of equity:
- add back the cash balance of the firm
- adjust for cross holding
- subtract other potential liabilities
- subtract the value of management options
- Market price vs value:
- You have made erroneous or unrealistic assumptions about a company’s future groth potential or riskiness
- That you have made incorrect assessments of risk premiums for the entire market
- The market price is rong and that you are right in your value assessment.
Becoming Warren Buffett premieres Monday, January 30 at 10PM, only on HBO.
This morning I have published a tweet about a talk at the Francisco Marroquín University, “Investment according to the Austrian School of Economics” by the Fund Manager Francisco García Paramés. Author of the book called Invirtiendo a largo plazo.
For him, investments like Google or Facebook are still Venture Capital, 15 years are not enough for Francisco to invest or try to understand the business. But technology (Internet in this case) does not mean that you cannot take advantage of this technology to increase the valuations in other company, you can find other ways to do it. For example:
- Look for non-Internet companies that indirectly benefit from Internet traffic. For example, DHL benefits from Amazon. Or other package delivery company does the same.
- An Internet business is embedded in a non-Internet company with real earnings and a reasonable stock price.
- Old-fashioned business uses Internet to cut costs, improve operations and become more efficient.
42 minutes. 2 geniuses. 1 moderator. Chicago Booth Review. Great talk.
So, are markets efficient?
At the beginning of this week, Alphabet passed Apple as the most market valuable company, see chart. All media and newspapers wrote about it.
So, what risks have Alphabet to invest in? I went to the S-1 statement that Google published in 2014 for the Google´s IPO. In that statement the company wrote about “Risks Related to Our Business and Industry”, all risk factors in 2004:
We face significant competition from Microsoft and Yahoo.
We face competition from other Internet companies, including web search providers, Internet advertising companies and destination web sites that may also bundle their services with Internet access.
We face competition from traditional media companies, and we may not be included in the advertising budgets of large advertisers, which could harm our operating results.
We expect our growth rates to decline and anticipate downward pressure on our operating margin in the future.
Our operating results may fluctuate.
If we do not continue to innovate and provide products and services that are useful to users, we may not remain competitive, and our revenues and operating results could suffer.
We generate our revenue almost entirely from advertising, and the reduction in spending by or loss of advertisers could seriously harm our business.
We rely on our Google Network members for a significant portion of our net revenues, and otherwise benefit from our association with them, and the loss of these members could adversely affect our business.
Our business and operations are experiencing rapid growth. If we fail to manage our growth, our business and operating results could be harmed.
If we fail to maintain an effective system of internal controls, we may not be able to accurately report our financial results or prevent fraud. As a result, current and potential stockholders could lose confidence in our financial reporting, which would harm our business and the trading price of our stock.
We are migrating critical financial functions to a third-party provider. If this transition is not successful, our business and operations could be disrupted and our operating results would be harmed.
Our business depends on a strong brand, and if we are not able to maintain and enhance our brand, our business and operating results would be harmed.
Proprietary document formats may limit the effectiveness of our search technology by excluding the content of documents in such formats.
New technologies could block our ads, which would harm our business.
Our corporate culture has contributed to our success, and if we cannot maintain this culture as we grow, our business may be harmed.
Our intellectual property rights are valuable, and any inability to protect them could reduce the value of our products, services and brand.
We are, and may in the future be, subject to intellectual property rights claims, which are costly to defend, could require us to pay damages and could limit our ability to use certain technologies in the future.
Expansion into international markets is important to our long-term success, and our inexperience in the operation of our business outside the U.S. increases the risk that our international expansion efforts will not be successful.
We compete internationally with local information providers and with U.S. competitors who are currently more successful than we are in various markets.
Our business may be adversely affected by malicious third-party applications that interfere with the Google experience.
If we fail to detect click-through fraud, we could lose the confidence of our advertisers, thereby causing our business to suffer.
We are susceptible to index spammers who could harm the integrity of our web search results.
Our ability to offer our products and services may be affected by a variety of U.S. and foreign laws.
If we were to lose the services of Eric, Larry, Sergey or our senior management team, we may not be able to execute our business strategy.
The initial option grants to many of our senior management and key employees are fully vested. Therefore, these employees may not have sufficient financial incentive to stay with us.
If we are unable to retain or motivate key personnel or hire qualified personnel, we may not be able to grow effectively.
Our CEO and our two founders run the business and affairs of the company collectively, which may harm their ability to manage effectively.
We have a short operating history and a relatively new business model in an emerging and rapidly evolving market. This makes it difficult to evaluate our future prospects and may increase the risk of your investment.
We may have difficulty scaling and adapting our existing architecture to accommodate increased traffic and technology advances or changing business requirements.
Problems with bandwidth providers, data centers or other third parties could harm us.
System failures could harm our business.
More individuals are using non-PC devices to access the Internet, and versions of our web search technology developed for these devices may not be widely adopted by users of these devices.
If we account for employee stock options using the fair value method, it could significantly reduce our net income.
We have recognized cost of revenue, and may continue to recognize cost of revenue, in connection with minimum fee guarantee commitments with our Google Network members.
We face risks associated with currency exchange rates fluctuations.
It has been and may continue to be expensive to obtain and maintain insurance.
Acquisitions could result in operating difficulties, dilution and other harmful consequences.
We occasionally become subject to commercial disputes that could harm our business.
We have to keep up with rapid technological change to remain competitive.
Our business depends on the growth and maintenance of the Internet infrastructure.
Shares issued, and option grants made, under our stock plans exceeded limitations in the federal and state securities laws.
As you can see, more or less, all of these statements are still risks factor to Alphabet. After more than 10 years risks did not change a lot.