This conversation is part of our “Wisdom in Books” series and podcast. Every week we inspire your reading with an exclusive author interview or John’s takeaways from an influential book on investing, business, or life.
My colleague Alex Gilchrist had the pleasure of hosting Aswath Damodaran for a discussion of his book, The Dark Side of Valuation: Valuing Young, Distressed, and Complex Businesses.
Professor Damodaran teaches corporate finance and valuation at the Stern School of Business at New York University. Due to his pioneering work in equity valuation, Prof. Damodaran is often called the “Dean of Valuation”.
The following transcript has been edited for space and clarity. (MOI Global members, access all features, including ways to follow up with Prof. Damodaran.)
Alex Gilchrist: Known as the “Dean of Valuation,” Professor Damodaran needs little introduction. Suffice it to say that he is exceptionally generous with his knowledge and shares a lot of his courses on his NYU Stern page, his blog, and his YouTube channel where the content is organized in such a way that one can take an evening class in almost any aspect of valuation. It’s tremendously generous when we don’t have the privilege to attend a live session with Professor Damodaran. He’s here to discuss his book The Dark Side Valuation. Thank you very much for taking your time.
Aswath Damodaran: Glad to be here. To start, though, I know CNBC somehow hoisted this Dean of Valuation moniker on me, and I’ve never been able to live it down. I prefer to think of myself as a dabbler in valuation. All you’re going to do in valuation, even if you spend the rest of your life in it, is get to the surface of things. You’re never going to get that deep.
Gilchrist: When you started your class, it was originally called security analysis. Doesn’t that make you the pioneer?
Damodaran: I don’t think it makes me the pioneer. People have always valued stocks, but for a long time, security analysis was the name for it because Ben Graham was the first to teach this class at Columbia University. He wrote the book Security Analysis in 1934. It’s one of the first books written on systematically thinking about how you value stocks. The title of the class came from his book. Once it got the title, inertia took over, and for a long time, I simply collected other material to go along. By the time I started teaching this class in 1986, it was called security analysis. It was getting a lot of debris from 35 years of adding on stuff without anybody systematically asking if it even made sense. It was merely a collection of topics, which is one reason I said, “Okay, we need to rethink this and think about a better way of organizing it. It’s not like we’re starting from scratch — people have always valued companies — but let’s focus on valuation specifically rather than get distracted by institutional information.” It’s what a lot of the class had become because it was about how to get stocks listed. Essentially, it was about things that had nothing to do with valuation.
Gilchrist: At that time, multiples were much more widely used than even discounted cash flows, weren’t they?
Damodaran: They still are – 95% of everything that passes for valuation is still multiples. You might see a discounted cash flow valuation, but often, these are what I call Kabuki DCFs, where you start by attaching a price to something based on a multiple, say, 15x earnings. Then, because it doesn’t look sophisticated enough, you do a fake discounted cash flow valuation to make it seem as if deep thought went into coming up with this number. There’s a lot of fake DCF out there. I tell people it’s better to do an honest pricing using multiples and comparables than a dishonest DCF. All banking DCFs are a waste of time. I don’t even know why they bother. Bankers shouldn’t be using DCFs. Their job is to price stocks. Just do an honest pricing. Say you’re using 10x EBITDA and leave it at that. Don’t give me this delusional DCF where you plug numbers and then go through the motions just to make it look like you’re interested in intrinsic valuation.
Gilchrist: There are two quotes in the book I especially like: “Pricing is driven by supply and demand” and “Value is driven by the discounted value of cash flows.”
Damodaran: They’re not independent, right? If demand and supply were driven purely by fundamentals, the price and the value should converge. In fact, it remains the faith of every investor that price and value will converge. The problem is that in addition to being affected by fundamentals, demand and supply are affected by mood, momentum, liquidity, and sometimes revenge. Take a look at GameStop. A lot of the trading in that stock was driven by Redditors wanting to take revenge on hedge funds. That’s not a fundamental, but it’s a human emotion. Pricing reflects our humanity. I don’t think of it as a good thing or a bad thing. As human beings, we’re going to let emotions drive some of the choices we make, and they’ll all show up in the price.
Gilchrist: It can also be reflected in what you call the storytelling in valuation. Tesla comes to mind, telling a story that is affecting the price in the market at that time.
Damodaran: Stories affect both values and prices. The difference is valuation reflects bounded stories, stories you test and make sure they pass the test of not being a fairytale. This is a story that can happen. Pricing stories are unbounded because there’s essentially nobody stopping anything. Does that even make sense? Can you really pull that off? In a pricing story, you can get carried away and push the price of a stock up to whatever number you want because you’re telling a story which is not being checked. Take NIO, a Chinese electric car company. Electric cars are the future, and that’s the extent of your analysis. You’re going to push the price up to whatever level you want. All investing is driven by storytelling. The question is whether it’s bounded, rational storytelling or whether it’s just storytelling for the sake of it.
Gilchrist: Also, if story that starts with some bounded rationality is extended on and on, maybe a person has to keep doing creative things to keep the story up.
Damodaran: The problem with telling an unbounded story is that you now have to try to deliver on that story, and in the process, you could destroy what might have been a great business. One of the things managers have to learn is to not build up a story, not tell a big story for the sake of telling a big story because sometimes, the best thing to do is keep your story bounded. Keep your story smaller. Deliver on that story, and if you can deliver on it, maybe you can move to the next phase and think about making the story bigger.
In Silicon Valley, there are now storytelling classes where founders are taught how to tell really big stories because the bigger the story you can tell, the higher the price you can get as a company. These founders go out there and promise everything but the sun and the moon to their investors. They tell really big stories. If they’re good storytellers, they might succeed in getting people to push the pricing up, but at what cost? You now have to deliver on that story, and the delivery might destroy you as a business because you’re trying to do things you shouldn’t be doing to build a good business. I don’t think that’s going to stop because as long as you can push the pricing up and get out before the dust settles, what does it matter to you whether you’re building a good business? If you’re a VC, why would you care about whether you build a good business? You make money by building up the story and flipping it to somebody else.
Gilchrist: And you satisfy your own limited partners because they’re also going to be happy.
Damodaran: That’s right. It’s not a bad thing. I don’t have a problem with VCs doing it. That’s exactly what defines success for a VC. A VC is not measured by the quality of the business they build but by how much money they make on the deals they do. If you can get in and out at the right time as a VC, you’re a hero. What does it matter that the business you got out of crashed and burned? That doesn’t make it their fault. They’re doing what they’re supposed to do. Let’s face it, self-interest is going to drive how people behave. It’s not the VC’s job to protect me as a public market investor. It’s my job to do that. I can’t expect VCs to think about my interest when they build up the business. People have to stop outsourcing and blaming others for their mistakes and start taking responsibility for their own actions. No banker or venture capitalist forces you to buy a company, so stop whining about the fact that you bought a company that dropped 50%. That’s your decision. You need to take responsibility for that.
Gilchrist: One of the themes in The Dark Side of Valuation is that when we approach complexity, we have a tendency to hide it. We try to imagine it’s not there, but I think you say it’s best to face it head on.
Damodaran: Do you mean uncertainty or complexity? Uncertainty is what we hide from. Complexity is what we build as a barrier to even take a look at uncertainty. Uncertainty makes all of us uncomfortable. As human beings, our first reaction to uncertainty is try to make it go away. We do lots of unhealthy things to make it go away. We go into denial, outsource it, and look for consultants and experts to tell us what to do. My advice with uncertainty is not to hide from it. It’s a feature, not a bug. It’s the nature of the beast. Let’s take 2020 as an example. Did we learn how uncertainty can upend the best of plans? Absolutely. But does closing our eyes make it go away? No. We have to face up to the fact that we’re surrounded by things we don’t control. Because of that, we have to make our best judgment with the data we have right now and then move on, accepting the fact that we’re going to be wrong 100% of the time, and that’s okay. All you have to do is be less wrong than everybody else. That’s the nature of investing. It’s not being right. It’s being less wrong than everybody else.
Gilchrist: In terms of valuation, many people think that you couldn’t valuate emerging markets or it’s extremely hard to. I think you were approached at one point by a gentleman from Syria who came here and said, “I’ve got a business in Syria, and I need some hurdle rate for it. How can I go about it?” You can’t do away with it. It does end up being a real-life issue.
Damodaran: I think that’s the point. Let’s face it, as investors in the US and Europe, we’ve been coddled for a long time, especially in the US, by the fact that we’ve lived in the most stable mean reverting economy of all time. Things always reverted to the way they used to be, which allows you to do a lot of lazy things in investing and get away with them, which is assuming things would revert to the way they used to be five or 10 years ago. You live in a macro environment where everything is changing. The reality is that’s not just emerging markets anymore. That’s all of us. This is going to be par for the course. Mean reversion, assuming things would revert to the way they used to be, is not going to give you any kind of answer. It does make us all uncomfortable. We wish we could go back to the 1980s or 1990s in the US, but we’re not going to. This is how it’s going to be, and we need to accept that and adjust our behavior accordingly.
Gilchrist: That’s something very timely today. People thought commercial real estate had a very predictable future ahead of it with contractual cash flows and so on, but even businesses we think of as very stable get upended. You have to be able to adapt and maybe have an opinion.
Damodaran: There are fewer and fewer safe places to hide. Fifty years ago, we said, “Are there any safe businesses?” We pointed to quite a few. Regulated utilities used to be safe. Think of a phone company. How can you lose money on that? Everybody needs a phone. Unfortunately, technology has upended that business. When you buy into a phone company now, you’re buying more of a technology company than a phone company. In a sense, the world has shifted, and this is the dark side of disruption. We talk about disruption, especially in the last decade, as a good thing, and it is for those who make money on it. Uber upended the car service business. It was a disrupter. We like to talk about how successful it’s been, but whenever there’s disruption, there’s damage. Go talk to cab drivers in New York City. Ask them what Uber has done for them and how disruption has upended their life, and you’re going to see the dark side of it. Every business is now open for disruption, which means there are no safe businesses or very few of them left on the face of the earth.
Gilchrist: You mention some special topics in the book, for instance, interest rates and exchange risks, which are not well accounted for. Could you tell us more about these?
Damodaran: These are macro risks. When you sit down to value a company, the first thing to remember is that if you immerse yourself in macro risks, you’ll never get to your company. There are things you control and things you don’t. What’s the point of worrying about the things you don’t control? When you sit down to value a company, your job is to do that, not tell me what’s going to happen to interest rates, exchange rates, or the political setup in that country, unless it affects your company directly. Analysts spend too much time worrying about the rest of the world and too little time valuing the companies they have to value. It’s tough enough valuing a company, so why become an interest rate forecaster, exchange rate forecaster, and political analyst all rolled into one? It’s impossible to do. My advice on macro risks is to accept that they are what they are. You have to live in the world you’re in, not the world you wish you were in. You’ve got to bring in whatever you can find about those risks into your analysis, charge a reasonable premium to cover them, and move on.
Gilchrist: Looking at different countries, you generally add an equity risk premium on top of the risk-free rate, but the risk-free rate can be quite different from one country to another.
Damodaran: No, the risk-free rates are not different across countries. They’re different across currencies. Countries and currencies sometimes go together, but often they don’t. Look at Europe. There’s only one currency, the euro, but you could be investing in Germany or Greece. The risk-free rate is the same in euros in both countries, but the risk premium you charge will be higher in Greece than in Germany. The notion that risk-free rates vary across countries is not true. Risk-free rates vary across currencies. Risk premiums vary across countries.
Gilchrist: How about inflation?
Damodaran: That’s in the currency. Inflation is entirely a currency issue.
Gilchrist: Then wouldn’t the inflation of, say, Greece and Germany be different?
Damodaran: Not if you have the same currency. The Greeks eat a lot of olives, and if the price of olives goes up relative to the price of gasoline, they will feel more inflation. That’s like saying the inflation rate in Texas can be very different from the inflation rate in New Hampshire. It can be because the basket of goods of the average Texan consumer might have items that have gone up more in price, but the inflation rate in US dollars is the inflation rate in US dollars. When you have inflation rates, it’s a purely currency phenomenon. To the extent that it affects countries, it’s going to show up in your cash flow. Greece is going to grow more slowly because the items it produces are disproportionately represented in the basket of goods that create that inflation. It is going to affect your cash flows and your growth rates, but your discount rate will still have the same expected inflation rate, and it always comes from the currency.
Gilchrist: Because you’re going to be paid back in that currency, and that’s connected to the value of the inflation of the currency at the time.
Damodaran: Yes. Currency is a choice you make. I can value a Russian company in rubles or in dollars. The risk-free rate is going to be very different, but the risk premiums are going to be the same. Here’s what’s going to also be different: if I value a Russian company in rubles, my cash flows have to be in rubles as well. The inflation rate in rubles is much higher than the inflation rate in dollars, but my growth rate in rubles will also be much higher than the growth rate in dollars for exactly the same reason. Inflation gives you in one place and takes away in the other. The key with currencies is to be consistent, meaning that if you decide to value a company in a currency, your risk-free rate has to be in that currency, and everything else also has to be in that currency, like your cash flows and growth rates. If you stay consistent, you’re going to be okay. If you mix and match, all bets are off.
Gilchrist: That’s something you’ve mentioned a lot, that people can introduce inconsistencies into valuation without being aware of them. One topic I found particularly interesting was creating possible scenarios for cash flows in the future. I think you mentioned Monte Carlo simulations, assigning a probability to different scenarios to come up with a different valuation.
Damodaran: In simulation, you don’t attach a probability. You do in scenarios. In simulation, you attach distributions to your variables. You get a distribution of value, which is actually reality. You don’t value a company at a particular number; you have a distribution. All simulations do is let you take the uncertainty you face in the future and be explicit about it rather than only talk about it. You say, “I’m uncertain because my margins could be different.” My answer is, “Okay, tell me how uncertain you’ll be, and I’ll build it into the valuation.” What it effectively does is take the uncertainty you face out there and force you to be explicit about it. What you get as output will be a distribution of value. It’s the best counter to hubris because you will never say, “The value of my stock is $35.” You’ll say, “The expected value or the median value is $35, but you know what? Based on the uncertainty I feel about the stock, its value could be as low as $28 or $42.” That is reality. That’s what we face in every investment. A simulation simply forces you to be explicit about that reality.
Gilchrist: When performing either this kind of scenario analysis or a simulation, did I understand well that you shouldn’t adjust the denominator you’re using?
Damodaran: Adjust for what?
Gilchrist: For risk. Normally, you’d add some kind of equity risk premium.
Damodaran: You still have to add a risk premium because doing a simulation is not going to risk-adjust the cash flow. It’s merely going to give you an expected cash flow. Risk premium is for something different. If we lived in a risk-neutral world, we’d accept expected cash flows. I tell people to watch the show Let’s Make a Deal with Howie Mandel. In that show, contestants are offered either a guaranteed amount or a choice between two suitcases, one having $1 million and the other having zero. The contestant will be offered $400,000. The reason I’d pick $400,000 is the expected value across the two suitcases is $500,000, but human beings are risk-averse. They will accept a lower guaranteed amount instead of an expected cash flow that is higher. That’s what we’re trying to do here. When we risk-adjust the cash flows, we are essentially bringing down the value below the expected cash flows. In simulations and scenario analysis, you still have to risk-adjust the discount rate.
Gilchrist: Isn’t there any risk of double counting because you’ve already assigned a probability to a specific scenario?
Damodaran: No, probabilities are not risk-adjusting; they are expected cash flows. In the example I gave you, there’s a 50% probability that you’ll get zero and 50% that you’ll get a million. The expected cash flow is $500,000. That’s not risk-adjusted; it’s only your expected cash flow. A risk-adjusted version of that would say, “I’ll take $400,000 for that $500,000 because you’re guaranteeing me.” That’s what Howie Mandel offers – a guaranteed cash flow. The notion that probability adjusting the cash flows gives you a risk adjustment is misplaced. Analysts do it all the time. I think they’ve forgotten their basic statistics when they do that. All you’re getting is an expected cash flow, and an expected cash flow is not risk-adjusting the cash flow.
Gilchrist: When you discount the cash flow in the future, in your denominator, you might build risk in by using a higher denominator, which would reduce the value.
Damodaran: That’s a good point. If we lived in a risk-neutral world, we would never do that. We’d discount everything at the risk-free rate.
Gilchrist: But if we add in the probability, aren’t we counting twice?
Damodaran: How? To go back to the example I gave you, you have the two suitcases, one with zero and one with $1 million. Let’s suppose I gave you the choice of $450,000 guaranteed instead of making that bet. You think a lot of people are going to take the $450,000?
Gilchrist: If they’re risk-averse.
Damodaran: We have a very simple test. If investors were not risk-averse, there’d be no need for risk-adjusting any number. This is not a hypothetical. This is reality. If we were risk-averse, stocks, in the long term, should earn the risk-free rate. If we were risk-averse, no participant in that Let’s Make a Deal show would take it because the guaranteed amount is always less than the expected value. Howie Mandel never offers $600,000. He offers $400,000 or $350,000, and 75% of the time, people take it. You see it right there. This is not some hypothetical economic exercise, and it’s for a simple reason. You’ll want to take a guaranteed amount rather than risk getting nothing. There’s a 50% chance you get nothing. That’s risk aversion. When you think about that chance and say you’ll take the guaranteed amount, you’re thinking about that 50% chance of getting nothing. The minute you think about it, you’ve told me you’re risk-averse because it’s weighing more than the expected value. There is this chance you will get nothing.
Gilchrist: Is that why risk often comes down to volatility in the sense that we know stocks outperform in the long run, but we’re very uncertain about it?
Damodaran: If we lived in a risk-neutral world, we wouldn’t care. That, again, is the example. We wouldn’t care about the volatility because we’d say that on an expected basis, it’s all going to average out, and therefore, we don’t need a risk premium. The fact that we demand a premium for the volatility is an indication that, collectively at least, investors are risk-averse. Are there some of us who are less risk-averse than others? Absolutely. In fact, a few of us might even be risk-loving, and we are the ones who will be willing to take that $500,000. Even if I offered you $600,000, you might say, “I’ll go for the expected value because there’s a chance I’ll make $1 million.” That’s what gambling is because in gambling, the expected value is negative. When you gamble, you’re essentially saying, “I’m going to go for this gamble even though my expected value is negative,” because walking in, you know that the casino takes 5% or 10%. Your expected value is already minus 5% or minus 10%, but you go in anyway. Some of us do it as entertainment, but others think that’s okay because they want that small chance of making $300,000, $500,000, or $1 million. A few of us are risk lovers, but in the aggregate, investors are risk-averse, so they demand a premium for being exposed to that uncertainty.
Gilchrist: So, should the expected value be calculated separately from the risk?
Damodaran: How can you separate it from the risk? We could compute an expected value as if you are risk-neutral. In other words, we could discount the cash flows with the risk-free rate, but then what am I going to do with that number? I still have to adjust it for risk, right? I’d have to do a Howie Mandel equivalent and say, “What would you pay for what I came up with Tesla? My expected value for the stock if I don’t use the risk-free rate is, let’s say, $1 trillion, but there’s a lot of risk.” You’d still have to make that judgment of how much less than $1 trillion you’re willing to pay. You can’t put off dealing with risk. You might as well bring in the discount rate rather than do it in two steps because all you’d be doing is computing an expected value using the risk-free rate and then trying to risk-adjust that value, in which case, you’ll be faced with exactly the same challenges you faced if you only adjust the discount rate for risk.
Gilchrist: Haven’t the probabilities we’ve assigned to different scenarios in the future already told us how we feel about the risk?
Damodaran: No. Think about it. What does it do? Think statistically – 50% chance of zero, 50% of $1 million. There’s no feeling in there. The expected value is $500,00. Up till now, it’s pure statistics. It’s whether you will accept less than $500,000 for that expected value that tells me about risk aversion. The very act of attaching probabilities is completely antiseptic. There is no risk premium. This is the expected value, $500,000. A hundred of us could do it, and we’ll all get $500,000, but about 80 of us will require at least $300,000. Ten of us might need $400,000. As you go through, this is where the differences from one person to the next will come across, what they will accept as a guaranteed amount instead of their expected value of $500,000.
Gilchrist: Isn’t one of the complications that it’s unobservable?
Damodaran: Yes, and that’s why we struggle. If you take a stock like Tesla, you might have hundreds of thousands of shareholders, each of them bringing in very different risk aversions. That’s why we compute estimates of what collectively, at least in the aggregate, you’re getting. That’s what all risk and return models try to do. It’s not easy, but there’s no choice other than do it, right? What alternative do you have? You have to try to come up with a consensus estimate. The expected return you end up using as your discount rate becomes a reflection of that consensus estimate, at least as you see it.
Gilchrist: You gave an example of Warren Buffett, saying that he presumably limits the number of companies he looks at to one where future cash is highly predictable. He’s highly conservative in that.
Damodaran: And it’s worked really well for him in the last 20 years, right? It shows you that even the very best investors are a function of the times they’re investing with. The strategy of finding stable companies with predictable earnings made Warren Buffett what he was. But remember, we talked about disruption making every business unstable. When Warren Buffett invested in Kraft Heinz in 2015, he was assuming that we will forever want those 57 types of ketchup and cheese that stays liquid until the next nuclear war. The problem is we don’t, so guess what? Kraft Heinz crashed and burned. Why? Because the assumption that things are predictable simply because they’ve been predictable in the past is an assumption. When the word shifts under you, that assumption breaks down. There’s a simple reason Buffett has become an average investor in the last 20 years – the world has changed under him. Who can blame him, though? The man is 92. It’s extremely difficult to change when you’re 92. I don’t have a problem with Warren Buffett. I have a problem with wannabe Warren Buffetts who are 40 or 50 years old and who blindly ape him, then complain about the world being unfair to them because it’s not delivering the returns it delivered to Warren Buffett.
Gilchrist: The only choice people have today is to make that leap, to try and make their best assessment of things.
Damodaran: Either that or they get pushed out of the market, and they’ve got to find something else to invest, and God help you with that because uncertainty is everywhere.
Gilchrist: How does that fit in the sense of an investor having a circle of competence, in the sense of saying, “I feel like I understand this”?
Damodaran: You don’t need a circle of competence. Just buy ETFs. Let’s face it, for 95% of people, this act of going out and trying to find stocks that beat the market will deliver nothing other than pain and cost. There is an easy way out, and circle of competence is vastly overrated. The only person who thinks they have a circle of competence is the person who claims to have it. What circle of competence are you going to bring? Unless you’re a PhD in biochemistry and you’re doing young biotech companies, there are very few businesses where your circle of competence will take you further than the one-yard line. For the majority of people, the most sensible thing is to not try to get rich through investing. Investing is not about getting rich. It’s about preserving and growing your wealth. Go back and live the rest of your life. Do your jobs. Be a good doctor. Be a good engineer. Be a good teacher. Take the income you make and save it. My only advice for saving is if you truly enjoy picking stocks, do so, but don’t do it in the expectation that you’re somehow going to beat the market. If you beat the market, think of it as the icing on the cake. If you don’t, don’t do too much damage to yourself. Don’t put your money in three stocks. Don’t overreach. Don’t try to get rich overnight. Don’t buy cryptos simply because everybody else is making money. The pathway to sensible investing is to not try too hard.
Gilchrist: How about when people say, “Well, I haven’t done as well as the market, but I’ve taken on less risk than the market”?
Damodaran: That’s plausible. I mean, it’s easy to check, right? If I look at your portfolio and find that it has been more volatile than the market, I’m going to present you with the facts and say, “Are you lying to yourself or are you lying to me?” The biggest enemy in investing looks at you in the mirror every morning when you’re getting dressed. It’s you. Our capacity for self-delusion is deep and won’t go away. My advice to people is to stop lying to themselves. Stop coming up with excuses, and for God’s sake, stop blaming the rest of the world for everything that goes wrong with your portfolio. People have a tendency to think that the Fed did it or the hedge funds did it. No, it’s you who did it to yourself. Let it go. If you invest out of frustration and out of anger, the only person you’re hurting is yourself.
Gilchrist: One of the very interesting topics in the book is how intangibles have become much more prevalent and have made it harder to think about companies as accounting statements don’t reflect them very well.
Damodaran: I don’t think it’s made it harder. The problem is with the accountants. They have this thing about physicality, tangibility. Part of the reason is that accounting as we know it was designed for the old-time manufacturing firm. If you think about the origins of accounting, they were in the 20th century for the Smokestack America, the GMs, the Fords, the GEs. The problem for accountants is that they’re about 50 years behind the times. They create investments in things they cannot see, like technology, R&D, and operating expenses. It’s stupidity, but it plays out as financial statements for these companies that don’t mean what they claim to mean. The earnings for Microsoft are not comparable to the earnings for GM because the earnings for Microsoft are after R&D expenses, which are really capital expenses. It’s not difficult to do, but you have to start with the accounting statements, not end with them. You’ve got to redo the accounting, and it’s not difficult. Nothing is rocket science. You can redo it to bring in the intangibles, and once you do it, you’re on firmer ground. It does add a layer of work when you value a Microsoft or an Apple or a Google, but it’s not difficult to do. I’m not going to sit here and complain about accounting not keeping up. Frankly, I’m not going to wait for accountants to come to their senses. It takes them a long time. I’m going to do it on my own. And guess what? I feel more in control when I do it on my own than when accountants do it for me. I have mixed feelings about what exactly accountants do when they come to their senses because I’m not sure they’re helping me out by trying to do the right thing.
Gilchrist: Unless the company explains, it can be quite difficult to figure out what portion of its expenses it needs just to cover its operations and what for growth for the future, such as research and development – it doesn’t need it for today, but it does need it for the future.
Damodaran: R&D is not difficult. Nothing is for today. More difficult are things like advertising expenses to build a brand name. That’s truly an investment for the future. R&D is the easiest of the items. I wouldn’t worry about it. The question is whether it will pay off in two, three, or five years. Customer acquisitions are much more difficult because you don’t know how long a customer stays on, but it’s difficult only because we don’t have the capacity to ask the follow-up questions. Uber claims that customer acquisition costs are capital expenditures. The question I’d have to ask is what the churn rate is. What percentage of riders stay on? When the churn rate is 50% or 80%, the customers keep turning over, customer acquisition costs go back to being an operating expense. We need to ask companies the right follow-up questions. We might not as investors, but analysts should be doing this. Why aren’t they doing their jobs? Why isn’t somebody getting up and asking Netflix, “You added all these users. Where in the world are they?” An Indian Netflix subscriber is worth about 1/5 of a US Netflix subscriber because they pay a lot less per month. Also, how long do they stay on as subscribers? Until we start asking the questions, we won’t be dealing with intangibles the right way. We have a template for what we need to do. We just seem unwilling or too lazy to do it.
Gilchrist: With Netflix, another thing I find quite interesting is that it counts as operational expense some of its movie development. It capitalizes some of it, but then on one level, the company does need to keep on making movies to sustain its current base of users.
Damodaran: That’s like a manufacturing company. Does a manufacturing company build a factory and just leave it? It’s got to go in and replace equipment. Think of existing content being renewed as equipment being replaced. It’s got to build new factories, which is like building new content. I don’t think it’s that different from a manufacturing company. It’s just that our frame of reference doesn’t include stuff like this. It’s more a failure of the imagination than a failure of the data, where our vision is still clouded by what used to be so that we’re not rethinking what a capex is, that when Netflix invests in a new show, it’s very much like Coca-Cola coming out with a new beverage. When it goes and maintains an old show, it’s like Coca-Cola going in and spending money to build up an existing brand. I don’t think it’s any different from a tangible investment. We simply need to think about it in more creative ways and not have this notion of “Show me something physical this company has done for it to be a capex.”
Gilchrist: What advice could you offer people to make that transition?
Damodaran: I think it’s hard work because the first company you do it in, it will be like pulling teeth. It’s like everything else in valuation. It’s a craft you keep working at, and it will get easier. The first technology company you value will give you all kinds of headaches. The second one will be easier. By the time you get to the 10th or 12th, you won’t even notice it’s a technology company. My advice is start with a company. Don’t go reading more about it because that seems to be the tendency for people now – they want to read up as much as they can before they try. It’s a waste of time. Just go start on a company. If you run into a roadblock, read up on it, and then keep working. Every time you value a company, it’s only going to get easier.
Gilchrist: Then there are factors such as total addressable market that can be quite hard to estimate.
Damodaran: Yes. Okay, it’s hard, but is it only you facing this challenge? We said uncertainty is a feature, not a bug. Does Airbnb know with certainty what its total accessible market is? No. It’s estimating. You’re estimating. We’re all trying to estimate something that none of us know, so why make this just about you?
Gilchrist: How would you think about the quality of management entering valuation?
Damodaran: It’s in your numbers, right? If it’s not in your numbers, you haven’t done your job. I’ve never seen a company pay dividends with management quality. Management quality has to show up somewhere. It’s got to show up in earnings and cash flows. If you tell me you have a quality management, but you keep losing money and I get no cash flows, I’m going to question your definition of quality. Ultimately, quality is simply a means to an end. If you tell me you have great management, show me where. What number is showing it? If you can’t show me a number, my response is, “I don’t believe you when you say you have quality management.” Often, people brand a management as high quality. You know how they branded it, right? They look at your history. Why is Amazon considered a great company? Because it’s delivered results and done so much better than expected. I think quality of management is one of these things people like to use as buzzwords. I blame the Oracle from Omaha for this because they have a fetish about quality of management. Do I think management matters? Absolutely. If it does, it’s got to be in the numbers. If it’s not in the numbers, let’s move on. There are more critical things to talk about than how much you like the manager and how great they are in terms of dealing with people. If they are that good at doing all of this stuff, why isn’t it showing up in the numbers?
Gilchrist: Could it be that they’re pursuing a long-term vision that hasn’t shown up as yet?
Damodaran: Right. How long term do we wait for this vision to show up? People think that management are some superhuman beings. They’re your employees as stockholders. If every year you come in and they say, “Just wait,” and you wait one, two, five, seven years, at some point, you’d say, “How long term is long term?” The Keynesian statement comes to mind. We are all dead in the long term.
Gilchrist: If we wait too long, it might get reflected in the prices.
Damodaran: Let’s face it, the average management team in a company is very average. I’d wager that you could replace the management team in most companies by a bunch of robots and get pretty much the same results. The reality is managers vastly overrate themselves. They think they’re all special. You ever talk to a management team that doesn’t think it’s a quality management team? I never have. Everyone claims to be high quality. This is like every parent thinking their kid is above average, at which point you’ve got to ask where the heck is the average if everybody’s above average.
Two-thirds of management teams around the world destroy value as they grow – two-thirds! Out of 45,000 companies, 30,000 managers destroy value when they come into work, not add value. The median management team is not a high-quality management team. It’s a below-quality management. If somebody claims to be high quality, then I need to see some tangible backing for that, otherwise it’s just words. Why would I pay a premium for words?
Gilchrist: You’ve also said that growth is one of the harder areas because a lot of growth is value-destroying, not value-creating.
Damodaran: That’s because companies get old. You get old and your business turns bad. It’s not your fault. There’s just nothing there. Find me an airline that grows and creates value. They’re in a bad business. It will be extremely difficult for you to create value. The sensible thing to do is shrink or at least don’t grow. You know how many management teams will take that advice? As a manager, you’re told that good managers grow their companies. When was the last time you saw a movie about a CEO who made his company smaller? I’ve seen a lot of movies about CEOs who made their companies bigger, the Steve Jobs movie about how he made Apple go from $10 billion to $1 trillion. I’d love to see a movie about a CEO who comes into a $100 billion company that’s past its best days and then finds a way to shrink it over time to reflect the fact that it’s way past its prime. We’re not going to see that movie made.
Gilchrist: How do you think about ESG, which is becoming much more prevalent?
Damodaran: I think it’s the most overhyped, oversold concept in the history of business. I don’t hold back. I’ve never ever seen a concept with so little behind it being adopted and hyped by so many people, and here’s why. A lot of people are making money on ESG. None of them are investors or company employees. These are consultants and advisors to portfolio managers. A lot of people are making money from this concept, but there’s very little there. Do you truly want your companies to become churches? Is that what this is going to be about? You know what happens when companies try to be churches? They’re neither good as companies nor as churches. That’s what we’re heading towards – companies that sound good but don’t do good. We all want companies to do good for society. Do we want them to operate with constraints? Absolutely. That’s why we have legislators to pass laws.
You know what this is? This is a complete abdication of responsibility by everybody. In the case of consumers, they want the convenience of shopping from Amazon, but they don’t want to think about the fact that every time a package arrives, it brings with it 15 tons of recycling. We want the convenience of going to Walmart and buying things cheap, so we’ve decided that because it’s too much work for us to be good, we should make companies do it for us. It’s the job of our politicians to pass laws that prevent social costs, but politicians are either too lazy or unable to do it. Guess what? They tell companies to be voluntarily good. Nothing good will come out of this. Ten years from now, you’ll only have a lot of ESG consultants who have gotten rich off this phenomenon. Companies will all sound good. When you open up their annual reports, it would be like reading the Bible. If you think about whether companies are actually doing more for society, I can almost guarantee you that 10 years from now, the answer will be no.
Gilchrist: In terms of valuation, is this part of the same problem of people wanting to go back to a simple time where everything seems to have a simple answer?
Damodaran: No, this is far worse because as a society, I think we have decided that all the things we need to do for goodness are too much work. We’ve decided that we’ll just pass on the responsibility to companies. This is a reflection of wanting to have our cake and eat it too. That’s the ESG promise. You will be good, and the companies will get valuable. It’s cake for all, calories for nobody. That’s never been a pitch that works out.
Gilchrist: Is there some kind of continuing advice you could offer in terms of developing the right mindset with valuation and being able to evolve over time?
Damodaran: My only advice to people is to be okay with being wrong. If you’re okay with it, your mindset will develop on its own. The problem is that people dig themselves into trenches. Once they’ve dug themselves in, they cannot admit that they’re wrong. If you’re okay being wrong, you’re going to be creative because being creative means you’ve got to take steps that will make you more wrong. I think people are looking for precision when they should be looking for accuracy. Precision basically means you have a model that delivers the same answer over and over again. Accuracy means you’re trying to get the right answer even if your model is all over the place. We need accuracy, not precision.
Gilchrist: Professor, thank you very much for taking the time to speak to us. I highly recommend your book, The Dark Side of Valuation, and all the other bits of knowledge you put out and generously share.
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