Share this post

🔑 Key Takeaways

  1. Valuing a company is a critical skill for stock investors and can be learned by anyone willing to collect and analyze information. Sound investing involves not paying more for an asset than it is worth based on expected cash flows.
  2. Valuation of assets involves intrinsic or relative methods, but most rely on market prices. Biases and forecasting errors are common, so consider them while using simpler valuation models. Remember time value of money and aim to be wrong less often than others for investment success.
  3. To calculate intrinsic value, consider existing asset cash flows, future growth rates, financing costs and future company worth. Accounting knowledge is vital to estimate future cash flows and appropriate discount rates.
  4. Calculating a company's intrinsic value involves considering the risk-free rate, equity risk premium, and relative risk/beta, along with historical growth rates and estimated terminal value. Adjustments like cash equivalence and minority interests must also be taken into account.
  5. Assessing a company's intrinsic value involves considering its growth potential and risk. Relative valuation should be adjusted to normalize comparisons. Metrics like P/E and EV/EBITDA help. Valuing young growth companies is challenging, but estimating future free cash flows and total addressable market is important.
  6. Valuing a young company requires consideration of potential risk, optionality, tough-to-imitate products, large market potential, and cost discipline. Mature companies have predictable earnings and characteristics such as stable margins, competitive advantages, and excess cash.
  7. When valuing companies, consider intangible assets, but be cautious of traditional accounting measures. Adjustments, like capitalizing investments and estimating their amortizable life, need to be made for an accurate valuation.
  8. To properly value a company, it's crucial to go beyond the numbers and understand the story behind them. This involves evaluating the three Ps, analyzing return on invested capital, and conducting thorough research to ensure a realistic and unbiased valuation.
  9. Williams-Sonoma presents a classic value investment opportunity with strong fundamentals, growing cash flows, and potential for significant growth. It also offers shareholder and executive alignment and downside protection, making it a wise long-term investment choice.
  10. Use finance tools to calculate intrinsic value and expect returns regardless of economic fluctuations. Williams-Sonoma is a strong business with a competitive advantage and solid financials.

📝 Podcast Summary

The Little Book of Evaluation – A Guide to Valuing Companies by Aswath Damodaran.

Valuing a company is a critical skill for stock investors. Aswath Damodaran's book, The Little Book of Evaluation, provides an overview of primary valuation methods, general truths about valuation, basic inputs, setting a growth rate, valuing growth and mature companies, and adjustments for intangible assets. Aswath is considered the Dean of Valuation and an excellent teacher, dedicated to making finance accessible. Valuation is simple and can be learned by anyone willing to collect and analyze information. Sound investing involves not paying more for an asset than it is worth based on expected cash flows. Purchasing a company based on the belief that others will pay a higher price in the future is not a sound investment strategy.

Methods and Challenges of Asset Valuation

Valuation of assets can be done using intrinsic valuation or relative valuation methods. While intrinsic value is based on the cash flows an asset generates and its certainty, most assets are valued based on market prices of similar assets. Bias is present in all valuations, and it's important to be aware of one's biases and consider them while valuing a company. Valuations require forecasting and are often wrong. The simpler the valuation model, the better. Time value of money is crucial for valuing an asset as a dollar today is worth more than a dollar in the future due to consumption preference, inflation, and risk of non-delivery. Success in investing comes from being wrong less often than others.

Understanding the Discount Rate, Intrinsic Value and Free Cash Flow

The discount rate is used to convert future cash flows into today's dollars, taking into account potential risks and inflation. The further away the cash flows are, the lower their present value. To calculate a company's intrinsic value, we need to consider the cash flow from existing assets, expected growth rate, cost of financing, and an estimate of the company's future worth. Free cash flow is calculated by making necessary adjustments to net income including adding depreciation and subtracting capital expenditures and principle repaid on debt. The comparison between capital expenditures and depreciation helps to measure the firm's investments in longer-term assets. Understanding accounting is important to calculate a company's future cash flows which are used to determine an appropriate discount rate.

Key Factors to Consider When Calculating a Company's Intrinsic Value

When calculating the discount rate for a company's intrinsic value, three factors should be considered: the risk-free rate, the equity risk premium, and the relative risk or beta. Companies with higher risk should have a higher discount rate. The expected growth rate of the company can be difficult to predict, but looking at history and considering Wall Street and management expectations can help. The value of the business at the end of the forecasting period, or the terminal value, can be estimated by either liquidation value or estimating the worth if operations were to continue. After calculating the present value of future free cash flows and considering adjustments like cash equivalence and minority interests, the intrinsic value of a company can be determined.

Factors to Consider When Calculating a Company's Intrinsic Value and Relative Valuation

When calculating the intrinsic value of a company, it's important to make realistic assumptions about its future growth potential and the riskiness of the company. A relative valuation can be helpful in determining whether a stock is undervalued or overvalued, but it's important to adjust the values to normalize your comparison between companies. Price to earnings and enterprise value to EBITDA are common metrics when performing relative valuations. It's also important to consider a young growth company's total addressable market to estimate future free cash flows, but valuing these types of companies can be difficult due to little historical data. Every company's value is based on its cash flows, growth potential, and risk associated with the business.

Valuing Young vs. Mature Companies

Valuing a young company involves considering the level of risk associated with such a purchase. Even though most young growth companies end up failing, every single company has some sort of value to it. When valuing growth companies, one should also consider the potential for optionality. You want to invest in young companies with tough to imitate products that have a huge total addressable market and disciplined to keep their costs under control. Mature companies are much easier to value than young growth companies because their future earnings are much more predictable. Common characteristics of a mature company are that their revenue growth is approaching the growth rate of the economy, stable margins, strong competitive advantages, and excess cash to pay dividends and buyback shares.

Valuing Companies: Leverage, Debt, and Intangible Assets

When valuing a company, it's important to consider leverage, debt levels, and intangible assets. Companies with declining revenues may offer long-term investment opportunities, but valuing them can be tricky due to the nuance involved. Investing in companies with intangible assets like technology and brand advertising has become popular, but traditional accounting measures like book value and capital expenditures for these companies can be misleading. Adjustments need to be made to accurately value these companies, including capitalizing investments in intangible assets and estimating their amortizable life. Some expenses, like those for augmenting brand name value or training employees, could also be considered capital expenses. However, evidence must be present that these investments will bring real benefits for the company over time.

The importance of understanding a company's story in valuation

When valuing a company, it's important to understand the story behind the numbers and ensure it passes the three P test: is it possible, plausible, and probable? Tesla is a prime example of varying opinions on the company's story. Additionally, return on invested capital should be carefully evaluated, as intangible assets must generate value and have a competitive advantage to earn high returns. A strong foundation in understanding the company, its markets, and competition is necessary to develop a good story. Research is vital to ensure the story is based on reality, not wishful thinking or personal bias. Valuation is a bridge between stories and numbers and requires second level thinking.

Comparing Tesla and Williams-Sonoma as Investments

While Tesla has a great story, it may be overvalued and risky to invest in. However, Williams-Sonoma is a classic value investment that has strong fundamentals, growing free cash flows, and trades at an attractive multiple. The company has adapted to the trend of online shopping and has been consistently growing its business over the past 10 years. With a 1% market share in a highly fragmented market and management's goal to grow revenue to 10 billion by 2024, there is potential for significant growth. Williams-Sonoma also has an alignment of shareholder and executive interests with an interesting executive compensation model and aggressive share buybacks. Overall, investing in Williams-Sonoma may provide downside protection and long-term growth potential.

Focusing on Free Cash Flows for Company Evaluation.

When evaluating a company, it's important to focus on free cash flows and not get caught up in projections. By using a finance tool, it's possible to calculate intrinsic value and expect returns even in the face of a recession or decline in earnings. Williams-Sonoma is a high-quality business with strong brand recognition and a competitive advantage backed by solid financials. While the policy of the investor podcast network prevents Clay Finck from buying or selling any stock mentioned on the show for the first two weeks after release, he has started a small starter position in Williams-Sonoma, which he believes is currently trading at a cheap to fair value.