Aswath Damodaran on Valuation: Four Lessons to Take Away

Aswath Damodaran participated in the “Talks at Google” series in 2015, sharing his insights
into equity valuation.

According to Damodaran, “The tools and practice of valuation is intimidating to most

laymen, who assume that they do not have the skills and the capability to value companies.
In this talk, I propose to lay out four simple propositions about valuation. The first is that
valuation is not an extension of accounting, insofar as it is not about recording the past but
forecasting the future. The second is that valuation is not just modeling, where people put
numbers into Excel spreadsheets and pump out values. A good valuation requires a
narrative that binds the numbers together. The third is that valuing an asset or business is
very different from pricing that asset or business, a difference that is often blurred in
practice. The fourth is that luck plays a disproportionate role in whether you make money
off your valuations. Put differently, you can do everything right and still walk away with
nothing or worse at the end.”

We are pleased to provide the following transcript as a courtesy. The transcript has been
edited for space and clarity. It may contain errors.

Aswath Damodaran: I am lucky to work at the intersection of three different businesses.

I’m a teacher first, I love to write, and I’m in finance. I’m in three businesses begging to be
disrupted. These are three big, badly run businesses, all of which need to be taken to the
cleaners. My objective at this point in my life aims to disrupt these businesses. Today’s
presentation is one of those acts of disruption because, for too long, we thought teaching
happens in classrooms and universities. I don’t see that restriction anymore.

My subject today is the subject I’ve taught for 30 years. To give you some background, I
came to NYU in 1986. When I first arrived, they gave me a class to teach called Security
Analysis. For those of you who know the history of that class, it was a class Ben Graham
taught at Columbia in the 1950s. A famous businessman you all know, who shall not be
named, took that class. It’s a class with long and hoary traditions. They handed it to me and
said, “You’ve got to teach this class.” I took one look at the class and said, no way. This is
the most boring collection of topics I can think of because, by the 1980s, the course showed
its age. I told the department head, “I’d like to teach a valuation class.” He said, “Don’t do
it. There isn’t enough stuff in valuation to teach a class.” He was right about the scarcity of
valuation resources. In 1986, there were no books about valuation. In fact, when I did my
MBA from 1979 through 1981, we spent only about 1.5 hours collectively on valuation.

I thought about it and decided to teach the valuation class. I considered two options. One is
to go the official route in the university, which is to ask officially for course approval – if
you’ve ever been in an academic setting, as most of you have, you know how difficult it is to
get things done officially at a university. A committee will be formed to report to another
subcommittee. By the time they get back to you, you’d be ready to retire! I discovered early

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 Aswath Damodaran on Valuation: Four Lessons to Take Away

in my academic life if you want to get something done, it’s best to do it subversively.

Here’s what I did: I said I’d teach the security analysis class, and I went into the classroom
and I taught a valuation class. They have absolutely no idea what I do in the classroom. I
could be teaching cooking for all they know. You know how long it took them to find out? In
2008, after teaching the course for 22 years, I got a call from the dean’s office: “We’ve
heard you’re teaching a valuation class.” I said, ‘Yes. I’ve been doing it for 22 years.” They
said, “We should call it valuation.” I said, “Welcome to reality.” If you look at the NYU
schedule, you won’t see valuation appear until 2008, but that’s because I hijacked six other
classes in previous iterations and made them all valuation classes.

I’m fascinated by valuation, and it is simple. Fundamentally, anybody can do valuation. We

choose to make it complex. Who is “we”? The people who practice valuation. Why? Because
that’s how you make a living. You’ve got to cover things with layers of complexity to keep
people away.

I want to get back to basics. In today’s 40-minute session, I won’t cover the details of
valuation. Rather, I’ll hit some points people miss sometimes, especially when people look at
valuation from the outside.

Here’s the first message I want to deliver: Valuation is not accounting. I say this because
most people think numbers, income statements, and balance sheets when you say valuation.

Every year I teach this class, I face this valuation and accounting equivalency
misunderstanding. In fact, many of the MBAs I teach come into my class in the first year
having taken one course in accounting. If you’ve looked at how MBA programs have
evolved, they are diverse now. I get museum directors, basketball players, and people with
other non-traditional backgrounds. Part of my job is to get them out of the accounting
mindset.

I see a difference in the way accounting and finance look at the world. Accounting is
backward-looking. Nothing bad about that. Consider the classic balance sheet contents. On
the asset side, the balance sheet divides assets into current assets, inventory, accounts
receivable, and cash. It divides fixed assets into land, building, and equipment. Accountants
are big on tangible fixed assets. For some reason, if they can see it, they’re more
comfortable with it. Then you have financial assets, which are investments in other
companies. Then accountants have what they euphemistically call intangible assets. If I
went around this room and asked people to name intangible assets, you’d see lots of things
come to the surface like brand name and technology. Do you know the most common
intangible asset appearing on an accounting balance sheet?

Audience Member: Goodwill.

Damodaran: Yes, goodwill, and let’s be completely clear about this: Goodwill is the most
useless asset known to man. For goodwill to manifest itself in an accounting balance sheet,
the company must acquire another company. If you’re the greatest company on the face of
the Earth and you’ve grown entirely with internal investments, goodwill does not appear on

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 Aswath Damodaran on Valuation: Four Lessons to Take Away

your balance sheet. The minute you do an acquisition, goodwill pops up. Imagine an
acquisition with a book value of $4 billion. Accountants say until the acquisition, the
acquired company was worth $4 billion. However, you offer $10 billion. The accountant has
a $6 billion problem to explain away. He calls it goodwill. The accountant must post the
goodwill because the balance sheet must balance. Goodwill is a plug variable. The problem
with goodwill is it sounds good and people feel the urge to pay for it.

Every week I get emails from people saying, “I’m valuing this company. It has $5 billion in
goodwill. How much should I pay for it?” And my response is, “It’s a plug variable. What the
heck are you doing paying for a plug variable?”

Accountants get carried away on the other side of the balance sheet, too. You have current
liabilities, accounts payable, supplier credit, deferred taxes, all kinds of stuff. Then you’ve
got long-term liabilities, bank loans, corporate bonds, and shareholders’ equity. If you get a
chance, look at Google’s balance sheet. You’ll find a shareholders’ equity number just like
on all balance sheets.

Do you know what goes into shareholders’ equity? Everything that’s happened to this
company over its lifetime goes into shareholders’ equity. When you look at the shareholders’
equity for Coca Cola, in that number is the original public offering Coca Cola made 100
years ago or so. The number includes everything that has happened since. Shareholders’
equity reflects the past.

Instead of using a conventional balance sheet, I prefer a financial balance sheet. At some
level, a financial balance sheet is simpler than an accounting balance sheet. At another
level, it’s more complex. Only two items list on the asset side of the financial balance sheet,
assets in place and growth assets. Assets in place is the value of investments the company
already made.

The growth assets item is a little messier. It’s a value I attach to investments I expect the
corporation to make next year, 2 years out, 5 years out, 10 years out, forever. I give the
corporation credit for investments it hasn’t even conceived of. That’s pretty scary. An
accountant can never do that, but I play by no rules. If I feel the corporation has great
investments in the future, I can give growth assets a large value.

Consider an example with Procter & Gamble. Where does most of the company’s value come
from? Value comes from investments it already made or growth assets. Most of the stuff it
has done are already on the ground. What else will Procter & Gamble do? However,
consider LinkedIn or any young growth company. On a good day, LinkedIn’s assets in place
are worth $1 billion because it made about $10 million in operating income last year. You’re
paying $40 billion for the company. The extra $39 billion is for what? Expectations,
perceptions, hopes. Nothing wrong with it, but that’s the first stop when you’re an investor.
You’ve got to stop and do a reality check.

What are you buying when you buy this company?

You assess a young growth company differently than you assess Procter & Gamble.

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 Aswath Damodaran on Valuation: Four Lessons to Take Away

Assessing Procter & Gamble requires focus on earnings reports and how much it made last
year. However, at LinkedIn, who cares what it made last year? Look at how investors freak
out with social media earnings announcements! If earnings per share were $0.02 below
expectations, I don’t care because value is not based on what it did last year. Rather, it’s
based on what the corporation can do in the future. When I look at a Twitter earnings
report, I don’t look at what it did last year. I look for clues about growth potential and
whether it does the right things to create value from its growth assets.

Most of the tools we have in accounting and finance were developed for mature companies.
You’re taught these things – P/E ratios, return on equity – in business school. If you assess a
growth company with these tools, it’s like using a hammer to do surgery. That will be bloody
and come to a bad end.

It can be interesting to contrast an accounting balance sheet and a financial balance sheet.
The younger a company, the less you will learn from the accounting balance sheet, and for a
simple reason. If the young company has not been around long, the accountant has nothing
to record. Twitter’s and LinkedIn’s balance sheets offer little information. This doesn’t make
them bad companies. It makes them different.

Only two items reside on the other side of the financial balance sheet, debt and equity. You
could slice and dice this as much as you want, but every business must have the same
choice. If you tell me where the bulk of your value comes from, I’ll tell you whether you
should fund your business with debt or equity. Let’s say you’re a young growth business.
How young? You’re an idea business. You’re a Snapchat with no revenues or earnings but
with plenty of potential. How should you fund your business? What’s the problem with
borrowing money to fund an idea of business? Have you tried paying interest with ideas? Go
to the banker for a loan and say, “You know what? I have a lot of ideas.” However, you can’t
make interest payments with ideas. If you’re an idea business, you must raise equity.

The first message I want to deliver is that valuation is not accounting. The second message
concerns the complementary value of story people and numbers people.

I often see valuation classes structured around spreadsheets. Some of you might have
attended courses by Training the Street. I like those guys. They come in with spreadsheets.
They teach you how to be an Excel ninja. You can write macros on top of macros. You can do
those shortcuts and turn columns into yellow, green, blue, etc. At the end of two days, you
are a master at Excel, and you think this is what valuation is about at the end of the process.

I like to step back and think about what drives the value of a company. If I’m asked to value
a company, I need answers to four basic questions.

First, what cash flows do existing investments yield? It could be small for a young growth
company. I look at the last financial statements because they give a measure of existing
cash flows.

Second, what value does the corporation create with future growth? Notice how I phrased
the question. I didn’t ask you what’s your future growth. Growth, by itself, can be worth a

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lot, worth nothing, or it can destroy value. Growth can be good, bad, or neutral because
growth comes with a price. I want to know the value created from future growth. This
question is more difficult to answer than the question about cash flows from existing assets.

Third, how risky are these cash flows? Notice I didn’t throw in any terms or buzz words like
“beta.” Those are tools. Don’t mistake tools for endgames. I need a measure of risk, and I
need to bring it into the value.

Finally, when will your business mature? I must put closure on this process. I cannot keep
estimating cash flows forever. Those are the four questions around which the valuation
swivels, which then brings me to the way about valuation.

When I start my valuation class, 200 people walk into the class. The first question I ask:
“Are you numbers people or story people?” I bet, based on the fact I address Google
employees, more people in this room would say they are numbers people.

I ask this question because we have two camps in the investing domain. The numbers
people love to grind through numbers. The story people like to be creative. The VC business
is a storytelling business. I know they throw numbers in, but they’re an afterthought.
Numbers are a negotiating tool. It’s a story game. The problem is the story people think the
numbers people are geeks, and the numbers people think the story people are crazy, and
they can’t talk to each other!

When I come into that class, I ask the numbers-story question in a simple way: “How many
of you enjoyed history in high school?” A small minority of students enjoyed history. Then I
ask, “How many of you preferred algebra to history?” The numbers people preferred
algebra.

My endgame for my valuation class is to have numbers people with imagination and story
people with discipline.

That’s the way to think about valuation. If you’re a story person, I’m not going to stop you
from telling stories. Stories are more effective at selling business than numbers. If you’re a
story person, I also want you to bring in enough numbers to discipline yourself. Because if
you don’t have the numbers, it’s easy to veer away into fantasy land.

If you’re a numbers person and you have no imagination, you will not do valuation well. A
good valuation should sing a tune. It should tell a story. Behind the numbers, what is the
story you’re telling about a company?

When you look at the two groups, each believes it’s the chosen people. The numbers people
say, “We’re the chosen people. We have spreadsheets. We have numbers. We’re on the right
side of history.” And the story people think, “Oh, you should listen to us. We are the creative
people.”

They’re both right, and they’re both wrong. There’s something to be gained from the other
side, and to me, that is the key in doing valuation right. You’ve got to work with both sides

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of your brain. Some of us prefer to work with numbers, and we must force ourselves to think
about stories. Some of us prefer to tell stories, and we must force ourselves to think about
numbers. Think about your weaker side and work on it because that will give you power in
valuation.

When I do a valuation, I use discounted cash flows. It’s a tool. Sometimes you hear DCF
used as a curse word. I’ve heard this from venture capitalists. Contempt oozes out of them.
They say you can’t value a company using a DCF. They misunderstand what discounted cash
flow valuation is. Ultimately, the value of a business equals the present value of its expected
cash flows. That’s been true for as long as business has been around. We can debate
whether we can estimate these cash flows, but don’t tell me cash flows don’t matter. We
heard the irrelevance sentiment about cash flows in the dot-com era and look at how well
that ended. It does matter how much you make. Discounted cash flow valuation amounts to
a tool that brings answers to the four questions I asked. My cash flows and existing assets
feed into my base here. My value from growth gets fed in through the growth rate I use and
how much I set aside to get growth. My risk is built in through the discount rate. I bring it
to closure by assuming at some point, things settle down and I can estimate the value of
everything that happens after that with this big number at the end. The DCF is not the
endgame. It’s a tool to convert your story into a number.

Let me use a simple example to illustrate this. I want to pick somebody who’s never done a
valuation before, and we’ll do some valuation 101. Is anybody here who’s never done a
valuation?

Audience Member: (Raises hand).

Okay, you can be my guinea pig. Here is an empty envelope. I am putting a $20 bill in the
formerly empty envelope. How much should you pay for this envelope?

Audience Member: $20.

Damodaran: Here’s the first rule in valuation: If you pay $20 for an envelope with $20, you
gain nothing. Let’s try again. How much should you pay for this envelope?

Audience Member: $10.

Damodaran: Go $1. You never know what disease I have. I might not be able to read
numbers. Here’s the second rule in valuation: If you know the value of something, don’t
throw it on the table. If you know the value of a company, don’t offer the value upfront
because then what do you have left for yourself? Put it in your back pocket, start low, and
then build up. This is such a transparent asset value, if I put it up for a bidding war, my
guess is by the end of the bidding you’d probably get close to $20. Now I’m going to make it
interesting by showing you this card. What does this card say?

Audience Member: Control.

Damodaran: Control. I will put control into this envelope. How much should you pay for

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 Aswath Damodaran on Valuation: Four Lessons to Take Away

this envelope now? It’s got control in it. I tried this illustration in an investment bank last
week. In investment banks, you’re trained. Control in a company demands a 20% premium. I
don’t know where that came from. The banker offered me $24. I sold it. He thought it was a
game. I said, “No, this is a real transaction. Pay me the $24.” Guess what he’d done. He paid
$4 for a 3×5 card I stole from NYU, and it cost me absolutely nothing. This is a money
machine. Now that I know you like to pay for 3×5 cards with nice sounding words, I can try
more. What does this next card say?

Audience Member: Synergy.

Damodaran: Synergy, that’s a big one. I’ll throw that in there. That will probably go to $26.
What does this next card say?

Audience Member: Brand name.

Damodaran: Brand name, that’s a big one. That’s $32 right now. If it doesn’t work, I have
my two trump cards. What does this next card say?

Audience Member: Strategic consideration.

Damodaran: Strategic. That is the most dangerous word. When I hear the word “strategic,”
I run out the door. A strategic deal is a stupid deal, but you want to do this. A strategic
buyer is a synonym for a stupid buyer, a buyer who makes up his mind to buy something and
then shows up at the table. If nothing else works, here is the trump card that always works.
What does this next card say?

Audience Member: China.

Damodaran: China. It’s amazing how much common sense leaves through the other door
when you mention China. The fact you’ve lost billions doesn’t matter. You have China. I call
these weapons of mass distraction. These weapons come out because the numbers don’t fly.

I have a simple test. When I read an analyst’s report, I count the number of times these
mass distraction words show up. I have a list of a dozen. The more times these words show
up, the less substance there is to that report. This is what you use when you can’t come up
with a real reason for doing something.

Here’s my first proposition. It’s called the “It Proposition.” If something does not affect the
cash flows or risk, it cannot affect values. “It” is the mass distraction words. I’m not saying
control doesn’t have value, but if you tell me control has value, tell me what it’s going to
change. Maybe by controlling this company, you’ll run it differently and generate different
cash flows. Maybe with synergy, revenues will grow faster.

Let’s talk about specifics. You can’t let buzzwords drive decisions. Buzzwords make bad
decisions worse. You won’t plan to deliver those because there’s nothing behind them.

The second proposition I call the “Duh Proposition.” I named it after a subset of emails I get
every week. Usually, this is how the emails go: “I’m valuing a money-losing company. I

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expect it to lose money forever. Which valuation model will work best in valuing this
company?”

This kind of question makes me feel like walking up to the person, slapping them around the
face and saying, “Wake up! You’re valuing a money-losing company, you expect to lose
money forever, and you’re thinking about paying for this company? What’s wrong with
you?”

The Duh Proposition brings me to the third and final proposition. Next week when my class
starts, I’ll let people pick companies. In fact, I insist they pick companies. They must value
those companies over the next 14 or 15 weeks, over the semester. They can pick whatever
company they want. They can pick Lukoil. They can pick Google. They can pick Amazon.
Sometime in the first or the second week, a subset of people will show up saying, “I must
change my company.” I say, “It’s a little early. Why are you panicking?” They say, “I worked
out the cash flows, and they’re negative. You said in the Duh Proposition if the cash flows
are negative, you can’t value a company.” I say, “That’s not what I said. I said if the cash
flows are negative forever, you can’t value the company. If cash flows are negative in year
one, year two, year three, it’s not the end of the world. In fact, there’s a subset of
companies, when you value the company, you should get negative cash flows upfront. What
types of companies will you get negative cash flows up front? Young growth companies
because to grow, a company must put money back into the business. There is no magic
bullet capable of growing at 80% per year. If I value Tesla, I should expect to see negative
cash flows up front. Why? Because Tesla must build those assembly plants to deliver 10
times more cars I expect you to sell five years from now. With negative cash flows upfront,
disproportionately large positive cash flows must emerge in the future. Do you see why they
must be disproportionately large? You use $1 billion in year one, you must make up for it
with $10 billion in year 10. With young growth companies, that’s exactly what you should
expect to see. You should see negative cash flows upfront, because that’s needed to grow
the company. Nirvana shows up, cash flows turn positive, and the big values start
appearing.

Here’s one way to think about the search for valuation. You sit down to value a company.
You pull up the financials, the annual report, 10-K, 10-Q. These reports give a sense of what
the company did last year. If you have a mature company, you might not need additional
information because mature companies might be set in their path. However, if you have a
company in transition or in a changing market, you must collect information about the
market’s evolution and competitors. When you think about risk, you look at the past. You
will look at the future. You will look at every piece of information.

When you value businesses, don’t do a blind Google search. For instance, imagine you must
value Uber. If you just type “Uber” in the search field, you get everything everybody ever
said about Uber. Focus your searches. When I search, I open an Excel spreadsheet with the
inputs I need. For each input, I state a number I seek now. I won’t be distracted even if I
find something interesting about something else. For the moment, I stay focused. If I seek
risk information about a company, I look for nothing else. At the end of the process, I keep
my eyes on the prize. This is not about getting more information. It’s about taking data and

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converting it into information. We live in a world with too much data. Our job takes the data
and compresses it into information we use in valuations.

Here’s a simple example of a valuation of a boring company. We all know what 3M does,
right? Incredibly sophisticated stuff like the Post-it Note. don’t laugh. It’s an incredibly
profitable product. 3M has a long history. This is a valuation I did of 3M in what I call the
days of innocence. Those are the days when developed markets were on one side and
emerging markets on the other, and they never overlapped. This was before 2008. It’s a
mature company in what I thought was a mature market. In hindsight, I was hopelessly
wrong. In valuing 3M, I needed to make estimates, but those estimates were easy to make.
Why? Because 3M offered ample history. I knew its business model. I didn’t need to figure
out what they would do in the future. It was a centered valuation. There was uncertainty,
but the uncertainty was smaller. Think about this, if you think about narrative and numbers.
In the case of 3M, the story is almost done. You’re in chapter 33. There’s no room to change
the story. You can almost do this valuation on autopilot.

This is the company you’re taught to value in a valuation class in school, but I have some
bad news for you. If this is the company you can value, anybody can value these companies.
In fact, I’m not even sure you need a body.

If you have an Apple device, go to the iTunes store and type in uValue. It’s a valuation app I
codeveloped with a friend, Anand Sundaram at Dartmouth. You download it, then plug in
the numbers. I wrote it because I wanted to disrupt this valuation business. So much of
what you pay for in valuation is a banker feeding numbers into something like the uValue
app. They spend days making it look like they did a lot of other stuff, and then charge you
millions of dollars. If you’re valuing 3M or companies like that with lots of history, you don’t
need an appraiser. You don’t need a banker. Anybody should be able to value companies like
that.

I did a valuation of Apple in March of 2013. I’ve valued Apple every three months forever,
but since 2010, I’ve posted my valuations on my blog. I post my valuations because I’d
rather be transparently wrong than opaquely right. In this business, people want to be
opaquely right. They say things so difficult to construe, no matter what happens, they can
say, “I told you so.” It drives me crazy, so I say, “This is the value of Apple. I will be wrong
in my valuation, but at least you can see where I went wrong.”

Every time a new earnings report comes out, I revalue the company. I’m due for one soon
because Apple’s earnings report came out last week. I’m trying to illustrate how to value a
company by traditional methods. You make expected value estimates for things like cash
flows, growth, risk, and point estimates. I ask you what the growth is, you give me a
number. You ask me what the risk is, you give me a number. The reality is uncertainty. You
have a distribution in your head, and I force you to give me a number. Part of you says it’s
8%, but it could be 3% or 11%. I can see why you would have been stuck 25 years ago
because we did not have the tools to bring in uncertainty. Today I have Crystal Ball attached
to my Excel. It’s a simulation add-on to Excel enabling users to enter a distribution for your
assumptions rather than a single number. Rather than say revenue growth is 6%, I can say
it’s uniformly distributed between 3% and 9%. Greater uncertainty leads to wider

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distributions. During simulation, the computer picks one outcome out of each simulation and
does a valuation. Crystal Ball’s default is 100,000 simulations.

In my March 2013 Apple simulation, my process resulted in a base case valuation of $580
per share. At the time, the stock price was $450. I could have said Apple was undervalued at
the time. I could have been wrong, but the distribution shows how wrong I can be. If I’m a
decisionmaker, I’d rather base the valuation on a richer set of information. I can give you an
expected value, like I did before. I can also tell you the chance you are wrong if you pay
$450. I can give an ex-ante probability, which could have been 21%. The process of
determining the ex-ante probability amounts to counting the number of values below $450.
Based on the distribution I used and my valuation, I said I know I can be hopelessly wrong
on my inputs. Based on the outcomes, however, it looks like there’s a 90% chance I’m right.
The 10th percentile was about $450. The stock traded at $450.

It looks to me like investing is a game of odds. Based on my assessments, the odds are in my
favor, of course. This is an investment that’s worked out hopelessly well, in some cases. I
say “hopelessly well” because the stock recently traded at $840 with a 7-to-1 split.

Not everything works out so well. Don’t let uncertainty stop you from valuing a business,
especially a technology business. I find it troubling when a person elects not to value a
company because of too much uncertainty. What does that mean? Your estimates could be
wrong, but that doesn’t mean you can’t make an estimate. Saying there’s too much
uncertainty to do a valuation and then investing in the company to me is the height of
insanity, and lots of venture capitalists go through that cycle repeatedly. They say, “I don’t
want to value the company, but I’ll invest in the company.” You can’t tell me one thing and
do the other if you cannot value the company. At least do the logical thing and never invest
in those companies. If you want to invest in young growth companies, you must get your
hands around those numbers and make your best estimates.

Of course, with a young startup the questions are more difficult to answer. If you are the
founder of a young startup, I have four questions to ask, and you’ll see why life is more
difficult.

First, what are your cash flows from existing assets?

Your answer might be, “What assets? I have nothing. I’m sitting on a chair. I don’t even own
it.” Okay, that was easy.

Second, how much value will future growth bring? You say “a lot,” but when I ask for a more
specific answer, you say you don’t even have a business model yet.

Third, how risky are you? You can’t answer because you have no past prices or earnings.

Fourth, I ask when your company will mature. You fall on the ground laughing because you
might not even make it through tomorrow!

Every question was like pulling teeth. This explains why people give up trying to value

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 Aswath Damodaran on Valuation: Four Lessons to Take Away

young startups.

I suggest making your best estimates rather than giving up. You need not put the weight of
the world on your shoulders requiring a correct valuation. You cannot be right, but you can
still make estimates.

For the last four years, with each big IPO I tried to value the issue. I do the valuation the
week before the IPO to avoid knowledge of the IPO pricing; that number gnaws away at
your brain when you do a valuation, and your number starts to wander toward the pricing
number.

I did a valuation for Twitter the week before its IPO. My appearance on CNBC triggered the
valuation. We had been talking about Twitter, and an analyst there expressed optimism
about Twitter suggesting it was worth about $65 or $70 per share. I asked, “Why do you
think Twitter is worth so much?” He said the online advertising business is huge, so I asked,
“How big is the online advertising business?” He said, “I don’t know, but it’s huge.”

This is exactly what gets us into trouble. It’s like China. Twitter’s online advertising
business is huge so I can pay whatever I want. I said, ” If I were to value Twitter, that’s
where I need to start. I’d need to figure out how big this business is.”

It didn’t take a whole lot of research to figure out the size of Twitter’s online advertising
business. The global market for online advertising in 2013 was about $120 billion. The
biggest player by far was Google with about 33% of the global online advertising market.
The next biggest was Facebook, and after that market share splinters.

Online advertising is gaining a larger portion of overall advertising. Print media is going out
of style.

To value Twitter, first I figured out how big this market was before I could talk about
Twitter’s revenues. I assumed the overall advertising market was about $550 billion with
about 20% of all online advertising. I figured the overall advertising market could grow only
about 3% a year because it’s an expense to companies. It can’t grow 10% a year. I figured
global online advertising would increase to share 40% of the overall advertising market.
That estimate gave me my endgame, the size of the online advertising market a decade from
now, about $200 billion.

Audience Member: How did you figure 40%?

Damodaran: I made it up based on how quickly traditional advertising media revenues are
dropping. Print advertising is falling through the floor, but TV advertising has been
surprisingly robust. Billboard advertising is not going away because if you’re driving, it’s
tough to read online ads. I made that assumption, and that’s a pivot point where you and I
might arrive at different values for Twitter. It’s important to take a stand. If you think it
should be 60%, you need only to marshal the ammunition for that conclusion. I used 40%
then made a judgment about the percentage Twitter would capture.

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 Aswath Damodaran on Valuation: Four Lessons to Take Away

You’ve all seen how Twitter ads work. It’s those sponsored tweets. They piss me off to no
end. I’ve never clicked on a sponsored tweet. I hope nobody ever does. That’s how Twitter
earns advertising revenues; and that’s Twitter’s strength and its weakness. Twitter’s
strength is 140 characters. Its weakness is 140 characters. The 140-character limit is a
strength because it makes for nice, compact presentations. However, the 140-character
tweet limit cannot serve as a business’s primary advertising medium. The way I see it, even
if Twitter succeeds it’ll never be a Google or a Facebook. It’ll always be a lesser player. That
conclusion led me to use a market share of about 6% for Twitter. That share still leaves it
with about $12 billion in revenues. Here’s a company with $0.5 billion in revenues now, and
over the next decade, I assume 24-fold growth to $12 billion.

That revenue figure gave me half the game. Next, I needed to figure how much money
Twitter would make after this growth phase. Google and Facebook represent two big
targets, both of which are immensely profitable. Google’s margins are about 22% of
revenues, and Facebook’s are about 30%. Facebook’s margins drop each year because as it
gets bigger, these immense margins are tougher to maintain. I thought I might have erred
on the optimistic side when I used a 25% end margin for Twitter. I said that’s what you’re
shooting for.

At this point I had revenue and margin numbers for year 10. Next, I estimated how much
Twitter would need to put back into the business for acquisitions and new technology. These
investments would be necessary because Twitter cannot go from $0.5 billion to $12 billion
in revenues without doing something! That’s the reinvestment I sought, and I computed it
based on how much its revenues changed each year. Those three pieces gave me my cash
flows. Small revenues become big revenues. Losses become profits. Reinvestment gives
them the engine to drive revenue growth. I spent the bulk of my time on that.

Discounted cash flow consists of two parts, the D and the CF, the discount rate and the cash
flows. Here’s my problem with the way analysts do DCF: Most analysts spend 80% of their
time on the D. They finesse it to the nth decimal point. They devote only 20% to the CF.
However, in my Twitter valuation, I spent 97% of the time on the CF. Toward the end, I
needed a discount rate. I used a discount rate of about 11%, I didn’t think about it too much.
Eleven percent puts you in the 95th percentile of U.S. companies. My 11% D says Twitter is
a risky company. I could have finessed this a little more, but I don’t care. This is the small
stuff. My bigger assumption concerns future revenues and margins.

This is not where I’m going to screw up. I must always factor in that with a young company,
and there’s a chance the company will not make it. In the case of Twitter, I assumed a zero
chance they would fail because Twitter has access to capital. It’s not that Twitter won’t
screw up, but it seems to have access to people who keep giving it money even if they screw
up. That’s a nice skill to have.

In the week before the IPO, I put up a value of $18 per share. It was priced at $26. On the
offering day, the stock didn’t even open for about two hours, and then it opened at $46.
Somebody called asking, “How do you explain the $46?” I said, “I don’t have to. I didn’t pay
it.” I have never felt the urge to explain what some other person pays.

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 Aswath Damodaran on Valuation: Four Lessons to Take Away

I get calls asking, “How do you explain Uber’s $41 billion?” Ask somebody who paid the $41
billion. I didn’t do it. I occasionally take Uber, but I’m not paying $41 billion to my driver. I
don’t feel the urge to try to explain it. In fact, that’s one final thing I want to say. Much of
what you see passing for valuation is not valuation, it is pricing. If you have no idea what I’m
talking about, let me give you a couple of simple tests.

How many of you own a house or an apartment? My wife and I recently looked to buy a
house in California, where housing prices are relatively high. The realtor priced the house
we liked at $995,000. How does a realtor come up with a number for an apartment?

Audience Member: Comparables.

Damodaran: Right, the realtor looks at other units sold in the same neighborhood and
adjusts the price based on the extra bedroom or bigger lot.

This is not valuation, it is pricing.

On one hand, you might think those realtors are unsophisticated in their method. On the
other hand, have you seen an equity research report? If you haven’t, save yourself the
trouble because here’s what the analyst does: The report includes a company name with a
multiple, which is like a standardized price. A multiple is like a realtor’s price per square
foot. The analyst might claim 15 other companies resemble your company. In what universe,
I don’t know. I’ve seen Google equity research reports naming 15 companies comparable to
Google. Oh, really? How do you find companies comparable to Google? I would argue the
realtor was on firmer ground looking at apartments around the neighborhood than an equity
research analyst trying to find 15 companies like Google. Yet, that’s exactly what the equity
research analyst does. The analyst prices your company based on what comparable
companies trade even though the companies are not comparable. There’s nothing
comparable about them. You might say those equity research analysts are unsophisticated
in their method.

If you pay a banker for a valuation, you get cash flows. The next time you see a valuation
from a banker, zero in on the biggest number in the discounted cash flow valuation. It’s
always the end number, the value at the end of your file. Look where that number comes
from. I’d wager in nine out of 10 banking valuations, that number comes from applying a
multiple to the year five number. What do I mean by that? In this case, here’s what I did. I
took the operating income in year five and multiplied it by 10. Why 10? Because that’s what
other companies trade at now. I can tell you all kinds of stories, but this is a pricing as well.
I’m just hiding it in year five. I call these pricing in drag. The drag component is the cash
flows. While you’re distracted by the cash flows, you slip in 10x EBIT. That’s what drives
this number.

Most of what passes for valuation is pricing.

You might say “So what.” It’s a different game. What sets prices? Demand, supply, mood,
and momentum. What’s sets value? Cash flows, growth, and risk. Could the two give you
different answers? Absolutely. If you are a trader, you care about prices. What’s CNBC?

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 Aswath Damodaran on Valuation: Four Lessons to Take Away

CNBC is an instrument for trade. You are trading the stock. All you care about is what
moves prices. My question is, what’s the mood, what’s the momentum, and where is it
going? If you ask me to explain why people pay $41 billion for Uber, it’s because they think
they can sell for $75 billion. That’s it, and they think they can take it in a public offering for
$75 billion. Are they right? If the momentum continues, they could well be right. Does that
mean Uber has a value of $75 billion? That’s a different question. Sometimes price and
value can diverge. If they diverge, they can give you different numbers.

The social media space is a pricing space. In fact, if you ask me why social media companies
trade at what they trade, I have a simple answer. It’s not because of how much they make in
revenues. It’s not because of how much money they make. Thank goodness for that because
most of them make no money.

I decided to let the data tell me what drove social media pricing. I took every social media
company. It’s easy to get public information on market value. I collected all the information
I could about these companies including revenues and earnings. I wanted to figure out how
the market prices these companies. I drew on statistics to answer my question. I simply
calculated a correlation between the market cap and different variables to see which had
the highest correlation. I discovered the most critical variable explaining the market value
of a social media company is, by far, the number of users.

I’ll give you a simple way to value a social media company. Here, again, you can save
yourself the trouble of hiring a banker. The market pays about $100 per user. If you tell me
the number of users, I’ll tell you the social media company’s value.

Twitter has 250 million users. 250 million times $100 equals $25 billion. We’re done. Who
cares about cash flows, growth, and risk?

Facebook has 175 million users. Multiply that by $100, you get $17.5 billion. Remember last
year when Facebook bought WhatsApp? How many of you have WhatsApp on your phones?
How many of you pay for your WhatsApp? The answer is about one in five people. In fact,
last year when Facebook bought WhatsApp it paid about $19 billion for the company. It
seems to have rounded up to $21 billion. Don’t ask me how those things happen. It’s a
couple of billions anyway. I got a call asking, “How do you explain what Facebook just did?”
I said, “You’re missing the point. Facebook is not buying WhatsApp for the earnings, the
cash flows, and the revenues. How many users did WhatsApp have? About 400 million. Even
if you allow for how about 80 or 100 million of WhatsApp users are already Facebook users,
you’re buying 300 million new users. If the market pays $100 per user, 300 million times
$100 is 30 billion. You get a bargain at $19 billion.

Don’t laugh. This game is going crazy now. People are buying users, because that’s what the
market rewards. You might ask, “What’s wrong with that?” Markets are fickle. Today, they
like users. Tomorrow, they might not. Remember, they liked website visitors for a long time
until they said, ” I can’t pay dividends with website visitors.” It’s tough to say in a financial
transaction, “I’ll take three visitors, please. Send them to my house. They’ll work around. I
paid a lot of money for your stock.” At some point, they will ask for substance.

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 Aswath Damodaran on Valuation: Four Lessons to Take Away

Social media companies are like a gigantic store with nothing on the shelves and lots of foot
traffic. That’s what you buy when you buy social media stock. Are you hoping if you put
something on the shelves, maybe they’ll stop and buy it? It’s not an unreal exercise. Call it a
Field of Dreams. Remember Kevin Costner: If we build it, he will come. Shoeless Joe? It’s
the same thing. If we have the users, it will come. How will it come? I don’t know, but it will
come. That’s what pricing is about. It’s about what the market is building in, which brings
me to my last point.

Luck is the dominant paradigm in venture capital investing and in regular investing. We like
to think it’s skill and hard work. If you’re lucky, you can do horribly sloppy things and
become incredibly rich. If you’re not lucky, it doesn’t matter how well you do things. You’ll
still lose money. If you’re lucky, all else is forgiven all too often. When people make money,
they like to claim it’s skill. For awhile, the hedge fund managers said, “We’re skillful guys.
We’re the smartest people in the room.” Says who? When people talk about smart money, I
always cringe. There is no smart money. Rather, there’s less stupid money and more stupid
money.

What happened to the hedge fund business collectively offers the best evidence of no smart
money in hedge funds. You know how hedge funds work, right? First, they take 2% of your
money upfront. Then they take 20% of your upside. It’s a horrendously bad setup, but
investors do it because they’re greedy. Investors think hedge funds can deliver more than
the market. Collectively, hedge funds deliver about one percentage point less than what you
could make by putting your money in an S&P 500 index fund.

The analogy would be starting a plumbing business called Floods ‘R Us. Here’s what you do.
You have a leak in your house, you call me to fix the leak, and I leave a flood. You would
never call me back. That’s what we do collectively with these hedge funds. We pay them
tons of money to do what? Earn less than what we could have made by not paying them. You
figure it out, because I certainly can’t.

Here’s my final point about valuation. The Wizard of Oz is one of my favorite movies of all
time. Remember the story? A tornado sucks Dorothy out of Kansas. It dumps her in Oz. She
wants to go back to Kansas. Don’t ask me why. I’d have stayed in Oz, but the movie starts
with, “I need to go back.” And of course, she’s given the classic advice to go meet the
Wizard of Oz. He has all the answers. The entire movie is about her following the yellow
brick road with this motley crew of characters she collects. They all arrive in Emerald City
to meet the Wizard expecting him to be an all-powerful person capable of helping them
solve their problems. The Wizard has a deep, loud voice until the curtain drops and viewers
realize the Wizard is only a little guy behind the curtain using voice amplification and
special effects to give people the impression he is all-powerful. There’s no real Wizard of Oz.
As the story turns out, Dorothy and her motley characters got all they needed during the
journey down the yellow brick road.

You say, what’s this got to do with valuation? You learn valuation by doing. If you want to
learn valuation, value a company. The first time you do it, it will be like pulling teeth. Then
value another company different from the first company.

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 Aswath Damodaran on Valuation: Four Lessons to Take Away

Next week, I’m posting a valuation of Uber on my website. It’s a crowd valuation in which I
ask you to decide what Uber is at each stage. Is it a car service company or a transportation
company? Is it a local networking benefit or a global networking benefit? I can tell you my
story, but I won’t. At the end of the process, your collective story will determine Uber’s
value.

The value for Uber ranges anywhere from $800 million to $95 billion depending on the story
you tell. When we get big differences in value, it’s not because the numbers are different.
It’s because we have different narratives. Not all narratives are equally likely, and you must
ask the likelihood question when doing valuation. You must ask, “What is the right narrative
for my company?”

I promised I would not talk about Google, but I will leave you with this thought. If you think
about Google from an investor perspective, what is the narrative you’ll tell? What do you see
this company doing? What Google does will drive Google’s valuation, not because of
exchange rate movements, you did not deliver the growth. Who cares? In the larger scheme
of things, those things don’t change your narrative. If investors react to it, let them react to
it. This is about telling a story and delivering the kinds of decisions backing up that story.

The following are excerpts of the Q&A session with Aswath Damodaran:

Q: I was wondering. You had graphs with distributions of your valuations. Have you done an
analysis of the accuracy of the distribution compared to…?

A: How would you do it? It’s like nailing Jell-O to a wall, and here’s what I mean by that. It’s
a noisy process. This is a distribution at a point in time. If I move forward a month and I
redo the distribution, the entire distribution shifts.

It’s not about the distribution of value. It’s about value versus price.

If you’re right about values, you’ll observe price moving toward your value. This happened
after the Apple valuation. That’s a sample of only one. It’s almost an article of faith. If you’re
an investor, you believe price ultimately moves toward value. There’s no guarantee. Price
will move toward value if you do your job, collect the information, make your best judgment,
estimate a value in a distribution, and you decide based on it to buy something. You’re not
checking to see if value gets delivered. You’re checking to see whether price moves toward
value. It does, and that’s why I stick with it, but it’s a fact-based process. If it doesn’t work,
you need to let it go.

Q: Was it ever proven that price moves over the value?

A: Ultimately, there is a reality here, which is perception. If you value a Picasso or price a
Picasso, it’s all perception. If tomorrow we all woke up and said Picasso can’t paint, the
valuation or pricing would change. A business can’t be all perception. Price can deviate
from value for extended periods. It’s not a question of whether it moves the value. It’s when
it does, then the debate occurs. Some people say it takes so long to happen, there’s no point
in waiting for it. Those are the traders. If your time horizon is only six months, don’t waste

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 Aswath Damodaran on Valuation: Four Lessons to Take Away

your time thinking about value. With short time horizons, you must play the pricing game;
the investor game is for longer time horizons.

Q: At Google, we often perform valuation as part of an acquisition. How do you mix in the
cost of bringing this whole team on board? How do you incorporate that into the valuation?

A: I’ll speak to acquisitions in general and not just about Google acquisitions. At the right
price, I don’t care what you buy. At the wrong price, I don’t care what you buy, either. At
the right price, you can buy the worst possible target, and you’ll come out ahead. At the
wrong price, you can do everything right, but you’re already screwed. In acquisitions, we
spend too much time finding the right target and all that neat analytic stuff and we spend
too little time asking, “What are we paying for”? After the acquisition, there’s all that post-
acquisition work to do. This is especially true of acquisitions from which we expect synergy
because synergy often drives acquisitions.

Satisfying the synergy expectation requires you to take the strengths of the company you’ve
acquired and add it onto your company’s strengths. It takes work, and it does not happen
magically.

That’s why I prefer creating synergy plans before the acquisition. This is better than waiting
until after the acquisition only to discover the synergy won’t work. An acquisition process
requires discipline, and it only works if you’re willing to walk away from the table even from
an acquisition of the best imaginable target when the price is too high. If you’re not willing
to walk away from the table, you will overpay.

In too many big companies, the company decides it will make a certain acquisition. Once at
the bargaining table, the acquirer is in a terrible position to bargain because of the
premature decision to complete the acquisition.

Q: What is your take on individual investors, people like us, with fulltime jobs? Many of us
are not MBAs or students of valuation. The traditional, conventional advice is to buy an
index fund. Do you endorse that? Or for someone who’s interested in learning, what do you
recommend?

A: Investing takes work. If you don’t have time for the work, it’s best not to put yourself at
risk because you heard somebody say it. I suggest going with a low time-intensive
investment strategy. It doesn’t always have to be an index fund. You must spread your bets,
but don’t overreach. You don’t get rich by investing. You get rich by doing whatever you’re
doing. Investing for you is about growing and preserving what you earned in your job. When
you get greedy about trying to make a killing on your investment, you tend to overreach.

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