Corporate valuation: No safe way to predict a firm’s future
Despite his reputation for punctuality, New York University Professor Aswath Damodaran was unable to make it on time for this interview; his audience after the special seminar of the Athens Laboratory for Business Administration (ALBA) would not let him go so easily. Not surprising for a man whom Business Week magazine has ranked among the top 12 business administration professors in 1994; but he is much more than a teacher, and is considered a guru on corporate valuation. His books «Damodaran on Valuation» and «Investment Valuation» are considered classics and he is now preparing one on the philosophy of investment. He travels continuously and this was his fourth time in Athens. Is corporate valuation a science or an art? I would say it is bit of both. I think we are trying to teach the science but there is the element of art, in the sense of a requirement for creativity. Valuation is never a process where you simply take the facts and weigh them; it requires a lot of subjective judgment. I can teach the science but not the art. There will always be some people who will never be good at valuation, even if they learn all the basic principles involved. Another way to put it is that in valuating stocks and firms you must take a risk; you must know that you may be wrong. There is no safe way; you cannot say, «I will not valuate unless I am absolutely certain,» because then you will never make a valuation. Therefore, the science part concerns the mechanics; the art part requires you to use all you know about a company – qualitative and quantitative data – and use it to make a forecast. Particularly as regards the new companies and the emerging markets, the art part prevails because there are many more things about the future than about the past. How are the divergences in the valuations of different analysts and between them and the market explained? The answer lies in your first question. Valuation is largely part science and part art. It is a way of forecasting the future. You and I may examine the same data about a firm, the same financial statements but reach very different forecasts – because of our different views on how the economy will go, the currency parities and so on. Now, as regards the differences between the valuations of the market and those of some analysts, we must be aware that the market itself exists because there are different views; at any given price, someone buys and someone else sells. The question regarding the efficiency of the market, of course, is different; what happens when a market price differs from a «real» price, which perhaps no one knows. We may ask, for instance, when the real value of Amazon is 25, why does the market give 84? The answer is that markets make mistakes, you can see it as inefficiency in this sense, but markets are not infallible because they are composed of people. We often make the mistake of seeing markets as autonomous entities with their own intelligence, but really they are collections of human beings. Think of the great social revolutions, for instance, the French or the Chinese: masses of people who made great mistakes in the process. A crowd of people may arrive at a collective agreement, but this does not mean that the agreement is the best for them. Naturally, it is a different thing to be able to exploit the mistakes of the market. We knew, for instance, that the market was mistaken with the New Economy shares in the 1998-1999 period. We can split the market efficiency question in two. Are the markets inefficient? The answer is: Sometimes yes. Can we gain from this inefficiency? This is much more difficult to answer. Portfolio managers may tell us that markets are inefficient and they may be right. But look at the performance of the funds some of these people manage. You can beat them simply by investing in an index-linked mutual fund. What are the basic methods, or approaches, in corporate valuation? There are two basic approaches. One is the use of discounted cash flows, the internal value of a firm. The other is the comparative valuation; that is, to look at how the market valuates a similar enterprise. This is used in about 90 percent of cases. Would the adoption of an international accounting system lead to better corporate valuations? It will certainly make my life much easier! One of the biggest problems I face in corporate valuations is the many different definitions in financial statements. Operating revenue is not the same in Greece, France, Germany or the US. This makes comparative valuation very difficult; when, for instance, you want to compare a Greek cement maker with a German or a French one. In the effort to create such a system, I would have the following advice to give: Keep the rules simple and allow the least possible discretionary leeway to accountants. Firms must not have many different options in presenting their accounts. If this possibility did not exist, we would not have Enron-type situations. What I expect from financial statements is more facts and less opinion. However, accounting is increasingly moving in the direction of opinion… With Enron, we learned that there are no facts, only opinion. We now have to look exhaustively at figures we took for granted two years ago. And the case of technology shares has made us aware that fundamentals, cash flows, growth and risk, are more important then ever.
