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March 3, 2023

16: Dr. Aswath Damodaran on Valuation and the Path Towards Investment Wisdom

16: Dr. Aswath Damodaran on Valuation and the Path Towards Investment Wisdom

Are you interested in learning more about value investing in the current state of the market? Today I am joined by my co-host Scott Phillips, along with our guest, Dr. Aswath Damodaran. Dr. Damodaran is known as “The Dean of Valuation '' for his teachings on the subject. He is a professor of finance at the Stern School of Business at NYU and offers free online courses on his website. Listen to this episode to learn more about Dr. Damodaran’s approach to equity valuation.

Dr. Damodaran’s Journey to the US and Teaching Background

Dr. Damodaran grew up in Chennai, India, and came to the US in 1979 to attend the UCLA MBA program. His upbringing in India made him an imaginative and creative thinker, but it was his calling to teach that led his deep exploration of valuation and mastery of this critical element to thoughtful investing.

After earning his Ph.D. from UCLA, he spent a few years as a visiting professor at UC Berkeley before accepting a permanent position at NYU. Dr. Damodaran considers himself a teacher first and foremost, and his interest in investing comes secondary. He says there is a danger in becoming too obsessed with investing, which is spurred on by social media: “I think we spend too much of our time thinking about markets, too much of our time thinking about stock prices, not enough time thinking about our own lives. So I think it's actually unhealthy.” -Dr. Aswath Damodaran (5:24-5:35)

Today, Dr. Damodaran shares his classes online for free—which he actually began doing nearly 20 years ago when online education was not common. His mission then and today is to teach a broader audience of students and make his lessons accessible.

Dr. Damodaran’s Thoughts on the Current Market

Every month, Dr. Damodaran calculates the implied equity risk rate to measure what kind of return people can expect to make on the stock market. At the start of 2022, the rate was 5.75%, the lowest he had ever seen. While 5.75% is a terrible return on stocks, many investors feel they have no other choice but to invest in the stock market anyway.

However, over the last 10-11 months, this perspective has shifted. As the world has shifted in the last year, the markets are returning back to a “normal” that we have not seen since before 2008.

“It's going to take a little bit of adjusting and what you've seen this year is markets adjusting back to a new norm. And to be quite honest, markets have been remarkably resilient this year. In fact, I'm surprised that they haven't dropped by more than they have. Because adjusting from a 5.75% expected return to close to 9%, which is where they are now takes a lot of doing.” -Dr. Aswath Damodaran (10:54-11:17)

The Field of Dreams Model in Today’s Market

Dr. Damodaran often links valuation with narrative. One narrative that he has followed for a long time is Amazon and its habit of experiencing near-term losses in pursuit of market share. Dr. Damodaran refers to this theory as the “field of dreams model.”

For the last 25 years, Amazon has been incredibly successful with this narrative because of its consistency and patience. For example, the company initiated Amazon Prime in 2004 but it took years for the program to make the company money. Amazon has done this over and over again with investments in Alexa, entertainment, and other initiatives.

However, for the “field of dreams” method to work, a company has to be exceptional. Today there are hundreds of companies using this method that are not exceptional.

“Amazon has earned enough credibility in my book that when they say, ‘look, trust us, we'll figure out a way,’ I'm going to trust them. But for every Amazon, there are 100 want-to-be Amazon's that I don't think will ever match up to Amazon's success. Because one or another half of the equation is missing. Either their stories keep shifting to catch the mood of the moment, or they don't behave consistently with their stories. So I think if we can put companies to the test of not just listening to stories, but looking at the numbers to see if they back up the story, then we'd be removing some of these fake companies, companies pushing these fake stories, out of the mix.” - Dr. Aswath Damodaran (22:21-23:00)

The 5 Buckets of Valuation

When Dr. Damodaran does a valuation of a company, he considers five buckets: revenue growth, profitability, reinvestment, cost of capital, and failure. The first three buckets capture the business model and the last two buckets capture risk.

When he reads a narrative or news story about a company, he asks himself which bucket that story goes into. Sometimes the answer is that it does not go into any of the buckets, so he disregards it. This method helps him process the amount of information he receives every day instead of drowning in all of the data.

The Keys to Long-Term Success in Value Investing

Many people who call themselves value investors are actually traders. To achieve real long-term success as a value investor, you need two things: the ability to go against the grain and time. As a value investor, you make decisions that are not popular at the moment but pay off over time. In fact, it’s better to experience long-term results over short-term results. 

The Role of Intellectual Humility in Investing

Sir John Templeton was ahead of his time when he talked about intellectual humility, and Dr. Damodaran agrees with him, stating that even when we study history and think we can predict the future, life will always surprise us. It is better to remain humble because we have seen what can happen when investors get arrogant time and time again.

“We've spent a decade putting people on pedestals, treating them as geniuses, just because they founded companies. And I think we're going to pay the price for that. Because we've given these people power, in perpetuity with voting shares and non-voting shares. It terrifies me. Because I think human beings when they're given that much power, no matter how smart they are, will find a way to bring themselves down.” - Dr. Aswath Damodaran (38:16-38:42)

In Dr. Damodaran’s opinion, personality-driven companies such as Tesla are dangerous because people live finite lives. Anytime you tie a company's value to a person, you face more risk than when a company is tied to a product or business model. The best companies have founders that have found a way to make themselves dispensable. 

Bill Gates and Jeff Bezos are good examples of humble leaders who have found ways to separate themselves from the success of the businesses that they built. 

Dr. Damodaran’s Advice for Young Investors

  1. Do not invest to get rich. Invest to preserve and grow your wealth.
  2. Be patient and stay clear about what you want to get out of the market.
  3. Take care of your career and save some of your income and use markets as a way to compound your savings over time.

Learn More From Dr. Damodaran

Dr. Damodaran’s free online courses

Dr. Damodaran’s Books

The information presented in this podcast or available on the website is not intended as and shall not be construed as financial advice. This podcast is produced for entertainment value. Investing is inherently risky. And I encourage you to seek financial advice from a professional who is aware of the facts and circumstances of your individual situation.