At the Money: Valuation Is an Exercise in Faith

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1:03Oscar Wilde once described a cynic as a man who knows the price of everything but the value of nothing. Nowhere is understanding value more important than in the stock market. Sure, prices get quoted every second, every tick, but value, that's a much more challenging problem. Whether you're buying broad indices or purchasing specific stocks, It pays to not be a cynic and understand both price and value of your investments. I'm Barry Ritholtz, and on today's edition of At The Money, we're going to explain how to become more savvy about understanding equity values. The value you pay for your investment has an outsized impact on your long-term returns.

1:53To help us unpack all of this and what it means for your portfolio, let's bring in Professor Aswath Damaduran of NYU School of Business. He is often referred to as the Dean of Valuation for his extensive work in the area. He's written numerous books on the subject, including Damadoran on valuation, narrative and numbers, and the textbook Investment Valuation Tools and Techniques for Determining the Value of Any Asset. So, Professor, let's just start with the basic question. Why are valuations so important when it comes to equities? I'm going to give you a cynical answer. They're not important if you're a trader.

2:35Traders live on pricing. I mean, the essence of pricing is you buy at a low price, you sell at a high price, and it doesn't really matter why the price changes if you get the direction right. Value matters if you're an investor. To me, the definition of an investor is you buy something for less than what it's worth. And the essence of value is you're trying to estimate what something is worth. But most, as I said, it depends on the philosophy you bring in. Are you an investor? Are you a trader? Because that's going to drive where the value matters to you. So let's talk about identifying that intrinsic value of what something is worth.

3:09With any specific company, how can you determine that valuation? It's as old as time. That Venetian glassmaker who sold his business in the Middle Ages probably sold it to somebody, bought it because of the cash flows he generated, the risk in those cash flows, and how much those cash flows are going to grow. It's cash flows, growth, and risk. That's the essence of value. That's always been true. We act like we invented valuation in the last century in finance because we came up with all these neat little models and metrics to measure risk and bring it into what you need to make. But value has always been driven by cash flows, growth, and risk.

3:47And how you get to that value can come from different pathways. I use intrinsic valuation in that sense as capturing anybody who thinks about those fundamentals. So let's dive into that intrinsic valuation. Based on cash flow, growth and risk, what different ways are there to measure the fundamental value of a company? And how do these different valuations reveal intrinsic value? I mean, ultimately, cash flows, growth and risk are not going to be different for different people. The way we think about risk, though, can differ depending on who you are as an investor and what you think matters. I mean, I'll give you an example.

4:27In traditional finance, we think about risk by looking at how prices move for a stock relative to the market. But there are intrinsic value people who argue the true measure of risk is what happens to your earnings, your revenues, your operating metrics. So even within people who believe in intrinsic value, we can have disagreements about how to measure risk. What is the right cash flow to look at? And what's a growth rate that you think about? Over what period? So while we might have 20 people in a room, all of whom buy into intrinsic value, we can come up with 20 different estimates of intrinsic value for the same company at the same point in time.

5:04So we always hear about price to sales, price to book, price to earnings. Are these all that different? They're just variations on fundamentals, or are they very different ways of looking at the same company? Philosophically, they're very different because when you compute the price earnings or the EV to EBITDA price to book for a company, what you do is you compare to other companies out there and you make a judgment and saying, hey, this company trades at 10 times earnings. Other companies like it. And I'm going to put quotes on like it. Trade at 15 times earnings. Therefore, it's cheap. That's a pricing judgment.

5:38There's nothing value in here. There's no intrinsic value judgment. That's why all of sell-side equity research, I would argue, is all about pricing. It's not about valuation. Nothing wrong with it, but we should be honest about what we're doing. So when you use ratios, it's because you want to find something cheap by comparing it to other things out there that are being traded right now, and you're looking at what other people are paying. So you're looking at price. When people look at stocks that way, they're looking at price and relative valuation, not intrinsic value. Let's talk about some of the things you've explained in your books.

6:15Valuation requires a deeper understanding of the business, including how it makes money and its future prospects. Give us a little more detail on that. I'll give you an example. It's a personal example. I bought NVIDIA purely by luck in 2018. I didn't see AI coming, none of this stuff. So sometimes your best investments happen by accident. So last year, I had to revalue NVIDIA for a simple reason. I mean, I bought it at$27 per share. The stock was trading at$800 per share. And I had to decide, is it time to leave? So as I sat down to value NVIDIA, I started with the presumption that was a computer chip company that had made chips and sold them.

6:57And I had to estimate cash flows based on that. It's only as I started digging a little deeper that I realized that they're not a chip maker, they're a chip designer. Every NVIDIA chip is made by TSMC, which basically changes the way you think about the business. If you're doing pricing, you might be able to gloss over it. It doesn't matter that they do it. But if you're doing intrinsic valuation, because I have to estimate cash flows, I have to think about what is it that they spend to create these revenues. And that requires an understanding of how they conduct their business. I mean, Warren Buffett had a famous saying that he doesn't buy stocks, he buys shares of businesses.

7:36That to me, in essence, is what you're doing in intrinsic valuation. You're not buying a share of Apple or a share of Amazon. You're buying a slice of those businesses. And if that's what you're doing, you better understand what you're buying before you pay a price. So can we apply the same theory of valuation to broad indices as opposed to just individual stocks? Absolutely. I mean, it's cash flows, growth and risk drive the value of Nvidia. Cash flows, growth and risk is what drives the value the S &P 500 or the NASDAQ. In fact, that's a process I use at the start of every month to come up with an estimate of what investors are pricing in the S &P 500 and what they can expect to earn given the cash flow.

8:18It's a very intrinsic value view of what can you expect to make as a rate of return on an index. So that raises, you know, the real important question. What do these measures of evaluations mean for future expected returns? The more you pay for something, let's cut away from all of the noise in this process. The more you pay for something up front, the lower your expected returns are going to be. Because if you pay more up front, and that's just common sense. So when you buy the S &P 500 at 5 ,300, you can expect to earn a lower return than if you bought it at$5 ,100. So if you bought it last week, your expected return was lower than if you bought it today.

9:05And that's at the basis of intrinsic value. It's about paying the right price for something up front is the most critical decision you make. So you consistently in all your books emphasize that value is not price. So how should investors think about the difference between the quoted fluctuated price we see every day, the quoted fluctuating price that we see every moment on the market, and that deep intrinsic value. Recognize that two different processes. Nothing makes one better than the other. Different processes. Values driven by changes in your earnings, cash flows, growth, and risk. And that that's captured by changing value over time.

9:49So I'm not saying intrinsic value is somehow a stable, stagnant number. The intrinsic value of NVIDIA doubled because of its entry into AI. Intrinsic value can change. Price is driven by demand and supply, driven by mood and momentum. And I think one of the best indicators you can take of mood and momentum is when the momentum is good, all news is good news. In fact, there's a whole segment of finance called behavioral finance. and behavioral finance tries to explain why price can not only deviate from value, but stay different for long periods. There's this inherent belief that value investors have that price will move towards value and it'll happen quickly.

10:31That's not true. Price can deviate from value. It can stay separated from value for long periods, which means if you're an intrinsic value investor, you're going to get incredibly frustrated because you think you got it right, but you keep losing money. So you're referring to mean reversion. The expectation is that pricey things eventually come back down to fair value and inexpensive things will eventually be recognized and return to fair value. How long does this process take? Is it guaranteed to happen? Does that mean reversion always occur? It's not just mean reversion. It's assumption that values what matters in the long term.

11:11I mean, that's almost, I mean, when I start my valuation class, I started the question, do you have faith? My students look at me and say, it's a valuation class. What are you talking about? I said, the essence of investing is faith. Faith that your estimated value is the right value and faith that the price will move to value. And the essence of faith is if you ask me to prove it, and if you told me, tell me what will cause it to happen? My answer is, I don't know. It's a mystery. I mean, it's like going to church and going up to your pastor or your rabbi and saying, can you give me some proof that God exists?

11:44I keep coming back every, you know, every week because I, and if that rabbi or priest or, you know, is telling you the truth, they should say, look, you know, I can't give you that proof. It's faith. And I think that's what makes investing so difficult is it's driven by faith rather than by proof. So if you ask me, you know, if I bought something undervalued, am I guaranteed to make money in the long term? Absolutely not. And you have to be OK with it. If you're not OK with it. Buy an index fund. Don't invest or be a trader. The essence of investing is you can do everything right and have nothing to show for it.

12:21And you have to be OK with that. Wow. So, Professor, bottom line it for us. When we think about valuation, when investors look at equities, what should be foremost in their mind before deploying capital? First, be honest with yourself. Now, what is the game you're playing? If you're playing the trading game, don't lie to yourself about caring about fundamentals and earnings and cash flows. Just play the trading game. Look at charts, look at technical indicators, look at mood and momentum, because that's what you're playing. If you want to be an investor, you need to do your homework. You can't hide behind the fact of, I've never done an accounting or a valuation class.

13:00I don't understand these financial statements. The essence of investing is you've got to be able to look through those financial statements and be able to gauge the value of a company. You might not want to use the full technology of intrinsic valuation, but you need to start thinking about businesses and value in a much deeper way than you're doing right now. If that's not your thing, that's fine. There are lots of people who get rich as traders and there's nothing wrong with trading. Just play that game well. So to wrap up, investors who have a long-term time horizon should be very aware of the variations in valuations.

13:39The more you pay for a given stock or a given market index, the lower your future expected returns are. understand that there are no guarantees in the market and merely buying cheap stocks is no guarantee that you're going to outperform or even market perform in the future. I'm Barry Ritholtz, and this is Bloomberg's At The Money.

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