Valuation in Four Lessons | Aswath Damodaran | Talks at Google
What this covers
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.
About the Author I view myself, first and foremost, as a teacher. I do teach valuation and corporate finance not only to MBAs at Stern but to anyone who will listen (on iTunes U, online and on YouTube). I love to write books, teaching material and blog posts. After 30 years of teaching finance, I still find it fascinating as an interplay of economics, psychology and number crunching.
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Domodaran argues that valuation is fundamentally about estimating cash flows, growth, and risk through disciplined storytelling combined with quantitative rigor, not about applying mechanical spreadsheet formulas or chasing market prices, and that most Wall Street practice is pricing masquerading as valuation.
- Valuation requires integrating narrative (story) with discipline (numbers), not one or the other
- Most financial practice is pricing (based on demand/supply and momentum) rather than valuation (based on cash flows, growth, risk)
- The fundamental valuation principle is that if something doesn't affect cash flows or risk, it cannot affect value
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Goodwill on accounting balance sheets is a useless asset because it only appears after an acquisition and is simply a plug variable—the difference between what a company cost and its book value—not a real economic asset that should be paid for separately
“Goodwill is the most useless asset known to man. And here's why-- for goodwill to manifest itself in an accounting balance sheet, do you know what a company has to do? It has to acquire another company.”
Growth by itself is neither good nor bad; growth destroys value when the cost of growth exceeds the returns from that growth, which is why the question about future growth should focus on value created, not growth rate alone
“Growth, by itself, can be worth a lot, can be worth nothing, or can destroy value. Grow can be good, bad, or neutral, because you've got to pay for growth. So I'm going to ask, what's the value you create from future growth. Much more difficult to answer then, what are your cash flows for existing assets?”
Venture capitalists criticize DCF (Discounted Cash Flow) valuation as inappropriate for young companies, but this criticism misunderstands what DCF is: at its core, DCF simply states that a business's value equals the present value of expected cash flows, which is a fundamental truth that has always applied regardless of the company's stage
“So when you hear DCF being used as a curse word-- and venture capitalists have used this on me. You're doing a DCF. And the way they say it, the contempt oozes out of them. You can't value this company using a DCF. I think they're completely misunderstanding what a Discounted Cash Flow valuation is. Because ultimately, what am I saying? The value of your business is the present value of your expected cash flows from running this business. That's been true for as long as business has been around.”
The 'It Proposition': if something does not affect cash flows and does not affect risk, it cannot affect value; this principle should discipline valuation by requiring that any claim about value creation (e.g., from control or synergy) must specify what it will change about the company's cash flows or risk
“So here's my first proposition. It's called the It Proposition. If it does not affect the cash flows and it does not affect risk, it cannot affect values. And what's it? Whatever it is controls synergy. 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.”
A company's value can be decomposed into two main components on the asset side: assets in place (the value of investments already made) and growth assets (the value of future investments the company is expected to make), which replace the accounting framework's distinction between tangible and intangible assets
“Look at the asset side of the balance sheet, there are only two items-- Assets in Place and Growth Assets.”
The methods and metrics taught in business school to assess company value—such as PE ratios and Return on Invested Capital—were developed for mature companies and are inappropriate for valuing young growth companies, like using a hammer to do surgery
“Most of the tools we have in finance were developed for mature companies-- PE Ratios, Return on Invested Capital, things you're taught in Business school. But if you have a growth company, you try to asses them using those tools. It's like using a hammer to do surgery. Think about it. That's going to be bloody, and it's going to come to a bad end.”
Mature companies like 3M can be valued with relatively high confidence using historical data because there is extensive history to draw from and the future is likely to resemble the past; young growth companies require more complex, narrative-driven approaches because there is little history and the future will likely diverge significantly from the past
“It's a mature company, in what I thought was a mature market... In valuing 3M, I had to make estimates. But those estimates were easy to make. Why? Because there was a lot of history I could use. I knew what their business model was. I didn't have to figure out what they would do in the future.”
Young growth companies should be expected to have negative cash flows in early years because they must reinvest heavily in the business to achieve the high future growth the market is pricing in; therefore, negative cash flows are not a reason to avoid valuing a company—only perpetual losses would make valuation impossible
“To grow, what do you have to do? You've got to put money back into the business. There is no magic bullet that you can use to grow at 80% a year. So if I'm valuing a Tesla, I should expect to see negative cash flows up front. Why? Because you've got to build those assembly plants to deliver those 10 times more cars I expect you to sell five years from now.”
Price and value can diverge for extended periods; the relevant question for investors is not whether price will eventually equal value, but when; traders betting on continued momentum can profit from divergence; investors betting on reversion to value require patience and conviction
“Price can deviate from value for extended periods. It's not a question of whether it moves the value. It's when it does. And that's really the debate. There are some people who say, it takes so long to happen, that there's no point even waiting for it. Those are the traders. They say, well look, I'm going to make money in the next. If your time horizon is six months, don't even waste your time thinking about value.”
A business cannot be pure perception (like art); there is an underlying reality of cash-generating potential. Therefore, price must eventually reflect value, though the timing is uncertain.
“If you're valuing a Picasso, or pricing a Picasso, it's all perception. If tomorrow we all woke up and said, the guy can't paint. He's got a nose in the wrong place. But a business can't be all perception. So price can deviate from value for extended periods.”
Individual investors without time to conduct serious valuation analysis should use low-time-intensive investment strategies like index funds or diversified portfolios, and should not attempt to beat the market through active stock picking unless they are willing to devote significant time and effort
“Investing takes work. And if you don't have the time for that work, it's probably best not to put yourself at risk by doing something because you heard somebody say it. So my suggestion is, go with the low-time-intensive investment strategy. It doesn't always have to be an index fund. It Has to be some kind of-- you've got to spread your bets and don't overreach.”
When making an acquisition, the price is critical; at the right price you can buy the worst target and succeed, and at the wrong price you can do everything right and still lose money
“At the right price, I don't care who you buy. At the wrong price, I don't care who you buy. Basically, at the right price, you can buy the worst possible target. And you're going to come out ahead. At the wrong price, you can do everything right, but you're already screwed.”
Most of what passes for valuation on Wall Street is actually pricing—determining what comparable companies trade at and applying similar multiples—rather than true valuation based on cash flows, growth, and risk; real estate agents price houses by comparing similar properties, and equity analysts do the same with stock multiples
“Much of what you see passing for valuation out there's is really pricing... How many of you own a house or an apartment?... You hire a realtor. The realtor shows you a house... How did the realtor come up with that $995,000 for the house? How does a realtor come up with the number for an apartment. What does he or she do? She looks at other apartments... It's pricing There's no valuation going on.”
Valuation is fundamentally different from accounting; accounting is backward-looking and records what happened, while finance and valuation are forward-looking and focused on what will happen and what investors will pay for future cash flows
“Accounting is backward-looking-- nothing bad about that... It's their job to record what's happened.”
Investing is fundamentally a game where luck is the dominant paradigm; with luck, investors can execute poorly and become rich; without luck, they can execute perfectly and lose money, because so much depends on forces outside individual control
“This is a game where luck is the dominant paradigm. When I say, this, I'm talking about investing-- venture capital investing, regular investing. We like to think it's skill and hard work. It's luck. If you're lucky, you can do a horribly sloppy things and be incredibly rich. If you're not, it doesn't matter how well you do things. You're still going to lose money.”
Valuation of acquired companies requires not just identifying the right target, but disciplined post-acquisition integration planning before the deal closes; without pre-planned integration, synergies claimed in valuation models will not materialize, and the acquisition will fail to create value
“In acquisitions, the problem I see is that we spend too much time on finding the right target and doing all that neat stuff where we fit stuff, and too little time asking, what are we paying for that... After the acquisition, there's all that post-acquisition work you have to do, to deliver, especially if you're talking about synergy... So that requires that you take the strengths of the company you've acquired and add it onto your strengths, to deliver it. That requires work.”
The 'Duh Proposition': investors who are valuing a money-losing company that they expect to lose money forever should not be paying for it at all; this is an absurd position that reveals confused thinking.
“The second proposition, I call the Duh proposition. I've named it after a subset of emails I get every week. And usually this is how the emails will go. I'm valuing a money-losing company. I expect it to lose money forever. Which valuation model will work best in valuing this company. I feel like walking up to the person, slapping them around the face, saying, wake up. You're valuing a money-losing company. You expect to lose money forever. You're thinking about paying for this company. What's wrong with you?”
Valuation pivots around four fundamental questions: (1) What cash flows are you generating from investments already made? (2) How much value will you create from future growth investments? (3) How risky are these cash flows? (4) When will your business mature? These four questions must be answered before any financial model or spreadsheet can be built
“If I'm asked to value a company, there are four basic questions to which I need answers. Here's the first one. You've already made those investments in the ground. What are the cash flows you're getting from those existing investments? Could be very small if you're a young growth company. But that's my starting point. That's why I look at the last financial statements, to get a measure of what your existing cash flows are. The second question I'm going to ask you is, what is the value that I see you creating 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 lot, can be worth nothing, or can destroy value. Grow can be good, bad, or neutral, because you've got to pay for growth.”
The online advertising market in 2013 was approximately $120 billion globally, with Google capturing about 33% of the market, Facebook second, and numerous smaller players, establishing the total addressable market that any company like Twitter must capture share from
“But the entire online advertising business in 2013 was about $120 billion. That's the whole global online advertising business. The biggest player, by far, is Google. And if you look at the breakdown, you can see, Google is about 33% of the global online advertising. The next biggest is Facebook, and then you have a splintered business.”
Hedge funds collectively deliver approximately 1 percentage point less return than an S&P 500 index fund, despite charging 2% fee upfront plus 20% of upside, making them a value-destructive business for investors and evidence that there is no 'smart money,' only 'less stupid money' and 'more stupid money'
“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. It's a strange business... There is no smart money. There's less stupid money and more stupid money. But there's really not smart money.”
The online advertising market was print-dominated, but print is going out of style; TV advertising has been surprisingly robust; and billboard advertising is unlikely to shift entirely online
“I looked at how quickly existing advertising media revenues are dropping. Print advertising is falling through the floor. But TV advertising has actually been surprisingly robust. So there are certain kinds of advertising where I think you're going to see other advertising. Billboard advertising is not going to go away. Because if you're driving, it's tough to have online ads. Maybe you'll figure something out. But you'll have a lot of accidents.”
Learning valuation requires doing, not just studying theory; you learn by valuing real companies and comparing your valuations to market prices and later outcomes; this process of applying the framework repeatedly, adjusting assumptions, and observing what happens is where the real learning occurs
“I firmly believe that you learn valuation by doing. You really want to learn valuation. Here's what you need to do. Value a company. The first time you do it, it will be like pulling teeth. Then value another company, as different from the first company as you get.”
People get rich by doing their primary work well, not by investing; investing is about preserving and growing wealth you have already made elsewhere, not about making your fortune in financial markets
“You don't get rich by investing. You get rich by doing whatever you're doing. And investing is about preserving what you made elsewhere and growing it. It's when you get greedy about trying to make that killing on your investment that you tend to overreach.”
Valuation is fundamentally simple and any person can do it; practitioners make it complex intentionally to hide their work, maintain mystique, and protect high fees.
“I think valuation is simple. Fundamentally, anybody can do valuation. I think we choose to make it complex. Whose we? The people who practice valuation. Why? Because that's how you make a living. You've got to cover things up with layers of complexity, keep people away.”
For investors evaluating Google (or any company) going forward, the key question is not recent quarterly performance or external factors like exchange rate fluctuations, but 'What is the narrative I'm telling about this company?' because the narrative about what the company will become is what drives valuation, not noise from near-term metrics
“If you're thinking about Google as a company going forward, as an investor, here's the question I'm asking. What is the narrative I'm telling about this company? What do I see this company doing? Because that's what's going to drive the valuation of Google, not the fact that 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.”
When people mention 'China' or buzzwords like 'strategic' in earnings reports, common sense leaves the room; investors immediately grant the benefit of the doubt without scrutiny, suggesting the word itself has power to override rational analysis.
“Just mention the word. It's amazing how common sense will leave through the other door. Take a look at earnings reports. Every company that reports it, even the most horrible, at the end they would say, but there's China. Nothing about China, but there's China. That alone doesn't it.”
Domodaran's Uber valuation project asks students to make narrative choices (is Uber a car service or transportation company? Local or global?) and shows that depending on narrative, Uber's value could range from $800 million to $95 billion, demonstrating that valuation differences stem from narrative disagreement, not arithmetic errors
“At each stage, I ask you to decide what Uber is. 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. And at the end of the process, say, based on your story, this is Uber's value. And 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.”
In a simple envelope auction, someone offered to pay $24 for an envelope containing a $20 bill with a card labeled 'Control' because investment banks train analysts that acquiring control of a company yields a 20% premium, despite control having no value unless it changes the company's cash flows or risk
“I tried this in investment bank last week. In investment banks, you're trained. If you put a control into a company, there's a 20% premium. I don't know where that came from. The guy offered me $24. I sold it. He thought it was a game. I said, no, no, no, no, this is a real transaction. Pay me the $24.”
When valuing a company in transition or in a changing market, searching for information requires focused, hypothesis-driven research rather than blind internet searches; the valuator should open a spreadsheet listing the inputs needed for the valuation and search specifically for those inputs, avoiding distraction from interesting but irrelevant information
“And my only suggestion if you value new businesses-- don't do a blind Google search... So if I'm looking at the risk in a company, that's all I'm looking for. Are there any clues I can get by looking at the company, the market, and the competitors, about that risk?”
Domodaran valued Apple in March 2013 with a base case of $580, when the stock was trading at $450, and used Monte Carlo simulation with 100,000 draws to assess uncertainty rather than a single point estimate, finding a 90% probability that Apple was undervalued based on the distribution of outcomes rather than just the central estimate
“The stock price was $450. In my base case valuation, I got about $580... But what the distribution shows you is how wrong I can be... I can give you an expected value, like I did before. I can also tell you, if you pay $450, what the chance you are wrong upfront is. I can give you an ex ante probability. There's a 21% chance you could be wrong. All I have to do is count the number of values below $450.”
Domodaran spent 97% of his analytical time on cash flow estimation for Twitter and only 3% on the discount rate, using an 11% rate (95th percentile of U.S. companies) without detailed analysis because he believes the biggest risks to valuation accuracy come from growth and margin assumptions, not the discount rate
“I'll make a confession. The Twitter valuation, 97% of the time that I spent was on the cash flow, and towards the end, said, I need a discount rate. And for the discount rate, what I effectively used a discount rate of about 11%... This is really the small stuff. My bigger assumption is what my revenues will be, what my margins will be. This is not where I'm going to screw up.”
Domodaran valued Twitter at $18 per share the week before its IPO; the stock was priced at $26 and opened at $46, and he explains he has no obligation to explain what others paid, only to assess the value relative to what he believes it's worth
“Those are the things that fed into my valuation of Twitter. And in the week before the IPO, the value that I put was $18. And if you remember your history, it was priced at $26. And on the offering day, it didn't even open for about two hours. And when it did open, it opened at $46. And I got a call from somebody saying, how do you explain the $46. And I said, I don't have to. I didn't pay it.”
Social media companies are like operating a 'gigantic store with nothing on the shelves and lots of foot traffic'—you have users and engagement but no mechanism to monetize, so you're betting that if you build user base, ways to make money will eventually emerge ('if we build it, he will come')
“the way I describe social media companies-- it's like having a gigantic store with nothing on the shelves and lots of foot traffic. That's you're buying. What are you hoping for? That 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.”
Uncertainty in valuation inputs should not deter making estimates; saying 'there's too much uncertainty to do a valuation' while simultaneously investing in the company is logically inconsistent; if you invest, you must be willing to estimate, because investing is itself a bet on fundamentals
“Saying that this 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 over and over again. 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.”
Valuing mature companies (those where the story is nearly complete) can be partially automated and does not require expensive investment bankers; Domodaran created an app called uValue that allows anyone to value a mature company by entering nine key numbers, disrupting the business of high-priced valuation services that charge millions for mechanical work
“If you have an Apple device, go to the iTunes store and type in uValue. It's an app that I co-developed with a friend of mine, Anand Sundaram at Dartmouth, that does valuation... I wrote it because I wanted to disrupt this valuation business. Because so much of what you pay for in valuation is a banker feeding in numbers into something like that and then spending 25 days making it look like he did a lot of other stuff and then charging you millions of dollars for something he has no business charging you millions for.”
The social media space is fundamentally a pricing space, not a valuation space; the driver of market value for social media companies is not revenue or earnings (most make little), but user count, with the market paying approximately $100 per user
“The social media space is a pricing space. In fact, if you ask me why social media companies trade at what they do, I have a very simple answer. It's not because how much they made in revenues. It's not because how much money they make. Thank god for that, because most of them make no money. So here's what I did. I decided to let the data tell me what drove the pricing.”
Traders care about price (what moves it, momentum, sentiment); investors care about value (cash flows, growth, risk); CNBC is an instrument for traders, not long-term investors, because it reports on price movements and momentum rather than fundamental value changes
“If you are trader-- not a traitor, but a trader-- you care about prices. What's CNBC? CNBC is an instrument for trade. You are trading the stock. All you care about is what moves prices.”
In valuation, if you pay $20 for an envelope containing a $20 bill, you get nothing; the value of transparency is that you must start low in negotiations and build up, never reveal the full value upfront
“First rule in valuation, if you pay $20 for an envelope with $20, you get nothing. So let's try again. How much should you pay for this envelope? AUDIENCE: $10. ASWATH DOMODARAN: Go $1. You never know what disease I have. I might not be able to read numbers. First rule in valuation-- if you know the value of something, don't throw it on the table. You know the value of a company. Don't offer that value up front. Because then what do you have left for yourself? Put it in your back pocket, start really low, and then build up.”
Twitter's advertising model (sponsored tweets) has structural weaknesses: the 140-character constraint limits its utility as a primary advertising channel, so Twitter can only be a secondary player—never Google or Facebook—limiting realistic market share to about 6% despite dominance in real-time conversation.
“Their strength is 140 characters. Their weakness is 140 characters. That's a strength, because it makes it nice, compact. The weakness is, it can't be your primary advertising. So the way I see it is, even if Twitter succeeds, it'll never be Google or a Facebook. It'll be a lesser player. And that led me to use a market share of about 6% for Twitter.”
Facebook's acquisition of WhatsApp for $19 billion (presented as $20 billion) was rational at the $100-per-user pricing; WhatsApp had 400 million users (roughly 300 million new to Facebook), and 300 million × $100 = $30 billion, so the purchase price was actually a bargain under the prevailing user-pricing model.
“Facebook is not buying WhatsApp for the earnings, the cash flows and the revenues. What are they doing? The users. How many users did WhatsApp have? Like 400 million. Even if you allow for the fact that about 80 or 100 million of those are already Facebook users, you're buying 300 million new users. if the market is paying $100 per user. 300 million times 100 is 30 billion. You're getting a bargain.”
Domodaran identifies 'weapons of mass distraction'—buzzwords like synergy, brand name, strategic consideration, and China—that analysts use to justify acquisitions or valuations when the financial numbers don't support them, signaling weak analysis rather than substance
“I call these weapons of mass distraction. You know they come out because the numbers don't fly. In fact, I have a very simple test. When I read an analyst's report, I count the number of times these words show up. I have a list of a dozen. And the more times these words show up, the less substance there is to that report, because this it's what you use when you can't come up with a real reason for doing something.”
Investors are divided into two psychological types—story people (creative, who rely on narrative) and numbers people (analytical, who grind through data)—and successful valuation requires integrating both: story people need quantitative discipline, numbers people need imagination to tell a coherent story about the business
“When I start my Valuation class, which doesn't start until Monday, there'll be 200 people who walk into the class. And the first question I ask them is-- are your numbers people? Are you story people?”
People paying $41 billion for Uber in 2013 were betting they could sell it at $75 billion in a public offering; pricing of such companies is speculative, dependent on momentum, not on intrinsic value derived from cash flows, growth, and risk
“If you ask me to explain why people are paying $41 billion for Uber, you know why? Because they think they can sell for $75 billion. That's basically it-- that they think that they can take it in a public offering for $75 billion. Are they right? If the momentum continues, they could very well be right. Does that mean that Uber has a value of $75 billion? That's a very different question.”
Domodaran assumed Twitter would achieve a 25% operating margin by maturity (between Google's 22% and Facebook's 30%), and would need to reinvest substantial capital in acquisitions and technology to achieve 24-fold revenue growth from current levels to $12 billion
“Google's margins are about 22% of revenues. Facebook's are about 30%... But I thought I was being optimistic, when I used a 25% end margin for Twitter... I also had to bring in that final piece, which is, this isn't going to happen by magic. You're not going to go from half a billion in revenues to $12 billion, without doing something.”
Damodaran is at the intersection of three disruption-worthy businesses: teaching, writing, and finance. Each is 'badly-run' and needs to be 'taken to the cleaners,' which motivates his effort to disrupt them.
“I just posted, a couple of days ago, on where-- I actually am very lucky at the intersection of three different businesses. I'm a teacher first. I love to write, and I'm in finance. And the way I described it, I'm in three businesses that are all the begging to be disrupted, three really big, badly-run businesses, all of which need to be taken to the cleaners.”
Damodaran was forced to teach Security Analysis (a prescribed course) starting in 1986 but surreptitiously taught Valuation instead for 22 years without administrative notice until the dean found out in 2008 and officially renamed the course.
“So I discovered early on in my academic life, that if you want to get something done, its best to do it subversively. So here's what I did. I said, OK, I'll 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.”