Facebook Pixel
Searching...
English
EnglishEnglish
EspañolSpanish
简体中文Chinese
FrançaisFrench
DeutschGerman
日本語Japanese
PortuguêsPortuguese
ItalianoItalian
한국어Korean
РусскийRussian
NederlandsDutch
العربيةArabic
PolskiPolish
हिन्दीHindi
Tiếng ViệtVietnamese
SvenskaSwedish
ΕλληνικάGreek
TürkçeTurkish
ไทยThai
ČeštinaCzech
RomânăRomanian
MagyarHungarian
УкраїнськаUkrainian
Bahasa IndonesiaIndonesian
DanskDanish
SuomiFinnish
БългарскиBulgarian
עבריתHebrew
NorskNorwegian
HrvatskiCroatian
CatalàCatalan
SlovenčinaSlovak
LietuviųLithuanian
SlovenščinaSlovenian
СрпскиSerbian
EestiEstonian
LatviešuLatvian
فارسیPersian
മലയാളംMalayalam
தமிழ்Tamil
اردوUrdu
The Little Book of Valuation

The Little Book of Valuation

How to Value a Company, Pick a Stock and Profit
by Aswath Damodaran 2011 256 pages
3.98
2k+ ratings
Listen

Key Takeaways

1. Understand the fundamentals of valuation: Time value, risk, and accounting

The simplest tools in finance are often the most powerful.

Time value of money is a fundamental concept in valuation. It recognizes that a dollar today is worth more than a dollar in the future due to inflation, consumption preferences, and risk. This principle is applied through discounting, which converts future cash flows into present values.

Risk assessment is crucial in valuation. The Capital Asset Pricing Model (CAPM) is commonly used to measure risk, where beta represents a stock's sensitivity to market movements. However, alternative models like multi-beta and proxy models have emerged to address CAPM's limitations.

Accounting knowledge is essential for valuation. The three main financial statements are:

  • Balance sheet: Summarizes assets, liabilities, and equity
  • Income statement: Shows profitability over time
  • Statement of cash flows: Tracks cash movements from operations, financing, and investing activities

Understanding these fundamentals provides the foundation for more advanced valuation techniques.

2. Master intrinsic valuation: Discounted cash flow analysis

All valuations are biased.

Discounted Cash Flow (DCF) is the cornerstone of intrinsic valuation. It involves estimating future cash flows and discounting them back to the present using an appropriate rate. The process requires four key inputs:

  1. Cash flows from existing assets
  2. Expected growth in cash flows
  3. Discount rate
  4. Length of time before the firm becomes mature

Analysts must be aware of their biases when performing valuations. Common biases include:

  • Selection bias in choosing companies to value
  • Confirmation bias in information gathering
  • Institutional pressures affecting recommendations

To mitigate these biases:

  • Be transparent about your assumptions
  • Use multiple valuation methods
  • Seek diverse perspectives

Remember that all valuations have a margin of error, and simpler models often perform better than complex ones.

3. Utilize relative valuation: Comparing assets using multiples

Multiples are easy to use and easy to misuse.

Relative valuation involves comparing the pricing of similar assets in the market. This approach is widely used due to its simplicity and ability to reflect market sentiment. Key steps in relative valuation:

  1. Find comparable assets
  2. Scale prices to a common variable (e.g., earnings, book value)
  3. Adjust for differences across assets

Common multiples include:

  • Price-to-Earnings (P/E) ratio
  • Price-to-Book (P/B) ratio
  • Enterprise Value-to-EBITDA ratio

To use multiples effectively:

  • Ensure consistent definitions across companies
  • Consider the distribution of multiples in the sector
  • Adjust for differences in growth, risk, and cash flow potential

Be aware that relative valuation can be affected by market bubbles and may not always reflect intrinsic value.

4. Adapt valuation techniques for young growth companies

Success in investing comes not from being right but from being wrong less often than everyone else.

Young growth companies present unique valuation challenges due to their limited history, negative earnings, and high failure rates. Key considerations when valuing these firms:

  1. Revenue growth: Estimate total market size and expected market share
  2. Path to profitability: Project how margins will improve over time
  3. Reinvestment needs: Assess capital requirements for growth
  4. Risk profile: Expect higher costs of capital that decrease as the company matures
  5. Survival probability: Adjust valuation for the likelihood of failure

Valuation approaches for young growth companies:

  • DCF with careful consideration of future scenarios
  • Relative valuation using forward multiples
  • Real options analysis for highly uncertain outcomes

Remember that valuing young companies involves more art than science, and it's crucial to reassess assumptions regularly as new information becomes available.

5. Navigate the challenges of valuing mature companies

The biggest challenge in valuing mature companies is complacency.

Mature companies often have stable cash flows and established market positions, but they can still present valuation challenges. Key considerations:

  1. Potential for operational improvements
  2. Financial restructuring opportunities
  3. Nonoperating assets and cross-holdings

Valuation approaches for mature companies:

  • DCF with focus on potential efficiency gains
  • Relative valuation using sector-specific multiples
  • Sum-of-the-parts valuation for conglomerates

Value drivers for mature companies:

  • Operating efficiency improvements
  • Optimal capital structure
  • Effective allocation of excess cash

Be wary of assuming past performance will continue indefinitely. Look for potential catalysts that could unlock hidden value, such as management changes, spinoffs, or industry consolidation.

6. Apply specialized approaches for declining and distressed firms

Flat revenues, declining margins, and the potential for distress make valuing distressed companies tricky.

Declining and distressed firms require a modified valuation approach that considers the possibility of bankruptcy or liquidation. Key steps in valuing these companies:

  1. Estimate cash flows assuming the firm survives
  2. Assess the probability of distress
  3. Estimate the liquidation value in case of failure
  4. Combine the going concern and distress scenarios

Valuation techniques for distressed firms:

  • Adjusted Present Value (APV) method
  • Option pricing models to value equity as a call option
  • Relative valuation using distressed firm multiples

Remember to consider:

  • Potential for turnaround or restructuring
  • Tax implications of net operating losses
  • Debt covenants and potential violations

When investing in distressed firms, diversification is crucial to balance the high risk of failure with potential high returns from successful turnarounds.

7. Tailor valuation methods for financial service companies

The key number in valuing a bank is not dividends, earnings, or expected growth, but what we believe it will earn as return on equity in the long term.

Financial service companies require specialized valuation approaches due to their unique characteristics:

  • Difficulty in separating operating and financing decisions
  • Regulatory capital requirements
  • Opaque financial statements

Valuation methods for financial firms:

  1. Dividend Discount Model (DDM)
  2. Excess Return Model
  3. Asset-based valuation

Key factors to consider:

  • Return on Equity (ROE) and its sustainability
  • Regulatory capital ratios and their impact on growth
  • Credit quality and loan loss provisions
  • Interest rate sensitivity

When using relative valuation, focus on equity multiples like P/E and P/B ratios, and adjust for differences in risk and growth across firms. Be aware of the impact of accounting choices and regulatory changes on reported numbers.

8. Account for economic cycles when valuing cyclical and commodity companies

Uncertainty and volatility are endemic to valuation, but cyclical and commodity companies have volatility thrust upon them by external factors.

Cyclical and commodity companies face unique valuation challenges due to their sensitivity to economic cycles and commodity prices. Key approaches:

  1. Normalize earnings: Use average earnings over a full economic cycle
  2. Adjust for current position in the cycle: Consider where we are in the economic or commodity price cycle
  3. Scenario analysis: Value the company under different economic or price scenarios

Valuation techniques:

  • DCF with normalized cash flows
  • Relative valuation using through-cycle multiples
  • Real options analysis for commodity companies with undeveloped reserves

Remember to:

  • Consider the company's cost position relative to competitors
  • Assess management's ability to navigate cycles
  • Factor in the potential for structural changes in the industry

When investing in these sectors, timing is crucial. Look for opportunities when pessimism is highest and valuations are depressed relative to normalized earnings.

9. Properly assess companies with intangible assets

Accounting first principles suggest a simple rule to separate capital expenses from operating expenses. Any expense that creates benefits over many years is a capital expense, whereas expenses that generate benefits only in the current year are operating expenses.

Companies with intangible assets, such as technology and pharmaceutical firms, require careful consideration of accounting inconsistencies. Key issues:

  1. R&D and advertising expenses are often treated as operating expenses rather than capital expenditures
  2. Earnings and book value may be understated due to accounting treatment
  3. Heavy use of stock options for compensation can distort earnings

Valuation adjustments:

  • Capitalize R&D and other intangible investments
  • Adjust operating income and invested capital
  • Account for the dilutive effect of stock options

When using relative valuation:

  • Be cautious when comparing multiples across industries
  • Use forward-looking multiples to mitigate accounting discrepancies
  • Consider using revenue multiples when earnings are negative

Remember that intangible assets can provide significant competitive advantages and barriers to entry, potentially justifying higher valuations. However, these advantages may erode quickly, requiring constant reinvestment to maintain value.

Last updated:

Review Summary

3.98 out of 5
Average of 2k+ ratings from Goodreads and Amazon.

The Little Book of Valuation receives mixed reviews, with an average rating of 3.98/5. Many readers praise it as an informative and comprehensive guide to company valuation, particularly for experienced investors. Some find it too technical for beginners, while others appreciate its practical examples and clear explanations. The book covers various valuation methods, including intrinsic and relative valuation, and discusses how to approach different types of companies. Some readers recommend it as a reference tool, while others suggest it may require multiple readings to fully grasp the concepts.

Your rating:

About the Author

Aswath Damodaran is a renowned finance expert and professor at New York University's Stern School of Business. He holds the Kerschner Family Chair in Finance Education and teaches corporate finance and equity valuation. Damodaran is widely recognized for his contributions to the field of valuation and has authored numerous influential academic and practitioner texts on Valuation, Corporate Finance, and Investment Management. His expertise and publications have made him a respected figure in both academic and professional finance circles, with his work serving as essential references for students, investors, and financial professionals alike.

Download PDF

To save this The Little Book of Valuation summary for later, download the free PDF. You can print it out, or read offline at your convenience.
Download PDF
File size: 0.25 MB     Pages: 13

Download EPUB

To read this The Little Book of Valuation summary on your e-reader device or app, download the free EPUB. The .epub digital book format is ideal for reading ebooks on phones, tablets, and e-readers.
Download EPUB
File size: 2.96 MB     Pages: 10
0:00
-0:00
1x
Dan
Andrew
Michelle
Lauren
Select Speed
1.0×
+
200 words per minute
Create a free account to unlock:
Bookmarks – save your favorite books
History – revisit books later
Ratings – rate books & see your ratings
Unlock unlimited listening
Your first week's on us!
Today: Get Instant Access
Listen to full summaries of 73,530 books. That's 12,000+ hours of audio!
Day 4: Trial Reminder
We'll send you a notification that your trial is ending soon.
Day 7: Your subscription begins
You'll be charged on Nov 21,
cancel anytime before.
Compare Features Free Pro
Read full text summaries
Summaries are free to read for everyone
Listen to summaries
12,000+ hours of audio
Unlimited Bookmarks
Free users are limited to 10
Unlimited History
Free users are limited to 10
What our users say
30,000+ readers
“...I can 10x the number of books I can read...”
“...exceptionally accurate, engaging, and beautifully presented...”
“...better than any amazon review when I'm making a book-buying decision...”
Save 62%
Yearly
$119.88 $44.99/yr
$3.75/mo
Monthly
$9.99/mo
Try Free & Unlock
7 days free, then $44.99/year. Cancel anytime.
Settings
Appearance