Wednesday, May 9, 2012

Damodaran, Investment Valuation, 3d ed.

Aswath Damodaran’s work is always worth reading. Earlier I reviewed The Little Book of Valuation. The subject of today’s review, Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, 3d ed. (Wiley, 2012), is the big book of valuation. It measures 7” x 10” and runs about a thousand pages. Damodaran has a web site designed to support the book, including solutions to the problems at the end of each chapter, spreadsheets and datasets that he updates periodically, and web casts of his course on valuation at NYU’s Stern Business School.

In 34 chapters Damodaran covers methods of estimating risk parameters, growth, terminal value, and equity value per share. He analyzes various valuation models. He discusses how to value companies that present challenges, such as financial service firms, firms with negative or abnormal earnings, distressed firms, start-up firms, and private firms. And much, much more.

There is, of course, no way I can possibly do justice to this book in a few paragraphs. So, by way of illustration of the book’s contents, let me share Damodaran’s explanation of a big-picture chart that tracks S&P 500 earnings-price (EP) ratios, T-bond rates, and the yield spread (T-bond minus T-bill rate) at the end of each year from 1960 to 2010. He regresses EP ratios against the level of T-bond rates and the yield spread over this data period; R2 = 0.478. “Other things remaining equal, this regression suggests that: Every 1% increase in the T-bond rate increases the EP ratio by 0.6869%. This is not surprising, but it quantifies the impact that higher interest rates have on the PE ratio. Every 1% increase in the difference between T-bond and T-bill rates reduces the EP ratio by 0.3655%. Flatter or negatively sloping term yield curves seem to correspond to lower PE ratios, and upwardly sloping yield curves to higher PE ratios. While at first sight this may seem surprising, the slope of the yield curve, at least in the United States, has been a leading indicator of economic growth, with more upwardly sloped curves going with higher growth.

“Based on this regression, the predicted EP ratio at the beginning of 2011, with the T-bill rate at 0.13% and the T-bond rate at 3.29%, would have been … 20.77. Since the S&P 500 was trading at a multiple of 15 times earnings in early 2011, this would have indicated an undervalued market.” (p. 478) As of May 4, 2012, the market was still undervalued: the trailing 12-month EP ratio for the S&P 500 was 15.93.

For investors and students of the financial markets who want to embark on serious fundamental analysis it is critical to understand how to go about valuing stocks and other instruments. There is no short cut. The person who runs a bunch of screens (low P/E, high growth, etc.) and thinks his output gives him an investing edge is deluding himself. Fundamental analysis involves hard work and an artful touch. Damodaran’s Investment Valuation explains the hard work part. I fear no book can imbue the investor with an artful touch.

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