In chapter one of Damodaran’s book Damodaran on Valuation, he talks
about six myths on valuation. I feel this is a good place to start
the section on picking stocks for a couple of reasons.
First, our ultimate goal when analyzing securities is to decide
whether to buy or sell a security. To do this we need to be able to
compare the price of the security with a value just like we would when
buying a car, an apple or a house. You first do your research and
decide if the good or service is appropriately priced before you buy
it or sell it.
Secondly, looking at the myths brings up many of the issues I would
like to get out of the way up front. Over the twelve years I have
been involved in the securities industry I don’t know how many times
fund managers, portfolio managers or other sell side analysts have
said to me “I don’t believe in discounted cashflow valuation because
its too hard to forecast that far out”. For me, if someone says that,
it just means one of two things. Either they don’t understand the
theory or their just bone-lazy. My advice would be to disregard these
individuals research as I feel they will not have thought through all
the issues and there research will be flawed. Yes it is hard to
forecast, but its not necessarily the final result that’s the most
important, but rather the journey there.
The six myths raised discussed by Damodaran are:
Since valuation models are quantitative, valuation is objective.
A well researched and well done valuation is timeless
A good valuation provides a precise estimate of value
The more quantitative a model, the better the valuation
The market is generally wrong
The product of valuation the value is what matters; the process of
valuation is not important
As you can possibly guess, the myth that is closest to my heart is
number 6. Let me start with 6 and work backwards as valuation and its
journey are the heart and soul of being a successful stock picker.
Myth 6 - The product of valuation the value is what matter; the
process of valuation is not important
When many people look at a valuation, the first and last thing they
focus on is the end valuation. This is probably the worse thing you
can do. Next time you see a valuation, or you see a price target put
on a stock by an analyst; the first question you should ask yourself
is how did they get to that number? If they used a discounted
cashflow (DCF) or economic value added methodology (EVA) ask what
capital asset pricing model (CAPM) assumptions did they make. If they
used comparative analysis, what companies did they use for comparison
and are they appropriate? Think about and question the journey the
analyst went through to get to this point. Do you agree with their
assumptions? If you don’t then why not? Has the analyst raised some
issues you have not thought about in your own research? Valuation is
a discipline that helps you to address the many many issues and
questions surrounding the difference between good stocks and bad
stocks buys and sells. The value in a valuation is not the value
achieved but the valuation itself.
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