Valuation in Four Lessons | Aswath Damodaran | Talks at Google

ASWATH DOMODARAN: Thank you. Thank you so much. I just posted, a couple of days ago, where... I'm actually very lucky at the intersection of three different businesses. First I am a teacher. I love writing and I'm in finance. And just as I described, I'm in three businesses that are crying out to be disrupted, three really big, poorly managed businesses, all of which need to be cleaned up. So my goal at this point in my life is to disrupt the businesses I'm in. And this is one of those acts of alteration. Because I think for too long we have thought of teaching as classrooms in universities, but I no longer see that restriction.

So what I'd like to talk about is what I've been teaching for 30 years. To give you some background, I came to NYU in 1986. And when I first came to NYU, they gave me a class to teach. It was called Security Analysis. And for those of you who know the history of that class, it was a class that Ben Graham spoke at Columbia in the 1950s, which you know who, he who shall not be named, took. And it is a class with long and ancient traditions. So they gave it to me and told me: you have to teach this class.

I looked around the class and said, no way. This is the most boring piece or collection of themes I can think of, because by the 1980s it was already showing its age. So I went to the head of the department and said: I would like to teach a Valuation class. And he said, don't do it. There are not enough assessment elements to teach a class. And you know what? In 1986, there was not enough material in Appraisal. There were no

valuation

books. In fact, when I did my MBA, which is way, way, way back in time (1979 to 1981), two years into the program, we spent about an hour and a half collectively on the assessment.

Then I thought about it. And I said, I'd really like to teach the class. And I considered two options. One is to go the official route at the university, which is to officially apply to pass the class. And if you've ever been in an academic environment, like most of you, you know how difficult it is to do things officially at a university. A committee will be formed to report to another subcommittee. And when they contact you, you'll be ready to retire. So I discovered early on in my academic life that if you want to do something, it's better to do it subversively.

So this is what I did. I said, Okay, I'll teach the Security Analysis class. And I went into the classroom and taught a Valuation class. They have absolutely no idea what I do in the classroom. I mean, I could be teaching cooking, for all they know. So do you know how long it took them to discover it? In 2008 I received a call from the dean's office. This is 22 years after I have been teaching this class. We heard you're teaching a

valuation

class. And I said yes. I've been doing it for 22 years. They said we should call it Appraisal.

I said, welcome to reality. So if you look at the NYU calendar, you won't see Valuation until 2008. But that's because I've hijacked six other classes in previous iterations and turned them all into Valuation classes. I am fascinated by Valuation. But I will tell you from the beginning what I think about the valuation. I think the assessment is simple. Basically, anyone can make a review. I think we chose to make it complex. Whose are we? The people who practice assessment. Because? Because that's how you make a living. You have to cover things with layers of complexity, keep people away.

That's why I want to go back to the basics. Obviously, in 40 minutes I'm not going to cover the details of the valuations. But I want to address some points that I think are sometimes overlooked, especially when people look at valuation from the outside. So here is the first message I want to convey. Valuation is not accounting. And the reason I say this is that most people, if you say valuation, they think about numbers, they think about financial statements, they think about income statements. Valuation is not accounting. And it's actually a task that I face every year that I teach this class.

In fact, many of the MBAs I teach enter my class during the first year of the spring semester. When they come in the spring semester, they have taken an accounting class. And if you've looked at how MBA programs have evolved, you'll see that they are now very diverse. I receive museum directors. I receive basketball players. So, for them, the only sense of finance they have ever had is Accounting class. And part of my job is to get them out of the accounting mindset. Let me start by explaining how I see the difference between the way accountants see the world and how finance views the world.

Accounting looks backward, and there's nothing wrong with that. So nothing I say should be considered bad. It's your job to record what happened. So if you look at a balance sheet, most of you, if you open a 10-K or an annual report, you'll see a balance sheet. This is a classic accounting balance sheet. So let me look at the breakdown of how accountants break down a company. On the asset side, they break them down into current assets: basically, inventory, accounts receivable, cash; Fixed assets: land, buildings, equipment. Accountants are big on tangible fixed assets. For some reason, if they can see it, they will feel much more comfortable with it.

Then you have financial assets: investments in other companies. And then there are what accountants like to euphemistically call intangible assets. Now, if you went around this room and asked people to name intangible assets, you would see a lot of things coming to the surface: brand technology. But if you look at an accounting balance sheet, do you know what the most common intangible asset is? AUDIENCE: Good will. ASWATH DOMODARAN: Good will. And let's be completely clear about this. Goodwill is the most useless asset known to man. And here's why: For goodwill to show up on a balance sheet, do you know what a company has to do?

You have to acquire another company. So if you are the largest company in the world and you have grown entirely with internal investments, there will be no goodwill on your balance sheet...period. The moment an acquisition is made, goodwill appears. And here's why it appears. You acquire a company. It has a book value of $4 billion. So what do accountants say until just before purchasing it? It is worth 4 billion dollars. It is worth 4 billion dollars. You offer 10 billion dollars. The accountant has a $6 billion problem to explain, right? So you know what he does? He calls it good will.

He puts it in the balance. And he has to do it because the balance sheet has this very unpleasant requirement. He has to balance himself. Goodwill is a complementary variable. The problem with Goodwill is that it sounds good. And when something sounds good, people feel the need to pay for it. So every week I get emails from people saying, "I'm reviewing this company." He has $5 billion in goodwill. How much should I pay for it? And my answer is that it is a complement variable. What the hell are you doing paying for a plug variable? On the other side of the balance sheet, once again the accountants get carried away.

You have current liabilities, accounts payable, supplier credit, deferred taxes, all kinds of things. Then there are long-term liabilities: bank loans, corporate bonds. And then you have an element called Net Worth. If you have a chance, take a look at Google and see the balance. There will be a Net Worth number. Let's take any company. There is a number of shareholders' equity. Do you know what it entails? Everything that has happened to this company throughout its life. Think about it. When you look at Coca Cola's stockholders' equity, in that number is the original public offering that Coca Cola did, which was 100 years ago, and everything that has happened since then.

Net Worth is a reflection of the past. So this is what I'm going to do first. I'm going to replace it with what I prefer to see as a business: a financial balance sheet. And, at some level, a financial balance sheet is much simpler than an accounting balance sheet. On another level, it is much more complex. Look at the assets side of the balance sheet, there are only two items: existing assets and growing assets. Let's take the easier half of that. In-place assets are investments you have already made as a business. That's pretty simple: value of the investments you've already made.

Choose the company you want. Think about the investments you have already made. Growth assets are a little more complicated. It's a value I attribute to the investments I hope you make next year, two years from now, five years from now, ten years from now, forever. I give you credit for investments you haven't even thought about yet. That's pretty scary, right? An accountant will never be able to do that. But I don't play by rules, so if I think you have great investments in the future, I can give you great value. Let's see a contrast. You look at Procter & Gamble.

Where does most of the value for the company come from? Investments they have already made or Growth Assets. Most of the things they have already done are already on the ground. What else are they going to do? But if you look at LinkedIn and you can pick any young growing company, I'm not going to pick it in terms of quality. Just think of any young growing company. On a good day, LinkedIn's existing assets are likely worth $1 billion, because they made around $10 million in operating income last year. You're paying $40 billion for the company. What are the additional $39 billion for?

Expectations, perceptions, hopes. There's nothing wrong. But that's the first stop when you're an investor. You have to stop and check reality. What are you buying when you buy this company? Because the way of evaluating the company is going to be very different, if it is Procter & Gamble, than if it is LinkedIn. If you're Procter & Gamble, you should focus a lot on earnings reports and say how much they made last year. If you're LinkedIn, who cares what they made last year. So when I see investors go crazy over earnings reports from young companies... and there are a lot of them.

Take any social media company as an example. Look how scared they are. Earnings per share were $0.02 below expectations. I don't care, because the value of your company doesn't come from what you did last year. It comes from what I think you can do in the future. So when I look at a Twitter earnings report, I don't look at what they did last year. I'm looking for clues as to whether his growth is potentially increasing or not. Are they doing the right things to create value from their growth assets? Most of the tools we have in finance were developed for mature companies: PE ratios, return on invested capital, things taught in business school.

But if you have a growing business, try evaluating it using those tools. It's like using a hammer to perform surgery. Think about it. It's going to be bloody and have a bad ending. It does not work. So one interesting thing you can do when you sit down with a company is take the accounting balance sheet and compare it to the financial balance sheet. The younger a company is, the less it will learn by looking at the balance sheet, for a simple reason. If you haven't been in business long, the accountant has nothing to record. So if you look at a Twitter balance sheet or a LinkedIn balance sheet, there's still not much.

It doesn't make them bad companies. It just makes a difference. And on the other side of the balance sheet, there are only two elements: debt and equity. There are only two ways to finance a company. You can borrow the money or use your own money. You can cut this and cut it as much as you want. You can call them bonds and stocks. But all companies should have that option. And guess what? Tell me where most of your value comes from. I will tell you whether you should finance your business with debt or equity. And think why.

Let's say you are a young growing company. How young? You are a business idea. You're Snapchat: no revenue yet, no profit yet, so much potential. How should you finance your business? What is the problem with borrowing money to finance a business idea? Have you tried paying interest with ideas? Go to the banker and say, you know what? I have many ideas. You cannot make interest payments with ideas. If you have a business idea, this is Corporate Finance 101. Don't look for problems. Capital must be increased. That is the first message I wanted to convey. Here is the second.

I often see ranked valuations structured in spreadsheets. In fact, some of you may have attended one of these Training the Street classes. I like those guys. They come with spreadsheets. They teach you how to be an Excel ninja. You can write macros on top of macros. You can use those shortcuts and turn the columns yellow, green, blue, etc. And at the end of two days, you'll be a master at Excel. And you think, that's what valuation is all about, at the end of the process. In fact, the way I like to describe this is to take a step back and think about what drives a company's value.

If I'm asked to value a company, there are

four

basic questions I need answers to. Here is the first one. You have already donethose investments on the ground. What are the cash flows you get from those existing investments? It could be very small if you are a young growing company. But that's my starting point. That's why I look at the latest financial statements, to get a measure of what their existing cash flows are. The second question I'm going to ask you is what value do I see you creating with future growth? Notice how I phrased the question.

I didn't ask you what your future growth is. Growth, alone, can be worth a lot, it can be worthless, or it can destroy value. Growth can be good, bad or neutral, because you have to pay for growth. So I'm going to ask what is the value that is created from future growth. So it's much harder to answer: what are your cash flows for existing assets? But I need that answer. Third, I'm going to ask how risky these cash flows are. Notice, I didn't add any terms to the buzzwords you add there. What is a beta? Those are tools.

Don't confuse tools with end games. I need a risk measure. And I need to incorporate it into the value. And finally, I'm going to ask when your business will be a mature business, because I have to close this process. I can't keep estimating cash flows forever. So those are the

four

questions that valuation revolves around, which brings me to my thinking about valuation. When I start my Valuation class, which doesn't start until Monday, there will be 200 people walking into the class. And the first question I ask you is: are your numbers people? Are you people of stories?

Think about it for a moment. I bet, given where I am, there are more numbers people in this room than story people. And the reason I say this is because when I look at investing, there are two sides. You have the numbers people, who love working with numbers. It's all about numbers. And it is the story of people who like to be creative. They like to tell stories. The VC business is a storytelling business. I know, they include numbers, like target rate of return. But it's an afterthought. It is a negotiation tool. It's a story game.

And the problem now is that the history people think that the numbers people are all geeks. And the numbers people think that the history people are all crazy. And they can't talk to each other. In fact, sometimes it's almost funny to watch two story characters and two number characters trying to talk about things. And they are talking without listening to each other. And this is the challenge I see myself having. When I walk into that class and say, how many history people? How many numbers of people? In fact, I ask you, in a very simple way, to see which one you are, if you are not sure.

I ask you: how many of you enjoyed History in high school? You have 20 people. I loved that class. Those are the people in the story. How many of you preferred Algebra to History? Those are the numbers, people there. And my ultimate goal for my Valuation class is to have number people with imagination and story people with discipline. That's the way to think about valuation. If you're a storyteller, I'm not going to stop you from telling stories. In reality, stories are much more effective at selling businesses than numbers. And it has been this way since humans have existed on Earth.

So if you tell a story, what I also want to include is enough numbers to discipline you. Because if you don't have the numbers, it's very easy to drift off into fantasy land. If you are a numbers person, you have no imagination, you won't be able to make judgments because it's all about numbers. If you do a good evaluation, it should sing a tune. You should tell me a story. Thats what Im looking for. Behind the numbers, what is the story you tell about a company? So when you look at the two groups, each believes they are the chosen people.

The numbers say that we are the chosen people. We have spreadsheets. We have numbers. We are on the right side of history. And the story that people think, oh, you should listen to us. We have the greats... we are the creative people. And I think they're both right and they're both wrong. There is something to be gained on the other side. And for me, that is the key to making a correct assessment. You have to work with both sides of your brain. I don't even know if it's mythology or not, that there's a left brain and a right brain.

But let's be realistic. Some of us prefer to work with numbers and have to force ourselves to think in stories. And some of us prefer to tell stories and have to force ourselves to think in numbers. Think about your weakest side and work on it, because that is what will give you power of assessment. So when I do a valuation, I use a discounted cash flow valuation. It's a tool. So when you hear DCF used as a dirty word, and VCs have used this on me. You are doing a DCF. And the way they say it, contempt wells up from them.

This company cannot be valued using a DCF. I think they don't fully understand what a discounted cash flow valuation is. Because ultimately what am I saying? The value of your business is the present value of the cash flows expected from running this business. This has been true for as long as the business has existed. We can debate whether we can estimate these cash flows. But don't tell me that cash flows don't matter, that it doesn't matter if your company ever makes money. We heard that in the dotcom era and look how well that ended. It does matter how much you earn.

So when I think about a discounted cash flow valuation, to me, a discounted cash flow valuation is just a tool to get answers to those four questions. My cash flows and my existing core fuel my foundation here. The value of growth is fueled by the growth rate I use and how much I am setting aside to achieve that growth. My risk is based on the discount rate. And I come to my conclusion, assuming that at some point things calm down. And I can estimate the value of everything that happens next with this big number at the end.

But DCF is not the end of the game. It's just a tool to turn your story into a number. Let me use a very simple example to illustrate this. I want to choose someone who has never done a review before. And we're going to do some valuation 101. Anyone who's never done a valuation before? Okay, you can be my guinea pig. I can't get too far away because I have to be in front of the camera. But this is an empty envelope. I'm not David Copperfield, there are no magic tricks. So this is what I'm going to do.

I'm going to put a $20 bill. It's a little wrinkled, but it's still legal tender. How much should you pay for this envelope? Don't think about it too much. That's what gets us into trouble. AUDIENCE: $20. ASWATH DOMODARAN: First rule in valuation, if you pay $20 for a $20 envelope, you get nothing. So let's try again. How much should you pay for this envelope? AUDIENCE: $10. ASWATH DOMODARAN: Buy $1. You never know what illness I have. Maybe you can't read the 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 you? Keep it in your back pocket, start very low and then build up. But this is such a transparent asset value, that if I put it up for a bidding war, I'm guessing that at the end of the bid, you'd probably get pretty close to $20. Now I'm going to make it interesting. What does this card say? AUDIENCE: Control. ASWATH DOMODARAN: Control... I'm going to put control on this envelope. How much should you pay for this envelope now? You have control over it. Did you know?

I tested this at an investment bank last week. In investment banks you are trained. If you put a check on a company, there is 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. So guess what he had done? He paid $4 for a three-for-five card that I stole at NYU and that cost me absolutely nothing. This is a money making machine. Now that I know you like paying for three-by-five cards with good-sounding words, I can tell you to try more.

What does it say? AUDIENCE: Synergy. ASWATH DOMODARAN: Synergy... that's very important. I'll throw it in there. It will probably amount to $26. What does this say? AUDIENCE: Mark. ASWATH DOMODARAN: Mark... oh, that's important. That's $32 right now. And if that doesn't work, I have my two trump cards. What does this say? AUDIENCE: Strategic consideration. ASWATH DOMODARAN: Strategic... that's the most dangerous word. When I hear the word strategic, I run out the door. Because you know what it means? The numbers don't fly, but I really, really, really want to do this. A strategic agreement is a really stupid agreement.

But you really want to do this. A strategic buyer is synonymous with a stupid buyer: a buyer who decides to buy something and then shows up to the table. And if nothing else works here, it is the trump card that always works. What does this say? AUDIENCE: China. ASWATH DOMODARAN: China. Just mention the word. It's amazing how common sense will come out the other door. Take a look at the earnings reports. All the companies that report it, even the most horrible ones, would eventually say, but there's China. Nothing about China, but there is China. That alone is not enough.

They said: China. Well, we'll forget all the facts. The fact that he lost billions doesn't matter. You have China. 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 appear. I have a list of a dozen. And the more times these words appear, the less substance there is in that report, because this is what is used when you can't find a real reason for doing something. So here is my first proposal.

It's called Proposition It. If it doesn't affect cash flows and it doesn't affect risk, it can't affect values. And what is? Whatever it is, control the synergy. I'm not saying that control has no value. But if you tell me that control has value, tell me what will change. Maybe by controlling this company, you will manage it differently, generating different cash flows, maybe by synergy, saying, my income will grow faster. Let's talk about details. Buzzwords cannot be allowed to drive decisions. Because if you let buzzwords drive your decisions, you'll make bad decisions. And worse yet, you're not going to plan to hand them over, because there's nothing behind them.

I call the second proposition the Duh proposition. I named it after a subset of emails I receive each week. And usually that's how the emails will go. I am valuing a company that loses money. I hope you lose money forever. What valuation model will work best to value this company? I feel like going up to the person, slapping them and saying: wake up. You are valuing a company that loses money. You expect to lose money forever. You are thinking of paying for this company. What's wrong with you? Which brings me to the third and final proposal: Next week, when my class starts, I'll let people choose companies.

In fact, I insist that they choose companies. They have to value those companies over the next 14 or 15 weeks, during the semester. They can choose the company they want. They can choose Lukoil. They can choose Google. They can choose Amazon. And at some point in the first week or two, a subset of people (not everyone in the class, thank goodness) but 10 of them will show up saying, I have to change companies. I say it's a little early. Why are you panicking? They say, well, I calculated my company's cash flows. And they are negative. And you said in Duh's proposal that if cash flows are negative, you can't value a company.

And I say, that's not what I said. If cash flows are negative forever, the company cannot be valued. But if your cash flows are negative in year one, year two, and year three, it's not the end of the world. In fact, there is a subset of companies, when valuing the company, negative cash flows must be obtained up front. What types of companies will get negative cash flows up front? AUDIENCE: Growing companies. ASWATH DOMODARAN: Young growing companies... and here's why. To grow, what do you have to do? You have to put money back into the business. There is no magic solution that you can use to grow at 80% annually.

So if I'm valuing a Tesla, I should expect to see negative cash flows from the start. Because? Because you have to build those assembly plants to deliver those 10 times as many cars that I expect you to sell five years from now. But if you have negative cash flows from the beginning, you have to have disproportionately large positive cash flows in the future. Do you see why they have to be disproportionately large? You use a billion dollars in the first year. You have to offset it with 10 billion dollars in year 10. So, withyoung growing companies, that's exactly what you should expect to see.

You should see negative cash flows from the beginning, because that's what you need to grow the company. And as a company matures, Nirvana appears. Cash flows become positive. You get the great values. But that's okay. Here's a way to think about searching for valuation. You sit down to value a company. You take out the financials: annual report, 10-K, 10-Q. That will give you an idea of ​​everything this company did last year. And if you have a mature company, that might be all you need. Because they are so set in their path, you can value the company using last year's financials.

But if you have a company that is in transition and a market that is changing, you need to gather information about how the market is evolving and who the competitors are. When you think about risk, you look to the past. You're going to look to the future. You're going to look at every piece of information. And my only suggestion if you value new business: don't do a blind Google search. Know that means? So if you say... For example, I have to value Uber. If I type Uber into Google, do you know what I get? Everything that has ever been said about Google on the face of the Earth.

When you search, you want focused searches. In other words, you first discover what you're looking for. And then you go look for it. In fact, what I do is I open an Excel spreadsheet with the data I need. And with each one I say, this is the number I'm looking for right now. I'm not going to get distracted, even if I find something interesting about something else, for the moment. I'll stay focused on... so if I'm looking at risk in a company, that's all I look for. Are there any clues you can get by looking at the company, the market and competitors about that risk?

And at the end of the process, I keep my eyes on the prize. It's not about getting more information. It's about taking data and turning it into information. We live in a world where we go on too many dates. That is the reality we face. Our job is to take the data and compress it into information that actually appears in our reviews. Here is a simple example of valuing a very boring company. We all know what 3M does, right? Incredibly fancy things like Post-It notes, but don't laugh. It is an incredibly profitable product. It is a company with a long history.

And this is an assessment I made of 3M in what I call the days of innocence. Those are the days when there were developed markets on one side and emerging markets on the other. And the twain will never meet... before 2008. So it's a mature company, in what I thought was a mature market. In retrospect, I was dead wrong. But what I mean is, in valuing 3M, I had to make estimates. But those estimates were easy to make. Because? Because there was a lot of history I could use. I knew what their business model was. I didn't have to imagine what they would do in the future.

So it is a focused assessment. There was uncertainty, but the uncertainty was much less. The way to think about it: If you think about the narrative and the numbers, in the case of 3M, the story is almost done. You're on chapter 33. There's not much room for you to change the story. You can't go back and rewrite history. Therefore, this is an assessment that could be done almost on autopilot. And this is the kind of company they teach you how to value in a valuation class in school. And I have very bad news for you. If this is the type of company that can be valued, anyone can value these companies.

In fact, I'm not even sure you need a body. In fact, how many of you have an Apple device? Or is that not allowed on Google? If you have an Apple device, go to the iTunes store and type uValue. It's an app I co-developed with a friend of mine, Anand Sundaram at Dartmouth, who does assessments. Then you download it. You enter the numbers. If your flight is delayed by 30 minutes you have nothing to do. You are one of those rare people who likes to work with numbers. You put nine numbers. You value a company. Keep going.

And I wrote it because I wanted to disrupt this valuation business. Because a lot of what you pay in valuation is a banker plugging numbers into something like that and then spending 25 days making it look like he did a bunch of other things and then charging you millions of dollars for something he has no business charging for. you millions per. So if you are valuing 3M or companies like that, you don't need an appraiser. You don't need a banker. Anyone should be able to value those companies. But let's talk about more interesting companies. This is a review I made of Apple in March 2013.

In fact, I have reviewed Apple every three months since forever. But since 2010, I have made my ratings public. What I mean by this is that on my blog, which is a Google blog, so think carefully about it, I publish my assessment of Apple, because I don't believe in hype. The way I describe it is, I'd rather be clearly wrong than opaquely right. And in this business, people want to be absolutely right. What I mean by this is that they will say things that are so difficult for you to interpret, that no matter what happens, they will be able to say: I told you so.

And it drives me crazy. So what I do is I say: this is what I think the value of Apple is. And of course, I'm going to be wrong. But at least you can see where I went wrong. This is an assessment I made of Apple in March 2013. Because every time a new earnings report comes out, I revalue the company. So I'm in for one very soon, because Apple's earnings reports just came out last week. However, what I'm trying to illustrate here is that, in traditional valuation, this is how a company is valued. You are presenting the best case.

Basically, even in the best of times, you don't make your expected value estimates for things like cash flows, growth, and risk. point estimates. So I ask them what the growth is. You give me a number. You ask me what the risk is. You give me a number. But the reality, if you think about it, is that you are facing uncertainty. You have a layout in your head and I'm forcing you to give me a number. And a part of you says it's 8%, but it could be 3%. It could be 11%. And 25 years ago, I can see why you were stuck.

It had to be done, because we did not have the tools to generate uncertainty. I actually have Crystal Ball attached to my Excel. If any of you use Crystal Ball, it is a simulation add-in for Excel. And what it allows you to do is enter a distribution for your assumptions, instead of just a single number. So if I write for a company like Apple, instead of giving a number, I can give you a distribution. So instead of saying revenue growth is 6%, I can say it's evenly distributed between 3% and 9%. And the more uncertainty you feel, the broader the distribution will be.

And if any of you have done a simulation, this is what happens. The computer selects a result from each simulation and makes an assessment. The default value of Crystal Ball is 100,000 simulations. This is my simulated value for Apple in March 2013. What is that? How does that help me? The share price was $450. In my base case valuation, I got around $580. So you could give them the base case value and say, I think Apple is undervalued. But your defense will be, but you could be wrong. Of course, I could be wrong. But what the distribution shows you is how wrong I can be.

And if I'm someone who makes decisions, I prefer to base them on a richer set of information. Because this is what I can tell you about Apple: I can give you an expected value, like I did before. I can also tell you, if you pay $450, what is the probability that you will be wrong up front. I can give you an ex ante probability. There is a 21% chance you are wrong. All I have to do is count the number of values ​​less than $450. And I made a distribution. And in March 2013, based on my assessment, I said: I know that I can be hopelessly wrong in my contributions.

But based on the results, it seems that there is a 90% chance. Do you see where that 90% comes from? The 10th percentile is around $450. The stock is trading at $450. Investing is a game of probabilities. And it seems to me, based on my assessments, that the odds are in my favor. And, of course, this is an investment that, in some cases, has worked hopelessly well. Desperately, well, because the stock now what? $840, split seven to one. Not everything goes so well. But what I'm trying to say is don't let uncertainty stop you. And especially in the technology business, I find this defense very concerning.

You ask people, why don't you value this company? Because there is too much uncertainty. What does that mean? Your estimates could be wrong, but that doesn't mean you can't make an estimate. To say that there is too much uncertainty to make a valuation and then invest in the company, to me, is the height of insanity. And many VCs go through that cycle over and over again. They say: I don't want to value the company, but I will invest in it. You can't tell me one thing and do the other. So if you can't value the company, at least do the logical thing and never invest in those companies.

But if you want to invest in young, growing companies, you need to know those numbers and make your best estimates. Now, of course, with a young startup, all of these questions become more difficult to answer. Since you are the founder of a young startup, let me ask you the four questions I need answers to. And you will see why life is much more difficult. First question: what are your cash flows from existing assets? You are a young startup. What is the answer to the question? What assets? I don't have anything. I'm sitting in a chair. I don't even have it.

Well, that was easy. So I ask you: how much value do you think future growth will bring? You say a lot. I say, can you be a little more specific? Not really... I don't even have a business model yet. I say, how risky are you? Very. But you can't give me previous prices and earnings because you haven't been there. I say, when will you be a mature company? And you fall to the ground laughing. Maybe you won't even be able to survive tomorrow. Each question becomes like pulling teeth. And that's why, with young startups, people give up.

My suggestion is that instead of giving up, make your best guesses. Don't put the weight of the world on your shoulders saying: I have to be right. You can't be right, but you can still make estimates. For the last four years, every time a big IPO came out, the week before the IPO, I would try to value the IPO. The reason I do it the week before the IPO is because if you wait until the IPO is priced, that number starts to eat away at your brain. So when you make a rating, your number starts to drift towards that number.

This is actually an assessment I made of Twitter the week before its IPO. So what triggered this was I was on CNBC. So from time to time I end up in that madness. And I was actually... we were talking about Twitter. And there is one analyst who was very optimistic about Twitter. So I said, why do you think Twitter is worth so much? He thought it was about $65 or $70 a share. He said because the online advertising business is huge. So I said, how big is the online advertising business? He said: I don't know, but it's huge.

This is exactly what gets us into trouble. People don't want to talk... it's like China. Online, it's huge. And since it's huge, I can pay whatever I want. So I said, you know what? If I want to value Twitter, that's where I have to start. I need to find out how big this business is. It doesn't take much research to discover this. But the entire online advertising business in 2013 amounted to about $120 billion. That's the entire global online advertising business. The biggest player, by far, is Google. And if we look at the breakdown, we can see that Google accounts for approximately 33% of global online advertising.

The next largest is Facebook, and then you have a fragmented business. So that's the business right now. What I do know is that online advertising is becoming an increasingly larger part of overall advertising. Print media is going out of fashion. So here's what I had to do first: rate Twitter. I had to calculate how big this market was going to be. Because before we talk about what Twitter's revenue will be, I need to figure out what it's going for. So I make some assumptions. I guess the total advertising market is about $550 billion. So about 20% of all advertising is online right now.

But the advertising market in general can grow around 3% a year, because it is an expense for companies. They cannot grow at 10% annually. But online advertising would increase as a percentage of that figure until it represents approximately 40% of the market. That gave me my ending. It will give me my online advertising market within a decade. It's about 200 billion dollars. AUDIENCE: How did you calculate 40%? ASWATH DOMODARAN: I made it up. And I invented it on the following basis: I observed the speed with whichthat revenues from existing advertising media are falling. Print advertising is falling through the cracks. But TV advertising has been surprisingly strong.

So there are certain types of advertising where I think you'll see other ads. Billboard advertising is not going away. Because if you drive, it is difficult to see online ads. Maybe you'll discover something. But you will have many accidents. So I made that assumption. Clearly, that's where you and I may have different values ​​for Twitter. But at least we're talking about substance. So if you take a stance saying, I think it's going to be 60% of the market, that's fine. So you have to gather the ammunition for that. So I use 40%. And then I had to judge what percentage of that market Twitter would capture.

That's hard. You've all seen how Twitter ads work, right? It's that sponsored Tweet that shows up... it pisses me off to no end. I have never clicked on a sponsored Tweet. I hope no one ever does it. But that's how they make their advertising revenue. And that is its strength and its weakness. Its length is 140 characters. Its weakness is 140 characters. That is a strong point, because it makes it nice and compact. The weakness is that it cannot be your main advertising. So the way I see it, even if Twitter is successful, it will never be Google or Facebook.

He will be a minor player. And that led me to use a market share of about 6% for Twitter, which is still about $12 billion. Here we have a company with $500 million in revenue right now. And over the next decade, I expect it will grow 24-fold to $12 billion. So that gave me half the game. Then I have to calculate how much money they will make once they are past this growth phase. And here there are two big objectives. One is Google and the other is Facebook. Both are immensely profitable. Google's margins represent about 22% of revenue. Those on Facebook are around 30%.

And Facebook's margins are falling every year you look at them. Because as they grow, it becomes increasingly difficult to maintain: these are huge margins. But I thought I was being optimistic when I used a 25% trailing margin for Twitter. I said, that's what you're looking for. So I have my revenue in year 10. I have my margins in year 10. I also had to bring in that final piece, meaning this isn't going to happen by magic. We are not going to go from 500 million in revenue to 12 billion dollars without doing something. So I had to estimate how much they would have to invest in the business, in acquisitions and in new technology.

That's a reinvestment I'm getting. And I'm calculating it based on how much your income changes each year. Those three pieces give me my cash flows. Small income turns into big income. Losses become profits. Reinvestment gives them the engine to drive revenue growth. I dedicated most of my time to that. Most people who do this type of cash flow valuation, the DCF, the discounted cash flow valuation, has two parts. There are the D and the CF. D is the discount rate. This is my problem with the way DCFs are done. 80% of the time most analysts spend on the D.

They will perfect it to the nth decimal place. 20% corresponds to cash flow. I will make a confession. The Twitter valuation, 97% of the time I spent was on cash flow and towards the end it said, I need a discount rate. And for the discount rate, I effectively used a discount rate of about 11%. And I didn't think too much about it. 11% places it in the 95th percentile of US companies. Basically I'm saying they are a really risky company. I could finish this a little longer. But I don't really care. These are really the little things. My biggest assumption is what my revenue will be and what my margins will be.

This is not where I'm going to go wrong. And I always have to keep in mind that, in a young company, there is a chance that they won't make it. In the case of Twitter, I assume there was no chance that they wouldn't make it, because they have access to capital. It's not that they won't make mistakes. But they seem to have access to people who continue to give them money, even if they make a mistake. And it's a good skill to have. Those are the things that influenced my Twitter rating. And in the week before the IPO, the value I put in was $18.

And if you remember its history, it was priced at $26. And on the day of the offering, it didn't even open for about two hours. And when it opened, it did so at $46. And I got a call from someone saying: How do you explain the $46? And I said, I don't have to do it. I didn't pay it. I have never felt the need to explain what someone else pays. AUDIENCE: What was your final assessment? ASWATH DOMODARAN: $18 per share? Yes. So I get calls asking me: how do you explain Uber's $41 billion? Ask someone who paid the $41 billion. I did not do it.

I only take Uber once in a while. But I'm not a lot of $41 billion for my driver. So I don't feel the need to try to explain it. In fact, that's the last thing I want to say. Much of what passes for valuation is actually pricing. If you have no idea what I'm talking about, let me run you a couple of very simple tests. How many of you own a house or an apartment? Google doesn't pay you enough to buy your own apartment? It's time to raise your salary, so I'll make sure that happens. You know how this works.

What do you do for a living? You hire a real estate agent. The real estate agent shows him a house. I'm thinking about moving to La Jolla, especially after two winters like... I'm done. 28 winter in New York, I'm leaving here. My wife is from California. I'm going back. I went to UCLA. I can't take this anymore. So I talked to my wife. And at the time I said it, she was looking at houses. Hey, this is a good thing. And choose the most expensive part of California to search: La Jolla. This is a poor neighborhood in La Jolla.

It's less than 1 million dollars. That shows that it is probably one of the cheapest houses in La Jolla. But here is my question. How did the real estate agent get that $995,000 for the house? How does a real estate agent get an apartment number? What does he or she do? She looks at other apartments. Or she looks at other units that have sold in the neighborhood and adjusts for the fact that you have an extra bedroom or a larger lot. It's the price. There is no valuation in progress. You think, those unsophisticated real estate agents. Let me show you a second.

Have you seen an equity research report? If you haven't, save yourself the trouble, because this is what the analyst will do. There will be a company name. There will be a multiple, which is like a standardized price, like a price per square foot, a price-earnings ratio. There will be 15 other companies that, according to the analyst, are like yours. In what universe, I don't know. I have seen reports from Google Equity Research. These 15 companies are like Google. Oh really? That is incredible. How do you find them? I'd say the real estate agent was on much firmer ground, looking at apartments in the neighborhood, than an equity research analyst trying to find 15 companies like Google.

But that's exactly what the equity research analyst is doing: pricing his company based on what comparable companies are trading at, even though there is nothing comparable about them. You're saying, those unsophisticated equity research analysts. Sometimes you see a discount...this looks like one of those discounts...if you pay a banker, this is what you get: cash flows. The next time you see a valuation from a banker, focus on the largest number in the discounted cash flow valuation. It is always the final number, the value at the end of your file. Look where that number comes from.

And I bet that in nine out of ten bank valuations, that figure comes from applying a multiple to the year five number. what do I want to say with that? In this case, this is what I did. I took the fifth year's operating income and multiplied it by 10. Why 10? Because that's what other companies operate right now. I can tell you all kinds of stories, but this is also a price. I'm only hiding it in the fifth year. I call these drag prices. The drag component is cash flows. While you are distracted by cash flows, you enter 10 times.

That's what drives this number. Most of what is considered valuation is price. You're saying, so what? It's a very different game. What sets the prices? It is demand and supply, mood and moment. What is the value of the set? Cash flows, growth and risk. Could they both give you different answers? Absolutely. If you are a trader (not a traitor, but a trader), you care about prices. What is CNBC? CNBC is an instrument for commerce. You are trading stocks. The only thing you care about is what moves prices. So the only question I ask is what is the mood?

What is the impulse? Where is he going? So if you ask me to explain why people pay $41 billion for Uber, do you know why? Because they think they can sell it for 75 billion dollars. Basically, that's it: they think they can take it in a tender offer for $75 billion. They are right? If the momentum continues, they may very well be right. Does that mean Uber is worth $75 billion? That is a very different question. Sometimes price and value can diverge. And if they diverge, they can give very different numbers. The social media space is a pricing space. In fact, if you ask me why social media companies operate the way they do, I have a very simple answer.

It's not because of how much they earned in income. It's not how much money they make. Thank God for that, because most of them don't make money. So this is what I did. I decided to let the data tell me what drove prices. And this is what I did to answer the question. I took on all the social media companies. It's easy to get public information about what the market value is. And then I collected all the information I could about these companies: what they had in revenue, what they had in profits. What I was trying to find out is how the market is valuing these companies.

What do you use to calculate prices? And I relied on statistics to answer that. All I did was a correlation between market capitalization and different variables, to see which had the highest correlation with the market. So what makes some social media companies valuable and others not? And correlations could be observed. And, from afar, look at the correlation. The most critical variable in explaining the market value of a social media company is the number of users. I'll give you a very simple way to value a social media company. Here too you can save yourself the trouble of hiring a banker.

Tell me how many users you have. If you go back to the previous page, the marketplace is paying about $100 per user. Tell me how many users you have. I will tell you what your value is going to be in the company. So how many users does Twitter have? 250 million. 250 million times 100 is 25 billion dollars. We're done. Who cares about cash flows, growth and risk? Facebook has 175 billion users, millions of users. They wish they had 175 billion. What planets are you heading to? 1.75 billion users: multiply that by 100. You get $175 billion. And remember last year when Facebook bought WhatsApp? How many of you have WhatsApp on your phones?

How many of you pay for your WhatsApp? That solves my case, like one in five people. In fact, last year, when they bought WhatsApp, they paid $20 billion for the company. $19 billion appears to have been rounded to 21. Don't ask me how those things happen. It's only a couple billion anyway. I got a call again, saying, how...? For some reason, people think I have to explain what other people do. How do you explain what Facebook just did? And I said, you're missing the point. Facebook doesn't buy WhatsApp for profits, cash flows and revenue. What are they doing? AUDIENCE: Users.

ASWATH DOMODARAN: How many users did WhatsApp have? Like 400 million. Even if we take into account the fact that around 80 or 100 million of them are already Facebook users, we are buying 300 million new users. if the market pays $100 per user. 300 million times 100 is 30 billion. You're getting a bargain. Do not laugh. This game is going crazy right now. People buy users because that is what the market rewards. You're saying, what's wrong with that? Markets are fickle. Today they like users. Tomorrow maybe they won't. Remember website visitors liked you for a long time? But they said, you know what? I can't pay dividends with website visitors.

It's a little hard to say, I'll accept three visitors please. Send them to my house. They will work to solve it. I paid a lot of money for your actions. At some point, they are going to ask for substance. And the way I describe thesocial media companies – it's like having a gigantic store with nothing on the shelves and a lot of foot traffic. That's what you're buying. What are you waiting for? That if you put something on the shelves, maybe they'll stop and buy it. It is not an unreal exercise. Call it a field of dreams.

Remember, Kevin Costner, “if we build it, he will come,” Shoeless Joe. Is the same. If we have the users, he will arrive. How he will get there, I don't know. But he will arrive. But that's what the price is about. It's not about what you and I think matters. It's what the market is building, which brings me to my last point. And I hate to be the one to break this. This is a game where luck is the dominant paradigm. When I say this, I mean investments: venture capital investments, regular investments. We like to think it's skill and hard work.

It's luck. If you're lucky, you can do terribly 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. If you're lucky, everything else is forgiven. And all too often, when people make money, they like to claim their skill. For a while, hedge fund managers were saying this. We are handy guys. We are the smartest people in the room. Says who? When people talk about smart money, I always cringe. There is no smart money. There is less stupid money and more stupid money. But there really is no such thing as smart money.

And in fact, the best evidence that there is no smart money in hedge funds is what happened collectively to the hedge fund business. You know how hedge funds work, right? First, they take 2% of your money up front. Then they take 20% of any advantage you have. It's a terribly bad setup. But you do it because you are greedy. You think they can offer more than the market. Collectively, hedge funds make about one percentage point less than you could earn by putting your money in an S&P 500 index fund. It's a strange business. I can't think of...the analogy would be starting a plumbing business called Floods R Us.

And this is what you do. There is a leak in your house. You call me and I leave you a flood. You would never call me back. That's what we do collectively with these hedge funds. We pay them tons of money to do what? Earning less than we could have earned if we didn't pay them. You figure it out, because I certainly can't. So here's my last point about valuation. It's one of my favorite movies of all time, "The Wizard of Oz." Do you remember the story? Dorothy is expelled from Kansas. She is abandoned in Oz.

She wants to go back to Kansas. Dont ask me why. She would have stayed me in Oz. Then, of course, the movement begins with: I need to go back. And of course, she has given him the classic advice. She goes to meet the Wizard of Oz. He has all the answers. The whole movie is about her walking down the yellow brick road and this motley group of characters that she collects: the Scarecrow who needs this and then the Tin Man, the Lion. And they all arrive in Oz, hoping that the wizard is this all-powerful person, which he grants...

They enter the chamber. Each one tells the magician what he wants. And the magician has that deep voice, until the curtain falls. And you realize it's a little guy behind the curtain who's been pulling... there's actually no Wizard of Oz. But it turns out that everyone got what they needed during the course of the trip. You say, what does this have to do with valuation? I firmly believe that valuing is learned by doing. You really want to learn to value. This is what you should 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 as you can. So next week I will do an assessment. It's a collective rating of the Uber post I made on my website. At each stage I ask them 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, let's say, based on your story, this is the value of Uber. And Uber's value ranges from $800 million to $95 billion, depending on the story being told.

When we get big differences in value, it's not because the numbers are different. It's because we have different narratives. Not all of these narratives are equally probable. And that's really the question you need to ask. It's, what is the right narrative for my company? I promised I wouldn't talk about Google. But I leave you with this thought. If you're thinking about Google as a company in the future, as an investor, this is the question I ask you. What is the narrative I am telling about this company? What do I see this company doing? Because that is what will drive Google's valuation, not the fact that growth has not been achieved due to exchange rate movements.

Who cares? In the larger scheme of things, those things don't change your narrative. If investors react, let them react. It's about telling a story and offering the types of decisions that support that story. That's all. Thank you very much for listening. If you have any questions, I have a couple of minutes to answer them. Yes. AUDIENCE: I was wondering. You had these graphs with distributions of what your ratings are. Have you done an analysis of how precise the distribution is, compared to... ASWATH DOMODARAN: How would you do it? It's like nailing gelatin to a wall. And this is what I mean by that.

It is a very noisy process. This is a distribution at a given time. If I go forward a month and redo the distribution, the entire distribution will change. It's not really about the distribution of value. It's about value versus price. So what you can observe is, if you are right about the values, the price moves towards a value. In Apple's case, it turned out yes. But it is a sample of one. So it's almost an article of faith. If you are an investor, you believe that price ultimately moves towards value. There is no guarantee that this will be the case.

So if you do your job. You collect the information. You make your best judgment. You estimate a value in a distribution and decide, based on it, to buy something. What you are checking is not whether the value is delivered, but whether the price is close to the value. And I think that's how it is. And that's why I continue with it. But it is a fact-based process. If it doesn't work, you should let it go. Yeah? AUDIENCE: Has price ever been shown to move on value? ASWATH DOMODARAN: Again, ultimately, there is a reality here, which is companies; the perception is good.

If you are valuing a Picasso or putting a price on it, it's all about perception. If tomorrow we all woke up and said, the guy doesn't know how to paint. He has his nose in the wrong place. But a business cannot be just perception. Therefore, the price can deviate from the value over long periods. It's not a question of whether it moves value. That's when he does it. And that's really the debate. There are some people who say that it takes so long to happen that there is no point in even waiting for it to happen.

Those are the merchants. They say, well look, I'm going to make money next time. If your time horizon is six months, don't even waste time thinking about value. You have to play the pricing game. So it's almost a given, when you play the investor game, that you have more time, or else. Yes. AUDIENCE: So, at Google, many times, our valuation is the first, because we are making an acquisition. How do you mix up the cost of bringing in all this equipment? And how is that incorporated into the valuation? ASWATH DOMODARAN: Well, I think on the right...

I'll tell you what I think about acquisitions in general, instead of talking about Google. At the right price, I don't care who you buy from. At the wrong price, I don't care who you buy from. Basically, at the right price, you can buy the worst possible lens. And you will get ahead. For the wrong price, you can do everything right, but you're already screwed. In acquisitions, the problem I see is that we spend too much time finding the right target and doing all those interesting things where we fit things in, and too little time asking how much we're paying for it.

You're right. After the acquisition, there's all the post-acquisition work you have to do to achieve that, especially if you're talking about synergy, because that's often what drives your acquisitions or any additional value you create. That requires you to take the strengths of the business you've acquired and add to your strengths to deliver it. That requires work. And I think that's the bottom line. It's not going to happen magically. And that's why I prefer it to be done before the acquisition, that you start making plans for what you're going to do, before the acquisition, rather than waiting after the fact and saying, Oh my God.

This is not going to work. So if you have an acquisition process. He has to be disciplined. And it will work only if you're willing to walk away from the table, even if it was the best goal you've ever found, but the price is too high. If you're never willing to leave the table, you'll overpay, time and time again. And in many large companies, the problem I see is that the company decides that it is going to make an acquisition and then goes to the negotiating table. You are in a terrible position to negotiate if you have already decided that you are going to do this.

Last question, then I'll stop. AUDIENCE: I have a question. ASWATH DOMODARAN: Go ahead. AUDIENCE: So I was curious. What's your opinion on an individual investor, people like us, who have full-time jobs? And many of us are not MBAs or valuation students. And the traditional and conventional advice is to buy at the point of the index. I was just curious. Do you support that? Or for someone who is interested in learning, what do you recommend? ASWATH DOMODARAN: Well, investing takes work. And if you don't have time for that job, it's probably best not to put yourself at risk by doing something because you heard someone say it.

So my suggestion is to go for the investment strategy that requires little time. It doesn't always have to be an index fund. It has to be some kind of... you have to spread your bets and not go overboard. You don't get rich by investing. You get rich doing whatever you're doing. And investing is about preserving what was done elsewhere and growing it. It's when you get greedy in trying to make a profit on your investment that you tend to overextend yourself. So I have to stop there. Unfortunately, I have a 4:18 train. I wish this were not true.

Normally I would have stayed until 5 o'clock. So thank you very much for listening.