We highly recommend this video for upping your investing game. Below are excerpts from a talk by Aswath Damodaran, a Professor of Finance at the Stern School of Business at New York University, where he teaches corporate finance and equity valuation.
Let's look at a contrast. You look at Proctor & Gamble. Where's most of the value for the company coming from? Most of the stuff they've already done is already on the ground. What else are they going to do?
But if you look at LinkedIn … Just think of any young growth company. On a good day, maybe LinkedIn's assets in place are worth $1 billion, because they made about $10 million in operating income last year.
You're paying $40 billion for the company. The extra $39 billion is for what? Expectations, perceptions, hopes. Nothing wrong with it.
What are you buying when you buy this company? Because the way you assess the company is going to be very different, if it's Procter & Gamble, as opposed to LinkedIn.
If you're Proctor & Gamble, you should be very focused on earnings reports and say, how much did they make last year? If you're LinkedIn, who cares what they made last year.
I don't care, because the value of your company is not coming from what you did last year. It's coming from what I think you can do in the future.
So when I look at an earnings report for Twitter, I'm looking for clues as to whether their 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 you're taught in business school.
But if you have a growth company, if you try to asses them using those tools, it's like using a hammer to do surgery. That's going to be bloody, and it's going to come to a bad end. It doesn't work.
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.
|Most of what passes for valuation out there is pricing. You're saying, so what? It's a very different game. What sets prices? It's demand and supply, mood and moment. What sets value? Cash flows, growth, and risk. Could the two give you different answers? Absolutely.|
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, or can be worth nothing, or can destroy value because you've got to pay for growth.
Third, I'm going to ask, how risky are these cash flows. I need a measure of risk. And I need to bring it into the value.
And finally, I'm going to ask, when will your business be a mature business? Because I've got to put some closure on this process. I cannot keep estimating cash flows forever.