# How to value a stock? (before investing) : The little book of valuation by Aswath Damodaran

## Jul 11, 2021 08:38 · 3693 words · 18 minute read

If you have bought a stock in the company, or a house in a locality, what made you make a decision to buy it at the price you bought it for? What do you think that you paid more for it? Or much less ? Was it because a youtuber told you to buy it looking at the charts, and drawing few trendlines? Or the price did not matter to you because someone told you that it is such a good quality company, and the price does not matter.

00:23 - Well if the only reason for you buying an asset is because someone else would be willing to pay a higher price for the same asset in the future, You are a fool and this theory is a called a greater fool theory.

00:37 - But since you are subscribed to the better investor.

00:39 - You do not have to be one. The top secret of making money in investing is to pay much less, as less as you can for a an asset then what it really is worth for.

00:49 - Which warren buffet says as buying one dollar for fifty cents.

00:54 - And To make sure that we do not pay, more that what the actual value of a house or an asset or a stock is, we must understand how we come to this thing called actual value.

01:03 - The art of determining the value of an asset, be it stock or a house is called valuation.

01:09 - And who can be the better person to learn this from other than Aswath Damodaran, who is an investor and proffessor in New York University and teaches Equity Valuation to the MBA and finance graduates.

01:22 - This is the better investor helping you achieve your financial goals and freedom through organizing your finance stock market investing and learning from the billionaires, and these are top five lessons from the book Little book of Valuation(how to value a company, pick a stock and profit) Written by Aswath Damodaran Lesson number 1: The Cash Flows If you are a learning investor, you must have surely heard the word called cash flows.

01:48 - And to understand how to value a company, it is impossible to do so, until and unless we understand what a cash flow is.

01:55 - It is compulsory for every company to release three documents for a general public.

01:59 - Some companies do it quarterly, and some annually.

02:00 - These are: 1. Income statement- Where a company declares how much worth of products did the company sell, how much was the expense, how many taxes did it pay, how much profit did it make after paying taxes.

02:12 - This is the most famous document that almost all investors are well worse with.

02:17 - 2. The Balance Sheet- The balance sheet is a document where a company lists down the value of all the assets of the company, and all the liabilities.

02:35 - The last one, and the one which very few people see is 3.

02:39 - Cash Flow statement: Cash Flow Statement actually tells us that how much actual cash was there in our bank account before the year or quarter started, and how this cash was used in which all activities and after every thing how much cash is finally left in our bank account at the end of the year.

02:56 - A positive free cash flow means, that there actually was addition to the cash balance in bank and negative means, the company has less cash than what it had before.

03:07 - But then you would ask how is the cashflow statement different from the income statement.

03:12 - If a company makes profit then that would the cash added to the company s bank account.

03:16 - Because according to the definition, net profit means, the profit left after all the expense, paying debt, taxes etc.

03:18 - Well not. Let us understand this with example: A company may have sold 100 soap to its dealer, the price of one soap being $2.

03:26 - But the shopkeeper may have not paid all the $200 right now.

03:30 - The shopkeeper may have told that he will pay only 1/4th of the amount right now and rest at the end of the year.

03:37 - So in income statement you will se that the total revenue which is for how much did we sell all our soaps.

03:43 - Which in our case is $200, lets consider cost of making one soap as 1$.

03:50 - So the expense for making 100 soaps is 100$.

03:55 - Profit comes out to be200$ - $100 For our example Consider that the company is debt free, and our company has to pay 20% in taxes on the profit.

04:09 - Which is 20% of 100$, so tax becomes $20. the Net profit comes out to be 100$-$20 tax which is $80 But did this all $80 of cash came to your bank account.

04:28 - Lets see In actual you only received 1/4th of the money that is 1/4th of $200, which is $50 And according to income statement you have to pay $20 as taxes.

04:40 - So after paying your taxes you are only left with $50-$20 that is $30.

04:48 - So on income statement you saw that the net profit is $80 but in actual the company only has $30 of cash.

04:57 - It is easier for companies to fudge and cook hypothetical numbers in income statement but not easy to fudge the cash flow statement, because all the transactions that are seen on cash flow statement are actually happening in the companies bank account.

05:11 - Which in case of an fraud or scam can easily be checked by the authorities.

05:15 - Thus even warren buffet refers to cash flow as a better measure of companies operation and capital management than an income statement.

05:23 - For this reason it is prudent to look at both the income statement for earnings of the company and then the cashflow statement to see the quality and proof of these earnings.

05:33 - Lesson number 2: Two approaches to valuation: Ultimately, there are dozens of valuation models but only two valuation approaches: intrinsic and relative.

05:44 - Lets understand what the relative approach is first and how do we use it.

05:47 - You go to a locality in New York City to buy a house.

05:50 - There are these two houses next to each other selling for $1million. They were built on the same day.

05:56 - When you inquire you find out, what rent are people paying who are living in them.

06:01 - The first family is paying$20,000 and the second family is paying $30,000 Which house will you buy? Obviously you would buy the one that is earning higher rent income, since the price of both the house is same.

06:14 - This is relative valuation. You compare two similar assets and see which is earning higher income to you in comparison to the price you are paying.

06:23 - Consider this now, first house is selling at $1M , generating a rental income of $20,000 per year.

06:30 - And second house is selling at $3M, generating a rental income of $70,000 which will you buy.

06:38 - You take price and divide it by earnings. So for first house.

06:42 - $1m divided by $20000 comes out to be 50 For second house $3m divided by$70,000 comes out to be 42. 8 This ratio of price to earnings is very famous among investors.

06:57 - Price to ratio of 50 means, for $1 earning every year I am paying $50 to buy this business.

07:04 - So it will take total 50 years to get all my money back from the investment considering, there is no inflation.

07:10 - Price to earning ratio of 42. 8 means, for $1 in earning every year.

07:15 - I am paying $42. 8 to buy this business. So it will take 42 years and 10 months for me to get all my money back from the second house.

07:25 - I am getting all my money back from the second investment much before than the first one.

07:30 - So the second one is more attractive The thing that is true for a house is also true for a company.

07:36 - You can compare any ratio. Price wrt the Revenue of the comoany, Price wrt cash flow of the company etc.

07:46 - This looks very simple, but we need to understand that just like the example of two house, businesses in market may not be so identical.

07:53 - One may be older and thus more experienced than other.

07:57 - One may be more technologically advanced than the other.

08:01 - One may have more debt than the other. But more or less, relative valuation is the most basic approach towards making an investment decision.

08:10 - Some of the key ratios to carry out relative valuations other than price to earning are as follows: 1.

08:16 - Price to book value: Book value is what remains when you subtract all the liabilities from the total assets that a company has.

08:24 - And then divide by number of shares that are there in the stock market.

08:30 - Lower the price to book value better it is indicating that the price is cheap 2.

08:36 - Price to sales ratio or price to free cash flow: It may so happen the companies that you are interested to buy may not be have any profits.

08:43 - For example google until 2009 was making losses, amazon reported its first profit in the year 2015.

08:49 - When comparing such companies price to sales ratio or price to free cash flow ratio may be a better metric You do not have to pick up a paper, pen and do the maths, all these ratios are already available online.

09:00 - You can just google them. Site which I know for Indian stocks is screener. in But the things mentioned above such as the experience of the manager of the company, the growth potential of the company etc. are also responsible for giving a company a higher valuation ratio with respect to its peers, other things remaining same.

09:16 - Lesson number 3: The Discount rate Lets assume in 1970 s two people were given a choice between taking 5rs today or taking 5rs in 2021 First one took 5rs today and the other one decided to take 5rs in 2021.

09:38 - The first one put the 5 rs in bank. And considering average interest rate given by banks to be 6%.

09:45 - The 5 rs in bank would have grown to 55rs in 2021.

09:49 - Or he could have bought 500gm of Amul Butter.

09:53 - Or he could have gone on a movie date with his girlfriend taking the luxury seat, which then cost 1rs per person.

09:58 - Or studied in the best of the educational institute, and skilled himself to earn more money, definitely more than 5rs by 2021 Or he could have invested it in Berkshire hatchway the company of worlds greatest investor warren buffet and those 5 rs would have been 9,700rs today.

10:09 - In every case you assume, he is better off than the person who decided to take 5rs in 2021.

10:17 - This brings us to a very important concept which is.

10:20 - The same amount of moneys has less value in future.

10:24 - And this value decreases the more into the future you go.

10:28 - That is why the things you could do with just 5rs in 1970 s could not be imagined in 2021 with same 5rs.

10:36 - In all the cases, the 6rs in 1970 s have compounded at certain rate because of which we are left with more than 5rs in 2021.

10:46 - In case of bank deposits at rate of 6% In case of Amul butter at the rate of 10% In case of investing in Berkshire hathaway at the rate of 20. 3 % Discount rate is exact opposite of Compound interest rate.

11:02 - With the help of compound interest rate we calculate the value of present money in the future.

11:08 - In case of discount rate we calculate the future value of the money in the present.

11:13 - Which means to say in 1970 s you would say if I was to have 55Rs in 2021, what is that money equaivalent to today if discount rate is 6%, and the answer would be 5 rs What would be the present value of 250Rs of 2021 if the discount rate is 10% answer is 5rs What would be the present value of 9700rs of 2021 if discount rate is 20%, answer is 5rs.

11:48 - There is a mathematical formula if you want to know about this, but you are better of using some online calculator for the same.

11:55 - Just look up for Present value calculator in google and you can find plenty of them Just like you can find compound interest calculator.

12:06 - This word called discount rate is many a times used by analyst, so next time they use it, you wont be a foreigner to it.

12:14 - Lesson number 4: Intrinsic valuation of the company: Intrinsic value of a company is the sum total of all the cash flow from present day until the last day of the business survival.

12:27 - Any free cash that a business generates can either be reinvested in the business, or can be distributed to the shareholders in the form of dividends.

12:37 - If it is reinvested in the business then over time the book value per share will increase, because reinvesting in business means buying more assets: these can be buying plant, machines, acquiring other company etc.

12:56 - As the assets increase and liability remains same the book value per share will increase.

13:02 - So if we say that the company is going to survive for 10 more years, then the intrinsic value of the company will be the new book value after increase in the book value per share plus all the dividends given by the company in these 10 years per share.

13:18 - So lets understand this with the example of KRBL, which is a global manufacturer of basmati rice.

13:25 - Here is a list of all the historic financial ratios of this company.

13:29 - I have got this from Morningstar. com What we are interested in is the book value per share: As you can see 26. 61 per share in 2012 to 144. 86 per share in 2021.

13:43 - Which is an 20. 7% annual growth in book value.

13:50 - Now we have to predict whether the company can continue to grow at such a pace for next 10 years.

13:56 - To be conservative, lets take from here on the company will start slowing its growth rate, and would only grow by 15% in next 10 years.

14:05 - So if we do that: This is how the book value per share will be increasing: The book value at the end of 10 years becomes 586. 04 So if we consider in total, how much of the money have we reinvested in the business at the end of 10 years, we come out with 441. 18 rs Now we need to understand how much dividends would be paid in the next ten years: As the company matures and it starts having more cash in its balance sheet, the dividend increases with time.

14:35 - As a conservative investor we take that the dividends remain same as they are.

14:39 - Which is Rs 2. 5 per share per year. So in ten years the dividend paid on one share is Rs 25.

14:48 - Now adding the money reinvested and the dividends given.

14:52 - We come up with 441. 18 + 25 which is rs. 466. 18.

15:01 - adding to this our present book value. 466. 18 plus 144. 86.

15:08 - Which is Rs611. 08 So at the end of 10 years, this is going to be the amount generated by the business.

15:16 - but the present worth of Rs611. 08 of 2030 would be much less than this number.

15:17 - Remember the discount rate. We have to find out what is 611. 08 of 2030 equivalent to today.

15:26 - So now you may ask that what discount rate must we consider.

15:30 - We must consider the discount rate as the annual returns that we expect from this investment.

15:36 - Taking this as 10%. The present value of 611. 08 of 2030 at the discount rate of 10 % comes out to be 235. 08 So the present value comes out to be 235. 08 rs, which means that if we buy the stock of krbl at the price of 235. 08 And the company continues to reinvest in its business at 15 % of its cash every year And distributes dividend of 2. 5 rs every year Then we must expect an annual return of 10% PER ANNUM FROM this investment As we can see that the current price is around 245 rs, which is higher then our calculated intrinsic value of 235.

- So we would not buy it here. We would only consider buying it when the price is significantly lower than our intrinsic value.

16:29 - This is just one method, there are various other models too, but all of them discounts the future cash produced by the business into present just like our example.

16:40 - Lesson number 5: Valautions are most of the times wrong As you have seen that the calulation of intrinsic value, requires us to forecast and predict a lot of things.

16:51 - And in all likely hoods, out forecasts and predictions may go wildly out of the reality.

16:57 - As future unfolds, the operation of business may change which yu must not have ever thought of.

17:03 - Who knows exactly if a company would continue to reinvest in its business at the rate of 15% and nor 5 %. Who knows the company will continue to give the same dividends, they may stop giving that all together, for many reasons And on top of that, our assumption of discount rate of 10% from this investment may be over expectations.

17:20 - It may so happen that economic environment goes for a toss and the returns we would have expected from the business should have been 7 percent in place of 10.

17:28 - Therefore two people calculating the valuation of the company may come out with different intrinsic value.

17:34 - It is for this reason that in the stock market some investors buy a particular stock since they think that the price is below the intrinsic value, whereas some people sell a stock since they think that the price is above the intrinsic value.

17:47 - Also there is no need t be afraid of calculations and get demotivated.

17:50 - All the calculations involved are elementary and can be done by any calculators available online.

17:58 - And last but not the least we must not forget what warren buffet said when asked by an investor about his formula for calculating intrinsic value.

18:06 - To those of you who do not know in early days warren buffet used to make money by selling newspaper.

18:12 - He said If the investment decisions that he has made in his life would have required him to use calculus and crunch numbers on the calculator, he would have gone back to selling newspapers.

18:26 - I buy when the opportunity screams at me that this is a clear buy Lets have a quick recap! 1.

18:31 - Cashflow is the amount of cash that is added to our companies bank account.

18:35 - Net profit that we see in income statement may not materialise into actual cash.

18:39 - For this reason it is important to look at both the net profit in income statement and cash flows in cash flow statement.

18:45 - 2. Relative valuation is pitting two similar kind of assets against each other to see which one is better priced than the other one.

18:53 - Some important ratios are Price to earning ratio, price to sales ratio, price to cashflow ratio.

19:00 - 3. Discount rate is used to calculate the present value of an amount in the future.

19:03 - A particular amount of cash in the present has less value in the future and the value reduces further, the more into the future we go.

19:11 - It is always better to take 1 dollar today then 1 dollar in future.

19:15 - 4. Intrinsic value of a company is the sum total of all the future cashflows from present till the last day of the business, discounted to the present value.

19:25 - Discount rate used to calculate present value must be taken as the rate of the return expected from the investment 5.

19:31 - Most of the valuations are wrong. These include lot of forecasts and predictions that may never materialise.

19:36 - Two people having same data can come onto different intrinsic value and thus different opinions about whether to buy or sell a stock.

19:44 - That s it guys, If you liked the video, please like share and subscribe.

19:49 - Do leave a comment if you found this video useful.

19:52 - Feedbacks are most welcome. You can check out my past video, about the book summary of concentrated investing.

19:58 - Untill then cheers guys. .