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Aswath Damodaran: ‘Investing is an act of faith’
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Aswath Damodaran: Investing Requires Faith, Not Just Analysis
In an interview with “Unhedged,” Professor Aswath Damodaran, a renowned expert in equity valuation, shared his views on market valuation, specifically addressing the current state of the S&P 500. Damodaran discussed the four key components of market value: earnings, cash flows, the risk-free rate (Treasury bond rate), and the equity risk premium. He noted that while the market appears fully priced, it is not necessarily in bubble territory, as the risk premium remains within a historical range.
Damodaran highlighted the challenges of predicting the future and the tendency of markets to overreact, particularly in sectors like AI, where companies like Nvidia have seen their stock prices soar. He acknowledged Nvidia’s strong position but cautioned that its current valuation might be ahead of its fundamentals, comparing it to past tech bubbles.
He also touched on the importance of understanding market efficiency, emphasizing that while markets make mistakes, taking advantage of these errors consistently is challenging. Finally, Damodaran discussed his personal investment philosophy, focusing on minimizing regret and maintaining a long-term perspective, even when the market behaves unpredictably.
For a deeper dive and better insights, feel free to read the full article here: https://www.ft.com/content/6b9537e2-3639-4c23-8136-e2ab9dfbe1da
The NYU professor on efficient markets, dangerous emotions, and Nvidia
Friday interview: Aswath Damodaran
Professor Aswath Damodaran of New York University is probably the world’s pre-eminent academic expert on equity valuation. His Musings on Markets blog is widely followed on Wall Street, and his views on companies from Tesla to Netflix are much debated. He also puts his money where his mouth is, investing personally based on his assessments of corporate value. He spoke to Unhedged last week.
Unhedged: Do you think the S&P 500 is fairly valued right now?
Damodaran: There are four elements to value. The first is how much earnings these companies generate. Here, coming out of 2023, the wind seems to be at companies’ backs. The second thing is cash flows, which increasingly take the form of buybacks and dividends. A few years ago cash flows had reached a point where you said, there’s no way they can sustain this — they were more than 100 per cent of earnings. Now they’re back to near where they’ve been for the last 20 years. About 80 per cent of earnings are being returned as dividends and buybacks. The third leg is the Treasury bond rate, which has been around 4 or 4.2 per cent.
I’m going to say something that’s going to sound weird: a market with a T-bond rate of 4 per cent is much healthier than a market with a T-bond rate of 1.5 per cent. People don’t feel the urge to do stupid things.
Unhedged: Speak for yourself.
Damodaran: People search for yield, and you can’t blame them — they need the cash flows. So the fact that the T-bond rate is 4 per cent is a good sign for the markets and for the economy. All this talk about “when will the Fed lower rates?” completely misses the point. This is where we ought to be.
The final component of value is the risk premium, which surged in 2023 and 2022 when inflation came back. Through history, inflation has been the most deadly force driving US equity premiums, because when people see inflation it changes the way they behave in every dimension. That has receded, but not gone away.
If you look at all four dimensions — earnings, cash flows, the risk-free rate and the equity risk premium — the market has found a sweet spot. The problem is that no sweet spot lasts forever. So which of these four components is the weakest link? I would be concerned about earnings the most. I know we put off a recession last year, but you worry about a slow motion slowdown. When things slow down, you don’t even realise what’s happening under the surface.
Given where those numbers are, I think the market is fully priced, not cheap by any means. The risk premium I’m looking at — the returns you can make over and above the risk-free rate — is about 4 to 4.5 per cent, which is roughly where it’s been for the last 60 years. From that perspective, this story of “this is a bubble that’s going to burst” is kind of overwrought. That story seems to be based on a PE ratio that’s too high. I don’t know when people will realise that when metrics haven’t worked for 15 years, perhaps the problem is the metric, not the market!
Will there be a correction in markets? Of course. When you’ve gone up this much this quickly, there will be cleaning up. Are there segments where the market has over-reached? Absolutely. Anything with the word AI in it probably has too much buzz in it. There are segments you should probably stay away from for the moment, if you are jumping into the market. But if you have them already in your portfolio, I wouldn’t be selling them and running for the hills.
Unhedged: How do you calculate equity risk premium?
Damodaran: The way in which 90 percent of people still do it is they look at the last hundred-odd years of the US market — primarily the US market, because it is the market with the longest history — look at what stocks did over that period, look at what T-bonds did over the period, and take the difference. Implicit there is the assumption that things revert to the way they used to be. And in the 20th century, the US was the most mean-reverting market and economy of all time. So it worked well, and people got lazy. But mean reversion works until it doesn’t, which is when there’s a structural change. In this case, we went from a US-centric global economy, which was what we had for a big part of the 20th century, to a true global economy, where you have China and Europe competing for global growth.
So I always push for a forward-looking premium. We know how to compute the yield to maturity on bonds. We look at the coupon yield and the face value, and we solve for a simple rate of return that makes the present value of the cash flows equal to what you pay today. So when I look at the S&P 500, I don’t enforce a theory or a hypothesis. I just see what rate of return is, given what you paid and what you get in cash flows.
Unhedged: But you do need an estimate of the future cash flows.
Damodaran: That’s where you can get disagreement. I use the analysts’ top-down estimates of earnings. Company analysts’ growth estimates tend to be biased upwards, for a lot of reasons. What I use are analysts who track the entire market. They have no bias. They make mistakes like everybody else [but] the analysts’ estimates I have used for the last 20 years and the actual growth have both averaged out to about 7 per cent. In individual years, all kinds of things can happen. Estimates can be wrong. But here’s the bottom line: even if the analysts are wrong by 2 or 3 or 4 per cent, the implied equity risk premium changes by only about 0.2 per cent.
Right now my implied equity risk premium is between 4 and 5.5 per cent. I try variations. What if I normalise earnings? What if the payout ratio goes to where it used to be? What if the growth is based just on fundamentals [reinvestment rate and return on assets]? My range is between 4 and 5.5 per cent, which sounds like a lot, but if we take historical risk premiums, the range in the US is between 1 and 9 per cent. That’s how much noise there is in stock prices.
Unhedged: Isn’t there a certain circularity in valuing the market using market prices?
Damodaran: There absolutely is. I calculate that the premium this month is 4.36 per cent. If you’re interested in whether the market’s overpriced, you ask, “am I OK with a 4.36 per cent premium?” You could argue that that looks too low. But in 1999, at the end of the dotcom boom, the premium was 2 per cent. T-bonds were over 6 per cent, and you are getting 8 per cent on stocks. I remember looking at that and saying, this is crazy. I can get 6.5 with little or no risk, and you’re offering me 2 per cent more? And that was the historic low for the equity risk premium.
My red zone, usually when I start to get worried, is when this number hits 4 per cent and starts going below that. That’s my replacement for the Schiller P/E or whatever people use as a measure of whether the market is fairly priced. The problem with the P/E and other metrics is they don’t bring in growth and the rest of the components of value. By applying the equity risk premium, I have no choice but to confront every component of the market.
Unhedged: It strikes me that your work is, in a way, very conventional. Your “secret sauce” is just taking the discounted cash flow model and trying to apply it with a lot of care.
Damodaran: Even the notion of a discounted cash flow valuation suggests that it’s all very very technical. To me, a discounted cash flow valuation is just an attempt to take a company’s business and convert it into “this is what I would make if I bought the business”. So you’re right. This is as old as time. As long as people have bought and sold businesses, good business people have asked “what am I getting?” I’m a very conventional thinker when it comes to value.
Unhedged: How carefully do you track your estimates of market value against subsequent returns?
Damodaran: I’m not a market timer, but here’s what I do. Every year I look at different proxies for the equity risk premium, the historical premium, the implied premium, the smoothed implied premium, the default rate. Ultimately, all of these are all different attempts to tell you, not what stocks will do next year, but in the next five or 10 years. I do a correlation between all these measures and the actual returns in the subsequent five or 10 years. I’ll tell you which one does the worst: the historical risk premium. It’s a very perverse indicator. When historical premiums are high, expected equity returns are low, for a simple reason: historical risk premiums get pumped up as you keep pushing prices higher. And the best predictor is the current implied premium. It does much better than the alternatives. For me, that is sufficient as a non-market timer to say, I’m OK using it.
I almost think of doing this as a way of putting my mind at rest so I can go back to valuing individual companies. A lot of analysts get distracted when valuing companies by what they think about the market. So every valuation becomes a joint statement. I’m trying to keep my company valuation as market-neutral as I can.
Unhedged: Assuming you do a good job at valuing very large American companies, aren’t you kind of a standing rebuke to the efficient markets hypothesis?
Damodaran: If you define efficiency as, “Do markets get it right?,” of course markets are inefficient. They screw up all the time. But if you redefine market efficiency as, “Can I take advantage of these market mistakes to make money?”, efficient markets have won hands down every single year for the last 65 years, compared to what the typical active money manager has done.
In my valuation class, I start by saying, if I truly believed in efficient markets, I would not be teaching this class. If you truly believe in efficient markets, valuation is just an exercise in explaining the price. So I believe markets make mistakes and we can find those mistakes. Then I use the word “faith”. I think that investing is an act of faith. When you value a company, you have to have faith in your value, and you have the faith that the price will correct to that value. If people ask me to prove that my value is right, I can’t, because I’m making assumptions. And if they ask me to prove that the price will adjust to value, I can’t do that either.
I’ve told people that if at the age of 85 I am on my deathbed and you came and told me, “You’ve spent the last 60 years doing intrinsic valuation and picking stocks, I’ve computed your returns over the last 60 years, and they’re roughly what you have gotten investing in an index fund,” I’d be perfectly OK with it. You need to be OK with it, because what makes investing go off the track is when you believe you are entitled to a high return because you did all the right things. Especially for people who believe in value, that’s a very corrosive thought.
Once you believe you’re entitled and you don’t make returns, you start to get angry at the market. If you don’t want to buy Nvidia at $850, don’t buy it, but don’t wag your finger at people who are: “Anybody doing this must be stupid, must be shallow, they don’t understand the markets like I do.” There’s no point. Move on. Let other people play a different game. They’re playing a trading game. It’s not your game, so leave the game.
I don’t invest to make an excess return. When I make more than the market, and I’ve been lucky enough to do it, I think of it as icing on the cake, because I enjoy the process. When I see people doing active investing who don’t enjoy it, I ask them, why don’t you go back to living your life and put your money in an index fund?
Unhedged: You mentioned Nvidia. Last summer you worked on it and found it a little overvalued. As if to illustrate the points you just made, the stock has doubled since. Have subsequent events changed your view?
Damodaran: Not enough to justify an $850 price. The AI story is expanding. I’m old enough to have seen multiple truly big changes, the ones that have changed not just markets, but the way we live. I started in 1981, so I saw the PC revolution. And then in the 1990s, the internet come in. And then social media come in. Each of these were kind of revolutionary, and in each of them we saw an over-reach — people taking every company in the space and pushing up prices.
It’s the nature of the process. When people talk about bubbles, I say, what’s so wrong about a bubble? A bubble is the way humans have always dealt with disruptive change. What makes us change is the fact that we underestimate the difficulty of change and overestimate the likelihood of success. Whenever you have a big change, everything in that space will tend to get overpriced because people will push up the numbers, expecting outcomes that cannot be delivered. Eventually they come back to reality. It happened with PCs, it happened with dotcoms, it happened with social media.
When it’s all said and done, you have four or five big winners standing. Even if you believe this in the AI bubble, there’s no easy way to monetise that view. Short all these companies and you’ll be bankrupt before you’re right. So I look at these bubbles and I try to stay out of them. But I never thought that we should somehow stop the bubbles. Do you want to live in a world run by actuaries? We’d still be in caves, sitting in the dark. “This fire thing will get out of control!” We need people to over-reach.
So with Nvidia at $850, it seems to me, the price has run ahead of the stock. I did a reverse engineering of how big the AI market would have to be and how big Nvidia’s share would have to be to justify the price. This was at $450. And I worked out that the AI chip market would have to be about $500bn, and Nvidia would have to have 80 per cent of the market, to essentially break even [In 2023, Nvidia’s revenue was $61bn].
You might say that’s perfectly reasonable, and that the CEO Jensen Huang is a genius walking on the face of the earth, and that they will continue dominating. And let’s face it, they have a head start. The one thing which I think sets them apart is this is the third big market that they’ve been first in: gaming, then crypto, now AI. The first time you got lucky. The second time you got really lucky. The third time you have to say there’s something in this company that makes them systematically successful in new markets. That’s a special skill. So when I valued and found it overvalued, I sold half of my position. And that drove people a little crazy. They said, if you’re a value person, and you find something overvalued, why not sell it all?
My response was behavioural. One of the most insidious components of investing is regret. And I said, this is my lowest regret pathway, because no matter what happens on half my investment, I feel pretty good. It sounds irrational. But for me as an investor, I’ve got to always be looking forward. Anything that makes me look back and say, I shouldn’t have done that, that does more harm than good.
Unhedged: Did you sell half again at $850?
Damodaran: Yes. I have a quarter of what I had. I bought at $27, so I’m not going to get greedy.
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