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Valuation 101 with Aswath Damodaran: Every Number Tells a Story
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Understanding Market Valuation with Damodaran
In an episode of “Equity Mates,” Professor Aswath Damodaran shared his insights on the fundamental principles of valuation. Damodaran emphasized that valuation is essentially a simple concept, focusing on estimating cash flows or comparing prices paid for similar assets. However, the complexity arises from the uncertainty of predicting the future, which investors must grapple with.
He also highlighted the difference between pricing and intrinsic valuation, noting that most people, even those claiming to perform valuations, are actually just engaging in pricing. Pricing is driven by market behavior, while intrinsic valuation requires a deep understanding of the business and its potential.
Damodaran further discussed the importance of combining numbers and narrative in valuation, explaining that data alone isn’t sufficient without a story that justifies those numbers. He cautioned against relying solely on financial models, stressing the need to understand the underlying business drivers.
Finally, Damodaran addressed the concept of a “probabilistic margin of safety,” where risk is factored into valuations not just by adjusting discount rates but by considering existential threats to a business. He encouraged investors to be patient and focus on preserving and growing wealth, rather than chasing quick profits.
This episode provides valuable insights into Damodaran’s approach to valuation, blending simplicity with the nuanced challenges of forecasting and decision-making in uncertain markets.
Read the full interview notes of Equity Mates’ Bryce and Alec with Professor Damodaran below:
Bryce: Aswath, welcome to Equity Mates.
Prof. Damodaran: Thank you for having me.
Bryce: So, when you have a new cohort of students at NYU, where do you start conceptually when you’re teaching them about valuation?
Prof. Damodaran: I start with the basics. I try to explain to them that they already understand the basics. All I can do is provide a structure to what common sense would give them. If you strip it down, there is no theory in valuation. It’s the simplest of all exercises. To put a number on something, you can do one of two things, either you estimate the cash flows you will get from owning the business or you look at what other people are paying for similar businesses. That’s it.
Now, you can add layers of detail to it. I start there and then say, look, I know at the moment you’re thinking, ‘How do I come up with these cash flows, and how do I adjust for risk and time?’ But those are details. It’s really that big-picture perspective that guides us throughout the class. So start with basics and then build up.
Alec: You make it sound so simple, but it is certainly the hardest part of investing, I think.
Prof. Damodaran: No, I think you’re mistaking life for investing. Life is hard. Forecasting the future is hard, right? What I’m trying to say is that the mechanics of investing are easy.
The real challenge people face is predicting the future. They often assume this difficulty arises from not knowing how to value assets. When you sit down to value something, your biggest challenge isn’t knowing how to estimate cash flows or discount rates—that’s easy enough to do. The real issue is that none of us knows how AI will evolve or how it will impact Nvidia’s sales of AI chips.
So, we need to distinguish between not understanding valuation and not wanting to confront the fact that the future is uncertain—and more uncertain in some businesses than in others—and this uncertainty will inevitably affect your valuation.
Alec: Yeah, I like that. That might be the title of the episode: Investing is easy. Life is hard. So, when it comes to valuation work, there are a few concepts that have become synonymous with your work, concepts you’ve written books about and spent a lot of time on. We would love for you to explain them and help us understand them better. When we were preparing for this interview, we thought the right starting point would be understanding the difference between price and value.
Prof Damodaran: I ask people to think about how much they pay for an apartment or a house they bought recently. For many Americans, that’s becoming out of reach. But when you consider how much you pay for a house or apartment, you don’t conduct an intrinsic valuation. You basically decide how much to pay based on what others are paying for similar houses.
That’s pricing. You’re essentially looking at what others are paying, and in a way, most of our lives are spent observing what the crowd does. For example, I don’t know about you, but I decide what to watch on Netflix by checking Rotten Tomatoes, and I decide where to eat by checking Yelp.
Think of markets as a reflection of crowd judgment on what companies are worth. You rely on that crowd judgment, and that’s what pricing does—you’re trusting the crowd to get it right on average. While individual crowds might make mistakes on companies, collectively they’re usually correct.
In valuation, you approach it differently. Don’t think about buying something just because everyone else is buying it. You buy it because you’re interested in it as a business. When you buy it as a business, what others think—whether they see it as glorious or awful—doesn’t matter. Ultimately, it’s about cash in and cash out.
You can’t escape that. So, when you think about an asset as a business, you have to understand the business. You need to understand what drives its growth, profitability, and risk, and bring all these factors into your assessment. We might call this a discounted cash flow valuation, but remember, discounted cash flow valuation predates the modern concept.
The concept of discounted cash flow valuation has been around for a long time, with John Williams’ 1937 book being one of the first to describe its mechanics. However, intrinsic valuation predates discounted cash flow valuation. Think of the Venetian glassmaker in the 1500s who decided how much to pay for a business based on cash flows, growth, and risk. It’s as old as time, but it requires more work because you need to understand the business to value it. So, when choosing between valuing something and pricing something, most people—including those who claim to be doing valuation—are really just doing pricing.
Alec: Yeah, it is. And, you know, I’ve read some of your writings about how people often claim they’re doing valuation work when they look at price-to-earnings ratios or compare price-to-earnings ratios with other peers in their field. But that’s not really valuation work—that’s a pricing exercise.
Prof Damodaran: But do you know why they do it? Because we’ve trained people to believe that pricing is shallow and valuation is deep. We all want to be like Warren Buffett; we don’t want to be someone who picks stocks based on what others are paying. So, they get the message that even if they’re doing pricing, they need to masquerade as if they’re doing valuation.
This is especially true if you’re a professional money manager. You have to create the facade that you’re thinking about cash flows, growth, and risk when, in reality, you’re focused on momentum, mood, and what everyone else is buying. I tell people, look, we could all be better investors if we were more honest with ourselves about what we’re doing.
There’s nothing worse in investing than trading while acting like an investor, or vice versa—investing while adopting trading strategies. Trading is what pricers do; investing is what those who use value do. There’s nothing inherently better or worse about one versus the other.
But most people who claim to be investors are really trading. They buy low and sell high, and there’s nothing wrong with that. It’s just as valid a way to make money as investing; it’s simply a different approach.
Alec: Now, related to this concept of price and value are numbers and narrative, and you literally wrote the book on this. So, could you talk us through the relationship between numbers and narrative and how they fit together when you’re doing a valuation exercise?
Prof Damodaran: I can tell you where that book was born. It came from observing a couple of things that seemed to be in direct contradiction with each other. We have far more data today than we did 40 years ago when we sat down to value companies. I’m old enough to remember using a physical annual report and doing a valuation with a pencil on a ledger sheet—minimal tools, very little data. We have far more data now, and we have much more powerful models than we ever did.
And here was the contradiction: I noticed that the quality of valuations was actually getting worse, not better. You’d think that with all this data and these tools, we’d be getting more sophisticated and producing better valuations. So I started thinking about why that was happening.
The more I thought about it, the more I realized that people are not valuing companies anymore—they’re doing financial modeling. To them, valuation is just an Excel spreadsheet. You change the numbers, project them out, use some neat little functions, build some macros, and maybe even bring Python into the mix.
It’s become a mechanical process, and people have lost sight of the fact that the numbers are essentially a reflection of a story you’re telling about a business. Because it’s so easy to grind out the numbers, people forget the story. Forty years ago, you had no choice but to tell the story because your numbers were limited.
You had to explain why you thought Coca-Cola was a great company going into the 1980s. It was a U.S. company poised to go global, which suggested faster growth. And because it spun off its bottlers, it didn’t make the actual product, so its margins could be high. Then you put the numbers on paper because there weren’t many of them.
Today, what do you have? You have a 20-year projection of growth and margins. But people have forgotten that those numbers don’t come out of nowhere. Every number tells a story, whether you want it to or not.
One of the exercises I do in my class is to give students an Excel spreadsheet of a banking valuation. Banking valuations are not valuations; they’re just financial models. I give them the spreadsheet and ask them to tell me what the implicit story is in these numbers and whether they think a company like the one described in the model could actually exist. The narrative in numbers is really about filling in that gap where people have lost the connection to the numbers. The models were running the analysts, rather than the other way around.
Alec: Yeah, I love that. And, you know, we certainly see this. I think you used the example in your book about a company like Uber, which reached billions of dollars in valuation without making a profit, and you can see how valuation is often driven by narrative. And I guess, you know, the AI boom that we’re living through now is similar.
Prof Damodaran: Let me back that up. It’s not that valuations are solely driven by narrative; it depends on where you catch a company in its lifecycle. Take Uber in 2013, for example—there wasn’t much history, and there wasn’t really a company yet. It was all potential, so the entire value came from the story.
There were no numbers to rely on, so trying to project historical figures would have been futile. In contrast, if you ask me to value Coca-Cola today, I could do a valuation entirely based on the numbers.
The way I describe it is that valuing a young company is like being called in to finish a book where the author has died and you’re asked to complete it. For a young company, you’re called in at chapter two of the book, knowing there are 33 more chapters to write. The range of stories you can tell is huge because the story is still being formed.
In contrast, if I ask you to join at chapter 33 of a 35-chapter book, there’s not much room to change the narrative. When you value Coca-Cola, there aren’t many divergent stories you can tell about where the company is going because its story has largely been told.
In contrast, when you’re valuing a company like Palantir, think of the range of stories you can create—or even NVIDIA, which is a bit further along than Palantir, but it’s still all about the future.
The more value that comes from what a company will do in the future, the more stories matter. When you can just grind out old numbers, you can get away with doing that. I mean, let’s face it, I don’t value very many Australian or Canadian companies because most of them are incredibly boring. The story is already well-established.
Alec: Yeah.
Prof Damodaran: Right? You take BHP—where are you going to go with this story? We can talk about how climate change can be an existential crisis for the company. That’s actually something interesting because you can’t just project that forward. The way people used to value commodity companies was to take the pricing cycle, average it out, and normalize the price, right?
Oil prices were assumed to always return to $51 a barrel when valued on that basis. That works if your cycle reverts to the way it used to be. However, when I think about valuing oil companies today, I consider climate change and the potential threat that fossil fuels will become a smaller part of our energy requirements.
When I value an oil company, I can’t just assume a reversion to the past or a normalization of the market. That now has to be part of my story. This means that the more you believe fossil fuels will be curtailed, the less likely you are to buy more Exxon. That’s how narratives drive valuation, and I think we need to make that more explicit.
Alec: Yeah, so now I guess we want to get into some of the different levels of valuation. You write about the four levels of valuation: revenue growth, operating margins, reinvestment, and risk. Could you talk us through how those four elements come together?
Prof Damodaran: I’m actually going to step back from the matrix, okay? Growth is obviously the first element. Why do I focus on revenue growth instead of earnings growth? Because the only measure that truly captures growth is revenue growth. You can grow your earnings as a mature company by cutting costs, but I want to understand how big your market is and how much you’re growing. So, revenue growth becomes my proxy for the growth in your business.
My second measure is profitability. I want to see that you’re in a profitable business, and I measure this with operating margins, not net margins. Because, again, you can take a profitable business, and if you borrow enough money, you can make its net margins look slow. So, I focus on the operating profitability of your business.
The third element is the dark side of growth. If you ask companies whether they want to grow a lot or not grow at all, every company will say, ‘I want to grow a lot.’ But if you’re an airline and want to grow, you have to spend a ton of money. In fact, it might not make sense for you to grow because, by the time you’re done, you may never recoup what you’ve spent. So, reinvestment is the sobering side of growth. It’s what I tell managers: ‘You want to grow? But are you willing to reinvest this much?’
This might mean you’ll never pay a dividend and might even have to issue fresh equity. If they don’t want to do that, I tell them to revisit their growth story because reinvestment and growth need to be consistent. The story you’re telling has to align.
As for risk, I think in finance we’ve made the mistake of reducing it to just a number, a metric, like a beta or a cost. But ultimately, there are two components of risk in a valuation. One is the operating risk of the company—the ups and downs that come from being a cyclical commodity company, a company that sells discretionary products. That’s what we capture in our discount rate: operating risk.
But there’s another risk we often don’t talk about, partly because it makes us uncomfortable, and that’s the risk of failure. Two-thirds of startups don’t make it. If you ask me to value a startup, I need to bring that in explicitly. You’d be surprised that venture capitalists don’t often do this; they tend to push all the risk into a target rate, like saying, ‘I want to make a 50% return,’ when in fact the bulk of the risk they’re worried about is whether the business will even survive.
So, I divide risk into two components: operating risk, which shows up in the discount rate, and truncation risk, which comes from the possibility that the business might fail, like running out of cash. Just last week, I wrote a piece on catastrophe risk, triggered by an email from a reader in Iceland. He was looking at a company called Blue Lagoon, an Icelandic spa that’s profitable and well-established, but it’s located right below an erupting volcano. The lava is moving down, and there’s a real chance—not just a tiny one—that this spa could be wiped out. He asked me how to factor that into valuation. You can’t just raise the discount rate for something like this.
This is an existential risk, and you have to assess the likelihood that the volcano will continue erupting and that the lava will flow in a certain direction. You might wonder, ‘How on earth am I going to do that?’ There’s no way around it—uncertainty is uncertainty. This is why people think valuation can solve all the problems of life, but it can’t. I can’t build an Excel spreadsheet that eliminates the risk of a volcanic eruption. All I can do is be realistic in assessing it.
So, think about risk on both levels: operating risk and truncation risk. These are the components that drive value. A discounted cash flow valuation is just a vehicle for bringing all of these elements together.
When I look at a discounted cash flow valuation, I don’t just see cash flows and discount rates—I see a story about growth, margins, reinvestment, and risk. The question I ask is, ‘Am I okay with this story?’
Alec: So conceptually, we’re covering several of the building blocks here: understanding the difference between price and value, understanding what you’re doing, and understanding the roles that numbers and narratives play in a valuation.
Next, we discussed some of the key levers of valuation that we’ve just covered. And finally, we thought it would be important to discuss the concept of the probabilistic margin of safety. Bryce and I are both big fans of Seth Klarman’s book Margin of Safety. It’s probably one of my favorite investing books. You’ve taken that concept and added your own twist with the idea of a probabilistic margin of safety. Can you tell us more about that?
Prof Damodaran: To me, it doesn’t show up as a margin of safety; it shows up as an expected value. Let’s say I value the Blue Lagoon at a billion dollars without considering the volcanic eruption. Now, imagine there’s a 30 percent chance that the volcanic eruption will send lava in its direction. And remember, it’s too late to go out and try to buy insurance now, right? Maybe 20 years ago, you could have, but no insurance company in the world is going to sell you insurance against an eruption that’s already in progress.
So if this eruption happens and there’s a 30 percent chance of lava coming down, the value of Blue Lagoon is going to be zero, right? It’s not even like you can sell the land—what are you going to sell? The lava will take several years to cool down, and you can’t do anything in the meantime. So, I’ve got a discounted cash flow valuation with a going concern of a billion dollars.
With a 70 percent chance of that value holding and a 30 percent chance of it being zero, the expected value is 700 million dollars. There’s no need for an additional margin of safety; it’s already incorporated. When people talk about a margin of safety, I love Seth Klarman’s work, but remember, it’s a post-valuation component you add because you think you could be wrong in your assessment of value. This has nothing to do with risk or cash flows; it’s about your own risk aversion.
If you’re risk-averse, you might value the company and then think, ‘I don’t know if I got that right,’ so you add a margin of safety by demanding that the value be at least 30 percent higher. But be careful. In statistics, there are two types of errors: Type 1 errors and Type 2 errors. If you translate that to valuation by putting in a large margin of safety, what are you doing?
You’re avoiding buying something overvalued because you miscalculated the value (avoiding Type 1 errors), but you’re also avoiding buying things that are undervalued because you added a margin of safety, which leads to Type 2 errors.
I would argue that in the world we live in, you can’t afford to have a large margin of safety. If you do, you’ll end up being all cash. In fact, one of the questions I ask people who claim to have a big margin of safety is: what percentage of your portfolio is in cash? If they say 60 percent, my response is that their margin of safety is too high.
If you have that much cash, you essentially don’t have the luxury to turn away investments. Maybe in Seth’s time, there were hundreds of potential investments that were cheap, and he could pick only 20. In that case, you can afford to have a margin of safety. But today, beggars can’t be choosers. We are in a world where it’s tough to impose a large margin of safety and still find good investments.
And there’s a flip side to this. I recently bought Tesla when the price approached its intrinsic value. People were surprised and asked, ‘Isn’t it a risky company? If it’s just fairly valued, why would you buy it?’ Because I think there’s a flip side to the margin of safety, which I call optionality.
What’s the optionality? You do a valuation of a company based on what you think it can do with its existing assets and business model. What you might be missing is whether that business model gives you a launching pad to do other things in the future. I bought Facebook when it got close to being fairly valued.
The reason is that it has a platform with three billion people. My valuation was based on advertising revenues, but with three billion people spending an hour every day on the platform, think of all the other things you might be able to do with them. That’s like icing on the cake. So, when I buy at fair value, if they can pull off any of that additional potential, it’s added value to me.
I would actually flip this concept on its head. There are some companies we should be buying as soon as the price hits intrinsic value because there’s so much potential that hasn’t been factored into the valuation.
Alec: Yeah, I love that.
Bryce: So, Aswath, before we move on to getting your views on markets today, there are a lot of people in the Equity Mates community who have just started their investing journey.
Alec and I remember back when we first started, there was this feeling that you wanted to be the next Warren Buffett, and the whole aim was to find undervalued hidden gems, even though we really had no idea what we were doing.
So, for all of those people who are in the first month or year of their investing journey and are just looking to build a portfolio that grows wealth over a long period of time, how should they practically be thinking about valuation in their investing journey?
Prof Damodaran: I think first you need to be realistic. Investing is about preserving and growing wealth; it’s not about getting rich. In fact, if you define investing as a way to get rich, you’re likely to crash and burn because you’ll overreach. You’ll concentrate your portfolio too much and make bigger bets than you should.
So here’s the bad news in investing: to invest, you need wealth. To get wealth, you need to do something. If you’re a doctor, spend your time being a good doctor. Don’t spend the middle of your day checking stock pages because you think you can get rich that way. Earn an income as a doctor and use investing as a way to preserve and grow your wealth.
I tell people who aren’t in the investment community that there’s nothing wrong with being interested in markets, but you need to earn in order to invest. Make sure you’re not putting your earning power at risk because you’re too fascinated by that next big hit you might get.
Second, think incrementally. Warren Buffett didn’t sit down in 1956 and say, ‘I want to be a billionaire.’ He built up over time. Along the way, he was good, but he also got lucky. He’s open about the fact that he hit the market at a time when it was easy to find undervalued companies because people weren’t digging very deep.
I’m not sure that if he started in today’s market and today’s age, he’d be able to pull it off. In fact, his advice to investors is to put your money in an index fund and go back to living the rest of your life, which is actually very good advice for most people in investing. More time, energy, and resources are wasted chasing the goal of beating the market than in any other activity.
So, first, don’t invest if you don’t enjoy the process of investing. Don’t invest because you expect to get rewarded.
This is a game where you can do everything right and still have nothing to show for it. I give people a very simple test. I say, let’s say you’re an active investor. You try to find these undervalued companies year after year. You read Ben Graham’s Security Analysis. You read every one of Warren Buffett’s letters to his shareholders. You’re immersed in value investing, and every year you do your homework and pick companies. Then, let’s say you’re at the age of 85, lying on your deathbed.
I’m a very cruel person, and I show up at your deathbed with your investment track record for the last 60 years, with all the work you put in, and a competing portfolio that shows what would have happened if you’d just taken your money at the age of 25, put it in an index fund, and left it there. The question I ask is, would you be okay if the index fund beats you? If the answer is no, don’t be an active investor.
Here’s what happens: people become active investors because they think they’re doing the right thing, and then they feel entitled to earn a higher return than their neighbors who are picking stocks based on watching Jim Cramer on CNBC or reading their horoscopes or whatever. Then they discover that their neighbor bought Nvidia by accident four years ago and is now rich, while they’re not. That’s when bad things start to happen—because you get frustrated, you get angry at the markets, and then you double down.
The key to investing is to remember that if things don’t go your way, they don’t. There are too many things you can’t control. You have to be okay with doing everything right and not getting a reward, but you’re okay with it because you enjoy the process. One of the questions I ask people is, while you’re listening to these shows and reading all this stuff, are you really enjoying yourself?
I enjoy looking at companies. I enjoy the business, and this is part of my life. I have to teach about these companies, but I also enjoy it personally. So, to me, even if I broke even with the market, I’m okay with it because I enjoyed myself along the way. The advice that follows then is, don’t do things that can create serious damage.
It’s like the Hippocratic Oath: do no harm. Like what? Don’t put all your money in four stocks. Why? Because you think you can get rich with four? That’s the path where you take action, spend all these resources, and end up with half the wealth of your neighbor. That’s not a good place to be.
So don’t overdo it. Just take it one step at a time. Enjoy the process. And if you find yourself not enjoying the process, step away. There are far better ways to live your life than chasing after stocks and getting frustrated—especially because, you know, it doesn’t work for most people who claim to be professional investors.
Why do you think it should work for you?
Bryce: Love that. Well, on that note, let’s move to today’s market. I want to chat about the Magnificent Seven because they’re certainly capturing investors’ attention and headlines. However, the question always turns to valuation for these ultra-mega caps. So, how are you thinking about the current valuations of some of these big tech stocks?
And, I guess, following that, are you actually seeing any opportunities based on valuation in the Magnificent Seven?
Prof Damodaran: They started with the bad news. I wouldn’t buy any of the seven at today’s stock prices—they’re fully valued. But at the same time, that doesn’t mean much, right? I mean, people then extrapolate from this and think, ‘I’ve lost my chance. I’ll never be able to own these seven companies.’ That’s not the case. I own all seven, but I didn’t buy them last year. I bought NVIDIA in 2018. I bought Microsoft during its catastrophic metaverse meltdown. I bought Apple after an iPhone upgrade didn’t pan out. I bought Microsoft when a new CEO came in and it looked like they were heading into the creeks with just Office and Windows and nothing else.
So the point I’m making is these are great companies. They’re amazing business machines, and they reflect what I call the ‘winner-takes-all’ economics of the 21st century. In every business we look at, you’re going to see one or two companies dominating because of the way we’re delivering that business.
Take the example of advertising. If you went back 20 or 30 years and looked at advertising market shares, you’d see companies like The New York Times with big market shares—3%, 4% was considered big. Why? Because you were localized; you were a newspaper, and you could only do so much. You couldn’t sell to the bulk of India because they didn’t even read English. Today, 60% of advertising is online. And if you look at online advertising as a business, two companies dominate: Google and Facebook. Everybody else is a bystander. Seventy percent of the growth in online advertising over the last decade has gone to these two companies.
And it’s not because they’re breaking the rules or violating antitrust laws; it’s the economics of the business. When you advertise online, you want to go where everyone else is. You don’t want to go to some niche platform—you want to go where hundreds of millions of people gather. So guess what? Google search and Facebook dominate.
As businesses become more and more like this, you’re going to see more of this phenomenon. A few companies are gaining at the expense of the vast majority of smaller or midsize companies. Does this mean you should just buy big companies? No, that’s not going to work either.
If you pick the winners, of course, it’s going to pay off, but ahead of time, you don’t know who the winners will be. So, I would keep a list of companies that are dominating their businesses and wait for the right time. And there will be a right time because the nature of these companies is based on expectation.
Think of NVIDIA. People think that Jensen Huang walks on air. At this moment, NVIDIA is considered the greatest company of all time. That’s a dangerous place to be if you’re management because the expectations are that you’re a genius and will figure out how to deliver 50% growth from now through eternity with the latest technology at 60% margins. You can’t do that. There will be disappointments. If you missed the NVIDIA bandwagon, never got on it, and now think, ‘Oh my God, that was an opportunity gone by,’ bide your time. It will be cheap again, but that means you’ve got to track the company, value the company, and understand the company.
It can’t be based on what other people are doing. You’ll actually be buying when they’re selling. I remember when I bought Facebook—well, I still call it Facebook—after the metaverse fiasco. People asked, ‘What are you doing? Nobody likes the company.’ I said, ‘But it’s got an advertising juggernaut that’s going to deliver tens of billions of dollars in cash flows.’
Why do I care that people don’t understand or don’t like the company? I’m going to get the cash flows. You can tell me whatever you want about privacy or whatever other issues you have with Facebook, but as long as people show up on the platform and the advertising is there, I get my value. So, I think part of being an investor, as opposed to a trader, is having a sense of what you’d like to do and biding your time. Time is your ally here.
I remember Buffett saying it’s like being a hitter in baseball, but you can never strike out. In baseball, three strikes, you’re out, so hitters have to swing with two strikes, otherwise they strike out. But if you can never strike out, you just stand there and wait for your pitch to come. But that takes patience.
Alec: One thing that I’ve certainly learned—so this is our seventh year of doing the podcast, and we weren’t really investing before that—is that when I would read or hear an answer like that, I would often think patience requires me to wait, you know, decades perhaps for the right time to buy a company.
But even in just the seven years we’ve been doing this podcast, some of those big tech companies have had multiple points where they were good buying opportunities. Take Facebook, for example. They fell out of favor after the 2016 election because of all the political controversies. Then in 2020, there was the COVID dip, and in 2022-2023, the metaverse issues. There have been multiple instances, even in the last five or six years. So, it’s a reminder that you’ve got to be patient.
Prof Damodaran: In fact, I generalize that. There isn’t a single stock that stayed overvalued throughout its entire life. Ever. I can’t think of a single one. I’ve valued Amazon every year since 1997, and we’re talking about the very top-end stocks now, right?
You pick Amazon, you think of Google, you think of Facebook—these are the big winners. Each of those stocks had multiple points, not just one, where you could have bought them. I mean, I’ve bought Amazon five times in the last 26 years. I’ve sold it four times in that period—one less because I still own it right now.
But that’s because I track the company. I have my story for the company. I have my investment thesis and valuation for the company, and the market does whatever it does. It’s not in my control. That’s why I tell people, don’t get frustrated with what the market is doing. It’s going to do what it does. In fact, because the market is so volatile and unpredictable, you’re going to get your chances.
So, while you might complain about it doing crazy things on Nvidia and the upside, prepare for it to do crazy things on the downside—and there’s your chance. I know it’s difficult to be patient, and that’s why I said you’ve got to start by accepting that investing is about preserving and growing your wealth. Because the minute you say it’s about getting rich, you can tell me all you want that you’re going to be patient, but you will not be, right? Because you need to get there in a hurry.
You need to pick the next winner. You put the weight of the world on your shoulders. And when you do that, you’re going to make some bad choices because you’re essentially treating the market like a casino. You’ve got to hit that number, or it’s not going to pay off.
Alec: So, we’ve just spoken about the Magnificent Seven, which seems to be capturing everyone’s attention at the moment.
Let’s turn away from that. Is there any part of the market that you believe people aren’t paying enough attention to, that perhaps you’re looking at and getting excited about, but you think the rest of the market hasn’t caught up with yet?
Prof Damodaran: I think every part of the market has a clientele. People do pay attention, and even when it seems like nobody does, there are actually people who specialize in those segments. That’s all they do. In fact, the problem here is that people often get tunnel vision because they become so focused on a specific segment of the market. Then, they come to believe that the rest of the world is unfair to that segment, whether it’s real estate, utilities, or energy.
I think that’s dangerous. One of the things we need to do is step back and gain perspective. Look at the broad market.
Right now, the broad market is priced well. It’s not overly rich. In fact, I compute an equity risk premium for the entire market, and much of that pricing is coming from this top tier of companies. If you remove them from the mix, the market actually looks much more modestly priced. The big companies, because of their market cap, have a disproportionate weight and are carrying the market to new heights. But if you break down the rest of the market, it’s reflecting very much what you’d expect to see in a world with four percent interest rates and growth that looks reasonably good now that people are not as worried about a recession.
Alec: On the macro side of things, you can’t make a finance podcast in 2024 without talking about inflation and interest rates. So, we’ll ask that customary question. In particular, for the context of our conversation around valuation, how do you factor inflation, interest rates, and monetary policy into your thinking around valuation?
Prof Damodaran: I try not to, because in a sense, there’s nothing I can do about it. In investing and valuation, we spend so much time worrying about things—I call it taking the karmic push. There are things you don’t control in investing, and worrying about them is not going to make them go away. It is true that inflation has been a clear and present player in this game for the last three years.
The reason it’s so shocking for people is that we spent a decade with low and stable inflation. If you look at the history of inflation over the last 200 years, the last 10 years were the aberration. So, rather than thinking of these times as abnormal, maybe we need to recognize that the last decade was the abnormal period.
We’re reverting back to a more normal time. But since we’ve become spoiled, lazy, and sloppy because of that decade, it’s taking us a while to catch up. We’re in better shape with inflation than we were a year ago, but the problem with inflation is that it’s incredibly stubborn. It’s very difficult. I called it a genie in the bottle in 2021 when I wrote about it.
I said, look, there’s a genie in the bottle that wants to get out. So, even if you think inflation is transitory, treat it as permanent. Fix it quickly because once you let it out of the bottle, getting it back in is going to be difficult. But at that time, the Fed didn’t want to do anything. They talked about this being due to supply chains and COVID, and by then, it was too late.
Inflation was out of the bottle. I think at this stage, it’s still out of the bottle—maybe halfway squeezed back in—but it can change its mind.
Bryce: Well, Aswath, it’s been a really enjoyable conversation. Before we close out, if there’s one company that’s really exciting you from a valuation point of view at the moment, or a story that’s unfolding, what would that be?
Prof Damodaran: I mean, how can it not be NVIDIA, right? It’s become a microcosm for how the world will change over the next decade. I think people are overreacting in terms of giving it almost all of the credit for the AI business. The way to think about NVIDIA is similar to how I thought about Cisco during the dot-com boom.
Cisco provided the architecture that allowed us all to connect online. Now, it happened in the background, right? None of us went on Cisco.com. We went on AOL.com or Amazon.com, but all those sites rested on an architecture built with Cisco networking equipment. If you think about NVIDIA, very few of us are going to use its products directly. There might be an NVIDIA chip in your Mac or computer, but the reality is you’re not even aware of it. However, it is providing the architecture for everybody else to do their stuff. So in a sense, it is going to be the entry point into understanding how big this is going to get and who’s going to use it.
While I don’t like the way people are pushing up the pricing and assuming that all of the rewards are going to go to NVIDIA, I think, as a company, it’s going to become, just as Amazon.com became the poster child for the dot-com market, NVIDIA could very well become the poster child for how big this business is getting, how well they are doing, and who’s using these chips.
Bryce: Love it. Yeah, we’ll be watching.
Alec: Yes, we’ll be watching.
Bryce: Well, Aswath, thank you so much for your time this morning. I truly have really enjoyed this conversation. I’m sure many people in the EquityMates community have taken a lot of value from this as well. So, yeah, we really appreciate you taking the time.
Prof. Damodaran: You’re welcome.
Watch the full video interview of Equity Mates with Professor Aswath Damodaran here:
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