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Díaz Alain

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Aswath Damodaran's Seven Myths Of Value

Aswath Damodaran is the Professor of Finance at the Stern School of Business at New York University and is one of the top professors in the school of value investing.

Investors of all experiences can learn a lot from Damodaran’s teachings on value, valuation, and corporate finance. And if you’re interested in learning more, head over ValueWalk’s Aswath Damodaran resource page, which has a selection of his work and authored books.

In this article, I’m covering Aswath Damodaran’s seven myths of value investing, as presented in his presentation, “Where is the “value” in value investing?”, which can be found in full here.

Three faces

Damodaran starts his presentation by covering the three faces of value investing:

1) The Passive Screeners: Investors that take a passive approach to investing, screening the market according to a set of value criteria, buying and holding.

2) Contrarian Investors: Investors that take an active approach, investing in those companies that have fallen out of favor with the market, either because they have/are doing badly, there’s some kind of legal/financial overhang, or their future prospects look bleak.

3) Activist Value Investors: Those investors that take a stake in undervalued companies and push for change. Carl Icahn and Warren Buffett in his early days are key examples.

Then, Damodaran moves on to the three biggest R’s of value investing. These are Rigidity, Righteousness, and Ritualistic. Simply put, these three R’s describe value investors’ emphasis on the same rigid strategies, belief that they are better than everyone else and ritual of reading Ben Graham’s Security Analysis and every Berkshire Hathaway annual report.

Value myth 1

Damodaran’s first myth of value investing is: DCF valuation is an academic exercise.

DCF has become an essential part of calculating intrinsic value for value investors today. (Unlike the value investors of yesteryear, such as Walter Schloss, Ben Graham, Peter Cundill and the Superinvestors of Graham-and-Doddsville who relied upon asset values). But while intrinsic value and DCF calculations have become an essential part of value investing, they have several key flaws.

Damodaran notes three key specific defects. Firstly, if “it”, which, in this case, refers to any factor that may impact the company, does not affect cash flows or alter risk, “it” cannot affect value.

Secondly, for an asset to have value, the expected cash flows have to be positive at some time point the life of the asset.

And lastly: “Assets that generate cash flows early in their life will be worth more than assets that generate cash flows later; the latter may, however, have greater growth and higher cash flows to compensate.”

These are all key issues that could affect the value of the business, but not alter DCF calculations.

Value myth 2

Damodaran’s second myth of value investing is as follows: Beta is greek from geeks…and essential to DCF valuation.

Damodaran picks up to other key points here. Firstly: “The need for diversification does not decrease just because you are a value investor who picks stocks with much research and care.” And secondly: “You can be a good value investor, and your picks can still lose money.”

Value myth number three: The “Margin of Safety” is an alternative to beta and works better.

The margin of safety principle, pioneered by Benjamin Graham has become an essential part of value investing. However, as Damodaran notes, the margin of safety should not be a substitute for risk assessment and intrinsic valuation. Finding a margin of safety could come into play at the end of an investment process, it should be flexible (not a fixed number) to reflect the uncertainties of intrinsic value calculation, and the margin of safety should not be overly conservative.

Value myth number four: Good management = Low Risk.

Sound management teams don’t always guarantee outperformance. In the words of Warren Buffett:

“I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.”

Value myth five: Wide moats = Good investments

Moat investing is another key principle of value investing. Companies with wide moats can achieve higher returns on capital, generate more cash for shareholders and will generally outperform non-moat businesses. However, there are two points that investors need to consider with growth investing, and both muddy the water.

Moats matter more for growth companies than mature companies. Wide moats increase company value, although the value increase is proportional to growth at these companies.

Stock returns don’t depend on moats alone but the width of the moat and the rate at which the size of the moat is shrinking/growing. Companies with wide moats can be bad investments if the moat shrinks. While companies with small moats can be good investments if the moat widens. Moreover, companies with no moats can be great investments if a moat stars to appear.

Value myth six: Intrinsic value is stable and unchangeable.

Damodaran notes that there is a belief amongst investors that intrinsic value is a stable, unchanging value. Investors buy and hold, never visiting the intrinsic valuation. Investors view the market as the volatile component in the equation. Multiple factors change almost every day that need to be reflected in an intrinsic value calculation. These include management changes (which can have an effect on reinvestment rates and the return on capital), fluctuating cost of capital and restructuring to improve margins or returns on capital.

And finally myth #7 is

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