Equity analysis: post-Covid-19 Jedi guide to investing - Aswath Damodaran (Musings on Markets)

Damodaran has been teaching valuation since before universities called their courses “valuation”. He’s analyzed Uber and Heintz and Tesla in his blog and I’m sure some Wall St analysts have shamelessly taken his free spreadsheet models and ideas and made them their own. Some of y’all may find it interesting if you’re into the first principles kind of analysis.

Recently, he’s posted some good stuff that should help some of us understand the equity investing world better. There are even videos to accompany the posts. He’s obsessed with valuation and has been on Bloomberg and has advised large companies. A total legend:

  1. Data Update 1: A Reminder that equities are risky, in case you forgot!
  2. Data Update 2: The Message from Bond Markets
  3. Data Update 3: Playing the Numbers Game
  4. Data Update 4: The Many Faces of Risk
  5. Data Update 5: Of Hurdle Rates and Funding Costs!
  6. Data Update 6: Profitability and Value Creation!
  7. Data Update 7: Debt, neither poison nor nectar!
  8. Data Update 8: Dividends and Buybacks - Fact and Fiction!
  9. Data Update 9: Playing the Pricing Game!

A cool chart from his 1st post:

Some interesting charts from his debt article (think Aston Martin’s IPO):

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Best title ever still…

Prof Damodaran was the first guest on Prof Galloway’s new podcast: https://pod.link/profg - hear his thoughts on FAANG + Microsoft stocks, as well as Uber and Zoom, liquidity, debt, etc.

The most valued professor at NYU Stern business school has been teaching the people of the internet about valuation for free on YouTube and his blog.

Recently, he’s shared a lot of thoughts - backed by numbers - that make a lot of Wall St “experts” look like amateurs.

He hasn’t charged a penny for any of his free content.


Price versus Value
I have long drawn a distinction between price and value, two terms that get used interchangeably in both academia and practice, but with very different drivers and implications. As we watch stock indices around the world gain and lose trillions each day, it is worth remembering that markets are pricing mechanisms, not value mechanisms, or as Ben Graham would put it, they are voting machines, not weighting machines, at least in the short term.

The Drivers
To draw the contrast between price and value, I will use a picture that I have used many times before, where I outline the drivers of value and contrast them with the determinants of price:

Note that the drivers of value are cash flows, growth and risk, familiar ingredients in both intrinsic value and fundamental analysis. The determinants of price are both less complicated and more powerful, demand and supply, and all of the forces that drive them. While rational investors may use only fundamentals in setting demand and supply, we know, both from research and experience, that fundamentals are drowned out in markets, by mood and momentum. Markets have always been pricing games, with the degree of weight put on fundamentals ebbing and flowing over time, with less weight assigned in good times, and more after market corrections. During periods like the last three weeks, the market is all pricing all the time, with fundamentals not even on the radar. That does not make markets wrong, but it does make them difficult to decipher and tricky to navigate.

The Differences
If you accept the distinction between price and value that I have drawn, it can be used to draw out why price and value diverge, and frame investment philosophies around those divergences.

  1. Price has no upper or lower bound. Value does.
    Since price is determined by demand and supply, and there is nothing that constrains those buying and selling in markets, at least in the near term, it follows that there is no upper or lower bound to prices. In short, the prices of stocks can move towards infinity or towards zero, depending on where mood and momentum take them. Value on the other hand has both upper and lower bounds, with both bounds being set by expected cash flows, growth and risk. The upper bound is set by those who are more optimistic about a stock and what they forecast the fundamentals to be (high cash flows, high growth and low risk) and the lower bound by those who are most pessimistic about that same stock, in terms of future expectations or liquidation value. It is true that reasonable investors can disagree about where these bounds lie, but they should not disagree about the existence of these bounds. It is possible, for some stocks, especially early in the life cycle and with substantial uncertainty about the future, for the lower bound on value to be zero, but stocks collectively cannot have that lower bound. For equities collectively to be worth nothing, you would require an apocalyptic scenario, one in which there is little point thinking about investments anyway.

  2. Price is reactive, Value is proactive!
    Information is the lubricant for market movements, but information works differently in the pricing and value processes, on two dimensions:

    Incremental Information versus Fundamental Information: If pricing is driven by mood and momentum, those forces can take information that, at least at first sight, seems insignificant, from a value perspective, and cause price changes that are disproportional. Thus, when the mood is upbeat, small pieces of good news can result in big jumps in stock prices, but if that mood turns sour, small pieces of bad news can cause large drops in stock prices. To illustrate, the 10% plus drop in US stocks on Thursday (3/12) was supposedly caused by the Trump Administration’s decision to bar flights from Europe for thirty days, and the almost equivalent jump the next day (3/13) by its decision to declare an emergency.
    Reactive versus Proactive: Since pricing is determined entirely be demand and supply, and there is no value center to it, it is, by its very nature, reactive. Put simply, traders react to the incremental information to adjust the price, and put little thought into whether the starting price itself has a basis to it. Thus, a starting price that is too high (low) will only get higher (lower), if the incremental news that comes out is good (bad). On the other hand, value is driven by expectations of cash flows, growth and risk, and incremental information has to be used to reassess those expectations, a more difficult task, but one that forces you to separate the wheat from the chaff.

In periods of pricing tumult, like the last three weeks, it is both futile and perhaps counter productive to try to explain big pricing moves, especially on a day-to-day basis, with the language and tools of value. If I could make a suggestion to the financial news channels now, here is what it would be. Remove all the talking heads (including me) from the screen, and just show the stock indices in real time. This is a market that needs no commentary!

  1. Equity prices may never converge on value (at least in your lifetime or mine).
    Old time value investors live by the adage that prices can go up and down, with little relationship to value, but that they eventually converge on value. That sounds reasonable until you consider what “eventually” means, at least in the context of equity in a publicly traded company. Absent a catalyst causing the convergence, it is true that price will not only diverge from value in the short term, but it could do so for very long time periods. Put simply, assuming that you will be rewarded for being right on value can be a pipe dream, and Keynes was correct when he said that the “market can stay irrational longer than you and I can stay solvent”. So what is it that keeps investors toiling at the fundamentals, hoping to get rewarded? The answer is faith, faith that they can estimate value and faith that the price will adjust to value. It is faith because I can offer you no proof for either proposition, and it is faith, because its strength will be tested by markets like this one.

An Investing Game Plan
If you are wondering what all of this discussion of price and value has to do with how you should react to the market drop, I will argue that your response has to be tailored to (a) whether you have faith in investing (b) how much liquidity you have or need and © where you see yourself as having the biggest edge over the rest of the market.

Do you have faith?
In the abstract, most market participants describe themselves as long term, patient and believers in value. Books about Warren Buffett outnumber those sold about any other market player, by ten to one, but I think one of his pithier sayings comes to mind, when evaluating whether people mean what they say about being long term value investors. Buffett once said that it is only when the tide goes out that you can tell who’s been swimming naked, and it is only when the market goes into crisis mode that you can tell the investors from the traders. So, if you came into the February 2020, describing yourself as a believer in value, do you still believe? If yes, what have you done or not done during the last three weeks that is consistent with that faith? My faith in value and price adjusting to value is strong, but it is not absolute. I have found myself questioning my own beliefs at times during these weeks, just I did in 2008, and I believe that is not only natural, but healthy. My faith still holds, but I have a feeling that there are more tests to come.

Are you selling or buying liquidity?
There is no stronger resource to have during a crisis than a cash cushion, since investors seek out liquidity and are willing to pay handsomely for it. That said, whether you can buy or sell liquidity may not be in your control and is affected by outside forces:

Income Predictability: If you are feeling a little less secure about your income prospects after the last three weeks, you are not alone, and while this will pass, it does affect how much cash you need to conserve, just in case.
Cash Needs: Virus or no virus, house payments have to be made, credit card bills paid and unexpected costs covered, and a shakier economy make all of these obligations more onerous.
Personal make up: I believe that the key to picking an investment philosophy that is right for you is to make sure that you can pass the sleep test, with it. Put simply, if you lie awake at night thinking about your portfolio, you’ve failed the test. If you are naturally impatient, your time horizon is shortened, and no lecture on the importance of long term investing or data backing up that it works, can change that.

If you add mortality to this list, and the fact that if you manage other people’s money (in a mutual or hedge fund), it is their time horizon that may matter, not yours, it is easy to see why what is perceived as liquidity in good times very quickly dissipates in bad one. If you are sitting on a cash cushion, you are already in a much better spot than those who do not have that luxury, but there are two uses that you can put the cash to, one passive and other active. The passive response would be to hold on to the cash, preserve your sanity and pass the sleep test, as markets stay volatile. The active response is to use the cash to take positions, though what you will invest in will depend on whether you believe in value or price, and within each of these, where you think that market is mistaken. If you are in the less enviable position of needing cash quickly, either to meet a liquidity crunch or to stop failing the sleep test, you should sell some of your holdings, though what you sell will reflect again your beliefs about market mistakes.

What is your edge?
To succeed as an active market player, you have to bring something to the table, and recognizing the edge that you bring is key to success, and that is true whether you are an investor (who believes in value) or a trader (who plays the pricing game).

As an investor, your skills may lie in assessing the entire market, sectors or individual stocks, and this crisis has brought those all into sharper focus.
As a trader, you can be good at riding momentum or detecting shifts in it and making money from reversals, and the opportunities for both have expanded, as market volatility has expanded.

In either case, you will get an opportunity in the coming weeks to plot your own path through this crisis, and as I mentioned at the start of this post, it will not be one size fits all.

Choosing your Game Plan
In the picture below, I have outlined how your faith or its absence, liquidity or lack thereof and your perceived edge will all come into play in determining what is your best path of action.

I have never believed in offering investing frameworks, without being open about the choices that I am making, not because they are the “right” ones, but because they are the ones that work for me. I believe in value, and I am lucky enough to have liquidity. I believe that I can bring more to the table, when valuing individual stocks, than I can, in assessing sectors or markets.

What now?
I know that this post has meandered and I am sorry, but in this last section, I will come back to the numbers, by first updating my valuation of the S&P 500 and then moving on to both update the tables on market damage from March 6 to reflect the last week’s market action.

Valuing the Index
While some of you will view this as a futile exercise, I revisited my S&P 500 valuation spreadsheet that I created two weeks ago, and updated it, to reflect an expectation that the earnings damage this year is likely to be larger than I initially estimated. Rather than provide a single value estimate for the S&P 500, I have run a Monte Carlo simulation around the four key inputs: earnings drop this year, the percentage that will be recouped by 2025, the percent that will be returned as cash flows and the equity risk premium:

Note that on the earnings drop and subsequent recovery, I have used distributions with more downside surprises than upside, reflecting my belief that there is a chance of significantly greater damage than expected, albeit with small probabilities. The median value of 2750 is marginally higher than 2011, the level of the index on Friday, March 13, but this is not an investment for the faint of heart.

I have held back on individual stock valuations for the last two weeks, but I will start looking, and to help decide where to start, I created this very simple structure for thinking about what companies are most affected and least affected by the virus:

Using this framework, firms that sell non-discretionary products, are non-travel related, have low leverage (operating and financial) and are cash flow positive should be least affected by the virus, and discretionary product/service or travel-related companies with high fixed costs and debt, should be most affected. In the table below, I have updated both my sector and industry tables that I had posted last week, to reflect the additional damage from last week:

The ten industry groups that were affected most and least by the market turmoil are below:

Updating the regional tables to include the last week’s data:


I also rechecked the momentum and PE tables, and while every decile of each lost money last week, there was no discernible pattern in either. Finally, I broke firms down by debt ratio (as percent of total market value of the firm), to see if firms with more debt were being punished by the market more than less indebted firms, and see only a mild relationship. You can download all of this data by clicking on this link. Collectively, global equity markets have lost a staggering $18.65 trillion in market capitalization, with US stocks accounting for $7.6 trillion in those losses. Note that the market damage lines up well with our priors, which is what makes investing tricky. In fact, there are two perspectives that you can bring to surveying these stocks, leading to contradictory strategies.

If you believe that markets have over reacted, your best chance at finding value might be to look in the rubble, the worst affected regions, sectors and companies
If you think that markets have not fully incorporated the economic damage from the virus, you should look at the regions, sectors and companies that are more protected.

The first two stocks on my radar for in-depth intrinsic valuation are Zoom, one of the few stocks that has benefited from this crisis, and Boeing, a stock that has lost more than half of its market capitalization, as its high-leverage, travel-focused business is put to the test by this virus. Implicit in both these valuations will be my own views on the macro and timing effects of this virus, but that is something that I cannot avoid taking a point of view on. Stay tuned!

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Like Ricky Gervais said on Irishmen, this post is great, long, but great :slight_smile:

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“In good times and when valuing mature companies, we become lazy and forget that conventional valuation approaches, where you project cash flows as far as the eye can see and beyond, and discount them back at a risk adjusted discount rate, are designed for going concerns. These are not good times, and even mature companies are facing threats to survival.”

– Professor Aswath Damodaran (NYU Stern Business School)


Back to Basics

As with all of my viral update posts, I will end with a focus on the future and a return to fundamentals, by looking at how to value companies in the midst of a market and economic crisis unlike any in history. While many investors have put their valuation tools away, using the argument that there is too much uncertainty now to even try, I will argue that this is exactly the time to go back to basics and try valuing companies, uncertainty notwithstanding.

The Dark Side beckons…

If your concept of valuation is downloading last year’s financials for a company into a spread sheet and then using historical growth rates, with some mean reversion thrown in, to forecast future numbers, you are probably feeling lost right now, and with good reason. Specifically, the last six weeks have upended almost all of the assumptions, explicit and implicit, that justified this practice.

  1. Historical data may be recent, but it is already dated: For most companies globally, the most recent financial statements are for 2019, and in calendar time, these financials are only a few weeks old. As the global economy shuts down, though, the one thing we know with certainty is that the revenues and earnings numbers reported in those recent financial statements are almost useless, a reflection of a different economic setting. The same can be said about equity risk premiums and default spreads, as I am painfully aware, since the numbers that I updated on January 1, 2020, are so completely out of sync with where the market is today that I plan to do a full update at the end of today. (March 31, 2020).

  2. This year will deliver bad news: There is almost no doubt that 2020 will be a bad year for all companies, with the key questions being how much of a drop in revenues companies will see this year, and how this will translate into earnings shocks. It is true that there are a handful of companies, like Zoom, Slack and Instacart, to name just three, that may actually benefit from the global quarantine, but they are the exceptions.

  3. Survival has become a central question: The magnitude of the shock to corporate bottom lines and the speed with which it has happened has put companies at risk, leaving debt-burdened and young companies exposed to default and distress. While some of the largest may get help from governments to make it through this crisis, their smaller and lower-profile peers may have to shut down or let themselves be acquired.

  4. The post-virus economy will be different from the pre-crisis version: Every major crisis creates changes in business environment, regulations and business models that reshapes the economy and resets competitive games, setting the stage for new winners and losers. Thus, for some companies, the bad news on revenues and earnings this year may be a precursor to superior operating performance in the post-virus economy, as their competition fades

Put simply, this is not the time for purely mechanical number crunching and a blind trust in mean reversion, since the landscape has changed. It is also not a time to wring our hands, complain that there is too much uncertainty and argue that the fundamentals don’t matter. If you do so, you will be drawn to the dark side of investing, where fundamentals don’t matter (paradigm shifts, anyone?), new pricing metrics get invented and you are at the mercy of mood and momentum. Ironically, it is precisely at times like these that you need to go back to basics.

A Jedi Guide to Valuation
With these lessons in mind, I decided to revisit my basic valuation model, which has always been built around fundamentals:

While the fundamentals remain the same, I considered how best to incorporate the effects of this crisis into the model and arrived at the following:

Note that this post-Corona valuation model stays true to the fundamentals but introduces three crisis-specific inputs into the valuation:

  1. Revenue Change & Operating Margin in 2020: These are the inputs that will reflect the effects of the global economic shut down on your company’s revenues and operating margin in the next 12 months. For companies close to the center of the viral storm (travel-related companies, people-intensive businesses and producers of discretionary products), the revenue decline this year will be large and they will almost certainly lose money. (See my third viral market update for a way of visualizing this damage)

  2. Expected Revenue Growth in 2021-2025 and Target Operating Margin: If you feel drained from having to estimate the 2020 number, I don’t blame you, but the more forward-looking part of this valuation is estimating how your company will fare in the post-virus economy (assuming it does not fail). For some companies, like cruise liners, the answers will be depressing, because the sights of large cruise ships stranded on the high seas, and acting as Petri dishes for spreading diseases will linger, but other companies will find themselves in a stronger position in the post-viral economy, partly because of their product offerings but also because of their financial strengths. In the tales told about Amazon, people often forget how much its current stature and success is due to the dot com bust (not the boom) of 2001, which wiped out their online competitors and handicapped their brick-and-mortar competitors.

  3. Failure probability and consequences: In good times and when valuing mature companies, we become lazy and forget that conventional valuation approaches, where you project cash flows as far as the eye can see and beyond, and discount them back at a risk adjusted discount rate, are designed for going concerns. These are not good times, and even mature companies are facing threats to survival. It is almost impossible to adjust for this concern in discount rates and it is therefore imperative that you make judgments about the likelihood that your company will not make it, and this probability will be higher for smaller companies, young companies and more indebted companies. Even with large companies that may be recipients of bail outs, because they are too big to fail, your equity may go to zero, if that is one of the conditions of the bailout (as was the case in the 2009 GM bailout).


Looking Past the Crisis

In one on my first posts on this viral market crisis, I mentioned that the first casualty in a crisis is perspective. As you get deeper and deeper into the specifics of the crisis, you will find yourself not only getting bogged down in numbers, and in despair. I have had moments in the last few weeks, when I have had to force myself to step back from the abyss, think about a post-virus world and to reclaim the initiative as an investor. If you are a pessimist, you may view this as being in denial about what you see as an economic catastrophe that is about to unfold, but I am a natural optimist, and I believe that this too shall pass!

The Economy

There is no disagreement that the virus will cause the economy to go into a deep recession, since commerce is effectively shut down for at least a few weeks. During that period, economic indicators such as unemployment claims and measures of economic activity will hit levels not seen before, bur that should come as no surprise, given how large and broadly based the shock thas been. There are two questions, though, where there can be disagreement.

  • How quickly will the global economy come back from the shut down, and when it does how completely will it recover?

  • How much permanent change will be created by this crisis in terms of both consumer (and investor) behavior and economic structure?

There are some who are more optimistic than others, arguing that once the viral fears disappear, there will be a return to business as usual for most parts of the global economy, stretched out over months rather than years, and that the changes to consumer behavior and economic structure will be small. At the other end, there are many more who feel that economies take time, measured in many years,to recover from shocks of this magnitude and also that there will be significant changes in consumer behavior and economic structure in the making.

Investment Strategies

Your views on the economy, both in terms of how quickly it will come back from this shock and how much change you see in economic structure, will determine your next steps in investing. If you believe that recovery will be quicker and with less structural change, there are two strategies you can adopt.

  • Bargain Basement: In this strategy, you focus on stocks that have been pounded in the last few weeks, losing 50% or more of market value, but which have the ingredients that you believe will allow them to survive, perhaps stronger, in the post-virus economy. Key among these ingredients will be low net debt ratios (Net Debt to EBITDA less than one) and pre-virus operating margins that were solid enough to take the hit from the crisis. To the extent that survival until the turnaround occurs is key, you may also keep your search restricted to larger market cap companies.

  • Distressed Equity: There is a more risky strategy you can adopt, where you also look for stocks that have seen a significant loss in value over the last five weeks, but focus on the most endangered of these, with high net debt and fixed costs. You are effectively buying options, with some already out-of-the-money, and as with any strategy built around doing that, you will see a significant number of your investments go to zero. The payoff from this strategy comes the companies that make it back to life, with equity values increasing by enough to cover your losses. At first sight, the airlines and Boeing meet these criteria, but there is a catch, insofar as they are large enough to be targeted for government bailouts, which are a mixed blessing, since they allow companies to survive, while wiping out or severely constraining equity claims. Thus, smaller companies that have to make it through on their own may be better candidates for this strategy than companies that are too big to fail, that attract large bailouts.

If you are more pessimistic about economic recovery, both in terms of its length and strength, and believe that the recovery will restructure the economy and how companies operate in many businesses, there are two strategies that you may find work for you:

  • Safety at a Reasonable Price (SARP): Here, you focus on companies that are best positioned to not just survive a long downturn, but have the ammunition to make it work to their advantage. Large market cap firms with low debt ratios and high cash balances, that had high growth and profit margins in the pre-virus economy, would be good candidates. Facebook, Alphabet, Apple and Microsoft, for instance, clearly fit these criteria, but since these companies are already sought after in a market where safety is rare and highly valued, you should add pricing screens that allow you to get them at reasonable prices.

  • Change Agents: This is as much a bet on changes in consumer behavior and economic structure as it is on individual companies. Thus, if you believe that this crisis will make people more comfortable with delivery services for a wider range of goods and online interaction (in business and education), you could seek out companies that are innovators in these spaces. Again, the highest profile players, like Zoom, may be priced out of your reach, but there are others like Chegg that may meet your criteria.

The picture below summarizes the four strategies:

My views on the economy are mixed. I do think that the global economy will come back, but it will take more than a few months, and there will be structural changes in some sectors. I ran screens for all of the strategies, other than the Change Agents strategy (which is less about screening, and more about detecting macro trends), across all publicly traded stocks (about 40,000+) on March 20, 2020. As I look at the companies that go through the screens, I realize that there is more work to be done and better screens that can be devised, but think of it as work in progress, and if you have access to a large database, try your own.