Interview With Prof.

Aswath Damodaran
Related Issue: September 2005 By Tom Gardner August 25, 2005 Tom Gardner: Welcome, Dr. Aswath Damodaran. Thanks for sitting down with us. I wanted to start with an early quote from your book Investment Fables in which you advise your reader, "This is not a book for pessimists who are convinced that picking stocks is an exercise in futility." That's an unusual stance for an academic to take! Aren't all business-school professors convinced that the market can't be beaten, and that there's no sense in trying? Aswath Damodaran: Tom, I'm an optimist by nature. I think every game can be won. This is a very tough game to win. I think it requires a lot of homework. It requires persistence. It requires that you understand yourself best before you start investing. Because if you look at the mistakes that people make in investing it's usually because they rely on a strategy or a philosophy that doesn't fit their strengths and weaknesses. So I think there are enough openings in the market that somebody who really understands what they're doing and knows their strengths and weaknesses can take advantage of those openings. Tom Gardner: What about the investor who is not quantitative by nature, someone for whom numbers are intimidating, do you believe there's a qualitative angle that one can master, leading to market-beating investing? Aswath Damodaran: I think a great deal of investment analysis is qualitative. I think we use numbers as a way of creating a framework for our qualitative thinking. At the same time, I would caution anybody who truly hates numbers that investing is probably not for them because it is very difficult to think about investing without at least dealing with basic calculations. Tom Gardner: You write about the danger of relying purely on stories when investing. David and I have often joked that America's greatest storytellers and marketers are the CEOs of tiny pink-sheet stocks. Big dreams, tiny realities. In

your writing, you wave the red flag for investors, warning them against buying story stocks. Aswath Damodaran: I think this really cuts to human nature. It is far easier to sell an investment with a story than it is to sell an investment with numbers, so even the most quantitative equity research report ultimately is a story being spun. Having said that, I have nothing against stories, per se, I just think that stories need to be followed through on. In other words, if there is a story, there are usually two or three questions you need to ask about that story before that story can be used to draw a lesson. My problem with a lot of selling is people start to tell the story, but they don't give you a chance to even listen to the whole tale. They want to sell you something before you get a chance to react to it. So the reason I wrote Investment Fables was I said, "Let's think about these stories. There must be something in them to give them the persistence that they have. Because if you go back 70 years, you'll find the same stories being told. I'm sure variations on these themes have been around for as long as you've had investments. 700 years probably. So there must be something in these stories that cuts to human nature that attracts people to them." But within each of these stories is also the kernel of why they often don't lead to great investments. The story makes a lot of sense, sure. You buy the stock and then a couple of years later you look at the stock and say, "Wait, I didn't make any money on the stock. It sounded so good. What happened?" The reason I wrote Investment Fables was to look at the underbelly of these stories. What could potentially go wrong? Not so much to debunk these stories because I think there is truth to many of them. But to understand them, and to kind of fine tune these stories so we can use them in a productive way in our investment choices. Tom Gardner: I want to go through a few of those stories but before I do, I'd like to focus on an individual company for the fun of it. We'll put the theories into action to start. There are so many people out there who have walked into a Krispy Kreme (NYSE: KKD), ordered a doughnut, and observed a ton of people

in line. They remember driving to work when that Krispy Kreme was opening up in their neighborhood, and they saw 50 cars waiting that first day. There was tremendous enthusiasm for a business that was popular and decades old. What was missed in the story by investors who bought the qualitative story and now see their stock down 80%? Aswath Damodaran: There are two things I think we miss when we buy a stock on a story, looking at how well the company seems to be doing. The first is that the market sees everything you are seeing as well. You are not the only person driving by Krispy Kreme seeing 50 people standing outside. Equity research analysts in New York see that, put out a buy recommendation on the stock, which pushes up the stock price. The way I would describe it is you can get a great company at a terrible price, in which case it becomes a terrible investment. You don't want that. Also, you can get an awful company at a great price. So that is part of the reason I think the story is only half of the investment idea. You have to look at the price you pay for the story. The other interesting aspect of Krispy Kreme is it also points to the danger of prosperity because not only are you and other people looking at Krispy Kreme's success as a harbinger of a good investment, you are seeing other people look at it and say, "Hey, I can make money selling doughnuts too." Unlike a business where there are solid barriers to entry, it is difficult to see how if you are successful, you keep other people from selling doughnuts coated in sugar or whatever makes Krispy Kreme doughnuts extra special. So this is, I think, one of those cases where you have got to ask yourself, "What will happen if they succeed? How do they keep the rest of the world out?" Because when you pay a high price for the stock, you are not just paying for high earnings now, you are paying for high earnings in the long term. You are paying for a competitive advantage that is going to be here this year, next year and ten years from now. That was always the missing piece in Krispy Kreme. Even without the accounting irregularities, that is what would have worried me about paying the high price for

Krispy Kreme. There is no obvious way to keep the competition out. You can't patent a doughnut. Tom Gardner: I want to go through the philosophies you present in Investment Fables and have you elaborate on them for us. We will start with low price-toearning (P/E) ratios. When are low multiples attractive? When aren't they? Aswath Damodaran: Let me start with when they aren't because that'll help me answer when they are. Low P/E stocks are not attractive if they come with low growth and high risk. Part of the reason some stocks trade down at five times earnings is because the growth potential is gone and/or the earnings are very volatile. Low P/E stocks of that variety are not interesting to me. The flipside of that is that a low P/E stock can be attractive if it comes with reasonable growth. I'm not expecting 30,40, 50% annual growth. Just reasonable growth and fairly low risk. In fact, those are the three factors that stand behind every investment. There are cash flows, there is growth, and there is risk. What you're looking for when you look for something cheap is something that looks good on all three dimensions or at least as good as you can get it to be, given the relative investments. Tom Gardner: High-dividend yields. When are they attractive, when aren't they? Aswath Damodaran: High dividend-yield stocks are attractive if you can expect the company to keep paying those dividends. One of the ways to think about a high dividend-yield stock is that you are really buying something like a bond. When you buy a bond, you get those big coupons, but you don't get price appreciation. A lot of people buy high dividend-yield stocks thinking they have hit the jackpot because they get the dividends, just like coupons, and they get the price appreciation as well. The difference, though, is dividends are not legally guaranteed. On a bond, you essentially get a coupon and that coupon has to be paid by the company. Dividends are expectations. If a company is paying out more than it can afford to in dividends, it might have a high dividend-yield number, but you can almost

predict that those dividends will have to get cut two years, three years, four years down the road. So high dividend-yield stocks, the thing I would probably look for the most is are there the cash flows to justify paying the dividends or is this company overreaching? Is it borrowing money to pay dividends? Is it selling assets to pay dividends? Because those are not sustainable ways of keeping dividends high. Tom Gardner: High earnings growth rates. When are they attractive? When aren't they? Aswath Damodaran: I think this goes back to the Krispy Kreme example. High earnings growth is attractive if it is sustainable. And for earnings growth to be sustainable, there has to be something in place to keep the competition out. At the risk of naming another stock, this is what troubles me with a company like Google (Nasdaq: GOOG). Google is a great company. It has got great management and a great business model. But the question I have got to ask myself is if they keep growing the way they are, how do they keep the rest of the world out? How do they keep Microsoft from entering in and creating its own search engine and trying to get a portion of revenues? So earnings growth is desirable if you find ways of protecting that earnings growth and sustaining it, but it can pass very quickly if there is not a competitive advantage you can hold onto. Tom Gardner: Aswath, while they are very critical, competitive advantages are also tough to define. I look back a dozen years and have to think that few would have thought Starbucks could have any meaningful competitive advantage. Yet with all its growth, there is no meaningful competition to Starbucks today. Can you give us an example of a sustainable competitive advantage? Aswath Damodaran: I'll give you my favorite example, and this is an oldfashioned one. Consumer brandnames. The reason I think consumer brandnames create sustainable growth, and you can look at companies like Coca-Cola which have been able to milk a brandname for decades of growth, is nobody is quite sure how you create a valuable brandname. It is not just throwing advertising money at it because there are companies that throw billions of dollars

at advertising and have nothing to show for it. At the other extreme, you have companies that spend nothing and have these incredible brand names. Being at the right place at the right time. So if you have a brand name, or if you have acquired a brand name over time, it is very difficult for an outsider to come in and recreate a new brand name or try to take revenues away from you. The reason for that is whatever makes a brand name valuable is very difficult to put together. Another very simple example of a competitive advantage is if you can get the government to step in and protect you against competition. That's effectively what happens with a patent, with a trademark. It is every company's dream. It is not always protectable from competition but this way of keeping the competition out comes with an enforcement mechanism to back it up. Tom Gardner: Next up, very well-run companies. When are they attractive, when are they not? Aswath Damodaran: Very well-run companies are attractive when you are the only people who can see that they are very well run. Very well-run companies are not such a good deal when everybody thinks they are very well run. In fact, I think one of the riskiest investments you can make is to buy into a company where everybody thinks the company is superbly run. Because if it is very well run and every owns the stock already, a negative surprise in the business can pummel the stock. In fact, the best investment to make might be in a company where everybody is convinced the company is run terribly because then all they have to do is walk and chew gum at the same time and the market is incredibly surprised when things go right. It is a positive surprise. So if you uncover the very well run part of it with your own research, it is not common knowledge, then jump in, buy the stock. It is going to be a good investment. Tom Gardner: Next up, in the book you write about the 35 worst-performing stocks of the last year. So, when are they attractive and when aren't they? Aswath Damodaran: This is the ultimate contrarian strategy, right? The stock has gone down so much, it can't go down any more. I think the first thing I would do

with the 35 worst performers is I wouldn't touch any of them that trade at less than $2 or $3 per share. It's amazing how many stocks, if you look at the worstperforming stocks of the last year, end up at $2 or $3 levels. The transaction costs at those levels are horrendous. I'm not talking about the brokerage fees but the bid-ask spreads, the price impact it can have, even if you are a mid-sized investor. What about the rest of them? They're good investments if the reason for the stock price decline is behind them. Whether it was a bad strike, a product that went bad, a lawsuit settled against them, you want problems that have been set to rest. You don't want problems that are ongoing problems. In fact, one thing I would look for is a catalyst of some sort that suggests that this company is going to be run differently in the future. An example would be Hewlett-Packard. When you have a change in top management, for better or for worse, you have a chance of changing the way the company is run. So in addition to a price drop, you are also looking for something that tells you that the worst is behind you. That's very important because sometimes you can buy a stock that has gone down a lot and it just keeps going down. Tom Gardner: In two of your books that I've read, Investment Fables and Investment Philosophies, you cite the study which shows that had you bought last year's 35 worst-performing stocks and held the group for five years, you'd average a very substantial outperformance of the market's average. However, for those who hold a year or less, it's not a great approach to take. So it rewards the value investor that is patient. The impatient value investor could be hurt by that approach. Right? Aswath Damodaran: Just as companies have competitive advantages, investors can, too. Sometimes when I talk to small investors, one of the first things they ask me is, "How am I going to have a competitive advantage against a Fidelity or a State Street?" I tell them that they have a very big competitive advantage. A Fidelity or a State Street can't afford to hold onto stocks for five years. They have too many competitive pressures forcing them to be much more short term.

You or I own our own portfolios. We can buy and hold with two constraints. One is liquidity, obviously. The other is you have got to get your spouse to agree to whatever you bought. But those are surmountable, right! So I think small investors have a huge advantage. And, Tom, you are absolutely right about patience, and that is not just on last year's loser stocks. Value investing strategies in general, I think, require long time horizons. That's why all these studies find that over time low P/E stocks do better than the market, as do low price-to-book stocks and stocks with high dividend yields. The cautionary note that I would add in all of these studies is exactly that you must have a long time horizon: four years, five years, seven years. These studies are not true, they fall apart if you have a six-month or a one-year time horizon. Tom Gardner: To the next factor you've written about: "strong buy" recommendations from Wall Street analysts. When are they attractive, when aren't they attractive? Aswath Damodaran: Well, I think the first thing I would look for is whether they are actually putting their money behind their buy recommendations. But, obviously, I think strong buy recommendations on Wall Street are attractive in the short term because you get this critical mass kind of feeding on itself, an immediate inflow of clients from the firm buying the stock. As long-term investments, I'm not sure they're ever attractive because in a sense you will be jumping onto the bandwagon a little too late. By the time equity research analysts decide that something is a strong buy, it's probably three years too late. In general, analysts reflect on what has happened in the market more than what they expect to happen in the future. Tom Gardner: Just a few more of these because I figure this could tire you out. But they're great lessons for investors to learn. So I'm going to toss three more at you. Aswath Damodaran: (Laughing) OK. Tom Gardner: Very low institutional ownership. When is that attractive, when is that not attractive?

Aswath Damodaran: It's attractive if you can do your own homework, if you do your research, because the upside of having low institutional ownership is there are relatively few analysts following. Analysts tend to follow stocks that have high institutional ownership. That means if you have low institutional ownership, you're more likely to be surprised in either direction. You're much more likely to get big news stories that nobody saw coming, which is a good thing actually if you do your research. Big news stories can move underfollowed stocks dramatically but the move isn't instantaneous as it is with very actively followed companies. Now these are not good investments if you just pick stocks with low institutional ownership based on gut feeling or because of what you read in The Wall Street

Journal. So I think low institutional ownership is usually an indication that stocks

are more likely to be mispriced, but it doesn't tell you which direction they are going to be mispriced. That's where you need to do extra research. But certainly great small companies with low institutional ownership can be very large winners for patient investors. Tom Gardner: High levels of long-term debt. When is that attractive, when is that not attractive? Aswath Damodaran: It's difficult to imagine a high-debt-ratio company being an attractive investment, with one caveat, which is that when the market thinks that a company is going to go under and prices it as such, if there is any chance of a turnaround of the debt being paid off and replaced with equity that company very quickly could become a valuable company. This is especially true if the company doesn't have operating problems. If the problems are purely financial leverage problems, and operations are getting stronger, this is actually a fixable problem. You just have to restructure your debt and replace it with equity. Easier said than done, but it can be done much more quickly than with a company that has operating problems. So if the high leverage is causing a problem, not because the operations are bad but because a company borrowed too much money, then the market's punishment of the equity of the company may be a real opportunity for new

investors. I can see an opening there. If this company can get restructured, then I think it can be a good investment. But this is a bit of a risky approach. Tom Gardner: Our final factor for today: a spin off. When is a spinoff attractive, when is it not attractive? Aswath Damodaran: A spinoff is attractive when it is done under duress. When a company has to spin something off at a bargain price either because it needs the cash or because it is legally required to spin off the company. So in those scenarios, you often get the spinoff at a bargain price because the company hasn't had the time to structure it right and spin it off right. Spinoffs can be unattractive if companies are using it as a way of exploiting market inefficiencies. An example I can think of comes in the late 1990s. Companies taking their online unit as tracking stocks. The New York Times created a tracking stock, spinning off its own online units. The firm did this not so much because these online units were worth more separately, but because they were trying to take advantage of what they thought was the market overpricing these units. Those are the spin offs I would avoid. I would probably buy the parent company after it spun these units off. Tom Gardner: I want to talk a little bit about your investment philosophy before moving into valuation. What is your opinion of diversification in a stock portfolio? Aswath Damodaran: I think everybody should diversify. I think that is independent of the way you should pick stocks. I think a lot of investors think of diversification and picking stocks as mutually exclusive. They are right if you think of diversification as complete and total diversification. But I think you can have your cake and eat it too. I think you can pick stocks based on whatever investing philosophy you have. All that diversification is saying is to spread your bets. Don't buy seven chemical companies as your stocks. So I think diversification is imperative in any investment strategy. Tom Gardner: What is your opinion of regular dollar cost averaging into your holdings?

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Aswath Damodaran: I think it is crazy. I think that throwing good money after bad seems to be a recipe for disaster. Unless you have some very strong reason to believe that your initial valuation of this stock was completely right and can never be wrong, I think it is dangerous to then go around essentially following it up with more and more money after the initial investment was made. Tom Gardner: Wow. I'm surprised by that answer, Aswath. Let me put those two together -- diversification and dollar-cost averaging -- and play devil's advocate for the fun of it. Aswath Damodaran: OK. Tom Gardner: Let's say I am managing a diversified portfolio and each month I put new money to work within that portfolio. Let's say I own 15 different stocks. To the best of my abilities, I then each month put new money in and try to pick the most attractive of the 15. I repeat this over and over again, adding to 15 core positions in my portfolio when they appear to be priced optimally for long-term investment success. Aswath Damodaran: Right. Tom Gardner: Is that a useful way to think about investing, to put money in each month and buy the best of what you've already got? Aswath Damodaran: I think it is useful to keep adding to portfolios. I am not sure whether I would stay with the 15. In a sense, I think that if your portfolio is growing, then I would like to see the number of stocks in it grow as well. So if you have a way of picking stocks that works, I don't see why it stopped working at 15. That seems to me a very restrictive investment strategy. We are able to find only 15 stocks out of the 9,000 traded that met your screen? I guess if you have such a strict screen that only 15 make it through, then I have no problem with your adding to those 15, but to me that is not blind dollar cost averaging. You are revaluing every stock in your portfolio every time you have new money coming in and saying this is where I want my new money to go. You are using your mind rather than thoughtlessly plowing new money into old positions. That's the reason

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I objected to dollar cost averaging above. Intelligent reinvestment, sure, that makes a great deal of sense. Tom Gardner: Aha! I understand your earlier complaint. That makes perfect sense now. Aswath, what is your opinion of beta as a measure of risk? Aswath Damodaran: I think measures of risk in portfolios are vastly overrated because if you are looking at a portfolio, you are no longer really focusing on individual companies and how risky they are. You are looking at the overall riskiness of your portfolio, which is a very different question than is asking how risky Cisco is as a company. I think betas are useful for a simple reason: they state risk in relative terms. I think one of the problems with risk is it is ultimately in your gut. That's not an objective measure, right? You say something is now risky because after you bought it, the stock falls, and you now want to call it risky. So what I like about beta is that it's numerical and objective. It replaces that gut feeling you have and tells you how risky this stock is relative to other stocks. But from both a valuation perspective and from an investment management perspective, I think beta should be way down on the list of things that you think about when you think about adding a stock to your portfolio. Beta measures stock-price volatility relative to all other stocks. It does not speak to the quality of the underlying business. Tom Gardner: Aswath, one of the things that you wrote about in Investment Philosophies that I believe in very much well, I'll phrase it a little bit differently than you did. I'll make an outrageous positioning statement to see if you agree. One of the most underrated factors in investment performance returns is the after-tax returns. The tax drag on returns is under-reported by mutual funds and the same is happening with money managers and brokers. You are not really seeing your after-tax gains very clearly. This practice excuses very active trading, making professionals who trade accounts actively look far better than they are. I wonder what would happen if there were a very public scorecard of all professional investors, forcing them to report their after-tax returns?

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Aswath Damodaran: I agree entirely. Maybe if you had a withholding tax on your investment income you would realize very quickly how much of your income is being lost to taxes. I think when I look at these mutual funds that have 300% turnover ratios, my first reaction is the only way you get away with this is because you report pre-tax returns. Because if you reported after-tax returns, your clients would be horrified. Tom Gardner: Your customers would never stop throwing up. Aswath Damodaran: (Laughing) Exactly. I think the requirements that after-tax returns be reported by mutual funds is an important one because I think the pretax return is a very misleading number to most investors. Tom Gardner: Next, a two-part question. What is your opinion of the dividend and capital gains tax laws presently in the U.S.? And I'd like to know what you think of our laws relative to those in foreign markets, since your work takes you all over the world. Aswath Damodaran: There are a lot of markets where neither dividends nor capital gains are taxed. I mean in fact there are some markets where investment income is viewed as essentially income made on your savings and essentially therefore exempt from taxes. Having said that, I don't think that's going to happen in the US. But I do think that the existing law of having the same tax rate on dividends and capital gains is the sane one. That's because by having different tax rates on dividends and capital gains, we were skewing what companies did. We were encouraging companies like Microsoft to hold back cash that could have been at play in the market in some other company. So I think the negative implications of treating dividends and capital gains differently from both a corporate finance and evaluation perspective vastly outweighed any social benefits you might have gained by having those different tax rates. So I think it is a welcome respite for us to have the same tax rate on dividends and capital gains at long last. I'm not certain that will last, though.

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Tom Gardner: Aswath, what do you think of technical analysis. You have written about it. Did you conclude that there was anything meaningful or is it all essentially a me-too effect? Aswath Damodaran: I actually think there is some basis to it. There is some momentum in prices and there is some price reversal and a good technical analyst is probably trying to catch those. Both the momentum and the reversal effects tend to be very small, though. So, here's the rub. If you are making money trading on technical analysis, you are making very small amounts of money on each trade. So your transaction costs better be really small if you want to walk away with profit at the end. And your taxes are going to be high. The problem, I think, with technical analysis is it is addictive. Once you start trading on these patterns, you can't stop. So even though you might have a mechanism that says I shouldn't be trading this much, at the end of the year when you look back, you say, "I wish I hadn't done that." So my fear with technical analysis is not that it cannot be used but that it gets overused once it starts entering your investment strategy. Tom Gardner: You probably have a similar feeling about options trading, even of the conservative kind. You'd say that, sure, maybe there are ways to hedge your portfolio with options, but it might become somewhat addictive and end up delivering high frictional costs. Aswath Damodaran: Yes, I think options are difficult because you get to play such large amounts with small amounts of money. There is a temptation again to overreach, to do things that are really much, much larger than your portfolio can take in terms of taking on risks. Tom Gardner: Aswath, do you think anyone can time the market, successfully and consistently? Aswath Damodaran: There are people who claim to, but I have looked at history and I can't think of many true winners. I mean, I can think of stock pickers over time who have made a fortune regularly picking stocks: the Warren Buffets, the

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Peter Lynches, et cetera. But I can't put my finger on any one investor who has been a good market timer over the long term. The way I would describe market timers is to think of them as being like comets. They have flashes of brilliance. You have a year in which somebody timed the market and he is in the news. But if you track the yearly winners for a couple of years after, like comets they seem to burn out. Whatever made them successful in the first place causes them to burn out very quickly. Tom Gardner: In your work, I love your opinion of companies that make a lot of acquisitions, particularly those companies with a high-profile, charismatic CEO. Can you talk about the concerns that you have that surround those investment opportunities? Aswath Damodaran: I think the combination of an imperial CEO, a CEO who basically is not answerable to anybody, alongside an investment banker with an incentive structure to facilitate that CEO's addiction for power, can lead to complete disaster. If fact, I have a presentation on my website called Acquirer's Anonymous: Seven Steps to Sobriety, which I designed for CEOs and CFOs of companies that are serial acquirers. It essentially lists out seven common mistakes that get made in valuing assets to be acquired. At the end of the seventh mistake, I ask people if they agree that this stuff is pretty obvious. We're not talking about brain surgery or rocket science. We're not talking about some difficult concept to understand. They say, "Aswath, you are right. These should be easy to catch. How come we don't catch them in advance?" I think that reflects the problem! There is something addictive about acquisitions. With many of these deals, the deal ends up driving the process. After a while, getting the deal done becomes the objective of the process rather than getting a good deal done. So I am always wary when a company I have invested in turns around and says we are going to embark on an acquisition strategy because we want to grow faster. It seems to me to be violating a lesson you are taught when you are very young. If somebody else builds something up and you pay for it, you are going to

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pay a premium for it. That's effectively what undercuts these strategies, particularly when a company buys other public companies. They have to pay a market price plus. Tom Gardner: So that might not be true -- and you have written about this -- for companies that buy a number of small, private companies or maybe obscure public companies. Aswath Damodaran: And we have had some very successful companies built up by buying private businesses. One of the more morbid examples I can think of is Service Industries, which was built up by buying funeral homes around the country. It essentially became a very successful company because it went to mom and pop operators and said, "You know what? You think this business is worth $300,000? We will pay you $400,000." That when, in effect, they could have paid as high as a million dollars. But because they were not negotiating from a market price-plus, they had much more leeway to get a bargain. Tom Gardner: I want to talk about valuation now. Let's just start with this one. What went wrong, in your opinion, in the valuation of a company like WorldCom, circa 1999? Aswath Damodaran: I think when you start with lies, you are going to end up with lies. I think that's one of those things where if an analyst who had access just to the 10K and the annual report used it as a basis for the valuation, I can't fault them for misvaluing WorldCom. The fault I have though is with analysts that had a chance to confront the management and did not ask the follow-up questions. Because if you look at the Enrons and WorldComs of the world, the Tycos, the problems were right below the surface. If anybody had been digging and asked the right questions, that would have been available to them. They just chose not to ask those questions. Tom Gardner: How about the valuation in a company, let's say a company like Sun Microsystems, whose CEO has since said, "Our stock was ridiculously overvalued in the 1990s and I tried my best, but I didn't really know what to do

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about it." How, in a relatively efficient market, can individual companies get so dramatically over- or undervalued? Aswath Damodaran: I think expectations get out of hand. It is not so much markets. I think if you think about the late 1990s, everybody's expectations got out of hand. People started businesses with expectations that they could do things they really couldn't pull off. I don't think that's a bad thing. In fact, I had a talk on bubbles asking, "Are bubbles a bad thing?" This was in the late '90s and I called it The Dot.com Debacle, Bubble or Blunder? I ended the talk saying, "Look, we can bemoan bubbles, but bubbles have always been around as long as you have had human beings around. And they reflect what I think is most appealing about the human spirit, which is you keep hoping to do things that are beyond your reach." The question I left them with was if you feel so badly about bubbles, if you feel that they are such terrible things, would you want a world run by people who assess the probabilities of everything and worked out whether everything was possible before they tried it? We would still probably be in caves if there was somebody out there who didn't say, "Hey, let's try this. I know it seems impossible, but I think I can pull it off." So I think bubbles reflect something I find very appealing in human nature where we think we can do things that we really cannot do. But in the process of striving we learn a lot about ourselves and we advance civilization, for better or for worse. I am glad the 1990s happened. Sure, I might have lost some money on dot.com stocks, but it changed the way that I live. And so I think that as long as you have markets and as long as you have human beings in those markets, you will have times when people's expectations get ahead of what they can do and you are going to have bubbles and you are going to have crashes and people say "I will never invest in a bubble again." But trust me, 15 years from now it will be a different bubble and a different expectation game you get caught in, but I think it is still a good thing. Tom Gardner: That's a very refreshing perspective. Aswath, I want to turn to an area of real expertise for you -- valuation. I'd like to start by paraphrasing

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something that Charlie Munger, Warren Buffet's right-hand man at Berkshire Hathaway, said about valuing businesses. He essentially said that as long as you are consistent in how you value businesses, your degree of inaccuracy, if it is replicated through consistency, will lead to a great model for relative valuations. So if your valuation model is not sophisticated, does not take into account six dozens variables, well, as long as you are applying it the same way to every company and you are looking at a lot of different companies, you will have a useful model for relative valuation which can lead to very superior investment returns. Aswath Damodaran: I think what he is saying is it is better to be wrong than biased. If your only mistake is you are screwing up on your numbers, I can live with that. If the problem, though, is that you are cooking the numbers, there is no easy way to live with that. Why? For the simple reason that there is a law of large numbers that bails you out when you make mistakes. You value 50 stocks, even if you are wrong in every single one of them, if you are just wrong in random directions, some you overestimated, some you underestimated, in your portfolio you are going to be OK. But if you are systematically biased, if you overestimate growth for every company, then you can have the largest portfolio in the world and you are still going to have trouble. So I think it reflects the problems that I have with equity research on Wall Street. It is not that analysts were wrong. That has never been my peeve about analysts. It is that they let bias enter so egregiously into their valuations that they were wrong in one direction all the time. Tom Gardner: One of the problems that early investors have is that they can't really get their heads around valuation. It seems so complex. A lot of the terminology is complex, the concepts are, and there is a lot of contrary thinking needed to effectively value businesses. How can it be made easier? How have you made it easier? Or can it not be? Aswath Damodaran: I think it can be made easier. I think we choose to make valuation complex, "we" being the valuation industry. Whether it is consulting

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firms, investment banks. The reason we do it is the same reason doctors never tell you that you have a boil. They give a medical term. Because if we let the world know how simple the underlying basics were, then they wouldn't respect us, they wouldn't pay us richly to do valuation in the first place. If you boil things down, valuation is about cash flows and getting those cash flows. Everything else is a side story. I think most investors, in fact I would say all investors, can get enough valuation philosophy to work with investments, learn enough valuation. They don't need to learn how to do Excel spreadsheet models with ten years of forecasts. All they need to do is understand the basics of valuation as for what drives the value company. Why does a stock rise? How does a business grow in value? If they can do that, I am comfortable with them investing. Tom Gardner: In one of your NYU lectures, you said, "There is always a point in every valuation when you fight the urge to flee." Explain. Aswath Damodaran: I think that valuation is about making leaps of faith. You are making judgments about the future, estimates about the future. It is human nature to be worried about making mistakes, so when you first start doing valuation and you must project out revenues next year and two years out and three years out, you get increasingly uncomfortable as you go out because your first reaction is, "I really don't know what revenues will be three years from now." At that stage, you do one of two things. One thing you do is you say this is all too uncertain. I am not going to do it. I am going to use something else instead. That something else turns out to be a price-to-earnings ratio or a price-to-sales ratio or reading up somebody else's equity research report on the company. What I tell people is when you do that, you have not made the uncertainty go away, you have just pushed it under the carpet, covered it up and acted like it is not there. The brave thing to do here is to confront the uncertainty. Say, "Look, I really don't know what Google is going to look like six years from now, but if I am buying Google, for better or for worse, I am buying into expectations. I might as well put those expectations down and see if they justify what I am paying right now."

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Are you going to be wrong? You are going to be wrong 100% of the time. That is a terrible percentage to be wrong by. You are going to be wrong 100% of the time, but what I tell people is it is not whether you are wrong, it is whether you are less wrong than everybody else looking at this same company. The reality is, most of the people have fled. They have given up. They are not even trying to project revenues six years from now. At least you are trying. For that trying, you are going to get a better understanding of the company than somebody else who buys the company for a surface-level recommendation. And you are going to get smarter, one company at a time. Tom Gardner: So is it not likely that any valuation model that we use, any traditional valuation model that we use, at the extremes, is going to be ineffective? I will just provide the example of Wal-Mart (NYSE: WMT). Is there any way to have used a valuation model in 1977 with Wal-Mart stock to say, "This company will continuously grow earnings at more than 15% a year for a couple of decades, meaning that one day this will be a company worth more than $200 billion." There really is no valuation model that could have taken that into account, and therefore you must always must be willing to reframe and rethink your valuation on a periodic basis. Aswath Damodaran: Absolutely. I think no model will ever give you a multidecade valuation. And, I mean, the Wal-Marts and the Microsofts are really the outliers. No model would have predicted those outliers then, so you need that extra dose of luck to be in the right place at the right time. So the way I describe it is at least in equity investing there is no reward for the virtuous and punishment for the wicked. What that means is that you can do everything wrong and walk away with a ton of money and you can do everything right and have nothing to show for it, at least over short periods. Stocks like Wal-Mart or Microsoft, if you are lucky to be at the right place and the right time using the right model, you might have got them. But there is no broad screen you could have used in 1977 or 1986 that would have caught both those stocks in your screen.

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Tom Gardner: My follow up to that is, how frequently are you reviewing your valuation of those companies? Aswath Damodaran: I look at them every time a new news item comes out about the company. I at least go back and look at the company. So, for instance, earlier this year, I sold half the shares I have in Apple because it is a company that has done very well for me, but as I looked at the last two earnings reports, I looked at the proportion of its revenues coming from the iPod and I said, "You know, I love the iPod, but it is not the most defensible product in the world in terms of competitive advantages. And looking forward, I am not as comfortable buying Apple at $60 as I would have at $15. I still think Apple is a great company. I just don't think it is a good investment anymore. So I usually revisit my valuations at least once a year when the 10K comes out and sometimes more than once a year if the most recent 10-K contains enough significant information that I should take a look at the company. Tom Gardner: Can you give us an example of what you would consider to be a great and a terrible investment you made. Maybe your greatest investment ever and your worst investment ever. Aswath Damodaran: My best ever investment was in Embraer, the Brazilian Aerospace Company that I bought after the election in 2000. For those people who don't follow Brazil, this is actually a lesson that can extend to emerging markets. Investors, in my view, tend to be indiscriminate when it comes to emerging market companies. When there is a crisis in an emerging market, they dump everything, good companies, bad companies, export, domestic. The reason I picked Embraer is that Embraer gets 97% of its revenues in Western Europe and North America. They are about as Brazilian as Boeing is in terms of what they do. But in that year, because people were concerned about Brazil and Embraer got knocked down to six times earnings, five and a half times earnings, because it was viewed as a Brazilian company. I just thought it was completely unfair that a company like that should get knocked down, but from an investment standpoint...

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Tom Gardner: It was wonderfully unfair. Aswath Damodaran: It was a wonderfully unfair opportunity for me. In fact, I think there are about six or seven stocks in my portfolio that are emerging market companies like Embraer that I bought after emerging market crises in those countries. So I have a list actually that I keep with me all the time. There is always a crisis in these emerging markets. It is not a question of whether, it is a question of when. You wait for the next crisis and you buy the unfairly hit stock. Embraer was perhaps my best ever. My worst investment was Reader's Digest. I bought it in '98 or '99 when Michael Price took a position at Reader's Digest. The reason I did it was I had thought about the company as an incredible franchise that had been let go to waste. Essentially the people running the company had never recognized what an incredible franchise they had. I overestimated how much influence Michael Price would have in changing the way the company was run. But what I really misestimated that I have learned from since is Reader's Digest has two classes of stock, voting and non-voting stock. And the incumbent management essentially controlled the voting stock. It is actually charities that they have given the stock to which control 75% of the voting stock. But the CEO of Reader's Digest also was the head of, I think, four of the seven charities that owned the stock. So they were completely protected against outside pressure. It is a stock that I held on to for, I think, four years hoping that something good would happen. Noting happened, nothing happened. So it is one of those companies where I look back and say, "You know what? I should be more careful because it wasn't just the fact that an activist investor was there, it was the fact that control was held by the voting shares." One of the lessons I have taken away is that I am very cautious about buying stock in companies like News Corp and Viacom and Comcast where you have voting and non-voting shares. Because sometimes incumbent management can hold on to control these companies with relatively few shares by holding onto all the voting shares. And they may not have outside investors' best interests at heart.

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Tom Gardner: Talking about control, Hidden Gems, the newsletter service that I run has tens of thousands of members now. I've actually entertained the idea, and was thinking more of it while reading Investment Fables, although it may have been Investment Philosophies, about control investing and activist investors. Would you foresee an opportunity for a service like ours, that had a large membership base, to become an activist investor? And if so, do you think it would be a good idea for us to think of ourselves as active and influential rather than passive, noncontrol investors? Aswath Damodaran: That would be great. The only problem, though, is it is a very time-intensive way of investing because you essentially have to be involved in food fights, proxy fights. You have to get to annual meetings. It would be great if Motley Fool ran a list of the ten worst managed, worst-run companies where change is most needed. Because if you can get the power of individual investors behind it, you can help make that change. For me, this is what an open marketplace is all about. When I listen to the corporate governance to date about Sarbanes-Oxley coming in and saving us from bad directors and bad CEOs, I think they are missing the point. If we want this corporate democracy to be a true corporate democracy, it has got to come from investors. Investors have to take responsibility for their investments, have to take responsibility for the companies they invest in. They have to take a role. Those proxies can't go in the recycling bin; they have to be used by investors to make a difference. So I think it would be wonderful if we can get small investors pooled together and make them a potent force and get management to listen to us. Tom Gardner: Time for a frivolous question. We release Hidden Gems on a Thursday each month. Statistics show that Mondays over the past 70 years have been proven to be a poor day for the stock market. Shouldn't we release our newsletter on Tuesday each month? Aswath Damodaran: I think you are long-term investors. I think what happens on that Monday in the larger scheme of things, is going to be such a small ripple you

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are not even going to notice it. This is why I have always been a skeptic about this time of the day, time of the week, time of the year investment strategies because when somebody buys, goes in and out of the market, it might make a big difference. If you are a day trader, it makes a huge difference, but if you are a five-year time horizon investor, it all evens out at the end. Tom Gardner: Okay, given that long time horizon, as a private investor who loves to study and value businesses, does not the probability of my success go up -- if I'm a skilled investor -- if I venture into illiquid markets? Aswath Damodaran: It does, and so does the work that you have to do. I think if you go into illiquid markets, the skill you probably need to brush up the most on is accounting, because in a sense you have got to go through those accounting statements with a magnifying glass looking not just at the numbers but for clues behind the numbers as to what is going on. Because there is a lot more hidden behind those numbers than what gets revealed in the financial statements of the company. Tom Gardner: We interview CEOs as part of our service. Each time we recommend a company, we interview the CEO after the recommendation because we don't want there to be any leak in advance. But the interviews have been very helpful. One sale -- TransAct Technologies (Nasdaq: TACT) -- was in part influenced by the interview that I had with the CEO. He seemed far too enamored with his business. Aswath, what would you ask a small-cap CEO? How would you, with a question or two, get at the heart of whether or not this person was a good business leader and friendly to outside shareholders? Aswath Damodaran: There are two parts to that question. One is I would want to know that the CEO is responsive to stockholders, that he or she thinks about stockholders in every decision they make. What I would like in a good CEO is that a good CEO always has an army of stockholders essentially looking over his or her shoulder every time they make a big decision. So if they are making an acquisition, the question they should ask themselves is not is this acquisition good for the company, because I cringe when I hear CEOs ask that question.

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The question is NOT if this is good for the company. The question they should be asking is is this acquisition good for the stockholders in my company? Because that reveals to me a very different mindset about whose money it is that they're playing with. The other question I would have is a strategic question. After all, CEOs are not the nuts and bolts people. They are the ones who create the competitive advantages and the barriers to entry that allow these companies to continue to be growth companies. So I would really like to hear what vision they have for the company. Not just what they did last year, but what are the competitive advantages you see for this company? How do you plan to build or augment these competitive advantages? If they have compelling strategic visions, that is going to lead to a much higher value for the company. Tom Gardner: If you could pick one person, over the last 100 years, anywhere in the world, to manage your money for the rest of your life, who would that one person be, if they were not allowed to index? Aswath Damodaran: I would probably pick Warren Buffet simply because he has been so consistent in his investment philosophy. Strategies have changed over time, but what has impressed me is every time one of his strategies runs out of steam, he has a core philosophy he goes back to that allows him to recreate a strategy for the next generation. If you think about his strategies, his strategies aren't actually very different now, now that he is a multi-billionaire, than they were in the late '50s or early '60s. So I would probably pick Warren Buffet as the person. Tom Gardner: And finally, how would you suggest that we go through reading your books? In what order? Let's say somebody says, "I have invested for two and a half years. I am doing pretty well. I am always learning more. I have read Peter Lynch. I have read a couple of other investment books and now I am reading this interview, and I'd like to study Aswath's work." Aswath Damodaran: I will give you my personal bias. My personal bias is that you really have to understand my definition of corporate finance. It is about decisions

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that every business has to make, investment decisions, financing decisions, dividend decisions. So if I was starting with a book, I would start with my Corporate Finance book because it gives you a vision of how these companies operate on the inside, what the right way to run these companies is. Because if you understand corporate finance, everything else is a reflection. Valuation is a reflection off the corporate financial decisions of the company. Their investment strategies, taking advantage of some companies that make these decisions well as opposed to all the companies that don't. So I would start with Corporate Finance, then move on to the nuts and bolts inValuation and then end up in Portfolio Management because in a sense, portfolio management is kind of an aggregation of all of these techniques. Tom Gardner: Guys, that is it for me. James? Philip? You can come sit up here in my place. Phillip Durell: First of all, I will just toss out a quick question about multiples or multiple expansions, excuse me. It makes me wonder about the mental consistency necessary in valuation. When people say the bulk of so-and-so's returns in a certain period came from multiple expansion, it sort of makes me wonder how much psychological buy-in is necessary on the part of the market to make any given valuation model work. I'll just toss out a quick example. It might be kind of silly and just let me know what you think about it, Aswath. Pretend I have a stock that has expected earnings growth of 36% next year. That's not bad. And pretend I buy based on forward P/E's. So I like that stock and I buy it. I sit there, use up those earnings for the next year, at which point I sell it to someone who buys based on trailing P/Es. Is there sort of a psychological wealth creation there with people buying from different perspectives and different time periods that might affect how these models work? Aswath Damodaran: You can have different perspectives, but ultimately the price should reflect the future always, so I would use trailing P/E's, current P/E's or forward P/E's. What you care about is expected cash flow in the future. Some

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people might build those expected cash flows using trailing earnings as their starting point. Some people might build those expected cash flows using forward earnings as a starting point, but the reality is you are both talking about the future. Neither of you is really talking about the past, even though you might use the past as a metric to compare the price to. Is it possible that different people, especially when you use multiples, can end up justifying different prices for the same stock? Absolutely. In fact, what is more common rather than trailing P/E and forward is I use price-to-book. Often you pick a multiple that best fits what you have already decided to do. You say this stock looks cheap because it trades at a low price-to-book, even though the price/earnings might be high. So I think there is that danger, with multiples especially, of taking a multiple to justify a decision you already made about the stock. This is where bias creeps in; you find what you want to see. Philip Durell: OK, a follow-up. Aswath, pretend I am going to buy a stock and hold it for at least five years at which point I am going to sell it. Why would I need to worry much about what that stock does between now and when I sell it? Why wouldn't I start my models from five years out going forward, because that is what, in theory, the buyer of that stock is going to be looking at? Aswath Damodaran: But in a sense, what happens over the next five years is going to determine what happens out at the fifth year. If your performance over the next five years was completely uncorrelated to what will happen after the fifth year, you would be absolutely right, but in the real world, what happens over the next five years tells me a great deal about what is going to happen beyond the fifth year. So I think we care about the next five years, not because of what they tell us about the next five years, but because of what they tell us after the fifth year. Philip Durell: So in essence, we're talking about every investor looking towards infinity as far as the company is concerned? Aswath Damodaran: I don't know if it is that long. The company might not care about investors looking to infinity. In fact, investors might have short time

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horizons, but ultimately all they are buying is a stream of cash flow that does stretch to infinity. Now we can debate whether we should be looking as investors towards infinity, but the reality is that that is all you are getting, is a stream of future cash. We put a name on the cash flow. We call it Google or we call it AT&T, but it is just a set of cash flows. James Early; My question might be getting more toward your life philosophy. Your website has an incredible amount of information for free, there for anyone who wants to look at it. Why do you do that? What about your passion for industry and prosperity? Aswath Damodaran: I measure return on capital very simply as I invest time capital into creating papers, books, lectures. For me, the maximum return on capital is if people use what I do. It has driven my publishers crazy because on my last four books, I put the entire book online for free. I have had calls from my publisher the next day saying, "What are you doing? You put your own book online. Aren't you worried that you will sell less?" They have completely misunderstood my objective in writing the book. They thought my objective in writing the book was actually to sell a lot of books and make money. My objective in writing the book was to get the most people to read the book. From that objective function, what I am doing makes complete sense to me because more people read my book if they can download the book and read it than if they are forced to pay an absurdly high price for that same book. In fact, the reason I did it was more for people outside the US than in the US because I have actually got emails from an Indonesian analyst saying I would love to buy a book, but it is a month's salary for me! I don't want to put him in a position of spending a month's salary to buy my book or not reading my book at all, so I said to go ahead and read. It is not as if I am losing sales by doing it. The reality is, if somebody wants the book they are going to buy the book, if they can afford it. If they can't afford it, this is all moot anyway. They wouldn't have bought the book. So it is the reason I write and the reason I teach is to get the message out. I am

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an evangelist at some level. Evangelists don't charge people to come into church. James Early: I've watched your lectures online and you obviously enjoy teaching a great deal. Aswath Damodaran: I love teaching. Every teacher I think is a repressed actor. For me, it is one of those cases where you get to grade the audience rather than the other way around. This is a dream audience for an actor because at the end of the show you say, "OK guys, I am going to give each of you a grade on how well you reacted to my show." (Laughing) Broadway actors would kill for something like this. Philip Durell: That's a great segue because I am both an instructor at a college and now an analyst. I have to say, I had a couple of questions on valuation, on the question you asked earlier, but in particular I wanted to mention the fact that all of your work at Stern is on your website. So, first of all, I say 'thank you' because there are a whole bunch of us, 20 of us in The Motley Fool Community, and I was one of their leaders, and we went right through the whole 26 investment valuation courses. Aswath Damodaran: Did you take the quizzes as well? Philip Durell: Oh we did, yeah. (Laughing.) I won't tell you how well we did, but we learned a lot from that. But one other thing that was quite obvious was that out of the 30 or 40 that expressed an interest in doing it, there were perhaps only six or seven or eight of us at the end. So it was quite complex for the average investor. Earlier when you were talking to Tom, you said that you believe that anyone could calculate a simple valuation, which I believe too. So I would ask you, how would you go about showing someone how to do a simple valuation? Aswath Damodaran: I actually went into my seventh grader's classroom this year to teach them about valuation and I started with a very simple concept. I took an envelope. I put $20 into it. I sealed the envelope and then I held it up and said how much would people be willing to pay for this? Essentially they looked at me like I was crazy and after a while they said maybe about $20. Then I said what if I

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told you that there were five people outside this classroom who were willing to pay $40 or $60 or $80 for envelopes just like this one, with $20 bills in them. How much would you be willing to pay for it? A couple of them said you know, I would be willing to play the game then. Maybe pay $35 and go out and sell it. I said that is the difference between intrinsic valuation and relative valuation. Intrinsic valuation you pay for what is in the envelope. Relative valuation you pay what you think other people will pay you for that same envelope. Then I took that concept of $20 in the envelope and said what if I told you that I would give it to you tomorrow? How much would you pay for it? One person in the room had some idea about present value and they were trying to compute the present value and I said, "You are missing a very important point. You might not be able to find me tomorrow. You pay $19 because that is the present value of the $20 in one day. You are missing the point that there is uncertainty about whether I'll be there to pay you." So it is actually very simple to bring home the basic concepts. It is cash flows. It is timing of the cash flows. It is uncertainty about the cash flows. We use concepts like betas and discount rates, but the underlying intuition is very simple. My concern often, with people who go to advance valuation, is they get so caught up in the details that they lose the underlying intuition. So I think that I can teach somebody with absolutely no math knowledge enough about cash flows and risk and growth that they can then invest. Now would I trust them to go out and value Gillette for Procter & Gamble (NYSE: PG)? Believe it or not, probably more than the analysts that are actually doing it because those analysts bring bias into the process! But they need more terms and concepts to get really good. So the valuation class I teach is actually for people who might end up at McKinsey or Goldman Sachs actually grinding these numbers out. So I have to go through what non-cash working capital is and how it is computed and how it can be miscomputed because that is going to be their job.

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Now, most of it is overkill. An investor does not have to define non-cash working capital to value a company or get a sense of whether a company is misvalued or not. That is why I actually like multiples at one level. Because even though people have these things about intrinsic valuation being a good thing and relative valuation being sloppy, you can actually use multiples and by asking three followup questions essentially to the multiples, get almost everything you'd have gotten in an intrinsic or a discounted cash flow model. So I think that there are short cuts to getting there and all it requires is common sense and a willingness to explore. Philip Durell: I am the analyst for our Motley Fool value newsletter, Inside Value, and the single biggest question that I get from our members is how do you value a company? We have talked about concepts so far and we have just put on the website a very simple, three-stage DCF calculator. Of course, the devil is in the inputs. Hopefully what we are going to start to do is just try and give them a simple way where they can find where to get the inputs from, SEC filings etc, and then build their knowledge from there. The whole idea of a simple calculator was that they can vary the inputs for a given company and then they can see the effect that changing their assumptions has on the outcome. That way they can get a real feel for valuation and eventually they can develop their own system, which is consistent. And as you say, it may be wrong on one side or the other side each time, but if they are consistent, they will be more accurate. Aswath Damodaran: I am a great believer in internal consistency tests. Ultimately, when I look at a valuation model, I am not looking at the assumptions because people disagree. There are optimists and there are pessimists. What I am often looking for in a valuation is whether the assumptions the analyst is using within the valuation are internally consistent? I will give you a very common one. Growth and reinvestment. In a lot of valuations, the growth assumption is made first, the reinvestment assumption is made later and the two assumptions are often not internally consistent. For optimists, the growth assumptions are set

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at 30, 40, 50%. But that growth comes out of nowhere. There is nothing being put back in the company. Often fixing that consistency problem takes away most of the mistakes in valuation because that is where you get these incredibly highly valued or misvalued companies. It comes from making internally inconsistent assumptions that growth can come without investment. So at some stage in the process, when they enter a growth rate, it is useful to then say, "To get this growth rate, this company will need to earn a 45% return on equity over the next five years." Then the investor can look at it and say, "Forty-five percent? Really? I don't think they can do it. Maybe they can do only 25%." In other words, it forces them to think about growth not as an exogenous input coming out of nowhere, but something that companies have to earn. That high growth is difficult to pull off at companies. Only a few companies are able to pull it off and identifying what it is that makes those companies work over long periods of time is, I think, the biggest part of successful investing. Philip Durell: Well, thanks very much and thank you for your spreadsheets because a lot of my customers use them. Tom Gardner: Aswath, thanks very much for your time and for keynoting our Motley Fool Analyst Conference this year. If your aim is to be read, and heard, and studied because your ideas have merit, you have succeeded again today. Aswath Damodaran: Tom, thank you. And thanks to everyone at The Motley Fool.

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