Aswath Damodaran's five valuation factors

Aswath Damodaran's insightful takes on valuations have garnered him the tag "Valuation Guru" over the years. For those unaware, he is a corporate finance and valuation professor at New York University known for his pioneering research on valuations.

We recently stumbled upon a podcast with 'Millennial Investing', where Damodaran discussed the factors driving the value of a business. According to Damodaran, one must consider five key factors when it comes to company valuation. These can be divided into two broad categories: quality and risk.

Quality factors

• Revenue growth: For any business, revenue growth is the optimum quality indicator as it is purely based on how the overall business is expanding and not on cost factors that are often susceptible to market forces. As per Damodaran, "The growth part of a business is captured in its revenue. This is because it is the most honest metric of growth. You can increase net income or earnings by cutting costs, but to increase revenues, you either have to sell more items or charge higher prices".
  
• Operating margin: Profitability is the heartbeat of any business, and operating margin is one of the best gauges of profitability. This is because it only considers earnings through business operations. A high operating margin is a vital sign of a quality business.
  
• Capital expenditure: Consistent and efficient capital allocation is a prerequisite for sustaining growth. A company might have an impressive topline or earnings growth at any given time. But without reinvestment, the growth is not sustainable.

Risk factors

• Discount rate: Considered by many as among the better valuation frameworks, discounted cash flow (DCF) analysis is a valuation method that estimates the value of a business based on the present value of the expected future cash flows. In simple terms, it values the business based on how much cash it can generate in the future. In this method, investors arrive at the present value of the expected future cash flow by discounting the latter by a certain rate. This rate (discount rate) is the opportunity cost, i.e., the amount investors will earn as interest if they invest their capital in a fixed-income (saving accounts, etc.) instrument rather than the company. Damodaran states that investors often either set the discount rate too high or too low. He argues that you may apply a lower discount rate if a company has stable cash flows. However, investors must be conservative and apply a higher discount rate if a company has unpredictable cash flow.. He says, "If you're investing in a business worth more predictable cash flows, you're going to be okay settling for a lower rate of return than if cash flows are less predictable".
  
• Failure risk: There's always a risk that a business may fail. That remains the fundamental risk factor in equity investment. Investors, therefore, should focus on the robustness of the business model. Damodaran says, "Failure risk is something people often forget, which is for your business to have all this potential and deliver value, it's got to survive. Companies sometimes fail. If you're valuing a young growth company, it could have the most incredible potential on the face of the earth, but if it doesn't make it through the next three years, you're never going to see that potential."

The above were the key highlights of the podcast. However, the podcast is a treasure trove of investing knowledge. We urge our readers to watch the full video.

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