"Aswath Damodaran Says “Go Back to Basics” Regarding Valuations

In a speech he delivered at this year’s CFA Institute Annual Virtual Conference, NYU finance professor Aswath Damodaran said, “It is precisely times like these that matter most. You need to go back to the first principles of valuation. Everything I have learned about valuation has been in the context of a crisis.”

He advised investors to stick with traditional valuation tools “with adjustments for the pandemic,” sharing the results of his analysis of more than 36,000 public companies by geography, sector, P/E ratio and dividend yield. Damodaran determined that unlike during other crises in history, the coronavirus pandemic was “not a full-scale panic where all stocks were punished indiscriminately.” He noted, “There was actually a rationality of how market knocked down stocks.”

The best performing industries, he explained, spanned those providing possible solutions to the pandemic (healthcare, pharma, and biotech) to those supplying everyday staples like toilet paper, cleaning supplies and food. The worst performers included financial services: “When oil companies default or when travel companies and airlines refuse to pay on their loans, who’s holding the loans?” He noted that most of the poor performers held large amounts of debt, adding, “the cautionary tale coming out of this crisis is companies should be much more careful about pushing the financial leverage button to obtain growth. This is the dark side of debt.”

Damodaran advised investors to consider a series of questions when evaluating valuations:

  • How will earnings growth be affected in 2020 and how much of this effect will be long term?
  • How will fears about the future impact the percentage of earnings returned to shareholders through dividends and buybacks?
  • How will the risk-free rate (10-year Treasury bonds) be affected by fears about the economy and central bank policy?
  • How will investor risk aversion be impacted by fear of a selloff?

According to Damodaran, the firms and sectors most impacted by the coronavirus pandemic include those linked to travel, consumer discretionary, “people-intensive” businesses, those with high fixed costs, and young start-ups, as well as highly-leveraged businesses across the board.

Damodaran concluded by saying “It’s all going to be okay. Go back to basics and the fundamentals and be willing to live with uncertainty. If you’re wrong, revisit your valuation.”