“It is precisely times like these that matter most,” said Damodaran, who is the Kerschner Family Chair Professor of Finance at the Stern School of Business at New York University. “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.”
With so much uncertainty around companies’ future earnings growth, cash flows and even their ultimate survival, it’s tempting to give up on traditional equity valuation methods. Pre-crisis historical financial data seem useless and there’s a wide range of predictions about the economy and individual companies for 2020 and beyond. But to value collective indices such as the S&P 500 Index, and individual companies, Damodaran urged investors to stick with traditional valuation tools with adjustments for the pandemic.
“This is the dark side of debt”
Damodaran started his conference talk with a damage assessment of financial markets during the worst part of the crisis, from 14 February to 20 March, when the US and Europe realised that novel coronavirus was not contained to Asia.
By dissecting more than 36,000 public companies (nearly all in the world) by region, country, sector, price-to-earnings (P/E) ratio, and dividend yield, Damodaran found that unlike other crises, this one was not a full-scale panic where all stocks were punished indiscriminately.
“There was actually a rationality of how markets knocked down stocks,” he said.
The best-performing industries ranged from those providing possible solutions to the COVID-19 pandemic, such as healthcare, pharmaceuticals and biotech, with the possibility of generating profits, to low capital-intensity businesses and those supplying everyday goods such as toilet-paper and food.
📽️ Watch the interview in full here.
The worst performing sector? Financial services, which fell 26% from 14 February to 1 May 2020. “Banks either live in reflected glory or reflected pain,” Damodaran said.
“When oil companies default or when travel companies and airlines refuse to pay on their loans, guess who’s holding the loans?”.
The second-worst performing sector was energy. The common denominator for many of the worst affected companies was high up-front investment usually funded with debt.
“The cautionary tale coming out of this crisis is companies should be much more careful about pushing the financial leverage button to obtain growth,” Damodaran said. “This is the dark side of debt.”
Though they had many naysayers during the crisis, growth and momentum outperformed value, according to Damodaran. Traditional “safe” stocks with low P/E ratios, low momentum, and high dividend yields were actually among the least safe places to hide.
A coronavirus valuation framework
To value the S&P 500 Index in the current environment, Damodaran recommends making adjustments to discounted cash flow (DCF) valuation models by asking a series of questions:
- How will earnings growth be affected in 2020 and how much of this effect will linger for the long term? This year will be a bad one, but it’s just as important to figure out how much earnings will recover by 2025 or 2029.
- How will fears about the future affect what percentage of earnings is returned to shareholders through dividends and buybacks? As companies get nervous about what lies ahead, they return less cash.
- How will the risk-free rate – 10-year US Treasury bonds (the UK equivalent would be the 10-year gilt bond rate) – be affected by a flight to safety, fears about the economy and central bank actions? US T-Bonds yields made a major move downward from 1.59% on 14 February to 0.64% on 1 May 2020.
- How will investor risk aversion be affected by fear of a market sell-off as reflected in the implied equity risk premium (ERP)?
On 13 March, the S&P 500 index was 2,400 and Damodaran’s median of possible values was 2,750, showing the S&P 500 was undervalued according to his assumptions. “This [COVID adjusted] model gives you the tools to try to get your hands around where the index should be,” he said.
A post-corona assessment to value individual companies
What firms and sectors are in the eye of the COVID-19 storm? Damodaran singled out those linked to travel, consumer discretionary and people-intensive businesses; those with high fixed costs; and young start-ups – and across the board, those with high net debt loads.
When valuing companies, Damodaran emphasised the importance of creating a story to go with your valuation, about how your sector will play out after the crisis and whether your company will emerge stronger or weaker. Damodaran advised investors to think about and adjust for:
- How the crisis will affect revenues and company operations in the near term.
- How the crisis will affect the sector the company is in and its standing in that sector over the longer term.
- New probabilities for the company’s “Failure Risk”.
- How the crisis has affected the price of risk and likelihood of default by updating the ERP and default spreads.
In closing, Damodaran offered some reassurance. “It’s all going to be OK,” he said. “Go back to basics and the fundamentals and be willing to live with uncertainty. If you’re wrong, revisit your valuation.”
This year, archived recordings of every presentation from the CFA Institute Annual Virtual Conference will be available online, with additional insights and commentary published on the CFA Institute Annual Virtual Conference blog.
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By Julie Hammond, CFA is a director in the Educational Events and Programs group at CFA Institute.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: CFA Institute archive