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Prof. Damodaran's Perspective on Valuation of Finance Firms

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Professor Aswath Damodaran of the Stern School of Business at New York University has written books on equity valuation (Damodaran on Valuation, Investment Valuation, The Dark Side of Valuation). These books are very popular among finance students all over the world.
Damodaran on Valuation

Professor Aswath Damodaran

Professor Aswath Damodaran is the David Margolis Teaching Fellow at the Stern School of Business at New York University. He teaches the corporate finance and equity valuation courses in the MBA program. His research interests lie in valuation, portfolio management and applied corporate finance. His books on equity valuation (Damodaran on Valuation, Investment Valuation, The Dark Side of Valuation) are very popular among finance students. His recent book, titled Strategic Risk Taking, is an exploration of how we think about risk and the implications for risk management. He was profiled in Business Week as one of the top twelve business school professors in the United States in 1994. He has received an MBA and Ph.D degrees from the University of California at Los Angeles.

The DG Editorial team speaks to him.

Thank you Professor Damodaran for speaking to!

The financial firms were overvalued in the beginning of 2008. Are their valuations in mid 2009 justified? Which method of valuation do you think works best for valuation of financial services firms?

The financial service firms were overvalued at the start of 2008. I am not sure that the premise holds. In hindsight, of course, we know that everything was overvalued. So I am not sure you can use hindsight to make judgments or at that point in time were they overvalued? I am not sure. I mean that depends on what your expectations were then. If in the book it is coming that at the end of 2008 would you value them at the same price as at the start of 2008? I don’t think so. So the first is the premise that everybody knew that financial service firms are overvalued at the start of 2008 is, I don’t think, a solid base. The second is the nature of the market. The definition of crisis is that it is unexpected and you cannot expect the unexpected, plan for it or build it into value. Remember this is exactly why we charge an equity risk premium. I would go a little easier on those people who did value financial services firms at the start of 2008 and not draw the conclusion that they are hopelessly wrong and they overvalued these firms.

Now I don’t think the fundamental principles for valuing financial service firms have changed but I don’t think that you can’t trust the regulatory authorities to do your due diligence for you. The assumption that banks are regulated and so they can’t do stupid things is not valid. The assessment of risk within a bank was faulty because we assumed that regulators kept a tight rein on risk taking. So when people compared across bank valuations, they tended to assume that risk was not a variable that had to be controlled for. You could just look at the return on equity and profitability and the more profitable a bank was, the more valuable it was. What we discovered in this crisis is that banks play the regulatory capital game very well. Some banks were actually taking a lot more risk than we were recognizing. So I think the two things that I would change while valuing a bank are: I’ll be much more dynamic in my assessment of risk of a bank and I would ask more questions about where the bank makes its profits.

Traditionally, banks have been valued due to the dividend discovery model, the assumption being that banks are going to pay out what they can afford to pay out and that these dividends are unlikely to change. I would keep a watch on the regulatory capital ratios. If a bank is paying high dividends but is getting pretty close to the limits of its regulatory capital ratios, then it is probably going to have to cut those dividends in the near future. So I’ll be more conservative in estimating dividends for such a bank.

In 2000, there was the IT bubble where we saw very high valuations of many tech companies. Where did the investors go wrong?

In the hindsight, we know that when something burst we call it a bubble. But again the implicit assumption there is that somehow we knew there is a bubble. The nature of equity is that it’s risky, that is why there is the equity risk premium, and that sometimes, you will have stock prices drop precipitously.

Earlier it was IT, then real estate - What's the next sector that's getting overvalued?

I don’t think that anybody knows that. I can tell you that the next mistake will look nothing like this one. We are very good at fighting the last war and are not ready for the next one. So all these regulatory changes would do nothing because they are taking care of the bubble that has already burst. The next bubble would be somewhere we’ll least expect it and it’ll be in the form that we don’t recognize. In the hindsight we’ll look at it and say, “Oh that was obvious, we shouldn’t have missed it”. The nature of investing is such that each bubble is different enough from the last one that while you are in it you don’t realize that strange things are happening.

Due to the financial crisis, not only has the valuation of companies gone down but also the value of the MBA. What are your comments?

Yes, it has gone down. The value of an MBA was derived, in large part, by the expectation that you could move into jobs with a financial service firm and increase your income. This financial crisis is centered in investment and commercial banking. Finance jobs are always going to be there. Every business, in fact, needs more finance jobs than they used to before this crisis. Every company has to do more risk management and more financial assessment. What’s not going to be there, or at least not in the numbers that there used to be, are those high paying investment banking jobs. That’s because there are fewer investments banks around and this is a long term shift towards stability in the business. I think in the last 20 years we actually had too many investment bankers. This business was sucking out the best of talents from other disciplines. Now I think it’s going to back towards more normal. If you take out the lucrative investment banking jobs out of the mix, then you take a big chunk of the value of the MBA out of the mix as well. 

How dangerous is the current financial position of AIG given that some of the toxic assets are still on its balance sheet?

I think it’s a question of how the economy recovers. If the economy strengthens, the toxic assets on banking balance sheets cease to be toxic. If we go through the second recession and a double dip, then I think banks are in big trouble.

Ten banks were given permission to emerge from TARP in the first week of July this year, and several banks could have done that around the same time. Does this signal the recovery of the banking crisis? What are your views about long term effect of bank bailouts?

I think the panic is gone. Now the banks are trying to get those funds off the books because they feel it’s going to constraint them in how they make decisions in the near future. The very fact that you see banks like to pay off the government signals that the banks feel that they can live without those funds. They feel the worst is behind them and they can access the capital market on much better terms.

What is your opinion about the statistical risk models used by banks recently, especially VAR? Do you think new risk measurement statistics/ techniques will be developed after the recent financial crisis?

Well, I think you need to have more dimensions on risk than just standard deviation. The problem with the existing models is that they are so heavily focused on the assumption that risks are normally distributed. There’s nothing wrong with statistics. Risk ultimately has to measured, but on multiple dimensions.

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