Investors concerned about uncertainty need to understand that it is fundamental to investing, but humans have a difficult relationship with it. Aswath Damodaran, a professor at New York University’s Stern School of Business and a prolific writer and social media publisher, is an expert on corporate valuation, finance and portfolio composition and is known as the “dean of valuation.”
“The truth is: uncertainty is a feature, not a bug of investing. It has always been there,” said Damodaran. Until about three or four hundred years ago, risk was mainly physical uncertainty. It’s clear, he said, that human beings don’t deal well with uncertainty – their first reaction is “paralysis and denial”.
Other ways uncertainty is dealt with is through mental shortcuts - he pointed to the frequent saying that “you cannot value young companies,” which he dismisses as “nonsense”.
Wisdom in herds
Another response to uncertainty is less problematic for Damodaran: herding, or doing whatever you see other people doing. “Don’t undercut it,” he said, speaking at the Skagen Funds 2023 new year’s conference last week. “I mean 90% of active investing is looking for a crowd and joining in.” For companies, one way of handling uncertainty is to call in an expensive consultant, like McKinsey.
Damodaran tells his students to make a list of everything they’re uncertain about when valuing a company. He then asks them to put the types of risk into boxes, each kind of uncertainty to be treated very differently
There are two major types of uncertainty – estimation uncertainty and economic uncertainty. He explained that the estimation type can be reduced by doing more work, collecting more data and doing more analysis. Economic uncertainty? “There’s nothing you can do about it.”
The inflation conundrum
One of the biggest uncertainties we face entering 2023, he said, is what will inflation do during the course of the year. “Nobody knows. Not the central banks, not the experts,” he explained.
Ninety percent of the uncertainty he faces in valuations is economic, he said.
As opposed to this macro uncertainty, there’s also a category of “micro uncertainty”. It’s the “uncertainty you feel about a company, who’s running the company, its business models,” he said.
Corporate teenager
Damodaran has become well-known in part for his valuations of big name firms like Tesla, which he described as one of his favourites to value. “I’ve called Tesla my corporate teenager,” he said, gleefully. “One person in the company gets up, looks in the mirror and says ‘I’ve got lots of potential. What can I do today to screw it all up?”
But he said, Tesla faces not only the micro uncertainty of Elon Musk, but the macro uncertainties of bigger things like “How many people will switch to electric cars? What will the future bring in terms of fossil fuels? What does climate change look like five years from now?
The difference between macro and micro, Damodaran said, is that micro uncertainty can be averaged out.
Discrete uncertainly
Discrete and continuous uncertainty, which is always with us, are another way to distinguish uncertainty, he said. Discrete uncertainty isn’t there until something happens. “We’re very good at dealing with continuous uncertainty in finance ” with it. But “we’re not very good at dealing with discrete uncertainty.”
Corporate stages
One of his favourite devices for analysing a company is to situate it in its corporate lifecycle. He likened startups to babies. “Need constant care and attention to get through. Lots of capital. Think of that as the mother’s milk of startups.”
Turning again to macro uncertainty, Damodaran said that at the start of 2023, “we’re in the heart of a storm, every single one of these inputs – he mentioned inflation, interest rates, exchange rates, the economy - is uncertain.
Damodaran was asked whether he could still be a good teacher if he didn’t invest. “I think you cannot teach investing and valuation without doing,” he said. “I’ve never believed in talking about valuation without being willing to act on my own valuations.”