Institutional Investors

Fundamental Investing Is Harrowing: Here’s Why

As usual, I find it helpful to work with an example.  The example used here is Apple because it is a relatively easy company to value.  On September 21, 2918, Prof. Aswath Damodaran posted on his website a valuation of Apple that included a full DCF model (available here).  His basic premise was that Apple was a mature company so that its revenues would grow at the same nominal rate as the overall economy.  On this basis, he assumed that the growth rate for Apple revenue was 3.00%.  Applying that assumption, Prof. Damodaran arrived at a fundamental value of Apple of $201.50 per share.  On that basis, he sold his Apple stock at the then current price of $220.00.

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Institutional Investors

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In the fundamental valuation of Apple prepared at Cornell Capital, we basically agreed with Prof. Damodaran’s outlook for the company and most of the details of his valuation with one exception.  We assumed that the long-run nominal growth rate for the US economy would be 5.0% (about 2.48% real growth and 2.48% inflation) rather than 3.00%.  If you go to Prof. Damodaran’s spreadsheet and substitute 5.00% for 3.00% (and change nothing else), the estimated value per share jumps from $201.50 to $279.00.  That implies that Prof. Damodaran should have been buying rather than selling!

The point here is not to argue that 3.00%, 5.00% or some other number is the proper growth rate, but to emphasize that even for a large mature company with a huge cash hoard, a relatively small change in a key assumption can have a huge impact on estimated value.  That is what makes fundamental investing harrowing.  It is reason why at Cornell Capital we do not take speculative positions in individual securities unless the evidence of mispricing is significant.  In our view, Apple is not an example.

Finally, if you think valuing Apple is scary, what about its trillion dollar cousin, Amazon?  In Amazon’s case, the great majority of the value comes from forecasts of future growth that are well in excess of those for the U.S. economy.  Reduce those growth assumptions and the value drops dramatically.

Article by Brad Cornell's Economics Blog


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