“This is a magnificent, creative, scholarly—indeed a noble—book and one
that will and should be in every investment library and every practitioner’s
desk. Like a good doctor, the author diagnoses a serious illness, and then
provides a prescription for how to alleviate it.”
—Victor Niederhoffer, Chief Speculator,
Manchester Investments
“Professor Damodaran systematically destroys the great myths of investment
management, attacking each in turn with remorseless logic. He shows how
many ‘systems’ for successful investing actually lose money, even though in-
vestors themselves are sometimes unaware of this. He shows too that hope
and good intentions are no substitute for information and analysis. Before
you make your next investment, read this book.”
—Morgen Witzel, Editor-in-Chief,
Corporate Finance Review
“A necessary part of a serious investor’s toolkit. Dissecting investment myths
is terribly important for the long-term investor. This book is an enjoyable
and systematic attack on long-held investment beliefs. A true etymology of
investment folklore that clinically tests out popularly held beliefs. A caution-
ary book for the serious investor.”
—Satya Pradhuman, Vice President,
Small Cap Research Department,
Merrill Lynch & Co.
fm01.qxd 1/29/04 08:12 AM Page i
fm01.qxd 1/29/04 08:12 AM Page ii
Investment Fables
fm01.qxd 1/29/04 08:12 AM Page iii
In an increasingly competitive world, it is quality
of thinking that gives an edge—an idea that opens new
doors, a technique that solves a problem, or an insight
that simply helps make sense of it all.

We work with leading authors in the various arenas
of business and finance to bring cutting-edge thinking
and best learning practice to a global market.
It is our goal to create world-class print publications
and electronic products that give readers
knowledge and understanding which can then be
applied, whether studying or at work.
To find out more about our business
products, you can visit us at www.ft-ph.com
fm01.qxd 1/29/04 08:12 AM Page iv
Investment Fables
Exposing the Myths
of “Can’t Miss”
Investment Strategies
Aswath Damodaran
www.damodaran.com
An imprint of PEARSON Education
London • New York • San Francisco • Toronto • Sydney
Tokyo • Singapore • Hong Kong • Cape Town • Madrid •
Paris • Milan • Munich • Amsterdam
fm01.qxd 1/29/04 08:12 AM Page v
Library of Congress Cataloging-in-Publication Data
A catalog record for this book can be obtained from the Library of Congress
Editorial/production supervision: Nicholas Radhuber
Executive editor: Tim Moore
Editorial assistant: Richard Winkler
Marketing manager: Alexis R. Heydt-Long
Manufacturing buyer: Maura Zaldivar
Cover design director: Jerry Votta
Cover design: Anthony Gemmellaro

Art director: Gail Cocker-Bogusz
© 2004 Pearson Education, Inc.
Publishing as Financial Times Prentice Hall
Upper Saddle River, New Jersey 07458
Financial Times Prentice Hall books are widely used by corporations and
government agencies for training, marketing, and resale.
Prentice Hall offers excellent discounts on this book when ordered in quantity for bulk
purchases or special sales. For more information, please contact:
U.S. Corporate and Government Sales
1-800-382-3419

For sales outside of the U.S., please contact:
International Sales
1-317-581-3793

Company and product names mentioned herein are the trademarks
or registered trademarks of their respective owners.
All rights reserved. No part of this book may be reproduced, in any form or by any
means, without permission in writing from the publisher.
Printed in the United States of America
1st Printing
ISBN 0-13-140312-5
Pearson Education LTD.
Pearson Education Australia PTY, Limited
Pearson Education Singapore, Pte. Ltd.
Pearson Education North Asia Ltd.
Pearson Education Canada, Ltd.
Pearson Educación de Mexico, S.A. de C.V.
Pearson Education—Japan
Pearson Education Malaysia, Pte. Ltd.

fm01.qxd 1/29/04 08:12 AM Page vi
To my father, who showed me the power of ideas,
and to my mother, who taught me the value of common sense.
fm01.qxd 1/29/04 08:12 AM Page vii
fm01.qxd 1/29/04 08:12 AM Page viii
F
INANCIAL
T
IMES
P
RENTICE
H
ALL
B
OOKS
For more information, please go to www.ft-ph.com
Business and Technology
Sarv Devaraj and Rajiv Kohli
The IT Payoff: Measuring the Business Value of Information Technology Investments
Nicholas D. Evans
Business Innovation and Disruptive Technology: Harnessing the Power
of Breakthrough Technology…for Competitive Advantage
Nicholas D. Evans
Consumer Gadgets: 50 Ways to Have Fun and Simplify Your Life with Today's
Technology…and Tomorrow’s
Faisal Hoque
The Alignment Effect: How to Get Real Business Value Out of Technology
Economics
David Dranove
What’s Your Life Worth? Health Care Rationing…Who Lives? Who Dies?

Who Decides?
John C. Edmunds
Brave New Wealthy World: Winning the Struggle for World Prosperity
Jonathan Wight
Saving Adam Smith: A Tale of Wealth, Transformation, and Virtue
Entrepreneurship
Oren Fuerst and Uri Geiger
From Concept to Wall Street: A Complete Guide to Entrepreneurship
and Venture Capital
David Gladstone and Laura Gladstone
Venture Capital Handbook: An Entrepreneur’s Guide to Raising Venture Capital,
Revised and Updated
Thomas K. McKnight
Will It Fly? How to Know if Your New Business Idea Has Wings…
Before You Take the Leap
Erica Orloff and Kathy Levinson, Ph.D.
The 60-Second Commute: A Guide to Your 24/7 Home Office Life
Jeff Saperstein and Daniel Rouach
Creating Regional Wealth in the Innovation Economy: Models, Perspectives,
and Best Practices
Stephen Spinelli, Jr., Robert M. Rosenberg, and Sue Birley
Franchising: Pathway to Wealth Creation
fm01.qxd 1/29/04 08:12 AM Page ix
Executive Skills
Cyndi Maxey and Jill Bremer
It’s Your Move: Dealing Yourself the Best Cards in Life and Work
Finance
Aswath Damodaran
The Dark Side of Valuation: Valuing Old Tech, New Tech, and New
Economy Companies

Kenneth R. Ferris and Barbara S. Pécherot Petitt
Valuation: Avoiding the Winner’s Curse
International Business
Peter Marber
Money Changes Everything: How Global Prosperity Is Reshaping Our Needs,
Values, and Lifestyles
Fernando Robles, Françoise Simon, and Jerry Haar
Winning Strategies for the New Latin Markets
Investments
Zvi Bodie and Michael J. Clowes
Worry-Free Investing: A Safe Approach to Achieving Your Lifetime Goals
Aswath Damodaran
Investment Fables: Exposing the Myths of “Can’t Miss” Investment Strategies
Harry Domash
Fire Your Stock Analyst! Analyzing Stocks on Your Own
David Gladstone and Laura Gladstone
Venture Capital Investing: The Complete Handbook for Investing in Businesses for
Outstanding Profits
D. Quinn Mills
Buy, Lie, and Sell High: How Investors Lost Out on Enron and the Internet Bubble
D. Quinn Mills
Wheel, Deal, and Steal: Deceptive Accounting, Deceitful CEOs, and Ineffective
Reforms
John Nofsinger and Kenneth Kim
Infectious Greed: Restoring Confidence in America’s Companies
John R. Nofsinger
Investment Blunders (of the Rich and Famous)…And What You Can Learn from The
m
John R. Nofsinger
Investment Madness: How Psychology Affects Your Investing…And What to Do

About It
H. David Sherman, S. David Young, and Harris Collingwood
Profits You Can Trust: Spotting & Surviving Accounting Landmines
Leadership
Jim Despain and Jane Bodman Converse
And Dignity for All: Unlocking Greatness through Values-Based Leadership
fm01.qxd 1/29/04 08:12 AM Page x
Marshall Goldsmith, Vijay Govindarajan, Beverly Kaye, and Albert A. Vicere
The Many Facets of Leadership
Marshall Goldsmith, Cathy Greenberg, Alastair Robertson, and Maya Hu-Chan
Global Leadership: The Next Generation
Management
Rob Austin and Lee Devin
Artful Making: What Managers Need to Know About How Artists Work
J. Stewart Black and Hal B. Gregersen
Leading Strategic Change: Breaking Through the Brain Barrier
William C. Byham, Audrey B. Smith, and Matthew J. Paese
Grow Your Own Leaders: How to Identify, Develop, and Retain Leadership Talent
David M. Carter and Darren Rovell
On the Ball: What You Can Learn About Business from Sports Leaders
Subir Chowdhury
Organization 21C: Someday All Organizations Will Lead this Way
Ross Dawson
Living Networks: Leading Your Company, Customers, and Partners
in the Hyper-connected Economy
Charles J. Fombrun and Cees B.M. Van Riel
Fame and Fortune: How Successful Companies Build Winning Reputations
Amir Hartman
Ruthless Execution: What Business Leaders Do When Their Companies Hit the Wal
l

Harvey A. Hornstein
The Haves and the Have Nots: The Abuse of Power and Privilege in the Workplace
…
and How to Control It
Kevin Kennedy and Mary Moore
Going the Distance: Why Some Companies Dominate and Others Fail
Roy H. Lubit
Coping with Toxic Managers, Subordinates…and Other Difficult People
Robin Miller
The Online Rules of Successful Companies: The Fool-Proof Guide to Building Profi
ts
Fergus O’Connell
The Competitive Advantage of Common Sense: Using the Power You Already Have
W. Alan Randolph and Barry Z. Posner
Checkered Flag Projects: 10 Rules for Creating and Managing Projects that Win,
Second Edition
Stephen P. Robbins
Decide & Conquer: Make Winning Decisions to Take Control of Your Life
Stephen P. Robbins
The Truth About Managing People…And Nothing but the Truth
fm01.qxd 1/29/04 08:12 AM Page xi
Ronald Snee and Roger Hoerl
Leading Six Sigma: A Step-by-Step Guide Based on Experience with GE and Other
Six Sigma Companies
Susan E. Squires, Cynthia J. Smith, Lorna McDougall, and William R. Yeack
Inside Arthur Andersen: Shifting Values, Unexpected Consequences
Jerry Weissman
Presenting to Win: The Art of Telling Your Story
Marketing
David Arnold

The Mirage of Global Markets: How Globalizing Companies Can Succeed as
Markets Localize
Michael Basch
CustomerCulture: How FedEx and Other Great Companies Put the Customer First
Every Day
Jonathan Cagan and Craig M. Vogel
Creating Breakthrough Products: Innovation from Product Planning
to Program Approval
Al Lieberman, with Patricia Esgate
The Entertainment Marketing Revolution: Bringing the Moguls, the Media,
and the Magic to the World
Tom Osenton
Customer Share Marketing: How the World’s Great Marketers Unlock Profits
from Customer Loyalty
Bernd H. Schmitt, David L. Rogers, and Karen Vrotsos
There’s No Business That’s Not Show Business: Marketing in Today’s Experience
Culture
Yoram J. Wind and Vijay Mahajan, with Robert Gunther
Convergence Marketing: Strategies for Reaching the New Hybrid Consumer
Personal Finance
Steve Weisman
A Guide to Elder Planning: Everything You Need to Know to Protect Yourself Legall
y
and Financially
Public Relations
Gerald R. Baron
Now Is Too Late: Survival in an Era of Instant News
Deirdre Breakenridge and Thomas J. DeLoughry
The New PR Toolkit: Strategies for Successful Media Relations
Strategy

Edward W. Davis and Robert E. Spekmam
The Extended Enterprise: Gaining Competitive Advantage through Collaborative
Supply Chains
Joel M. Shulman, With Thomas T. Stallkamp
Getting Bigger by Growing Smaller: A New Growth Model for Corporate America
fm01.qxd 1/29/04 08:12 AM Page xii
Investment Fables: Tall Tales about
Stocks xxv
Chapter 1 Introduction 1
The Power of the Story 1
Categorizing Investment Stories 2
Stories for the Risk Averse 2
Stories for the Risk Seeker 4
Stories for the Greedy 6
Stories for the Hopeful 8
Deconstructing an Investment Story 9
I. Theoretical Roots: Isolating the Kernel of Truth 10
II. Looking at the Evidence: Getting the Full Picture 11
III. Crunching the Numbers: Developing a Frame of Reference 13
IV. More to the Story: Probing for Weaknesses 14
V. Lessons for Investors 15
Conclusion 16
Chapter 2 High Dividend Stocks: Bonds
with Price Appreciation? 17
Core of the Story 18
xiii
Contents
fm01.qxd 1/29/04 08:12 AM Page xiii
Theoretical Roots: Dividends and Value 19
Dividends Do Not Matter: The Miller-Modigliani Theorem 20

Dividends Are Bad: The Tax Argument 21
Dividends Are Good: The Clientele and Signaling Stories 22
Looking at the Evidence 23
Do Higher Yield Stocks Earn Higher Returns? 24
The Dividend Dogs 26
Dividend Increases 29
Crunching the Numbers 30
Dividend Yields: Across Companies and Over Time 30
Sector Differences in Dividend Policy 33
A Portfolio of High Dividend Stocks 35
The Rest of the Story 35
Unsustainable Dividends 38
Low Growth 44
Taxes 47
Lessons for Investors 50
Conclusion 51
Chapter 3 This Stock Is So Cheap!
The Low Price Earnings Story 57
Core of the Story 58
Theoretical Roots: Determinants of PE Ratio 59
What Is the PE Ratio? 60
A Primer on Accounting Earnings 61
Determinants of PE Ratios 63
Looking at the Evidence 66
Ben Graham and Value Screening 66
Low PE Stocks versus the Rest of the Market 67
Crunching the Numbers 70
PE Ratios Across the Market 70
Contents
xiv

fm01.qxd 1/29/04 08:12 AM Page xiv
PE Ratios Across Sectors 73
PE Ratio Across Time 75
A Low PE Portfolio 77
More to the Story 77
Risk and PE Ratios 81
Low Growth and PE Ratios 84
Earnings Quality and PE Ratios 87
Lessons for Investors 88
Conclusion 91
Endnotes 91
Chapter 4 Less than Book Value:
What a Bargain? 95
The Core of the Story 96
Theoretical Roots Theory: Price to Book Ratios
and Fundamentals 97
Defining the Price-to-Book Ratio 97
How Accountants Measure Book Value 98
Determinants of PBV Ratios 100
Looking at the Evidence 103
Evidence from the United States 103
Evidence from Outside the United States 106
Crunching the Numbers 107
Distribution of Price-to-Book Ratios Across the Market 107
Price-to-Book Ratios by Sector 108
A Low Price-to-Book Portfolio 109
More to the Story 112
High-Risk Stocks 112
Low-Priced Stocks 115
Poor Projects: Low Return on Equity 117

Lessons for Investors 121
Conclusion 122
Contents
xv
fm01.qxd 1/29/04 08:12 AM Page xv
Chapter 5 Stable Earnings,
Better Investment? 127
Core of the Story 128
Measurement of Earnings Stability 129
Theoretical Roots: Earnings Stability
and Value 131
Diversification and Risk 131
Stable Earnings, Risk and Value 132
Looking at the Evidence 133
Stable Businesses with No Competition 134
Diversified Business Mix: The Allure of Conglomerates 135
Global Diversification 137
The Risk Hedgers 138
The Earnings Smoothers 141
Crunching the Numbers 145
Earnings Volatility Across the Market 146
A Portfolio of Stable Earnings Companies 148
More to the Story 151
Stable Earnings, Risky Investment? 151
Giving Up on Growth Opportunities 153
Priced Right? 155
Earnings Quality 156
Lessons for Investors 158
Conclusion 159
Chapter 6 In Search of Excellence: Are Good

Companies Good Investments? 163
Core of the Story 164
What Is a Good Company? 165
Financial Performance 165
Contents
xvi
fm01.qxd 1/29/04 08:12 AM Page xvi
Corporate Governance 167
Social Responsibility 169
The Theory: Building Quality into Value 170
Inputs in a DCF Valuation 171
EVA and Excess Return Models 172
Looking at the Evidence 174
Project Quality and Stock Returns 174
The Payoff to Corporate Governance 175
The Payoff to Social Responsibility 176
Broader Definitions of Good Companies 177
Crunching the Numbers 180
Across the Market 180
A Superior Company List 182
More to the Story 187
Failing the Expectations Game 187
Revering to the “Norm” 188
Lessons for Investors 190
Conclusion 192
endnotes 193
Chapter 7 Grow, Baby, Grow!:
The Growth Story 197
The Core of the Story 198
The Theory: Growth and Value 199

Growth in a Discounted Cash Flow Valuation 200
The Value of Growth in a Relative Valuation 203
Looking at the Evidence 204
High PE Strategy 204
Growth at a Reasonable Price (GARP) Strategies 208
Crunching the Numbers 212
Across the Market 212
Contents
xvii
fm01.qxd 1/29/04 08:12 AM Page xvii
The Value of Growth 214
A High Growth Portfolio 216
More to the Story 219
Identifying Growth Companies 219
Screening for Risk 223
Poor-Quality Growth 225
Lessons for Investors 228
Conclusion 229
Chapter 8 The Worst Is Behind You:
The Contrarian Story 233
The Core of the Story 234
Theoretical Roots: The Contrarian Story 235
Information and Price 235
The Random-Walk World 238
The Basis for Contrarian Investing 239
Looking at the Evidence 240
Serial Correlation 241
Loser Stocks 244
Crunching the Numbers 247
Across the Market 247

The Sector Effect 249
A Portfolio of Losers 250
More to the Story 251
Transactions Costs 251
Volatility and Default Risk 256
Catalysts for Improvement 257
Lessons for Investors 258
Conclusion 259
Endnotes 260
Contents
xviii
fm01.qxd 1/29/04 08:12 AM Page xviii
Chapter 9 The Next Big Thing: New Businesses
and Young Companies 263
Core of the Story 264
Theoretical Roots: Risk
and Potential Growth 265
Additional Risk 266
Potential for Excess Return 268
Looking at the Evidence 270
Small Companies 270
Initial Public Offerings 275
Private Companies 279
Crunching the Numbers 283
Market Capitalization 283
Initial Public Offerings 286
Private Equity Investments 290
A Portfolio of Small Cap, Lightly Followed Stocks 291
More to the Story 292
Small and Lightly Followed Stocks 295

Initial Public Offerings 300
Private Companies 303
Lessons for Investors 304
Conclusion 307
Endnotes 308
Appendix: Small-Cap Companies That Are Lightly
Followed: January 2003 310
Chapter 10 Mergers and Returns:
The Acquisitive Company 311
Core of the Story 312
Theoretical Roots: Acquisitions and Value 315
Acquisitions and Value Creation 315
Acquisitions and Value Division 319
Contents
xix
fm01.qxd 1/29/04 08:12 AM Page xix
Looking at the Evidence 321
Acquisition Date 321
From Announcement to Action 325
After the Acquisition 327
Crunching the Numbers 328
Acquiring and Acquired Firms 328
Creating Portfolios 332
More to the Story 336
Investing in Acquiring Firms 336
Investing in Target Firms 341
Lessons for Investors 344
Conclusion 346
Endnotes 347
Appendix: Potential Takeover Targets Among

US Companies—March 2003 350
Chapter 11 A Sure Thing: No Risk
and Sure Profits 353
Core of the Story 354
Theoretical Roots of Arbitrage 355
Pure Arbitrage 356
Near Arbitrage 361
Pseudo or Speculative Arbitrage 363
Looking at the Evidence 363
Pure Arbitrage 364
Near Arbitrage 366
Pseudo or Speculative Arbitrage 371
Crunching the Numbers 373
Futures and Options Arbitrage 373
Depository Receipts 376
Closed-End Funds 378
Contents
xx
fm01.qxd 1/29/04 08:12 AM Page xx
More to the Story 379
Pure Arbitrage 380
Near Arbitrage 380
Speculative Arbitrage 382
Lessons for Investors 385
Conclusion 387
Endnotes 388
Chapter 12 It’s All Upside:
The Momentum Story 391
The Core of the Story 392
Theoretical Roots of Momentum Investing 393

Measures Used by Momentum Investors 393
Models for Momentum 395
Looking for the Evidence 397
Serial Correlation in Stock Price Drifts 398
Information Announcements 400
The Confounding Effect of Trading Volume 405
Momentum in Mutual Funds 406
Crunching the Numbers 409
Momentum Measures 409
Constructing a Momentum Portfolio 415
More to the Story 421
Risk 421
Momentum Shifts (When Do You Sell?) 424
Execution Costs 426
Lessons for Investors 426
Conclusion 429
Endnotes 430
Contents
xxi
fm01.qxd 1/29/04 08:12 AM Page xxi
Chapter 13 Follow the Experts 435
The Core of the Story 436
Theoretical Roots: The Value
of Expert Opinion 437
Looking at the Evidence 439
Insiders 440
Analysts 445
Investment Advisors and Other Experts 453
Crunching the Numbers 455
Insider Trading 455

Analyst Recommendations and Revisions 457
Portfolio of “Expert” Stocks 461
More to the Story 463
Following Insiders: Timing Is Everything 463
Earnings Revisions 465
Analyst Recommendations 465
Lessons for Investors 467
Conclusion 469
Chapter 14 In the Long Term
Myths about Markets 475
Core of the Story 476
Theoretical Roots: Market Timing 477
Market Timing Trumps Stock Selection 477
Market Timing Works 478
Looking at the Evidence 479
Do Stocks Always Win in the Long Term? 480
Market Timing Indicators 484
Market Timers 499
More to the Story 505
Stocks Are Not Riskless in the Long Term 506
Contents
xxii
fm01.qxd 1/29/04 08:12 AM Page xxii
Market Timing Works Only Infrequently 509
Lessons for Investors 513
Conclusion 515
Chapter 15 Ten Lessons for Investors 519
Lesson 1: The more things change, the more they
stay the same. 519
Lesson 2: If you want guarantees, don’t invest

in stocks. 520
Lesson 3: No pain, no gain. 520
Lesson 4: Remember the fundamentals. 520
Lesson 5: Most stocks that look cheap are
cheap for a reason. 521
Lesson 6: Everything has a price. 521
Lesson 7: Numbers can be deceptive. 522
Lesson 8: Respect the market. 523
Lesson 9: Know yourself. 523
Lesson 10: Luck overwhelms skill (at least in
the short term). 524
Conclusion 525
Index 527
Contents
xxiii
fm01.qxd 1/29/04 08:12 AM Page xxiii
fm01.qxd 1/29/04 08:12 AM Page xxiv