The Most Important Aspect of Valuation?
If there is one single thing that I believe analysts normally either do not understand, ignore, or do not show in their valuations to a large enough extent, it is interlinking narrative and numbers when doing valuation. There are so many things to say on this topic, but I will only cover some of them in this post. I furthermore strongly encourage you to read the book “Narrative and Numbers” by Aswath Damodaran. It covers everything from the how to tell a story about a company and the elements of storytelling to the power of numbers and number-crunching tools. He covers how to create and test-drive a narrative with common sense and ultimately connect them to credible numbers and values and furthermore what happens with values of companies when we alter a narrative of a company going forward. I will talk about four aspects of the book that we believe every analyst should consider: closing the gap with valuation, the dangers of just sticking to one side, the three Ps, and the story-assumptions-cash flow-value-onepager.
Closing the Gap with Valuation
What did you like the most in high school: History and languages or Algebra and physics? If you belong to the first group, you are probably one of the story-people, i.e. a right-brainer. If you belong to the second group on the other hand, you might be one of the numbers-people, i.e a left-brainer. Some people are born with an ability to think effectively and in an integrated way with both sides of the brain, but most of us are less fortunate, and are naturally more comfortable with one than the other. Consequently, most of us have a hard time relating to arguments and insights coming from the opposite side of whatever side we are on. Interestingly, valuation has to incorporate both an underlying story and numbers. Consequently, a great valuation is as much about closing the gap between the number crunchers and the storyteller as it has to do with coming to an investment decision.
So why do the detail oriented excel wizards that can construct meaningful models and analyze data have to listen to the compelling narratives and ideas of the storytellers, and why should the convincing, charismatic storytellers bother understanding the mathematical relationships that govern value creating activities of a company and the market it operated in? The answer is that the valuations simply becomes more accurate. Just thinking with one side of your brain is highly dangerous if you are trying to beat the market since you might mislead yourself into making key assumptions that are way off. The dangers are too many not to bother creating an integration between narrative and numbers.
The Dangers of Stories and Numbers on an Individual Basis
We can all understand the value of stories. They can be remembered for decades, they connect to listeners and can change their emotion more than simple facts, and they cause people to act. In business, they motivate employees, they cause customers to pay premium prices and they make investors more patient and trusting in the long-term vision of a company. We, as human beings, also see the value of numbers. They are precise and tangible, objective when scientific in their use, and indicate control in the sense that they can measure and monitor aspects which people can act upon. All these aspects of stories and numbers are true and important, but the dangers of telling stories and crunching numbers are perhaps more valuable to understand for an analyst. Some of the dangers are listed below.
The three P’s
The three P’s - Probable, Plausible and Possible - refer to the conclusion that should be reached about the viability of a story or several stories. It is an interesting framework to use for several reasons. First of all, if you start thinking of the future of a company, you can create several storylines, and then make a judgement regarding which storyline that fits in which category. If something is possible, but you have no idea how, or even what this “thing” is that might happen, the valuation response is valuing it as an option. The value then increases with potential market size and the exclusivity of the company’s access to that market. Having a better idea of the market potential and having some indication that for example other companies have pulled off a product launch or succeeded in another similar way, the story becomes plausible. Then value it in expected growth but adjusted for the risk in expected return (or Cost of Capital). The value here also obviously increases with the size of the market but are also connected to the company’s competitive advantages. If the probability of occurrence of your story is increasing even more, for example after the company having showcased a product success and delivered financial results, you can call the story probable. There can still be uncertainty in the expectations, but here the valuation response is to show the story in the base year numbers and expected cash flows, adjusting for the risk in the expected return.
Interestingly, we can often group different types of investors on where they choose to invest on the narrative spectrum. Early stage Venture Capitalists on the possible side, and Ben Graham on the Probable side, with late stage VCs and aggressive growth investors to conservative growth investors and aggressive value investors in the middle. No type of strategy is necessarily always better than the other, but be sure to use the right valuation tools for the right type of story in the underlying business. For example, there are high quality pharmaceutical companies that has stable cash flows that we can include as probable in nature, but there are also real options in that type of business, which would be preferable to include not to underestimate the value of the enterprise.
I am going to list some potential pit-falls that some analysts might fall into when doing their valuations. I will, like Damodaran, list them under the impossible stories, the implausible stories, and the improbable stories.
- To get closure on a DCF, you will estimate the intrinsic value of a company at a future point in time (the terminal value) using either a liquidiation value or a growing perpetuity. Using a growing perpetuity, never set your growth rate above the growth rate of the economy. That assumption would assume that the company in eternity becomes bigger than the economy since it is based on an infinity formula.
- The eventual market share can not exceed 100%, which it often does in valuations where we look to the past and forecast revenues to the future. Revenues will quickly approach the total market and go even further.
- Companies that happen to have strong advantages in the marketplace today might have very high profit margins and are increasing efficiency. In modeling, profit margins can by mistake exceed 100% due to continued efficiencies. Obviously, a company cannot in real life generate profits higher than revenues.
- Just because equity holders do not charge interest on its capital, the money does not come without a cost. The capital has an implicit cost. If the investors do not get dividends, they want price appreciation, so measures like the dividend yield is not a measure of cost of capital. The idea of costless capital is sometime thrown around, but no such thing exists.
- Do not count on being able to get the best of several worlds, like being in a competitive sector, capturing market share, but simultaneal raising prices. The market has certain dynamics that you most likely can’t get around.
- Just because a market is big (think China), does not mean it is a good market to enter. The firm doing so most likely have a lot of company, is a part of an overvalued group, will see a smaller market share of the total and a low revenue growth, and has a high chance of ending up with nothing. Overpricing is big when capital providers and entrepreneurs are overconfident, the size of the market is huge, there is great uncertainty, and where one player gets to walk away with everything.
Narratives that are improbable often have some type of inconsistency. Not inconsistencies with other investors, but rather internally with itself, i.e. internal inconsistencies. These inconsistencies often show up when one of the following three questions can’t be answered with a yes. Damodaran calls this device the iron triangle of value.
- Risk & Growth: Is your risk reflective of how much, how, and where you are growing?
- Risk & Reinvestment: Is your risk consistent with your reinvestment strategy?
- Growth & Reinvestment: Are you reinvesting enough, given your growth?
The Story-Assumptions-Cashflow-Value One Pager
The main ideas behind a valuation should be able to fit on one page. Having looked at different types of equity research reports, stock pitches in magazines, spread sheets valuation summaries and other similar tools for giving the reader information about a valuation, I can one again reach the conclusion that Damodoran is one of the few valuation experts that manage to connect narrative and numbers into one page. I do not know what he calls them, but I have chosen to call them the “story-assumptions-cashflow-value” one pager, simply because that is what the summary contains. Here is one example which I found in an excel sheet he provided on his website doing a valuation of Tesla in August 2017.
I hope you enjoyed this post on the importance of Narrative and Numbers in Valuation!