Narrative and numbers
Business insights through tales
Description
Valuing an asset requires analyzing both quantitative and qualitative factors. The numbers alone don't tell the full story. Equally important is understanding the narrative behind the asset.
An effective valuation blends numerical analysis and contextual insights. Stories without numbers are fanciful. Numbers without stories lack meaning. Good valuation draws on both to reach a figure that makes sense. In effect, valuation forces storytellers to ground their tales in reality, and number-crunchers to recognize when their figures don't align with a credible narrative.
Ultimately, valuation is about building a bridge between the quantitative data and qualitative factors to arrive at a valuation that incorporates both elements. This provides a more complete picture of an asset's worth than either numbers or stories alone could offer.
Table of contents
01Step 1 - examine the current state.
Understanding a company's value requires a deep dive into its business model, financial health, product offerings, market dynamics, and historical context.
It's also crucial to recognize the strengths and weaknesses of both narrative and numerical valuation methods. People often gravitate towards being a "numbers person" or a "storyteller," which reflects the dominance of one hemisphere of their brain over the other.
Numbers people argue that valuation should be based purely on financials, viewing narratives as distractions. Conversely, storytellers see valuation as an evolving story and consider precise future projections as presumptuous. These two groups often fail to understand each other and dismiss the opposing viewpoint, each believing their approach is superior.
02Step 2 - craft a future growth story.
Crafting a persuasive business story is essential for establishing a strong company valuation. The narrative should encapsulate your vision for the company's future in a simple, credible, inspiring way that motivates action. Start by telling the company's origin story - the thinking behind its founding and any memorable events throughout its history. This grounds the narrative in real events and provides context.
Next, analyze the market landscape to build your storyline. Is the market growing rapidly? Are parts expanding faster than others? Do profitability and risk levels vary across the industry? Understanding market dynamics allows you to position the company credibly.
With this background, articulate your vision for the company's path to profits and leadership. Frame it along several dimensions: - Big Vision vs Regional Start - Will you start locally before expanding, or lead with an ambitious global vision? Big stories inspire but risk overpromising. Regional beginnings allow focus. Both work. - Disruptor vs Incumbent - Will you challenge the status quo or strengthen current practices? Disruptors excite interest, but stability has merits too. Be clear which you are. - Finite vs Everlasting - Do you have a defined endpoint or plan to operate perpetually? Most natural resource companies accept finite lifespans well. - Start-up, Growth, Maturing - Where are you on the spectrum? Be explicit about your growth stage.
03Step 3 - validate the story against reality.
A compelling business narrative must be grounded in reality, and to assess its realism, Aswath Damodaran suggests applying the "Three P's Test": Possible, Plausible, and Probable. A narrative becomes impossible when it defies basic economic constraints, such as projecting growth beyond the market's total size or assuming profit margins over 100%. Similarly, narratives veer into implausible territory with unrealistic assumptions about the future, like expecting to raise prices and maintain high margins amidst fierce competition or planning to cut wages while expecting more from employees. Markets often expose these flawed narratives, especially in young, hyped industries, leading to speculative bubbles that eventually burst.
A narrative becomes improbable when it overlooks risks, suggests growth without investment, or assumes global expansion without operational investment. Investor skepticism is warranted when risks seem to diminish as revenues grow or when significant growth is projected without corresponding investment. Business narratives must align with market realities, considering total market size, competition, and the operational investments required. They should incorporate risk factors and challenges to profitability, with reasonable assumptions about employees, prices, margins, and funding.
04Step 4 - identify key value drivers.
Connecting a business narrative to concrete metrics effectively bridges the gap between qualitative storytelling and quantitative analysis. A versatile approach to achieve this is through the Discounted Cash Flow (DCF) model, which allows for the integration of any business story into a structured valuation framework.
This model begins with estimating total revenue by multiplying the addressable market size by the estimated market share. Revenue, when multiplied by the pretax operating margin, yields operating income. After-tax operating income is obtained by subtracting taxes, and free cash flow is calculated by subtracting reinvestment needs. The value is then determined by discounting these cash flows to the present using a risk-adjusted rate.
Different business narratives emphasize various valuation inputs. For instance, narratives focusing on big markets stress the importance of overall market size. Network effect narratives prioritize market share and winner-take-all dynamics, while competitive advantage stories highlight high market share and margins. Tax optimization narratives concentrate on after-tax operating income, rapid scaling stories on low reinvestment rates, and low-risk business narratives on their risk profile.
05Step 5 - connect drivers to valuation.
Valuing an asset involves a comprehensive process that integrates projected cash flows from existing assets and growth initiatives, while also considering the need for reinvestment and making necessary risk adjustments. This process is crucial for determining the fair market or present value of assets, which can range from tangible assets like buildings and equipment to intangible assets such as brands, patents, and trademarks.
The valuation of a business as an ongoing concern is predicated on the earnings power of its current assets after accounting for taxes and the reinvestment required to sustain those earnings. Additionally, it includes the present value of projected future earnings from growth initiatives, again adjusting for taxes and reinvestment needs, and subtracts a risk adjustment to account for the higher risk associated with these future cash flows.
The calculation of the total enterprise value further refines this valuation by adding any excess cash and investments not needed for operations, subtracting interest-bearing debt, and making adjustments for major contractual commitments, potential repatriation taxes on foreign capital, the value of cross-holdings in other companies, future stock-based compensation, and variations in currency and interest rates. It also considers the cost of acquiring future equity funding.
06Step 6 - iterate the process.
The interplay between narrative and numbers in valuation is a nuanced process that requires flexibility, openness to feedback, and a balance between storytelling and quantitative analysis. Aswath Damodaran, a leading authority in valuation, emphasizes the importance of starting with a narrative that outlines the future trajectory of a company or project. This narrative is not fixed but should evolve with new information, integrating scenario and Monte Carlo analysis to better understand potential outcomes.
Valuation narratives should be tested for their possibility, plausibility, and probability, avoiding biases and ensuring consistency across assumptions. It's crucial to acknowledge the inherent uncertainty in valuation, using it as a tool to refine and improve the narrative rather than seeking absolute precision.
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