The perfect recipe for valuations
Known worldwide as an authority on valuation, Aswath Damodaran tells us what it takes to value a business
By Aarati Krishnan | Sep 10, 2018
When you're fighting for a chair in an overpacked auditorium on a Sunday evening to listen to a talk on stock valuation, you know that it's a talk by Aswath Damodaran, professor of finance at Stern School of Business, New York University.
With a blog ('Musings on Markets') that attracts a global fan following that pop stars would envy, Professor Damodaran attracts adulation from students and market veterans alike for his lucid and practical posts on valuation. His willingness to stick his neck out on some of the most hard-to-value assets in the financial world, be they Uber, Tesla, Bitcoin or Facebook, is a big reason for this fan following.
Professor Damodaran recently delivered a talk at a fund-raiser event sponsored by the Rotary Club of Chennai Kilpauk to an eclectic crowd of students, analysts, fund managers and private investors at Chennai. Here are some of the takeaways from the lecture, which had the audience glued to their seats though dinner time.
Valuation is like cooking
No, the professor isn't referring to the kind of cooking that Indian managements like to do with their companies' books.
He begins his talk with the theoretical question: is valuation an art or a science? Many analysts believe valuation is a science because they work with spreadsheets and calculators to put a precise number to a company's stock price. But he demolishes this notion quickly by pointing out that different folks can arrive at vastly different valuations for the same business. Poking some fun at analysts who can value a business right down to the second decimal place, he points out that mathematics is the only pure science because there's only one right answer to a question. But different people can arrive at different valuations for the same business.
But then, valuation is not wholly an art either, as it isn't based wholly on perception and has a basis in numbers.
He concludes that valuation is a craft, like cooking. He advises people keen on learning about valuation to practise it as often as they can. 'Valuation cannot be learnt by reading books or listening to lectures,' he quips. 'So, go on, pick a company and value it. Just like the first time you cook, it will most probably be a disaster. But keep doing it and you'll get better.'
He regales us with the story of how there was no subject called valuation when he first began teaching his course at the Stern School, NYU. 'Students thought they were enrolling into this boring course called securities analysis. But I taught valuation and gradually the class size expanded.' He found that as he valued more companies, there was more course content to teach!
Number cruncher or story teller?
Most of us in the business of investing think we're hard-headed folks who are great at numbers and have no room for stories. But the professor takes a diametrically opposing view.
To be good at valuation, he claims, you need to be a good story teller and also a good number cruncher. He asks the audience to think if they would describe themselves as number crunchers or story tellers first. He says people usually have an affinity for one or the other. People who love algebra hate English. Those who love literature hate numbers and love nuances and hidden meanings.
But as the audience chuckles, he adds that number crunchers think they have the upper hand, but they don't. Number crunchers suffer from the delusion of precision, the delusion of being objective and the delusion of being in control. But then valuations depend on assumptions and can go badly wrong if the assumptions are wrong.
Story tellers on the other hand get carried away by the delusion of creative exclusivity. They extrapolate too much from a few anecdotes. Often fanciful stories don't translate into real-world valuations.
So, his message is - 'A good valuation is never all about the numbers, and never all about stories. Good valuation is a bridge between stories and numbers.'
Weapons of mass distraction
He takes a mild detour to pick up a $20 bill, put it in an envelope and hand it to a volunteer from the audience.
What would you pay for it, he asks. Then he writes the word 'control' on a piece of paper and slips it into the envelope and challenges, 'Now would you pay three times that sum? Four times?'
His point is that often, in acquisitions, companies use words such as 'control premium', 'synergy' and 'brand value' to justify overpaying for a business. He asks investors to take the 'fairness opinions' done by investment bankers with a bucket of salt. No deal can be fair to both sides. If it is fair to the other side, investment bankers use 'synergies' to justify it, he quips.
He makes a special mention of another really dangerous word - 'strategic'. To mask a stupid deal, companies often call them 'strategic'. Words are weapons of mass distraction in valuation, he concludes. Don't pay for empty words.
Getting to the narrative
So how does one go about mixing and matching narratives with numbers? He cites his own first attempt at valuing Uber in 2014. He had heard about Uber from a friend and decided to hail an Uber to experience the ride for himself.
After asking the driver to drive around the city aimlessly, he chatted with him to find out more about this new taxi service. Not only was he impressed with how promptly the car arrived to pick him up, he was also impressed with the business model which ensured that Uber was an aggregator and not asset owner. It was making profits off every ride simply on account of its technology.
The following was the narrative that formed the basis of his Uber valuation model. Uber was an urban car service company far more convenient than the local taxis. It functioned on very low capital. It could scale up on the back of a local network effect, i.e., new customers and drivers in a locality automatically joined Uber's network because it was the largest there. Thus, he posited that Uber could rapidly eat into the market for conventional taxi services in cities where it managed to be first. Once he had this narrative, all he had to do was model the numbers that fit this narrative. This helped him build out the worksheet where he valued Uber at $6 billion, far below what private-equity investors were then paying for it.
He has two lessons to offer from that. One, to have faith in your valuation and act on it, you need a story that holds together the numbers. Every part of your spreadsheet needs to be consistent with the story you are telling.
Two, private-equity investors are great at 'pricing' companies, not valuing them. They try to second-guess what other investors will pay for a business. The most successful private-equity guys are those who get in and get out at the right time. Mark Cuban of the Shark Tank fame, he points out, made his millions by exiting a tech venture at the top of the dot-com boom.
Five steps to valuation
Drawing on his own experience, he lays down the five steps to valuing any business.
1. Tell a story about a company
2. Evaluate if it is possible, plausible and probable (be realistic).
3. Convert the narrative into numbers in a spreadsheet. Make sure the numbers are consistent with the story.
4. Check your story and numbers with outsiders. Your own circle may be an echo chamber.
5. Keep the feedback loop open.
Taking off from his own Uber example, he talks of how his blog post was shared in a variety of forums around the world. The most valuable feedback he got and one which helped him hugely improve his valuation model was that from a ride-sharing association, whose members had a lot of criticisms on his blog. These taxi drivers gave him insights about Uber's business model that he wouldn't have got from any company management.
His message is that company managements are the last persons to talk to if you want to build a realistic valuation model. It is far better to talk to customers, workers, suppliers, associates. 'I have never ever spoken to the top management of a company I am valuing.'
Keep the feedback loop open
Finally, it is very important to be humble and open-minded. Welcome opportunities to talk to people who will be the devil's advocate on your valuation.
He remembers how an email from Bill Gurley, who was on Uber's board of directors, vastly changed his story about Uber and caused him to sharply revise his valuation upwards. Basically, Gurley made the point that Damodaran was wrong in valuing Uber as a car-services company, when in fact, it was a logistics and delivery company. That small tweak led to a vast upward revision in Uber's potential market size in the professor's spreadsheet and upped its valuation by many billion dollars.
The final message: Don't fall in love with your spreadsheet or story. Revise them as many times as needed based on feedback from those in the know. That's the recipe for a perfect dish.