Sunday, April 1, 2018

The Value of Stories in Business: Aswath Damodaran

Gyan on Treadmill dated 30-Mar-2018

In his book Tao Jones Averages, author Bennett W Goodspeed complains that the traditional financial analysis is too left brain oriented and it doesn't consider those information that are not available in numbers. The book encourages investors to use 'whole brain investment' strategy.

It is almost like Prof.Aswath Damodaran, professor of Business Valuation, and a global expert in Business Valuation, read the book and decided to act on it. The talk on 'The value of stories in business', by professor, may be the closest that one may have come to 'whole brain' valuation. Professor encourages us to build our valuation case as a story and attach numbers to each key aspect of the story.

Professor Damodaran is very liberal with sharing his knowledge. You can read his ideas and opinions in his blog 'Musings on Markets'

Also puts up his entire course on Youtube.

Professor Damodaran has elaborated his ideas on the stories that are related to numbers in his book 'Narratives and Numbers-The value of stories in business'. The current talk by Professor is based on this book.

Professor is very articulate and very humorous. You will find the PRESENTATION very enjoyable.

He starts off by dividing his class into two groups, one, the 'number crunchers', who thrive on numbers and are left brained and two, the 'story tellers', who are more imaginative than analytical. Each group maintain some delusions. The former has delusion of precision - the idea that data is precise and more precise the data, more precisely it describes reality, delusion of objectivity - that the data has no bias and delusion of control - that you control information since you have the numbers. The delusions of the latter group include, 'You cannot quantify creativity', 'If the story is good, the investment will be - I have told you a great story, it should be worth 3 Billion, right?' and 'Experience is the best teacher'.

In addition, the tools used by these groups are different. While number crunchers use tools like accounting statements, spreadsheets, statistical methods and pricing data, the story tellers use tools like anecdotes, experience (own or others) and behavioural evidence.

The objective of this presentation is to create 'disciplined story tellers' or 'imaginative number crunchers'. The approach is first to right the story (he calls it narrative) and then attach numbers to it to come up with valuation. There are five steps in converting the story to numbers. These are:
  1. Develop a narrative for the business you are valuing: In this narrative, you tell the story of how you see business evolving over time
  2. Test the narrative to see if it is Possible, Plausible or Probable: There are a lot of possible narrative, a subset of these are the plausible and a subset of plausible are probable narratives.
  3. Convert the narratives into value drivers: Take the narrative apart and see how you will bring it into valuation with potential market size down to cash flows and risk. Each part of your narrative should have a corresponding number attached to it and each number should have a story attached to it. 
  4. Connect the value drivers to valuation: Create a valuation model that connects the inputs to a final business value
  5. Keep the feedback loop open: Listen to people who knows business better than you and use their suggestions to fine tune your narrative and perhaps even alter it. Work out the effects on value of alternative narratives for the company. 
While developing the narrative you make assessment of the company (its products, management and history), the markets that you see it growing in, the competition and the macro-environment.

The narrative should answer questions like why the business will be scalable (Network effect in case of Uber, more the drivers affiliated with Uber, more will be motivated to join the Uber network), why should customer buy the product, Why the revenue will grow in future, why the margin will grow / shrink in future, what are the risks etc.

As an example, Professor discusses the valuation of Uber and Ferrari. He had valued Uber in 2014 at about 6 Billion, when PE firms had priced it at 17 Billion.

For Uber, the initial narrative in 2014 was as follows.
  1. It would be an urban car rental business with focus only on car services
  2. It would expand business gradually (40% over 10 years) through new customer acquisition
  3. It has local networking business, which means that if it establishes in one city, it will quickly become larger. But the size in one city is irrelevant as it moves into a new city
  4. Will maintain its current revenue sharing model due to competition.
  5. Continue its current business model, with drivers as contractors and very little investment in infrastructure.
Once the narrative is established it can be put in a visual framework as shown below

Figure 1:The Narrative Framework for Uber
Once this framework is completed, it is easy to fill in numbers and find the valuation of the company.

This blog is not going into the details of valuation. Kindly watch the full video for details.

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