ASWATH DAMODARAN is a world-renown valuation expert who teaches at the Stern School of Business, New York University. At the May 2022 Alpha Summit GLOBAL by the CFA Institute, he shared insights on the art and pitfalls of valuing young companies in a presentation titled "Dreams and Delusions: Valuing and Pricing Young Businesses".
The greatest challenge in valuing companies isn’t coming up with better metrics or models. It’s dealing with uncertainty. In fact, more precisely, the problem is NOT dealing with uncertainty. As humans, we tend to respond to uncertainty with denial or avoidance: Our first reaction is to make the problem worse.
And uncertainty is always greatest with younger companies because they have not only less history and more unknowns but also virtually infinite potential.
Uncertainty comes in many forms.
Estimation Uncertainty vs. Economic Uncertainty. While we can reduce estimation uncertainty by gathering more or better information, economic uncertainty is harder to mitigate. Ninety percent of the uncertainty we face in valuation is economic uncertainty. No amount of homework or data is going to allow it to go away.
Micro Uncertainty vs. Macro Uncertainty. Micro uncertainty focuses on the company— what it does, its business model, etc. Macro uncertainty encompasses interest rates, inflation, government policies, and other factors beyond a company’s control. In most valuations of publicly traded companies, macro uncertainty dominates the discount rate.
Continuous Uncertainty vs. Discrete Uncertainty. For example, under normal conditions, exchange rates fluctuate continuously without having a major impact on a company’s cash flow. Discrete uncertainty involves things that don’t happen often but that can be disastrous if they occur. If the company’s main operating currency suddenly devalues by 75%, that kind of discrete event will have a catastrophic effect on the business.
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Uncertainty in valuations for younger firms.
Understand the life cycle of companies, going from younger to middle aged to old. Each stage has different characteristics and risks. For younger companies in particular, micro-uncertainty tends to be most important. As companies mature, macro-uncertainty becomes more significant. But uncertainty is greatest for young companies because everything is in flux, which is why they tend to provoke the unhealthiest responses.
What do these responses look like?
- First, we sometimes simply shut down because the uncertainty is overwhelming.
- Second, we deny that the uncertainty exists or pretend that we can’t see it.
- Third, we use mental accounting: We make up rules of thumb based on companies we valued in the past.
- Fourth and very dangerous form of dealing with uncertainty, which is you outsource. When you feel uncertain, what do you do? You call in a consultant. You just don’t take responsibility then for what goes wrong.
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A process to arrive at more accurate valuations.
Come up with a story. We have grown too dependent on financial models, to the point of losing the plot. A good valuation is a marriage between stories and numbers. When you show me the valuation of a company, every number in your valuation has to have a story that’s attached to it. And every story you tell me about a company has to have a number attached.
With well-established companies, it’s possible to project numbers into the future. But this doesn’t work with young companies: It generates junk valuations because last year’s numbers can’t be projected forward. With young companies, it’s hard to convert a story into numbers. Doubt becomes a factor and we’re afraid of being wrong.
Keep your valuations parsimonious. Less is more. The instinct that a lot of people have in valuing companies is to add more detail, and we now have the tools to do it. We’re drowning in detail. I see valuations that often run to 300-line items and 15 worksheets. Let it go. Instead, focus on:
Factors related to the business model:
- revenue growth
- target operating margin (to capture profitability)
- sales-to-invested-capital ratio (to reflect how efficiently growth is captured).
Factors related to cost of funding:
- what does it cost to raise equity?
- what does it cost to raise debt?
Risk-related metric:
The likelihood that your company will fail. Every discounted cash flow valuation is a valuation of your company as a going concern. But there’s a chance your company might not make it, especially for young companies.
The component to measure riskiness itself is cost of capital. With higher growth and higher reinvestment, one expects to see higher risk. A valuation that shows high growth, low reinvestment, and low risk should raise questions. If there are internal inconsistencies, we need to have solid reasons for them.
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The Bermuda Triangle: Uncertainty, Complexity, Bias
To value young companies well, we have to account for different types of uncertainty, and we have to manage our own reactions to uncertainty: paralysis, denial, avoidance, and outsourcing.
The three greatest challenges in valuation constitute the Bermuda Triangle of uncertainty, complexity, and bias. The first two can be managed and mitigated, but bias is unavoidable. The presumption of objectivity is dangerous, and denying bias makes everything worse. We should admit our biases and be open about them. This point gets back to storytelling and connecting the story to the numbers. Admit that we have a story about the company and use it with intention and awareness.
We shouldn’t fall blindly in love with our story. We need to recognize when we get the story wrong and fix it. To avoid being blinded by our biases, show your analysis to people who think differently and who will tell us when they disagree with our story. We should listen to them.
Turn the anxiety of dealing with uncertainty into something much better, fun. Enjoy the challenge of valuing young companies. I’d rather value young companies than mature companies, but it comes from being willing to be wrong and to be willing to correct the mistakes you make in your stories.
The above extract has been taken from Enterprising Investor.
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