There’s a common saying, often mistakenly described as a Chinese curse: “May you live in interesting times.”
Aswath Damodaran puts a modern spin on it to characterize our current era:
“We live in disruptive times.”
Disruption is everywhere. Upstarts are constantly challenging the status quo, whether it’s a company coming up with a novel way to grow food indoors, develop diamonds in a lab, or photograph the Earth.
“In a sense, you can divide the whole world into the disruptors and the disrupted,” Damodaran told the audience at the CFA Institute Equity Research and Valuation 2019 Conference. “No matter what business you’re in, you’re either being disrupted, in which case you feel very depressed, or you’re a disruptor, in which case you feel a little upbeat — but you’re burning through cash like crazy.”
While it’s harder to value disruptors, the bright side is that there is an opportunity to shine when valuing young companies.
Except for one matter: Disruption makes us uncomfortable. Deeply uncomfortable.
Get Comfortable with Being Uncomfortable
Why are we so uneasy with disruption? Because it brings with it the one thing we dread the most: uncertainty. “As human beings,” Damodaran said, “we don’t like to deal with uncertainty.”
And we respond to uncertainty in the ways we always have, he explained:
- By seeking divine influence: “Praying for intervention from a higher power is the oldest and most practiced risk management system of all,” Damodaran said.
- With inertia and denial: “When faced with uncertainty, some of us get paralyzed,” he said. “Accompanying the paralysis is the hope that if you close your eyes to it, the uncertainty will go away.”
- Heuristics, or rules of thumb: “Behavioral economists note that investors faced with uncertainty adopt mental shortcuts that have no basis in reality,” he explained.
- By herding: “When in doubt,” Damodaran said, “it is safest to go with the crowd.”
- By outsourcing: “Assuming that there are experts out there who have the answers does take the weight off your shoulders,” he said, “even if those experts have no idea what they are talking about.”
But for investment professionals, who are by definition very much vested in numbers, the disruption dilemma goes a bit deeper.
“I think at the core, what makes us uncomfortable about disruption is the uncertainty it brings into every number that we measure,” Damodaran said.
What Kind of Uncertainty?
Uncertainty comes in several forms, he said: Estimation uncertainty versus economic uncertainty, micro versus macro uncertainty, and discrete versus continuous uncertainty. And depending on the form, uncertainty can be mitigated to some extent.
But uncertainty also evolves as companies mature and move through their life cycles. So, for example, in the start-up phase, the uncertainty may be over whether the idea has potential. As the company advances to the young-growth stage, the uncertainty may be about whether there is a business model with which to commercialize the idea. For a company in the high-growth phase, it may be about whether the business model will generate growth. And later, when a company is in decline (the final stage), there may be uncertainty over whether management will own up to reality.
A company’s life cycle is just like a person’s, according to Damodaran.
“Start-ups are like babies,” he explained. “The difference is start-ups have a much higher mortality rate than babies. Two-thirds of all start-ups don’t make it.”
Then comes the terrible twos.
“If you make it through the start-up phase, you become a toddler,” Damodaran said. “What do toddlers do? They run into things, they fall all the time. And companies that are in the toddler stage will have good years, bad years, almost make it, almost fail, almost succeed. You make it through the toddler years, you become a teenager. What do teenagers do? Wake up every day and ask a question. What’s the question? ‘What can I do today to screw it all up?’”
Tesla, he said, a company that he owns, is his “corporate teenager.”
“It has lots of potential,” Damodaran observed. “But every morning Elon Musk gets up and he says, ‘What can I do today to screw it all up?’”
Of course, once the teenage years pass, the company starts to approach its full potential.
“You’re at the peak of your life,” Damodaran said. “Think of Facebook and Google two years ago. Everything you touch turns to gold. Enjoy the moment, because beyond the peak of your life lies middle age. In middle age, life’s not as exciting anymore. But enjoy that moment as well, because beyond middle age lies the dark days, when you get to be old, and then you die.”
What Has This Got to Do with disruption?
“Uncertainty is greatest when you’re in the young phase,” he said. “The kinds of uncertainty you face change, and so does the amount of uncertainty. That’s why we feel more comfortable valuing nice, mature companies and why we spend so much time on cost of capital.”
But the real value is in valuing young companies.
Given the choice between valuing iconic jeans company Levi Strauss, which went public in March 2019, or the Ubers and WeWorks of the world, Damodaran is unequivocal:
“You can value Levi Strauss more precisely, but so can everybody else. Why? Because they have exactly the same advantage as you do,” he explained. “Whereas with the Uber or WeWork, when you value the company, you’re already special. You know why? Because most people give up. Most people price the company. They say, ‘What’s everybody else paying?’ You’re at a decided advantage, because you actually finish the valuation.”
Damodaran’s bottom line: “The payoff to doing valuation is greatest when you feel most uncomfortable, when you feel like giving up.”
The Dark Side of Disruption
But for every Tesla, there is a Ford. For every Amazon, a J.C. Penney. There are winners and losers in the disruption equation.
For every disruptor that challenges the status quo with a new way of doing things, there is the disrupted company.
Damodaran calls this “the disruption dance,” and with it comes his take on the Kübler-Ross model of the five stages of grief — what he calls the five stages of being disrupted:
- Denial and delusion
- Failure and false hope
- Imitation and institutional inertia
- Regulation, rule-rigging, and legal challenges
- Acceptance and adjustment
Storytelling and Faith
Damodaran likes to say that disruption is easy, making money on disruption is hard. “There is always the risk that while disruption may succeed, many disruptors, especially the early ones, do not benefit from the disruption,” he explained.
Storytelling is a key tool when valuing the disruptors, he says. So much so that he calls it “the biggest hidden secret in valuation.”
“A good valuation is a bridge between stories and numbers,” he said. “I think the most dangerous thing that has happened to valuation in the last four years is Excel. In most valuation classes and financial modeling classes, you become an Excel ninja. We’ve lost the capacity to tell stories with numbers.”
But it’s not just the ability to tell a story that matters. You have to have faith in your story.
“I don’t do valuation for a living. I don’t do valuation because I’m intellectually curious. I don’t lie awake and say, ‘I wonder what Facebook’s worth right now,’” he said. “I do valuation for one reason and one reason alone: I want to act on my valuations. And I’ll give you why faith and value have to go hand in hand. Because to act on your valuations, you need faith in your own valuations. That’s not as easy as it sounds. You might follow every rule, but again, it’s just a number. And then you need faith. What kind of faith do you need? That the price will adjust to the value.”
Damodaran outlined the five steps involved in developing a valuation story:
- “Develop a narrative for the business you are valuing. In the narrative, you tell your story about how you see the business evolving over time.
- “Test the narrative to see if it is possible, plausible, and probable. There are lots of possible narratives; not all of them are plausible, and only a few of them are probable.
- “Convert the narrative into drivers of value. Take the narrative apart and look at how you will bring it into valuation inputs starting with potential market size down to cash flows and risk. By the time you are done, each part of the narrative should have a place in your numbers and each number should be backed up by a portion of your story.
- “Connect the drivers of value to a valuation. Create an intrinsic valuation model that connects the inputs to an end value for the business.
- “Keep the feedback loop open. Listen to people who know the business better than you do 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.”
But take heed: Stories aren’t static, so be prepared to adapt.
“Stories can break. Stories can change,” Damodaran said. “I’ve never felt ashamed about saying I wouldn’t change my story. And you have to. Young companies, if you get stuck on your story, you’re in big trouble.”
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image courtesy of Paul McCaffrey
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