Aswath Damodaran doesn’t care how rigorous our valuation methods are. 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, according to Damodaran. 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 not only have less history and more unknowns but also virtually infinite potential.
At the Alpha Summit GLOBAL by CFA Institute, Damodaran discussed the art and pitfalls of valuing young companies. The key is learning to deal with the biases that lead us astray when we encounter uncertainty. “Those unhealthy practices are what get in the way of valuing your company,” he explained in his presentation, “Dreams and Delusions: Valuing and Pricing Young Businesses.” To help us overcome uncertainty and improve our valuations, he laid out a framework of simple valuation rules.
Choose the Form of Your Destructor
Uncertainty comes in many forms, and Damodaran sorts them into three categories. The first is estimation uncertainty versus economic uncertainty. While we can reduce estimation uncertainty by gathering more or better information, economic uncertainty is harder to mitigate.
“I’m going to give you some bad news,” Damodaran said. “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.”
The second grouping is micro uncertainty versus macro uncertainty. Micro uncertainty focuses on the company itself — 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.
The third category is continuous versus 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.
With these three categories in mind, Damodaran turned to the larger question of dealing with uncertainty in valuations for younger firms. The process begins with understanding 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.
“Then there’s a 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,” Damodaran said. “You just don’t take responsibility then for what goes wrong.”
Want Better Valuations? Tell Better Stories
To value young companies well, we have to account for all these different types of uncertainty, and we have to manage our own, often unhealthy reactions to uncertainty: paralysis, denial, avoidance, and outsourcing. Damodaran suggested some simple coping mechanisms and a three-step process.
Step one is to come up with a story, something he describes in Narrative and Numbers: The Value of Stories in Business. Damodaran believes 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,” he said. “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. We’re afraid of being wrong. But we’ll come back to that.
“Second step: Keep your valuations parsimonious. Less is more,” he said. “I know the instinct that a lot of people have in valuing companies 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.”
Rather, Damodaran recommends homing in on a few essential variables. For young companies, he focuses on six factors. The first three apply to the business model: revenue growth, target operating margin (to capture profitability), and sales-to-invested-capital ratio (to reflect how efficiently growth is captured).
“The other three metrics are related to risk. Two relate to your costs,” he said. “One is what does it cost you to raise equity. And the second is how much does it cost you to raise debt. That goes to your cost of funding.”
What’s the last 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,” Damodaran said. “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, Damodaran 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.
The Proper Care and Feeding of Discounted Cash Flow Analysis
What’s the most common error when applying discounted cash flow analysis to young companies? Ignoring economic first principles, according to Damodaran. Too often, analysts forget about basic economic reality, especially when it comes to calculating terminal value.
“The terminal value, of course, is going to be 70%, 80%, 85% of your value, and you see people making up rules about terminal value that make absolutely no sense,” he said. For example, with young companies, terminal value cannot be estimated as a multiple of revenues, EBITDA, or earnings because that would mean taking the biggest number in the valuation and turning it into a price.
The second most common error is using a stable growth model and assuming a company can grow faster than the economy forever, which is impossible. To analyze a young company, we should assume it will grow slower than the economy over the long term and that the company will make enough reinvestment to sustain that growth. We should also abandon misleading rules of thumb, such as terminal value not being more than 75% of intrinsic value. For young companies, terminal value can be more than 100% of today’s intrinsic value.
We have to estimate some macro numbers, including risk-free rates and equity risk premiums. But we shouldn’t waste too much time trying to figure them out. In Damodaran’s opinion, these are precisely the kinds of numbers that should be outsourced to the market.
Another number we shouldn’t spend too much time on: the discount rate. Although discount rates are key to using DCF to estimate company value, Damodaran thinks we obsess over them at the expense of focusing on cash flows.
In his own yearly valuations, Damodaran looks at the cost of capital for each of the roughly 46,000 publicly traded companies in the world, finds the median, and gets a distribution. When he values a young company, he uses the 90th and 10th percentiles from the distribution rather than trying to estimate a discount rate for the company. For example, at the start of the current year, the cost of capital for a median company in US dollar terms was about 6% to 7%. The 90th percentile was about 10% and the 10th percentile about 4.5%.
“Think about that,” said Damodaran. “Eighty percent of global companies have caused a gap of between 4.5% and 10%, and we’re wasting our time trying to estimate that number to the second decimal point.”
Finally, any good valuation of a young company must account for failure risk. A common mistake and one often made by venture capitalists, according to Damodaran, is to squeeze failure risk into the discount rate. This doesn’t work because the discount rate is a “blunt instrument” that was never intended to include failure risk.
We need to accept the uncertainty instead of trying to create false precision. Damodaran recommends applying the logic of Monte Carlo simulations. Discounted cash flow analysis generates point estimates for revenue growth, margins, reinvestment, etc.; however, these estimates are too uncertain. But if we turn them into distributions — rather than decide the margin will be 15%, we give a range between, say, 11% and 19% — we can generate simulations from the inputs.
To demonstrate, Damodaran used Elon Musk’s offer to purchase Twitter for $54 a share. A Monte Carlo simulation gave him a distribution of values for different scenarios. And $54 a share turned out to be the outcome in the 75th percentile.
“As you’re making these estimates of the inputs, as I said, part of you is screaming, ‘But I could be wrong,’” Damodaran said. “Let me save you the trouble. You’re definitely wrong.”
“If your reaction is ‘I don’t want to be wrong,’ don’t value companies,” he continued. “Here’s your consolation prize: You don’t have to be right to make money. You just have to be less wrong than everybody else.”
Don’t Get Lost in the Bermuda Triangle
The three greatest challenges in valuation constitute what Damodaran calls the Bermuda Triangle: 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, Damodaran recommends showing our analysis to people who think differently and will tell us when they disagree with our story. We should listen to them.
By following his advice, Damodaran believes we can turn the anxiety of dealing with uncertainty into something much better: “fun.” His final tip is to enjoy the challenge of valuing young companies. “I’d rather value young companies than mature companies,” he said, “but it comes from being willing to be wrong and to be willing to correct the mistakes you make in your stories.”
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Tell Me a Story: Aswath Damodaran on Valuing Young Companies is written by Roger Mitchell for blogs.cfainstitute.org