Narrative and Numbers – Aswath Damodaran on intrinsic value

In his book, Narratives and Numbers: The Value of Stories in Business, NYU finance professor Aswath Damodaran suggests that plausible valuation of companies and investments requires meaningful financial models and compelling narratives. We review some of Damodaran’s views on the relationship between narratives, numbers and the intrinsic value of a company in this post.

Our first post summarised Damodaran’s observations on business stories, and how the combination of numbers and narratives can inform investment analysis. The third post highlights important considerations and diagnostics that Damodaran believes are important to any discounted cash flow analysis.

Numbers that drive intrinsic value

Intrinsic value is the value of an asset based upon the fundamentals of cash flows, expected growth and risk. There are three key drivers of value: The first refers to capacity of existing assets to generate cash flows, net of taxes and reinvestment needed to sustain this base.

The second value is growth, which describe future cash flows attributed to growth in revenue and/or improved margins, as well as the reinvestment required to generate such growth.

The final driver is the cost of capital, which reflects the level of risk from the perspective of investors. The mix of debt and equity can affect the cost of capital. This includes the effects of tax benefits and default risk that increased debt might bring.

It is important to undertake company and market analysis to develop the company the narrative, and understand its potential underlying value. Investors should ask questions with respect to numbers and factors that drive intrinsic value:

(1) Growth: How quickly is the company and overall market growing?

(2) Profitability: How profitable has the business and its competitors been over time?

(3) Investing for growth: How and where might the company and its competitors invest for growth over time?

(4) Risk: What is the consistency and trends in revenues and earnings for the company and the market over time?

It is important to think about the plausibility and consistency of the company’s story and value. A company’s value should increase as the company grows. However, its value will decrease as its risk or reinvestment need increases. A high growth company typically requires high reinvestment to achieve such growth. It will often be riskier than average as well.

Companies that enjoy high-growth, high profitability, little reinvestment needs, and low operating risk are rare (or perhaps unlikely to exist in the long run). Such companies or industries should expect intense competition and new entrants that wish to capture such value for themselves.

The company’s size (big or small), business model (establishment or disruptor; going concern or finite-in-life), and stage in the corporate lifecycle are important considerations here as well. Natural or man-made disasters, legal or regulatory action, failures to make contractual payments, government expropriation, capital squeeze and acquisitions are examples of potential events that can break or transform company narratives.

Three questions can be asked to test the consistency of a company’s value narrative:

(1) Reinvestment-growth: Are you reinvesting enough given your growth?

(2) Reinvestment-risk: Is your risk consistent with your reinvestment strategy?

(3) Risk-growth: Is your risk reflective of how much, how, and where you are growing?

Mapping narratives to intrinsic value

The discounted cash flow (DCF) model is an intrinsic valuation model because it values an asset based on its expected cash flows with adjustments for risk.

As you develop a company’s narrative, it is helpful to structure your narrative inputs against each major component of value within a discounted cash flow analysis.

(1) Revenue (sales) = total market x market share

(2) Operating income = revenue (sales) – operating expenses

(3) After-tax operating income = operating income – taxes

(4) After-tax cash flow = after-tax operating income – reinvestment

(5) Value as going concern = after-tax cash flow adjusted for time value and risk

(6) Value of business = value as going concern x probability of going concern + liquidation value x probability of failure

Big market narratives, networking and winner-take all narratives, strong and sustainable competitive advantages can drive revenue and operating income narratives upwards.

Strong and sustainable competitive advantages, and attractive tax breaks or benefits could lower operating expenses and taxes and increase after-tax operating income.

All else equal, industries with low barriers to market entry, low-cost to scaling up, and low levels of consumer inertia should expect a more rapid lifecycle growth phase. Easy-scaling narratives may lower the assumed reinvestment rate, while low-risk narratives may increase value via a lower discount rate.

For new companies, it is helpful to consider the customer’s reasons for switching to new products, and your company’s capacity to overcome inertia and/or fight off the status quo.

We believe it can be helpful at this stage of the investment process to reapply observations from legendary investors on what makes outstanding companies to stress-test the plausibility of your narrative mapping.

Phil Fisher for example highlights how functional factors (i.e. low-cost production, strong marketing, effective research, good accounting systems) and business characteristics (e.g. barriers to entry, economies of scale, first-mover advantage) can contribute to sustained earnings growth in the long-run.

Narratives should also consider the impact of implicit normalisation (e.g. assuming commodity prices at its peak), stickiness of political risk (e.g. drawn-out trade wars), and the debt effect (e.g. higher default risk).

Continue reading in our third post: Narrative and Numbers – Damodaran on investment analysis

References

Damodaran, D. (2017). Narrative and Numbers: The Value of Stories in Business.

Damodaran, D. (2019). Musings on Markets. Accessed at <http://aswathdamodaran.blogspot.com/ >

Further reading

The Warren Buffett Way – Robert Hagstrom on Buffett’s investment tenets

One Up on Wall Street – Peter Lynch on investment principles

The Outsiders – William Thorndike on unconventional CEOs and a blueprint for capital allocation

Investing Without People – Howard Marks on passive and algorithmic investing

Return on Invested Capital – Credit Suisse

Conservative investors sleep well – Philip Fisher on investment principles