Narrative and Numbers - Aswath Damodaran on storytelling in business

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 his reflections on common business narratives, and the risks that investors and businesses face in numbers and storytelling briefly in this post.

Common business narratives

Aswath Damodran suggests that it is helpful to think about a company’s narrative in the context of its corporate life-cycle: (1) start-up; (2) young growth; (3) high growth; (4) mature growth; (5) mature stable; and (6) decline. Investors are attracted to early-stage companies for their expansive narratives, big markets and potential rewards.

For young and high growth companies, the focus tends to be on costs, profitability and scalability. For mature industries, narratives tend to look at barriers to entry and sustainable competitive advantages. For companies in decline, it is about maximising cash generation as investors look for an exit strategy.

Common business stories include:

(1) The bully is a company with superior market share, brand name and access to capital. Their reputation for ruthlessness means they will overrun competition for more revenue and profits.

(2) The underdog or mousetrap is a company with low market share but claims to have a better or cheaper product than its biggest competitors. They will work harder to out manoeuvre the competition, eat existing market share, and better please their customers.

(3) The eureka moment describes a company that has found an unmet need and a method to meet this need. They will succeed if they can implement their vision and business model.

(4) The disruptor is a company that has fundamentally altered its production, operations, product and/or service. The status quo has become inefficient since this disruption is the new way to do business and make money.

(5) The low-cost player has a cost-advantage and is willing to lower prices in expectation of selling more.

(6) The missionary describes a company on a noble mission (beyond profit maximisation). They are expected to produce benefits for society (while making some money).

A focus on narratives bares resemblance to Peter Lynch’s approach to investing. When investing, Lynch likes to classify the companies he looks at under one or more categories: slow growers, stalwarts, fast growers, cyclical, turnarounds and/or asset plays. He believes that categorisation allows him to ask more targeted questions about the company’s narrative and prospects, and subsequent road to prosperity.

Company news (internal and external) and macroeconomic stories (e.g. interest rates, inflation, commodity prices, etc.) can affect or reveal a company’s narrative, prospects and value. Stories tend to be more important for early-stage company valuations while numbers have a larger role in value as the company’s age and history develops. Companies and its founders may have one or more narratives. These narratives may also change over time.

Common founder narratives

Investors tend to look for executives and narrators that match the lifecycle stage of the company. Business transitions may be easier if the CEO and management team is versatile and adaptable; and/or the business growth lifecycle sufficiently long such that the management team can learn or prepare for changes.

If we think of transitions along the corporate lifecycle, a company’s transition can be difficult if the CEO and management team are visionaries who cannot build; builders that cannot scale; scalers that cannot defend; or defenders that cannot liquidate.

Common founder stories include:

(1) Horatio Alger: Investors are attracted to the founder for his or her tenacity in the face of overwhelming odds

(2) Charisma: The narrative here is built around the epiphany or vision of its founder.

(3) Connections: Special deference are sometimes given to those with connections whether due to family ties, political history, etc.

(4) Celebrity: Many achieve fame first for non-business reasons and use this status to attract businesses and investments.

(5) Experience: An assumption here that the track record of its founders may suggest success in their next venture.

Stories work well when they involve listeners but allows them to make their own connections. Subjects are less likely to remember stories when the causal relationship is too weak or obvious. It is more effective when causality is understated, and readers are required to connect links themselves. Good stories are simple, credible, authentic and emotional.

A business that depends too much on its founder may not survive development beyond them, and any failures on their part. It is important to remember that the elements of a founder story should provide information on the value drivers and prospects of a business. Everything else is noise.

Beware the market delusions

When investors are captured by a story, they are at greater risk of accepting arguments uncritically. We are more willing to suspend disbelief the more absorbed we are in a story. In a similar way, reading widely and deeply can help us to learn about our biases and to think critically.

On other occasions, it might also reinforce certain biases and traits that may be better unlearned. Memories are fickle and it is often easy to mix real and imagined experiences. Investors may reinvent stories to suit their emotional needs of the time.

While some stories might be plausible at the individual company level, they can become implausible at the aggregate. The classic example refers to a large group of venture capitalists, each investing in similar start-ups within the same industry.

Each individual start-up may have potential growth prospects, but it is unlikely that that most of them will survive until maturity. Since each venture capitalist believes he or she has picked a winner, it is very common for such companies to attract valuations well beyond their expected returns and probability of success.

There are common ingredients in the story of companies that achieve astronomical valuations before a spectacular downfall. These companies will typically employ a strategy that is ‘too complicated for outsiders to understand’ and ‘too proprietary to explain in detail’. Their strategy, technology and business models are so promising that they are expected to transform markets and/or minimise downside risk altogether.

A combination of investor exclusivity, executive passion and charisma, missionary zeal and emotional appeal can generate inertia, exuberance and excitement in such companies before its underlying story unwinds. Part of the company’s original narrative is often grounded in reasonableness to help investors suspend disbelief on other aspects of the company’s story.

The likelihood of overpricing in markets will grow with: (1) the degree of overconfidence; (2) size of the market; (3) uncertainty; and (4) winner-take-all environments. Collective overpricing tends to emerge in young markets every decade or so. This appears to be a feature of financial markets.

Investors in the start-up phase should watch for macro- and market delusions. Investors in the young to high growth phase should be wary of value distractions (looking at the wrong drivers) and growth illusions (ignoring the cost of growth). Investors in the mature and stable growth phase should avoid disruption denial and failure to see new threats. Finally, investors in the decline phase should be wary of liquidation leakage and avoid unrealistic assumptions about realised cash returns.

We remember stories better than spreadsheets

As an ironic consequence of the digital age, we appear to put less trust in numbers today, due in part to today’s data and information overload. However, this also puts us at greater risk of making simplistic and irrational decisions. Increased access to information has made us less comfortable with our judgement, and evidence suggests that it can have negative impacts on information retention. Damodaran suggests that to make good decisions with numbers, we should:

Follow simple rules to data collection. This requires good judgement on what data to select and ignore, and how we manage our biases.
Use basic statistics and statistical tools to manage large and sometimes contradictory datasets.
Identify methods to present data in understandable ways to audiences that might not grasp statistics well.

Notwithstanding the risks of narratives – A good story can affect a company’s success, particularly during the early stages of its life. A successful business needs a great product and business model, as well as a good story to raise capital from investors and entice purchases from customers.

Similarly, a valuation is more trustworthy if it has a story to back it. To approach storytelling in the context of investment and business valuations, we should:

Develop a narrative and understand the company we are valuing (e.g. history, operations, competition, etc.)
Apply the 3P test by asking whether the story is possible, plausible or probable.
Pair the narrative with drivers of value (e.g. market size, cash flows, risks, etc.)
Develop estimates of intrinsic value based on the drivers of value
Keep the feedback loop open. Listen to comments, questions and critiques to improve our story.

The hidden dangers of numbers

While numbers can be an antidote to the big market delusion and the glowing narratives of a company and its founders, they also present a variety of dangers that are not always talked about.

Accuracy versus precision: It is possible to create precise but inaccurate models, as well as accurate models that are imprecise.

Framing: Behavioural economics suggest that framing numbers in different ways can lead to different responses.

Illusion of objectivity and control: Application of complex models and academic concepts can provide users with a false sense of security.

Intimidation factor: Numbers can be used to obscure and disguise, and intimidate others from critical inspection.

Imitation problem: Insights derived purely from numbers are easy for machines and algorithms to replicate.

Lemming problem: Insights derived from the same data source may create herding.

Data bias: Data analysis is at risk of selection bias, survivor bias, noise and error.

Analysis bias: We are quick to trust averages. We often assume normality because it’s easy. We commonly forget to account for or omit outliers.

Fighting our hubris

Valuations and narratives are point in time estimates. Assumptions for growth, margins, cost of capitals, etc. come from a probability distribution of many possibilities. We should consider the use of what-if analysis, scenario analysis, decision trees and/or simulations to understand how the valuation and story might change under different circumstances.

We should also tell our stories and valuations to people who are most likely to disagree; be open about areas of uncertainty and explain how it might affect our estimates; separate facts from assumptions that are just beliefs; avoid covering our mistakes when new information debunks our work (simply review and change as necessary).

Continue reading in our second post: Narrative and Numbers – Damodaran on intrinsic value

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/ >

Narrative and Numbers – Aswath Damodaran on storytelling in business