'Narratives and Numbers' book review: The fine art of valuation

Narratives and Numbers
The Value of Stories in Business
Aswath Damodaran
Columbia University Press
288 pages; Rs 1,098
 

As I usually do in my class, let me start with a simple example. Consider a company that will generate an equity free cash flow of Rs 100 next year with a perpetual growth rate (g) of 4 per cent and a cost of capital (CoC) of 10 per cent. Based on these parameters, the equity value today is Rs 1,667. If you increase g by 1 per cent or decrease CoC by 1 per cent, the value jumps 20 per cent to Rs 2,000. If you decrease g by 1 per cent or increase CoC by 1 per cent, the value decreases 14 per cent to Rs 1,429.

 
A seemingly small change in one of the inputs changes the final value by a relatively large amount. Not surprisingly, students find this challenging to understand and are often left with an impression that valuation is a meaningless exercise where any value can be obtained by tweaking the inputs. If you have faced a similar conundrum, then this book is for you. Indeed, this book is a must-read for anyone even remotely interested in finance. Like many, I consider Aswath Damodaran one of the foremost valuation experts in the world and this book is a distilled summary of his experiences and valuation wisdom spanning more than 30 years.

 
The essence of the book is easily captured in the following sentence in it: “I think of valuation as a bridge between stories and numbers, where every story becomes a number in the valuation and every number in a valuation has a story behind it”. Professor Damodaran’s usage of the first person throughout the book may be unconventional for a business book but is entirely warranted as he draws extensively on his own experiences of valuing different companies.
 
Professor Damodaran demarcates the world into two “tribes” — the storytellers and the number crunchers. While storytellers can communicate their narratives effectively, they have a tendency to forget reality. Numbers provide the perfect antidote to runaway stories but a valuation model built by a number cruncher, who ignores the company’s story or narrative, will always be on shaky ground. Professor Damodaran argues that for a well-thought-out valuation, it is necessary to combine the strengths of both types and avoid the pitfalls of each.

 
Like all good teachers, Professor Damodaran exhorts the reader to focus on the valuation process rather than the end result. He achieves this effortlessly by walking the reader through multiple valuation case studies — starting each case study with the big picture and systematically narrowing down the narrative to hard numbers. He considers a wide range of companies including Ferrari (a mature company with an established business model), Vale (a mature company exposed to the vagaries of macro factors), Alibaba (an emerging market online behemoth), and Uber (a young company with a new business model in a new industry).

 
For me, the highlight of the book is his valuation of Uber and his exchange with Bill Gurley, an early Uber investor. Professor Damodaran uses this episode to drive home three important points. First, valuations are not static but are extremely dynamic. As new information is revealed or as new developments take place, it is critical to update the valuation narrative and the valuation numbers. Second, in order to do that, it is vital to keep the feedback loop open and avoid getting stuck with one’s original narrative or model. Third, valuing young or private companies (especially in nascent industries) is challenging due to the inherent uncertainty and data unavailability. However, the potential rewards (both monetary and intellectual) are highest in this space.

 
Towards the end of the book, Professor Damodaran discusses his narratives and numbers approach in the context of valuation driven by macro factors and how the approach can be applied to companies based on their position in the corporate life cycle. For example, the valuation of a start-up will be driven mostly by its narrative, whereas numbers play the dominant role in the valuation of a mature company. Although most of the book is written for investors, he also provides a few tips to corporate managers on communicating the right story and relevant information so that the market can value the company fairly.

 
One thing that is missing from the book is a good discussion on estimating the cost of capital. Professor Damodaran takes a rather simplistic approach to arrive at his cost of capital estimates. Even though discussing cost of capital estimation might have got technical, I would have liked to see a non-technical summary of various cost of capital models along with a discussion of applying the narratives and numbers approach to estimate the cost of capital for different types of companies.
 
Coming back to the example I gave at the beginning, a valuation approach that simultaneously incorporates aspects of narratives and numbers provides a stronger understanding and a sound base to valuation practitioners. Of course, there is no guarantee that such valuations will always make money for their analysts (capital markets have a mind of their own!) but the iterative process of ensuring consistency between the valuation narrative and the valuation model will invariably lead to better thought out valuations. The reviewer is assistant professor, finance and accounting, IIM-Trichy