Let’s say you have a business story, grounded in reality and tested for plausibility. In this chapter, I look at connecting the story to numbers that determine the value of a business. I begin this chapter with a very quick introduction to valuation, not so much to delve into the theory, but to link value to key drivers that cut across businesses in different industries and different stages in the corporate life cycle. I then describe the value drivers for different narratives, ranging from big-market stories to low-risk stories. In the last part of the chapter, I take my chosen companies (Uber, Ferrari, Alibaba, and Amazon), which range the spectrum on life cycle, growth and sector, to illustrate the use of the process.
Breaking Down Value
To make the link between stories and value, you have to start with the basics of intrinsic valuation. While there are far more in-depth reviews of the topic that you can find elsewhere, the fundamentals of intrinsic value are not difficult to summarize. The intrinsic value is the value you would attach to an asset based upon its fundamentals: cash flows, expected growth, and risk. The essence of intrinsic value is that you can estimate it for a specific asset, without any information on how the market is pricing other assets (though it does certainly help to have that information). At its core, if you stay true to its principles, a DCF model is an intrinsic valuation model, because you are valuing an asset based upon its expected cash flows, adjusted for risk. Even a book value approach can be an intrinsic valuation approach in which you are assuming that the accountant’s estimate of what fixed and current assets are worth is the true value of a business.
In a DCF valuation, the intrinsic value is estimated in an equation that ties value to expected cash flows, and these expected cash flows incorporate your estimates of growth and a discount rate that carries the weight of reflecting risk (see figure 8.1).
Figure 8.1
The “theory” of intrinsic value.
This picture also keys in on the drivers of value for any business. The first is the capacity of existing assets to generate cash flows, with assets with stronger earning power creating more value than assets with weaker earnings power. The second is the value of growth, the net effect of the trade-off of its benefits, which include rising revenues and earnings, against what it costs the firm in reinvestment to generate this growth. The third is risk, with higher risk translating into a higher discount rate and lower value.
One of the limitations of DCF valuation is that it is designed to value going concerns, that is, businesses you expect to stay operating for long periods, and that the value that you get will be too high if there is a significant chance the company will not make it. This failure risk is high for young companies that have to make it through a gauntlet of tests to become operating businesses and for older, declining busineses that are overburdened with debt. In these cases, to estimate an expected value, you should consider the probability and consequences of failure for investors in the company explicitly, which leads to an adjusted value shown in figure 8.2.
Figure 8.2
Value and truncation risk.
This may seem like a cursory explanation of intrinsic value, but it does provide the big-picture perspective that I will return to as I value individual companies.
Connecting Stories to Inputs
The chapters leading into this one have been focused on telling a story about a company, one that fits the company’s circumstances and the business arena in which it operates, and the challenge you face is in how to reflect that story in value. While there are many ways you can do this, the most versatile framework, in terms of being capable of incorporating almost any story, is one that uses the structure of a valuation model. Thus, if you think of cash flows as your endgame, you can start by first estimating revenues as the product of the total market that you see the company aiming at and the market share that you estimate it will be able to command within this market. Multiplying these revenues by the pretax operating margin yields the operating income of the company, and netting out taxes generates the after-tax operating income. Netting out what the company has to reinvest to generate growth will result in the free cash flow. Finally, discounting these cash flows back to today at a risk-adjusted discount rate gives you value.
Every story has an input that is best suited to reflect its impact on value. If you have a big market story, it is the total market that will reflect it; even a small share of this market will generate big revenues. If you are pushing a strong networking benefit story, one that promises that your company will find it easier to grow as it gets larger, or a market dominance story, in which your company will overpower its competitors, the market share is the input that will allow you to incorporate this effect in value. If the business you are valuing has strong and sustainable competitive advantages, you will see the payoff in high operating margins and income. If a business will benefit from tax breaks, the tax rate will be lower, pushing up after-tax income and cash flows. If your business is built on low capital intensity, that is, it can scale up easily, it is the reinvestment that will show that advantage, remaining low for big increases in revenues. If a business is low risk, the discount rate that you use to bring the cash flows back to today will be lower (and the value higher). Figure 8.3 summarizes the effects.
Figure 8.3
Connecting stories to valuation inputs.
Simplistic though this framework may be, it is remarkably flexible in terms of being able to factor in story lines for companies across the life cycle and in different businesses.
CASE STUDY 8.1: UBER—FROM STORY TO NUMBERS
Lead-in case studies:
Case Study 6.2: The Ride Sharing Landscape
Case Study 6.3: The Uber Narrative
In case studies 6.2 and 6.3, I told my story for Uber in June 2014, describing it as an urban car service company that would draw new users into the car service business, while using its competitive advantages (access to capital, first mover) to maintain local networking benefits and its revenue-sharing model, doing all this with its existing low-capital business model. Converting this story into valuation inputs:
1. As an urban car service company, the market that it is pursuing is the taxicab and car service market in cities. Aggregating the taxicab and car service revenues of cities, I obtain a value of $100 billion for the urban car service market.
2. The local networking benefits will allow Uber to emerge as the dominant player in a subset of cities, while facing competitors (both domestic and foreign) in others. The market share that I assign in steady state for the company is 10 percent. While this is far higher than the highest market share of any of the existing players in this splintered business, it is capped at 10 percent rather than 30 or 40 percent because my story does not presume global networking benefits.
3. Uber’s first-mover status, its strong capital position, and its technological edge will allow the company to maintain the revenue-sharing agreement that it has with drivers (80 percent to the driver, 20 percent to Uber) and sustain strong operating margins (40 percent in steady state).
4. Continuing on its prevailing path of not owning cars or investing in infrastructure, the company will be able to generate $5 in revenues for every dollar in capital invested. To provide some perspective, the median value for this statistic across all U.S. companies is about 1.5 ($1.50 in sales for every dollar invested in capital) and a sales-to-capital ratio of 5.0 would be around the 90th percentile of all companies. Figure 8.4 summarizes these inputs.
Figure 8.4
Uber, 2014—valuation inputs.
That story can of course be challenged at almost every turn, and in chapter 10 I will look at those challenges.
CASE STUDY 8.2: FERRARI—FROM STORY TO NUMBERS
Lead-in case studies:
Case Study 6.1: The Auto Business
Case Study 6.4: The Ferrari Narrative
Case Study 7.2: Ferrari, the Exclusive Auto Club
In chapter 6 I outlined my basic story for Ferrari and described it as a superexclusive automobile company, with that exclusivity restricting it on its revenue growth but helping it sustain its high profit margins and low risk profile. In figure 8.5, that story finds its connection to valuation inputs.
Figure 8.5
Ferrari: the exclusive club—valuation inputs.
In chapter 7 I outlined a plausible counternarrative, in which Ferrari aspires for higher growth and, to deliver that growth, introduces a lower-cost model and increases advertisting spending. Figure 8.6 shows the conversion of that narrative into valuation inputs.
Figure 8.6
Ferrari: the rev it up narrative—value inputs.
While these narratives are both plausible, neither dominates in terms of value effects. The exclusive club scenario has lower sales, but it also has higher margins and lower risk. In chapter 9 we will look at the resulting valuations for both narratives.
CASE STUDY 8.3: AMAZON—FROM STORY TO NUMBERS
Lead-in case studies:
Case Study 6.5: Amazon, the Field of Dreams Model
Case Study 7.3: Amazon—Alternative Narratives
In my initial narrative for Amazon, I described it as a Field of Dreams company, one that would accept low or even no profits in return for high revenue growth in multiple businesses (retail, entertainment, cloud computing) on the expectation that it would be able to generate higher profit margins in the future. Figure 8.7 shows the conversion of that story into valuation inputs.
Figure 8.7
Amazon: the Field of Dreams narrative—valuation inputs.
As I noted in chapter 7, Amazon is a company for which there are many plausible counternarratives with widely divergent value consequences. I presented two extreme cases: one in which the revenue growth with no profits becomes the steady-state model and another in which Amazon’s relentless expansion decimates the competition, allowing Amazon significant pricing power. In figure 8.8, I look at both stories.
Figure 8.8
Amazon: counternarratives.
While there are differences on the revenue growth rates across the narratives, the most significant divergence is in the target operating margins, with my narrative built around the presumption that Amazon’s margin will converge on 7.38 percent, the median of the retail and entertainment businesses, the optimistic counternarrative arguing for a 12.84 percent margin (the 75th percentile), and the pessimistic one settling for a 2.85 percent margin (the 25th percentile).
CASE STUDY 8.4: ALIBABA—FROM STORY TO NUMBERS
Lead-in case studies:
Case Study 6.6: Alibaba, the China Story
Case Study 7.4: Alibaba, the Global Player
In chapter 6, my story for Alibaba was a China story, with Alibaba continuing to dominate, grow, and profit from the Chinese online retail market for the long term. The size and growth in China’s online retail business forms the basis for Alibaba’s value proposition, augmented by Alibaba’s dominant market share and low cost structure. Figure 8.9 shows how closely my Alibaba revenue growth story tracks the Chinese online retail market.
Figure 8.9
Alibaba revenue growth and Chinese online retail.
In figure 8.10 I summarize the links between this story and my valuation inputs (with all the estimates in U.S. dollar terms, partly to reflect the fact that Alibaba’s IPO was planned for the United States and partly for convenience).
Figure 8.10
Alibaba, the China story.
That story, though, may be missing Alibaba’s global ambitions, and there is a plausible counterstory that I developed in chapter 7, in which Alibaba extends its success in China into other markets, including the United States, and perhaps even into other businesses. In this alternate story, Alibaba could generate higher revenue growth than in my narrative, albeit with lower operating margins and more reinvestment. Figure 8.11 summarizes the effects of this global player story.
Figure 8.11
Alibaba, the global player.
As noted before, it remains to be seen whether the net effect of this global push adds or takes away value from Alibaba.
Qualitative Meets Quantitative
The chasm between story people and numbers crunchers is most visible when the discussion turns to qualitative factors. To the storytellers, the obvious weakness of valuation models seems to be their failure to consider corporate culture, the quality of management and employees, and a multitude of soft factors that affect the value of a business. To the number crunchers, the raising of qualitative factors is a red flag, an indication of shallow thinking and the use of buzzwords to justify premiums. I find myself in the middle on this one, since I believe that both sides have a point.
Do qualitative factors affect value? Of course! How could the value of a business not be determined by whether its management can think strategically, how loyal and well trained its work force is, and the brand name that it has built up over time? Before you put me in the storytellers’ camp, let me hasten to add that as an investor, you cannot collect your dividends in corporate culture units, strategic considerations, or brand name bragging rights. The key, then, is to bridge the gap, and at the risk of inviting the scorn of both sides, I think that any qualitative factor, no matter how fuzzy, can be converted into numbers.
If you look back at the valuations I am setting up just in this chapter, each of the companies I have valued has qualitative strengths that are at the core of their success. Uber is managed by a risk-taking team that aggressively seeks out opportunities and is backed by skilled technology, but that is why I feel comfortable making the assumption that they will conquer the ride-sharing market over the next decade. Ferrari has one of the best-known brand names in the world, but it is that brand name that gives them the pricing power to charge more than a million dollars per car and earn a profit margin in the 95th percentile of the auto business. Amazon has Jeff Bezos as CEO, a visionary who is also pragmatic, and this may explain why investors have been willing to go along with the Field of Dreams model, in which revenues get delivered today but you have to wait for profits. Alibaba has the benefit of being the largest player in China, a market with immense potential, but that potential is what allows me to assume a revenue growth rate of 25 percent a year in conjunction with sky-high margins for the company for the next few years.
I think that both sides will benefit from this conversation. Storytellers, who naturally gravitate to qualitative factors, will be forced to be more specific in their stories and be able to check them for plausibility. Thus, arguing that a company has good management means little until you start to explain what it is that management does that makes them “good.” For number crunchers, bringing in qualitative factors will bring depth to their numbers and perhaps even lead to a reassessment of whether those numbers will hold up.
Finally, connecting the qualitative to the quantitative can allow investors a way of scrutinizing claims made by founders and managers about a business. A brand name story for a company whose profit margins are below the median for a sector should be viewed with skepticism, as should a high-growth story for a company that has consistently reported single-digit revenue growth for the last decade.
Pricing a Story
In this chapter, I have focused on converting stories into numbers in an intrinsic valuation framework. However, there are many investors who feel that the intrinsic value process is too complex and that it is simpler and more effective to price companies, rather than value them. That pricing usually takes the form of computing a pricing multiple (of revenue drivers, revenues, earnings, or book value) and comparing this multiple across “comparable” firms. In this section, I will lay out the structure for connecting pricing to storytelling, a well-worn path followed by many equity research analysts, and explain potential dangers with the approach.
The Essence of Pricing
To set the table for the comparison, let me start with an assessment of the differences between the valuation and pricing processes. The value of a business is determined by the magnitude of its cash flows, the risk/uncertainty of these cash flows, and the expected level and efficiency of the growth that the business will deliver. The price of a traded asset (stock) is set by demand and supply, and while the value of the business may be one input into the process, it is one of many forces, and it may not even be the dominant force. The push and pull of the market (momentums, fads, and other pricing forces) and liquidity (or the lack thereof) can cause prices to have a dynamic entirely their own, which can lead to the market price being different from value.
The tools for estimating value and price reflect the differences in the processes. To estimate value, as we noted in the previous section of this chapter, we use DCF models, make assumptions about the fundamentals that drive value, and estimate a value. To figure out a price, we take a much simpler path. We look at how “similar” assets are being priced in the market today and try to estimate a price that the market would attach to the company in question, given its characteristics. There are three steps in pricing:
1. Find comparable or similar assets in the market: While the conventional practice for doing relative valuation, at least in the context of stocks, is to look at other companies in the same sector as the company you are pricing, it is ultimately a subjective judgment and will depend largely on how investors in the market classify a company. Thus, if Tesla is being treated by investors as a tech company and not an automobile company, the pricing may very well have to do the same.
2. Look for the pricing metric that investors use in pricing these companies: When pricing companies, it is not your place or mine to determine what investors should be using to price companies, but what they actually are using. Thus, if the metric investors focus on when pricing social media companies is the number of users these companies have, you should focus on that metric in pricing your company.
3. Price your company: Now that you have the metric or metrics that investors are using to price companies, you can price your company based on that metric and the pricing ratios across the comparable companies. Using the social media example again, if social media companies are being priced based on users, and the average price that the market was paying was $100/user in 2013, you would have priced Twitter, which had 240 million users in October 2013, at approximately $24 billion.
The pricing process can yield a very different number for your company than the valuation process. As to which number you would use, it depends on whether you are an investor or a trader, with no negative connotations on the latter intended. Investors focus on value and invest on the faith that price will move toward value. Traders focus on price and are judged on whether they get the direction of price movements right.
Connecting Stories to Prices
It is my view that most individuals in public markets, including many who call themselves value investors, are really traders, afraid to accept that labeling because they view it as a reflection of shallow analysis and are afraid of being called speculators. In the private capital markets, the delusion is even deeper, as most venture capitalists have little interest in value and are relentlessly focused on pricing. In fact, the venture capital (VC) valuation model is a pricing tool in which the pricing is consigned to the exit multiple, as can be seen in figure 8.12.
Figure 8.12
Venture capital valuation (pricing).
Since the exit multiple is obtained from the pricing of comparable firms and the target rate of return is a made-up number (more a negotiating tool than a discount rate), there is very little pricing in this process.
If you are playing the pricing game, your challenge with stories is to bring them into the pricing game. To do so, you will have to mold the story around the pricing metric, whatever that might be, a simpler and more straightforward task than the full-fledged connections that were made in the intrinsic value process. Thus, if your start-up is a social media company and the market is indeed focused on users, your story should revolve around users. Alternatively, if the market’s basis for pricing is earnings, you have to tie your story to future earnings.
Dangers of Pricing Stories
We are drawn to pricing stories for their simplicity and directness. They do come with their own set of weaknesses, perhaps as a consequence of the shortcuts taken along the way:
1. Intermediate variable: No matter what metric is used in the pricing, it is, at best, an intermediate step on the way to value or, at worst, a proxy for nothing substantial. Pricing a social media company on the basis of the number of users implicitly assumes that future revenues, earnings, and ultimately value are correlated with the number of users today. Even with more value-driven metrics like earnings, there is the assumption that earnings today are good indicators of future earnings, a dangerous leap of faith in unstable and volatile sectors.
2. Markets are fickle: If your defense is that it is your job to deliver what markets want (users, revenues, or earnings), it is worth remembering that markets are fickle. Young companies, particularly, will be faced with what I call “bar mitzvah” moments, where the market suddenly shifts its attention from one variable to an entirely different one. I will come back to this question in chapter 14, when I talk about corporate life cycles.
3. Game playing by companies: If investors do become focused on a metric, companies will start to not only mold their stories around the metric but may start changing their business models to focus on delivering on that metric. If you add in the possibility of gaming the numbers, where accounting and measurement tools are twisted to deliver higher numbers on the metric in question, you have the makings of a disaster.
Conclusion
If valuation is a bridge between stories and numbers, this chapter is the girder that brings them together. It converts the words in stories into inputs in valuation models and will allow you to make the final steps to get to value in the next chapter. The process is not always sequential, and it is entirely possible that as you attach valuation inputs to your story, you may feel the need to revisit earlier parts of the story and tweak or change them. I believe that the process will make your stories stronger and your valuations more credible.
