DCF Myth 2: A DCF Is An Exercise In Modeling And Number Crunching by Aswath Damodaran, Musings On Markets
Most people don't trust DCF valuations, and with good reason. Analysts find ways to hide their bias in their inputs and use complexity to intimidate those who not as well versed in the valuation game. This may surprise you, but I understand and share that mistrust, especially since I know how easy it is to manipulate numbers to yield almost any value that you want, and to delude yourself, in the process. It is for this reason that I have argued that the test of a valuation is not in the inputs or in the modeling, but in the story underlying the numbers and how well that story holds up to scrutiny.
Left brain, meet right brain!
This fall, as I have twice a year, for almost 30 years, I will be teaching a valuation class at the Stern School of Business at New York University. When the 300 registered students walk into my classroom, I know that they will come in with preconceptions about what the class will cover. Many will bring in their laptops, with the latest version of Microsoft Excel installed, eagerly anticipating session after session on modeling, hoping to become Excel Ninjas, by the time the class is done. They expect it to be a class about numbers, more numbers and still more numbers, with Greek alphabets (alphas and betas) thrown in.
[drizzle]I begin the class by asking students to tell me whether each of them is more comfortable with numbers or with stories, and not surprisingly, the class draws disproportionately large numbers of the former, but there are more than a handful of the latter. (There are a number of tests online, like this one, that you can take to make this judgment for yourself, but most of us have a sense without tests.). I then explain my vision of valuation, as a bridge between the two groups, a way of connecting narratives to numbers.
While this picture is only an abstraction in that first class, the rest of the class is really my attempt to flesh out the picture and make the bridge real. I don’t always succeed, but my vision of a successful class is that my number-crunchers walk out of to with a little more imagination and that my storytellers acquire a bit more discipline along the way.
Connecting Stories to Numbers: The Process
The process by which you connect stories to numbers is neither obvious nor intuitive but it can be learned. In an earlier post on the topic, I laid out five steps in this process, not intended to be either exhaustive or sequential.
To illustrate, consider Amazon, a high profile company where the world is dividend into those that believe that it is a extraordinary company with a plan to conquer the world and those that use it as an example of how you can fool a lot of people for a really long time. In a post in October 2014, I valued Amazon and arrived at a value of $175 per share.
Rather than get stuck into the details, it is worth laying bare the narrative that I have for Amazon that is determining its value. In my story, Amazon will continue on its path of delivering high revenue growth (with revenues growing to $249 billion by year 10), generally by selling products or offering services at or below cost for the near future (note that margins stay close to zero for the next 5 years), but will eventually start to use its market power to deliver profits, but this market power will be checked by the entry of new players into the retail business, leaving the target margin at a number (7.36%) that reflects the overall retail business in 2014.
To see where the optimists in the spectrum come up with higher value, consider an alternative narrative, where Amazon’s market power is unchecked allowing it to expand into more extensively in the media market (with revenues of $329 billion in year 10) and earn an operating margin of 12.84% (the 75th percentile of retail/media firms). Those changes increase the value per share to $468/share.
To complete the process, consider the pessimistic narrative. In their story, they see Amazon as a company with a charismatic CEO (Jeff Bezos) who is less interested in creating a profitable business than he is in changing the retail world. In that story, Amazon will continue to grow revenues with little attention paid to margins, with the end game being world domination (at least of the retail business). In the valuation, that translates into higher revenue growth and paper-thin operating margins (2.85%, the 25th percentile of large US retail/media firms), even in steady state, the value per share drops to $32/share.
I followed up my post on narratives and numbers with one on how a change, shift or break in the narrative can translate into a significant change in value, and why the conventional view that intrinsic value, if done right, is timeless is nonsense. Using earnings reports as the vehicles that deliver news about narratives, I looked at my narratives for Apple, Twitter and Facebook in August 2014, and valued them. Since the last few weeks have brought new earnings reports from all three companies, I will be doing an updated version of that post in the next few days.
If you are a number cruncher, this process may seem too free form and subjective to you, and if you are a storyteller, the numbers will seem made up. To me, though, it is the essence of valuation and If you are interested in my extended discussion of this process of connecting narratives to numbers, you may want to take a look at this keynote talk that I gave at the CFA Institute Conference last year. I have to warn you that the length of the webcast (almost 3 hours) could lead you to seek the protection of the Geneva Conventions.
Tie to the life cycle: The Investor Angle
While narrative and numbers are tied together in every company’s valuation, the importance of each in driving value will shift over a company’s life cycle, as it evolves from a start up to a mature firm to one in decline. Very early in the life cycle, when numbers on the company are either scarce or uninformative, it is almost entirely narrative that drives value. In addition, that narrative can also have a much wider range of possibilities and end values, depending on the path that you map out for the company. In December 2014, I let readers pick their narrative for Uber and mapped out widely divergent values (ranging from less than $1 billion to in excess of $90 billion) for the company, based on the narrative path picked.