DamodaranAswath Damodaran addressed CFA members in a talk on valuation in Singapore on 23 May 2017 (Photo by Sim Kih)

Professor Aswath Damodaran, the celebrated author of several widely used academic and practitioner texts on valuation, corporate finance, and investment management, illustrated his 5-step approach to valuing Uber in his address to CFA members on how every number in a valuation model is to be backed up by a story.

About 330 people attended the event that took place at Joyden Hall, Bugis+ on 23 May 2017. It was organized by the Society’s Professional Development Committee and facilitated by Arun Kelshiker, CFA, who is the committee Co-Chairperson.

This article, an excerpt of his discussion, is republished (with permission) from the CFA Singapore quarterly newsletter produced by NextInsight.


LQM000066The way to think about valuation is: It is a bridge between stories and numbers.

Good Valuation


If I ask you, “Why is the revenue in your forecast $60 billion?”

Here is the answer I don’t want to hear: “Because I used 15% for revenue growth in the first five years, and 5% for the next five.”

I want to hear what you know about the company that justifies a $60 billion revenue. Every number in your valuation has to be backed up by a story. Conversely, every story about how great the company is has to be backed up by a number.


Damodaran ML
“Never use the word value when you mean price. Never use the word price when you mean value. They are two very different concepts.”

- Aswath Damodaran

Professor of Finance
New York University, Stern School of Business
(Photo by Mabel Lee)

Number crunchers tend to have the following delusions:

      • Delusion of precision: When in doubt, add decimals – makes us feel more ‘precise’.
      • Delusion of being objective: I’m just using numbers. How can I be biased?
      • Delusion of being in control: I’m in control because I’ve put in numbers.

 

        Story tellers tend to have the following delusions:
      • Contempt for number crunchers: Number crunchers are boring people who don’t dream in color.
      • Great believers in the anecdote: If I tell a really good story, I will be rewarded with a multi-billion dollar value. A sample size of one can be generalized to the entire universe.

 

      Left to our own devices, chances are we will find and stay in our own delusions.



5-step Process to Valuation

Step 1: Develop a narrative for the business you are valuing

In every company I value, the first thing I do is: I tell a story about the company. Before I open my spreadsheet, I first have to get my story straight before I put a number down. 


Uber Example
Uber is probably the most valuable private company today. It has a valuation of US$71 billion. I first heard about Uber when I read a Wall Street Journal article in 2014 that said venture capitalists had priced Uber at US$17 billion.

 

♦  Things to Find Out
  1. Why Partners Like the Service
    Uber enables a driver to take excess capacity and use it by connecting him to customers and earning a second income from a car he already owns.
  2. Customers Like the Service
    Uber rides are cheaper than other cabs, waiting time is shorter, and they are cleaner.
  3. How the Company Makes Money
    For providing a match-making service, Uber gets to keep 20% of what the passenger pays for the ride.
  4. How the Company Grows
    Uber doesn’t own the cars. They don’t hire the drivers. All they have to do is go into a new city, hire a guy, and put him in a room.
  5. Barriers to Entry
    Why can’t I just go into my basement and start a match-making service? Then, I realized that Uber had 3 things that were a big advantage over me. Firstly, they had US$3bn from the venture capitalist. Secondly, once they started signing up drivers, there was a networking effect. This means the bigger you get in the ride-sharing service, the more difficult it is for a new player to enter because you have already tied up the resources. Thirdly, they use the data that they collect on you in effective and creative ways like the Search Pricing service when demand is high.


Step 2: Test the narrative to see if it is possible, plausible, and probable

♦  Talk to People who Use the Service

In 2014, intrigued by a news report on Uber’s huge valuation, the Professor downloaded the Uber app onto his smartphone, called a cab, and asked the driver to drive him around for half an hour so that he could ask some questions.

Professor: Is this an Uber car you’re driving?
Cab Driver: This is my car.

Professor: Are you an Uber employee?
Cab Driver: No, I’m an independent contractor.

Professor: Why do you doing this?
Cab Driver: I’ve got a regular job. I don’t make enough money. I already own a car. I just decided to make a second income.

Professor: What does Uber do for you?
Cab Driver: In New York City, it’s illegal to pick up passengers from the street. Uber connects people to customers.

Professor: Did you tell the insurance company about this?
Cab Driver: What they don’t know doesn’t hurt them.

When the Professor wanted to pay for the ride, the cab driver said: “You don’t have to pay.”

Professor: It’s free?
Cab Driver: When you downloaded the app, you had to enter your credit card number didn’t you?

Professor: How do you get paid?
Cab Driver: They send me 80% of whatever you pay them.

Professor: Why 80%?
Cab Driver: I don’t know. That’s what they all do.

Why Passengers Like Uber

Professor: Why do you use Uber on these ride-sharing trips when you already own a car?

Professor’s son: Dad, on Friday nights and on Saturday nights, I really like Uber. I can call Uber from a bar. It’s cheaper than a cab. They come quicker than a cab. They are cleaner than a cab.

There are lots of possible narratives, not all of them are plausible, and only a few of them are probable. Don’t base your valuation input on a fairy tale story.

For example, it is impossible for a company’s revenue to grow so much that it has more than a 100% market share. It is also impossible for earnings growth to exceed revenue growth for long enough that profit margin eventually exceeds 100%. It is implausible that a company grows and earns higher profits without competition. It is also implausible that it generates high returns with no risk.

It is improbable that a company has high growth with low reinvestment needs.

Step 3: Convert the narrative into drivers of value

The third step is where the craft of valuation comes in. Check the narrative against history, economic first principles, and common sense. Take the narrative apart and look at how you will bring it into valuation inputs starting with potential market size down to cash flows and risk.

By the time you are done, each part of the narrative should have a place in your numbers and each number should be backed up by a portion of your story.

What if I come to a part of a story that I cannot convert into a number? I firmly believe that no matter how fuzzy your story seems, you can convert it into a number. You just haven’t tried hard enough.

Step 4: Connect the drivers of value to a valuation

Once you convert each part of your story into inputs for your valuation, your valuation will emerge. Create an intrinsic valuation model that connects the inputs to an end-value in the business.

When you come to step four, you should seek out people who are most likely to disagree with you. Don’t let your defense mechanisms kick in too soon.

Instead of thinking: How dare you criticize my cost of capital!

Think: There’s someone out there who knows more about this than I do, and I’m going to find that person. Before you start on the valuation process, you have to understand the company and the businesses.

Unfortunately, some people restrict their valuation process to getting templates and going through the financial statements. The way to understand a company is to talk to people who use the products and services of the business.

Step 5: Keep the feedback loop open

Face up to the uncertainty in your own estimates of value. Create a process where people who disagree with you the most have a say. Provide a structure where the criticisms can be specific and pointed, rather than general.

Damodaran 5StepListen to people who know the business better than you do and use their suggestions to fine tune your narrative and perhaps even alter it. Work out the effects on value of alternative narratives for the company.

Bill Gurley, partner of Benchmark Capital, one of the first venture capital companies to invest in Uber (with a US$2 billion valuation), is on Uber’s board of directors. Obviously, he knew more about Uber than I do.

He sent me an email that said, ‘I read your blog on how you valued Uber and I did not like it. I put up a blog post to counter your blog post.’ I went to Bill Gurley’s blog, Above the Crowd. His post said: “Uber is not a car service company. It is a logistics services company.”

By using the word logistics, he expanded the potential market to car service delivery and moving. He said Uber can create new demand for car service in parts of the country where taxis are not used including suburbia and small towns.

He said that they are converting their local networking benefits to global benefits. The next time you make a flight reservation on United Airlines, you will get an option that says, “Get me an Uber car when I land in Singapore.” By linking with technology and credit card companies, Uber can have global networking benefits.

I was fascinated by the story. After I read the story, I took my US$100 billion market and made it US$300 billion to include logistics services. I took my 10% market share and made it 40% to extend local networking benefits to global. My valuation of US$6 billion went to US$53 billion.

I emailed the revised valuation to him and asked, “Do you like it?”

“I like it a lot. By the way, we’re going to lower the 80:20 revenue split to 90:10,” he said. I went to my spreadsheet and changed it to 90:10 and came up with a valuation of US$29 billion. Every time I value a company and someone comes up with a much higher valuation than I do, it’s not my business to step in and say that valuation doesn’t make sense. It doesn’t make sense to me, but I can’t generalize that into: It doesn’t make sense to anybody.

Input

June 2014

September 2015

Rationale

Total Market

US$100 billion
Urban car service

US$230 billion
Logistics

Market is broader, bigger, and more global than I thought it would be. Uber’s entry into delivery and moving businesses is now plausible, perhaps even probable.

Growth in Market

Increase maret size by 34%;
CAGR of 6%.

Double market size; CAGR of 10.39%.

New customers being drawn to car sharing, with more diverse offerings.

Market Share

10% (local networking)

25% (weak global networking)

Higher cost of entry will reduce competitors, but remaining competitors have access to capital. In Asia, they have hometown advantage.

Slice of Gross Receipts

20% (left at status quo)

15%

Increased competiton will reduce car service company slice.

Operating Margin

40% (low cost model)

25% (partial employee model)

Dirvers will become partial employees, higher insurance and regulatory costs.

Cost of Capital

12% (ninth decile of US companies)

10% (75th percentile of US companies)

Business model in place and substantial revenues.

Probability of Failure

10%

0%

Enough cash on hand to fend off threats to survival.

Value of Equity

US$5.9 billion

US$23.4 billion

Value increased more than four fold.

Table: Damodaran’s assumptions for valuing Uber

LQM whiteWe are missing the point when we argue over the revenue growth rate over the next 5 years. Your argument should be about the vision for the company and which vision is more probable and plausible. Why argue over beta or cost of capital, especially over numbers which are not on the top 10 list of things that drive the valuation?

The number is never quite done as the world changes. Every time there is an earnings report, I update my valuation because there might be something in the earnings report that changes my story for the company. It could be a macro factor. For example, if there is a crisis that may affect an oil company, that changes my valuation of the company. Everything that happens around you can change the valuation.

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