The Art of Valuation: Telling a Story with Numbers
Valuation is a critical aspect of finance and investment, and every valuation tells a story about a company. In this chapter, the author discusses the missing skill in valuation and outlines a five-step process for connecting stories to numbers. The process includes devising a story for the company, ensuring it is not a fairy tale, converting the story into inputs for valuation, performing the valuation, and seeking feedback to improve the story. The article provides a comprehensive understanding of the valuation process, using the author's example of valuing an Indian online food delivery business, Zomato, at the time of its IPO in 2022.
Constructing the Story: Understanding the Business Environment
The first step in valuation is constructing a story for the company. Understanding the company's business, products, target market, competition, and macroeconomic factors is essential in devising a coherent narrative. Additionally, analyzing the company's financial history, market potential, and competitive landscape helps in shaping the story for valuation.
In the case of Zomato, the author emphasizes the importance of considering the Indian food delivery market's size, growth potential, and competitive dynamics. The story must reflect the company's position within the market, its market share, and its potential for future growth. Furthermore, acknowledging the macroeconomic factors that influence the business, such as income levels, connectivity, and cultural trends, is crucial in crafting a realistic and nuanced story for valuation.
Testing the Story: Plausibility and Probability
After devising the story, it is essential to test its plausibility and probability. The author highlights the importance of ensuring that the story is not a fairy tale by subjecting it to rigorous scrutiny. The story's plausibility is evaluated based on whether similar narratives have played out in the industry, while its probability is assessed by testing its viability in real-world scenarios.
Through the example of Zomato, the author demonstrates the process of verifying the story's validity by examining historical industry trends, market dynamics, and the company's competitive position. This rigorous testing ensures that the valuation story is grounded in reality and aligns with practical expectations for the company's future performance.
Converting the Story to Numbers: Inputs for Valuation
Once the story is validated, the next step involves converting the narrative into inputs for valuation. The author emphasizes the importance of keeping valuations parsimonious by focusing on critical inputs such as revenue growth, operating margins, reinvestment requirements, and risk factors. These inputs are derived from the underlying elements of the story, reflecting the company's market potential, profitability, and competitive positioning.
In the case of Zomato, the author translates the narrative of India's growing food delivery market, the company's dominant market share, and its operational efficiencies into tangible inputs for valuation. By quantifying revenue projections, margin targets, reinvestment needs, and risk assessments, the story comes to life in the form of numerical inputs that drive the valuation process.
Performing the Valuation: Transforming Inputs into Value
With the inputs in place, the valuation process becomes mechanical, yielding a tangible assessment of the company's worth. The author demonstrates how the inputs drive the valuation of Zomato, generating cash flow projections, discount rates, and terminal value estimates. This step culminates in the determination of the company's operating assets value, incorporating the probability of failure and adjusting for debt and cash positions to derive the equity value.
Through meticulous calculations and assumptions, the story of Zomato is translated into a numerical valuation, reflecting the company's potential to generate future cash flows and create value for investors.
Seeking Feedback and Adapting the Story: Refining the Valuation
The final step in the valuation process involves seeking feedback on the valuation and using it to refine the story. The author emphasizes the importance of presenting the valuation to individuals who think differently and challenging the narrative. This feedback loop enables the storyteller to improve the valuation story, incorporating diverse perspectives and refining the narrative based on constructive criticism.
In the case of Zomato, the author highlights how feedback from stakeholders prompted a reflection on the breadth and depth of the valuation story. By presenting alternative valuation scenarios based on different narratives and market assumptions, the author exemplifies the continuous evolution of the valuation story in response to external input.
Conclusion: Adapting to Changing Stories
In conclusion, the valuation process is an art that involves storytelling, analysis, and adaptation. Every valuation tells a story about a company, and the ability to construct, test, and refine that story is crucial in deriving meaningful valuations. The case of Zomato illustrates the dynamic nature of valuation storytelling, where narratives can break, change, or shift in response to market developments and evolving business realities.
Ultimately, the process of valuation is not a one-time endeavor but a continuous journey of storytelling and adaptation, where the narrative of a company's potential is shaped, tested, and refined over time. By understanding the interplay of stories and numbers, investors and financial analysts can gain deeper insights into the value creation dynamics of companies in the market.
In summary, the art of valuation lies in the seamless integration of storytelling and numerical analysis, allowing for a comprehensive understanding of a company's potential and value within the market landscape. Through the incorporation of diverse perspectives, rigorous testing, and continuous adaptation, valuations can transcend mere numbers and reflect the evolving stories of companies in the ever-changing business world.