Narrative and Numbers: The Value of Stories in Business
by Aswath Damodaran
Aswath Damodaran is a professor of finance who has written several books on business valuation, including The Little Book of Valuation: How to Value a Company, Pick a Stock, and Profit.
In this book, he computes valuation based on the business narrative. “One of the most important lessons I have learned is that a valuation that is not backed up by a story is both soulless and untrustworthy and that we remember stories better than spreadsheets.” Conversely, “when a storyteller has wandered into fantasyland, the easiest way to bring him or her back to Earth is with data that suggests the journey is either impossible or improbable.” Thus, “you need to bring both stories and numbers into play in investing and business, and valuation is the bridge between the two.”
“Good storytelling can make a huge difference in the success of a business, especially early in its life. To be a successful business, not only do you have to build a better mousetrap, but you have to tell a compelling story about why that mousetrap will conquer the business world to investors (to raise capital), to customers (to induce purchases), and to employees (to get them to work for you)… Storytelling in business comes with more constraints than storytelling in novels, since you are measured not just on creativity but on being able to deliver on your promises.”
A business narrative “is less about specifics and details and more about big picture and vision.” The author says a great story must be simple, credible, authentic, and emotional “in the sense that it comes from the heart.” He adds, “Nothing will undercut your story more than mangling the facts.” According to psychology research, stories are more likely to be remembered if the listeners “have to work to make inferences and see the connections” and less likely to be remembered if the causal relationships are either too obvious or too weak.
“Stories create connections and get remembered, but numbers convince people. They give a sense of precision to even the most imprecise stories, and putting a number on a judgment call makes you feel more comfortable when dealing with uncertainty.”
But the author writes about the “the dangers of trusting numbers too much… I am naturally drawn to numbers but one of the ironies of working with numbers is that the more I work with them, the more skeptical I become about purely number-driven arguments. In my work with financial data, both accounting and market driven, I have learned about how much noise there is in that data and how difficult it is to make predictions based on that data. I believe in the scientific method, but I don’t believe there are many pure scientists out there. All research is biased, with the only questions becoming about the direction and magnitude of the bias.”
Survivor bias is an example of how analysis can be distorted. “Professor Brown argued that the mistakes many analysts were making was that they were starting with the hedge funds in existence today and working backward to see what returns those funds earned over time… The worst-performing hedge funds go out of business and not counting the returns from those funds pushes up the computed return for the sample.”
Stories should be reality-checked for “possibility, plausibility, and probability, in that order.”
“I think that we can all agree that no company can grow so much that it becomes larger than the economy in which it operates. That may be stating the obvious, but I am surprised at how often I see this simple mathematical constraint violated in valuation.”
Another example of an impossible story is one in which the revenue growth projections exceed 100 percent market share. “To keep a check on this, you should build in the assumptions that scaling up will get more difficult as a company gets bigger and that the growth rates you use in future years will have to be lower than past growth rates.”
A story also breaks down when it is internally inconsistent. “The three corners of the triangle—growth, risk, and reinvestment—are the drivers of the value of a business… As growth increases, value will go up, but as risk or reinvestment increases, value will go down. Not surprisingly, a storyteller with an agenda of making a company more valuable will tell a story that combines high growth with low risk and low reinvestment, but that story is usually implausible because it is inconsistent. A company with high growth will generally need to have high reinvestment to deliver that growth, and it will be riskier than average much of the time.”
“Connecting the qualitative to the quantitative can allow investors [to scrutinize] claims made by founders and managers about a business. A brand name story for a company whose profit margins are below median for a sector should be viewed with skepticism, as should a high-growth story for a company that has consistently reported single-digit growth for the last decade.”
The author uses the discounted cash flow method to value companies. Throughout the book there are examples of how he converts narrative to valuation numbers for Uber, Ferrari, Alibaba, and Amazon.
To compute the equity per share in a publicly traded company, Damodaran makes adjustments, such as the following: “Lease commitments, for instance, should be considered as debt… Stock-based compensation… Since these are employee compensation, there is no conceivable argument for not treating them as operating expenses at the time that they are granted.”
“One test of whether an analyst is mechanically plugging numbers into models or has a serious story will come out in how he or she responds to your questions… When you see projected revenues for a company in a valuation spreadsheet or model, your questions will have to zero in on what the analyst who did the valuation sees as the total market for the company and the market share that he or she has given the company. That then opens the discussion to the business or businesses that the company operates in and what networking and competitive advantages it brings to these businesses.”
“Being open to changing your narrative is not a sign of weakness but of strength… It is worth remembering that your narrative is not the only plausible one and that there might be alternative stories for the same business. Rather than dismiss these alternative narratives as wrong and defend your own, you will be better served if you keep the feedback loop open and consider whether any of these alternative narratives have parts that you may want to borrow or adapt to make your own better. In some cases, these changes may be because others know more about the company being valued and the business it operates in than you do.”
A corporate story is constantly subject to change due to internal and external news. “When companies alter their conventional patterns of returning cash [dividends or stock buybacks], there may be information in their actions that can affect your story and value.” Acquisitions can dramatically change the narrative; the author notes that the price paid is the key factor in determining whether value will be created or destroyed. “Scandal can unalterably change the reputation of the company, and to the extent that its narrative was built on that reputation, its story as well.” The narrative can also be changed by macroeconomic news, such as changes in interest rates, commodity prices, or the geopolitical conditions.
As a company moves through the corporate life cycle (start-up, growth, maturity, decline) its narrative will change. “There is nothing more disconcerting in business than watching a narrator… tell a story about a company that does not fit where the company falls in the life cycle.”
“The one problem that adding stories to numbers will not solve, at least in the near term, is herding. The groupthink that leads people to pile into the same stocks and investments because the numbers lead them there will also lead to them to reinforce one another’s stories. There is an argument to be made, though, that the best way to break the madness of crowds is with a combination of an alternative (and more realistic) story, backed up by numbers to give it credibility.”
“The implications [of herding] are sobering. As we move increasingly to a data-driven world, and more and more people have access to that data, it stands to reason that we will see more booms and busts than we have historically. Bubbles in markets will be bigger than they used to be and when these bubbles burst, as they inevitably will, the carnage is going to be greater as well.”
In summation, “stories without numbers are just fairy tales and number without stories to back them up are exercises in financial modeling… A good business story is simple, credible, and persuasive… You are the storyteller and that means you have to be willing to make judgments, which though based on data and information, are still judgments. You can and will be wrong, but that is not a reflection of your weaknesses, but a consequence of uncertainty.”
Disclosure: I received a review copy of this book.
Damodaran, Aswath. Narrative and Numbers: The Value of Stories in Business. New York: Columbia Business School Publishing, 2017. Buy from Amazon.com