The Story Behind Your Valuation: Damodaran’s Five-Step Framework

One of the lessons learned from the COVID-19 crisis is that a coherent narrative is more important than ever in business valuation, says Dr. Aswath Damodaran, of New York University Stern School of Business, who gave the keynote address at the CBV Congress 2021. A valuation needs a marriage of narrative and numbers, Damodaran says. In a good valuation, the numbers are “bound together” by a coherent narrative and storytelling is kept grounded with numbers. Too much emphasis on numbers can make valuations mere “plug-and-point exercises” that may be perceived to be sales pitches or a confirmation of preconceived values.

With such a disruptor as COVID-19, what happened to the subject company becomes more key in the overall valuation report. The answers to the following questions will help the valuator understand what happened to the subject company:

• Where was this company before the crisis?
• What happened to it when the crisis hit?
• How did it respond?
• Did it rise to the challenge and retool to deal with the crisis?
• How did it treat its customers and employees?
• Did it avail itself of government stimulus money?
• How is it emerging from the crisis—is it stronger or crippled?

In the recent Business Valuation Update (BVU) article, “Damodaran Says COVID-19 Crisis Puts More Emphasis on the Story Behind a Valuation,” we list Damodaran’s five-step framework on how help to develop your story:

1. Come up with a storyline.

What is the firm’s story? Company founders and managers will have their stories, but valuation experts need to develop their own, which may or may not be in sync with theirs. Damodaran’s initial narrative for Uber was this: “Uber is an innovative car service company, with the untested potential to expand into other logistics businesses. It will expand the car service business (by attracting new users), while gaining a significant (though not dominant) market share and preserving its profitability.” Someone else may come up with a narrative such as this: “Uber is a logistics company that will find a way to expand its profitable car service business model into the moving, car rental and electric car businesses.”

2. Test the narrative.

See whether your story withstands several tests: history, experience, and common sense. Have any other companies lived the narrative you developed? What do they share in common? In terms of experience, have you valued any similar companies (or invested in any companies) and recall the problems you ran into in practice? To test for common sense, draw on first principles in economics and mathematics to evaluate your narrative’s weakest links. For Uber, Damodaran justified his assumption of it gaining market share because the taxi and limo business was “a splintered, regulated and inefficient business that is ripe for disruption.”

3. Convert key parts of the narrative into drivers of value.

This is a relatively simple step for valuation experts, who will look at the total market and boil it down to after-tax cash flow and then discount for time and risk. Along the way, key parts of the narrative will be connected to value. For example, a narrative that includes a strong competitive edge will convert to high market share and high operating margins.

4. Connect the drivers of value to a valuation.

Apply a valuation model such as the discounted cash flow (DCF) to connect the drivers of value to value. Damodaran points out that the classic venture capital valuation takes a short cut by using expected earnings (or revenue) in a future period, an exit multiple (based on what others seem to be willing to pay today for similar companies) that converts that number into a future value, and a target return to discount that value back to the present (and adjust for risk).

5. Keep the feedback loop open.

You need to be able to admit that your initial valuation may need to be adjusted as events unfold. When he valued Uber, the comments Damodaran received from people in the venture capital and technology space gave him ideas that he incorporated into his DCF analysis.

Conclusion

Business valuation is the bridge between narrative and numbers, which requires the use of both sides of the brain. “If you do a good valuation, it should tell a story. In the process, it makes both sides, the numbers people and the narrative people, better,” Damodaran says. “If you’re a storyteller, it forces you to be disciplined. If you’re a numbers person, it makes you think about the narrative.”

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