Key Points:
- The greatest challenge in valuing companies is dealing with uncertainty.
- Uncertainty is highest for younger companies due to less history and infinite potential.
- As humans, our first reaction to uncertainty is often denial or avoidance.
- Damodaran recommends learning to deal with biases that lead us astray when facing uncertainty.
- He suggests a framework of simple valuation rules to overcome uncertainty and improve valuations.
Aswath Damodaran believes that the greatest challenge in valuing companies is not coming up with better metrics or models, but rather dealing with uncertainty. In his view, the problem lies in our response to uncertainty: as humans, we tend to react with denial or avoidance, which only makes the problem worse.
Uncertainty is particularly high for younger companies, which have less history and more unknowns, but also infinite potential. Damodaran discussed the art and pitfalls of valuing young companies at the Alpha Summit GLOBAL by CFA Institute. He emphasized the importance of learning to deal with the biases that lead us astray when faced with uncertainty. These biases, according to Damodaran, are the biggest obstacles to accurately valuing a company.
To overcome uncertainty and improve valuations, Damodaran laid out a framework of simple valuation rules. The first step is to understand the three categories of uncertainty: estimation uncertainty versus economic uncertainty, micro uncertainty versus macro uncertainty, and continuous versus discrete uncertainty. While estimation uncertainty can be reduced by gathering more or better information, economic uncertainty is harder to mitigate. Micro uncertainty focuses on the company itself, while macro uncertainty encompasses factors beyond a company’s control. Continuous uncertainty involves fluctuations that don’t have a major impact on a company’s cash flow, while discrete uncertainty involves rare events with catastrophic effects.
For young companies, micro uncertainty tends to be most important. As companies mature, macro uncertainty becomes more significant. However, uncertainty is greatest for young companies because everything is in flux, leading to unhealthy responses. Damodaran identified four common responses to uncertainty: shutting down, denying the uncertainty, using mental accounting based on past valuations, and outsourcing to consultants. He warned against these unhealthy practices and emphasized the need to take responsibility for valuing a company.
To effectively value young companies, Damodaran suggested a three-step process and some coping mechanisms. The first step is to come up with a story that combines narrative and numbers. For young companies, it’s hard to convert a story into numbers, but the key is to understand the life cycle of companies and the different risks and characteristics of each stage. The second step is to keep valuations parsimonious by focusing on a few essential variables. Damodaran identified six factors for young companies: revenue growth, target operating margin, sales-to-invested-capital ratio, cost of equity, cost of debt, and the likelihood of failure. The third step is to avoid common errors in discounted cash flow analyses, such as ignoring economic first principles and using misleading rules of thumb for terminal value.
Lastly, Damodaran highlighted the importance of recognizing and managing bias in valuation. He referred to the three greatest challenges in valuation as the Bermuda Triangle: uncertainty, complexity, and bias. While uncertainty and complexity can be managed and mitigated, bias is unavoidable. Damodaran urged valuation analysts to admit their biases, be open about them, and seek input from those who think differently. By following these principles, Damodaran believes we can turn the challenge of valuing young companies into something enjoyable.
