At the 2019 CFA Institute Equity Research and Valuation Conference, NYU finance professor Aswath Damadoran spoke about disruption and the challenge associated with valuing disruptors.
“As human beings, we don’t like to deal with uncertainty,” he said, adding that we typically respond with either prayer, denial, heuristics, herding behavior, or by outsourcing to experts. For investment professionals, however, Damadoran argues that the “disruption dilemma” goes much deeper because it brings uncertainty into “every number that we measure.”
Damadoran explains that uncertainty evolves as companies progress through their life cycles, offering the following examples:
- In start-ups, there is uncertainty around whether a business’s idea has potential.
- A young businesses grapples with whether their business model can be commercialized.
- A growth-phase company must determine whether its model with generate enough growth.
- A late-stage company may face uncertainty regarding how and if management will face reality.
Because uncertainty is greatest during the young phase of a company’s life, Damadoran argues, we “feel more comfortable valuing nice, mature companies” but valuing young companies offers the greatest potential. He cites storytelling as a “key tool” when valuing disruptors: “A good valuation is a bridge between stories and numbers,” but he adds that you have to be confident enough in your storytelling to act on it.
He outlined the following five steps in creating a valuation story:
- Develop a narrative for the business.
- Test the narrative “to see if it is possible, plausible and probable.”
- Convert the narrative into value drivers—each part should “have a place in your numbers and each number should be backed up by a portion of your story.”
- Connect the value drivers to an “end value” for the business.
- “Keep the feedback loop open” by listening to people who know the business and use their suggestions to fine-tune your valuation.
“But take heed,” Damodoran concludes: “Stories aren’t static, so be prepared to adapt.” Especially for younger companies, he said, “if you get stuck on your story, you’re in big trouble.”