Let’s Talk Valuation

JUNE 21, 2024

Reflecting on some of the help sessions I’ve had these past few months, I came across some discussions that I would like to highlight. In the world of finance, valuation stands as a cornerstone, an intricate tapestry woven with numbers, assumptions, and narratives. It’s a concept that transcends mere calculations, encapsulating the essence of a business’s worth—a worth that lies not just in tangible assets but in the intricacies of its story. I say this, in good measure to have a crack at what the “Dean of Valuation”1 usually says, tell me a story . . .

To grasp the nuances of valuation, it’s imperative to understand that no single method reigns supreme. Each approach offers a unique lens through which to view a company’s value, akin to examining a diamond from various angles to appreciate its true brilliance.

While valuation is an art, it demands an unwavering commitment to rigor and objectivity. One of the cardinal rules is to ground assumptions in verifiable data and industry benchmarks, resisting the temptation to succumb to bias or overly optimistic projections. Rigorous due diligence, thorough market research, and a critical examination of the company’s financial statements and competitive landscape are essential to ensure credible valuations. Nevertheless, in the end, your valuation will depend on the story of which you’ll try to convince others.

Moreover, it’s crucial to embrace a range of valuation methods, recognizing that each approach offers unique insights. By triangulating multiple methods, one can develop a more comprehensive understanding of a business’s worth, mitigating the limitations of any single approach.

Comparables

One of the most widely used methods, the comparable approach, relies on the wisdom of the market. By analyzing similar companies that have recently been acquired or are publicly traded, this method seeks to establish a valuation benchmark. It’s similar to evaluating the worth of a home by considering the prices of neighboring properties that have recently sold.

However, it’s essential to exercise caution, as no two companies are truly identical (just as much as no two properties are alike), and adjustments must be made to account for differences in size, growth potential, and competitive advantages.

The key to a successful comparable approach lies in the careful selection of “truly” comparable companies. This requires a deep understanding of the industry, the competitive landscape, and the unique characteristics that drive value in the sector.

That is . . . the business model. Factors such as geographic presence, product offerings, customer segments, and growth strategies must be carefully evaluated to ensure an apples-to-apples comparison.

Discounted Cash Flows

Another prevalent approach is the discounted cash flow (DCF) method, which hinges on forecasting a company’s future cash flows and discounting them to their present value. This method acknowledges that a business’s true value lies not in its current state but in its ability to generate future profits. It’s like assessing the worth of a plantation not by its current fruit but by the harvests of the years to come.

As with much in life, with DCF valuations assumptions reign supreme. Projecting future cash flows and determining an appropriate discount rate demand a delicate balance of art and science. Best practices suggest conducting thorough industry research, analyzing historical trends, and understanding the company’s competitive advantages and growth strategies. Additionally, sensitivity analyses should be performed to gauge the impact of varying assumptions on the valuation outcome.

1 NYU Valuation professor Aswath Damodaran is usually known by this moniker.

In DCF valuations, the terminal value—the value of the business beyond the explicit forecast period—can account for a significant portion of the overall valuation. As such, it’s crucial to carefully consider the appropriate terminal growth rate and the assumptions underlying it or the appropriate multiple that serves you to determine the value of the unknown. Overly optimistic terminal growth rates can lead to inflated valuations, while overly conservative assumptions may undervalue the business’s long-term potential.

Another critical aspect of DCF valuations is the selection of an appropriate discount rate, which reflects the risk associated with the company’s future cash flows. This rate should consider factors such as the company’s cost of capital, industry risk, and market risk premiums. Failing to accurately assess the discount rate can lead to a significant over- or undervaluation of the business.

Recent Transactions

In some cases, valuation can be influenced by recent transactions involving the company itself or its peers. This approach recognizes that the market’s perception of a business’s value can be swayed by the prices paid in recent acquisitions or investments.

It’s akin to gauging the worth of a rare coin not only by its intrinsic value but also by the prices fetched at recent auctions. However, it’s important to understand the motivations behind these transactions and to adjust for any unique circumstances or synergies that may have influenced the price.

The Book Value

While often considered the most conservative approach, the book value method focuses solely on a company’s tangible assets, subtracting liabilities to arrive at its net worth. This method serves as a reminder that, at its core, a business is grounded in the physical assets it possesses—a foundation upon which its future potential is built.

However, it’s important to note that this approach may undervalue intangible assets, such as brand equity, intellectual property, and human capital, which can be significant drivers of value in many industries.

Valuation Is an Art too! Let’s Go Beyond the Numbers

Valuation is more than just a mixture of these methods. It’s an art form, a delicate dance between quantitative analysis and qualitative storytelling. As Aswath Damodaran eloquently stated: 2“A good valuation is a bridge between stories and numbers.”

While numbers and calculations form the backbone of valuation, best practice demands an embracing of the qualitative aspects that shape a business’s narrative. Understanding the company’s competitive advantages, brand equity, intellectual property, and management team’s vision can profoundly impact its perceived value. Skilled practitioners weave these intangible elements into their valuation stories, painting a vivid picture of the company’s potential.

In this light, valuation becomes quilted with narratives—the tale of a brand’s resonance with consumers, the potential for market disruption, the resilience of a business model, and the visionary leadership at the helm—the needles and threads. These intangibles, often overlooked by mere numbers, can significantly influence a company’s perceived worth.

Ultimately, the value of something is what others are willing to pay for it. Say you have a business with a recognized brand such as Nike, Mercedes-Benz, and the other thousands of examples like that.

Do you value the name, the brand, what it represents (which cannot be put to paper)? Or do you value the assets, the underlying business model that is there? Say whatever you want about valuation, but I bet you that if Nike were to sell a sports-related MBA, you would probably be interested in buying that, not just the running shoes they make.

How you spin a story about your numbers is just as important as the numbers and assumptions themselves.

2 You can see him saying this here: https://www.youtube.com/watch?v=tDqTHFBKwsY

Herein lies the true essence of valuation: it’s a subjective endeavor, a reflection of the beholder’s lens. A brand that commands unwavering loyalty in one’s eyes may hold little value to another who prioritizes tangible assets. A disruptive technology that promises to redefine an industry may be deemed priceless by visionaries yet dismissed as a fleeting fad by skeptics.

This subjectivity underscores the importance of approaching valuation with an open mind and a willingness to embrace multiple perspectives. Just as a painter’s masterpiece can evoke vastly different emotions and interpretations from its viewers, a business’s value can be perceived through myriad lenses, each offering unique insights.

Valuation as a Continuous Process

It’s important to recognize that valuation is not a one-time exercise but rather an ongoing process. As businesses evolve, market conditions shift, and new information emerges, valuations must be updated accordingly. Regular monitoring of key performance indicators, industry trends, and competitive dynamics is essential to ensure that valuations remain relevant and reflective of the company’s true worth.

Moreover, valuations must be nimble enough to adapt to changing market conditions. Economic downturns, regulatory shifts, or disruptive technologies can rapidly alter the competitive landscape and the assumptions underpinning a valuation. Skilled practitioners must remain vigilant, continuously reassessing their valuations in light of new developments and adjusting their narratives accordingly.

In the entrepreneurial realm, valuation takes on a particular significance. Entrepreneurs are inherently visionaries, pioneers who see potential where others may see obstacles. Their valuation of a business often extends beyond mere numbers, encompassing the transformative power of their ideas, the passion that fuels their pursuits, and the audacity to challenge conventional wisdom.

For entrepreneurs, valuation becomes not just a financial exercise but a decision-making tool.

One of the most complex but better served for guiding their attention towards critical assumptions and critical decision-making processes. Having a clear DCF of how your business operates, and its financial model, can guide you critically toward that series of assumptions that indicate the conditions under which your business maximizes its value. Not only is this critical, but it also guides your senses and attention to those insights you don’t realize are critical yet.

As we navigate the intricate landscapes of finance and entrepreneurship, it’s crucial to embrace valuation not merely as a numerical exercise but as an art form—one that blends quantitative rigor with qualitative storytelling—entrepreneurial storytelling.

By acknowledging the multifaceted nature of valuation and the subjectivity inherent in how it is interpretated, we open ourselves to a deeper understanding of a business’s true worth and the underlying ways of how best to operate it.

To this end, let us be guided by the wisdom of those who have gone before, inviting others to share their narratives and embracing the richness of diverse perspectives. In the grand and complex quilt that is a valuation, each thread contributes to the intricate design, weaving together art and science to unveil a business’s true potential.

The Role of Storytelling in Valuation

Storytelling plays a pivotal role in the art of valuation, serving as a bridge between cold hard numbers and the intangible elements that shape a business’s future. A compelling narrative can breathe life into financial projections, painting a vivid picture of a company’s trajectory, its competitive advantages, and the transformative impact it can have on its industry.

Effective storytelling in valuation requires a deep understanding of the business, its industry dynamics, and the broader economic and social landscape in which it operates—the context. It demands the ability to weave together data, insights, and strategic vision into a cohesive and compelling narrative that resonates with investors, stakeholders, and decision-makers.

In the ever-evolving world of business, valuation practices must adapt and evolve.

Continuously learning and staying abreast of new methodologies, emerging trends, and industry-specific nuances is essential for practitioners to maintain their edge. Attending seminars, participating in professional networks, and engaging in ongoing self-study ensure that valuations remain relevant and reflective of the latest thinking and best practices. This will guide the entrepreneur’s wit.

Closing Thoughts

Valuation is an art that demands humility and adaptability. No matter how seasoned the practitioner is, there will always be instances where assumptions prove incomplete, methodologies fall short, or unforeseen events challenge even the most well-crafted valuations.3 Embracing this reality with humility and a willingness to adapt is crucial for maintaining credibility and delivering “accurate” valuations.

The true masters of valuation will be those who can seamlessly blend the power of technology with the artistry of human insight, creating rich interpretations of business models that capture the essence of a business’s worthwhile leveraging the latest analytical tools and techniques.

In the valuation’s quilt, every thread—be it a financial metric, a market trend, or a visionary idea—contributes to the intricate design, weaving together art and science to unveil a business’s true potential. As we navigate this ever-evolving landscape, let us embrace the multifaceted nature of valuation, fostering collaboration, honing our storytelling skills, and continuously adapting to the changing tides of innovation and market dynamics.