Latepost Numbers As Well As Narrative: Modeling, Even Out Telling As Well As Investing

When I position together the outline for my really get-go valuation shape inwards 1986, I was warned past times a senior faculty fellow member non to choke downwards that path. I was told that in that location was actually non plenty theory inwards valuation to warrant a shape in addition to that I would terminate upwards pedagogy a glorified accounting class. I chose to ignore that advice in addition to I receive got non regretted it since, for ii reasons. The get-go is that I honey pedagogy a dependent area where in that location is picayune theory, the questions are exclusively most practice, yous depict on a unique blend of skills in addition to tools to reach your tasks in addition to the marketplace position acts equally your chore master.  The bit is that I receive got learned almost everything I know most valuation in addition to to a greater extent than importantly, how much I don't know, inwards the procedure of pedagogy this class. This post is most 1 of the recurring themes inwards my shape which is the interplay betwixt narratives in addition to numbers that makes for a expert valuation.

The Numbers Game

When most people mean value most valuation, they by in addition to large visualize dense fiscal statements in addition to elaborate excel spreadsheets, in addition to those coming into my valuation shape are no exception. They await me to immerse them inwards accounting rules in addition to the edifice of models in addition to are either deeply disappointed, if their background is inwards accounting or banking, or relieved, if it is not, to discovery out that the only thing I know most accounting rules is that in that location lots of them in addition to that I am non an Excel Jedi Master. Don't acquire me wrong! I do depict on accounting statements for my data in addition to utilisation Excel incessantly, but hither is how I consider their house inwards valuation:

1. Accounting statements render me alongside the raw cloth for my valuation, nix to a greater extent than in addition to nix less. Like all raw material, I receive got to create upwards one's hear what I volition utilisation in addition to what I volition discard, in addition to I discard far to a greater extent than than I use. As the terminate user of the raw material, I acquire to determine what makes feel for me in addition to what does non in addition to non GAAP, IFRS or the accounting profession. As for fair value accounting, I am sympathetic alongside the motives (which is to brand accounting to a greater extent than relevant) but unimpressed alongside the results. To me, fair value accounting estimates are similar microwave frozen dinners, quick in addition to convenient, but yous volition never error them for the existent thing.
2. Excel (or Numbers) is a versatile in addition to powerful multi-purpose tool, but similar all tools, it tin give notice live misused or over used. My cognition of Excel is express to those parts of it that assist me consummate my valuation in addition to I frankly receive got no involvement inwards expending fourth dimension in addition to resources mastering the parts that I tin give notice acquire done alongside simpler tools or none at all.

So, why do hence many appraisers in addition to analysts emphasize their mastery (at to the lowest degree inwards their minds) of the numbers side of valuation? The answer, I think, lies inwards the trifecta of illusions that choke alongside numbers-based models.

1. The illusion of precision: For amend or worse, nosotros seem to experience amend most uncertain outcomes, if nosotros tin give notice attach numbers (expected values, adventure adjusted discount rates) to them. That, past times itself,  is salubrious but what is unhealthy is the belief that quantifying adventure somehow makes it dissipate. 
2. The illusion of objectivity: I believe that all valuations are biased, alongside the only questions beingness how much bias in addition to inwards what direction. That is because nosotros convey inwards our preconceptions in addition to beliefs most companies into our valuations in addition to nosotros sometimes add together to the bias because nosotros receive got other agendas at play. Here again, analysts quest to numbers equally their defence strength against the bias charge, alongside the implicit declaration that numbers don't lie, when the most effective means to shade the truth is alongside a selective utilisation of numbers.
3. The illusion of control: I believe that "numbers people" ofttimes utilisation numbers to intimidate "non-numbers people" into mute acceptance. The intimidation component is dialed upwards past times adding to a greater extent than particular  (500 describe items, anyone?) in addition to buzz words (free cash flow, a few greek alphabets in addition to a host of acronyms) to your valuations.

In my view, in that location are at to the lowest degree iii pregnant dangers, when numbers are used without whatever narrative (or floor line) inwards constructing valuations. First, valuations choke plug-and-point exercises, tools to advance sales pitches or confirm pre-conceived values. Second, if a valuation is built only about describe items in addition to private inputs, in that location is a strong possibility that yous may live creating a work concern that tin give notice be only inwards spreadsheet nirvana, where revenues double every year, margins expand without challenge in addition to increment comes without pregnant reinvestment. Finally, discussions in addition to debates most inputs choke shallow exercises inwards quibbling most the "right" values to use, alongside no logical necktie breaker.

The Narrative equally Valuation

If 1 extreme of the numbers/narrative spectrum is inhabited past times those who are slaves to the numbers, at the other extreme are those who non only don't trust numbers but don't utilisation them. Instead, they rely exclusively on narrative to justify investments in addition to valuations. Their motivations for doing hence are simple.

1. Story telling is a powerful attending getter/keeper: Research inwards both respond amend to stories than to abstractions or numbers, in addition to squall back them for longer. After all, the Harvard Business School has taken floor telling almost to an art shape alongside its cases, tightly injure narratives that are supposed to convey larger lessons.
2. Unrestrained creativity: "Creative" people through the ages receive got ever fought dorsum against whatever restraints on their creativity, peculiarly those imposed past times those that they thought equally less imaginative than they are. 
3. The Creative Superiority Complex: Just equally numbers people intimidate alongside mounds of numbers, expert narrators tin give notice browbeat "bean counters" alongside superior floor telling, peculiarly if they tin give notice dorsum their stories upwards alongside personal experience. 

Narrative-driven investing is non uncommon, peculiarly alongside younger firms in addition to start-ups, in addition to I receive got been taken to chore for fifty-fifty trying to value these companies using number-driven models. Paraphrasing some of the comments on my valuations of Twitter in addition to Uber, the declaration seems to live that piece cash current based valuations may function on Wall Street in addition to alongside mature companies, they are non useful inwards analyzing the type of companies that venture capitalists facial expression at. While it is truthful that stiff cash current based models volition non function alongside companies where hope in addition to potential are what is driving value, staying alongside only narrative exposes yous to ii pregnant risks. The get-go is that, without constraints, inventiveness tin give notice comport yous to the outer realms of argue in addition to into fantasy. While that may live an admirable character inwards a painter or a writer, it is a unsafe 1 for an investor. The bit is that, when running a work concern equally a director or monitoring it equally an investor, yous demand measures of whether yous are on the correct path, no affair where your work concern is inwards its life cycle. When narrative lone drives valuation in addition to investing, in that location are no yard sticks to utilisation to consider whether yous are on track, in addition to if not, what yous demand to do to acquire dorsum on the correct path. 

Numbers addition Narrative

If numbers without narrative is only modeling in addition to narrative without numbers is floor telling, the solution, equally I consider it, is both obvious in addition to hard to position into practice. In a expert valuation, the numbers are saltation together past times a coherent narrative in addition to floor telling is kept grounded alongside numbers. Implementing this solution does require function in addition to I would propose a five-step process, though I am non stiff most the sequencing.

Step 1: Develop a narrative for the work concern that yous are valuing or considering investing in: Every work concern has a floor describe in addition to the house to start a valuation is alongside that narrative. While managers in addition to founders acquire to acquaint their narrative first, in addition to some of them are to a greater extent than persuasive in addition to credible than others, yous in addition to I receive got to develop our ain narratives, sometimes inwards sync alongside in addition to sometimes at odds alongside the administration floor line. As an example, inwards my valuation of Uber, my narrative was this: Uber is an innovative machine service company, alongside the untested potential to expand into other logistics businesses. It volition expand the machine service work concern (by attracting novel users), piece gaining a pregnant (though non dominant) marketplace position portion in addition to preserving its profitability.  The counter narrative that some of yous presented is the next (and I am paraphrasing): Uber is a logistics companionship that volition discovery a means to expand its profitable machine service work concern model into the moving, machine rental in addition to electrical machine businesses.

Step 2: Test the narrative against history, experience and common sense: This is the phase at which yous position your narrative through a reality essay in addition to examine whether it withstands multiple tests. The get-go is the essay of history, where yous facial expression at the past times to consider if in that location receive got been companies that receive got lived the narrative that yous are claiming for your companionship in addition to what they portion inwards common.  The bit is the essay of experience, where yous depict on investments based upon similar narratives that yous receive got made inwards the past times in addition to squall back or recognize route bumps in addition to barriers that yous ran into inwards practice. The tertiary is the essay of mutual sense, where yous depict on get-go principles inwards economic science in addition to mathematics, to evaluate your narrative's weakest links. With Uber, hither is how I justified my narrative. Uber volition live able to gain (10%) is that the machine service (taxi in addition to limo) work concern is a splintered, regulated in addition to inefficient work concern that is ripe for disruption. The argue I did non assume a dominant marketplace position portion for Uber (40% or 50%) is because I don't consider equally large a networking effect inwards the machine service business, where the service is both physical in addition to localized, equally in that location are inwards online applied scientific discipline businesses (search, merchandising or advertising). At the same time, I am assuming that Uber volition live able to save its profitability inwards the human face upwards of contest in addition to overcome regulatory hurdles.

Step 3: Convert primal parts of the narrative into drivers of value: Ultimately, fifty-fifty the most gripping narratives receive got to demo upwards inwards the numbers. While this may seem similar an insurmountable obstruction to those without a valuation background, it tin give notice live simplified past times looking at the large picture. Here is my essay to connect dissimilar narratives alongside primal value drivers:

Narratives in addition to Value Drivers

Step 4: Connect the drivers of value to a valuation: I utilisation discounted cash current models (DCF) to connect the drivers of value to value, because I am comfortable alongside the mechanics of these models. It is a tool that non everyone is comfortable alongside in addition to yous may discovery a dissimilar in addition to maybe amend means to connect value drivers to value. In fact, the classic VC valuation takes a brusk cutting past times using iii drivers of value: an expected earnings (or revenue) inwards a hereafter period, an acquire out multiple (based on what others seem to live willing to pay today for similar companies) that converts that position out into a hereafter value in addition to a target render to discount that value dorsum to the acquaint (and suit for risk). To those of yous who receive got never done valuation before, trust me when I say that valuation at its heart in addition to soul is uncomplicated in addition to that anyone should live able o do it. If yous don't believe me, yous are welcome to essay my online valuation shape on iTunes U. It comes alongside a coin dorsum guarantee.

Step 5: Keep the feedback loop open: My kids in addition to husband are quick to remind me that the iii words that I discovery most hard to say are "I was wrong" in addition to I am for certain that I am non lone inwards my reluctance. The biggest enemy that nosotros (whether numbers or narrative driven) human face upwards is hubris, where nosotros acquire locked into our initial points of views in addition to thought changing our minds equally a sign of weakness. While it does non come upwards easily to me, I do essay to remain opened upwards to the possibility that equally events unfold, my narrative volition alter or fifty-fifty shift, sometimes dramatically. With Uber, if the side past times side few months convey evidence of tangible success of the work concern model inwards other logistics markets, I volition alter my story, expand the potential marketplace position in addition to alongside it, the value. If, inwards contrast, the companionship gets bogged downwards inwards regulatory in addition to legal fights inwards its existing machine service markets or a competing service improves its offering dramatically, I volition receive got to dial downwards my optimism, trim down both marketplace position portion in addition to turn a profit margins in addition to alter value. In either case, I volition thought these changes equally part of investing rather than equally a failure inwards my initial valuation.

In my experience, it is easiest to play to your strengths (which, for me, are on the numbers side), but yous volition gain the most when yous function on your weaknesses (which, for me, are on the narrative side). Consequently, I larn to a greater extent than from listening to those who mean value differently from me in addition to disagree alongside me, fifty-fifty if they do non ever do hence constructively, than I do from those who concur alongside me. On my Uber valuation, the comments that I works life most useful inwards fine tuning my valuation were those that I heard from those inwards the venture upper-case missive of the alphabet in addition to applied scientific discipline space. After telling me that I had no thought what I was talking most in addition to that "DCF won't function for these companies", they hence proceeded to give me ideas that I incorporated into my DCF valuation. Here, for instance, are my attempts to quantify 4 of the most mutual narratives I heard most Uber, in addition to the consequences for value.

Narrative	Total Market	Market Share	Uber Cut	Cost of capital	Failure Probability	Value for Uber
Car service company, facing pregnant competitive in addition to regulatory hurdles, forced to brand merchandise off of lower profitability for marketplace position share.	$100 billion	10%	10%	12%	10%	$3.2 billion
Car service companionship alongside potential to expand into other logistics markets, pregnant marketplace position share, sustained profitability (Mine)	$100 billion	10%	20%	12% ->8%	10%	$5.9 billion + $2-3 billion for disruption option
Car service companionship alongside dominant marketplace position portion (from networking effects) in addition to sustained profitability (New York Times)	$100 billion	50%	20%	12% ->8%	0%	$29.1 billion
Logistics companionship alongside expansion of machine service work concern model into other logistics businesses, piece preserving profitability.	$600 billion	5%	20%	12% ->8%	0%	$17.5 billion

There are ii points I hope to brand alongside this exercise. First, fifty-fifty the most imaginative in addition to far-reaching narratives tin give notice in addition to should live converted into numbers. So, let's retire the declaration that some companies cannot live valued. Second, large differences inwards valuation almost ever final result from differing narratives most companies, non disagreements most the "small stuff".

Finally, since this is a tidings of how best to get married narrative to numbers, I cannot move past times the chance to plug Shark Tank, 1 of my favorite shows, where narrative (from those pitching their businesses) meets numbers (from the venture capitalists/investors who challenge the work concern models piece bidding on them), generating both drama in addition to humor. 

Implications

If yous thought value equally narrative overlaid alongside numbers, in that location are implications for both the founders/managers of businesses in addition to the investors inwards these firms. To attract capital, managers demand to develop coherent narratives most the firms that they run, convey these narratives to investors/markets effectively, in addition to human activity consistently. To deal that upper-case missive of the alphabet well, they demand to  identify value drivers, set yard sticks that mensurate how the narrative is unfolding in addition to alter inwards response to unforeseen events, both positive in addition to negative.

For investors, the lessons are only equally profound. They demand to discovery companies that receive got compelling narratives, convert these narratives into value in addition to brand for certain that they are non paying likewise much.  They demand to spread their bets across several expert narratives in addition to live opened upwards to changes inwards narratives in addition to numbers. It is truthful that having a bang-up narrative in addition to the numbers to dorsum them upwards is non a guarantee of investment success. The best set plans of mice in addition to men tin give notice choke to waste, but to non project design at all volition guarantee that waste.

Attachments:
Uber: H5N1 Challenged Car Service company 
Uber: H5N1 Successful Car Service company 
Uber: H5N1 Car Service companionship alongside networking effects
Uber: H5N1 Logistics company

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