Aswath Damodaran on valuation, VCs, and more

Excellent interview here and here of Aswath Damodaran where he summarises what he's long argued with eloquence. Some snippets. 

1. On the difference between valuation and pricing

Pricing essentially is a very simple process. You decide how much to pay for something by looking at what other people are paying for similar things... In pricing, you attach a number to an asset based on what other people are paying for similar assets. It's how we decide how much to pay for a house or an apartment. Pricing is intuitive. We all do it. 

Valuation, on the other hand, requires that you understand a business. So, if you want to buy the Chennai Super Kings as a business, you’ve got to understand how they make money, how much money they make from the stadiums, how much money they make from media, and essentially think about how much you will pay for the business you buy. It's more work, but your assessment then drives your decision. Most people price things, they don't value them. They like to use the word value when, in fact, they're pricing things.

This is an area of fundamental misunderstanding, one that underpins the irrational exuberance that pervades capital markets. As Keynes famously said, equity prices essentially emerge from a competitive pricing contest. 

2. On the real investment strategy adopted by venture capital investors

VCs [firms] don't value companies. They're incapable of valuing companies. They price them based on what? Based on total addressable markets, number of users, number of subscribers. I understand why they do what they do, but remember it's a pricing game, which means the game does well when the momentum is with you, but when the momentum shifts, guess what? The price adjusts as well. So, VCs are traders. They're not investors. They trade on companies and a successful VC is one who times a drive, times entry and exit drive. So, I would not shed any tears for VCs who lose money when the momentum goes against them because they make money when the momentum is in their favour. I don't expect VCs to have deep thoughts about businesses because they're interested in whatever metric will allow them to flip the company to other people at a higher price.

At best, valuations are done by support teams using models with wildly optimistic and flawed assumptions that in turn are used to justify the irrational pricing decisions made by senior partners in the investment teams and committees. These irrational pricing decisions have long been dictated by the fear of missing out in a market that's collectively irrationally exuberant and the need to deploy large volumes of dry powder mobilised from investors and sitting idle. 

3. He suggests this practical approach to the valuation of firms when faced with uncertainties

First, you need to look at the uncertainties you face and organise them. Not all uncertainties are created equal. I believe in putting uncertainties in buckets, so you have a sense of what's going into which bucket. So, it'll keep you from getting overwhelmed... Second, recognise that the nature of the uncertainties you face will be very different depending on the company you value... As companies age, the kinds of uncertainties you face will vary. Once you've decided which uncertainties are the big ones with this company, face up to the uncertainty. Don't hide from it. Don't go into denial. And facing up to the uncertainty means figuring out how uncertain you are, and actually incorporating it into your analysis. 

I do what I call simulations and valuations, but rather than valuing a company with point estimates, revenue growth is going to be 23 percent, margins are going be 15 percent, you build distributions around your assumptions, and you come up with distributions of value. It's a much more honest way of saying, look, I can give you a value for a company, but I'm going to be wrong. Why? Not because I haven't done my homework, but because I'm not God. Essentially, you're going to be uncertain because you don't control what the future will deliver. And I think facing up to it gives you a much better chance of dealing with it. And my final advice when you face uncertainty is keep it simple. Don't have hundreds of line items because again, you'll get overwhelmed. Less is more. And I think that message more than anything else stood me in good stead when I think about valuing companies where there's a lot of uncertainty.

However, this process requires experience. The ability to make good judgments is based on one's experience. Organising all the relevant uncertainties, and more importantly, attaching weights to them, is an exercise in judgment. This comes from the experiential knowledge of a lived career and cannot be short-circuited through learned knowledge in a classroom setting of a top college or MBA course. This is about wisdom.  

4. This is a much-needed reminder that our times are not as extraordinary as we have come to believe. 

I'm going to push back on the notion that we live at a time of extreme uncertainty. Do we? Do you think the people who came out of the second World War faced less uncertain times than we do? Or the invention of the automobile, and how it changed the way people live, or electricity, or the original factory system? I don't think we live in special times. Each generation likes to think it's special. 

You know why we feel that we're in more uncertain times? Because everybody's problem becomes everybody else's problem... I think one of the reasons we feel more uncertain is we're inundated with information and everything happening in real time, not just around us, but around the world. And I think that's making us very uncomfortable, because as human beings, uncertainty makes us uncomfortable. So, in a strange and contradictory way, our access to data is actually making us more susceptible to doing emotional things because we now feel we're more surrounded by uncertainty. And when you do, you behave in unhealthy ways.

The combination of information deluge and social media has dramatically shortened our attention spans. The long-term view of anything has been pushed aside by the focus on the now and the immediate. Commentators and experts have collectively embraced this perspective. 

5. And this is profoundly wise advice for life in general, one that many experts would do well to heed. 

I have everything I need, and could I get more? Yes. What am I going to use it for? So, from that perspective, I've never been tempted to be anything other than what I am as a teacher. I've never consulted a day in my life. I don't do expert witness work. I don't serve on boards of directors. I essentially don't do any of those things because I don't see the need to. I'm lucky enough that I don't have to do those things. I'm not looking down on the people who do it, but for me, teaching is front and centre, what I do... There is no day that I wake up and say, I wish I didn't have to teach today. When you have something that truly brings together your passion and your livelihood, why would you ever want to go explore something else?