Stories play to people’s emotions, which is why scammers rely on tall tales to take their victims’ money. But companies’ representatives can tell stories responsibly; a business needs intriguing narratives to share with its investors, customers and employees. Even a great product won’t sell itself without an underlying story. Valuation is where the two tribes find common ground. Numbers make storytellers recognize when their stories don’t make sense. Stories compel the numbers tribe to acknowledge when its figures lack credibility.
“In business, few things ever happen the way that you expect them to, and it is a given that you are going to be surprised, sometimes in good ways and sometimes in bad.”
In baseball and other sports, storytelling has long dominated the practice of picking players. The narrative focused on which promising prospects displayed the raw talent to succeed at the highest levels. But, as author Michael Lewis described in Moneyball, baseball’s Oakland Athletics judged players not by talent scouts’ accounts but by the statistics the players produced on the field.
“Being told that you are wrong is never easy, but listening to those who disagree with you the most will make your stories stronger and better.”
This approach, called “Sabermetrics,” swept the sports world, but the rise of statistics is more pronounced in financial markets, where powerful new tools manipulate vast amounts of data. Amid such a data overload, numbers can overwhelm investors.
People who face staggering amounts of information tend to respond with emotional, illogical decisions – exactly the outcome data providers seek to prevent. As the amount of information proliferates, people trust numbers less and revert to stories. They “are drawn to pricing stories for their simplicity and directness.”
Theranos, a consumer health care technology company, offered a great story that trumped reality. The firm, started by a 19-year-old Stanford dropout, promised to make blood tests cheaper and easier. Theranos reached a $9 billion valuation.
“Measuring the standard deviation of a portfolio only tells you that it is risky but does not protect you from that risk.”
However, its tale unraveled in 2015 when The Wall Street Journal reported that its blood tests proved neither revolutionary nor accurate. Theranos crashed, despite a storyline featuring a female CEO, a disruptive technology and a fast-growing company.
Storytelling and Your Valuation Model
Valuation experts and quantitative analysts belong to the same numbers tribe. But bean counters can become storytellers by following this five-step storyboarding process:
- Spin a yarn – Develop a story about the firm. What are its growth prospects? What’s its “competitive landscape”? Who are its managers? Where is the enterprise in its life cycle?
- Apply the “3P’s” – A story without numbers could be fantasy, so apply the 3P test: Is your story possible? Is it plausible? And in the most stringent test, is it probable? “A business story has to be credible to convince investors,” so if it’s probable, you may have a winner. If not, delve into the numbers to research the likelihood that the story will yield profits.
- Connect the story to the numbers – Support each part of your story with numbers. Market potential, cash flows, risk mitigation – these statistics and others can back up your narrative. And your story must align with the numbers.
- Put the numbers in a spreadsheet – Once you have a legitimate story and the numbers to back it up, create a valuation model that ties it all together. What does your compelling narrative mean? How much is the company worth? Apply the story to estimate the revenue, operating margins and tax rates.
- Constantly test your story – You may grow attached to your narrative. But story lines must change when facts change; continually reassess your narrative. Economic shifts, management churn and new regulations could make a story that was true yesterday untrue today. Heed your story’s harshest critics. To spin a credible, compelling tale, respond to their skepticism.
The Art of Storytelling
A good valuation narrative mixes emotion and logic, so remember these rules:
- Know your stuff– To spin a cohesive story, you must possess a deep understanding of the company. Any confusion that a founder or executive feels about a business will become obvious to the audience. Form a clear picture of your customer, your vision and the reasons your firm will succeed.
- Gear your story to the listeners– Employees, investors and customers form distinct audiences, and each audience will connect with different aspects of your story. Workers want to know how they’ll share in your success. Investors want profits. Customers care how your product will benefit them. Tailor your tale to its different stakeholders.
- Provide details– Big trends and promising opportunities are just part of your story. You must specify what your company offers that no one else provides.
- “Show, don’t tell”– Steve Jobs was a master of this skill. He unveiled Apple’s new products as part of his storytelling.
Amazon: Storytelling and Valuation
Amazon’s dominant narrative has been the Field of Dreams story. In this scenario, Amazon pursues top-line growth at the expense of profitability. It expects to achieve its desired market share, raise prices and transform itself into a solidly profitable enterprise.
“The real world is very much a part of your story, and much as you would like to control it, you cannot.”
In its more optimistic scenario, Amazon’s expansion into cloud computing and entertainment could lead to hefty profit margins. Amazon could so decimate its competition that it would face no meaningful rivals. If that story of fast growth and hefty profits plays out, Amazon becomes a much more valuable company. But if it were to face an onslaught of competition that kept profit margins low, then it would become a less valuable investment.
“I find that the more uncertainty there is around a company, the more open I have to be to alternative story lines.”
Convert the story you prefer into numbers, or “value inputs,” to determine how much you should pay for an Amazon share. Revenues are a starting point. Under the Field of Dreams scenario, revenue growth is 15% per year for five years and then slows. Amazon continues to discount prices, and its operating margin rises to 7.38% by year 10, which is the median for retail and media companies. In the optimistic scenario, revenue growth is 20% per year for five years before declining, and Amazon’s operating margin jumps to 12.84%. In the pessimistic scenario, growth remains at 15% for five years and then slows, achieving a margin of just 2.85%.
“As numbers come to dominate so many business discussions, people are trusting them less, not more, and falling back on stories.”
The valuation model factors in other financial metrics, including Amazon’s tax rate, its pace of reinvestment and its cost of capital. In the Field of Dreams scenario as of October 2014, the value of an Amazon share was $175.25. The stock was trading at $287.06 at the time, underscoring the variations among even detailed valuation models.
“Rather than let hubris keep you wedded to your old story, you should think about how your narrative is altered by events, small and large.”
If a sober and exhaustive analysis yields a valuation that is very different from the current market value, your assumptions don’t match those of the market. Under the pessimistic scenario, a share of Amazon would be worth just $32.72. In the optimistic scenario, which anticipates Amazon’s future domination, the share would be worth $450.34.
“As we enter an age when numbers are gathered in cyberspace and everyone can access and analyze them, we are also seeing them displace storytelling in unexpected places.”
This wide value swing, story to story, emphasizes that uncertainty is part of the process. You can use valuation modeling to estimate present value down to the penny, but that doesn’t mean your story or estimate is the infallible truth. Your value assessment is just a possible version of reality. Numbers provide certainty, but they can lead to false confidence.
Ferrari’s Slow-Growth Story
Ferrari pursues a different strategy than Amazon’s low-margin, high-growth story. Ferrari guards the exclusivity of its product by manufacturing a limited number of cars. It boasts hefty margins but deliberately paltry growth. By focusing on wealthy customers who aren’t sensitive to shifts in the broader economy, Ferrari insulates itself from the cyclicality that many automakers experience.
“It is difficult to tell a story about a business if you don’t understand the business yourself.”
In an alternative story, Ferrari could accelerate sales growth by introducing a more affordable car, as in Maserati’s move to sell to a mass market.
Under the slow-growth theory, Ferrari’s sales growth would be 4% per year for five years. Its operating margin would be 18.2%, and its cost of capital would be just under 7%. This yields an enterprise value of €6.3 billion [$6.86 billion]. In the fast-growth version, Ferrari grows at 12% per year, and its margin falls to 14.3%. The cost of capital rises to 8%, because the super rich are more reliable clients than the merely rich. In that story, the company is worth €6 billion.
“In a world of uncertainty, numbers offer us a sense of precision and objectivity and provide a counterweight to storytelling.”
Ferrari went public at a valuation of €9 billion, underscoring the inexact nature of valuation and storytelling. Ferrari’s name also appears on watches and pens. It’s a luxury brand with a broader reach than its core business, and that spawns an entirely different story and a richer valuation.
How to Hear a Numbers Story
If you are an investor, keep these tips in mind when listening to a valuation narrative:
- Don’t be intimidated – Anyone can grasp the basics of accounting and the math required to properly value companies.
- There’s no “magic bullet”– Don’t expect to hit upon a secret recipe that will help you find undervalued companies. The Amazon and Ferrari case studies show that even rigorous analyses lead to valuation estimates that differ from actual market value.
- Valuation trends change– Ben Graham’s Security Analysis is a classic guide to value investing. Generations after it was written, its specific formulas have grown irrelevant, but you can use it to frame your underlying approach.
- You can be right and still not make money– Valuation remains subjective. You can correctly identify an undervalued stock and still fail to make a profitable trade. If your story doesn’t align with the narratives told by others, your thesis won’t prove true.
“A good story is magical in its capacity to create connections and evoke action.”
Corporate managers should consider these guidelines:
- Take control of your story– As an executive or an entrepreneur, your job is to deliver a compelling, plausible account of your company. If you don’t, analysts, journalists and investors will frame the story for you.
- Be flexible– “No story is forever,” so adjust your narrative as your firm’s financial reality shifts. Wanting to hold onto and defend your story is natural, but don’t fall victim to overconfidence. Continually retest your story.
- Apply discipline to your storytelling– If your story features skyrocketing growth and unlimited possibilities, you’ll suffer if your results don’t match your optimism.