Speaker: Dr. Aswath Damodaran, Professor of Finance, Leonard N. Stern School of Business, NYU
Moderated by: Amit Rathi, Managing Director, Anand Rathi Financial Services
Contributed by: Ishwar Chidambaram, CFA, Member, IAIP
Delegates of the 6th India Investment Conference were regaled by the Master Class conducted by the iconic Prof. Damodaran. He started with an anecdote which drove home the point that growing up and ageing gracefully is often the hardest thing to do. He explained the various stages of the Corporate Life Cycle, from the initial “Light bulb Moment” to the final “End Game”. Essentially, Accounting is backward looking and Rules-driven, focusing on what the firm owns, owes and makes in net earnings over the past year. Finance, on the other hand, and Valuations in particular, need to be forward looking as they forecast the future. Fair Value Accounting is itself an oxymoron and destined for failure. Accounting is less useful earlier in the Life Cycle. More accurate picture is given by contrasting the Accounting Balance Sheet with Intrinsic Value Balance Sheet and Market Price Balance Sheet. An example of an Early Stage Company is Twitter, for which Accounting B/S yields Negative Equity, which paints a false picture of Twitter’s equity value. As one moves up the Life Cycle, the 3 statements will converge.
The length of the Life Cycle depends on key determinants. For example tech companies age much faster than others due to high level of disruption. Microsoft took just 15 years to move from Growth to Maturity phase. Corporate Finance across the Life Cycle rests on 3 pillars- the Investment Decision, the Financing Decision and the Dividend Decision. For a mature firm like Microsoft, you have only 2 cash cows (Office and Windows). So it makes sense to shut down the R&D function as it’s a drain on resources, and focus on the cash cows. For a young firm like Flipkart, however, the opposite holds true. It must increase R&D spending to stay competitive, and forget about raising Debt or Paying Dividends. US Billionaire investor Carl Icahn’s strategy is to target declining companies and take them over. As the firm ages, it faces a choice between Dividends and Buybacks. Companies that don’t “act their age” will destroy value. Vulture Capitalists like Icahn exploit this truism to their advantage.
A “Good Valuation” acts as a bridge between the Numbers and the Narrative. It’s often more difficult to train Numbers people to spot the Narrative, than vice versa. As a firm ages, the tilt moves from central, divergent, volatile Narratives to more streamlined Narratives and actual Numbers. For example, the global Automobile Industry is a mature sector, plagued for decades by anaemic revenue growth, poor operating margins and increasing reinvestment, all of which are bad for business overall. For Uber, the compelling narrative is that as it expands, growth will get progressively easier, due to its strong competitive advantage of being the first mover along with its low-capital business model. For Ferrari, the narrative is that it will stay super-exclusive and continue to charge exceptionally high prices. Next, the narratives must be checked against history, economic first principles and common sense.
Responding to questions- Prof. Damodaran envisages 4 scenarios with respect to valuing young companies – (1) Winner Takes All (e.g. Uber), (2) Loser’s Game, (3) US Mafia from 1920s, and (4) Not a Viable Business Model. He feels the ride sharing business currently falls into scenario #4. On Liquidation Preference – one must be skeptical about the projections of venture capitalists (VCs), as they can be “delusional”. Billion dollar companies in USA are called “Unicorns”. These days, Unicorns are created out of thin air by manipulating assumptions used for projections by VCs. The assumption is that the founders are last in queue to sell their stake. But in reality, there are disturbing true stories of employees at start-ups who are stuck with useless equity options, as VCs and firms liquidate and undercut the employees. On the Corporate Life Cycle,-he gave examples of Apple under Steve Jobs and IBM under Lou Gerstner as companies, which transformed themselves. By the same yardstick, he blames entities like Harvard Business School for bad things that happen, as professors trivialize corporate examples into case studies. On Amazon- He terms the company as “Field of Dreams”, saying their approach is to “Build revenues first, profits will follow later”. Jeff Bezos has an incredibly consistent narrative. Markets therefore trust him. At the time of its IPO as well as today, Google has consistently earned 97% of its revenues from search and online advertising. Microsoft is a 2-trick pony, whereas Google is all about Search and therefore a 1-trick pony.
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