Chapter 5: The Little Book of Valuation - Narrative and Numbers
Introduction
- Missing Skill in Valuation: Valuation is not just about numbers but about storytelling.
- Valuation Process: A five-step process to link stories to numbers.
Five Steps in Valuing a Company
- Constructing a Story
- Understand the company, business, competition, and market.
- Testing the Story
- Ensure the story is not a fairy tale.
- Tests: Is it possible? Is it plausible? Is it probable?
- Converting Story to Inputs
- Inputs include: revenue growth, operating margins, reinvestment, risk inputs.
- Valuation
- Mechanical process after converting story to inputs.
- Feedback
- Present valuation to others for constructive criticism.
Building a Story
- Understand the company's business model, financial history, market, and competition.
- Consider macroeconomic factors influencing the business.
Case Study: Zomato
- Background: Indian online food delivery company.
- Market Analysis: Small market relative to other countries but growing rapidly.
- Competitors: Zomato, Swiggy, Amazon Foods.
- Zomato's Story:
- Tied to India's economic growth.
- Dominant market share expected to continue.
- Intermediary company with low capital intensity.
Valuation Inputs
- Revenue Growth: Market expected to grow to 225 billion rupees.
- Profitability: Operating margins expected to reach 35%.
- Reinvestment: Efficiency in reinvestment expected to improve.
- Risk Assessment: Incorporate country risk and business risk into the cost of capital.
Financial Projections and Valuation
- Cash Flows: Transition from losses to profits over time.
- Terminal Value: Assumes sustainable long-term growth rate.
- Equity Valuation: Adjusts for failure risk and subtracts debt.
- Per Share Value: Calculated based on story-converted inputs.
Variability in Valuation
- Different stories yield different valuation outcomes.
- Important to recognize potential changes in the story due to market or regulatory shifts.
Conclusion
- Every valuation tells a story.
- Test and refine your story and valuation through feedback.
- Be prepared for stories to change, break, or shift over time.
This chapter emphasizes the importance of blending narrative with numerical analysis in valuation, using Zomato as a practical example.