Blending Narrative and Numbers in Valuation

Hi, welcome to this chapter 5 of the Little Book of Valuation. In this chapter, which was not in the prior edition, I want to talk about what I think is the missing skill in valuation. That every valuation tells a story about a company and getting that story right is a key to doing valuation right. So I'm going to go through a five-step process that I find useful to connect stories to numbers. And let me back up. I am naturally a number cruncher. My natural inclination is to open a spreadsheet and start entering numbers. So I've created these steps to force myself to bring storytelling into the picture. And I have to be quite honest, when I first started, this was difficult. It was like pulling teeth. But the good news is it has become easier over time. So here are the five steps. steps in valuing a company. The first step is devising or constructing a story for the company that makes sense. To do this, you've got to understand the company, the business, the competition, the market. There's no way around it. The second step, you've got to make sure the story you've told is not a fairy tale. It's possible. And then you've got to pass it through two other tests. Is it plausible? Is it probable? It sounds like I'm playing with words, but with each one I'm raising the answer. and they are making it a tougher test to meet. Third step is I'm going to take the story, break it into pieces, and convert it into inputs into valuation. As you've probably already noticed, my valuations tend to be parsimonious. I value companies based upon four critical inputs. Revenue growth, operating margins, a profitability input, a reinvestment input, and a risk input or two risk inputs. A cost of capital captures operating risk and a failure risk. And my job is to bring the story. into those five numbers. Once I put the story into inputs, the inputs kind of do the valuation themselves. The valuation is pretty mechanical. So in step four I actually have a valuation of a company and you're going to be tempted to stop it at step four. I have been but you have to go to step five. What do you do in step five? You show your valuation to other people. Let's face it, you want those people to pat you on the back and tell you how amazing you are, how they agree with you. waste your time with those people. Show your valuation to people who think least like you, who will push back because you're going to use that pushback to make your story better. So let's try this out. As I said, the first step in valuation is constructing a story. What are some of the things you should look at? You should probably look at the company's business. What does it do? What are its products and services? Who is it designed for? Is it selling to consumers? Is it selling to other businesses? Start with an understanding of a business. Second step, you are going to look at the company's financial history. How useful is it going to be? Depends on the company. If you're a company like Coca-Cola with a long history in an established business, the history itself might tell your story. It's an extension. If you have a young company that's been around just a few years, it's still getting its feet on the ground. There's not much you will learn by looking at the financial history, but you should still look. Third, you got to look at what total market this company is going to go after. Now that comes out of step one. one when you tell me what your product or service is you're indirectly also telling me the market you're going after and understanding that market how big it is how much is it growing is a critical ingredient telling your story right fourth you gotta understand who you're competing against I mean it's good to have weak competition but you might have strong competition understanding who your existing competitors are and more critically who your potential competitors might be is part of the story and finally Finally, there might be a macroeconomic component to your story. It makes your story more difficult, but it might be unavoidable. That macroeconomic component can come from interest rates or inflation. If you're a cyclical company, it can come from the government. If you're a company that is, in a sense, dependent on the government for at least a portion of your business success. Here's what I'd like to do. I'd like to take a company and use it to take the storytelling process through to fruition. The company I'm going to value is a company called Zomato. And this is a valuation I did at the time of its IPO in 2022. It's an Indian online food delivery business. It delivers food from restaurants. And to set up the story, let's do some background. The Indian food delivery market is still a small one. If you take a look at this table, you can see that the entire market in India for restaurant food delivery is only about 4.2 billion. Tiny relative. to China, 90 billion, or even to the US, a much smaller country in terms of population. You say, why? Three factors. One is to order food from restaurants, you've got to have discretionary income. And as countries become more prosperous, you're going to see more food delivery. India is still poorer than China, the US or the EU. That's one factor working against it. Second, to order food online, you need a smartphone or a device that connects you online. India is still less connected than China, the US or the EU. That's playing against it. And third, culturally, Indians are less likely to eat out at restaurants than the Chinese are, especially. And that's showing up in the total market. So it's a small market. It's growing as Indians change. And right now, that market is dominated by Zomato, Swiggy and Amazon Foods, three big food delivery companies, with Zomato having the largest market share at about 42%. So it's a small market that's growing. And Zomato has a large market share. It's a concentrated market. That's my setup for my story. Because the second step is I have to tell a story about the company. Two suggestions on valuation stories. First, keep them simple. You're not a creative novelist. Don't create characters who wander on and wander off for no reason at all. Focus on your business and tell your story, not in 50 bullet points, but as a narrative. My test is if you cannot tell your story in five or ten minutes to somebody who is not in that business, you're not telling the story right. So keep it simple because you've got to convert the story into numbers and keep it focused. And what? No matter what kind of business you start, at the end of the process you've got to show me a pathway to making money. Notice what I said, a pathway to making money. I'm not requiring you to make money now, but tell me you've thought about how to make money. That is a critical ingredient of a story. So keep it simple, keep it focused. I'm going to try to take that advice and tell you my story for Zomato. My story for Zomato has to start with a story for India as a country. Here's why. Remember what I said about restaurant delivery. To order from restaurants, you've got to be doing well. You've got to have discretionary income. So this story is going to be tied to how well India does as a country. In my story, I think India will grow strongly over the next decade. And as it grows, it's going to have a larger and wealthier middle class that's going to be able to order from restaurants. So my $4.2 billion, that's the total market, is going to grow over time because India is growing and culturally there will be a change. It's already happening where Indians are more willing to eat out. So part of the story is a macro story. I'm going to assume in that much larger market that Zomato will continue to have a dominant market share. Now, whether the other two players will be Swiggy or Amazon Foods, I don't know. But in my case, I'm going to focus on Zomato. It'll continue to have a significant market share, perhaps the largest market share. I'm also going to assume that as an intermediary company, Zomato will end up with healthy operating margins because intermediary companies don't have to produce products or services. There's no significant cost to goods sold. The unit economics work in your favor. And I will assume that the company will remain. a low-intensity, capital-intensity company. No big plant equipment investments, no stores or godowns that you've got to invest in. But they will have to do acquisitions of new technologies and startups to grow. going to be my story. Let's stop and make sure the story I've told is not a fairy tale. That's what the is it possible path. Is it plausible? Basically show me that somebody somewhere has done something like this before. So you might point to DoorDash and point to its history and say, hey, here's how DoorDash grew. Is it probable means that the story can be tested, that there's some part of India where Zomato has actually tried this and it works. Is it possible? Is it plausible? Is it probable? Lots of things are possible, a subset are plausible, and even smaller subsets are probable. To me, this is a critical part of storytelling, is being honest with yourself and passing your story through these tests. And with Zomato, I feel pretty comfortable with the story I've told. Because in my story, Zomato remains a restaurant food delivery business at its core. As a consequence, the story is easier to defend because it's already a restaurant food delivery company and it already has a dominant market share. Now, I could have made the story bigger. There were others telling bigger stories about a grocery delivery company or a food delivery company in general. That would have been a bigger story. It would have required playing more defense, but that's not the story I was telling. The bigger your story, the more you have to be careful about asking, is it possible? Is it plausible? Is it probable? Next step of the story is of course to convert to numbers and as I said it's nice to keep your valuations parsimonious because if you have 50 inputs in your valuation you're going to struggle to convert your valuation to numbers. My valuations are built around relatively few inputs. To get my cash flows I need only three inputs. A revenue growth input that captures the growth part of my story. a profitability input, margin input that captures the profitability of my business and a reinvestment input that determines how much I have to reinvest to get the growth story that I'm telling. And the risk plays out in two places. One is as a discount rate. Higher risk businesses should have higher discount rates and is a failure risk. If there is a chance, my company will not make it. Now incidentally, just as a tangent, depending on the story you're telling, there's going to be a key input. that is reflective of that story. So if you're telling me a story about being in a big market, AI, China, the way it's going to show up is it's a big total market. If your story is about a networking winner-take-all business, it's going to show up as a high market share. If your story is about strong competitive advantages, barriers to entry, it's going to show up as high margins. If your story is about how your company is going to benefit from tax breaks and tax benefits, it's going to show up as a low tax rate. If your story is about how your company can scale up easily, it's a low capital intensity business, it's going to show up as low reinvestment. And any part of risk stories are going to show up either in your cost of capital or your failure risk. Ultimately, your challenge is to find an input to reflect your story. So I'm going to take my Zomato story and convert to input. So in my Zomato story, India continues to grow. It gets more prosperous. More Indians are willing to eat out and they're more connected. The Indian food delivery market is going to go strongly from what it is today to hit about 225 billion. So if you look at the size of the market right now, it's about 225 billion rupees. It's going to go up almost ninefold over the next decade. I think that's very reachable in dollar terms. the $4.2 billion will become close to $40 billion. Zomato will be one of the winners in this market. That's part of my story. So it's going to end up at the market share of about 40%, roughly where it is today. And the portion of that revenue that Zomato keeps, remember how Zomato makes money is when you order food from restaurants, it keeps a slice. Right now it keeps about 22%. I'm going to assume that that 22% is going to stay pretty stable. Now the margins I'm going to give Zomato reflect those of intermediary companies. I'm going to give it a target operating margin of about 40%. And finally, for my reinvestment, I'm going to look at Zomato's own history. As they've grown over time, and I look at their reinvestment over time, it looks like they're getting about two and a half rupees of revenues for every rupee that they reinvest. That, I think, will improve over time. They'll get more efficient over time and become three rupees for every rupee that they invest. And that reinvestment will primarily take the form of expanding the platform and acquisitions. Now to capture the risk, I am going to look at the restaurant business as my core business in terms of risk. And I will bring in the Indian country risk into my cost of capital. So to start the process, my cost of capital is about 10.25% in rupee terms. And that will decrease over time as the company gets bigger and more profitable. So Mato is still a money losing company. There still remains a chance it will not make it. So I'm going to attach a 10% failure risk low because it's going to go public and raise. an immense amount of cash and that cash should provide some insulation. So I'm ready. Here are my projections based on my inputs for the operating income of the company. So if you look at the total market, it's going from the existing levels to about one point, in this case, almost two trillion rupees by the time I get to year 10. The market is expanding ninefold over the next decade. The market share for Zomato remains pretty stable. It's a pretty upbeat story, right? Newcomers are not taking away that market. The share of the revenues that are the gross billings that you get on this platform that Zomato gets to keep stays stable at 22%. And I do assume that over time, the operating margins will move fairly quickly to get to about 35%. Earlier, it said 40%, about 35% in steady state. So that's a healthy margin, but it's a margin that should be eminently deliverable for an interview. intermediary company. The last column you see my operating losses in year one. Turn to still remain losses in year two, turn to profits in year three, and then build up very quickly as the company becomes more mature. From a money losing to a money making company. Now to get to free cash flows, I need reinvestment. My reinvestment is very simply computed by taking the change in revenues each year and dividing by my sales. capital ratio. Remember, I get two and a half dollars or two and a half rupees for every rupee that I invest. So my revenues go up by two and a half billion. I'll have to reinvest a billion. So my reinvestment reflects how much my revenues increase. You subtract the the reinvestment from my after-tax operating income. Incidentally, if you look at the after-tax operating income, the company loses money in the first two years, so it has no taxes. In year three, they actually continue to lose money. They make money, but they pay a very low tax rate. You're saying, why is that? Because they're able to carry losses forward and cover a lot of the income they make in year three from being taxed. So my tax savings, my NOLs, are built into my cash flows. already. So the last column you see my free cash, the third to last column you see my free cash flow to the firm. Negative numbers for the first three years, it turns positive in year four and then builds up over time. You discount those back at the cost of capital. Remember what we did earlier when the cost of capital changes, use accumulated cost of capital to do the discounting. You get a present value of those cash flows for the next 10 years. There's one big number I haven't dealt with here and that is what happened. happens after year 10. After year 10, I'm going to assume the company will continue to grow, but at a growth rate it can sustain forever, which I've capped at the risk-free rate in Indian rupees of four and a quarter percent. So I'm going to have my earnings after year 10 grow at four and a quarter percent. So that's a 43,474 in earnings growing at 4.25%. But remember, I have to reinvest money to get that 4.25% growth and to estimate how how much I have to reinvest? I assume a return on capital of about 12% in perpetuity. That's part of my story that they can earn more than their cost of capital, which happens to be about 9%. That gives me my elephant in the room, the big terminal value, which I proceed to discount back to today. So if I add up the present values of the cash flows you saw on the previous page to the present value of the terminal value, which is after all in year 10, I get a value for the operating assets. There is a 10% and chance of failure and if I fail I get half of my estimated value so that's the adjustment for failure you know 14.8 billion not a big drop off because the company I think has passed its most dangerous period for survival I subtract out debt and add cash I get a value for equity now a big chunk of the company has been given away to venture capitalists to founders in the form of equity options you subtract out the value of those options and you divide by the number of shares, you get a value per share of about 43 rupees per share. Now, this is entirely a function of the story I've told, but it reflects my story converted to numbers, my numbers converted to value. So you ask me why my valuation of Zomato is 43 rupees. I'm not going to give you a set of numbers to justify it. I'm going to give you my story for Zomato being one of the larger, I mean, a dominant market share company in a growing... and huge online food market in India. In my story, I'm keeping Zomato India-focused. It might continue to get some of its revenues from the United Arab Emirates, which it does right now, but it's not going to be a global food delivery business because its core networking benefits will be in India. Now, remember what I said in step five, keeping the food feedback loop open. I posted this on my blog right after I valued it at the time of its IPO, and I got a lot of push. pushback from people saying, well, why aren't you giving it a bigger story? And I said, no, that's true. You could have a bigger story for Zomato. And in fact, here, I've estimated what the value per share would be with a series of different stories. So they're a delivery juggernaut and the total market is much bigger than I estimated. We remember in my estimate, it was 2 trillion rupees in 10 years. What if it's 5 trillion? India grows faster. Indians eat out more. Leaving. the market share where it is and the revenue slice higher so it's a delivery juggernaut you can set your own terms and a higher target margin I could come up with 150 rupees. At the other end of the spectrum if I am much more pessimistic about the size of the market and the revenue slice drops off over time and my target margins are lower I end up with a much lower This is not to suggest that any value per share is okay, but to show you that when you come up with a value per share for a company, it is a function of your story. And with young companies like Zomato, you're going to get large variations in the value. Not because one person is going to is right and the other person's wrong it's because they're telling different stories for the company now as a final point when you tell a story for a company you come up with the value you might heave a sigh of relief I'm done but remember stories can change In fact, there are three things that can happen to stories. One is the story can break because something fundamental in the company could alter. What could that be? What if there's a regulatory change in India that says you cannot order restaurant food online? I don't think it's likely to happen. But if that happens, Zomato's business is broken. That's a story break. A story change is when something happens that makes your core story still holds, but it could expand or shrink. So the Indian government passes restrictions on what percentage of that gross bill you can keep as Zomato. They say, look, it cannot exceed 20% to protect restaurants. Your core story is the same, but you're going to get a smaller slice. That's a story change. A story shift is Zomato does something. We say, you know what, maybe I need to tell a bigger or a smaller story. With Zomato, that could take the form of being successful in grocery delivery. So you're a... or two from now, Zomato shows evidence that they can be successful, make money in grocery deliveries. That opens up an entirely new market. So here's the summary of this chapter. Every valuation tells a story. So understand your company, tell a decent story about the company, test your story to make sure you're not lying to yourself. Convert the story to inputs and the inputs to value. Then show the value to people who might disagree with you. and see if you can make your story better. And once you've told your story and valued a company, act on that valuation, but recognize that stories can break, stories can change, and stories can shift. I hope you found this session useful, and thank you very much for listening.

I am naturally a number cruncher. My natural inclination is to open a spreadsheet and start entering numbers. So I've created these steps to force myself to bring storytelling into the picture. And I have to be quite honest, when I first started, this was difficult.

It was like pulling teeth. But the good news is it has become easier over time. So here are the five steps. steps in valuing a company.

The first step is devising or constructing a story for the company that makes sense. To do this, you've got to understand the company, the business, the competition, the market. There's no way around it. The second step, you've got to make sure the story you've told is not a fairy tale.

It's possible. And then you've got to pass it through two other tests. Is it plausible?

Is it probable? It sounds like I'm playing with words, but with each one I'm raising the answer. and they are making it a tougher test to meet. Third step is I'm going to take the story, break it into pieces, and convert it into inputs into valuation.

As you've probably already noticed, my valuations tend to be parsimonious. I value companies based upon four critical inputs. Revenue growth, operating margins, a profitability input, a reinvestment input, and a risk input or two risk inputs.

A cost of capital captures operating risk and a failure risk. And my job is to bring the story. into those five numbers.

Once I put the story into inputs, the inputs kind of do the valuation themselves. The valuation is pretty mechanical. So in step four I actually have a valuation of a company and you're going to be tempted to stop it at step four.

I have been but you have to go to step five. What do you do in step five? You show your valuation to other people.

Let's face it, you want those people to pat you on the back and tell you how amazing you are, how they agree with you. waste your time with those people. Show your valuation to people who think least like you, who will push back because you're going to use that pushback to make your story better. So let's try this out.

As I said, the first step in valuation is constructing a story. What are some of the things you should look at? You should probably look at the company's business. What does it do? What are its products and services?

Who is it designed for? Is it selling to consumers? Is it selling to other businesses? Start with an understanding of a business.

Second step, you are going to look at the company's financial history. How useful is it going to be? Depends on the company.

If you're a company like Coca-Cola with a long history in an established business, the history itself might tell your story. It's an extension. If you have a young company that's been around just a few years, it's still getting its feet on the ground. There's not much you will learn by looking at the financial history, but you should still look.

Third, you got to look at what total market this company is going to go after. Now that comes out of step one. one when you tell me what your product or service is you're indirectly also telling me the market you're going after and understanding that market how big it is how much is it growing is a critical ingredient telling your story right fourth you gotta understand who you're competing against I mean it's good to have weak competition but you might have strong competition understanding who your existing competitors are and more critically who your potential competitors might be is part of the story and finally Finally, there might be a macroeconomic component to your story.

It makes your story more difficult, but it might be unavoidable. That macroeconomic component can come from interest rates or inflation. If you're a cyclical company, it can come from the government.

If you're a company that is, in a sense, dependent on the government for at least a portion of your business success. Here's what I'd like to do. I'd like to take a company and use it to take the storytelling process through to fruition. The company I'm going to value is a company called Zomato. And this is a valuation I did at the time of its IPO in 2022. It's an Indian online food delivery business.

It delivers food from restaurants. And to set up the story, let's do some background. The Indian food delivery market is still a small one.

If you take a look at this table, you can see that the entire market in India for restaurant food delivery is only about 4.2 billion. Tiny relative. to China, 90 billion, or even to the US, a much smaller country in terms of population.

You say, why? Three factors. One is to order food from restaurants, you've got to have discretionary income.

And as countries become more prosperous, you're going to see more food delivery. India is still poorer than China, the US or the EU. That's one factor working against it.

Second, to order food online, you need a smartphone or a device that connects you online. India is still less connected than China, the US or the EU. That's playing against it. And third, culturally, Indians are less likely to eat out at restaurants than the Chinese are, especially.

And that's showing up in the total market. So it's a small market. It's growing as Indians change.

And right now, that market is dominated by Zomato, Swiggy and Amazon Foods, three big food delivery companies, with Zomato having the largest market share at about 42%. So it's a small market that's growing. And Zomato has a large market share.

It's a concentrated market. That's my setup for my story. Because the second step is I have to tell a story about the company. Two suggestions on valuation stories.

First, keep them simple. You're not a creative novelist. Don't create characters who wander on and wander off for no reason at all.

Focus on your business and tell your story, not in 50 bullet points, but as a narrative. My test is if you cannot tell your story in five or ten minutes to somebody who is not in that business, you're not telling the story right. So keep it simple because you've got to convert the story into numbers and keep it focused.

And what? No matter what kind of business you start, at the end of the process you've got to show me a pathway to making money. Notice what I said, a pathway to making money.

I'm not requiring you to make money now, but tell me you've thought about how to make money. That is a critical ingredient of a story. So keep it simple, keep it focused.

I'm going to try to take that advice and tell you my story for Zomato. My story for Zomato has to start with a story for India as a country. Here's why.

Remember what I said about restaurant delivery. To order from restaurants, you've got to be doing well. You've got to have discretionary income. So this story is going to be tied to how well India does as a country.

In my story, I think India will grow strongly over the next decade. And as it grows, it's going to have a larger and wealthier middle class that's going to be able to order from restaurants. So my $4.2 billion, that's the total market, is going to grow over time because India is growing and culturally there will be a change. It's already happening where Indians are more willing to eat out. So part of the story is a macro story.

I'm going to assume in that much larger market that Zomato will continue to have a dominant market share. Now, whether the other two players will be Swiggy or Amazon Foods, I don't know. But in my case, I'm going to focus on Zomato.

It'll continue to have a significant market share, perhaps the largest market share. I'm also going to assume that as an intermediary company, Zomato will end up with healthy operating margins because intermediary companies don't have to produce products or services. There's no significant cost to goods sold. The unit economics work in your favor.

And I will assume that the company will remain. a low-intensity, capital-intensity company. No big plant equipment investments, no stores or godowns that you've got to invest in.

But they will have to do acquisitions of new technologies and startups to grow. going to be my story. Let's stop and make sure the story I've told is not a fairy tale. That's what the is it possible path.

Is it plausible? Basically show me that somebody somewhere has done something like this before. So you might point to DoorDash and point to its history and say, hey, here's how DoorDash grew. Is it probable means that the story can be tested, that there's some part of India where Zomato has actually tried this and it works. Is it possible?

Is it plausible? Is it probable? Lots of things are possible, a subset are plausible, and even smaller subsets are probable. To me, this is a critical part of storytelling, is being honest with yourself and passing your story through these tests.

And with Zomato, I feel pretty comfortable with the story I've told. Because in my story, Zomato remains a restaurant food delivery business at its core. As a consequence, the story is easier to defend because it's already a restaurant food delivery company and it already has a dominant market share.

Now, I could have made the story bigger. There were others telling bigger stories about a grocery delivery company or a food delivery company in general. That would have been a bigger story.

It would have required playing more defense, but that's not the story I was telling. The bigger your story, the more you have to be careful about asking, is it possible? Is it plausible?

Is it probable? Next step of the story is of course to convert to numbers and as I said it's nice to keep your valuations parsimonious because if you have 50 inputs in your valuation you're going to struggle to convert your valuation to numbers. My valuations are built around relatively few inputs.

To get my cash flows I need only three inputs. A revenue growth input that captures the growth part of my story. a profitability input, margin input that captures the profitability of my business and a reinvestment input that determines how much I have to reinvest to get the growth story that I'm telling. And the risk plays out in two places.

One is as a discount rate. Higher risk businesses should have higher discount rates and is a failure risk. If there is a chance, my company will not make it.

Now incidentally, just as a tangent, depending on the story you're telling, there's going to be a key input. that is reflective of that story. So if you're telling me a story about being in a big market, AI, China, the way it's going to show up is it's a big total market.

If your story is about a networking winner-take-all business, it's going to show up as a high market share. If your story is about strong competitive advantages, barriers to entry, it's going to show up as high margins. If your story is about how your company is going to benefit from tax breaks and tax benefits, it's going to show up as a low tax rate. If your story is about how your company can scale up easily, it's a low capital intensity business, it's going to show up as low reinvestment. And any part of risk stories are going to show up either in your cost of capital or your failure risk.

Ultimately, your challenge is to find an input to reflect your story. So I'm going to take my Zomato story and convert to input. So in my Zomato story, India continues to grow. It gets more prosperous.

More Indians are willing to eat out and they're more connected. The Indian food delivery market is going to go strongly from what it is today to hit about 225 billion. So if you look at the size of the market right now, it's about 225 billion rupees.

It's going to go up almost ninefold over the next decade. I think that's very reachable in dollar terms. the $4.2 billion will become close to $40 billion. Zomato will be one of the winners in this market. That's part of my story.

So it's going to end up at the market share of about 40%, roughly where it is today. And the portion of that revenue that Zomato keeps, remember how Zomato makes money is when you order food from restaurants, it keeps a slice. Right now it keeps about 22%. I'm going to assume that that 22% is going to stay pretty stable. Now the margins I'm going to give Zomato reflect those of intermediary companies.

I'm going to give it a target operating margin of about 40%. And finally, for my reinvestment, I'm going to look at Zomato's own history. As they've grown over time, and I look at their reinvestment over time, it looks like they're getting about two and a half rupees of revenues for every rupee that they reinvest. That, I think, will improve over time.

They'll get more efficient over time and become three rupees for every rupee that they invest. And that reinvestment will primarily take the form of expanding the platform and acquisitions. Now to capture the risk, I am going to look at the restaurant business as my core business in terms of risk.

And I will bring in the Indian country risk into my cost of capital. So to start the process, my cost of capital is about 10.25% in rupee terms. And that will decrease over time as the company gets bigger and more profitable. So Mato is still a money losing company.

There still remains a chance it will not make it. So I'm going to attach a 10% failure risk low because it's going to go public and raise. an immense amount of cash and that cash should provide some insulation.

So I'm ready. Here are my projections based on my inputs for the operating income of the company. So if you look at the total market, it's going from the existing levels to about one point, in this case, almost two trillion rupees by the time I get to year 10. The market is expanding ninefold over the next decade.

The market share for Zomato remains pretty stable. It's a pretty upbeat story, right? Newcomers are not taking away that market. The share of the revenues that are the gross billings that you get on this platform that Zomato gets to keep stays stable at 22%. And I do assume that over time, the operating margins will move fairly quickly to get to about 35%.

Earlier, it said 40%, about 35% in steady state. So that's a healthy margin, but it's a margin that should be eminently deliverable for an interview. intermediary company.

The last column you see my operating losses in year one. Turn to still remain losses in year two, turn to profits in year three, and then build up very quickly as the company becomes more mature. From a money losing to a money making company.

Now to get to free cash flows, I need reinvestment. My reinvestment is very simply computed by taking the change in revenues each year and dividing by my sales. capital ratio.

Remember, I get two and a half dollars or two and a half rupees for every rupee that I invest. So my revenues go up by two and a half billion. I'll have to reinvest a billion. So my reinvestment reflects how much my revenues increase.

You subtract the the reinvestment from my after-tax operating income. Incidentally, if you look at the after-tax operating income, the company loses money in the first two years, so it has no taxes. In year three, they actually continue to lose money. They make money, but they pay a very low tax rate.

You're saying, why is that? Because they're able to carry losses forward and cover a lot of the income they make in year three from being taxed. So my tax savings, my NOLs, are built into my cash flows. already.

So the last column you see my free cash, the third to last column you see my free cash flow to the firm. Negative numbers for the first three years, it turns positive in year four and then builds up over time. You discount those back at the cost of capital.

Remember what we did earlier when the cost of capital changes, use accumulated cost of capital to do the discounting. You get a present value of those cash flows for the next 10 years. There's one big number I haven't dealt with here and that is what happened.

happens after year 10. After year 10, I'm going to assume the company will continue to grow, but at a growth rate it can sustain forever, which I've capped at the risk-free rate in Indian rupees of four and a quarter percent. So I'm going to have my earnings after year 10 grow at four and a quarter percent. So that's a 43,474 in earnings growing at 4.25%. But remember, I have to reinvest money to get that 4.25% growth and to estimate how how much I have to reinvest? I assume a return on capital of about 12% in perpetuity.

That's part of my story that they can earn more than their cost of capital, which happens to be about 9%. That gives me my elephant in the room, the big terminal value, which I proceed to discount back to today. So if I add up the present values of the cash flows you saw on the previous page to the present value of the terminal value, which is after all in year 10, I get a value for the operating assets. There is a 10% and chance of failure and if I fail I get half of my estimated value so that's the adjustment for failure you know 14.8 billion not a big drop off because the company I think has passed its most dangerous period for survival I subtract out debt and add cash I get a value for equity now a big chunk of the company has been given away to venture capitalists to founders in the form of equity options you subtract out the value of those options and you divide by the number of shares, you get a value per share of about 43 rupees per share.

Now, this is entirely a function of the story I've told, but it reflects my story converted to numbers, my numbers converted to value. So you ask me why my valuation of Zomato is 43 rupees. I'm not going to give you a set of numbers to justify it. I'm going to give you my story for Zomato being one of the larger, I mean, a dominant market share company in a growing...

and huge online food market in India. In my story, I'm keeping Zomato India-focused. It might continue to get some of its revenues from the United Arab Emirates, which it does right now, but it's not going to be a global food delivery business because its core networking benefits will be in India. Now, remember what I said in step five, keeping the food feedback loop open. I posted this on my blog right after I valued it at the time of its IPO, and I got a lot of push.

pushback from people saying, well, why aren't you giving it a bigger story? And I said, no, that's true. You could have a bigger story for Zomato.

And in fact, here, I've estimated what the value per share would be with a series of different stories. So they're a delivery juggernaut and the total market is much bigger than I estimated. We remember in my estimate, it was 2 trillion rupees in 10 years. What if it's 5 trillion?

India grows faster. Indians eat out more. Leaving. the market share where it is and the revenue slice higher so it's a delivery juggernaut you can set your own terms and a higher target margin I could come up with 150 rupees.

At the other end of the spectrum if I am much more pessimistic about the size of the market and the revenue slice drops off over time and my target margins are lower I end up with a much lower This is not to suggest that any value per share is okay, but to show you that when you come up with a value per share for a company, it is a function of your story. And with young companies like Zomato, you're going to get large variations in the value. Not because one person is going to is right and the other person's wrong it's because they're telling different stories for the company now as a final point when you tell a story for a company you come up with the value you might heave a sigh of relief I'm done but remember stories can change In fact, there are three things that can happen to stories.

One is the story can break because something fundamental in the company could alter. What could that be? What if there's a regulatory change in India that says you cannot order restaurant food online? I don't think it's likely to happen. But if that happens, Zomato's business is broken.

That's a story break. A story change is when something happens that makes your core story still holds, but it could expand or shrink. So the Indian government passes restrictions on what percentage of that gross bill you can keep as Zomato.

They say, look, it cannot exceed 20% to protect restaurants. Your core story is the same, but you're going to get a smaller slice. That's a story change. A story shift is Zomato does something.

We say, you know what, maybe I need to tell a bigger or a smaller story. With Zomato, that could take the form of being successful in grocery delivery. So you're a... or two from now, Zomato shows evidence that they can be successful, make money in grocery deliveries.

That opens up an entirely new market. So here's the summary of this chapter. Every valuation tells a story. So understand your company, tell a decent story about the company, test your story to make sure you're not lying to yourself. Convert the story to inputs and the inputs to value.

Then show the value to people who might disagree with you. and see if you can make your story better. And once you've told your story and valued a company, act on that valuation, but recognize that stories can break, stories can change, and stories can shift. I hope you found this session useful, and thank you very much for listening.

Transcript for:Blending Narrative and Numbers in Valuation

Transcript for:
Blending Narrative and Numbers in Valuation