One of the major pitfalls of investing is the danger of getting wrapped up in a good story about a stock while neglecting to substantiate the narrative by looking closely at the numbers. It’s easy to get excited about a company that has a compelling pitch, but if it’s too expensive or has too much debt, a low profit margin, negative cash flow or a weak competitive advantage, for example, those things can undercut the story.
NYU finance professor Awath Damodaran, who is an expert in company valuation, wrote a post on his blog this week, arguing for the importance of both narrative and numbers in investment decisions. Just as it’s possible to put too much emphasis on a good story, he says, it’s also dangerous to give too much weight to complex models and projections without backing them up with a convincing story:
In my view, there are at least three significant dangers, when numbers are used without any narrative (or story line) in constructing valuations. First, valuations become plug-and-point exercises, tools to advance sales pitches or confirm pre-conceived values. Second, if a valuation is built around line items and individual inputs, there is a strong possibility that you may be creating a business that can exist only in spreadsheet nirvana, where revenues double every year, margins expand without challenge and growth comes without significant reinvestment. Finally, discussions and debates about inputs become shallow exercises in quibbling about the “right” values to use, with no logical tie breaker.
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While it is true that rigid cash flow based models will not work with companies where promise and potential are what is driving value, staying with just narrative exposes you to two significant risks. The first is that, without constraints, creativity can carry you to the outer realms of reason and into fantasy. While that may be an admirable quality in a painter or a writer, it is a dangerous one for an investor. The second is that, when running a business as a manager or monitoring it as an investor, you need measures of whether you are on the right path, no matter where your business is in its life cycle. When narrative alone drives valuation and investing, there are no yard sticks to use to see whether you are on track, and if not, what you need to do to get back on the right path.
For an accurate valuation the story and numbers must work together. Just as an appealing story can be a distraction from what is actually going on with the company, an analysis that focuses only on numbers tends to have a false sense of precision and objectivity that is also dangerous because it hides the assumptions in the model.