Test Driving A Narrative
The narrative has to go through the stage of introspection. This is done via the 3P approach of Professor Damodaran, which is accessing whether the story is Possible, Plausible or Probable. Refer to the graph below in order to understand the stages of a narrative better.
Lets understand this via an example.
Professor Damodaran valued Uber in June 2014 as an urban car services company which means that professor hypothesized that Uber will be able to take over the urban taxi market. This narrative clearly met the possibility and plausibility test at that time since Uber was already operating in dozens of cities in 2014.
But as he started exploring and indulging more into the analysis (which is an essential step in narrative build-up) he recognized that Uber was increasingly penetrating the sub-urban markets and was also competing with the rental companies. This expanded the market size significantly and can be regarded as a plausible story.
Another addition to the narrative was that Uber could eventually disrupt the automobile industry in a way that people would not buy a car and prefer Uber for daily commutes. This at that moment seemed just a possible story.
Tween the possible, plausible, and probable are not always easy to draw, but one simple technique professor suggests is to think about the distinction between impossible, implausible, and improbable.
Impossible and improbable are quantifiable, the first because you are assigning a zero probability to an event happening and the latter because you are attaching a probability (albeit a low one) that an event will happen. Implausibility lies in the middle, since proving that it cannot happen is not feasible and attaching a probability judgment to it is just as difficult. At the risk of sounding fuzzy, these are the parts of stories that just don’t sound right, and the figure shown below where he would put it in what he calls the “continuum of skepticism.”he lines bet.
The Continuum of Skepticism:
Let’s now listen to some of the impossible stories:
- Bigger than the economy: Sometimes the analysts/storytellers become so indulged in their stories that they forget to be realistic. In Discounted Cash Flow analysis, there is a concept of calculating the terminal value. Its significance is that one cannot go on estimating the cash flows of a company forever. Therefore, analysts usually do it for the next 5-10 years and then put in a terminal value, which basically is the present value of annuity. As a matter of fact, it is not possible for a company to grow infinitely at a growth higher than the growth rate of the GDP of the country’s economy in which it has operations. If this happens, the company will somewhere down the line become the economy. In the Indian context since the economy is growing at 5-6%, if you see an analysts DCF report signaling a 9% perpetual growth rate, it basically creates an impossible story.
- Bigger than the market: Similar is the case with the market. You cannot assume that your company’s revenue will grow at a growth rate higher than the growth rate of the market in which it is operating. This is simply because, as you grow at a rate faster than the industry, it indicates that you are gaining market share, however, you can gain market share only to a limit of 100% of the market and not more than that.
- Costless capital: Businesses need capital to grow, and those who supply capital invest to earn a return. With debt, that required return is explicit and takes the form of an interest rate, but with equity, there is scope for wishful thinking, since the bulk of the cost is implicit. In other words, when investors buy your equity, they hope to get their returns in one of two ways: as dividends while they hold the stock and in price appreciation when they sell the stock.
Lastly, the professor explains a very interesting approach to judge the probability of a story.