Narrative and Numbers

1. Storytelling and numbers are complementary forces in valuation

Stories not only help us connect with others but, as research indicates, they are far more likely to be remembered than numbers, perhaps because they trigger chemical reactions and electrical impulses that numbers do not.

Stories create connections. They appeal to our emotions and make information more memorable. Research shows that stories trigger the release of oxytocin, a neurochemical associated with trust and caring, which can lead to changes in behavior. Additionally, stories can cause the brain waves of the storyteller and listeners to synchronize, enhancing communication effectiveness.

Numbers provide precision and objectivity. They offer a sense of control and can be used to counterbalance the potential biases in storytelling. However, numbers can also be manipulated and misinterpreted, leading to false precision or objectivity. The key is to use both stories and numbers in valuation:

• Stories provide context, vision, and emotional engagement
• Numbers offer measurable metrics, data-driven insights, and analytical rigor
• The combination of both creates a more comprehensive and persuasive valuation

2. A good business narrative is simple, credible, and actionable

A good business story is simple, credible, and persuasive. Telling one, though, requires that you understand both the business and the market in which it operates.

Simplicity is key. A good business narrative should have a clear, concise core message that is easy to understand and remember. Avoid unnecessary complexities or distractions that might detract from the main point.

Credibility is crucial. The story must be grounded in reality and supported by facts, data, and logical reasoning. It should acknowledge limitations while highlighting strengths and potential.

Actionability drives results. A compelling narrative should inspire action, whether it's from investors, customers, or employees. It should clearly communicate:

• The problem or opportunity the business addresses
• How the business solves the problem or capitalizes on the opportunity
• The potential impact and value creation

To craft an effective narrative, thoroughly research and understand:

• The company's history, operations, and unique value proposition
• The market landscape, including competitors and industry trends
• The target audience and their specific interests or concerns

3. Test narratives for possibility, plausibility, and probability

Not everything that is possible is plausible and many stories that pass the plausibility test flounder when put to the probability test.

The three Ps of narrative testing:

1. Possibility: Is the story theoretically achievable?
2. Plausibility: Is there evidence to support that it can happen?
3. Probability: How likely is it to occur?

This framework helps evaluate the strength and credibility of a business narrative. As you move from possibility to probability, the level of scrutiny increases:

• Possible narratives: These are the most inclusive but least reliable for valuation purposes. They include any scenario that doesn't violate fundamental laws or constraints.
• Plausible narratives: These are supported by some evidence, such as similar occurrences in other companies or industries. They require more careful consideration and analysis.
• Probable narratives: These are the most likely to occur based on available data, market conditions, and company capabilities. They form the strongest basis for valuation.

When assessing narratives, consider:

• Historical data and industry trends
• Company-specific factors (resources, capabilities, management)
• Market conditions and competitive landscape
• Regulatory and technological factors

4. Convert narratives into quantifiable valuation inputs

Every story has an input that is best suited to reflect its impact on value.

Translate stories into numbers. To bridge the gap between narrative and valuation, it's crucial to convert qualitative elements of a story into quantifiable inputs. This process involves identifying key value drivers and estimating their impact on financial metrics.

Key valuation inputs derived from narratives:

• Total addressable market (TAM): Reflects the potential size of the opportunity
• Market share: Indicates the company's competitive position and growth potential
• Revenue growth rate: Captures the company's expansion trajectory
• Operating margins: Reflects the efficiency and profitability of the business model
• Reinvestment rate: Indicates the company's ability to fund future growth
• Cost of capital: Reflects the perceived risk of the business

When converting narratives to inputs:

1. Identify the core elements of the story that drive value
2. Research comparable companies or industries for benchmarks
3. Make reasonable assumptions based on the narrative and available data
4. Adjust inputs to reflect different scenarios (optimistic, base case, pessimistic)
5. Document and justify your assumptions to ensure transparency

5. Valuation is a bridge between stories and numbers

If valuation is a bridge between stories and numbers, this chapter is the girder that brings them together.

Valuation combines art and science. It requires both qualitative assessment (storytelling) and quantitative analysis (number crunching). The valuation process serves as a bridge, connecting the narrative aspects of a business with its financial realities.

Key components of the valuation bridge:

1. Narrative: The qualitative story about the business, its potential, and its risks
2. Inputs: Quantifiable metrics derived from the narrative (e.g., growth rates, margins)
3. Model: The financial framework used to calculate value (e.g., DCF, multiples)
4. Output: The estimated value or range of values for the business

Benefits of using valuation as a bridge:

• Forces storytellers to ground their narratives in financial reality
• Helps number-crunchers understand the context behind the figures
• Provides a common language for investors, managers, and analysts
• Allows for sensitivity analysis and scenario testing of different narratives

Remember that valuation is an iterative process. As you refine your narrative or uncover new information, you may need to adjust your inputs and recalculate the value.

6. Keep the feedback loop open to improve narratives

Being open to changing your narrative is not a sign of weakness but of strength.

Embrace feedback and adaptation. A good narrative is not static; it should evolve as new information becomes available or circumstances change. Keeping an open feedback loop allows you to refine and improve your story over time.

Strategies for maintaining an effective feedback loop:

1. Seek diverse perspectives: Engage with people who have different viewpoints or expertise to challenge your assumptions.
2. Monitor key metrics: Regularly track performance indicators that validate or contradict your narrative.
3. Stay informed: Keep up with industry trends, competitive developments, and macroeconomic factors that might impact your story.
4. Be transparent: Share your narrative and valuation process openly, inviting constructive criticism.
5. Conduct post-mortems: Analyze why predictions or valuations were inaccurate to improve future assessments.

Benefits of an open feedback loop:

• Improves the accuracy and credibility of your narratives
• Helps identify blind spots or biases in your thinking
• Allows for timely adjustments to changing market conditions
• Builds trust with stakeholders through transparency and adaptability

Remember that changing your narrative based on new information or feedback is a sign of intellectual honesty and rigorous analysis, not weakness.

7. Narratives evolve as companies progress through their life cycles

As a company ages, its history begins to restrict the potential narratives that different investors can derive for it.

Life cycle stages shape narratives. A company's narrative evolves as it moves through different stages of its life cycle, from start-up to growth, maturity, and potentially decline. Each stage presents unique challenges and opportunities that influence the story.

Key narrative shifts across the corporate life cycle:

1. Start-up: Focus on potential market size, innovative solutions, and founding team
2. Growth: Emphasis on scaling operations, market share gains, and profitability
3. Maturity: Highlight market dominance, efficiency improvements, and cash flow generation
4. Decline: Address market changes, potential turnaround strategies, or value extraction

Factors influencing narrative evolution:

• Historical performance and track record
• Competitive landscape and market dynamics
• Technological advancements and industry disruption
• Regulatory changes and macroeconomic factors

As companies mature:

• Narratives become more constrained by historical data
• The range of plausible future scenarios narrows
• Investor expectations become more aligned with past performance
• The impact of individual management decisions may decrease

Understanding a company's position in its life cycle helps investors and managers craft more realistic and appropriate narratives, leading to more accurate valuations.

8. Different stages of the corporate life cycle require different management skills

Success when investing in young companies comes from getting the narrative right, not the numbers.

Management skills must evolve with the company. As a business moves through its life cycle, the challenges it faces change, requiring different leadership skills and approaches. Recognizing these shifts is crucial for both managers and investors.

Key management skills for different life cycle stages:

1. Start-up:

   • Visionary thinking and storytelling
   • Adaptability and resilience
   • Resource allocation under constraints

2. Growth:

   • Scaling operations efficiently
   • Building and managing teams
   • Balancing innovation with execution

3. Maturity:

   • Optimizing processes and costs
   • Defending market position
   • Managing shareholder expectations

4. Decline:

   • Identifying new growth opportunities
   • Managing downsizing or restructuring
   • Maximizing value extraction

Implications for investors and boards:

• Assess management team's skills relative to the company's life cycle stage
• Consider leadership transitions when a company enters a new phase
• Look for CEOs with adaptable skill sets or experience across multiple stages

Remember that mismatches between management skills and company needs can lead to underperformance or missed opportunities, highlighting the importance of aligning leadership capabilities with the business's current challenges.

9. Macro stories can significantly impact company valuations

If narrative drives numbers and value, the contrast between Uber and Lyft was in their narratives.

Macro factors shape company stories. While company-specific narratives are important, broader economic, technological, or societal trends can have a significant impact on valuations. Understanding and incorporating these macro stories is crucial for comprehensive analysis.

Types of macro stories affecting valuations:

1. Economic cycles: Recessions, expansions, and their impact on different sectors
2. Technological disruption: Emerging technologies reshaping industries
3. Regulatory changes: New laws or policies affecting business operations
4. Demographic shifts: Changes in population, consumer preferences, or workforce composition
5. Geopolitical events: Trade wars, political instability, or global conflicts

Incorporating macro stories in valuation:

• Identify relevant macro trends for the company or industry
• Assess the potential impact on key valuation inputs (e.g., growth rates, margins)
• Develop multiple scenarios based on different macro outcomes
• Adjust discount rates to reflect macro-level risks

Case study: Uber vs. Lyft

• Uber's narrative emphasized global expansion and diversification
• Lyft focused on the U.S. ride-sharing market
• These differing macro stories led to significant valuation disparities

Remember that while macro stories are important, they should be balanced with company-specific factors to create a comprehensive and nuanced valuation narrative.

Last updated: February 24, 2025