Investing for growth What assets do companies in this business have to invest in, to grow? How much investment are companies making collectively in this business to generate their growth? How easy is it to scale up? With manufacturing companies, investments is generally in plant, equipment and assembly lines, but with technology and pharmaceutical companies, the investment may take the form of R&D. Risk How much do revenues and earnings vary across time? What are the forces that cause these operating numbers to change? How much debt (or fixed commitments) do companies in this business tend to carry? What are the risks that companies in this business may fail? What is the trigger (debt payments due, running out of cash) that cause failure? Volatility in your revenues/earnings can be caused by macroeconomic variables, which can include interest rate, inflation, commodity price and political risk or from company-specific variables. With established companies in mature businesses, this analysis is relatively simple to do, since the market characteristics are observable (market growth, profitability, trend lines) and often forecastable. Your job gets more difficult if you have companies in evolving or changing businesses, with that change coming from a maturing of the business, a shift in consumer behavior (as is the case with the entertainment content business as consumers shift to streaming), changes in regulatory rules/restrictions (for example, the telecommunication business after deregulation) or geographical shifts. In these cases, you will not only have to make a judgment about the current state of the business but also how you see it evolving over time.
include in it, and the answer is that it should comprise not just the interest-bearing liabilities that you see on a company’s balance sheet, but also other contractual commitments that the firm faces. Lease commitments, for instance, should be considered as debt and brought into your debt number, making a significant difference in the debt value at retail firms and restaurants, which have substantial operating leases. With cash, you have two details that need to be ironed out. The first is a phenomenon specific to the United States, and largely the result of the US corporate tax law. The US tax code requires US-based companies to pay the US corporate tax rate on their foreign income, but only when that income is repatriated to the US. US companies, not surprisingly, choose not to bring their cash back to the United States, thus trapping that cash in foreign locales. In late 2015, about $120 billion of Apple’s $200 billion cash balance was trapped in its foreign operations and bringing that cash back to the US would result in a tax bill of close to $20 billion. When valuing Apple, you have to decide whether you, as equity investors in the company, will ever face this tax bite, and if so, when. The second is in markets where cash balances can be invested in risky securities, where the book value (reported in the financial statements) may be very different from the current value. Cross Holdings: It is not uncommon for a company to hold portions of other companies and as an investor, you partake in these holdings. As a consequence, you have to bring in the value of these holdings into your estimated value and to do this, you first have to understand how the firm accounts for these holdings. With both US and international accounting standards, holdings can broadly be classified into majority holdings, where you own a controlling stake, usually (but not always) more than 50%, of another business, or minority holdings, where you hold a smaller stake in another business. With majority holdings, you are required to consolidate your financial statements, act as if you fully own the subsidiary, and report operating
In my Uber narrative, I viewed Uber as a car service company that would disrupt the existing taxi market (which I estimated to be $100 billion), expanding its growth (by attracting new users) and gaining a significant market share (10%). The Gurley Uber narrative was a more expansive one, where he saw Uber's potential market as much larger (drawing in new users) and much stronger networking effects for Uber, leading to a higher market share. In many ways, this is exactly the discussion I was hoping to have when I first posted on Uber, since it allows me to see how these narratives play out in the numbers. In table 10.3, I contrast the narratives and the resulting values: Table 10.3: Uber Narratives – Damodaran versus Gurley Uber (Gurley) Uber (Damodaran) Narrative Uber will expand the car service market substantially, bringing in mass transit users & non-users from the suburbs into the market, and use its networking advantage to gain a dominant market share, while cutting prices and margins (to 10%). Uber will expand the car service market moderately, primarily in urban environments, and use its competitive advantages to get a significant but not dominant market share and maintain its revenue slice at 20%. Total Market $300 billion, growing at 3% a year $100 billion, growing at 6% a year Market Share 40% 10% Uber’s revenue slice 10% 20% for Uber $28.7 billion + Option of entering car ownership market ($6 billion+) $5.9 billion + Option value of entering car ownership market billion)
Case 11.1: Narrative Breaks At the start of 2014, a company called Aereo claimed to have found a legal way to broadcast cable channels on handheld devices, without users having to pay cable fees. While the response from most people was disbelief, that did not stop investors from valuing the company at $800 million in early 2014. In the summer of 2014, the United States Supreme Court, which was called to rule on the legality of Aereo’s streaming, ruled against it. Overnight, the value of the business dropped towards zero and a few months later, the company folded. A more perverse example is Ashley Madison, an online service that facilitates cheating on spouses, with online connections. Without passing judgment on the morality of this business the company had no shortage of investors and was looking forward to an imminent initial public offering, where it planned to raise $200 million from the market. Those plans came crashing down to earth, when a computer hacker got into Ashley Madison’s website and released a partial list of its customers, not good news in a site dedicated to cheating. While the company was not put out of business, it was mortally wounded and its valuation crashed in the aftermath of this news story. Narrative Changes In a narrative change, a part or many parts of your story are changed significantly by real world developments. These changes can come from different sources and have positive or negative effects, but one way to organize them is to use the narrative framework that we developed in chapter 8: Figure 11.1: News Stories and Narrative Changes When you make these changes, though, recognize that you will have to explain what parts of the story you have changed and why, but also be ready for criticism from two sources:
Lyft Uber Potential Market US-centric, company. Global, logistics company Growth Effect Double market in US in next 10 years Double logistics market globally in next 10 years Market Share Weak national networking benefits Weak global networking benefits Competitive Advantage competitive advantages Semi-strong competitive advantages Expense Profile Drivers as partial employee Drivers as partial employees Capital Intensity Low capital intensity Low capital intensity, with potential for shift to more capital intense model