Aswath Damodaran

Aswath Damodaran: The life cycle approach to company valuation

Like people, companies have a life cycle and a firm’s valuation should reflect its position along the journey from startup to declining elder. That’s the simple yet profound message delivered by Aswath Damodaran, Professor of Finance at NYU’s Stern School of Business, at Nordic Business Forum 2018.

Damodaran reminded the audience of the three stages of the corporate life cycle: companies are born, reach maturity and then decline. Just like humans, companies don’t like to get old but aging has to be accepted as inevitable. Companies must, therefore, modify their focus as they age or they will fail. The renowned corporate finance and valuation expert warned that fighting the corporate life cycle is the most dangerous thing a firm can do and counseled companies to act their age. “More value is destroyed around the world by companies not acting their age. Young companies trying to act old and old companies trying to be young again. And there’s an entire ecosystem that feeds these companies. Consultants, bankers, essentially the plastic surgeons of business. If I give you a facelift, you can be young again. And companies keep buying into this notion over and over again,” Damodaran warned.

He cited valuation as another key perspective for companies as they navigate their life cycles. Perhaps surprisingly for a number-cruncher par excellence, Damodaran advised that corporate valuation should not be based exclusively on numbers. “A good valuation has a story and the balance between the story and the numbers changes during the course of a company’s life cycle,” he explained.

In the same way that the balance between valuation and story changes throughout the arc of a firm’s existence, so too does the profile of its chief executive. That’s because companies at different stages of the life cycle need a CEO with different skills sets. “What makes for a great CEO in a young company, is very different from what makes for a great CEO in a mature company,” Damodaran continued.

From startup to decline – in dog years

Using his skill as a storyteller and lecturer, Damodaran painted the picture of a company’s life cycle by likening it to the stages of human development. He compared birth to the startup phase, noting that like newborns, many emerging companies face the highest mortality rates in early infancy. The ones that survive progress to become young growth companies, which Damodaran saw as similar to teenagers.

“And you know what teenagers do? Incredibly stupid things,” he quipped. He cited firms such as Uber and Tesla as examples of wayward teens “who don’t always think through the consequences,” but are nevertheless full of future promise.

The firms that realize their potential for greatness and progress to become highgrowth companies like Netflix, while mature growth companies perform like Facebook and Google, posting high earnings, revenues and margins.

But at the same time, the factors that allow companies to progress rapidly to become high-growth firms – ease of entry into the business, a minimal investment to scale up and ease of scaling – are the same variables that can cause them to decline.

And like humans, firms reach maturity only to slip into the inevitable decline that precedes old age and death. What’s different today is that corporate life cycles are becoming compressed, Damodaran observed.

“Tech companies age in dog years. They grow fast, don’t remain immature for very long and then they decline,” Damodaran declared. He pointed to early internet forerunner Yahoo, which he described as “the walking dead”, and the speed with which it once became a USD 100 billion company. “What took GE fifty years to do, Yahoo did in seven years,” he remarked.

However, the company went from startup to star to near-death in just 25 years. As companies’ life cycles shorten, experts should adapt their valuation approaches to the new reality, Damodaran advised.

Valuation, corporate finance, and age-appropriate behavior

Damodaran went on to draw a distinction between valuation and corporate finance. “In valuation, I look at companies from the outside in. I look at a company as an investor,” he explained, adding that by contrast, the corporate finance perspective involves an inside-out perspective where the evaluator considers how to change the firm from the inside.

According to Damodaran, the corporate finance approach revolves around three pillars: the investment decision, the financing decision, and the dividend decision. For Damodaran, the corporate finance approach offers the highest level of flexibility as the age of the company determines which of the three decision metrics is most appropriate in the valuation.

He noted that since startups have no borrowing capacity or cash for dividends, they should focus only on the investment decision, which means identifying good projects that will help grow the business to the next stage. Although young growth companies may possess a great deal of potential, they should not borrow because of the risk posed by interest rates.

“If you’re a young company, why would you put your entire future at risk by going out and borrowing money?“ Damodaran queried, pointing to the example of car and energy upstart Tesla, a fast-growth firm that borrowed USD 5 billion in 2016 alone.

As companies mature, however they will find themselves in a better position to focus on financing decisions, which involves finding the right balance of equity and debt to minimize the hurdle rate, a concept that reflects the riskiness of the investment and the required mix of debt and equity needed to finance it.

Finally, businesses that have passed maturity and are in decline should be guided by the dividend principle, Damodaran advised. He noted that at this stage, it’s time for companies to think about how much money to return to shareholders if they cannot find investments that satisfy their hurdle rates. This is not the time to re-invest he cautioned, pointing to the risk of a cash burn.

“If you look at the hundred largest businesses in the U.S., I would say that for 60-70 percent of them investing back in the business is almost a guarantee the money will be burnt,” he claimed. He went on to advocate for a share buyback by mature-stage firms. “Why not instead reduce shares outstanding, increasing shareholder wealth?”

Teenager companies like Tesla are not the only firms that are guilty of behavior that is not age-appropriate, Damodaran said. Mature and declining companies also do not act their age. In August 2018, US retail giant Walmart bought money-losing Indian e-commerce startup Flipkart for USD 21 billion, ratcheting up its rivalry with Amazon. However, Damodaran dismissed the investment as “the most expensive facelift in history;” an attempt by an aging player to stay young and in the game.

Amazon bucks the trend

Companies at different stages of their life cycle also have varying relationships with cash.

During the start-up phase, a cash burn should be seen as a normal feature rather than a bug, the lecturer noted, because it’s necessary to build the business and reach profitability. “It’s not that you need to make money right from the start, but eventually you have to make money,” Damodaran added.

Although cash flow is a good indicator of a company’s lifecycle phase, Damodaran said that there are some exceptions. He cited the example of online retail behemoth Amazon, which he said is not acting like a mature company but is behaving like a young growth company with USD 1 trillion in market capital behind it. “It’s never been seen before in history and I’m not sure what’s next, it’s going to be fun watching, but it’s not going to be fun playing against it,” he declared.

Damadoran said that Amazon is difficult to value precisely because it doesn’t act its age. He noted that the conventional wisdom is that Amazon is a retail company, however, he said that he has given up on that notion. Now, he said, Amazon can be considered a disruption platform that can effectively target any business on the face of the earth.

“Amazon is now a disruption platform with an army called Amazon Prime, 100 million absolutely loyal members that they can turn loose on any business they want.”

“The day it entered the grocery business, collectively every other business lost USD 40 billion of market capitalization.”

“Whatever business you’re in, every night get down on your knees and say, ‘Please God, don’t let Amazon come into my business’ because they will destroy your business and leave nothing left,” he continued.

Age drives valuation approach, CEO selection

According to Damodaran, a good valuation is “a bridge between stories and numbers”, because “all numbers have a story and all stories need a number.” Moreover, depending on a company’s life cycle age, the valuation changes and either the number or the story carries greater weight.

This means that the valuation of a young company is all about the story. Uber, Damodaran said, is a classic example of how a startup’s origin story influences its valuation. His initial valuation of the company was USD 6 billion, based on his perception of it as an urban car services firm. However, positioned as a logistics company, the valuation soared to USD 53 billion.

However while the story drives valuation for a young company, as a firm ages, numbers assume greater importance.

A company’s position on its life cycle trajectory should also determine the kind of CEO it appoints, Damodaran argued.

Wall Street’s ‘dean of valuation’, as Damodaran is sometimes called, outlined specific CEO profiles appropriate for different stages of a company life cycle, starting with Steve the storyteller, the visionary CEO needed to pilot a startup. In the next stage, that of a young growth company, Bob the builder is the person who is more likely to ensure that the trains will run on time.

Next, during the mature stage of business, Don the defender is required to ensure that the company can safeguard its success, while Larry the Liquidator is the person firms should turn to when they find themselves in decline.

At the same time, as companies experience a compressed life cycle, they should also be prepared for disruption in the ranks of management. “This is something we are going to face in a lot of companies. Great founders suddenly becoming inappropriate CEOs.” For the C-suite and investors alike, Damodaran concluded, very interesting times lie ahead.

About Nordic Business Forum 2018

Nordic Business Forum 2018 was held on 26-27 September in Helsinki, Finland, gathering together 7,500 CEOs, top executives, and entrepreneurs from over 40 countries.

Download the full Executive Summary and read what the speakers said on stage at Nordic Business Forum 2018.



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