The tools and practice of valuation is intimidating to most laymen, who assume that they do not have the skills and the capability to value companies. In this talk, I propose to lay out four simple propositions about valuation. The first is that valuation is not an extension of accounting, insofar as it is not about recording the past but forecasting the future. The second is that valuation is not just modeling, where people put numbers into Excel spreadsheets and pump out values. A good valuation requires a narrative that binds the numbers together. The third is that valuing an asset or business is very different from pricing that asset or business, a difference that is often blurred in practice. The fourth is that luck plays a disproportionate role in whether you make money off your valuations. Put differently, you can do everything right and still walk away with nothing or worse at the end.

About the Author
I view myself, first and foremost, as a teacher. I do teach valuation and corporate finance not only to MBAs at Stern but to anyone who will listen (on iTunes U, online and on YouTube). I love to write books, teaching material and blog posts. After 30 years of teaching finance, I still find it fascinating as an interplay of economics, psychology and number crunching.

I just posted a couple of days ago on where I actually am very lucky to the intersection of 3 different businesses.

I'm a teacher first, I love to write, and I'm in finance.

And the way I described it, I'm in 3 businesses that are all begging to be disrupted.

3 really big, badly run businesses, all of which need to be taken to the cleaners.

So I've made it my objective at this point in my life to disrupt the businesses I'm in.

And this is 1 of those acts of disruption, because I think for too long we've thought about teaching as being classrooms in universities, but I don't see that restriction anymore.

So what I'd like to talk about is actually what I've been teaching for 30 years.

To give you some background, I came to NYU in 1986.

And when I first came to NYU, they gave me a class to teach.

And for those of you who know the history of that class, it was a class that Ben Graham taught at Columbia in the 1950s that you know who, he who shall not be named, took.

And it's a class with a long and hoary tradition.

So they handed it to me and said, you've got to teach this class.

I took 1 look at the class and said, no way.

This is the most boring piece of collection of topics I can think of.

Because by the 1980s, it was showing its age.

So I went to the head of the department and said, I'd like to teach a valuation class.

There isn't enough stuff in valuation to actually teach a class.

In 1986, there wasn't enough stuff in valuation.

In fact, when I did my MBA, which was way, way, way back in time, 1979 through 81, 2 years of the program, we spent about an hour and a half collectively on valuation.

So I thought about it, and I said, I'd really like to teach the class.

1 is to go the official route in the university, which is to ask officially for the class to be okayed.

And if you've ever been in an academic setting, as most of you have, you know how difficult it is to get things done officially at a university.

A committee would be formed to report another subcommittee, and by the time they get back to you, you'd be ready to retire.

So I discovered early on in my academic life that if you want to get something done, it's best to do it subversively.

I said, OK, I'll teach a security analysis class.

And I went into the classroom, and I taught evaluation class.

They have absolutely no idea what I do in the classroom.

I mean, I could be teaching cooking for all they know, right?

So you know how long it took them to find out?

In 2008, I got a call from the dean's office.

This is 22 years after I've been teaching this class saying, we've heard you're teaching evaluation class.

And I said, yes, I've been doing it for 22 years.

So if you look at the NYU schedule, you won't see valuation until 2008.

But that's because I've hijacked like 6 other classes in previous iterations and made them all valuation classes.

I'm fascinated by valuation, but I'll tell you up front what I think about valuation.

Who's we, the people who practice valuation?

You've got to cover things up with layers of complexity, keep people away.

Obviously in 40 minutes, I'm not going to cover the details of valuation, but I want to kind of hit some points that I think sometimes get missed, especially when people look at valuation from the outside.

So here's the first message I want to deliver.

And the reason I say that is most people, if you say, valuation, think numbers, think accounting statements, think income balance sheets.

And it's actually a task I face every year I teach this class.

In fact, many of the MBAs that I teach come into my class in the first year in the spring semester.

When they come in the spring semester, they've taken 1 class in accounting.

And if you've looked at how MBA programs have evolved, MBA programs are very diverse now.

So to them, the only sense of finance they've had is the accounting class.

And part of my job is to get them out of the accounting mindset.

So let me start off by explaining the way I see the difference between how accountants look at the world and how finance looks at the world.

So nothing I say should be viewed as bad.

It's their job to record what's happened.

So if you look at a balance sheet, and most of you, if you open up a 10K or an annual report, you'll see a balance sheet.

This is a classic accounting balance sheet.

So let me look at the breakdown of how accountants break down a company.

On the asset side, they break assets down into current assets, basically inventory, accounts receivable, cash.

Fixed assets, land, building, equipment, accountants are big on tangible fixed assets.

For some reason, if they can see it, they're much more comfortable with it.

Then you have financial assets, investments in other companies.

And then you have what accountants euphemistically like to call intangible assets.

Now, if I went around this room and asked people to name intangible assets, you'd see lots of things come to the surface, brand name, technology.

But if you look at an accounting balance sheet, you know what the most common intangible asset is?

And let's be completely clear about this.

Goodwill is the most useless asset known to man.

For goodwill to manifest itself on an accounting balance sheet, you know what a company has to do?

So if you're the greatest company on the face of the earth, and you've grown entirely with internal investments, there will be no goodwill on your balance sheet, period.

The minute you do an acquisition, goodwill pops up.

So what did the accountant say until just before you acquired it?

The accountant has a $6 billion problem to explain away, right?

And he has to do it because the balance sheet has this very unpleasant requirement.

The problem with Goodwill is it sounds good.

And when something sounds good, people feel the urge to pay for it.

So every week I get emails from people saying, I'm valuing this company, it has 5000000000 in goodwill, how much should I pay for it?

And my response is, it's a plug variable.

What the heck are you doing paying for a plug variable?

On the other side of the balance sheet, again, accountants get carried away.

You have current liabilities, accounts payable, supplier credit, Deferred taxes, so all kinds of stuff.

Then you've got long-term liabilities, bank loans, corporate bonds, and then you have an item that's called shareholder's equity.

If you get a chance, take Google, look at the balance sheet.

There will be a shareholder's equity number.

Take any company, there's a shareholder's equity number.

Everything that's happened to this company over its lifetime.

When you look at the shareholder's equity for Coca-Cola, in that number is the original public offering that Coca-Cola made, which was about 100 years ago, and everything that has happened since.

The shareholders' equity is a reflection of the past.

I'm going to replace it with what I prefer to look at a company as, a financial balance sheet.

And at some level, a financial balance sheet is far simpler than an accounting balance sheet.

Look at the assets out of the balance sheet.

There are only 2 items, Assets in place and growth assets.

Assets in place are investments you've already made as a company.

It's a value of investments you've already made.

Think about the investments they've already made.

It's a value I'm attaching to investments I expect you to make next year, 2 years out, 5 years out, 10 years out, forever.

I'm giving you credit for investments you haven't even thought about yet.

An accountant can never do that, but I play by no rules.

So if I feel that you have great investments in the future, I can give you a large value.

Where's most of the value for the company coming from?

Investments they've already made or growth assets.

Most of the stuff they've done is already in the ground.

But if you look at a LinkedIn and you can pick any young growth company, and I'm not going to pick them in terms of quality.

On a good day, maybe LinkedIn's assets in place are worth a billion, because they made about $10 million in operating income last year.

You're paying $40 billion for the company.

But that's a first stop when you're an investor.

You've got to stop and do a reality check.

What are you buying when you buy this company?

Because the way you assess the company is going to be very different if it's Procter & Gamble as opposed to LinkedIn.

If you're Procter & Gamble, you should be very focused on earnings reports and say, how much did they make last year?

If you're LinkedIn, who cares what they made last year?

That's why when I see investors freak out over earnings reports from young companies, and there are lots of them, right?

Earnings per share were $0.02 below expectations.

I don't care, because the value of your company is not coming from what you did last year.

It's coming from what I think you can do in the future.

So when I look at an earnings report for Twitter, I'm not looking at what did they do last year.

I'm looking for clues as to, Is their growth potential increasing or not?

Are they doing the right things to create value from their growth assets?

Most of the tools we have in finance were developed for mature companies.

PE ratios, return on invested capital, things you're taught in business school.

But if you have a growth company, you try to assess them using those tools.

That's going to be bloody, and it's going to come to a bad end.

So 1 interesting thing you can do when you sit with a business is take the accounting balance sheet and contrast with the financial balance sheet.

The younger a company, the less you will learn by looking at the accounting balance sheet, for a simple reason.

If you haven't been around long, the accountant has nothing to record.

So you look at a Twitter's balance sheet or LinkedIn's balance sheet, there isn't much there yet.

And on the other side of the balance sheet, You've got only 2 items, debt and equity.

There are only 2 ways you can fund a business.

You can borrow the money or use your own money.

You can slice this and dice this as much as you want.

But every business has to have that choice.

You tell me where the bulk of your value comes from.

I'll tell you whether you should be funding your business with debt or equity.

Let's say you're a young growth business.

No revenues yet, no earnings yet, plenty of potential.

What's the problem with borrowing money to fund an idea business?

Have you tried paying interest with ideas?

Go to the banker and say, you know what, I have a lot of ideas.

You can't make interest payments with ideas.

If you're an idea business, this is corporate finance 101.

So that's the first message I want to deliver.

I often see valuation classes structured around spreadsheets.

In fact, some of you might have sat in 1 of these classes by training the stream.

You can do those shortcuts and turn columns into yellow, green, blue, et cetera.

And at the end of 2 days, you are a master at Excel.

And you think this is what valuation is about at the end of the process.

In fact, the way I like to describe this is to step back and think about what drives the value of a company.

If I'm asked to value a company, there are 4 basic questions to which I need answers.

You've already made those investments in the ground.

What are the cash flows you're getting from those existing investments?

Could be very small if you're a young growth company, but that's my starting point.

That's why I look at the last financial statements, to get a measure of what your existing cash flows are.

The second question I'm going to ask you is, what is the value that I see you creating with future growth?

I'm going to ask you, what's your future growth?

Growth by itself can be worth a lot, can be worth nothing, or can destroy value.

Growth can be good, bad, or neutral, because you've got to pay for growth.

So I'm going to ask, what's the value you create from future growth?

Much more difficult to answer than, what are your cash flows from existing assets?

Third, I'm going to ask, how risky are these cash flows?

Notice I didn't throw in any terms, the kind of buzzwords you throw in there.

I need a measure of risk, and I need to bring it into the value.

And finally, I'm going to ask, when will your business be a mature business?

Because I've got to put some closure on this process.

I cannot keep estimating cash flows forever.

So those are the 4 questions around which the valuation swivels, Which then brings me to the way I think about valuation.

When I start my valuation class, which doesn't start on Monday, there'll be 200 people who walk into the class.

And the first question I ask them is, are you numbers people?

I'd bet, given where I am, that there are more numbers people in this room than story people, right?

And the reason I say that is when I look at investing, you have 2 camps.

You have the numbers people who love to grind through numbers.

And if the story people like to be creative, they like storytelling.

The VC business is a storytelling business.

I know they throw numbers in like that target rate of return, but it's an afterthought.

And the problem right now is the story people think that the numbers people are all geeks.

And the numbers people think that the story people are all crazy.

In fact, it's almost funny to sometimes watch 2 story people and 2 numbers people trying to talk about things, and they're talking right past each other.

And here's the challenge I see myself having.

When I come into that class, and there are how many story people and how many numbers people?

I asked them actually in a very simple way to see which 1 you are, if you're not sure.

I asked them, how many of you enjoyed history in high school?

And he left 20 people, but I love that class.

So how many of you preferred algebra to history?

And my end game for my evaluation class is to have numbers people with imagination and story people with discipline.

If you're a story person, I'm not going to stop you from telling stories.

Stories are actually much more effective at selling businesses than numbers are.

And it's been true for as long as human beings have been on the earth.

So if you tell a story, what I want you to also bring in is enough numbers to discipline yourself.

Because if you don't have the numbers, it's very easy to veer away into fantasy land.

If you're a numbers person and you have no imagination, you're not going to be able to do valuation, because it's all about the numbers.

If you do a good valuation, it should sing a tune.

Behind the numbers, what is the story you're telling about a company?

So when you look at the 2 groups, each believes they're the chosen people.

The numbers people say, we're the chosen people.

And the story people think, oh, you should listen to us.

And I think They're both right, and they're both wrong.

There's something to be gained from the other side.

And to me, that is the key in doing valuation right.

You've got to work with both sides of your brain.

I don't even know whether this is mythology or not, that there's a left brain and a right brain.

Some of us prefer to work with numbers, and we have to force ourselves to think about stories.

And some of us prefer to tell stories, and we have to force ourselves to think about numbers.

Think about your weaker side and work on it, because that's what's going to give you power and valuation.

So when I do a valuation and I use a discounted cash flow valuation, it's a 2.

So when you're DCF being used as a curse word, and venture capitalists have used this on me.

The way they say the contempt oozes out of it.

You can't value this company using a DCF.

I think they're completely misunderstanding what a discounted cash flow valuation is.

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Valuation in Four Lessons | Aswath Damodaran | Talks at Google