Forbes India 15th Anniversary Special

VCs are traders. They are not investors: Aswath Damodaran

The 'dean of valuation' debunks how 'price' is different from 'value' and why most venture capital firms are incapable of valuing companies

Neha Bothra
Published: Sep 15, 2023 11:00:50 AM IST
Updated: Sep 22, 2023 11:04:29 AM IST

VCs are traders. They are not investors: Aswath DamodaranAswath Damodaran, professor of finance, NYU Stern School of Business Image: Jerod Harris/Getty Images for Vox Media
Let me begin with a confession. ‘Valuing a company’ and ‘pricing a company’ are as different as chalk and cheese in investing. But unknowingly, I often use the two terms interchangeably. Here’s where the masterclass with professor Aswath Damodaran on Forbes India Pathbreakers helped me understand why the two are not the same. “Most people price things, they don’t value them,” the dean of valuation explains. “In pricing, you attach a number to an asset based on what other people are paying for similar assets. Valuation, on the other hand, requires that you understand a business.”

For example, most venture capital (VC) firms claim to value companies on the basis of the future growth potential of the business, in other words, the addressable market size of consumers or subscribers. However, this hypothesis can often be quite far-fetched and misleading. “VCs don't value companies. They're incapable of valuing companies... I don't expect VCs to have deep thoughts about businesses because they're interested in whatever metric will allow them to flip the company to other people at a higher price,” Damodaran says.
The last two years, particularly, exposed the chinks in the valuation models of many startups. Unicorn after unicorn saw stock prices crash by 50-60 percent after listing. As the avalanche of easy money dried up with the rise in interest rates, access to capital also became scarce. In India, as per Venture Intelligence, total VC investments in the first half of the calendar year dropped to $3.8 billion from $18.4 billion in the corresponding period last year, and the number of deals also declined from 727 in H1CY22 to 293 in H1CY23.
This is part 2 of a multi-part series from the interview with Damodaran, professor of finance, NYU Stern School of Business, on Forbes India Pathbreakers. Edited excerpts:

Pricing versus valuation: ‘Most people price things, they don't value them’ 

Let's first take the contrast between pricing and value. Pricing essentially is a very simple process. You decide how much to pay for something by looking at what other people are paying for similar things. So, let's say you wanted to buy the Chennai Super Kings. Why? Because you're a billionaire. You want to have an IPL team as your trophy asset. You know how you're going to decide how much to pay for it? You're going to look at what somebody paid for another IPL team or maybe another professional sports franchise, and you say, hey, they paid a billion dollars, I'll pay a billion dollars as well. That's pricing. In pricing, you attach a number to an asset based on what other people are paying for similar assets. It's how we decide how much to pay for a house or an apartment. Pricing is intuitive. We all do it.
Valuation, on the other hand, requires that you understand a business. So, if you want to buy the Chennai Super Kings as a business, you’ve got to understand how they make money, how much money they make from the stadiums, how much money they make from media, and essentially think about how much you will pay for the business you buy. It's more work, but your assessment then drives your decision. Most people price things, they don't value them. They like to use the word value when, in fact, they're pricing things.

Also read: There is no day that I wake up and say, 'I wish I didn't have to teach today': Aswath Damodaran

The role of narratives: ‘Your numbers convey a story’ 

I think a lot of people, when they think about valuing a company, think about inputs. What's my revenue growth? What are my margins? They think about numbers. But those numbers reflect the story you're telling about the company. Ultimately, what keeps those numbers held together, what keeps them consistent is the underlying story. So, if we go back and look at my Zomato valuation, you can agree with it or disagree with it. It's not about what I'm using as revenue growth and margins that's giving me the value. It's my story of Zomato as a restaurant food delivery business that's going to feed off the growth of that business in an immense market like India. That's the story that's driving it. Now you could tell a different story about Zomato. You might say, look, it's not a restaurant food delivery business. It is a grocery delivery business in addition. That changes the story, it changes your inputs. Will it make the value higher? Maybe it will, maybe it will not, but it's a different story. I tell people, look, when you build a spreadsheet, think about the underlying story you're telling, because even if you say I have no story, your numbers convey a story and you've got to believe in that story.

Busting the hype: ‘VC firms are incapable of valuing companies’ 

I'm going to do something that bugs students in my class. Whenever they use the word valuation in a context where I think it should not be used, I step in and say, do you mean pricing? VCs [firms] don't value companies. They're incapable of valuing companies. They price them based on what? Based on total addressable markets, number of users, number of subscribers. I understand why they do what they do, but remember it's a pricing game, which means the game does well when the momentum is with you, but when the momentum shifts, guess what? The price adjusts as well. So, VCs are traders. They're not investors. They trade on companies and a successful VC is one who times a drive, times entry and exit drive. So, I would not shed any tears for VCs who lose money when the momentum goes against them because they make money when the momentum is in their favour. I don't expect VCs to have deep thoughts about businesses because they're interested in whatever metric will allow them to flip the company to other people at a higher price.

Dealing with uncertainty: ‘I don't think we live in special times’ 

I'm going to push back on the notion that we live at a time of extreme uncertainty. Do we? Do you think the people who came out of the second World War faced less uncertain times than we do? Or the invention of the automobile, and how it changed the way people live, or electricity, or the original factory system? I don't think we live in special times. Each generation likes to think it's special.
You know why we feel that we're in more uncertain times? Because everybody's problem becomes everybody else's problem. Over the last weekend, we had a hurricane, or at least rumours that we're going to have a hurricane in Southern California where I live. And I received calls from my family in India saying, are you OK? We heard about the hurricane. In 1981, if there'd been a hurricane in Calcutta, forget about Southern California, you probably wouldn't read about it in Chennai till, what, three days after the cyclone hit.
So, I think one of the reasons we feel more uncertain is we're inundated with information and everything happening in real time, not just around us, but around the world. And I think that's making us very uncomfortable, because as human beings, uncertainty makes us uncomfortable. So, in a strange and contradictory way, our access to data is actually making us more susceptible to doing emotional things because we now feel we're more surrounded by uncertainty. And when you do, you behave in unhealthy ways.

Also read: Have VCs been fair in valuing startups?

Valuation playbook: ‘Not all uncertainties are created equal’ 

First, you need to look at the uncertainties you face and organise them. Not all uncertainties are created equal. I believe in putting uncertainties in buckets, so you have a sense of what's going into which bucket. So, it'll keep you from getting overwhelmed. I tell people, look, if you make a list of everything, you're uncertain about and you value a company, it's going to run to hundreds of items. You're going to feel overwhelmed. Organising it is the first step.
Second, recognise that the nature of the uncertainties you face will be very different depending on the company you value. When I valued Zomato, the kinds of uncertainties I've faced were very different than when I valued Asian paints, or when I valued Grasim, or when I valued ITC. As companies age, the kinds of uncertainties you face will vary. Once you've decided which uncertainties are the big ones with this company, face up to the uncertainty. Don't hide from it. Don't go into denial. And facing up to the uncertainty means figuring out how uncertain you are, and actually incorporating it into your analysis.
I do what I call simulations and valuations, but rather than valuing a company with point estimates, revenue growth is going to be 23 percent, margins are going be 15 percent, you build distributions around your assumptions, and you come up with distributions of value. It's a much more honest way of saying, look, I can give you a value for a company, but I'm going to be wrong. Why? Not because I haven't done my homework, but because I'm not God. Essentially, you're going to be uncertain because you don't control what the future will deliver. And I think facing up to it gives you a much better chance of dealing with it.
And my final advice when you face uncertainty is keep it simple. Don't have hundreds of line items because again, you'll get overwhelmed. Less is more. And I think that message more than anything else stood me in good stead when I think about valuing companies where there's a lot of uncertainty.  
Watch the full conversation on Forbes India Pathbreakers on September 20.