Whether you’re investing in mature companies in the public market, or fast-growing startups in the private market, one question separates good and bad investors:
Do you understand valuation?
Valuation is the rationale by which you determine which opportunities to pursue. To develop your understanding of valuation is to develop your ability to recognise potential.
Despite the central role in investment decisions, valuation is often misconstrued as financial engineering or market-driven pricing exercises.
Valuation is an opinion
Here’s three things valuation is not:
- Based on verifiable inputs
- Provably accurate in output
- A mirror of market sentiment
Instead, valuation is always an opinion based on a set of assumptions about an unknowable future.
“People act like it’s an award for past behavior. It’s not. It’s a hurdle for future behavior.”
Bill Gurley, VC at Benchmark
Whether that valuation is based on a detailed DCF model or napkin-math, it’s an opinion. And it’s no more or less of an opinion as your process gets more or less sophisticated; the only difference is how clearly you outline the assumptions.
When one investor states that a company is overpriced, and another that it is undervalued, neither is right or wrong in the moment — they just have differing opinions.
Valuation can be a simple, implicit part of the process, or it can be an explicit exercise used to better understand an opportunity and check assumptions.
Valuation is an opinion on a story
In order to form an opinion about a particular future, you must first listen to its story.
“The value of a stock is what people believe it is and could be. A stock is a story.”
Lulu Cheng Meservey, Founder of ROSTRA
All investment decisions are bets on today’s fiction.
- Elon Musk is telling you that we must get to Mars
- Brian Armstrong is explaining the importance of Bitcoin
- Parmita Mishra is describing the future of medicine
- Aaron Slodov is laying out a reindustrialisation roadmap
- Augustus Doricko is talking about rivers in the sky
Do you believe them, when they have nothing but a story?
Does that story involve unleashing a huge amount of economic energy? How much capital does it require?
Based on the credibility of that story, and the potential scale of that economic energy, is it worth paying-up today?
“The scarcest resource isn’t capital or talent. It’s the ability to make people believe in your specific tomorrow strongly enough to fund it today.”
Howard Yu, LEGO® Professor of Management and Innovation
Valuation is the art of developing better opinions about the future
Valuation can be broken down into a few pieces:
- How do you judge the credibility of a story?
- How do you estimate the economic potential of a story?
- How do you estimate the risk associated with a story?
You can think about this via two extremes:
- You’re looking at a company you’re familiar with. You’ve got a good mental model of the industry, the technology, the market forces, trajectory, and risks. It’s relatively simple for you to make a rough judgement on value in your head. This reflects Kahneman’s “System 1” thinking.
- You’re looking at a company you have no familiarity with. The technology is novel, the market is emerging, and there’s no real precedent. In order to make a good judgement, you have to submerge yourself in details and scenarios. This reflects Kahneman’s “System 2” thinking.
In the latter case, a more sophisticated valuation process can help you understand the credibility and economic potential of a story. It provides a framework for ingesting information that can control biases, while allowing you to recognise and scrutinise the main drivers of value.
Valuation is essentially the act of running simulations of the future described in a story, focused on the numbers rather than the narrative, to explore the potential.
Pricing is not valuation / Trading is not investing / The present is not the future
Venture capitalists often choose to focus on relative pricing, instead of valuation, as an attempt to proxy experience through crowdsourced activity — allowing for speedy “System 1” style investment decisions.
This means analysing industry activity, which biases investment towards categories with low information friction like B2B SaaS, at a cost to sectors with more idiosyncracy, like deeptech.
Unfortunately that focus on market data also means these investors are not developing their ability to make judgements about the future, only to pattern match today. This compounds into a ‘knowledge worker atrophy‘ problem, weakening venture capital’s institutional competence at funding creative endeavors and novel solutions.
That would appear to be a critically weak link in the value proposition of venture capital, and the premise that it funds important solutions to humanity’s problems.
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