Volume 171: Valuation Narratives, Part One.
Valuation Narratives, Part One.
tl;dr: It’s getting a bit wonky in here.
My apologies for there being no Off Kilter last week. I struggled with this edition and decided to hold off until I got it closer to right.
After a couple of false starts, including one that ended up being little more than a long-winded history of shareholder capitalism. Did you know colonialism was a major driving force behind the invention of the publicly traded corporation? Yup, the world’s first IPO was The Dutch East India Company way back in 1602.
After a while, I realized the only way to touch this subject is to massively oversimplify, overgeneralize, and break it into two editions. Sorry for doing that, but there’s literally no other way. So, here goes. Oh, and don’t worry—I’m not about to dive into a Finance 101 class.
Over the years, much has been written on corporate valuation and its ramifications, from animal spirits to market efficiency, quantitative trading, stock buybacks, day trading, passive investing, wealth distribution, and more. Today, I want to talk about valuation narratives and how we, as branding professionals, have a role to play. The examples I will use are all publicly traded corporations since there’s greater transparency and liquidity here, but the principles are also applicable to privately held businesses.
If we massively oversimplify, the easiest way to think of the value of any corporation is that it’s based on some combination of two things: historical business performance, which provides insight into likely near-term future performance, and a story of the future, which provides insight into longer-term potential. From now on, I’ll refer to these as “performance” and “potential.” Nested within these are the value of the assets owned by the corporation, including intangible assets such as patents or brands.
Different corporations in different sectors generally see either performance or potential dominate their valuation narrative. For example, a large, slow-growing, mature business with valuable assets like P&G will see its value based primarily on the consistency of past performance and the contribution of its hard-to-replicate assets (brands, in this case) toward maintaining this consistency in the future. Such corporations are viewed as mature and stable, so their market capitalization tends to live within fairly narrow bounds. Here, investors aren’t typically looking for significant capital gains (stock price rising and business valuation increasing as a result) because growth opportunities are limited. Instead, they’re more likely to look at the consistency of dividends as the corporation distributes profits back to shareholders. As a result, the stability and predictability of such firms tend to attract a more (small c) conservative investor profile, which in turn rewards the management team for delivering safe, conservative leadership that avoids big risks in the pursuit of growth. (I’ll talk more next week on how capital dictates leadership).
At the opposite end of the spectrum, smaller, fast-growing corporations, which have less of a track record and where past performance doesn’t reflect the future, tend to be overwhelmingly valued based on their story of future potential. Such investments tend to be riskier (because the growth story might not pan out). Here, as a reward for accepting greater investment risk, investors are explicitly looking for large capital gains from a growing stock price and associated rise in company value. As a result, they’re more likely to reward aggressive leadership teams that are bolder and more open to taking risks.
During the pandemic, we heard a lot about ‘story stocks,’ which is simply a term for a corporation where the story of future potential is the dominant factor in its valuation. We also heard of ‘meme stocks.’ The easiest way to think of a meme stock is that it skipped the story phase entirely and went straight to…vibes. While a story stock must have a plausible enough story to attract investors, meme stocks don’t even have that. As a result, meme stocks should be viewed as vehicles of speculation without material underlying value. (AKA: Invest at your own risk).
To maintain and grow the value of a story stock, realized performance and the story of potential must align over time. Should they diverge materially, valuations tend to follow. This is why DTC darlings Allbirds and Warby Parker have fallen so hard upon entering the public markets. As performance figures became publicly available, investors saw a big divergence between reality and story and reacted accordingly. In other words, they sold the stock, which dropped the value of the business more in line with its realized performance than its claimed potential.
One of the most significant story stocks of the past decade is Tesla. In 2021, it achieved a company valuation of $1.3trn, while today, it’s worth approximately $540bn. Why the huge drop? Well, there are plenty of factors, but a big one is that realized performance is increasingly diverging from the story of potential: Sales are down, competition is up, unit profitability is down, and investors are increasingly seeing a business that isn’t hitting the milestones it needs to in order to live up to such a stratospheric valuation.
This drop in value is a direct reason Elon Musk announced the unveiling of the ‘Robotaxi” on August 8th, rather than the affordable Tesla we all expected. If a fully self-driving robotaxi can be realized, it will significantly shift the Tesla story of potential. Instead of being valued based on how many electric vehicles it can put on the roads, it will now be valued based on the potential of a new recurring revenue business that could put Uber, Lyft, and others out of business. However, if Musk stays true to form, the robotaxi that’s unveiled will be little more than a proof of concept and not a production vehicle, with a date for actual production way off in the never-never. So, why make such an announcement now? Well, put very simply, the realized performance of Tesla today cannot support its current valuation, let alone $1trn, so unless he can juice the story of potential, the stock price will continue to slide. To put this in perspective, the world’s largest automotive company, Toyota, sells 10X more vehicles than Tesla yet is valued at around $400bn. As a result, should investors decide Tesla and Toyota are in fact equal in terms of both performance and potential, its actual value might be closer to $50bn than $500bn. An outcome Musk will do pretty much anything to avoid.
Of course, stories of potential aren’t solely limited to new corporations without track record. Even large, mature companies can have what Andy Grove of Intel referred to as a ‘strategic inflection point,’ where a significant shift in strategy, often driven by disruptive technology, can add a new story of potential that, in turn, raises its valuation. Microsoft is an excellent contemporary example. Its core business is massive, consistent, and stable in terms of historic performance. This enabled it to achieve the heady heights of a $2trn market capitalization. However, the disruptive potential of generative AI and how Microsoft has woven this narrative into its core strategy is why it now tops $3trn. As a result, one way to look at Copilot isn’t as a product per se but as an investor-facing branding vehicle that just added $1trn to the company's valuation by positioning Microsoft as The GenAI company. (Contrast this to the utter shitshow surrounding Google Bard/Gemini, but that’s a different story I’ll save for another day).
The other tools in the armory of corporations that can significantly change both performance and potential are mergers and acquisitions (M&A) and demergers/divestments. I’m not going to spend much time on M&A right now (It really deserves its own edition), but divestments are interesting because we’ve recently seen GE, Johnson&Johnson, and 3M all divest significant parts of their businesses. Typically, divestments happen when a leadership team and board believe the market to be undervaluing their business, normally because there’s a part of it with significant growth potential that’s being undervalued because it’s attached to another part of the business with low potential. This is why J&J spun out the abysmally branded Kenvue, its slow-growing, low-margin consumer business, leaving J&J as a faster-growing, higher-margin, B2B business. The intent being that this will accelerate stock price growth, increasing the overall value of J&J.
There are so many other things we could talk about, but the final thing I want to point out is that external context is something that has a huge role to play. This is too complex to cover in detail, but one contemporary factor worth mentioning is the impact of interest rates. Put simply, the higher interest rates go, the more likely investors will park capital in a safe vehicle, earning a steady stream of interest. The lower they go, the more likely investors will shift capital toward riskier investments because they earn nothing by leaving money in the bank. This is a big reason why profitless corporations with big stories of future potential were supported by investors when interest rates were at zero. And why that support then evaporated when interest rates went up. In essence, investors decided that a riskless return right now beats a risky return that might or might not pan out in the distant future.
OK. So, now that we’ve set the stage, what is our role in all of this?
Hopefully, my description above will help us realize that company value is far from an exact science. Instead, it’s more of a fuzzy interplay, where financial narratives of current and past performance combine with stories of future potential to sway investor audiences in much the same way that narratives can sway other audiences.
As a result, we can impact both the performance and potential ends of the valuation narrative. This will be the focus of next week’s edition, but to whet your appetite:
At the performance end: Brands are moats.
For an investor audience, defining a brand as, for example, a promise is utterly irrelevant. What they need to know is that brands are moats. They are moats because brand strength mimics the effects of monopoly in situations where you don’t have monopoly power. Specifically, it provides both sustainable pricing effects (lifts you beyond commodity pricing) and sustainable volume effects (attracts more demand). As an aside, this is why the Interbrand “best brands” list is really the “biggest monopolists” list. It’s extremely hard to separate brand effects and monopoly effects. But this goes both ways: building a stronger brand will mimic the desirable-to-investors effects of monopoly.At the potential end: Positioning the corporation’s story.
In a similar fashion to how we position brands to appeal to customer audiences, we can also work to position the corporation for investors, specifically helping shape its story of potential. Now, this isn’t a magic wand you wave to double the value of the corporation, but it doesn’t need to. Even shifting a valuation multiple by a small amount, say from 8 to 9, represents a material impact and a potentially significant amount of money.
Next week, I’ll expand on the above with a bit more practical advice. I’ll also touch on why this is the real reason private equity (PE) companies are finally dabbling with branding in a meaningful way, how capital priorities dictate leadership, and why differing investor priorities can drive very different corporate strategies.
Watch this space. More to come.