Volume 172: Valuation Narratives, Part Two.
Valuation Narratives, Part Two.
tl;dr: Influencing corporate valuations.
Last week, I talked about how, if we oversimplify and overgeneralize, business valuation is based on some combination of two things: A track record of business performance combined with a story of future potential. Summarized as performance and potential.
Young companies with little or no track record (e.g., early-stage startups) are primarily valued based on the scale of their potential. Older businesses with a long track record (e.g., blue chip stocks) are primarily valued based on their consistency of performance.
To understand how we might influence how investors value a company, the easiest baseline is to consider that investors are a stakeholder audience in much the same way that customers represent an audience. And, much like a customer audience, we can view investors in aggregate or through specific segments. In general terms, we can segment an investor audience through the lens of private capital (private equity, VC) versus public (listed on the stock market) scale, which runs from individual retail investors (you and I) right up to massive institutional investors (Fidelity, Calpers, etc.), risk tolerance, which runs from investors who are quite risk averse (retirement focused asset managers) to investors willing to take big risks (venture capital, angel investors, day traders), and time-horizon, which can run from high-frequency algorithmic traders buying and selling many times per second to long-term holders, that operate along multi-year time horizons.
As a result, just as customers have differing needs and priorities, investors do too. And just as heavily hyped products can move customers, investors can often be swayed by heavily hyped companies.
If anyone uses the platform formerly known as Twitter, this is why your timeline is now filled with Tesla boosterism, especially for its recent self-driving update. Almost certainly, the algorithms have been tweaked to boost Tesla posts in an effort to maintain Tesla’s market capitalization by appealing to its large retail investor base of Elon-stans.
All of this is to say that while much scientific and quantitative analysis goes into finding the ‘fair value’ of a corporation, there’s also a large element of subjectivity, emotion, and greed, commonly referred to as ‘animal spirits.’ This means that in much the same way we might think about positioning a brand for a customer audience in a competitive marketplace, we can use the same skills to position a company within the competitive marketplace for ownership.
In terms of influencing valuation, I want to focus on two things:
Brand as moat
The reframing of potential
Brand as moat
Economic moats have become a subject of much discussion among investors of all types. In simple terms, a moat represents a source of sustainable advantage that directly drives increased revenue, profitability, and growth. As a result, corporations that are perceived to have sustainable moats tend to achieve significantly higher valuations than competitors in ostensibly the same market or industry. For example, the ‘big 7’ that dominate public valuations are all perceived to have strong, sustainable, monopolistic moats. What’s interesting about this is that brand effects often mimic monopoly effects.
Over the years, I’ve realized that the problem we have in defining what a brand is is that we try to use singular definitions based on the customer when, in truth, it’s conceptual and audience-dependent. I’ll write more on this in a future edition, but I think it’s better to define brands cyclically. For the internal audience, the brand is what you stand for, which dictates your behavior and the experience you offer. For the customer audience, this translates into a desirable consistency of promise you should expect. And for the investor this translates into a competitive moat. This is a direct reason Apple can charge $1200 for an iPhone, while a similarly specced commodity Android might cost a few hundred.
As has been widely reported, one of the defining factors of the post-pandemic period is that corporations have used supply chain issues to raise prices beyond the increase in their costs, leading to record corporate profits while also contributing to increased inflation. While personally, I’m concerned about the cost of living crises high inflation creates, from a professional point of view, it has brought brand and marketing to the forefront of investor interest for the first time in a long time. Suddenly, investors see a direct link between brand strength, price premiums, and demand inelasticity. In other words, the stronger the brand, the higher the premium that can be charged, and the lower the volume loss to cheaper rivals. This can be further simplified as strong brand = higher profits = more valuable company. As a result, this is why major corporations like Coca-Cola are now having very serious conversations with investors about a renewed marketing model moving forward.
The investor context that matters most here is that brand effects mimic monopoly power in categories where you don’t have a monopolistic position. Since we know there’s strong investor appetite for rewarding monopolists with higher valuation multiples, there’s a direct narrative throughline toward brand strength driving a higher valuation. While I think unregulated monopolists should be broken up to reduce or eliminate abuses of market power (congratulations! You won capitalism, now let's break you up and rerun the game), building brand strength over time to achieve a similar effect is an entirely acceptable competitive dynamic. After all, being willing to pay more for one brand over another is voluntary on the part of the customer because they view it as a fair exchange of value (or else they wouldn’t buy), whereas, with a monopolist, you must use them no matter the cost because you have no other choice.
Thus, brands present an opportunity to influence the valuation narrative in one of two ways directly: 1/ Demonstrating the moat effects of the brand you’ve already built and how brand investments accelerate the performance of the underlying business, or 2/ Demonstrating how you are building your brand to create that performance accelerating moat, which informs your story of potential.
The Reframing of Potential
There are two types of stories of potential: the startup story that’s built new from whole cloth and the transformative story that seeks to reshape perceptions of an existing business. Rather than the whole-cloth startup narrative, I’m instead focusing here on how transformative stories of potential can reframe the valuation of existing businesses.
I’d further divide the reframing of potential for an existing business into three types: 1/ The inflection point narrative, typically connected to new and disruptive technology; 2/ The value transformation narrative, typically aligned to demonstrated investor priorities; 3/ The efficiency narrative focused on lowering costs to increase profits.
For each of these narratives, the goal is to position the corporation's potential in the minds of investors (and analysts) to influence their behavior in much the same way that we might consider positioning a brand with a customer to influence their behavior.
For examples of each of these in action:
Microsoft - Inflection point driven by disruptive technology
Microsoft has masterfully reframed its story of potential through generative AI as a disruptive technology. Positioning itself as the de facto leader in enterprise AI has led directly to it doubling market value from $2trn to $3trn.
Apple - Value transformation
In the value transformation camp, Apple historically doubled its market value by adding a layer of recurring subscription revenue via services. What’s notable here is that there isn’t a one-to-one relationship. Recurring services revenue makes up just 19% of Apple’s total revenue, but it drove a doubling of market capitalization. Why? Very simply because investors value the consistency of recurring revenues much more highly than the volatility of transactional revenues. As an aside, this is also why every automotive company wants cars to become subscription platforms. No consumer on earth wants to pay a monthly subscription for a warm butt in their $85k SUV, but it’s being forced upon them because the companies believe it will spike their value with investors.
Meta - Efficiency
In the efficiency camp, look no further than Meta. Here, Mark Zuckerberg first attempted to drive a disruptive technology narrative centered around dominating the nascent ‘metaverse.’ However, investors balked at the $30bn invested without any sense of there being a real business there. As the stock price tanked, Meta quickly pivoted to a much-heralded ‘year of efficiency,’ which was a 180-degree shift toward refocusing on increased profitability within the core business, which investors rewarded by buying the stock and significantly lifting Meta’s total market capitalization.
The challenge with the efficiency narrative is that its short-term, non-strategic, and beyond a certain point slips into diminishing returns as you mortgage your future on the alter of short-term gain before ultimately compromising product and service quality. As an egregious example of such cost-driven management in action, we have Boeing. For over twenty years, its leaders drove cost efficiency as its narrative, leading it to compromise safety before, ultimately, aircraft began crashing and falling apart in the sky. The irony is that an approach focused solely on short-term shareholder returns has destroyed long-term shareholder capital in direct conflict with the fiduciary responsibilities of the board and leadership team. (As an aside, the issue I have with the ‘profits are moral’ dogma crowd isn’t that corporations shouldn’t make profits. Of course they should. It’s that they believe the corporation has no other responsibilities, which, as Boeing demonstrates, is utterly nonsensical).
Now, if, like me, you’ve spent the bulk of your career helping corporations figure out better ways to create value for customers, it can be a shock to witness corporations engage in what appears to be obviously anti-customer behavior. However, if you understand the nature of ownership and what owners value, we can seek to overlay it with customer opportunity. Ideally, our job is to find the balance where value creation exists for both customers and investors, creating a virtuous cycle and positive forward momentum.
To give a quick generalization of how different ownership can drive differing strategic priorities and, thus, valuation narratives: In general terms, a VC-backed startup will be driven to grow as fast and as aggressively as possible, a private equity-owned company will be driven to reduce costs as far as possible to maximize profits, a public company will be driven to deliver consistent performance every quarter, and a privately held family company will take things slow and steady.
On the subject of private equity (PE), the pay-to-play tabloid trade rags have been heavily publicizing a recent spike in PE firms’ newfound focus on brand, marketing, and design as levers of value creation. The reason for this is simple: they paid more for the businesses in their portfolio during the ZIRP years than many are now worth. It’s impossible to cut costs far enough to make them worth more than they paid, and the way a PE business model works is to try and grow the value and then sell the business at a profit within a circa 5-year timeframe. Unfortunately for them, such exit opportunities have become harder as interest rates have risen. As a result, they’re being forced to focus on innovation and not just cost-cutting to lift performance value and craft more compelling and credible narratives of the business's future potential. In other words, everything I wrote about about brands as moats and narratives of potential, certain PE companies are now focused on in ways they haven’t in the past.
Anyway, thank you for bearing with me for the past two editions. I know that most people reading this aren’t focused on investor narratives at all, yet investors are critically important stakeholders who directly or indirectly influence everything we do. And in a feat of symmetry, can also be influenced by us by using many of the same techniques we use to influence customers.