Damodaran, Narrative and Numbers

Even as flagging, high-profile hedge funds are looking for salvation in the quant world, academics are raising a red flag. Perhaps we’ve gone overboard in our efforts to reduce all financial activity to a set of numbers. For instance, Robert J. Shiller, in his presidential address delivered at the annual meeting of the American Economic Association at the beginning of this year, extolled the virtues of studying (admittedly quantitatively) popular narratives to understand economic fluctuations.

In Narrative and Numbers: The Value of Stories in Business (Columbia University Press, 2017) Aswath Damodaran, professor of finance at New York University Stern School of Business and a self-avowed numbers man, delves into the role of storytelling in the context of valuing businesses and making investments. Valuation, he claims, is a bridge between numbers and stories. “In effect, valuation allows each side to draw on the other, forcing storytellers to see the parts of their stories that are improbable or implausible, and to fix them, and number crunchers to recognize when their numbers generate a story line that does not make sense or is not credible.”

In the early chapters Damodaran looks at storytelling in general and business storytelling in particular. At issue is whether the stories a business tells (or the investor creates) are possible, plausible, or probable. Damodaran admits that “the lines between the possible, plausible, and probable are not always easy to draw.” He suggests instead thinking about the distinction between the impossible, implausible, and improbable, laying them out on a continuum of skepticism. “Impossible and improbable are quantifiable, the first because you are assigning a zero probability to an event happening and the latter because you are attaching a probability (albeit a low one) that an event will happen. Implausible lies in the muddled middle, since proving that it cannot happen is not feasible and attaching a probability judgment to it is just as difficult.”

Since Damodaran argues that “stories without numbers are just fairy tales and numbers without stories to back them up are exercises in financial modeling,” the core of his book deals with the process of connecting a plausible story to value drivers, using value drivers to estimate value (and, in reverse, extracting stories from existing valuations), and then, in a feedback loop, improving and modifying the narrative.

Damodaran illustrates his points in some detail using the examples of Uber, Ferrari, Amazon, and Alibaba.

The intended audience of Narrative and Numbers includes both entrepreneurs (and managers) and investors. With both groups the goal is to prevent wishful thinking from becoming expectation. Damodaran has carefully and convincingly developed an antidote to that financial poison.