A version of this article was previously published on TKer.co.
In a podcast taped in June, Sparkline Capital’s Kai Wu spoke with NYU Professor Aswath Damodaran about SpaceX and how to value such a company.
At the time, Damodaran, aka “The Dean of Valuation,” had concluded that SpaceX was worth about $1.3 trillion, significantly below the $1.77 trillion valuation set at its IPO. (As of Friday, SpaceX was worth about $1.4 trillion.)
The conversation is interesting and wonky. If you want to nerd out a little, check it out on Spotify, Apple Podcasts, or YouTube.
While they focused on SpaceX, I thought Damodaran had some great quotes that spoke to the challenges of valuing any company.
“‘That’s a lot of assumptions you’re making.’ Yeah, absolutely. What choice do I have?”
In theory, a company is worth the present value of all its future cash flows. To put it more crudely, it’s all the money you expect the company to make after some adjustments for the fact that you won’t get much of that money until some time in the future.
The equations involved aren’t too complicated. It requires some understanding of accounting and how discount rates work.
What’s hard is getting all the inputs right.
You need to know exactly how much product the company will sell and what the costs will be. And you need to know what those numbers look like every year for the rest of the company’s existence, which means knowing if that company will last forever or when that company will eventually shut down.
Additionally, you have to know what the company’s capital structure (e.g., how much debt and equity financing it will use) will look like. Once you have that figured out, you have to know what interest rates for its debt will look like as well as what the premium to own its stock will look like — again, for the rest of the company’s existence.
If you get any of these assumptions wrong, you’ll have something that professional financial analysts call a “garbage in, garbage out” problem.
Now, the nature of these assumptions is arguably unusually uncertain with SpaceX and all of the speculative areas the company intends to explore. And Damodaran is aware.
“If your reaction as you look at my story and valuation is, ‘That’s a lot of assumptions you’re making.’ Yeah, absolutely,” he said. “What choice do I have?”
If you look back at history, I’m not sure you’ll find a single company whose future path was easily predictable, especially considering the swings in the economy, the shifts in consumer interests, and the direction of technology.
And by the way, when’s the last time you heard about an interest rate or stock market forecaster nailing it year in and year out?
But to Damodaran’s point, analysts aiming to derive the value of a company have no other choice but to make a ton of assumptions, many of which are likely to miss the mark by a wide margin.
“Do you know what the biggest intangible is? Future growth.”
Wu’s podcast is called “The Intangible Economy.“
Damodaran leaned into the wordplay.
“Do you know what the biggest intangible is?” he asked. “Future growth.”
A company’s assets can be divided into tangible assets (e.g., real estate, factories, machines, inventory, cash, and cash equivalents) and intangible assets (e.g., patents, copyrights, trade secrets, and goodwill).
Intangible assets are often the target of skeptics who aren’t convinced by the values companies attach to these items. To be fair, it’s just very hard to assign a dollar value to something you can’t really touch or sell for scrap.
In the context of valuing a company, it’s worth emphasizing that the bulk of the theoretical value usually doesn’t come from what’s earned this year or even next year. It comes from all the money it’s expected to earn many years in the future.
This is critical to understanding why unprofitable companies can boast massive valuations. Investors aren’t betting on how much these companies have already lost and how much they’ll lose in the near future. They’re betting on what they’ll make down the road.
“If you’re numbers-bound, I’ll tell you up front: SpaceX looks awful as an investment if all you can focus on is what they have in their books,” Damodaran said.
Unfortunately, what SpaceX could do in the future won’t be found on a balance sheet.
“My definition of intangible is you can’t see it,” Damodaran added.
It’s no wonder people struggle when investing in the stock market, especially when it comes to stocks in new industries.
“It’s like having a kindergartner’s report card and extrapolating from that what they’ll be doing in college.”
One of the first things Damodaran asks students taking his valuation class is, “What are you more comfortable with: working with numbers or telling stories?”
He’s observed that numbers-oriented students tend to become traditional financial professionals like bankers and value investors. Meanwhile, the storytellers go on to be venture capitalists and founders.
He doesn’t necessarily think one approach to finance is more right than the other. Rather, he believes if you’re too entrenched in one camp, you’ll miss a big part of what goes into a well-thought-out valuation.
For example, he noted that the numbers-oriented folks tend to overemphasize current financial statements to a fault.
“The analogy I would offer is this: It’s like having a kindergartner’s report card and extrapolating from that what they’ll be doing in college, which is essentially what you’re getting with the SpaceX financial statements,” he said.
By the way, nothing is stopping SpaceX from pivoting its business strategy in big ways as the business environment evolves.
And that wouldn’t be unprecedented. Almost every major successful company makes big changes that aren’t mapped out in any prospectus. Apple, Alphabet, Microsoft, Amazon, and Meta Platforms all earn billions every quarter from businesses almost no one imagined they would be in.
The big picture 🖼️
All of this speaks to the challenge of picking stocks.
It’s just not enough to know the ins and outs of a company’s flagship offerings and the customers it sells to.
You also need confidence that management will reallocate capital optimally as business opportunities evolve.
On top of all that, history also shows that most companies fail to evolve and execute in ways that generate worthwhile stock returns.
That said, I think it’s a worthwhile exercise to build financial models in an attempt to estimate a company’s valuation. Among other things, it helps you understand what the company’s current price implies about future expectations. But don’t be surprised to learn the assumptions you make in the modeling process prove to be way off.
A version of this article was previously published on TKer.co.