Business Valuation

Book Recommendations: Damodaran, Holthausen and Koller

Corporate or business valuation is a topic that is near and dear to the hearts (and bank accounts) of many of us, but how well do we really understand this complex topic? In my experience, not well enough, and so I think it is never too late to learn more. In today’s post, I would like to bring to your attention a few excellent books on corporate valuation from three sources: Professor Aswath Damodaran of NYU Stern School of Business, Professors Holthausen and Zmijewski of the University of Chicago Booth School of Business, and Tim Koller and colleagues from McKinsey & Co.

I have written before about the work of Professor Damodaran and I have recommended that students follow his blog, Musings on Markets. Professor Damodaran is a prolific writer on the topic of corporate valuation, and he kindly shares much of his insight and research free of charge on his website, Damodaran Online. I have read much that he has written, and though his various valuation books tend to recycle previously published material, I can generally recommend them all for serious students of corporate valuation.

Professor Damodaran’s book, Narrative and Numbers: The Value of Stories in Business was published in 2017, but I only came upon it recently based on a student recommendation. (Thanks Aristides!). I read the book this summer and I think that some of you may find it helpful. Many students struggle with the valuation of business corporations, but even those who have mastered the technical intricacies of DCF analysis and other valuation methodologies nevertheless have difficulty putting their valuation analyses into the context of a company’s overall strategy and competitive positioning (or vice versa). The financial numbers in a valuation model, and the resulting valuation, cannot be divorced from what is actually happening competitively and operationally in the business being valued. And yet this is what I see all too often when I review students’ valuation work. The numbers in the valuation model simply don’t tie to the business story being told. Hence Professor Damodaran’s book.

Think for example about the various stages of development of Uber. Uber’s business strategy and operating and financial metrics have changed dramatically since it launched operations in 2010 and so has the marketplace for its services. These changes need to be reflected in any Uber valuation model, not only in the historical results (provided for context) but more importantly in the assumptions about future results (used to drive the valuation). We also need to recognize that a single-point estimate of value, perhaps linked to a purportedly “base case” set of financial projections, is almost never accurate. And this is particularly true in sell-side investment banking, when “base case” often means “best case”.

We don’t really know with a high degree of confidence what the future financial results of Uber will be, although we have a better handle on this now than we did ten years ago. And so in valuing Uber we must consider various alternative future operating scenarios, which capture a realistic range of possible outcomes, and then value each of them. This sort of “scenario analysis” is fundamentally different from the “sensitivity analysis” which most students of valuation are familiar with. Scenario analysis looks at the financial implications for an array of different operating and/or competitive scenarios and comes up with a range of valuation estimates. By contrast, sensitivity analysis attempts to quantify the valuation impact of defined changes in specific drivers of value (eg terminal growth rate or WACC) for any given operating scenario. In the real world, scenario analysis is often the more important part of the valuation process, but it is also much harder to do and requires an extensive understanding of a company’s business. Sensitivity analysis by contrast is simply number crunching, which Excel can do for you; it is important but not in the same way as scenario analysis.

And this is where Damodaran’s book, Narrative and Numbers, comes in. In this book, Professor Damodaran explains how the numbers in a set of financial projections relate to the changing drivers of a company’s valuation: the size of its target market, its market share, operating margins, return on capital investment, etc. And he walks us through numerous real world examples, including Uber, Tesla and many other interesting companies. If you are not yet comfortable doing this sort of scenario analysis, linking the drivers of cash flow in your valuation model to what is happening (or expected to happen) in the company’s business or operations, then I recommend that you read the Damodaran book and spend some time with his detailed examples.

Those of you W&M students taking the new course on Valuation taught by Professor Agnew will be using as your text, Corporate Valuation: Theory, Practice and Evidence, Holthausen and Zmijewski, professors at the University of Chicago Booth School of Business. I have read this book at Professor Agnew’s recommendation and I thought it was outstanding. What I like most about this valuation text is that it is grounded in financial statement analysis more than in the academic theory of financial economics. The valuation examples in the text link to published financial statements of real companies, so students get much needed practice in financial statement analysis along with their valuation work. And this is how corporate valuation work is done in the real world; the goal is to come up with an estimate of intrinsic value, but we do this by manipulating accounting data reported in a company’s financial statements. If we don’t understand the business, we won’t understand the accounting. And if we don’t understand the accounting, we won’t be able to do the valuation. So to do corporate finance we need to understand both accounting and finance.

However, my number one book recommendation on the topic of corporate and business valuation remains Valuation: Measuring and Managing the Value of Companies, by Tim Koller and several of his McKinsey colleagues (7th edition due out in December 2021). Like Damodaran and Holthausen/Zmijewski, the McKinsey (Koller et al) book also links corporate valuation to what is happening in the company’s business, as reflected in the accounting data reported on the company’s financial statements. The McKinsey book also addresses other important valuation-related topics, including basic topics like capital structure and dividend policy as well as more advanced topics like leasing, deferred taxes and pension plan liabilities. I have asked numerous corporate finance practitioners, within corporations as well as investment banks, what valuation book they recommend to young people and the almost unanimous answer is McKinsey (Koller et al) on Valuation. So get this book. This will be the best $50 investment that you will ever make. Yes, better than cryptocurrencies!

And for those of you who are not pursuing careers in corporate finance, but who understand that you probably need to know more about business valuation than you do now, I can also recommend McKinsey’s condensed book on the topic, Value: The Four Cornerstones of Corporate Finance (Koller et al). I use Valuation in my advanced MBA corporate finance book, where we dig deeply into valuation, and I use Value in my undergraduate course on corporate financial strategy, where we focus mostly on related topics of financial strategy but don’t get deeply into the weeds of valuation per se. Reading Value will help you understand the conceptual framework of Economic Value Added (EVA), the theory that underlies all corporate valuation, without bogging you down in financial statement information and detailed valuation analysis.

So to summarize: For those of you pursuing careers in corporate finance, buy McKinsey (Koller et al) on Valuation, read it in installments, and keep it on your bookshelf for future reference. Or better yet start with Value (a very quick read) and then begin to tackle the more extensive material in Valuation. And when you have mastered McKinsey, check out some of Professor Damodaran’s work, including Narrative and Numbers. And for the rest of you, read McKinsey (Koller et al) on Value. I promise that you will not regret it.