Valuation Narratives.

Adapted from Off Kilter, Editions 171 and 172.

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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. I will use examples of publicly traded corporations since there’s greater transparency and liquidity here, but the principles also apply 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 on the basis of 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:

1. 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. Its 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.
2. 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.

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 a corporation's ‘fair value’, 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:

1. Brand as moat
2. 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.