A Panoramic Look at the Corporate Life Cycle

Aswath Damodaran has written extensively about corporate finance, valuation, and investment philosophies.  He brings it all together in his most recent book, The Corporate Life Cycle.

In the first chapter, “The Search for a Unifying Theory,” Damodaran says that the quest for a universal theory is a common pursuit for researchers and practitioners in disparate fields, which often leads to overreach and bias.

He then gives a concise guide to the progression of similar efforts in the three major strands of research in finance:  foundational economic theories, data-driven models and theories, and behavioral models.  None of them have provided a “comprehensive pathway to explaining market behavior, but each offers promise with regard to some aspect of it.”

Not quite a unifying theory, Damodaran uses the corporate life cycle (a concept more common to research in management and strategy than to finance) as the organizing principle for the book, writing that “while it is neither new nor the answer to all questions in finance, it has a surprisingly comprehensive explanatory power.”

The basics

Damodaran begins by describing the phases of the life cycle — start-up, young growth, high growth, mature growth, mature stable, and decline — and summarizes for each phase the business challenge, the financial picture, and the capital and ownership challenges.  From there he looks at variations in the dimensions of the life cycle (length, height, slope, and time at the top), as well as issues like competitive advantage, the trend to shorter life cycles, and the disruptors and disrupted.

The opening section concludes with a look at the key transitions from one phase of the cycle to another.  The remainder of the book uses the concepts laid out to look at the life cycle from different points of view:  corporate finance, value and price, investing philosophies and strategies, and managing a firm.

Corporate finance

Throughout the book there are more than a dozen illustrations that summarize developments across the life cycle.  Here is one that outlines the key emphases for corporate finance policies (investing, financing, and dividend/buyback) at each stage:

As with the other topics that are covered, Damodaran offers an in-depth look at the key principles involved in corporate finance, provides data to support the analysis, and gives practical examples.

For instance, the financing section looks at corporate choices regarding the use of equity or debt:

The choice of borrowing money or using equity in many businesses is still driven by what I label as illusory reasons, some in debt’s favor and some against it.

These illusory reasons are used by firms across the lifecycle and often explain seemingly inexplicable choices made by firms at each stage.

An exhibit featuring those illusory reasons is followed by one that summarizes “the real factors,” the financial trade-offs that should drive decision making.

Unfortunately, a major factor in financing policy is what Damodaran calls “me-too finance,” whereby important decisions are shaped by a peer group assessment, despite the fact that it’s all too common for companies to use peers that are only superficially similar.  Copying what others are doing might lower career risk, but it is not the way to set an appropriate policy.

Value and price

The dance between value and price is what drives markets.  Best known for his valuation work, Damodaran first lays out the process for valuing a company and then deals with the pricing of companies by investors, all the while referencing how each of those processes changes across the life cycle.

The author of an earlier book called Narrative and Numbers, Damodaran has always stressed that a good valuation is “a bridge between stories and numbers,” that to estimate the drivers for a valuation, you need a narrative about the business in question.  Here’s a summary of how the mix of narrative and numbers changes across time:

In Damodaran’s view, “the best valuations are parsimonious, relying on a few key inputs,” and he warns against doing probability distributions on too many variables.  He recommends a five-step process:

1) Tell a story

2) Run the 3P test (Possible? Plausible? Probable?)

3) Convert the valuation story into valuation model inputs

4) Value the business

5) Keep the feedback loop open

The last step is very important since it is “easy to develop blind spots and get attached to your own stories.”  Those who have followed Damodaran across the years have seen how he is much more willing to rethink his valuation assumptions than the typical analyst is.

Estimation challenges are different at each stage of the life cycle.  An analyst needs to arrive at a valuation that makes sense given the available numbers and the narrative she thinks best describes where the company is and will be.  All the while, the market is providing signals of its own:

Value is determined by cash flows, growth, and risk, and the discounted-cash-flow approach tries to bring these determinants into an estimate of the value of the business today.  Price is determined by demand and supply, and while the fundamentals (cash flows, growth, and risk) may be drivers of price, mood, momentum, and liquidity all play key roles in the pricing process.

Those dissonant perspectives provide dilemmas for investors.  From the section on high-growth companies:

Much as I would like to preserve the myth that intrinsic valuation is an exercise where the market price never intrudes, the reality is that once you value a high-growth company and come out with a value that is very different from the price, there will be the temptation to “play” with the inputs until the value converges on or at least gets closer to the price.

Pricing and valuing along the life cycle:

Among the case studies in the book is one about Tesla, for which Damodaran has published a number of valuations since 2013.  For the core valuation inputs, he gives a series of possible future values, attaching to each one the scenario that would make it probable.  So, for example, expected revenue numbers for 2032 range from $100 billion (Tesla as a “luxury winner”) to $1 trillion (“Tesla Winner-Take-All,” with almost all cars globally being electric and Tesla having 40% market share).  There are similar analyses for operating margins, reinvestment, and cost of capital.

Then comes “The Musk Effect,” in which there are three states:  Elon Musk as a Negative Force (a discount “to reflect value lost due to distractions”), as a Neutral Force, and as a Positive Force.  Recent events have shown that including this element — to account for “the sheer unpredictability of Mr. Musk” — was prescient.  Just in the last few months we’ve seen the stock explode higher because of Musk’s emerging influence on the new administration and then crater due to his questionable behavior in his seat of power and the ripple effects on Tesla sales around the world.  While in one sense those moves fall into the pricing category, Damodaran astutely identified an unusual valuation variable to incorporate into his analyses.

Investing philosophies and strategies

Investors with much different approaches have one thing in common:

Underlying every investment philosophy is a view about human behavior.

In categorizing investment philosophies, two of the key parameters are market timing versus security selection and investing versus trading (“If you play the pricing game, you are a trader, and if you play the value game, you are an investor”).  Regarding the standard categorization of value investing versus growth investing:

Put simply, the contrast between value and growth investing is not that one cares about value and the other does not, but is where in the company the investor believes the “value error” lies.

Walking through the life cycle, Damodaran covers a range of investment strategies, providing evidence about their effectiveness and observations about the gaps between theory and practice.  For instance, in venture investing, pricing mistakes tend “to spiral up and down the pricing chain,” so that “one new round of overpricing or underpricing can spawn many more rounds of overpricing or underpricing.”  (That “me-too” behavior in corporate finance?  It’s endemic among professional investors.)

In the growth stage, earnings forecasts and revisions drive most results, so being better at estimating earnings is a differentiator.  However, somewhat surprisingly, Damodaran also says that macro forecasting skills are a determinant of success, something that few growth investors would claim as part of their approach.  But recessions blow up earnings projections, so his assertion makes sense.

Value investing has seemed to be lost in the wilderness for quite a while, at least in terms of relative performance.  Damodaran analyzes four explanations (or excuses) he has heard — “This is a passing phase!  The Fed did it!  The investment world has become flatter!  The global economy has changed!” — and provides prescriptions for responding to those shifts.

He believes that “the troubles in value investing are deep” and can be summed up in this way:  “It has become rigid . . . It has become ritualistic . . . It has become righteous”:

Put simply, value investing, at least as practiced by some of its advocates, has evolved into a religion rather than a philosophy, viewing other ways of investing as not just misguided but wrong and deserving of punishment.

Managing

In the preface of the book, Damodaran writes:

The most destructive acts in business occur when companies refuse to act their age, behaving in ways that are incompatible with where they are in the life cycle and often spending large sums in this endeavor.

That theme pervades the section on managing a firm, which looks at each stage in the life cycle, identifying the most important roles that management needs to play, from “Steve the Visionary” to “Larry the Liquidator.”  Having the wrong kind of CEO at a particular stage can be damaging and even fatal.  And, while the right thing for a company to do is to “act its age,” there will be plenty of contrary advice:

Management consultants and bankers generate a large portion of their fees from their capacity to convince companies that they can reverse the aging process and getting them to act on that belief.

While Damodaran argues that acceptance of where you are is usually the best option, in some cases renewals, revamps, and rebirths actually succeed.  The odds are long, but those are the stories that get told and retold.  Conversely, when the grand plans fail, there are usually steep falls, leading to sudden death or zombieland.

The book closes with some “serenity lessons” for managers.  Among them:

As the owner or manager of a business, you need to assess, given where the company is in its life cycle, whether you should be playing offense or defense and, if the latter, the competitive advantages or moats that you will be defending.

And some lessons for investors too, including:

Choose the game that you want to play, with a sense of why you think you can win at that game, and stop deluding yourself.  In short, if you are trading, don’t masquerade as an investor or talk about value, and if you are investing, stay clear of pricing plays.

Communication lessons

Damodaran writes from the first person, with a clear point of view.  He always sets up his intentions at the start of a section (“I will . . .”), reviews what has been covered at the end (“I have . . .”), and makes similar contextual references throughout.  The reader is never lost.  (That approach fits with the recommendations of another professor, Patrick Henry Winston, in his excellent book Make It Clear: Speak and Write to Persuade and Inform.)

The power of repetition can be seen in the use of the many life cycle graphs that were included.  Each dealt with a different topic, but the cumulative effect reinforced the thesis in an atypical way.

The book is packed full of charts, but many of them serve as reminders that it is much harder to discern complicated graphs when they are presented in grayscale.  A color insert that repeated some of the illustrations drove home that point.

Recommendation

It is difficult to communicate in a short review the depth and breadth of material found in the book.  Damodaran has written an essential guide for newer analysts that weaves theory and practice together — and reveals analytical and behavioral challenges that they must face.

Experienced investors can benefit from reading it too.  Like other good books on research and investing, it can serve as a useful guide to check in on investment processes, which can get stale over time.

Taking the framework laid out by Damodaran, an analyst could map the positions of his companies along the life cycle and evaluate how they stack up.  Which ones aren’t acting their age?  Are they susceptible to the pitfalls common in the phase they are in?  How are they valued and priced (and why)?  What kinds of investors are moving in or out?  (Portfolio managers could go through the same exercise for their holdings.)

Finding new angles of inquiry — or repurposed ones — is an essential part of analysis.  Aswath Damodaran has done so in a comprehensive way.

 

Damodaran’s website is a gold mine.  The images from the book used here can also be found in a posting on the corporate life cycle from his blog (which is now available via Substack too).  Also on the site are information from his courses at NYU, datasets, online tools, podcasts, and YouTube videos.  One set of 21 videos explores the corporate life cycle.

An upcoming essay on this site will consider the life cycles of investment organizations.