What Does Aswath Damodaran Say About Valuation Models?

 Aswath Damodaran ( Professor of Finance at the Stern School of Business at New York University) mentions,  that " Your understanding of a valuation model is inversely proportional to the number of inputs required for the model" what does that mean though?

*Link To the PPT Of One Of His Classes* 

Damodaran’s observation underscores an important principle in valuation: 

The simplicity of a model often enhances its clarity and understanding. When a valuation model is straightforward, requiring fewer assumptions and inputs, it becomes easier to comprehend the fundamental drivers of value. On the other hand, models that demand numerous inputs, many of which may be estimates or prone to error, become more difficult to interpret. The complexity can obscure the underlying relationships between variables, making it challenging to assess how changes in one factor impact the overall valuation.

For instance, a basic discounted cash flow (DCF) model, which relies on a few key inputs such as projected free cash flow, growth rates, and a discount rate, is more transparent and accessible than a highly intricate model that incorporates numerous adjustments and assumptions. The latter can obscure the true dynamics at play and increase the likelihood of errors or misinterpretations. Damodaran’s insight highlights the value of simplicity, suggesting that the more inputs a model requires, the less likely one is to fully grasp its core logic. Ultimately, this advocates for streamlined models that remain effective tools for analysis rather than becoming opaque systems of complex numbers.

He also talks about the "Bermuda triangle of valuation":

Damodaran’s concept of the “Bermuda Triangle of Valuation” serves as a metaphor to illustrate a critical and challenging aspect of valuation models, particularly discounted cash flow (DCF) analysis. In this context, three essential inputs interact in a manner that can render the final valuation highly sensitive, and at times, unpredictable.

3 Critical Components-

Discount Rate: This represents the rate at which future cash flows are adjusted to reflect their present value. Even minor variations in the discount rate can lead to significant changes in the valuation, particularly due to its role in the exponentiation of cash flows that are projected far into the future.

Terminal Growth Rate: A substantial portion of a Discounted Cash Flow (DCF) valuation often stems from the terminal value, which accounts for the value beyond the explicit forecast period. Therefore, assumptions regarding long-term growth are vital. Even a slight alteration in the terminal growth rate, especially when it is close to the discount rate; can result in considerable shifts in the valuation outcome.

Reinvestment/Return on Capital: The extent to which a company reinvests its earnings and the effectiveness of those investments (reflected in the return on capital) are key factors in projecting future growth. This variable is also subject to uncertainty, and inaccuracies here can amplify the impacts of assumptions related to the discount rate and terminal growth rate.

So, Why Is Like a Bermuda Triangle?

Similar to the Bermuda Triangle, which is infamous for unexplained disappearances, this 'valuation triangle' operates under a similar principle. Even small miscalculations or minor variations in any of the three key factors can result in significant, and often unexpected, shifts in the final valuation 

Interdependence: A high terminal growth rate coupled with a low discount rate can produce an unrealistically large terminal value. Even a slight modification to either parameter can cause significant fluctuations in the overall valuation.

Sensitivity: Given that the terminal value often constitutes a substantial portion of the total valuation, any uncertainty in the underlying inputs can undermine the precision of the model. This dynamic can obscure the clarity of the analysis, similar to a ship navigating through a storm.

Complexity vs. Simplicity: Damodaran emphasizes that models relying on numerous inputs, particularly within this sensitive "triangle," can become opaque. As the complexity of interactions increases, it becomes more challenging to pinpoint which assumption is driving the outcome, thus diminishing the reliability of the valuation. 

The Lesson: 

Damodaran’s advice underscores the importance of maintaining simplicity and transparency in valuation models. It is essential to focus on the most critical inputs while exercising caution with the assumptions that fall within the so-called "Bermuda Triangle." A significant portion of the final valuation often stems from the terminal value, which is highly sensitive to both the discount rate and growth assumptions. Overcomplicating this aspect of the model can result in seemingly precise outputs that are, in reality, based on assumptions fraught with uncertainty. A clear understanding of this triangle and the inherent uncertainties it entails is crucial for developing robust and dependable valuations.