Company valuation is one of the more recent iterations of the ancient human tradition of storytelling. Like all traditional narrative forms, it pits a protagonist (company managers) against a problem (how to generate profits) and details how they overcome the struggle. NYU professor Aswath Damordaran, widely recognized as a master of fundamental valuation, once wrote in a blog post that “[in] a good valuation, the numbers are bound together by a coherent narrative and storytelling is kept grounded with numbers.” The markets, then, are built on collective narratives, with each investor suggesting their own story arc as the invisible hand writes out the plot. A traditionalist and a futurist value the same company very differently. There is even a form of valuation “nihilism” – purely technical trading which rejects the concept of “intrinsic value.”

This may be an interesting metaphor, but there are in fact lessons to be drawn from the analogy. The first principle is that the plot must be coherent. In a financial sense, this means that the elements of a company narrative must ultimately match its core business model. Tesla is an excellent case study in this; they make money when people buy cars. This should put them in a similar stratum to companies such as Ford or Volkswagen, though admittedly they could be afforded a moderate premium as an electric vehicle producer. Instead, the market has frequently valued Tesla at staggering multiples of its industry peers. The reason for this is in no small part the narrative Elon Musk has built around himself and his company. Cars, even swanky electric cars, are not magical money printers – they cost money to make, and consumers are only willing to shell out so much to buy them. Even if Tesla were wildly successful in selling cars, it would have difficulty living up to the hype inherent in its valuation. That’s not to say Tesla is a bad company, simply that the narrative around the company (and, truth be told, around its founder) leads investors to believe its core business is not making cars.

That brings us to the second lesson: good business narratives do not always correspond to good business outcomes. Many Silicon Valley tech startups serve as examples of this; the bankruptcy courts are littered with companies whose “groundbreaking technology” would “disrupt entire industries.” These narratives need not be malicious to be damaging to value, and indeed few are intended to defraud (with a few notable exceptions). But the “genre” of technology company narratives tends towards fantasy. The extreme success of the “unicorns” has created a template for ambitious startups to model themselves after. As more and more companies mimic the methods of the highest fliers without replicating the quality of product which propelled them there, millions of dollars of venture capital have been thrown at wildly overpriced technologies, with calamitous effects for value. Investors bought into a good narrative that was not grounded in reality.

The third lesson of narrative valuation is that the details of the story are secondary to the main idea. At the risk of committing nerd heresy, The Lord of the Rings could just as easily have been titled The King of the Bling – that is to say, Tolkien had less to say about lords or rings than he did about courage, companionship, and compassion. The details of the story serve the narrative purpose. In the same way, a valuation is ultimately a story of how a company expects to generate returns for shareholders in the coming years – whether they accomplish that by efficiency improvements or new products is secondary to the fact that they generate returns. That is not to say that the method is unimportant – after all, a company that lays off workers to preserve margins is obviously in a very different situation to one who improves their margins with new products. But cash flow is the ultimate measure of whether a valuation story is worth investing in. If the company does not return enough cash for the level of risk taken, its story is not worth buying.

Even as humans use stories to make sense of the world as it was and anticipate the world as it will be, so investors use stories to predict the trajectory of a company’s growth and how much money it will return to its owners. Future-telling is a traditionally difficult business, and prudent students of valuation will always bring a measure of humility to their forecasts. By applying the principles of storytelling to valuation, investors build the context necessary for understanding how a company will generate value for them.