When valuing corporations there is a tendency to heavily weight present performance on the ground that the past is decreasingly applicable and the future is increasingly uncertain. Yet as demonstrated by the Lindy Effect there is a good argument that longevity should be taken into consideration as an important value component.

A 50 Year Swordsmanship Challenge

In my very first kendo lesson in Tokyo in 1998 I was taught how to hold the shinai, a bamboo practice sword.

At first glance holding the shinai looks extremely easy. You simply take the sword in your left hand, grip it near the base of the handle with your pinky and ring finger and then close your other two fingers and thumb around the handle. Then you place your right hand on the handle of the shinai about the distance of a fist above the left hand, forming an imaginary straight line in the space between the thumb and the forefinger of both hands.

As I watched the sensei carefully demonstrate the proper technique, I asked how long it would take to master holding the shinai properly so I could move on to what I imagined to be the more challenging parts of kendo. The answer was a little longer than I expected: “50 years.”

This seemed to me to be an impossibly long period of time but having struggled to learn the basics now for more than 20 years I have come to the conclusion that the sensei only said 50 years to not discourage me on the very first day. In reality 100 years would probably be far short of the mark.

Part of the reason for this lies in the fluid minutae of swordsmanship mechanics. The way you hold the shinai and the pressure or slackness you use in different parts of your hands varies slightly based on whether and how you are attacking or defending.

Since there are countless ways that kendo matches can develop, the number of potential ways the shinai can be held is mathematically extremely high. Being exposed to each and every potential kendo match scenario and every way the sword can be manipulated would take a very long period of time.

The second and even more complicated reason why such a seemingly simple posture can take so long to master is that one can have many different states of mind when holding a sword and these states of mind can negatively affect one’s ability to see opportunities and take advantage of them. Remaining free from these states of mind in the emotionally charged midst of a challenging competition for many people takes much longer than mechanical sword posture proficiency.

The lesson in this for me has been how valuable the consistent practice of an art for many years can be because it results in knowledge that cannot be inferred from mere intellectual descriptions of what something is like. Surely the same is true in all activities, from making pizza to piloting an airplane to running a company.

Time and Valuation

In the area of finance time impacts the process of determining value in different ways. One of the most obvious ways is the application of the rules of depreciation in accounting which assume that the more objects age the less they are worth.

In the area of finance time impacts the process of determining value in different ways.

When valuing companies, one way to derive a company’s value is by applying a multiple to the company’s EBITDA. In the use of this valuation method, the company’s most recent financial performance is believed to be the most relevant for valuation purposes and the amount of years a company has been in business typically is not expressly taken into consideration.

A second way of deriving the value of a company’s business is by calculating the value of the company’s future free cash flows and then discounting the value of those free cash flows back to the present by a discount factor which theoretically is meant to represent the risks related to those future cash flows. So an investment in a guaranteed cash flow would be discounted at a very low discount rate and an investment in an experimental technology would be discounted at a high discount rate.

While there are different ways to model future cash flows, many people take the view that future cash flows are less valuable than present cash flows because they face greater risk and take longer to receive. Stated another way, the amount of time that a business will be running into the future is often not expressly recognized when analyzing the value of future business peformance.

The Lindy Effect

It is interesting to compare how the passing of time is viewed in traditional valuation approaches with the Lindy Effect. The Lindy Effect, a term which was coined by Benoit Mandelbrot, states in essence that the best predictor of how long something will continue to be used is how long it has already been used. This concept was named after Lindy’s, a chain of New York City restaurants.

The Lindy Effect states in essence that the best predictor of how long something will continue to be used is how long it has already been used.

There are several reasons why the Lindy Effect may hold true in business.

First is the power of habit. Any business activity is a collection of actions and many actions are based on habit. These habits can include ways of running a restaurant, relationships with clients and relationships with distributors. The longer a business activity succssfully continues, the greater the likelihood that good business habits will outweigh bad business habits. The longer good habits remain in place, the greater the likelihood that they will continue to strengthen.

Second, the street performer phenomenon. Once someone does something there is a tendency for other people to do the same thing because of the assumption that whatever is being done must be worth doing. As with watching street performers, as more people are attracted to an activity this attracts even more people.

This is a very powerful dynamic and often works to even eliminate well founded doubts that people have about how valuable the activity really is on the ground that “other people must know something that I don’t.” This reality and reasoning process of course heavily favors businesses that have been operating for long periods of time.

Third, there is simply the reality that the more that you do anything the more experience that you gain. This experience makes it more likely that you will have seen a range of situations and know how to react to them whether that involves taking advantage of opportunities or defending against risks.

Limits of the Lindy Effect

Of course the Lindy Effect is far from infallible as a forecasting tool and as an unfortunate illustration of this point, the last Lindy’s was closed down in 2018. Similarly many businesses and even industries that have been in existence for long periods of time can suddenly cease to operate effectively, be disrupted or fall into obsolescence.

It has to be pointed out, however, that the collapse of a long-standing business does not mean that all of the factors that drive the Lindy Effect (the power of habit, the street performer phenomenon and the power of experience) were not present. It simply means that these very strong factors were outweighed by negative factors. These factors cannot be overlooked in a valuation exercise.

Conclusion

When calculating value, it can be easy to fall into the trap of taking a limited view of the impact of time on what something is worth. It is important to take a flexible view of time and realize the passing of the years often leads to many positive and often self-sustaining trends and dynamics which strengthen busineses and help shield them from risk.

The photo for this article was taken from Unsplash. The photographer is Liam Pozz.