AI's Bar Mitzvah moment: Aswath Damodaran explains what AI means for businesses

While artificial intelligence continues to keep investors on the edge with advocates and skeptics at opposite extremes, Aswath Damodaran, widely known as the ‘Dean of Valuation’, highlighted that revolutionary change has been a constant through human existence and follows a cycle.

In his long blog post, Damodaran said the debate about AI has gone off the track with advocates and skeptics often talking past each other, with advocates focusing on its the technology’s alleged massive potential market, and skeptics zeroing in on massive upfront investments as too large. While the valuation expert does not attempt to prove any of the sides wrong, he attempted to move the discussion towards examining AI as a business, recognising that it is ground breaking, while also acknowledging that it has to be judged like every other business in history.

“In short, the AI optimists may be right about AI usage exploding in the future, but big markets don't always become big businesses, and the skeptics have to concede that spending a lot on capital expenditures raises the ante for businesses, but don't necessarily doom them to value destruction,” he wrote.

Cycle of revolutionary change

Damodaran noted that revolutionary change has been a constant through human existence. Even when the change has led to advancement of humanity, it has always come with pain for those whom the change renders obsolete and with unanticipated side costs. This comes as several analysts worry that AI will render several tech jobs obsolete, which in turn can lead to massive layoffs.

The valuation expert argues that every major disruptive change goes through four phases - a period of hope and hype, where the change is viewed as big, but it is unclear how and in what form it will be delivered, followed by a period of build-up, where a subset of people (with more belief in the change and more willingness to take risks) start investing and building products to make the change happen. Then comes a period of business building, where the change is monetized and businesses form, followed finally by a recalibration, where the change works its way through the economy and society, in both good ways (increased productivity and welfare, new businesses) and bad ways (displacement and damage).

Damodaran feels that the “big market delusion” may occur at the second phase, which is the investing build up. “That delusion has its roots in selection bias, where the people building products for the change to come tend not only to be true believers but also over confident, resulting in a collective over reach by companies and investors pricing these companies, and a correction,” he wrote.

Where does AI fall in this cycle?

OpenAI launched ChatGPT back in 2022, which got the hype cycle rolling, and social media amplified and accelerated that rollout, and its broad reach meant that almost everyone has seen it at work, according to Damdaran. He noted that it was not just financial market participants that saw its allure, as hyper scalers and new entrants invested hundreds of billions into AI capex, partly because they believed in its promise, but partly out of a fear of missing out

It is only in around the past one year where people are seeing the beginning of business building, where companies are being able to generate revenues from selling products made by the AI factory, with Anthropic and OpenAI as the most prominent examples, the expert said. Those revenues are small when compared to the massive sums of capital invested, and the profitability is still a far way to go, but there is a host of experimentation going on on model type (open versus closed), business models (subscription versus usage) and pricing, he noted. The seeds of disruption have been sown, and there are signs that AI's rise will make a significant dent in the profitability of some businesses, with technology companies in the software and intermediary segments being the first casualties, he warned.

“The AI story is clearly further advanced than it was a year ago, but it is still early, and there will be changes and challenges that face both the players in the space and the investors in these players, making this AI's bar mitzvah moment,” the valuation expert said.

(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of The Economic Times)