Price is what you pay, value is what you get
Warren Buffet, Berkshire Hathaway
If you have not heard of this person already, and are new to finance/investing, I would recommend him a listen: Aswath Damodaran. Not your usual professor, he is able to uncover interesting valuation methodologies for different types of companies.
In my stint as an Investment Analyst, it can be difficult to look at the hot, new technology companies IPO-ing one after another. There are no revenues. Expenses are through the roof, and the business models are so out of tune with traditional businesses. There is a reason why startups or tech companies have a burn-rate and ‘runway’ – take off, or face imminent crash!
But that is also the point – their approach is different, they are disruptive, and new. The metrics are different, and so are its operations, and way of doing growth. How does one do business valuation of a company when it does not even make money yet? Hang on, perhaps there is a way!
Not all businesses, and not all users are equal
We can start with an assumption that the way to value a ‘traditional’ business (gold miner) and a technology company is different. What is constant in both however, is cashflow per action.
What is cashflow per action? There are a few activities in business that really drives profit. For tech companies, here are some of them:
Uber: Makes money whenever a user hails a ride with its app. No money is made if the user does not open the app at all.
Facebook: Makes money whenever they sell an impression ad. Money is made regardless if the user logs in or not (and eventually drops off).
Netflix: Makes money whenever users subscribe to their plans.
Bread-and-butter Business Models
Technology companies typically sell subscriptions as services, commissions from transactions if they are a platform, or sell ads based off their user data. How these are implemented depends on the company’s unique proposition, and therefore have some in-built advantage if they have for example, high user stickiness compared to their competitors (TikTok vs Snapchat as an example).
How to start making sense of numbers?
There are three main components in modelling user-based valuations.
First: The Existing users, and the value attached to them
There is existing profitability based on how much revenue is being brought in. You can model the traditional Present Value of cashflows. Other things you can do are to see how loyal they are – you want repeat customers, and you also want them to bring their friends!
So we can come up with variables to define the renewal rate, the lifetime of each user (how long they stay), the grow in cashflow per user, and their uncertainty. We can then derive what the existing customer base should be worth. You will notice that revenues are important even for a tech company. Equally or even more important in some cases, is the growth of a user base.
Second: Future users, and their future value. Taking the above “snapshot” of current users, we can project out based on changing our variables, and over N number of years, what the expected user base should be like. This is closely followed by the costs involved in doing so, to acquire users (marketing, personnel costs for customer service, etc).
Third: Corporate “drag” – expenses in running the business. This you cannot run away from, but you can gradually decrease over time. As a technology company, incorporating scaleable techniques and technologies allow you to do more, with less. As such, the larger your volume/users/transactions, it should cost less to acquire new users or maintain existing ones. We will come back to this in awhile.
A user that stays on for 20 years, is worth a lot more than a user that uses for 6 months to a year. Thus the renewal rates matter in the valuation too.
How to model the cashflows?
In comparison with these three models, which is easier to model cashflows? Take Netflix. Steady user growth, steady increase in paying customers if they convert. However, you may also see this model tapering off as users have watched enough content, and flock to other sites (read: Amazon Prime).
Which of the businesses have higher growth potential? Uber or Facebook? Facebook, because as the user base grows, the ability to sell advertisements rises – think about how many audience segments, demographics and user data is being collected. Such rich data is essential for advertisers and publishers who can make tons.
So, poor Uber then? Well no, not exactly. They are still making money, albeit not as much. The kicker is in their long-term dynamics – if and only if self-driving comes about, they essentially have an automated taxi-force. However, there is a cap to that – how many cars can be on the road at once?
The Costs of Running A Technology Business Operation
There is also the cost of every day business, an operational expense if you will.
However you also have the cost of acquiring a user. And this is the magic in the technology company’s model – The value of a user differs! A user for Facebook may be worth more than a user for Uber. However, the acquisition cost may be lower, or higher! Think about it – how does Facebook go viral? It is easy to share the link, inviting your friends, and finding their friends and so on. How about Uber? It is mostly an individual ride, and perhaps a friend of two if you share some promotional coupons. Thus, it costs tremendously more to acquire a user at Uber, as considered to Facebook.
A user base as large as Facebook’s gives you a “Real Option” value. Imagine how many ads can be sold per hour to your different audiences in your larger user base.
Recall when we talked about how being larger allows economies of scale? If you can acquire users at a low cost, thats great. You would want to spend more to acquire larger users, as the user base is worth more when it is larger (multiplier effects – think of ads going into the thousands or millions of impressions).
So let’s dive deeper into Uber’s financials (circa 2016). We can use traditional “Income Statement” numbers, and upgrade it with our “growth metrics” stated above:
Taking Uber as an example. Cost of servicing existing users, and acquiring users are under operating expenses. However, it is difficult to draw conclusions if they are truly losing money, or spending money for future growth.
So there is a need to separate how much went into spending for the future, and how much they are actually losing, and this is definitely possible to do.
Taking the difference in user growth, the cost of servicing existing members. Estimate that it costs Uber $239 per user in 2016. Estimate that for overall expenses, 69% of every dollar went to servicing users. Is that a lot? Well it depends, because we can do comparables now!
If we use the same approach, we can model Uber vs Lyft (comparables in the same space), but we cannot do Uber vs Amazon. That needs a totally different approach. But at least we have a basic framework to valuing technology companies now.
Well one cannot just set a 10% year on year growth of revenues or users without incorporating elements of risk. Come 2020, technology companies are under intense scrutiny.
Facebook is getting lawsuit after lawsuit for data privacy. Google, for monopolisation and/or making free money off news publishers, Apple for similar reasons except the victims are App publishers. Uber and its rival Lyft, for classifying their drivers as non-employees, and thus saving a ton of personnel costs…The list goes on.
Now, if you were a fledgling startup, this is hard to do – you don’t have size, and your technologies are more or less the same as the larger companies. How do you differ? Why should investors put their money with you? I’ll cover this and more in the next series of posts.
View the full, excellent piece by Prof. Aswath Damodaran:
1. Profits are better than losses: If you are an investor in a business, you would rather that the business makes money than loses money
2. Young companies lose money: If you have a young company, you should expect the company to make losses, even if it is a valuable business
3. Not all losses are created equal: For young growth companies, dependent upon users or subscribers, there are good ways to lose money and bad ways to lose money.
4. Investor beware: To invest in these companies, you need to know why they lost money, not just how much
5. A company whose expenses are primarily fixed (will not grow with revenues) will be worth more than an otherwise identical company whose revenues grow as fast as costs (or not as fast!)
6. Not all growth types are equal. Rather have growing more intense subscribers, than just a user that does not monetize.
7. If everyone has low costs of acquiring users, competition kicks in.
8. Networking benefits: If you are already bigger, it is easier to grow. If networking effects kick in early, costs per acquiring user goes down quicker.