Start up Valuation - Bubble or Leap of Faith

Are the newly listed digital marketplaces at close to bubble valuations? or will growth justify the price you pay?
Zomato, Policybazaar, Paytm, Nykaa - how do you value these. all are down close to 43% on an average in 6 months.
Is it an end or a beginning of a beautiful new journey.
Unemployed? Salary cut - take it .

There is a lot of debate around start-up valuation. Some people say, it's crazy. some see multibaggers in them. One thing that can be said with certainty is that digital businesses will grow leaps and bounds. This growth has so far been driven by data penetration and booming digital payments system. 

Riding this wave, a host of companies have gone public. Companies like paytm, zomato, policybazaar, nykaa, etc encahsed this wave to raise large sums of money from ipo. Following picture shows the last 6 month performance of these digital companies.

On an average the prices are down 43% compared to 10% decline in nifty and sensex.

The question is - Is the market rational? 

You might argue that the market was irrational then or it is now. But if you were to believe the principles of benjamin graham, you would understand that the market is always right. Investing largely is a game of probabilities. There is no certainty in investing. More than 70% of the companies that went public since 2000 are now bankrupt or merged or got eaten up. You can pick any industry and you will find successes and failures. Look at retail. future retail once used to be the rockstar of india's retail with venture funded money and today is bankrupt. on the other hand, d-mart, without any venture funding is today a company worth more than a whoping 2 lac crore. Usually there are excesses in rapidly growing industries and people tend to inflate the prices of these assets. This has happened time and again. early 2000's tech companies were inflated. 2005-2010, real estate companies. Look at DLF. It encashed the real estate boom and came up with an IPO. The price back then in 2007 was 600 and today its share price is roughly 300 after 15 years. a massive destruction of wealth. 2015-2022-2023 i think is a similar time for e-commerce companies. We will come to why this happens in investing world and is very common. It is nothing new to inflate asset valuation. It is true that there are failures and that these investment can very well erode over time, but it is also true that some of these can be 100x in 10-5- even 1 year. So it is all a game of probabilities. I have explained this later in the article.

What's special about e-commerce.

Never in the history has it been possible for businesses to scale so rapidly. Imagine setting up a store in all cities/towns/villages in India. It is practically impossible and even if you attempt it, it will take a company 100's of years to achieve that. Flipkart / amazons of the world did that in less than 5 years. That's the power of digital and e-commerce. The opportunity is massive. The scale is just mind boggling. If you have a good product, you can practically reach out to millions of people within days. So one thing is for certain. It is a gold-mine. There is indeed a lot of gold and where there is gold, there will be blood. All sorts of people will come out with spades, JCB, Breaker machines, crane and if you are lucky enough, an army of bouncers, serial killers, bombs, missiles, and everything and anything to help you dig that gold. It is a dirty world out there. Competition is bound to happen.

That brings us to the question - what is in it for thou??

if you are an entrepreneur - there is no better time than this and there is no worst time than this.

Better for people who can tell stories, can get people to back you up, can supply you with the armoury to win the battle. People who can do this have been supplied with immense amount of muscle in the form of capital to go out and dig as much gold as possible - and ofcourse bring it back to them whatever gold they find and take a small percentage for the effort or risk taking abilities. 

Worse for people who did not want the backing of these VC/PEs for variety of reasons - say flexibility, righteousness, stress avoidance, not being money minded, or people who just said - "mujhse naa ho payega". For such people, i would say- stick around. do what you do. Focus on your work. After all that should drive you and not the result. Failure and success is again a game of probability and may not be completely in your hand. Keep driving with razor sharp focus.

If you are an employee?

You are probably the biggest beneficiary of all this. You are the ones whose salaries have gone up 200-300-500% in the last 3 years. My suggestion is - Ride the wave, encash it..but don't forget who you are..or rather who you were 3 years back. Don't immediately increase your lifestyle to the current levels. I would suggest - be atleast 2 years behind..meaning your lifestyle should increase with a lag of 2 years. behave and spend as if you are earning what you were earning 2 years back. Such irrational increases in salaries might not last and even worse, you might face unemployment or decline in salary. One thing I can say with experience is that people don't like reducing the luxuries or going down in life. It not only is difficult from a practical standpoint, but it kills you slowly in terms of your own mindset and your social status. It's always easy to increase and spend more, but almost impossible to reduce or spend less. Ask yourself - when the entire economy has grown by 10-15-20%, how has your salary become 3x. do you deserve it. If the answer is no - immediately start working on your skill set and better start deserving it before it is late.

Most important of all ..if you are an investor.. - how do you value such companies.

2 things drive valuation in the market. cash flows (say profits) and discount rate (the return investors want for investing in an asset)

I will explain this with an example.

Lets say there is an asset that provides me cash flow of 1 Lac next year and promises to grow at a rate of 6% every year. Let's say this is from the govt of india and promised cash flow has almost 100% certainty. So in that case, i will discount this cash flow by the risk free rate which lets assume is 8%. in that case the valuation of this asset comes out to be 100000/(8%-6%) = 50 lacs. 

So to acquire such an asset i would be willing to pay 50 lacs. If it is so simple, why can't everyone arrive at the same valuation. Why does stock market keep changing every minute and every day? This is where it gets interesting. Both these variables are moving all the time. Because we are talking about future cash flows. and nobody on earth can predict the future cash flows of companies. specially in the industries that are new and still exploring. like e-commerce. Even stable large companies find it difficult to predict future cash flows and are wrong most of the times. However the variation in prediction is what determines the outcome. Let's say if you were to predict future profits of ITC - You could most certainly predict with an error rate of 10-20%, but the same error rate for ecommerce would range wildly between 0 and 100%. That probably explains the differences in opinions and extreme movement in valuation - a decline of 43% in 6 months.

The best way for investors for such companies is to do a rough back of the envelope calculation. for example, zomato did a revenue of 4000 crore in last 12 months with a loss of 1200 crore. so i would create various scenarios and attach probabilities to it. Let's say we want to answer the question - what will be the worth of zomato 10 years down the line. Most mature businesses operate at 10% net profit margin. so if zomato was to be the one of the 2 players in this market, most likely both the players would be able to achieve 10% margin 10 years  later. so we come up with the following scenarios

Ofcourse in reality these scenarios are not finite. they are infinite and continous in the spectrum. But for simplicity if we were to come up with the back of the envelope calculations, the probability weighted valuation of zomato comes out to be 148000 crore 10 years from now. This brings us to the second piece of the puzzle. which is the discount rate.

As you can see the current value of zomato is about 80000 crore if you were to discount the valuation of 10 years later by the rate of 6% and declines by almost 17% if the discount rate goes upto 8% and declines by further 17% if it goes up by 2%. 

This probably explains the impact that the FED have had on the asset prices across the globe. This discount rate is usually calculated based on the US Risk free rate, country risk premium and the beta (riskiness) of an asset. 6 month's back US risk free rate (10 year treasury yield - check here for chart) was close to 1.2% which probable yeilded a discount rate as follows.

1.2% + equity risk premium of 6%  = 7.2% (assuming beta of 1 as there is no precedent or beta computation)

the same number has now gone upto 

3.3% + 6 = 9.3%. which is an increase of 2.1%. We have seen the impact on asset prices due to increase in required return and the sensitivity of it. This probably explains the recent decline in asset prices globally. What has happened is that there is an increasing realization that investors might have probably over-estimated the growth of these companies leading to series of downgrades, and at the same time requried return has increased due to FED tightening. It's kind of a double whammy situation currently.

Having said this, should you invest, or not, - i think it's still a probability game. Market is big, but competition will obviously be cut-throat. Spotting winners is the key. Pay attention to the details. Do your own math. If you are okay with taking the risks for higher returns, go for it. If you are risk averse and are ok to settle for lower but more assured returns, then invest in stable companies with deep MOATS.

Is it close to an end or there is more pain?

Frankly anybody's guess is just that - a guess. But my view is that it is just a start. The risk attached to these investments don't justify the probability of higher returns. I would invest in zomato at less than 25 per share (about 20000 crore valuation), i would invest in policybazaar at less than 200 per share (7000 crore valuation), i would not touch paytm with a stick, and nykaa maybe yes or maybe not at even such a valuation at Rs 130 (1/10th of current value and 1/20th of IPO listing value - valuation of about 7000 crore ). But then as i said, all of this is just a guess and personal opinion with some bit of probability and imagination. You need to do your own math and think for yourself. after all it is your hard earned money. Nobody can tell you what will happen next. If someone tries to do that, turn around and run.

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