Gone with the wind

Just when I thought I have been writing quite a bit on valuations and should take a break comes the news of another (among many others, in India and elsewhere) valuation creating close to a unicorn ($ One billion) out of an extremely ordinary, simple, laborious  business. In fact, almost all such valuations in recent times are all simple businesses and so many valuations seem to have no relation to published figures of business (both revenue and profits) that I wonder what logic is at work.

Increasingly, value seems more a figment of imagination than reality. So much value has been lost owing to flights of fancy since the birth of the commercial use of the internet that it is difficult to believe otherwise even as students of accounting and finance are taught that valuation is based on a credible process. These students must be bewildered at these valuations of unlisted start-ups and IPOs as they seem to defy all that students were taught, which is that typically (projected) cash flows are valued. The logic is that any recovery of what is invested hinges upon cash being generated in business, adjusted for time value, so that you compare apples and apples.

Accepted madness

At some stage, it became acceptable to take a certain multiple of the revenue as the valuation. Many investment bankers took between one to one and half times the revenue as the reasonable figure. No one asked why. After all the valuation was an exercise done by investment bankers putting together deals and they would know what they are doing! In the mid-90s, in India, there was the famous merger of Hindustan Lever Limited (it was then HLL not HUL) and TOMCO (Tata Oil Mills and Company) which manufactured the famous Hamam soap. The valuation was an average of three independent figures – average of the stock price of the preceding six months, projected income and asset values – with equal weightage given to the first two and a half of that to the third, resulting in a 2:2:1 ratio. For reasons no one could understand, this weighted average became the standard reference point for valuations since then. I am reminded of what George Bernard Shaw said in another context: fashion is accepted madness!

And madness it must be when valuations pose a challenge to any standard of measurement. Perhaps, the good old law of supply and demand will help explain what is happening. The Wall Street Journal notes (December 29, 2021) in its title, “The $900 Billion Cash Pile Inflating Startup Valuations”, (https://www.wsj.com/articles/the-900-billion-cash-pile-inflating-startup-valuations-11640539562?mod=tech_lead_pos13). This is one of the characteristics of money: it has to find uses and when there is a lot of mobilized money chasing after potential uses, values will move up. One of the most popular forms of mobilizing funds is through SPACs – special purpose acquisition companies, “also known as a “blank check company”, is a shell corporation listed on a stock exchange with the purpose of acquiring a private company, thus making it public without going through the traditional initial public offering process” (Wikipedia). As the Journal notes, SPACS and venture capitalists (VCs) are going to pour in a lot of money ($900 billion) in early-stage firms in 2022 and beyond.

In an article titled BT 500: Will unicorns justify their high valuations? (https://www.businesstoday.in/magazine/bt500-indias-most-valuable-companies/story/bt500-will-unicorns-justify-their-high-valuations-312402-2021-11-17), Business Today offers a similar explanation based on liquidity, quoting Mohit Gulati, Managing General Partner, ITI Growth Opportunities Fund, who says that “The world has never been as hyper-liquid as it is today. Traditional companies have all moved up as much as they could. Valuations are very expensive across sectors and companies. It’s not possible to ascribe more premiums to some of the legacy traditional businesses, so where does the liquidity go next? It has to go into the unlisted market or those moving to the listed side. That’s exactly what is happening”.

Financial Times observes (October 21, 2021) that few venture capitalists are willing to pass on a deal, even if it looks expensive. “Private companies that get venture capital are seeing their valuations double with each round of funding, the biggest median increase since record began, according to PitchBook data. Last year, by contrast, the median step-up was a multiple of 1.5. The metric is obtained by dividing the company’s current valuation by the valuation it received in the previous round of funding” (https://www.ft.com/content/d88f8da5-bc10-4b8b-9561-0ceae5ac59fc).

Between fund-raising rounds

Let us look closely at this metric with an example. According to CNBC (March 14, 2021), “Online payments technology provider Stripe announced Sunday that it has raised a new $600 million round of funding that values the company at $95 billion — nearly triple its last reported valuation of $36 billion from April 2020, according to PitchBook data” (https://www.cnbc.com/2021/03/14/stripe-valued-at-95-billion-in-600-million-funding-round.html). The difference between two and three is huge, not just one! Forbes (November 18, 2020) observed that “Online learning platform Udemy announced today that it had raised an additional $50 million, boosting its valuation from the $2 billion it reported in February to $3.25 billion. The new round brings the San Francisco-based company’s total funding to more than $273 million. Bloomberg reported that the lead investor in the new round is Chinese tech company Tencent Holdings. Udemy’s news comes the same day that online language-learning app maker Duolingo announced its valuation had surged to $2.4 billion as a result of a new funding round. The pandemic has fueled investor interest in online learning. People stuck at home, many of them newly unemployed, are looking to learn new skills or at least pass the time in productive ways”. (https://www.forbes.com/sites/susanadams/2020/11/18/udemy-adds-more-than-1-billion-to-its-valuation-in-new-funding-round/?sh=239f77a12993). I am sure you can find many more examples.

My point is that valuation becomes an end in itself. One of the ‘logical’ explanations for the high valuations is that investors are betting on higher future revenues and are willing to pay for it. Some are willing to pay a ‘strategic premium’ if they wished to run the business. Such projections have to move upward between every round of fund-raising, which becomes the ‘basis’ for a higher valuation. Any reasonably informed reader can relate this to the many cases that we see in India. In effect, all that promoters have to ensure that such revised projections come across as credible. And this higher valuation allows existing promoters and investors raise funds by selling a lower stake, thus helping them retain control. Equally important, this opens up an exit route to existing investors who can, if they chose to, sell their stake to new investors. Or wait until the initial public offer (IPO). This is quite common. Please check how many recent IPOs are trading at, below or above their issue prices.

Everything is fair game because the intent is to keep adding to the ‘evidence’ about how extremely promising the businesses are with the result that a sustained orchestrated campaign becomes an integral part of this process. In fact, everything boils down to this: what is your story? How convincingly can you portray the fortunes in and of what you are selling? Franklin Templeton once warned that the most dangerous words in investing are “This time it is different”. But for those seeking valuation, this is the revered mantra!

Takeaways

Normally valuations are expected to follow a credible process

Astronomical valuations are explained more by liquidity than anything else

Focus is on valuations at the next round of funding

Convincing narratives hold sway and block out uncomfortable details