Why valuations of Digital companies are more art than science?

Introduction

  1. Increase in M&A activity globally has pushed the valuation multiples of companies.M&A activity right now has become a seller market with more buyers vying for few quality assets.Technology companies are the major targets for acquirers due to demand for Digital capabilities. Hence companies offering services using latest emerging technologies like AI, Machine Learning and IoT have huge demand from acquirers.This has pushed the valuation of digital companies to all time high.Many digital startups have been receiving financing from Venture Capitalists at high valuation multiples.
  2. This has raised a pertinent question to all analyst/investors whether Digital companies are valued fairly or whether they are overvalued.With majority of Digital companies still not profitable or burning cash, huge valuations for these companies does not seem logical.Take the case an industrial conglomerate like GE which is a market leader.GE which incurred losses for 1st time in 50 years had their stocks lose around 70% of their value but a company like Zoom Video that is still not fully profitable are valued at 70X revenues.
  3. Traditional valuation models including Discounted cash flow are valued based on EBITDA multiples.The hypothesis is that companies with high EBITDA and steady growth will have better cashflows generating from its business.Such businesses have predictable cashflows and pose less risk to investors.This free cashflows generated after taking into account the Financing(CAPEX) and Operations(Changes in Working capital) would be returned to shareholders resulting in higher shareholder value.

Why traditional way of valuing company will not work for Digital?

  1. If traditional valuation techniques would be applied to new age Digital companies, then most of these companies will have extremely low valuations.Yet these companies are valued at premium.
  2. One of the biggest reason is way our accrual Financial accounting rules are set up.The definition of asset in a Balance sheet has changed.Previously, tangible assets like Plant, Machinery and servers are considered as assets as they are physical.These assets generate revenues for a long period of time.The expenses incurred to generate revenues are taken as Depreciation expense and is capitalized across the life of the asset.
  3. Most of the assets in the balance sheet of companies are intangibles.Digital companies spend money on R&D to build a platform that can be leveraged by customers.R&D expenses for building the platform cannot be capitalized as GAAP does not recognize intangibles as assets because it is difficult to predict that revenues can be generated from intangibles. Google spends a part of its budget on moonshot projects and not all these projects are successful. Most of these investments are written off as these projects does not give any revenues.This is the reason why Digital companies does not show profitability even though their Gross Margins may be high.Financial accounting rules ,not recognizing Intangibles as Assets prevents Digital companies to capitalize their R&D expenses.
  4. Digital companies major investments are in using technology to build platforms at scale.For this, one requires skilled resources.Many acquisitions are happening today to just access these skilled talent.These talent come at an extremely high price.These talent are used to build scalable platforms. As per Financial accounting, Employee costs is an expense and not an asset.Hence high employee wages are one of the reasons for low margins for Digital companies.
  5. In Financial accounting, Assets have a fixed life and their value declines over time.This decline in the asset value can be depreciated by the companies.In case of a Digital company, when the company platform matures and more customers use this platform, then the value of the platform increases.This is called Networking effect.For instance, Facebook platform is more valuable today that few years back due to the number of users in the Facebook network.More the users on a platform, the value of that business increases.

What is the best way to value a Digital company?

  1. As we have seen above, valuing a digital company using Financial accounting principles will provide the correct valuation of the business to a prospective investor.
  2. Hence it becomes important to do a qualitative assessment of the business.For instance, whether the target business is in a high growth market and what are the revenue drivers.Whether the business was able to capture a higher market share by acquiring customers through its services.
  3. Quality of the management and demand for services by customers are also vital indicators. The ability to increase the market share by adding as many customers as possible in its platform is also an indicator to value a business.
  4. In a digital company, few details like No of users in a platform, %increase in users YoY, revenue/user details can help the investor to identify if the company is doing well.This shall help investor to assess if the company value is increasing.
  5. Investments in R&D vs marginal costs to generate incremental revenues should be shared by business so that investor can assess if the business continues to invest money to update its service offerings.
  6. Switching costs for user in Digital platform.For instance, even though both Uber and Lyft are digital ride menberplatforms, the switching costs for a customer to move from Uber to Lyft is minimal. The situation changes when comparing Facebook with Snapchat where Facebook has higher customer stickiness compared to Snapchat.

Conclusion

  1. Valuing a Digital company is more art than science.Science behind the valuation is riddled with inconsistent application of accounting principles to intangibles.
  2. Hence valuing a Digital company is more of an art.Reviewing the revenue drivers and future growth prospects of digital targets by analyzing target management and the macroeconomic impact on the industry would require valuation experts that are intuitive and storytellers against number crunching analysts.


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