Does Big Market Delusion Work?
One of the difficulties we face when valuing young companies or companies with newย #businessmodelsย is our delusion of the big markets that these firms claim to serve when they arrive at theirย #TAM (Total Addressable Market). As a result, investors/VCs justify high pricing for these companies by pointing to their TAM. We have observed this phenomenon in Food deliveryย toย #ridesharingย andย #EVs.
๐๐ผ๐ฒ๐ ๐ฏ๐ถ๐ด ๐บ๐ฎ๐ฟ๐ธ๐ฒ๐ ๐ฑ๐ฒ๐น๐๐๐ถ๐ผ๐ป ๐๐ผ๐ฟ๐ธ?
Let us take the instance ofย Zomato, that listed last year with a ๐บ๐ฎ๐ฟ๐ธ๐ฒ๐ ๐ฐ๐ฎ๐ฝ ๐ผ๐ณ ๐ต๐ฌ,๐ฎ๐ญ๐ต.๐ฑ๐ณ ๐ฐ๐ฟ๐ผ๐ฟ๐ฒ๐ and whose EBIT was -41.6% but traded at ๐ฐ๐ฌ.๐ฐ๐
๐๐ฉ/๐ฆ๐ฎ๐น๐ฒ๐. Investors justified this high pricing due to the TAM that Zomato was serving and the confidence that Zomato would capture most of the TAM. In effect, Zomato positioned itself in a ๐๐ถ๐ป๐ป๐ฒ๐ฟ ๐๐ฎ๐ธ๐ฒ ๐ฎ๐น๐น ๐บ๐ฎ๐ฟ๐ธ๐ฒ๐.
To substantiate how overconfident Zomato was in making this claim, I did a #dcfย valuation of Zomato. I assumed the following:
1)Zomato’s operating margins stabilise at 11% when it matures as a firm.
2)Due to theย #networkeffects, its asset turnover ratio will improve as the firm needs to reinvest less for its high growth.
Then, i varied the revenue growth rate (using Solver in excel) until i arrived at the market cap.
In 2021, at a market cap of 90,219.57 crores, Zomato needed to grow at a ๐ญ๐ฑ๐ฌ% ๐๐๐๐ฅ ๐ณ๐ฟ๐ผ๐บ ๐ฎ๐ฌ๐ฎ๐ญ ๐๐ผ ๐ฎ๐ฌ๐ฎ๐ฒ. Its 10-year CAGR from 2021 to 2031 is 81.03%. The food delivery market in India will grow at a ๐ฎ๐ด% ๐๐๐๐ฅย from 2022 to 2026, implying that ๐ญ๐ผ๐บ๐ฎ๐๐ผ ๐๐ถ๐น๐น ๐ด๐ฟ๐ผ๐ ๐๐ฒ๐๐ฒ๐ป ๐๐ถ๐บ๐ฒ๐ ๐ณ๐ฎ๐๐๐ฒ๐ฟ ๐๐ต๐ฎ๐ป ๐๐ต๐ฒ ๐ผ๐๐ฒ๐ฟ๐ฎ๐น๐น ๐บ๐ฎ๐ฟ๐ธ๐ฒ๐, which is absurd.
Fast forward to ๐๐๐น๐ ๐ฎ๐ฌ๐ฎ๐ฎ, when Zomato trades at ๐ฅ๐.๐ฐ๐ฐ.๐ฎ/๐๐ต๐ฎ๐ฟ๐ฒ ๐ฎ๐ ๐๐ต๐ฒ ๐บ๐ฎ๐ฟ๐ธ๐ฒ๐ ๐ฐ๐ฎ๐ฝ ๐ผ๐ณ ๐ฏ๐ฐ,๐ฐ๐ด๐ญ ๐ฐ๐ฟ๐ผ๐ฟ๐ฒ๐ย – A decline of 162% from its listing. The market has priced Zomato will grow at 66% CAGR (23% correction) for the next ten years, implying that ๐ญ๐ผ๐บ๐ฎ๐๐ผ ๐๐ถ๐น๐น ๐ณ๐ฎ๐ฐ๐ฒ ๐ฐ๐ผ๐บ๐ฝ๐ฒ๐๐ถ๐๐ถ๐ผ๐ป.
๐๐ผ๐น๐น๐ผ๐๐ถ๐ป๐ด ๐ฎ๐ฟ๐ฒ ๐บ๐ ๐๐ฎ๐ธ๐ฒ๐ฎ๐๐ฎ๐๐:
1)Young companies ๐ฐ๐ฎ๐ป๐ป๐ผ๐ ๐ฑ๐ฒ๐บ๐ฎ๐ป๐ฑ ๐ต๐ถ๐ด๐ต๐ฒ๐ฟ ๐๐ฎ๐น๐๐ฎ๐๐ถ๐ผ๐ป ๐ฏ๐ ๐ณ๐ผ๐ฐ๐๐๐ถ๐ป๐ด ๐ผ๐ป ๐ง๐๐ . Instead, they must justify how their business models will capture this growth.
2)Startups ๐ฐ๐ฎ๐ป๐ป๐ผ๐ ๐ฑ๐ผ๐๐ป๐ฝ๐น๐ฎ๐ ๐ฒ๐ ๐ถ๐๐๐ถ๐ป๐ด ๐ฐ๐ผ๐บ๐ฝ๐ฒ๐๐ถ๐๐ถ๐ผ๐ป as well entry of new players and how competitors can spoil their growth projections.
Finally, we need to move away from pricing growth that ignores business models to fundamentals that focus on profitability.
Ultimately, the foundation of business is generating cash, and young companies have to focus on the path to profitability to justify their pricing.