Does Big Market Delusion Work?
One of the difficulties we face when valuing young companies or companies with new #businessmodels is our delusion of the big markets that these firms claim to serve when they arrive at their #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 delivery to #ridesharing and #EVs.
𝗗𝗼𝗲𝘀 𝗯𝗶𝗴 𝗺𝗮𝗿𝗸𝗲𝘁 𝗱𝗲𝗹𝘂𝘀𝗶𝗼𝗻 𝘄𝗼𝗿𝗸?
Let us take the instance of Zomato, that listed last year with a 𝗺𝗮𝗿𝗸𝗲𝘁 𝗰𝗮𝗽 𝗼𝗳 𝟵𝟬,𝟮𝟭𝟵.𝟱𝟳 𝗰𝗿𝗼𝗿𝗲𝘀 and whose EBIT was -41.6% but traded at 𝟰𝟬.𝟰𝘅 𝗘𝗩/𝗦𝗮𝗹𝗲𝘀. 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 𝘄𝗶𝗻𝗻𝗲𝗿 𝘁𝗮𝗸𝗲 𝗮𝗹𝗹 𝗺𝗮𝗿𝗸𝗲𝘁.
To substantiate how overconfident Zomato was in making this claim, I did a #dcf valuation of Zomato. I assumed the following:
1)Zomato’s operating margins stabilise at 11% when it matures as a firm.
2)Due to the #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 𝟭𝟱𝟬% 𝗖𝗔𝗚𝗥 𝗳𝗿𝗼𝗺 𝟮𝟬𝟮𝟭 𝘁𝗼 𝟮𝟬𝟮𝟲. Its 10-year CAGR from 2021 to 2031 is 81.03%. The food delivery market in India will grow at a 𝟮𝟴% 𝗖𝗔𝗚𝗥 from 2022 to 2026, implying that 𝗭𝗼𝗺𝗮𝘁𝗼 𝘄𝗶𝗹𝗹 𝗴𝗿𝗼𝘄 𝘀𝗲𝘃𝗲𝗻 𝘁𝗶𝗺𝗲𝘀 𝗳𝗮𝘀𝘁𝗲𝗿 𝘁𝗵𝗮𝗻 𝘁𝗵𝗲 𝗼𝘃𝗲𝗿𝗮𝗹𝗹 𝗺𝗮𝗿𝗸𝗲𝘁, which is absurd.
Fast forward to 𝗝𝘂𝗹𝘆 𝟮𝟬𝟮𝟮, when Zomato trades at 𝗥𝘀.𝟰𝟰.𝟮/𝘀𝗵𝗮𝗿𝗲 𝗮𝘁 𝘁𝗵𝗲 𝗺𝗮𝗿𝗸𝗲𝘁 𝗰𝗮𝗽 𝗼𝗳 𝟯𝟰,𝟰𝟴𝟭 𝗰𝗿𝗼𝗿𝗲𝘀 – 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 𝗭𝗼𝗺𝗮𝘁𝗼 𝘄𝗶𝗹𝗹 𝗳𝗮𝗰𝗲 𝗰𝗼𝗺𝗽𝗲𝘁𝗶𝘁𝗶𝗼𝗻.
𝗙𝗼𝗹𝗹𝗼𝘄𝗶𝗻𝗴 𝗮𝗿𝗲 𝗺𝘆 𝘁𝗮𝗸𝗲𝗮𝘄𝗮𝘆𝘀:
1)Young companies 𝗰𝗮𝗻𝗻𝗼𝘁 𝗱𝗲𝗺𝗮𝗻𝗱 𝗵𝗶𝗴𝗵𝗲𝗿 𝘃𝗮𝗹𝘂𝗮𝘁𝗶𝗼𝗻 𝗯𝘆 𝗳𝗼𝗰𝘂𝘀𝗶𝗻𝗴 𝗼𝗻 𝗧𝗔𝗠. Instead, they must justify how their business models will capture this growth.
2)Startups 𝗰𝗮𝗻𝗻𝗼𝘁 𝗱𝗼𝘄𝗻𝗽𝗹𝗮𝘆 𝗲𝘅𝗶𝘀𝘁𝗶𝗻𝗴 𝗰𝗼𝗺𝗽𝗲𝘁𝗶𝘁𝗶𝗼𝗻 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.