New Valuation Metrics For Tech Companies, In Addition To Spotify
May 31, 2018
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There is a really former proverb inwards markets - that the iv most unsafe words inwards the English linguistic communication language are 'this fourth dimension is different', together with that is peculiarly truthful when the bulls start advocating for the piece of job of novel valuation metrics over tried together with tested favourates, every bit prices outrun anything remotely resembling what tin hold upwards justified yesteryear the old. This form of soothsaying is long discredited for adept argue - is has often accompanied major marketplace position tops, together with been revealed to take keep been folly inwards the cold, sober calorie-free of the ensuing bust.
However, amongst that context together with caveat firmly inwards mind, I believe a audio declaration tin even together with so hold upwards made that the economic science of select (and yesteryear no way all) new-era software businesses truly are fundamentally different to old-world (non-digital) businesses, together with thus that their financials demand to hold upwards interpreted - together with their stocks valued - amongst these differences inwards mind. And when such differences are properly understood, it becomes clear that for sure businesses (again, not all) tin inwards many instances hold upwards revealed to hold upwards reasonably priced despite the fact that they are losing prodigious amounts of money.
At this phase inwards the cycle, where tech stocks are already relatively expensive, the forgoing may take keep to a greater extent than utility inwards cautioning against shorting for sure plainly bubblesque names, rather than justifying going long. Many smart VC operators together with other tech enthusiasts take keep long figured out the foregoing, but many traditional value investors take keep not. Some of them (e.g. Einhorn) are good into the procedure of blowing upwards their funds shorting these sorts of names every bit a result.
The telephone commutation divergence amongst software/online/app-based businesses, every bit compared amongst traditional businesses of yesteryear, is that the meshing has removed nearly all of the traditional barriers of fourth dimension together with distance, which has resulted inwards businesses existence able to at nowadays target a global marketplace position amongst picayune to no marginal costs of additional product/service delivery. This is because many online services are, for the most part, delivered yesteryear a calculator algorithm where the marginal costs-to-serve is basically zero, together with incremental gross margins are thus unopen to 100% (in practice, somewhat below due to marginal spider web hosting together with other variable applied scientific discipline infrastructure costs).
In addition, many of these industries are 'winner takes all' networked businesses where the start businesses to larn large together with dominate a given manufacture is probable to monopolise manufacture revenues together with profits long into the distant future. Economies of scale is non a novel concept, but the economies of scale for such businesses tin hold upwards unprecedented inwards magnitude.
What this way inwards practise for a software trace of piece of job organisation inwards the early-stages of S-curve adoption is that revenues together with gross profits are apt to grow exponentially, whereas back upwards costs (e.g. applied scientific discipline together with back-end systems development) are probable to grow to a greater extent than linearly. This divergent geometric tendency inwards revenues/gross turn a profit together with back upwards costs way that loss-making business, provided they tin laissez passer on on to scale revenues exponentially, take keep the potential to achieve a betoken where profitability literally explodes upwards. This reward profile is fundamentally different to old-world industrial or consumer businesses, where revenues together with costs scale much to a greater extent than proportionately to ane some other (as marketplace position access tin by together with large only hold upwards grown incrementally over fourth dimension inwards the form of physical distribution networks - e.g. yesteryear opening to a greater extent than stores). In addition, for the latter businesses, high levels of profitability were required finance the important working capital missive of the alphabet expenditures together with working working capital missive of the alphabet investments required to expand marketplace position access to perpetuate growth, whereas inwards many cases, applied scientific discipline businesses are 'capital light' together with human face upwards no such barriers.
Furthermore, a important fraction of development/support costs demand to hold upwards incurred upfront (software development, every bit good every bit client & merchant acquisition), together with are also incurred largely independent of the grade of revenue/gross turn a profit existence generated (and inwards the illustration of customer/merchant acquisition costs, they are by together with large a component of new customer additions, whereas revenues/gross turn a profit are a component of cumulative customer additions). Consequently, a fast growing SaaS or online platform business, for instance, may hold upwards booking important operating losses, but provided the unit of measurement economies are attractive (LCV/CAC - or lifetime client value over client acquisition costs), together with the trace of piece of job organisation has the capability to exponentially scale into a large addressable market, electrical flow accounting profits tin truly hold upwards a highly misleading indicator of the value of the business.
A ameliorate framework, inwards my submission, than electrical flow multiples of revenue, earnings, or volume value, is to instead value the trace of piece of job organisation using the next approach: (1) justice the full revenues/gross turn a profit that could ane 24-hour interval hold upwards generated if a realistic proportion of the full addressable marketplace position is captured; (2) justice what the back upwards costs volition probable aspect similar at this betoken inwards time, relative to that grade of gross profit, together with hence justice the overall potential profitability of the enterprise at this latter date; (3) justice a conventional final PE multiple that is probable to prevail at this betoken of fourth dimension when the trace of piece of job organisation is approaching maturity; (4) justice how long yous retrieve it is going to take keep to achieve that point, together with discount that estimated final value dorsum to acquaint value at a realistic discount rate; (5) conform for whatever interim working capital missive of the alphabet raisings necessary to fund the trace of piece of job organisation to positive FCF; together with (6) possibly most importantly together with often overlooked, probability-weight the higher upwards outcome.
By fashion of example, let's take keep a trace of piece of job organisation similar Spotify (SPOT US). The stock has a marketplace position capitalisation of US$28bn; meshing cash is US$0.5bn, together with the society is expected to generate US$5.2bn inwards revenues this year; US$1.3bn inwards gross turn a profit (25% gross margin); together with US$400m inwards operating losses (i.e. SG&A costs are almost US$1.7bn). On conventional valuation metrics, this stock looks really expensive, at 5x forrad revenue, amongst the enterprise making consistent together with sizable losses. However, alternative metrics propose that at that spot is soundless a plausible value-based bull illustration for owning the stock.
SPOT has an extraordinarily scalable trace of piece of job organisation together with is emerging every bit the a clear marketplace position leader inwards an manufacture where the long full addressable marketplace position could testify to hold upwards a non immaterial fraction of the entire world, assuming paid streaming eventually becomes a widely-adopted consumer service, together with the way yesteryear which most consumers access music. Furthermore, absent tape label collusion, the company's 25% gross margins could quite good testify sustainable, every bit the mass of the company's cost of sales are royalties paid to tape labels/artists, together with those key tape label suppliers are major shareholders inwards SPOT. Furthermore, every bit SPOT's size together with authorisation grows, having access to SPOT's distribution platform volition laissez passer on every bit of import to the tape labels every bit it is for SPOT to take keep access to those tape labels to attract listeners (SPOT could come upwards to drive the mass of music manufacture revenues, together with amongst a large installed user base, existence dropped yesteryear SPOT could resultant inwards a severe loss of revenue/listening marketplace position percentage for the relevant label, which would peril creative somebody defections together with a loss of uncovering of novel artists).
SPOT currently has almost 75m paying users, but every bit the marketplace position leader inwards an exponentially growing manufacture - online music streaming - let's hypothesise that they tin larn to 1bn paying users long term at maturity (about 13% global population marketplace position share). At a chip nether US$10 a month, or enjoin almost US$100 per somebody per year, that is a potential revenue base of operations of US$100bn, together with at 25% gross margins, a potential gross turn a profit puddle of US$25bn. How are SG&A costs probable to scale during this growth? They are probable to grow at a much slower charge per unit of measurement given the tremendous economies of scale associated amongst many of SPOT's back upwards costs. Let's enjoin they grow 3x inwards size, to enjoin US$5bn. This would larn out SPOT amongst operating profits of some US$20bn, or enjoin almost US$15bn afterwards tax.
At maturity, the stock would probable merchandise at almost 20x earnings, given the business' global authorisation together with capital-light earnings, suggesting its marketplace position capitalisation could achieve every bit high every bit US$300bn, or 10x the electrical flow level. Furthermore, amongst the society currently existence US$0.5bn meshing cash, together with losses declining, it seems unlikely major farther equity working capital missive of the alphabet raisings volition hold upwards needed. As a counterpoint, nosotros volition ignore whatever positive cash flows that mightiness hold upwards generated prior to our final year.
How long volition it take keep to achieve 1bn users? Let's assume 10 years, together with lets discount that dorsum to acquaint value at 15% pa. That would propose a acquaint value of that US$300bn final value of US$75bn.
However, we also demand to probability-weight this bullish outcome, because it is far from 100% assured. Spotify is competing amongst heavyweights such every bit Apple Music together with Amazon, together with it is possible SPOT volition hold upwards unable to differentiate itself sufficiently long term - peculiarly if Amazon starts giving away music for costless to its growing terra firma forces of Prime members; signs all labels together with develops comparable playlists together with user algorithms that counter whatever client 'lock in' SPOT mightiness hold upwards able to secure. Apple is less of a threat every bit the bulk of global smartphone users are Android users, although Apple Music may good secure a meaningful percentage of high-value Apple users.
If nosotros ascribe a 50% probability to success, together with for simplicity, a 50% probability to wholesale failure (i.e. no intermediate states of lesser success), nosotros would derive a valuation of US$35-40bn, which is inwards the broad ballpark of SPOT's electrical flow marketplace position cap. One tin play amongst whatever of the higher upwards variables, adjusting the probability of success; final user estimates; the timeframe needed to larn there; the discount rate; together with final operating margins, to justice valuations. If I run diverse scenarios, I achieve the decision that SPOT is roughly fairly valued, together with may inwards fact soundless hold upwards somewhat cheap.
However, SPOT's exact valuation; investment merits; or whether it volition succeed is non truly my point. My betoken is that the levers of the stocks' valuation take keep exceedingly picayune to produce amongst electrical flow earnings, together with far to a greater extent than to produce amongst the probability of success, together with the size together with timing of the potential reward if things work. This highlights why markets are non paying a lot of attending to curt term profitability for these types of stocks, together with are instead (appropriately) paying far to a greater extent than attending to trends inwards paying users together with gross turn a profit margins. It is non that trends inwards curt term SG&A back upwards costs are irrelevant; it is that they are a far less of import driver of long term valuation outcomes. This is sometimes why nosotros meet tech names deliver outsized percentage toll gains inwards reply to favourable subscriber growth trends (e.g. Netflix before this year), fifty-fifty if curt term earnings immature lady expectations.
Understanding this framework is of import - particularly if ane is inclined to curt scalable tech businesses that seem expensive on electrical flow earnings metrics. Einhorn is ane such investor, together with he truly needs to figure this stuff out every bit shortly every bit possible together with unopen his disastrous 'bubble basket' tech shorts, which are proving ruinous to his fund. The fact that he does non sympathise the higher upwards is evident non only inwards the names he has chosen to curt (and the considerable coin he has lost doing so), but also his comments inwards his quarterly letters, where he has expressed bewilderment every bit to why these stocks laissez passer on on to laissez passer on upwards despite missing quarterly estimates. He is alone missing the point.
Whether ane is optimistic or pessimistic together with is inclined or disinclined to laissez passer on long SPOT or other high-flying tech aristocrats is a different number (I am non long or short), but ane should hold upwards extremely weary of going curt these names, inwards my view.
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However, amongst that context together with caveat firmly inwards mind, I believe a audio declaration tin even together with so hold upwards made that the economic science of select (and yesteryear no way all) new-era software businesses truly are fundamentally different to old-world (non-digital) businesses, together with thus that their financials demand to hold upwards interpreted - together with their stocks valued - amongst these differences inwards mind. And when such differences are properly understood, it becomes clear that for sure businesses (again, not all) tin inwards many instances hold upwards revealed to hold upwards reasonably priced despite the fact that they are losing prodigious amounts of money.
At this phase inwards the cycle, where tech stocks are already relatively expensive, the forgoing may take keep to a greater extent than utility inwards cautioning against shorting for sure plainly bubblesque names, rather than justifying going long. Many smart VC operators together with other tech enthusiasts take keep long figured out the foregoing, but many traditional value investors take keep not. Some of them (e.g. Einhorn) are good into the procedure of blowing upwards their funds shorting these sorts of names every bit a result.
The telephone commutation divergence amongst software/online/app-based businesses, every bit compared amongst traditional businesses of yesteryear, is that the meshing has removed nearly all of the traditional barriers of fourth dimension together with distance, which has resulted inwards businesses existence able to at nowadays target a global marketplace position amongst picayune to no marginal costs of additional product/service delivery. This is because many online services are, for the most part, delivered yesteryear a calculator algorithm where the marginal costs-to-serve is basically zero, together with incremental gross margins are thus unopen to 100% (in practice, somewhat below due to marginal spider web hosting together with other variable applied scientific discipline infrastructure costs).
In addition, many of these industries are 'winner takes all' networked businesses where the start businesses to larn large together with dominate a given manufacture is probable to monopolise manufacture revenues together with profits long into the distant future. Economies of scale is non a novel concept, but the economies of scale for such businesses tin hold upwards unprecedented inwards magnitude.
What this way inwards practise for a software trace of piece of job organisation inwards the early-stages of S-curve adoption is that revenues together with gross profits are apt to grow exponentially, whereas back upwards costs (e.g. applied scientific discipline together with back-end systems development) are probable to grow to a greater extent than linearly. This divergent geometric tendency inwards revenues/gross turn a profit together with back upwards costs way that loss-making business, provided they tin laissez passer on on to scale revenues exponentially, take keep the potential to achieve a betoken where profitability literally explodes upwards. This reward profile is fundamentally different to old-world industrial or consumer businesses, where revenues together with costs scale much to a greater extent than proportionately to ane some other (as marketplace position access tin by together with large only hold upwards grown incrementally over fourth dimension inwards the form of physical distribution networks - e.g. yesteryear opening to a greater extent than stores). In addition, for the latter businesses, high levels of profitability were required finance the important working capital missive of the alphabet expenditures together with working working capital missive of the alphabet investments required to expand marketplace position access to perpetuate growth, whereas inwards many cases, applied scientific discipline businesses are 'capital light' together with human face upwards no such barriers.
Furthermore, a important fraction of development/support costs demand to hold upwards incurred upfront (software development, every bit good every bit client & merchant acquisition), together with are also incurred largely independent of the grade of revenue/gross turn a profit existence generated (and inwards the illustration of customer/merchant acquisition costs, they are by together with large a component of new customer additions, whereas revenues/gross turn a profit are a component of cumulative customer additions). Consequently, a fast growing SaaS or online platform business, for instance, may hold upwards booking important operating losses, but provided the unit of measurement economies are attractive (LCV/CAC - or lifetime client value over client acquisition costs), together with the trace of piece of job organisation has the capability to exponentially scale into a large addressable market, electrical flow accounting profits tin truly hold upwards a highly misleading indicator of the value of the business.
A ameliorate framework, inwards my submission, than electrical flow multiples of revenue, earnings, or volume value, is to instead value the trace of piece of job organisation using the next approach: (1) justice the full revenues/gross turn a profit that could ane 24-hour interval hold upwards generated if a realistic proportion of the full addressable marketplace position is captured; (2) justice what the back upwards costs volition probable aspect similar at this betoken inwards time, relative to that grade of gross profit, together with hence justice the overall potential profitability of the enterprise at this latter date; (3) justice a conventional final PE multiple that is probable to prevail at this betoken of fourth dimension when the trace of piece of job organisation is approaching maturity; (4) justice how long yous retrieve it is going to take keep to achieve that point, together with discount that estimated final value dorsum to acquaint value at a realistic discount rate; (5) conform for whatever interim working capital missive of the alphabet raisings necessary to fund the trace of piece of job organisation to positive FCF; together with (6) possibly most importantly together with often overlooked, probability-weight the higher upwards outcome.
By fashion of example, let's take keep a trace of piece of job organisation similar Spotify (SPOT US). The stock has a marketplace position capitalisation of US$28bn; meshing cash is US$0.5bn, together with the society is expected to generate US$5.2bn inwards revenues this year; US$1.3bn inwards gross turn a profit (25% gross margin); together with US$400m inwards operating losses (i.e. SG&A costs are almost US$1.7bn). On conventional valuation metrics, this stock looks really expensive, at 5x forrad revenue, amongst the enterprise making consistent together with sizable losses. However, alternative metrics propose that at that spot is soundless a plausible value-based bull illustration for owning the stock.
SPOT has an extraordinarily scalable trace of piece of job organisation together with is emerging every bit the a clear marketplace position leader inwards an manufacture where the long full addressable marketplace position could testify to hold upwards a non immaterial fraction of the entire world, assuming paid streaming eventually becomes a widely-adopted consumer service, together with the way yesteryear which most consumers access music. Furthermore, absent tape label collusion, the company's 25% gross margins could quite good testify sustainable, every bit the mass of the company's cost of sales are royalties paid to tape labels/artists, together with those key tape label suppliers are major shareholders inwards SPOT. Furthermore, every bit SPOT's size together with authorisation grows, having access to SPOT's distribution platform volition laissez passer on every bit of import to the tape labels every bit it is for SPOT to take keep access to those tape labels to attract listeners (SPOT could come upwards to drive the mass of music manufacture revenues, together with amongst a large installed user base, existence dropped yesteryear SPOT could resultant inwards a severe loss of revenue/listening marketplace position percentage for the relevant label, which would peril creative somebody defections together with a loss of uncovering of novel artists).
SPOT currently has almost 75m paying users, but every bit the marketplace position leader inwards an exponentially growing manufacture - online music streaming - let's hypothesise that they tin larn to 1bn paying users long term at maturity (about 13% global population marketplace position share). At a chip nether US$10 a month, or enjoin almost US$100 per somebody per year, that is a potential revenue base of operations of US$100bn, together with at 25% gross margins, a potential gross turn a profit puddle of US$25bn. How are SG&A costs probable to scale during this growth? They are probable to grow at a much slower charge per unit of measurement given the tremendous economies of scale associated amongst many of SPOT's back upwards costs. Let's enjoin they grow 3x inwards size, to enjoin US$5bn. This would larn out SPOT amongst operating profits of some US$20bn, or enjoin almost US$15bn afterwards tax.
At maturity, the stock would probable merchandise at almost 20x earnings, given the business' global authorisation together with capital-light earnings, suggesting its marketplace position capitalisation could achieve every bit high every bit US$300bn, or 10x the electrical flow level. Furthermore, amongst the society currently existence US$0.5bn meshing cash, together with losses declining, it seems unlikely major farther equity working capital missive of the alphabet raisings volition hold upwards needed. As a counterpoint, nosotros volition ignore whatever positive cash flows that mightiness hold upwards generated prior to our final year.
How long volition it take keep to achieve 1bn users? Let's assume 10 years, together with lets discount that dorsum to acquaint value at 15% pa. That would propose a acquaint value of that US$300bn final value of US$75bn.
However, we also demand to probability-weight this bullish outcome, because it is far from 100% assured. Spotify is competing amongst heavyweights such every bit Apple Music together with Amazon, together with it is possible SPOT volition hold upwards unable to differentiate itself sufficiently long term - peculiarly if Amazon starts giving away music for costless to its growing terra firma forces of Prime members; signs all labels together with develops comparable playlists together with user algorithms that counter whatever client 'lock in' SPOT mightiness hold upwards able to secure. Apple is less of a threat every bit the bulk of global smartphone users are Android users, although Apple Music may good secure a meaningful percentage of high-value Apple users.
If nosotros ascribe a 50% probability to success, together with for simplicity, a 50% probability to wholesale failure (i.e. no intermediate states of lesser success), nosotros would derive a valuation of US$35-40bn, which is inwards the broad ballpark of SPOT's electrical flow marketplace position cap. One tin play amongst whatever of the higher upwards variables, adjusting the probability of success; final user estimates; the timeframe needed to larn there; the discount rate; together with final operating margins, to justice valuations. If I run diverse scenarios, I achieve the decision that SPOT is roughly fairly valued, together with may inwards fact soundless hold upwards somewhat cheap.
However, SPOT's exact valuation; investment merits; or whether it volition succeed is non truly my point. My betoken is that the levers of the stocks' valuation take keep exceedingly picayune to produce amongst electrical flow earnings, together with far to a greater extent than to produce amongst the probability of success, together with the size together with timing of the potential reward if things work. This highlights why markets are non paying a lot of attending to curt term profitability for these types of stocks, together with are instead (appropriately) paying far to a greater extent than attending to trends inwards paying users together with gross turn a profit margins. It is non that trends inwards curt term SG&A back upwards costs are irrelevant; it is that they are a far less of import driver of long term valuation outcomes. This is sometimes why nosotros meet tech names deliver outsized percentage toll gains inwards reply to favourable subscriber growth trends (e.g. Netflix before this year), fifty-fifty if curt term earnings immature lady expectations.
Understanding this framework is of import - particularly if ane is inclined to curt scalable tech businesses that seem expensive on electrical flow earnings metrics. Einhorn is ane such investor, together with he truly needs to figure this stuff out every bit shortly every bit possible together with unopen his disastrous 'bubble basket' tech shorts, which are proving ruinous to his fund. The fact that he does non sympathise the higher upwards is evident non only inwards the names he has chosen to curt (and the considerable coin he has lost doing so), but also his comments inwards his quarterly letters, where he has expressed bewilderment every bit to why these stocks laissez passer on on to laissez passer on upwards despite missing quarterly estimates. He is alone missing the point.
Whether ane is optimistic or pessimistic together with is inclined or disinclined to laissez passer on long SPOT or other high-flying tech aristocrats is a different number (I am non long or short), but ane should hold upwards extremely weary of going curt these names, inwards my view.
LT3000