Why Book Value May Be of No Value

What investors/acquirer companies are essentially paying for, is the potential value that could be created by the company in the network it operates in.

Justifying the price tag of a company, in an era in which intangibles provide the biggest impetus to the valuation process, is a tough task. Traditional financial statements normally, do not reflect the true value of such assets. However, the tangible by-products of these intangible assets significantly impact the value a company creates over time.

Needless to say, valuations of companies in tech seem high. What investors/acquirer companies are essentially paying for, is the potential value that could be created by the company in the network it operates in.

On a platform where user growth (in turn, revenue growth) can be exponential, sometimes the valuations we read/hear about today can be justified to a certain extent. It’s common to see companies, whose value-add is extracted through intangibles, trade at 20–30x revenue. This is now the norm, rather than the exception. This just goes to show the expectations that investors have of future growth.

Old-economy companies, primarily depend on physical assets and capital intensive inputs to develop new competencies that could drive growth. However, the ‘tech’ companies rely on knowledge, networks, relationships and sometimes, other people’s assets ( case in point: Uber, Airbnb, TaskRabbit). This essentially means that, these companies do not require any linear input of capital to achieve growth, which in turn leads to an almost negligible cost of capital and higher ROE/ROCE. They can achieve significant scale and could do so, with minimal costs, in proportion to the revenue growth that can be achieved.

There also is, bit of a misconception regarding the barriers to entry in this space. The layman consensus is that anyone can make a a messaging app and compete with the likes of a WhatsApp. It sure is possible to build a similar platform, but what is tough to replicate is, operational efficiency, brand loyalty and the user-dependence of the brand in general.

Today, factors like indispensability and ubiquity of the product/service are factored into the valuation process and have become crucial parameters for firm valuation as well. The value of the service the company provides, constitutes only a part of the valuation. New age companies may not have a positive bottom line, but a strong network leads to an increased dependence on the service and as a result the service becomes indispensable over time.

These brands still have scope to gain more traction in emerging markets and I think the numbers are only going to go higher. And of course, bring in the operational efficiency of these companies, and any argument regarding valuations tilts in their favor, notwithstanding regulatory concerns. They will get over those too, in due-course.

If you are wondering where all the funding raised from investors is spent, in case of Indian companies like Ola, Zomato, Flipkart etc. it goes in giving discounts to customers and/or acquisitions. Their agenda is to increase the number of users, create a large customer base and breed brand loyalty. This might be bit of an extremist statement to make, but accounting methods could include discounts given, as investments, rather than as expenses. The whole point of reduced prices is to position the product/service as a utility rather than just an occasional add-on. Utilitarian considerations need to be factored in as user-dependency solely relies on that aspect.

Also, companies in the new economy do not have rigid market structures. Uber today, is not limited to just being a cab service, it’s much much more. It’s much easier for such companies to scale internationally as well. That gives them, a much bigger potential market, which institutional investors seem to recognize and are willing to shell out cash for that as well. This is obviously subject to how much dry powder there is.

From a user perspective, an ‘e-whatever’ service eliminates uncertainty. That’s what sets it apart. The end product is still the same. I can still take a regular cab to the mall, but I don’t mind paying a little more (or even lesser sometimes) to sit in a nice Toyota Etios and reach my destination. The whole micro-entrepreneurship angle to this is a big deal too.

I personally think, it’s all about the number of people who finally end up treating the company’s product as the go-to one. Ultimately, if the company succeeds in building an ecosystem in which the participants proliferate, and create significant monetary value over time, valuations might just be fair.

Btw, Facebook’s book value for YE 2014 was around $36 billion.