How to Value a Tech Company?

Do you remember last year’s listing of Snapchat on the New York Stock Exchange?

I bet you do.

It was page to page news for months. The biggest tech story of 2017 by far.

At the time demand for the newly issued stock was huge.

Everyone wanted their hands on some ‘Snap’ stock.

Both professional funds, as well as amateur investing millennials, were eager to own a stake of their favourite phone app.

In just three years, the novelty camera phone app had taken the world by storm.

Check out the growth in users up until the 2017 listing date:

Markets & Money 9-05-18

Source: Techcrunch

[Click to open in a new window]

There was no doubting the popularity of the product.

But as an investment?

Well that’s a different story…

Losses, losses everywhere!

The prospectus document given to investors before investing in the Snap Inc. IPO contained this statement:

We began commercial operations in 2011 and for all of our history we have experienced net losses and negative cash flows from operations. If our revenue does not grow at a greater rate than our expenses, we will not be able to achieve and maintain profitability.

A sombre warning for investors.

Nevertheless, the company surged on listing.

The share price rose 44% in its first day of trading.

This loss-making company that might never make a profit ended the day valued at a hefty $25 billion.

Madness?

Maybe…maybe not.

The share price of Snap has since fallen to a more modest $12.13 per share over the last year, valuing the company at around $14 billion.

And it’s still making a loss.

This week they released quarterly earnings. A loss of $217 million for the first three months of the year.

The stock plummeted 17%.

Not because the loss surprised the market, but because the scale of the loss was more than expected.

And more importantly, the growth in user numbers missed estimates too.

But its user base is still growing.

And importantly the amount of money they’re making from each user is growing too.

Markets & Money 9-05-18

Source: The Atlas

[Click to open in a new window]

Nevertheless this is still a $14 billion company right now.

So how do such valuations come about? Are they just the product of ‘pie in the sky’ hype and gullible investors?

Well, it’s a bit of both…

It’s all about growth with tech companies

If you want to invest in tech, you’re going to have to throw out your copy of Ben Graham’s The Intelligent Investor.

Investing in loss-making companies like Snap Inc. with no clear path to profitability is fraught with uncertainty and risk.

And yet, they’re often the most in demand stocks on the market.

Why?

Two words — potential gains.

As companies like Facebook have shown in the past, capturing a specific demographic to your platform is very valuable.

But it takes time to realise that value.

It took Facebook five years to turn a profit. And by that time, it had grown to a US$6.5 billion company.

The key for a lot of tech companies revolves around these growth rates.

It’s not the present numbers that matter to investors. It’s the growth rate of those numbers.

Metrics like price-earnings ratios give way to other metrics like user growth and cost per user acquisition.

Of course, this makes it all very risky.

Not even the company always knows what it will do next.

But that’s the nature of tech.

The relatively new field of ‘growth hacking’ grew hand in hand with the rise of Silicon Valley.

The idea is to test and adapt as fast as possible. Find what works through trial, error and constant tracking.

Then when you find the magic formula, go hard at it.

For the right product in the right market, the rewards can be huge.

For example, Snap’s huge valuation is based on their unique user base. Millennials are a prized demographic in the advertising world.

They’re slowly going to replace the ageing baby boomers as the largest earning and spending section of the population.

This is not a traditional valuation metric. But, it matches reality.

The downside to all of this is — of course — huge.

If growth rates falter, if a fickle user base moves on to pastures new (see MySpace for historical precedents), if the company simply runs out of cash and investors are all tapped out, you can lose the lot.

But if the company hits the right notes and that sweet spot of circular growth, it can rise in value rapidly.

Unlike traditional investing where you are trying to find inefficiencies in asset values, in growth investing like tech, you’re trying to find hidden value in rates of growth.

I find the process of looking for this more creatively satisfying. You need to understand more about how the business works.

To actually understand the business model and the key determinants of future profitability and success, you have to make judgements and educated guesses.

It’s fun!

And then as the story plays out, you can track the progress against your own model.

This is the essence of exponential investing.

Finding hidden growth before anyone else.

It’s certainly not easy.

But the rewards are substantial when you get it right.

Good investing,

Ryan Dinse,
Contributing Editor, Markets & Money


Ryan Dinse is an analyst at Markets and Money. He has two decades of experience in financial planning, equity analysis and credit markets. Ryan combines fundamental, technical and economic analysis to identify and invest in good ideas at the appropriate stage of the economic cycle. He has a strong interest in technology, economic history and disruptive business models. His focus at the moment is as lead analyst on two of our most recent and innovative investor services, Crash Market Investor and Sam Volkering’s Secret Crypto Network. He will write about the exciting opportunities for investors to benefit from significant changes in world markets. He is a member of Fintech Australia, a former member of the Digital Currency Council, and is a fully accredited financial adviser.


Leave a Reply

Your email address will not be published. Required fields are marked *

Markets & Money