In What to be aware of when valuing younger companies, the point made was that the greatest challenge in valuing such companies isn’t coming up with better metrics or models. It’s dealing with uncertainty.
MAHESH PATIL, chief investment officer at Aditya Birla Sun Life Mutual Fund, tells us how he looks for value in new age companies.
Discounted Cash Flow
The problem with the conventional model of DCF projecting future cash flows is the uncertainty. One cannot predict those cash flows with certainty, because one is making a lot of assumptions with respect to the economy and business environment, which is pretty dynamic. It's easy to make projections on an excel sheet, but they could change, because the competitive landscape could change. There could be certain pivots the company could do along the business.
Unit Economics
Some of these companies are making losses because they are growing. So, they are investing upfront for future growth because the growth rates could be around 30%, 40%, 50%, 60%, and you need to invest for growth because of customer acquisition. But at the unit level, if the companies are making a profit, then you can take that as a case and then try to build a case that at least when the growth kind of moderates down, the company will start to make cash flows, and how soon the companies will start making cash flows.
A delivery company, for example. The unit economics will be at per delivery level. When you're delivering, there is a revenue and costs associated to that delivery.
So, at the unit level, is it making money and a reasonable return on the investment? This is before apportioning all the other overheads because there is a high of subscriber acquisition cost; for acquiring new customers, you need to spend money.
If that is in place, then at least you can predict other things as that grows, as volume grows, and as the other fixed costs or the market, because initially there's a huge expenditure they need to make on customer acquisition or advertising which doesn't increase as you go forward.
So, you can then get an inflection point at, say, three years down the line or four years down the line, you can start making cash flows. And then, you can at least predict, say, for the next 7 – 8 years, in your mind, if you can get certain fixed in terms of what is the kind of contribution margin it can make and then try to give a multiple.
Unit Economics.
Revenue per customer.
Contribution margin per unit.
Addressable Market
The target addressable market (TAM) decides what is the runway of growth for these companies. So, if the TAM is very large, then the runway for growth for some of these companies can be very big if they have got the unit economics in place.
Competitive dynamics.
We want to invest only when we are pretty sure that this company is going to be the leader in that space. Because that is the player that will make money. If those dynamics are already in place, then it's much easier to take a call on that company. If there are multiple players, it will continue to burn money as long as funding is available.
Multiples
You have to rely on multiple factors to arrive at a more reasonable level in your mind which valuation level you are comfortable with.
You can look at a contribution profit and give a multiple to that compared to similar businesses, conventional business in that particular industry and then try to see whether there's some sense you get in terms of what could be the baseline valuation.
In the case of a delivery company, it was very clear there were two market players and they have reached a certain level and scale it was very difficult for anybody else to come in, then you can start building a model based on that. Because if the competitive dynamics are not in place, then it's very difficult to build a model also because you don't know what extent they will continue to burn cash flows.
Sectors don’t matter.
Instead of sectors, look at other factors.
Have they established a large customer base, where they already have a large customer ownership? Because once you have the customers and ownership, then you can leverage that to sell multiple products within the same particular sector itself. We would look at that rather than sectors.
And, where we've seen the unit economy – the road to profitability. We need to see profits today, at least at the unit level. And it could be across sectors.
The Network Effect is an intangible asset.
A new player will have to spend that much capital to again acquire customers or whatever. To some extent, the asset is intangible in a way.
If you have spent money rightly to acquire a certain customer base, a new player will have to burn at least an equal amount to take that away from you. This network effect comes into play, especially in some of the companies like Delhivery.
So, the larger the size you have, the larger network in play which gives you economies of scale. And any new entrant will find it difficult to displace that. Amazon, for example, has done that over a period of time.
This is the asset we should be looking at rather than physical assets.
Look beyond the numbers.
One doesn’t know much about the promoters, so it is important to get qualitative feedback from the marketplace. What do the suppliers and distributors think about the company? Such feedback can aid in terms of taking a more informed decision.
The exit decision should not be based purely on valuations.
I’ve gone wrong in the past when purely selling on valuations. We have missed and sold some stocks too early, which went on to become big compounders.
Look to see if the business fundamentals have changed and whether assumptions made at the beginning have gone wrong. Valuations can move up and down with the market. But is the company delivering as promised or even outperforming?
If it is a good company which has got a long runway of growth, and you sell based only on valuations, you will miss out on the long runway. If the business fundamentals and growth are still intact, then you can have a more lenient view in terms of valuation.
If the call on the management has turned out to be wrong. Or, if the business model has changed because of the market conditions or probably burning more cash, then you need to decide whether to exit or reduce holdings.
Beyond a point when it doesn't really justify you taking a longer-term view, then you can reduce the weightage in the portfolio. Because when you bought a stock, it was, say 1% of the portfolio and goes on to become 5%, then you at least normalize that and reduce the risk of that.
So, let’s say I put 3% or 4% of a fund’s portfolio in two or three such stocks, because you don't know which one will work. Even if I want to play these names, they should not become a large part of my portfolio. These are all small add-ons and one individual stock should not become a significant part, because if something goes wrong, it will hurt.
So, in one of our funds, that's what happened that a food delivery company became 3% of the fund. Nobody said anything. Instead, they said “well done”. But when it fell and became 1% of the fund, everyone questioned why we were not selling when it was 3% of the fund.
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All the above views were shared during the Morningstar Investment Conference India, September 2022
