Common Fallacies About The Valuation Of Public and Private Technology Companies
First, ask any MBA how to value tech companies, she’ll say “discounted cash flow, just like any other company”.
Problem: For new and rapidly growing tech companies, up to 100% of value is in terminal value 10+ years out, so the discounted cash flow framework collapses. You can run as many discount cash flow spreadsheets as you want and may get nothing that will help you make good tech investment decisions. Related to the fact that tech companies don’t have stable products like soup or brick companies; future cash flows will come from future products. Instead, the smart tech investor thinks about:
- Future product roadmap/oppurtunity
- Bottoms-up market size and growth
- Talent and skill of the team.
Essentially you are valuing things that have not yet happened and the likelihood of the CEO and team being able to make them happen. Finance people find this appalling, but investors who do this well can make a lot of money, but spreadsheet investing is often disastrous. It doesn’t mean cash flow doesn’t matter, in fact the opposite is true: this is the path to find tech companies that will generate tons of future cash.
Corollary: For tech companies, current cash flow is usually useless for forecasting future cash flow, a lagging not leading indicator. This trips up value investors (Prem Watsa!) all the time; tech companies with high cash flows often about to fall off a cliff. Because current cash flows are based on past products not future products and profitability often breeds complacence and bureaucracy.
Always, always, always, the substance is what matters: WHO and WHAT. WHO’s building the products and WHAT products are they building?
Brand will not save you, marketing will not save you, channels will not save you, account control will not save you. It’s the products. Which goes right back to the start: Who are the people, what are the products, and how big is the market? That’s the formula.https://twitter.com/PGuru714/status/456683768841904128