The Elusive Valuation

Elon Musk valued Twitter at roughly US$44 Bn.

Mark Zuckerberg valued Whatsapp at US$20 Bn.

What is common in these two deals? No one knows how the value was arrived at.

Corporate valuations are tricky, subjective and often fuelled by ‘gut’ – in a word, valuations are elusive. In theory, an active market of traded securities brings out the precise value of any company. Then, in essence, corporate valuation is a product of the collective intelligence of a rather influenced public. Yet the market valuations are relied upon as they are assumed to reflect the true ‘market price’ of a company. I hope Linus’s law in software development – given enough eyeballs, all bugs are shallow – is at play in stock markets too.

As the traded market is accepted to reflect the true worth of any company, investors try to map private investments with publicly traded securities to assign them a worth. Hence the “P/E ratios” of the world have become a benchmark in arriving at valuations. The recently broadcasted Shark Tank episodes support my point. If I try to correlate this with behavioural science, I can say that ratios or multiples are used because using those reduces the cognitive stress on the investor’s mind. A seasoned investor might as well arrive at multiple-based valuations without even invoking the ‘System 2’ of her brain (referring to the work of Daniel Kahneman) – thus substantially reducing cognitive load.

But such reliance on multiples is a challenge for start-ups, especially pre-revenue startups. How does a founder justify the value of a company if investors are arriving at the worth by multiplying its non-existent revenues with a revenue multiple? I am sure that investors know better, or I should hope so. Theory dictates that the worth of any company is measured as the present value of the probable future cash flows from the business. Hence, the value is calculated today, but it essentially lies in the future and the future can only be estimated. Now estimating the future cash flows for a company is difficult. So many variables come into play that multiple scenarios may be built. The more scenarios are built and considered, the more reliable and precise worth is calculated. But all this is grunt work. Renowned investment banks do such analysis for the investors to help them arrive at the ‘correct’ value of a company. However, the calculated worth is just a play of numbers in its essence. The number of scenarios and the probability of any happening is subjective. The renowned investment banks then just justify the values given by the investors by preparing an elaborate financial model to make the value look complicatedly correct. This brings us back to the point where the seasoned investor essentially gives the value by listening to her gut or the system 1 of her brain which lies in the comfort of intuition and does not want to invoke the logical system 2 to follow the difficult route of calculating the true worth.

To sum up, the valuation of a company is what the investor thinks it is and if the founder can convince her to think otherwise, then that. No offence to investors here. Cheers!

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