One of the most overrated term in corporate finance is growth while the most undervalued & ignored concept is that of the momentum.
Momentum in physics means the quantity of motion of a moving body, measured as “mass x velocity”. Important attribute of momentum is its seemingly self-propelling energy that keeps a system moving without any further external stimulus. Physicist call it the conservation of the momentum.
Momentum in context of any human endeavor results from “a pattern of decisions made over time, each decision influencing subsequent decisions” (Haseeb Qureshi says in his book quoted in one of my earlier blogs).
For an entrepreneur or an investor, it means the combination of (a) continued evolution and innovation (as opposed to the stagnation) – signifying the velocity of the business, and (b) critical presence (as opposed to being an ‘also ran’ market participant) in marketplace – signifying its mass. Achieving deep and broad market presence for its products & services is great. But, investors don’t value such an enterprise much, unless the market presence is combined with incessant pursuit of new product opportunities or process innovations.
Tracking momentum is way more important than paying obsessive attention to the growth achieved in past quarters by a corporation. In fact, there can be no consistent growth without momentum! Significance of the momentum cannot be better explained than by comparing the stock performance of Apple and Amazon (see chart). Clearly, the difference in the momentum these two companies have and its impact is stark! It is the momentum that determines how valuable a business is. Yet, B-Schools that drill profitability, liquidity, and leverage analysis in their student’s brains, do not talk of momentum. Is it because it is too abstract a concept to put a value to it? I think not. Here are some of the data-points that can be tracked to measure the momentum:
Revenue from new products/ services/ markets ÷ the total revenue: revenue from the new launches in, say, previous 2 years – historic & forecast; Year-over-Year growth/ decline in revenue-weighted market share: by product or service category/ by region; Benefit from new initiatives ÷ EBITDA: not just launches but any initiative such as product/ service promotions, process improvements, etc.
Whether you are an investor or a corporate executive, you can find your own way to track the momentum of the businesses you are involved in. But there is no denying the fact that momentum is the single most important driver of the corporate valuation!
Uber’s frantic chase for a market grab and top line growth has meant a negative bottom line of a whopping $1.2 billion in the first half of 2016. This, indeed, is an extreme case of the bottom line sacrifice for an impressive top-line growth of 18% in a quarter. And all this seems like a great strategy as its valuation reaches $69 billion.
But this strategy has its critics, too. Some experts feel that Uber’s indirect subsidizing its users (drivers and riders) can create a temporary shift in its favor but may not guarantee a long-term customer loyalty. When subsidies are withdrawn, the value Uber offers can easily be replicated by others (including traditional taxi services) and Uber may quickly loose its charm!
This is a conundrum that almost all businesses go through to some degree or the other. It can present not just a choice between top-line growth and bottom-line but also a choice between long term investment in soft assets such as people/ systems and chasing an attractive short-term EBITDA. Current market valuation techniques do not take non-GAAP assets not captured by accounting books into account. Valuation models taught in business schools assume long-term cost of capital as well as long term growth. Many a times, positive cash flow and growth shown in distant future year on and around the plan horizon can translate in to a very high valuation at present value terms based on a “terminal value”.
Given these market realities, corporate decisions would always be guided by the desire to achieve a high valuation by “projecting” a bright future – be it by projecting high growth at the expense of present profitability or by projecting healthy short-term EBITDA at the expense of building a sustainable infrastructure. It is up to the investors to kick the tires and make sure that the company has a sustainable business model and has built a good infrastructure in terms of its people and systems, for it to travel the distance to reach that projected bright future!
In my long finance career, I was involved in numerous ‘transactions’ that involved valuation – not just valuing companies and businesses but also valuing intangibles like Intellectual Property or Wireless Spectrum. The value of assets that I valued varied from single-digit millions to a few billion dollars. And one striking conclusion that I have reached after multitudes of transaction is this – today’s valuation theories are meant to explain valuation after the deal is done or at best to define the value boundaries for the deal participants but not to actually arrive at the valuation number at which the deal will be done.
Most of the valuation modern theories such as DCF look at the future earning potential of the business or the asset and arrive at what is called a “present value” using the valuer’s cost of capital or expected returns as the discounting rate. What these valuation models try to do is to mirror the deal-makers’ mind-set in financial terms.
But these theoretical methods have two inherent shortfalls.
- They require some big assumptions – regarding long term cost of capital or the hurdle rate at which to discount future earnings to the present value and the long term growth rates … to name a few.
- More importantly, these methods present purely one-sided perspective and completely ignore the deal dynamics between the dealing parties, i.e. The seller and the buyer.
These shortcomings have plagued the valuation industry for decades and have pushed the deal makers/ arrangers to depend on generic data-driven dubious market multiples to strike deals! These dubious market multiples, which become circular self-fulfilling prophecies have, in fact, unwittingly led to many market hysteria & crashes fed by unreal frenzies & fears.
Perhaps, emerging game theory could help us come to a better valuation theory that can actually be used to arrive at the valuation by using the dynamics between the “players”. Till such time, the theorist will be religated to the role of being the coroners of the deal industry conducting the value postmortems!