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3 reasons why Tech companies
command strong valuations.
The Indian IPO market has made
some unprecedented records. Thanks to liquidity in the markets, many companies
can raise capital swiftly. The key attraction in this IPO rush has been new-age
tech companies. We witnessed some emerging brands like Paytm, Zomato, Nykaa,
etc. launch their IPOs. Some of these new-age companies had a resounding
success. Paytm, on the other hand, had a tepid response. Before an Initial
public offering (IPO), any diligent investor would want to deep dive into the
valuations and estimate possible gains he can achieve. With these new-age
companies, traditional valuation methods do not justify their potential. Most
companies are making significant losses, and some do not even have substantial
revenue. The question then is, why are investors ready to pay a hefty price for
these tech companies? Let us look at the top three reasons; why these tech
companies command steep valuations.
The innovative business models
Food delivery, selling cosmetics,
or selling insurance are not new businesses. These tech companies do not have
their own cloud kitchen or an insurance product. The common underlying aspect
here for these companies is that they are aggregators of existing businesses.
With the advent of technology, these companies can scale the model
exponentially. If you look at the growth numbers in terms of restaurants or
premium or the total sales, these companies will have a phenomenal track
record. With growing disposable income and busier lives, people need
convenience. These companies provide a long catalogue for selection with easy
access for a small fee. These companies can cater to a large target using
technology and scale. Aggregation of businesses existed in smaller
buckets in India, now with technology scale becoming a reality.
These tech companies or
aggregators have to target economies of scale. For economies of scale, it is
necessary to tap as many users as possible. This can be only possible through
mega advertising campaigns and dishing out freebies like cashback and
discounts. The customer acquisition cost for these companies is steep because
of these freebies and advertising campaigns. The idea is to scale as much as
possible and gain the maximum market share. Once a substantial market share is
achieved, these companies could optimise their customer acquisition costs.
New-age companies would mint money, through these algorithms, from all the
current investment towards onboarding and retaining customers. Basically,
the valuations are anticipated for a bright future based on high market share
and lower sales costs. This anticipation is highly interlinked on the other two
factors.
Data is the new oil
There was a time around 2010 when
India’s low internet penetration was an area of concern. With the launch of
Jio, we saw exponential growth in the number of internet penetration. Not only
this, it initiated the rise of the ecosystem around new internet users.
The demographic dividend started to show up in real terms with more internet
and mobile users. This whole ecosystem is poised for sustained growth over a
long period. Data is generated from almost every interaction, right from
watching short videos of
TikTok to selling products
on WhatsApp and what not. With increased interactions, there will be more
data collected and aggregated. This data then further will become the
foundation of optimised algorithms. Once a system understands a user
through the data collected, there can be targeted marketing. There will be
targeted and reduced freebies. For example, a food delivery company knows that
you regularly order food on Sunday evening, they can offer you freebies for
ordering on other days but on Sunday. The idea here is you are now hooked
on to the platform for Sunday; you need to be pulled in for other days as well.
Tech companies track and
streamline a humongous amount of data. These data help gain insights on
behaviour right from how often you visit the app to how often you place orders.
It also includes micro-interaction information like did you get the slot and
the product you were initially looking for. These data pointers help sharpen
the efficiency expected by the customer. Not only this, with the available
data, there are tremendous avenues of cross-selling and up-selling. If these
opportunities are minted well, they could foray into new segments. Compared to
traditional businesses, only a few companies collect this level of detailed
data about the user. There has been a saying that ‘Customer is King’. The data
helps you know the pulse of your king and serve them better. Hence these
tech companies command high valuation. Many may argue that this is again all
long-term and debatable. However, many companies have proven this business
model in other countries, which brings us to the next factor.
The success of FAANG companies
FAANG is the commonly used
acronym for large tech companies; Facebook, Amazon, Apple, Netflix, and Google.
All these companies enjoyed a premium valuation since listing on bourses. The
faith in these companies has paid back handsomely for their investors. All
these companies had dealt with low revenues and increasing losses. Let’s pick
the example of Amazon. When Amazon started, it was a disruptive idea. But it
took 14 years post IPO for Amazon to turn profitable. Amazon became profitable
majorly based on its cloud offering AWS (Amazon web services). But today,
Amazon is a trillion-dollar company. So is the case with other FAANG companies.
Those investors who held on to
the long-term story despite not so strong numbers were richly rewarded.
Investors are anticipating a similar story to happen in Indian markets. You
might have heard people speaking about ‘India’s Amazon’ or ‘Next Google‘. This
anticipation involves risk. However, this risk with faith could pay hefty
dividends in the longer run. Investors hence are okay to shell out a portion of
their portfolio in these new-age companies. If the bet pays off, it would be a
huge success.
Does the bet always Pay off?
There is always a possibility of
any bet failing, depending on the probabilities.
As per
research, 50% of the start-ups in their 5th year and 70% of the companies
in their 10th year wind up operations. Most of the companies being listed today
have survived that early phase. Only a few companies achieve great success, but
there is hope that a few of these tech companies could reach greater heights.
During the dot com bubble, most internet companies could not survive the crash.
There will be a crash in valuations. Such a crash will be a good testing time
for these companies.
A Note of Caution
India has had a demographic
dividend for a few centuries. It has been called ‘Sone ki Chidiya’ for
centuries now. A demographic dividend alone will not make a company great. An
investor must look at various aspects other than the demographic dividend and
market sizing. Evaluate opportunities, where you can have faith for a longer
run, during the thicks and thins of the company. After all, Investing
does involve taking bets and who knows; which bet will pay off handsomely.
Happy investing !!
