Bubble talk doesn't worry startup investors in India

Sandeep Murthy
8th April 2015

The nature of the game and the implied rules of determining value for disruptive companies are very different than the game being played by traditional companies.

The sense of FOMO (Fear of Missing Out) has never been more palpable than it currently is in the Indian Internet scene. Everyone from institutional investors to day traders to common consumers wants in on the wave of change. This is not a unique phenomenon... in fact the earliest such sense of FOMO dates back to 1637 when the price of tulips in Holland rose over 20x - in one month*! And then abruptly crashed.

An asset is considered to be in a bubble if it is intrinsically worth less than what people are willing to pay for it. So how do we figure out what something is worth? Traditional approaches to valuation say that a company's value is determined by using historical data to project future cash flows and then discounting those future cash flows by a certain risk adjusted discount rate. You then add on a terminal value that is determined by assuming a future perpetual growth rate.

Trying to apply this method to disruptive technology companies doesn't work for a few reasons:

1.There is often little or no historical data to use to make future projections - companies are burning cash today with the goal of generating massive profits in the future.

2.The risk to future cash flows is so high that the discount rate required is large - there is no historical basis upon which to believe that the future cash flows can be real.

3.The upside if they succeed is so high that the terminal value can be enormous - if they turn the corner and win, you could have a Google, Facebook or Alibaba.

Rather than trying to determine intrinsic value by looking backwards at historical cash flows, investors in disruptive technologies rely more heavily on the idea of how big a given business could be if they are able to achieve the changes that they have set out to affect.

For example, in a country that has a 94% fragmented retail market with strained infrastructure and a growing urban population, how big could the leading eCommerce company be? What if the company was able to get 2% of the Indian retail market - a market that is currently $500 billion and expected to grow to $950 billion by 2018? A business that had a 2% market share would generate $20 billion in revenue in 2018 (3 years from now!). Any company that can manage to scale to $20 billion in revenue should be able to find a way to profitably monetize that distribution. So, intrinsic value is not figured out by looking at what history is telling us about the future, but more about what is possible if a company achieves its goals. How big could it be? Where could it go from there?

The nature of the game and the implied rules of determining value for disruptive companies are very different than the game being played by traditional companies. This is actually a fundamental factor that often catches traditional companies off guard. Traditional companies operate within the confines of the rules of traditional value creation, where historical cash flows (or at a minimum, currently understood expectations of cash flows) is what defines value creation. In the world of disruption, valuation is not about what was, but what could be.

The crux of this new game is all about changing consumer behavior... this applies to both B2C companies as well as B2B businesses. Disruptive companies' goals are achieved based on changing the way their customers operate. Studies have shown that the most effective way to change customer behavior is to provide a financial incentive. This is evident in all of the offers currently available to consumers in the Indian market. From 50% off on purchases, to no hassle returns, to buy one get one free offers. Companies are trying every financial incentive possible to get customers to take a small step towards the promise land.

Traditional valuation methods that look at historical behavior to determine future cash flows, would posit that the continuation of these irrational incentives will result in perpetual losses and imply a negative value for the businesses engaged in this madness. However, for the disruptors who play by a different set of rules, they believe that the incentives are just the first step in a long game where eventually differentiated user experience, choice and efficiency will retain customers and create a stream of cash flows that will look very different. The disruptors believe that they are bearing the burden of changing customer behavior and that they will eventually be rewarded with loyalty and a deeper understanding of customers which will enable them to be massive winners in the new world.

While the traditionalist valuation methods tend to outnumber those willing to play the disruptors game. Fortunately, for consumers and innovators, there are enough believers. In fact sometimes there are too many believers. In some cases there are more believers than there is market potential to satisfy all of the contenders. For example, in the world of social networking, there were many companies who believed that there was tremendous value in capturing the social graph...remember MySpace, Friendster, HiFive or in India - Big Adda? The spoils of the social networking game were allocated in an even more extreme manner than that of other verticals. The one who got the most traction won it all.

Each of the players who lose in the disruption game will, in retrospect, seem over valued, however the winners will seem to have been drastically undervalued. In 2007 Microsoft invested $250 million in Facebook at what was derailed as a bubble-esque valuation of $15 billion. Today, sitting at $220 billion in value it seems like that was a terribly low value. Meanwhile, NewsCorp acquired MySpace in July 2005 for $580 million and then sold it in 2009 for $35 million. So was MySpace a bubble price and Facebook a recession price?

The question of a bubble comes up when those who are paid lots of money to invest can't apply traditional methods to understand value. There is an immediate sense that market value has outpaced intrinsic value due to FOMO. While this is partially true, it is not the whole truth and therefore cannot be the lens through which disruptive changes are assessed.

So when FOMO, What If and Bubble walk into a bar... the end result is the same as any great party - someone gets lucky, someone wakes up with a hangover and someone refuses to stop partying.