Valuation or Profitability: What do businesses really need?

Valuation or Profitability: What do businesses really need?

The five most prominent technology companies in the world, i.e., Apple, Amazon, Alphabet, Microsoft, and Facebook, reported a jaw-dropping $75 billion in after-tax profits at the end of the second quarter of 2021. 

The results were nearly 90 per cent higher than the year before and 30 per cent higher than expected. These companies have led the current stock market boom; also fuelled by generous stimulus plans announced by most of the developed countries. This has pushed liquidity levels to unprecedented degrees. 
The story developing in India is no different, with stock indices spiralling to new all-time highs within short frequencies. Riding on the boom is the market for initial public offerings (IPOs), seeing extraordinary interest from investors. 

With nearly 18 start-ups acquiring a unicorn status this year, the queue is building up for large IPOs, and it is clearly a great time to raise funds. With heady valuations pumped up by private equity, the conventional core financial performance indicators such as cash flow and profitability have faded in the background, with investor money overwhelming the landscape.  
In July, Zomato, the food-delivery start-up, quickly reached a capitalisation of $13 billion post its IPO. Unsurprisingly, the valuation of its nearest competitor Swiggy has also reached a valuation of $5.50 billion after the latest round of investment, during which it raised $1.25 billion from Softbank.

However, the financials tell a different story; for March 2020, Zomato recorded a revenue of $350 million with an equivalent loss. For the same year, Swiggy had clocked a revenue of $370 million but ended up losing $502 million, much more than its revenue.  
When quizzed about the new street favourite, Zomato, the iconic investor, Rakesh Jhunjhunwala, quipped that people should focus only on business models that produce cash rather than taking foreign money and burning billions of dollars. He added that he was interested in a cash flow model and that valuations will have to follow.  
Fortunately, there haven't been any significant failures in this balloon ride where valuations have crash-landed, which typically causes panic amongst investors. 

However, one such story is of WeWork, a company that typifies the age of monstrous start-ups with enormous losses. The implosion of WeWork in September 2019 was an extraordinary moment in business. Nearly $40 billion, in value, vanished overnight.

The investment world woke up to the reality that America's most valuable start-up wasn't a tech company but simply a real estate company, and one that was losing more than $1.6 billion a year. 

The authors of a recent book 'The Cult of We' conclude that it was a story about the toxic brew of confirmation bias, fuzzy math, and hubris. It is debatable whether the WeWork story was an exception or simply the most stunning example of a cultural decay that has set in in the investment culture of the twenty-first century. 
Contrast this to the relatively untold story of ZOHO, a company led by Sridhar Vembu, which is truly inspiring. Started as bootstrap with no celebrated birth date (the founder confesses that he does not know exactly when the company was started), ostensibly, for the year March 2020, earned a profit of $107 million. 

However, the company remains unlisted and has always been self-funded. Little wonder then that when one googles Zomato, 610 million results pop up, but when you do the same for ZOHO, the results are a mere 120 million.  
The new-age companies can raise hundreds of millions of dollars on the back of lofty market valuations, only to collapse when they cannot figure out how to turn profitable.

Regardless of the value created, an industry will be attractive only if its structure allows participants to earn decent returns. 

In their excitement to exploit the new opportunities that they spotted before anyone else, many entrepreneurs fail to see that the more value their business model creates, the more competition they're likely to face. 

Business valuations should not be more important than business models, as investors tend to get too optimistic about how fast the new-age companies would produce cash.  
One of the keys to long-term success based on profitability is to be part of an industry with an attractive structure and a sustainable competitive advantage.

Unfortunately, many flavours-of-the-season businesses cannot sustain this advantage, given that barriers to entry may be low because of the simplicity of the business model, with even more companies are likely to jump in. 

To compound the situation, the quicker these ideas are adopted, the faster competitors enter the race, and the more rapidly the industry's attractiveness will deteriorate. 

In the end, a profitable journey will remain the true mark of a successful business but not necessarily huge valuations. The former sustains while the latter, which is a function of the market, is transient.