Arrogant Valuations

Arrogant Valuations

Do You Know What Your Business is Really Worth?

Last month I wrote about the evil of arrogance in leadership, and in your life overall. Arrogance can get you somewhere in the short-term. However, in the longer term your failure to admit you don’t understand everything you need to be successful will hurt you and most likely be the end of your business. It’s one of the reasons businesses fail in the first 5 years. They believe they understand everything, but they don’t. Most don’t even know what “everything” entails. It is every aspect of your business, not just your product, not just your marketing. It is your people, processes, training, adherence to regulations and standards, understanding of your competition, understanding your customer’s motivations, and much more.

Recently there have been some great examples of arrogance in valuation. The “West Coast” method of valuing a business based on the amount of money people want to invest in a concept and growing the top line. You will hear people say things like “I don’t care if it makes money right now” or “It is worth “x” times annual gross revenue”. Great examples abound like Uber and Lyft, amongst others. You know them all and their stories are celebrated.

Uber and Lyft are growing by leaps and bounds and just had Initial Public Offerings of stock to raise large sums of money. Both attracted very large sums of investment prior to going public.

If I grow an apple and sell it to you at a profit, you gain the value of the apple and I gain the value of the profit. You get a tasty meal and nutrition while I get the benefit of using that profit to my own benefit. But if I sell you that same apple at a loss each time, you get the value of the apple and I build up debt. That debt may be value to my debtors (and the lawyers when I go bankrupt), but being the one in business I would hope the value came to me in the form of profits.

While this is a simplistic example, it drives home the point. In business, at least for investors/owners, the real and only value comes from generating a profit. Duh, you say. That is obvious! Then tell me how does Uber start generating revenue in 2011 and continued to do so through today, July of 2019 without ever making a profit? I get the first 2-3 years since they actually started in 2009 but launched their first market in 2011. Eight years though and they have not figured out how to do it profitably? With Lyft who was founded in 2007 and launched in 2012 it is seven years. Where is the real value of these businesses?

Neither are projecting profits in the near future, although both are hoping that the large infusions of cash that they just received from their IPO’s will propel them to profitability soon. I was once told that if you lose $1 each time you sell something, making it up on volume does not work. You lose $100 if you sell 100 somethings and you lose $1000 if you sell 1000 somethings. It is basic math. Real value is basic math, not hope and dreams.

Crazy or smart investment?

Yet somehow Uber went public with a valuation of $76B and Lyft at $24B…yes those are billions. Why am I surprised? Why is that arrogant? If you agree that business value comes from profit, the valuation of a business should derive from the combination of its current/past ability to generate a profit and its future ability to do so. In fact, the proper valuation model looks at current and projected profits into the future. Based on those data points, value can be calculated based on risk and what we call the time value of money.

Quick lesson: If I take $100 today and invest it at a 10% return each year ($10), in five years I am going to have $150. So, if you tell me you are going to give me $150 in five years, today it is only worth $100 to me. The value of that $150 today is $100. The difference is called the time value of money. Since I can invest my money at some rate of return (10% in the example), anything of value that I may be able to get in the future is worth less to me today.

Since we know neither Uber or Lyft has generated a profit to-date, there are no current profits to include in the valuation calculation. So, all of those profits creating value today are being projected to take place in the future, and not in the next year. To be worth $76B today, at that same 10% rate, they will need to generate around $760B in profits over the next 10 years. Why 10 years? Because if you deduct 10% per year after ten years all profits gained in the future are worth $0 today.

This past year Uber generated $11.1B in top line gross revenue, while losing $1.8B (and that was good!). Over 10 years that $11.1B is only $111B in gross revenue. Even with phenomenal growth over the next 10 years they would need to increase 7-fold just to generate $760B in gross revenue. I cannot even imagine how many times they need to increase revenues in order to be able to generate $760B in profit. Right now, we have no idea if they can even achieve a profitable model and if/when they do, what level of profit that will be at. The same issue, with different numbers applies to Lyft and others (Tesla).

Yet, the reality is large numbers of people are betting that their current valuations are not only correct, but low since they want a decent return on their investment. Crazy or a great investment? I believe the answer is much closer to crazy.

This week’s challenge for you is to ask yourself if you have a good handle on the value of your business? If not, I suggest it is worth the time and effort to figure it out. Doing so will help you identify true Key Performance Indicators for your business and may even alter your course of thinking for your business. If your plan is to someday sell your business, this will become a salient point. The sooner you understand your true value, the better you can plan for that day.

I can help you value your business! Reach out.