I’m trying to understand more about how the modern economy works. You may safely assume I know nothing.
One thing I’m failing to understand right now is how tech companies are valued at such high levels when they aren’t running a sustainable business model. As I understand it, Netflix, Uber and now many AI companies have these huge valuations despite comparatively piddling revenues, many of them operating at a significant deficit.
Why would investors give money to a company without a sustainable business model?
How can a company running a deficit exist successfully for so long?
How does valuation work and why is it so weird with tech companies?
What does valuation mean, for practical purposes? How would investors use a company’s valuation to make decisions?
Any other insight you could provide would be most appreciated. Bonus points if you have any book recommendations about the tech economy.
Investors are betting the company will hit it big with a new product and make a gob of money in the future.
The company continues to exist because investors keep putting money into it
Here’s where it gets really wonky. Valuation depends on what a bunch of investors think the company might be worth in the future if the founders can actually do what they say they can do.
There’s nothing especially unique about the tech market. The telephone was a toy when Bell et al started Bell Telephone. Radio was a hobby when David Sarnoff convinced investors that you could string a bunch of independent radio operators together, bring programming to a national audience and most importantly, get sponsors to pay for it.
OTOH, Edison used his success with the light bulb to branch into industries like mining – much less successfully, to his investors’ regret. John DeLorean was very successful at designing and developing cars, but a spectacular failure when he tried to build his own company from the ground up.
Just to pile on top of Kent Clark’s succinct and excellent answers. “Valuation” has many different ways of being calculated, and attempts to either justify the excess or try make apples to apples comparisons.
pre-IPO companies (companies that are not listed on a publicly traded stock exchange) often have an “implied valuation.” To illustrate, a legal company has issued 100 shares total. The founder has 75 shares, and he sold 25 shares for USD1 million. One might think that implies the company (100 shares) are worth USD5 million. And that would be correct if the founder can find buyers at that price for the remaining 75 shares. However, it is “expected” that the start-up will productively use that USD5 million (like make a product that can be sold), make the company worth more with a better forecast, and the next round of buyers are then willing to pay 5x or 10x per share. So, the early investor took on more risk/paid less, the next round of investors have a more mature company/greater chance of success/paid significantly more.
More mature companies, say Microsoft, Alphabet, Meta & Amazon have a public history of their financial reports. Analysts then can calculate all sorts of things like the Price/Earnings Ratio (PER) based on past data, make assumptions on future financial forecasts, in an attempt at apples-to-apples comparison to figure out what stocks are “cheap” vs “expensive”. It aint an exact science.
Back to basics, shares are worth only what someone will pay for. And in a recession or uncertainty or a stock market crash, those shares will not be “worth” the multiple that some investors paid, and could become completely worthless.
In principle, the value of a company is the present value of all it’s future earnings and losses, plus the value of its assets and less the value of its debits. By present value, I mean that each of those future values must be discounted by the time value of money, assuming some reasonable discount rate. So $1M ten years from now is worth a lot less than $1M today, so it has to be discounted. Calculation of the present value is called a discounted cash flow analysis. So a high valuation of a company losing money means (again in principle) that the person estimating the value thinks it is going to make big enough profits in the future to compensate for all the near term losses.
In practice, it is usually too hard to accurately estimate these things, and the people who do the estimates always have an axe to grind, depending on whether they are buying or selling. In reality, the valuations are often inflated by irrational exuberance, fear of missing out, and people hoping to sell to an even bigger sucker in the future. Caveat emptor.
Many of the these companies have the strategy of maximising subscriber numbers regardless of cost, on the assumption that within a few years they will have a monumental subscriber base and will have essentially cornered the market, and at that point they can start charging and make bank.
If you have a billion subscribers and you make no money from them things look bad. But if next year you change your business model and can extract a mere $0.10 per customer per year, then suddenly you have a $100M per annum income. The effect of large numbers can give surprising results.
Another point here. As a company is getting going, investors do actually give money to the company in exchange for new shares in it, with the expectation that the company will (probably) be profitable later and their money will be returned many-fold. The company spends that money on building their business, and once spent it’s gone just like any other spending. The goal of course being that that spending does grow the company, bring in more revenue, etc.
Those kinds of investors also expect to fund 9 dud companies that lose all their money and disappear, yet the 10th one pays off so well the 9 total losses are avenged and then some.
Contrast that with somebody buying existing shares of, say, Amazon today. The company derives no direct benefit whatsoever from somebody buying shares of Amazon. They get no money from that. In fact the only thing they get is the expense of recording the change in ownership of the shares from Smith to Jones. (Which is a niggling detail and is subcontracted in any case).
All the money Jones pays for the shares goes to Smith. Jones evidently has some reason to think somebody else in the future will pay even more for those shares. And, depending on the company, Jones may expect to receive dividend payments while they hold the shares. Meanwhile evidently Smith has decided that now’s a good time to sell at the currently available price. Maybe they like Amazon, but have some other even better use for the money and needed to raise cash for that other thing. Maybe they’ve become disenchanted w Amazon’s prospects and just want out. Why doesn’t matter.
What does matter is that Smith wanted to dispose of shares and Jones wanted to obtain shares. So they swapped those shares for some cash going the other way.
Amazon itself and all the other shareholders aren’t directly affected by this. However … the collective actions of lots of buyers and sellers will move the share price up or down, Ouija-like. And everybody else re-labels their own holdings in Amazon according to the price last paid. That relabeling is simultaneously hard and factual, and built also on nothing more substantial than the smoke and hot air of the sentiment of the last buyer and seller.
“Valuation” is 10% accounting and 90% confidence game. In both the beneficial and pejorative meanings of “confidence”.
The CEO or CFO does these calculations if they are seeking investment. Potential buyers or investors do the calculation to determine how much they are willing to pay. Analysts do it to advise their clients, etc., etc. Assumptions have to be made about future sales, cost of goods sold, R&D expenses, capital purchases, etc. In a startup, the CEO will often make wildly optimistic estimates of sales and expenses. Investors will make pessimistic assumptions. In the end, the decisions are probably going to made more on gut instinct than on what the spreadsheet says. When the stock is publicly traded, the valuation is fixed by the market and easy to compute, i.e. stock price times number of shares. This is unlikely to agree with the theoretical discounted cash value.
