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Vetting new-age businesses: Know the valuation metrics for new-age firms

Customer lifetime value and customer acquisition costs are the most critical metrics for evaluating new-age companies

Investors should note that network effects lead to a winner-takes-all scenario.

The year 2021 was a blockbuster year especially for the primary markets. During the calendar year, 63 companies came out with initial public offerings (IPO) and raised around Rs 1.3 lakh crore from investors. Out of the above, roughly one-third of the funds was raised by many new-age companies such as Paytm, Zomato, Car Trade, Fino Payments Bank, Nykaa, PB Fintech, etc. Let us understand the characteristics of the new-age companies and how investors should evaluate the same before investing.

Characteristics of new-age companies
New-age companies generally have an innovative business model belonging to the knowledge-based, technology sector. Their business model is completely different from that of traditional firms which are asset-heavy in nature. Often, new-age firms leverage technology/internet to drive their operations, acting as a platform wherein buyers meet sellers. Their focus is to facilitate the smooth functioning of a business transaction. There are also other types of business models such as a subscription-based model as seen in music-streaming app (Gaana, Saavn) firms or transaction-based firms such as Swiggy.

Use different valuation metrics
Conventional ways of valuation metrics such as discounted cash flow, multi-stage valuation, etc., would not hold good and investors should rely on different metrics. There are many new-age companies such as Mobikwik, Oyo, and Delhivery in the pipeline. In the absence of positive operating cash flows/profits, new valuation parameters should be used and different valuation parameters applicable such as expected growth in cash flow / operating profit. Though metrics are not the same across the new-age businesses, broadly investors could use the following parameters.

Network effects
It refers to a situation wherein the value of a product/service/platform is dependent on the number of buyers, sellers or users who use it. Generally, the higher the number of users/buyers/sellers, the greater the network effect and the greater is the value created by the offering.

For example, Google today has a market share of more than 90% in the online search business. The addition of each
user improves the search results for other users, thereby providing an impenetrable moat to Google. Investors should note
that network effects lead to a winner-takes-all scenario.

CLV and CAC
Customer lifetime value (CLV) and customer acquisition costs (CAC) are the most critical metrics. In simple terms, CLV is the total revenue that a business expects to generate from a single customer during the business relation. For instance, Netflix is a subscription-based OTT platform which offers a yearly subscription plan of Rs 699. Assuming that on average, a customer stays on Netflix for a period of  five years, then the CLV for a single subscriber will be Rs 3,495.

Customer acquisition cost is the cost of acquiring each new customer. It is computed by dividing sales and promotion expenses by new customers. Today’s new-age businesses, especially e-commerce models offer various discounts which are part of CAC. Those companies whose customer acquisition costs are greater than the lifetime value of customers are not a great pick.

To conclude, before investing in any of the new-age businesses, investors should understand the business model. Assess whether the firm is relevant to make a disruption in the segment it operates, whether the business model will stay relevant in the years to come, past track record, current size and scale, future business scalability, potential growth, path to profitability, etc.  If you feel that the business model is too complex and difficult to understand, better stay away from those businesses.

The write is a professor of finance & accounting, IIM Tiruchirappalli

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