Having worked in private markets and M&A for a while, there is something which still bugs me. I could be being thick or I know the answer but it just isn’t satisfactory.
Why is a tech company valued higher than a more traditional business e.g. oil or a newspaper business?
I completely understand the general rhetoric of:
- If successful, monopolistic ownership of future profits/ cash flows in the industry vs highly competitive traditional marketplaces
- Maturity of traditional business’s and their markets - traditional businesses hey days are over, many of these businesses produce good cash flows but they will never have yoy growth of >100%
- Lean teams, tech companies can scale very quickly and into a large business with less employees than a traditional business would require
- Marginal cost of production of an additional unit of the software is less than in a traditional business which would need plant and equipment
Criticisms to this theory/ model:
- Time value of money. We are taught a $ today is worth more than a $ tomorrow. Why is a business which doesn’t achieve profitability for 10yrs valued more than one making money today? There is no guarantee the business will ever achieve profitability, tech companies come and go, hard to believe Twitter will be around for 100 years.
More on the above - there are many issues with forecasting in DCFs, how do you know the company will achieve these cash flows
There are others, but I am trying to keep the post short…
I ain’t reading all that
You’re not being “thick” (is that a British term??) you’re being overly academic. Valuation only matters truly in the context of your holding period. Why as a VC do I care about the accuracy of a 10-yr DCF if I can give this founder $5M today and 5x the second they raise their next round at an over inflated price 2.5 years from now? How do I know the price will be over inflated? Well shit somehow they keep growing 100%+ YoY some shlump with FOMO down the maturity hierarchy will certainly bite on it if I as a VC “sell the dream”. GE “sells the dream” to PE. PE puts lipstick on a pig and guts it just right to be primed for a big IPO pop etc..
just spitballing here but software co's have less operating leverage, high returns on incremental invested capital (partly bc their SG&A/R&D investments arent capitalized), and high margins. typically have predictable enterprise contract revenue (i.e. SaaS) or network effect moats (anyone can spin up a Twitter clone using Cursor/open source (e.g. Truth Social) but the users are the source of value). for the reasons above, they trade at higher multiples.
VC valuations are a different beast and largely based on private comps and expected exit value discounted to PV, sometimes with some real option theory baked in.
It's an interesting question and you already have the pieces to arrive at the right answer which is quite simple. While prices can fluctuate in the short term, the ultimate value of a company is the present value of its future cash flows. Full stop, no buts. To arrive at the value, you need to know its future free cash flow and you need to know the cost of capital to discount those cash flows. Regarding free cash flow, why do tech companies have higher projected cash flows than traditional businesses? Because as you said, they typically have higher margins/better operating leverage. Two companies with the same revenue will have different cash flows based on their margin profile. The second component is growth - tech companies generally grow faster than traditional companies because they are less capital intensive. As to your question around some companies never reaching profitability - yes thats true but you are valuing the company today based on future cash flows, not today so the only thing that's relevant is the ultimate cash flows the company can generate and tech companies business model are positioned in a way that enables them to reach profitability quicker. So that's why your numerator in the DCF equation is higher for tech companies than other traditional companies. The denominator in the DCF is your cost of capital. The most important to thing to understand about your cost of capital is that it accounts for risk. Tech companies may have higher cost of capital given its volatility so this is where you adjust your projections. When you net everything out, you typically arrive at a higher value for tech companies versus traditional ones.
Free cash flow magnitude and growth rate
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