Are You Still Valuing Tech Stocks by Traditional Methods? It's Time to Rethink.

Our brains are wired to evaluate things relative to its peers as well as to its own historical value.

In the stock market there is a popular example of this - PE ratio. It's one of the most widely used methods to value a stock. Every student studying finance is taught to use it.

But what if I told you, the PE ratio is no longer one of the holy grails of investing?

As far as new age business are concerned, PE is impractical.

Well first, it gives you an error when the denominator, 'earnings', is negative. A majority of the new age business are loss making currently.

There are other factors too, which make traditional methods like the PE ratio useless.

If business models have evolved why shouldn't valuation metrics evolve too?

I am talking about platform business. They're facilitators between buyers and sellers online. Aggregators in all industries, right from food delivery to cab aggregators to shopping enablers.

The internet boom has not only enabled the Platform/Digital eco systems to prosper but also accelerated their growth.

To add to it, covid has given a further push to these digital companies.

Now, the jury is still out on the valuations of loss-making companies like Zomato and dozens of IPO bound digital companies.

But I'm sure traditional methods like PE are useless in such cases.

Let's take the example of Zomato. It's one of the most talked about IPO in recent times. It was a water shed moment for the start up industry. A home-grown unicorn listed on the Indian stock market.

There has been much talk about its market capitalisation on listing.

After all, a loss making company achieving a market cap of Rs 1 tr on listing day is unheard of. Many critics, looking at its financials, are baffled by the high valuation.

On a lighter note, my colleague Rahul Shah shared a meme which said, 'Zomato crossed Hero MotoCorp market cap by selling food on Hero bikes'.

Ironical but true. Hero MotoCorp's marketcap is nearly half of Zomato's.

However, the cash and investments on Hero's books are 2.5 times the revenue of Zomato in FY20.

Insane, isn't it?

And yet it trades less than half the value of Zomato. That's because markets are always forward looking and they know something which the critics are missing out.

So, the billion-dollar question is how do you value Zomato?

I came across a very important concept spoken by Mr Ramdev Agarwal of Motilal Oswal which I complete resonate with.

You cannot value Zomato and its likes via the traditional way.

If old economy companies in the steel, cement or the textile sectors want to start operations by setting a greenfield plant, my sense is an initial outlay of at least Rs 20-30 bn for a sizeable capacity.

The payback period for this will be at least 3-4 years as the ramp up happens gradually. It's only after this payback period, the company starts making profits.

So the first 3-4 years cash flows will be negative, the burden of which won't be reflected in the profit and loss statement.

This is called balance sheet investing. Here, the initial outlay is funded through the balance sheet. That is where traditional valuation methods will be useful.

However, the new age business like Zomato have a miniscule amount of fixed assets. This is because they are aggregators. Their investment isn't plant and machinery but customer acquisition and retention. That is where major costs are expensed.

Their job is to grow the market and simultaneously gain market share.

The initial huge sum of capital outlay which traditional companies route through the balance sheet is done by digital companies on a recurring basis through the profit and loss account.

It's expenses such as customer acquisition costs (discounts) leading to huge cash burns that hits the profit and loss account on a recurring basis.

Zomato had a monthly cash burn of US$3.9 m which adds up to Rs 3.5 bn of cash burnt in FY21. The cash balance would suffice for at least 7-8 years of cash burn for the business at the current rate. If the cash burn reduces going forward, it would probably suffice for 10 years.

The difference between traditional and new age business is the initial outlay versus the recurring outlay of capital.

Tech platform companies have shifted to the profit and loss method of capex rather than the traditional balance sheet approach of fixed assets. This makes it pertinent to discard the traditional valuation methods.

Factors like cash burn per month and cash as a percentage of assets would be critical to watch out for to evaluate the financial health and prospects of the company.

Therefore, the next time you evaluate a tech business, remember that markets are smart enough to look deep into the future and see things many cannot.

Warm regards,


Aditya Vora
Financial Writer