Multiplier effect and Valuations

Over 50% of the US market cap is from tech companies — FANG ( Facebook, Apple,Netflix and Google). Many new age companies with poor profitability have valuations that are difficult to believe for the traditionalists. What gives?

The factors that drive these valuations have implications for any startup /ideation not to build valuations but to imagine a business model and product for the digital age.

There are a number of multipler effects in play that cause these valuations and here are a few below:

1. User Adoption : Most of the digital natives focus initially on user adoption rather than revenue/profit. While this is not to belittle the criticality of cashflows/profit, the reasons for user adoption are different. Most of the digital natives reimagine a business model and rewrite the traditional methods. This needs users to adopt to the new way of doing things , realise the benefits and create ‘word of mouth’. Focus on bottomlines initially takes the focus away from user adoption and building a sizable user population.
2. Upgrade Cycles: Once the user population is built, the focus is on user engagement to keep them hooked on to the platform, come back to it more often, spend more time on the platform, try newer features of the platform. Every click on the platform is noted, analysed to ‘learn’. This enables upgrades, buy paid products /services in a ‘freemium’ model and build stickiness/moat.
3. 24/7 Feedback and weekly /daily enhancements: User engagement enables continuous feedback to switch on/off new features , focus on enhancing the items that users care about and make quick corrections. When Xiomi makes weekly software updates based on user feedback on the platform/forums, Amazon talks about customer centricity — measures metrics on each feature every minute, when startups update apps ‘on the cloud’, all of this is to get it ‘absolutely right for the user/customer’.
4. ‘Almost Zero cost of Cross-sell’ : Once Paytm has millions of customers using the platform and there are mechanisms to bring them back all the time, cross selling is as simple as adding a new category/offering on the platform and instantly its available to the user population to try and add to topline/bottomlines. Every new offering addition to the platform comes at much much lower costs improving the margins and enabling geometric profit growth.
5. Built in Non-Linearity : Built in non-linearity means addition of users do not mean costs for every user added.

Thus the factors for valuing the digital firms is quite different and the traditional models of Discounted cash flows, P/E multiples , peer comparisons do not work here. Having said that, each business is finding the emergence of ‘digital duopolies’. Thats a topic for another post.

Engineering the 'Switch'

Whether you are planning a new product /platform/service, it is most likely that the target customers are already doing the same thing in a ( less efficient/more cumbersome/ costlier/ longer) way but doing it all the same. Be it a financial transaction or a business process or a life activity.

It is also likely that the alternatives to ‘current way of doing things’ are also many. In the digitally native world, there are literally 100s of taxi ride apps, e-commerce apps, payment apps, news apps, personal finance apps….

So you are starting with a ‘set, old way of doing things’ and a bunch of alternatives to ‘ do it better’. Since digital world is all about ‘user adoption’, getting the user/customer to ‘do it your way’ is the absolutely critical thing.

How to engineer this switch?

1. Power of Inertia : Nothing is your bigger enemy than inertia. Inspite of cheaper loans, cards with better rewards, data plans with better goodies etc, only a small percentage of customers switch to the ‘smarter’ option. Why? Simply because it takes effort to change and also the comfort with the present.
2. Small ‘Delta’ : No matter how great you think about your product/service/platform and consider everything else to be from stone age, most of the times customers find that the delta between the ‘current’ and ‘new’ is not significant. Combine this with the pain of change and you can be sure , what the customer would do.
3. Power of ‘Viral’: Functionally an Amazon Pay or Google Pay or Apple Pay might be better than Paytm. But if paytm is viral across the population compared to others, the functional differentiation does not matter.
4. Power of ‘Soft’ factors : Inspite of how ‘you want the customer to think’, customer processes/likes/dislikes on their own criteria. Customer may pick a product not necessarily based on what gives most value but which is ‘easiest/smoothest to use’, which is ‘more fun to use’ ( think gamification) and which has nicer bells and whistles.

So how to engineer the switch?

a. Focus on the product attributes that make the delta the largest possible

b. Look for items/ make it easy to share /crowd source/like/viral

c. Sweat the ‘soft’ stuff. Remember , most of the digital natives are young and younger. User Experience, Gamification, Fun…