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.