The Overvaluation Engine
High growth companies competing for large total addressable markets may not be creating long-term value. Cheap capital has created a vicious circle of unproductive investment.
It’s Cash Flow
Cash flow creates value. An investment is worth the present value of its future cash flows. There is no other metric that will ultimately define value. While a company with high revenue growth competitively positioned in a large total addressable market can potentially create long-term value, today’s market is defining it as if this were the most important metric to determine long-term value. This thinking is misguided.
Have We Got a Disruptor for You
There are plenty of examples outside of the most public ones, such as WeWork, Uber, and even Netflix, that will ultimately prove this valuation logic of “growth and markets” to be folly. This thinking assumes there will be no competition for attractive market sectors, that prices can be raised because of strong competitive positions, and high and increasing capital investment requirements stripping away any prospect of positive cash flow are somehow insignificant. We are “disruptors” after all. What else matters?
For example, in order to justify the current valuation for Netflix, one has to assume that the company will be able to raise its monthly subscription to $15 while attracting additional subscribers. No problem, right? No matter that there is increasing competition from Disney, Hulu, AT&T (HBO) and others with meaningful resources, important brands, and unique content. Downward pricing pressure and the inability to increase subscribers and prices is more likely. Of course, it also assumes there will be no customer pushback. This is also hard to justify considering consumers have increasing choices and are gaining power — supply and demand economics have not been vetoed.
What We Really Do
Another critical driver to overvaluation is misunderstanding the actual business model versus the marketing pitch. Valuations are ignoring accurate business descriptions, and therefore, are leading to inaccurate economic models and producing misguided valuations of the imagined “disruptive technologies” they are purported to represent. There are many examples, but the most flagrant and obvious ones we see getting attention include the following:
· WeWork. It is a commercial real estate leasing company with long-term obligations and short-term revenue sources, cancelable on short notice. This is a dangerous long-term business model, as the markets have finally recognized that it is not disrupting the office real estate market so much as providing consumers with an attractive environment, but at an uneconomic cost to the company.
· Uber. It is a car service, with aspirations to be a logistics and delivery company. Perhaps it will transform into something completely different, but right now, it is an unprofitable taxi service that has an excellent communication platform to enable additional services. While it is more efficient than a taxi and delivers convenience and attractive pricing, the overall cost to provide this service seems to indicate that the company may never actually have positive cash flow. Unless there is a material change to its cost structure, investors are transferring their capital to deliver value to consumers, not equity investors.
· Netflix. It is an entertainment content subscription company. It must generate new content at substantial capital requirements (over $12 billion annually — also Disney’s budget) in order to maintain its current business. Its subscriber levels are slowing and, potentially decreasing in important markets, and its ability to raise pricing is questionable. Another great service giving value to consumers, but that does not mean the current stock value is justified.
There’s Still a Competitive Market and “Technology” is Not a Business — It’s a Tool
Each business has increasing competition and consumer choices, requires substantial capital investment to remain viable, and it is likely each will never generate sustainable positive cash flow. These are only the most public and obvious examples, but many more exist — both public and private. Defining these businesses as “technology companies” attempts to apply a different metric to how they should be valued. They provide excellent service, and their technological tools allow for more efficient and effective delivery of that service to consumers, but it is consumers who are benefiting. Increased competition will enhance the value consumers receive, but this will reduce any potential return on capital investment from these competitors. Technology is not the core business, and these companies should not be valued as such. The technology used to deliver better service certainly creates consumer value, but it may not create long-term value for investors in those companies.
Accurately defining the real business, understanding the true competitive dynamics, realizing the total capital investment required to remain competitive, and analyzing the real net potential cash flow is the only way to accurately analyze these companies. Without a clear and realistic path to truly sustainable cash flow, these companies are overvalued.
In the meantime, money is flocking into the market and propping up overvalued companies. Real sustainable value is not being created by enough of this capital.
Free Money — What Could Go Wrong?
Interest rates are unsustainably low. Governments are increasingly accessing debt markets that offer extremely low or negative interest rates. Large government deficits are increasing substantially, requiring governments to sell even more debt. These amounts cannot naturally be absorbed by the financial markets without driving up interest rates — which would be catastrophic. Therefore, central banks will increasingly step in to buy this sovereign debt and maintain quantitative easing, lowering interest rates and keeping a false lid on inflation — until they can’t.
So, central banks will buy all this debt produced with freshly printed money. Therefore, sound and fundamental economics are being ignored in the equity and debt markets — at our peril. Unfortunately, this trend looks to only accelerate.
If money is essentially free but being applied inefficiently where value is not being created, and worthy capital recipients are finding capital less available, we have an unsustainable economy. Markets will correct this overvaluation and misappropriation with a rather unpleasant bang.