With WeWork getting ready to start its pre-IPO road show, I’ve been thinking a lot about initial public offerings. The company, which provides shared workspace, has been valued at up to $47 billion despite the fact that it lost $1.9 billion last year. To last, every system needs order. Yet, in today’s IPO market, there is no consistent, defensible basis for valuing companies.
Any asset is worth what one person will sell it for and what another person will pay for it. This is called a market. If there are 10 people in a community who eat apples, the price of those apples is just a function of what those 10 people will pay on average, whether it’s $100 per apple or 10 cents. It is not up to me or anyone to assign a relative value to an apple.
However, there are important differences between apples and companies. There are imperfect but reasonable valuation metrics that give one confidence in valuing a company. The impetus is that investments in companies have a goal: to get a return.
Let’s say the cash flow a company generates is the most reasonable proxy for its value and that a given company generates $100 per year in cash profit. Let’s also say an investor in that company wants a 10% return. In this example, the investor might be willing to pay very roughly $1,000 for the company ($100 divided by 10%). If the company has 1,000 shares outstanding, the value of each share is $1 ($1,000 valuation for the company divided by the number of company shares). This is a crude valuation barometer, but it makes sense.
Now, if the above valuation methodology is not the one to use, what other one would be reasonable? The further we move away from cash flow analysis, the more we move towards arbitrary methodologies. But, given a market where almost every company going public is losing money, let’s go to a secondary, less valuable metric: measuring the ratio between the sales of a company and its valuation. Let’s call this the valuation to sales ratio. (I am not thrilled with this one because sales don’t necessarily tie to cash flow). If a company is valued at $1 billion and its sales are $100 million, its valuation to sales ratio is 10 — for every $1 of sales the company is generating, it is purporting $10 worth of value.
Let’s now talk about some companies that have gone public recently. The first company we’ll look at is Beyond Meat. Since the company does not have profits, we have to move to valuing it by looking at sales. The year prior to going public, its sales were $88 million, and its net losses were $30 million. It went public at a valuation of $1.47 billion. Its valuation to sales ratio was therefore 17 (valuation/revenue). Today, since its IPO, its valuation to sales ratio is 107.
WeWork’s most recent valuation in the private markets, $47 billion, is roughly 26 times revenue, even though it is losing more money than it is making in annual revenue. In the good old days of five years ago, even if you were losing money, it was nice if your losses at the bottom were not greater than your total revenue on the top. News broke yesterday that the company is considering significantly dropping its IPO valuation to around $20 billion, which would make its valuation to sales ratio 11.
Another company to go public this year is Slack. In 2018, Slack’s net losses were $140 million and it went public at a valuation of $16 billion. Sales were $401 million. Its valuation to sales ratio was therefore around 40.
What does all this mean? As a back-check on cash flow and valuation to sales ratios, let’s turn to historical markers. When Google went public, not only was it profitable, but its valuation to sales ratio was 24. When Facebook went public, it was also profitable, and its sales multiple was 28. So, the valuation to sales ratios were high, but both companies were actually making money, not a small footnote. I realize it seems like ancient history, but when Microsoft went public in 1986, it was profitable, and its sales multiple was 6. So Slack started trading at roughly 6 times the relative value of Microsoft.
I’ve never heard a convincing argument that puts the value of a company beyond future expected cash flows. It’s not just that the companies are losing money and trading at very high sales multiples. It’s that there is no accepted, reliable, and consistent way to value tech IPOs. I did recently hear a counterargument from Bill Gurley of Benchmark Capital on a podcast. Smart dude. He basically made an indirect argument for high prices by saying these companies are vying to be the leader in the market, the value of which is immensely high and possibly more than we can currently calculate. My argument to this is that it will hold about as long as a bull market.
There are two possibilities. The first is that I’m wrong or am missing some new way to value technology companies. The second possibility is that I’m right, and that the technology companies going public today are vastly overpriced. The fact that WeWork is now talking about slashing its valuation in half when it IPOs indicates I’m right. Although half of $47 billion is probably still too high.
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