Are Digital startups valued correctly, especially their intangibles?

Introduction

• Today we are in Digital age.Digital is the area where many companies spend most of their budgets on.Digital investment has contributed to the overall growth of the Global GDP.In fact the boom of stock markets which still continue to persist and enjoy the longest boom period since post recession period of 2009 in the history owes its growth to Digital economy and services.
• Technology companies focused on providing digital services have a different business model and come up with innovative revenue streams to capture revenues and market share.Many of these companies have managed to achieve huge valuations. Digital firms like Zoom that provides voice conferencing services are valued at 70x revenues where as cybersecurity firm Crowdstrike at IPO was valued at 35X revenues.
• Most of these Digital companies are still not profitable and continue to burn cash but investors still value these companies at premium. In fact the "digital companies as the industry" that use technologies like Cloud,AI and IoT as their business model to drive revenues and capture market share are valued at a higher multiple that internet and Hi tech stocks.
• Such astronomical valuation of these companies raises a serious question, if these companies are overvalued and are we doing the same mistake that we did in early 2000 also called as dotcoms bubble where ecommerce companies were also valued at astronomical levels.
• A part of the reason for these high valuations can be due to macroeconomic indicators like low interest rates along with sstrong stock markets that makes the investment climate favorable for companies launching IPO's.

Are the Digital Companies really overvalued above their intrinsic value?

• The answer to this question lies in how we report our Financials and measure assets/ revenues of a company.
• For a digital company, intangible assets form a major part of the company's cost.For any digital company to differentiate itself against its competitors, it needs to focus on three areas:

1. Technology
2. R&D Costs
3. Customer Relationships

The above three areas determine the brand of the company which is also an intangible asset.

• Take the case of Facebook which started as a social networking site where users can connect with each other and share content/information. The key areas of investments for Facebook at initial stage would be
• Technology to build the platform along with R&D costs to ensure improvements in the underlying platform and protecting their IP from other competitors.Over a period of time more users started to register in Facebook thus creating a massive user base.The revenue model for Facebook users was a Freemium model where basic features of the platform is free and requires subscription costs for premium services.The companies wanted to exploit this massive userbase of Facebook by advertising their goods/services to target users aimed at increasing their revenues.These companies paid fees to Facebook for using their platform to market their services to target users.
• This increase in user base brought more users and hence businesses to advertise their business to Facebook platform due to networking effects.This networking effect brought in huge revenues.
• The benefits from intangible assets like technology and Patents is going to continue for years to come and hence these investments are required to be treated as assets not expenses.
• As per the accounting conventions, asset is an investment which is able to generate revenues for a longer time.For instance, improving the skillsets of employees is an asset as the benefits of this investment helps in employees providing innovative services to customers which help in increasing revenues for longer timeframe, but as per the current accounting norms these are taken as expenses in the P&L sheet.
  Intangibles like R&D costs or patents that contribute to the major part of digital companies costs are not considered as Assets but as expenses.This means that these expenses will reduce the profitability of the company and at the same time not able to report these costs as assets will reduce the value of the company.
• On other hand, assets like Plants and Machinery, equipments and datacenters/servers are considered as fixed assets and these capital expenses can be depreciated/amortized over a period of life span of the asset.
• This major flaw of not recognizing the intangible costs that forms around 70-80% of initial costs of a Digital startups as assets but as expenses is the reason why many of these companies still continue to report negative margins and shown as burning cash.Alternatively if these investments are shown to be assets then the book value of the startup will increase due to the addition of assets and at the same time these investments can be capitalized over the lifetime of assets which helps in reporting less expenses for the startup thereby achieving better margins.
  Since these intangibles investments done by the startups accrues benefits that can be realized over a long period of time, the PE firms/ other investors value these companies highly and pay huge money to buy these firms.

Why additional disclosures on reporting Financials of Digital companies is required?

• It is important that additional information needs to be included as per the frame work of Financial reporting norms to guide investors on better valuing Digital companies.
• Current Financials reporting norms are not sufficient to cover Digital companies and need to include key information like:

1. How the digital companies generate revenues?
2. What is the supply chain process?
3. Who are the important parties in its business model
4. Detailed segregation of the areas where the capital expenses/Opex are spent.This detailed split can give investors an idea of how much revenues are generated from such expenses. For instance if AI forms 70% of the expenses, then the investor decides that AI is a value driver and would find the revenues/cashflows coming from AI.
5. Future Areas of growth where the additional cashflows would be spent on.This would give investor an idea about the new emerging area which is going to be a value driver for future revenues.

Conclusion

• Confusion over how digital companies are valued stems from the fact that our Financial reporting standards have not evolved to cope with changing business landscape of Digital economy.
• The current Financial reporting standards still continue to accept physical tangible asset like Machinery and Plants as fixed assets which can generate benefits/revenues over lifespan of asset but fail to recognize intangibles that form majority of costs for Digital company as assets.
• Hence to value a digital company, the critical parameter to evaluate for an investor would be the markets share/customer base, no of users in that platform, revenue/user, customer acquisition costs and customer retention rate.