New Age Actions | Investment strategy: how to value new-age stocks and which investment strategy to follow: Mahesh Patil

The Securities and Exchange Board of India (Sebi) has recently proposed rules to tighten and seek clarity from new era companies on the pricing of its shares in IPOs. This comes against the backdrop of the recent volatility seen in new-age company stocks. Few companies operating in various industries viz. fintech, insurance aggregation, food delivery, online retail, used car market, etc. had launched their IPOs in 2021. The business models of these companies are unique and contrast with asset-heavy and traditional companies. Additionally, all of these industries are at different stages of evolution and maturity, making it difficult to measure value with the same objective.

Since most of these companies do not generate positive cash flow/earnings, conventional valuation methods cannot be relied upon to determine their intrinsic value. Investors should rely on various key performance indicators (KPIs) that should be used to assess the true potential of these companies. Some of the most commonly used KPIs include active users, users transacting, transaction frequency, gross merchandise value (GMV), average order value (AOV), contribution margin, and more.

First, investors must determine the total addressable market (TAM) opportunity of the company based on the product/service offered by the new company. These companies provide convenience, accessibility and other quality services to consumers and with the ever growing adoption of technology in India, these companies are expected to have a huge avenue for growth.

GMV is the most common metric among online businesses. It measures the total value of sales. Additionally, AOV tracks the average amount spent by a customer each time a purchase is made. GMV is obtained by multiplying AOV by the total number of transactions. Some companies’ business models are based on transaction fees such as Payments Company. For these companies, Gross Transaction Value (GTV) is used instead of GMV.

Other business operating metrics that should be on investors’ radar when evaluating these companies include a number of registered users, as well as users with annual and monthly transactions. This metric helps understand the number of unique customers using the service/purchasing the company’s product on a yearly and monthly basis. Transaction frequency should also be considered in conjunction with this metric. This gives an overview of the customer traction the business is seeing, which in turn is a key factor in driving revenue.

Since these companies are trying to gain market share at a rapid pace, they incentivize consumers heavily and incur huge operating losses. While this is normal, it is important to understand if the company’s unit economics are in place, so that it is on the path to profitability.

Profit/contribution margin, which measures profit per unit, is calculated by deducting variable costs such as processing fees, promotional cashback and incentives, logistics and other expenses from revenue. Once the scale of the business expands and with consolidation or competitive intensity, the reduction in contribution margins can increase significantly.

The KPIs discussed above are used as input data to forecast the financial statements of companies. Additionally, since these new-age companies have greater growth longevity, much of the present value is derived from the future and so building a long-term growth forecast is imperative. Given the lack of EBITDA/earnings, market capitalization/sales and long-term discounted cash flow (DCF) are the two best methods to use when valuing these companies.

Other qualitative factors should also be considered when investing in new era companies. Leadership in the operations industry becomes essential. This is because these companies need to invest heavily in technology upgrading, ad spend, and more. Leadership in their respective space would mean that adequate cash burn has already taken place and therefore puts them ahead of their competitors in the industry. Investors should also seek entrepreneurial zeal and thought leadership in the management of these businesses.

Some new age companies that had stellar listings in 2021 have corrected in recent months as the liquidity premium in the market has begun to fade. The tightening of liquidity by central banks is expected to continue and therefore caution should always be maintained when investing in these companies. Understanding the business model and identifying the risks as a whole becomes an important criterion.

Finally, the risk associated with these companies being high, investors should favor investing in a portfolio of companies rather than choosing a specific company. The allocation may be increased based on the life cycle and achievement/improvement of key financial and operational metrics of these companies.

(The author is Mahesh Patil, CIO, )

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