A renowned valuation expert, Bala Dharan is Robert B. and Candice J. Haas professor and senior lecturer at Harvard Law School and Research Affiliate at MIT Sloan School of Management. In this conversation with VCCircle, Prof. Dharan says while startup valuations are at the upper end of the spectrum, a tech bubble is still far away. Rather, much of the increase in valuation has been accruing to the top one or two companies in each product category.
In this interview, Prof. Dharan talks about how Indian startups compare with their US counterparts, potential unicorns, and public market versus private market valuations.
How is India different from the US when it comes to valuations of companies?
India is different, but not very different once you take into account differences in growth rates. Indian economy’s current growth rate of 7-7.5 per cent is huge compared to the 1-2 per cent growth rates observed in the US and Europe. The business sector in India is growing at an even higher rate. Companies in tech and banking showing the potential for even higher growth rates are consequently enjoying very high valuation multiples.
A number of Silicon Valley startups have received a poor response to their IPOs. Does this mean the public market offers a more realistic valuation?
The startup companies are being valued in private market based on a relatively low number of funding transactions. Their valuations also reflect the unique supply and demand for ideas and capital in the private market. So their valuations are not necessarily reflective of what is going on in the public stock market for tech stocks.
The investors in these companies are either high net worth individual or institutional investors such as venture capital firms, mutual funds and hedge funds. They have a higher tolerance for losses compared to the average investor. Moreover, they are taking a bet on the overall prospects of the various companies in their portfolio of investments. They can afford to lose their investments in some of these portfolio companies and yet come out well overall. When such companies start to trade in public markets, the investor clientele changes to more traditional institutional and individual investors, and as a result the valuations might change.
What are your views about a tech bubble forming among the startups of Silicon Valley?
It seems everyone today is looking for bubbles. But trying to figure out whether a sector is in a valuation bubble is very hard, if not impossible, for most investors. This is true for valuation consultants and professional investors.
For every Flipkart or Snapdeal, there are so many companies that get created and don’t get funding and get sold or shut down
Valuations are on the upper end of the historical averages, so individual investors should take that into account and keep the allocation to the tech sector at a level they can afford to lose if there is a large price reduction. You should not bet your mortgage money or EMI payments money on tech investments. For every Flipkart or Snapdeal, there are so many companies that get created and don’t get funding and get sold or shut down.
Much of the increase in valuation has been accruing to the top one or two companies in each product category. For example, a few companies such as Apple, Netflix, Amazon, Google, and LinkedIn have been the main beneficiaries of recent valuation increases in Nasdaq stocks in the US. By contrast, during the tech bubble of the late 1990s almost all tech companies witnessed large price increases. We don’t see that today in the tech industry.
The Indian experience as far as unicorns are concerned have been limited to e-commerce. What other sectors do you see creating unicorns in the next few years?
I think companies that aspire to have high valuations are those that expect to show potential for growth at high double-digit rates or rates in the 20+ per cent range. Companies promising to realize such growth rates in India can come from a variety of sectors, including construction, real estate, infrastructure and banking, particularly personal banking. There is a tremendous opportunity in India to make affordable and mobile banking services available to individuals, constructing affordable housing for the middle class, and innovating in the renewable energy sector. Consumer products continue to have a potential for high growth rates as the tax system gets streamlined and as wages show double-digit growth. The education sector is also a perennial favourite for high growth. Finally, bio-tech remains a huge opportunity. In many of these sectors, if you have smart managers, entrepreneurs, scientists and engineers you can compete on equal footing with the United States, China and Europe.
As valuations have changed over the last decade, so have valuation techniques. Is discounted cash flow (DCF) still the way to go for valuation of companies?
Valuation techniques are based on economic models of how the world works. The methodologies change only slowly over time. Time value of money is a basic concept that remains as relevant today as it was in the 1930s when the methodology was developed. Net present value represents the value increment from undertaking a project. This idea is based on some basic assumptions of a rational firm and investors. Behavioural finance is starting to make an impact on our understanding of how individual investors think and act. More work, however, needs to be done to extend the understanding of behavioural economics at the individual level to how large groups of investors behave in the market place. At this point, the discounted cash flow methodology remains the primary method to evaluate projects and investments.