The evolution of the Tech Valuation Shorthand
A generation since the first internet listings, our tech valuation shorthand has moved down the P&L statement from Eyeballs to Revenues, and now to, Gross Margins.
Back in the late 1990s, when internet (now called Web1) stocks were the new, new thing, no one knew how businesses would make money. And so stocks were valued on the basis of the very top of the funnel — eyeballs.
Investors in the newer breed of dot-com stocks can't really determine by conventional means the worth of a company that has no profit and little revenue. So instead of looking at earnings, they look at measures such as "page views per quarter," "unique visitors," "questions per quarter," "stickiness" and my favorite, "eyeballs." - Washington Post, Nov 1999
Twenty years later, a new generation of investors moved one level down from eyeballs (or user discovery) to the actual revenue line to value tech stocks on the back of Revenue Multiples.
Valuing a company on the back of a multiple of a number in the P&L statement is a shorthand for its cousin, Discounted Cash Flow, which is notoriously difficult to estimate. And these shorthands become even less useful as you move up the P&L statement from Profit After Tax → Profit Before Tax → EBITDA → Gross Profit → Revenues — simply because sectors have different innate profitability levels based on their Cost of Goods Sold.
Yet, the positive thing is, tech investors moved from eyeballs to revenues in a generation and have finally evolved to focusing on Gross Margins now.
Misstated Revenues are easier to identify. But Gross Margin (and its new cousins Contribution Margin 1, Contribution Margin 2, Contributions Margin 3, which everyone defines in their own unique way) can be calculated almost any way that you want.
Far too many companies lie to themselves about margins, pushing out variable costs such as payment processing costs (which should be reduced from revenues) or delivery fees (which should be part of Cost of Goods Sold) to optically display positive “unit economics”.
But how do you get people excited when your current gross margins are poor but directionally improving? Hari Raghavan has an interesting view how to value tech companies on Price to Compounding Gross Profit (“PCG”) — or essentially on a multiple of 2 to 3 years forward Gross Profit.
Founders best serve their businesses by being honest to themselves first. The market is not dumb (it’s generally smarter than you think except at extremes when it goes mad with greed or fear). Stay honest to the numbers, communicate your plan to take the business to profitability (while not losing sight of how you will grow revenues) — and you’ll find the best investors in the world flocking to your cap table.
Case study: Atlassian ($TEAM) which is best known for the popular issue tracking product, Jira.
