We should use the word “valuation” with care — and sparingly

The figure quoted in start-up funding rounds is not a value but a price, and the difference is important

If you’re reading the same blogs as me, hardly a day goes by without a bombastic claim about a startup raising funding. The heading will usually be in the form of:

“Startup CreamyGoodness raises $250m at a $3b valuation to become the AirBNB for yogurt.”

Almost as often, you will read articles wondering what can possibly justify these values. Even Stewart Butterfield, of Flickr and Slack fame, commented that “It’s arbitrary as fuck. There’s no logic to what you get valued at” (source).

Uber was last valued at $48b. One does not pay $48b “arbitrarily”, so it’s worth digging a bit deeper instead of throwing our hands up.

The root of the confusion is that the quoted figures are not actually values: They are prices, and those are entirely different beasts. Here’s why.

Valuation 101

What is value? This question has been the source of much philosophical debate, but in the case of companies (or any other cashflow-generating assets), the generally accepted theory is intrinsic value, which is defined as the sum of future discounted incomes generated by the asset.

Trust me: it’s much simpler than it sounds.

Let’s imagine I present you with a magic box. This box has one button: when you press it, a $100 bill comes out and the box disappears. What’s the value of the box? It’s easy, it’s one hundred dollars.

Now let’s imagine a different box, very similar to the first, but now when you press the button, the $100 bill comes out only one year afterwards. What’s the value of that second box? It must be lower than the first, since in that year many things can happen: the dollar can collapse, the box may be stolen, you could die, and so on. How much lower will depend on the risk, and this deduction is called the discount rate. With a 15% discount rate, the second box will be worth $87*; this is the present value of the box. A third box paying out after two years would have a present value of $76*.

Likewise, the value of a fourth box which would pay immediately, and in one year, and in two years would be the sum of the previous, so $100 + $87 + $76 = $263*.

The math is pretty basic: to value a company, substitute its projected income for the $100.

Where valuation gets challenging is in making the actual forecasts. What income will the asset generate? What discount should we use? The assumptions you take on these parameters can lead you to very different results.

*The present value of a cashflow generated at time N with discount rate r is calculated as PV = CFn / (1+r)^n. This is why the second box is worth $86.95 and not, as one could imagine, $85.

It is possible to value a startup… but it’s hard

In the very early stages, valuing a startup is extremely difficult since you will most likely be projecting a period of losses during which you will be developing the product and its customer base, before a hopefully meteoritic rise.

Initial losses are not a problem per se: many start-ups have run for years at a loss and had a exceptional growth afterwards, ultimately representing very profitable investments. However, the present value will in those cases be very sensitive to your assumptions.

Let’s take an example. CreamyGoodness is growing 100% year-over-year. Since they are a high-risk startup, they are discounting at 30%. In year 1, their income is 1. Their net present value, over the next 15 years, is 1'827. Not bad!

But wait! This is based on a cashflow forecast. Let’s see what happens if the growth turns out to be different.

Going from 100% to 90% yearly growth slashes the value of the company by half. And mind you, we’re not talking about a loss-making venture, just one that grows a tiny bit slower. If you invested in this company at a value of 1000, you just went from nearly doubling your investment to not even breaking even.

Peter Thiel, in a lecture at Stanford, explained how PayPal’s discounted cash-flow analysis predicted 3/4 of their value to be due to revenue more than 10 years into the future, with a 100% growth rate and 30% discount. Had they grown by 90% instead, the whole PayPal story would have been very different indeed.

Many other sources of potential errors exist — and you should also beware of the false precision fallacy. An example of what a detailed valuation analysis, in the case of Snapchat and Spotify, can be found here for those interested ; for the others, just remember than valuation is very challenging.

Pricing is easy

Pricing, on the other hand, is much simpler. The price is whatever someone is ready to pay for something. What’s the intrinsic value of a Monet painting? It’s zero, or very close to it: you could estimate the return you’d get by burning the canvas or frame, but that’s it.

Its price is easy to determine though: put it on auction and you will get it as soon as the gavel strikes.

Let’s return to our magic boxes. We’ve determined that the first box, which pays immediately, has a value of $100. If you can purchase the box for a price of $90, you’re making a $10 profit on the transaction, so it’s a good investment, but nothing prevents you from paying $100 or more for it. Perhaps the box is shiny and has a very nice color and Kim Kardashian has one and therefore you feel $150 is a bargain — the price is whatever you pay for it, regardless of whether it is fair or not.

The price you pay for something does not necessarily reflect its value.

On public markets, it is hoped that the trading will bring the price of assets close to their value — although there is ample reason to believe that this is not always the case. Celebrity-endorsed items’ prices are far from their value, as was analyzed by the Economist in the case of the Birkin bag.

You hear the price, not the value, of a startup

When you read “Uber has a valuation of $48b” what is actually meant is “someone paid $48b for Uber”. It is the price, not the value. Is Uber’s value close to it? I don’t know! You should ask the person who paid it why they felt the price was fair.

One can hope that that the investor figured that there is sufficient likelihood of Uber’s value living up to that price, after doing a proper valuation analysis. But we should also keep in mind that the buyer may be emotional, a victim of hype, a fool — or all of the above. In those case, the price will be, like that of the Monet painting, only a reflection of one person’s fancy.