And its impact on cash flows and valuations
The typical method for valuing companies consists of trying to predict cash flows, discounted far into the future. This sounds complicated, but it can be understood as the cash a business owner can pull out of a company over its lifetime, with a larger “discount” for money received in the future. This makes intuitive sense, as most people are likely to place higher value on $100 “in the bank” now, versus the “promise of $100” years into the future.
These discounted cash flows (DCFs) are typically dominated by a “terminal value”, which is an estimate as to how much a cash a company can generate “in perpetuity.”
If you believe that the value of a business is determined by its stream of discounted cash flows, and most DCFs are dominated by terminal value, it follows that any investment should be supported by a high degree of certainty about the durability of that business 10+ years into the future. For example, one might be fairly certain that people will still be smoking cigarettes and drinking alcohol in 10+ years, but less certain about whether or not they will all be riding Pelotons. Some business models and industries are more durable than others, and this durability gives greater credibility to DCF valuations dependent on certainty far into the future.
Facebook is a good example of the difficulty in determining the durability of a business and its impact on valuation. Many investors think Facebook is undervalued, but its business model is nearly 100% dependent on advertising, which is in turn entirely dependent on how long users spend on its “family of apps” (Instagram, WhatsApp, Facebook). Younger people are already spending more time on competing apps like TikTok and Snapchat, and Facebook’s growth has already stalled in developed markets. It is difficult for me to guess with any certainty whether or not people will still be using Facebook or Instagram in 10 years, or how actively engaged they will be even if they are still using it.
Furthermore, the effectiveness of Facebook’s advertising is largely determined by factors outside of its control. Apple’s push for increased user privacy has already impacted Facebook’s ability to track users for advertising purposes, and its most recent restrictions are likely only the beginning.
If Facebook’s growth continues to stall, or even turn negative, its current “bargain” valuation could end up being significantly overpriced because terminal value assumptions are widely off the mark. This may seem unlikely, but the historical record (the average lifetime of a company in the S&P 500 is 21 years), the fickleness of the social media industry, and the corporate life cycle in general, hint that it is more of an inevitability than an impossibility.
Other big tech businesses may be more durable, but its difficult to predict this durability before the fact. How many people had Amazon Web Services (responsible for most of Amazon’s operating profits) as part of their bull thesis in 1997? Similarly, Google’s 2006 acquisition of YouTube, which currently drives a significant portion of its growth, was viewed skeptically at the time (Mark Cuban, no stranger to tech investing and bubbles, said “anyone who buys [YouTube] is a moron” and questioned why anyone would “want [their] advertising dollars spent on a video of Aunt Jenny watching her niece tap dance”).
Small, unprofitable growth companies are even harder to assess. Many of them have unproven business models, which lends great uncertainty to any long term predictions about durability. Some of them may end up being wildly successful, but it’s worth noting that Google, Facebook and Microsoft were all profitable even on their IPO dates. Great businesses and durable business models are typically apparent from the beginning, and it’s unclear how sustainable some of these new business models will be if we enter an era of normalized monetary policy and easy funding is less readily available.
Even if you approach speculative growth investing with the idea that you’ll make small, diversified bets in a large number of companies (similar to a venture capital or angel investment portfolio), upside may be limited at current valuations (despite some companies being down 70%); in essence you might be taking on “early stage” private company investing risk with “fully valued” public company upside.
Disclaimer: Long GOOGL.