Is it the Myth of the “algorithm” or the Myth of the “revenue”?

Rick Webb, in his article “How the Myth of Algorithm Fools the Market”, attempts to bust the myth of the ‘algorithm’ that gets higher valuation for a tech company as compared to non-tech companies. He recollects that from the time of dot com boom, because tech companies did get a higher valuation, many companies with real businesses believed in spinning of their services arm to enhance their valuation at better revenue multiples. 

He alleges “The reason that Google could achieve a market cap of $23 billion from its IPO—because it was an algorithm”. He also suggests that it just gives a perception that machines could make the multiples stretching that logic to other tech companies such as Twitter, Facebook, Foursquare and Tumblr.   

Webb brings out an interesting analysis wherein he calculates revenue per employee per month of some tech as well as non-tech companies. He compares this figure with the market cap of the company to understand the revenue multiples. Some of the tech companies that Webb cited are Google, Groupon and Facebook and on the other side, the non-tech companies are Omnicom, GE and INTL FCStone. INTL FCStone is one of the most profitable companies among the Fortune 500. He calculates that Google generates revenue of $116,000 per employee per month, while Groupon is at $11,500. Facebook is slightly better amongst tech companies at $118,600 per employee per month.  GE generates revenue of at $43,500 Omnicorn generates $15,600 and INTL FCStone beats everyone hollow at $5.3 million per employee per month. However when he looks at the market cap of all these companies, that of the highest revenue generator per employee per month is just above 1x, and so is that of Omnicon, GE is at 1.25x. Whereas, in sharp contrast to non-tech comapnies, Groupon has market cap of 18x and Google has some 21x, The market cap of the company that makes most revenue per employee per month is revenue multiple of 1x whereas of Groupon at 18x and Google and Facebook at 21x.

While Webb has raised an important point, which is to draw emphasis on valuation of tech firms, to say only revenue can tell the complete story of a firm’s market cap may be unconvincing. While revenue per employee per month can be one of the metric, it is not the only factor that should be considered while valuating the company. Bill Gurley, explains how ‘all revenue is not created equal’ in an article that looks at several other important factors. It may be a gross mistake comparing revenues of apples and oranges on valuing companies through the lens of revenue per employee per month.

Investors look for a lot more than revenue such as working capital, discounted cash flow, asset performance, capitalization, predictability of future cash flows, gross margins, profits, marginal profitability, low barriers to entry for a business and the competitive advantage.  It is also important to understand if the growth of the company is largely organic or requires lots of market spending or whether the growth is really happening or not.

An interesting example that Bill takes to bust the myth of ‘revenue related valuation’ is to sell a dollar for 0.85 cents. While it can generate unquestionable revenue, and also startling revenue per employee, can it really give profits to investors? Would you like to invest in this business?

While it is good to use metrics such as what Webb has used to understand the underlying correlation of revenue, profits and market cap, it may be better to take into account all other factors that help valuate a firm, tech or non tech.

Source: BetaBeat