Promise and perils of the internet IPO frenzy

Essentially, more individual investors believe in the ability of Zomato, an internet business, to deliver good shareholder returns through its business model than Reliance, TCS or HDFC Bank (the country’s third-most valued firm). The current annual revenues of the top 3 leading lights of India Inc are 60-220 times that of Zomato. Yet, the stock market values every rupee of Zomato’s revenues 7-16 times more when compared to the other three.

Zomato’s 3.2 million individual investors believe that its current valuation of ₹1.04 trillion is a storehouse of its current prowess and future potential. However, there are many who disagree. In a 22 July blog post, Aswath Damodaran, a professor at the Stern School of Business at New York University who specializes in corporate valuation, valued Zomato at ₹39,000 crore using conventional valuation tools adapted for Zomato’s situational context.

Expect more such valuation differentials in the weeks to come. Zomato is after all the first in a slew of high-profile and high-potential—and importantly, no-profit—internet businesses to list this year. Paytm and MobiKwik are up next. Other Internet businesses reportedly prepping up include Nykaa and PolicyBazaar.

A confluence of factors has contributed to this sudden beeline. The trigger was an easing of conditions and norms related to institutional investors in such companies as a requirement for listing. As it is, private investors in these internet businesses, who have been invested for upwards of half a decade, were seeking exits. What better time than a market that is awash with liquidity, and is trying to find—even create—investment stories. But do such mega valuations reflect the true value of these internet businesses, even factoring in their unique nature and the associated novelty value?

Outliers in a storied set

One prism to examine this question is through the storied set of companies with similar valuations. As of 16 July, there were 73 companies with a market capitalization above ₹65,000 crore—Zomato’s valuation at its issue price.

These 73 companies are studies in contrast to Zomato and Paytm. Unlike these fledglings, they are some of the most durable names of India Inc. Unlike these new-economy businesses, they are all old-economy companies, with the exception of Info Edge, a co-promoter of Zomato. Unlike these promising businesses that are yet to turn a profit, they are extremely profitable.

A comparison on certain metrics shows the gulf that will become a matter of reckoning at some point. “In the short run, the market is a voting machine. In the long run, it is a weighing machine," said Benjamin Graham, a 20th century American economist who produced several seminal works and pioneered the concept of value investing.

When the needle moves from voting to weighing, there are a few things that the market will consider. The median revenues of this set of 73 companies in 2020-21 was ₹33,139 crore—about 15 times the latest full-year revenues of Zomato and 10 times that of Paytm’s. Zomato and Paytm will have to register brisk growth in their revenues—year after year. Zomato doubled revenues in 2019-20, but in pandemic-hit 2020-21, its revenues fell by a steep 22%. Paytm’s revenues, on the other hand, have tapered in the last four years.

At some point, these internet businesses will also need to show profits. Both Zomato and Paytm (as well as most of the other firms in line for a public listing) are yet to post a net profit in their short lifetimes. In comparison, as many as 70 of the 73 companies in the sample set posted a net profit even in 2020-21, the exceptions being Bharti Airtel, Tata Motors and IndiGo. The median net profit of this set was ₹2,404 crore.

The absence of profits among internet businesses is often defended—even sold—as a necessity to build and acquire customers for scale. Once acquired, customers will stay, and provide a multiplier effect. So, the hope is that the Zomato customer will keep using its platform to order food, even as the company earns more per order.

Further, if Zomato, say, diversifies into delivering groceries, it has an easier path towards drawing the same customer.

Amazon did this very well. Paytm has tried, but without success. Paytm built a successful e-wallet business, aided immensely by the November 2016 demonetization. In 2017-18, its revenues grew four-fold. Since then, it has struggled to grow in spite of diversifying into ticketing, e-commerce and insurance, among others. Customers have not followed, underscoring how network effects of internet businesses can’t be taken for granted.

Also, building businesses doesn’t come cheap. Zomato and Paytm don’t generate enough cash by themselves, and they need to draw on external capital to meet running expenses like paying employees, maintaining offices and airing ads. In 2020-21, Zomato’s net cash from operating activities was minus ₹1,017 crore and Paytm’s was minus ₹2,242 crore. This deficit had to be funded by external capital. Unless their core business improves in terms of profitability, they will keep needing such a sum every year—just to stay where they are now. By comparison, the set of 73 companies generated median cash flows from operating activities of ₹6,170 crore (see Chart 1). At the same time, the companies in this set invested a median amount of ₹2,435 crore—for a better return in the future.

An IPO has two sides

So far, Zomato has been using private capital to grow. Now, it has additional public capital of about ₹9,000 crore. At its current scale of operations, that’s a runway of about eight years. This is expected to feed its ambition to build business lines that have large competitive moats and that deliver above-average growth.

For private investors in internet businesses, a listing brings to fruition years of handholding a company. It gives them an exit option, which needs to be watched. In an edit-page piece in the Hindustan Times on 23 July, Prabal Basu Roy, Sloan Fellow at the London Business School, makes a case for “differentiating between potential outcomes of retail investors and institutional ones" in such IPOs.

He writes: “The fact is that such humongous value creation of VC- or PE-funded consumer plays would have been impossible without a closed clique of inter se investments by foreign PE (private equity) funds. As global liquidity continues with negative interest rates, this can potentially be construed as an ingenious play to generate mega returns by inflating assets prices through investor subsidized business models." What investors are riding currently in IPOs is momentum. In the past year, the US has seen 401 IPOs, many in the digital economy space, according to IPOscoop.com, which tracks listing gains. As many as 75% IPOs listed at a price higher than their issue price. But only 55% were still delivering a positive return. And if the entry point was their first-day closing price, only 34% were delivering positive returns. Even the quantum of returns keeps falling over time (see Chart 2).

A bullish market does offer a listing bounce. But over a longer period of time, returns from IPOs tend to veer towards normal market returns. This can be seen in the performance of exchange-traded funds (ETF) in the US that aim to ride the promise and momentum of IPOs, especially technology IPOs. For example, First Trust US Equity Opportunities ETF was launched in 2006 and manages $2 billion in assets. It apes in its composition a share index that invests in 100 of the largest and most liquid IPOs in the US. This index invests in a stock on its sixth trading day and holds it for 1,000 trading days (or about four years). It is rebalanced and reconstituted quarterly.

Given the stream of technology IPOs, as of 30 June, about 36% of its portfolio was in technology stocks. Its top 10 holdings included Uber, Zoom and Pinterest. While it has outperformed the market consistently, the degree of outperformance drops with time. In the last three years, it has delivered a compounded annual return of 21.9%, against 12% for the S&P 500 index. Since its inception in 2006, 13.8% against 10.5%.

Share diversification is one way that the First Trust ETF reduces portfolio risk. In India, since such ETFs are not present, individual investors are on their own in being on the right side of this price equation.

Judging value

In essence, valuing a business involves calculating a present value for its future cash flows. For mature, listed companies with a proven track record, cash flows can be reasonably estimated. But for young businesses like Zomato and Paytm, this is trickier, given they are cash-negative and deploy big capital in untested domains.

When estimating cash flows is difficult, another valuation method that is commonly used is the ‘relative valuation method’. This involves benchmarking a company’s valuation to a relevant metric for listed companies in the same space. The underlying belief is that the stock market has worked out a fair value.

A commonly used metric is revenue multiple: the number of times each rupee of revenue is valued. At ₹1.04 trillion, Zomato is valued at 49 times its latest full-year revenues. At ₹75,000 crore, Paytm would be valued at 24 times revenues. By comparison, the median revenue multiple of the sample set of 73 companies is 5 times.

DoorDash, the largest food-ordering company in the US, listed in December 2020 at a revenue multiple of 11 and is currently valued at 20 times. Zomato’s only direct competitor in India, Swiggy, is unlisted. Food franchise businesses like Jubilant Foodworks (Domino’s Pizza) and HardCastle Restaurants (McDonald’s) are valued at 13 times and 9 times revenues, respectively. Today, investors either believe that these large gaps will be bridged by expanding revenues or they are not thinking about it.

Among them are new investors who haven’t seen, let alone endured, a market slump. Between March 2019 and March 2020, India added 4.3 million demat accounts. In the 12 months after that, as a pandemic boxed people inside their homes and the market hit new highs, India added thrice as many new demat accounts. Many of these new entrants are below the age of 30 years who are prime consumers of these internet businesses, and they trade in stocks on online platforms.

Only one Indian IPO has received more retail applications than Zomato: the ₹10,500-crore IPO in 2008 by Anil Ambani-promoted Reliance Power Ltd. Even today, there are 3.4 million individual investors who continue to hold Reliance Power shares, although it trades at just 4% of its issue price. Amid financial duress, most institutions have exited and the promoter holding is a mere 9%. The 3.4 million individual investors own 85% of the company—about the same as what the promoter group held in January 2008. Therein lies a cautionary IPO tale for individual investors.