Is the value of startups still sustainable?

It is a fact that we are experiencing extraordinary times, especially the last year, primarily influenced by the global pandemic. Startup valuations have soared to incredible heights, as have cryptocurrencies and other investment forms like recently NFT (non-fungible tokens). Everyone explains this differently. Some argue it is due to quantitative easing, meaning people are increasingly inclined to invest as their money loses value even more than before. Another reason might be the rise of various investment platforms that give smaller investors a chance to participate in the stock market, investing partially but especially mobile and in real-time, without brokers and the associated fees that were once barriers for the masses to investment opportunities.

Given all this, any platform with the potential to scale and reach a large number of people naturally gains tremendous value. However, the problem arises when we encounter companies that do not show financial results nor the prospect of achieving positive numbers or break-even, leading to what is called the "hot potato spiral." Who ends up holding the company when it can no longer financially continue and the initial investor-visionary enthusiasm fades? It seems too much trust is placed in startups without them presenting a range of business models and without a prospect of generating positive cash flow.

How is it possible that many startups going public have P/E ratios that a few years ago no one would accept, yet people remain optimistic and rather skeptical to short such a company/startup? Is this hype?

Simply put, the P/E ratio is the price-to-earnings ratio, i.e., the price of a share divided by the company's earnings per share. The main role of the P/E ratio is to find the company's value and whether it is overvalued or undervalued. This ratio essentially identifies the market value of the share compared to the company's earnings.

I won’t now discuss whether a lower or higher P/E ratio is better, as it depends on perspective (investor vs. company), and it’s a topic for a separate article.

For example, the average P/E ratio for the S&P 500 has historically ranged between 13 and 15. Today, most companies, at least new ones, commonly exceed double these figures, not to mention extreme cases where companies exceed 1,000.

A higher P/E ratio suggests investors expect high growth rates in the future, which in practice may mean the stock is overvalued. Related factors include investor expectations of higher earnings and dividends, supporting this view.

You may also encounter companies without a P/E ratio, often because the company has no earnings or is losing money, so the ratio cannot be calculated.

This is not to diminish the perspective of startups currently building and not yet financially healthy but expected to be in a few years. However, it is necessary to consider how venture capital was born and where the sustainability boundary lies between a startup’s value and its real output concerning risk/potential return within a timeframe. Unfortunately, as with previous bubbles, the current situation suggests the bubble is inflating, and it is only a matter of time before it bursts. We live in a time when almost any startup going public receives an extraordinary valuation not corresponding to its future prospects or financial situation.

The question then arises: what added value does the startup bring, and can it at least partially justify its value in the short term by its role in society until it reaches true growth?

Startups bring many benefits to their environment and society: they drive innovation, employ people, advance education in their surroundings, and increase the value of the area where they are located. However, it is important to maintain a rational view of value and be guided by a cluster of factors indicating where the startup stands in terms of value.

Many startups take benchmarks only from other players in the same field for valuation, forgetting to compare development stages. Yes, scaling potential is a fundamental factor, but other drivers must be considered as well, such as product or service stage (concept, prototype, functioning product/service), team composition and background, strategy and distribution (key partnerships), or other reasons that justify the startup’s value or potential future value.

It is truly difficult to set an exact valuation for a startup. That is part of the risk, but the more factors the team can internally identify, the closer they can get to their true value.

Author: Filip Orth

Source: Investopedia, P/E Ratio, 30.01.21

Tags: wanderer capital , venture capital , startup , early stage , wanderer capital blog , filip orth , entrepreneurship , p/e ratio , VC , IPO , valuácia