[Matrix Moments] Valuations come in the context of the risk you are taking, says Avnish Bajaj of Matrix Partners

Today, India has nearly 20 unicorns. And here, valuation is the key. But then, what are the factors that help determine this? How are valuations decided? And what makes a company in one sector be valued more than the other? 

Avnish Bajaj, Founder and Managing Partner, Matrix Partners India, says the reason most people invest in an early stage company is because of high returns. But high returns come with high risks. 

“The reality is, before we go into valuations, we should talk about why valuations matter. Valuations come in only if you are investing, and what is the value at which you are investing,” he says.

Avnish adds that valuations come in the context of the risk you are taking. “There is one theory on which everything is valued - it is called capital asset pricing model (CAPM). Based on this, a formula is derived, which is: Expected Return = Risk free rate + Beta * Risk premium. Here, Risk Premium = Return expectation from the asset – Risk free rate and Beta = measure of risk in the asset,” he explains. 

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Determining returns based on risk 

Underlying the fact that there are risk-free return investments like government insurance bonds, as you start taking more risks, depending on the risk of the asset class, you want more premium on that return. 

“So, if you invest in Government of India bonds, the rate is 6.5 percent. If you are investing in a bank fixed deposit (FD), you want your rate to be 8.5 percent, if you are investing in the stock market, you may want 15-20 percent, and if you are investing in an early-stage company, you maybe want 50 percent. The underlying theory is that essentially you are looking to generate some kind of return, which ultimately has to be cash flows, and therefore there is a model called discounted cash flow,” says Avnish. 

The present value of this is the value of the asset, and the risk you take determines how much one can discount it back the internal rate of return (IRR). It is the capital asset pricing model that determines based on the riskiness of the asset, and what returns the investment should be getting. Avnish adds, 

“So, this is the first set of principles on how things are valued. Everything is an assumption, and I don’t how to measure the risk of the asset. I don’t know how to measure the future cash flows, and I don’t know so many things that it ends up becoming an excel spreadsheet, which will potentially churn out garbage depending on the inputs. Now, in certain businesses it can be done. What happens is people start moving - the best investors understand this theory and then they start moving away from this theory to second principles after understanding it and saying. 'what are the best proxies for it, right?'”

Challenges in the VC space

Avnish adds that there are different challenges in the VC space - one being companies not making enough money and another is that they are sometimes growing very fast. 

“Also, they’re often ‘illiquid’, meaning sometimes you can’t even trade them. So, it becomes hard to figure out how one values these businesses,” he adds. 

Citing examples, he says, in ecommerce, price to gross merchandise value (GMV) is used as proxy; in enterprise businesses, price to revenue is the proxy; in financial services, price to book is used as proxy; and in capex-heavy businesses, people use price to EBITDA as a proxy. 

“The problem is many people think these are new valuation techniques, but they actually are not. They are proxies for underlying first principle valuation techniques, because you don’t have all the data to be able to apply that first principle’s valuation technique as the business is not profitable,” says Avnish. 

He says investors are not able to do a price to earnings multiple, which is the first principle valuation technique because the business’ cash flows are uncertain. But what works is the capital asset pricing model. But the problem here is that proxies can cause mistakes. 

Listen to the podcast here

(Edited by Megha Reddy)

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