IPO watch. Beware the over-hyped valuations of new age IPOs

With great valuations come great expectations! When we are in the age that assigns numerically higher price-to-sales multiples to growth stocks than the price-to-earnings multiple assigned in the previous market cycle, it is implicit that the expectations are great.

With several new age companies hitting the bourses, starting with Zomato this year, markets have bought strongly into their growth story, with some like PB Fintech even trading at levels as high as 60 times their sales! Zomato, Paytm trade at around 50 and 30 times sales now. Is there a method to this madness or are we just re-playing the dotcom or housing bubble?

Bulls narrative

The narrative from market bulls is that the lofty multiple to sales of these companies is justified based on their revenue growth prospects, even as they are loss making currently, some at the EBITDA level as well. They are also quick to highlight the performance of new age company stocks in the US over the last decade.

However, if one digs deeper into data, this is only one half the story. A study of new age companies that traded in the US in the last decade shows that one of the key reasons (besides strong business performance) for their stellar returns since listing or start of last decade (Amazon stock at 35 per cent CAGR, LinkedIn CAGR of 34 per cent), is that most of them also came out with their IPO at a much lower price-to-sales multiple.

Odds not in favour

There are primarily two levers for long-term stock returns — one, business growth (as stocks track the revenue/earnings growth), and the other, multiple expansion. With Indian new age companies already listing/trading at extremely high multiple of sales, this lever for future returns seems to have been exploited already.

Further, the study indicates that the odds are strongly stacked against lofty sales multiple based valuation if EBITDA margins are low/negative. Investing at high multiples based on companies becoming profitable in the future does not appear a wise strategy (see table). Companies like Groupon and India’s own new age company of the previous decade, MakeMyTrip, have given sub-par returns after listing with much fun fare. Thus, strong revenue growth and healthy margins appear to be prerequisites to justify high valuations.

Best in class

In contrast, best in class new age companies with low margins like Amazon and Netflix yielded substantial returns to investors over the years partly because they were quoting in the exchanges at a humble 2 and 1 times sales respectively in 2011. When Amazon was a $15-20 billion market cap company during 2005/06, it had over $8 billion in sales.

In contrast, Nykaa was a $15-billion company for a while before recent market correction, when it had sales of just $320 million in FY21. Amazon, too, had its share of frothy multiples trading at over 30 times revenue during the dotcom boom, but it crashed 90 per cent from those peaks and took 10 years to recoup back to those levels. In 2012, if hypothetically Amazon had Nykaa level revenue multiple of close to 40 times, its investors would have lost their wealth at a CAGR of 2 per cent till date despite the company growing its revenue at 26 per cent CAGR during the same period.

Thus investors getting tempted to join the new age wave, must first ascertain what the companies have to deliver in future, determine if that is realistically possible, before taking the plunge.

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