Fortune has an article asking whether VCs can be value investors:
After all, the philosophy of value investing, in theory, should cut across all asset classes and managers. The precepts and principals therefore should apply to the venture capital business as well.
Sadly, they don’t.
Jeffrey Bussgang, the author, identifies the problem as an inability to invest with a margin of safety:
Klarman writes: “Investing in bargain-priced securities provides a “margin of safety” — room for error, imprecision, bad luck, or the vicissitudes of the economy and stock market.”
Unfortunately, VCs don’t operate with a margin of safety, even if they are able to find and negotiate good deals. Later stage investors may have downside protection if they buy smart, but early-stage VCs do not. If a portfolio company goes bad, there is typically barely any salvage value.
I don’t know that venture capital investing necessarily means investing without a margin of safety, but I agree that many early stage investments lack a margin of safety.
An estimate of intrinsic value is key to determining a margin of safety. Early stage businesses by definition lack a track record, and – BYD aside – not even Buffett can value a business without a track record. It is more difficult when the business has promise, but is burning cash, if only because the blue sky makes it easier to ignore the ugly financial statements.
Confronted with this state of affairs – no track record, no ability to see the future – most value investors would do as Buffett suggests and simply refuse to swing. This is one of the nice things about value investing. You don’t have to know everything about everything, or even much about anything. All you have to know is what you do know, and what you don’t know, and the location of the line separating the two.
Venture capitalists, however, must know stuff about the future, and must be able to “see around corners” (seriously?). To the extent that venture capitalists undertake any sort of valuation that a value investor might recognize, they must extrapolate revenue growth from non-existent revenue, hope that some of it eventually falls to the bottom line, and then into the hands of shareholders, and plug it into a model with the Gordon Growth Model (GGM) at its heart. (As an aside, I could barely type with a straight face that part about venture capitalists waiting for the dividends. I know they “exit” in a trade sale or IPO, which I guess is a euphemism for “sell to a greater fool.”)
Every value investor knows that big growth assumptions in the GGM – even those based on a historical track record – are a recipe for disaster. Why? Simply because the growth is always going to be so astronomical as to overwhelm the discount rate portion of the model, leading to a “Choose your own value” output. To wit:
Value = D / R – G
Where D is next year’s dividend, R is your discount rate and G is the perpetuity growth rate
If R is say 10-12%, any G over 9-11% gives a value that is more than 100x dividends, which is pricey. I doubt there are any VCs getting out of bed for 10% growth assumptions, so I assume they crank up their discount rates, but the result is the same. As G approaches R, value approaches infinity, and, in some instances, beyond. The solution to this problem is obviously to assume a short period of supernormal growth and then a perpetuity of GDP (or some other, lower) growth figure. This just creates another problem, which, for mine, is too many assumptions, and too many moving parts to get a meaningful valuation.
In this vein, I had a chat with a friend who is a value guy about Facebook’s “valuation”. He says:
Originally thought that the $33b Facebook valuation was ridiculous but am beginning to breathe the fumes. It is taking over the world. Set me straight please!
I responded:
Sounds pretty crazy to me. Might be based on a Gordon Growth Model-type valuation which #Refs out once the assumed growth exceeds the discount rate (which it almost assuredly would for Facebook). That said, these crazies don’t seem to think it’s so crazy.
Says he:
One of the commenters on that site has set me straight:
“Google provides a relevant service. FB is a spam hole. No one is going to pay for spam unless it’s from the guy at the other end of the ad stealing your credit card #. FB is worthless. And of that 1 billion (doubt it), they still owe around 150 million for financing servers and other things. If they had the funds, don;t you think they’d be smart enough to pay CASH, instead of paying interest on a LOAN?”
Insightful stuff. Shame on me.
So the answer for VCs is simple. The valuation is too hard so ignore it, but buy a portfolio of interesting businesses and hope that you get a few home runs. Oh, also sell some of your early shares in Facebook at that $33B valuation because you never know what lurks around the corner.
Greenbackd 