If you’re a student of finance, the valuations being talked about for Indian e-commerce start-ups may appear mind-boggling. With the $500 million it received in funding, e-commerce major Flipkart is now valued at $15.5 billion. This is higher than the market capitalisations of Nifty bigwigs Tata Steel, ACC and Hindalco put together. The four-year old Ola Cabs already sports a valuation of $2.5 billion, more than half of the market value commanded by any of the above the metal and cement behemoths.
While global hedge funds, private equity firms, and angel investors have been cheerfully buying into Indian e-commerce firms at these valuations, traditional market players have been warning of a bubble.
How it works
But how exactly did e-commerce firms get to this multi billion dollar valuation? The answer lies in the valuation metrics used by private equity and venture capital investors to assess e-commerce firms.
Stock market investors like to use metrics such as price-earnings multiple, price to book value or discounted cash-flow analysis to arrive at a value for traditional manufacturing businesses. Price to earnings captures the ratio of the company’s stock price to its annual profits per share. Price to book value gauges if markets are under pricing the assets on a firm’s books. Discounted cash-flow analysis arrives at the present value of future cash-flows likely to be generated by a company’s operations.
Essentially, all of these metrics are applied to a business that either earns profits, or owns manufacturing facilities or generates free cash-flows.
Why GMV?
But Indian e-commerce companies currently do none of these. For one thing, most of them, giants like Flipkart included, don’t make a net profit because they subsidise the cost of goods sold as well as delivery charges. Two, they don’t have a large book value because they don’t manufacture anything — they are only marketplaces for others to transact in and, at best, operate a logistics network. Three, they may not net free cash-flows because they invest heavily in brand-building and promotion.
In the listed space, companies that don’t turn in profits are usually valued through a market-cap to sales metric. In the world of e-commerce, the commonly used parallel is the price to GMV (Gross Merchandise Value). The GMV is essentially the value of all goods and services that are transacted on an e-commerce marketplace. It is simply the total price of each product multiplied by the number of units sold in a year.
Estimates suggest that consumers ended up buying $4 billion worth of mobile phones, bags, books and sundry stuff on Flipkart in 2014. That number, therefore, becomes Flipkart’s GMV. Flipkart is hoping to double that GMV to $8 billion in 2015. Therefore, investors are willing to proactively value Flipkart at nearly twice its GMV (nearly $16 billion).
Growth plays
But what’s the logic in using GMV to value e-commerce firms? In the Indian market, e-commerce firms are essentially high-growth plays. Investors who buy them believe that, given the tiny size of the Indian e-commerce market in relation to the overall retail market, players who get in early and scale up quickly will be able to earn manifold growth in their sales and profits.
Therefore, they believe that the current profitability (or the lack of it), for these firms is a non-issue. Once an e-commerce player like Flipkart scales up to its potential size with a large base of Indian consumers, its volumes will be large enough to do a Walmart and vanquish smaller rivals.
It would then be free to reduce the steep price discounts, stop the freebies and even charge consumers for doorstep delivery. This would automatically help it turn in a hefty profit.
As the GMV is the most direct metric that captures a firm’s market share in e-commerce sales, it is the most common metric used to value e-commerce firms. So far, these believers have proved quite right.
As its GMV has expanded at a scorching pace, Flipkart’s market valuation has zoomed from $3 billion in early 2014 to $15.5 billion in the latest round of funding. That’s not all paper profits; when new investors get in, early investors in these e-commerce plays exit or get bought out at current valuations.
Bubble warning
But sceptics, or those who predict that e-commerce valuations in India are in bubble zone, poke many holes in the above arguments.
For one, they argue, GMV, unlike a company’s reported revenues or profits, is an imperfect metric. It isn’t audited. It isn’t even precisely defined. If a company sells five pairs of jeans on its portal and accepts a free ‘return’ of four pairs, shouldn’t the four pairs be netted out for calculating GMV? Also, should not the GMV subtract the ‘free shipping’ costs that the company incurs to deliver the goods? In brick and mortar retail, products returned would certainly be netted out of the sales to arrive at the accounting revenues.
Two, they argue that the GMV cannot be blindly applied to all e-commerce players, given that not all of them sell products like Flipkart does. For instance, if you look up neighbouring restaurants in Zomato and use its reviews to visit them, what is Zomato’s GMV? Is it the food bill you run up at the restaurant? If you book an airline ticket at Makemytrip, it may receive a commission from the transaction. So if the value of the tickets you bought or the food you ate becomes the portal’s GMV, wouldn’t that be over-stating the firm’s value?
Therefore, they argue, the gap between a company’s GMV and its actual revenues really matter. If the GMV is a large multiple to the actual topline of the company, and you value the firm at a multiple to its GMV, you would be ‘double-counting’.
Will they last?
Finally, there are also worries about whether the central premise surrounding e- commerce players and their market share gains is valid. Admitting that the Indian e-commerce market is in a nascent stage, how can you be sure that the e-commerce players of today will be the winners or the market leaders of tomorrow?
Customer loyalty is a rare commodity on the Internet, with people willing to switch even their social media providers pretty quickly if a fancier one comes along (remember Facebook’s predecessor Orkut?).
What’s more, if the big brands of the brick and mortar world set up online shops, would consumers not prefer them to the new marketplaces? Or what if newer better market-places of the future crowd out first-movers like Flipkart or Snapdeal?
This is why smart institutional investors in Indian e-commerce companies are not investing in just one player but in several of them. They may be able to afford multiple investments to diversify their bets. But can individual investors?