Can tech be a value investment? Well, I certainly think it can be, but we can’t use the old methods of valuing companies to accord for difference in the way invested capital allows the companies to grow.
Asymmetric Return Profile
An asymmetric return profile is what we look for as value investors. This means a small downside for a potential much larger upside — this could be 20% down for 100% up. In a traditional value investment, in the style of Buffett or Ben Graham, the downside is protected by an asset base and the upside is a revaluing of the company to a more sensible valuation.
In tech we have also have an asymmetric return profile, but the potential downside is greater due to higher valuations but the upside is also greater: for example, a 50% downside and a 300% upside so the return profile is again asymmetrical.
Why Valuing Tech Companies Is Different
With classic industrial companies or asset-based business we try and calculate the owners earning which I have written about before. This is the difference between the accounting rules and what, as owners of the business, it is actually making.
The classic adjustment is the capital expenditure. In the accounts, capital expenditure is often high as the company grows and it pays for new factories or opens up new territories. The growth part of this capital expenditure is often large and would only exist for growth. So to calculate the owners’ earnings we add this back to the P&L.
In a tech company, the capital expenditure is much smaller — to scale, a tech company may need an additional office and more servers but it doesn’t need huge spend on factories or infrastructure. However, in certain tech companies other lines of the profit and loss need to be considered differently. In Software-as-a-Service (SaaS) businesses, there are huge expenses for sales and marketing. This sales and marketing spend is normally charged to the profit and loss account in the year it occurs, even if the customer may last 10 years. The smart SaaS companies that can profitably acquire more customers will spend as much as possible on sales and marketing, as it is investing in the future and is short term tax efficient. Generally accepted accounting principles don’t really account for this, and great tech companies tend to be conservative in their earnings reporting.
In Google’s case, the spend that has to be adjusted is Research and Development (R&D). This is always where things can get tricky. Tech companies have to spend on R&D to keep their products current and competitive. Google’s underlying margins from its Search business are huge, and it has to spend some money on R&D to stay competitive.
But much of Google’s R&D spend is to improve the monetisation of its core products and to build new ones. For example, an R&D project to improve the value per search on Google has a lasting profit-increasing impact, but it is expensed in the year of research only.
Another example is Google Maps. Over the years Google has invested heavily in its Maps product which, to date, has only been a small revenue generator for them. Now Google Maps is the leading mapping application globally but Google still have yet to monetise it. They invested in R&D to take the mapping market before thinking about monetising it. Sergey and Larry have always preferred to give the product away, get the whole market share, and work out how to monetise it afterwards.
So to value tech companies through the value-investor’s lens, you need to understand the business model and be prepared to adjust other parts of the cost base like sales & marketing and R&D, not just capital expenditure.
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