Internet IPOs | Cannot always have different metrics, have to toe the traditional parameters over time

It appears to be a historic month ahead for the Indian startup and internet ecosystem as three unicorns—Nykaa, Policybazaar and Paytm—will together raise over $4 billion from initial public offerings (IPOs) over the next few weeks. Oyo, Delhivery, Mobikwik and Ola too are lining up plans for a listing.

What's more, a large number of new investors entering these new-age companies are aged below 30, as India's young population is looking at newer avenues to maximize returns. But is this just FOMO (fear of missing out)? Are the current valuations justified? What principles should a retail investor keep in mind while looking at internet IPOs, beyond the excitement and euphoria?

Moneycontrol MasterClass episode 18 on the topic ‘Internet IPOs: Should you Subscribe or Stay Away’, moderated by Moneycontrol’s Chandra R. Srikanth on November 3, aimed to answer some of these questions. The speakers included Rajeev Thakkar, chief investment officer, PPFAS Mutual Fund, Harsha Upadhyaya, CIO, equity, Kotak Mutual Fund, Shyam Sekhar, chief ideator, ithought, an investment advisory firm, and Deepak Shenoy, founder, Capitalmind, a wealth management startup.

Thakkar said, “It is a very exciting time where you are having all these unlisted companies coming to the markets, raising money and being listed companies down the road. So it's a good thing that we are having these startups listed in India and Indian investors getting to participate in them.”

But he also said that a larger chunk of the value of internet IPOs goes to early investors. “It’s difficult for current investors to make sustainable returns at high valuations,” Thakkar added.

While investors have more listed companies to choose from, there are concerns about how to gauge whether one should invest or not in internet companies, when traditional metrics such as profitability and cash flow do not apply to these companies.

Challenge of evaluating internet IPOs

Many of these internet companies are at the nascent stage and are more scalable than their traditional peers. But they do not generate much cash flow at this point and continue to burn money.

In addition, these companies also have steep valuations. For instance, Paytm will be valued at close to $20 billion, making it India’s biggest IPO, yet it continues to make losses. The company’s revenue was up 46 percent at Rs 948 crore in the first quarter of fiscal 2022, while its losses stood at Rs 382 crore.

As much as an exorbitant valuation does not make sense, the execution these companies bring to the table is underrated, says Capitalmind’s Shenoy.

For instance, in the case of online food delivery, what Zomato and Swiggy did was scale this up by getting the entire logistics in order and changing user behaviour. This can be said for Ola or Uber as well, which have now become household names. “Ideas and innovation are overrated, and changing user behaviour and execution are underrated and involve money,” Shenoy explained.

All these make evaluating internet IPOs a challenge for retail investors. But there are ways one can assess them.

What to look at?

Kotak’s Upadhyaya said that in the case of internet IPOs, people need to look at the long-term profitability projection, though they are fraught with risk since a longer time frame reduces the ability to predict those cash flows or profitability streams. “Nevertheless, that is required for these internet companies in terms of longer-term profitability and that's how you need to decide,” he said.

Upadhyaya added that of all the IPOs that have got listed in the last decade, only a handful have actually created wealth relative to the benchmark on a sustainable basis.

Other metrics to look at include the market the company is addressing and the agility of the management team. “Compared to traditional businesses, the agility of management is much more critical in internet businesses,” Upadhyaya added. For more often than not in internet companies, you are betting on the founder's ability to execute.

PPFAS Mutual Fund’s Thakkar pointed out two things retail investors can look at—unit economics and the ability of the company to survive on its own.

Unit economics, he said, means that your selling price for the product should be higher than the variable cost associated with it. This could be customer acquisition costs, fixed costs and other overheads for a single unit. “If unit economics itself is not there and companies have to subsidize each unit of sale, then I would not see a very great future for such a business,” Thakkar explained.

Second, the company should be able to sustain itself without external funding. “(A company) can’t depend on external funding endlessly. So let’s say one or two years out, the market is not so hot or if the VCs (venture capitalists) stopped pumping in more money, the company should be able to survive on its own,” Thakkar said.

Sekhar of ithought said that even as companies have steep valuations as they go for listing, given the future prospects, investors should pick those companies that will justify them.

“Eventually every business will have to submit itself to the same parameters of valuation. When business is in a very rapid growth phase, then the gamble is that the money that is burnt will bring it to profitability and bring it to a stage where it becomes self-sustaining.”

“It is important to give time and capital for growth for these companies but you are limited by both these aspects. They will have to come to comparable metrics in time, since they are in the same business as their brick and mortar peers,” Sekhar said.

“You cannot forever have a different set of parameters for evaluating internet companies,” Shenoy too pointed out. If in 2008 it was eyeballs that benchmarked a website’s valuation, it is gross merchandise value for e-commerce now, or price to sales/price to earnings.

“In the end, the business will be valued at the amount of value it generates and how that value translates to profit for shareholders. You can twist or turn this equation any way you like, but eyeballs (need to) turn into profits, which is what happened for Amazon but did not happen for a lot of other companies,” Shenoy said.

Advice for investors

He added that while there is merit in sensitizing an investor about what he is getting into in an internet IPO, moderation is what he would advise, not abstinence. “It is quite likely that 10% of these IPOs will be successes,” he said.

Thakkar too said investors should guard against putting all their eggs in one basket. “Invest small amounts across a variety of internet companies,” he said.

Shenoy added, “Every single IPO will see a 25-40% drop in the coming years. If you can't accept the volatility, you are not built to invest in these kinds of businesses.”

At the same time, Upadhyaya said IPOs alone can give investors the kind of wealth they want to build. “There has to be a more systematic approach,” he said.