The ball you need to keep your eye on here is the underlying principle that wealth is what people want. If you plan to get rich by creating wealth, you have to know what people want. – Paul Graham, YCombinator
I’ve been reading some of the older essays that Paul Graham, the co-founder of YCombinator, has penned over the years and one of them has answered a question that has bugged me for a while.
Why is it that companies that make no money are sold at such astonishing valuations?
Facebook, LinkedIn, Twitter, Google, Snapchat, Instagram are all examples of billion dollar companies that were making no money at one time.
I grew up reading the essays of Warren Buffett, which in turn pointed me to the work of Benjamin Graham, the father of value investing who pointed to even earlier works that defined value in terms of the present value of future cashflows.
If you wanted to buy a company, for example, that made a good, steady product and you figured that it would keep selling for the next ten years, you might buy that stream of money at a discount today.
As a rule of thumb, for example, you might pay between 6 and 10 times earnings for such a business.
What if you thought that business was likely to grow?
Well, if you were bullish on that, you might go up to 20 times earnings.
And to protect yourself, you might actually work that out on the average of the last three years of earnings.
But the ideal, in those days of Graham and the early work of Buffett, was to pick bargains – to go shopping for discounts.
So I tried that first, when I was trying my hand at investing, and my picks turned out to have a disappointing tendency to go to zero fast.
Companies like JKK and Aquarius Platinum and Herbert Brown pawnbrokers don’t hold good memories for me.
Fast forward a few years and Buffett started listening to Charlie Munger and talked about buying great companies at a good price.
That tied in with the ideas of Peter Lynch, who suggested buying what you knew.
The increases I experienced buying into Superdry and Drax at particular times when they were cheap but still were good are a better memory of those times.
My early adventures at stock picking were more about the learning than the result really and so when it came to more serious investments I went with passive index funds – which have never really caused the kind of anxiety and euphoria that came with the active picks I made.
But in all that time one thing remained constant – the companies I bought made money.
So, how do you value a company that is making no money?
The answer, when you read Graham, is astonishingly simple.
Simply crowdsource the question.
What does that mean?
It means letting people tell you who the winners are.
Graham says that investors, venture capitalists and potential acquirers really have little to no idea of how good your plan is or whether your technology is really light years ahead of the competition.
So they turn to the market and ask what users think of your business.
They figure that users must have the good sense to select services and products that work for them.
When you tried to set up your first email account, for example, you probably tried rocketmail, hotmail, msn among others.
Do you now use gmail?
And if millions of people are making the same choices all you have to do is meet all the providers of such services and ask them how many users they have.
The most successful service will be the one that has the most users.
That’s why google pulled ahead in search, despite starting after Yahoo.
Now there is a danger in looking at large startups for all the examples of a successful approach because that makes you think only software businesses need to think of this.
It’s really about systems.
The question to ask is which “system” is most favoured by users.
McDonalds, for example, is a system, just like Google is a system.
And your construction business is also a system, anyone looking at your business can work out how successful you are by how many users you have.
And that means you need to ask yourself what your business is doing to get more users.
That’s a different question from selling – how many sales you’re making.
If you’re selling a service, for example, the price is immaterial – you could sell it for free and lose nothing but your time.
If you can’t get users, even if you’re giving it away, then you have a real problem.
If they’re signing up in droves, you can make money later on – you’ll figure out a way to do that because you’re giving people what they want.
Think about this for a second – what is the one thing you need to have if you want to persuade someone to work with you?
You need examples of work you’ve done with previous clients.
No one wants to be the first to try you out – most people are conservative and will pay more for something that is proven.
And there is no better proof than existence and growth of other users of your service.
And so, focus on users, because having them is the thing that will get you noticed.
And you can only get users by giving them what they need and want.
Which is why the number of users you have seems to have become the investment valuation rule of thumb for the digital world.