WhatsApp on the asset valuation front?

With the announcement of the Facebook-WhatsApp deal, there has been a spate of articles on the buyout. While some tried to explain it in terms of the “principles” of valuation, others tried to show how valuation is nothing but mumbo jumbo masquerading as science.

So, what is financial valuation? It is nothing but a set of principles to estimate the value of an asset.

The asset may be an equity share, a business, a distribution network, a licence to exploit a patent or a brand — just about any investment that will provide a series of cashflows in future in return for a consideration to be paid today.

Financial valuation answers a very rudimentary question: Will cash flows from this investment reward the investor with a commensurate rate of return?

Central to the notion of commensurateness is the idea of how risky or variable profits or cash flows from the investment are likely to be.

Businesses with risky profits are required to deliver higher rates of return.

Two facts are rarely appreciated about valuation. First, valuation is relative. The rate of return demanded is in relation to rates of return that can be realised from other similar investment opportunities.

Second, valuation is based on an estimate of future outcomes — of cash flows and rates of return. The moment of truth cannot be upon us until events have played themselves out.

To any lay reader, all that should appear commonsensical. Why then does valuation generate so much heat and excitement each time an HP buys a Compaq or a Facebook buys an Instagram or WhatsApp or when, nearer home, a Little Eye Labs or a Sify bought IndiaWorld way back in 1999?

The trouble lies in the notion of scientific infallibility and accuracy that is often attributed to valuation; whereas, strictly speaking valuation is nothing more than a systematic approach to determining the fair price of an asset.

So where does all the appearance of science come from? It comes from tools that analysts use to estimate cash flows and compute a commensurate return.

But that is based on the basic notion that if we use right tools on data about the past behaviour of profits and returns, we can derive meaningful predictions about the future.

All that is fine when two conditions are satisfied: One, there is plenty of past data that justifies the use of these statistical tools. Two, the past is a reasonable basis for approximating future outcomes of cash flow or rates of return.

What then is a reasonable basis for forecasting cash flow from WhatsApp?

Certainly, not its own past, for it has not started earning any profit. Nor the past of any other company, given that it is defining a new category of services that has not existed hitherto.

What is a comparator for demanding a rate of return from WhatsApp? Well, that’s even more tricky, given that the riskiness of its profitability is anyone’s guess.

That amounts to acknowledging that valuation is all mumbo jumbo — at least in instances such as the WhatsApp deal — doesn’t it?

Not quite. In such situations, the principles of valuation provide a framework for understanding the basis of valuation.

One method of valuation, for example, would suggest that at $19 billion, Facebook valued each of WhatsApp’s current 450 million users at roughly $400.

If each of those users generates an annual profit of $40, they would produce an annual rate of return of about 10 per cent. That helps us ask a more tractable question: Will each of the WhatsApp users generate $40 in profits and how?

Hopefully that understanding will, in turn, add to our ability to put a value on similar acquisitions in future.

As in all attempts in acquisition of scientific knowledge, in this instance too, we are constantly in search of a framework that will help us estimate the fair price to pay for an asset.

And every time we have a new input that validates our earlier effort, or even points to an error, we have gained, because it has added to our body of understanding. Absent that framework, we would not even be able to learn from our own experience.

On a more philosophical note, the path to acquisition of knowledge, at least in the world of valuation, is indeed strewn with instances of apparent errors and follies. More so when the underlying object of study is human behaviour, as it is in the case of valuation.

To borrow a Shakespearian metaphor, one might say the fault lies not in the principles of valuation but in ourselves, the way we understand them.

The writer teaches at IIM Bangalore. The views are personal