Competition gives you monopoly, but monopoly itself is a great business in the future. Compare the value of The New York Times Company with that of Twitter. Each employs a few thousand people, and carries news to millions. But when Twitter went public in 2013, it was valued at $24 billion—more than 12 times the market capitalization of the Times—even though the Times made $133 million in 2012 while Twitter lost money. What explains the huge premium for Twitter?
The answer is cash flow. It seems odd at first glance that, while the Times was in profit, Twitter was in loss. But a great future business is defined as one with the ability to generate cash flow. Investors expect Twitter to make monopoly gains over the next decade, while the days of newspaper monopoly are over. It has been said that the value of today's business is the sum of all the money earned in the future.
The distinction between low-paying businesses and high-growth startups is most important when compared to the Discounted Cash Flow model. Most of the value of low-growth businesses is in the near term. An old economy business (like a newspaper) can sustain its current cash flow for five or six years. However, the close firm will see competition in its profits. Nightclubs or restaurants are good examples: successful ones may rake in money today, but their cash flows will probably dwindle in the next few years as customers turn to newer and trendier options.
Technology companies use the opposite trajectory. They often suffer losses for the first few years: it takes time to build something of value, and that means delayed revenue. Most tech companies will be valued at least 10 to 15 years into the future from turning a profit.
In March 2001, PayPal had not yet turned a profit, but our revenues were growing 100% annually. When I projected its future cash flows, I found that 75% of the company's present value would come from profits generated in 2011 and beyond, and that's hardly enough for a company that's only been in business for 27 months. It was hard to believe. But it turned out to be an underestimation. Today, PayPal continues to grow at about 15% annually, which is less than the discount rate a decade ago. It now appears that much of the company's value will come in 2020 and beyond.
LinkedIn is a good example of a company whose value exists in the distant future. As of early 2014, it had a market capitalization of $24.5 billion—high for a company with less than $1 billion in revenue and only $21.6 million in net income in 2012. You can look at these numbers and conclude that investors have gone crazy. But this valuation makes sense when you consider LinkedIn's projected future cash flow.
The importance of future profits is also anticipated in Silicon Valley. For a company to be valuable it must grow, but many entrepreneurs only focus on short-term growth. They have an excuse: development is easy to measure, but sustainability is not. Who are obsessed with weekly figures, monthly revenue goals, and quarterly earnings reports. However, you can ignore those numbers, ignoring hard-to-understand problems that threaten the sustainability of your business.
For example, both Zynga and Groupon managers and investors have driven rapid short-term growth from long-term challenges. Zynga scored early wins with games like FarmVille and claimed new releases with an in-depth "psychometric engine." But Hollywood ended up with the same problem facing the studios: How do you create a steady stream of popular entertainment for voracious audiences? (No one knows.) The group quickly grew among hundreds of thousands of local businesses. But persuading customers to become repeat customers of those businesses was harder than they thought.
If you focus on near-term growth to the exclusion of all else, the most important question you must ask is: will this business still be around a decade from now? Numbers alone won't give you the answer; Instead, you should think seriously about the qualitative characteristics of your business.
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