The shares of the three Chinese EV giants recently listed in the U.S. have all skyrocketed. Matrix Partners China, a leading venture capital (VC) firm that has backed major Chinese tech firms at their early stages, released their thoughts in an article published Wednesday.
In the article, David Zhang, founding managing partner of the VC firm, says that the market's judgment of company value is changing and that traditional valuation methods are somewhat ineffective, requiring investors to take a fresh look at valuation methods.
Behind this, he argues, are low global interest rates that have forced investors to chase a limited number of high-quality targets, making crowded deals even more crowded.
He says that the growth logic of many companies today has changed. Previously, most companies grew linearly, and we could even predict business growth based on a country's per capita income level and GDP growth.
But the new economy has broken that growth model and it has become exponential. Companies may be losing money until a tipping point, but once they break through, it's exponential growth, which has revolutionized capital market valuation, he said.
Today, we are increasingly entering a world of uncertainty. The pricing power of company valuation is not in the hands of the company, nor in the hands of VCs, but in the hands of the market, and valuation is entirely determined by supply and demand. The "good price" no longer exists, and we need to rethink the margin of safety, he said.
He says we need to be "friends of valuation", meaning you don't always think your friends are right, but you're willing to take the time to understand them, much like valuation at the moment.
The following is a translated version of the full article.
A lot of people have been asking lately, why exactly are electric car stocks soaring?
Our investment in Li Auto rose 280% and XPeng rose 370% after its IPO.
BYD, the A-share leader in new energy vehicles, is also up 280% since the beginning of the year, while Tesla's market capitalization is almost twice that of Toyota's, yet all the electric car companies have delivered a fraction of the number of gasoline cars.
We ourselves, though, are very bullish and surprised by such a short period of stock price gains.
If we had to look for a reason, it might have something to do with the market's sudden recognition of the long-term potential of EVs, the strong push in China and Europe to replace gasoline cars with EVs, the support for new energy from the next US President Biden, etc. But these are just some of the things that have happened since then. But these are just reasons that are summed up after the fact.
In fact, this year's market craziness is far beyond imagination, not only the listed companies that you can see are rising, but also the valuation of many outstanding companies in the primary market.
Since the beginning of the year, the valuations of at least 100 companies that recently received funding from Matrix Partners have increased 2-8 times.
Ape Tutoring, for example, which we invested in in 2013, saw its valuation soar from $7.8 billion in March to $15.5 billion in October.
We both love and hate this increase as well. We've made money on our own investments, but also the companies we missed out on in the first place have now become very expensive. We also have to think about whether we want to keep adding to the companies we've already invested in.
Matrix Partners has been an early-stage fund focused on startups, and we have formed a reservoir of over 300 good companies.
For these great companies, we also raise capital when they refinance to protect their share ratios. But this year, their valuations have risen so fast that I often have trouble deciding.
Is the valuation reasonable or not? I have tried to analyze some of the reasons for this common interest, and perhaps the market will prove me wrong when I finish, but I think we need to look at valuation in a new light.
Traditional valuation methods fail
There are many ways to measure value in the financial world, all of which were developed in the United States in the mid-20th century.
At that time, the economy was stable and the stock market was clearly moving up and down around a value line.
So the search for undervalued companies became an effective tool at that time, and valuation methods such as P/E ratios became mainstream.
But today, we need to look at valuation in a new light.
Aswath Damodaran, a professor at New York University, has always been against using the Shiller P/E ratio. Many people take a quick look at historical numbers based on the Shiller P/E ratio and arbitrarily say that there is a bubble in the stock market.
Where do you get your data from? The Shiller P/E data started in 1871, and it would be lazy to use it now, when the business and technological environment is completely different.
Our perception of bubbles has gradually changed since 2015.
Before 2015, we tended to think that bubbles were irrational, and that it was only a matter of time before the temporary quantitative easing or low interest rates adopted during the crisis returned to normal.
But as it turns out, after 2015, while global capital markets gradually emerged from the 2008 financial crisis, everything still seemed expensive.
This situation makes traditional valuation methods somewhat ineffective. Because it's hard to value young companies that are still building their business model using P/E ratios, P/E ratios, or the ratio of enterprise value to earnings before interest, taxes, depreciation, and amortization (Ebitda), the numbers are inevitably high and seem unapproachable.
The core factors that determine a company's valuation: cash flow, growth, and risk, all start with the future, so valuation thinking should move from static to dynamic, from retrospective to prospective, and long historical data should not be a crutch.
This year is especially different, as the low interest rate era has forced investors to chase a limited number of quality targets, making crowded deals even more crowded, and the market is exaggerating the value of companies up front.
Originally it could take six years for a company to build a full business cycle, for profits to start releasing and for customer value to thicken.
But now that the market is more up front, the market may move earlier, and by the third year of a company's life, based on expectations, it will have already reached the valuation level of the sixth year.
It used to be said that we should look for "good company + good price", but now "good price" needs to be redefined.
For example, both Li Auto and XPeng were able to go to market at a slightly higher P/S than Tesla because the market was based on Tesla's development path. There is a clear expectation of good latecomers, especially since both Li Auto and XPeng have had good deliveries.
As for Tesla itself, when the market recognized the expectation of electrification and intelligence of cars, the story became very valuable and the market started to value it by "revenue of car companies + profit margin of technology stocks".
Car companies often have hundreds of billions of dollars in revenue, but low margins; technology companies are highly profitable, but not as large as car companies.
This expectation has led to Tesla's market cap today being greater than that of Toyota and Volkswagen combined.
Even so, most institutions don't actually fully understand or explain the reasons for today's sector gains, led by Tesla.
What is the nature of the change in valuation thinking? In fact, the growth logic of many companies today has changed. In the past, most companies grew linearly, and we could even predict the growth rate of a company's business based on a country's per capita income level and GDP growth.
But the new economy has broken this growth model and it has become exponential.
Companies may be losing money until a tipping point, but once they break through, it's exponential growth, which has revolutionized capital market valuation.
Previously, most of the primary market was in pursuit of such companies, but now the "secondary market level" has increased significantly, and investment judgments are more and more upfront, much more exaggerated than 2-3 years ago.
Whether it is Pinduoduo, Tesla, or Snowflake listed at 120x P/S (previously, a head SaaS company with 30-40x P/S would have been high enough, even the super-hot video communication company ZOOM only rose to 70x after Covid-19), the results are obvious.
An interesting phenomenon is that, for us early stage funds, who were already fighting in the primary market, the valuation of some high quality technology and pharmaceutical companies in the secondary market is the "price front valuation model" that we are already familiar with, and we have started to adapt and make some later investments. Of course, this does not affect our nature and the tone of our investment.
Today, we are increasingly entering a world of uncertainty. The power to price a company's valuation is not in the hands of the company or the VC, but in the hands of the market, and valuation is entirely determined by supply and demand.
"Good prices" no longer exist, and we need to rethink the margin of safety.
But for VCs, the core is always "can you make the right pitch".
The anchoring criteria for valuation has changed
Next I would like to talk about interest rates, because they are the basis of our understanding of many phenomena.
Interest rates are the "anchor" of all financial assets, and today's low interest rates have changed so many things that it would be a mistake to stick to past experience.
During the Covid-19 period, global interest rates were cut 67 times, and in particular, the Federal Reserve reduced the U.S. federal funds rate several times. This rate is important in the financial markets because it is directly related to the discount rate at which securities are valued, and this "anchor" has now reached historically low levels.
For all types of assets, the lowest building block is Treasury bills (Treasurys, which are priced based on the federal funds rate described above).
When the Fed lowered this risk-free rate after Covid-19 this year, it changed all the expected returns, and generally speaking, the lower the starting point, the lower the expected return for all assets.
Most decisions in investing are relative; we're all looking for the best balance of risk and return. And money is smart, it will move from one asset class to another as fast as it is profitable to do so.
When you're faced with a traditional portfolio of bonds and stocks, at the extreme, you have to choose one or the other. As bond returns fall, they become less competitive with stocks, so stocks don't have to be cheap to attract buyers, and buyers will flock to stocks with high growth potential.
That's what's happening right now. Low interest rates are pushing up valuations, and Covid-19 is causing valuations to be concentrated in specific areas (like technology and health care), and everything that qualifies is increasing in price like crazy.
Apple alone has a larger market cap than Wal-Mart, Procter & Gamble, and Coca-Cola combined, and is equal to the combined energy+utilities+materials sector (which includes ExxonMobil, American Electric, Dow Chemical, etc.). The market capitalization of Facebook alone is larger than that of the entire energy industry.
When the "anchor" of valuation - the prime rate - changes, we see a world in which.
One is that the valuation level of the S&P 500 has exceeded the peak of the dot-com bubble in 2000.
Second, the madness has been led by high-growth tech giants such as the Big Five - Facebook, Amazon, Apple, Netflix, and Google - which account for 23% of the S&P 500's market capitalization, while traditional value stocks (e.g., energy stocks), which have seen slower growth, have fallen considerably.
Covid-19 adds to this divide, which is exacerbated by the fact that it is not just the "growth" stocks, but the "value" stocks as well. The phenomenon is also evident in several of China's leading platform-level Internet companies (e.g., Meituan, Pinduoduo, Bilibili).
How long will the boom last? How to deal with the future?
When we look at these changes with fresh eyes, it's easy to understand some of what's happening.
In the primary market, money is competing like crazy for head-to-head projects, and Covid-19 has greatly exacerbated this.
Today, it is easier to raise a billion dollars for a company that is absolutely at the head of a large industry than it is for an average company to raise 100 million RMB.
Many of Matrix Partners' portfolio companies, in which we just completed our investment at the beginning of the year, are now valued 1.5-4 times higher.
As of October 2020, Matrix Partners has invested in nearly 75 new companies, raised more than 50 additions to existing projects, and the Matrix Partners family of companies has raised new funding for nearly 140 companies.
We have found that the volume of first place in each segment may be higher than the combined volume of second and third place, and the distance is increasing.
Of course, a temporary factor in this is that many dollar funds completed a new round of fundraising earlier this year. The vast majority of funds have their own life cycle, which has contributed in part to the short-term market boom.
This is somewhat similar to the 2014-2015 firestorm.
In retrospect, the fund was relatively aggressive in putting in a lot of "seeds" because it had the money, but the recent market environment is unique, especially the hot IPO market at home and abroad, and today they are "blossoming". This in turn will affect the next wave of the market again, and so on and so forth.
How long will this boom last?
It is true that one has to be wary of the variables in the secondary market, as no one today would use FAANG's current revenue and profits to value them, but rather a forecast for the future.
But FAANG's high valuation comes from the large market share they occupy, and the high profit margins that come with it.
This is where they are vulnerable, because the US federal government is pursuing antitrust litigation against large technology companies, and similar possibilities exist in China.
Another uncertainty is the U.S.-China trade frictions, which will probably be a medium- to long-term condition in the future, and will certainly affect Chinese companies on U.S. stocks.
Valuation adjustments will also become the new normal, and the stock market is a very important bellwether that will eventually feed through to primary market pricing.
So, if these uncertainties eventually explode and cause the secondary market to go down, the ripple effect will be transmitted to us based on the linkage between the primary and secondary markets.
Just like the A-share market crash in 2015, it eventually penetrated into the primary market as well, with a 50% drop in valuation and funding for a large number of startups, and some money-burning models (e.g., O2O) becoming unsustainable.
With all the above said about the market sentiment and future direction, as someone who deals with entrepreneurs on a daily basis, I think we can still do some advice for the companies we invest in.
● Regardless of whether or not the environment shakes out, the rewards of being a head are certainly higher now than ever before, and the top three in an industry will essentially be a 6-3-1 pattern.
However, I've been talking to a lot of people lately and it's important to point out that a lot of people will mistakenly think they're heads.
On the one hand, it is necessary to analyze through rational data and honest comparisons, such as market share, revenue and net profit scale, whether the industry is number one; on the other hand, it is necessary to think through emotional dimensions, such as team iterations, their own growth, and playing strategies.
● In the post-Covid-19 era, there are opportunities for qualitative change, not just quantitative change, in many industries.
Many entrepreneurs are looking for a quantitative growth at the beginning, but the arrival of Covid-19 has catalyzed many advanced means, from software implantation to SaaS, to bring a qualitative change to the business model.
Every founder should figure out where this qualitative change is likely to occur, and then quickly adjust.
Take ourselves as an example, we found that some edge industries are moving faster to the mainstream this year, and only by thinking quickly about layout and industry switching can we get the ultimate victory.
● Take money early and take it hard, now that capital has become a core competency.
Don't overthink dilution, but rather put financing certainty first, get plenty of bullets, and don't be careless or misjudge and run out of food.
In his course at the Billion Dollar Institute, Haoyong Yang ranked several elements of capital: first is certainty, second is amount, and then valuation and terms, which I agree with.
As a lead institution, I always encourage our portfolio companies to take more money, even if it sometimes dilutes us, but it increases the likelihood of winning in the end.
Many people have doubts about China's future development in the context of today's worsening U.S.-China relationship.
But the rapid growth of many companies today depends on China's ability to withstand Covid-19 and enjoy the dividends.
Today's founders need to have a clearer position on many key points and can no longer tread on both sides of the fence, trying to benefit from both markets.
Good companies need to focus on China, then take the Chinese market and turn it into a head of state, and then look overseas.
The speed at which individual founders can learn on all fronts is now more important than ever.
Have the founders been nourished by the input from the people around them, the money, their own learning, and the various courses like the Billion Dollar Academy?
It is possible to measure quality improvement in three-month increments, using the scientific method plus external feedback, and continuous growth is the only constant key point for all companies that end up getting bigger.
Everything needs to change this year, including ourselves: the sectors Matrix Partners is investing in this year have changed a lot from the past 2-3 years.
We have never had the same focus on scenario-based hard technologies, innovative medicines, enterprise services, new consumer, B2B model optimization, new manufacturing and import substitution, etc., and the post-pitch teams are iterating rapidly.
The market is changing rapidly, and people need to be tolerant.
Now that we are in an era of unprecedented low interest rates, it is important to look at valuations with new eyes and not just assume a bubble against historical experience.
But it is also important to be alert to the risks in the environment, whether the stimulus will continue and whether the stock market will go down quickly if the stimulus is stopped, thus transmitting to the primary market.
It is important to be vigilant, because what ends the boom may be the boom itself.