I have been working in tech for 22 years. I remember when Netscape went public at around $28 a share and closed several times higher, some time in August of 1995. Netscape did not have a clear path to profitability, but they had a good leadership team and were able to get acquired by AOL for about $97/share several years later.
One of the interesting things that has happened in the last 20 years is the removal of the Glass-Steagall act, a 1930s era piece of securities legislation that prevented banks from entering the securities business. While the law was in force, banks did money lending, savings, mortgages, and brokerage houses did stocks, bonds, and mutual funds.
After Congress repealed Glass-Steagall, banks began borrowing from the Federal Reserves at the discount rate and using it to finance buy-side activities. Some of those buy-side activities include venture capital investments in promising, and not-so-promising new companies.
Due to the global financial meltdown in 2008, the Fed’s Open Market committee cut interest rates significantly for the best customers, and essentially to 0% for banks (including buy-side funds owned by banks), allowing interest-free capital to be invested in venture capital funds.
The result of this interest-free investment in venture funds is extremely high valuations that are over and above what is a reasonable multiple.
Case in point: Uber has a valuation at last investment round of $62billion. Let’s deconstruct that and figure out a reasonable price-earnings multiple based on default risk, cost of capital, and prevailing interest rates.
As of the time I am writing this, the yields on US Treasuries, the highest quality debt instruments, are approximately 2%. The full faith and credit of the US Government backs these notes and Congress will set aside their ideologies in order to make interest payments on them.
If we give Uber a 500 basis points risk premium over and above US treasuries, we get an acceptable yield of 7%. In reality it may be much higher, but let’s be generous. At a yield of 7%, the PE ratio of Uber should be about 14.
Let’s take the valuation of $62billion, divide it by 14, and we get an expected profit of approximately $4.4billion.
Last year Uber did 140million passenger rides. If we take $4.4billion and divide it by 140million, we get a per-ride profit of $31.63. If we give Uber a very generous gross margin of 90%, then Uber’s cut from each ride should be about $35
Most of the rideshare companies seem to charge about 20% commission on each ride, so to gain a $35 commission, the ride would have to be about $175.00 cost to the consumer.
Yes, the average ride size would be about $175.00 in order to justify a $62billion valuation in even the best scenarios.
The average fare for Uber is $15.97. If we assume a 20% cut for Uber, that’s $3.19. If Uber can recoup 90% of that as a profit (they can’t), that would be $2.87. Multiply that times 140million trips per year and we arrive at a profit in the vicinity of $400million. At 14 times earnings, that’s a valuation of $5.6billion, LESS THAN TEN PERCENT OF ITS CURRENT VALUATION.
Also, there are surprisingly low barriers to entry in the ride share market. Uber’s software patents are not enough to prevent new entrants. Let’s give them an 800 basis point risk over the 2% US Treasuries, for a P/E of 10, and arrive at a valuation of $4billion.
Hope I didn’t ruin anyone’s day.