Disruptive Innovation: How much would you pay?

By Douw Steenekamp*

Innovative start-ups driving established companies out of business never fail to excite investors. While the concept isn't new, the catch-phrase "Disruptive Innovation" has gained everyday notoriety since it first appeared in "The Innovator's Dilemma," a book published by Harvard Business School professor Clayton Christensen in 1997. His prescience has subsequently been demonstrated by such icons as Steve Jobs (Apple) and Andy Grove (Intel Corp) whose innovations have disrupted of a number of established industries.

But, while there is general agreement about the transformative nature of their business models and product offerings, there is a massive divergence of opinion as to what they are actually worth.

Today, every promoter of the latest start-up strives to attach the moniker "disruptive innovation" to their company's doings in the hope of attracting a deep-pocketed angel investor or two. Even CEOs of established companies are not immune to the allure of the transformative effect on the perceived value of their business if they are seen as "disruptive" of the status quo. And so it has become almost compulsory to have a "disruption" slide in your presentation pack.

During the recent Morgan Stanley TMT Conference in San Francisco, investors' obsession with this notion was unmistakable. There seemed to be a direct correlation between the size of an audience and the perceived disruptive character of the various presenting companies. No disruption, poor audience attendance.

Presentations by Facebook, Twitter, Uber, Netflix, PayPal and salesforce.com were overcrowded, with standing room only (in the 300 seat main hall), whilst Microsoft, IBM and Time Warner only half-filled the venue. The likes of Cisco Systems and Discovery Communications were pushed out to smaller venues.

What was also evident, was how the level of interest corresponded neatly with the relative level of valuation. For someone who vividly remembers the dotcom

phenomenon of the late 1990's, the sense of déjà vu was palpable. Back then, companies that are now regarded as cannon fodder for today's vibrant innovators were seen as ushering in a new world and were valued commensurately. We all know what happened next.

Listening to Sheryl Sandberg, the Chief Financial Officer of Facebook, explain how their detailed and unique insight into the likes, dislikes, habits and associations of their roughly 1.3 billion active users enables them to offer advertisers an unparalleled value proposition, one cannot help but be enthralled by the thought of the myriad opportunities still to be explored. This promise of unlimited opportunities still to be explored – echoed in presentations by Uber, Netflix, Twitter and PayPal – has worked its magic in investors' minds. There is little doubt that these companies are changing the world, shaking things up and threatening the livelihood of established incumbents in a number of important industries. 

The meteoric trajectory of well-known unlisted "disruptor company" valuations, powered by successive funding rounds, has added fuel to this fire. These valuations are regularly used to justify the inflated prices of their listed counterparts. It is little wonder that objectivity abandoned in the face of the hype created by headlines reporting the ongoing juggernaut of these valuations. However, investors would do well to remember that the outlandish values placed on these unlisted companies by investment banks and venture capitalists are decided behind closed doors; amongst groups of self-interested insiders. There is little reliable public financial information to support any of these appraisals.

These frenzies make it difficult for traditional value investors, like SIM Global, to comprehend the value that the devotees see. Few of these companies are currently profitable and even when using optimistic assumptions about future profitability, the implied valuation multiples are still many times that of the overall market. Our counterparts in the growth camp argue that profits are unimportant and that the only significant factors are the rate of growth in revenue and the ubiquitous user base. These optimistic investors contend that huge valuation premiums are justified by all the unspecified good stuff that will inevitably result when these companies have successfully displaced all incumbents. But there seem to be two serious flaws in this argument:

First, there is no precedent for the persistence of such extreme valuation multiples beyond a relatively short time horizon. In this respect the valuation history of Microsoft, one of the darlings of the dotcom mania, is instructive.

After peaking at a price of $59.56 per share and a price earnings multiple (P/E) of 85 times in December 1999 (during the height of the frenzy), the share fell 65% to $20.75 per share and a P/E of 26 times the following year. For the next thirteen years the price traded in a band between $22 per share and $30 per share while the steady growth in its earnings systematically eroded the multiple.

By mid-2013, when the price finally broke decisively above $30 per share, the P/E was more than one standard deviation below the 20 year market average. Despite this recent recovery, the price remains significantly below the high recorded in 1999. I won't be surprised if, in fifteen years' time, a number of today's favourite companies display a similar history.

Second, these optimistic growth projections assume that the incumbents are simply going to roll over and play dead. This seldom happens, even in those instances where the established players suddenly find themselves facing a previously unthinkable disadvantage. Typically they tend to mount a spirited defence, conceding profits, offering revised products and mustering all the vested interests they can to erect barriers wherever possible. While such efforts seldom succeed in preventing a seismic shift in the status quo, they often succeed in retarding the "disruptive" process for longer than is expected and moderating its financial impact. The considerable regulatory obstacles that are currently being raised against Uber in multiple jurisdictions at the instigation of the incumbent taxi operators, as well as the competing mobile apps that have been launched by many of them, serve as a good example of a defence against disruption.

Aswath Damodaran, Professor of Finance at the Stern School of Business at New York University and a renowned expert in the field of asset valuation, has commented extensively on the futility of trying to make sense of the valuation of these companies by applying traditional valuation methods and parameters. He has postulated that the only possible explanation for the extreme price premium that some investors are willing to pay is the existence of a very substantial "disruption option". This option refers to the implied, but as yet undefined, threat to enter and disrupt adjacent industries and markets that seems to be attributed to these companies. Judging from many of the responses elicited by his hypothesis, the magnitude and scope of the disruption foreseen often extends far beyond what can reasonably be assigned a probability.

For example, in the case of Uber, it is posited by some that it is reasonable to assign a value to the boost their profit margins will enjoy once the technology exists to replace their current insourced fleet of cars with driverless vehicles. This wildly optimistic statement takes no cognisance of the fact that Uber is yet to report its first dollar of profit!

Damodaran's conclusion, with which I concur, is that the pricing of these companies is currently the domain of speculators who base their decisions on technical indicators, non-financial operating metrics such as enrolments and page views, and their intuitive reading of investor behaviour. It is futile for those who believe that value must be underpinned by the relatively certain prospect of a decent return on the capital invested to even try to understand this mind-set or to reason with its practitioners.

Whatever one's position, it is indisputable that in the long term price and value will converge and that the path of this convergence most often includes a severe and unpredictable correction when the gap is wide.

When deciding whether to participate in this game of chicken with the mood of the market, you had better know your own fallibilities. There is certainly money to be made, provided you have a knack for successfully riding the wave and bailing out at precisely the right time. If however, like me, you are wary of the considerable risks inherent in such a strategy, you are best advised to remain a spectator and look for value elsewhere.

*Douw Steenekamp manages the Sanlam Global Best Ideas Fund & SIM Global Equity Income Fund.

 Douw started at SIM Global in July 2011. Prior to joining SIM Global he co-founded Orthogonal Investments, a boutique asset manager managing domestic long only balanced, bond and equity mandates. He also co-managed the Nedgroup Investment Equity Fund. He spent 15 years with Old Mutual Asset Managers (now OMIGSA) where he held several research positions, including head of the industrial sector research team, before assuming responsibility for the value equity style boutique in 2002.  During his tenure at OMAM, Douw was at various times the manager of the OM Global Equity fund, OM Consumer fund, OM Value fund and OM High Yield Opportunity fund unit trust portfolios, in addition to a number of institutional client portfolios.