What is an APP worth? Finding Rational Valuations in an Irrational World

Determining the value of any business can be an interesting process. Even in a data-filled discipline like economics, business valuation often remains very subjective.

If you stayed awake in Economics 101 you might have learned that in a liquid market, we believe that prices are determined by rational buyers and sellers of goods and services, each assessing the transactions in regards to their own self-defined best interests.

Price theory was developed in the 18th Century for a mercantile economy where the buyers and sellers were primarily merchants. Adam Smith considered merchants to be rational because they all wanted to buy goods for a price less than the price for which they could re-sell them. Little consideration was given to how the ultimate consumers might act or think.

In our modern consumer economy rationality plays a diminished role. Many consumer transactions are emotionally based. If you do not believe me consider the vast amount of economic activity that emanates from a single, strategically placed dab of perfume. The human mating ritual is full of transactions that are not based upon a rational allocation of resources.

It would seem easier to find rational buyers and sellers in the financial markets. People buy stocks because they believe that the market price of the shares will increase. The people who are selling those same shares in the same transaction may be doing so because they believe that the price will rise no higher. A buyer and seller in each transaction may be assessing the exact same data and reaching opposite conclusions. Each still acts rationally.

We seem willing to accept that a company’s value as being equal to the number of shares that it has outstanding in the market times the last price at which the shares were sold. But is it?

In active trading markets, the price of a stock may change constantly. For any stock, the last trade of the trading day is the price upon which margin accounts are valued and capital computations will be made throughout the global banking system. All that actually occurred between the next to last trade and the very last trade of the day was that one person bid the stock up or down. Valuing a company’s shares at the last trading price of the day eliminates the rational thinking of the other market participants who traded the shares seconds or minutes earlier.

Consider the case of Uber. Recent reports suggest that the not yet public company might have a value of $50 billion.This valuation was assessed at the time of its latest round of financing in mid-2015.

For a private company that is fairly new, an actual value of $50 billion would be quite rare. There are not a lot of larger companies that could spend $50 billion to purchase Uber. It would require $25 billion to take one-half of the company public and more to maintain a liquid secondary market.

Uber has demonstrated that its business model is viable and expandable and should certainly be profitable, given that its direct cost to provide the labor that it sells is zero. Uber operates in more than 200 cities, worldwide, cultivating its brand and customer loyalty.

At its core, Uber is essentially an APP, which the company itself will tell you. The company has structured its business so that the “employees” whose labor is the primary source of the company’s revenue are not employees at all. They are independent contractors.

The independent contractors (drivers) utilize the APP to connect with customers who might hire them. Once hired, the APP does the billing, Uber takes its cut, and the contractor gets a check. It is not a complicated concept.

If one assumes that Uber captures $2 (net) per transaction worldwide, it would need ½ billion transactions per year and a 50/1 price to earnings ratio to achieve a $50 billion valuation. Even with a lot of customers and a lot of drivers to service them, that is a lot of rides. There is no indication that Uber has ramped up to that level.

The replacement cost of Uber’s APP would seem to be a fraction of that $50 billion value. The APP is, of course, just a few million lines of code. Its functionality now defined, could not 1000 code writers replicate the APP’s functions in 1000 days, more or less?

Uber already has credible competitors. Some amount of Uber’s “loyal” customers could be coaxed away with price incentives and clever advertising. Some number of Uber drivers could be incentivized to change firms for a higher payout or a different business model. Certainly the $50 billion valuation for Uber seems high.

Valuation is one of the most elusive concepts in economics. If Uber’s value may be off by $10 or $20 billion despite its simple business model, what values can we trust?

For their first week’s home work assignment, I would send my Economics students into one of the large department stores in San Francisco’s Union Square. I would instruct them to make a purchase but not to pay the price on the product’s tag. Rather, I wanted the students to actively bargain and to convince the sales clerk or department manager to let them have the item for less. You would be amazed how easy it is to accomplish this.

Modern economics is based on price theory. We just have to remember that prices are rarely rational and always negotiable.

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