Hypothetical Value To Real Value

I remember when my son came home one day in high school and told me he wanted to “day trade” along with some friends who were doing it. We opened a TD Ameritrade account and staked him with a small amount of money, enough to trade but not enough that if he lost it all it would be an issue. And off he went.

A few weeks later he asked me “Dad, what is a PE ratio?” So I said to him “you know that deli that you stop in every morning and get a bacon egg and cheese on the way to school?” He said “yes”. I said “let’s say tomorrow the owner says to you, I’m selling the business, do you want to buy it? We make $1mm a year in profits and have for the last thirty years.” Then I said, “how much would you pay him for it?” My son thought about it and said “Four to five million dollars.” I asked him why. He said, “Because I would get my money back in four to five years and then make a million dollars a year after that.” I said, “you offered to pay a PE of 4 to 5.” And he said, “Oh, I get it.”

I like to call that kind of valuation “real value”. You pay $4-5mm for a business and you get your money back after a few years and then cash flow after that. While nothing in life is guaranteed, real value is tangible. You can see your way to realizing it. It’s right there in front of you.

Then there is what happens in early-stage investing. We offer $1mm for 20-25% of a company and value it at the same $4-5mm. But there is no cash flow. There is no revenue. There are no customers. There is no product. Just a few people and an idea. That is hypothetical value. We think “if this becomes worth a billion dollars, we might hold onto half of our initial ownership and end up with $100 million or more”. And we plunk down the money and go.

Here is the thing. A startup becomes a company and eventually, that company gets valued on real value metrics. Someday it will have customers, and revenue, and profits. And investors will think “how many years of profits will I be willing to pay for that company?” A PE ratio will be applied and it will be valued on the business fundamentals and not what can or could be.

Venture capitalists and seed funds and angel investors make or lose money on the journey from hypothetical value to real value. And when the spread between the two narrows, the money we make is less. When the spread increases, the money we make is more.

It is easier to drink your own Kool-Aid in the world of hypothetical values. You handicap the odds of winning more aggressively. You trade ownership for capital at work. You accept the new normal.

Real value doesn’t move so fast. Because it is right in front of you. You can see it. So it is not prone to flights of fancy.

I try to keep this framework front and center in my brain as we meet with founders and work to find transactions that work for everyone. I find it to be a stabilizing force in an unstable market.

#VC & Technology

Comments (Archived):

  1. William Mougayar

    …which reminds us that we still don’t have a clear PE equivalent for valuing crypto-based protocols, apps & networks.

    1. Mac

      William, I thought that’s what we’re counting on you to figure out.

      1. William Mougayar

        I’m trying 😉 Still ongoing.

  2. pointsnfigures

    The math is the math. The real art is what an investor sees that others don’t-even in mature companies (See Warren Buffett) If you can arbitrage the information you root out in diligence, or see the world in a different way than everyone else, you can create an edge.

  3. Tom Labus

    Information means different things at different times based on sentiments/motions. Market psychology is such an unknown factor even when glaring you in the face.

  4. Mike

    I suppose the only thing not hypothetical is the past, but current or past cash flows is a very strong indicator. Businesses are cash generating machines. They need to generate more cash than they take in, or have the potential to do so in the future. The higher projected future cash flows the higher the present value. The best investors are simply very good at projecting and pricing future cash flows. Or convincing other buyers of the future value….. Entrepreneurs build these cash generating machines.

  5. Elia Freedman

    This works in a person’s life too. I’ve spent my entire career trading real value for hypothetical value running start ups. Last month I took an actual paid position at a company for the first time. It’s strange to wake up every other Friday and see cash deposited in my bank account!

    1. Salt Shaker

      Absolutely nothing wrong w/ accepting a regular weekly pay check that isn’t tied to chasing a dream. There’s also nothing wrong w/ chasing a dream, as long as it’s tied to some semblance of calculated risk tolerance. When one is young or single or in a life stage w/ limited obligations or has other sources of income (i.e., a working spouse), then high risk tolerance is certainly acceptable. When one is still pursuing a dream at the expense of one’s peak earning years, a ticking meter, then that (potentially) is a pretty serious opportunity cost. There are actuarial tables for life expectancy, presume there’s similar data wrt peak earning years. Too often pursuit of a dream turns into “Fool’s Gold.” Unfortunately, many times in life there are no do overs. Never minimize the importance of common sense when assessing one’s age, earning potential and fin security.

    2. Donna Brewington White

      You had a long run.Now injecting new options into your future.A different type of investment. 🙂

  6. jason wright

    How to value the paragraph, and WeWork?

    1. Mike

      In the absence of cash flows you can use measurable comps to similar assets to assign value and project the value of future cash flows. This is where the science becomes more art, otherwise the math is pretty simple. Amazon ran huge losses in the late 90s. Looking back, the valuations at the time were probably low. I haven’t researched the financials of a WeWork or Uber (discussed on this blog) but the expectations of investors are probably pretty similar.

  7. sketharaman

    Short and sweet post! I’ve known the concept of P/E ratio for a long time. But I’ve never really understood why someone would pay a multiple of that to buy a business. After reading “Because I would get my money back in four to five years and then make a million dollars a year after that”, I’ve got a good grasp on that. Kudos to your son for demystifying the topic!

    1. fredwilson

      yup. i love that story because it makes things simple.

  8. JLM

    .Every valuation is an exercise in determining the NPV of future cash flows whether the cash flows are easily predictable (as an example the sixth year of a twenty-five year lease) or not.When they are not, then the reliability of the valuation is less certain, but it should still be undertaken to set the trend for future such analysis.It is not just the Price/Earnings; it is the Price/Actual Earnings or the Price/Future or Projected Earnings.P/E(act) is the past as prologue.P/E(future, projected) is the future.Future or projected earnings are the result of assumptions and if one documents the assumption and plays with them a bit — sensitivity analysis — then one can understand what will happen when different assumptions happen or fail to happen.Situations like We (WeWork) are cautionary as the IPO S-1 clearly says that there is no certainty they will ever have earnings. Sure this is a massive overdisclosure, but it is cautionary.Disciplined financial analysis with a great number of assumed variables being tested is a good way to analyze any business. It also teaches us the sensitivities of the numbers.I often see a paucity of such projections and a lot of intellectual laziness when looking at projections.These projections can reliably “box the compass” as individual data points/assumptions go from being assumed to “real.”Today was yesterday’s projection. If we observe harder and keep more data, then figuring out tomorrow is not as hard as people think.JLMwww.themusingsofthebigredca…

  9. David Spiva

    PE value is not that important of a concept when central banks keep printing money via low interest loans, but it sure sounds nice and intellectual.You’ve single handedly described a situation that valorizes what VCs do, while simultaneously obscuring the fact that it’s essentially high dollar gambling.Even Ray Dalio will bluntly explain that the key to his success is gambling in many different classes, with little correlation, because at least the risk all of them will fail at the same time is low.Why do you go out of your way to obscure this?

  10. lunarmobiscuit

    Great summary, but the logic has an unstated assumption…For early-stage, hypothetical valuation investors, the returns don’t necessarily come from future protists. The norm is that the returns come from exits, 99% of which are acquisitions.With that assumption is a second layer of risk that buyers of real value don’t take. The risk that some future investor/buyer will exist and will pay a reasonable PE. That doesn’t happen in every industry or in tech in every city/region/country.

  11. sigmaalgebra

    Your “hypothetical value” is just an estimate of future value; new terminology is not needed.

  12. sigmaalgebra

    ForWe opened a TD Ameritrade account and staked him with a small amount of money, enough to trade but not enough that if he lost it all it would be an issue. And off he went. how well did he do?Did he look for tech IPOs with “a big first day pop”, wait for time X, maybe a week, short them, wait time Y, maybe two months, and close out the positions?Did he collect some data on such IPOs, find what looks like the best pair of times X and Y, and use those?Another lesson:For theThen I said, “how much would you pay him for it?” My son thought about it and said “Four to five million dollars.” I asked him why. He said, “Because I would get my money back in four to five years and then make a million dollars a year after that.” Well, for the next “four to five years”, theWe make $1mm a year in profits and have for the last thirty years. is not guaranteed, e.g., there is the“you know that deli that you stop in every morning and get a bacon egg and cheese on the way to school?” so, the sandwich is a “bacon egg and cheese”? There is a name for that, an Egg McMuffin from a potential competitor, McDonald’s. And, sure, when a deli is doing really well is just when McDonald’s will notice and consider opening another instance. Also the lease on the retail location might expire with a new lease costing more. NYC might pass a law for $15 an hour minimum wage which might reduce the $1 million a year. Etc.As Yoda said, “Always difficult to see, the future.”.So, the million dollars a year is not guaranteed for the next four to five years.The business might grow to yield more than $1 million a year or might shrink to yield less. So the earnings per year might fall in a range from, say, 1/2 to 1 1/2 million dollars a year.So, that is some uncertainty of $1 million a year.There are lots of delis in NYC, and we could take an average of the annual earnings; suppose we do get the $1 million. Then, with the deli in question, we would expect the $1 million. This is like flipping a coin: In 1000 flips, we expect the fraction of HEADS to be fairly accurately 50%, that is, 500.There is a result in some relatively advanced math called the law of large numbers. Actually, there are two versions, the strong one and the weak one. The strong one is harder to prove but more powerful.Either version says that if we keep flipping the coin, say, 10,000 times, 100,000 times, the percent of HEADS will be, to put the situation in simple terms, closer and closer to the 50%.Similarly for buying that deli: That’s like flipping a coin once and might get earnings anywhere between the 1/2 and 1 1/2.But there is a way to get the earnings quite accurately at the expected value of $1 million: Own 1% of each of 100 such delis.And can get still closer to the expected value if invest 1% of the money in each of 100 different stocks of businesses that are essentially independent of each other.The independence lets us use the law of large numbers,So, sure, the 100 delis are not independent, so we hedge the deli risk so that given the hedge the 100 delis are conditionally independent.And if buying the stocks, we could hedge the market risk.If we can get the risk low enough, then we could consider borrowing money to buy more stock.The law of large numbers is, with enough assumptions, mostly about independence, to justify what investing commonly calls diversification.While used, old books on advanced math commonly go for about $5 each, I just noticed Ioannis Karatzas and Steven E. Shreve, Brownian Motion and Stochastic Calculus, Second Edition, ISBN 0-387-97655-8, Springer-Verlag, New York, 1994. David G. Luenberger, Optimization by Vector Space Methods,John Wiley and Sons, Inc., New York, 1969. are now going for $200 or much more each.Gee, my copies have become much more valuable!So a suspicion is that lots of people on Wall Street have been buying copies. Or it’s not Wall Street but out on Long Island at Renaissance Technologies?Both books — Karatzas and Shreve, Luenberger — have prerequisites of, say,Paul R. Halmos, Finite-Dimensional Vector Spaces, Second Edition, D. Van Nostrand Company, Inc., Princeton, New Jersey, 1958.Walter Rudin, Principles of Mathematical Analysis, Third Edition, McGraw-Hill, New York, 1964.and the first half ofWalter Rudin, Real and Complex Analysis, ISBN 07-054232-5, McGraw-Hill, New York, 1966.and Ioannis Karatzas and Steven E. Shreve, has a prerequisite of, say,Jacques Neveu, Mathematical Foundations of the Calculus of Probability, Holden-Day, San Francisco, 1965.all now really old books!The ones Ioannis Karatzas and Steven E. Shreve, David G. Luenberger, Jacques Neveu are rarely taught anywhere.Tough to believe that there are many people on Wall Street with the prerequisites for Karatzas and Shreve or Luenberger!Uh, Luenberger makes heavy use of the Hahn-Banach theorem.Gee, what’s going on?

  13. kenberger

    How did the day trading turn out for Josh?