The post I wrote yesterday generated a lot of discussion. I followed it on Twitter and engaged with much of it there.
One of the best things about writing is all of the feedback you get. It helps to sharpen your arguments and also makes you rethink them too.
Here are some of the takeaways:
- Some readers interpreted the post as arguing for only investing in high gross margin businesses. I don’t believe that is the right takeaway. The better takeaway is that high margin businesses are often less dependent on capital markets because they can internally generate cash more easily. That is not the case with low margin businesses. So how you value and how you finance low margin businesses becomes very important. They can’t be valued too highly or you risk a financing crisis.
- Bill Gurley tweeted his blog post from 2011 that “all revenue is not created equal.” That is a great way of saying what I was trying to say.
- Apple and Amazon were put forth as great lower margin businesses. Amazon is a roughly 25% gross margin business and trades at a little over 3x revenues. Apple is a roughly 40% gross margin business and trades closer to 4x revenues. I think that emphasizes the point that revenue multiples ought to reflect gross margins.
- Many people argued that operating margins and growth rates should be the two numbers that matter most in valuing a business. I totally agree. But it is hard to have 40% operating margins if you have 40% gross margins. The truth is that operating margins will be highly dependent on gross margins. But there will be edge cases where that is less true.
- I got a lot of people saying “isn’t this totally obvious?”. To which I say “it should be but clearly it is not.”
The most important takeaway for me is that the public markets are showing us in tech/startup/VC land that the economic fundamentals of a business, even those that are driving massive disruption in their markets, really does matter and that we need to pay attention to them when we finance these companies.