Absurd valuations and the beauty contest!

Recently I came across this article by The Ken describing the bull run by Cred. While a lot has been written recently analyzing the business model or the lack of one in the case of Cred, the members only credit card bill payment platform raised US$80mn in Jan 2021 at a valuation of US$800mn. While the article probes every reason including Cred's premium customers, its brand recall, its proven founder, the probable business models, the supposedly 'other' VC-luring metrics and the climatic exit, it misses out on the effect of investors' bounded rationality and herd behavior.

Let me explain using the famous analogy presented by the celebrated economist John Maynard Keynes. Kenyes described a newspaper “beauty contest” in which picture of some women were printed and readers were invited to select the most beautiful of them. The reader whose choices most closely matched with those of the consensus of other entrants would go on to win a prize. Remember, judging true beauty would ultimately become less important to winning the contest than guessing other people’s opinions of other people’s opinions. Keynes reasoned similar behavior was at work with the stock investors who would eventually want to sell their investment to others. They would be more concerned about other people’s valuation of their investment than the investment’s true worth. The best investors, in his view, are therefore those who are good at outguessing mass psychology.

In case of Cred, its marquee investors who have invested or are contemplating investment are playing the same contest of outguessing the psychology of the other investors. How else can you explain the rationale behind the $2bn valuation for a company that had operating revenues less than $100k in the last financial year. Because beyond the realms of rationality and logic, lies our irrational herd instincts- the natural human impulses characterized by a lack of individual decision making. Add to that the effect of bounded rationality, a term used to describe wide range of descriptive, normative, and prescriptive accounts of effective behavior which depart from the assumptions of perfect rationality; and you have a perfect recipe which entices investors to base their decision not on what they think the fundamental value is, but rather on what they think everyone else think their value is.