Failed IPO’s, Risk/Uncertainty and the next bubble

In the last months, we saw several failed IPO’s including the world’s most profitable company (Aramco) and one of the hottest start-ups (WeWork). At the same time, loss-making UBER is trading significantly below its IPO price. To a value investor, this is not a big surprise as these companies were seriously overvalued. Aswath Damodaran wrote some excellent articles on valuation in general and the valuation of these three companies in particular (https://pages.stern.nyu.edu/~adamodar/).

As Gatekeeper of the Angel Syndicate Apollo Informal Investment and Consultant with Vivolution I see many start-ups and scale-ups. Some of them with solid projections and a clear valuation but there are also companies that spend little time on these important parts of an investment proposal. Their argument is that the future is unpredictable, and modelling is a waste of time.

Although I fully agree that the future is unpredictable, I think they are making the classic mistake of not understanding the difference between Risk and Uncertainty. Risk is something that can be measured while Uncertainty is the famously known unknowns and unknown unknowns (The Black Swans). Good modelling will turn known unknowns into Risk while accepting that unknowns’ unknowns can’t be modelled but there are ways to mitigate these and create exposure to good Black Swans and make yourself more resilient against bad Black Swans.

The difference between Risk and Uncertainty is perhaps best explained by an example from the gambling industry. If we roll two dice the most likely outcome is seven with a minimum of 2 and a maximum of 12. If we charge a gambler ￡1 per game and give them ￡30, if they roll a 2, we are certain to make money in the long run. We might become unluckily early on with a lot of 2’s but as long as we have enough starting capital, we will make a lot of money. The known unknown is, how often we can play this game. You could, however, argue that is can be modelled as well turning uncertainty into risk. An example of an unknown unknown is when someone uses 3-sided dice which completely changes the odds in the favour of the gambler and will put us out of business quickly.

With the gambling example, it is relatively easy to understand what the risks are and what drives value. For analysing companies, you need more advanced tools. In the Damodaran articles you can read why Aramco, WeWork and Uber are overvalued (or using the gambling example: offer odds above ￡36 for rolling a two). Some of the same mistakes I see with start-ups/Scale-ups. Financial projections that got fundamental flaws and valuations that are too high to generate a good risk-adjusted return for the investor. 

There are good reasons to call the private equity market overhyped/overvalued and that a correction is likely. There are however many markets that are overpriced (Real Estate, Cyber Currency, Cannabis, Growth Sticks, Bond prices etc, etc) and there is an abundance of Liquidity. I will leave it to the Macro-Economists to argue which market(s) will correct and when this will happen but in the meantime, I think it would be prudent for both companies and investors to move from a story-based approach to investing to a more value-based approach.