Businesses start and fail every day. Most of those that fail do so in the startup phase.

Startups are typically in the earlier stages of developing their business strategies and demonstrating their models to a wide audience.

In the development stage, startups typically face financial constraints and rely on external funding to stimulate growth.

This principle results in two trends: negative cash flows and substantial asset growth.

Facilitated by this asset growth and funding, companies may expand their customer base, and increase monetization possibilities, finally generating genuine assets.

At this point, if the startup can establish and sustain itself, it may cross the threshold to become operationally sustainable.

Theoretically, this makes sense, but it also appears practical in today’s market. Just look at Uber (UBER).

Uber is a world-renowned ride-hailing company. And yet, it didn’t turn a profit until this year. In the second quarter, it reported a net income of $394 million, its first profit in company history.

From 2016 until 2022, Uber recorded Uniform ROA levels as low as negative 134% in 2016. Despite its nonexistent profitability, Uber was valued as high as $120 billion by investors upon its 2019 initial public offering (“IPO”).

One could argue that these were very optimistic valuations, as the company never turned a profit. However, asset growth may have been a different factor driving investors’ high valuations.

Under all of the red numbers, Uber was investing in the business and growing its asset base. In the same period as its negative cash flows, Uber recorded an average of about 50% asset growth each year.

This growth in turn allowed Uber to grow from 19 million users in 2016 to about 100 million users in 2019.

Take a look.

However, there may be more than meets the eye.

Market expectations convey a similar story but the limitations are apparent. A comparison of market-implied insights with realized performance provides multiple powerful insights for investors.

In analyzing a universe of 3,000 companies, research indicates startups tend to see an improvement in profitability, with Uniform ROA rising by almost 12 percentage points.

However, start-ups are likely to have a lower likelihood of succeeding than markets anticipate, or their positive cash flows are likely to be further away than the market anticipates.

This is evident in Uber’s pre-IPO valuations. The market and analysts priced in profitability to come sooner than it did. It took another five years for the business to finally turn a profit.

Yes, start-ups can be a great place to generate exponential returns. Though, it is worth noting that start-ups typically underperform the market’s optimistic expectations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

This portfolio analysis highlights the same insights we share with our FA Alpha Members. To find out more, visit our website.