Finding new methods to value net-based firms

As an equity investor, whether one makes or loses money depends much on nimble moves and quick decision-making ability, particularly in terms of determining the valuation of a company and, by extension, its stock.

Take US-listed Chinese companies for example. Owing to regulatory measures, their shares have been sliding of late, making investors frown, not only because of the downtrend but also due to uncertainty over their future. In such circumstances, determining their valuations isn't going to be easy.

The traditional discounted cash flow or DCF model, which is widely used by industry experts to arrive at the right valuations, may not work in the case of US-listed Chinese companies, as most of their businesses are internet-based.

Even before trouble erupted in the United States for these companies, they faced rough weather in China where regulators cracked the whip on certain companies whose market behavior was found wanting or suspect.

It's very likely that their profitability will get squeezed and their future cash flows will be difficult to measure－which renders the classic DCF model inapplicable.

A less direct gauge, say, the comparison of price-to-earnings or P/E ratios, might work better. But finding the right benchmark is bound to prove tricky.

Take Chinese e-commerce giant Alibaba for example. Its trailing P/E, which measures a company's P/E ratio over the previous 12 months－has kept falling to touch the current 23 times. In contrast, Alibaba's US counterpart Amazon sees its trailing P/E still as high as 42 times despite the share price plunges after US interest rate hikes.

Of course, the overall subdued interest in US-listed Chinese companies is one cause for Alibaba's contracting P/E ratio. But the more fundamental reason is the Chinese regulators' changed attitude toward such online platform companies, most of which are listed in the US where some might even get delisted.

When Chinese regulators started investigating Alibaba's e-payment arm Ant Financial in October 2020, some investors thought it was a case in isolation.

When the State Council, China's Cabinet, released the "double reduction" policy in July 2021 to relieve the twin burdens of homework and extracurricular activities that were weighing down primary and middle school students, share prices of online education platforms nosedived. But still, some investors believed it was only one industry segment that seemed troubled.

When the regulators looked into ride-hailing giant Didi for data security issues in July last year, and also fined online food delivery platform Meituan over 3.4 billion yuan ($514 million) three months later, investors should have sat up and taken notice. They should have realized that Chinese regulators meant business－which was restoring order to the haphazard growth of the internet-based industry.

There were a number of regulations and guidelines aimed at reining in trade practices like creating monopolies and unfair competition.

All in all, recent developments in China and the US suggest there will be a profound change in the internet-based industry. Exponential growth in sales revenue and stratospheric P/E ratios, which came to characterize internet-based companies, will soon become things of the past. The business model of these companies will change to bear more resemblance to public service companies.

In this context, analysts should remodel the way they determine valuations of internet-based companies. For their part, investors should also find the right benchmark to refer to when they are about to compare P/E ratios.