“A higher valuation could have been achieved but we decided to price it at a level where everyone makes money,” said Madhur Deora, group chief financial officer at Paytm, after the public issue. The stock was issued at Rs2,150, got listed at Rs1,950, hit a high of Rs1,955 and then went into a relentless decline. Closing at Rs944.50, the stock has more than halved. Mr Deora’s comment of pricing at a level where 'everyone makes money', has turned out to be a joke. On 4th February, Paytm announced its December quarter results. It reported a loss of Rs780 crore against a loss of Rs520 crore for the same period of the previous year. Paytm has turned out to be the poster boy of overvaluation, with the company, investors and even the regulator now being asked to be accountable for the massive losses inflicted on shareholders.
There is always a variance between the price of the stock, which the investee company seeks, and its market value. Hence, the performance of investee companies is constantly analysed in order to identify undervalued stocks for buying and overvalued stocks for selling. Apart from this, technical analysts seek to time their buy-sell decisions. Securities evaluation has been a fertile ground for research from the days of Benjamin Graham in the 1920s, followed by John Burr Williams’s Theory of Investment Value, followed by the pathbreaking Markowitz Portfolio Theory in 1952, Capital Asset Pricing Model (CAPM) in 1960s and Three Factor Fama French model (1993), etc. The CAPM model is now universally employed for estimating expected return on equity. How does all of this apply to the Paytm valuation? Was the stock significantly overvalued at the issue price?
Estimate of the earning per share (EPS) divided by the expected return on equity gives the share price based on no-growth scenario. The difference between the market price of the share and the price based on no-growth scenario represents present value of growth opportunities (PVGO). No wonder, the well-managed growth-oriented companies have high PVGOs reflected by high P/E (price-to-earnings) ratios. For example, the trailing P/E ratio of Infosys Limited and TCS Limited remain high at 34+, whereas commodity companies such as Tata Steel and JSW Steel are a faction of that. The PVGO is discernible for well-established listed companies but poses a challenge for start-ups such as One 97 Communications Limited, particularly before they break even.
One 97 Communications Limited, better known by the brand name Paytm, made initial public offer (IPO) of Rs18,300 crore in November 2021. A major part of the issue, i.e., Rs10,000 crore was offer for sale from the existing shareholders who used the IPO to harvest their returns. Before the IPO, the company split the face value of the shares from Rs10 each to Rs1 each. So, IPO price of the share at Rs2,150/share was equivalent to Rs21,500/share of the face value of Rs10/each. The size of the IPO and pricing for a start-up with history of losses was path-breaking.
The selling shareholders who received Rs10,000 crore included promoter Vijay Shekhar Sharma who diluted his paltry pre-IPO shareholding from 9.1% to 6%. While the selling shareholders are having a ball, new investors have suffered a whopping value loss of Rs10,073 crore with a 56% fall in share price in just three months since its listing on 18 November 2021. Is it due to overpricing? Let’s figure out.
Paytm’s business segments include payment services, financial services, and commerce and cloud services. Its large consumer / merchant base of approximately 333mn (million) / 21mn, aided by large payments platform handled gross merchandise value (GMV) of Rs4.03 trillion in FY20-21 clocking a two-year compounded annual growth rate (CAGR) of 33%. This resulted in a two-year CAGR of 11.5% in its revenue from payment and financial services. However, the revenue from commerce and cloud services clocked a negative two-year CAGR of 32.8%. Thankfully, aided by a two-year compound average operating cost reduction of 22.4%, the company had the lowest negative earnings before interest, taxes, depreciation and amortisation (EBITDA) during FY20-21.
The key to Paytm’s profitability is substantial increase in revenue and reduction in operating costs. However, while revenue has grown, the downward trend in operating cost has been reversed in second quarter of FY-21-22. It is unclear how and when the proposed strengthening of Paytm's ecosystem and acquisition / retention of consumers, etc, with the IPO proceeds will help the company to induce efficiency, turnaround and catalyse return on equity.
The digital payment ecosystem powered by India’s robust Unified Payments Interface (UPI) is expected to continue to hold the sway due to the economics, security and efficiency it provides. UPI, which had started with a pilot launch in April 2016 has emerged a preferred mode of digital transactions (see the figure below).
On the UPI platform, Phone Pe and Google Pay have marched ahead of Paytm with market shares in value, of 46.6% and 37.8%, respectively, against 8.7% of Paytm. With almost 20 UPI third- party apps including Phone Pe, Google Pay, Amazon Pay and WhatsApp Pay, and those of large finance companies and banks, the competition is set to intensify.
The offer for sale of shares from 21 shareholders, including eight global PE funds / investors and the solitary founding promoter aggregated about 46.51mn shares (7.63% of the shares pre-IPO outstanding) at a price of Rs2,150/shares. Average acquisition cost by these investors was Rs816.90/share with a maximum of Rs1833.30/share and minimum of Rs. 0.50/share belonging to the founding promoter. The share prices paid by the global PE funds / investors must have been preceded by intense negotiations as usual. Such investors often use the formula:
The fund / investor invests “I” for an investment horizon of “N” years during which it seeks a return of “R” depending upon the business risk profile. Hence, the value of the investment must swell to I*(1+R)N at the end of investment horizon. The value I*(1+R)N divided by the estimated market capitalisation i.e., PAT * PE Ratio constitutes the fund’s ownership (“S”) part in the investee company for investment “I”.
Thus, if value of “S” works out to say 30%, share pricing must ensure that the investor / fund with investment of “I” has a 30% ownership in the investee company. Estimation of market value of equity for an unlisted firm entails discounted cash-flow modelling which is finalised after intense negotiations. Often, the initial investment is in convertible debt and eventual conversion into equity depends on the actual performance which is constantly monitored by the investor.
Thus, the pricing of shares placed by Paytm with the several PE funds / investors over the past few years must have been based on the DCF model. Yet the RHP’s (red herring prospectus) basis for the offer price was perfunctory, and carried no basis whatsoever and seems to have been drafted to avoid inconvenient questions. Surprisingly, the mandarins at the Securities and Exchange Board of India (SEBI) accepted polite nothings in DRHP (draft RHP) without a murmur.
Paytm’s outstanding equity shares of 648,273,659 had IPO value of Rs1,393.79 billion (US$18.58 billion) on November 8, 2021. At close on the listing date, its price was Rs1,560.80 and, currently, the share price is Rs944.50 reflecting loss to the investors of Rs10,072 crore (56%) in just three months.
With low trading volumes of just 0.02% of the shares outstanding and deliverable quantity of around 30%, the share price may see sawtooth fall, if the company fails to break even and demonstrate EPS (earnings per share) growth that can justify even the current depleted value, soon.
Though promising, the digital payment landscape has not evolved profitability parameters which typify this industry. Assuming that this turns out to be a growth-oriented industry which justifies P/E ratio of, say, 25, based on (i) EBITDA margin of say 15% (from the currently negative 35%), (ii) 5-year growth phase till FY-26-27, a steady state phase thereafter with a robust perpetual growth of 10% per year, weighted average cost of capital of 20% (assuming marginal debt levels), clocking a P/E ratio (based on issue price) of 25 would require five-year CAGR of over 25% in revenue.
Growth in revenue is evident in first half of FY21-22. But the operating cost reduction which is crucial for positive EBITDA is not evident. To correct this anomaly, substantial reduction in payment processing charges and other expenses is a must. Whether this will happen in FY22-23 will be clear in first quarter of FY22-23. Whether Paytm manages to reduce the payment processing charges, 49% of which were remitted to related party is to be seen. If such reduction with a related party is a zero-sum game the wait for positive EBITDA could turn longer, and the market will discover the true value of Paytm share by first quarter of FY22-23.
It is obvious that the IPO was grossly overpriced. Out of the unrealised loss of Rs10,072 crore as on date, the Indian subscribers have a share of Rs15,018.7 crore with individual subscribers accounting for a major part of Rs9,949 crore (table below).
At the pre-IPO marketing stage, a few buy recommendations were for listing gains. So, the market had gauged the aggressive pricing. Yet it is amazing how even three mutual funds, insurance companies and finance companies each invested in the IPO.
Variance between valuation and market cannot be wished away. So good companies often buy back shares whose market price is perceived to be lower than intrinsic value. If the Paytm’s IPO price was fair, will it buy back share when it starts earning profit?
For a fairly-priced IPO, a minor negative variance on listing is understandable. The fall which Paytm has experienced confirms unfair overpricing. It is hoped that SEBI will insist on the issuers sharing most likely, upside and downside valuation details in basis for the offer price so that the investors are not in kept in dark. The merchant bankers should also be required to do market-making for a certain period after the IPO listing. This will induce fair IPO pricing and the intermediaries will not be able to get away with mere disclaimers.