How much is that unicorn in the window?

As with any company, a unicorn’s value will ultimately depend on the cash flow it can generate, which in turn depends on its potential revenue, profit, and return on capital. To answer the question, you could analyze how much revenue and profit a company would have to eventually generate to be worth $1 billion today. For example, if you believe a company could generate $200 million in pre-tax operating profits 10 years from now, with an enterprise value multiple of 15 times, it would be worth $3 billion in 10 years. Further assume that all the cash flows between now and then net out to zero and discount the $3 billion to today at 10%; you get a value of $1.15 billion. So, it’s not outrageous to have a $1 billion valuation on such a startup: plenty reach $200 million of pre-tax operating profits.

However, for a similar company to be worth $10 billion, it would have to generate $2 billion of operating profit in 10 years. Assuming a generous 20% profit margin, the company would need to generate $10 billion in revenues. That’s more difficult. What kind of company can earn $10 billion in revenues, have a 20% profit margin and achieve a sustainable enterprise multiple of 15 times? To achieve such results, the company would need to be in a large market, have a unique product or business model, and possess a defensible competitive advantage.

The history of innovation shows how difficult it is to earn monopoly-size returns on capital for any length of time

Such a combination is rare. You would likely need a near-monopoly position driven by what economists call “network effects” (also called increasing returns to scale). The basic idea is this: In certain situations, as companies grow, they can earn higher margins and return on capital because their product becomes more valuable with each new customer. In most industries, competition forces returns back to reasonable levels. But in industries with network effects, competition is kept at bay by the low and decreasing unit costs of the market leader (hence the tag “winner take all” for this kind of industry).

Take Microsoft’s Office software suite. Early on, as the installed base of Office users expanded, it became ever more attractive for new customers to use the suite for word-processing, spreadsheets and graphics because they could share their documents, calculations, and images with many others. As the customer base grew, margins rose because the incremental cost of providing software through DVD or download was so low. Office has become one of the most profitable products of all time. That said, even this successful product may be threatened by competition as computing increasingly moves to the cloud.

Such network effects are not the usual case. The history of innovation shows how difficult it is to earn monopoly-size returns on capital for any length of time except in very special circumstances. Many companies and investors didn’t realize how rare this was during the dot-com bubble of 1999–2000, believing that many business categories could have winner-take-all economics. More recently, a similar overenthusiasm took hold. In 2019, as some unicorns went public, or tried to, investors realized that not all of these companies could earn extraordinary returns from network effects, and values fell considerably. It’s unlikely that businesses offering analytics services, selling e-cigarettes, or renting short-term office space will achieve long-term network effects. Nevertheless, the mystique of the unicorn is bound to persist, and so is the media attention and public interest around them.

Tim Koller is co author of Valuation, the seventh edition of which was published this past spring. He is also a core leader of McKinsey’s Strategy and Corporate Finance practice.

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