NOTE: This is preview content and under review by the Technical Advisory Council and is subject to change.
How can companies leverage cloud costs to optimize their valuation and investment opportunities? And how can FinOps address these challenges?
This white paper examines the specific challenges faced when valuating companies with a significant amount of expenses in the cloud. It specifically addresses the difficulties in understanding and predicting costs associated with operating in the cloud. The paper provides a comprehensive approach using industry-specific metrics and case studies to overcome these challenges.
Additionally, it explores the implications of operating expenses (OPEX) on valuations and offers suggestions for accounting for these costs under traditional valuation methods. By understanding the nuances of valuating companies with a significant amount of their expenses as cloud costs, this paper aims to assist investors and analysts in making more informed decisions and understanding the potential of these companies.
Before diving into our analysis, we would like to state that our approach to corporate finance is based on the principles presented in the book Principles of Corporate Finance (Brealey, Myers, Allen, Edmans). However, we recognize various valid viewpoints in the field, and our conclusions may differ from those that follow alternative frameworks.
Therefore, we want to emphasize the significance of defining our assumptions when modeling corporate finance. By doing so, we can identify potential biases and uncertainties in our analysis and make more informed decisions.
In addition, we have chosen to utilize performance-based methods instead of trading comparables as an assumption for this whitepaper. Trading comparables involves comparing a company to similar companies that are publicly traded, using financial metrics such as price-to-earnings ratios and enterprise value-to-revenue ratios.
On the other hand, the performance-based valuation involves forecasting a company’s future financial performance and discounting the projected cash flow to represent its cash value today (present value). Therefore, we want to emphasize the significance of defining our assumptions when modeling corporate finance. By doing so, we can identify potential biases and uncertainties in our analysis and make more informed decisions. We have endeavored to be transparent and rigorous in our approach, and we encourage readers to scrutinize our assumptions critically and provide feedback where necessary.
Valuing a company is generally considered more difficult than valuing other assets such as real estate because it involves forecasting future financial performance, which is subject to more significant uncertainty. Additionally, a company’s value is closely tied to its management and strategic decisions, which can be challenging to predict.
Proper valuation of a company is vital for its stakeholders because it represents a clear understanding of a company’s financial health and potential for growth. For shareholders, reasonable valuation helps them make informed decisions about further investing in, selling, or holding onto their shares. For managers and executives, proper valuation helps them make informed decisions about allocating resources and strategic investments. For creditors, lenders, and investors, an accurate valuation helps them determine the risk associated with lending to or investing in the company.
Facebook’s acquisition of WhatsApp provides a prime example of how challenging it can be to accurately determine a company’s value. Although WhatsApp’s extensive and quickly expanding user base made it an attractive acquisition target, the company’s straightforward approach to monetization and lack of revenue streams made assessing its actual value difficult.
In 2014, Facebook bought WhatsApp for $19 billion primarily because of its large and rapidly growing user base, its significance in communication, its popularity in emerging markets, and the valuable data it had on its users. This purchase granted Facebook access to a sizable user base, valuable data, and a strong presence in the messaging industry. However, whether the revenue streams could generate enough profit to justify the acquisition price was uncertain.
An example of how sometimes the “potential” value is stronger than concrete earnings and best management practices is in the mind of an investor considering an opportunity. Was WeWork wrongly valued over $47B in 2019? Later, concerns were raised on its business model (how does this company make money exactly?) and when investors realized there were no profits in sight, the valuation dropped to $4B, the latest investors lost up to 91.5% of their investment. Even if the WeWork CEO Adam Neumann led the company to bankruptcy, investors still value his ability to deliver and change a market; the market cap for his new business “Flow”, offering financial products, loans and sub-loans, is well back despite WeWork’s challenges.
Valuation is harder for companies with a material amount of cloud spend. Instead of buying assets like a Data Center (CapEx), these Companies could procure resources by paying fees (OpEx). For e.g. look at how different accounting is for a Traditional and a Cloud Native Company:
|Company Type||Year 1||Year 2||Year 3||Year 4|
|$2.5M Depreciation||$2.5M Depreciation||$2.5M Depreciation|
|Cloud Native||$2.5M Cloud Bill||$2.5M Cloud Bill||$2.5M Cloud Bill||$2.5M Cloud Bill|
In this example, the Traditional Company builds a data center for a total of $10M, which it considers as an asset with a shelf life of four years, so it depreciates $2.5M per year. The Cloud Native Company owns no asset, just pays a Cloud bill of $2.5 (assuming they re-platformed and optimized costs to achieve this equivalence – in real life this requires exceptional FinOps ability). In this crafted example, these can run and serve exactly the same software or service, and/or enable operations. They are the same!
This misunderstanding of accountability in tech companies and/or how to operate more efficiently in the cloud can configure an overvaluation. When that happens its stock price is higher than it should, and this causes a false sense of success leads to complacency among management and to poor or risky decision-making, like expensive acquisitions or expansion into new markets or investing in unproven technologies.
The story of Nubank, the largest fintech bank in Latin America, is a lesson for all rapidly growing companies. In the banking industry, an efficiency ratio has a specific meaning. For banks, the efficiency ratio is non-interest expenses/revenue. Despite that, most investors are unfamiliar with cloud accounting, leading to NuBank’s “Index of Efficiency” as a misleading assumption for its valuation. This oversight caused a panic when concerns were raised about the business model, causing the final value to drop by 60% on their Initial Public Offering (IPO).
Generally, enterprises in rapid growth put a strain on their engineering teams, who prioritize new features and product development over the ever-growing infrastructure needed to support them. This leads to technical debt and a need for more resources to develop new sources of revenue properly.
Contrary to popular belief, the lack of significant Capex was not an advantage for Nubank. The high cloud costs associated with the company’s business model meant that the lack of depreciation did not act as a tax shield.
When Nubank entered the Mexican market, it may have used its Lifetime Value (LTV)/Customer Acquisition Cost (CAC) metrics from another market as a reference. But when entering a new market, it’s crucial to take a comprehensive and tailored approach to understanding the unique challenges and opportunities rather than relying solely on past operational efficiency metrics. This story serves as a reminder that fast-growing companies must work on allocating resources for building new features and supporting infrastructure and be mindful of the potential pitfalls of relying on metrics without proper context.
We are concerned with the risk of overvaluation of rapidly scaling cloud-native tech companies using the traditional Corporate Finance valuation methodologies. This is because the cost per customer increase is not linear with the technological debt and application modernization that is needed at various scales (e.g. 100 customers, 10,000 customers, 100,000 customers, 1M customers). It is important to holistically plan and budget for cloud investments needed at various customer acquisition checkpoints to ensure a most accurate valuation of a rapidly scaling, cloud-native tech company.
After pointing out that companies that heavily utilize the Cloud have different accounting methods and indicators for equivalent scenarios compared to traditional companies, we will establish a FinOps methodology that can be integrated into Generally Accepted Accounting Principles (GAAP)/International Financial Reporting Standards (IFRS) to ensure similar indexes for both types of companies. This will allow them to appear identical despite their differences. We aim to balance Capital and Operational Efficiency whenever possible, and accurately classify and account for cloud-related costs.
For example, accounting for R&D costs can be controversial as GAAP only considers it an incurred cost, but in some cases, it may be accounted for as a CapEx asset or Opex if it is tied to a tangible delivery or increases Operational Efficiency. This can lead to confusion and hinder transparency, making it difficult for investors to understand the financial health of a company. Therefore, we will provide prescriptive guidelines to aid in the integration of FinOps with GAAP/IFRS.
In a Cloud environment, traditional GAAP principles such as Regularity, Consistency, Sincerity, Continuity, and Periodicity are challenged by new workflows, standard operating procedures, human error, and a more complex RACI matrix. For example, Citrix VDI provides an extra layer of security to documents but was not designed to optimize operational efficiency, rather to meet compliance standards. To most accurately account for future IT expenses, FinOps leadership should align on business value delivery as well as a product vision. This will allow for budgeting for future cloud infrastructure commitments (CapEx) to take advantage of discounted cloud cost, accurate understanding of pay-as-you-go (PAYG) consumption and other operational costs (OpEx).It is also a good practice for a company to analyze the opportunity cost of allocating human resources for managing cloud infrastructure versus adopting fully managed cloud solutions or hiring contractors.
Managing cloud infrastructure can be complex and time-consuming, requiring specialized skills and knowledge. Allocating human resources to this task can divert resources from other essential business functions. In addition, hiring full-time employees for this task can be costly and may not be necessary if fully managed cloud solutions or contractors can provide the same or better service at a lower cost. By analyzing the opportunity cost of different options, a company can decide how best to allocate its resources. This analysis should consider factors such as the company’s budget, current staffing levels and expertise, the complexity of its cloud infrastructure, and the potential risks and benefits of each option.
Our goal is to provide greater transparency and understanding of financial and investment decisions for the benefit of both investors and company owners. A company’s value is tied to its ability to generate wealth for its owners. While a significant amount of free cash flow or reserves may indicate strong performance, it may also suggest that the company is holding onto funds rather than investing them in new ventures or opportunities, potentially leading to careless spending or a lack of drive.
Financial managers are tasked with making decisions that will increase wealth for shareholders, but this opportunity cost is often overlooked or underestimated. Managers have a greater level of expertise and insight, but may sometimes make decisions that are more self-serving or fail to fully consider the opportunity cost, resulting in agency costs. To better assess future IT expenses which may affect a company’s valuation, FinOps leaders can collaborate to project CapEx and OpEx expenses in the cloud with relation to talent, IT infrastructure, IT services, product development, and business value.
The following image depicts how Financial Managers are making an investment decision every time they decide to spend company money. FinOps capabilities can reduce agency costs, risk and increase the quality of these decisions.
Increased visibility of a company’s investment decisions and resource allocation can lead to better decision-making. This was seen when Toyota introduced real-time feedback on gasoline consumption on their Prius, which resulted in drivers adjusting their driving behavior to reduce fuel consumption.
By implementing FinOps Showback loops for investment decisions and setting a baseline opportunity cost instead of $0, companies can reduce risk and agency costs while improving financial performance for company owners. Chargeback can be applied as a markup on investments, with the delta going to a reserve and all transactions logged in an immutable ledger. With visibility into the cost of cloud allocated to each relevant cost center, future development can be better basedlined and budgeted for based on historical data.
Shareholders are fully informed, and companies can decide the scope, periodicity, and granularity of information for Showback. Companies that integrate the FinOps framework into their financial statements reduce their risk and make better investment decisions, with the sole focus on maximizing Free Cash Flow (FCF). When the budget is high, staff acquire passion for even boring initiatives, and profit and payback become clear, providing investors with real-time visibility on any exception approved by management.
When examining budgeting and forecasting, precisely the concept of strategic forecasting, we noticed a common misunderstanding in this area which results in companies wasting resources on unnecessary overplanning and reworking. Some companies mistake tight budgeting for forecasting, which leads to a waste of time and resources. Instead, a better approach is to forecast the value of an investment, such as the revenue and FCF generated from selling an app that utilizes upcoming hardware.
Maximizing a company’s wealth is essential, as it makes investors happy, regardless of individual preferences. This is referred to as the Fisher Theorem. Maximizing FCF involves generating as much cash as possible from the company’s operations while minimizing non-operating assets, such as investments in inventory or fixed assets. This approach focuses on generating cash that can be used to pay dividends, repay debt, or invest in growth opportunities. On the other hand, optimizing FCF utilization involves finding the most effective and efficient ways to use the cash generated by the company’s operations. This approach maximizes shareholder value by investing in growth opportunities, making strategic acquisitions, or returning cash to shareholders through share buybacks or dividends. Ultimately, the strategy should optimize FCF utilization, and the Cloud’s elasticity eliminates the need for overly precise capacity planning.
Unit Economics (UE) can provide clarity when assessing the value of a feature. For instance, Spotify’s minimal song start-up delay was highly valuable metric in the past, but its worth has waned with market evolution. To determine the value of a click and its impact on costs and income, it’s crucial to include fully loaded costs and a key strength-related exogenous variable. This approach enables better pitching of a feature’s value to the company.
To ensure that UE and opportunity costs are measured, a yearly audit performed by large accounting and analyst firms is recommended. The audit’s outcomes can help determine the company’s capabilities. A high opportunity cost indicates that the management has high standards, while a low one shows that the company may lack resourcefulness. Without this audit, investors may perceive any positive cash flow as good, when it may be losing total value. It’s important to pick the right UE since too much or too little detail can result in diminishing returns or lack of usability and value.
Strategic Forecasting utilizes order-of-magnitude capacity planning to optimize FCF. The preparation of operations differs significantly when aiming to generate $10 million versus $1 billion, and is based on measuring (and presenting) effective value through the utilization of the FinOps Framework.
Incorporating the perspectives and capabilities of investors into the FinOps Framework can help companies avoid wrong valuations by providing a more comprehensive understanding of the company’s financial health and investment decisions
Transparency and understanding of investment decisions and resource allocation can lead to better decision-making and improved financial performance.
Analyzing opportunity costs can help determine the most efficient use of resources when managing cloud infrastructure.
Now that our Working Group has started this discussion, we’re open to hearing other community stories and perspectives on how FinOps can better define the valuation of companies of all types and sizes. Get in touch with us on our chat channel <TODO> to discuss parts of this paper, or to find out more about getting involved with future sprints and iterations of this work.
The FinOps Foundation extends a huge thank you to the members of this Working Group that broke ground on this documentation:
Also, we’d like to thank our Technical Advisory Council (TAC) Liason, Bindu Sharma.
Thank you to all of our survey responders and interviewers, without your insights this playbook would not be what it is today!
Lastly, a big thank you to the FinOps Foundation support team for helping us bring our work to life: Rob Martin (Staff Sponsor), Samantha White (Program Management), Tom Sharpe (Design), and Andrew Nhem (Content).