Valuation 201: Happy Birthday Dear Company!

Last week, with Valuation 104, we closed out the basic course in this series on valuation. Starting today, for the next four weeks, we will be delving into the intermediate course on valuation, where we will discuss valuation strategies for various companies, based on the stage at which they are, in the company life cycle.

Now, the company life cycle can be divided into four distinct stages. Birth, growth, maturity and decline or liquidation. Today we will look at valuation strategies for young companies, which are either newly born, or within the first few years of their existence.

We will first look at characteristics of such companies, issues in valuation of such companies, specific strategies strategies for intrinsic and relative valuation of such companies, and end up with highlighting characteristics which make a certain company a better value buy over other young companies.

Young companies are usually those which are either newly born, or within the first few years of their existence, as stated above. Young companies can range from startups to idea companies. The first few years of their existence, usually the first five years, are crucial to the health of such companies, because if they are able to get through these five years unscathed, then they invariably go on to have a substantially long life.

These companies are characterized by the absence of a well defined product or service offering, which in leads to the presence of thin, or even negative, revenues and earnings, which makes valuing such companies a tricky proposition.

Take the example of Groupon for instance. Groupon is an America based e-commerce company. They also have operations in India, where they offer discount deals on restaurants, spas and so on, through the issuance of Groupon coupons.

In 2010, just after Groupon launched operations, Google attempted to buy Groupon for $6 billion. Groupon turned the bid down because they felt they had the potential to grow by themselves, and thankfully for Groupon, that’s exactly how things ultimately panned out. Now, going back to 2010, you can say that $6 billion was a well thought out and calculated valuation by Google, but I’d still wager that, at that point of time, Google was taking a big risk by paying such a sizeable sum for a company which was a little more than a year old at the time.

Now, I say this because, valuing a young company, whether you’re doing it intrinsically or relatively, throws up the following issues:

  • Thin Or Negative Revenues And Earnings: As I already pointed out earlier, young companies are usually characteristics by thin, and sometimes even negative, revenues and earnings. So, when you are valuing such companies to see how much they’re worth, you are doing it on the basis of expectations and future potential, which for me personally, equates to taking a big risk.

  • Limited Financial History: We all know that the core ingredients for an intrinsic valuation are cash flows, growth rates and discount rates. All these ingredients find their roots in the financial statements of the company, and because a young company has been around for only a few years at best, we have very little data to work with, maybe even too little, to come up with an effective valuation.

  • Key Managerial Person Risk And Survival Risk: Okay, lets give a young company the benefit of the doubt, and say they have substantial revenues and earnings, and enough historical financial data. But don’t forget that even with all of this, there is still the risk of the company not being able to survive. This is because these companies are usually heavily reliant on their key managerial people. Taking them out of the company is invariably like taking the heart out of the company, and anything without a heart is as good as dead.

At this point, you would probably tell me, okay, intrinsic valuation is tough, but I can still value a young company relatively. In that case I ask you the following two questions before you value a young company relatively:

  • Which Multiple Would You Scale Value To?: As we all know, valuation multiples are invariably defined ambiguously by default, and this would be even more true with young companies, because of the lack of historical financial data. And don’t forget that multiples will be of no use if your company doesn’t survive.

  • Which Are Your Comparable Firms?: Relative Valuation is always based on comparison with similar firms in the same industry or sector. Now for a young company to have comparable companies, most or all of the companies in a sector would have to be young companies. But for all practical purposes, that is rarely if ever the case. One or two other young companies in a sector would see you basing your decisions on a very small sample size.

But don’t fret, there are solutions available to value young companies both intrinsically and relatively. So if you’re trying to value a young company intrinsically, look at the following aspects:

  • Revenue Growth: First, look at how quickly the company can grow revenues in the future. To do this, first estimate the total market size the product or service offering of the company will be able to serve. Next, estimate the share of that total market that the company you are analysing will be able to capture. The revenue growth will be a direct function of these two data points.

  • Operating Expenses: Growing revenues would undoubtedly come at some amount of operating cost. Estimate how high the operating expenses for your company are likely to be and whether they can keep operating expenses on a leash, because the lower the operating expenses are, the higher the profit margins will be.

  • Discount Rates: When trying to estimate a discount rate, look at sector average costs of capital or costs of equity, depending on whether you are valuing the entire company or just the equity, and adjust these averages for company specific risks. It would also make sense to see how much access the company has to additional capital, because the greater the amount of access, the less risky the company will be, because it can infuse fresh capital as and when it needs to.

  • Survival Risk: To estimate the survival risk, estimate the value of the firm under the assumption that the company survives and makes it to stable health. Do this by discounting future cash flows at the cost of capital or your personal required rates of return.

Next, estimate the value of the company, under the assumption that the company will not survive past the initial period. Do this by discounting future cash flows at the failure rate for the sector. The failure rate shows what percentage of new companies don’t survive in that particular sector.

Finally compare the difference between the two values. If the survival value is greater than the failure value, you’re on to a good young company and if its the other way around, its probably best to stay away. If both are fairly equal, both eventualities are equally possible, so the decision to stick or twist is left to you.

So much for intrinsic valuation solutions. When valuing a young company relatively, it is always better to use forward multiples rather than current or historical multiples, because current or historical multiples don’t provide a true and fair picture. Next adjust the forward multiple for the likelihood of failure. For example, if the forward multiple of a sector is 10 and the failure rate for young companies is 30%, the effective forward multiple for your young company would be 7 (10 - 30%).

So in summary, look for young companies with a big market, exclusive product or service offerings, ability to track and control expenses, easy access to capital and low dependence on key managerial people, because these are the traits that help a young company stand out amongst the crowd of young companies.

See you next week for Valuation 202, where we will discuss valuation strategies for high growth companies.