Young and start-up companies pose the most problems in valuation, for a variety of reasons.
Start-ups have a limited history, are generally not publicly traded, and often don’t survive to become successful commercial enterprises.
Faced with daunting estimation challenges, analysts often fall back on simplistic forecasts of revenues and earnings, coupled with high discount rates, to capture the high failure rate.
In this article I suggest that traditional valuation models can be used to yield better estimates of the value of these firms.
Although the fundamentals of valuation are straightforward, the challenges in valuing companies shift as they move through their life cycle: from the initial idea and start-up business, often privately owned, to young growth companies, either public or on the verge of going public, to mature companies with diverse products and serving different markets, and finally to companies in decline, marking time until they disappear. At each stage we may be called on to estimate the same inputs—cash flows, growth rates, and discount rates—but with varying amounts of information and different degrees of precision.
Determinants of Value
If we accept the premise that the value of a business is the present value of the expected cash flows from its assets, there are four broad questions that we need to answer in order to value any business:
1. What are the cash flows generated by existing assets?
If a firm has significant investments that it has already made, the first inputs into valuation are the cash flows from these existing assets. In practical terms, this requires estimates of: how much the firm generated in earnings and cash flows from these assets in the most recent period; how much growth (if any) is expected in these earnings/cash flows over time; and how long the assets will continue to generate cash flows.
2. How much value will be added by future investments?
For some companies, the bulk of the value will be derived from investments they are expected to make in the future. To estimate the value added by these investments, you have to make judgments on both the magnitude of these new investments relative to the earnings from existing assets; and the quality of the new investments, measured in terms of excess returns, i.e. the returns the firm makes on the investments over and above the cost of funding them.
3. How risky are the cash flows, and what are the consequences for discount rates?
Neither the cash flows from existing assets nor the cash flows from growth investments are guaranteed. When valuing these cash flows, we have to consider risk somewhere, and the discount rate is usually the vehicle we use. Higher discount rates are used to discount riskier cash flows, and thus give them a lower value than more predictable cash flows.
4. When will the firm become mature?
The question of when a firm is mature (i.e. when the growth in earnings/cash flows is sustainable forever) is relevant because it determines the length of the high-growth period and the value we attach to the firm at the end of the period (the terminal value). It is a question that may be easy to answer for a few firms, including larger and more stable firms that are either already mature businesses or close to it, and firms that derive their growth from a single competitive advantage with an expiration date (for instance, a patent).
A framework for valuing any business that takes into account these four considerations is shown in Figure 1.
Although these questions may not change as we value individual firms, the ease with which we can answer them may change, not only as we look across firms at a point in time, but also across time—even for the same firm.
Valuing Young Companies
Every business starts with an idea stimulated by a market need that an entrepreneur sees (or thinks that he or she sees) and a way of filling that need. Although many ideas go nowhere, some individuals take the next step of investing in the idea.
The capital to finance the project usually comes from personal funds (from savings, friends, and family), and if things work out as planned the result is a commercial product or service. If the product or service finds a ready market, the business will usually need more capital, and the providers of this are often venture capitalists, who provide funds in return for a share of the equity in the business. Building on the most optimistic assumptions, success for the investors in the business may ultimately be manifested as a public offering to the market or sale to a larger entity.
At each stage in the process we need estimates of value. At the idea stage, the value may never be put down on paper, but it is the potential of realizing this value that induces the entrepreneur to invest time and money in developing the idea. At subsequent stages of the capital-raising process, valuations become more important because they determine what share of ownership the entrepreneur will have to give up in return for external funding. At the time of the public offering, the valuation is key to determining the offering price.
From the template for valuation that we developed in the last section, it is easy to see why young companies also pose the most daunting challenges. There are few or no existing assets, and almost all of the value is based on the expectations of future growth. The current financial statements of the firm provide no clues about the potential margins and returns that may be generated in the future, and there are few historical data that can be used to develop risk measures.
To complete our consideration of estimation problems, we should remember that many young firms do not make it to the stable growth stage. Estimating when this will happen for firms that do survive is difficult. In addition, these firms are often dependent on one or a few key people for their success, and losing them can have a significant effect on value.
Figure 2 summarizes these valuation challenges.
Given these problems, it is not surprising that analysts often fall back on simplistic measures of value, guesstimates, or on rules of thumb to value young companies. In the process, though, they risk making serious valuation errors.
Meeting the Estimation Challenge
Given the challenges we face in estimating cash flows and discount rates for the purpose of valuing young companies, it should come as no surprise that many analysts use shortcuts, such as applying multiples to expected future earnings or revenues, to obtain dubious estimates of value. We believe that staying within the valuation framework and making the best estimates of cash flows is still the best approach.
Cash Flows and Growth Rates
For many young companies, the biggest challenge in estimating future cash flows is that there is no historical base of any substance to build on. However, we can still estimate expected cash flows using one of two approaches:
In this approach, we begin with the potential market for the firm’s products and services and work backwards:
Estimate the share of this market which the firm hopes to gain in the future and how quickly it can reach this share; this gives expected revenues in future years.
Finally, evaluate what the firm needs to invest to accomplish this objective; this represents the capital that it has to reinvest in the business, which is a cash drain each year.
Generally, as the firm’s revenues grow and it moves toward the target margins, we should expect to see losses in the earlier years become profits in the later ones. With high growth, it is entirely possible that cash flows will stay negative even after profits turn the corner, since the growth will require substantial reinvestment. As growth subsides in the later years, the reinvestment will also decline and cash flows will become positive.
The key to succeeding with this approach is getting the potential market share and target margin right, and making realistic assumptions about reinvestment needs.
For those who believe that the top-down approach is too ambitious, the alternative is to start with what the young company can generate as output, given its resource constraints, and make estimates of the revenues and profits that will be generated as a consequence. This is more akin to a capital budgeting exercise than to a valuation, and the valuation will depend on the quality of the forecasts of earnings and cash flows.
The projected earnings and cash flows from both approaches are dependent on the promoters of the company not only being able to come up with a product or service that meets a need, but also that they can adapt to unexpected circumstances at the same time as delivering their forecast results.
The absence of historical data on stock prices and earnings makes it difficult, but not impossible, to analyze the risk of young companies. To make realistic estimates of discount rates, we need to be able to do the following:
Assess Risk from the Right Viewpoint
The risk in an investment can vary, depending on the point of view that we bring to the assessment.
For the founder/owner who has his or her entire wealth invested in the private business, all risk that the firm is exposed to is relevant risk.
For a venture capitalist who takes a stake in this private business as part of a portfolio of many such investments, there is a diversification effect, where some of the risk will be averaged out in the portfolio.
For an investor in a public market, the focus will narrow even more, to only the risk that cannot be diversified away in a portfolio.
As a general rule, the discount rates we obtain using conventional risk and return models, which are built for the last setting, will understate the risk (and discount rates) for young companies, which are usually privately held.
Focus on the Business/Sector, Not on the Company
Since young firms have little operating history and are generally not publicly traded, it is pointless trying to estimate risk parameters by looking at the firm’s history. We can get a much better handle on risk by looking at the sector or business of which the firm is a part and evaluating the riskiness of publicly traded firms in the same sector at different stages in the life cycle.
Adjust Risk Measures and Discount Rates as the Firm Matures (At Least in the Projections)
Our task in valuation is not to assess the risk of a young firm today, but to evaluate how that risk will change as the firm matures. In other words, as revenues grow and margins move toward target levels, the risk that we assess in a company and the discount rates we use should change consistently: lower growth generally should be coupled with lower risk and discount rates.
In most discounted cash flow valuations, it is the terminal value that delivers the biggest portion of the value. With young firms this will be doubly so, partly because the cash flows in the early years are often negative and partly because the anticipated growth will increase the size of the firm over time.
Consider Scaling Effects and Competition
When firms are young, revenue growth rates can be very high, reflecting the fact that the revenues being grown are small. As revenues grow, the growth rate will slow, and assessing how quickly this will happen becomes a key part of valuing young companies. In general, the speed with which revenue growth will decelerate as firms get larger will depend on the size of the overall market and the intensity of competition. In smaller markets, and with more intense competition, revenue growth will decline much more quickly and stable growth will approach sooner.
Change the Firm’s Characteristics to Reflect Growth
As a firm moves from start-up to stable growth, it is not just the growth rate that changes, but the other characteristics of the firm as well. In addition to the discount rate adjustments we mentioned in the last section, mature firms will also tend to reinvest less and have lower excess returns than younger firms.
Consider the Possibility That the Firm Will Not Make It
Most young firms do not make it to become mature firms. To get realistic estimates of value for young firms, we should consider the likelihood that they will not make it through the life cycle, either because key employees leave or because of capital constraints.
It is far more difficult to estimate the value of a young company than a mature company. There is little history to draw on and the firm’s survival is often open to question. However, that should not lead us to abandon valuation fundamentals or to adopt fresh paradigms. With a little persistence, we can still estimate the value of young companies. These values may not be precise, but the lack of precision reflects real uncertainty about the future of these companies.
Making It Happen
To value young growth companies:
Assess the potential market and the company’s likely market share (if successful).
Estimate what the company has to do (in terms of operations and investments) to get to this market share.
Estimate the cash flows based on these assessments.
Evaluate the risk in the investments and also how it will change as the company goes through the growth cycle, and convert the risk into discount rates.
Value the business and the various equity stakes in that business.