Valuation of Early Ventures

In previous blogs, we have discussed several valuation models, including the famous Dividend Discounting Model, Earnings Capitalization and P/E ratio. While these traditional methods can be used to value companies with track record of revenues and profits, they are irrelevant for determining value of a start-up company. Too many assumptions of moving variables make valuing early ventures using these methods useless.

Determining expected growth rate of revenue and profits is meaningless when the success of a start-up cannot be confirmed. A market may reject the new product or the regulators might not approve the product in the first place. Moreover, several ventures may be based on new ideas which are not yet tested and do not have an established market. Valuing start-ups is still important, especially for investors as it helps them in deciding the percentage of ownership they will receive. Investors in early ventures expect to gain a good multiple on their investment. In other words, the business should be expected to reach a higher Market-to-Book ratio.

It is normal for start-ups to lose money during initial years. Several new technology companies which are internet based tend to be loss making even at the time they are being sold. While Price to Sales can be applied, it completely ignores the operating efficiency, growth rate and relative market size.

It is generally observed that new technology companies are valued higher than companies from other sectors like consumer products, chemical and other manufacturing sectors. One prime factor distinguishing technology sector and traditional sectors is that while traditional companies face geographical constraints due to product weight, jurisdiction wise regulation etc; technological companies can avoid these constraints by using third-party distributors or internet. They can expand and grow globally very fast compared to other sectors, that too with a very low capital base. Moreover, their gross margins can easily range between 70% and 100%, as against commodity companies that run on low margins.

Successful ventures can either be sold to larger companies or they can opt for an IPO. Early venture investors tend to determine two values; the potential value at the time of next round of fund raising and the potential value of the company at the time of exit or sale. They then determine the value of the venture today to get an idea of the multiple they would gain. This method is referred to as ‘Venture Capital Method’.

For valuing a start-up, a venture capitalist also depends on his intuitions and knowledge and perception about the industry. Following are some of the important factors which the investor should examine while judging the value of an early venture:

• Valuations of comparable publicly listed companies
• Addressable size of the market
• Valuations of merger and acquisition transactions
• Gross margins of similar companies
• Expected long run growth rate
• How different is the new product or service

Several start-ups launch new products and services. In such cases, it is difficult to judge competitiveness of these ventures and valuing them based on comparative valuations will be inappropriate. Using Cash Flow Discounting Model would be ideal in such cases if it is possible to forecast future cash flows. Several venture capitalists prefer valuing intangibles to overcome the shortcomings of traditional methods.

Discounting Cash Flow Method

Companies paying dividends can be valued using the Dividend Discounting Model and companies that do not pay dividends because they want to invest their earnings to expand further can be valued using Earnings Capitalization Method.

But what about companies that have been generating negative earnings and have never paid dividends?? In this case we discount the expected cash flows, using Discounting Cash Flow Method (DCF). According to experts, cash flows are a better projection of a company’s fundamentals. While earnings can be dressed up easily by manipulating income and expenses, manipulating cash flows is extremely difficult. Cash Flow Statement of a company is a true reflection of its income generation capacity, asset efficiency and how efficiently it employs its capital structure. Moreover, unlike cash flows, profitability does not necessarily indicate solvency.

The cash flows used in this valuation technique are Free Cash Flows (FCF), which are calculated as below:

FCF = Operating Profit + Depreciation + Amortized Goodwill – Capital Expenditure – Cash Taxes Paid – Change in Working Capital

Alternatively, it can also be calculated as:

FCF = Cash Flows generated from Operations – Capital Expenditure

From the above calculations, it is evident that negative FCF is not necessarily bad as it may also suggest that the company is making significant capital investment towards expansion, thus increasing its potential to earn higher returns in future.

Discount rate used to discount FCF should ideally be Weighted Average Cost of Capital (WACC). Besides valuing a business, DCF can also be used to estimate the value of a new project in isolation. If DCF of a project is higher than the initial investment required, it is worth taking up. In this case, cash outflows for the project would include:

• Initial Investment
• Expenses incurred during the life of the project
• Interest paid on borrowed capital
• Expenses incurred during termination of the project

Similarly, cash flows from a project would be:

• Annual income
• Proceeds received on termination of the project
  

While DCF is considered to be the most effective valuation method compared to Earnings Capitalization and Dividend Discounting Model, all these models have the one major shortcoming; they are as good as the assumptions used therein. Cash flows for DCF are generally projected over a relatively longer time horizon, and hence, any minor change in the assumptions and business environment can have a huge impact on valuation. Investors must therefore bear in mind that DCF is a running value and needs to be continuously updated for even a minor change in the applied variables.

Business Valuation using Earnings Capitalization

In our previous blog, we discussed the valuation of a company’s stock based on the expected dividends. Growing companies generally prefer to plough-back their income into their business for future expansion, instead of shelling out dividends to their investors. Using Dividend Discounting Method for valuing such companies will therefore be difficult.

Value of growing companies that do not pay dividends can be determined using ‘Capitalization of Earnings’ method. That is, simply dividing the earnings that are expected one year ahead by a capitalization rate. Capitalization rate is the discount rate adjusted for growth rate (.i.e. Capitalization rate = Discount rate less Expected Growth rate). It can also be WACC (Weighted Average Cost of Capital). Capitalization rate represents the risk associated with the business to be valued.

Earnings used in the calculation are EBIT (Earnings before Interest and Tax) which are adjusted for non-recurring income and expenses. Adjusting one time items is important to arrive at a realistic valuation and avoid making wrong investment decisions. Please note that discounting EBIT will give you the value of the whole business. To determine the value for equity holders, you will have to subtract the value of debt from this value.

Also remember that value arrived by capitalizing earnings will depend on the strength of assumptions made about expected earnings and long term growth rate. Several estimates and projections go in determining the future growth rate of a business. The shortcoming of this method is that one cannot value companies that generate negative earnings.

Dividend Discounting Model

Valuing a stock is very important when it comes to fundamental investing, that is, for investors who plan to invest for a medium to longer time period. According to ‘Value Investors’, investing in a business is worth while only if its ‘Intrinsic value’ (also referred to as ‘Present Value’ or ‘Fundamental Value’) is more than its current market value. In simple words, it is worth investing in a stock only if present value of all the expected gains from this stock (in the form of dividends and capital appreciation) is higher than the current market value. When Present Value (PV) is higher than the current market price, the stock said to be being ‘Undervalued’, and when it is lower than the market value, the stock is referred to as being ‘Overvalued’.

For example, consider stock of a Company A with current market price of $20. A value investor will consider investing in this stock only if he feels that the intrinsic value is greater than $20. That is, he assumes that Company A is ‘undervalued’. On the contrary, if the PV is less than $20, an investor may consider selling it short. It’s important to remember is that a cheap stock is not necessarily ‘under valued’. A low price may reflect poor market sentiments or a general economic slowdown and may not necessarily mean that it is under valued.

PV is calculated by discounting all the future gains expected from a stock using the rate of return expected by the investor. These gains may be in the form of dividends and capital appreciation.

Dividend Discounting Method (DDM)

This is the most familiar method applied for valuing companies that have consistently paid out dividends to their investors over the last few years, and are assumed to pay dividends over the next few years as well. Mature companies generally pay-out dividends regularly and are valued using this method. DDM can be modified for companies that are expected to grow consistently at the same rate, or at a higher rate for the first few years and later grow at a lower rate. Following are some of the commonly used DDM formulas.

Companies that are expected to pay consistent dividend per share perpetually can be valued as:

Present Value = Dividend Per Share / Discount Rate

This is the most basic DDM formula. However, its biggest shortcoming is that it assumes zero growth, which is taken care in the following formula:

Present Value = Dividend Per Share / (Discount Rate – Dividend Growth rate)

Companies that are expected to grow at a constant rate perpetually can be valued using this formula, which is also referred to as Gordon Model or Constant Growth DDM. However, it cannot be applied if dividend growth rate exceeds the investor’s rate of return, as the denominator will be negative and a stock value can never be negative.

DDM can be further modified as a Multi Stage DDM for valuing companies that are expected to grow at varying rates initially and then at a constant rate perpetually. For example, a company say, A, can be expected to grow at 10% annually for the initial 3 years, at 7% for the following 3 years and then at 4% perpetually.

While applying DDM for valuing stocks, investors should bear in mind that the value calculated will be as good as their assumptions applied in DDM. A lot of assumptions need to be applied while valuing a stock using DDM. An investor should have a strong fundamental understanding of the company to determine its earnings growth rate and its dividend pay-out ratio, besides knowing his/her own risk adjusted rate of return. Understanding your risk profile will enable you to set a realistic expected rate of return. Hence, PV of a stock will be different for every investor. Higher the expected return, lower will be the PV. Similarly, longer the time period for holding the stock, lower the PV.