Category Archives: Valuation

The Basic Math of Valuations – Why Mid-Market Companies Are Valued Lower Than Their Public Company Peers?

For public companies, analysts express the value of a company as a multiple of earnings.  It is called the price-earnings ratio or P/E ratio.  If the price of a stock is trading at a low multiple (say eight times earnings) and its prospects are strong, it would be good value; at 50 times earnings that same company would probably be expensive.  For private companies we typically look at a multiple of EBITDA. Let’s say a company has been valued at $20 million; it can sustainably generate $5 million in EBITDA, then it is valued at four times EBITDA.  As I noted earlier, four times EBITDA is equivalent to generating a 25% pre-tax return on capital per annum; more if cheaper debt is used to lever the equity (for an explanation of this see my “What Will a Financial Buyer Pay?” post).

How do you decide if that is a proper risk adjusted rate of return for your capital?  Risk adjusted is the key word here.  To figure this out we have to start at the risk-free rate and build on layers of risk to see where comparable assets should be priced.  We start with the risk-free rate.  The risk free rate is the rate generated by the most secure assets possible.  The proxy for this is typically federal governments.  They can print money at will so you can be assured you will get your money back (what it will be worth is another matter).  Countries such as Canada, Germany, Austria, and the Netherlands are rated AAA by S&P and are as close to risk free as you can get and therefore set the proxy.

Let’s say the 10 year risk free rate is 3%.  What is the next bucket of riskier assets?  State bonds, Municipal bonds, AAA corporate debt, AAA preferred shares?  All riskier, but lets jump straight to S&P 500 equity.  What is the risk premium of a top tier, multi-billion dollar S&P 500 company?  About 5% to 7% (note: even within the S&P 500, there are riskier subgroups.  i.e. cyclicals vs. consumer staples).  Adding this risk premium to the risk free rate, you get approximately 10%.  So getting back to my introduction, buying a S&P stock at 10 times earnings may very well achieve a proper risk adjusted return.

The concept of the risk-return curve is that it measures the risk premium required for riskier assets.  The idea is that you should be indifferent between different asset classes on the curve because you are being properly compensated for the additional risk.

risk return curve

Intuitively, it makes sense that a small private company is riskier than a S&P 500 company but what are the specific drivers of this?  A small private company typically has fewer customers, more customer concentration, comparatively a less established brand, a limited R&D budget, less access to funding sources (be it banks or equity investors) and much less liquidity for the holders of its equity to name a few key drivers and, as such it is riskier than an S&P 500 company.

So is four times EBITDA a fair value for a small private company?  It could be, but it depends on many company specific risk-return factors such as its growth prospects, the nature of its revenues (highly recurring or project based) and the size and diversity of its customer base.  I will expand on these factors and their impact on valuations in future posts.

Valuation 201: Comparable Company Analysis

Ever since I wrote “The Basic Math of Valuations”, which explains the valuation differential between different asset classes, I have been meaning to write a follow-up on specific valuation techniques.  There are market based approaches such as public company trading multiples and comparable transaction analyses and cashflow and earnings based methodologies such as the Discounted Cashflow (DCF) analysis.

In this post I’d like to look at market based approaches.  Let’s start with the easier one to explain; comparable company transaction analysis.  This is just like when your real estate agent shows you what houses sold for in your neighbourhood.  You compare your neighbour’s house in terms of number of bed and bathrooms, lot size, etc. and then you figure, well, if that one sold for $500K then, since mine is better, mine must be worth about $600K.  If you have a $200K mortgage you end up with net $400K after the sale.  The logic is the same for companies however it is very rare that you find: (i) a truly comparable company transaction, (ii) completed very recently (or else different economic conditions will have to be considered), and (iii) there is full information available on consideration components (i.e. cash, earn-out, amount of debt assumed, working capital adjustments, deal exceptions, etc.).  Public company trading analysis can provide trending and current day valuation comparisons but the challenge of assembling a good representative sample remains.

Both market approaches need subjective adjustments in order to derive at an attributable value range. Comparable transaction data and public company shares are typically available from larger public companies which means that, in order to attribute this data to a smaller private company, two types of discounts need to be applied, a small company discount and a private company marketability discount and, in addition, public company shares trade at a minority discount which raises the question of how much of a control premium to apply.

How are these discounts and premiums determined? Large public companies benefit from easier access to capital, lower cost of capital, in many cases a strong brand and generally scale, diversification of suppliers and customers and many more risk reducing attributes.  Small companies typically have higher customer concentration, a less established brand, less access to funding sources (be it banks or equity investors) and, private companies are illiquid; it takes a lot of time and effort to find the right buyer.  As such, small private companies are riskier than large public companies.  Every comparison is unique but generally speaking, more risk means a higher required rate of return.

Minority Discounts and Control Premiums are two sides of the same coin.  Public company shares trade at a minority discount because any individual shareholder does not have enough influence (i.e. votes) to change the direction of the company.  However as soon as a control block is in play, the minority discount disappears.  Control premiums are tracked by Mergerstat and were on average 50% in the first quarter of 2012.  So how do the various discounts and premiums stack up?  Generally speaking, small private companies are valued below the trading values of public companies – even without the control premium applied. In other words, public minority share valuations are still higher than small private company control share valuations.

Both market approaches need subjective adjustments in order to derive at an attributable value range.  The question of whether a comparison of a $1 billion public company to a $50 million private company deserves a 30% or a 50% discount requires consideration of many factors and is best answered by an experienced, accredited professional valuator.

Valuation 301: The DCF and Forecasting

In my last post, I reviewed the various discounts and premiums to be applied in the market comparable approach to valuing a company.  Other approaches that use company specific earnings and cashflow include the capitalized earnings and the Discounted Cashflow (DCF) method.

A DCF requires a forecast of the company’s revenues and earnings and then a terminal value is established (to represent the value beyond the forecast period), all of this is then discounted to arrive at present values to be added up.  The discount rate must reflect the inherent risk in generating the cashflows and the terminal value must reflect the growth rate beyond the forecast period.  The cashflow used is “free cashflow” which requires adjustments for capital expenditures and working capital requirements and is net of taxes. Technically, the DCF is the more sophisticated valuation methodology but practically speaking the determination of the discount rate and the terminal value are highly subjective and small changes in assumptions can result in large changes in value.

Irrespective of the discipline brought to the process, multi-year forecasting can be challenging for any company and is particularly hard for early stage, new product/service companies.  I want to note three things about emerging company forecasts: (i) they should be bottom-up, (ii) they should be integrated, and (iii) they should sync with valuation expectations.  Many investor presentations will say: “…look, I only need to capture 1% or 2% of the market and I will reach $100M in sales”.  There are two problems with this statement, one you end up being a small market participant when VCs are looking for the sector winner and, two, you don’t say how you will get the 1%.

Forecasts should be bottom-up, meaning, they should reflect specific actions such as: (a), we will hire Joe and he is going to call 100 prospects and he will close 5 deals and generate $1M in sales in the first year; then, (b) in six months we will hire Mary and she will…etc.  Forecasts should be integrated, meaning an income statement should feed a cashflow statement which should feed a balance sheet on a monthly basis for at least three years.  Based on this investors can clearly determine the use of funds and impact on the cash position.  Lastly forecasts should result in the expected valuation.  For example, if you are looking to raise $5M for geographic expansion and you are willing to sell 33% equity for this, your forecast better illustrate an aligned use of proceeds and justify a pre-money value of $15M.

Once a sound forecast is prepared and the valuation math is solid, the question for the investor becomes; do I believe this team can, and will do a, b and c.  If they are comfortable with this, then the due diligence moves on to other items such as management’s past accomplishments, credentials, relationships etc.  While the value proposition and competitive differentiators are the primary attractions in a business plan, a sound, logical forecast is a core component needed to close a successful transaction.

While there are complexities in all valuation methodologies, it is perhaps most important to remember that value is relative and of the moment.  Whether that is relative to recent market information or relative in the context of an appropriate discount rate and terminal value.  It is affected by macro-economic factors such as public sentiment and company specific factors such as patents.  A valuation, like a balance sheet, is a representation at a moment in time but value changes on a daily basis.  Value does not naturally accrete with time.  When profit growth is accelerating there may be hubris but when it decelerates it will go away just as quickly.  When the collective wisdom decided that Apple’s growth would slow, it lost over 30% of its value in just three months.

Revenue Quality: What Does it Really Mean?

High quality revenue companies are valued higher than low quality revenue companies.  But what does this really mean and why is this? It is simply a question of risk. High quality revenues reduce risk and therefore result in a higher valuation. What are high quality revenues?  Primarily it is about revenue continuity but also diversity and profitability.

Revenue Continuity
Long term customer contracts provide future revenue predictability.  In many cases capital projects will not get financed without long term customer contracts.  But what if you don’t have long term contracts, what else can give an investor or financier comfort that revenues will stick around? Questions that get at this answer include: How much of an “annuity” does your business model have?  What percentage of revenues can be counted on to recur every year?  Is the product/solution mission critical?  Is it embedded in your customers’ businesses?  Are switching costs high?

As an example, cloud based Software as a Service (“SaaS”) solutions such as Salesforce, Workday or NetSuite are often sold on a per seat, monthly subscription basis.  In some cases upfront customization is required and in all cases customers have to learn how to use the new software.  Once customers have adopted such a solution, they will not switch very quickly.  The solution becomes embedded in another business’ processes which results in high switching costs.  As a result, its recurring revenues are usually quite stable.

There are a number of ways to grow recurring revenues; license or lease your product or technology instead of selling it outright, sell products that need periodic supplies or maintenance, sell service or maintenance agreements, franchise, etc.

Revenue Diversity
The greater the customer concentration the greater the risk.  The opportunity to supply a major retailer (i.e. Wal-Mart or Home Depot) or a major manufacturer (Ford or GE) can be a tremendous opportunity for a small company but it can also drain a lot of resources and result in pressure on margins and tremendous customer concentration.  While the growth that it drives will increase value, the associated risk of these revenues will reduce value.

Early-stage companies tend to have only a few customers that make up a large portion of revenues but, over time, they must strive to build a diverse revenue base.   Ideally no customer generates more than 10% of revenues.

If you operate in a low barrier to entry, fragmented market then it will be hard to increase prices and produce sustainably strong margins.  Of course different business models generate different margins.  For example, a grocery business will have a lower gross margin than a cloud based SaaS business which can generate gross margins of over 70%.  Over time, competition will put pressure on margins but under certain circumstances, such as first-to-market solutions, proprietary products and processes or patents, companies can sustain high margins for a considerable period of time.

Most entrepreneurs will say they have excellent customer relationships and that certain customers would not leave them no matter what.  But stuff happens.  Maybe this belief is based on personal relationships which cannot be sold with the business.  There are always opportunities to improve revenue quality, whether it is to extend revenue continuity, increase revenue diversity or to improve margin.  Improving revenue quality should be an ongoing priority for business owners as it is a strong contributor to company value.

The Top Five Impediments to Securing Exceptional Value in the Mid-Market

Many owner-entrepreneurs develop expectations for their business’ value based on news items and industry chatter about M&A and financing activity.  However, the small percentage of transactions that make the headlines are not reflective of the average transaction.  The factors we see most often (not in order of frequency or importance) that prevent private mid-market companies from achieving a premium valuation include:

Small Size:  Most transactions in the news concern multi-billion companies.  While we have seen one in a million start-ups fetch billion dollar valuations, most small companies are discounted to larger companies because of their riskier operating profile and because there is less liquidity in the lower end of the M&A market.  Companies valued at less than $10M will not find as much interest as larger companies.

Customer Concentration:  The issue of customer concentration varies by industry and by business model.  In the automotive sector, if you are a supplier to Ford, GM, Chrysler, VW, Honda and Toyota; six clients, then you are in a good position.  Generally, for B2B companies one would like to see at least 20 clients and if your business is a cloud based consumer or SMB focused business than 100 or even a 1000 clients will be seen as small.  Ultimately, it is not the total number of customers that is the measure of risk but the exposure to any particular customer.  Ideally no customer generates more than 10% of revenues.

Modest Growth Rate: Growth needs to be measured over an appropriate period and in the context of the economy and peers.  While a single digit growth is respectable for a mature company, in many sectors it needs to be double digit to warrant a premium valuation.

Principal Goodwill: Principal goodwill is the value of the knowledge and relationships that the Principal holds.  Large companies have documented relationships, usually multiple points of contact and formal processes for dealing with change.  This reduces risk and improves value.

Lack of Business Model Focus: The challenge with a business pursuing various services and segments at the same time is that it reduces the buyer universe.  As an example, take a business that starts out as a IT services/consulting business and then develops a SaaS based service.  It gets some traction and now the revenue mix is 60% consulting and 40% recurring SaaS revenues.

We would market this business as having recurring revenues but to pure SaaS companies this would dilute them.  Certain consulting businesses won’t have the appetite or capital on hand to invest in the marketing that the SaaS business needs.  Lack of focus in the business model will reduce buyer interest and hence value.

So, what does produce a headline grabbing valuation?  Simply put, you have to be viewed as being on a path to achieve a leading position in a new segment that is expected to be enormous.  Rare, but we do have a number of Canadian technology sector examples including Hootsuite in social media monitoring, D2L in personalized learning solutions, Shopify in online stores and Wattpad, creating a brand new segment, in a community of readers and writers.