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.