There are market based valuation approaches such as examining public company trading multiples and comparable transaction analyses, and there are company specific cashflow and earnings based methodologies such as Discounted Cashflow (DCF) analysis. In this post we review both market based approaches and company forecast analysis.
Comparable Transaction Analysis
Let’s start with the easier one to explain; comparable company transaction analysis. This is similar to when your real estate agent shows you what houses sold for in your neighborhood. You compare your neighbor’s house in terms of the 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.
No Two Businesses are the Same
The logic is the same for companies however it is very rare that you find: (i) a truly comparable company transaction, (ii) that was completed very recently (or else different economic conditions will have to be considered), and (iii) where 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 Multiples
Public company trading comparisons benefit from the full disclosure provided by public companies and the day by day valuation performed by the stock market.
Public company analysis can provide good trending and current day valuation comparisons but the challenge of assembling a good representative sample remains.
The Private / Small Company Discount
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 considered, (i) a small company discount and, (ii) 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.
Discounted Cashflow (DCF) analysis
Company specific valuation approaches 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.
Forecasting is Hard
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. When creating an emerging company forecast: (i) they should be bottom-up, (ii) they should be integrated (see below), 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 is 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 monthly and bottom-up
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 into a cash-flow statement which should feed into 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 25% equity for this, your forecast better illustrate an aligned use of proceeds and justify a pre-money value of $15M (post money valuation would be 5 into 20 or 25%).
Due Diligence will look into technical skills and experience
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.
Valuation, like a balance sheet, is a representation at a moment in time
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 (i.e. improve over time). When profit growth is accelerating there may be hubris but when it decelerates it will go away just as quickly.
Recommended Further Reading
For more valuation concepts, see: Private vs public Company: Valuation Differences and Rationale
For more on what drives a strong EBITDA multiple, see: What Drives a Strong EBITDA Multiple?