Valuation of a High Growth Business

Comparing a Dynamic Company to Similar Firms on the Stock Market is the Simple Approach to Valuation

A Market Brief by Steven Kim

MintKit Investing
www.mintkit.com

2011 MintKit.com

Summary
The valuation of a high growth business is a key concern for the owners of the enterprise as well as outsiders such as prospective investors. As an example, a corporate buyer that plans to acquire the high flyer has to figure out how much the business is worth. The same is true of a savvy investor who wants to buy a block of shares in a company listed on a stock exchange. A simple way to gauge the value of a business is to compare it to similar firms in the equity market. The matchup against listed firms is directly relevant, for instance, in the case of a public offering of shares. However, the same analysis can serve as a point of reference in other settings. An example of the latter is a decision by the owners to sell the company, whether in whole or in part, by way of a private transaction.

* * * Keywords: Finance, Valuation, Growth, Business, Company, Venture, Investing, Strategies, Fundamental, Analysis, Stock, Market, IPO, Cash Flow

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The valuation of a dynamic firm is a vital issue for the owners as well as other stakeholders. As an example, the business has to be sized up if the principals plan to list the company on a stock exchange. Another scenario involves the sale of a minority stake to a bunch of external investors through a private transaction. There are two broad ways to figure out the value of a business: simple and knotty. In the straightforward mode of valuation, the company in question is compared against similar firms listed on the stock market. By contrast, the intricate scheme requires a detailed examination of the prospects for the business over the foreseeable future. More precisely, the analysis requires a forecast of financial conditions on an annual basis, along with an estimate of the present value of the future flows of cash. The purpose of this article is to spotlight the breezy method for valuing a firm. A second, and related, task is to examine the relative merits of the simple and arcane approaches to pricing a business.

Top-Down versus Bottom-Up The direct approach to valuation may be viewed as a top-down method. The crux of the technique is a comparison of the financial profile of the chosen firm against those of its brethren. In this effort, the relevant factors include the gross revenues, net income, growth rate, and suchlike. By contrast, the convoluted scheme may be viewed as a bottom-up approach to pricing the business. The recipe calls for a projection of the cash flow on an annual basis while taking into account the revenues, expenditures and other factors.

Slosh of Cash For the nitty-gritty approach to valuation, the planning horizon is split up into two or more segments. The first portion is the heady period of rapid expansion. By contrast, the subsequent phase deals with one or two stretches of subdued growth or relative stagnation. To bring up an example, a gutsy venture is expected to flourish at a lively rate during the first 5 years, then slow down to a languid pace thereafter. In that case, the evolution of the business can be split up into two segments: a sprightly stretch followed by a mature stage. On the other hand, a rival firm might zoom ahead at a breathless clip during the first 4 years, then pull back to a leisurely trot for the next 3 years, before settling down to a sedate shuffle in the final phase. For this company, the pattern of growth can be partitioned into three segments: rampup giving way to slowdown followed by coasting. For the nuts-and-bolts approach to pricing, the next task is to figure out the present value of the flow of cash on a yearly basis. Then the net influx of cash for each year is converted into the equivalent amount today by taking into account the likely rate of interest in the interim. A similar calculation is performed for the final stage of subdued performance, which is expected to last into the indefinite future. For this portion, too, the expected stream of cash flows is converted into its present value. As noted earlier, the appraiser may decide to split up the planning window into three segments rather than just two. In that case, the middling portion is subjected to an analysis similar to that for the first phase. The main difference is that the growth rate at this stage will be lower than the spurt during the initial spell of sizzling growth. The foregoing approach to valuation is known to financial wonks as the discounted cash flow (DCF) model. At first glance, the methodology might seem like a rational and precise way to size up a business.
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To be fair, the latter viewpoint might be valid in an abstract sense in an ideal world. From a pragmatic stance, however, the apparent precision turns out for the most part to be a mere illusion.

Flights of Fancy The discrepancy between theory and practice springs from the need for a heap of augury. To wit, the contrived scheme requires scads of guesswork in connection with internal factors as well as external conditions. In practice, no one has a solid grasp of all the salient factors. To compound the challenge, even a small change in the assumptions can lead to whopping differences in the envisioned outcome. An example of an internal factor is the level of expenditures five years down the road. For a fast-growing firm, its hard enough to estimate the outlays required a few months from now, let alone several years downstream. Meanwhile, an example of an external factor lies in the interest rate to be used in figuring out the present value of a future wad of cash. Even the central bank, which is solely responsible for setting the basic rate of interest, does not know in advance whether the figure it decides on will be 5%, 1%, or some other level a year from now or even a few months down the line. In spite of the mushiness, the forecast of the interest rate is a pivotal factor in crunching the numbers for the DCF model. In other words, a small change can have a huge impact on the outcome of the analysis. As an example, a tweak of just 1% in the value of the interest rate could lead to a difference by a factor of two in the present value of a series of cash flows. In that case, a fixed stream of income that is valued today at a billion dollars based on an interest rate of

1% is apt to be worth only half that amount if the value of 2% is used instead. As it happens, some people think that the discrepancy of half a billion bucks is no small change. In these ways, both external conditions and internal factors can have a humongous impact on the outturn of a DCF review. At first blush, the mounds of numbers that seem to back up a bottom-up analysis may look impressive to an outsider. In truth, though, the end result depends on a pile of guesswork which may or may not bear much resemblance to the real world in due course. Worse yet, a part-time investor or even a full-time observer is unlikely to have enough time or data required to perform a bottom-up analysis in a meaningful way. For instance, the appraiser is apt to have little or no idea how much money the company will earn, or how much the firm plans to spend, over the next decade. In fact, the prober will not even know for sure how things will turn out just a few months down the line. Without intimate knowledge of the strategic plans and detailed budgets, the seeker has no business taking up the nitty-gritty approach to valuation. In that case, the simple scheme is the plain recourse for pricing a dynamic firm.

Showcase of a Virtual Venture Up to this point, we talked about the top-down approach to valuation in general terms. However, the best way to grasp the methodology is to look at a specific example. For this purpose, we take up a case study of a hypothetical but plausible venture at the cutting edge of innovation. The pioneer produces a germinal line of smart software designed to support high-level decision making in a corporate setting. Suppose that the vanguard can do a half-decent job of product development. Then the gogetter should be able to grow rapidly during the first decade or two of its entry into the marketplace. For the sake of clarity, we will work with a concrete set of numbers rather than talk about vague generalities.

During the first couple of years, the main task of the spearhead is to focus on product development. The output at the end of this period will be a novel line of adept programs driven by advanced techniques in data mining. The launch of a marketing campaign toward the end of the second year will set the stage for shipments and revenues starting in the third year. For the third year as a whole, we will assume that the company rakes in sales of $10 million. The goal over the next few years is to expand the gross revenues by a factor of 10 each year. In that case, the volume of sales during the fifth year would be a billion dollars.

Matchup against Comparable Firms One of the first things that prospective investors will do is to compare the business against existing firms in the stock market. As a point of reference, the net income often hovers in the neighborhood of 30% of the gross revenues in the case of a company like Microsoft or Google. On one hand, the pacesetters of the digital economy conduct their operations with a high degree of automation and efficiency. As an example, the employees of Google interact with their customers via online channels rather than make house calls in the flesh. Admittedly, there are limits to the scope of automation that a company can rely on. For instance, a vendor will likely face a plethora of pointed questions from their customers. However, the current state of software technology is too primitive for digital agents to come up with adroit responses all by themselves. For this reason, each reply has to be crafted in part or in whole by a human worker. On the bright side, though, a selection of the most common inquiries and their responses in the past can be packaged into a gallery of reference materials. An example of the latter is a lineup of Frequently Asked Questions. A resource of this sort can then be deployed online for the benefit of subsequent visitors to the Web site. The reference materials may be accessed by all comers without any direct intervention by the corporate staff.
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As a rule, a key attraction of software systems lies in the scalability of operations: a virtual package, once it has been created, can be replicated and deployed with ease on a multiplicity of hardware. In that case, there is scarcely any difference in the cost of producing a thousand versus a million copies of the program. The same is true of the cost of operations after a software module has been developed and deployed. An example in this vein is the provision of routine information to the online community. As a rule, the expense entailed in running the program will hardly budge whether the system happens to handle a thousand queries or a million hits each day. For these reasons, a virtual business can be highly profitable after it reaches a crucial threshold of sales and earnings. The product at hand could take the form of a software package such as Microsoft Windows, or a virtual service such as Google Search. On the other hand, the purveyors of digital products tend to spend a lot of money on research projects in order to upgrade their wares on a continual basis. For instance, a gogetter might funnel billions of dollars into product innovation every year in order to refine and extend the existing lineup. In other cases, though, the outlay for product development will be gigantic only during the initial period of incubation prior to the launch of the seminal product. By comparison, the subsequent phase of product refinement would be far less onerous. Moreover, a software builder may be able to hold down the time and cost required for product development by making good use of open source software. By adopting generic components, the spearhead could ease the burden of cobbling together a landmark product. As a rule, the use of open modules also helps to ensure a high level of reliability in the final product. In that case, the upshot is higher quality at lower cost for the vendor as well as the customer.

To be conservative, we will assume that the net margin for our fledgling venture comes out to just 15% of the gross revenues. If the sales during the fifth year add up to $1 billion, then the net income would be $150 million. The profit margin of 15% happens to be only a bit higher than the corresponding figure of 12% or so at the dawn of the millennium for a software outfit named Red Hat (redhat.com). The company built its business around a generic product; namely, a variant of an operating system called Linux. The programs that comprise the Linux system are open source and thus freely available to all comers. The initial version of the software has spawned a medley of flavors designed to run on an assortment of hardware. The target machines span the spectrum from compact tablets and svelte laptops to beefy desktops and hulking mainframes. The code for the Linux system is improved and extended on an ongoing basis by an army of volunteer programmers scattered round the globe. Due to the long-standing culture of service within the virtual community, the resulting software can be obtained for free by any Netizen. Given this backdrop, Red Hat did not have much to offer in terms of a proprietary product. When a firm has little or nothing in the way of a competitive advantage, it faces a harsh environment in which mere survival is by itself a notable achievement. Despite the hardships in store, however, Red Hat managed to eke out a living in the barren landscape of a commoditized market. Better yet, the hardy firm was able to turn in a respectable level of profits. If a company struggling under such harsh conditions can generate a decent profit, then a venture with a compelling product should be able to do much better. Put another way, the pioneering firm will find itself in the drivers seat. In the case of a company growing at breakneck speed, the price of the equity may exceed the earnings per share by a factor of 100 or even higher. In other words, the valuation of

the firm on the stock market could dwarf the net income over the past year by a hundredfold or more. According to the scenario sketched out earlier, the net income for our novel venture during the fifth year would be $150 million. Moreover, the market value of the company could well be a hundred times its annual earnings thanks to the blistering pace of growth. In that case, the measure of the firm turns out to be $15 billion.

Value on the Stock Market Once again, we will take a conservative tack. In particular, we assume that the stock market is wallowing in a funk. For instance, the bourse might have experienced a spate of turbulence just prior to the initial public offering (IPO) for our chosen venture. After a stormy spell on the bourse, the financial community will be skittish and standoffish. In the moody climate, the investing public are sure to be less enthusiastic about the IPO than usual. As a result, the equity will be priced lower than the norm under sunny skies. Suppose that the price tag turns out to be just one-third of the figure to be expected under normal conditions. Under this scenario, the total value of the firm will come out to $5 billion. Once again, to err on the side of timidity, we will assume that the crew of early backers in the venture ends up with only one-fifth of the outstanding shares in the wake of the IPO. In that case, their stake will be worth $1 billion. In spite of the strained conditions, however, the payoff is still nothing to sneeze at. Suppose that the original patrons had invested a total of $50 million in the venture at the outset. Then the benefactors would end up with a bounty that is worth 20 times their original stake within a span of 5 years or so. In other words, the average rate of return on investment would turn out to be a mite over 82% per year.

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An alternative outcome for the story lies in a sale of the bantam venture to an acquisitive firm in the software industry. In that case, the valuation of the business for a prospective listing on the stock market would still serve as a baseline for negotiation amongst all parties when they haggle over the purchase price. In short, the punch line is similar whether the venture ends up in a public offering on a stock exchange or a trade sale to another company. In the cameo above, the prospective outturn for the original band of investors was a windfall in the neighborhood of 82% a year.

Roundup for Valuation The value of a firm is a crucial concern for the insiders within the enterprise as well as the outsiders who want to obtain a stake in the business. In sizing up the outfit, the techniques of valuation may be classified into two broad types: top-down and bottom-up. The workhorse of the bottom-up approach is the method of discounted cash flow. Due to the slew of numbers floating about, the DCF scheme has the advantage of impressing novice investors with the heap of busywork required to carry out the analysis. On the other hand, the outcome of the model is determined by a raft of forecasts such as gross sales, interest rates, and other factors. Unfortunately, the auguries of this sort have a way of going awry in a serious way. Moreover, the final result is highly sensitive to a host of assumptions regarding the internal plans of the company as well as external conditions in the marketplace. A prime example lies in the future course of interest rates. Due to the uncertainties in store, the output of the DCF model is in practice useful only for pricing a mature company with a long history of financial data. Even then, however, the vagaries of the marketplace could well render the analysis meangingless as time goes by. A good example of an upset is a recession that rips apart the projection of sales and profits. Another sample is a swerve in the course of interest rates which play such a pivotal role throughout the calculations.
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By contrast, a youthful venture comes with little or nothing in the way of a financial history. For this reason, the appraisal of a sapling firm using the DCF method is tantamount to sheer guesswork. To make matters worse, the mass of external investors have little or no information on the internal plans of the target firm. An example of the sort is the allocation of funds for capital expenditures a couple of years from now. Another sample lies in the schedule of royalties from licensing proprietary products half a decade down the road. For these reasons, an outsider usually has little choice but to turn to the top-down technique. In this approach to valuation, the prober compares the target business against comparable firms listed on the stock market. The appraisal happens to be a telling exercise even in the absence of any plans for a debut on the stock market. A plain example is the sale of the company whether in whole or in part to a corporate buyer via a private transaction. In a deal of this kind, the prospective valuation of the firm on the bourse serves as a baseline for negotiation by all the parties concerned. A big advantage of the top-down approach lies in its inherent linkage to the real world. On a negative note, the players in the stock market are notorious for being emotional and irrational, especially in the throes of a bubble or the depths of a panic. Even so, the throng of participants in the arena cannot be accused of double-talk. In particular, the gamers are willing to back up their convictions or delusions with hard cash, however loony those views might be. For this reason, a comparative analysis of the target company against listed firms using hard data does in fact have a real and immediate significance. To wrap up, the top-down approach is a relatively quick and simple way to figure out the worth of an enterprise. By contrast, the bottom-up approach is largely out of the question for an outsider due to the dearth of information on the internal plans and business prospects for the firm.
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Moreover, even the principals within the company have a shaky grasp of the revenues and expenditures to crop up over the years to come. The outlook on the business climate at large, ranging from the state of the economy to the level of interest rates, is yet more blurry and uncertain. The lack of assurance applies to companies of all stripes. However, the level of uncertainty rises to a high pitch in the case of a bantam venture caught up in a spree of frenzied growth. As a result, the turnout of a DCF analysis has to be taken with a heap of salt. Put another way, the fancy projections by the number cruncher which may look impressive to some outsiders are for the most part nothing more than flights of fancy. Given this backdrop, the technique of choice is to size up the target company against comparable firms listed on the stock market. As a rule, the simple tack is also the best approach to the valuation of a high growth business.

Resource on the Web Wikipedia. Business Valuation. http://en.wikipedia.org/wiki/Business_valuation A survey of techniques for the valuation of a company.

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