Sep 23, 2016

Young company valuation

Hi,

So recently I was in a recruiting process for a position as an equity researcher for small/midcap tech companies. As a part of that process we were asked to do a small analysis of a firm. They were happy with my description and analysis of the firm and industry. However they were dissatisfied with my valuation, believed it to be naive and weak, at best. I would love to get some feedback from this community, so if I decide to pursue an ER career again, I won’t fall into the same trap.

(Apologies for the limited information I’ll present to you! But, the firm only have public information in Swedish and I’d like some degree of anonymity)

The firm:
Market Cap: 700m SEK.
Provided an algorithm to software to improve video recording: “exclusively” B2B.
Zero sales: That means zero sales; they haven’t yet launched their product, no contracts, nothing to benchmark against etc.
Relatively new-to-the-world technology: few competitors, difficult to estimate/predict attractiveness etc.

The typical football field valuation isn’t really possible. All multiples were negative, DCF-model would require too many assumption to ever hope to be of any use, B2B meant I couldn’t EV/non-financial/operating statistic e.g. visitors, DAU, or valuation of users.

My logic when assessing the valuation was that mature companies are valued on their future earnings (very simplified) while start-ups are valued on their potential. In order to assess their potential I used http://people.stern.nyu.edu/adamodar/pdfiles/pape… - Aswath Damodaran’s ideas when valuing a young company. Which of course is a very speculative assessment. I accompanied the potential valuation with a comparable company analysis, benchmarking their product and valuation, and to its competitors. Summarized it all to a football field valuation.

My question is how you could go about to value such a company? (No detailed description needed, just the very broad approach).

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Aintnobodygottimeforthat

Baboon

Bumping. If this thread is suited better at a different forum segment, would moderators be so kind to move it.

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HY.r.e.a.m

King Kong

Your logic doesn't sound wrong. I assume their feedback is more related to how you benchmarked things, analyzed the product, forecasted market penetration, etc. etc.

Saying "I did comps" is not very informative. You could have done extensive comps with a broad compset, or you could have chosen a totally nuts compset of only mature companies, etc.

This is the type of case where really there's no way of grilling you without seeing the materials, which you have your own valid reasons not to share.

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Authored by: Certified Private Equity Professional - 2nd Year AnalystCertified Private Equity Pro

Aswath Damodaran

Neanderthal

Best Response

Valuation Myths: Young companies cannot be valued (Originally Posted: 11/26/2013)

Twitter is now officially a publicly traded company, and I AM glad that we no longer have to debate the IPO price and what will happen in the aftermath. While the opening may have veered a little off script, to the extent the price popped a little more than “desirable”, I am sure that the bankers, the preferred clients who were able to get the shares at $26/share and even the owners who left money on the table (just over a billion dollars) are all happy with the outcome, at least so far. While they may be tempted to claim “mission accomplished”, I think that there are a few more rounds to go before we make that judgment.

In an earlier post, I noted the divergence between investors, who trade based on value, and traders, who make judgments about price movements, and how they often talk past each other. If you have been following the conversation about Twitter online or in the financial media, the last week has also brought reminders about enduring myths about the valuing and pricing of young, growth companies that both sides seem to hold dear. At the risk of irking both groups, I would like to argue that they are holding on to preconceptions that are not only shaky and self serving, but also damaging to their portfolios.

Investor Myths

Let’s start with the three misconceptions that some “value” investors have about young, growth companies.

Young, growth companies cannot be valued: How often have you heard someone say that young companies cannot be valued because there is too much uncertainty about the future? This rationale is used by value investors not only to avoid entire segments of the market but as a shield against even discussing the value of young, growth companies. While it is true that there is more uncertainty about the future prospects of a young company than for a mature business, you can still make estimates of expected earnings and cash flows into the future and value the company, as I tried to do in these spreadsheets to value Tesla and Twitter. You can and should take issue with my assumptions and come up with your own values for both companies but you cannot argue that these companies cannot be valued.
Even if you can value companies, that value will change significantly over time (making it pointless): As you learn more about a new company, from its early operating successes and failures, you will reassess value and your estimates will change, often significantly over time.I know that bothers some value investors, because they have been taught (wrongly in my view) that intrinsic value is stable and should not change over time. I am not bothered by the volatility in my value estimate, since the information that causes my estimate of value to change will also cause the price to change, and generally by far more. As an illustration, let me point to Facebook, a company that I have valued a half dozen times since its initial public offering in March 2012. My initial estimate of value for the company on the day of the offering was $27.07, well below the offering price of $38. A few months later, after a disappointing earnings report that suggested that their mobile advertising revenues may be lagging, I re-estimated the value of Facebook to be $23.94, a drop of approximately 13%, but the stock was trading at just under $19 (a drop of 50%). In fact, my value for Facebook has ranged from $24 to $30, while the price has fluctuated from $18 to $51. If your payoff in value investing is in finding mispriced stocks, I think that your odds are much better with stocks like Facebook and Twitter, where both your estimates of value and the market prices are subject to change, than in mature companies like Exxon Mobil or Coca Cola, where there is more Consensus about the future, and fewer uncertainties.
Young, growth companies are always over valued. This is an insidious myth that can be attributed to one of two forces. The first is that some value investors are born pessimists, who seem to believe that making bets on the future is a sign of weakness. The second is that some value investors rely on approaches for estimating value that are not only outdated, but simplistic. If your measure of value is to apply a constant PE (say 12) to next year’s earnings or to use a stable growth dividend discount model to value equity, you will never find a young, growth company to be a bargain. If you are creative in estimating value, willing to make assumptions about the future, persistent in tracking that value and patient in terms of timing (your buying and selling), there is no reason why you should not find growth companies to be bargains. I did not like Facebook at $38/share in March 2012 but I loved it at $18/share in September 2012, and while I would not touch Twitter today at $42/share, I would be interested at $15/share.

Trader Myths
On the trading side, there are two broad misconceptions about “value” that are just as misplaced and as dangerous as the three myths that value investors hold on to.

With young growth companies, value does not matter. This is, of course, the mirror image of the value investors’ lament that a young growth company cannot be valued. While value investors use it as a reason to not invest in the company, traders use it as a reason to ignore value, arguing that if no one can value a company, its price is entirely a function of what the market thinks it is, rather than fundamentals. Perception may be all that matters if you are pricing a piece of art (like this one that just sold for $142 million), but it cannot be with a share of a publicly traded business. After all, no matter what the promise or potential of a company, the stories eventually have to show up as numbers (revenues and earnings), and if perception is at odds with reality, it is perception (price) that will change, not reality.
Even if value does matter, it is best determined by focusing on the short term, where you have a chance of estimating numbers, rather than on the long term. With young, growth companies, analysts seem to prefer that the focus stay on the short term – next quarter, next year or perhaps two years out, using the excuse that going beyond that is an exercise in speculation. Ironically, it is the end game (the long term) that determines the value of young companies, rather than the near-term results. Put differently, it is not how Twitter does in 2014 that will be the arbiter of its value, but how the choices it makes in 2014 affect its long-term growth path.

I know that you are probably still skeptical about whether you can value young, growth companies and I empathize. I have struggled with young company valuations both technically (in coming up with cash flows, growth rates and discount rate) and psychologically (in fighting the instinct to flee from uncertainty) and I know that I will never quite master the process. However, each time I value one of these companies, I learn something new that I can incorporate into my tool kit. I have taken some of these lessons and put them into this paper on dealing with uncertainty that you are welcome to read (or ignore). Better still, pick a company that you are convinced cannot be valued and try valuing it. You may find it difficult, the first time around, but I promise you that it will only get easier. And it is so much more fun that valuing a utility or a bank!

Link to the original article: Valuation Myths: Young companies cannot be valued

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Professor of Finance at Stern Damodaran's Blog -- See my other wso posts

CorpFinHopeful

Neanderthal

Great article, thanks for sharing!

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Authored by: Certified Risk Management Professional - 1st Year AnalystCertified Risk Management Pro

Esuric

Human

Just capitalize R&D. It's easy.

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“Elections are a futures market for stolen property”

Extelleron

King Kong

I'd say Prof Damodaran is making a straw man argument. He assumes that when value investors say that "you can't value a tech startup or similar business" they literally mean that there is no way to estimate the value of these kinds of businesses. I don't think that is the case at all. Of course with some knowledge of what the business does you can come up with reasonable-looking projections and a reasonable-looking estimate of intrinsic value. But as an investor the question is not whether or not you can estimate intrinsic value, it is to what degree of accuracy you can estimate intrinsic value, specifically in regards to downside risk - how much lower could the real intrinsic value possibly be than your estimate? The goal is never to simply estimate intrinsic value and buy at any price below this; the goal is to buy only when there is a "margin of safety" and losing money is very unlikely. For a stock like Facebook or Twitter, where almost all of your estimate of value is coming from future growth and the company holds very few tangible assets, the required margin of safety would be enormous.

This then covers his second/third bullet points as well. I think value investors agree intrinsic value can change over time, particularly for some companies - but they would simply prefer to avoid such companies if possible, and would only invest in such companies at a high margin of safety. On the Third Point, again it comes down to the accuracy of your estimate. Maybe you value FB at $20/share, but all that really means is it's worth a range such as $10-30/share and $20 is the midpoint. If that's the case, then for a value investor whose primary goal is to not lose money, they would not buy the stock even at $18.

I just think Prof D has a warped view of value investors. Everybody knows you can do a valuation of any company; what separates value investors is they would argue that, for young, highly uncertain companies, the result of that valuation is not helpful for investing if your most important criteria is to not lose money. I'd say a value investor makes a conscious choice not to be "creative in estimating value."

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Authored by: Certified Hedge Fund Professional - 1st Year AnalystCertified Hedge Fund Pro

Ziad-Abouchadi

Monkey

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Authored by: Certified Sales & Trading Professional - 1st Year AssociateCertified Sales & Trading Pro

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