This chapter is from the book
This chapter is from the book
This chapter is from the book
Valuation Issues
The shared characteristics of growth firms—dynamic financials, a mix of public and private equity, disconnects between market value and operating data, a dependence on equity funding, and a short and volatile market history—have consequences for both intrinsic and relative valuations.
Intrinsic Value
If a company’s intrinsic value comes from its cash flows and risk characteristics, we will run into problems while valuing growth companies that can be traced back to where they are in the life cycle. This section breaks down the valuation issues specific to growth companies by the key components of intrinsic value—existing asset value, growth asset value, risk (discount rates), terminal value, and equity value per share.
Existing Assets
To value existing assets, we start with the cash flows generated by these assets and discount back at an appropriate risk-adjusted rate. Two considerations can make this measurement complicated for growth firms:
Poorly measured earnings: With growth firms, existing assets tend to be a small part of overall value and can easily be swamped by what a firm expends to sustain and nurture its growth assets. Consider, for instance, the standard assumption that we make in discounted cash flow valuation that the existing operating income can be attributed to existing assets and thus be the basis for valuing those assets. With any company, the existing operating income (or loss) will be after selling, advertising, and other administrative expenses. While we assume that these expenses are associated with existing assets, that assumption might not hold up in a growth company. After all, the sales force in a growth company might be less interested in pushing existing products and more focused on cultivating a customer base for future products. By treating all sales expenses as operating expenses, we are understating the earnings from and consequently the value of existing assets.
Shifting profitability: If one of the key inputs into value is the measure of the firm’s future profitability, the fact that margins and returns at growth firms change significantly over time can make it difficult to make forecasts. Unlike mature firms, where margins usually move within a narrow range and returns are stable, using past margins and returns to forecast future values for a growth firm might not yield reasonable numbers.
Growth Assets
The bulk of a value for a growth company obviously comes from growth assets, making it imperative that we assess the value correctly. The challenges we face in attaching a reasonable value to growth assets in a growth company can also be daunting:
The scaling effect on growth: One of the biggest questions we have to answer about a company’s expected growth rates is how they will be affected by the company’s changing size. Consider, for instance, a company that has posted a compounded annual growth rate of 80% over the last five years. The company today is obviously much larger (by a factor of 18) than it was five years ago.1 It is extremely unlikely that it will be able to maintain an 80% growth rate for the next year given its larger size. In general, delivering a given growth rate becomes more difficult as a company gets bigger.
Success attracts competition: A small company can operate under the radar and sometimes show exceptional profitability. As the company grows, though, its success attracts attention from larger and more predatory competitors, often possessing more significant resources. This competition, in turn, results in lower profitability and value for growth.
Macroeconomic effects: While all companies are susceptible to macroeconomic shocks, small companies are more exposed to economic downturns, because their products are often niche products that are discretionary. While customers might be inclined to buy them in good economic times, they are likely to hold back during recessions or economic slowdowns.
Questions about how quickly growth rates will scale down, how profitability will survive competitive assaults, and the effects of overall economic growth will have to be answered if we intend to attach a value to growth assets.
Discount Rates
The two key determinants of discount rates are the risk in the underlying investments of a business and the mix of debt and equity used to fund the business. On both dimensions, growth companies pose a challenge in valuation:
Risk of existing assets versus risk of growth assets: Because growth companies derive significant value from both growth assets and existing assets, delineating the risk in each category can make a big difference in how we value them. In other words, if growth assets are riskier than existing assets, we should be using higher discount rates for expected cash flows from the former and lower discount rates for cash flows from the latter. However, making this judgment on risk from the historical information is difficult, especially using stock price data, because it is for the consolidated firm (and not for existing or growth assets as individual groupings).
Market value versus book value ratios and volatile market value: The conventional practice of estimating the weights to use for debt and equity in the cost of capital computation is to use market values for both. With growth firms, we should follow the same practice, but the volatility in stock prices can result in weights that change with the prices. In particular, a drop in the stock price can lead to a much higher debt ratio and potentially a lower cost of capital for a firm; this will strike some as counterintuitive.
Changing risk for the firm over time: If computing the current risk parameters and debt ratio for a growth firm is difficult, the task is complicated further by a simple fact. On both dimensions, growth firms can be expected to change over time, leading to discount rates that vary across the years. To be more specific, as a firm becomes larger over time (as it will in future periods, with growth), we should expect existing assets to become a larger proportion of overall value and risk measures to change to reflect the firm’s increasing (and more stable) earnings. Concurrently, the firm’s capacity to borrow money will increase. If it exploits this capacity, its debt ratio will change as well. Generally speaking, the discount rates used to value growth firms should be higher in the earlier periods and decrease in later periods toward mature company levels.
Terminal Value
Two key questions that overhang the valuation of any firm relate to when the firm will become a stable growth firm and the characteristics it will possess in this phase. The answer to the first question will determine the length of the high-growth period, with the terminal value being computed on the assumption that growth beyond that point will be sustained forever. The answer to the second question, especially on risk and the returns generated on new investments, will influence the value we assign to the firm, for any given level of growth. Again, while these are estimation issues that arise in any valuation, they can be more problematic for growth companies for the following reasons:
Terminal value is a big proportion of value: Because growth companies generate relatively low cash flows from existing assets, the terminal value comprises a much larger proportion of their overall value. Thus, the assumptions we make about how a firm gets to its terminal value, and what it will look like when that happens, will matter more in any assessment of current value for a growth firm than at a mature firm.
More uncertainty about terminal value assumptions: Concurrent with the terminal value being a larger proportion of the value of a growth company than for a mature firm is the fact that there is significantly more uncertainty about assessing that value for two reasons. First, we are looking at a young and often untested firm and assessing not only how quickly it will continue to grow but also how it will respond to more aggressive competition. Second, the fact that the firm is evolving makes it difficult to evaluate what market it is aspiring to be in or even who its direct competitors are.
Terminal value characteristics: Earlier in this section we noted the difficulties we face in arriving at the current cash flows, returns, and discount rates for a growth firm. We will be called on to estimate all these numbers again, when we put the firm into stable growth, in 10 or 15 years. If we cannot estimate the current cost of capital for a growth firm, it seems unreasonable to believe that we can estimate this and other numbers for the same firm ten or 15 years in the future.
The irony of terminal value estimation for growth firms is that it is more important that we get it right and that we have far less basis for making the estimate in the first place. How we resolve this contradiction will play a key role in whether the value we arrive at for a growth firm is a reasonable one.
Value of Equity per Share
To get from the value of the operating assets to the value of equity per share, we generally add the value of cash and cross-holdings, subtract debt and nonequity claims, and then divide by the number of shares in the firm. While these steps stay intact for growth companies, we face issues at each step:
Cash balances and cash burn ratios: In most firm valuations, we get information on cash balances from financial statements (usually the most recent balance sheet). For growth firms, especially early in the growth phase, where reinvestment needs can be substantial, cash balances can be dissipated very quickly. The pace of cash usage, generally called the cash burn rate, can result in a cash balance today (which is when we are valuing the company) that is very different from cash balance on the most recent fiscal statement.
Convertible debt and preferred stock: When growth firms raise funds from nonequity investors, they seldom use conventional debt—bank loans and straight bonds. More common is the use of the convertible debt, either in the form of bank loans with equity sweeteners or convertible bonds. The key advantage of using hybrids such as these is that interest payments are kept low in return for providing equity options to lenders. Because only debt should be subtracted to get to equity values, we should break convertible debt into debt and equity components, with the equity options going into the latter.
Voting and nonvoting shares: Voting and nonvoting shares are not unique to growth firms, but they are much more common in these companies than in mature firms. This is largely because these firms are young, and the founders are still not only significantly stockholders but also value being able to control the firms they have created. One way to maintain control, while raising equity from the general public, is to create two classes of share and to preserve a hold on the company by retaining the voting shares. When estimating the value of equity per share, we therefore must determine how (if at all) we will differentiate shares with higher voting rights from shares without (or with lower) voting rights.
In summary, getting from the value of operating assets to the value of equity per share can pose a series of roadblocks and diversions with growth firms.
Relative Valuation
Many analysts, when confronted with the intrinsic valuation problems outlined earlier, decide that relative valuation is a much easier path to follow with growth companies. Not surprisingly, the issues that make discounted cash flow valuation difficult also crop up when we do relative valuation:
Comparable firms: The conventional practice of using other publicly traded companies in the same sector can be dangerous for a couple reasons. The first is that a growth company in a mature sector will (and should) bear little or no resemblance on either fundamentals or pricing multiples to the rest of the firms in the sector. The second reason is that even if every firm in the sector has growth potential, growth firms can vary widely in terms of risk and growth characteristics, thus making it difficult to generalize from industry averages.
Base year values and choice of multiples: Most multiples are stated as a function of base year values for revenues, earnings, and book value. To estimate the PE ratio, for instance, we divide the stock price today by the earnings per share in the most recent fiscal year or four quarters. If a firm is young, the current values for these numbers will bear little resemblance to the firm’s future potential. Using PE ratios to illustrate this point, this can lead to either very high PE ratios (because current earnings per share will be small relative to stock prices today) or not meaningful values (because earnings currently are negative and PE ratios cannot be computed) for many growth companies. Moving up the income statement to EBITDA or revenues offers little solace, because the values for these items will also be low relative to value.
Controlling for growth differences: Because growth potential is the key dimension on which these firms vary, it becomes critical that we control for growth when comparing firms or extrapolating from industry averages. Unfortunately, the relationship between growth and value is too complex to lend itself to the simplistic generalizations that make relative valuation so attractive to both analysts and investors. Not only does the level of growth make a difference to value, but so does the length of the growth period and the excess returns that accompany that growth rate. Put another way, two companies with the same expected growth rate in earnings can trade at very different multiples of these earnings, because they vary on other dimensions.
Controlling for risk differences: Growth and risk are twin variables, with higher values for one generally going with higher values for the other. Determining how the net trade-off will affect value is difficult to do in any valuation, but it is doubly so in relative valuation, where many companies have both high growth and high risk. Furthermore, as risk and growth characteristics change over time, as they inevitably do for any growth company, the multiple we will apply to the company’s operating numbers should also change.
Analysts who use multiples and comparable firms to value growth firms might feel a false sense of security about their valuations, because their assumptions are often implicit rather than explicit. The reality, though, is that relative valuations yield valuations that are just as subject to error as discounted cash flow valuations.