This publication is broken up into three sections:
TL;DR - For those wanting a quick take
Summary - For those wanting a bit more context and high level points
Article - Main body of work containing full detailed article and explanations that you might want to consume over several readings
TL;DR
Valuing high-growth, high-uncertainty companies is a challenge for a couple of reasons:
No long dated historical data
Growth rates that exceed 15% p.a. usually are short-lived
Usually high-growth companies are growing out from their development cost phase i.e. J-Curve
One of the best ways that has been identified to value high-growth companies is with an ‘old school’ Discounted Cash Flow (DCF) valuation backed up with unit economic fundamentals and some scenario analysis.
Key steps to execute on the above:
Start from the present but keep the future in mind
Size the market and potential to capture portion of market
Apply judgment for reasonableness
Estimate operating margin, capital intensity and ROIC
Link future state to current state
Develop scenarios
See main article for application of above approach used on a high growth venture called Open Table.
Summary
The core principles of economics and finance are still applicable despite claims they no longer apply i.e., ‘zero marginal cost believers’ which might be true for services in the bits realm but less true in the world of atoms.
For a high-growth business the emphasis of the various components of a DCF valuation vary. Instead of analysing historical data, we need to start by examining the expected long-term development a company’s market and then work backward.
One of the best ways that has been identified to value high-growth companies is with an ‘old school’ Discounted Cash Flow (DCF) valuation backed up with unit economic fundamentals and some scenario analysis.
Key steps to execute on the above:
Start from the present but keep the future in mind - High-growth company valuation requires you to start with considering how your industry and company could look like as a company evolves from its current high-growth, uncertain condition to a sustainable, moderate growth state in the future.
Size the market - To forecast the potential market for a high-growth business you need to estimate the potential market for your product or service.
Apply judgment for reasonableness - Consider what is Possible, Plausible and Probable.
Estimate operating margin, capital intensity and ROIC:
Understanding Long-Term Operating Margins
Required Capital Investments
Return on Invested Capital
Link future state to current state
To determine the speed the speed of transition from current performance to target state performance you need to consider the historical progression for similar companies.
For high-growth companies historical financial performance can be misleading because long-term investments for high-growth companies tend to be of an intangible nature. Under the current accounting rules these investments must be expensed.
Develop scenarios - Actionable scenario analysis takes a probabilistic approach i.e., probability-weighted scenarios. Scenario analysis is useful for explicitly making assumptions and key interactions transparent.
See article below for application of above approach used on a high growth venture called Open Table.
Article
Quick revision
The last article mentioned core tenets of value creation and destruction which boil down to the following management rules of thumb:
Conservation of Value - Any management action that does not increase cash flow does not increase value.
Value Destruction - When Return on Invested Capital (ROIC) is lower than a company’s Weighted Average Cost of Capital (WACC) (i.e., WACC > ROIC), faster growth necessarily destroys value.
Focus on ROIC before Growth - If a company has a high ROIC and is greater than the cost of capital (i.e., ROIC > WACC), focusing on growth (g) will increase value exponentially versus when ROIC is less than the cost of capital captured via WACC.
The above is neatly summarized in the following:
Where a company’s value can be concisely described with a few simplifying assumptions into the following:
Where NOPLAT stands for Net Operating Profit Less Adjusted Taxes.
One thing that is clear is that difficult economic conditions (circa 2022) are forcing already established and fast-growing companies to consider business fundamentals like unit economics and free cash flow generation.
Given this context one could ask how could such a valuation approach be applied to fast growing start-ups especially where long-run historical data does not exist and fast growth will continue increasing at a decreasing rate?
What makes fast growing start-ups different?
Valuing high-growth, high-uncertainty companies is a challenge for a couple of reasons:
No long dated historical data
Growth rates that exceed 15% p.a. usually are short-lived
Usually high-growth companies are growing out from their development cost phase i.e. J-Curve
One of the best ways that has been identified to value high-growth companies is with an ‘old school’ Discounted Cash Flow (DCF) valuation backed up with unit economic fundamentals and some scenario analysis.
The core principles of economics and finance are still applicable despite claims they no longer apply i.e., ‘zero marginal cost believers’ which might be true for services in the bits realm but less true in the world of atoms.
Alternative methods of valuation like price-earnings multiples, generate imprecise results when earnings are volatile and cannot be used when earnings are negative and highlight very little as to what drives a company’s valuation. High-growth start-ups are usually not earnings positive in the early years and have volatile growth rates.
Real options can be used but require the same sort of inputs used in DCF calculations like long-term revenue growth, long-term volatility of revenue growth and profit margins.
Issues to Consider When Valuing High Growth Start Ups
For a high-growth business the emphasis of the various components of a DCF valuation vary. Instead of analysing historical data, we need to start by examining the expected long-term development a company’s market and then work backward.
Given that high-growth companies operate in conditions of high uncertainty it is always important to create multiple scenarios. The scenarios specify how a market could develop under different conditions.
Valuation process for high-growth businesses
Usually we start with analysing historical performance data for established businesses however for a high-growth company, historical financial results provide limited clues about future prospects.
It makes far more sense to start with the future and to look back. What I mean by this is that you need to focus on sizing the market you operate in, predicting levels of profitability and estimating the investments necessary to achieve scale.
This sounds very much like the approach used by VCs to assess nascent businesses in new markets providing new products and services.
Making these estimates requires you to choose a point well into the future, at a time when your business’s financial performance is likely to stabilize and begin forecasting.
Once you have developed a long-term future view, work backward to link the future to current operational performance measures. Given high uncertainty associated with high-growth companies, do not rely on a single long-term forecast.
Factors to consider in a market development include scenarios, including total market size, ease of market entry. Scenarios should include revenue growth, profitability margins, capital investment which should be consistent with the underlying assumptions of a particular scenario. Valuations that rely too heavily on unrealistic assumptions can lead to overestimates of value and to strategic errors.
1. Start from the present but keep the future in mind
High-growth company valuation requires you to start with considering how your industry and company could look like as a company evolves from its current high-growth, uncertain condition to a sustainable, moderate growth state in the future.
The future state should be defined and bounded by measures of operating performance such as penetration rates, revenue per customer and gross margins.
Estimate how long hyper growth will continue before growth stabilizes. Since most high-growth companies are start-ups stable economics probably lie at least 10 to 15 years in the future.
2. Size the market
Total Addressable Market - To forecast the potential market for a high-growth business you need to estimate the potential market for your product or service. It’s the maximum amount of revenue a business can possibly generate by selling their product or service in a specific market. Total addressable market is most useful for businesses to objectively estimate a specific market’s potential for growth.
Service Addressable Market - The next step is to estimate the portion of the market you could feasibly address. The serviceable addressable market is most useful for businesses to objectively estimate the portion of the market they could feasibly acquire to determine their targets.
Service Obtainable Market - Due to the limitations of your business model (such as specialization or geographic limitations), you will not likely be able to fully capture your service addressable market.
3. Apply judgment for reasonableness
Sizing the potential market for your business’s products and services requires numerous inputs, each of which is uncertain. Small errors can compound into large errors in the aggregate.
It’s useful to compare the first five years of revenue growth with other similar or comparable companies to get a baseline or reference point.
Estimates should be consistent with economic principles and industry characteristics. For example, for operating margin you need to consider how long fixed costs dominate variable costs resulting in low margins. In the case of capital turnover what scale is required before revenues rise faster than capital requirements.
Consider what is Possible, Plausible and Probable.
4. Estimate operating margin, capital intensity and ROIC
Once the initial revenue forecast is in place, the next issues to address are:
Understanding Long-Term Operating Margins – to estimate operating margin you need to triangulate between your internal project cost projections (CAPEX) versus market prices and operating margins (OPEX) for established businesses. Critical to building this view is that senior management or executives need to provide input into long-terms business expenditure like operations, product development, sales, marketing etc.
Required Capital Investments – Forecasting capital requirements enables us to estimate cash flow from operating profit. Most businesses require capital to grow however there are instances of companies having negative invested capital. This comes about in cases when stakeholders like customers, suppliers and employees provide more capital than is needed for receivables, inventory, property and equipment.
Return on Invested Capital – the returns generated on invested capital in a fixed period of time. If a business is capital light then the ROIC will be high versus capital heavy businesses which will have relatively lower ROICs e.g., software technology companies have lower capital requirements as compared to hardware technology manufacturers.
5. Link future state to current state
By now the following forecasts should be available:
Total Market Size
Market Share
Operating Margin
Capital Intensity
An important caveat is that analysing historical performance for high-growth companies tends to be misleading because long-term investments for high-growth companies tend to be intangible. Current accounting rules require these investments to be expensed. This means that both early accounting profits and invested capital will be understated. Another key implication is companies with early accounting profits and very little formal invested capital will have unreasonably high ROICs as soon as they become profitable.
6. Develop scenarios
Actionable scenario analysis takes a probabilistic approach i.e., probability-weighted scenarios. Scenario analysis is useful for explicitly making assumptions and key interactions transparent.
To develop probability-weighted scenarios, estimate a future set of financials for a full range of outcomes e.g., a negative/pessimistic scenario, a base case/neutral scenario and a positive/optimistic scenario.
Scenario probabilities are unobservable and highly subjective. Forecasts built on fundamental economic analysis such as market size, market shares and competitor margins should be calibrated against the historical performance of other direct peer or comparable high growth companies.
There is a lot of uncertainty associated with figuring out if a high-growth company will tend towards being a winner in its market or whether it will be a has been. A few players can win big but determining who they will be upfront is incredibly difficult.
One key point to emphasise is that judgement is key here.
Case Study
Let’s look at an example from the McK & Co. book on Valuation 7th Edition.
1. Start from the present but keep the future in mind
OpenTable started as a company that provides that provides the end customer with an online-up-to-date list of available restaurant seating near the customer’s location. The list could be sorted by cuisine, price, other features plus a description of the establishment.
With a single click the user can select a restaurant, select a time for seating and get directions.
OpenTable acts an aggregator for diners on the demand side and eateries on the supply side and facilitates booking interactions between diners and restaurants.
In exchange for facilitating and managing the interaction, OpenTable monetized their solution by licensing a product called Electronic Reservation Book (ERB) and they also installed proprietary computer systems and software that manages reservations, manages table seating, recognizes guests and markets through emails.
The OpenTable business model revolves around charging an installation fee, a monthly subscription fee to the restaurant and a seated-diner fee.
Between 2004 and 2008 revenues grew from $10m to almost $56m representing a compound annual growth rate (cagr) of 53 percent per year.
As of 2008 approximately 34m diners had used OpenTable to book reservations at 10,335 restaurants.
In 2008, 90 percent of revenues were generated in the United States but they were in the process on expanding to other countries like German, Japan and the United Kingdom.
What are the key questions for growth?
What new markets could OpenTable enter?
What unmet but important needs could OpenTable meet that would require product development?
What incremental extensions could be made to existing products and services to further entrench their existing solutions
What adjacent business models could they create that leverage existing capabilities?
Are there white space opportunities they could deploy their capabilities against that are not being considered?
The above questions can help to frame a growth narrative around business strategy and how a business intends to grow for years to come.
2. Sizing the Market
To size the opportunity you can start off by estimating the potential market for subscription fees. Based on information supplied by then management, OpenTable served 30 percent of the 30,000 U.S.-based reservation taking restaurants. To contextualise the number we need to remember TAM, SAM and SOM. All restaurants constitute the total market, whereas reservation-taking restaurants constitute the addressable market.
Growth in restaurants was correlated with growth in US economy. To set an upper bound on the estimate of OpenTable potential market share, they used San Francisco, the company’s first market as a reference market. In 2008 they served 60 percent of San Francisco reservation-taking restaurants, which is twice the share of the addressable U.S. market. An assumption could be made that they reach 60 percent nation-wide.
Generally forecasting a 60 percent market share is very aggressive since competitors could enter the space however for certain types of businesses like online aggregators combining business software capturing a large chunk of the market is a real possibility. Examples of this type of effect can be found with Microsoft’s Windows Operating System and IBMs MVS mainframe software, they both have 80 percent share of their respective markets.
OpenTable at the time estimated that restaurants would grow at 2 percent a year (twice the rate of population) which leads to an estimate of just over 36 500 restaurants by 2018. Assuming the 60 percent market this leads to a client base of approximately 21 900 in 2018 in the United States.
OpenTable at the time was also considering entering international markets. For international growth a separate forecast would be required as well. The figures shared for international growth increased the total number of restaurants to 37 930.
The business model for OpenTable was mixed: it included a once-off installation fee, an ongoing monthly subscription fee and a seated diner fee.
Based on the subscription business model OpenTable could be forecasted to generate $191m of revenue based at $5.1k annual subscription.
3. Assessing Reasonableness
Sizing the potential market for OpenTable requires numerous inputs each of which is uncertain to a degree. Small errors can compound into large mistakes on aggregate.
Useful checks to employ include comparing the first five years of revenue growth with other internet companies that hit $10m of revenue. Between 2004 and 2008, OpenTable grew revenues from $10.1m to $55.8m which is aligned to other median internet companies passing that threshold.
4. Estimating operating margin, capital intensity and ROIC
This speaks to the core of how a business operates and generates value. OpenTable management projected eventual margins of 30-35%.
To contextualise these margins you would need to compare against other aggregator like businesses for instance online travel brokers like Expedia, Priceline.com and Orbitz Worldwide. Expedia back in 2008 or so generated 25.9 percent EBITDA margin, whereas the smallest player Orbitz Worldwide generated only 11.5 percent. OpenTables EBITDA margin forecast of 30 percent plus or so is reasonable given that they were the market leader in the space and had very little competition.
However if you look at other aggregator businesses like Monster. Monster provides online career services that match job seekers with potential employers. Unlike the travel industry, Monster competes in a market where the largest player has a natural advantage. Similar to OpenTable’s market job seekers want to affiliate with a site that contains the most job openings or postings and employers want to post employment on a site with the most candidates.
In 2007 Monster generated more than $1.3bn in revenue and EBITDA margins of 24.8 percent. OpenTables margin estimates of 30-35 percent could be a bit aggressive.
When it comes to forecasting capital requirements OpenTable generated $5.5m of capital on $55.8m of revenues. This is mainly because operating liabilities, which include accounts payable and customer prepayments, exceed operating assets like property and equipment.
Based on the data at the time a question could be asked as to whether OpenTable can expect operations to continue providing capital. Based on other similar aggregator technology businesses the answer is yes. At the time Expedia, Orbitz Worldwide and Monster have negative invested capital for example Monster generates $0.095 cents in capital for every $1 in revenue.
With positive operating profits and negative invested capital, return on invested capital (ROIC) is no longer meaningful.
A question could be asked what prevents other competitors from entering and competing away the profit pool?
4. Link future state to current performance –
To determine the speed the speed of transition from current performance to target state performance you need to consider the historical progression for similar companies.
For high-growth companies historical financial performance can be misleading because long-term investments for high-growth companies tend to be of an intangible nature. Under the current accounting rules these investments must be expensed.
With very little formal capital and early accounting profits, ROICS will be extremely high.
Amazon.com in 2003 had an accumulated deficit of $3.0bn even though revenues and gross profits had grow. How did this occur?
Marketing and technology-related expenses (SG&A) significantly outweighed gross profits. In the years between 1999 and 2003, Amazon.com expensed $742m in marketing and $1.1bn in technology development.
In 1999, Amazon’s marketing expense was 10 percent of revenue whereas a company like Best Buy at the time was spending 2 percent of revenue on advertising. The differential could be explained as Amazon undertaking a brand building exercise which is a long-term asset that is not really well captured by today’s accounting systems.
This ends up distorting ROIC which is overstated for a high-growth company since invested capital is understated. This also partly explains some barriers to entry for future entrants that will need to spend significantly to build their brand and awareness of their organization’s existence.
5. Scenario Analysis
To develop probability-weighted scenarios estimate a future set of financials for a full range of outcomes: base case, optimistic case and a negative case.
Scenario A (Optimistic Case) - Assume OpenTable progresses better than expected. The company is able to move from reservation management into general restaurant management, including food and beverage management, staffing and accounting systems. By replacing competitors, OpenTable is able to more than double expected subscription fees for 2018 from $430 to $890 per restaurant. This leads to an equity valuation of $1.14bn.
Scenario B (Base Case) – Revenues grow to $310m, restaurants served grow to 37 900 with an average subscription fee of $430 per restaurant and operating margins rise to 31 percent. In this scenario OpenTable has an estimated equity value equal to $719m
Scenario C (Pessimistic Case) – In scenario C, OpenTable only generates $220m in revenue by 2018 because international expansion goes poorly. Although the company has grown in target markets, they are force to withdraw in some markets and growth is sluggish in other markets. In this scenario, OpenTable has an equity value of $545m.
6. Valuation
To derive current value for OpenTable, weight the potential equity value from each scenario.
As was mentioned previously each probability is unobservable so this is a judgment call. Consider the narrative on your valuation, what is possible, plausible and probable?
To estimate the company’s current equity value find the sum of each scenario’s contribution.
Based on the above OpenTable’s equity valuation comes out as $751m with an implied share price of $34. In May 2009, OpenTable went public and their shares closed at $31.89 on the first day of trading.
Accurately predicting which scenario will occur is note worthy but achieving it is unlikely. Investors struggle to incorporate new information every day and this leads to high volatility in the share prices of of young companies.
For example OpenTable had three times the volatility of the S&P 500during its first year of trading. As OpenTable grows and its prospects solidify however , it should be possible to tighten the range of potential outcomes. These gains in precision should be reflected in a decrease in the stock’s volatility
Post Script
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Resources
Revenue growth and ROIC are all that matter
Return on Invested Capital and Growth: Key Value Drivers
Valuation by Tim Koller, Marc Goedhart and David Wessels