Entrepreneurial Finance H2

Valuation

Involves reasonable margin of error. Its not a precise estimate.

Asset valuation is difficult, because

Future returns associated with the asset are uncertain
Picking the right valuation model is not easy

Direct/absolute valuation methods used in practice

DDM
Operating Cash Flow model
Free Cash Flow model

Relative valuation used in practice

Peer group multiples

Why and when do VCs valuations?

To estimate an exit value before liquidating their investment position. For example, before an Initial public offering (IPO) or Acquisitions (Trade Sales).

Myths about valuation

Because valuation models are quantative, valuation is objective
Valuation numbers are timeless
Good valuation provides a precise estimate of value
The more quantitative a model, the better the valuation.

Debunking the myths about valuation

Value matters, not the process of valuation. Its more important to understand the company you value. The process of valuation can help you ask right questions about determinants of value.

Infinite dividends

Value is determined by an infinite stream of discounted dividends.

Infinite DDM model assumptions

Dividends grow at constant rate g
That constant growth will continue for infinite period
r must be greater than g

How can we estimate g in theory?

Sustainable growth rate is determined by growth of earning and the proportion of earnings reinvested in the company. Fundamental growth formula:

g = plowback ratio ROE
ROE = Net Income/Shareholder Equity
plowback ratio = (1-payout ratio)

How can we estimate g in practice?

use firm fundamentals (sustainable growth) g = plowback ratio * ROE
use historical avg growth (arithmetic, geometric)
use analysts forecasts (consensus growth forecasts)

How can we estimate r in practice?

Asset pricing model, like CAPM:

CAPM = rf + b*(rm-rf)

Estimate beta for non-traded betas (because Entrepreneurial companies are not traded)

Use fundamental factor analysis (regression with beta)

Comparable firms

Problem with growth companies using DDM model

Growth companies have opportunities to earn a return on investments  greater than their required rates of return.

To exploit these opportunities, entrepreneurial firms generally retain a high percentage of earnings for reinvestment, and their earnings grow faster than those of a typical firm.

Such time-varying growth rate is inconsistent with the dividend discount model assumptions. ‘Dividends grow at a constant rate’

Growth companies have opportunities to earn a return on investments greater than their

required rates of return

How do do growth companies exploit opportunities

Entrepreneurial firms generally retain a high percentage of earnings for reinvestment, and their earnings grow faster than those of a typical firm. (Inconsistent with DDM, where dividends grow at constant rate)

Advantages of DDM

Easy, because dividends are dollars which shareholders actually receive

Dividends fairly stable in short term which makes them easy to forecast in short term

Disadvantages of DDM

Dividend payout is not related to value in short term, and dividend forecasts ignore capital gains

Requires long forecast horizon

Most entrepreneurial firms do not pay dividends

When to use DDM

When payout is tied to value generated, for example when there is a fixed payout ratio (dividends/earnings)

Idea of FCF model

Firm value = discounted free cash flows available for distribution to all capital providers (debt and equity holders)

What is the discount rate for FCF model?

WACC

What is the terminal value TVn?

Price at which we can sell the firm at the end of the investment (time n, TVn = pv at time n of all future cash flows)

What is the WACC formula?

WACC = re*E/(D+E)+rd*(D/(D+E)*(1-tc)

Re

required return of equity investors

Rd

Cost of firm’s debt

Change in Net Working Capital

The money needed to run the business

Depreciation

Non-monetary fictional costs. Generates tax shield.

Capital Expenditures

Amount of money spent on investments that is a monetary outflow but not a cost

Advantages of FCF

Cash flows not affected by accounting rules

Formally correct and can accommodate variety of assumptions and scenarios

More realistic than DDM, as most entrepreneurial firms do not pay dividends

Disadvantages of FCF

FCF does not measure value added in short term, harder to forecast positive distant cash flows

FCF fails to recognize value that does not involve cash

Requires forecasting and assumptions of the evolution of many balance sheet items

To perform relative valuation

We need to identify comparable assets and obtain market values for these assets

We convert these market values into standardized values (since absolute prices cannot be compared). This creates price multiples.

Compare the multiple for the asset being analyzed to the multiples for comparable assets. Control for any differences between the firms that might affect the multiple. Decide whether the asset is under- or overvalued.

How can prices be standardized?

Using a common variable such as earnings, cash flows, book value, or sales.

What are the earnings multiples?

PE, PEG, relative PE

Value/EBIT(DA)

Value/cash flow

What are book value multiples?

Price/Book value

Value/Book value of assets

What are revenue-multiples?

Price/Sales per share

Value/Sales

What are industry-specific variables?

Price/customer, price per ton of steel, price/page view

How can we understand multiples?

Define the input to the multiple. Look at the distribution of the multiple. Cross sectional distribution provides a benchmark. It helps determine whether the multiple is too high or too low compared to the peers.

Define the comparable companies (peers): Defining the comparable universe.

How can we make sure the input is consistently defined?

Both the value (numerator) and the standardizing variable (denominator) should accrue to the same stakeholders in the firm. Therefore, the value of equity should be divided by equity earnings or equity book value, and firm value should be divided by firm earnings or firm book value.

How can we make sure the multiple is uniformly estimated?

The input variables used in defining the multiple should be estimated uniformly across all assets in the list of comparable firms.

If earnings-based multiples are used, the accounting rules to measure earnings should be applied consistently across assets (the same rule applies with book-value based multiples)

Why is the median more reliable comparison point than the average?

Because the average can get skewed up or down by extreme outliers

How to deal with these outliers?

Throwing them out (censoring) may seem obvious, but if they lie mostly on the side (usually large positive numbers), this can lead to a biased estimate (skewness).

Are there cases where the multiple cannot be estimated?

When the denominator is negative or 0 (for example negative P/E-ratio is meaningless)

What is the danger of ignoring missing values? (negative profits)

When you let out some negative or bad ratios, you mislead the valuation process.

Why should you watch out for a right-skewed distribution with multiples over time?

During bubbles, multiples of some firms can shoot up a lot. This will create a right-skewed distribution which will be misleading for the average.

Comparable firm traditional view

A firm in the same industry/sector

Comparable firm valuation theory view

A firm that is similar in fundamentals. (risk, growth, cash flow patterns; So you can compare a firm in different industry with same fundamentals)

Why is PE-ratio one of the most widely used multiples?

Relates the price paid to current earnings

Simple to use for most stocks and widely available (Making comparisons across stocks easy)

Has a link to firm fundamentals, such as growth and risk.

Caveats/Risks of using PE-ratio

Its a way for some analysts to avoid being explicit about their assumptions risk, growth and payout ratios

They are much more likely to reflect market moods and perceptions, which can be viewed as weakness, especially when markets make systematic errors (e.g. The Dotcom bubble)

What is the link between PE-ratio and fundamentals?

PE ratio is driven by fundamentals like growth, risk and payout. Similar to absolute valuation model, like cash flow models.

How to apply PE ratios?

Exploiting the entire cross-section in a regression approach.The info in the entire cross section of firms can be used to calculate PE ratios. This info can be summarized with a multiple regression, when the PE ratio as the dependent variable, and proxies for risk, growth and payout forming the independent variables. Then use the estimated coefficients to predict the PE of the target firm.

When comparisons are made between firms, we have to control for differences in fundamentals. Does using other firms as the control group work?

No, because firms within the same industry can have very different business risk and growth profiles.

Pros of using comparable firms

Choose a group of comparable firms, calculate the average PE ratio, and subjectively adjust this average for differences.

Cons of using comparable firms

The definition of comparable firm is subjective.

Why are Value/EBIT(DA) multiples popular?

This multiple can be computed even for firms with net loss, because earnings before interest, taxes and depreciation are usually positive.

For firms in certain industries requiring substantial infrastructure investment and long gestation periods, this multiple seems more appropriate than the price/earnings ratio.

By looking at the enterprise value (not just equity value) and pre-debt cash flows, the multiple is capital structure-neutral → allows for comparisons across firms with different financial leverage. Different leverage is more common in Private Equity/Later-stage VC deals.

Link between both DCF and DDM model and Value/EBIT(DA) multiple

The terminal value in DCF and DDM valuation often calculated using exit multiples, usually based on Value/EBIT(DA)

Free cash flow

Maximum dividend the firm is able to pay

Link between multiples and and DDM and Cash flow valuation?

Both driven by fundamentals

When assuming an infinite horizon, it can be mathematically shown that the dividend discount model and cash flow model …. ?

Generate similar value estimates (Lundholm and O’Keefe, 2001)

Kaplan and Ruback (1995) and Gilson, Hotchkiss, and Ruback (2000) find that multiples and discounted cash flow models perform at least as well in ….

Valuing leveraged buyouts and bankrupt firms

Which model to choose?

Usually based on availability, theoretically not much difference between models.

Gompers et al. (2019), find the early-stage VCs are more likely to use multiples, while late-stage VCs are more likely to use the FCF model. The late stage VCs are also likely to …

Use more than just 1 model.