Let’s start this topic with an important question: How will you categorize a company into high-growth? Many practitioners have defined that to be considered as high-growth, the company must generate organically a growth in revenues that exceed 15 percent annually.
Now let’s consider that you would like to value one company which is classified into high-growth. How will you proceed? It is challenging even some professionals have described it as hopeless. However, I am going to tell you the recipe to bring some correct numbers on the table.
As I wrote previously in an article regarding Private Company Valuation, there are three major approaches to value private companies:
Income approach: Values a firm as the present value of its future income. It relies on different assumptions and variations.
Market approach: Values a firm using the price multiples based on recent market transactions.
Asset-based approach: Values a firm’s assets minus its liabilities.
The selection of an appropriate valuation method depends on the firm’s operations and its life cycle stage. For Early-stage companies, future cash flows may be subject to uncertainty and we may use an asset-based approach. For mature companies, we might pick the market approach. For high growth companies, we might use an income approach.
Indeed, the best way to value high-growth companies is with a discounted cash flow (DCF) valuation, buttressed by economic fundamentals and probability-weighted scenarios. DCF may sound suspicious for you however it works where other methods fail since the core principles of economics and finance apply even in uncharted territory. Alternatives, such as price-earnings multiples, generate imprecise results when earnings are highly volatile, cannot be used when earnings are negative, and provide little insight into what drives the company’s valuation.
Discounted Cash Flow Valuation for High-Growth Companies
As you certainly know, for well-established companies, we analyze historical performance. But in the case of a high-growth company, historical financial results provide limited clues about future prospects. Therefore, for high-growth companies, we start by examining the expected long-term development of the company’s markets and then work backwards.
To do so, we focus on sizing the potential market, predicting the level of sustainable profitability, and estimating the investments necessary to achieve scale. To make these estimates, choose a point well into the future, at a time when the company’s financial performance is likely to stabilize and begin forecasting. Once you have developed a long-term future view, work backwards to link the future to current performance.
Due to the uncertainty relative to the long-term projections, we will not rely on a single forecast. We will create multiple scenarios. Each of them will detail how the market might develop under different conditions.
When you build a comprehensive scenario, be sure all forecasts, including revenue growth, profitability margins, and required investment, are consistent with the underlying assumptions of the particular scenario. Apply probabilistic weights to each scenario, using weights that are consistent with long-term historical evidence on corporate growth.
And keep in mind that while scenario can help bound and quantify uncertainty, they will not make it disappear. Moreover, as we saw during the Internet bubble in 2000-2001, valuations that rely too heavily on unrealistic assessments can lead to overestimates of value and to strategic errors.
Think Future
As I mentioned above, when valuing high-growth companies, you will start by thinking about what the industry and company might look like as the company evolves from its current high-growth to a sustainable and moderate-growth state in the future. Then interpolate back to current performance.
Next, you will determine how long hyper-growth will continue before growth stabilizes to normal levels. Since most high-growth companies are start-ups, stable economics probably lie at least 10 to 15 years in the future.
The process will be as follow:
- Sizing the market – To estimate the size of a potential market, start by assessing how the company fulfils a customer need. Then determine how the company generates (or plans to generate) revenue. Understanding how a start-up makes money is critical. Many young companies build a product or service that meets the customer’s need, but cannot identify how to monetize the value they provide.
- Assessing reasonableness – Sizing the potential market for a company requires numerous inputs, each of which is uncertain. Small miscalculations in individual forecast items can compound into large mistakes in aggregate. Therefore, we must compare our forecasts with the similar companies that experienced the same growth a few years back.
- Estimating operating margin, capital intensity, and ROIC – With a revenue forecast in hand, firstly we will estimate operating margin, that we triangulate between internal cost projections (versus market prices) and operating margins for established players. For internal cost projections, we rely on company projections that we forecasted at a previous stage. We must take into account the management’s economies of scale impact. To address this question, we will examine other companies that provide a similar conduit between consumers and businesses. Secondly, to convert after-tax operating profit into cash flow, we next forecast capital requirements. Most businesses require significant capital to grow. Finally, we calculate the ROIC and compare with companies that experienced a similar situation.
Work Backward to Current Performance
Now we have to reconnect the long-term forecast back to current performance. To do this, you have to assess the speed of transition from current performance to future long-term performance. We will examine the historical progression for similar companies. Unfortunately, analyzing historical financial performance for high-growth companies is often misleading, because long-term investments for high-growth companies tend to be intangible.
Under current accounting rules, these investments must be expensed. Therefore, both early accounting profits and invested capital will be understated.With so little formal capital, many companies have unreasonably high ROICs as soon as they become profitable. Consequently, ROIC overstates the potential return on capital for new entrants because it ignores historically expensed investment.
Develop Weighted Scenarios with Historical Evidence
A simple and straightforward way to deal with the uncertainty associated with high-growth companies is to use probability-weighted scenarios. To develop probability-weighted scenarios, estimate a future set of financials for a full range of outcomes, some optimistic, some pessimistic.
To derive current equity value, we will weight the potential equity value from each scenario by its estimated likelihood of occurrence. Be aware that the scenario probabilities are unobservable and highly subjective. As a result, the final valuation will be quite sensitive to probability weightings.
Thus, any set of forecasts built on fundamental economic analysis – such as market size, market share, and competitor margins – should be calibrated against the historical performance of other high-growth companies. Otherwise, assigning too high a weight to an implausible scenario could make the valuation too high (or it will be too low if you are overly conservative).
Conclusion
The emergence of the Internet and related technologies created impressive value for some high-growth enterprises at the end of the twentieth century.
By adapting the DCF approach, we can generate reasonable valuations for dramatically changing businesses. But investors and companies entering fast-growth markets like those related to the Internet should expect to face huge uncertainties. Accurately predicting which scenario will occur is a laudable goal, but achieving it is unlikely.
A great deal of uncertainty is associated with the problem of identifying the eventual winner in a competitive field. It is difficult to predict which companies will prosper and which will not. Neither investors nor companies can eliminate this uncertainty. Though you cannot reduce the volatility of these companies, at least you can understand it.
