Class 5 - Valuation continued Flashcards
What are the VC goals
To finance a developing company
To achieve a high return
What are the 2 factors of value creation
Company with high growth potential
Return on invested capital (ROIC) which “greatly exceeds” the cost of capital…
in order to finance growth with internal cash flows
What is the main financial criterion
Yield is a function
The difference between the cost of the investment and the exit value
(…)
And time (the quicker, the better)
DOUBLE THE MONEY IN TEN YEARS VS 1 YEAR, generally speaking VC are looking for a 5 year horizon
2 ways of exiting + 1
Initial Public Offering (IPO), or
Sale of business…
if terms and conditions are better than for an IPO
normally the IPO offers the highest price : they are the one willing to pay the highest price for the shares
consolidation play might offer a higher price depending on the state of the market or the type of business
Follow-on financings with third parties
vc fund produces return and revenue trhough sales of businesses and have to report on regular basis the performance of the pf to the investors
its hard to report withouth a market that is liquid but if youre ivnested in a comapny into which anotehr investor invests at a higher valuation, the vc fund managers can report an increase in the fund valuation
»2 years after another independant vc fund decided to invest on a valuation of x M» so you can report an increase in value
its not a liquidation but its an incearese in value
the fund however has to be indepednant , if its the same vc fund that doesnt count!
3 methods to value the company at the exit
Discounted Cash Flow - DCF ; works well with a stable company with ebitda margins and net margins stable and stable and reasonnable growth
Comparables
Price/Earnings (P/E)
Enterprise Value/ Earning Before Interests, Taxes Depreciation and Amortization (EV/EBITDA)
see often times on the stock market PE ratio, it gives a good idea of the value of the compagny
EV/EBITDA : used most often in MA transactions, they will but the value based on a multiple of EBIDTDA because you dont care of the financial structure, looking only at ebitda is independant of the capital structure
also used in the stock market to validate the valuation
Average value at exit
Based on exit experience (Metrick and Yasuda, p. 180)
funny one
avg value based on comparables of all the same sector that went to market
you go to market when youre ready, which as to do with the size of the company so the valuation is similar
whats the VC method
Based on VC cost of capital and probability of success
have to keep in mind that the lps have an expectation of returns on their investment. theres fees to be paid to the manager
have to calculate what you need to do on a net basis
rather that using a high discount rate to value the company, you use the historical return on vc fund investments which was calculated at the time of 15%, and then you apply a probability of success
so rather than trying to assess the chance of bringing the company to makret and than value the company with a high discount rate, you have a better grasp of the situation
this probability can be based on experience and data
whats the multiple of money
other way to express the same thing
how many times are you gonna grow the initial investment.
if initial investment is 5, and mutliple of money 10x, you will have 50 at the end
Expected retention
Subsequent rounds of financing “dilute” the initial investment
need to take into account the dilution
they want to protect themselves of dilution
if you invest 10M in a 50 company so you had 20% and then theres dilution and you only have 10%
bill gates is so rich because he did not to suffer dilutoin since he was financed internally
VC fund management costs
the return that the fund realizes is different than what the ivnestors realizes
if you promise a 20% return to the LPS, you have to generate more because you take management fees to the vc fund manager
yearly management fee payed to the vc fund which is a % of the value invested (2% a year)
youre the investor, you invest 10M and pay 2% per year, after 10 years you payed 20% of mangement fee so you did not invest 10M, you invested 8M because the fund itself has to pay mngt fee
carry : participation in the upside of the value of the fund of the vc fund manager
normally the fund manager receive a % of the money invested in their fund (2%) and they receive a certain percentage of the upside of the fund
if the fund makes 1 billion dollars, the fund manager will get 200M$ and the 800M will go to the clients
so if you dont get into account the carry, you will misrepresent the eventual return that you may realize from an investor POV. is this net return, ent of costs and carry
Valuing high growth companies
1 . No (or little) revenue base, no EBITDA, no earnings
EV/EBITDA and P/E multiples are useless
if youre a vc fund that want to make an investment, you look for a company that as no revenu, you invest in a concept
on that basis, the multiples are useless
- Sizable R&D investments
Not necessarily capitalized…
… making book value irrelevant
the innovative companies normally have uncapitalized RD charges. as you are spending money on RD and building the software, the value is not represented in the balance sheet so the book value is irrelevant! theres nothing on the balance sheet except huge loss
if youre expensive all the cahrges and creating losses, the book value becomes meaningless
- Business with high growth potential and superior investment returns
Evaluation : « DCF » method
Basic method generally used in business valuation
The comparable method is used to validate a DCF or in the context of stock market investment
Theres 3 approach of the DCF method, kholler, arzac and metrick, what are they
Koller :
Project the company into the future
Establish different scenarios to which are attached probabilities
assess what would be the size of the company once the product is on the market. what would it look like. its reasonnable for someone familiar with the industry to be able to assess the value. in the boiotech you can base that on statistics
probable market size, probable market share : as to do with experience but also precedence, other companies on the market : is it gonna follow the same development
forcast Target revenue (and growth in revenue)
Set sustainable margins : based on the reality of other businesses in the same sector
Necessary investments to achieve goal
revenue based on market share and size, operating margins with comparables companies, impact of dilution when its necessary to make other investments
ROIC irrelevant because accounting method: relevant based on kollers book but it depends on the invested capital. in order for ROIC to be relevant, you need to be the ROIC to be relevant!! its an accounting number
these companies are not generating net earnings, because you spend money on RD and its not capitalized so the balance sheet means nothing, normally have negative equity number the invested capital is not a good representation
if invested capital is the book value and you write off the RD, the book value will be irelevant
can develop scenarios based on assumptions, transparnet method, or real options
metrick :
FCF = ebit(1-t) + depr/amo - capex - nwc
arzac : nopat
concepts of the terminal value (graduation value)
when you arrive at a point that the results are stable and predictable, value it based on a perpetuity
valuation of Apple : we valued the company with a certain growth in the futur, if we were to justify the value of the company based on a set constant growth %, if you want to forecast the growth in hte model itself : growing the revenue in the model it self and then calculate the TV, you can assess the real growth : reverse engineer
growth on a perpetual basis, you can to make sure that the growth can be sustained : it will keep its market share, introduce new products etc normally it grows at the same rate of the economy, however innovative companies grow higher than that
growth is a function of the investment rate and return on capital
if you have 25% on return on capital and investment rate of 90%, the growth will be 25%*90%
your growth as to be sustainable, which means that its a function of the reinvestment and the return you get!
the higher the investment rate, the higher the growth
but if you reinvest everything, your cashflow becomes 0.
you have to balance this. a cash flow of 0 in the calculation of the GV (theterminal value), the company would be 0!
cash flow is a function of the investment rate and the earnings. if you take all the net earnings and pocket it, its free cash flow. if you reinvest it all, then the fcf will be 0
the terminal value is the relation between the growth and the retunr
if the growth is the same as the return, the GV will be 0
you cannot just assume any growth. you have to take into account if you will be able to sustain the growth and thus generate growth internally. they were able to sustain 25% growth is because the return was 25% or more. you have to assess if the growth is sustainable internally et sinon tu dois te diluer
the assumed growth has to be financed internally. thats a major assumption : theres not gonna be dilution. if you calculate a perpertuity you have to be able to finance that growth
you want to make sure that the growth is able to be financed internally
this takes into account the limitation of growth based on the earnings done
vc take into account the capacity to finance internally
takes into account that they can generate high return and have high growth
on a perpetual basis you cant beat the economy
“DCF analysis is a form of absolute valuation because it does not use information from relative values of similar companies.”
what he means is that the multiple valuation method is a relative method
no because when u do a dcf you set a discount rate you will be using and you set the discount rate based on the beta of the firm and the comparbales, its a relative valuaiton because u dont use a beta out of thin air!
its the same as a comparable because you compare the didscount rate based on other companies
multiples
P/E (Price / Earnings)
Widely used for company valuation in the context of the stock market…
… to establish the offer price of an Initial Public Offering (IPO) :mthe price at which the comanies goes public is based on a multiple because when you bring a company to market, all the information needs to be in the prospectus so you cant present it based on a dcf based on forecasts
if the company does not meet the forecasts, it can be sued.
EV/EBITDA
ev/revenue when you have nothing else
if margins are the same in the industry its gonna be the same if you base yourself on ev revenue
but you have to be comparable margins
least used price/book
book is an accounting number
tech never have a book value signficant
selection of comparables :Selection criteria
Companies in the same sector that compare themselves according to the two main factors of value creation
but then you have to take inot acocunt your own growth potential
than you reconcile your computations make sense, you look at the EV with the DCF and the PE
PE is linked to a DCF calculation! theres an equivalence
”Comparables analysis is dangerous for VC investors…”
because its difficult to compare compagnies that are innovative! more often then not they are innovative and hence dont have comparables
