Where are company valuation coming from ?

This post tries to answer a question that was posted here on valuation, and how valuation are computed...

We at Occam Capital are using two different types of valuation analysis as standard:
• Comparative analysis
• Exit analysis

Comparative analysis

Comparative analysis compares the investee company valuations against that of comparable public companies. The average market capitalisation to revenue multiple for comparable public companies is compared to the current valuation to revenue multiple for the investee company.

Market capitalisation values used for the public companies should be based on the average over the previous three months and any cash balances should be subtracted.
Weaknesses in this method
• There will be significant differences between the investee and the public companies e.g. size, geographical coverage, product diversification, access to financing.
• Assumptions need to be taken as to the investee companies ability to hit revenue targets which can lead to significant fluctuations in the results of the analysis
• Larger public companies tend to be lower growth and applying their multiples to early stage higher growth investment opportunities could underestimate their value.

Exit Analysis

1. The first step is to identify the stage of the investment and therefore the returns that Occam should expect – this is expressed as a multiple of the cash invested. E.g. If $5m is invested and $50m is returned on exit then the multiple is 10x. An early stage investment might have a required return of 10x, a mid-stage of 5x and a late stage of 3x.
2. The exit multiple required is then calculated in the same way as described for the DCF analysis (below) and this is then compared with the current valuation.
3. The required exit multiple should be below the average market capitalisation to revenue multiple at which the comparative public companies have been trading over the previous three months, again adjusting for cash.
4. Recent private company M&A transactions involving similar companies can also provide a good source of comparable data, if this is available.
5. Note that it is important to ensure that there are a sufficient number of potential acquirers and that a trade sale is a realistic possibility. Potential acquirers should have a good strategic fit with the company and should be large enough that acquiring a company at the anticipated exit value would be a reasonably frequent event.

Discussion of alternative valuation methodologies
Traditionally the generally accepted method for valuing companies was via discounted cash flow analysis (DCF). This type of analysis calculates the current value of a company as:

Present Value (-Current Value, +Exit Value at assumed exit date)

However, this type of analysis is rarely suitable.

1. The first problem is in selecting a discount rate. The weighted average cost of capital (WACC) is impossible to predict for early stage private companies. In addition, to use a uniform hurdle rate for the fund as a whole would ignore the very different risk profiles of different companies, the result of which would be to over-value riskier companies.
2. The second problem is that the result will be totally driven by the Exit Value. The Exit Value is calculated as the product of an assumed multiple of either profits or revenues and estimating all of these variables is fraught with difficulty (see above).

DCF is more useful for relatively mature companies in stable industries. In this case, where possible, the exit multiple should be calculated on profits rather than revenues and averaged over three years. It is also advisable to adjust for any specific risks. This would normally be in the 20-50% range to reflect past performance in meeting financial targets, general confidence in the sector and the company, etc.

Comments

[Kien Lam]

I've recently started out as an analyst for a biotech VC and it seems that there are a few "standard" valuation techniques one of the principals like to use. With regards to the comparative analysis, I am using the P/E ratio of the industries I believe the early stage company I'm valuating is in and multiple the earnings from their first projected profitable year. I then discount by relatively arbitrary discount rates to reflect obstacles that separate this company from other similar public companies in the industry. What do you think are the biggest shortcomings of this method?

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