Valuing Hard to Value Firms

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Valuing Hard to Value Firms

• What is a hard to value firm?
• Superfast revenue growth
• No earnings (NI
• No history
• No comparables
• Discounted Cash Flow is still the dominant model!
• Value is still the PV of future cash flows
• Alternative methods may use multiple approach
  (Price/Sales)

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Measuring Cash Flow 2 common measures

• FCFF EBIT(1-t) - (Capital Expenditures -
  Depreciation Expense) - Change in Working Capital
• gFCFF RR x Return on Capital
• Value of Firm FCFF1/(WACC - gFCFF)
• Value of Equity Value of Firm - Value of Debt
• FCFE NI - (Capital Expenditures - Depreciation
  Expense) - Change in Working Capital - Change in
  Debt
• gFCFE RR x Return on Equity
• Value of Equity FCFE1/(k - gFCFE)

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Problems Negative Earnings

• Cant estimate growth from current earnings!
• Possible Solution? Normalize Earnings
• Are earnings normally positive?
• Firm had a bad year
• Cyclical firm during a recession
• How long with this last?
• Average firms earnings over prior periods
• Average firms ROC, ROE, or profit margins over
  prior periods
• Use ROC, ROE, or margins for comparable firms

4
Problems No History, No Comparables

• No History? Use contemporaneous data form
  comparable firms
• This is how software firms get valued at IPO
• What are comparables?
• Similar business
• quality of information
• industry life cycle
• No Comparables? Use history!

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The Big Problem No Earnings, No History, No
Comparables

• Stay focused on Discounted Cash Flows!
• 1. Get the most recent financial info (TTM)
• 2. Estimate expected revenue growth
• past growth of firms revenues
• growth rate for overall market firm services
• recognize barriers to entry, competitive
  advantages
• 3. Estimate sustainable operating margin
• what will operating margin look like when revenue
  growth stabilizes?

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The Big Problem No Earnings, No History, No
Comparables

• 4. Reinvestment needs
• RR gEBIT x ROC
• assume net Cap. Expense and change in WC will
  grow with revenue or that revenue growth lags
  reinvestment.
• 5. Risk Parameters and Discount Rate
• Must estimate Beta for firms equity ke
• Must estimate kd (use bond ratings)
• Must estimate target capital structure
• ke and kd will change as growth stabilizes

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The Big Problem No Earnings, No History, No
Comparables

• 6. Firm valuation and equity valuation
• forecast FCFF to point of long-term, stable
  growth (at industry average)
• Value at t FCFFt1/(WACC - g)
• Value of firm PV of all estimated FCFF
• VEquity VFirm - VDebt
• Share value Vequity/No. of Shares

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Key Inputs to DCF approach

• What matters most in valuation of young,
  high-growth firm with negative earnings?
• Estimates of revenue growth
• estimates of sustainable profit margins
• time to reach stable, long-term growth

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An Inductive approach to Valuation

• Observations
• Amazon is currently valued at 35/sh.
• Shares outstanding 356.17 million
• Market Cap. 12.466 billion
• Most recent 12 mo. revenues 2,465.7 million
  (TTM)
• Assumptions
• Amazon will achieve a net profit margin of 5
• On current revenue, that makes 123.29 million NI
• Beta 2, km 12, RFR 6

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An Inductive approach to Valuation

• kAMZN 6 2(12-6) 18
• If Net Income does NOT grow
• Value of equity 123.285/.18
• 684.92
• Divided by 356.17 shares 1.92/share!
• A constant growth model would need to use a
  growth rate of 16.8 to get current market value.
• Is this reasonable?
• (Note Weve assumed that NI FCFE)

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A Price/Sales approach

• Amazons P/S 12,466/2,465.7 5.06x
• Yahoos P/S 37,630/998.1 37.7x
• Is Yahoo 7 times richer than Amazon?
• Is this a valid comparison?
• Amazon to Barnes and Noble?
• Yahoo to AOL?

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Summary

• It is difficult to value hard to value firms!
• More art and less science
• Can develop DCF or multiplier model
• either approach requires many assumptions
• Can value firms on a relative basis
• may be best we can hope for!