“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends.
That assumes I can get that by my shareholders.
That assumes I have zero cost of goods sold, which is very hard for a computer company.
That assumes zero expenses, which is really hard with 39,000 employees.
That assumes I pay no taxes, which is very hard.
That assumes you pay no taxes on your dividends, which is kind of illegal.
That assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate.
Now, having done that, would any of you like to buy my stock at $64 Do you realize how ridiculous those basic assumptions are? You don’t need any transparency.
You don’t need any footnotes. What were you thinking?”
Scott McNeely, CEO of Sun Microsystems, after the dot.com bubble burst. (His company was trading at 10x EV/ Sales.)
*Inspired by Aswath Damodaran, Professor of Finance at NYU Stern, and Graeme Davies.
1. At First Glance
Intrinsic Value is derived from
- Cash ow from assets
- Growth in cash ows
- Quality of growth
Ever wondered why markets go crazy? Prices are driven by FMP’s behaviour, sentiment, equity stories as well as momentum. Always keep the drivers of Intrinsic Value in mind. The bad news is that there is no correct answer on HOW to arrive at the true intrinsic value. The good news: we have multiple options to make sure that we do not overpay an asset.
The basic tool set is
- Peer Group
- Financier’s test
- Free Cash ow yield
Whoever uses Multiples for valuing startups has not understood that it ONLY makes sense when peers are really comparable which is usually the case in settled marketplaces and parameters like management, basis effect, financing costs, CAC and when long-term pricing dynamics become visible. Well, why do so many VCs then still use this method for Early-Stage companies? Because it clearly simplifies the valuation process, allows us to pick the only measure of cash ow that we have: EARNINGS BEFORE ALL (or just call it Sales). Besides, many VCs and Growth PEs use multiples to justify their Fund NAVs allowing for nice portfolio value appreciations.
Applying trading multiples on early-stage startups with the justification that it comes with higher growth rates is total eyewash and clearly neglects associated risks, earnings visibility and quality of growth or proven resilience of growth assets. The DCF method also seems to be of limited use here. The Terminal Value will easily account for more than 85% of total EV. Considering that for emerging companies
- the quality of forecasts is substantially lower than in the case with more mature
- the visible time frame shorter,
- the use of a perpetuity and the discount rate in this context is entirely guesswork.
I can only conclude that we MUST treat early-stage companies like binary options, incorporating a premium ONLY IF there is any REAL and EXCLUSIVE opportunity that can be exploited at any given time in future.
When talking about valuation, it is important to note that we have two distinct
- The COMPANY’s return on its deployed capital
- The INVESTOR’s return on her investment
While the former tells us about the competitive quality of a company, it has absolutely NOTHING to do with the investor’s return!
2. Sources of Value
Buffet once stated, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”. I state: “Anyone prioritizing investor’s return over the company’s return is a hoax.”. Any talk about valuation has to occur within the boundaries of
- Cash ow from assets,
- Growth in cash flows, and
- Quality of growth.
This is true from the company’s as well as investor’s perspective. Textbooks will use the liquidation or reproduction value of an asset to define its quality. In times in which value is mostly created by intangibles that definition seems impractical. Instead, the quality of assets should be measured by the ability to produce or support cashflows.
The most important sources of value are sustainable EARNINGS and GROWTH. Sustainable in this context means to clean the figures from any one-offs or postponed re-investments. If a client needs special care to retain him, this should be viewed as necessary re-investment. Same applies for keeping up the brand value or maintaining machinery.
Franchise Value = Earnings from Existing Assets – Costs of Existing Assets
Take the soft drink industry for instance and compare a no-name product with Coca-Cola. Any incremental margin can be classified as Franchise Value. The reason why Hidden Champions produce great margins is because they focus on what they do best. Only growth within their franchise will add to their moat. The value of a franchise is the value created through the competitive advantage by the incumbent and needs to be PROTECTED by all means. Generally, companies MUST anticipate major shifts in trends and respond to new dynamics in the form of, say investment in global sales networks, R&D or marketing. Any company’s strategy must be based around defensible returns.
Figure 1: Three Slices of Value1
3. ROCE – One Measure to Rule them all
The Return on Capital Employed (ROCE) is the return component and key measure to determine a company’s quality.
It allows us to evaluate how the company is utilizing its financial resources in the long-run and if the company is destroying or creating value. Value creation is directly linked to the Cost of Capital, the WACC, or any Hurdle Rate that is set by the Head of (Portfolio) Strategy, CEO, Investor, PE rm, etc. It is important to understand hat ROCE equates directly to the growth of the company as it indicates a higher return on the capital employed and as such, a higher surplus available reinvest. This again leads to both a contribution to competitive quality as well as business growth.
The 5 key issues mentioned by Graeme Davies are:
1 Greenwald et al. (2004). Value Investing: From Graham to Buffett and Beyond. Wiley Finance.
- What level of return (ROCE) does the business generate? In principle 10 to 15% is a normal return. Anything less than this should be considered too low to invest and fails to reflect the risk of being in equity markets.
- To what extent is this abnormal? Abnormally high returns deserve higher valuations provided that they are sustainable.
- Since abnormality is rarely sustainable, to what extent can the business defend these returns? High returns attract compeitition – which needs to be resisted or returns will diminish.
- What specific level of value is justified by the individual business characteristics? High returns, coupled with high growth and low return risk supply the basis for premia
5. to what extent is either a discount or a premium to fundamental value justified by less quantifiable characteristics? Demand and supply influenced as much by psychology as fundamentals.
Hence, investors as well as company decision makers need to seek investment opportunities that exceed their opportunity cost. In short: Seek assets at a price (EV) that will return an annual operating cash ow (operating prot, plus depreciation, less maintenance capex/ re-investments) above your hurdle rate.
What are the hurdle rates to aim for?
(this is only a best guess, reflecting my industry experience):
VC Seed Stage: 10x MoM
VC Later Stage: 60%
Private Equity : 25%
Public Equities : 10%
Thus, any asset that generates an operating cash ow return equal or above the hurdle rate becomes an interesting asset and worth evaluating. Any asset that is able to generate a return of say 20% in the public equities space, becomes twice as interesting, etc., however, a company generating a ROCE of 20% and is also trading at 2x its capital value, will result in 10% cash return for the investor (Company’s return vs. investor’s return).
Understanding the above is a fundamental prerequisite for understanding business quality as well as valuation. Thus, earnings growth becomes irrelevant without considering the financing costs or the capital employed. 200% earnings growth, from, say 10m to 30m USD, for a company that has 1bn USD additional Capital Employed a 20m increase in earnings would have generated an incremental ROCE of 2% and assuming higher cost of capital, that year in fact would have been value destructive. Obviously, we need to look at the sum of all cash flows during the lifetime of an asset in order to assess the success of an investment. At the same time it becomes clear why earnings growth is a bad indicator, and so are PE ratios.
The foregoing examples makes an important point about valuation. Both companies generate identical sales figures, identical operating margins and are growing at identical rates at the bottom line. Both trade on identical P/E multiples. Company B, however, has a lower capital turn. This is either because:
- The company is less well managed and its assets do not run as profitably as company A’s
- The company produces different products which command lower prices per unit of capital employed.
- The result is that the shareholder’s investment in company “B” hardly grows.
This implies substantially higher risk than in company “A” because:
- the company’s reserves after tax may be failing to keep pace with inflation | it is destroying value | relative to inflation the balance sheet may be shrinking in size
- there are NO funds left for reinvestment in the business
- the company has no leeway for error
In this scenario, either the company would die, or it would be bought by a company whose ownership of scale would allow it t offset the disadvantage of unattractive pricing by reducing the cost of production | thus enhancing returns. In value terms, the two companies are not worth the same; indeed company B is worth considerably less.
The formal quantification of this difference using the “financier’s test” or the “quick and dirty” rule supplies three (C and A being identical) companies with the same fair enterprise value of EUR 100 reflecting the same P/E multiple of 20x. That is important is not so much that the number is common but that this forms the basis for an intelligent analysis of the level of P/E people ought to be paying for stocks able to demonstrate these sort of characteristics. It also supplies the justification for premium and discount valuations.