Stable Diffusion - a colourful yet serious stock market full of vitality Matters2

MARKET-BASED VALUATIONS

THE MARKET GOES UP - THE MARKET GOES DOWN

Many factors weigh on the valuation of a company, and for sure there are no two businesses alike. Furthermore, even similar companies find themselves at different stages of their lives when they start talking with investors and buyers: some are consolidating while others are expanding; some are profitable right away and others are not for a long time; some are not even generating revenues when they are acquired.

But a very effective way to monitor the market (albeit quite simplistic) is to benchmark the M&A activity in a specific sector and in a given period. Markets go through different phases after all and there might be more or less appetite for companies like yours, and therefore investors might be inclined to accept higher or lower valuations.

The problem with assessing the market though, is exactly the fact that there are no two businesses alike. Different companies might have been acquired in the past few months, some for sums many times greater than others; some for strategic reasons, some for opportunistic motives. How do we gauge the overall market and reconcile transactions that might be very different in scale and nature?

EXIT MULTIPLES

Entering the “exit multiples” (pun intended): industry experts normally divide the valuation of the company by an indicator that encapsulates the performance of the company. The multiple that is most often used is the EV/EBITDA multiple or, in short, the EBITDA multiple.

EV/EBITDA stands for Enterprise Value on EBITDA, and simply divides the value of the company by its last year’s EBITDA. This is the industry favourite as it reflects both revenues and costs and doesn’t consider financial instruments and D&A. In fer words, it’s considered to be the best indicator to reflect operative performance.

But what if the EBITDA is negative (or just barely positive)? Aside from specific considerations on why that is the case, a negative EBITDA would yield a nonsensical result. In this case, one option is to look at EV/REVENUES, or at the value paid by the acquirer divided by the revenues of the company.

THE SIMPLE METHOD

Once you know the EBITDA (or revenues) of a company and the relevant market multiple, you can now have an idea of the business value by simply multiplying the indicator by its multiple. You will end up with a roughly-cut ballpark that can give a pretty good idea of where your company stands.

  • Is this a precise method? No
  • Is it exhaustive? No
  • Is it simple and good enough to start pinpointing a value? Oh yes, and that’s why it’s so widely used.
Stable Diffusion - a colourful yet serious stock market full of vitality Matters2

Stable Diffusion: a colourful yet serious stock market full of vitality

DCF WITH MULTIPLES

A more complex approach is to use market benchmarks in more sophisticated models. One of these models is the DCF, or Discounted Cash Flow. All DCFs calculate the future cash flows that a company will generate and then discount that value to today (1 penny today is worth more than a penny tomorrow after all).

While all these models use the management projections for the next 3 to 5 years in order to ground the valuation, there are mainly two ways to calculate what happens from the end of that period onwards. 

The most well known DCF, uses the so-called long term growth (LTG), that we have already addressed here and that considers a continuous growth of the company in perpetuity. The second method is the DCF with Multiples. This last one, takes into consideration a potential exit after the last year of projections and uses its EBITDA multiplying it with the relevant market multiple in order to calculate the residual value of the company,

In this sense, a DCF with LTG reflects all the cash flow that the company generates, while the DCF with Multiples takes into consideration a liquidation event after the first 3-5 years.

VC METHOD

The Venture Capital method, or VC method, is one of the most common approaches when valuing early stage companies. How this works is by figuring out the return that an investor wants, in order to deploy cash into the business. The company will have a valuation that is therefore consistent with a predetermined return at the exit. The potential exit value is derived from the specific EV/EBITDA multiple of the benchmarked market. The final valuation equals this exit value discounted by the return on investment (ROI) required by the VC firm. 

This method depends on a number of factors, including the startup’s stage of development, as well as the kind of investors that might invest in the company. The return on investment will naturally be higher for early stage and riskier companies, lower for more mature and stable ones, and it is the minimum rate that will allow investors to have positive returns from portfolios where most companies fail and gains come from only a selected few.

At Matters2, we use different ROI rates based on the stage of development of the company, assuming that companies at different levels of maturity will attract different investors with different risk tolerances. In particular, we use percentages that range from 50% to 25% returns according to several development stages. We use mainly 7 stages and we define them like this:

  • ​​Idea stage 
  • Proof Of Concept (POC) / Prototype / Minimum Viable Product (MVP) 
  • First production run 
  • First sales in 
  • Established sales with little penetration 
  • Established sales but capital intensive 
  • Established sales and still booming

Check out Prof. Damodaran book “Valuing Young, Start-up and Growth Companies: Estimation Issues and Valuation Challenges” (May 2009) for his insights on this topic.

WHICH IS THE RIGHT METHOD FOR YOU?

Want to know more about how we blend many of these methodology into our Third Party Pre-Money Valuation? Check out our Valuation Report here.

Stable Diffusion - a colourful yet serious stock market full of vitality Matters2

SUBSCRIBE TO OUR NEWSLETTER
TO RECEIVE UPDATES ON NEW ARTICLES

You Can Get It Matters2

You Can Get It If You Really Want

This tune is not just fun to listen too - it also contains an inspirational message for any entrepreneur. But how does a song about overcoming all odds link to the start-up…
Spock Meme Matters2 ORIGINAL

A Call For Logical Thinking

REDISCOVER SCIENCE Please let’s start behaving rationally, people. The strain that this coronavirus pandemic is having on our social behaviour, coupled with the velocity and accessibility of social media is fuelling a…
teamwork matters2

A TEAM

Considering we spend, on average, forty hours a week with our colleagues, it’s no surprise that they often become an integral part of our lives. Whether they hired us, or we hired…
wizards beard matters2

The Funding Dictionary

Here you can find a short summary of the specific vocabulary of the funding process. This is a list we share with our founders before diving into negotiations. You can download our…
Manifesto Matters2

What Really Matters

OUR MANIFESTO: The world advances thanks to the effort of single brave individuals that innovate starting from zero. All successful companies become institutions sooner or later, and loose the ability to change…
Blind Teaser Matters2

Blind Teaser

If you have decided to sell your business or are looking for investments with Venture Capital, you may be wondering whether to advertise your business with an anonymous teaser...
Speachless Matters2

Skimpflation

Surely you can recall people saying “Now it is not as good as it used to be” or “It was just so much better before”... even without fancy economic terms, I bet…
Pivot Matters2

Lean Startups & Pivots

The lean startup method aims to find and develop a business or product for which there is demand. You start with your idea, then you test and develop from the feedback you…
Balloon Leprechaun Matters2

Values First – ESG Later

THE IMPORTANCE OF BEING EARNEST Environmental, Social, and Governance (ESG) criteria are an almost mandatory aspect of today’s investment markets. But is this a fad?

SUBSCRIBE TO OUR NEWSLETTER
TO RECEIVE UPDATES ON NEW ARTICLES

Leave a Reply

Your email address will not be published.Required fields are marked *