Week 4: Valuing

In the HBO comedy Silicon Valley, a group of IT nerds finally get the big break their startup has been waiting for. A venture capitalist is ready to put down serious money and fund the company. And indeed the figures bandied about are eye-popping: the VC estimates the value of the startup at $100 million. The VC will put $20 million into the company immediately.

However, a knowledgeable advisor warns the founder not to take the deal. Why?

The advisor’s rationale revolves around her belief that the $100 million valuation is too high – the logic being that valuation would put the startup into a situation it can’t possibly meet expectations in, and eventually lead to a “down round”. So the founder ultimately asks the investor to put in $10M at a $50M valuation.

All things considered it probably wasn’t a bad move: the Silicon Valley guys were coming off a huge wave of hype which created a backlash down the road.

Although this situation is fictional, it brings up the question of just how to value a company. Is there any logic to the process? Sometimes there is and sometimes there isn’t. Let’s review a few of the ways one might get a sense of how much a company is worth.

Back to Basics: The Accounting Equation

In the first week of the first semester of an accounting class, the accounting equation is presented as follows:

Assets = Liabilities + Owner’s Equity

Under this measure, if you have a company that has taken out a $100K loan (a liability) and the founder himself has injected another $100K of his own money into the company, you have a company worth $200K. Although that $100K loan is a liability, the idea is that you will use that money to buy an equal amount of assets – say, $100K worth of vehicles if you are a package delivery company. The vehicles (an asset) balance out the loan (a liability). Then you have the remaining $100K injected by the founder to cover expenses, purchase more assets, and so on.

You can ultimately use these figures to determine the book value of the company. The book value gives you a more accurate value about what cash-producing assets the company truly has available. Book value takes into account expenses like depreciation against assets and rules out intangible assets like goodwill.

The accounting equation and its resulting information is a hard-nosed, dispassionate gauge of what a business is worth.

The Multiplier Effect

Now things start to get interesting.

The thing that stops the accounting equation from being the final word is that the world changes around us. The accounting equation is more of a historical record than a preview of things to come. Businesses can grow and expand, sometimes exponentially. A good question to ask oneself when valuing a business is: “do I expect this business to grow?” If so, it can be useful to find a unit-based measure of the business.

Our package delivery company makes $0.10 every time it delivers a package. Every time it delivers 10,000 packages, the business generates $1000 of revenue. If the delivery company is expanding into a new territory where it expects to deliver 50,000 packages a day total, the business can expect to generate $5000 of revenue a day.

If the business is operation for 360 days per year, you can project revenue to come to around $1.8M per year. Add the company’s assets to that and then subtract its expenses and liabilities, and you start to get a general idea of what this business is worth following that projected growth.

The next question is to ask what percentage of the company you might like to own. Which leads us to…

Discounted Cash Flow (DCF)

Discounted cash flow can be a nice compliment to the multiplier effect, in that it has the capability to tell you what your future profit is worth in today’s money. This information can guide how much money you should invest. Instead of providing a glib and potentially misleading overview of DCF, I would recommend Investopedia’s take on the subject.

Speaking from past experience, one of the trickier parts of DCF when first starting out is the concept of future value. Future value is the underlying concept between much of finance and investment. That dollar in your pocket might not actually be worth a dollar; it depends on when you spend it.

If you were to lose that dollar for two years under the sofa, you would find two years from now that dollar could not purchase as much if you hadn’t lost it in the first place. In 2017, a 12 oz. can of Pepsi cost perhaps 79 cents. In 2019, that can of Pepsi might have gone up to $1.25.

Since the norm for paper currency is steady devaluation, any investment that promises future returns should be viewed in light of the future value of money. DCF factors in future value and present value to arrive at an estimate of what one might ought to consider when weighing an investment.

Summary

Today we covered a few of the methods available to arrive at valuations of companies. In practice, things like book value, DCF and projections are only part of the picture. One might argue they are merely the surface reflections of the business. More important is the idea, the strategy and the people in the business.