Chapter 6: Promise aplenty - Young Growth Companies

Hi, welcome to this chapter six of the Little Book Evaluation.

In this chapter, we're going to talk about valuing young growth companies.

Kind of an extension of what we did in the last chapter, but a deeper dive into what it is that makes young growth companies difficult to value.

To set up the question, let's start by stepping back and looking at what characterizes young growth companies.

When you look at young growth companies, here's what you will see in many of these companies. You see revenues growing strongly. Revenues.

You might actually see operating losses. Why? Because the company is still struggling putting a business model together.

There are some young growth companies that make money, but many of them are still struggling. So they have losses.

And they'll have even more negative cash flows because they're reinvesting to create future growth.

So soaring revenues, high revenue growth rate, Partly because they're building off tiny revenue bases, losses, and negative cash flows.

So with that said, let's think about what it is that makes young growth companies so challenging to value.

First is they're young. What does that mean? You don't have much historical data.

If your response is so what, think of how much in valuation we just extrapolate the past.

Having 10 or 20 years of data makes your life easier. But in the case of young companies, you don't have much historical data.

Second, their existing revenues are small or perhaps even non-existent.

Many young companies can be pre-revenue companies and they have operating losses.

Again, much evaluation, especially in its simplistic versions, you take existing revenues and grow them.

You take existing margins and extrapolate them. You can't do that with a young growth company.

Third, many young growth companies don't make it, don't survive.

In fact, the Bureau of Labor Statistics maintains a database of all startups in the U.S.

If you look at that database, only 45% of the companies that were founded in 2006 made it through 2005 years, and only 24% made it through the next 15 years.

76% failure rate. Much of that failure is front-ended. A lot happens in the early years.

This is not always the case, but many young growth companies, especially if they're very young, tend to be privately owned by venture capital.

They're not liquid. And that illiquidity can affect how much you pay for an investment.

And to the extent that there's still private companies raising money from venture capital, each venture capital round is so unique that it creates a distinct class of equities.

It's like having five or six different voting rights classes or rights classes in your equity.

And finally, because these companies have negative cash flows, but they still need to attract employees.

They have to almost, they have no choice but to use stock based compensation, restricted stock units and options to reward their employees.

Again, none of these are unique to young growth companies, but they're particularly visible in young growth companies.

So from a valuation and a pricing perspective, let's see how this plays out.

When you try to value a young growth company, most of your value comes from future growth. It doesn't come from existing assets.

It doesn't come from book value. That's going to be challenging because everything is in the future.

And when you're pricing these companies, you run into the same issue. Why?

Because first, remember to price something, you've got to scale the price to a variable.

Now, normally we scale price to earnings or book value. Neither will work with the young growth company.

With earnings, you often have losses. With book value, there's nothing there. Even revenues, you have tiny revenues.

So basically, deciding what to scale it to is a challenge. Second, how do you find comparable companies?

All the other companies just like yours are all privately owned and venture capital funded.

It's really difficult to get the pricing for these companies. And finally, even if you can get past those first two challenges, what to scale it to in comparable companies, how do you adjust for the failure risk?

So those are the questions I'd like to answer. So let's start with the intrinsic value side.

Let's suppose your challenge when you sit down to value young growth companies to Ford.

First, estimating revenues for this company over time. Remember, there's very little to go on right now in terms of historical data.

And you've got to project out the revenues in the future. Let's lay out what you might look at to make that estimate.

First is you have to be, you have to get a sense of what that total market you're going after.

In fact, in Silicon Valley, this became a buzzword, total addressable market, T-A-M.

But basically it's not a buzzword. It really is critical to valuation.

What is the total market you're going after in terms of the product, in terms of geography?