Six months ago, a growth-stage company in the field of 3D printing was valued at $300 million. Let’s call it RocketCo because it fabricates components for space vehicles, and management’s expectations were headed to the stratosphere. Today, the company closed its doors.
RocketCo was deemed a healthy, growing company, and it suffered no obvious fatal wound. Its demise was like observing a vigorous young lion simply fall over dead not long after being examined in the field by experts and deemed healthy and strong. Sometimes disease can go unnoticed, but would you be concerned about the health assessment if it was premised solely on the weight of the lion compared to a group of other lions? In business valuation terms, this type of assessment is called the market approach, which looks to performance indicators in the competitive marketplace as a proxy for the expected health and growth of a subject company. When performed properly, it offers a reliable snapshot of the subject company’s value. Too often, though, the market approach is poorly orchestrated, and even manipulated, in a manner that can make an ailing company look like the next king of the jungle.
Below, we’ll examine the three steps the market approach generally involves, as well as the professional judgement required by an analyst and common pitfalls throughout the process.
Assuming sufficient familiarity with the subject company and its operations, in the first step the analyst identifies a set of comparable companies exhibiting similar business characteristics. These companies are often selected from within the same industry so that they share a common competitive environment. The analyst that prepared the RocketCo valuation, for example, identified twelve companies with similar products and customers, ranging from large, stable firms with over $1 billion in annual revenue to newly public firms with annual revenues ranging $50 to $100 million, exhibiting high growth rates. This selection represents the closest set of companies for which market information is available, based on the closing price paid for shares of equity, and as reported through stock exchanges or merger and acquisition transactions.
The analyst uses various income metrics like revenue and EBITDA (earnings before interest, taxes, depreciation, and amortization) to yield income “multiples” with which to estimate the value of the subject company.
While simple in theory, selecting comparable firms should be carefully considered. In our example, the analyst included three deeply troubled firms with negative EBITDA and declining revenue over several quarters, which ran contrary to the positive industry trends over the same period. Firms ordinarily experience ups and downs in earnings, but such problematic firms usually have issues extending well beyond the normal and do not provide useful guidance. Worse, these divergent firms exhibited high revenue multiples, skewing the collective results. The analyst should have excluded these firms from the set or applied an adjustment to the multiples to account for their excessive deviation.
Next, the analyst applies appropriate adjustments to the income multiples to account for material economic differences between the firms. Analysts typically focus on adjustments related to market size and expected growth rate. Larger, more stable firms tend to exhibit greater product line diversity, customer diversity, access to resources, and R&D activity. Smaller firms are riskier due to less such diversity and access to resources; but being more focused and nimble, they more often innovate and grow quickly. Investors tend to pay a lower multiple for smaller, riskier firms, while conversely paying a higher multiple for a higher rate of growth. This trade-off is illustrated by the well-known Gordon Growth Model that equates company value to expected earnings, adjusted for risk and earnings growth. The latter adjustment is represented as the risk rate (or discount rate) minus the expected long-term rate of earnings growth.
The analyst in the RocketCo example used market-based data available in the Duff & Phelps’ Cost of Capitalreports to make adjustments to the income multiples. The analyst failed, however, to account for at least the size and growth differences between the multibillion-dollar firms and the subject company, resulting in a higher income multiple and, in turn, an overstated company value. A further adjustment to the income multiple for survival and related risk associated with early-stage companies is warranted. The size adjustment for smaller firms derived from market-based data ordinarily reflects the risk associated with firms that are late-growth-stage or mature, as the market data is derived from public firms.
To illustrate, consider the adjustments to Company A in Figure 1 account for the gap in market capitalization and earnings growth between it and the selected comparable companies. Younger firms at earlier growth stages, represented by Company B in Figure 2, tend to exhibit additional risks due to greater dependency on fewer customers, lack of product diversity and resources, and uncertainties in market viability or other purported competitive advantage. These differences result in a much bigger gap, and correspondingly, investors require a greater risk premium to account for these differences.
Figure 1: Illustration of Gap Between Company A and Comparable Companies
Figure 2: Illustration of Gap Between Company B and Comparable Companies
The final step performed by the analyst involves selecting the appropriate measure of earnings of the subject company to apply to the income multiples. Analysts often use a blend of prior-year EBITDA and projected EBITDA to reflect historical and expected earnings, but the choice depends largely on the circumstances of the subject company. For growth-stage companies that are not yet cash flow positive, a negative or unstable EBITDA is not a feasible metric. Instead, analysts tend to rely on a multiple of revenue, widely considered to be a legitimate, but less meaningful, basis for valuation due to its lack of insight on operating efficiency and vulnerability to revenue manipulation. Its indication of value is often better than nothing, as they say.
The value of growth-stage companies is also greatly influenced by the choice of time; namely, whether to apply a measure of expected (e.g. next year) earnings, historical (e.g. prior year) earnings, or a blend of both. The analyst for the RocketCo valuation applied only the next-year revenue multiple, which reflected an 80% growth rate. As actual revenue the following year was far less than projected, and the rate of revenue growth was reduced to 40% for the intermediate term, the analyst’s valuation greatly exaggerated the company’s value based on revised financial metrics. Had the analyst taken a more conservative measure of value using a blend of the prior-year and next-year revenue multiples, in addition to the adjustments mentioned earlier, the resulting value of RocketCo would have been more consistent with actual company performance.
Prepared properly, a company valuation based on the market approach can provide a useful and reliable measure of value. Investors and company stakeholders, however, should be aware of the dependency on professional judgment and the general ways the analysis can be mishandled or manipulated to produce an exaggerated, if not meaningless, result. This vulnerability is particularly acute where the market approach is presented as the sole basis for a valuation.