Nate, the chief financial officer (CFO) of an early-stage manufacturer of graphene-based nanoparticle coatings with a new photosynthesis additive, was confused by the disagreement of two valuations for his firm provided by independent valuation consultants. Nate was looking for updated guidance on pricing the firm’s stock for its employees and planning for a new round of investment to fund the firm’s fast-paced expansion. One analysis concluded that his firm had a fair market value of $150 million and the other concluded a fair market value of $250 million for the same period. Why such disparity?
Wide-ranging valuation opinions are commonplace for dynamic young companies. Early- and mid-stage technology firms typically experience periods of high growth as they expand into the marketplace with newly commercialized technologies. Nearly always the firms are private companies that aren’t required to disclose or maintain the same level of detailed financial information that are required for public companies. And what information they do provide as guidance to analysts is quickly outmoded by the growth of the firm, which renders historical performance increasingly less helpful to predict future earnings. Understanding how valuation analysts account for these challenges can help to decipher the confusing differences in opinions.
Conventional approaches to business valuation are directed to more mature firms with stable earnings. Analysts typically synthesize a mix of relative and intrinsic valuation methods to arrive at a value opinion. Relative methods assess how similar businesses are priced by the market. Market data provides strong, objective evidence of value, if applied properly, and a host of historical pricing data readily available. Analysts select comparable companies with available pricing data and use that information to estimate the value of the subject company.
In practice, however, relative valuation methods are challenging to apply to young, high-growth companies because “comparable” companies observed in the market tend to exhibit mature and more predictable operating characteristics than companies in the dynamic, high-growth stages of the company life cycle. In some cases, high-growth companies are pioneering technology -solutions unlike any existing offerings, so sufficiently comparable companies may not exist among the available data. Even where comparable companies are identified, a high-growth subject company may lack a sufficient track record of operational profits for bottom-line metrics to serve as a reliable base. More commonly, a top-line metric like revenue is employed, which is often less correlated to value than bottom-line metrics and obscures many differences in operational efficiency and performance. The wide discretion analysts tend to employ to account for these challenges can lead to large differences in opinion about the subject company’s market value.
In contrast, intrinsic valuation methods examine the fundamentals of a company’s operation and generally seek to estimate the market value of a subject company based on the expected future cash flows, with the discounted cash flow (DCF) method remaining the “gold standard” in this category. Discrepancies in valuation opinions stem from assumptions analysts must make to employ the DCF method, which can significantly affect the results – some of which are especially debatable in the context of high-growth companies. For example, often the base information for the rate of sales growth is provided by management’s financial projections. But many factors can influence an analyst’s confidence in management’s guidance, including experience, track record and whether the projected growth is consistent with other aspects of company operations.
An important, often underappreciated, consideration of analysts is the firm’s competitive position in view of increasing competition. Many technology companies face little competition early in their life cycle, but high growth inevitably attracts competitors. A company with strong competitive advantages and barriers to entry, such as a patent portfolio, is more likely to sustain above-normal growth for an extended period of time beyond the growth stage of companies relying primarily on first mover advantage. Another important consideration is whether the subject company has invested sufficiently in income-generating assets, including production and marketing capacity, to achieve projected cash flows, as well as risks particular to young, high-growth companies. These risks often include a higher-than-normal likelihood of failure for firms early in the commercialization process and the overdependence on a key person to achieve projected growth, such as a founding CEO who developed the core technology and is integral to further development and sales.
Analysts vary to the extent they examine these issues, and they tend to take a variety of actions in response to perceived uncertainty about growth projections. As a result, their opinions about company value differ. Returning to our example, Nate reviewed the opinions of the two analysts and found that $60 million of the $100 million difference in the concluded value of the subject business was attributed to a greater risk premium applied by the first analyst. The risk premium accounted for the analyst’s concern about the firm’s ability to sustain a competitive advantage with its coatings technology where none of the firm’s ten patent applications had been granted to date and a major company recently announced the development of a competing product based on the same technology. Nate’s optimism that the firm’s key patents would be issued in time to protect its market position is reflected in the sales projections he provided to the analysts, ultimately affecting the outcome.
Which valuation opinion is “correct” is a matter of perspective. It depends on the reason the valuation was prepared and how well the underlying assumptions align with the firm’s circumstances. In Nate’s case, the lower valuation opinion may be more appropriate for establishing, as of that date, the fair market value of company common stock provided to employees under IRS guidelines. No patent rights exist as of that date, and valuations tend to ignore potential earnings rooted too deeply in speculation. But the higher valuation opinion is instructive for company planning purposes, as it offers guidance about the value of the firm under the assumption the patents are granted in a timely manner. Understanding how business valuations are prepared can help you to reconcile differences in estimates of value and turn seemingly conflicting analysis into useful insights.