The Ride of Unicorn IPO’s
As big tech firms such as Uber, Lyft, Pinterest and Airbnb go public, a decade of innovations is being harvested. As this rush of technology offerings set out to bring new wealth to Silicon Valley, the mystery of increasing investor appetite for companies with negative earnings becomes more profound. This trend becomes almost equally important for a history buff as a finance enthusiast, as subtle, yet serious, similarities between the dot com bubble and the tech-IPO rush pop up. Last week, the division analyzed recent global market conditions, as well as the potential drivers and expectations driving an IPO process. The cause of alarm that has been driving worrisome headlines, however, is the question of how to value such “high-growth”, cash burning companies. This week’s article aims to take a closer look at how to answer this question.
In the wake of this current tech boom, valuation of tech unicorns becomes increasingly important so as to effectively predict or at least understand where this trend is headed. Discounted-cash-flow valuation, though it may sound vastly old school, works where other methods fail, since the core principles of economics and finance apply even in uncharted territories, such as start-ups. The truth is that alternatives, such as price-to-earnings or value-to-sales multiples, are of little use when earnings are negative and when there are not proper benchmarks for sales multiples. More importantly, these shorthand methods fail to account for the unique characteristics of each company in a fast-changing environment, and they provide little insight into what drives valuation. Furthermore, little to no historical data, negative earnings and high growth, as well as the absence of comparable companies make the valuation of these unicorns rather daunting.
The following points are to be considered while implementing a discounted cash flow for such companies (Source: Ashwath Damodaran). With the example of the hottest IPO of Lyft, the points are elaborated as follows:
For firms with negative earnings and high growth in revenues, the numbers tend to change drastically between time periods. Consequently, it makes more sense to look at the most recent information that one can obtain, at least on revenues and earnings, for firms that are growing at very high rates. Using the revenues and earnings from the trailing twelve months, for instance, will provide a much better estimate of value than using earnings from the last financial year. If the updated information is not readily available, which is often the case, estimates obtained by scaling all of the inputs to reflect the growth in revenues that has occurred between the last financial year and the trailing twelve months can be used.
The second key input in these valuations requires drawing on a number of sources to estimate.
In many ways the true test of these valuations is being able to visualize what a young, high-growth firm will look like when growth stabilizes. In the absence of comparable firms, the difficulty of this task is magnified. Again, a few guidelines help:
Growth in operating income ultimately is a function of how much a firm reinvests and how well it reinvests (measured by the return on capital). This formulation cannot be used to estimate reinvestment needs for start-up firms that are losing money, especially in the years of transition. In steady state, however, the reinvestment needs can be computed using the expected growth rate and the expected return on capital: Expected Reinvestment Rate (stable) = Expected Growth (stable) / ROC (stable)
There are three alternatives to using this formulation:
Sales to Capital Ratio = Revenues/ Capital Invested
A sales to capital ratio of 2 would indicate that a dollar invested in new capital (which can take the form of internal capital expenditures, acquisitions or working capital) creates two dollars in revenues. The dollar reinvestment needed each year can then be estimated based upon the expected dollar revenue change each year and the sales to capital ratio.
$ reinvestment in year n = Change in $ Revenues in year n / (Sales/Capital)
The higher the sales to capital ratio, the lower the reinvestment needs for any given revenue growth and the higher the value of the firm. To estimate this ratio, we can look at the company’s own limited history, and look at its marginal sales to capital ratio (change in revenues/change in capital) in prior years. Alternatively, we can look at the sector and the average sales to capital ratio for the sector. The advantage of using this approach as opposed to the other two is that growth and reinvestment are tied together. Increasing one will increase the other. Thus, we take into account the correlation in valuation, where growth rates are increased and reinvestment needs are decreased simultaneously.
Owing to lack of historical data, the regression beta estimates for firms that have a limited history tend to have substantial error associated with them. If there are comparable firms that have been listed for two or more years, the current risk parameters for the firm can be estimated by looking at the averages for these firms. If such firms do not exist, risk parameters can be estimated using the financial characteristics of the firm – the volatility in earnings, their size, cash flow characteristics and financial leverage. These risk parameters should not be left unchanged over the estimation period. As the firm matures and moves towards its sustainable margin and stable growth, the risk parameters should also approach those of an average firm. In addition to estimating the cost of equity for these firms, how leverage will change over time also has to be estimated. Again, targeting an industry-average or an optimal debt ratio for this firm (as it will look in steady state) should yield reasonable estimates for the cost of capital over time.
With the inputs on earnings, reinvestment rates and risk parameters over time, this valuation becomes much more conventional. In many cases, the cash flows in the early years will be negative, in keeping with the negative earnings, but turn positive in later years as margins improve. The bulk of the value will generally be in the terminal value. Consequently, the assumptions about what the firm will look like in stable growth are significant.
The conventional way to estimate value per share is to divide the equity value by the number of shares outstanding. For high-growth, start-up firms, especially in the United States, there is one significant consideration. These firms often reward their employees, not with cash bonuses (they cannot afford them) but with options on the stock, as in the case of Lyft. Over time, these option grants can amount to a significant portion of the outstanding equity in the firm. To get to the value per share, we need to net out the estimated value of these options from the equity value. Since firms in the U.S. are required to report the number of options that they have granted, the average strike price on these options and the average maturity, simple option pricing models can be used to value these options.
Value of Firm – Value of Debt = Value of Equity
Value of Options granted to Employees = Value of Equity in Common Stock / Number of Shares outstanding = Value per Share
This approach contrasts with a much more widely used “treasury stock approach”, where the exercise value of the options is added to the value of the equity, and the total value is divided by the fully diluted number of shares. That approach will understate the value of the options, because they do not consider the time value of the options. If the options outstanding are deep in the money, this approach should give very similar results.
In general, the inputs that have the greatest impact on value are the estimates of sustainable margins and revenue growth. To a lesser degree, assumptions on time taken to reach a sustainable margin and reinvestment needs in stable growth have an impact on value, as well. In practical terms, the bulk of the value of these firms is derived from the terminal value. While this can be tricky, it mirrors how an investor makes returns in these firms. The payoff to these investors takes the form of price appreciation rather than dividends or stock buybacks. Another way of explaining the dependence on terminal value and the importance of the sustainable growth assumption is in terms of assets in place and future growth. The value of any firm can be written as the sum of the two:
Value of Firm = Value of Assets in Place + Value of Growth Potential
For start-up firms with negative earnings, almost all of the value can be attributed to the second component. Not surprisingly, the firm value is determined by assumptions about the latter.
How are unprofitable, cash-burning companies earning such faith in the markets?
Investors are increasingly willing to buy in now in order to subsidize and grow a company that could make large amounts of money later. They seem to believe that the companies’ future profits will trump the current losses.
Remembering the Amazon prototype, the retail giant has been notorious for taking in little profit relative to revenue in order to grow its business and invest in new initiatives for future profitability — a strategy that has worked wonders and that many companies are trying to replicate, often forgetting the diverse revenue stream the giant produces. It is also important to note that just because a company doesn’t report a profit doesn’t mean it couldn’t be profitable. For instance, in the case of Lyft, if the company had not spent any money on sales and marketing or R&D, it would have turned profitable in 2018. The flip side is that without those expenses, Lyft’s customer base would not grow, and it could not venture into new trends such as driverless cars that have massive potential for future profitability.