Valuing Young Companies: A Complete Guide Using a DCF (FCFF) Model

Equity Models, Valuation

Valuing a young company is one of the more difficult tasks in valuation. Trying to pin a value on a young company, startup, or idea business is difficult because of little or no revenues and large operating losses.

Other challenges are the short financial histories of young companies, plus the dependence on outside capital to start the business. All of those aspects make valuing these young companies much more challenging.

Other considerations are the fact that many new companies don’t survive beyond the first few years. As with any other company, you are basing any valuation work largely on estimations, and working with young or startup companies is no different.

In today’s post, we will learn:

What are the four questions to ask?
Avoid the dark side of valuation
The Steps to Valuing a Young Company
Putting it all to work with a real company
Investor Takeaway

Okay, let’s dive in and learn more about valuing young companies.

What Are the Four Questions to Ask?

Before we can start valuing any company, we need to understand where each company is in its life cycle. Whether they are Amazon, Apple, or the most brilliant idea in someone’s head, each company is part of a life cycle. Each company, as they grow to go through this cycle, move from:

Idea companies – no revenues, operating losses
Startups – small revenues, increasing losses
Second-stage companies – growing revenues, moving towards profits
Mature companies – stable revenues, growing profitability
Declining companies – falling revenues, stable profitability

As you can see from the list above, the newer companies have little to no revenue with zero profitability, so assigning a value should be difficult but not impossible.

Why is it not impossible?

Because each company has certain characteristics that allow us to estimate the future and then assign a value based on those future projections.

To determine the value of a new company or startup, there are four questions we need to ask. These questions are the basis of valuing a young company and are ideas that Aswath Damodaran promotes in his fantastic book, The Dark Side of Valuation, and his phenomenal lectures as a professor of finance at NYU Stern.

What are the cash flows from existing assets?
What is your value from future growth?
How risky are the assets and cash flows?
When will the firm become mature?

Asking the above questions allows us to dig deeper into the three sources of information available when valuing young companies.

Company’s current financial statement
Financial history
Industry and comparable firm data

Using the publicly available financials from SEC.gov, we can determine what is going on with the company today and any financial history that might be available. Sometimes there might be only one-quarter of public info if the company recently went public via an IPO or SPAC.

These financials can be a great source of foundational information on revenues, margins, and prospects. It also helps us see into the minds of the managers running the company. Other great sources are recent earnings presentations or calls, which provide additional insights into management thinking; particularly when listening to the analyst’s questions, which provide deeper insights into management thinking beyond the prepared remarks.

Other sources are trade magazines or newsletters, subject-relevant blogs, podcasts, and other sources outside the normal channels.

These resources help give you a better picture of the particular company and insights into the company’s sector. With these resources, we can better craft an idea of what is likely to come for the sector.

Using this information helps us build a model using any DCF (discounted cash flow) basics such as revenue growth, margins, and any risk associated with an investment.

Avoid the Dark Side of Valuation

As we will see, valuing young companies involves a heavy dose of estimates. It is no surprise that in the world of young companies or startups that there is a dark side of valuation offering solutions for those estimations.

Many of these solutions offer a way out and sound good on the surface, but underneath they are often the source of many errors in valuing young companies.

Below are some of the more common mistakes:

Focusing on the top line and bottom line

Many investors and analysts focus completely on the top line (revenues) or the bottom line (earnings) without much discussion on the sources of revenue or the costs associated with creating and growing those revenues or earnings.

Those costs, such as R&D, payroll, costs of goods sold, reinvestment, and taxes, have a direct bearing on the growth of revenues and profitability, and by ignoring those impacts, we run the risk of overestimating growth.

Short-term focus

Estimating growth beyond a few years is a difficult task, and many analysts or investors rely on short-term estimates because they rationalize that estimating uncertain long-term futures is too difficult, and why bother?

Instead, they focus on the next quarter’s performance or comparing short-term performance. Focusing on the short-term can lead to not focusing on the factors that matter, such as long-term prospects, shifts in the macroeconomics of the sector, or any long-term changes in customer behavior.

Mixing relative valuation with intrinsic valuation

Many analysts use exit multiples in their valuations, such as EV/EBITDA, as a terminal value, instead of intrinsic value methods.

The mixing of relative metrics can lead to errors in valuation because many of the metrics used are not in line with the principles of intrinsic value. For example, if the EV/EBITDA multiple is high relative to others in their industry, but overall that same industry is high relative to the rest of the market, the estimate runs the risk of being overvalued overall.

Assigning sky-high discount rates

There are tons of risks associated with young companies, and many analysts assign higher discount rates to attempt to encompass all of the potential risks in one single metric.

They use the discount rate as a means of rolling all of their concerns about the company into the discount rate, including any risk of failure.

The biggest issue with valuing young companies comes from the temptation to swing to the dark side by embracing three ideas:

Paradigm shifts
New metrics are created
The story is all that matters

The paradigm shifts and stories become the main focus of valuation for companies because the industry or sector is shifting customer behavior. The story about the founder or CEO becomes the focus.

A perfect example of this is WeWork; the company’s CEO became the focus of the company and how he and his company were going to change the way we work and where we work. Instead of focusing on the economics of the business, or the likelihood of that change occurring, it instead became the focus on the paradigm shift and the CEO and his vision.

Another focus is creating new metrics, such as click per user or revenue per click, and moving away from GAAP accounting standards. Analysts start creating new ways to measure the performance of a young company that focuses on the positive instead of focusing on the overall picture.

Both examples provide probable situations, but not necessarily likely to happen; that probability entices investors and creates a narrative around the company that focuses on the short-term and positive, instead of focusing on the likelihood of success and the reality of the market they are entering.

The Steps to Valuing a Young Company

There are multiple steps we need to follow to value a young company. Below are the steps we can use to value a young company.

Assess the company’s position
Estimate revenue growth
Estimate operating margins in sustainable growth stages
Estimate reinvestment rates for growth
Discount rates
Estimate the value of the company

Let’s look at each step in detail to outline the process.

Assess the company’s position

Most analysts use the financial numbers from the latest financial year, and in keeping with that idea, it is best to use the most up-to-date financials, which often means using the TTM or trailing twelve months.

Keep in mind that young companies typically have negative earnings and high revenue growth, and these numbers can vary wildly. That is why it makes the most sense to look at the most recent financial information, particularly for revenues and earnings.

Using the most up-to-date info will help give us the best benchmark for estimating the company’s value.

Estimate revenue growth

One of the trickiest parts of valuing young companies is estimating revenue growth because young companies tend to have small revenues, expecting these will grow to much bigger revenues.

Because revenue growth is the big driver of value in young companies, it is best to focus on several sources of information to help guide our estimates.

Based on its historical record, historic growth for the company is the first, best source of information. Keep in mind as the company scales up, those huge revenue growth numbers will be harder to replicate. For example, if our company grew at 300% two years ago and 200% one year ago, this year’s rate will likely be lower.
Look at the growth rate of the overall sector in the company resides. It is easier for our company to grow at high rates if others in the same sector grow.
Barriers to entry or competitive advantages for our company help give us a leg up on the others in our sector. For any company such as Amazon, it has to have a competitive advantage to generate high revenue numbers. If that competitive advantage is sustainable, then the sustained revenue growth is far more likely. If there is no competitive advantage, then revenue growth tends to fall off quickly.

Estimating operating margins in sustainable growth stages

Companies losing money with high revenue growth numbers will accomplish nothing more than bigger losses over time. The expectation is that money-losing companies will begin to have positive operating margins over the long term.

Here are a few ideas:

Look at the business the company is in and find comparables to measure against, and as the company grows, it moves toward profitability that matches the competition.
Deconstruct the income statement to align the operating costs such as R&D, marketing, and SG&A to align with how the company is investing in its growth. The growing operating costs that lead to unprofitability are often reinvested in the company and need to be amortized instead of expensed. Accounting conventions regard these as operating expenses, but many of these expenses are their reinvestments in the new world of internet-based companies. The company won’t realize the benefit for many years. To learn more about this valuable idea and how to deconstruct an income statement, check out this article:

Analyzing Intangible Assets and Their Impact To Assets and Operating Income

Estimate reinvestment rate for growth

As with any company, you have to reinvest to grow, and with young companies, that is especially important. But unlike a more mature company, the historical data to help estimate that reinvestment rate won’t be there.

As the young company grows, the nature and rate of the reinvestment will change, which leads to additional challenges in estimating the reinvestment rate.

Typically, we would look at the expected growth for a company based on the following formula:

Expected growth = reinvestment rate * return on capital

But, with young companies having negative operating margins, the formula becomes unusable because we can’t estimate returns on capital with negative operating margins.

Instead, we would use a sales to capital ratio, which would allow us to assess a number that would help us determine a reinvestment dollar amount for each dollar of revenue created.

For more on the sales to capital ratio, follow the link to learn more:

Sales to Capital Ratio: Measuring the Efficiency of a Company’s Reinvestments

For example, suppose we use the sales to capital ratio to determine the growth of reinvestment. In that case, we see that to grow revenues by $1 billion with a sales to capital ratio of 4, we would need a reinvestment of $250 million.

We can estimate this number by looking at industry averages or the company’s historical average to get us in the ballpark.

The sales to capital ratio can change throughout the valuation as it approaches a steady state of growth; no law states reinvestment rates need to remain steady throughout the valuation.

Discount rates

Estimating the risk and discount rate for young companies present a few problems to work through, the first being the risk. The standard measure of risk is to use the beta, and for young companies, the simplest course of action is to assign a higher beta than more stable companies in the same industry.

Estimating the cost of debt for young companies is difficult because, as they are new to the market, they typically won’t have any debt rating, and that makes it a challenge to estimate the cost of that debt. One solution is to look at the interest coverage ratio for companies in the same industry, project those same ratios for your company, and use similar debt ratings from Moody’s, S&P Global, and others.

As the company grows over time, we should change the discount rate or cost of capital over time. As the company moves towards a more stable state, we should assume more stable costs of debt and betas to reflect the stable state of the company.

The same rules apply for estimating the cost of equity; as the company matures, we need to adjust our cost of equity to reflect that maturation.

Bottom line, as the company moves towards a more stable state, adjust your discount rate to reflect that stable state with numbers that are more in line with the industry.

Estimate the value of the company

Now that we have our inputs for revenues, operating margins, reinvestment rates, and discount rates, we can value our companies.

We can use a FCFF (free cash flow to the firm) DCF model to help us find the value of our company. Once we have our equity value, we subtract the cash and equivalents and then divide by the shares outstanding to find the company’s per-share value.

Putting It All Together to Value a Young Company

The first company I would like to analyze using our guide from above is Crowdstrike (CRWD). Crowdstrike is a cloud-based security software system that provides protection. It operates as a software as a subscription-based model and sells through its platform and sales team.

The company started in 2011 and recently went public on June 6, 2019, and currently has a market cap of $56.9 billion.

Okay, let’s start to work through the problem of valuing this growing company with negative operating earnings. In the end, I will include a downloadable file for you to check my work and adjust anything you see fit. I based the model on the work available from Professor Damodaran’s FCFF model.

Revenues

The company’s latest TTM numbers show that Crowdstrike has earned $999.2 million in revenues over the last twelve months, with expectations for greater growth into the future.

Analysts predict sales growth this year of 55.9%, with numbers approaching 36% and 33% over the next two years, respectively. Over the last five years, the revenue growth year over year (YoY):

2018 – 125.14%
2019 – 110.37%
2020 – 92.70%
2021 – 81.64%
TTM – 77.35%

As we can see from above, the revenue growth is falling sequentially as the company scales up, aligning with our study earlier.

Predicting revenue growth will be an item to check on an annual basis and adjust accordingly; for now, let’s assume the revenues will continue to grow over the valuation period before topping out at 11% at year-end, and then growing at the rate of the 30-year Treasury rate which is 1.97% currently.

Operating Margins

The company currently has negative operating margins as the company is expending a ton of R&D, 71.74% of revenues, and SG&A, which is 44.69% of revenues. As we mentioned earlier, the prudent approach is to amortize the R&D because that is unquestionably reinvestment in the company, as Crowdstrike is a tech company that stays cutting edge by improving its products and services. It spends little to nothing on traditional Capex, such as buildings or other large expenses.

Crowdstrike will grow based on improving their products through R&D or acquisitions, and studies have shown that reorganizing the income statement will give a truer picture of the financials.

The next step will be to look to others in the industry to get a sense of where the margins should be once the company starts to mature.

Two of the more mature companies in the space that Crowdstrike operates are:

VMware (VMW) – 19.38%
Fortinet (FTNT) – 19.52%

Next, we can compare it to the sector average, which Crowdstrike operates in the software (system and application) sector. The current operating margin (EBIT) is 23.30%, so let’s target 23.30% for our operating margins.

Until the company reaches that goal, I will go with six years as our convergence, but you can adjust as you feel accordingly.

Reinvestment rate

As we mentioned earlier, with negative operating margins, the usual ROIC calculations will not work. Instead, we can assign a sales to capital ratio to factor in the reinvestment.

Per Professor Damdodaran’s worksheet, the sector average is 2.22. We can assume that Crowdstrike will reinvest at a higher rate now to continue their growth so that we can assign a sales to capital ratio of 3 for the duration of our valuation.

Discount rate

To account for the higher volatility, we can assign a higher than normal beta to account for the volatility. The sector beta is 1.04, and to account for the additional risk; we can use a beta of 1.53.

That beta will return closer to the industry average over time, increasing our discount rate over the valuation.

The starting discount rate for our work will be 8.50% and will fall the industry average of 5.05% over the valuation.

Valuation

The spreadsheet below is a screenshot showing the valuation results based on all the above inputs we used to create a possible value. Remember that any model is only as good as the inputs, and remaining consistent is one of the keys.

None of this is investment advice; rather, it is an attempt to find the value of a young company as a guide to help you calculate your valuations. Far better to teach someone to fish than to provide the fish.

As you can see, it is close to the current market value, but again these are all assumptions. Before buying any company, we need to do our due diligence to learn about the company, sector, and potential opportunity.

Here is the model for you to download to play around with any assumptions or use as a basis for your valuations.

CRWD-Young-Company-Valuation Download

Investor Takeaway

Valuing young companies is a challenge, but it is not impossible; the main focus needs to remain as consistent as possible and follow the steps to determine how likely we are in our assumptions.

Professor Damodaran includes several diagnostic tabs to view better our assumptions and how they play out, giving us the chance to assess our numbers and determine the likelihood.

For more resources on this subject, here are few more links to give you data and deeper subject matter.

And with that, we will wrap up our discussion on valuing young companies.

As always, thank you for taking the time to read today’s post, and I hope it helps you on your investing journey. If I can be of any further assistance, please don’t hesitate to reach out.

Until next time, please take care and be safe out there,

Dave