Valuation Across the Life Cycle
Although the inputs into valuation are the same for all businesses, the challenges we face in making the estimates can vary significantly across firms. In this section, we first break firms into four groups based on where they are in the life cycle. Then we explore the estimation issues we run into with firms in each stage.
The Business Life Cycle
Firms pass through a life cycle, starting as young idea companies, and working their way to high growth, maturity, and eventual decline. Because the difficulties associated with estimating valuation inputs vary as firms go through the life cycle, it is useful to start with the five phases that we divide the life cycle into and consider the challenges in each phase, as shown in Figure 1.3.
Figure 1.3 Valuation Issues Across the Life Cycle
Note that the time spent in each phase can vary widely across firms. Some, like Google and Amazon, speed through the early phases and quickly become growth companies. Others make the adjustment much more gradually. Many growth companies have only a few years of growth before they become mature businesses. Others, such as Coca-Cola, IBM, and Wal-Mart, can stretch their growth periods to last decades. At each phase in the cycle, some companies never make it through, either because they run out of cash and access to capital or because they have trouble making debt payments.
Early in the Life Cycle: Young Companies
Every business starts with an idea. The idea germinates in a market need that an entrepreneur sees (or thinks he sees) and a way of filling that need. Most ideas go nowhere, but some individuals take the next step of investing in the idea. The capital to finance the investment usually comes from personal funds (from savings, friends, and family), and in the best-case scenario, it yields a commercial product or service. Assuming that the product or service finds a ready market, the business usually needs to access more capital. Usually it is supplied by venture capitalists, who provide funds in return for a share of the equity in the business. Building on the most optimistic assumptions again, success for the investors in the business ultimately is manifested as a public offering to the market or sale to a larger entity.
At each stage in the process, we need estimates of value. At the idea stage, the value may never be put down on paper, but it is the potential for this value that induces the entrepreneur to invest both time and money in developing the idea. At subsequent stages of the capital-raising process, the valuations become more explicit, because they determine what the entrepreneur must give up as a share of ownership in return for external funding. At the time of the public offering, the valuation is key to determining the offering price.
Using the template for valuation that we developed in the preceding section, it is easy to see why young companies also create the most daunting challenges for valuation. There are few or no existing assets; almost all the value comes from expectations of future growth. The firm's current financial statements provide no clues about the potential margins and returns that will be generated in the future, and little historical data can be used to develop risk measures. To cap the estimation problem, many young firms will not make it to stable growth, and estimating when that will happen for firms that survive is difficult to do. In addition, these firms are often dependent on one or a few key people for their success, so losing them can have significant effects on value. A final valuation challenge we face with valuing equity in young companies is that different equity investors have different claims on the cash flows. The investors with the first claims on the cash flows should have the more valuable claims. Figure 1.4 summarizes these valuation challenges.
Figure 1.4 Valuation Challenges
Given these problems, it is not surprising that analysts often fall back on simplistic measures of value, "guesstimates," or rules of thumb to value young companies.
The Growth Phase: Growth Companies
Some idea companies make it through the test of competition to become young growth companies. Their products or services have found a market niche, and many of these companies make the transition to the public market, although a few remain private. Revenue growth is usually high, but the costs associated with building market share can result in losses and negative cash flows, at least early in the growth cycle. As revenue growth persists, earnings turn positive and often grow exponentially in the first few years.
Valuing young growth companies is a little easier than valuing start-up or idea companies. The markets for products and services are more clearly established, and the current financial statements provide some clues to future profitability. Five key estimation issues can still create valuation uncertainty. The first is how well the revenue growth that the company is reporting will scale up. In other words, how quickly will revenue growth decline as the firm gets bigger? The answer will differ across companies and will be a function of both the company's competitive advantages and the market it serves. The second issue is determining how profit margins will evolve over time as revenues grow. The third issue is making reasonable assumptions about reinvestment to sustain revenue growth, with concurrent judgments about the returns on investment in the business. The fourth issue is that as revenue growth and profit margins change over time, the firm's risk will also shift, with the requirement that we estimate how risk will evolve in the future. The final issue we face when valuing equity in growth companies is valuing options that the firm may grant to employees over time and the effect that these grants have on value per share. Figure 1.5 captures the estimation issues we face in valuing growth companies.
Figure 1.5 Estimation Issues in Growth Companies
As firms move through the growth cycle, from young growth to more established growth, some of these questions become easier to answer. The proportion of firm value that comes from growth assets declines as existing assets become more profitable and also accounts for a larger chunk of overall value.
Maturity—a Mixed Blessing: Mature Firms
Even the best of growth companies reach a point where size works against them. Their growth rates in revenues and earnings converge on the growth rate of the economy. In this phase, the bulk of a firm's value comes from existing investments, and financial statements become more informative. Revenue growth is steady, and profit margins have settled into a pattern, making it easier to forecast earnings and cash flows.
Although estimation does become simpler with these companies, analysts must consider potential problems. The first is that the results from operations (including revenues and earnings) reflect how well the firm is utilizing its existing assets. Changes in operating efficiency can have a large impact on earnings and cash flows, even in the near term. The second problem is that mature firms sometimes turn to acquisitions to re-create growth potential. Predicting the magnitude and consequences of acquisitions is much more difficult to do than estimating growth from organic or internal investments. The third problem is that mature firms are more likely to look to financial restructuring to increase their value. The mix of debt and equity used to fund the business may change overnight, and assets (such as accounts receivable) may be securitized. The final issue is that mature companies sometimes have equity claims with differences in voting right and control claims, and hence different values. Figure 1.6 frames the estimation challenges at mature companies.
Figure 1.6 Estimation Challenges in Mature Companies
Not surprisingly, mature firms usually are targeted in hostile acquisitions and leveraged buyouts, where the buyer believes that changing how the firm is run can result in significant increases in value.
Winding Down: Dealing with Decline
Most firms reach a point in their life cycle where their existing markets are shrinking and becoming less profitable, and the forecast for the future is more of the same. Under these circumstances, these firms react by selling assets and returning cash to investors. Put another way, these firms derive their value entirely from existing assets, and that value is expected to shrink over time.
Valuing declining companies requires making judgments about the assets that will be divested over time and the profitability of the assets that will be left in the firm. Judgments about how much cash will be received in these divestitures and how that cash will be utilized (pay dividends, buy back shares, retire debt) can influence the value attached to the firm. Another concern overhangs this valuation. Some firms in decline that have significant debt obligations can become distressed. This problem is not specific to declining firms but is more common with them. Finally, the equity values in declining firms can be affected significantly by the presence of underfunded pension obligations and the overhead of litigation costs—more so than with other firms. Figure 1.7 shows these questions.
Figure 1.7 Questions About Decline
Valuing firms in decline poses a special challenge for analysts who are used to conventional valuation models that adopt a growth-oriented view of the future. In other words, assuming that current earnings will grow at a healthy rate in the future or forever will result in estimates of value for these firms that are way too high.