Valuation World Cup: Group B – (Business)

Breaking news out of the Governing Body of the CVWC!  Due to improper accounting practices, EV/Earnings has been removed from group play and EV/Sales Expense has been included! Its a disappointing turn of events because our CVWC analysts had EV/Earnings as a dark horse to win the tournament because it can be an extremely valuable term for later stage companies by providing “smoother” earnings analysis and its ability to analyze the business as a whole.

Day Two of the Valuation World Cup brings us Group B: the business metrics methods. This has to be the group of death in the tournament, considering these are tried and true methods applicable to one-year-old startups and hundred-year-old behemoths. Get your spreadsheets ready, cause it’s about to go down…

*Editor’s Note: Confused? Lost?  Head over to the Valuation World Cup Homepage for more information!

1. Enterprise Value/Sales

Explanation and Use Case
The first of the “multiples” approaches,” EV/Sales (aka: EV/Revenue) values a company based on the dollar value of their sales, typically on an annual basis. By looking to comparable companies – in size, stage, business model and sector – an average multiple can be determined and applied to the company’s revenue. Using the revenue run rate of the next twelve months, rather than the previous years’ sales, can be a better measure of value for fast growing startups, so long as you use a forward multiple to maintain timing consistency.

This method is especially useful when valuing revenue-generating companies currently operating at a loss, as it provides a measure tied to financial health without relying on earnings.

Pros and Cons
EV/Sales is like a strong cross from a sprinting winger into the box for a 6’8” striker: simple but effective. As long as the comparables are carefully chosen, this metric can provide great insight into both current value and anticipated growth prospects. The higher the multiple, the greater the upside potential.

A metric this simple has its downsides as well, namely with how varied business models can be.  The costs to make a dollar of sales will be vastly different for a company generating word-of-mouth sales versus a competitor with a full-time direct sales team. When choosing comparables, it’s not enough to simply pick a number towards the middle of a range. Careful consideration must be given to how these costs and margins will evolve.

Example
SecuriCloud is out raising a seed round after booking $100k of sales over the past year. Silver Lining Security recently raised their Series A at a pre-money valuation of $5M with revenue of $250k, and SkyKeys was recently bought by CloudTight.ly for $6M with estimated sales of $500k. All three companies have margins of 55-75% and have small, experienced sales teams. It appears the multiple should fall between 12-20x. Total Value: $1.6M.

2. Enterprise Value/EBITDA

Explanation and Use Case
With EV/Earnings out of the tournament, it’s up to EV/EBITDA to defend what investors are really looking for: returns!  EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization) falls between Revenue and Earnings for a happy middle-ground indication of financial performance, including cost of sales but foregoing tax, financing and non-cash expenditures. Once again, look to similar firms to determine the appropriate multiple.

EV/EBITDA is useful for companies with strong revenues and positive cash flows, but lacking consistent earnings, with applications well beyond Series C+ rounds.

The Pros and Cons
EBITDA is an unlevered measure of the pre-tax cash flows, and, should also provide consistent comparisons across time measuring growth in sales and margins. Also, the “pre-tax” component eliminates tax-loss carry forwards which, while valuable, are not indicative of future performance.

However, one useful part of the EV/EBITDA metric can be rather  meaningless for startups: it measures the unlevered cash flows to allow for comparisons across different capital structures. Most early stage startups are 100% equity-owned already.

Example
CornBorn Energy is raising a Series C to fund their sixth ethanol plant. Despite consistent losses over the past five years, their EBITDA has grown tenfold over that time to $100M. Other publicly traded ethanol companies, regardless of their leverage position, have EV/EBITDA multiples in the 5-7x range. Total Valuation: $600M

3. EV/Sales Expense

Explanation and Use Case
Two sales multiples? It looks like they’ve put East Germany and West Germany in the same bracket! EV/Sales Expense is simply the Enterprise Value compared to how much does it cost to generate revenue (Sales).  This is a very telling metric about the priorities of a company as well as what stage of the life-cycle they are in (land grab/scale vs. harvest/mature).  This is a widely used metric when trying to determine how effectively a company can drive top line growth.

The Pros and Cons
A good (high) EV/Sales Expense ratio is like that same strong cross to a 6’8 striker in the box but this time you are up 2-0 in the 85th minute; simple, effective, and most importantly a great way to get a positive long-term outcome (profitability/win the game).  A bad (low) EV/Sales Expense ratio is that same cross to that same striker but this time you are down 3-0 in 88th minute and you had to send your whole team ahead leaving you completely exposed to any counter-attack.  Simple, effective, but unfortunately not a great way to get a positive long-term outcome.

Example
Security startup RainEye is looking to raise a Series C and has $20M in sales but has $12M in Sales Expense.  The prevailing analysis of similar security companies at their stage (land grab/scale) revealed an average EV/Sales Expense multiple of 4x.  Total Value: $48M

4. Discounted Cash Flow

Explanation and Use Case
Open your “Intro to Finance” textbooks to Chapter 1 and you’re likely to find the Discounted Cash Flow analysis. The model relies on a cost of capital and a set of projections regarding future returns. Then discount those future cash flows back to find your present value. I’m sure if Ian Darke was there to see the naming of this method, I’m certain he’d say, “Clever, that.”

This has been the preferred model for everyone from book building investment bankers to Fortune 500 middle managers determining capital budgeting.

The Pros and Cons
The Discounted Cash Flow analysis method is like Spanish tiki-taka futbol (bear with me). At first glance, the DCF is an incredibly complex system, but in actuality a very logical progression of precise movements. Every bit flowing into the next, and finally all is brought back to the present. This brought Spain the World Cup in 2010, no?

But precision does not always mean accuracy.

Example
We have given enough written examples, see the video tutorial below!

Match to Watch

In a group of behemoths, it will be interesting to see how the three income statement line items will stack up against one another. At what point do startup revenues have to generate cash flows? And when can we see those cash flows translate to business earnings? And can any of these one-off metrics stack up against the completeness of a DCF?

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4 thoughts on “Valuation World Cup: Group B – (Business)

  1. Pingback: Monday Morning Memo | Capital: Ventured.

  2. Pingback: The Valuation World Cup Begins! | Capital: Ventured.

  3. Pingback: Valuation World Cup: Group B – Winners Revealed! | Capital: Ventured.

  4. Pingback: Valuation World Cup: A Champion is Crowned!! | Capital: Ventured.

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