In the latest McKinsey Quarterly, one of the articles is an excerpt of an updated Valuation book (Link: Valuing High Tech Firms) suggests that investors should return to more traditional methods of valuing early stage high tech firms including the use of Discounted Cash Flow (DCF). The article notes the issues with using multiples like Price-to-Revenues, Price-to-R&D Expenses, etc. in that they consistently overvalue the true value of a firm due to market conditions.
The article is a good reminder but a bit late and too simplistic. Using the process suggested for many years by Professor Bill Sahlman of the Harvard Business School and others (especially in the Jim Southern case), it’s important to use a variety of valuation techniques to obtain a range of values. More importantly, it’s important to distinguish between a company’s Intrinsic Value, Market Value and its Price.
The Intrinsic Value (or worth) of a company should be valued using methods like Discounted Cash Flow or asset valuations (depending on if you’re buying the assets or equity of the company). DCF is a well-tested theoretical method that should be conducted under current management and under your management (after you’ve made the investment). Doing so under the two separate conditions will help an investor identify if they can bring additional value under their ownership versus the current management.
Of course,DCF has its limitations. What Discount Rate? What Conversion Rate of customers from users to payers? (they use Yelp as an example). What growth rates to use (especially five years out)? What will be the exit value? All important parts of a DCF forecast that have lots of variability, especially when taking all components together. The authors suggest multiple scenarios at various weights to take variability into account but still there is a lot of room for error.
When ascertaining the market value of a firm (or at least estimating it) you want to incorporate market multiples pertinent to that industry. For instance, many commercial brokers use a Price to Sellers Discretionary Earnings multiple to provide a rough market estimate for privately-held small businesses. Other industries may use a Price-to-Book value, Price-to-Patient Census (health care), or Price-to-# of Rooms (hotels) to gauge value. Whatever multiple is used, it is important to gauge market conditions. If we are in a significant market expansion and rising stock market values, prices of privately held businesses tend to follow (including gold fever situations). On the other hand, when we are in a recession or a tight money environment, market values will trend downward with the public markets.
Finally, just because you have a DCF and a market value estimate, it doesn’t necessarily mean the price that is negotiated, especially when dealing with privately held companies, will be close to the rationale values developed using intrinsic and market methods. Emotions can play in negotiations. How badly the venture needs capital also enters into the equation. Finally, how much PR has the venture received creating a competitive investment strategy between multiple investors that may drive up prices?
All these factors play into the valuation process. The McKinsey does a nice job suggesting the tried and true but yet so much more is needed in valuing high tech or any venture when dealing with the privately held business arena.