Valuation is about the future, not about the past. But any corporate financier will tell you how much more comfortable you feel when you have a company track record (the longer the better) as a basis to build your future projections.
But how to value a company that has neither a past performance record nor a present business, just some vision and a few ideas?
Here are my 3 takeaways from watching Aswath Damodaran’s webinar on YouTube:
Lesson #1
We have too much data at our fingertips nowadays. Data is readily available and is almost begging to be used. Succumb to the temptation and you end up with a spreadsheet containing tens of variables. Does it make your valuation of higher quality? It is doubtful.
Aswath admits that he is using just 5 inputs for valuation:
– revenue growth (which can be achieved either by selling more output or by increasing prices);
– operating margins (which show how the company is making money);
– growth and investment efficiency (reinvestment, including R&D and customer acquisition costs, can affect revenues and margins; quite often growth could destroy value);
– cost of equity (what kind of return the investors would expect for taking this kind of risk);
– cost of debt (the cost at which the company can borrow funds in the market).
In addition, one has to be careful to consider the probability of failure — either because at least 2/3 of startups do not make it, or because of some catastrophic event that may endanger the business model (after Covid you have to keep the threat of another pandemic in mind as a possibility). This may require a further adjustment to the value.
Aswath’s recommendation — “Use imagination. Keep your valuation simple, but not simplistic!”
Lesson #2
When valuing an early-stage startup you have to keep an eye on the endgame — how is the company going to make money? The answer to this is what we often call a business model.
Most companies make money in one (or several) of the following ways:
– entering into transactions — selling their product or service;
– offering subscriptions — selling continuous access to services over a period of time;
– advertising — offering advertising opportunities on their platform.
It would not be wise to assume that the startup founders always have a clear vision and can answer the questions about which business model they are building. You might have to use your judgment here.
Lesson #3
We are all living in the “winner takes it all” economy. The most profitable companies are techs with enormous platforms. You win in this game when you have built a default platform. And when you have succeeded in creating “stickiness”. Netflix is sticky because you want to continue watching your favourite series of the moment. Facebook makes it difficult to leave because all your and your friends’ lives are there. Many users are too worried or even scared to consider switching away from Microsoft products. These are all examples of what Aswath calls proper stickiness.
None of the ride-sharing companies is making money because the stickiness is simply not there. Consumers have no particular loyalty, they shop around with 1 or 2 other platforms and choose the cheapest option available. The ride-sharing companies have been putting so much focus on supporting growth that they have failed to tweak their business model to create stickiness. Now they are trying to figure out how to achieve this.
And, as a final note, Aswath argues that venture capitalists do not value companies, they just price them. They take the metrics and numbers from some similar businesses and apply them. Their process has little to do with valuation as it usually ignores the most basic question — how is this company going to earn money?
For those willing to try and pick top lessons of their own here is the link.
* from anything that you are reading, watching or hearing you can realistically expect to remember a limited number of things only. My solution is to pick just 3 items or ideas from any material. This number is non-negotiable. Even the most extraordinary experience has to be compressed into 3 things to remember. This approach has worked for me so far.
This note was first published on Medium.com on 6 October 2024
