1. Text Jussi Autere April 5 th, 2016 Growth & Harverst, Spring 2016 What is the price? How companies are valued

2. Contents 1.The underlying logic: DCF 2.Peer multiples 3.How investors define the valuation 4.Strategic premium 5.The company can have multiple valuations at the same time

3. The underlying logic: Discounted Cash Flow

4. 4 Buyer wants to get his money back The underlying logic of valuations is based on simple logic Buyer wants to get more money back ultamately than she/he invests When an investor buys company stock, it value is based on calculation that investor will get his money back with an interest The money can come back as dividends or by selling company, its assets or its business

5. Approaches to the Valuation Price of the assets that the company owns The value of the assets if they are sold, or The book value, or The sunken investment. In scale-ups, the asssets do not usually have clear value Future returns than the target produces The business generates money gradually back (generates cash flow) There is a need to earn interest over time, thus the future cash flows need to be discounted Calculating discounted future cash flows is the dominant method to define valuations

6. Formula to calculate future cash flows Where: CF1 = cash flow in period 1 CF2 = cash flow in period 2 CF3 = cash flow in period 3 CFn = cash flow in period n r = discount rate (also referred to as the required rate of return) CFn/(1+r) n = net present value (NPV) of cash flow in year n If it is assumed that the business will continue for ever, last years can be taken into account by calculating Terminal Value

7. Process to calculate DCF 1.Calculate the future free cash flows In calculating this from company’s projected net profit, you should first take operating profit and reduce taxes = EBIT(1-tax rate) Add depreciation + amortization Reduce necessary investments Reduce increase in net working capital 2.Estimate the long-term growth rate 3.Select discount rate 4.Discount future cash flows by discount rate 5.Sum up

8. How to select discount rate All the companies have their assumed minimum return rate, WACC (Weighted Average Cost of Capital) Weighted average of costs of equity and debt (including tax effect) Public companies have lower cost of equity (liquidity discount) Smaller companies have higher cost of equity Typical WACC = 8-15% But WACC does not take into account the uncertainities related to investment transactions Typical VC discount rates (Duff & Phelps) "Startup" - early product development and less than a year old - 50%- 70%" "First Stage" - market studies, testing prototypes, limited mfg. - 40%-60% "Second Stage" "viable product and established market" - 35%-50%

9. Peer multiples

10. 10 DCF has multiple problems 1.The results are highly dependent on assumptions and parameters Discount rate selected Growth rate used to calculate terminal value 2.Realisticality of predictions are not assessed by the method itself Garbage in – garbage out 3.Environment and economic situation change, impacting risk free rate -> The VC and PE valuation guidelines nowadays do not recommend using DCF as primary method in valuation

11. Peer comparisions The recommended method is base the valuation on comparing the company on similar companies: ”Let’s find the market price” There are two sources of comparision data: publicly listed companies and companies that have been sold The valuations of publicly listed companies are typically higher than their private peers: Liquidity premium The valuations in acquisitions are usually higher than company’s share prices Control premium Strategic premium

12. Earning’s based multiples The official guidelines recommend using earnings based multiples Price per Earnings Ratio (P/E or PE) is the simplest the most universal. Easy to find for public companies Currently P/E = 6 the start for private companies Fast growth increases valuation In the case, there are large balance sheet items, extra taxes of heavy investments EV/EBIT is often used EV = Enterprise value = Price of the business without extra debt or cash Comparing companies with similar structure, also EB/EBITDA is used

13. Price per Sale (=PS or P/S) Making the comparision baseed on peer revenues Should not generally be used Could be used between companies with similar business and profitability Is used more often than this, reasons Sales is the most reliable and stable of company’s financial figures It is easy to grasp and calculate ”You can change speed (sales growth) to height (profitability)” especially in professional services Price per subscriber of user, etc. is also sometimes used

14. What is extra cash or debt? The modern finance theory starts from the assumption that the assets or debts of a company should not be valued separately Assets are needed to produce future returns The debts are part of the business model In real world valuations, the ”extra” assets are important The company can have for taxation reasons kept profits as cash and not paid them to shareholders The company could have terminated a business and is still have the assets related to it The company could have terminated a business, but has not been able to pay the debts related to it

15. Text How investors define valuation

16. 16 How company without revenues can have 3 M€ of valuation The general idea is to figure out, what is the valuation in 3-5 years, and then discount that valuation to present day Investor invests now 600 000 € and gets 20% Year 1 Year 2 Year 3 Second investor invests 3M and dilutes investor to 15% Company is sold for 40 M and investor gets 6 M The return in 4 years is 6 M€ The investor discounts this by 75% and gets a NPV of 6.4 M€ In real world, seed VCs do not care about exit time but invest in targets, whose valuation can grow over 10x Year 4

17. 17 Many times convention is more important than calculations In real world transactions, the valuation is a result of negotiation process Many times the final valuation is set in a meeting This is one reason why P/S is used: it is easy to grasp and calculate ”Extra cash” is a negotiation tool in exits Seller usually aims at getting ”euro-for-euro” for all the cash in the target In early stage, the convention is many times: Ca 1/3 of the company belongs to management Ca 1/3 of the company belongs to earlier investors New investor gets ca 1/3

18. Investor valuations do not tell the whole story In most cases, investor is given a liquidation preference: In exit the investor gets his investment out before owners divide remaining This makes investments resemble like debt: you have to pay principal out Investment can be a preferred stock: principal to be paid out after 5-10 years and carries an interest Sometimes the investment is debt and the debtor is given warrants of certain % of ownership

19. Text Strategic premium

20. 20 A company can be more valuable to the buyer than to its current owners The price in current setting is called Fair Market Value E.g. a larger company can increase sales, bcause it has better sales channels Buyer can have more efficient production Buyer can have better prices with major customers Or simply Our P/E is 20 in stock market, but we can buy smaller private company for P/E 12 This is called Strategic Premium The theory of M&A states that there needs to be Strategic Premium for a transaction to happen Example?

21. Text The company can have multiple valuations at the same time

22. 22 At the same time, there are multiple correct valuations of a company One is for taxation One is for ”fire sales” liquidity One is for current owners One is for a strategic acquirer This imposes problems in e.g. Bankrupcy situation: how a company that raised 0.6 M€ in 3M€ valuation be worth 0 € in 12 months? Accounting. The basic principle in accounting is that there is one exact figure for everything

23. Text eitdigital.eu Dr Jussi Autere Manager, Helsinki DTC Jussi.i.Autere@aalto.fi +358 400 422 565