Valuing Hard to Value Firms zWhat is a “hard to value” firm? ySuperfast revenue growth yNo earnings (NI<0) yNo history yNo comparables zDiscounted Cash Flow is still the dominant model! yValue is still the PV of future cash flows yAlternative methods may use multiple approach (Price/Sales)

Measuring Cash Flow: 2 common measures zFCFF = EBIT(1-t) - (Capital Expenditures - Depreciation Expense) - Change in Working Capital zg FCFF = RR x Return on Capital zValue of Firm = FCFF 1 /(WACC - g FCFF ) zValue of Equity = Value of Firm - Value of Debt zFCFE = NI - (Capital Expenditures - Depreciation Expense) - Change in Working Capital - Change in Debt zg FCFE = RR x Return on Equity zValue of Equity = FCFE 1 /(k - g FCFE )

Problems: Negative Earnings zCan’t estimate growth from current earnings! zPossible Solution? Normalize Earnings yAre earnings normally positive? xFirm had a bad year xCyclical firm during a recession xHow long with this last? yAverage firm’s earnings over prior periods yAverage firms’ ROC, ROE, or profit margins over prior periods yUse ROC, ROE, or margins for comparable firms

Problems: No History, No Comparables zNo History? Use contemporaneous data form comparable firms yThis is how software firms get valued at IPO yWhat are comparables? xSimilar business xquality of information xindustry life cycle zNo Comparables? Use history!

The Big Problem: No Earnings, No History, No Comparables zStay focused on Discounted Cash Flows! z1. Get the most recent financial info (TTM) z2. Estimate expected revenue growth ypast growth of firm’s revenues ygrowth rate for overall market firm services yrecognize barriers to entry, competitive advantages z3. Estimate sustainable operating margin ywhat will operating margin look like when revenue growth stabilizes?

The Big Problem: No Earnings, No History, No Comparables z4. Reinvestment needs yRR = g EBIT x ROC yassume net Cap. Expense and change in WC will grow with revenue or that revenue growth lags reinvestment. z5. Risk Parameters and Discount Rate yMust estimate Beta for firm’s equity => k e yMust estimate k d (use bond ratings) yMust estimate target capital structure yk e and k d will change as growth stabilizes

The Big Problem: No Earnings, No History, No Comparables z6. Firm valuation and equity valuation yforecast FCFF to point of long-term, stable growth (at industry average) yValue at t = FCFF t+1 /(WACC - g) yValue of firm = PV of all estimated FCFF yV Equity = V Firm - V Debt yShare value = V equity /No. of Shares

Key Inputs to DCF approach zWhat matters most in valuation of young, high- growth firm with negative earnings? yEstimates of revenue growth yestimates of sustainable profit margins ytime to reach stable, long-term growth

An Inductive approach to Valuation zObservations: yAmazon is currently valued at $35/sh. yShares outstanding = million yMarket Cap. = $ billion yMost recent 12 mo. revenues = $2,465.7 million (TTM) zAssumptions: yAmazon will achieve a net profit margin of 5% yOn current revenue, that makes $ million NI yBeta = 2, k m = 12%, RFR = 6%

An Inductive approach to Valuation zk AMZN = 6% + 2(12%-6%) = 18% zIf Net Income does NOT grow: zValue of equity = $ /.18 y= $ yDivided by shares = $1.92/share! zA constant growth model would need to use a growth rate of 16.8% to get current market value. zIs this reasonable? z(Note: We’ve assumed that NI = FCFE)

A Price/Sales approach zAmazon’s P/S = $12,466/2,465.7 = 5.06x zYahoo’s P/S = $37,630/998.1 = 37.7x zIs Yahoo 7 times “richer” than Amazon? zIs this a valid comparison? yAmazon to Barnes and Noble? yYahoo to AOL?

Summary zIt is difficult to value “hard to value” firms! zMore art and less science zCan develop DCF or multiplier model yeither approach requires many assumptions zCan value firms on a relative basis ymay be best we can hope for!