IPOs: The Unicorns Moment of Truth

It has been said that in finance things take longer to happen than you would expect, but then unfold faster than you would have thought. This fact seems to be occurring in the mythical land of unicorns. I am fascinated with unicorns because their purported valuations seem to violate basic economic logic. Values not dependent on cash flow, risk and time would upset how we approach mergers and acquisitions. Rest easy as it appears unicorns do not violate the first principles of finance. Rather, their financing round based implied valuations are worse than theoretical (the usual compliant against discounted cash flow models)-they are just fanciful.

Some many unicorns are getting long in the tooth at 5-7 years of age (tech firms age in dog years). Investors are pressing for liquidity AKA an IPO. The IPO process or test is exposing some of the inconvenient facts I have previously highlighted about unicorn implied valuations. A stark example is provided by the pricing range assigned to the pending Square IPO. Last year Square was valued at over $6B based on its last financing round. Fast forward to the present and the IPO values Square in the $4B range. So what the!@#$ happened?

Something could have dimmed the prospects for Square such as the loss of Startbucks next year and continued large operating losses. Also, IPO market conditions have softened somewhat following the August correction. Worse yet is the possibly that Square was never was worth $6B. It seems that investors in the 2014 financing round did not receive ordinary shares. Rather, they received “super shares” providing them with protection against an IPO priced below their financing round value. Basically, they get more shares at bargain prices to make them whole if the IPO is priced at less than their investment. Thus, unicorn values may be inflated and exposed during the IPO process. No wonder many unicorns are trying to postpone going public for as long as they can. It will get even more interesting after they are public when they face scrutiny of real market disciple. Perhaps, things may not be so different for unicorn valuation after all.

J

Valuation in M&A - Reports from the Field

In teaching finance to MBAs, I stress an analytical approach to decision making and strive to give the students the latest tools of our field and to discuss the latest empirical and theoretical research.  But I also stress that 'People Make Decisions', not algorithms or analytical techniques.  Also, it is people who implement decisions.  Certainly, this is crucial in the field of mergers where integration remains one of the major concerns.  Finally, I note that there is an Art and a Science to finance.  We can teach the science, but the art is nuanced and requires a great intuitive grasp of the subject blended with experience.

Here is an interesting article on how practitioners are actually valuing companies in M&A transactions.  It makes the same points.  The authors interviewed investment bankers who confirm use of the techniques often discussed in these posts: discounted cash flow and comparable transactions.  The article also highlights the use of judgement in making these decisions, noting:

"While leading practitioners routinely use DCF methods in mergers and acquisitions (M&A) valuations, the application is often far from “routine”; it requires art and judgment in the face of inherently uncertain business forecasts such as those surrounding merger synergies. Our results serve as yet another reminder that analytic techniques such as DCF do not make decisions but only inform them."

From "Company Valuation in Mergers and Acquisitions: How is Discounted Cash Flow Applied by Leading Practitioners? by W. Todd Brotherson, Kenneth M. Eades, Robert S. Harris, and Robert C. Higgins"

All the best,

Ralph

Venture Capital Discount Rates: Precisely Wrong or Roughly Right?

The standard  Discounted Cash Flow valuation approach discounts an investment’s expected cash flows at their risk adjusted cost of capital. This rate is usually estimated using a Portfolio Theory based approach like CAPM. These models concentrate on Systematic Risk not total risk. Idiosyncratic Risk can be diversified away. Hence investors can expect no compensation for holding it. An example is a resort island which has two firms-one selling suntan lotion and the other umbrellas. Holding shares in just one firm exposes you to weather risk (idiosyncratic).If you hold shares in both you are no longer exposed-you have diversified the risk. Nonetheless, you remain exposed to systematic risk of a tsunami.

Some take this to mean idiosyncratic risk can be ignored. For passive minority investments in larger more stable going concern firms this is a good enough approximation. For VC type startups idiosyncratic –total risk cannot be ignored. These firms are not and may never be going concerns due to their failure to execute their business plans. This risk is unique not systematic. In fact failure rates for startups is very high-greater than 50% in the first five years of existence. The firm never realizes on it growth potential, which represents the majority of startup firms’ value, if it fails. Furthermore, liquidation values for VC investments are usually low. This is because the assets are primarily intangible meaning they have limited value if the firm ceases to exist. Thus, the key to value creation is management’s ability to exploit the firm’s idiosyncratic opportunities. Successful venture capitalists can identify these unique undiversified winners.

The standard DCF approach utilizing portfolio theory understates the discount rate and over states value. This is why many venture capitalists use arbitrarily high discounts rates of 25%+ instead of the lower academically determined rates. The rates VC’s use vary depending on the stage of the investment with earlier stage investments having higher rates than later stage follow-on investments.

Another measure of failure risk is the Cash Burn Rate. This is the cash raised and remaining from the prior funding round divided by cash operating losses. Firms with high burn rates need access to get additional funding to fund continued losses. This access can be difficult to measure. It depends largely on VC market condition which can turn on a dime. One possible reason for the current buoyant VC valuations is inexperienced investors may be using low discount rates ignoring failure and refinancing risks.

Academics dismiss the venture capitalists’ ad hoc approach. They argue that instead of raising the discount rate you should adjust the cash flows downward to reflect their uncertainty. The problem with startups is how to make such adjustments when you lack historical operating history. Instead of the false precision from cash flow adjustment the rough approach of increasing the discount rates may not be so bad after all. As Keynes noted-it is better to be roughly right than precisely wrong.

j

Getting Real: Real Options and M&A

Facebook is at it again. Following up on their February Whatsapp announcement- they now plan on a $2B purchase of Oculus. This new transaction is even more difficult to justify using traditional valuation methods as Oculus is an early stage virtual reality firm with no customers or revenues. It is tempting to write it off as an unjustified irrational bubble. In fact, the initial market reaction was negative. Alternatively, the problem may be with the traditional Discounted Cash Flow (DCF) methodology used to value Oculus and other early stage firms. 

DCF was designed for mature assets with identifiable bond like cash flows from an installed asset base. Growth can be considered in the relatively short forecast period before it decays into a steady state terminal value. It is less well suited for evaluating the entry and exploitation of attractive new markets thru the acquisition of rapidly growing targets. In these instances, cash flows from installed assets, often negative, are of secondary importance. The real value is in the follow-on growth investments. Failure to consider this fact under values the target.

DCF views targets as independent projects based on passively managed identifiable cash flows. It ignores the sequential interdependence among projects, and management’s ability to revise the investment profile so as to increase value. It is like trying to value a convertible bond focusing only on the coupon while ignoring its option value. Real Option Valuation (ROV) provides a means of thinking about the alternative supplemental option value sources, and helps close the gap between strategy and finance.  The gap is illustrated as follows:

1) Financial analysis is frequently overridden for strategic reasons
2) Strategic considerations such as diversification at the firm level are ignored by finance
3) Overvaluation based on DCF methodology is deemed irrational. Markets and managers may, however, recognize hidden value
4) Uncertainty increases option value unlike in DCF where uncertainty reduces value
5) Option like investments have a time value even if their intrinsic value is zero (i.e. out of the money)
6) Bastardized DCF methods like the Venture Capital Method way of evaluating start-ups which relies on ad hoc high discount rates to evaluate uncertain cash flows
7) Questionable synergies-synergies can be viewed as a crude ROV

ROV is best limited to smaller private targets with limited comparables. Value for these firms depends more on future market developments and management’s reaction to them not existing operations. They have a small chance of large payoffs (i.e. right skewed distributions with winner take all characteristics). Frequently missed is management’s ability to actively manage the target after the acquisition to change its value from the following actions:

1) Delay further investments while it moves up the learning curve. Competition can, however, reduce the option value of waiting in the fast changing tech world.
2) Scale back investments should growth slow
3) Expand investments if growth accelerates
4) Abandonment or put options to truncate losses if the market fails to materialize

Care is needed when dealing with ROV as it can used, just like DCF, to justify overpaying. Some investors are wondering if Facebook’s acquisition spree, which could be viewed as a complement to internal R&D, is beginning to look like Hewlett Packard.Thus, it should be used to supplement not replace DCF only in narrow circumstances satisfying at least the following:

1) The option must be exclusive like a patent. If everyone has it then no one has it.
2) Make sure it is an option not just an opportunity. This means identifying the underlying asset and the payoff contingency
3) Limit to very early targets-more relevant for Facebook than General Motors
4) Management has the ability to exercise successfully the option
5) The option is not over priced
6) There is some rational expectation of future cash flow

If the only tool you have is a hammer, then everything looks like a nail. You now have another tool in your valuation toolbox. Chose and use wisely.

j

Cookbook WACC Estimates: Wrong Recipes?

The weighted average cost of cost (WACC) is used to discount a target’s expected free cash flows (EBITDA less taxes , CAPEX and working capital increases) to determine its value. The target’s business risk profile and the intended capital structure are used to arrive at WACC. Estimating WACC suffers from severe application issues-especially in the current unsettled quantitative easing environment.

The WACC cookbook approach embedded in many financial models involves the following steps:

                  1) Determine a capital structure based on target ratings. For example, a BBB

                      rating target for an industrial firm usually means 40-50% debt to capital

                      range.

                  2) Estimate the cost of debt (Kd) for firms with that capital structure based

                      on observations from sources like Bloomberg.

                  3) Calculate the cost of equity (Ke).

                  4) Combine the after tax debt cost with Ke using appropriate weights to get WACC.

The weak link in the above steps is calculating the unobservable Ke.  Most firms use the capital asset pricing model (CAPM) to calculate Ke. The calculation involves adding a risk mark up to the risk free return (Rf) based on an asset’s units of risk (beta-B) times the price per unit of risk (market risk premium- MRP). The inputs used can vary considerably. Note some of the issues and choices:

1)     Rf: Treasury bills,5 , 10 or 30 year bond? Usually try to match with the asset’s expected life.

2)     B: what period and which one-Value Line, Bloomberg or forward looking fundamental B such as Barra?

3)      MRP: historical 1926-2013 (e.g. Ibbotson-Morningstar), implied forward (e.g. Damodaran), survey, etc. The range runs from around 2%-8%. Many use 6% as a shortcut.

 WACC ranges based on differing input choices can be large. For example, the difference between the high and low estimates for Target Stores is 400 basis points. This has huge implications when making capital allocation decisions. A related problem is that CAPM (and to be fair, all equity models) are estimates of truth. (As we have noted, Value is Estimated, Price is Paid). Alternative multi factor models like the Fama-French 3 factors offer some hope in addressing the CAPM deficiencies.  However, any mechanistic run the spreadsheet approach to calculating discount rates, is trouble in the brewing.  

Finally, evidence indicates that the market price of risk changes based on investor risk aversion and central bank polices. For example, Fed QE policies have depressed interest rates like Rf. Evidence indicates the MRP varies inversely with rates. Thus, in the current low rate environment, MRP inputs can be under estimated.

Bottom line-forewarned is forearmed. Beware of the seductive simplicity of cookbook recipes built into many valuation models. Investors like Warren Buffett avoiding using WACC for the reasons outlined above. He uses certainty equivalent cash flow estimates discounted at the observable (as opposed to the calculated WACC) Rf rate. For those using WACC- I suggest using a range of different estimates based on alternative inputs and models. The key is to use judgment before cranking out numbers. In so doing you can avoid getting indigestion from using the wrong recipe.

J

Estimating value: Part 1 An Overview of Discounted Cash Flow

Previously, we've written that Value is estimated, Price is paid.  Today we  start to discuss some of the many ways to estimate value.  Each method has advantages and disadvantages.  None is perfect but taken together they provide a meaningful framework for estimating value.

Some of the major techniques used to estimate value include:

• Discounted cash flow
• Multiples
• Comparable Transactions

In today's post, I'll provide an overview of discounted cash flow, returning to multiples and comparable transactions at a later time.  We'll also ignore liquidation value and book value for this post.  Liquidation value is useful when you are anticipating dismantling a company and book value is, well, historic.  The book value of any asset doesn't necessarily reflect true value and is often dramatically different.  That said, there seems to be some  information in book value.  Multiples of book value, for example, are often used in valuation.

True or intrinsic value
So we mentioned 'true value'.  It is often called 'intrinsic' value, and yes, it exists in the eye of the estimator.  The true worth of an asset, of course, is what someone else will pay for it.  But in valuing our company this is unknown.  How can we get estimates of intrinsic value, estimates that inform a meaningful selling price?

DCF in practice
Let's start with discounted cash flow.  Simply put, the value of any business asset is the stream of cash flows it will generate throughout its life, expressed in today's dollars.  We generally assume that businesses, and the equity that represents ownership in these businesses have an infinite life.  Products follow a life cycle.  Companies that produce them can last indefinitely by continuing to adapt, replacing old products with new ones.  Now, we can't meaningfully think about cash flows at year seventeen, let alone at infinity so we often use a shorter term investment horizon.  Let's take five years and assume (probably artificially) that we sell the company or stock at the end of this period.  Whether we do is immaterial, it just helps us conceptualize the issue.

So in the diagram below we have two cash flow streams, one stretching to infinity and one truncated at five years.   The present value of each of these streams is the current worth of the company.

The equation describing the discounting process (converting the cash flows into today's values) is shown below.

Terminal value
Note that in the arrowed diagram and in the equation the cash flows stretching from year six to infinity are replaced by SP5, the terminal value.  This is the assumed selling price in year 5.  How do we estimate this selling price?   Two standard techniques are: a) a constant growth model and b) price multiples.  The first technique is a mathematical reduction of assuming cash flows will grow at a constant rate forever.  The second is based on the valuations of related companies.  Both methods have some merit.  I'll cover multiples in a separate post, but let me address an often voiced concern with assuming 'constant growth'.  Sure, no company is likely to actually have constant growth, but as we noted above, it becomes impossible to estimate growth precisely at some date in the future.  What is your estimate of growth in year 17 ??  Our choice is to either ignore the future or incorporate our best guess.  Constant growth does the latter.  Also, commonly used multiples (of earnings, book value, etc) have built-in but unstated assumptions just as heroic.  A word of caution: probably 70-90 percent of a firms value will occur after year five.  Be very  careful with that estimate.  

Advantages and disadvantages of DCF

An advantage of the discounted cash flow technique is that it can be applied to any business from purchasing a motel in Orlando to a photography store in Crested Butte to purchasing General Motors. In each of these examples, the value of the business to the owners is equal to the present value of all the distributions the business will generate. 

It is sometimes argued that discounted cash flow is difficult to understand.  To the contrary, the mechanics are easily applied using spreadsheets or financial calculators.  The intuition behind discounting is also easy to understand: money received in the future is worth less than money received today. The intuition behind the rate we use is also straightforward: We should discount cash flows at the appropriate opportunity cost. In other words, evaluate this project at the rate we could earn on projects of similar risk.  Our answer to the question: “What rate could we earn elsewhere with the money at this risk level?” answers the rate question.  And since higher discount rates (associated with riskier ventures) lower the present value this method adjusts for risks.

It is also asserted that the DCF method requires too many assumptions.  It is true that forecasting the amounts received in the future and estimating the opportunity cost of funds require challenging assumptions.  Nevertheless, all valuation methods utilize assumptions.  With some techniques, however, the assumptions are hidden in the apparent simplicity of the process.  As a consequence, users are often making implicit assumptions without even being aware of it.  A major advantage of discounted cash flow is that the assumptions can be quite explicit.  The ability to fine tune projections of cash flows to recognize individual firm characteristics is a tremendous advantage. Moreover, most alternatives to discounted cash flow, such as using ad hoc rules of thumb to value an asset, do not allow for easy updating. Rules of thumb that held in the past may quickly become obsolete if some underlying factor of the economy (e.g. inflation) changes. Discounted cash flow with its component parts expressed in a spreadsheet allows for immediate revisions.

In a subsequent post, we'll take a brief look at multiples and comparables.