Question

Not all valuation methods use discounted cash flow (DCF). Suppose Juan runs a small startup that doesn't yet generate revenue but has users which may become valuable in the future. Use the internet to find a valuation method Juan could apply to his firm that doesn't depend (at least not directly) on discounting projected cash flows and making projected financial statements. Describe the method you find, discuss the pros and cons of the method, and compare & contrast your method with DCF/NPV-based methods (all methods in chapter 10 of the book are DCF-based methods). Reference all sources and write for clarity.

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Answer 1

The three major approaches to valuation are

1. Income Approach

2. Cost Approach

3. Market Approach

Income approach :

The income approach is widely used for valuation under "Going Concern" basis. It focuses on the income generated by the company in the past as well as its future earning capability. The Discounted Cash Flow (DCF) Method under the income approach seeks to arrive at a valuation based on the strength of future cash flows.

Cost Approach :

The cost approach values the underlying assets of the business to determine the business value. This valuation method carries more weight with respect to holding companies than operating companies. Also, asset value approaches are more relevant to the extent that a significant portion of the assets are of a nature that could be liquidated readily if so desired.

Market Approach :

Under the Market approach, the valuation is based on the market value of the company in case of listed companies and comparable companies trading or transaction multiples for unlisted companies. The Market approach generally reflects the investors’ perception about the true worth of the company.

Conclusion :

Income Approach :

Juan runs a small startup and doesn't generate revenue, company does not have past record of financials to project revenue, therefore income approach can not be considered for valuation of start up.

Cost Approach :

NAV method under the cost approach does not capture the value of its intangibles (with no historic costs) and future earning capacity of the Company therefore it can not be considered for valuation of start up.

Market Approach :

First step is to find out comparable companies, as mentioned Juan has a small start-up, it might not be possible to find out a listed company to same size.

The Next step is to find out comparable transactions, in our case, buy-out of other start-ups with users, funding of similar start ups and compare the valuation of those other startups with Juan's start up.

Now to address the elephant in the room, the valuation method Juan could apply to his firm that doesn't depend (at least not directly) on discounting projected cash flows and making projected financial statements is comparable transaction method under market approach of valuation.

How to apply this method :

Step 1 : Find out key revenue driver, It is given that the start up has users which may become valuable in future and that means in future the success of startup will depend upon number of users. More users will bring more revenue and ultimately more value.

Step 2 : Identify transaction or funding of other user based start-ups, look for private equity funding or angel capital funding or any other transaction on Bloomberg or other financial websites. Make a list of these transactions

Step 3 : Find out valuations of these start-up.

For example - A private equity has bought 50% stake for $1 million then the valuation of startup is $2 million.

Step 4 : Find out valuation multiples for key revenue drivers, in our case Valuation per user.

Step 5 : Apply the multiple to users in Juan's start-up.

For example : - the company with $ 2 million valuation has 500000 users that means value per user is (2000000/500000) $4 and Juan's start-up has 100000 users then value will be (100000 * 4) $400000.

In practice average multiple of more than 1 transaction is applied to value the company.

Pros of Method

1. Can be used to value the company which does not have financial history

2. Value is determined on the basis of multiples derived from valuations of similar transactions in the industry, therefore it represents markets perspective of company

Cons

1. Transaction may not be available in similar companies.

2. though the other company is also user based, their business model be completely different and one company's success may not represent others.

Comparison of different approaches has already discussed above.