Just recently, an acquaintance informed me that when he presented to potential financiers, they kept inquiring as to how his company’s valuation was calculated. From their perspective, it seemed that the analysis had been incorrect. Valuation is the present value of what an investor assumes the company is worth from several years of operation – generally less than 5 years. Another way of looking at valuation is the determination of the stock value of the company to day and what it will be worth in the same time frame. The classical business school model takes into account the number of the years and the company’s growth. However, that model is too overly simplified, since it leaves out two major elements to the growth in the perception of potential investors. As an example, I like to look at Uber – the car sharing program and why it has attracted over $1 billion dollars in investments.
Free Cash Flow
Free cash flow is the left over cash after revenues cover the product costs and operations. That is cash that can be distributed for dividends or pay for expansion, and, therefore, that is extremely attractive. In the case of Uber’s business model, any investor can see the free cash flow potential. Uber does not pay for the geo-locational data. The smartphone users do. Uber piggy backs on the telecommunications infrastructure at little or no marginal costs. For every new driver signed up, the marginal costs are minimal as well. Even with millions of signups, the costs are minor for hardware enhancement and labor costs. Meanwhile, Uber earns a percentage for every trip registered through Uber adding to continuous cash flows. So, in effect, the gross margins for every transaction is extraordinary.
Now, the Uber model is not the only way to augment free cash flows. Manufacturing companies can build the economy of scale so the margins increase over increased sales. To even beef up those margins a company can automate manufacturing and reduce labor costs – as many car manufacturers have done.
So, for a company to increase its valuation has one important feature of its business model, by demonstrating on how its free cash flow is determined. The fatter the gross margins, the higher the valuations.
Diversity of Revenue Sources
Let’s go back to Uber. Soon after deploying its model in the U.S., Uber sought to expand its model outside of the U.S. Not only was the strategy attacking a population of 370 million, it now expanded to a population of 7 billion. So geographic reach matters to valuation. It also diversifies the cash flow risk. Of course, as I relate earlier, international deployment carries its own risks. But the investors are seeing a large cash flow model. And that is why many investors are flocking around Uber.
Another terminology used by the financial industry is the “total addressable market” or TAM, for short. I do address TAM in detail through other writings. But every investor looks at the TAM as its first or second parameter in measuring the valuation. There is no question that the size of the market is critically important in the determination of valuation. Diversity of revenue and the TAM can be synonymous since big markets do diversify the risks.
Not too long ago, I viewed a presentation by a biotech company, claiming that the U.S. TAM for its sickle cell treatment totaled only 80k. Yet he was attempting to raise over $2 million. Even if such treatment represented daily doses, I could see that his TAM had been too small to attract investors.
Therefore, the two key factors in bloating up valuations are a) free cash flow and b) diversity of revenue sources. One can increase the margins creatively by looking at the business model to see how one can pump up its valuation. The business model must include some of the risks, which can be handled systematically. However, even discounting those risks, the valuation by employing those 2 key factors – free cash flow and revenue diversity — is pushed up dramatically.