Only a few days ago, I was participating in a conference call with an investor. During our discussions with the Pitchdeck, he underscored one undeniable fact – that the valuation is based on what is measured on the day of the investment – not based on the “hockey stick” projections. I certainly could not dispute that. However, the reasons for the projections were based on future earnings related to a realignment of the company. He did say what I expect any potential investor would dictate.
These guys are in the business of paying something of value for today, not tomorrow. What “tomorrow” determines is the future potential. And that alone is speculative.
What neophytes do is apply their business school tools – NPV, EVA, PV, and EV. And that is a major fallacy. Yes, these algorithms do help to some degree, but I never show my results to any potential investor my ideas of the valuation of the company. Regardless, I would research similar deals and use that data as comparison. In one actual deal, one company’s CFO and I argued profusely over his idea of the valuation – his being identical to Business School models, and I countered that it should rely on historical data. Mine was a fraction of what he determined. He used the hockey’s NPV as the determination. My analysis was the closest to the investor’s offer. The CFO was several hundred percent off.
And the WSJ went over the ways how institutional investors were valuing companies such as Uber that are not publicly traded. Since they must put something on their books, they did their own analysis. They compared the value per share for companies that are similarly traded in the stock exchange. They also made adjustments based on other companies in the industry – in terms of financial performance. Then they discounted the value of their privately held shares. And again, they went to use comparables.
The basic accounting tool used for valuations is the P/E ratio, ever so present on each stock quote in the WSJ. “E” stands for EBITDA earnings, not gross revenues. These ratios are compared to other companies with similar industries. I hear the mistaken belief that “earnings” means gross. How can that be? The EBITDA tells me about the profitability, if at all, of the company. Companies that demonstrate profitability are healthy ones. I even worked for a company whose gross earnings rose consistently, but so did the loses. Finally, it went bankrupt. And EBITDA multiples is the most common performance yardstick of a company’s valuation.
The other fallacy is “sweat equity”. One CEO responded to the investor that his concept of valuation is based on his sweat equity. Wrong again. Investors are guided by numbers, not fictional numbers. Anyone can value any sweat equity value indiscriminately. One can value it at $1,500 per hour or $5,000. To the investor, cash invested is King. Now there are tricks to placing cash in the coffers, but this strategy is not material to this blog.
The next fallacious remark is the inventory of “patents.” With one founder, I found myself trying to determine how he reached his valuation. He boasted that he had over 50 patents. But I have noticed that to make a company to be successful, it needs more than a patent. And there are other factual truths behind patents: some don’t work as designed, and some cannot generate revenues. Now it doesn’t hurt to have patents or some form of IP. But it is better to generate traction with that IP. With that in mind, one would then discount the idea, just like sweat equity, that patents create value for the company. In fact, I would say that a patent that doesn’t generate revenues is valueless.
In conclusion I always recommend to avoid the fallacies. Determine the valuation as any investor would. These investors are motivated by cash and the return on investments. Anything beyond that is speculative to them and useless.