How estimation issues impact valuation is one of the critical business problems Gabriel Domale Consulting work with clients to solve.

Start-ups and early-stage tech firms present the most difficult estimation issues in valuation. This may be due partly to the absence of operating history, small or no revenues and operating losses.

Investors are increasingly expressing more interest in internet companies and technology-related companies because of their high growth. However, companies in the tech industry like many start-ups experience high birth rates and death rates. In addition, the tech industry tends to have inconsistencies in valuation.

Many investors find precise valuation to be generally acceptable. They favour discounted cash flow valuation and prefer valuation to be rooted in the core principles of finance and economics.

When earnings are negative and benchmarking is not feasible against other companies in the same industry, then discounted cash flow is seen to be more dependable than the price-to-earnings method.

While valuing technology companies could seem intuitive, not properly addressing estimation issues could lead to valuations based on biased estimates. Since equity investments in some tech firms tend to be privately held and in non-standardized illiquid units, it is difficult to benchmark them against publicly traded companies.

The four components of valuation are – existing assets cash flows, cash flows from new investments, the discount rate (weighted average cost of capital) and time horizon to normal growth.

Tech firms vs Traditional companies

Valuation of tech companies differs from the valuation of traditional companies. For the valuation of tech companies which are high-growth companies, the methodology should include:

1. Past vs Future: The emphasis should be more on the forecasting of the future market dynamics rather than on the current performance. We look first at the future before turning to look at the present and the past.
2. Valuation factors: Some factors to consider as variables in the valuation are the future market size and expected return on capital.
3. Scenario building: The future is full of uncertainty and complexity. Using different weighted scenarios in valuation gives a realistic view but it does not mitigate the inherent risks in the valuation.
4. Estimating the future state: Extrapolate current performance the into future states namely high-growth, moderate growth and state of stability. Then reconcile the future states to the current state.
5. Measures of operating performance: Analyse the market potentials by looking at the such as customer-penetration rates, average revenue per customer and the return on invested capital.
6. Time horizon: Determine how long the high growth rate will continue before a normal level of growth is reached. For high-growth companies like those in the tech industry, normality is about a decade. However, due to limited data, the forecast is typically for a 5-year period.
7. Estimating market size potential: Understand how the company meets customers’ needs and assess how the company generates revenue.
8. Existing assets: Using current financial statements to value existing assets is problematic because the existing assets are low in value relative to the overall value of the firm. The difficult decision is whether it is even relevant to estimate the value of the small existing assets.

Understanding the revenue model

Apparently, most young companies do not know how to adequately monetise the value they offer to customers. The core areas that knowledge is critical are: (i) understanding how the tech company makes money (ii) do you directly charge the customers or (iii), do you charge for access to the customers.

Start your valuation by estimating the potential market and product by product. Assess how many businesses have shown interests in the company and estimate how many are likely to convert to paid customers. Also, estimate the numbers of companies that may want to do business with this company being valued. Analyse historical data to form a baseline.

Next step is to estimate the revenue per potential client company. By aligning the estimated revenue profile to the forecasted market share, one is able to test the reliability of the revenue estimates.

The absence of data from prior years also makes it more difficult to analyse how revenues would vary if there are changes in macro-economic variables. The expenses that tech firm incur to generate future revenue are often mixed in with the expenses associated with generating current revenues. The challenge is how to decouple the expenses and revenue.

Margins and Returns

After obtaining the revenue profile, it is key to estimate operating margin, capital intensity, and return on invested capital. Examine the business model, and how its fundamentals compare with the fundamentals of other companies operating similar business models.

To test our forecast reliability, we benchmark against 3 companies – companies with high-growth, moderate-growth and normal-growth rates. The benchmark is against key value drivers.

It is advisable to adopt a cautious approach as current business success does not necessarily translate into successful future financial outcomes. Competition in the market and new entrants can erode margins.

Due to the nature of tech firms, they spend some of their capital on brand and supply-chain capabilities. Intriguingly these capital investments are treated as intangibles and are expensed under traditional accounting statements.

Takeaways

Unlike traditional companies, tech firms do not require large capital as they go through their growth stages. Interestingly, tech firms have high ROIC (return on invested capital) once they start getting profitable. This is as a result of high operating margin and low invested capital. The challenge is that high ROIC is not a meaningful ratio to use.

Thus using historical financial performance for high-growth companies such as tech firms is being seen as unreliable because of the treatment of some of the capital investments as intangibles. The implication is that the use of accounting profit alone may lead to undervaluation when compared to real economic profit.

Overall, the estimation process should rely on accounting methods, economic principles and industry specifics. Developing scenarios brings some form of transparency to the assumptions in our estimations. Having different scenarios enriches decision-making than single-point valuation. Although scenarios are both probabilistic and subjective judgements.

How Gabriel Domale Consulting create value for clients

Gabriel Domale Consulting leverages our deep hands-on industry experience to provide consulting services including data analysis, estimation, financial modelling and valuation.

The growth of our firm is hinged on the strategic perspective of growing a strong relationship with our clients and working with them to achieve competitive advantage and viable market growth.

We are committed to continuously engage with clients to develop innovative solutions and to collaboratively implement business decisions to achieve sustainable outcomes.

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Author

Dr Leesi Gborogbosi | CEO – Gabriel Domale Consulting | Nigeria

Dr Leesi Gborogbosi – CEO, Gabriel Domale Consulting

Dr Leesi Gborogbosi is the CEO of Gabriel Domale Consulting, a management consulting firm based in Nigeria, that helps companies in Africa to grow, provides insights to leaders and transforms institutions.

He has about three decades of leadership experience in the oil and gas industry (Shell Nigeria). He is an expert in finance, strategy, corporate governance, transformation, cost management, leadership development and due diligence.

Dr Leesi Gborogbosi was Project Finance Manager of Upstream Oil & Gas Projects (7 projects - Headline size: $8 bln) - Southern Swamp Associated Gas System, Forcados Yokri Integrated Project, Otumara, Adibawa, Agbada and Assa North/Ohaji South Projects.

He provided advisory services namely, strategic planning, budget management, funding strategy, risk management, governance, due diligence and investment plan covering the full life cycle of the seven major upstream oil/gas projects, power facilities and export pipelines.

He collaboratively works with business leaders and their organizations to identify growth opportunities and create value through operational excellence in strategy implementation and capital efficiency by delivering projects within costs, building strategy and planning frameworks and crafting of innovative funding solutions.

Dr Leesi Gborogbosi provides support to finance leaders to make crucial decisions and optimize performance through financial excellence in finance systems and accounting operations, budgeting, finance transformation, cost reduction, governance, risk, and compliance.

He has doctoral degrees in strategy and business studies and MSc (Research Methodology in Management) from IE Business School, Madrid and an MBA (Finance and Banking) from the University of Port Harcourt, Nigeria; and BSc (Accountancy) from the University of Nigeria, Nsukka. He had his secondary education at Federal Government College, Jos, Nigeria.

His doctoral dissertation focuses on strategy implementation, collaboration, the role of middle managers, and the dynamics of social movements (host communities).

Dr Leesi Gborogbosi leverages his professional experience as a Certified Management Consultant (CMC); Fellow, Institute of Chartered Accountants of Nigeria; and The Institute of Management Consultants. He is member of the Chartered Institute of Procurement & Supply, London; Nigerian Institute of Management (Chartered); and Strategic Management Society, Chicago, United States.

He was nominated by the Strategic Management Society, Chicago for "Best International Conference Paper Prize Awards" in 2017 and 2015. He was appointed the Chair for the Session on “Leading change implementation processes” at the Strategic Management Society conference in Denver, United States in 2015.

Dr Leesi was a member of the Strategic Management Society “Special Committee on Diversity and Inclusion”, Chicago, USA, with the responsibility of providing the Strategic Management Society Board of Directors with a good audit of where the Strategic Management Society stands with respect to inclusiveness in its activities.