Model construction by company life cycle: from venture to decline

What changes with the company’s characteristics?

Three things shape the model. The first is the company’s development stage . The second is data availability , meaning how much financial history exists and how good it is. The third is the analyst perspective : a new private investor, a minority shareholder or a controlling owner each looks at the company differently.

Four building blocks get adjusted: the cash flow forecast (the numerator), the discount rate (the denominator), the forecast horizon and the choice of terminal value. The generic form uses the required return r.

$$IV_t = \sum_{i=1}^{n} \frac{E(CF_{t+i})}{(1 + r)^i} + \frac{E(P_{t+n})}{(1 + r)^n}$$

The models in earlier modules, except the two-stage model, quietly assume a mature company. The areas of valuation focus move as a company ages, and the company life cycle stages vary widely in length.

Company life cyclestages vary widely in length

• Start-up Memorize metric: sales · driver: market potential · history: little or none
  • Terminal value P/S × revenue at the horizon
• Growth Memorize metric: cash flow to fund high growth · driver: sustainable growth and margins · history: limited
  • Terminal value P/E × earnings at the horizon
• Mature Memorize metric: earnings and cash flow for stable growth · driver: sustainable profits · history: long
  • Terminal value constant growth or peer multiple
• Decline Memorize metric: cash flow to return capital · driver: long-run margins after decline · history: long
  • Terminal value weight going concern against distress

How do you value a start-up?

Use it

Start-ups often have little or no revenue, negative cash flow, no operating history and a high chance of failure, so existing statements say little. Their value is future potential. A start-up valuation skips the near-term cash flows and focuses on the terminal value: expected revenue at the end of the horizon times a price-to-sales (P/S) terminal value multiple taken from later-stage peers, discounted at the investor’s target return.

$$IV_t = \frac{\text{Expected revenue}_{t+n} \times P/S}{(1 + r)^n} = \frac{\text{Expected revenue}_{t+n} \times P/S}{ROI}$$

The return on investment (ROI) here is the multiple of the original investment that comes back, with no cash flows in between. It relates to the internal rate of return (IRR) through the number of years.

$$ROI = (1 + IRR)^n$$

To attract investors to such risky ventures, start-ups often must offer returns of more than 10 times the investment over five years or more. Venture capital (VC) is the small, sometimes controlling, equity stake such investors take to fund the next stage.

The value the formula gives is the company’s value after the new money: the post-money valuation . Subtract the new equity to get the pre-money valuation , and divide the new equity by the post-money value to get the new investor’s fractional ownership .

$$\text{Pre-money} = \text{Post-money} - \text{New equity}$$

$$\text{Fractional ownership} = \frac{\text{New equity}}{\text{Post-money}}$$

Exam tip The VC formula gives post-money value. Subtract the new money for pre-money; divide the new money by post-money for the stake.

How do you value a growth company?

Use it

Growth firms have a proven product and revenue (sometimes earnings) and raise new equity to grow assets and sales fast, aiming at sustainable profitability over a set horizon. Value drivers are detailed revenue and profit projections, and earnings are retained and reinvested.

A growth-phase valuation targets the investor’s return through a terminal multiple, as a start-up does, but on earnings (the P/E of mature peers), not sales. That is the earnings multiple terminal value . Unlike a start-up, the company’s own statements are a usable base, and forecasting each line at its own growth rate beats a simple two-stage model.

$$IV_t = \frac{\text{Net income}_{t+n} \times P/E}{ROI}$$

Go deeper Two-stage model or growth-phase model?

The two-stage model grows one cash flow fast and then slowly. The growth-phase model forecasts revenue, costs and assets separately, so margins can expand. Calderon’s pre-tax margin rises from 5% to about 30%, something a single cash flow growth rate cannot show.

How do you value a firm in decline?

Decline comes from competition, changing tastes, technology or poor management: falling sales and share, lower profits and a higher chance of financial distress , the inability to meet future obligations to debtholders. Firms in decline can end in a sale, a restructuring under new management or liquidation. If asset sales do not cover the debt, shareholders lose everything.

Long histories do not help much, because extending the old relationships misses the distress.

Valuation of a firm in decline

• Cash flows Know the idea customers and suppliers leave, assets are impaired; timing uncertain
• Discount rate Know the idea cost of debt jumps with default risk; required return on equity becomes unstable
• Terminal value and horizon Know the idea a going concern is no longer certain; healthy peers' multiples distort

• Cash flow adjustments : customers and suppliers leave and assets are impaired, so the timing of cash flows is uncertain.
• Denominator issues : the cost of debt jumps with default risk and the required return on equity becomes unstable.
• Terminal value and horizon issues : a going concern is no longer certain, and the multiples of healthy peers distort the value.

The better route is to make the probability of distress explicit. Weight the going-concern value and the distress sale value by their probabilities. Discount a future distress sale value to today first. It works for any company with a real chance of failure, not only declining ones.

$$IV_t = \text{Going-concern value} \times (1 - p_{distress}) + \text{Distress sale value} \times p_{distress}$$

Exam tip For distress risk, do not just raise the discount rate or borrow healthy peers’ multiples: weight the two outcomes.

Go deeper Why ROI and IRR are the same target

An ROI of 12 times over five years and an IRR of 64.38% a year describe one hurdle. Dividing by the ROI is discounting at the IRR.

Does it matter who controls the shares?

A financial investor holds a non-controlling stake and has no influence on operations, so the analyst values the company as its current management runs it.

A strategic investor and an activist investor may hold a significant minority or a majority and push for change through board seats, a shareholder vote or taking the company private: asset sales, combinations, cost cuts or a restructuring.

Shareholder typecontrol changes how the company is run

• Financial investor Use it no influence: value as currently run
• Strategic investor Use it control to combine or reshape
• Activist investor Use it minority or majority stake; pushes a plan: model it as a scenario

When an activist sets out its plan to shareholders, the analyst can translate it into an operating, investing and financing forecast and value it as a scenario in which the plan succeeds. Lesson 5 shows how to weight a scenario. The shareholder voting process is covered in Learning Module 2.