Question

Suppose that you were hired as an expert to value start-up (unicorn) firms in Indonesia.

1. Design a method to estimate the cash flows from a start-up firm!
2. Explain how you evaluate the start-up firm's cost structure and sensitivity!

thank you

Answer 1

Business valuation is never straightforward - for any company. For startups with little or no revenue or profits and less-than-certain futures, the job of assigning a valuation is particularly tricky. For mature, publicly listed businesses with steady revenues and earnings, normally it's a matter of valuing them as a multiple of their earnings before interest, taxes, depreciation, and amortization (EBITDA) or based on other industry specific multiples. But it's a lot harder to value a new venture that's not publicly-listed and may be years away from sales.

Cost-to-Duplicate:- This approach involves calculating how much it would cost to build another company just like it from scratch. The idea is that a smart investor wouldn't pay more than it would cost to duplicate. This approach will often look at the physical assets to determine their fair market value.

The big problem with this approach – and company founders will certainly agree here – is that it doesn't reflect the company's future potential for generating sales, profits and return on investment. What's more, the cost-to-duplicate approach doesn't capture intangible assets, like brand value, that the venture might possess even at an early stage of development. Because it generally underestimates the venture's worth, it's often used as a "lowball" estimate of company value. The company's physical infrastructure and equipment may only be a small component of the actual net worth when relationships and intellectual capital form the basis of the firm.

Market Multiple:- Venture capital investors like this approach, as it gives them a pretty good indication of what the market is willing to pay for a company. Basically, the market multiple approach values the company against recent acquisitions of similar companies in the market. The market multiple approach, arguably, delivers value estimates that come closes to what investors are willing to pay. Unfortunately, there is a hitch: comparable market transactions can be very hard to find. It's not always easy to find companies that are close comparisons, especially in the start-up market. Deal terms are often kept under wraps by early-stage, unlisted companies – the ones that probably represent the closest comparisons.

Discounted Cash Flow (DCF):- For most startups – especially those that have yet to start generating earnings – the bulk of the value rests on future potential. Discounted cash flow analysis then represents an important valuation approach. DCF involves forecasting how much cash flow the company will produce in the future and then, using an expected rate of investment return, calculating how much that cash flow is worth. A higher discount rate is typically applied to startups, as there is a high risk that the company will inevitably fail to generate sustainable cash flows.

The trouble with DCF is the quality of the DCF depends on the analyst's ability to forecast future market conditions and make good assumptions about long-term growth rates. In many cases, projecting sales and earnings beyond a few years becomes a guessing game. Moreover, the value that DCF models generate is highly sensitive to the expected rate of return used for discounting cash flows. So, DCF needs to be used with much care.

Conclusion:- It is extremely hard to determine the accurate value of a company while it is in its infancy stages as its success or failure remains uncertain. There's a saying that startup valuation is more of an art than a science. There is a lot of truth to that. However, the approaches we've seen help to make the art a little more scientific.