Question

Discuss how you might expect the financial statements reported by a high tech company to differ from that reported by a financial firm.

Answer 1

Although the components of high-tech valuation are the same, their order and emphasis differ from the traditional process for established companies: rather than starting with an analysis of the company’s past performance, begin instead by examining the expected long-term development of the company’s markets—and then work backward. In particular, focus on the potential size of the market and the company’s market share as well as the level of return on capital the company might be able to earn. In addition, since long-term projections are highly uncertain, always value the company under different probability-weighted scenarios of how the market might develop under different conditions. Such techniques can help bound and quantify uncertainty, but they will not make it disappear: high-growth companies have volatile stock prices for sound reasons.

When valuing high-tech companies, start by thinking about what the industry and company might look like as the company evolves from its current high-growth, uncertain condition to a sustainable, moderate-growth state in the future. Then interpolate back to current performance. The future state should be defined and bounded by measures of operating performance, such as customer-penetration rates, average revenue per customer, sustainable margins, and return on invested capital. Next, determine how long hypergrowth will continue before growth stabilizes to normal levels. Since most high-tech companies are start-ups, stable economics probably lie at least 10 to 15 years in the future.

With a revenue forecast in hand, the next step is to forecast long-term operating margins, required capital investments, and return on invested capital (ROIC). But are these forecasts realistic? To address this question, examine other software companies that provide a similar conduit between consumers and businesses, funded by businesses. The key value drivers for Google, LinkedIn, and Monster Worldwide, though not a perfect comparison, offer some insight into what is possible.

Having completed a forecast for total market size, market share, operating margin, and capital intensity, it is time to reconnect the long-term forecast to current performance. To do this, you have to assess the speed of transition from current performance to future long-term performance. Estimates must be consistent with economic principles and industry characteristics. For instance, from the perspective of operating margin, how long will fixed costs dominate variable costs, resulting in low margins? Concerning capital turnover, what scale is required before revenues rise faster than capital? As scale is reached, will competition drive down prices?

A simple and straightforward way to deal with uncertainty associated with high-tech companies is to use probability-weighted scenarios. Even developing just a few scenarios makes the critical assumptions and interactions more transparent than other modeling approaches, such as real options and Monte Carlo simulation. To develop probability-weighted scenarios, estimate a future set of financials for a full range of outcomes, some optimistic and some pessimistic.

As a result, understanding what drives the value of the underlying business across the scenarios is more important than trying to come up with a single-point valuation.