In a previous lesson, we reviewed why it’s essential to identify what stage a company is in the Business Growth Cycle before determining the best method to value that company.
Today’s lesson will examine four common valuation methods used throughout the growth cycle.
Future lessons will dive into the nuts and bolts of these valuation methods, walking investors step-by-step through examples.
Let’s look at why investors find these valuation tools so helpful from the 30,000-foot view.
Enjoying this so far? These lessons are free, and the whole goal is to make investing concepts actually click.
Better known by its acronym TAM, this is a useful but imprecise valuation method for companies in the startup or hypergrowth phases.
TAM is the annual spending in the markets where the company operates. In other words, it is the yearly revenue opportunity that the company is pursuing.
The formula for estimating TAM is multiplying the number of potential customers by the average annual spending per customer for that market.
TAM is useful because investors usually need more concrete data for Stage 1 and 2 companies. Often, these companies are not generating revenue but are trying to establish market fit.
TAM helps investors estimate the upside potential for investing in these early-stage companies.
Multiples are ratios that compare a company’s current market value to a financial metric. These are especially useful for companies in Stages 2 through 5.
The math is straightforward, using different figures on a company’s income statement.
A company’s market capitalization, or market cap, is the total equity value of a company. It is figured by multiplying the current stock price by the number of shares.
By dividing a company’s market cap by its trailing twelve months’ sales, we get the price-to-sales (P/S) ratio.
By dividing a company’s stock price by earnings per share (EPS), we arrive at the price-to-earnings (P/E) ratio.
One of our favorite multiples comes from the cash flow statement. We get the price-to-free cash flow (P/FCF) ratio by dividing a company’s market cap by its free cash flow.
This is an excellent tool for determining the value of companies in Stages 4 and 5 of the Business Growth Cycle.
Discounted cash flows value a company by projecting future cash flows into the future by a specific number of years.
That value is multiplied by an exit multiple (e.g., P/E or P/FCF ratio) that you believe the company will trade at the end of that cash flow period.
This is one of the simpler forms discounted cash flow models can take, but it can also be more complex. For instance, discounted cash flow models can use various figures, such as total cash flow, net present value, and terminal value, instead of exit multiples.
Discounted cash flows start with some known variables, such as the company’s current free cash flow or earnings per share. Investors then make assumptions about the company’s growth rate and exit multiple, and the formula spits out a price that the company is worth.
Reverse discounted cash flows work with the same variables but in a different order.
In reverse discounted cash flows, investors input the price and the company’s current results to see what growth rate assumptions are currently priced into the stock.
Investors can then determine if the growth assumptions are too optimistic or pessimistic.
Like the discounted cash flow model, this tool is best used on companies in Stages 4 and 5 of the Business Growth Cycle.
We will walk you through specific examples using the above methods in upcoming lessons. Today, we want you to understand when these methods are used and why investors find them useful to value companies.
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