Valuation tips: an introduction to the Aswath Damodaran approach to valuation of startups in Africa

Valuation
Investor and VC4Africa Pro Account member Jerome Kisting of Baobab Capital gives an introduction to the The Aswath Damodaran approach: a systematic valuation approach that removes some of the uncertainties in valuations, by taking the long way to estimate the unique characteristics of a startup or growth company. The estimation approach used by Damodaran is a great way to really understand your business and the industry in which you operate.
 Also see Jerome Kisting’s introduction to different valuation approaches for startups in Africa published earlier this week.

Disclaimer: The Aswath Damodaran approach explained below is quite technical and may require entrepreneurs to solicit financial expertise. Keep in mind that there are workarounds to everything as long as they can be plausibly substantiated.

The Aswath Damodaran approach to valuation of start ups and growth companies is the approach used by Baobab Capital in its valuation and to promote its own understanding of the companies it chooses to invest in. If you want to read more on the approach after this introduction, see Aswath Damodaran’s paper “Valuing Young, Start-up and Growth Companies”.

This is a discounted cash flow valuation approach that uses top down and bottom up approaches to estimate cash flows and makes adjustments.

Top Down Approach for estimating cash flow

With Discounted Cash Flow Valuation, future cash flows are estimated, based on a number of factors. First, the potential market for the product or service. Second, challenges, defining the product or service and estimating the market size. Third, changes in the market over time. Fourth, market share (factors to consider when determining market share include the capacity of management and resources the company can draw on). Sixth, operating expenses. Seventh, investments for growth, i.e. how much is the firm reinvesting to reach target growth rates (‘in any competitive business, though, neither revenue growth or margin improvement is delivered for free’ – Damodaran). Eighth, the tax effect, at marginal or effective tax rate. No past earnings means no effective tax rate – cumulate all expected losses and keep track of the Net Operating Loss carry forward (NOL) – in the first years of positive earnings NOL is used to offset tax payable, when exhausted the company moves to a marginal tax rate.

It’s important to check for internal consistency – maybe too little is reinvested to achieve targeted growth rates. Check using the following formulas:

Imputed return on capital = Expected Operating Income after taxt

Capital invested in firmt-1 – capital invested in firm = total of all reinvestment

(in the second formula, the total of all reinvestment is the net of capital expenditure (CAPEX) and changes in non-cash working capital) through period t-1 plus initial capital investment (at time of valuation). Compare the imputed capital to the industry average return on capital. If well above the industry average and cost of capital, capital reinvestment forecasted is not sufficient to achieve the targeted earnings.

For an example of how this approach is applied see Valuing Young, Start-up and Growth Companies: Estimation Issues and Valuation Challenges by Aswath Damodaran (Page 24).

Bottom up Approach for estimating cash flow

Focus on capacity, or investment needed: limitation on availability of either or both human or financial capacity means start ups may have to settle for less capacity initially.

The bottom up approach looks at the following points. Unit sales / revenue: how many units can the company sell in a certain period and at what price? Operating costs: use the number of units sold in each period to determine the cost of inputs and therefore production costs in each period. Taxes: use revenue and expense estimates to calculate taxes payable in each period. Additional reinvestment needed to enhance or maintain earnings capacity of the company.

For an example of how this approach is applied see Valuing Young, Start-up and Growth Companies: Estimation Issues and Valuation Challenges by Aswath Damodaran (Page 29).

Estimating the discount rate

To estimate the cost of equity and debt with discount rates, two key risk parameters are needed. First, the Cost of Equity: this should include firm specific risk and not only market risk. The practice of estimating beta using the stock price will not work as most African start ups are not publicly traded. Second, the Cost of Debt: use a measure of default risk for this; start ups usually don’t have bonds outstanding and rely on bank loans, if at all. Interest coverage and other ratios may not accurately reflect actual interest rates paid, as banks charge a premium to compensate for the risk. On the Debt ratio: since the equity and debt is not publicly traded, i.e. there is not a market for it, market values can’t be used to weight the debt and equity to calculate the cost of equity.

Alternatives to using arbitrary target rates

Damodaran suggests an alternate that is based around the following steps:

  1. Sector averages – use betas of similar companies that have made it through the early stage life cycle and are traded publicly. Take average of regression betas across publicly traded firms and unlever the beta to arrive at the beta of the firm.
  2. Adjust for diversification or its absence – determine market beta of publicly traded firms above (using R-squared and correlation coefficients in the regressions), and then divide the market beta by correlation of publicly traded firms with the market to get a ‘total beta’ that captures the market risk and business specific risk.
  3. The ‘total beta’ will be much higher than the market beta and, resulting, cost of equity will reflect lack of diversification or undiversifiction (for example, a founder with everything tied up in the company)
  4. Consider use of debt and cost – synthetic bond ratios can be estimated for any firm based on financial ratios available even for private businesses. Interest coverage ratio can be calculated for a small company and used to compute a synthetic rating and a pre-tax cost of debt (by adding the default spread based on the rating to the risk-free rate)
  5. Management proclivities and industry averages – use management’s views on use of debt i.e. what debt ratio levels have been forecast, which can be used to calculate the cost of capital. More common to use average market debt ratio of publicly traded firms in same sector as the debt ratio for the company for which the valuation is being done.

Build in expected changes to all these inputs over time. Allow for changes in cost of equity, debt and capital over time.

Estimating value today and adjusting for survival

Terminal value is the value of the company at the end of the cash flow forecasting period.

The value of the company is determined as a going concern. This makes the assumption that cash flows will grow into perpetuity. Terminal value is a function of the perpetual growth rate and the excess return accompanying that growth rate (excess returns = difference between return on invested capital and cost of capital): Net Present Value of Cash Flows – Assumption of how long cash flows will grow beyond forecast period.

Salvage value = terminal value. This assumes that the company will be liquidated at the end of the forecast period. Salvage value = value of assets accumulated until liquidation. This is best used in businesses that come with time limits on operating lives like an operating license that will expire.

Valuing the company on the assumption it will survive. This is what we assume when using a terminal value and discounting cash flows back to the present at a risk-adjusted discount rate.

What is the probability the company will not survive? Look at sector averages – determine the probability of survival from research studies. Check Probits – look at companies that have succeeded and failed over a time period (say 10 years), then build a model that can predict failure based on characteristics such as cash available, history of founders, industry, and debt. Try simulations – specify probability distributions for revenues, margins, costs, etcetera, and use these to predict the conditions under which a company will face failure and then estimate probability of failure.

Key Person Discount

This assumes the loss of key persons built into revenues, earnings and expected cash flows. See the formula below:

Key person discount = Value of firm Status quo– Value of firm Key person lost/ Value of firm Status quo

It’s no simple formula, as variation will not only be across the business but also across key persons lost.

Valuing equity claims on the business

Add back prevailing cash balance i.e. cash balance today, using the following formulas:

Pre-money firm value = Expected(Free Cash Flow to the Firm) at time t / (1+Cost of Capital) + Cash and Marketable Securities

Pre-money equity value = Pre-money firm value – DebtExisting

Additional capital in the form of debt or equity that stays in the firm (not cashed out by owners) will enhance value:

Post-money firm value = Pre-money value + (EquityNew+ DebtNew – Owner cash out)

Post-money equity value = Post-money firm value – DebtExisting– DebtNew

The effect of illiquidity

It’s difficult to measure illiquidity in an investment and to turn that measure into a ‘value discount’. With fixed discount – fixed for all firms or a range for the discount – an analyst uses subjective judgment to determine where in range discount should fall.

With firm specific discount, there are 3 ways to adjust illiquidity discounts for individual firms:

  1. Start with a fixed discount and adjust for specific characteristics of the company valued, using parameters such as size of revenues and profitability
  2. Take the view all investments are illiquid and that illiquidity in a publicly traded company takes the form of a bid-ask spread – spread is used as an illiquidity discount
  3. Holders of liquid assets have the option to sell at prevailing market price – lack of liquidity represents the loss of that option.

Adjusting discount rates

Take illiquid publicly traded assets and back out the illiquidity effect from what people are willing to pay for them. Subtract past returns on illiquid asset classes (private equity investments in large companies) from past returns on liquid asset classes (blue chip stocks) and use the difference as an illiquidity premium. Note: when adjusting discount rates for illiquidity don’t discount the end value as this would be double counting.

Damodaran also goes into Relative Valuation and Real Options in the paper on which our approach is based. I have decided not to include these in this post.

Overall, while the Damodaran approach is quite resource intensive, it does provide a comprehensive and far more accurate approach to valuation of early stage companies, like the ones we invest in at Baobab Capital. Again, the approach is quite technical and may require entrepreneurs to solicit financial expertise. Keep in mind that there are workarounds to everything as long as they can be plausibly substantiated.

Questions? Comments? Please share them in the comments section below!