I have dabbled in this topic a bit. But we need to talk about Business Valuation when we talk about Equity. That is the key to understanding Equity Investments and Equity Investors.
There are 4 basic types of Investors in the Public Market:
1 - Value Investors: These people look at the numbers associated with the Operational Part of the Business as well as other Financial Metrics.
2 - Growth Investors: These people look at the Market and Market position of the company to evaluate the potential for future growth.
3 - Technical Investor: These people study metrics around the stock price and recent price trends to look for positive and negative signs in the price of stock.
4 - Day Trader: These people look to trade regularly for small variations in the stock price to be able to extract value.
These last two will not be part of our conversation today. They require the public market and its open nature to work. You can't use these techniques to invest in private companies.
Everyone else is a combination of the other two. Private Market transactions will have a significant weight on Financial Metrics of the company, especially for established businesses. Startup businesses will depend more on the Growth that is envisioned and thus the future of improved Valuation to be able to establish a price.
For an established business, most of the time it will be pretty simple. There is a multiple of cash flow and an addition for excess capital on the balance sheet. The cash flow multiple is specific to certain industries and there will often be comparable transactions that can be used to set the multiple. The biggest single issue is the state of the financials in most small companies. Small businesses are captured financially to maximize the tax benefits to the owners. In general, that means that the company is actually making more money than is stated by the P&L. There are expenses that the company takes that are benefit to both the business and the business owner outside the business. In a large, public company these expenses are not allowed, but often pollute the value of smaller companies. What is required is that what is handed to investors are Generally Accepted Accounting Practice (GAAP) financials. In the case of a private company transaction, there may need to be a reconciliation of the normal books to GAAP Books to ensure that things are clear.
This is also true for the Balance Sheet. I often look at Internet Service Providers in my Consulting Business. These companies tend to have extensive Capital Investment where a normal business may own its building. These investments are great on the Balance Sheet and are depreciated over the life cycle of the asset. Here too there are tax accounting considerations. Small Capital Investments are often expensed as Cost of Goods Sold (COGS) and not depreciated. This accelerates their tax benefit, by lowering earnings. But since we are looking at a multiple of Cash Flow, this needs to be dealt with properly.
There can be additional issues with expenses, particularly the use of cash versus accrued accounting. In most smaller business, this will tend to have a smaller impact but can be important. As can the amortization of expenses over the year. The important part of both styles is that expenses are taken in the same year that they are used and that they are smoothed so that Cash Flow is as consistent as possible over the year.
Now let's take a look at the Growth side of the equation. Here what we are really talking about is setting a floor for value or a higher than normal multiple of cash flow based on what business you are in. Alternately, this can be also a strategic set of customers that the business has. The challenge for most smaller businesses is that they are small. Most strategies involve larger moves...things that move the financial needle. So, here what you need to think about is what is so invaluable that a competitor would have to spend a lot of money to get at. This is a lot less deterministic and thus there are a lot more disagreements on this front. This is particularly true for Startup businesses. So next week we will talk about a solution to this called Venture Debt.
Have a great day!
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