Source – Forbes
“This is a guest post by the daughter of Steve Denning, Stephanie Denning, who writes about leadership issues from a millennial perspective. The views expressed here are her own.
What Is A Valuation?
Just the other day, I was chatting with a friend who was mesmerized by the $3.3 billion price tag Wal-Mart paid to acquire Jet.com. Jet.com just two years old, a toddler company. It was a lot. And the press that followed pointed out that, at $3.3 billion, it might be overvalued.
What I found most peculiar about the acquisition was how many people parroted this point of view without ever wondering what made up that $3.3 billion valuation. After prodding a little as to why one person found it overvalued, the only answer I got was that last November the valuation was reported to be around $1.35 billion, less than half of the $3.3 billion.
Valuations are subjective creatures. They are built on assumptions: growth rates, future cash flows, and risk. I see valuations frequently reported; I rarely see those assumptions. Of course, we want to believe there is a definitive, right answer in any valuation. But studying corporate finance with Damodaran, a professor at NYU Stern and also the yoda of valuation in my opinion, opened my eyes to how much bias is embedded in valuation. I realized there is no right answer.
There are, however, better ones. Before even getting to the assumptions in a valuation, it’s worth taking a moment to note that there are also different approaches. After studying various approaches, my bets are most often on intrinsic valuation to provide the best estimate. Damodaran defines intrinsic valuation as, “the value of an asset to its intrinsic characteristics: its capacity to generate cash flows and the risk in the cash flows.”
There is another approach though, and one much more commonly used: relative valuation. This approach is based on valuing “comparable” assets. I remember one class with Damodaran where I was astounded to learn: “Most valuations on Wall Street are relative valuations. Almost 85% of equity research reports are based upon a multiple and comparables. More than 50% of all acquisition valuations are based upon multiples. Rules of thumb based on multiples are not only common but are often the basis for final valuation judgments.”
Looking back, this isn’t really surprising. Working through an intrinsic valuation feels a lot more like a walk in the jungle compared to relative valuation, a walk in the park. Perhaps more importantly, it’s also a lot easier to convince yourself your valuation is the right one when comparing against similar companies. The danger in relative valuation is the assumptions you’re making are now implicit in the comparable assets you’re choosing to value the company in question. For a good relative valuation estimate, and for companies to be truly comparable, they need the same risk, growth and cash flow profile. A lot less easy to find.
Jet.com: Over- or Undervalued?
Let’s go back to Jet.com for a minute. I read one article comparing the Price:Revenue ratio of Jet.com to that of Amazon.com. Price:Revenue is a common multiple used to assess a company. But this multiple has a fatal flaw: it combines the price, the market value of equity, to the revenue of the entire firm. Since many startups don’t carry debt, this ratio ekes by, but when comparing it to companies like Amazon that the ratio starts to unravel. Price:Revenue ratio is not a consistent multiple when companies carry debt. It’s the valuation equivalent of apples and oranges.
Everyone recognizes there are strategic advantages for Wal-Mart to acquire Jet.com to compete with Amazon, specifically around ecommerce. But when expounding on the overvaluation of Jet.com, rarely have I an assessment of these synergies and how it translates to a lower valuation. Synergies can be classified as either operating or financial synergies. Presumably, Walmart acquired Jet.com for certain operating synergies around growth. I can see a scenario where this acquisition would generate a higher return on capital and a higher growth rate thanks to operating synergies. But to quantify the value of synergies, you have to value both acquirer and acquired entity and specify the type of synergy the company is hoping to get and by when. I’d like to see those numbers next time I read about an evaluation of synergies.
Valuation is a notoriously grey area, which might be why Silicon Valley is especially skeptical of businessmen and their tools. Silicon Valley would pick engineers over M.B.A.s any day (I should disclose here that I also have an M.B.A., the Scarlet Letter of Silicon Valley.) But don’t discount valuation just yet. Running a business can feel a little like working in the dark. Understanding valuation is one way to give yourself a guardrail.
At it’s simplest, valuation can be boiled down to this: An asset gets it’s value from future cash flows. If your business doesn’t make money, suffice it say it’s probably not looking at a very long lifetime.
Valuation: Both Art And Science
One of the biggest surprises I’ve found in business is the gap that exists between the tools you’re taught in school and how businesses are actually run in real life. In my ten years in business, I can count on one hand the number of times I’ve seen an executive evaluate an investment decision based on corporate finance techniques. It’s been so rare that I started to wonder whether any company actually used corporate finance in practice at all. It wasn’t until I came across the book The Outsiders by William Thorndike, which chronicles a number of CEOs including Warren Buffet, who use the principles of corporate finance to drive the success of their respective businesses, that I was amazed to find these executives do exist.
It was after reading this book that I started to segment businesses into two: those who use corporate finance to guide investment decisions and those who use decisions to guide corporate finance analysis. Corporate finance can be used to evaluate investments at the project level or at the company level in the form of valuation. Businesses either use this analysis to guide investment decisions or use the analysis to validate a decision that’s already been made.
I recently read an article by Ben Lerer, CEO and founder of Thrillist and Managing Partner at Lerer Hippeau Ventures, where he explained his investment philosophy: “Like I’ve said before, I don’t have a finance background; I learned venture capital on the job, which makes me an operator first and an investor second. Because of that, while I appreciate spreadsheets, when it comes to assessing the viability of early-stage investments, I tend to listen to my gut and my experience as a business owner. From a practical standpoint, that means getting to know a founder’s personality, their background, and their values. If all of those things resonate with me, the deal is probably on its way, but it’s not a lock by any stretch.”
This isn’t to say I disagree with Lerer’s approach. In fact, following your gut is critical to any success story. But the risk comes in only following your gut. In the same way that numbers can go awry, no one is right 100% of the time. Following your gut should not replace a spreadsheet approach, but complement it. As Damodaran often explains, valuation acts like a “life vest” against the lemming mentality that can become pervasive in any market.
Great valuations are built on the yin and yang of investing: both quantitatively and qualitatively sound. But valuations are estimates at best. And they aren’t useful unless we see all the inner-workings of that valuation. Judging a valuation only by the final number is a little like judging a house only from the outside. To do it justice, you have to look at what’s inside.”