Abstract This study compares the market enterprise value of former unicorns to 10 individual calculated enterprise values based on the corresponding discounted cash flows and comparable company analyses. This research aims to investigate whether investors correctly perceive the valuation of unicorns. For our sample of 66 former unicorns entering capital markets between 2004 and 2019, we found that former unicorns appear to be undervalued in capital markets. Furthermore, we show that the accuracy of firm valuations increases with the amount of public information. Finally, we argue that Multiples are better suited for the assessment of a unicorn’s value once public.
Abstract The importance of the diversification and the related diversification factor in business valuation has not been studied in depth. In CAPM, due to the model assumptions, it is implied that an investor holds a perfectly diversified portfolio, which answers the question of diversification. The objective of this paper is to clarify the definition of diversification and to show how diversification effects can be incorporated into business valuation. Our research contribution entails demonstrating methods to capture the risk situation of an investor based on its asset allocation and then deriving the diversification effect from this assessment. As a methodological approach, we have opted for one that encompasses the most diverse degrees of diversification. Our analysis shows that this approach captures all non-hedged risks and thus performs a stand-alone valuation without diversification effects. If the diversification effect of a specific portfolio is to be included in the valuation, the analyst must shift from a stand-alone approach to a portfolio based approach, where the diversification factor cannot simply be equated with the correlation coefficient but must be calculated using various aggregation methods. Given that the conventional variance-covariance method excludes extreme risks, we propose the use of the copula approach. This approach can enhance risk modeling and yield more accurate results in diversification effect calculations. Our analysis demonstrates that it is possible to effectively model different diversification effects in business valuation. However, this entails substantial data expenses and demands a high degree of methodological expertise from the analyst.
Abstract In this paper, we develop two complete discounted-cash flow (DCF) frameworks for the valuation of constant-growth annuities and perpetuities. By ‘complete’ we mean that these frameworks allow the valuation of a firm or project by means of different DCF methods, particularly, the equity method, the free-cash-flow (FCF) method, the adjusted-present-value-method, and the capital-cash-flow method. This also requires the derivation of formulas that allow the translation between different required returns, like the required return on unlevered and levered equity, the discount rate in the FCF method, and the required return on the tax-shield. Our paper departs from the two most advocated and mutually exclusive frameworks when dealing with DCF. The first is based on Modigliani and Miller (M&M), where the FCF at different points in time are independently distributed. The second framework rests on the analysis of Miles and Ezzell (M&E) who presume a first-order autoregressive cash-flow process. Some elements of a ‘complete’ framework exist in the literature, but in our opinion, a complete picture has not been developed yet. The contributions of this paper are the following: (1) We develop (or expand) the set of formulas that are required for the valuation of constant-growth annuities and perpetuities; (2) The formulas we develop in this paper are based on a backward-iteration process, which in itself represents a suitable tool for firm valuation; (3) Using a numerical example, we show that the two mutually exclusive frameworks of M&M or M&E achieve very different valuation results; (4) It turns out that the expected returns and the growth rate of the FCF are partly linked, but this relationship is different in the two frameworks; (5) In our numerical examples, we show how the constant-growth annuity or perpetuity, can be integrated with an explicitly planned FCF.
Abstract This study conducts a comprehensive benchmarking analysis on analyst forecasts of revenue and EBITDA for exchange-traded public companies in the U.S. spanning the period from 2009 to 2022. Our findings reveal a consistent and statistically significant upward bias present in both revenue and EBITDA forecasts, on average, as evidenced by various measures of forecast error. This bias is explored at both market sector and market-wide levels of aggregation to check for macro-consistency. Recognizing the significance of these biases, we propose bias-adjustment frameworks aimed at enhancing the accuracy of future analyst forecasts pertaining to revenue and EBITDA. The implications of our study underscore the importance of mitigating such biases for improved forecasting precision in financial markets.
Abstract We seek to determine whether a firm specific risk premium (FSRP) exists for private firms. We show that private equity investors price firm specific risk as part of establishing the expected rate of return hurdle rate. Our research is based on survey data constructed by the Private Capital Markets Project. We decompose the rate of return into its component parts-market risk premium, size premium, liquidity premium and firm specific risk premium (FSRP). We find that on average PE FSRP varies between zero and six percent. These findings indicate that the cost of capital buildup used in valuing private firms should include a premium for firm specific risk unless facts and circumstances suggest otherwise.
Abstract The discounted cash flow (“DCF”) model is widely used for valuing corporate assets. But valuable assets that do not generate cash flows will be missed by the DCF approach. Because cash interest income is generally not included in the projected net cash flows of operating assets, the value of cash is regarded as a non-operating asset whose value must be added to the DCF enterprise value. Unfortunately, it has become standard practice on Wall Street and for the courts to exclude some amount of cash from non-operating assets on the basis that it will be used to finance the immediate operations of the business. The exclusion of so-called “operating” or “working-capital” cash is widely accepted as necessary and is recommended in virtually all valuation texts and treatises. We disagree and show that all cash should generally be added as a non-operating asset, except in unique circumstances where “wasting cash” is not earning a fair market return. We explain that excluding operating cash is correct only if either the interest income on cash is included in the net cash flows projections used to compute DCF value, or if the specific (near-term) operating expenses that will be covered by operating cash are excluded from the net cash flow projections. In either case, the full economic benefits of owning operating cash are fully reflected in the DCF enterprise value of the company, causing the DCF value to be higher by the exact amount of operating cash that is excluded. We call this the symmetry principle of operating cash. In practice, neither condition is normally met, so that all cash should generally be treated as a non-operating asset.
Abstract Startups play a substantial role in the economic growth of a nation, by introducing new technologies, ground-breaking innovation, creating jobs, etc. A couple of decades back, it was extremely difficult to start a business, but today new businesses pop up every day, all around the world. Recognizing the importance of a startup, governments across the globe are doing their best to provide an atmosphere where startups can bloom. Despite its importance and all the support, the startup failure rate is at 90%; about 10% of startups fail in the first year and 70% fail in two to five years. The startup boom saw the emergence of alternative sources of funding like Venture Capitalist, Angel Investors, etc. These investors (Venture Capitalist, Angel Investors, etc.) played a crucial role in startup success by providing easy access to funds which is a critical and scarce resource for any founder. Traditionally business success is linked with sustainable profitability but in the startup world most used method to define success is valuation. Based on CB Insights research, as of January 2022, there are more than 900 unicorns (startup with a valuation of over $1 billion) around the world and of these unicorns less than 10% are profitable. It’s difficult to explain/comprehend how startups’ which are neither profitable nor foresee profitability in near future are valued higher than traditional business with stable profitability. Current valuation methods have impacted the startup ecosystem. Today, founders start their business with exit in mind, the focus of founders is on growth/scale rather than profitability. There is a school of thought that believes that such valuations will soon result in the bursting of the startup bubble just like the dotcom bubble seen in late 1990s. The focus of this paper is to investigate the techniques used by investors for startup valuation and how these techniques are impacting the startup ecosystem and its founders. The paper looks at all stages of the investment cycle, from seed to IPO or takeover and understands the process of valuation at each stage and how it impacts all stakeholders in the ecosystem.
Abstract Valuation analysts adjust prices of private firm’s stock downward from their fully marketable counterparts, reflecting the private firms’ lower level of marketability. This discount for lack of marketability can be substantial in magnitude. This study examines the performance (according to bias and accuracy employing estimation error methodology) of seven popular option pricing models in generating discount estimates to coincide with empirically observed discount benchmarks (based on the pre-IPO methodology) in European Union member countries over the period 2004 until 2018. The results allow for the general conclusion that some option pricing models are superior in most settings, coinciding with their individual benefits and deficiencies. The detailed analysis indicates that (i) the superiority of these option pricing models holds for a wide range of periods of assumed restricted marketability, (ii) segmenting discount benchmarks according to their size improves the performance of the option pricing models, (iii) segmenting discount benchmarks according to both, the underlying volatility of stock returns and dividend yields, does not improve the performance of the option pricing models, and (iv) IPO underperformance has no material impact on relative option pricing model’s performance.
Abstract This article focuses on the topic of the relative valuation from the perspective of non-publicly traded companies and the determination of industry multiples allowing the subsequent application of this approach to specific industries. I chose the Czech brewing industry as the target industry, represented by the 50 most important entities (covering more than 99% of the industry’s turnover). Due to the fact that no market value data are available for this type of company, I first used an income valuation approach – the discounted cash flow (DCF) method to assess the market value of each company in the sample. I then quantified valuation multiples of P/E, EV/EBIT, EV/EBITDA, P/S, EV/S, P/BV, and EV/IC for each company, from which I determined industry statistics. I verified their suitability for use in the relative valuation approach and compared them with the results of existing studies on the most commonly used valuation approaches in the Czech Republic. Furthermore, I compared my own calculations of industry multiples for non-publicly traded companies with available data on industry multiples of publicly-traded companies in the brewing industry across Europe. The results of the comparison show that these multiples are on average lower for non-publicly traded companies than for listed companies.
Abstract In any context where a discounted cash flow valuation is required, there is the issue of estimating the continuing value. The most common way to do that is to assume that by the terminal horizon the company is in a steady state and is growing at a constant rate. The issue is how to handle inflation. The problem is that it is often done wrong and the impact is typically material. Because there remains significant confusion, in this paper we simplify the analysis by isolating the two key issues and providing example calculations. We show that even at the current 2% level proper treatment of inflation has a sizeable impact on valuation. If inflation were to accelerate as a result of current monetary and fiscal policies, the significance of this issue will increase.
Abstract It seems to be increasingly common that some personal injury lost earnings projections are being extended by some experts to the “Normal Retirement Age” (NRA) – the age where workers can receive full, unreduced Social Security benefits. The selection of this age often implies a rejection of the worklife expectancy. However, statistics on claiming behavior of Social Security benefit recipients show that only a minority of recipients wait until the NRA to claim benefits. We use actual claiming behavior and the respective ages to show the use of the NRA for determining the ending date of lost earnings projections, instead of the well-researched worklife expectancy, results in exaggerated and speculative lost earnings damages.
Abstract As a result of studies demonstrating a correlation between a patent’s value and its forward citation count, patent valuation using forward citations has been increasingly used by practitioners when a patent’s value has not been otherwise established. Although potential limitations of patent citation analysis have been discussed in the past, there is little empirical research demonstrating the sensitivity of estimated patent values to various assumptions embedded within the method. We first summarize an approach that has been used by prior practitioners to estimate the relative value of patents within a portfolio using forward citations, and then perform various analyses to investigate the sensitivity of the approach to certain assumptions. We find that some concerns of prior literature are well-founded, while others are less so. For example, we confirm that biased valuations will result from failure to properly control for patent age and technology. Our analysis also finds that truncation bias is a problem when analyzing recently issued patents, which confirms findings from existing literature. We estimate the rate at which such truncation bias dissipates as patents age and find that the bias for the median patent is reduced to below 10% within five years from the date of publication, although additional variation can remain on an individualized level. Regarding the issue of self-citations, we find that the valuation approach using forward citation analysis can be (but is not always) sensitive to the issue of self-citations, with a median difference of 16.8%. Finally, the valuation approach using forward citation analysis appears to be robust to assumptions underlying patent cohort construction.
Abstract We examine whether private companies are valued with a discount compared to publicly traded companies. The analysis is based on a comparison of private company transactions with those of public companies. Whereas prior studies build pairs based on industry membership, we match private companies with public counterparts that are comparable in value relevant firm characteristics, i.e. profitability, risk, and growth, to calculate the percentage difference in valuation multiples. We find that private companies are valued on average with a discount on the EBITDA-multiple of 13% compared to their public counterparts. Private companies sell at lower discounts, if the acquirer firm is publicly listed. As size is associated with lower risk, we show that larger private companies sell at lower discounts.
Abstract Valuation of a distressed company is a very tricky issue, for which many approaches and methods have been provided by the literature. Unfortunately, many of the more suitable proposals from a theoretical point of view (i.e., those based on option pricing theory, and even integrated with game theory) are very difficult to apply to real cases. To face the many contingencies emerging in a real case valuation, a scenario discounted cash flow (SDCF) model is provided here. The focus is on companies at an advanced stage of distress, where their ability to operate as a going concern is in question, and maintenance or recovery of business continuity requires significant interventions in the firm’s strategic, operational, and financial structure. In this context, SDCF, with a number of arrangements elaborated here, appears useful for valuing assets, debt, and equity – from current or potential new investors – and the interactions between them, which are particularly critical for distressed companies. At the same time, SDCF takes into account the firm’s liquidation option, not only at the valuation date but even after a restructuring plan has been launched. The going-concern value including the liquidation option should be the reference point for judging the suitability of business continuity compared to liquidation. In presenting the model, the key concepts and methodology adopted are set out following a numerical example inspired by a real case.
AbstractIn relative valuation peer groups of comparable companies are essential to derive the value of the firm. Valuing a target firm that is in financial distress by using a set of healthy peer group firms probably leads to an overvaluation. We examine whether the financial distress risk has an influence on a company’s value and quantify the discount through financial distress. We identify financial distress by Standard and Poor’s long-term issuer ratings and Altman’s z″-score. We then match the identified firms in financial distress with healthy counterparts that are comparable in value relevant characteristics, i. e. profitability, risk, and growth, to estimate the percentage difference in valuation multiples. Using rating information, in every year almost half of the companies are in financial distress whereas by Altman’s z″-score about 20% of the companies in the sample are in financial distress. We find that the discount caused by financial distress makes up about 4–7% of firm value. The discount increases for lower rating classes and lower z″-scores. Besides the degree of financial distress, market downturns as the financial crisis affect the distress discount.
Abstract Estimating the market price of a company with multiples is common practice. Especially if several multiples are used simultaneously, the bandwidth of value estimates might be wide. The paper aims at narrowing down this bandwidth with a conceptual analysis. I analyze the different ways to average peer multiples, the links between common multiples (‘inter-multiple’ analysis), the relevance of their components (‘intra-multiple’ analysis) and the resulting choice between a bottom-up and a top-down approach for deriving a multiple, and the impact of differing capital structures.
Abstract Much has been written about various remedies in litigation involving intellectual property (“IP”) infringements, some economic and other non-economic. A common remedy across different types of IP is lost profits. This paper explores similarities and differences among different types of IP infringement: patent, copyright, trademark, and trade secrets. Common elements needed in any lost profits claim, especially causality, are presented and along with damages implications for plaintiff and infringer by type of IP. These are a few of issues considered along with brief discussion of key statutes, cases, and the alternative of damages based on reasonable royalty rates.
AbstractThis study focuses on answering whether EV/EBITDA multiple of public companies in the food industry can be useful to obtain the Terminal Value (TV) in the valuation of unlisted small and medium-sized food companies. A case study into Spanish unlisted agribusinesses is designed for several samples and accounting years from 2010 to 2013. By means of a discounted cash flow (DCF) model combined with bootstrap techniques, the TV/EBITDA empirical distribution of the unlisted multiples is obtained for two different scenarios of free cash flow (FCF) growth, and then compared with the EV/EBITDA of the listed companies in the same industry. The results show that the stock market EV/EBITDA multiple may be used to determine the TV in the valuation process of unlisted small and medium-sized food companies that consistently obtain positive cash flows.
