financial analysts! how do you...

[tortvader]

I'm doing the valuation of a software company. It's a garage operation with an inisignificant revenue flow over the past three years of operations. It is, however, developing a software that will support the entire operations of an educational institution. The same software may be used for business applications, as all its modules uses generally-accepted principles (GAPs) as a standard.

The company does not keep its books (esp in its R&D efforts) and its historical performance is not indicative of its potential.

So, how would you value the company (empahsis on revenue and opex models) ?

What forecast horizon is optimal?

[mac_bolan00]

what's the valuation for? for equity investment or for crdit evaluation? if i'm a bank, i wouldn't lend to it. if i'm a venture capitalist, i'll insist it has the capacity to crank out at least one good software every year with annual upgrades.

assuming its new SW is as good as you say and it will be the primary source of revenues for the coming year, then estimate net cash flow for the year. i don't think you can project anything farther than that with confidence.

[tortvader]

for equity investment. the software is actually an integration (and upgrade) of all its existing products plus it also has new features.

anyway, how do you go about estimating its net cash flow? specifically, what key drivers will you use for revenues?

[mac_bolan00]

a software designed for an institutional client usually must have some sort of contract or MOA before design can begin. therefore, revenues for the year depend on the service/sales contract(s) realized. following a contract signing, the buyer must give a downpayment for mobilization. from there, the developer will proceed with the research work and software design. he will also order the needed hardware from a supplier. then, as he installs, debugs and trains the client's personnel, he will charge the client based on a billing schedule. a complete cycle usually takes 4 months. at the end of four months, the software company usually ends up with a whole lot of collectibles, plus a whole load of payables to the hardware supplier. finally, he must hve money to pay his people from the very start.

don't tell me that company developed a software with no ready buyer! :)

going to cash flow, make it simple beginning with day zero (the time the contract was clinched) to the time the project ended. example:

sales 10,000,000
less:collectibles (3,000,000)
to get cash from sales 7,000,000

cost of hardware (5,000,000)
add: payable to supplier 1,000,000
to get cash production cost (4,000,000)

ang get gross cash profit 3,000,000

less: salaries, admn exp. (1,500,000)
less: taxes (450,000)

to get net operating cash 1,050,000

so, assuming it's like that, the business should crank out around 1 million after 4 months.

[tortvader]

That the market exists is not an issue here. There is a market. Hence, the R&D efforts.

The crux of the problem here is how to project the revenues of the company. You gave me P10M in the hypothetical problem, but you didn't explain how you got it. I was asking for the revenue drivers.

Since Revenue = Price * Quantity, the problem now is what figures to place under Price and Quantity. Let's say that the company prices its product at P1.0 M. How do you project quantity? What's your universe? the entire universities basket? or univs with a population of a certain level only? What portion of the business sector do you consider as your market?

BTW, mac, your modeling style is quite unorthodox. :)

[mac_bolan00]

it doesn't matter that the market buys $ 100 billion a year if you can't clinch a deal with even just one potential client. as i said, you must be able to have sufficient working capital to finance the development of a customized software/system on a project basis.

assumptions:

average project cycle = 4 months

cost to develop a stand-alone system = number of programmers and technicians plus consultants times their fair remuneration rate for four months plus utilities, administration expenses. add a 30% overrun allowance.

also estimate the cost to market and negotiate the deal for each project

pricing should be cost-plus, based on direct espenses. a 100% mark-up is common for new systems. this mark-up diminishes greatly if there are competing products.

operating sequence:

negotiation -->contract -->mobilization -->research/design -->installation, debugging, training

cash-in:

downpayment/mobilization charge, external funds -->progress billing -->release retention -->collection of past-due receivables

cash-out:

marketing/negotiation -->salaries, cost to develop --> purchases from hardware supplier --> payment of taxes, interest, remaining payables to supplier and lenders, employees, consultants, returns and rebates to customer.

as you can see, i'm not so much into simple mathematical modelling. most of those 'models' just screw you up when you get down to the nitty-gritty.

[tortvader]

the issue here is to value the company so that the buyer will have some standard before the negotiations start. What we need is a benchmark. The point of view we're taking is that of an equity investor who has to make do with the lack of financial data.

I think my statement of the prblem is quite unclear. The company has two sofware products - A and B. Both are already out in the market. Among its users is the university that sells sweet corn. :) Right now, they're developing an integrated software that will support the operations of an educational institution. It's about to be released. Now, we're planning to buy an equity stake in the company. Let's say it's 60%. Now, given that the company has no records of the costs incurred and revenues generated, and given further that the financial info available was obtained mostly from interviews with the developers and from comparables, how do you go about valuing the 60% equity stake?

I gravely doubt it if the company will allow itself to be bought at book value.

[mac_bolan00]

again, you are not sure how many contracts you can generate every year, though you may have figures on the potential market. in this case, the future cash flow discounting method is acceptable (assuming a going concern with no foreseeable time horizon limit) since you can base it on an existing project (the corn huskers on the other side of katipunan road). assume the project is all he can manage for this fiscal year:

free cash flow per year/the required hurdle rate will give you the business' enterprise value

simple as that.

[Lek-Lek]

Originally posted by mac_bolan00
again, you are not sure how many contracts you can generate every year, though you may have figures on the potential market. in this case, the future cash flow discounting method is acceptable (assuming a going concern with no foreseeable time horizon limit) since you can base it on an existing project (the corn huskers on the other side of katipunan road). assume the project is all he can manage for this fiscal year:

free cash flow per year/the required hurdle rate will give you the business' enterprise value

simple as that.

just a question, mac: why does your valuation formula above assumes a perpetuity? aren't we supposed to make adjustments somewhere? it's a tech company, and as we know, the product life cycles in the tech industry are a lot shorter than your usual merchandise. (i.e. you might thinking that you're in the early market stage, then suddenly, you become a laggard). given the possible industry forces, i think, adjustments on annual cash flow must be made.

your suggestion with regard to signing MoAs before starting the research work is right--that at least assures the cash flow. but in adjusting, i guess we have to go back to the basics of marketing. what's the profile of the customer being served? given that the current customer is the University which used to have a corn field :) then i guess that could indicate something about market demographics and psychographics. then, perhaps, tortvader can consult the CHED for a list of all the universities in the Philippines and probably he can come up with a reasonable percentage that represents the universities who have the resources to purchase the software. after that, he can probably take into account possible changes in technology and industry factors, which must then direct him into identifying future revenue and cost drivers. all of these drivers such as price, market growth, costs of research and technology must then be used in the projections.

i dunno--if you find my suggestions helpful or stupid. if you do find it stupid, then maybe that just shows the fact that i still have to gain more work experience in this field. after all, i have just started more than a month ago. :)

[roadrage23]

Originally posted by tortvader
the issue here is to value the company so that the buyer will have some standard before the negotiations start. What we need is a benchmark. The point of view we're taking is that of an equity investor who has to make do with the lack of financial data.


Allow me to share my two cents' worth.

Assuming that you've come up with an acceptable financial model, I guess a quick and dirty approach in deriving a pre-money valuation is by multiplying a full year of sales (2003?) by a certain Price/Sales multiple.

For listed comparables, the closest local proxy would have to be SPi Technologies (1.23x 2003 sales) but the bulk of their revenues are call center and BPO-related and is thinly-traded. Regionally, the closest would be Frontline Technologies and Singapore Computer Systems, both listed in Singapore. Between the two, the Price/Sales multiple would be somewhere between 0.40 and 1.2x.

My sense is that you have to use the lower end of the range taking into account the start-up nature of the firm, the narrow product range, etc. In terms of done local deals for local startup software firms, I have no idea. Perhaps the iAyala or IdeaFarm people lurking in PEx could provide a benchmark.

[mac_bolan00]

VICTORY, HELP!!!! i'm caught between a cash flow projector named lek-lek and a P:E cruncher named road_rage! :lol:

first the future cash scenario - like i said, i can't for the life of me project the first 5 years with confidence. so assuming a steady payment from one client at a time (whether in cash or in corn) you might as well assume CF/r. that will be your optimistic estimate.

now to P:E - is there is publicly-listed software developer? i think there is (PSI tech ba yun???) ok then get his avg. price for 1 year and divide by current eps. the market being down, you'll probably get a per share valuation lower than estimated book value by end-2002 :lol: this will then be your low-end guesstimate.

other possible valuation tools - go back to your potential market (and follow what ek-ek's implying). come up with a client development plan. if you could keep the ball rolling with one new project every 4-6 months for the next 2-5 years, then you can estimate future earnings and cash flow more fundamentally. i strongly urge this method. it beats the first two by a mile.

[roadrage23]

Firstly, I don't recall mentioning anything about P/E in my previous post. I assume that the startup firm will likely register a net loss on its first full year of operations, thereby negating the use of a P/E multiplier. But if the firm generates full year 2003 revenues of, say PhP15 Million and using a Price/Sales multiple of 0.40x (which is the lower Price/Sales multiple range mentioned in my previous post), then the firm has a pre-money valuation of PhP6 Million (PhP15 Million x 0.40).

Also, I remember that SPi Technologies has a software development group, which has yet to deliver revenues as significant as its call center and BPO operations.

Moreover, PSi Technologies is a different firm and is the first Philippine company to be listed in NASDAQ. Unfortunately, PSi is not a software development firm but an EMS provider.

Just some follow-up thoughts from a quick and dirty P/S cruncher. :D

[roadrage23]

I forgot this other point: Multiplying a start-up firm's net loss by a P/E multiple results in a negative pre-money firm valuation. Yup, that's likely to be lower than the estimated book value. :D

Surely, the founders wouldn't want to use that as part of the indicative lower range for negotiating the firm's pre-money valuation. :rolleyes:

[mac_bolan00]

you don't apply P:E straightaway when a start-up business expects a loss on the first rainy season. what you do is predict future performance and thence estimate future P:E. future P:E in listed stocks can be deduced through fibonaci band simulations. :rolleyes: :rolleyes: :rolleyes:

[tortvader]

Originally posted by mac_bolan00
again, you are not sure how many contracts you can generate every year, though you may have figures on the potential market.

simple as that.

This UNCERTAINTY is what i'm trying to make certain - the number of contracts generated given a certain forecast horizon. I share your fear that any projections beyond one year does not inspire a great degree of confidence but on the toher hand, i also fear that we might be undervaluing the company by ocnsidering only a year's projections in the valuation.

from lek-lek

then, perhaps, tortvader can consult the CHED for a list of all the universities in the Philippines and probably he can come up with a reasonable percentage that represents the universities who have the resources to purchase the software. after that, he can probably take into account possible changes in technology and industry factors, which must then direct him into identifying future revenue and cost drivers. all of these drivers such as price, market growth, costs of research and technology must then be used in the projections.

this is what I actually did. My basket was PAASCU and CBCP. My problem was how to project the revenue growth rates. (In your own words, find out the REASONABLE PERCENTAGE...". I based my projections mostly on information from interviews and their current take-up rate. the big headache relates to their probable success in the business sector.

[tortvader]

Originally posted by roadrage23

Allow me to share my two cents' worth.

Assuming that you've come up with an acceptable financial model, I guess a quick and dirty approach in deriving a pre-money valuation is by multiplying a full year of sales (2003?) by a certain Price/Sales multiple.

My sense is that you have to use the lower end of the range taking into account the start-up nature of the firm, the narrow product range, etc. In terms of done local deals for local startup software firms, I have no idea. Perhaps the iAyala or IdeaFarm people lurking in PEx could provide a benchmark.

Thanks. I tried this approach. (I made two models for this valuation problem) The sales multiple model, however, has the tendency to overvalue the company. It also further compounds or builds on other uncertainties. For example, I'm not confident with the number of contracts per year that the company can generate. And now we're going to use a multiple which is at best a rough approximation of teh company's value. But I think the optimism can be offset by your suggestion tot take the lower end of the range.

[BULLD0GS_FAN]

Humingi ng projections, 3-5 years. Tapos do your due diligence at i-adjust mo ang mga line items tulad ng revenue components at ibang expense items.

Humanap ka ng mga ibang software companies na medyo in the same line of business maski hindi exacto.

I-compare ang Price/revenues, price/EBITDA ratios. Tapos make your adjustment based on what you know. Eg adjust downwards kung walang proprietary software ek ek. Kung medyo bobiski ang management, adjust downwards etc.

Ang basis mo sa valuation is the first full year of operations after the current year. Use yung mga P/R at P/Ebitda ratios to get a range of valuation.

Yung ang isang approach.

Pwede rin ang NPV approach na using DCF. Pero since start-up ang ina-analyze mo, just stick to a proxy tulad ng P/Revenue or P/Ebitda approach.

Yun lang.

NU Rulezzzzzz!

[roadrage23]

Originally posted by mac_bolan00
you don't apply P:E straightaway when a start-up business expects a loss on the first rainy season. what you do is predict future performance and thence estimate future P:E. future P:E in listed stocks can be deduced through fibonaci band simulations. :rolleyes: :rolleyes: :rolleyes:
That is exactly the reason why I suggested using a Price/Sales multiplier approach. This is in order to address the problem of the owner needing some standard in coming up with an indicative valuation as a basis for negotiations with an equity investor who has to make do with the lack of financial data. But I have no problem using CF/r in initially valuing the firm.

Assuming that the owner and the investor agree on an indicative valuation, the investor can now proceed to perform due diligence. This would be the perfect time for the investor to tinker with the owner's financial projections, particularly the key assumptions, after getting a better feel of management and key personnel, technology, market prospects, patent protection, possible exit scenarios (IPO, trade sale or buyback), etc.

Having done all of that, and if the investor feels that he has come up with his stable financial model, he can now proceed using the more sophisticated financial valuation tools.

[roadrage23]

tortvader: It would be interesting to know how the deal plays out, if it ever progresses beyond the initial valuation exercise, as we can treat this as VC 101. Cheers.:D

[tortvader]

Roadrage23:

Thanks! We closed out the valuation and we find the company to be quite expensive than we initially thought it to be. So right now, as an alternative, we're looking at acquiring the software instead. We're seriously pursuing this course. Any thoughts on this?

[roadrage23]

tortvader: I'm sorry to hear that. Regarding your alternative plans of acquiring the software, my immediate reaction to this is that negotiations are likely to go nowhere as well. Absent any meaningful due diligence, the software product seems to be the only valuable asset of the firm. Having said that, do you think there is a big difference in the perceived value between the firm and the software at the moment?

[GARFIELD M]

Originally posted by tortvader
Roadrage23:

Thanks! We closed out the valuation and we find the company to be quite expensive than we initially thought it to be. So right now, as an alternative, we're looking at acquiring the software instead. We're seriously pursuing this course. Any thoughts on this?

Sometimes the decision to acquire a product which becomes obsolete in a matter of months or years due to fast techonology change and innovations is not hinged on financial viability alone.
The limited market such as particular industries that it is going to target, the inadequacy of the software to meet the targeted market' system requirements and the alternative software that is readily available in the market have to be included among the factors for investment decision exercise.

If the software is limited to a particular field or industry, the latter's growth will determine the realization of the projected revenues.

Given the limited life of product of this type, from the financial point of view, how short will the investment be recovered before it calls for additional capital expenditures for upgrade ?

[GARFIELD M]

Given the acquisition cost of the software...what will be the projected revenues ?

What are the projected clienteles in terms of demographics.? Will the sales be ...one shot deal or there will be maintenance or consultancy paid post-installation?


If this is some sort of over the counter software, user friendly type and can be used by all industries regardless of the type..i.e. educational...non-profit...merchandising...service...the market is definitely broader and therefore recovery of investment is quicker.

I am for payback period rather than long term profitability prospects for products which are affected by fashion and techology developments.

[roadrage23]

A well-designed financial model and due diligence review should take into consideration GARFIELD M's points, e.g., target market and potential competition, product technology, potential revenue streams and funding/capital calls.

[GARFIELD M]

Originally posted by roadrage23
A well-designed financial model and due diligence review should take into consideration GARFIELD M's points, e.g., target market and potential competition, product technology, potential revenue streams and funding/capital calls.

I usually make several assumptions using the worst scenario of constant volume and SP.

The high projection takes into account the increases in both...with the correspoding sales strategies to achieve the targeted sales goal....

I used three measures of viability of the project.

DCF, NPV and payback period.

The rate that can be used to discount the cash flows may be the ROR of an alternative investment option or it could be the
expected yield from a similar project.

I make at least 5 year- projections with varying assumptions.


The sum total of [EBIT x 60% (assuming tax is fixed at 40 per cent) +D+A ] x DCFRR-Capital outlay

IF NPV is >...then project is ok
IF NPV is <...the project cannot give revenues that will give the expected return from the cut off rate..

The longer the payback, the greater is the exposure to the risk of obsolence of the product.

The Capital outlay includes capital expenditure as well as an estimated working capital that is enough to sustain the company until it is making money.

[roadrage23]

Originally posted by GARFIELD M


I usually make several assumptions using the worst scenario of constant volume and SP.

The high projection takes into account the increases in both...with the correspoding sales strategies to achieve the targeted sales goal....

I used three measures of viability of the project.

DCF, NPV and payback period.

The rate that can be used to discount the cash flows may be the ROR of an alternative investment option or it could be the
expected yield from a similar project.

I make at least 5 year- projections with varying assumptions.


The sum total of [EBIT x 60% (assuming tax is fixed at 40 per cent) +D+A ] x DCFRR-Capital outlay

IF NPV is >...then project is ok
IF NPV is <...the project cannot give revenues that will give the expected return from the cut off rate..

The longer the payback, the greater is the exposure to the risk of obsolence of the product.

The Capital outlay includes capital expenditure as well as an estimated working capital that is enough to sustain the company until it is making money.

In addition to the above, a VC's alternative financial model includes his investment/s into the startup, additional equity financing rounds and the share in the proceeds following an exit event, e.g., trade sale or share buyback. Also, to account for post-investment dilution/s, the model also takes into account dilutive events such as IPO and employee share options.

[tortvader]

Thanks for the inputs. We've been working on the deal. I've also been sidelined because it's registration time at school.

:D

[tortvader]

Does anyone here have an access to a CHEAT SHEET?

It's a table containing a basket of publicly-listed companies (usually those in the Phisix) with their P/Es and market caps. It aims to get the "market P/E." I used to keep one but I've been out of the market for three years now.

Help, anyone?

[mac_bolan00]

why don't you call your broker?

[GARFIELD M]

Originally posted by mac_bolan00
why don't you call your broker?

hINDI KAYA BROKE ? OOPS

[mac_bolan00]

wrong. he makes YOU broke. :lol:

[r_moriarty]

tortvader:

The problem with cheat sheets is that they use the firm's internal projections as basis for the market P-E. When you compare market P-E's across several firms, you will find out that some "sales-oriented firms" will depress their P-E's while there are some who would stick to consensus P-E's.

I can provide you with the template, but it's up to you to fill in the consensus estimates. Check Bloomberg and Technistock.