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Valuing some pre-revenue companies can be extremely difficult, particularly those in Tech and other new industries. The core issue is that a lot of smaller pre-revenue companies are not in a place where they can give reliable earnings guidance or NPVs (Present value of future cashflows generated from the company). It is therefore necessary to use a screening tool to quickly filter the potential cash cows from the dogs. I have included below something I developed some years ago to identify potential companies to invest in. The tool asks a number of questions and points are awarded based on your response. Please note this tool is not appropriate for resource companies, these companies are generally more straight forward to value, I have written a separate post on reserve based valuations here.
Pick a pre revenue company and if you do receive 8, 9 or >10 pts then that is a great start, it shows potential but this does not make the company an automatic buy, good companies can still be overvalued, so close down your dealing screen for now. The first thing you should do is remember that the valuation of a company in the long term is based solely on how much money the investment generates for shareholders through dividends or share buybacks. You should then look to do some quantitative analysis to consider that point further.
The best way of really estimating the value of a company, i.e. the potential Free Cash Flows (FCF) the company can make and potentially return to shareholders is comparing the NPV to the Enterprise Value of a company. I have a detailed NPV calculation that I have built in a recent analysis of Hurricane here that you can take a look at by way of example. It is actually not overly complicated to prepare a NPV computation, I’ll look to do a worked example in the future but for now this guide is fairly useful, a gentle introduction to the concept. Once you understand the concept you just need to have fairly sensible assumptions for revenue, costs, CAPEX, financing etc. Some assumptions you can glean from company presentations, other assumptions you may need to look to competitors and for some you may need to come up with your best educated guess!
The key is that you are looking for NPVs well in excess of the current Enterprise Value of the company, this will allow plenty of scope for further derisking.
If you don’t feel comfortable with NPVs, you can do some more basic analysis, look at the competitors, what Price to Earning ratio are they on? So if your company has a market cap of £100m and competitors are on PEs of 20, is it realistic that your company can turn £5m of profit on a forward looking basis. If not then is the valuation of your company too high? If yes, can it keep growing its earnings going forward? It would take your company 20 years to generate enough earnings to justify its share price and how many years would that be in dividends for shareholders? I could go on and on but these are the sort of questions you need to ask yourself and remember the valuation of a company in the long term is based solely on how much money the investment generates for shareholders through dividends or share buybacks.
The screening test should enable you to filter companies fairly quickly, but make sure you do some number crunching and be as prudent as possible with your assumptions. Once you have developed an NPV for a stock on your watchlist there is always an opportunity to revise your assumptions. At some point you will find an entry level on a stock where you have a solid piece of research on.
No method is never infallible and you of course can amend some of the screening questions as you see fit, just make sure you are very honest and as prudent as possible with your costing and revenue assumptions.
Finally, If all of the talk of NPVS, CFOs and PE ratios scares you then not to worry, keep following my articles and generally I will use analytical methods where I can and I am always happy to answer questions…. And as always I welcome your feedback!