A New Way to Gauge a Start-Up’s Worth

Published: December 31, 2006
INVESTORS in young, fast-growing companies have a new way to calculate their value without regard to the prices of other companies’ stocks. This is an important advance, because most other appraisal methods for start-ups are based on relative valuation, which — as we saw at the top of the Internet bubble — grossly overvalues a new company when comparable companies in the same industry are also overvalued.
The new approach is the brainchild of Andrew Metrick, an associate professor of finance at the Wharton School of the University of Pennsylvania. He calls it a “reality check model,” and he introduced it in his new book, “Venture Capital and the Finance of Innovation” (Wiley & Sons, 2006).

Relative valuation is widely used to analyze start-ups because there seems to be no other choice. After all, a brand-new company has little hard financial data to plug into the standard valuation models that analysts use for mature companies. But by using relative valuation — basing stock value on that of others in the industry — a young company’s share price can occasionally become wildly divorced from reality.

In an interview, Professor Metrick acknowledged the dearth of hard data on start-ups. But he also said that this should not be used as an excuse for “anything goes.” By substituting some reasonable assumptions for the data otherwise needed to apply the conventional models, his model provides its reality check.

One important assumption deals with how fast a start-up’s revenue will grow. Investors are especially prone to exaggerating this, because before a start-up goes public its typical growth rate is very high.

To arrive at a realistic assumption for a specific start-up, Professor Metrick looks at the revenue growth rates of all other companies in its industry after they went public. He assumes that the start-up’s revenues will grow faster than those of 75 percent of the comparable initial public offerings — an assumption that gives the start-up a big benefit of the doubt.

Another crucial assumption involves how long a start-up can grow faster than its industry average. In his research, Professor Metrick found that the median start-up does so for five years after going public. Again, to give start-ups the benefit of the doubt, he assumes they can outpace their industry for seven years.

Armed with these and other assumptions, he can calculate the present value of a start-up’s future earnings. This approach, known as the discounted cash flow model, is perhaps the one most widely to value mature companies. He concedes that the number produced by his model is by no means perfect. But because it makes generous assumptions about start-ups’ growth in several crucial ways, he said, it sends a warning signal if the valuation it reaches is significantly less than the market’s.

Consider Riverbed Technology, a data network company that went public in October. Professor Metrick’s model calculates a value for the company of $184 million, or less than 10 percent of its market capitalization of $2 billion. To bet on Riverbed Technology at its current price, you presumably would need to believe that its revenue growth rate will be even higher than his model already assumes, and that it will beat the industry average for far more than the next seven years. Those are high hurdles, Professor Metrick reminds us.

As an example of a new issue that may be more fairly valued, he offers InnerWorkings, which provides printing solutions to corporate clients. His model calculates a value for this company that is nearly double its current market cap of $702 million.

His model is also helpful as a reality check on companies that have been public for a couple of years and that investors may be valuing on the assumption that their high growth rates will continue forever. In such cases, analysts’ estimates of growth are now available, so the model can rely on them.

Consider the conclusion reached by this model when retroactively applied to Cisco Systems in early 2000, just before the Internet bubble burst. At the time, the market valued Cisco as the most profitable public company. If applied to Cisco then, the model would have calculated it was worth only about one-tenth as much.

That’s a remarkable conclusion, because the analysts themselves were then wildly optimistic about Cisco’s future growth. “The model at that time would have shown that the analysts’ growth assumptions, high as they were, were not nearly high enough to justify Cisco’s valuation,” Professor Metrick said. Cisco’s stock, of course, fell to less than $10 a share in 2002 from more than $80 in early 2000.

AND what about Google, which has risen to around $460 a share from an initial offering price of $85 in August 2004? As with Cisco, Professor Metrick fed into his model the consensus of analyst estimates for Google, rather than basing his growth-rate assumptions on an average of other young tech companies. His model values Google at more or less its current price.

But that doesn’t necessarily mean Google is a good investment at the current price, he says. To believe that it is, you presumably have to believe in the consensus growth assumptions of analysts. Still, he added, his model shows that the market is not overvaluing Google anywhere nearly as much as it did Cisco in 2000.

Mark Hulbert is editor of The Hulbert Financial Digest, a service of MarketWatch. E-mail: