As I’ve been doing more and more angel investing, I’ve started to dust off my valuation chops from my investment banking days.
One common difficulty is valuing a company that currently is not profitable.
If we assume a company is growing revenue at the same rate as the overall S&P 500 (5% or less), they should expect a P/E (price to earnings) ratio of 15-20x.
While the historical average has been closer to 15x, the last 3 decades have sustained a 20x or so multiple.
So how do you figure out what the revenue multiple should be?
The easiest way is by figuring out what the average profit margin is. For software companies, this is typically around 20%.
Revenue multiple = P/E multiple X profit margin
For instance, for software companies:
20x * 20% = 4x revenue multiple.
The key to understanding revenue multiples is understanding that different types of businesses have different abilities to produce earnings. Some, like software, are high-margin (20%+ net income margin) while others are low margin (e.g. retail at 5%). A high margin business commands a higher revenue multiple because more of that revenue will turn into earnings. For instance, both Oracle and Target have about a 20x P/E multiple. Target, however, trades at a 0.8x revenue multiple because its net income margin is only about 4%. Oracle, on the other hand, has a 24% net income margin (6x that of Target) and trades at a 4.8x revenue multiple (6x that of Target). Funny how that all works.
So what profit margin can you expect at scale?
Mostly likely, you’ll end up around where the average is for your industry. Here’s a quick analysis: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/margin.html
If you can’t pinpoint where your company falls on that list, find the closest comp that’s a public company and look at their financial statement.
For instance, Away, the luggage maker, can look to Samsonite. They made around an 8% profit margin the last couple of years (source: http://www4.samsonite.com/_investordocs/20190415140343_E_Lux%20Consolidated%20Financial%20Statements%202018%20(Final%202019-04-15).pdf).
If you take a 20x P/E multiple (though Samsonite’s is closer to 15x), they imputed revenue multiple based on 8% profit margin is 1.2x revenue.
Away reported that they expect to double the $150m of revenue they had in 2018 for 2019, putting them at $300m. Based on the revenue multiple above, they would be worth about $360m, if they immediately stopped growing.
That would suggest their latest valuation of $1.4b was 4x their current value (source: https://www.forbes.com/sites/amyfeldman/2019/05/14/at-a-valuation-as-high-as-145b-valuation/#5bf917d933d7_)
In another post, I’ll talk about the “growth multiple” and how it relates to future cash flows. This will explain why paying 4x for a fast growing company isn’t crazy. In fact, it’s often a steal.
As a final note, if a startup can show how they realistically can have outsized margins at scale versus the traditional public comp, that will drive a higher revenue multiple as a function of a higher future expected profit margin. While many startups claim to be able to do this (direct to consumer, new way of manufacturing, etc), this rarely is the case. See Casper’s recent filing as a great example.