Valuing high risk investments
Valuing high risk, longer term investments is an inherently difficult process characterised by significant uncertainty and a substantial degree of judgement. As the unpredictability, and therefore risk, of an investment's financial performance increases to extreme levels, commonly used valuation methods, such as discounted cash flows, earnings multiples, and net asset value prove less reliable. This degree of uncertainty is frequently encountered when valuing early stage ventures, with untested products or business models. For such uncertain investments, a method commonly used by venture capitalists to price deals can be used to value investments where the current value must be estimated, despite the level of uncertainty regarding future financial performance and cash flows.
Venture capital method
The venture capital method can be described as a hybrid between two regularly used valuation techniques – the discounted cash flow method (“DCF”) and the capitalisation of future maintainable earnings (“CFME”) method (commonly referred to as an “earnings multiple” approach). The method comprises the following steps:
Project the investment’s net income for a terminal year in the future, for example, six years from the present. This estimate should present a “success scenario” in which the business achieves its revenue, margin, and net profit expectations. Investors and founders should remain realistic in their view of ‘success’ and their approach to calculating successful profit expectations.
Determine a hypothetical earnings multiple that would be appropriate for the enterprise had it achieved the degree of success projected e.g. projected EBIT, EBITDA or net income. This earnings multiple is typically estimated by reference to current comparable companies that have similar operations and risks to that which the subject venture could be expected to have were it to achieve its “success scenario” in the future. Comparable companies are selected based on characteristics such as the nature of operations, industry, geography, risk profile, growth rate, capital intensity, and size.
Multiply the projected earnings by the hypothetical earnings multiple to determine the investment’s projected value in the future (terminal value).
Convert the terminal value of the investment to a present value using a very high discount rate reflecting the attendant risk of achieving the “success scenario” (discount rates between 30% and 90% are common for this type of investment). The result is an estimate of the value of the investment today, in light of its significant uncertainty.
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