Constructing Equity Valuation Models Based on Company Characteristics

• Stable revenue growth
• Sustainable profitability and cash flow
• Established market position
• Positive free cash flow

Valuation Approach:

Mature firms are typically valued using:

• Constant-growth models
• Stable profit margins
• Asset growth in line with revenue growth
• Discount rates reflecting lower risk

Decline Phase

Characteristics:

• Falling sales and market share
• Lower profitability
• Greater likelihood of financial distress
• Potential restructuring or liquidation

Valuation Approach:

For firms in decline, analysts should explicitly incorporate the probability of financial distress:

$$ \mathrm{IV}_t = \text{Going-Concern Value} \times (1 – \text{Prob }{(\text{Distress})}) + \text{Distress Sale Value} \times \text{Prob}(\text{Distress}) $$

Key Adjustments:

• Identify and adjust key balance sheet and income statement items affected by decline
• Recognize that discount rates are difficult to estimate given distress possibilities
• Avoid terminal value estimates based on non-distressed industry peers

2. Effect of Shareholder Control on Valuation Model Construction

Financial Investors (Non-Controlling):

• No influence over firm operations
• Valuation based on how existing management operates the firm
• Standard discounted cash flow or relative valuation approaches apply

Controlling Investors (Strategic or Activist):

• Hold significant minority or majority stakes
• Seek board representation or full control
• Initiate changes to increase shareholder value

Valuation Implications:

When activist investors propose changes, analysts can translate these into detailed forecasts of operating, investing, and financing activities. This includes modeling:

• Asset sales or acquisitions
• Expense reductions or restructurings
• Changes in capital structure
• Dividend policy revisions

Example: Growth Company Valuation

NovaTech Solutions is a private technology company founded four years ago. The company provides cloud-based software for small businesses. Base year (Year 4) financials:

$$
\begin{array}{l|r}
\textbf{Item} & \textbf{Year 4 (USD)} \\
\hline
\text{Sales} & 18,500,000 \\ \hline
\text{COGS} & 15,170,000 \\ \hline
\text{Gross Profit} & 3,330,000 \\ \hline
\text{SG&A} & 3,330,000 \\ \hline
\text{Net Income} & 0 \\
\end{array}
$$

Assumptions:

• 40% annual sales growth over five years
• COGS and SG&A grow at 28% annually
• Tax rate: 30%

Step 1: Forecast Year 9 Sales and Net Income

$$ \begin{align*} \text{Sales }{(\text{Year 9})}& = 18,500,000 \times 1.40^5 = 99,497,440 \\
\text{COGS }{(\text{Year 9})} & = 15,170,000 \times 1.28^5 = 52,123,723 \\
\text{SG&A }{(\text{Year 9})} &= 3,330,000 \times 1.28^5 = 11,338,714 \\
\text{Net Income}& = [\text{Sales} – \text{COGS} – \text{SG&A}] \times (1 – \text{Tax Rate}) \\
\text{Net Income} &= (99,497,440 – 52,123,723 – 11,338,714) \times (1 – 0.30) = 25,224,502 \end{align*} $$

Step 2: Estimate Intrinsic Value

Industry peers trade at P/E = \(18\times\). Target ROI = \(4\times\) over five years.

$$ \begin{align*} \text{Terminal Value} &= 25,224,502 \times 18 = 454,041,038 \\
\mathrm{IV}_0 &= \frac{454,041,038}{4} = 113,510,260 \end{align*} $$

Question

A valuation model for a company in the start-up phase of its life cycle is most likely based on a P/S multiple using expected:

1.  sales in the next year.
2. sales at the end of the forecast horizon.
3. earnings at the end of the forecast horizon.

Solution

The correct answer is B.

Start-up companies generate little to no revenue and negative cash flow, with no operating history. Valuation focuses on future revenue potential rather than earnings, and the terminal value should reflect sales at the end of the expected growth phase, not in the next year.

A is incorrect. The next year’s sales do not capture the full revenue growth potential of a start-up company. The valuation horizon must extend to the point where the company achieves meaningful scale.

C is incorrect. Start-ups typically have negative or negligible earnings in early phases. An earnings-based multiple yields a negative or meaningless valuation. Sales-based multiples are more appropriate.

Strengthen your understanding of equity valuation models, company characteristics, and valuation approaches in CFA Level I Equity with study notes, practice questions, and mock exams.