The value of a firm is based on its capacity to generate future cash flows and the uncertainty associated with these actions (Damodaran, 2001).
The value of a firm is also influenced by a number of variables (Sevenius, 2003). Each variable have different signification for different interested party, which make valuing more complex (Sevenius, 2003).
When valuing a firm, traditionally there are three sources of use to gain information (Damodaran, 2001).
• The first is the current financial statements for the firm. This statement is used to determine how profitable a firm’s investments are or have been, how much it reinvest to generate future growth, and for all the inputs that are required in any valuation.
• The second is the past history of the firm; both earnings and market prices. A firm’s earnings and revenue history over time makes it possible to make judgments on how cyclical a firm’s business has been and how much growth is has shown. The firm’s price history can also improve the judgments on how to measure its risk.
• Finally, the firm’s competitors or peer group to estimate how much better or worse a firm is than its competitors. Looking at comparables also estimates key inputs on risk, growth, and cash flows.
The difference of new technology firms from traditional firms is in many cases the three traditional sources to gain information from are missing, due to the new technology firm’s insignificant age (Damodaran, 2001). They usually have not been in existence for more than a year or two, leading to very limited history. Second, they reveal very little of their expected growth in their financial statements that contributes the most of their value. Third, these firms often represent the first of their kind of business, which makes it hard to find any competitors to benchmark (Damodaran, 2001).
When valuing new technology firms all sources of information are constrained, due to the reasons bulleted above. Damodaran (2001) states that these constraints have caused different types of responses on how to deal with the problem with new technology valuation. Some of the investors have decided that these kinds of stocks cannot be valued and should not be held in a portfolio. Other analysts have argued that these companies cannot be valued with
traditional valuation models (Damodaran, 2001).
5.1. Valuing from derivatives
Two common metrics when measuring the value of an investment is the Price-Earnings ratio (P/E ratio), the ratio of the market price of a security to its expected earnings, and
Price-to-Sales ratio (P/S ratio), the ratio of the market value of equity in a business to the revenues generated by that business.
The Price-Earnings ratio is, according to InvestorWords (2006) “the most common measure of how expensive a stock is.” The P/E ratio is equal to a stock’s market capitalization divided by its after-tax earnings over a 12-month period, usually the trailing period but occasionally the current or forward period. The value is the same whether the calculation is done for the whole company or on a per-share basis. The higher P/E ratio, the more the market is willing to pay for each dollar of annual earnings. . Companies that are not currently profitable (that is, ones which have negative earnings) don't have a P/E ratio at all, why the majority of new technology start-ups cannot be measured by P/E ratio.
The Price-to-Sales ratio is according to InvestorWords (2006), a stock's
capitalization divided by its sales over the trailing 12 months. The value is the same whether the calculation is done for the whole company or on a per-share basis. A low price to sales ratio (for example, below 1.0) is usually thought to be a better investment since the investor is paying less for each unit of sales. However, sales don't reveal the whole picture, since the company might be unprofitable. Because of the limitations, price to sales ratio are usually used only for unprofitable companies, since such companies don't have a P/E ratio (www.investorwords.com, 2006).
On both measures, technology firms distinguish remarkable, compared to the rest of the market (Damodaran, 2001).
0 10 20 30 40 50 60 70 80
Computers &
Peripherals
Computer Software & Svcs
Semiconductors Auto & Truck Chemicals Specialtry Retailers Figure 5.1. P/E Ratio Comparison across sectors. Damodaran, 2001.
0 5 10 15 20 25 30 35 40
Computers &
Peripherals Computer
Software & SvcsSemiconductors Auto & Truck Chemicals Specialtry
Retailers Internet
Figure 5.2. P/S Ratios by Sector. Damodaran, 2001.
The Price-to-Earnings ratio is the most common and widely used measure of all multiples (Damodaran, 2001). The P/E measure is attractive to choose in pricing initial public offerings because of its simplicity, but it is also highly limited. Its relationship to a firm’s financial fundamentals is often ignored, which may lead to significant errors in applications
(Damodaran, 2001). The P/E ratio is a measure for public companies, that is, companies that already have conducted an IPO, which makes the measure very limited to new start-ups, since they suffer from public stocks. The concept of the P/E ratio will not be further elaborated because of its limitations to new start-up companies.
5.2. Two approaches of valuing new tech firms
When exploring prior research in the topic of Internet valuation, there are two main
approaches argued about which is the best way to use. First there is the traditional financial statement approach, which claims the best and accurate way of valuing, since it has financial and often historical substance. The other approach is the non-financial measurement approach, which claims measurements like “unique visitors” and “page-views” are crucial variables that drives value creation. Since the two ways of valuing, are controversial to each other I will present both approaches further on.
5.2.1. Paradigm 1. A financial statement approach – Cash is King!
The value of any asset is a function of the cash flows generated by that asset, the life of the asset, the expected growth in the cash flows, and the risk associated with the cash flows.
Generally, the higher profit the firm makes, the more valuable it is, compared to firms less profitable. This approach appeals to traditional businesses, and sounds reasonable to apply on all industry. The conflict of the view to value firms only with this tool is based on the
environment where new technology firms are operating. During the Internet shakeout in year 2000 and afterwards in year 2006 the prices of new technology firms boomed and are still booming, and skeptics asserts that the business is overvalued, because of the extreme difficulties to reach break-even for all investments. An example of this overvaluation is Amazon.com, an online bookstore11.
When looking at new technology firms with significantly great losses, like Amazon.com prior year 2002, the proposition of high profitability – high valuation seemed to be turned on its head, that is firms that lose money seem to be valued more than firms that make money, at least on the surface.
11 Amazon.com started their online bookstore in America, but has afterwards extended their assortment to the characteristics of a wholesale.
Using only traditional measurements will get valuations that hardly match the value the market de facto is paying12 (FT, 2006). Since it is difficult to forecast and analyze internal business strategies and business models from the outside of a firm, an analyst hardly gets all information that justifies abnormal prices. Traditional valuing has a great advantage in
credibility, since the numbers of the valuation stems from real transactions. The disadvantage of traditional valuation is that it makes it hard to put a price on activities that not specifically drives value in the organization. Theses activities might still be very crucial for the process, but they tend to have of no value.
In an interview with an accountant at a well-known and world-wide accountant firm with office in Sweden, the accountant claims that the traditional approach must apply, also in the new technology industry.13
5.2.2. Paradigm 2. A non-financial approach – The value of an eyeball Using the non-financial data to get a snapshot of a firm’s economical development is a delicate inquiry that divides the opinion in two groups – those who advocate the traditional view and those who claim that a renaissance of valuation models is needed. Studies have shown that some non-financial measures have significant value-relevance in some operations, but also no or limited significant value-relevance in other areas (Trueman et al, 2000).
Trueman et al’s (2000) study were discussed after the paper was published and resulted in an article on “Discussion of The Eyeballs Have It: Searching for the Value in Internet Stocks” by Keating (work paper, undated) who stressed that the Internet is a nascent industry, the
previous analysis is constrained by the short trading history, limited financial and
non-financial data, and a small sample size. In Keating’s commentary she add econometric, modeling, and interpretation-related concerns with the Trueman et al’s (2000) paper and offers suggestions for future research on "New Economy" firms.
The non-financial measures play a significant role, and healthy commentaries are driving the concept further. Still, the added commentaries are accounting related issues, concerning econometrics, and do not interfere with the concept of non-financial data, but polish and improve the way of thinking.
12 Examples of Skype and YouTube
13 The accountant and the firm must be kept anonymous according to company policy.
5.3. Renaming Old Principles or embracing New Paradigms
Referring to Damodaran, he also argues that the search for new paradigms is misguided (Damodaran, 2001). He asserts that the problem with technology firms, in general, and new technology firms in particular, is not that they lose money, have no history, or have
substantial intangible assets. The problem, according to Damodaran (2001) is that these new technology firms, which show on strong high-growth potential more often are exposed for valuation activities, than traditional industries in their early phases. They have often to be valued before they have established market for their product. Early valuing of new companies in novel industries contains a large portion of uncertainty, due to the lack of historical
information about the company. Damodaran (2001) further claims that the problem is not conceptual, but is an estimation problem, due to the large estimation and managing of risk.
The value of a firm is still the present value of expected future cash flows, but those cash flows are likely to be much more difficult to estimate (Damodaran, 2001).