How the financial evaluation of IT startups is formed: McKinsey Method

Experts at research company McKinsey have published material on how to evaluate the cost of high-tech start-up companies. We present to your attention the main points of this document.

It is quite difficult to predict the behavior of start-ups and, in general, high-tech companies in the stock market. McKinsey & Company analysts argue that the only adequate way to evaluate such companies is the so-called DCF method.
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In the past few years, investors have again begun to actively invest in stocks of companies that are characterized by rapid growth and high risks. Especially in those related to Internet technologies. A similar story had already taken place at the end of the 20th century, when many similar companies showed a rise and an equally unpredictable fall. Today, when the technological boom has reached its peak, the question of the influence of these processes on the general state of the market is more relevant than ever. Representatives of the US Securities and Exchange Commission even announced at the end of 2015 that they would conduct a special study on this issue.

Consequently, the question arises, what methods can reliably estimate the cost of high-tech companies? According to the authors of the article, the most suitable for this is the Discounted-cash-flow or DCF method. Although it can be attributed to the methods of the "old school", it works where other analysis options do not allow to achieve acceptable results.

The fact is that alternative methods, such as price / earnings ratio (price & earnings, P / E) or price / sales multiplier counting, are not suitable when the company's revenue is negative, and massive sales of shares have not yet begun. But, more importantly, these methods do not provide a detailed picture of the state of the company in a rapidly changing environment; they cannot identify growth drivers.

The components of the analysis of high-tech companies are the same as those of traditional ones. The order and key points change: instead of researching the company's behavior in the market in the past, a long-term development forecast is studied, after which work is done in the opposite direction. In particular, the focus is not only on comparing the potential size of the market and the growth potential of the company, but also on the level of profit that the company is able to receive.

Given the precariousness of long-term forecasts, several scenarios of market behavior in different conditions should be considered. Uncertainty will noticeably decrease, but will not disappear at all. Further, the authors demonstrate an adaptation of their methodology, published in 2015, which used data from the market in 2014-2015. They warn readers that the companies mentioned in the text are taken as an example. All this cannot be considered as a commentary on the current situation on the stock market or as a guide to action.

Back to the Future

We should start with a simulation of the situation: what the industry and the company itself will look like when the latter evolves into a sustainable organization that maintains an average growth rate. Then you need to interpolate this situation on the current state of affairs. The future state is described in the categories of operating activities: an indicator of customer acquisition, revenue for each customer, steady profit and return on invested capital. Then we determine how long the rapid growth can continue until the growth curve stabilizes at normal values. For startups, this interval can be 10-15 years.

For example, take the popular site review of local companies Yelp and use for the analysis of public data about it. In 2014, its audience was about 545 million people, 18 million reviews were posted on 2 million companies to help other customers make their choice.

At the moment, the company serves about 150 cities around the world. Between 2009 and 2014, Yelp's revenue grew more than tenfold, from $ 26 to $ 378 million. The average annual increase was about 71%. (By the third quarter of 2015 - 48% compared to the previous year). In order to assess the size of the potential market, you need to understand how the company meets all the needs of customers. Then we determine what the company makes its revenue.

This is the key point - to understand what a startup actually earns. Many start-up companies give out a product or service that is demanded by people, but do not know how to monetize this need. In the case of Yelp, his team provides end-users with extensive information that helps them make a choice whether or not to use the services of a company. Yes, they have a convenient service for customers, but today users are not willing to pay for online reviews.

Therefore, Yelp relies on the sale of advertising for local companies registered on the site. Basic accommodation for them is free. But there are additional packages of services that can be purchased. In 2014, this direction gave $ 321 million of the company's total $ 378 million revenue. Taking into account this driver, it is possible, in principle, to estimate the volume of the potential market.

Market valuation

For Yelp, a critical condition for development is the ability to attract local business as a customer. You can calculate how many local companies are potential customers of the service. How many of them can register and pay for additional services. According to McKinsey analysts, this number is 66 million small and medium organizations. In 2014, 2 million of them were already registered. And only 84 thousand ordered paid advertising services. With such indicators of market penetration, the potential for further growth is enormous.

To make a forecast on revenue, you first need to estimate the number of companies that can register on Yelp. For this we use the data service. Provided that the service is quite popular, and registration is free, the final entrance may be 60% of the total number of companies. Or 8.5 million organizations by 2023. The figure does not take into account the emergence of successful competitors. Suppose that for local producers this service will remain the most popular, because it generates the most traffic, and consumers are used to it.

Now we calculate the conversion rate from registered companies to those who are willing to pay for improved service. Based on the data already available, it can be assumed that it will grow from 4% to 5% as business develops and services are improved. This is quite a cautious figure, but Yelp has not shown sharp jumps since its inception.

Supplement the forecast with the calculation of the income from the client. And here, as in the previous case, the data for the past period is relatively stable. On average, about $ 3,800 for each local business. Suppose that the average income per customer will increase by 3% per year and will be $ 5070 by 2023. We multiply this figure by the total number of customers that the company is able to attract to paid services by 2023 (423 thousand) and we get revenue of $ 2.2 billion. Other services of the company - placing logos and other things - can save $ 0.2 billion more.

Let's look at the estimated market volume in this industry by 2023. Analytical agency BIA / Kelsey has calculated that local businesses spent on advertising in 2013 $ 132.9 billion, $ 26.5 billion on online advertising. By 2017, they predict a 14% increase in this market. Assume that this trend will continue, and the market will grow by 5% per year. Then, by 2023, the online advertising market is close to $ 60 billion. It is clear that search engines, first of all, Google will continue to take away the lion’s share of the market. But for companies like Yelp, there is still a big piece of cake.

Operating profit, capital intensity and return on invested capital

Since Yelp as a fast-growing startup cannot be reliably predicted from its current profit, how the indicator will behave in the long term, a fundamental analysis of their business model will be useful compared to other similar companies. OpenTable is another rapidly growing company, built on cooperation with local businesses. This is a restaurant reservation service. The model of attracting customers from two companies is comparable. OpenTable management assumes an operating profit of 25% at its peak. Combined with the authors' forecast, this gives a potential increase in operating profit from $ 8.1 million loss in 2013 to a profit of $ 619 million in 2023.

How realistic is this scenario? To answer this question, consider examples of other companies practicing the same model of interaction between business and customers. Comparison with Google, LinkedIn, and Monster Worldwide is incorrect, but it gives a chance to evaluate potential opportunities.

If you compare Yelp with Google, then 25% look quite adequate. But not every b2b company on the Internet is able to maintain such a high level. For example, Monster Worldwide in 2010 reached a level of 30% of profits, but later shrank significantly under the pressure of competitors. In 2015, their profits in the home market fluctuated around 15%, while the total fell below 10%.

To estimate future cash flows, we must also estimate the need for capital expenditures. Many companies show a steady increase in this indicator. Another thing is the Internet company. In 2014, Yelp used only $ 92 million out of 378, or 24%, for these needs. That is, for such companies, most of the funds are placed in short-term assets, such as receivables. Let us take this percentage as a basis for assessing financial flows. With a high operating profit margin and small investment of funds, the calculation of return on invested capital will also be high, so this indicator does not carry much benefit in this case.

What about competition? After all, with such indicators of return on investment in this niche competitors should rush and bring down prices. Quite possible. But the bottom line is that the real capital of Yelp is intangible assets: a brand and a distribution network. And they are not so easy to get in the current situation.

Invert to the current state

In order to extrapolate all previous calculations to the current state of affairs in the company, it is necessary to estimate the speed with which changes will occur. It should be based on the economic principles and parameters of the industry. For example, you need to understand how long fixed costs will prevail over variable costs that affect the decline in profits? Given the turnover of capital, when will revenue start to grow faster than fixed capital? If this limit is reached, will prices decline amid growing competition?

Often there are more questions than answers. To assess the speed with which a company is able to achieve projected figures, you should look at the historical results of similar companies. But in the case of startups, this can be misleading for obvious reasons. But a general understanding of the rules of the game is still possible.

Take for example Amazon. By 2003, the company had accumulated a deficit of $ 3 billion, despite the fact that revenues and gross revenues increased steadily. This was because the cost of marketing costs and technological costs significantly exceeded gross income. From 1999 to 2003, Amazon spent a total of 1.85 billion for these needs. In 1999 she spent 10% of her profit on marketing expenses.

For comparison, Best Buy allows only 2% of advertising revenue. You can consider this 8% difference as an investment in a brand that is a long-term asset. Consequently, the rate of return on invested capital overestimates the potential return on new investments, because it does not take into account past costs.

Creating a weighted average script

Uncertainty in the case of fast-growing companies can somehow be leveled using a weighted average scenario that would take into account several possibilities. Creating multiple scenarios will make the interaction of various factors more transparent and understandable than using other modeling approaches. For example, the Monte Carlo method.

You can evaluate the financial performance of various outcomes: optimistic and pessimistic. Analysts at McKinsey & Company have formulated three possible scenarios for 2023 for Yelp. In the first, revenue rises to $ 2.4 billion when the total number of accounts is 423,000 converted. In the second, the authors suggested that the company will develop at the best pace, and Yelp will be able to bring the conversion from 5% to 10%. Revenue in this case will be $ 4.6 billion. This is an optimistic scenario, but the figure in 10% of companies that have decided to switch to a paid package of services does not look very plausible. In the latter case, the company can count on revenues of $ 1.2 billion, because for some reason the expansion into foreign markets will be complicated. Now, to understand the cost of Yelp in the market, the average cost is taken based on the calculations for each of the scenarios. In this example, it was $ 2.9 billion, or $ 39 per share.

Then you can check the realism of this assessment. If, say, the possibility of implementing the worst scenario increases by 10%, then the value of the company, respectively, decreases by 10%. For startups with a good idea, but in the absence of an organized business, the risks, of course, increase. Take for example, a startup in which you need to invest $ 50 million to build a business worth $ 1.2 billion with a probability of 5%. Its current weighted value would be $ 10 million. But, if for some reason the probability of success decreases by at least half a percent, its price on the market will more than double. It is clear why stocks of such companies are much more volatile than those of traditional companies.

Ultimately, it is important to understand which drivers drive the development of a company, and try them on in different scenarios. In the case of Yelp, an important criterion is the development of the advertising market and the assessment of the share that they can get in it. All this can be calculated more or less accurately. But, what is even more significant and difficult to predict is an indicator of transitions from free to paid on the service and profit from each such placement in subsequent years.

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Source: https://habr.com/ru/post/391317/

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