Let’s take a look at a hypothetical situation: you are presented with the opportunity to make a once-in-a lifetime investment in an up-and-coming company. The company is revolutionizing the industry in which it operates, experiencing exponential growth year over year and leaving legacy providers behind. There is one problem though: the company has yet to make a profit. This situation has been reality over the past couple of years as start-up entities such as Uber, Dropbox and Airbnb attempt to raise money for continued operations in the hopes of eventually becoming profitable. Because of this, the question becomes, “How can I put a value on this company?”
The three fundamental methods of valuation are the income, asset and market approaches. Applying these approaches to a company like Uber seems problematic at first. In its early stage, Uber has been unable to obtain positive net income that would attribute value to the company; thus, the income approach cannot be used for current year earnings. In addition, since the main function of the business is a mobile app that connects drivers with passengers, the value obtained from the Asset Approach would be unassociated with the operations of the business. The market approach requires similar transactions for which comparisons can be made to the operating characteristics of the company. Since Uber is the first company of its kind, there may not be any transactions to make comparisons.
To get around this problem, one has to look into the future to estimate the future cash flows of the business. Once this is done, the future income can be taken into account to come up with a present value of the business. In the case of Uber, growth is one of the main factors that the company is relying on to become profitable. One would have to estimate the percentage of the total taxi market that the company will be able to capture and determine the cash flow at this level of operations in each future year. This growth would be extended until a terminal growth year is reached, and a discount rate would be used to obtain the present value of the future cash flows. In businesses like this, it can also be beneficial to project cash flows under a variety of scenarios to understand all of the potential outcomes the company might face and their impact on value and risk.
Although this process involves many uncertainties, a reasonable value can be obtained by taking into account the most likely scenario based on facts and circumstances on hand.
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.